Thread by @niravstoons

I would disagree on the NDF volumes moving onshore and there are a few reasons for it ... 🧵

https://twitter.com/meandmarkets/status/1216205971929718784

Bulk of FX activity globally is speculative. And a tiny bit is actual hedging. (I would say from volumes 95% is speculative)

The hedging activity from corporates hedging grade flows and institutional investors hedging equity or debt holding is held for long tenor ...

While speculators are trading for short term gains and trades could be held for a fraction of a second (HFT) or few hours to few days ... depending on the type of trader

Onshore FX forwards due to capital controls - one needs to show the underlying asset to be hedged.
And one needs to have an ISDA and CSA agreement with the bilateral counterparty for the trade.
Also given the trade is gross (say 1 million USD for 72 million ₹upees)

The total amount of exposure is large.

For a Non Deliverable Forward - it’s cash settled.
If some one sold $1 million to buy ₹72 million a month forward.

On the final date if 1$ = 73₹ then the difference is the only payment made and it is in USD

All interbank NDF trades are cleared via a clearing house (typical London Clearing House ‘LCH’)

So some one can sell USD to buy INR (typical carry trade as Indian interest rates are higher)
And buy USD sell CNY (say due to trade war pressures)
...

This long USDCNY vs short USDINR trade is mutually offsetting and less margin is taken

In summary
- NDF doesn’t need documentation (reason for trade or underlying asset to hedge)
- needs ISDA vs a clearing house and more international counter parties acces
- less margin requirements due to net settlement
- Cross margin with other currencies

Looking at other markets where NDF trades happen and how it impacts volume - let’s look at China, Korea and Indonesia (where I have most experience) and also Turkey and South Africa (fully open current account)

China has a 3 tier FX market
1. Chinese Yuan CNY’ (or RenMinBi - literally peoples money) trading onshore - this has similar restrictions as Indian Rupee, and speculative element is curbed, foreigners can trade CNY for actual trade (imports/exports) hedging assets (debt/equity)

2. Chinese Yuan NDF trading overseas - this is cash settled derivative contract and similar to the Indian Rupee. The fixing on cash settlement is done at the PBOC Fx rate 9:15am. This is published rate could be +/- 2% from the prevailing spot rate.
...

Given this slippage between NDF fixing and prevailing fx rate - it’s a bad hedge.
Mainly favored by speculative traders, who bet on the fixing set by PBOC (which is used to guide direction of the market)

Also Chinese Banks are active in the market in HK

3. Chinese Yuan in Hong Kong (CNH)
This is a currency which is freely trading in HK without capital controls and if one has proper documents then 1 CNH can be remitted for 1CNY.

Though there remains significant differences in spot and forward rates as arbitrage isn’t easy

The CNH market is again heavily controlled by the HK branches of Chinese banks.

Thus link between onshore and offshore is maintained. And the Central Bank (PBOC) has a good control on the currency - at the same time due to speculators presence the market has enough liquidity...

Which allows large volumes to trade without affecting the underlying price as much.

To copy Chinese model - we need large PSU banks having a big fx desk in Singapore / London / Dubai and intervening on behalf of RBI.

This isn’t doable given the indian banks don’t have capacity to handle large flows and have bad balance sheet not allowing mtm volatility

2. Indonesia

Here FPIs own 40% of domestic debt and hence many are hedging the requirements in NDF offshore.
Also it exports coal and imports manufactured goods.

They have a Domestic NDF (DNDF) contract onshore - which removes issues of Gross margin and settlement risk

This has seen some of domestic importers moving to hedging their risk onshore instead of offshore.

Also with Indonesian banks trading Indonesian Rupiah NDF and DNDF both - there is a connect between forwards and it’s better linked.

Indian parallel to DNDF is FX futures on NSE

So India should allow domestic banks to be active in both NDF overseas and FX futures.
At the same time allow foreigners to trade FX futures with limited documentation (right now it’s capped at $100 mln)

3. South Korea

Here the banks onshore itself can quote NDF sitting in Seoul to overseas clients.
Banks can maintain a Onshore ‘deliverable fx forwards’ and a Offshore NDF book.

This is the best solution - while speculators might face an overseas entity of a foreign bank

E.g. Hedge fund ABC trades USDKRW with Citi bank Singapore. There is a back to back hedge between Citi Singapore and Citi Seoul.

This ensures all KRW risk is reflected in books onshore. Bulk of offshore market is covered by foreign banks. But they in turn hedge with local banks

So in Korean example - RBI could allow domestic banks (say SBI ICICI) and Indian Branches of foreign banks (say Citi, Standard Chartered, JP Morgan) would finally own all the risk.

But in this case too, the NDF market will remain offshore.

The bar for FPI to come and trade USDiNR onshore is very high, especially with uncertainties about taxation (restrospective tax liability no one wants), counterparty risk, and settlement risk. (NDF only risk is net settlement of difference instead of gross settlement of 2 amounts

So just by 24 hour trading - doesn’t do much for moving currency onshore. (Meanwhile - CNH trades 24h, but onshore CNY, KRW, IDR all only trade in local hours)

Coming to South African Rand (ZAR) and Turkish Lira (TRY) have no restrictions and anyone can move money in our out.

This has seen a lot of domestic rich guys move money out and foreigners flood in and out.

Makes currency too volatile for any local business to plan

Or the central bank to control the currency.

For a non mature economy - fully open current account can be risky and too painful.
No business can invest long term if currency can fluctuate wildly.
Thus both are stuck in middle income traps.
Rich locals all move money outside

So in summary

- India can learn from Indonesia and open up FX futures market (and clear up taxation laws for FPI or NRI)

- India can learn from Korea and allow foreign banks and Indian banks to quote NDF from onshore.
Keep proper risk management and record keeping

Can’t do what China does - Indian banks don’t have the size (Chinese GDP is 4.5x of India and large State Owned Banks have HUUUGE balance sheets) and India doesn’t have a pocket of capitalism under its control like HK.
And India isn’t mature enough to open up its capital account