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					  FEATURES                                                                                                                                                                                                                                >>>

Currency Options:
                                                                                                                          risen substantially, in the recent BIS
                                                                                                                          figures. This reflects that hedge
                                                                                                                          funds and asset managers are
                                                                                                                          focussing on foreign exchange and
                                                                                                                          FX options as an asset class as a
                                                                                                                          means to generating alpha and

new dimensions to                                                                                                         increasing portfolio yields.

                                                                                                                          “This is really good news for the
                                                                                                                          exchange as these customers highly

exchange-based e-trading                                                                                                  value the transparency, the security
                                                                                                                          and the anonymity of the
                                                                                                                          exchange,” he says.

                                                                                                                          In FX options, the OTC market
                                         futures and options in New York          of its strongest months ever in         accounts for 98% of total volumes
                                         and Dublin, began looking for an         November. Overall options               traded globally, but LeVeille
                                         electronic platform and ended            averaged $3.5 billion a day in          believes FX options will follow the
                                         2006 by agreeing to a full               notional value, based on average        same pattern as FX futures versus
                                         acquisition by InterContentinental       daily volume of 24,336 contracts,       OTC spot and forwards. “We are
                                         Exchange (ICE). The futures              up 51 percent from November             starting to attract more customers
                                         contracts migrated onto the ICE          2006 average notional. Electronic       from the OTC market. The basic
                                         electronic trading platform in           options averaged $2.0 billion a day     benefits of trading on the exchange
                                         November 2007 and it has yet to          in notional value, up an impressive     centre on the security of a central      its product line closer to the OTC      on a volatility basis and just agreeing
                                         be decided when, and if, currency        642 percent from last November’s        counterparty. It gives complete          market. “In some ways, the two          to exchange the hedge with
                                         options will follow the same route.      average. The average of 14,374          transparency, offers financial           worlds are converging as a lot of       thecounterparty, and that has
                                                                                  options traded a day in November        safeguards not found in the OTC          the platforms in the OTC market         allowed the FX options market to
                                         ICE, an electronic energy-trading        represents a new monthly record         market and virtually eliminates
           Francis Maguire                                                                                                                                         are trying to move closer to the        grow substantially over-the-counter.”
                                         marketplace, is well versed in           and a 54 percent increase in            counterparty risk. CME Clearing          exchange model,” says LeVeille.         At least 70% of the OTC market
                                         successfully bringing the exchange       volume over November 2006.
                                                                                                                          monitors intra-day and marks to                                                  uses this convention to trade vanilla
  As the volume in electronic            clearing model to markets that had       Overall FX volume for November
                                                                                                                          market twice daily, using publicly       Volatility                              options.
  trading in exchange-traded             previously traded over-the-counter       was $83.6 billion in notional terms.
                                                                                                                          traded rates, every customer’s
  currency options continues to          (OTC) so it will be interesting to see                                                                                    Recently, CME announced plans to
                                                                                                                          position. These are attractive                                                   CME has reduced trading fees for
  rise, Frances Maguire looks            if they take up the mantle with FX       Boosted demand
                                                                                                                          characteristics when increasingly,       launch a volatility quoted options      market makers providing
  at the changing landscape              options as the exchanges chip away       LeVeille says that short-term           the high volatility events are created   product in the first quarter of         continuous liquidity in electronic
  and what the exchanges are             at the OTC market for market share.
  doing to attract new                                                            factors such as volatility and the      by credit concerns.” He adds that        2008. Not strictly a new product,       FX options. LeVeille says: “Our
  customers and win volume                                                        uncertainty created by credit events    there has also been cross-over of        this is a new methodology for
                                         Craig LeVeille, head of FX options                                                                                                                                basic approach is that it is essential
  from the OTC market.                                                            tend to boost the demand for            multi-asset players as equity            quoting CME’s existing FX
                                         at CME Group, says volume in FX                                                                                                                                   to build liquidity, and then the
                                                                                  options, and the exchange               participants come into FX, as part of    options, which borrows from the
                                         options has steadily switched from       environment provides the benefits                                                                                        customers will come to us so we are
                                                                                                                          the growing acceptance of FX as an       OTC market. “In the OTC market,
                                         the trading floor to the exchange’s                                                                                                                               providing market maker incentives,

         he drive to trade currency                                               of security and transparency, which     asset class, where historically, asset   implied volatility is the primary       in terms of reduced fees for the
         options electronically has      electronic trading platform, CME         are well suited for times of            managers focussed primarily on
                                         Globex. Electronic volume now                                                                                             measure that traders use to value       provision of certain levels of
         created an arms race                                                     uncertainty, particularly when          equities and fixed income.
                                         accounts for just less than 60% of                                                                                        options, relative to the underlying.    liquidity.”
amongst the exchanges where                                                       credit concerns are high. Longer-
                                         total volume traded in FX options.       term, the underlying growth in                                                   Quoting in volatility terms is a
cutting-edge technology is being                                                                                          LeVeille believes it is the
brought to the asset class for the       In December 2006 when CME                options, and FX in general, is really   environment that is driving volume       delta-neutral convention, which         Key to the CME trading platform
first time in a bid to build liquidity   listed the majority of its FX            down to the fact that foreign           on exchange, as much as having the       basically removes the delta risk from   is that the first person on the price
and incentivise new entrants.            options on CME Globex, only              exchange has been accepted as its       right products. However, the             a transaction. The OTC market           gets the trade – there are no special
                                         about 15% of FX options were             own asset class.The proportional        exchange shop window is                  realised they can trade the             allocations to liquidity providers.
Last year, the New York Board of         traded electronically. CME FX            increase in the dealing segment         continuously being extended and          optionality component of FX             The exchange provides a fair, equal
Trade, which trades currency             options on futures experienced one       between financial institutions has      filled as the exchange tries to move     options more efficiently by trading     access and level playing field.

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 FEATURES                                                                                                                                        Currency Options: new dimensions to exchange-based e-trading                         >>>

                                                                                Attracting new players                                                                                                    but in the FX market it is
                                                                                                                                                                                                          something a lot of FX traders are
                                                                                Kris Monaco, director of new
                                                                                                                                                                                                          not used to seeing. He says an FX
                                                                                product development at the
                                                                                                                                                                                                          options trader traditionally phoned
                                                                                International Securities Exchange
                                                                                (ISE), says the exchange is focused                                                                                       round single dealers or went to a
                                                                                on bringing in new players that will                                                                                      one-to-many platform, operated by
                                                                                convince OTC participants to trade                                                                                        a single dealer.
                                                                                exchange-listed FX products.
                                                                                He believes the increase in trading                                                                                       New trading functionality
                                                                                volume is being driven by                                                                                                 Monaco says that ISE is using its
                                                                                technology, which is enabling                                                                                             existing options trading technology
                                                                                broader participation from both                                                                                           to deliver new trading
                                                                                buy-side and sell-side as well as                                                                                         functionalities to the FX market.
                                                                                individual investors and                                                                                                  For example, ISE offers spread
Almost all of CME’s 31 options          The biggest advantage the OTC           quantitatively-driven trading firms,                                                                                      trading for complex orders, with
products, in 19 different               market has over the exchanges is        which are now using the same                                                                                              multiple legs, in a single currency
                                        the customisation, and the CME is       trading techniques from the equities                                                                                      pair, that can be executed in the
currencies, are now listed on CME
                                        looking at ways to making its           market, using turnkey solutions so                                                                                        same way as equity and index
Globex. As in the OTC market,
                                        products more flexible as               they can start trading quickly and                                                                                        options trades. “This is a
liquidity is the greatest in the                                                leverage existing infrastructure,
                                        corporates need suitable                                                                                                                                          tremendous break-through for the
major currency pairs. Features on                                               distribution networks and trading
                                        instruments for accounting                                                                                                                                        FX options market. Also, tools for
the CME Globex platform include                                                 tools. “There has been a                                                                                                  market makers, that are also
                                        purposes. The primary model of                                                                             Overseeing the markets at ISE
a Request For Quote (RFQ)                                                       proliferation of new FX venues that                                                                                       brokers themselves, are available to
                                        the exchange is based around
function to post strikes and                                                    are either white-labelled by banks or                                                                                     offer functionality such as
                                        lower-margin, commoditised                                                      Says Monaco: “This has really              the same protections in place
currencies to the whole market to                                               independently run, which provide                                                                                          solicitation and preferencing to
                                        products for high-volume, efficient                                             opened the market up to investors          because it is trading on a regulated
get special attention to a particular                                           quick and easy access to a large                                                                                          enable market makers to better
                                        distribution whereas the OTC                                                    and this is why we are seeing              securities exchange.”
order.                                                                          range of participants,” he says.                                                                                          service their customers.”
                                        market is suited to one-off                                                     increased volumes in FX overall.
                                        sophisticated transactions. LeVeille                                            The new security and security-like         He believes one of the main
                                                                                Product proliferation                   instruments are providing more                                                    Additionally, ISE has introduced a
The User Defined Spreads (UDS)          believes the two markets can                                                                                               attractions of using exchange
functionality enables customers to                                              The second factor adding to             hedging opportunities for risk             traded FX products is that the         new membership structure
                                        successfully exist side-by-side.
                                                                                increased volume is product             management and to make markets             banks and brokers can leverage         specifically for FX in order to
put together multiple products
                                                                                proliferation. As a result of the       in FX.”                                    existing infrastructures. “Market      attract as many liquidity providers
within one package so they can          He adds that even the interbank
                                                                                increased number of trading venues                                                 makers have invested heavily over      as possible, creating a new class of
build their own structures with up      dealers now want to access the                                                                                                                                    FX market makers, using the same
                                                                                there is now a greater range of         He says that one of the main               the years in building complex
to 40 different instruments and get     CME Globex platform as it is a                                                                                                                                    model as the ISE options
                                                                                interesting new trading tools and       reasons ISE decided to offer FX            quoting engines for equities-based
a price from market makers.             way for them to internalise CME’s                                                                                                                                 marketplace. “We have a two-tiered
                                                                                exotic FX products that bring more      products was because US online             instruments and now they can
                                        liquidity and find natural offsets to                                                                                                                             market maker system with a
                                                                                opportunities for trading and           securities brokers did not offer FX        leverage this investment for a new
Once market makers see these            the vanilla flows at the bottom end                                             products and a lot of their                asset class, and a whole new suite     Primary Market Maker and several
                                                                                improved risk management. For
quote requests their automated          of their distribution channel. “This    example, some ECN-like venues           customers wanted to trade FX and           of products on the ISE, while          Competitive Market Makers. This
trading machine pick up on them         also means they can efficiently         are offering trades that are very       were forced to open accounts at            investors can access FX products       is a similar approach to that used
                                        offset the vanilla risk of their        highly margined, as well as exotic      trading venues that had little             from their equity options accounts,    for our other options products, but
and begin auto-quoting them.
                                        higher margin, more exotic trades.      options such as one-touch and           operating history. Brokers lost            and on a regulated market.”            we have made it very low cost to
“This helps the exchange manage
                                        We are now seeing the big banks         binary options. Also, there are new     business because they did not want                                                enlist as many market makers as
bandwidth usage which, from an
                                        internalise our differentiated          types of products on the exchanges,     to connect to the unregulated              But Monaco says the most               possible, including those that are
electronic trading standpoint, is       liquidity pool and we certainly         such as the currency trusts             trading venues, as they did not            apparent benefit of trading            not new to FX but are new to ISE.”
one of the biggest challenges,” says    believe that we can co-exist. “We                                               have the same infrastructure to
                                                                                launched on the New York Stock                                                     exchange-listed products is having
LeVeille. “Ultimately the UDS           will never replace the function the     Exchange that allow an asset class      provide safeguards to their                real, actionable quotes from           Although ISE has only launched
functionality will be very helpful in   large banks are providing in the        to be repackaged into a securities      investors. “The standardised FX            multiple dealers, competing with       options on four currency pairs to
enabling the exchange to bring          creation and distribution of            instrument that can be traded           option on ISE gives brokers an FX          each other on a neutral platform.      date, the exchange has received
more complex instruments to the         structured solutions and high-end       through the same distribution           product that trades the same way           In the securities market this is       regulatory approval from the
electronic platform.”                   exotic products,” says LeVeille.        networks as stocks.                     as equity and index options, with          something that is taken for granted    Securities & Exchange

42   | january 2008 e-FOREX                                                                                                                                                                                       january 2008   e-FOREX   | 43
 FEATURES                                                                                                              >>>

                                                       The algorithms that               They are quoted in terms of US
                                                       exist today for equity            dollars per unit of the underlying
                                                       and index options can             currency and premiums are paid and
                                                       be used for FX                    received in US dollars. Because
                                                       options. “One of the              option premium and settlement are
                                                       benefits we have over             in US dollars, rather than the
                                                       the OTC market is                 underlying foreign currency, they
                                                       that everything that is           settle in the customer’s securities
                                                       building up for the               account, once broker approved.
                                                       options space overall             PHLX World Currency Options are
                                                       can be applied today              currently available on six of the most
                                                       for FX options,” says             heavily traded currencies in the
                                                       Monaco. He also adds              global interbank and futures markets.
                                                       that the exchange will
                                                       be reviewing capacity             Dan Carrigan, vice president, new
                                                       in the light of                   product development, at the
                                                       supporting a new                  Philadelphia Stock Exchange says
                                                       asset class. “Overall             that the reason why WCOs are
Commission to list 19 US dollar-        the securities exchanges have built              growing at an exponential pace is
based currency pairs, and 47 cross-     up an incredible infrastructure and              their trading size and ease of access.
rates. “We have only listed four –      distribution network over the years              Given contract specifications of
the euro, pound, yen and                to support traditional equity                    10,000 currency units, he believes
Canadian dollar -- to focus             options but now it is all going to be
participation on these particular                                                        that WCOs are ‘right-sized’ for
                                        leveraged to grow FX.”                           retail investors. Additionally, PHLX
pairs and to ensure we reach a
critical mass point before adding                                                        claims to have demystified foreign
                                        WCO's                                            exchange trading for retail investors.
more products. We chose to start
with these four because they are        US dollar-settled World Currency
some of the most actively traded        Options (WCO) traded at the                      He says: “The realisation that retail
and are able to attract the broadest    Philadelphia Stock Exchange                      investors can participate in foreign
participation.”                         (PHLX) enable retail investors,                  exchange trading that has long been
                                        currency traders, asset managers                 missing from their portfolios.
Monaco believes FX options will         and companies to easily implement                Investors can express trading views
follow the same path as equity          foreign exchange into their                      on the Dow Jones and crude oil,
options, where it was originally a      investment strategies.                           but only since our launch of dollar-
retail-orientated market. The
smaller institutions and retail
investors will grow liquidity in the
FX options market. The bigger
players will only come in when
there is proven liquidity.

The market has been conditioned
to judge liquidity with open
interest, because originally the
options market did not have
actionable quotes on the screen.
Today, Monaco says that the
thousands of contracts quoted at the
best bid and offer on the options
trading screen, alongside the spread,
is the true measure of liquidity.                        An FX Options order through ISE’s front-end, PrecISE Trade®

44   | january 2008 e-FOREX

settled PHLX World Currency
Options has the retail investor been
able to express a trading view on the
direction of the Euro.”

He believes the exchange is proving
to be a popular marketplace for
currency option traders as an
alternative to OTC because of the
ease of access. Investors with online
securities accounts can trade dollar-
settled PHLX World Currency
Options in the same manner they
trade options on equities.

Carrigan adds that PHLX is forging
ahead with new technology to
                                                                        PHLX XL Options Platform
attract new users. “The launch of
dollar-settled World Currency            launch of physically deliverable FX          market. The main brokers – GFI,
Options marries ‘streaming quote         options for institutions. In 2007,           ICAP, Cantor Fitzgerald and Tullet
technology’ with foreign exchange        PHLX pioneered dollar-settled                & Tokyo – which each have a web-
trading for the first time. Long held    (cash-settled) options with the              based trading outlet, as well as the
as an options industry protocol,         launch of dollar-settled PHLX                ICOR offering from Reuters. For
streaming quotes is a highly efficient   World Currency Options. Says                 the most part they are linked to the
trading-message delivery mechanism       Carrigan: “ This new product suite           voice-broking business to provide
that specialists use to make markets.    brought together retail and                  hybrid models that offer a limited
In essence, this is a 180-degree turn    institutional traders for the first          number of at the money strikes and
from existing futures exchanges that     time, creating a robust market for           deltas that can be traded
utilise ‘order delivery’ technology --   foreign exchange option price                electronically. Ultimately they need
streaming quote technology               discovery. Accordingly, institutions         to separate this function to be
provides exponential message             are already trading options.”                successful in electronic trading as
throughput versus order messages.”                                                    users want total transparency and a
PHLX XL is a fully electronic            PHLX already facilitates algorithmic         level playing field. This cannot be
platform, which matches specialist       trading via use of streaming quote           achieved on a hybrid platform as
quotes with customer orders.             technology and offers the necessary          the voice trading can always impact
Specific details include mass            means to trade at millisecond speed          what is being done electronically.
quoting capabilities with fully          with trading protections afforded by
transparent displayed bid / offers       PHLX XL. “Rapid Fire is a PHLX               Also, the OTC market is also
disseminated via the Options Price       XL protection feature whereby a              migrating towards the CCP model,
Reporting Authority (OPRA).              specialist controls his risk by setting      which since the launch of CLS,
PHLX offers a competitive fee            a control whereby if ‘hit’ on two or         some brokers have been able to
schedule to add value to customer        more quotes out of several hundred,          offer. Even in the OTC market there
trading decisions.                       the PHLX XL platform will cancel             is a debate over whether FX options
                                         all remaining quotes and allow one           will ever truly be traded
The exchange, which is planning to       second to refresh quotes. This               electronically, and certainly a hybrid
expand the PHLX World Currency           means the specialist will not get run        model still dominates for the bigger
Options program to include the           over by a truck if his technology            deals but it may be that the centrally
“BRIC” currencies of Brazil, Russia,     goes haywire,” says Carrigan.                cleared model of the exchanges, and
India, and China in 2008, claims to                                                   the anonymity, could tip the balance
have pioneered foreign exchange          There are several electronic trading         when it comes to trading vanilla
options trading in 1982 with the         systems for options in the OTC               options electronically.

46   | january 2008 e-FOREX

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