Chicago bucks the currency futures trend

Only a few years ago even those working in the Chicago Mercantile Exchange believed that the currency futures market was heading for a dive. How wrong they were, says Jim Kharouf.It was a humbling experience, but former currency futures trader John Conolly isn’t ashamed to admit he was wrong about the prospect for Chicago Mercantile Exchange’s (CME) currency contracts.

Mr Conolly recalls a recent visit with Jim McNulty, CME chief executive officer, who showed him a bar chart of how far currencies have come since April 2001. That’s when the exchange decided to put currency futures onto CME’s electronic trading platform, Globex, to trade side-by-side with currencies in the trading pits.

“Jim McNulty said: ‘Remember how you thought currencies were going to die and that’s why you left the floor? Well look at this,’” Mr Conolly says of Mr McNulty, pointing to a volume chart that shows currency volumes rising virtually every quarter since April 2001.

Now, as head of futures trading at Terra Nova Trading in Chicago, Mr Conolly is seeing more institutional customers returning to CME currency futures. Last year, CME currency futures volumes, both pit and electronically traded, rose 8% year on year to 24.3 million contracts with an average daily volume of 96,289 contracts. This year, from January through August, the total currency complex posted a volume of 21.5 million contracts, up 34.8% from a year earlier. And on August 21, electronically traded euro FX futures hit a record 53,443 contracts, with an underlying value of $7.3bn. In August, CME currency futures averaged 113,000 contracts traded daily with volume up 51% from a year earlier.

“At the end of 2000, the volume was well below 100,000 contracts traded daily and heading toward 60,000,” Mr Conolly says. “Now they’re up to doing 120,000 a day regularly.”

The rise of CME

The transformation is interesting and relatively simple to explain. With the growth of electronic over-the-counter (OTC) currency trading over the past decade, CME had to catch up by making currency futures cheaper and easier to trade.

“Banks were pulling their on-floor trading operations because it was becoming too expensive to run,” Mr Conolly says. “In the late 1980s and early 1990s, every bank was there at the CME. Locals were providing good liquidity and trying to get the edge. But in the mid-1990s when that institutional paper began to dry up, you ended up with locals trying to pick the pockets of other locals and it became a zero-sum game.”

CME managing director Rick Sears agrees that the renaissance of CME forex futures is largely due to putting the contracts on Globex. But he adds that it has been much more. CME secured commitments from five major (but unnamed) banks to serve as electronic market makers on Globex. Mr Sears says: “There’s clearly room for more.”

CME also introduced a new internet-based currency trading tool that allows traders to look at futures in cash terms and put the basis to the futures date. Essentially, it helps OTC users hedge with futures on an apples-to-apples basis.

Currency pairs

Sears says growth can be seen across its established currency futures dollar pairs with the euro, Swiss franc, yen, sterling, Mexican peso, Canadian and Australian dollar contracts. CME’s euro futures contract continues to be the top currency contract with an average daily volume from January through August of 40,841, up 44.7% from 28,061 a year earlier. Yen futures volumes were up 45.1% from January through August while the peso jumped 51% and the Canadian dollar 30.2%. For some banks and other institutions, offering an exchange traded platform with a central clearing house to process and settle the contracts is a major attraction.

“We’re particularly strong in the Canadian dollar and peso from a market share standpoint,” says Mr Sears. “Because many of the major players in the Mexican peso are pretty constrained, central counterparty clearing goes a long way to getting them liquidity at the best price. And in the Canadian dollar, some of the anonymity that you gain on a futures exchange helps the large players move positions quietly. As soon as you make a move on the OTC market, your name is splashed all over the place.”

What is equally interesting about the currency futures growth is that it has also boosted trading on the floor. While 60% to 65% of currency trades are done electronically, the majority of trading during rollover months still occurs in the pits.

“Globex trading has actually enhanced the open outcry business because there are some synergies between the two,” says Alan Bush, a vice president who specialises in currencies for AG Edwards in Chicago. “There was some fear that the electronic platform would take all the business and that hasn’t been the case.”

In addition, CME added 13 new currency pairs over the past year and launched the dollar index futures in spring. Those contracts are still in their infancy and draw modest volumes. But for market participants, the CME’s renewed focus on currency futures as a primarily Globex-traded product has made the difference. Julian Knight, global head of forex trading for Fimat International Banque in London, says hedge funds and commodity trading advisers are using currency futures in their portfolios.

“The transparency and ability to trade electronically 23 hours a day is a big issue, and the ability to deploy those prices to many different types of people around the globe is important,” says Knight. “You’ve got good volume going through the bid and offer. In some cases, for instance in sterling-US dollar, they’re tightening up what you would see on the electronic brokering market. And in currency futures terms you’re seeing a tighter price with more liquidity in the futures than you see in the cash.”

Global market

Mr Sears understands CME has a long way to go with its currency futures volumes, which represent a mere 3% of the $387bn OTC spot market. And because 80% of the OTC currency trading volume comes from outside North America, CME is reaching out to more potential European users through its expanded marketing effort in London. CME’s London office is also attempting to attract market makers for its euro/dollar futures contract on Globex, to create liquidity on the platform during European and Asian market hours.

And CME is exploring ways to enter the OTC marketplace and grab some of the volume that currently trades on EBS or Reuters terminals, especially on forward currency contracts. Mr Sears says the entire forex market has been moving more toward an exchange type model, a structure the CME is well positioned to offer with electronic trading and clearing services.

“When you look around the forex space, many of the models are mini-exchange models, if you will,” Mr Sears says. “They are electronic platforms that hang two or three prime brokers off it who act as a sort of central counterparty between the buy side and sell side. But they are all somewhat less efficient than we are with central counterparty clearing with multi-lateral netting. So we are definitely interested in increasing our relevance to the OTC market by offering a cleared solution to various parts of the OTC market.”

Today, Mr Conolly is convinced the currency futures market will be around for quite a while. “It’s still a small piece of the overall forex market,” he says, “but there is the need for hedging and arbitrage between the two.”