The current landscape
From a sellside perspective, a number of drivers are affecting FX clearing, although they originally emanate from the margin requirements associated with Uncleared Margin Rules (UMR) and the associated benefits of netting margin requirements of a portfolio against a single counterparty. More recently the focus has switched to capital and sellside participants have become increasingly focused on how clearing can reduce risk weighted asset (RWA) requirements and improve leverage ratio (LR) calculations. Each bank has a nuanced focus in these areas, but all have a fundamental requirement to manage associated costs of both margin and capital. With $15 million in margin and capital savings realised annually, on average, per LCH ForexClear Member Group, the benefits of clearing are obvious.
LCH ForexClear, clearing almost 20% of the NDF market (as a % of BIS 2022 volumes), now represents one of the largest counterparties in the NDF market – the netting benefits are therefore substantial and continue to grow.
Other less quantifiable drivers also come into play around access to both broader market liquidity and a variety of counterparties that may not have previously been available, as well as aiming to improve trading capabilities, market presence and operational efficiency.
On the buyside, the situation is rather different. Unlike rates or credit derivatives, which have mandatory clearing, G20 regulators took a different approach to FX in relation to UMR. Under UMR, the buyside has to assess the relative benefits of clearing versus bilateral counterparty exposures and costs. “This assessment depends on a variety of factors, including margin savings, workflow considerations and counterparty requirements,” says Kah Yang Chong, Acting Head of State Street TradeNeXus. “These factors impact each buyside firm differently, based on the complexity of their operations, directionality and size of portfolios, and counterparty relationships.”
This approach has meant that buyside adoption of FX clearing will typically take longer, and the infrastructure that supports the ecosystem will evolve over time as client requests feed in. Recognising clients’ strategic requirements for a clearing workflow solution, State Street TradeNeXus has built out a clearing workflow to LCH ForexClear and now actively supports both cleared and bilateral workflows within a single application.
The voluntary nature of buyside FX clearing means that TradeNeXus buyside clients are able to opt to adopt clearing within the platform seamlessly for any of their funds for which it is beneficial to clear.
Enquiries and interest from clients are increasing post- UMR Phase 6 as they continue to evaluate their options.
In 2022, State Street TradeNeXus supported the FX clearing of the first ever Japanese asset manager at LCH ForexClear. This achievement demonstrates the success of the TradeNeXus partnership approach with clients.
NDFs and other hurdles
One area where buyside adoption of FX clearing has been particularly cautious is the related workflow, as asset managers have a strong preference for retaining existing operational models relating to post-trade allocations, confirmations and matching. Therefore, the consequent need to minimise change when adding support for a new workflow has led State Street TradeNeXus to build out the clearing workflow to complement clients’ existing use of TradeNeXus for bilateral workflows.
“Another significant hurdle to clearing adoption has been the lack of clearing features within the client’s OMS that enable them to determine whether or not a trade should be cleared,” says Kah Yang Chong.
“Without this, the process of clearing is highly manual and operationally risky.”
By utilizing TradeNeXus’s proprietary rules engine, clients can make a determination as trades are sent to the system, on whether they should be cleared or not based on settings at fund, currency and counterparty level. This provides the flexibility and positive outcome for clients who use either TradeNeXus’s scalable integration solutions, or integrate directly via their OMS. Finally, by operating a
single platform for FX post-trade, clients are able to utilize the TradeNeXus dashboard to monitor, on an exceptions basis, all their FX activity across bilateral and cleared trades, alongside their settlement statuses and custodian messaging.
Streamlining, standardising and reducing costs
LCH ForexClear is also strongly cognisant of the need to enhance the buyside’s FX clearing experience. The forthcoming launch of NDF Matching1 (treated in more detail in the case study following this article) represents the first pre-trade ‘intent to clear’ NDF execution venue.
Execution to clearing and the post-trade transaction journey for the buyside is fundamental to greater adoption. Buyside firms do not have the middle office, support and settlement functions that banks have built up, and so the focus needs to be on automation and STP, as far as possible. The recent progress by some of the buy-side online trading platforms (such as FXall’s Settlement Center, Bloomberg and, of course, FX Connect’s TradeNeXus platform) to incorporate a clearing journey into their settlement functionalities has been a positive development for buyside firms, considering how clearing could fit into their risk management activities. The ability for order management systems to consume clearing messages and data is similarly important.
Dealing with volatility
Recent stress events such as the pandemic, economic sanctions on Russia and increasing interest rates have given FX clearing providers an opportunity to assess the robustness of their solutions. In the case of ForexClear this has highlighted the stability and resilience of its margin model. Crucially, it also demonstrated that it provided sufficient protection for its members and their clients.
LCH ForexClear’s model has also demonstrated its resilience through market uncertainty and volatility, owing in large part to the anti-procyclicality buffer embedded in the margin model that ensures margin is not returned too quickly through periods of low volatility and not increased suddenly through period of high volatility. The introduction of portfolio margining in Q1 2023 has allowed more diversification benefits in the IM model, providing greater protection from margin requirement increases due to individual risk factor idiosyncrasies. This anti-procyclicality nature of LCH ForexClear’s model ensured clearing members were not required to post large amounts of collateral following an increase in volatility – something not necessarily true in the bilateral/prime brokerage space.
The pandemic posed specific problems beyond market risk, particularly for operational resilience and business continuity. “With a successful transition to remote working, disaster recovery has been drastically improved, providing more stability to our members and their clients,” says Loic Moreau, Head of Risk & Operations at LCH ForexClear
“The pandemic also posed the question of whether a default could be managed virtually; a few swift procedural updates ensured that this could be implemented and has been successfully simulated since – providing more tools and improving resilience in the event of a default.”
Buyside counterparty relationships
Periods of market volatility, such as those outlined above, further underline the need for providing the buyside with flexibility and choice. Consequently, many on the buyside have been engaging with their counterparties to ensure FX clearing workflow support is available to them on their buyside post-trade platform of choice. Platforms such as State Street TradeNeXus are designed specifically to support asset managers’ unique needs, and the buyside continues to lead the way in evolving the FX clearing ecosystem by requesting that counterparties match and clear transactions on platforms such as TradeNeXus.
However, whilst FX clearing provides a critical utility for managing counterparty credit risk, settlement risk and other benefits – such as reduced margin and exposure – execution is still largely relationship-driven in the OTC FX market. Buyside clients continue to focus on best execution metrics from providers such as BestX to manage their execution through FX Connect with their key counterparties. “This is why it has been so critical to provide the asset management community with a post-trade ‘election to clear’ mechanism that allows them the flexibility to obtain the best pricing from their chosen banks and then opt which funds or positions to clear post trade,” says Kah Yang Chong. “FX remains very different from rates, so the solutions that TradeNeXus provides to its client base have to fit seamlessly with their existing workflows and not disrupt the rest of their ecosystem.”
Conclusion
Looking ahead, it seems apparent that any continued periods of market stress will encourage market participants to look to clearing as a protective solution. LCH ForexClear fully appreciates that under these circumstances the protection of its members is the highest priority. Elsewhere, firms already embedded in the clearing ecosystem clearly wish to clear a broader range of currencies and tenors. To that end, LCH ForexClear extended the tenor of its G10 and BRL NDFs to five years and has plans to add additional higher-volume crosses – EUR/BRL, JPY/BRL, EUR/CNY – into the service. A broader product offering would also ensure a more complete clearing solution for firms at which workflows are standardised. Additionally, portfolio netting benefits (from both a capital and liquidity perspective) can
be leveraged across the entire FX product suite.
The clearing decision-making process will need to be more flexible and shift towards becoming a pre-execution decision, where firms could optimise their outcomes by choosing the elements of their FX portfolios they wish to clear, with the market ultimately moving towards a differential price for cleared trades. To this end, the ecosystem needs to expand, with the volume of each new entrant bringing new opportunities for existing participants and with all participants being able to clear against each other, on a currency-by-currency basis, in an easy and increasingly automated and instant fashion.
From a buyside perspective, this improved ecosystem will also need to include support from OMS and service providers to help drive increased buyside adoption of FX clearing. More specifically, any pricing differentials or counterparty preferences in NDFs that develop between cleared and bilateral trades could also play a big role in the buyside adoption of clearing. As the interbank market for NDF transactions is now generally cleared, further opportunities to optimize with asset managers will continue to be assessed by market participants. To this purpose, State Street TradeNeXus will continue to evolve and innovate its offering in partnership with buyside asset managers to cater
for their operational and workflow needs.
Workflow that NDF Matching will offer is subject to regulatory approval.