The introduction of the T+2 finality arrangement on 25 July for securities and money settlement by the Hong Kong Exchanges and Clearing Limited (HKEx) will help to lower settlement and counterparty risk for brokers, marking a major step towards delivery versus payment (DvP) in Hong Kong.
Under T+2 finality, both securities and money settlement will be completed and finalised two business days after the trade takes place.
Currently most securities settlement already takes place on a T+2 basis, with exchange trades settled in the Central Clearing and Settlement System (CCASS), operated by HKEx's wholly-owned subsidiary Hong Kong Securities Clearing Company (HKSCC).
However some related money obligations are settled via the overnight interbank bulk settlement processes operated separately by Hong Kong Interbank Clearing Limited (HKICL) in the morning of T+3.
HKICL is a private company jointly owned by the Hong Kong Monetary Authority and the Hong Kong Association of Banks.
A HKEx spokesman said, “A majority of exchange trades by value already settle on T+2 under a process known as prepayment, but where prepayment is not involved, the current settlement mechanism results in a one-business-day gap between securities and money settlement.”
Holding the risk
Bruno Campenon, head of BNP Paribas Securities Services for Hong Kong, explained that, at present, the custodian businesses of banks have to bear the risk created by the gap in settlement times.
“As a custodian, what you do for the client is to settle both the cash and the securities at the same time.” he said. “But the risk for the custodian is that you only receive the confirmation on the cash settlement the following day. What the HKEx is doing now is helpful because they are repatriating all cash settlement on T+2, so it means that on the same day, you will have full settlement of both the securities and the cash components.”
The introduction of T+2 finality brings HKEx closer to DvP, he noted, but it's “not quite there yet” because true DvP involves the simultaneous settlement of cash and securities.
Campenon said, “The major benefit for us [from having T+2 finality] is that the risk is significantly reduced, and we have the opportunity to reuse that cash before the end of the day.”
In its ”Consultation Paper on Introduction of a T+2 Finality Arrangement for CCASS Money Settlement', which HKEx published in November 2009, the market and infrastructure operator acknowledged the risks that the current system creates. One order type, settlement instruction (SI) transactions, which can include broker-custodian transactions, stock borrowing and lending transactions, stock pledging transactions and portfolio movements in CCASS, allows users to specify a DvP settlement.
The consultation noted that although CCASS has achieved very high settlement efficiency under its T+2 settlement cycle, both HKSCC and CCASS participants are still exposed to overnight settlement risk for transactions settled on a DvP basis due to the time gap between securities and money settlement.
“While the average daily market turnover grew six times from US$10.2 billion in 2003 to US$71.8 billion in 2008… the value of SIs settled increased by 668% to US$193 billion for the same period,” it said.
DvP on hold
The paper also conceded that the current money settlement arrangement in Hong Kong lags behind international best practices. Today, most of the major overseas securities markets, including the UK, the US, Germany, Australia and Singapore, achieve settlement finality for both money and securities before the end of the settlement day.
However full DvP was rejected in the consultation conclusion document, which was published in August 2010.
“To implement real time money settlement for all CCASS transactions would create liquidity pressures and additional operational and funding costs to market participant and will not be considered at this stage” it said, noting that the ability to SIs on a DvP basis or to arrange cash prepayments and intraday real-time gross settlement payments via CCASS offered faster settlement options where needed.
Derrick Fung, HKEx's head of clearing, said, “The new arrangement will reduce the overnight credit risk of the securities market and align the money settlement arrangement in Hong Kong with the international best practices by bringing finality of securities and money settlement on the same day.”
“To get to real DvP is costly because you need to settle the cash on the real time settlement system, so it means no netting and only gross settlement,” Campenon explained. “What HKEx has accomplished is already quite a big step forward and over time, we will see whether it makes sense to go to real DvP.
Today, the markets work with four batches of settlement per day.
Perhaps at some point we could say “why not do cash settlement per batch”, so when there's a settlement batch on the security, you would settle the cash at the same time. There are many ways of doing it.”
Risk framework
HKEx also published a consultation paper on 8 July to seek views on its proposals to reform the risk management framework of HKEx's clearing houses, which it said is crucial to the long term stability and competitiveness of Hong Kong.
Campenon said, “Today the market does not offer what we call an ”initial' margin. This makes credit people a bit nervous because there is no initial margin kept somewhere by the market as a guarantee, which creates a credit risk. The move to introduce an initial margin would be the next step forward.”
HKEx has proposed to introduce a margin credit of HK$5 million (US$641,025) per HKSCC participant; a Dynamic Guarantee Fund credit of HK$1 million per HKSCC participant; and Contingent Advance Capital to share half of the Hong Kong Futures Exchange Clearing Corporation (HKCC) Dynamic Reserve Fund requirement of each HKCC participant.
In addition, HKEx is proposing to set aside additional shareholders' funds of HK$900 million to boost its support to the clearing houses' financial resources. HKEx said this additional funding support is not expected to affect its profitability or dividend payout.
Author: Jill Wong