In the third week of January, Capitolis completed its 19th standardized approach – counterparty credit risk (SA-CCR) optimization run for FX derivatives.
This latest series of compression trades incorporated a record number of participants, while also driving a record reduction of over $290 billion in effective notional.
In aggregate over the past 12 months, the firm has enabled a $2.5 trillion reduction in effective notional.
The leading banks in foreign exchange trading were hit hard in 2022 by the impact of new capital requirements from the SA-CCR rules finally being applied to short-dated FX forwards, FX swaps and swaptions.
In other asset classes, the largest global systemically important banks (G-Sibs) banks long ago grew used first to netting and then to compressing large portfolios for example of interest-rate derivatives positions taken out between one another. They would periodically identify multiple off-setting transactions that could be terminated or replaced with far fewer trades.
It was a way to reduce gross notional exposure while leaving the same net underlying market risk intact.
“It is key for banks to have a detailed understanding of their G-Sib scores, particularly as classification is assessed relative to their peers,” Magnus Jonsson, head of business management triReduce and triBalance, at OSTTRA, said late last year when the firm announced that in a single month it had compressed $26.4 trillion in gross notional of interest-rate derivatives.
“The challenge is that G-Sib assessments are highly sensitive to gross notional of derivatives contracts.”
Notional exposure
The imposition of SA-CCR requires new capital to be set against counterparty risk embedded within large numbers of short-dated directional FX derivatives trades with investors, hedge funds, large corporations and smaller banks that are less likely to have natural off-sets of equivalent long and short positions in the same currency pairs that can invariably be found between wholesale dealers.
Reducing notional exposure here requires more complex, multilateral portfolio optimization processes, with algorithms searching out new routes between a larger number of different types of counterparties along which to novate trades.
“None of us honestly knew what was going to happen in 2022, but it was a game changer for the compression industry, with four or five leading players all working up solutions for SA-CCR in interdealer FX for large banks,” says Gil Mandelzis, founder and chief executive of Capitolis, a company set up in 2017 to unlock capital constraints on banks.
Capitolis is backed both by leading technology venture-capital investors, such as Andreessen Horowitz, Canapi Ventures and Sequoia Capital, as well as by large banks including JPMorgan, Citi and State Street.
Multilateral derivatives portfolio optimization runs typically take up to five days to complete. The leading firms in the compression business tend to schedule them once a month or so. But amid the volatility at the end of the third quarter of 2022, Capitolis completed one within a single day, reducing the risks involved and resources required from banks, and raising the prospect of on-demand optimization at times when it is most needed.
That one-day execution followed the firm’s swift response in March 2022 to urgent requests for a compression run to clear rouble FX swaps between the leading banks, who were struggling to find a currency to physically settle them in in the days after Russia’s attack on Ukraine.
“The settlement of those rouble trades was a big challenge for the banking industry, and the banks really appreciated how we stepped up as a firm and executed that first run within just three days,” says Mandelzis. “It was a watershed moment.”
Capitolis continues to build momentum in the optimization of FX derivatives that banks and their customers do not want to execute as futures trades on the leading derivatives exchanges.
Shifting from FX forwards to currency futures might bring some relief from SA–CCR but would instead require the financing of initial margin and subsequent variation margin, which could be almost as expensive.
The futures exchanges had hoped that high volumes in FX forwards would come to them for clearing through central counterparties, but banks and their customers continue to trade over the counter.
Banks became more interested in FX compression in 2022 when SA-CCR brought clear constraints and all of a sudden made FX derivatives a much more significant consumer of RWAs
Gil Mandelzis, Capitolis
“Banks became more interested in FX compression in 2022 when SA-CCR brought clear constraints and all of a sudden made FX derivatives a much more significant consumer of risk-weighted assets,” says Mandelzis. “The key issue now is how to grow the network to include more participants – investment firms, non-G-Sib banks, corporates – that are less directly impacted by SA-CCR.”
Compression effects
Some leading FX banks were quicker than competitors to spot the likely impact from SA-CCR and acted at the start of last year to compress FX derivatives portfolios faster than rivals, whose pricing became less sharp. That led to loss of market share and, so banks tell us, to some marked movements down the Euromoney FX survey rankings.
But this is not just a problem for the biggest banks. Smaller regional lenders are often distributors for the biggest FX banks, and if the G-Sibs’ capacity to take on FX risk is constrained, that will mean those smaller banks have to pass less-competitive pricing on to their own relationship customers.
“If I am a regional bank, I need to understand the capital and balance sheet impact of my activity with larger bank providers,” says Mandelzis. “Do you just learn to live with wider spreads? Because one of the easiest things to do is to instead lean in and optimize your portfolio with your large-bank counterparty, either bilaterally or through multilateral compression. We are now seeing clients of all sizes seeking to understand ways to reduce the cost for big banks of dealing with them.”
As Capitolis seeks to expand the network of participants in multilateral compression, continuing innovation will be crucial. The crisis in rouble swaps might provide a useful example for pre-empting potential future constraints in clearing swaps in emerging-market currencies.
“What happened with the rouble was a wake-up call,” says Mandelzis. “There are substantial volumes in other deliverable currencies with similar characteristics, and the more thoughtful banks are now saying they need to be ready ahead of time if something similar happens.
“It doesn’t have to be every month, but one way to get ahead of any such problem is to get into a routine of compression.”
