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Bridging the Gap

Galen Stops takes a look at the new initiative from the CME that aims to bridge the gap between the OTC and listed FX markets.

It’s an old debate in the FX industry – will the market inevitably move towards an exchange model? Indeed, this question was the cover story on a 2001 edition of Profit & Loss

As part of the response to the financial crisis, regulators favoured pushing more trading activity towards a centrally cleared model, while certain other regulations looked to add extra costs into bilateral trading. All of this led some market observers to predict that more trading activity would shift towards an exchange traded model. 

But then, as exchange groups started to snap up OTC platforms in recent years – with the acquisition of Hotspot by Bats Global Markets and 360T by Deutsche Boerse Group – others suggested that this was an implicit acceptance from the exchanges that FX would remain stubbornly OTC. 

But for many others, this dichotomy between OTC and exchange traded FX has always been a false distinction. What market participants really wanted, they argued, was a way to move between these two markets with less friction.

That’s why CME Group has launched spot FX basis spreads, called CME Link, on its global platform, creating what it says will be the first ever central limit order book between the OTC spot FX and CME FX futures markets.

Expected to launch in Q1 2018, CME FX Link connects the OTC and futures markets via a single spread trade on the Globex trading platform, thus allowing efficient credit line management across both markets. 

The FX basis spreads will be available in the new release testing environment on November 18, and will initially be supported for six currency pairs: EUR/USD, JPY/USD, GBP/USD, CAD/USD, AUD/USD and MXN/USD. The spreads will be offered against each of the front three CME FX futures expiry months and new spreads added 10 business days prior to the last trade date of an expiring CME FX futures contract.

Connecting the markets

According to Paul Houston, global head of FX products at CME, the genesis of this launch began 15 months ago during conversations with market participants who said that they like the firm FX liquidity and the all-to-all market provided by the CME, but indicated that the futures credit model was distinct and apart from the OTC markets and credit relationships.

For example, market participants generally need to have credit lines and post margin with both their FCMs on the exchange traded side and their FX prime brokers (PB) on the OTC side. Historically, exchange for physical (EFP) transactions helped to some extent in bridging the two markets but, Houston notes, the EFP market doesn’t offer the scale and operational simplicity that a Globex listed basis spread could provide for meeting this need. 

As part of CME FX Link, the exchange is partnering with Citi’s FX prime brokerage unit, which will act as central prime broker for the spot FX transactions resulting from the spread. This will allow participants to leverage existing OTC FX interbank credit relationships and the scale of the established OTC FX prime brokerage network.  

“The spreads will be quoted against the first three expiry months, including the liquid quarterly. The futures will clear as normal through the counterparty’s FCM with no extra work required. On the spot side, we are leveraging the existing PB network; Citi will be the central counterparty, and we will onboard all the major FXPBs, plus the trading desks of banks as credit counterparties of Citi. We have built an OTC credit checking functionality and credit front end that allows Citi to allocate credit to the major bank PBs and those major bank PBs will allocate credit to their clients. So it’s leveraging the standard workflow that exists in the FXPB market today,” explains Houston.

Going back to the initial concept for CME FX Link, Houston says that comments received from the banks indicated that, once again, they liked the firm FX liquidity, the central limit order book (CLOB) and the regulated market place offered by the CME, but indicated that they didn’t necessarily always want to hold a quarterly futures position.

Houston points out that CME FX Link should solve this problem because, if the spread is priced properly, then it would allow the banks to move fluidly between the OTC and listed futures markets to offset their positions.

On the buy side, firms have been considering how the new uncleared margin rules for physically delivered FX products that are coming into effect in January 2018 would impact their costs and trading activity in OTC FX. Houston says that CME FX Link will allow these firms to trade spot and, where futures are an adequate proxy, they can move that spot into a listed future, as a synthetic swap. This allows them to face one central counterparty and get the benefits of netting. In addition, no further documentation is needed and the clearing house offers operational infrastructure to manage workflows and collateral efficiently. 

The CME is also pushing a few new products to go alongside this new launch.

“We have new monthly FX futures, we recently enabled implied functionality. We are also offering a new analytics tool showing the OTC and CME listed markets alongside each other enabling users to see how the prices compare. So we’re looking to attract spread traders and firms that trade FX swaps and outrights to our markets, and if those futures serve as an adequate proxy, then we expect them to be taken up because of the capital advantages that they offer,” says Houston.

Reducing risk

A number of market participants confirm the potential benefits of CME FX Link listed by Houston. Mark Meredith, head of FXLM e-trading at Citi, says that he is very excited about how this new product can bridge the gap between the OTC and futures markets.

Meredith notes out that on the e-trading side, Citi – like many e-trading businesses and HFTs – provides liquidity in both the OTC and CME futures markets.

“Up until this point we have had to be reliant upon, to some extent, a non-electronic market in order to navigate between these two products that are otherwise fungible. This will give us a much greater degree of transparency. I’d also add that while the CME has been a very important venue to us for many years as a spot e-trading business, it is becoming even more important relative to other platforms and I think that’s borne out in their share of the volume wallet,” he says. 

Meredith adds that Citi’s short-term interest rate trading (STIRT) business, which includes the swaps and forwards desk within the bank, perform execution activity on the CME and that CME FX Link will enable Citi to manage its open interest in a safer manner. 

He explains: “The risk that we bear from any deviation on the futures/OTC basis can become a meaningful risk for us. It’s a risk that’s also borne by most banks, and it’s a significant issue because of our scale, and this product gives us a way to meaningfully manage that risk now, so it actually should help to mitigate potential systemic risks in the market as well.”

A source at a US trading firm says that, because they are margined independently by their FCM and FXPB, it is hard for them to hold a large position across both futures and spot FX, even though the two positions might effectively offset one another. 

“We can end up with a futures position and a cash position that are offsetting, there’s very little risk because there’s just the forward points between the two, which let’s say is between one week and three months and a week out, meaning that the futures contracts roll every three months. So depending on how far out you are, you’re left with three months of forward point risk, but that’s still very small relative to the outright risk,” the source says.

The essential point here, adds the source, is that when holding both FX futures and FX spot positions, the trading firm can effectively be completely hedged, but the two are not fungible unless taken to delivery.

A trader at a London-based hedge fund opines that the CME launch “makes complete sense”, particularly since EFP trading has become more challenging.

“So there is already a way to basically move between the futures and spot market, by using an EFP. The problem a lot of firms have is that this is a manual process, so what this FX Link product seems to be, at heart, is just an automated way of doing an EFP,” the trader adds. 

Pricing concerns

One key concern mentioned by a number of buy side firms regarding the new CME launch is, perhaps unsurprisingly, the price. Sources say that it hasn’t yet been made clear to them exactly how the exchange group plans to price CME FX Link.

The head of FX at one non-bank market maker says that creating fungibility between the FX futures and spot market would certainly have potential benefits for the trading strategies used by their firm, but adds that they hope the CME doesn’t price the new product so high that it negates these benefits. They speculated that much of the pricing might be determined by the deal that the exchange group struck with Citi for the clearing of the spot FX side.

Likewise, the source at the US trading firm comments: “I hope they price it competitively, I hope they launch on time, they’re only launching with six currencies out of the gate, it would be more convenient if they just turned them all on.”

The source adds: “I don’t think it’s a hard sell, I think the CME has to get some buy side firms or STIRT desks at banks to seed it with pricing, but as long as they do that I think it will take off and link the markets together. There will be losers, some people are making money off the fact the markets are delinked, because there’s some market participants that can run that risk and have the trading acumen to work in the spot versus futures positions and manage them profitably.”

Discussing whether CME FX Link will impact the balance between FX futures and the OTC spot market, the hedge fund source says that it’s funny that this debate has continued for so long, when many firms just wanted to maintain more or less the current balance, but just be able to move between the two markets easier.

Houston says that he doesn’t see exchange traded futures products replacing OTC FX ones, but says that there is a growing need to “bridge the gap” between these two markets, especially in the face of changes caused by new regulatory requirements contained within Mifid II and Basel III.

“Futures can certainly offer greater capital efficiency and offer certain regulatory benefits so, all else being equal, I think that they can be used as a proxy for certain OTC products and I see the market using these futures more extensively going forward,” he says. 

Houston adds: “We’re linking our market to the OTC market, offering a fluid way to transfer risk between the two, and subsequently we expect a wider variety of clients to be able to access futures liquidity while being able to house their positions against a central counterparty, the exchange. So I’m excited about this launch because there’s a lot of client demand and interest regarding it and because it meets a number of current needs in the market place.”


Galen Stops

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