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FX Swaps Remain RFQ (Not Automatic) For the People

By Phil Hermon, Executive Director, FX Products, CME Group

The FX swap market is booming. Over the course of the past three Bank for International Settlements triennial surveys, the total global FX market has grown from ~$5.3 trillion a day in 2013 to $6.6 trillion a day in 2019. As such, the percentage of the market represented by FX swaps has grown from 42% in 2013 to 49% in 2019. 

One of the reasons for this strong growth is that FX swaps can be quoted from any date to any date and with the standard structure being spot to a future date. In some instances, both legs can also trade as forwards e.g. forward date to forward date. While most FX swaps trade three months and under, customers who cover the full spectrum of commercials, hedge funds and asset managers, can trade anywhere on the curve (out to 2yrs+).

While FX spot, forwards and options have all undergone a degree of electronification and trade via primary venues such as the CME FX and EBS Market central limit order books (CLOBs) for price discovery, the FX swaps market remains more resolutely bilateral. This is because of the variety of trade types, structures and complexity for liquidity providers (LPs). As such, FX swaps typically require STIR traders to make quotes to their clients, or for banks to stream prices to their clients on a bilateral basis via their single dealer trading platform or via multi dealer aggregators.

In a recent article, Digitech suggested that “pricing in the FX swaps market is mostly bilateral and therefore non-transparent.” While there have been new entrants to the market, the model still appears to be largely client-to-dealer and with clients relying on multiple requests for quote (RFQ) from their panel of LPs to understand where the market is. Within this relationship, the end user buyside customer remains the taker with the LP (typically still a bank) as the maker, with some hedge fund clients choosing to roll forward or execute their FX swap activity with their prime broker on a ‘captive’ cost basis. Large clients have often told us that the spreads they are quoted can be very competitive especially on short-dated transactions, and so while not perfect, this model isn’t necessarily broken.

The interbank market continues to be well served by a combination of voice brokers and electronic matching platforms, but still relies on sufficient credit and capacity from the network of names involved at a given point in time. Given the standardised nature of interbank transactions, the frequency of trading and the focus on bank balance sheets, this activity could be better served by an electronic solution that solves for automated credit while also optimising capital utilisation.  

For the FX swap market to change materially, it requires investment from banks to enhance their trading algorithms to support FX swaps. However, for them to commit the time and resources to do this there needs to be a catalyst for change which to date has been lacking. On the CME Group side, we’re starting to see some green shoots of investment and change. FX Link, which provides an electronic CLOB for FX swap risk where the near leg is OTC spot and the far leg is a cleared FX futures contract, has seen several banks using algorithms to provide two-sided market making throughout trading in multiple currency pairs. This is alongside other banks using algorithms to trade in the marketplace, albeit not providing two-sided pricing. The enhanced dealer involvement has ultimately improved FX liquidity with tighter spreads and enhanced depth) as a result trading volume has recently grown 59%. However, this growth has taken time and investment from institutions so it’s unsurprising that large, tier one banks active on FX Link are participating on a purely manual basis where the trader has to point and click within their chosen front-end system.

While bank participation within an FX swap CLOB is a small step towards evolving the FX swap market, for the first time ever, the FX swap market now has increased transparency and certainty via firm pricing available on a credit agnostic basis. While currently limited to spot versus standardised monthly or quarterly IMM dates for the far leg and, therefore, not the full range of dates available in the OTC market, this is a positive development for the market. It is also backed by Refinitiv, Bloomberg, Fidessa and Trading Technologies who have integrated with FX Link to provide pricing direct to their clients. As the ecosystem of participants using the FX swap CLOB develops further, there will be additional opportunities to provide peer-to-peer and passive trading; possibilities that historically have not existed within FX swaps but are commonplace within cleared FX futures.

As we look towards the next BIS triennial survey later this year, it will be interesting to evaluate what will truly accelerate change within the FX swap market. The most obvious catalyst for change in any market is client demand. For FX swaps, this could be driven by large buyside customers seeking greater transparency, certainty via firm pricing and consistently competitive spreads, especially around the ‘year-end turn.’ Clients can also benefit from the far leg of the FX swap being cleared to remove the gross notional from the Aggregate Average Notional Amount (AANA) calculation of UMR as well as operational and netting benefits of facing a central counterparty (CCP). However, given the importance of the large dealers in the FX swap market, greater support from the LPs is required. The impact of SA-CCR and the ongoing dealer pressures on balance sheets which require banks to re-assess how and who they do business with to optimise capital and improve returns may be the catalyst for this change. Having an electronic CLOB for distribution, combined with the far leg being a cleared FX future can allow dealers to achieve material capital efficiencies while helping with wider sources of friction such as freeing up lines against interbank counterparts.

Bottom Line

  • FX swaps are ~50% of the global FX Market, and have materially grown in size between 2013 – 2019
  • The FX swap market remains largely a dealer versus client ecosystem, with clients comparing multiple LP quotes to understand where the market is 
  • Banks currently remain critical to this ecosystem, providing large size and competitive quotes to customers – especially on shorter dated transactions 
  • New venues that enable price transparency and certainty are available but require investment from LPs in to trading algorithms (both banks and non-banks) to enable true scale
  • The combination of a CLOB for price discovery with central clearing may help provide benefits and catalysts for change for both end user clients as well as bank and non-bank LPs
  • An electronic trading solution that uses clearing to help solve credit challenges like FX Link can potentially add value to both the interbank and dealer to client segments of the FX swap market
  • There are multiple potential catalysts for change, but the strongest one may be the evolving capital regime for the LPs and their hunt to optimise their balance sheet usage whilst still serving their customers