What are Non-Deliverable Derivatives (NDD)? Features, Risks and RBI Move Explained

Why in News ?

• The Reserve Bank of India (RBI) has directed banks to avoid participation in Non-Deliverable Derivative (NDD) contracts involving the rupee, reflecting concerns over currency volatility and speculative pressures.
• The move comes amid increased fluctuations in the rupee and global uncertainties, where offshore markets have been influencing domestic currency trends.

About Non-Deliverable Derivatives (NDDs)

• A Non-Deliverable Derivative (NDD) is a financial contract in which two parties agree on a future exchange rate for a currency, but settle the difference in cash rather than through physical delivery of the currency.
• In the case of India, such contracts are typically settled in foreign currency, usually US dollars, instead of the Indian rupee.
• These derivatives are primarily traded in offshore markets, beyond the direct regulatory jurisdiction of the RBI.

Why NDD Markets Emerged

1. Capital Controls in India

• India follows a partially convertible capital account, which restricts the free movement of capital across borders.
• Due to these restrictions, foreign investors cannot freely trade the rupee in onshore markets, leading to the development of offshore alternatives like NDDs.

2. Need for Hedging Currency Risk

• Foreign investors holding Indian assets face exchange rate risk, especially due to rupee volatility.
• NDDs provide a mechanism to hedge against currency fluctuations without requiring actual rupee transactions.

3. Offshore Financial Market Development

• Global financial centres such as Singapore, London, and Hong Kong have developed active NDD markets, catering to international investors dealing with restricted currencies.

Participants in NDD Markets

• The NDD market is widely used by:
  • Foreign institutional investors (FIIs/FPIs)
  • Hedge funds
  • Global banks
• These participants typically do not have direct access to India’s domestic forex market, making NDDs a key instrument for exposure to the rupee.

Key Features of NDDs

1. Cash-Settled Contracts

• Unlike standard derivatives, NDDs involve no physical delivery of currency, and only the net difference between contracted and actual exchange rates is settled.

2. Offshore Trading

• These contracts are executed outside India’s regulatory framework, limiting the RBI’s direct control over such transactions.

3. Forward Rate Agreement Nature

• NDDs function similarly to forward contracts, where parties lock in an exchange rate for a future date.

4. Influence on Rupee Markets

• Despite being offshore, NDD rates often influence domestic rupee expectations, especially before Indian markets open, acting as an informal price signal.

Issues with NDD Markets

1. Distortion of Price Discovery

• Since NDD trading occurs offshore, it may not reflect actual domestic demand-supply conditions, leading to distorted exchange rate signals.
• This weakens the effectiveness of the RBI’s monetary and exchange rate management.

2. Speculative Trading Practices

• Market participants may engage in frequent entry and exit of contracts to exploit short-term currency movements, turning a hedging instrument into a speculative tool.
• Such speculative behaviour can increase volatility in the rupee exchange rate.

3. Reduced Regulatory Control

• As these markets operate outside India, the RBI has limited oversight and intervention capability, making it difficult to manage sudden capital flows or currency pressures.

4. Transmission of External Shocks

• Offshore markets can transmit global financial shocks into the domestic currency market, even when domestic fundamentals remain stable.

Significance of RBI’s Directive

1. Strengthening Onshore Forex Market

By restricting bank participation in NDDs, the RBI aims to shift trading activity back to regulated domestic markets, improving transparency.

2. Reducing Speculative Pressure on Rupee

Limiting exposure to NDDs can curb speculative attacks and excessive volatility, stabilising the currency.

3. Enhancing Monetary Policy Effectiveness

Better control over exchange rate dynamics ensures more effective transmission of monetary policy decisions.

Way Forward

• Gradually deepen and liberalise onshore forex markets to provide better alternatives to offshore trading
• Enhance regulatory coordination with global financial centres
• Strengthen monitoring of speculative activities
• Balance capital account openness with financial stability concerns