FX: a market in flux

Jens Quiram, global head of FX at Eurex, outlines how the changing nature of FX trading could open up new opportunities for market participants

Following the global financial crisis that began in 2007–08, a wave of regulation swept over the financial services industry, significantly changing how certain markets operate in a relatively short span of time. This was particularly noticeable in the derivatives markets, as firms rushing to meet mandatory central clearing mandates – most notably in the interest rate swaps and credit default swaps markets – shifted more of their trading activity towards exchanges.

However, no clearing mandate ever materialised for FX, and indeed the asset class as a whole has remained largely untouched by the post-financial crisis reforms. And yet, even without the invisible hand of regulation, we now see FX slowly heading in the same direction. All of which naturally raises the question: why are participants in this marketplace voluntarily changing their behaviour?

One factor driving this change is the broad desire among FX market participants to have more execution options at their fingertips. 

FX is traded by a diverse universe of firms for a wide array of different reasons and, consequently, there is no one-size-fits-all solution to optimising the execution of these products. Different choices about what liquidity to interact with and how to interact with it are based on varying, and sometimes changing, desired execution outcomes.

This means having access to more liquidity is always preferable to less, and so market participants are increasingly looking towards listed FX products as a complement to traditional over-the-counter (OTC) FX liquidity sources. This is one of the key reasons Deutsche Börse Group decided to put more emphasis on FX as an asset class, with 360T and Eurex Exchange offering OTC and exchange-traded FX alongside each other in one place.

By bridging the gap between these two worlds, Deutsche Börse Group maximises the execution choices available to users of these platforms, providing a level of flexibility that simply isn’t available anywhere else.

Building a European marketplace

Another element driving changing behaviours is geography and, while this might sound somewhat simple, it is nevertheless crucially important. Looking at a map of where FX is traded on exchanges today, a glaring disparity becomes immediately apparent, namely that there is no noticeable activity occurring within Europe.

While it might be tempting to dismiss this as merely a geographical curiosity not terribly important in FX – given that it is, after all, a truly global marketplace – on closer inspection, this actually has significant ramifications for market participants in Europe.

For instance, market participants in this region trading FX futures elsewhere today are subject to unnecessary costs. One of these is funding costs, as firms in Europe often have to turn their assets into euros and then their euros into the local currency of whatever exchange they are trading on in order to fund their trading activity. 

By contrast, Eurex is establishing a European liquidity pool where users can deploy their existing assets as initial margin to avoid these additional costs. Additionally, infrastructure and legal agreements are in place so additional operational and legal costs can be saved. 

On top of all this, Eurex exists in the same legal and regulatory environment as these firms in Europe, reducing the complexity of having to operate across different jurisdictions.

Exchange groups in other jurisdictions also sometimes rely on a range of service providers across the trade lifecycle, which of course pushes costs up further. This is why some asset managers report seeing significant implicit and explicit savings potential from the combination of lower intermediary and collateral costs when executing on a venue to which they are already connected and where they trade other asset classes on a daily basis.

Thinking ahead

Eurex strongly believes the long-term growth in the exchange-traded FX market will lead to symbiotic growth in the OTC market, whereby both markets will benefit from each other.

One of the catalysts for this growth is likely to be the uncleared margin rules (UMR), which are due to start impacting a much wider range of buy-side firms in September 2022 and will make it more capital intensive for firms to conduct FX trades in the historical bilateral structure. 

Although physically settled FX products are exempt from these margin rules, they still count towards the average aggregate notional amount (AANA) calculation, which determines whether or not firms themselves are subject to UMR. This is significant, given that FX is often traded in very large notional amounts, and is one reason many market participants are now looking to reduce their bilateral FX exposures.

We’ve actually seen this in practice – some market participants we partner with have been shifting their bilateral exposures towards central clearing already to manage their AANA threshold proactively for phase six of the UMR implementation in September 2022. This foresight is likely to minimise their costs going forward, ultimately leading to better returns for investors. 

Attention to detail

Another key differentiator for Eurex’s listed FX offering is how its products are designed. Leveraging the vast experience that 360T, also part of Deutsche Börse Group, has in the OTC space, Eurex has created FX futures products that replicate the look and feel of that marketplace.

Eurex currency pairs are listed in exactly the same way as in OTC markets, and the contract size is easy to understand because it’s 100,000 and the tick size is 0.00001, just like the OTC equivalents. This means that, if someone is trading in the OTC market, they can easily see if there’s a better price in Eurex and choose to trade there instead.

This differentiates Eurex from other exchange groups that list currency pairs inversely (JPY/USD rather than USD/JPY), making it harder for users in a fast-paced trading environment to immediately determine whether they’re long or short on the currency pair. In addition to this, odd contract sizes and larger tick sizes make it more challenging for traders to make a direct comparison between the listed and OTC markets.

Meeting market needs

Eurex sees growing cost pressures, new capital requirements, geographical considerations and a desire for alternative trading mechanisms as a driver for change within the FX industry, with the exchange-traded market set to grow as a result. 

To facilitate this, Eurex has built a robust liquidity pool of FX liquidity and has developed listed products specifically designed to meet the needs of market participants.

To be clear, this is not a zero-sum situation whereby the listed FX market can only grow at the expense of the OTC one. Many participants are looking for solutions that allow them to bridge liquidity pools and access the product that best suits their needs at a given time, which is why Eurex expects these marketplaces to grow in tandem.

So, as the OTC market grows, market participants will increasingly look towards central clearing and listed FX products as an additional solution that can benefit both the outcome of their FX trading activity, and their portfolios as a whole. 

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