FX industry weighs up clearing options

Clearing for the foreign exchange (FX) market has been heavily debated issue over the years but the global market has been regarded as too big and too liquid to warrant the huge sums involved. Settlement risk in the world’s currency markets had always been considered the biggest risk and the introduction of Continuous Linked Settlement (CLS) in 2002 put clearing firmly on the back-burner until 2009, when the G-20 leaders met in Pittsburgh, US and ruled that central clearing must be put in place for all standardised over-the-counter (OTC) derivative contracts.

While central clearing for the financially settled non-deliverable forwards market began in 2013, through three central counterparties (CCPs) that are also poised to offer clearing for FX options, a solution is yet to be built. Clearing FX options would involve delivering both the currency sold and bought and so, as a result, there is a potential liquidity disruption, of an entirely different magnitude, should there be a problem in the settlement. As physically settled OTC FX contracts have never been centrally cleared, the size and scale of this risk was unknown, until now.

The results are in

The Global Financial Markets Association's (GFMA's) global FX division, with its 23 global FX member firms, has completed a year-long study to understand the scale of transactions in the physically settled OTC FX options market to size the same-day liquidity challenge associated with clearing this market.

Results from the analysis indicate that, based on historical OTC FX options traded globally and exercised, the size of the same-day liquidity shortfall could have been as high as $161bn in total across the 17 currencies settled by CLS. This could be reduced by nearly 75%, to $44bn, if the adopted clearing solution were to utilise a net settlement mechanism.

Mandy Lam, the GFMA’s managing director in North America, says that the objective of the study was to quantify the size of the same-day liquidity shortfall for clearing and settling. This risk is unique to deliverable FX transactions and presents a challenge that is above and beyond the risks that CCPs traditionally cover for products they clear.

She says: “Until now there hasn’t been a sufficient understanding of the size of the same-day liquidity risk shortfall that would need to be managed by CCPs based on the Bank for International Settlements, the Committee on Payments and Settlements System and the International Organisation of Securities Commission's principles for financial market infrastructures [FMI Principles] jointly published in April 2012.

"The results of the analytics run against this comprehensive data set finally shed light on the size and the nature of this challenge. With this information, interested stakeholders have something concrete and tangible to focus on as they try to solve the problem through the design of their solutions and regulators are also better able to assess the adequacy of those models.”

Problem solving

The problem is due to the deliverable aspect of physically settled OTC FX options. CCPs traditionally focus on ‘replacement cost risk’, often referred to as ‘mark-to-market risk’. While there is a fair amount of cash settled and even FX futures products in the clearing space, the new FMI Principles on liquidity risk and, in particular same-day liquidity risk provide an expectation that CCPs must be able to provide a credible full and timely guarantee that, in a failure situation, the CCPs can deliver to the non-failing clearing firms the currencies they were expecting to get on that day – not just in terms of the value, but in the currencies they transacted to receive.

“One of the most significant observations from the study is the degree to which the size of the problem ($161bn) can be affected by the settlement mechanism used by the clearing solution, i.e. how the CCP goes about settling the funds on the settlement date," says Ms Lam.

"While we are not suggesting that the industry adopt a net settlement mechanism when clearing this product, it is notable that the size of the problem that needs to be solved could be dramatically reduced if it were to. This number could be further reduced by the specifics of the clearing solution’s design but the GFMA doesn’t have a view on at what level this number is manageable. That is up to the CCPs and its participants to determine.”

Today, however, CLS utilises a gross settlement mechanism even though funding, for liquidity reasons, is calculated on a multilaterally netted basis.

While the GFMA is continuing to help the interested stakeholders examine and understand the study’s findings, it remains to be seen how the industry will move onto the next stage: how to solve the problem. Potential next stages include the investigation of solutions, impact analysis and then implementation, but Ms Lam says the GFMA currently does not have specific plans regarding its involvement going forward.

She says: “The detailed design of an FMI – whether it is one, two, three or more CCPs – and of the settlement infrastructure used – whether it is CLS or otherwise – is unique to that particular FMI. While collaboration could be possible on specific target areas, for example where stakeholders identify areas of common interest or need, any further specific role for the GFMA, as an organisation, has not been defined at this time.”

Towards a solution

While it is still early days, since the results of the analysis were published in mid-November 2013, David Puth, chief executive officer of CLS Group, says: “We welcome the analysis as an important contribution to the industry, aimed at reducing the risk in the FX market. We will participate with the stakeholders to define an industry solution and evaluate a potential role for CLS. We are committed to working with the industry to find a way to do this.”

Today, CLS takes $5000bn of gross settlement instructions and generally achieves 96% to 99% efficiency, which results, after adjustments, in actual payments of roughly $50bn. Mr Puth adds: “The clearing of FX options is a whole new phenomenon for the marketplace and one that hasn’t yet been adopted so it is difficult to predict what the outcome would look like.”

However, the FX industry is already bearing this gross liquidity; these trades actually settle today and putting them into CCPs will not create the liquidity risk but it does concentrate it and, as result, creates a heightened importance that that centralised place deal with it prudently.

A senior industry source believes that a solution for clearing FX options could be found, using a combination of CLS providing a service to the CCPs, some of which are already members of CLS. He says: “At $44bn, this is eminently solvable. The trick is getting the mechanism to achieve it and finding what it takes to create a multilateral net settlement of the underlying payment-versus-payment [PvP] payments.”

It would take a central entity to have an account at each of the central banks of issue – something that CLS already has – for CCPs to have all the currencies paid in, verified, then released if they are there and if they are not, then have the CCP activate its liquidity arrangements to fill in the gap.

“Structurally, CLS would be well positioned to work with the industry to provide such a service and I am quite optimistic. The GFMA analysis shows this is achievable and it is something the industry could start building right away," says the industry source. “Today, CLS provides a settlement service to firms that individually, and bilaterally, want to settle their trades on a PVP basis. Couldn’t CLS provide a service to CCPs to allow them, and their members, to settle their trades on this basis too?”

Behind schedule

Mandatory central clearing of FX products raises questions about how CLS will mitigate settlement risk for cleared FX products, and whether clearing houses can become direct members of CLS. Allowing CCPs to settle FX trades bilaterally would reintroduce Herstatt (settlement) risk, so it would certainly be preferable to have CCPs become either direct or third-party members of CLS, and of these it is understood direct membership would be preferable as third-party membership would concentrate the risk on the direct member enabling the access.

Although it is highly likely that CLS would be part of any clearing solution for FX, any changes to its current structure will be very carefully considered. To date, the CCPs have been planning clearing services based upon interfacing to CLS for settlement after clearing. While it is still to be decided if FX options could be physically settled outside CLS, a very likely scenario is that the market infrastructure built would involve creating a new category of membership of the consortium for the CCPs, either individually or as a group, as currently only banks can be members.

Gavin Wells, CEO of clearing solution ForexClear, at clearing house LCH.Clearnet, welcomes the results of the analysis and says: “We very much look forward to working with central banks, regulators, CLS and market participants to leverage these results to define a solution for FX options clearing, before the implementation of the Basel Committee on Banking Supervision’s margin requirements for non-centrally cleared derivatives.”

The requirement to collect and post initial and variation margin on non-centrally cleared trades will be phased in over a four-year period, beginning in December 2015. With this on the horizon, it is hoped that a blueprint for the design and cost of FX clearing can now be drawn up as it is already running behind schedule – the G-20 leaders stipulated that all standardised OTC contracts should be cleared through central counterparties “by the end of 2012 at the latest”.