Eurex Clearing recently cleared its long-awaited first cross-currency swap transaction.
The company only offers interdealer clearing of EUR/USD and GBP/USD cross-currency swaps, although it says it plans to introduce client clearing next year.
Cross-currency swap clearing is not a new development – Hong Kong Exchanges and Clearing (HKEX) subsidiary OTC Clear has been clearing USD-HKD swaps for more than 18 months.
However, as the product becomes more established, other clearing houses can be expected to follow suit.
In turn, the number of swaps covered will increase, especially if market participants perceive a notable credit or settlement risk to these transactions, which combine an FX product and an interest-rate product.
R5FX CEO JonVollemaere notes that his platform has always used a central counterparty clearing (CCP) model because problems with bilateral credit are even more concentrated in emerging markets.
“Whether in places like China – where netting isn’t currently recognised – or India and Brazil, where risk amongst both resident and non-resident traders is reduced by using a CCP model, providing customers with the choice of either cleared or uncleared is the way the market is moving,” he says.
“If it works for emerging market currencies, it will certainly work for the G10.”
The progress of FX clearing to date has been driven by market participants identifying substantial benefits, says PaddyBoyle, head of ForexClear at LCH.
“With no clearing mandates in FX, there would be no clearing without benefits accruing to users,” he says. “The 10,000 or so trades we clear every day speak for themselves on this point.”
The interbank structure is highly competitive, which has kept spreads and costs low. The extent to which central clearing results in increased costs will obviously depend on the price offered by the clearing house.
Vollemaere says: “For some time, we have had the prime broker versus clearing debate where prime brokerage has been much cheaper as a form of access, but costs are increasing for all and UMR [uncleared margin rules] will further impact this market over the next two years.
“The clearing house that prices itself to compete with prime brokers will win the lion's share of the cleared FX market.”
Central clearing is more efficient than bilateral trading as market participants can net their exposures with a single counterparty and settle variation margin on a net basis- Sunil Cutinho, CME Clearing
Eurex Clearing’s longer-term plan is to develop a cleared FX liquidity pool as providers are attracted by lower capital and margin costs. The challenge it and other clearing houses face is ensuring that multiple exchange venues offering the same services does not lead to fragmented liquidity.
There is a view that central clearing offers more certainty or visibility to market participants and will drive what is a large over-the-counter (OTC) market into a more transparent and standardized model.
CCPs require market participants to post initial margin as a performance bond and settle current exposures at least once per day as their positions are marked to market. In CME’s futures and options markets, mark to market occurs twice a day, so gains and losses don’t accumulate in the system.
“Central clearing is more efficient than bilateral trading as market participants can net their exposures with a single counterparty and settle variation margin on a net basis,” says Sunil Cutinho, president at CME Clearing.
“Our centralized FX clearing also offers portfolio margining opportunities between cleared OTC FX and exchange-listed FX futures and options, with margin savings of up to 90% against emerging-market futures and 56% against G10 futures.”
However, the interbank structure is well established with standard contracts and continuous linked settlement, meaning banks operate with low risk between each other.
A powerful motivation for promoting central clearing is that the central counterparties (exchanges) have seen pressure on revenues from trading in their traditional product offerings and appreciate that even a modest share of the FX market would be extremely lucrative.
Greater use of cross-currency swap transaction clearing is potentially another step towards central clearing becoming the prevalent credit model in FX.
However, Jason Hughes, global head of sales at ADSS, warns that there is still a long way to go.
“With transaction reporting requirements, we are seeing more visibility within the traditional OTC space and therefore an element of increased transparency without a centralized counterparty system,” he says.
“Deutsche Börse has been active with acquisitions in the FX trading space. Eurex only has only a small number of banks connected, though, and this will need to grow significantly to really affect the OTC interbank business.”