What Is a Restricted Market?

In forex trading, a restricted market is one that does not allow for a freely floating exchange rate for a specific currency. Most currencies trade worldwide and fluctuate in relative value based on supply, demand, and other market factors. However, some money has oppressive government control with exchange rates that do not reflect economic variables. Instead, these currencies have artificial pricing at levels that vary widely from how they would trade if exchanged on free markets.

Key Takeaways

  • In forex trading, a restricted market is one that does not allow for a freely floating exchange rate for a specific currency.
  • Restricted markets can take many forms depending on the level of control a country’s government may take in managing its currency.
  • For traders, it is possible to open a position in a restricted currency using a non-deliverable forward (NDF) options contract.

Understanding a Restricted Market

Restricted markets can take many forms depending on the level of control a country’s government may take in managing its currency. Some currencies are entirely blocked and non-convertible into other currencies. Other nations will ban the export of their currency, enact laws that make the domestic use of other currencies illegal, and forbid citizens from holding assets in the currencies of other nations.

Non-convertible currencies are often those in nations lacking economic stability. At various times such currencies as the North Korean won, the Angolan kwanza, and the Chilean peso have been blocked. Such controls are less frequent than they were several decades ago, as more nations become willing to allow flexibility and freedom in foreign trade.

In many cases, black markets emerge when a currency is restricted. These black markets have currency exchange rates which differ widely from the government-mandated levels.

Other governmental controls are less strict, allowing the trading of their currency, but pegging it to another country’s currency. Also, trade may be permissible only within narrow bands.

Other restrictions include the allowable amount of money exported and requirements that allow trading only on government-approved exchanges. Examples of currencies where conversions may happen, but which are subject to restrictions or pegging to other currencies, including the Nepalese rupee, the Libyan dinar, and the Jordanian dinar.

Restricted Market Trading

Restricting trade of a currency can prevent potential economic volatility and disruption in cases when many citizens decide to move assets outside the country. Examples of such volatility can be found in countries that have experienced periods of hyperinflation resulting from government monetary or fiscal policies.

Although the International Monetary Fund (IMF) encourages global monetary cooperation and exchange rate stability, its Article 14 allows exchange controls for transitional economies. These Article 14 countries are generally poorer nations with weaker economies.

However, even with controls in place, it is possible to open a position in a restricted currency using a non-deliverable forward (NDF) options contract.

Like futures contracts, NDF contracts allow two parties to agree to exchange a thinly traded, or non-convertible currency, at terms that include a specific fixing and settlement date. However, unlike standard futures contracts, NDFs do not require delivery because restricted currencies may not be deliverable. Instead, the gain or loss on such an arrangement is settled in another freely trading currency.

Example of a Restricted Market

Let's assume that an American counterparty wants to buy the $100,000 equivalent of Cuban pesos (CUP). The U.S. dollar ceased to be accepted by Cuban businesses in November 2004 in retaliation for continued American sanctions. The United States has had a trade embargo against Cuba that has been in place since 1960 and remains in effect to date. 

Because the currency may be controlled and is undeliverable, any difference in value has the settlement in U.S. dollars or another non-controlled currency. These NDF contracts are often traded outside a restricted market because they may be illegal within those markets.