Volbroker.com, a bank consortium, may soon turn the FX options market upside down.

Spot FX was one of the first markets to embrace electronic trading. These days, approximately 65 percent of the total global interbank spot trading (and some 20 percent of all foreign exchange volume) runs through the Electronic Brokerage System (EBS). But if a dealer wants to trade a currency option, the dealer still has to call a voice broker, who in turn shouts volatility bids and offers across speaker boxes to other institutions.

The voice-brokered currency options system will soon be under intense pressure to change. On March 8, 2000, Deutsche Bank, Citibank and Warburg Dillon Read announced their intention to launch Volbroker.com, the first Internet-based electronic interdealer broker for the foreign exchange options market.

"The real goal is

trying to streamline operational processes that historically have not been very efficient.” —Dirk Ward Deutsche Bank

Each institution (and possibly a few others who may be invited to join the effort) will post its bid/offered prices on a system that will execute deals electronically, price uoption details and offer a great deal of middle-office functionality as well.

"The Internet is changing the way all markets work,” noted Simon Jagot, global head of foreign exchange at UBS, on the day of the announcement. "Volbroker.com will accelerate this in currency options, and in the future, for other products.” Guy Whittaker, global head of foreign exchange at Citibank concurred. "Our ambition is to help make a more effective and efficient market in currency derivatives,” he noted. "Volbroker.com allows that because it is transparent, quick and easy dealing for all participants.”

Volbroker.com will present term-structure volatility curves for at-the-money-forward options on a variety of currency pairings. Although definitive terms have yet to be set, the quotes will likely come from the Volbroker.com owner institutions only, but be made available to a wider universe of bank and brokerage firms. The size of bids and offers in millions of dollars would be visible for the immediate best market and next-best bids and offers as well, giving some sense of depth but not a complete order book.

Most who participate in the system will provide a credit file to pre-check automatically whether a trade between two counterparties can take place from a credit perspective. If the credit criteria are met, and one bank deals on another's volatility price, then the system will automatically prompt the market-making bank with the message, "You have been dealt upon,” and produce a set of details for the trade—strike price, expiry date and premium levels. Both sides to the transaction will then have a chance to review the details and accept or contest them.

Because the system may occasionally pick a bad interest rate, spot price or forward price to calculate option trade details, Volbroker.com expects to provide a "chat functionality” between banks and even a human Volbroker.com arbitrator to help resolve any problems or disputes that might arise.Once confirmed, however, trades would feed directly into a bank's position and risk management system, allowing option desk managers to see instantaneously the changes in their second-derivative risks, such as theta, gamma and vega, as new trades occur.

If things go as planned, this could dramatically reduce costs and increase the speed of booking an average foreign currency option. Currently, banks rely on middle-office personnel to confirm deals verbally and then enter them into risk management systems one by one.

"We have little doubt that Volbroker.com will increase market transparency and access,” states Dirk Ward, chief technology officer for the global markets e-commerce division of Deutsche Bank, "but the real goal here stems from trying to streamline operational processes that historically have not been very efficient.”

Starting with the currency salesman, moving to the trader, on to the broker, and then back to the customer, with the middle office squeezed in between—there has always been a huge amount of duplication in the option pricing and confirmation process. To get everyone to agree to the details of a transaction and then to get that transaction properly entered into a risk management system often takes the better part of an hour. Clearly, Volbroker hopes to standardize this inglorious work by compressing it into no more than a few minutes.

Difficult Hurdles

Before this grand vision becomes a reality, Volbroker.com will have to figure out a way to go beyond vanilla at-the-money-forward options to trade things like odd-dated expiries and strikes. Another difficult task will be to handle option spreads properly. "A large part of our interests these days are things like two-week options against a two-month maturity, or the at-the-money option against the .17 delta put,” says Mark Leonhard, a managing director at Prebon Yamane who specializes in currency options. "I don't think Volbroker.com is going to have the capability to develop that price.”

Users who depend exclusively on Volbroker could also find themselves in trouble for other reasons. "Even if Volbroker.com ends up with six or seven owner/price supporters, there are times each year when all these big guys will be going the same way,” says Mike Gooch, chairman and CEO of GFI, an active derivatives broker. "There is no way that these dealers will be able to move their positions trading among themselves. They need the little guys within the system showing the $20 million bids all the way down or up. Those little guys may or may not be there if they value a more independent intermediary who helps look out for their best interests.”

Volbroker will

have to figure out a way to go beyond vanilla at-the-money forward options.

Deutsche Bank's Ward admits that specific odd-dates, odd-striked options and spreads will be among the more difficult tasks for Volbroker to tackle, but he fully anticipates there will be a Volbroker screen to handle such interests. "We want to provide everything a voice broker does,” says Ward, "but just do so on a more efficient platform.” He points out that OTC option brokers in other areas, such as Treasury bond options and exotic foreign exchange options, have long used Reuters-based screens to display diverse groups of specific option interests. But primarily for technology reasons, these prices have seldom been "live” to deal on. The technology now clearly exists to make them so.

Ward also insists that the purpose of Volbroker.com is to make the market easier and more accessible to non-market-making banks. "The participating banks want to create simplicity and liquidity, and, within reason, will be committed to maintaining a more consistent market than they otherwise would in the current system. The owners of Volbroker all know that if they quote consistently and well, the flows into the system will follow.”

Hot Button

An initial prototype of the system was built by Deutsche Bank, which then showed it to Citigroup and Warburg Dillon Read. "It just seemed to make sense to invite others to join,” says Ward. "When we did, the response was pretty instantaneous that this was something that made sense and should have been done a long time ago.”

The system has now gone through a number of prototypes, with traders recommending a series of enhancements. The one feature almost all traders insisted on was a big red button to cancel prices when news breaks or some other dramatic event occur. "We have tried hard to build in enough safeguards so that no one accidentally leaves up a stale or old price and gets hurt,” says Ward. "If the system is safe to use, then more people are likely to use it.”

Volbroker.com also promises various other transactional niceties. One of these allows users to show option interests only selectively to designated dealers either by name or as ranked in market-making prowess. This feature could become critical for larger trades. For example, let's say ABN Amro bought a large amount of six-month 1.12 euro calls through Volbroker.com a month ago on behalf of a client. Now the client wants to sell them back. ABN might make the decision to show the interest first to every bank other than its original counterpart for fear that the original counterpart would recognize the deal and start front-running its unwinding. Alternatively, ABN might decide to show the deal to just three names, including its original counterpart, in order to solicit the best bid. ABN's original counterpart would know that they were not being handed an "exclusive,” and if they wanted to close out this pre-existing position, that they would have to compete to do so.

Volbroker.com is hoping to post its first trade by the end of the second quarter of this year. For the moment, the site shows little more than a press release and a sample volatility quoting screen that enticingly flashes changes in a volatility curve. But when the system is fully built, its owners intend to include some volatility analytics.

The one feature

almost all traders insisted on was a big red button to cancel prices when news breaks occur.

The system should provide a continuously updated history of implied volatility movements, relative volatility spreads, and recent market commentary. "You can't look at a volatility surface over a broker box,” explains Ward, "but you will be able to on Volbroker.com.” To the extent that we can make dealers more comfortable with the market—by leveling the playing field a bit—we think this will be good for market liquidity.”

Indeed, for reasons that are not entirely clear, the overall liquidity of currency options has been somewhat suspect in recent years. Bank risk management platforms may have become more capable of sniffing out second-derivative risks, but dealers have also become more selective and careful in the prices they offer to noncustomer dealing counterparts and brokers. At times, the voice broker market has been emptier than it has ever been before.

Volbroker is clearly being designed first and foremost to streamline middle-office costs and functionality. But if Volbroker can also succeed in re-creating a core pricing mechanism that increases confidence in this market's depth, it could also provide something of a rejuvenation to currency options trading. "If we can allow non-market-making banks to increase their customer-driven business and some of this business flows into Volbroker,” says Ward, "we'll know it's been a success.”

Other Banks Contemplate Their FX Options

While Goldman Sachs and Morgan Stanley are keeping mum on Volbroker.com, Tim Leitch, global head of currency options trading at Chase, said that "we are ready to participate in any system that improves liquidity and transparency.” He does not envision Volbroker.com necessarily being a consortium of only three institutions, and volunteered that "others are likely to be invited to participate.” JP Morgan, meanwhile, already has the beginnings of a competing product in "Volatility Center,” a service launched in September 1999, but geared more narrowly to JP Morgan foreign exchange and commodity clients. The system does not yet offer electronic execution, but it does provide a market matrix of indicative spot prices, forward term structures and volatility surfaces for multiple currency pairs. The site also offers an option pricing calculator, strategy suggestions and news updates about the options markets. Planned enhancements include real-time pricing for nonbenchmark maturities, an expanded product set including exotic options, a two-way dealer chat feature, a derivatives research corner and—notably—electronic execution. Barclays Bank also recently launched an Internet-based Java system for trading spot and forwards called BarCapFX that it hopes to someday adapt for foreign exchange options as well. Barclays' e-commerce head Justin Bull expects options will be part of that system within three months. "We'll be looking for feedback from our clients on the system over time,” states Bull, "and we will try to respond intelligently to that feedback. I am sure that offering options electronically will eventually be part of that.” For the moment, BarCapFX's dealing is limited to spot trades of less than $5 million. Its biggest client for the product is Charles Schwab. The BarCapFX system is designed to provide different levels of service to different types of clients, drawing its core spot pricing from the best of EBS, Reuters Match and manual trader entry. —B.L.

Brokers Fight Back

E-commerce may threaten all established names in the capital markets business, but the institutions with the most to lose are the interdealer brokers. Their numbers have diminished in recent years via a spate of mergers.

Now, many of them are scurrying to develop their own competing products while they defend their traditional role.

Garban-Intercapital just announced a multiproduct electronic platform called GTN, and David Gelber, the firm's CFO, says Garban is working to form strategic electronic delivery initiatives with members of its client base. Nonetheless, he says, he does not see the market migrating instantaneously from a voice platform to an electronic one. He envisions a more evolutionary process. "Even today, Instinet—a system everyone considers electronic—has a large number of real human beings behind the scenes taking orders over the phone and typing them into the system,” he says. "We do not view currency options as being so commoditized and fungible that you can snap your fingers and have them trade electronically. Instead, new technology is likely to slowly integrate itself with current voice brokers, without a single all-electronic outcome.”

We would like

to make some strategic alliances. A classic portal/distribution setup might be in everyone's best interest. —Mike Gooch GFI

GFI Group is hot on the development trail of its own Internet-based dealing system. "We would like to make some strategic alliances in that area,” says Mike Gooch, chairman and CEO, "and to the extent that GFInet has distribution and loyal customers who like our objectivity and access to various derivatives markets, I would not rule out an application program interface from GFI into Volbroker.com. I have not had any discussions to this effect yet, but it might easily be in everyone's best interest: a classic portal/distribution-type set-up in the age of web commerce. Volbroker.com should want order flow from wherever it can get it, and for GFI it would simply mean going to one central pricing mechanism instead of multiple banks individually.”

GFInet currently offers its clients the ability to trade various equity markets electronically on-line, and has created a real-time option calculator for over-the-counter currency and precious-metal options on its web site. The calculator downloads volatility levels, spot prices and forward calculations automatically from GFI's broker data feeds. Once an option is traded, positions can be stored in a portfolio management area. The on-line trading of currency options will be introduced shortly, and when it is, GFI may go after institutional clients beyond simply banks. The company already refers to itself as a "financial Internet company” rather than a derivatives brokerage firm. If it can change the concept of a brokerage fee by calling it an access fee, anyone could be a subscriber and get uniform web-based access to a wide variety of derivatives markets.

Meanwhile, Prebon Yamane is planning to adapt electronic derivatives systems in use for other market sectors to currency options, and has already taken an active electronic presence in the credit derivatives and energy markets (via its respective investments in CreditTrade, Altrade Power and Altrade Gas). Prebon is probably ahead of similar e-commerce efforts by the recently merged Tullett & Tokyo Liberty PLC, but Ken Wagner, COO of the Liberty Direct e-commerce initiative, promises that "any product we now broker will eventually be traded on an electronic Liberty Direct platform. It's just a matter of time.”

The standard-bearer for broker-based electronic commerce is, of course, Cantor Fitzgerald, which has not only its Cantor Exchange product, but also Cantor e-speed.com. E-Speed was launched last summer after three years of research and development, and as a standalone company is currently being valued at a total market capitalization of approximately $2.4 billion. The system is still targeting fixed-income products and derivatives for the moment, but adaptations into other areas including currency options are sure to follow.