Bankers are still uncertain how far new clearing requirements in the EU and US will affect foreign exchange, but they are moving ahead with extending market infrastructure in any case.

The first obligations of the European Market Infrastructure Regulation (EMIR) became effective on March 15 this year. These included new rules on confirmations, the need for non-financial counterparties over the clearing threshold to notify their regulators, as well as the requirement for financial counterparties and non-financial counterparties over the clearing threshold to produce daily mark-to-market or mark-to-model valuations of their over-the-counter (OTC) derivatives positions.

Joe Halberstadt, head of foreign exchange (FX) and derivatives markets at interbank messaging group Swift, says a start in clearing FX products has been made ahead of the regulations and expects that FX clearing will take off later this year.

“There are various CCPs [central clearing counterparties] offering clearing of NDFs [non-deliverable forwards]. It is not quite yet required by regulation that you have to use those CCPs but there are a number of organisations that are connected and are putting some volume through and we are likely to see a ramp-up from the middle of this year and onwards,” he says.

Mr Halberstadt believes the big question is whether NDF clearing will remain an oddity that affects a relatively small section of the FX market or whether it will become more mainstream. The regulations in the US require that FX options should be cleared but there is no solution as to how yet. “However, even if options were to become cleared at some point in the future, that is still a small part of the FX market. It is only if we look at forwards and swaps then it becomes a very big issue and we still do not know if this is what the regulators are looking at in the long term,” he says.

But while the cash-settled NDFs and FX options are covered by both the new EU and the US regimes regulating OTC derivatives, it seems likely, unless further clarification is forthcoming, that the obligations under EMIR will apply to FX forwards and swaps. This stance differs from the US where the US Treasury exemption has carved out FX forwards and swaps from the requirements of the Dodd-Frank Act in terms of clearing and margining, although reporting and certain business conduct rules laid down in the Dodd-Frank Act will still apply.

Transatlantic rift

Chris Bates, partner at Clifford Chance, says that the exemption of swaps and forwards in the US is based on a specific provision in the Dodd-Frank Act, which gave the US Treasury the power to grant this exemption. EMIR does not include any similar power for exemptions and EU regulators do not have the power to change the definition of a derivative used in EMIR for specific purposes. This means, for example, that they cannot simply take FX forwards and swaps outside clearing and margining while maintaining the reporting requirements and the other risk mitigation rules.

However, EMIR itself contains clauses giving further guidance stating that before any decision to require clearing of a class of derivatives, it should be considered whether the real risk is settlement risk. This recognises that clearing may not be appropriate for some physically settled transactions. The UK regulator, the Financial Services Authority (FSA), has also indicated that physically settled forward FX transactions could fall outside EMIR altogether if they are entered into for commercial and not investment purposes, but it does not give any guidance as to how this distinction should be applied in practice.

“It is unfortunate that we have reached the eve of EMIR coming into effect without any helpful guidance from the European Commission or ESMA [European Securities and Markets Authority] on the application of EMIR to FX. It would be immensely valuable to have a clear statement of what is intended to be covered by these definitions, whether they agree or disagree with the FSA or have an alternative view. We can only hope that it comes soon,” says Mr Bates.

The FX industry is gearing up for clearing, with three CCPs – LCH.Clearnet, the CME Group and Singapore Exchange – already clearing NDFs, and the Intercontinental Exchange (ICE) preparing to launch. All CCPs have said they intend to extend their clearing offerings into FX, most likely to FX options first, as soon as they get the go-ahead. They are even hoping to clear FX forwards and swaps at a later date if market demand is there, whether or not clearing becomes mandatory.

Gavin Wells, chief executive of LCH.Clearnet’s ForexClear facility, says: “FX forwards are exempt under Dodd-Frank. The product set mandated under EMIR has yet to be confirmed. A number of market participants, on the buy and sell side, wish to clear forwards to mitigate counterparty risk. We will add these to the service, based on member and client demand, once a solution for the settlement of physically settled FX products is agreed with the regulators.”

Option complications

But clearing cash-settled instruments, such as NDFs, is much more straightforward than FX options, where there is a physically settled contingent that is hard to quantify. With the ruling that CCPs would have to provide “full and final settlement”, work is ongoing to try and quantify the risks and the sums involved.

The global FX division of the Global Financial Markets Association is leading this effort to quantify the liquidity risks created should one or two major banks go into default when they have been clearing options. Their analysis was expected last year but is still ongoing. It is also highly likely an appropriate process for CCPs to connect to the FX settlement system Continuous Linked Settlement will be necessary to avoid reintroducing Herstatt risk – named after the German bank that failed to make dollar payments on Deutschemark FX transactions following its licence withdrawal in 1974.

“Clearing physically delivered FX presents special challenges for a CCP. In particular, if the next Lehman were to fail, how could a CCP source enough physical currency in many denominations to meet the defaulter's FX payment obligations? Margins only cover profit and loss; here we are talking about a lot of hard cash that would have to be found quickly in what would almost certainly be a highly stressed market. So far this problem has not been solved,” says Huw Evans, a managing director and chief operating officer at UBS's global FX business.

Until this is resolved, the CCPs cannot begin building a clearing solution for FX options. Even so, Mr Wells at LCH.Clearnet adds that it is likely that ForexClear’s next product offering will be clearing for FX options.

Decision time

The banks are in the same position as the CCPs, building what they can now in anticipation of further clarification. Dale Braithwait, co-head of futures, options and OTC clearing product development at JPMorgan, says that while the bank has been able to build out a risk methodology for its operational processes, there is as yet no CCP to connect to for OTC FX options.

JPMorgan began clearing trades with CME Group last year and expects to start clearing with LCH.Clearnet and ICE shortly. It is also in talks with the Singapore Exchange and it seems likely that the larger players will in fact connect to all the CCPs initially.

Mr Braithwait says: “Sometimes clients choose a clearing house based on the actual model used by the CCP or it can come down to where they see liquidity being driven. As there is no clear leader in FX right now, there is an incentive for clearing houses to set up in a bid to grab early market share, but at some point we expect the number of clearing houses clearing a particular product will reduce.”

Managing the impact

The impact of clearing on the FX market is significant and will change the workflow and operations of the banks' clients. JPMorgan’s focus is on reducing the impact of the changes on their clients. One of JPMorgan’s core strengths is prime brokerage and Mr Braithwait says the bank is extending this platform into clearing so clients can see a front-to-back offering across all FX products.

However, while exchange-traded products provide an interesting alternative to certain clients who are happy with the limitations of a futures product, Mr Braithwait does not believe there will be a wholesale shift from OTC into exchange-traded derivatives on FX, even though it is still unknown what impact centrally cleared FX options will have on cost and margining.

Mr Braithwait says: “If trades had the same risk, you would expect clearing houses to charge the same margin. I know there have been products that have been released where that is not the case and that is something we have been concerned about as a bank. In the future, we hope to see that exchange-traded FX would have the same risk mechanics as the OTC clearing regime. There are instances in the futures world where there could be some economies of scale that could be captured by utilising futures contracts, but there are limitations to this approach so we continue to support both types of products.”

To this end, Mr Halberstadt says Swift is building a scaleable solution that could encompass FX options and beyond. Swift is also trying to make these changes as painless as possible in terms of the connectivity needed by partnering with the vendor MarkitSERV to offer a single gateway to all the CCPs.

Mr Halberstadt says: “Together with MarkitSERV, we are enabling banks to use their traditional FIN MT300 confirmations, which are used to confirm NDF trades, as a way of actually feeding the trades to MarkitSERV for clearing as well. This means that banks, investment managers and corporates have a very simple way of getting that data into the CCP and likewise getting status updates back from MarkitSERV over their trusted Swift interface.”

The infrastructure is there. The CCPs are ready to build FX clearing solutions. The banks are preparing their customers for the changes ahead and deciding how they can ease the burden of clearing while providing new services. All that is needed now is greater clarity and the go-ahead from the regulators.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter