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FX clearing: what's next?

The delays in enacting regulatory mandates for central clearing of FX derivatives highlight an interesting trend—even though clearing remains optional, the industry continues to increase the level of activity booked through central clearing counterparties (CCPs). Market participants should continue to prepare for the day when clearing becomes the norm.

Earlier this year, the European Securities and Markets Authority (ESMA) backed away from its timeline for mandating the clearing of non-deliverable forwards (NDFs).It has not, however, completely ruled out such a move in the future and indicated in February that it is assessing the concerns raised by the industry during last year’s consultation period on FX derivatives clearing. Similarly, the US Commodity Futures Trading Commission (CFTC) proposed rules for clearing NDFs in 2013, but has gone quiet following consideration by its global markets advisory committee in late 2014.

Mandates aside, the FX market is already relatively standardised and certain products such as NDFs are well suited to clearing.  Notional volume for NDFs cleared at LCH.Clearnet’s ForexClear has increased steadily since the debut of the service in 2012. In July 2015, LCH’s monthly notional outstanding for NDFs stood at around US$84 billion. Worldwide, several other CCPs have launched NDF clearing services in the last few years.   

This is not the first time central clearing has taken hold in an OTC derivatives market prior to a regulatory mandate.  In the interest rate swap market, interdealer trades began to clear as early as 2003, close to a decade before the Dodd-Frank Act. The initial driver for dealers was the treatment of capital offered to cleared swaps. Post the 2008 financial crisis, the industry focus switched to counterparty risk and the mutualisation of credit risk offered by a CCP. The credit derivatives market followed a similar path a few years later, with some encouragement from regulators. 

FX derivatives tend to be of shorter duration than other OTC derivatives, making a move to voluntary clearing less pressing from a risk / cost perspective. However, Basel III capital requirements and margin rules for uncleared OTC derivatives are moving voluntary clearing up the agenda. 

So how ready is the FX market? While the level of trading automation in FX is high compared to its OTC siblings, the FX market lags in post trade systems. Take the interest rate swap and credit derivative markets which proved operationally resilient during the credit crisis and beyond.  These markets have amply demonstrated the benefits of centralising and standardising trade confirmation and lifecycle management. Once clearing and reporting became mandatory, technology was already in place to streamline management of cleared and uncleared flows.

FX market participants need to modernise post trade systems so they can manage and clear trades effectively – on a voluntary or mandated basis - scale for future growth and remain resilient in times of market volatility.

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