With concerns over a ‘hard landing’ still weighing on the world’s second largest economy, many multinationals will be wary of the impact that a Chinese downturn might have on their operations. But how should a corporate approach hedging their FX exposure to a currency such as the renminbi when the PBoC still has strict controls in place? Here we explore one of the main tools that corporate hedgers use for getting around convertibility restrictions – NDFs.

What are forwards?

When a company requires a certain amount of foreign currency at a certain point in the future, it faces the risk that the exchange rate may move unfavourably in the meantime. In order to mitigate this risk, it can – subject to exchange control regulations – purchase the currency using a spot contract. However, this will tie up the company’s liquidity until the currency is actually needed.

Alternatively, it can – again, subject to exchange control regulations – enter into an agreement known as a forward outright, to buy the foreign currency at a specified point in the future, at a price fixed today.

It is important to note that the forward prices are based on the current spot rate and the interest rates on the two currencies in question. The cost of entering into a forward contract is the same as if a company were to purchase the currency in a spot transaction and then invest the currency until it was needed.

What are NDFs?

Large-scale NDF trading began in the early 1990s in Latin America, but had its roots in Australia in the 1970s and 80s. An NDF is a type of forward derivatives contract used for trading where one of the currencies is non-convertible – that is it cannot, due to local restrictions, be traded freely in the foreign exchange markets with other currencies. Non-convertible currencies are typically found in emerging market nations, where the government may put them in place to protect their economies from speculative attack.

One key distinction between an NDF and a traditional forward contract is that upon maturity NDFs are paid in cash rather than settled through physical delivery of the underlying.

Trading in the NDF market, because of the legal restrictions, takes place in offshore centres. The market for NDFs is typically divided by regions – Latin American currencies are typically traded in New York, Singapore and to a lesser extent Hong Kong tend to dominate trading in Asian NDFs, while London spans both of these markets. The key thing to remember about NDFs is that no exchange of the principal sums takes place – the only money that changes hands is the difference between the NDF rate and the prevailing market spot rate. This is settled in a ‘hard’ or fully convertible currency – usually US dollars.

Daily NDF volumes are still very small in comparison to traditional FX products, around 3% of daily FX volumes according to data. NDF markets are usually bigger in those currencies that have considerable cross-border capital movements but still have convertibility restrictions in place, such as South Korea. Conversely, in countries where adjustments to the regulatory regime have allowed greater convertibility, NDF markets have over time, dissipated. Australia, for instance, also had an NDF market that evolved in the early 1970s in the presence of currency restrictions. These restrictions were removed by the authorities when the Australian dollar was floated in 1983, removing the need for a non-deliverable market for the currency.

Demand for NDFs has increased substantially in recent years. According to Alfred Schorno, Managing Partner at the multi-bank FX platform 360T, there are two main reasons that explain the recent growth in NDF volumes. Firstly, the fact that NDFs are being used more frequently by corporate hedgers is most likely a reflection of the increasing importance of emerging markets in the global economy.

Secondly, speculative investors, who remain the most active players in the market, are moving away from major currencies because of the lower levels of volatility which have been witnessed in these assets of late, says Schorno. “When we look at institutional volumes, bank-to-bank business, hedge funds, macro funds – due to lesser volatility in major currencies lots of people have been driven to deal in currencies with more volatility, and the NDF market is definitely a playground for that.”

This shift, he believes, may have been accelerated by technological developments. “A lot of market makers are quoting NDF currencies by machine nowadays,” he says. It’s no longer like the old days, or even five years ago. With manual quoting you had to wait quite a while to get a good market overview, nowadays for currency pairs like Brazil, China, Malaysia, you can easily get quoted by machines in seconds. And that, I think, has helped volumes to grow.”

The benefits

So why should corporate treasurers be interested in NDFs? Here is a summary of the instrument’s key benefits.

• A tool for hedging.

  An NDF can provide you with protection from adverse movements on foreign exchange markets.

• A way round capital restrictions.

  NDFs can be purchased where restrictions prohibit the physical delivery of the currency.

• Flexibility.

  The maturity date and the contract amount can be tailored to meet your particular needs.

Points to consider

But, as with any derivative, there are considerations to bear in mind too:

• Opportunity loss.

  You could miss out on the opportunity to benefit from favourable movements in foreign exchange markets.

• Early termination expense.

  Although a trader can vary or terminate an NDF early a cost will be incurred by doing so.

• Counterparty risk.

  As is the case with many financial markets products, you risk exposure to market exchange rate fluctuations if your provider defaults and is unable to fulfil its obligations.

Also, NDFs are an over-the-counter or OTC derivative product, as opposed to an exchange traded product. This can make it difficult to find accurate data regarding volumes of contracts traded.

Regulatory changes: an uncertain future for NDFs?

In recent years, NDFs have become embroiled in attempts by US regulators to reform the world of OTC derivatives which for a long time has existed in the shadows. The proposals, which at the time of writing have yet to come into effect, are aimed at reducing the systemic risks associated with derivatives and address concerns regarding a lack of market transparency. The US legislation stipulates that NDFs in Latin American currencies should be moved to clearing houses and even exchanges and subject to trade reporting, a migration which some clearing houses, such as the CME group, have already begun ahead of implementation of the Dodd-Frank mandates.

However, the proposals have proved incredibly contentious. Some analysts argue that the changes will significantly drive up trading costs. While conforming to the regulatory changes is unlikely to trouble larger organisations, the inevitable costs that the migration involves could, so the argument goes, squeeze smaller players out of the marketplace. If that scenario was to play out then one obvious consequence would be a drop in volumes, which would translate into reduced liquidity.

This is far from being a consensus view – some industry experts, such as 360T’s Schorno believe that the forthcoming changes will have little impact upon overall market volumes for NDFs. “360T is one of the multi-bank portals which has quite big volumes in NDFs which have built up over the last three or four years,” he says. “During this period, NDF volumes have increased 200%-300% year on year. And since the announcement of the Dodd-Frank proposals volumes we have not seen any downturn.”

Despite regulatory changes, corporates will still need to hedge their exposures to the currencies of emerging market economies and while exchange controls remain in place the NDF will continue to be the instrument of choice for carrying out this task, says Schorno.

One of the other issues arising from the Dodd-Frank proposals Schorno highlights, is the possibility that institutional investors will move to areas beyond the jurisdiction of the new Dodd-Frank regulations to avoid the additional reporting requirements that the US market will be subject to. “Market makers might transfer their business into areas where they don’t have to comply with Dodd-Frank and other related regulation. And the question is could there be a shift in terms of volumes from existing markets to places like the Middle East and the Far East, due to the regulations coming into force?” If this happens then corporates, he argues, may have a problem. Conversely, institutional investors, who are not bound to particular booking centres, will have no issues following the liquidity, especially in the era of electronic portals. “But for corporates”, he says, “this is not so easy”.

This is the main reason why Schorno believes that there should be an exemption for NDFs under the Dodd-Frank regulatory proposals (this is looking unlikely but it is yet to be confirmed at the time of writing), particularly with respect to corporate hedgers. “I would strongly vote for exempting corporates who use NDFs”, he says. “It would have totally the wrong effect if corporates were to stop hedging and therefore increase their risk on their balance sheets – because the regulatory issue is that there should be more transparency and therefore less risk – not more.”

Outside of the US the picture is no clearer. Dodd-Frank is US legislation and the proposals only have bearing on markets that reside within the jurisdiction of US law. Derivatives, including NDFs, sold in non-US financial centres such as Hong Kong or London will therefore not be subject to the mandates contained in the Dodd-Frank. But the EU has, however, brought forward its own proposals for regulatory reform of the derivatives marketplace – The European Market Infrastructure Regulation (EMIR).

The proposals, like in the US, have not passed to the implementation stage unopposed and legislators are currently considering whether to introduce a Dodd-Frank style exemption for FX forwards.