As the transition to the new capital regime on counterparty risk and uncleared financial instruments gathers pace, an increasing number of firms with substantial exposure to over-the-counter (OTC) FX derivatives are looking for ways to reduce their gross notional and counterparty exposure in the most efficient manner.
In 2021, their toil is proving particularly laborious. Hundreds of firms will have been caught by phase five of the uncleared margin rules (UMR), which took effect on September 1, and many more will have to adapt the manner in which they calculate their exposure to derivatives contracts when the last remaining – and some of the largest – jurisdictions shift from the current exposure model to the standardised approach to counterparty credit risk (SA-CCR) by the end of 2021.
To fulfil their obligations, many financial firms have sought out our compression and optimisation solutions over the past year, with noteworthy effects on the risk exposure of those in the network.
In January alone, $541 billion of gross notional was eliminated by our clients through our OSTTRA triReduce compression service, more than double the amount achieved the previous year. And, similarly, OSTTRA triBalance executed its largest ever optimisation FX cycle at the beginning of 2021.
“Looking at the past 12 months, I’m most proud of the fact that we are live optimising capital exposures in an ever-growing network,” says Erik Petri, head of OSTTRA triBalance solutions at OSTTRA. “I can say with confidence that we offer the market’s largest optimisation network for bilateral counterparty credit risk for the FX market.”
While reducing gross exposure to meet UMR rules and rebalancing counterparty risk to satisfy SA-CCR requirements can be met separately, Petri strongly encourages firms to accomplish both of these within the same cycle, rather than running separate compression and optimisation cycles.
“It is extremely important for firms to consider optimising both UMR and SA-CCR in one go, otherwise they risk suppressing one exposure while increasing the other, and that’s not ideal. In the FX market there is the opportunity to optimise the two in an extremely efficient way.”
The way we enable firms to achieve both of these goals simultaneously is that, during the set of forward and swap trades are replaced with new transactions with a combined gross notional that is worth less than the original notional. During the optimisation portion of the cycle, short-term risk-reducing FX non-deliverable forwards and forward hedge trades are introduced across all relationships, so each participant remains market-risk neutral. In this way, both initial margin and counterparty credit exposures can be reduced simultaneously, while at the same time reducing the gross notional outstanding.
Until recently, running this type of scenario was largely the remit of global systemically important banks – known as G-Sibs. In the past 12 months, however, an increasing number of smaller sell-side players have joined our network, with the buy side also showing interest in the benefits that compression and optimisation can offer.
“We are now seeing that interest filtering beyond the top-tier banks with regional banks and second-tier banks more focused on net optimisation, not only because of the introduction of SA-CCR but also more generically,” Mattias Palm, head of OSTTRA triReduce FX.
“While SA-CCR is only applicable to banks, we also see increasing interest on the buy side, even though they’re not directly driven from a capital cost perspective,” says Palm. “Bilateral exposure comes with a cost to everyone, and a lot can be done across all kinds of institutions to minimise it.”
While making the necessary technological investments to centralise their portfolios can be considerable for many firms, the benefits for our network of participants, that come from reducing risk through compressing and rebalancing a derivatives portfolio, can run into the millions, not only in the funding cost of initial margin but also the cost of capital.
“It’s impossible to put an exact number at the moment, but we know there are significant savings to be achieved,” says Petri.
“The transition to SA-CCR is a big deal for the industry,” he says. “And it’s something that we expect will drive growth over the coming years. There will be an increased need in the FX industry to keep counterparty credit risk down through rebalancing and compression. FX is one of the asset classes where bilateral liquidity – in terms of outstanding trades – is significant.”
Also, worth noting is that OSTTRA triCalculate has developed a SA-CCR engine that calculates SA-CCR figures for portfolios containing a wide variety of derivatives transactions – margined and unmargined, as well as bilateral and cleared – across all asset classes according to the latest guidelines.