The New York Foreign Exchange Committee, which operates under the auspices of the Federal Reserve Bank of New York, has published a paper that seeks to address the risk management benefits of additional life-cycle event processing for simple exotic options.
Specifically, the FXC says the focus of the paper is the “added market value of adopting standardised operational processes for notifying counterparts of Barrier Event occurrences”, otherwise known as “barrier breaches”.
The paper provides an overview of different barrier products available, and while the FXC’s research finds that barrier options are typically valued at approximately 3% of total options volume, the triggering of barriers remains an occasionally sensitive subject in the market. The paper notes that the market has no uniform standard regarding the notification of the occurrence of a Barrier Event. With that in mind the paper outlines how a notification may be provided, but notes that the failure to give such notification does not invalidate the occurrence of a Barrier Event.
The paper lays out recommended procedures for front and back office as well as other risk mitigation actions.
It concludes that although there is no legal requirement to notify counterparties of the occurrence of a Barrier Event (and no such requirement is advocated by the FXC), current practice is for the initial notification of such events to occur at the trading desk level. “We propose the adoption of a best practice in which a secondary notification is provided on the operational side, initially through issuance of paper (at a minimum) or standard electronic messaging and, possibly later, full electronification if the industry is able to leverage new infrastructure developed in the context of meeting applicable central clearing requirements.”
The full paper can be accessed at http://www.newyorkfed.org/fxc/2011/LCEP_SEO.pdf