Trading instruments are becoming more variable, evolving from traditional asset classes, like stocks and currencies, to extended options, like futures and swaps. There’s another type that started gaining popularity over the last few years, which is non-deliverable forwards.
NDFs are relatively new trading instruments that investing newbies might not have heard of, while proficient traders, especially in the US, have been trading with these assets and are seizing their chance of the growing popularity of NDFs.
Let’s discuss non-deliverable futures and the benefits of trading them compared to other futures contracts.
What are Non-deliverable Forwards?
NDFs are contracts agreed between two parties who decide on the exchange of a particular commodity or assets on an agreed date and price. This might look similar to the usual futures contracts, so what’s the difference?
NDFs do not necessitate transferring the ownership of the subject asset. Instead, both parties engage in paying and receiving the net price difference between the contract and execution days.
NDFs can be executed on a wide range of tradable securities, such as Forex, cryptocurrencies, bonds and commodities. However, it is a common practice in volatile markets, where exchange rates and volatility levels fluctuate.
Traders prefer NDFs to mitigate the market risks associated with transferring the underlying asset associated with the contract, especially if the market undergoes unexpected changes in supply or exchange rate.
If the supply level suddenly drops, the subject security becomes more expensive beyond the contracted price. Thus, the seller incurs massive losses, and the buyer may find challenges in claiming ownership of the asset.
Therefore, non-deliverable forwards mitigate these risks by focusing on exchanging the price difference, making these contracts faster and safer.
NDFs have gained popularity because they allow Forex traders to explore currency pairs that are not usually allowed in regular markets. Due to some restrictions, a few currencies cannot be paired together.
However, thanks to NDFs, Forex brokers can offer an extended selection of currency pairs, including exotics and rares, which hold additional benefits and gain opportunities.
Who Regulates Non-deliverable Forwards
Due to the nature of NDFs, these contracts used to be limited to selected financial institutions and market participants. Moreover, with classic trading methods, finding an interested party to enter the NDF contract was challenging.
However, with the digitalisation of trading processes and the rise of electronic platforms, NDFs have become more common. Most NDF contracts today are OTC executions involving two parties agreeing on the price and asset directly without an intermediary.
Therefore, NDFs have exceptionally grown and are now worth more than $200 billion from trading activities every day, which calls for careful regulations and supervision of these practices by the US Securities and Exchange Commission.
The SEC regulates the NDF contract markets, imposing strict rules and frameworks that mitigate the risks of manipulation and taking advantage of this market.
Thus, Forex brokerage companies have gone offshore to offer NDF contracts to their clients, enjoying higher flexibility and more relaxed rules to offer different types of Forex investments.
NDFs as a Risk Mitigation Tool
Unlike traditional futures contracts, which entail transferring asset ownership, NDFs focus on trading the price difference, making it easier and safer for both parties, especially in markets with high volatility.
For example, if two parties enter an NDF contract on a non-major currency pair, like the CHF/JPY, volatility levels may highly change due to the different nature of the Swiss and Japanese economies.
These changes may include unexpected retractions in liquidity supplies or exchange rates, which can highly affect participants of a future contract. Therefore, non-deliverable contracts help traders avoid these risks by netting the price difference of the currency pair between the contract and the execution dates.
Non-deliverable forward contracts are futures that involve paying the price difference of the subject asset according to the NDF contract. An NDF contract is signed between two parties who agree on paying/receiving the price difference of a certain security at a particular date and price.
Thus, NDFs do not entail transferring the principal ownership, making it easier and safer to exchange these assets without the risk of liquidity and volatility fluctuations.