Higher capital requirements for derivatives trading will create economic incentives for banks and other market participants to move their foreign exchange positions into clearinghouses.

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Most participants in the global foreign exchange markets have been reluctant to adopt central clearing, but that may soon change due to the impact of new capital and margin requirements. The vast majority of trading in the global FX markets is done over-the-counter, and until recently there was little appetite for clearing.

One major reason why many market participants expect this to change is the implementation of a new set of capital standards on the banking industry. This will make it more expensive for banks to trade derivatives, creating an economic incentive to send some portion of their trades to clearinghouses. Another key factor is the implementation of margin requirements on all uncleared derivatives.

This will affect a much wider range of market participants, and is expected to encourage greater use of clearing as it comes into effect over the next several years.

Other trends in the FX markets also may encourage greater adoption of clearing. More and more of the liquidity in the FX markets is coming from trading firms that specialize in automated market making.

These firms tend to favor clearing as a way to reduce counterparty risk and expand access to the market. In addition, electronic trading is becoming more common, paving the way for changes in market structure that support greater use of clearing. The path forward will be quite different, however, from the trends seen in other asset classes. In the interest rate and credit default swap markets, clearing is now mandatory for most market participants in the U.

Japan has similar requirements, and Europe will begin implementing mandatory clearing for interest rate swaps later this year. In contrast, regulators have not adopted a mandatory clearing requirement for foreign exchange derivatives.

Instead the main driver to bring FX contracts to central clearing is likely to be Basel III capital requirements, and in particular the requirements to pay and collect margin on uncleared derivatives and set aside more capital for derivatives positions. These requirements will come into effect in phases over the next several years and banks and other financial institutions are scrambling to reduce their derivatives exposures. The impact will fall more heavily on some types of FX derivatives than others.

For example, the margin requirements for uncleared derivatives will require banks and other financial institutions to pay and receive both initial and variation margin on their FX options and non-deliverable forwards. For FX swaps and deliverable forwards, only variation margin will be required. This makes it difficult to calculate the ultimate impact on the FX markets, but there is no question that it will soon become a lot more expensive to trade derivatives if they remain outside of clearing.

On forwards they will have to pay VM every day. From NDFs to Options. Clearnet is positioned to be the one of the first beneficiaries.

OTC FX Clearing Service - CME Group

The clearinghouse's ForexClear service has offered clearing for non-deliverable forwards since Although its share of the overall NDF market is very small, the flow of trades into the clearinghouse is slowly rising. The service is primarily aimed at clearing trades between dealers, but LCH.

Clearnet is trying to attract client trades as well. In May, ForexClear expanded its service to include European clients and signed up four firms, including HSBC, Societe Generale and Standard Chartered, to offer NDF clearing to their clients.

As Societe Generale explained at the time, the goal was to give give buy-side firms time to prepare for clearing NDFs well before the margin requirements on uncleared derivatives come into effect. Clearnet is also building operational connections with swap execution facilities, the trading platforms established to meet the swap trading requirements of Dodd-Frank.

Clearnet cleared a client trade that had been executed on SwapEx, the SEF operated by State Street, with Societe Generale acting as the clearing firm. Clearnet also has established connectivity with the SEF operated by Thomson Reuters, which concentrates on bank-to-client trading in NDFs. Clearnet's next move is to extend clearing to foreign exchange options. In August, the clearinghouse announced that it was working with CLS, the major FX settlement system, to provide physical settlement for cleared FX products, starting with FX options in six major currencies.

Clearing FX options presents some difficult challenges, however. Unlike NDFs, which are cash-settled, the options have physical delivery. That means that in a default scenario, the clearinghouse needs to have the ability to actually deliver the underlying currency.

That is the main reason for the partnership with CLS, which mitigates settlement risk in the FX market by arranging for simultaneous payments on both sides of an FX trade on a real-time basis.

The launch date for clearing FX options has not been set yet, and it is not clear how much demand the service will actually have.

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Some market participants are skeptical, saying the cost benefits of clearing have been overstated. But Simon Manwaring, global head of FX options at RBS, said that while clearing of NDFs and options has been slow to materialize, the impact of margin requirements will make it inevitable.

A Hybrid Model for Exchanges. Clearnet has focused on clearing, Deutsche Boerse is targeting the trading side of the business.

The German markets operator reached an agreement in July to buy T, one of the largest multilateral trading platforms in the FX markets. In effect, the deal gives Deutsche Boerse a way to integrate its clearing and other post-trade services with one of the leading electronic platforms for trading foreign exchange products.

Past efforts by exchanges to capture a share of the FX markets have sought to encourage market participants to adopt exchange-style trading, with a central limit order book similar to what exists in the equities and futures markets. In contrast, Deutsche Boerse's current strategy is based on a hybrid model, where trades continue to be executed via request-for-quote from dealers and other OTC trading protocols.

Deutsche Boerse has had success with this model in other asset classes, notably equity futures and options, and its clearinghouse, Eurex Clearing, offers several ways for customers to bring contracts executed away from the exchange into its clearinghouse. Alfred Schorno, one of the top executives at T, explained that his firm expects the market to evolve towards this hybrid approach that combines the flexibility of OTC trading with a pipeline into central clearing.

That was part of the deal rationale for Deutsche Boerse and also the T management. Schorno added that the hybrid approach also extends to supporting several different approaches for managing counterparty risk.

He expects that corporate customers will continue with the direct model. Because they need their transactions to have specific dates, otherwise they have balance sheet and profit implications," he explained..

They see that as bringing additional charges.

The bank-to-bank business, however, will be different, particularly with respect to NDFs, options and FX swaps. Schorno also pointed to another factor that may drive market participants to adopt clearing. He noted that prime brokerage charges have gone up considerably since the Swiss National Bank removed its currency peg in January, a move that caused a massive disruption in the FX markets. From our point of view, it will only be another year or so before the economic reason to use clearing outweighs the regulatory one.

Mark Suter, chairman and founder of options trading platform Digital Vega, also expects a gradual move toward clearing. The company specializes in electronic trading of FX options, drawing on liquidity provided by 13 banks, and has a small but growing share of bank-to-bank trading of options. Suter added that while the focus will initially be on relatively low volume products such as NDFs, the far bigger spot and swap markets may get dragged into clearing as well.

So the move will start to feed on itself. Back to the Futures? CME Group is another potential beneficiary of the trend towards clearing, but it is taking a different approach. Although it began offering clearing for NDFs in , the service has failed to gain any traction, and the group is now more focused on promoting its listed futures and options products.

Those markets have long served as an alternative liquidity pool for firms that trade FX in the OTC markets, and CME officials are emphasizing the capital efficiencies that listed derivatives can offer in the post-Basel III world as well as the operational efficiencies that come from highly automated electronic trading.

FX trading on CME and other futures exchanges has risen dramatically over the past decade, but it is still only a fraction of the overall market for FX derivatives.

The exchange views this trend as an indication that new customers are coming in from the OTC markets. Patrick believes credit costs are at least part of the reason. And looking at our products, people have started to see advantages, such as true netting. A clearing environment enables more of that to take place. One such non-bank market maker is Virtu Financial. The New York-based firm actively makes markets on a large number of FX trading venues, including EBS, Reuters, Hotspot, Currenex, FXall and CME, and provides liquidity to a growing number of dealer-to-client platforms.

John Shay, the firm's senior vice president for transaction and technology services, is convinced that the capital efficiencies of clearing will drive changes in market structure. He explained that in the current environment, market makers like Virtu are providing liquidity across a large number of trading venues and trading relationships. That means the firm has to manage the cost of having margin deposits and account balances at a large number of individual prime brokers around the world.

That's in addition to the funds they hold at clearing firms to cover the margin requirements for their trades on futures exchanges and any other cleared trades. Even spot will definitely go at some point. Economically it makes sense.

Market participants will force a more efficient way of trading. Fia Search Search form Search. Essential Elements of a Clearinghouse Recovery Plan Fintech Trends Cooking With Gas.

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