The growth of the non-deliverable forwards (NDF) market has been one of the defining trends of FX trading over the last two years, driven by a number of factors – from regulation to technology development and including a number of geopolitical and economic factors.
But if the market is to keep pace with the surge in demand, there will need to be a further electronification of the trading process, the use of more NDF algos and measures taken to improve the relatively fragile liquidity of the asset class.
Real money demand
The NDF market has grown largely through the demand among ‘real money’ participants to access local markets, says Geoff Jones, director of FX spot venues at Refinitiv, an LSEG business. “NDF trading is a function of the market needs. Corporates can facilitate payments to local suppliers in local currency but to hedge their currency-risk they use NDFs. Asset managers want exposure to emerging markets but there are constraints in accessing local onshore markets.”
Growth has also been aided by the volatility in global markets that has resulted from political uncertainty and economic instability and which have in turn made hedging via NDFs more popular among traders. It also used to be default state that these currency products were fully convertible, however this is not currently the case, says Neill Penney, Group Head of FX, LSEG.
But the growth of the NDF market has not been overnight or merely a result of the current volatility. According to James Pearson, head of ForexClear at LCH, an LSEG business, it has been a continuous 25 year process. “As this continues, people have become more comfortable with trading NDFs. And central banks have done a good job of showing that this is a stable product,” says Pearson.
There are two key regions for the NDF market – Asia and Latin America. Despite that, NDFs involving Brazil, Korea, China and India are largely traded offshore in London. But LSEG is launching its NDF matching engine in Singapore. According to Jones, it will be the only primary market central limit order book in Asia and the first regional deployment of their new technology for LSEG.
Asia remains a varied region when it comes to FX markets. For example, countries such as India are relatively sophisticated and allow clients to trade both onshore and offshore, hence onshore price discovery is a driving force. Yet there are still exceptions such as Malaysia where the central bank recently began reinforcing a ban on offshore Malaysian ringgit trades. Consequently, foreign banks with local subsidiaries must ask permission from their onshore counterparts and from the central bank before executing any offshore FX trades, including NDFs.
The greater electronification of the market has also driven the need to be closer to the point of execution, says Neill Penney of LSEG’s decision to set up a matching engine in Singapore. “It is not necessarily a latency issue, but we recognise more Asian banks are providing sophisticated Asian clients pricing via regionally hosted single dealer platforms,” he says.
In addition to the new matching engine, LSEG has also looked to improve the fragile liquidity of the NDF market through the promotion of central clearing. “It is difficult to believe that credit isn’t the major cause of fragile liquidity across the FX market,” says Jones. “One of the things we recognise is that the use of clearing can increase participation and will help defragment the market. We want to make sure everyone can access the market and central clearing is the obvious next step.”
The driver for central clearing over the last three years has been the Uncleared Margin Rules which impose a higher capital charge on uncleared OTC derivatives. The regulation has helped generate 40% growth in the last two years and this has been very concentrated among primary dealers. LSEG’s strategy with NDF Matching has been to ensure that when trades are executed, they go straight to clearing, meaning that it is no longer a post-trade decision.
“It is not necessarily a latency issue, but we recognise more Asian banks are providing sophisticated Asian clients pricing via regionally hosted single dealer platforms,”Neill Penney
However, much like every convertible product, venues such as LSEG need to provide different execution means for different participants. LSEG has a bilateral trading facility through FXall as well as a matching engine for central clearing. Its plan is to develop a more consistent link between the two.
The NDF interbank market is de facto cleared, says Penney. “We are bringing a new order book which provides one single link to the clearing house. The benefits that come from that order book – better market-data, more efficient trading, it all makes sense. We are also opening the Singapore platform in the second half of 2023 after it was announced in May 2022. All of these steps will support a market that continues to grow, so we are particularly excited.”
Growth of the BRICS (Brazil, Russia, India, China, South Africa) countries GDP has led to an increase in demand for NDFs as a hedging tool to manage currency risk for banks and corporations with exposure to these countries, says John McGrath, chief revenue officer at BidFX.
But NDF’s are also being used as a speculative tool in response to an increase in products and services flowing into and out of BRICS nations. “NDFs offer a facility to trade currencies that are potentially illiquid or subject to capital controls that might limit cross border payments,” says McGrath. “China is a good example of a country that has capital controls on its currency whilst experiencing rapid economic growth which has clearly attracted attention and participation from the global FX marketplace as trading in Chinese Yuan continues to grow exponentially year on year.”
From a treasury/balance sheet perspective, NDF’s offer traders the opportunity to gain exposure to a currency risk without committing the company balance sheet to additional stress especially given that there is no exchange of the underlying asset, adds McGrath. However Uncleared Margin Rules (UMR) do require that market participants exchange collateral with one another to cover potential future credit losses on uncleared OTC derivatives of which NDF’s are one, and this has the potential to increase the cost of NDF trades.
This is where central clearing comes in. “Whilst the increased use of NDFs reflects the growing demand of market participants to manage currency risk and speculate in a wider range of countries and currencies than just G7 (or traditional Emerging Markets), the introduction of UMR seems to be incentivising more central clearing of NDF’s in order to keep counterparty risk low,” says McGrath.
“These rules aim to reduce systemic risk and improve the stability of the market by reducing the amount of leverage in OTC derivatives. This means increased collateral requirements, greater operational complexity, and observation of legal & compliance mandates – all of which can be eased with a centrally cleared approach. Central clearing helps to reduce the operational complexity and cost of trading NDFs, as market participants don’t have to negotiate and manage bilateral margining arrangements with multiple counterparties.”
It is difficult to predict with certainty what the future holds for NDF trading but in all likelihood, the future is inextricably linked to the progress in the currency’s countries of origin, says McGrath. “Where we see continued success of countries like BRICS and other industrially evolving nations, we will undoubtedly see an increased appetite to trade these currencies for both hedging and speculative purposes.This will happen as companies get involved on the ground with the delivery of products and services, and as Hedge Funds and more speculative accounts see the price moment as opportunities for growth. Changes in regulations could also continue to impact the cost and risk of trading NDFs. We’ll need to see if these rules become more stringent or more relaxed,” he states.
“The use of clearing can increase participation and will help defragment the market. We want to make sure everyone can access the market and central clearing is the obvious next step.”Geoff Jones
There are several developments in the electronic trading space which could help to maximise the potential of NDF trading including improved price discovery, better market data transparency and greater liquidity, says McGrath. “The job of electronic platforms is to facilitate price discovery by bringing market participants together in one place. As the volume of asymmetric information in the market is reduced, so price discovery and transparency is improved creating more efficient markets. This has already been seen in the G10 space as spreads have been consistently compressed since the inception of e-trading in the early 2000’s. It’s realistic to expect that as price maker continue to gain confidence in the availability of liquidity and in the reduced risk of trading NDF’s, that the price should narrow in a similar way to what we’ve already seen with G10 CCY’s. We have already seen an increase in streaming liquidity, broken dates, cleared NDF’s and NDF Algo’s. The onset of liquidity provision analytics (LPA) into the NDF space also offers clients greater visibility into the commitment of their liquidity providers to this process,” says McGrath.
Path to electronification
Although still in early stages, in many regards the path to the electronification of NDFs resembles the one for FX spot, says Oleg Shevelenko, FXGO product manager at Bloomberg. “Leading market makers and electronic trading platforms started with solving for electronic pricing which in turn enabled automated hedging and risk management. As automated hedging required development of respective algorithms, market makers are now able to offer basic NDF algos to their clients to leverage. A very well-defined regulatory framework around NDFs enabled market infrastructure providers to offer multi-dealer offerings in the form of Swap Execution Facilities (SEFs) in the US and Multi-lateral Execution Facilities (MTFs) in Europe. Finally, long awaited regulatory equivalence via the cooperation amongst the global regulators allowed for consistent implementation of regulatory framework across the globe and avoided liquidity fragmentation,” he says.
One of the factors which accelerates further electronification of NDFs is the client’s expectation to have a consistent and efficient framework to trade all their FX instruments, says Shevelenko. “As trading desks on the buy-side are becoming multi-asset and are resource constrained, traditional voice trading stops being a viable long-term option. Electronic trading via Request-for-Quote (RFQ) and streaming protocols which exist for FX spot, Forwards and Swaps had to be extended for NDF offerings, not just the workflow efficiency for the trading firms, but also for bringing price transparency and best execution to new levels.”
There has also been an effort to improve the fragile liquidity environment in which some NDFs operate, says Shevelenko. “Both the regulatory requirements dictating price transparency and the electronification of FX NDFs have allowed market participants to have a much clearer picture of NDF liquidity in various currency pairs and tailor their trading activities accordingly. In addition, due to the direct correlation between NDF and onshore markets, one often drives the other in leading overall improvements in the consistency and quality of pricing for both,” he says.
While NDF algos are being offered by the major liquidity providers and being actively evaluated by the buy-side, there are still several challenges prior to meaningful adoption, says Shevelenko. “For example, the number of venues offering electronic trading of NDFs is still limited. Liquidity is inconsistent and nuanced across NDF pairs. Algorithms themselves are not as well proven and well-defined as for spot. Some buy-side firms don’t have reliable access to market data to trigger the algo. On the bright side, as we learned from the spot market, the introduction of algo execution itself brings efficiency, consistency of pricing, and standardization to the market which creates a ripple effect for further algo adoption. We are starting to observe the same with NDFs.”
“We learned from the spot market, the introduction of algo execution itself brings efficiency, consistency of pricing, and standardization to the market which creates a ripple effect for further algo adoption. We are starting to observe the same with NDFs.”Oleg Shevelenko
There is still some way to go though before e-trading in NDFs can be considered a mature market, says Shevelenko. “The NDF market consists of a multitude of markets representing respective currencies, economies, and regulations. Although many of the infrastructure, pricing and post-trade themes are common across the spectrum of NDF currencies, each currency is still very different. While some of them are quite mature and support electronic pricing and hedging, others have some way to go,” he says.
Due to the rapid growth of various emerging market economies, asset managers are likely to continue to increase their asset allocation in respective markets which will drive the usage of NDFs as a hedging tool, adds Shevelenko. “In response, electronic trading capabilities of NDFs including trading on regulated venues (SEFs and MTFs), accessing streaming liquidity and the usage of NDF algos will continue to evolve. The industry will need to settle on the clearing debate which will largely depend on whether the FX clearing framework can be expanded beyond NDFs. Finally, bank and non-bank liquidity providers as well as multi-bank venues would need to work together on standardizing access to liquidity and pricing to match what is currently available in FX spot,” he states.
Euronext FX launched NDF trading out of its Singapore-based SG1 matching engine in 2019 in response to the growing interest in the asset class. Euronext FX has since seen a 25% plus increase in NDF trading from H1 to H2 2022 on its ECN. According to Trent Beacroft, CEO of Euronext Securities, there are several factors behind this increase.
For example, increased volatility has made NDFs popular with FX market participants because of their ability to hedge against volatile currency movements. NDFs also provide a way for investors to bypass currency controls implemented in some countries and are a more cost-efficient way to hedge against currency risks compared to traditional forward contracts due to the lack of physical delivery.
And as NDFs have become more mainstream, so has the depth of liquidity, says Beacroft. “As participants find it easier to manage risk, an increasing number of participants are including NDFs in their trading strategies. Market makers are attracted by the wider spreads consumers pay, and takers find opportunity in the volatility, higher than traditional spot FX.”
There are also various factors influencing the further electronification of the NDF market, says Beacroft. “Automation has been a major factor in driving the further electronification of NDF markets. Automated trading systems have allowed trading firms to execute trades, reducing market impact and improving liquidity quickly and accurately.”
Regulatory pressure has also helped, says Beacroft. “Regulators around the world are increasingly pushing for greater transparency and efficiency in financial markets, which has been a major driver of electronification. By requiring firms to move to electronic trading systems, regulators hope to reduce market manipulation and improve market integrity.”
The possibility of cost savings, improved liquidity and greater access to data are also factors, says Beacroft. “By moving to electronic trading systems, trading firms can reduce costs associated with manual trading, such as the costs of hiring traders and administrative staff. This can lead to increased profitability for trading firms,” he says.
Electronic trading systems have made it easier for trading firms to find counterparties and execute trades. They have also allowed trading firms to access real-time market data, allowing them to identify trading opportunities and make more informed decisions more quickly. This can lead to increased profits for trading firms. Euronext Markets Singapore offers real-time NDF market data to clients and participants looking to enter the market.
While the electronification of the NDF market has multiple benefits, there are also challenges, especially when it comes to delivering NDF algos, says Beacroft. “The main challenge is that they are complex and require a lot of data to be processed to accurately calculate the forward rate. Additionally, NDF algorithms can be sensitive to market conditions and changes in foreign exchange rates, which can make them difficult to implement.”
“Changes in regulations could also continue to impact the cost and risk of trading NDFs. We’ll need to see if these rules become more stringent or more relaxed.”John McGrath
To improve upon these challenges, machine learning algorithms are being used to better predict the forward rate, says Beacroft. “Furthermore, NDF algorithms are being improved by incorporating more data points and creating more sophisticated models. This allows them to better account for potential shifts in the foreign exchange rate and react accordingly. Finally, the use of big data analytics and artificial intelligence is being used to further enhance the capabilities of NDF algorithms.”
Consistent and reliable liquidity are prerequisites for algo trading, says Beacroft. “As liquidity in the NDF market improves and as prices stabilize, participants can leverage algo trading in the same way they do in the spot market. At Euronext Markets Singapore, we had to ensure we had an adequate depth and mix of liquidity before offering our pegged NDF algo. Now live, participants can use our pegged orders to move their interest with our ECN,”.
Despite the advancements, the electronic trading of NDFs is a relatively new and developing market and there is still room for improvement in terms of infrastructure, liquidity, and market transparency, says Beacroft. “For NDFs to reach a more mature state, there needs to be further development in the standardisation of products, pricing, and market data, as well as increased participation by market makers and liquidity providers. Some liquidity providers still limit their trading to local time zones and only price specific tenors. Many of these local providers have historically been restricted by technology but are increasingly able to participate electronically. The NDF market will grow in maturity when liquidity providers and consumers can meet in a more fluid manner. In addition, more sophisticated risk management tools and technologies need to be implemented to mitigate counterparty risk and ensure the accuracy and reliability of pricing,” he states.
“As more financial institutions adopt electronic trading systems, the market for NDFs will become even more efficient and liquid, allowing for more competitive pricing and faster transactions.”Trent Beacroft
So what does the future hold for NDFs and what developments in the electronic trading space could unleash their potential even further? “At Euronext FX and Euronext Markets Singapore, we certainly believe in the future growth of Non-Deliverable Forwards (NDFs) trading,” says Beacroft. “We’ve invested in and established a NDF platform in Singapore, the heart of the Asian NDF trading pole. Here, we successfully connect local and global players with the same speed and technology as we offer in spot trading.”
As the global economy becomes increasingly interconnected, demand for NDFs will continue to grow, says Beacroft. “The continued growth of electronic trading platforms further strengthens the market for NDFs and makes them more accessible to a wider range of investors. Additionally, the development of automated pricing models, increased liquidity, and better price transparency will make NDFs even more attractive to both buyers and sellers. As more financial institutions adopt electronic trading systems, the market for NDFs will become even more efficient and liquid, allowing for more competitive pricing and faster transactions. As the market matures, more exotic currencies will become available, allowing market participants to access markets they may have previously been unable to access. All these developments will help to further unlock the potential of NDFs and make them an even more attractive financial option.”