CFTC Poised to Fire the Starting Gun for Mandatory FX Clearing

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1 ISSN: P&L Services Ltd. All Rights Reserved. This article first appeared in: Profit & Loss Magazine, June 2014 issue 152 vol. 15 CFTC Poised to Fire the Starting Gun for Mandatory FX Clearing With guidelines on the mandatory clearing of NDFs and FX options expected by US regulators any day now, Galen Stops looks at some of the challenges of clearing OTC FX. The foreign exchange market emerged largely unscathed from the 2008 financial crisis and this, combined with the fact that these markets were ringfenced, meant that they have avoided the vast majority of the regulations being introduced to the financial markets. Non-deliverable forwards (NDFs) and FX options were included in the Dodd-Frank rules though, and as such these products must be traded on Swap Execution Facilities (SEFs). But firms won t trade FX on these venues until they are mandated to do so, and this can t happen until these products can be centrally cleared by a CCP. This has led to a scramble by regulators and clearing houses to come up with a viable method to centrally clear NDFs and OTC FX options. But despite their best efforts, the timeline for mandated clearing of these FX products remains unclear. In March the Commodity Futures Trading Commission s (CFTC) Scott O Malia was widely quoted by media outlets as stating that the guidelines for the mandatory clearing of FX derivatives contracts were in the final drafting stages and would probably be published in the second quarter of the year. However, at the beginning of May, he said that CFTC staff were still finalising the rules. I understand that the workflow to achieve clearing and straight-through-processing for NDFs is more complicated than for interest rate and credit default swaps, so I hope that Commission staff highlights these issues in its future proposal. It is also important to note that NDF participants should prepare for a quick transition to mandatory SEF trading after the clearing requirement takes effect because the Commission does not have much say in made available-to-trade determinations, said O Malia. At the time of writing the guidelines had still not been published, but even when they are it will take time for them to be adopted. First, the CFTC must gather comments on the proposed rules from the industry before they publish the final clearing determinations. New Commissioners Perhaps more significantly, the CFTC is also waiting for three new Commissioners to be confirmed, including the new chair of the agency. The starting date for clearing FX will largely be driven by the confirmation of the new commissioners at the CFTC. Once they i

2 are in place, we expect a renewed focus on this issue, says Mark Gonzalez, head of OTC clearing sales Americas at Newedge. On 8 April, the Senate Agricultural Committee approved the nominations of Timothy Massad, Sharon Bowen and Christopher Giancarlo to become the new CFTC commissioners. Next, the full US Senate must vote to confirm the nominees. The new commissioners have the ability to change the discussions around clearing FX products and currently represent a big unknown for the industry. In particular it will be interesting to see what angle Massad selected by President Barack Obama to head up the CFTC will take on this issue. Little seems to be known about Massad considering he is being appointed to such a high profile role, but it has been suggested that because he is coming from the US Treasury, which has traditionally been the regulatory body that focuses on FX, he will have strong opinions on how this market should be regulated. Overall, the general consensus in the market appears to be that a mandate to clear NDF products will be implemented some time between the end of the third quarter this year and the end of the first quarter next year. The next big question is: within NDFs, which currencies will be mandated to clear? Again, this isn t known for certain but it is rumoured that the overlap in offerings between CME Clearing and LCH Clearnet US will be the ones set for clearing. This remains an issue that is up for debate though, and is one of the factors that could be significantly influenced by the new commissioners. It is important to note that the hotly anticipated guidance on FX clearing will only cover NDF products. For now, the clearing of OTC FX options remains too complicated for the Commission to be able to publish any kind of definitive guidance. Estimations for mandatory clearing of these products are less optimistic, with predictions from market participants ranging from the back end of 2015 to never. The Economics of NDF Clearing One of the reasons why there was debate over whether FX products would be included for clearing was that FX contracts tend to be short-dated with less leverage and therefore less counterparty risk, compared to products such as credit or rates. However, the short-term nature of the contracts could make clearing them uneconomical, says Kevin McPartland, head of Greenwich Associates market structure and technology advisory service. The problem with FX options and NDFs is that the margin rates that the clearing house would have to set would have to be so high that they could completely change the economics of products and force people to look elsewhere, he claims. In a report published at the beginning of the year, McPartland noted: Iosco proposed 6% initial margin for uncleared FX trades. This compared to 1% for Rates trades less than two years, and 2% for credit trades less than two years. Assuming cleared swap trades are margined at about half of the uncleared rate, NDFs would face initial margin requirements of 3-4%. That is a considerable sum for trades with durations likely less than six months. This new margin requirement will obviously have an impact on firms trading strategies, forcing them to re-think how they use these products. Not everyone agrees with this assessment that NDFs will become too expensive to be economical, and the clearing houses claim that the new regulations could actually drive more firms to use NDFs. Sofiane Saidi, head of ForexClear products in the US, LCH Clearnet, says that clearing FX NDFs can pose fewer challenges compared to other asset classes mandated to clear under the Dodd-Frank rules. According to Saidi, NDFs are more standardised; there is just one flow on one date as NDFs cash settle in a single currency, ie, USD, so the characteristics of the product are similar to futures. In contrast, interest rate swaps contracts are more OTC with numerous different flows involved. Additionally, the electronic nature of the FX market makes it susceptible to central clearing, according to Saidi. He points to existing middleware providers that are similar to SEFs that could make the move to central clearing easier. New Capital Requirements Perhaps more significant from a clearing perspective are the Basel III capital requirements. As a result of the new capital rules, banks are looking for solutions like NDFs because they deliver the settlement amount, not the large notional amount. This means a lower capital charge, which could incentivise banks to clear more, says Saidi. Deliotte recently estimated that the additional costs incurred for trading a centrally cleared OTC derivative will be per I June 2014 ii

3 1 million notional amount traded. It also calculated the cost for OTC derivatives transactions that will not need to be centrally cleared and put this figure at an additional per 1 million traded. David Holcombe, head of FX product at Nasdaq OMX, says that the capital requirements, certainly those being proposed in Europe, mean that the clearing mandates are not at the forefront of people s minds. Currently, less people are focused on the clearing mandates because the CRD impact of keeping OTC positions bilateral is such that they re going to have to clear non-mandated products as well. The common question we hear is about the breadth of FX products that we are planning to offer for clearing, he says. There s a lot of FX businesses around the world looking for where new revenue streams are going to come from and how to protect these revenue streams using tools that an organisation such as Nasdaq OMX can provide. Roles and relationships within the FX industry are also evolving. Increasingly, banks aim to serve client relationships with risk pricing and more of an agency model in certain cases. The objective is to better use capital and better use credit lines. Responding to the suggestion that clearing NDFs might be too expensive, Saidi points out that firms are already clearing these products. Many within the buy side community have already made the transition and are clearing NDFs with their prime brokers. Clearing of FX exists already, the problem rests in defining the best framework to better mitigate the credit risk of such activity, ie, do you let that happen within the prime broker world or the CCP world? For instance prime brokers don t have the concept of a Guarantee Fund like CCPs, which can be an issue given the big tail risk existing in the EM NDF markets. Another potential problem that has been highlighted with regards to centrally clearing NDF products is their liquidity. A clearing house can only clear very liquid products, leading some market participants to question if clearing is necessary or possible for NDFs. Although not as liquid as a contract like EUR/USD, currencies in the BRIC economies and emerging markets such as Indonesia and Korea can offer significant liquidity. Correlated Markets What does liquidity mean for a clearing house? If any of its members default, then liquidity is its ability to liquidate that position within the liquidation time that they have. CCPs argue that firms will probably clear NDFs even if they are not mandated in order to maximise their margin offsets at the clearing house. For example, even if the CFTC mandates that the BRIC currencies be cleared, firms will likely clear other positions as well because bifurcating their books between cleared and uncleared will prove more expensive than putting all of their positions in one place where they can benefit from higher margin offsets. Just 10 years ago such margin offsets would not have been possible because there was not the same level of correlation between different markets. Saidi says that looking back over the past 20 years there has been a noticeable increase in correlations between emerging market countries, but big market events have accelerated this trend. These countries are also trading within themselves more than ever before, further driving up correlations. The often higher correlations in emerging market countries means that there can be more credit risk which makes the argument for clearing even stronger. Central clearing also provides a beneficial framework that enables participants to have all their positions within a single clearing house which provides for better margin offsets, he adds Options Remain Problematic When it comes to clearing FX options, however, things are slightly more complicated. I think everyone understands what NDF clearing is going to look like. With regards to options it s much more complex and it s a grey area because we don t know how the CCPs, the limit hubs and the SEFs are going to handle them. There are many more variables in play, says Gonzalez. Part of the problem in clearing FX options is the complexity involved in valuing the products themselves. They re customisable and I think that options are, almost by definition, mark-to-model, so there s always a little bit of educated guesswork involved in valuing them. Any product where you have a mark-to-model in a clearing house opens up risk which means that they need to set the margin rates much higher, says McPartland. Again, this could make such products too expensive to clear, if the CPPs were even willing to offer clearing services for a product that they couldn t accurately value. The customisable nature of options is not an insurmountable problem though. The real problem in clearing FX options lies in the settlement of these contracts. Namely, that no one currently knows how to do it. A joint paper published by Iosco and the Bank for International Settlements (BIS) in 2012 states that clearing houses should provide clear and certain settlement instructions for all cleared trades. FX options have underlying hedges that are forwards and spots and so to clear a hedged portfolio the clearing houses must also clear the underlying forwards and spot trades and they must also guarantee the trade from execution to maturity. This means that they must guarantee that the trade will complete final settlement. It s not the complexity of the products, it is the issue of how final settlement can be guaranteed that still needs to be addressed, says Saidi. FX options are settled in the underlying currency, so in order to provide this service clearing houses would need to have vast amounts of numerous different currencies immediately available in any stress scenario. When discussing the clearing of FX options, it is European-type options rather than American being referred to. American style options can be exercised at any point in time and Source: GFMA therefore it is very tricky for a CCP to iii

4 The often higher correlations in emerging market countries means there can be more credit risk, which makes the argument for clearing even stronger forecast settlement obligations on these products. Fortunately, European-style options represent 95% of the vanilla market. Significant Liquidity Shortfall In November 2013 the Global Financial Markets Association (GFMA) FX Division released the results of a year-long study, which aimed to quantify exactly how big this settlement problem is for CCPs. Results from the analysis indicate that, based on historical OTC FX options traded globally and exercised, the size of the same day liquidity shortfall which the CCPs must demonstrate they are capable of managing could have been as high as $161 billion in total, across 17 currencies, concludes the report. It also noted that this figure of $161 billion was reached using a gross settlement mechanism and that it could potentially be reduced by nearly 75% to $44 billion if a net settlement mechanism was used instead. CLS currently processes payments on a gross basis, so if CCPs were to plug-and-play into the CLS settlement mechanism as things currently stand then if there was a default of its two largest clearing firms the first figure would represent the liquidity risk shortfall, according to the GFMA. So a natural first step that the industry could potentially explore to make the problem more manageable is to figure out how it and CLS could, for example, operationally, legally and from a risk perspective evolve into a net settlement mechanism for cleared FX, suggests Mandy Lam, managing director, North America for GFMA Global FX Division. But one risk management professional that Profit & Loss spoke to was not impressed with GFMA s study and suggested that the figures that it produced might be misleading. I ve looked at the way that they ve calculated the numbers and the problem is that they ve used CLS methodology, which is no good because it means that they re mixing bananas and apples, they claim. According to this source, in normal risk management practice firms calculate worst case scenarios in currencies over a set look-back period, but using the same currencies on the same days. What they did was they took the worst case scenario for the euro which happened, say, June 2011 and they took the worst case scenario of the dollar which happened in 2003, the worst case for GBP, etc. There s no risk management house in the market which is going to support that, they add. The source also says that the GFMA numbers were calculated using naked options, but that firms using options are usually hedging their book and if the underlying hedge is incorporated then the risk might be further reduced. There is definitely a liquidity shortfall for CCPs settling at present, according to this person, but they estimate the figure to be closer to $10-12 billion. No Immediate Solution Lam explains why the GFMA used this CLS-style methodology. What s important to appreciate in the context of liquidity risk is the assumption that there s sufficient value in the clearing system to ensure that they can make nondefaulting clearing members financially whole at the end of the day, but not necessarily in the currency non-defaulting clearing firms want and when they want it that is the heart of the problem, she says. The non-defaulting clearing firms don t want a currency other than the one they contracted for. So while the CCP is working on the assumption that there s always going to be sufficient value in the CCP for example, whether it s US dollar or US Treasuries collateral to provide restitution to the nondefaulting member, it has to be capable of demonstrating that it can convert that collateral into the currency that the nondefaulting member was expecting to receive. While CLS does not guarantee settlement, it does provide a high degree of confidence that its non-defaulting members will receive the currencies that they re expecting to receive. But as Lam notes, CLS does also create liquidity risk shortfall, due to the short positions that CLS extends to its participants. In the case of a payment system such as CLS, there is also a risk of same-day liquidity shortfalls due to its design. The risk of same-day liquidity shortfalls exists in CLS because of the short positions in each currency CLS extends to its member banks. Each is offset by long positions in one or more other currencies to mitigate the credit risk associated with the extension of the short positions, but this in turn creates market risk. The market risk is then mitigated by currency volatility haircuts applied to each of the long and short currency positions. These are quite thick upwards of 40% currency haircuts on a bilateral basis. But the residual risk that now remains is liquidity risk. Even if CLS has sufficient value in offsetting currencies, it doesn t necessarily have it in the currency or currencies that the defaulting settling member was supposed to pay in. To address that liquidity shortfall, CLS has committed liquidity facilities in each of the currencies it settles, and uses a combination of limits and risk management tests to ensure it can provide a high degree of confidence to its members that they will get the currencies they want, for all payments settled by CLS, even if the largest member has defaulted, explains Lam. So for the time being there is no obvious solution as to how to effectively settle FX options contracts, nor is one likely to present itself in the immediate future. CLS/CCP Linkage on the Cards? With this in mind, what is the next step for the industry in regards to clearing FX products? As noted earlier, when it comes to clearing NDFs it is now largely a waiting game for market participants. Nothing can realistically move forward until the CFTC issues its guidance while the confirmation of the new Commissioners could impact the content and tone of the final rules. Options remain more complex and the industry will need to work collaborate to find a solution. McPartland suggests that if firms wanted to be creative then they could look to develop new products or options alternatives. For example, there could be non-deliverable options which could settle in US dollars or euros, but then not deliver the underlying currency. According to the Greenwich report, the move to central clearing is likely to encourage more firms to trade futures instead or lead to the futurisation of OTC FX products. The big winners are obviously the exchanges as the report notes that: A conservative 5% move out of OTC FX derivatives I June 2014 iv

5 into futures would cause futures volumes to grow by over 50% a huge boon for futures exchanges. Profit & Loss understands that while at least one major CCP has had advanced conversations with individual firms about offering deliverable FX settlement that does not use CLS, the reality is that some agreement must be reached between the settlement and clearing utilities. Currently, it looks like the clearing of deliverable OTC FX options will require the industry to utilise CLS, says Holcombe. How exactly this will work is another complex issue. The Iosco/BIS paper states that the clearing house is responsible for settlement, but if they effectively outsource it to CLS does this fit within such a framework? This is a problem that the industry is attempting to come to terms with. The GFMA hosted a meeting at the end of April between CLS and various clearing houses to discuss this in more detail and another meeting that is set to include regulators is scheduled for June. Competition Between Utilities very shortly. The CCPs will not require a separate default fund contribution from members, which is also quite appealing, says Gonzalez. Like most market participants Gonzalez expects a phased roll-out for FX clearing and claims that regulators should try and imitate the IRS mandatory clearing roll-out. A lot of people were expecting disruptions and dislocations in the market but we didn t see it, it was very quiet and I think that it would be a good model to follow again, he says. Firms that will be required to clear must connect to the SEFs to make sure that the CCPs can accept the trades coming in from them. They must also connect to the CCPs, either indirectly through middleware providers such as MarkitServ and Traiana or through building the connectivity themselves. This is a typical buy versus build decision where it might be cheaper to build the connectivity in the long term, but the initial cost to build is prohibitive to many firms and using middleware providers is much easier. 2015: The Big Year for Mandatory OTC Clearing Any linkage between CLS and the clearing houses has the potential to be politically charged, though. Although everyone in the FX industry publicly insists that there would be no competition between CLS and the CCPs because one does settlement and the others do clearing, in private some market participants express a different opinion. The nature of how CLS works means that it solves a big portion of the counterparty risk problem in FX, even without clearing. Both sides need to pay before the money gets transferred so if one side doesn t pay the other doesn t get their money back. So its still mark-to-market and therefore it hasn t completely eliminated the counterparty exposure, but certainly limits it, says one source. Following this logic it could be argued that CLS provides an alternative to the clearing framework for certain FX products. There are also some that view CLS as being under threat from the CCPs. CLS has no intention of seeing clearing happening because this will threaten their pipeline of business, one person tells Profit & Loss. For instance, they point to buy side firms that want to trade FX products, but have no interest in going through CLS and paying the fees associated with doing so. They claim that hedge funds trading FX because there s volatility, rather than to exchange flows at the end of a trade, are an example of this. And even though this is just a buy side view, they could push their executing brokers on the banking side to just clear products. This could be exacerbated by the Basel requirements. Although the final rules pertaining to FX have not been released yet, it is conceivable that the requirements could make spot and forward transactions cheaper to clear than to settle which would put the CCPs and CLS into greater contention for flow. Phased Roll-Out Expected In terms of the buy side and the executing brokers, there shouldn t be any drastic changes required to adopt mandatory FX clearing. From our perspective it s quite manageable because we re already clearing IRS on CME and LCH, and we will be live for FX Although the US remains ahead of Europe and Asia in terms of regulatory reform, the mandatory clearing of FX products is expected to be implemented shortly after in the other regions. The industry is expecting to have a mandate for clearing in Europe in the first quarter of 2015 for NDFs, says Holcombe. A consultation paper from European Securities and Markets Authority (ESMA) on the clearing obligation is expected in mid and central clearing regulatory technical standards are due to be adopted in Q Asia is obviously much more fragmented along geopolitical regulatory and jurisdictional lines, but significant progress on clearing OTC products is also being made in many countries in the region. In Singapore, central clearing requirements are still being consulted upon, but they are expected to be effective in the second half of the year, most likely towards the end of Q4. To provide the regulatory framework for the OTC derivatives market to clear a bill was tabled before the Legislative Council in Hong Kong in July Subject to the completion of the necessary legislative process, the new regulatory regime is expected to be adopted imminently. Following a consultation period, it is then expected that mandatory clearing obligations will be phased in by different types of market participants. Like a set of dominos, the publication of the clearing guidelines by the CFTC will set off a chain reaction in the industry. The CCPs and CLS will have a greater understanding of what is required of them and will have something concrete to focus on. To help facilitate this the GFMA has organised another roundtable between the CCPs, CLS and this time some of the regulators. Once they have a clear set of guidelines these firms can begin to prepare themselves and their clients for the clearing of FX options. The preparations will then move down through the banks and FCMs to their buy side clients. For many firms they will have to conduct a re-evaluation as to how economical it will be for them to trade certain FX products. However, there is no easy solution to this problem. Post-2008 regulations aim at making the financial services markets stronger and safer for market participants. But whether it is through increased clearing fees and margins or new capital requirements, this inevitably comes at a cost for the market. CLS has no intention of seeing clearing happening because this will threaten their pipeline of business v