The Korea Exchange: A cautionary tale on CCP waterfalls and non-defaulting members taking the loss

Apropos of our post last week in CCP default insurance, a March 5th article in Risk by Viren Vaghela “Korea clearing structure in question after HanMag trading error” is worth evaluating. It is a cautionary tale about what could happen to non-defaulting members when the risk waterfall isn’t what they expected.

HanMag, a Korean securities firm with $20 million of capital lost $45 mm in one day after an algo trade went haywire. The article said,

“…The strategy was ostensibly to buy at limit-low and sell at limit-high to arbitrage any mispriced orders. However, by mistake, orders were sent in the opposite direction for both sides and were filled at the market price. The total loss reached 46 billion won…HanMag Securities had to settle payments worth 58.4 billion won including losses and other client margin by 4:00pm on the following day but only paid 1.4 billion won…”

Making matters worse were the Korea Exchange (KRX) margin rules. For agency trades done for clients, margin has to be pre-funded and sent to the exchange T+0. But for proprietary trades (like this one), margin is deliverable to the exchange T+1.  HanMag went bust the same day as the trade.

But instead of the “traditional” risk waterfall, Korea’s structure is a little different.

“…The conventional waterfall structure at international clearing houses outlines that the first layer of losses are absorbed by initial and variation margin of the defaulting member(s). In practice, variation margin, which is calculated on a daily mark-to-market basis, will have been used up before the initial margin if there is a clearing problem…”

and

“…This is followed by the defaulting members’ default fund and if this is still insufficient, the clearing house should introduce a junior tranche of its own capital and then if further funds are still required, non-defaulting members’ default fund contributions should be dipped into. The final layer in cases of a serious or multiple default is a second tranche of CCP capital…”

In Korea, the clearing house’s capital came after the non-defaulting members default fund contributions. Vaghela wrote“…In Korea the exchange only assumes losses after a 200 billion won ($190 million) default fund contributed to by members firms has been exhausted….” Non-defaulting members ate $45 mm in losses, of which $10 came from the pockets of four foreign firms (Newedge, Morgan Stanley, JP Morgan, and Credit Suisse).

The exchange simply followed their waterfall rules. The KRX had some “skin in the game”, but it was the last to get tapped in a default. The lesson is to pay attention to the fine print and when best practices – like having clearing house capital higher in the waterfall, if for no other reason than to make sure they are paying close attention – are established, the rules and processes are then updated. KRX is overhauling their rules, including giving the exchange a “kill switch” allowing them to cancel trades “…if it determines that such action is necessary to preserve market stability in cases where a large-scale default in the execution of trading, or a similar failure, is expected to occur or where circumstances indicate a significant trading error has taken place…”

As for the firms that made the money on the back of HanMag, some are giving the money back. But, according to the Risk article, Singapore-based hedge fund Cassia Capital made $36 million and is not being so generous. Cue the lawyers, stage left.

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