Over the past several years, we have seen a continuous migration of client FX flows away from voice channels to electronic delivery channels. Recent surveys would suggest that +/- 80% linear products are now executed electronically. FX option flows are probably closer to 30% but that number is gradually increasing.
The recent COVID pandemic rapidly upended long accepted working practices in major financial institutions across the globe, forcing them to rethink and optimise the delivery of products and services in an extremely challenging new environment. In this stark situation, robust electronic delivery channels were least affected, remained up and available throughout the major market dislocation in late March and April of this year. As a direct result, we have already seen an increasing number of active consumers more willing to fully embrace electronic trading as long as the products are available.
Against this background, major bank providers will continue to focus on and continue to invest in their proprietary single dealer platforms and an increasing number of 2nd tier banks and brokerages are now partnering with tech providers to offer online trading solutions to their franchise clients.
There will also be an increasing focus on delivering products and services via mobile devices; as the “Iphone” generation becomes increasingly ubiquitous across financial markets, particularly in the hedge fund and private banking/family office space, demand for mobile solutions will continue to grow. Active users will expect to be able to pick up targeted news alerts, trade ideas and position/p+L alerts via different mobile platforms and act accordingly, either through order submission or the ability to interact with executable liquidity across the full suite of supported products.
Understandably competition has continued to increase as more bank providers and aggregators enter the fray to the point that there is now very limited opportunities for growth in the delivery of linear products. We expect to see a wave of consolidation, particularly against a background of major banks starting to cull aggregators that generate limited value.
FX options – a different story
In the FX option space, the story is a little different; for many years this was the domain of a handful of the major FX banks, who having made significant investments in their option pricing engines and risk management tools, generated significant revenues in a much less competitive environment.
Thus far, the Foreign Exchange Option market has continued to lag the electronification of the cash markets by 5-7 years and now represents 25%-30% of daily turnover. Development and adoption of dedicated option platforms has been slow for various reasons. FX options represent on average 5% to 7% of daily turnover, are regularly used by a much smaller subsection of the FX market and are at least 4 times more complicated; the argument for making a significant, long term investment into such a small and specialised business opportunity was less than compelling, even for larger, established service providers.
It is therefore unsurprising that not many new entrants have managed to gain any kind of foothold. Most importantly, major bank single dealer platforms have historically dominated the B2C space which they have jealously guarded from inception. This has meant that accessible liquidity has remained fragmented, cumbersome and ultimately expensive for the consumer to access. Market data (read transparency) has not really improved and there is still no single source of accurate, aggregated market data.
Due to the complexity of the product, particularly when you include complex structures, the widely differing requirements of diverse client segments, it is unsurprising that until recently, there has not been a viable multi-dealer alternative.
Recent changes in regulation, specifically proof of best execution have however provided sufficient impetus to bring about a change in both client and provider attitudes. This is already proving to be an important driver of growth and increasing migration to platforms that are able to provide rich functionality, previously only available on SDPs but with the added benefit of competitive, aggregated pricing and best execution reporting.
Thus far, FX option services made available via MDP’s have generally provided a basic range of services; indicative pricing, aggregated vanilla liquidity across a limited range of structures, a smattering of 1st generation exotics and a suite of reporting/analytics for both buy and sell side users. The current range of products and services have in general, been designed to offer a basic service that meets at least some of the requirements of as many client types as possible.
Raising the bar – looking to the future
In order to flourish, a new generation derivative platform will need to significantly raise the bar; it will require major tech investment, deep, specialist product and market knowledge and equally importantly, strong working relationships with key clients. If FX option platforms are to thrive and gain further market share in the near future however, they will require significant investment to compete with the more advanced and feature rich SDPs
In order to better service the private banking and sophisticated corporate hedging community, they will need to provide comprehensive structuring and pre trade analytics using rich market data and robust pricing models. This solution should be backed up by competitive aggregated liquidity across all FX cash and option products.
An increasing number of market users are looking for aggregated pricing across all type of option products; vanilla structures are already available but the operational risk of entering a complicated “schedule product” into multiple SDP’s is fraught with operational risk and does not meet best execution reporting requirements.
As a corollary to a major boost in functionality and product complexity, there will be increasing demand for an integrated lightweight and real time portfolio/risk management service. Managing portfolios of complex derivatives either for in house positions or clients in real time using accurate revaluation tools will become increasingly important. Most large OMS providers do not provide any such functionality and trading desk are forced to use separate stand-alone risk systems or the inevitable Excel spreadsheet solution. The ability to evaluate, execute, confirm and risk manage complex structures seamlessly in a single robust environment will become increasingly valuable.
In order to further enhance their appeal, platforms may consider offering both derivative and linear pricing across other asset classes via a single portal; this may encompass interest rate, commodity or equity products and may further provide direct access to listed products alongside liquid OTC.
Additionally, such new platforms should not be simply aggregators of executable liquidity, rather they should aim to provide a much wider, more holistic range of services; these would include aggregated and targeted market research, trading ideas, market activity heat maps and aggregated indicative and actual market data that may be used for modelling.
As TCA and best execution requirements continue to weigh on clients and providers, next generation option platforms should also provide detailed pre- and post-trade reporting tools.
As option flows increasingly migrate to electric execution channels, providing much greater flexibility and the ability to transact many smaller transactions efficiently, much greater levels of automation will be required to better facilitate this change of behaviour. Ideally, automation of trade upload or order generation, order splitting where relevant, automated execution of orders based on configurable parameters, automated confirmation generation and matching by allocation or by block, automated price quality monitoring, reporting and substitution based on performance. Algo trading of FX options has thus far not been embraced.
The final piece of automation that will help the FX option market flow more easily is automation of the option expiry process – for years this has been a bugbear for both clients and providers alike; it has been a completely manual, inefficient and gating bottleneck in the whole FX option trading workflow. This is now being addressed by one major FX option platform using a 3rd party benchmark and which is now being used by all major fx option providers.
This path to growth is by no means easy however; as clients become increasingly comfortable with the use of options in their day to day activities, access to pricing, liquidity and analytics through a state-of-the-art trading platform remains half the battle.
Many of the major OMS providers have only limited support for OTC derivative structures which limits the ability and scope of users to fine tune investment or hedging strategies using customised strategies.
As DLT progressively replaces outdated, legacy FX confirmation and settlement systems, we would expect to see FX option flows also start to be included in this process allowing more rapid access to available trading limits. Additionally, as large option portfolios have a habit of eating into available position limits, option platforms may provide an independent venue to facilitate portfolio compression to free up limits.
In a similar vein, as UMR edges closer, we would expect to see option platforms establish direct connectivity with CCP’s to facilitate rapid and efficient execution and submission to clearing.
In summary, we would look for the following evolution in the development of e-option platforms:
- Increasing buy-side migration to electronic channels as result of COVID pandemic
- Continued regulatory pressure around best execution and reporting
- Increased coverage of more exotic products and structures
- Increasing automation of end to end workflow – execution, algo trading, expiry management
- Liquidity optimisation; continuous monitoring of price and service quality
- Detailed pre and post trade TCA
- Integrated, real time portfolio and exposure management
- Standardised external connectivity options – credit API etc
- DLT connectivity and limit optimisation
- Non-bank liquidity will be embraced