Not so long ago, sharp market moves resulting from government policy tended to happen after a carefully orchestrated press conference or crafted announcement where one word or phrase was seized upon by ravenous traders, leading a particular product to tip one way or the other.
Today, such volatility can be orchestrated by a single Tweet from inside the White House. At precisely 8.47am eastern time on August 10, President Trump took to social media to declare he had authorised the doubling of tariffs on steel and aluminium coming from Turkey, at 50% and 20% respectively.
The result was spectacular. USD/TRY jumped 65% intraday, ending 16% up on the previous close of 5.55. Liquidity providers were understood to be in short supply during the period, making it difficult to quote two-way options prices as volatility headed north.
But for some market-makers, among them BNP Paribas, heightened volatility became a boon to competitively price USD/TRY options on both sides of the market as others had to step away.
“When USD/TRY started to move towards 5.00, we began to buy risk reversals. Our reasoning was that the risk reversal trade plays into the local dynamic between spot and volatility and, in a currency like USD/TRY, the risk of a blow-up, which we thought was underpriced,” says Jon Spriggs, head of local market foreign exchange options at BNP Paribas.
The risk reversal structure BNP Paribas used is a common one – a bank would typically buy a strike at a higher level than the spot price and sell a strike lower than the spot price. As a result, when spot goes higher, the market maker becomes long vega and vice versa if spot heads lower.
“When you put on a risk reversal position you’re paying for the correlation between spot and vol. It can make money if both go higher than priced in or lower than priced in, but normally you’re paying a bit extra for the probability of blow-up, and you can lose a small amount if you don’t get the blow-up,” says Spriggs.
The call was spot on, and instrumental in putting the local market options business on track for a record year. Having built positions from late July, the bank was long vega as USD/TRY ticked up – initially in an orderly manner – making it easier to sell options to clients that wanted to take advantage of heightened volatility.
“We’ve had a stellar year in local market options and we’re set to surpass the last record year we had in 2015 during the height of USD/CNH target redemption forward (Tarf) business,” he says.
The standout performance was a bright spot for the bank’s forex franchise and partially offset reduced profits across other parts of the business.
Revenue at BNP Paribas’s fixed income, currencies and commodities business was down 15% year-on-year during the third quarter, which was partly attributed to forex. BNPP took action, shifting its forex, local markets and commodities division away from a co-heads structure. Adrian Boehler, who co-headed the unit since 2016, left his role in November to pursue other opportunities within the bank, leaving Francisco Oliveira as sole head.
We’ve had a stellar year in local market options and we’re set to surpass the last record year we had in 2015Jon Spriggs, BNP Paribas
The French dealer was not alone in its flow trading malaise. Increased automation forced a compression in bid/offer spreads, initially in spot markets but more recently in derivatives, where electronic market-making has pushed margins on once-lucrative products to razor-thin levels.
“Most of the flow businesses have suffered from spread compression and increased electronic trading in FX, and that’s true of the last few years,” says Spriggs.
For the French dealer, success in 2018 meant seizing opportunities, often within a narrow window. Turkish lira provided rich pickings, and in October, the local market options desk was back on a winning streak. The one-year USD/TRY cross-currency swap rate blew up from 29% on October 2 to 35% on October 8. Surprisingly to Spriggs, volatility did not initially follow suit. The reaction was delayed. By the end of the month, markets had calmed; the spot rate fell back to 5.58, down from a high of 6.16 on October 4.
“When the one-year rate went above 35%, we bought one-year out-of-the-money options as they appeared so cheap at the time. Then spot eventually came lower and the interest rate came lower, so the one-year outright actually moved a lot quite quickly and helped us make money on those contracts,” he says.
Despite the wider Q3 set-back, the bank’s push to be a more visible and consistent player across the entire forex business remains intact. An ambitious e-trading programme is beginning to deliver results. Market share gains and improved visibility on where future profit opportunities lie are already being attributed to recent technology advancements.
The increased electronic nature of the forex flow business has made it hard for human traders to keep their seat. Spreads are so tight in certain derivatives such as EUR/USD swaps that they can equal less than one five-thousandth of a basis point. “That’s the bid-offer, so it’s unrealistic to expect a human to keep up,” says Adrian Averre, global head of forex forwards trading.
For example, the French dealer’s forex swaps and forwards business is now 90% electronic. That figure has climbed every year, according to Averre. The shift has helped the bank become a top five participant on multi-dealer platforms including FXall, 360T and Bloomberg, at the same time as doubling market share.
“We have much more precise control of where our mid-markets are, the spreads we charge, and we’re doing a lot more analysis of the data. When you double your market share, you get much more depth to look at and see where the profitability in your business sits,” says Averre.
On swaps and forwards, I set a target to get to 80% and we’re significantly exceeding that goal, but there’s still room to improveAdrian Averre, BNP Paribas
Market share gains allowed the bank to reduce its reliance on external marketplaces, too.
“One of the things we’re seeing is, by taking market share, we’re cranking up the internalisation levels, which means we have less slippage and keep the books close to square,” says Averre. “On swaps and forwards, I set a target to get to 80% and we’re significantly exceeding that goal, but there’s still room to improve.”
Pressure on the forex flow business to respond to the more electronic trading environment has not halted innovation. With the help of the strategy and risk division that sits in BNP Paribas’ global markets team, the bank was quick to spot possible opportunities in US dollar funding pressures banks and asset managers were likely to face at the end of 2017.
The largest US banks have made a habit of reducing their balance sheet exposure in over-the-counter derivatives before the year-end in order to not fall foul of the highest category in the Federal Reserve’s global systemically important bank (G-Sib) scoring system, which would result in a bank being placed into a 4% capital surcharge bucket. The Fed uses end-December data to determine the G-Sib surcharge for the year after next.
For example, a Japanese investor might be long 10-year US Treasuries, which it has been financing via the forex swap market. But at the end of the year, a US-based swap counterparty may be less keen to extend balance sheet. Either the investor can sell the asset to get out of the position, or find a cheaper way to finance it.
Through 2017, BNP Paribas built an inventory of US dollar forex swaps to meet anticipated year-end demand from its clients.
Later that year, EUR/USD basis trades blew out to levels not seen since 2011. During the first two weeks in December, the one-day rate on the EUR/USD cross-currency basis reflected a rising premium to borrow dollars; from 20% to 70%. For some clients, even at any price, there were very few dealers willing to provide balance sheet over year-end.
“As year-end approached, we decided to ring fence some balance sheet for our biggest clients,” says Averre. “We anticipated the basis would widen out given the underlying was getting more expensive and the availability of liquidity providers was also decaying. We aimed to have plenty of US dollars on hand to sell to investors, and we sold the vast majority of the inventory that we had collected.”
Innovation stretched into an area that had become a substantial source of revenue for the forex derivatives business in previous years – USD/CNH Tarfs.
These derivatives are typically used by corporates to buy or sell a currency at an enhanced rate for a number of expiry dates, with zero upfront premium. The product automatically expires if the enhanced rate reaches a target level. But if spot moves in the wrong direction, holders can be forced to trade regularly at unfavourable rates for the full life of the product.
To offer more protection on the downside of the traditional Tarf product, BNP Paribas devised a ‘trigger Tarf’. “If one fixing is observed below a pre-defined trigger barrier, then the client becomes long call options [and can] benefit if there is a sharp move of USD/CNH higher,” says Frédéric Han, deputy head of forex structuring at BNP Paribas.
The bank claims to be the first institution to trade this product, and has executed five since February. It also created a separate variation of the trade in April, which also traded five times.
“If this Tarf knocks out because the client has reached their profit target, then a strip of out-of-the-money options knock in, so the client is always protected. Most clients don’t want really complex payoffs any more and this helps protect them even more,” says Han.