The regulatory drive to get as many of the more standardised OTC products onto electronic trading venues and cleared from central counterparties (CCPs) has been the catalyst for innovative new launches on the world’s derivatives exchanges, as well as new entrants into the exchange-traded FX market, in a bid to appeal to an increasingly diverse user base of currency traders. While the exchanges can already offer the FX market greater capital efficiency and a more effective environment to manage risk, they are going further in creating new products to meet the needs of currency traders with more regionally-focused requirements that are tailored to their own specific business models, trading preferences, month-end expirations and local trading hours.
Will Patrick, Executive Director, Foreign Exchange products, at CME Group, says the exchange now offers 44 currency pairs in FX futures. The last three currency future listings have been Indian rupee, deliverable Chinese renminbi and Chilean peso to support the regional customer base the exchange is drawing to the futures trading model. He says the outpaced growth is coming Russia, China, South Korea and South Africa as the exchange continues to diversify and distribute its trading platform, Globex, across 150 countries worldwide.
The exchange is also continuing to innovate. For FX options, some electronic market makers have been added to the exchange’s weekly FX options to give more granular and short-dated liquidity points along the options’ curve. Patrick says the subsequent growth in FX options has come from new clients that have traditionally traded OTC markets.
For Patrick, one of the biggest advantages of trading on an exchange, over bilaterally, is the netting benefit gained from trading with more than one counterparty across a wide portfolio. On bilateral credit lines this starts to get stressed. He says: “The exchange CCP model has a great degree of capital efficiency. Even using prime brokers, only if the prime broker has netting agreements in place with other counterparties, can you move towards comparable efficiencies. Otherwise, all the line item trades are gross margined in collateral terms, on a bilateral basis. Trading against a central counterparty makes this much more efficient. Larger clients, with either more capital or higher trade turnover, may find they are less impacted but more and more banks counterparties are being asked for collateral and we feel this is going to accelerate as we move through Basel III, and capital requirements are increased on dealers.”
Basel III has many dimensions. It will bring the leverage ratio and capital requirements globally and systemically into focus.
“As the banks have to become more capital efficient, trading with them could likely require more collateral from their customers. As we get further through Basel III, there will be more capital efficiencies from trading on exchanges,” Patrick says.
However, in order to attract more OTC FX participants to trade on-exchange, additional specially designed products have also been launched by the CME Group including a new exchange, CME Europe, in May 2014. This has a London-based clearing house and was also built to provide multi-asset class exchange-traded derivatives for the European market.
Patrick says: “When we launched CME Europe, we built FX futures contracts that mirror the European FX market as closely as possible. We built them as a proxy for FX spot and FX forwards. They are cleared by CME Clearing Europe, which was launched prior to the exchange. These settle during European hours and the monthly contracts are quoted in a way that they look as close to OTC products as possible.”
With new members joining all the time, CME continues to upgrade its global electronic trading platform, Globex. Last December, the exchange added circuit breakers that are triggered when there are very large moves in the market, to provide a cooling-off period where necessary. Velocity logic also offers the same safety precautions, but in a shorter period of time offering a couple of seconds market suspension to protect and promote an orderly market.
As the FX market becomes increasingly electronically traded, both OTC and listed, Patrick says CME Group is seeing a substantial growth in volumes. In July 2007, 70% of FX options were electronically traded. Since then volumes of CME’s FX options have multiplied almost five times. Says Patrick: “Electronic markets breed transparency, and they can then be distributed globally. As a result companies are coming to the CME Group for surety of execution, risk mitigation and capital efficiencies. Events like the SNB event, the situation in Greece, and also last year’s benchmarking scandals are why you are starting to see more people move to exchange-traded listed products.”
An established exchange remerges
The Moscow Exchange Group (MOEX) has central limit order book platforms for foreign exchange, money, equities, fixed income, futures & options and commodity markets trading. All MOEX markets make use of its clearing and settlement entities, the National Clearing Centre (NCC) and National Settlements Depository (NSD).
MOEX was set up in December 2011 as a result of the merger of Russia’s two leading exchange groups – MICEX and RTS. As a result, MOEX FX Market is Russia’s oldest regulated FX trading venue. The FX Market is the primary and dominant liquidity centre for the rouble and a core component of Russia’s national financial system.
Igor Marich, Managing Director of FX and Money Markets, says MOEX differs from other global exchanges and the usual ECNs that FX participants are used to: “Today, our core service is an electronic central order book, using technology similar to derivatives and equities exchanges, but MOEX is different because it evolved out of the Moscow Interbank Currency Exchange (MICEX), formed by the Central Bank of Russia (CBR) to develop FX trading in Russia, to become the oldest and most experienced fully serviced and regulated electronic FX exchange in the world.”
MOEX FX Market operates a central limit electronic order-driven trading platform with full pre and post trade transparency. All participants are treated equally with equal access. The market is able to operate in this way because NCC is the exclusive counterparty to every FX trade – a model familiar to equities and derivative markets – with MOEX maintaining stringent pre-trade collateral based risk checks.
Marich says: “Other exchanges typically only provide cash settled futures or NDFs products, but MOEX has a suite of products – including deliverable FX swaps and forwards – using the same technology, clearing and net settlement services as our outright spot FX. Unlike most FX venues, MOEX supports TOD FX contracts with settlement today alongside its other spot contracts TOM and T+2. In addition, MOEX is responding to the needs of clients with more regionally-focused requirements and operating hours by adjusting the FX market trading and net settlement times to suit the regions of the currencies traded and we recently introduced longer dated maturities in response to market demand. There is strong demand from local participants to take up our market maker schemes, not just in the spot market of new FX pairs but right along the swaps curve.”
According to Marich, FX Futures traded on the MOEX Derivatives Market encourage hedging as well as complimenting basis trading with its FX Market spot and swaps contracts. The CCP is uniquely able to offer net margin risk offset for tradable products within the same asset class and underlying contract – a massive benefit of trading FX on MOEX by reducing collateral and margin funding costs for spread and arbitrage traders as well as investors with a range of open FX positions, contracts and maturities.
In addition to the flagship USD/RUB, EUR/RUB and the CIS currency pairs – which continue to be well supported – MOEX FX Market has added FX currency pairs relevant to local regions, such as the CNY/RUB. In fact, CNY/RUB has the highest growth rate in volumes on MOEX. More recent additions include GBP/RUB and HKD/RUB.
The addition of a CCP some years ago has also boosted participants and volumes by eliminating bi-lateral counterparty risk, according to Marich. Last December, MOEX opened up its clearing membership to global banks, enabling international clearing members for the first time.
He adds: “This was an important step in the globalisation of our exchange. In a short time, MOEX has moved from being a local interbank market to becoming a global marketplace. International order flow now accounts for 40% of our trading volume and 80% of our client-driven business. Our transparent trading model with a well-capitalised CCP is becoming more and more popular, particularly in light of the recent scandals in the global FX market. Consequently we are now seeing regulators in other countries starting to push FX markets towards this model. This is also being driven by changes in market structures and market technology, but we have been a totally electronic exchange from day one.”
DMA increases members
The development of full direct market access (DMA) has facilitated a significant increase in member activity and an expansion of the client base due to the arrival of new client categories including non-residents, Russian and foreign brokers/sub-brokers and individuals. The number of registered clients increased from 46,600 in 2013 to more than 300,000 in 2015.
“Today we have a global member base with banks joining from other countries and regions; such as CIS, US, EU and APAC banks and brokers who wish to trade directly on our FX Market,” Marich says. “In total we have clients accessing our markets from over 60 countries, making up about 50% of our FX trading volume.”
He adds: “For many years, global banks have traded FX on MOEX through their local Russian subsidiaries – this is another substantial part of our business – as well as the many single bank platforms that are connected to our market for pricing for their clients’ liquidity and hedging needs. Russian and international banks come to MOEX for our dominant central liquidity and central pricing in rouble. More than 50% of rouble FX transactions take place on MOEX.”
In 2014 on-exchange operations accounted for approximately 50% of USD/RUB trading in Russia and 64% of EUR/RUB trading. The CBR implements monetary policy via MOEX FX Market as well as using MOEX certified FIXings, calculated by an algorithm from the results of on-exchange FX trading, to set the official USD/RUB exchange rate. MOEX FX FIXings are also used to settle MOEX FX derivatives contracts and, due to MOEX’s dominant RUB FX market share, licensed to settle other FX products traded off-shore.
Marich says: “We have a lot of market makers on the exchange, attracted by our centralised clearing model. They use our markets for the pricing of OTC non-deliverable forwards and contracts for difference, as well on onshore and off-shore derivatives trading, proprietary trading and cash management. We have managed to stay ahead of the trend and this model clearly benefits our market participants. They can enjoy some relief and efficiencies in terms of the regulatory requirements for capital adequacy ratios – which meet international equivalence standards – by utilising MOEX’s CCP as well as the natural benefits arising from MOEX’s net settlement system, with liquidity backed by swap lines with the CBR. In the past this was a big problem for both local and international players trading FX”.
According to Marich, the CCP sophisticated collateral based pre-trade risk controls and net settlement services are key to the MOEX risk mitigation process. MOEX has being providing FX Market participants with a more sophisticated net settlement facility than CLS for much longer, with the added benefit of central clearing from the outset. Recent legislation in Russia means that the exchange has been able to reduce even the residual risk and further mitigate this risk through segregation and stability measures taken by the exchange. Changes include improved international standards for the legal and regulatory framework surrounding net settlement and closed out netting – to protect the clearing members and also their clients with segregated accounts.
“The fact that the rouble is also traded in other financial centres means that banks need tools to minimise their settlement instructions and reduce related funding costs. This can be done with our netting technology,” he says.
Marich adds that at the beginning of August the electronic exchange launched new innovative technology to help customers connect to the exchange’s trading and clearing platform more easily, and to encompass the recent regulatory changes along with the final technological changes to its DMA system. He says: “This allows us to bring our exchange in line with global standards, for both Russian and international clients.”
Unique tie-up for Asia
In recent years, Singapore Exchange has significantly grown its product suite to deliver a comprehensive offering of Asian currencies, including 15 FX futures contracts, to its global customer base. This portfolio will cater to a broad pool of global investors seeking more exposure into Asian markets.
SGX is also expanding its distribution network through strategic partnerships to strengthen the liquidity in both the FX OTC and futures markets in Asia. In January 2015, SGX announced a partnership with EBS to develop a new range of Asian currency products and services. Ivan Han, Vice President, Derivatives (FX & Rates), at Singapore Exchange (SGX) says: “This is a unique collaboration that will complement the FX OTC and futures markets in Asia. It will also strengthen the liquidity in both markets.”
“EBS and SGX will jointly develop new business opportunities and product offerings, bringing to the partnership their respective unique assets, market presence and relationships throughout Asia.”
EBS and SGX will initially offer customers access to SGX-listed currency derivatives via the EBS platforms, to be cleared by SGX. Customers will be able to execute and clear selected SGX Asian FX Futures contracts in specific large sizes, called Negotiated Large Trades. Subject to respective regulatory approvals, implementation is targeted by the end of this year.
Han believes that exchange-traded products arguably provide the best format for managing portfolio margining efficiencies across multiple asset classes. SGX’s clearinghouse has a dominant base for managing equity risk premium and offers margin efficiencies between Asian FX and equity derivative products. Cross-margining is made possible where stable and significant correlations are available between futures and OTC cleared products, based on related underlying instruments.
Han says: “For SGX, the most important netting pool currently is between Asian currencies and equities, due to the close pairing between currency and equity risk premiums in Asia. For example, the SGX rupee future has a margin offset of more than 50% against the SGX Nifty future. This means greater capital efficiency when investors manage their risk premiums across multiple correlated asset classes.”
According to Han, SGX takes a strong client-centric approach when designing its products to meet client requirements, which continue to evolve with the changing regulatory landscape.
SGX FX futures products provide a complementary, cleared solution alongside existing OTC FX instruments. For example, to cater to finer hedging requirements, the contract sizes of SGX’s FX futures are designed to be smaller than OTC trade sizes.
Says Han: “Our market participants have also been able to benefit from highly competitive bid-ask spreads as we have also put in finer price increments/tick sizes in our FX products. A good example is the SGX INR/USD contract, which has consistently shown a very tight bid-ask spread equivalent to 0.6 of a pip in the Non-Deliverable Forward (NDF) market. This provides investors with greater pricing efficiency when compared to the 2-3 pip spreads seen in equivalent rupee NDFs traded in the OTC market.”
SGX FX futures contracts are designed to be net settled, which Han believes removes risks associated with gross settlement and closely mirrors existing settlement practices in the OTC NDF market.
He believes FX futures can promote greater financial inclusion by improving accessibility for a wider segment of market participants, in particular the non-primes, small hedge funds and SMEs which may be experiencing increased costs of credit in today’s regulatory environment.
According to Han, exchange-traded products promote greater price transparency through a central limit order book accessible by all market participants. “This has greatly benefited clients and end users such as asset managers, hedge funds and corporates which see an increasing need to fulfil best-execution requirements.”
“We have seen trading in exchange-traded FX products jump by tenfold in the past 10 years, with about US$160 billion in average daily turnover by the end of 2013 according to BIS,” he adds.
While this still represents less than 5% of total FX volumes traded globally, Han believes there is a lot of potential for further growth in exchange-traded FX products, particularly in Asia where this growth will most likely be driven by a combination of changes in market infrastructure and regulatory drivers.
In fact, some of SGX’s FX futures products have already seen strong adoption by currency market participants. SGX listed its Indian rupee contract less than 18 months ago, and in that relatively short period of time, the contract has seen exponential growth in trading volumes - record volumes in August was more than US$700 million in notional value traded per day, up by over 800% year on year.
Says Han: “Trading in SGX USD/CNH futures has also soared in recent months, buoyed by an expanded pool of market makers including Bank of China (Singapore) and other financial institutions. Trading volumes surged more than twofold month-on-month in August to about 40,000 contracts or US$4 billion in total notional value traded.”
The ‘futurisation’ of FX
The changing regulatory landscape has been driving the debate within the FX industry on how the market structure may change in favour of exchange-traded products, and on potential transformation of the traditional FX prime brokerage business model. Han believes recent events, such as the Swiss National Bank’s unexpected policy reversal on capping the Swiss franc, the capital scrutiny brought about by Basel III gross leverage ratios, as well as the implementation of the Volcker Rule, have caused both intermediaries and clients to consider whether the futures clearing model can be a viable alternative for some parts of the FX market, such as NDFs.
He says: “We think that events such as the large CHF move will keep the door open to the ‘futurisation’ and ‘equitisation’ of FX trading for both retail and institutional clients, and place additional scrutiny on the world of OTC FX. The timing is opportune for exchanges such as SGX, where we have been building our Asian FX product shelf to meet both the clearing needs of the market, which has been much discussed over the past three years, as well as the trading needs of the market, which regulatory changes are now bringing into focus.”
FX represents a new market for NASDAQ. A lot of work has been done over the past few years designing its suite of products, getting regulatory approval and meeting market participants to ensure new products are addressing a market need and will be well supported.
David Holcombe, Head of FX Product at NASDAQ, says: “There is a lot of history of exchanges in FX and FX futures are not new, but there tends to be quite a distance from those products to the OTC principal-to-principal market, which is entirely relationship based.”
Futures are very different, not only because they are CCP-cleared, but because it is an anonymous trading model. For this reason, Holcombe says NASDAQ has been focused on closing this gap and creating FX products that look and behave much more like some aspects of the OTC market, such as a rolling spot product, that actually benefits from the changes coming around capital efficiency and market structure.
Says Holcombe: “The regulatory change going on in the FX market is ultimately incentivising the use of CCP clearing. It is an OTC bilaterally-settled market that is going to have to embrace the use of CCPs, which are regulatory approved, to benefit from the lower capital charge not achievable bilaterally.”
A study carried out by Deloitte last year about the new costs coming into the OTC market values the additional cost that regulatory compliance has, on a portfolio of FX and interest rate products, as an extra E13 per million Euros invested. However, compared to the cost of keeping the same positions bilaterally, an extra E170 per million Euros invested is needed. “The economic drivers for clearing in a CCP are massive,” he adds.
Holcombe says that firms go through a three tier process when addressing the way forward through the regulatory changes. The first stage, ‘protect’, is to address any mandatory requirements; next, in ‘survive mode’, they look to optimise those new costs of mandatory compliance by taking advantages of the offsets that CCPs offer, and using listed and OTC products in the same portfolio of FX; and finally in ‘thrive’ mode, they take a strategic overview to exploit new opportunities and alternatives arising from the structural change in the market.
He says: “It is a big change for an OTC market, which has last-look built into its workflow, to trade on exchange or a true ECN model.”
Additional liquidity pools
MiFID II will seek to regulate rolling spot – where participants enter into spot FX
contracts, with no intention of taking delivery of the currency on vale date, so the positions are rolled in order to avoid delivery. Holcombe says that NASDAQ is looking to capture the speculative trading and hedging around rolling spot and has developed and gained regulatory approval for a listed FX product in response to this.
However, Holcombe is well aware that firms do not simply choose where to trade just for regulatory certainty; it is an important driver and a catalyst, but there still needs to be a strong value proposition. “FX participants have been comfortable with the liquidity providers and relationships for many years, and relationship trading will endure, although the exchange landscape will increasingly gain traction as participants look at venues as additional pools of differentiated liquidity.”
As exchange trading in FX evolves, Holcombe says the focus will be on standardised contracts, and concentrating liquidity in venues. He believes this is part of the process of the electronification of the FX market, which started with spot FX. He adds: “Over the next 18 months, the focus will be on tackling the most standardised products first. The participants that will embrace exchange trading first will be those that favour and use standardised contracts, but as liquidity builds the more traditional OTC users will start to tailor how they manage their risk to that they can access this liquidity.”
Mirroring the OTC market
Eurex Exchange went live on July 7th 2014 with FX futures and options that combine best-practice OTC market conventions with the transparency and minimised risk of exchange-traded and centrally cleared contracts.
Reny Morsch, Senior Vice President at Eurex, says that the detailed consultation undertaken with existing clients, participants in the OTC market and buy-side end users allowed the exchange to develop an optimal product and market infrastructure, delivering the flexibility of the OTC market with the safety of the exchange-traded market.
This has been reflected by listing exchange products in OTC conventions, creating an option on the spot market, and by offering block trading via Eurex Trade Entry services alongside the order book trading. Morsch says: “The existing block trading facilities still feature standardised expiry but we are currently working on a flexible contracts functionality. This is something we are offering for other Eurex products already, such as single stock futures and index futures. A flex product takes a bilaterally agreed trade and clears it through Eurex Clearing using non-standard expiry, either physical or cash-settled.”
Eurex has also looked closely at the OTC market in terms of settlement for its FX product solutions and its products are similarly physically settled via CLS, but Eurex Clearing remains counterparty to the trades until the transaction is settled. “This means at expiry there is no give-up to a clearing member, where the counterparty changes. Because the counterparty to the trade remains Eurex Clearing, the trader can be sure that the counterparty risk is mitigated by the clearing house. Eurex Clearing is the only clearing house that offers mitigation of counterparty risk until the trade is settled.”
While it is not yet mandatory that FX options and futures are cleared centrally, Eurex Clearing is already migrating counterparty risk for these products. “The ideal solution is to have the CCP as the counterparty until the trade is settled. Our solution has been developed following feedback both from market participants and regulators as well,” adds Morsch. “The driver for this design was customer demand.”
Currently two European banks are market makers for Eurex’s FX derivatives and while Morsch says there is evidence that the FX banks are once again looking at exchange-traded FX, most are prepared to be liquidity takers at the moment, rather than liquidity providers, but demand is there. There are a relatively small number of clients live, but Morsch says this is due to clearing member readiness as the combination of a cleared product with CLS settlement requires relatively extensive up front investment in back office infrastructure to set up.
One of the advantages of the exchange, according to Morsch, is the diverse base of traders, across all the asset classes, with the inclusion of FX now, and all with different hedging requirements. Going forward, she believes these traders will begin to look at netting trades and margin off-setting in a bid to gain cost efficiencies on the exchange.
Furthermore, Eurex not only has competitive transaction fees, but Morsch believes the exchange’s transparent pricing scheme will win out over the individually negotiated transaction fees of the OTC market. “With all the incoming regulation, the total costs will increase for OTC trades and this is making the transparent exchange model, where further capital cost savings can be made through netting on the clearing layer, much more attractive. While not everything will go on to the exchanges, it is important to have a choice, and to be able to decide which suits individual models best.”