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Exchanges can’t seem to get enough of FX!

Following the recent spate of exchanges buying FX platforms (Deutsche Boerse buying 360T, BATS Global Trading buying Hotspot, and talk of ICE buying FastMatch), we now hear Nasdaq is readying the launch of their new FX platform.

So, what’s the attraction?

Well, for one thing size, at $5.3tn/day, it’s by far the largest globally traded market. It’s predominantly a bilaterally traded OTC market, highly liquid and although decentralized and fragmented into multiple liquidity pools, is nonetheless very efficient and increasingly electronically executed.

The size and liquid nature of the market play to the scale and efficiency of exchange infrastructure.

But, this is about more than size. The FX markets have been large and growing for a long time, but exchanges have only recently been looking to buy their way into the FX game.

The exchange interest is a strong play on the confluence of a number of regulatory themes around: increased pre/post trade transparency, reduced counterparty risk and higher capital charges for bilateral compared to centrally cleared trades. At the same time, trust in banks has been hit as a result of the continued fallout surrounding legal action on FX fixings, and other possible manipulation and conflicts of interest charges that have so far seen banks being hit with fines in excess of $10bn. Such conflicts of interest which can arise more easily when banks act as principal rather than agent in executing client trades, have negatively impacted client relationships.

According to Hans-Ole Jochumsen, Co-President and Head of Nasdaq’s transaction business;

“Nasdaq’s forex platform will benefit the industry by providing transparent pricing and reducing counterparty risk…..The criticism of banks and the fines show the market is not transparent and compliant and it speaks for it to be organized more like a stock market.”

It’s important though to make the point, that most participants still value the OTC nature of the FX markets, and will continue to trade on that basis.

However, the exchange model will appeal to an increasing number of participants looking for greater pre-trade transparency, a central limit order book (CLOB), and those seeking to mitigate counterparty risk, and reduce regulatory capital charges. They will also benefit from cross margining opportunities by migrating from OTC bilateral to a centrally cleared exchange execution model.

Given the sheer size of the FX markets, a small shift in the percentage of execution from OTC to exchange, and from bilateral to cleared, will translate into large amounts of FX being transacted and cleared on exchange.

Commenting on the timing of the launch, Mr Jochumsen said;

“We have a system ready that banks can test in their own systems but we don’t want to launch it before we have enough banks committed to secure sufficient liquidity.”

Unlike other exchanges who have entered the FX market through platform acquisition, Nasdaq are hoping to build their FX franchise organically, and that means working closely with banks and other liquidity providers, and not looking to compete directly on trade execution.

As part of this strategy, Nasdaq are working on an FX client clearing model, which will complement the banks’ principal execution model, by providing a highly capital efficient counterparty novation process. Whereby, upon execution, transactions will be ‘presented for clearing’, which will transform bilaterally executed bank-to-client trades which carry counterparty exposure and high capital charges, over to bank-to-exchange centrally cleared and margined transactions, with low capital charges.

We covered this initiative in Incentives for Central Clearing – paper by BIS, which looked at the additional capital charges of OTC derivatives for bilateral vs cleared transactions, and discussed the idea of banks offering clients the choice of cleared vs non-cleared pricing on their platforms.

The main elements of the additional costs incurred by OTC derivatives being: new margin requirements, new capital charges and compliance costs.

Table above contrasts the additional costs for cleared vs non-cleared OTC Derivative trades (Source: Deloitte)

This should lead to banks providing clients with the choice of cleared vs non-cleared pricing via their SDP. With tighter spreads for instruments that are designated for clearing, and much wider spreads for the same instrument that would remain as bilateral trades and not be cleared. Thus giving clients a choice, or perhaps for certain clients where credit is an issue, only offering cleared trading, which is better than having to stop trading with the client!

Above is a POC example by Caplin, of a trade tile showing both bilateral and cleared prices via Nasdaq clearing, with the cleared pricing in blue, showing narrower spreads, due to lower CVA and capital charges.

Filed under: FX, Paul Blank, Regulation, Single-Dealer Platforms, Web trading technology |