CLS Group, a risk mitigation and operational services provider that settles trades for the FX industry, and TriOptima, which provides OTC derivatives post-trade and risk reduction services, have launched the triReduce CLS Forward FX Compression Service.
Portfolio compression enables counterparties to reduce the gross notionals of their outstanding portfolios without fundamentally changing their market positions. Eligible trades for all the counterparties are aggregated and grouped together so that any offsetting trades can be eliminated or replaced, while maintaining risk neutrality.
This enables them to reduce overall notional amounts, as well as operational, credit and counterparty risk for institutions, while enhancing capital efficiency – something international regulators have encouraged for non-centrally cleared OTC derivatives.
At present there is no central counterparty clearing house clearing FX forwards and swaps, as the Dodd-Frank legislation in the US exempts them from mandated clearing. So far they have not been mandated for clearing under the EU's EMIR rules either. Should a segment of the market move into a centrally cleared model, CLS says separate compression cycles would need to be run to support uncleared trades independently of cleared trades.
Peter Weibel, CEO of triReduce, TriOptima’s compression service, says: “It is more than just netting, compressed trades will actually cease to exist, eradicating the costs and risks associated with those trades. It is the multilateral nature of the process that makes compression so powerful; the more participants there are using the service the greater the offsettable volumes for all, quite in contrast to bilateral compression, where not much can be achieved.”
CLS and TriOptima have now completed the first successful compression cycle for FX forwards and swaps transactions. They declined to elaborate on the details of this cycle, but indicated that more information would be available to quantify the savings participants had achieved in coming quarters, once they had gone through more cycles.
How it works |
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Source: CLS and TriOptima |
The new service combines CLS’s infrastructure and market connectivity with TriOptima’s triReduce compression product, triReduce, which is used for OTC derivatives across asset classes, both cleared and uncleared. According to TriOptima, market participants have eliminated more than $687 trillion in notional principal with this product from its inception in 2003 to September 2015.
According to the 2013 Bank for International Settlements' Triennial Survey, the average daily notional value of FX swaps was $2.2 trillion as of April 2013.
Russell Dinnage, senior consultant at consultancy GreySpark, says: "The CLS TriOptima FX swaps and forwards margin compression offering is just one example within a broader trend in the capital markets for institutions or technology companies to create new, utility-like services designed to remedy trade lifecycle issues that have developed as a result of regulatory mandates or other imperatives." CLS itself is another good example of this.
This is the first time the service has been available for FX forwards and swaps, something banks have been calling for CLS to offer for some time, says Alan Marquard, general counsel at CLS. It is therefore confident the service will gain traction quickly with its members, overwhelmingly banks – although it plans to roll the service out to other types of institution in due course.
Similarly, when TriOptima first released triReduce, its first clients were banks. Today it counts many buy-side institutions and corporates among its clients.
Marquard says: “CLS is the natural home for the FX swaps and forwards population, which banks already settle through us. Participants trading these products are already entering trades onto the CLS system, where they are perfectly matched, so it is simpler for us to transfer this matched trade data seamlessly and safely to TriOptima.”
Despite triReduce having experience compressing trades for OTC products outside FX, looking at the savings achieved there will not necessarily give an accurate picture of what to expect for traders of FX forwards and swaps, says Weibel. “Every asset class has its own specific characteristics. FX forwards have shorter maturities than many other OTC derivatives, but the add-on factors for the leverage ratio calculation are considerably higher than in other asset classes. You cannot make a like-for-like comparison.”
In January the International Organization of Securities Commissions (IOSCO) released a paper, “Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives”, in which it called on market participants to “establish and implement policies and procedures to regularly assess and, to the extent appropriate, engage in portfolio compression”.
Portfolio compression has, IOSCO said, “wide ranging benefits for market participants as well as the market as a whole”. Reducing notional exposures is beneficial, it said, because “certain risks and inefficiencies may be more pronounced in larger portfolios”. It might also provide a more accurate expression of overall market size and composition.
However, IOSCO also warned that portfolio compression might carry some disadvantages specific to a party’s legal, tax, accounting or operational status, and so might not be appropriate in all circumstances.
Where it is appropriate, compression should help market participants comply with a number of different global regulations that apply to FX traders, including EMIR and Dodd-Frank – both of which also make reference to compression as a way to manage risk, as well as Basle III.
Marquard says: “One key regulation that has driven appetite for compression is the Basle III leverage ratio, which is being introduced globally, though not yet in a unified way. The leverage ratio measures capital coverage against exposures, including for derivatives, and there is an add-on element of the exposure that is calculated as a percentage of notional, based on the duration of contracts. This is what makes it critical for banks to reduce their notionals, which is precisely what compression does.”
Although the case has always been there for compression, “the leverage ratio has created additional incentives to compress, which has led to increases in the frequency of the cycles in other asset classes,” says Marquard. “This trend makes the scope for compression much larger.”
It is worth noting that while FX is captured within the scope of these new global regulations, they are not the object of their focus. Dinnage says: "Cleared and uncleared OTC FX swaps and forwards were originally created to act as a low-risk, vanilla hedging instrument for underlying spot FX positions. As such, interest rates swaps represent the bulk of the focus of the central clearing mandates of the Basle III accords and their accompanying regional regulatory regimes.”