Franck Mikulecz, managing director of the newly established clearing house FXCH, explains why and how his firm is using distributed ledger technology to clear spot FX transactions.
Profit & Loss: You’ve launched a clearing house to clear spot FX using distributed ledger technology. Why?
Franck Mikulecz: We think that in some respects, the FX market is broken and needs to change. What we’ve found is that even some of the largest non-bank liquidity providers are having credit issues because sometimes they want to trade with certain retail brokers, smaller financial institutions or financial institutions outside of G10 countries and their prime brokers won’t facilitate this.
In addition, there are real money firms and hedge funds that the non-bank LPs would like to trade directly with. These firms have the technology to integrate the market makers’ feeds directly rather than going through a platform, meaning that where the banks have credit lines with those counterparties they could trade in a low cost and high tech environment. But the banks are retrenching from the FXPB space and they don’t want to facilitate four way give-ups.
This has created a problem in the market. FX is the largest asset class in the world and you have financial institutions that depend on access to it, but the retrenchment of credit providers is choking the market.
P&L: And how do you think distributed technology can help alleviate this problem?
FM: We think that this technology is powerful, as it underpins the bitcoin world where participants can complete transactions in a trustless environment.
So we ask our members to deposit their collateral at our bank and as soon as they do that, we record the collateral on a distributed ledger. Because of the nature of distributed ledgers, every participant has a copy of this same ledger and everyone knows that this copy cannot be falsified. At the same time, we make our bank statement public, we also show everyone how much money is at the clearing house via a distributed ledger.
So if a firm deposits a set amount of money with us, they can then see what has happened to their money and where it is in real time. Because they can use the distributed ledger for verification, it eliminates the need for trust.
P&L: Can you explain how clearing with a distributed ledger actually works?
FM: What happens is that we receive a trade via straight-through processing, exactly like a normal prime broker. We then inject the trades into our clearing system and we do mark-to-market for the position. As soon as we receive positions, we do a reservation of their cash on the ledger, and what this means is that we impose an additional cryptographic signature on the ledger so that the firm cannot touch or withdraw that money without our permission as it is now locked as collateral to secure their position.
All confirmed client trades are novated against the clearing house, so that the clearing house remains the counterparty of every trade.
When the position comes to maturity and settlement happens, we make one registry on the ledger of the plusses or minuses of the currencies that they’ve traded.
It is the same process as our prime-of-prime business, except there when it comes to settlement, the details were maintained on a database held by us. Now this database is made available via a distributed ledger and the magic of this is that the ledger cannot be falsified and is available to everyone who wants a copy.
PL: Isn’t it a big jump for firms to shift away from traditional prime broker or clearing operations and towards a distributed ledger solution?
FM: Yes, it’s a big jump. Because a clearing house business is basically managing the risk that occurs when people trade with a counterparty that they don’t know, you have to provide reasonable security that if one clearing member suffers terrible losses that the others will not be impacted.
So we’ve come up with a structure that is very similar to one used by some of the normal futures clearing houses. There are two types of membership for our clearing house.
The first type is called a general clearing member (GCM), and these members can trade for themselves and can also carry trades of their clients. These members have to put $5 million in a guarantee fund, which is then used if there is a catastrophic event and the collateral that we have from a member is not enough to cover the losses.
The second type of member is an individual clearing member (ICM), and they can only trade for themselves. Normal ICMs have to contribute $1 million to the guarantee fund and, like the GCM, needs to have a minimum of $1 million in collateral.
There is a maximum net open position (NOP) of $100 million for GCMs and $20 million for ICMs, which can be extended if the firm agrees to increase its participation in the guarantee fund. In our model, the GCM pays $1 per million and the ICM pays $2 per million in fees.
P&L: How did you reach these figures?
FM: We did some stress test calculation based on scenarios that we’ve seen in the past eight years and put the collateral that’s required to trade on G10 currency pairs as 3% for initial margin, 2% maintenance level and 1% close out level. These are quite classic amounts in the PB world.
You need to have a certain level of commercial attractiveness to your collateral requirement so that you can interest clients, but not have them so low that you can get wiped out by a big risk event.
So you have to find that point in the middle where the collateral you collect is enough to cover losses in 99% of situations. The difference between being able to handle 99% of situations and 99.999% of situations is what you cover with the guarantee fund and that’s why we have to ask members for extra to collectively protect the community a bit more, and they have a mutual interest in doing so.
P&L: But is there really a demand for spot FX clearing?
FM: Well the banks are focused on NDF and options clearing, because the regulators want those products to be cleared eventually. And the reality is that the banks will be happy to do so in a lot of cases because they don’t want those products encumbering their balance sheets, which could become very costly for them under the new capital requirements.
But for spot they’re not interested at all, because two days later it’s off their balance sheet.
What we’re doing is going in the opposite direction. We’re going out to non-banks and firms that can no longer get a PB service or are not satisfied with the PB service that they currently get. The banks don’t have a problem for spot FX, but that’s not necessarily true for the rest of the market.
P&L: And have these non-banks been receptive to the idea of clearing spot using distributed ledgers?
FM: When we first started to speak to people they were sceptical; they couldn’t believe that we were planning to clear FX without a bank involved.
But what we’re doing is actually incredibly simple. When one user makes $100,000 the other loses, so we’re not actually making any transfer, the money stays at our deposit bank and then we settle the currencies on the ledger.
So we just change the ownership of these amounts on the ledger, meaning that there’s no movement of cash anywhere, no CLS and no Swift. We can make these settlements totally cost free.
This is a very attractive proposition to non-banks and firms that don’t want to go to full delivery in the underlying size of the trade.
P&L: Isn’t there an issue of scale?
FM: Well a regular clearing house in the EU needs to have between $200-$300 million of capital to become a registered clearing house. But because we’re only focusing on spot FX, which is not a regulated product, we do not need to do this.
We can do everything mechanically like a clearing house, but we don’t need this huge amount of capital, although we have to convince market participants that our model is still safe with a much smaller amount of capital behind us.
P&L: What is the biggest concern that prospective members have when you explain your model to them?
FM: The question we get asked the most is: what happens when there is an event like the Swiss National Bank removing the floor of CHF and the market moves 30% and you only have 3% of collateral from these firms?
The biggest question that a clearing house needs to answer is regarding how they manage default. That is why we have the guarantee fund, but that by itself is not enough.
So we looked at how some other clearing houses manage default and have replicated their method of creating an auction for a defaulting member. Under this model, if someone defaults, all the members have to participate in an auction to liquidate the defaulting portfolio.
Because the members have contributed to the guarantee fund, they’re incentivised to participate in the auction and give a good price as we liquidate the portfolio. Even in a case like SNB, we calculated that we would still have enough resources to absorb the losses of a few defaulting portfolios.