Malcolm Baker Head of Product Development and Market Making at OSTC Ltd.
Malcolm Baker Head of Product Development and Market Making at OSTC Ltd.

Exchange penetration of FX Swaps Markets for 2017

Exchanges are currently annually trading about $800b per year of ‘listed FX swaps’ compared to $2.3Trn which trade every day in the OTC FX Swaps markets. So this is a market the exchanges should attack. But why aren’t they penetrating as they probably should? And more importantly how will they accomplish this?

By a long distance, CME Group has the largest listed turnover in the FX space of all the exchanges. Of the $150b which trades in listed FX, CME Group owns around a 75% share. Of this 75% share, almost all the volume trades as FX Futures which trades as a proxy for Spot FX. Meaning instead of trading Spot currencies (T+2 for most Majors, T+1 for some and End of month for NDF currencies) those trading will instead trade a fixed Forward contract, with one pool of liquidity called an IMM date (3rd Wednesday of March, June, Sep & Dec each year) and manage or ignore the Forward FX pips (Basis) between Spot (T+2) and the nearest IMM Date. Many like this extra source of strong liquidity, but if you are a FX Swaps or Forward trader, one single pool of liquidity at a fixed point in time does not really provide much in terms of hedging.

Moscow Exchange, Brazilian Exchange, Mexico Exchange, SGX, HKEX, DGCX all have strong regional currency offerings. ICE US has the widely-viewed USD Index Future which trades circa $5b per day and a handful of major currencies which trade sporadically. Outside ICE US FX, regional exchanges that offer regionally focused FX products enjoy much success. In many cases the volumes traded on these regional exchanges are in EMFX like USDRUB, USDINR, USDBRL and USDMXN. The volumes can be considerable in size and banks have been plugging into these regional sources for some time to source much needed liquidity.

Back to the Listed FX Swaps activity. Of this $800b annual turnover 99.99% takes place in the ‘roll period’ at the CME Group where, over a 10 Day period every quarter, Open Interest Holders of FX Futures will ‘roll’ their Front month exposure to the next ‘active’ Front month contract to avoid delivery and maintain their exposure on each Currency Future they hold. Recently the CME Group experienced record Holders of Open Interest and Record Delivery, so it feels as if the Exchange model is beginning to resonate more with the global OTC FX Players in the new regulatory capital restricted world they do business in.

Most OTC FX swaps do trade in Standardised Dates but the OTC FX Swaps are far more bespoke in nature than Exchange listed FX Forward-Forwards. The most common Products quoted and traded are; O/N (overnight), T/N (Tom-Next), S/N (SpotNext), Tom-1week, 1 Week, 2 week and 3 week. Longer Maturities are 1, 2, 3, 4, 5, 6, 9 and 12 months (all these Spot starting). Of course, if you trade a Spot starting 3 month FX Swaps today, tomorrow you have a Tom starting 3month, and if not covered, the next day you are taking and making delivery of the currency. Most FX Swaps players will have multiple line items of FX exposure down the curve out to 2 or 3 years, in many cases, with FX exposures on every single business day of the year.

At settlement, CLS (continuous linked settlement) handles the delivery exposures between counterparties, but it does not handle the vast exposures down the Forward Curves of multiple line items between multiple counter parties. Major players in the FX Swaps markets will hold multiple trillions of dollars of exposure. These vast exposures represent a huge opportunity for exchanges to offer a centrally cleared alternative; however, the gulf between making this a reality and where we are now is huge.

Here are some of the challenges and opportunities exchanges may experience if they attack the FX swaps market.

A) Lack of bespoke-ness of Listed FX Futures model.
FX Futures usually trade with a limited number of Expiry (maturity dates) Whereas OTC settles every business day of the year.

B) Absence of capital efficient clearing model.
FX futures receive no margin offsets from offsetting Interest rate Futures positions. For example, Long US yields (Short 2year UST) & Short UK Yields (Long 2 year Gilts) & Short GBPUSD 2 year FX Swap.

It feels as if the Exchange model is beginning to resonate more with the global OTC FX Players in the new regulatory capital restricted world
It feels as if the Exchange model is beginning to resonate more with the global OTC FX Players in the new regulatory capital restricted world

C) Distribution into major FX Swap players, market awareness and education.
FX swaps are an interest rate product with a FX ‘handle’/ name, essentially speaking, Interest Rate differentials between currencies priced in FX pips. Exchanges must distribute their liquidity into the Money Market desks of Major FX players. This could be accomplished by having Banks e-commerce departments connect to and plug into this new FX forward liquidity and ‘morph’ / display these FX derivatives into OTC equivalents, allowing the Forward trader and the banks FX customers to access the new liquidity pool created from new Buy-Side players, not new to FX Spot, but new to FX Swaps.

D) Education.
As much as asset managers need to understand how to replicate UST Cash Bonds exposures with UST Futures, exchanges will need to provide a comprehensive education programme to ensure that end users and market makers understand; Pricing, Clearing and Settlement risks of FX Futures to replicate OTC FX Swaps.

E) Access.
Nine out of ten new products that are launched by exchanges fail. This can be down to many reasons: bad timing, lack of Buy and Sell Side interest demand for the product, bad execution, clearing issues/ delivery issues, bad product design or just bad Luck. But ultimately none of the above will matter if the major players cannot access your product via ISV’s, or regulatory barriers exist or there is a lack of clearing members or brokers willing to promote these new products.

Major players in the FX Swaps markets will hold multiple trillions of dollars of exposure
Major players in the FX Swaps markets will hold multiple trillions of dollars of exposure

F) Credit risk of global clearing houses.
Whilst Central Clearing (CCPs) offering considerable benefits/ risk mitigation to end users, however, do they offer a total ‘risk free’ solution?

G) Settlement / delivery risk?
I am convinced there is no settlement/delivery risk from taking delivery at an exchange, as these models have been tested vigorously aver many years. Despite my confidence, major players whom do not already trade FX Futures and take delivery may be concerned about upcoming $20 Trillion maturity dates and potential inherent risks that arise.

H) Agency vs Prop.
The major banks are slowly but surely pulling away from prop activity and in many markets where Liquidity is driven / created by HFTs there has been little erosion of liquidity (UST and FX Spot). HFTs like XTX Markets, Jump Trading, and Citadel have spotted the void created by the banks desertion as prime Liquidity makers.

The same cannot be said for markets like FX Swaps, IRS, Credit Markets and Cross Currency Swaps. In these markets banks are still occupying the Sell Side mantle they have held for decades in the Financial Markets Without these major Liquidity providers ‘buy-in’ to a Listed FX swaps alternative, I doubt there will be much product success. To receive that buy-in, exchanges will need to assure the major FX swaps players that their core business will be enhanced not demolished by creating a new FX Swaps ecosystem on exchange.

I) Fees & Commission structure.
If exchanges do manage to provide an all-encompassing FX solution for FX swaps solving all the problems FX Swaps players have, they still will need to look at fee structures. Bank to Bank (Direct) fees are zero, Bank to Bank (via brokers) fees are for the most part negligible, these having been discounted for volume by brokers struggling to adapt to falling Liquidity, new players and the electronification of the OTC markets. Whilst banks may receive some considerable Capital savings by trading more in a CCP, traders must factor in considerable transaction fee increases when calculating their TCA.

Exchange fees could be somewhat staggering for NonMembers whist exceptionally appealing for exchange Members when talking about the notional sizes that trade in FX swaps. Therefore, exchanges will need to bust their current approaches to exchange fees to fit in with the OTC pricing, unless of course the solution is that amazing?

J) OTC FX Swaps Liquidity providers are diminishing.
Much like Money Markets liquidity having all but vanished since 2005, FX swaps liquidity players have fallen considerably since 2010. In products like GBPUSD there are only a handful of major players that will quote prices. Compare this to pre-2005; The OTC FX swaps market was literally huge, both in volumes and in participants.

K) Broker Buy-In / Distribution.
Global brokers, like ICAPTullets, RPMartins, ED&F Man, and Tradition all have a huge stake in a thriving Global Financial Markets. As further electronification of the Global Financial Markets takes place, slowly but surely broking desks are either morphing/evolving, going into a niche product or vanishing from the broking floors.

Without doubt these brokers have unparalleled distribution networks. Any new product launch, and especially a challenge to an existing ecosystem, will require broker buy-in. Brokers will need to be able to ‘broke’, provide distribution of pricing and be the exchanges most engaged sales force in the new product push. Brokers will need to be incentivised as much as anyone on the Buy or sell side.

L) Clearing Brokers (FCMs), ISVs & Data distribution.
Without a solid distribution network that is second to none, any new product will probably fail. This distribution is not just limited to Clearing banks willing to commit to clear these new products but also ISV’s willing to write to and support the new products.

If exchanges do manage to provide an all-encompassing FX solution for FX swaps they still will need to look at fee structures
If exchanges do manage to provide an all-encompassing FX solution for FX swaps they still will need to look at fee structures

M) Clear Product approach.
It would be easy to say an exchange listed FX Calendar Spread economically replicated a Forward Starting FX Swap in the OTC markets. That would be true, but the solution to becoming relevant to the OTC FX players is not providing a bit part solution and hope it sticks (remember the 9 out of 10 failure rate?) The solution needs to break down the problem into little pieces; Pricing, Distribution, Clearing, Access, Product design.

N) Partnerships with OTC Pricing vendors.
Such as Kalahari and alike, FX Swaps markets are niche. You probably can count under 100 global FX swaps traders still ‘in the market’ that have run a FX Swaps book. Partners like Kalahari, who provide niche FX and Interest Rate pricing tools, could be able to provide valuable education on these new products.

O) Target ‘nontraditional’ Sell Side.
Exchange traded derivatives liquidity is mainly provided by traditional non-sell side players; Props, Hedge Funds and Independent Props. As we mentioned earlier FX Swaps are Interest Rate products wrapped in a FX swaps name, it should be very easy to find an army of traditional STIR type liquidity providers willing to begin the journey of bringing OTC FX swaps to an exchange.

P) Target traditional Sell Side.
Tier two banks. No-one likes to be referred to as Tier two or Tier three as a Bank, but it is important to know what services you provide to your customers and what liquidity you provide to, and take from, the Interbank Market. These non-top 10 FX players should have a strong interest in accessing and developing these new listed FX swaps.

These banks can either plug into the new pricing to help drive their e-commerce FX platforms as additional liquidity to improve the depth of markets or those more aggressive banks would probably want to offer liquidity in these new products to a new client base. For instance, those active in AUDUSD FX swaps (Aussie Banks) whom see most of the regional liquidity, but are not the same size as a JPMorgan or Goldman Sachs in FX swaps globally, can help develop a new stream of client flow internally and externally.

Q) Target traditional Sell Side.
Tier one banks. Depending on currency, there are around 10 major FX Swaps players that make up the lion’s share of the Global volumes. These same banks are active in FX Futures and are active in Calendar Spreads of UST, STIRs and FX. Given their current activity in listed products, connectivity should not be a barrier to entry.

There can be a comparison made between Interest Rate Swaps (IRS) to Listed Swap Futures and FX Swaps and listed FX Swaps. Where Interest Rate swaps should be a prime candidate for a successful listing on exchanges, yet despite some fantastic products like ERIS IRS swaps and CME MAC Futures, the sell side are still unwilling to shift trading volumes in any meaningful way onto exchanges Can you blame them?

This failure to grow listed Swap futures volumes on exchanges comes even with a backdrop from Mandated Central Clearing for IRSs. In the IRS case the products design is not the issue, so maybe it’s that OTC IRS predominately trade (>85%) in Blocks? Yet Exchanges have Block facilities from Market Makers, so that’s not it!

The question should be “was there a problem that needing fixing in the first place for the need for Swap Futures to be listed?”

Finally, are the Major IRS players willing to push the IRS onto exchanges? I don’t think so.

FX Swaps will share the same problems as IRS, but an even harder challenge as FX is not mandated to be cleared. Major tier one banks dominate the FX swaps markets. The desire for improved liquidity from new buy-side players will outweigh the protectionism that is highly evident in the Interest Rate swaps market, leading to less friction along the journey.

R) Targeting corporate hedgers.
The clear majority of Corporates and Commercials with hedging needs are already connected to trading on exchanges for their Commodity and Energy hedging needs. These same corporates have considerable currency hedging needs for Forward dated FX. Usually banks are the main providers of Forward FX liquidity as they have the warehousing capabilities and clients accessing the Single Dealer Platforms. For exchanges to attract corporates to hedge FX with them the exchange needs to list far more expiries down the curve, natural hedgers require many more bespoke dates that exchanges simply cannot provide in their current format of either Quarterlies or Monthly Dated Expiries down the curve. And of course, find an efficient way to provide liquidity/transparency & access.

The four types of target for Listed FX Swaps

Group A (Day One):
Those with the desire, ability, technology, IP, access & capital to trade listed FX Swaps.

For Example Sell Side.
Tier two banks with Market Making ambitions and major Prop STIR Market Makers.

For Example Buy Side.
Relative Value HFTs, major CTAs Group B (Day two): Those with the desire, but without the ability, technology, IP, capital but with the access to trade Listed FX swaps. For Example Sell Side. Smaller traditional STIR players. For Example Buy Side. Large FX corporates & systematic CTAs.

Group C (Day Three):
Those with the will, capital, ability, IP, but without the Futures knowledge, technology to trade listed FX swaps.

For Example Sell Side.
Tier two banks; European & Asian banks.

For Example Buy Side.
Large Asset Managers & Hedge Funds.

Group D (Day Four):
Those without the desire, to trade listed FX swaps.

For Example;
Low Latency HFTs & major tier one FX banks.


By exchanges introducing new players to a previously OTC dominated FX swaps market, bringing OTC, listed buy & sell side together will create a flourishing centrally cleared streaming FX Forward and Swaps curve that the FX markets needs to continue growing.

The Three options facing exchanges for market growth in Listed FX Swaps

A) Do nothing, business as usual. Failure to penetrate FX swaps Markets.

B) Listed FX calendar spreads as proxy for FX Fwd-Fwd FX swaps. Roll out monthly FX Calendar spreads with implied-in and implied-out functionality from the most liquid contract to populate the FX forward curve.

C) Utilizing a model that the LME use so well in its Base Metals markets. A Rolling Spot (outright), and Spot 1week, spot 1month, Spot 2m, 3m, 4m, 5m, 6m, 9m, 12m and 24m. My preference will be either B or preferably C to attack FX Swaps. Hope you enjoyed my ‘back of a napkin’ thoughts on how to attack FX Swaps. I see no reason why exchanges cannot enhance the FX Swaps market much like they do for Bonds, Equities and Spot FX.