THE EUROMONEY FOREIGN EXCHANGE & TREASURY MANAGEMENT HANDBOOK2014

COVER+SPINE_FX_2014 17/12/13 13:02 Page 1

This chapter was originally published in:THE EUROMONEY FX & TREASURY MANAGEMENT HANDBOOK 2014

For further information, please visit www.euromoneyplc.com/yearbooks, or contact theManaging Editor, Pam: pam@euromoney-yearbooks.co.uk or +44 (0) 1206 579 591

If you are interested in joining the editorial board of experts in other future Euromoney Handbookspublications, please contact Scott Morton: scott@euromoney-yearbooks.co.uk or +44 (0) 20 8519 9885

CHAPTER 7 I EUROMONEY HANDBOOKS

48

Exercising the right to evolve – CMEFX options by Craig LeVeille, CME Group

But as many FX venues have seen dramatic decreases in

trading volume, CME FX markets have witnessed significant

growth in one key area – options. In fact, through early

December 2013 our research shows CME FX options volume

has grown 48% year over year, with FX open interest 49%

higher than levels a year earlier.

The growth in options is not too surprising given recent

major risk events, like QE tapering discussions and

Abenomics. Investors tend to use options as a safer tool to

hedge exposures during periods when risks are very

difficult to quantify. However, a closer look at CME’s recent

experience suggests that the growth in options may be as

much the result of market evolution as it is about volatility.

Given the early stage of automation in the global option

market, there are strong reasons to be optimistic about

future growth prospects.

CME’s role in the FX marketplace

FX is very different from other asset classes, primarily

because it is not a domestic market – it is a global product

in a global market. FX touches every cross-border

transaction – whether it is commodities, equities, or hard

and durable goods. Since 1972, CME has offered FX futures

There has been no shortage of major market influences and central bankactions affecting the FX markets in 2013. Abenomics was one key drivingforce for the rise in Japanese yen trading, and the continuance ofquantitative easing (QE) in the US has made hedgers and speculatorsrealise that currency risk can no longer be an afterthought. Emergingmarket currencies like the Brazilian real, Indian rupee and South Africanrand have depreciated in value when talk of QE ‘tapering’ arose, only to bestabilised when Fed remarks indicated that the end of the programmewould be at least several months away.

Craig LeVeille

Executive Director, FX Products

CME Group

tel: +1 312 454 5301

email: craig.leveille@cmegroup.com

web: www.cmegroup.com

48-54_CME_FX_2014.qxd 17/12/13 12:27 Page 48

CHAPTER 7 I EUROMONEY HANDBOOKS

and options dating back to the breakdown of the

post-WWII Bretton Woods agreement that imposed fixed

exchange rates between the world’s currencies.

The availability of currency futures, and later, options,

have allowed businesses to manage risk exposure to FX

uncertainty.

Most of the recent growth in FX has been driven by

financial institutions adopting FX as a new asset class, as

was confirmed by the most recent Bank for International

Settlements (BIS) survey. These new participants are

primarily interested in seeking alpha and tend to be more

innovative with their use of products and trading

methodology. This new participation can be seen in the

volume and open interest growth in CME FX markets.

We reached a record high in the number of large open

interest holders in FX futures earlier in 2013, and on

December 5, 2013, open interest in our FX options hit an

all-time high of US$131bn.

Open interest levels provide information regarding not only

the liquidity of our FX market, but more importantly it

demonstrates the market’s belief and trust in transacting

in standardised FX options contracts on a fully regulated

and transparent marketplace with the full financial

safeguards and guarantees of a clearing house.

Currently, CME offers 73 FX futures and 31 FX options

based on 22 currencies. Combined, CME FX futures and

options contracts provide more than US$112bn in daily FX

liquidity as illustrated in Exhibit 1.

A global platform for all participants

Advances in communications have made today’s financial

markets nearly seamless globally. While FX markets have

historically been fragmented, this fragmentation is

becoming less about geography and more about differing

formats of liquidity pools. In this context, the success of

CME’s FX futures platform has been achieved by providing

an open, fair and anonymous trading environment that

delivers equal access to markets and pricing information

whether you are a bank, a multinational corporation or an

active individual trader. The complete book of prices is

49

Source: CME Group

FX options volume and open interest (January 2008 – present) Exhibit 1

90,000

80,000

70,000

60,000

50,000

40,000

30,000

20,000

10,000

0

1,000,000

800,000

600,000

400,000

200,000

0

FX options ADV Open interest

JAN

FEB

MA

RA

PR

MA

YJU

NJU

LA

UG

SEP

OC

TN

OV

DEC

JAN

FEB

MA

RA

PR

MA

YJU

NJU

LA

UG

SEP

OC

TN

OV

DEC

JAN

FEB

MA

RA

PR

MA

YJU

NJU

LA

UG

SEP

OC

TN

OV

DEC

JAN

FEB

MA

RA

PR

MA

YJU

NJU

LA

UG

SEP

OC

TN

OV

DEC

JAN

FEB

MA

RA

PR

MA

YJU

NJU

LA

UG

SEP

OC

TN

OV

DEC

JAN

FEB

MA

RA

PR

MA

YJU

NJU

LA

UG

SEP

OC

TN

OV

DEC

2008 2009 2010 2011 2012 2013

US$131bn

48-54_CME_FX_2014.qxd 17/12/13 12:27 Page 49

CHAPTER 7 I EUROMONEY HANDBOOKS

50

visible to every customer and transaction costs and fees

for all parties are fully disclosed. Electronic trading allowed

CME to offer a similar global value proposition in FX

options, and in the past eight years CME FX options volume

increased 364% to over US$8.3bn in daily turnover, with

86% of it executed electronically.

As we look back at what has been driving the shift towards

electronic execution in FX options, a few interesting factors

have come into play:

Efficient access to liquidityTraders will only rely on a trading platform if they have

confidence they will have access to liquidity when they

need it, and particularly when events occur and everyone

else is trying to get in. Hence having the ability to handle

peaks is essential. One of the limitations of voice

execution is that it does not scale well. CME’s platform

provides option traders flexibility of execution and efficient

access by combining a voice-driven trading floor venue

with an increasingly powerful Globex electronic venue.

Interconnectivity between the two effectively creates one

pool with maximum liquidity. So customers who still prefer

to handle their execution via a voice broker may find that

their order could have been executed either in the pit or

electronically, or both. While most of the growth has come

from electronic trading, it would not have happened

without the interaction from the floor traders via their

electronic trading tablets, and from the floor brokers

becoming adept at executing customer orders on CME

Globex when optimal.

Growing confidence in the technologyTraders today have grown up surrounded by technological

innovations and tend to feel confident in the reliability and

validity of automated execution and matching systems.

CME continues to invest in improvements in its technology

to ensure that this confidence is well-founded.

The development of mass-quote messaging technology,

which provides an ability to include multiple two-sided

quotes within a single message, increased network

efficiency and the built-in market-maker protection features

allowed market-makers to more safely quote hundreds of

strikes across multiple maturities and multiple currencies.

Skeptics of the electronic trend always pointed to the

complexity of trading options spreads as a reason why it

would not happen. Again, a few key developments helped

overcome this hurdle. First, CME introduced functionality

that allows participants to create and submit option

spreads on demand rather than having the exchange

pre-list the innumerable permutations of possible spreads.

This functionality was further improved to ensure strict

spread construction that followed market conventions to

simplify quoting and minimise errors. Independent

software vendors (ISVs) played a key role in making this

functionality as user-friendly as possible.

These steps increased trader speed and confidence in

executing spreads electronically. As a result, volume of FX

options spreads traded on the CME Globex platform went

from 6% in 2009 to 56% in 2013 and accounted for 16% of

total volume.

A standardised, model agnostic venueOne of the key issues facing the early over-the-counter

(OTC) electronic platforms was the difficulty of building

pooled liquidity in a bespoke trading environment.

This was partly resolved by limiting usage to a set of term

maturities, such as one week and one month, but these

dates change daily so the pooled electronic liquidity only

works for getting into a trade. Any attempt to offset the

contract subsequently becomes a bespoke request subject

to high position bias.

By contrast, the standardised nature of listed options

provides a more viable solution with fixed dates that are

the focus of liquidity throughout their maturity.

Participants can initiate and offset trades in the central

electronic liquidity pool with no individual bias.

Furthermore, the premium-quoting convention made the

platform model agnostic, and allowed for definitive

matching, leading to further confidence in the matching

process from traders. The key dependency for such a

model is the need for a highly accessible and deeply liquid

underlying market for delta hedging. Not surprisingly, CME

FX options have piggy-backed the electronic growth

success of FX futures.

48-54_CME_FX_2014.qxd 17/12/13 12:27 Page 50

No one offers you more ways to efficiently manage your risk and capital than CME Group.

• Access a deep, global and increasingly diverse FX liquidity pool

• Trade 73 futures and 31 options spanning 22 currencies

• Clear 12 OTC NDF currency pairs and 26 Cash-Settled Forwards

There’s never been a better time to participate in the world’s largestregulated FX marketplace. Learnmore at www.cmegroup.com/fx

$140

120

100

80

60

40

20

0

2003

Val

ue

inB

illio

ns

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 YTD

$112 BillionCME Group FX Average Daily Notional Value

FX Options Volume

UP 48% year over year

85% executed electronically

Open Interest

$256 Billion

Clearly.A TREND WORTH FOLLOWING.

This communication does not constitute a Prospectus, nor is it a recommendation to buy, sell or retain any specific investment or to utilise or refrain from utilising any particular service.

This commu nication is for the exclusive use of Eligible Counterparties and Professional Clients only and must not be relied upon by Private Clients who should take independent financial advice.

Chicago Mercantile Exchange Inc. is a Recognised Overseas Clearing House (ROCH) recognised by the Bank of England. Chicago Mercantile Exchange Inc., Board of Trade of the City of Chicago and

the New York Mercantile Exchange are Recognised Overseas Investment Exchanges (ROIEÕs) recognised by the Financial Conduct Authority.

Issued by CME Marketing Europe Limited. CME Marketing Europe Limited (FRN: 220523) is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

CME Group is a trademark of CME Group Inc. The Globe logo, CME, Chicago Mercantile Exchange and Globex are trademarks of Chicago Mercantile Exchange Inc. CBOT and Chicago Board of Trade

are trademarks of the Board of Trade of the City of Chicago. NYMEX, New York Mercantile Exchange and ClearPort are trademarks of New York Mercantile Exchange Inc. COMEX is a trademark of

Commodity Exchange Inc. Copyright © 2013 CME Group. All rights reserved.

*Volume and Open Interest figures are based on notional values as of October 31, 2013

48-54_CME_FX_2014.qxd 17/12/13 12:27 Page 51

CHAPTER 7 I EUROMONEY HANDBOOKS

52

Expanded market-maker participationIn addition to floor traders using early hand-held trading

devices, many of the early electronic market-makers at

CME Group were trading firms who had established

systems from the listed equity space and who later found

FX as a way to diversify their strategy. More recently,

increasing participation from larger banks has provided

diversification and more depth to the liquidity pool.

While there are now well over 15 dedicated FX options

electronic market-makers on CME Globex, it is important

for customers to know that the matching algorithm is a

pure price/time priority, regardless of participant status.

Market-makers are incentivised to maximise coverage

across products, maturities and geography. With CME

Group’s global infrastructure, this expanded coverage led

to strong growth from Europe (+97%) and Asia (+127%) in

2013; numbers that continue to support strong global

demand for an efficient and liquid electronic option trading

platform.

Paying and playing for time – FXweeklies

Options allow for hedgers to play, and pay, for time.

News-driven volatility is becoming the norm within global

markets. Risk is difficult to quantify when market

participants are unable to know the outcome of a rate

decision, or whether the Federal Reserve is going to taper

its security purchases. Anticipation leading into such

announcements can fuel volatility, not to mention the

aftermath of unanticipated announcements that lay

unforeseen, and counter to the majority opinion and

expectation. Most often such market dislocations are

short-lived, but remain significant contributors to risk.

The ability to pay only for the time required for insurance

coverage creates a strong incentive to use weekly FX

options as a first-choice hedging instrument. Evidence of

this can be found in the surge in daily trading volumes in

the CME weekly FX options contracts (Exhibit 2). Clearly

market participants are looking for bespoke hedges, or

speculative exposure, to these potentially market moving

announcements. Weeklies are an ideal choice to maximise

leverage for short-term speculative trades, or minimise

premium cost for last minute hedging requirements.

With short-dated options, traders pay only for the time that

they want exposure in the market. Market participants

have seen this as a great way to tailor their positions to fit

Source: CME Group

FX weekly option volume by expiry date (no serial or quarterly expiries included) Exhibit 2

90,00080,00070,00060,00050,00040,00030,00020,00010,000

0

Jan

13,2

012

Jan

20,2

012

Jan

27,2

012

Feb

10,2

012

Feb

17,2

012

Feb

24,2

012

Mar

2,20

12M

ar16

,201

2M

ar23

,201

2M

ar30

,201

2A

pr13

,201

2A

pr20

,201

2A

pr27

,201

2M

ay11

,201

2M

ay18

,201

2M

ay25

,201

2Ju

n1,

2012

Jun

15,2

012

Jun

22,2

012

Jun

29,2

012

Jul1

3,20

12Ju

l20,

2012

Jul2

7,20

12A

ug10

,201

2A

ug17

,201

2A

ug24

,201

2A

ug31

,201

2Se

p14

,201

2Se

p21

,201

2Se

p28

,201

2O

ct12

,201

2O

ct19

,201

2O

ct26

,201

2N

ov2,

2012

Nov

16,2

012

Nov

23,2

012

Nov

30,2

012

Dec

14,2

012

Dec

21,2

012

Dec

28,2

012

Jan

11,2

013

Jan

18,2

013

Jan

25,2

013

Feb

1,20

13Fe

b15

,201

3Fe

b22

,201

3M

ar1,

2013

Mar

15,2

013

Mar

22,2

013

Mar

28,2

013

Apr

12,2

013

Apr

19,2

013

Apr

26,2

013

May

10,2

013

May

17,2

013

May

24,2

013

May

30,2

013

Jun

14,2

013

Jun

21,2

013

Jun

28,2

013

Jul1

2,20

13Ju

l19,

2013

Jul2

6,20

13A

ug2,

2013

Aug

16,2

013

Aug

23,2

013

Aug

30,2

013

Sep

13,2

013

Sep

20,2

013

Sep

27,2

013

Oct

11,2

013

Oct

18,2

013

Oct

25,2

013

Nov

1,20

1369

,505

81,906

62,369

52,655

Non-farm, unemployment,after govt shutdown

Non-farm, unemployment,ISM, initial jobless claim

Fed rate decision, inflation stats,ISM manufacturing

Fed rate decision, FOMCprojections and policy statement,initial jobless claim

48-54_CME_FX_2014.qxd 24/1/14 11:49 Page 52

CHAPTER 7 I EUROMONEY HANDBOOKS

53

their objectives. That shows in the breadth of participants

who are using weeklies. The adoption of these contracts

has occurred across several segments, including managed

accounts and self-driven traders, and nearly 98% of this

trading has occurred electronically.

Future visions

One of the constants of the FX market is that major events

will create volatility and, in turn, the need to manage the

risk of fluctuating currencies. When these events occur,

participants depend on efficient access to the most reliable

liquidity pools. As new needs arise for market participants,

so does the need to innovate. CME is continuing to invest

in its FX options platform to ensure an optimal combination

of products, features and liquidity. With a comprehensive

product suite that offers enhanced trading versatility, and

the security of one of the world’s largest central

counterparty clearing houses, the future is bright for this

dynamic and evolving marketplace.

48-54_CME_FX_2014.qxd 17/12/13 12:27 Page 53