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Foreign exchange: A solution for option expiry

FX option clearing plan stalls; Option expiry concerns might deter smaller participants

SurfaceExchange, a US-based multi-dealer option trading platform, is offering a service that could streamline FX option exercises on expiry dates. This will alleviate the expiry concerns raised when new Dodd-Frank regulations come into effect in the FX derivatives markets in 2012.

Since regulators mandated that FX options should be processed through clearing houses and traded on multi-dealer platforms (known as swap execution facilities) banks and clearing houses have been grappling with how to resolve two key issues.

The first of these is whether CLS (which guarantees trade settlement for the industry) would take clearing-house settlement risk when options were exercised and, secondly, how option exercises could be processed efficiently through clearing houses when they are traded across a multitude of trading platforms.

With regard to the issue of settlement risk the industry hasn’t resolved the guarantee of principal for clearing houses, which has stalled progress in CCP implementation. And clearing houses have abdicated responsibility to the counterparties of option contracts to exercise bilaterally, and then notify the clearing houses on the same day.

"SurfaceExchange has committed to making the FX option exercise process easier, so that anyone can trade the instrument"

Evgeni Mitkov,SurfaceExchange

Evgeni Mitkov, SurfaceExchange’s chief executive


The manual exercise process is too clunky for the new era of electronic trading and has kept many players away from the market. It has also forced existing market participants to trade with a small number of counterparties in large notional amounts, according to Evgeni Mitkov, SurfaceExchange’s chief executive. "SurfaceExchange has committed to making the FX option exercise process easier, so that anyone can trade the instrument, and they don’t need a trading desk of 10 people to trade in this market," says Mitkov.

Smaller participants are placed at a distinct disadvantage because of differences in how they access spot markets when they offset option exercises. These are largely determined by the credit quality of the counterparty or access to different pools of liquidity. For instance, a small regional bank in Germany might not have the same market access to the best bid and offer in the market as a member of the primary market, EBS.

Additionally, there is no market standard to establish what the rate should be at the expiry in each currency pair, across one or two cuts daily, which makes it impossible for clearing houses to auto-exercise options.

The exchange traded equity option model isn’t likely to be replicated in the FX market. For example, US equity exchanges operate what is called NBBO – National Best Bid and Offer – so across the board at a particular millisecond there’s an NBBO in the entire equity market.

"You have to have some methodology that does it very fast, does it across different platforms," says Mitkov. "But even then, if you get exercised at that rate, and you don’t have access to that market, you could lose a couple of pips here or there, and you’re going to be out of pocket. You’re running a lot of basis risk."

As for the issue of guaranteeing the exchange of principal, prime brokers and option traders tell Euromoney that implementation of clearing is being delayed until a compromise can be found between the clearing houses and the banks that own and operate CLS.

The banks are believed to have come up with some proposals, although the Fed does not like them. It is believed there have been two possible solutions pitched to the Fed.

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