Despite hurdles, clearers map out forex ambitions

The focus on NDFs has come at the expense of forex options – a product that has proved tricky for some. Last December, Risk magazine broke the news that LCH.Clearnet was about to unveil a forex options clearing venture – a press release had been drafted but the firm’s planned announcement was put on hold. Dealers say CME has also put plans to launch a forex options clearing service on ice.

Guaranteed to frustrate

The biggest obstacle has been a proposal by regulators that CCPs provide “clear and certain final settlement, at a minimum, by the end of the value date”, and preferably in real time – a concept known as guaranteed settlement. The call was issued by the Basel-based Committee on Payment and Settlement Systems (CPSS) and the Madrid-based International Organization of Securities Commissions (Iosco) in a report in March, which has since thrown plans to clear forex options into disarray.

Guaranteed settlement means that – in addition to collecting margin as the market value of a trade fluctuates during its life – a CCP would also have to provide certainty about the final exchange of currencies in a forex option trade. Achieving this by holding margin would effectively mean tying up enough cash on day one to settle the trade at maturity – not strictly impossible, but prohibitively expensive, dealers say. In some options trades, the notional sums involved can run into the billions.

“The size of the flows involved would potentially be very large, so CCPs would require a very large amount of settlement margin to be posted. It’s not a very palatable model to clearing members as margins could shoot up exponentially,” says Lee Butler, forex and commodities chief operating officer for Europe, the Middle-East and Africa at HSBC.

Alternatively, CCPs could introduce a settlement risk mechanism to complement their counterparty risk mechanism – some market participants have suggested a payment-versus-payment approach of the kind used by the forex market’s existing settlement risk guarantor, CLS Bank. This would be a long and costly process, sceptics argue, and if one party failed to settle, the CCP would need to make good on its guarantee – requiring huge financial firepower and access to central bank liquidity, says Andrés Choussy, New York-based global head of foreign exchange clearing at JP Morgan.

“It would require significant backing, either from governments or commercial credit lines, to fund this. It would also require access to all the different currencies that are going to be cleared. Other alternatives also need to be explored,” he says.

An alternative would be involving CLS Bank directly in the process. But the firm currently only guarantees to return principal in the event of a settlement failure – and this is a long way from guaranteeing the final leg of a forex options trade, say dealers. The US Federal Reserve is currently leading a working group of supervisors seeking to fix the impasse, but most dealers interviewed for this article doubt a forex options clearing service will be up and running by the end of 2012 – the deadline set by the Group of 20 nations for clearing standardised derivatives trades.

Despite the heartburn, industry figures are not unsympathetic to the regulatory position. “The CPSS-Iosco principles are basically designed to ensure that risk is not fragmented throughout the clearing process. If the CCP covers the mark-to-market element, then hands the trade over to CLS, the process gets broken, and it’s our understanding that regulators would, in general, want to see risk managed within a tight infrastructure framework,” GFMA’s Kemp says.

Dealers say discussions with CCPs have thrown up other roadblocks too. For one thing, some CCPs wanted to see cleared OTC forex options automatically exercised. In other words, the CCP would exercise an in-the-money option without needing the holder’s say-so – a convention typically followed in the exchange-traded options market. Dealers objected to the idea, preferring instead to choose when – and whether – to exercise the options, in line with OTC market practice.

But that arrangement would make life extremely difficult for a CCP clearing foreign exchange options, says Colin Telmer, head of foreign exchange prime brokerage at Barclays Capital in New York.