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08 Feb 2024

Eurex

The electronification of cleared FX

With the Eurex Derivatives Forum Frankfurt taking place at the end of this month, we caught up with Shuo Wu, Global Head of Forward e-Trading at Deutsche Bank. We discussed the path forward for cleared FX derivatives, how the industry is overcoming the challenges of migration from OTC and where to expect innovation in the market.

Dealers have been increasingly keen to move OTC FX activity into the cleared space, to reduce their leverage and balance sheet footprints. What steps are they taking to convince clients to make the transition too?

If you look at the everyday FX trading volumes being reported through CLS, more than half the activity is coming from FX swaps and FX forwards. That can amount to between $2 trillion- $4 trillion on any given day. Both products are entirely executed on OTC platforms, either single-dealer platform or multi-dealer.

Since the introduction of SA-CCR, these products have represented very low fee, small margin business for banks. They are often treated as a service that we provide to clients in return for higher margin business.

The volume of transactions is large and the needs of clients diverse. That makes the traditional way of creating FX futures —which currently only trade according to IMM days — very difficult to match with client demands for services like monthly rolls on their forwards.

This means that many clients can’t move their existing OTC trades to an exchange traded format. So, they lose benefits such as aggregating all their credit lines and holding one margin account instead of posting CSA against every single counterparty. They also have to worry about who they opened up their position with, whereas with cleared futures, their counterparty risk will be exactly the same at the end of the day.

A standard OTC client cannot enjoy these benefits because the FX futures market represents a subset of the products offered on the OTC side. In OTC markets, the product range is very diversified — you can access forward starting swaps, spot starting swaps uneven swaps, batch trades and multi-lag allocations, to name a few.

To address this imbalance, we are working with exchanges to roll out a new exchange-traded product called daily futures or flexible futures. This will use the same margin calculations as other cleared products. However, instead of having to be executed in a Central Limit Order Book on IMM dates, we allow people to trade the products off-exchange, in the OTC markets.

This mechanism means they can leverage OTC pricing and deeper OTC liquidity pools, constructing the trade one-on-one with their counterparty. After, they can flip the trade through an Exchange for Related Position and turn the OTC exposure into a future trade that faces an exchange.

These flexible, or daily futures, can be settled on any date, not just an IMM date. This will allow more market participants to enjoy the benefits of facing a clearing house instead of bilaterally facing a bank. This should create a very different dynamic in FX trading.

For banks, the regulations and capital requirements that make OTC products a drain on our balance sheets do not apply to a clearinghouse or exchange. Moving a trade from OTC to exchange not only benefits clients, but also significantly reduces the footprint of the banks providing the business. If we are able to save on overall costs by 50%, most firms will be happy to share that saving with our clients and further improve the pricing we offer.

What challenges do users face when they transition from OTC to cleared FX?

The biggest challenge is adapting existing workflows. OTC transactions are executed very differently from the workflows involved in the STP process for futures. The majority of our OTC clients, whether they are corporates, real money or even retail platforms, do not have any previous experience or expertise in how to connect to futures. It would take years to transition those end users and would also require a lot of technology investment.

We are looking at ways to embed the benefits of futures trading into existing OTC workflows. For example, Eurex has a partnership with 360T, which is a traditional OTC platform with significant market share and client penetration on the OTC side.

In an ideal future situation, clients will be able to request pricing from five banks for an FX swap trade and tick a box so that when the trade is confirmed it automatically converts into a futures position facing a clearing house.

360T and Eurex will create the pipelines to post the futures, but also work with the banks to facilitate OTC confirmations, OTC cancellations and booking the futures — essentially all the necessary technology work.

For the end user, they just have to tick a box and experiment with the product, rather than being forced to spend hundreds of thousands, even millions of investment dollars without knowing what actual benefit they're going to get.

Another difficulty is the commercial aspect of trading. In FX swaps, common practice is a broker schedule that depends on the maturity of the transaction. So, a short-dated swap, normally used for funding, that matures next day, will be charged at around one cent to five cents per million. But a longer-dated swap, that matures three to six months later, will be charged at a much higher rate than normal IMM trades.

Exchanges currently charge a standard fee for their FX futures. There's no variation by risk or tenor. Market participants transitioning to flexible futures or daily futures will have to gradually work out a solution. This will have to calculate a brokerage fee on a trade-by-trade basis based on tenor so that the costs that both counterparties face when moving exposures to exchange will be appropriate and on the same level as the bid/offer spread they're paying for OTC execution.

Taking a step back from clearing, where else do you see innovation taking in place in the FX market in the future?

The FX future looks thrilling in 2024 and 2025 – with electronification taking center stage in FX forwards and swaps. These established e-trading products are about to undergo a revolutionary transformation, breaking free from limited interactions with banks. No more opaque RFQs — transparency is the new name of the game, with TCA analysis catching up to speed.

Swap TCA analysis is in for a makeover, offering clients a clear evaluation of execution approaches. Drawing on the advanced technology of spot FX, we are set to shake up the offering for FX swaps. Clients will soon enjoy tools such as standardized vanilla order executions, limit orders, and clients leaving orders instead of paying the spread. Spot algos like TWAP, VWAP, and PEG orders are set to make a grand entrance into the swaps arena. The spot side already boasts a plethora of algos, and swaps are gearing up for a similar transformation. Get ready for DB to pioneer swap algos, soon to be featured on Autobahn and multi-dealer platforms, offering traders unprecedented flexibility and customization.


Join the Derivatives Forum Frankfurt on Feb 28-29 and hear more about this topic.

Speakers: 

  • Carlo Kölzer, Group CEO, 360T Group
  • Shuo Wu, Global Head of Forward eTrading, Deutsche Bank
  • Marco Murgida, Head Markets Sales, Bank Julius Baer
  • Further speakers to be announced

Moderator: Radi Khasawneh, Derivatives Editor, FOW

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