The FX swaps client clearing comeback

Chatter about the service is picking up again, but significant hurdles remain

  • When FX swaps and forwards were exempted from the non-cleared margin rules, many people wrote off the chances of client clearing being developed for the products.
  • But talk is growing once again that there could be merit in clearing the products voluntarily.
  • Passive asset managers faced with growing swaps and forwards books have been looking at ways to limit credit line consumption, and clearing could offer one route.
  • Changes to counterparty risk capital rules that favour clearing of swaps and forwards could allow banks to offer cheaper prices at a CCP than bilaterally.
  • Some also see benefits to market structure: for example, allowing non-banks to compete. At least two firms suggest they are interested if clearing gets off the ground.
  • Significant hurdles remain however, particularly the requirement to post margin unnecessarily, and the lack of a solution for settling client trades.

With possible price savings and non-bank competition, chatter about the service is picking up again – but significant hurdles remain

August was supposed to be the month when foreign exchange forwards were finally brought into clearing.

“By September 2020, anyone trading OTC options or non-deliverable forwards will have to pay initial margin and variation margin every day. On forwards they will have to pay variation margin every day. It’s so much easier to do that with a single CCP rather than bilaterally with every counterparty you trade with,” said Gavin Wells, then-head of LCH’s ForexClear service, speaking in 2016.

But things didn’t quite pan out that way. Forwards and swaps were exempted from variation margin, and the final phases of the initial margin rollout won’t be completed until September 2022. With little motivation from the buy side to post variation margin unnecessarily – and no mandatory clearing requirement – client clearing was more or less off the agenda.

However, after interdealer clearing was launched at LCH and Eurex, client clearing talk is quietly starting to pick up again, as market participants start to weigh up the potential benefits of clearing once more.

As investment increasingly flows into passive asset managers, the volume of swaps and forwards used for hedging indexes continues to grow. Limited credit lines at the dealers mean they’re looking for other options – like clearing.

At the same time, LCH has been vocal about the potential capital savings dealers could have from clearing swaps and forwards under an incoming counterparty credit risk methodology – savings that could be passed onto clients, creating a greater pricing incentive to clear.

Meanwhile, as the non-cleared margin rules kick in, the theory is that clients might decide it’s easier operationally to put deliverable forwards in the same place as the rest of their derivatives.

There are other potential benefits to clearing. At least two non-bank liquidity providers are understood to be interested in market-making swaps and forwards if clearing was available. It’s something they’re currently unable to do at scale, as they lack the credit capacity at their prime brokers to do so – a problem clearing the products would solve.

The deliverable forwards market can – and should – clear as a way to remove bilateral credit as a friction within the market
Jeremy Smart, XTX Markets

Some buy-side sources are backing the non-banks’ move, in the hope it would increase competition in the forwards market from alternative liquidity providers.

Jeremy Smart, global head of distribution at XTX Markets, argues clearing can also improve the way the market functions. He says bilateral trading fosters a focus on big balance sheets and abundant credit access over effectiveness and efficiency, which obscures price transparency and stunts market growth. It also undermines the smooth exchange of liquidity, stopping the market from functioning properly during times of crisis.

“The deliverable forwards market can – and should – clear as a way to remove bilateral credit as a friction within the market, which would in turn aid price formation and the smooth functioning of the market as a whole, and facilitate price formation in a central limit order book structure,” says Smart.

Jeremy Smart
Jeremy Smart

LCH and Eurex declined to comment, but a source at one clearing house says the topic has been gaining traction: “How we get clients into a clearing framework is something we’re discussing internally among ourselves and externally with some of our clients,” says the source. A client clearing solution is by no means imminent, but “we’d love to see it happen”, he adds.

That said, many of the same hurdles that have existed for years remain in place. First, it’s unclear whether any of these benefits will outweigh the cost for the buy side to fund initial and variation margin just to trade at a clearing house.

It’s also unclear how settlement risk will be dealt with given that clients would not be members of CLS. Put together, it makes some sceptical that client clearing will take off at all.

“To me, the likelihood of client clearing is very low. I don’t see the real benefits for market participants to really make these moves feasible,” says the head of FX prime brokerage at one large dealer.

Swap or no swap?

Swaps and forwards have long been treated slightly differently than other derivatives. In the Dodd-Frank Act, they were included in the definition of a swap, making them eligible to be subject to mandatory trading and electronic execution. But, the Act included a provision that allowed the Secretary of the Treasury to specifically exclude FX swaps and forwards from the definition of a swap.

The Treasury duly did this in 2012, arguing the products have fixed payment obligations and are predominantly short dated, meaning there is little counterparty credit risk. Instead, they are settled by the exchange of actual currency, often in a payment-versus-payment settlement system, limiting settlement risk.

When the non-cleared margin rules were therefore finalised in 2016, it was no surprise that FX swaps and forwards remained exempt. Europe eventually followed suit in 2017.

That meant the non-cleared margin rules – which were supposed to encourage more use of CCPs – would not have any immediate effect on swaps and forwards. Few people would want to post margin on products when they don't have to.

But things are slowly changing, and talk of client clearing is picking up again for a multitude of reasons. First, passive asset managers are receiving more and more inflows. Index-tracking asset managers, in particular, rely on FX swaps to avoid tracking errors arising from currency movements in their portfolios and, as the inflows continue, are using increasing amounts of swaps.

The economic argument for clearing is there between banks as it would save us money
Head of FX prime brokerage at a large dealer

For some, such as Vanguard and Eaton Vance, this growth has meant they require a wider array of relationships to maintain access to credit lines. While both have looked at innovations such as peer-to-peer platforms, for Eaton Vance at least, clearing is seen as a key way to solve the credit intermediation problem.

Another change is the Basel Committee on Banking Supervision’s introduction of the standardised approach to counterparty credit risk (SA-CCR). Compared with the existing current exposure method, SA-CCR gives better treatment for cleared trades and recognises netting benefits that come from facing a single counterparty.

Introduced in different jurisdictions in the next two years, SA-CCR will be the way derivatives exposures are measured in the leverage ratio. LCH believes the new methodology means exposures for cleared swaps and forwards could be up to 90% lower than non-cleared versions. If this comes to pass, banks believe the capital savings from clearing could outweigh the costs of posting margin for the first time ever.

Dealers also have other benefits at the clearing houses, such as a better ability to net and, at some point, the ability to compress existing trades to bring down derivatives exposures.

This has led to greater momentum for clearing in the interbank market: “The economic argument for clearing is there between banks as it would save us money. There are margin and balance sheet cost efficiencies that could be gained from clearing on the bank side. There have been talks of going in that direction,” says the head of FX prime brokerage at a second large dealer.

If those savings are passed on to clients, this in theory could result in better prices available in the clearing house than in the bilateral market, as is seen with other products such as interest rate swaps.

Virus vol

The Covid-19-driven volatility in March – and the resulting squeeze in liquidity in the swaps and forwards market – has also led some participants to reconsider the benefits client clearing of forwards could bring to the market.

The crisis forced average bid/offer spreads for euro/US dollar spot trades to widen by almost 164% in March compared with February, whereas one-month forwards on the same pair widened by a whopping 618%, according to Bloomberg (see figure 1).

 

 

Proponents of client clearing argue that if the service was around, alternative liquidity providers such as non-banks could have picked up the slack.

Non-bank market-makers currently use prime brokers for credit intermediation in the spot market, but lack the credit limits to make markets in deliverable swaps and forwards. Much of this is due to the tenor of the trades – while spot trades settle after two days, forwards go out to longer dates.

“If you’re trading spot, then after two days all the positions you have on with that counterparty roll off or settle, whereas if you’re trading a six-month forward, then that will stay on your book and will count against your counterparty credit for six months until it settles or rolls off,” says a source at one non-bank market-maker.

Clearing would see a non-bank trade through a clearing member instead and effectively transfer its credit risk to the CCP. This could “initiate a complete sea change in market structure”, according to a source at a second non-bank market-maker, and allow them to compete with the banks to provide liquidity to the market – particularly at times when it’s needed most.

James-Binny
James Binny

Jamie Gavin, head of prime brokerage clearing for Europe, the Middle East and Africa at Societe Generale, agrees that clearing deliverable forwards could help to improve liquidity within the market overall.

“As we’ve seen within the interest rates and credit default swap market, the influx of non-bank market-makers has definitely improved liquidity, as we’ve seen a consistent rise in popularity of the products in a post-clearing environment. There’s no reason as to why that can’t happen for the forwards market too,” he says.

James Binny, global head of currency and head of investments for Ireland at State Street Global Advisors (SSGA) says the introduction of non-banks into the swaps and forwards market could also help from a competition point of view.

“If having client clearing means we could use non-bank market-makers for forwards, then I think that would help from a pricing perspective, as a lot of these guys produce a great service in the spot market but currently can’t offer credit, and so aren’t terribly helpful to us when it comes to trading forwards,” says Binny, who highlights that 80% of SSGA’s business is forwards.

“Our priority is always to get the best price for our clients, and if clearing allows greater competition and more people are able to make prices to us, then that might lower the costs, which is definitely a good thing and within our clients’ interests,” he adds.

Price discovery

Some argue client clearing could also bring in positive changes to market structure, such as price discovery. While swaps and forwards are increasingly traded electronically, there is no central limit order book (Clob) to trade them on – instead they’re traded across multiple RFQ venues or over voice, which some market participants say makes it difficult to benchmark a price at any one time.

Given that clearing is a much more electronic system than trading via voice within the traditional bilateral model of forwards trading, Kevin Kimmel, global head of e-FX at Citadel Securities, says it could encourage further electronification of the market. In turn, this would provide more transparency to pricing.

“There’s less price transparency in the forwards market, and, as a result, less participation than in the spot and futures markets, which have a broader array of participants. Enhanced transparency also allows end-users to conduct more robust transaction cost analysis and ultimately achieve better execution, which is a fast growing and beneficial trend that we’ve seen in the spot market,” says Kimmel.

Clearing could also help the market move towards Clob trading for the most popularly traded dates and tenors at least, he adds. While Clob trading is highly desirable for non-bank market-makers – as they can use the streaming prices to automate market-making as much as possible – Kimmel believes the increased price transparency from Clobs could also help improve liquidity in times of stress.

“Markets that are more transparent and robust generally hold up better during periods of extreme volatility, which is another reason to move deliverable forwards into a more transparent and centrally cleared model,” he says.

Margin hurdles

However, a number of hurdles to client clearing – ones that have existed for many years – still remain, the biggest being that clients would have to post initial and variation margin if trading via a CCP.

While market participants such as Eaton Vance believe this exemption for swaps and forwards won’t last forever, in the meantime, the cost of funding the margin presents a significant hurdle for clients considering clearing.

“You might get better forward prices because you have more competition, but there will also be extra costs. In particular, if our clients have to collateralise, as that would lead to inefficiency, and means they can’t be 100% invested in their underlying assets,” says SSGA’s Binny.

The potential price savings of clearing versus bilateral are also disputed. Some point out that the savings on SA-CCR are still being worked through – and don’t necessarily apply to banks that aren’t constrained by the leverage ratio – so not everyone could offer a benefit.

David Reid, global head of FX prime brokerage at Deutsche Bank, also says there are plenty of clearing costs that would eat into a potential price benefit, whether it be the fees paid to the CCP, or technology cost of the new systems that would be required.

For clearing to be beneficial, you either need everything to clear or nothing at all
Oscar Kenessey, NN Investment Partners

“It’s a bit like moving from a petrol car to an electric car – we’ve got a big historical infrastructure around one mode of transportation and potentially moving to another one. That transition isn’t a free transition, as it might be cheaper to run an electric car once you plug it in, but the car costs more in the first place and you have to figure out your charging networks and so on,” he says.

“You’ve got to figure out how you move from one system to another, and doing that is definitely non-trivial that’s for sure.”

SSGA’s Binny says it will be tricky to find out whether, on the whole, clearing swaps and forwards would be economic: “Are we getting greater value add from getting better prices and is that offsetting the extra costs? That is something I don’t know at this stage and is something that would have to be proven to us,” he says.

Some clearing proponents argue that when asset managers start having to post margin on other non-cleared derivatives products to all their different counterparties, netting them together at a CCP will start to make more sense, especially as it requires less initial margin. At that point, it might make sense just to start clearing swaps and forwards voluntarily so everything is in one place from an operational perspective.

Oscar Kenessey, head of fixed income at NN Investment Partners, agrees a central model is preferable in theory, but says it would require all his own clients to want to clear to make economic sense.

While clearing would no doubt give rise to new entrants, these new players would be joining what is already a very competitive landscape
Holden Sibley, TPIcap

“For clearing to be beneficial, you either need everything to clear or nothing at all, as you don’t want to be in a position where you’re having to pay all of the running costs for clearing, only for a large group of your clients to still want to trade on a bilateral basis,” he says.

SSGA’s Binny also notes that most of their clients would not meet the notional-based threshold that would bring them into the initial margin requirement for non-cleared derivatives anyway.

Similarly, Deutsche Bank’s Reid notes that market participants have a lot of inertia when it comes to changing their trading, settlement and post-trade operational processes, so there has been little movement on the topic as yet.

“There’s a great deal of conversation and dialogue in multiple directions between ourselves, our clients, CCPs, and also the post-trade technology providers involving the potential direction of travel, but there’s not much in the way in terms of boots on the ground,” he says.

Some market participants are also resistant to the idea that new liquidity providers will automatically make the forwards market more competitive. Holden Sibley, head of FXHub at TPIcap, says that while it’s broadly true that more competitors in a market makes pricing tighter, it’s hard to say what impact clearing would have on the swaps and forwards market.

“Competition in the dealer-to-client space is already fierce among the existing liquidity providers, who fight hard to win trades from end-clients and thereby maintain desired market share. So while clearing would no doubt give rise to new entrants, these new players would be joining what is already a very competitive landscape,” he says.

He adds that the forwards market these days competes less on spread, and more on the ability to provide discounted prices driven by a bank’s positioning.

Deutsche Bank’s Reid also argues it’s not a given that non-banks will have the best prices if they did step into the swaps and forwards market: “Banks are very good at producing prices and we compete with non-bank market-makers all the time. Looking at the evidence from clients who trade with banks and non-banks, I would say the client experience doesn’t necessarily show non-bank pricing is in any way markedly superior to bank pricing,” he says.

That said, Eric Donovan, head of FX and interest rates at StoneX, says banks will not be falling over themselves to move to a market structure that puts them on a level playing field with the non-banks, as it could cannibalise their own trading desks.

“Banks are under assault from non-bank market-makers in the spot market, so they’re doing everything they can to keep them out of the forwards market; that’s absolutely happening,” he says.

Un-settled

Settlement risk is the other major challenge that has not yet been solved to allow for client clearing. For non-deliverable products, the main risk is that a counterparty defaults and you lose the mark-to-market value of the product at the time. But with deliverable FX products, the main risk is that you pay your leg of the trade – which could be hundreds of millions of dollars or more – but never receive the other side.

For interdealer clearing of deliverable forwards, clearing members all settle their trades at CLS in a payment-versus-payment system – where transfers only go through when both sides have submitted their respective sums. But if clients who are not members of CLS are involved, the risk on the clearing member to client leg is left with the clearing members, who would have to settle gross with all their clients.

The head of FX prime brokerage at a third large dealer says this would leave them not only with settlement risk to the client but a liquidity issue, whereby the clearing member to CCP leg settles in CLS at one time, but the offsetting client leg is settled at a different time.

“You don’t want to be in a position where your liquidity position is hurt due to settlement timelines, so we need to come up with a system that settles real time across the board with maximised netting. The technology is out there, we just need to apply it to the ecosystem,” he says.

Some suggest LCH could create a CLS-type mechanism to solve the problem. Societe Generale’s Gavin says another possible option could be for the client to deliver directly into CLS, or perhaps there could be some sort of third-party guarantee. But it’s still an issue that’s yet to be solved.

“I don’t really think there’s a workable solution out there just yet, which really is the challenge to overcome for clearing physically settled products,” he says.

Additional reporting: Alessandro Aimone

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