Abstract

The financial crisis of 2008 was an inflection point for the financial markets which have never been the same since then. Rated one of the worst financial crises the world faced since the great depression in the 1930s, it led to an estimated loss of a whopping $19 trillion in net worth as stock markets plunged worldwide. Questionable high-risk mortgage lending practices by financial institutions and overexposure to OTC derivatives impelled by lackadaisical regulatory oversight brewed a perfect recipe for colossal disaster. Some prominent financial institutions back then like Lehmann brothers and AIG faced severe financial distress and eventual bankruptcy. The crisis prompted worldwide governments to devise and implement significant regulatory reforms such as the Dodd-Frank Act, Basel III, EMIR etc. in a bid to overcome the prevalent lack of oversight, inadequate risk management practices and lack of transparency in the financial markets by creating a resilient, robust and transparent financial system.

Central clearing was considered as a panacea for many of the problems exposed by the financial crisis, because of its apparent advantages in reducing credit risk and enhancing market transparency. Consequently, over the last decade, notable push came in from regulators worldwide for increased clearing and central counterparty (CCP) executions, especially in the opaque and infamous OTC derivative markets. OTC Instruments like interest rate swaps (IRS), credit default swaps (CDS) and certain other equity/commodity derivatives were quickly brought under the central clearing mandate gamut.
Nevertheless, FX markets have been traditionally over-the-counter (OTC) and often less regulated than other markets. Although there has not been any regulatory mandate to clear FX products to date, newer credit and margin-based regulations being imposed (like SA-CCR and UMR) mean that it may be more economically and operationally efficient for the financial participants to clear a part of the FX exposure in their portfolios rather than continue maintaining multiple bilateral relationships.

Clearing in FX markets is slowly evolving. There have been initiatives by sell-side and clearing houses to introduce post-trade workflows to enable clearing of FX trades executed bilaterally between participants (viz. Block trades and EFPs) while some exchanges provide central limit order book (CLOB) based matching for completely anonymous “built to clear” trading of certain FX instruments like FX futures and options.

Clearing does bestow material benefits on paper. It leads to increased operational efficiency by streamlining and standardizing post-trade processes, lowers margin rates and provides access to more counterparties than the bilateral model. Moreover, worldwide regulatory authorities also seem to be vouching for it. However, the clearing yang comes from potential drawbacks like increased costs, reduced flexibility, market fragmentation and enhanced operational burden.

Status Quo

FX clearing is achieved through specialized and standardized processes facilitated by the
clearinghouses. Some of these are as follows,
Pre-execution (“Built to clear”)
FX futures and Options are exchange-traded standardized instruments currently offered by major exchanges like CME, Eurex etc. The matching is held in an exchange central limit order book (CLOB) with completely anonymous and transparent all-to-all firm liquidity. All trades executed are cleared and multilateral netting results in compression of cash movement. This also results in a reduction of the credit risk exposure of each participant. LCH has recently introduced a new CLOB-based matching facility for FX Non-deliverable forwards (FX NDFs) trades bringing the NDF clearing to the pre-execution phase of the trade life cycle for the first time.
Post-execution
In this case, the FX trade is first negotiated and executed bilaterally between the concerned parties. The trade is then submitted to the clearing house using the trading venue’s connectivity or independently by the counterparties. The trade is matched and novated afterward by the clearinghouse and reported to the members. Margin requirements are calculated on an intra-day basis and trades are fixed and settled on maturity.

In addition, there are clearing mechanisms provided by various exchanges where the trading counterparties can negotiate on-exchange FX products bilaterally and then report the trade to the clearing house. One of these is the ‘Block’ trade (offered by CME and Eurex), where the institutional counterparties can negotiate an FX futures or options trade privately and report it later to the clearing house for clearing. These trades are subject to minimum transaction size and/or reporting time thresholds that vary from exchange to exchange.

Another such product is called the ‘Exchange for Physical’ (EFP) in Eurex or ‘Exchange for Related Positions’ (EFRP) in the Chicago Mercantile Exchange (CME). This transaction is a mechanism that enables an FX futures or options contract to be traded off-exchange in combination with a related, off-setting FX OTC position. This mechanism helps parties to move their OTC positions to cleared positions thereby reducing their uncleared exposure and achieving operational gains through CCP clearing at the same time. Moreover, it enables the participants to tap into two different liquidity pools, i.e. both off and on-exchange liquidity.

The numbers show that clearing volumes are increasing gradually. A report on Clarusft shows that NDF clearing reached a staggering $3.3 trillion by the end of Q3 2023, a 10% increase over the Q3 quarter last year. FX option and forward clearing has almost doubled while FX spot clearing is also picking up.

Drivers

There have been numerous drivers underpinning the rise of clearing in FX over the last few years.
On the sell-side, the interest in clearing as a solution to optimize both margin and capital is slowly gaining traction. The sell-side participants are realizing the counterparty credit benefits that a central clearing counterparty (CCP) can offer by removing counterparty risk (that they otherwise have against their bilateral counterparties) and netting the exposures against a single counterparty (i.e the CCP itself) with much lower risk weight.

On the buy-side, the largest driver for clearing appears to be managing the UMR requirements, which makes bilateral trading more capital-intensive by mandating the exchange of initial margin (IM) for uncleared OTC derivate transactions. Instead of posting this IM with every counterparty the buy-side client has a credit line with, the margin can be efficiently managed by posting it with a central clearing house on a netted basis. Moreover, cleared transactions do not count towards "aggregate average notional amount" (AANA) calculations in UMR either, making clearing a useful tool in managing UMR thresholds. Additionally, cleared products provide an alternative source of liquidity to the buy-side vis-avis
the OTC markets.

In addition to reducing the counterparty risk, multilateral netting of transactions centrally streamlines the operation processes for all participants, lowers trading costs and enhances overall efficiency. It also reduces the settlement risk by leveraging a market settlement infrastructure like CLS.

Challenges

Transitioning to clearing workflows in FX might not exactly be a walk in the park and may involve navigating through financial implications and potential regulatory complexities.

FX instruments are not mandated to be cleared. Moreover, clearing involves cost overheads related to margin requirements and clearing fees. Some smaller players might find it challenging to meet the collateral/capital requirements essential to be able to clear and may continue to stick with the existing bilateral trading models.

A point worth pondering is that clearing is not a blanket solution. It may not suit all the participants all the time and in all situations. The risk exposure portfolio will need to be optimized with the right mix of cleared and uncleared volumes. Clearing in a selective way to minimize the margin requirements while maximizing capital savings will prove to be the key. This will require a change in existing processes to determine the optimized proportion of cleared and uncleared FX derivative exposure based on a variety of factors like currency pairs traded, trading counterparts, available credit per counterpart, maximum risk change allowed etc. Additionally, the technology infrastructure will also need an upgrade to be able to consume clearing related messages and data while not disrupting the existing workflows. Fintechs are at the forefront of devising new algorithmic models, where client risk portfolios are analyzed and optimized by selectively moving existing uncleared trades into the clearing house, resulting in margin and capital gains for the client. However, these are still in their nascent stage and PoCs are being run at present to test and certify the efficacy of these models before they can be declared production-ready.

Finally, although CCPs mitigate credit risk, they may create liquidity risks, especially in highly volatile and stressful market conditions.

Emergence of Blockchain

Blockchain and digital ledger technology (DLT) have been hailed as a holy grail for the transformation of post-trade processing for some time now, but adoption in clearing could be slower than in other areas like master data management, settlement, collateral management etc. DLT can conceptually incorporate appropriate rules to implement netting and clearing within its framework, potentially improving today’s centralized counterpartybased clearing processes. However, these clearing processes of today have evolved over time and have played a critical role in creating stable, scalable, resilient and cost-efficient market infrastructure. Prima facie, it seems difficult to replace these time-tested current clearing processes without a significant risk and cost-benefit. To exacerbate the matters, DLT still is not mature enough, unproven in stressful market conditions and may have inherent scalability and integration limitations when applied to financial market infrastructure.

Conclusion

Clearing has been in vogue since the troubled times of the 2008 crisis. Dodd-Frank, EMIR and the capital and margin-based frameworks (like UMR and SA-CCR) have led to an increase in the clearing of many different types of OTC derivatives, but the take-up in FX has been slower. The reasons are obvious, FX instruments are not mandated to be cleared, FX trades are generally of shorter tenors thereby limiting the counterparty risk and certain FX instruments like spots are excluded from the IM calculations. All these together with perceived additional clearing costs inhibited participants from taking up clearing big time.

However, market participants are slowly warming up to FX clearing as resource management and balance sheet optimization take center stage. The renewed focus on efficient use of margin, credit and collateral is spurring the FX markets to lean towards clearing. FX clearing opportunities are increasing, market infrastructure is growing, and the cost of capital is rising, all these factors are propelling FX clearing forward. Market infrastructures like clearing houses and exchanges are enabling new innovative clearing workflows both for pre-execution and post-execution phases. Trading venues and sell-side are bolstering their existing systems and connectivity to be able to incorporate these workflows and offer them to the buy side as an alternative to the traditional OTC way of trading. Fintechs are chipping in with new cutting-edge technology developing models to optimize and transfer risk to clearing houses to enhance capital and margin usage. Technological innovation like Blockchain and digital ledger technology that runs cryptocurrency transactions is also being explored to support the clearing use case.

All this collaboration between financial institutions, clearing houses, regulatory bodies and other market participants together with advances in technological innovation is imperative to foster a resilient and efficient FX clearing ecosystem. FX clearing though in its infancy is taking rapid strides towards becoming mainstream.

References

1. Financial crisis 2008 - https://www.investopedia.com/terms/g/greatrecession.
asp#:~:text=As%20a%20result%20of%20the,U.S.%20Department%20of%
20the%20Treasury.
2. Cleared volumes for FX derivatives - https://www.clarusft.com/3q23-ccp-volumesand-
share-in-crd-and-fxd/
3. https://www.quantile.com/wp-content/uploads/2023/05/eFOREX-FX-Clearing-
Supplement-2023-Final.pdf
4. ForexClear | What We Clear | LCH Group
5. Central Clearing and Systemic liquidity risk
6. https://www.dtcc.com/~/media/Global/Tapping-the-Potential-for-Distributed-
Ledger-EN