Might regulatory requirements under the UMR and SA-CCR drive an increase in the adoption of FX futures and OTC FX clearing among financial institutions? A recent research report conducted by CME Group analysed this potential incentive for change and other factors at play. Phil Hermon, Executive Director of FX Products at CME Group, shares some of the findings.
Q. In a recent paper, CME Group provided analysis of how Uncleared Margin Rules (UMR) and the Standardized Approach to Counterparty Credit Risk (SA-CCR) implementation may impact FX clearing and specifically, NDFs and FX options. Can you explain the main reasons why both regulations may be this impetus for change now?
A. The advent of UMR served as a catalyst for changing the bilateral status quo for certain parts of the FX market, with the most obvious impact on interbank activity for Non-Deliverable Forwards (NDFs). However NDFs, which in total represent roughly 4% of the $6.6 trillion per day FX market, are currently the only part of the OTC FX market being cleared to any great extent – and even then only by the interbank community.
With phases 5 of 6 of UMR still to come in 2021 and 2022 respectively, the wider impact on the buy-side still remains to be seen. But given the direct impact of UMR on margin requirements for bilateral products like NDFs and FX options, there may be a compelling case for entities ultimately caught by the regulations to consider migrating impacted trades to a cleared alternative. However, even if the next two to three years do see a wider adoption of clearing for NDFs and FX options, these products combined only account for about 8% of the total FX market.
Outside of UMR, the other big piece of regulatory change that may impact clearing decisions for a broader set of FX instruments is all around bank capital – and this is where SA-CCR comes in. SA-CCR (the standardized approach to counterparty credit risk) represents a material change in how banks calculate the capital they are required to hold to cover the risk of default by counterparts to derivatives transactions. Some of the differences of the SA-CCR model are that it is more risk sensitive (and less focussed on gross notional), that it allows more netting benefits, and that it improves the recognition of margin as off-setting to counterparty risk. These differences may provide a further impetus for the use of cleared alternatives or clearing for products like FX Forwards, but we anticipate dealers to make decisions on a more holistic basis than capital alone. The interplay between capital, margin, fees and other considerations such as operational complexities are likely to be part of the decision making process for each bank as to which pockets of their trading activity they migrate to cleared alternatives such as listed FX futures or OTC cleared FX.
Q. What are some of the non-regulatory factors that would push market participants in the same direction of increasing FX clearing and use of FX futures? Are these factors likely to also play a role in influencing behaviour in 2021? If so, why?
A. At first glance, the $6.6 trillion a day FX market has not been as heavily impacted by derivatives regulations in the last five to ten years as other asset classes. As such, the voluntary adoption of clearing or a cleared alternative for the deliverable FX market is likely to come as a result of wider cost considerations and/or qualitative client pressures such as operational efficiencies, mitigating counterparty risk, and gaining greater transparency.
These drivers are certainly among the primary catalysts behind the continued growth we have seen in the adoption of FX futures and in the initial uptake of cash settled cleared FX products, which have helped to deliver all-time records for open interest, number of large open interest holders, and single day volumes in CME listed FX futures during 2020.
During 2020 the growth in adoption of FX futures by both banks and buy-side customers, and to a lesser extent the buy-side adoption of clearing for G10 NDFs, currently appears driven by a variety of other factors that are largely unrelated to UMR and to SA-CCR. These factors include catalysts such as access to more liquidity providers and differentiated liquidity from OTC markets, trading on a regulated marketplace, freeing up bilateral lines and no need for ISDAs, and access to firm pricing that is traded on a credit agnostic all-to-all basis.
Q. In the research paper you provided analysis of common scenarios different banks could face when assessing the quantitative considerations for clearing or not (funding vs capital considerations specifically). The results varied greatly. What would your key conclusions be from the analysis?
A. Based on our analysis and discussions with banks, our view is that cost and capital efficient clearing solutions, such as FX futures and G10 NDFs, may well see increased utilization as mechanisms to mitigate the capital requirements of certain parts of the bilateral FX market. However, we anticipate that it is unlikely for dealers to migrate the bulk of their FX Forwards or FX swaps activity to a deliverable cleared solution when the costs are so high and complexities so onerous. A more likely outcome is the continued evolution of cost efficient clearing solutions as a portfolio management tool to help optimize the pockets of bilateral FX activity that are attracting the highest capital requirements, as well as the extended usage of FX futures as a capital efficient hedging tool that is complementary to OTC Forward and swap activity.
From our analysis, the first finding was that the impact of SA-CCR is likely to vary a lot between banks, and as such the impetus or need to adopt clearing as a potential mitigant to the capital requirements is likely to be equally varied.
Moreover, dealers that we spoke with aren’t looking at the potential capital efficiencies of clearing in isolation. In addition to the impacts on capital, dealers are mindful of other factors such as the cost of funding Initial Margin (IM), central counterparty (CCP) fees, capital on committed swap lines needed to run a deliverable cleared solution, and the funding of the CCP guaranty fund. Outside of these first order quantitative elements, there are also other factors of relevance that include the counterparty credit risk benefits and operational efficiencies of facing a large and well capitalized CCP. As such, the decision of whether and what to clear becomes a much more holistic decision for the trading desk, XVA desk, and multiple other parts of the bank to consider.
Q. How might CME respond to the trends mentioned above?
A. The continued adoption and growth of FX futures and OTC FX clearing at CME Group during 2020 appears driven by a variety of factors including accessing additional and differentiated liquidity, trading on a regulated marketplace without needing an ISDA, and netting of positions against a highly rated clearing house.
The move to SA-CCR along with the implementation of phases 5 and 6 of UMR may provide further catalysts for change, but we anticipate clients taking a more holistic cost verses benefit analysis of using clearing and/or listed FX products rather than considering one element like capital on a standalone basis.
As we look forward in to 2021 our focus remains to position our listed FX and OTC cleared FX offerings as cost and capital efficient products to help meet the needs of our customers. On the back of the success of the 50-60% reductions to the minimum price increment for quarterly roll spreads in G5 currency pairs we will continue to review and deliver further cost efficiencies, including a 50% MPI reduction in AUD outrights planned for November 23rd. We are also committed to delivering new analytics tools to help customers better evaluate and understand the potential efficiencies and opportunities available via our products; so far in 2020 we have delivered the FX Vol Converter and FX Swap Rate Monitor, and later this month we will be launching the FX Market Profile.
I’d also highlight that whilst CME FX futures are a very well established product and marketplace, they have historically been used mainly as alternative liquidity for both spot and Forwards markets. Given the potential impacts of regulation such as SA-CCR we have also been working to ensure our cleared and capital efficient products can be used by FX swaps traders as well. In line with customer feedback and demand, we have worked to reduce the minimum price increments in the calendar spreads by 50-60%, added additional participants to both spreads and FX link, and have made integration for the downstream messaging easier for these products by partnering with major infrastructure providers. We will continue to work with market participants to further enable calendar spreads of FX Futures and CME FX link as cleared and capital efficient mechanisms for transacting FX swap risk via a central a limit order book.
Q. What are your expectations for 2021 in terms of how banks will make changes based on their own analysis? How will cleared volumes change?
A. There are many potential dynamics for a bank to consider when reviewing if and how to optimise their trading activity by using OTC clearing and/or listed derivatives. While central clearing against a highly regulated and well capitalized clearing house provides significant risk management, operational and counterparty credit risk benefits, traders and XVA desks are likely to also continue evaluating the quantitative impacts on both capital and funding of IM.
Based on our analysis and discussions with banks, our view is that cost and capital efficient clearing solutions, such as FX futures and G10 NDFs, may well see increased utilization as mechanisms to mitigate the capital requirements of certain parts of the bilateral FX market. There is likely to be a continued evolution and adoption of cost efficient clearing solutions as a portfolio management tool to help optimize the pockets of bilateral FX activity that are attracting the highest capital or margin requirements, as well as the extended usage of FX futures as a capital efficient hedging tool that is complementary to OTC Forward and FX swap activity.
