Stacking up the benefits of centrally cleared futures in FX

Demand for FX futures and options is driven by the benefits  of central clearing, which include capital, margin and operational efficiencies, as well as demand for the unique liquidity that CME FX futures offer the marketplace. says Paul Houston, global head of FX products at CME Group. 

“There is a virtuous effect of having a broad range of over 90,000 traders  using FX futures. This large and diverse ecosystem of traders helps to generate a unique, robust liquidity pool with naturally opposing flows and interest. Given the all-to-all market customers can trade passively with more control over execution as well as take the firm liquidity that is available in the central limit order book,” he says.

“On the clearing side, netting against a central counterparty drives several benefits – netting of exposures helps with margin and capital efficiencies; facing a single counterparty drives operational standardization and removes the need for multiple legal documents’’ says Houston. “The ability for customers to move notional from the OTC market to clearing to assist with generating capacity to trade, as well as potentially managing uncleared margin rule calculations is increasingly resonating, and we have seen some of the worlds largest hedge fund names engage us on these topics during 2024.”

“The impact of regulatory change is more long-term and structural,” says Houston.  “Regulations such as UMR and SA-CCR continue to shape the FX marketplace, but it is often more immediate drivers such as volatility, unique liquidity, or freeing up trading capacity that brings more traders into the centrally cleared markets. For example, our biggest ever trading day was on March 8 last year during the volatility triggered by the retail banking crisis, when 3.15 million contracts were traded with a notional value of $296 billion USD.”

“The potential benefits of central clearing for FX products has to go hand in glove with there being sufficient liquidity to not only establish new positions, but also to roll or exit existing positions”, says Houston. “At CME there is a combination of a deeply liquid and robust central limit order book that combines with the ability to trade on an OTC basis with 25+ liquidity providers. The combination of these two trading mechanisms is critical for clients to get the certainty and trading efficiencies they need to manage their FX activity.”

A key benefit of the anonymous all-to-all orderbook, is that participants can trade passively with a wide range of client types. In Q4 of 2023, buyside participants were able to trade passively 63% of the time in G10 pairs, which not only delivers trading efficiencies for those customers but also serves to deepen the liquidity available to other participants. 

“The development of the hybrid OTC-style trading model via Blocks and EFRPs is ongoing. Block and EFRP trading serve to augment the central limit order book, providing clients with additional flexibility and complementary liquidity. The recent all time record in cleared open positions from asset managers helps to illustrate that the combined liquidity from the central limit orderbook with the ability to trade OTC style via Blocks and EFRPs is resonating and allowing a significant shift to occur,” says Houston.

The major project for CME Group this year will be the launch of its CME FX Spot + offering, which it describes as an “all-to-all spot FX marketplace” connected to CME FX futures liquidity via implied matching through CME’s FX Link platform. “We are looking at offering our FX futures in spot form. New clients continue to adopt and embrace the trading of FX futures, but some traders have expressed a clear desire to access the FX futures liquidity via trading FX Spot+ as it will remove the need for booking, clearing and processing an FX futures position,” says Houston. 

This will give CME five main offerings – EBS Market, EBS Direct, FX Futures, FX Link and FX Spot + – and it will enable spot FX participants to access CME FX futures liquidity in OTC spot terms within an open central limit order book environment.  At the same time, it will give FX futures market users expanded access to OTC FX liquidity.

The offering will be accessible via the CME Globex network, including via existing EBS Market Globex connectivity. It is expected to be available for client testing in Q4 and will initially cover seven to nine currencies. 

“We have done this to unlock the liquidity of the futures market for those that can’t trade futures and prefer to trade spot. It will be electronic and automated so it is particularly attractive for small banks,” says Houston.

Impact of volatility

For Singapore Exchange (SGX), the focus to date has been on Asian FX futures, for which it is the leading venue. One of the big developments so far in 2024 has been the rising volumes for Asian currency pairs. “We have seen a succession of single-day volume and open interest records for our flagship contracts (CNH, INR and KRW) and we are still in the first quarter of the year,” says KC Lam, executive director and global head of FX and rates at SGX.

The growth has been most evident in SGX’s USD/CNH futures contract, given that it is the most widely traded international RMB futures. The trend is also reflected in other currencies such as the Korean won and the Indian rupee.

The reason for this trend is the macro-environment, says Lam. In addition to the volatile interest rate environment and the major conflicts in Israel/Gaza and Russia/Ukraine, there are a number of general elections due to take place. “Almost half of the world is going to the polls this year and that means that there will be a lot of volatility.”

The numerous discussions and rumours around the likelihood of U.S. Fed rates reductions, and anticipation of policy easing by Asian central bankers for currencies such as the Indian rupee and the Indonesian rupiah, have also driven volatility in the FX world and will therefore have an impact on volumes. 

Consequently, for centrally-cleared FX, 2024 will be a big year, says Lam. “It is not just about regulation anymore,” he says. “Our liquidity has increased. And given the volatility we expect this year, liquidity will be more important than ever because it will allow traders to manage risks, to easily get in and out of positions. The tailwind of regulation will help but liquidity is the biggest driver now.”

Liquidity begets liquidity and when you hit a certain level, it results in more volume, says Lam. “For example, the USD/CNH contract is now the second most-traded currency futures behind USD/EUR futures. It did not even feature in the top ten, a decade ago. SGX has an 80% market share of the open interest in USD/CNH futures contract. The ongoing geopolitical tensions between the two largest economies in the world, U.S. and China, the unipolar versus the multipolar world and resultant volatility has increased the volume of trading, a development which reflects the risk appetite and risk management strategies of market participants.”

The increase in volume has been accompanied by an increase in the number of new market participants opting for centrally-cleared FX futures. Many of these have come from buy-side firms, including asset managers and hedge funds as well as commodity trade advisors looking to hedge their commodity trades, says Lam. “The USD/CNH futures in SGX trades up to 12 to 18 months and has very high liquidity so it is appealing to hedgers.  Moreover, SGX offers margin offsets to reduce the cost of trading.”

So what product developments are in the pipeline for SGX? “We continuously listen to our clients and continue to use their feedback to refine our products, for example; to be more in line with OTC options market, we are making changes to the final  settlement time aligning it to OTC FX options expiry at 2 pm Singapore time (3 pm Tokyo Cut),” says Lam. 

“SGX has also made acquisitions in recent years, including the purchase of BidFX, MaxxTrader, as well as our establishment of an electronic communications network CurrencyNode. We are looking at how we can introduce more synergy between OTC and futures trading. For example, we are looking at developing a product that can sit in both environments. Traditionally, this has been done manually but we are looking at ways to enhance the trading experience by placing it on a venue. We are looking to bring more transparency and efficiency to the process. At the same time, we are looking to broaden our product offering to include short-term interest rate derivatives linked to Singapore and Japan’s overnight interest rate benchmarks,” says Lam.

Despite the increase in centrally-cleared FX futures, Lam does not see it replacing OTC trading. “Central clearing is a complementary tool that people can use to grow the market. And as markets grow, your needs change. It allows you to leverage a liquid OTC FX market but with the security and efficiency of centrally-cleared markets,” he says.

Lam is not about to predict the outcomes of the upcoming general elections around the world. “With over half the world’s population having election, this year will be one of change and volatility which is always very exciting for the financial markets .”

Macroeconomic environment

According to Lee Bartholomew, global head of fixed income and currencies product design at Eurex, the current macroeconomic environment has been supportive for trading in the listed market and for promoting the virtues of centrally cleared derivatives.

“The broader rates market has enjoyed a strong start to the year. Fixed income made record numbers in January and there was further double-digit growth in February. Central banks have been playing a cat-and-mouse game on rates. Yes, inflation has been coming down, but it is still unclear if central banks have the tools to keep inflation down in the longer-term,” says Bartholomew. “Fixed income volatility is still in tight ranges in Europe, so that market has been subdued. Similarly, FX markets have been quiet in recent months but there has been some volume growth.”

The influence of the macroeconomic environment is also important given that the regulatory tailwinds that have driven the development of the centrally cleared futures market have stilled somewhat in recent months. “Whenever you’re trying to build out a nascent market, it always takes more time than you think, unless you have a regulatory tailwind,” says Bartholomew.

Both the Uncleared Margin Rules (UMR) and the Standardised Approach to Counterparty Credit Risk (SA-CCR), served their purpose of making bilateral trading more expensive and pushing more firms to consider central clearing as a more cost-effective alternative. Now it is about showing that central clearing has benefits beyond cost and can be a long-term complement to bilateral trading. 

“Regulators want to see listed markets co-exist with OTC markets,” says Bartholomew. “And from a market participant’s perspective, it is about more liquidity. If you’re allocating a lot of capital to FX markets and using leverage, you want to see returns increased. So there has been a lot of focus on listed markets becoming more liquid. This is a medium-term project with exchanges, like Eurex working with the market.” 

In terms of the FX market, overall activity has been somewhat subdued in comparison to the high volatility of two years ago that created bigger volumes. The involvement of more hedge funds operating in the rates space has seen an increase in focus on Yen. 

To this end, Eurex has recruited more clearing members. 

“Eurex is focused on executing our strategy,” says Bartholomew. “The LP scheme has been tweaked and we have brought in more market makers in order to improve liquidity in terms of the depth of the order book and pricing. Liquidity is increasingly important for market participants. Banks want to improve the return on their capital.”

Electronification is another way for banks to improve their return on capital and there has been an increase in the electronification of the market, says Bartholomew.  The support of regulators has also acted as an accelerant and led to a co-existence between OTC and exchange traded/centrally cleared FX.  

At the credit end of the market, there is likely to be a move to an equity-lite market, says Bartholemew. “That would be more attractive to bank and non-bank liquidity providers. The buy-side wants access to more liquidity pools so I see our role as facilitating that move and providing more products.

“We are looking at the synergies between Eurex and 360T and to accelerate the development of the hybrid trading model in FX. We are looking at the distribution of listed products through 360T which would reinvigorate our options offering. Then the focus will be on executing currency pairs, ” says Bartholomew. 

“Banks are looking at their bilateral trading costs and ways that they can be reduced. The banks are more comfortable with the notion that listed products and OTC trading can co-exist and they are looking to scale this. They also like the automation that comes with the listed market,” says Bartholomew. “We are likely to see a continuation of that this year. It is a portfolio effect. We are also seeing a growing demand to trade basis. Then it is about making sure we are competitive and focused,” he says.

“Sometimes you need to focus on your core strengths as well as execute on the new developments you have committed to. Now we need to bring those two elements together – new currency pairs; EFP; new product offerings and making sure clearing members can interact smoothly,” says Bartholomew. “We launched credit futures several years ago and now we are close to a tipping point. When Credit Suisse happened, we weathered the storm well and our volumes were consistent. We are looking to do the same with FX. It is likely that we will have some market events this year which might mean that risk is currently being underpriced but I believe we have the right product mix and the right market focus to ensure that liquidity remains consistent,” says Bartholomew.