Nick Pratt

The best of both worlds

March 2022 in FX On Exchanges

As the demand for on-exchange FX trading and FX futures continues, Nicholas Pratt looks at the role of the exchanges in bridging the gap between the OTC and centrally-cleared FX trading markets.

There has been an increasing demand in the market for FX futures. This is partly the result of some global macro trends, such as energy shortages and supply chain disruption, both of which have been exacerbated by the military conflict in Ukraine and the resulting economic sanctions against Russia. One of the beneficiaries of this trend has been Singapore Exchange (SGX), which saw its foreign exchange (FX), SGX USD/CNH Futures traded volume gained 15% y-o-y in February to 823,524 contracts, with open interest hitting a record US$12.4 billion during the month.

SGX FX Futures trading volume
Data Source: SGX

According to SGX, the CNH or offshore RMB is “increasingly being adopted as a safe-haven currency amid heightened risk aversion”, and SGX’s contract is the world’s most widely traded CNH futures. Total FX futures volume on SGX stood at US$107.8 billion in the month of February, with month-end open interest up 56% y-o-y at US$13.9 billion.

The other major driver for the growth of FX futures is regulation and the uncleared margin rules (UMR) for derivatives that is now applicable to asset managers, as well as numerous sell-side firms. In fact, at the end of 2021, the fastest growing client segment for SGX was the buy-side – from trading firms to asset managers and commodity traders.
Not only has this created a larger and more diverse liquidity pool, it has also led SGX to invest more in developing services for what it calls a hybrid trading model that enables centrally cleared FX to co-exist with OTC FX trading.

SGX sees itself playing a key role in the development of this market and has made acquisitions and launched new services to further these ambitions. In 2018, the exchange introduced FlexC FX Futures, a new version of its FX futures contracts that has the same security and capital efficiency advantages as standard futures but can be traded bilaterally with tailored expiration dates.
SGX has since launched mini CNH futures contracts to appeal to smaller trading firms. It has also invested in two OTC trading engines – BidFX and MaxxTrader – which it acquired for $128 million and $125 million respectively.

Hybrid trading

Eurex is another exchange group anticipating a growing interest in on-exchange trading of FX, Since Deutsche Boerse Group’s $800 million acquisition of FX trading platform 360T in 2015, it has been at the forefront in developing a hybrid trading model combining OTC and exchange trading environments.

“Hybrid is a compelling concept for FX,” says Jens Quiram, Head of FX Derivatives at Eurex, Deutsche Boerse Group.

The 360T acquisition was intended to add an OTC FX venue to Deutsche Boerse’s multi-asset trading capabilities and this OTC scope has been further extended, including with the subsequent 360T acquisition of the GTX ECN business from Gain Capital for $100 million in 2018.

“The biggest driver for the demand for on-exchange trading of FX has been uncleared margin rules and, more specifically, the imminent arrival of phase 6 which will bring market participants such as asset managers and pension funds into the scope of the regulation.”

Jens Quiram

“After the 360T acquisition we realised there was more that we could do together. This resulted in a bigger programme focused on developing client service solutions and products in the FX space, and using 360T’s deep FX expertise to grow the listed FX offering on Eurex,” says Quiram. “The work with 360T has initially focused on our G7 currency offering, using contract and tick sizes in keeping with OTC traders’ expectations, and physical settlement of FX Futures to align use cases as close as possible to traditional OTC market practice,” he says. “In the beginning we secured committed liquidity providers to ensure a competitive price picture and discovery processes. Then we attracted liquidity takers and their banks as clearing members to support the credit mitigation process at Eurex Clearing as central counterparty to all executed trades.”

“We have seen a steady growth in volume over the last two years, despite the impact of the pandemic. But most importantly, the client onboarding pipeline with Eurex FX is very encouraging,” says Quiram

“The biggest driver for the demand for on-exchange trading of FX has been UMR and, more specifically, the imminent arrival of phase 6 which will bring market participants such as asset managers and pension funds into the scope of the regulation”, he adds.

“Asset managers are asking what the regulation means for them in terms of trading rules and are looking at additional products and execution models. The listed world is firm, secure and transparent, and in partnership with a CCP provides multilateral netting to reduce bilateral exposure. Under the margin rules, efficient collateralisation, standardisation and funding flexibility become much more important,” says Quiram.

“Liquidity levels are good, and we see a strong interest from banks, not just as clearing members but also as off-book liquidity providers,” he adds.

Source: Eurex

Quiram envisages more use of integrated solutions to trade listed FX derivatives via blocks and Exchange for Physicals (EFPs) on the same platform as OTC FX spot and forward activity, to reduce trading costs and complexity, as well as developing more efficient hedging strategies.

It helps, says Quiram, that asset managers’ trading habits and counterparty relationships already span both the on and off-exchange world, so hybrid trading such as EFPs is more about bringing two existing worlds together rather than introducing a new one.

“All of these relationships exist already. An asset manager typically uses a combination of OTC and exchange-based trading, so we don’t have to break any networks. It is more about the linkage between an existing service and solutions whilst offering an efficient and smart alternative to connect listed FX and OTC FX liquidity pools,” says Quiram.

He also expects the hybrid theme will serve to demonstrate the benefits of an exchange as an execution venue to those not already active. “On-exchange trading is extremely fast and transparent and easy to use. It helps with position and collateral management, reduces bilateral exposure, and there is no last look involved.” says Quiram.

Regulation served as a trigger to look at the exchange market, says Quiram. Although he adds that the OTC market works very well and showed resilience in a volatile environment. “And while I see a hybrid Listed and OTC FX market developing, I believe that under stabile market conditions and current regulation the traditional OTC FX market will remain as liquid and at the core of the FX world,” says Quiram.

Eurex is also looking to expand its geographical reach, having started with an initial focus on existing clients in the German and European markets where there is a familiar regulatory environment which therefore delivers legal and regulatory certainty for FX market participants.

Eurex will work on currency and service expansions but believes following the existing OTC FX market structure and products in use is the way forward, says Quiram. “It is not about new products but about new services to get access to these products such as collateral management, settlement services and payment services. It is about connecting FX liquidity pools seamlessly. Optimisation of position management to offer FX market participants a broader choice whilst unlocking benefits of listed and OTC FX worlds.”

FX futures growth

The FX futures market has been a lucrative asset class for exchanges and trading activity has continued to increase in recent months. Data from the Chicago Mercantile Exchange (CME) Group, which claims to be the largest regulated FX marketplace, shows that during 2021 more of its customers migrated open positions into FX futures than ever before. December 2021 closed with more than three million contracts with a notional value of $293.7 billion.

According to the CME’s quarterly FX report, this surge in activity can be attributed to the combination of macro factors such as new capital regulation, Standard Approach to Counterparty Credit Risk (SA-CCR) and uncleared margin rules (UMR), and the “fundamental benefits” of cleared, listed derivatives as a complementary pool of liquidity that can be accessed without an ISDA intermediary. Another factor has been the increase in buy-side firms choosing FX futures, states the CME report. During 2021, the number of large open positions in CME FX futures rose by +8.6% year on year, as did the largest ever number of gross notional positions held by asset managers in EUR/USD FX futures.

“In combination, they confirm a notable trend of consistent adoption of listed futures and options by the buy-side community,” states the CME report. The number of block pricing providers on CME’s platform also grew in 2021 to more than 20 firms including US and European banks alongside non-bank market makers all offering block liquidity specifically for FX options.

“Demand for blocks, and pricing providers, has increased because they enable participants to access our liquidity and gain the capital and credit efficiencies of our markets, whilst operating like they do in the OTC market – negotiating deals privately with their chosen counterparties,” states the CME.

Client adoption of listed FX futures and options on CME Source: CME Group

That’s why block volume across futures and options increased by 38% from Q4 2021 vs. Q4 2020, and trades increased by 63% over the same period. It’s not just the network that’s grown – it’s also participants’ use of this type of modality to achieve their strategy,” concludes the report.

Exchanges have also looked to capitalise on the growing demand for cryptocurrencies. The CME introduced micro bitcoin futures in May 2021 and then added micro ether futures in December. As of March 2022, nearly 5.2 million combined micro bitcoin and micro ether futures contracts had changed hands.

The exchange is now looking to trade options on micro bitcoin and ether futures. According to Tim McCourt, global head of equity and FX products at CME Group: “Micro-sized options will enable traders of all sizes to efficiently hedge market-moving events with greater precision and flexibility or fine-tune their cryptocurrency market exposure.”