FX Futures swell as SA-CCR and UMR come online

The tsunami of trading volume from the OTC FX market to futures that some predicted when uncleared margin rules began to kick in has not happened. Instead, exchange traded FX volumes have steadily swelled higher, building a robust momentum that is set to increase with incoming regulation.

For all that the UMR roll-out is making FX futures trading an attractive product, it is not making it obligatory. That has meant that market participants have not faced a cliff-edge transition, as some expected. Instead, the rules have instigated a step-by-step process. This seems most likely to lead to a hybrid market, where listed and OTC products co-exist.

“The lack of a wave doesn’t mean that the interest is not there,” says Jens Quiram, Executive Director, Head of FX Derivatives at Eurex. “Nor does it mean that the development of a hybrid market will not happen. Instead, it will be a slower progress."

“People are reluctant to change their entire workflow from one day to another. This means risk and effort. Market participants are instead transitioning some of their portfolios, testing and moving them step by step into the workflow. It is not a big bang approach."

“Once people have tested and seen the benefits of FX futures, they will move more in this direction. The benefits are crystal clear, especially under UMR. It means multi-lateral netting and significantly reduced funding costs.”

Those already making the transition are very pleased with the results. Christoph Hock, Head of Multi-Asset Trading at Union Investment, and his team have now moved 15-20% of the existing FX forwards position into futures. He describes the transfer as “a tremendous success story for FX futures."

"We have clearly seen a tendency away from business traded in a bilateral way towards a centrally cleared business."

- Christoph Hock

“It fits absolutely into the strategy we have as an asset manager,” says Hock. “Looking at our derivatives business as a whole over the last four to five years, we have clearly seen a tendency away from business traded in a bilateral way towards a centrally cleared business. And centrally cleared business means either you stay in the OTC world like fixed income [swaps] or in FX either go into the listed future business or NDFs and trade a centrally cleared version."

“This central clearing element is a key component of our strategy in derivatives - to deliver a highly robust, best in class service to our end investors.”

Hock adds that the lower liquidity in futures compared to the OTC markets was less significant because of the high liquidity in the underlying instruments itself and the mechanism of EFRP (Exchange for Related Position Transaction). He pointed out that his desk’s experience in other products, like MSCI World Index Futures, where the derivatives’ liquidity had started low before improving, had helped with their adoption of FX futures.

That liquidity is already building, and it is important not to mistake the lack of an UMR big bang for a dearth of liquidity. A steady move is happening and those involved in the market are witnessing healthy growth.

“We are already witnessing this shift to an extent,” says Scotte Moegling, Institutional Trading at Flow Traders, “with exchanges and ourselves seeing an uptick trend in FX futures blocks recently. 

“We have observed requests coming in from new counterparties, and an increase in inbound price requests from historical relationships, which has translated into higher volumes for us as a market maker in these products.”

SA-CCR set to provide extra push

The effects of UMR’s final phase are set to be more subtle than expected. But FX futures are also set to receive a regulatory boost that has carried less headlines than UMR. SA-CCR, which has been phased in since its became effective in 2017, is set to make the capital cost of servicing directional clients very punitive for some banks, who may have to increase fees to compensate.

“In FX, the impact of UMR has been consistently overestimated over the phases of its implementation and I feel that that is going to be the case with phase six as well,” says David Reid, Managing Director, Global Foreign Exchange at Deutsche Bank. “There is a slow burn impact to it where some clients will modify behavior but there is no cliff edge to UMR because of the way it has been implemented."

"SA-CCR in FX is going to have a bigger impact than UMR"

- David Reid

“If anything, I think that SA-CCR in FX is going to have a bigger impact on the short to medium-term evolution of this marketplace. Because of the way it has impacted on short-dated forwards in particular. I think there is a potential for it to really accelerate the way banks especially look at this segment of the market. Certainly, a greater impact than UMR will have on behavioral change.”

Flow Trader’s Moegling agrees: “There is a limitation with operational efficiency that can be gained to minimize the impact of SA-CCR for such businesses, and it will come to a point where the only variable to toggle will be the fees they charge such clients.  This increase could come as an increase in prime fees or via bid-ask the bank is quoting. 

“This will factor into the assessment firms are performing for their cost of execution, and if increased enough could make the futures market more appealing. If this holds true, it would be another driver for liquidity to pick up in the futures space, which could present a compelling argument for others to see the execution benefits over OTC.”

Ultimately, the listed and OTC FX markets are set to exist in harmony. This effects of this are already starting to be seen in products like Eurex’s monthly FX options, which are unstandardized contracts designed to mimic the flexibility of OTC options but in an exchange traded environment.

“I 100% think FX derivatives will be a hybrid world,” says Quiram. “The OTC market is so huge, flexible and liquid. There are so many currencies there that cannot move under the exchange and CCP umbrella. I think it will stay hybrid and the OTC market will remain the main place for liquidity.

“The question is how can you combine these two worlds. The biggest objective for the ETD market is how can it be linked to the OTC market. How can a user benefit from the OTC liquidity as well as benefiting from the multi-lateral netting and the position netting capabilities of a CCP?

“If exchanges and CCPs can offer very flexible ways of linking these two worlds this will help the ETD market to grow and increase the offerings of both OTC and ETD liquidity.”