Clearing house of the year: HKEX and Shanghai Clearing House

Asia Risk Awards 2023

Glenda So, HKEX

Swap Connect, the latest pioneering innovation in the Hong Kong-Mainland China Connect Story, took many years of work to bring to fruition. But the scheme is expected to make a vital contribution to the development of China’s fixed-income market for many more years to come.

Swap Connect is a joint initiative between Hong Kong Exchanges and Clearing Limited (HKEX) and Shanghai Clearing House (SHCH), with China Foreign Exchange Trade Systems (Cfets) overseeing the trading infrastructure.

The scheme allows foreign investors, for the first time, to tap the onshore renminbi (CNY) interest rate swap market while remaining offshore. This makes it easier for foreign investors to hedge their CNY bond holding, since onshore CNY swaps offer better liquidity and pricing than tends to be available in the offshore CNY non-deliverable interest rate swap market.

It’s fair to say that Swap Connect’s launch on May 15 generated much excitement among dealers. The markets head of one international bank says Swap Connect is “definitely going down in the history books” while a trading head at another bank describes it as “a hugely important innovation”.

“The launch of Swap Connect marks another significant milestone in the opening-up of China’s financial markets, facilitating China’s integration into the global financial market,” says Jacky Mak, head of fixed income and currency product development at HKEX OTC Clear. “By providing offshore investors with a one-stop clearing and settlement service for investing in onshore CHY interest rate derivative products, Swap Connect raises the efficiency and level of financial market connectivity between the Mainland and the rest of the world, so as to constantly inject new vitality and momentum into deepening reform and opening-up of financial markets in the Mainland.”

Swap Connect has arrived at a time when foreign investment flows into mainland China’s bond market have been challenged by central bank interest rate divergence. With the US Federal Reserve hiking rates and the People’s Bank of China keeping rates low, foreign investment began to drop off in 2022, which has naturally had a dampening effect on foreign investors’ CNY interest rate hedging needs.

But Mak is nevertheless happy with the traction Swap Connect has been getting with investors so far. The first day of trading on Swap Connect saw a notional value of 8.3 billion yuan in swaps traded by 27 institutions, including both offshore banks and asset managers, according to figures published by Cfets.

Clearing brokers at HKEX are also reporting increased interest from investment firms in signing clearing brokerage agreements since details of Swap Connect entered the public domain.

“Since launch, Swap Connect has seen great progress and good volumes, the onshore market is adapting to the needs of international investors and their practices in some areas,” says Leilei Cheng, head of product development department at Shanghai Clearing House.

Glenda So, group head of emerging business and FIC, at HKEX, adds that Swap Connect is a natural next step after the success of the Bond Connect scheme. 

“At HKEX, we are committed to the continued development of our landmark market connectivity programmes that link the Hong Kong and Mainland Chinese markets. Building on the success of Bond Connect, which has facilitated international investors’ access to the Mainland bond markets, we are proud to introduce Swap Connect as the next phase of development, connecting capital with opportunities.”

“Through Swap Connect, global investors can trade Chinese onshore interest rate swaps and have the trades cleared and settled using Hong Kong’s internationally-recognised post-trade infrastructure,” she adds. “This will enable investors to better manage their exposure to Mainland China’s bond market, and will further support international participation in the Mainland’s capital markets.”

Innovating in OTC clearing

Teams at both HKEX and SHCH spent more than two years trying to work out how they could help offshore investors access to CNY swaps onshore without forcing them to change the way they traded.

The solution arrived at was a highly novel interoperability arrangement between HKEX and Shanghai Clearing House – a connectivity design that has never before been undertaken between two derivatives clearing houses.

 “SHCH provides clearing services to onshore investors while OTC Clear provides clearing services offshore investors,” says Cheng. “Each clearing house has a distinct role and needs to comply with International Organization of Securities Commissions standards and exchange financial resources against default risk.”

While HKEX already has a significant amount of experience launching other market access programmes – chiefly Stock Connect, Bond Connect and ETF Connect – there were some particular complexities that partners had to grapple with when setting up an equivalent scheme for cleared interest rate swaps.

One challenge that arose concerned the maintenance margin that must be posted against multi-year trades. This resulted in the introduction of a ‘lockbox’ structure, in which each clearing house would contribute 50% of the inter-CCP margin amount. The HKEX OTC Clear (OTCC) contribution to this pool is funded through deposits by clearing members, known as participating margin, or PM. In trades executed through client clearing, clients are typically expected to stump up for the PM.

There remains some still unresolved technical challenge for users of Swap Connect, however. One of these concerns the unwinding of trades.

Unlike in many other markets, Swap Connect does not allow for so-called broken-dated swaps, and all trades must be put on at yearly intervals. For example, while traders can enter a 10-year swap, a swap that has a duration of nine years and six months is not allowed.

This can make it tricky to perfectly close out some positions. For instance, if an investor puts on a 10-year swap and then wants to unwind that trade after six months, then they would need to execute a nine-year and six-month swap in the opposite direction to do so. Since such broken-dated trades are not allowed, in this particular example the cashflows would not quite match.

The ability to unwind trades is understood to be one Swap Connect enhancement to the scheme that both banks and real money investors in the offshore market are keen to see in the future. These firms are known to like the freedom to be able to trade in and out of positions when they need to, as they are used to doing in the offshore swap market.

Mak says HKEX and Shanghai Clearing House are still exploring various enhancements to Swap Connect, however. He adds there are a lot of opportunities for Swap Connect to develop further and for the market to leverage off the platform to develop a whole suite of new products.

“We are seeing strong market appetite and hearing lots of proposals for further expansion and new products, and we are working closely with market participants and our stakeholders to see how we can make further enhancements to the Swap Connect programme,” says Cheng.

HKEX’s Mak adds that SHCH and OTC Clear are committed to further developing Swap Connect to deliver reliable and efficient clearing and settlement services for overseas investors to access the Mainland interbank IRS market.

“We will closely collaborate with various business partners to continuously expand product categories, optimise business functions, improve service systems and efficiency, and jointly promote Swap Connect to better service onshore and offshore investors’ needs, contributing to the high-quality opening-up of China’s financial market.”