Quick Takes: FX clearing 2024 – A break out year for options
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Ali Curi: Hi everyone, and welcome to ION Markets Quick Takes. I'm Ali Curi. And every week, along with my guests, Chris Barnes and Mark Bell, we take a quick dive into the headlines on the Clarus blog. Let's get started. Hi, Chris. Hi, Mark. 

Chris Barnes: Hey, Ali. How you doing? 

Mark Bell: Hey, Ali. 

Ali Curi: Hello, gentlemen. Welcome back to Quick Takes.

Chris, let's start with you. What's your Quick Take for this week? Which headline from the Clarus FT blog would you like to discuss? 

Chris Barnes: All right, this week, I'm covering FX clearing. The blog's called "FX Clearing 2024 — A breakout year for options." And that kind of gives the game away about the podcast up front.

I'll give you a bit of background, a bit of color, a bit of stuff that's not on the blog. But your key takeaway is that 2024 really seems to have been the year where clearing started, let's say en masse in FX options. In terms of my own personal journey, I've followed FX clearing really, really closely since at least 2016, certainly before the uncleared margin rules. Always thought that, you know, NDFs in particular would be very well suited for clearing back in 2017.

NDFs were really what started driving proper cleared volumes. LCH ForexClear is the predominant clearer. I think it has something like a 90 percent market share. And it's really, really interesting to see for me personally, the growth of FX clearing, as many of, you know, as I bang on about, I was a cross currency swaps trader for many years, I've been involved in projects looking to clear cross currency swaps.

And of course, under the uncleared margin rules. There is somewhat of a dichotomy for FX trades. Generally speaking, the physical FX component of any trade that covers FX risk is exempt from the margin requirements of uncleared margin rules. So FX forwards, which are a physically settled product, you don't have to post margin against your FX risk.

For cross currency swaps, the FX risk is stripped out. What that means is that whilst in swaps where your, in terms of interest rate swaps I mean, whereby you are grossing up all of your rates delta amongst your counterparties by keeping products uncleared, and then you are benefiting from the netting and clearing.

Therefore, your margin is generally lower in net in clearing. For FX products, you don't have that kind of one-for-one comparison because, in uncleared markets, that FX component is actually exempt from margin. And I think that's a really important backdrop whenever we talk about FX clearing. NDFs, they don't benefit from that because they're net settled.

And so your margin, if you hold it outside of clearing is pretty much the same as if you hold it in clearing. Therefore, you want to send as much of your NDFs into clearing as possible. That's why we continue to see increased growth in volumes or NDFs in particular. And NDFs do continue to be the major source of volumes for FX clearing. And they were the big driver of growth over the 33 percent increase in volumes we saw from 2023 to 2024.

So they're still like, you know, super significant portion of the cleared FX space. However, because I've been blogging on this for so long, right? I'm always interested in what has changed in the market as well. And what I think was particularly interesting in 2024 was that we saw real meaningful volumes of FX options clearing.

Really, I would say for the first time. And what do I mean by meaningful? Well, I've tried in the blog to kind of relate the volumes in FX options to a particular currency of, of NDFs. Brazil is the fourth largest cleared currency for NDFs. Cleared volumes in FX options were larger in 2024 than cleared volumes of BRL NDFs.

So a real potential significant change for the FX clearing landscape. And I thought some of the particular market dynamics were interesting because from an outsider's perspective, again, I have to stress I've never traded FX options, but I kind of assumed that market participants would be using clearing as like an optimization hub, looking to net as much of their existing bilateral FX options risk into a clearinghouse.

And so when you think of that process, you naturally think, "ah, right, okay. Those opportunities may be more valuable over year end. Capital is traditionally more expensive to hold." Therefore I did expect to see FX options volumes, let's say in December or Q4 as a whole as at the highest of the year, but that wasn't actually what we saw in the data.

We still saw signs of balance sheet window dressing in terms of open interest in December in cleared FX dropping, but we didn't see that spike in FX options being cleared, which I was expecting from an optimization perspective. I think that probably points towards the fact that there is kind of real flow of FX options.

It's not just an optimization play. And so as a result of that, I think it's really important through 2025 to keep a close eye on cleared FX options to see if this growth can both continue, whether it can expand across different currency pairs, and also then begin to look at what kind of percentage of the total markets are cleared.

I haven't taken that step in the analysis on the blog because it involves combining BIS data, which tends to be a bit out of date with our latest data. And so it's not necessarily a straightforward exercise. When I've tried to do it for NDFs in the past, I've relied heavily on the CFTC swaps report, which has suggested somewhere between 20 and 30 percent of the NDF market is cleared. That does vary massively by currency, but appears to have been fairly stable over the years. I don't know why it stalled at that take up, whether there's a lot of internal trades, whether this is availability of client clearing. I really have very little insight as to what has put a cap on the growth, even though it is impressive growth in terms of volumes.

Mark, that was a bit of a rambling intro covering a little bit of history, a little bit of uncleared margin rules, a little bit on effect options clearing as well. I do think it's a particularly interesting subject. I would get all of our listeners to read the blog for the numbers. Do you have anything specific that you want to call out or, or ask me?

Mark Bell: Thanks, Chris. Yeah, I've got a couple of questions. I mean, I think FX clearing certainly has improved systemic risk, even though there hasn't really been a major crisis that's tested the infrastructure yet. I'm thinking along the lines of the Korean crisis in '97, '98, where there was some significant issues.

I think two questions that I have for you, firstly, what's the impact [it's] had on liquidity? Has it improved liquidity? And what do you, you know, you mentioned a limited number of NDF pairs are cleared. Should there be other currencies that people are looking to clear, maybe, you know, Egypt or Kazakhstan? Both of them have got in the SDR data for a little bit of volume, not nearly as much as Brazil, as example, should they be pushing someone like standard charge or the standard jet bank be pushing to have those types of currency clear that ForexClear?

Chris Barnes: I think two things I I'd call out there. One is that I would say it's. It's really baffling from a market participant's perspective at how resilient the FX market is and how liquid it is. Like, if you started with a blank piece of paper, would you ever end up with the market infrastructure that we actually have in FX trading now?

Hell no, right? And yet, as you say, like the one market that continues to go through crisis after crisis after crisis without any changes seems to be the FX market. And it's kind of related to the expansion of currencies as well. I don't know what the exact process is to be able to list a new currency, but I imagine that you really, as a central clearinghouse, you want to notify the central bank of the currency involved, right?

It's worth a phone call at least go, "Hey, we're about to launch your currency." I think there's probably political questions around it. Certainly a question of liquidity. Are there enough market participants? Is there enough access to client clearing? Are there enough banks supporting it? Et cetera.

I think with all of these things, it's not a straightforward thing for a clearinghouse, just to say, "Right, we've got a price feed, we're confident of end of day marks, let's list it." There really has to be a very, very solid business case for it. 

Mark Bell: Very quickly, my second question, the uncleared margin rules, it's been noted for the fact that it doesn't handle volatility particularly well, particularly for out-the-money options.

Have the margin models improved, or are the margin models better in a clearinghouse such as LCH for FX options? 

Chris Barnes: I wasn't expecting that one. You've got to think really in both cases, right? It's accepted wisdom that drives these models. Is the SIM has to naturally make some pragmatic choices?

Because it's implemented by thousands of market participants, it has to be reconciled every day. If you look at what a CCP is doing, that also has a huge governance around its models. They also have to be stress tested. They have to go through rigorous regulatory approval. You would hope in this day and age that CCPs have the best access to the best quants, the best models. They are pivotal. They are systemically important. And you would think that they don't quite have the same degree of limitations as an ISDA SIM, which has to be adopted by maybe market participants who are not quite as sophisticated. Clearing houses probably have a little bit of an edge, but ultimately I think you still have to remember the point of the margin model. It's to collateralize the daily changes in market to market. It cannot completely remove the chances or remove the chance of a loss that is over and above the variation margin called previously or, or the initial margin. Right? So are the models good for collateralization purposes? Are the models reducing your credit risk compared to not even having a model in place?

Yes. Therefore, are the models fit for purpose? Yes. Will there be people that want to criticize them? Sure. But at some point you have to make a pragmatic leap and say, it's better to do this than to not even clear the product. 

Mark Bell: Thanks, Chris. 

Chris Barnes: No worries. Ali, I'll hand back over to you after that quick rundown of FX Clearing.

Ali Curi: Thank you, Chris. And please, share with us again the title of your blog post. 

Chris Barnes: That was "FX Clearing 2024 — A breakout year for options." 

Ali Curi: Great, that works. Chris Barnes, Mark Bell, thank you both for sharing your Quick Takes. Let's do it again next week. 

Chris Barnes: Looking forward to it, Ali. Thank you. 

Mark Bell: Thanks, Ali. 

Ali Curi: And that's our episode for today.

You can read more about these topics on the Clarus blog, and you can follow ION Markets on X and on LinkedIn. Thank you for joining us.