Spot FX and forwards are exempt from regulation under the Dodd-Frank Act in the US, but FX options have been categorized as swaps under the legislation. That means they will have to be cleared and subject to reporting requirements, as well as trade over an SEF.
Although more than 20 trading venues have expressed their intention to become an SEF, progress has been hampered by the lack of headway made by the Commodity Futures Trading Commission (CFTC) in ironing out the rules for the venues.
There was a breakthrough last week, however, as the final rules were eventually published. One of the main developments saw a watering down of the CFTC’s controversial initial proposals, published in January 2011, which would have required investors to send request for quotes (RFQ) to a minimum of five market makers.
The final rules reduced the required number of RFQs to two during a one-year transition period, rising to three thereafter.
SEFs will be allowed to start trading as soon as they receive a temporary registration from the CFTC, and the new rules will take effect 60 days after they are published in the Federal Register.
“Now that the CFTC has provided some clarity around SEFs, swap dealers, buy-side firms and corporations can begin the long-overdue process of complying with the second key plank of Dodd-Frank: central trading on a regulated exchange,” says Zohar Hod, global head of sales at SuperDerivatives, which runs an electronic FX options platform with broker FXCM.
He says all eyes are now on the trading platforms that have been waiting in the wings to become registered SEFs.
“Many have been claiming they were ready for months, and now they control their own fate,” says Hod. “Not all of the 20-plus SEFs will survive. Ultimately, technology, volumes, liquidity and connectivity will decide the outcome over the next 12 to 18 months.”
A number of new electronic multi-dealer options platforms have been launched in recent years in anticipation of the new regulation. In addition to SuperDerivatives’ joint venture with FXCM, Digital Vega, Tradeweb and SurfaceExchange all claim to have attracted support from leading liquidity providers.
Meanwhile, larger players such as Thomson Reuters’ FXall and Bloomberg have also entered the fray.
Banks, understandably, would prefer to keep profitable options business on their single-dealer platforms or trade in the traditional way over the phone. The new regulations, however, will mean an inevitable migration towards the multi-dealer environment and electronic trading of FX options.
That should see an increased appetite from liquidity providers to connect to the platforms and stream prices, which in turn should promote the growth of electronic FX option trading.
As well as providing impetus for market incumbents, however, the finalization of the SEF rules is also likely to attract new entrants into the market.
Bill Goodbody, managing director and business manager at Hotspot FX – the multi-dealer trading spot platform that was the most improved venue by market share in this year’s Euromoney FX survey – says entering the FX options business is something the firm has been considering for some time.
He believes, however, there was no first-mover advantage in the electronic options trading business. Indeed, Goodbody says the legislative environment slowed down the electronification of FX options, with the market getting stuck in a “five-year quagmire” waiting for the regulations to come in.
“We have been watching the development of the market and now that the rules have finally been finalized, it gives us something to plan around,” he says. “Now at least we know the requirements and can evaluate a business model around them.”
Goodbody says he would not be shocked if Hotspot FX moved into options. “We would definitely like to see our product base expand and find more ways to interact with our clients,” he says.
The development of the FX options business has wider implications for the currency market.
Indeed, the prospect of increased electronification of FX options, traditionally the preserve of bigger, more sophisticated investors, has the potential to level the playing field, simplifying trading execution and opening up the market to other less-savvy client segments.
That could be welcome news for some market participants. Many believe, for example, that customers such as corporates can increase the efficiency of their currency trading strategies by moving away from hedging their exposure using forwards towards using options.
After years of waiting on the launch pad, the finalization of the SEF rules might be pushing FX options trading towards lift off.