Known Unknowns: preparing for SEF-traded FX options
“With respect to transactions involving swaps subject to the clearing requirement … counterparties shall … execute the transaction on a board of trade designated as a contract market … or execute the transaction on a swap execution facility.”
With these words, the Dodd-Frank Act launched a new acronym into the alphabet soup of modern capital markets. In the years since, Swap Execution Facilities have been the subject of repeated discussions, consultations, submissions and interpretations, writes Robert Gray. Deadlines have been pushed back, and pushed back again. FX traders watched in relief from the side-lines before it was confirmed that FX options and NDFs were to be classed as swaps by the CFTC and subject to the new demands for exchange trading.
And now, after three years of furious wrangling, SEFs are finally here.
Clarity and confusion
Almost 20 organisations registered as a SEF with the CFTC before the deadline in October last year. But in keeping with the confusion and complexity that has surrounded SEFs since they were first proposed, the move hasn’t created the clarity that some were hoping for.
Despite the very clear deadlines, at least two operators of electronic options platforms failed to register, citing unexpected changes to the final rules and regulations. The CFTC has published a series of no-action letters giving SEFs more time to meet certain rules, including pre-execution screening, reporting and confirmation requirements. Users are also being given more time to review the SEF rulebooks and sign user agreements.
If this wasn’t enough, the other glaring problem is that the prescriptive tendencies of U.S regulators contrast with the more direct approach taken in Europe. The treatment of FX options is very different in both jurisdictions and to date, FX options do not fall under the remit of EMIR. In contrast, MiFID and MiFID II, which introduced competitive, multi-market trading environments, already cover all financial instruments. Nominally at least these include an FX option, which further complicates the international landscape.
Fully alive to the possibility of regulatory arbitrage, and reluctant to see New York’s swaps business decamp to London or Frankfurt, regulators are unlikely to leave these anomalies in place for long. We have already seen a more concerted effort to create a level playing field and clearly define the rules. Most recently, the European Securities and Markets Authority (ESMA) announced a firm deadline of February 12th 2014 for firms needing to sign up to mandatory trade reporting. This is not just across FX, but all other over-the-counter asset classes.
So what does all this mean for participants in the FX options markets? We can certainly expect eventual consolidation among the first tranche of SEFs to be launched. However, the underlying principles of transparency, visibility and control are abundantly clear. Every aspect of the trading and decision-making process will be recorded, reported and ready to audit. Trading houses will need to meet these demands, and build best practice into their operations so that they are able to adapt to these and any further changes down the line. Unfortunately, despite deadlines such as ESMA fast approaching, reporting is not something the market is currently prepared for. The problem is that many participants are without the infrastructure and software tools required to fall in line with mandatory reporting procedures.
Preparing for the future
Translated into the day-to-day reality of FX options trading, it will no longer be enough for banks to execute a trade on behalf of a client and simply inform them of the results. Nor will it be acceptable to provide that client solely with a straightforward execution capability.
The particular challenge of the FX options space is that it is a very bespoke market. According to a survey from the Bank of International Settlements (BIS), nearly 10 per cent of all trades are accounted for by non-financial corporates, many of which will be using options to hedge their currency positions. Treasurers at these organisations are looking for a unique contract that applies to their particular circumstances. There is no historical pricing data, and finding the mid-market rate is challenging at best. Banks need to guarantee an unprecedented level of transparency, not only to demonstrate the effectiveness of their trading strategy, but also to protect themselves against potential accusations of shady behaviour.
To do that, FX options traders will need three essential capabilities. Firstly, they will require accurate and open pricing as well as valuations that are applied consistently at every stage of the workflow. Secondly they will require flexibility regarding the selection of pricing models to ensure that the most appropriate are selected. Finally, support is needed for efficient price discovery both for single trades and whole books of options.
There will also need to be the ability to conduct pre and post-trade analysis of trading decisions, and effective reporting to ensure that clients are informed at each stage. That will almost certainly include accurate stress testing and scenario analysis to ensure that portfolios are compliant with client mandates as well as regulations.
Should FX options move on to exchanges, they become more sensitive to market movements. The overnight run is unlikely to satisfy clients, who want to know the valuation of their holdings in near real-time. Traders will likely need the ability to calculate the mark-to-market of multiple portfolios and thousands of options positions in a very short timeframe.
The role of corporates in the FX options market has thrown up another challenge with regards to the SEF regulations. Initially the CFTC required investors to issue Request for Quotes to five banks or market makers for each potential trade. Lobbying has reduced that to two, but it will eventually rise to three. The concern is that although multiple RFQs give the impression of increased competition, it also increases the risk of information leakage – again enhanced by the bespoke but sporadic nature of the market – which has the exact opposite effect.
Banks and their clients therefore need tools that allow them to work from the same blotter (record of trades made over a period of time) and pricing model to facilitate a trade. With this kind of system in place, a corporate treasurer can rely on his bank being able to send back a price for a particular structure at the click of a button. Traders can price it up and assess how it fits into their book, and the treasurer can decide whether or not to complete the trade. Each stage is captured in the same system so pricing remains accurate, the gap between an order being placed, priced and executed is reduced to seconds, and information leakage is minimised.
Finally, firms will eventually have to predict and manage end-of-day collateral requirements. Central clearing will inevitably lead to firms holding sizable positions with each clearing house, with capital adequacy requirements demanding that they are able to calculate and then hold sufficient capital against these positions. It’s also a challenge for clearing houses and trade repositories who need to be able to calculate margin.
This is a challenge for the FX options space as a whole. Currently central clearing is not mandated, but the regulatory trajectory suggests that it is only a matter of time. The unprecedented levels of data now being directed at these bodies are overwhelming the systems in place. There is also still some confusion about how and whether clearing houses will be able to translate that data into meaningful information and enable trading parties to conduct a mark-to-market of their books.
Windows of opportunity
So for all the confusion surrounding SEFs, clearing and overall regulatory rules, there are also some very clear requirements that have emerged. While industry bodies and regulators continue to work on refining the framework, participants can usefully spend this time preparing for upcoming changes. The window for pushing back on regulation and extending deadlines is closing fast.
In its place a window of opportunity to steal a march on competitors is opening up. The move to electronic exchanges is likely to increase the market share of FX options and dramatically increase traded volumes – as happened to FX markets. Perceived risks will diminish, more corporates are likely to shift their hedging strategies from futures to options, and simplifying execution will open up the market to more non-traditional players. However, the advantages of early adoption will only be available to trading firms that get their own processes and systems in order.