Coalition Greenwich: FX Market Hasn’t Got the Clearing Memo
Posted by Colin Lambert. Last updated: August 11, 2023
With The Full FX View
A new study from Coalition Greenwich says that while OTC derivatives clearing has been with markets for over 15 years, “the foreign exchange market still hasn’t gotten the memo”.
The study notes that while interest rate markets are seen a surge in demand for clearing, FX is lagging behind, mainly because there is no clearing mandate, a chunk of the market is excluded from initial margin rules and trade tenors are predominantly short-dated. The report adds that FX participants will always be more selective about what they clear and perhaps never attain the 75% ratio currently being seen in interest rate swaps, however it also observes that volumes are finally increasing “as the driver shifts from a lack of proscriptive clearing mandates to the need for prudent financial resource management”.
The study reflects on the current growth in FX clearing, noting cleared OTC FX on LCH ForexClear is up 42% in the past two years (cleared notional has risen 25% over the same period) and that other clearinghouses support FX products as well. It observes, however, that “more innovation from trading venues and middleware will help support the transition”.
There is an acknowledgement that much of the clearing, in NDF especially, has been dealer-to-dealer and not yet dealer-to-client. Hedge funds, it notes, have shown less of a propensity to clear, and other client types may simply not be ready, whether operationally or for financial reasons.
Additionally, the study suggests that dealers may not be pushing clients toward clearing as it could diminish the value of the relationship, and that for some on the buy side, especially the largest asset managers, advantageous credit relationships with their banks can further discourage clearing.
This measured uptake of clearing by the buy side has somewhat slowed growth, the study acknowledges, but regional banks are currently expressing a greater interest in clearing and are likely to counteract the buy side’s reluctance. “The conflicting drivers may somewhat muddy the outlook, but the net effect is for more clearing,” Greenwich states.
The Full FX View
It is becoming something of an annual question – is this the year FX clearing really comes to FX? – and every year, early optimism is wiped out by reality. This report makes much of the fact that FX clearing is growing, but it needs to be remembered that it is growing in NDFs and FX options, two products that make up a fraction (around 8% as best guess) of global daily FX turnover.
A strong focus of the report is the possibility of a mandate from regulators, such as came in fixed income, but this ignores two realities. Firstly, the authorities have had more than a decade to include FX in a mandate and have declined to do so, and secondly, relatedly, imposing a clearing mandate on such a geographically (and jurisdictionally) diverse product as FX has “nightmare” written all over it!
There is more to suggest in 2023 that the influence of clearing in FX could expand, not least thanks to, as the report notes, SA-CCR and the initial margin rules generally, but it is still to be determined whether the cost of these rules, especially given the opportunities of optimisation (which are also noted in the report), which does not appear, at the moment, to outstrip the cost of clearing.
There is also an assumption in the study, intended or otherwise, that workflows will be changed to push more trades to clearing – I am unsure this is really the case. Banks in particular have long technology “to do” lists, much of which are targeted at increasing net profits. Spending money and resources on technology that may bring a financial benefit is unlikely to push a project anywhere near the top of the list. If it is to promoted, then clearing advocates have to come up with hard data showing a real monetary benefit to the institution, rather than some vague notion of a mandate that may, or may not, emerge.
Finally, when it comes to cleared FX, there are the hard numbers. In the major markets at least (there are some regional exceptions naturally such as Brazil and Korea) CME Group dominates FX futures and options trading, and therefore is a good bellwether for growth. Average daily volumes for FX at CME over the past eight years (to end-2022) have grown, but not substantially (it averaged just over $94 billion in 2022, compared to just over $91 billion over the seven previous years). 2022 was in fact, CME’s busiest year for FX since 2018, so there is perhaps evidence that interest is growing, but even that is tempered by the fact that every other platform to report data, with the exception of EBS, also saw their busiest year in 2022.
Equally, no challenger has emerged to CME in any shape or form – volumes on other exchanges to offer FX products remain at levels that barely move the needle in terms of notional amounts – so again, is this telling us that the industry is content to explore other avenues?
Ultimately, for clearing to become a real mainstream factor in FX markets, more volume has to be attracted in, mainly, FX swaps (and again, while always expected to be a “slow burner” CME’s FX Link is growing, but not dramatically). This means connecting to OTC markets venues and being agnostic with those connections. The sense is that for clearing to grow in influence outside of NDFs and options, there has to be an openness regarding where and when clearinghouses are connected – it cannot be along “in-house” parent company lines alone. This includes optimisation providers as well as trading platforms.
There is a whole workflow re-engineering and a radical overhaul required if the FX industry is to attain substantial clearing volumes. I am not sure the desire or resources are available in the industry to achieve that, but there are opportunities if clearinghouses collaborate with, and embrace, existing workflow solutions outside of their business’ walls.
So, yes, clearing will see greater numbers in FX, but it is far from certain the volumes will be meaningful enough in the big picture for some time yet. In other words, I am not sure there was ever a memo for the FX market to get.
Based upon a survey of 34 respondents to a derivatives market structure survey conducted earlier by Greenwich Coalition, margin rules were seen as the most likely boost to FX clearing, with 29% ranking this the number one driver. Capital constraints at banks attracted a number one ranking from 24%; improved clearing infrastructure 18%; the ability to cross margin with other asset classes 15%; and greater participation by CCPs 9%.
The survey delves into the area of regulatory interference by asking if respondents support an FX clearing mandate, just 4% were “very supportive”, while 29% were against a mandate. Predictably perhaps, the middle ground of uncertainty was most popular with 43% of respondents in there, mainly suggesting the industry will do the regulators’ work for them.
The good news for those offering clearing services is that 81% of 43 respondents to the derivatives survey, expect an increase in FX clearing. Greenwich notes that the 19% that do not anticipate any increase “may be in for a surprise over the coming 18 months, given the momentum and incentives to clear, especially on the dealer-to-dealer side”.
It adds that the alternative to more clearing in many cases would be to post more margin or use more balance sheet, which for most “is not a desirable outcome”.
In a table of products that 54 respondents most wanted cleared, NDFs and FX options – both of which are currently cleared of course – garnered 24%, but they were behind cross currency swaps (43%) and Swaptions (39%).