Despite more than two years of planning and nine months of industry consultation, the rollout of correspondent clearing in Hong Kong--originally due in the third quarter--has been delayed as potential clearers, Hong Kong Exchanges and Clearing (HKEx) and broker-dealers grapple with market and processing risk issues.
"The operating model and implementation timetable is still under consideration to take further market feedback into account," said a spokesman for the HKEx.
HKEx runs its settlement for equities through CCASS (the Central Clearing and Settlement System) where, in addition to serving as the central counterparty, CCASS itself acts as a custody participant. In that capacity, the exchange provides nominee services for some 10,000 investors through its investor participant (IP) accounts. In these accounts, holdings are dematerialized--that is, there is no physical scrip--but the remainder of investor holdings are certificated and held by custodians and broker-dealers on investors' behalf. Herein lies the risk. Most of HKEx's 480 market participants are small broker-dealer firms (known as Class C brokers) and since the HKEx doesn't allow outsourced clearing, these small shops act as clearing and settlement participants in CCASS.
From HKSE's perspective, the exchange is looking to financial institutions to manage brokers' settlement obligations and responsibilities and take on the credit risk of brokers through the novation process, said YF Cheung, head of custody and clearing services for Hong Kong and China at Standard Chartered Bank.
Added Cheung: "They would prefer the brokers to focus more on trading activity and the investment advisory role, with the clearing and settlement function offloaded to a third-party clearer."
According to the HKEx spokesman, the exchange is carefully considering the likely market response from Class C broker-dealers as part of its current round of consultations, but apart from foreshadowing an extension of clearing and settlement services directly to retail investors through their IP account service, the exchange has not been forthcoming about its risk management model for retail investor clients of small broker-dealers.
However, risk is a major issue for banks as they prepare to enter the market as clearers. "The whole thing was put into motion by the failure of some small brokerages, and it was a wake-up call as to the suitability to continue to let smaller brokers participate in the clearing system," said James Wong, SVP and manager of custody and clearing at HSBC in Hong Kong. Most individual retail investors hold physical scrips with their broker, so if the broker absconds, they will be exposed, he added.
"[HKEx] would be much happier having an international bank like Citibank as a clearing member in CCASS than the 400 or so Class C broker-dealers. That is one of the main drivers from their perspective," said Michael Sleightholme, manager of global securities services for intermediaries at Citibank.
That, of course, makes a major assumption that the banks are willing to take on that settlement risk, and for Class C brokers, that's a big question mark. Trading, credit and settlement risk, as well as exposure under HKEx's Capital Guarantee Fund structure, are key concerns.
For the most part, potential clearers interviewed would target the larger Class A and B broker-dealers, leaving open the question of how Class C firms would be serviced. There are a number of proposed solutions.
The HSBC plan involves multiple outsourcing models in addition to self-clearing participants-third-party clearing for Class A brokers; agency clearing (i.e., outsourcing part or all the back office) for Class B broker-dealers; and "white-label services" for the rest.
"Here broker-dealers would only manage the relationship with the customer and when they issue the order from the customer, they place it with the white-label service provider--just as they do in the United States and other markets," said Wong.
But according to Citibank's Sleightholme, even though there are no regulatory reasons why a broker currently couldn't outsource its back office to an agency clearer, the exchange will not allow it.
"Hong Kong is the only place I know of globally where [the exchange has] gone straight to the third-party clearing option while preventing participants from engaging in an agency-type structure--i.e., allowing broker-dealers to outsource the operations of their own account with CCASS," he said. "There is a rule that said written approval must be obtained from the exchange and while there is no other regulatory reason that written approval is not forthcoming, the exchange just won't do it. It's difficult to understand."
Standard Chartered's Cheung agrees that "large broker-dealers are more keen on seeing the agency clearing initiative take off at the moment."
Sleightholme believes there is a fundamental divergence of drivers for third-party clearing and as these take time to unwind, the absence of any outsourcing alternative for broker-dealers is damaging the market.
"There is a divergence in goals," he said. "The banks obviously see this as a way of extending product service offerings to our major international clients--which include A and B class broker-dealers, in most cases. And the major brokers--the major internationals--are looking at this as a way of converting their fixed costs into variable and reducing their infrastructure in Hong Kong, which is an expensive place to do business. From the perspective of brokers and banks, the agency model pretty much gives them 90 percent of the benefit anyway-third-party clearing doesn't really add a huge amount. But from the exchange's point of view, the driver is different-its market risk, and that's why third-party clearing is attractive to them.
"At the other end of the scale with Class A brokers, the danger is that the longer this goes on with third-party clearing, with no other outsourcing options open to them, we will continue to see significant players pull out of the Hong Kong market. In my view--and I think it's the view of the big players out there--if they were able to outsource their operations, they could run a slimmer shop and it would be easier to justify staying in Hong Kong as a direct market participant. Those departures could have been avoided if we had outsourcing in place," Sleightholme added.
On the issue of agency clearing, the HKEx indirectly refers to risk mitigation. "The objectives of third-party clearing are not being met by agency clearing," according to the HKEx spokesman. Neither does HKEx share concerns potential clearers have about their exposure under the Capital Guarantee Fund, which already exists to manage the impact of potential participant default. "The introduction of third-party clearing would not necessarily cause changes in the Guarantee Fund structure or rules," the spokesman added. "Contributions are in proportion to clearing activity and risk. The relative exposure of the larger clearers doesn't seem to be an issue at present."
However, banks don't share this view. "We are looking for ways to limit our exposure to the Guarantee Fund before we can participate," said HSBC's Wong. "They will want us, as a third-party clearer, to contribute to the Guarantee Fund and the fund is a good-to-the-last-drop' mutual insurance mechanism. HSBC would take the deep-pocket risk, because the bank would be the participant with the deepest pockets and if the other participants fail, we would always be the ones asked to come up with the funds."
"Market risk is also of concern," Wong added. "In Hong Kong, in theory, you can trade an astronomical number with a small balance sheet."
Control over nonclearing-participant market orders is also an issue. In markets such as Australia, while clearers may elect not to vet orders placed by their correspondent firms, they do get real-time confirmations when orders are executed on the market. The HKEx has confirmed it is considering the provision of trading information for risk management purposes, but details on such an offering are still unclear.
Sleightholme believes that the exchange could be more cooperative in helping minimize risk. "There is an underlying assumption that the major international banks will come in and absorb all that market and settlement risk, and maybe we will absorb some of it, but we want to have some checks and balances in place that allow us to control that risk, and certain things have been requested to be built into the model that have been turned down," he said. "The Guarantee Fund is probably the most visible example, and I'm sure our competitors would agree that none of us wants to be the last man standing because we have the biggest balance sheets; it just doesn't make business sense."
Managing settlement for Class C broker-dealers remains the core issue. The exchange itself may take on this function. According to HSBC's Wong, CCASS' current management of IP accounts only occurs indirectly as the exchange acts as a custodian, and while effectively competing with others offering custody services, the broker-dealer remains the clearing participant. After consulting with the HKEx, Wong subsequently said: "The HKEx revealed that they are looking at bypassing the brokers when clearing for the IP accounts. We need to know more to make further comment."
Overall, the banks remain positive about the HKEx third-party clearing initiative. "We are very keen to participate," said Wong. "The only concern is risk management."
Added Sleightholme: "We all really should have the same goal, which is to make Hong Kong a more efficient and cheaper place to do business and an easier place to access and get some new entrants into the market."
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