Debating whether to propose a clearing mandate for nondeliverable forwards (NDFs), the Commodity Futures Trading Commission (CFTC) recently met with industry representatives from the US and Europe who raised concerns about fragmentation and higher costs.
Timothy Massad, CFTC Chairman since June, noted the session “should be very important in our decision on whether to impose clearing on NDFs.”
NDFs are forward or future foreign exchange (FX) derivative contracts settled in cash that are based on the movement of the two currencies, rather than requiring physical delivery of the currencies. They are especially useful to hedge the currency risk of local, illiquid currencies, such as emerging-market currencies that are not freely convertible. Multinational corporations are frequent users of NDFs to hedge risk stemming from currencies of countries including China, India and Brazil, which apply strict currency and capital controls.
On October 1, the European Securities and Markets Authority (ESMA) issued a consultation on regulatory technical standards, as required by the European Markets Infrastructure Regulation (EMIR), the European equivalent of the US’s Dodd-Frank Act. Comments are due by November 6. The ESMA proposal covers 11 reference currencies, while CFTC staff is currently considering the same 11 currencies as well as the Peruvian Nuevo Sol.
Rodrigo Buenaventura, head of markets division at ESMA, said the law requires ESMA to decide whether NDFs must be traded over Europe’s version of swap execution platforms (SEFs) within six months after adopting a clearing obligation. Thus if the ESMA staff delivers a clearing proposal by year-end, and under the typical timeframe the ESMA commission adopts it by March, the regulator would have to decide whether to propose a trading obligation by September.
“We could decide not to propose it. But if we decide to propose it, it would not be effective before January 2017, which is the earliest date the trading obligation can take place,” Mr. Buenaventura said.
Europe’s head start could pose problems if trading and clearing obligations there arrive before comparable US requirements, or if the CFTC ultimately decides to head in a different direction. A number of participants at the meeting voiced concerns about new rules fragmenting NDF liquidity and potentially inhibiting access to the market, which represents about 2.5 percent of the overall market in FX swaps, estimated to have daily turnover volume of $2.5 trillion.
Participants also pointed to concerns about higher operational costs for clearing platforms and brokers. Clearing could offset those higher costs by providing brokers with capital relief from Basel III requirements taking effect in December 2015, but without the capital-relief incentive cleared NDF transactions have been sparse so far.
“Currently there are 20 clearing members of LCH.Clearnet [set up to clear NDFs], of which two are clearing at this stage,” Mr. Buenaventura said.
The European Banking Authority’s (EBA) proposal, for which comments were due in July, would require European financial counterparties to impose margin on corporate counterparties based outside the European Union for NDFs and other over-the-counter derivatives. Nevertheless, most corporate derivative end users are exempt from clearing over the counter (OTC) derivatives.
“The end user exemption trumps, so corporates will not be subject to NDF clearing requirements,” said Luke Zubrod, director of risk and regulatory advisory at Chatham Financial.
US regulators also stepped back from an anticipated final rule requiring banks to set margin thresholds over which their customers would have to post margin, essentially maintaining the status quo and exempting most corporates from margin requirements on NDFs and other uncleared OTC derivatives as well. Nevertheless, most financial companies such as insurance companies and asset managers would face clearing requirements, and companies highly active in the NDF market could as well. Even exempted corporates could face higher hedging costs as costs increase for their bank counterparties to hedge their own exposures.
Buenaventura said ESMA considers three elements when considering whether to permit clearing of swaps and other derivatives: standardization of the product, availability of pricing and liquidity.
David Bailey, director in financial markets infrastructure supervision at the Bank of England, said CCP’s regulators must consider the capacity of CCPs to manage the anticipated volumes of OTC derivatives that may be cleared as well as their operational capacity and ability to manage the potential default of clearing members.
“While those are things we consider when we authorize a CCP to clear an NDF, it’s especially important when a clearing mandate is being considered,” Mr. Bailey said. “With NDFs, the bulk of the market is currently uncleared and it may result in a major change if we implement a clearing mandate.”