OTC Clearing In Asia: Under Construction
There are important differences among countries, however, reflecting the characteristics of the local market and the priorities of the local regulator. In this article, we describe progress towards OTC clearing in three jurisdictions that are relatively far along in the process—Japan, Singapore and Hong Kong.
Japan expects to begin offering clearing in October for its interest rate swaps market, the largest in the region. Singapore already has begun clearing interest rate swaps and is hoping to capitalize on certain comparative advantages to attract business. Hong Kong is leveraging its proximity to China to carve out a niche as the center for clearing derivatives denominated in renminbi.
Japan: IRS Clearing by October
Japan in some respects has made the most progress of all the countries in the Asia-Pacific region. Legislation mandating central clearing was enacted in May 2010, before both the U.S. and Europe. The Japan Securities Clearing Corporation has begun clearing credit default swaps and expects to begin clearing interest rate swaps in October.
Rather than building a new clearinghouse from scratch, Japan’s dealers coalesced around the JSCC, a clearinghouse owned by the Tokyo Stock Exchange that serves the cash equities and corporate bond markets as well as the TSE’s futures and options markets.
After extensive consultation with dealers, the JSCC launched clearing in July 2011 for its first set of OTC derivatives: five-year credit default swaps based on the iTraxx Japan index of 50 investment-grade Japanese corporations. Markit, the owner of the iTraxx indices, provides the pricing data, and Calypso Technology, a specialist software provider, provides the technology that JSCC is using to manage the clearing service. Trades are submitted after they are matched on DerivServ, a service maintained by the New York-based Depository Trust and Clearing Corporation that is widely used among dealers.
The JSCC’s CDS clearing service has not been very active so far. As of year-end 2011, the clearinghouse had cleared only 96 transactions worth 128.68 billion yen in notional value ($1.58 billion). Part of the reason is that only five entities have signed up as clearing members: Daiwa Securities Capital Markets; Mitsubishi UFJ Morgan Stanley Securities; Mizuho Securities; Morgan Stanley MUFG Securities; and Nomura Securities.
Next up are interest rate swaps, a much bigger prize. Interest rate swaps account for 73.5% of the total OTC market in Japan, and approximately half of the entire region’s interest rate swaps market, according to estimates from the International Swaps and Derivatives Association.
JSCC has been discussing its plans with regulators and swap dealers and is on track to start clearing “plain vanilla” yen-denominated swaps in October. According to a detailed plan recently published by JSCC, the clearinghouse plans to accept yen-denominated interest rate swaps referencing three-month and six-month yen Libor, with durations of up to 40 years. Margins will be determined by using a scaled historical value-at-risk methodology. Members will be able to post cash, Japanese government bonds and U.S. Treasuries as collateral.
About six months after the initial launch, JSCC plans to expand the range of clearable contracts to include interest rate swaps referencing one-month Libor and six-month Tibor. Clearing initially will be limited to trades involving clearinghouse members and their affiliates, but JSCC intends to begin offering true client clearing about a year after launch.
One big issue ahead is whether the JSCC will be the only option for clearing in the Japanese interest rate swaps market. Japan’s Financial Services Agency has been meeting with market participants as it prepares the regulations that will implement the clearing mandate, and several industry sources said the FSA is leaning towards a domestic-only requirement for some portion of the market.
That poses an issue for global dealers. Many of them already have begun using LCH.Clearnet for their yen-denominated interest rate swaps and would like to continue. As of mid-February, LCH.Clearnet had cleared 158,000 yen-denominated interest rate swaps with a notional value of 2,903 trillion yen ($35.7 trillion). Virtually all the major dealers are members, including two Japanese banks—Mitsubishi UFJ and Nomura.
The position of the global dealers was spelled out by ISDA in a September letter to the FSA. The association agreed that purely domestic transactions should be cleared onshore, but urged the FSA to allow counterparties to cross-border transactions to have some choice in where they clear their transactions. In practical terms, this would allow a yen-based swap between a European bank and a foreign branch of a Japanese bank to be cleared at an offshore clearinghouse, provided that the clearinghouse meets Japanese standards. ISDA estimated that 58% of the Japanese swap market would be subject to the FSA’s clearing mandate, but only 19% of the transactions would fall into the category of “must be cleared onshore” because both booking parties are located onshore.
The most recent development came at the end of December, when the FSA held a meeting with market participants to discuss progress towards meeting the G-20 goals. According to a summary issued by the FSA, the clearing mandate initially will apply only to swap dealers with a “significant” amount of business in clearing-eligible yen-denominated swaps. The summary was silent on whether those firms would be able to use an offshore clearinghouse such as LCH.Clearnet to meet that requirement.
The FSA also said that it will establish a regulatory framework for the use of electronic trading platforms for OTC derivatives. That is a departure from trends elsewhere in the region; most other regulators are concentrating on just clearing and reporting. The FSA explained that electronic trading platforms for swaps would give regulators more oversight of the market, improve price transparency, promote straight-through processes, and improve the market’s resiliency in financial crises. The FSA noted, however, that actual implementation could take up to three years and will be limited initially to inter-dealer trading in plain vanilla interest rate swaps.
Singapore: Pragmatic Approach
While Japan was the first to begin implementing the G-20 reforms, Singapore has made the most progress in terms of actual clearing activity. The Singapore Exchange began clearing commodity derivatives in 2006 (see “The Many Flavors of OTC Clearing” in the June 2009 issue of Futures Industry). In November 2010 SGX introduced clearing for interest rate swaps denominated in Singapore and U.S. dollars, and in November 2011 it added non-deliverable forwards, a type of currency derivative, in seven currency pairs.
SGX’s clearing service for interest rate swaps and NDFs is based on a different platform than what it uses for traditional futures and options. The membership criteria are more strict; only banks licensed in Singapore with at least one billion Singapore dollars in capital are eligible. And the technology comes from a different provider; SGX uses the Secur system developed by Nasdaq OMX for listed derivatives and commodity swaps, but uses Calypso for interest rate swaps and NDFs.
Trades are submitted to the clearinghouse via approved third-party trade registration systems, such as MarkitWire for interest rate swaps and Thomson Reuters for NDFs. To calculate margin, SGX uses a historical simulation Value-at-Risk methodology. Each clearing member’s exposure is marked-to-market three times a day and margin requirements adjusted accordingly. Clearing fund contributions are set at a minimum of $10 million.
Although the use of the service is voluntary—the Singapore authorities have not yet implemented a clearing mandate—11 banks have signed up as clearing members for interest rate swaps. Of this group, three are local banks and the rest are based in Europe, Japan and the U.S. As of the end of 2011, $186 billion in notional value of interest rate swaps had been cleared since launch, not an especially large number in the OTC derivatives world but more than any other clearinghouse in the region.
SGX Clearing Members for OTC Financial Derivatives
• Barclays Bank PLC
•Credit Suisse AG
•DBS Bank Limited
•Deutsche Bank AG
•The Hong Kong and Shanghai Banking Corporation Limited
•The Royal Bank of Scotland PLC
•Standard Chartered BankUnited Overseas Bank Limited
Industry reactions are mixed. Some clearing firms that have joined the SGX initiative commented that they saw it more as an obligation than an opportunity, while others said they are actively preparing to use the service.
One example of the latter is Royal Bank of Scotland, which is planning to clear its Asian NDF business through SGX. RBS officials explained that they see clearing as an important complement to their FX prime brokerage business in Asia, and intend to use SGX because it offers clearing in a wider range of Asian currencies than LCH.Clearnet.
SGX currently offers NDF clearing in seven Asian currencies: Chinese renminbi, Indian rupee, Indonesian rupiah, Korean won, Malaysian ringgit, Philippine peso, and Taiwan dollar. (LCH.Clearnet offers clearing for NDFs in only three Asian currencies.) SGX will accept NDFs with a term of up to one year and 10 days, which captures most of the commonly traded instruments in the market, according to one industry source.
That points to one of Singapore’s comparative advantages. There is a sizeable amount of NDF trading in Asia, and many of the leading brokers use Singapore as the hub for their trading desks. Using the local clearinghouse is a logical extension of that trading activity.
Another comparative advantage is the appeal to Singapore banks that cannot or do not want to join the global clearinghouses. For local banks like DBS, OCBC and UOB, the ability to offer interest rate swaps is an important part of their corporate banking business. The Singaporean banks also are important players in the currency market, particularly as counterparties for local banks in other countries in the region. One industry source commented that the economics of clearing at SGX will look especially attractive for these banks when the Basel 3 capital requirements take effect. This will require banks to set aside more capital for OTC derivatives that are not cleared.
Meanwhile, the Monetary Authority of Singapore is working on regulations that will implement the mandatory clearing and reporting provisions agreed to by the G-20. In mid-February, the MAS issued a consultation paper on the regulatory oversight of the over-the-counter derivatives market in Singapore. The proposed regulatory regime will cover both financial and commodity derivatives and includes provisions requiring the use of clearinghouses and trade repositories as well as rules for market operators, clearing facilities, trade repositories and market intermediaries.
In terms of who will be required to clear their OTC trades, the MAS proposal is fairly broad. The consultation paper proposes that the clearing obligation will apply to all contracts with at least one leg booked in Singapore and with at least one counterparty present in Singapore.
On the other hand, the regulator did not propose that all trades subject to the clearing mandate should be cleared by the local clearinghouse. The MAS said such an approach would have a number of negative consequences, including limiting choices for market participants and the “fragmentation of liquidity.” The MAS also said that such an approach would reduce netting benefits and increase costs for financial institutions currently clearing with foreign clearinghouses. The MAS instead proposed a mutual recognition framework under which foreign clearinghouses could apply for authorization to offer their services in Singapore.
To determine which OTC derivatives should be subject to the clearing mandate, the MAS proposal said it would look at such factors as potential for systemic risk, degree of standardization, depth and liquidity of the market, availability of pricing data, the clearinghouse’s risk management capabilities, and the “international regulatory approach” to that type of contract. The MAS tentatively identified two types of products as fulfilling these criteria—interest rate swaps denominated in Singapore and U.S. dollars and NDFs in Asian currencies.
Another interesting feature of the MAS consultation is that it does not propose mandatory trading on electronic platforms or exchanges. The MAS acknowledged that the G-20 declaration called for such a requirement where appropriate, but said it is talking with the industry on the potential costs and benefits and taking into consideration the characteristics of the OTC derivatives market in Singapore. The MAS also said it will continue to work with the industry to “encourage” trading of OTC derivatives on organized platforms.
Hong Kong: The Gateway Strategy
In Hong Kong, regulatory and commercial initiatives are advancing rapidly. The Hong Kong authorities—the Hong Kong Monetary Authority and the Securities and Futures Commission—issued a joint consultation paper in October laying out their vision for the regulatory framework, while Hong Kong Exchanges and Clearing is busy constructing an OTC clearing service.
As in Singapore, the focus is on interest rate swaps and NDFs. The key difference is the linkage to Hong Kong’s status as the offshore center for renminbi. The Chinese government is using Hong Kong as the testing ground for its long-term strategy of making the Chinese currency fully convertible. As a result, HKEX and its regulators are particularly focused on the clearing of derivatives based on renminbi.
In their consultation paper, the HKMA and the SFC proposed allowing overseas clearinghouses to register with the local authorities and provide their clearing services in Hong Kong. On the other hand, they also asked for comment on whether only domestic clearinghouses should be designated for products with “systemic importance.”
“Our initial thinking was that such a restriction may not be necessary” and could lead to a “proliferation of CCPs” that would fragment the market and reduce liquidity, they said in the consultation. “However, more recently, concerns have been raised about permitting overseas CCPs to clear transactions in domestic products that are of systemic importance.” The regulators pointed in particular to concerns raised by regulators in Australia and Japan about the potential macroeconomic implications if systemically important products are cleared offshore.
HKEX, in its response to the consultation, agreed that OTC derivatives with systemic importance to the Hong Kong financial system should be subject to an onshore clearing requirement. HKEX explained that a financial institution subject to the new regulatory framework should be required to use a Hong Kong clearinghouse to clear renminbi-denominated interest rate swaps or renminbi forwards.
Taking the opposite side was the Managed Funds Association, a Washington-based group that represents hedge funds and commodity trading advisors. In its response to the consultation, the MFA warned that if the HKMA and SFC do not permit foreign clearinghouses to become designated CCPs, the derivatives market could become fragmented along jurisdictional lines. That could cause “significant harm” to the markets, MFA said, by impeding competition, impairing portability and interoperability, limiting participant access to clearing, and ultimately creating “artificial barriers” across a global marketplace and instrument type.
Another important feature of the proposed regulations is that the clearing requirement would apply not only to trades that are booked to a financial institution in Hong Kong but also to trades that are “originated or executed” by a financial institution in Hong Kong. The regulators explained that much of the OTC derivatives activity in Hong Kong is not booked in Hong Kong. Instead the Hong Kong arm in most cases is the sales desk or trading desk, rather than the ultimate counterparty. Consequently, a clearing mandate would not be effective, they said, if it applies only to counterparties.
Another key characteristic of the emerging regime in Hong Kong is the concept of a “threshold” for determining what should be cleared. A market participant whose swaps trading is below this threshold would not be subject to the clearing requirement. The Hong Kong regulators said in their consultation paper that this would ease the cost burden on less active players. But organizations such as the MFA point out that this will be difficult to implement, given that a firm’s outstanding swaps can fluctuate significantly from month to month.
The Hong Kong regulators are now digesting the responses to the October consultation and preparing to issue another more detailed consultation in the first quarter that will set out the details of the mandatory obligations, such as to whom the obligations apply, the types of transactions that are covered, the manner in which the obligations must be fulfilled, and the procedures for designation as an authorized clearinghouse. HKMA officials have said that they are “tentatively” targeting January 2013 for the new regulations, with a six-month grace period before banks and other financial institutions have to comply with the mandatory clearing requirements.
Meanwhile, HKEX is moving forward with its plans to build a new clearinghouse for OTC derivatives. The new clearinghouse will support interest rate swaps and NDFs in the initial phase, with OTC equity derivatives and other asset classes under consideration. HKEX officials said the exchange recognizes that the processing of OTC derivatives is more complex than the futures and options that it now clears, and for that reason it has contracted with Calypso for a new clearing and risk management platform for these products. By the middle of 2012, it expects to begin testing the new system with market participants.
Although the clearing landscape in Asia-Pacific is far from finished, a number of leading clearing firms are moving now to build an OTC clearing service for Asian clients. Executives at several major clearing firms said they are bringing additional staff into the region, assessing the risks and rewards of joining various clearing initiatives, talking with clients about margin requirements and clearinghouse rules, and generally preparing for the introduction of OTC clearing.
For example, Christopher Perkins, global head of OTC clearing at Citi, has been crisscrossing the region over the last several months, meeting with customers and regulators. Citi has cleared several interest rate swaps on behalf of Asia-Pacific customers through LCH.Clearnet and CME Group and expects the business to pick up considerably this year as clients grow more familiar with the process.
In February, the firm assigned Hiro Matsuki, a member of its prime finance team in Japan, to lead the origination of new clearing business in Japan for both listed and OTC derivatives. Perkins said Matsuki’s primary role is to provide hedge funds and other Japanese clients with access to central clearing in the U.S. and Europe as well as Japan once the local solution comes online. Citi also has added people to the OTC clearing team in Australia led by Ian Nissen and has established a hub in Singapore for the processing of cleared OTC trades.
Perkins says Citi sees the region as “strategically important” even though the size of the business is much less than in the U.S. or Europe. He is wary, however, about the risks of joining too many clearinghouses in the region. Partly that is driven by commercial considerations, but more importantly he is concerned about the potential risk to the bank itself. “We cannot be subject to unlimited liability through our membership in a clearinghouse,” he explained. “We are working with regulators, industry peers and clients to ensure that the clearing solutions take into account our need as clearing members to limit our liability in case of a default.”
Another key issue is fragmentation. In addition to Japan, Singapore and Hong Kong, there are numerous other clearing initiatives under way around the region. The Korea Exchange is working on plans to establish clearing for interest rate swaps later this year. Australia’s regulators have issued a consultation paper on the regulation of OTC derivatives. China’s central bank has established a clearinghouse in Shanghai for OTC derivatives. And the Clearing Corporation of India is targeting currency forwards and interest rate swaps.
The proliferation of new clearing solutions raises a simple question: Is there enough business to support all of these services? According to ISDA, the entire region accounts for less than 8% of the global market in OTC swaps. International swap dealers and clearing firms are urging regulators to allow them to use global clearinghouses such as LCH.Clearnet and CME. They claim that this is vastly more efficient from a margin perspective and greatly reduces the operational costs of running a clearing business across the region.
The regulators have other concerns, however. Their main responsibility is to protect against systemic risk and economic instability. If they allow risk exposures in the local currency to be cleared at an offshore clearinghouse, that could undermine their ability to monitor the local market and the financial condition of local market participants. In addition, if positions and collateral are held in a different jurisdiction, that could make it more difficult for local regulators to recover customer funds in case of a default.
How this issue is resolved is likely to vary by country. There is not much time; most of the regulators say they are trying to comply with the 2012 deadline set by the G-20 leaders back in 2009. The regulators say they are well aware of the cost issue and expect that in the early stages only the most plain vanilla types of products will be subject to a clearing mandate. Even so, it seems very likely that the OTC clearing business will be divided up among multiple jurisdictions. Mutual recognition could be a way forward, but it remains to be seen if that will be adopted in practice.
Will Acworth is the editor of Futures Industry magazine. firstname.lastname@example.org