Nearing Middle Age, FX Futures Show No Sign of Slowing Down

Foreign currency futures celebrated their 40th anniversary in May, but shifts in the global marketplace appear to be giving it a second wind. Even as markets – and businesses – turn more global, concerns about the financial health of certain European nations after the 2008 financial crisis continue, weighing on banking entities and increasing market participants’ sensitivity to counter-party risk.

That means growth in hedge needs and a desire for centrally cleared financial contracts, industry analysts say.

An estimated $120 billion a day in foreign exchange products trade daily at CME, with the total including 56 futures and 31 options products across 20 underlying Group of 10 and emerging market currencies.


A Revolution in Markets

The exchange’s current offerings dwarf the sector’s start of seven currency products on opening day at the International Monetary Market on May 16, 1972.

“The launch of the IMM was revolutionary,” says Leo Melamed, CME Chairman Emeritus, who led the charge to put the markets in place. “It was a revolution in markets generally,” he says. Until that moment, futures were thought of as only commodities, and the CME was branded as a “pork belly market.”

It was not until Melamed met with renowned University of Chicago economist Milton Friedman that support for a futures exchange in foreign currencies fully coalesced. Friedman had long predicted the fall of Bretton Woods, the system that tied major world currencies to the U.S. dollar. He strongly supported the idea for the IMM and, for a fee of $7,500, wrote a paper explaining the reasons for his support.

CME chartered the IMM in December 1971, setting the stage for the launch of foreign currency futures specifically, and financial derivatives more broadly.


Foreign Exchange Trading Comes Into Its Own

Derek Sammann, global head of foreign exchange and interest rates at the CME Group, says the need to use currency futures as a hedge vehicle is as critical as ever today.

“The economy continues to globalize, and as the world gets smaller, technology has increased communications, “ he says.  “Cross-border asset flows are not showing any signs of slowing down any time soon. … it creates an amount of natural risk for people to manage.”

Yra Harris, a veteran independent trader at CME, who has been trading currency futures for about 35 years, said the IMM has grown up since the early days of currency trading and has become a central pricing mechanism.

“Hedges have come to market … and prices have gotten better,” Harris says, noting that in 1977, when he started doing currency arbitrage trades, there could be 20 to 30 ticks between the cash market and futures, but market efficiency improved and volume climbed, and by 1993 was just one-half tick, where it remains.

Sammann notes that many people “used to consider foreign exchange as a liability.” U.S. industrial companies who maintained a global profile, for example, considered fluctuations in foreign currencies as risk to get rid of, the cost of doing business.

In the last several years, Sammann says, trading foreign exchange products as an asset class in and of itself has come into its own. That’s similar to a trend seen in gold and other commodities, which also trade as emerging asset classes in their own right, he notes.

Friedman, who died in 2006 and would have been 100 on July 31, would tell an interviewer years after the launch of FX futures:

“The more important evidence was what the market did. The IMM had said there is a need for some way in which individuals can trade foreign exchange. That need was certainly demonstrated by the reaction of the establishment of the IMM.”


Financial Crisis Heightens Need to Limit Risk

In addition, the global financial crisis of 2008, and the resulting legislation – or proposed legislation – that followed, appears to add to the case for currency futures.

Richard Levich, a professor at New York University’s Stern School of Business studied the impact of the period surrounding the crisis and found that the market share of currency futures compared to interbank forward contracts has grown when compared with the pre-crisis period.

In a May 2012 draft paper, “FX Counterparty Risk and Trading Activity in Currency Forward and Futures Markets,” to be published in the Review of Financial Economics, 2012, Levich looks at data collected on trading activity in currency forwards and futures over the period of three years before and after Lehman Brothers’ bankruptcy in 2008.

Volume data suggests a shift toward currency futures and away from interbank currency forward contracts, at least among the currencies he analyzed, Levich says.

Prior to Lehman Brothers’ collapse, currency futures’ market share for the Euro/USD currency contact, compared with interbank forwards, was in the low-to-mid 30-percent-range, according to Levich’s research. Three years after, futures’ market share was in the low-to-mid 40-percent range, a “pretty perceptible difference,” he says.

In dollar terms, that means the daily average volume of currency futures expanded by 102 percent from $29.8 billion in April 2009 to $60.2 billion in October 2011.

“Possible explanations for the shift toward currency futures include an increase in bank counterparty risks,” Levich writes, “especially at the onset of the European sovereign debt crisis in late 2009.”

In an interview with OpenMarkets, Levich said forward contracts experienced “guilt by association” as a result of the perceived increase in counterparty risk in banks that trade currency forwards.

The period of post-crisis turbulence also spurred legislators to review and shore up financial market regulation, with the Dodd-Frank Act of 2010 requiring swap transactions to be traded and cleared through a centralized counterparty.

Levich notes the U.S. Treasury proposed in April 2011 that FX swaps and forward contracts be exempted from the centralized counterparty mandate, possibly because of the existence of the “well-functioning” CLS Bank, an intermediary for settling certain FX transactions.


Newest Buzz: Over-the-Counter FX Clearing

“More people than ever before are looking at the benefits of central clearing,” says Sammann. “It’s more capital efficient.“

CME Group is beginning to clear over-the-counter foreign exchange trades, and on April 27 became the first exchange to clear a customer FX OTC non-deliverable forward trade, the Brazilian real. The group also offers FX clearing in 12 emerging-market forward contracts, including the Chinese Renminbi yuan.

“The big change that’s coming is cleared FX Options, says Gordon Wallace, of Infinium Capital, a proprietary capital management firm with offices in Chicago, New York and London.  ”I think when that takes effect and clients have moved over then you will see a large shift in the marketplace,” he says.

As for existing exchange options, as overall volumes grow, they should as well. “Some will move from the OTC, but I think the biggest opportunity for them (the exchanges) is capturing as much of the clearing they can in the first phase,” he adds.

“Once the market goes to cleared, I think we’ll see an explosion in options volumes over time,” Wallace says. “Transparency and ease to trade will blow the door wide open, much as the cash market did in the early 2000s with the ECNs (electronic communications networks)” that brought buyers and sellers together to execute trades.

CME Group has broad vistas in clearing, says Melamed. “The over-the-counter markets give us huge potential.”

Suzanne Cosgrove spent much of her career at financial wire services and the Chicago Tribune, where she served as assistant financial editor. In 1996, she opened the Chicago bureau for the Market News International wire service and served as bureau chief for four years. In addition to freelance work, Suzanne is an adjunct professor at the Medill School of Journalism at Northwestern University.

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