In this article, we explore the extent to which the new counterparty credit risk calculation for derivatives – SA-CCR – will drive participants toward cleared FX products as a means to mitigate the expected impact on their bottom line.
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 because of wider cost considerations and/or qualitative client pressures such as operational efficiencies, mitigating counterparty risk, and gaining greater transparency.
Uncleared Margin Rules – just the warm-up?
The uncleared margin rules (UMR), which started with Phase 1 in September 2016, have served as a catalyst for change within a small part of the global FX market. NDFs (which according to the last BIS survey accounted for 4% of the daily turnover in FX markets) have seen increased use of clearing from the largest dealers for their interbank activity.
Phase 6 of UMR, which occurs in September 2022, may well bring further change in due course – with potential impacts on the clearing or usage of cleared alternatives to bilateral NDFs and FX options for initial margin efficiencies, and of deliverable FWDs to help remove their gross notional from the annual average aggregate notional amount (AANA) calculation.
However, UMR isn’t the only potential catalyst for change coming from a changing regulatory environment. The Standard Approach to Counterparty Credit Risk (SA-CCR) has been introduced as the default required mechanism for banks to calculate the counterparty credit risk in their derivatives portfolios. SA-CCR replaces the Current Exposure Method (CEM) and contains several differences in structure that may impact the FX market in particular.
SA-CCR – the real punch?
Recent articles in FX Markets have illustrated the impact that SA-CCR is having on the pricing and appetite for bilateral FX FWDs from a leading U.S. liquidity provider, as well as the forthcoming potential impacts on European banks. The message from those articles appears very clear: due to the increased capital requirements, SA-CCR is changing the landscape for bank liquidity providers in terms of their ability to provide the competitive pricing for products such as FX FWDs and FX Swaps.
Clarus published a series of articles (most recent one here) that help document and explain the differences between SA-CCR and CEM. As part of their most recent findings, they noted that a stand-alone sub 1-year EUR/USD trade would generate 2.8 times more capital under SA-CCR. Clarus does stress that while this number is a good soundbite, it doesn’t really tell the whole story. They conclude that SA-CCR will consume around 4.8 times more capital compared to the old CEM model. The same paper also suggested the benefits of clearing were up to 98% in terms of the reduced credit exposure before the additional margin requirement is taken into account.
SA-CCR vs. CEM – key differences
The headline characteristics of the SA-CCR approach that are most relevant to any potential catalysts for increased central clearing include the following:
- SA-CCR is more risk sensitive and less focused on gross notional.
- SA-CCR allows netting benefits – and so, benefits the migration of risk to one counterpart.
- SA-CCR improves recognition of collateral/recognizes margin as offsetting to counterparty risk.
For the FX market, and for large bank liquidity providers in particular, these differences create new decisions and trade-offs around how best to optimize trading. While the use of clearing (OTC cleared or Listed FX) can help achieve benefits via netting and lower capital, it introduces a cost of funding for the margin requirements, which don’t exist on bilateral FX FWDs and Swaps. A study by TriOptima showed that, on balance, holding cleared positions as futures reduced capital costs by at least two thirds, but that the cost of funding the margin also needed to be considered to calculate the all-in cost or benefit.
Net Result – there is a material growth in clearing
Cleared FX, via the use of Listed products, has seen material growth over the last two years – hundreds of new customers are using Listed as a cleared complement to OTC for deliverable FWDs, FX Options, FX Swaps, and NDFs. In the first quarter of 2022 alone, CME Group cleared over $20 trillion in FX products including more than 60,000 customer accounts. Two areas of growth are blocks and EFRPs, and FX Link.
Blocks and EFRPs allow customers to trade on an OTC basis directly with chosen liquidity providers and to lean on OTC liquidity before reporting the trades to CME for their subsequent clearing to generate potential capital, margin, netting, and operational efficiencies. Given this structure, the liquidity provider is still able to maintain and service their client relationships to “win” trades but can then do so with a cleared trade as a result to optimize their capital usage. In addition, clients benefit from negotiating a trade with their chosen liquidity providers, leaning on OTC liquidity, and then holding the position as a cleared, netted derivative. As of the end of June, these trades types had increased in volume by 202% compared to the same period in 2021. Looking at EFRPs only, activity had increased by 465%, with the most volume in GBP, EUR, and JPY.
In contrast, FX Link provides a cleared complement for FX Swaps risk where the near leg of each trade is OTC Spot FX and the far leg is a cleared FX future. This structure enables banks to optimize the capital and counterparty credit impacts of the far leg (typically a bilateral FX FWD), which can be potentially very beneficial for both interbank and client transactions. In June 2022, FX Link achieved its all-time record single-day volume of over $7.2 billion — overall, June average daily volumes were up 143% year-on-year.
<tbody><tr><th colspan="2">The existing trading community is a large and hugely diverse ecosystem covering the full spectrum of retail, buy-side, regional banks, non-bank market makers, and Tier 1 banks.</th>
</tr><tr><td>The model enables peer-to-peer</td>
<td>The marketplace is truly all-to-all and any-to-any, enabling customers to trade with other customers while also providing liquidity from other market participants.</td>
</tr><tr><td>Credit is already separated from liquidity</td>
<td>There is no relationship that exists nor is needed between the liquidity provider and the liquidity taker.</td>
</tr><tr><td>Anonymity guaranteed, and entirely credit agnostic</td>
<td>Everyone can see and trade upon the best price, and no one knows who was involved in each trade.</td>
</tr><tr><td>Access to potentially lower spreads through passive trading</td>
<td>A trader can place passive interest and then wait to execute at that level so avoiding and potentially earning the spread; traders don’t have to act aggressively on a price provided by a liquidity provider and so don’t have to cross the spread unless they wish to for immediacy.</td>
</tr><tr><td>Removes the need for costly ISDAs and the need for credit relationships with the liquidity providers</td>
<td>Each customer just needs a clearing arrangement with an FCM; no ISDA or bilateral credit line is needed with any of the participants to trade in the CLOB.</td>
- UMR provided an initial catalyst for a small part of the FX market to embrace central clearing for margin efficiencies.
- UMR Phase 6 may provide further incentives to use clearing for FX options and NDFs.
- SA-CCR is potentially providing another material catalyst for dealers to consider using clearing on a selective basis to optimize their activity – especially for FX FWDs and Swaps.
- CME Group has cleared over $20 trillion in FX products year to date 2022, with the most activity in deliverable FX products for major currency pairs.
- Blocks and EFRPs enable liquidity providers and clients to maintain OTC relationships, utilize OTC liquidity, but also benefit from the potential efficiencies for the resulting trades.
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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.