Data from the Reserve Bank of India show that increases in spot trading volumes in the initial days after the devaluation were comparable to those of the NDF trading reported in the DTCC data, but onshore DFs showed lower increases. Spot trading rose by more than that of NDFs over a five-day period in the case of the real, according to the Central Bank of Brazil. Using DTCC and Triennial data, this box explores how renminbi market developments in August 2015 spilled over into emerging FX markets. This analysis using newly available turnover data sheds new light on international spillovers from China’s currency markets, heretofore identified through prices (Shu et al (2016)). The displacement of the renminbi NDF by deliverable CNY trades has progressed furthest in the offshore centres that have traded the renminbi the longest. Asian centres enjoyed an early lead in renminbi trading under the strategy of renminbi internationalisation.
Growth was much stronger in exchange rate-adjusted terms (30.9%, Table 1) than in current dollar terms, owing to depreciation against the dollar of the real, rupee and rouble. Indeed, BRL NDF turnover would have doubled in the absence of BRL depreciation. By contrast, the substantial decline in CNY NDFs and the rapid growth of KRW and Taiwan dollar (TWD) turnover owed little to movements against the US dollar.
Deliverable Forward vs. Non-Deliverable Forward
NDF markets developed in response to restrictions that constrained access to onshore markets. Despite significant financial account liberalization across Asia, most Asian emerging market currencies are only partially convertible and not deliverable offshore. Restrictions take many forms including requirements on underlying asset exposure for currency positions.
Taiwan POC also maintains limits on non-resident investment in local currency bonds and has onshore currency transaction reporting requirements. Turnover data for NDFs is mostly available from surveys, given the over-the-counter nature of NDF trading. A shift to centralized trading and clearing in recent years (McCauley and Shu 2016) also made data from clearing and settlement service providers available. Data sources vary in coverage and frequency but the relative importance of currencies across sources is broadly consistent. Non-deliverable forwards are most useful and most essential where currency risk is posed by a non-convertible currency or a currency with low liquidity.
NDFs and derivatives reform
The wide spectrum of policy approaches to NDFs across Asia highlights policy tradeoffs. This paper provides a comprehensive and current overview of Asian NDF market developments, discusses policy approaches, and analyzes the direction of influence between NDFs and onshore currency markets. The notional amount is never exchanged, hence the name “non-deliverable.” Two parties agree to take opposite sides of a transaction for a set amount of money – at a contracted rate, in the case of a currency NDF. The primary purpose of using an NDF is to manage currency risk in situations where traditional currency trading may be restricted or when dealing with non-convertible currencies. Businesses engaging in international transactions, particularly in emerging markets with currency controls, use NDFs to hedge against exchange rate fluctuations. NDF markets in major Asian currencies are large, often with higher trading volumes than onshore FX markets.
This category includes not only institutional investors hedging their holdings but also leveraged accounts. The London Foreign Exchange Joint Standing Committee, a Bank of England-hosted group, reports more prime broker customers – mainly hedge funds and the like – for NDFs than for DFs, including FX swaps. The role of such traders may have contributed to the suspicion with which some policymakers are said to view NDFs (IGIDR Finance Research Group (2016); see also Ibrahim (2016)). Consequently, since NDF is a “non-cash”, off-balance-sheet item and since the principal sums do not move, NDF bears much lower counter-party risk.
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Prior to COVID-19, deliverable onshore forwards, NDFs, and DNDFs were priced close to each other. Deviations in Korean won NDF and onshore forward implied interest rates have been limited. Pricing differentials between onshore and offshore markets can be very large. Non-deliverable forward trades can be thought of as an alternative to a normal currency forward trade. Whereas with a normal currency forward trade an amount of currency on which the deal is based is actually exchanged, this amount is not actually exchanged in an NDF. NDFs enable economic development and integration in countries with non-convertible or restricted currencies.
NDFs are settled with cash, meaning the notional amount is never physically exchanged. The only cash that actually switches hands is the difference between the prevailing spot rate and the rate agreed upon in the NDF contract. A deliverable forward (DF) is a forward contract involving the actual delivery of the underlying currency at maturity. A DF is usually used for currencies that are freely convertible and traded in the spot market, such as the euro (EUR), British pound (GBP) or Japanese yen (JPY). The corner of the foreign exchange market represented by NDFs also opens a window for assessing the progress of derivatives reforms. Trading of NDFs has begun to shift to centralised platforms, and higher margin requirements for non-cleared derivatives trades implemented in September saw centralised clearing of NDFs jump.
Basics of NDFs
With a background in higher education and a personal interest in crypto investing, she specializes in breaking down complex concepts into easy-to-understand information for new crypto investors. Tamta’s writing is both professional and relatable, ensuring her readers gain valuable insight and knowledge. As the name suggests, a deliverable forward contract involves the delivery of an agreed asset, such as currency. So, for example, in a forward contract involving a currency pair of USD/AUD, there would be a physical exchange of USD equivalent to AUD.
NDFs, by their very nature, are the most valuable to markets where traditional currency trading is restricted or impractical. This creates a niche yet significant demand, allowing brokers to capitalise on the spread between the NDF and the prevailing spot market rate. With the right risk management strategies, brokers can optimise their profit margins in this segment. The settlement date, the agreed-upon date for the monetary settlement, is a crucial part of the NDF contract.
Understanding Non-Deliverable Forwards (NDF)
Similar increases in NDF trading occurred during a bout of CNY turbulence in January 2016. On this evidence, it appears that, even though the CNY NDF turnover is fading, renminbi developments are boosting Asian NDFs. For those seeking liquidity in NDFs, it’s essential to turn to specialised financial service providers and platforms that fit this niche market. These platforms and providers offer the necessary infrastructure, tools, and expertise to facilitate NDF trading, ensuring that traders and institutions can effectively manage their currency risks in emerging markets.
- While borrowers could theoretically engage directly in NDF contracts and borrow dollars separately, NDF counterparties often opt to transact with specific entities, typically those maintaining a particular credit rating.
- For example, to obtain the KRW interest rate implied in a KRW/USD NDF one would take the NDF price, the spot price, and the US interest rate as given and solve for the KRW interest rate using the standard CIP equation.
- If we go back to the example of a business that will receive payment for a sale it has made in a foreign currency at a later date, we can see how a forward trade is used to eliminate currency risk.
- For the renminbi, the daily onshore spot trading through the China Foreign Exchange Trade System (CFETS) rose by 50% on average in the five days after 11 August, a modest increase compared with that of NDF trading registered with the DTCC.
The INR, KRW, and TWD accounted for 55% of total daily global NDF turnover of USD258 bn as of April 2019 (Figure 1). Outside of Asia, the Brazilian real (14%) and the Russian ruble (2%) have sizeable NDF markets. NDF trading in INR, TWD, and KRW experienced the fastest growth since 2016, rising 204%, 168%, and 100%, respectively. With a forward trade, once one has been agreed to, both parties are contractually obliged to complete the agreed exchange of currencies. While there is a premium to be paid for taking out an option trade, the benefits provided by their optional nature are significant.
With an option trade, a company that is exposed to exchange rate risk can rely on a similar agreement to a forward trade. There are various alternatives when it comes to finding protection from currency risk to normal forward trades and non-deliverable forward trades. On the other hand, if the exchange rate has moved favourably, meaning that at the spot rate they receive more than expected, the company will have to pay the excess that they receive to the provider of the NDF. In order to avoid the restrictions imposed by the foreign currency in question, NDF is settled in an alternative currency. Usually, the foreign currency is sent to the forward trade provider who converts it into the original company’s domestic currency and transfers it to them. Also known as an outright forward contract, a normal forward trade is used to lock the exchange rate for a future date.
Pricing and valuation
However, the notional amount in a non-deliverable forward contract is never exchangeable. This binding contract locks in an exchange rate for the sale of the purchase of a specific currency on a predetermined future date. In other words, it is a customizable currency-hedging tool without upfront Non-custodial Vs Custodial Wallets margin payment. Understanding the principles of a deliverable forward vs. non-deliverable forward contract can help you leverage your investments in the foreign exchange market. Both are forward contracts but with different provisions, and it’s important to be able to distinguish between them.