What Are NDFs and How They Assist Investors in Risk Hedging

Since the inception of broad trading markets, liquidity, demand, and supply have firmly dictated investors' strategies. Regardless of the tradable assets, every market experiences risks related to liquidity. Low liquidity levels impact the volatility of tradable assets, from stocks, bonds and fiat to crypto assets.

Non-deliverable forwards have gained global popularity thanks to their unique ability to minimise volatility risks. They allow investors to lock in desired contracts several months in advance, ensuring that they receive favourable exchange quotes in the near future. This article will explore the unique characteristics of NDFs and how to utilise them effectively in the trading market. 

Non-deliverable forwards (NDFs) are two-way agreements between parties to conduct a predetermined exchange of currencies or other commodities at a specified date and price. However, it is crucial to mention that NDF contracts do not imply transferring the principal amount between the two parties. Instead, NDF agreements focus on the net difference between the agreed-upon exchange rate and the current rate of a specified currency. 

Thus, NDFs provide a safety blanket for investors expecting material market volatility movements. By correctly predicting the expected price variance, investors can sign the corresponding NDF contracts and ensure to minimise their losses related to a specific currency. Signing a non-deliverable forward contract requires two parties that have aligning needs.

Previously, finding an NDF counterparty posed a significant challenge in some instances, as there were limited channels for seeking them out. But with digital innovations simplifying global communications, NDF contracts have become far more common and easy to initiate. 

It is crucial to mention that NDFs are mostly over-the-counter contracts, which means they are executed directly between the issuing parties. NDFs are also primarily conducted in offshore markets, as volatile currency markets can often ban or restrict such practices within the domestic market. In some cases, the currencies subject to NDFs might be prohibited from moving offshore.

However, cunning traders have found a way around the currency restrictions by leveraging the freedom of the international market. Simply put, the NDF counterparties can execute the deal in a freely traded currency, transferring the respective equivalents of the initial currency. 

As of 2023, NDF trading is one of the most popular types of forward contracts, reaching up to $260 Billion in daily transactions, according to the Bank for International Settlements (BIS). The popularity and global adoption of NDFs are not surprising as they provide additional risk-hedging options for problematic and volatile currencies. No other forward contracts can provide a viable risk-mitigating alternative for traders dealing with highly fluctuating currencies, including cryptos. 

Understanding non-deliverable forward trading is no easy task. NDFs are one of the most complex and advanced mechanisms in the trading market. So, let's explore a simplified example to visualise the entire NDF process, from the initial agreement to the final settlement date. 

Suppose there are two traders on the market. Trader A wants to exchange GBP for USD. Conversely, trader B is interested in conducting the opposite exchange. Thus, the two parties decide to sign an NDF contract, legally binding themselves, to execute a currency exchange on the predetermined future date. First, the two parties must agree on the mutually beneficial NDF rate, which will then be fixed for the duration of the contract. Let's say the two parties have chosen an NDF rate of 1.2 for GBP/USD in this case. NDF rates are generally calculated by combining the interest rate compounds, liquidity forecasts and market risks to derive a fair exchange figure for both parties. 

Investors A and B should also agree on the notional amount, the principal exchange volume. In this case, the exchanged amount is £10,000. Finally, the parties agree on the fixing date, which will be utilised in the final formula to determine the NDF cash flow. Fast forward to the fixing date, the two traders see that the current spot rate is 1.3 GBP/USD. Since the current spot rate is greater than the NDF rate, the NDF contract is favourable for investor A, who will receive the difference between the two currency rates multiplied by the notional amount. Thus, investor A nets £1,000 profit from the NDF agreement. 

Conversely, if the prevailing spot market rate for GBP/USD turned out to be 1.1, investor B would receive profits equal to £1,000. The exchanged amount is only the difference between the rates without requiring a physical exchange of the principal amount. Finally, the two parties must transfer the remaining difference at a specified settlement date, usually shortly after the fixing date. And thus, the NDF contract is fully honoured by both parties. 

The formula for calculating the NDF difference to be transferred is as follows: 

Deliverable forwards (DFs) share many similarities with the NDFs. In practice, these trading mechanisms function similarly. In the case of DFs, trading parties agree on the exchange date, fixing date, the predetermined exchange rate and the principal amount. However, unlike the NDF method, trading parties must exchange the principal amounts and the spot rate difference. 

Thus, the DF mechanism is a more straightforward futures contract that enforces the principal exchange between the parties. This seemingly slight difference is crucial in two aspects - DF contracts are more costly and require more liquidity. Additionally, DFs must be conducted with currency pairs that can be legally exchanged for each other. 

Due to jurisdictional constraints and international laws, many currencies can't be exchanged directly, which is a substantial limitation for numerous traders. Therefore, deliverable forwards are not the best mechanisms for traders who wish to capitalise on price discrepancies and different liquidity levels on the international market. 

Currency risk is a prevalent factor in the global forex market and beyond. Regardless of the trading industry, every investor keeps cash reserves in their preferred currencies. So, mitigating the currency volatility is a universal mission for all active traders. While some popular currencies, like the US dollar, are reliably backed by various trading instruments and fiscal policies, most foreign currency types do not have this luxury.

Thus, numerous cases of market volatility and liquidity concerns emerge at frequent intervals. The causes for price variation can be socio-political, economic or strictly commercial. Regardless of the causing factors, numerous currencies experience volatility across the globe. On the one hand, traders that mainly trade with the above-mentioned illiquid currencies wish to hedge their risks and acquire a mechanism that helps them control potential damages.

On the other hand, opportunistic traders across the globe wish to fill the liquidity gaps to reap considerable returns. However, numerous government restrictions and international regulations forbid them to enter the volatile markets directly. With NDFs, traders can swiftly fulfil both strategies, increasing their defensive and offensive capabilities simultaneously. 

For many traders, the main attraction of NDFs is their ability to honour indirect currency exchanges, which puts the entire global exchange market in play. In this context, NDFs function similarly to synthetic foreign currency loans, where the financial transaction is settled with an exact equivalent of the nominal currency stated in the contract. Thus, with correctly placed NDF contracts, no currency is off the table for international traders. 

Naturally, the degree of freedom and risk hedging provided by NDFs has turned them into a globally demanded mechanism. In 2023, NDFs enjoyed an unprecedented level of popularity without showing any signs of slowing down. The over-the-counter nature of NDFs puts them in uncertain regulatory waters, but they are not strictly illegal. 

Moreover, NDFs are quite complex and require substantial trading knowledge to be executed. However, their increased popularity despite the numerous technical challenges showcases the sheer significance and value of NDFs on the international market. 

Naturally, NDF trading is supported by liquidity providers on the trading market. While the practice of supplying NDF liquidity is relatively fresh in the trading landscape, several reputable brokers are providing good terms for interested investors. To acquire NDF liquidity, traders must first analyse the initial terms carefully. 

Some brokers might provide significant capital for creating NDF contracts but also charge substantial service fees. Thus, selecting a liquidity option that provides optimal capital without overcharging for their rendered services is important. 

Additionally, since NDF trading is an over-the-counter practice, the reputation of liquidity providers must be flawless without exceptions. NDFs are not closely regulated in the digital trading landscape. Thus, if the traders partner with unreliable LPs, there are high chances of getting scammed or flat-out robbed. So, checking liquidity providers' backgrounds and overall track records is vital to eliminate fraud possibilities. 

It is no secret that the trading landscape continuously iterates on its mechanisms and concepts. Brokers, financial institutions and market makers are frequently trying to provide superior mechanisms that accumulate different strengths of existing instruments. One such novel offering was recently presented by the B2Prime liquidity provider. 

The creative team behind B2Prime decided to fuse the CFD and NDF concepts together to provide an instrument that is both a tremendous risk-hedging device and a gateway to earning handsome returns. In simple terms, NDF CFDs work like standard contracts for difference, allowing traders to acquire positions far beyond their current financial capabilities. 

Unlike the standard NFD offerings, B2Prime has constructed a combined trading instrument that enables traders to access settlements as CFD contracts within the next business day. Thus, the entire NDF contract will be executed smoothly, efficiently and in a fraction of the time, minimising the client settlement risks in the process.  

With this option, B2Prime intends to open up the international trading market for small to mid-sized investors. Currently, NDFs are mostly traded by larger-scale traders and companies. However, with NDF CFDs, B2Prime has paved the way for smaller players to enter the market and acquire significant trading positions.

NDF CFDs also enable investors to settle the NDF agreements in the US dollar equivalent of the original currencies. Alternative currency options are also available on B2Prime's website for traders who wish to execute the NDF contracts in the form of CFDs directly. 

B2Prime's NDF as CFD offering is presented in seven currencies, an unprecedented freedom of choice in this field. B2Prime allows investors to access money markets otherwise prohibited for their trading needs. Here's a list of NDF currencies presented by B2Prime: 

As the NDF trading landscape continues to evolve, adding new currencies to the equation is crucial, keeping the trading options varied for investors. B2Prime is dedicated to adding any emerging market currencies to their list, allowing traders to enter new sectors without hassle. 

NDFs are undeniably complex trading tools not suited for every investor worldwide. They require deft knowledge of the trading markets, international economy and political developments. However, NDFs can handsomely reward those who decide to master this niche in terms of hedging their risks and diversifying their portfolios. Due to the global uprise in NDF popularity, brokerage firms should carefully consider adding them to their instrument roster, potentially boosting their returns.