SPECIAL INTEREST PAPER
Report prepared for the City of London Corporation
by London School of Economics and Political Science
Published December 2012
BRIC currencies
trading in London
City of London Economic Development
PO Box 270, Guildhall, London, EC2P 2EJ
www.cityoflondon.gov.uk/economicresearch
SPECIAL INTEREST PAPER
Report prepared for the City of London Corporation
by London School of Economics and Political Science
Published December 2012
BRIC currencies
trading in London
City of London Economic Development
PO Box 270, Guildhall, London, EC2P 2EJ
www.cityoflondon.gov.uk/economicresearch
BRIC currencies trading in London is published by the City of London. The author of
this report is the London School of Economics.
This report is intended as a basis for discussion only. Whilst every effort has been
made to ensure the accuracy and completeness of the material in this report, the
authors, the London School of Economics and the City of London, give no warranty
in that regard and accept no liability for any loss or damage incurred through the
use of, or reliance upon, this report or the information contained herein.
December 2012
© City of London
PO Box 270, Guildhall
London
EC2P 2EJ
http://www.cityoflondon.gov.uk/economicresearch
Executive summary ...............................................................................3
Introduction ............................................................................................5
1.
Brazil, Russia, India and China: the BRICs ...................................6
1.1.
Brazilian real..................................................................................................... 7
1.2.
Russian ruble .................................................................................................... 8
1.3.
Indian rupee .................................................................................................... 8
1.4.
Chinese renminbi ............................................................................................ 9
1.5.
Will the BRIC currencies become fully convertible? ................................. 9
2.
Non-deliverable forwards ..........................................................10
2.1.
How NDFs work ............................................................................................. 10
2.2.
Why NDFs exist............................................................................................... 10
2.3.
Differences between NDFs and deliverable forwards ........................... 13
3.
Developments in the FX and NDF markets ...............................15
3.1.
The FX market globally and in London...................................................... 15
3.2.
Global spot trading in BRIC currencies ..................................................... 17
3.3.
Global forward trading in BRIC currencies ............................................... 18
3.4.
NDF trading in London ................................................................................. 19
3.5.
Reasons for London’s success and outlook ............................................. 21
3.6.
Regulation and NDF trading ....................................................................... 23
4.
Summary and conclusion ..........................................................24
Bibliography .........................................................................................
Executive summary
This report has been commissioned from the London School of Economics by the
City of London Corporation to explore the trading of BRIC currencies in the London
FX market. The BRIC currencies (together with the South Korean won) constitute the
most important currencies for non-deliverable forwards (NDFs). As the BRIC
economies grow, without immediately moving to a fully flexible exchange rate
regime, offshore FX markets and NDFs in particular are expected to become ever
more important.
NDFs account for the overwhelming majority of the forward volume in BRIC
currencies. An NDF contract is an outright forward contract in which counterparties
settle the difference between the contracted NDF price and the contracted NDF
fixing rate at an agreed notional amount at maturity. NDFs are prevalent in
currencies where unrestricted trading is not possible due to the existence of strong
controls imposed by the governing body. As the restrictions are lifted and the
currencies move to a flexible exchange rate regime, NDFs gradually become
obsolete and trading volume switches to deliverable (or plain vanilla) forwards.
Deliverable forwards constitute contracts whereby a party agrees to buy or sell a
pre-specified asset at a future date.
Overall, the UK (or London) segment of the FX market accounts for roughly 40% of
the global turnover, securing the top spot for London among the global FX centres.
Between April 2008 and April 2012, the average daily UK trading volume in NDFs in
the four BRIC currencies – Brazilian real (BRL), Russian ruble (RUB), Indian rupee (INR)
and Chinese renminbi (CNY) – increased by almost 70% to almost USD 20bn. While
NDF contracts account for only about 2% of volume in the London FX market as of
April 2012, their growth in the last four years has by far outstripped the growth of
other FX transactions.
The aim of this report is to summarise existing information and data on NDF trading in
the London FX market, provide a qualitative outlook on the future of NDF business in
the BRIC currencies by way of interviews with relevant players and to highlight any
risks or concerns when considering investing or trading in NDF contracts.
Key conclusions:
BRIC currencies. Paralleling the impressive economic growth of the BRIC countries,
trading volume in BRIC currencies has increased dramatically since 2008. Given the
domestic restrictions on these currencies, NDFs account for a large fraction of the
overall volume of FX trading in these currencies. The daily global volume for NDFs in
the Brazilian real, the Indian rupee and the Chinese renminbi is more than USD 40bn,
compared to global spot transactions of USD 30bn in 2010. For all BRIC currencies,
the NDF and deliverable forward rates are almost perfectly correlated with
correlation coefficients generally exceeding 99.5%.
BRIC currencies in London. NDF volume in BRICs has increased by almost 70%
between April 2008 and April 2012, thus dwarfing the overall growth in FX volume in
London of 13% during the same period.
3
NDFs vs deliverable forwards. NDFs mainly exist because the underlying currencies
have controls in place which restrict the international exposure and use. A move to
a fully flexible exchange rate regime makes NDFs obsolete. This has happened in the
past with the Mexican peso and history could repeat itself if controls on BRIC
currencies are lifted. However, market participants in London do not expect this to
happen in the near future. As a consequence, the importance of NDFs will continue
to grow along with the BRIC economies.
Use of NDFs. The surveyed market participants estimate that about half of trading in
NDFs in London is due to firms hedging an existing exposure in the respective
currency and about half of trading is driven by investors who want to trade on their
views about the currency or the country in general. There is a consensus amongst
interviewees that this will remain the case in the near future. As BRIC currencies
become more established, it is further expected that NDFs for more exotic currencies
(like in particular the African currencies) will gain more traction.
Regulation and NDFs. NDFs are OTC products and therefore by nature subject to
minimal regulation. This is expected to change given the fallout from the financial
crisis and a general trend towards more oversight. The main change that is
expected to be implemented before the end of 2013 concerns central clearing and
additional reporting requirements. While asset managers and hedge funds will be
subject to the additional regulation, corporate clients which use FX instruments for
commercial hedging purposes will be exempt. This will undoubtedly result in an
increase in operational and trading costs for banks and clients. Costs are also
expected to rise because of new capital standards outlined in Basel III. The extent of
the additional costs will most likely turn out to be the main determinant of how the
NDF market will evolve as clients may seek out more cost efficient alternatives. In
addition, market liquidity may suffer, as new clearing and reporting requirements will
limit the willingness of dealers to provide competitive prices for less liquid products.
London and the future of the NDF market. There is wide consensus among the
surveyed banks that London is well prepared to tackle the challenges that lie ahead.
The working day in London overlaps with all BRIC countries. In addition, London
boasts a prime position as an international financial centre with a reliable legal
system and access to highly qualified talent. It is therefore expected that London will
maintain or even extend its lead in the FX market in general and the NDF market in
particular. Moreover, even if the BRIC currencies are eventually moving to a more
flexible regime, London is not expected to lose business as it will be the natural
market for trading in deliverable FX forwards.
The main area of challenge in the intermediate future is the upcoming regulatory
changes, and it is essential to ensure that London’s competitiveness will not suffer by
imposing regulatory standards that are more stringent than those imposed on other
financial centres in the rest of the world. A likely outcome is that due to increased
costs, economies of scale will become more important and NDF trading will be
concentrated in the top tier banks, while second and third tier banks, which are still
in the market at the moment, will be squeezed out. However, this is not necessarily
bad news for London as an FX centre as it could even result in the big banks
increasing and concentrating their presence in London.
4
Introduction
London is currently the leading centre for FX trading in the world with a share of
almost 40%.1 While the NDFs only account for about 2% of FX trading in London (and
20% of the volume in FX forward contracts), they have become a widely used
instrument for hedgers and speculators alike to manage exposures to the underlying
currencies in an effective way. As the importance of emerging markets (and
especially the BRIC countries) is expected to grow, trading in NDF contracts is
expected to follow suit.
According to the semi-annual foreign exchange surveys conducted by the Foreign
Exchange Joint Standing Committee (FXJSC), the average daily UK trading volume
in non-deliverable forwards (NDFs) in the four BRIC currencies – Brazilian real (BRL),
Russian ruble (RUB), Indian rupee (INR) and Chinese renminbi (CNY) – has increased
by almost 70% from just over USD 11bn in April 2008 to almost USD 20bn in April 2012.2
As the BRIC economies are growing further, presumably without moving to a fully
flexible exchange rate regime in the near future, offshore FX markets and NDFs in
particular are expected to become ever more important.
NDFs are foreign exchange derivative products traded over the counter (OTC).
Different from deliverable exchange rate forwards, they trade outside the direct
jurisdiction of the authorities of the corresponding currencies. Major centres of NDF
trading are Hong Kong, Singapore, Seoul, Taipei, Tokyo, London and New York.
London is the main market for NDFs on Eastern European and Asian currencies. While
the majority of the trading volume is on foreign currency to US dollar pairs, the OTC
nature of the market enables other currencies such as the British pound and the
euro to be used as the base currency as well.
While it is relatively easy to obtain a wide range of information on FX trading in the
most liquid currencies such as the US dollar, the euro, the Japanese yen, the British
pound, or the Swiss franc, the same is not true for the emerging market currencies
typically underlying NDF contracts. This report has been commissioned by the City of
London Corporation to fill this gap. In particular, the report has three objectives: First,
it provides an introduction into NDF contracts in general and as such can be used as
a reference. Second, the report summarises the available data on NDF trading in the
London FX market. Here, the focus is on the BRIC currencies, which (together with
the South Korean won) constitute the most important currencies for NDFs. Finally, the
report discusses the outlook for the NDF market with a particular focus on how its
development will affect the position of London as a dominant centre for FX trading.
The views relating to the future of NDF trading in London are shaped by interviews
conducted with senior managers in global investment banks that play a significant
role in the FX market in London and with proponents of central banks that have
regulatory and supervisory roles in the market.3
The latest global numbers are from the Triennial Central Bank Survey on “Foreign exchange and
derivatives market activity” last conducted by the BIS in April 2010.
2 The London Foreign Exchange Joint Standing Committee (FXJSC) was established in 1973 under the
auspices of the Bank of England, in the main part as a forum for banks and brokers to discuss broad
market issues and the focus of the Committee's regular work remains issues of common concern to the
different participants in the foreign exchange market.
1
3
The sample of surveyed banks includes Barclays, Deutsche Bank, HSBC, JP Morgan and Standard
5
The first chapter introduces the BRIC currencies, which together with the South
Korean Won are the most important currencies for NDFs. The chapter also describes
the reasons why those currencies are traded offshore using NDFs as opposed to
onshore using outright forwards.
Chapter two introduces the concept of non-deliverable forwards. It covers some of
the obvious risks and concerns related to trading in BRIC currencies using NDF
contracts. Furthermore, it discusses the differences between deliverable and nondeliverable forwards and elaborates on the reasons for being active in the NDF
market in the first place. Detailed quantitative data on investors in NDF market is very
difficult to source. As a result, the section heavily draws on the insights derived from
interviews conducted with the major banks that execute trading in NDFs on behalf
of their clients.
Chapter three summarises the relevant data and discusses how the NDF market has
developed globally and in London. FX markets globally have grown significantly in
the last decade and global turnover reached about USD 5tr in 2012. London as the
dominant FX centre accounts for roughly 40% of total turnover. It is estimated that
London accounts for at least the same fraction of global NDF turnover. NDF volume
in the London FX market has experienced a strong growth in the last four years.
Furthermore, the chapter provides a qualitative outlook on the future of NDF trading
in BRIC currencies based on interviews conducted with the relevant players in the
London FX market.
The chapter also considers key uncertainties with regards to the future of London as
a trading hub, principally the proposals for regulation that are currently being
discussed as a reaction to the financial crisis. There is some concern that regulation
in Europe and in London in particular could become more restrictive than regulatory
changes implemented in other FX centres, which could eventually hurt London's
competitiveness.
1. Brazil, Russia, India and China: the BRICs
The BRIC countries are some of the fastest growing emerging countries in the world.
Combined they encompass over 25% of the world's land coverage and 40% of the
world's population and they hold a combined GDP (PPP) of USD18.5tr. As these
countries grow and their companies increasingly trade outside their borders, greater
international use of their currencies can be expected. Figure 1.1 shows the steady
increase in their imports and exports as a percentage of world trade on the right
hand side axis.
However, these four countries all have in place currency controls (or, in the case of
Russia, a managed exchange rate regime coupled with significant political risks),
which restrict the international exposure and use of their currencies. With the
exception of Russia, none of the currencies are fully convertible. The regulatory
environment for the BRIC currencies is summarised in sections 1.1. to 1.4.
Chartered, as well as the Bank of England and the Swiss National Bank. Their participation and in
particular their insights are highly appreciated.
6
Figure 1.1: BRIC countries’ trade balance (billions of EUR)
2,000
1,771
1,800
1,600
1,400
1,200
25%
1,541
1,526
20%
1,271
1,194
Imports
15%
1,049
1,000
800
10%
600
332
400
230
222
5%
Exports
Balance
Imports (%)
Exports (%)
200
0
0%
2008
2009
2010
Source: IMF
1.1. Brazilian real
The Brazilian real (BRL) is managed in a free-floating regime with occasional
interventions. The Banco Central do Brasil (BCB), Brazil’s central bank, monitors
foreign investments and currency exchange, and the National Monetary Council
(CMN) sets FX regulations. The Monetary Policy Committee (COPOM) sets the target
for the SELIC rate, which is the overnight government bond repo rate.
Over the last decade, the CMN and the BCB have been gradually lifting restrictions
from the Brazilian foreign exchange markets. The foreign exchange normative
framework was renewed in 2005 in the form of the Exchange and Foreign Capitals
Market Regulation (RMCCI), marking a significant step towards a less regulated FX
environment. However, in periods of a strong appreciation of the real, the authorities
have implemented measures to limit portfolio inflows and/or reduce US dollar selling
pressures. In September 2011, for example, the authorities introduced a 1% financial
transaction tax (IOF) on trades that increase long positions in the real via the onshore
derivatives market.
The onshore market offers deliverable and non-deliverable derivatives. Foreign
investors can access the Brazilian derivatives markets via a portfolio investment
account. All incoming investments must be registered with the Central Bank Foreign
Capital Registration and Supervision Office (FIRCE). However, the foreign investor
must have custodian, legal and tax representatives in Brazil. In addition, all OTC nondeliverable derivatives must be registered at CETIP, the main securities depository, or
the Brazilian Mercantile and Futures Exchange (BM&F Bovespa). A foreign investor
wishing to trade derivatives through the BM&F Bovespa must open a brokerage
account in a Brazilian brokerage house.
7
1.2. Russian ruble
The Russian ruble (RUB) is operated under a managed floating currency regime by
the Central Bank of the Russian Federation (CBR). While the ruble is fully convertible
but pegged to a EUR-USD basket with a gradually widening band, the CBR is yet to
complete the transition to an inflation targeting regime by 2015, with a shift to a
quasi-floating currency regime. Although the CBR does not target any particular FX
level to defend, it intervenes in the FX market in order to reduce excessive volatility
and ease speculative pressure.
Before the 1998 Russian financial crisis, forward markets were developed onshore.
However, the losses suffered by many Russian banks due to the currency
devaluation led to a rule by the Russian courts that forward contracts were not
legally enforceable. Subsequently, offshore NDFs became the primary means by
which rubles were traded in order to avoid some of the additional risks of trading in
outright forwards.
Generally, there are no restrictions on ruble transactions for either resident or nonresident companies alike. Deliverable and non-deliverable spot and forward deals
can be performed without restrictions. However, local and multinational corporates
registered in Russia must trade only through accounts with authorised banks.
1.3. Indian rupee
The Reserve Bank of India (RBI) maintains the Indian rupee (INR) in a managed
floating regime. The value of the rupee is tracked against the Real Effective
Exchange Rate (REER). 4 However, the rupee exchange rate has been known to
deviate significantly from the long-term REER average. Though there is a stated
policy of allowing market moves based on underlying fundamentals, the RBI can
intervene actively in the foreign exchange market in cases of excessive volatility.
Exchange controls are established by both the government and the RBI. Although
market participants are able to buy the rupee freely from any bank for most current
account transactions, the rupee remains restricted on the capital account. Anything
not specifically allowed under the Foreign Exchange Management Act (FEMA) is
deemed to be disallowed. There is limited access to onshore FX contracts for
resident entities. Foreign Direct Investors (FDI) & Non Resident Indians (NRIs) can also
hedge their exposure subject to compliance with specific conditions.
4
REER is calculated by the Reserve Bank of India (RBI) based on a basket of 36 global currencies.
8
1.4. Chinese renminbi
The Chinese renminbi (CNY) is non-deliverable under the maintenance of the
People’s Bank of China (PBoC) in a managed floating regime. The renminbi is
partially convertible – fully convertible on the current account but only on a
restricted basis on the capital account. Trade-related transactions are permitted
cross-border if supported by appropriate documentation. No entities outside China
are allowed to participate in onshore trading of the renminbi.
The PBoC, however, has taken concrete steps in the process of the renminbi
internationalisation since 2008 and opened up the offshore RMB market (CNH). The
renminbi became deliverable offshore in Hong Kong in July 2010. Although the
transfer between Hong Kong and onshore is still subject to regulations and approval
by mainland authorities, the offshore market is developing rapidly and the
interaction with the onshore market is growing. However, this report focuses on CNY
NDFs, whereas deliverable offshore CNH products are not considered.
1.5. Will the BRIC currencies become fully convertible?
In 2000, the BRIC's share of global GDP was 8%. By 2010, this share had risen to 25%.
The high GDP growth rates in these countries led their governments to loosen capital
controls to spur further investment. However, the 2008 financial crisis and, as a
consequence, expansive monetary policy of the United States Federal Reserve Bank
together with the appreciation of the emerging markets currencies, led many
emerging countries to introduce new capital controls in 2009.5
The levels of capital flows to the BRIC countries differ markedly. Brazil has been
experiencing the highest level of inflows during the past couple of years due to its
more open capital markets (compared to China and India), perceived
improvement in post-crisis growth, lower leverage (compared to Russia) and very
high interest rates. At the same time, Brazil has accumulated far less foreign
exchange reserves (as a share of GDP) than China and Russia, both of which
combine small capital account surpluses (China) or deficits (Russia) and large
current account surpluses with a more or less aggressive FX intervention policy. On
the other hand, India more than doubled its foreign exchange reserves between
2005 and 2010 mainly to prevent an appreciation of the rupee vis-à-vis the USD and
to prevent excessive volatility in the foreign exchange market.
The degree by which the BRIC countries are struggling with capital inflows (and,
more generally, external surpluses) differs significantly, as do their policy responses in
terms of currency appreciation, reserve accumulation and capital controls. Both
China and Russia are experiencing much lower levels of gross capital inflows (and,
indeed, much higher levels of gross private outflows) than Brazil. But large currentaccount-related inflows contribute to much larger balance-of-payments surpluses in
both countries. Their greater capacity and willingness to prevent nominal currency
appreciation have resulted in greater official reserve accumulation. As a result,
China and Russia perceive much less of a need to tighten controls on capital inflows
than Brazil, whose capital account is very open and whose currency has
appreciated tangibly, albeit starting from low immediate-post-crisis levels. India falls
5
The Brazilian finance minister Guido Mantega called it a “Currency War” in September 2010.
9
somewhere in between Brazil, on the one hand, and China and Russia, on the other
hand, as regards its capacity and the perceived need to absorb (smaller) external
surpluses.
Overall, it is unlikely that Brazil, India and China will move to a regime with fully
convertible currencies in the immediate future, ensuring that NDFs will remain
relevant. The Russian ruble is accessible and fully convertible and onshore and
offshore markets exist side-by-side. However, liquidity is still much higher in the
offshore market due to settlement and delivery risks in the ruble. As a result, the BRIC
currencies will remain among the most important currencies in the NDF market.
2. Non-deliverable forwards
NDFs usually exist because trading in some emerging market currencies is subject to
restrictions and capital controls. NDFs can thus be used to hedge or build an
exposure to emerging market currencies. In addition, NDFs are a convenient and
effective tool used by international investors to gain exposure to a particular
emerging market without the need to invest in onshore equity. This is possible
because during the early stages of market development, currency and equity
returns are highly correlated. This chapter briefly explains how non-deliverable
forwards work and provides a short history of the market. A case study illustrates
what happens when a currency becomes fully convertible.
2.1. How NDFs work
A non-deliverable forward (NDF) is an outright forward contract in which, upon
maturity, counterparties settle the difference between the NDF exchange rate and
the prevailing spot rate on an agreed notional amount via a cash payment. It is
analogous to other cash-settled forward contracts in markets such as commodities.
The features of an NDF contract include the notional amount specified in the
quoted currency, the settlement date, and the contracted NDF fixing rate.
Conventionally, the reference rate is fixed at the spot rate two business days before
the settlement date. The difference between the NDF rate and the reference rate is
applied to the notional amount and settled on the settlement date in the base
currency. Note that the notional amount is not exchanged, effectively lowering the
exposure of both parties compared to a standard forward contract.
Table 2.1 provides a simple example of an NDF contract with the Brazilian real as the
underlying currency. Note that the settlement is in US dollar and there is no
exchange of Brazilian real. Also, the notional amounts are not exchanged either. If
XYZ Corp wants to convert the received Brazilian real into US dollars, it still has to do
so in the spot market.
2.2. Why NDFs exist
NDFs are prevalent for currencies with limited convertibility, usually an emerging
market currency with capital controls – hence “non-deliverable”. Convertible
currencies on the other hand are essentially any currencies that can be quickly
purchased or sold without the need to obtain permission from a central bank.
10
Limiting convertibility can help protect against capital outflows during crisis periods
but it also allows limiting inflows and thus can help against unwanted currency
appreciation.
Table 2.1: Hypothetical NDF contract
Trade date
Reference currency
Reference currency notional amount
Notional amount
Forward rate
Reference currency buyer
Reference currency seller
Settlement currency
Settlement date
Settlement
Valuation date
08/31/2012
Brazilian real
BRL 3,000,000
USD 1,971,429
BRL/USD 2.80
ABC Bank
XYZ Corp
US dollar
03/31/2013
Non-deliverable
2 days before settlement
Capital flows into emerging markets grew significantly during the 1980s and 1990s.
However, despite the transition to free market orientated policies in most developed
economies, many emerging markets retained at least partial capital control. Their
objective was to limit speculative capital movements and to avoid excess
exchange rate volatility. Consequently, non-deliverable forward contracts
developed as a tool for investors to hedge their exposures in these emerging market
currencies.6
Major NDF trading began in the early 1990s in the Mexican peso and other Latin
American currencies.7 The outbreak of emerging markets currency crises in the 1990s
and early 2000s, such as the Mexican peso crisis, the Asian currency crisis, the 1998
Russian financial crisis, and the Argentine peso crisis have further contributed to the
establishment of offshore derivative markets for companies to hedge foreign
exchange risk. Over the years, the NDF market expanded to more Latin American,
Asian and Eastern European currencies.
Before focusing on the NDFs in the BRIC currencies and the relevance for the
London FX market, it is instructive to consider a historical example to better
understand the drivers of the NDF market. NDFs are an instrument designed to deal
with non-convertible currencies. As restrictions are lifted and currency moves to a
fully floating regime, NDFs become obsolete. The case study of the Mexican peso
(see box below) neatly illustrates this life cycle of the NDF market. In the early 1990s,
the Mexican peso was the most actively traded currency in NDFs worldwide. When
the currency became fully convertible, NDFs were replaced by FX futures and
deliverable forwards. Thus, in order to provide an outlook on the NDF market in BRIC
currencies it is important to understand the likelihood of these currencies moving to
fully floating exchange rate regimes in the foreseeable future (see case study).
6
7
See, e.g., Misra and Behera (2006).
See, e.g., Lipscomb (2005).
11
Mexican pesocase study
Mexican peso NDFs were among the first to develop in the early 1990s. In early 1988,
Mexico was operating under a fixed nominal exchange rate regime in an effort to
contain inflation. It then modified its exchange rate system several times between
1988 and 1994, moving gradually to an exchange rate band with a sliding ceiling.
The liberation of capital accounts was also welcomed by the financial markets with
a surge of capital inflows into Mexico – at levels exceeding 7% of GDP in 1991 to
1993.
Following the advancement in voice brokerage in 1994 that facilitated interbank
intermediation, trading volume in NDFs began to increase as deals could more easily
hedge the risk from their market-making activities. Trading volume in the Mexican
peso became the largest of NDFs, leading to the Mexico crisis of 1994/1995. It is said
that the trading volume in Mexican peso NDFs reflected market participant's
expectations for a devaluation of Mexican peso, given the slow productivity growth,
fiscal account deficit and political unrest.
Despite efforts to sustain the
pegged exchange rate, the
outbreak of the crisis led to the
announcement to abandon the
exchange rate regime on 22
December 1994, followed by
soaring interest rates, a further
plunging peso and difficulties for
the government to roll over its
debt.
Figure 2.1 Mexican peso exchange rate and
target band
The devaluation of the Mexican
peso did not stop and prevailing
law prevented the Mexican
central bank to step in as a lender of last resort. Eventually, in March 1995, the
Mexican government stepped in to prevent a collapse of the banking system, and a
few days after Mexico reached agreement with the United States, Mexico also
arranged a loan package from the International Monetary Fund and others to help
it stave off devaluation. The experience of the Mexican peso highlights required
market environment for NDFs to be actively traded. One of our interviewees
suggested that NDFs tend to exist for currencies with capital control, but not for
those in distress. Indeed, trading in Mexican peso NDFs never picked up following
the 1994/1995 crisis.
Mexican peso futures were reintroduced in April 1995 and trading volume has been
high as investors hedged their exposures to pesos. Under the fully floating exchange
rate regime, NDFs became redundant in the presence of a liquid futures market.
12
2.3. Differences between NDFs and deliverable forwards
As NDFs represent a market response to underdeveloped and restricted emerging
financial markets, their pricing tends to vary from that of onshore deliverable
forwards (which reflects spot and relevant interest rates). The extent of any
discrepancy in pricing, however, depends on the stringency of regulations impeding
flows between the markets: the less restrictive the controls, the tighter the link
between offshore and onshore prices (and hence the greater the extent to which
NDF prices reflect spot and interest rates). The more restrictive the regulations, the
weaker the link between prices (and the greater the influence of factors other than
interest rates on NDF prices).
A good example constitutes the pricing of NDFs and deliverable forwards for the
Brazilian real. Although NDFs have tended to price the BRL at a greater discount
relative to deliverable forwards, prices on the two markets have been highly
correlated (especially at tenors below one year), suggesting that the pricing of
Brazilian NDFs is largely interest rate driven. By contrast, in a case such as Vietnam,
where underdeveloped financial markets preclude trading of deliverable forwards,
NDF pricing largely reflects expectations about the future spot level rather than
interest rates. For the BRIC currencies in general, the discrepancy between the
observed NDF and deliverable forward prices is minimal and the correlation
between the respective time series is close to perfect (in general above 99.5%).
In terms of risk characteristics, NDFs differ from deliverable forwards in their exposure
to market, credit and liquidity risk.
Market risk. Although NDFs can face considerable exposure to market risk, it is not
significantly greater than that of the deliverable forwards of other emerging market
currencies or major currencies. Figure 2.2 plots the average bid-ask spread for the
spot, NDFs and deliverable forward rates at different tenors for the four BRIC
currencies. The bid-ask spreads, which proxy for overall liquidity in markets, have
dropped considerably over the past three years. The averages for 2012 show that
the bid-ask spreads in NDF markets are not significantly different from the ones in the
spot or outright forward markets. One difference, however, is the fact that the rate
volatility of NDFs tends to increase with the tenor, while that for deliverable forwards
(both emerging market and major currencies) does not tend to rise with the tenor.
By implication, the forward premia or discounts of NDFs appear more volatile than
those for deliverable forwards. For risk managers using NDFs to hedge emerging
currency exposures, the instrument's cash settlement, based upon the observed
difference between the agreed-upon forward rate and the value of the designated
fixing rate, leaves hedgers exposed to transfer, basis and rollover risk:

Transfer risk: When used, say, to hedge foreign currency revenues, an NDF
provides compensation for any difference in value between the agreedupon forward rate and the fixing rate. The hedger, however, retains
responsibility for executing the spot sale of its underlying foreign revenue. As
such, the NDF provides no protection against the imposition of foreign
currency controls that impede that spot transaction or the transfer of funds.

Basis risk: Even if able to execute the underlying spot transaction, the hedger
is unlikely to execute it at the same rate as the fixing rate used to settle the
13
NDF. As such, firms hedging with NDFs retain exposure to basis risk between
the fixing rate and the rate on the underlying spot transaction.

Rollover risk: Finally, if short-term NDFs are employed as hedges of longer-lived
assets or liabilities, the periodic rolling of the NDFs upon their expiry will result in
rollover risk – a cumulative version of the previous basis risk. This is because the
fixing rate used to settle each expiring hedge is unlikely to match the spot
rate used to establish the forward rate on each new hedge. To mitigate this
risk, hedgers usually use forward-forward swaps (initiated a day or two before
the expiry of a hedge to be rolled) to roll NDF hedges. The forward-forward
swap ensures that a single, (i.e., common) spot rate is used both to settle the
expiring hedge and to establish the forward rate associated with the new
NDF.
Figure 2.2: Bid-ask spreads for BRIC currencies (NDFs and deliverable Fwds)
Sources: Bloomberg, Datastream and authors’ calculations
Credit risk. Because offshore-traded NDFs involve major international banks as
counterparties in the transactions, they enable hedgers and investors to avoid direct
credit exposure to emerging market entities. For multinational firms seeking to limit
emerging market exposure and investors seeking to establish it carefully, this feature
of NDFs adds to the instrument's appeal.
Liquidity risk. As NDFs involve emerging market currencies, their markets are
inherently less liquid and more exposed to fluctuations in liquidity than the markets
for major currencies. Figure 2.3 illustrates the liquidity characteristics of emerging
market currencies. NDFs tend to have wider and more volatile spreads – especially
at longer tenors – than the deliverable forwards of major currencies. The Brazilian
real, Indian rupee and Russian ruble in particular are vulnerable to fluctuations in
liquidity. The spreads for other NDFs, however, suggest exposure to fluctuations in
liquidity comparable to that of emerging market currencies traded via deliverable
forwards, such as the South African rand, for example.
14
Figure 2.3: Average bid-ask spreads for BRIC currencies by maturities
0.5
Spot
0.4
NDF 1M
NDF 3M
0.3
in %
NDF 6M
NDF 12M
0.2
Fwd 1M
Fwd 3M
0.1
Fwd 6M
Fwd 12M
0.0
Brazil
Russia
India
China
Sources: Bloomberg, Datastream and authors’ calculations
3. Developments in the FX and NDF markets
This chapter documents the evolution of the NDF market in London, and summarises
how FX markets in general and NDF markets in particular have evolved in the past
few years.
3.1. The FX market globally and in London
Since 1995, the Bank of International Settlements (BIS) has conducted the “Triennial
Central Bank Survey of Foreign Exchange and Derivatives Market Activity”. One of
the goals of the survey is to yield comprehensive and internationally consistent
information on the size and structure of foreign exchange (FX) markets. Between
1995 and 2010 the daily global FX turnover has roughly tripled to around 5 trillion US
dollars. This number includes spot transactions, outright forwards, foreign exchange
swaps, currency swaps, options and other products.
The UK (or London) is by far the biggest FX market in the world. It currently accounts
for almost 40% of global turnover, more than double the share of New York, a distant
second. Growth rates in London have also been far bigger than in any of the
competing large FX centres around the world. Total daily turnover in London has
almost quadrupled in the period from 1995 to 2010 that is covered by the BIS survey.
Apart from the BIS surveys which are only conducted every three years, a second
main source of information about FX trading is local FX committees, which are global
industry groups, sponsored by major FX centres around the world. These committees
provide a forum for market participants to discuss issues of common interest and are
essential in developing standards and best practices related to FX trading and
15
operations. In London, the Bank of England hosts the Foreign Exchange Joint
Standing Committee (FXJSC). 8 The FXJSC along with other committees conduct
semi-annual surveys to provide more timely information on the respective local FX
markets.
Bech (2012) provides an overview of the various committees and compares the
results of the various surveys. Based on the latest FX committee surveys, he estimates
that the overall daily average turnover per October 2011 was roughly USD 4.7tr.
According to FX committee surveys, trading activity grew by 18%, on a weighted
average basis, between April 2007 and April 2010 alone. This is in line with the total
foreign exchange turnover reported in the 2010 BIS survey (see Figure 3.1).
Figure 3.1: FX committee survey daily volumes (USD trillion)
2.5
Apr-05
Oct-05
Apr-06
2
Oct-06
Apr-07
Oct-07
1.5
Apr-08
Oct-08
Apr-09
1
Oct-09
Apr-10
Oct-10
0.5
Apr-11
Oct-11
Apr-12
0
London
New York
Singapore
Tokyo
Australia
Canada
Source: FX committee surveys
Furthermore, comparing the results from the various surveys reveals the dominant
role of London as a centre for FX trading as the turnover in the London market
dwarfs that of any other market centre. At slightly over USD 2tr per day in 2011, its
reported volume is larger than the other surveyed markets put together (the latest
number for London comes in at USD 2.3tr as of April 2012). Again, New York is ranked
a distant second with less than half of London's volume, while the remaining markets
are nowhere near to breaking the USD 500bn mark.
Other committees in FX centres include the New York Foreign Exchange Committee (FXC), the
Singapore Foreign Exchange Market Committee (SFEMC), the Tokyo Foreign Exchange Market
Committee (TFEMC), the Australian Foreign Exchange Committee (AFXC) and the Canadian Foreign
Exchange Committee (CFEC).
8
16
Using the latest available data for London from the semi-annual FX turnover survey
published by FXJSC, total turnover has almost quintupled since 1995. Figure 3.1
displays the evolution of total turnover in the various FX markets as documented by
the surveys since April 2005.
Figure 3.1 also illustrates that the gap between London and its competitors has
widened. Over the period between 2007 and 2010 London has recorded overall
growth in excess of 30% as compared to the global average of 18%. Over the last
four years between April 2008 and April 2012, the overall growth has been even
higher reaching 70%. There seems to be a wide consensus among market
participants based in London that it will retain its global edge for the foreseeable
future. Some of the reasons supporting this view are discussed in section 3.5.
3.2. Global spot trading in BRIC currencies
All the BRIC currencies have either controls or restrictions in place, which gave rise to
trading in NDFs in the first place. However, even the volume of spot transactions has
increased tremendously over the last decade as documented by the Triennial
Central Bank Survey conducted by the BIS. The global volume of spot transactions
for BRIC currencies between the 2001 and the 2010 survey has increased more than
five-fold to a daily average of over USD 48bn. In particular, the market in Chinese
renminbi has developed significantly during this time, from a turnover of only USD
39m in the spot market in 2001 to USD 8bn in 2010. However, as mentioned earlier,
only licensed onshore counterparties are allowed and appropriate documentation is
required.
Table 3.1: Global average daily trading volume in 2010
Spot
Forwards
USD m
(% global)
USD m
(% global)
Brazilian real
8,518
(0.57%)
12,866
(2.71%)
Russian ruble
18,139
(1.22%)
2,262
(0.48%)
Indian rupee
13,527
(0.91%)
13,620
(2.87%)
8,123
(0.55%)
14,248
(3.00%)
1,187,699
(79.70%)
391,501
(82.42%)
Euro
691,210
(46.38%)
149,687
(31.51%)
Japanese yen
300,214
(20.15%)
115,111
(24.23%)
British pound
212,976
(14.29%)
54,844
(11.55%)
92,090
(6.18%)
19,076
(4.02%)
1,490,205
(100.00%)
475,007
(100.00%)
Chinese renminbi
US dollar
Swiss franc
All currencies
Source: BIS Triennial Central Bank Survey, April 2010
In comparison, global turnover for spot currency transactions has almost quadrupled
during the same period to just under USD 1.5tr per day. In terms of volume, the BRIC
currencies account for just 3% of global spot transactions and it reflects the limited
convertibility of these currencies. The number almost seems negligible given that the
most important currencies such as the US dollar, the euro, the British pound, the
17
Japanese yen and the Swiss franc, account for a share of 160% of global volume.9
However, over the past decade, the BRIC currencies have increased their share in
spot transactions by more than one third as they have become more integrated
with the world economy. The first column in Table 3.1 reports the volumes in spot
transactions expressed in million US dollars as per the last BIS survey conducted in
2010.
While BRIC currencies will not achieve the importance of the established and most
liquid currencies of developed countries in the near future, the continued growth of
the BRIC economies will have a positive impact on the demand for their currencies.
3.3. Global forward trading in BRIC currencies
Paralleling the growth of spot FX transactions, volumes in the FX deliverable and nondeliverable forward market have also increased almost four-fold during the last
decade. The numbers from the 2010 BIS survey are displayed in the second column
of Table 3.1. The US dollar, the euro, the British pound, the Japanese yen and the
Swiss franc again account for over 150% of total turnover, while the BRIC currencies
only have a share of 9% with a global daily turnover of over USD 42bn. While it is not
possible to obtain separate global numbers for deliverable forwards and NDFs, NDFs
in general account for over 95% of the forward volume in the BRIC currencies.10 Thus,
in the following, the global numbers for BRIC currencies are interpreted as reflecting
NDF volume.
While the overall share of 9% is still relatively small, growth numbers are much more
impressive: the global growth in FX forwards for BRIC currencies in the past decade
has been more than six times more than the overall growth in forwards according to
the BIS surveys. Even allowing for the extremely low starting levels in 2001, growth is
substantial: from 2007 to 2010, volume in BRIC currency forwards increased by over
150%.




Growth in the Brazilian real has been 144%.
Growth in the Russian ruble has been 80%.
Growth in the Indian rupee has been 134%.
Growth in the Chinese renminbi has been 210%.
By comparison, global growth in FX forwards has remained below 30% over the 2007
to 2010 period.
It is not surprising to see that volumes for spot transactions in the most important and
most liquid currencies like the US dollar, the Japanese yen or the euro are much
larger than volumes for forward transactions, given their role as reserve currencies.
For example, the volume of forward transactions in the largest currencies listed in
Note that the transactions of a particular currency are measured against all other currencies. Hence,
the fractions sum up to two hundred percent instead of one hundred percent.
10 In the past surveys (including the most recent published in 2010), the BIS has subsumed NDF trading
volume in the outright forward category. This will change with the next survey, which will be published in
2013 (containing detailed numbers as of April 2013), since the new questionnaire contains specific
questions about NDF trading. Using the FXJSC semi-annual survey conducted in London, it is possible to
estimate what fraction of the BRIC currency forward contract volume can be attributed to NDFs. With
the exception of Russia, these fractions are 95% or higher.
9
18
Table 3.1 reaches only about 30% of the corresponding spot transactions. For the
BRIC currencies, the pattern looks entirely different and global spot transactions
exceed the forward transactions by only about 12%. Unsurprisingly, excluding the
Russian ruble which is in fact fully convertible, reverses the picture. Global spot
transactions in the Brazilian real, the Indian rupee and the Chinese renminbi reach a
daily volume of USD 30bn in 2010, whereas the corresponding volume for (non)deliverable forwards is more than USD 40bn.
3.4. NDF trading in London
Data from the semi-annual FXJSC surveys allows the development of the FX market
in London to be described in more detail. In particular, since the survey reports NDF
trading volume separate from deliverable forwards, it is possible to gauge the
importance of NDFs and to the track the evolution of the NDF market in the UK.
As discussed earlier, the London FX market has grown significantly in the recent past
to reach a daily turnover of just over USD 2.3tr in April 2012. Spot transactions
account for roughly a third of the volume, while deliverable forwards and NDFs
account for about 10% of the overall turnover, with swaps and options accounting
for the remaining 58%.11 NDFs only account for about 2% of the overall turnover in
London. However, they are very relevant within the forward market segment, where
they account for almost 20% of the daily turnover of USD 215bn, up from just 10%
three years earlier.
In terms of growth rates, the NDF market has fared very impressively in the last three
years. Table 3.2 contains the time series of the daily NDF trading volumes in the four
BRIC currencies from April 2008 to April 2012, taken from the semi-annual FXJSC
surveys. Trading in all currencies but the Russian ruble has increased significantly, with
the biggest growth seen in the volumes for the Indian rupee.




NDF trading volume in the Brazilian real has increased from USD 4.3bn in 2008
to USD 6.3bn in 2012, which corresponds to an increase of 45%.
The Russian ruble has seen a drop in NDF volume from USD 3.5bn in 2008 to
USD 2.4bn in 2012. However, the ruble is the only convertible currency and
unlike the other BRIC currencies, there is significant volume in deliverable
forwards as well. Overall, volume in deliverable and non-deliverable forwards
on the Russian ruble has dropped slightly from USD 4.7bn to USD 4.1bn
between 2008 and 2012, which corresponds to a reduction of about 13%.
Given the good convertibility of the Russian ruble, NDFs and deliverable
forwards can be used as substitutes.
NDF trading volume in the Indian rupee has increased from USD 1.5bn to USD
5.2bn, which corresponds to an increase of almost 250%.
NDF trading volume in the Chinese renminbi has increased from USD 2.1bn to
USD 5.5bn, which corresponds to an increase of 160%.
These numbers are comparable to other major FX centres. For example, in New York, the fractions for
the spot and forward transactions are 50% and 17%, respectively, while in Singapore, the fractions are
27% and 12%, respectively.
11
19
Table 3.2: Average daily NDF turnover in London for BRIC currencies (USD m)
BRL
RUB
INR
CHY
Total
Apr 08
4,325
3,515
1,481
2,147
11,468
Oct 08
4,272
2,679
1,386
1,510
9,847
Apr 09
3,469
1,158
1,312
1,154
7,093
Oct 09
6,128
1,345
3,479
2,089
13,042
Apr 10
4,234
1,136
3,212
3,948
12,529
Oct 10
6,337
1,564
6,099
6,046
20,046
Apr 11
7,589
2,169
4,950
5,873
20,581
Oct 11
6,168
1,497
4,627
6,398
18,690
Apr 12
6,282
2,401
5,159
5,545
19,387
Source: FXJSC Semi-Annual FX Turnover Survey
Using information contained in Tables 3.1 and 3.2, it is possible to roughly estimate
the importance of London for the global NDF market. In order to compare the results
from the two different sources, it is necessary to use the London data as of 2010. The
NDF volume reported for London in 2010 accounts for, respectively, 49%, 69%, 42%,
and 45% of the global turnover in all forward contracts (i.e. NDF and deliverable
forwards combined) in the Brazilian real, the Russian ruble, the Indian rupee and the
Chinese renminbi reported in the latest BIS survey from 2010. This seems like relatively
little considering the previously documented dominance of the UK FX market.
However, given the available data, it cannot be ensured that the comparison is fully
consistent and appropriate. For instance, the NDF volumes in London almost double
from the April 2010 to the October 2010 survey, but corresponding updated BIS
figures are not available for comparison. Using the numbers from the October 2010
FXJSC survey, the NDF market in London accounts for almost 50% of the global
forward volume in the BRIC currencies. This would represent a considerably higher
share for London in the NDF (and also overall forward) market compared to the
London share of the overall FX market.13
In addition, Figure 3.1, which illustrates the widening gap in overall FX volume
between London and its main competitors, suggests that, if anything, the global
importance of the London NDF market has increased further in the last two years
since the last BIS survey was conducted. This notion was also supported by the
interviewed market participants, who had seen volumes growing. Finally, the FX
centres contained in Figure 3.1 neither report deliverable nor NDF volumes for the
BRIC currencies separately.14 This means that turnover in forwards (or NDFs) on the
One obvious inconsistency between the data released in the BIS Triennial survey and the local surveys
conducted by the foreign exchange market committees is for example the daily trading volumes for
forwards on the Russian ruble. The London survey reports a combined NDF and deliverable forward
volume in Russian ruble in April 2010 that exceeds the global number that is reported by the BIS for the
same time.
13
The exceptions are New York and Singapore. New York reports an average trading volume in
forwards on the Brazilian real that is about 80% higher than London, and Singapore reports an average
trading volume in forwards on the Chinese renminbi that is about 70% lower than London.
14
20
BRIC currencies do not seem to be large enough to warrant a distinct category. It
can therefore be concluded that there is no other central hub for NDF trading in the
BRIC currencies.
3.5. Reasons for London’s success and outlook
As long as the underlying currencies are subject to capital controls or trade
restrictions, NDFs will play a relevant role in hedging emerging market currency risks.
There is some uncertainty about whether and when the BRIC currencies will move to
a fully floating exchange rate regime, but there is a consensus among the surveyed
market participants that this is not likely to happen in the near future. However, all
market participants agree that London will unconditionally retain its dominant
position in the FX market.
There are various reasons why all surveyed market participants for this report are
confident that London will retain its dominant role in the FX market. In the view of the
interviewees, London is in a unique position as it has certain natural advantages,
such as being in the right time zone for instance. Other reasons include the pool of
available talent, the existing infrastructure, and the stable political and regulatory
environment.
Time zone. London, compared to New York or Singapore, has a time zone
advantage especially for the African currencies and the Russian ruble. This is
mirrored in London's dominant position in NDF trading in these currencies. Figure 3.2
plots liquidity measured in trading volume for the four BRIC currencies around the
clock. Time intervals are in terms of GMT. As one can see, trading hours overlap with
the London working day in the first instance and London is in between the trading
hours of Asia and Latin America. London's main competitor, New York, has a twelve
hour difference to the Asian countries, which makes it difficult for New York based
traders to cover these currencies.
Talent & infrastructure. London already constitutes one of the largest financial
centres in the world in particular for fixed income and foreign exchange markets. It
has all the infrastructure and talent it needs to provide the necessary conditions to
trade in any asset.
Political climate. London has a very stable political climate and, despite the higher
taxes compared to some financial centres including Singapore and Geneva, traders
in general prefer to live in London (see, eg., Economist, 2011).
Regulatory environment. The regulatory framework is very business friendly
(especially compared to other European countries), although there is some
uncertainty on how this will evolve in the future (see also section 3.6).
21
Figure 3.2: Liquidity at a glance
12am
2am
4am
6am
8am
10am
12pm
2pm
4pm
6pm
8pm
10pm
BRL
CNY
INR
RUB
= least
= med
= most
These issues are not exclusive to NDF trading but pertain to the London FX market in
general. However, the interviewed bankers felt that some of the reasons mentioned
are even more important for the relatively less liquid NDFs. Given the small size of the
NDF market, it is for example important that the banks that are active in the NDF
market have a critical size in order to keep costs to a reasonable size. Achieving the
critical size is easier for global banks that operate from a centre where they have
ideal access to clients and other market participants.
As illustrated by the Mexico peso example, it is essential to constantly gauge the
probabilities that one or all of the BRICs will lift its capital controls and move to a fully
flexible exchange rate regime. The case study nicely illustrates the life-cycle of an
NDF from its origin to its conversion to a deliverable forward. For a time horizon of five
years, some of the interviewed bankers predict that NDF trading in the Russian ruble
will be replaced by deliverable spot or deliverable forward trading (a trend that
seems to be supported by the trend in Table 3.2) given that the ruble is already fully
convertible and deliverable. Similarly, China is expected to further open its market to
foreign investors. Liquidity in the Chinese renminbi is already very high, which is also
reflected in the small bid-ask spreads. Among the four BRIC currencies, India is
expected to remain one of the most closed countries and, therefore, NDF trading in
the Indian rupee is expected to continue to grow.
To conclude, it should be noted that the disappearance of capital restrictions and
the subsequent move from NDFs to deliverable forwards should not have a negative
impact on the competitive edge of London. In fact, all the arguments favouring
London as an FX centre obviously carry over to deliverable forwards as well. While
the interviewed bankers believe that the importance of the NDF market is not yet
declining, London would just as easily pick up the additional business if there was
indeed a substitution of deliverable forwards for NDFs.
22
3.6. Regulation and NDF trading
Among all interviewees, the regulatory changes in the US (Dodd Frank Act) and
Europe (European Markets Infrastructure Regulation) were raised as the most
important factors affecting the future of NDF trading in London. The main regulatory
changes and their implications can be summarised as follows:
Market participants. Asset managers and hedge funds are expected to centrally
clear NDFs and FX options, and execute them on electronic platforms. They will also
need to report a significant proportion of these transactions. Corporate clients, on
the other hand, which use FX instruments for commercial hedging purposes, are
expected to be exempt from these requirements.
Bifurcation of FX. NDFs and FX options will be migrated to electronic platforms and
central clearing. Spot and most probably FX swaps and forwards will continue to be
traded on a bilateral OTC basis.
Costs. Costs will rise for most market participants not only because of the new
regulatory framework but also because of the new capital standards, which are
outlined in Basel III. Clients which currently trade FX through prime brokerage
accounts will be required to move part or all of these transactions to clearing which
will increase transaction and margin funding costs.15 In general, the new rules will
mean higher margin requirements for cleared and uncleared transactions and
increased costs for end users choosing to trade bilaterally.
With the target date for the implementation of central clearing regulation in Europe
in the beginning of 2013, one essential result of the new regulatory framework will be
the bifurcation of FX as an asset class, which will see NDF products under the full
extent of the European Markets Infrastructure Regulation. BRIC NDFs are already
being cleared by LCH.Clearnet, an independent clearing house based in London.
CME will most likely follow suit and is expected to introduce an OTC FX clearing
service on its London exchange in 2013. However, the extent and manner of the
impact of the new regulations will depend on the type of market participant, as
analysed below tracking the full trade lifecycle.
Pre-trade transparency. The NDF market is expected to migrate to electronic
platforms which aggregate liquidity from a number of dealers. Having been the
preserve of single dealer portals, NDF market participants are likely to benefit from
greater visibility of multiple quotes.
Execution. All parties trading in NDFs are subject to centralised execution and
clearing apart from qualified non-financial entities that trade in the FX market to
hedge or mitigate commercial risk. It is expected that liquidity will be dispersed
across a number of service providers who compete to offer the most comprehensive
aggregation services, the best technological offering and additional services like
cross-asset margining and clearing services. This will be likely to improve the
efficiency of the NDF market.
15
See Deutsche Bank (2012).
23
Post-trade transparency. Trade reporting requirements will have a material impact
on all market participants. NDF trades are subject to real-time public disclosure of
trade data on an anonymous basis. While this has a large impact on market liquidity,
it is yet to be seen whether it will further reduce spreads. Some have voiced concern
that greater transparency will reduce dealers' willingness to make markets. Moreover,
prompt disclosure requirements result in substantial technical and operational
burdens that may best be minimised by dealing on a central counterparty.
Pre-settlement risk. Financial counterparties will be required to centrally clear NDFs,
resulting in higher margin requirements. The clearing process is further made
expensive as the proposed regulations also place limits on the types of collateral
accepted. In turn, such costs are likely to be passed on to non-financial clients.
Moreover, clearing rules are likely to result in the standardisation of NDF products,
since individually tailored transactions become expensive to trade bilaterally. This
would entail a transfer of basis risk from the sell side to the buy side.
Overall, two main impacts of the prospective regulatory change are expected:
transaction and operational costs will increase. Indeed, most interviewees from
major banks mentioned that the cost issue is going to be the main determinant of
how trading volumes of NDFs will evolve in the future as clients seek more cost
efficient alternatives. Consequently, market liquidity will be altered and fragmented
as the pre- and post- trade reporting as well as clearing requirements limit the
willingness of dealers to provide competitive prices for less liquid products.
Interviewees indicated that they expect NDF trading to be increasingly
concentrated in the top tier banks, while second and third tier banks, which are still
in the market at the moment, will be squeezed out.
In summary, like the FX market overall, the future of NDF trading in London depends
heavily on the new regulatory changes currently taking place around the globe.
While all interviewees agree that there will always be a demand for NDFs (due to the
need to hedge emerging currency risk), trading volumes in certain currencies will
certainly drop as a function of political and macroeconomic conditions.
4. Summary and conclusion
Over the last four years, the UK trading volume in NDFs in the four BRIC currencies,
which are the focus of this report, has increased by almost 70% to reach a daily
average turnover of almost USD 20bn.
The key conclusions from the study are:
BRIC currencies. Paralleling the impressive economic growth, trading volume in BRIC
currencies has increased dramatically in the last three to four years. Given the
existing restrictions in these currencies, NDFs account for a large fraction of the
overall volume of FX trading in these currencies.
BRIC currencies in London. NDF volume in BRICs has increased by almost 70%
between April 2008 and April 2012, thus dwarfing the overall growth in FX volume in
London of 13% during the same period.
24
NDFs vs. deliverable forwards. A move to a fully flexible exchange rate regime in the
BRIC currencies would make NDFs obsolete. However, the surveyed market
participants in London do not expect this to happen in the near future. As a
consequence, the importance of NDFs will continue to grow along with the BRIC
economies.
Use of NDFs. The surveyed market participants estimate that about half of trading in
NDFs is due to hedgers that have an underlying exposure in the respective currency
and about half of trading is driven by investors and speculators who want to trade
on their views about the currency or the country in general. This is not expected to
change dramatically in the future.
Regulation and NDFs. NDFs are OTC products and therefore by their nature, subject
to minimal regulation. This is expected to change given the fallout from the financial
crisis and a general trend towards more oversight. The main change that is
expected to be implemented before the end of 2013 concerns central clearing and
additional reporting requirements. This will undoubtedly result in an increase in
operational and trading costs for banks and clients. It is essential to ensure that
London’s competitiveness will not suffer by imposing regulatory standards that are
more stringent than those imposed on other financial centres in the rest of the world.
London and the future of the NDF market. There is a consensus among the surveyed
banks that London will maintain or even extend its lead in the FX market in general
and the NDF market in particular. Moreover, even if the BRIC currencies are
eventually moving to a more flexible regime, London will be the natural market for
trading in deliverable FX forwards.
25
Bibliography
Bank for International Settlement, 2010. Report on Global Foreign Exchange Market
Activity in 2010. Triennial Central Bank Survey.
Bech, M. L., 2012. FX Volume During the Financial Crisis and Now. BIS Quarterly
Review, 1 March 2012.
Deutsche Bank, 2012. Exchange Rate Perspectives: How Regulation Will Reshape the
FX Markets.
Economist, 2011. Financiers in Switzerland: Careful what you wish for. Economist, 3
March 2011.
Lipscomb, L., 2005. An Overview of Non-Deliverable Foreign Exchange Forward
Markets. Working Paper, New York Federal Reserve Bank.
Misra, S. & Behera, H., Winter 2006. Non Deliverable Foreign Exchange Forward
Market: An Overview. Reserve Bank of India Occasional Papers, 27(3).
City of London Economic Development
PO Box 270, Guildhall, London, EC2P 2EJ
www.cityoflondon.gov.uk/economicresearch