Regulatory changes under the standardized approach for counterparty credit risk (SA-CCR) have imposed stricter capital requirements on banks for bilateral over-the-counter (OTC) derivative trades since the start of 2022, forcing market participants to re-evaluate their FX portfolios from a capital cost perspective.
Many FX market users – especially corporates – either do not post collateral or rely on non-cash collateral to margin positions, something that can be punitive under SA-CCR. For instance, sell-side banks that trade with corporates, pension funds and long-only asset managers that trade long-dated instruments with directional positions, face some big increases in capital requirements.
SA-CCR does not recognise the diversification benefits across hedging sets within an asset class, which results in multiple exposure values being calculated across multiple currency pairs.
“Therefore, the overall FX risk-weighted assets under SAC-CCR tend to be quite conservative and risk-insensitive, which ultimately results in a significant increase in the capital charge,” explains Kishore Ramakrishnan, managing director of capital markets advisory at Treliant Capital Markets.
The right mix
The precise impact of moving to SA-CCR depends on the exact book of FX positions in question. In an analysis of hypothetical dealer portfolios holding FX forwards in seven major currency pairs, CME Group found that moving to SA-CCR could increase some dealers’ capital requirements by up to 44.5%. For others, it might even reduce the regulatory capital required to be held.
“Our analysis suggests a more holistic cost-benefit analysis of using the right mix of clearing and FX futures and options is warranted,” says Paul Houston, global head of FX products at CME Group.
Unless there is a better recognition of initial margin and variation margin in the calculation of total exposure, SA-CCR is likely to incentivise FX markets to central clearing
Kishore Ramakrishnan, Treliant Capital Markets
Erik Petri, Osttra’s head of triReduce, a portfolio compression service, and triBalance, a counterparty risk optimization service, observes that banks have managed the situation by getting better at calculating and managing exposures. But, he adds, those with a higher number of prime brokerage customers are so far bearing the brunt of the change.
“For the leading FX prime brokerage teams supporting clients with trades worth billions of dollars, it will be incredibly difficult to achieve reductions by following an approach that makes tweaks at the edges,” he says. “Banks need to better manage the allocations internally across teams using a variety of mechanisms, rather than treat the costs of capital in siloed groups.”
Prior to their introduction, supporters of the new rules suggested that increased collateralization of bilateral positions could push the FX industry towards clearing in light of inadequate recognition of the client initial margin and variation margin.
According to Jens Quiram, global co-head of FIC derivatives and repo sales at Eurex, both banks and buy-side participants feel genuine interest in sending some of their FX business to a clearing house to benefit not only from state-of-the-art risk management, but also to receive the preferential treatment from a margin or capital perspective intended by regulators.
“Unless there is a better recognition of initial margin and variation margin in the calculation of total exposure, SA-CCR is likely to incentivize FX markets to central clearing,” adds Ramakrishnan at Treliant.
Exchange infrastructure
FX clearing has the potential to provide lower margin requirements than the bilateral space and offers capital optimization opportunities through multilateral netting and reduced risk weights, says James Pearson, head of ForexClear at LCH.
“We have seen some of the largest FX banks increase their cleared flow and actively cleared currency pairs, and additional banks are preparing to go live with FX clearing in the second quarter of 2023,” he says. “While this momentum has been driven primarily by bilateral margin, other factors such as operational and counterparty credit efficiencies are making clearing at a CCP even more appealing.”
We see an increasing number of participants seeking liquidity pivoting to directly trading our benchmark FX futures contracts
KC Lam, SGX Group
Ramakrishnan predicts an uptick in the voluntary adoption of capital-efficient clearing alternatives such as FX futures, G10 NDFs, deliverable forwards, FX options and FX swaps on the back of the capital requirements from both SA-CCR and uncleared margin rules.
“FX futures have gained traction because many market participants are already familiar with the mechanics of futures instruments,” says Quiram. “They are traded on the same exchange infrastructure that many banks and buy-side firms already use to trade fixed income or equity index futures.”
KC Lam, global head of FX and rates at SGX Group, notes the record trading volumes for FX futures.
“We see an increasing number of participants seeking liquidity pivoting to directly trading our benchmark FX futures contracts,” he says. “This is clearly seen in the various volumes and open interest records we have reported.”
CME Group’s Houston adds that firm, transparent pricing for FX swap risk – combined with the ability to move the forward risk off-balance sheet via a centrally cleared FX future – are two of the main drivers for the accelerated growth in CME’s pools of cleared liquidity for FX swaps.
Clearing FX swaps and using FX futures rather than forwards has the potential to reduce SA-CCR capital by enabling cleared trades to be treated as settled-to-market (which reduces their exposure compared with bilateral contracts), and reducing the counterparty risk weight on cleared trades compared with those facing a bilateral dealer.
Overall costs
However, while SA-CCR capital would be reduced, the cost of margin would increase. FX forwards and swaps do not incur initial margin under the bilateral margin rules, whereas initial margin would be required on the equivalent cleared products, notes Stuart Nield, global head of product, financial risk analytics, at S&P Global Market Intelligence.
Putting all trades through clearing may force square pegs into round holes
Erik Petri, Osttra
“Therefore, from an overall cost perspective the decision to clear FX trades is an optimization problem that is portfolio dependent,” he says.
“X-value adjustment desks would be best placed to make the decision, as with a capable system they could quickly and efficiently calculate the lifetime cost of capital against the lifetime cost of initial margin under the two approaches.”
Petri at Osttra reckons the question of whether clearing should or should not be used to reduce capital costs somewhat misses the point and that in order to make portfolios more capital-efficient in the time of SA-CCR, clearing needs to be used as part of an approach that can optimise capital costs for FX trades in bilateral, cleared OTC and exchange-traded derivatives markets.
“Putting all trades through clearing may force square pegs into round holes,” he says. “Clearing is most effective when taken as part of a holistic approach that focuses on the net outcome of the bank’s FX operations across bilateral, cleared and exchange-traded derivatives, rather than homing in on cost reductions on a line-item basis.”
