Regulation to Drive Changes in FX Derivatives Market

Changes brought on by new regulations will drive trading activity in foreign exchange (FX) away from options and non-deliverable forwards (NDFs) to futures, which will become a much bigger and more important part of the FX market, predicts Greenwich Associates.

In its report, entitled ‘The Futurization of FX Derivatives’, the US research and consulting firm says the movement of trading activity to futures will require investors to rethink how they access the FX market, dealers to revamp business models to facilitate trading in a profitable way, and technology providers to offer solutions to help all market participants adapt and succeed in the new market.

“A conservative 5% move out of over-the-counter (OTC) FX derivatives into futures would cause FX futures volume to grow by over 50% – a huge boon for futures exchanges,” said Greenwich Associates principal Kevin McPartland, head of market structure and technology advisory service and author of the report.

Three Reasons for a FX Derivatives Victory

The report identifies three drivers of the coming shift of FX trading volumes to futures:

1. While FX swaps and forwards received exemptions from trading and clearing requirements imposed on derivatives in other asset classes, they will still feel the impact of trade reporting requirements, anti-evasion authority, business conduct standards and Basel III capital requirements. These influences are likely to encourage a shift of some FX swaps and forwards business to futures.
2. NDFs and FX options did not escape the grasp of trading and clearing requirements and the high margin rates they bring, setting the stage for their users to migrate some of their trading to futures as well. Once these rules set in, trading these products will become more expensive. Greenwich Associates data shows that the trend away from NDFs has already started. Whereas over half of investment firms used NDFs in 2010, at the end of 2012 only 35% used them, with hedge funds leading the pull back.
3. Financial users of these products, which drive most of the volume, require less customisation than corporate users, making it likely that they will migrate some of their flow to less expensive futures.

“The bottom line is that some trading volume will shift to futures because under the new rules futures will provide a cheaper means of accessing the FX market,” said McPartland.

“These are not exotic products. FX futures contracts have existed for years providing exposure similar to that offered by OTC contracts, and among the major global exchanges, FX futures liquidity has steadily grown over the past few years. Investors are already comfortable with the products and now they will have a big incentive to make much more use of futures.”

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