«Report prepared for the City of London Corporation by London School of Economics and Political Science Published December 2012 BRIC currencies ...»
SPECIAL INTEREST PAPER
Report prepared for the City of London Corporation
by London School of Economics and Political Science
Published December 2012
trading in London
City of London Economic Development
PO Box 270, Guildhall, London, EC2P 2EJ
SPECIAL INTEREST PAPER
Report prepared for the City of London Corporation
by London School of Economics and Political Science Published December 2012 BRIC currencies trading in London City of London Economic Development PO Box 270, Guildhall, London, EC2P 2EJ www.cityoflondon.gov.uk/economicresearch BRIC currencies trading in London is published by the City of London. The author of this report is the London School of Economics.
This report is intended as a basis for discussion only. Whilst every effort has been made to ensure the accuracy and completeness of the material in this report, the authors, the London School of Economics and the City of London, give no warranty in that regard and accept no liability for any loss or damage incurred through the use of, or reliance upon, this report or the information contained herein.
December 2012 © City of London PO Box 270, Guildhall London EC2P 2EJ http://www.cityoflondon.gov.uk/economicresearch Executive summary
1. Brazil, Russia, India and China: the BRICs
1.1. Brazilian real
1.2. Russian ruble
1.3. Indian rupee
1.4. Chinese renminbi
1.5. Will the BRIC currencies become fully convertible?
2. Non-deliverable forwards
2.1. How NDFs work
2.2. Why NDFs exist
2.3. Differences between NDFs and deliverable forwards
3. Developments in the FX and NDF markets
3.1. The FX market globally and in London
3.2. Global spot trading in BRIC currencies
3.3. Global forward trading in BRIC currencies
3.4. NDF trading in London
3.5. Reasons for London’s success and outlook
3.6. Regulation and NDF trading
4. Summary and conclusion
Executive summary This report has been commissioned from the London School of Economics by the City of London Corporation to explore the trading of BRIC currencies in the London FX market. The BRIC currencies (together with the South Korean won) constitute the most important currencies for non-deliverable forwards (NDFs). As the BRIC economies grow, without immediately moving to a fully flexible exchange rate regime, offshore FX markets and NDFs in particular are expected to become ever more important.
NDFs account for the overwhelming majority of the forward volume in BRIC currencies. An NDF contract is an outright forward contract in which counterparties settle the difference between the contracted NDF price and the contracted NDF fixing rate at an agreed notional amount at maturity. NDFs are prevalent in currencies where unrestricted trading is not possible due to the existence of strong controls imposed by the governing body. As the restrictions are lifted and the currencies move to a flexible exchange rate regime, NDFs gradually become obsolete and trading volume switches to deliverable (or plain vanilla) forwards.
Deliverable forwards constitute contracts whereby a party agrees to buy or sell a pre-specified asset at a future date.
Overall, the UK (or London) segment of the FX market accounts for roughly 40% of the global turnover, securing the top spot for London among the global FX centres.
Between April 2008 and April 2012, the average daily UK trading volume in NDFs in the four BRIC currencies – Brazilian real (BRL), Russian ruble (RUB), Indian rupee (INR) and Chinese renminbi (CNY) – increased by almost 70% to almost USD 20bn. While NDF contracts account for only about 2% of volume in the London FX market as of April 2012, their growth in the last four years has by far outstripped the growth of other FX transactions.
The aim of this report is to summarise existing information and data on NDF trading in the London FX market, provide a qualitative outlook on the future of NDF business in the BRIC currencies by way of interviews with relevant players and to highlight any risks or concerns when considering investing or trading in NDF contracts.
BRIC currencies. Paralleling the impressive economic growth of the BRIC countries, trading volume in BRIC currencies has increased dramatically since 2008. Given the domestic restrictions on these currencies, NDFs account for a large fraction of the overall volume of FX trading in these currencies. The daily global volume for NDFs in the Brazilian real, the Indian rupee and the Chinese renminbi is more than USD 40bn, compared to global spot transactions of USD 30bn in 2010. For all BRIC currencies, the NDF and deliverable forward rates are almost perfectly correlated with correlation coefficients generally exceeding 99.5%.
BRIC currencies in London. NDF volume in BRICs has increased by almost 70% between April 2008 and April 2012, thus dwarfing the overall growth in FX volume in London of 13% during the same period.
NDFs vs deliverable forwards. NDFs mainly exist because the underlying currencies have controls in place which restrict the international exposure and use. A move to a fully flexible exchange rate regime makes NDFs obsolete. This has happened in the past with the Mexican peso and history could repeat itself if controls on BRIC currencies are lifted. However, market participants in London do not expect this to happen in the near future. As a consequence, the importance of NDFs will continue to grow along with the BRIC economies.
Use of NDFs. The surveyed market participants estimate that about half of trading in NDFs in London is due to firms hedging an existing exposure in the respective currency and about half of trading is driven by investors who want to trade on their views about the currency or the country in general. There is a consensus amongst interviewees that this will remain the case in the near future. As BRIC currencies become more established, it is further expected that NDFs for more exotic currencies (like in particular the African currencies) will gain more traction.
Regulation and NDFs. NDFs are OTC products and therefore by nature subject to minimal regulation. This is expected to change given the fallout from the financial crisis and a general trend towards more oversight. The main change that is expected to be implemented before the end of 2013 concerns central clearing and additional reporting requirements. While asset managers and hedge funds will be subject to the additional regulation, corporate clients which use FX instruments for commercial hedging purposes will be exempt. This will undoubtedly result in an increase in operational and trading costs for banks and clients. Costs are also expected to rise because of new capital standards outlined in Basel III. The extent of the additional costs will most likely turn out to be the main determinant of how the NDF market will evolve as clients may seek out more cost efficient alternatives. In addition, market liquidity may suffer, as new clearing and reporting requirements will limit the willingness of dealers to provide competitive prices for less liquid products.
London and the future of the NDF market. There is wide consensus among the surveyed banks that London is well prepared to tackle the challenges that lie ahead.
The working day in London overlaps with all BRIC countries. In addition, London boasts a prime position as an international financial centre with a reliable legal system and access to highly qualified talent. It is therefore expected that London will maintain or even extend its lead in the FX market in general and the NDF market in particular. Moreover, even if the BRIC currencies are eventually moving to a more flexible regime, London is not expected to lose business as it will be the natural market for trading in deliverable FX forwards.
The main area of challenge in the intermediate future is the upcoming regulatory changes, and it is essential to ensure that London’s competitiveness will not suffer by imposing regulatory standards that are more stringent than those imposed on other financial centres in the rest of the world. A likely outcome is that due to increased costs, economies of scale will become more important and NDF trading will be concentrated in the top tier banks, while second and third tier banks, which are still in the market at the moment, will be squeezed out. However, this is not necessarily bad news for London as an FX centre as it could even result in the big banks increasing and concentrating their presence in London.
London is currently the leading centre for FX trading in the world with a share of almost 40%.1 While the NDFs only account for about 2% of FX trading in London (and 20% of the volume in FX forward contracts), they have become a widely used instrument for hedgers and speculators alike to manage exposures to the underlying currencies in an effective way. As the importance of emerging markets (and especially the BRIC countries) is expected to grow, trading in NDF contracts is expected to follow suit.
According to the semi-annual foreign exchange surveys conducted by the Foreign Exchange Joint Standing Committee (FXJSC), the average daily UK trading volume in non-deliverable forwards (NDFs) in the four BRIC currencies – Brazilian real (BRL), Russian ruble (RUB), Indian rupee (INR) and Chinese renminbi (CNY) – has increased by almost 70% from just over USD 11bn in April 2008 to almost USD 20bn in April 2012.2 As the BRIC economies are growing further, presumably without moving to a fully flexible exchange rate regime in the near future, offshore FX markets and NDFs in particular are expected to become ever more important.
NDFs are foreign exchange derivative products traded over the counter (OTC).
Different from deliverable exchange rate forwards, they trade outside the direct jurisdiction of the authorities of the corresponding currencies. Major centres of NDF trading are Hong Kong, Singapore, Seoul, Taipei, Tokyo, London and New York.
London is the main market for NDFs on Eastern European and Asian currencies. While the majority of the trading volume is on foreign currency to US dollar pairs, the OTC nature of the market enables other currencies such as the British pound and the euro to be used as the base currency as well.
While it is relatively easy to obtain a wide range of information on FX trading in the most liquid currencies such as the US dollar, the euro, the Japanese yen, the British pound, or the Swiss franc, the same is not true for the emerging market currencies typically underlying NDF contracts. This report has been commissioned by the City of London Corporation to fill this gap. In particular, the report has three objectives: First, it provides an introduction into NDF contracts in general and as such can be used as a reference. Second, the report summarises the available data on NDF trading in the London FX market. Here, the focus is on the BRIC currencies, which (together with the South Korean won) constitute the most important currencies for NDFs. Finally, the report discusses the outlook for the NDF market with a particular focus on how its development will affect the position of London as a dominant centre for FX trading.
The views relating to the future of NDF trading in London are shaped by interviews conducted with senior managers in global investment banks that play a significant role in the FX market in London and with proponents of central banks that have regulatory and supervisory roles in the market.3 The latest global numbers are from the Triennial Central Bank Survey on “Foreign exchange and derivatives market activity” last conducted by the BIS in April 2010.
2 The London Foreign Exchange Joint Standing Committee (FXJSC) was established in 1973 under the auspices of the Bank of England, in the main part as a forum for banks and brokers to discuss broad market issues and the focus of the Committee's regular work remains issues of common concern to the different participants in the foreign exchange market.
The sample of surveyed banks includes Barclays, Deutsche Bank, HSBC, JP Morgan and Standard The first chapter introduces the BRIC currencies, which together with the South Korean Won are the most important currencies for NDFs. The chapter also describes the reasons why those currencies are traded offshore using NDFs as opposed to onshore using outright forwards.
Chapter two introduces the concept of non-deliverable forwards. It covers some of the obvious risks and concerns related to trading in BRIC currencies using NDF contracts. Furthermore, it discusses the differences between deliverable and nondeliverable forwards and elaborates on the reasons for being active in the NDF market in the first place. Detailed quantitative data on investors in NDF market is very difficult to source. As a result, the section heavily draws on the insights derived from interviews conducted with the major banks that execute trading in NDFs on behalf of their clients.
Chapter three summarises the relevant data and discusses how the NDF market has developed globally and in London. FX markets globally have grown significantly in the last decade and global turnover reached about USD 5tr in 2012. London as the dominant FX centre accounts for roughly 40% of total turnover. It is estimated that London accounts for at least the same fraction of global NDF turnover. NDF volume in the London FX market has experienced a strong growth in the last four years.
Furthermore, the chapter provides a qualitative outlook on the future of NDF trading in BRIC currencies based on interviews conducted with the relevant players in the London FX market.
The chapter also considers key uncertainties with regards to the future of London as a trading hub, principally the proposals for regulation that are currently being discussed as a reaction to the financial crisis. There is some concern that regulation in Europe and in London in particular could become more restrictive than regulatory changes implemented in other FX centres, which could eventually hurt London's competitiveness.
1. Brazil, Russia, India and China: the BRICs