According to a report by the Bank for International Settlements in 2016, FX spot transactions are traded electronically 80% of the time, with currency derivatives lagging behind quite comfortably in the currency markets. However, there are now several factors driving an increased take-up of electronic trading in derivatives contracts that have historically been stuck on the phone.
“Now you have different approaches to executing transactions by the next generation of traders. For example, we may have a bank client on our FX options desk who four to five years ago, had five senior traders managing the banks’ options risk. Due to cost cutting and other changes at the banks the very same desk may only have three traders. These traders don’t have the bandwidth to price every trade and rely on the efficiencies of technology. The banks connect directly to our API so their pricing systems can electronically responded to request for quotes,” says David Perkins, Global Head of electronic markets at TP ICAP in London.
FX options appears to be where many market participants are seeing a bounce in levels of automation. An interesting statistic from the 2017 Euromoney survey this year suggested that electronic trading of FX options had gone from 15% to 29%. Digital Vega, an FX options dealer-to-client trading platform, has seen its volume grow significantly year-on-year, according to its executive chairman and co-founder Mark Suter. “There are a range of factors as to why we’re seeing volume growth. An increasing number of people we work with are a little younger, have grown up with technology and are less keen on voice interaction – they just want to see a price, click a button and be done with the trade and move on. It’s like Uber – it’s cheaper, much more efficient and there’s always a full audit trail,” he says.
Against a tough new regulatory background, banks are increasingly focused on increasing efficiency and achieving regulatory compliance, particularly in the interdealer space. Digital Vega is now working with 16 major banks to deliver a unique new electronic block trading and Central Limit Order Book solution, the first phase of which: Liquidity Hub, will launch in the next few weeks. To help attract market-makers to the new wave of electronic trading, Digital Vega has introduced a maker-taker model, akin to the equities market.
“We’re implementing a radical new fee structure where we pay market-makers for providing liquidity and charge price takers significantly less than they are currently paying; on average, active interdealer players should be able to reduce their brokerage bills by more than 50%,” says Suter.
Major regulatory change is also driving significant change in the currency markets. The second Markets in Financial Instruments Directive (MiFID II) is in essence forcing the market to become more efficient in the way it functions, including best execution for buy-side participants, which will mean it is to comply with a modernized back office with straight-through processing and API connections to trading platforms.
To help with this process, Digital Vega has introduced a neat solution called ‘Intelligent Execution’, which filters smaller orders that come in and, if they are within certain pre-defined parameters, the whole workflow becomes completely automated; bank group request creation, premium validation, execution, confirmations, and give-ups are all carried out by the machine. For those trading desks that do a lot of small trades, the algorithm will give firms the benefit of best execution analysis, transaction cost analysis (TCA), all in-built within the platform and allow traders much more time to focus on larger transactions.
“There is a greater availability of choice now, whether that’s a multi-dealer platform where vanilla options and strategies are widely on offer, or via e-commerce solutions which have been made more widely available through the lowered technology barrier-to-entry,” says John Crisp, Director of Product Strategy and Development at FENICS in London. “The demand from the customer side is also seeing an increase because of MiFID II coming into focus. While it is possible to have audit trails and create metrics around non electronic flows, it is certainly a lot easier to do it electronically.”
“We’ve invested a lot in terms of technology and modelling to enable the electronic trading of options, as they are a lot more complicated than simply cash products. The momentum supports continued investment in the next few years,” says Christophe Leruste, head of electronic options trading at Bank of America Merrill Lynch (BAML) in London.
Traditionally unwilling to move the market more electronic, market participants say that they are now embracing some of the new technology that is available.
“Our business brands (including Tullett Prebon and ICAP) adapt their solutions for different clients across a range of products, including FX Options. For instance, at Tullett Prebon, we developed a request-for-quote platform to accommodate our clients evolving trading requirements. All of the major banks are either already connected or are in the process of doing so. This allows the traders to consume our FXO data and electronically price in-coming interests more efficiently. This has increased transparency and improved our clients’ workflow,” says TP ICAP’s Perkins.
The specific investment from some banks such as BAML was focused around how to effectively model the risk that the bank would be pricing electronically as opposed to via a voice method.
“On the voice-traded side, most of the market is driven by brokers and not every price is available electronically, so it is a bit of an art to determine where the market is. One of the aspects that we developed was how to automate that process. We built logic and reasonable behaviors into the volatility surface so that we could have an accurate volatility surface at all times of the day, not just when we got a price request,” says BAML’s Christophe Leruste. “The other aspect on the risk management side is that, when you make a price on the FX option, you have to take into account several factors - like maturity, strike, vol risk, event risk and gamma risk etc,” he continues. “We had to incorporate all those risks into our automatic pricing. We also had to build a real-time link to our existing positions in order to skew prices correctly and generate axes; the traditional representation of our risks wasn’t suitable for that purpose, so we had to develop an alternative representation, more suited to algorithmic treatment.”
“We borrowed some concepts from exotic trading, like stochastic modelling. Another important part of the work was to make sure that traders can intuitively interact with this new risk management system and control the automated pricing, passing what their views of the market are onto the machine. These have become useful tools for traders in managing voice flows too,” he adds.
Smaller banks are beginning to take market share, says Crisp: “Technology being more available, combined with a slight pull back from some of the traditional market makers, makes it a good time for new liquidity providers to pick up some of the FX option flows. These new entrants are becoming a significant source of liquidity.”
Increased automation is also helping firms that have made a name for themselves in more standardized, electronic markets such as futures and FX spot.
“There is now the ability for ‘non-bank’ liquidity providers to feed accurate pricing into the FX derivatives markets. These participants have high quality technology and powerful analytical tools which can often deliver liquidity more efficiently than the banks are able to,” says TP ICAP’s Perkins.
While the progress in FX options will encourage those keen on seeing more electronic liquidity provision, Perkins says that this is likely to be with vanilla options initially as they are easier to standardize.
“Esoteric options that trade infrequently will continue to be traded over the phone with the voice brokers providing invaluable price and size discovery, but with regulatory change and a drive to central clearing, the more popular ‘at-the-money options’ will increasingly be executed via an electronic central limit order book (CLOB),” he says.
The best example of non-bank liquidity providers making an impact into currency derivatives markets is in NDFs. For example, one of the most notable liquidity providers in this market is XTX Markets, which so far just trades NDFs and FX spot in currency markets. This is helped by the fact that the market is very liquid and standardized in the one-month tenor, such as USD/KRW.
Most of this liquidity is traded via EBS, one of the largest FX spot platforms and part of the NEX Markets division of NEX Group. However, even they have had to wait their time before seeing significant growth in the market.
“We were the first to launch the NDF platform electronically for the dealer market back in 2008,” says Jeff Ward, global head of NDFs and forwards and head of FX for Asia at NEX Markets in Singapore. “We look for markets that are maturing, becoming large, international in scope and nature that would benefit from having an efficient electronic market where you can have price discovery and see volumes grow. It was a long hard road with NDFs and we saw a period of time where the market was slow to adopt electronic trading for them. But through persistence it took off.”
“We focus on liquid, commoditized instruments trading in a CLOB, and rolling one-month is the most liquid as far as that goes in NDFs. In something like CNY, the market is driven more by rate differentials and is less tied to spot because it doesn’t move that much, so rolling one-month isn’t necessarily the bigger tenor. Banks hedging their risk is through CNH now as it is a better hedge,” says Chris Soriano, head of emerging markets, Americas at NEX Markets in New York.
NEX Markets is setting its sights on the South American market next, with Brazilian NDFs making up roughly the same volume as the entire Asian market traded on swap-execution facilities (SEFs), with those separate markets totting up $5 billion and $5.5 billion per day, respectively. The Latin American (LatAm) market, however, has traditionally been transacted via voice, and any electronic liquidity in Brazilian contracts have traded as futures on the BMF Exchange. Not every institution has access to this liquidity though, so NEX Markets is targeting this to market to help those in need of hedging Brazilian currency risk.
“At the time we first launched, liquidity and activity in Asian NDF was lower, so the brokers and traders tended to be happy with how the market operated because in a way, Asian NDF was not ready to become electronic. There are the same drivers as there were in Asia – Banks need a central place to hedge, and a reference price, and these were the two main drivers in Asian NDF, and they are showing themselves now in Brazil,” says Ward.
The introduction of central clearing may also be a big factor in pushing through electronic trading in currency derivatives as it significantly reduces the counterparty risk between two trading entities. LCH is the primary marketplace for central clearing in NDFs, and the market picked up significantly once the initial margin rules for non-cleared swaps came into effect in September2016, which forced counterparties to post collateral against non-cleared derivatives, including NDFs.
This meant the dealer community in particular decided to begin clearing trades in earnest as the non-cleared initial margin requirement is higher than for cleared trades, based on a 10-day, 99% value-at-risk (VaR) model, compared with a five-day 99.7% VAR for cleared house trades – making it cheaper for dealers to clear their NDFs than leave them bilateral, and encouraging greater use of clearing.
LCH saw a huge spike in September and October last year in trades cleared each month, from approximately 10,000 up to June 2016 to approaching 130,000 processed in August this year.
“Credit is very important in NDFs, so clearing potentially unlocks significant trading opportunities between counterparties and will mean market grows significantly once that transition to clearing is complete. Smaller counterparties may choose to go through third parties, but access will change too,” says Ward.
FX options clearing has been slightly tougher to work out and is why perhaps electronic trading will be harder to accelerate compared to NDFs. As options is a bigger market than NDFs, some CCPs had originally planned to launch clearing in that market before NDFs, but that was made harder when regulators demanded that clearing houses need to guarantee ‘full and timely’ settlement of currencies.
CCPs including LCH and CME Group have been working on solutions since, but it is yet to be known what take-up either offering will have.
“Clearing has got great potential. CME and LCH are offering different models and are aiming at slightly different customer segments, with the former’s a non-deliverable offering so is likely to be more appealing to institutional clients. The LCH deliverable model is more useful for options for hedging purposes with a need for delivery of the underlying delta position,” says FENICS’s Crisp.
“Clearing makes it a lot easier for new liquidity providers to come in. We have already built functionality into our own system as discussions on FX options clearing have been ongoing for a few years now,” he says.
Banks like BAML take more of a mixed view about the impact of FX options clearing on the rise of electronic trading helping liquidity and the market in turn.
“I think FX options clearing might help the electronic trading of options, but it’s not directly linked, strictly speaking. We anticipate that the bigger savings through clearing will come from interbank trades because that is where a higher frequency and higher volume of trades take place,” says BAML’s Christophe Leruste.
His colleague, Mauricio Sada-Paz, head of electronic FICC sales for EMEA at BAML agrees concluding that, “The lessons we have learned from NDFs is that they are not products that need to be mandatory cleared but yet non-cleared margin rules have made it an economic mandate for banks, so banks have begun to clear their NDF trades with LCH because it was more economic to clear them rather than post initial and variation margin. In options, that same template will likely occur, however I wouldn’t consider that clearing has made NDFs more electronic. Clients will be inclined to trade electronic NDFs if they can get the same fast and reliable tight prices that they can get via voice, so while clearing doesn’t hurt, it is not the driver.”