In an evolving market for trading FX options, the move to deal and manage the process of a transaction electronically has made great strides. But as the user base expands and products become more complex, the impetus to develop an ever-more efficient workflow will inevitably lead to further progress. This evolution will, in turn, encourage greater usage of the electronic format as the preferred means to satisfy the raequirements of the end user, the distribution strategies of the liquidity providers and the obligations enforced by increasing layers of regulation.
That said, it is clear that there is no panacea when it comes to trading FX options electronically. The universe of users is many and varied, with each of them approaching the market to satisfy their own particular needs and bringing with them diverse levels of sophistication and experience. A “one size fits all” system may not be the best forum to deal with such a broad range of non-standard requirements, but increasing automation will result in improvements to the process of trading FX options for a growing number of participants.
So far, advancements in electronic trading have mostly materialised in the facilitation of different workflows, the expansion of the product range and the development of increasingly user-friendly interfaces.
In the vanguard of transitioning FX options trading onto the electronic format has been the Single Dealer Platforms (SDPs). They still, today, offer the customer the widest range of products: from plain vanilla to the more exotic end of the spectrum. The product offering on each platform is tailored to reflect the distribution strategy for exotics within each bank which, for some, has recently expanded to embrace accrual products including TARFs (Target Accrual Redemption Forwards).
As well as an expansive product coverage, SDPs also promise a level of service that complements the platform’s functionality, a level of service that is difficult to replicate in most other trading venues.
These platforms benefit from an integrated approach to dealing and communication, which essentially presents the client with a choice of sophisticated workflows. In addition to offering live prices over the product range, the inclusion of user alerts and the capability to share ideas and information electronically are relatively new features to be found on some platforms that enhance the end user experience. Improving the customer experience is an important factor in supporting the client towards greater use of electronic trading.
Sharing ideas and information between colleagues (or between bank sales and client) assists in the generation, propagation and explanation of potential trading strategies, while alerts can be individually engineered to indicate when vols hit a certain level, thereby prompting the customer into action.
The next stage in alerts development is in the automated actioning of a trading strategy, and while this is currently offered only rarely on some SDPs, this type of functionality is likely to become more commonplace.
At the moment, SDPs are the domain of the Tier 1 banks. Developing and maintaining an SDP is a hugely expensive exercise, making this type of venue only cost effective to institutions that either already have the requisite extensive client base, or the desire to create such an audience electronically. That will change, however, as technology vendors help lower the cost of entry into this space, and we expect to see SDPs for more banks rolled out in the near future.
For other banks, it is Multi-Dealer Platforms (MDPs) that represent the best way to distribute prices to, and win business from, as wide an audience as possible. MDPs may not have the same product coverage or functionality as SDPs, but they have gained traction in FX options by presenting the customer with a variety of counterparties from which to search for the best dealing prices.
And although there has recently been progress in MDPs adding to the product range - with the inclusion of multi-leg structures on some platforms and early signs of first generation exotics being added, it is prices in vanilla options that dominate on these multi-dealer venues.
Customers use the platform to express an interest and it is then up to the individual banks to respond, either by way of a dealing engine or manually by inputting directly into the MDP. Those banks with automated dealing engines linked to the MDP have the upper hand over the competition in relation to speed of quoting as they return prices to the client “instantaneously”. They also benefit from the ability to programme dealing engines to support streaming price adjustments as the market moves.
Improvements in vendor technology are effectively lowering the barrier to entry for new price makers to compete with Tier 1 banks for options business. Where once the price to compete with the major players was the huge development costs of building a bespoke, in-house platform, it is now a much more straight-forward (and cheaper) process to join the ranks of dealers on MDPs.
It’s not just reductions in the technological barrier that are opening up the market to more price makers, regulatory considerations are also making an impact.
As the cost of capital becomes an increasing focus for Tier 1 banks, decisions need to be made as to where best to employ that capital, and there are signs that the major players are becoming more selective with their product offering. This leaves the door open to banks outside the top ten to fifteen Tier 1 institutions to become market makers on multi-dealer venues and further establish themselves in the market.
Technological and regulatory costs are considerations in the wholesale market but dealing with retail-type clients comes with an additional burden. Here, the transactional costs associated with processing and managing a ream of small notional positions with irregular strikes and expiries has prompted some of the retail vendors to offer trading on fixed contract grids.
Not only does this practice mitigate the expense of managing an enormous flow of tickets but the savings can be passed onto the customer in the form of improved prices.
It would seem that the arguments for trading electronically stack up, yet despite the undoubted benefits of automation it is still important for banks to interact with clients in person and that is perhaps most evident when it comes to trading in sophisticated products such as FX options. Banks, particularly in certain parts of the world, clearly favour the human touch when it comes to explaining the effectiveness and benefits of complex transactions to their key customers.
So voice and chat are not about to disappear any time soon, but as the level of sophistication within the customer base increases, so more trading will inevitably move into the electronic world. The incentives are speed and transparency of prices as well as the potential for pre-trade analysis, and post-trade risk management.
Speed and transparency of pricing, and therefore trading, has been enhanced with developments in automated streaming over the more-traditional RFQs. Streaming has also improved the operational efficiency in pricing more exotic transactions and for quoting in premiums. Quoting in premiums, the preferred trading method for retail, is time sensitive as it is susceptible to movements in the underlying.
Connectivity and FIX
Given all the various venues that can be used by different market participants, each of which uses their own, distinct technology, the speed at which the market can expand is limited by the ease with which systems communicate.
In fact, it is the resolution of communication protocol used between venue and price maker that has probably been one of the more significant developments towards the wider trading of FX options electronically. Improvements in connectivity enable a more turn-key approach to the market.
If a bank wants to become a liquidity provider to a particular MDP, then connectivity is now a thankfully less challenging process. That improvement can be put down to the increasing use of FIX as a basic standard protocol.
Historically, for a bank as price maker interacting with a range of venues - or a venue connecting with a number of price makers, connectivity was an expensive prospect but the wider use of FIX has greatly improved the ease of interaction throughout the market.
FIX does not describe the FX options world in its entirety so there is still work to be done to establish effective communication between counterparties. Nevertheless, the level of standardisation in protocol has improved the efficiency and speed at which players can participate and is helping to expand the user base. For price takers looking to a programmatic interface for execution, FIX has similarly been the protocol adopted.
In addition, FIX is increasingly being used to communicate an expanded number of trade details for each transaction, such as USIs/UTIs. Not only does this help in conforming to the increasing regulatory requirements surrounding trade reporting, but it also automates the enrichment of post-trade data.
Pre trade and Post trade
Support of post-trade workflows and pre-trade analysis are areas that will attract further attention in the future. Development in the infrastructure to manage trades’ expiries or fixings (in the case of NDOs), for instance, is ongoing and could realistically expand into the more time-sensitive management of triggering events for exotic options. Interestingly these features are not something to be found on the trading venues but are more in the domain of firms offering risk management and regulatory compliance infrastructure.
Pre-trade analysis will be greatly enhanced by increased transparency in prices, but transparency in pricing needs to go some way yet before TCA is the big topic it has become in spot. That’s simply down to the paucity of data. The paucity of data is also hampering developments in algo trading.
Improvements in data gathering and transparency will appear as other influences push the market towards that goal. One of those influences is clearing.
Clearing has many implications. Combined with regulation such as MiFID II / MiFIR in Europe, it would go some way to provide the transparency, and hopefully liquidity, necessary to support algo trading and pre-trade analysis, and to supporting the central limit order book model in vanilla instruments.
In theory, clearing could accommodate all types of trade within the FX derivatives world, but the reality is that the first wave of trades to follow NDFs into clearing will either be the most heavily traded plain vanilla options in the major currency pairs or in the simpler world of NDO emerging markets where there is no physical delivery to be addressed.
The move to clearing will also play an important part in facilitating the introduction of non-bank liquidity, thanks to it creating a level playing field for participants in terms of counterparty risk. Although the market for FX options is not being forced down this road, it is likely that some trading will head that way once such offerings are available from clearing houses, so 2017 may well be the year in which clearing in some products becomes reality.
While the adoption of electronic trading in FX options may not be suitable for all users of the product, it is certain that as the level of sophistication within customers increases, the number of users and the range of instruments traded will expand accordingly.
Regulatory changes and the constant need to manage risk, cost of capital and margin requirements will lead to changes in the types of venues on which dealing is conducted and the type of players making markets and servicing different types of clients.
The challenge is to develop the technology to help facilitate and enable these transformations.