LONDON, March 9 The growing trade in currency forwards acted as a useful "adjustment valve" for emerging markets in the past year by allowing investors to hedge exposure to the asset class, a BIS report said on Sunday.
Emerging markets have been buffeted repeatedly since the U.S. Federal Reserve announced last May that it would start cutting the monthly bond-buying that had financed an investor spending spree on higher-yielding emerging assets.
But the turbulence may have been worse without the ability to hedge currency exposure via forward markets, the Bank for International Settlements said in its quarterly review.
"Surprisingly, when seemingly impending 'tapering' ... led investors to reduce their exposures to emerging market bonds, some markets experienced little net selling. Instead, investors sold local currencies in well-functioning forward currency markets, including NDFs," BIS said.
It was referring to non-deliverable forwards, derivatives that allow investors to take positions in currencies where trade is subject to official controls. An NDF deal is a contract for the difference between an exchange rate agreed months before and the actual spot rate when the trade matures.
The forwards served as "the 'main adjustment valve, allowing investors to hedge the currency risk in their bond holdings," the BIS added.
Turnover in the emerging currency derivatives, including NDFs, increased by 40 percent in the past three years until 2013, the BIS said last year, attributing this to investors seeking to cut exchange rate risk.
NDF turnover doubled between 2008-2013 to 2.4 percent of overall currency trade, the BIS said, and 23 percent of the trade in forwards. It estimated that turnover in Asian NDFs was 10 times what it had been in the early 2000s.
Daily NDF turnover in London currency trade amounted to $43 billion, compared with $19 billion in October 2008, the report said, though it contracted from April 2013 levels. BIS attributed this partly to U.S. regulatory changes aimed at making derivatives trading more transparent.
Indications are the selloff in emerging market currencies is giving this market a fresh impetus.
"Since April 2013, NDF trading has been affected by investors' and borrowers' hedging in anticipation of a reduction in global monetary easing," BIS said, adding that hedging had been driven by foreigners invested in emerging markets and emerging market companies that had borrowed overseas in hard currencies.
However, growth in NDF popularity is not uniform. BIS highlighted the Chinese yuan where Beijing has permitted a limited offshore trade in the currency.
As a result, between April 2010-2013 offshore yuan deliverable forwards rose from zero to $7 billion per day, while NDFs rose by less to $17 billion per day.
Since April 2013, the offshore yuan may have closed in further on the NDF market, BIS said, noting that the share of yuan NDFs in the total yuan forwards market fell to 75 percent from 85 percent between April and October 2013.