Motivated by their need to fulfil fiduciary responsibilities and to address regulatory headwinds, Institutional Asset Managers are increasing their adoption of listed FX futures and Futures options. Over the the past five years, this trend has picked up pace as Managers increasingly choose 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 participation is even more pronounced, with CME (the largest regulated venue for listed FX Futures and Options globally) volume hitting more than treble that average daily volume as large players in the FX market turn to the CME for efficient transfer of risk.
Surging buyside participation in listed derivatives can be evidenced by both greater volume and the open interest being contributed by AMs. Notably, 48% 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.
The Shift to Listed FX: Industry level trends and observations
Over the last 10+ years, overall assets under management ("AUM") have been steadily increasing. It is estimated that by 2025 AuM will rise from US$84.9 trillion in 2016 to US$145.4 trillion in 2025, but the greater weightage 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 is more scrutiny than ever before on 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, reflecting rising comfort with these products, mechanisms and rules in line with their experiences and use of listed Equity and Interest Rates products.
Why Asset Managers are increasing allocations to exchange-traded FX: Solving challenges
1. Central Limit Orderbook: 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 absence of these practices at regulated exchanges. CME's Central Limit Orderbook 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 Asset 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 Associates participants reported executing FX futures at mid, 35% of the time on average. So even the narrowest of spreads available in an aggregator may be avoided to further improve execution TCA.
- 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 buyside 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.
- 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 UMR. Once impacted, bilateral FX options and NDFs are then included within the ISDA SIMM calculation for the 2-way Initial Margin requirements under new regulations
Listed and cleared FX derivatives on the other hand are exempt from the AANA calculation and 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.
In summary: Conventional and new asset managers are leading the adoption of listed FX derivatives
The ever-evolving regulatory landscape, need to deliver cost and operational efficiencies and rising capital impacts on dealer banks trading OTC derivatives help to reinforce 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 we believe to be driving client adoption of listed FX Futures, but other benefits 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 ever more like OTC and make it easier for Institutional participants traditionally only attune to OTC FX to make the transition.
The catalysts for change and adoption of 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 suggests that a key wave of transition may now be well underway and that is being led by Asset Managers.
Divay Malhotra is director, FX Products, CME Group