Motivated in part by their need to fulfil fiduciary responsibilities and to address regulatory headwinds, institutional Asset Managers have beenare increasing their adoption of listed FX futures and options on futures. Over the the past five years, this trend has picked up pace as Managers have increasingly chosenose to augment their FX trading activities with listed FX derivatives in order to diversify their risk, reduce counterparty credit exposure, mitigate UMR impacts, and/or to access over $88bn of additional daily liquidity.
On days of big market moves, this activity is even more pronounced. As CME is the largest regulated venue for listed FX futures and options globally, volume can reach more than treble the average daily volume1 as large players in the FX market turn to the CME for efficient transfer of risk.
Crucially, data shows that buy-side volume and open interest are now key driversfeatures of that activity. Notably, 498% of all open interest in CME EUR/USD futures is now held by Asset Managers, reflecting a noteworthy migration to listed FX from, or in addition to, traditional bilateral OTC FX.
Over the last 10+ years, overall assets under management (“AUM”) have been steadily increasing in the asset management community. It is estimated that by 2025 AUM will rise from US$84.9 trillion in 2016 to US$145.4 trillion in 20252, andbut the greater weighting towards passive investment means cost pressures have never been more relevant.
Further themes surrounding conduct, best execution, compliance, fiduciary responsibility and connectivity have also come to the forefront for the Asset Management industry. As a result, there has never been more scrutiny than ever before on the selection of instruments, venues, methods and markets which are both acceptable and optimal for the execution of derivative transactions.
Collectively, more real and leveraged money managers are turning to listed FX derivatives as an efficient complement to their OTC FX trading activity, reflecting rising comfort with these products, mechanisms and rules in line with their experiences and use of listed Equity and Interest Rates products.
1. Central limit order book: Solves for firm liquidity and “best-execution” requirements
As ‘last look’ practices (which allow banks and liquidity providers optionality to cancel trades) have been challenged and the FX Global Code of Conduct has been embraced, more asset managers are encouraged by the clear rulebook, firm liquidity and absence of ‘last look’ in regulated marketplaces such as CMEabsence of these practices at regulated exchanges3. CME Group’s cCentral lLimit oOrderbook is an all-to-all marketplace where all participants have access to the same price. Additionally, all trades are governed by venue rules, and full transparency enables any clientAsset Managers to demonstrate they achieved ‘best execution’.
Furthermore, studies have shown that Asset Managers are able to trade passively within the listed FX futures order book – meaning that they do not need to ‘aggress’ in to the order book by hitting the best bid or lifting the best offer. In a study conducted by Greenwich Associates4 participants reported executing FX futures at mid, 35% of the time on average. As such, even the narrowest of spreads available in an aggregator may be avoided to further improve execution TCA.
2. Optimal execution: Solves for flexible execution with a variety of trading styles
Historically, one of the greatest impediments to large scale adoption of FX futures by traditional Asset Managers was the lack of flexibility in order execution. In the current ecosystem, most participants prefer the anonymity and scalability of executing electronically on CME’s Globex platform, but buy-side clients can also utilize futures Blocks or Exchange for Physicals (“EFPs”) to transact directly with their preferred liquidity provider(s) and thus leverage relationships and workflows from their bilateral OTC activity.
In addition, new products in the listed derivative marketplace have helped further connect the OTC and listed ecosystems. FX Link provides an automated bridge for clients wishing to trade in the OTC market and then transition that risk in to cleared futures. A prominent use case for FX Link is for buy-side customers who trade spot FX algorithmically and wish to roll their position forward – clients are now able to roll forward in to a listed FX future using the FX Link CLOB instead of transacting the roll bilaterally with the spot provider, conveniently accessing listed liquidity and the efficiencies of a centrally cleared model.
3. Confidence in compliance: Solves for Uncleared Margin Rules
Uncleared Margin Rules (“UMR”) are encouraging many clients to reconsider direct and indirect costs involved in their OTC bilateral activity. FX FWDs, NDFs, Swaps and Options are all included in the Average Aggregate Notional Amount (“AANA”) calculation to determine whether and when each client is directly impacted by UMR5. Once impacted, bilateral FX options and NDFs are then included within the ISDA SIMM calculation for the 2-way Initial Margin requirements under these new regulations.
Listed and cleared FX derivatives on the other hand are exempt from the AANA calculation and can potentially benefit from the netting of market positions against a central counterparty (“CCP”), portfolio offsets across asset classes and a reduced IM burden when compared to ISDA SIMM.
The ever-evolving regulatory landscape, need to deliver cost and operational efficiencies and rising capital impacts on dealer banks trading OTC derivatives, point towards reinforcing the business case for asset managers to seriously consider moving portions of their FX trading activity to exchanges.
This paper contains three of the most prominent catalysts that are driving client adoption of listed FX futures, but other potential catalystscapabilities include the capital efficiencies for dealers (and ensuing potential for better pricing for the buyside) as well as operational efficiencies (including no need for bilateral credit lines or ISDA master agreements with multiple trading counterparts). Furthermore, product enhancements in the listed marketplace continue to make futures products to complimentever more complementary to the its OTC marketcounterparts and make it easier for institutional participants traditionally only familiar with OTC FX, to make the transition.
The catalysts for change and adoption of listed FX futures noted above will be relevant to different degrees and at different times to each individual firm – but the growing number of customers, record volumes and record open interest in CME FX futures (as of February 18 2020), suggests that a wave of transition may now be well underway, and that it is being led by Asset Managers.
For more information or to discuss any of the themes detailed here, please contact your CME account representative or firstname.lastname@example.org.
Authored by Divay Malhotra, Director, FX Products CME Group
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