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Currencies are traded in the global market at different time zones. And so, they have onshore and offshore markets. Since currencies are a popular asset class, adding it to your portfolio will let you diversify it and optimise your profit-earning potential. However, currency trading is a different and therefore you need to have a good understanding of its fundamentals.
Currency trading in the domestic market is quite straightforward. You can trade in currency derivatives on NSE or BSE exchanges. When currencies are sold within the local market, it is called an onshore market. The onshore market is regulated and monitored by market regulators like RBI and SEBI. But when foreign currencies are exchanged in the overseas market, it’s called the offshore market. It is much more complicated and also difficult to monitor, which is why regulators are wary of the offshore foreign exchange market.
Key Takeaways
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Onshore currency markets operate within a country and are closely regulated, ensuring transparency and stability in INR trading.
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Offshore markets allow foreign participants to trade currencies through NDF (Non-Deliverable Forward) contracts without physical delivery.
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NDF markets offer flexibility as well as global liquidity but remain outside direct regulatory oversight.
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Acknowledging both markets helps traders make informed decisions, manage risks effectively, as well as spot opportunities across global currency movements.
How Do Offshore and Onshore Currency Markets Work?
Understanding how onshore and offshore currency markets function helps traders navigate the broader forex ecosystem with more clarity. Both markets play important roles in facilitating global currency movement, though they operate under very different conditions. Here’s a detailed overview of how they work:
1. Working of the Offshore Currency Market
The offshore currency market operates outside the issuing country and allows foreign participants to trade freely without domestic regulatory limitations. Because it is not bound by local conversion rules or capital controls, traders often find higher liquidity and round-the-clock activity. Prices in this segment may differ from domestic levels, creating gaps between onshore and offshore rates.
Much of the offshore volume takes place through non-deliverable forward (NDF) contracts, which allow participants to take positions on currency movements without requiring physical delivery. This makes offshore trading appealing to global banks, hedge funds, and multinational entities looking to hedge currency exposure efficiently.
2. Working of the Onshore Currency Market
The onshore market functions entirely within domestic financial boundaries. It is regulated, monitored, and supported by the country’s central bank and market authorities to maintain transparency and stability. Traders buy and sell INR-related currency derivatives through recognised exchanges, ensuring security and controlled speculation.
Since domestic rules apply strictly, capital movement, settlement cycles, and participation criteria are well defined. These protective measures help avoid excessive volatility and ensure that onshore and offshore price differences remain manageable. For retail traders, onshore markets offer a simplified and compliant structure for trading currency futures and options.
3. Trading NDF Contracts in the Offshore Market
NDF or non-deliverable forward contracts form the backbone of offshore currency trading. These are cash-settled agreements where the difference between the contracted price and the spot price is exchanged on the settlement date.
Since no actual currency delivery takes place, NDFs allow participants to trade currencies that may be restricted or heavily regulated in domestic markets.
Differences between onshore and offshore exchange rates often drive interest in these contracts, making them essential tools for hedging, speculation, and managing exposure to currencies that cannot be freely traded.
Example of NDF
To understand how an NDF works, consider a trader who expects the domestic currency to weaken against the US dollar. Since currency delivery is not allowed in certain jurisdictions, the trader enters into an NDF contract in an offshore market.
Suppose the agreed rate is 78, and on the fixing date, the spot rate becomes 79. The difference is settled in cash, usually in USD, without any actual currency exchange. This example shows how NDFs help traders manage exposure when normal trading is limited, while also reflecting pricing gaps between onshore offshore markets.
Trading NDF Contracts in the Offshore Market
Currency trading can be complex due to the split between the domestic Indian market and the offshore market. In India, USD/INR is traded on regulated exchanges like the NSE. In contrast, foreign investors who lack direct access to India's markets trade Non-Deliverable Forwards (NDFs). NDFs are OTC contracts, not exchange-traded futures, and are primarily settled in financial hubs like London, Singapore, and Dubai. This separate NDF market creates a unique set of price dynamics that domestic traders must also consider.
NDF market typically develops for currencies where the local currency derivative market is underdeveloped, or traders are restricted by unfavourable tax structure. So, traders shift their focus to the NDF market, which grows in an offshore location.
Let’s understand NDF with an example. A foreign trader can’t trade in rupees and needs to settle deals in his native currency. Suppose he expects Indian rupee to depreciate against the dollar in the next three months and buys a forward for Indian money, which he settles in dollar due to convertibility restrictions. Hence, he deals in non-deliverable forward or NDF.
Key players in the offshore currency market include the foreign banks, companies doing business in countries with foreign currency regulations, currency traders, hedge funds, commercial and investment banks.
Although offshore currency trading through NDF enjoys growing interest among investors, it’s not free from controversies. Trading in a foreign location makes it particularly challenging for regulators like RBI and SEBI to monitor, which is why the regulators are wary of offshore currency trading.
Moreover, overseas markets also eat into the share of local market trading as big investors shift their deals to foreign locations where it is less regulated and cheaper. That is why the government is trying to amend its policies towards foreign exchange dealings to control the growth of offshore Indian rupees market.
Fabric Of the NDF Market
As we have discussed above, physical settlement of the asset never takes place in NDF trading. Two parties agree to settle the differences in rate, between the agreed price on contract and spot rate, in cash, preferably in US dollar. Hence, all deals in NDF market are quoted in USD.
Cash flow= (NDF Rate – Spot Rate )*Notional amount
These contracts are over-the-counter deals; quoted for a short duration between one month and one year. The contract mentions a currency pair, notional amount, fixing date, settlement date, and NDF rate.
The fixing date on an NDF is the same as the expiration date of a futures contract. On fixing date, NDF is settled on the spot rate of that day, and one party pays the difference to the other.
Example: Suppose one person agrees to sell Indian rupees (buy USD) at the rate of 78 to another party which will buy rupees (sell USD). Now if rate changes to 77.5 in one month, then the party who bought rupee will owe. Conversely, if the rupee depreciates to 78.5, then the party who is selling will owe to the other party.
The offshore currency market for NDF emerged during the 90s for Korean Won and Brazilian Real, but now other major foreign currencies also trade in it. There is a big market for offshore currency trading in Chinese Renminbi, Indian Rupees, Malaysian Ringgit, and more.
Spot traders, arbitrageurs, exporters and importers, scalpers, positional dealers are some of the key participants in the NDF market.
Features of Onshore and Offshore Markets
The Onshore and Offshore Markets operate differently based on accessibility, regulation, and trading flexibility. Here are their features:
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Onshore markets are supervised by domestic regulators, making them more transparent and structured.
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Trades in onshore markets happen during local market hours, with strict rules on currency convertibility and settlement.
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In contrast, offshore markets offer greater flexibility, allowing participants to trade round-the-clock with fewer restrictions.
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Offshore markets often handle large volumes, especially in NDF contracts, and attract global investors seeking higher liquidity.
Together, the onshore and offshore markets influence currency pricing, hedging opportunities, and overall market sentiment.
Benefits of the NDF Market
Key advantages include:
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Access to restricted currencies: NDFs provide access to restricted currencies that cannot be readily traded or settled domestically. This exposes global participants to capital-controlled markets like as the CNY, INR, and KRW, among others.
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Efficient currency hedging: NDFs are used by corporations, multinational enterprises, and global investors to effectively hedge risks in emerging-market currencies, stabilising cash flows during exchange rate volatility.
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Cash-settled with little operational risk: NDFs are settled in USD, thus physical delivery is unnecessary. This reduces documentation, facilitates settlement, and reduces counterparty risk.
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Useful for speculating: NDFs allow traders to take directional views on currency fluctuations without having to cope with onshore laws, making them ideal for speculative and arbitrage tactics.
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Customisable contract structures: Contract size, duration, and settlement conditions may be adjusted to match individual hedging needs, providing greater flexibility than many deliverable forwards.
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Global hubs have high liquidity: Trading activity in places such as Singapore, London, and Dubai assures high liquidity, competitive pricing, and timely execution.
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Round-the-clock availability: NDF markets have extended hours, allowing participants to respond swiftly to global developments, as opposed to onshore markets, which follow domestic trading schedules.
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Bridging onshore-offshore gaps: NDFs assist in controlling volatility in locally regulated currencies by providing flexible access and effective hedging.
Market Dynamics: Onshore vs Offshore Currency Trading
The dynamics of onshore vs offshore currency trading vary based on regulation, liquidity, and market behaviour. Onshore markets are closely monitored by domestic regulators, leading to controlled volatility and structured price movements.
Offshore markets, on the other hand, operate with fewer restrictions, resulting in higher liquidity and quicker reactions to global economic shifts. These differences often create price gaps between onshore vs offshore markets, influencing hedging strategies, speculation patterns, as well as overall currency sentiment for global traders.
Drawbacks of the NDF Market
Despite its global relevance, the NDF market comes with several limitations that traders must consider:
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Lack of Regulatory Oversight: NDFs operate outside of domestic financial institutions; therefore, they are not subject to local regulations, resulting in a lack of regulatory oversight, particularly when compared to the structured environment of onshore and offshore domestic currency markets.
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High Volatility: Prices can vary dramatically since NDF rates frequently respond to global sentiment rather than domestic economic fundamentals, resulting in a divergence from actual currency circumstances.
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Onshore Offshore Price Gaps: These gaps can lead to arbitrage opportunities, influencing speculative trades that put additional pressure on the domestic currency. For emerging economies, this can trigger instability, as offshore speculation may move faster than local regulatory responses.
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Liquidity Concentration: Only a few global financial hubs dominate NDF trading, limiting broader participation and increasing reliance on external markets. Additionally, since NDF contracts do not involve physical currency delivery, domestic participants may struggle to hedge exposures accurately, especially when large market players influence rates.
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Limited Hedging Flexibility: NDFs may have shorter tenors than exchange-traded instruments, limiting long-term hedging opportunities.
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Counterparty and Basis Risk: NDFs, like OTC contracts, have counterparty default risk. Settling against a reference rate rather than the actual current rate raises basis risk.
Concerns Over NDF Market
Concerns are rising over the expanding offshore currency market. In the past, the foreign currency market played a critical role in indicating the domestic market crisis. Both in 2013 and 2018, signs were present in the offshore market before the crisis hit the Indian economy. The change in sentiment in the overseas market led to a change in demand in the domestic market.
Also, differences in rates in the internal and offshore markets give rise to onshore-offshore currency arbitrage opportunities.
Thirdly, the offshore market is less regulated and highly liquid, which means it can cannibalise the stringent domestic market as traders shift to the NDF market to evade government regulations.
Conclusion
Even amid rising concerns over the offshore currency market, it is unavoidable. Since currency makes a great asset choice to diversify your portfolio, you can add it to amplify your profit earning. Even if you limit your exposure to the domestic market, garnering a fair idea about how the offshore market works will help you make sensible speculations in the native market.