Diversifying the IRS Clearing Market: Non-bank FCMs

Terry Hollingsworth, Global Head of Futures Clearing Sales

Since the 2008 financial crisis, many large clearing members have left the market following new bank capital requirements. While futures and interest rate swaps (IRS) clearing volumes have increased alongside interest rate volatility, the number of clearing members, or futures commissions merchants (FCMs) as they are called in the US, has decreased from 150 to fewer than 65 (based off the CFTC reported data). BNY Mellon, Deutsche Bank, NatWest, Nomura, and State Street have reduced their clearing services in the past decade. On Swaps clearing, the numbers of clearers offering client IRS clearing has gone from 20 to 12 in the last 5 years.

Amidst this market consolidation, Marex is proud to launch the first non-bank IRS client clearing service in partnership with LCH’s SwapClear. As the first non-bank FCM to offer IRS clearing to clients, Marex is strengthening the market by providing greater diversification of counterparty risk, additional clearing capacity, and improved market connectivity. To fully understand the benefits non-bank FCMs bring to the clearing market, it is useful to first understand the risks of market consolidation and the importance of the swaps clearing market.

The risks of market consolidation

The rate of consolidation in the clearing market is staggering. A recent analysis published by Risk Quantum of 16 central counterparty clearing houses (CCPs) found that, in the third quarter of 2023, the five largest clearing members of the median clearing service were responsible for 49.3% of its initial margin (IM). A small number of CCPs were responsible for about half of the total outstanding open positions and IM. In the fourth quarter, the median proportion of open positions held by the five largest clearing members at global CCPs rose to 51.72%, representing a 2.36% increase and setting a record for quarter-on-quarter growth.

Basel III endgame threatens to further restrict institutions’ ability to offer clearing services due to its requirement that banks adopt the standardised approach for counterparty credit risk (SA-CCR) and increased capital requirements. These increased capital requirements, arising from both the SA-CCR requirement and the requirement to capitalise for losses on derivative valuations from counterparties’ changing credit quality, will result in banks having reduced clearing capacity.

This consolidation in the market increases the threat of clearing member default, as interconnectedness means one member defaulting will likely result in a cascade of problems on multiple CCPs. Other clearing members may be hesitant to take on more capacity in this scenario, given the increased capital requirements it entails. If the auction of a defaulted position fails, the CCP would have to liquidate its positions resulting in greater downward pression and volatility in the market.

As John McPartland of the Chicago Federal Reserve has noted, this may be an unlikely worst-case scenario, as those clearing members remaining in the space are well capitalised. Still, increased capital requirements and the greater concentration in the market may result in reduced access to clearing, particularly for more capital-intensive trade types, those with low volumes, and directional portfolios.

Pension funds, which are currently exempt from mandatory clearing of certain derivative contracts in the UK, may be at particular risk of losing access to clearing services as they tend to hold long-dated, directional rates positions and are less likely to hold large capital reserves.

The importance of the interest rates swaps market

As Axios notes, the market for IRS alone is circa USD$162 trillion (2023, BIS) and it is one of the largest markets in the world. Regional banks, mortgage lenders, hedge funds and other financial institutions use swaps to hedge risks related to interest rate moves, or to make money by speculating on them. Following the financial crisis, it was identified as a major potential source of systemic risk and Dodd Frank rules mandated the clearing of swaps on more standardized venues, with the Swap Execution Facilities coming into effect in February 2014.

The Benefits of Non-Bank FCMs in IRS

As the world’s first non-bank FCM to offer IRS clearing to its clients, Marex is addressing a gap. I have repeatedly heard from customers that there is a need for greater diversification of counterparty risk, greater clearing capacity, and improved market connectivity. As an entrepreneurial firm that consistently strives to bring greater diversification to the global market, we are excited to offer this service to our clients.

Diversification of counterparty risk

Interest Rates Swaps are particularly important for hedging risk in a volatile market, as they help provide borrower flexibility. By offering a counterparty alternative, non-bank FCMs like Marex enable hedge funds and other market participants to diversify their risk which is especially pertinent given the trend of increased consolidation in the clearing market.

Account diversification & additional capacity

By providing account diversification, non-banks FCMs are able to offer clearing services to those seeking additional capacity. While increased capital requirements put additional capacity constraints on G-SIBs, non-bank FCMs are not subject to these same requirements, enabling them to offer capacity in areas where banks may be limited.

Major market connectivity

Like traditional financial institutions, non-banks with major market connectivity can offer clients connection to major venues, like LCH, as well as specialist vendor ecosystems.

Non-bank FCMs ultimately complement clearing services offered by banks. While the services Marex offer will be the same as traditional financial institutions, our presence enables market participants to diversify counterparty risk and access additional capacity, while retaining the connectivity benefits of major banks. As impending regulatory changes make further consolidation in the clearing market seemingly inevitable, non-bank FCMs are a necessary and much needed solution.

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