Regional clearing houses push for third-country equivalence

Clearing houses across Asia have been working to meet global standards for CCPs in order to make themselves eligible for non-domestic trade flow. This article looks at how three clearing houses – in China, India and Korea – have upgraded their infrastructure to enable them to start clearing OTC derivatives

Just four months ago Asia's smaller clearing houses – those in China, India and Korea – were like a series of unfinished stadiums in the lead-up to hosting a major international sporting event with the participants fretting about the risk of injury caused by playing in an incomplete infrastructure.

Dealers at foreign banks were expressing concerns about systems and processes not meeting international standards, the capital costs being punitive and a lack of recognition from European and US regulators. But to their credit Asia's central counterparties (CCPs) have confounded the naysayers and are ready for mandated clearing.

On June 2, India kicked off with mandated foreign exchange forward clearing at Clearing Corporation of India. Korea followed on June 30, when the Korea Exchange launched mandatory clearing for won interest rate swaps (IRS). And next came Shanghai Clearing House with the mandatory clearing of renminbi IRS on July 1.

The over-the-counter derivatives markets in the six emerging Asian economies – China, India, Indonesia, Malaysia, South Korea and Taiwan – are limited in size and scope. The economies of these six states accounted for 61% of Asia's total GDP, 68% of its international trade, and 57% of the region's equity trading in Asia in 2012, but their share of OTC derivatives turnover was less than 10%, according to data from Celent. OTC derivatives trading volume in these countries reached $29.1 trillion in 2012 with South Korea leading the pack in terms of trading volume, followed by India and China (see chart).

For economies with smaller derivatives markets, the Group of 20 commitment to clear all standardised derivatives may not have been a big priority but many have taken the task very seriously as part of a push to develop national financial centres.

Asian CCPs have set great store on meeting the CPSS-Iosco principles for financial market infrastructure (PFMI). The challenge, however, has been less the PFMI than the unwillingness of the US and Europe to rely solely on the determinations of national authorities that their clearing houses are compliant with the PFMI. Instead, Europe has a complex approval process for recognition of third-country CCPs and the US requires countries to apply to become a derivatives clearing organisation, or DCO, before US banks are permitted to clear at any CCP.

Foreign intervention

For China, India and Korea, international banks constitute at least a third of the swaps business, making their participation crucial to the future success of their CCPs. But until recently there was uncertainty over whether international banks would be able to participate.

Several jurisdictions in Asia including Hong Kong, Singapore, Korea and India applied for recognition from the European Securities and Markets Authority (Esma) back in September 2013 but no determinations have yet been made.

Esma has 180 working days from when a complete application is submitted to make a determination. According to Terry Yang, senior associate at Clifford Chance in Hong Kong, it can extend the process by not accepting the application as completed, or by asking for more documents or information to support the application, which has the effect of delaying the time when the 180 days starts ticking.

"Korea Exchange is on the list of CCPs that have applied for recognition but we understand that Korea will not be among the first wave of jurisdictions which will be recognised as equivalent for regulation of CCPs by the European Commission on July 1 so it still has some work to do.

"At present it is in transitional relief under the European Market Infrastructure Regulation (Emir) and as the transitional deadline for Europe's Capital Requirements Regulation – in relation to collateral requirements for CCPs – is pushed back until December, it is a cautious business as usual for European banks to join or use the clearing house. However, if KRX's application is rejected then European banks would face a couple of problems that would effectively prevent them from joining and would probably require them to stop or curtail using its clearing service."

Ik Jun Lee, senior manager for OTC clearing and settlement at KRX in Seoul, is less concerned, however. "There remains a possibility of not being recognised but we are sure that that risk has reduced a lot," he says. KRX has also been granted no-action relief until December 31 from the Commodity Futures Trading Commission in the absence of DCO registration so that US banks can clear at KRX without breaching US rules.

For some time there was a concern about whether European banks would be able to join India's clearing house, CCIL. In January, the Reserve Bank of India gave CCIL a qualifying CCP (QCCP) determination, and on June 27 Esma said it will grant equivalence to five countries, including India, which will enable CCPs within these jurisdictions to clear EU derivatives trades. The other four countries are Australia, Hong Kong, Japan and Singapore.

A six-month delay in the introduction of Europe's Capital Requirements Regulation also means that the increased capital charge against non-qualifying CCP exposures that could be as much as 1,250% will not now kick in until December 15. An Asia clearing head at a European bank says that "we have more breathing room" following the extended timeline for Europe's CRR. "European banks have been comfortable in joining CCIL based on the December 15 delay and there may be an equivalent determination before then. CCIL will get across the line in terms of its standards," he says.

However, as for Korea, the absence of an equivalent determination for CCIL could be problematic as all the European banks operate as branches in India so they would effectively be barred from participating by European rules which stipulate that only subsidiaries can operate in such circumstances. For US banks the situation is more clear-cut as forward foreign exchange contracts are exempt from clearing under Dodd-Frank.

KRX and CCIL are at least playing by the rules. In contrast, China has not even applied for recognition from European or US authorities, creating a potential issue for banks from either region wishing to join Shanghai Clearing House. Nine of the 10 foreign branches that have joined up as Asia Risk went to press are subsidiaries with onshore capital (see box below). The tenth bank, Credit Suisse, has joined up via its Shanghai branch as it isn't constrained by Esma given Switzerland is outside of the European Union.

"Some foreign banks that operate as branches in China rather than subsidiaries, such as Barclays and Bank of America Merrill Lynch are facing compliance issues. Specifically, under Dodd-Frank, the issue is over the requirement to clear through a DCO or exempt DCO, and under article 25 of Emir, banks must clear through a recognised CCP," says an Asia-based lawyer.

Barclays confirmed there is a potential regulatory issue, while Bank of America Merrill Lynch failed to respond to a request for comment.

In addition to the regulatory barriers, the small scale of the China onshore IRS market means some players simply saw no value in joining the Shanghai CCP. According to a 2013 Celent report, China accounts for just 2% of Asia's IRS market, versus 32% for Singapore, and a Hong Kong-based executive at a major offshore renminbi dealer that did not apply to join Shanghai Clearing House says as a result of this, the economics of SCH do not stack up. "The market cost of joining clearing houses is significant and the figures for the amount of IRS business we do onshore doesn't justify joining – particularly with the amount of uncertainty surrounding SCH," he says.

House rules

Aside from the recognition issues, a whole set of processes at all three clearing houses were not within the comfort zone of international banks but an extensive lobbying effort has ushered in changes. "Some rules didn't match with the global standard but KRX and foreign banks discussed and concluded the issues so we revised our rules and are not worried about recognition as much as before," says Lee.

Changes to the procedures included clarifying the ability of members to close out against the CCP in the event of failure and a change in the capital requirements for CCP membership. KRX also removed the three-year time-out period for re-entering as a CCP member – a change that enables "clearing members with extraterritorial issues and regulatory overlap to re-enter the CCP membership more freely", says Lee.

Additionally, in the event of a third member default, the cap period was removed but now remains in place to improve the limitation on clearing members' liability. An OTC clearing source at an Asian bank says that "there are no big surprises and KRX now largely stacks up".

In India too, rules were amended to enable clearing members to close out against the CCP in the event of default. The Reserve Bank of India was responsive around providing legal certainty on termination and netting, according to the source.

Now that clearing is up and running with broad participation from the most active banks globally, dealers are focusing on refining some of the processes.

In Korea, the main outstanding point is to get the local banks to use MarkitWire to affirm trades, which mitigates the operational risk of double-keying a trade.

"There is a technology difference between local Korean banks and global banks so that when we face an international bank the trade goes on to MarkitWire and it flows to KRX and we get updated on MarkitWire but if we face a domestic Korean bank we need to book it twice in KRX and our own platforms so there is a danger of a fat finger incident," says the OTC clearing source.

In India, despite the positive overall picture, the issue of calculating the risk weight against default fund contributions is still an area of contention. According to Keith Noyes, regional director for Asia-Pacific, at the International Swaps and Derivatives Association, India's central bank has asked all banks to use the simplified approach to calculating capital exposure – which produces a large risk number – as domestic banks may struggle to implement the systems to calculate the more granular figures.

"Foreign banks would like to use the risk-sensitive approach but at present the Reserve Bank of India has said they should use the simplified method. With this approach banks end up with a risk weight assumption that is the same as for a non-QCCP so the question is why bother with the hard work to change clearing house rules to achieve QCCP status and Esma recognition if the risk weight on your default fund contribution ends up being the same number," says Noyes.

However, current low volumes in the Indian market mean that this is not a significant issue in the short term but it is likely to generate higher costs for banks expanding in India. "At present this is not a big issue as default fund contributions are minimal – for most of the foreign banks the amount stands at less than $200,000," says Siddhartha Roy, chief risk officer at CCIL.

Nonetheless, he says that a solution is being discussed with participants. "In India, regulators haven't yet approved a risk-sensitive approach for member banks to calculate capital requirements on default fund contributions but we are trying to find out if the computation can be done by foreign banks in their home jurisdictions and applied to contributions made to CCIL," says Roy.

In China some of the issues are more fundamental such as whether finality of settlement and payment is available as stipulated by the PFMI. "Without this there is a danger of a member default and an administrator coming in to disrupt the clearing process. Most concerns are not related to SCH as an entity but rather an assessment of Chinese law. The People's Bank of China hasn't given a definitive answer on whether SCH is a QCCP, they have just said they will regulate SCH in accordance with the QCCP criteria," says Simon Zhang, attorney at Linklaters in Hong Kong.

Client clearing also has a number of unanswered questions such as whether a principal or agency based client clearing model is used, which will determine whether collateral sits at the clearing house or at the bank.

"Banks take more comfort if collateral is held at the CCP than the bank as it has the backing of the regulator. But there are also issues with collateral in the first place as there is no collateral opinion in China so that in a default scenario we could see a recharacterisation of the collateral by a bankruptcy court for the purposes of clawing back assets," says an Asia-based regulatory source.

China may be lagging its regional and global peers in terms of its clearing efforts but China doesn't see this as a major issue, says the regulatory source who recently held a meeting with Chinese regulators. According to the clearing head, the Chinese authorities were bullish about the long term prospects of their CCP.

"They just said, 'this is the Chinese way of doing things. We may start out behind but then we leapfrog to the front on the technology and manage any bumps in the road on the transition and then we are number one in the world."

Country-by-country: the state of clearing in three Asian jurisdictions 1. Korea In preparation for the June 30 mandate for won IRS clearing, 16 foreign bank branches have joined Korea's clearing service. What's covered: Korea's mandate covers won IRS below 10 years and at three-month multiples: so, for example, a five-year four-month trade would not be clearable. Who's in: Foreign banks admitted as direct members so far are: ANZ, Bank of America Merrill Lynch, Barclays, BNP Paribas, Crédit Agricole, Credit Suisse, DBS, Deutsche Bank, Goldman Sachs, HSBC, ING, JP Morgan, Morgan Stanley, RBS, Societe Generale and UOB. Citi and Nomura operate as subsidiaries and are already direct members. Societe Generale, Barclays and Deutsche Bank are believed to have the biggest share of the won IRS market at between 4-6% each. Who's out: The notable absentee from the list is UBS, which is believed to have a 1.65% share of the won IRS market. A Hong Kong-based spokesman for the Swiss bank said that nobody was available to comment on why it had not joined. A total of 36 domestic institutions are direct members. Korea is also commencing client clearing at the same time as dealer clearing. Clearing will be mandatory for institutions with an investment business licence from the Financial Services Commission, which should capture around 80 institutions but only 50 are thought to be active. According to KRX, 98% of the won IRS market is covered by direct members. So far only NH Investment & Securities and Shinhan Securities have joined to clear client trades.

 

2. India Following the June 2 mandate of dollar/rupee forwards at CCIL, cleared volumes have doubled. What's covered: Standardised tenors below 13 months. Who's in: A total of 79 banks including more than 15 foreign banks have become members of the forex forward clearing segment, including Deutsche Bank, HSBC, Standard Chartered, Citi and Rabobank. Who's out: There are no obvious absences. Dodd-Frank has exempted forex forwards from being cleared so US banks are not constrained from participating, however the situation will be more complicated when CCIL mandates IRS clearing next year. The volume of cleared trades has doubled from a notional of $94.7 billion on May 30 to $181.7 billion as of June 17. According to market participants, 90% of the forex forward market is below 12-month tenors and most transactions are three months and shorter. According to a Mumbai forex head from a regional bank, mandatory clearing has been straightforward so far. "The process has been smooth and banks have been broadly happy. It has also helped us free up credit limits and capital. Collateral can be in rupee cash or Indian government securities, which has worked well as banks generally have an excess of government securities on their books," he says.

 

3. China On July 1, clearing of renminbi interest rate swaps becomes mandatory onshore in China for dealers and clients. What's covered: Transactions must be fixed rate versus floating rate and the floating reference rate must be: overnight Shanghai interbank borrowing rate (Shibor), three-month Shibor or the interbank seven-day repurchase rate. Who's in: Thirty-five direct clearing members have been admitted so far, including 10 foreign banks: ANZ, Bank of East Asia (China), BNP Paribas China, Citibank China, Credit Suisse (Shanghai branch), DBS China, Deutsche Bank China, HSBC China, OCBC China and Standard Chartered Bank China. Who's out: Significantly, this means several major global dealers, including Bank of America Merrill Lynch, Barclays, Goldman Sachs, JP Morgan, Morgan Stanley and UBS – which are clearing members on Singapore Exchange's AsiaClear CCP – are not on the approved list in Shanghai, potentially giving dealers a headache. International banks operating in China's IRS markets without having a direct clearing membership on SCH are obliged to use one of the designated local banks as a conduit. So far, five comprehensive clearing members have been accepted to clear proprietary trades and client trades: Bank of Communications, Citic Securities, ICBC, Industrial Bank and Shanghai Pudong Development Bank.