RBS launches gamma hedging algo for forex clients

Royal Bank of Scotland (RBS) will this month launch a spot foreign exchange trading algorithm designed to help clients automatically manage the gamma sensitivity associated with forex options portfolios – a task the bank claims can absorb 20% or more of an option trader’s time when gamma hedging is conducted manually.

“It is an algorithmic trade engine that understands gamma,” said Tim Carrington, the bank’s London-based global head of foreign exchange.

Dubbed RBS Agile, the tool can be used in various ways, but the simplest application is to monitor the gamma of an option’s position and automatically buy or sell spot FX to ensure the gamma remains within predetermined boundaries. Gamma measures the change in an option’s delta relative to a change in the underlying.

The bank is not doing this altruistically – the algorithm is plugged into FX Stream, its existing electronic forex trading platform, so it will help drive volume to RBS trading desks. In addition, competition over the provision of algorithms could become a new battleground for dealers, as more markets and products – including the over-the-counter space – switch to electronic trading.

“Banks need to offer more of a one-stop-shop approach to clients. Clients are no longer going to want to transact with 11 different banks. They’re going to look at banks that can offer them a broad suite of products – and banks can no longer rely on price to be the differentiator,” says Carrington. He claims RBS Agile will be the only algorithm of its kind available to clients.
That will probably change, however. “It’s an interesting product and it’s something we’d like to offer,” says one New York-based forex e-trading head at a major dealer. He adds the bank’s own options traders use a similar in-house tool to help manage gamma.

Likewise, RBS Agile started life as a time-saving device for RBS options traders, and Carrington says it helped reduce the workload substantially, freeing traders to focus on clients. In normal conditions, around a fifth of a trader’s time can be spent on spot trades to balance up the gamma position – with that burden increasing as markets become more volatile, he says. “Firms don’t always trade gamma on a mathematical basis. Some traders typically spent a lot of their day hedging gamma when they could better optimise their time bringing value-added expertise to clients.”

The bank has already tested the product with a small group of clients. “It’s a very positive and promising tool, which will probably be useful for a number of players in the industry,” says one volatility trader at a New York-based asset manager.

The firm has been using the product to hedge its options portfolio – and has been pleased with the results, the asset manager says. “It takes inputs about the level at which we would trade. When our delta gets to a certain level, it transacts hedges in the spot market. The product automatically does a lot of the things we would do intra-day in terms of hedging, so it takes away a lot of the work we would otherwise have to do,” he says.
Another agrees. “I have been in the industry for six years, and this is the first time somebody has proposed a product like this. It’s a small change but it makes a big difference,” says a trader at a major Canadian pension fund.

Although Carrington expects the bulk of clients to use RBS Agile to hedge their options exposures, its ability to understand the spot implications of gamma means it can also automatically replicate the payout of an option by executing a series of spot forex trades. “One of the advantages is that it allows you to trade synthetic options portfolios. You don’t necessarily have to trade the underlying options,” says Carrington.

Instead of buying an option, RBS Agile will purchase an amount of spot forex corresponding to the initial delta of the option it is replicating. This cash position will then be adjusted up or down, so the cash position always matches the delta the option would theoretically have. If the option finishes in-the-money at expiry, the client would have bought the full face amount of the replicated option. If not, the net cash position would be zero.

RBS Agile can also replicate volatility swaps with different fixings, allowing clients to trade hourly gamma against daily gamma, for example. Carrington believes this functionality will make volatility trading more accessible to buy-side clients that might lack the resources to do it themselves. “It will enable hedge funds and real-money clients to be more comfortable trading volatility, because they will be able to capture and manage the gamma effects more easily,” he says.