The foreign exchange and over-the-counter interest rate derivatives market in the United Kingdom
By Harry Goodacre (Market Intelligence and Analysis Division) and Elias Razak (Data and Statistics Division).[1]
- Since 2016 there has been substantial growth in foreign exchange (FX) volumes, both globally and in the UK. The UK retained its position as the leading international location for FX trading.
- The over-the-counter (OTC) interest rate derivatives market in the UK has also seen significant growth since 2016. The UK is the largest centre for OTC interest rate derivatives activity in the world.
- This article, based on market intelligence and data from a triennial survey by the Bank for International Settlements (BIS) of trading activity, considers some factors that are likely to account for the increase in foreign exchange turnover over the past three years.
Overview
As was the case globally, the FX market in the UK saw a large rise in average daily turnover between the 2016 and 2019 surveys. In 2019 the UK has retained its position as the leading international location for FX trading.
There are multiple drivers behind the strong growth in FX volumes globally, and these have also helped increase UK volumes. First, for both the UK and the wider global market, the largest product contributor behind the increase in total reported turnover numbers was the large increase in FX swap volumes. Second, the rise in reported volumes is consistent with the continuing shift from voice to electronic trading.
Like the FX market, the OTC interest rate derivatives market both globally and in the UK saw a large rise in average daily turnover between the 2016 and 2019 surveys. This was in part due to technical factors such as more comprehensive reporting of related party trades, and increased use of trade compression services. Based on the 2019 triennial survey, the UK was the largest centre for OTC interest rate derivatives activity in the world.
Introduction
For more than 30 years, the BIS has been gathering data on activity in global financial markets in a bid to give an accurate picture of trading volumes and trends. Every three years, it co-ordinates an international survey that draws on turnover data for the reporting month of April from central banks and monetary authorities across the globe.
In doing so, it aims to give a snapshot of market activity, increasing transparency of markets and thereby helping central banks, other authorities and market participants monitor developments in global financial markets. With data collected on a consistent basis, the survey gives a picture of the types of trades that take place, the overall scale of trading and the locations that dominate trading activity.
As the UK’s central bank, we participate in this exercise, conducting a survey of UK financial institutions who are active in the FX market and the OTC interest rate derivatives market.
The latest data, published in September 2019, demonstrate the UK’s role as a global financial centre. The UK has retained its position as the leading international location for FX trading. The UK accounts for 43% of global FX turnover. As well as retaining its position as the key international hub for FX trading, the UK also saw the scale of FX trading here rise significantly over the past three years. Between April 2016 and April 2019, average daily turnover of FX trades each day increased by 49% to reach US$3.6 trillion.
Based on the 2019 triennial survey the UK was the largest centre for OTC interest rate derivatives activity in the world. The UK’s market share increased to 50% in 2019 from 39% in 2016, and now stands broadly in line with the 2010 and 2013 surveys.
In this article, we explore the trends behind these figures. First, we assess the UK in a global context and second, we try to shed light on what is driving growth in FX and OTC interest rate derivatives trading in the UK.
The UK market in a global context
As was the case globally, the FX market in the UK saw a large increase in average daily turnover between the 2016 and 2019 surveys. Average daily turnover grew by 49% during this period, increasing from US$2.4 trillion to US$3.6 trillion.
The UK has been an important location for the overall global FX market since the BIS triennial survey began. In 2019 the UK has retained its position as the leading international location for FX trading. Forty-three per cent of global turnover in the FX market is arranged by UK-based traders, up from 37% in April 2016. Some of the drivers behind the increase in global volumes, and how these contribute to the high UK market share, are outlined in the next section.
As was also the case globally, in the UK market the US dollar continued to be the most traded currency.[2] Ninety per cent of FX trades arranged in the UK involved the US dollar, similar to the results of the 2016 survey.[3] Globally, the UK has 44% of US dollar market share.
Globally the US dollar/euro pair is the most traded currency pairing, accounting for just under a quarter of FX business.[4] The US dollar/euro also remained the most traded currency pair in the UK, comprising 28% of total FX turnover.
By product, 49% of all FX turnover globally is attributable to FX swaps. Spot activity accounts for a further 30%. FX swaps are contracts between two counterparties to agree to exchange currency for a period of time, traditionally used by institutions for liquidity management and hedging purposes. FX swaps also remain the most traded instrument in the UK, accounting for 46% of total FX turnover in 2019.
US dollar/euro and sterling/US dollar are the most common denomination of FX swaps in the UK, accounting for 34% and 16% of all FX swaps in 2019 respectively. Behind the US dollar/euro and sterling/US dollar, the third most traded currency pair for FX swaps was also the same as in 2016. US dollar/Japanese yen accounted for 12% of FX swap trades in the UK in 2019, down from 14% in 2016.
FX swaps continue to have the highest market share of all FX products, both in the UK and globally. But other FX products have also seen growth. A product that has grown its share since 2016 is outright forwards. An outright forward is a type of contract that allows the purchaser to buy or sell a currency at a fixed exchange rate in the future. Globally, trading in outright forwards rose by 43% to an average of US$999 billion per day in 2019. Outright forwards accounted for 15% of all FX products traded in the UK in 2019, up 4 percentage points since 2016.
When looking at contracts by maturity, institutions still favoured shorter-term contracts in FX swaps. In the UK, two thirds of all FX swaps contracts have a maturity of up to and including seven days, down slightly from 2016. Globally, 64% of trades in FX swaps have a maturity up to and including seven days. However, for outright forwards, the market data indicate a wider range of maturities. In the UK, outright forwards with a maturity date of over seven days and up to one month comprised 36% of the total market, maturities of over one month and up to three months comprised 32% of the total, and short-term contracts of up to and including seven days accounted for 22% of outright forwards.
As well as giving a sense of what is being traded and where, the survey also shows us who is trading. In the UK, the largest share of FX contracts comprised trades between reporting dealers and ‘other financial institutions’. This sector comprises hedge funds and proprietary trading firms, institutional investors, non-reporting banks (those not directly participating in the triennial survey as reporting dealers), official financial institutions (such as central banks, sovereign wealth funds and public institutions) and other institutions that are not explicitly reporting banks or non-financial institutions. Contracts between reporting dealers and these other financial institutions comprised 58% of all UK FX business recorded in 2019, up from 45% in 2016. Breaking down this sector split further, non-reporting banks have the largest share, with 43% of all trades within the ‘other financial institutions’ sector.
Figure 1 The geographical distribution of foreign exchange turnover (a)
(a) FX turnover figure is on net-gross basis, based on daily averages in April 2019.
What is behind the large increase in reported UK volumes
There are likely to be multiple drivers behind the large growth in FX trading globally, and these have also helped increase UK volumes. The UK market may have benefited proportionally more from these drivers for the reasons outlined below.
First, for both the UK and the wider global market, the largest product contributor behind the increase in total reported turnover was the large increase in FX swap volumes (Chart 1). FX swaps increased by US$485 billion in the UK market and by US$1,025 billion in the global market. Market contacts have suggested various reasons for the substantial increase in FX swaps.
The growth in cross-border bank lending over the period is consistent with a rise in the use of FX swaps as a means of funding liquidity management, especially by non-reporting banks. The use of FX swaps by non-reporting banks increased by 139% in the UK between 2016 and 2019. Banks located in jurisdictions with access to relatively cheap liquidity may have swapped their local currency liabilities into dollars via the FX market in order to lend US dollars at a higher rate. Also, as the FX swap market is skewed towards the short end, growth in the use of FX swaps can result in more contracts being rolled over in any one month. This increases the volumes of FX swaps.
The rise in reported FX volumes is also consistent with the continuing shift from voice to electronic trading in this market. The shift to electronic trading of FX markets provides opportunity for other types of market participants such as principal trading firms to trade, and some evidence points to electronic trading having helped to reduce the cost of trading. This is a global trend, with penetration of electronic trading versus voice trading edging up in the past three years to 58% in the UK. Although e-trading for developed market currencies has been high for some time, there has been a shift to e-trading for emerging market currencies and non-deliverable forwards (NDFs). More market participants are dealing electronically directly with banks, with many banks dealing out of London. The shift to electronic relative to voice tends to favour London as a financial centre because many major firms run their global e-trading from London.
While not being the largest driver of the increase in FX turnover, the 2019 survey saw a global rise of 46% in the trading of emerging market currencies (Chart 2).[5] The UK saw an 85% increase in volumes of these currencies over the same period. This was in the context of a low interest rate and low volatility environment. Some market intelligence suggested these currencies have been more attractive to market participants for speculative trading purposes, given their volatility compared with developed currency pairs in recent years.
In particular, total UK FX trades in Chinese renminbi pairs increased by 45%, from an average of US$39.2 billion per day in 2016 to US$56.7 billion per day in 2019. There was also a substantial 284% increase in trading of Korean won, with total FX trades in Korean won pairs increasing from an average of US$13.8 billion per day in 2016 to US$53.2 billion per day in 2019. Market intelligence indicated that the Korean won is being used by some market participants as a proxy or alternative for trading other less-traded currencies in the region.
In the UK market there were also increases in trading in some other emerging currencies. Trade in the Brazilian real was up from an average of US$11.6 billion per day to US$34.1 billion per day; the Indian rupee was up from US$8.8 billion per day to US$46.8 billion per day; and the South African rand was up from US$24.2 billion per day to US$44.5 billion per day between the 2016 and 2019 surveys.
The rise in emerging market currency trading is also consistent with the notable rise in NDF trades of 187%. NDF contracts settle in the same currency (typically the US dollar) at maturity, based on the movement of the underlying exchange rate, and are often used to trade emerging market currencies. Market intelligence pointed to non-banks now being able to trade NDFs using high-frequency trading algorithms on electronic trading platforms, where previously they could not. This has increased pricing competitiveness in NDF products, which has supported significant growth in client interest in NDFs.
Chart 1 Growth in FX turnover in the United Kingdom by product
Source: Breakdown of the 2019 BIS triennial survey for the UK, Bank of England.
Chart 2 Growth in notable emerging market currencies by geography
Source: Triennial Central Bank Survey, Global foreign exchange market turnover in 2019, BIS.
Box A: The BIS triennial survey and the Foreign Exchange Joint Standing Committee survey
Alongside the BIS triennial survey, a related and more frequent survey offers some additional insight into foreign exchange market trends. Since October 2004, the London Foreign Exchange Joint Standing Committee (FXJSC) has been publishing FX turnover data for the United Kingdom. The FXJSC, a market liaison group established by the banks and brokers of the London FX market, is chaired by the Bank of England. Data are published on a six-monthly basis, for the reporting months of April and October.
The FXJSC survey collects similar information to the FX section of the BIS triennial survey. Institutions that participate in both surveys report consistent results and account for 99% of turnover in the BIS survey. But there are two differences in institutional coverage and definition. First, the reporting basis for the FXJSC survey is based on the location of the price-setting dealer or trading desk (where transactions are executed), while the BIS triennial survey is based on the location of the sales desk (where transactions are arranged). Second, more institutions participate in the BIS survey.
Chart A shows the development of UK FX market turnover since 2004 by combining FXJSC and BIS triennial survey results. The difference between the two surveys in 2019 is much bigger than in previous periods. In the 2019 BIS triennial survey, volumes are 25% higher than in the corresponding period’s FXJSC survey. Around half of this difference in notional volumes is accounted for by spot FX transactions and another quarter is accounted for by FX swap transactions.
The larger difference in volumes between the FXJSC and triennial survey in 2019 may reflect reporting improvements made by institutions in the 2019 triennial survey. Alternatively, pre-existing differences between the two surveys’ reporting methodologies may have been magnified in 2019.
Chart A UK FX turnover in FXJSC and BIS triennial surveys
Sources: The London Foreign Exchange Joint Standing Committee Survey, Bank of England; and Breakdown of the 2019 BIS triennial survey for the UK, Bank of England.
Box B: OTC interest rate derivatives turnover in the United Kingdom
As well as capturing data on the global FX market, the BIS triennial survey also looks at trading trends for OTC interest rate derivatives. Interest rate derivatives are contracts whose value is dependent on the value of an underlying interest rate, and OTC derivatives are not traded on an exchange. In over-the-counter markets, participants trade directly with each other, typically through electronic systems or by telephone.
Based on the 2019 triennial survey, the UK was the largest centre for OTC interest rate derivatives activity in the world. Like the FX market, the OTC interest rate derivatives market in the UK saw a large rise in reported average daily turnover between the 2016 and 2019 surveys (Chart A). Reported average daily turnover more than trebled during this period, increasing from US$1.2 trillion in April 2016 to US$3.7 trillion in April 2019.
Chart A Interest rate derivatives average daily turnover in the United Kingdom and other major centres
Sources: Breakdown of the 2019 BIS triennial survey for the UK, Bank of England; and Triennial Central Bank Survey, BIS.
The substantial increase in UK average daily turnover figures is consistent with the global trends. Average daily turnover in the US has almost doubled and in Hong Kong it has nearly quadrupled. Part of the increase reflects more comprehensive reporting of ‘related party trades’, including the recording of ‘back-to-back’ trades.[6] This is due to multiple trades being traded within the bounds of a consolidated institutional group, while still being recordable within this survey. These internal trades do not necessarily reflect true market activity. Market intelligence corroborates this, indicating that the inclusion of ‘back-to-back’ trades had been a notable factor in the 2019 survey results.
The proportion of related party trades increased significantly, up from 17% in 2016, to 37% of all UK trades recorded in 2019 (Chart B). Data for related party trades are not available by product or currency. This means adjusted turnover cannot be calculated for these breakdowns, and this should be kept in mind when comparing against earlier surveys.
Chart B Total interest rate derivatives in the United Kingdom and the proportion that are related party trades
Sources: Breakdown of the 2019 BIS triennial survey for the UK, Bank of England; and Triennial Central Bank Survey, BIS.
Compression trades may have also played a role in increasing turnover of OTC interest rate derivatives. Compression trades are a post-trade netting technique through which market participants can modify or replace outstanding trades in order to reduce overall market gross position without modifying net positions. The BIS triennial survey picks up both the original trade and the resulting compression trade, thereby inflating the total amount of turnover.
Compression services are particularly attractive to global systemically important banks, with compression cycles scaling down balance sheet capital. This allows institutions to more efficiently manage their derivatives exposure. The use of compression services has increased significantly since the 2016 survey. This is in part due to regulations that have either required or incentivised the use of compression trades.[7]
Splitting the UK market into product types, interest rate swaps were the biggest driver of total turnover growth in absolute terms. Interest rate swaps, which account for 61% of the OTC interest rate derivatives market in the UK, are contracts for an exchange of payments between two counterparties at some point in the future according to a specified formula. UK average daily turnover in interest rate swaps rose by 194% between 2016 and 2019, climbing from US$0.8 trillion to US$2.2 trillion a day.
Reported turnover in forward rate agreements (FRAs) also increased significantly, up 167% to US$1,000 billion per day. FRAs are contracts whereby two parties agree, at the point of contract initiation, on a fixed interest rate that is to be paid or received on an agreed date in the future. Reported turnover in interest rate options also increased significantly to reach US$442 billion per day. Interest rate options are contracts that give the bearer the right, but not the obligation, to benefit from a rise or decrease in interest rates.
The UK’s share of the global OTC interest rate derivatives market increased from 39% in the 2016 survey to 50% in the 2019 survey. This is broadly in line with the UK market share recorded in previous surveys. In contrast, the US saw its market share decrease from 41% to 32% between 2016 and 2019.
The strength of global activity in US dollar-denominated contracts could be viewed as another factor behind increased UK turnover (Chart C). US dollar-related global activity increased from US$1,357 billion to US$3,274 billion per day over the period. The UK share of global US dollar activity increased from 14% to 33%.
As a result there was a notable increase in US dollar activity in the UK market from 18% of total turnover to 32%. Similarly, euro-related global activity in the OTC interest rate derivatives market grew by 148% from US$641 billion per day in 2016 to US$1,587 billion per day in 2019. The UK remained the main centre for euro-denominated contracts, with its share increasing from 75% in the 2016 survey to 86% in the 2019 survey. But the proportion of UK turnover attributable to euro decreased from 49% to 43%.
Chart C Interest rate derivatives turnover of selected key currencies in the United Kingdom
Source: Breakdown of the 2019 BIS triennial survey for the UK, Bank of England.
