OTC derivative reform still confusing for many Hong Kong players
Survey finds 85.5pc of market players believe hedging costs are going to rise after the reforms
The jury is still out over whether the Hong Kong Monetary Authority and Securities and Futures Commission's recommended reforms on how over-the-counter (OTC) derivatives should be traded will do more harm than good.
"There are a lot of industry players in the mid-tier that don't know what's going on and what the practical implications are," said Urszula McCormack, partner at law firm King & Wood Mallesons, which advises the Hong Kong Association of Banks.
Banks in Hong Kong were given four weeks to read through a dense 184-page document that will form the basis of the rules and regulations expected to be voted into law by the Legislative Council in January. They have until the end of October to give their views.
Yet, as of last week, even senior business heads at top 10 banks contacted by the South China Morning Post who would be directly affected were unclear about the consequences. Most said they are unaware of the full scope of the changes.
That does not bode well for the world's fifth largest centre for forex activities. A single day's forex trades are worth US$274 billion in Hong Kong while interest rate derivatives turnover amounts to US$27.9 billion.
Starting from interest rate swaps in Hong Kong dollars, US dollars, euro, Japanese yen, and the pound, institutions will need to have their trades centrally cleared at the Hong Kong Exchange and Clearing or at a recognised overseas equivalent, possibly from June next year. This will replace the loose bilateral trading model that has existed for as long as interest rate swaps have been around since 1985.
The move to ask banks to move their bilateral derivative trades to the exchange is the result of seven years of soul-searching since the 2008 global financial crisis, when derivatives - among others - were blamed for crashing the financial markets. G20 leaders said in 2009 they wanted central clearing and regular reporting for derivatives trades to monitor and contain risks.
Hong Kong is not a G20 member, but it has closely followed the proposals, consultations, legislation and reforms in other leading hubs before coming up with its own legislation to align itself with global markets.
The city has already implemented a form of mandatory reporting. This is due to be expanded, covering reporting for more products in the next phase of the reform. Regulators are now in possession of data and software that can flag traders' indiscretions in real time.
"We have to revisit the trading platform. I still don't know how they can achieve this," said Dominic Wu, senior risk manager, Asia-Pacific at BNY Mellon.
While traders at banks' trading desks are sophisticated enough to know what to ask of other banks in posting margins and collateral when trading, the margin model has yet to be decided once trades move to an exchange.
The double costs of meeting international and local standards have prompted banks to consolidate derivatives business globally. As the costs of producing OTC derivatives become higher for banks, the current reform drive by regulators is seen to have negative consequences for bank clients.
"Ultimately the costs of financing the regulation will be passed onto bank customers," said Anthony Woo, research director at Asia Financial Risk Think Tank.
"Getting people to clear their own derivatives may be a challenge. If these costs are passed down, some clients may not fully hedge themselves."
The market believes the same. Some 85.5 per cent of market players polled by Thomson Reuters last week said they believe hedging costs will surge after the reforms - with 43.4 per cent saying they would "rise significantly".
"The market is less deep and not as liquid," Wu noted. Greater fragmentation of markets looks to be the end game. Banks would do well to rethink their business models, he said.
A likely scenario would be Asian banks doing well out of local currency swaps, such as in Hong Kong dollars and offshore yuan, while US banks dominate trades for dollar swap instruments from the city.
Keith Noyes, regional director, Asia-Pacific, at the International Swaps and Derivatives Association, said the requirement by the HKMA and the SFC for a T+1 clearing cycle - or, transaction day plus one day - could easily be breached when Hong Kong's trading days coincide with bank holidays in other jurisdictions where the trades might be cleared.
"A longer allowance for the clearing cycle would be preferred. The consultation draft recommends that trades that are not accepted for clearing by the end of T+1 must be terminated. Trade participants will already have put on hedges versus these transactions so any termination could result in losses unwinding the hedges," Noyes said.
There is also the HKEx's OTC Clear business model to be considered. Global banks with existing relations with LCH.Clearnet, which has leadership in most interest rate swap trades, would more likely prefer to continue clearing in London rather than switch to Hong Kong.
"Local banks may not yet have a relationship with LCH and may prefer to clear with a local CCP [central counterparty clearing]," Noyes added.
"Time will tell whether each country can sustain its own CCP. We'll have to wait and see," said McCormack.
Even matters as simple as reporting may get confusing. Traders work together to execute individual parts to complete a full trade for clients. Can a lowly dealer carry the same responsibility as a full-fledged trader?
"That looks at where is the trade; where is the person who makes the decision for the trade. It's a question we will have to grapple with…Very often you have different desks communicating with each other but it might not be clear as to who has done a 'sufficient amount' to trigger the reporting requirement," said Alice Molan, registered foreign lawyer for Mallesons.
McCormack said: "Many financial institutions in this region use offshore books, so some have very small books in Hong Kong itself, even if trades are arranged here. We have a reasonably expansive net that has been cast, which includes trades booked in Hong Kong as well as those 'conducted in Hong Kong'. This is still a nebulous area."
Yet for all of the current talk, the actual products being affected are only interest rate swaps - products that matter to US and European markets but only have a fraction of trades in Asia, where local participants worry more about exchange rates.
As volatility of Asian currencies surge against the backdrop of China's market liberalisation reforms, what Asian investors are really interested in is yuan or other Asian cross-currency swaps. There is no word on that in the reform plan.
The HKEx's OTC Clear business depends on the development of the offshore yuan. Noyes believes that if Hong Kong becomes the hub of offshore yuan clearing and if the yuan becomes a global currency, HKEx OTC Clear will have a good business model.
"Very few exchanges want to deal in FX. It kills the economics of the exchanges," Woo said.