Clearing of FX options looks set to begin later this year, marking the next phase in the industry’s journey to manage post-trade risk.
Post-trade processing may not be the most glamorous area of finance, focusing as it must on resilience, risk management and scalability, with little of the drama of return generation that characterises the front office. But the post-trade space in foreign exchange is going through a renaissance of sorts, much of it driven by industry-led initiatives rather than the direct force of regulatory mandates.
In the past year alone, some of the most notable developments include the addition of the Hungarian forint to the CLS settlement system, the development of a clearing service for physically delivered FX options and the launch of a compression service for FX forwards and swaps. These are important steps forward for an industry that has long recognised settlement risk – the possibility that a counterparty might fail to deliver – as the most significant threat, but is now beginning to tackle other risks as well.
“There has been a recognition in recent years that counterparty risk needs to be managed as well as settlement risk, and that can be done in a number of ways, including clearing, compression or bilateral arrangements,” says David Puth, chief executive of CLS. “It is positive that the market has chosen to do this voluntarily at first, rather than being driven solely by regulators.”
Regulators appear to have deliberately held back from regulating FX at the same speed as interest rate and credit derivatives. Following the US Treasury’s decision in 2012 to exempt FX swaps and forwards from mandatory clearing and trading on electronic platforms under the Dodd-Frank Act, participants began to prepare for an expected clearing mandate for non- deliverable forwards (NDFs) and FX options. But both US and European regulators have consulted with the industry and decided not to proceed for the time being.
A number of reasons have been given, including the fact that only one clearinghouse – LCH.Clearnet – is currently authorised to clear NDFs in Europe and not enough of the market is being cleared voluntarily to give confidence that a mandate could be imposed without causing any disruption. The delays in finalising the recast Markets in Financial Instruments Directive (MiFID II) have also played a part, as it is MiFID II that will introduce equivalent platforms to US Swap Execution Facilities (SEFs).
“We may see clearing mandates for FX products in the future, but as we’ve seen in rates and credit, you need to have the systems and procedures in place and have a level of voluntary clearing taking place before any mandate makes sense,” says James Kemp, managing director of the global FX division of the Global Financial Markets Association (GFMA). “In the US, a clearing mandate would trigger an SEF trading mandate as well, which could bifurcate market liquidity if it happens before MiFID II comes into force – that is in no one’s interest.”
In spite of the decision to hold off on a mandate on both sides of the Atlantic, some level of voluntary clearing is already taking place. Since its launch in 2012, LCH.Clearnet’s ForexClear service has expanded to clear NDFs in 12 currencies and it cleared an average of 8,514 trades per month in 2015. Although it is difficult to estimate the current percentage of global NDF trading being cleared, it is likely at this stage to be only a small proportion of the estimated $127 billion daily turnover.
Demand for clearing on a voluntary basis in the future may be driven not just by the need to be prepared for an eventual mandate, but also by the economic incentives for clearing that will be introduced by separate regulations. Basel III, for example, will introduce higher capital requirements for derivatives not cleared through a central counterparty (CCP), while margin requirements for non-centrally cleared derivatives will be phased in from September 2016.
Despite the costs and resources needed by buy-side and sell-side firms to access a CCP, capital and margin requirements could ultimately make central clearing cheaper than taking a bilateral exposure to a counterparty.
“Under the forthcoming capital rules, we expect clearing to be the most cost-efficient option because it allows market participants to manage their counterparty risk through a single relationship with a CCP,” says Edward Hughes, chief operating officer of ForexClear at LCH.Clearnet. “Initial margin requirements for non-cleared NDFs and options will be introduced in September, followed by variation margin requirements for swaps and forwards in March 2017, and we expect clearing to gradually become more widely adopted in line with these.”
Many practitioners believe such economic incentives offer a more natural way for the market to adapt to clearing, rather than using a mandate as a blunt instrument to force clearing before the market is operationally ready. A similar approach is likely to be taken to the use of electronic platforms in Europe, as MiFID II will include incentives to use such platforms.
“There are subtle reasons why trading will migrate to regulated platforms under MiFID II, such as the fact that if you trade on a multilateral trading facility, you discharge the trade reporting obligation to the platform,” says Jodi Burns, global head of regulation and post-trade at Thomson Reuters. “The same is true of clearing – the easier and more attractive it is made to use regulated platforms and CCPs, the more likely it is that volume will migrate.”
The expansion of the ForexClear service to FX options, expected later this year, will be a seminal development for the industry as it follows extensive work to find an appropriate clearing mechanism for deliverable FX instruments. Unlike NDFs, interest rate swaps and credit default swaps, FX options, swaps and forwards are physically settled, creating a much bigger challenge for CCPs.
According to principles issued by the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions, CCPs must ensure clear and certain final settlement, which would require them to have large volumes of liquid assets on hand in the event of a default.
Following detailed analysis led by the GFMA on the potential liquidity shortfall CCPs would need to manage, and dialogue with market participants and central bankers, LCH. Clearnet partnered with CLS last year to deliver a clearing platform for FX options. CLS will create a new settlement session for LCH to settle its cleared FX options activity separately from the core system.
“The market is now much more familiar with clearing than it was five years ago,” says Hughes. “The infra- structure has been built to support clearing, the liquidity analysis has been done and the service for clearing and settling FX options is being developed with CLS. With these three elements in place, the industry is moving towards a robust solution.”
Beyond the expansion of clearing, the introduction of a compression service for FX swaps and forwards has also been heralded as an important development in reducing operational and credit risk as well as enhancing capital efficiency. Launched by CLS and post-trade technology vendor TriOptima in October 2015, the new triReduce service allows non-cleared FX products to benefit from compression, while LCH. Clearnet plans to offer compression as part of its clearing service for FX options.
“The compression project was one of the biggest breakthroughs we have made in recent years because by reducing the gross notional value of FX portfolios without changing the underlying position, it creates a clear path for market participants to reduce their risk as well as their costs,” says Puth.
Adding currencies to CLS also remains a top priority across the industry. While the addition of the Hungarian forint in November 2015 marked a major milestone as the first currency to be added to the system since 2008, the fact that fast-growing currencies such as Chinese renminbi and the Russian ruble are not yet settled in CLS represents a considerable source of risk.
CLS is committed to expanding its currency coverage and is in active dialogue with authorities in both China and Turkey, but positive moves forward in Russia were stalled in 2014 after international sanctions were imposed against the country. To settle through CLS, any prospective currency must meet a series of strict eligibility criteria, including convertibility and finality of settlement, which can require changes to a country’s legal framework that take time to effect.
“There is no question that CLS could play a role in the further internationalisation of renminbi, and when the Chinese government is ready to take the next step, we are ready to work with them towards the launch of the currency on the CLS network,” says Puth. “After ensuring the resilience of our service, the addition of new currencies and participants is our top priority.”
Bitcoin to blockchain
Considering the scepticism with which digital currency bitcoin has been treated since it was unveiled by the mysterious Satoshi Nakamoto in 2009, it is perhaps ironic that the technology that underpins it is now the subject of frenzied investment across the financial services industry.
The so-called blockchain is an encrypted public ledger that maintains a decentralised record of transactions. Over the past year, the concept of a distributed ledger has sparked a number of industry initiatives designed to bring together market participants to consider and test possible use cases.
“The potential applications of distributed ledger technology are endless. Ultimately, blockchain will allow for the distribution, verification and record-keeping of transaction information more effectively and quickly in a decentralised manner, leading to both cost-saving and time-saving efficiencies,” says David Rutter, chief executive of R3, a bank-backed financial innovation firm that has been testing block-chain technologies.
But while the momentum behind blockchain gathers pace, some FX industry practitioners are more cautious, suggesting that while the technology could yield significant efficiencies, there is a need to tread carefully when dealing with a global payment system.
“Blockchain is clearly a very smart piece of technology but I don’t think it is as simple as some people think, particularly if you imagine the entire FX market being operated and settled on a single system, and the risks that would entail,” warns one industry veteran.