HKEx moves to introduce margins for cash clearing members

The Hong Kong Exchanges and Clearing (HKEx) plans to consult market participants this year about charging clearing members of its cash equity clearing house - which also clears exchange traded funds and structured products - an up-front margin as well as expanding the size of its guarantee fund to patch up holes in its risk management exposed by the default of Lehman Brothers in 2008.

In beefing up risk management of its cash equities clearing division, the Hong Kong Security Clearing Corp (HKSCC), the exchange is moving in step with other major exchanges in its bid to introduce margins. HKEx chief executive Charles Li said unlike their counterparts at derivatives clearing houses, cash equity clearing participants have not been traditionally charged an initial margin.

The HKEx will soon decide on a standard stress testing model for its HKSCC division, which will in turn help formulate a standardised formula based on which clearing members will be charged "either a margin or collateral" upfront. The stress testing model will also lead to a change in how clearing members contribute to a guarantee fund upon their admission. Currently, a direct clearing member is subject to a minimum HK$50,000 ($6,400) cash contribution per each exchange trading right it holds.

Until now, margin payments from members has been patchy. An interim measure triggered by the default of Lehman Brothers in September 2008 resulted in the HKEx charging selective clearing members a cash margin while others received a waiver. Those that had to post additional collateral were institutions deemed as having concentrated positions in highly volatile stocks, brokers with significant market share which raised concerns about systemic risks and clearing participants with assets tied to countries seriously affected by the global financial crisis.

Regardless of these interim measures, the impending consultation is poised to trigger intense debate within the city's broader brokerage community which, unlike dealers in the derivatives market, has not been used to the idea of paying an upfront margin or collateral before being allowed to put through clients' trading positions for trade confirmation, netting and settlement at the clearer.

The margin and guarantee fund overhaul for cash clearing has come in light of Lehman Brothers' collapse in September 2008, a default event which resulted in a loss of HK$155 million to the exchange from the closing-out and related expenses of Lehman Brothers Securities Asia (LBSA), a clearing participant at the HKSCC.

The loss was incurred by the exchange's cash clearing division due to the Securities and Futures Commission, the city's securities watchdog, having issued a restriction notice on LBSA, prohibiting it from settling its outstanding positions recorded in HKSCC's securities clearing system. This was despite strong opposition from the board and management of HKEx.

This meant LBSA was declared a defaulter and, as the central clearer - the HKSCC provided a "guarantee of settlement" for all the exchange trades settled under its securities clearing system - the HKSCC had to close out all HK$3.5 billion of unsettled stock positions of clearing participants facing LBSA by facilitating opposite transactions to offset these positions. The loss was incurred because HKSCC had to fill a HK$2.5 billion funding gap in a very tight credit market at the time to fulfil its settlement obligations as the central counterparty.

The net result is that HKSCC's guarantee fund, which amounted to HK$400 million prior to Lehman's default - an amount Li believes was already small - has been further depleted to HK$245 million.

"Our risk management needs to be at a global standard, and we're not today," he said. "So we will consult the market, adopting a set of stress testing assumptions." He added that this is how losses are projected when something negative occurs, based on different ways of testing and that currently, with more conservative assumptions projected, more has to be set aside as guarantee funds.

Dynamic guarantee fund
Another source close to the exchange said that the example of the LBSA default has highlighted to HKEx management that any market risks incurred from the default from a clearing member is, essentially, "hidden" by the guarantee fund - hence there has been a concurrent drive by clearing houses in the region to overhaul their risk management measures afforded to their cash clearing units.

Li said HKEx plans to be receptive to the introduction of a ‘dynamic guarantee fund' - with its size positively correlated to market volatility. Therefore, the more volatile the market, the more clearing members - and the exchange itself - will contribute to the fund collectively.

Meanwhile, HKEx's derivatives clearing house, the Hong Kong Futures Exchange Clearing Corporation (HKCC), enjoyed a diverging fate from its cash clearing sister division in the aftermath of the Lehman Brothers default. The Securities and Futures Commission (SFC) permitted Lehman Brothers Futures Asia (LBFA) to take the action necessary to facilitate the closing and transferring out of existing futures and options contracts in Hong Kong Futures Exchange leading to clients' instructions being confirmed. LBFA closed part of its options and futures positions during a two-day period, and the HKCC stepped in to close out all remaining positions before market close on September 18.

The key difference compared with the worse-off consequence faced by the HKSCC was due to sufficient margin collateral being in place to cover the close-out costs of the LBFA default, thus no loss was incurred by HKCC. The HKEx said in its 2008 full year report that in accordance with its rules HKCC has refunded all surplus margin collateral to LBFA's provisional liquidator. As at end of 2008 the HKCC had a reserve fund of HK$578.85 million.