CME Paper Pushes Central Credit Utility Model for FX

A new paper by CME Group’s Traiana studies the current FX credit landscape and argues that the evolution of a central utility model would avert the chance of FX markets promoting “discriminatory execution” or removing access for a segment of those markets.

The paper argues that given appropriate tools for measurement, monitoring and enforcement of credit, FX intermediaries can effectively manage their exposures to clients and liquidity providers without wholesale disruption to existing global execution models or the credit processing and framework that underpins the FX markets.

In a statement that may not find agreement in the ranks of fintechs seeking to provide new solutions to the industry, the paper also argues the FX industry “does not need to tear up existing technology and tools, procedures and controls in order to achieve the desired balance for all FX participants”, adding, “engagement and involvement in defining core API, data and interactions is a crucial first step”.

There will undoubtedly be arguments in the FX industry that the paper is very much aimed at providing better access to non-bank firms – a segment that remains a strong element of the CME client base – however data continues to indicate a growing presence of these firms in FX markets and as such a credit utility would probably provide some benefits.

In laying out its argument, the paper uses recent Turkish lira events – and the increased presence in these markets of non-bank firms – and states, “The combination of economic uncertainty, policy changes and requirement for real-world physical settlement of currency created a squeeze on funding markets which led to large volatile moves in FX rates and subsequent triggers for OTC FX options, a perfect storm for credit intermediaries.”

The paper does acknowledge that the circumstances could be unique to Turkey and are an anomaly, it also accepts that “no large losses can be directly attributed to the volatility in the lira”, however it adds, “We have seen similarities with currency shocks in Russia, Indonesia and will continue to experience these going forward with Argentina, Poland, China, India and Brazil can be volatile currencies.”

The paper argues that traditional net open position (NOP) and daily settlement limit measurements “may not recognise risky or volatile settlement conditions in an appropriate manner”.

It argues that better credit controls across a wider spectrum of venues and intraday liquidity savings mechanisms, or pre-settlement tools and funding, may be beneficial “or required where CLS processing is not available”.

The importance and inclusion of all participating firms: vendors, platforms, price takers and makers are crucial to the successful transition into a viable FX credit microstructure.

As an example, the paper notes that “a large PB (prime broker)” suffered losses from client FX exposures, stating, “In 2018 PB Reports of losses in the range of $180m vs $30m in margin against a single counterparty due to exotic FXO.”

It continues, “Margining and collateral controls are essential and should be linked into credit for execution purposes, but due to the nature of options exercise and post-trade settlement the risks in FX options can be more extreme than cash products. In this specific scenario the PB would have had a matched book, i.e. Client->PB and PB->EB and potentially because of this model, the intermediary may not have had sufficient tools to manage the risks appropriately. It was evident that the PB margin requirement was well below the potential losses.”

The paper studies potential challenges for FX markets going forward with the background of the G10 goal to incentivise central counterparty clearing through margin and balance sheet constraints – with the acknowledgement that the impact on FX markets has been “muted to date” dur to the cash nature of the product.

The fact that FX products are not mandated for clearing beyond NDFs and FX options, means, the paper observes, that executing parties and intermediaries have a choice. “This implies that FX credit models may need to incorporate multifaceted execution to settlement paradigms, including PB to clearing, bilateral to clearing or indeed a cleared product from point of execution,” it suggests.

The paper closes by proposing a “strawman” utility model, that focuses on core principles to address the needs of market participants, including central banks. It says an industry utility model to link in execution to full and final settlement processing across a more diverse set of FX liquidity pools would enabling and extend the current credit process and framework.

This new framework would need to involve a partnership with an FX industry body, the paper says, adding all primary participants would contribute to the definition of a set of core data models and APIs that would allow participants to interact more efficiently. They would also establish some core de minimis requirements for each participant in their interactions with the FX credit microstructure.

It further suggests that a central utility service could be the centrepiece of the ecosystem and could implement and enable the interactions. “The merits and benefits of a utility model are well understood within the financial markets and provide value for both participants and regulators,” the paper states. “We have observed this with varied level of success within the FX markets with the introduction of CLS in 2002.

It further says that the FX clearing infrastructure has evolved organically since early 2010’s with some market penetration for the NDF product but little traction across other cash products. “Importantly, the challenges with an FX credit utility are much broader in scale and participation, unlike CLS and CCP, an initial bank only focus may not address the core issues,” the paper argues. “The importance and inclusion of all participating firms: vendors, platforms, price takers and makers are crucial to the successful transition into a viable FX credit microstructure.

Increasing participation, improving tools and links, increasing distribution and addressing the overallocation issues would be the primary goals of the service.

“As a minimum, a holistic design approach should be taken in order to meet the needs of all participants in the ecosystem,” it adds.

Although the paper acknowledges it is unknown if the utility would need to register as a Credit financial market infrastructure (FMI), it says an appropriate governance structure, rulebook and legal framework would ensure appropriate access for FX participants. Additionally, future iterations could enable extension into other asset classes such as exchange traded derivatives, repo and OTC equity derivatives where similar credit intermediation issues exist, it says.

“Whilst providing access and implementing core processing would be paramount to the service, the credit utility would need to ensure some core improvements to the current toolkit which would allow intermediates to meet their goals in order to manage, monitor, measure and control FX credit risks,” the paper states. “Increasing participation, improving tools and links, increasing distribution and addressing the overallocation issues would be the primary goals of the service.”

The paper concludes by observing that structured formal engagement is a first step and one of the core initial debates would centre around the need for and merits of a central utility. “Indeed, the intention of the paper was not to provide all the answers and disclose a definitive service proposal,” it says. “Instead, this is the start of a journey. We welcome and encourage broader engagement and debate on the merits of extending the current process and framework to a central utility model in order to enable an efficient well-functioning FX credit ecosystem.”