How will USD/INR NDF impact volatility?

Will RBI's move of tapping offshore market curb Rupee volatility?

Offshore market prominence is rising from spotting the pre opening levels including the gap in opening trades. This made RBI to take some deliberate steps and tame the NDF markets (Non deliverable forwards). The Central bank has now permitted international banking units of Indian banks to participate in the NDF market from 1st June 2020. This would help in reducing the transmission from offshore to onshore.

What is the difference between onshore and offshore market?

The Onshore market is controlled by RBI and trading is done through OTC or exchange. While in the offshore market, the moves are as per the market expectations and trading sentiments. Price discovery is done by market without any central bank regulations. The major difference lies here is the delivery of the contract. An NDF contract is almost similar to our forward contracts, but there is no physical delivery of currency at maturity and the contract is settled in cash.

What is significance behind such move?

We have seen in recent times that the offshore 1m forwards have traded above onshore by more than Rs 1. Such dislocations skew sentiment and rub off on onshore as well. Participants in offshore are generally those who do not have ready access to onshore. Their interests are often on the same side. During times of risk on, they tend to sell usdinr for carry and during times of risk aversion they unwind. The market there often tends to become one way. We have practically seem times when offshore drives onshore. This move would ensure that such dislocations do not persist for long as number of participants would increase.

What will be the impact?

Since January, the central bank authorised domestic banks to offer foreign-currency transactions and exchange rates post local market hours.i.e (After 5 PM). Rupee offshore is traded in the IFSC centers such as such as Singapore, Hong Kong, London, Dubai and New York. The ideology behind permitting the banks for offshore trading is to control the damage which materializes during uncertain times. The move will allow more participation and curb volatility as the spreads narrow when the market depth is huge. This could avoid gap up opening trades over previous day closing rate. This will enhance volume trading and participation encouraging price discovery.

What will be disadvantage of RBI’s move?

Contrarily there is a catch here; sometimes offshore trading limits have thrived than the onshore trading raising concerns for the central bank at the time steep depreciation/appreciation in the currency. It can prove to be a conundrum for RBI as this will lessen the control over currency, unlike stocks and bonds.

Forward premiums crashed

There is abundant INR liquidity after the slew of measures announced by the RBI. Banks are doing a Buy-Sell USDINR swap and lending the USD to earn a clear spread of 1%. Eg: Domestic Banks could borrow 3M at 4.4% (repo rate), receive 3.95% by doing B-S in forward market for 3M. The loan amount will be parked in USD where 3M LIBOR is at 1.45%. Hear lies a clear 1% arbitrage risk free income. Forwards crashed with Cash-tom even flipping into a discount. The April end forward points had reduced to merely 0.60p per day. Annualised forward premium have come down from on an average of 4.7% to 3.8%.