Can Clobs level the playing field in OTC FX options?

Electronification could be a “game changer” for smaller liquidity providers, say participants

  • Interdealer FX options trading has remained heavily reliant on voice and chat-based execution at interdealer brokers, which often come with high broker fees and the majority of flow handled by the top dealer banks.
  • Digital Vega is attempting to disrupt the status quo with the launch of a central limit order book for the interdealer market, where it will slash fees for price-takers and pay out brokerage for liquidity providers.
  • The hope is that this will make it significantly more cost effective for banks to make markets for LPs and will level the playing field for smaller dealers to gain access to liquidity and market information.
  • At the same time, interdealer brokers are aiming to offer a hybrid model that combines elements of electronification with an RFQ screen.

The drive towards electronification in the FX options market has accelerated over recent years, with buy-side clients dragging their FX dealers into the modern-day world of e-trading.

But the interdealer market has largely stayed in the past and is one of the last true bastions of the over-the-counter world that has yet to embrace electronification. It remains heavily reliant on voice and chat-based execution at interdealer brokers, with expensive broker fees, making it a world dominated by a handful of large dealers.

Things might be changing, however, as Digital Vega is poised to offer a central limit order book (Clob) for the interdealer market, and BGC-owned Fenics Direct is also mulling a move. Clobs have been tried before – and failed – but with FX volatility returning to pre-Covid lows and bid/offer spreads continuing their tightening trend, some market-makers sense that things may be different this time.

“The intense pressure on margin compression is causing banks to reassess what is important to them. The surprise in the FX options space is how little the market has changed,” says Logan Campbell, head of FX derivatives at Deutsche Bank.

“This may change because it doesn’t make sense to manually quote tight prices on medium tickets, and as these pressures come on, it is forcing people to reconsider how they distribute prices.”

Of the two Clobs, Digital Vega’s is far closer to fruition, and is expected to go live by the end of February. At the end of last year, the firm completed a live-trading beta launch of the Clob with seven to 10 of the largest dealer banks participating.

The big selling point is on the fee side. Whereas voice brokers charge price-makers and takers a flat fee, the new venue plans to pay the price-maker and charge the price-taker much smaller amounts than the voice brokers.

For the large established dealers, slashing brokerage charges – one of their biggest business expenses – is of course attractive, as is the potential for extra trading data that can be used for price discovery purposes.

Digital Vega is coming in as a potential leveller. We are tempted by the transparency, openness and equal access that it offers
Fredrik Lockne, SEB

But for some smaller players, the advent of a Clob levels the playing field and holds out the prospect of better access to flows and information than under the current market structure.

“Over the years, as a regional player we tend to miss flows that go on in the market in terms of the information gathered. There has been an issue that we don’t always see what happens, and that can be a limitation on our touch on the market,” says Fredrik Lockne, head of FX options, spot and non-deliverable forwards trading at SEB.

“As things stand, this progression has opened the field for Digital Vega and makes it more even for us to participate,” says Lockne.

Big beasts, big vol

Like other instruments, the interdealer market for FX options is there for banks to lay off risks they take in from clients.

But options market-making is an increasingly expensive business. And the decline of FX volatility and tightening of bid/offer spreads has meant a successful franchise needs to offer a number of features to compete in the modern market.

Examples include a sophisticated pricing engine that can consider all manner of event risks; tools to monitor client profitability to ensure they don’t routinely take on losing trades from the same counterparties; and single dealer platforms that allow for an array of pre-trade analysis and pricing tools.

The biggest dealers are also looking at other tools to cut the cost of trading, such as using algorithms to hedge out the gamma – the rate of change of an option’s delta – from their books. Some smaller dealers have also looked to take liquidity in popular pairs from the larger banks through white-labelling arrangements (see box: The appeal of white labels).

Over the years, this has meant that volumes in the interdealer market have shifted to the larger FX dealers, which have not only the balance sheet and capital to take on this business but also the risk appetite to deal in these complex products.

“There are only six to eight banks for whom [FX options] is worthwhile to do, and they now get the business which used to be spread across multiple smaller banks,” says the head of FX derivatives at an emerging market-based dealer.

The way the market has evolved means these dealers get bigger volume-based discounts on their brokerage fees and are the first port of call when other banks are trying to lay off their risk.

One former global head of FX options trading at a European-based bank says it’s no different to any client-facing relationship where the big companies get better prices.

“The brokers do focus on bigger banks, but it doesn’t mean they get better prices – they don’t hold off better rates from the non-profitable banks. But they know the big banks will pick up every time and are more relevant – they see tight pricing quickly because they respond quicker,” says the former FX options trader.

Price-making and taking

The introduction of a Clob, though, changes these dynamics. Clobs are exchange-like trading environments where essentially the best price wins, regardless of who you are. There isn’t a broker sitting in the middle deciding where to send the enquiries and, in Digital Vega’s case, the fee structure is the same for everyone.

Although they are not a new concept in the FX options market previous efforts have failed to gain traction among the interdealer community (see box: Clob challenges).

But this levelling of the playing field in the current resources-constrained environment is attractive to regional banks, who when operating in markets beyond their local currency can sometimes find themselves less prioritised than the bigger FX dealers.

This could mean they miss out on trades that would have met their risk profile, or they miss out on key market data.

“You are relying on a single person for the flows and information of the market. We have some brokers that we have a fantastic experience with and others where we feel are less prioritised. That said, if we have a EUR/USD interest, we would be serviced and be given the price – but it’s the nuances that are sometimes missing,” says SEB’s Lockne.

Garth Appelt, head of FX and emerging markets macro trading at Mizuho Americas, says if regional banks can match risk through a Clob, this will open up possibilities for them to be both price-makers and takers in any currency.

“The more transparent the market and the more a single platform can feed into an electronic database, it creates a lot more liquidity for solution-orientated firms like Mizuho that specialise in complexity and duration,” he says.

“Other regional banks and financial institutions that use options to hedge a variety of risks will benefit from transparency and liquidity. A Clob means options users can send flow to a mid-point and be a price-maker/taker from different venues without going through several layers to get to the end-buyer or seller.”

Lockne agrees, saying the launch of Digital Vega’s Clob will provide the Nordic-specialist bank greater opportunities to participate alongside the big banks.

“Digital Vega is coming in as a potential leveller. We are tempted by the transparency, openness and equal access that it offers, and we will see how it goes. Historically, no one has been able to create an electronic channel to replace the voice brokers, and for the vanilla options side it is something the market has been waiting a long time for,” he says.

The big dealers, though, aren’t too concerned about renewed competition from smaller players. A senior FX source at one US bank says it believes its superior technology means it should easily be able to hold off challengers on a Clob.

Another source at a European bank says that without the mass flow the big dealers can use to internalise, smaller banks would generally find it hard to price clients more cheaply than the big dealers and lock in the hedge on the Clob at an acceptable profit.

However, John Rothstein, chief executive of Optiver UK – the Dutch non-bank market-maker’s FX unit – says adoption of Clobs can also mean all participants can benefit from more diverse sources of liquidity and pricing.

“Lit, liquid, accessible markets mean you end up with multiple players, and you get complementary skills, either from incumbents that can do multiple things or with alternative liquidity providers that can give quick pricing. We believe in those things, and any market is better for them. A Clob matches these principles – and any MDP or exchange that promotes readily available information in a single place is making a good decision,” says Rothstein.

“But it requires uptake. They [Digital Vega] would have to follow that up by inviting the biggest LPs to this,” he adds.

Fee appeal

At this stage, a number of big dealers are definitely intending to sign up. The main draw for them is the fee structure. It is understood that voice brokers can charge between $6 per million on euro/US dollar for both price-makers and takers, while for emerging markets currencies it is even more, with US dollar/offshore renminbi brokerage rates at $15 per million.

Under Digital Vega’s fee model, for EUR/USD they pay the price-maker $1 per million and charge the price-taker $3 per million, and for USD/CNH pay $2 per million to the maker and charge $5 per million to the taker.

Jeremy Woolfenden, head of interbank business at Digital Vega, says trading desks have shrunk by 60%, with many banks only running books in their own local currencies and everything else sent out to brokers. But he says broker fees haven’t gone down and the service hasn’t improved.

[Digital Vega’s] aggressive Clob brokerage model and their limitation on the number of liquidity providers per RFQ, we think are game changers
Ciara Quinlan, UBS

“This is where interest in using MDPs has grown, and if we can give banks an alternative where they can use an order book at a fraction of what they pay now, then this will open up the interdealer market to more liquidity,” says Woolfenden.

One head of FX options at an Asia-based bank tells FX Markets that the savings for trading options on emerging market currencies could be significant.

Some are also interested in the platform’s plans for offering request-for-quote (RFQ) trading on block sizes, but with a limit on the number of market-makers that can be asked at once. If a price-taker asks too many banks for a price, the losing banks can readjust their pricing before the winning dealer can hedge, making it hard to lock in a profit on the trade.

Ciara Quinlan, head of principal electronic trading at UBS, says the bank will favour those venues that can deliver cost efficiencies, liquidity aggregation and value-add services.

“Digital Vega is a leader in MDPs for FX options and we are excited to see what happens with their Clob. Their aggressive Clob brokerage model and their limitation on the number of liquidity providers per RFQ, we think are game changers,” says Quinlan.

Others that are more on the fence say they will probably end up joining to tap into the data generated by Clobs, which will help their price discovery process become more efficient and lead to richer analytics capabilities.

The appeal of white labels

The cost and technology pressures facing tier two and three banks has forced them to seek answers outside of their own capabilities. This has made outsourcing white-label solutions an enticing arrangement for them.

For a regional bank that is only really competitive in its local market, this enables it to partner with a larger bank to use their liquidity and pricing for G10 currencies as its own, in order to focus on its core competencies and operate within its own risk parameters.

As the market becomes more electronic, white labelling provides a cost-effective alternative to remain active in G10 currencies.

“I think many banks have realised they can’t really survive in the FX market unless they have an electronic solution – whether that’s augmenting their manual pricing capabilities or going fully automated. White labelling is something that we’re probably going to continue to see growth in as the market becomes more electronic,” says Tod Van Name, global head of FX electronic trading at Bloomberg.

The head of FX derivatives at a large European dealer says they have had many conversations with other banks about using their tech and risk management. Ian Daniels, head of eFX distribution at Nomura, agrees, and suggests it is something that the bigger banks may also have to consider.

“White labelling has its positives and it’s something you have to bear in mind for the future as you develop. If you talk to a lot of the Street, there are large banks that are using other sources of liquidity and using a white-label arrangement already with their clients,” says Daniels.

Clob challenges

The use of central limit order books in the interdealer FX options market isn’t new – many of the interdealer brokers, including GFI and TP Icap, have operated their own Clobs for some time.

One of the more famous examples is Volbroker, owned by Icap and Tradition. On this system, brokers post and hit bids and offers on an internal Clob on behalf of their bank clients. The platform ran into trouble with US regulators when it emerged brokers were posting fake bids and offers on the venue, and the owners and certain executives were fined a total of $8 million in 2020.

But while they are prevalent in the broker market, Jeff Pio, managing director at Fenics Direct in North America – a spinoff firm from interdealer broker BGC – says most banks are still extremely comfortable with executing by voice or chat functions.

“Every voice brokerage institution has their own Clob and has for over a decade. Banks have built aggregators to harness the liquidity across Clobs but they remain view only. Our Clob has over 7 million prices including non-bank liquidity, but until banks turn their aggregators on, we will continue to see the business executed by voice,” says Pio.

FX Markets reported in June last year that Fenics Direct was mulling the launch of its own interdealer Clob that might compete with Digital Vega. It’s understood the firm is still actively exploring this but the project remains in the very early stages.

Tod Van Name, global head of FX electronic trading at Bloomberg, says it’s the nature of banks’ trading that makes it hard to translate it into a Clob environment.

He says where an order book would make sense for banks is for at-the-monies (ATMs) on specific tenors, such as one, two, three or six months. But where it gets complicated and harder to manage an order book is with specific options strategies.

“How do you manage offsetting bids and offers for that many permutations? It becomes very challenging, and I think that’s why the market, to a certain extent, is really based on RFQ using an implied volatility surface, where a particular interest is requested from market-makers. Those market-makers can then assimilate those trades into a larger book and manage their volatility, interest rate, time and spot risk accordingly,” he adds.

Digital Vega plans to tackle this by offering standard tenors and structures, while specific interests go via a “negotiation and auction” protocol to achieve the best price.

Other brokers have looked to hybrid approaches. In 2020, TP Icap launched a new FX options platform – FXOhub – providing banks with a single login to its order book screen for at-the-money straddles, risk reversals and butterflies, and an RFQ screen. Banks can access these liquidity pools through an API on a single screen.

Nick Carey, desk manager for FX options at Tullett Prebon – part of the TP Icap group – says take-up and liquidity on the FXOhub platform has been good since its launch. “The banks want a good source of liquidity that’s easy to access and equal, so via our Clob and the classic kind of screen trading, they have bought into the way it works,” he says.

“For the other products that we do, as well as ATM straddles, risk reversals, butterflies etc, you can see all the depth and liquidity for those straight away, which is something that’s quite unique of our platform. The banks really like that because they don’t have to keep clicking in and out of 100 different windows.”

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