Korea trading error prompts global clearing house review

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After HanMag Securities caused $45 million of losses in December by submitting a series of incorrect trades at Korea Exchange's (KRX) listed derivatives service, triggering the use of non-defaulting members' default funds under KRX's rules, the Futures Industry Association (FIA) plans to review the waterfall structure at every clearing house globally.

For the first time in recent history, non-defaulting members were asked to top up millions of dollars in default fund contributions through no fault of their own after a Korean securities company botched its trading strategy.

Bill Herder, executive director at the FIA Asia, says that "it's a scary situation" and that a number of FIA members were caught up in the incident but he points out that Korea acted within its own rules. He also says that the incident has prompted a major examination of clearing houses.

"We are going through an extensive global review of all clearing houses including whether the waterfall makes provision for clearing house skin in the game. To the best of my recollection, the non-defaulting members' default fund has never been hit until now," he says.

Under the CPSS-Iosco principles for financial market infrastructure, when a loss occurs at a clearing house a structure is in place that sees defaulting members' initial margin used up first and if the loss is still not covered, the defaulting members' default fund is depleted. At this point clearing house capital is used – known as skin in the game. If this is still insufficient to cover the losses, a non-defaulting member's default fund is called upon.

However, KRX's risk waterfall structure departs from the international standard by putting non-defaulting members' funds at risk before its own capital. In contrast, when MF Global defaulted the Chicago Mercantile Exchange backed everything in excess of losses not covered by MF Global.

"There is some confusion about how KRX is structured as defaulting members were affected before they should have been and losses were mutualised across all clearing members which is contrary to the international standard," says a Hong Kong-based clearing source.

Clearing members are angry because KRX did not have adequate circuit breakers or risk limits in place when the incident took place. KRX has 60 members who contribute to a default fund of 200 billion won ($190 million). The bigger members contribute more to the fund and after the HanMag incident several securities houses lost around $1.5 million.

Herder says the industry is concerned that other clearing houses may also have a structure that doesn't conform to the international standard. "Major exchanges in Asia do have skin in the game but smaller exchanges and clearing houses are currently an unknown and may be considered riskier. From a global viewpoint, [KRX] may be a small fish in a big pond but when they blow up it's a big deal," says Herder.

Baeyoung Kim, senior vice-president and head of the derivatives regulation team at KRX, says that after meetings with aggrieved member firms, KRX may change its risk waterfall structure.

We are going through an extensive global review of all clearing houses

"We are considering changing our internal processes because of the HanMag incident. Member firms asked us to change our waterfall structure so our clearing and settlement department is looking into this. OTC clearing is already implemented according to global standards especially on the default waterfall process and we are positively looking to change this for listed clearing and are in discussions with the government," he says.

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