Volatility could pave way for FXOs’ electronic evolution

In recent years, the FX options market has been evolving away from the somewhat archaic over-the-counter voice execution model. Between the end of the global financial crisis and the start of the pandemic, and aided by a prolonged period of low volatility, banks increased their electronic market-making and risk management capabilities.

Progress towards electronification of FXOs has been steady rather than spectacular, and the sector lags behind other asset classes. Yet the return of volatility has breathed new life into the market. This in turn has raised questions about whether volatility might provide a shot in the arm for the electronification of FXOs and how the market’s nascent electronic capabilities might cope in a higher volatility world.

Over the last decade, most banks have developed the capability to price their customers’ FXO requests for quotes with no direct intervention from human traders. These prices are then distributed to customers via single dealer platforms, multi-dealer venues or directly through application programming interfaces. Some banks also electronically price both requests for quotes and “runs” of generic tenors to brokers in the interdealer market, and stream whole volatility smiles on CME Group’s central limit order book.

The spectrum of sophistication in this field has been broad and, until the events of recent months, banks felt comfortable pushing the envelope in terms of what could be automatically priced. However, with the return of volatility, some may find themselves underprepared to stream to such a degree and may revert to manual pricing.

This should provide encouragement to those that are able to continue pricing electronically, notwithstanding the higher volatility. Some customers have come to expect a near-instantaneous electronic response to their requests for quotes. A return to multi-minute response times from human traders could come as a shock and ultimately drive business to those liquidity providers that are better equipped.

Those that are currently less well equipped will then be given an incentive to catch up. Simply setting a symmetric bid/offer spread around a mid-price will not be adequate. The most successful e-FXO traders have learned from their counterparts in the FX spot and forwards markets – where spreads and skews update dynamically based on market conditions and inventory, multipliers can be set and adjusted, and spreads can be automatically widened over events.

One issue that sets FXOs apart from the spot and forwards markets is the availability of market data that banks can use in constructing their pricing. Spot traders have many electronic communication networks from which to consume pricing and build their rates accordingly. The more sophisticated e-FXO traders consume and aggregate data electronically from the interdealer market and CME Group’s central limit order book; those that do not instead rely on incomplete or obfuscated data that their traders have gleaned manually.

This issue becomes acute in times of high volatility when liquidity is thin and both electronic and human traders are pricing clients based on low or non-existent visibility. This is where those taking market data from as many sources as possible have a competitive advantage, as they can construct better mid-prices and react more quickly to price changes.

Volatility in FX has risen dramatically this year and looks set to remain high. Bid/offer spreads widened in March following Russia’s invasion of Ukraine. Although they soon reverted to more normal levels, they have remained wider than had previously been the case – albeit at a similar percentage of the underlying volatility base (a 0.25% spread when the volatility is around 10% is comparable to a 0.125% spread against a volatility of 5%).

However, bid/offer spreads have been relatively unstable since March, and traders have had to dynamically change their pricing far more frequently than they did before.

This has marked a significant change for e-FXO pricing. Traders can no longer rely on hard-coded widths and must instead be able to change spreads dynamically during the course of a day – and, ideally, automatically in response to market conditions.

Now is the time for the FXO market’s electronic evolution to gather pace. As volatility has returned, so have the cross-asset funds that had previously ignored FXOs because of a lack of opportunities.

CME has seen a 31% increase in the number of hedge funds and asset managers trading listed FXOs this year compared with over the same period in 2021. Many of those are accounts that are more commonly active in rates or equity index options. Non-bank liquidity providers are also becoming more significant in the market, bringing with them electronic pricing capabilities honed in other asset classes.

The return of volatility in FX will undoubtedly present opportunities to those that can best use electronic price distribution and risk management. It may even herald a seismic shift in the electronification of the FXO market.

Chris Povey is head of FX options at CME Group

Editing by Daniel Blackburn