Will uncleared margin rules change the FX landscape?

As the next phases of uncleared margin rules come into force, there will be an economic driver for more clearing of FX. By Phil Hermon, Executive Director of FX Products at CME Group

Among foreign exchange market participants, there is a nearly unanimous view that uncleared margin rules (UMR) are the major catalyst for the adoption of central clearing for over-the-counter (OTC) FX derivatives.

This conclusion may in and of itself seem evident given that the higher volumes of FX clearing only really began in 2016 in line with the first phase of UMR, and that those volumes (and number of participants in the cleared ecosystem) continued to grow over 2017 and 2018 as the UMR phases continued to roll out.

SIMMple Economics?

For entities directly impacted by UMR, ISDA SIMM is the most prevalent model for the calculation of the Initial Margin (IM) requirements that have to be posted by both counterparts to every trade (Not all bilateral FX Trades are directly captured in the initial margin calculation under UMR. For example, physical FX Forwards are excluded, while both non-deliverable forwards and FX options are included.)

The headline comparison of ISDA SIMM versus a clearing house IM model often centers on the Margin Period of Risk (MPOR), with ISDA SIMM using a 10-day MPOR and a clearing house such as CME Clearing using a 5-day MPOR.

The model differences do, however, go far deeper than the time horizon for coverage. This can be illustrated in a side-by-side comparison of the indicative IM as a percentage of notional requirement on positions cleared to CME Clearing and the same positions under ISDA SIMM in the bilateral environment (Analysis conducted by CME Group in October 2019 on standalone long $3 billion notional one-week maturity non-deliverable forward trades)

These IM model differences are only the first level consideration in trying to mitigate and optimize the funding costs imposed by UMR.

Migrating trades from a number of bilateral trading counterparts to clearing also enables all of the positions to be netted, and for any correlations and offsets in the portfolio to be recognized.

 

Embracing Complexity

If the voluntary clearing of FX is indeed all about economics and centered on market participants working to reduce costs, then the next two years could be very interesting in terms of further developments within the FX marketplace.

The calculator below illustrates the main economic factors for consideration in the cleared environment, and of these we feel that liquidity add-ons, default fund construction and clearing house fees are the additional areas of complexity that market participants should ideally revisit, understand and include in their optimization decisions rather than just considering the model and netting benefits of moving from ISDA SIMM to a clearinghouse.

 

Wider Adoption

As UMR Phases 5 and 6 come in to force in September 2020 and 2021, respectively, there will be a clear economic driver for more firms across both the buy side and sell side to embrace clearing of FX. Such a strong drive to clearing can arguably feel like an implicit clearing mandate.

It is, however, worth noting that depending on the entity involved, the adoption of Listed FX Futures & Options and/or OTC clearing for FX isn’t always driven by initial margin optimization alone.

For example, clearing can assist dealers in freeing up their balance sheet and helping to improve return on equity by moving FX forwards, options and swaps in to a clearing house. Whilst for a buy side firm not using a FX prime broker, clearing may provide an effective mechanism to free up bilateral credit lines, access more liquidity providers, achieve netting for daily settlements and automate the trade allocation process.

While this combination of potential benefits may serve as tailwinds for market participants to revisit using Listed FX futures & Options and OTC clearing for FX, it also remains true that clearing is not available for all FX products and won’t necessarily be relevant for all FX market participants – especially those not directly impacted by UMR and those with economic prime brokerage arrangements.

It may feel like there is an implicit clearing mandate of FX products for some market participants, but it remains very much a voluntary choice to help those trading in FX markets achieve margin efficiencies and to optimize their trading activities.

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