Analysis: Complex foreign exchange options not ready for prime time
NEW YORK (Reuters) - Trading forex options on registered U.S. platforms is a long-awaited step in making derivatives markets more transparent, but so far it has failed to take off.
Rules became effective in October that required these trades to move to swap execution facilities, or SEFs. However, there is no established clearing-house for these trades, and with the additional paperwork and legal requirements needed to trade on SEFs, many market players are electing to stick with trading the old-fashioned way, that is, by telephone or on bank platforms.
Commodities Futures Trading Commission rules require FX options and non-deliverable forwards traded between U.S. entities to be executed on a SEF, the designated trading platform for regulated derivatives. However, that requirement will not fully be in effect until these FX products can be cleared. At the moment, there is no entity that can clear FX options.
Currently, the limited number of FX options traded on SEFs are being cleared and settled between counterparties.
Shifting derivatives trading to central clearing-houses was a key part of the Dodd-Frank Act that emerged after bad derivative bets contributed heavily to the 2008 financial crisis. The new regulations were meant to lower the risks of these products through greater transparency.
Eventually, the necessary structures to support SEFs will be built, and market participants say electronic trading on these platforms will increase. But for now, dealers see no urgency to use the SEFs because they are still untested.
"If you are a buyside (asset manager) and there is no mandate to trade on the SEF, why would you go through all the hassle of trading on that, when you don't have to?" said Tod Skarecky, senior vice president at technology provider Clarus Financial Technology in Chicago.
Daily U.S. activity in FX options amounts to $52 billion, including $23 billion through electronic systems. By comparison, FX options turnover on SEFs for the week ended December 6 showed an average of about $9 billion in daily trading, according to data from Clarus, which tracks SEF volume.
Dealers have moved trading offshore or stuck with platforms run by major banks. They say there is resistance to using the SEFs because it is unclear whether certain trades are regulated, along with the ability of SEFs to handle complicated types of transactions.
The CFTC did not respond to multiple emails and telephone messages for comment.
FX options are often used by multinational corporations to hedge cash flows in a specific currency or by portfolio managers to protect exposure in foreign assets.
"Right now, it's just a trickle because people are choosing the path of least resistance. Trading on the SEF is a little bit more work than off the SEF," said Harpal Sandhu, chief executive officer at Integral Development Corp. in Palo Alto, California.
But Sandhu, whose firm's SEF license was approved in September, expects FX options volume to pick up as the move to SEFs approaches late next year or in 2015.
Under the new rules, FX options trades have to be reported to a swap data repository, or SDR, and cleared and settled through a derivatives clearing organization, or DCO.
U.S. regulators said in 2011 that clearing-houses would not only have to clear FX options, but also guarantee final settlement, which requires access to large amounts of cash and liquid assets in case of a counterparty default.
As these issues have not been resolved, some investors are still sourcing liquidity directly from prime brokers or banks.
"Currently we have no plan to trade on SEFs... at least not for another five years," said Harald Hild, portfolio manager of Quaesta's FX volatility fund, based in Zurich, Switzerland. They continue to trade off the regulated venues.
Liquidity in FX options has stayed with single-dealer platforms run by the big banks, or gone offshore as foreign entities shun the U.S. market to avoid CFTC rules, industry participants say.
"That's a shame, because those swap execution platforms are supposed to be more transparent and promote more competition," said Ludovic Saverys, president of SurfacExchange, a multi-dealer FX options venue launched in 2011.
SurfacExchange halted FX options trading in July, frustrated by the regulatory uncertainty, particularly with regard to clearing and settlement.
Without the clearing, the impetus to use the SEFs remains low. In the meantime, these designated platforms, especially those specializing in FX options, continue to accumulate the costs of running a SEF without the volume.
"The complex rules have affected FX options volume," said David Collins, president of SDX Trading in London. "I am pretty certain that since October, volumes have become depressed because of confusion around the regulations."
SDX Trading, a unit of London-based technology provider SuperDerivatives, is awaiting the approval of its SEF license.
One source of confusion is how transactions between a non-U.S. firm and a U.S. entity are treated.
"What we're hearing from European counterparties is that they're a bit confused as to whether trading with a U.S. bank would make you subject to SEF regulations," said SDX's Collins.
"Are you going to get into trouble because you didn't report the trade? And what is the rule if a European bank trades with the European entity of a U.S. bank? Is that trade under SEF?"
There is also concern about the legal uncertainty surrounding the SEF's confirmation and reporting of an FX trade, the Global Financial Market Association said.
"The challenge in the FX market is that there can be a number of very specific bespoke terms that go with these trades," said James Kemp, managing director at GFMA in London.
If a SEF is unable to fulfill its newly assumed reporting obligations, it may affect the quality of data it is expected to report, he said.
"At this point, there hasn't been enough time to build the functionality to get those terms across to the SEF."
(Editing by David Gaffen and Dan Grebler)
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