FX Invest: Implications for collateralisation under new CCP model

The foreign exchange industry is about to be hit by the biggest set of regulations that haven't yet been written. It’s still not clear whether FX swaps and forwards will get their much-desired exemption from mandated clearing under the US Dodd-Frank Act and, potentially, the European Market Infrastructure Regulation (Emir). But with FX options and non-deliverable forwards seemingly swept into the broader US OTC derivatives rules ratified last July, clients of FX are sounding alarms.

Concerns become even more pronounced when discussions move onto proposals for collateralisation under the new central counterparty clearing (CCP) model, rather than the incumbent credit support annexes (CSA). Chief among the changes is the introduction of initial margin, which would not only have to be posted on a dollar-for-dollar basis with the CCP through a clearing member-owned futures commission merchant (FCM), but would also have to be marked to market daily.

And to protect such collateral from possible misuse, the Commodity and Futures Trading Commission (CFTC) proposes it be placed in a segregated account at the FCM, which acts as the guarantor to the CCP. The only credit risk the client assumes is that of the CCP.

“The FCM guarantees the client obligation to the CCP, so it says to the CCP: ‘I’ll make you whole if the client goes bad,’ and then there’s a series of exceptional procedures that occur in the event something goes wrong,” says Joseph Buthorn, global head of foreign exchange prime brokerage at BNP Paribas in New York. “That’s different to what happens today, where the client and the bank have each other’s bilateral credit. It’s a fundamental difference that has implications for how things are collateralised; it has significant differences in what happens in the event of a default by one of the three parties.”

Specifically, Buthorn cites the proposal that client collateral posted with the CCP via the FCM be on a gross basis, with no netting taking place at the FCM. This differs from the current futures model, where client assets sit in a common account at the FCM, which satisfies obligations of all clients, while a separate FCM account exists for proprietary house business. What is then posted to the CCP is the net of all obligations.

Large numbers of clients who today don’t post collateral in the new world will have to find places to get eligible collateral – and it’s not clear yet exactly how that’s going to happen

“[Under the CFTC proposal for collateralisation of swaps] every dollar of required margin we receive from clients at the FCM we will forward straight to the CCP. That’s fundamentally a different collateralisation structure, which has implications for funding and for credit risk management,” says Buthorn. 

A further point is that most CCPs will require variation margin be posted in the underlying currency of the contract. This differs from the existing requirements under CSAs, which accept collateral in currencies such as the US dollar or euro. Andres Choussy, global head of FX clearing at JP Morgan in New York, says that, although under the new construct a client could continue to post collateral in major currencies, they will incur a funding charge by the clearing member, who will then have to transform that currency and fund the underlying currencies out into the clearing houses.

“Some firms might elect to post the underlying currencies directly themselves,” says Choussy. “In which case, instead of getting a single currency collateral call, you might end up having multiple currency calls, which you will need to meet through different instructions.”   

The ability to transform or upgrade collateral becomes much more pertinent when looking at the numbers. According to research published by Morgan Stanley and Oliver Wyman on February 16, as much as 40–50% of the total annual traded volume of over-the-counter contracts could be cleared by 2012/13, creating an additional collateral requirement of between $2 trillion and $2.5 trillion.

Adding to this, the proposed ban on rehypothecation of initial margin will, dealers say, lead to short-term funding risks. “Large numbers of clients who today don’t post collateral in the new world will have to find places to get eligible collateral – and it’s not clear yet exactly how that’s going to happen,” says Buthorn. “They’re reaching out to their banks and their custodial banks to potentially provide collateral transformation, but of course those banks have to get it from somewhere too.”

Perceiving a significant burden of obligations, JP Morgan supported letters by FIA and Isda to regulators for an expansion of the defined eligible collateral (see page 14). “This is in line with the commentary and feedback provided to regulators as part of the ANPR [advance notice of proposed rulemaking] process,” says Choussy. “Particularly for asset managers, insurance companies or any entity that generally holds very little cash and sits on securities – unless the proposed rules are changed, clients will need to transform those assets
into clearing-eligible collateral to be posted to their clearing member.”

But valuing that call, or indeed closing books at month-end, comes with its own set of headaches, particularly as it pertains to cross-border foreign exchange trades. Under the proposals, valuation agents will be the clearing houses, which will mean there is no room to dispute margin calls and also introduces complexity in that each clearing house will have its own end-of-day price. 
“So you might have particular contracts cleared through multiple clearing houses that could potentially have different prices, and will end up requiring a different
amount of variation margin for the same client,” says JP Morgan’s Choussy.

JP Morgan began supporting the transition to the central clearing model from a legal and operational standpoint in 2010, when it started documenting clients for credit and rates using the OTC addendum format. “In North America, the current model relies on an Isda and CSA but, under the new FCM clearing model, documentation will rely on a futures agreement with an OTC addendum. The OTC addendum will be a different document but, where possible, will mirror most of the terms existing in the Isda and CSA,” says Choussy. “Some new terms will be introduced, such as zero threshold value, and clients will need to adjust to that.”

So far, CME, Ice, LCH.Clearnet and SGX are known to be looking to launch FX clearing businesses. The CME said in May it is ready to clear the Chilean peso, though no trades have been done. SGX is due to go live with Asian forwards in September, while LCH.Clearnet is eying a year-end launch for its FX options clearing product, ForexClear. Australia, Hong Kong, Japan and South Korea are also looking to establish OTC derivatives clearing houses. 

Choussy highlights Asia as a region aggressively trying to meet a G-20 set of commitments and a 2012 timeline to introduce clearing for standard OTC derivatives. “The region is moving ahead and actively trying to meet those timeframes,” says Choussy. “Local requirements, such as to clear through a local clearing house, pose additional sets of issues. However, we have been working with local regulators, clearing houses and other market participants to ensure the clearing model operates under a robust risk management framework and that we are ready to service our clients.”

He continues: “When clearing houses were set up for credit and rates, we spent a lot of time ensuring that the risk management, the infrastructure and the overall risk that the clearing members were exposed to was appropriate. Back then, clearing houses were set up a lot faster, but this time there is still work to do before we can fully understand the risks involved to both banks and their clients.

“One of the biggest lessons we’ve learnt from the credit and rates clearing experience over the past two years, is the actual time it takes to design an efficient and comprehensive risk management framework. The chosen structure needs to take into account all the different risks introduced into the systems, ensuring the risks and rewards are properly allocated to the clearing members. We are in a better position now because we have a better understanding and knowledge of the risks we’re exposed to.”