Galen Stops takes a look at whether the predictions of FX moving towards a centrally cleared model might finally be coming true.
Central clearing for FX has endured a number of false dawns in recent years. As long ago as 2011, Profit & Loss published an article, “FX Clearing – Are You Ready?” in which it was argued that Dodd-Frank was likely to drive FX options and NDFs products into clearing.
Then back in the first quarter 2014, staff at the US Commodity Futures Trading Commission (CFTC) indicated that the guidelines for the mandatory clearing of FX derivatives products, which included NDFs could be finalised within weeks. Indeed, Profit & Loss reported in mid-June 2014 that the CFTC was poised to fire the starting gun for mandatory FX clearing.
The mandate never came, of course, but in October 2014 it suddenly looked like the European regulators might overtake their US counterparts as the European Securities and Markets Authority (ESMA) issued a consultation paper on a potential clearing mandate for NDF products.
However, in February 2015 ESMA announced that it would not be implementing a clearing mandate for FX products, while staff at the CFTC made it clear that such a mandate was far from the top of the commission’s regulatory agenda. Since then, the idea of a clearing mandate for FX has basically fallen off the agenda completely for both sets of regulators.
“Given that there is currenty no mandate in Europe, we went back to first principles and asked ourselves what the way forward would look like,” says Edward Hughes, COO of ForexClear, the FX clearing service that was established by LCH in 2012.
In answering this question Hughes and the team at ForexClear looked ahead at the capital requirements that were due to be introduced under the Basel III regulation and the new uncleared margin rules and decided that these regulations would eventually achieve what the regulators had declined to do, namely push more FX activity into central clearing.
This trend is already visible on the dealer-to-dealer (D2D) side, with Clarus FT estimating in June that 35% of the D2D NDF market is now cleared, and that 14% of the overall global NDF market is cleared. This is a dramatic shift considering that only about 5% of the D2D NDF market was being centrally cleared in June 2016.
Data from Clarus FT also shows that cleared NDF volumes hit a record high in March 2017, with nearly $500 billion being cleared across the three CCPs that month. Open interest in cleared NDFs, meanwhile, has been hovering at just over $600 billion per month since March.
Client Clearing on the Way?
Hughes sees potential for more of the D2D NDF market to move towards central clearing, noting that the next phase of implementation for the uncleared margin rules comes into effect in September and that ForexClear is in discussions with a number of the entities impacted by this phase about bringing their NDF flows into the clearing house.
“The dealer side is pretty well established, but although we built out the capability for client clearing some time ago, it’s only recently that we have started to see more serious interest and take up from end users,” he says. One factor that is causing more buy side firms to consider central clearing for FX products is the fact that they will also become subject to the uncleared margin rules for derivatives in 2019 and 2020. Hughes explains that this will push buy side firms towards central clearing because it can provide operational efficiencies.
“When you’re posting margin against a number of different counterparties you’ve got the challenge of calculating what the margin is, exchanging it and managing disputes. This isn’t really a value-add process, so if you can put all that business through central clearing and end up facing a single counterparty, then it’s a lot more efficient,” he says.
In addition to NDFs, firms are increasingly looking at clearing OTC FX options in a bid to mitigate the impact of the regulatory requirements on their trading revenues.
“From our discussions with market participants, one of the biggest pain points for banks is FX deltas and FX options, and so we believe that there is a cost incentive to clear in order to optimise and manage uncleared margin exposures and capital costs. Many of the Basel III capital costs – such as the leverage ratio, the liquidity coverage ratio and the net stable funding ratio – are all materially reduced by clearing,” says Paul Houston, global head of FX products at CME Group.
This is why both CME and ForexClear have plans to launch clearing for OTC FX options in Q4 of this year, although each are taking a different approach with their respective services.
LCH announced in the summer of 2015 that it had partnered with CLS to launch a clearing service for deliverable FX products, including FX options. The way this partnership is due to work is when an options trade comes in, ForexClear goes through its normal risk management procedures, actively monitoring and managing the settlement risk throughout the whole lifecycle of that trade.
As the option reaches maturity, the option buyer decides where or not to exercise the trade, and if exercised, the resulting cashflows are better and settled via CLS. To settle these trades, CLS will run a CCP-dedicated settlement session in addition to the one that it already runs for spot, forwards and swaps.
“There’s a lot of moving parts that you have to get right with FX options,” says Hughes. “Putting a non-linear product into clearing is not simple and there needs to be a sufficient degree of standardisation to make clearing possible, while we also need to offer a model that retains the characteristics that our members and clients expect from an OTC product.”
In contrast, the CME plans to offer a cash settled model for clearing OTC FX options after gaining regulatory approval from the CFTC to do so in June. Houston explains that this model reduces considerably the cost of delivering a service for a product that, for the majority, doesn’t necessarily need to be deliverable.
“If a CCP offers FX clearing on a deliverable basis then it is required to ensure that all the transactions are settled and that they’re settled in the currency that they’re traded in,” he says. “This poses quite a big challenge because it means that the CCP has to have a swap line guarantee for any liquidity shortfall in the event that a default has to be met, and those swap lines can be very expensive.
“The cost of the swap lines needed to accommodate the default of the two largest FX market participants trading FX options is potentially huge, and this cost would have to be passed down to the clearing members, potentially negating the economic benefits of clearing,” Houston continues. “So when we considered the cost of the swap lines needed to support the clearing of OTC FX options, and the fact that market participants don’t usually trade these options for delivery, we decided that it was best to offer a cash settled FX options solution.”
When it comes to clearing, the CME emphasises additional cost savings and efficiencies it can offer by having one base guarantee fund that applies across all the cleared products it offers, both on the futures and the OTC FX side.
“This gives market participants a lot more efficiencies than if you have a standalone fund for each product. It means that, in terms of default fund contributions, you can almost get your FX clearing for free when it’s in a diversified fund,” says Houston.
Even if these OTC FX options services prove to be an instant hit, FX clearing is likely to remain peripheral to the overall FX market. According to data from the Bank for International Settlements (BIS). FX options and NDFs only accounted for $254 billion and $134 billion, respectively, of the overall $5.1 trillion per day global FX market in 2016, BIS shows.
Scratching the Surface
This is why Hughes insists that ForexClear has “only just started to scratch the surface” when it comes to FX clearing.
As a result, ForexClear has plans to launch G10 NDFs in the near future, subject to regulatory approval. Hughes concedes that this is hardly a large market at the moment, but claims that the firm has had “reasonable” interest from both existing members and new ones that are in the process of onboarding.
“There are a number of different use cases for G10 NDFs and in the short term, we expect to see members driving efficiencies by moving FX delta that is subject to bilateral margining into clearing,” he adds. “Longer term, we may see some interest from market participants who would like exposure to the offering, but who don’t need delivery.”
The products will clear in much the same way as the EM NDFs that ForexClear already offers, meaning that the build out for these G10 NDF products will be a relatively light one for the clearing house.
But the real prize for clearing houses when it comes to FX could be the swaps and forwards markets, which represented 2.4 trillion and $556 billion, respectively, over the overall $5.1 trillion market. The logic from a clearing house perspective is that, once firms start putting NDFs and FX options into central clearing, they could realise additional efficiencies and margining benefits by putting these other products into clearing as well.
Houston appears somewhat bearish about the prospect of this happening though, noting that the size of these markets would mean that the cost of the swap lines needed to support them would dwarf any potential benefits that clearing could provide.
By contrast, Hughes is more positive, claiming that because ForexClear has deliverable forward and spot included as hedges as part of its planned options clearing service, it wouldn’t be too complex a proposition for the firm to offer deliverable forwards.
“You have slightly different challenges with forwards as you have to be able to manage larger operational scale and liquidity provisions need to be signficantly higher than for options,” he notes.
Is Spot FX Clearing Viable?
When discussing the future of FX clearing, the concept of cleared spot is often raised as a hypothetical. One reason why cleared spot FX is a particularly interesting concept is because of the implications it would have on the overall structure of the FX market.
If spot did ever shift to a centrally cleared model, then it would enable a much wider selection of market participants to face each other directly, the most obvious beneficiaries of this would perhaps be the non-bank market makers that would no longer be reliant on FX prime brokers (FXPBs) and could trade with counterparties that they are unable to face today. This in turn could lead to the more all-to-all trading model that exists in exchange traded environments.
“I think that the concept of voluntarily clearing spot FX is out there, but the cost has to come down,” says a senior figure at one firm offering prime-of-prime services. “I know that some of the non-banks are keen on the idea because some of these firms have prime relationships with nearly all of the tier one banks and that’s not collaterally efficient. If they can clear through a CCP, that would alleviate some of those problems but, as I said, the costs need to come down.”
Many other market participants are skeptical that there is enough demand right now for spot FX clearing though. One senior industry source claims that there is interest in spot FX clearing, but adds that they’re uncertain that there’s any immediate need for it. “From a risk management point of view it doesn’t seem to be the obvious place to start because you’ve only got short-term exposures, the current system is understood and works pretty well and the infrastructure to support it has been in place for a long time,” they say.
Meanwhile, Houston comments: “There may be a need for new credit structures and new ways to facilitate credit and manage risk, but I don’t think there’s a need for spot FX to move into clearing in a traditional sense.”
Talk of central clearing for swaps, forwards and spot FX is perhaps premature considering that NDF clearing is only now beginning to gain traction and OTC FX options clearing has not yet begun. If recent history is any indication of what to expect in the future, then the shift towards central clearing in FX is likely to be a slow one.
“I think we’ll see a gradual shift to central clearing, where it makes sense,” says Houston. “The OTC market will continue to operate bilaterally, but where there are cost benefits for clearing we’ll see a gradual shift towards this model.”
Similarly, a senior figure at one major bank predicts: “Some parts of the portfolio that are standardised and liquid that are attracting charges under the new regulations will lend themselves to a cleared model. So I think once the clearing houses have rolled out their capabilities for deliverable FX, some parts of the portfolio will move to a cleared model, but I don’t see a wholesale lock-step move towards clearing.”
Now that economics rather than regulators are driving firms towards central clearing for FX options and NDFs, it seems unlikely that this is another false start. There is little or no evidence to suggest that the current upward trend of cleared NDF volumes will reverse, while the fact that LCH and CME plan to offer different methodologies for clearing FX options could be beneficial by providing market participants with a choice about which model they think will be the best for their business operations.
Maybe, just maybe, certain segments of the FX market are finally set to move into a centrally cleared environment. Are you ready?