Central counterparty as risk controller for OTC derivatives

Early in May this year, the Korea Exchange hosted the 2013 IOMA (International Options Market Association) conference in Busan. The conference participants included derivatives experts from some 40 countries around the world, and they discussed emerging issues and actions required for the regulation and risk management of over-the-counter (OTC) derivatives.

The participants agreed entirely with the need to bring the OTC derivatives trading under control. Then, the question might arise — why is it important to regulate and manage the risks associated with OTC derivatives and what actions are necessary to manage them?

As for the questions, we need to look back to the financial crisis in 2008 when serial bankruptcies of major investment banks and hedge funds, such as Lehman Brothers and Bear Stearns, drove the global financial system to the brink of failure. The main cause of such bankruptcies turned out to be a lack of sound risk management of OTC derivatives which were widely used to capitalize on the real estate boom and low interest rates.

A year after the global financial catastrophe, at the G20 Pittsburgh Summit in November 2009, the leaders made a strong commitment to the regulatory reform of OTC derivatives. They declared that OTC derivatives that can be standardized should be traded on the electronic trading system or on exchange markets, cleared through central counterparty (CCP) and reported to the trade repositories, where it is appropriate.

In addition, the G20 also agreed to provide a legal basis on the clearing and settlement of OTC derivatives. In relation to the G20 declaration, the International Organization for Securities Commissions (IOSCO) and the Bank for International Settlements (BIS), the international organizations for securities and banking industry, released in April 2012 the principles of financial market infrastructure (PFMI). The PFMI includes the risk management requirements for the financial market institutions specialized in the payment and settlement such as central bank, CCP clearing and depository.

Accordingly, a number of countries have established a legal foundation for introducing the CCP clearing of OTC derivatives; for example, the Dodd Frank Act in the U.S. and European Market Infrastructure Regulation (EMIR) in the EU. Korea also amended the Financial Investment Services and Capital Market Act in March 2013, which authorizes the Korea Exchange as a legitimate CCP for the clearing of OTC derivatives.

What are the implications and challenges for the Korean financial market? Most of all, the role and responsibility of CCP as risk controller has become more important and indispensable than ever before to safeguard the integrity and stability of the overall financial system.

It is quite understandable once we take a look at the traded volume of worldwide OTC derivatives. According to BIS, its notional value is estimated at $633 trillion as of 2012, about 40 times the U.S.’s GDP in the same year.

The utility of the CCP as a risk controller was proven during the global financial crisis in the late 2000s when many CCPs prevented the aggravation of crisis by guaranteeing the settlement of derivatives contracts valued at tens of trillion dollars.

In light of the global trend in regulations and its implication, the Korea Exchange will reinforce the risk management system for the derivatives transaction made on and off the exchange market.

To that effect, we will augment the financial resources to secure the reliable and efficient operation of the Korean financial market even during such disruptions as the credit crunch or other financial squeezes. Also, global standards will be adopted to enhance the reliability of clearing and settlement, including the introduction of intraday margins and the integration of a risk management system.

In addition, to promote information sharing and cooperation among global CCPs, the Korea Exchange signed a memorandum of understanding with Singapore Exchange to explore the joint clearing of OTC derivatives transactions

Finally, the Korea Exchange will make thorough preparations for the implementation of mandatory clearing of OTC derivatives such as Korean won interest rate swap, which is scheduled to commence in June next year.

To sum up, after the global financial crisis in the late 2000s, CCP as risk controller is required to undertake an essential role and responsibility for managing the risks involved in derivatives transactions, particularly in OTC derivatives. The dependable and smooth circulation of capital and securities through reliable and efficient risk management system became more crucial for the stability and sustainability of the financial system. Accordingly, the G20 countries and international regulatory bodies collaborated to secure the integrity and resilience of the global financial system. Korea also has taken corresponding measures to strengthen the soundness of the risk management system for the domestic financial market.

Hopefully, the enhanced risk management will contribute to further development and efficient operation of the Korean financial market becoming one of the global financial centers.