CCPs eager for first forex clearing mandate

Market participants claim a clearing mandate for non-deliverable forwards is written, but has been languishing while the Commodity Futures Trading Commission puts new leadership in place. With that now done, some say the rules could be issued within weeks. Fiona Maxwell reports

Central clearing of foreign exchange derivatives has been a long time coming. More than three years after the first central counterparty (CCP) launched a service for the clearing of non-deliverable forwards (NDFs) – and over a year since US clearing mandates kicked in for interest rate swaps and credit default swaps – the market is still waiting for the Commodity Futures Trading Commission (CFTC) to pull the trigger. Some believe the wait could soon be over.

"I think it will happen in July. They've been working on the determination since September last year; they now have a full complement of commissioners again and are ready to issue the proposed determination to get public comment. Lots of people have been consulted already," says one clearing house source, who adds he receives almost daily enquiries on the topic from clients.

Despite the fevered speculation, NDFs account for only a tiny fragment of trading in the vast forex market. According to the latest triennial survey by the Bank for International Settlements, taken in 2013, roughly $127 billion is traded daily in NDFs – just 2.4% of the $5.3 trillion daily turnover in the broader market.

But small as the NDF market might be, it is currently the only forex product that can be centrally cleared. Spot, swaps and forwards, which make up nearly 93% of daily trading, are all exempt from clearing under the Dodd-Frank Act. Forex options will eventually be mandated for clearing but they are physically delivered, presenting a much greater challenge when it comes to settlement. As international standards require financial market infrastructures (FMIs) to guarantee final settlement of trades, the industry must first find a mechanism that would ensure CCPs have access to sufficient liquidity to provide that guarantee.

In the meantime, CCPs are itching for an NDF clearing mandate that should ignite competition. As far back as 2011, CME Group and Singapore Exchange (SGX) announced they were ready to clear NDFs, closely followed by LCH.Clearnet's ForexClear, which launched in March 2012.

the words have been written and everyone's been waiting to see what it says, but the new commissioners need to get their feet under the table

Voluntary clearing of NDFs so far appears to have been very limited. ForexClear has been most vocal about its success, having expanded since launch to cover 11 currencies, accounting for around 95% of the NDF market, and also opening up to client clearing late last year. But its actual cleared volume is still fairly low, with a monthly notional value of $68 billion cleared in June 2014, while its record was $99 billion in April 2013. By comparison, SGX has cleared $2.6 billion since their launch in October 2011, and a spokeswoman for CME says there is currently no volume to report.

To some extent, the lack of voluntary clearing isn't surprising. Market participants might want to test the systems prior to the arrival of a mandate, but few would want to transition to ongoing clearing – which can involve some hefty one-off costs – if they can avoid it. Some believe that will change once the CFTC publishes its draft determination.

"One of the major reasons not to voluntarily clear is when you do, you're stepping into a higher level of regulatory responsibility, including potentially pre-limit checks and similar things. I do not believe the firms across the Street are trying to avoid regulation by not doing so, it's just that it would be a higher level of responsibility, which is costly and resource-heavy," says the head of over-the-counter clearing at one large bank.

But while most large banks and funds are probably well versed in the mechanics of clearing by now, and should be able to adopt NDF clearing fairly smoothly when it becomes mandatory, the same may not be true for all users of NDFs. As the product provides offshore access to many emerging market currencies that still have strict exchange controls, users of the product could include both small corporates with exposure to those currencies and small investors. These firms may not have experience of clearing other products and will therefore need to begin testing prior to the mandate.

"I'm not sure how many clients have started any onboarding or testing. I suspect the uncertainty about the mandate probably means they haven't in a meaningful way. However, I expect they will have had conversations with their prime brokers and will just amend existing prime brokerage relationships to also include the clearing relationship," says Mark Croxon, global product manager for OTC derivatives clearing at Nomura in London.

It is not clear why the CFTC has taken so long to mandate NDF clearing, but market participants are willing to guess. One possible explanation is the recent change of leadership at the agency, with Timothy Massad sworn in as the new chairman on June 5, following the departure of Gary Gensler at the end of 2013. Two further commissioners, Sharon Bowen and Christopher Giancarlo, have also only just been sworn in, replacing Bart Chilton and Jill Sommers. Some believe the change of staff has delayed publication of a clearing determination for NDFs that is widely believed to have been written some months ago.

"It's a political thing. A new commissioner comes in and there are two ways of doing things – you either get the document out without that new commissioner, who can then come in and make his mark by saying ‘Oh no, we should have done this', or you don't release the document and he comes in and makes his mark by waiting and making the CFTC look like a unified group," says one London-based market source.

Another possible explanation is that the CFTC is holding back until European regulators get to the point where they are also ready to mandate clearing of NDFs, effectively aligning the two regimes. Given that widespread clearing of interest rate swaps and credit default swaps is not set to happen until 2016 in Europe, few are holding their breath on this score.

Esma is also still seeking clarification from the European Commission (EC) on the precise definition of derivatives under the European Market Infrastructure Regulation (Emir), and specifically whether forex forwards should be included in the scope of Emir, which covers both trade reporting and central clearing. Esma wrote to the EC in February requesting clarity, but it remains an unanswered question.

All this uncertainty in Europe means the US is far closer to being ready for NDF clearing, and CCPs are naturally anxious that the CFTC ploughs ahead.

"The foreign exchange market is truly global, so I believe the introduction of the US mandates will lead the market as a whole to move to clearing. We have as much interest from members and clients in Asia and America as we do from Europe," says Gavin Wells, global head of ForexClear at LCH.Clearnet in London.

But some warn a situation in which clearing is mandatory only in one jurisdiction increases the danger of regulatory arbitrage, as market participants may look to avoid the regulations by dealing only with non-US counterparties.

"If NDFs are mandated to clear in the US first, you'll get the same issues we've seen in rates and credit, meaning some people potentially look to trade with non-US houses so they're not caught by the clearing requirement, if they don't want to clear the products," says one London-based head of clearing at a large bank.

"There is a fear of fragmentation," agrees Steve French, director of product strategy at post-trade technology provider Traiana in London. "What we saw in Asia was that Asian counterparts stopped trading with US counterparts to avoid the cross-border jurisdiction issues. Instead, they started trading with European counterparts. There's a similar fear that if there is no NDF clearing mandate in Europe, NDF trading may move to Europe as much as it can."

Once the CFTC does publish a draft determination, it will still be some time before clearing becomes mandatory in the US, given the need to seek public comment and consider responses – a process that would typically take up to 90 days. Assuming clearing will then be phased in with specific categories of user, as was the case with other asset classes, the first round of clearing is now unlikely to start before the first quarter of 2015 at the earliest.

"The CFTC change of commissioners has created a delay – the words have been written and everyone's been waiting to see what it says, but the new commissioners need to get their feet under the table and work out whether the text says what they want it to say. There now seems to be a spread on when that's expected, between September and the end of the year, which would probably pushes the US mandate into the second quarter of 2015," says David Holcombe, London-based head of foreign exchange at Nasdaq OMX, which is allowing participants to test clearing of NDFs as it waits for approval from Esma.

But while Nasdaq OMX has sensed an opportunity in the forthcoming mandate, Holcombe views the resulting cross-border tug-of-war as a problem: "The forex market used to be global, allowing everyone to feasibly trade with everyone else, but as a result of all this regulation, what we're getting now is a lot of fragmentation where the rules don't quite align between jurisdictions. People will naturally try to avoid the burden of regulation if they can, so it is vital regulators fully consider their rules' impact on the global forex market as well as the jurisdiction they specifically wish to control."