Since its inception, the $6.6 trillion foreign exchange (FX) market has traded over-the-counter (OTC) between counterparties. While trading on exchange, like in equities and commodities, has been around for decades, the take-up in FX has been much slower. However, since the 2008 financial crisis, subsequent regulation has started altering the FX landscape. Average daily volume (ADV) and open interest in FX futures and options has steadily grown, and market participants from banks to buy-side firms have started to recognise some of the cost savings and benefits of trading on exchange.
Most impactful has arguably been the introduction of the margin rules for uncleared swaps, known as ‘UMR’. These rules have come in on a staggered basis since 2016, with the first four phases complete as of 2019. As a result of Covid-19, the remainder and bulk of market participants that would be impacted by these rules have been given a reprieve until September 2021 and 2022. (See article on page 20) By 2022, around 1000 firms will be required to post initial and variation margin on swaps that are not centrally cleared at a central counterparty (CCP). In FX, this will include options, non-deliverable forwards (NDFs) and physically-settled forwards. Other regulatory incentives include the introduction of ‘SA-CCR’ (the standardised approach for measuring counterparty credit risk). Long in the works, this is the Basel Committee on Banking Supervision’s new model for the calculation of capital needed to be held to cover the risk of default by counterparties in derivatives trades. This will be implemented in June next year in the EU and on January 1, 2022 in the US.
The danger for OTC FX is the new rules could result in a significant cost increase for bilateral FX trades. Given the complexities, it is not a slam dunk, but SA-CCR could still prove a further catalyst to on-exchange FX as it presents meaningful cost savings. Some incentives to trade FX on exchange do not come from increased regulation. Trading listed products can give investors access to additional and complementary liquidity due to its all-to-all nature, providing a more diverse set of liquidity providers than their current panel of banks in the OTC markets.
There are also less barriers to entry. Clients do not need a bilateral master agreement supplied by derivatives body ISDA, or have to set up prime brokerage relationships with banks - a part of the market that has been slowly shrinking in recent years. And as exchange-traded instruments are almost entirely electronic in nature, there is a transparency element that is becoming increasingly more important for market participants with the need to prove best execution to customers.
So let’s take a more detailed look at how trading of FX products continues to grow on the major global exchanges.
As one of the largest financial exchanges in the world, CME Group is well placed to tap into any growth in listed FX products. With the volatility in 2020, this year has been no exception and has helped to solidify growth at the exchange. In Q1, ADV in CME FX futures was roughly $100 billion and March itself saw bumper trading volume of around $125 billion per day. Versus that volatile period, the rest of the year has been more subdued. As of the end of September, ADV was $77.3 billion. In open interest, March culminated in the highest ever figure of $255 billion, topping off a seven-year trend. All of CME’s top ten open interest days for EUR/USD, for example, have occurred this year, with the highest ever for that pair - $120 billion - recorded in September.
In terms of number of active participants, data published by the Commodity Futures Trading Commission (CFTC) of Large Open Interest Holders (LOIH) showed an 11-year growth story that topped in February at 1,310 but dropped around 10% on a year over year basis in late March as leveraged funds in particular scaled back their positions as a result of Covid-19.
“However, as of October 13th, LOIH are now back to around 1,100 as clients have returned to trading and begun to rebuild their positions. This re-building of positions has occurred across all currency pairs of CME FX futures, but is more pronounced in the Majors with 6% growth in the last 13 weeks versus 3.4% growth in the same period for EM,” says Paul Houston, global head of FX at CME.
Alongside its listed business, CME continues to offer OTC clearing in FX across 11 NDFs, 26 forwards, seven FX option pairs. These products are cash settled as this enables the optimal balance of capital, margin and cost efficiencies combined with ease of operational processing for both direct members and clearing member firms for end user clients.
Houston says the bulk of volumes being cleared are CME’s cash settled forwards (CSFs), also known as G-10 NDFs, with the drivers for clearing these products going beyond simple regulatory explanations.
“While UMR has been the driver for interbank clearing of NDFs, the clearing of CSFs and use of OTC FX clearing by the buy side appears more driven by catalysts such as access to more liquidity and more liquidity providers, mitigation of counterparty risk, netting of positions against a highly regulated CCP, and removal of physical settlement challenges, especially relevant for clients such as US 40 Act funds,” he says.
The work to help improve the cleared market for customers does not stop there. CME is working on developing more client analytics, such as its enhanced FX Market Profile tool, which allows customers to see and compare top of book liquidity throughout the day in FX futures versus its spot FX trading platform, EBS. CME will also be making specific adjustments in certain markets, such as in Aussie dollar futures. It plans to cut the minimum price increment by 50% on November 23.
CME has also taken a similar approach to its listed FX options offering, too, says Houston. “Over the past few years, we have transformed our listed FX options into a flexible and liquid offering that offers capital efficiency along with a near seamless transition for participants from the traditional OTC FX Options market.”
“Further enhancements to the liquidity available in CME FX link as a cleared and electronically traded pool of additional liquidity for the OTC FX swap market are in the works too, as well as partnering with major infrastructure providers to make trading and integration more accessible,” says Houston.
All of this continued investment and product enhancements in CME’s FX futures markets appears to be facilitating new client adoption. Over 170 end users among hedge funds, asset managers and corporate customers have either added new currency pairs or have started using CME FX Futures for the first time during 2020. The currency pairs generating the most new client adoption are EUR, CAD, JPY, AUD and GBP.
Eurex Exchange offers FX Futures and Rolling Spot Futures that combine best-practice OTC market conventions with the transparency and minimized risk of exchange-traded, centrally cleared derivatives. The Germany-based exchange is planning to launch listed FX options in Q4, 2020. Following Deutsche Börse’s purchase of OTC trading platform 360T, Eurex sees the futures and OTC FX ecosystems continuing to blur, as the merger enables clients to switch between OTC and futures markets.
“A typical question is around whether there is sufficient liquidity in the futures markets, but by making use of an electronic exchange for physical trades, clients are able to benefit from OTC FX liquidity whilst benefiting from a cleared, transparent futures position,” says Joshua Hurley, FX sales and business development at Eurex.
Eurex continues to see growth in the EUR based products, with record daily highs of over 130,000 contracts. Open Interest typically sits around €5 Billion, highlighting the interest from asset managers and real money to add FX futures to their capabilities.
“With a number of new clearing members and clients joining the market in Q4 2020, we anticipate further growth in the volumes and open interest across the product suite,” says Hurley.
Eurex’s parent company, Deutsche Börse, has launched the online analytics platform ‘A7’. It offers access to both Eurex and Xetra order-by-order historical market data in nanosecond granularity within an easy-to-use environment, providing insights into market situations and microstructures.
Unlike the US markets, the European listed product set is still a two-tier structure, where, especially in options and illiquid futures, a lot of trading happens outside the order-book, which is mainly voice traded. Therefore, Eurex has invested in electronifying the off-book market via its selective off-book RFQ platform Eurex EnLight, with FX products planned to benefit from the platform functionalities next year.
“EnLight opens up the off-book universe to all market participants, allows users to interact with liquidity providers they have formerly not known and liquidity providers to interact with flow, which they may not have seen before in a fully electronic fashion without any manual interventions,” says Hurley. In central clearing, Eurex is on the verge of launching a cross-currency swap and OTC FX clearing service and is looking into NDF Clearing as well.
“By offering clients the possibility to also clear these products and working with 360T, we can offer the full range of possibilities to clients. This means clients can decide the product that best fits their requirements and optimise any UMR based margin requirements,” says Hurley.
Singapore Exchange (SGX)
This year has also been a boon time for SGX as the heightened market volatility thanks to Covid-19 yielded new monthly records at the Singapore-based exchange across FX and a number of its commodity products. In particular, the need for continuous price formation and round-the-clock risk management drove demand from international participants has been paramount for its customers, and was reflected by an increase in trading activity in non-Asian hours or the T+1 session.
“We also saw a very interesting flight to quality, at least for exchange-traded FX,” explains KC Lam, head of rates and FX at SGX. “When liquidity went missing and prices were gapping, we saw more volume coming to us because we have liquidity on a continuous basis all the way to closing of US hours and we were told by clients that we demonstrated deeper liquidity in Asian currencies as compared to the OTC market.”
In March, SGX saw a significant increase in hedging activity as commodity traders and asset managers were hedging their currency exposure to protect the value of their assets. This resulted in SGX FX volumes rising above S$171 billion, which was up more than 70% year-on-year.
“Consequently, we have maintained our market share for key products, including being the largest global market share in INR/USD Futures (more than 60%), and having a market share in offshore Renminbi futures of more than 80%,” says Lam. Aggregate SGX FX Futures volume hit 2.25 million contracts with a notional value of US$121 billion, aided by higher FX market volatility. Aggregate year-to-date volume is at US$1.07 trillion, up 8% year-on-year.
“FX is a promising growth pillar for us. We are Asia’s largest and fastest-growing FX exchange, and since we introduced FX futures contracts in 2013, we now have 20 FX futures and two options contracts,” says Lam.
With that ambition in mind, SGX bought BidFX to bring together both pools of liquidity, allowing SGX to establish itself as a one-stop venue for global FX OTC and futures participants. This allows the exchange to expand into a much larger global OTC FX market, and advance SGX’s global ambition to offer an end-to-end FX platform and solutions. With UMR in mind, SGX launched FlexC FX Futures. This helps market participants trade customisable FX futures in an OTC manner, and clear trades on SGX’s platforms, helping lower trading costs.
“With FX markets moving towards central clearing, FlexC FX Futures offers a more effective way of mitigating counterparty credit risk while retaining bilateral trading relationships, and expanding opportunities for improved Asian FX price discovery and risk management workflow,” says Lam.
In the future, SGX will also be launching a new USD/INR futures product that would allow NDF market participants to trade listed INR futures in the OTC format. This new Indian rupee futures contract is denominated in US dollars, with IMM expiry similar to the OTC format. “We are seeing a lot of interest from buy-side customers,” says Lam.
Moscow Exchange (MOEX)
At MOEX, the volatile year has also posted major growth in its FX business. This was fueled by the pandemic, swings in oil prices, and RUB depreciation. In the first nine months FX spot volumes and longer-term FX swaps were up by 24% year-on-year. ADTV of FX deliverable spot and swaps was as high as USD23 billion on certain months. In cash-settled FX futures and options volumes were up by 75% year-on-year with ADTV at USD3.3 billion,
Although volumes got almost back to normal by July, the exchange is still seeing increased interest from international traders, while the most notable growth came from Russian individuals. The number of active investors-individuals trading directly at MOEX in FX instruments increased five-fold to around 543K with their market share of total spot FX trading volumes increasing from 7% to 13% and in FX derivatives from 41% to 44%.
New product offerings have also been on the agenda for MOEX, specifically for OTC market traders. One of the most important is the clearing via MOEX CCP of FX trades originally done in the OTC market either bilaterally or on electronic platforms. In 2021 MOEX plans to launch a settlement and clearing solution for all OTC FX trades which will help market players to reduce settlement risks. This has already been implemented for longer-terms swaps in standardized derivatives and as the result volumes increased by 26% year on year with notional outstanding at USD $6.3 billon.
MOEX is also planning to launch new services linked to disseminating and licensing MOEX FX fixings. Currently MOEX operates an electronic service of matching at the FX fixing, with the most important being the USD/RUB fix at 12:30 Moscow time. This is used throughout the world as benchmark in the primary settlement rate for cash-settled Ruble OTC forwards, swaps and options. The estimated daily turnover of the instruments, for which MOEX RUB fixing is used, is around USD 4-5 billion.
In September this year MOEX has authorized the use of its MOEX USDRUB and EURRUB FX fixings by CME Group’s EBS eFix Matching Service platform. This collaboration will promote MOEX fixings among a wider range of international banks and their clients, allows them to reduce risks associated with FX ruble non-deliverable derivatives instruments - NDFs which daily volume totals USD 5-6 billion globally.
MOEX has also been busy upgrading its own trading infrastructure in 2020 as it launched a new FIFO MFIX Trade Service. It has a number of benefits, including a faster trading interface, with reduced latency and jitter, based on a “First In - First Out” principle of message ordering.
“The FIFO MFIX Trade Service along with our Speedbump orderbook will enhance a flexibility of routing orders for different types of clients depending on their level of sensitivity to latency and provides a fair price,” says Marich.
Following demand from its corporate clients, MOEX also introduced a new algorithmic order type - TWAP (Trade Weighted Average Price) - which helps corporates and institutions execute large volumes more smoothly.
Like some other exchanges, MOEX has also made investments in the OTC market. It bought a 25% stake in an operator the e-FX OTC platform NTPro. “The acquisition of NTPro marks an important milestone in the delivery of MOEX’s new strategy, as the exchange seeks to strengthen its offering for rapidly developing OTC market segments adjacent to its existing business. We strongly believe NTPro will help us increase out footprint to both in the Russian and international markets,” says Marich.
MOEX has also continued to expand its execution methods, with speed bump instruments and request-for-stream services with full amount capabilities. “These facilitate the execution of larger amounts than our traditional FX order books at the best prices with minimal costs,” says Marich.
The Russian exchange has been developing greater ties with global liquidity providers too, which aims to provide domestic banks access to global OTC G10 FX liquidity on major G10 currency pairs. The volume in this project has increased two-fold year-on-year.
Dubai Gold and Commodities Exchange (DGCX)
Moving into the final quarter of 2020, DGCX maintained its strong momentum, providing investors with a wide range of derivative products to manage their risk. In September, the DGCX’s three newly launched FX Rolling Futures Contracts – EUR, GBP, and the AUD, all against the US Dollar, – saw an increase in trading activity, and have now traded a combined total of 6,449 lots valued at USD 75 million since their launch in July.
“Owing to a substantial increase in currency volatility, caused by ongoing Covid-19 cases, a lack of progress in Brexit trade negotiations, and a recent string of much lower than expected economic growth forecasts, DGCX recorded significant traction in its new FX Rolling Futures Contracts last month, as members increasingly looked to leverage dynamic tools to manage their risk,” says Les Male, chief executive of DGCX.
“Heading into the last quarter of the year, global uncertainty still looms, and we expect these unique products to continue on their strong growth trajectory, enabling investors to mitigate the risks involved in the currency market. As an exchange deeply committed towards fulfilling the needs of our member base, we will soon be announcing the launch of more innovative products aimed at providing significant value to investors during this challenging period,” he added.
DGCX’s FX Rolling Futures Contracts have given the investors the ability to take advantage of the arbitrage opportunities that exist between DGCX’s traditional quarterly futures contracts and these perpetual rolling contracts.
At the same time, margin offsets help ensure maximum capital efficiency for market participants. During September, the Exchange’s EUR and GBP Futures contracts also performed strongly, and have now registered year-to-date volume growth of 193% and 327% respectively, compared to the same period last year.
Given the seismic growth in listed FX trading in 2020 and the scale of the exchanges involved, currency futures and options will likely continue to move forward in the years ahead. Regulatory changes like UMR and SA-CCR could also play their part, while exchanges appear to understand the importance that the OTC style of trading still plays in FX markets, resulting in a bunch of purchases from major exchanges recently. Marrying the two trading styles together, as well as central clearing, could help propel these exchanges to the forefront of the FX market in years ahead.