NDFs in emerging markets: a problem or a solution?

Non-deliverable forwards (NDFs) are a key tool in FX today, offering easy access to illiquid currencies in emerging markets. But is that always a good thing?

The forex market has seen a surge of NDF innovation in recent years, notably the launch of NDF algorithms. And, by increasing efficiency and accessibility, these algos have boosted NDF liquidity. A number of banks have launched NDF algos focused on a range of currency pairs, including BNP Paribas, Credit Suisse, and Barclays.

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Global pressures

There are a range of developing themes in emerging markets that investors must consider, some of which have the potential to cause volatility in FX. While the effects of the Russian invasion of Ukraine are the most obvious cause for concern, there are also broader macroeconomic questions over the eurozone, India’s economic growth and the stuttering Brazilian economy.

Often, these tensions can move in unexpected directions: for example, in early March, the early stages of Russia’s invasion of Ukraine turned the Taiwan dollar into a proxy for risks in Asia.

Such concerns are nothing new for FX traders, although the rise of NDFs – particularly the accessibility brought by NDF algos – can induce new headaches. Perhaps most notably, NDF markets in regions like Asia tend to be large and growing, according to the IMF, posing the risk of significant ‘spillover’ risk to onshore markets.

What is more, they are also usually more volatile than their counterparts onshore, pricing significant depreciation during market stress episodes like COVID-19. The large deviations in NDF pricing could make hedging expensive. Still, the IMF notes that influences tend to run both ways after controlling for differences in time zones.

Overcoming obstacles 

NDF algos also face technical challenges, such as broken dates, which differ from the expected maturity date, posing implications for price. There are also potential issues around liquidity duplication, with a need for aggregation.

However, major players are working to resolve such issues. Gordon Alexander, head of client access & flow execution FIC in Asia Pacific for Deutsche Bank’s Global Emerging Markets business, says: “Algorithms are focusing on improving execution around broken dates and market events by using other tools to augment liquidity, such as FX Futures to improve electronic price creation.”

With major players working to resolve such issues, there is no doubting the potential of NDF algos to boost liquidity in emerging markets.

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