Two central counterparties are currently being built to clear foreign exchange options. The FX industry is still waiting for the final decision about the treatment of forwards and swaps, and there is a great deal of preparation to be done.

The US's Dodd-Frank Act has ruled that central clearing for foreign exchange (FX) derivatives products will be mandatory. While FX spot trading does not fall within the remit of Dodd-Frank, FX options and non-deliverable forward (NDFs) will become cleared products and in July, the US Treasury will decide whether to include FX swaps and forwards. Many in the market still hope that short-dated products will be exempt.

The new regulation states that FX swaps and forwards will be considered to be swaps, and subject to oversight by the Commodity Futures Trading Commission (CFTC), unless the US Treasury makes a written determination that either or both types of transactions should not be regulated as swaps. But even if the US Treasury ultimately decides to exclude FX swaps and forwards, they will still need to be reported to a swap data repository or to the CFTC.

Prepare for clearing

As a result, the FX market is gearing up for clearing. At least two FX central counterparties (CCPs) are being built for launch by early 2012.

The Chicago Mercantile Exchange plans to offer a post-trade clearing service for over-the-counter (OTC) FX products, out to five years, by extending the use of its existing platform, CME ClearPort, to cover all the products within FX – including FX spots, forwards, swaps and NDFs – by the end of 2011. LCH.Clearnet is currently building a CCP for European vanilla options, in nine currency pairs, out to two years’ maturity.

Both providers are still in discussions about how they will interoperate with CLS, the industry-owned consortium that currently delivers FX settlement to the global FX market. However, Jonathan Butterfield, director of communications at CLS Group, says that clearing for FX is still in the process of being defined. The current view in the interbank market is that cleared trades will be sent to CLS one by one.

Settlement similarities

The settlement of cleared FX using physical currency would be just the same as OTC settlement, delivering one currency against the other currency. Physical settlement risk reduction would be via the payment versus payment (PvP) process provided by CLS. CLS nets trades at settlement but it is likely that trades will be cleared at gross value.

Cash settlement (for differences) has not been advocated for FX clearing. Cash for differences is where each trade is marked-to-market – or to the rate set by the clearing house – and then the cash difference between the original trade and the close-out is calculated and paid to whichever party it is owed to. Normally this payment will be in a pre-agreed consistent currency, most often the US dollar.

How to send transactions?

Another issue still to be decided is how the transactions are sent to CLS from the CCPs – whether indirectly through an agent bank or directly, as a clearing member. Mr Butterfield believes it is likely that a new category of membership for CLS will be needed, due to the fact that the potential values being moved would be significant and therefore it would likely be unreasonable for a third party bank to carry the risk.

“There is an understandable concern from the central banks who manage the currencies we settle to fully understand how the addition of one or more CCP will change the daily flows and liquidity in their currency. This effect could be positive or negative but must be assessed,” says Mr Butterfield.

He adds that while the technical connection between CLS and the CCPs would look similar to the resilient messaging connection banks currently have with CLS, the terms and conditions still need to be decided, and a technical implementation would be required.

“We have very specific legal protection around the necessary finality of our payments. This finality is generally granted in jurisdictions to banks and not to other types of entities, so work will need to be done with the jurisdiction to make sure the flows between the CCPs and CLS are appropriately protected,” says Mr Butterfield.

Regulation response

In response to the incoming regulation, the Global FX Division of the Association for Financial Markets in Europe and its partners, the Securities Industry and Financial Markets Association and the Asia Securities Industry and Financial Markets Association, formed a new working group earlier this year to focus specifically on the challenges and issues surrounding global FX prime brokerage and to implement OTC FX clearing for clients.

The participants of the new group, co-chaired by Citibank, Deutsche Bank and JPMorgan, comprise a number of the biggest global prime brokerage firms, and will work closely with the regulators and central banks to implement best practices and technology solutions for the FX clearing industry.

Peter Klein, head of global FX prime brokerage at JPMorgan, says that the bank is involved in several industry bodies looking at this particular issue, to define the right structure for client clearing in FX and to make sure it works well with the current infrastructure, which has done well in safeguarding the FX market.

“We need to try and leverage the current infrastructure we have today,” he says. “CLS is by far the most important component of the FX market and to a large extent the FX market was more able to absorb the impact of the Lehman collapse in 2008 due to the existence of CLS.”

Arguably, adding a clearing component to a very long-dated trading product makes sense, but for instruments of less than three months the risks are more about settlement than counterparty risk. Mr Klein says: "Even if FX options and NDFs are included, and forwards and swaps, we are still only talking about a much smaller proportion of the total exposure of a client. For most clients, 90% to 95% of their trading is done in FX spot, which is completely excluded [from the clearing requirement]."

For this reason, Mr Klein says the challenge for FX prime brokers is to leverage the existing FX prime broking infrastructure (which he says is already very efficient due to the technology used), to ensure that the clearing component of a client's service needs are seamlessly added to what they already get.

"For many FX trading clients, the clearing component is probably going to be fairly small in comparison to the total volume that they would be trading, so prime brokers need to ensure that they can act effectively both as a clearing broker and as a intermediation prime broker as they do today," he says.

Demand increase

Demand for FX prime brokerage is increasing once again, as FX continues to develop as an asset class and as investors increase their use of currency overlay and discover the benefits of using a prime broker. However, the introduction of a CCP for FX instruments traded bi-laterally will mean that margins need to be calculated, collected from both counterparties and lodged with clearing houses for the first time.

Andrew Coyne, global head of prime brokerage at Citi, also sees central clearing of FX as an extension of the bank's clearing service. “There is a lot of existing infrastructure and practices that lend themselves very well to the addition of clearing through a central clearer so we are looking to use what is already in place as far as possible,” he says.

To enable this, Mr Coyne adds that work still needs to be done in terms of connectivity to the clearing houses and understanding the differences between the FX clearing services being offered. Additionally, banks must look at the issues that will impact clients – such as the margin requirements, the timing of margin calls and what information is available. “We see ourselves as providing a service to our clients across all of their FX instruments, cleared and non-cleared, as the platform is going to become more complicated,” he says.

Customer choice

For interbank trades, banks will most likely choose one CCP, but in terms of client business, it is expected that customers will be given a choice. This may come down to competitive offerings or clients may choose an FX CCP based upon where other products they are also trading are cleared.

There are two layers of netting, according to Mr Coyne. “The FX prime brokers will have OTC cleared trades and CCP cleared trades but because we hold the portfolio of transactions we will have the perfect view of the client's credit status that will allow us to assist the client with margin offset between the two models or margin financing across both. We would be the first layer of netting benefit available, and depending on the clearing house's offering there may be some additional benefit on a cross-product basis.”

However, Mr Coyne adds that, currently, traditional exchange-traded FX derivatives and anything given up for clearing cannot be offset at clearing house level, although this may change.

And, aside from the additional cost, Mr Coyne says there are also unresolved issues about settlement: “Cost is being added and the more FX that is cleared, the more concentration risk there is on the clearing houses. The big question mark is FX settlement. No one wants to concentrate settlement risk on a clearing house. It needs to be spread across the FX community, which are CLS bank members, as CLS has worked extremely well to ensure that settlement risk has been eliminated.”

Prime brokers undermined?

There has been some suggestion that the introduction of FX clearing could undermine the value of the FX prime broker. Others argue that because the largest and fastest-growing segment of the FX market is the spot market, which will not be affected by the new regulations, this is unlikely. 

Gil Mandelzis, co-founder and chief executive of post-trade processing firm Traiana, says that the FX OTC market will continue to exist in its present form and the need for FX prime brokers will not go away. In fact, their pivotal role will most likely increase.

“A bank’s client used to be either cleared through a prime broker, or not. When they were cleared, frequently their entire flow was cleared," he says. "In the future, some of the flow of the client will either be cleared or not, adding significant complexity to trading and processing FX.”

According to Mr Mandelzis, even if a client only clears a few options trades a year, over multiple CCPs, the industry's complexity has increased exponentially, much more than the volume associated with cleared trades would indicate. Positions and margins will need to be managed and reported over multiple destinations. The prime brokers will be working closely with their futures commission merchants to offer an integrated solution, which should be as invisible as possible to the client.

The development of FX CCPs is still in its very early days. More CCPs are expected to come to market with, perhaps, differing clearing models, mirroring what happened in the interest rate swaps market.

The FX market has always been regarded as different to other asset classes, but it looks increasingly likely that it will have to adapt to the same regulatory regime as other products. And banks' FX prime brokerage desks – as well as the central services currently being built – are positioning themselves to capitalise on the opportunities presented by this extra layer of regulatory oversight.

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