A new report from Greenwich Associates argues that the incoming Uncleared Margin Rules (UMR) will fundamentally change the economics of OTC FX options trading to a point where buy side firms will increasingly trade these products on listed exchanges.
“Historically, most FX options trading was done over the counter, but UMR has the potential to make that trading significantly more expensive for the buy side, so what we’re seeing here is that the buy side is actually open to looking at alternatives to OTC trading and seeing that there’s a potential opportunity to move some of their options trading on exchange and into a listed environment. And I think what we’re seeing too is that the exchanges are seeing that opportunity and making changes to their products in order to make them more OTC-like in order to increase their own ADV,” David Stryker, a principal within Greenwich’s Markets team and author of the report, tells Profit & Loss.
Options trading remains the least electronic segment of the FX market, with only 37% of these products trading electronically in 2018, according to an earlier study from Greenwich. Given that this is double the amount of electronic FX options trading that was taking place in 2013, according to Greenwich, the suggestion is that there is both plenty of room and appetite for more of this market to shift towards electronic channels.
Stryker’s report identifies a number of specific factors pushing FX options towards electronic, and specifically exchange, venues. The key one is the UMR, which will require buy side firms to exchange initial margin (IM) and variation margin (VM) for FX options positions held bilaterally and to hold balances over $50 million at a third-party custodian where they cannot be re-hypothecated.
Profit & Loss has reported extensively on the UMR rules, which will impact firms trading a notional daily amount of $750 billion or over on the products included under the rules starting September 2019, with this threshold then lowering to $8 billion in September 2020, at which point many more buy side firms will be subject to the requirements.
The essential point in the Greenwich report is that the UMR rules will fundamentally make trading FX options bilaterally in the OTC market more expensive. Moreover, Stryker points to a recent report from Citi – which Profit & Loss also reported on – to argue that centralising operational exposures through an FX prime broker (FXPB) will not fully shield buy side firms from the impact of the new rules.
While these additional costs create an incentive for buy side firms to look at alternatives to the OTC market, the exchanges themselves are making changes to their FX options products in order to make them more attractive to these firms, he says.
“Beside the significant increase in electronic liquidity, exchanges are simplifying their offerings and aligning them with the OTC conventions familiar to most traders; they are also adding more strikes and maturities to improve hedging flexibility. Additionally, CME’s block trading capability allows traders to leverage their bilateral relationships during times when it is less conducive to trade options electronically or when clients want or need special pricing attention,” he notes in the report.
This type of functionality, Stryker adds, could help encourage more buy side firms to consider listed FX options as a viable alternative to the OTC market.
Compounding all of this is the fact that transaction cost analysis (TCA) tools are becoming ever more prevalent and sophisticated in the FX market, especially in a post-Mifid II era, meaning that buy side firms are able to more accurately and easily compare the economic benefits of executing in the OTC market versus the listed futures market.
Moreover, the Greenwich report makes it clear that in many cases it will be far more capital efficient for buy side firms to trade FX options in the listed market compared to OTC once the UMR comes into effect. For example, it points to the findings of a capital and funding analysis from CME Group, which simulated a portfolio consisting of 30 randomly generated positions of three-month maturities in five currencies, across five counterparties, and just under $1 billion gross notional exposure. The results showed that the portfolio generated 65% less margin requirement in a listed trading environment compared to the netted standard initial margin model (SIMM) via PB, and 89% less than the bilateral SIMM.
All of this seemingly makes a compelling argument for more FX options trading to move from the OTC to listed markets, but there are other impediments to this trend. Most notable is the fact that, no matter how many tweaks the exchanges make to their FX options products, they can never truly replicate the flexibility and granularity of FX options negotiated and executed OTC.
But Stryker argues that the impact of the UMR rules will cause more buy side firms to consider the trade-offs between flexibility and cost when executing FX options.
“The data shows that the biggest hurdle to moving [FX options] onto exchange is that clients want customisation and the ability to tailor the product to meet their specific needs. But what we’re seeing is clients thinking more about whether they can accept slightly less flexibility and use a more standardised product in order to save on transaction fees. TCA is ubiquitous in equities, but it’s catching up in FX and as clients become more sophisticated in understanding how much it costs to trade, they might be willing to make that trade off. In addition, as the exchanges are adding strikes, it means that the flexibility and granularity is less of an issue. So there’s two converging factors there,” he explains.
Thus, Stryker concludes in the report that once the UMR rules kick in for a broader swathe of buy side firms in 2020, there will be a “strong motivation for buy side firms to take a more aggressive approach in investigating listed options as a viable complement to their OTC activity”.
Stryker does, however, acknowledge that there are clear limitations on the extent to which FX options trading will shift onto listed exchanges. For example, he says that large trades will continue to be executed in the OTC market, either through voice transactions or via a broker-dealer.
“We’ve seen this in other markets. If you look at the credit market, for example, the average ticket size on electronic venues for trading corporate bonds is much smaller than you would expect. There’s a lot of tickets going electronic, but most of those are smaller size, the majority of block trades are still done over the phone and that will stay the same in the near-future,” he says.
Stryker also notes that the limited flexibility of listed FX options contracts ultimately creates a ceiling with regards to how much of this market can go onto exchange.
“There’s always going to be a natural limit because clients do want to retain their relationships with broker-dealers, so from that perspective they value the content and service that they get from broker–dealers. If you look at equities, which is one of the most transparent markets, there’s still a lot done over the phone. It’s surprising because obviously the broker-dealers themselves will put a lot through algos, but the clients, from a commission perspective, still generate 30-40% of the commission on the phone with brokers. So even though it’s a highly electronic market, there’s still a place for high touch coverage. The same thing goes in the options market with OTC versus exchange, there will still be a significant role for the sell side to play in an OTC market,” he says.
But the point being made by the Greenwich report though, is that there’s a ways to go before the FX options market starts pushing up against this ceiling.