The Hong Kong Stock Exchange (HKEx) this week announced the results of its review of clearing house risk management procedures, after admitting last year its current system would be inadequate in the face of major defaults by clearing parties. The review, launched as a ‘Consultation paper on HKEx Clearing House risk management reform measures,’ included meetings with over 100 market participants, as well as seminars, between 8 July 2011 and 28 October 2011.
“The risk management framework currently used in HKEx’s securities market was adopted at the establishment of the Central Clearing and Settlement System in 1992. The framework has remained largely unchanged and failed to keep up with the rapid market development over the last 20 years,” said an HKEx spokesperson.
“For example, when the HKSCC Guarantee Fund (GF) was first set up in 1992, the average daily turnover (ADT) was only HK$3 billion whereas the fund size was HK$105 million. The ADT reached almost HK$12.68 billion in 2000. In 2011, when the ADT increased 23 times from 1992 to HK$69 billion, the fund size only doubled to HK$245 million. It is obvious that the small and static GF is not sufficient to support the ever growing market volume,” continued the spokesperson.
HKEx’s admission of vulnerability is unusual for a major exchange, though it did face the danger of collapse during the crash of 1987 and had to be bailed out.
The exchange described the review as “long overdue” and said there was a “pressing need” for it because the 2008 global financial crisis prompted governments, regulators, and financial institutions in the world to, among other things, raise capital adequacy standards and tighten risk management measures. HKEx recognised that it needed to enhance its regime to keep up with the changing global standards.
The Lehman Brothers collapse cost HKEx close to HK$160 million and reduced the GF size to HK$245 million. The exchange said a well-funded GF would be closer to HK$1.3 billion.
“The default of Lehman Brothers exposed the weakness of the current risk management regime…on that day, Lehman was not even one of the top ten clearing participants (CPs) by position,” the HKEx spokesperson said.
Clearing houses and the robustness of their risk management measures are crucial to the long-term stability and competitiveness of Hong Kong’s financial markets, as institutions of systemic importance, according to the exchange.
“HKEx recognises that risk management reform is therefore not only necessary but also demands immediate attention,” he said.
Measures to be taken include: a standard margin system and a Dynamic Guarantee Fund at HKSCC (Hong Kong Securities Clearing Company Limited) and the Stock Exchange of Hong Kong (SEHK) Options Clearing House Limited (SEOCH); revision of certain price movement assumptions and counterparty default assumptions in the clearing houses’ stress testing, as well as revision of the collateral assumptions at HKCC and the SEOCH.
“I would like to take this opportunity to thank the market for understanding the urgency and necessity of this reform, even though it may bring additional financial obligations to some market participants. The reform is a major milestone in enhancing the long term stability and competitiveness of the Hong Kong financial market,” said Charles Li, HKEx chief executive, at the announcement of the review completion.