The structural, foundational, and utterly disruptive changes to the good old days of FX are still playing out, and the pure economics of trading FX are changing. The operating model of each successful FX business is changing, and 2017 looks like it will be the tipping point for the major structural evolution that will free the market from many of its current constraints, marking a new generation of FX activity.
With forthcoming un-cleared margin rules shining its spotlight on the benefits of CCP clearing, adding to the interest in clearing already building as a solution for many problems faced in a post-SNB credit-constrained, and BASEL capital-utilisation focused landscape, why hasn’t everybody already just moved to everything into CCP-Cleared FX?
The answer is because the right sort of FX clearing capability does not exist in any CCP yet. Even with product offerings to mitigate the immediate margin hit coming with the new rules, the range of FX products that are CCP-clearable – even including all current Listed FX products – still accounts for less than 5% of the overall market. So the majority of FX market activity literally cannot be cleared, because no mainstream CCP offers the services that will allow this.
It is worth pointing out that this isn’t something all CCPs have shied away from. However, the massive barrier to offering clearing services for deliverable OTC FX products, including spot, forward, swaps where the majority of activity and ADV exists, has been settlement risk - something the FX industry knows all about. There is light at the end of this tunnel. Thanks to the efforts of industry groups as well as proprietary initiatives working though how CCPs can mitigate the concentration of settlement risk they present – delivering the right currency amount to all members on settlement date, regardless of whether one or more members have failed to pay in - it is evident that 2017 will be the year that CCP services are offered that allow members to realise the benefits of clearing deliverable OTC flow.
What FX products will clear
This coincides with a shift in sentiment about what FX products will clear. While two years ago you would face seasoned FX participants acknowledging the capital and credit benefits of clearing longer dated FX products, in addition to satisfying whatever clearing mandates are finally made, they would often also opine that “spot will never clear”. However, as participants are starting to think strategically about how they can exploit the benefits that a CCP can bring, we are increasingly meeting clients who expresses an interest to clear deliverable FX, not only seeking the multilateral netting optimisation and margin efficiency possible within a cleared FX portfolio, but also quite specifically asking whether it will be possible to clear their spot business as part of that service.
While there is a lot of focus on clearing benefits right now, the execution landscape is not immune from forthcoming enforced change too. It is evident that MiFID will dramatically reshape single dealer offerings beyond spot products, marking a new normal where customers move from just being a taker of single dealer liquidity, instead to having agent access to multiple liquidity pools. With the FX foundations of being a largely electronic market facilitating this shift, you should plan and ultimately demand to be able to use the right product, in the right venue, at the right time.
Given the number of established venues, particularly in spot, with venue-neutral OTC settlement hard-wired into the market, it has been difficult to imagine a new trading product taking any market share. However, last year’s FX M&A activity suggests all the major exchange groups globally have seriously considered how to either enter the FX market or build up their share in FX, and while there haven’t been any major exchange FX headlines in the last few months, this focus and activity hasn’t gone away.
Whether by acquisition or by organic efforts, it is evident we should expect to see the current gap between the “n-deliveries per year” Listed FX market and “whatever size and shape you need” OTC market starting to close, to allow users to access the benefits of a cleared portfolio of both OTC and Listed FX. Whether you count this as new trading products or just a maturing Futures proposition, it will be interesting to see the level of innovation each group chooses to pursue, as the “right product, right venue, right time” mindset really opens the door for streamlined products that can let you avoid the baked-in costs of the OTC market, while still getting the trade you need to achieve your risk/exposure goal, and also to achieve the portfolio benefits that will ensure your business can thrive in the next generation of FX.