In mid March, 12 of the largest banks in the world realized they had a big problem brewing with rouble FX swaps falling due.
Sanctions on Russian banks and on the Bank of Russia itself meant that, suddenly, it was almost impossible to secure the roubles needed for delivery. Many rouble FX swaps would not, therefore, clear, leaving banks in chains of unsettled claims.
Deutsche Bank cannot pay Credit Suisse, which leaves the Swiss bank owing money to Citi, which in turn cannot pay JPMorgan.
The potential losses stood to be in the billions of dollars. What were the banks to do?
Turnover
FX swaps are very big business. And it is easy to forget that these instruments are physically settled. Counterparties must deliver the actual currencies between each other when swaps are written and when they mature, typically in under one year.
It’s pretty unusual for 12 banks to come together to ask to get something done and to manage that in just three days
That physical delivery stands in contrast to many cash-settled, exchange-traded derivatives on commodities such as metals, where, on expiry, the out-of-the money counterparty might deliver cash reflecting the change in price to the other side of the trade rather than delivering a boatload of silver or iron ore.
In its last triennial survey of the foreign exchange market in 2019, the Bank for International Settlements reported daily turnover in over-the-counter FX swaps at $3.2 trillion, with most of that in the main pairs of dollars, euros, yen and sterling; then a chunk in Australian dollars, Canadian dollars, Swiss Francs and renminbi; and fully $735 billion a day in other currencies.
The BIS did not specify an amount for FX swaps with one leg in roubles, although it noted $47 billion equivalent of daily spot turnover in the Russian currency.
In January 2022, the Bank of England released its six-monthly survey of the London-based FX market, noting average daily turnover in FX swaps of $1.43 trillion in October 2021.
Compression
For the 12 banks faced with rouble FX swaps to clear in March, there was, thankfully, a solution. The banks compressed the trades.
Derivatives compression is a more complicated and algorithmic form of netting. Banks find themselves with large numbers of trades, each carrying counterparty credit, market and operational risk. They want to achieve the same underlying economic exposure but reduce the complexity, so they agree to cancel or sometimes to off-set various of the trades and reduce their gross exposures, while leaving their net position the same.
Usually, a bank will approach a specialist compression shop to do this for them, which will run its algos to suggest an optimal sequence of transactions to resolve the complexity.
The biggest risk here is doing nothing because that would have left so many trades in limbo
This time, the group turned to Capitolis, a firm formed in 2017 and backed by venture capital investors including Andreessen Horowitz (a16z), Index Ventures, Sequoia Capital, Spark Capital, SVB Capital and S Capital, as well as leading global banks such as JPMorgan, Citi and State Street.
“It is pretty unusual for 12 banks to come together to ask to get something done and to manage that in just three days,” Gil Mandelzis, chief executive and founder of Capitolis, tells Euromoney. “In our five-year history, we have had banks come in around problems with certain countries, for example with Turkey or Argentina. But by the time they rally the teams and agree to a solution, the crisis is usually over.”
He says: “This time, however, the need was acute.”
Justin Klug, president of Capitolis, picks up the story.
“Compression works in a couple of ways: either with banks agreeing to cancel certain trades or putting on new off-setting ones,” he says. “The clear goal here was to reduce the equivalent of many billions of dollars of near-term settlement amounts and not the number of transactions. And we achieved that.”
Klug adds: “This was a meeting of a large number of banks with a strong desire to reduce settlement risk; they needed the right technology to do that and a trusted third party that had established its capabilities and credibility with those banks to do it.”
Euromoney thinks of Archegos and the brief meeting of exposed banks that realized they had all been lending far too much secured against the same overvalued collateral, before a quick bolt to be first through the exit door to sell it. This was different.
“It happens fast, but only after every bank has agreed to it,” says Mandelzis.
Klug explains: “There is complexity in different banks having different messaging formats, for example to cancel trades. Every bank that participates gets a benefit. But nothing can happen if the number eight bank in the chain would be worse off as a result. And absolutely the biggest risk here is doing nothing because that would have left so many trades in limbo and banks facing billions of dollars in losses.”
Near miss
A disaster was averted here. But this near miss highlights how fragile very large, complex and interconnected financial markets have become amid the prevailing volatility and uncertainty over the Russian war in Europe.
We should note that Capitolis will donate half the revenues from this optimization exercise to Ukrainian relief and humanitarian efforts.
“I think the banks were pleasantly surprised at how successful it was and it has opened peoples’ eyes to what is possible,” Mandelzis says. “We are going to do another run next week. There’s a lot of inventory to work through.”
Though Capitolis has not spoken directly to regulators about this great compression trade, it will get back to them through the heads of trading and heads of markets at the leading banks that sit on the traded market committees at central banks. Regulators and risk managers need eyes everywhere right now.
"Since we got this done,” Mandelzis says, "banks have been coming to us asking us to look at other markets that either don’t have regular compression cycles or want to increase the frequency of compression runs – and these include both FX derivatives and derivatives related to other asset classes."
Everywhere Euromoney turns there’s talk of trouble coming, for example in cross-currency swaps that include interest rate as well as currency risk and in both collateralized and uncollateralized commodities derivatives, which are far bigger than the underlying physical markets.
This is not over. It may just be beginning.
