The foreign exchange market and the stock and derivatives exchanges have had a checkered past with the exchange-traded business always being the tip of the iceberg. The tables were turned, post financial crisis, when the G20 leaders at the Pittsburgh 2009 Summit ruled that all standardised OTC derivative contracts be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties (CCPs); that OTC derivative contracts be reported to trade repositories; and that non-centrally cleared contracts be subject

to higher capital requirements. There is little doubt that the impact of OTC reform has been greatest in FX which has always found a natural affinity with the customised products offered by the OTC market. However, the exchanges have been chipping away at the iceberg and with the higher capital requirements for OTC instruments, coupled with innovations from the exchanges, such as smaller contracts and adopting the OTC quoting conventions, it looks as though the exchanges are gearing up for a new round of growth.

GaininG critical massWith average daily notional value now at US $123 billion, CME Group’s global FX franchise has grown almost four-fold in eight years, outstripping the growth of the large cash ECNs, such as EBS and Reuters, making CME Group a major must-have liquidity pool, according to Derek Sammann, Senior Managing Director, Interest Rate and Foreign Exchange Products, at CME Group. Added to this, he says, the realisation that counterparty risk is real and the benefits of trading on-exchange, coupled with a central counterparty, are factors helping CME Group gain critical mass.

The regulatory capital charge changes that are coming to the FX market will benefit cleared products and Sammann believes this is already having an impact.

The unstoppable pace of FX on exchanges

With the incoming regulatory environment favouring centrally cleared products over OTC instruments Frances Faulds looks at how the exchanges are gearing up for continued growth.

Published in e-Forex July 2013 edition

He says: “Futures and listed options are not only already compliant with the rules if they were to be implemented today but they have beneficial treatment relative to cleared products in terms of the lower margin requirements.”

Sammann also says that the exchange is seeing significant growth in its portfolio of emerging market currencies. The biggest growth has been in the Mexican Peso contract; Brazilian Real is up 230 per cent year-on-year, its Turkish Lire product has increased by 110 per cent and South African Rand increased by 64 per cent.

He says: “Growth is not in any one particular country. The interest in currency trading at this point is not country-specific; it is actually yield-specific. The FX global market, particularly emerging markets, is really focused on the carry trade and there have been very interesting currency plays where there has been a view of relatively high base rates compared to Europe or the US.”

For Sammann, it is as though the central counterparty model has purpose-built for emerging market futures because the counterparty risk mitigation mechanism it brings, borne out by the growth in open interest by 454 per cent in emerging markets contracts alone. “This tells us that not only is the daily trading volume growing, but the amount of risk that our global customers are carrying in the form of CME FX futures is expanding,” Sammann adds.

Another important prong of the exchange offering is, according to Sammann, FX options. By having both the underlying asset as well as the options trade on the same platform there is a beneficial relationship whereby the options can be hedged with the future seamlessly, with the added benefit of cross-margining and portfolio margining of the positions. “This

allows very powerful capital margin efficiencies when customers are trading cash against futures or futures against options,” he says.

Sammann says that there has been an additional boost to the exchange through the need to centrally clear OTC instruments. Although currently, this is only for interest rate and credit derivatives, NDFs and FX options will be included within the next year. Preparing for this has created a need to connect the exchange-traded infrastructure to the cash OTC infrastructure by the middleware providers, and Sammann says that they are now seeing a greater number of firms using this connectivity to directly access the exchange-traded products as a whole. He says: “We are leveraging the opportunity brought by the convergence of these markets, and the networking connectivity, to make sure we are placed to not only receive transactions that are executed on other platforms for clearing but also

to distribute our products out into that network as well.” Volume in Exchange-For-Physicals (EFPs) has also increased as a direct result of this connectivity.

But the biggest weapon in the CME Group’s armoury is the creation of the wholly new exchange to tap into the expected growth in demand for exchange-traded FX products. CME Europe will launch this later this year pending regulatory approval. The first products of the UK-based exchange will be FX futures. He says: “There is a huge demand from non-US clients to exchange trade foreign exchange products but they would like to do so in the regulatory framework of their own country.”

CME will take the opportunity to tweak the FX products so that they will be even more attractive to the OTC market. Currently, in the US, all products are quoted as the number of dollars per foreign currency, unlike the OTC market where it is always inverted. The same currency pairs will be dual listed in Europe, but they will reflect the OTC quoting convention. Additionally CME Europe will list monthly contracts to appeal to forwards and swaps traders looking for liquidity on specific dates out to one year.

While CME Group is the largest regulated platform for trading FX, Sammann believes there will be a change in the competitive landscape for SEFs, for the OTC products, and a lot more competition for exchange-traded FX in the near future. “Customers are looking for alternatives to OTC FX trading and outside of a US jurisdiction there is

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“There is a huge demand from non-US clients to exchange trade foreign exchange products but they would like to do so in the regulatory framework of their own country.”

nothing available to them as yet. We think there will be a reduction in some of the OTC trading venues over time, even though new spot platforms are still launching. We think the FX markets will continue to get more electronic and there will be greater competition for exchange-traded FX,” he adds.

Benchmark for Best executionCurrently NASDAQ OMX offers a total of US dollar-settled options on seven major world currencies as part of its PHLX World Currency Options. Dan Carrigan, President of NASDAQ OMX Futures Exchange, believes that buy-side firms are seeking exchange-traded venues for FX products to lessen instances of counterparty default and to have a benchmark reference for quality of execution. He says: “For example, OTC FX does not have a central limit order book (CLOB). However, an exchange by definition does maintain a CLOB. Buy-side firms can point to trading fills with a reference to price history to authenticate ‘best execution,’ which is hard to do in an OTC environment.”

NASDAQ OMX PHLX brought to market cash-settled (USD) securities options on FX in 2006. This marked the first time retail investors were provided the ability to hedge or trade the direction of major currencies utilising options trading strategies paralleled to equities. Moreover, NASDAQ product innovation delivered FX options which better fit the wallet size for retail investors with contracts underlying just 10,000 currency units, enabling retail investors to tap into the global FX market from an online securities account without the need to open a separate FX trading account.

Carrigan says that by delivering regulated products underlying FX as an overall product class, NASDAQ OMX provides global investors with

the assurance of a daily mark to market and having transaction funds held by regulated members. “The result is confidence in performance reporting by investment managers to clients. Exchanges provide a price history roadmap for investors to consult when conducting due diligence of various investor programs touting investment recommendations,” he adds.

NASDAQ OMX operates three SEC-regulated options exchanges and one CFTC-regulated futures exchange in the US. All options and futures products clear at the

Options Clearing Corporation (OCC). Accordingly, all FX related products listed by NASDAQ OMX in the US clear in a fully regulated central counterparty clearing agent (CCP). Says Carrigan: “This exchange clearing model promotes services which cater to CTA’s and hedge funds. For example, large trades may be allocated on a post-trade basis at OCC to multiple firms and customer accounts. Investment managers can identify allocation algorithms, e.g. high-to-low for each buy and sell order to provide investors with confidence that their fill is on par with other investors.”

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SeanPavonePhoto / Shutterstock.com

In 2012 NASDAQ OMX launched the NASDAQ OMX Market Street Educational Series online for retail and institutional investors alike. The FX webinar provides a short introduction to options and then focuses on foreign currency options. Carrigan says: “Our focus is on educating investors how to use products to improve their investing experience and manage open market risk.”

Furthermore, NASDAQ OMX has proven INET technology for high throughput of orders and quotes, regardless of asset class. All NASDAQ OMX’s US exchanges are resident in the same data centre to ensure the greatest cost efficiencies when connecting directly to the exchange or utilising its co-location services.

In readiness for the expected surge in interest in exchange-traded instruments FX futures will be listed on the NASDAQ OMX Futures Exchange platform during Q4 this year. Carrigan adds: “FX options are available today for investors who already have an options-approved securities account. The new futures products are expected to cover various commodities and we’re considering how to leverage

our footprint in the fixed income space.” He believes exchange-traded products provide transparency for investors of all types. Given the appeal in recent years to create new FX products, such as FX options and Exchange Trade Products (ETP), the acceptance of FX as a mainstream investment class has grown rapidly. Furthermore, as the sea change by regulators toward more OTC derivatives, he believes market players are finding the exchange environment better able to define initial margin and rules in which to operate. Says Carrigan: “When all these factors are taken together, knowing all inputs when placing a trade or hedge boosts investor confidence in the exchange model.”

transparency and low counterparty riskFor Gary Anderson, CEO of Dubai Gold and Commodities Exchange (DGCX) the global investment

and hedging markets’ increased preference for exchange-traded instruments dates back to the financial crisis in 2008. He says: “This was primarily driven by the key benefits that exchange traded instruments offered, including low or no counterparty risk, transparent price discovery, fair and equitable

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“Exchanges provide a price history roadmap for investors to consult when conducting due diligence of various investor programs touting investment recommendations,”

access to trading on exchanges, the wide range of products that exchanges started offering as a result of increased innovation, increased liquidity in exchanges and cutting-edge trading technologies that allowed HFT traders to aggregate exchange feeds across time zones, which encouraged them to shift to leveraged delta neutral trades from complex structured products.”

He adds that a majority of volumes of exchange-traded currencies is shifting to Asian and emerging markets, especially BRIC nations. “The growth of onshore currency exchanges e.g. in India, Russia and Brazil has been phenomenal,” he says. With emerging market economies opening up and global investment interest in these markets increasing, Anderson says there has been a corresponding increase in the need to hedge exposure to the currencies of these countries. These needs are driving exchange-based trading volumes of these currencies. Furthermore, he says that these markets are also seeing the emergence of a new breed of sophisticated trading/investment firms that are contributing significantly to trading volumes of emerging market currencies on exchanges.

Since inception, DGCX has steadily widened its range of currency and commodity products. Currently DGCX is seeking to develop a strong offshore platform for the trading of a range of Emerging Market (EM) contracts. Anderson says: “We are engaging with both regional and international markets to explore the introduction of select Emerging Market currency and Index based futures. Two unique equity products that we are set to launch soon are the MSCI India Index Futures and the SENSEX Futures. The latter is a futures product based on the equity index of India’s leading exchange the Bombay Stock Exchange (BSE). These products are designed to give institutions tools to not only offset investment risk but also gain exposure to one of the world’s largest emerging markets.”

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The exchange style execution model, which is at the core of an MTF concept, is the most effective way to trade liquid products, such as spot FX. Just as on an exchange, orders are matched in price/time priority but trading is still bi-lateral with FX trades cleared through the prime broker network. Furthermore, LMAX Exchange is not a market-maker, and unlike many ECNs, the open order book is driven by streaming, non ‘last-look’ limit orders supplied by our liquidity providers.

To date only LMAX Exchange has launched a truly exchange-style trading model. The value proposition focuses on efficiency, fairness, trading transparency combined with ultra-low latency, precise and consistent execution.

David Mercer, CEO of LMAX, explains that, “The existing client base is mostly institutional and includes broker dealers, proprietary trading firms, money managers and funds.” However, he says “the client demand for transparent, precise, consistent, low latency execution exists across all FX client segments and this is the opportunity that LMAX Exchange is addressing”.

The LMAX Exchange business model is also at the forefront of the regulatory changes that are advocating greater transparency, on-exchange trading and centralised clearing of FX

derivatives. LMAX Exchange, though only for spot FX and metals, is leading the industry’s transformation towards transparency. From an execution standpoint, LMAX Exchange already offers on-exchange trading as well as pre- and post-trade transparency. From the clearing perspective, LMAX Exchange technology is set up and enables all three clearing models: prime brokerage, central counterparty (CCP) and centralised clearing through LCH.Clearnet.

In summary, LMAX Exchange addresses key industry challenges, such as the lack of transparency of the true cost of OTC traded FX, and the lack of precise consistent and reliable execution in FX trading. Expansion into other client segments, including the recently launched LMAX InterBank, extension of the global client base and potential diversification into other on-exchange traded FX products are planned.

LMAX Exchange Exchange style trading for spot FXLMAX Exchange is the leading MTF for FX, regulated by the FCA. Established to deliver the benefits of exchange quality execution to both buy-side and sell-side trading institutions, LMAX Exchange brings market participants together in an anonymous, order-driven and fully transparent environment

David Mercer

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As part of a systematic process, DGCX regularly reviews all its contracts to further enhance them, and specifically, looks at introducing strategic contract changes as well as the introduction of market makers to further enhance trading volumes and liquidity in a range of products. Over the last year, the introduction of contract changes for certain products based on market needs resulted in significant increases in market participation and liquidity. “For example, DGCX recently introduced a ‘matching intent’ facility for its gold futures product that allowed both physical and cash settlement of trades making it a more flexible tool for retail and institutional traders in Dubai’s vast gold market,” he adds.

Launching innovative products in response to market demand is a strong priority for DGCX and to this end it recently launched a mini-Indian Rupee contract that responds to the hedging needs of the large population of Indians living in the

GCC. The contract size supports retail remitters, individual investors and small and medium-sized businesses (SMEs) in cost-effectively managing currency risk exposure to the Indian Rupee. Anderson says the smaller size of the contract enables participants to construct precisely tailored hedges on the Indian Rupee for any underlying commodity. The mini contract is priced at 200,000 Rupees per lot compared to two million rupees per lot for DGCX’s regular Indian Rupee contract.

He says: “This contract responds to the needs of retail participants while complementing the demand and use of our larger Indian Rupee contract. The exchange has also incorporated new features like implied spreads that increase the duration of the futures curve till far months, which will help regional players with exposure to the G6 currencies (Euro, Canadian Dollar, Australian Dollar, Pound Sterling, Swiss Franc and Japanese Yen) better manage their exposures.”

smaller contractsThe exchange has taken several initiatives to help global investors manage their currency risk better. These include the introduction of implied spreads for investors to hedge their currency exposure beyond the first month. Also, Anderson says DGCX is looking into introducing smaller contracts to meet increasing demand from SMEs and for retail participants, contracts that allow them to execute trading strategies without making high capital investments. These products also seek to help participants prevent slippage while hedging.

Clearing services are evolving with the introduction of new technology and Anderson says new clearing technology is enabling DGCX to add exciting new functionalities to its platform, such as the ability to accept a broader range of collateral including bonds, gold and other currencies; and the facility to cross margin correlated products. Anderson says: “The new technology has also encouraged one of our clearing banks to propose the introduction of clearing services on a Friday, which is a holiday in the UAE and the GCC. All this is allowing us to significantly broaden the value we are providing our members, which

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“As the market gets used to traditional OTC products being listed and traded on exchanges, we will see greater depth and breadth in the derivatives marketplace and a wider product offering from exchanges.”

in turns supports our strategic goals for the exchange’s growth.”

Last year, the exchange launched the DGCX Academy, an initiative aimed at providing the education and training necessary for both seasoned and beginner traders to trade effectively and profitably. The initiative is part of a broad objective of extending awareness of the benefits of exchange-traded derivatives to a wider audience. The DGCX Academy provides educational support via weekly seminars and webinars and periodic research, concept papers and trading strategy ideas. The Academy also conducts customised and open seminars for specific industry groups like gold merchants and wealth managers, as well as extensive training opportunities for its member community.

DGCX recently launched a new trading platform EOS Trader Platform developed in partnership with Cinnober. With its faster matching engine, the new platform is geared to the needs of high-frequency traders and FX trading firms seeking alpha. Backed by third generation data centres, Anderson says the new platform provides DGCX’s growing member community with superior transaction speeds, more efficient means to access liquidity, higher reliability, enhanced trading flexibility and superior global connectivity. He says: “In our endeavor to increase accessibility to the trading of our products, we have constantly expanded the pool of trading technology providers within the DGCX community, partnering with several major technology providers to achieve this.”

Anderson believes global OTC derivatives reforms can bring fundamental changes in the derivatives market in almost every single aspect of the market including business models, profitability, and

technology. “The requirement for most standardised OTC derivatives contracts to be cleared will drive increased participation and volume for exchange-traded FX products as well as enhance interest in its other products,” he says.

Furthermore, the injection of more liquidity into the exchange marketplace will benefit the entire spectrum of market participants and eventually drive greater volumes and revenue for all. This in turn will enable exchanges and participant institutions to invest more in infrastructure and innovation, according to Anderson. “As the market gets used to traditional OTC products being listed and traded on exchanges, we will see greater depth and breadth in the derivatives marketplace and a wider product offering from exchanges.”

asian price discoveryIn Asia, the Singapore Exchange (SGX) is set to launch Asian FX futures in the third quarter – the

US dollar, Australia dollar, the Japanese Yen, the Indian rupee and the Singapore dollar – which will be cleared and settled in US dollars and yen in order to target different user groups already trading on SGX, wanting FX hedging facilities.

The exchange, which was the first in Asia to launch clearing services for NDFs two years ago, will also, most likely, launch a futures contract on the Indian rupee as it already has such a significant franchise in Indian equity futures. SGX’s latest initiative complements Singapore’s position as the fourth largest FX trading centre in the world. FX and FX derivatives turnover in Singapore has more than tripled in the last decade, with an average daily traded volume of about 360 billion US dollars.

Michael Syn, Head of Derivatives at the Singapore Exchange, says: “We seek to add some value to the FX world by ensuring that many participants now have a central facility for price discovery for these Asian currencies, in the Asian time zone.”

By offering centrally cleared, margined, products with anonymous execution on a well-regulated platform, Syn believes it is the key characteristics of exchange trading that are the driving force behind the growing interest in exchange traded FX. He says: “Firstly, futures are traded on a centralised order book, meaning that unlike many FX venues which are only open to a limited number of people, exchanges are open to all. Exchanges also have a higher degree of regulation.”

He adds that feedback from SGX’s client survey shows that they are

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“…futures are traded on a centralised order book, meaning that unlike many FX venues which are only open to a limited number of people, exchanges are open to all.”

already actively trading on futures exchanges for equities, interest rate and commodities and that many of them would welcome the convenience of multiple asset class trading on a single integrated electronic platform in which they have already invested. Says Syn, “Associated with this, because the clearing house on exchanges offer clearing with margin and there is very often the possibility of margin effi ciencies when they trade FX futures alongside equities and commodities in particular.”

He adds that a growing number of fi rms have mandates that require that they try their best, or even prove, that they achieved best execution and exchange-traded products, where they are suffi ciently liquid, almost by defi nition, show the best price on the screen, which is an important factor.

“The fi rms we talk to have different reasons for trading FX, either hedging an equity-based portfolio or hedging FX, and they typically need to do their FX hedging, and

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re-hedging, relatively frequently and automatically, almost algorithmically, so using an exchange for this makes it very easy because a typical equity investor already has this set up for their equity futures and adding the incremental execution of FX is straight-forward,” says Syn.

As well as the regulated marketplace, he adds, the pre-trade risk controls, which have recently been made mandatory on SGX, and the strict rules governing trade certainty give fi rms a level of comfort they do not get in the OTC market. “If you execute a trade on SGX, you will know whether you have completed a trade or not, you do not have to wait to see if it is disputed,” he says.

While the launch products have been chosen with existing customers in mind, Syn expects new customers

will follow. Once the critical mass in terms of open interest and liquidity has been attained, SGX will look at the other Asian markets such as Japan and Taiwan to educate and market these products.

While there are a growing number of high frequency traders in Asia, Syn believes that due to the infrastructure, arbitrage opportunities are sought after more than speed. He says the nature of alpha seeking in Asia is slightly different due to the geographical location of Singapore. Instead, Syn says the exchange looks to reduce the search costs for best execution so that speed is less of an issue for many of the end-users.

He says: “We ensure it is a cost-effi cient and as fair as possible for someone in London, Chicago or Tokyo to connect to us. We try to

co-locate as many of the fi nancial service providers into a single location, which is our data centre, to reduce the number of expensive cross-connections. We also throw open our data centre to all other exchanges to lower the cost of entry for everyone.”

As the whole OTC landscape is being reshaped in FX, Syn says that while SGX offers centrally cleared products, it has never benefi ted from any regulatory mandate. “Whatever business we have, we have only achieved because we offer some kind of value proposition or risk reduction or management offering for our clients. So having the regulatory focus put onto counterparty credit risk is incrementally even more useful to us because our services are already commercially attractive.” The fact that SGX’s open interest doubled

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last year, and volume went up by more than 30 per cent, is for Syn the strongest indicator that firms are actually choosing the services of a central counterparty.

russian perspectiveIn terms of offering exchange-traded FX, Russia has in some respects led the way. MICEX trades FX, cash equities and bonds. One of the innovations the Moscow International Currency Exchange (MICEX) brought to the FX market was that it established the market ruble exchange rate to the US dollar for the first time, and which is still the most frequently traded currency pair on the exchange.

In December 2011 MICEX merged with the derivatives exchange, the Russian Trading System (RTS) to create the Moscow Exchange, the largest stock exchange in Russia, offering trading in equities, bonds, derivatives and currencies in one place. The Moscow Exchange also launched its first exchange-traded fund earlier this year.

Otkritie Capital offers international institutional investors electronic access to stock markets and prime brokerage services and has wide experience of the Russian market.

Sergey Sinkevich, head of DMA at Otkritie Capital, says that a wide range of banks and companies are looking to trade currency products on exchanges, including High Frequency Trading firms and quant-driven funds, ETF market makers, hedge funds, traditional buy-side, tier 1 investment banks, agency brokers, and traditional consumers of market services.

Sinkevich says: “It really depends on their objectives. The HFT traders are looking arbitrage opportunities, whereas the hedge funds are looking for investment opportunities and traditional asset managers want to purchase shares on the Moscow Exchange but along with this we provide them with a transparent price discovery for their cash equities transactions.”

From a single account Otkritie’s clients can trade local shares on MICEX and RTS while covering positions on LSE IOB section, and hedge FX in the local USD/RUB spot market. Otkritie’s clients can buy and sell single-stock futures or hedge their investments with RTS Index and currency futures on FORTS in Russia.

Using DMA access gateways and various protocols, such as FIX, Otkritie is enabling firms to execute trades in a low latency environment, while providing HFT with co-location and post-trade services as well as specialist DMA services to firms that are ultra-sensitive to latency.

However, Sinkevich adds that a growing number of traditional asset managers and hedge funds, although not as sensitive to latency as their HFT counterparts, are showing a greater interest in adding direct market access to their execution strategies.

He says: “Most of the world now trades electronically. We provide our clients with the ability to have a one-stop-shop where they can execute their standard transactions using DMA but where they need market advice or a tailored transaction they can work with our trading desk.”

He believes the move by investors towards using DMA is down to the transparent pricing by going directly to the order book and having full market visibility. For high frequency traders, he says the attraction is the low latency of the solution. While asset managers and hedge funds use algorithms, they are used for best execution rather than HFT.

conclusionSinkevich believes the incoming OTC regulation will drive more liquidity to the exchange market and force OTC market to be more transparent although he points out that Russia is different from the rest of the FX world in that the currency markets grew out of the very transparent price discovery mechanism provided by the exchanges. “Before MICEX started up in 1995 there was no FX market in Russia. To a certain extent the world is following the model Russia grew up with. We already have examples such as ICAP and EBS,” he says.

The fact that FX volume on the exchanges actually grew during the financial crisis, indicates, says Sinkevich, that the risk management provided by the exchanges becomes critically important to investors in times of instability and exchanges are considered a safer haven when there is high volatility.

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“Before MICEX started up in 1995 there was no FX market in Russia. To a certain extent the world is following the model Russia grew up with.”