Dragging OTC FX options into the modern day

FX dealers may finally have a viable way to trade the instruments electronically, but limitations remain

“Why are we even talking about voice broking in 2022?”, jokes the head of electronic trading at a major European foreign exchange dealer. While electronification has become part and parcel of the FX landscape, many are bemused by the fact that picking up the phone to trade is still the major way that banks deal in over-the-counter FX options.

Speaking to several liquidity providers, the overall feeling is one of surprise that options trading hasn’t changed as fast – if it has changed at all – in comparison to spot or swaps.

The evolution of the central limit order book (Clob) for the options market has been a hard slog. Attempts to introduce it over the past 20 years have failed to resonate with the big banks.

But now even the big FX dealers – which have largely been the first port of call for voice brokers – are demanding change. As electronification takes hold of the FX market, people managing those books want as much transparency in the price-discovery process as they can get. According to the electronic trading head, the more data points they have via a Clob, the more accurate they can be with price distribution.

Digital Vega is hoping to garner day-one liquidity from the big banks through an enticing fee model where they would effectively pay brokerage to market-makers, while significantly reducing the amount they charge to price-takers.

But there are valid reasons why options market-makers have been dragging their heels in keeping up with the rest of the FX market.

Firstly, there is the product itself. It is a low-volume market with highly specific tenors and strategies, making centralisation difficult for anything outside of standard vanilla options.

Secondly, dealers use the interbank market to try to spread the risk from their client trades to other banks with the opposing view. Collapsing the matching process into one electronic order book could be very hard to do, especially for more exotic structures.

Finally, operating an options market-making business demands a high level of risk appetite, as well as technological investments and capital. Electronification will provide benefits to regional banks to make markets, but if they are to participate and offer competitive spreads they must be willing to take on market risk. This is why most of the electronic flow in other markets is still held with the big liquidity providers.

Despite these limitations, the result is that many interdealer brokers are updating their offering to incorporate the screen, as well as order books and request-for-quote execution processes.

Digital Vega does pose a major challenge to the incumbent voice brokers, and it will be interesting to see how other platforms could be encouraged to do the same. Let’s see if banks will be encouraged to trade because of the actual liquidity benefits, rather than just to save on brokerage.

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