Hong Kong Clearing House Risk Management Reforms
The Stock Exchange of Hong Kong completed an industry consultation for reforming its 3 clearing houses, the HKFE Clearing Corporation (HKCC), the SEHK Options Clearing House (SEOCH) and the Hong Kong Securities and Clearing Company (HKSCC), on October 28, 2011 with an 8 question survey. After the collapse of Lehman, the losses both the local and global industry sustained, and under the direction of the Securities and Futures Commission (SFC) the HKEx has begun a vigorous examination of its role as central counterparty (CCP). There were 4 main proposals contained within the consultation:
I. introduce a normal margin structure and a Dynamic Guarantee Fund at HKSCC;
II. implement more aggressive price changes for stress testing;
III. modify the counterparty default parameters for stress testing; and
IV. improve the Reserve Fund collateral constraints at the SEOCH and HKCC
A press release issued by the exchange on July 8 cited Kevin King, HKEx’s Head of Risk Management. “The proposals reflect the changing dynamics of our markets and are vital to the strengthening of the risk management framework of our clearing houses.” He further went on to say “They also better reflect the risks associated with our market participants’ business activities.”
In the past decade there were two defaults borne by the CCP, Tai Wah Securities Limited in 2003 that lost HK$1.7 million and Lehman in 2008 recording a loss of HK$154.6 million. Are the changes far reaching enough? “The reforms are badly needed because the current level of clearing house guarantee funds is clearly inadequate” said Professor Jayanth R. Varma of the Indian Institute of Management. Bruno Campenon at BNP Paribas Securities Services agreed “Definitely, the reforms are much more dynamic and are reflective of what is happening in the market. “
In March 2011, IOSCO issued a consultative report “Principles for financial market infrastructures” intended to set a higher standard for the pillars of the capital markets. The report, containing 24 principle directives, including recommendations for central counterparties, is what the HKEx is striving to attain. Among them is adequate margining which the proposed Dynamic Guarantee Fund (DGF) hopes to achieve. As it stands, the HKSCC does not offer a comprehensive margin facility or a scalable Guarantee Fund structure potentially exposing the CCP to significant risk. The current Fixed Guarantee Fund has remained at HK$120 million since 1992 while turnover and market capitalization has grown by around 30 times over the years. “The design does address scalability” said Professor Varma when asked about the Dynamic Guarantee Fund. The size of the DGF would be derived from daily stress testing and will have no ceiling with counterparties required to pay a share reflective of their market exposure. Additionally, DGF contributions cannot be classified as liquid capital under the Financial Resource Rules of the SFC and they must be paid in three days down from the current seven days.
Smaller brokers, which Hong Kong has in abundance, will not be penalized under the new system. “Contributions are paid on the number of transactions traded not on the size of the company transacting them” added Robert Rooks, a Capital Markets Regulatory Consultant. A margin credit of HK$5 million will be given to every member leaving the burden of capital requirements on those who add risk to the market. Dr. Varma recognized that “The margin credit clearly benefits the small brokers.” Mr. Campenon opined on the margin credit” I think it sustains the growth for those players and it’s a move in the right direction”
Under the proposed stress testing overhaul, price movements will be changed to 22% from 20% and up to 25% for Hang Seng Index (HSI) derivatives. Assumptions on default parameters will also be changed. Currently, default is calculated as the higher of the single largest counterparty or a 30% loss making position. It is proposed to be revised to the default of the largest and fifth largest counterparty. Mr. Rooks believes the changes “will help to further underwrite Hong Kong’s position as a safe place to trade”. Under the IOSCO report “when conducting stress testing, a CCP should consider a wide range of relevant stress scenarios, including peak historic price”. Hong Kong had witnessed an all time high price change of 21.75% back in June 5, 1989 thus the proposed changes by the HKEX appear to be in line with IOSCO recommendations. Professor Varma would like to see more however saying “it’s a good first step, but more stringent assumptions need to be made over a period of time.”
The calculation of the Reserve Fund (RF) at both the HKCC and SEOCH is the remaining proposal under consideration. Because of the capital deficiency generated under the stress test revisions stated above a Risk Management Fund (RMF) is being considered that could be built up over time from resources provided by all stakeholders of Hong Kong’s financial industry. More immediately, an HKCC Contingent Advance is on the table through which the HKCC shares 50% of the daily Dynamic RF contribution with its counterparties where CPs are liable to pay in the event of a default. The changes to the RF at the SEOCH are intended to align itself closer to the practices of the HKSCC and HKCC. The biggest change will be that credit will be given to risk margin deposits and surplus funds in the daily RF calculation where none had existed before. The end result would see close to 90% of the SEOCH CPs having to pay less into the Dynamic RF.
If these proposals do indeed come to pass in Hong Kong the following financial resources will be required from the market:
• HK$1.4 billion margin daily increase to the HKSCC
• HK$1.1 billion daily increase of the HKSCC Dynamic Guarantee Fund
• HK$280 million daily increase of the HKCC Dynamic Reserve Fund
• HK$200 million daily decrease of the SEOCH Dynamic Reserve Fund
In addition, HKEx is proposing to set aside additional shareholder funds of HK$900 million to boost its support to the clearing houses’ Risk Management collateral on top of the current HK$3.1 billion. While these funds will come out of shareholder equity rather than industry capital “the clearing houses do need the third line of support” maintained Professor Varma.
The HKEx has taken a proactive approach to its role as counterparty rather than reactive in the event of a default it would have been unable to support as a CCP. The proposed clearing house risk management reforms appear to be fair, flexible and follow international standards. The final report is due in early 2012.