We know FX forwards clearing is on the horizon so can you give us some context on LCH ForexClear today?
LCH ForexClear is already the market leader in clearing non-deliverable forwards (NDFs) and FX options. Multilateral netting means that initial margin is significantly less expensive at the clearing house than if these instruments remained bilateral and subject to the Uncleared Margin Rules (UMR). Adding forwards into this clearing mix and portfolio margining them together can further reduce margin costs, while providing regulatory capital relief due to the CCP 2% counterparty risk weight, as forwards can be offset against existing FX option and NDF risk positions. This means that even though forwards aren’t subject to UMR, clearing them can reduce financial resource requirements for banks by providing regulatory capital relief for zero to minimal initial margin increase (or even a margin reduction).
Where does demand for forwards clearing come from?
FX swaps and forwards represent 64% of the global market volumes, and the recent implementation and ongoing phase-in of SA-CCR internationally makes trading more capital-intensive than ever before. This means that, in order to continue using these products and providing them to clients, banks need to increase the efficiency with which they deploy capital to support these products.
Can you explain to us what FX Smart Clearing is?
FX Smart Clearing is the ‘intelligent’, selective clearing of FX forwards and swaps to help banks reduce their capital costs across their entire FX portfolio, while constraining margin costs to an acceptable level. By facing a qualifying CCP, banks can reduce their counterparty risk weights over bilateral counterparts, lowering capital requirements vs. equivalent bilateral positions, for both risk-weighted assets (RWA) and the leverage ratio (LR) calculation.
We work with Approved Trade Selection Providers (ATSPs), such as Quantile, whose optimisation processes suggest which trades to clear with LCH ForexClear. Cleared trades will keep cleared margin within predefined tolerance levels set by each bank, while significantly reducing regulatory capital requirements.
What’s the current situation with forwards clearing and where do you see growth coming?
We’re currently building a network of banks that can undertake optimisation of forwards and clear them at reduced costs in terms of margin by accessing natural hedges against their cleared NDF and FX options portfolios, or on their own merits to a level of margin the bank deems acceptable. As this network expands and adoption grows, the benefit to the banks is expected to grow significantly as the addition of each bank to the network offers a disproportionately greater number of potential offsets for the ATSP optimisation process to find. Banks each have their own set of constraints, such as credit limits to bilateral counterparties in the network, how much initial margin they’re prepared to take on for a given capital benefit, and how many trades they want to clear. The more these constraints are eased, the higher the optimisation efficiency becomes.
There’s lots of talk about selective clearing. Are there plans to push ‘native’ forwards clearing?
Absolutely. FX Smart Clearing helps banks show that they can manage the margin and capital impacts of clearing forwards in a cost-effective way, meaning that they can demonstrate a business case that clearing all forwards – not just a small subset of trades – is resource-efficient too (in terms of capital saved vs. margin incurred).
There are a number of ways banks could achieve ‘native’ forwards clearing. They could clear with a filter at the point of trading, i.e. certain currencies that are smaller so they won’t drive margin increases, smaller notional or even margin reducing only. They could periodically ’backload’ or sweep portfolios of existing trades into clearing on the same financial resource efficiency basis as they send new trades. They could do different combinations of ’filter’ and ’sweep’.
We are now working with banks to understand the most beneficial way to move to ’native’ forwards clearing, while focusing on ensuring forwards clearing is more resource-efficient than keeping those trades bilateral.
Can you describe your ideal end-state?
Ideally, we’d like to see banks first clear everything that’s eligible, with the knowledge that it can then quickly be optimised, rather than optimise and then clear. This speeds up how quickly banks can access the benefits of clearing.
There has been lots of talk about the interdealer space but are there plans to address the buy-side? And what would this look like?
Forwards clearing has the potential to offer huge value for the buy-side by reducing the cost of trading, reducing the buy-side’s usage of prime broker balance sheet, freeing up credit lines with prime brokers and providing better access to liquidity.
It also reduces reliance on prime brokers, providing backup and portability options in the event of a prime broker running out of credit lines or going under for any reason – making trading easier, cheaper and operationally safer, in the same way clearing already does for so many other instruments.
What are the barriers to adoption of forwards clearing?
Bank technology can be rigid and most clearing infrastructure was built to work by asset class and counterparty for mandatory clearing, so banks often have an inflexible clearing logic in their technology stack.
With FX Smart Clearing, our workflow gets round this by bypassing a substantial part of the normal clearing workflow because the trades come directly from the ATSP to LCH ForexClear. Then all the banks have to do is perform a reconciliation and ensure the trade is booked facing LCH – what was a bilateral trade is now cleared.
Banks are often set up to expect the case for clearing to be regulation-led (e.g. by mandate or SIMM), rather than economically led. This makes it extremely important to get the economic case for forwards clearing, and make it visible throughout each bank, to ensure those benefits are widely, as well as deeply, understood. Our growing forwards clearing network demonstrates that this is already happening.