For companies looking to take advantage of favourable currency moves or seeking a hedging alternative to forwards when exposures are uncertain or risk is asymmetrical, FX options are a handy solution.
The problem is they have traditionally come at a price that has prohibited their use on a more regular basis.
The options market has evolved in recent years, but this development has not delivered the lower costs that aspiring market participants might have hoped for.
“The fact that there are more companies entering the FX options and FX structured products market to compete against the pricing of banks has helped pricing to become more competitive,” says Chris Towner, managing director at HiFM, a specialist FX advisory firm.
“However, there has also been an increase in premiums this year to compensate for event risk.”
Amol Dhargalkar, managing director of Chatham Financial, a risk-management company, observes that new entrants to the market might find it difficult to grab share without having some differentiating capability, especially since corporate treasury departments tend to reward business to their partner banks that provide them with capital markets, cash management and/or M&A support.
Increased regulation – particularly Basel III – has forced many banks to assess the capital requirements of participation across the products that they offer.
“In some cases the business, risk or economic justification to remain a market maker in the options market may not be strong enough to warrant the same level of commitment they have made in previous years,” says Tod Van Name, global head of FX and commodities electronic trading at Bloomberg.
|Chris Towner, HiFM|
According to HiFM’s Towner, another factor limiting the use of options by corporates is the complexity of vanilla options and structured products pricing.
“It is also important to point out that as FX structured products are credit intensive, pricing needs to reflect the accompanying credit terms,” he adds.
Stephen Best, head of FX options at EBS BrokerTec, says a lack of data negatively impacts volumes. He notes there is demand from liquidity consumers for indicative volatility data from trusted sources across all tenors, currency pairs and instruments, and acknowledges that better transparency fosters higher levels of confidence and, subsequently, more trading activity.
Clearing will have an impact on data transparency, although it is unclear when its effects will start to be felt. Best suggests that mandatory FX option clearing is at least a couple of years away.
David Blair, an independent treasury consultant based in Singapore, reckons options will not be clearing en masse in the short term. Bloomberg’s Van Name thinks it is possible it could happen sometime next year.
Alfred Schorno, global head of sales 360T Group, agrees there will be FX clearing in 2017, but says it will be limited to spot, forwards and swaps, adding: “FX options will come later as a natural progression of that clearing activity.”
The evolution of electronic trading has impacted the options market. Bloomberg cites advances in technical solutions for price generation, distribution and risk management, plus increased scrutiny of operational efficiency as factors that will help to drive growth in the e-options market.
Yet few observers are willing to predict the elimination of voice trading for options.
Blair suggests that although vanilla options are increasingly traded online, more specialist products – including structures and second- and third-generation options – are so specific and rare they will likely remain voice-traded.
Electronic trading helps FX providers process a high volume of clients economically, which works well with smaller notional trading tickets, says Towner, adding: “However, for the high notional tickets, people still like to talk through strategy, pricing and do the deal over the phone.”
According to Best at EBS BrokerTec, the two channels are complementary.
“There will be growth in the trading of commoditized products such as first-generation exotics and G10 currencies over electronic platforms, but more illiquid products – including emerging-market currencies – will continue to be transacted by voice,” he says.
Schorno at 360T Group disagrees, noting a significant uptick in the use of electronic trading tools for options during the past 12 months in line with better and more comprehensive request features – and an increasing number of liquidity providers who quote automatically and in a wider range of option types via pricing engines.
“We strongly believe that due to more attention on efficiency, mounting requirements for greater transparency and auditability of the execution processes and compliance requirements, there is no room for voice trading in standard OTC FX products going forward,” he concludes.