CFTC Considering FX NDF Clearing Mandate, Issues Report | Practical Law

CFTC Considering FX NDF Clearing Mandate, Issues Report | Practical Law

The CFTC Foreign Exchange Markets Subcommittee (FEM) has submitted a report on a prospective clearing mandate under Title VII of the Dodd-Frank Act for foreign exchange (FX) non-deliverable forward contracts (NDFs).

CFTC Considering FX NDF Clearing Mandate, Issues Report

Practical Law Legal Update 4-591-9045 (Approx. 5 pages)

CFTC Considering FX NDF Clearing Mandate, Issues Report

by Practical Law Finance
Published on 04 Jan 2015 • USA (National/Federal)
The CFTC Foreign Exchange Markets Subcommittee (FEM) has submitted a report on a prospective clearing mandate under Title VII of the Dodd-Frank Act for foreign exchange (FX) non-deliverable forward contracts (NDFs).
On December 22, 2014, the CFTC Foreign Exchange Markets Subcommittee (FEM) submitted a report to the CFTC Global Markets Advisory Committee (GMAC) regarding a prospective clearing mandate under Title VII of the Dodd-Frank Act for foreign exchange (FX) non-deliverable forwards (NDFs). The FEM recommended that the CFTC create a clear timeline and method of implementation should it decide to proceed with a clearing mandate for NDFs.
NDFs are FX transactions that, unlike conventional FX trades, do not result in an exchange of principal. Rather, the counterparts agree to settle based on the difference between the exchange rate at the time of the trade and the exchange rate at maturity. NDFs are usually transacted outside the jurisdiction of the currency in question. A large number of market participants trade and hedge NDF exposures against other financial products, such as local fixed income markets. However, NDFs comprise a small portion of the overall FX market.
The FEM completed a report addressing:
  • The appropriateness of a US FX NDF clearing mandate.
  • The best way for the CFTC to implement a US FX NDF clearing mandate.

Appropriateness of an NDF Clearing Mandate

In the report, the FEM recommends that, should the CFTC decide to proceed with a US clearing mandate for NDFs, that mandate should include a clear timeline and method of implementation to ensure that market participants have appropriate opportunity to address the issues outlined in the report.
According to the FEM, the appropriateness of a clearing mandate is critically linked to the objective of mitigating systemic risk, consistent with the goals of the G20. While a CFTC clearing mandate for FX NDFs would result in a system-wide reduction of counterparty credit risk, it may not reduce systemic risk in the financial system given the NDF market's:
  • Small size (about 2% of the overall FX market).
  • Short-dated tenor (over 90% of volumes are transacted in tenors of less than three months).
The FEM also notes in the report that the appropriateness of a clearing mandate is critically dependent upon the manner in which NDF clearing is implemented. In the report, the FEM cites the following factors relevant to this determination:
  • NDFs are distinct from other FX products in that they do not have an exchange or delivery of principal and instead are cash settled at maturity. NDFs are not subject to liquidity and settlement risk issues associated with clearing deliverable products.
  • The FX NDF market is used by corporations, investors, banks and others in all geographic regions. Failure to consider the impact of a clearing mandate on market access could lead to segmentation, limiting access the existing broad pool of liquidity for certain market participants and instead creating two or more smaller/shallower pools with less competitive pricing.
  • The schedule for solving certain issues for regulators and market participants prior to implementation of a clearing mandate for FX NDFs is critical to the CFTC's adoption of the timeline proposed in the report. These issues include:
    • the handling of package transactions;
    • amending prime brokerage flows; and
    • addressing outstanding no-action relief letters.

Best Way for CFTC to Implement NDF Clearing Mandate

The FEM identified four issues that should be factored into the decision-making process on the manner of implementation of a US FX NDF clearing mandate:

Harmonization Across Major Jurisdictions

The FEM recommends that the following should be synchronized across major jurisdictions:
  • Product harmonization (e.g., currency pairs and tenors).
  • Counterparty category harmonization. The CFTC and ESMA have already decided on different phase-in periods among categories of counterparties for mandatory clearing in their respective markets. (Both the CFTC and ESMA have created "categories" of counterparties to determine clearing timelines -- Dodd-Frank has three categories and ESMA has four). As a means of solving the potential disparities between the CFTC and ESMA phase-in decisions, the FEM suggests that the CFTC and ESMA strive to keep the implementation of the FX NDF clearing mandate for Category 1 and Category 2 counterparties close together, as the sum of the two is broadly consistent across jurisdictions.
  • Timeline for the phase-in of mandatory clearing. The FEM suggests that the following timeline be applied for the FX NDF mandate in order to give market participants sufficient time to prepare for centralized clearing:
    • the CFTC should submit, no later than August 1, 2015, an initial proposal to clear NDF transactions;
    • the CFTC mandate would be finalized on November 1, 2015;
    • Category 1 participants (under Dodd-Frank, these include swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, or active funds) would be subject to the clearing mandate on February 1, 2016;
    • Category 2 participants (under Dodd-Frank, these include commodity pools, hedge funds (other than active funds) and persons predominantly engaged in activities that are in the business of banking or in "activities that are financial in nature" excluding accounts managed by third-party investment managers) would be subject to the clearing mandate on May 1, 2016; and
    • Category 3 participants (under Dodd-Frank, these include ERISA plans, accounts managed by third-party investment managers and non-financial commercial end users) would be subject to the clearing mandate on August 1, 2016.
For more information on these Dodd-Frank categories, see Practice Note, The Dodd-Frank Act: The Commercial End-user Exception to the Mandatory Swap Clearing Requirement: Compliance and Other Aspects of the Rules.

Standardization Via Use of EMTA Currency Templates

The Emerging Markets Trade Association (EMTA) has standardized the terms under which many NDFs are traded by creating template documents that specify:
  • Settlement currency.
  • Settlement date.
  • The primary fixing source to be used for valuing the contract for settlement.
  • The secondary fixing source to be used in disruption events.
  • Fallback conventions that address the risk of potential market/sovereign events disrupting the value or settlement of certain emerging-market currencies that some of these contracts are based on.
The FEM suggests that any FX NDF contract that does not use one of these EMTA template documents may not be sufficiently standardized to be suitable for a clearing mandate.

Market Readiness for Client Clearing

Given the highly decentralized market infrastructure that supports the over-the-counter (OTC) FX market, there are still many bilateral operational processes that need to be enhanced and standardized for a cleared environment, developed by clearing firms and implemented by their clients to support any clearing mandate for FX NDFs. These include:
  • Clearing and allocation of voice trades.
  • Pre-allocated and bunched order trades on swap execution facilities (SEFs).
  • Voice block trades, package trades and others.
The FEM believes its recommended timeline for a clearing mandate provides adequate time for preparation by market participants.

Preparation to Support Trade Certainty and CFTC Rule 1.73 Compliance

According to the report, in order to ensure that counterparties have confidence that their transactions will clear, there must be certainty of clearing at the time of trade execution. The readiness of SEFs and their participants for FX NDF trading that is compliant with CFTC Rule 1.73 (17 CFR 1.73) should be considered when implementing the FEM's recommended timeline. These Rule 1.73 processes include support for FCM credit checks, pre-allocated trades and post-clearing allocations. According to the report, this would avoid disruptions similar to those that took place in the rates and credit markets in October 2013 as pre-trade checks were unexpectedly required on SEF trades.