Nicholas Pratt

NDFs: The market looks towards increasing electronification

January 2024 in Special Reports

As the demand for NDFs continue to surge, Nicholas Pratt examines the role of electronic trading and technology to meet this.

The NDF market enjoyed a huge surge in demand between 2016 and 2019 when, according to the BIS Triennial Survey of 2019, average daily volumes more than doubled, from $127 billion to $258 billion. The acceleration slowed somewhat in the BIS survey of 2022 with average daily volumes reaching $266 billion. 

Yet demand remains high, particularly in emerging markets, driven by a confluence of factors. Chief among these is the ongoing globalisation of financial markets as investors allocate more assets to emerging markets in the face of slowing economies in developed markets. This has fueled the need for hedging against currency risk, within which NDFs can play a critical role. 

The electronification of local market makers has also helped to meet the demand for NDF trading by increasing the access to NDF pricing and reliable sources of liquidity, as have some regulatory tailwinds that have helped to promote a more diverse market for product development. But more investment in electronic trading services will be needed if the NDF market is to reach its potential. 

Due to differences in FX volatility between developed and emerging markets, asset owners are often reallocating risk to EM countries. And because many of the currencies in these countries are still non-convertible, the typical way for offshore investors to trade in those markets is via NDFs. “Asia in particular accounts for four of the top five traded NDF currencies globally based on the BIS survey including large manufacturing-based economies like China, South Korea and India,” says Oleg Shevelenko, FX Product Manager at Bloomberg. 

“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,”

Oleg Shevelenko

While NDF markets are typically used to hedge FX exposures often linked to fixed income holdings, speculative trading is also on the rise, says Shevelenko, which is generally a reflection of market growth and sophistication. “In most cases, NDFs have higher volumes than their deliverable onshore currency equivalents due to a wider group of market participants and recent technological advances in the NDF markets such as locally hosted order books and the rise of algorithmic trading,” says Shevelenko. “The fact that the NDF market is a part of global derivatives reform and as such is subject to clear regulatory trading and reporting standards removes various regulatory concerns and opens wider investment opportunities.”

New electronic services

As a consequence of the surging NDF demand, FX providers are launching new electronic trading and clearing services for these instruments. In 2023, FXGO, Bloomberg’s multibank FX trading platform, launched a regional hosting service in Singapore for its Asia Pacific clients designed to improve transparency and pricing for local markets. FXGO also hosts a number of regional banks’ algos. “Despite the absence of a clearing mandate, a proportion of NDFs is being centrally cleared,” says Shevelenko. “This helps reduce the cost of capital, counterparty risk and improves market efficiency, contributing to the overall growth of NDFs.”

There has also been some work done to improve the fragile liquidity of the NDF market, says Shevelenko. “Industry surveys continue to highlight that NDF turnover in aggregate is on the rise. For example, the Bank of England reported record highs for NDF turnover in its latest semi-annual FX turnover survey, with a 4% increase. However, the paths of each NDF currency are very different. Some emerging market countries embrace and support the growth of their existing NDF markets allowing local investors to participate directly or indirectly, while the others carefully regulate and restrict access to it. In addition, the internationalization of China’s renminbi resulted in the rapid growth of the deliverable forward CNH market as an alternative to NDFs. FXGO deployed its trade negotiations and analytics tools in various emerging markets to help participants optimize access to both onshore and NDF liquidity via RFQ, auctions, streaming, central limit order book and algorithmic orders.”

There is still more work to be done though, says Shevelenko. “Although still in early stages, in many regards the path to the electronification of NDFs resembles the one for FX spot. Leading market makers and electronic trading platforms started with electronic pricing of NDFs which in turn enabled automated hedging and risk management. As automated hedging is a key operational requirement for algorithms, market makers are now able to offer basic NDF algos to their clients to leverage.”

Despite those recent advances, many NDF markets still operate on a very thin liquidity especially outside of local market hours, says Shevelenko. “Due to the bilateral nature of FX markets, participants don’t always have access to the local liquidity providers, especially as NDFs are derivatives compared to spot. A more widespread adoption of FX clearing is likely to bring more market participants together and facilitate further market growth. Finally, as buy-side desks are becoming multi-asset and take additional execution responsibilities, voice execution ceases to be a viable option due to the time it takes to analyse, execute and book the trade.”

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 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.”

“As technology continues to evolve, onshore participation will continue to improve, utilizing tools and infrastructure to seamlessly engage in NDF trading, enhancing market accessibility, liquidity and transparency,”

Brian Andreyko

And what of the future growth prospects for NDFs? “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,” says 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, workflows and post-trade clearing and settlement practices to match what is currently available in FX spot.”

Solutions tailored to NDFs

As the demand for NDFs undergoes rapid upswing in adoption, due in part to large swings in country interest rate differentials, leading FX providers are strategically responding by introducing innovative electronic trading products and clearing services, tailored specifically for these instruments.  

“At Edgewater, we have been providing solutions to onshore institutions that enable them to embrace electronification and scale their operations to meet the growing global demand for NDFs,” says Brian Andreyko, chief product officer at Edgewater Markets, the US-based FX trading technology provider. “By offering electronic trading platforms and tools, onshore institutions can not only compete, but thrive in servicing the global marketplace.  This enhances overall market efficiency while reducing operational complexities. This increases profitability of onshore participants and adds a new and expanded global client base, capitalizing on data-driven optimized trading. This strategic approach aligns with the broader trend of technology-driven transformations of other financial markets, compressing spreads and costs for clients, and matching global client interest with onshore market inventory.”

To facilitate further electronification we would need larger adoption of e-FX solutions from tier 2/3 banks in emerging markets

But in emerging markets, technology is not enough, he says.  “Leading FX providers are also introducing credit intermediation services that cater to global distribution. Edgewater recognizes the global nature of NDF trading, and the diverse array of participants and counties involved. Offering credit intermediation solutions that broaden trading relationship become paramount, particularly in emerging markets where credit is restrictive. For example, at Edgewater, through a single credit clearing relationship with one of our global Prime Brokers, we connect our clients to multiple onshore participants in multiple countries, eliminating the need for global participants to set up hundreds of ISDAs with individual onshore providers.  Bridging the credit gap between Edgewater’s clients and onshore liquidity partners has significantly enhanced overall liquidity and accessibility of NDF markets.”

A significant role played by service providers involves credit intermediation, says Andreyko. “By leveraging the services of third-party intermediaries, market participants can access a broader pool of liquidity providers. This approach helps alleviate liquidity constraints by connecting buyers with an array of sellers, fostering a more dynamic, interconnected, and efficient marketplace. Edgewater’s credit intermediation services are one of the most robust and compelling parts of our offering that enhances NDF trading for all participants involved.”

Furthermore, there has been a strategic shift in bank workflows to capitalize on increasing global market demand, says Andreyko. “This adaptation involves optimizing internal bank processes that allow them to scale and better service not only their existing onshore business, but global NDF demand as well. By aligning workflows with credit resources, market participants direct flows to those that specialize in a particular currency, fostering a more stable and resilient trading environment. At Edgewater, our liquidity partners tell us often how transformative their business has become with our global distribution abilities comingled with our credit intermediation and technology services.”

To facilitate further electronification, there is a need for continued development and adoption of various trading methodologies alongside global connectivity solutions that match onshore and offshore participants, says Andreyko.  “Specifically, our clients are looking for solutions that address larger trade sizes with the efficiency that electronification offers.  To provide this, Edgewater has recently implemented anonymous Request for Quote (RFQ) trading, incorporating technology that emulates voice driven markets while providing the efficiency and scale of electronic trading. This development has expanded trade flow, allowing firms to source competitive pricing and execute trades more efficiently and cost effectively, eliminating middlemen.  This interaction is instrumental in building trust among market participants, ultimately fostering increased participation and liquidity.”

One notable challenge of delivering NDF algos is the requirement for the algo to interact with liquidity providers that have deep enough books of business to warehouse the transaction flow, says Andreyko. “To address this challenge, collaboration with onshore banks becomes crucial. Onshore banks, equipped with warehouse capabilities broadened by their onshore flow, can play a pivotal role in improving NDF algo performance that has been lacking. By leveraging electronic access and risk management expertise of onshore banks, NDF algorithms can expand their scope and effectiveness, while reducing market impact, an inherent risk associated with algorithmic trading performance,” he says. 

The future outlook is promising, with several factors contributing to NDFs continued expansion, says Andreyko. “The continued development in arming onshore participants with technology to participate in global markets is paramount. As technology continues to evolve, onshore participation will continue to expand and improve, utilizing tools and infrastructure to seamlessly engage in NDF trading, enhancing market accessibility, liquidity and transparency. This will significantly contribute to the overall growth and vibrancy of NDF markets, providing geographical diversification that unlocks new opportunities for participants, further fuelling the growth of NDFs on a global scale.”

Additionally, the provision of credit intermediation services that enable onshore participants to participate in global markets is a crucial component, says Andreyko. “By facilitating secure and efficient global distribution and credit intermediation services, we bridge the gap between onshore and offshore markets. This not only enhances market inclusivity but also encourages a diverse range of participants to engage in NDF trading, further amplifying market liquidity and activity. Lastly, one significant trend is the ongoing discussions in many markets, including India, Korea, and Chile, regarding the eventual opening up of their currencies. The potential maturation of these new markets will first go through a robust period of NDF trading as these markets begin that transition.”

Improving liquidity

The adoption of electronic trading platforms has played a significant role in improving liquidity in NDF markets, says Andrea Sanna, head of liquidity management at London-based institutional FX broker Alp Financial. “These platforms offer transparency, efficiency, and accessibility, attracting a broader range of participants. Moreover, regulatory authorities have been active in addressing liquidity issues and any regulatory barriers that hinder market liquidity,” says Sanna.

“The increased capabilities of e-FX trading systems nowadays allow for much more advanced and tailored liquidity offerings. Current technology can handle with no difficulty pricing in NDFs according to several workflows such as RFQ, RFS, or Streaming to accommodate customer needs. 

Liquidity providers, both brokers and market makers, are adapting swiftly to structure their pricing models to this market that in the new future will see an increasing spillover effect from voice to electronic trading,” says Sanna.

“Similarly, to what was observed in recent years in full amount auto-pricing the tendency to auto-price and auto-hedge risk coming from NDFs will gradually extend to tickets larger in size and to products that result less liquid as soon as models and liquidity pools migrate towards electronic marketplaces,” says Sanna. “The clarity of the regulatory environment plays a pivotal role in allowing brokers and market makers to get the necessary confidence to price more extensively NDFs on an electronic fashion. However, at AlpFin we do think that the process already started, we can see that with respect to Asian NDFs, and this tendency will extend gradually to other regions.”

“The evolving landscape, influenced by factors such as ESG considerations, economic trends, and integration with traditional FX markets, will shape the trajectory of NDF markets, requiring ongoing collaboration among stakeholders for a resilient and efficient future.”

Andrea Sanna

Facilitating further electronification within NDF markets involves addressing challenges such as market fragmentation, liquidity concerns, and regulatory considerations, says Sanna.  “Improvements in technology infrastructure, standardized clearing processes, and enhanced market structures are key to fostering electronification. Achieving these improvements will create a more efficient environment for trading firms to thrive in electronic trading. To facilitate further electronification we would need larger adoption of e-FX Solutions from tier 2/3 banks in emerging markets; increased clarity on the regulatory front with respect to NDF products; and reduced capital and margin requirements for customers and LPs willing to trade these products. The improvement of these points will initiate a virtuous circle that will naturally bring improved liquidity, lower spreads, larger volumes, and standardized and less VaR intensive risk management protocols.” 

There are challenges involved in delivering more electronification to the NDF market though, says Sanna, especially when it comes to NDF-specific algos. “Although algos are a prerogative of banks and venues, one of the main challenges to offer algos in NDF is connectivity to end customers that would like to use them either via GUI or API. At the moment, the customers that would like to use this service either don’t have an e-FX Solution or they don’t have enough credit standing to get a prime broker that allows them to connect to Tier 1 or Tier 2 liquidity providers,” says Sanna.

“Delivering NDF algos presents diverse challenges, including liquidity concerns, market fragmentation, volatility, data quality issues, regulatory compliance, and technological infrastructure limitations. To address these challenges, NDF algorithms are designed with features such as intelligent liquidity sourcing, risk management strategies, data processing capabilities, and compliance checks. Technological advancements will contribute to algorithmic adaptability to changing market conditions, and continuous collaboration among quantitative analysts, technologists, and compliance professionals is essential for the successful deployment of NDF algorithms,” says Sanna. 

The future of NDFs is poised for growth with potential developments in regulatory frameworks, trading technology, and market dynamics, says Sanna. He points to four developments that would help the NDF market grow further.  

  • Larger adoption of e-FX solutions from tier 2/3 banks and buy-side takers and providers in the Sub-Saharan region together with Latin America
  • Clarification of the MiFID requirements for brokers to operate in the NDF space in emerging countries
  • Increased presence of venues that do offer streaming liquidity pools in South American and African NDFs
  • Increased liquidity that will underpin a decrease in clearing costs and reduce spreads.

“The evolving landscape, influenced by factors such as ESG considerations, economic trends, and integration with traditional FX markets, will shape the trajectory of NDF markets, requiring ongoing collaboration among stakeholders for a resilient and efficient future,” adds Sanna.

Regulatory drivers and reliable data

Historically, the fragility of the NDF market is due to a lack of depth of liquidity in the market which can create gaps in directional trading, says Wyman Shing, sales director APAC at Euronext FX. “Also, there has been a lack of reliable market data to inform participants. Liquidity providers cannot price without knowing where the market is.”

Regulators have also taken several steps to improve the fragility of NDF liquidity environment, says Shing. “Regulators have implemented capital and margin requirements to reduce counterparty risk and encourage more liquidity. They have also implemented a range of measures to encourage more transparency in the NDF market, such as the introduction of standardized contracts and reporting requirements for trades. And they have worked to implement new regulatory frameworks to ensure a more stable and transparent environment for NDF trading.”

“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,”

Wyman Shing

In addition to regulatory action, the market itself has also adjusted and innovated to face the liquidity challenges in the NDF market, says Shing. “Market participants have developed a range of solutions to enhance liquidity in the NDF market. These include the introduction of a central limit order book and the use of algorithms to match buy and sell orders.  Banks and other financial institutions have increased their presence in the NDF market by providing liquidity through their own trading desks. Market participants have also established several electronic trading platforms to facilitate trading in NDFs. These platforms provide access to a range of NDF currencies and have also reduced transaction costs. ECNs such as Euronext Markets Singapore have increased and improved access to quality liquidity at high speeds and increased transparency via more reliable market data.  And local liquidity providers with access to uncorrelated flow have advanced their technology and now can participate in electronic markets directly.” 

Work to be done

In terms of what needs to be done to ensure further electronification of the NDF markets, Shing highlights five measures – increased automation, regulatory pressures, the need for cost savings, improved liquidity and improved access to data. “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,” says Shing. 

“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,” says Shing. “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.”

Electronic trading systems have made it easier for trading firms to find counterparties and execute trades, says Shing. “At Euronext Markets Singapore, we’ve seen increasing liquidity from Tier 1 banks expanding their global reach as well as from local specialists as they embrace advancing technology. Electronic trading systems 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.”

The main challenge of delivering NDF algorithms is that they are complex and require a lot of data to be processed to accurately calculate the forward rate, says Shing. “Additionally, NDF algorithms can be sensitive to market conditions and changes in foreign exchange rates, which can make them difficult to implement. To improve upon these challenges, machine learning algorithms are being used to better predict the forward rate. 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,” he states.

As the global economy becomes increasingly interconnected, demand for NDFs will continue to grow, says Shing. “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,” says Shing.