A tale of two trading places

Exposure to foreign exchange rate risk is often hedged with forward foreign exchange or FX contracts which fix an exchange rate now for settlement at a future date. The parties to a FX contract agree to buy or sell a currency at a specified exchange rate, at a specified quantity and on a specified date in the future. On that the two parties exchange the currency amounts, to settle their claims under the contract. In some countries monetary authorities impose restrictions on their currency’s convertibility in order to regulate the currency’s inflows and outflows. This creates difficulties for offshore parties in hedging their exposure with onshore forward contracts. This has led to the development of markets that overcome this issue. These are markets for non-deliverable forward contracts which do not require the exchange of the non-convertible currency.

A non-deliverable forward foreign exchange contract (NDF) is similar to a regular forward FX contract but does not require physical delivery of the designated currencies at maturity. Instead, the NDF specifies an exchange rate—contracted forward exchange rate or simply forward rate—against a convertible currency, typically the US dollar (USD), a notional amount of the non-convertible currency and a settlement date. On the settlement date, the spot market exchange rate is compared with the forward rate and the contract is net-settled in the convertible currency based on the notional amount.

The manner in which the spot rate is determined is agreed upon at the initiation of the contract and varies by currency and jurisdiction. This might be the daily rate published by the central bank of the non-convertible currency or an industry group reference benchmark which is typically an average of rates from several banks and FX dealers. How the latter “shadow” fixing system has emerged, alongside the official rates set by the central banks, is a bit of a mystery. Bankers say this happened because traders didn’t historically trust the onshore fixing.

NDFs are traded primarily in over-the-counter markets and are cash-settled in the convertible currency. Since March 2012, NDFs can also be cleared through several exchanges such as the Chicago Mercantile Exchange or CME, the Intercontinental Exchange or ICE (a network of American exchanges and clearing houses for commodity and financial markets) and ForexClear, a European exchange.

The NDF market trading began in the early 1990, originally as a product for entities to hedge their position to emerging market currencies with current or potential foreign exchange convertibility restrictions. While the initial development came from the demand for Latin-American currencies (Brazil and Mexico), recent growth in trading activity in these products have come from demand for Asian currencies, including the rupee driven by the growing importance of these economies and prevalence of capital controls. For example, the average daily trading volume across all NDF currency markets has grown from about $20 billion to $60 billion over last five years. The rise in activity in NDF markets is particularly noticeable for the rupee, the Brazilian real and the Chinese yuan. These economies are becoming increasingly important in the global trade.

NDF markets, which developed in financial centres such as New York, Singapore and London, are by construction beyond the local monetary authorities’ jurisdiction with foreign exchange convertibility restrictions. NDF markets in currencies that were becoming increasingly convertible have either weakened or have disappeared.

Understanding the nature and functioning of NDF markets and their relationship with onshore markets is necessary because of the increasing attention this market is receiving from participants and regulators in recent times. In a world of increasingly volatile currencies, investors are looking at NDF markets as an avenue for effective hedging of and profitable speculation on currency movements. Most of the emerging market currencies, whose economies are gaining importance in global trading and investment, also happen to have capital controls thereby limiting the opportunities to hedge and speculate in currencies in onshore contracts. Even though the costs of transaction as measured by the bid-ask spreads is better in onshore markets, market participants choose to trade actively in offshore markets due to better availability of liquidity.

Central banks are concerned about the rapid growth of NDF markets having adverse effects on their ability and costs of intervening in FX markets. Regulators, both in local markets as well as the global financial ones, are worried about the systemic risks associated with the micro-structure of NDF markets—in terms of the non-transparency of the deal terms and the clubby nature of transactions that are characteristic of over-the-counter markets. The Reserve Bank of India (RBI) in its December 2010 Financial Stability Report noted the problems and risks associated with offshore markets.

Many empirical studies have shown that the currency rates in off-shore markets are increasingly acting as leading, and not lagging, indicators for those on onshore markets, thereby highlighting the possibility of offshore “fixed” currency rates having significant impact on the volatility of onshore rates particularly during the periods of sharp depreciation. A 2012 study, titled A Tale of Two Markets and One Asset—Analysis of Migrating Price Discovery in emerging FX markets by this author finds that while the trading volumes in NDF markets may not appear to be substantial compared to those on the onshore markets, NDF currency rates have had significant leading impact on the onshore spot and forward rates in the recent past even though it was the other way around in the initial period.

Domestic market participants seem to believe that NDF rates have more information about the currency fundamentals than onshore market rates since the former are determined in “open markets” and reflective of the markets’ expectations. It is interesting to note that despite the higher bid-ask spreads than those on onshore markets the activity in NDF markets has remained high and increasing over the years. A cross-country comparison of such evidence indicates that for countries with developed currency futures markets (such as Brazil and Korea); onshore markets play a leading role in terms of higher trading activity and in the price discovery process. For countries with controlled domestic currency markets (such as India and China), on the other hand, offshore markets continue to play a dominant role.

Emerging market concerns

While it is natural to expect trading activity (by private hedgers or speculators) to migrate from a restricted trading place to an unrestricted trading place, from a public policy point of view this could raise some concerns. First, if price discovery is driven by offshore markets, the costs of intervention in the domestic markets by the central banks will be much higher than otherwise. Second, the non-transparent, over-the-counter nature of the microstructure of offshore markets will increase the probability of price manipulation, thereby raising the systemic risks.

Realizing that offshore markets have become important over time, many central banks and domestic regulators have tried to exert pressure on domestic and offshore market participants through overt and covert interventions. But this is precisely the wrong thing to do as more restricted onshore markets become, more will be the migration of price discovery to offshore markets.

Experience in Brazil and South Korea suggests that the best way to bring back offshore market activity to onshore markets is to develop the latter. Development of domestic currency futures markets, with liberalizing position limits on domestic financial institutions, allowing foreign institutional investors (FIIs) in onshore markets, synchronization of trading hours across onshore and offshore markets to minimize latency arbitrage etc. are some of the measures that could reduce the importance offshore markets over time. Similarly, allowing domestic financial institutions to participate in offshore markets could equilibrate the currency rates in these markets. By encouraging wider participation in exchange traded currency derivatives, one could bring the much needed transparency in to currency trading. In addition, global regulators must recognize that unregulated offshore markets, with its non-transparent trading and risk management systems, if unattended to, pose additional threats to global financial stability.

Despite the overwhelming evidence in support of the importance of offshore markets for rupee trading, RBI chose to ignore it initially. After realizing their importance in the recent past, it started imposing implicit curbs on the transactions of FIIs that are major participants. Both approaches are incorrect. Offshore markets should be seen as important indicators of global currency demands on the rupee and should be monitored carefully. At the same time, any attempts to control the activity in offshore markets through explicit directives will only aggravate impending currency depreciation.

It should be realized that with the growing importance of India in the global economy, there will be a surge in hedging and speculative demand for rupee and prevalence of capital controls will only increase the activity in offshore markets. The best way to attract the market activity in terms of volumes and price discovery back on to onshore markets is to liberalize and develop domestic currency derivatives markets with transparent microstructure.

Gangadhar Darbha works for an investment bank in Mumbai. These are his personal views.

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