Posts this month
A blog on financial markets and their regulation
Last month, the Hong Kong Exchanges and Clearing Limited (HKEx) released a 73 page consultation paper on risk management reforms at the clearing house. Now, HKEx is nobody’s idea of best practices in risk management – this was after all the clearing house that needed a government bail out after the crash of 1987. Even today, the cash equities market of HKEx collects only mark to market margins and not initial margins – only the futures market collects initial margins. But, the HKEx consultation paper goes far beyond what most other exchanges have done and provides much needed transparency on the issue of clearing corporation risk management.
I have long argued that the international standards (the CPSS-IOSCO Recommendations for Central Counterparties, 2004) issued jointly by the BIS Committee on Payment Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) are woefully inadequate. They only allow even the worst run clearing houses to claim to be compliant with global standards. Even the consultative report issued by CPSS-IOSCO earlier this year still falls well short of what is needed for such a systemically important entity as a clearing house.
What HKEx has done is to (a) explain (and strengthen) its stress testing procedures, (b) publicly admit that its guarantee fund is inadequate and (c) set out the process by which this guarantee fund will be built up to acceptable levels.
HKEx also states clearly that while some exchanges treat “margins” as a pooled resource, HKEx does not want to go down that path. It wants only the contributions to the guarantee fund to operate as a pooled resource. In other words, in case of a default, the exchange will have access to the margins of the defaulting member and the guarantee fund contributions of both defaulting and non defaulting members, but not the margins of the non defaulting members. Some exchanges are permitted under their bylaws to use even the margins of the non defaulting members. I believe that the HKEx is right in taking this “non-pooled upfront margin + pooled default fund” approach. In practice, if an exchange taps the margins of the non defaulting members, the market place would regard it as a default by the clearing house regardless of what the bylaws might say.
In conformity with Hong Kong’s well known plutocratic traditions, HKEx proposes:
To ensure long term sustainability and scalability of funding to support these changes and to mitigate any higher funding requirements for CPs that may detract from the markets’ competitiveness, we are keen to work with the HKSAR Government and the regulator in establishing a RMF which is funded by the SFC, HKEx and the market in equal proportion. The model is based on the principle that all key stakeholders, including the market players, the CCP and the regulator will support the stability of the securities and derivatives markets.
While reformers are struggling to avoid having to bail out the finance industry when things go badly wrong, HKEx is seeking a bailout in advance. We can see very clearly the moral hazard created by the 1987 bail out of HKEx.