In August, Tullett Prebon announced a partnership with GMEX group to develop a hybrid voice and electronic trading platform for trading FX options. But what are the drivers behind such a deal and can it really give Tullett an edge in today’s electronically traded markets? Nicola Tavendale writes.
Despite a 24% decline in average daily turnover since 2013, global trading volumes in FX options remain significant at $254 billion, according to the most recent
Bank for International Settlements (BIS) survey. But there is a significant difference between the amount of liquidity available in the spot FX versus that in the FX derivatives markets. That’s according to David Perkins, managing director, electronic broking at Tullett Prebon, which entered into a partnership with GMEX group in August to develop a hybrid voice and electronic trading platform for FX options.
“One of the plus points about electronification is that, because there are so many different types of options available to trade, having an electronic platform as a price dissemination tool is critical for distribution,” Perkins says. “In terms of turning an ‘indication of interest’ on a screen into a trade, however, the hybrid approach still represents the preferred business model.”
Tullett’s existing FX options technology is also the first global platform launched by the interdealer broker, but as such it is now over eight years old and specific to the management of liquidity on a central limit order book (CLOB). Yet the increase in new forms of execution methodology, such as request for quote (RFQ) and volume matching, has seen OTC FX options trading in the wholesale space start to shift away from a CLOB environment and move towards more of an RFQ driven market. “That trend is driven by the general lack of liquidity in the marketplace required to support a CLOB throughout the whole trading day,” says Perkins. “We believe that RFQ technology is more appropriate for a market with such episodic liquidity.”
The new FX options trading platform, expected to launch in Q1 2017, will integrate Tullett’s existing CLOB capability with GMEX’s RFQ technology. According to Hirander Misra, GMEX Group CEO, Tullett recognised that while “at-the-money” FX options can be very liquid and can trade on an order book, a lot of the other option strategies can be very illiquid. In their case, it is more difficult to seek liquidity using a standard CLOB model. “It became readily apparent that the old model of voice broking has to marry up with the order book model,” he adds. “In between that, there has to be an element of quote-driven trading as well, i.e., through RFQ and similar models. That’s how this whole project came about.”
Meeting Market Demand
As the market evolves and new generations of traders arrive, inevitably there are fewer and less experienced traders at each bank, explains Perkins, yet they are also trading more instruments and have more positions to manage than ever. “The electronification of that market aids efficiency for these traders,” he says. “We achieve this by integrating our RFQ process into the trader’s systems via a two-way API. This gives us the ability to source an electronic quote, as opposed to a voice quote, direct from the trader’s systems without their manual intervention.”
To a certain extent, this enables Tullett to go directly into the trader’s pricing system and capture an electronic price for a specific option. If it has a counter to their price or it wishes to trade, Tullett can then do this either on the phone or electronically. But in general, the current preference is still for execution to be managed over the phone, Perkins claims.
In addition to the GMEX-version of the FX options platform offering a more modern and agile technology, the group will also be providing Tullett with its trading system and market surveillance solutions supported by its development partner, Forum Trading Solutions. In its first instance, the platform will be a new RFQ hub, but Tullett also has the ability to develop it further to offer other means of execution methodology. “There are lots of ways to trade,” says Perkins. In the case of auctions, for example, Tullett is seeing demand for increased functionality in volume matching technology, Perkins claims, which means it acts more like a dynamic CLOB. Meanwhile, the CLOB itself is becoming more functionally rich, incorporating features more akin to mid-price matching and “request for stream” functionality. Perkins adds: “The result of this is a convergence of functionality across the different protocols.”
Market Colour’s Edge
Significantly, the move coincides with Tullett’s proposed acquisition of Icap’s global hybrid voice broking and information business, which it expects to complete this year, subject to regulatory approval. But discussions with GMEX had started prior to this announcement, according to Misra, and there has been no subsequent material change made to their deal as a result.
Yet investment in hybrid voice technology still comes at a time of rapid electronification in the FX markets generally. According to Aite Group research, in the case of spot FX, 70% is currently traded electronically and this is expected to rise to 85% by 2019. “Less will be traded by voice due to better margins on electronic and the fact that speed of market data/execution favours electronic methods,” according to a Profit & Loss source who specialises in electronic trading and technology.
But while Perkins agrees that there is indeed increased electronification in the spot FX space, when it comes to FX derivatives, he argues that there is a problem with regular periods of illiquidity. He explains: “Often one of the benefits of talking to a voice broker is that although the market already knows the price, so price discovery may be relatively straight- forward, our brokers add real value and come into their own in the realm of ‘size discovery’, which is far harder to establish.
“We want to bring together electronic price capture by using the new RFQ system alongside the ability of a voice broker to overlay their services,” Perkins adds. “In the FX derivatives space, the trade flow is very much electronified for the price discovery, price dissemination, trade capture and STP, but in terms of creating colour and liquidity, the voice broker still plays a critical role.”
In addition, despite a general belief five or six years ago that everything will go electronic and move away from voice trading, that has not happened, according to Misra. He finds that voice desks have instead just got more efficient and innovative in how they seek out liquidity, working with both the manual and electronic means at their disposal. “That will be no different in the short to medium term going forward,” he adds.
Furthermore, Misra claims that although we view exchanges as order-driven, electronic market places, even they are struggling with liquidity in illiquid assets – such as corporate bonds. While the sell side obviously remains important, he believes that IDBs also need to reach out to other institutional customers as well, which Tullett appears to be doing by diversifying its client base. “There isn’t a one size fits all for some assets,” he says. “In addition, being able to marry up activity, whether it’s execution via RFQ or whether its execution via the CLOB, is a very clever strategy. I think it makes them well-positioned between the existing world and the new world.”
While market consolidation is appropriate given the oversupply, according to Perkins, it is also creating a testing environment for the banks. With fewer venues, the platforms have to offer a differentiator, he adds. “For us, this is in our mix of a quality voice service, offering an efficient execution process and our provision of a functionally rich platform to enable powerful price distribution and electronic post-trade flow and services,” he says.
In addition, he believes that customers will expect to be able to mine rich data and analytics and have the ability to be more API, as opposed to GUI, focused in the future.
Even so, Perkins expects that standardised, commoditised products will certainly trade more electronically in the years to come. He sees a time, for example, where the majority of the “at-the-money” options will trade in this way. For that reason, he also believes that Tullett’s systems must be able to, and can already, handle those “pure-e” trades. “However, for the more off-the-run, esoteric currencies, I still see a long-term requirement and reliance on the hybrid model, which requires voice broker intermediation,” he adds.
Ultimately, the aim is to make use of the most efficient mechanism for liquidity discovery. Misra explains that he was surprised to learn that one of the major market making HFT firms also has voice desks. Ultimately, with illiquid assets you have to innovatively seek out liquidity from a multiple range of sources, he argues. Market impact can be huge on illiquid assets, which is also why they are not necessarily transparent on CLOBs either. “So we’re deploying a model to seek out liquidity in the best way we can using both electronic and more traditional means,” Misra says. “That validated the case for a project such as this.”
But new regulation, such as MiFID II, is coming and requirements to prove best execution and accompanying accuracy of timestamps will further drive markets to electronic methods, warns one source. For the fixed income and derivatives markets, this means that most execution venues will need to become regulated venues from January 2018. Yet Perkins adds that the main objective behind all of Tullett’s completed technology deals is the need for greater governance and increased agility of its technology development. “This will be crucial in the run up to MiFID II as it gives us the ability to flex development for certain time-sensitive requirements, whether regulatory or commercial,” he says.
Innovation not Inertia
Additionally, Perkins asserts that every venue Tullett Prebon has developed can already be used as a pure electronic platform. “We are very aware, however, that with the exception of very liquid markets, such as FX spot, there is not enough liquidity and information in the market to trade those instruments purely electronically,” he says. “The inertia is not from us, but from our customers who still rely on broker support to source liquidity.”
Ultimately, he expects that trader behaviour will depend on the evolution of the product and will adapt as the trading community evolves. A lot of venues are currently wholesale in nature, but as the banks pull away from liquidity provision and market-making, disruptive players will enter the market with an expectation that they will compete with the banks by being able to efficiently provide electronic liquidity.
In addition, recent research by Commerzbank found that while FX forwards remain the most popular hedging choice in the market, FX options can often prove to be a more effective and cheaper hedge. And even if the FX options market did become more electronic, Perkins says, Tullett’s strategy ensures it has designed and developed the appropriate functionality and workflows. The key for us is agility and the ability to make functionality changes as needed, in a timely fashion.”
Ultimately, the IDB market is ever-changing and IDBs are becoming more like exchanges while the exchanges are becoming more like IDBs in many ways, according to Misra. “In the spirit of evolution, firms have to adapt otherwise they fall behind,” he says. “Some of the larger firms are realising that innovation from the outside-in can help propagate that change. Combine that with innovation from the inside-out and you can effectively re-position yourself even in the face of regulatory change and a rapidly evolving market.”