The post-trade space in foreign exchange (FX) is going through a renaissance of sorts, much of it driven by industry-led initiatives rather than regulation.
The FX industry has long recognized settlement risk as one of its most significant threats. But in the past year, we have seen some important steps towards tackling other risks.
Notable developments include the development of a clearing service for physically delivered FX options and the launch of a compression service for FX forwards and swaps.
“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 U.S. 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 U.S. and European regulators 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 authorized to clear NDFs in Europe.
Not enough of the market is being cleared voluntarily to give confidence that a mandate could be imposed without causing disruption.
The delays in finalizing the Markets in Financial Instruments Directive (MiFID II) have also played a part, as it is MiFID II that will introduce equivalent platforms to U.S. 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 spite of the decision to hold off on a mandate, some level of voluntary clearing is already taking place.
Demand for clearing on a voluntary basis in the future may also be driven by the economic incentives 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).
Meanwhile, margin requirements for non-centrally cleared derivatives will be phased in from September 2016.
Despite the costs and resources needed to access a CCP, capital and margin requirements could ultimately make central clearing cheaper than taking a bilateral exposure to a counterparty.
Many practitioners believe such economic incentives offer a more natural way for the market to adapt to clearing.
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.”
Room to grow
The expansion of the ForexClear service to FX options, expected later this year, will be a seminal development.
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 and dialogue led by the GFMA, 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.
Beyond the expansion of clearing, the introduction of a compression service for FX swaps and forwards has also been heralded as an important development.
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.
Adding currencies to CLS also remains a top priority.
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 are not yet settled in CLS represents a considerable source of risk.
“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.”