How RBI Managed To Fend Off An Old Foe — The Offshore Rupee NDF Market

In each of these episodes, a familiar foe emerged—the non-deliverable forwards market for the dollar/rupee pair. Trades in this segment, which the Reserve Bank of India had least control over, would often spill over into volatility in the spot markets, making the central bank's job that much tougher.

Starting June 2020, the RBI had allowed Indian banks to trade in this segment via their branches at the International Financial Services Centre at GIFT City. In the two years since, dynamics of this segment have changed significantly.

Monthly NDF volumes on the IFSC, according to industry estimates, are now between $20-25 billion, and this has brought down the arbitrage between offshore and onshore markets. No public data on volumes is available.

"The arbitrage between onshore and offshore market has narrowed considerably as Reserve Bank’s action has created a level playing field for all participants," said Bhaskar Panda, senior vice president at the treasury advisory group at HDFC Bank.

What used to be a 10-15 paise gap between the two rates is now down to 2-3 paise, said the head of treasury for a foreign bank, speaking on the condition of anonymity. Even if the gap widens in times of stress, there are now a large number of banks active, who would jump in to take advantage of the arbitrage, which will then dissipate quickly, this person said.

The arbitrage has narrowed most for the one-month non-deliverable forwards where the market is most liquid, said an executive at a private bank treasury. The arbitrage for the 3-6 month contracts has narrowed but is still wide, this person said, speaking on the condition of anonymity.

"While the arbitrage between the NDF and onshore markets had been narrowing since 2013-14, after merchanting trade was opened up, the opening up of the segment to Indian banks has certainly made a difference," said Ananth Narayan, associate professor at the SP Jain Institute of Management and Research.

An email sent to the IFSC authority seeking details on this segment on Thursday was not answered.

As the RBI defines it, "an NDF is a foreign exchange derivative contract, which allows investors to trade in non-convertible currencies, with contract settlement in a convertible currency, mostly U.S. dollars".

These contracts, until recently, mostly traded offshore. In times of stress, foreign participants would take positions in this segment, which traded outside of local hours, based on local and global news flow. When domestic markets opened, the movements in the NDF market would spill over quickly.

Over the years, as volumes grew, the NDF market became a source of consternation for the central bank.

Data from the Bank of International Settlements, last released in 2019, showed that the rupee NDF segment had become one of the largest, with daily volumes surging across centres like London, Hong Kong and Singapore.

More importantly, the 2019 survey showed that the size of the market had increased to become almost thrice as large as the onshore market.

A committee, headed by former deputy governor Usha Thorat, examined the issue in 2019 and suggested that onshore market hours be extended to improve access of overseas users and that banks should be allowed to freely offer prices to global clients around the clock. It also suggested that rupee derivatives (settled in foreign currency) be traded on exchanges in the International Financial Services Centres in India.

The committee, however, was not in favour of allowing Indian banks to operate in the NDF market.

"The onshore rupee derivatives market is currently more deep and liquid as compared to the offshore rupee market and participation of the Indian banks in the offshore market might, over time, take away this advantage,” the committee said. It also feared that allowing Indian banks access to the NDF segment would mean that price discovery will happen offshore rather than onshore.

Despite the committee's recommendations, the RBI decided to allow Indian banks to operate in the NDF segment starting June 2020.

Since then, most large private sector banks and foreign banks with branches at the IFSC have begun operating in this segment. As a result, volumes have started to build up.

"Some part of the volume from offshore would have transferred to the IFSC as MNCs and funds with presence in India would be able to use that route," said Panda.

In addition, foreign banks can now take larger positions, explained the treasury head quoted above. Foreign banks can do one leg of the transaction offshore and one leg onshore and net it off so net open position is not high, this person said, explaining that this too would add to volumes.

A majority of the volumes would be on account of trading rather than hedging, said the private bank treasury executive quoted above. However, it is possible that Indian banks may be handling one leg of the hedging of underlying transactions by foreign corporations and funds, this person said.

More robust local NDF trade means that the risk from the offshore market dissipates to a considerable extent. It is not that offshore can't still lead the onshore markets but the spread and arbitrage gets absorbed more quickly, the foreign bank treasurer quoted above explained.

"While we cannot say that risk has completely gone away, it has certainly reduced," said Panda.

In addition, more liquidity in the NDF market is leading to price discovery and concerns that the price setting would happen offshore have not proved to be correct, the private bank treasury official said.

Depth in the segment also gives RBI more room to intervene.

While it was suspected that the RBI was intervening in the NDF market offshore, it can now do so via banks operating in the IFSC as well, said Narayan. There are indications that it has done so via large public sector banks, said the private bank treasury official quoted above.

According to Narayan, in some ways, additional liquidity added by Indian banks to this segment could allow for foreign players to take larger positions since low liquidity would no longer be a concern. He added that India hasn't been tested in recent years in a way where large positions are accumulated offshore against the rupee. While the probability is low, in such a situation, things could still go awry, Narayan said.