Managing differing degrees of complexity across the post-trade FX options space demands a combination of operational change and technology investment – and the human factor should not be underestimated either.
Recent market data highlights the growing significance of the FX options market, with traders seemingly increasingly willing to accept higher potential exposure at sale time in exchange for lower risk when buying.
From a post-trade perspective, the challenges inevitably vary depending on whether the trades are bilaterally transacted or cleared. It is therefore important to consider both the differences and areas of overlap between these two approaches given that many clients value the flexibility of being able to choose between clearing or remaining bilateral.
FX options specifically add greater layers of complexity where the more exotic the option, the more data points there are to capture, agree and monitor. Furthermore, the majority of FX options are still manually traded, which reduces STP and increases the risk of error.
Simplifying workflow
“For asset managers, workflow is a key consideration post-trade,” says Louisa Kwok, head of TradeNeXus, part of State Street’s GlobalLINK suite suite of electronic trading solutions. “These managers typically manage a large number of funds spanning different asset owners, jurisdictions and investor bases. This can create a large number of unique requirements across the standardised workflow which translates to a higher cost base.”
External providers like TradeNeXus help address these needs and reduce costs by implementing features to help with data quality (such as rules engines to improve data input) and data insights (for example, reports and metrics) as well as offering best-in-class partnership products.
FX options pricing models are naturally more complex than forwards or spot. However, one of the benefits of clearing and standardisation of post-trade, with market participants facing a CCP or under a central agency agreement, is that some of these complexities can be reduced.
That is the view of Stuart Crabtree, FX options subject matter expert at LSEG, who goes on to outline some of the costs and benefits associated with the clearing of FX options. “Whenever you move into a cleared environment there will be additional fees – such as clearing house and potentially clearing broker fees,” he says. “In addition, there are initial margin and default fund contributions, which have to be deposited with the clearing house.”
However, those margin calculations are done on a multilateral net basis, so participants will see a reduction in overall margin needed when clearing options rather than facing counterparties in the bilateral market. “When we look at the margin reductions in addition to the capital benefits of facing the clearing house, we see our members saving considerable amounts by clearing their FX portfolios”.
Margin management
However, those margin calculations are done on a multilateral net basis so participants may see a reduction in overall margin or the financial resources they use when clearing options rather than facing other counterparties in the bilateral market. There are also capital benefits.
Kwok observes that FX options clearing can significantly change the governance and mechanism of the trade though. “For example, there are significant benefits to standardised margin calculations, dispute resolution and governance, but there are also new considerations around understanding the settlement model, the exercise/expiry model and the likely points of concerns/failures,” she adds.
Since OTC FX is still largely traded bilaterally and the concept of clearing in FX is relatively new to asset managers, clients may choose to delay adopting clearing – or manually manage their clearing workflows initially until they hit a volume threshold to invest in new solutions and technology to automate.
Portfolio focus
In relation to bilateral post-trade challenges, management of portfolio hygiene has been a key focus for banks with changes in regulation such as SA-CCR and Basel III Endgame to come. “Buy-sides are now also increasingly reviewing their margin and counterparty exposures,” says Kwok. “Another form of management is in trade reduction through compression where there are effectively fewer trades to manage and process.”
While highlighting the need for greater automation of workflows, Kwok suggests human intervention will still be required to resolve disputes between front office, counterparty, custodians and clearing brokers particularly if there is negotiation or deeper investigation. “Data quality will be crucial to ensure a resolution can be found in a timely manner,” she says. “We have invested in our data strategy through the delivery of a data hub that allows us to deliver more data products that encompasses both trading and back office, as well as advanced analytics to help optimise workflows.”
This centralisation of portfolios and messaging flows allows for standardisation and automation in the market. “There is additional complexity with options and that is the expiry process,” says Crabtree. “In a bilateral world, you are facing each counterparty directly, so you need to inform every party when exercising an option. Whereas in the cleared world, all expiries are against the clearing house. That messaging now needs to be sent to the clearing house and then out to the other side of those trades.” LCH has implemented standardised reference price sources and a process to logically exercise or expire options automatically.
For all the talk of automation, Crabtree says there will continue to be a role for human intervention in the future of post-trade processing of FX options. “On the processing side, features such as automated exercise and expiry processes and running all cleared settlement flows together to determine net payments bring efficiencies,” he observes. “But people will still be involved in some of the decision-making processes, especially at trade inception. No matter how well you design or code a process, there is always going to be an edge case that you may not have thought about, which is why ensuring there is appropriate oversight and people who understand what is supposed to be happening, and have the required expertise and knowledge, is really important.”
Streamlined settlement
In terms of market developments that are going to be significant in the short to medium term, Crabtree refers to LCH moving into the main CLS settlement session this year, which will streamline and consolidate settlement and funding requirements for members, open up the service to the buy-side, as well as adding additional currency pairs.
“We have only just started the journey of physical FX clearing with options,” he adds. “The more of these flows that end up being cleared, the more the benefits of the cleared model can be realised – the obvious ones being the credit intermediation and process benefits the clearing house brings.
At the moment, we only have options being cleared by the biggest banks in the market. The network effect will become much more powerful when there are more participants and different users involved, which is when the credit, capital, and process benefits from clearing can have an even greater impact.”