Exchange trading has always represented the tip of the iceberg in any market, but more so in the global 24x7 FX market, where trading averages $5.1 trillion a day. For this reason, the focus for derivatives exchanges is very much upon creating new ways of trading on-exchange and the development of new types of contracts and incentives, that echo and attract the OTC market.
Paul Houston, Global Head of FX Products, CME Group, says: “Our aim is to have the most comprehensive and efficient suite of FX products, across listed and OTC, whether they be listed futures, listed options or OTC cleared products and there will be mechanisms to link them together, to achieve capital and cost efficiencies.” This has involved listing new products that have attributes from the OTC market, such as a monthly expiry dates for FX futures and volatility-quoted options. CME Group made a significant expansion to its FX offering earlier this year with the launch of FX monthly futures contracts, providing FX market participants with access to the front months of the FX forward curve with the capital and operational benefits of trading listed futures. This combines greater choice, with the cost benefits of trading on-exchange.
The exchange is continuing its drive to find new ways to trade FX on exchange and is now preparing to offer implied functionality for FX futures. CME Group will introduce implied functionality on six the FX monthly futures contracts launched in February - the euro, yen, sterling, Australian and Canadian dollar and EUR/GBP - and all SD calendar spreads in a bid to help increase liquidity in the contracts, and across its FX futures complex. The changes, which will be effective 24 September.
Implied functionality links bids spreads and outright markets to optimise liquidity. Switching it on will link all implied combinations between outrights and calendar spreads within one year and will help increase liquidity in the contracts, and across its FX futures complex.
Houston says: “The launch of monthly futures in February has seen well over 200 participants trade the product to date. Implied functionality is the next step in the launch process and is expected to substantially build liquidity in those contracts. As well as offering additional hedging points, we are looking to enhance forward trading opportunities alongside the capital and credit efficiencies that trading futures bring.”
Foreign exchange volume at CME Group continued to grow, averaging 863,000 contracts per day in July 2017, up 19 per cent from July 2016. Average daily volume in its flagship Euro FX futures and options contracts increased by 38 per cent, year-on-year. According to the Futures Industry Association (FIA), CME’s Euro FX future was the world’s 10th most traded contract in 2016. Trading in Emerging Market currency pairs futures and options also grew, with South African Rand up 417 per cent, Indian Rupee up 137 per cent, Brazilian Real up 37 per cent and trading in the Russian Ruble futures contract increased by 18 per cent in the same period.
Clearing for FXO options
Meanwhile, on the clearing side, CME Group is also breaking new ground by building a clearing solution for FX options (FXO). While a clearing solution for over-the-counter (OTC) physically-settled FX options has long been sought by the FX industry, CME Group is stepping up to the mark with a cash-settled solution. In June, CME Group received regulatory clearance from the Commodity Futures Trading Commission (CFTC) for the service, expected to launch by the year-end.
“This is a significant milestone in providing our FX clients with the broadest and most capital efficient FX clearing solution in the market. In addition to our cleared NDFs and cash settled forwards, which are already live for clearing, we will work toward launching G7 FX options later this year so that clients will have a holistic FX clearing solution that offers unparalleled portfolio margining opportunities between cleared FX products and our exchange listed FX futures and options,” says Houston.
The initial launch will include cash-settled OTC FX options with up to a two-year expiration in seven major currency pairs, including AUD/USD, EUR/USD, GBP/USD, USD/CAD, USD/CHF, USD/JPY, and EUR/GBP.
The CME OTC FXO clearing service will be cash settled, the rationale, according to Houston, being that this model is simpler to both implement and run, and importantly it reduces the costs of managing the risks associated with physical delivery.
He adds: “If a CCP offers clearing on a deliverable basis then it is required to ensure that all the transactions are settled in the currency they are traded in. This means that the CCP is required to put in place swap lines to guarantee delivery in the event of a liquidity shortfall. These swap lines represent additional costs that need to be borne by the clearing members which in our view changes the economics of clearing deliverable FX”.
CME Group offers OTC FX clearing through its base default fund - the same default fund that houses all CME listed products across asset class.
Houston says: “Offering OTC FX Clearing within our base default fund generates substantial efficiencies for our members when compared to the alternative such as a siloed fund by product. In terms of default fund contributions, you can almost get your FX clearing for free when it is in such a large diversified fund.”
Impact of MiFID II
With much in the pipeline, developments are continuing apace in terms of the integration of 360T and the MiFID II and OTC offering, according to Lee Bartholomew, Head of Derivatives Product R&D, Fixed Income and FX at Eurex, who says that some of the exchange’s launches have been put on hold due to preparations for MiFID II and the change in priorities in both buy-side and sell-side firms.
He says: “With the best execution component under MiFID II, we may see more of the buy-side using standardised contracts, more than the OTC market, as they are able to better demonstrate best execution. MiFID II, and the development of algorithmic execution across the buy-side, has also played into the favour of some of the exchange-traded products as they are able to set those systems in place for low-touch and build this out. While this favours the FX futures market, and it is positive for the market, we are not expecting to see a seismic shift from OTC to listed products, but a continued combination of both.”
Bartholomew believes that there will be a greater merging of the OTC and listed markets but that the preparations for MiFID II and the need to refocus their businesses should come first. He says: “Banks need a strong franchise and the business case for entering a new market must be very strong. Pre-crisis banks would have gone into asset classes, or segments, not necessarily needing a full franchise model but today it is the case.”
360T, acquired by Deutsche Börse Group in 2015, is a central part of the exchange’s global FX strategy and while some finer details are still being tweaked and OTC and exchange-traded FX business is being built out side by side, and various components will be launched towards the end of the year.
Bartholomew says: “We are still on track to launch new products in the second half of this year; some of this will be in the listed space and we are also on track with the OTC FX clearing piece, together with a cross-currency swap component. There is potential for us to launch a new product on the exchange side later in the year and I see that as helping us build up the liquidity in the existing products that we have. Phase One was to move to 23-hour trading, this was necessary for the exchange and we have done this, then it was to come up with a pretty compelling offer and I think the integration of 360T and the OTC component did this, and now it is about bringing new products to the FX listed space, without reinventing the wheel too much, and then building up liquidity.”
Asia sees growth
The Singapore Exchange (SGX) has continued to see strong growth in its FX business over the past 12 months. SGX’s FX complex now consists of 18 currency pairs, and two options on futures contracts, and the overall year-on-year growth in the FX contracts was 74 per cent in July, in volume terms. There was also a 15 per cent growth in open interest across the exchange’s currency contracts and average daily volume has consistently grown since the launch of FX futures at SGX in 2013, reaching 36,190 contracts in July.
SGX’s two largest FX contracts are the offshore RMB and Indian rupee futures. KC Lam, director and head of FX and Rates at SGX, says: “This makes sense, as based on the economies, purchasing power and parity, these contracts represent the biggest and second biggest economies in Asia, and rightly so, the futures are very much on our radar and both are showing stellar growth.”
Year-on-year growth, July 2016 to July 2017, for SGX’s Indian Rupee futures is close to 50 per cent, and for SGX’s USD/CNH futures, in the same period, there has been 410 per cent growth, with open interest in the contract growing by 96% year-on-year.
In July, SGX launched contracts in four more currency pairs: Indonesian rupiah; Malaysian ringgit, against the USD and Singapore dollar; and the Philippine Peso, to augment its range of Asian currency futures contracts. “Before launching any contract we undertake thorough consultancy with the market to see where the demand is and what contracts they need to trade and hedge. This feedback is very important to us. To this end, we are looking at introducing a product, towards the end of this year, that will address some of the issues facing our customers currently trading non-centrally cleared OTC, due to the greater regulatory requirements and higher capital requirements,” says Lam.
Regulators in Australia, Hong Kong and Singapore joined their European counterparts in delaying collateral requirements for non-cleared OTC derivatives. The Monetary Authority of Singapore (MAS) guidelines on margin requirements for non-centrally cleared derivatives contracts are now expected to be rolled out by the first quarter of 2018.
Despite being one of the later entrants to the FX derivatives market, Lam believes that SGX has outperformed regional competitors with its strong focus and specialisation on Asian currency futures. “If you were to compare with similar freely accessible exchanges in the region, SGX’s FX is ranked at the top in terms of notional traded and volume for Asian currencies, excluding G10 currencies. We have tried to avoid launching contracts in isolation; we have focused on building a suite of products that our customers can hedge and trade because the entire Asian market is getting more interconnected. While the newly launched contracts have all traded it will take time to build this market as many of our market participants are more used to trading OTC derivatives, especially as the regulatory requirements for trading on exchanges have not really kicked in,” he states.
Lam says that feedback from its members indicates that one of the biggest drawbacks to exchange-traded futures for the OTC market is the standardisation, and aspect in particular is the single expiry dates of contracts, whereas OTC players need greater flexibility to carry out back-to-back deals. For this reason, SGX is developing a contract that provides the flexibility of OTC and the surety of a CCP, in the FX market. “We have always tried to complement the OTC market and the challenges they face. We expect a strong symbiotic relationship between OTC and exchange-traded but we are trying to see if we can offer a solution to participants facing the impacts of the implementation of Basel III.”
“It is less than four years since we launched our first currency pair and we have evolved but we have still much to do and I believe the growth we have seen in our volume and open interest is encouraging us to continue to innovate.”
RMB trading incentives
Hong Kong Exchanges and Clearing (HKEX), the first market in the world to start offshore Renminbi (RMB) business after the Mainland government appointed a clearing bank for RMB business in Hong Kong in 2003, currently trades five currency futures and one currency options contract and while FX derivatives still represents a small proportion of the exchange’s total volume it is a growth area.
Since its introduction in September 2012, HKEX’s USD/CNH futures contract has seen an annual growth rate of 57 per cent. Total trading volume in 2016 was 538,594 contracts (notional value of US$54 billion), an increase of 105 per cent from the previous year. This year, there was record single-day volume of 20,338 contracts (notional value of US$2 billion) on 5 January 2017 and the average daily turnover of RMB currency futures for the first eight months of 2017 was 2,799 contracts, an increase of 49 per cent when compared with the 1,880 contracts for the same period last year..
This has been achieved due to the growing acceptance of increased volatility in the RMB exchange rate, following the RMB exchange rate mechanism reform in August 2015 and with the increasing marketisation of the exchange rate system in Mainland China. Trading statistics show that the RMB futures contracts on HKEX have exhibited their functionality as RMB currency risk management tools at times of high volatility in the RMB exchange rate.
Julien Martin, Managing Director and Head of Fixed Income and Currency (FIC) of HKEX, says that, “the liquidity growth of HKEX’s USD/CNH futures has been helped by, among other things, Hong Kong’s role as the international financial centre of China, the city’s large RMB liquidity pool and growing international investor interest in the RMB.”
Further to the four additional RMB currency futures contracts added in May 2016 (EUR/CNH futures, JPY/CNH futures, AUD/CNH futures and CNH/USD futures) and to prepare for the expected increase in demand for FIC derivatives for risk management, HKEX introduced product enhancements for its RMB currency futures in July 2017. These include the extension of trading hours to cover nearly 16 hours of trading per day, and enhancements to its market maker and incentives schemes to support the development of liquidity in the FIC derivatives products at HKEX, including a fee waiver for cash-settled RMB currency futures until the end of the year. “These enhancements are aimed at providing investors with additional RMB risk management solutions for hedging interest rate and foreign exchange exposure,” says Martin.
The global OTC RMB options market already has a sizeable average daily turnover of approximately US$18 billion according to the BIS Triennial Central Bank Survey of foreign exchange and OTC derivatives markets in 2016. Since HKEX’s USD/CNH options were rolled out in March 2017, liquidity has continued to grow with total volume traded at 6,205 contracts at the end of August, and open interest at 2,305 contracts. In order to enhance cost effectiveness, HKEX has offered an exchange fee waiver for USD/CNH options until the end of September 2017. Martin says that the exchange-traded options offer better price discovery - typically, continuous quotations on around 150 option series are available from dedicated liquidity providers, with average spreads of 12-40 pips for short tenors and 80-160 pips for long tenors.
“HKEX’s RMB currency options contracts complement HKEX’s RMB currency futures contracts. The options are risk management tools against non-linear sensitivities and offer volatility trading opportunities on RMB exchange rates, addressing market demand not previously satisfied by HKEX’s RMB currency futures,” states Martin.
As the RMB becomes more international and policy development continues, and the exchange rates are in transition from policy rates to market-driven rates, greater volatility in the USD/CNH exchange rate is expected to increase demand for RMB currency options contracts for hedging and volatility trading. The relative lack of transparency in the over-the-counter market, the associated margin requirements in new regulations and the counterparty risk, is also increasing demand for exchange-traded RMB currency options trading. The USD/CNH options contracts are centrally cleared through the HKFE Clearing Corporation Limited, providing enhanced price discovery and market transparency, and much lower counterparty risk compared with off-exchange products.
HKEX has plans to introduce RMB currency index futures to provide RMB exposure against a basket of key currencies under a transparent, rules based methodology. The exchange also plans to offer other RMB-denominated interest rate and commodity products, according to Martin.
Moscow Exchange (MOEX), with its FX and Derivatives Markets, is the dominant liquidity venue, and the centre of trading, for both deliverable and non-deliverable Russian Rouble FX instruments. Exchange-traded markets have faced a number of challenges recently and with the new international standards for financial markets being rolled out, Igor Marich, Moscow Exchange’s FX, Money and Derivatives Markets Managing Director, believes that MOEX’s role as the regulated market, with transparent rules and guaranteed net settlement, has strengthened its dominance.
He says: “MOEX is expanding its presence versus the interbank FX market with the market structure exhibiting spectacular growth in FX swap transactions against a steady and consistent flow in FX spot volumes.”
In 2017, MOEX’s market share on the Russian FX market grew to 56 %. MOEX FX Market’s average daily trading volume rose to USD 25 billion (up 29 % year-on-year) with FX swap transactions (primarily USD/RUB) accounting for 77 % of total market turnover.
The RUB FX market has undergone remarkable changes, and MOEX’s Sponsored Market Access (SMA) and International Clearing Membership (ICM) services are fully in line with global standards. This is due to a number of factors, firstly, that international investors and traders have greater demand for RUB liquidity.
This is mainly driven by the reduced risks of the Russian market and increased returns from investing into RUB assets amid appreciating national currency and high interest rates. Secondly, according to Marich, “FX market players are increasingly turning away from banking platforms to more centralized liquidity pools - multilateral electronic marketplaces, such as MOEX, to take advantage of international regulatory and compliance standards. They show more interest in the agency model, which satisfies the clients’ needs for direct technical access to these multilateral trading venues. We see it clearly as a growing trend in access to MOEX RUB FX market.”
Thirdly, MOEX has offered global banks the ability to become ICM of MOEX FX Market through a direct business relationship with Russian domiciled Trading Members. ICMs benefit from a direct credit relationship with MOEX CCP and their highly effective liquidity and settlement management tools: the ability to roll settlement obligations in the liquid RUB FX Market alongside a guaranteed net settlement facility for both its on-exchange and OTC FX transactions.
Says Marich: “Both these services reduce settlement risks and funding costs significantly: an international credit institution can now perform FX transactions and settlements with considerably reduced or even no exposure to ‘Russian’ risks. Furthermore, the evolution of MOEX’s regulated, safe, RUB net settlement infrastructure and liquidity/settlement management tools, have increased interest from private and institutional investors in deliverable FX instruments and operations.”
In 2017, the MOEX FX Market became truly international: more than 10,000 non-resident clients from 100 countries have been registered with their share of the spot market totalling 40 per cent.
The promotion of MOEX FX benchmark, the MOEX USD/RUB FX Fixing, is an important development area for the exchange with the benchmark adopted globally as the basis for cash settlement by the RUB NDF and derivatives markets since 2016. It is subject to annual assurance review of compliance with the IOSCO Principles for Financial Benchmarks, and it is also incorporated into the ISDA’s FX Definitions. Marich adds: “We are currently working on submitting our FX benchmark for recognition and inclusion into the FSA ESMA Registry in 2018. A prototype for the MOEX FX benchmark electronic matching service, called USD/RUB Fixing Based Matching, was launched in the summer of 2017 to meet the needs of major international and local participants of the RUB NDF and derivatives markets; this FX benchmark matching service will continue to be enhanced with the engagement of these participants.”
As the dominant liquidity and pricing venue for the Rouble, Moscow Exchange’s fixing rate is now recognised internationally, replacing all previous RUB benchmarks, Marich adds: “We are implementing a comprehensive set of measures to improve the on-exchange FX market microstructure: fees were changed in 2016 to correlate with the size of the order traded; an increased tick size of 0.25 kopecks for the main currency pairs has led to higher fill ratios; the user parameters of iceberg orders were changed recently with the resulting volume and number of iceberg trades increasing and the market share for this order type rising to 12 per cent.”
Furthermore, in June 2017, the exchange’s market making program for the flagship USDRUB_TOM instrument was relaunched, with international participants rewarded for continuously maintaining a tight two-sided quote spread above USD 1 million. As a result, the bid ask spread has narrowed and the average size of spot trades has risen, says Marich.
MOEX is now researching a marketing program to be introduced by 2018 to incentivise the broader market participants, stimulate trading in bigger lot sizes, launch effective market making programs and tariff initiatives as well as introduce new instruments and trading schemes.
MOEX offers a wide range of FX instruments that meet the needs of a variety of clients, both institutional and individual.The number of registered FX clients exceeded 900,000 names in 2017 and the exchange hopes to further expand its client base through the addition of Russian domiciled corporate members.
Marich adds: “The admission of large Russian corporations as first tier member participants to MOEX FX and Money Market has been the most prominent event of the year. Their presence should stimulate extra liquidity and trading on both markets significantly. Since April 2017 11 large corporations (including majors such as Rosneft, ALROSA) have joined the FX market.”
Last year, MOEX relaunched a service that optimises/offsets collateral requirements for outstanding FX and derivatives positions, reducing margin costs.
A unified collateral pool is already in the pipeline, which will allow a single collateral account across all markets and portfolio margining. The new service will facilitate reduced margin requirements for most participants across all markets and help cut costs considerably.
The product offering will be also enriched to include new instruments on currencies of the G10 member countries and Eurasian states (for instance, JPY/RUB, TRY/RUB, GBP/USD, USD/CHF etc), and the exchange plans to develop links with the large global FX platforms to distribute RUB liquidity among their users.
Strengthening the exchange proposition
Gaurang Desai, Chief Executive Officer, at the Dubai Gold and Commodities Exchange (DGCX) believes there has been a change in the mindset of professional traders, treasury departments and market participants with liabilities in other currencies looking to protect themselves from market fluctuations. “The election of President Trump, the Brexit vote, European elections and a number of other events has caused greater volatility over the last twelve months. This has meant market participants are looking to protect themselves and hedge their exposure. For example, anyone that lives in the UAE is typically earning money in UAE Dirhams, which is pegged to the US dollar. Quite often, the chances are that they are looking to hedge their risk with their home currency,” he says.
As well as attracting more niche players, DGCX has seen growth in its flagship contracts, such as the Indian Rupee, its largest contract, and more recently the Euro, Pound Sterling and the South African Rand. DGCX has also seen increased demand for its Chinese Yuan (USD/CNH) contract too. DGCX continues to be the largest global liquidity pool in Indian Rupee futures: at present, it holds approximately 32 per cent of the global futures market. As well as the main Rupee futures contract, DGCX also offers a Rupee Index contract, a Rupee Mini contract as well as a Rupee Options contract. The exchange is seeing increased maturity in its Indian Rupee product range, especially contracts with long-dated expiries that are starting to trade more regularly.
The growing interest in trading on-exchange and in clearing OTC is a trend the exchange has observed for a number of years, in both currencies and commodities. Commodities markets are increasingly moving to a screen-based proposition, due in-part to the regulation around the Dodd-Frank Act, moving OTC trades into a regulated market. “This has greatly strengthened the exchanges trading proposition in terms of safety and security, bringing an audit trail, better mitigation of risk, and hedging against currency fluctuations and volatility,” Desai adds.
One of the exchanges recent launches, the USD/CNH future, was driven by the demand of new members from the Far East and the need of domestic members originally from the Asia-Pacific region to access an exchange-traded tool to hedge exposure in either currency. For DGCX, the smaller contract size is not necessarily aimed at individual traders. “Certainly, the Yuan contract is aimed at the professional traders because of the size of the contract,” continued Desai. “It corresponds with other liquidity pools globally, so naturally it is attractive. The smaller contract allows smaller companies to also trade and hedge their risk.”
Desai says that the launch of the Chinese Yuan contract instigated the Exchange’s ventures into other Chinese-related products. Last year, DGCX obtained a license from the Shanghai Gold Exchange to launch the Shanghai Gold futures contract on the DGCX’s platform; this was launched in the first quarter of 2017. As the world’s first licensed product from China, this contract uniquely allows access to the Chinese Gold market. “Immense efforts were required to get market participants ready for the Chinese Yuan settlement account, as well as the roll-out of Chinese Yuan settlement off-shore, here in Dubai,” says Desai.
Since the Exchange has a wide range of currencies available to trade on its platform, including the G6 currencies, its members can now trade the Shanghai Gold contract, priced, denominated and traded in Yuan, as well as use the Yuan contract to pair up with the other FX contracts, and effectively trade gold in any currency they desire. Desai adds: “With China being a closed market, this contract is especially appealing to traders who would like to gain access to Chinese pricing and Chinese gold markets, and therefore they are keen to trade the DGCX Shanghai Gold Futures.”
At present, the majority of the exchange’s volume comes from the currency segment. This is due to DGCX being the first exchange to launch an Indian Rupee futures contract, which is gaining liquidity and attracting different market participants, including high frequency players and algorithmic traders. A number of service providers are now also offering low latency solutions to these traders.
While there are new products in the pipeline, the exchange will most likely look to list Emerging Markets’ currencies, such as Brazil, Pakistan and Turkey. Desai confirms that there is also a growing interest in Crypto-currencies, which could become part of the Exchange’s future plans.
In July, DGCX signed a Memorandum of Understanding with the Abu Dhabi Securities Exchange (ADX) to start the basis for collaboration on a unified clearing house (CCP) in the UAE. The creation of a unified, national, clearing house with the size, scale and capability to clear all asset classes is expected to strengthen the exchange’s market position and ability to launch more products. Desai commented: “We are in discussions to create a unified clearing house: this would essentially allow us to expand on our current clearing house capabilities, for which has we’ve obtained ESMA’s recognition as a TC-CCP, in order to include more products, and possibly some of ADX’s products as well.”
Having received ESMA equivalence in March of this year, the exchange and its CCP subsidiary, Dubai Commodities Clearing Corporation (DCCC), has been recognised as a remote Exchange and Clearing House by the Financial Services Regulatory Authority (FSRA), the regulatory authority for the Abu Dhabi Global Market (ADGM), enabling ADGM companies to access its trading and clearing platforms.
Desai adds: “We have recently received remote non-member recognised status. This means that companies set up as part of the ADGM can have access to DGCX, providing they fulfil all the membership criteria. We are a global exchange, and have members from all over the world. Our partnerships are strategic and are aimed at strengthening both the DGCX and the DCCC within the UAE and regionally, in order to meet world-class standards.”
As we have seen, exchanges are growing their FX operations, not just in terms of volumes traded and products offered but also in expanding their footprint and reach and it is a path that will continue as regulators look to push for more business to be traded on a regulated exchange and centrally cleared. And while the entire OTC market cannot go on-exchange, there is a possibility and scope for the exchanges to go into the OTC market.