Rocky road ahead for central clearing in FX
The regulatory requirement for better understanding of cost is pushing market participants towards central credit despite the disruption caused by last year’s unexpected Swiss franc appreciation.
The Basel III leverage ratio framework and disclosure requirements, known as BCBS 270, imposes onerous capital requirements for bank exposures on a non-risk-adjusted basis.
Meanwhile, new Basel rules on the risk-based capital regime, including the standardized and advanced approach, challenge the profitability of bank lending given higher equity requirements, while penalizing foreign-currency exposures, among other things.
As a result, banks more than ever are paying attention – both from an operational and regulatory risk perspective – to how they set intra-day credit exposures to their counterparties.
A bilateral credit model is where two parties extend credit to each other for trades, whereas under central credit or central clearing a third party interposes itself between the two counterparties, becoming the buyer to every seller and the seller to every buyer. A debate is now brewing about the relative appeal of both models.
Proponents of central credit such as Jon Vollemaere, CEO of R5, says the central credit model improves credit efficiency, provides wider access to new participants and enables banks to trade with an expanded group of counterparties via their prime broker while also reducing the number of credit lines that have to be maintained.
“Banks are already reviewing their trading relationships,” says Vollemaere. “In the past, we saw an 'arms race' where the big banks were flow monsters – we don’t see that any more. As credit becomes more costly there will be a continued focus on key accounts, as opposed to chasing the whole market.
"If you have to collateralize every bilateral credit relationship, a CCP model makes more sense in terms of cost. Whilst most banks already have accounts with each other, collateralization will mean changes in terms of minimums and margin calls.”
R5 uses a centralized credit model on its InterBank platform. Vollemaere observes that the requirement for bilateral credit relationships when trading emerging-market currencies means the market is limited to a relatively small universe of counterparties.
The over-the-counter (OTC) market has operated using bilateral credit for a long time, but it has always been difficult to allocate a precise cost to that credit, he says, adding: “Now the industry [given increased regulatory scrutiny] will be forced into better understanding its costs relative to its risk.”
This is not to say that bilateral relationships are doomed. As James Sinclair, CEO of fintech firm MarketFactory, observes there will be customers – especially those who are hedging rather than seeking alpha from FX – who want a broad cross-product, full-service relationship with just a few banks.
Also, the headline cost of clearing can be higher than that derived from bilateral relationships. Most clearing houses insure against both settlement risk and market risk in case a counterpart fails, whereas many participants accept insurance of only the settlement risk and effectively self-insure market risk.
In addition, credit intermediation is not exempt from global trends.
“The world is becoming more peer-to-peer, unbundled and networked,” says Sinclair. “It has affected execution – witness how the market first consolidated around two major ECNs but then fragmented. It is affecting consumer lending and, though we don't yet know how, will surely affect credit intermediation.”
Marco Baggioli, COO of ADS Securities London, an FX brokerage and ECN, refers to a move away from centralized credit since the turmoil caused by the Swiss National Bank removing its currency peg in January 2015, especially for mid-level brokers and smaller funds.
“Beyond tier-1 banks, many market participants are being forced away from their prime brokerage relationship and more into bilateral credit arrangements," he says. "Prime-of-prime brokerage firms [which provide leverage alongside the largest prime brokerage units often to small and mid-sized clients] may have stepped in to fill this void, but it will take time for this model to fully settle in.”
However, once this is achieved, Baggioli says the market will return to favouring a central credit model.
According to Dmitri Galinov, CEO of FastMatch, an FX ECN, this would create one significant clearing exchange beneficiary since the market will not tolerate multiple clearing exchanges with non-fungible instruments.
“Such exchange would also benefit from increased trading volumes due to cross-margining of the OTC FX versus the products traded on the exchange,” says Galinov. “A good central clearing solution would increase liquidity since it would bring more players to the market and decrease margin requirements and the cost of post-trade processing.”
While the group of institutions that no longer have direct access to a tier-1 institution might not have direct access to the diversity of liquidity they once did, there is still a sufficient number of organizations with significant credit lines and reach that will act as intermediaries on a prime-of-prime basis, adds Bryan Seegers, director of eFX pricing & execution at ADS Securities Abu Dhabi.
“The liquidity is still there, although costs are likely to increase,” he concludes. “Further to this, many ECNs are enticing people to use their venues for disclosed direct relationships, further allowing people access to the liquidity they need – although counterparties are then obliged to use the ECN’s pricing.”