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All Change: Options Set for a Different World

Many have come to drink at the FX options multi-dealer well, but how
many will actually access liquidity? Colin Lambert takes a look at the industry landscape.

It must be tempting for some to look at the developing FX
options multi-dealer platform (MDP) world and see the spot
market just after the turn of the century. The similarities can
be compelling; the market is increasingly going electronic, there
are a number of providers circling the start line hoping to get a
jump on each other, some are targeting workflow, others pure

The fact is though, this assumption is wrong. This is not the
spot market.

As is widely recognised, and has been for the best part of a
decade, FX options are much more complex, tailored products –
end users want specific strikes (rates and dates), deltas, amounts
and structures. They do not, typically, manage buckets of risks in
the manner of a trader at a liquidity provider. This alone makes
the FX options MDP space different, but there is another, equally
compelling reason for stating things will be different – this time
the banks could well be onside.

In spite of the protestations to the opposite, the cash MDPs
have long been in competition with the bank single dealer
platforms for volume – it is only the demands of clients that have
pushed volume to most of the these platforms, after all, why
would a bank actually volunteer to pay brokerage when they have
an equal mechanism to do the trade?

In FX options, it will probably be different. Not only have
clients decided they like the multi-dealer method of executing
risk – and the platforms are providing the necessary flexibility –
but the regulators may well push the banks onto MDPs anyway.
At the time of writing, we still have no established SEF (Swap
Execution Facility) rules but the cloud surrounding these rules
appears to be clearing – and not necessarily to everyone’s liking.
It has been reported that CFTC commissioner Mark Wetjens
has proposed a two RFQ rule, elsewhere a consensus appears to
be forming that rather than the original five RFQs in competition,
the CFTC may opt for three. Whilst the latter may just be
acceptable to people, the two RFQ rule – meaning simply that all
trades will be put out to just two or more dealers – would have
caused several people in the industry to go a little pale, and not
just on the MDP side.

Clearly, such an event would make it harder to sell the value
proposition of an MDP, after all, customers typically like the
workflow tools offered by the banks from pricing to execution, so
why go through all the work of connecting to a SEF when one
can merely take liquidity from two single dealer platforms?
Platforms, it might be added, that the customer probably already
has for other trades.

But that is also where the problem exists for the banks – some
of which have stopped investing in their options silo on their
single dealer platforms in the expectation that such functionality
will be defunct in a short while. This means catch up, at a time of
tight technology budgets, or a strong commitment to the MDPs in
the hope of maintaining a presence.

So customer preference for competitive execution (aside from
the regulations that may be imposed, customers’ best execution
rules will surely be tightened in coming years), allied to some
banks taking their foot off the gas, offers a ray of light for the
MDPs in FX options. But what will it take to survive?

Getting it Right

The likelihood is that different market segments will favour
different mechanisms. The sidebar to this story attempts to lay
out the different value propositions of the various platforms as we
 did in the September 2012 issue of Profit &
Loss for the cash platforms.

As far as market participants are concerned, a
strong consensus appears to be growing that the
keys to success will be scale and workflow
efficiency, the latter very much being
something that is recognised by providers in the
space. Whether that workflow needs to be end-
to-end on one platform is open for debate,
several banks are in the throes of examining
their FX options offering to decide whether the
single dealer offering stays, or is transformed
into a gateway to the market. The chances are
some will seek to offer both services – budget

The gateway strategy is seen as attractive in many quarters. As
more than one banker has pointed out, clients are very unlikely to
want to connect to multiple SEFs, and they are even more
reluctant to pick out a potential winner in the current morass of
platforms. It seems sensible for a client to continue to trade with
their relationship banks until such time as they can be assured of
the longevity and liquidity on a venue (and that it suits their style
of trading), or until their best execution rules dictate the use of

In spite of the frenzy of activity in the market over the past two
years, the general consensus is that the industry will not be ready
for FX options clearing until 2015 – several believe even that date
is too optimistic – and as such regulation to mandate SEF trading,
if it comes, will not occur until then. This is a bleak scenario for
several of the options MDPs because it means clients can
effectively sit back and do nothing. They can continue to execute
on SDPs and work with their key bank providers to ensure access
to SEFs is available as and when (or even if) it becomes

The subject of scale would appear to favour the established
players in the space, after all a firm like Bloomberg has desktops
in place across the markets, GFI is truly embedded in the fabric
of the inter-dealer market and DCX has the advantage of
SuperDerivatives’ presence on dealing desks. In addition, firms
like Tradeweb and FXall would expect to gain traction through in
the first place ownership, and the second the established nature of
the firm. The same can be said for 360T, which has options as
one of its products on its MDP.

But it may not work out like that at all. Firms such as Digital 
Vega appear to have a lot of support amongst the banks – and if
the events in the cash market over the past two years have taught
us anything it is the banks still have control of this market – and
other new ventures, such as Bridge and SurfacExchange, have
been built by options dealers with options dealers in mind.

To succeed, any platform has to have the bulk of the (currently)
seven or eight electronic market makers in FX options – another
difference with the spot market is that FX options liquidity is
much harder to recycle, meaning there is (hopefully) less chance
of a liquidity mirage. In spite of some platforms chasing the non-
bank market making segment, the chances for success without the
major banks, or at least three or four of them, is seen as remote if
only because it would bring these platforms into competition with
the exchanges, specifically CME.

Another factor seen limiting the chances of platforms hosting
non-bank market making liquidity is that asset managers typically
will shy away from those venues, as one FX options trader
explained to Profit & Loss, maintaining anonymity of order in FX
options is tough enough without the best “flow sniffers” in the
business having access to the information.

Green Fields

Something that is in favour of the newcomers to this
competition is that the market is starting pretty much from zero.

Unlike in the spot market, there is no Reuters
Matching/EBS legacy to feed off, equally the market is
looking for an efficient way to do things – meaning
innovation can help propel a firm to a leadership

This innovation has to have a more prosaic
foundation of course, usability. It may be the most
innovative product in the world, but if people don’t like
looking at it – if it is not familiar to some degree – and
find it hard to move around then they will look

Innovation is well and good, but the platform has to
have certain basics, or at least most of them,
depending upon their model. Functionality for active
traders on an ECN-type venue is vastly different to
that on a relationship venue but in general most
providers seemed to have recognised that some features are so
popular they have to be present.

Primarily among these “must haves” is, where dealers are in
competition, the best bid and offer highlighted. As many single
dealer platforms are discovering, visualisation is becoming more
popular, and it starts with something as simple as highlighting
best bid/offer. It may also sound obvious, but an interactive
blotter is equally important, especially in the new, auditable
world. All interactions with the platform, not just trades, need to
be on the blotter.

In terms of options specifics, a degree of solving functionality
is required, as is the ability to trade live or against delta. It is also
felt, in some quarters at least, that the ability to negotiate, either
by chat or by counter bidding or offering against a price, will
help bring volume to the platform.

In addition to certain functionality, there is a also a benefit in
familiarity. People like to be able to work on a platform
without searching too hard, so the successful platform will be
intuitive – the industry may be trying to change dealer habits
but it can only do so if those dealers are comfortable with how
the “new” world operates.

This seems to have been recognised by the various providers,
for it is striking when looking at the various platforms how alike
they look and feel – especially those targeting the active traders.
This could be, as one vendor describes it, the result of a lot of
minds looking at the same problem and coming to the same –
logical – conclusion.

Elsewhere, the workflow processes put in place are also similar,
which means success could come down to how “light” your
technology is – an increasing number of clients are concerned
about both screen real estate and download capabilities becoming
onerous and want a solution that helps solve that – and the
number of dealers/customers on your platform.

One lesson that can be taken from the cash world – and it is
certain that the banks have learnt it well – is that the venue to
follow is the one on which most of your customers are. In the
early days of cash MDPs (especially once the FXall/Atriax
conundrum was solved) many banks connected to all venues, the
result of which was the fragmentation of liquidity and the rise in
influence of the high frequency trading community.

This, of course, could create a stand off. If banks are less than
willing to commit, and customers want to sit back and see who
wins, we end up in a game of smoke and mirrors trying to discern
who is best at what. In reality there already seems to be a shift on
the part of some end users, Digital Vega in particular has picked
up some influential buy side customers attracted to its workflow
solution, as has Bloomberg among those clients looking for the
single dealer experience in a multi-dealer environment.

Next Generation

One gets the sense, looking at the options MDP industry, that it
is approaching tipping point and that when volume starts to grow,
it will grow quickly. One also gets the sense that the first
generation providers will also face a testing time, not only from
existing providers such as Icap and Tullett Prebon with their voice
hybrid model, but from technology providers outside the space.

Already one hears chatter over the possibility of using
aggregators in FX options, much as they are used in spot FX. On
paper it looks like a reasonable idea and it may come to fruition –
indeed one could argue that the Tradeweb offering is actually a 
bespoke liquidity pool akin to an aggregator. The challenge to
aggregation in this space however is that FX options require more
work, and banks may be reluctant to stream a price to an
aggregator, as opposed to respond to specific enquiries.

Hand in hand with aggregation – more accurately with
fragmentation – comes algorithmic execution. Currently algo
strategies for FX options are thin on the ground – if they exist at
all – because the electronic liquidity pool is so shallow. As that
changes, then demand for algorithmic execution will grow
exponentially, especially among those players with large interest
to execute. A $500 million 25 delta, three month option may not
attract much attention among dealers, a multi-billion dollar,
specific strike or date, trade will.

Currently the only solution available to a customer seeking to
avoid leaving a rather heavy footprint on the market is to break
such a large order down among dealers. This is an unpopular
strategy because not only do the dealers not want to see only a
piece of the order (especially as it will be large enough to hurt
them), but news gets out pretty quickly that there is a deal on the
street and people start skewing prices accordingly, meaning the
customer does not get best execution.

This means that like it or not, as more volume goes electronic,
more customers will either design or adopt algos to execute larger
trades. Currently platforms such as GFI ForexMatch support the
use of Icebergs (where only a fraction of the order is public at
any given time) but going forward the intelligence gathered by
price engines will spot an Iceberg operating and again could lead
to price skewing.

A real, tangible benefit of using algos to execute should be a
lack of slippage, leading to better transaction costs. Allied to this
issue is the cost of using a platform. Aside from Bloomberg,
which does not charge for trading (the user pays for the Terminal
instead and all trades are free) no-one is willing to divulge costs
in terms of market data and brokerage. Very soon, especially
when volumes start to lift, these costs will come under scrutiny
and, consequently, pressure. The development of Transaction Cost
Analysis tools will change attitudes in more than spot.

So challenges do exist for those seeking to tap into this market,
but there is some very good news that far outweighs all of the
negatives – this is a market ripe for growth. FX options volume
has pretty much flatlined since dropping in the immediate
aftermath of the global financial crisis, but the tide could be

More importantly, e-trading in FX options remains very
modest. Profit & Loss estimates that around $200 billion per day
of notional is traded in FX options globally, and that around 10%
of that is executed electronically. Even if overall volumes do not
go higher, there is still plenty of room for growth for those
seeking to tap into the e-trading trend.

There is also evidence that people are embracing e-trading,
albeit in a different solution. Much of the focus of this article has
been about the barriers to success and the various approaches
taken to ensure that success, but one venue has been growing
steadily – and it provides heart for those that follow it.

CME Group’s FX options volumes have continued to grow
exponentially, and while the model is different, being
exchange trading of specific standardised products with a
direct link to clearing, it highlights how traders are willing to
execute electronically. If nothing else, the success of CME in
this space should provide sustenance for those seeking to eat
at the same table.

And if that is not enough, then a combination of best execution
rules, mandatory SEF trading and clearing, and more banks auto-
pricing should do the rest. The gates are open, it is now up to the
individual platforms to get customers and volumes onboard to
maintain the wave of growth. 

Paul Gogliormella

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