NDF Clearing: The tide is about to turn

Henry Weindling, non-deliverable forward (NDF) sales at Eurex, and David Holcombe, head of product: FX futures and FX clearing at 360T, explain how a new type of liquidity is changing the economics of NDF clearing for buy-side firms.

Henry Weindling

Within the FX market we’ve been talking about NDF clearing for a long time. There’s been traction within the interbank market but less so from the buy-side. Why is there disparity between the two?

Henry Weindling: The first reason is the Uncleared Margin Rules (UMR), which have introduced legal, operational, and technological complexity around bilateral trading in addition to requiring impacted firms to exchange two-way margin.

Clearing is one way to help mitigate the impact of UMR, but in the first four phases of its implementation only the sell-side and the very largest buy-side firms have come into scope of the regulation. This has naturally caused the initial drive towards clearing to be very lopsided.

However, with Phase 5 of UMR now in force, and Phase 6 hitting a much broader swathe of buy-side firms in September this year, we’re now seeing this community seriously assessing how they could benefit from clearing parts of their FX portfolios.

Secondly, it’s important to understand that the sell-side and buy-side have fundamentally different views regarding how central clearing should work. In the interdealer world, clearing has been established as a post-trade process, where the clearing itself takes place after the actual execution. But we know from our experience working with buy-side firms in other major asset classes that they require a very different solution.

This is why, rather than trying to shoehorn buy-side firms into a system designed for the interdealer market, Eurex and 360T have created a unique NDF clearing solution which is specifically tailored to their needs. This involves providing them with a cleared workflow which is more operationally streamlined and more attractive from a pricing point of view.

David Holcombe

How does that NDF clearing solution work?

HW: There is the price of the NDF product itself, the currency that you are trying to buy, and then the price of processing that transaction via CSAs, custody agreements and ultimately the bilateral exchange of margin. What we’re doing is leveraging the benefits of central clearing to create an environment where the price of the NDF itself can be reduced.

David Holcombe: In theory, the pricing for cleared trades generally should be better than non-cleared trades because there’s no additional credit risk costs that need to be baked into the pricing. In practice it hasn’t been possible for liquidity providers to offer differentiated pricing based on whether or not the trade will be cleared, because these NDFs are executed bilaterally in an over the counter (OTC) manner and clearing is very much a post-trade decision. What we’re doing differently is providing a “to-clear” pool of liquidity on 360T, so that when an NDF trade is requested the price taker makes it evident that they wish to clear the trade, and then liquidity providers can offer prices in the knowledge that the trade will be cleared.

Will it make to-clear liquidity cheaper?

HW: The to-clear price that buy-side firms are hitting should be more attractive because for both parties it greatly reduces the counterparty credit risk element and removes the need for trade matching at a middleware provider.

DH: It’s not just about the execution price though. Another benefit is that it can reduce the amount of margin buy-side firms need to provide based on their entire portfolio, so that’s an important consideration as well.

HW: From the sell-side perspective, the ability to offer improved pricing to clients means that there is an opportunity to grab market share, with those who begin offering “to-clear” NDF liquidity quickest gaining the most benefit. It will also enable them to free up capital while enjoying the benefits of multilateral netting and a standardised rulebook, all of which creates a level playing field for market participants.

If the NDF market does indeed shift towards a centrally cleared model, could this lead towards more FX Future trading?

DH: I can certainly see the logic behind this view because once firms are clearing, then use of futures, with their even lower margin rates than OTC cleared, provide routes for further optimisation within your NDF flows. That being said, we see the trading volumes of NDFs and FX futures both continuing to grow and so I don’t necessarily think that the use of one of these products has to come at the expense of the other. Instead, I think clearing enables a symbiotic growth across both.

How can buy-side firms go about calculating and quantifying the benefits of clearing for their organisation?

HW: First of all, they should talk to the CCPs who can help them to do some analysis and number crunching. Then they should also talk to their clearing broker, because they’ll have an even better picture of that firm’s margin requirements across multiple asset classes. Finally, they also need to be communicating with their NDF trading counterparties to request better pricing when clearing via Eurex.

Not all the benefits of clearing are quantifiable ahead of time. For instance, consider the recent sanctions levied against Russia in response to the invasion of Ukraine — in a moment of market shock like that would you rather have bilateral exposures or be facing a clearing house which is in full compliance with the European Markets Infrastructure Regulation (EMIR)?

How easy or complicated is it for firms to begin accessing this to-clear liquidity?

DH: It’s very straightforward. They need a clearing broker relationship so that they have someone to clear the products, and then assuming that broker supports 360T and Eurex, we use normal OTC permissioning models. This allows them to face the liquidity providers of their choice on 360T, with all to-clear trades fed immediately through to Eurex for clearing.