Forex: cash vs. exchange traded

With Eurex launching currency futures contracts on Sept. 23, which will compete with the Chicago Mercantile Exchange's (CME) currency contracts, Eurex will become more than a direct competitor against the CME, it'll be another option in the wide world of foreign exchange. While currency futures contracts and currencies traded on the OTC forex market are not the same thing, many say they're close enough. In fact the futures prices and the spot prices move in parallel.
While the OTC forex market used to be the only way to trade forex and was only used by big traders, technology and competition has brought the market to retail accounts. The CME has been offering currency futures since 1972.
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"The [currency] futures have been around for a while but futures have been around for less time than the [OTC] cash FX market," says Gleiin Stevens, managing director at Gain. "The difference here is that in the last five years in particular the retail product and the retail user has seen a more viahle two options. Some time ago the only option for a retail user, other than going through a private bank, was to use the futures. In the last five years there's been a better opportunity for the individual. Now he's got two choices."
Michael Stumm, president of Oanda, agrees on that timeline. "The forex market has been growing substantially. Five years ago there was no such thing as a retail forex market and today it's large and growing very quickly, and because of the gaining popularity and higher volumes, the exchanges want to be a part of that. And that's why [Eurex is] introducing currency futures," Stumm says.
Alex De Khtyar, founder and president of Fini FX adds, "The industry is so different today because you can open an account with $1,000, and some firms offer mini accounts and you could open an account with even $300."
There's a lot of jargon that goes with forex and it's hard to compare the OTC market with exchange traded contracts without understanding the main terms. Simply put, the interbank, cash and spot are all part of the OTC foreign exchange market; and exchange-traded currencies are forex futures contracts traded on a regulated exchange. The interbank market is literally the market between the major dealer banks. "Cash market" is another term for foreign exchange and usually refers to a market in foreign currencies made by large banks, but now includes diverse participants. Cash forex do not trade to a contract date, the position is rolled every day if you have one. Spot forex transactions are those that settle two days after they are entered as opposed to an agreement to make a transaction some time in the future, like a forward, an option or a future.
"The currency futures contracts being launched by Eurex are very similar to those already trading at the CME," says John H. Eley, president and CEO at hotspot Fx, a forex broker. "They are traditional futures contracts, standard contract [specifications], cleared through [a] clearing corporation. The interbank foreign exchange is the traditionally spot market, which is an OTC market as opposed to a listed contract and it's uncleared, so each of the counterparties are extending credit to each other."
The primary difference, according to Stumm, is that futures get traded on regulated trading floors or through electronic matching engines and you go through a quasi central site with oversight.
"With futures, you can always calculate what the spot price is, and anything you can do with spot you can, in theory, do with futures and vice versa," Stumm says.
"The futures product is an exchange rate at a price agreed on today for which settlement occurs at some later time," Stumm says. "They are effectively quoted the same and if you want to hedge you can do it with either market. In some sense the spot market is an unregulated market, it's more OTC and it's a little more cowboyish in a sense. Regulated markets will have certain rules, like they'll specify the number of units you can trade in, whereas on spot there's more flexibility in unit size. With Oanda you could buy $23 spot EUR/USD, which you couldn't do with futures because it's too small an amount to bring over an exchange."
The size differences can make a difference for hedgers. "A company with a European client may be getting a payment from that client in two months of $145,000," Stumm says. "On the futures exchange you can't trade $145,000 to hedge that amount, but on the spot market you can."
Stevens says the CME's currency futures product mirrors its other products in terms of standardization and being deliverable. "That works well if you're a farmer hedging a particular product," Stevens say. "Where it doesn't work as well is for the retail speculator or the small money manager who wants to be able to get in and out of the market with plenty of liquidity, price discovery and a fluid market that runs 24 hours, which echoes more the interbank market."
The difference in liquidity between OTC and futures depends on what pair you want to trade and the CME routinely provide narrow spreads with ample liquidity for retail traders despite Stevens' claims.
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