Impetus for change: Will the introduction of SA-CCR provide an industry wide catalyst for behavioral change in FX markets?

At first glance, the $6.6 trillion a day FX market has not been as heavily impacted by derivatives regulations in the last five to ten years as other asset classes. As such, the voluntary adoption of clearing or a cleared alternative for the deliverable FX market is likely to come as a result of wider cost considerations and/or qualitative client pressures such as operational efficiencies, mitigating counterparty risk, and gaining greater transparency.

These drivers are certainly among the primary catalysts behind the continued growth we have seen in the adoption of FX futures and in the initial uptake of cash settled cleared FX products, which have helped to deliver all-time records for open interest, number of large open interest holders, and single day volumes in CME listed FX futures during 2020.

The advent of UMR, which started with phase 1 in September 2016, served as a catalyst for changing the bilateral status quo for parts of the FX market, with the most obvious impact on the interbank activity for NDFs.

With phases 5 of 6 of UMR still to come in 2021 and 2022 respectively, the wider impact on the buy-side still remains to be seen. But given the direct impact of UMR on bilateral products like NDFs and FX options, there may be a compelling case for entities ultimately caught by the regulations to consider migrating impacted trades to a cleared alternative. However, even if the next two to three years do see a wider adoption of clearing for NDFs and FX options, these products combined only account for about 8% of the total FX market.

Outside of the interbank NDF clearing activity that appears driven by UMR, the growth in adoption of FX futures, and to a lesser extent the buy-side adoption of clearing, for G10 NDFs currently appears driven by a variety of other factors that are largely completely unrelated to UMR. These factors include:

• Access to more liquidity providers and more liquidity
• Netting of risk and positions against a highly rated CCP
• Ease of allocations and operational processing
• Freeing up bilateral lines and no need for ISDAs
• All-to-all anonymous and credit agnostic pricing (futures only)
• Firm pricing with no last look (futures only)
• Ability to trade passively (futures only)

The other big piece of regulatory change that may impact clearing decisions for FX is around bank capital. The Basel Committee on Banking Supervision (“BCBS”) designed a new model for the calculation of the capital held to cover the risk of default by counterparts to derivatives transactions. This new model, the standardized approach to counterparty credit risk (“SA-CCR”), is due to be implemented by European banks in June 2021 and on US banks (with assets over $250B) by January 1, 2022.

Under the Basel accords, banks have been using the Current Exposure Method (CEM) or Standardized Method (SM) for over 30 years to calculate their capital requirements. The move away from these models to SA-CCR has been reported in some recent industry press as resulting in a huge impact on bilateral FX positions, potentially resulting in a direct catalyst for the wholesale clearing of deliverable FWDs (including the FWD leg of FX swaps).

However, we anticipate that the impact is likely to be far less binary. Based on our analysis and discussions with banks, our view is that cost and capital efficient clearing solutions, such as FX futures and G10 NDFs, may well see increased utilization as mechanisms to mitigate the capital requirements of certain parts of the bilateral FX market. But it is unlikely for dealers to migrate the bulk of their FX FWDS or swaps activity to a deliverable cleared solution when the costs are so high and complexities so onerous.

A more likely outcome is the continued evolution of cost efficient clearing solutions as a portfolio management tool to help optimize the pockets of bilateral FX activity that are attracting the highest capital requirements, as well as the extended usage of FX futures as a capital efficient hedging tool that is complementary to OTC FWD and swap activity.

The headline characteristics of the SA-CCR approach that are most relevant to any potential catalysts for increased central clearing include the following:

• SA-CCR is more risk sensitive and less focused on gross notional.
• SA-CCR allows netting benefits – and so benefits the migration of risk to one counterpart.
• SA-CCR improves recognition of collateral/recognizes margin as offsetting to counterparty risk – and this includes client margin on cleared trades for FCMs.
• SA-CCR mandates a margin period of risk (“MPOR”) of 10 days for direct member cleared trades, and whilst the floor for bilateral is the same, it rises to 20 days for CSAs with more than 5,000 transactions.

Whilst the headline characteristics of SA-CCR look to be a tailwind behind clearing, the real answers may lie in the actual capital numbers generated by this model for each impacted bank entity. As such we conducted analysis of the impacts of SA-CCR on hypothetical interbank FX FWDs books of 20 large banksⁱⁱ.

From the analysis, our first finding was that the impact of SA-CCR varied a lot between the 20 banks. The shift from CEM to SA-CCR ranged from a 44.5% increase in the capital requirement to a 20.5% decrease. As this high-level observation illustrates, the introduction of SA-CCR will impact portfolios differently, which will influence a bank’s decision as to when to adopt the new regime before the mandatory deadline. This range of impacts will likely also result in a similar range in the impetus or need to adopt clearing as a potential mitigant to the capital requirements.

Our second finding was that by virtue of the improved recognition for netting along with increased sensitivity to risk, all 20 banks migrating the entirety of their interbank FX FWDs transactions to clearing would achieve a 72% reduction in capital under SA-CCR versus a 44% reduction under CEM.

Dealers that we spoke with aren’t, however, looking at the potential capital efficiencies in isolation. In addition to the impacts on capital, dealers are mindful of other factors such as the cost of funding IM, CCP fees, capital on committed swap lines needed to run a deliverable cleared solution, and the funding of the CCP guaranty fund. Outside of these first order quantitative elements, there are also other factors of relevance that include the counterparty credit risk benefits and operational efficiencies of facing a large and well capitalized CCP. As such, the decision of whether and what to clear becomes a much more holistic decision for the trading desk, XVA desk, and multiple other parts of the bank to consider.

As noted above, there are many potential dynamics for a bank to consider when reviewing if and how to optimize their trading activity by using OTC clearing and/or listed derivatives. Whilst central clearing against a highly regulated and well capitalized CCP provides significant risk management, operational and counterparty credit risk benefits, the traders and XVA desks we spoke with largely focus on the trade-off between capital efficiencies and funding of IM. 

Looking at our same set of hypothetical interbank FX FWDs portfolios, our analysis calculated that the total IM cost of moving all the risk to OTC clearing would be $30.8B and in to Listed FX futures would be $24.3B. Once the cost of funding this IM is considered, the average estimated annual bottom line saving for each dealer would be $2.6 million by using listed FX and $900K by using OTC cleared FX.

The other material considerations that can impact on decisions as to if, when, and where to utilize OTC cleared FX solutions and/or listed FX futures to optimize trading include the following:

• CCP Fees – onboarding, membership, and ticket fees
• Guaranty Fund contributions – capital posted and put aside against contributions to a CCP guaranty fund
• Fees, limits, and operational complexity associated with a separate CLS settlement cycle for physically delivered cleared FX
• Committed swap lines required by CCPs with physically delivered cleared FX
• Counterparty credit risk and risk management best practices
• Operational efficiencies

• UMR helped create an impetus for D2D clearing of NDFs, and to a far lesser degree, FX options ‒ given the costs and complexities associated with a cleared physically delivered solution.
• The majority of UMR impacts on buy-side clients are still to be seen, given that phases 5 and 6 were delayed until 2021 and 2022.
• The continued adoption and growth of FX futures and OTC FX clearing at CME Group during 2020 appears driven by a variety of factors including accessing additional liquidity, better pricing, trading without an ISDA, and netting of positions against a highly rated CCP.
• Central clearing of physically delivered FX FWDs presents costs, risks, and operational challenges. Cash settled clearing of FWDs and/or use of physical settlement via FX futures can be more scalable.
• The move to SA-CCR is another potential catalyst for change, but the impact will be dealer specific. Furthermore, the analysis we have done suggests a more holistic cost vs. benefit analysis of using clearing and/or listed FX products is warranted rather than considering capital on a standalone basis.

To discuss these topics directly, or to explore the potential costs and benefits of adding listed FX futures or OTC cleared FX, please contact fxteam@cmegroup.com.

ⁱ Based on statistics from the BIS Triennial survey 2019: https://www.bis.org/statistics/rpfx19.htm
ⁱⁱ Our assumptions and dataset for the analysis includes the following:

• Hypothetical interbank activity of 20 dealers
• FX FWDs (including the far leg of FX Swaps) only – no FXO, NDFs or X-CCY swaps
• 7 currency pairs only (EUR/USD, USD/JPY, GBP/USD, AUD/USD, USD/CAD, USD/CHF, and EUR/GBP)
• Every relationship has more than 5,000 trades (so 20-day MPOR for bilateral).
• 50bps cost of funding for margin
• Leverage ratio requirement of 5%