Pulling it altogether: Maximising workflows with e-FX options

FX options have become increasingly commoditised. What was once very bespoke are now standard, well-understood vanilla structures that are easily comparable across different liquidity providers. Best execution demands from institutions make it difficult for voice and/or single relationship environments to continue to dominate and therefore multi-dealer EMS environments are now coming to the fore.

SGX FX reacted to rising demand from institutional clients by building FX option functionality into its FX cash EMS, giving clients access to high levels of automation across both cash and derivative FX products in a single offering. Chief Operating Officer, Buyside Solutions, of the firm Alan Dweck notes though that more complex FX option structures continue to be voice-based as they have not yet become commoditised. “The evolutionary direction is the same but the bespoke nature of such products make automation and electronification harder and therefore the demand is currently not as pressing,” he explains.

The rising importance of automation can be attributed to a combination of increased efficiencies for both the sell- and buy-side, cost reduction, and increasingly onerous regulatory reporting requirements suggests Mark Suter, executive chairman Digital Vega FX.

“We have had increasing success in building internal white label solutions; workflow management tools and processes for banks as there are much stricter requirements in terms of reporting, audit trails and timestamps,” he says. “As for automation, we are following the way the cash markets have gone, albeit with much greater levels of complexity.”

Key drivers

One of the key drivers for electronic FX options over the last few years has been the requirement for best execution. The buy-side are much more sensitive to the fact that they need to be able to prove best execution on transactions they do on behalf of their clients or funds.

“For some of the big systematic funds we have automated the entire lifecycle of a trade, from importing orders, executing them automatically, breaking large orders into smaller child orders, automatically selecting providers based off pre-trade TCA and finally fully automating the expiry process,” says Suter.

The next phase of development via DV’s Hydra platform focuses on structured products such as target profit forwards, accumulators and pivots as well as first generation options, which are a little bit more complicated as there is currently less product standardisation across bank pricing engines. 

For this reason, Digital Vega FX has tried to create a standard so when pricing a particular target profit forward, everybody is speaking the same language and knows what they are pricing.

Meanwhile Audra Scharf, head of FXall notes that electronification of options is still in its early stages but at the beginnings of rapid evolution with growing regulatory and reporting demands with FXall offering several regulated platforms allowing customers to trade in a compliant framework.

“Trading electronically also allows clients to maintain best execution and maintain the same or similar workflows used for executing their cash trades,” she says.

Liquidity challenge

When asked how the challenges of electronifying the FX options market – such as the operational complexities and high-touch processes of trading options, credit considerations, liquidity fragmentation – have been overcome, she suggests that the biggest challenge to drive flows from voice to digital is liquidity across automated pricing engines.

“There is still a sense that the best liquidity and pricing is achieved by negotiation,” adds Scharf. “However, if you can digitally capture flow at the point of negotiation it will set the stage for the next phases of growth.”

Suter observes that there are relatively few platforms operating in this space and that his firm’s focus has been on differentiating itself by focusing on advanced products and the workflow that goes around these products, such as automated expiries and provider selection.

“We have always tried to preserve the balance between buy- and sell-side,” he says. “Liquidity in the options market is not the same as in the cash market so there are a finite amount of liquidity providers and amount of risk that they can manage. This creates variations across different platforms driven by market segments that they cover.”

As for how challenges to FX options market electronification have been overcome, Dweck refers to the commoditisation of vanilla structures and pricing methods and observes that such commoditisation is the natural evolution of most OTC markets.

“FX options are not unique insurance policies – they are financial tools operating in a market environment that provide both risk management and speculative opportunities,” he says. “Like any other market tool, it is essential that their structures are well understood by participants and that their pricing and execution are not so opaque as to make their use questionable to downstream investors.”

Standalone limitations

Dweck notes that there are a number of FX options platforms that have traditionally worked on a standalone basis, which he describes as ultimately limiting to the long-term future of FX options trading.

“I do not believe that systems should decouple FX options from the underlying cash markets that drive them – truly market leading platforms bring together cash FX, NDF and FX options in a single offering,” he says. “Furthermore, staging workflows, order shaping, credit and risk controls all need to underpin the market leading FX option platforms on top of the transparency and pricing/data capture and STP that are fundamental to all systems.” Suter agrees; “Standalone solutions work for a majority of clients, however, in forging strategic partnerships and close integration with major cash liquidity platforms, we are able to deliver a best-in-class holistic solution across all products,” he states.

On the question of what specific attributes FX buy-side and asset managers are looking for from e-FX option platforms to help them to optimise their workflows, Dweck says attributes vary according to particular client needs.

“In general, I would say that the key drivers for asset managers are staging workflows fully integrated with their OMS, pricing transparency, best execution, allocations, credit and risk controls, and STP into their order management systems and liquidity management tools,” he says.

One of the most interesting aspects of this market is the extent to which electronic access to competitive pricing and independent pre-trade FX option analytics is being widened with the arrival of new solutions and platforms from non-banks.

Bank ‘awakening’

According to Dweck, just as we saw with cash FX the arrival of non-bank liquidity is serving to ‘wake up’ banks who now have to compete with new sources of liquidity.

“For a long while, investment banks have offered electronic access to FX options exclusively through their single-dealer portals and this has allowed them a large degree of exclusivity and effectively limited clients’ ability to shop around for the best possible prices,” he says.

“Non-bank liquidity cannot utilise similar strategies and needs to offer aggressive FX options pricing in multi-dealer environments in order to win business. This will ultimately provide a better outcome to buy-side investors and a more level playing field for all parties.”

While Dweck acknowledges the potential attraction of new FX option trading models such as central limit order book, he is sceptical that such trading models would work for FX options as there are too many variables for each option.

“We could potentially see some centralised derivative trading of underlying volatilities, but I doubt that FX options could directly trade on a CLOB,” he suggests. “FX options are driven by the world’s largest OTC markets and though there is room for some CLOB in FX the vast majority of the $7 trillion traded every day is OTC. I doubt that is going to change in my lifetime as the bottleneck that would create is unthinkable. FX options are too closely tied to the underlying cash markets for them to trade in any significantly different way.

Entry barriers

Suter is also doubtful that there is much scope for new players to emerge, suggesting that anyone entering the market would need deep pockets. “It’s a relatively small market compared to spot with a much smaller number of active users.” he adds. “It is complicated to build and manage these platforms and people with the right skill set are at a premium in terms of specific market and product knowledge.”

However, this does not mean that there is no scope for new models to gain traction (see the last page of this article). Digital Vega FX was approached by a number of the big banks about four years ago to build them a fully electronic inter-dealer order book. These banks were tired of paying very high brokerage to voice brokers and were concerned about transparency and regulation.

“That is a completely different model in the sense that it is a true and – I think – the first full electronic OTC order book,” says Suter. “It will be going live very soon. It has taken a little longer than expected because just getting a new GUI on a big bank trading floor now takes two to three years given the regulations, surveillance, legal processes and hoops you have to jump through.”

In addition, the company is working on a joint venture with CME to support large order liquidity into CME blocks with the objective of giving buyers easy access to OTC or listed and enabling them to easily jump between the two.

In terms of how this segment of the market is going to evolve over the next few years, Suter reckons it may continue to broaden the product offering in terms of complexity, particularly in relation to some of the more esoteric products which currently don’t trade electronically.

Dweck reckons best execution and buy-side demand will continue the process of commoditisation of FX option structures, which in turn will lead to better end investor confidence and increased demand.

“This will deepen the requirement for best execution and in so doing will drive further electronification,” he says. “I would end with the following message to those who are concerned about such changes: a rising tide floats all ships.”