Greenwich Associates Publishes New TCA Study

FX Options in the Age of Uncleared Margin Rules

Greenwich Associates have published a paper which states that buyside firms could achieve significant savings on execution costs, up to 70% on some trades, by shifting some of their trading to listed FX options. In addition, for those impacted by uncleared margin rules (UMR), funding costs could be reduced by 86%.

Crucially, their total cost analysis (TCA) research also shows that listed FX options can be more cost-efficient alternatives to bilateral trading, independent of the incoming regulations, as the electronification of FX options accelerates and liquidity responds.

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Report: In Brief

  1. Today, 37% of FX Options volume is executed electronically – however, this is double the volume from only five years ago. In terms of where the market will execute more on screen, 70% of survey respondents stated that they saw value in the all-to-all model for FX Options – of which CME Group provides the largest in the world.
  2. In the wake of MiFID II, the use of TCA across all desks is increasing, along with a need to demonstrate transparent pricing and best execution – which has remained a challenge in the bilateral FX Options market. This, coupled with incoming UMR regulations, is causing dealers, FXPBs and buyside firms to consider costs, compliance, counterparties and future sources of liquidity with more urgency.
  3. The result, 40% of all surveyed are identifying listed FX Options as a potential solution and tool to help solve these challenges – especially as listed options are being updated and adapted to better align with OTC market conventions – and market participants should recognize them as an untapped source of new liquidity.
  4. The TCA analysis, full methodology below, revealed substantial potential savings for buyside participants, ranging from $2,000 to $7,000 per trade of $50 million notional.
  5. Finally, when the Listed Options TCA is combined with funding and capital cost savings which can be accrued through netting, the research shows savings up of to 70% per trade, for market participants with average trade sizes of $50 million and under on the CLOB.

Methodology: Overview

  • Greenwich Associates Interviewed 54 institutions across hedge funds, asset managers, banks, broker-dealers and others in the US and Europe
  • Performed a quantitative TCA on OTC quoting behavior and pricing data collected from the above institutions and CME-provided listed options market data 
  • Analyzed a funding and capital cost model comprising of data provided by CME Group of a simulated portfolio of 30 randomly-generated positions of 3-month maturities, in five currencies, across five counterparties, and just under $1 billion gross notional exposure

Portfolio Analysis: Methodology

  • Average spreads and quantity were collected for the two first levels of the orderbook.  The data reflects averages for a 1-week period during core trading of RTH (7am-4pmCT).  This was done for one contract with maturity of <30days and one with >90days, and for an ATM strike and for an OTM strike of ~25 delta.
  • For the short date bucket (maturity < 30days), we used the H9 contract, and week of 2/11/19-2/15/19, drawing data from the ATM & ~25 delta strikes each day.
  • For the long date bucket (maturity > 90days), we used the M9 contract, and week of 2/25/19-3/01/19, drawing data from the ATM & ~25 delta strikes each day.
  • Data was collected across four major currency pairs (EUR/USD, JPY/USD, AUD/USD, CAD/USD) and an average volume-weighted spread and book depth was calculated.
  • The bid/ask spread is shown in US$ pips, and the quantity is expressed in US$ million notional-equivalent.
Avg of Majors Short dated Long dated
OTM ATM OTM ATM
1st level spread 1.72 2.16 1.97 2.56
size $59 $30 $40 $21
2nd level spread 2.86 3.39 3.03 3.79
size $97 $55 $69 $42

The liquidity data for the EUR/USD book is provided below for comparative purposes. As expected, it has better than average liquidity than the other currencies, but not to an extent that it distorts the averaging process.

EURUSD Short dated Long dated
OTM ATM OTM ATM
1st level spread 1.62 1.93 2.00 2.44
size $85 $46 $63 $33
2nd level spread 2.67 3.03 3.02 3.61
size $179 $103 $127 $69

One of the main benefits of an electronic central limit order book is that all participants can trade against all other participants (i.e. an all-to-all matching process), and furthermore all participants can choose to use limit orders (passive participation). This allows many participants to improve their execution price from the existing spread. 

A significant proportion of buyside activity takes place inside the top-of-book spread at CME and this is observed in the percentage of buyside client volume traded in passive mode which averaged 55% in a recent six-month period. To estimate the value of passive trading, two further assumptions were made:

  1. Estimated the percentage of such trades done on the bid or ask
  2. Estimated the percentage of the spread that is “saved” for the remainder of the orders done inside the spread.
Benefit of limit orders on CME Short dated Long dated
OTM ATM OTM ATM
Pre 1st lvl 0.86 1.08 0.99 1.28
2nd lvl 1.43 1.70 1.52 1.90
Post 1st lvl 0.69 0.87 0.77 1.02
2nd lvl 1.17 1.39 1.20 1.52
Saving 1st lvl -20% -19% -22% -21%
2nd lvl -18% -18% -21% -20%

Note: the table above shows spreads in $ pips expressed in terms of mid-to-bid or ask (i.e cost of trade should be relative to the mid-market at the time of the order going into the book).

Capital Efficiency Analysis: Summary Findings

Analysis Using SA-CCR Model Assumption
in thousands Futures CME SPAN Netted SIMM (PB) Bilateral SIMM
Funding Requirements      
Initial Margin (IM) 7,987 22,806 74,431
IM as % of Notional 0.8% 2.3% 2.6%
Default Fund 0 0 0
Total Funding $7,987 $22,806 $74,431
Capital Requirements      
Leverage Ratio (SA-CCR) 442 442 1,190
Default Fund 0 0 0
CVA VaR 18 19 48
Total Capital $461 $462 $1,238
Annualized Costs      
Funding Costs 160 456 1,489
Capital Costs 46 46 124
CVA Costs 64 68 168
LCR Costs 40 114 372
Total Costs Annualized $310 $684 $2,152
Cost differentials over CME: +121% +595%
Analysis Using CEM Model Assumption
in thousands Futures CME SPAN Netted SIMM (PB) Bilateral SIMM
Funding Requirements      
Initial Margin (IM) 7,987 22,806 74,431
IM as % of Notional 0.8% 2.3% 2.6%
Default Fund 0 0 0
Total Funding $7,987 $22,806 $74,431
Capital Requirements      
Leverage Ratio (SA-CCR) 198 198 576
Default Fund 0 0 0
CVA VaR 18 19 48
Total Capital $216 $217 $624
Annualized Costs      
Funding Costs 160 456 1,489
Capital Costs 22 22 62
CVA Costs 0 0 0
LCR Costs 40 114 372
Total Costs Annualized $221 $592 $1,923
Cost differentials over CME: +168% +770%
Assumptions:
Default Fund as % of IM 5% CME Ranges
Funding Costs 2.00% CME Estimate
Cost of Capital 10% CME Estimate
Annualized CVA 1.20% CME Estimate
LCR (based on Funding) 0.5% CME Estimate
Default Fund C-Factor 1% CME Ranges
CVA VaR multiplier 0.34% CME Estimate
SA-CCR C/V Ratio 125.0% Over 100% indicates OC
Margin Model Assumptions: MPOR
Bilateral SIMM 10 days
Netted SIMM (PB) 10 days

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