Options Cut White Paper

NCFX Options Cut Methodology – Fast Becoming the Market Standard   

The NCFX FX Spot mid-rate benchmarks[1] are increasingly being adopted as the benchmark rate for the clearing and determination of automated FX option expiries. In the complex landscape of FX markets, where reaching consensus on market clearing rates can be challenging, a robust and transparent benchmark is essential[2]. The NCFX FX Options Cuts represent a special use case for benchmarks, given the decentralized nature of FX trading.   

An FX Fixing operates as a call market nested within and concurrent with a continuous auction market. This dual market structure is a key characteristic of FX markets. This has important implications for the choice of benchmarks, particularly with respect to pin risk and market manipulation. We discuss the NCFX methodology and compare with alternatives in the market: TWAP, Median and VWAP and document some of the most pertinent literature. This paper argues that NCFX’s transparent and robust approach offers a superior alternative for ensuring fairness and accuracy in FX option expiries.   

Independent Benchmarks in a Dual Market Structure   

The NCFX FX Spot mid-rate benchmarks were created in the wake of the WMR and Libor fixing scandals that came to light in 2013[3]. In FX markets, the continuous auction model is the primary mechanism for price discovery. Trades occur continuously throughout the trading day, with prices fluctuating based on supply and demand. This environment is highly dynamic, with prices responding in real-time to market conditions, news, and order flows.   

The FX fix, or fixing process, operates as a call market at specific times of the day. Unlike the continuous auction market, where trades occur on an ongoing basis, a call market aggregates orders over a period and executes them at a single, determined price (the "fix"). This price is intended to serve as a reference or benchmark for various transactions.   

The nature of a call market, which determines a single price based on aggregated orders, inherently differs from the continuous auction market where prices are constantly shifting. This can lead to disputes, especially if participants feel that the fix does not accurately reflect the true market conditions or if the process lacks transparency. Discrepancies between the fix and the continuous market prices can cause issues in the settlement of contracts, the valuation of positions and the ability for market participants to manage their pin risk.   

Mitigating PIN Risk with Continuous Price Visibility   

One of the critical challenges in FX option expiries is managing pin risk, which arises when the market price hovers around the strike price as options approach expiration. This proximity can create significant uncertainty for market participants, leading to adverse outcomes and disputes, especially in automated exercise processes. The NCFX Options Cut is specifically designed to address this issue by providing a continuous, transparent stream of mid-rate prices leading up to the cut. This continuous visibility allows participants to accurately assess market conditions as the expiration time approaches, significantly reducing the ambiguity associated with pin risk.   

NCFX ensures that market participants can see the actual prices leading into the cut. This transparency is crucial because it allows for an accurate and fair reflection of market conditions at the critical moment of expiry. Crucially, it enables option writers to hedge against the option based on observing the price formation.  

Additionally, while the input prices are visible in many benchmark processes, NCFX’s point-in-time snapshot provides a simple and transparent method, making attempted manipulation apparent. In contrast, benchmarks like TWAP, which aggregate prices over time, can obscure subtle manipulative actions, as the effect of price impacts are averaged out over the calculation window. 

Comparison with Alternative Benchmarking Methods   

The NCFX methodology stands in contrast to other widely used benchmarks such as the TWAP or Median approach, which aggregate prices over a period or range. Marsh, Panagiotis and Payne[4] studied the impact of the WMR fix, which uses a combined TWAP and Median approach, on the currency market. Their work looked at price impact during the fixing window. They found the benchmark methodology can favour price makers over price takers. Oomen and Muhle-Karbe[5] expand on that research to evaluate fixing methodologies with a focus on the trade-off between price impact and ability to hedge. They conclude that the length of time over which the fixing process takes place determines whether price takers or price makers are favoured by the fixing process. A longer window makes it harder for price makers to hedge but reduces market impact. Duffie and Dworczak[6] seek to propose a fairer process based on VWAP. Each of these approaches have notable limitations in the context of FX option expiries:   

• TWAP (Time-Weighted Average Price): While TWAP is simple to calculate and offers a straightforward time-based average, it is susceptible to sampling bias. This bias can occur if significant price movements happen between the sampling points, leading to a benchmark that may not fully capture the market’s dynamics. Additionally, the sampling schedule offers an opportunity for stealthy manipulation, making it harder to spot bad behaviour.   
• Median Pricing: Median benchmarks, while less prone to being skewed by outliers, do not account for the sequence of prices. This can be problematic in FX markets where the order of trades can significantly impact the true market-clearing rate at a moment in time.   
• VWAP (Volume-Weighted Average Price): VWAP is often used for its ability to reflect the average price of trades weighted by volume, but it suffers from a lack of transparency. Since the volume data is not publicly available, VWAP can be difficult for participants to verify, and it is potentially open to manipulation, especially in low-liquidity environments where a few large trades can disproportionately affect the outcome. Crucially, VWAP and TWAP can present the opportunity for stealth manipulation.   

In contrast, the NCFX Options Cut provides a robust and transparent benchmark by capturing a broad and anonymous set of market data at high frequency, thereby reducing the risks of both manipulation and misrepresentation of market conditions.   

Ensuring Fairness and Accuracy in FX Option Expiries   

The growing adoption of the NCFX Options Cut rates by leading option market participants, including LSEG, Digital Vega and SpectrAxe underscores the industry’s recognition of the need for a transparent and fair benchmark. By providing a continuous stream of observable prices and mitigating the risks associated with pin risk and market manipulation, NCFX ensures that the clearing and determination of FX option expiries are handled with the highest degree of accuracy and fairness.   

This paper argues that the NCFX mid-rate benchmark, with its independent, high-frequency aggregation of market data, offers a superior alternative to existing benchmarks. By addressing the critical challenges of pin risk and the need for transparency, NCFX helps to safeguard the integrity of the FX market, ensuring that all participants can rely on a fair and accurate reflection of market conditions at the time of options expiry.   

[1] NCFX Family of Mid-Rate benchmarks are FCA registered benchmarks   

[2] see Duffie, Dworzak and Zhu, “Benchmarks in Search Markets”, 2017 for a full discussion of the role of benchmarks in OTC markets.  

[3] https://www.reuters.com/article/business/the-fx-fixing-scandal-idUSL6N0M71KO/   

[4] Marsh, Panagiotis and Payne, “WMR fix and its impact on currency markets”, 2017. They propose a very narrow interpretation of price impact. We prefer Perold’s definition of market impact which measures price movements between the arrival price when an order is externalized to the market and the price received by the client. Price takers must leave their orders with the dealers many minutes before the beginning of the fixing window, giving dealers ample time to pre-hedge the client order. The client arrival price will look very different to the dealer’s arrival price.  

[5] Oomen and Muhle-Karbe, “A comparison of FX Fixing methodologies”, 2024. The authors seek to shed light on which methodologies will favour price makers (shorter fixing windows) or favor price takers with lower market impact (longer fixing windows) The find that the SIREN benchmark offered the lowest market impact costs.  

[6] Duffie, Dworczak, “Robust Benchmark Processes”, 2018.  

Digital Vega Quote:   

"Digital Vega has been using the New Change options cut to feed its proprietary auto-expiry service for more than 3 years. Since launch, we have never had an issue with the feed and on busy days we can seamlessly process more than 400 expiries in seconds. 

Active clients and liquidity providers increasingly appreciate how much this service reduces both operational risk and costs replacing a cumbersome and dated process."  

- Mark Suter, CEO Digital Vega. 

Find out how NCFX together with our strategic partners can support your FX Option business by contacting the team at info@newchangefx.com.