What is a Restricted Market
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 which do not reflect economic variables. Instead, these currencies have artificial pricing at levels which vary widely from how they would trade if exchanged on free markets.
BREAKING DOWN 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 which 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.
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.
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.
Trading Restricted Market Currencies with NDFs
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 are 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 allows two parties to agree to exchange a thinly traded, or non-convertible currency, at terms which include a specific fixing and settlement date. However, unlike a standard futures contracts, NDFs do not require delivery because restricted currencies may not be deliverable. Instead, the gain or loss on such an arrangement has the settlement in another freely trading currency.
For example, one party may wish to buy the $100,000 equivalent of Cuban Pesos. Because that currency may be controlled and undeliverable, any difference in value has the settlement in U.S. dollars or other non-controlled currency. These NDF contracts are often traded outside a restricted market because they may be illegal within those markets.