Regulation shifts focus to listed FX

With the woes of the Covid-19 pandemic fading into the background, it was regulation that took centre stage for many market participants in 2022. With uncleared margin rules (UMR) phase 6 coming into effect and the standardised approach to counterparty credit risk (SA-CCR) launching in the US, the roll-out of two major regulatory developments was completed last year. The fact the two regulations are affecting FX market participants very differently raises the question: why are buy-side firms and sell-side institutions increasingly relying on FX futures to maintain their bilateral trading relationships? 

While phase 6 of UMR is said to have affected more than 1,000 firms, it by no means resulted in the cliff-edge event that many had feared. Buy-side firms are applying a variety of strategies to optimise their portfolios under the new regulatory regime. This ranges from working with third-party optimisation providers to avoiding certain (uncleared) derivatives entirely, actively monitoring the relevant UMR thresholds or starting to clear FX transactions. Ultimately, what all of these strategies have in common is that they aim to optimise uncleared FX exposure with the goal of minimising cost.

Banks, on the other hand, are required to revaluate their FX portfolios from a capital cost perspective. Historically, regulators spared FX transactions from any clearing mandates and exempted deliverable over-the-counter (OTC) FX forwards and swaps from the requirement to exchange margin bilaterally. In contrast, SA-CCR is now addressing counterparty credit risk and is highly punitive towards such uncleared and uncollateralised portfolios, and can therefore impact the short-dated and directional FX business the most. The effect of SA-CCR wasn’t long in waiting as banks naturally passed on these higher costs to the buy side in the form of wider spreads, particularly on forwards and swaps. And, of course, liquidity in the market took a hit as well.

As a result, the current regulatory environment with UMR and SA-CCR has created substantial incentives for participants to manage or reduce their uncleared FX derivatives exposure with the help of cleared solutions.

Back to the future: where relationship trading remains vitally important

Both banks and buy-side participants feel genuine interest in sending some of their FX business to a clearing house to benefit not only from state-of-the-art risk management, but also to receive the preferential treatment from a margin or capital perspective intended by regulators.

One instrument that has gained particular traction among market participants are FX futures. This is because many market participants are already familiar with the mechanics of futures instruments. Access to FX futures is often instantaneous, as they are traded on the same exchange infrastructure that many banks and buy-side firms already use to trade fixed income or equity index futures.

Traditionally, derivatives exchanges have facilitated the trading of FX futures through the central limit order book (Clob), which allows for anonymous trading between participants on an all-to-all basis.

This structure offers a strong value proposition for participants because of its fair, transparent and democratic nature. However, exchanges such as Eurex also support trading FX futures in a bilateral fashion, allowing banks and clients to privately negotiate the price of a transaction without taking or showing prices in the Clob. This enables clients to trade FX futures with their OTC counterparties – and therefore offers access to OTC liquidity. 

On Eurex, FX futures may be traded outside the order book as block trades or exchange-for-physicals (EFPs). Block trades are outright transactions, comparable to FX forwards. EFPs, on the other hand, comprise an FX futures leg in combination with an OTC leg in the same currency pair but in opposite directions.

The use of such ‘off-book’ trading models allows for the transfer of risk of virtually any size in a single ticket, providing uncorrelated liquidity comparable to the depth of OTC FX markets. While the bilateral trading of FX forwards and swaps has become increasingly costly from a capital and funding perspective, bilateral trading in FX futures minimises the impact of balance sheets or UMR-related thresholds.

In combination with off-book trading models, FX futures offer the infrastructure for clients and their banks to efficiently trade fully cleared FX instruments while maintaining their long-standing bilateral relationships. Market participants are therefore increasingly relying on FX futures to maintain their bilateral trading relationships.

Creating the universe for bilaterally traded FX futures

Eurex is supporting the transition of OTC FX participants into FX futures by providing a flexible framework for transactions taking place outside the order book. This framework includes the absence of minimum transaction size requirements, and a simple and transparent rule book. Eurex also offers highest flexibility for EFPs by allowing for the inclusion of a broad range of instruments in the OTC leg, such as spot, non-deliverable forwards or even FX futures traded at other exchanges.

To bridge the gap between listed and OTC FX markets Eurex also allows its clients to trade block trades and EFPs via its sister company and multi-dealer platform, 360T. Users of 360T can access off-exchange liquidity pools using request for stream/request for quote price enquiry models, as well as price streams from their OTC liquidity providers, with the resulting agreed futures trades automatically sent to Eurex for registration. This enables trading in FX futures with OTC counterparties to keep the look and feel of OTC markets, with the difference being that FX futures benefit from multilateral netting across counterparties, eliminate counterparty credit risk and reduce capital costs. And naturally, clients using an order or execution management system in their 360T workflow can easily use those for FX futures as well, allowing for an efficient use of straight-through processing, end-to-end in their trading lifecycles.

Even though this process largely mimics the processes in OTC markets, the trade participants never build up any bilateral counterparty credit risk and, therefore, optimise their portfolios under both SA-CCR and UMR when choosing FX futures. Buy‑side firms in particular are also drawn to the operational efficiencies that listed FX futures provide over traditional uncleared OTC FX transactions. For FX futures, the exchange manages the trade over its entire lifecycle and participants do not even need to enter into an International Swaps and Derivatives Association agreement or negotiate credit support annexes when adding new trade counterparties.

What the future holds

Many market participants have taken the plunge. Indeed, in 2022 Eurex onboarded a substantial number of new clients – both bank and buy side – to our FX franchise. We saw significant growth in the average daily volume and open interest on the platform. As the FX market continues to evolve, we anticipate that more banks will take steps to monitor the impact of their FX business on capital and be conscious of an increasing cost base. As a result, we anticipate that more banks and buy-side participants will turn to FX futures as means of navigating the present market structure changes.

With an increasing number of dealer banks entering the FX futures market, the emerging relevance of EFPs and platforms such as 360T connecting relevant markets, listed FX futures and OTC FX markets will form a combined liquidity pool. As a result, we will continue to see trade records in FX futures executed on derivatives exchanges – both in terms of average daily volume and peak ticket sizes.

We expect banks will utilise the bilateral trading models of FX futures as suitable instruments for transacting in short-dated FX with their clients, while reducing the impact of capital on their prices. By choosing FX futures, an increasing number of participants on the buy side will continue to enjoy the liquidity that is currently available to them in OTC markets.

Given the growing relevance of FX futures, we expect to see a growing number of single- and multi-dealer platforms to follow the lead of 360T by enabling trading in FX futures. Eurex continues to work with relevant banks and platforms to drive electronification in the FX futures market.

Eurex is also working on the introduction of flexible FX futures to help greater market adoption. These flexible futures will allow for customised maturity dates, in addition to the existing quarterly or monthly expirations. This will help participants accustomed to the flexibility of OTC FX markets.

We therefore see FX futures as a complementary instrument in OTC markets to maximising efficiencies in FX portfolios from an operational and risk perspective – all while minimising the impact of UMR and capital requirements. Derivatives exchanges such as Eurex will continue to play a crucial role in granting all participants access to FX liquidity.