Although the announcement that the CME is to launch a service to clear over-the-counter foreign exchange products was no surprise, the way the exchange made it was. Once, the launch of such an initiative would almost certainly have been accompanied by a loud fanfare and the wheeling out of the great and the good by the exchange. But it would seem that the CME has learnt some important lessons over the past few years; so rather than proclaiming the move with a big bang, it did so more with a bit of a whimper.
Despite the modesty, though, the CME is no doubt feeling some satisfaction that it has what appears to be first-mover advantage in what might prove to be one of the most important developments in the history of FX. Of course, similar things were written when the exchange launched its ill-fated and ultimately doomed FXMarketSpace joint venture with Thomson Reuters just over three-years ago (see FXMS – Space 2007: an FX market odyssey?, Euromoney June 2006).
That initiative made much of how it was bringing centralized clearing to the OTC FX market and that in doing so it would change the industry’s structure. But even before it was launched, the venture was routinely described by many market participants as a solution looking for a problem.
Wave of change
However, times have changed. As the CME’s chief executive, Craig Donohue, remarked when he announced the plans: “Structural risks, such as counterparty risk and regulatory reform, are creating yet another wave of change in global FX markets.” The fact that FX continued to function extremely well throughout the fallout from the sub-prime crisis will not in itself prevent clearing being introduced. Nor will the traditional argument that if it’s not broken, it does not need fixing.
Again, though, the CME has learnt its lessons well and the exchange seems keen to show that it is not about to try to foist on the market a solution it does not want. Instead, it is talking about flexibility and cooperation and says that the service will not be launched until consultations with a broad range of market participants have been concluded. And, importantly, the clearing service will not be tied to a specific trading venue.
|
“Initially, we will clear spot, swaps and outright forwards to five years. That’s what we have received regulatory authorization for from the CFTC” |
 |
“We will provide a platform-agnostic, post-execution cleared-only service for the global OTC FX market. It has to be completely flexible, so that it can handle broken dates, odd amounts and any maturities,” says Derek Sammann, the CME’s global head of FX. “What has been made clear is that OTC market participants wanted execution severed from clearing. People want to have the flexibility of OTC trading, but they say there’s no need for another trading platform that’s linked to clearing…. What we’ve heard very clearly from the OTC FX market is that the clearing service is a compelling proposition, but customers want this to reside purely in the post-execution space. We can accept trades at whatever point in the post-trade cycle people want – they can come directly from an ECN, from a prime broker or from someone’s own back office.” The CME is able to point to the success of its ClearPort service, which has operated successfully for six years in clearing transactions in the OTC energy market as proof of concept that such an offering could work in FX. “The service will leverage on our existing clearing model,” says Sammann. “Participants will have to be an existing CME clearing member, or one of their clients. It has all the same functionality that we already provide. It will allow offsets against FX futures and against other OTC products. All positions will cross-margin down. So if you have a VAR-neutral portfolio in the CME clearing house, then you will see significantly reduced margins due to the power and scale of cross-margining.”
Sammann adds: “Initially, we will clear spot, swaps and outright forwards to five years. That’s what we have received regulatory authorization for from the CFTC, allowing us to treat these positions as ‘segregated customer funds’, allowing us to confer all the financial safeguards customer protection of the CME clearing house, such as bankruptcy protection.”
CCPs assessed
A recent white paper from the FX Joint Standing Committee, which meets under the auspices of the Bank of England, debated the merits of using a central counterparty. “CCPs have existed in some areas of the FX market for many years, but thus far their take-up has been limited, even during periods of heightened market stress,” it states. “While FX spot and swaps account for the biggest proportion of the daily UK FX market turnover, the benefits of a CCP would arguably be more pronounced in longer-dated currency products such as FX forwards, FX options and in particular cross-currency swaps… However, some of these longer-dated products are sometimes less standardized, possibly making them less suitable for CCP clearing. Moreover, a CCP that focuses solely on a sub-set of FX products (such as spot or forwards) might have an adverse impact on FX hedging strategies and inadvertently increase individual credit exposures.”
Regulatory pressure
If the market was left to its own devices, it is hard to envisage spot in particular being put through a CCP. However, market participants cannot ignore the regulatory pressure FX is being put under, regardless of whether or not that is warranted. Politics will play a huge part in whether or not FX does adopt a CCP for all products, something that the CME seems to have fully recognized. “We think it’s clear that the market doesn’t want, and we shouldn’t accept, mandated exchange-based trading in all products,” says Sammann. The CME, and any other clearing initiatives that emerge, will also be wary of ending up as a depository for the market’s more toxic or harder to revalue transactions. Much will also depend on how willing regulators at a national level – whatever they might say in public – are about seeing their currencies cleared effectively offshore. But for the moment, it looks as if there is a degree of inevitability about greater use of a CP in FX.
