Updated: August 12, 2021 5:34:45 am
An internal study conducted by the Reserve Bank of India (RBI) has proposed that a real-time basis monitoring of the offshore non-deliverable forward (NDF) market in the rupee is essential to contain any significant spillovers to the domestic market.
As per the study, a closer examination of the data on volatilities in the two markets shows that volatility increases in offshore market before it rises in onshore markets with a lag of one to two days. “Consequently, volatility spillover increases from offshore to onshore markets, as discussed earlier, during the stress period.”
Globally, NDFs are traded only in a handful of locations with the maximum turnover in London followed by New York, Singapore and Hong Kong. South Korean won and the rupee are the most widely traded NDFs in London.
As compared to the onshore market, the turnover in offshore rupee markets has more than tripled between 2016 and 2019. In fact, the rupee NDF turnover at $50 billon exceeded the combined OTC and exchange traded forex turnover of $48.8 billion in April 2019. “Volatility spillovers become unidirectional, from offshore to onshore, and increases significantly during the periods of heightened uncertainty (for example, during April 2012-November 2014 and October 2017-December 2019),” the RBI study said.
As NDF volumes have increased in the recent period, they have begun to play an important role in both price discovery and driving volatility, particularly during heightened uncertainty period. “Thus, a real-time basis monitoring of the market is essential to contain any significant spillovers from the offshore NDF market,” it added.
“The rise in offshore trading can disrupt the price discovery process of exchange rates in onshore market,” the study said. Large spread between onshore and offshore market encourages market players to take arbitrage advantage while speculative activity in the market result in wide divergences. The large spread between the rupee NDF rate and the rupee futures/forward rate can influence the spot rates significantly.
Players in the offshore market do not have access to enough information that domestic market players have and therefore, they react expressively in response to any global shocks that may not have much implications for the domestic economy. “Moreover, the volatility in the onshore segments is contained by central bank intervention. However, a rise in volatility in offshore market is ultimately transmitted to onshore forex markets once the domestic market players start reacting to the movements in NDF segment,” the Reserve Bank study said.
In 2020, the RBI permitted banks in India, which operate International Financial Services Centre Banking Units (IBUs), to participate in the NDF market with effect from June 1, 2020. The RBI took the decision despite the recommendation by a task force set up by it against allowing banks in the NDF market. NDFs are foreign exchange derivative instruments on non-convertible or restricted currencies traded over the counter (OTC) mainly at offshore centres outside the direct jurisdiction of the respective national authorities.
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. 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.
The RBI said some policy measures undertaken by the central bank recently are likely to help in reducing rupee turnover in offshore centres and improve efficiency of price discovery. Some of these measures include the extension of trading hours, introduction of rupee derivatives at International Financial Services Centres (IFSC) and permitting Indian banks to participate in NDF market are likely to improve the access for overseas participants and curb turnover in offshore centres. Domestic banks participation in NDF segment would also support central bank at a time if it wants to intervene in offshore segment.
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