Bank of England FX data show shift to options for hedging

Finance news

Strong growth in options trading highlighted in the latest FX data from the Bank of England is indicative of a move away from the use of forwards and swaps for hedging, say market participants.

The Foreign Exchange Joint Standing Committee FX turnover survey – based on data collected in October 2018 from 28 financial institutions active in the UK foreign exchange market – shows that while options turnover grew by more than 15% between April and October, swaps were down by 11%.

Although overall daily trading turnover was down by $116 billion from the record high of $2,727 billion reported in April 2018, the fall in swap turnover compared with the previous six month period was even higher, at $157 billion, indicating that factors other than market shrinkage contributed to this decline.

In the context of increased appetite for hedging transactions due to market volatility, the traditional method of using forwards and swaps for hedging is being eschewed in favour of options, according to Henry Wilkes, chief executive of pointFX.

The development of trading technology has made it much easier to provide efficient delivery of transparent, simple and flexible option pricing, he adds.

“This is a positive trend in the market and will lead to much more competitive rates in short-term option pricing,” he says, “allowing a greater number of market participants to hedge their foreign exchange risk with simple and cost-effective option strategies.”

Forwards and swaps have become less liquid and more expensive because of the increased capital requirements banks have to meet on their balance sheet, which has in turn reduced their appetite for long-dated risk and credit exposure.

Sucden Financial’s head of options, Pritesh Ruparel, agrees that clients are showing a greater appetite for options.

“We have seen a sharp interest and subsequent growth in option activities, given the macro uncertainties around Brexit and US-China trade relations,” he says. “We see the current trend continuing as clients become more comfortable and confident in adding optionality to their portfolios.”

Risk off

More generally, financial markets were operating in a risk-off environment through and beyond October, explains Roger Rutherford, chief operating officer of ParFX, noting that GBP’s share of daily market turnover was down from 16.7% in April 2018 to 16.1% last October.

“In the UK, GBP has essentially been a proxy for Brexit sentiment,” he says. “In addition, the political impasse over the government shutdown in the US and fears of a global economic slowdown – led by China – continue to weigh on market sentiment.”

Spot increased for the third successive reporting period, recording its highest level ($775 billion) since April 2015.

Curtis Pfeiffer,

Pragma Securities

This surge in spot trading activity may well have been the result of counterparties’ increased perception of risk in the market caused by a rise in geopolitical tensions and concern over an economic slowdown, says Pragma Securities chief business officer, Curtis Pfeiffer.

As volatility increases, there is generally less certainty from market participants, which induces more trading volume.

Non-deliverable forwards turnover fell by almost 10% from April to October 2018. However, the total value of NDF trading was much higher on a 12-month basis, from $90 billion in October 2017 to $270 billion, indicating that the FX market has continued appetite to trade less liquid currencies.

Given that market activity in trading instruments varies based on a number of exogenous factors, Pfeiffer says it is difficult to say with certainty that FX swap activity will continue to fall.

“One needs to see a trend develop, and one measuring period is not sufficient for this purpose,” he says.

The 17% increase in Chinese yuan turnover reported in the FXJSC turnover survey suggests that London’s efforts to become a hub for yuan trading are paying off. However, perhaps more notable was the 12% increase in the value of Australian dollar trading, which moved further clear of the Swiss franc as the fifth-most traded currency.

“The Australian economy was performing very strongly and there was a very strong bullish trend in AUD, which was very attractive to investors,” concludes Wilkes. “Commodity prices were very volatile based on a slowdown in the Chinese economy and the trade war with US, encouraging more uncertainty about the Australian economy as the year went on.”

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