‘Barrier running’ investigation alarms FX traders

Regulators’ investigations into the unregulated FX markets have largely focused on the $3.5 trillion spot market, and have resulted in billion-dollar fines for dealers found guilty of attempting to manipulate benchmarks.

However, their attention is now shifting to the FX derivatives market, which accounts for a much smaller proportion of overall trading volumes, but is arguably a more lucrative business for dealers due to the higher margins on offer.

Unlike equities, FX options are largely traded over-the-counter as opposed to on exchange, and the more complex options, known as exotic options, are typically traded over the phone.

The UK’s fair and effective markets review (FEMR) released a consultation document in October for its investigation into the fairness and effectiveness of fixed-income, FX and commodities markets. The Association for Financial Markets in Europe (AFME) is still in consultation with the banks and is due to publish an official response in January.

Barrier running

The FEMR investigation focuses on two types of exotic options: barriers and digitals. Barriers are either activated or cancelled if a pre-determined level of the underlying market price is reached. That pre-determined level is agreed between the dealer and client at the time the option contract is written.

Digital options are binary – they pay out either a fixed amount or nothing, depending on whether the underlying price reaches a particular level at a specific point in time.

The concern from regulators is the temptation for buyers and sellers of these options to try to move the market of the underlying asset because they stand to gain or lose substantial amounts if it hits a certain trigger level.

For example, if the underlying asset is EUR/USD, a one-pip movement in the currency pair from 1.2329 to 1.2330 could mean the difference between the seller of an option having to pay out millions to the buyer or nothing at all.

FX traders have to constantly monitor options during their lifecycle and, as the trigger level or expiry date of the option looms closer, hedge their exposure in the spot market.

However, this gives rise to the temptation to put on a hedge that is so large it moves the market and swings the outcome of the option. This is known as barrier running. If a dealer can move the market sufficiently, they can kill the option altogether.

Meanwhile, they keep the original premium paid for selling the option and all the risk goes away. If a buyer can move the market, they win and secure a pay-out on the option.

The FEMR consultation states such trading might temporarily force the market to an artificial level, harming other users of that market.

Exotic game

A former head of currency options at a global investment bank, who wished to remain anonymous, described barrier running as “commonplace”.

“[It’s] really awkward now,” he says. “Things we regarded as common practice [back] in the day [are] being looked at with an entirely different lens these days.”

A former trader and exotic options specialist described the practice as “part of the exotic game” and accepted among the trading community.

“It was considered to be fine and known about by senior management; [an] endorsed policy,” he says. “Senior managers in banks cannot pin this on rogue behaviour – this is endorsed by management. Desk heads knew exactly what was going on [and traders were] encouraged to do it. Almost everyone is tarnished by this. If you’re an exotics trader, you’re in trouble.”

It is crucial to note that barrier running is a temptation for buyers and sellers. Banks sell these instruments, but buyers of exotic options are typically sophisticated market participants such as hedge funds who, just like the banks, have the power to move markets.

According to one exotic options trader, these types of instruments are almost entirely traded by market professionals.

“It’s banks versus hedge funds,” he says. “The regulatory focus has been on protection of retail investors, but the idea is that if you are a bank or hedge fund, you know what is going on – caveat emptor.”

All three admitted that, at times, clients had got wind of barrier running on their options and demanded to be reinstated. The decision whether to do so hinged on how important the client was to the bank, they said.

Barrier running is banned under market abuse rules, but, crucially, this rule only applies if the underlying asset is a listed security. Therefore, FX is exempt from these rules, although the Financial Conduct Authority’s principles for business might still apply.