ForexClear, part of the London Stock Exchange’s clearing unit LCH.Clearnet, has cleared more than $3 trillion in non-deliverable forwards as it plans to enter the larger market of clearing foreign exchange options next year.
Forwards in non-deliverable currencies involve a foreign exchange trade where one currency is from a country that has imposed capital controls.
Gavin Wells, global head of ForexClear, said in a media briefing: “ForexClear had its best ever month in August, in terms of cleared volumes, despite there being no regulatory mandate for clearing FX. We recently hit the milestone of clearing $3 trillion in notional of FX NDFs since launching in March 2012.”
ForexClear covers 12 currencies enabling more than 95% of the NDF market to be cleared. Although regulators have not mandated NDF clearing, many sell-side firms have started clearing voluntarily due to the capital and operational efficiencies.
Wells believes that FX clearing volumes will be boosted next year when new regulations requiring margin payments for over-the-counter derivatives positions will begin to be phased in.
“In September 2016 the uncleared margin rules will begin to kick in and we have estimated that exchanging initial and variation margin on a bilateral basis could be at least double the cost of that required by a CCP,” he added.
The margin exchange rules will also encourage buy-side firms to begin voluntarily clearing foreign exchange as bilateral deals will become expensive.
“Some buy-side firms are ready to clear NDFs but have not yet done so,” added Wells. “Within five years, as the bilateral margin rules are phased in, we anticipate that more than 50% of the buy-side and 75% of banks will be clearing FX.”
This month ForexClear cleared its first NDF that was executed on a swap execution facility, in this case, State Street’s SwapEx platform.
Virtu Financial was the underlying client with French bank Société Générale acting as electronic trading firm’s clearing member at ForexClear. Traiana, the pre-trade risk and post-trade processing technology provider, used its Credit Link service for credit checking and clearing certainty for swaps.
Steve French, head of regulation at Traiana said in a statement: “This completes a key milestone in the development of the Traiana CreditLink service and we are now working with clearing members and trading venues to prepare the service for FX options and the post-trading issues as specified in the MiFID II draft technical standards.”
Non-deliverable forwards, unlike the remaining 97% of the foreign exchange market, are not physically settled through an exchange of principal. Instead one counterparty pays the profit to the other, based on the difference between the exchange rate at the time of the trade and at maturity. ForexClear will enter the much larger physically settled market when it starts clearing FX options.
Wells said ForexClear plans to launch a compression service for FX later this year and clearing FX options in 2016, subject to regulatory approval.
Edward Hughes, chief operating officer of ForexClear, said in the briefing: “Many banks are looking to increase their NDF clearing activity and we have seen good interest in FX options clearing.”
Wells estimated that daily NDF volumes are $100bn and between $65bn and $70bn of that total is eligible for clearing. In FX options, between $200bn and $220bn will be eligible for clearing each day. Together with hedges for the options trades, the size of the FX options market available for clearing could be three to four times its current size in NDFs.
“It is not unreasonable to think that even in the absence of a mandate between 70% and 80% of NDFs could be cleared over time,” added Hughes. “In FX options that figure could be between 60% and 70%.”
The physical settlement of the cleared FX options will operated by CLS, the bank-owned utility which was set up to eliminate settlement risk in the FX market. CLS has been designated a systemically important financial utility by the US authorities.
It is possible that the technology developed by ForexClear for clearing FX options could be used for other asset classes. ForexClear said the settlement service being developed with CLS is designed to be leveraged by other products involving FX physical settlement.
Clarus Financial Technology posted a blog today analysing the volume of FX options trades reported to US swap data repositories and volumes published by US SEFs. Clarus said volumes of FX options on SEFs this year are 30% higher than last year; US persons are transacting 27% of FX options on SEFs while the remaining 63% remains over-the-counter and the most active pair is EUR/USD with up to 11,500 trades or $600bn notional a month.
It is estimated that just over half of the FX market, which turns over more than $5 trillion per day, is traded electronically and that proportion is expected to increase. Last month Markit made two acquisitions in the foreign exchange space as the financial information services provider expects the use of electronic trading and central clearing to increase in the asset class.
Jeffrey Maron, managing director at Markit, told Markets Media last month: “There will be more electronic trading, although not necessarily on exchanges, and over time more volume will move into central clearing.”
Featured image by /Dollar Photo Club