Single-dealer platforms win out in electronic FX options trading

Foreign exchange options dealers are making hay while the sun shines. Although the Dodd-Frank Act in the US includes FX options and non-deliverable forwards (NDFs) in the list of derivatives markets that must move on to swap execution facilities (Sefs) and central clearing counterparties (CCPs), single-dealer platforms (SDPs) continue to drive growth in the electronic FX options markets, with significantly higher volumes compared with multi-dealer platforms (MDPs).

Daily volume of FX options traded on SDPs in the UK rose from $3.34 billion equivalent in October 2010 to $5.87 billion in October last year, while options volume traded on MDPs fell from $4.39 billion equivalent to $1.03 billion during the same period, according to the latest Bank of England foreign exchange joint standing committee's FX turnover survey. Taken on a
monthly basis, SDP traded options volume rose to $123 billion from $70 billion, while multi-dealer volume fell from $92 billion to $21 billion over the same period.

Emerging markets-focused NDF and currency swap products, the two smallest segments of the total FX market, are the only products more actively traded on MDPs, given emerging markets' participants' preference for the transparency afforded by multiple price points. For example, SDPs captured a total of $1.72 billion NDF and currency swap turnover in October 2011 versus the $10.4 billion traded on MDPs, according to the report.

Notwithstanding this sharp e-commerce growth spurt, voice platforms continue to dominate with an average daily turnover of $26 billion, as many banks and buy-side institutions opt for the privacy of a phone call and the ability to structure bespoke products.

However, with US Securities and Exchange Commission (SEC) chairman
Mary Schapiro requesting a budget increase from Congress on March 6 amid a significant slowdown in Dodd-Frank rule-making, and a potentially pivotal US general election looming in November, uncertainty around the content
and timing of the new regulations persists. Indeed, the substantial investment made in expanding their single-dealer capabilities represents a risky gamble for banks that face the double jeopardy scenario of publishing volatility surfaces in trading venues that could soon become obsolete.

"A bank's pricing surface is one of the core competitive advantages it has in the FX options market. As such, there is much less willingness to make that information public than in the spot markets," says Simon Nursey, global head of FX options at BNP Paribas in London, which launched its Cortex FX SDP in March. "It's essential to know who you are giving the volatility
surface to and that it will result in a trade. The need to keep liquidity close has therefore driven most of the electronic volume through SDPs."

While some dealers are offering streaming options prices on both singleand
multi-bank platforms, Nursey explains that the high-volume customer segments such as second- and third-tier banks, private wealth managers and hedge funds are attracted by the efficiency gains offered by the single-dealer environment. "Customers that appreciate the tight pricing and efficient execution have become high-volume users. They need every ticket
to be executed with minimal fuss and maximum accuracy," he says.

Moreover, as volumes grow, these customers can expect options to follow a
similar development path to spot, where prices and minimum ticket sizes have fallen as the overall volume traded online grew. "We expect the online option market will follow spot, with lower fixed costs and ticket sizes supported by increased volumes, which will attract further increases in participants and volumes," Nursey says.

However, straight-through processing remains a work in progress for some client groups, and a lack of derivatives trading infrastructure has precluded some of the largest buy-side institutions from signing up. For example, Axa Investment Managers in London uses FX options as a hedging tool for its offshore fixed-income portfolio as well as for alpha generation at a portfolio
level, yet does all its options trading in the voice markets despite a strong presence in other electronically traded financial markets. "We trade 100% of our FX option business in the voice markets, as we don't have the connectivity via our existing order management system to capture FX options electronically," says Lee Sanders, head of FX and money-market execution at Axa Investment in London.

With the regulatory status of FX derivatives still uncertain, the decision to
invest in new infrastructure remains problematic for buy-side institutions. "If the new rules require us to receive quotes and trade FX derivatives electronically in 2014, we will have to implement the necessary upgrades to our infrastructure to be compliant.We will do what the regulators want, but it's not very clearwhat the outcome will be for FX.We have a fewyears
towork on getting it right," Sanders says.

To this end, Thomas Soede, global head of electronic markets at BNP Paribas in London, says dealers able to offer an integrated solution compatible with their clients' own systems are more likely to capture market share. "As with the underlying product, there are many different permutations to the way clients are set up to execute and settle FX options.
Dealers that are able to offer straight-through-processing solutions for these
diverse requirements at a low cost are likely to attract more customers," he says.

Given dealers' preference to keep their market-making activities in-house, and the lack of regulatory clarity on whether options will have to be traded on Sefs, it's not surprising the multi-dealer sector is struggling to gain traction on either side of the market. Indeed, taken together with the
anaemic market share data, the withdrawal of Thomson Reuters from the interbank options market last year signals the difficulties MDPs are having in convincing some banks to contribute.

But Digital Vega, GFI Fenics and SurfaceExchange, which were among the
first to go live with multi-dealer platforms, cite some initial success (see box). The latest to join in is New York-based trading technology provider Tradeweb, which launched its own FX options MDP in February. It says while regulatory uncertainty remains a factor, there is a place for both single- and multi-dealer trading venues to co-exist. For example, SDPs seek to offer as much of the dealers' options franchise as possible, including proprietary
research and commentary, while MDPs tend to have more generic coverage
focusing on G-10 currencies and relatively vanilla instruments. Tradeweb's platform, for example, offers outright plain vanilla options and multi-leg strategies across G-10 currencies, using the same request-forquote
mechanism the vendor built for its fixed-income cash and derivatives products.

"SDPs offer a different value proposition that is complementary to the multi-dealer solution we offer, which focuses on execution and post-trade processing. Although some of the early regulatory indications suggest the future may be challenging for SDPs, there is space in the market for both types of platform," says Enrico Bruni, head of European markets at
Tradeweb in London. "Overall, the more electronic a market becomes, the more robust its infrastructure. The development of the MDP market is an essential part of that in the context of providing flexibility to market participants," he says.

Bruni says Tradeweb is soliciting liquidity agreements with the options
dealer community, and expects to have added an eighth dealer to its panel before the end of March, although he declines to disclose any of their identities. Similarly, he refuses to disclose daily turnover on the
Tradeweb FX options platform. "We are talking to clients on both sides of the market to build both the liquidity pool and the buy-side customer base," he says.

The sustainability of the SDP business model notwithstanding, the inclusion of FX options and other derivatives in Dodd-Frank and subsequent European regulation could have far-reaching consequences for client demand on any kind of platform - if options have to be cleared, clients will have to pay
for access to clearing services.

The additional cost layer could reduce hedging activity significantly, says James Bindler, global head of FX options and Central and Eastern Europe, Middle East and Africa head of trading at Citi in London. The firm operates its own single-dealer platform and streams prices to selected multi-dealer offerings.

"If the regulations are introduced as currently proposed, there is a strong
possibility clients will look for trading venues with less friction and costs. That mightmean executing their FX hedges in regulatory environments that are less onerous, such as the Middle East or Asia. Past experience
shows us, however, that whenever corporates face increased hedging costs, they hedge less or not at all," Bindler says.

Although buy-side institutions are convinced of the risk and efficiency gains of derivatives clearing, they are not happy about paying for it and will seek to defer costs to a provider if possible. "Clearing would be the biggest no-brainer in the investment world if costs were less of a factor. But the 15%of notional initial margin costs currently being discussed in the credit
default make it prohibitively expensive. Increased transaction costs will translate into performance reduction for investment managers. Do we want to ask pensioners to work longer because FX options liquidity is
not what it was?" asks Sanders.

With US policy-makers apparently not convinced FX should qualify for the same regulatory overhaul as credit and interest rate swaps, and a presidential election that could delay the regulatory process altogether, the next six months could prove critical for the survival of SDPs. There might be reason to be quietly optimistic.

"The main focus of the existing Dodd-Frank legislation is on getting the credit and interest rate swaps markets ready for clearing. Given the complexities of that task, the Commodity Futures Trading Commission and the SEC are already struggling to meet the regulatory timetable. They will probably get round to FX eventually, but probably not right away," a London-based options dealer says. "Our viewis it's a green field for options at the moment. There is sufficient event risk in the markets to encourage long-term hedging and adequate volatility to encourage options trading. We've seen a backdrop of broadly rising FX volumes for the past couple of years that we see continuing until the regulatory drag starts to become effective for us," says another dealer.

Should Barack Obama win in November, and the legislative coalition around
Dodd-Frank remain intact, will all the work on single-dealer functionality have been for nothing? Against a backdrop of inconsistent liquidity in the FX options market, it's unlikely banks will give up a tool that has become a valuable source of internal liquidity and increasingly important for
servicing their clients. "The FX options platform is not only increasing our volume, it is increasing our internal market liquidity at a time when traditional market-makers are pulling back from the market. An
online tool that constantly puts prices into the market improves our liquidity and gives us more market colour," Bindler says.

In the event the SDP is no longer compliant with derivatives regulations,
banks could hand their SDPs to third-party vendors to operate, although it's not yet clear how such an arrangementwould work.A further complicating factor is the apparent discrepancy betweenUS and European regulation, which bars dealers fromowning a Sef in the US,while no such restriction has
been made for organised trading facilities in Europe. "If Dodd-Frank becomes binding on FX, the bankwill have to put its SDP into a Sef, presumably a third party that already has the infrastructure in place, or pull out of thatmarket. Proprietary systems will not be permitted," says Axa's Sanders.

Bindler is confident the research and development investment in electronic
options trading will continue to add value for clients regardless of the outcome. "The bottom line is we will put our prices where the clients want to see them. Whether it's single- or multi-dealer, the shape of the platform will be dictated by the client and the bank will respond to that," he says.