Client Types

Many different types of client use FX derivatives for reasons that can generally be classified as hedging, investment, or speculation.

Corporates

• International companies primarily concerned with managing their FX exposures and funding. For example, consider a car manufacturer with production in Europe but sales in America. This company is exposed to the EUR/USD exchange rate. If unhedged, when EUR/USD goes higher the company will be relatively less successful because the USD received from sales are worth fewer of the EUR needed to pay their workers and build new factories. Likewise, when EUR/USD goes lower the company will be relatively more successful. Fundamentally, the success of the company should depend on their ability to design, manufacture, and sell cars rather than exchange rate fluctuations. Therefore, expected future foreign exchange exposures are hedged—potentially using FX derivatives.

Institutional

• Real money: Professional money managers who use foreign exchange as an asset class. Simply put, they seek to take positions that will generate positive P&L as markets move.
• Hedge funds: Professional money managers but typically trade to shorter time horizons than real money.
• Sovereigns: Central banks/NGOs (e.g., IMF/World Bank), interested in FX volatility plus potentially manage currency reserves.

Regional Banks

• Have smaller FX derivatives trading desks or perhaps hold no risk at all and transfer (i.e., “back-to-back”) all exposures to larger banks. Regional banks usually trade with international banks as clients in a nonreciprocal trading relationship, meaning that the international bank cannot request prices from the regional bank.

Retail

• Individuals who trade simple FX-linked investment products, for example, dual currency deposits (DCDs). Within a DCD the client deposits money in one currency for a fixed term. At the end of the term, the bank has the option to return the money either in the deposited currency or in a second currency. The client has effectively sold a call option on the deposit currency, and the premium earned from selling the option gives the client an enhanced coupon on the deposit.

Bank FX Derivatives Trading Desk Structure

FX derivatives trading desks usually deliver follow-the-sun coverage to clients from three global centers, normally London, New York, and one in Asia-Pacific. Traders within the three centers are in constant communication and they aim to provide the best possible client service in terms of pricing consistency between centers, speed, and bid–offer spread.

On the trading desk in each center there are various roles. In practice these roles often overlap and what is presented in Exhibit 4.3 is enormously simplified.

Traders are responsible for keeping desk pricing in line with the market. They make prices for clients and risk manage desk trading positions. In addition they perform various other tasks that assist with their pricing or risk management, for example, market analysis and trade idea generation.

Traders are usually responsible for risk managing G10 or emerging market (EM) currency blocks. Related currency pairs are put together into a currency block, so, for example, the CAD block might actually contain AUD/CAD, CAD/CHF, CAD/NOK, CAD/SEK, EUR/CAD, GBP/CAD, NZD/CAD, and USD/CAD, although the majority of the risk will likely be in USD/CAD and possibly EUR/CAD. The main book-runner for a particular currency block usually sits in the most appropriate center; for example, the AUD block will normally be run out of Asia-Pacific while the Latam (Latin America) block will normally be run out of New York.

Structurers work with sales and relationship managers to understand clients' FX hedging and investment requirements. They design and construct solutions and work with traders to price more complex products. Structurers also educate sales on new derivative products offered by the trading desk.

Quants (quantitative analysts) are usually PhD-level mathematicians who develop and implement the pricing and analysis models and tools used by the trading desk.

Middle office ensure trading positions are correct and that new deals hit the trading positions quickly and accurately. In essence they are responsible for keeping desk risk management running smoothly.

Tips for a Trading Internship

When you first start on the trading desk, don't race through any learning material you're given: It isn't a race. Developing a good understanding of the material is far more important than showing off that you've read a 40-page document in an afternoon. On the other hand, don't just sit there waiting to be told what to do; ask junior traders for assistance in getting training material if it isn't given to you.

If you're given rubbish jobs to do, just get on and do them; put the team first. Everyone went through the same thing; getting coffees and lunches for traders gives you exposure to them. By doing this they will start to get to know you and will be more likely to help you learn.

Get the right balance between project work and learning about trading. Sitting there the whole time just doing your project is folly (and one to which I fell prey during an internship in 2001). You are there to learn what the trading job involves and whether it is a career you would like to pursue. Speak to people and make connections. At the end of the internship a range of people on the desk will be asked what they thought of you; no impression is almost as bad as a negative impression.

Go and sit with the different parts of the trading desk (structuring, middle office, quants), other teams within the same asset class (sales desks and trading desks), and other asset classes (interest rates, equities, credit). The more you understand about different roles on the trading floor, the better.

Always be on the desk over economic releases and major option expiries. This is when market activity is most likely to occur and it is important to see how traders react to this.

Tips for a Junior Trader

Don't be sloppy. This is the worst possible trait for a junior trader. Be precise when describing your position, book trades properly the first time, and be able to explain your P&L and position accurately at all times.

Learn to be aware of multiple things at once: Brokers are shouting, spot traders across the room are shouting, spot is moving, and your boss is asking you a question. This is a difficult skill but it is one that must be learned. Traders become experts at flipping from chatting about sports or the weather to quickly reacting to something that has occurred in the market. If you're sitting and talking with traders, always keep half an eye on the market because you can be sure they are.

Don't get gripped watching spot moving up and down at the expense of all other work. Learn to be aware of spot without staring at it. In practice, traders view their trading positions and pick approximate spot levels where they will hedge ahead of time.

Don't panic under pressure; stay calm and keep your thoughts clear. If you lose your nerve, you might as well not be there.

Don't be lazy: If something looks wrong in the position, investigate and find what is wrong; don't assume problems will fix themselves.

Never exaggerate or bluff. Experienced traders will pick up on bluffs in picoseconds and will delight in taking you apart for it. Saying, “I don't know, let me find out,” is usually acceptable. Lying is never acceptable. Also, describe market moves in terms of what has actually happened and try to avoid hyperbole (e.g., “it's going insane” or “it's getting completely destroyed” when implied volatility moves 0.2%).

Don't be afraid to admit you've made a mistake. Everyone makes mistakes. Fix it, learn from it, and make sure it doesn't happen again. Obviously, however, repeated similar mistakes can be harmful to career progression.

Learn how to round exposures and P&Ls when describing them. Traders usually only care about their deltas to the nearest one million or five million, depending on how much risk is being run, so, if asked for a delta exposure, “long ten million, three hundred and twenty-one thousand, five hundred and seven U.S. dollars” is too much information when “long ten bucks” gets the required information over.

Judging market liquidity is a skill that is acquired over time. Knowing where to price a large client trade by estimating how the market will absorb the risk if it is recycled must be experienced to be learned.

Follow as many different financial markets as you can, not just your own. Know where ten-year USD rates, the Nikkei, the Vix, and so forth are all trading. The best traders have a view on the whole market and see the connections between the different parts.

Understand what kind of trading desk you are on and how it makes its money. What were the annual P&Ls of the desk for the last five years and what is the split of that P&L between client trades and position taking? How much of a presence does the trading desk have in the interbank broker market and the direct market? Who are the main client groups (corporate, institutional, etc.) of the desk and what kind of trades do these clients like to transact?

Learn the official desk P&L currency and how the P&L conversion from the natural P&L currency per currency pair into the desk P&L currency is handled. Does this effect create a trading exposure which needs to be managed?

Always have an opinion about the market and a plan for your trading position. Always know and be able to justify your current position. The justification can be made in many different ways, but if you can't justify why you have a position, you shouldn't have it. Trading positions could be taken as a result of, for example, market analysis (see Chapter 17), client flows, or market positioning.

FX Derivatives Interbank Direct Market

FX derivatives traders at different banks can contact each other directly to request prices on simple vanilla contracts. The process is straightforward: Trader A calls bank B via a recorded messaging system and requests a price on a vanilla contract. Trader B picks up the request (because they are currently trading that currency pair) and makes a price on the contract in implied volatility terms. Trader A then has a short amount of time (approximately up to 20 seconds) to deal (hence crossing trader B's spread) or pass on the price. After an implied volatility price is dealt on, the traders agree the market data (spot, forward, deposit rate) and option premium between themselves and the deal must then be booked into both risk management systems.

Exhibit 4.4 shows a typical direct call between traders A and B. Note the assumptions made within the call, which enables efficient communication.

1. A> USDJPY PLS
2. B> HIHIHIHI
3. A> USDJPY 25TH AUG 103 NY IN 75M PLS
4. B> 4.9 / 5.5%
5. A> BUY PLS
6. B> SURE 102.50 SPOT OKAY?
7. A> AGREED -1 SWAP 0.15% USD DEPO 0.185 USD% 40 DELTA OKAY?
8. B> AGREED THANKS FOR THE DEAL BIBIBI
9. A> THX BIBI

Trader A has requested a price in USD75m of 103.00 USD Call/JPY Put with August 25, 2014 NY cut expiry. Within direct calls, notional is always quoted in CCY1 terms; if a year is not specified, the next occurrence of the date is assumed and the out-of-the-money side, in this case a USD call, is always dealt (this is explained in Chapter 7).

Traders have a choice between calling direct or using the interbank broker market. Therefore, the decision to call direct is usually made because it compels the other trader to make a price with none of the safety provided by the broker market. This decision might be made because the trader wants to transact in large size and may need to trade with multiple banks at once in a way that would not be possible through the broker market, or perhaps the market is volatile and there is currently limited liquidity available in the broker market.

There is a well-established etiquette within the direct market: Traders don't call each other too often and most trading desks rarely reject a price request. Also, once a contract has been in the broker market and a price has been made, it is not usual to receive a direct call on the same contract. Most importantly, if the price received is far from what was expected, the price making trader should be given an opportunity to check their rate to avoid bigger problems later when a mistake is discovered.

Direct relationships between traders work best when they call each other with similar frequency on similar-size contracts. Mutually beneficial direct relationships exist but there is always a tension involved that arises from the price making process. When quoting a direct call, the trader thinks, “Why are they calling on this contract?” There is often a catch; otherwise, the contract could be worked in the interbank broker market and probably transacted closer to midmarket. Direct calls are dangerous because they can expose traders who aren't following the market closely enough.

FX Derivatives Interbank Broker Market

The interbank broker market is a crucial part of the FX derivatives market structure since it is where the vast majority of bank-to-bank FX derivative transactions occur. This section explains in detail how the broker market works.

In the FX derivatives market there are currently four main interbank brokerage firms. Each broker shop has global teams of FX derivatives brokers who between them speak to the FX derivatives traders at all the banks in the market in a structure shown in Exhibit 4.5.

Brokers are split by currency block (e.g., G10 majors/G10 crosses/Asia EM, etc.) and also by option type (e.g., short-date vanillas/long-date vanillas/exotics).

Communication between broker and trader has traditionally been done either by voice over recorded fixed telephone lines or via recorded text messaging systems. Over time, communication is moving away from free-form text messaging toward standardized electronic messaging.

Market instruments at market tenors are often quoted in the interbank broker market but specific contracts make up a large part of the market, too. Specifics are nonstandard vanilla contracts. For example: July 23 1.3250 NY in EUR/USD or 6mth 102.00 TOK in USD/JPY are both specific contracts.

The trader at bank A wants to transact a specific vanilla contract and requests a price from their broker at one of the interbank brokerages. This is called trader A's interest, which broker A is working as shown in Exhibit 4.6. Brokers are usually working multiple interests for different traders simultaneously. Note that the trader does not have to disclose a contract size at this stage; it may help the broker if the trader reveals that the interest is in large size, but initially a standard “market size” would be assumed. In major G10 currency pairs, market size is roughly USD30m to USD50m in normal market conditions. In cross G10 currency pairs and EM currency pairs, market size is smaller.

Broker A tells the other brokers at their shop about the interest and the brokers go to the relevant traders at all the banks in the market requesting a price as shown in Exhibit 4.7.

The traders price the contract in their pricing tools and when ready they return their prices, quoted in implied volatility terms:

• Bank B: no price
• Bank C: 6.75 / 7.25%
• Bank D: no price
• Bank E: 6.6 / 7.1%

In trader A's pricing tool, the mid-value of this vanilla contract is 7.0% implied volatility.

Note that traders are not compelled to make a price and there are many possible reasons why they might choose not to. Perhaps they are busy pricing another contract for a client, perhaps they are remarking their curves, or talking to their boss, or perhaps they are off the desk getting lunch.

The importance of the trader/broker relationship should be starting to become apparent. If a broker and trader have a good relationship, the trader is both more likely to request a price from a particular broker (remember there are four different shops to choose from), and more likely to make prices for the broker.

The relative power of the specific broker within their firm is also important. To get the most rates (prices) possible back from the market, and hence maximize the chance of getting a tight composite rate, broker A must get the other brokers to push their traders for rates. In some instances this will mean bothering a trader who does not want to make a rate. Again, relationships are vital for managing this.

The best composite rate between the two prices made is 6.75/7.1%: bid from bank C and offer from bank E. The broker goes back to trader A with this rate but does not disclose which bank is the bid or the offer. This process is shown in Exhibit 4.8.

Trader A now has five options:

1. Pay the offer.
2. Show a bid.
3. Give the bid.
4. Show an offer.
5. Pass.

If trader A is a buyer (called a buying interest), options 1, 2, and 5 are valid choices. If trader A is a seller (called a selling interest), options 3, 4, and 5 are valid choices.

If trader A pays the offer or gives the bid immediately, the trade is done and the process is complete. However, in FX derivatives the interbank broker market normally works slower than that. Traders usually make a relatively wide initial rate even if they have a preference to buy or sell the contract; they wait to see whether the interest is a buyer or a seller before showing their own hand.

Therefore, in normal markets, transacting on the “opening rate” is rare. It is far more likely that trader A will show a “counter” (i.e., a bid or offer) to start a process that will result in transacting at a better level. However, in volatile or illiquid markets, where the brokers may struggle to get any rates at all, a trader may have no option but to trade on an opening rate and hence cross the full spread.

Trader A is a seller of the contract and shows a 7.0% offer. The process now becomes a negotiation between trader A and trader C only (since trader C showed the best bid) via their respective brokers as per Exhibit 4.9.

The broker goes back to trader C only and shows them the 7.0% offer (this would be described as a “seven-oh top”). Trader C then has three main options:

1. Keep the 6.75% bid at the same level (“stuck on the bid”).
2. Show a higher (“better”) bid.
3. Remove (“pull”/“ref”/“refer”) the bid. Orders aren't usually pulled unless something has fundamentally changed in the market (i.e., spot has moved sharply) since the order was placed.

Trader A is then told what trader C has chosen to do and similarly can either show a better offer or be stuck, assuming trader A doesn't want to walk away at this point.

This process goes back and forth between traders A and C via their brokers until either the prevailing bid is given or offer is paid and hence they transact, or both traders are “stuck” at different levels. As the price gets closer to being traded, the broker will start to discuss the potential size of the transaction to make sure that enough size exists on the bid or offer for the interest to trade in the required notional.

When both sides are stuck, the broker will ask both traders if they are happy to “show it out,” which means letting all traders in the market see the two-way price with the aim of further tightening the rate, which at this point is 6.9/7.0%.

Showing the rate out is a risk for trader A since another trader may decide that 6.9% is a good bid to hit and “give it ahead of the interest.” Therefore, the trader's judgment about the current state of the market is vital: Have there been more buyers or sellers of similar contracts in the market recently?

Exhibit 4.10 shows how the brokers show the rate out to the market.

Trader D, who had previously not made a rate, is alerted to this tight price and realizes that buying the contract fits their position. Trader D therefore pays trader A's 7.0% offer but only in EUR50m. Trader A has managed to sell half their full amount at their midmarket rate. The brokers inform everyone in the market about the transaction, without mentioning the names of any of the counterparties involved, known as “printing” the trade. This is shown in Exhibit 4.11.

The level at which this transaction was completed is important information for traders in the market. Even if they have been paying little attention up to this point, traders should price up the contract in their own pricing tools. If the contract is priced differently to the trading level, traders must judge whether their volatility surface needs tweaking or trading the contract represents an opportunity to buy below the midmarket level or sell above.

The information that the contract is “sell on” is also important. That there are no more buyers in the market is a sign that the price of similar contracts is falling in the market. Likewise, if traders have more of a contract to buy, with no sellers found, the brokers report the contract as “bid on” and this is a sign that the market for similar contracts is rising. If the interest managed to trade their full size, the broker would report that the interest has been “taken out.”

The brokers continue to match buyers and sellers at the trading level until they are sure that everyone in the market is aware of the trade. Once there are no more interested parties, the contract dies.

The final step in the process is to agree contract details. Vanilla deals are quoted and traded in implied volatility terms but a cash premium is required when booking the deal. Therefore, the traders agree midmarket levels for spot, forward to maturity, and deposit rate (see Chapter 10) to maturity, which is then turned into a spot or forward premium using the Black-Scholes formula. Note that a forward premium (i.e., a premium paid at the delivery date rather than the spot date) will not depend on the deposit rate.

At no point during this entire process were brokers required to have opinions about the “correct” price on the interest, or any knowledge about foreign exchange, derivatives contracts, or anything except the evolution of the price of the contract. However, good brokers have all this knowledge, plus they know which traders in the market are likely to be interested in a particular contract based on recent behavior. They also have a feel for whether a rate might be paid or given ahead of the interest if shown out, and if a price made is off-market (i.e., the price is away from the correct level), they provide protection to traders.

The sidebar provides an example of a broker chat reporting market activity to a trader. Note the combination of requesting prices, reporting live prices (including the interest direction, e.g., “buyer”), and reporting trades.

Brokers are paid commission on the notional (size) of trades they transact. Brokerage rates (often just called “bro” on the trading desk) are quoted in dollar-per-dollar terms, meaning the level of commission in U.S. dollar terms for each USD1m of notional transacted. It is important that traders know the brokerage rates in different broking shops for their currency pairs since that should (at least partially) determine which broker to place an interest with. In general, the more liquid the currency pair, the lower the brokerage rates.

There is an enormous amount of flexibility within this transaction structure. Brokers can work an interest in many different ways. For example, a broker can “build size” at a particular level (i.e., get USD200m on a particular bid for the interest to give all in one go) or they can work an interest more quickly or slowly to get the best fill possible. However, this flexibility inevitably means that part of the broker's skill sometimes involves manipulating the trader's impression of the market in order to get them to trade. Sales 101: Create a sense of urgency:

• “If I show this out, I'm sure it will get paid ahead of you. You should pay it yourself.”
• “The guy is pretty shaky on his bid—I think he's about to ref it. You should give it.”

In general, the more traders put in, the more they get out of the broker market. By making prices (i.e., being a good liquidity provider), brokers will work harder to get better fills on the trader's interests. Traders who follow the broker market closely (and therefore know the prevailing market sentiment for different types of contract) and have their own pricing up-to-date maximize their chances of transacting at good levels.