CME Group offers the largest regulated marketplace for FX in the world, covering more than 40 currency pairs across both G10 and EM. Average daily volumes for Listed FX futures and options in September 2022 were over $120bn, with single day record volumes in 2022 surpassing $230bn, helping to illustrate the liquidity available in CME Group FX futures as a complement to OTC FX markets.

Transtrend is a leading systematic investment manager who specialize in trend-based investing with over $6bn in assets under management.

This interview features:

• Phil Hermon, Executive Director for FX Products at CME Group, based in London
• Harold de Boer, Managing Director at Transtrend, based in Rotterdam

Transtrend: We currently trade 28 currencies in 70 different currency pairs, mostly through futures contracts. We trade only nine of those pairs as OTC forwards/NDFs. For many of the other 61 pairs there isn’t an appropriate futures contract available either, but we trade these ‘synthetically’ by combining two existing futures contracts. For instance, we trade Japanese yen against Korean won and Indian rupee against British pound by combining yen/dollar and pound/dollar futures listed on CME Group with dollar/won and rupee/dollar contracts listed on Asian exchanges. We also trade currency futures as part of ‘hybrid’ cross-sector combinations. We, for instance, trade various commodities against the euro by combining U.S. dollar denominated commodity futures with euro/dollar contracts listed on CME Group.

Transtrend: We are strong advocates of centralized clearing. The long history of futures trading has proven this to be a particularly strong concept. From time to time there have been individual market participants that have traded quite recklessly – just think about the Hunt brothers in the silver market, Nick Leeson in Nikkei futures, Amaranth in Natural gas, or Einar Aas in Nordic power – but in none of these cases the participants at the other side of the trades were dragged down with these crash pilots. Compare that to what happened to the counterparties of the OTC trades of LTCM and Lehman Brothers!

However, as the recent nickel debacle has reminded all of us, this virtue is not a sure thing. Exchanges do have to be strict in order to preserve this strength and to help us manage the risks to our clients’ money. There are many different stakeholders with potentially different agendas and different expectations about the functioning of exchanges, and we continue to partner with all the exchanges we trade on (including CME Group) to ensure that the right balance is being struck between conservative risk management and optimizing scarce resources.

Take for example margin requirements. Having to deposit less margin may sound very attractive from a cost of capital point of view. However, having the assurance that all participants are depositing enough margin for the risks they are running ultimately means more to us as it is an effective insurance against counterparty credit risk. That's why we don't necessarily cheer when margins are lowered. We will start asking questions when we believe margins are too low and hope that other market participants do so too.

Transtrend: Our view on liquidity has changed fundamentally in the last 10 years, and with that, also what we expect from exchanges in this respect. We used to see ourselves as pure liquidity takers. And exchanges as the liquidity pools that we could tap into. Futures exchanges still paint this picture, showing volume and open interest charts as proof of the liquidity they are offering. But the simple fact is, exchanges cannot offer liquidity. They can only offer the infrastructure that enables market participants to offer liquidity. Exchanges are simply the marketplace; they are not the market.

In the past, whenever we weren’t happy with a futures contract’s liquidity, we asked the exchange to improve it. Which, in the specific case of FX futures, really wasn’t that difficult; the exchange designs incentive programs for market makers to offer liquidity in the futures contract. Furthermore, market makers receive a liquidity premium for this service and we essentially paid that liquidity premium in return for avoiding any OTC counterparty risk.

Over time, we realized that this was not exactly our role in the market. Nowadays, we see liquidity premium as just one of the various types of risk premium that can be either paid or harvested. Our clients are investors; they expect to receive a risk premium, not to pay it.

We are not blind to the peculiar characteristics of the FX market. It is still highly fragmented and there is a lot of trading done bilaterally. By extending the panel of liquidity providers for relationship-based trading via blocks and EFRPs, CME Group created a bridge for new entrants to dip their toes into the futures market. Participants have more choice on how and where to trade, which has a longer-term positive impact on the volumes traded in the central limit order book.

7orca: There is no straightforward answer to this question, as the choice of instrument always depends on the individual situation of the client and the regulatory framework or market environment he is operating in. Therefore, it is subject to a certain dynamic. 

In situations of market stress the picture can deviate largely. FX futures become even more appealing as, unlike FX OTC forwards, they do not bear counterparty risk to a financial institution. This feature is particularly important during periods of market uncertainty, and has helped the widespread acceptance of FX futures by our clients to help mitigate their counterparty risk.

Transtrend: Different participants may have different expectations about the functioning of an exchange. Is an exchange defined as a place where investors can buy or sell at the advertised price? Or is an exchange a place where participants willing to buy and participants willing to sell meet to negotiate a fair price? We would say that the first definition defines a shop, while only the second definition defines an open outcry exchange. We regularly touch upon this subject in publications around Responsible Investing. When running a shop, you don’t need your clients to offer liquidity. You offer that yourself at prices you determine yourself. But where does a shop owner base its prices on? Most just look at the prices set somewhere else.

From our perspective we feel that CME Group’s order book and marketplace does act as an exchange rather than a shop – providing an all-to-all and any-to-any structure where everyone can see, provide, and access the tightest pricing on a credit agnostic basis. This model allows buyside customers like ourselves to provide liquidity, to earn the spread, and to trade on a peer-to-peer basis.

Transtrend: We consider price discovery to be one of the main roles of (above all futures) exchanges. Or to be more precise: one of the main roles of the participants trading on these exchanges. They have to negotiate fair prices. This price discovery is closely linked to the offering of liquidity. Both are dependent on participants that are willing to sell at prices above what they consider to be the fair price and on participants that are willing to buy at prices below what they consider to be the fair price. To make this work requires exchanges that accept the prices set by their participants. Not exchanges that adjust these prices to the benefit of participants that just blindly submit orders, and by doing so, undermine the price discovery process.

Transtrend: While we’ve certainly had some discussions with CME Group on this topic in the past, nowadays we believe this process functions very well. Especially around the moments when liquidity and price discovery are required the most. For instance, around interest rate decisions by central banks. FX futures listed on CME Group typically spike immediately after such a decision, often in two directions, reaching a new equilibrium within minutes. I can hardly think of a more efficient way of price discovery.

Transtrend: In my opinion, around such crucial events, it’s even more efficient. In the cash market, banks and executing brokers still tend to use the last look principle and might decide to cancel orders that have a negative impact on their trading book during news moments.