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Central clearing concerns have been reignited after an erroneous options trade pushed South Korea's HanMag Securities to the brink of bankruptcy and set in motion the Korea Exchange's default waterfall, mutualising US$43 million of losses among clearing member firms.
The latest clearing debacle is a stark reminder of the potentially risky path regulators have set upon as they mandate large chunks of the US$693 trillion over-the-counter derivatives market for central clearing. December’s costly mistake could force regulators to take a closer look at central counterparty capitalisation requirements in an effort to meet key regulatory goals of avoiding taxpayer bailouts and minimising the systemic impact of default situations.
“There’s been a big overhaul of the way that everything is done, but all that has really happened is that we’ve swapped well capitalised too-big-to-fail institutions for thinly capitalised too-big-to-fail institutions", said a credit structuring head at a European house. “CCPs are a must for banks with the new capital rules. Without a CCP, the system doesn’t work, but along with deposit insurance, CCPs are an example of mutualisation that is at odds with the general idea of individualisation that is behind the new regulations.”
KRX’s default contribution fund was only partially depleted, but the scale of losses stemming from the one-off event raised fears that risk management practices at CCPs may not reflect the rising levels of risk they are housing as a result of the swaps clearing mandate. “No one has yet been able to show that the risk waterfall actually works, and there’s a good chance that it doesn’t work because of correlation", said the credit banker.
IOSCO warns of rising CCP risk in its global outlook. “The clearing mandate creates a large risk concentration on newly emerging CCPs. It’s something that IOSCO has identified as a potential source of risk and, if that’s the case, then the whole issue of whether CCPs are properly capitalised is re-emerging", said one clearing expert.
Although designed to reduce counterparty and systemic risk, IOSCO notes that clearing has increased the burden of risk being borne by clearing brokers. In addition to the effect of competitive pressures on the quality of collateral CCPs accept, the regulatory authority raised concerns of shared risk management models across CCPs and the interconnection with the banking system. For KRX, the “fat finger” debacle, believed to have stemmed from a mix-up between puts and calls, has spurred new operational processes to improve the security of derivatives transactions. Alongside key regulators including the FSS and FSC, KRX will step up its oversight of algorithmic trading, which accounts for around 40 per cent of Kospi 200 options activity.
Many believe that the most pressing issue is capitalisation and the structure default waterfall – particularly as KRX is set to begin clearing OTC derivatives in June this year. ISDA recommends that CCPs insert both junior and senior slices of capital around the default fund to bear some losses ahead of any non-defaulting members.