Foreign exchange futures were the very first financial futures contracts traded globally. Once the domain of institutions such as central banks, commercial banks and large corporations, trading in FX or forex futures has begun to blossom at the retail level. The history of retail foreign exchange trading starts in the 1970s with the creation of the International Monetary Market (IMM) by CME Group’s then Chairman Leo Melamed.
When the Bretton Woods international monetary system collapsed, and U.S. President Richard Nixon closed the gold window – ending the convertibility of U.S. dollars to gold – in August 1971, every nation had to adjust their currencies’ value to the U.S. dollar. This served as an impetus for Mr. Melamed to introduce FX futures, an idea supported by Nobel laureate, economist Milton Friedman, who had long been an advocate for floating currency rates.
The FX futures market began trading on May 16, 1972. At the end of the first day, 333 contracts were transacted across the British pound (GBP), Canadian dollar (CAD), Swiss franc (CHF), Deutsche mark (DEM) and French franc (FRF)). By the end of 1972, an impressive 144,928 contracts were traded.
As the FX financial futures market developed in the 1980s, various major brokers engaged in active arbitrage between the FX futures and OTC FX spot markets, providing excellent liquidity for both retail and institutional clients.
The FX futures market was available to any retail futures trader with an account at a futures commission merchant (FCM), and participation by retail traders was a part of the early success of these products.
Note that retail FX activity had already been going on since the 1970s. This paper focuses on the period since electronic FX platforms developed in the 1990s, an innovation that led to the surge in retail FX trading activities that has endured until today.
Prior to the 1990s, FX trading was the domain of financial institutions. The rise of the internet led to the eventual proliferation of trading software, paving the way for interest to build among retail FX traders. And as FX brokers started to allow trading on margin, this sparked the growth of retail FX trading around the turn of the century.
Around 1996, the first generation of web-based FX trading platforms came online. Retail customers were able to access the FX markets and trade currency pairs from their own personal computers.
Initially, trading platforms used basic programs that had to be installed on home computers. As better interfaces and charting tools developed, more innovative platform solutions followed. Today, retail FX traders can trade via web-based platforms on their mobile telephones.
As the retail FX market grew, the institutional FX market gradually converged with it. The average size of institutional spot FX trades came down from over $5 million per transaction in the early 2000s to about $1 million, overlapping with retail spot FX trades.
The Triennial Survey in 2013 was the first time the Bank for International Settlements had reported retail-driven FX trading volumes as a distinct category. The 2016 Triennial Survey published in September this year showed that global spot FX average daily trading volumes (ADV) had remained stable at around $2.0 trillion to $2.1 trillion per day.
This is also validated by analyst estimates based on semi-annual surveys by Foreign Exchange Committees of major banks, and are shown in Figure 2.
Based on the Triennial Survey, retail FX average daily volume (ADV1) had increased to $238 billion in 20162 from $185 billion in 2013, with other estimates3 placing retail FX ADV peaking at $415 billion in 2012. The 10 largest retail FX currencies, most of which are traded against the U.S. dollar, are shown in Figure 3.
Despite the “retail” label, most of the trading in this segment is done by former exchange, bank, and hedge fund trader-types who now trade from professional offices at home or satellite offices via computer.
Individual, non-professional traders account for only a small fraction of the retail FX market volume.
Retail FX traders mostly take directional trading views on macroeconomic events. Arbitrage strategies are not that commonly practiced as that requires waiting for prices to converge, which could take weeks – tying up capital. Retail FX traders predominantly day trade and do not hold term-trading positions.
Single-bank portals and electronic communications networks (ECNs) such as Currenex and FXall generally do not offer retail clients access to their platforms. Retail FX traders mostly trade FX via a retail FX broker, or an FCM in the case of FX futures. The various cost models used by retail FX brokers will be analyzed in a separate study.
A common FX product offered to retail clients in Asia is the contract for difference (CFD). This is a contract created by the broker who offers its own price quotes and bid-ask spreads to its clients. Typically, the broker would accumulate all those small orders into larger orders and trade the large orders in the Over- the-Counter (OTC) market (through EBS BrokerTec, ECNs or bank portals).
Retail brokers, such as eTrade and TD Ameritrade, may also provide retail traders access to FX futures contracts.
Basically, a futures contract is an agreement to buy or sell something at a set price at a set date in the future. One can buy a contract that expires in September 2016, and a separate contract that expires in December 2016, for the same underlying asset.
In contrast, a CFD has no set future price and no set future expiration date. It is essentially a spot contract that rolls over every day.
In institutional FX trading, where a position may be held for relatively long time periods, the differences between trading spot and futures, and between trading futures contracts with different expiry dates, may matter.
However, retail FX traders tend to hold their trading positions for a relatively short time horizon, ranging from a few days to a few minutes. And, they typically trade the most liquid futures contract month. So the differences between CFDs and futures tend to be largely irrelevant, as far as trading strategies are concerned, to a retail trader.
However, the bilateral risk exposure needs to be carefully considered when trading FX CFDs.
The key difference between OTC instruments and futures contracts is the risk mitigation measures that have been put in place. The fact that the Dodd-Frank Act, and Consumer Protection Act in the United States, and the Markets in Financial Instruments Directive (MiFID) in the European Union (EU) are advocating the central clearing of traded OTC products on regulated exchanges attests to the importance placed on robust risk control systems to protect retail investors.
The key benefit of trading FX futures is the risk mitigation by central clearing through a clearing house. A retail FX broker faces bilateral credit risks when offering FX CFDs. The potential losses posed by bilateral credit risks which are not cleared and settled, to both the broker and the retail trader, are well documented in the Swiss franc event, described below.
On January 15, 2015, the Swiss National Bank (SNB) unexpectedly announced its decision to stop supporting the EUR/CHF rate6.The background was that the SNB had concluded that, with the depreciation of the euro against the U.S. dollar, it was no longer justified to cap its currency at 1.20 CHF per euro. The CHF promptly fell to 0.99 CHF per euro that day.
CFD FX traders who had placed stop-loss orders with their brokers were not able to execute these trades at the stop-loss points. Retail FX brokers were not able to get corresponding prices from their spot FX liquidity providers or prime brokers. Many retail FX brokers suffered millions of dollars in losses as a result of the SNB action to decouple the Swiss franc from the euro.
In contrast, the FX futures market rode through the turbulence with no payment or physical delivery defaults. The USD/CHF and EUR/CHF futures markets remained liquid throughout the trading day, and contracts cleared through the CME Clearing House were all settled.
As a result of the CHF event, some jurisdictions have imposed limits on the amount of leverage available to trade FX, largely to protect retail traders.
For example, even though retail FX brokers are advertising offers of 200 times leverage on their online portals, restrictions are imposed by local central banks. This means that, in many FX markets in Asia, actual leverage limits that can be extended to retail customers may be as little as 20 times or less of their deposit.
Financial regulators in some countries have also mandated health warnings to be posted by retail FX brokers about these types of trading activities.
FX trading has often been promoted to the retail market in Asia as an easy way to make money. However, retail FX traders do not have the financial protections that apply to institutional traders. In the U.S., the Dodd-Frank and Consumer Protection laws have shifted derivatives trading to regulated exchanges such as CME Group.
As a result of the tight regulation of retail FX trading, the number of retail customers trading FX via online portals has historically been relatively small in the U.S. However, regulatory enforcement may not be as stringent in Asia compared to the U.S., and retail FX is still a thriving segment of the Asia FX market.
The retail FX market is driven largely by volatility. Despite the restrictions and tight regulation, retail FX has remained vibrant, and currently trades over $282 billion per day globally7.
With tighter market regulation and closer scrutiny, retail brokers offering CFDs on FX have imposed higher collateral on their clients, and lowered the leverage offered to retail FX traders.
However, with renewed awareness in risk mitigation, retail brokers are increasingly widening their product offers to include futures products, which were once perceived to be ‘too risky’ for the retail market but whose risk mitigating features are now increasingly being recognized.
1 A large proportion of retail FX is transacted as contracts for difference (CFD) trades. Although intended to be traded as spot, CFDs are classified as swaps in the Triennial Survey. Retail FX figures include FX spot and FX swaps from the survey.
3 Raymond James industry report dated 9 December 2014, and estimates based on semi-annual surveys conducted by New York, London, Tokyo, Singapore and Canada FX Committees.
4 Note that each side of a traded currency pair is separately counted, so the sum of all the currencies would have added up to twice the total global figure (i.e., the sum of FX spot and FX swaps that are retail-driven).
5 The term ‘CFD’ tends to be used for commodities asset classes. The term ‘Margin FX Trading’ tends to be used for FX. However, ‘CFD’ is used here to distinguish it from the spot FX offered by retail FX brokers via the prime broker model.
7 BIS 2016 Triennial Survey – total FX volumes which are retail-driven.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
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