On December 22, 2014, the CFTC announced that its Subcommittee on Foreign Exchange Markets (“FEM”), which is comprised of several private industry market participants, submitted a report to the CFTC’s Global Markets Advisory Committee regarding a potential clearing mandate for foreign exchange (“FX”) non-deliverable forwards (“NDFs”). The CFTC invited comments on the FEM report, but did not provide a deadline for such comments.
The FEM report addresses the following three questions:
- Is an NDF clearing mandate appropriate?
- What is the best way for the CFTC to implement a clearing mandate?
- Are there likely to be any execution issues in light of the Made Available to Trade (“MAT”) determinations?
Is an NDF clearing mandate appropriate?
The FEM did not directly address whether or not a clearing mandate would be appropriate for NDFs, but emphasized that any such mandate should contain a clear timeline and method of implementation. According to the FEM:
- An NDF clearing mandate would reduce counterparty credit risk in the NDF market, but may not reduce systemic risk due to: (i) the small size of the NDF market relative to the overall FX market and (ii) the short-dated nature of typical NDF transactions.
- NDFs are not subject to the same liquidity and settlement risks as certain deliverable FX products, such as FX options, because NDFs do not require the exchange or physical delivery of the principal amount.
- Mandatory clearing for NDFs, without sufficient time to prepare, could segment the market, cutting off access for corporations, investors, banks and others that use NDFs to the existing broad pool of liquidity.
What is the best way for the CFTC to implement a clearing mandate?
The FEM recommended that, in issuing a clearing mandate for NDFs, the CFTC: (1) harmonize its requirements with those of the European Securities Markets Authority (“ESMA”); (2) require clearing only of NDFs that reference standard Emerging Markets Trade Association (“EMTA”) terms; (3) ensure that the market is ready for client clearing (i.e., not merely dealer-to-dealer clearing) of NDFs before implementation; and (4) ensure that clearing members and swap execution facilities (“SEFs”) are prepared to perform and facilitate pre-trade credit checks and straight-through processing regulatory requirements before implementation.
Importantly, regarding timing, the FEM urged, based on the timeline that the CFTC has previously established, that any NDF clearing requirement be phased-in between February 1, 2016 and August 1, 2016. The FEM also recommended that the CFTC base its determination on the same currency pairs and tenors as those used by European regulators.
Are there likely to be any execution issues in light of the Made Available to Trade (“MAT”) determinations?
If a swap is subject to mandatory clearing, it also will be required to be traded on a SEF once there is an approved “MAT determination” for that swap (unless an exemption applies). The FEM opined that there could be a negative impact on the market if mandatory trading on SEFs begins too closely after a mandatory clearing determination. The FEM identified the following issues as particularly problematic:
- Package Transactions: A package transaction is a multi-leg transaction where at least one leg is a swap subject to mandatory trading and at least one leg is either not subject to mandatory trading or is not a swap. Migrating package transactions onto SEFs presented problems for interest rate and credit default swaps (some of which are yet to be resolved). The FEM recommended that the CFTC treat FX package transactions consistently with those for rates and credit.
- Prime Brokerage: Certain market participants have requested guidance from the CFTC regarding migrating prime brokerage swaps (particularly those in the FX market) onto SEFs, but the CFTC has not yet provided such guidance. The FEM stated that certain complications will arise if mandatory clearing for NDFs begins before prime brokers are successfully migrated onto SEFs.
- Confirmations: The CFTC staff has provided time-limited no-action relief to SEFs from certain aspects of the CFTC’s confirmation requirements, but the underlying difficulties in this area have yet to be resolved. The FEM noted that SEF-issued confirmations may still be problematic for end-users, among others, even after the clearing mandate becomes effective.
Despite these challenges, the FEM noted that, in determining a timeline for implementing any NDF trade execution mandate, the CFTC should consider that many SEFs were created over a year ago and that it is important for them to have certainty as to when mandatory trading of NDFs will become effective.