The regulatory push to get as much of the standardised OTC business as possible onto electronic trading platforms or at least cleared through CCPs is having a tremendous impact on the world’s derivatives exchanges. Already this year, two exchanges have launched new currency contracts in Europe. In July, Eurex began trading currency futures and options contracts for the first time following hot on the heels of the launch of CME Europe, a wholly new exchange for Europe which opened its doors in London on 28 April with 30 FX futures products.
Derek Sammann, Senior Managing Director for FX, Metals and Options, at CME Group and board member of CME Europe, says CME’s European launch was prompted by the belief that FX was an underserved market in Europe and that although it has a well-oiled machine on the OTC side, there was little in terms of exchange traded listed products.
He says: “When customers are looking at increasing demands and changes as a result of, not just US regulations around Dodd-Frank or European regulations around EMIR, but also BCBS/ISCO rules that are going to be changing the regulatory capital requirements for OTC bilateral trading. This is a change that is going to unfold in the global FX market. When European customers look at how these capital charges are going to impact their businesses they are going to have to find the most cost effective and capital efficient way to continue to trade in the FX market.”
“It is a different set of challenges when you are talking about a global market and where you are starting to see a balkanisation of regulations. This is why we wanted to bring exchange-traded foreign exchange to the European marketplace. It was underserved and we decided we needed to globalise our infrastructure and provide those attendant benefits to non-US customers should they wish to choose our European regulated entity to do their business,” he adds.
Sammann believes the regulatory landscape has still a long way to go in unfolding. The impact on market structure of the new capital charges is already putting the bilateral credit model under threat.
CME Europe went live with FX futures and a small suite of bio-fuel products. Sammann says that the main focus of the launch was FX. This was in order to make the same products available to European customers as global participants are already trading in the US, at CME Group. “The European client-base is now seeing the impact of MiFID, Basel III, BCBS/ISOCO and EMIR and they need to make changes to their business model. When you look at the global FX marketplace, it is massive market that has got to go through a huge amount changes. When we announced this in August 2012, there was no European platform providing on-exchange trading for FX in Europe. We have the global leadership position in our US franchise and we wanted to be able to serve an underserved market in foreign exchange,” he says.
However, Sammann welcomes the Eurex launch in July as being good for the market because customer choice is paramount. He believes it increases customer focus on the benefits of on-exchange trading, provides customers with an increased set of connectivity options, and it is raising awareness of the capital and operational efficiencies of a centralised exchange-traded FX marketplace. He adds: “Over the last ten years we have proven that on-exchange trading in foreign exchange is real. We have invested in our client base, our product sets, building our options business, building our infrastructure with our clearing house and now a European exchange. We absolutely believe that over time exchange-traded FX will continue to play a larger and larger role in the global FX market, so others following our lead are validating our business model and what our customers have told us.”
CME allows customers to choose between physically settled, an exchange of two principle amounts through CLS, and cash settled FX, where deliverable currencies are converted and not physically exchanged, just the difference in P&L, and this is the same in the European exchange.
Other products will be announced in due course but Sammann can confirm that CME Europe is not going to be an FX-only exchange and it is looking at certain fixed income products to complement its swaps clearing capability in Europe. He says: “It makes more sense in capital intensive businesses like trading for CME Europe to be multi-asset class to achieve the same success in our US exchanges. The benefits of multi-asset exchanges are significant in terms of capital efficiencies for the customer. To ensure we can provide our customers with the most capital efficient model we are aligning the OTC products that we clear with the exchange-traded products that we trade on our exchange. By having those in the same European clearing house, over time we can provide margin offsets as we do in the US with our OTC swaps clearing against Treasury futures, for example.”
Sammann says CME Europe will continue to add currency pairs as well as FX options on the foreign exchange side. “A large number of European customers are already trading in our US markets and have already been able to access the cross-margining benefits of our US business, mostly on the fixed income side. We are working to be able to provide portfolio margining as quickly as we can in our European clearing house and exchange. We have found in our US franchise that the portfolio margining benefits are significant.”
Equity and retail participants
Nasdaq OMX offers a total of US dollar-settled options on seven major world currencies as part of its PHLX World Currency Options. The cash-settled (USD) securities options on FX, launched in 2006, marked the first time retail investors were provided the ability to hedge or trade the direction of major currencies utilising options trading strategies paralleled to equities.
Phil Harris, Head of FX Strategy at Nasdaq OMX says: “We believe strongly in the increased participation and overall growth of the FX market, including the use of FX options. Specifically I would highlight our engagement with retail participants. Our seven FX options contracts are tailored for equity options participants who want to express a macro position via a currency – these are under the SEC and are not impacted by Dodd Frank. They behave like an index, but track the underlying spot FX prices in increments of 10,000 units of currency. We are encouraged by the recent uptick in our ADV and the increasing level of interest shown in this product due to investments in education despite record levels of low volatility.”
Nasdaq OMX’s European CCP is focused on ensuring its members are able to clear all mandated-to-clear FX products with Nasdaq OMX. For this reason, as well as providing NDFs, Nasdaq OMX is participating in the GFMA GFXD CCP group, which is working through the challenges the industry faces in order to satisfy an expected clearing mandate for OTC FX options.
Further to this, the exchange is broadening its FX product set to meet the changing demands of the FX market in the light of the new regulatory clearing requirements.David Holcombe, Head of FX Product, at Nasdaq OMX adds: “We have the broadest scope of FX products in the CCP landscape, not only services addressing mandated clearing, but also a toolkit of non-mandated products for members to establish new client offerings; targeting the obvious benefits of CCP clearing such as reduced capital charges, and also clearing specific areas of FX business in order to minimise utilisation of scarce credit lines.”
“While a FX clearing mandate will of course be a catalyst to large scale FX clearing, we are increasingly engaging with more astute market participants already looking beyond the mandate for new FX business opportunities and revenue streams,” he says.
Nasdaq OMX recently tied up with middleware vendors, Traiana and MarkitSERV, to make connectivity easier for both existing and new clearing customers to clear FX at the exchange. Says Holcombe: “Not only do we have an easy-lift membership process for existing clearing members so they can also clear FX with us, but we have been steered and supported by members who have already established a workflow with Traiana or MarkitSERV, as their approach is to route OTC trades using these industry-standard infrastructures, rather than having to code to a new API for each CCP they need.”
New business models
For Holcombe, the FX industry is still in transition, evolving to cope with mandated changes affecting pre-trade, post-trade, and execution itself. “Even without all regulation being in place, a significant section of the market is already establishing new business models to secure new revenue opportunities in FX – they are now making their ‘land grab’ in the future-state FX landscape,” he adds.
But, he says, exchange-traded and CCP-cleared FX bring obvious benefits to market participants looking for regulatory-certainty on product and execution venue, and where an agency model secures revenue without taking the risk position or assuming the credit and capital cost burden of maintaining a bilateral OTC position with that counterpart.
Holcombe believes that because the move to agency is a very difficult transition currently, especially as incumbent FX exchange venues are constrained to old-school listed FX products that do not offer the flexibility that OTC products intrinsically offer, banks are already looking at how best to offer exchange-traded FX via their single dealer platforms and algorithmic offerings to give the customer a choice of execution venue.
However, he believes exchange-traded FX will not be the ‘one-size-fits-all’ endgame for the FX market. The drivers to clear and the increasing challenges of retaining a pure principal to principal OTC FX franchise are already playing out. “With product innovation to bring the flexibility and scope of OTC into the exchange-traded/CCP-cleared space, gaining the benefits those highly regulated venues bring, and an acceptance that the agency model is at least a component part of an overall bank relationship, we will look back on 2015 as the year exchange traded FX really took off,” Holcombe says.
At the Dubai Gold and Commodities Exchange meanwhile, while there was a slight decline in the currencies volume year-to-date its Indian Rupee futures showed a growth of 22 per cent month-on-month in July, while Mini Indian Rupee futures rose 3 per cent.
Currency as an asset class
Ian Wright, Chief Business Officer, at DGCX says: “In comparison to the global flows, regional currency trading is still at a low level but it is on the rise. The key factors that are driving the currency growth in the region include the growing attractiveness of currencies as an alternative asset class, the fact that UAE is emerging as a centre for forex trading, and the stronger regulatory environment, which offers participants the opportunity to trade directly in a transparent, secure and regulated environment with full-fledged clearing facilities.”
The Mini Indian Rupee futures contract has been designed to meet increasing demand from market participants for a smaller product and it allows them to use it as a hedging and investment tool without making high capital commitments. The contract particularly benefits individuals and businesses that regularly remit funds to India, and SME traders who import from and export to India.
Says Wright: “Those who trade the main DGCX Indian Rupee contract are also able to leverage the smaller size of the contract to easily scale up or down their Indian Rupee trading volumes - in response to price-sensitive market and policy changes. Participants can construct precisely tailored hedges on the Indian Rupee. The Mini Indian Rupee Futures can be cross-margined with the regular DGCX Indian Rupee product offering, which means that any excess margin in an account for one of the Indian Rupee products can be used to cover an account in the other Indian Rupee product that has fallen below the margin requirement. Other cross-margining commodities also are being developed.”
The DGCX Indian Rupee options contract was temporarily suspended in 2012 to facilitate migration to a new trading infrastructure. With the new technology platform in place, the exchange is able to support high volumes in innovative products such as the Indian Rupee options contract.
DGCX is the only exchange outside India to offer trading in both futures and options in the Indian Rupee. “Rupee options contracts launched by Indian exchanges have proven to be highly successful, which augurs well for the success of our contract. The contract will build on the success of DGCX’s Indian product offering, which has seen significant growth in trading over the past year,” Wright adds. Since the relisting on July 18, the DGCX Indian Rupee options traded 2,300 contracts in its first month.
As an exchange, DGCX’s product strategy aims to deliver products that compliment the INR, such as other EM currencies or Indian centric products, and products that enhance business and trade in and through Dubai, such as gold and plastics. In keeping with this strategy, Wright says the exchange places great emphasis on what the market needs and structures its products based on constant feedback from its broker members and market participants. In response to its member and market needs, DGCX is focused on developing a strong offshore platform for the trading of a range of emerging markets products. DGCX’s emerging markets currency contracts, like Indian Rupee futures, allow international investors to hedge their exposures offshore in a safe and regulated environment. Wright adds: “These contracts are attracting increasing attention from both retail and international institutional participants, ranging from multinational banks, non-deliverable forward (NDF) markets, traders and other business entities, and have contributed significantly to the growth of the exchange’s member base.”
Wright also believes that the increasing trade between India and the Middle East is also a key factor behind the remarkable growth in the contract’s volumes. So far this year, the DGCX Indian Rupee futures contract increased its share of the total value of Indian Rupee futures traded globally to 40 per cent of on-exchange business. In July, DGCX Indian Rupee futures recorded the highest ever average daily open interest of 43,929 contracts.
As part of the expansion of DGCX’s Emerging Market currency portfolio the exchange is considering listing three new currency futures including South African Rand, Russian Rouble and the Korean Won. DGCX also plans to add the MSCI India Index futures to its equity suite in Q4.
Wright believes that FX trading is emerging as an attractive investment option in the Middle East. Market participants now have a better understanding of trading strategies, the FX market and more sophisticated technology. He says: “Tapping this growing demand and further building on the success of our currency portfolio, we are exploring the introduction of new futures contracts in emerging market currencies. The objective is to offer a platform for offshore trading of emerging market currency contracts as DGCX offers a safe and regulated environment for international investors to hedge their exposures in emerging market currencies offshore.”
Today, Singapore is Asia’s largest FX trading centre, and a leading price discovery centre for many Asian currencies. As the leading Asian gateway, the Singapore Exchange (SGX) is the most liquid and biggest offshore market for key Asian equity derivatives, and the preferred price discovery centre for key commodities such as natural rubber and seaborne iron ore. The emergence of Asian currencies, Singapore’s well-placed time zone and its USD$2.4 trillion of assets under management are key drivers in forging future volume growth.
Michael Syn, Head of Derivatives and Executive Vice President, at the Singapore Exchange, says: “FX, as an asset class, is highly complementary to SGX’s equities and commodities franchise, and we believe this confluence of liquidity across different major asset classes on a single market platform gives SGX a strategic edge to become a price discovery centre for Asian FX.”
Syn says that though they are still in early stages of liquidity growth, SGX FX futures have been very well-received by market participants, with more than US$6 billion in notional value traded since the launch in November 2013. In particular, the SGX INR/USD futures has achieved new record volumes in recent months, with over US$1.6 billion in notional value traded during the month of August 2014 and a peak single-day record of US$350 million in notional value traded on 21 August 2014.
SGX has a dominant base for managing equity risk premium in its clearing house and it offers margin efficiencies between regional forex and Asian regional equities. Cross-margining is made possible wherever stable and significant correlations are available, including those between futures and OTC cleared products on related underlying. “For SGX, the unique risk adjacency is between currencies and Asian equities, with margin efficiencies arising from the strong coupling between currency risk premium and equity risk premium,” says Syn.
SGX is expanding its current suite of Asian FX futures with new currency futures contracts on the Chinese renminbi, Thai baht and Japanese yen in the coming few months.
Syn believes that futures have been the most preferred format to provide portfolio margining efficiencies. SGX FX futures products are designed to provide a complementary and cleared solution to OTC market participants. In catering to finer hedging requirements, the contract sizes of SGX’s FX futures are designed to be smaller compared to OTC trade sizes. He says: “Our market participants have been able to benefit from highly competitive bid-ask spreads as we have also put in finer price increments/tick sizes in our FX products. A good example is the SGX INR/USD contract which has consistently shown a very tight bid-ask spread of 0.6 to 1.2 bps, as compared to the 3 to 4 bps spreads seen in equivalent rupee NDFs traded in the OTC market. SGX FX futures contracts are designed to be net-settled, which in our view, remove risks associated with gross settlement and closely mirrors existing settlement practices in the OTC NDF market.”
Syn believes that regulations, such as Basel III and Dodd Frank, have led investors to re-think their counterparty risks associated with unregulated OTC trades and operational and capital efficiencies in the way they conduct their FX business. As exchange-traded products promote greater price transparency through a central limit order book accessible by all market participants this has greatly benefited end users such as asset managers, hedge funds and corporates which are now seeing an increasing to fulfil best-execution requirements.
He adds: “For fiduciary managers and corporate treasurers, trading and clearing on a trusted and well-capitalised exchange have proven to support them in overcoming challenges of counterparty risks. SGX is also seeing corporates, particularly small and mid-size firms, choosing to hedge their foreign currency risks using futures due to the finer trade sizes and tighter price spreads offered on NDF futures. The upcoming clearing mandates and higher capital charges to be imposed on uncleared exposures could drive more participation on exchanges for FX transactions in the near future.”
As the world’s first central counterparty to clear Asian NDFs, SGX has seen clearing on a voluntary basis already begin in the region’s actively traded currencies. Syn says: “Though clearing of NDFs has yet to be mandated in any jurisdiction, interest at SGX has been healthy amidst the evolving regulatory frameworks in the major centres and in Asia. With our recent service expansion to cater for client clearing, we at SGX are confident of positive developments in the clearing front as clients in the marketplace gain greater awareness of the benefits of clearing. Forthcoming mandates expected in NDFs can further propel this too. We will continue to engage our global market participants to explore solutions and services that will meet their evolving needs.”
Clients can easily connect to SGX through widely-used industry platforms so that it is a seamless process from execution of trade to an electronic trade affirmation and onward to SGX for clearing. To facilitate greater efficiency, SGX has a dedicated API to enable market participants that are using multiple channels and platforms to route their OTC NDF trades to SGX for clearing.
‘Futurisation’ of FX
While trading in exchange-traded FX products has jumped by tenfold in the past 10 years, with about US$160 billion in average daily turnover by the end of 2013 this still represents less than 5 per cent of total FX volumes traded globally. For this reason, Syn believes that there is a lot of potential for further growth in the ‘futurisation’ of FX, particularly in Asia where this growth will likely be driven by a combination of changes in market microstructure and upcoming regulatory mandates.
He adds: “For some Asian currencies, this ‘futurisation’ is already in evidence. One such example, where futures have been swiftly adopted is the Indian rupee, which is already being actively traded across a number of exchanges (both onshore and offshore) with US$2-3 billion traded each day.”
Looking ahead, as regulatory mandates in US and EU begin to take effect for non-deliverable currencies (of which a number are Asian currencies), market expectations are that these clearing requirements are likely to increase the overall costs of trading non-deliverable currencies on OTC basis.
“In this respect, futures may offer a cheaper way for some clients to gain the exposures they need. Nonetheless, some customers will still have certain bespoke requirements for which they will continue using the OTC market. As cross-border investment and trade flows between Asia and other geographies continue to increase, FX transactions in Asia will grow in tandem as well, likely benefitting both FX exchanges and OTC markets in Asia,” concludes Syn.