Are you ready for the HKEx Guarantee Fund changes?
Hong Kong exchange’s clearing house reforms: Not my problem?
The imminent reforms to the HKEx’s risk management framework does not seem to be bothering many people. In the recent BNP Paribas / Asia e-trading online poll, not a single respondent could say that they were clear on the impact of these changes on their business – and over 70% are “still waiting for someone to explain it to them”. Given the sizable projected impact of these changes and their historic role in reshaping clearing in other markets, why do Hong Kong’s clearing participants seem so removed from what is around the corner?
What is all the fuss about?
Announced on 11 March 2012, the “HKEx Clearing House Risk Management Reform Measures” are the Territory’s response to an extended local consultation and to the recommendations of IOSCO (the world association of securities and futures regulators). Motivated originally by the lessons learned during the collapse of Lehman Brothers, the measures envisage a departure from the largely stable Guarantee Fund (GF) structure of today – towards a more dynamic “user pays” principle designed to ensure that participants who create risk pay for it in terms of collateral requirements at the HKEx. The reforms will increase the total daily collateral held by the HKEx by approximately HKD2.5 billion.
In practice, this means that Hong Kong’s top 100 clearing participants will be asked to fund an exponential increase in exchange collateral. This increase will be sourced through the introduction of an Initial Margin and a Dynamic Guarantee Fund. The combined effect of these elements will be to ensure that brokers’ collateral requirements remain variable and based on market conditions at all times – meaning not only an initial shock event upon implementation, but also a continuing need to source and manage liquidity as trading volatility rises and falls.
Most importantly, these changes are due to be implemented in September; less than three months from today.
It’s not ready yet…
In an era of unprecedented liquidity scarcity and given the significant financial requirements, why are more people not concerned about this? One answer is that some of Hong Kong’s more informed brokers are still lobbying for revisions to the proposed framework in the hope that change can be achieved in the coming months.
Most notably, many brokers hope that the SFC and the HKEx will be able to agree on a framework under which the new GF contributions can be counted towards their regulatory capital (their FRR). Without this essential change, the additional capital and collateral requirements placed on Hong Kong’s brokers will significantly impact the viability of their Hong Kong businesses – tipping some into negative territory.
To date however, there has been no confirmation that this concession has been agreed to.
A treasury problem….
Far more widespread is the belief that someone else is taking care of this. In the face of an increasing regulatory burden in the region, many C-level managers are assuming that, like many other recent requirements, their finance or compliance teams are leading the way on this initiative. The proposed measures are seen and managed solely in the context of a liquidity question – to which the answer is, however painfully, to ask their overseas “HQ” for more cash.
…. with an operational solution
This approach is fundamentally flawed.
Aside from the evident dangers in assuming that “colleagues have it covered”, evidence of similar reforms in other markets shows that the solution lie not on the balance sheet but in the operating model.
In Australia and in markets across Europe, IOSCO-led reforms in the last three years have driven a surprising number of participants to give up their clearing memberships and to transfer their clearing obligations to a Global Clearing Member (or Participant) “GCP”. Under this model, the clearing house risk is assumed by the GCP who is, in turn, able to provide economies of scale and to offer a consolidated (ie cross market or cross asset) and hence reduced margin requirement to the broker.
This model (also known as Third party clearing) has gained appeal in Hong Kong only in the last two years – since GCPs such as BNP Paribas began to clear over 5% of HKEx’s turnover on behalf of other Exchange members. Hong Kong’s brokers are now faced with a choice in terms of operating models – and hence they have more answers to the question of how to deal with the HKEx reforms.
What should I do now?
Our belief is that it is essential for C-level managers to use this as an opportunity to review and improve their clearing model in Hong Kong. Managed well, these reforms could trigger an improvement in the liquidity model for many brokers – simply through a few key steps.
1. Contact the HKEx: Ask for a simulation of the impact of the proposed reforms on your clearing account. This can be provided free of charge and will help you to size the impact quickly.
2. Seek a comparative view from Hong Kong’s major GCPs to help understand the collateral pact of the third party clearing model for you.
3. Ensure that your operations, finance and compliance teams are all aligned on the best approach to proceed.
Whatever you do, don’t sit and wait until September.
|How the industry voted|
The Hong Kong Exchange is revamping the way it calculates risk and how much members are going to have to have on deposit with their three clearing houses. The changes are expected this quarter so we ran an opinion poll to see how prepared the industry in Hong Kong is. The results are telling. No one really understands what the changes mean with 71 percent of voters waiting for someone to explain how exactly the changes will impact their business. It’s interesting in that the HKEx issued a press release claiming wide industry support for the reforms citing ‘626 responses from Clearing Participants professional and industry associations, market practitioners and individuals.” Then why are people waiting for someone to explain the changes? Granted, the scope of our opinion poll couldn’t possibly reach the over 500 brokers in Hong Kong but we do believe that we are engaging the institutional firms who are in fact directly affected by this reform by the likelihood of higher capital requirements.
We do want to point out the first response to the poll that received no votes “Clear on GF (Guarantee Fund) changes”. That is amazing. In the HKEx press release, amongst the 3 clearing houses, the market share the respondents garner in Hong Kong was not less than 83 percent. Everyone was providing feedback but no one understands the reforms and everyone is waiting for an explanation. Something is amiss. The 14% of voters that are hoping that the changes don’t affect them must surely know to some degree what the impact on their risk capital will be. We also saw a small percentage (14%) lobbying for changes. It sounds like this group does understand that the bigger firms supporting the market (the top 14 firms comprise 58% of market share) are going to have to bare the highest cost when the changes bare down on Hong Kong. The reforms are putting the burden of the capital requirements on the larger brokerages that generate the lion’s share of business for the exchange. The local brokers, who are in majority, will have capital freed up under the Margin Credit provision will be happy for the changes. This is seen as a boost to them possibly even encouraging more small brokerage firms to open shop. In the end we expect to see that the reforms are going to be delayed because it doesn’t seem anyone knows what’s going on and if they do it’s because they realize that the capital required might force them to rethink their clearing membership.