India onshore/offshore NDF markets tipped to converge

Prices for India’s non-deliverable forwards (NDFs) traded in onshore and offshore markets are expected to converge, say market participants, as more local banks look to take advantage of a regulation that allows them to trade in both markets.

The regulation has brought a new dynamic to US dollar/Indian rupee NDF trading since it was introduced by the Reserve Bank of India (RBI) in 2020. The rule change allowed local banks to trade onshore US dollar-denominated NDFs in a special economic zone called the Gujarat International Finance Tec-City in Ahmedabad, known as Gift City, for the first time. It also allowed Indian and foreign banks that had units incorporated in the zone to trade NDFs in the larger offshore market.

The India country head at a European bank in Mumbai says that as the regulation has made it possible for local banks to take advantage of the price differential between onshore and offshore NDFs, it should help the two instruments converge over time.

“For instance, a one-year [onshore] forward was trading at 83 rupees or so. Now they can keep buying at 84 rupees from offshore and selling at 83 rupees onshore. Earlier, they were not allowed to trade NDFs both onshore and offshore,” says the country head.

Gift City’s NDF volumes are still low compared to those traded offshore, but the country head says they are likely to increase: “It’s been only one-and-half to two years since state-owned banks started trading NDFs. The large state-owned banks are still trying to get their act together and will need to put in place systems and processes [to trade]. Once the large Indian and state-owned banks start trading more onshore, the onshore volume will grow.”

Ashutosh Tikekar, head of global markets at BNP Paribas India, believes it will be difficult to fully eliminate the differences between offshore and onshore NDFs, given that the offshore market is more sensitive to risk-off scenarios than onshore, which is under the RBI’s purview.

But in an extreme scenario that impacted the rupee, where for instance the central bank managed currency volatility through limited intervention onshore, there would be a chance for local banks to benefit from the likely price differential between the two markets.

“Any bank with a branch in Gift City can possibly use this arbitrage opportunity in the risk-off environment and that could give some stability to the rupee,” says Tikekar.

Location, location, location

Although established in 2017 as an international financial centre in the special economic zone, the Gift City project was not very successful in attracting volumes until the introduction of the RBI’s NDF regulation in 2020.

“This is an enabling regulation which presents greater operational efficiency to both local and foreign banks,” says Deepak Bhayana, head of global markets, India at MUFG. “Gift City encourages banks and investors to ‘return business back to India’ which is currently in other countries.”

The regulation was initially envisioned with foreign banks in mind, but the RBI eventually agreed to extend its scope to domestic banks after the latter claimed it would give foreign banks’ Indian branches an unfair advantage.

“Local banks urged the RBI to eliminate asymmetry of information… and provide a level playing field to all banks through opening a Gift City branch,” says Tikekar.

Given that it has been only two years since NDF trading started in Gift City, volumes remain negligible compared to those traded in overseas markets. Unofficial monthly figures released by 19 banks involved in NDF trades in Gift City put volumes at roughly $30 billion, up from $10 billion last year.

The latest Bank of England semi-annual turnover survey from October 2021 put the volumes of rupee NDFs traded in London at more than $22 billion per day.

The India country head at the European bank in Mumbai says NDF trading will continue in leading financial centres such as Dubai, Hong Kong, London, New York and Singapore largely because clients will trade out of the location where they are based.

“If they are based in London, they will call someone in London. [They are] not going to call someone onshore in India and trade NDF in India,” he says.

MUFG’s Bhayana agrees that offshore NDF markets are unlikely to diminish in importance. “We reckon there is a large segment of users who would continue to use London as a centre for internal efficiency related to documentation around NDF hedging. Hence, these markets would co-exist but with greater price correlation,” he adds.

But the India country head believes volumes may shift to where pricing is better at any point in time: “If the pricing in India is much cheaper, then people will want to come to Gift City. If the pricing is flat, they will trade in [their] respective countries.”

For the Gift City NDF market to grow further, he says, the next step must involve getting local businesses established in the zone and encouraging them to hedge using the instruments.

“Currently, only banks are set up there. If Gift City is to be like Singapore or Dubai, it needs to have a lot of local clients. Businesses need to set up shop there. Otherwise, how much can banks do with one another?”