The Last Look…

I have noted through various channels over the past few months, how the FX swaps market structure appears to be changing, or at least be on the cusp of significant change, which has got me thinking about the FX options market – what’s likely to happen there?

It needs to be understood from the start that FX options, as is the case with FX swaps, is largely unaffected by automation – both remain largely a manual business – therefore the technology boost that provided the driver of growth in spot and NDFs over the past two decades is not in play here.

Also, while swaps activity has definitely been boosted by the return of interest rate volatility, the jury seems to be out on FX options still if we look at the limited amount of data available.

Anecdotally, talking to bankers in recent months, there is a sense that customers have been a little slower to turn back to options, in spite of the sustained volatility of the past 18 months. Some, not all I should stress, believe the relative lack of automation is behind the slower-than-expected re-adoption.

Greater automation will play a role in boosting access to FX options, I don’t doubt, but perhaps what is also needed is access to a wider set of products in an electronic environment? I have noted before how bespoke the FX options market is when it comes to client demands, this makes increased automation difficult, but in a more volatile market generally, surely the products exist to attract more traders to the product? Certainly, looking at CME’s FX volume data, there are all manner of contracts available.

In the OTC world, looking at the data from the UK and New York FX committees it’s a bit of a mixed bag. In both centres, FX options volume went up from April 2019 to April 2022, but then both dipped again in April 2023. This could be a natural result of FX markets calming down somewhat this year compared to conditions last year, but it could also be that certain segments of the market still feel FX options are just too much work to get involved with.

The evidence on automation is also mixed between the UK and US, with the much larger UK market (it executes about three-times what the US does in an average day) seeing a definite shift away from voice channels, but the US offering a much more ambiguous picture.

Between the e-channels covered by the UK survey, the share of FX options volume rose to 20.8% in April 2022 from 15.1% in the same month in 2019. In the US the e-channels handled 19.4% of volume, down from 23.8% in 2019. In the UK the increase was taken from the voice broking and customer direct channels, while in the US, the ECNs lost ground at the expense of dealing direct by voice and, slightly, through the voice brokers.

It is notable, though, that the single dealer platform channel in the US saw a 1% increase in market share to 7.1% over that time – indicating the D2C automation push may well be starting to bear fruit.

I have selected April 2022 because that was a good indicator of busy markets and what happened in FX options, comparing that month to one year later, the trend has been reinforced in the UK, the e-channel share rising to 21.9%. In the US in April 2023, there was a slight bounce, to 19.7% of volume.

One challenge cited by traders when looking at FX options is the impact of regulation – and here we have to wonder whether the same impact will be felt, in time, by the FX swaps market? The problem is, looking at the data, it doesn’t look like much is actually happening.

Yes, there is evidence from ForexClear that options clearing volumes are going up, but they are hardly dominating. Data from that firm indicates that broadly, clearing volumes in FX options have doubled over the past year (they were negligible in 2019 so a comparison isn’t realistic), but at around $10 billion per day, it still only around 3% of global daily volume. It remains, however, early days, and could look very different in one or two years’ time.

The FX swaps space is definitely changing, but it could be that in the short-term, this actually starves the FX options market of oxygen for change

The data from CME’s FX options product suite is also illuminating, in spite of more products being available to trade in the first half of 2023 compared to the same period in 2022, activity seems to have dropped about 11% in terms of contracts numbers traded.

Of course, this is likely the result of the quieter markets generally, and given the significant change in CME’s product suite over the past few years, comparison to 2019 is almost impossible, but again, the sense is that the e-traded, cleared, products are still not grabbing traders’ attention.

So, what will it take to change this? I think in one word, the answer is ‘patience’. We have been talking about FX swaps automation for a long time but being able to electronify the workflows and deliver workable solutions has taken a long time – perhaps longer than even proponents thought – therefore FX options has to go through the same process.

What will be interesting to see is whether the process is quicker than in swaps, and to me that depends upon how the banks, and the customers, view the issue. The banks have largely shown antipathy towards attempts to develop competitive environments for customers to trade FX options. Digital Vega is making some headway it seems, but if you look back GFI struggled to get enough support – indeed word has it the firm encountered significant opposition.

One driver of change in the spot FX market was the rise of the non-bank market maker, which was helped by several banks in the second and lower tiers, pulling back from their market making activities. For the same to happen in the FX options market, you sense that more trading has to be done on exchange, or on venues where clearing is the default post-trade process.

If that is indeed to occur, then the clients have to be open to changing how and where they trade; the venues have to offer a wide enough range of products for them to trade; and the clients again have to be open to taking liquidity from non-bank players.

That’s a lot of ‘ifs’ to get serious change to take place, and it is probably not helped by the fact that many expect the first influx of non-bank option market makers to come from the equity derivatives world, where the sense is they are still HFTs masquerading as market makers.

Overall then, it is too early to talk in terms of serious market structure change in FX options – in spite of the influence of regulation. At the moment it is not so much in the ‘too hard’ drawer, more it is several drawers down the cabinet while more important changes are implemented.

The FX swaps space is definitely changing, but it could be that in the short-term, this actually starves the FX options market of oxygen for change. The market will evolve, but perhaps its time has not yet quite come.

colin@thefullfx.com