Unlocking more opportunities with new FX option trading models and platforms

One of the obvious inefficiencies in FX options trading is around identification of – and access to – liquidity. This is exacerbated by well-known OTC market headaches such as credit intermediation, increasingly stringent capital requirements and operating with opaque data in a fragmented liquidity landscape.

“Operationally, the FX options market is extraordinarily manual – price requests are still taken from chats and re-keyed into different dealing systems, only to be re-posted back into a chat for execution,” observes Chris Jackson, CEO & founder OptAxe.

“Due to the proliferation of multi-strategy portfolio managers and reduction in sales teams, a single salesperson is now typically covering scores of clients. A lot of information is lost on chats which are not optimised for liquidity discovery and pricing.” 

Better communication is vital

How trades are communicated between portfolio manager, trader, OMS, EMS, back office and the market impacts pricing, trading and booking adds Katharine Furber, global head of FX trading at Bloomberg.

“So how do we solve those problems? Firstly, the coverage of strategies that the market supports electronically has been greatly enhanced. The other thing that is beneficial from a technology perspective is that you can not only trade by chat or voice but also via RFQ, RFS, or direct order routing.”

Some of the initial challenges within the business of trading FX options electronically can be attributed to the time it takes to get traditional traders comfortable with a new way of trading. That is the view of Mark Suter, executive chairman Digital Vega, who refers to many asset managers being on the cusp of starting to trade more options electronically.

“Another opportunity lies with private banks who tend to trade the more complex structural products, which up until now has been very manual and primarily delivered by a handful of global banks,” he says. “Then there are second tier and regional banks under increasing pressure from clients to provide accurate rapid pricing and regulators to provide accurate and timely reporting. When it comes to best execution, you really need robust, automated processes, not screenshots or writing things down.”

From a bank’s point of view, one of the reasons why electronic options trading has not advanced as rapidly as it might have is that pricing options electronically could lead to competition that will compress spreads.

“The technology for full electronic trading of FX options has been available for some time and AI is poised to help the buy-side construct effective option strategies tailored to their risk profiles,” notes Alan Dweck, COO buy-side solutions at SGX FX. “As technologies advance, more complex option structures will start to trade electronically, ensuring more competitive pricing and better execution.”

Non-bank liquidity significant

Dweck describes the entrance of non-bank liquidity providers into the institutional OTC FX options market as particularly encouraging and notes that more banks are joining EMS platforms.

Whilst the risks associated with a single option are relatively clear, managing a portfolio of options introduces complexity. As more options are added, the overall risk profile becomes increasingly opaque and difficult to measure.

Dweck explains that correlations between different options can negate or increase risk in ways that are not immediately apparent, adding to the complexity. This makes accurate risk assessment challenging, requiring sophisticated tools and strategies to manage it effectively.

Jackson says dealers want to show axes directly to other market participants, but in a discreet, controlled fashion with a flexible protocol. The buy-side want to see more liquidity, but in a way that improves their pre-trade process and reduces their transaction costs.

“Bespoke venues provide comfort that both sides will benefit from exposing this interest, with a higher chance of trading and minimal market impact,” he adds. “Liquidity takers are now able to scan for offsetting risk that gives them favourable entry points without signalling intent by asking multiple providers in competition.”

In terms of liquidity, Suter references growing interest in (and use of) first generation products and says the company is close to launching a range of barrier-based products to be followed by digitals.

“As the next generation of people working in ultra-high net worth family offices become more active, they want to embrace electronic trading,” he says. “They are looking for access to competitive pricing for a range of complex products.”

Electronic trading leads to better risk management by booking trades in a more efficient, formatted manner. But how have these innovations impacted liquidity? According to Furber, transparency helps because if traders are comfortable with market transparency, they are much more willing to trade a variety of different strategies and currency pairs.

“We now have about 140 firms that are market makers in options and around 30 of those can price instantaneously by API,” she says. “Banks and liquidity providers are aggressively increasing their ability to trade these products electronically. If you look at the number of currencies that trade electronically, we did north of 145 different pairs over the last 12 months – an increase of 15%.”

Multiple strategies boosting liquidity

Efforts to enhance liquidity in FX options trading are converging across market structure innovation, protocol diversification and buy- and sell-side engagement, explains Jackson.

“Firstly, the market is able to access a number of different protocols that combine RFQ, streaming and CLOB models,” he says. “Workflows have been simplified to cater for users to manage these hybrid positions while SDPs and direct connectivity to banks’ streaming liquidity have provided end-users with higher volume lit liquidity.”

Liquidity is being deepened by expanding the range of market participants and advances in cleared FX options and prime brokerage models are reducing bilateral credit risk, allowing more firms to interact with a broader set of counterparties.

“This is particularly relevant as regulatory capital constraints continue to shape the willingness of banks to warehouse options risk,” adds Jackson.

When asked to what extent workflow automation toolsets for FX option trading are tailored to meet the specific requirements of each client, Suter refers to ‘variations on a theme, but the variations can be pretty wide and are getting wider all the time’.

“Workflow automation is increasing across the board. Many clients have identified manual areas in their workflows and are working to address them. But some of the more technology-savvy systematic funds already automate all their trading processes which includes splitting and randomising trades and using auto-expiries and auto-fixing.”

One of the factors behind the push for market data is that compared to cash markets, affordable, accessible data is limited.

“Market participants are more comfortable if they have an idea of what’s going on, who is providing good service and who is strong in specific currency pairs,” says Suter. “Historically, the buy-side has had limited data to work from; what we are working on is being able to say ‘these are the best firms’ based on real-time, empirical evidence. As buy-side clients start to see less market impact and enhanced returns from better pricing, they are encouraged to do more.”

Workflow solutions increasingly sophisticated

Dweck observes that from an EMS perspective, pre-trade workflows can mirror those used in FX cash trading.

“FX options can be staged into a trading platform, netted and shaped into orders, sliced into smaller components and then sent for execution,” he says. “Post-trade workflows involve specific workflows around hedging Greeks and the exercising of options that are unique to OTC FX options. To offer these workflow features, trading platforms need to have a strong presence in the cash market.”

Dweck expects this to shake up the electronic FX options market and move trading from specialised platforms to those with a wider presence across all FX trading. 

Data and analytics play a crucial role in market timing, strategy creation and liquidity curation – without data, traders and portfolio managers are operating blind. However, Dweck observes that data alone is insufficient and that analytics are necessary to contextualise and interpret the information they are seeing so they can have actionable insights to drive better decision-making. 

One of the interesting aspects of data in the FX market is that it isn’t just about looking at the trade blotter – it’s about looking at activity before and after the trade, known as event data. Buy-side clients want to quantify their counterparties’ performance by looking at the number of trades rejects or volume attempted.

“They are interested not only in the rejection rate but who’s rejecting trades and for which currency pairs or strategies,” explains Furber. “They want to know how much time it took for the dealer to respond with a quote and if they did the trade, what happened in the market afterwards. For example, did the market move because the dealer just went and passed that back into the marketplace or did they put it in their book because they are taking principal risk.”

On the flipside, if dealers can figure out how many times a client calls for a price on a particular strategy or currency pair, how many times they traded away and how their price compared, they can be a better liquidity provider to that client.

“The appetite from our clients for more data is huge and our job is to make sure we have an accurate database that we can package appropriately,” says Furber. “Clients can then use our systems or reporting structure to figure out how to do better with a specific strategy or currency.”

Jackson observes that beyond the pre-trade stage, data analytics in FX options remains limited. Visibility of inventory across the market is still largely absent, with most platforms offering only indicative pricing via multi-bank RFQs. 

“There have been some efforts to bring TCA to FX options, but progress has been slow,” he says. “The bilateral, fragmented and often opaque nature of the market makes consistent post-trade analytics and benchmarking difficult to standardise. As a result, data analytics has so far concentrated on enhancing pre-trade intelligence rather than transforming the full trade lifecycle.”

According to Jackson, FX options is often seen as a place where innovation can really elevate the user experience.

Market structure constantly evolving

“We are witnessing market structure evolve as demands for transparency, automation and liquidity discovery are being met,” he says. “Existing platforms are evolving and new platforms are emerging to cater for these demands. Regulatory push, capital cost rises, efficiency demands and client experience all lead to the same conclusion – innovation is essential. It is widely accepted that there has always been a lot of upside in FX options technology, but the timing finally feels right.”

Dweck acknowledges that electronification of the FX options market is increasing but adds that regulatory pressures have added associated costs that make it increasingly difficult for new players to enter the market.

“Therefore, we may not see a significant increase in the number of platforms,” he says. “Instead, competition among existing platforms is likely to intensify as they strive to gain market share. This heightened competition will drive the development of new features and technologies, benefiting the marketplace overall. Platforms that can offer a comprehensive solution across both cash and options will prevail.”

Suter is also unconvinced that we going to see a wave of new platforms and order management solutions pushing the options market forward, stating that bank liquidity is required to make any platform viable in the long term.

“We’ve been working on a central limit order book project,” he says. “Banks told us they were looking for an alternative e-focused solution. It took us about 18 months to build the first version and start connecting people. But the reality is that you need to show good liquidity to launch and to get integrated into any of the major dealers via API and for them to price onto a GUI or an API is taking much longer to achieve these days.”

“People talk about having an all-to-all market but it is difficult to achieve this with limited bank participation,” adds Suter. “There are so many different currency pairs, strikes, deltas and combinations that trying to achieve a perfect match every time is going to be challenging indeed.”

Furber expects FX options volumes to increase but cautions that although the technology is not over-complicated, new market entrants would need to offer a wider range of services and a deeper range of currency pairs and strategies. “New firms will enter the market with sophisticated technology,” she concludes. “The question is, how will clients react and who is able to provide the most reliable and widest range of services? It takes time to incorporate workflows into a package that is easily consumable.”