The Evolution of the FX Swaps Market

The FX swaps market is changing. The Covid-19 pandemic has acted as a catalyst for electronification in the space, but the journey is far from over. Much remains to be done in the dealer-to-dealer (D2D) space, where voice remains the primary means of execution, but the process promises to yield better pricing and product innovation in short order. Deutsche Bank’s Shuo Wu, global head of forward e-trading, explores this evolution

Much like the FX spot market before it, FX swaps are becoming increasingly electronic, but the transition has not been universal. The market remains characterised by a split between the dealer-to-client (D2C) and dealer-to-dealer (D2D) spaces. While D2C trades are largely performed electronically, D2D trades are still primarily performed via voice – creating a host of challenges for dealers.

Shuo Wu

The new frontier is therefore the electronification of the D2D side of the market, where platform providers such as 360T are working with dealers to create a new electronic marketplace, complete with auto-hedging and mid-matching capabilities to free up liquidity for banks.

Yet the increasing electronification of the market doesn’t yet spell the end of voice trading. As the electronic market matures, there must also be a focus on continued stability and resilience – something best offered by a combination of voice and electronic pricing.

Pricing, however, is just one differentiator in this emerging landscape. The maturation of the electronic FX swaps market also heralds an opportunity for liquidity providers to offer new and innovative products and services, tailored for individual customers, via their proprietary platforms.

A Split Landscape

In June 2021, CLS – a primary counterparty that settles FX transactions between two parties and a good indicator of market volumes – handled instructions with a notional value of approximately $1.9 trillion, representing a 6.2% increase from May. Of this total, around $1.3 trillion came from the swaps market – an increase of 7.8% month-on-month – while spot activity totalled $428 billion – a decrease of 4% month-on-month. The year-on-year figures tell a similar story, with total volumes up 7%, and swap volumes up 11.5%.^[i]

It is clear that the swaps market is undergoing a period of growth, yet a surprisingly small number of swaps are currently traded electronically. This is due to the disparity in the way business is carried out in the client and interbank spaces. While the market for electronic trading on the client side is booming, the interbank trading market is still heavily reliant on OTC voice trading.

For FX participants, this is causing a number of challenges, with the mix of online and offline elements embedding inefficiencies at the heart of the process. Electronic activity on the client pricing side is naturally driving spread compression, since traders can quickly and easily compare pricing across a broad range of liquidity providers. As a result, these providers are offering trades faster and cheaper than before via electronic platforms, yet they can still only hedge the risks associated with these trades slowly and at greater cost via voice on the D2D market.

To bridge this divide, liquidity providers are increasingly collaborating with platform providers to create a more structured process for hedging FX swaps risk on the inter-dealer market.

Taking Interbank Trading Online

360T is one of the protagonists attempting to use the position it has built up in the D2C market over the last 20 years to create products which will power the D2D market over the coming 20.

Simon Jones

“Auto-pricing has been a common part of the swaps landscape for a number of years – particularly for the short end of the curve” notes Simon Jones, chief growth officer, 360T. “The same, however, cannot be said for auto-hedging. Credit complexities and a strong voice broker presence has meant that this segment has lacked investment. That said, a change in mindset – in part driven by the pandemic – combined with the growth of available swaps market data has helped elevate the urgency with which the market will move towards automated hedging models.

“Our new 360TGTX MidMatch solution is the first fully automated orderbook for FX swaps trading,” he continues. “We have worked for years on creating a reliable FX swaps market data source and paid particular attention to the most difficult challenge for this market, which is credit. The result has been an approach that also confers cost benefits on to those who auto-price with their clients and auto-hedge with their counterparties through us, leaving us strongly positioned in the D2D space. We anticipate large swap providers, such as Deutsche Bank, who are incorporating pricing and hedging as part of a unified process, will continue to gain a larger and larger slice of the pie.”

As more of the D2D market is moved online, the additional liquidity made available will also allow providers to create new, value-added services for clients. According to Jones, “Our 360TGTX MidMatch and Auto-hedging solutions are not about altering the taker client experience. Clients will continue to execute how they want, but more advanced providers, like Deutsche Bank, who are using the tools and data in the interbank space, will look to pass the benefits onto their corporate or asset management clients. This will ultimately translate into an even greater share of wallet.”

As an example of this evoltuion, the additional liquidity made available by taking the interbank trading process online will enable Deutsche Bank to offer innovative new products electronically, including swap orders, swap algorithmic execution, forward fixing, G10 non-deliverable forwards (NDFs) and more, which will allow clients to trade in a much more sophisticated way.

A Hybrid Approach

The electronification of the FX swaps markets has been an ongoing trend for several years – one that has certainly been accelerated by the pandemic. As clients moved to a work from home environment, many chose to move more of their trades online – favouring the simplicity and efficiency afforded by electronic platforms.

At the same time however, some clients were forced to revert to voice trading during the pandemic. In March 2020, for example, due to the rapidly changing world, many clients were initially not ready to operate from home in the same way as they had in the office. The role of the voice trader was critical at this time, ensuring the continued provision of liquidity in an uncertain market environment by heavily complementing electronic offerings.

The FX swaps market of the next few years seems set to be considerably more mature than those of previous years, with greater balance between execution in the D2C and D2D markets and between the use of MDPs and SDPs

What became clear is that even with the proliferation of electronic platforms, market makers need to ensure they can provide their clients with consistent and resilient pricing regardless of the underlying environment – making it clear that voice and electronic markets will continue to co-exist for many years to come.

The path forward – at least for the foreseeable future – looks to be a hybrid approach. For instance, Deutsche Bank has started to combine traditional OTC voice quoting with an automated price discovery model that factors in real-time market data and the bank’s axes, to provide a single competitive price for clients, as opposed to separate electronic and voice quotes.

The approach also enables the bank to adjust quickly and effectively, providing the flexibility to perform under almost any scenario by dynamically adjusting the weighting between voice and electronic inputs to provide consistently intelligent and competitive pricing, better service quality and a more diverse product suite. Moving forward, this hybrid approach can guarantee a consistency and resilience to FX swaps pricing that voice or electronic quoting alone cannot – and this stability has driven a sharp increase in the number of transactions executed by the bank over the past 12 months.

The New Landscape

These innovative approaches to pricing and product differentiation are just some of the examples why the FX swaps market – despite best execution and regulatory requirements such as MiFID II pushing traders towards multi-dealer platforms (MDPs) – still has appetite for single-dealer platforms (SDPs). MDPs have been hugely effective and successful in standardising flow and generating efficient processes and pricing for vanilla transactions but, as the electronification of the market increases, SDPs are still able to stand out as sources of innovation that meet clients’ more sophisticated needs.

The latest advances in electronification – as well as the use of hybrid pricing – mean that liquidity providers are starting to roll out a range of new products tailored to meet unique client requirements that aren’t necessarily supported yet on more generally targeted multi-dealer platforms.

Looking ahead, the FX swaps market of the next few years seems set to be considerably more mature than those of previous years, with greater balance between execution in the D2C and D2D markets and between the use of MDPs and SDPs. Finding this right balance is important as the evolution of the FX swaps market continues.

[i] https://thefullfx.com/fx-swaps-drive-cls-volume-higher-360t-non-spot-hits-new-high/