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The Battle of the NDF Trading Venues
Non-Deliverable Forwards (NDFs) have become essential tools in emerging market investing, allowing access to emerging and frontier currencies that do not otherwise have an FX market. NDFs, unlike standard currency forwards, do not involve the physical exchange of currencies. Instead, counterparties settle the difference between the contracted NDF price and the current spot price at the maturity of the contract. Market adoption of electronic trading and central clearing in NDFs has not kept pace with other emerging market derivatives but is quickly catching up and rapidly becoming more complicated. Emerging market investors must develop a clear understanding of NDF market structures and the regulations that impact them if they are to successfully implement an execution strategy in these instruments.
The electronification and central clearing of emerging market NDFs has been made more complicated by two significantly different interpretations of the electronic trading regulations. Under Dodd-Frank, standard emerging market currency forwards were exempt from these regulations — so the larger foreign exchange market has not previously encountered these issues. Other emerging market fixed income derivatives, such as interest rate swaps, implemented trading rules in 2013, meaning these markets have already suffered through the growing pains necessary for regulators and the industry to coalesce around market standards. Investors therefore could be lulled into thinking these reforms were also completed for NDFs, but the journey is just beginning for those instruments. The quality of execution in NDFs, however, depends on investors understanding of the obstacles along the journey.
Competing interpretations of NDF regulations by trading venues has led to the emergence of two distinct business models in the space: registered and unregistered. The difference in interpretation revolves around the counterparty to the trades. While trade execution may appear similar between these two models, their pre-trade and post-trade policies can differ significantly. Therefore, it is essential for investors to understand the advantages and disadvantages of each protocol. Grasping the nuances of each option can significantly enhance execution outcomes and help traders optimize their strategies. Failure to understand these nuances, however, could result in less desirable execution. Investors are not limited to a single model, however. Instead they can, and should, assess each trade based on their specific needs and select the most suitable model on a case-by-case basis.
The controversy and intense competition between the two business models has sparked an information campaign to convince investors to favor one model, despite there being no requirement for investors to do so. The information campaign can be misleading at times, particularly when industry groups publish white papers that do not explicitly disclose important biases such as only involving registered venues in the preparation.
Emerging market investors should stay vigilant in understanding the risks inherent in all market structures. Potential issues, such as regulatory disputes, often lie beneath the surface and can affect execution quality. Experienced traders know to dig deeper to identify these risks, allowing them to capitalize on the opportunities that may arise.
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