Banks launch clearing review after Korean broker default

The world's biggest banks have launched an urgent global review of how clearing houses manage defaults after the collapse of a futures broker in South Korea left many banks shouldering far more than they expected to bail it out.

The case highlights how clearing houses have moved centre stage as regulators and market participants reform the financial system in the wake of the 2008 crisis, which was triggered by the Lehman Brothers default.

They stand between counterparties in a trade, ensuring a deal goes through in the event of a default. As part of sweeping reforms of the financial system launched in 2009, G20 countries have mandated greater use of clearing houses, also known as CCPs.

The South Korean case involves HanMag Securities, a futures broker that collapsed late last year after a trading algorithm went wrong. It was the first time a South Korean securities group faced bankruptcy due to erroneous electronic trades, which lasted 143 seconds.

The case alarmed foreign banks and brokers operating in the country after KRX, the Korean exchange, bypassed using its own funds to help repay counterparties in the Won46.2bn ($4.3m) default and dipped straight into a "default fund" for non-defaulters at its clearing house.

Typically an exchange will use its own resources, known as "skin in the game", before resorting to other default funds, which is a pool of money provided by banks and brokers that are members of the clearing house.

KRX was acting in accordance with its rules by going straight to the default fund. The effect was that banks were liable for more than they expected, bankers said.

Foreign banks such as Citi, JPMorgan and Bank of America Merrill Lynch are all members of KRX's clearing house. Some privately admit they were unaware of the KRX's rules.

But they are now scrambling to see which other CCPs globally have similar rules, so that they are not again caught out.

"The Korea situation really took a lot of people by surprise, we just want to make sure that CCPs have skin in the game," said Conor Cunningham, head of futures and over-the-counter (OTC) derivatives clearing at Citi, based in Singapore.

The banks, as well as the Futures Industry Association, a US-based industry body, are working on a review of CCPs' default procedures, also known as the default "waterfall". An initial focus in Asia.

"Very few of the smaller or emerging markets clearing houses have gone out of their way to amend their rules, so it's the smaller clearing houses in Asia where there is the concern," said Paul Landless, counsel at law firm Clifford Chance in Singapore.

KRX says it is considering changing its default waterfall rules "to match global standards", according to Kim Bae-young, head of the derivatives regulation team at the exchange. "We are now in discussions with the government about it," he told the Financial Times.

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A survey of default procedures at 27 of the world's largest CCPs last year by Thomas Murray, a UK-based consultancy, found widespread differences.

KRX, it found, was one of the few clearing houses that only turned to its own resources after all members' contributions, including non-defaulters, had been exhausted. KRX is also one of the few large clearing houses that does not separate the balance sheet of its clearing house from other assets of the exchange, such as the corporate building or the pension liabilities.

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"Although we rely on default funds after using up defaulting members' initial margins to cover the losses, the exchange takes full responsibility for the remaining losses after the Won200bn ($188m) default fund gets depleted.

"In other countries, clearing houses cover the losses before tapping default funds but the amount they cover is relatively small, up to 1-2 per cent of default funds," he said.

Alex Harborne, senior analyst in CCP risk assessment at Thomas Murray, said that there was no clarity on how market participants could be sure of clearing houses' standards globally. "There's no regulation that says anyone has to do due diligence on clearing houses," he said. "We would welcome the FIA looking at that if only to keep the clearing houses on their toes."

The banks' reviews have taken on an added urgency because the use of algorithmic trading in futures and options markets is growing across Asia, the latest region to adopt the practice.

The fear is that another default could be triggered by an algorithm - or "algo" - going awry. "With a pick-up in algo you could see this happening again," Mr Landless said.

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