NDFs – The New Model Market?

Volumes in NDF markets have increased dramatically in recent years, but what is behind this accelerated activity and will it continue? More importantly, what role are the lessons learned from the G10 markets playing? Colin Lambert finds out.

The biggest growth story in foreign exchange over the past two years since the Bank for International Settlements’ 2016 Triennial Survey of FX Turnover has largely taken place in the shadows, for while spot volumes have largely plateaued, activity in the non-deliverable forward segment has grown exponentially. NDF average daily volumes, as reported by the UK and US foreign exchange committees, is 50% in the two years from April 2016 – a pace of growth no other product can match.

In the UK, NDF daily volumes are rapidly approaching those in FX options, while in the US, NDFs have already surpassed options in terms of activity levels. The same may be the case elsewhere, but anecdotal evidence is all that is available because outside of the UK and US, no other foreign exchange committee breaks out NDF volumes. Even more remarkably, given how NDFs are approaching FX options in terms of their importance, the 2016 BIS survey did not even break out NDF volumes – an oversight likely to be corrected when next April’s survey is taken.

All of this goes to highlight how NDFs have, to a degree, been flying under the radar – people are aware of the product set but few are as aware of the pace of growth. “I think people are confused with NDFs,” suggests a hedge fund manager in Europe. “They are seen as this product with really good margins – and no little risk – but the reality is spreads have tightened considerably. The banks especially are under pressure to compete and I just don’t think some of them are ready for that yet, they still think its like FX swaps where they have a virtual monopoly.”

The biggest market structure difference between NDFs and FX swaps is, of course, that the former are treated as a derivative by most regulators and are therefore subject to margin rules. The advent of NDF clearing has helped newer players into the market. Although global trading data is not available, clearing data is and LCH, which is the dominant player in the space, has recorded serious growth over the past two years. In April 2016, LCH says it cleared $86 billion in notional value; in April 2018, it was $1.3 trillion. That amounts to around $62 billion per day – in other words, LCH is likely pretty soon to be clearing as much per day as it was per month just a short while ago.


Although manual traders continue to make up the majority of participants in NDF markets, the proportion of electronic trading is growing rapidly. “Our volumes are up 25-30% year-on-year for the past three years and this reflects the larger number of participants pricing and trading electronically,” says Jeff Ward, head of NEX Markets, Asia. “Our LPs are more comfortable pricing these markets because they have better quality data, and this feeds back into the market, which creates a positive feedback loop.

“In emerging markets generally we are seeing increased use of algos, obviously it is still behind G10, but the market impact benefits – which are crucially important in NDFs – mean it continues to be a growth story,” he adds. “The extra data that is provided by increased activity will also help feed the algos, so I think the growth will continue.” The European hedge fund manager agrees, “Without a basic algo strategy it would be a lot harder to trade these markets, the best order type to use is the Iceberg. About 90% of orders we submit to platforms that support the order type are Icebergs.”

Market sources say that Iceberg orders account for around 50% of flow in some NDF pairs, with others seeing a 25% ratio for the order type. While an Asia-based hedge fund manager sees the benefits of Icebergs, they also stress the importance of the right structure. “We keep hearing that some platforms want to reduce the minimum amount shown on a Iceberg from $3 million to $1 million and I think that would be a mistake because it could encourage pinging from players just looking to sniff out the larger orders.”

An Asia-based e-trading head agrees, “You have to look after the manual traders – the clickers. They still make up the majority of the market and as an LP they are probably the most lucrative counterparties on a dollars-per-million basis. If these guys are selling five or 10 million, they don’t want to hit one million – what if it is someone sniffing around for orders? If the minimum hit on an Iceberg is higher, then that will encourage manual traders to engage with the market.”

Ward is fully aware of the need to protect the trading ecology. “The key for a platform provider is the rules,” he explains. “We have spent a lot of time looking at the ecology of our market, and that involves the use of MQLs (minimum quote lifespans) and other behavioural rules. Without these rules you risk the market structure and we have to be careful we don’t allow behaviours that could disrupt these markets because they are smaller and more fragile and therefore more sensitive to events.”

Another driver of growth has been the introduction of non-bank liquidity providers to the NDF market. “Better data brings a broader set of players to the market and is helping strengthen the market structure,” observes Ward. “We have definitely seen the benefits of some of our prime clients being able to participate in NDF markets.”

The Asia e-trading head has also seen a change in the make up of market participants. “We definitely see more non-bank LPs than we did even six months ago. It varies but in the more liquid NDF pairs I reckon upwards of 20% of tickets we print are with this segment. It’s by no means uniform, but there is a growth story there for sure.”

Paradoxically, in the UK – the only centre to break out such data – in April 2018, 22% of NDF volume was via a prime broker, whereas two years ago it was over 30%. “What we have seen is the non-banks make up a larger piece of a bigger pie,” suggests a source at major prime broker. “There is no doubt that having a strong primary market like EBS is helping to build volumes, and the combination of a strong CLOB and better access via prime brokerage is helping grow the market further. The non-banks undoubtedly have a bigger presence than they did – they were nonexistent just a year or so ago – but unlike in spot where it could be argued they drove some banks away from the role of liquidity provider, in NDFs they seem to have encouraged more participation.”

There is little doubt, however, that another big driver has been clearing. “The combination of a strong central limit order book at EBS and clearing has made it less expensive to trade NDFs,” says Paddy Doyle, head of Forexclear at LCH. “Since the start of clearing, we have seen banks take another look at the NDF market because with all trades booked against a central counterparty, their risk weighting for the trades goes to 2%, whereas previously it was 20% for a AAA-rated bank.”

Doyle is keen to stress the good job that prime brokers do in allowing market access to NDF markets and points out that clearing itself is rarely seen as a market access tool for new participants. “Prime brokers facilitate market access,” he acknowledges. “Clearing is a more capital efficient mechanism that enables the PBs to better manage their costs of capital.”

By way of explanation, Doyle points out that without clearing, the capital cost allocated to a prime broker could be as high as $20-40 per million “and that kills the business”. He adds, “We are not here to change the market structure, we see ourselves as a crucial support for the prime brokers that facilitate their business. Without this mechanism the uncleared margin costs for PBs would be significant.”

Lessons Learned

There are those who believe that the NDF market has experienced the growth it has thanks to lessons learned from the G10 markets over the past 15 years. “NDFs have done well because they have grown without denigrating the market ecology,” argues the Asia-based e-trading head. “Part of that is to do with the rules on EBS especially, where care has been taken not to promote a race to zero the way it may have been in G10 a decade or more ago.”

This has been helped in no small part by the change in attitude of a small, but important group of non-bank firms, which have shifted their business models towards that of a bank with a preference for the disclosed, bilateral relationship-based approach. “There is no doubt that the blurring of the lines between some non-bank players and the banks has helped build a healthy ecosystem” accepts the Asia-based hedge fund manager. “In G10 there was an unhealthy competition between the two which wasn’t helpful for customers because it was hard to know who to listen to. One group was top of book in small and predicated upon speed, the other was wider and slower. The two models have merged to a great degree now and I think that is showing up in NDFs where everyone is on the same page when it comes to market development and structure.”

The Asia-based e-trading head agrees, “In NDFs, the LPs have control because they all understand the value of their liquidity and they are not willing to give it away to anyone, at any price, for market share purposes the way they were in G10 five years ago. This is not just about banks, the non-bank firms feel the same way.

“This in turn means the platforms with the fairest trading environment will be supported and have to maintain their standards because if they don’t, the LPs will move to another platform,” the e-trading head continues. “It’s not a question of protecting value, the spreads are tight – it’s about making it a fair and transparent market place in which everyone can operate.

“I can’t emphasise enough the importance of protections. It’s not for one group, it’s about all players, its about protecting the future of the market and all views need a voice. It is important that the market place reflects that, it is about so much more than the price.”

To the e-trading head the behaviours that have been clamped down include, flashing, pinging, spoofing, shadow pipping, and layering. “These are not unique to the NDF market, of course, but in G10 all had their time in the sun, periods where they were tolerated, or not observed. In NDFs everyone – most importantly the platform operators – know what to look for and so they can clamp down much quicker.

“We are also lucky in that we are developing these markets with much better data around how people are trading. The analytics that people are using in G10 are just as useful in NDF markets and that will help root out unfair behaviour before it can become embedded, as was the case in G10.”

The result of what may be seen in some quarters as a more stricter market structure appears to be increased activity, although that could be down to macro-economic drivers – as always, in 2018 there have been events in emerging markets guaranteed to increase volatility.

The underlying growth is what gives heart to proponents of the NDF market model, however, as NEX’s Ward observes. “The NDF market is more robust than it was three or five years ago. You can get a two-way price pretty much all day and the time of day activity has smoothed, there are no longer activity windows the way there used to be. These markets are still subject to volatility events of course, so they can still be a challenge for customers, but liquidity levels overall seem more robust.”

Interestingly, Ward warns that the NDF markets tend to react differently to volatility spikes than G10 markets. “Volatility does not necessarily have the same impact in emerging markets as it does G10, where activity goes higher,” he explains. “In NDFs we have seen instances where volatility has spiked higher but activity levels haven’t and that has led to the inevitable impact of wider spreads and less inventory.”

For the Asia-based hedge fund, however, volatility equals opportunity. “We can exploit opportunities in NDFs now that we couldn’t three years ago because the pricing and liquidity is more robust. Banks’ pricing has become tighter because of the entry of non-banks. It hasn’t been great for all of them, but the smart ones realise there is still good value in this business at tighter spreads. It’s just not as easy as it once was when spreads were much wider.

“Having said that, there is still a bunch of banks whose pricing is nowhere near as good as one or two of the non-banks and they will see their position eroded. You can’t get away with wide pricing in NDFs any more, we’re all too well informed and the competition levels are higher,” the hedge fund manager says.


As inferred earlier, however, these markets are not without challenges – the most obvious being volatility spikes based around events. As with all markets, however, the more events the market witnesses, the better it becomes at handling them. “Crises will always trigger increased flows,” says Ward. “But my sense is the baseline levels of activity are higher, that’s definitely true on our platform where “normal” days average much higher activity than just a short while ago. There is real investor and hedging interest in emerging markets and that is helping build a more robust liquidity pool.”

It is not only about the inevitable events, however, there are also issues with how the market promotes growth from here. LCH’s Boyle acknowledges that the pace of growth in clearing NDFs will inevitably slow as the clearinghouse handles a greater proportion of trades, and it is not only here that constraints may emerge.

“We have done a great job as an industry of building an efficient electronic market in one month NDFs,” observes Ward. “The question now is how do we serve the broader portion of the market, those traders that want off the run dates and longer tenors and rolls? Providing a solution for that would be a real value add because these areas are still voice dominated, because there is no concentration of liquidity in a CLOB.”

The head of FX trading for a bank in Asia also points out that while the CLOB has grabbed a chunk of market share, larger tickets are still executed via the voice channel. “While I think the environment on the public markets is much better in NDFs than it was in G10, it is still not a place you want to put decent size. Icebergs help to a degree, but too many players have Iceberg sniffers operating and the information leakage even from those order types is too much.

“Managing sizeable risk in NDFs is still a real challenge, that’s where the real risk warehousing in foreign exchange is going on,” the FX head continues. “We haven’t yet found anything to beat an experienced trader, with a feel for market conditions, when it comes to the bigger tickets. Do I think that will change? Yes, undoubtedly, but I don’t think it will be as soon as people think.”

Interestingly, the FX head also believes that the regulatory regime in the US may hinder growth there. “No-one wants to put any serious trades through a SEF,” they argue. “So people are reluctant to assume big risk in the US time zone because the hedging will be spotted and front run. This is still a market that needs subtlety and patience – a little darkness if you will – and SEFs don’t offer that. I think the NDF market will evolve like G10 where most of the business is done in the local market or in London.”

The data would suggest that the FX head may have a point, for the growth of NDF volumes in the UK over the two years to April 2018 is 80%, whereas in the US it is just under 8%.

A final challenge for NDF markets is very basic – miss-hits. For all the increased activity in NDFs there remains a lack of depth of book. Sources tell Profit & Loss that in many NDF pairs the second level in the book could be 100 points away. “And that is a challenge for the manual trader who clicks,” explains the e-trading head. “If they hit top of book and a fraction of a second before they click, it is traded, they could be trading a long way from the market. This means you do tend to see more out-trades that need amending or cancelling here than anywhere else. It’s not a huge issue, in fact it only becomes a problem when one side doesn’t want to cancel the trade – and that’s when you need a robust rule book. You can’t just put price limits on, some of these markets move 100 points a time, there has to be some rationality about it, but something has to be in place that protects people from honest, genuine mistakes.”


Probably the best indicator of how well NDF markets are developing comes from the Asia-based e-trading head, who reveals an increasing number of onshore traders are trying to get access to offshore markets. “The prices are better and the market is open longer,” is the simple explanation for this phenomenon, however it does come with a caveat. “A lot of local regulators don’t want to see this and frown upon it. They recognise the need to access liquidity after local market hours, however, so often they will allow the local trader to execute offshore as long as it is by voice and not electronic. They feel they can control matters much easier that way apparently.”

“The best definition for me regarding how market conditions have got better is the longer trading window in Asian NDFs,” says Ward. “Take Korea as an example. There used to be no trades in the NDF market when the onshore market was open, but now it is very liquid and we have LPs market making 24 hours a day.

“NDF markets are driving growth in Asian FX markets,” he adds. “It’s the big growth story here, it dominates the region.”

The bottom line for NDF markets is that they are developing at a pace rarely seen in FX circles. They are able to do so because market participants are coming into the product with their eyes open and in that way, NDFs have found some luck in the timing of their development.

Five years ago banks were eager to point out that they treated NDFs little differently to G10 currencies (subject to local regulations of course) but in reality there was a difference – spreads and depth of liquidity. Neither measure of market quality is, or is likely to get near, G10; however, when it comes to behaviours, or more importantly the monitoring of behaviour, the two markets stand side-by-side.

Spreads have also been compressed by the entry of new market makers, however unlike in G10 markets a decade or more ago, these new entrants have just as keen an interest in maintaining a fair and equal market structure.

It may be a question of fortuitous timing in that the FX world got a whole deal better at understanding what makes up a fair and transparent market structure, but it is hard to get away from the notion that the NDF market is the market that FX really wanted to be when it set out on the e-trail.

Galen Stops

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