Hong Kong Futures Clearinghouse Case Study

Hong Kong Futures Clearinghouse Case Study

Qin Rong, Fei Wang, Qiao Wang

What Is The Background of HK Future Clearinghouse Case?

Hong Kong Future Exchange went bankrupt during October, 1987 and ended up with being bailed out by Hong Kong government. It is one of the most severe clearing house crisis cases in the world. In this section, background of this case is investigated from two parts: exogenous shock and endogenous weakness.

The exogenous shock comes from global stock market crash during October 1987. On October 19th, 1987, the stock market and its associated future and option markets crash in United States. Dow Jones plunged 508 points to 1738.74, which accounts more than 20% one-day loss (Figure 1[1]). Other markets followed suit. London, Singapore, Tokyo and other main Asian markets got their record declines during the next few days.

Just as other major Asian markets, Hong Kong market fell tremendously (more than 11%) on October 19th. However, Hong Kong market has some unique features after Black Monday. After huge fall on Monday, Hong Kong decided to close the stock market as well as stock index future market for the rest of the week. During this period, massive future brokers default and in order to save the rest of Hong Kong financial system, a 2 billion rescue package was raised by government along with major banks and brokers to bail out Hong Kong Future Guarantee Corporate (HKFGC). After reopen on October 26th, 2013, the market plunge for more than 30% and a further 2 billion rescue package had to be prepared by government along with major banks.

However, the unprecedented exogenous shock from global market is not the only reason that drove Hong Kong Future Exchange to bankruptcy. In fact, the endogenous weakness of risk management structure greatly amplified the reaction towards the market trembling.

The risk management arrangements in the Hong Kong future market at that time were complex. The exchange, HKFE, should use a clearing house and a guarantee fund. With this provision, HKFE delegate International Commodities Clearing House Hong Kong Limited (ICCH (HK)) as clearing house and the Hong Kong Future Guarantee Corporation Limited (HKFGC) as guarantee fund. As a result, HKFE run the market, HKFGC guarantee trades and ICCH(HK) provide clearing service.

HKFE mainly generated its revenue mainly from the rebate from clearing fees paid to ICCH(HK). The more volumes traded on the exchange, the more rebates HKFE will get from clearing fee. In 1986, the revenue generated from rebate accounts for two-thirds of revenue of HKFE and this number climbed to 90% during 1987. However, HKFE does not have a strong incentive to ensure the stability and integrity of financial system because its revenue comes from the volume.

The income of ICCH(HK) comes from the registration fees on all trades and interest on deposit and it does not have any financial exposure in its clearing role. However, its holding company, ICCH(UK) held 20% of HKFGC.

HKFGC was the guarantee fund and a limited company owned by a couple major banks illustrated in Figure 2 [2]. It is managed by ICCH(HK) and its major revenue was generated by investing the margin collected.

Neither ICCH (HK) nor HK was able to audit inspect the capability of its own. Hence, they neither ceased to clear for members in question nor liquidated the position or called for more margins. In fact, they did rely on the exchange to investigate the nature of nature of any problems and chose to do nothing. This regime composed by HKFE, ICCH(HK) and HKFGC does have problems of lack of supervisory. As a result, the responsibilities and incentives were too vague to form a strong system that is able to withstand large exogenous shock.

Who Was Responsible for The Loss And The Big Debacle?

There are two sources of problems in this debacle: market structure and clearing house structure. Specifically, market structure problems includes the concentration of market participants, margin enforcement, capital requirements, client understanding problems, risk concentration and risk control. The clearing house structure also has serious problems in asymmetry of information and risk because the guarantee fund was separate from the clearing house.

The weakness in the market results from a set of market practice at that time. First of all, the central governor was exposed to the credit risk within entire market because all traders in the market were members of clearing house. It was naturally impossible for Hong Kong Future Guaranteed Corporation to have enough guarantee funds to handle all the credit risk in the entire market. Second, the margin enforcement in the market is not very strict. In other words, some brokers did not closely monitor their clients' margin and collect the margin from their clients. In this way, the brokers expose themselves to higher risks and in return, the CCP are exposed to more risk. Third, some brokers do not have enough capital to support the risk they are taking. If defaults actually happen, they will not have sufficient capital to cover the liability they have to other parties and CCP. Fourth, since the stock future market just started in HK at that time, some market participants were not well-educated in this new area and they were not even aware of that they were exposed to an open-ended risk. Finally, the risks are mainly burdened by a few major brokers and their default would have huge impact on the CCP.

In addition to the problem from market structure, there are also problems from the structure of clearing house. At that time, guarantee fund (HKFGC) was separated from clearing house. With this clearing house structure, guarantee fund is exposed to the losses from defaults but their losses were dependant on the clearing house consistently monitoring the risk. This structure leads to two severe results. First, since clearing house did not burden any losses, if there were any, traders had little incentive to monitor the risk management of clearing house and to follow prudent trading strategies. Second, regarding guarantee fund, they are more likely to suffer if information was not effectively shared.

Who Suffered From The Debacle?

Almost everyone suffered from the debacle. First of all, CCP is clearly the biggest failure in this event. The Hong Kong Futures Exchange fell apart in 1987 after the stock market crash – in just one day the market fell almost 30%. The CCP had to look towards clearing members to meet huge margin calls on equity futures, who were unable to provide the increased collateral. The guarantee fund was eventually bailed out by the government.

Most brokers suffered in the event as well, no matter it is in short position or long positions. After market goes down sharply, short position holders will benefit from the event while long position holders will suffer.

Suppose there are two brokers, A and B. Broker A has two clients, X and Y, while broker B has two clients, M and N. Further suppose that X long 20 contracts and Y short 8 contracts through broker A; meanwhile, M short 600 contracts and N long 590 contracts from broker B (Figure 3). In this hypothetical case, both of the brokers have 10 contracts net exposure to clearing house.

During Black Monday, a large fall in cash market occurs and short position holders will benefit from the event (i.e. client M, client Y and broker B). In contrast, long position holders suffered from this market situation.

Suppose client Y asks broker A for repayment. Broker A will then turn to client X to cover its liability to both client Y and clearing house. However, if client X defaults, broker A has to cover these liabilities with its own reserves. In this way, net long position holding brokers suffers.

Similar case could be seen in broker B case. However, if long position holder, client N, defaults, broker B will cover more liability for it to repay client M. Though broker B does not have liability to clearing house because of its net position, it may still go bankrupt through the liability to client M. In this case, even net short position brokers suffered the event.

Besides the case met by broker B shown above, short position holding brokers would not benefit much when the entire market go crash. When the entire market goes crash, for their own interest in the long term, they are going to participate in the rescue plan.

How Much Did Company And The Clearinghouse Loss from This Failure Affair? What's The Aftermath of This Affair?

As stock disaster spread through the world, the Hong Kong stock market was bound to crash. The stock exchange and futures exchange decided to shut down the market. At the same time, the world’s stock market had fallen further. Most investors were aware that the value of long futures on Hang Seng Index would plummet. As the system risk existed in the structure of Hong Kong Futures Exchange, when the exchanges were reopening, many investors didn’t increase their guarantee funds, but default the contracts. Meanwhile those who hold short positions could not get margin money returned on their profitable positions.

The clearinghouse almost went bust. A group of banks, brokers and Hong Kong government supplied huge funds to rescue the clearinghouse. The amount was totally 4 billion HKD, and 2 billion HKD was drawn down very soon. [3]

As the data is limited to the public, we can say the brokers and clearinghouse loss at least 2 billion HKD from this failure affair.

On Oct 19 1987, the HSI was 3665.70. After the four days’ closure, the HSI had dropped to 2517.40. About 31% of the capitalization of Hong Kong Stock Exchange had been disappeared. The crash again spread west to the Europe, and then the United States. By the end of October, the HIS had dropped about 45.5%. Most stock markets around the world dropped a lot during the stock disaster. [4]

After the crash, Hong Kong had done a lot of reforms. Kinds of regulations and laws on futures were rewritten and published, and the relationship between the clearinghouse and exchanges were restructured. Only those powerful institutions can be members of the clearing system.

What’s more, The Hong Kong exchanges introduced, or enhanced various measures to manage risk, including circuit breakers, price limit moves and so on. They focused on the risk management. The risk would not be concentrated on some main members, but would be diversified though the system. When the risk increased to a limited value, investors would be asked to increase guarantee funds. The process was named as MARGINING AND DYNAMIC GUARANTEE FUND by HKSCC. [5]

What Lessons Can We Learn From The Hong Kong Futures Clearinghouse Case?

According to the Davison Report, there are some significant defects in the Hong Kong Futures Exchange. (1) All parts in a transaction are the members of the clearinghouse. There was no direct legal relationship between the clearing members and the Futures Guarantee Corporation. (2) Many brokers failed to ask their customers to increase guarantee funds quickly and strictly. (3) Many brokers did not have sufficient fund to control their own risk. (4) Many investors did not understand the risk of the futures market, so that they did not have the awareness of risk control. (5) The risk was concentrated. Many brokers and their investors all held long positions. (6) It lacked of market monitoring and risk control. [3]

In a financial market, the system risk could be voided if there are effective approaches to monitor the market, and control risk. Detailed regulations and adequate frameworks of laws are the base of a financial market. Different effective risk measure methods should be used to control risk frequently. Kinds of risk control approaches should be introduced into the market to all parts.

Why Is Hong Kong Futures Clearinghouse Case Important to OTC Clearing Landscape Today?

A wide range of OTC products are cleared today including credit products, interest rate swaps, commodity contracts and FX products. Nowadays, following the G20 in Pittsburgh, major markets participants are ready for the mass OTC central clearing.

Hong Kong Futures Clearinghouse case gives us an opportunity to glimpse the logic behind central clearinghouse. The clear flaw in the move to central clearing is that you may mitigate counterparty risk by passing trades through in the traditional bilateral OTC model. Unfortunately, it does not mean we are reducing risk as a whole because banks will have to repo assets to meet collateral requirements, and then, they remain exposed.

This is true that clearing model successfully mitigate market disaster in the collapse of Lehman Brothers. But we can’t infer that clearing model is invincible. In fact, CCPs have withstood a lot of client failures and the potential influence of CCP failures are much more serious than in the past. Hence, we are supposed to think about how to prevent clearing houses from becoming creators of systemic risk in the CCP consolidation and new regulation environment.

References

[1]"Black Monday (1987) ", Wikipedia, the free encyclopedia. Web. 20 Oct. 2013.

<http://en.wikipedia.org/wiki/Black_Monday_(1987)>

[2]Ian Hay Davison, "The Operation and Regulation of the Hong Kong Securities Industry -Report of the Securities Review Committee", Securities Review Committee" Web. 20 Oct. 2013.