What is a Non‑Deliverable Swap (NDS)?
An NDS is a currency swap used when one of the currencies is restricted or non‑convertible in the local foreign‑exchange market. Unlike a conventional currency swap (which involves exchanging principal and interest flows in two currencies), an NDS never physically exchanges the restricted currency. Instead counterparties settle the difference in a freely‑convertible currency (commonly U.S. dollars) based on a pre‑agreed contract (strike) rate and the spot fixing on each settlement date.
Key takeaways
– NDSs let parties hedge or transfer economic exposure to a restricted or illiquid currency without exchanging that currency.
– Settlements are cash‑only in a freely tradable currency (usually USD) and reflect the difference between the contract rate and the prevailing spot fixing.
– NDSs are widely used by multinationals and financial institutions exposed to countries with capital controls or limited market liquidity.
– Because they are bespoke and can carry counterparty and basis risk, NDSs are typically used by experienced institutional participants and are subject to swap/derivatives regulation (e.g., under Dodd‑Frank in the U.S.). (Sources: Investopedia; CFTC; Silicon Valley Bank.)
How NDSs work (conceptual)
– Parties agree a notional amount and a contract exchange rate (e.g., X local currency units per USD), settlement currency (typically USD), fixing dates, and periodic settlement dates.
– On each settlement date a fixing (spot) rate is observed (often two business days before settlement).
– The net cash settlement (in USD) equals the dollar amount needed to make the economic effect equivalent to exchanging the currencies at the contract rate versus the observed spot. No local currency is delivered.
– An NDS can be viewed as a series of non‑deliverable forwards (NDFs) for each settlement date packaged together.
Key variables in an NDS
– Contract (strike) exchange rate (local currency per USD).
– Fixing (spot) exchange rate observed on the fixing date.
– Notional amount and which cash flows are being hedged (e.g., periodic interest, principal).
– Settlement currency (typically USD) and the settlement formula/obligation.
– Tenor and frequency of settlements (monthly, quarterly, semiannual, etc.).
– Counterparty credit arrangements and documentation (ISDA, credit support annex).
Practical settlement formula (presentation used in many examples)
A commonly used way to express the per‑period net USD settlement is:
Net settlement (USD) = USD‑cash‑flow_for_period × (Spot_fixing / Contract_rate − 1)
Notes:
– Express both contract_rate and spot_fixing in the same quote convention (e.g., local currency units per USD).
– USD‑cash‑flow_for_period is the USD amount being hedged for that period (this could be interest or principal, or a USD equivalent of local currency cash flow).
– If Spot_fixing > Contract_rate, the term in parentheses is positive and the USD receiver obtains funds (reflecting local currency depreciation vs. the contract). If Spot_fixing < Contract_rate, the USD payer owes funds.
Worked example (based on the Investopedia illustration)
Context: A bank in Argentina (LendEx) has a US$10 million loan at 4% p.a. It is concerned the peso will depreciate, making USD repayments more expensive. Suppose an NDS is arranged with a contract rate of 6 pesos per USD, and settlements are expressed against the USD cash flows of the loan.
– Annual USD cash flow (interest) = 10,000,000 × 4% = $400,000 (this example uses annual cash flow in the settlement formula).
– If a fixing two days before settlement is 5.7 pesos/USD:
Net settlement = $400,000 × (5.7 / 6 − 1) = $400,000 × (0.95 − 1) = −$20,000.
Interpretation: LendEx pays $20,000 to its NDS counterparty (the peso strengthened relative to the contract).
– If a later fixing is 6.5 pesos/USD:
Net settlement = $400,000 × (6.5 / 6 − 1) = $400,000 × (1.083333 − 1) = +$33,333.
Interpretation: LendEx receives $33,333 (the peso has weakened vs. the contract), offsetting its higher local‑currency cost to obtain USD.
(These numbers illustrate the mechanics; actual settlement calendars, day‑count conventions and whether you use period‑specific cash flows or annualized flows will be defined in the trade terms.)
Who uses NDSs and why
– Multinational corporations: hedge repatriation risk and avoid costly or illegal local FX conversions.
– Domestic banks in FX‑restricted jurisdictions: hedge foreign currency loan or deposit exposures.
– Hedge funds and institutional investors: take or hedge views on restricted currency moves without needing direct access to the local FX market.
Advantages and limitations
Advantages
– Provides economic hedge when local delivery is impossible or prohibitively expensive.
– Avoids the operational and legal complexities of transacting in restricted local currency markets.
– Flexible tenors and tailored settlement schedules.
Limitations and risks
– Counterparty/credit risk: settlements are bilateral unless centrally cleared or collateralized.
– Basis risk: NDS cash settlement uses a given fixing source — actual business FX costs may differ.
– Liquidity and pricing: markets for some restricted currencies are thin; spreads can be wide.
– Regulatory and documentation complexity: swaps can fall under derivatives regulation (see below).
– Accounting/tax: hedge accounting requirements and tax treatment must be considered.
Regulation and documentation
– In many jurisdictions, swaps (including currency swaps and some NDF/NDS structures) fall under financial‑derivatives regulation. In the U.S., Dodd‑Frank gave the Commodity Futures Trading Commission (CFTC) authority over the swaps market; regulations require reporting, centralized clearing for certain standardized products, and margining for uncleared swaps where applicable (see CFTC/Dodd‑Frank). (Source: CFTC.)
– Standard documentation is usually an ISDA Master Agreement with an NDS confirmation or bespoke terms; a Credit Support Annex (CSA) may be used to manage collateral/margin.
Practical steps to implement an NDS (step‑by‑step)
1. Define the exposure
– Identify which cash flows or notional you want to economically hedge (periodic interest, principal, currency‑cash receipts). Quantify timing and amounts.
2. Understand local FX mechanics and regulation
– Confirm whether the local currency is non‑convertible or subject to controls, and which market fixings are accepted. Check whether an NDS is legally enforceable under local and counterparties’ jurisdictions.
3. Choose contract terms
– Notional currency and amount to be hedged.
– Contract (strike) exchange rate and whether it’s fixed or formula‑based.
– Tenor and settlement frequency.
– Fixing source (e.g., an agreed FX spot rate provider and the fixing convention).
– Settlement currency (usually USD) and exact settlement mechanics/formula.
4. Select counterparties and credit arrangements
– Use banks or dealers with capacity and willingness to trade restricted‑currency products. Consider credit lines, collateral, and clearing options (if any). Negotiate collateralization (CSA) to mitigate credit risk.
5. Negotiate legal documentation
– ISDA Master Agreement + confirmed terms for the NDS. Ensure definitions, fallback provisions for missing fixings, events of default, and close‑out and netting provisions are clear.
6. Price the trade and consider accounting
– Obtain market quotes and run valuation models (mark‑to‑market) to assess costs/benefits. Coordinate with accounting and tax teams to determine hedge accounting eligibility and tax consequences.
7. Monitor and manage
– Monitor fixings, collateral calls, counterparty exposure, and the effectiveness of the hedge relative to actual operational FX flows. Be prepared for settlement netting and potential margin requirements.
8. Close or unwind
– If you need to unwind early, negotiate an offsetting NDS with your counterparty or enter a reversing trade; valuation will reflect current market levels and counterparty/supply/demand.
Accounting, tax and reporting considerations
– Hedge accounting requires documentation of the hedging relationship and demonstration of hedge effectiveness under applicable accounting standards (IFRS or US GAAP).
– Tax treatment of periodic NDS settlements can differ by jurisdiction; consult tax counsel.
– Regulatory reporting and trade repository requirements may apply under local derivatives rules (e.g., Dodd‑Frank reporting in the U.S.).
Best practices and risk mitigation
– Use reputable counterparties and documented CSAs to reduce credit risk.
– Specify robust fixing sources and fallbacks in the confirmation to avoid disputes.
– Consider collateralization or third‑party guarantees in long‑dated NDSs.
– Stress‑test the hedge for extreme currency moves and consider correlation/basis risk to your operational FX flows.
– Maintain clear internal processes for monitoring settlement dates, margining and cash management.
Fast facts
– Settlements are almost always in a freely convertible currency (commonly USD), not the restricted local currency.
– An NDS economically replicates buying or selling the local currency at a contract rate without delivering the local currency.
– Used especially in emerging markets with capital controls, pegged or managed exchange rates, or thin FX markets.
Bottom line
A non‑deliverable swap is a practical tool for managing currency exposure when one leg involves a restricted or nonconverted currency. It provides economic protection without requiring access to the local FX market, but it brings counterparty, basis, regulatory, and documentation complexities. Institutions using NDSs should carefully define exposures, use robust legal documentation (ISDA/CSA), manage credit and liquidity risk, and coordinate with accounting, tax and compliance teams.
Sources and further reading
– Investopedia — “Non‑Deliverable Swap (NDS)” (detailed explanation and worked example). https://www.investopedia.com/terms/n/nondeliverableswap.asp
– Silicon Valley Bank — “Non‑Deliverable Forward/Swap Contract (NDF/NDS)” (product note).
– Commodity Futures Trading Commission (CFTC) — Dodd‑Frank Wall Street Reform and Consumer Protection Act (derivatives/swap regulation). https://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm
If you want, I can:
– Rework the worked example into semiannual settlement periods showing precise period cash flows and day‑count adjustments; or
– Draft a sample NDS confirmation and list the specific clauses and fallback language you should include. Which would you prefer?