James Pearson

FX Clearing: A market still in its infancy but with enormous potential

May 2023 in Supplements

James Pearson, Head of LCH ForexClear, responds to a few questions about the current state of FX Clearing and how LCH has been broadening its product offering to meet the opportunities that the uncleared market presents.

What have been the primary factors driving the evolution of the FX clearing landscape over the past few years?

There have been numerous drivers underpinning FX clearing over the past five years, with both Uncleared Margin Rules (UMR) and the Standardised Approach to Counterparty Credit Risk (SA-CCR) coming into effect, leading to a significant increase in the financial resource requirements of banks’ FX portfolios. FX clearing provides potentially lower margin requirements than the bilateral space, offers capital optimisation opportunities through multilateral netting, materially lowers counterparty risk and has settled-to-market (STM) benefits, alongside the operational benefits that come with facing a central counterparty clearing house (CCP).

LCH has a strong reputation as ‘The Markets’ Partner’ and has robust risk and margin models that protect our members and clients during periods of market stress.

In 2022, LCH ForexClear saw record total service volumes for the 10th year in a row, driven by strong participation in cleared deliverable and non-deliverable products. The service cleared $24.8 trillion in total notional, up 14% versus 2021, with $95 billion in average daily volume (ADV). This momentum has continued into 2023, with Q1 being a record quarter for both our FX options volume, which was 146% higher than Q1 2022, and for client clearing volume, which was 83% higher than Q1 2022.

What effect have those factors had in shaping the FX clearing services available today?

LCH ForexClear initially offered members and clients the ability to clear their NDF portfolios and, subsequently, their members’ deliverable FX options via the deliverable service. Demand to clear these products originated from a requirement to post bilateral initial margin (IM) under UMR, with clearing ensuring IM requirements netted efficiently against one counterparty rather than multiple ones in the bilateral space.

More recently, banks wanting to better manage their SA-CCR obligations have found clearing to provide notable benefits here too. At the same time, LCH ForexClear offers portfolio margining across products, thus further enhancing margin and capital savings.

The next step in our product evolution has been to respond to our member requests to continue to see leverage ratio (LR) and risk-weighted asset (RWA) improvements by clearing their deliverable forwards portfolios. This has entailed a need to balance the IM requirements with the capital benefits achieved.

We would not expect our members to want to clear the entirety of their FX forward portfolios for this reason – instead, clearing in a selective way to minimise IM requirements while maximising capital savings. This is how we have developed our Smart Clearing offering, as we discuss with Quantile in this supplement. We aim to continue the development of deliverable forwards clearing, ensuring that members can clear in a way that suits their aims and technology infrastructure.

We also know that clients would like to access a scalable deliverable forwards clearing offering in the
future, and we would expect this to be made available to the client base following the member offering. Over time, we expect FX clearing to become ‘business as usual’ for many market participants, and with more clearing occurring at trade execution, we expect pricing differentials for cleared versus uncleared trades to become evident, as we have seen in the interest rate swap markets.

What were your expectations regarding how long it would take for FX clearing to reach wide adoption across the industry?

This is still a market in its relative infancy, with huge immediate future potential, as momentum is now building. The Over The Counter Non-Deliverable Forward (OTC NDF) market is now clearing 18% of daily volumes via our 19 members and 60 clients, and we continue to work with this network to increase the number of clearing connections among them. We also expect to welcome several new members to the NDF service this year, the first in five years, and to maintain the growth in new client numbers that we experienced in Q1 this year. The new NDF Matching platform*, launching in Q4 of this year, will bring NDF clearing to the pre-execution part of the trade lifecycle for the first time, creating further opportunities and attracting new clearing participants and liquidity. And we still have additional currency pairs to add and other geographical locations to establish ourselves in.

FX clearing is not mandated as it is in the interest rate swap market, and therefore, it must be commercially compelling. Changing the way a market operates (in terms of market convention, infrastructure and technology platforms) takes time, but the foundations have now been laid. However, numerous current and prospective participants are asking us to be even quicker, given their desire to leverage the efficiencies that clearing brings.

Currently, we are seeing month-on-month and quarteron-quarter records in our FX options volumes as part of our deliverable service. We have seen some of the largest FX banks increase their cleared flow and actively cleared currency pairs, and several additional banks are preparing to go live with FX clearing in Q2 2023. We delivered our portfolio margining initiative in Q1 this year, meaning there are now margin offsets between our deliverable and non-deliverable products, providing our members with further benefits.

The next development in our deliverable offering will be the launch of Smart Clearing and our multilateral bulk load capability with direct connectivity to optimisation providers. While both forwards and swaps are eligible for clearing today, we have partnered with our members and market providers to create a workflow that aids our members in selectively clearing their FX forwards and swaps portfolios – we call this Smart Clearing. Securing this workflow will allow our largest members to optimise their capital more efficiently, increase the liquidity in the service and enable us to reach out to the next tier of banks in H2 2023 and beyond.

We have a strong two-year membership pipeline focusing on sell-side participants who have both margin and capital drivers incentivising them to clear and are currently executing the first stages of that pipeline delivery. We are aware that segments of the buy-side are also ready to clear, and we are continually looking to expand the number of trade sources into LCH ForexClear and partner with providers who sit in various stages of the client clearing journey to ensure we can enhance and improve it.

Overall, the uncleared FX market remains enormous, and that is our opportunity – but we remain confident from the momentum we are seeing and the numerous drivers for FX clearing, such as the operational and counterparty credit efficiencies and multilateral netting, that we are on the path to a turning point. More product equals more benefits, which equals more participants, which equals more volume, which equals more benefits and more participants. By broadening our product offering (from NDFs to FX options to FX forwards) and expanding our customer base, we are accelerating towards that market tipping point. 2025 is when we think this virtuous clearing circle will really start to form, so watch this space!

*Workflow that NDF Matching will offer is subject to regulatory approval.