Will NDFs be required to trade on SEFs under Dodd Frank?

What will happen with NDFs?

As I mentioned in my last post, non-deliverable forwards (NDFs) will be subject to Dodd Frank regulations here. This means, they will be subject to central clearing, and trade reporting. But, that being the case, the question is:

Will NDFs also be required to trade on SEFs? Is the market able/ready to migrate NDF liquidity away from current channels over to SEFs. Will they actually provide greater levels of liquidity, and greater pre trade price discovery – in standard tenors (maturities) and for the more liquid NDF pairs, in nominal size?

By way of background: A Non Deliverable Forward (NDF) is a cash-settled, forward contract on a thinly traded or non-convertible foreign currency. Typically they are used by corporations and financial institutions looking to invest or hedge exposure to the non-convertible currencies.

Daily NDF volumes are still tiny compared to traditional FX products, accounting for some 3% of daily FX volumes. Although, global trade volumes have risen dramatically in recent years, it has been estimated (by NY Fed) that somewhere between 60-80% of NDF volume is based on speculative trades, rather than commercial hedging.

As the name implies, the NDF currencies are not physically delivered, instead the contract is cash ‘net settled’ by calculating the difference between the agreed upon (forward) exchange rate at the time the NDF was taken out, and the subsequent spot fixing rate, which for most NDFs will be 2 days before the forward value date. One party in the agreement will then make a payment to the other party on the basis of the profit or loss on the contract (in the deliverable ‘other currency’ against which the NDF was quoted).

NDFs are mostly, quoted and settled in US dollars, but can be quoted in other liquid currencies such EUR, GBP, JPY, CHF, CAD etc.

Trading Protocol: The NDF market is characterised by what one could call ‘punctuated, or discontinuous liquidity’. Meaning, there are times during the trading day when liquidity is very poor. Therefore, depending on the liquidity of the market, trading in NDFs is currently achieved via streaming, or RFS/RFQ protocols, and may have defined trading times (based on maximum liquidity for each time zone). Due to their ‘relative historical’ complexity, compared to more established FX instruments, most NDF trading is still done manually by phone.

NDF volume by Channel: The Bank of England data (April 2010) shows that the vast majority of NDF trading is still manual, as follows:

Hybrid (Electronic/Voice): 69%
Inter Dealer Direct (inc phone): 24%
Customer Direct (inc phone): 36%
Voice Broking (phone): 9%

Electronic only: 31%
Electronic Broking: 5%
Single & Multi Dealer Platforms: 26%

Electronic Confirmations: Much of the infrastructure and documentation standardization is now in-place within the FX market to support a far more rapid migration to electronic trading for NDFs. Although, currently only around 25% of NDFs are electronically confirmed.

Documentation/Regulation: NDFs require a special contract that meets the provisions of the internationally recognized International Swaps and Derivatives Association (ISDA). Good reference source from US Fed on legal documentation for NDFs here.

MiFID: Under MiFID, NDFs are regarded as FX instruments and not as Investment Products, which means that market participants are not required to ‘prove’ Best Execution’.

Central Counter Party (CCP): Under Dodd Frank, NDFs will be subject to CCP, and other regions like HK (from 2012) have stated that financial institutions incorporated in the region will have to clear NDFs through a recognised central counterparty (CCP). CLS Bank currently offers clearing for 50 NDF currencies, in some 17 deliverable currencies here.

Conclusion: The infrastructure is available to facilitate increased migration of NDF trading to purely electronic channels, certainly for the more liquid pairs in standard tenors. Although, it will be interesting to see whether that is mandated, and if so, how many NDF pairs are actually required to trade on a SEF, and what effect that would have on overall liquidity.

3 Responses

  1. […] and Fwds will be exempt from Dodd Frank and SEF regulations! Although of course that still leaves NDFs and FX options within the Dodd Frank regulations 9and some MDPs are preparing to become SEFs in those […]

  2. […] DNF and FX Options which do fall under Dodd Frank may continue to trade on the banks SDP unless all the following criteria are fulfilled; a) It’s a cleared product: meaning that a clearing house actually clears this instrument b) It’s deemed available for trading on a SEF: meaning that the CFTC has deemed that a SEF does quote this instrument, and that it’s sufficiently liquid to trade on a SEF. c) It’s in standard size is tenor (to be defined). […]

  3. […] 5. Will NDFs be required to trade on SEFs under Dodd Frank? […]

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