Following the implementation of phase six of the Unmatched Margin Rules (UMR) in September, buy-side companies in scope are thinking carefully about how to allocate capital and collateral more efficiently. Uchenna Uduji, Chief Commercial Officer of ForexClear, discusses the crucial role of clearing and the benefits for FX market participants

Uchenna Uduji, CHL ForexClear

Following the global financial crisis that began in 2007-2008, the Group of 20 launched a regulatory review of global standards governing OTC derivatives markets and participants. The International Organization of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision have been tasked with creating a set of global standards aimed at reducing systemic risk and promoting central counterparty (CCP) netting, which reduces counterparty credit risk.

A framework for margin requirements has been developed for non-centrally cleared derivatives, with the simple aim of ensuring that derivative transactions are backed by initial margin (I AM) and variation margin (MV). The Basel/Iosco Committee framework was then implemented by regulators in some jurisdictions, forming a set of rules to be phased in, with the initial phase beginning in 2016.

Scope and deadlines

All in-scope entities that hold positions in non-centrally cleared derivative transactions must exchange I AM and MV to hedge future and current counterparty credit risk exposures. With the exception of persons physically installed Effects futures and swaps, I AM the requirements apply to all non-centrally cleared derivatives. Effects stains are not considered derivatives.

To determine the range in UMRa company must calculate its average aggregate notional amount (AANA). The International Swaps and Derivatives Association (Isda) provides the following guidance: “Calculating the total notional amount of AANA-covered products for each relevant business day during the AANA calculation period, sum the aggregated notional amounts for each relevant business day during the AANA calculation period and divide by the number of relevant business days in the period.

Since the establishment of the Basel/Iosco Committee framework in September 2016, companies have gradually moved to UMR according to their AANA level and jurisdictions in which the framework has been implemented. The initial phases saw the global banks, which form the heart of CHLForexClear membership falls within the scope, with phases five and six capturing smaller regional banks and asset managers. From 1 September 2022, all companies having AANA greater than or equal to $8 billion (or approximate local currency equivalent) in applicable jurisdictions are subject to UMR.

Risk0922_LSEG_Fig1

After the implementation of phase six, companies still need to calculate AANAgiven that it is possible that establishments which were not taken initially could infringe AANA threshold in the future.

UMR and CCP clearing

With the establishment of UMR and margin bonds, companies are expected to look more carefully at the efficient allocation of capital and collateral. This section explores the case of compensation Effects transactions through a CCP – such as CHL through its ForexClear service – discussing its key benefits through a UMR lens:

1. Manage AANA thresholds with Effects clearing

Cleared transactions are excluded from AANA calculation, and its notional cannot be deducted from the gross notional for UMR. Companies can use Effects clearing to manage their AANA level and make sure they stay below the UMR threshold when accessing the Effects liquidity pool. In addition, regular compression of trade can help reduce the gross notional amount for companies subject to global systemically important banking calculations.

2. Manage I AM minimum transfer amount (MTA) with Effects clearing

Once a business has identified that it is within the scope of UMRthere is a second threshold to be exceeded before triggering the bilateral transfer obligation I AM with counterparties: the MTA. The MTA stipulated by regulators is set at $50 million (or approximate equivalent in local currency), which means that for each bilateral counterparty, I AM does not need to be transferred unless it exceeds the MTA.

Deleting a subset of a Effects portfolio is an incredibly powerful lever that can ensure companies stay within their MTA between all bilateral counterparts. It can also reduce the operational burden required to set up margin transfers/receipts with, for example, custodians and credit support annexes. The additional benefits of netting, such as multilateral netting, ensure that netting can be used to manage I AM MTA without incurring a prohibitive margin cost to the CCP.

3. Multilateral compensation and reduction of funding costs

Central clearing offers highly efficient clearing at the portfolio level, with transactions being cleared together under the same counterparty. With erased I AM it is generally expected to be lower than unclarified I AMcompanies can pay I AM and MV daily with CHL ForexClear while gaining net benefits, resulting in lower cost of funding. More recently, with a higher cost of funding and changes to Isda’s Standard Initial Margin (Simm) model increasing the bilateral margin, netting presents an increasingly cost-effective solution.

4. Stabilize margin requirements through central clearing

Whereas UMR requires I AM to trade bilaterally against each counterparty, trading activity with a counterparty may result in higher margin requirements, even if the portfolio’s net risk has not changed materially. By using a CCPmargin management is simplified and operationally more efficient.

CHL ForexClear has shown resilience and stability during times of market uncertainty, such as during the Covid-19 pandemic and, more recently, the Russia/Ukraine conflict. During these periods, the CHL The margin model has demonstrated the effectiveness of its inherent anti-procyclicality cushion, with the margin increasing by less than 10% during these periods of stress.

5. Optimize margin requirements with Effects clearing

CHL ForexClear offers full portfolio margining on members’ and clients’ cleared portfolios, allowing for offsets between various clearing-eligible currencies and products. The standard bilateral margin calculation model, Simm, applies rigid correlation settings between currencies and does not contain the granularity to ensure a high correlation setting when pairs are highly correlated and vice versa.

CHL can run margin simulations on full Effects portfolio of clearing-eligible transactions at ForexClear to help identify potential benefits achievable with central clearing and estimation UMR obligations.

Risk0922_LSEG_Fig2

6. Liquidity, risk management and operational advantages

A key function of a CCP is to provide risk management to its clearing members and clients. Netting removes exposure to multiple counterparties and replaces it with exposure to CCP. Within the framework of the Basel/Iosco Committee, the use of a CCP authorized to operate in jurisdictions that have implemented international standards for financial market infrastructures leads to CCP benefiting from a lower credit risk weighting and more favorable treatment. At its Pittsburgh Summit in 2009, the G20 set the following target in response to the global financial crisis: “Non-centrally cleared contracts should be subject to higher capital requirements.

Clearing also provides standardized pricing through the use of standardized guarantees and discount curves. Otherwise, CHL ForexClear provides a unique pool of liquidity, along with the associated capital and operational advantages. Businesses benefit from the cost savings and operational gains of only dealing with a CCPas opposed to multiple bilateral relationships.

Customer clearing growth at CHL ForexClear

CHL ForexClear is a leading central clearing provider for Effects in the industry and has seen phenomenal growth in its non-deliverable futures contracts (NDAC) volumes since UMR went to live. You can join CHL ForexClear as a Clearing Member or Client via CHLit is WE or international (including European) clearing broker models. In 2022, ForexClear allowed more NDACs than ever before – leading to record daily, monthly and quarterly figures. With nearly 800 additional counterparties to be gradually integrated under UMR phase six, this growth trend is expected to continue. Companies captured by UMR phases five and six are likely to use a customer compensation offer. Figure 3 details the strong growth observed in this area of CHLservice.

Risk0922_LSEG_Fig3

In addition, greater awareness of the impact of UMR results in increased demand for compensation, including – but not limited to – information on how a subset of a portfolio might be optimally compensated to maximize capital benefits, as opposed to global clearing of an entire portfolio, CHL Forex Clear.

In addition, growth in client clearing is driven by increased choice of clearing brokers and lower clearing cost to the buy side. In the first half of 2022, CHL ForexClear had 14 clearing brokers live on the service, offering clearing solutions to clients through its WE and international compensation models. This number has increased to 19 and is expected to increase further in 2023.