Industry divided as regulators mull NDF clearing
European proposals for mandatory clearing of non-deliverable forwards (NDFs) published in October seemed to be a decisive step toward a new framework for FX derivatives trading. However, responses to the consultation reveal deep divisions among FX market participants over the way forward.
As its counterpart in the US – the Commodity Futures Trading Commission (CFTC) – considers its position, the European Securities and Markets Authority (ESMA) on October 1 launched a public consultation in respect of an NDF clearing obligation under European Market Infrastructure Regulation (EMIR), with responses published on its website on Friday.
Under the EMIR proposals, cash-settled forward contracts will be subject to mandatory clearing from 2017, with physically settled forwards excluded. Trading of NDFs has increased sharply during the past five years, ESMA says, with daily volumes in London reaching around $40 billion, compared with $20 billion five years ago.
In its consultation, ESMA considers 11 contracts cleared by LCH.Clearnet. The contracts are settled in US dollars and include the Brazilian real, Chilean peso, Chinese yuan, Colombian peso, Indonesian rupiah, Indian rupee, Korean won, Malaysian ringgit, Philippine peso, Russian rouble and Taiwanese dollar.
While some market participants support a move to mandatory clearing, others are vociferously opposed, and many sit somewhere in the middle, agreeing with the principle but citing numerous practical difficulties.
Those opposed focus on the fact the NDF market is small relative to the other asset classes mandated to be cleared – credit and interest rate swaps – and is relatively underdeveloped in terms of clearing infrastructure. Only 2% or 3% of trades are cleared at present, according to the ESMA consultation document.
Some respondents pick on specific aspects of the proposal, for example the decision to impose an obligation on maturities from three days to two years, despite more than 90% of liquidity being concentrated in maturities of less than three months, according to DTCC data.
Others are more balanced in their view, but seem overall to caution against moving forward without a full consideration of the consequences.
“We support the principal of clearing, but the NDF asset class differs from those already mandated to be cleared,” says James Kemp, managing director of the Global FX Division at the Global Financial Markets Association. “Given the small size of the market and the fact that only a tiny proportion is centrally cleared at present, there may be a timing issue to consider.”
Before clearing of NDFs proceeds, standardization of the product would be ideal, Kemp says.
Others are less equivocal.
“NDFs should not be subject to the clearing obligation at all,” says the Deutsche Kreditwirtschaft (German Banking Industry Committee). “Given the low liquidity of the European NDF market, in particular with respect to contracts settled in USD, we do not think that such products should be subject to the clearing obligation.
“This argument is further supported by the fact that only one CCP has been authorized to clear such products and that only two of its 20 clearing members offer clearing services to clients.”
Good starting point
Still, that view is not universal, even among German banks, and Deutsche Bank is among those that says it supports the proposal overall and that the 11 asset classes represent a good starting point. Others supporters include clearing houses, naturally, and Thomson Reuters, which runs the FXall trading platform.
One issue on which almost all market participants agree is that any move to mandatory clearing should be preceded by agreement between regulators. The point is germane because while ESMA has proceeded with its consultation with alacrity, policymakers at the CFTC have been dragging their feet, after first suggesting an NDF clearing mandate in early 2013.
The initial CFTC announcement has been followed by a series of delays, during which officials were said to be “finalizing” proposals, after which, according to then-commissioner Scott O’Malia, participants “should prepare for a quick transition to mandatory SEF trading after the clearing requirement takes effect”.
O’Malia’s speech was in May of this year, but to date no CFTC proposals have appeared.
In a speech on October, CFTC commissioner Mark Wetjen seemed to take a more sanguine view, saying the characteristics of NDFs seem to render them clearable, but that “the related market-structure issues involving clearing house, FCM and service-provider risk management, as well as those related to trade execution for NDFs, are important to the analysis of whether and when a clearing mandate is appropriate”.
At a meeting between US and European regulators after that speech, there was agreement on the need for coordinated action to move forward, say sources close to the situation. If that is to be the case, much works needs to be done on both sides of the pond.