Monday 28 April saw CME Group open the doors to its new London-based exchange: CME Europe. In conjunction with CME Clearing Europe, European traders are set to benefit from improved portfolio margining efficiencies by availing of the same clearing and exchange infrastructure that has served CME Group so well from its headquarters in Chicago.
“Customers understand that their world is changing, not because of the clearing mandate under Dodd-Frank or EMIR but because the capital charges associated with bilateral OTC transactions are becoming much more expensive. Over the last three years we’ve seen a steady shift in clients adding exchange-listed FX derivatives to their overall FX portfolio. This is why we have established CME Europe,” Derek Sammann, senior managing director for metals, options and FX at CME Group, and Board member of CME Europe tells Hedgeweek.
The first phase roll out at CME Europe will be 30 FX futures and a small suite of biofuels contracts. The second phase, later in the year, will be additional currency pairs and FX options whilst phases three and four will involve OTC FX clearing and the addition of other asset classes on the exchange (e.g. fixed income futures).
“The exchange will be multi-asset class over time but the first 12 months will really be focused on getting FX right to meet client demand,” says Sammann.
Over the last eight or so years CME Group has witnessed what Sammann refers to as “explosive growth” in its FX business on the exchange. Globally, clients have come to appreciate the ability to trade and clear OTC and listed FX on its US infrastructure but the establishment of CME Europe has arisen largely due to a tipping point in client demand; particularly among those based in Europe and Asia who have increasingly asked CME to provide access to the same capital and operational efficiencies in the same jurisdiction as their underlying business.
“We have regionalized our infrastructure by building out a London-based regulated exchange – CME Europe - that will be clearing listed FX derivatives on our existing central clearing house - CME Clearing Europe,” says Sammann.
There are a number of drivers – aside from client demand – that have prompted CME Group to establish CME Europe.
Firstly, over the last 10 years listed FX derivatives have steadily overtaken and outperformed the broader OTC FX markets. Of course, OTC trades do not need to be reported so proxies need to be used to gain some idea of the shift in momentum. One such proxy that CME Group has used is to compare the growth of its listed FX business with trade volumes on ICAP’s EBS platform; one of the largest interbank OTC spot FX platforms.
As ICAP is a public company it publishes monthly volume figures. “We wanted to determine what our volume was relative to their volume and how has that shifted,” explains Sammann. “Back in 2005 the daily volume of our listed FX derivatives business as a percent of EBS’s volume was around 25 per cent on any given day.
“Fast forward to calendar year 2013 and for the first year ever we have now overtaken the volume that EBS has been transacting on a daily basis. We averaged 106 per cent of EBS’s daily volume last year and in 2014 our volumes are up to around 114 per cent.”
A second driver at work is that the market structure has changed markedly since the global financial crisis. With counterparty risk firmly on the agenda, operational and capital efficiencies have moved front and centre in investors’ minds. Having a transparent exchange that clears on a central counterparty (CCP) has increasingly been accepted as a way to overcome the counterparty risk challenge.
Moreover, the adoption of CCPs – central clearing houses that act as the single counterparty to both sides of a trade – has leveled the playing field. “In the OTC bilateral world one might deal with 10 different counterparties requiring 10 different credit lines. Buying USD10mn of yen with counterparty ‘A’ and selling to counterparties ‘B’ and ‘C’ significantly increases the customer’s exposure to counterparty risk,” says Sammann, adding that the story here is one of convergence between the OTC market and the exchange market.
Part of that convergence is happening in the form of centralized clearing of OTC derivatives, but a far greater part of that convergence is people adding a greater proportion of their FX business in the form of listed FX derivatives. And herein lies another driver: the cost of margining in the OTC world under Dodd-Frank regulation in the US and EMIR in Europe, which is beginning to mandate the use of CCPs for centralized clearing of OTC risk.
The Basel Committee on Banking Supervision and Board of the International Organisation of Securities Commissions (BCBS IOSCO) rules differentiate between non-cleared OTC transactions versus cleared OTC transactions versus exchange-listed transactions and further differentiates an exchange transaction in Europe versus one in the US. Broadly speaking, non-cleared OTC derivatives require a 10-day margin period of risk, falling to 5-day margining for cleared OTC contracts and 2-day margining for exchange-listed derivatives.
“Firms are starting to say, ‘It’s time to do some calculations on our portfolio and look at the total financial impact to our balance sheet’,” says Sammann, and this is pushing investors more towards the more capital efficient exchange-listed FX derivatives model.
Hence why CME Europe is now opening up for business. European clients will be able to reduce not only their margining costs but, in time, benefit from cross-margining efficiencies by trading and clearing OTC FX and listed FX futures on CME Europe and CME Clearing Europe.
Right now, CME Clearing Europe (the CCP) clears a suite of OTC swap contracts in interest rate swaps, agricultural contracts and energy contracts.
“When we launch CME Europe for the initial suite of 30 FX futures and biofuels contracts CME Clearing Europe will also commence clearing these futures contracts. Then, later this year we will add OTC clearing for those contracts to provide cross-margining efficiencies against the futures contracts.
“We don’t subscribe to the theory of throwing spaghetti against the wall to see what sticks; our clients want us to get FX right, build from a position of strength and then focus on additional asset classes. Our initial efforts are focused on making sure the suite of FX futures are as successful as possible,” stresses Sammann.
In the US, CME Group’s OTC interest rate swap clearing initiative has garnered significant traction over the last 12 months thanks to its ability to manage and clear significant risk in the Treasuries and Eurodollar futures markets. Having that ability to clear listed and OTC contracts – in this case FX – for European clients will be a major advantage.
“We’ve had great success clearing IRS in the same clearing house as treasuries and Eurodollar futures. By the end of 2014 we’ll roll out OTC FX clearing in Europe to give European clients the same portfolio margining benefits that our US clients enjoy with fixed income swaps and futures,” says Sammann, who concludes:
“All the products and services that we’ve become a leader in on the back of our US infrastructure will now be provided to clients in a European infrastructure as well.
“There’s been overwhelming client demand since we received our regulatory approval from the Bank of England and the FCA last month. We’ve been actively connecting clients to FCMs to make sure they are connected and ready to go from Day One.”