Market Review: The electronification of NDFs

The pace of growth in non-deliverable forwards (NDFs) has been slow and steady at best, but the past year may have finally seen the long-awaited shift to the more widespread adoption of NDF trading. Nicola Tavendale takes a look at the landscape.

In the UK, the Bank of England reported record highs for NDF turnover in its latest semi-annual FX turnover survey, with a 7% increase in NDF trading compared to October 2021. Longer term, the central bank noted that NDFs had also seen the largest relative increase by instrument since April 2016 after rising 125% to $136 billion. The impending release of the latest BIS Triennial Central Bank Survey of FX and Derivatives Market Activity will provide a more global overview of the trend in NDF growth, with the 2019 report having highlighted that NDFs accounted for a “significant share of the increase in trading” since 2016 within the outright forwards category.

Yet NDFs continue to be regarded as a relatively nascent sector of the FX market, with even the BIS having only started collating NDF data for its 2013 Triennial FX survey and still only a small number of the leading FX platforms reporting specifically on their NDF turnover. Changes on the regulatory front, however, could potentially accelerate the uptake in NDF trading. The final phase of the Uncleared Margin Rules (UMR), which came into force on 1 September 2022, will significantly impact more buy-side firms than the previous five phases, with the threshold of uncleared OTC assets having dropped from the previous level of $50 billion down to $8 billion. Previous phases had already seen evidence of more firms turning to NDF clearing to optimise their balance sheets, according to analysis from post-trade service provider OSTTRA. The first half of 2022 saw NDF clearing volumes on OSTTRA’s FX clearing platform increase by just over 30%, with each phase of UMR said to have correlated directly to volume growth. 

Meeting the demand with NDF algos

In addition, the standardised approach for counterparty credit risk (SA-CCR), which was introduced at the start of the year, may potentially prompt more FX dealers to weigh-up NDF clearing. A growing push to demonstrate adherence to the FX Global Code of Conduct might even promote further NDF uptake by increasing transparency. Clearing NDFs aligns well to the principles and aims of the Code, while a couple of key platforms which offer NDFs, such as 360T, have recently made changes to allow only signatories to the latest version of the Code (or market makers offering firm liquidity) to make prices anonymously.

Perhaps even more significant to the growth of NDF trading has been the development by leading banks of NDF algo trading strategies, with a number of new providers also having entered this space over the past year. WBR Insights, in its latest buy-side FX trading report ‘Navigating crypto, turbulent markets & ESG’, found that while only 8% of FX trading desks have already adopted NDF algo execution, an additional 27% said they were planning to implement them in the next six months. Nearly half of the respondents were also evaluating NDF algos with their counterparties, but said they have no immediate plans to adopt them, indicating the potential for further growth. 

Balancing the benefits

Improved market transparency was perceived to be among the most important impacts of NDF electronification, with 70% citing this as one of the three key benefits. In addition, reduced trading costs and the ability to reduce operational risk were also said to be important to FX trading desks. Improved execution efficiency and the ability to generate greater returns also ranked high among the benefits chosen, while accessing new liquidity was the least significant factor, at 34%, which was due to liquidity originating from clients wishing to sell, not from algos or other technology, according to the report. 

Commenting on the findings, Elke Wenzler, head of trading at MEAG, noted that her firm had a lot of success in their employment of NDF algos, adding that they were especially beneficial when dealing with high volumes to minimise market impact. “I agree that the most significant advantage for us would be market transparency and lower trading expenses, as well as improved execution efficiency,” she said. 

“However, I am surprised that gaining access to new liquidity comes in at the bottom of the list. That is most likely going to need some time since many market participants are not currently utilising it. Maybe it is in the difference between the deliverable currencies: a lot of small flows are going from very different counterparts and market participants, which is not exactly the same for NDFs.” 

Infrastructure and market challenges

According to Wenzler, there is also still some development necessary to make them even more accessible for buy-side firms. “It is developing more slowly and there are fewer participants,” she adds. “The offering of the banks definitely has to improve. However, I think we have already made quite good progress in recent months.” Other barriers were identified by respondents, including need for “more transparency” in NDF algos, the lack of the necessary technology infrastructure to use NDF algos efficiently – including the necessary expertise to integrate the right environment – as well as the very fragmented nature of the NDF market itself. 

Other key challenges remain, such as broken dates or how to aggregate NDF liquidity into one system lot. As FX algo providers look to attract further adoption of NDF algo strategies, they will need to offer an increasingly sophisticated range of data analytics, algo execution tools and liquidity management in order to facilitate access to NDF markets and to overcome some of the barriers to entry cited by these firms. 

“NDF trading is a complex process, but if these challenges can be overcome, it will provide FX traders with more opportunities for sourcing liquidity,” the report concluded.