BRIC currencies trading in London

Transcription

1 SPECIAL INTEREST PAPER Report prepared for the City of London Corporation by London School of Economics and Political Science Published December 2012 BRIC currencies trading in London City of London Economic Development PO Box 270, Guildhall, London, EC2P 2EJ

2 SPECIAL INTEREST PAPER Report prepared for the City of London Corporation by London School of Economics and Political Science Published December 2012 BRIC currencies trading in London City of London Economic Development PO Box 270, Guildhall, London, EC2P 2EJ

3 BRIC currencies trading in London is published by the City of London. The author of this report is the London School of Economics. This report is intended as a basis for discussion only. Whilst every effort has been made to ensure the accuracy and completeness of the material in this report, the authors, the London School of Economics and the City of London, give no warranty in that regard and accept no liability for any loss or damage incurred through the use of, or reliance upon, this report or the information contained herein. December 2012 City of London PO Box 270, Guildhall London EC2P 2EJ

4 Executive summary... 3 Introduction Brazil, Russia, India and China: the BRICs Brazilian real Russian ruble Indian rupee Chinese renminbi Will the BRIC currencies become fully convertible? Non-deliverable forwards How NDFs work Why NDFs exist Differences between NDFs and deliverable forwards Developments in the FX and NDF markets The FX market globally and in London Global spot trading in BRIC currencies Global forward trading in BRIC currencies NDF trading in London Reasons for London s success and outlook Regulation and NDF trading Summary and conclusion Bibliography...

5 Executive summary This report has been commissioned from the London School of Economics by the City of London Corporation to explore the trading of BRIC currencies in the London FX market. The BRIC currencies (together with the South Korean won) constitute the most important currencies for non-deliverable forwards (NDFs). As the BRIC economies grow, without immediately moving to a fully flexible exchange rate regime, offshore FX markets and NDFs in particular are expected to become ever more important. NDFs account for the overwhelming majority of the forward volume in BRIC currencies. An NDF contract is an outright forward contract in which counterparties settle the difference between the contracted NDF price and the contracted NDF fixing rate at an agreed notional amount at maturity. NDFs are prevalent in currencies where unrestricted trading is not possible due to the existence of strong controls imposed by the governing body. As the restrictions are lifted and the currencies move to a flexible exchange rate regime, NDFs gradually become obsolete and trading volume switches to deliverable (or plain vanilla) forwards. Deliverable forwards constitute contracts whereby a party agrees to buy or sell a pre-specified asset at a future date. Overall, the UK (or London) segment of the FX market accounts for roughly 40% of the global turnover, securing the top spot for London among the global FX centres. Between April 2008 and April 2012, the average daily UK trading volume in NDFs in the four BRIC currencies Brazilian real (BRL), Russian ruble (RUB), Indian rupee (INR) and Chinese renminbi (CNY) increased by almost 70% to almost USD 20bn. While NDF contracts account for only about 2% of volume in the London FX market as of April 2012, their growth in the last four years has by far outstripped the growth of other FX transactions. The aim of this report is to summarise existing information and data on NDF trading in the London FX market, provide a qualitative outlook on the future of NDF business in the BRIC currencies by way of interviews with relevant players and to highlight any risks or concerns when considering investing or trading in NDF contracts. Key conclusions: BRIC currencies. Paralleling the impressive economic growth of the BRIC countries, trading volume in BRIC currencies has increased dramatically since Given the domestic restrictions on these currencies, NDFs account for a large fraction of the overall volume of FX trading in these currencies. The daily global volume for NDFs in the Brazilian real, the Indian rupee and the Chinese renminbi is more than USD 40bn, compared to global spot transactions of USD 30bn in For all BRIC currencies, the NDF and deliverable forward rates are almost perfectly correlated with correlation coefficients generally exceeding 99.5%. BRIC currencies in London. NDF volume in BRICs has increased by almost 70% between April 2008 and April 2012, thus dwarfing the overall growth in FX volume in London of 13% during the same period. 3

6 NDFs vs deliverable forwards. NDFs mainly exist because the underlying currencies have controls in place which restrict the international exposure and use. A move to a fully flexible exchange rate regime makes NDFs obsolete. This has happened in the past with the Mexican peso and history could repeat itself if controls on BRIC currencies are lifted. However, market participants in London do not expect this to happen in the near future. As a consequence, the importance of NDFs will continue to grow along with the BRIC economies. Use of NDFs. The surveyed market participants estimate that about half of trading in NDFs in London is due to firms hedging an existing exposure in the respective currency and about half of trading is driven by investors who want to trade on their views about the currency or the country in general. There is a consensus amongst interviewees that this will remain the case in the near future. As BRIC currencies become more established, it is further expected that NDFs for more exotic currencies (like in particular the African currencies) will gain more traction. Regulation and NDFs. NDFs are OTC products and therefore by nature subject to minimal regulation. This is expected to change given the fallout from the financial crisis and a general trend towards more oversight. The main change that is expected to be implemented before the end of 2013 concerns central clearing and additional reporting requirements. While asset managers and hedge funds will be subject to the additional regulation, corporate clients which use FX instruments for commercial hedging purposes will be exempt. This will undoubtedly result in an increase in operational and trading costs for banks and clients. Costs are also expected to rise because of new capital standards outlined in Basel III. The extent of the additional costs will most likely turn out to be the main determinant of how the NDF market will evolve as clients may seek out more cost efficient alternatives. In addition, market liquidity may suffer, as new clearing and reporting requirements will limit the willingness of dealers to provide competitive prices for less liquid products. London and the future of the NDF market. There is wide consensus among the surveyed banks that London is well prepared to tackle the challenges that lie ahead. The working day in London overlaps with all BRIC countries. In addition, London boasts a prime position as an international financial centre with a reliable legal system and access to highly qualified talent. It is therefore expected that London will maintain or even extend its lead in the FX market in general and the NDF market in particular. Moreover, even if the BRIC currencies are eventually moving to a more flexible regime, London is not expected to lose business as it will be the natural market for trading in deliverable FX forwards. The main area of challenge in the intermediate future is the upcoming regulatory changes, and it is essential to ensure that London s competitiveness will not suffer by imposing regulatory standards that are more stringent than those imposed on other financial centres in the rest of the world. A likely outcome is that due to increased costs, economies of scale will become more important and NDF trading will be concentrated in the top tier banks, while second and third tier banks, which are still in the market at the moment, will be squeezed out. However, this is not necessarily bad news for London as an FX centre as it could even result in the big banks increasing and concentrating their presence in London. 4

7 Introduction London is currently the leading centre for FX trading in the world with a share of almost 40%. 1 While the NDFs only account for about 2% of FX trading in London (and 20% of the volume in FX forward contracts), they have become a widely used instrument for hedgers and speculators alike to manage exposures to the underlying currencies in an effective way. As the importance of emerging markets (and especially the BRIC countries) is expected to grow, trading in NDF contracts is expected to follow suit. According to the semi-annual foreign exchange surveys conducted by the Foreign Exchange Joint Standing Committee (FXJSC), the average daily UK trading volume in non-deliverable forwards (NDFs) in the four BRIC currencies Brazilian real (BRL), Russian ruble (RUB), Indian rupee (INR) and Chinese renminbi (CNY) has increased by almost 70% from just over USD 11bn in April 2008 to almost USD 20bn in April As the BRIC economies are growing further, presumably without moving to a fully flexible exchange rate regime in the near future, offshore FX markets and NDFs in particular are expected to become ever more important. NDFs are foreign exchange derivative products traded over the counter (OTC). Different from deliverable exchange rate forwards, they trade outside the direct jurisdiction of the authorities of the corresponding currencies. Major centres of NDF trading are Hong Kong, Singapore, Seoul, Taipei, Tokyo, London and New York. London is the main market for NDFs on Eastern European and Asian currencies. While the majority of the trading volume is on foreign currency to US dollar pairs, the OTC nature of the market enables other currencies such as the British pound and the euro to be used as the base currency as well. While it is relatively easy to obtain a wide range of information on FX trading in the most liquid currencies such as the US dollar, the euro, the Japanese yen, the British pound, or the Swiss franc, the same is not true for the emerging market currencies typically underlying NDF contracts. This report has been commissioned by the City of London Corporation to fill this gap. In particular, the report has three objectives: First, it provides an introduction into NDF contracts in general and as such can be used as a reference. Second, the report summarises the available data on NDF trading in the London FX market. Here, the focus is on the BRIC currencies, which (together with the South Korean won) constitute the most important currencies for NDFs. Finally, the report discusses the outlook for the NDF market with a particular focus on how its development will affect the position of London as a dominant centre for FX trading. The views relating to the future of NDF trading in London are shaped by interviews conducted with senior managers in global investment banks that play a significant role in the FX market in London and with proponents of central banks that have regulatory and supervisory roles in the market. 3 1 The latest global numbers are from the Triennial Central Bank Survey on Foreign exchange and derivatives market activity last conducted by the BIS in April The London Foreign Exchange Joint Standing Committee (FXJSC) was established in 1973 under the auspices of the Bank of England, in the main part as a forum for banks and brokers to discuss broad market issues and the focus of the Committee's regular work remains issues of common concern to the different participants in the foreign exchange market. 3 The sample of surveyed banks includes Barclays, Deutsche Bank, HSBC, JP Morgan and Standard 5

8 The first chapter introduces the BRIC currencies, which together with the South Korean Won are the most important currencies for NDFs. The chapter also describes the reasons why those currencies are traded offshore using NDFs as opposed to onshore using outright forwards. Chapter two introduces the concept of non-deliverable forwards. It covers some of the obvious risks and concerns related to trading in BRIC currencies using NDF contracts. Furthermore, it discusses the differences between deliverable and nondeliverable forwards and elaborates on the reasons for being active in the NDF market in the first place. Detailed quantitative data on investors in NDF market is very difficult to source. As a result, the section heavily draws on the insights derived from interviews conducted with the major banks that execute trading in NDFs on behalf of their clients. Chapter three summarises the relevant data and discusses how the NDF market has developed globally and in London. FX markets globally have grown significantly in the last decade and global turnover reached about USD 5tr in London as the dominant FX centre accounts for roughly 40% of total turnover. It is estimated that London accounts for at least the same fraction of global NDF turnover. NDF volume in the London FX market has experienced a strong growth in the last four years. Furthermore, the chapter provides a qualitative outlook on the future of NDF trading in BRIC currencies based on interviews conducted with the relevant players in the London FX market. The chapter also considers key uncertainties with regards to the future of London as a trading hub, principally the proposals for regulation that are currently being discussed as a reaction to the financial crisis. There is some concern that regulation in Europe and in London in particular could become more restrictive than regulatory changes implemented in other FX centres, which could eventually hurt London's competitiveness. 1. Brazil, Russia, India and China: the BRICs The BRIC countries are some of the fastest growing emerging countries in the world. Combined they encompass over 25% of the world's land coverage and 40% of the world's population and they hold a combined GDP (PPP) of USD18.5tr. As these countries grow and their companies increasingly trade outside their borders, greater international use of their currencies can be expected. Figure 1.1 shows the steady increase in their imports and exports as a percentage of world trade on the right hand side axis. However, these four countries all have in place currency controls (or, in the case of Russia, a managed exchange rate regime coupled with significant political risks), which restrict the international exposure and use of their currencies. With the exception of Russia, none of the currencies are fully convertible. The regulatory environment for the BRIC currencies is summarised in sections 1.1. to 1.4. Chartered, as well as the Bank of England and the Swiss National Bank. Their participation and in particular their insights are highly appreciated. 6

9 Figure 1.1: BRIC countries trade balance (billions of EUR) 2,000 1,800 1,600 1,526 1,771 1,541 25% 20% 1,400 1,200 1, , ,049 1, % 10% 5% Imports Exports Balance Imports (%) Exports (%) % Source: IMF 1.1. Brazilian real The Brazilian real (BRL) is managed in a free-floating regime with occasional interventions. The Banco Central do Brasil (BCB), Brazil s central bank, monitors foreign investments and currency exchange, and the National Monetary Council (CMN) sets FX regulations. The Monetary Policy Committee (COPOM) sets the target for the SELIC rate, which is the overnight government bond repo rate. Over the last decade, the CMN and the BCB have been gradually lifting restrictions from the Brazilian foreign exchange markets. The foreign exchange normative framework was renewed in 2005 in the form of the Exchange and Foreign Capitals Market Regulation (RMCCI), marking a significant step towards a less regulated FX environment. However, in periods of a strong appreciation of the real, the authorities have implemented measures to limit portfolio inflows and/or reduce US dollar selling pressures. In September 2011, for example, the authorities introduced a 1% financial transaction tax (IOF) on trades that increase long positions in the real via the onshore derivatives market. The onshore market offers deliverable and non-deliverable derivatives. Foreign investors can access the Brazilian derivatives markets via a portfolio investment account. All incoming investments must be registered with the Central Bank Foreign Capital Registration and Supervision Office (FIRCE). However, the foreign investor must have custodian, legal and tax representatives in Brazil. In addition, all OTC nondeliverable derivatives must be registered at CETIP, the main securities depository, or the Brazilian Mercantile and Futures Exchange (BM&F Bovespa). A foreign investor wishing to trade derivatives through the BM&F Bovespa must open a brokerage account in a Brazilian brokerage house. 7

10 1.2. Russian ruble The Russian ruble (RUB) is operated under a managed floating currency regime by the Central Bank of the Russian Federation (CBR). While the ruble is fully convertible but pegged to a EUR-USD basket with a gradually widening band, the CBR is yet to complete the transition to an inflation targeting regime by 2015, with a shift to a quasi-floating currency regime. Although the CBR does not target any particular FX level to defend, it intervenes in the FX market in order to reduce excessive volatility and ease speculative pressure. Before the 1998 Russian financial crisis, forward markets were developed onshore. However, the losses suffered by many Russian banks due to the currency devaluation led to a rule by the Russian courts that forward contracts were not legally enforceable. Subsequently, offshore NDFs became the primary means by which rubles were traded in order to avoid some of the additional risks of trading in outright forwards. Generally, there are no restrictions on ruble transactions for either resident or nonresident companies alike. Deliverable and non-deliverable spot and forward deals can be performed without restrictions. However, local and multinational corporates registered in Russia must trade only through accounts with authorised banks Indian rupee The Reserve Bank of India (RBI) maintains the Indian rupee (INR) in a managed floating regime. The value of the rupee is tracked against the Real Effective Exchange Rate (REER). 4 However, the rupee exchange rate has been known to deviate significantly from the long-term REER average. Though there is a stated policy of allowing market moves based on underlying fundamentals, the RBI can intervene actively in the foreign exchange market in cases of excessive volatility. Exchange controls are established by both the government and the RBI. Although market participants are able to buy the rupee freely from any bank for most current account transactions, the rupee remains restricted on the capital account. Anything not specifically allowed under the Foreign Exchange Management Act (FEMA) is deemed to be disallowed. There is limited access to onshore FX contracts for resident entities. Foreign Direct Investors (FDI) & Non Resident Indians (NRIs) can also hedge their exposure subject to compliance with specific conditions. 4 REER is calculated by the Reserve Bank of India (RBI) based on a basket of 36 global currencies. 8

11 1.4. Chinese renminbi The Chinese renminbi (CNY) is non-deliverable under the maintenance of the People s Bank of China (PBoC) in a managed floating regime. The renminbi is partially convertible fully convertible on the current account but only on a restricted basis on the capital account. Trade-related transactions are permitted cross-border if supported by appropriate documentation. No entities outside China are allowed to participate in onshore trading of the renminbi. The PBoC, however, has taken concrete steps in the process of the renminbi internationalisation since 2008 and opened up the offshore RMB market (CNH). The renminbi became deliverable offshore in Hong Kong in July Although the transfer between Hong Kong and onshore is still subject to regulations and approval by mainland authorities, the offshore market is developing rapidly and the interaction with the onshore market is growing. However, this report focuses on CNY NDFs, whereas deliverable offshore CNH products are not considered Will the BRIC currencies become fully convertible? In 2000, the BRIC's share of global GDP was 8%. By 2010, this share had risen to 25%. The high GDP growth rates in these countries led their governments to loosen capital controls to spur further investment. However, the 2008 financial crisis and, as a consequence, expansive monetary policy of the United States Federal Reserve Bank together with the appreciation of the emerging markets currencies, led many emerging countries to introduce new capital controls in The levels of capital flows to the BRIC countries differ markedly. Brazil has been experiencing the highest level of inflows during the past couple of years due to its more open capital markets (compared to China and India), perceived improvement in post-crisis growth, lower leverage (compared to Russia) and very high interest rates. At the same time, Brazil has accumulated far less foreign exchange reserves (as a share of GDP) than China and Russia, both of which combine small capital account surpluses (China) or deficits (Russia) and large current account surpluses with a more or less aggressive FX intervention policy. On the other hand, India more than doubled its foreign exchange reserves between 2005 and 2010 mainly to prevent an appreciation of the rupee vis-à-vis the USD and to prevent excessive volatility in the foreign exchange market. The degree by which the BRIC countries are struggling with capital inflows (and, more generally, external surpluses) differs significantly, as do their policy responses in terms of currency appreciation, reserve accumulation and capital controls. Both China and Russia are experiencing much lower levels of gross capital inflows (and, indeed, much higher levels of gross private outflows) than Brazil. But large currentaccount-related inflows contribute to much larger balance-of-payments surpluses in both countries. Their greater capacity and willingness to prevent nominal currency appreciation have resulted in greater official reserve accumulation. As a result, China and Russia perceive much less of a need to tighten controls on capital inflows than Brazil, whose capital account is very open and whose currency has appreciated tangibly, albeit starting from low immediate-post-crisis levels. India falls 5 The Brazilian finance minister Guido Mantega called it a Currency War in September

12 somewhere in between Brazil, on the one hand, and China and Russia, on the other hand, as regards its capacity and the perceived need to absorb (smaller) external surpluses. Overall, it is unlikely that Brazil, India and China will move to a regime with fully convertible currencies in the immediate future, ensuring that NDFs will remain relevant. The Russian ruble is accessible and fully convertible and onshore and offshore markets exist side-by-side. However, liquidity is still much higher in the offshore market due to settlement and delivery risks in the ruble. As a result, the BRIC currencies will remain among the most important currencies in the NDF market. 2. Non-deliverable forwards NDFs usually exist because trading in some emerging market currencies is subject to restrictions and capital controls. NDFs can thus be used to hedge or build an exposure to emerging market currencies. In addition, NDFs are a convenient and effective tool used by international investors to gain exposure to a particular emerging market without the need to invest in onshore equity. This is possible because during the early stages of market development, currency and equity returns are highly correlated. This chapter briefly explains how non-deliverable forwards work and provides a short history of the market. A case study illustrates what happens when a currency becomes fully convertible How NDFs work A non-deliverable forward (NDF) is an outright forward contract in which, upon maturity, counterparties settle the difference between the NDF exchange rate and the prevailing spot rate on an agreed notional amount via a cash payment. It is analogous to other cash-settled forward contracts in markets such as commodities. The features of an NDF contract include the notional amount specified in the quoted currency, the settlement date, and the contracted NDF fixing rate. Conventionally, the reference rate is fixed at the spot rate two business days before the settlement date. The difference between the NDF rate and the reference rate is applied to the notional amount and settled on the settlement date in the base currency. Note that the notional amount is not exchanged, effectively lowering the exposure of both parties compared to a standard forward contract. Table 2.1 provides a simple example of an NDF contract with the Brazilian real as the underlying currency. Note that the settlement is in US dollar and there is no exchange of Brazilian real. Also, the notional amounts are not exchanged either. If XYZ Corp wants to convert the received Brazilian real into US dollars, it still has to do so in the spot market Why NDFs exist NDFs are prevalent for currencies with limited convertibility, usually an emerging market currency with capital controls hence non-deliverable. Convertible currencies on the other hand are essentially any currencies that can be quickly purchased or sold without the need to obtain permission from a central bank. 10

13 Limiting convertibility can help protect against capital outflows during crisis periods but it also allows limiting inflows and thus can help against unwanted currency appreciation. Table 2.1: Hypothetical NDF contract Trade date 08/31/2012 Reference currency Brazilian real Reference currency notional amount BRL 3,000,000 Notional amount USD 1,971,429 Forward rate BRL/USD 2.80 Reference currency buyer ABC Bank Reference currency seller XYZ Corp Settlement currency US dollar Settlement date 03/31/2013 Settlement Non-deliverable Valuation date 2 days before settlement Capital flows into emerging markets grew significantly during the 1980s and 1990s. However, despite the transition to free market orientated policies in most developed economies, many emerging markets retained at least partial capital control. Their objective was to limit speculative capital movements and to avoid excess exchange rate volatility. Consequently, non-deliverable forward contracts developed as a tool for investors to hedge their exposures in these emerging market currencies. 6 Major NDF trading began in the early 1990s in the Mexican peso and other Latin American currencies. 7 The outbreak of emerging markets currency crises in the 1990s and early 2000s, such as the Mexican peso crisis, the Asian currency crisis, the 1998 Russian financial crisis, and the Argentine peso crisis have further contributed to the establishment of offshore derivative markets for companies to hedge foreign exchange risk. Over the years, the NDF market expanded to more Latin American, Asian and Eastern European currencies. Before focusing on the NDFs in the BRIC currencies and the relevance for the London FX market, it is instructive to consider a historical example to better understand the drivers of the NDF market. NDFs are an instrument designed to deal with non-convertible currencies. As restrictions are lifted and currency moves to a fully floating regime, NDFs become obsolete. The case study of the Mexican peso (see box below) neatly illustrates this life cycle of the NDF market. In the early 1990s, the Mexican peso was the most actively traded currency in NDFs worldwide. When the currency became fully convertible, NDFs were replaced by FX futures and deliverable forwards. Thus, in order to provide an outlook on the NDF market in BRIC currencies it is important to understand the likelihood of these currencies moving to fully floating exchange rate regimes in the foreseeable future (see case study). 6 See, e.g., Misra and Behera (2006). 7 See, e.g., Lipscomb (2005). 11

14 Mexican pesocase study Mexican peso NDFs were among the first to develop in the early 1990s. In early 1988, Mexico was operating under a fixed nominal exchange rate regime in an effort to contain inflation. It then modified its exchange rate system several times between 1988 and 1994, moving gradually to an exchange rate band with a sliding ceiling. The liberation of capital accounts was also welcomed by the financial markets with a surge of capital inflows into Mexico at levels exceeding 7% of GDP in 1991 to Following the advancement in voice brokerage in 1994 that facilitated interbank intermediation, trading volume in NDFs began to increase as deals could more easily hedge the risk from their market-making activities. Trading volume in the Mexican peso became the largest of NDFs, leading to the Mexico crisis of 1994/1995. It is said that the trading volume in Mexican peso NDFs reflected market participant's expectations for a devaluation of Mexican peso, given the slow productivity growth, fiscal account deficit and political unrest. Despite efforts to sustain the pegged exchange rate, the outbreak of the crisis led to the announcement to abandon the exchange rate regime on 22 December 1994, followed by soaring interest rates, a further plunging peso and difficulties for the government to roll over its debt. Figure 2.1 Mexican peso exchange rate and target band The devaluation of the Mexican peso did not stop and prevailing law prevented the Mexican central bank to step in as a lender of last resort. Eventually, in March 1995, the Mexican government stepped in to prevent a collapse of the banking system, and a few days after Mexico reached agreement with the United States, Mexico also arranged a loan package from the International Monetary Fund and others to help it stave off devaluation. The experience of the Mexican peso highlights required market environment for NDFs to be actively traded. One of our interviewees suggested that NDFs tend to exist for currencies with capital control, but not for those in distress. Indeed, trading in Mexican peso NDFs never picked up following the 1994/1995 crisis. Mexican peso futures were reintroduced in April 1995 and trading volume has been high as investors hedged their exposures to pesos. Under the fully floating exchange rate regime, NDFs became redundant in the presence of a liquid futures market. 12

15 2.3. Differences between NDFs and deliverable forwards As NDFs represent a market response to underdeveloped and restricted emerging financial markets, their pricing tends to vary from that of onshore deliverable forwards (which reflects spot and relevant interest rates). The extent of any discrepancy in pricing, however, depends on the stringency of regulations impeding flows between the markets: the less restrictive the controls, the tighter the link between offshore and onshore prices (and hence the greater the extent to which NDF prices reflect spot and interest rates). The more restrictive the regulations, the weaker the link between prices (and the greater the influence of factors other than interest rates on NDF prices). A good example constitutes the pricing of NDFs and deliverable forwards for the Brazilian real. Although NDFs have tended to price the BRL at a greater discount relative to deliverable forwards, prices on the two markets have been highly correlated (especially at tenors below one year), suggesting that the pricing of Brazilian NDFs is largely interest rate driven. By contrast, in a case such as Vietnam, where underdeveloped financial markets preclude trading of deliverable forwards, NDF pricing largely reflects expectations about the future spot level rather than interest rates. For the BRIC currencies in general, the discrepancy between the observed NDF and deliverable forward prices is minimal and the correlation between the respective time series is close to perfect (in general above 99.5%). In terms of risk characteristics, NDFs differ from deliverable forwards in their exposure to market, credit and liquidity risk. Market risk. Although NDFs can face considerable exposure to market risk, it is not significantly greater than that of the deliverable forwards of other emerging market currencies or major currencies. Figure 2.2 plots the average bid-ask spread for the spot, NDFs and deliverable forward rates at different tenors for the four BRIC currencies. The bid-ask spreads, which proxy for overall liquidity in markets, have dropped considerably over the past three years. The averages for 2012 show that the bid-ask spreads in NDF markets are not significantly different from the ones in the spot or outright forward markets. One difference, however, is the fact that the rate volatility of NDFs tends to increase with the tenor, while that for deliverable forwards (both emerging market and major currencies) does not tend to rise with the tenor. By implication, the forward premia or discounts of NDFs appear more volatile than those for deliverable forwards. For risk managers using NDFs to hedge emerging currency exposures, the instrument's cash settlement, based upon the observed difference between the agreed-upon forward rate and the value of the designated fixing rate, leaves hedgers exposed to transfer, basis and rollover risk: Transfer risk: When used, say, to hedge foreign currency revenues, an NDF provides compensation for any difference in value between the agreedupon forward rate and the fixing rate. The hedger, however, retains responsibility for executing the spot sale of its underlying foreign revenue. As such, the NDF provides no protection against the imposition of foreign currency controls that impede that spot transaction or the transfer of funds. Basis risk: Even if able to execute the underlying spot transaction, the hedger is unlikely to execute it at the same rate as the fixing rate used to settle the 13

16 NDF. As such, firms hedging with NDFs retain exposure to basis risk between the fixing rate and the rate on the underlying spot transaction. Rollover risk: Finally, if short-term NDFs are employed as hedges of longer-lived assets or liabilities, the periodic rolling of the NDFs upon their expiry will result in rollover risk a cumulative version of the previous basis risk. This is because the fixing rate used to settle each expiring hedge is unlikely to match the spot rate used to establish the forward rate on each new hedge. To mitigate this risk, hedgers usually use forward-forward swaps (initiated a day or two before the expiry of a hedge to be rolled) to roll NDF hedges. The forward-forward swap ensures that a single, (i.e., common) spot rate is used both to settle the expiring hedge and to establish the forward rate associated with the new NDF. Figure 2.2: Bid-ask spreads for BRIC currencies (NDFs and deliverable Fwds) Sources: Bloomberg, Datastream and authors calculations Credit risk. Because offshore-traded NDFs involve major international banks as counterparties in the transactions, they enable hedgers and investors to avoid direct credit exposure to emerging market entities. For multinational firms seeking to limit emerging market exposure and investors seeking to establish it carefully, this feature of NDFs adds to the instrument's appeal. Liquidity risk. As NDFs involve emerging market currencies, their markets are inherently less liquid and more exposed to fluctuations in liquidity than the markets for major currencies. Figure 2.3 illustrates the liquidity characteristics of emerging market currencies. NDFs tend to have wider and more volatile spreads especially at longer tenors than the deliverable forwards of major currencies. The Brazilian real, Indian rupee and Russian ruble in particular are vulnerable to fluctuations in liquidity. The spreads for other NDFs, however, suggest exposure to fluctuations in liquidity comparable to that of emerging market currencies traded via deliverable forwards, such as the South African rand, for example. 14

17 in % Figure 2.3: Average bid-ask spreads for BRIC currencies by maturities Brazil Russia India China Sources: Bloomberg, Datastream and authors calculations Spot NDF 1M NDF 3M NDF 6M NDF 12M Fwd 1M Fwd 3M Fwd 6M Fwd 12M 3. Developments in the FX and NDF markets This chapter documents the evolution of the NDF market in London, and summarises how FX markets in general and NDF markets in particular have evolved in the past few years The FX market globally and in London Since 1995, the Bank of International Settlements (BIS) has conducted the Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity. One of the goals of the survey is to yield comprehensive and internationally consistent information on the size and structure of foreign exchange (FX) markets. Between 1995 and 2010 the daily global FX turnover has roughly tripled to around 5 trillion US dollars. This number includes spot transactions, outright forwards, foreign exchange swaps, currency swaps, options and other products. The UK (or London) is by far the biggest FX market in the world. It currently accounts for almost 40% of global turnover, more than double the share of New York, a distant second. Growth rates in London have also been far bigger than in any of the competing large FX centres around the world. Total daily turnover in London has almost quadrupled in the period from 1995 to 2010 that is covered by the BIS survey. Apart from the BIS surveys which are only conducted every three years, a second main source of information about FX trading is local FX committees, which are global industry groups, sponsored by major FX centres around the world. These committees provide a forum for market participants to discuss issues of common interest and are essential in developing standards and best practices related to FX trading and 15

18 operations. In London, the Bank of England hosts the Foreign Exchange Joint Standing Committee (FXJSC). 8 The FXJSC along with other committees conduct semi-annual surveys to provide more timely information on the respective local FX markets. Bech (2012) provides an overview of the various committees and compares the results of the various surveys. Based on the latest FX committee surveys, he estimates that the overall daily average turnover per October 2011 was roughly USD 4.7tr. According to FX committee surveys, trading activity grew by 18%, on a weighted average basis, between April 2007 and April 2010 alone. This is in line with the total foreign exchange turnover reported in the 2010 BIS survey (see Figure 3.1). Figure 3.1: FX committee survey daily volumes (USD trillion) London New York Singapore Tokyo Australia Canada Source: FX committee surveys Apr-05 Oct-05 Apr-06 Oct-06 Apr-07 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Furthermore, comparing the results from the various surveys reveals the dominant role of London as a centre for FX trading as the turnover in the London market dwarfs that of any other market centre. At slightly over USD 2tr per day in 2011, its reported volume is larger than the other surveyed markets put together (the latest number for London comes in at USD 2.3tr as of April 2012). Again, New York is ranked a distant second with less than half of London's volume, while the remaining markets are nowhere near to breaking the USD 500bn mark. 8 Other committees in FX centres include the New York Foreign Exchange Committee (FXC), the Singapore Foreign Exchange Market Committee (SFEMC), the Tokyo Foreign Exchange Market Committee (TFEMC), the Australian Foreign Exchange Committee (AFXC) and the Canadian Foreign Exchange Committee (CFEC). 16

19 Using the latest available data for London from the semi-annual FX turnover survey published by FXJSC, total turnover has almost quintupled since Figure 3.1 displays the evolution of total turnover in the various FX markets as documented by the surveys since April Figure 3.1 also illustrates that the gap between London and its competitors has widened. Over the period between 2007 and 2010 London has recorded overall growth in excess of 30% as compared to the global average of 18%. Over the last four years between April 2008 and April 2012, the overall growth has been even higher reaching 70%. There seems to be a wide consensus among market participants based in London that it will retain its global edge for the foreseeable future. Some of the reasons supporting this view are discussed in section Global spot trading in BRIC currencies All the BRIC currencies have either controls or restrictions in place, which gave rise to trading in NDFs in the first place. However, even the volume of spot transactions has increased tremendously over the last decade as documented by the Triennial Central Bank Survey conducted by the BIS. The global volume of spot transactions for BRIC currencies between the 2001 and the 2010 survey has increased more than five-fold to a daily average of over USD 48bn. In particular, the market in Chinese renminbi has developed significantly during this time, from a turnover of only USD 39m in the spot market in 2001 to USD 8bn in However, as mentioned earlier, only licensed onshore counterparties are allowed and appropriate documentation is required. Table 3.1: Global average daily trading volume in 2010 Spot Forwards USD m (% global) USD m (% global) Brazilian real 8,518 (0.57%) 12,866 (2.71%) Russian ruble 18,139 (1.22%) 2,262 (0.48%) Indian rupee 13,527 (0.91%) 13,620 (2.87%) Chinese renminbi 8,123 (0.55%) 14,248 (3.00%) US dollar 1,187,699 (79.70%) 391,501 (82.42%) Euro 691,210 (46.38%) 149,687 (31.51%) Japanese yen 300,214 (20.15%) 115,111 (24.23%) British pound 212,976 (14.29%) 54,844 (11.55%) Swiss franc 92,090 (6.18%) 19,076 (4.02%) All currencies 1,490,205 (100.00%) 475,007 (100.00%) Source: BIS Triennial Central Bank Survey, April 2010 In comparison, global turnover for spot currency transactions has almost quadrupled during the same period to just under USD 1.5tr per day. In terms of volume, the BRIC currencies account for just 3% of global spot transactions and it reflects the limited convertibility of these currencies. The number almost seems negligible given that the most important currencies such as the US dollar, the euro, the British pound, the 17

20 Japanese yen and the Swiss franc, account for a share of 160% of global volume. 9 However, over the past decade, the BRIC currencies have increased their share in spot transactions by more than one third as they have become more integrated with the world economy. The first column in Table 3.1 reports the volumes in spot transactions expressed in million US dollars as per the last BIS survey conducted in While BRIC currencies will not achieve the importance of the established and most liquid currencies of developed countries in the near future, the continued growth of the BRIC economies will have a positive impact on the demand for their currencies Global forward trading in BRIC currencies Paralleling the growth of spot FX transactions, volumes in the FX deliverable and nondeliverable forward market have also increased almost four-fold during the last decade. The numbers from the 2010 BIS survey are displayed in the second column of Table 3.1. The US dollar, the euro, the British pound, the Japanese yen and the Swiss franc again account for over 150% of total turnover, while the BRIC currencies only have a share of 9% with a global daily turnover of over USD 42bn. While it is not possible to obtain separate global numbers for deliverable forwards and NDFs, NDFs in general account for over 95% of the forward volume in the BRIC currencies. 10 Thus, in the following, the global numbers for BRIC currencies are interpreted as reflecting NDF volume. While the overall share of 9% is still relatively small, growth numbers are much more impressive: the global growth in FX forwards for BRIC currencies in the past decade has been more than six times more than the overall growth in forwards according to the BIS surveys. Even allowing for the extremely low starting levels in 2001, growth is substantial: from 2007 to 2010, volume in BRIC currency forwards increased by over 150%. Growth in the Brazilian real has been 144%. Growth in the Russian ruble has been 80%. Growth in the Indian rupee has been 134%. Growth in the Chinese renminbi has been 210%. By comparison, global growth in FX forwards has remained below 30% over the 2007 to 2010 period. It is not surprising to see that volumes for spot transactions in the most important and most liquid currencies like the US dollar, the Japanese yen or the euro are much larger than volumes for forward transactions, given their role as reserve currencies. For example, the volume of forward transactions in the largest currencies listed in 9 Note that the transactions of a particular currency are measured against all other currencies. Hence, the fractions sum up to two hundred percent instead of one hundred percent. 10 In the past surveys (including the most recent published in 2010), the BIS has subsumed NDF trading volume in the outright forward category. This will change with the next survey, which will be published in 2013 (containing detailed numbers as of April 2013), since the new questionnaire contains specific questions about NDF trading. Using the FXJSC semi-annual survey conducted in London, it is possible to estimate what fraction of the BRIC currency forward contract volume can be attributed to NDFs. With the exception of Russia, these fractions are 95% or higher. 18

21 Table 3.1 reaches only about 30% of the corresponding spot transactions. For the BRIC currencies, the pattern looks entirely different and global spot transactions exceed the forward transactions by only about 12%. Unsurprisingly, excluding the Russian ruble which is in fact fully convertible, reverses the picture. Global spot transactions in the Brazilian real, the Indian rupee and the Chinese renminbi reach a daily volume of USD 30bn in 2010, whereas the corresponding volume for (non)- deliverable forwards is more than USD 40bn NDF trading in London Data from the semi-annual FXJSC surveys allows the development of the FX market in London to be described in more detail. In particular, since the survey reports NDF trading volume separate from deliverable forwards, it is possible to gauge the importance of NDFs and to the track the evolution of the NDF market in the UK. As discussed earlier, the London FX market has grown significantly in the recent past to reach a daily turnover of just over USD 2.3tr in April Spot transactions account for roughly a third of the volume, while deliverable forwards and NDFs account for about 10% of the overall turnover, with swaps and options accounting for the remaining 58%. 11 NDFs only account for about 2% of the overall turnover in London. However, they are very relevant within the forward market segment, where they account for almost 20% of the daily turnover of USD 215bn, up from just 10% three years earlier. In terms of growth rates, the NDF market has fared very impressively in the last three years. Table 3.2 contains the time series of the daily NDF trading volumes in the four BRIC currencies from April 2008 to April 2012, taken from the semi-annual FXJSC surveys. Trading in all currencies but the Russian ruble has increased significantly, with the biggest growth seen in the volumes for the Indian rupee. NDF trading volume in the Brazilian real has increased from USD 4.3bn in 2008 to USD 6.3bn in 2012, which corresponds to an increase of 45%. The Russian ruble has seen a drop in NDF volume from USD 3.5bn in 2008 to USD 2.4bn in However, the ruble is the only convertible currency and unlike the other BRIC currencies, there is significant volume in deliverable forwards as well. Overall, volume in deliverable and non-deliverable forwards on the Russian ruble has dropped slightly from USD 4.7bn to USD 4.1bn between 2008 and 2012, which corresponds to a reduction of about 13%. Given the good convertibility of the Russian ruble, NDFs and deliverable forwards can be used as substitutes. NDF trading volume in the Indian rupee has increased from USD 1.5bn to USD 5.2bn, which corresponds to an increase of almost 250%. NDF trading volume in the Chinese renminbi has increased from USD 2.1bn to USD 5.5bn, which corresponds to an increase of 160%. 11 These numbers are comparable to other major FX centres. For example, in New York, the fractions for the spot and forward transactions are 50% and 17%, respectively, while in Singapore, the fractions are 27% and 12%, respectively. 19

22 Table 3.2: Average daily NDF turnover in London for BRIC currencies (USD m) BRL RUB INR CHY Total Apr 08 4,325 3,515 1,481 2,147 11,468 Oct 08 4,272 2,679 1,386 1,510 9,847 Apr 09 3,469 1,158 1,312 1,154 7,093 Oct 09 6,128 1,345 3,479 2,089 13,042 Apr 10 4,234 1,136 3,212 3,948 12,529 Oct 10 6,337 1,564 6,099 6,046 20,046 Apr 11 7,589 2,169 4,950 5,873 20,581 Oct 11 6,168 1,497 4,627 6,398 18,690 Apr 12 6,282 2,401 5,159 5,545 19,387 Source: FXJSC Semi-Annual FX Turnover Survey Using information contained in Tables 3.1 and 3.2, it is possible to roughly estimate the importance of London for the global NDF market. In order to compare the results from the two different sources, it is necessary to use the London data as of The NDF volume reported for London in 2010 accounts for, respectively, 49%, 69%, 42%, and 45% of the global turnover in all forward contracts (i.e. NDF and deliverable forwards combined) in the Brazilian real, the Russian ruble, the Indian rupee and the Chinese renminbi reported in the latest BIS survey from This seems like relatively little considering the previously documented dominance of the UK FX market. However, given the available data, it cannot be ensured that the comparison is fully consistent and appropriate. For instance, the NDF volumes in London almost double from the April 2010 to the October 2010 survey, but corresponding updated BIS figures are not available for comparison. Using the numbers from the October 2010 FXJSC survey, the NDF market in London accounts for almost 50% of the global forward volume in the BRIC currencies. This would represent a considerably higher share for London in the NDF (and also overall forward) market compared to the London share of the overall FX market. 13 In addition, Figure 3.1, which illustrates the widening gap in overall FX volume between London and its main competitors, suggests that, if anything, the global importance of the London NDF market has increased further in the last two years since the last BIS survey was conducted. This notion was also supported by the interviewed market participants, who had seen volumes growing. Finally, the FX centres contained in Figure 3.1 neither report deliverable nor NDF volumes for the BRIC currencies separately. 14 This means that turnover in forwards (or NDFs) on the 13 One obvious inconsistency between the data released in the BIS Triennial survey and the local surveys conducted by the foreign exchange market committees is for example the daily trading volumes for forwards on the Russian ruble. The London survey reports a combined NDF and deliverable forward volume in Russian ruble in April 2010 that exceeds the global number that is reported by the BIS for the same time. 14 The exceptions are New York and Singapore. New York reports an average trading volume in forwards on the Brazilian real that is about 80% higher than London, and Singapore reports an average trading volume in forwards on the Chinese renminbi that is about 70% lower than London. 20

23 BRIC currencies do not seem to be large enough to warrant a distinct category. It can therefore be concluded that there is no other central hub for NDF trading in the BRIC currencies Reasons for London s success and outlook As long as the underlying currencies are subject to capital controls or trade restrictions, NDFs will play a relevant role in hedging emerging market currency risks. There is some uncertainty about whether and when the BRIC currencies will move to a fully floating exchange rate regime, but there is a consensus among the surveyed market participants that this is not likely to happen in the near future. However, all market participants agree that London will unconditionally retain its dominant position in the FX market. There are various reasons why all surveyed market participants for this report are confident that London will retain its dominant role in the FX market. In the view of the interviewees, London is in a unique position as it has certain natural advantages, such as being in the right time zone for instance. Other reasons include the pool of available talent, the existing infrastructure, and the stable political and regulatory environment. Time zone. London, compared to New York or Singapore, has a time zone advantage especially for the African currencies and the Russian ruble. This is mirrored in London's dominant position in NDF trading in these currencies. Figure 3.2 plots liquidity measured in trading volume for the four BRIC currencies around the clock. Time intervals are in terms of GMT. As one can see, trading hours overlap with the London working day in the first instance and London is in between the trading hours of Asia and Latin America. London's main competitor, New York, has a twelve hour difference to the Asian countries, which makes it difficult for New York based traders to cover these currencies. Talent & infrastructure. London already constitutes one of the largest financial centres in the world in particular for fixed income and foreign exchange markets. It has all the infrastructure and talent it needs to provide the necessary conditions to trade in any asset. Political climate. London has a very stable political climate and, despite the higher taxes compared to some financial centres including Singapore and Geneva, traders in general prefer to live in London (see, eg., Economist, 2011). Regulatory environment. The regulatory framework is very business friendly (especially compared to other European countries), although there is some uncertainty on how this will evolve in the future (see also section 3.6). 21

24 Figure 3.2: Liquidity at a glance BRL CNY INR RUB 12am 2am 4am 6am 8am 10am 12pm 2pm 4pm 6pm 8pm 10pm = least = med = most These issues are not exclusive to NDF trading but pertain to the London FX market in general. However, the interviewed bankers felt that some of the reasons mentioned are even more important for the relatively less liquid NDFs. Given the small size of the NDF market, it is for example important that the banks that are active in the NDF market have a critical size in order to keep costs to a reasonable size. Achieving the critical size is easier for global banks that operate from a centre where they have ideal access to clients and other market participants. As illustrated by the Mexico peso example, it is essential to constantly gauge the probabilities that one or all of the BRICs will lift its capital controls and move to a fully flexible exchange rate regime. The case study nicely illustrates the life-cycle of an NDF from its origin to its conversion to a deliverable forward. For a time horizon of five years, some of the interviewed bankers predict that NDF trading in the Russian ruble will be replaced by deliverable spot or deliverable forward trading (a trend that seems to be supported by the trend in Table 3.2) given that the ruble is already fully convertible and deliverable. Similarly, China is expected to further open its market to foreign investors. Liquidity in the Chinese renminbi is already very high, which is also reflected in the small bid-ask spreads. Among the four BRIC currencies, India is expected to remain one of the most closed countries and, therefore, NDF trading in the Indian rupee is expected to continue to grow. To conclude, it should be noted that the disappearance of capital restrictions and the subsequent move from NDFs to deliverable forwards should not have a negative impact on the competitive edge of London. In fact, all the arguments favouring London as an FX centre obviously carry over to deliverable forwards as well. While the interviewed bankers believe that the importance of the NDF market is not yet declining, London would just as easily pick up the additional business if there was indeed a substitution of deliverable forwards for NDFs. 22

25 3.6. Regulation and NDF trading Among all interviewees, the regulatory changes in the US (Dodd Frank Act) and Europe (European Markets Infrastructure Regulation) were raised as the most important factors affecting the future of NDF trading in London. The main regulatory changes and their implications can be summarised as follows: Market participants. Asset managers and hedge funds are expected to centrally clear NDFs and FX options, and execute them on electronic platforms. They will also need to report a significant proportion of these transactions. Corporate clients, on the other hand, which use FX instruments for commercial hedging purposes, are expected to be exempt from these requirements. Bifurcation of FX. NDFs and FX options will be migrated to electronic platforms and central clearing. Spot and most probably FX swaps and forwards will continue to be traded on a bilateral OTC basis. Costs. Costs will rise for most market participants not only because of the new regulatory framework but also because of the new capital standards, which are outlined in Basel III. Clients which currently trade FX through prime brokerage accounts will be required to move part or all of these transactions to clearing which will increase transaction and margin funding costs. 15 In general, the new rules will mean higher margin requirements for cleared and uncleared transactions and increased costs for end users choosing to trade bilaterally. With the target date for the implementation of central clearing regulation in Europe in the beginning of 2013, one essential result of the new regulatory framework will be the bifurcation of FX as an asset class, which will see NDF products under the full extent of the European Markets Infrastructure Regulation. BRIC NDFs are already being cleared by LCH.Clearnet, an independent clearing house based in London. CME will most likely follow suit and is expected to introduce an OTC FX clearing service on its London exchange in However, the extent and manner of the impact of the new regulations will depend on the type of market participant, as analysed below tracking the full trade lifecycle. Pre-trade transparency. The NDF market is expected to migrate to electronic platforms which aggregate liquidity from a number of dealers. Having been the preserve of single dealer portals, NDF market participants are likely to benefit from greater visibility of multiple quotes. Execution. All parties trading in NDFs are subject to centralised execution and clearing apart from qualified non-financial entities that trade in the FX market to hedge or mitigate commercial risk. It is expected that liquidity will be dispersed across a number of service providers who compete to offer the most comprehensive aggregation services, the best technological offering and additional services like cross-asset margining and clearing services. This will be likely to improve the efficiency of the NDF market. 15 See Deutsche Bank (2012). 23

26 Post-trade transparency. Trade reporting requirements will have a material impact on all market participants. NDF trades are subject to real-time public disclosure of trade data on an anonymous basis. While this has a large impact on market liquidity, it is yet to be seen whether it will further reduce spreads. Some have voiced concern that greater transparency will reduce dealers' willingness to make markets. Moreover, prompt disclosure requirements result in substantial technical and operational burdens that may best be minimised by dealing on a central counterparty. Pre-settlement risk. Financial counterparties will be required to centrally clear NDFs, resulting in higher margin requirements. The clearing process is further made expensive as the proposed regulations also place limits on the types of collateral accepted. In turn, such costs are likely to be passed on to non-financial clients. Moreover, clearing rules are likely to result in the standardisation of NDF products, since individually tailored transactions become expensive to trade bilaterally. This would entail a transfer of basis risk from the sell side to the buy side. Overall, two main impacts of the prospective regulatory change are expected: transaction and operational costs will increase. Indeed, most interviewees from major banks mentioned that the cost issue is going to be the main determinant of how trading volumes of NDFs will evolve in the future as clients seek more cost efficient alternatives. Consequently, market liquidity will be altered and fragmented as the pre- and post- trade reporting as well as clearing requirements limit the willingness of dealers to provide competitive prices for less liquid products. Interviewees indicated that they expect NDF trading to be increasingly concentrated in the top tier banks, while second and third tier banks, which are still in the market at the moment, will be squeezed out. In summary, like the FX market overall, the future of NDF trading in London depends heavily on the new regulatory changes currently taking place around the globe. While all interviewees agree that there will always be a demand for NDFs (due to the need to hedge emerging currency risk), trading volumes in certain currencies will certainly drop as a function of political and macroeconomic conditions. 4. Summary and conclusion Over the last four years, the UK trading volume in NDFs in the four BRIC currencies, which are the focus of this report, has increased by almost 70% to reach a daily average turnover of almost USD 20bn. The key conclusions from the study are: BRIC currencies. Paralleling the impressive economic growth, trading volume in BRIC currencies has increased dramatically in the last three to four years. Given the existing restrictions in these currencies, NDFs account for a large fraction of the overall volume of FX trading in these currencies. BRIC currencies in London. NDF volume in BRICs has increased by almost 70% between April 2008 and April 2012, thus dwarfing the overall growth in FX volume in London of 13% during the same period. 24

27 NDFs vs. deliverable forwards. A move to a fully flexible exchange rate regime in the BRIC currencies would make NDFs obsolete. However, the surveyed market participants in London do not expect this to happen in the near future. As a consequence, the importance of NDFs will continue to grow along with the BRIC economies. Use of NDFs. The surveyed market participants estimate that about half of trading in NDFs is due to hedgers that have an underlying exposure in the respective currency and about half of trading is driven by investors and speculators who want to trade on their views about the currency or the country in general. This is not expected to change dramatically in the future. Regulation and NDFs. NDFs are OTC products and therefore by their nature, subject to minimal regulation. This is expected to change given the fallout from the financial crisis and a general trend towards more oversight. The main change that is expected to be implemented before the end of 2013 concerns central clearing and additional reporting requirements. This will undoubtedly result in an increase in operational and trading costs for banks and clients. It is essential to ensure that London s competitiveness will not suffer by imposing regulatory standards that are more stringent than those imposed on other financial centres in the rest of the world. London and the future of the NDF market. There is a consensus among the surveyed banks that London will maintain or even extend its lead in the FX market in general and the NDF market in particular. Moreover, even if the BRIC currencies are eventually moving to a more flexible regime, London will be the natural market for trading in deliverable FX forwards. 25

28 Bibliography Bank for International Settlement, Report on Global Foreign Exchange Market Activity in Triennial Central Bank Survey. Bech, M. L., FX Volume During the Financial Crisis and Now. BIS Quarterly Review, 1 March Deutsche Bank, Exchange Rate Perspectives: How Regulation Will Reshape the FX Markets. Economist, Financiers in Switzerland: Careful what you wish for. Economist, 3 March Lipscomb, L., An Overview of Non-Deliverable Foreign Exchange Forward Markets. Working Paper, New York Federal Reserve Bank. Misra, S. & Behera, H., Winter Non Deliverable Foreign Exchange Forward Market: An Overview. Reserve Bank of India Occasional Papers, 27(3).

29 City of London Economic Development PO Box 270, Guildhall, London, EC2P 2EJ