On Oct. 9, the Commodity Futures Trading Commission hosted a discussion with market participants on a clearing mandate for non-deliverable forwards and the potential impact on foreign exchange markets.
The discussion, which was held under the auspices of the CFTC’s Global Markets Advisory Committee, revealed significant disagreement about the timing of such a mandate. While some participants emphasized that mandatory clearing could be put into effect relatively easily, others warned that the introduction of a clearing mandate would lead very quickly to a trading mandate because of the way the rules are written.
In other words, once a clearing mandate takes effect, market participants would have to start using swap execution facilities or their European equivalent within a short period of time. According to several participants in the discussion, this would lead to the fragmentation of liquidity in the NDF market and higher costs for market participants.
The discussion also revealed that the CFTC staff are currently considering a proposal for mandating clearing for 12 currency pairs over a three to nine month time frame, and that the European Securities and Markets Authority, the CFTC’s counterpart in Europe, envisages mandatory trading for NDFs taking effect in Europe in early 2017.
The meeting, which was chaired by CFTC Commissioner Mark Wetjen, started with presentations from three regulators: ESMA, the U.K. Financial Conduct Authority, and the CFTC itself.
The CFTC has not yet proposed a rule requiring clearing for NDFs, but Brian O’Keefe, a deputy director in the CFTC’s division of clearing and risk, said the staff is evaluating a request for mandatory clearing for cash-settled non-deliverable forwards in 12 currency pairs with tenors of three days to two years. He did not identify which clearinghouse made this request, but LCH.Clearnet is currently clearing those 12 pairs and CME Group has made preparations to clear those same 12 pairs. He also noted that Singapore Exchange and Hong Kong Exchanges and Clearing offer clearing for a more limited range of NDFs.
O’Keefe said the staff are examining market data to evaluate whether the NDF market meets certain criteria necessary for a mandatory clearing determination. He noted that a very small number of market participants are currently using the existing clearing services for NDFs, and said approximately 99% of NDF trades are not cleared.
O’Keefe said that the staff expect to recommend a three-tier phase-in of the requirements if and when a rule becomes final:
- Swap dealers, major swap participants and “active funds” would have to comply within 90 days.
- Banks and other funds would have to comply within 180 days
- All other market participants, including pension plans, would have to comply within 270 days.
He added that the clearing requirement would not apply to central banks, sovereign governments, U.S. federal entities and certain other entities.
Rodrigo Buentaventura, head of the markets division at ESMA, confirmed that the proposed NDF clearing mandate issued by ESMA on Oct. 1 covers the same set of instruments, with the exception of NDFs in the Peruvian currency. He noted that the NDF market has sufficient liquidity and trading activity to meet ESMA’s criteria for determining whether an asset class should be subject to mandatory clearing, and he added that several clearinghouses are either engaged in clearing these products today or will be soon. Buenaventura outlined the timetable for moving from consultation to final rule, and suggested that the clearing mandate would be fully phased in by early 2017, with all four categories of market participants subject to clearing requirements.
Buenaventura also noted that under EU rules, ESMA is required to propose a separate set of requirements for trading NDFs on exchange-like venues. While these requirements have not been issued yet, he said EU rules specify a set period of time for completing these requirements, and under this timetable the trading mandate is likely to take effect starting in January 2017.
David Bailey, head of market infrastructure policy at the FCA, offered a supervisory perspective on the issue. He commented that his agency’s main concern is the potential impact on the clearinghouses subject to its supervision. He urged the CFTC to consider the capacity of the clearinghouses to handle defaults, and noted that liquidity in the NDF market drops off considerably in tenors beyond three months, making it more difficult to liquidate large positions in case of a default.
A number of participants in the discussion urged the regulators to move forward with mandatory clearing. Gavin Wells, the chief executive officer of LCH.Clearnet’s ForexClear service, said that while the current amount of NDF clearing is quite small, there are a number of clearing firms preparing to offer this service. Phil Weisberg, global head of FX at Thomson Reuters and the founder of the FXall trading platform, commented that a clearing mandate would help expand the NDF market by bringing in new participants. Adam Cooper, chief legal officer at Citadel, added that mandatory clearing would encourage more competition in the NDF market.
Several participants also noted that the U.S. and the EU seem to be moving forward on the same timetable and encouraged the regulators to synchronize the implementation of a clearing mandate. This synchronization would be “ideal,” said several participants, especially given the U.S.-EU timing gaps on the clearing mandates for interest rate swaps and credit default swaps.
Other participants raised a number of red flags, however. Jason Vitale, global head of FX prime brokerage at Deutsche Bank, emphasized that the FX market has a different “structural dynamic” than the IRS and CDS markets. Liquidity for the most actively traded NDFs—in currencies such as the Chinese RMB, the Indian rupee, and the Korean won—is mainly in Asia, he said. He estimated that U.S. and European customers account for less than third of the global NDF market, and he urged regulators to avoid taking actions that might disrupt U.S. and EU access to liquidity pools in Asia.
Troy Rohrbaugh, co-head of global rates, foreign exchange and commodities, raised the possibility that a trading mandate would come soon after a clearing mandate because of the way that the CFTC’s “made available for trading” requirements work. He warned that an overly rapid transition to mandatory trading in the U.S. would “bifurcate” liquidity, with U.S. market participants forced to use swap execution facilities while the rest of the world continued with existing methods for executing NDF trades.
Robert Klein, associate general counsel at Citigroup Global Markets, agreed that a rapid move to a trading mandate would be problematic. He added that the SEF landscape today suffers from a number of regulatory and infrastructure problems that have caused fragmentation of liquidity in the markets for IRS and CDS. He warned that the NDF market would be even more susceptible to this problem because of the “disconnects” among the SEFs on the rules around the trading of NDFs and the terms of the contracts traded on their platforms.
Yasushi Takayama, general counsel at Nomura Securities International, raised a concern about the treatment of package trades. He noted that his firm often sells options on non-deliverable currencies bundled together with NDFs in the same currency. If one leg had to be traded on a SEF and not the other, this would create a “difficult situation” for Nomura and its clients, he said. LCH.Clearnet’s Wells countered this, saying that only a small number of these options are traded in combination with NDFs. Citi’s Klein pointed out that this issue would also affect the market for bonds denominated in those currencies that are traded in combination with NDFs.
Supurna Vedbrat, co-head of market structure and electronic trading at Blackrock, commented that her firm has sought to use clearing for NDFs on a voluntary basis, but discovered a number of problems. For one thing, “very few” clearing firms are able to handle this business, she said, and for another, the clearinghouses do not allow customers to eliminate offsetting positions in cleared NDFs. She also pointed out that the SEFs currently do not provide the functionalities for electronic trading that are needed by asset managers like Blackrock, and as a result her firm has had to revert to voice trading.
LCH.Clearnet’s Wells disagreed with the comment about the lack of clearing firms. Although he acknowledged that only a few firms are currently live on the ForexClear service, he said that there are several others in various stages of readiness, and he predicted that they would complete the process as soon as clearing is mandated.
Michael Dawley, global co-head of futures and derivatives clearing services at Goldman Sachs, also emphasized the problems in the current SEF landscape and urged the CFTC to address these issues before moving to mandate NDF clearing. “There is a lot of unfinished business” in the clearing of IRS and CDS, he said, pointing in particular to the risk checking process required by the CFTC’s Rule 1.73. “Until these issues are sorted out, I would be very cautious about adding additional asset classes.”
Dawley also pointed out that futures commission merchants and their customers are grappling with the effects of new capital requirements under Basel III as well as the introduction of new clearing services and new clearinghouses all over the world. He urged the CFTC to take this into account and provide the industry with enough lead time to prepare for NDF clearing.
Following this discussion, Wetjen asked the group to suggest the appropriate amount of time between the clearing and trading mandates. George Harrington, global head of fixed income trading at Bloomberg and one of the executives that oversees Bloomberg’s SEF, suggested that a 12-18 month separation would be appropriate. He noted that clearing firms generally are not set up to clear NDFs, and commented that while there is some trading of NDFs on SEFs today, the trades are settling mainly via traditional over-the-counter processes.
Paul Hamill, global head of foreign exchange, credit and rates execution services at UBS, added that there is “meaningful noncompliance” with CFTC rules in the SEF world and urged the CFTC to focus on the resulting fragmentation of the IRS and CDS markets.
Wetjen ended the meeting by reiterating his interest in gathering more feedback on these issues. He also emphasized the importance of a newly formed subcommittee on foreign exchange markets that will make recommendations to the GMAC. The subcommittee consists of eight people from banks, trading platforms and other market participants. A list of the participants is available here.