FX derivs market overhaul begins

IFR 2047 23 August to 29 August 2014
4 min read
Americas
mike kentz

A year after over-the-counter interest rate and credit derivatives first migrated into a mandatory clearing environment, US regulators have been forced to back away from plans to authorise foreign exchange derivatives rules as the market struggles to harmonise the clearing process with the physical delivery of FX transactions.

Market structure changes have already begun to occur, if at a glacial pace, in what are the early stages of work that is likely to extend into late 2015 and take on increasing importance as the market decides how to mitigate systemic risk factors associated with FX derivatives markets.

“While it seems like a simpler market in many ways, it’s actually much more sensitive to changes, given its global nature, and more representative of systemic risks than people realise,” said Gavin Wells, chief executive of LCH.Clearnet’s ForexClear service. “In the absence of a functioning FX derivatives market, a significant portion of cross-border activity may have difficulty transacting.”

Launched in the spring of 2012, ForexClear has cleared more than US$1trn in non-deliverable forwards across 11 currency pairs as the dealer community looks to move OTC products into clearing ahead of a coming CFTC mandate.

CME Group also launched NDF clearing in 2012, although volumes are virtually non-existent since the firm’s clientèle is more buyside-based – a segment that according to market participants has no incentive to move into clearing until the mandate hits.

As for the mandate, CFTC commissioners Wetjen and O’Malia stated earlier this year that a draft proposal was likely to come before the end of summer. However, by all accounts the agency has been focusing its attention on the more pressing issue of equivalence standards for clearing across borders.

Options difficulty

While market structure changes have already occurred ahead of the mandate, it is likely that regulatory impetus is needed to solve the thorny problem of how to clear FX options. The main issue is how to mitigate settlement or Herstatt Risk – so-called after the German bank that failed to honour FX payments across different time zones after it went bankrupt.

The marriage of clearing houses and industry-run FX payments settlement system CLS Bank for the clearing and physical delivery of FX options has already begun to shift the landscape in the futures space.

Frankfurt-based Eurex became the first provider to guarantee physical settlement at CLS through its own clearing house when it introduced FX futures in July.

Meanwhile, both CME and the InterContinentalExchange have announced plans to a move to a so-called paired delivery mechanism for the guaranty of currency delivery in FX and commodity futures and options. CME will make the transition early in September while ICE made the move in June.

Previously, bank members of CLS provided clearing houses with third-party access and guaranty of settlement through the CLS system. But the risk-return profile of providing the guaranty for a clearing house’s entire futures complex has proved to be too unwieldy, with banks dropping CCPs from their third-party settlement agreements, according to one head of FX prime brokerage at a major bank.

The shift has been precipitated as a result of more products entering clearing, which have added to the FX settlement risk for banks and forced CCPs to overhaul processes.

The paired delivery system will de-aggregate all the relevant settlements, and match bank clearing members’ open long and short positions with one another to facilitate delivery at the maturity of the contract. The system may work well for futures, but there are concerns that it may not fit well for FX options.

“You’ve got the concern if you’re a settling institution that you may be matched up with an entity that does not have access to CLS – that you may move from matching up with one entity to maybe 100 that you didn’t know about,” said the FX head. “It’s come about due to the absence of any other viable alternatives at this point.”

Market participants point out that it will be important to figure out the issues around options clearing ahead of December 2015, when uncleared derivatives margin requirements are scheduled to come into effect – and are expected to make non-cleared transactions significantly more expensive.