uTrade Algos
The Indian currency market, known as the foreign exchange market, facilitates the buying and selling of foreign currencies against the local currency, the Indian Rupee. Trading involves major global currencies like the US Dollar, Euro, British Pound, and Japanese Yen, among others. Compliance with the regulations set forth by the Reserve Bank of India (RBI), the central bank, is essential for currency trading. The RBI oversees and governs foreign exchange transactions, establishing the exchange rate regime in India. Through your trading account, you can monitor real-time currency prices and actively engage in the currency market. Read on to know more.
Table of Contents
Offshore and Onshore Markets
Offshore Markets
● Offshore markets refer to financial markets that are located outside of the jurisdiction where the securities themselves are issued and traded.
● These types of markets are commonly located in countries with low taxation and less stringent regulations, making them attractive for investors looking to avoid stricter onshore regulations.
● Consider this example: Many securities issued in the US are traded in offshore markets in the Caribbean or London.
● Offshore markets allow easier access to international investors and can have different disclosure requirements compared to onshore markets. However, trading in offshore markets may involve higher intermediation costs.
Onshore Markets
● Onshore currency markets, or domestic financial markets, are where securities are both issued and traded within the same jurisdiction.
● For example, the BSE is considered an onshore market for Indian securities.
● Onshore markets have the advantage of closer proximity to the companies they are trading with and easier access for domestic investors.
● Onshore markets are regulated by domestic regulators like SEBI in India, which offers strong investor protections.
● However, onshore markets can be more expensive for companies as they need to comply with stricter regulations.
● Trading costs may be higher compared to offshore markets due to tighter regulations.
How Do Offshore and Onshore Currency Markets Work?
Working of the Offshore Currency Market
● Offshore currency markets operate outside the jurisdiction of a country’s financial regulators and function with less regulatory oversight.
● For example, the trading of Indian Rupee outside of India is considered the offshore rupee market. Banks and financial institutions carry out arbitrage activities between onshore and offshore markets to take advantage of differential regulatory environments and exchange rate differences.
● Participants benefit from anonymity and lower transaction costs in offshore markets. However, offshore markets are open to higher volatility and speculation due to a lack of central bank intervention.
Working of the Onshore Currency Market
● Onshore currency markets operate within the jurisdiction of a country and are regulated by its central bank.
● For example, the onshore Indian Rupee market is regulated by the RBI. The central bank closely monitors the currency exchange rate and intervenes periodically to stabilise excessive volatility.
● The onshore market has lower credit risk as banks operate within the purview of domestic regulations.
● Market liquidity is higher due to the presence of local banks, businesses, and investors. However, transaction costs are higher for participants due to regulatory restrictions and compliance requirements.
● Participants get better prices but have less flexibility and anonymity.
Trading NDF Contracts in the Offshore Market
Trading in the currency market is definitely complicated for every trader. As a trader who wants to trade outside the nation, you need to know the challenges. Fortunately, there is a solution to this problem. This solution can be solved by using non-deliverable futures (NDF) contracts.
Suppose a USD/INR futures contract is sold in the over-the-counter (OTC) market based in London. Many non-deliverable futures are traded on offshore foreign exchange. Similar to your futures contract, these contracts are traded in large financial markets such as Singapore, Dubai, and the New York Stock Exchange, where the delivery of underlying assets doesn’t happen.
The NDF market is made for currencies where the local currency derivative market is not developed up to the mark or has some restrictions for different reasons. Key players in the offshore market are international banks, companies doing business, currency traders, hedge funds, and investment banks.
Example of NDF
● An XYZ trader, requiring settlement in their native currency, can engage in trading using Rupees but ultimately needs settlement in their home currency.
● In a scenario where the Indian Rupee is anticipated to depreciate against the Dollar in the coming months, a trader opts to purchase a forward contract for Indian currency. Due to exchange restrictions, settlement occurs in dollars.
● Traders can utilise non-deliverable forwards (NDF) for currency trading, effectively navigating liquidity barriers. NDFs enable traders to access the currency market and manage exposure, particularly in situations with limited liquidity or exchange constraints.
Fabric of the NDF Market
With the use of NDF, currency traders can reach an agreement to settle the differences in rates of currencies. So here, there will be an agreed price on the contract and the spot rate in cash, mostly in US Dollars. Here, all the deals in the NDF market are held in USD.
Cash Flow = (NDF rate – The spot rate)* Face value
Most of these contracts are held for a short period of time. Here you can see the currency pair, notional amount, spot rate, settlement date, NDF date, and lastly, the fixing date.
The fixing date on an NDF can be considered the same as the expiration date of a futures contract. On the fixing date, the NDF is settled on the spot rate of that day, and one party pays the difference to the other.
Benefits of the NDF Market
Here are the benefits of the NDF market in the currency market:
● Access to different currencies: NDFs allow trading in currencies that have restrictions on capital flows and cannot be easily exchanged onshore. For example, the Chinese yuan trades actively in the NDF market despite capital controls in China.
● Hedging currency risk: Entities with exposure to a restricted currency can use NDFs to hedge their currency risk. Multinational corporations use it to hedge emerging market currency exposures to mitigate the risk of currency rate change in the future.
● Speculation: The NDF market provides an avenue for investors to speculate on the movement of currencies. Traders take a view on the future direction of exchange rates and accordingly manage their currency trade.
● Lower counterparty risk: Unlike deliverable forward contracts, the NDFs have lower counterparty risk as no physical delivery of the underlying currency takes place. As a result, traders can simply focus on the price change of the currencies.
● Customisable contracts: NDF contracts can be customised in terms of size, tenor, and settlement terms to meet specific risk management needs. Thus making it flexible for both partners in the contracts.
● Operational efficiency: Lack of physical settlement reduces documentation, operational workflows and costs associated with deliverable forwards.
Drawbacks of the NDF Market
The NDF market has certain drawbacks, these being:
● Limited Accessibility: NDFs are typically offered for currencies of emerging or restricted markets where exchange controls exist. This restricts access for traders and investors who seek exposure to these currencies but face limitations due to regulatory constraints.
● Lack of Transparency: The NDF market often operates in over-the-counter (OTC) settings, which can lead to a lack of transparency compared to exchange-traded markets. This opacity may result in pricing discrepancies and less efficient price discovery.
● Counterparty Risk: As NDFs are typically traded over the counter, they involve counterparty risk. There is a potential risk of default or financial instability of the counterparties involved in these transactions, leading to financial losses.
● Limited Hedging Tenors: NDF contracts might have limited available tenors or maturity dates compared to standardised exchange-traded currency futures or options, reducing flexibility for hedging specific exposures over longer durations.
● Basis Risk: NDFs are settled based on a reference rate and not the actual spot rate. This discrepancy between the reference rate and the actual spot rate introduces basis risk, potentially leading to differences in realized and expected gains or losses.
● Regulatory Changes Impact: Changes in regulations or policies in the involved countries can significantly impact the NDF market’s functioning and liquidity, causing uncertainty for participants.
Conclusion
As India’s economy connects more with global markets, its currency market has grown, offering hedging chances for traders. However, this connection also brings exposure to risks from global currency changes. To excel as a currency trader, it’s vital to explore opportunities in the market. Learn diverse strategies and their implementation with Share India to make informed trading decisions and navigate currency fluctuations smartly.