LCH mulls FX spot clearing as buy-side demand grows

Anticipated ForexClear service could reduce funds’ reliance on prime broker credit lines

The entrance to the London Stock Exchange
London Stock Exchange, home to LCH

LCH is considering an expansion of its clearing services to include spot foreign exchange trades, as hedge funds and proprietary trading firms (PTFs) become increasingly weary of prime brokers tightening credit lines when they are most needed.

Sources familiar with the matter say the spot FX offering is being examined at LCH’s ForexClear and could be launched within the next two years.

The move comes after a large buy-side firm approached the clearing house about the possibility of clearing its spot trades to better optimise credit lines and mitigate counterparty risks after becoming frustrated with its FX prime brokers (FXPBs).

Participants see a strong rationale for clearing in the $2 trillion-a-day spot market. Firms would then face a single credit counterparty rather than a host of bilateral connections, allowing for netting and operational efficiencies.

FX is the largest asset class by volume, yet, in many ways, it is less evolved and less efficient than some of the other asset classes. And I think central clearing is one of those key pieces,” says an FX market-maker at a large non-bank trading firm.

“Spot is the simplest product and probably a good place to start where you would see a lot of the benefits of central clearing, and it may not be as complex to get up and running.”

LCH declined to comment.

LCH currently offers clearing for non-deliverable forwards and FX options through its ForexClear platform, where average daily volume now stands at $99 billion. The clearing house also handles processing, margining and settlement of bilateral cross-currency swaps through its SwapAgent service for non-cleared trades.

LCH is targeting spot as part of a wider push into deliverable FX instruments, including forwards and swaps. The central counterparty is also looking to add a cross-currency swap clearing service in 2023.

FXPBs normally provide market access to PTFs and hedge funds by taking them under the bank’s credit profile for a fee. By acting as a credit facilitator, an FXPB eliminates the need for buy-side clients to sign multiple legal trading agreements with other counterparties.

However, the mechanics can be unwieldy. A hedge fund wishing to execute a euro/dollar trade, for example, would first execute the trade with a dealer. Both parties would then ‘give up’ that trade to the prime broker. The FXPB completes simultaneous back-to-back trades with the hedge fund and the dealer, becoming the counterparty to the two transactions and settling with both parties.

This can be a complex web to navigate when there are multiple prime brokers involved, adding latency for PTF firms and hedge funds whose business thrives on speed. For example, if the firm uses a PB that is different from its client’s PB, it would have to manage an agreement between the two PBs.

One of the big benefits of central clearing is that you’re not taking on counterparty risk
FX market-maker at a large non-bank trading firm

In addition, some PBs limit the types of trades they offer, meaning an alternative PB must step in if a client’s product suite extends beyond the existing menu.

By connecting all participants, a central counterparty would – in theory – eliminate the need to manage multiple credit agreements. At the same time, the move could be more economical for dealers, as the FXPB model could be replaced with a more capital-efficient futures commission merchant (FCM) approach, in which banks provide client access to the clearing house.

FXPBs have undergone a major shift in recent years as market events forced them to reassess their businesses and take stock of the type of clients they serve.

In 2019, Citi severed relationships with some of the largest PTF firms and restructured its business following a $180 million loss from risky Turkish lira bets placed the year before by a hedge fund client.

Those firms have since found homes at other banks, but FXPBs remain cautious about extending credit to PTFs, since the speed of their trading makes it hard to monitor their exposures. Pre-trade credit checks and kill-switches can help with this, but they do not work for all trades and have not been universally adopted in the FX market.

Bilateral relationships have their inefficiencies too. Participants taking this route must be vigilant about assessing the credit risk of each of their counterparties and factoring this into pricing. Prices can vary dramatically from client to client, depending on their credit quality.

“One of the big benefits of central clearing is that you’re not taking on counterparty risk, you’re just facing a single, central clearer that’s regulated and well capitalised. So, you have confidence that the central clearing house is a genuine and bona fide counterparty with very little to zero credit risk,” says the FX market-maker.

The success of any FX spot service would depend on the structure of the clearing model, the market-maker source stresses. This would require clarity over how delivery and settlement work for deliverable currencies, and what – if any – role CLS would play. A cleared spot service may see the two work together, with LCH handing trades over to CLS for settlement after they are cleared. CLS already provides settlement for bilateral cross-currency swaps handled by LCH SwapAgent.

A spokesperson for CLS did not respond to a request for comment.

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