## tarea2025064-print-pdf - Preface

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### Preface
- Mission requested by the National Bank of Ukraine (NBU).
- Monetary and Capital Markets (MCM) Department mission held virtual meetings on September 25–26, 2024, and visited Vienna, Austria, during September 30, 2024, to October 4, 2024.
- NBU delegation members:
  - Mr, Mykola Selekhman, Deputy Director of Open Market Operations (OMO) Department
  - Mr. Maksym Drobiazhin, Deputy Director of Financial Stability Department
  - Mr. Yaroslav Balytskyi, Head of Liquidity and Market Risk Competence Centre, Banking Supervision Department
  - Ms. Nataliia Vagina, Head of Monetary Policy Implementation Tools Office, OMO Department
- Mission objective: assist with reintroducing foreign exchange (FX) derivatives and supporting FX market development as part of Stage III measures for easing temporary FX restrictions under Martial Law.
- Mission activities included virtual meetings with private sector institutions and an interbank survey of commercial banks.

### Executive Summary — Key Findings and Focus
- Context and constraints:
  - NBU operates under challenging circumstances with temporary FX restrictions instituted under Martial Law.
  - Reintroduction of FX derivatives is part of Stage 3 measures for easing these restrictions.
  - Current permissible exchange transactions adhere to NBU Resolution No.18, restricting FX forwards and limiting FX swaps.
- Market and policy observations:
  - Macroeconomic risks remain elevated; war prolongation challenges normalization.
  - Structural excess of Ukrainian hryvnia (UAH) liquidity should be managed more effectively to support FX liberalization.
  - FX operational strategy adjustments may be needed to facilitate greater two-way exchange rate movements.
  - Current FX volatility is limited; NBU meets structural shortfall in spot market, mitigating apparent FX risks and reducing immediate need to hedge.
- Infrastructure and readiness:
  - Market infrastructure, legal requirements, and prudential regulations limiting banks’ FX exposures and liquidity exist.
  - Derivative trading occurred prior to the war (limited volumes); phased reintroduction is doable.
  - Some intermediaries report challenges concerning the cost for derivatives, expected to be addressed over the long term.
- Risks and sequencing:
  - Backlog of FX demand attached to restricted transactions could immediately affect spot and derivative markets once restrictions are eased.
  - NBU could start easing with controlled increase in risks and transaction volumes.
  - Control options for forwards include direction-based controls, absolute or relative limits, contractual documentation, or combinations thereof.
- Key message:
  - Further relaxation of FX restrictions should be combined with strong, consistent supporting policies and a prioritized sequenced approach.
  - Mission endorses NBU’s commitment to articulate a Concept Note to guide steps, conditions, and timing for reintroducing FX derivatives.

### Recommendations (Table 1 — Key Recommendations)
- Priority and Timeframe conventions:
  - Priority: High, Medium, Low
  - Near term: < 12 months
  - Medium term: 12 to 24 months
- Setting the Pre-Conditions for Re-introducing FX Derivatives
  - 1. Streamline monetary operations for effective structural liquidity management [¶32]. — Priority: High; Timeframe: Near-term
  - 2. Consolidate FX operations within specific period of trading day and expand allocation of FXI from sole use of Bloomberg Matching [¶32]. — Priority: High; Timeframe: Near-term
- Reintroduction and Market Development for FX Derivatives
  - 3. Articulate Concept Note with RoadMap for Reintroducing FX Derivatives, in line with TA advice [¶34]. — Priority: Medium; Timeframe: Near-term
- Monitoring and Evaluation of FX Derivative Trading
  - 4. Establish an internal follow-up process for monitoring, evaluation and fine-tuning in line with the principles detailed in the report [¶39]. — Priority: Medium; Timeframe: Near-term
  - 5. Define the key indicators to monitor and evaluate when assessing the preconditions of the possible next steps [¶41-42]. — Priority: Medium; Timeframe: Near-term

### Introduction — Context and Core Questions
- Operating environment:
  - NBU faces elevated risks due to prolonged war; monetary and foreign exchange frameworks have significant changes and capital account restrictions.
  - Exchange rate stability is crucial for stabilizing inflation under flexible inflation targeting.
  - Monetary operations are largely overnight; NBU frequently meets structural FX shortfall via spot market operations.
  - Money market operates with excess reserves and limited transactions.
- Stage 3 liberalization:
  - Reintroduction of FX derivatives is part of Stage 3 reforms.
  - Current permissible transactions follow NBU Resolution No. 18, restricting FX forwards and FX swaps.
- Mission questions:
  - Are underlying markets functioning effectively to support derivative trading?
  - Is there a business need for FX derivatives given exchange rate stability?
  - What preconditions and opportunities exist to foster depth and liquidity in FX derivatives?
  - Under what conditions could FX derivative transactions be (re)considered under Martial Law?
- Observations and preconditions:
  - Perceptions and financial impact of FX risks are low; banks show relatively low net open FX positions in relation to capital.
  - Unhedged FX exposures among corporates remain unclear.
  - Preconditions recommended before removing FX forwards restrictions:
    - Reduce UAH liquidity to avoid self-fulfilling depreciation spirals.
    - Adjust FX operational strategy to allow greater two-way exchange rate movement.

### I. FX Hedging Market Development — Foundations
- A. Current context of FX and money markets
  - Exchange rate regime and interventions:
    - Fixed exchange rate introduced February 2022; devaluation of UAH by 25 percent in July 2022; release of fixed peg to USD.
    - NBU committed to a de facto managed floating exchange rate regime with eventual reintroduction of a floating exchange rate.
    - NBU trades account for on average one-third of spot market turnover while meeting structural net demand.
    - Transactions-based reference exchange rate published daily for government transactions.
    - UAH volatility: volatility beyond 1.0 percent has been rare in the past year.
  - Resolution No.18 and transaction limits:
    - Since February 2022, banks are prohibited from conducting certain transactions established by Resolution No.18.
    - For individuals and legal entities: prohibition on FX derivatives for FX forwards generally; FX swaps allowed only on the sell side for foreign currency (buy-side using FX swaps is prohibited).
    - Individuals can purchase cash FX without limit and can purchase FX instruments including three-month FX deposits with banks and six-month FX hedged deposits with the NBU.
  - Monetary operations and liquidity specifics:
    - Monetary operations largely subordinated to fiscal financing.
    - Banking system has large excess UAH reserves held in overnight standing deposit facility remunerated at the key policy rate.
    - Reserve requirement (RR) has a dual objective; up to 60 percent of RR can be fulfilled with qualified government securities.
    - Structural liquidity defined as reserve balances for banks before NBU operations.
- B. Business needs for FX derivatives
  - Demand drivers:
    - Economic openness and diversification amplify demand for hedging.
    - Reallocation of risks via derivatives requires heterogeneous market participants.
  - Specific corporate hedging needs cited:
    - Manage lumpy FX transactions currently splintered into smaller lots for spot trading.
    - Hedge import payments by purchasing foreign currency while selling UAH earnings forward.
  - Prudential environment:
    - No prudential requirement for natural hedges, though prudential regulations impose higher provisioning on FX loans.

### The expected rise of derivative instruments — International trends and market rationale
- Market structure and global context:
  - In flexible exchange rate regimes, derivatives account for around two-thirds of foreign exchange market turnover and spot transactions account for one-third.
  - Turnover in FX markets rose globally; volatile conditions, evolving interest rate expectations for major currencies, and the war in Ukraine have heightened FX risk management.
  - FX swap markets are vulnerable to funding squeezes given the short-term maturity of off-balance sheet obligations.
  - Trading of EME currencies has become increasingly international; international transactions share approaching that of AE currencies.
  - Greater internationalization of EME currencies implies monetary policy transmission is increasingly influenced by markets abroad and non-resident intermediaries.

### Banks’ exposures, behavior, and supervisory context
- Key statistics and behaviors (exact figures preserved):
  - Average net open position amounts to USD 50 million (as of beginning of June 2024).
  - This represents about 4.5 percent of capital relative to the maximum limit of 5.0 percent.
  - The lower limit of -5.0 percent of capital is rarely tested.
  - Any open position is typically closed same day in the spot market.
  - FX lending has reduced by some 30 percent since the war.
  - The share of FX loans in total loans is close to 30 percent.
  - Provisioning and credit risk:
    - Default rate of large borrowers on FX loans is close to 10 percent.
  - Liquidity buffers:
    - Banks maintained on average close to 23 percent of net assets in nostro accounts for the first three months in 2024 (the equivalent of USD 4.8 billion in April 2024) as qualifying high-quality liquid assets.
  - Perceived FX risk assessed as low in recent quarters; UAH/USD volatility has slightly increased.

### Corporate sector awareness and constraints
- Corporate environment:
  - Broad awareness of FX risks among corporates, but restrictions limit hedging ability.
  - Notable regulatory actions:
    - From February 24, 2022, to March 21, 2022, FX forwards were prohibited.
    - From end-March 2022, NBU allowed purchase of foreign currency for hryvnia under FX forwards concluded before February 23, 2022; only sell-side FX swaps for US dollars allowed.
  - Banks indicate current regulations (restrictions per Regulation No.18) are the dominant obstacle to forward market development; hedging cost and inadequate price formation are also important obstacles.

### Enabling conditions for FX derivative markets (building blocks) and market infrastructure
- Required components:
  - Enabling regulatory environment: close-out netting, eligible collateral, hedge accounting, margin requirements.
  - Diverse underlyings and hedgeable assets: overnight interbank references, reliable FX spot and FX forward references, assets with fixed/floating coupons in different currencies.
  - Robust market infrastructure: payment and settlement systems, trading platforms, market data providers, trade repositories, treasury and risk management systems.
  - Broad, heterogeneous user base with incentives and knowledge to manage financial risks.
- Mission assessment and shortfalls:
  - Most FX regulations and market infrastructure components can satisfactorily support derivative trading.
  - Shortfalls in risk management practices and options may limit efficient use of derivatives; scope to address these is constrained under Martial Law.
- Regulatory and infrastructure highlights (as reported):
  - Prior experience with derivative trading exists; country-specific Master Agreement developed before the war (ISDA usage is missing).
  - No reported instances about enforceability (or lack thereof) of derivative contracts according to national legislation.
  - Trading platforms: Bloomberg, Reuters used.
  - Central Counterparty (CCP): Yes, used for limited FX swap volumes.
  - Market Data Providers: Bloomberg.
  - Treasury and Risk Management Systems: Yes.
- Complementary markets and pricing issues:
  - Synthetic hedging depends on functioning FX spot market and short-term borrowing/lending markets.
  - Investment and borrowing on a term basis in local currency are available, enabling synthetic hedges of the hryvnia leg.
  - Lack of FX borrowing options at affordable terms may hinder synthetic hedging of the foreign currency leg in forward purchases.
  - UONIA provides a reference for short-term money market rates; benchmark zero coupon yields estimated and published using limited bond trading.
  - Banks indicate lack of adequate pricing information and market depth for longer maturities.

### Market participants and liquidity dynamics
- Participant structure and liquidity constraints:
  - Commercial banks dominate and typically assess risk equivalently, limiting potential speculative counterparties.
  - Bank-centered and highly concentrated financial sector limits potential gains from derivative trading.
  - Non-resident appetite for government bonds has reduced over the past year, constraining potential liquidity support and carry-trade opportunities.
  - Corporates: large corporates aware of hedging; smaller corporates may lack awareness or knowledge per bank surveys.

### Risks and sequencing for reintroducing FX derivatives
- Key near-term risk:
  - Close to USD 20 billion in FX payments remain under restrictions (legacy debt payments, refunds on prepayments, repatriation of direct investments) and may generate substantial demand to sell UAH on spot or via derivatives once eased.
  - Rapid easing could make depreciation expectations self-fulfilling and provide a gateway for low-cost speculation against the UAH.
- Policy sequencing recommended:
  - Transition to more flexible exchange rate regime and gradual lifting of FX restrictions on foreign exchange outflow transactions in parallel.
  - Ensure derivative products suitable for hedging exchange rate risk are available in a liquid and deep market when liberalizing FX flows.
  - Use gradual implementation of liberalization of foreign exchange derivatives to support the transition.
- Expected benefits from gradual liberalization:
  - Greater need for hedging will arise, increasing demand for liquid, competitive derivatives markets.
  - Increased derivatives liquidity can reduce cost of exchange rate fluctuations, facilitate hedging (including natural hedges), and reduce risk of exchange rate overshooting.
  - Presence of foreign players after liberalization can increase market liquidity, expand product range, and improve price discovery.

### Framework, Roadmap, and pre-conditions for liberalization
- Guiding principles:
  - Broad liberalization of capital flows should be preceded by abandonment of the fixed exchange rate and easing of the majority of FX restrictions that distort FX market functioning.
  - Easing steps should follow the Strategy’s principles and indicators and proceed cautiously with pre-conditions met before moving to subsequent phases.
- Exchange rate developments and reserve adequacy (exact phrases preserved):
  - Since October 2023, the exchange rate exhibited:
    - "close to 13 percent devaluation over a year"
    - "two-way fluctuations around the trend line"
    - "degree of volatility ... around 5 percent on a yearly basis"
  - Reserve assessment and coverage:
    - "as of September 2024 the FX reserves were above 110 percent of IMF’s ARA metrics"
    - Reserves "were sufficient to finance five months of future import"
  - Conclusion: pace and dynamics of depreciation are considered controlled; overall risks do not rule out cautious continuation of the easing process.
- Re-orienting monetary and FX operations (priority measures):
  - Realign monetary instruments and streamline operations to effectively manage structural liquidity and keep UAH scarce relative to current levels.
    - Recalibrate the RR to focus on liquidity management; "for the same RR ratio, the NBU gradually eliminates the portion fulfilled using government bonds."
    - Conduct weekly operations using longer-term instruments priced using an auction for selective short-term tenors; outturns could serve as references for derivative instruments.
    - Calibrate instruments so weekly operations can steer interbank market liquidity and keep structural liquidity within desired levels.
  - Reorient FX operations strategy to enable two-way flexibility:
    - Use intervention budget for a set window of the trading day to encourage more price variation and stimulate FX liquidity.
    - Diversify allocation methods beyond sole use of Bloomberg Matching for FX intervention.
  - Sequence reintroduction of FX derivatives: re-orient monetary/FX framework first; then introduce forwards and NDFs in limited quantities; adjust operational strategy to include money market operations longer than overnight tenor to close pricing gaps.

### Forward transactions, NDFs, and control options
- Forward easing options and trade-offs:
  - Direction-based rules:
    - Allow forward deals only in the UAH purchase direction.
    - Advantage: simple and effective at limiting positions against UAH.
    - Disadvantage: does not address cash flows related to import payments and capital transactions (debt servicing).
  - Limit-based rules:
    - Control total amount of FX forward deals tightly; limits can be nominal or relative (e.g., linked to regulatory capital).
    - Advantage: familiar to banks; NBU has database/infrastructure; flexible and adjustable.
    - Disadvantage: basis like regulatory capital links limits to banks’ characteristics, not corporate end-user needs.
  - Contract-based rules:
    - Require documentation of underlying business; quantity limited by contracted amount.
    - Advantage: method familiar from spot transactions; infrastructure largely in place.
    - Disadvantage: resource-intensive and time-consuming.
  - Combination of methods:
    - Apply different rules/limits by trade direction (e.g., UAH buys allowed freely; UAH sells restricted).
    - Advantage: fine-tunable and adaptable.
    - Disadvantage: complexity requires strong communication to market participants.
- Non-deliverable forwards (NDFs):
  - NDFs present substantial demand; cash-flow limited to P/L settlement, impact on exchange rate is moderate.
  - Easing NDFs can start with less risk; consider position-limiting restrictions similar to forwards:
    - Permit only trades with UAH on the buy side; link permission to a limit; or require demonstration of real economic need evidenced by a contract.
  - Wait-and-see approach possible: defer NDF easing until experience from forward easing is observed.
  - Complexity: NDF cash-flow footprint smaller than forwards; calculating limits and linking volumes to risks is less straightforward.
- Benefits of tailored combinations:
  - Tailored combinations of easing methods, applied differently across FX derivative types, provide flexibility for high uncertainty.
  - Asymmetric lifting (e.g., allowing buying UAH forwards/NDFs more freely than selling UAH) can be an initial step.
  - Forward transactions where UAH is sold can be allowed to a lesser extent using underlying contract requirements or quantity limits; such limits adjustable or removable quickly.

### Follow-up process: monitoring, evaluation, and fine-tuning
- Multi-step iterative follow-up process recommended:
  - Main building blocks:
    - (i) continuous monitoring of key indicators;
    - (ii) regular evaluation using indicators and soft information (market intelligence, feedback);
    - (iii) possible fine-tuning of measures based on evaluations.
- Monitoring phase: key variables to cover at least:
  - exchange rate developments; exchange rate expectations; transactions and FX positions by sector and by instrument type; central bank presence in the FX market; reserve adequacy; financial stability risk indicators.
- Example indicators (non-exhaustive):
  - UAH depreciation (appreciation) and volatility;
  - volume of sell/buy transactions in spot and derivative markets;
  - exchange rate expectations;
  - volume of central bank interventions;
  - usage of intervention budget (daily and longer term);
  - level of FX reserves and reserve adequacy;
  - usage of banks’ NOP limits (or other position limits, if introduced);
  - exchange rate (sub)component(s) in Financial Stability Report.
- Evaluation phase:
  - Regularly assess measures based on selected variables and soft information.
  - Provide analyses to the Board and decision-making bodies via regular and ad hoc reports.
  - Possible outcomes: further easing/lifting of restrictions; wait-and-see; or fine-tuning.
- Fine-tuning phase:
  - Modify size, nature or basis of limits; change stakeholders involved; etc.
  - Any parameter change restarts the monitoring-evaluation-fine-tuning cycle to ensure graduality, preconditions, and safeguarding of macroeconomic and financial stability.

*IMF Technical Assistance Report — Preface and initial chapters (content unit).*

### Preface ................................................................................................................

### tarea2025064-print-pdf - Preface

### Preface
- Mission requested by the National Bank of Ukraine (NBU).
- Monetary and Capital Markets (MCM) Department mission held virtual meetings on September 25–26, 2024, and visited Vienna, Austria, during September 30, 2024, to October 4, 2024.
- NBU delegation members:
  - Mr, Mykola Selekhman, Deputy Director of Open Market Operations (OMO) Department
  - Mr. Maksym Drobiazhin, Deputy Director of Financial Stability Department
  - Mr. Yaroslav Balytskyi, Head of Liquidity and Market Risk Competence Centre, Banking Supervision Department
  - Ms. Nataliia Vagina, Head of Monetary Policy Implementation Tools Office, OMO Department
- Mission objective: assist with reintroducing foreign exchange (FX) derivatives and supporting FX market development as part of Stage III measures for easing temporary FX restrictions under Martial Law.
- Mission activities included virtual meetings with private sector institutions and an interbank survey of commercial banks.

### Executive Summary — Key Findings and Focus
- Context:
  - NBU operates under challenging circumstances with temporary FX restrictions instituted under Martial Law.
  - Reintroduction of FX derivatives is part of Stage 3 measures for easing these restrictions.
  - Current permissible exchange transactions adhere to NBU Resolution No.18, restricting FX forwards and limiting FX swaps.
- Mission discussed:
  - The current functioning of money and foreign exchange markets.
  - Business need for FX derivatives given exchange rate stability underpinning flexible inflation targeting.
  - Preconditions and opportunities to foster market depth and liquidity in FX derivatives.
  - Conditions under which FX derivatives could be (re)considered under Martial Law.
- Market and policy environment observations:
  - Macroeconomic risks remain elevated; war prolongation challenges normalization.
  - Structural excess of Ukrainian hryvnia (UAH) liquidity should be managed more effectively to support FX liberalization.
  - FX operational strategy adjustments may be needed to facilitate greater two-way exchange rate movements.
  - Current FX volatility is limited; NBU meets structural shortfall in spot market, mitigating apparent FX risks and reducing immediate need to hedge.
- Infrastructure and regulatory readiness:
  - Market infrastructure, legal requirements, and prudential regulations limiting banks’ FX exposures and liquidity exist.
  - Derivative trading occurred prior to the war (limited volumes); phased reintroduction is doable.
  - Some intermediaries report challenges concerning the cost for derivatives, expected to be addressed over the long term.
- Risks and sequencing:
  - Backlog of FX demand attached to restricted transactions could immediately affect spot and derivative markets once restrictions are eased.
  - NBU could start easing with controlled increase in risks and transaction volumes.
  - Control options for forwards include direction-based controls, absolute or relative limits, contractual documentation, or combinations thereof.
- Key message:
  - Further relaxation of FX restrictions should be combined with strong, consistent supporting policies and a prioritized sequenced approach.
  - Mission endorses NBU’s commitment to articulate a Concept Note to guide steps, conditions, and timing for reintroducing FX derivatives.

### Recommendations (Table 1 — Key Recommendations)
- Priority and Timeframe conventions:
  - Priority: High, Medium, Low
  - Near term: < 12 months
  - Medium term: 12 to 24 months
- Setting the Pre-Conditions for Re-introducing FX Derivatives
  - 1. Streamline monetary operations for effective structural liquidity management [¶32]. — Priority: High; Timeframe: Near-term
  - 2. Consolidate FX operations within specific period of trading day and expand allocation of FXI from sole use of Bloomberg Matching [¶32]. — Priority: High; Timeframe: Near-term
- Reintroduction and Market Development for FX Derivatives
  - 3. Articulate Concept Note with RoadMap for Reintroducing FX Derivatives, in line with TA advice [¶34]. — Priority: Medium; Timeframe: Near-term
- Monitoring and Evaluation of FX Derivative Trading
  - 4. Establish an internal follow-up process for monitoring, evaluation and fine-tuning in line with the principles detailed in the report [¶39]. — Priority: Medium; Timeframe: Near-term
  - 5. Define the key indicators to monitor and evaluate when assessing the preconditions of the possible next steps [¶41-42]. — Priority: Medium; Timeframe: Near-term

### Introduction — Context and Core Questions
- Operating environment:
  - NBU faces elevated risks due to prolonged war; monetary and foreign exchange frameworks have significant changes and capital account restrictions.
  - Exchange rate stability is crucial for stabilizing inflation under flexible inflation targeting.
  - Monetary operations are largely overnight; NBU frequently meets structural FX shortfall via spot market operations.
  - Money market operates with excess reserves and limited transactions.
- Stage 3 liberalization:
  - Reintroduction of FX derivatives is part of Stage 3 reforms.
  - Current permissible transactions follow NBU Resolution No. 18, restricting FX forwards and FX swaps.
- Mission questions:
  - Are underlying markets functioning effectively to support derivative trading?
  - Is there a business need for FX derivatives given exchange rate stability?
  - What preconditions and opportunities exist to foster depth and liquidity in FX derivatives?
  - Under what conditions could FX derivative transactions be (re)considered under Martial Law?
- Observations:
  - Perceptions and financial impact of FX risks are low; banks show relatively low net open FX positions in relation to capital.
  - Unhedged FX exposures among corporates remain unclear.
  - NBU’s market presence provides assurance of FX availability by meeting structural FX deficit.
- Preconditions recommended before removing FX forwards restrictions:
  - Reduce UAH liquidity to avoid self-fulfilling depreciation spirals.
  - Adjust FX operational strategy to allow greater two-way exchange rate movement.

### I. FX Hedging Market Development—Foundations
- Overview:
  - Section examines foundations for using FX derivatives: current market functioning, business needs, and infrastructure.
- A. The Current Context of Foreign Exchange and Money Markets
  - Exchange rate regime history and stance:
    - Fixed exchange rate introduced February 2022, devaluation of UAH by 25 percent in July 2022, followed by release of the fixed peg to USD.
    - NBU committed to a de facto managed floating exchange rate regime with eventual reintroduction of a floating exchange rate.
    - NBU developed and communicated a Strategy of its plans regarding the exchange rate and FX restrictions.
  - FX spot market functioning:
    - NBU trades account for on average one-third of spot market turnover while meeting structural net demand.
    - A transactions-based reference exchange rate is published daily and used as the official rate for all government transactions, including transactions with companies providing defense services.
  - Volatility and interventions:
    - UAH remained in a generally predictable trading and volatility range relative to USD in the past year; volatility beyond 1.0 percent has been rare.
    - NBU interventions meet structural shortfall and reduce excessive exchange rate volatility (see Figure 1 and Figure 2).
  - Capital flow measures and Resolution No.18:
    - Since February 2022, banks are prohibited from conducting certain transactions established by Resolution No.18.
    - For individuals and legal entities: prohibition on FX derivatives for FX forwards generally; FX swaps allowed only on the sell side for foreign currency (buy-side using FX swaps is prohibited).
    - Individuals can purchase cash FX without limit and can purchase FX instruments including three-month FX deposits with banks and six-month FX hedged deposits with the NBU.
  - Monetary operations and liquidity:
    - Monetary operations remain largely subordinated to fiscal financing.
    - Banking system has large excess UAH reserves held in overnight standing deposit facility remunerated at the key policy rate.
    - Reserve requirement (RR) has a dual objective; up to 60 percent of RR can be fulfilled with qualified government securities, reducing central bank control over structural liquidity.
    - Structural liquidity is defined as reserve balances for banks before NBU operations.
- B. Business Needs for FX Derivatives
  - Macroeconomic structure influences derivative use:
    - Higher degree of economic openness and a diversified economy with a deep financial system may amplify demand for hedging.
    - Reallocation of risks via financial instruments requires heterogeneous market participants with differing perspectives on the risk being managed.

*IMF Technical Assistance Report — Preface and initial chapters (content unit).*

### 13. The expected rise of derivative instruments is a natural process in the evolution of foreign

### The expected rise of derivative instruments is a natural process in the evolution of foreign exchange markets

### International trends and market rationale
- In flexible exchange rate regimes, derivatives account for around two-thirds of foreign exchange market turnover and spot transactions account for one-third.
- Turnover in FX markets continued its upward march at the global level; volatile FX market conditions, evolving interest rate expectations for major currencies, and the war in Ukraine have brought FX risk management to the fore.
- FX swap markets are vulnerable to funding squeezes given the short-term maturity of off-balance sheet obligations.
- Trading of EME currencies has become increasingly international; the share of international transactions in the overall trading of EME currencies has approached that for advanced economy (AE) currencies.
- The greater internationalization of EME currencies implies that monetary policy transmission is increasingly influenced by conditions in markets abroad and by the behavior of non-resident intermediaries.

### Banks’ exposures, behavior, and supervisory context
- Banks take very little exposure in foreign currency:
  - Average net open position amounts to USD 50 million (as of beginning of June 2024).
  - This represents about 4.5 percent of capital relative to the maximum limit of 5.0 percent.
  - The lower limit of -5.0 percent of capital is rarely tested.
- Any open position is typically closed same day in the spot market.
- FX lending has reduced by some 30 percent since the war.
- The share of FX loans in total loans is close to 30 percent.
- Provisioning and credit risk:
  - With higher expected credit loss assessments since full‑scale war, banks have increased provisioning on FX loans.
  - The default rate of large borrowers on FX loans is close to 10 percent.
- Liquidity buffers:
  - Banks maintained on average close to 23 percent of net assets in nostro accounts for the first three months in 2024 (the equivalent of USD 4.8 billion in April 2024) as qualifying high-quality liquid assets.
- Perceived FX risk has been assessed as low in recent quarters given relative exchange rate stability, although UAH/USD volatility has slightly increased.

### Corporate sector awareness and constraints
- Broad awareness of FX risks among corporates, but restrictions on types of FX instruments limit hedging ability.
- Notable regulatory actions:
  - From February 24, 2022, to March 21, 2022, FX forwards were prohibited.
  - Starting from end-March 2022, the NBU allowed the purchase of foreign currency for hryvnia under FX forwards concluded before February 23, 2022; only transactions involving the sell-side for US dollars are allowed for FX swaps.
- Corporate needs for hedging cited by users:
  - To manage lumpy FX transactions currently splintered into smaller lots for spot trading.
  - To hedge import payments by purchasing foreign currency while selling UAH earnings forward.
- No prudential requirement for natural hedges, though prudential regulations impose higher provisioning on FX loans.

### Enabling conditions for FX derivative markets (building blocks)
- Key components required:
  - An enabling regulatory environment ensuring legal certainty of derivative contracts (close-out netting, eligible collateral, hedge accounting, margin requirements).
  - A diverse range of financial instruments serving as underlyings and hedgeable assets (overnight interbank references, reliable FX spot and FX forward references, assets with fixed/floating coupons in different currencies).
  - Robust market infrastructure (payment and settlement systems, trading platforms, market data providers, trade repositories, treasury and risk management systems).
  - A broad, heterogeneous user base with incentives and sufficient knowledge to manage financial risks.
- Mission assessment:
  - Most FX regulations and market infrastructure components can satisfactorily support derivative trading.
  - Shortfalls exist in risk management practices and options that may limit efficient use of derivatives; scope to address these is constrained while operating under Martial Law.

### Regulatory status and market infrastructure (summary of findings)
- Regulation and documentation:
  - Prior experience with derivative trading exists; some regulatory components are in place for client appropriateness, accounting, valuation, and capital adequacy.
  - A local, country-specific Master Agreement was developed before the war (ISDA usage is missing); documentation subject to extensive consultation is available but not formally adopted due to the war.
  - No reported instances about enforceability (or lack thereof) of derivative contracts according to national legislation.
- Table 2 (status highlights):
  - Close-out Netting: Essential — FX Swap: Yes.
  - Hedge Accounting/Tax Rule: Good to have — FX Forward: Possible review; FX Swap: Possible review.
  - Reporting Rules: Essential — In progress for both FX Forward and FX Swap.
  - Risk Management Guidelines: Essential — Yes for both FX Forward and FX Swap.
- Market infrastructure (Table 3 highlights):
  - Trading platforms: Bloomberg, Reuters used.
  - Central Counterparty (CCP): Yes, used for limited FX swap volumes.
  - Payment and Settlement Systems: Essential — Yes.
  - Market Data Providers: Essential — Bloomberg.
  - Treasury and Risk Management Systems: Essential — Yes.
- Complementary markets and pricing:
  - Synthetic hedging depends on functioning FX spot market and short-term borrowing/lending markets.
  - Investment and borrowing on a term basis in local currency are available, enabling synthetic hedges of the hryvnia leg.
  - Lack of FX borrowing options at affordable terms may hinder synthetic hedging of the foreign currency leg in forward purchases.
  - UONIA provides a reference for short-term money market rates; benchmark zero coupon yields are estimated and published using limited bond trading.
  - Banks indicate lack of adequate pricing information and market depth for longer maturities as obstacles to providing FX derivatives.

### Market participants and liquidity dynamics
- Market concentration and participant heterogeneity:
  - Commercial banks dominate and typically assess risk equivalently, limiting potential speculative counterparties.
  - The bank-centered and highly concentrated financial sector limits potential gains from derivative trading.
  - Non-resident appetite for government bonds has reduced over the past year, constraining potential liquidity support from foreign participants and positive carry-trade opportunities in UAH government bonds.
- Corporates:
  - Large corporates show awareness of hedging instruments; smaller corporates may lack awareness or knowledge according to bank surveys.
  - Banks indicate current regulations (restrictions per Regulation No.18) are the dominant obstacle to forward market development; hedging cost and inadequate price formation are also important obstacles.

### Risks and sequencing for reintroducing FX derivatives
- Key near-term risk from easing restrictions too quickly:
  - Close to USD 20 billion in FX payments remain under restrictions (legacy debt payments, refunds on prepayments, repatriation of direct investments) and may generate substantial demand to sell UAH on spot or via derivatives once eased.
  - Rapid easing could make depreciation expectations self-fulfilling and provide a gateway for low-cost speculation against the UAH.
- Policy sequencing recommended:
  - Implement transition to more flexible exchange rate regime and gradual lifting of FX restrictions on foreign exchange outflow transactions in parallel.
  - Ensure derivative products suitable for hedging exchange rate risk are available in a liquid and deep market when liberalizing FX flows.
  - Use gradual implementation of liberalization of foreign exchange derivatives to support the transition.
- Expected benefits from gradual liberalization and increased flexibility:
  - Greater need for hedging will arise, increasing demand for liquid, competitive derivatives markets.
  - Increased derivatives liquidity can reduce cost of exchange rate fluctuations, facilitate hedging (including natural hedges), and reduce risk of exchange rate overshooting.
  - Presence of foreign players after liberalization can increase market liquidity, expand range of financial products, and improve price discovery.

*IMF Technical Assistance Report*

### 31. The Strategy and the Roadmap have set out the framework and the place of the related

### 31. The Strategy and the Roadmap have set out the framework and the place of the related

### Framework and guiding principles
- The Strategy and the Roadmap set out that broad liberalization of capital flows should be preceded by the abandonment of the fixed exchange rate and that further increase in exchange rate flexibility should be preceded by easing the majority of FX restrictions imposed on trade transactions and those that distort the functioning of the FX market.
- The Roadmap for the Gradual Easing of FX Restrictions emphasizes that the primary consideration for easing FX restrictions is the urgency of correcting market distortions and supporting economic recovery, taking into account the risks to exchange rate sustainability and international reserves.
- Easing steps should follow the Strategy’s principles and indicators and proceed cautiously, with pre-conditions met before moving to subsequent phases.

### Exchange rate developments and reserve adequacy
- In October 2023, the NBU abandoned pegging the official exchange rate to the USD and shifted to managed flexibility of the exchange rate.
- Since October 2023, the exchange rate exhibited:
  - "close to 13 percent devaluation over a year"
  - "two-way fluctuations around the trend line"
  - "degree of volatility ... around 5 percent on a yearly basis"
- Reserve assessment and coverage:
  - "as of September 2024 the FX reserves were above 110 percent of IMF’s ARA metrics"
  - Reserves "were sufficient to finance five months of future import"
- Conclusion: pace and dynamics of depreciation are considered controlled; overall risks do not rule out cautious continuation of the easing process.

### Re-orienting monetary and FX operations as pre-conditions (priority measures)
- Overarching need: strong and consistent supporting policies with a prioritized sequenced approach.
- Priority actions for the NBU:
  - Realign monetary instruments and streamline operations to effectively manage structural liquidity and keep UAH scarce relative to current levels.
    - Recalibrate the RR to focus on its liquidity management role; "for the same RR ratio, the NBU gradually eliminates the portion fulfilled using government bonds."
    - Avoid using a single instrument to achieve two objectives; example: if RR fulfillment had been entirely in NBU reserves, "the increase in the RR in January 2023 would have resulted in a liquidity shortfall" that could help keep UAH liquidity scarce.
    - Conduct weekly operations using longer-term instruments priced using an auction for selective short-term tenors; outturns from these auctions could serve as references for derivative instruments to close the information gap observed by corporates.
    - Calibrate available instruments so weekly operations can steer interbank market liquidity conditions and keep structural liquidity within desired levels.
  - Reorient FX operations strategy to enable two-way flexibility:
    - Use the existing intervention budget for a set window of the trading day to encourage more price variation in a wider volatility band and to stimulate FX liquidity.
    - Use alternative methods for allocating the intervention budget to allow the market to display more intraday volatility, including diversifying beyond sole use of Bloomberg Matching for FX intervention.
  - Sequence reintroduction of FX derivatives: re-orient monetary/FX framework first; then introduce forwards and NDFs in limited quantities; adjust operational strategy to include money market operations longer than overnight tenor to close pricing gaps.

### Opportunities for fostering market development
- Market development is delicate: easing restrictions has benefits and poses risks; a careful balance by the NBU is required.
- Primary objective: reintroduce FX hedging products without undermining the exchange rate regime, compromising the external balance, or reversing IMF Program progress.
- Risk consideration: "Rapid lifting of the 2022 FX derivative trading restriction could trigger speculative depreciation" especially if "the war extends beyond 2025."
- The mission endorses an articulated Concept Note to set steps, conditions and timing for reintroducing FX derivatives; this TA report provides guidance.

### Forward transactions: options and trade-offs
- Forwards are effectively prohibited now except to close contracts concluded before the war; several controlled easing options exist:
  - Direction-based rules:
    - Example: allow forward deals only in the UAH purchase direction.
    - Advantage: simple and effective at limiting positions against UAH.
    - Disadvantage: does not address cash flows related to import payments and capital transactions (debt servicing).
  - Limit-based rules:
    - Control total amount of FX forward deals tightly; limits can be nominal or relative (e.g., linked to regulatory capital).
    - Advantage: well-known to banks; NBU has necessary database/infrastructure; flexible and adjustable.
    - Disadvantage: basis like regulatory capital links limits to banks’ characteristics, not corporate end-user needs.
  - Contract-based rules:
    - Require documentation of underlying business similar to spot-market rules; quantity limited by contracted amount and usage of FX regulated.
    - Advantage: method familiar from spot transactions; infrastructure largely in place.
    - Disadvantage: resource-intensive and time-consuming documentation process.
  - Combination of methods:
    - Apply different rules/limits by trade direction (e.g., UAH buys allowed freely; UAH sells restricted).
    - Advantage: fine-tunable and adaptable.
    - Disadvantage: complexity requires strong communication to market participants.

### Non-deliverable forwards (NDFs)
- NDFs present substantial demand; because notional is not delivered and cash-flow is limited to P/L settlement, impact on exchange rate is moderate and less direct.
- Easing NDFs can start with less risk; advisable to consider similar position-limiting restrictions as forwards:
  - Possible restrictions: permit only trades with UAH on the buy side; link permission to a limit; or require demonstration of real economic need evidenced by a contract.
  - A wait-and-see approach is possible: defer NDF easing until experience from forward easing is observed.
- Complexity and measurement challenges:
  - NDF cash-flow footprint is significantly smaller than forwards; calculating limits and linking volumes to risks is less straightforward.
  - Methods based on contract justification require further examination before application.

### Benefits of tailored combinations
- Tailored combinations of easing methods, applied differently across FX derivative types, can provide flexibility suitable for high uncertainty.
- Asymmetric lifting (e.g., allowing buying UAH forwards/NDFs more freely than selling UAH) can be an initial step.
- Forward transactions where UAH is sold can be allowed to a lesser extent using underlying contract requirements or quantity limits; such limits can be adjusted or removed quickly based on circumstances.

### Follow-up process: monitoring, evaluation, and fine-tuning
- Establish a multi-step iterative follow-up process to back-test impacts and adjust measures:
  - Main building blocks:
    - (i) continuous monitoring of key indicators;
    - (ii) regular evaluation using indicators and soft information (market intelligence, feedback);
    - (iii) possible fine-tuning of measures based on evaluations.
- Monitoring phase: select a wide range of key variables covering at least:
  - exchange rate developments; exchange rate expectations; transactions and FX positions by sector and by instrument type; central bank presence in the FX market; reserve adequacy; financial stability risk indicators.
- Example indicators to include (non-exhaustive):
  - UAH depreciation (appreciation) and volatility;
  - volume of sell/buy transactions in spot and derivative markets;
  - exchange rate expectations;
  - volume of central bank interventions;
  - usage of intervention budget (daily and longer term);
  - level of FX reserves and reserve adequacy;
  - usage of banks’ NOP limits (or other position limits, if introduced);
  - exchange rate (sub)component(s) in Financial Stability Report.
- Evaluation phase:
  - Regularly assess implemented measures based on the evolution of selected variables and soft information.
  - Provide analyses to the Board and decision-making bodies via regular and ad hoc reports.
  - Possible outcomes: further easing/lifting of restrictions; wait-and-see; or fine-tuning.
- Fine-tuning phase:
  - Modify size, nature or basis of limits; change stakeholders involved; etc.
  - Any parameter change restarts the monitoring-evaluation-fine-tuning cycle to ensure graduality, preconditions, and safeguarding of macroeconomic and financial stability.

### Supporting evidence and engagement
- TA mission prepared a detailed questionnaire sent to major banks and conducted interviews with large non-financial corporations active in FX markets and export-import activity.
- Findings and feedback were presented to NBU staff on September 30, 2024, with majority feedback validating market actors’ experiences.

*IMF Technical Assistance Report — content as provided in the source document.*

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_Source: https://www.imf.org/-/media/files/publications/tar/2025/english/tarea2025064-print-pdf.pdf_