Futures vs. Forwards
by Keith Schap and Will Acworth
During the decade of the 1990s, some of Chicago Mercantile Exchange’s most important customers drifted away to the over-the-counter currency market and began using currency forwards instead of futures. Today, CME officials say that more than half of trading in CME currency futures is done by commodity trading advisors and hedge funds, yet many of these firms say the currency forwards market is much deeper and more liquid, making it easier to do large trades.
This is especially true of the larger CTAs with more than $500 million in assets. They have the size to attract the attention of the banks that dominate the forwards market, and the clout and sophistication to negotiate a good price. But even some of the smaller CTAs favor the forwards market for their foreign exchange trading, in part because they can get one price for a large trade. CME does not permit block trading in its currency futures, so a large order typically is filled at multiple prices.
Bruce Terry, a managing director of Marathon Capital Growth Partners, L.L.C. in Westport, Conn., uses both markets. He says his firm, which currently has around $145 million under management, trades currency forwards because “it’s easier to do size in that market.” The firm then uses the CME exchange-for-physical facility to convert the position into futures.
James Meyer, principal of Meyer Capital Management, a $200 million CTA based in Barrington, Ill., says he does his currency trading on the Globex platform. He uses a longer-term trading style and may only make four to six currency trades a year. His typical currency futures trade is 300 to 400 contracts, a relatively small size, and these trades will typically remain in place for anywhere from one to six months with 60 days being about average.
Meyer prefers futures because, as a former CME floor trader, that’s what he’s more comfortable with. Also, he says, “the simplification of the accounting with the futures account statement is a plus for us.” He does admit that this could change. “As our assets grow, we’ll probably take a closer look at other ways to trade currencies.”
Benefits of the Clearinghouse
One important advantage held by CME is that the exchange’s clearinghouse is the central counterparty to every trade. That virtually eliminates credit risk and reduces the overall exposure to a single net amount owed to the clearinghouse, rather than many exposures with multiple bank counterparties. In the current environment of heightened sensitivity to counterparty risk, exchange-traded derivatives in general have gained ground on their OTC counterparts.
“Post-Enron, exchange markets have seen huge growth in notional value of futures traded,” says Richard Sears, managing director of foreign exchange products at CME. “That is strong testimony to the value market participants put on the transparency of the exchange markets and the clearing guarantee.”
CME also plans a fee cut for CTAs and hedge funds to encourage them to do more of their trading on Globex. Specifically, the fees for these types of traders will be cut from 70 cents to 44 cents per side for currency futures traded on Globex. In an April 12 press release announcing the move, CME said the fee reduction was intended to bring its prices more in line with offerings on the electronic platforms in the spot market, a clear sign that the exchange is taking this competition very seriously indeed.
The Online Competition
Most of the trading on these systems was in spot transactions, and therefore not directly in competition with currency futures. But there is a significant amount of forwards being traded online. Of the $8 trillion traded electronically last year by institutional and corporate customers, approximately 40% was in spot transactions, according to Greenwich Associates, the consulting firm. Another 39% was in forex swaps, 16% was in outright forwards, and 5% was in options. In other words, the total volume of outright forwards—the product that most closely resembles futures—that institutional customers traded online last year was around $1.28 trillion. That is only a fraction of what CME does online, but it is growing fast.
CME officials are well aware of the emerging competition from these electronic marketplaces and are working hard to make Globex more attractive. One of the immediate goals is to increase the number of banks that are providing liquidity to the platform. Currently, only a “handful” of banks are performing this function, according to Sears, but the CME is stepping up its efforts to improve this area.
In essence, what these banks are doing is adding CME to the range of portals on which they are willing to post prices. According to a source at one of the banks that provides this service at CME, the real value is not in the spread—arbitrage takes care of that—but in the depth of the market. CME has not disclosed the names of the banks that are providing automated market making services, but industry sources said they believe there are three to five banks sending prices down the pipe to CME. For these banks, CME looks like one of the many pools of liquidity in the overall forex market, gathering demand from certain types of traders and money managers that for various reasons favor the futures mode of execution over the cash market.
In May, CME will begin offering a sizeable cut in fees to encourage more banks to provide automated market making services on Globex. This program is aimed mainly at banks that are particularly strong in certain currencies, such as the Australian dollar, and also are not members of the exchange. These banks will receive a significant reduction in fees, provided that they maintain the bid-ask spread within a certain size and provide a certain minimum level of market depth. They will not qualify, however, for the even lower level of fees paid by CME members
Keith Schap is a freelance writer based in Chicago who writes regularly on risk management and market outlook topics. He has been a member of the business development staff at the Chicago Board of Trade and a senior editor of Futures Magazine. Will Acworth is the editor of Futures Industry.
