New regulations, specifically the push towards central counterparty clearing, are having a huge impact on banks' over-the-counter foreign exchange operations. As the banking sector undergoes significant changes, what will this mean for banks' organisational structures and the foreign exchange market?

The world’s derivatives exchanges must have been rubbing their hands in glee in September 2009 when the G-20 leaders in Pittsburgh agreed that: “All standardised over-the-counter [OTC] derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.”

Two years on, two regulations – the Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR) – regulate the mandatory clearing of eligible OTC contracts, which for the foreign exchange (FX) industry means FX options and non-deliverable forwards (NDFs), through central counterparty clearing houses (CCPs). Further regulation will define the swap execution facilities (SEFs) required for executing OTC contracts.

The response of several of the larger FX banks has been to bring together their OTC and exchange-listed clearing businesses in a bid to offer cleared OTC as part of a comprehensive service across asset classes. However, the emergence of these new business models, as well as the regulatory response, ignores the part of the G-20 statement, which states in the first instance that OTC derivatives should actually no longer be OTC but exchange-traded.

Ahead of the pack

JPMorgan began reorganising its business – combining its OTC prime brokerage desks and clearing operations into its futures and options infrastructure – as early as 2008, when mandatory clearing for OTC instruments was first discussed.

Andrés Choussy, global head of FX clearing and prime brokerage at JPMorgan, says: “We saw a tremendous amount of opportunity from combining our OTC prime brokerage and exchange-listed clearing businesses. Since then, we have been working towards integrating these business lines and trying to leverage best-in-class processes from both worlds. Even though each of the products was at a different stage in its development, there were still benefits in combining the OTC products across FX, credit and rates, as most of our clients trade multiple products.”

There is a limit to the current legacy FX infrastructure that can be used in the new clearing model

Andrés Choussy

JPMorgan expects that FX, credit and rates clearing will mirror many of the characteristics of exchange-traded clearing, and has selected its technology platform to simulate the impact of some of the expected new elements – such as regulatory reporting – by applying the infrastructure, and teams, already established for its regulated futures clearing and reporting operations for FX OTC instruments.

“The advent of clearing made us look at consolidation across OTC cleared products, and then at integration with our futures clearing infrastructure [in order] to meet the potential new types of requirements,” he says. "There is a limit to the current legacy FX infrastructure that can be used in the new clearing model,” Mr Choussy adds.

Consolidate to comply

JPMorgan is currently integrating tools to allocate block trades executed on SEFs to multiple accounts, similar to what is done in the exchange-traded market but tailored to the FX market – another feature that is likely to be in demand. This will also enable prime brokerage clients to see all their trades in a single window, and gain cross-product margining and collateralisation benefits.

Mr Choussy says that there is also the possibility that JPMorgan could provide its clients with aggregated data from multiple SEFs so that they might use JPMorgan’s platform as a single entry point, or gateway, for FX cleared trades pricing. This could be linked to existing tools in JPMorgan’s FX prime brokerage offering. “We already have the capability [to provide] our clients with access to multiple price sources, and we think this is going to be a particularly important requirement for many clients that are not currently accessing electronic communication networks,” he adds.

Deutsche Bank has also recently merged its existing OTC and listed derivatives clearing businesses, creating a new group dedicated to providing execution and prime clearing services across all asset classes. Global head of the new unit, markets clearing, and former co-head of global prime finance at Deutsche Bank, Jon Hitchon, says that the genesis of the new group is a result of the principles laid down by the G-20. The new Tier 1 capital requirements of Basel III will also drive the need for a changed model, he adds.

Red tape

Although under the Dodd-Frank Act many corporates are exempt from having to send their OTC transactions to a central clearer, sell-side firms are subject to Basel III, and while trades may not be eligible for clearing, the amount of capital and margin that they will need to set aside will be much higher for these bilateral trades. “Effectively this is an incentive scheme to move as many bilateral OTC transactions into a standardised CCP-type model,” says Mr Hitchon.

Mr Hitchon believes the incoming capital requirements added to clearing for OTC contracts will drive demand for a ‘one-stop-shop’ across FX, rates and credit, enabling Deutsche Bank to offer clients value-added services. He says: “This new business model includes: risk aggregation; cross-margining where it is allowed; cross-margining for portfolio effect, from a risk attribution effect for both cleared and non-cleared products; consolidation of all this information in one place, similar to a prime broker service; and the provision of collateral substitution where only cash and treasuries can be used. There are very few firms that can provide all these pieces, or provide this footprint, alongside trading capabilities.”

Offsetting changes

In the US, the Commodity Futures Trading Commission has proposed a rule by which clearing houses might elect to move OTC instruments into a futures account or move futures contracts into the OTC account. This would provide cross-margining across these two product types, so long as the risks are managed and the offsets are calculated. Under the current rules that have been drafted for CCPs, banks would not actually have third claim on any equity posted for their clients with the CCP as margin, but the prime broker would be able to look at the overall portfolio, based on the new horizontal model, and grant credit lines to manage collateral more effectively.

Mr Hitchon says: “We view this move as just a natural progression of putting together all the various asset classes from a cross-margining point of view, from a platform perspective in terms of technology and infrastructure, and at the same time linking in with the various execution venues on a bilateral basis and through the rules being written around SEFs."

He believes that in three or four years there will be five to six major sell-side firms with a global footprint in terms of trading capabilities, and the ability to integrate, on a horizontal model, across custody, listed derivatives capabilities and prime brokerage business models.

The Royal Bank of Scotland (RBS) is also merging its OTC derivatives clearing unit with its futures business in response to the regulatory changes. Tim Carrington, global head of foreign exchange at RBS, says that the bank is undertaking a high-level review of its business model as it believes that the regulatory changes will be progressive, with new elements added over time.

Mr Carrington also says that if clients are going to have to clear and margin FX options, some may want their forwards transactions treated the same way. “Ultimately, I think the scope of regulatory change is moving the foreign exchange market more towards the equity model,” he says.

New model

Unlike the equities market, the FX market is, arguably, the most transaction-focused of all the asset classes in terms of the number of deals processed. “The FX business is based primarily on the facilitation of transactions, rather than the management of an inventory of securities. Revenue is largely generated from execution, whereas in other asset classes there is more commission-based work, such as research and brokerage services,” he adds. Although it may take many years for the full impact to be felt, Mr Carrington believes that this is the start of a fundamental shift away from transactional value to more of a service value, more like a brokerage, for the FX market.

The FX business is based primarily on the facilitation of transactions, rather than the management of an inventory of securities. Revenue is largely generated from execution, whereas in other asset classes there is more commission-based work

Andrés Choussy

In the short term, RBS is working to build FX clearing links with London Clearing House, Clearnet and the CME Group, but is waiting for greater clarity on the development of the SEFs for the mandatory trading of FX options and NDFs. It is yet to be decided whether they will be built by the banks themselves or by the market infrastructure providers.

As with the equities market, Mr Carrington says the introduction of SEFs and CCPs is changing the traditional FX model as banks will no longer be dealing directly with clients. Initially, however, it is expected that the SEFs will only be highlighting two or three banks, so the relationships will remain in place, but further down the line it could change the model for trading FX options quite dramatically.

Already, he says, banks are unable to compete on pricing for high-frequency trading business and high-frequency trading clients will choose providers based on the speed of pricing and the strength of the FX prime brokerage business.

Mr Carrington believes that RBS is well placed to benefit from this expected move away from the focus on execution, towards more of a service value proposition. He says: “This means that the big warehouse supermarket banks for FX, such as RBS, have the infrastructure, the pipe work, the algorithms, the global footprint, the connections with clearers, and soon, SEFs, so that the cost of entry into this newly emerging market model will be very low. One thing the market needs to prepare for is greater capacity to trade larger volumes and RBS has been up scaling our back office for the past 18 months.”

He believes that the positive impact of this move will be the creation of greater liquidity for FX options and higher transparency for derivatives, which should give rise to tighter margins and tighter pricing for the end-user. The only caveat to this are the ongoing discussions around end-user exemptions. There are concerns that small and medium-cap corporates could find it harder to hedge, not easier.

“This will drive clients towards ‘one-stop’ shopping, and the message we are getting from our client base is that the entire range of clearing and prime brokerage services has to be complete. We have seen signs of this already in the prime brokerage market as clients are restricting the number of prime broker relationships they have. The regulations are simply forcing these trends to happen at a faster pace," says Mr Carrington.

Still evolving

BNP Paribas began a review of its FX options business strategy several months ago and the bank has been working with the regulators, via the Association for Financial Markets in Europe's global FX division, to ensure that as few unintended consequences as possible arise from the regulatory changes. Although OTC instruments will continue to be traded at different desks, the bank will maximise the synergies across these products. BNP Paribas has centralised its back office in preparation for processing spot, swaps, options and NDFs.

Hubert de Lambilly, deputy global head of BNP Paribas' FX and FX hybrids, in charge of FX spot, FX options and emerging market FX, says: “The whole point of clearing is not to create exchange-traded options, it is clearing of OTC, it has never been specified that we must use exchange-traded options. Obviously OTC will be more and more regulated. There are some contracts that are highly illiquid, which can still be cleared, but trading them on a SEF might be difficult.” He adds that the fact that the regulators have decided to treat NDFs as derivatives is difficult to understand, but that they will follow the same clearing route as options.

There will always be innovation and a need to process non-standard products

Neil Vernon

A changing market

Many of the issues that the FX market is grappling with at the moment are not only being caused by regulation but by the fact that banks’ customers are trading more globally, giving rise to a greater consumption of FX, and the expectation of consistent processes across all currencies.

Neil Vernon, development director at real-time financial solutions provider Gresham Computing in London, says: “Clearing of OTC products simply adds to the complexity, as centrally cleared products very often have an FX element to them and this will impact FX operations.”

Standardisation is the main message that Mr Vernon believes is coming from regulators, with the pressure to standardise OTC financial instruments as much as possible. “Let’s suppose that the regulators are successful and everything becomes standardised and effectively no longer OTC. How long will it be before a bank innovates and creates a product outside of the standard? There will always be innovation and a need to process non-standard products,” he says. Mr Vernon believes the dual markets of standardised flow products and the new OTC products will continue to exist.

The trend emerging among the banks is preservation of the best of both worlds. The interpretation, and end result, of the commitment made by G-20 in 2009 may well be the emergence of three markets, that of OTC, cleared OTC and exchange-traded, albeit in an all encompassing ‘one-stop shop’ that makes it just as  easy to trade on-exchange as off-exchange.

The moves are a further step towards reducing systemic risk and providing a more realistic recapitalising of those contracts that remain bilaterally traded, but a shift to exchange trading it is not.

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