Case Study: Mitigate counterparty risk when using an FX overlay manager to hedge an illiquid asset

A Canadian pension fund owns a U.S.-based toll road worth USD $1B and uses an FX overlay manager to hedge the toll road’s USD cash flows to CAD using FX forwards. The pension fund sells the USD/CAD forward on a regular basis, coinciding with the regular cash flows from the toll road (assume quarterly). The USD/CAD overlay is sized at USD $1B such that all FX risk is managed from the asset. The pension fund maintains an account with the FX overlay manager, where daily mark-to-market cash flows on the forwards position occur. The FX overlay manager trades OTC FX forwards bilaterally with banks.

The pension fund faces a key firm/service provider risk in the overlay manager. Should the FX overlay manager experience an adverse impact (key staff turnover, operational issue, changes to terms, and so on) that requires the pension fund to seek an alternative overlay service provider, the pension fund is unlikely to be able to move its exposures to a new overlay manager before the pension’s forwards need to be rolled per OTC market convention¹. Further, since the asset being hedged is physical infrastructure and illiquid (a toll road), the pension fund would not have the ability to liquidate a piece of the asset to support the cash flows required to physically settle the forward². The plan theoretically could need to deliver USD equivalent to the size of the asset if the overlay manager were unable to perform its duties.

The pension fund can enter into an agreement with one or multiple counterparties to trade Exchange for Related Positions (EFRPs) to convert the OTC FX forward into a cleared FX futures position at CME Group. EFRPs would allow the pension fund to trade directly with any of the 20+ liquidity providers to close out the existing OTC FX forward position and reestablish it as a cleared FX futures with CME Group as the counterparty. The FX hedge would be maintained, but the pension fund would be able to remove the FX overlay manager and therefore mitigate counterparty risk.

The EFRP is executed as follows: The pension fund agrees to execute EFRPs with a counterparty, typically a bank. If the pension fund uses futures (not just FX futures) today, they can be set up to trade EFRPs typically within one to two business days. In the EFRP, the pension fund would buy $1B USD/CAD forward, maturing on the precise date their existing short USD/CAD forward matures, and USD $1B equivalent CAD/USD futures at CME Group of a later maturity (approximately 13,386 contracts)³.

The price of the EFRP would represent the differential in dates between the OTC FX forward and the FX futures, and the interest rate differential between USD and CAD. The OTC forward trades offset, leaving the pension fund with a long CAD/USD futures exposure economically equivalent to the OTC forward hedge it had previously. Going forward, the pension fund can then roll its futures exposures just as it had been doing with its OTC FX forwards positions, but with the benefit of ultimately facing CME Clearing and transacting in CME Group’s highly liquid futures market. In 2022, FX futures ADV at CME Group was over $81 billion across all currencies, making CME Group one of the world’s largest primary FX venues⁴.

An EFRP transaction is a mechanism that enables a futures contract to be traded in combination with a related financial instrument. An EFRP transaction involves the off-exchange execution of an Exchange futures contract and, on the opposite side of the market, the simultaneous execution of an equivalent quantity of the cash product, by-product, related product, or OTC derivative instrument corresponding to the asset underlying the Exchange contract⁵.

EFRPs are flexible as they allow a variety of OTC instruments to be traded against the FX futures contract. Forwards of any date and quantity⁶, as well as spot, can be traded in an FX futures EFRP. EFRPs also preserve bilateral relationships as they are transacted off-exchange with one (or more) counterparties on a disclosed basis, just like OTC trades today.

• Exchange for Related Positions (EFRPs) are a trading mechanism that can be used to move existing OTC FX positions in to clearing. In doing so, market participants can flatten or close out existing OTC trades and reestablish those positions as centrally cleared positions with CME Group as the counterpart.
• Multiple bank and non-bank counterparties can be used as liquidity providers to achieve this trade type, and the trade negotiation and execution is done on an OTC basis directly with the chosen LP(s).
• The setup required to transact an EFRP can be established in as little as one to two business days if a customer already trades an asset class of CME Group futures (including rates, equities, commodities, etc.).
• Having the ability to trade EFRPs may serve as an operational risk mitigant against adverse developments at an FX overlay manager, allowing a pension fund the ability to quickly and efficiently move OTC FX forward exposure to cleared listed FX futures with one trade. The speed with which one can establish an EFRP relationship, combined with the flexibility of the EFRP mechanism, make EFRPs a useful risk management tool.

• FX EFRP trade example: A Look at FX EFP
  
• List of block and EFRP liquidity providers: Directory for listed FX Blocks, EFRPs, and Committed Cross
• Market Regulation Advisory Notice on EFRPs: Exchange for Related Positions

¹ 90% of USD/CAD outright forwards mature within three months, 66% mature within one month, 28% mature within seven days, and 27% mature between 7 days and 1 month. Source: Triennial Central Bank Survey of foreign exchange and Over-the-counter (OTC) derivatives markets in 2022 (Triennial Central Bank Survey of foreign exchange and Over-the-counter (OTC) derivatives markets in 2022 (bis.org)).

² The fund would need to deliver US Dollars as it is short US Dollars via the outright USD/CAD forward.

³ Each CAD futures contract is sized at 100,000 CAD. CME CAD futures are quoted as USD per 1 CAD, inversely to OTC convention. For specifications: Canadian Dollar Futures Contract Specs.

⁴ See appendix for notional average daily volumes by currency pair.

⁵ See FX Futures and Options Block and EFRP Quick Reference Guide for more detail.

⁶ EFRPs require the futures leg of the trade be at least 1 contract.