The growth of FX Swaps and the drive for automation

January 2023 in Expert Opinions

By Stephan von Massenbach, CRO at DIGITEC

With increasing trading volumes, greater involvement from banks of all sizes and further buy-side participation, the FX swaps market continues its rapid growth and migration from voice brokers to electronic channels. This has driven significant demand for accurate and robust pricing engines that can support all sizes of trading firms, and a more automated end-to-end workflow.

The growth of FX Swaps

The 2022 BIS Triennial survey shows that FX swaps are the most traded FX instrument, with market share increasing from 42% in 2013, 47% in 2016, 49% in 2019 to 51% in 2022.
Overall turnover in global FX markets reached $7.5 trillion per day in April 2022, but more granular data from the Triennial survey shows that the growth of turnover in FX swaps and forwards between 2019 and 2022 was due to more FX trading in shorter tenors with maturities of one week or less. Of this, the overnight segment, split out for the first time in 2022, accounted for close to half of short-maturity swaps.

Inter-dealer trading gained ground in the Triennial survey, and in FX swaps it grew from 47% in 2019 to 54% in 2022. Inter-dealer FX swap trading is predominantly in short tenors, the higher inter-dealer share in 2022 is one of the factors leading to the shortening of maturities.

Traditionally, repos and money markets have been the main ways for firms looking to roll, hedge, or fund their positions. Over the past few years, there has been a move by client firms towards FX swaps fulfilling this need as a source of global funding.

Increased demand for pricing technology

As the FX swaps market has grown, clients have increasingly demanded that their relationship banks provide liquidity across multiple currencies and tenors. Whereas in a smaller market, banks used to price FX swaps manually or use Excel, the increased volume of FX swaps has led to growing interest in more efficient and scalable technology solutions.

Market evolution

The dominance of voice brokers has meant the FX Swaps market has resisted change for many years. However increased regulation, better technology access via the cloud, and the need for transparency are driving change. As FX workflows have become more automated throughout the trade lifecycle, the FX swaps market is also evolving to become more electronically traded.

In this electronic market there is more pressure than ever for Market Makers to make fast and accurate prices. In the past, where trading was manual, small movements were usually covered by the trader’s bid-offer spread, giving the trader time to react and adjust. But in electronic markets any misprice can quickly lead to losses.

The complexities of pricing FX swaps

There are many challenges presented by FX swaps having extremely tight spreads, which become obvious at times of market movements. In the liquid currencies that show these tight spreads today, the bid-offer spread cushion has now been largely eliminated, especially with high levels of volatility in the market created by central bank activity.

For a large Market Making bank, up to 20,000 data points need to be priced along a forward curve, which quickly adjust when the market starts to move. Models that solely rely on FX swap prices published by brokers are particularly vulnerable, as these data points are not only among the last to update in times of movement, they also do not cover relevant points such as central bank dates and liquidity events (e.g. month- and year-end) that show the largest effect. Pricing models need to incorporate a range of market data.

Accurate pricing requires better data

A key source of reliable FX swaps data is provided by the DIGITEC/360T Swaps Data Feed (SDF), which enables clients to build fully automated and accurate real-time curves. The SDF is based on participating major FX banks’ raw pricing, which represents Interbank quality. Today, the SDF has established itself as a reliable data source used by many banks and FX swaps market participants in their active pricing of currency curves.

Modern pricing models also require the speed and accuracy that can only be found in efficient and transparent markets. A good source for such data is the STIR Futures market. Instruments like the one-month and three-month USD SOFR Futures or the still prevalent three-month EURIBOR Futures need to form the backbone of FX swaps pricing. They do however need to be supplemented with market data from other assets, creating the need for a pricing model that is able to combine multiple assets into a cohesive model.

While the short end of the curve is based on Futures, the long end required to price Cross-Currency swaps will need to be built out of swaps. Here, the effect of the LIBOR transition can be observed.

Previously, practically all the liquidity was found in the IRS market. With LIBOR being phased out, this is changing. Some markets, such as GBP, already show almost all liquidity in long-dated OIS, while others are transitioning (USD) or lagging (EUR). This highlights the need to be able to quickly adjust the pricing models once the liquidity has shifted.

Cloud adoption

In the past, smaller banks and Asset Managers could not justify the investment in on-premise technology, and many used Excel to price FX swaps. The recent adoption of applications deployed on the cloud makes pricing engines more affordable and accessible for an increased number of firms, helping them to move away from a reliance on Excel.

At DIGITEC we recognised the growing technology needs of smaller banks and Asset Managers, launching D3 Lite (a SaaS version of the D3 pricing engine) to enable them to price FX swaps and forwards, providing key functionality in an intuitive web-based GUI, with auditing functionality.

The road ahead

Driven by Risk Free Rates and tight bid/offer spreads, combined with the need to capture and process ever more data from multiple asset classes, the pace of change in FX swaps is accelerating. Using Excel or relying on old inflexible systems is no longer an adequate workaround in a world where even the smaller Market Makers are using more flexible, robust, fast, and configurable pricing technology.

Increased electronification, automation and the use of sophisticated technology allow banks to increase their product range and, ultimately, their Market Making and trading volumes. For example, many regional bank clients of DIGITEC use the services of D3 and SDF to expand their offering beyond G10 and specialist currencies. Additionally, they have seen increased workflow efficiency, enabling traders to diversify trading books and manage multiple instruments.