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LCH ForexClear and Quantile launch FX Smart Clearing to address SA-CCR challenges

Rick Steves

While SA-CCR provides a more risk-sensitive framework for assessing counterparty credit risk in derivatives, it also introduces challenges like higher capital requirements and operational complexities, particularly for FX derivatives. This has significant implications for financial institutions’ risk management strategies and capital allocation.

Quantile and LCH ForexClear, both part of LSEG Post Trade, have launched the first FX Smart Clearing service. This service began operating on November 15th.

It allows participants to selectively clear FX Forwards through LCH ForexClear. The primary benefits are significant reductions in capital requirements and counterparty risk.

FX Smart Clearing service reduces counterparty risk

The service works by selecting existing uncleared trades for clearing through LCH ForexClear. It also optimizes portfolios with new rebalancing trades.

This optimization aims to reduce counterparty risk and the financial resources required by participants. Participants can fully customize the optimization process.

They can control their risk, resource changes, preferred currency pairs, and trading partners. Additionally, portfolios can be compressed to reduce trade count and notional.

SA-CCR has raised capital requirements for FX

FX Smart Clearing was developed in response to customer demand. Customers sought solutions to manage counterparty risk, initial margin (IM), and capital effectively. The introduction of SA-CCR has raised capital requirements for FX, creating an incentive to clear. This assumes that the differences in cleared and uncleared IM are well-managed.

By moving FX Forwards into LCH ForexClear, participants gain several advantages. These include multilateral netting, lower counterparty risk weights, and settled to market treatment. All these factors contribute to reduced capital requirements and counterparty risk. Quantile’s optimization ensures risk reduction within relevant IM and risk constraints.

Before the official launch, Quantile and LCH ForexClear conducted several Proof of Concept (PoC) runs. These runs demonstrated the service’s potential. In these tests, 19 participating banks achieved an average 51% reduction in capital requirements, without significantly increasing IM. Quantile and LCH ForexClear anticipate potential capital reductions of over 70% as the clearing network and eligible products expand.

Esben Urbak, Head of Product at Quantile, acknowledged client participation and support in the first live run. “We are pleased to have pioneered FX Smart Clearing with LCH ForexClear, and would like to thank our clients for their participation and support in the first live run. By using Quantile’s optimisation to intelligently clear risk, we can now drive new levels of capital reduction and enable participants to access the benefits of clearing in an extremely operationally efficient way. The launch cements Quantile’s commitment to help make FX portfolios easier, and cheaper, to maintain.”

Andrew Batchelor, COO and Head of Product at LCH ForexClear, highlighted the efficiency of LCH ForexClear in holding risk and the capital and funding requirement reductions under SA-CCR, thanks to Quantile’s optimization service. “We are delighted to have partnered with Quantile to deliver FX Smart Clearing. LCH ForexClear is a very efficient place to hold risk, and by leveraging Quantile’s optimisation service, we can now significantly reduce capital and funding requirements under SA-CCR for our members. We look forward to welcoming more participants to the live service so they can benefit from the strong network, improved capital efficiency and further optimisation benefits from facing a CCP.”

Quantile and LCH ForexClear plan to offer regular FX Smart Clearing runs from early 2024. These will initially be for FX Forwards, with other cleared products to be included later.

SA-CCR and its impact on the FX industry

SA-CCR, or the Standardized Approach for Counterparty Credit Risk, is a regulatory framework designed to determine the counterparty credit risk associated with derivative transactions. It was introduced by the Basel Committee on Banking Supervision as part of the Basel III regulatory framework.

  1. Purpose: SA-CCR aims to provide a more risk-sensitive and accurate measurement of counterparty credit risk in derivative transactions compared to previous methods.
  2. Scope: It applies to all derivatives transactions, including those involving foreign exchange (FX), interest rates, equity, commodities, and credit derivatives.
  3. Calculation Methodology: The approach uses a formulaic calculation to assess the Exposure at Default (EAD) of derivatives. This calculation considers various risk factors like the type of derivative, its maturity, and the volatility of the underlying asset.

Main Requirements of SA-CCR

  1. Trade-Level Measures: Calculating the Replacement Cost (RC) and the Potential Future Exposure (PFE) of each derivative contract.
  2. Netting Sets: Recognition of netting agreements for contracts under the same legal framework, allowing for offsetting positions to reduce overall exposure.
  3. Margin Period of Risk: Adjusting the exposure calculation based on the period over which collateral is collected and replaced.
  4. Add-on Factors: Applying specific add-on factors to different asset classes to estimate potential future exposure.
  5. Hedging and Risk Offsetting: Recognizing hedges and offsets within the same asset class to reduce the calculated exposure.

Challenges Posed in Terms of Capital Requirements for FX

  1. Increased Capital Requirements: SA-CCR can lead to increased capital requirements for FX derivatives, as it generally produces higher exposure values than previous methods.
  2. Complexity in Calculation: The methodology is complex, requiring detailed data on each derivative contract and sophisticated systems for calculation.
  3. Adjustment to New Methodology: Firms need to adapt their risk management and reporting systems to comply with the new approach, which can be resource-intensive.
  4. Impact on Hedging Strategies: The recognition of hedges and offsets in the SA-CCR calculation may affect the effectiveness and cost of hedging strategies.
  5. Liquidity Considerations: The increased capital requirements under SA-CCR might affect the liquidity management strategies of financial institutions, especially those heavily involved in FX derivatives.

While SA-CCR provides a more risk-sensitive framework for assessing counterparty credit risk in derivatives, it also introduces challenges like higher capital requirements and operational complexities, particularly for FX derivatives. This has significant implications for financial institutions’ risk management strategies and capital allocation.

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