Hong Kong prepares boost to equity derivatives booking

Proposed revamp of large exposure limits would allow netting to reduce capital charges

Big potential: HKMA makes changes as Hong Kong reaches for a larger slice of the $540trn derivatives market

The Hong Kong Monetary Authority (HKMA) is set to push through new rules allowing banks to net their equity derivatives positions when calculating large exposure limits, in a move likely to boost the city-state’s allure as a derivatives-booking hub.

Under current regulation, in place since 1997, a bank’s exposure to a single counterparty – or counterparties contained in a single corporate group – cannot exceed 25% of the bank’s capital base at all times. While this is in line with global rules, the local implementation fails to reconcile derivatives positions. Exposures are calculated on a gross basis, and banks cannot reduce a single exposure by netting off their long and short positions.

“The HKMA is trying to make it easier to book trades here without materially increasing the amount of risk that is in the entity,” says a senior director in the equity financing division of a global bank. “That is the right thing to do, but the question on everyone’s mind is whether the capital consumed [in Hong Kong] will be less than the capital consumed in another market. I haven’t done that analysis [yet], but it’s a good question.”

A new banking bill passed in January by Hong Kong’s parliament, LegCo, gives the HKMA the power to change the limits on large equity exposures. Daryl Ho, the regulator’s executive director for banking policy, has indicated new legislation is imminent.

“Our current plan is to put in place new rules on equity exposures… as soon as practicable within 2018,” he said in a letter to Hong Kong’s financial institutions at the start of February, adding other rules on large exposures – such as through credit risk, for example – will follow in 2019, in accordance with the timetable set out by the Basel Committee.

…the question on everyone’s mind is whether the capital consumed [in Hong Kong] will be less than the capital consumed in another market. I haven’t done that analysis [yet], but it’s a good question
Senior director in the equity financing division of a global bank

HKMA is putting in place the changes as Hong Kong tries to grab a larger slice of the $540 trillion derivatives market. The UK’s decision to leave the European Union and the introduction of the second Markets in Financial Instruments Directive (Mifid II) in Europe are prompting banks, including HSBC and Standard Chartered, to review their booking models.

Modernising the exposure limit laws is simply the most recent piece of the jigsaw. Other steps already taken, such as overhauling the regulator’s model-approval process, have also provided an incentive for banks to choose Hong Kong as their booking hub.

Reform of the equity exposure limit law is likely to be welcomed by banks, as it would allow them to move not only fixed-income and currency exposures but also equities business from London or New York.

Almost a dozen banks are said to be reviewing their booking models, with a few already in the process of migrating Asia-originated risk to Hong Kong or Singapore.

HSBC chose Hong Kong as its central risk location and began moving its trades in late 2015, beginning with the fixed-income side but more recently transferring equities as well. Credit Suisse, on the other hand, has selected Singapore as its booking hub, following the launch of an Asia-Pacific standalone business division in October 2015.

Standard Chartered is said to be operating a dual-booking model in Asia. While the UK lender’s principal booking hub is Singapore, it has been exploring the possibility of booking some trades in Hong Kong. This is likely to include equity trades executed with its Hong Kong or Chinese clients.

Representatives of Credit Suisse, HSBC and Standard Chartered declined to comment for this article.

“It would be unfair to say people will start moving their derivatives business to Hong Kong purely based on the resolution of this issue… but, until [the rules are] rewritten, those that do shift their equities booking to Hong Kong will, depending on the size of this business, keep coming up against these limits,” says Tom Jenkins, a consultant for KPMG.

Cross-asset hedging

Kishore Ramakrishnan, a partner at consulting firm Temple Grange Partners, says banks initially focused on moving over the booking of their fixed-income portfolios to Asia. This was largely because they were under pressure from home regulators to book credit risk closer to origin, he says, rather than routing such exposures through a global booking hub such as London.

Migrating the equities books is the logical next step, he adds. As fixed-income products have moved across, banks have quickly found that certain business lines were becoming more expensive, because they were not able to net across asset classes.

For example, a common way of hedging the exposure on a credit default swap is to take an opposing position on the underlying stock. If the risk management is undertaken in a single booking centre these positions can be netted off, but if exposures are split between jurisdictions this becomes difficult.

There is a trade-off to be had though, and not all banks may be keen to split the booking of their equity exposure between jurisdictions since this would mean maintaining separate risk infrastructures, which can be costly.

“There is no one-size-fits-all [solution]. If a bank doesn’t see any economic advantage in booking their equities business in Asia – for example, if they are unlikely to derive any netting benefits from moving it over – then they might as well keep it where it is,” says Ramakrishnan.

Market access trades

One popular way in which equity derivatives are used in Asia is to access markets that are otherwise difficult for investors to trade. These trades use equity swaps or other types of derivatives to reference a market’s underlying equities, with a short position taken on one side and a long position on the other.

China, right on the doorstep of Hong Kong, is a major destination for such market access products, since regulatory hurdles to setting up onshore often mean offshore access products are the most cost-effective solution for those who want to tap into the country’s sizeable markets.

KPMG’s Jenkins says for banks carrying out large numbers of these China delta one trades (so-called because the price of the derivative moves more or less with the price of the underlying asset), any rule change by the HKMA will make it easier to book in Hong Kong. This is because making a market for equity derivatives in the largest Chinese names could result in banks exceeding the large exposure limit under the current rules, which calculate exposures only on a gross basis.

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