Remember the late 1990s and banks’ frenzied pursuit of e-capability across all asset classes? In the foreign exchange market, that rapidly led to commoditisation of cash trading platforms. But in the derivatives arena, banks have followed very different strategies. Take, as an example, the differences in their approach to online execution in the options market.
Among those banks that offer online execution across the full spectrum of forex options, UBS is probably recognised as the market leader. Its click-and-deal system, FX Option Trader, offers execution in multi-legged exotic structures as well as plain vanilla options. Ed Hulina, global head of forex marketing at UBS, says that is viewed by the bank as a critical link in its fully integrated forex trading chain. “We are committed to providing a full front- to back-office service for our clients, which means everything from pre-trade advice through to execution and post-trade services,” he says.
But Hulina suggests that execution capabilities are probably of equal importance to the provision of the analytical tools that clients need to manage risk independently and efficiently. Those tools, he insists, are anything but commodities routinely churned out by all the banks. To provide value-added, web-based analytical tools, says Hulina, banks need three things. They need top-quality technology and IT professionals who can build websites and applications, and they need good in-house quantitative analysts capable of translating raw data into interesting, relevant and informative analysis. But above all, says Hulina, they need a mine of historical data. “Not all banks have access to really rich and robust data,” he says. “For example, for a number of years we’ve been broadcasting live dealable volatility surfaces from five delta to 95 delta, from overnight to two years, in every currency pair. That means we can look in much more depth at historical volatility than other banks, and at changes in risk reversals or butterflies, or at the components of any other complex structure that a derivatives trader may be looking at. So I would say there is still very considerable differentiation between provider banks in this space.”
A number of others have moved towards the broader panoply of forex products with caution. Goldman Sachs, for example, has offered vanilla options execution for several years via its FX Web ET platform. That system was complemented in 2001 by Quote Online, offering instant access to a broader suite of instruments as well as vanillas. But while Quote Online was initially made available to no more than a handful of clients, it was only in 2003 that the bank provided the platform to a wider clientele. Today, Goldman Sachs reports that it has more than 100 clients actively using Quote Online.
Deutsche Bank has been even more circumspect in its approach to online forex options execution. Its gigantic Autobahn system has been one of the industry’s most successful cash execution electronic trading platforms in recent years. But in forex, it was not until November 2003 that it expanded the Autobahn cash system to include options. Chris Berry, head of global liquidity services at Deutsche Bank in London, says this was the first stage in a carefully phased approach to online execution, allowing clients to trade vanilla options along with some simple risk reversals and strangles, all on a delta-hedged basis. The next phase, scheduled for this year, will provide clients with an expanded pricing tool allowing for trading of more complex strategies involving barrier options, knock-ins and knock-outs, with the third phase opening up the system to a full range of live, non delta-hedged products.
Berry concedes that in comparison with UBS or Goldman Sachs, Deutsche is new to the online execution game in forex options. But he gives the strong impression of refusing to be hurried. “I think this part of the business is still in its infancy and it’s not for everybody,” he says. “We are growing, and we have significant targets for the end of this year, but we want to make certain that as we expand we also provide training and education to our clients, and therefore build the business on very solid foundations.”
However, Berry is clearly happy with the progress made by Autobahn’s forex options trading platform since November. “In the first round of rolling out the product, we’ve had some excellent feedback from clients,” he says. “They love the functionalities and the transparency, and they are already trading off the system. By no means are they trading in the same volumes as they trade cash instruments on Autobahn, but I believe volumes will grow as trading vanilla options becomes more commonplace.”
Others would certainly agree with Berry’s observation that online forex options trading is not necessarily a service that clients would demand or use. Credit Suisse First Boston (CSFB), for example, has developed LOCuS (Locally Oriented Customer System), a highly flexible cross-product platform, the forex component of which offers what the bank describes as “an array of tools including pricing models, relative value analytics, volatility analysis, forecasting tools, trade ideas, research, risk management and portfolio analysis”. Conspicuous by its absence in that inventory is execution, but Richard Attrill, who previously ran the bank’s exotic trading desk in New York and is now director of global options marketing at CSFB in London, says the client base has not yet demanded online execution. “By the end of the year, we will be adding basic cash execution,” he says. “On the derivatives side, we have focused on idea generation, relative value analysis and client portfolio structuring as a way of adding value.”
The principal emphasis at CSFB appears to be on the development of partnerships with the client base, or a shared workspace, giving clients interactive and customisable tools that they can use in conjunction with the bank’s sales force to tailor solutions and create ideas. “Even in the exotics market, options pricing has become so homogeneous that in addition to consistent tight pricing you need to add value for clients in other ways,” says Attrill.
For some other banks that have invested in innovative web-based platforms, adding forex derivatives to the suite of available products appears to remain a low priority. Take Centradia, the multi-bank ‘European e-treasury market-place’ launched in 2001 by San Paolo IMI, Santander Central Hispano, Société Générale and Royal Bank of Scotland. For the time being, Centradia has confined itself to pricing and trading spot, forward and swap rates in the forex market, which is a reflection of demand from the platform’s clients, many of which are medium-sized European corporates. “Feedback from clients and banks’ sales-staff has driven Centradia to focus on its existing multi-product offering. Forex options are closely watched, but the European clients we register on Centradia, including asset managers, financial institutions and corporates, are demanding new functionalities rather than new products,” says Reine Dossou, head of foreign exchange e-business at Société Générale Corporate & Investment Banking.
If the jury is out on the potential of online execution of forex derivatives trades, there is much less division of opinion over the credentials of the internet as a means of providing options pricing data, which have been substantially enhanced by the FAS 133 and IAS 39 regulations requiring all derivatives to be marked to market on the basis of independent data. Options market participants’ increased preoccupation with reliability of data has been especially welcome for non-bank providers such as the GFI Group and the more specialised SuperDerivatives.
Through its ownership of Fenics FX, which GFI describes as “the benchmark forex option pricing and risk management platform”, the group is providing an increasing number of treasurers and risk managers with its Revaluations Fixing data, with JP Morgan, Bank of America, Deutsche Bank and Bank of Montreal all signing up to the initiative in December.
GFI argues that, as a broker providing options pricing that takes no market positions, its data is entirely transparent and independent, and therefore in accordance with accounting guidelines calling for derivatives to be valued on the basis of ‘market observable’ data. “The ‘market observable’ notion might sound a bit woolly,” says Matt Woodhams, analytics manager at GFI, “but it is a big step forward from the murky standards that we used to have in the options market.”
SuperDerivatives also argues that it has been instrumental in demystifying the options market since the launch of its pricing website in 2001. David Gershon, its chief executive officer, says most options pricing systems had traditionally relied on the Black-Scholes model, which provided theoretical pricing only, and that there were vast differences between theoretical value and actual market values. Hence the launch of the SuperDerivatives system based on proprietary technology and successfully backward-tested for more than 10,000 options prices over a period that included the Asian crisis of October 1998.
Today, SuperDerivatives reports that its clients range from central banks to global investment banks, corporate treasuries, accountancy firms and hedge funds, and Gershon insists that it is easy to see why his client base has swelled so quickly over the past three years. “We have two points of strength that nobody else can come close to,” he says. “The first is the accuracy of the model behind SuperDerivatives, which allows any user to be as accurate in his pricing as the most experienced derivatives trader on Wall Street or in the City. And the second is the fact that the system is extremely user-friendly, giving hundreds of institutions around the world direct access to the vendor.”
Gershon explains that his system is as appealing to banks as it is to corporate users. “On the risk management side, the platform allows corporates to revalue their positions online and comply with new accounting standards,” he says. “Banks obviously have their own risk management systems, but they welcome the third-party revaluations we can provide on a weekly or monthly basis.” For evidence of the value of third-party revaluations, Gershon says banks need look no further than to the recent travails of National Australia Bank (NAB). “A third-party revaluation would have identified the losses at NAB immediately,” he says.
Sceptics of the SuperDerivatives model say the proprietary nature of the system means the pricing is ‘fuzzy’, but there’s no arguing with the confidence of its chief executive officer, who says he ultimately plans to extend the platform well beyond forex. “SuperDerivatives is going to be an all-derivatives platform,” he says, “which is why we call it SuperDerivatives rather than SuperFX. If we can achieve in equities what we’ve already achieved in forex, in five years from now people may look back and say that SuperDerivatives was the company that changed the whole world of derivatives.”