Currency derivatives house of the year: BNP Paribas

Risk Awards 2023: Paris-based bank profits from dollar/offshore renminbi volatility

L to R: Neehal Shah, Adrian Hudd, Adrian Averre, Nathalie Naffi, Xavier Gallant, Frédéric Han and Joe Nash

Photo: Geraint Roberts

In late April 2022, BNP Paribas’s FX options desk was tracking extreme movements in the exchange rate between the dollar and the offshore renminbi (CNH). A rising greenback and declining economic expectations in China resulted in the Chinese currency breaking above its 200-day moving average of CNH6.40 against the dollar and rising to CNH6.80. This led to an influx of demand from hedge funds to buy call options.

BNP Paribas faced a problem. The traditional supplies of CNH options from Asian corporates had dried up as many in the market adopted a wait-and-see approach in case the currency rebounded.

Conversely, there was a robust supply of options on the yen from Japan’s regional banks, which were originating the risk from local corporates. The challenge for banks such as BNP Paribas was to bridge this liquidity gap in order to meet the demand for CNH options, while minimising the amount of risk warehoused on their books.

“The industry simply doesn’t have the warehousing capacity of eight to five years ago,” says Adrian Averre, BNP Paribas’s head of FX derivatives electronic trading. “We’ve got fewer participants. The amount of VAR [value-at-risk] that remaining dealers are prepared to deploy has diminished. So, we really got to thinking about how we can boost liquidity, and one of the things that we’ve been fairly successful at is using the correlation of markets.”

The options desk’s market-making strategy would aggregate portfolios and apply an electronic risk management engine to identify high correlation currencies and thereby offset the risk. Its traders recognised the correlation between CNH and JPY volatility markets, such that a long JPY position offered significant VAR reduction against short CNH exposure. The approach enabled BNP Paribas to take on several billion dollars more of USD/CNH notional by offsetting it with USD/JPY risk.

We really got to thinking about how we can boost liquidity, and one of the things that we’ve been fairly successful at is using the correlation of markets

Adrian Averre, BNP Paribas

“BNP Paribas’s FX options desk is very strong in pricing,” says an executive at a large European-based asset manager. “They are very reliable and always consistent. They have spent the past few years building their capabilities and are now one of our main counterparties for FX.”

An integrated approach was key to BNP Paribas’s success in navigating 2022’s macro environment. In March, it combined its commodities and foreign exchange businesses with their rates trading counterparts. The new macro trading unit has enabled the market-making business to think and act on a cross-asset basis by pooling liquidity and managing risks during periods of volatility.

“When we trade with BNP Paribas, it’s with the whole bank, not just a single trading desk,” says a global asset manager. “They are one of our strongest counterparty relationships and are number one across all FX derivatives. They are very good on execution outcomes and will always tell us if they can’t meet a price.”

Correlation is causation

BNP Paribas first began to adapt its market-making strategy in the fourth quarter of 2021. Its options traders had noticed that volatility was beginning to rise after the US and UK central banks signalled they would raise interest rates. The impending return of volatility meant the bank would have to alter the tactics it had deployed to manage risk in more tranquil conditions.

“It required a different type of strategy than the micromanagement of Greeks that we had before,” says Neehal Shah, Emea head of global macro institutional sales for the bank. “In previous years, we focused on specific event weightings and how to manage those. Whereas when the level of vol increases, that becomes less of a focus [than] managing the aggregate risks and sourcing liquidity.”

In a stressed market environment, hedging can be more difficult and costly as liquidity is harder to find. However, as volatility correlations rise, proxy hedges tend to work better.

The bank decided the solution was organisational rather than technical, and aggregated its portfolios into three global trading books: G10 (including CNH) and local markets split into two regions (Asia; and Central and Eastern Europe, the Middle East, Africa and Latin America). This enabled it to net the risk across multiple pairs and find offsetting flows, and to expand the liquidity pool it provides to clients and profit from wider spreads. As a result, the options desk doubled P&L year-on-year.

Risk aggregation was vital for meeting demand from clients trading CNH and JPY. The bank amassed speculative and hedging flows from hedge funds and asset managers looking to buy options and go long vol in those currencies. It also realised it could take advantage of the high correlation with its franchise supply of euro options to offset risk and continue providing liquidity.

Photo: Geraint Roberts

Neehal Shah, BNP Paribas

Averre says the correlation between a long euro vol position and a short CNH/JPY vol position meant it could pool the risk and reduce the magnitude of any drawdowns. For a given drawdown tolerance, the desk could increase the amount of short JPY/CNH positions it could run. “We could give liquidity to clients on CNH and JPY without exposing the bank to unacceptable or unnecessary drawdowns,” he adds.

The bank regularly saw tickets with notional volumes of multiple billions of dollars a day during Q1 and Q2, when hedge funds were most active in the JPY and CNH markets respectively.

Aggregation also meant BNP Paribas had a clearer view of event risks, such as the release of data on US inflation and how it would affect currencies. Averre says the bank could identify netting opportunities and enact hedges to reduce its portfolio’s exposure to risk events. This gave it a better view of its risk framework and allowed it to continue making markets for less liquid pairs.

Shah adds that managing its inventory of volatility has been key to handling these big macro events. The options desk had built up a long gamma bias in several currencies in anticipation of selling it back when client demand returned.

“That’s helped us in many of the events that have taken place,” he adds. “It’s ultimately very hard to predict the date these would happen.”

When sterling volatility began to spike in the wake of the UK’s disastrous “mini-budget”, the bank was able to build client GBP positions while controlling the overall theta by selling short-dated EUR options. When the buyers came for GBP vol, it had enough inventory to sell and it controlled gamma by allowing the EUR trades to roll off.

Its approach proved particularly effective as the Bank of Japan moved to support the yen. Prior to the intervention, BNP Paribas’s options traders noticed flows indicated that the bullish sentiment was rapidly receding, as clients looked to profit on their existing trades. It was thus necessary for the bank to adjust its own positions.

“When you do see those flows going through the markets, you can understand how this is driving the skew and how it’s potentially going to change as well, which helps you manage your risk,” adds Shah. “If you’re not market-making into that, you are essentially trading in the dark.”

Any return to the previous segregated trading desk model will depend on access to liquidity and the bank’s confidence in spreads.

Once traditional suppliers of CNH volatility returned to the market, BNP Paribas consolidated its position as a top renminbi options dealer due to its onshore presence on China’s interbank platform, CFETS. This enables it to constantly source local liquidity and act as the intermediary when there is demand from the offshore market.

“There’s maturity intermediation – the supply of vol tends to be longer-term and the demand tends to be short,” says Averre. “There’s also timing issues, so we’ll have times where there’s a huge wave of demand, whereas the supply is very steady. We as a bank have to take a little bit of risk in terms of the term structure and in terms of calendar. But, generally speaking, those risks are small compared to having to sit on the outright on the other side of the trade.”

Emerging presence

BNP Paribas has a presence in many emerging economies that experienced volatility in their FX markets. This has let it capture flow from corporate clients exposed to rising geopolitical risk.

One of its European-based corporate clients says: “We trade in eight difficult Asian currencies, and BNP Paribas is there to help us hedge and put on specific trades electronically.”

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One client that benefited from a unique hedging solution was a large Italian utility that was planning to sell a Brazilian asset to a local firm that needed to be paid in reais. The currency had appreciated against the euro from BRL6.4 at the beginning of the year to BRL5.1 by April.

BNP Paribas worked with the company to structure an opportunistic net investment hedge for the sale, consisting of a five-month vanilla EUR/BRL non-deliverable forward – a relatively illiquid currency pair – with a notional size of several hundred million euros. It also hedged the risk in the local spot market, using its Brazilian onshore trading capabilities and tapping into its local corporate clients and institutional investors to recycle the risk over a short period.

“In these markets like Brazil and other regulated countries in Lat Am, Asia-Pacific or in MEA, having an onshore presence helps us deliver integrated hedging solutions to corporates, from offshore hedging to onshore deliverability of the currency,” says Xavier Gallant, head of corporate FX and local sales, EMEA.

Overall, the bank saw a rise of around 45% in emerging market trading volumes year-on-year.

Automatic for the people

BNP Paribas has also spent the past few years developing its automated pricing and risk management infrastructure for foreign exchange swaps.

Adrian Hudd, the bank’s head of G10 FX swaps trading, says it typically prices between $75 billion and $100 billion of average daily volume electronically. With its ebook running smoothly for the G10 business, the bank began expanding this to the emerging market desk in 2021.

“It’s the same pricing engine for both G10 and EM, and it can be integrated into the EM rates trading desk,” he says. “This gives us access to different pools of liquidity. You can aggregate across products and extend thresholds and maturities.”

After the bank integrated the EM FX swaps desk with its rates business in March, the teams could offset risks across various rates products instead of relying on just FX swap liquidity. Its EM FX swaps desk can trade forward-rate agreements or repos, and issue supranational bonds to create funding when there is a shortage of cash. This also makes it easier to offset cross-currency basis risks.

As a result, Shah says the bank now electronically prices 50% of its EM FX swaps volumes, compared with 0% in 2020.