By Jack Callahan, executive director at CME Group
Many market participants were caught off guard in March when news of a potential non-deliverable forward (NDF) clearing mandate surfaced at the Futures Industry Association (FIA) conference in Boca Raton, Florida, and it was reported that this mandate could be announced in the coming weeks.
This would mean that global market participants who are defined as U.S. persons could have to start clearing their NDF trades as early as Q4 2014. This is a departure from many of the legacy FX prime brokerage workflows, and this could alter the way clients handle initial margin, mark-to-market, position reporting and legal agreements for their NDF trades.
Fortunately, many market participants have already experienced mandatory clearing with interest rate swaps (IRS) and credit default swaps (CDS), so they are aware of all of the work required to fully prepare their firms for NDF clearing. However, the migration to NDF clearing will be a much heavier lift for the marketplace for three key reasons:
1) NDF clearing will impact far more market participants than IRS/CDS
The market saw firsthand leading up to the IRS/CDS mandate phases that there can certainly be operational constraints when a large number of clients are trying to do the same things at the same time. Fortunately, the IRS/CDS mandates only impacted a finite number of market participants who are involved in fixed income/macro trading, and at CME Group we’ve had approximately 450 global market participants clear IRS/CDS.
Many emerging markets funds and long/short equity investors who utilize NDFs to hedge currency exposure do not trade IRS/CDS, so this will be their first foray into clearing. There could be a significant amount of work required to get all of these clients up to speed on clearing, in addition to the regular workload for existing clearing clients to add NDFs as additional cleared products.
2) The swap execution facility (SEF) trading mandate for NDFs could closely follow the clearing mandate
IRS and CDS had the benefit of almost a year gap between the start of the clearing mandate in March 2013 and the SEF execution mandate in February 2014. Now that SEFs are live and the rules are in place, it is widely expected for a SEF to file a Made Available to Trade (MAT) submission as soon as mandatory NDF clearing begins. This could create a scenario where mandatory SEF trading for NDFs begins as soon as 30 days after the clearing mandate begins. In this case, clients will have to simultaneously prepare their infrastructure, processes, and personnel for market structure changes in both clearing and execution.
3) There has been limited early adoption of NDF clearing from buy-side clients.
Clients have been swamped with the work required for mandatory clearing and execution in the U.S., and many of them have also had to comply with European Market Infrastructure Regulation (EMIR) reporting obligations for their European accounts. This has meant less time to focus on NDFs, and we’ve seen this come through in the data, with very few clients voluntarily clearing NDF trades.
IRS clearing had the advantage of an initial spike in client clearing volume back in August 2011, which was well ahead of the eventual mandate starting in March 2013. This approximately 18-month ramp-up period enabled many clients, dealers, clearing members, technology platforms and custodians to adequately identify issues and address them well ahead of when they had to begin clearing on a mandatory basis.
Where do we go from here? Before NDF clearing and execution mandates are upon us, market participants can get ahead of the game by doing some of the following steps that IRS/CDS early adopters found beneficial:
• Select clearing members for those clients who are not already clearing IRS and CDS
• Select and connect to a middleware provider (affirmation platform) and/or SEF
• Setup futures commission merchant (FCM) and clearinghouse reports on positions/valuations/margins
• Run initial margin simulations to understand the funding requirement in a cleared environment
• Determine whether it could be advantageous to backload legacy bilateral trades into clearing to for margin, operational or risk management reasons