Interest in clearing OTC FX, and more specifically, non-deliverable forwards (NDFs) is on the rise, as institutional asset managers seek to reduce the amount of margin they need to post under phase six of the uncleared margin rules (UMR) later this year (September).
As institutional asset managers continue their preparation ahead of the final phase, a more evolutionary, rather than revolutionary, approach is required. FX is, after all, a by-product for the real-money asset management community. As opposed to trading currency markets for alpha, the vast majority of money managers are looking to manage risk around their currency exposures.
When it comes to NDF trading specifically, this currently only accounts for around 4% of the total FX trading, according to Bank of international Settlements data. While it may seem to be a marginal activity for many market participants, the percentage is only going to rise as the clock ticks down to UMR phase six. The gradual phase-in of the rules, which, under phase 6, will apply to firms with average aggregate notional amounts (AANA) of $8 billion or more will require these firms to post initial margins for certain uncleared derivatives. This lower threshold has certainly incentivised greater central clearing of NDFs for real money asset managers.
The challenge is that, for too long, a lack of liquidity, and therefore pricing transparency, has been an issue for asset managers when using NDFs, making them one of the most expensive FX trades. At the same time, very few firms are in a position or have the desire to rip and replace their existing FX trading systems just to solve this predicament. Instead, it makes more sense for asset managers who fall under UMR rules to adopt best in class, existing vendor solutions which not only electronifiy their NDF prices but can help seamlessly clear these trades as well. That way, they will have the distinct advantage in being able to benefit from a much tighter spread due to better liquidity.
The electronification of streamed pricing also provides the immediate benefit of being able to determine the best method of execution—from how much it will cost to trade a specific amount at a given point in the day, to which liquidity provider is offering the best pricing at that time, to which tenor(s) offer the tightest spreads. These pre-trade decisions help facilitate greater automation that, in turn, reduce operational risk, which can have a significant impact on the potential to achieve provable best execution. In addition, this electronic pricing also needs to be supported by a strong trading system that can process a more complex NDF trade and not just simple spot transactions. That includes features such as staging incoming orders pre-trade and straight through processing (STP) after the trade.
With the FX market boasting turnover of $8.7 trillion a day, even a trajectory to just 10% of that total would be a substantial increase in NDF volume. Future entrants to NDF electronification may discover that late is too late. The more nimble and sophisticated firms that have already embedded electronification of NDFs into existing systems are likely to be the ones to prosper. As NDFs continue the transition from a decentralised, bilateral microstructure to one characterised by centralised trading, disclosure and clearing, dealing with the specific pain point of electronifying NDFs will be a big step towards complying with UMR when it comes into force.