Paul Houston, Global Head of FX Products, CME Group, recently caught up with Traders Magazine to discuss the drivers causing change in the FX derivatives market, what CME Group has been doing to alleviate the pain points from these changes, and the exchange’s future plans.
What factors are driving increased demand for trading currencies (futures and options) on exchange and what factors are influencing this?
It’s hard to pinpoint a single driver, rather there are several factors. One of these is regulatory change which is happening, albeit gradually, in FX markets. In particular, the uncleared margin rules (“UMR”) have acted as a catalyst for the adoption of clearing especially for interdealer NDF activity, and to a far lesser degree the interdealer FX options activity. As phases 5 and 6 of UMR grow ever closer we expect that managing the impacts of UMR will serve as a further potential tailwind for client adoption as all listed FX products are exempt from both the AANA calculation and from the ISDA SIMM initial margin calculations.
Also of significance is SA-CCR (the standardized approach to counterparty credit risk). The rules pertain to bank capital and represent a material change in how banks calculate the capital they are required to hold to cover the risk of default by counterparts to derivatives transactions. The SA-CCR model is more risk sensitive (and less focused on gross notional), which allows more netting benefits, and improves the recognition of margin as off-setting to counterparty risk. These differences may provide a further impetus for the use of cleared alternatives or clearing for products like FX forwards, but we anticipate dealers to make decisions on a more holistic basis than capital alone. The interplay between capital, margin, fees and other considerations such as operational complexities are likely to be part of the decision-making process for each bank as to which pockets of their trading activity they migrate to cleared alternatives, such as listed FX futures or OTC cleared FX.
It is also important to remember MiFID II’s transparency requirements. The regulation is well-established now, but the need to measure and demonstrate best execution is increasingly important trend in FX markets for all products whether they are covered by MIFID II or not. CME Listed FX market, being a regulated all-to-all central limit order book, greatly assists in providing best execution for end users. This has been one of the drivers behind increased usage by asset managers and investors in the Listed FX market.
Outside of regulations, are there any other important factors impacting trading behavior in FX derivatives?
The adoption and growth we have seen in listed FX markets, in both major and emerging market (EM) pairs of FX futures, has also been driven by factors other than regulatory change. Generally, the advantages of Listed FX products facing a regulated central counterparty not only drives lowers capital costs and counterparty credit risks, they enable participants to achieve efficiencies through standardization of processes such as collateral management, payments and documentation. The latter has been a notable driver of new business from buyside participants. CME Listed FX also offers an all-to-all differentiated liquidity pool that is complimentary to OTC activity. The ability to trade passively in an anonymous, all-to-all order book with firm pricing and no last look continues to be a draw for customers, as does the additional and complementary liquidity to a participant’s OTC FX relationships.
Taking into account the changing market structure of FX, what has CME Group done with its futures and options markets to alleviate customer pain points?
Over the last 12-18 months we have delivered MPI reductions, in the range of 50-60% on the quarterly roll spreads in all of the G5 currency pairs followed by 50% reduction of MPI in AUD outrights on Nov 23, 2020. These MPI reductions have delivered enhanced price discovery and lowered cost of trading in our marketplace. In all cases liquidity has improved representing substantial cost savings to our customers
There is also an increasing opportunity to use FX futures as a proxy for FX swaps enabling capital and cost-efficient risk transfer. CME’s FX link, is a tradeable spread between OTC FX spot and CME FX Futures and therefore represents a firm all-to-all order book for FX swaps, but with the efficiencies of a cleared future. This may become especially relevant as capital changes such as SA-CCR impact the costs of trading FX swaps and the market generally moves more electronic, at least for standard points and risk transfer.
Recognizing that activity in FX options across both listed and OTC markets has been challenged by decreasing volatility over the past two years, we have transformed our listed FX options to further position them as a flexible, capital efficient and complementary pool of liquidity to the traditional OTC FX options market (changes include greater strike granularity, more maturities and expiry times aligned with OTC). The relative cost benefits of Listed FX options should become more pronounced as UMR becomes more widely adopted, with upcoming phases in September 2021 and 2022 impacting a greater number of firms. In addition, given that OTC participants are still primarily trading options via non-electronic conduits, we have also introduced a new block trading mechanism, known as Directed RFQ, which allows clients to seek liquidity for larger listed trades, known as blocks, on a bilateral basis with their preferred liquidity providers and benefit from automated submission to CME clearing post execution.
During the 2nd half of 2020 CME launched 3 new tools aimed at providing existing and potential customers data and analytics to understand our products better and their decision making. In summary these tools are:
- CME FX Market Profile tool, which allows clients to compare Listed FX futures and EBS spot liquidity by-side to optimize the use of both liquidity pools
- CME FX Swap Rate Monitor, which is designed to give greater transparency to the $3.2 trillion a day FX swap market by providing current and historical FX Link pricing and bid/offer spreads as well as interest rate differentials for eight currency pairs as implied by CME FX futures and FX Link markets.
- CME FX Options Vol Converter. This tool converts CME Listed FX options quotes into an equivalent OTC vol surface, allowing participants to make direct comparisons between CME listed and OTC markets, and making it easier to select listed contracts to benefit from our competitive liquidity.
Since launch we have had thousands of users access the tools- all are available on CMEGroup.com and represent a valuable data source irrespective of whether users trade in CME Listed FX markets or not.
In the face of the market structure changes, how have the volumes of CME’s FX futures and options changed in the last year? How are investors responding to your own products and unique capital and margin efficiencies that CME provides?
Our average daily volume for 2020 was 861k contracts; equivalent to $81.2 Bn in daily traded notional. Drilling down deeper into the specifics, we can see that the futures market is where demand is growing the most. Last year, over 160 end users – including asset managers, hedge funds and corporates – added new currency pairs or have started using CME FX futures for the first time. In Q1 of this year, a further 120 new users of Listed FX have been recorded, which has helped contribute to growing volume in contracts traded and open interest.
For example, in January 2021 FX futures Average Daily Volume reached 747K contracts – the highest non-roll month volumes we have witnessed since February of 2020 (~958K), prior to the onset of COVID. FX Futures Open Interest for Jan 2021 reached 1.76M contracts – the highest non-roll month OI level witnessed post the March 2020 roll where significant deleveraging of Large Open Interest Holders (LOIH) occurred under increased market stress.
Due to the regulatory factors driving change in FX, the futures market has seen the biggest demand. However, end-user customer participation in Listed FX options continues to grow. We have also witnessed some of the largest ever trades go through on our Listed FX options while the average daily volume of FXO block trades went up by 4.5 times between March 2020 and December 2020. This further strengthens our position as a leading venue where participants can manage sizeable risk positions in FX options, with enhanced capital efficiency.
Bearing in mind the trends you have just discussed, what does your product roadmap look like over the next 12 months and what areas are you particularly focused on?
Our product strategy remains focused on making listed FX futures and options as cost effective and accessible as possible. We have already reduced the tick increments on block G10 futures to 1/10’s to allow more granular execution for participants wishing to trade that way and in selective cases we will continue to review contract design for our contracts traded on screen. A large focus will be to continue the build of the FX Link market- we have just announced integration with Refinitiv Trade Notification and IHS Markit’s MarkitSERV to make connectivity easier and will also focus on distributing prices through partner ISVs. Finally, our analytics tools are an important mechanism in demonstrating the value in our markets, we plan further enhancements here to improve their use to the marketplace.