Clearing cross-currency swaps is not an easy thing to do. If it were, many more central counterparties (CCPs) would already be doing it. But so far only one – the Hong Kong Exchange – has rolled out a comprehensive solution for clearing these kinds of derivatives trades, and this is why the exchange wins this year’s Asia Risk award for Clearing House of the Year.
The main challenge in clearing foreign exchange derivatives is managing the settlement risk: the danger that one counterparty exchanges its side of the transaction but the other player doesn’t. HKEX’s OTC Clear system gets around this problem by leveraging off the Real Time Gross Settlement system operated by the Hong Kong Monetary Authority.
“RTGS gives us the capability to clear and settle products denominated in offshore renminbi using a payment-versus-payment arrangement,” says Calvin Tai, head of global clearing at the exchange. “The payment to a counterparty will only go through once the payment has come in from the other side. This isn’t just mitigating counterparty risk, it is eliminating it altogether.”
OTC Clear was launched at the end of 2013, but Tai says it was hard to get members to sign up to the new venture at first.
“We needed to come up with a proposition that was attractive enough for banks to make the effort – not just at the local branch or the local office, but also at headquarters – to join us as a member, and that was a very difficult exercise,” says Tai. “International banks don’t see an imminent need to come to us for clearing, so we needed to demonstrate how we can put them and the mainland banks together.”
Clearing of cross-currency swaps was launched in August last year, and the volumes now going through the exchange speak for themselves. A year ago, OTC Clear was clearing notional trades amounting to less than $1 billion per quarter, while this year cleared volumes have been four times that amount.
One initial complaint about the new system has been the limit on how much notional each bank can clear per day, largely because of liquidity constraints at the exchange. When the service was first launched, this was just $50 million per bank per day, whereas many large players trade daily notional of up to $100 million. However, HKEX was quick to recognise this limitation and worked hard to improve capacity, with the cap now standing at $90 million (and this may yet be increased further).
Two member banks – ICBC and Standard Chartered – currently provide the liquidity backstops for the exchange, but OTC Clear is hoping to sign up more banks as liquidity providers in the coming months, which could either allow it to increase the trading limit further or to extend its clearing service to new currency pairs. HKEX is currently exploring the possibility of clearing swaps between the Hong Kong dollar and the US dollar.
HKEX’s decision to launch cross-currency swaps was a farsighted move that other CCPs around the world are now trying to emulate. It was particularly prescient given that, unlike interest rate swaps, cross-currency swaps are not subject to initial margin (IM) requirements when trading bilaterally, although there may be some exchange of collateral depending on the counterparty arrangement. The drivers for clearing cross-currency swaps are therefore different from interest rate swaps, meaning OTC Clear has really had to demonstrate the cost savings in using its service. To this end, HKEX has engaged an external consultant to properly analyse the cost benefit of clearing cross-currency swaps as opposed to trading them bilaterally.
“Deal-by-deal, bilateral IM will be lower than CCP IM, but it doesn’t make any differences at portfolio level due to multilateral netting achieved through central clearing. In addition, there is a huge saving in capital cost in the cleared world because credit valuation adjustment has to be calculated in the bilateral world and the risk weights can be quite high, especially in the absence of Isda credit support annex agreements and the ability to net off capital. That’s why it’s economical to clear cross-currency swaps when both margin and capital cost are taken into consideration,” says Jacky Mak, head of OTC clearing at the exchange.
Those that have started clearing their cross-currency swaps through HKEX appreciate the cost savings. One head of RMB trading at a global bank says they have been able to reduce their capital charge by $40 million by going through OTC Clear rather than doing things bilaterally.
“If we didn’t participate in OTC Clear, then we would need to add on a lot of XVA, and that would be a huge extra cost,” he says. “It’s all about competitiveness: if we weren’t using the service then we would not be able to price in the same way as other members that do.”
Mainland banks recognise the value OTC Clear brings in terms of connecting them to the global banking network. “Most counterparties treat China as a non-netting jurisdiction and so often don’t want to sign credit support annexes with our bank. This makes it hard for us to hedge our risk using cross-currency swaps,” says a senior manager at one Chinese bank. “If we go through the clearing house, this is so much better for a foreign bank that wants to do transactions with us.”
Given the growing internalisation of the renminbi, being able to connect China with international markets is an important value proposition from OTC Clear.
“This all fits into the wider role we want to play in helping China open up,” says Tai. “Just as we did with [the role we played in] Stock Connect, we are helping build that bridge between Chinese and international markets.”