NDF growth challenged by buy-side concerns, product competition
Non-deliverable forwards (NDFs) have experienced impressive growth in recent years, providing a solution to the problem of trading spot FX in many emerging markets (EMs) where currencies are not deliverable. Regulatory and liquidity concerns, combined with competing FX products, have moderated buy-side enthusiasm.
NDFs have established themselves as an important cog in the FX machine. According to the latest Bank for International Settlements (BIS) triennial survey, total NDF daily turnover was $127 billion, as of 2014, around 19% of all forward trading globally and 2.4% of all currency turnover.
Jon Vollemaere, R5FX
Providers have been keen to manage this growth by resisting the temptation to launch too many new NDF products for fear of cannibalizing liquidity.
In 2014, BIS attributed the growth of the NDF market to an increased desire to hedge EM exposure in anticipation of US tapering. Institutions were looking to hedge the exposures they had built up over several years in local currency bonds – while EM firms were also looking to hedge their dollar exposures.
Although these factors are still in play, trading among hedge funds and other buy-side institutions has not met expectations over the past year, say market players, citing regulatory and liquidity concerns, the cost of setting up new infrastructure, and competition posed by other FX products.
Chris Soriano, global head of NDFs at EBS, explains: "It is early days for the buy side with NDFs. It is difficult for the banks' middle and back offices to process large volumes of buyside trades. But as they make more investments in the necessary infrastructure, funds will trade them in larger numbers," he predicts.
This will be a continuation of the steady investment banks have made in this area. Two years ago many large banks couldn’t offer STP for NDFs, while some are still in the process of fully integrating their e-businesses.
Jon Vollemaere, CEO of R5FX – a new electronic NDF trading platform that was built partly to help resolve such challenges – acknowledges the challenge for institutions processing large volumes of NDFs.
“It’s not uncommon to spend all day slowly working a big order,” he says, adding some market participants have placed iceberg orders to overcome this problem.
EBS’s Soriano adds: “It took 10 years for the buy side to fully embrace G10 spot FX. Banks have only offered access to the NDF market via their electronic trading desks for the last two years. It won’t take as long this time around, but it will still be relatively gradual.”
The buy side typically uses NDFs to hedge debt and equity flows in EMs, says R5FX’s Vollemaere, arranging deals with their bank.
However, despite some notable numbers, he concedes overall there is a very low amount of buy-side-to-buy-side trading in NDFs.
Stephane Malrait, chairman of the Financial Markets Association’s (ACI) FX committee, thinks some buy-side institutions might be deterred from embracing NDFs since underlying currencies could become deliverable in the next few years.
“Russia, India and China, for example, are all in the process of opening up their economies,” he says. “People don’t want to make large investments in their ability to handle NDF trades now, only to find in two years that these currencies have become deliverable and there is no need to trade NDFs.”
Cyclically, NDF trading has been relatively weak in recent months thanks to regulatory confusion. In particular, European proposals for mandatory clearing of NDFs was published in October and seemed to be a decisive step toward a new framework for FX derivatives trading.
This triggered confusion among market participants about how such a product would be cleared, given the lack of central clearing and underdeveloped infrastructure.
We don’t see any other instrument
James Rockall, Record
However, as James Rockall, director of trading at Record Currency Management, referring to European Market Infrastructure Regulation, explains, the latest indications suggest NDFs will now be exempt.
“The latest news from both the European and US regulatory authorities has seemingly become less onerous for NDFs as both jurisdictions have indicated that NDFs will not be included in the mandatory cleared instrument list after all,” he says.
However, the regulatory issue remains a concern.
The ACI’s Malrait says: “The regulatory confusion in the treatment of NDFs in the US and Europe is discouraging people from trading them for fear of accidentally doing something wrong. I think a lot of people will avoid trading them until the matter is settled.”
In the meantime, the clearing houses have seen business booming, suggesting either the regulatory debate around NDF clearing has left a lasting impression on traders. Since LCH.Clearnet, a leader in the NDF space, launched ForexClear in 2012, it has seen steady growth in cleared NDF volumes, it says, and it expects this to continue over the coming year.
It says it clears notional between $3 billion and $7 billion a day across 300 to 500 trades, with 22 live members clearing through ForexClear and interest coming from the buy side and sell side.
Liquidity and competition
Whether cleared or not, much of the liquidity in NDFs is being driven by banks, which use them primarily to hedge their EM exposures against currency fluctuations. However, while there is still clear interest in these contracts, some have been looking for other ways to hedge this risk, creating competition for NDFs.
Russell Dinnage, senior consultant at GreySpark Partners – a capital markets research boutique – says: “Banks have increasingly been looking for alternative models to hedge the volatility in their currency exposures. For many, the solution has been to turn to exchanges where they can trade FX futures or swap indexes, where they can mimic the exposure of an NDF hedge more cost effectively, with no need to clear.
“My sense is the larger buy-side institutions are looking at the same thing.”
He adds: “For the sell side, the onerous part of NDF trading is managing the balance-sheet restrictions, finding a way to warehouse the risk and hold it long term.”
Naturally, NDFs can’t be lumped together given the heterogeneity of EMs.
Record’s Rockall says: “Trading currencies such as the Chinese renminbi, Korean won and Brazilian real is very different to trading Peruvian nuevo sol or Ukrainian hryvnia.
“Underlying currency liquidity as driven by trade flows, hedging, etc, and the nature of any currency-management regime is a bigger determinant of currency liquidity, spreads, volatility, etc, than whether the instrument is technically an NDF or not.”
However, NDF traders face common challenges.
Rockall says: “The bid/offer spread will typically be wider for NDFs than deliverable currencies and volatility for NDFs is typically higher than deliverable currencies. In times of stress, NDFs often become correlated to each other, which loses any positive benefit of diversification that may be sought in a specific strategy.”
Paul Chappell, chief investment officer at C-View, adds: “Whilst liquidity is generally good when the centre represented is open, the fact is that the spread on price widens quite quickly and considerably if there is a requirement for a single large amount.
“To that extent, NDF positions and exposures are generally established on a little and often basis in order to take advantage of narrower spreads and not to disturb markets.”
Chappell says the biggest disadvantage for NDFs is the intermittent nature of the market.
“In a number of instances, prices and liquidity are mostly available during the hours when a centre represented is open, and in some instances there are quoting conventions that mean that market makers are only available during those certain hours,” he says.
“Prices and exposures are therefore subject to jump risk between that centre closing and its opening the next day if an unexpected event occurs. In that regard, the structure of NDF markets generally preclude the involvement of the HFT community, a fact considered by some to be a mixed blessing.”
However, Soriano insists the bifurcation of liquidity is becoming less of a problem.
“For the most part, the NDF market on EBS either trades on or off SEF based on time of day, [so] there is very little confusion over where liquidity resides,” he says.
Some corporates agree. One unnamed corporate told the investigating ACI FX committee: “We need to adapt to the new market conditions, which are more like they used to be 10 years ago. In other words, liquidity is not there in unlimited amounts at any time.
“We always have the possibility to use on-shore markets in case liquidity is scarce, so we never really feel left out of the financial marketplace totally as we are always local in all NDF markets. As long as central banks locally provides liquidity, we are OK with some volatility.”
Some traders do appear to be considering their options.
GreySpark’s Dinnage says: “A forward or swap index can work just as well when hedging vanilla risk exposures, though an index won’t work as well for more complex hedges. I can imagine NDF growth being concentrated around this more complex, bespoke end of the market, with more of the vanilla business gravitating towards the index swaps market.”
Others disagree. “We don’t see any other instrument competing effectively with NDFs for clients who want to benefit from, or indeed protect against, future currency movements in markets where exchange controls make deliverable forward contracts impossible to access,” says Rockall.
Malrait concurs: “In theory, there are other products [including ETFs with currency exposures, swaps and futures], people can trade to hedge their EM currency risk, but these products also require significant investment in back-office infrastructure.
“In practice, we don’t see that happening.”