Over the better part of the past 15 years, most of the innovation in the foreign exchange (FX) market has been dedicated to spot transactions, which benefitted from electronification, automation, and algorithmic trading. The nondeliverable forward, or NDF, market is finally catching up. Not long ago, these instruments were traded over the phone and chat, and were just another clunky and opaque financial product. Today, NDFs are attracting more volume and, more importantly, are being traded with a far greater degree of sophistication and efficiency.
Overlapping developments pave the way to more adoption of electronic trading. The trend toward a slimmer trading desk has been in the works at many buy-side firms for some time, motivating traders to do much more with fewer resources. Additionally, the shift to a work-from-home environment brought about by the novel coronavirus crisis has encouraged displaced workers to find faster, streamlined ways to trade with less desktop space. Advanced trading tech checks a lot of boxes in this respect, allowing traders to automate processes and free up their time to focus on other activities.
Roughly 40% of the NDF market is electronically traded (Figure 1). While e-trading adoption has lagged that of other FX instruments, NDFs have garnered a lot of attention as different forces push the product into a more transparent and technologically advanced place. The uncleared margin rules (UMR), which are set to bring many buy-side firms into scope beginning in September 2021, have created more demand for clearing to alleviate margin cost with a knock-on effect of more e-trading to foster straight-through processing of trades to the clearinghouse. Meanwhile, the commoditization of trading in the spot market and subsequent search for new revenue streams, combined with light bank balance sheets, have motivated the sell-side to begin expanding algorithmic tools to NDF investors.
Will modern NDF trading remain Old School?
According to the Bank for International Settlements (BIS), NDFs account for roughly 4% of total FX volume. More than half of the market’s activity is concentrated in a handful of emerging market currencies. Despite concentration, average daily volume has nearly doubled in the past three years as market participants see greater opportunities with more robust pricing and liquidity. NDF nuance, however, has resulted in a preference for disclosed trading practices and a tendency toward traditional execution methods, such as the use of request-for-quote protocols on multidealer platforms and voice trading.
How does such a market modernize? The NDF market is at the early stages of an evolution in trading that will likely lead to more expansive e-trading, even beyond standardized instruments. For instance, new and evolving protocols are gaining traction. Executable streams, which have long been available in the spot FX world, may be going mainstream, pushing NDF trading to the next level. An increasing number of trading venues are aggregating streaming liquidity from providers and offer executable streams to their clients for both one-month and broken-dated NDFs.
The aggregation of streaming liquidity on multidealer platforms has become a crucial step to accommodate the ever-increasing number of spot FX bank algorithms—including an expansion of these tools into the NDF market. BNP Paribas, JPMorgan, and Goldman Sachs were early entrants, providing their clients with a set of robust options for streaming NDF algos. Goldman Sachs, for instance, launched the first “smart” algo for NDFs in February 2019; the first trades were executed via its NDF dynamic hybrid algos, which were developed from existing algos for deliverable currencies.
A tale of two liquidity pools
While modern trading techniques and greater transparency are fostering better liquidity in NDFs, regional regulatory differences have created market fragmentation. In the U.S., post-2008 financial crisis reforms pushed regulators to rein in risk through a series of measures that included mandatory clearing and reporting of swaps transactions.
On the trading side, over-the-counter swaps, including NDFs, were shifted to a more financial futures-like marketplace as swap execution facilities (SEFs) were born. Non-U.S. investors are not subject to these rules unless they are trading with a U.S. counterparty and trade off-SEF in a separate liquidity pool.
As Figure 2 shows, monthly NDF SEF volume has steadily increased over the past five years, exceeding US$850 billion in March 2020. Volatility linked to the novel coronavirus influenced trading volume higher during the month as average daily volume grew to nearly US$40 billion. According to data reported by BIS, trades enacted by U.S. persons represent about one-third of the overall global NDF market.
What about the other two-thirds? The off-SEF market for NDFs has opened up opportunities that attract innovative players and a broader range of liquidity providers to the market. In the U.S., SEF market-making is limited to U.S.-registered swap dealers. Consequently, many of the nonbank liquidity providers that have had success in other parts of the FX market do not participate.
The off-SEF environment allows these firms to offer liquidity to investors using some of the newest tech and aggressive pricing. A handful of new electronic communication networks (ECNs) have also emerged. For instance, 24 Exchange, an ECN that launched in December 2019, offers a unique market that aggregates on- and off-SEF liquidity into a single trading pool, helping to mend fragmentation.
More room to grow
As is the case with most financial instruments that haven’t moved beyond the inflection point of manual processes to electronic and automated ones, NDFs are still characterized by “ownership” constraints.
Despite newer entrants to the market, certain banking groups dominate some currency pairs, and the wholesale market is essentially driven by a single firm making prices. In this environment, barriers to entry may persist, inhibiting NDFs from achieving the benefit of better tech and workflows, as top institutions may not have much reason or interest to invest in better systems without a competitor’s push.
Other headwinds are also prevalent. Although the market for NDFs has greatly improved in terms of transparency and more robust liquidity, challenges linked to the structure of the product remain as the ecosystem continues to develop.
Nuances, including a wide range of liquidity levels for each currency product and related dates, prevent greater adoption of e-trading as investors continue to rely on traditional execution means for more obscure currency pairs and broken-dated contracts.
Overall, there is not enough electronic liquidity in all of the NDF currencies to reach critical mass and shift to a world in which all traders are relying on e-trading protocols and algorithms. Even though that world may not be realized for several more years, optimism prevails that NDFs will get there some day.