Changing behavior by sell-side participants is bringing new participants to the FX futures market, according to research by Greenwich Associates.
In “A Bright Future for FX Futures,” Greenwich Associates says its research showed participants who use futures markets to trade FX can save up to 75 percent of the cost versus executing those trades in the over the counter (OTC) market. Those cost savings could be higher for participants who are affected by Basel III regulations.
David Stryker, principal at Greenwich Associates and author of the paper, says Basel III capital requirements and uncleared margin requirements are raising costs in the OTC FX markets.
Trading in other financial markets have shifted to futures markets from OTC because of regulatory changes created since the 2008 global financial crisis, so it was only natural for this shift to happen in the currency markets, Stryker says.
OTC Becomes Costly
CME Group FX Futures volume saw 10 percent growth in 2017, as regulatory structural changes drove more market participants to choose futures versus OTC.
Paul Houston, global head of FX at CME Group, says volume grew strongly in many of the core currencies last year. Euro FX futures and options average daily volume grew 15 percent and British pound futures and options average daily volume rose 27 percent in 2017.
Emerging market currency pairs futures and options saw increased volume, with top performers including Indian rupee, up 206 percent; South African rand, up 178 percent; and Russian ruble, up 79 percent. In addition, CME hit a record open interest, record large open interest holders and had a record volume day. Volumes and holdings increased across customer segments which evidences broader, as well as increased, participation in CME FX markets.
Stryker says the paper looked at trade sizes ranging from $1 million to $10 million, for both a 60-day and 120-day holding period.
“It’s not necessarily getting cheaper to trade, given the rate pressures faced by some banks,” he says.
It might just get costlier, he wrote, as the costs of capital and liquidity coverage ratio costs under Basel III have the potential to nearly double the total cost of trading OTC FX. Those costs are likely to eventually be passed on to clients.
Changing Client Relationships
Broker-dealers are also reviewing client relationships, something Stryker found when interviewing buy- and sell-side participants. Small-to-mid-sized asset managers who trade $2 billion to $3 billion or less may get less personalized service from broker-dealers, he says.
“If you’re a mid-sized asset manager it may be harder to get A-level service from broker dealers. Many banks are saying, it will be difficult for me to prioritize 1,500 clients like I used to, so I’m going focus my research efforts on the clients that are key for our firm,” Stryker says.
Houston says CME Group is seeing more business from asset managers, and the lower costs are a big factor. The regulatory changes make futures a cheaper option for many trades, and about two years ago the exchange cut the minimum tick size on many of the major contracts, which also lowered trading costs.
“In 2017 there was a significant shift in asset managers trading futures. They’re increasingly facing more best-execution requirements, so they have to justify how they execute FX and the associated costs. CME’s regulated marketplace helps with these transparency requirements” he says.
FX Reaction to Brexit, Elections
Geopolitical events like Brexit helped drive some trading in the British pound sterling, according to Houston. And the uncertainties with various elections in Europe and localized geopolitical factors may have driven volume in specific currencies, such as South African President Jacob Zuma surviving a no-confidence vote earlier in 2017.
This year there will be a number of new launches planned for FX futures, building on 2017’s success, Houston says. He’s particularly excited about CME FX Link, a basis spread between the OTC spot market and CME’s listed futures marketplace..”This will offer a central limit order book between OTC spot and FX Futures for the first time; allowing participants to offset exposures and credit between each market and serve as an efficient listed alternative to OTC FX swaps.”
Stryker says trade may grow in areas like non-deliverable forwards, as hedge-fund strategies are likely to migrate to futures markets, given the costs advantages. Overall, he writes in the Greenwich report, the trend toward futures is likely to continue.
“Combined with the pressure that the sell side is facing to meet their capital and return requirements, we expect that the implicit and explicit cost of trading OTC FX will only continue to increase in the coming years. And, as liquidity in the futures markets continues to rise, trading FX on an exchange will be easier than ever.