Swift is ready to support on-exchange FX trading

• Exchanges are buying FX trading platforms because they see FX as a growth market.
• The 40 per cent FX market share controlled by platforms conceals the continuing dominance of banks as major counterparts on the primary or professional platforms, principal suppliers of liquidity to multi-dealer platforms and controllers of the 60 per cent of the business transacted directly.
• Non-bank liquidity providers (NBLPs) have attracted a lot of attention, but they are largely confined to the spot market and remain dependent on bank credit.
• The asset managers and corporates that use FX mainly to purchase assets will continue to find banks a more efficient way of transacting this business than exchanges.
• If exchanges can make a success of integrating on-exchange and OTC trading of FX, and the management of collateral across cleared and non-cleared business, they will attract some business on the basis of collateral and capital savings.
• Whatever proportion of FX business moves on exchange and into clearing, Swift can support the sending of clearing instructions to the CCPs and settlement instructions to the banks appointed by the CCPs.

The recent wave of acquisitions of FX trading platforms by exchanges indicates that they believe more trading activity – including OTC trading - will shift on to exchanges and into netting through central counterparty clearing houses (CCPs) before proceeding to settlement. If and when this happens, it will create new service requirements.

Market participants will need to communicate with the clearing brokers that provide access to the CCPs and instruct correspondent banks to settle the cleared and netted trades. Swift is ready to help, since these are post-trade message flows of exactly the kind Swift exists to support.

Which exchange has bought which platform?

Regulators and asset managers have long seen on-exchange trading as a solution to opaque pricing, manipulation of rates and mitigation of capital-consuming market and counterparty risk. Now, leading stock and derivatives exchanges are turning that idea into reality by buying FX trading platforms.

The Chicago Board Options Exchange (Cboe) acquired Hotspot four years ago. Chicago Mercantile Exchange (CME) took control of the EBS FX platform last year. Euronext bought the FastMatch ECN. Deutsche Börse, which has owned the 360T FX trading platform since 2015, is now negotiating the purchase of trading platforms from Refinitiv that might include FXAll. If that sale goes ahead, only one major FX platform, the State Street-owned FX Connect, will remain outside exchange ownership.

Why are exchanges buying platforms?

For exchanges, FX offers four opportunities:

• First, currency trading is the biggest financial market in the world and (CME apart) no exchange enjoys a meaningful share of it. Platforms currently control around 40 per cent of transaction volumes in the FX market.
• Secondly, exchanges can attract new business by offering counterparties margin and capital savings through integrated management of collateral for both cleared and non-cleared FX derivatives.
• Thirdly, exchanges reckon they can profit from a convergence between OTC and on-exchange trading and clearance of FX. CME FX Link, launched by CME Group in March 2018, connects the FX futures business of the exchange to the OTC spot market in FX to facilitate trading of the spread between them in eight currency pairs. In March this year, trading volumes hit a record level of $2.7 billion. Deutsche Börse Eurex subsidiary 360T plans a similar link.
• Fourthly, the clearing arms of the exchanges can expect to capture FX OTC derivative business that is driven into clearing by the margin requirements imposed by regulators on non-cleared derivative trades.

Why exchanges will not disintermediate banks

The exchanges are betting that they can integrate on-exchange, OTC, derivative and spot market liquidity in the major currency pairs and clear the trades through their own CCPs before passing the netted amounts on for settlement. For deliverable contracts, CCPs have already created links to settle CLS-eligible currencies in CLS.

None of this means that the exchanges are about to disintermediate the banks. Within that 40 per cent market share claimed by platforms, banks remain the primary sources of liquidity. And banks dominate the remaining 60 per cent of flows, partly through their own direct-to-customer platforms. LMAX Exchange, the one platform that offers an order-matching service of the kind modern exchanges provide directly to customers in other asset classes, has so far garnered a mere 0.25 per cent market share.

Though much is made of the growing importance of non-bank liquidity providers (NBLPs), they are largely confined to the spot market and remain entirely dependent on credit relationships with the major prime brokers – which are, of course, also owned by banks. In short, banks continue to dominate the FX markets, and will do so for the foreseeable future.

The end-users of FX – namely, corporates and asset managers - prefer to deal with banks because they raise currency to finance and hedge their activities in the real economy. Exchanges are ill-equipped to deliver to a large corporation, say, US$ 500 million against the equivalent in euro on a fixed date.

Swift makes it easier to trade on-exchange and clear

Exchanges nevertheless have some benefits to offer banks’ customers. Clearing of OTC FX trades through CCPs is now getting under way. Integrating this activity with on-exchange trading offers users savings in collateral posted to CCPs, while clearing itself adds further savings in capital allocations. In the long term, dealing at prices set on an exchange and clearing the trades via a CCP could reduce current dependence on credit relationships with banks.

So a gradual transition of some FX business on to exchanges and into clearing is likely. Swift can make that transition much easier for FX market participants, because its users can adopt Swift standards to send clearing instructions to the CCPs and settlement instructions to the banks appointed by the CCPs or CLS.

In short, Swift can help its users shift business on-exchange and into clearing without the need to invest in new information processing infrastructure.