LONDON, March 25 Banks are strengthening their foreign exchange options desks, investing in people and technology, as companies and hedge funds seek protection or profit from big moves in major currencies.
Options volumes surged in early 2013, mirroring a pick-up in the spot market and reflecting strong trends in major currencies, which analysts expect to continue.
These trends, particularly in the yen and sterling, increase money-making opportunities for hedge funds and are an incentive for corporate investors to protect their exposure.
Barclays said they saw a 40 percent rise in options volumes in January compared with a year earlier, and banks in general were looking at foreign exchange as an area to expand.
FX options give holders the right to buy or sell currencies at an agreed price and time, reducing the risk if prices swing wildly, and are mostly traded over the telephone or via instant message on computer screens.
"We are optimistic on the coming year. We have seen stress in a global economy that is operating at different speeds, which offers potential for greater currency management. It makes sense to use options to take or reduce risk," said James Bindler, head of global FX options at Citi.
"It's the hedge funds that have really picked up activity."
As the market revives, demand has risen for so-called exotic options with more complex features. That follows a sharp drop-off after the 2008 financial crisis when many companies booked heavy losses on exotic bets that turned sour.
The bigger banks, including Morgan Stanley, are channelling more resources into electronic options trading in anticipation of looming regulations that are likely to push the market towards increasing automation.
But the sheer complexity of some exotic structures means machines will struggle to take over entirely, with many options still needing to be priced manually by humans.
Among banks boosting their firepower, Nomura has hired three new traders since mid-2012. Global head of foreign exchange, Jai Rajpal, said there would be further investment this year.
While agile hedge funds seek to profit from bets on currencies rising or falling, banks also report an increase in hedging by companies seeking protection from sharp price swings.
Many were caught off-guard by the dollar's 20 percent rise versus the yen since November and the British pound's 7 percent slide against the U.S currency this year.
"What we have seen more and more over the last two years is some corporates having a very good result in terms of their core business, but ending up with a loss because of the weaker currency in which they trade," said Remo Fritschi, head of FX bank sales for EMEA and North America at Morgan Stanley.
Regulatory changes under the Dodd-Frank financial reforms passed by the U.S. government, look set to push more of the opaque derivatives market on to transparent trading and clearing platforms in the next couple of years.
"You have to ask a number of banks and be able to show you traded on the best price. You have to be electronic in that world," said Giles Jewitt, head of FX options automated trading at HSBC. His role was created two years ago as the bank stepped up its efforts to automate options.
Straightforward "vanilla" options lend themselves to electronic trading, but exotics can include unique terms and conditions that make them hard to commoditise.
The more complex an option, the fewer people post prices and the thinner the liquidity, making it less suitable for electronic trading.
This and the prohibitive costs mean even an expanded FX options market is likely to be dominated by the deep-pocketed big banks, just like the spot market.
Market players estimate only 10 to 15 of the bigger banks trade options electronically and smaller players may struggle to bridge that gap.
"It's going to be hard for second-tier banks to make that investment. In terms of expense, it took us the better part of three years to deliver a system that can deliver tight and accurate prices," said Citi's Bindler.
The main advantage of electronic trading, whether streaming live prices to clients or using algorithms to generate smaller quotes automatically, is that it enables traders to concentrate on larger flows and the banks to handle higher volumes.
But Nomura said corporate clients will always need bespoke exotic structures tailored to fit their individual businesses and that can only be handled by a person.
Even banks that are already established in electronic trading recognise its limitations.
"A corporate who has $6 billion of hedging exposure will always want to do it through voice," said one head of options trading.
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