Derek Sammann, managing director of financial products and services at CME Group
US and European regulators want as many over-the-counter derivatives as possible to be traded on exchanges or cleared through a central counterparty but the foreign exchange market will not go quietly. Writer Frances Maguire
Foreign exchange (FX) has always been considered different to other asset classes - in fact it is only in recent years that hedge funds and currency overlay managers have begun trading FX as an asset class.
Corporate use of FX derivatives to hedge foreign currency exposure means that a higher proportion of FX contracts are short-dated, putting a greater emphasis on settlement risk than counterparty risk - 75% of the total value for FX forwards and FX swaps submitted to CLS Bank mature within four months.
In the light of this, the FX market is transacted over the counter (OTC). Whereas standardised, liquid exchange-traded contracts are used to gain financial exposure to other asset classes, FX market users, who need a specific amount of currency in a specific place on a specific date, have remained firmly in the OTC market.
Peter McLady, a managing director in Deutsche Bank's global finance and foreign exchange business, says: "FX is different from the other asset classes due to the short-term nature of trading. FX trades have an average balance sheet maturity of one month, and because FX is physically settled, settlement risk, rather than counterparty risk, represents the major risk in the market.
"Furthermore, moving the global FX market into a centrally cleared environment would create vast sums of initial and variation margin, leading to concerns around the concentration risk that would arise from using a small number of clearing houses. For these reasons, continuing to develop a robust settlement system is a high priority for the FX market."
However, the G-20 has called for new rules on central clearing and regulatory reporting of OTC derivatives to come into force by 2012. As a result, both the US Senate and the European Commission (EC) are drafting legislation to mandate clearing through a central counterparty for all 'standardised' OTC contracts, and higher collateral requirements for contracts that continue to be bilaterally traded.
Best guess
It is still uncertain what the final legislation from the Senate and EC will look like. At present, the implication is that while legislation would exclude physically settled spot and forward transactions from the definition of a swap; it would not exclude those foreign exchange transactions that are options or cash settled.
In December, the US House of Representatives voted for an exemption for FX swaps and forwards from mandatory central clearing requirement, but the financial reform bill, which the Senate has yet to consider, included a clause stating they would be eligible for mandatory central clearing if regulators and the Treasury secretary jointly determine the contracts should be subject to the legislation.
Two drafts of derivatives legislation are currently being debated within the Senate, which will need to be reconciled with each other, and then will have to be reconciled with the House bill passed in December.
Mr McLady hopes the exemption survives the reconciliation of the two bills. "What we had hoped for was an extension of the exemption for FX swaps and forwards to non-deliverable forwards [NDFs], which are really just cash-settled forwards, and also FX options."
Waiting game
Although the EC stated in October that the forthcoming legislation on central counterparties (CCPs) would cover the same range of financial instruments as the Markets in Financial Instruments Directive (MiFID), it has still not produced a draft outlining exactly what is included. This is not expected until June, but it is hoped that the specific nature of the FX market will be taken into account.
Gavin Wells, a consultant in foreign exchange at independent clearing house LCH.Clearnet, says: "MiFID breaks instruments down into those used for hedging purposes and those that are used for investment or speculative purposes. Currently the line is drawn at seven days - a corporate using a forward under seven days would be seen as most likely a hedge for an exposure or a payment - so the categorisation of the product changes with duration. While the EC has yet to confirm its exact intentions as it is looking at MiFID, we can infer that it is likely that products will be exempted, and included, in line with MiFID."
But Simon Gleeson, a partner in the regulatory group at UK law firm Clifford Chance, says the regulatory debate centres around the repricing of risk, and collateral. Rather than ruling that all standardised derivatives must be cleared, the EC says that those derivatives not conducted on exchange will be subject to higher collateral charges.
"The thrust of the EC proposal is really to do with collateral, and the requirement-prescribed standard levels of collateral. This is the issue, rather than a requirement for clearing or standardised documentation," he says.
Clearing house requests
Even if the banks do not pass on these collateral requirements, they will be subject to these requests from the clearing house and will have to charge corporate users of the market the cost of putting up this collateral. "No matter which way you look at it, the imposition of these obligations on the FX market will have negative effects for end users," says Mr Gleeson.
In her testimony to the Senate Agriculture Committee, Blythe Masters, a managing director and head of the global commodities group at JPMorgan Chase, said that while greater transparency and oversight was needed in the OTC market, any mandate must take into account that not all OTC market participants are capable of clearing and not all OTC derivatives contracts are capable of being cleared. She said that the prohibitive cost of clearing across all contracts to corporate end users must be considered.
In an open letter from the European Association of Corporate Treasurers, its chairman, Richard Raeburn, argues that companies using derivatives to hedge risk rather than speculate would be unfairly penalised by the increased cost that margin calls and posting collateral would place on hedging currency exposure. He argues the impact of the proposed regulation will be to replace counterparty risk, which corporates are comfortable with managing, with an inherently unmanageable liquidity risk.
"The economic effect of the requirement to provide cash collateral is to convert the primary risk for companies from that associated with counterparty exposure into liquidity risk. Non-financial companies are highly experienced in managing their counterparty risk with financial institutions; managing liquidity risk in collateral requirements is substantially more difficult for them and is less efficient."
Mr McLady says: "Companies and end users need to buy and sell currency every business day of the year, and hedge expected foreign currency flows to an exact date, and to go through the centrally cleared model they would need to reserve capital for the initial and variation margin process. These are all factors that have led to increased use of the OTC market in FX."
Damaging split
In its response to the legislation being proposed, the International Swaps and Derivatives Association (ISDA) argues that managing the split that would inevitably arise between cleared and OTC transactions would have damaging effects on the FX market, and could even lead to higher levels of risk.
It may prevent netting and cross-margining of positions across all FX transactions, which in turn could increase the credit risk on the non-cleared trades. Also, requiring that options be exchange-traded and cleared will make it harder to effectively manage option positions as options incorporate spot, rate and volatility components that would have to be hedged in entirely different markets. Hedging in different markets will tend to increase costs and introduce 'basis risk' in that the transactions executed in different markets may not exactly hedge or offset each other.
While the regulator's decision to impose central clearing of transactions is intended to reduce credit, or counterparty risk, ISDA argues credit risk has not been a major factor in the FX market. This is not only due to the short-dated nature of the transactions, but because of the use of collateral to secure mark-to-market exposure.
Addressing risk
Historically, the FX industry has addressed counterparty credit risk via either netting, covered within the close-out clause in trading agreements, or through the exchange of collateral between counterparties. Collateral exchange is typically provided under the terms of credit support annexes (CSAs) to master agreements for FX transactions, although according to ISDA figures the collateralised percentage for FX (63%) is much lower than those for credit derivatives (97%), reflecting the lower perceived counterparty risk of shorter-dated trades.
In effect, CSAs provide many of the risk-reducing benefits of a central exchange while maintaining the flexibility offered by an OTC market, but without engendering the practical challenges that a country-specific central counterparty model would likely face in a highly international marketplace.
Currently, at least two FX CCPs are being built. Adrian Berendt, director of foreign exchange at LCH.Clearnet, says that while the clearing house is keeping a watching brief on what the regulators finally decide, its primary focus is on FX options, where it is building a clearing solution that it expects to pilot in the first half of 2011.
"This has come from demand from our members. We view the regulatory developments as an indication of what members might need next. Although there might be a number of domestic CCPs for individual currencies, LCH.Clearnet is targeting the global market of highly liquid currencies, where we expect there to be a single solution," he says.
Cleared vision
Providing there is market demand, LCH.Clearnet could incorporate any FX products into its FX clearing solution. Cleared trades would still need to be settled via CLS or settlement risk would be reintroduced. For this reason, LCH Clearnet says that any FX central clearing solution it would build would be in conjunction with CLS, which fully intends to provide settlement of cleared FX and also would expect all cleared trades to be visible within the single industry trade repository.
Rob Close, chief executive officer at CLS Bank, says that whatever the outcome of the legislative process, any solution will need to be developed in conjunction with the industry participants to be workable.
Likewise, the CME Group, the largest market for listed FX futures and options, which posted its highest monthly volume in February, averaging a daily volume of $120bn, is developing a post-execution clearing service through CME ClearPort for the global FX market.
Later this year, CME ClearPort will offer central clearing for spot, swaps and forwards, with flexible notional values and settlement dates out to five years, across eight currencies pairs, regardless of where they are traded. Clearing for FX options, additional currencies and NDFs will follow. In addition, all OTC FX positions sent to CME Clearing can gain the same cross-margin efficiencies as exchange-traded FX futures and options.
Plenty of room
Derek Sammann, managing director of financial products and services at CME Group, says that the size and scope of the FX market, and the fragmented nature of the market, such as the proliferation of electronic communication networks, has proven again and again that there is ample room for different business models to co-exist within the same asset class. "There is no 'one-size-fits-all' solution for the global FX market," he says.
"One of the hallmarks of the OTC market is product choice and execution choice, so we are looking to provide post-execution, platform-agnostic, open clearing services that enable participants to continue to trade bilaterally in the OTC market, if they prefer, and clear them at CME Group."
The FX market has already had, and closed, a CCP. Launched in March 2007, the CME/Reuters joint venture, FXMarketSpace (FMS), closed its doors at the height of the financial crisis, just one month after the collapse of Lehman Brothers. During the second half of 2008, liquidity in FX forwards and swaps was impaired, signalling that there were some concerns around counterparty exposures.
But few believe that FMS would get a better welcome today, even in the current regulatory environment, due to the model it used. It was execution-dependent and did not even clear trades traded on CME and Reuters but attempted to create, and then clear, a brand new pool of liquidity. Mr Sammann says that one of the clear lessons learnt from FXMarketSpace is that the market does not want an integrated execution and clearing mechanism - but rather an open clearing solution to clear transactions from any upstream execution venue.
While Ms Masters testified that JPMorgan supported comprehensive oversight of dealers and major swap participants, reporting requirements for all transactions and mandatory clearing requirements for dealers and major swap participants, she believes that market participants should continue to have the ability to choose whether to execute their risk management transactions on exchange or OTC.
"Transparency can be achieved through increased reporting and monitoring without mandatory exchange trading, which deprives participants of this choice. For example, the US treasury security market, which exists entirely OTC, is an enormously transparent market. The systemic benefits that arise from clearing are not at all enhanced by exchange trading, and in fact it is likely that mandatory exchange trading will result in overall damage to the market," Ms Masters told the Senate committee.
Reduced trades
Furthermore, depending on its implementation, ISDA argues the clearing requirement could have the unintended effect of reducing the volume of trades in CLS, which will drive up its costs per transaction and make it less attractive for participants to settle their trades through it. At a time when the FX market is pushing to bring more participants and currencies into CLS, any possibility of an increase in settlement risk, if parties were to refrain from using CLS due to its higher costs, would be a much more significant factor in the FX market.
If this, and the risk that pushing a significant amount of foreign exchange trading into a handful of clearing houses could substantially concentrate credit and operational risk to a degree not present in the OTC markets, does not give the regulators something to think about, perhaps the possibility that non-bank users of OTC derivatives could begin dealing among themselves will. That the regulated exchange-traded market has been available for years, yet still makes up less than 5% of the notional value transacted, speaks volumes.
