Agnes Koh, the chief risk officer at Singapore Exchange (SGX), understands the public scrutiny of derivatives clearing houses in the wake of the damaging default at Nasdaq last year. But she also believes her company and many of its peers have curbed risk on their own, and warns against overly prescriptive regulation that could hinder clearing houses in managing future defaults.
Koh argues that existing tools such as liquidating brokers to resolve a default event will continue to work well for futures clearers.
“The regulators have set their minds and hearts on ensuring there are harmonised risk standards across CCPs,” says Koh. “There are already existing CCP risk practices – and the guidance makes it very clear to all, especially for those participants who are new to the clearing ecosystem.”
Since the Einar Aas default, some banks have voiced concerns over the clearing of certain products at central counterparties (CCPs). Regulators, meanwhile, have pushed CCPs to tighten standards around everything from membership requirements to margin adequacy – and, most prominently, to review practices around the sale of portfolios from defaulting members.
SGX was already in the midst of a two-year review of its margin methodology at the time of the Nasdaq loss, with the broad aim of improving responsiveness to changes in volatility and reducing procyclicality. The review culminated in a raft of changes to the clearing house’s model, which it announced in March.
In parallel, SGX has revised its default auction rules for risky and concentrated products, following a consultation that ended 12 months ago. The exchange announced its new procedures in July, featuring mandatory auctions for certain instruments.
The initiatives add to a sense that SGX and other exchanges are wary of regulators imposing unnecessary rules on the clearing process when CCPs are already addressing any deficiencies themselves. Global standard-setters released a discussion paper on changes to CCP auctions in June.
Koh, a former regulator and 14-year veteran of the exchange, is not shy of pushing global supervisors to take local market dynamics into account when setting standards: in 2016, she issued a rallying call to fellow Asia-Pacific jurisdictions to lobby against “irrelevant” elements of the Fundamental Review of the Trading Book that risked damaging liquidity in younger capital markets.
If it ain’t broke
Existing default management practices, if executed correctly, can insulate CCPs and their members from harmful losses, Koh insists. She uses the Lehman Brothers collapse in 2008 as an example. Lehman’s Singapore entity did not itself default, as it had sufficient collateral to meet its financial obligation to SGX’s clearing houses; but the CCP took pre-emptive measures that included imposing additional margin requirements and porting customers’ positions to other clearing members, enabling it to execute an orderly wind-down of Lehman’s remaining positions.
“We worked closely with our liquidating brokers to complete the liquidation process,” Koh says. “Both our clearing houses did not suffer any financial loss from the fallout, and we were able to return excess collateral to the liquidators of Lehman.”
The use of liquidating brokers as a first measure to dispose of portfolios works well for exchange-traded derivatives with robust liquidity, Koh argues. But it is important for CCPs to retain the flexibility to call on a range of weapons in response to default.
“We need to remind the industry that a CCP can work with many tools, depending on the kind of products that you’ve listed and the complexity in the market and members,” Koh says. “For example, in the listed market, where the instrument is very liquid and with efficient price discovery, the use of liquidating brokers, which have worked in the past, will continue to work in the future.”
As part of recent changes to its default management rules, SGX has proposed mandatory auctions for products that have non-linear risks or enjoy cross-product margin offsets and strong portfolio effect.
“It’s more efficient to liquidate them as a whole, rather than breaking them into individual products and liquidating them separately,” says Koh.
It’s highly unlikely that we will have a one-size-fits-all approach
The mandatory auction will be limited to non-defaulting clearing members that have open cleared positions in the contracts that constitute the auction portfolio at the time of the relevant default event. But those clearing members may involve their customers in pricing the auction portfolio, SGX says.
If the bourse doesn’t want to pursue a mandatory auction, it also has the option of other recovery tools, such as liquidating a defaulted portfolio in the open market. This may take the form of a voluntary auction where a broader range of bidders, from inside and outside the clearing member pool, are invited to participate.
“This mode of liquidation may be particularly suitable for liquid outright futures contracts with linear risk, which may attract interested parties from both members and non-members to bid for,” says Koh.
Not all cleared markets are liquid, though. Some are dominated by a few large directional players, which means that any auction process may have only a handful of prospective participants. There is talk that some futures products are simply not fit for clearing.
Koh has sympathy for the concerns, but believes regulators should treat each market on its own merits and resist issuing blanket diktats.
“There are differences in the product, market structure and membership among the various CCPs,” she says. “It’s highly unlikely that we will have a one-size-fits-all approach. That’s why I think workshops could be a discovery process for the industry.”
Koh is actively involved in industry workshops and conversations with regulators. She is currently an executive committee member of CCP12, a global association for central counterparties. Koh worked for the Monetary Authority of Singapore for 11 years until 1998, steering investment of the central bank’s foreign reserves and developing a framework for investment in new asset classes. She later joined a management consultancy, providing accounting and tax services to small and medium-sized enterprises.
The other looming issue exercising banks in futures markets is margin coverage. Even before the Nasdaq episode, dealers were concerned at the steep rise in margin breaches – instances in which models do not fully capture a sharp price move in the underlying, necessitating a top-up from the client.
The market’s largest futures clearers, CME Group and Ice, are in the throes of updating their legacy Span models to ones based on value-at-risk, which promise greater accuracy. SGX, which licenses the Span framework from CME, has pre-empted those changes by tweaking its current margin model to give more weight to recent volatility so that base margins are more responsive to the prevailing volatility regime, Koh says.
While still using Span model outputs, the CCP has amended the input parameters, ditching the previous standard deviation approach that gave equal weight to all price observations during the previous year when setting margin requirements, and adopting volatility scaling so that margins are more sufficiently responsive to the prevailing volatility regime.
SGX then backstops this with an anti-procyclicality floor, ensuring margins cannot dip lower than those that would be arrived at using a 10-year lookback, even during benign periods of low volatility. “The 10-year lookback means that, should there be a sudden catastrophe or unexpected event, there won’t be a shocking spike in margin requirement and imposing liquidity constraints on our members,” says Koh.
The changes, which will apply to SGX’s entire suite of listed derivatives, in effect leave the bourse with something akin to a Span 1.5 model. With CME set to roll out Span 2.0 in the first half of 2020, exchanges including SGX may ultimately have to move away from the existing version. Koh declines to comment on the timeline of any change, but says SGX will keep evaluating the necessary improvement.
Margin models and default processes are not the only area of change for SGX. Last November, the exchange surprised rates users by revealing plans to shut its swaps clearing business. Clearing of interest rate swaps denominated in Singapore dollars is mandatory, and with rivals LCH and CME only clearing the shorter end of the curve, that risked leaving in the lurch some clients that were trading longer-dated swaps: SGX was the only CCP offering clearing of Malaysian ringgit swaps and Singapore dollar swaps with a maturity of more than 15 years.
In response to market demand, LCH extended clearing for Singapore dollar swaps out to 21 years. SGX began a de-clearing process with IHS Markit and clearing members on the trades of Singapore dollar swaps and Thai baht and ringgit non-deliverable interest rate swaps before it hit the April deadline. The exchange then executed “trade compression and subsequent re-clearing of some positions to LCH”, Koh says.
SGX is refocusing its franchise on clearing over-the-counter foreign exchange futures, it says – a sounder long-term bet, with Singapore the world’s third-largest forex trading hub after London and New York.
Biography – Agnes Koh
2014–present: Chief risk officer, SGX
2005–present: Senior vice-president and head of clearing risk unit, SGX
2002–2005: Director, SolidTrack Mgt
1987–1998: Assistant director of portfolio management, Monetary Authority of Singapore
Editing by Alex Krohn and Tom Osborn