European banks stop clearing Korean won swaps at KRX

Fresh uncertainty over Esma's recognition of KRX's OTC clearing house

A stop-no-go sign

Doubts over European recognition of KRX's over-the-counter derivatives clearing house and the robustness of its risk management procedures are forcing European banks to reduce trading of Korean won interest rate swaps or move to non-standard products.

Korea launched its OTC clearing operation three months ago to meet a regulator-imposed deadline of June – one which was deemed too soon by many market participants. The decision by Korean regulators to mandate won interest rate swaps out to 10 years, at three month intervals, forced international banks to join up or face being frozen out of a large part of Korea's swaps market.

But while local regulators are mandating clearing, European authorities are more reluctant to approve KRX's efforts. On June 27 Commissioner Barnier announced his intent to propose that the European Commission grant third-country equivalence to five central counterparties (CCPs) in Asia: Japan, Singapore, Australia, Hong Kong and India. But Korea was left out and instead is understood to be part of a second group that will receive recognition at a later stage. Market sources say this now appears to be unlikely. The European Securities and Markets Authority (Esma) is tasked with assessing third party CCPs.

"We hear that Esma has concerns and may not recognise KRX," says a clearing source at a European bank. "We urged Esma to communicate this to KRX but as far as I know that is still the position. The application is on hold but we don't know why."

Esma declined to comment on individual applications by foreign CCPs.

The HanMag incident is still fresh in people's minds so we need reassurance through additional procedures and safeguards

If KRX was not approved by Esma it would create a major problem for European banks: if they fail to clear they would be in breach of local laws, yet if they do clear they would be liable to be sanctioned by Brussels.

A chief operating officer at a European bank in Hong Kong says that trading volumes have been very low for the mandated products especially by foreign banks. Banks are instead using tenors outside the prescribed range of Korean regulators and are also switching to forward starting swaps and non-deliverable swaps.

"KRX is still waiting to obtain Esma approval. A waiver by Esma has been extended until the end of this year but banks are not sure that recognition will be achieved and consequently they are trading non-eligible products," he says, adding that his bank has cleared only a "limited number" of trades.

KRX tells Asia Risk it has observed the trend by European banks to move away from the cleared market but insists that most of the market is still clearing. Foreign banks make up as much as a third of the Korean swaps market.

"We are aware of this and believe it has to do with Esma recognition still pending. As the result is uncertain for now we guess that some players are waiting for the result to be final before trading. Foreign banks, especially US banks with Seoul branches, have been clearing as they have no-action relief from the US regulator," says Hye-lin Han, OTC clearing, derivatives division at KRX.

Despite KRX's statements that a large part of the Korea market is clearing, volumes for the products designated by the regulators are believed to be in the region of 2,000 trades so far, with an average daily notional value of $2 million – small numbers given that 80 firms trade won swaps as direct members.

According to the European bank COO, firms are upset over the implementation process of the Korean authorities and are therefore withholding co-operation on clearing in protest. "Some banks are extremely annoyed – when Korea forced implementation in June the market was not ready and rules were not yet finalised but it was pushed through by Korean regulators so some banks just want to show their frustration by not participating," says the COO.

There is also continuing uncertainty over whether KRX has learnt lessons from the HanMag failure last December, which caused dealers to lose their default fund contribution following the default of a small Korean securities firm trading listed products. The clearing source says that close to a year later the Korean exchange has still not taken some basic steps to reassure dealers.

"The HanMag incident is still fresh in people's minds so we need reassurance through additional procedures and safeguards that something similar wouldn't be allowed to happen on the OTC side. The market has some concerns around KRX's OTC clearing service with some players choosing non-clearable trades or trading less.

"We would at least expect prior to launch that a CCP conducts a fire drill for assurance that the CCP and surviving members can manage a member default, safely immunising and auctioning a portfolio of trades. This has yet to be done in Korea," says the clearing source.

The European bank COO says that his institution also has some risk management concerns outstanding, including the fact that "KRX wants to bring in as many direct members as possible" and has allowed so many firms to be direct members including small securities firms "which has weakened the CCP".

He also believes that liquidity concerns pose a substantial risk due to the types of collateral being accepted by KRX for its OTC service.

"They have allowed equities to be pledged as collateral which is unique among major OTC clearing houses. It's surprising and risky as in a crisis situation the equity market is the first to take a hit and leading CCPs such as LCH.Clearnet are even looking to reduce the securities they accept rather than extending the list of eligible assets to better manage their liquidity risks as required by regulators."

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