Industry efforts to begin central clearing of over-the-counter (OTC) foreign-exchange options in line with new regulation are finally gathering pace after several false starts, with a workshop due to take place later this month at which key stakeholders will attempt to jointly determine a way forward.
FX options fall within the scope of Dodd-Frank clearing requirements, and several central counterparties (CCPs) had hoped to begin clearing the product several years ago.
The problem is that, unlike other OTC products, FX options are physically settled, which means CCPs would need access to large volumes of liquid assets if, as regulators have demanded, they are to guarantee full and timely settlement of cleared trades.
An extensive industry analysis of historical data from the options market concluded in November that the same-day liquidity shortfall faced by CCPs could be as high as $161 billion in the case of a stress event in which the two largest clearing members failed.
Determining a workable mechanism for clearing of options that could deal with that kind of shortfall will require collaboration between CCPs, banks, supervisors and industry settlement utility CLS.
The global FX division (GFXD) of the Global Financial Markets Association, which represents the 23 largest FX dealers and coordinated the industry analysis, has now committed to facilitating the next stage of the process, although it won’t involve supervisors until later in the year. The first industry workshop will take place in London on April 24.
James Kemp, managing director of GFXD, says: “Most of the industry clearing focus has naturally been on rates and credit, but the debate on clearing of deliverable FX – in particular OTC FX options – has continued and we are hopeful that the workshop we will hold this month will be a constructive step in reaching a solution.
“In the first instance the workshop will involve key market participants – CCPs, CLS and dealers – but assuming it proves a successful format, we would hope to repeat with supervisors and regulators later in the year as potential models emerge.”
The first priority, Kemp adds, will be to reach a common understanding of the main challenges involved in options clearing, and then to prioritize the issues that need to be tackled. One issue CCPs are keen to discuss is the extent to which the liquidity shortfall could be reduced through inclusion of the hedges associated with cleared FX options.
“The GFXD analysis covered only options and not the associated hedges – there are very few market participants apart from corporates that don’t hedge options with spot, forwards or futures,” says Derek Sammann, senior managing director for FX, metals and options solutions at CME Group.
“Most of our customers plan to clear hedges as well as the options themselves, so while the final number was very large, inclusion of associated hedges could reduce it dramatically.”
The GFXD analysis also acknowledged the scale of the liquidity burden could be significantly reduced if CCPs were to use a net settlement mechanism rather than gross settlement. Across the 17 currencies settled by CLS, it determined net settlement could bring the shortfall down by nearly 75%, to $44 billion.
However, while the possibility of net settlement is likely to be discussed at the workshop, some clearers are cautious about the challenges associated with such an approach.
“Netting of trades reduces the number of payments and the value of those payments, but the challenge comes when you want to unwind the net during a default and go back to gross,” says Gavin Wells, global head of ForexClear at LCH.Clearnet. “It is crucial that this can be done in a very resilient and efficient manner.”
The fact the original analysis looked at the worst-case scenario without accounting for hedges is a good thing, Wells adds, and it will now be up to CCPs to determine whether the clearing solution should include either netting or hedging.
However, whatever its ultimate size, the liquidity shortfall could be a sticking point, as CCPs would have to have access to liquidity from either commercial banks or central banks in the event of a future crisis. Some believe there is little desire from either sector to provide such a backstop.
“I don’t think there is a clearing house anywhere that could be built robustly enough to be able to handle the settlement challenge – you’d have to over-capitalize it to such an extent that it would be prohibitively expensive for banks to clear options,” says a senior FX options trader at one US bank.
“Unless central banks are willing to backstop a clearing house, which they have zero appetite to do, I just don’t think it’s possible to come up with a clearing solution.”