FX futures: why they matter in currency overlay management

By CME Group

In September 2021, CME Group and 7orca collaborated to discuss why currency overlay managers are using futures, and why 7orca is using CME’s listed FX products specifically, to gain the exposure and returns they require.

Introducing CME FX and 7orca

CME Group offers the largest regulated marketplace for FX in the world, covering more than 40 currency pairs across both G10 and EM. Average daily volumes for FX futures in September 2021¹ were USD 92.6bn, with the single day record for 2021 of $270.4bn occurring on September 8^th, helping to illustrate the liquidity available in CME FX futures as a complement to OTC FX markets.

7orca Asset Management AG is a specialist investment firm managing EUR 8bn. The independent, quantitative asset manager offers institutional investors solutions to manage FX risks and capture volatility as an alternative source of return.

As a leading specialist in managing the FX risks of its institutional clients, 7orca uses both FX futures and FX OTC forwards.

This interview features:

• Phil Hermon, Executive Director for FX Products at CME Group, based in London.
• Holger Bang, CFA, Head of Currency Overlay at 7orca, based in Hamburg.

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The discussion

Question 1: Holger, 7orca was an early adopter within European currency overlay managers in using both listed futures and OTC forwards to hedge FX risks. Based on your broad experience, how do these compare in terms of transparency?

7orca: Our standard set-up for all currency overlay mandates foresees the use of both FX futures and FX forwards as a hedging instrument.

Trading on the exchange ensures a high degree of confidence, as the market segment is regulated, and the processes for clearing and settlement are very well established. Furthermore, the central limit order book displays a high degree of price and volume information; any executed order is displayed post trade for all market participants, including price and volume information, thus ensuring a very high level of transparency. If traded as request for quotes, FX OTC forwards cannot quite keep up due to their bilateral character. Forwards that are concluded as part of an algorithm transaction also provide good transparency, as the details are broken down for each fill in real-time and in post-trade reports.

CME: Are there any differences in firm liquidity when looking at these instruments?

7orca: FX futures probably provide the firmest liquidity. Once a lot is traded in the central limit order book the deal is concluded without last look. In the OTC forward segment, a last look is possible in volatile markets with certain liquidity providers. Yet, FX OTC forwards as a proven currency hedging instrument offer a very good liquidity level for G10 currencies. The same applies to FX futures – especially in currencies such as EUR/USD, with liquidity in the order book for other G10 currencies being comparatively lower. For emerging market currencies, however, whilst the futures liquidity can be useful in some pairs it is less established than in G10, and can be limited when traded against the Euro. In this case, we prefer hedging via OTC non-deliverable forwards. Obviously, it is always possible to provide OTC liquidity in futures via block trades. A growing number of the major FX OTC houses offer this service.

In situations of market stress the picture can deviate largely. FX futures become even more appealing as, unlike FX OTC forwards, they do not bear counterparty risk to a financial institution. This feature is particularly important during periods of market uncertainty, and has helped the widespread acceptance of FX futures by our clients to help mitigate their counterparty risk.

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Question 2: Does the all-to-all nature of a futures marketplace, the ability to trade passively, and access to a range of liquidity providers provide tangible benefits compared to the OTC FX marketplace?

7orca: When comparing the all-to-all nature of the futures market to the more classic way of bilaterally trading forwards via single dealer platforms the biggest first order benefit is that the futures marketplace features numerous participants with different risk profiles compared to a relatively small number of the classical liquidity providers available in the bilateral market. In certain situations this offers a much needed liquidity diversification. However, this diversity can also be achieved by employing OTC forwards if such as advanced algorithms are employed, as they also make use of a variety of liquidity pools.

“In my view, the biggest advantage of FX futures is the ability to trade passively in the central limit order book of the exchange.”

Buy side investors normally act as market taker, hitting the respective side of each intended trade and paying the bid-ask spread. Trading FX futures on the exchange enables buy-side customers to act similarly to market makers and place orders passively. This offers an attractive potential of saving bid-ask spreads during trading. The probability of saving the spread increased considerably after the reduction of the minimum price increments for both spread trades in the G5 currency pairs as well as in the outrights for AUD/USD and NZD/USD at the CME. Trading futures enables us to roll our positions on average below mid, saving our customers a decent amount of money.

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Question 3: Let’s talk about costs. How do the all-in costs of FX futures compare to FX OTC forwards? In your opinion, do FX futures represent a cost-effective solution for more asset managers and real money clients to consider?

7orca: There is no straightforward answer to this question, as the choice of instrument always depends on the individual situation of the client and the regulatory framework or market environment he is operating in. Therefore, it is subject to a certain dynamic. 

“This is also the reason why we at 7orca give our currency overlay clients access to both first class OTC brokers and FX futures and switch from one instrument to another, depending on the situation.” 

Greenwich Associates published an interesting study, titled ‘A Bright Future for FX Futures’, that covers your question. The study addresses topics such as the percentage of trades that can probably be executed in FX futures at mid on average, the typical rejection rate and the size of the bid-offer spread. The results show that the use of FX futures can have advantages over OTC forwards. Especially the recent reduction of minimum price increments by the CME has made the use of futures more attractive.

On the other hand, it is important to take a closer look at the infrastructure costs of both products, such as charges in connection with the custodian or with the execution broker as well as for the in-house post-trade processes regarding reconciliation. It is hard to just compare like for like – futures offer some clients non-quantitative benefits such as minimizing counterparty risk, trading at a regulated marketplace, providing firm and transparent pricing without last look.

From a more general perspective, I think it makes sense for every asset manager to examine the subject in greater detail on the basis of his current situation.

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Question 4: For which mandates do you use futures today and which clients would you advise to consider futures?

7orca: As I mentioned before, the majority of our currency overlay mandates allow trading in FX futures and FX OTC forwards. That way, the benefits of FX futures and OTC forwards can be fully exploited at all times.

For smaller European mandates up to a certain size, which are mainly invested in USD, it generally makes sense to use only futures as a cost-effective hedging tool. Taking into account all costs, such as those for the collateral manager, the onboarding of several FX OTC brokers is comparatively more expensive than the use of FX futures.

“Larger clients as well as asset managers and real money firms benefit from access to additional and diverse liquidity in FX futures that complements the pricing and access they have in the bilateral OTC market.”

This situation is also reflected in the figures of the ’Commitment of Traders‘ report. It shows that there are a substantial number of large open interest positions held by customers; 1,224 as of September 14^th to be precise. Unsurprising, that within this growing ecosystem asset management and institutional clients have grown from holding 31% of open interest in EUR/USD FX futures in February 2017 to 44.8% in September 2021.

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Question 5: Does the mitigation of counterparty risk and freeing up of bilateral credit lines resonate with clients as a benefit of listed FX over OTC FX?

7orca: The issue of counterparty risk is definitely of great importance to some of our clients, especially in light of recent periods of market uncertainty. Although all hedges implemented with OTC forward positions are secured with variation margin, there are circumstances in which a short-term counterparty risk exists despite the collateralization, in particular if a hedge is rolled over to the next term.

This is the case if the hedged currency appreciates and results in the market value of the FX OTC transaction turning negative. Accordingly, the market value must be collateralized daily. At maturity of the OTC forward, the negative market value is paid out, with the collateral being transferred back only one day later.

This is not the case when using FX futures. We continue to monitor counterparty risk very closely, and should a situation lead to recognisable hardship for the banking sector we would shift all eligible mandates to FX futures.

Currently, however, we are not worried about our clients who use FX OTC. The release of credit lines is not a big issue for them, since as real money investors they have a very high credit rating and the availability of bilateral credit lines is therefore posing no problem.

Considering investors with stressed credit relationships or leveraged positions, the use of futures could be useful.

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About 7orca: Investment Philosophy

7orca is a focused quantitative investment firm. The company offers institutional investors strategies for managing currency risks and for tapping volatility as an alternative source of returns.

7orca’s investment approach is systematic and quantitative. The company’s rule-based decision algorithms and risk management processes are implemented in a stringent and disciplined manner. Performance is transparent and traceable, ensuring a high level of consistency from its investment solutions. The company’s services are aimed at institutional investors, with a maximum of individualization and client orientation.

In the conversation

Holger Bang, CFA, Head of Currency Overlay, 7orca

As Head of Currency Overlay, Holger Bang with his team are responsible for managing 7orca’s  FX hedging programs. He has more than 15 years of expertise in currency management and quantitative asset management, gained at both German and global financial institutions.

Prior to the foundation of 7orca Asset Management AG in 2017, he served as Head of Overlay at Bank Berenberg.

Holger holds a Diploma in Economics and is a CFA Charterholder.
 

Phil Hermon, Executive Director, FX Products, CME Group

Phil Hermon serves as an Executive Director of FX Products at CME Group and is based out of London. He is responsible for the management, development and go-to-market initiatives of listed FX and OTC cleared FX products.

Before joining CME Group, Phil served in various roles across sales, client solutions, derivatives operations and relationship management at both Morgan Stanley and RBS.

Prior to his career in finance, Phil was a Captain in the Royal Tank Regiment within the British Army and holds a bachelor’s degree in business studies from the University of Sheffield.

To discuss any of the themes detailed here, please contact [e-mail]

¹ Month to date September 2021 as of September 24^th

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