NDFs are versatile instruments that unlock new trading opportunities. We explore why they’ve been invaluable in Asian and Latin American markets historically and what continues to make them appealing to traders today.

Derivatives are a complex solution to a simple problem. No wonder Wall Street invests so heavily in attracting the pick of the top young brains.

Non-deliverable forwards (NDFs) are a good case in point. NDFs can be an excellent way for traders to get exposure to less liquid asset pairs. But their complexity means they have not always been accessible to everyone who might have wanted to take advantage of their flexibility, such as retail brokers and their clients.

To help address that complexity, Finalto introduced a more streamlined forex solution that enables clients to access NDFs seamlessly, using their existing infrastructure, without worrying about complexities such as fixing dates and settlement risk.

To understand NDFs, and their popularity in LATAM and Asian markets, let’s start a bit of background.

A capital idea

Suppose you operate a company in a country with a volatile currency and capital controls. If the business engages in cross-border business (such as imports and exports) they will be subject to currency risk.

However, capital controls mean they can’t easily exchange the local currency for hard currency, making it harder to hedge.

In such cases, you need an effective means of gaining exposure to foreign currency without contravening currency controls.  

Historically in these cases – such as in Brazil in the 1990s – NDFs and other derivatives have proven effective means to “allow traders to replicate financial strategies originally conceived with the underlying financial assets”.

An NDF (as we have previously discussed) is a foreign exchange forward contract whereby the counterparties agree to settle the difference between the contracted NDF rate and the prevailing spot exchange rate on a specified future date. Crucially, that difference is settled in cash, rather than physical delivery of currency. Thus, a non-deliverable forward contract.

So, for example, suppose a Brazilian firm trades a USD/BRL NDF. The agreement between the counterparties is that they will settle the difference in cash, rather than actually exchange currency.

NDFs remain popular in countries with capital controls, but these are not the only reason to prefer NDFs. An IMF working paper points out that even when lawmakers lift capital controls, NDFs still confer benefits. “Convenient trading hours and good liquidity make NDFs attractive,” the paper explains. And “in crisis episodes, convertibility risk can be a consideration in favour of NDFs”, which means that “factors besides restrictions in onshore markets matter as well”.

Flexible FX trading

This brief background sketch helps explain the emergence of NDFs, but not their value to traders.

As our LATAM clients will remind us, it takes two to tango. Hedging is only one side of the NDF equation. For investors, the instrument provides an opportunity to makes trades on currency pairs which may be less accessible, such as the USD and the Brazilian real.

For instance, the Brazilian real is a relatively volatile currency which is present a challenge in terms of trade predictability but an opportunity for investors.

The volatility of many LATAM currencies thus makes NDFs attractive to both sides of the NDF trade – both for hedging and speculation.

The bigger picture

The basic principles behind NDFs are relatively straightforward. However, as discussed above, executing an NDF trade can be challenging, both in terms of trading strategy and technology requirements. To address precisely that challenge, Finalto introduced a groundbreaking NDF solution that seamlessly fits into a client’s existing infrastructure.  

But due diligence needs to go beyond technical considerations, taking into account regulatory and other concerns. For instance, while NDFs are popular in Asia, Malaysia’s central bank does not permit MYR NDFs.

As always, businesses need an integrated trading solution to ensure they have the resources to trade and manage risk effectively.

Want to learn more about how NDFs could fit into your strategy? At Finalto, we don’t do one size fits all. Get in touch for a customised liquidity and technology solution designed to help your business accelerate its growth.

All opinions, news, research, analysis, prices or other information is provided as general market commentary and not as investment advice and all potential results discussed are not guaranteed to be achieved. The information may have been derived from publicly available sources, company reports, personal research, or surveys. Past performance is not indicative of future performance. Trading carries risk of capital loss. Service available to professional clients only