Are FX Futures a Cost-Effective Proxy for FX Forwards?

Whilst Total Cost Analysis (“TCA”) has been at the center of much industry discussion for several years, more recently there has been an increased focus on its application to FX. This originally stemmed from conduct issues, post the financial crisis, and thereafter followed by the inclusion of some FX products in MIFID 2. The CME, which is the largest regulated venue for FX products, has seen a further step change in client engagement on this topic which appears to be driven by a combination of more clients considering the use of FX futures as an additional source of liquidity to the OTC market, and by more clients engaging in detailed discussions around ways to optimize their trading and mitigate their costs within the context of the Uncleared Margin Rules (“UMR”).

In relation to UMR, deliverable FX forwards are not always a big area of focus as whilst their notional is included in the AANA calculation, they are not in scope for the Initial Margin requirements. However, in the context of a broader conversation around TCA, accessing liquidity and optimizing trading behavior, deliverable FX forwards (which trade more than $740bn per day¹) have become extremely topical – especially for the asset management community who have historically traded the bulk of their FX on a bilateral basis with a relatively small panel of executing brokers.

A comprehensive TCA includes several factors including fees, margin funding costs, and a like for like comparison between futures and OTC of bid-ask spreads along with clarity on what mid-market is on a ‘normal’ trade size. However, as more clients from the asset management community have approached us to explore the cost-benefit considerations of embracing listed FX, the two most important areas of focus for them have consistently been around liquidity and cost of execution. As such, this short paper will just focus on the headline execution costs and considerations for FX futures to help address whether FX futures are now a more viable source of additional liquidity to bilateral FX forwards than ever before.

Traders immediately want to understand the cost of execution for new positions in the listed marketplace, which centers on how the bid-ask spreads in FX futures compare to bilateral FX forwards and if there is sufficient liquidity available to execute ‘large’ trades.

From a quantitative perspective, CME’s central limit order book (“CLOB”) for listed FX futures is underpinned by a clear rulebook which translates to firm all-to-all pricing with no last look. The result of this is that traders can easily evidence some of the available liquidity in the marketplace by simply looking at the CLOB and can then compare the prices on the screen to the quotes they are receiving in the OTC market.

Previous modifications to the minimum price increments (“MPI”) of FX futures were made on the back of feedback from clients after doing this analysis. The MPI for outrights were reduced by up to 42% in currency pairs including EUR/USD, JPY/USD, CAD/USD and MXN/USD in order to deliver improvements to the potential bid-ask spread and so reduce the cost of an aggressing order.

Additionally, a core purpose of trading on the CLOB that has resonated well with asset managers in particular is the ability to trade passively – meaning that traders 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 Associates² participants reported executing FX futures at mid, 35% of the time on average, and so even the narrowest of spreads available in an aggregator may be avoided to further improve execution.

For larger trades, the speed at which the order book replenishes and the size of daily trading ranges will be key considerations, as is the ability to execute ‘block’ trades directly with chosen liquidity providers outside of the CLOB³. To that end, rather than just looking at the ‘visible’ depth available in the CLOB, the total volume of listed FX futures executed each day along with other key metrics such as daily trading ranges will help to better illustrate the overall liquidity and cost of working large orders in our marketplace⁴.

In addition to the capabilities of trading passively, the firm liquidity and anonymous all-to-all nature of the CLOB also delivers key features to traders that are more qualitative in nature. Whilst these are harder to measure, they are potentially no less valuable. These include:

• Greater certainty of execution (as compared to venues with last look pricing which provides optionality to the liquidity provider)
• Pricing that is not adjusted for skew, credit or knowledge of counterparty positioning, that is transparent and available to all participants
• A diversity of liquidity and the potential for client to client trading

Historically, end-users have indicated that the minimum price increment (“MPI”) of the quarterly roll spreads in major FX futures were misaligned with comparable alternatives and were the single greatest impediment to the adoption of FX futures.

To address this, the MPI in non-consecutive calendar spreads for CME FX futures have been materially reduced in five currency pairs, with 50-60% reductions for GBP/USD, EUR/USD, JPY/USD, CAD/USD and AUD/USD. These reductions in the MPI have improved price discovery and lowered the cost of execution for many end-users – contributing positively to comparisons on execution costs.

Listed FX futures have some key differences to the bilateral market for FX forwards which can make a direct side-by-side comparison difficult. The qualitative benefits of using listed FX futures such as trading in a regulated, transparent, all-to-all marketplace with firm liquidity and no last look are very important to many market participants but are hard to measure in a standard ‘total cost analysis’ spreadsheet. Similarly, the ability to remove counterparty credit risk by using a listed derivative is also a capability that is hard to quantify but, from our discussions across the industry, is increasingly important to the marketplace.

Modifications such as the MPI reductions for non-consecutive calendar spreads have helped to facilitate the growth of the FX futures ecosystem and to deliver more participation in futures than ever before, with asset managers leading the charge of new client adoption. All-time records of the number of large open interest holders (Feb. 25), the number of contracts traded on one day (March 12) and in open interest for currencies such as EUR/USD (March 13) suggest that for many clients FX futures are a viable and cost-effective source of additional and different liquidity for their risk management needs.

For more information or to discuss any of the themes detailed here, please contact your CME account representative or fxteam@cmegroup.com.

Authored by:
Graham McDannel, Senior Director, FX Products, CME Group
Phil Hermon, Executive Director, FX Products CME Group
 

1. BIS Triennial Survey 2019
2. www.cmegroup.com/bright-future
3. https://www.cmegroup.com/trading/fx/files/pm2377-fx-blocks.pdf
4. The average daily volume for CME listed FX Futures in Q1 2020 was $95.4bn. On days of big market moves volumes has risen to nearly three times that amount, as large players in the FX market turn to CME for efficient risk transfer combined with the capital and counterparty risk management of a cleared derivative