Block by block, building a cleared FX marketplace for asset managers and hedge funds
With year-to-date trading activity in blocks and EFRPs across CME listed FX products up more than 180% versus 2021, this paper looks at what’s driving increased interest, why now, and who is benefiting.
Foreign Exchange (FX) products remain outside of any direct mandate or regulatory requirement to be centrally cleared, but a growing number of end-user customers are embracing or considering clearing as a mechanism to achieve potential efficiencies – be that liquidity, operational, or margin efficiencies.
Regulatory drivers, such as the uncleared margin rules (UMR) and the introduction of the standardized approach to counterparty credit risk (SA-CCR) as the new calculation mechanism for bank capital, are both providing further catalysts for change within the world’s largest financial asset class.
“With changes in UMRs, we have seen a growing appetite to trade listed FX futures, especially via block markets, which offer additional liquidity to the centralized order books that is more synonymous with existing spot and forward markets.”
— Lee Spicer, BNP Paribas, Global Head F&O High Touch Execution
Benefits to end-users: cleared FX
Listed FX products provide a complementary pool of liquidity and the ability to access clearing via a very well-established and operationally efficient marketplace. Over the last two years, buy-side accounts have continued to embrace CME listed FX products, helping to achieve all-time records in open interest, client positioning, and trading volumes for both major (G7) and EM currency pairs during 2021. The drivers for the growing adoption and usage of cleared, listed FX covers a number of angles from best-execution drivers on the ‘front end’, through to margin and operational efficiencies on the ‘back-end’; including the ability to trade without an ISDA and the removal of counterparty credit risk against the liquidity provider firms.
Figure 1: Number of large open positions held by customers in CME FX futures as of March 15, 2022.
“The evolution of EFRPs and relevant use cases amongst institutional investors have expanded exponentially. The value proposition in the FX space is clear – FX EFRPs present an opportunity to pair dynamic OTC execution strategies along with high quality market making, and then wrapping the result in a cleared product.”
— Richard Condon, Morgan Stanley, U.S. Head of Investor Sales and Global Head of FX Product/Services
Familiarity driving adoption: OTC conventions and OTC liquidity
While the central limit book order (CLOB) is the foundation of the listed FX marketplace, providing firm pricing on an all-to-all basis for competitive price discovery and risk transfer, a growing number of clients are also using ‘ex-pit’ trading mechanisms to access clearing by leaning on OTC liquidity and trading on a disclosed basis with chosen counterparts.
In our most recent article, we looked at the potential efficiencies available to buyside customers who transact their FX futures and options in our CLOB, which include both the ability to trade with peers and also to trade passively in order to avoid paying away the spread. However, the CLOB may not be suitable for all customers or all trade types. Some customers prefer leaning on OTC liquidity while trading on a disclosed, relationship basis price as opposed to working orders in the CLOB, and this can be achieved via both blocks and EFRPs.
“Block trading represents the best of both worlds, combining the liquidity and flexibility of OTC trading together with the central clearing that's a benefit of the listed space. For institutional investors seeking to execute large transactions at a single price, it’s become a quick and convenient way of doing so, particularly when markets are volatile.”
— John Rothstein, Optiver UK, Chief Executive Officer
Blocks and EFRPs both fall under the ‘ex-pit’ category of trading mechanisms for listed FX products – allowing both futures and options to be privately negotiated with chosen counterparts away from the all-to-all trading environment in the CLOB. As such, ex-pit trading allows customers to trade on OTC liquidity and in a manner consistent with how they trade with counterparts in the OTC market today, but with the result being a centrally cleared and netted listed FX product.
“As portfolio managers continue to increase their exposure to FX listed derivatives, usage of blocks and EFRPs in order to implement their investment strategies plays a key role. Blocks offer the possibility to execute cross asset strategies and hedge FX exposure in an efficient mechanism directly with chosen LPs.”
— Rafael Sogorb Diaz, Santander, European Head of ETD and Equity Structured Product Sales
Not only does the familiarity of how to trade a block or EFRP resonate with many customers, but so does the potentially available liquidity which is synonymous with the OTC market. Whilst the CME FX CLOB provides both transparency and certainty by virtue of it being available 23 hours a day on an all-to-all credit agnostic basis, the firm pricing means that the size posted at top of book is often below the total amount a client may wish to transact. Our free FX Market Profile tool has provided further transparency on the liquidity available in FX futures (showing spreads, order book depth, and volumes traded), but looking at the available liquidity in the CLOB doesn’t show the ‘hidden liquidity’ that is available – i.e., the CLOB may not show how much liquidity providers are willing to trade in totality.
Traded volumes and order book replenishment rates can help to illustrate the liquidity underlying a marketplace, but the ability to lean on OTC market liquidity and relationships via ex-pit trading mechanisms is appealing to some customers as they can negotiate a price for immediate risk transfer in whichever currency pair and size that their chosen counterparts are willing to support, subject to the rules and requirements of the exchange.
“Block trading is complementary to the liquidity in the CLOB and allows us to provide competitive, single price executions on larger trades to relationship counterparties akin to RFQs in the OTC, but with the resulting trade benefiting from the capital efficiencies and risk mitigation of centrally-cleared futures products.”
— Yordan Marinov, SIG, Senior FX Derivatives Trader
Buy-side and sell-side adoption driving change: Blocks and EFRPs as a mechanism to access clearing for FX forwards, NDFs, and options
CME Listed FX products had 1,194 large open positions held by customers on March 15 (up +5.4% year on year) and a total open interest of $293B, and with buyside participants holding more than 60% of open interest in contracts such as EUR/USD. Alongside this growing activity there has been growing demand for OTC trading access and functionality from the asset manager and hedge fund community to complement the CLOB.
As a result, more than 20 entities are now willing to facilitate block and/or EFRP trades for customers, with some participants also able to do so on an automated, electronic basis rather than manually booking voice negotiated transactions.
In 2022 year-to-date*, blocks and EFRPs of CME listed FX products are up 183% compared to the same period in 2021, helping to contribute to the total average daily traded volume of $110.9B during March*.
Figure 2: Year-to-date 2022* change in average daily volumes for blocks and EFRPs of CME Group listed FX products versus 2021
“Using a relationship based ‘off-exchange’ price provider to transact a block or EFRP gives you both the benefits of a listed product along with the liquidity and spread very similar to the OTC market.”
— Chris Callander, Societe Generale, Head of FX Futures Sales and Trading
Benefits to liquidity providers: Blocks and EFRPs as a means to manage UMR and SA-CCR while still maintaining client relationships
From a buy-side, end user customer perspective, the “why” of ex-pit trading styles combined with the liquidity of the CLOB is relatively easy to see. Clients can have the best of both worlds by seeing firm, transparent prices in an order book while also being able to access liquidity from chosen providers that leans on the OTC market, with the result of either mechanism being a centrally cleared and netted position that provides operational efficiencies, potential margin savings, mitigated counterparty credit risk, and the removal of the gross notional from the AANA calculation for UMR requirements.
For the sell-side/liquidity providers (LPs), the support of blocks and EFRPs is arguably a little more nuanced. These ex-pit trading mechanisms provide the ability for the LPs to maintain and trade on a relationship basis to serve their customers and to use their house trading capabilities to price the transactions. LPs are able to do so with reduced requirements for bilateral trading documents and without use of bilateral credit lines in the case of blocks. By trading listed products on an ex-pit basis the resulting position is a cleared and netted contract at CME Group, helping banks to achieve potential efficiencies relative to margin requirements under UMR (especially for FX options where using listed products can be up to 86% more efficient), freeing up credit lines, and achieving potential capital efficiencies (cleared listed FX products benefit from 0 CVA, reduced RWA and potential efficiencies versus SA-CCR given the netting and treatment of margin).
SA-CCR was designed by the Basel Committee on Banking Supervision to replace the Current Exposure Method (CEM) and Standardized Method which have been used by banks for 30+ years to calculate their capital requirements. The introduction of SA-CCR (which is now in place for banks in the U.S., UK, and EMEA) and the changes the model holds versus CEM may provide another catalyst for bank liquidity providers to consider using ex-pit trading styles as mechanisms to service and maintain their relationships, win client flow, but ultimately hold the positions in a cleared and capital efficient manner.
SA-CCR has some headline characteristics that make it very different from CEM, some of which are listed below. Our previous analysis on SA-CCR showed that the potential impacts vary a lot between bank entities, with our simplified modelling on 20 bank entities showing the impact of moving from CEM to SA-CCR ranging from a 44.5% increase in the capital requirement to a 20.5% decrease:
- SA-CCR is more risk-sensitive and less focused on gross notional.
- SA-CCR allows netting benefits – and so benefits the migration of risk to one counterpart.
- SA-CCR improves recognition of collateral/recognizes margin as offsetting to counterparty risk – and this includes client margin on cleared trades for FCMs.
- SA-CCR mandates a margin period of risk (‘MPOR’) of 10 days for direct member cleared trades, and whilst the floor for bilateral is the same, it rises to 20 days for CSAs with more than 5,000 transactions.
Bottom line
- Year-to-date activity in blocks and EFRPs in CME FX products is up more than 180% versus 2021.
- Blocks and EFRPs allow clients to lean on OTC liquidity and trade on a disclosed, relationship basis against chosen liquidity providers to access clearing for FX forwards, NDFs and FX options.
- There are now more than 20 providers willing to facilitate blocks and/or EFRP trading in CME listed FX products.
- Liquidity providers can also benefit from potential benefits around margin, capital and freeing up of bilateral credit lines whilst still maintaining their client relationships and winning client trades.
- SA-CCR and UMR may contribute to continued growth in the utilization of blocks and EFRPs.
*as of March 22, 2022.
Block and EFRP trades are subject to certain participation requirements and must be transacted in accordance with the rules of CME Group. The rules that govern Blocks and EFRP trades can be found in the links below, and more details can be obtained by contacting marketreg.outreach@cmegroup.com
Blocks and EFRPs: Definitions and Rule Books
Blocks and EFRPs allow CME Group clients to lean on OTC liquidity and trade on a disclosed, relationship basis against chosen liquidity providers to access clearing for FX forwards, NDFs and FX options.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
