LCH Clearnet, one of the world's largest clearing houses, is looking at introducing clearing for the $1.9 trillion a day foreign exchange market, in an attempt to cut out credit risks between agreeing and settling trades.
Foreign exchange dealing generally takes place on an over-the-counter basis, with the counterparty in a trade exposed to the credit status of the other counterparty.
LCH Clearnet would act as a central counterparty, shouldering the risk that one counterparty fails after agreeing to a trade but before paying for it.
A clearing system could save banks money by enabling them to net, or offset, payments with a wide range of banks.
"The foreign exchange market is a much more diffuse market than any other, there is no single point of reference or exchange," said Rory Cunningham, director of strategy and development at LCH Clearnet.
"Since we already have so much of the necessary clearing infrastructure in place, it would not be a complex product to introduce."
LCH Clearnet clears trades carried out on a number of exchanges, including the London Stock Exchange and Euronext.LIFFE.
In the foreign exchange market, deals are usually done via inter-bank dealing systems like those offered by Reuters and EBS, via voice brokers, or via trading platforms aimed at corporates and fund managers like FXall and Currenex.
LCH Clearnet's system would be designed to clear trades conducted via any of these methods.
A clearing house differs from a fully-fledged exchange because there is no central forum for price information.
LCH Clearnet already has clearing systems for the over-the-counter swap and repo markets.
Cunningham said it would not be difficult to develop foreign exchange clearing, but there would have to be market demand.
"We would of course need a clear indication from market participants that this would be a service that they would be prepared to support and invest in."
Although foreign exchange dealing is carried out almost exclusively on an over-the-counter basis, currency futures are listed on some futures exchanges, of which the largest is the Chicago Mercantile Exchange.
There has been talk that the CME is planning something similar to what LCH is looking at.
The July minutes of the Bank of England's FX Joint Standing Committee, made up of senior figures from the foreign exchange industry and from the Bank of England, mentions a CME proposal to clear currency forwards, but the CME declined to comment.
Industry regulators have been fretting over risks in the foreign exchange industry for the past decade and more.
CLS Bank was launched in 2002 with the backing of major foreign exchange banks to eliminate settlement risk, the risk that one counterparty to a deal defaults before both sides of a currency payment are made.
Settlement is made simultaneously in a narrow daily window, linked to the gross settlement systems of the major central banks participating in CLS.
CLS says it is settling an average of $700-800 billion daily.
LCH Clearnet says its clearing systems cut out risk slightly earlier in the deal process, from the time of trade. Clearing reduces and nets exposures between agreeing a trade and settlement, which is typically one or two days.
"It's very much a concept at the moment, but there is interest from parts of banks and from individuals," said Cunningham.
"There are benefits of clearing, for instance, the market-maker is insulated from the credit risk of the counterparty. This should be of particular benefit in the FX swap/forward market, but we have been encouraged to include spot in any service."
Critics of the proposals say clearing systems clear deals on a net basis, while CLS settles deals on a gross basis, making the two systems incompatible.
But LCH.Clearnet is open-minded on this, Cunningham says.
"Clearing through a central counterparty does not necessarily mean settlement on a net basis - in the equity market it can be optional. It depends on what the market wants."
Any clearing service would have to save money for the banks if they are going to adopt it, industry participants say.
There would be costs for banks in setting up the operational processes and in providing margin payments for the clearing service.
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