Futures aim to put a dent in FX swaps supremacy

Advent of margin rules sharpens appeal of exchange-traded instruments for buy-siders

  • Foreign exchange futures make up only 2% of the total FX market, a fraction of the volumes seen in swaps and forwards.
  • Despite the small footprint, some believe the instruments are poised to grow in popularity as buy-side firms adjust to incoming margin rules.
  • Alternatively, futures could provide netting benefits for firms that are already posting margin voluntarily.
  • However, detractors believe futures liquidity is still too measly to represent a viable alternative to over-the-counter derivatives.

Foreign exchange traders generally like to see the whites of each other’s eyes – metaphorically speaking, of course.

The vast majority of foreign exchange transactions take place over-the-counter, in bespoke deals between two parties. This differs from other asset classes, where exchange trading is more common.

But attitudes may be changing, albeit slowly. The onset of non-cleared initial margin rules provides an incentive for some to switch from OTC swaps and forwards to futures, which are traded on-exchange. An increase in voluntary clearing is another reason for firms to trade futures, so they can net exposures and cross-margin. Exchanges and dealers are also trying to woo customers with new futures products and execution styles.

“Previously, the cost of on-boarding to futures and learning how to trade them when people had years of experience trading OTC was a huge barrier to the market, but things like the non-cleared margin rules are providing that trigger,” says Joshua Mathew, head of FX at Flow Traders, a futures market-maker. “Futures are definitely gaining more interest from the real money space than ever before.”

Volumes and liquidity in FX futures are inching up. Daily average turnover of FX futures stood at $165 billion in March 2021, according to data from the Bank for International Settlements. That’s an increase of 30% from full-year 2019. Activity in exchange-traded FX options stood at a paltry $13 billion, flat from the figure two years ago.

Volumes in FX swaps, by contrast, stood at $3.2 trillion and forwards at $1 trillion, dwarfing their exchange-traded cousins, the most recent BIS data shows.

For some clients, the patchy liquidity, particularly at longer maturities or non-standard dates, means the effort required to set up systems to trade futures isn’t worthwhile. Others believe the margin benefits from trading futures are overstated.

“We do see some requests in the market [for FX futures] and we follow up on that but the overall interest is muted. The lion’s share of trading in the FX market is still bilateral,” said Andre Besant, head of FX for Germany, Austria and Switzerland at Deutsche Bank, speaking on a Eurex webinar in March.

But, speaking on the same webinar, Christoph Hock, head of the multi-asset trading desk at Union Investment, argued that liquidity in order books for FX futures is “decent” and that the instrument is “highly accepted”.

“We definitely expect that acceptance in the market will further increase,” he added.

Inflexible friend

FX futures are agreements between a buyer and seller of currency to transact at a predetermined price and time in the future. Traded on an exchange’s central limit order book and cleared by a central counterparty (CCP), the contract requires users to post both initial and variation margin. Futures contracts dates are also rigid, with trading typically limited to International Monetary Market (IMM) dates four times a year.

This setup contrasts with OTC swaps and forwards, which don’t require initial margining or variation margin in many circumstances, and can be struck on any day of the month the user wants. This flexibility has meant that OTC swaps and forwards have been the preferred choice of the buy side, and liquidity has followed.

“FX swaps are incredibly liquid and can trade anywhere from three days up to however many years while the longest really liquid tenor currently available in futures is six months,” says the head of FX futures trading at a European dealer.

But upcoming rules for non-cleared margin might be changing the way some people think about futures. Variation margin has been required for many non-cleared products since 2017. From September 1, the fifth phase of non-cleared margin rules will require firms with more than €50 billion or $50 billion equivalent in average aggregate notional amount (AANA) of OTC derivatives to start exchanging initial margin with counterparties. In September 2022, the sixth and final phase of UMR will see firms come into scope if they have an AANA equivalent to more than €8 billion or $8 billion.

OTC swaps and forwards are currently exempt from posting initial margin, and trades involving the buy side are exempt from posting variation margin in many jurisdictions. The instruments also count towards the thresholds that determine when a buy side firm has to start posting initial margin. Therefore, buy-side firms near the thresholds could simply trade more exchange-traded products to avoid an AANA breach. This could be done through the use of exchange-for-physical type executions, which allow users to effectively replicate FX swaps in futures markets (see box: EFPs to replicate FX swaps).

“Margin rules are certainly a factor that could drive a shift [from swaps] to more listed futures activity,” says Kevin Kimmel, global head of eFX at Citadel Securities.

 

 

However, sources believe broader potential lies in the wider adoption of clearing and margining in bilateral markets that the margin rules are designed to promote. Many buy-side firms already voluntarily collateralise their swaps and forwards to take advantage of better pricing, and to bring the products in line with the rest of their derivatives book.

This means big asset managers and pension funds are now paying variation margin back and forth with dozens of banks daily.

At the same time, more and more asset managers are using CCPs since mandatory clearing was introduced on some fixed income derivatives instruments. Products like non-deliverable forwards may soon move into clearing for some clients, too. Using futures would therefore see the clearing house as the only counterparty, meaning clients can net down all exposure in a way that OTC trading with multiple counterparties cannot.

While OTC trading does not always require initial margin like futures does, Robbert Sijbrandij, head of FX at Flow Traders, points out that trading bilaterally comes with its own strings attached. For example, an asset manager might receive a larger credit line with more favourable terms if it does more business with a given dealer or prime broker.

“So you might say that there’s no initial margin, but it’s not that transparent in terms of what determines the amount of line you get from each and every bank. It also quite often has a lot to do with the wallet that you pay the bank,” said Sijbrandij, speaking on the same Eurex webinar as Besant and Hock.

FX futures have seen an 18% and 16% increase in hedge fund and asset manager participation respectively, according to recent figures from CME – with open interest equating to $298 billion in June for CME-listed FX products, up 28% from this time last year.

“FX futures is by no means a new product but recent regulations have forced the industry to reconsider the way in which they use the FX market,” says Jens Quiram, global head of FX derivatives at Eurex. “So we’re seeing growing demand for futures to complement traditional OTC products – particularly from the asset management side of the market.”

Win some, lose some

Not everyone buys into the argument that margin rules will fuel a shift to futures. Van Luu, head of currency at $300 billion asset management firm Russell Investments, says margin paid on futures at the CCP could in some cases be higher than the margin on bilateral trades.

The firm calculates that its annualised spread cost of trading futures on developed currency pairs would be roughly three to four times greater than if it were to trade OTC.

“From a cost perspective, we still see an advantage in using swaps,” Luu says.

Eric Donovan, global head of institutional FX at broker StoneX, agrees that the supposed cost benefits associated with trading futures over FX swaps aren’t guaranteed and therefore a significant switch from swaps to futures is unlikely.

“Some of the simulations that we’ve run with different counterparties in certain scenarios under non-cleared margin rules have seen people pay a little bit more margin, others a little bit less. It’s certainly not enough for us to consider pushing our volumes and liquidity preferences to futures over swaps,” he says.

Experts say it’s hard for individual firms to work out whether they would enjoy margin savings from the switch. The cost benefits include improved netting sets and credit exposure. However, for firms that haven’t already used futures, it can be expensive to make the required operational changes.

Given additional work involved in Isda documentation for each of the underlying funds, it’s easier for them to go down the listed route than it is to go down the bilateral route

Chris Callander, Societe Generale

Often, smaller companies are drawn to the simplicity of trading futures because OTC products require setting up International Swaps and Derivatives Association (Isda) documentation with each counterparty. This can be a cumbersome process.

Larger investment firms are less deterred by the red tape because they are able to enjoy greater benefits from the flexibility of OTC products.

Chris Callander, head of FX futures sales and trading at Societe Generale, agrees the main driver for futures growth has come from asset managers that want to avoid setting up Isda documentation for OTC trading.

“When we speak to clients and ask them about their increased interest in trading futures with us, they say it’s because their underlying funds are mandated to trade on a listed setup rather than going down the Isda route. Given additional work involved in Isda documentation for each of the underlying funds, it’s easier for them to go down the listed route than it is to go down the bilateral route,” he says.

A further reason for some portfolio managers to switch from FX forwards to futures is that forwards are often closed out with offsetting contracts. This means the exposure is reduced to zero but the items remain on the balance sheet, which can be an operational nuisance.

Hock from Union Investment points out that some active portfolio managers have up to 150 single lines in their portfolio without any economic exposure.

Hock said his firm had already “massively” increased its use of FX futures by 40% between 2019 and 2020, with FX futures now making up 28% of Union’s FX trading book.

Variations on a theme

The futures market has also been working hard to come up with new contract types to attract different types of users.

Singapore Exchange offers a product for users that do not want to trade only on IMM dates. It launched its so-called FlexC futures in 2019, which allow bilaterally agreed trades to be cleared as though they were standard futures positions. The products can use tailored expiration dates up to 100 business days after the contract’s start date.

While contracts are currently negotiated on a bilateral basis and then submitted to SGX for clearing, SGX is hoping to be able to stream the product on its platform by the end of this year. The product has seen $192 million worth of contracts cleared to date.

Speaking in March, Eurex’s Quiram said the exchange was also working to provide flexible contracts to clients – allowing them to negotiate their strikes and maturities individually.

“That change won’t occur overnight but it’s a step-by-step process that’s already happening,” he said.

Eurex also launched so-called rolling spot futures contracts in 2017. These are perpetual contracts that are rolled daily if an open position exists, however usage has been low and there was zero open interest as of June 30.

Futures proponents also point to new execution styles that could tip the balance in their favour.

One emerging approach is block trading, where privately negotiated contracts are executed away from the central limit order book, but are subsequently submitted for clearing. This allows users to stream block prices from disclosed dealers, which can be useful for institutional investors looking to manage their trading wallet across multiple liquidity providers, for example.

We would like to make use of algos for futures and are discussing this with our partners on the broker side

Christoph Hock, Union Investment

Societe Generale, BNP Paribas, Flow Traders, and on the exchange side Eurex and SGX all state that their businesses have seen growth in block trading in the past 12 months – with a 60% increase being seen by BNP.

An innovation that could turbo-charge futures growth has yet to come: algorithmic futures trading. Algo trading is common in spot FX markets, and the technique could be well suited to the transparent and liquid order books that futures have, insiders believe.

Flow Traders’ Mathew says the ability to trade futures algorithmically would be “extremely beneficial” in driving further demand and liquidity in FX futures.

Union Investment’s Hock says the firm is willing and able; now it’s down to the banks to get prepared. “We would like to make use of algos for futures and are discussing this with our partners on the broker side,” he said.

“The market is ready, we are ready, our broker firms are not ready. But we’re in in-depth discussions,” he added.

However, an FX trader at an asset management firm remains sceptical about the potential for algorithmic futures trading. While he “totally agrees” that greater usage of FX algos in futures would contribute to greater growth, he warns that the current lack of liquidity in the futures market provides a hurdle to algo trading.

“In FX, you need a basic level of liquidity for the algos to make sense, as the primary goal of algorithmic execution is to trade the currency pair in a way that doesn’t impact the market and to do relatively large sizes in an acceptable amount of time by approaching the market more gradually,” he says.

“I don’t see algorithmic futures trading happening any time soon. Maybe in the future,” he adds.

EFPs to replicate FX swaps

One of the big potential use cases FX futures supporters cite is their ability to act as a cleared alternative to FX swaps.

This was only made possible in the last few years, with the launch of exchange-for-physical execution for FX futures – for example through CME’s FX Link service, and on 360T with clearing at Eurex.

An FX swap is a spot FX transaction in one direction combined with a forward in the other. EFP allows a user to simultaneously execute a spot and futures contract to mimic a swap. The spot trade is done via a FX prime broker to preserve anonymity.

According to CME, it can be cheaper to trade this way. OTC swaps incur a FX prime brokerage fee plus a bid/ask spread of 0.2 to 0.3 basis points, it says, whereas for FX Link there is a spot FX prime brokerage fee, plus $2–$8 per million fee on the futures, and a bid/offer spread of 0.1–0.2bp.

Since its launch in 2018, FX Link has traded nearly $1 trillion in notional – with the product being made more accessible to market participants in April due to its new integration with messaging hubs such as Refinitiv Trade Notification, IHS Markit and Traiana.

“We’re definitely seeing more clients interested in trading FX Link as it provides both clients and sell-side liquidity providers with a mechanism to easily flip in and out of OTC and futures positions when they see fit,” says Lee Spicer, global head of listed derivatives high touch execution at BNP Paribas – who highlights the bank has seen an 80% increase in FX Link trades among clients.

Paul Houston, global head of FX products at CME Group, hopes FX Link will eventually see market participants trading futures as a proxy for FX swaps – an area of the FX market which remains opaque thanks to its bilaterally traded nature. As futures are instead traded on transparent all-to-all venues, their prices could be used as a proxy central limit order book for FX swaps.

“The credit efficiency of FX futures means they are well suited to serve as a firm source of pricing as a central limit order book for FX swaps,” he says.

However, the FX head at the European dealer remains unconvinced that the futures market has the liquidity necessary in order to provide such a proxy and therefore doubts that increased futures usage will stem from using FX Link as a proxy for FX swaps.

“For futures to be a real proxy for FX swaps there’s a long way to go as when you look at the liquidity currently available on FX Link it’s nowhere near comparable with what’s available in the OTC market. There needs to be more development as trading futures still isn’t as optimal as trading OTC,” he says.

Correction, July 8, 2021: This article has been amended to better reflect current non-cleared margin rules. While FX swaps and forwards are currently exempt from initial margin requirements, in some jurisdictions variation margin is required for trades between certain counterparties. A previous version of the article incorrectly suggested there is no variation margin requirement for any parties.

Editing by Alex Krohn

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