Margin rules lead to NDF clearing surge

Back in 2010, the UK government set up a ‘nudge' unit, which used behavioural psychology to improve public policy. For instance, it found income tax was paid quicker when payees were sent a reminder letter explaining most of their neighbours had already done so.

Similarly, the new non-cleared derivatives margin rules, which came into force on September 1, are designed to make it more economically desirable for market participants to centrally clear their positions than keep them bilateral – a move regulators hope will cut systemic risk. On the face of it, this is already working – the interdealer inflation derivatives market moved quickly to clearing, and now parts of the foreign exchange market look like they are beginning to make the big shift.

"Without a regulatory mandate, there weren't enough compelling factors to drive dealers or end-users into centralised clearing. However, I think that is changing now, specifically with the commencement of uncleared margin rules. You will begin to see forex clearing pick up in earnest as dealing desks assess the dollar-for-dollar charge on their trading book – they will try and seek relief wherever they can get it," says John O'Hara, head of forex prime brokerage and clearing at Societe Generale Corporate and Investment Banking (SG CIB) in New York.

The two products caught by the non-cleared margin rules are non-deliverable forex forwards (NDFs) and forex options. NDFs can be cleared at central counterparties (CCPs), but are not yet required to be. From a margin point of view, these products are now cheaper to trade via a clearing house than bilaterally, and greater netting is available at a CCP, which can cut capital requirements. As a result, over the past few months, dealers have ramped up clearing of their interdealer NDFs.

We used to clear about $4 billion in notional and about 500 trades per day, but from September 19–21, we cleared 2,400–3,000 trades and $22–24 billion in notional each day
Paddy Boyle, LCH

"When I joined in April, we had nine members clearing on any given day," says Paddy Boyle, LCH's head of forex products in London, and former global head of G10 forex options at Goldman Sachs. "Since then, we've had five new members start clearing in significant volume, and expect the majority of the remaining 10 members to start clearing very soon, with new membership enquiries increasing too."

In April, ForexClear, LCH's forex clearing house, had an outstanding notional value of $160 billion cleared and 13,800 outstanding trades at month-end. By the end of August, those numbers had risen by 25% and 46%, respectively. The CCP cleared a record $100 billion notional volume in the week ending September 23.

"We used to clear about $4 billion in notional and about 500 trades per day, but there's been gathering momentum since the uncleared margin rules came into force on September 1. From September 19–21, we cleared 2,400–3,000 trades and $22–24 billion in notional each day. Before Labor Day, ForexClear had only cleared over $10 billion in notional or over 1,000 trades three times," says Boyle.

SG CIB's O'Hara predicts between now and the end of the year, that number will increase to $30 billion in average daily volume.

By comparison, CME has never really been able to get its NDF clearing service off the ground. While it has a monopoly in the forex futures business, CME has only cleared $21.3 million notional of NDFs since launching in 2012, and has not cleared a single contract since 2014.

But that small number has not put off Paul Houston, who joined CME as head of forex products from Deutsche Bank in April to help restart an initiative that had fallen by the wayside. "We do see natural netting benefits even though NDFs are not mandated, as we have seen that in other asset classes with similar cost pressures," he says.

Clearing of interdealer NDFs has been available since 2012 at LCH, but the requirement to post initial margin and daily variation margin – not to mention contribute to the CCP's default fund and hold capital against those exposures – have meant there has been little incentive to use it. Forex products are also typically more short-dated than interest rate and credit derivatives and therefore less capital-intensive – reducing the netting benefits clearing brings to a derivatives book.

The start of leverage ratio reporting in September 2014 forced banks to look at how they could efficiently net down client exposures to reduce derivatives exposures, but still did not lead to any great rise in NDF clearing volume.

I don't think our clients have understood [what has happened] yet. I think they will see there has been an increased cost to trading derivatives. We are supportive of [clearing NDFs] and maybe they will be next to clear at some point
Tracey Vallarta Jordal, Pimco

The new margin rules for non-cleared derivatives, which came into force in the US, Japan and Canada on September 1, however, require the largest dealers to post initial and variation margin on non-cleared over-the-counter derivatives trades. As both counterparties need to post gross initial margin to a third party, and rehypothecation is severely restricted, this requires funding, which generates a cost to the bank.

The non-cleared initial margin requirement is higher than for cleared trades, based on a 10-day, 99% value-at-risk model, compared with a five-day 99.7% VAR for cleared house trades – making it cheaper for dealers to clear their NDFs than leave them bilateral, and encouraging greater use of clearing.

Given most market participants will have to exchange variation margin on non-cleared NDFs from March 2017 under the new margin rules, and that entities with more than €8 billion of aggregate non-cleared derivatives will be required to post initial margin from 2020, according to the timetable set out in the Basel Committee on Banking Supervision's final non-cleared margin rules, the buy side is also starting to look at clearing its dealer-to-client NDF trades.

While buy-side clearing began at LCH and CME in 2013 and 2012, respectively, trades that have been executed so far appear largely ceremonial.

However, speaking at the International Swaps and Derivatives Association's North America conference on September 15, Tracey Vallarta Jordal, senior counsel and global practice head of derivatives at Pimco, said NDFs could well be next in line to clear.

"I don't think our clients have understood [what has happened] yet. I think they will see there has been an increased cost to trading derivatives. We are supportive of [clearing NDFs] and maybe they will be next to clear at some point. We've not seen a huge interest historically, but maybe as a result of these rules there will be," she said.

Others are also keen on the idea: "I would really like to see clearing take off," says Patrik Safvenblad, chief investment officer at Harmonic Capital Partners in London. "For banks, it's getting more expensive to trade bilaterally, so I think it makes economic sense to move the over-the-counter market risk to central clearing."

Smaller clients that don't cross the initial margin threshold won't be spared a price increase, however. Many use a prime broker to access multiple forex dealers, and the non-cleared rules require initial margining of the dealer-to-dealer leg – a cost that dealers warn will be passed on to clients by the end of the year (see box: Prime brokerage to get more expensive).

With forex options and cross-currency swaps, the need to exchange notional means you would have to put up huge amounts of margin to cover those cashflows, which makes it uneconomic
Gavin Dixon, BNP Paribas

However, while NDFs are fairly straightforward to clear due to being cash settled, forex options – which are also caught by the non-cleared margin rules – are physically settled, making clearing much more challenging. Physical settlement requires counterparties to exchange the full notional amount of the options at expiry, creating settlement headaches, and CCP liquidity shortfalls estimated by one industry group to be as large as $161 billion.

The margin needed to cover the risk of physical exchanges also brings extra costs. "With forex options and cross-currency swaps, the need to exchange notional means you would have to put up huge amounts of margin to cover those cashflows, which makes it uneconomic," says Gavin Dixon, former European head of derivatives clearing at BNP Paribas in London.

As a result, major CCPs are yet to clear the instruments, and CME's Houston acknowledges the challenges involved. "The liquidity backstops tend to be fairly expensive and require banks to either pre-fund, establish committed swap lines or contribute to liquidity funds, so they do incur extra costs that might offset the benefits of clearing," he says.

LCH has been working on bringing forex options clearing to the market since 2011, when then-managing director of forex clearing, Gavin Wells, said it would be going live later that same year. Five years later LCH appears no closer to launch. It teamed up with currency settlement utility CLS in August 2015 and now says the service will launch in 2017.

According to its website, CME plans to launch clearing services for options, spot, swaps and forwards in the future. The timetable for launching these products is unclear, however.