FX swaps and forwards received exemptions from trading and clearing requirements imposed on NDFs, FX options and derivatives in other asset classes. However, they will still feel the impact of trade reporting requirements, anti-evasion authority, business conduct standards and Basel III capital requirements, and according to a recent report by Greenwich Associates these influences are likely to encourage a shift of some FX swaps and forwards business into exchange-traded futures.
Already, higher costs of margining and clearing are impacting the use of NDFs. Greenwich Associates reports that over half of investment firms used NDFs in 2010 and at the end of 2012 only 35 per cent used them, with hedge funds leading the pull back.
Furthermore, the Greenwich Associates report estimates that as little as a 5 per cent shift of OTC FX markets to exchange-traded FX instruments could result in a 50 per cent increase in FX futures activity on exchanges as the FX industry looks for cheaper alternatives. Further still, the study points to three reasons exchange-traded derivatives have become more attractive globally: international reporting, money laundering, and capital requirements; new scrutiny of NDFs and currency options because of the leverage they carry; and pricing pressures that new regulatory changes will have on OTC derivatives.
Levels the playing field
Dan Carrigan, President of NASDAQ Futures, says that the exchange-traded FX levels the playing field and is increasingly appealing to a more diverse user base globally. He says: “When brokers service client FX orders, they must adhere to the rule ‘know your customer’ before executing orders, large or small. The same rule applies when it is time for the broker to find an FX counterparty. At some point, big players like banks and brokers may bump up against pre-established credit limits. NASDAQ OMX brings a solution to all players in a fair an openly transparent market; an exchange-listed FX options product which clears at the Options Clearing Corporation (OCC).”
Carrigan says OCC is the backbone of US equity options industry, handling clearing for NASDAQ OMX FX options. Accordingly, risk management is in place from the carrying brokerage firm collecting initial margin to NASDAQ OMX regulating trading through to the OCC guaranteeing the performance of each trade. Says Carrigan: “This is one straight-through-processing model that knows its customers can count on for FX trading strategies.”
He adds that whilst NASDAQ OMX’s FX options have been around since 2006, they are now increasingly gaining attention from OTC participants. “We believe they see value in a fully electronic central order limit book which affords a full picture of all resting bids and offers. Since our FX options are standardised, they are easy to understand, easy to trade and easy to manage,” he adds.
As an SEC-registered exchange for the listing and trading of options, NASDAQ OMX PHLX is already fully integrated with its member firms, including banks and broker dealers. The exchange has multiple security layers in place with its members. In turn, members put into place their own security layer for market access to customers. Clients can leverage NASDAQ OMX FX options no matter where they reside. As long as investors have a securities account with a US broker dealer, they may access standardised products where capital requirements are handled.
FX options are tradable in any options approved brokerage account. Simple options strategies of long and short put and call strategies may be complemented by complex order ‘spreads’ of up to six legs. One-year expiry FX options are available to assist hedging operations.
The traditional role of the exchange is to match specialist and market maker quotes (bids and offers) with customer orders. NASDAQ OMX PHLX offers specialists and market makers the necessary means to trade on its open outcry trading floor or electronically with proper risk management systems in place. Also, all displayed bids and offers are disseminated via the Options Price Reporting Authority (OPRA).
Says Carrigan: “NASDAQ OMX is a proven innovator in various asset classes. Our focus is on improving the customer experience both in listed products and services.
Many OTC FX traders have been forced to leave the US for opaque and unregulated market destinations. One of our solutions is products delivered in a transparent and regulated environment that engenders investor confidence. We believe we can win back these customers by building an ecosystem of market makers and order flow providers seeking to deliver a robust FX trading experience. Today, we have extended this value proposition to securities traders everywhere with NASDAQ OMX FX Options. Tomorrow, we look to add additional FX products that provide even more investment and trading opportunities.”
On the back of the expected growth in interest in exchange-traded FX, the Moscow Exchange (MOEX), created from the merger of the RTS and MICEX exchanges at the end of 2011, has progressively broadened access to FX trading. The first step allowed banks licensed to trade FX to offer direct market access to primary clients. The second step, completed in December 2012, widened access to open, direct FX trading on the exchange to licensed brokerage firms. FX Market members post full or partial collateral to execute their trades, monitored by a highly efficient and reliable risk management system. Trades are settled on a payment versus payment basis, whereby delivery is made when a member fulfils all of its obligations to the National Clearing Centre (NCC), which is owned by the Moscow Exchange group and acts as the central counterparty and clearer. Settlement (including inter-regional) may be made via the Central Bank’s national real time gross settlement system.
Igor Marich, Managing Director of the Moscow Exchange and Head of FX&MM, says: “In general, the volume of swap operations on our foreign exchange market increases when banking liquidity deteriorates. For example, in 2013 swap operations represented 63 per cent of trading volume (by value) on our foreign exchange market, compared with 46 per cent in 2011. During volatile periods, foreign exchange swaps expand opportunities for banks to refinance in a foreign currency, or roubles, and manage foreign exchange positions. In addition, the share of on-exchange foreign exchange transactions, as compared to OTC transactions, has increased following the global financial and economic turbulence as counterparties seek to minimise clearing and settlement risk. For example, during volatility growth (December 2013) the share of on-exchange USD/RUB and EUR/RUB transactions of Russian banks was more than 43 and 66 per cent respectively in comparison with overall interbank market volumes and December 27 saw a record daily trading volume of USD 35.6 billion.”
The FX Market comprises 569 professional participants including the Central Bank of the Russian Federation (CBR), investment and commercial banks (including those from Eurasian Economic Community [EAEC] member states), and brokers. Non-residents have sponsored DMA to the FX Market.
DMA technology has been available on the FX Market since October 2010, and clients have had access to the system since February 2012. The number of market operations has increased significantly since 2012, resulting in a considerable increase in volumes generated by clients using DMA.
Marich says these clients include non-residents, domestic and international brokers/sub brokers, and individuals. The number of registered clients in 2013 increased from 3,600 to 46,000. The client trading volume came to RUB 31 trillion, while Moscow Exchange’s clients’ share in spot operations exceeded 23 per cent. The number of registered Russian and non-resident clients in Feb 2014 totalled 108,000. All together more than 1700 non-resident sponsored DMA clients from 58 countries are registered at the exchange FX market.
He adds that trading by foreign investors is important to the performance of the exchange’s FX market. Trades conducted by market participants that are Russian subsidiaries of foreign banks and foreign investors indirectly accessing the foreign exchange market through DMA facilities represented approximately 28 per cent of total trading volume (by value) on Moscow Exchange’s foreign exchange market in 2013.
Marich says: “We aim to continue to increase the share of foreign investors trading on our foreign exchange market as new foreign investors access the market as indirect market participants via sponsored DMA.”
Moscow Exchange introduced deliverable FX swaps with a tenor up to one year in the USD/RUB currency pair in April 2012. In October 2013, the exchange added a variety of long tenor swaps in EUR/RUB and CNY/RUB currency pairs. LTV contracts (deliverable FX forwards) are negotiated transactions with terms from one day to one year and trade in the USD/RUB, EUR/RUB and CNY/RUB currency pairs. Total volume of long tenor swaps in 2013 exceeded RUB 1 trillion. In 2010, the exchange received approval to use onshore accounts in China for CNY/RUB trading and began trading CNY/RUB spot and swap instruments last year.
In October 2013, Moscow Exchange launched on-exchange trading in precious metals on the same platform as the Foreign Exchange Market. As well as FX spot and swaps markets the Moscow Exchange also operates a derivatives market where FX futures are traded and volumes of EUR/RUB futures for example in January 2014 exceeded by 70.5 per cent and options by 43 per cent, the highest previous total ever on these instruments.
Says Marich: “We believe electronic trading is the main growth driver for our foreign exchange market. Accordingly, we have made advanced trading capabilities one of our primary strategic priorities. In particular, sponsored DMA facilities are now available for trading on our foreign exchange market. With sponsored DMA facilities, the customers of market participants, or ‘indirect market participants’, can engage in self-directed trading by using the direct market participants’ infrastructure to connect to the exchange. This reduces transaction costs and execution timing, enabling indirect market participants to exploit liquidity and price opportunities more efficiently.”
Furthermore, since February 2012, market participants have been able to register their individual client and settlement codes in the trading and clearing system, which allows market participants to increase trading volumes and reduce their settlement risk because they no longer have to aggregate the concurrent orders of all customers as one trade under a single registration number.
Marich also states that: “There is a clear indication that in periods of high volatility and instability market participants have turned to exchange-traded and centrally cleared FX as compared to the OTC market. We have also witnessed increased trading via low-latency execution methods, which leads to higher trading volumes.”
The average daily trading volume at FX MOEX equalled $19.4 billion in 2013, compared with the average daily trading volume of $14.9 billion in 2012.
In line with the global electronic FX market, ICE offers electronically-traded FX futures that are available on screen, an average of 21 hours a day. These trading hours cover business hours in virtually all geographies. Local requirements are reflected in settlement procedures, contract specifications like the term of the futures contracts (quarterly cycle, monthly cycle) and how far products are available out the expiry calendar. In addition, ICE continuously monitors regional markets to determine if there are products that reflect local activity that can be sustained when offered as an internationally-accessible futures product on a round-the-clock electronic trading platform.
Scott Brusso, Director, FX Sales, at ICE Futures US says that exchange-traded FX is catering to an increasingly diverse global user base by offering a more capital efficient and effective environment to manage risk, as well as by providing gateways to a wider range of trading opportunities. He says: “For 40 years, FX futures have offered a regulated, transparent, universally available marketplace with clearing, and capital solutions to a wide range of participants.We are seeing significant changes in the FX market as regulatory reform increases. In effect, the traditional advantages of exchange-traded FX have become more important to a wider variety of market participants. And as futures exchanges offer more products encompassing more regions and currencies (like the rupee, real, and ruble), the advantages can be realized by market participants in those areas in even more direct ways than before.”
To this end, the exchange recently launched cash-settled futures on the Indian rupee and the Brazilian real and Brusso says the exchange has seen growing interest in emerging market non-deliverable forward currencies from a range of market participants, including CTAs and funds, in recent years.
Brusso states that, “The ICE platform is designed to support new product development and offers highly functional trading and risk management features. Our markets are available via direct connections, telecom hubs, the internet, over 30 front-end providers (ISVs) and ICE’s web-based front end, WebICE. Our trading systems are protected by the latest digital security technology and processes, including high-level encryption technology, complex password protection, multiple firewalls, network-level virus detection, intrusion detection systems and secured servers.”
Brusso also says that: “Developing and supporting our own technology allows us to introduce new products, serve new markets and improve capital efficiencies that translate problems into solutions for our customers. Our suite of nearly 60 FX futures contracts feature arbitragable units – same size and specifications as the most-traded currency futures; half-tick trading in most currencies; EFP and block trading with no EFP or block surcharges (regular exchange and clearing fees apply to off-exchange transactions like blocks and EFPs); and Trading at Settlement -- the ability enter an order to buy or sell a futures contract during the course of the trading day at a price equal to the settlement price for that contract, or at a price up to five ticks above or below the settlement price.”
According to Will Patrick, Executive Director, FX Products at CME Group, the evolution of FX trading means CME Group’s exchange-traded FX products are more suitable than they have ever been. He says: “Our products are no more capital-efficient than they were a few years ago. However, with the regulatory changes and the impact on capital it is more a case of the market aligning with our model of exchange-traded, centrally cleared FX.”
Patrick says that mandatory reporting and clearing for NDFs will have a significant impact on the exchange trading world. The capital charges that NDF trading will incur look like they are going to be quite onerous and as a large amount of FX NDFs are traded in a standardised way, giving rise to greater interest in exchange-traded emerging market currency futures. He says: “The one big difference is paying margin, which previously was not second nature to some OTC traders, but this has changed and now everyone is coming to terms with paying initial margin and variation margin.”
Proxy for forwards
In response to this, CME Group has expanded its emerging markets futures suite of products, launching a deliverable Chinese Renminbi and Indian Roupee futures, a very fast growing NDF, and re-launching the South African Rand futures contract, last year. The dollar/Rand contract was flipped, to be quoted in the same way as the OTC market, in a deliberate attempt to attract OTC users. “As capital charges from Basel III start to filter through, these products are just going to become more suitable to OTC traders as they will be more capital efficient ways of accessing those markets,” adds Patrick.
Listed standardised futures contracts herd liquidity into certain points along the curve, making it easier to trade and also making it easier to liquidate in a default process. Standardisation also keeps trading costs and margins down. Patrick says generally listed products at the exchange have been used as a successful proxy for spot but adding granularity, which CME Europe plans to do when it launches, opens up a new market, and quite a large market, as a proxy for forwards too. “I think there is a meeting point where you can add at least some more granularity to that curve and monthly futures is where it takes you,” he adds.
The growing number of large open interest holders in CME FX futures, from 406 at the end of 2009 to more than 834 at the end of 2013, infers that traders are moving from the OTC FX market to the listed futures space. Patrick adds: “It is also a very good indicator of risk on/risk off and a good indicator of how people are switching to futures to hedge their currency risk.”
CME Group’s volumes are very much geared to electronic trading – 99 per cent of CME’s currency futures are now traded electronically and 90 per cent of FX options, which is the most electronic options market within the CMR Group.
Patrick says that investment in being made in terms of CME’s EMEA’s distribution strategy, which includes the establishment of a presence in the Equinix data centres, where a lot of the OTC FX platforms are located, and that exchange is fully prepared for further growth as the FX market beds down into the newly emerged landscape.