At a Glance
- 40% of traders surveyed say listed FX options could replace their OTC options trading when new margin rules take effect
- A renewed focus on electronic trading is essential to fuel longer term FX options growth
Data from the latest Bank of International Settlements survey shows that daily FX options trading globally rose 16% since April 2016 to $294 billion per day in April 2019, however it is still 13% below the $330 billion mark from 2013. The six years of mostly flat volume growth in options is surprising given the broader FX market has seen continued strong growth with this year’s $6.6 trillion a day headline nearly 25% higher than 2013.
Why have options underperformed? It could be argued that the slow transition to electronic trading, the adjustment to new conduct and capital rules, and historically low volatility have been important factors holding back growth over the past six years.
Electronic Trading Leads to Higher Volumes
Options has been the slowest segment of the FX market to embrace electronic trading. The Greenwich Associates 2018 Global Foreign Exchange Study found that just 37% of global listed FX options volume is executed electronically compared to 87% for spot and 74% for deliverable forwards.
Data from the semi-annual surveys from the UK and U.S. central banks indicate that the percentage of electronic trading has remained close to 20% of total activity since 2013, coinciding with the period of stagnant volume growth. Interestingly, the last significant surge in volume according to BIS surveys occurred between 2010 and 2013, a growth of 62% over the period, also corresponded with a surge of electronic trading from 11% to 36%. A similar electronic growth story was seen on the CME between 2007 and 2018 when option moved from primarily traded in the pit to 98% traded electronically and volume surged 400%.
It seems incongruous given the greater regulatory scrutiny of trading practices and conduct that traditional voice conduits would still be favored over electronic trading. In addition, the market needs to refocus on adopting electronic trading of options to achieve scalable, low cost operational capability. This seems particularly important in the vanilla G10 currency options where dwindling profit margins do not justify the higher manpower cost of voice-driven trading.
Uncleared Margin Rules
The adoption and implementation of regulatory requirements resulting from Dodd-Frank, MiFID I&II and Basel related rules is nearly complete. Focus should now turn to the last two phases of uncleared margin rules (UMR), which require participants to exchange initial and variation margin for FX options positions held bilaterally.
These last phases are expected to impact nearly one thousand participants, and they could certainly dampen market activity if many find themselves unprepared to manage the anticipated higher operational cost.
David Stryker, a principal with Greenwich Associates and author of a recent report on the FX options market, observes that the cost of trading could rise considerably in September 2020 when most of the industry becomes impacted by UMR, and that the benefits of trading an exchange-cleared product will become increasingly important over the next 12 months.
Almost 40% of the traders surveyed for the report described listed FX options as a potential tool to complement and, in some cases, to replace their OTC options trading when they become subject to exchanging margin. Stryker notes that most market participants would see meaningful costs savings by trading on a central limit order book – potentially up to 70% per trade compared to OTC. An CME analysis further showed that listed options that clear on a central counterparty can reduce capital and funding cost by nearly 90% compared to position held bilaterally.
Low Volatility Will Not Last
FX volatility has been in a long-term down trend and is nearing a 25-year low based on the JP Morgan G7 Volatility Index. Extreme values of volatility, whether high or low, tend to reduce the use of options. At very high levels, liquidity becomes stressed and high option premiums make it difficult for participants to trade or hedge.
When volatility is low, liquidity is strong but participants are less motivated. For example, institutional participants who favor yield enhancement strategies based on selling options find the risk/reward at very low volatility unattractive due to the heightened risk of a possible sharp reversion creating large losses.
It is difficult to predict changes in structural volatility that can create longer period of heightened risk across multiple currencies, but it is clear from the chart above that the turn up from major lows tends to be fast and pronounced.
With adequate solutions in place to deal with the final phases of UMR, and a focus on adopting the efficiencies and scalability of electronic trading, the FX options market could be in a great position to handle the next surge in volatility and achieve its true growth potential.