CME to expand paired delivery as banks rethink third-party CLS

New settlement model underpinning CME Europe will extend to US futures

clearing and settlement

CME Group is to extend its new paired-delivery model for the physical settlement of foreign exchange futures from Europe to the US in September, as banks step back from the provision of indirect settlement through CLS to financial market infrastructures (FMIs), which include exchanges and central counterparties (CCPs).

Following a seven-month delay, due to concerns over the physical delivery of currencies, CME launched its new London-based futures exchange in April using paired delivery, whereby the clearing house pairs clearing firms with open long and short positions at expiry, rather than having a bank provide settlement in CLS, which had been the case for its US business.

The exchange will now roll out the same model for its US futures business. Paired delivery began in June for a subset of CLS-eligible pairs, including CAD/USD, and it will be extended to the remaining pairs in September, according to an advisory notice to the exchange's clearing members, dated May 12.

"CLS settlement members are exiting the business of providing third-party services to FMIs. We cannot comment on the CLS settlement members' decisions. We plan to migrate US FX futures business to paired delivery in September," says a spokesperson for CME Group.

As the direct settlement of currency trades through CLS is only available to bank members of the industry utility, non-members such as smaller banks and FMIs use third-party providers to ensure their trades are settled on time. Seventeen banks are listed as third-party providers on CLS's website, and banks that have offered settlement to FMIs in the past are understood to include Citi, HSBC and JP Morgan.

All three banks declined to comment for this article, but CLS confirmed third-party providers have been reviewing their arrangements.

"CLS has been aware that CLS third-party service providers have been assessing their risks more carefully of late. That said, third-party activity in CLS is strong and continues to increase, with another CCP recently joining CLS as a third party," says a spokesman for CLS.

Although the exact reasons for third-party CLS being scaled back from CME are unknown, a part may have been played by the international standards for FMIs, finalised in 2012 by the Committee on Payment and Settlement Systems and the International Organisation of Securities Commissions (CPSS-Iosco).

A requirement that FMIs must "provide clear and certain final settlement" on an intraday or real-time basis, where possible, would place far greater responsibility on settlement providers than in the past. In the US, CME's futures business has grown significantly, with average daily volumes of $93 billion in June, creating a significant settlement obligation for any third-party provider to manage.

"Banks are reviewing the provision of third-party CLS to exchanges and clearing houses in the current environment, and it has therefore got a lot harder for CCPs to find a partner to use that kind of facility," says a senior FX official at one large bank that provides third-party CLS.

"When CME first launched FX futures in the US, this was new to the market and expected to be quite small. It was also expected that a lot of the contracts would be rolled and therefore not taken to settlement, so the flow going through the third party would be quite small. But as the futures business has grown, and with CPSS-Iosco requirements for finality of settlement, banks have revisited this and realised third-party CLS to FMIs might not make sense," the official adds.

While CME had little choice but to find a new model for settlement, there has been some criticism that paired delivery is more difficult to risk-manage and may deter some banks from using CME Europe.

"There are some concerns over the paired-delivery model," says the official. "In a bilateral or cleared market with settlement against the CCP, I can manage my exposure to the counterparty throughout the life cycle of the trade until settlement. But with paired delivery, I face the exchange or CCP and the trade is then assigned to a new counterparty just before settlement. I don't know who I'm going to be paired with until the last minute and I might not have the credit appetite for that. It's a much harder model to risk-manage and I'd be interested to see how much volume it attracts."

CME counters that the model is robust and has the approval of the Bank of England. "As in any physically delivered futures contract, the clearing house and clearing firms monitor the positions going into delivery, and assess the ability of market participants to make or take delivery," says the CME spokesperson.

But some FMIs, including Germany's Eurex, which launched FX futures and options on six currency pairs on July 7, still use third-party CLS. Eurex currently uses only one bank for settlement while CME has two third-party relationships in the US.

"We participate in CLS as a third party, so Eurex Clearing is the counterparty until the trade settles. As a new business, we expect gradual growth in volumes, so we have only one bank doing third-party settlement, but as our volumes grow, we may need to consider ways to diversify risk. If other CLS connectivity models become available, such as direct participation of CCPs in CLS, then we would examine those too," says Archana Varshney, senior vice-president in clearing product design at Eurex Clearing in London.

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