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LOW VOL, HIGH COSTS: NAVIGATING HEADWINDS IN FX OPTIONS TRADING

 * 4 Oct 2021
 * By CME Group
 * Topics: Foreign Exchange

In this paper, we explore some of the headwinds facing FX option traders and how
expanding their repertoire to include both OTC and listed products can help
overcome those challenges. We take a closer look at the nuances and features of
listed FX options. While adoption of listed FX options by OTC participants may
seem onerous at the outset, leading vendors like Murex have already developed
solutions to manage OTC and listed FX options in a combined portfolio. The paper
concludes by exploring the Murex offering.

FX volatilities have been at or near historic lows for the past three years.
March 2020 and the onset of the COVID-19 pandemic provided some notable
exceptions. However, the overall trend for volatility seems to be “lower for
longer.” The JP Morgan G7 Volatility Index has hovered in the bottom decile of
the last three decades. The CME CVOL G5 Index (FXVL), a shorter-term measure,
also reflects a similar trend.

FX options traders also face headwinds from Uncleared Margin Rules (UMR). These
rules require qualifying firms to post margins for bilaterally traded uncleared
trades. UMR started to be phased in from September 2016. Phases 5 and 6,
implemented in September 2021 and September 2022 respectively, are expected to
capture more than 1,000 firms (according to ISDA) and will have a far-reaching
impact on the market.

For more on the impacts of UMR Phases 5 and 6, read UMR Phase 5: A Real
Challenge for Real Money.

The mandatory posting of initial margin (IM) and variation margin (VM) on FX
options for firms captured by these rules will bring a direct cost to firms
having to post these margins for the first time. There will also be an indirect
second-order impact if prime brokerage (PB) costs rise as a result, which would
potentially lead to dealers widening bid-offer spreads in response to higher
costs of trading FXO.

These changes—which also bring a considerable administrative burden in the form
of legal costs, custodian relationships, and operational processes—may act as a
catalyst for the market to consider alternatives. Clearing FX options and facing
a central counterparty may help reduce these costs (i.e., through lower margin
requirements and the feature of netting exposures) and offers a simpler
operational and regulatory wrapper for trading participants. Listed FX options
can offer a cost-effective, scalable, and accessible way to trade cleared FX
options. Given recent changes in product design to match key OTC FX options
characteristics and the ability to execute bilaterally, as well as
electronically, they provide a close proxy to OTC options for many participants.

Difficult trading conditions combined with a shifting regulatory environment
create a challenging context for FX options traders. In such an environment,
reducing the cost of trading becomes critical.


GREENWICH ASSOCIATES STUDY ON FX OPTIONS TOTAL COST ANALYSIS

Greenwich Associates conducted a total cost analysis (TCA) study that compared
the pricing of OTC FX options versus listed FX options for buy-side firms. The
study (read here) indicated that most market participants would see transaction
cost savings of around 40 percent to 70 percent per trade, depending on the
option’s expiry and strike price, by trading the first level of the CME Globex
central limit order book.



Beyond execution cost savings, trading listed FX options can provide the
advantage of margin offsets through netting of FX options positions at CME
Clearing. It also includes capital relief, as CME FX options require a lower
initial margin based on one-to-two days margin period of risk* in comparison to
a 10-day margin period of risk used to calculate IM, based on ISDA SIMM.

CME Group conducted its own research to quantify these benefits using a model FX
options portfolio. The research found that lower IM (referenced above) combined
with advantageous capital treatment under the Standard Approach for Counterparty
Credit Risk (“SA-CCR”) made the listed FX options portfolio 55 percent more
capital efficient than the portfolio with netted SIMM via PB and 86 percent more
efficient than the portfolio with bilateral SIMM.


CME EXCHANGE-TRADED FX OPTIONS

CME Group is the largest electronic, all-to-all venue to trade listed FX
options. It offers transparent, credit-agnostic, near round-the-clock access to
FX options liquidity to participants ranging from banks to prop traders, hedge
funds to asset managers, commercials to professional retail—all backed by the
safety and efficiency of central clearing at CME Clearing.

Since the turn of the millennium, CME Group has led the electronification of FX
options trading, which has grown in the past few years to reach a turnover of $5
billion to $8 billion daily (volumes reported here). Increasing adoption by
end-users has helped the average open interest in CME FX options reach $90
billion (up 35 percent YoY).

Key features of CME FX options:

 * Options are European-style and, for major currencies, the expiration time is
   10 a.m. New York/Eastern Time, in line with the OTC convention.
 * Auto-exercised against a transparent, rule-based fix with no contrary
   instructions.
 * A range of expiries including weekly Monday, Wednesday, and Friday in the
   short term, supplemented by monthly expiries over the first year.
 * Increased strike granularity offering precision in risk management.
 * Deep, on-screen liquidity in G5 currencies and a wide ecosystem of banks and
   non-banks providing on-demand liquidity in emerging markets and cross
   currencies.
 * A no-last-look, first-on-price/first-to-fill model on a central limit order
   book, allowing participants to work orders and reduce transaction costs.
 * Choice of execution modalities:
   * Central limit order book (CLOB): The FX options CLOB on Globex, CME’s
     electronic match engine, is a central execution point for firm orders.
   * Blocks: Block trading is a form of relationship-based trading that can be
     carried out bilaterally, with or without the support of a broker, and where
     the size of the transaction is above a certain threshold.*

*FX options contract specifications can be found here.

**View the block trading market regulation advisory notice here.


CME GROUP TRADING TOOLS AND ANALYTICS

Helping traders better manage their positions, CME Group actively developed new
tools and analytics. With regards to FX options, the following are recent
additions and are noteworthy:

 1. FX Options Vol Converter: Converts live CME premium quotes into
    OTC-equivalent implied volatility surface. This tool summarizes the whole
    surface in convenient, easy to track grid by tenor and delta, which OTC
    participants are familiar with. The tool helps traders compare listed and
    OTC FX option pricing efficiently.
 2. CME CVOL Indices: Extensive set of 30-day implied volatility indices based
    on a simple variance methodology. CVOL indices are available for eight major
    currencies, including a G5 composite to help participants analyze volatility
    at a glance. There are auxiliary indicators, including skew and convexity,
    to help analyze market behavior in currencies or at the G5 index level to
    assist participants in formulating their trading strategies.

Having examined the factors driving increased interest in listed FX options
trading by market participants, it is also important to consider pricing,
valuation, and risk management considerations for market participants who wish
to include listed FX options in their portfolios of OTC FX options. One such
solution, for managing positions across OTC and listed venues, is offered by
Murex, a global leader in trading, risk management and processing solutions for
capital markets.


EXPANDING TO LISTED FX OPTIONS IN MX.3 IS STRAIGHTFORWARD AND COST-EFFECTIVE

The Murex MX.3 platform provides wide, cross-asset products coverage ‒ including
OTC and listed FX options. The expansion of an existing OTC FX business on the
platform to listed FX options is straightforward and cost effective. Advantages
can be felt throughout pricing and evaluation, position management, trade
lifecycle management, and interfacing capabilities.

Pricing and evaluation

Market data, such as prices and volatility surfaces, can be linked to OTC curves
for intraday valuation, when relevant. Importantly, FX-listed data can be easily
derived from OTC. This derivation can lead to a reduction in market data costs.

Model validation costs can also be minimized: European-style and American-style
listed FX options leverage the same pricing engine as OTC products. Volatility
interpolation logic and Black-Scholes pricing formulas are identical.

These advantages on the pricing and evaluation sides can contribute to reducing
time to market and enabling compliance.

Positions management

The MX.3 platform allows clients to house and aggregate listed and OTC risk on
the same screens. Associated risks such as delta and vega can be hedged
together, capitalizing hedging costs.

Greeks of listed FX options are displayed on the OTC underlying curves and on
the same maturity buckets. Risk on cross-currency pairs’ OTC and listed products
can be projected together on the same leading pairs.

To anticipate expiries, both OTC and listed strikes of expiring options are
displayed together on a common strike scale.

What-if scenarios on OTC curves are applicable to listed products. The results
of P&L and Greeks impacts are produced both for OTC and listed products and can
be aggregated ‒ enabling quick, risk-informed trading and hedging decisions.

Trade lifecycle

Operational costs are cut throughout the trade lifecycle. On the CME side, the
process has been streamlined to match OTC (e.g., featuring the cutoff times). To
ensure consistency in the trading book, if CME-listed prices are not available,
OTC prices are used as a default.

The trade representation closely mirrors that of the OTC market, and the booking
model is the same.

Also, the listed FX contract definition inherits most of the OTC contract
definition and is enriched by critical data specific to the exchange-like lot
size and maturity sets.

By adapting OTC FX trading systems currently in use at minimal cost,
institutions can potentially exploit substantial expected advantages offered by
listed FX options, especially in terms of capital efficiency under UMR pressure.
Institutions might also benefit from synergies and efficiency in implementing
FRTB, SIMM, SA-CCR, CVA capital charges in one platform.

* The funding analysis in the Greenwich Associates TCA report used a more
conservative time period of five days margin period of risk in the calculation
methodology.




 * * 
 * 


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