## Offshore (NDF) market > [!info] [Is India ready for full Capital Account Convertibility? by G Padmanabhan, 2015](RBI_Speeches_20150518_Is%20India%20ready%20for%20full%20Capital%20Account%20Convertibility?.pdf) > Anyone anywhere in the world with an exposure to the Rupee should be able to enter into a derivative transaction to hedge the currency risk, and the transaction should be in the on-shore market. Beyond that, we have been endeavouring to expand the set of derivative transactions. We are not ready yet to allow unfettered trading of the rupee for pure speculation. ## Origin 1. NDF stands for non-deliverable forwards. It is one of the non-deliverable rupee forex derivatives 2. Here we discuss about NDF involving Rupee 3. In NDF markets, trading is settled in a convertible currency, usually in US dollar, as most non-convertible currencies are restricted to be delivered offshore. 4. The origin of the NDF market actually dates back to 1970s in response to the capital controls in Australia (Debelle et al., 2006). These markets then started growing in Latin American countries during the 1990s and subsequently expanded rapidly in Asia and Eastern Europe. ## 2006 1. In 2006, RBI Occasional Paper, 27, Winter, 25-55, authored by Misra, S. & Behera, H. (2006), titled [Non Deliverable Foreign Exchange Forward Market: An Overview](RBI_Research_Occasional%20Papers_200710_Occasional%20Papers%20–%20Winter%202006.pdf#page=29&selection=11,0,13,1) was published ## 2011 >[Box V.2 - NDF Market and its Implication for the Domestic Financial Markets](RBI_Annual%20Report_2011.pdf#page=113&selection=43,0,43,66) in RBI's Annual Report 2011 ## 2013 1. Dec 2013 - A Working Paper titled [Non deliverable forward and onshore Indian rupee market: a study on inter-linkages](RBI_Research_WP_20131220_RBI%20WPS%20(DEPR)-%2011:2013-%20Non%20Deliverable%20Forward%20and%20Onshore%20Indian%20Rupee%20Market-%20A%20Study%20on%20Inter-linkages.pdf) (Working Paper Series, No. 11) was published. > [Box II.9-Non Deliverable Forward Market and Onshore INR Market: Evidence on Inter-linkages](RBI_Annual%20Report_2013.pdf#page=73&selection=23,0,24,81) in RBI's Annual Report 2013 ## 2019 1. Aug 08, 2019 - [Report](RBI_Report_20190808_Report%20of%20the%20Task%20Force%20on%20Offshore%20Rupee%20Markets.pdf) of the Task Force on Offshore Rupee Markets (Chairperson - Usha Thorat) ## 2020 1. Aug 13, 2020 - An [article](RBI_Monthly_Bulletin_Article_20200813_Onshoring%20the%20Offshore.pdf) titled *Onshoring the Offshore* was published in the RBI Bulletin. ## 2021 Here we discuss ==RBI Working Paper Series No. 04 - Does Offshore NDF Market Influence Onshore Forex Market? Evidence from India==, by Harendra Behera (ex-Director, RBI), Rajiv Ranjan (ex-Officer-in-Charge in the Monetary Policy Department, RBI), Sajjid Chinoy (Chief India Economist, J.P. Morgan). 1. The paper answers these questions: 1. Is there long-run relationship between the two markets-offshore and onshore? 2. Second, if so, what is the degree and directionality of influence? 3. Third, whether the volatility in the onshore market is driven by that of the offshore market? 4. Fourth, if so, how does this change over different time periods – in “normal times” versus “stressed times”? > [!normal] > 1. The findings of the study: > 1. In the long-run, there is stable relationship between NDF and onshore market. The offshore market cannot permanently “diverge” from the real Indian market > 2. Most of the information about rupee’s value which is determined by factors like (interest rate changes, policy moves, or risk perceptions) gets reflected first in the spot and forward markets, not in the offshore (NDF) market. > 3. ==NDF-> SPOT, FOWARD, FUTURES - The sub-period analysis finds short-term mean spillover effects from NDF markets to onshore spot, forward and futures markets during the stress period==. *An example - 2013 taper tantrum* > 4. SPOT, FORWARD -> NDF, volatility spillover in normal circumstances > 5. SPOT, FORWARD ↔ NDF, volatility spillover in times of depreciation pressure on the rupee. > 6. NDF ↔ FUTURES, two-way volatility spillovers > 7. NDF -> FUTURES, volatility spillover during episodes of intensified global risks. > 8. ==Moreover, the magnitude of volatility spillovers from offshore to onshore markets also increases during periods of stress== > 9. A spillover means that price movements or shocks in one market affect another market. > 1. MEAN spillover is how much changes (returns) in one market affect changes (returns) in another. Here "mean" in mean spillover doesn't mean average of prices, but the mean equation in time-series models. > 2. Volatility spillover is how much one market’s volatility in price level or influencing another market’s volatility price level. > 10. Thus, a real-time monitoring of the market is essential to contain any substantial spillover from the offshore NDF markets. ### Rise of an offshore market: 1. Let us consider what factors or developments have given birth to a parallel market for EME currencies in offshore centres known as non-deliverable forward (NDF) markets. 1. **Forex Flows:** Emerging market economies (EMEs) have, in general, experienced a sharp and sustained rise in trade and capital flows over the last three decades. This is due to 1. rise in demand for emerging market capital assets due to improved domestic economic prospects, 2. liberalisation of their external sectors, and 3. a gush of global liquidity that advanced economy central banks have injected by aggressively expanding their balance sheets after the global financial crisis. 4. The electronification of trading a further boost to demand for EME currencies (Wooldridge, 2019). 2. Rising flows has led to non-resident's increased interest in rupee or in general emerging market currencies, both for risk management and speculative ends. 1. The above factors created economic agents with direct or indirect exposure to a currency but limited or no avenue to hedge the risk either due to regulatory restrictions in the host country or non availability of hedging products or markets or simply because of cumbersome nature of entering into a hedging contract in an unfamiliar country. 2. However even when regulatory regime was relaxed and full access to the domestic market was available to the non-residents, the NDF market continued to be significant, presumably due to the fact that it afforded the interested non-residents ease of transaction and a familiar market. 3. The surge in offshore market turnover is also likely attributable to the transformation of NDFs from a decentralized and bilateral microstructure to centralised trading with greater disclosure and better clearing system (McCauley and Shu, 2016). 4. Given the time zone differences and advanced infrastructure availability, the maximum trading in NDF currencies takes place in few international financial centres like London, Singapore and New York. 3. **Response by central banks** - Such interest is often offset by central banks through capital controls and underdeveloped onshore financial markets. 4. ==So there is Forex Flows -> Risk Management and speculation, all supported by electronic trading, capital controls and underdeveloped onshore financial markets .== 2. As documented by a report of the RBI (2019), the rising prominence of NDF markets could be mainly on account of: 1. restrictions on foreign exchange transactions, 2. cumbersome documentation and Know-Your-Customer (KYC) requirements, 3. restrictions on market participants (especially, non-residents) in hedging activities, 4. cancellation and re-booking of contracts, 5. permission to participate in various existing derivatives product offered by the market regulators, 6. and inconvenient market hours for those in other time zones. 3. **Volume:** As per the latest Triennial Survey of the BIS (2019), for example, turnover in offshore markets for the Indian rupee outpaced that of the onshore market. 1. Strong surge in NDF trades were also seen in the case of Brazilian Real (BRL), Taiwanese New Dollar, Indonesian Rupiah (IDR) and Philippine Peso (PHP). 2. As compared to the onshore market, the turnover in offshore rupee markets has more than tripled between 2016 and 2019 ([Chart 2](https://rbi.org.in/scripts/PublicationsView.aspx?Id=20388#C2)). 3. In fact, the INR NDF turnover at USD 50 billon, exceeded the combined OTC and exchange traded forex turnover of USD 48.8 billion in April 2019. 4. The share of the Indian rupee in the global NDF turnover has also increased significantly from 12.6 per cent in 2016 to 19.4 per cent in 2019 whereas the growth in turnover during this period was more than 200 per cent ([Table 1](https://rbi.org.in/scripts/PublicationsView.aspx?Id=20388#TA1)). 5. As reported by the BIS Triennial Central Bank Survey (2019), the turnover in NDFs has almost doubled between 2016 and 2019, mainly driven by the Korean won, Indian rupee, Brazilian real and New Taiwan dollar. 6. The rise in demand for emerging market assets and the electronification of trading providing access to a wider range of market participants has also contributed to the recent surge in NDF turnover (Patel and Xia, 2019). 7. **Which country sees maximum trading in NDF currencies?** Given the time zone differences and advanced infrastructure availability, the maximum trading in NDF currencies takes place in few international financial centres like London, Singapore and New York. 8. **Speculation:** 1. Moreover, the contracts with shorter maturity have maximum liquidity, accounting for about 70 per cent of overall turnover, reflecting the speculative positions (Kumar and Rituraj, 2020). 2. The speculative activity in the market result in wide divergences. 9. If the gap is large, it encourages market players to take arbitrage advantage while speculative activity in the market result in wide divergences. 10. The correct approach to address this problem is not to engage in an _ad hominem_ tirade against the NDF market and its participants but to address the genuine need by increasing the access to domestic onshore market to all those who have a legitimate Rupee exposure. Several steps have been taken in this direction and more are in the offing [^1]. ### Impact of NDF > [!normal] > 1. Due to capital account restrictions, transaction costs and basis risk, etc., the offshore market volume is significant or larger than that of the onshore market. > 2. Thus there is always [some gap](https://rbi.org.in/scripts/PublicationsView.aspx?Id=20388#C3) between the exchange rates of the Indian rupee (INR) in onshore and offshore markets, > 1. This gap is seen between 1-month NDF when compared to all three prices–spot, 1-month forward, 1-month futures. > 2. **The large gap between INR NDF rate and INR futures/forward rate can influence the spot rates significantly** > 3. The speculative activity in the market expands this divergences. > 4. If the gap is large, it also encourages market players to take arbitrage advantage. > 3. Along with gap, as found by Misra and Behera (2006), there are volatility spillovers from NDF market to spot and forward market. > 4. The existence of this gap (spread) and spillovers tells us that the domestic market price discovery remains vulnerable to influences from price discovery in the offshore market. > 5. *In other words, the the price discovery can get fragmented-determined across segmented markets, that is both the onshore deliverable forward market and the offshore (NDF) market* > 6. <span style="background-color: #fff9ae">The presence of a large offshore market, therefore, sometimes dilutes the effectiveness or raises challenges for central banks in foreign exchange management and/or hinders the pursuit of domestic financial stability objectives.</span> > 7. RBI therefore sells dollars in NDF market in times of depreciation of rupee to signal their intent of reducing speculation and arbitrage. This reduces gap and hence arbitrage trades, and limits volatility in Rupee in offshore and hence onshore market. ### Price Discovery 1. Now we have discussed that _the price discovery can get fragmented - like weaker Rupee in offshore (NDF) market than onshore market in times of depreciation of Rupee. 2. **But the challenge is to find relative importance of each of these markets in driving “price discovery".** 3. However, simply using (offshore versus onshore) volumes as a means to proxy relative price discovery is imperfect at best. 4. <span style="color:red;">The ability of NDF volumes to drive price discovery, for any given quantum of volumes, is ultimately a function of how inter-connected onshore and offshore markets are, and the ability of economic agents – hedgers, arbitrageurs, speculators – to link these markets.</span> 1. For example, if NDF markets have grown sharply, but it is found that price linkages between the two markets are still tenuous or have not increased commensurately with volumes, – say, because arbitrage opportunities between the two markets have not grown in tandem – then the growth of NDF markets, and the consequent “loss of control” will be of less concern to Indian policymakers. 2. Conversely, if price linkages have grown over time – proportionately to volume increases – then policymakers would rightly worry about the growing role of NDF markets in driving price discovery. ### Why there is a linkage between offshore and onshore exchange rates? 1. **No capital controls:** 1. The relationship between onshore and offshore markets can be drawn from *Covered interest parity (CIP)* condition which holds when countries do not have capital controls. 2. In this case, there would be no arbitrage opportunity 3. The forward rate essentially represents the interest rate differential between two currencies. The equation would be: $ \begin{aligned} &F = S \frac{(1 + r)}{(1 + r^{\$})} \end{aligned} $ $F= \text{ forward rate, } S = \text{ spot rate, } r = \text{ interest rate on the home currency, and } r^{\$} = \text{ interest rate on the foreign currency (e.g., US dollar).}$ 2. **Some capital controls:** 1. However, the deviation of CIP has been observed for the countries with some forms of capital controls. 2. Under such condition, F only can be approximated by the above equation as: $\displaystyle F \sim S \frac{(1 + r)}{(1 + r^{\$})}$ 3. **Existence of currency convertibility restrictions:** 1. There is CIP violation in the presence of capital account restrictions. 2. This makes the markets inefficient, and provides opportunity to the arbitragers and speculators to earn profits by taking positions on the currency. 3. A trader can earn arbitrage profits by borrowing in low yielding currency, converting the proceeds into the high yielding currency in the spot market and lending the same, and converting back it to the original currency using a forward contract if forward rate deviates from CIP. This is possible through carry trade or taking position in an offshore center and settling the difference through a convertible currency. 4. Hence, the NDF rate should be anchored by the onshore forward rate to the extent that arbitragers can link these markets. 5. ==The extent of CIP violation could be much larger during global uncertainty situation due to significant rise in counter-party credit risk and liquidity constraints (Coffey et al., 2009), even in case of convertible currency. As a result, the volatility spillover increases between markets during the times of heightened uncertainty.== $NDF \sim F \sim S \frac{(1 + r)}{(1 + r^{\$})}$ ### Related Research: 1. Analysts and policymakers began recognizing the presence of NDF markets and their inter-relationship with onshore market across several countries and regions, including Asian currencies (Ma et al., 2004; Colavecchio and Funke, 2008; Gu and McNelis, 2013; Ma and McCauley, 2013), the Korean Won (Park, 2001), the Indonesian Rupiah (Cadarajat and Lubis, 2012), the Chinese Yuan (Fung et al., 2004; Colavecchio and Funke, 2008; McCauley and Shu, 2019) and 2. the Indian Rupee (Misra and Behera, 2006; Guru, 2009; Behera, 2011; Goyal et al., 2013; Kumar and Jain, 2018). 1. For example, Misra and Behera (2006) find that it’s the onshore markets that largely influenced the NDF market, between 2004 to 2007, largely because of restricted participation of domestic players in the offshore market. 2. In a subsequent study, Behera (2011) found that there are volatility spillovers from the NDF market to spot and forward markets in India and the magnitude of volatility spillover has become higher after the introduction of currency futures in 2008. 3. Guru (2009) and Saravanan and Shanmugam (2014) find qualitatively similar results with the role of currency futures in India. 4. Darbha (2012) finds that offshore markets play an important role in price discovery. 5. Kumar and Jain (2018) investigate the interrelationship between spot, forward and NDF markets and conclude that the relationship between the three markets is dynamic owing to the policy measures taken by RBI to curb volatility. 6. Finally, Goyal et al. (2013) find a long-term relationship between NDF and onshore markets, and provide the evidence that the relationship is bidirectional, as both markets adjust to any deviations from the equilibrium state. *Their study also finds that shocks originating in the NDF market carry more information during periods of depreciation, leading to mean and volatility spillovers in corresponding on-shore segments.* 3. Various empirical studies found an impact of NDF markets on 1. the onshore forward market (Park, 2001; Wang et al., 2007; Cadarajat and Lubis, 2012), 2. onshore spot market (Behera, 2011, Goyal et al., 2013) and 3. onshore futures market (Behera, 2011). 4. Conversely, a few studies found evidence of the domestic market influencing the NDF market (Wang et al., 2007; Misra and Behera, 2006). 5. Patel and Xia (2019) find a bidirectional relationship between the onshore and offshore markets during normal times but with the offshore market driving movements in the onshore markets during times of global stress 6. More recently, a comprehensive analysis by Schmittmann and Teng (2020) finds a one-way influence from NDFs to onshore markets. ## 2023 1. July, 2023 - [Report](RBI_Reports_20230705_Report%20of%20the%20Inter-Departmental%20Group%20(IDG)%20on%20Internationalisation%20of%20INR.pdf) of the Inter-Departmental Group (IDG) on Internationalisation of INR. ## Timeline of RBI Measures 1. [1.2 Cash-Settled/Non-Deliverable Forex Derivatives](Forex%20Markets.md#1.2%20Cash-Settled/Non-Deliverable%20Forex%20Derivatives) in Forex Markets >[Box V.2 - NDF Market and its Implication for the Domestic Financial Markets](RBI_Annual%20Report_2011.pdf#page=113&selection=43,0,43,66) in RBI's Annual Report 2011 >[Box II.9-Non Deliverable Forward Market and Onshore INR Market: Evidence on Inter-linkages](RBI_Annual%20Report_2013.pdf#page=73&selection=23,0,24,81) in RBI's Annual Report 2013 ## Groups and Committees 1. RBI. (Aug 08, 2019). Report of the Task Force on Offshore Rupee Markets (Chairperson - Usha Thorat). [pdf](RBI_Report_20190808_Report%20of%20the%20Task%20Force%20on%20Offshore%20Rupee%20Markets.pdf) 2. RBI. (July 10, 2019). [Report](Report%20of%20the%20Internal%20Working%20Group%20on%20Comprehensive%20Review%20of%20Market%20Timings%202019.md) of the Internal Working Group on Comprehensive Review of Market Timings 2019 3. RBI. (July, 2023). Report of the Inter-Departmental Group (IDG) on Internationalisation of INR. [Link](https://m.rbi.org.in/scripts/PublicationReportDetails.aspx?ID=1244) | [pdf](RBI_Reports_20230705_Report%20of%20the%20Inter-Departmental%20Group%20(IDG)%20on%20Internationalisation%20of%20INR.pdf) 4. RBI. (May 2, 2025). Report of the Working Group to undertake a comprehensive review of trading and settlement timings of markets regulated by the Reserve Bank. [pdf](RBI_Group-Committee_20250502_Working%20Group%20on%20Comprehensive%20Review%20of%20Trading%20and%20Settlement%20Timings%20of%20Markets%20Regulated%20by%20the%20Reserve%20Bank.pdf) ## References 1. Misra, S. & Behera, H. (2006), *Non Deliverable Foreign Exchange Forward Market: An Overview*. RBI. Half-Yearly/Occasional Papers, 27, Winter, 25-55. 2. Goyal, R., Jain, R., & Tewari, S. (2013). *Non deliverable forward and onshore Indian rupee market: a study on inter-linkages*. Reserve Bank of India Working Paper Series, No. 11, December 3. RBI. (Aug 08, 2019). *Report of the Task Force on Offshore Rupee Markets* (Chairperson - Usha Thorat). [pdf](RBI_Report_20190808_Report%20of%20the%20Task%20Force%20on%20Offshore%20Rupee%20Markets.pdf) 4. RBI. (Aug 13, 2020). *Onshoring the Offshore*. RBI Bulletin. [pdf](RBI_Monthly_Bulletin_Article_20200813_Onshoring%20the%20Offshore.pdf) 5. Harendra Behera, Rajiv Ranjan and Sajjid Chinoy. (Aug 11, 2021). *Does Offshore NDF Market Influence Onshore Forex Market? Evidence from India*. RBI WPS (DEPR). [Link](https://rbi.org.in/scripts/PublicationsView.aspx?Id=20388#FO@)| [pdf](RBI_Research_Working%20Paper%20Series_2108_Does%20Offshore%20NDF%20Market%20%20Influence%20Onshore%20Forex%20Market?%20%20Evidence%20from%20India_RBI.pdf) 6. RBI. (July, 2023). *Report of the Inter-Departmental Group (IDG) on Internationalisation of INR.* [Link](https://m.rbi.org.in/scripts/PublicationReportDetails.aspx?ID=1244) | [pdf](RBI_Reports_20230705_Report%20of%20the%20Inter-Departmental%20Group%20(IDG)%20on%20Internationalisation%20of%20INR.pdf) ### Others 1. Barry Eichengreen (2011), ’Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System’, Oxford University Press 2. Peter B. Kenen, 2011, ’Beyond the dollar’, Journal of Policy Modeling, Elsevier, vol. 33(5), pages 750-758, September. 3. Robert McCauley, Chang Shu and Guonan Ma (2014), ’Non-deliverable forwards: 2013 and beyond’, BIS Quarterly Review, March 2014 4. Robert McCauley and Chang Shu (2016). ’Non-deliverable forwards: Impact of currency internationalisation and derivatives reform’, BIS Quarterly Review, December 2016 5. Nikhil Patel and Dora Xia (2019), ’Offshore markets drive trading of emerging market currencies’, BIS Quarterly Review, December 2019 6. Harald Hau, Peter Hoffmann, Sam Langfield and Yannick Timmer (2019), ‘Discriminatory Pricing of Over-the-Counter Derivatives’. IMF Working papers. [^1]: Harun R Khan (ex-Deputy Governor of RBI. (2016, June 11). *Foreign Exchange Market & Cross-border Transactions: Some Random Reflections* \[Speech\]. 11th Annual Conference of the Foreign Exchange Dealers Association of India (FEDAI), Hong Kong. RBI. [Link](https://rbi.org.in/scripts/BS_SpeechesView.aspx?Id=1008)| [[Foreign Exchange Market & Cross-border Transactions- Some Random Reflections_RBI_21062016.pdf|pdf]]