What is the onshore and offshore currency market?

Almost all investors with extensive knowledge about the financial market have one motto: Why restrict your investments to one asset class when numerous others can give you better returns at a quicker pace. The same goes for investors who, in one place, invest in equities after a detailed fundamental analysis and keep the shares for the long term. On the other hand, they allocate a portion of their capital into other high-risk asset classes, giving them big profits in a short period.

Among various other asset classes, almost every investor chooses derivatives. A derivative is an instrument that derives its value from the underlying asset. The asset can be equity, a commodity, a currency, or even an index. Derivatives are usually in the form of a contract, where the buyer is obligated to buy, or the seller is obligated to sell the underlying asset at a specified price on a specified date in the future. As derivatives offer investors the option to choose any financial instrument as the underlying asset, it is one of the most widely traded instruments.

Within derivatives, the goals of diversification, better profits, and broader trading potential are evident to investors using currencies as the underlying asset. As currencies have two markets: onshore market and offshore market to trade in, it is one of the most sought-after assets used by traders to invest in derivatives.

Within derivatives, the goals of diversification, better profits, and broader trading potential are evident to investors using currencies as the underlying asset. As currencies have two markets: onshore market and offshore market to trade in, it is one of the most sought-after assets used by traders to invest in derivatives.

What is Currency Trading?

Currency trading refers to the exchange of currencies, where the difference in the currency value is used to make profits. It is a huge market, with the traded value being higher than equities. A few years ago, currency trading was restricted to large banks and corporations. Now, technological advancement has equipped retail investors with easy access to currency trading, and even individual investors consider it an attractive avenue for investment.

Where are currencies traded?

The foreign exchange market, also known as FX or forex, is a global marketplace that facilitates the trading of foreign currencies. The marketplace is responsible for determining the exchange rate for various currencies and is an over-the-counter marketplace. Participants in the foreign exchange market are buyers, sellers, exchangers, and speculators who trade in various currency pairs and make a profit based on the fluctuations in the exchange rates.

A foreign exchange market generally comprises banks, commercial companies, forex dealers, investment firms, central banks, retail investors, hedge funds, and forex dealers. The market works on one principle that currencies are always traded in pairs. For example:

• Indian Rupee vs United States Dollar (USD-INR)
• Indian Rupee vs Euro (EUR-INR)
• Indian Rupee vs Great Britain Pound (GBP-INR)
• Indian Rupee vs Japan’s Yen (JPY-INR)

What is the Onshore and Offshore Currency Market?

For currency traders, there are two options to buy the currencies–from the country of citizenship or buy it from a foreign country when the currency pair’s price might be lower. Hence, the two currency markets are defined as below:

• Onshore Market: Onshore market is the local currency market of the country in which the trader is a legal citizen. For example, for Indian citizens, the forex market in India will be the Onshore market. In an onshore market, the rules and regulations are rigid, pre-determined and currency trading comes with numerous tax obligations. Most currency traders restrict their trades in onshore markets as they are better equipped to understand the factors that may affect the prices of the currencies. It is also easier for them to trade in the onshore market.

• Offshore market: In simple terms, an offshore market refers to a location that is outside a trader’s home country. For example, if you are buying currencies from London’s currency exchange, the trade would be known as offshore market trade. In an offshore market, the rules and regulations may be flexible and can allow traders to decrease their tax obligations.

How does the onshore and offshore market work?

Non-residents have preferred Emerging Market Currencies for risk management and speculation to make profits. However, underdeveloped onshore financial markets and capital control are used to offset the rising interest in EMCs often. This led to a parallel market for EMCs in offshore markets known as Non-deliverable forward (NDFs). A PDF is similar to a futures contract but does not lead to the physical delivery of the asset. Since it is not possible to take delivery of currencies when trading outside the country, traders use NDFs to trade in convertible currencies, as non-convertible currencies are restricted in an offshore market.

In the case of the onshore market, the working principle is simple. You buy currency pairs at the Foreign Exchange Market and sell when the exchange rate is high, making you profits. Here, the central bank regulates the trading; for India, it is the Reserve Bank of India.

In the case of the offshore market, the working principle is complex. You buy currency pairs that are trading at that country’s foreign exchange as a non-resident and sell them when the global exchange rate is higher. Here, the FX market, not the central bank, regulates the currency trades that are unavailable for delivery.

The offshore market and the onshore market are interconnected with each other in case of transactions and the subsequent volume. The price discovery in the onshore market becomes vulnerable to influences from the offshore market if the volume in the offshore market is higher than the onshore market. Therefore, central banks frown upon the idea of an offshore market for currencies as the larger the offshore market, the harder it is for the central banks to manage their country’s financial stability.

Advantages of onshore and offshore markets

Here are the advantages of the onshore market and offshore market:

Onshore Market:

• Allows investors to trade in currencies in a market that is recognized by the Central Bank.
• The currency trades are quicker than the offshore markets.
• Currencies that are traded are available for delivery according to the investors’ preference.
• The risk is lower when trading currencies in the onshore market.

Offshore Market:

• Allows investors to trade in currencies that are not available in the onshore market.
• The tax obligations in an offshore market are low when compared to an onshore market.
• There are no restrictions on foreign exchange transactions and market participants.
• There are no cumbersome documentation and Know-Your-Customer requirements in an offshore market.

Is trading currencies in the Offshore Market legal in India?

Although you can trade currencies in an offshore market legally, the RBI is slightly wary of the market and the growing interest in NDFs of Indian residents. As it becomes hard to manage India’s financial stability because of the high volume of offshore currency trades, the offshore market also decreases the currency trading share in India. Furthermore, as the offshore market is less regulated and comes with negligible rules and regulations, the RBI fears that it can be used for illicit trades or to launder money in and out of India.

If you are doing everything legally and following predetermined channels in the offshore market, you have nothing to fear. However, it is also better to stick to the onshore currency market for trading currencies as it helps the Indian economy, and as a result, helps appreciate the value of the Indian currency in foreign exchanges.

Now that you understand the onshore and offshore markets meaning, you can go ahead and make informed decisions regarding which market you should enter for currency trading. The offshore and onshore markets have their advantages and disadvantages and come with different risk factors. You should assess both markets in detail before entering currency trades. If you are unsure about the affecting factors for both markets, you can consult IIFL.

IIFL is one of the leading players in the broking space in India and offers broking services in various categories of equity, commodities, currency, derivatives, and so on. These services are backed by in-depth research and an excellent customer support system. Trader Terminal, the proprietary trading terminal of IIFL, offers the convenience of trading in currencies through a terminal that can be accessed as a desktop application and a Web application through a browser. The terminal provides real-time streaming quotes and executes transactions at lightning-fast speed to ensure the timely execution of your currency transactions.