UMR has increased the cost of holding OTC FX positions for the buy-side and prime brokers. This makes the traditional FX model (OTC and PB) more expensive.

Source: TradeTech FX - published by The TRADE magazine as part of The TradeTech FX Daily

The recent growth in the FX futures market is driven from two sides. Firstly, the benefits of holding a centrally cleared product vs an OTC FX trade. Secondly, recent changes made by CME Group (and other exchanges) to allow futures participants access wider OTC liquidity pools. Holding a future can have substantial benefits in terms of leverage/sum of notional calculations, margin requirements, counterparty risk, as well as operational efficiencies. Changes made to FX futures contracts in recent years have substantially reduced some of the liquidity barriers to trading FX futures, particularly in less liquid contracts outside G4 currencies. In the past, the only option was to trade on the exchanges Central Limit Order Book of the future directly, which limited sources of liquidity for larger trades. The CME have now introduced ‘EFRP’ (Exchange for Physical), so one can now agree an OTC FX trade and exchange that for a future once the OTC trade is done. This allows us to have the best of both worlds, in that one can access all available liquidity (across the CME Group order book, and the OTC market), while holding a centrally cleared product. 

Many market makers/banks continue to look at FX futures as distinct products/separate risk to OTC FX. Historically, this made sense as these products were not fungible/interchangeable. Now that CME Group allows exchange of an OTC FX trade into a future, market makers need to rethink this separation and come up with products that give buy-side participants flexibility to move between OTC and futures liquidity more easily. Most banks require a manual step to Block or EFRP to FX options and futures, this makes pricing slow and cumbersome. We need solutions that automate this process in order to make it scalable and operationally safe. 

UMR has increased the cost of holding OTC FX positions for the buy-side and prime brokers. This makes the traditional FX model (OTC and PB) more expensive. Prime Brokers are also finding their FX PB less profitable in this environment which ultimately makes it less attractive as a business for them. I expect this will lead to substantial changes in how the FX market is intermediated in the next 3 to 5 years. The two obvious alternatives to FX PB are FX futures or a centrally cleared OTC market like we have in interest rate swaps and credit. The centrally cleared OTC offering in FX is still very limited, mostly to Non-Deliverable Forwards and lacks scale due to lack of uptake. This lack of scale ultimately makes it less diversified and more expensive at present. This leaves FX futures as the most attractive option, for now, to gain FX exposure in a scalable, cleared market. 

Building a knowledge base on how the FX futures market works and different ways to access various pools of liquidity is a key starting point. For some currencies/trade sizes it might be optimal to trade on the central limit order book of the exchange, while trading FX futures in less liquid currencies in large size, it is essential to understand how one can gain access to OTC liquidity, using EFRPs and Blocks to translate this into a future. 

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 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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