Eurex tees up OTC forex clearing with CLS

Net settlement at CLS could slash liquidity risks for CCPs clearing OTC forex contracts

Settlement service could reduce liquidity burdens

Eurex Clearing has struck a deal with CLS to utilise its net settlement service for cleared over-the-counter foreign exchange derivatives, Risk.net has learned.

The move allows Deutsche Börse-owned Eurex, which currently clears and settles forex futures and listed options, to add OTC forex products such as swaps and forwards to its clearing service.

“This co-operation [with CLS] allows us to further expand our forex product portfolio,” says Heike Eckert, deputy chief executive of Eurex Clearing in Frankfurt.

The deal comes more than a year after Deutsche Börse acquired the dealer-to-client forex trading platform 360T for $796 million in October 2015 and advances its strategy of offering a full service for forex products.

LCH, which struck a settlement agreement with CLS in August 2015, is also expected to launch a forex options clearing service later this year. The firm began clearing non-deliverable forwards, which are cash-settled, in 2011 and has indicated it will start clearing cash-settled forwards in 2017.

CME also offers clearing of non-deliverable forwards but has yet to garner any significant volume.

Regulatory approval processes are underway at CLS and the clearing houses.

Questions over whether clearing houses can guarantee full and timely settlement of currency trades have dogged efforts to bring OTC forex derivatives into central counterparties (CCPs). This is because currency trades are typically settled on a gross basis, which poses significant liquidity risks for clearing houses.

Net settlement

According to a study conducted by the global forex division of the Global Financial Markets Association (GFMA), CCPs that clear forex options that are physically delivered on a gross basis could be left with a liquidity shortfall of as much as $161 billion if their two largest clearing members were to default.

The CLS service for CCPs solves this problem by settling OTC forex products on a net basis. “In the event of a clearing member failure, payment netting substantially reduces the size of the participating CCP’s potential liquidity shortfall, mitigating systemic liquidity disruption,” says a CLS spokesperson.

The net settlement service for CCPs operates separately from CLS’s payment-versus-payment real-time gross settlement system (RTGS) for bilateral trades, which currently settles around $5 trillion of currency trades a day on behalf of its bank members.

The GFMA study found that a net settlement mechanism would reduce the liquidity shortfall in the event of member defaults at CCPs clearing forex options by 73% to $44 billion.

The Principles for financial market infrastructures – published by the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions in 2012 – require CCPs to maintain sufficient liquidity resources to survive the failure of their two largest members. 

In the event of a clearing member failure, payment netting substantially reduces the size of the participating CCP’s potential liquidity shortfall, mitigating systemic liquidity disruption
CLS spokesperson

The CLS settlement service greatly reduces the liquidity burden on CCPs but does not eliminate it entirely.

“Each CCP in this service is required to have in place the liquidity backstops to satisfy settlement under its PFMI obligations. CLS is not responsible for this,” says Naresh Nagia, chief risk officer at CLS in New York.

To facilitate settlement at CLS, firms that clear contracts at a CCP will route the resulting novated and netted multi-currency payments to CLS’s central bank accounts, with the CCP named as the beneficiary. CLS then makes the appropriate payouts once all clearing members’ payments have been received.

To date, the Shanghai Clearing House and Hong Kong Exchanges and Clearing (HKEx) are the only CCPs to offer a clearing service for forex options and cross-currency swaps. The former launched a clearing service for forex options last August and HKEx began clearing cross-currency swaps in the same month.

It is unclear how either CCP manages settlement risk, but a senior HKEx executive claimed its ability to access the multi-currency RTGS system operated by the Hong Kong Monetary Authority made its cross-currency swaps clearing service possible.

In January, CLS introduced two new membership categories – affiliated settlement and non-shareholder settlement – in an effort to expand participation in its settlement service. Its core membership currently numbers 68 banks, but CCPs will not be eligible to become members in the legacy or new categories, despite previously being considered.

“[The] CCP service is independent of core service membership. Participation in the separate CCP service is governed by a separate agreement between CLS and each CCP. There is no membership concept; so CCPs are not actually becoming CLS members,” says Nagia.