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General Education

26 NOV 2020

Replicating OTC FX Market Positions with CME FX Futures

By CME Group

In this white paper, we explore the advantages that CME FX futures offer traditional market practitioners in the OTC FX markets, and how they can be used to replicate cost-efficient, manageable synthetic exposure to OTC FX spot, forwards, and swaps.

A cleared and capital efficient pool of additional liquidity

The industry has changed an appreciable amount since 2017 with the imposition of new market regulation including Basel III, the revision of the Markets in Financial Instruments Directive (commonly known as “MiFID II”), and the Uncleared Margin Rules (UMR), with phases 5 and 6 still to come in September 2021 and September 2022, respectively. These new regulatory frameworks have been designed to protect OTC market practitioners, but in turn, have introduced new burdens and costs that many now wish to optimize. CME FX futures, traded on a highly liquid, regulated exchange, can offer an attractive alternative to many OTC FX trading strategies.

CME Group offers 53 FX futures contracts on 40 different currency pairs. This product offering covers all major currencies, including cross rates, and a wide range of emerging market currencies. At settlement, futures on major currency pairs are physically delivered, with settlement supported by CLS. Where appropriate, emerging market currency pairs are cash settled to an industry standard reference rate. CME Group’s FX futures can be traded electronically via a range of trading platforms1 and can also be privately negotiated directly with chosen liquidity providers2.

With monthly and quarterly expiries, CME FX futures can provide market practitioners with IMM-dated exposures that cover the first six months of the FX forward curve – capturing the vast majority of FX forward and swap trading activity. These products can be traded both as outrights and as spreads, and so can be effectively used to replicate a variety of cost and capital efficient FX forward and FX swap positions.3 Furthermore, because FX futures on major currencies are physically delivered, they are highly correlated with the underlying OTC FX markets and are able to provide market participants with a simple, cost-efficient, and standardized alternative for OTC FX spot.

Key features of CME FX futures

Potential margin efficiencies

The key features of FX futures, with respect to initial margin, include the use of SPAN for the calculation as opposed to a bilateral model such as ISDA SIMM, the netting of positions against a central counterparty (“CCP”) (which reduces overall exposure and enables cross margining of positions within the portfolio), the standardization of eligible collateral that can be posted, and portfolio margining of FX positions versus other asset classes such as interest rates, commodities, and equities. 

Capital efficiencies

CME FX futures offer a way to alleviate Basel III capital costs. Risk weighted assets, total leverage exposure, and liquidity coverage ratio related costs are reduced considerably by compressing exposures against a highly regulated and well capitalized CCP. Furthermore, banks are not required to include any credit value adjustment (“CVA”) charges on CME FX futures.4 In contrast, OTC FX forward and swap traders must contend with gross mark-up of market positions on a counterparty by counterparty basis that substantially increases capital surcharges based on total risk-weighted assets5, CVA charges, and liquidity requirements. In turn, these factors are likely to impact end user customers via differing bid-ask spreads – especially on longer dated positions.

CME Central Counterparty Guarantee

CME Clearing serves as the counterparty to every transaction and substantially mitigates counterparty credit risk for every market participant. In its more than 100-year history, there has never been a failure of a clearing member firm resulting in a loss of customer funds, verifying efficiency and stability to the market. This model enables customers to access an extremely diversified ecosystem of liquidity providers without ever needing bilateral credit lines, master trading agreements, or any counterparty risk against them.

Regulated marketplace

CME is a regulated designated contract market where the activities take place under a set of rules and regulations, in a transparent and systematic manner. In contrast, the OTC FX market is highly decentralized, with counterparties often dealing directly with each other on a bilateral basis. CME Clearing is also a regulated designated clearing organization, subject to the jurisdiction of the Commodity Futures Trading Commission and rules and regulations of the Commodity Exchange Act.

FX Global Code of Conduct

The FX Global Code of Conduct is a set of principles of good practice for foreign exchange market participants. It aims to promote the integrity and effective functioning of the wholesale foreign exchange market. The BIS market committee called for more participants to adopt the code after launching in 2017 and it is now widely affiliated. CME FX futures markets are aligned with the principles of the FX Global Code; futures promote a robust, fair, liquid, open, and transparent market in which market participants are able to confidently and effectively transact at competitive prices that reflect available market information and in a manner that conforms to acceptable professional standards of industry behavior.

Low operational cost

CME FX futures effectively remove the need for entering into time-consuming ISDA® Master Agreements and Credit Support Annex’s (CSA’s). In OTC FX, these are necessary for establishing, managing, and maintaining bilateral collateralization; for posting counterparty credit surcharges; and to manage counterparty credit exposure rules. With CME’s FX futures, participants have a single agreement with their clearing member firm, which streamlines the process for initial market access as well as making it cheaper to maintain on an ongoing basis. 

Firm liquidity on central exchange

Liquidity is notably one of the most important conditions when trading, which can mean the ease of trading (the speed or effort required) and the quality of prices (for example, any slippage between the expected price and executed price). CME FX futures can provide firm real-time liquidity that is traded anonymously on an all-to-all basis and with no last look. These features of FX futures can provide all customers with the same level of price discovery, transparency, and certainty of access to the best price available. 

All-to-all marketplace

As a CLOB marketplace, CME’s FX futures enable all traders on the system to see and trade with all active orders. As FX futures are a centrally cleared product, it enables traders from all entities to access the market on the same terms (credit agnostic) and to certainty of execution, given that it is a ‘hard credit’ model. Combined, these attributes mean that a trader can trade anonymously with thousands of counterparties and always access the best price available in the market.

Multiple trading methods supported

Traders can access FX futures via multiple trading modalities depending on their preference, technology, and size of order that they wish to transact. Electronic trading directly in to the CLOB enables traders to either aggress into the existing liquidity being shown in the order book or to work orders over a period of time, in order to potentially achieve a better cost of trading for larger positions. Firms that utilize algorithmic trading are especially well-suited to interacting with the CLOB. Additionally, customers can choose to use either blocks or EFRPs to trade on a relationship basis by privately negotiating deals with their chosen liquidity providers outside of the CLOB.

Replicating OTC FX spot exposure with CME FX futures

In the FX spot market, institutional market participants – i.e. asset managers, banks, and hedge funds – will establish a long or short position in FX spot and then maintain this position by ‘rolling it forward’ – to a date in the future, typically anywhere from two weeks to one year. This is to extend the settlement date of the open position and avoid physical delivery of the currency; spot delivery being typically two days post transaction date6. Market practitioners using this technique usually want to hedge against or capitalize on changes in exchange rates and thus have no immediate intention of taking physical delivery of the currency they buy.

CME FX futures can be used to replicate this position and create synthetic spot exposure whilst avoiding the costly process of rolling positions on a daily basis. Institutional participants commonly focus their trading on the front quarterly CME FX futures contract since it is generally the most liquid expiry in the CLOB, thus making it the preferred expiry to replicate FX spot positions.

Example of replicating OTC FX spot exposure with CME FX futures

Assume that a hedge fund thinks the Canadian dollar will depreciate steadily versus the US dollar between September and mid-December, and therefore wants to modify its FX book to reflect this view. To do this, the fund would sell 15 million CAD on September 16 in the OTC FX market and then roll its position daily until Tuesday, December 15, when it closes out the position to avoid physical delivery. In doing so, transaction costs and interest costs are incurred daily.

Alternatively, the hedge fund could replicate its FX spot position by selling 150 CME CAD/USD futures contracts with a December 2020 quarterly expiry date on September 16. In order to calculate the number of futures contracts needed to replicate the position, take the notional size of the trade and divide by the notional size of the CAD/USD futures contract ‒ in this case it would be 15 million CAD divided by 100,000 CAD = 150 contracts. To terminate the futures position, assuming the fund only seeks to capitalize on changes in the USD/CAD spot exchange rate over its three-month investment horizon and thus has no intention of taking physical delivery, the fund can simply offset its short futures position by buying back its December 2020 futures contracts prior to futures expiration on the last trading day on December 15.

Replicating OTC IMM-dated FX forward and forward-starting forward exposure with CME FX futures

At any single point in time, CME lists five futures expiries within the closest six calendar months – three monthlies plus two quarterlies – for a range of futures contracts. This listing cycle provides market practitioners with a broad array of IMM-dated FX futures expiries for greater granularity across the IMM-dated FX forward curve that can be effectively used to replicate a variety of synthetic OTC IMM-dated FX forward market positions. Because the futures call for the physical delivery of currency, these FX futures are highly correlated with OTC IMM-dated FX forward market.

Table 1:  Near Term Listing Cycle for CME FX Futures Contracts

IMM Start Date

1

2

3

4

5

6

14 Dec 2020

January 2021

February 2021

March 2021

April 2021

- - - - -

June 2021

18 Jan 2021

February 2021

March 2021

April 2021

May 2021

June 2021

- - - - -

15 Feb 2021

March 2021

April 2021

May 2021

June 2021

July 2021

- - - - -

15 Mar 2021

April 2021

May 2021

June 2021

July 2021

- - - - -

September 2021

19 Apr 2021

May 2021

June 2021

July 2021

August 2021

September 2021

- - - - -

17 May 2021

June 2021

July 2021

August 2021

September 2021

October 2021

- - - - -

14 Jun 2021

July 2021

August 2021

September 2021

October 2021

- - - - -

December 2021

19 Jul 2021

August 2021

September 2021

October 2021

November 2021

December 2021

- - - - -

16 Aug 2021

September 2021

October 2021

November 2021

December 2021

January 2022

- - - - -

13 Sep 2021

October 2021

November 2021

December 2021

January 2022

- - - - -

March 2022

18 Oct 2021

November 2021

December 2021

January 2022

February 2022

March 2022

- - - - -

15 Nov 2021

December 2021

January 2022

February 2022

March 2022

April 2022

- - - - -

13 Dec 2021

January 2022

February 2022

March 2022

April 2022

- - - - -

June 2022

Table 1 illustrates the listing cycle for CME’s major currency FX futures based on specific IMM trade dates. On December 14, 2020 (Row 1), for example, the listing cycle was composed of three monthlies (January, February, and April 2021) and two quarterlies (March and June 2021). This listing cycle can be used to replicate five different FX forwards and ten different forward-starting FX forwards – 15 instruments in all.

The process of creating and terminating synthetic FX forward exposure with CME FX futures is simple and straightforward, and as previously discussed, has a variety of benefits over bilateral trading. To create a synthetic long (short) IMM-dated FX forward position, all that is needed is a purchase (sale) of a specific tenor of CME FX futures in the correct notional size. To terminate a position, just a reverse out of the CME FX futures position prior to futures expiration on the last trading day is needed.

Example of replicating OTC IMM-dated FX forward exposure with CME FX futures 

Assume a bank needs to hedge its forward currency book because it believes the euro will appreciate steadily versus the US dollar between December 2020 and mid-February 2021. To capitalize on this, the bank can purchase a two-month IMM-dated OTC EUR/USD forward on December 15 with a notional size of 10 million EUR for delivery on Wednesday, February 17. Assuming the bank only seeks to capitalize on changes in the EUR/USD exchange rate over its two-month investment horizon, and thus has no intention of taking physical delivery of 10 million EUR, the bank can terminate its forward position by selling 10 million EUR on a spot basis on February 15 for delivery on February 17.

Alternatively, the bank could replicate this specific forward position by purchasing 80 CME EUR/USD futures contracts with a February 2021 monthly expiry date on December 15, 2020. The notional size of the forward divided by the notional size of the EUR/USD futures contract is 10 million EUR divided by 125,000 EUR = 80 contracts. To terminate its futures position, the bank can simply sell 80 February 2021 EUR/USD futures just prior to futures expiration on the last trading day on February 15.

A forward position on a forward starting basis is another common way of expressing a view in the FX market – and very simple to replicate using CME FX futures. All that is needed is to simultaneously combine a purchase (sale) of a specific tenor of a long-dated FX futures position with a sale (purchase) of a specific tenor of a short-dated FX futures position in the correct notional size to fit the market participant’s view. By combining long- and short-dated FX futures positions, i.e., a future calendar spread, one can effectively isolate a specific forward segment of the IMM-dated FX forward curve to synthetically replicate an IMM-dated FX forward-starting forward position. To terminate the position, all that needs to be done is a reverse out of one’s long- and short-dated CME FX futures positions prior to futures expiration on each contract’s last respective trading day.

Example of replicating OTC IMM-dated FX starting forward exposure with CME FX 

In the previous example, a bank needed to hedge its forward currency book against a steady appreciation of the euro versus the US dollar between December and mid-February. Suppose, however, the bank instead believes the euro will rally against the US dollar not over a two-month span but over a narrower one-month time horizon between mid-January and mid-February. In this case, the bank could decide in December to buy a one-month forward starting IMM-dated EUR/USD forward in the OTC FX market for 10 million euros ‒ commencing on Wednesday, January 20 for delivery on Wednesday, February 17 for a net pay-off. This is achieved by buying the February position and simultaneously selling a EUR/USD forward for delivery on January 20. Assuming the bank only seeks to capitalize on changes in the EUR/USD exchange rate over its one-month forward investment horizon and thus has no intention of taking physical delivery of 10 million EUR, the bank can unwind its starting forward position by selling 10 million EUR on a spot basis  on January 18 for delivery on January 20, and on February 15 for delivery on February 17.

Again, the bank could replicate this forward-starting forward position with CME FX futures. This could be done by simultaneously buying 80 CME EUR/USD futures contracts with a February 2021 monthly expiry while selling 80 EUR/USD futures contracts with a January 2021 monthly expiry. By going long, the January-February 2021 futures calendar spread, the bank effectively isolates the forward segment of the IMM-dated FX forward curve between mid-January and mid-February by synthetically replicating an IMM-dated FX forward-starting forward position that covers the one-month forward view. Since the bank only wants to capitalize on from movements in the EUR/USD exchange rate and thus has no intention of taking physical delivery of 10 million EUR, the bank can simply offset its long calendar spread position by buying back 80 January 2021 EUR/USD monthly futures just prior to the futures expiration on January 18 and selling back 80 February 2021 EUR/USD monthly futures just prior to the futures expiration on February 15.

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Replicating OTC IMM-dated FX swap exposure with CME FX futures

In the OTC FX market, market practitioners use IMM-dated FX swaps to roll their expiring IMM-dated FX forwards further along the IMM-dated forward curve. A long (short) FX swap is essentially an interest rate transaction that simultaneously combines a long (short) FX forward with a short (long) FX spot trade. Market participants roll their expiring IMM-dated FX forwards by combining the FX swap with their outright forward position such that the latter is offset by the FX spot leg of the FX swap at the settlement of the expiring forward, while the forward leg of the FX swap extends the expiring forward out to an additional term. As in the previous section, CME FX futures can be used to create low-cost, synthetic exposure that replicates IMM-dated FX forwards, whether outright or starting forward transactions. Below shows an example of how market participants can use CME FX futures to replicate low-cost, synthetic IMM-dated FX swaps to roll their IMM-dated FX forward positions.

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Example of replicating OTC IMM-dated FX swap exposure with CME FX futures

Assume an asset manager expects the New Zealand dollar to appreciate versus the US dollar between December 16 and mid-March and thus needs to mitigate its USD exposure in its FX forward book to reflect this view. To capitalize on this, the asset manager goes long a three-month IMM-dated NZD/USD forward with a notional amount of 12 million NZD that will deliver on Wednesday, March 17. As the expiring forward position approaches settlement, the asset manager finds that its market view is correct, and now expects the NZD to continue its price appreciation against the USD further, between mid-March and mid-June. Therefore, wishes to roll its expiring forward position by three months to keep participating in their view. In this case, they could decide to buy a three-month IMM-dated FX swap for 12 million NZD on March 15 in the OTC FX market. The short spot leg of the FX swap would offset the long spot position resulting from the expiring forward position while the long forward leg of the FX swap effectively rolls the expiring forward out an additional month with delivery on Wednesday, June 16.

To replicate this using CME FX futures, the asset manager could roll its expiring forward position on March 15 by selling 120 CME NZD/USD March 2021 futures contracts just prior to expiration on the futures’ last trading day while buying 120 CME NZD/USD June 2021 futures contracts. This can be achieved by trading the calendar spread between the two futures contracts. The notional size of the forward divided by the notional size of the NZD/USD futures contract is 12 million NZD divided by 100,000 NZD = 120 contracts. The short March 2020 futures position will offset the long FX spot position resulting from the expiring forward position on March 17 while the long June 2021 monthly futures position effectively rolls the expiring forward out an additional three months with delivery on Wednesday, June 16.

Additional Considerations

As standardized, exchange-traded instruments, CME FX futures present additional considerations that can be easily managed to successfully replicate cost-efficient, synthetic exposure to OTC FX spot, forward, and swap transactions.

  • CME pricing convention. The CME pricing convention for most FX futures has the US dollar as the quoting currency and the underlying notional amount for physical delivery denominated in foreign currency7. For AUD/USD, EUR/USD, EUR/GBP, and GBP/USD futures, the CME pricing convention is aligned with OTC conventions, meaning a trader needs to buy futures if they are replicating a long forward position and sell futures if they are replicating a short forward position. However, for CAD/USD and JPY/USD futures for example, the CME pricing convention is opposite to OTC conventions, meaning a trader would need to sell futures if they are replicating a long forward position and buy futures if they are replicating a short forward position in these two currencies.
  • Scaling the trade. CME FX futures have standardized notional sizes and therefore may require traders to round up or round down the number of contracts in order to replicate the exact notional size of an OTC position precisely. To determine the number of FX futures needed to replicate an FX spot, forward, or swap transaction, it is a case of simply dividing the notional size of the OTC position by the notional size of the FX futures contract presented in the same currency terms.
  • Physical delivery. OTC FX traders typically want to capitalize only from changes in exchange rates and want to avoid physical delivery of the currencies they buy or sell. Traders usually offset their OTC positions with matching spot transactions when they mature to mitigate currency deliveries. The same is true for futures, with most positions being closed out prior to expiry, and only a fraction of transactions being taken to delivery. When replicating OTC positions with CME FX futures, traders need to be mindful that they must reverse out of their expiring futures positions just prior to 9:16 a.m. Central Time on the last trading day or they will be bound to make or take physical delivery in the underlying cash currencies.

For more information on CME FX futures, please visit cmegroup.com/fx.

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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 authors 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.

1 https://www.cmegroup.com/partner-services.html#pageNum=1&filters=ProviderInfo:market/FX,ProviderInfo:primary-business/isv

2 Pursuant to the CME rulebook for blocks and EFRPs

3 Publicly available market data indicate that the majority of average daily outright FX forward volume and average daily FX swap volume by tenor takes place within six (6) months.

4 Credit valuation adjustment is the difference between the risk-free portfolio value and the true portfolio value that considers the possibility of a counterparty's default. In other words, CVA is the market value of counterparty credit risk.

5 Under the final rule and using the most recent available data, the Federal Reserve Board estimates surcharges for a global systemically important bank (“G-SIB”) will range from 1.0 to 4.5 percent of a G-SIB’s total risk-weighted assets. Because the final rule relies on individual G-SIB data that will change over time, the currently estimated surcharges may not reflect the surcharges that will apply to a G-SIB when the rule becomes effective.

6 In most currency trades, market participants are required to make or take delivery of the currency two days after the transaction date. However, by rolling the position forward in time – i.e., simultaneously closing the existing FX spot position at the daily closing rate and then reentering the position at the new opening rate the next trading day – participants can extend the settlement period of the open FX spot position by one day.

7 The USD/CNH futures contract is the primary exception to this rule.