Frances Maguire
Frances Maguire

A better way to manage risk?

The financial crisis brought with it unprecedented volatility and credit concerns that are still having their effects on all global markets, including FX – namely in the form of the widespread financial reforms that are now underway. Aside from the recent flight to quality that exchanges experienced throughout the crisis as credit lines and liquidity suddenly dried up, the clear message from the G10 is that, by 2012, a very different landscape will emerge, where as much vanilla business as possible will be transacted on regulated exchanges, or at least cleared through a central counterparty. Furthermore, increased collateralisation requirements will be laid out by the regulators for those instruments that continue to be traded over-the-counter (OTC).

First Published: e-Forex Magazine 40 / FX on Exchanges / July, 2010

With this level of change facing the industry, many are already reviewing structures and trading decisions in order to comply with incoming liquidity risk requirements, as well as gearing up for the likelihood that FX options at least, and possibly swaps and forwards will need to be centrally cleared in the future.

Derek Sammann, managing director of Interest Rates and FX Products at CME Group, says that one of the key value propositions of using exchange-traded futures is the credit mitigation facility of a central counterparty.

He says: “When you introduce a central counterparty mechanism you are mitigating the bilateral counterparty risk that exists between any two sides of an over-the-counter (OTC) transaction. Because of this, we, as a Clearinghouse and as an exchange, are able to bring together the broadest possible and most diversified set of market participants to trade with one another. A large part of our business is coming from hedgers and investors who have positions outstanding, not just speculators.”

Derek Sammann
“When you introduce a central counterparty mechanism you are mitigating the bilateral counterparty risk that exists between any two sides of an over-the-counter (OTC) transaction.”

Derek Sammann

“When you introduce a central counterparty mechanism you are mitigating the bilateral counterparty risk that exists between any two sides of an over-the-counter (OTC) transaction.”

Open interest

One of the most important metrics used to show the split between speculative day traders and buy and hold participants is open interest, the total number of transactions that remain on the books at the end of the day. According to Sammann, CME’s open interest grew by 87 per cent, to a total of $220 billion (1.8 million contracts) between Q2 2009 and Q2 2010. “This illustrates the strength and the growth in our FX futures market. We manage the health of business by making sure we focus on the breadth of customer participation, providing products that are interesting to hedgers, investors and liquidity providers across all geographies,” he says.

May 2010 average daily volume in CME’s FX products was US$160 billion, representing growth of 141 per cent year on year, with futures growing 133 per cent and options growing 344 per cent versus May 2009. “When you talk about risk management, investing or hedging, for a large part you are also talking about extended use of options. Options are a tremendously flexible risk management tool,” says Sammann.

The healthy growth of both FX futures and options is critical, says Sammann, as they complement each other. A very deep and liquid underlying futures market is needed because customers are trading futures against options – the two are very tightly linked.

A large part of this growth is that currency by its very nature is deeply tied to the capital markets, both equities and debt, and as capital flows move around the world there is a natural currency risk.

Bilateral credit risk

Ever since the Lehman, AIG and Bear Stearns events, there has been a much more heightened awareness of bilateral credit risk and this has been a key driver of our exchange traded FX products growth, according to Sammann. “With an exchange, or central clearing, this counterparty risk is mitigated and neutralised which is a very attractive proposition to market participants. In addition, the transparency of exchange-traded market adds to the safety offered by a regulated marketplace, which is hugely important for global participants. And finally, an important driver for growth is liquidity. CME is one of the biggest FX platforms in the world, and the largest in listed FX products. There is a reassurance that comes from that kind of liquidity from a customer’s point of view because they know their entry and exit costs are very small due to the deep liquidity.”

CME also offers the full range of asset classes under a single umbrella: energy, metals, FX, equities, agriculturals, and interest rates alongside alternative investments, such as weather. “This is a huge draw for participants in addition to operational execution, connectivity, relationship of the Clearinghouse and understanding how their business can be done in a single venue.”

CME expanding product portfolio

In terms of products, the bulk of the product portfolio is futures and options on individual currency pairs, but CME is currently planning to expand its global index services. Earlier this year, CME purchased a 90 per cent stake in the Dow Jones Index Services Business. To complement many of its individual products, CME is looking at ways to leverage this relationship and ownership stake to look at index products and basket products in currencies to enable investors to take a view on a basket of currencies, as opposed to the individual currencies.

A better way to manage risk?

Sammann says: “We have skills and expertise in building liquidity, in bringing customers and delivering technology. The Dow Jones Index Services business brings a track record of building index products based on customer needs, so we think there are some exciting opportunities in extending the index services business outside the equities space and across asset classes.”

Additionally, with the rise in options trading, CME is also examining ways to deliver a new product to customers that look at volatility as a tradeable asset, in terms of a volatility index that allows investors to trade and take a position on volatility in foreign exchange.

CME is also planning to extend its OTC clearing services to the FX market later this year. Clearing services will be available for spot, forwards, options and NDFs in a bid to extend the benefits of the central counterparty out to the OTC market, across asset classes. Regardless of the final regulatory decision, CME will comply and remain flexible.

“There is clear distinction between this and migrating products to a central order book where you both execute and clear. What the market is telling us is that they would like to see a convergence of the bilateral model and the exchange model with central counterparty services provided at the post-execution level to the OTC market. This means that customers will still be able to trade on a bilateral basis on an OTC execution venue, but their trade can be sent for clearing into a clearinghouse,” Sammann says.

Sammann says that the deep liquidity of CME’s products and the transparency of the mark to market are very important to users with hedging needs. The ability to know, at any point, what the price is and what the settlement price enables the investor to constantly monitor both the underlying exposure and the hedge in order to manage risk.

On exchange growth elsewhere

Arshad Khan, Managing Director, at the Bahrain Financial Exchange says that the increased volatility in forex markets was driving increased business on to the exchange as market forces generate currency fluctuations, which make exposure in the OTC market more prone to risk.

He says: “There are also Euro zone issues, which have generated a lower GDP to debt ratio, resulting in the need to divert exposure from the OTC markets to the exchange-traded futures markets, where hedging and risk management tools are more accessible. Finally, the credit crisis has been one of the major contributors in driving participants to use exchange-traded currency futures. Where prior to this, a large proportion of trades were taking place off exchange with limited risk management opportunities. By routing all trades through central clearing, participants can eliminate credit risk through margining, and the risk of loss due to counterparty default.”

Arshad Khan
“There are also Euro zone issues, which have generated a lower GDP to debt ratio, resulting in the need to divert exposure from the OTC markets to the exchange-traded futures markets, where hedging and risk management tools are more accessible.”

Arshad Khan

“There are also Euro zone issues, which have generated a lower GDP to debt ratio, resulting in the need to divert exposure from the OTC markets to the exchange-traded futures markets, where hedging and risk management tools are more accessible.”

To manage currency exposure, market participants are using both currency futures and options. Currency futures allow the forex investor to hedge against foreign exchange risk. With this type of product, the investor is able to close out of their position, and exit from the obligation to buy or sell the currency prior to the contract’s delivery date.

An option is a contract that gives the purchaser, the right, but not the obligation, to buy (call option) or sell (put option) the underlying reference asset at a specified price level known as a strike price, at any time until an agreed expiry date, or only on the expiry date. In order to lower the risk of currency exposure, either a plain call or put option is used, or else exchange participants are using different combinations of these two options.

Managing risk

Khan says that real-time tracking of margins, mark-to-market loss limits, circuit filters or daily price range, exposure limits based on deposits in the form of cash and cash equivalents, ensure that exchange participants using exchange traded instruments are able to efficiently, and effectively manage their risk. “Institutional investors have exposure in various markets across the globe, and thus are more exposed to FX risk. They enter a market to bet on say a particular sector like equities or commodities and can hedge the FX risk using FX futures,” he says.

All currency contracts that are traded on an exchange usually include futures contracts and plain vanilla options. These contracts are standardised in terms of quantity and quality of the particular underlying currency. Khan says: “Hedging in currency futures enables investors to improve their return profile against the risk of depreciation or appreciation. It can be a possibility that due to depreciation, an investor’s pay-off is lower or even in negative, when compared with a hedged position.”

The major advantage for investors and risk managers taking exposure in options is that only the option premium is being paid for purchasing option contracts, while the possibility to profit from favorable price movements still exists. When buying FX option contracts, the right, but not the obligation, to buy or sell a futures contract at a given price is obtained. “Therefore when price movements are not favorable, this right will be exercised by the buyer or holder of the option, and therefore the purchase of options provides protection against unfavorable price movements, while permitting to profit from favorable ones, and this strategy limits the exposure to volatile conditions in global markets,” he adds.
 
Khan says that since the emergence of the credit crisis there has been a marked movement of trading from the off exchange or OTC market to the exchange traded environment.  “The key attraction of this form of trading is the removal of unregulated bi-lateral trading where counterparty risk is common. Although there are many participants who will continue to use this, the natural attraction to the on exchange fully cleared environment will prevail,” he says.

Kris Monaco
“All exchange listed and traded instruments are cleared through a clearinghouse.  The reduction of risk allows capital to be used more effectively, eventually lowering the overall costs of a risk management program.”

Kris Monaco

“All exchange listed and traded instruments are cleared through a clearinghouse.  The reduction of risk allows capital to be used more effectively, eventually lowering the overall costs of a risk management program.”

New currency contracts

Khan says that the launch of new currency contracts especially in the emerging market segment will be on BFX’s radar, since there has been increasing transactions between banks and non-financial customers in emerging markets, resulting from higher economic growth and trade. Reports indicate that the share of currency trade between non-resident counterparties has increased. Also, the G10 currencies will also be on the launch list due to the growing significance of a global platform and the associated price volatility embedded in global trading. 

“Last but not the least, the G10 currencies are considered to be the 10 most liquid currencies in the world, therefore one can expect active participation, if launched on the exchange,” he adds.

Kris Monaco, director of New Product Development at International Securities Exchange (ISE), says there are two significant factors that will continue to push this growth trend: the increasing number of institutions and even individuals that need to efficiently manage their currency risk, and the drive to reduce counterparty credit risk.

He says: “Geographic distribution of revenue continues to expand as businesses become more global.  Even the liabilities of individual investors are expanding beyond their normal territory.  For example, an investor may own real estate in another country where the loan is denominated in a currency that needs to be hedged.  That investor can easily hedge that risk using the same brokerage account that allows him to invest in stocks, ETFs, and options on those underlying instruments. Specifically in the US, FX options are tradable through virtually every online and full service broker that provides access to the options markets.”

There are a variety of instruments available to investors at ISE: cash-settled FX Options, currency grantor trusts (which are ETF-like products), options on grantor trusts, and futures. FX options are available through a wide network of brokers because the products are exchange-listed.  That increased distribution results in competition among brokers, further resulting in lower commissions and innovation in trading functionality (e.g., order types, execution capabilities, analytics, etc.).

Monaco says that efficiency also comes from centralising and mitigating counterparty credit risk.  “All exchange listed and traded instruments are cleared through a clearinghouse.  The reduction of risk allows capital to be used more effectively, eventually lowering the overall costs of a risk management program.”

Options are so flexible

According to Monaco, options are one of the most powerful yet flexible derivative instruments, regardless of the underlying asset class.  Global exposure can be managed with options by employing simple directional trades, or by using multi-legged strategies that can hedge volatility risk. 

“Consider an investor that expects to have exposure to a certain currency over a fixed period.  The cost of hedging that exposure depends on the level of protection that the investor seeks and the length of time that the protection is needed.  In this case, an options position can be considered synonymous with other types of insurance, such as home or car insurance.

When hedging with options, an investor needs to know the value of the asset at risk, has an understanding of the probability of certain events occurring, and ultimately determines the most suitable strike and expiration.  That level of customisation allows an investor to tailor its risk management programs to suit its specific needs,” he says.

Although many hedging strategies are simply one-directional, options provide risk managers with more sophisticated capabilities.  For example, spread strategies enable risk managers and investors to protect themselves from or gain exposure to volatility in currency prices.  These positions can be entered into easily because they are exchange-traded products.  On ISE, investors can execute these multi-legged strategies in a single trade while avoiding legging risk. ISE is planning significant enhancements to its FX options product suite over the coming year, including additional pairs, new product structures, and new FX benchmarks.

FX products set to grow

Monaco believes the demand for new and innovative FX products will only increase and that the number of new instrument types already in use illustrates this. However, he adds, the growth in exchange listed product usage so far has not cannibalised OTC trading as much as it has introduced new participants to the FX market. “In the end, we will see a healthy mix of OTC vs. exchange-listed trading because the lines will become blurred between the two areas.  Exchanges will seek to do more to accommodate, and perhaps facilitate, certain trades that are complex or unique enough to require an off-exchange solution.”