The chief risk officer of one of Asia’s largest clearing houses, Hong Kong Exchanges and Clearing (HKEx), had some ominous words to say last month: dealers may have to brace for more losses like those suffered by Nasdaq Clearing.
While Roland Chai was referring to the September default by commodity trader Einar Aas that burnt through two-thirds of Nasdaq Clearing’s default fund for commodities, his warning is very relevant for Asian central counterparties as clearing members could be troubled by the unwinding of monetary policy stimulus and trade spats that may result in losses.
While CCPs can’t control the macro risk, they should use it as a catalyst to overhaul their creaky margin models. It is also about time Asian CCPs depart from the narrative that they plough far more of their capital into the default fund than their global peers do, because high levels of ‘skin in the game’ can’t be an excuse for shoddy margining practices amid looming risks.
CCPs in Asia typically put at least a quarter of their own capital into default funds, compared with less than 5% of own capital at European and US CCPs. But with dealers increasingly turning to clearing in order to reduce the collateral they will have to post when initial margin requirements on non-cleared trades finally take hold in the region in 2020, the CCPs need to shore up their risk management, stress-testing and margining practices to prevent outsized losses due to member default.
The firms also have to factor in concentration risk, since most domestic clearing houses in the region tend to clear the lion’s share of derivatives denominated in their home currencies or linked to local benchmarks.
The comforting factor is that at least some Asian CCPs are acknowledging their shortcomings and taking steps to address them
The CCPs have already had a taste of the embedded risk. The October sell-off in equity markets saw the value of contracts at many Asian CCPs far outstripping the levels of margin that members set aside for trades: by 26.7% for Nikkei 225 futures traded at the Japan Securities Clearing Corporation (JSCC); 43.5% for Topix futures at the same CCP; and more than 50% for some of the contracts traded on Taiwan’s Taifex.
To improve margin practices, the CCPs need to rework a whole plethora of processes from factoring in the right period and span of stress and volatility, calibrating in the local risk factors, extending lookback periods and eventually introducing a robust method to calculate right up to intraday margin calls.
The comforting factor is that at least some Asian CCPs are acknowledging their shortcomings and taking steps to address them. JSCC is currently conducting an internal review of its margin methodology. Singapore Exchange is looking to introduce a 10-year lookback floor and will also replace its current volatility-based approach to calculating scanning ranges. HKEx plans to roll out a more sophisticated risk-based margin methodology next year for its securities and listed derivatives.
But there is a lot more work to be done. For instance, dealers say CCPs in India and China need to step up their game, and those in some of the smaller financial jurisdictions – such as Taiwan, Thailand, Malaysia and Indonesia – are a considerable way behind.
It often takes years, not just days or months to come up a revised risk and margin methodology. Given the emerging macro challenges, CCPs need to put in their best foot forward now to be well prepared to come out relatively unscathed from a repeat of a Nasdaq Clearing-like scenario.