Revamping of Korea's clearing model up for parliamentary vote

Fears are growing that Korea could be left out of the second wave of European Union decisions to grant equivalence status to third-party central counterparties (CCPs) as Korea grapples with a change to its default risk waterfall model.

This could make the cost for European derivative dealers more expensive than in those jurisdictions that are deemed to be equivalent. The deficiencies in Korea's clearing model were highlighted when HanMag Securities collapsed in December 2013 with losses of $45 million.

Under Korean law, the exchange only assumes losses after a 200 billion won ($185 million) member contribution fund has been exhausted. This is counter to the model used in Europe, which says that the exchange must assume a portion of the losses before non-defaulting members start to foot the bill – so called "skin in the game".

Whilst there is a new bill on the table that seeks to bring Korea's clearing structure more in line with European standards, some are anxious that the change has been too long in coming.

For the bill to make it into law, it must first be approved by the legislative subcommittee – due to sit on April 20 and 24 – before going before the National Assembly on April 30 and May 6.

However, with political crisis engulfing the government – prime minister Lee Wan Koo (pictured) and other senior officials are being investigated for corruption – some are uncertain whether the National Assembly will even sit.

With a new capital requirements directive (CRD IV) due to be fully implemented by June of this year, and Europe's regulatory body Esma due to conclude its recognition analysis of Korea's counterparties by September, time is of the essence, says Keith Noyes, regional director of Asia-Pacific at the International Swaps and Derivatives Association.

"If Korea is not recognised by the EU as being third-country equivalent by the time that CRD4 comes in, then subsidiaries of European banks may have to pay significant additional charges as treating KRX as a non-QCPP will be more expensive," he says. "Branches of European banks in the country will not be able to become clearing members if equivalence is not achieved before the conclusion of the Esma recognition analysis in September."

Only two European banks operating in Korea – HSBC and Standard Chartered – are subsidiaries. The others operate as branches.

"The problem is that, once you make the decision – or the decision is made for you – that you cannot be a clearing member, this changes your business model and it is not something that you can easily go back to. Once you're out of the market, you're out of the market," says Noyes.

Unclear wording

Some also worry that, although the new bill is an improvement, the text isn't clear enough about how much KRX should be on the hook for before the members' fund is touched.

"My concern is that the amount of loss that each member has to take with the joint compensation fund is still not capped by regulation," says Kevin Lee, managing director of New Edge in Seoul.

Members are expected to replenish the joint compensation fund once it is exhausted, and so in the case of a really large default – possibly where multiple firms are defaulting – they could be on the hook for much more than 200 billion won.

Hyo Seob Lee, a research fellow at the Korea Capital Market Institute (KCMI), says the amount of the KRX reserve to use before the contribution fund is hit has also not been defined in the legislation. The KRX reserve that is available changes in line with the profit-and-loss account each year and is currently 400 billion won.

"A portion of this will be used, but we don't know how much," he says, adding that this will require a separate legislative change to the Korea Capital Market Act.

However, French bank BNP Paribas, which has a strong presence on the Korean market, is not overly concerned with this lack of detail – and Michael Chae, head of global markets in South Korea, says that the new default waterfall model will greatly improve things.

"I think that the commitment by KRX to bring its capital into the waterfall model should meet the conditions that the European Commission is looking for, because it does bring them into alignment with western standards and provide more of a cushion for the members of the Korean CCP," he says.

"My sense is once this is communicated to Esma, and they understand this, they will take a more supportive stance in terms of Korean equivalence."

The important thing is for the new waterfall model to be in place, says Chae, because the current situation makes it more expensive to operate in Korea.

"The whole idea of centralising things was to make transactions much cheaper and more cost-efficient, but unfortunately the current status will require further fine-tuning through ongoing working groups in order to meet these goals," he says. "The complete CCP landscape can only change if it gets full endorsement by the EU and the risk weightings are not classified in the way that they are."

The extra costs are reflected in the collateral that BNP Paribas has to post against counterparty credit risk, and certain fees that have to be paid if the CCP isn't fully EU equivalent.

Higher charges

Isda's Noyes says the higher charges that banks may have to face could manifest themselves in a number of ways.

"Does it mean that European banks will charge higher bid-offer prices? Will banks look to consolidation in order to increase market share, which would deprive local banks of liquidity?" he says.

Korea is a country where local banks and corporations tend to operate on one side whilst foreign banks are the liquidity providers on the other side, he adds.

But Chae does not think that the costs for dealing with a CCP not deemed EU equivalent will materially affect the way that foreign banks do business in the country.

"This will simply be the price that you have to pay for being involved in the business and doing business in Korea. We do not think these costs will be so significant that we have to stop our trading, or that IRS trades in Korea will be so pricey that we cannot handle them," he says.

The cost implications for European banks may not be as significant as Isda fears, since not all swaps have to be cleared in Korea and, as Risk.net reported last year many European banks in the market have chosen to use tenors outside the mandated range.

However, this trend may reverse in the future as the introduction of Basel III is expected to make non-cleared trades much more expensive.

Furthermore, as Noyes argues, a proportion of a bank's client base will always prefer their trades to be cleared, and if European banks are having to pay more than domestic institutions the latter could look increasingly attractive.

So far, four countries from Asia have been granted EU equivalence – Hong Kong, Japan, Singapore and Australia. The EC is now looking at both Korea and India for inclusion in the second wave of decisions.

India is understood to be a strong candidate for inclusion, whilst it remains to be seen whether the new waterfall structure will alleviate EU concerns about Korea.

"The Commission's services continue to be in close contact with the Korean authorities to discuss and have a full understanding of regulatory developments in order to reach a decision to adopt an equivalence decision under EMIR," said a spokesperson for the EC.

KRX could not be reached for comment.