Euroclear Collateral Management Solution Conference –

A New Regulatory and Clearing Landscape for OTC Derivatives in Hong Kong

Kelvin LeeVice President, HKEx

13 September 2012

Factors Driving Growth in OTC Clearing

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OTC Derivatives

Market

Risk Management

Needs

Regulation

n Rapid OTC derivatives market growth in past 10 years with 17% CAGR

n Outstanding notional amount of OTC market has reached USD 648 trillion

n Increasing use of OTC derivatives across asset classes by more market participants

n Contract standardization and electronic trading further fuel the growth of OTC market

n Central clearing provides an effective credit risk reduction solution to market participants

n CCP’s risk management and collateral management policies help reduce the systemic risk of the OTC derivatives market

n Basel III gives banks strong regulatory push to central clearing to avoid 1,250% risk weighting

n CPSS-IOSCO and major jurisdictions (e.g. Dodd-Frank in US and ESMA in Europe) have been enacting new OTC derivatives regulations

n The SFC and HKMA are developing new regulatory regime in Hong Kong to mandate trade reporting and clearing in 2013

n Resolving trade counterparty credit limit issue under bilateral settlement model limiting trade volume

n Better client clearing services to local clients via direct clearing participant-ship

CommercialIncentive

Growth of OTC Derivatives Volumes (Outstanding notional value, US$ trillion)

2001 – 2011 CAGR : 17%

2008 2009 2010 2011 2012

n Financial Crisis (Lehman Brothers default)

n Financial Crisis (Lehman Brothers default)

n Enacted Dodd-Frank Act in July 2010 to avoid too big to fail bailouts

n Enacted Dodd-Frank Act in July 2010 to avoid too big to fail bailouts

n Introduction of BASEL III to strengthen bank capital requirements

n Introduction of BASEL III to strengthen bank capital requirements

n G20 Declaration on November 15, 2008

n G20 Declaration on November 15, 2008

n New CPSS-IOSCO principles issued on April 2012

n New CPSS-IOSCO principles issued on April 2012

Development of Global Regulatory

Breakdown of OTC Derivatives in the Global Context

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Source: 1. BIS Quarterly Review, December 2011 and earlier reports2. BIS, DTCC, Morgan Stanley

OTC Trades Breakdown by Products in 2009(2) OTC Trades Breakdown by Counterparty in 2009(2)

USD604 Trillion

n Interest rate swap products dominate the OTC derivatives market, amounting for >70% of volumes, though strong growth has been seen in 2006

n Dealers represent the largest customer group, with 70% of overall trading

Outstanding Amount of Global OTC Derivatives from 2004-2009(1)

USD Tn

Opportunity for OTC Clearing in Hong Kong

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n Capitalizing on Hong Kong’s advantage in being the premier Asian banking hub and the gateway to China

Asian Financial Hub

n HKEx OTC clearinghouse provides a local clearing solution to enable Mainland and local banks to become direct clearing participants

Mainland/Local Banks

n HK is the largest offshore RMB centre providing offshore RMB clearing and settlement

Offshore RMB Centre

n Asian time zone clearing and settlement finality allow banks to avoid risks and extra cost in cross time zone operation

Asian Time Zone

n HKMA and HKEx are partnering to develop trade repository and CCP respectively as part of Hong Kong OTC infrastructure

n Voluntary OTC derivatives clearing in Q4 2012 to provide market contract protection and mandatory clearing in 2H 2013

Regulatory Support

RMB Deposits in Hong Kong(RMB billion)

RMB deposit in Hong Kong is RMB552bn at end April 2012

Authorised Institutions in Hong Kong

Source: “Monthly Statistical Bulletin”, HKMA

Source: HKMA website, as of 30 June 2012

Total authorised insitutions: 213

Overview of HKEx

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■ The world’s #1 IPO venue 3 years in a row

■ The dominant offshore capital raising centre for Mainland-related issuers since 1990s

■ Asia’s #1 IPO venue for international issuers

Listing

■ The world’s leading structured product market

■ Asia’s second biggest stock options market by volume

■ Asia’s second biggest ETF market by trading value

Trading

■ 3 clearing houses with over 750 Clearing Participants

■ Vertically integrated across all businesses

■ Deep experience in cash and derivatives clearing and risk management

Clearing

IPO Funds Raised by Various Exchanges in 2011Existing Core Business

HKEx has developed a highly successful equities business portfolio and a solid foundation in clearing and risk management

Source: Dealogic (figures include funds raised by REITS; full value of dual listing deals are allocated to the respective exchanges)

Major Listed Exchanges Market Capitalisation(in US$ bn)

(in US$ bn)

Source: Reuters, as of 8 June 2012

HKEx Background

■ Formed by demutualisation and merged of Stock Exchange, the Futures Exchange and Hong Kong Clearing in March 2000■ Listed on the Hong Kong Stock Exchange in June 2000■ Primarily in cash equities■ Currently, expanding into FICC

HKEx Strategic Direction

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Riding on the success of equities market, HKEx is moving into new asset classes. OTC Clearing is one of the key pillars of HKEx’s extension strategy

Chapter 1Chapter 1ChinaChina’’s Capital Formation Centres Capital Formation Centre

Chapter 2Chapter 2ChinaChina’’s Offshore RMB Centres Offshore RMB Centre

1993 2010 2011 2012 . . .

Chapter 3Chapter 3Moving to a New Asset ClassesMoving to a New Asset Classes

n China IPOsØ New Issues from China remain

strongn International listings

Ø Incremental growth leveraging on existing platform

Ø Great branding effectn China Add-on’s

Ø Financial Institutions (FIs): strengthen capital adequacy

Ø Non-FIs: funding growth and overseas expansion

n RMB productsØ Critical to the sustainable growth of

offshore RMBØ Prepare for the arrival of Mainland

investorsn Cross-border market access

Ø Huge need for Mainland investors to go offshore driven by domestic economic growth

n Structural uplift in ADTØ Higher velocity from Mainland investors

will drive ADT

n OTC clearing

n Financial derivatives

n Commodities

HKEx’s Niche and Positioning on OTC Clearing

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ü RMB & Chapter 3 – OTC IRS & F/X is a strategic fit of the broader Chapter 3 and RMB build out

ü Diverse Members – Direct and indirect participation of international banks, Mainland banks, local and regional banks. Growing buy-side need for enhancing yield and structured products

ü Regulatory Regime – OTC CCP that will maximize capital benefits for it’s members in prudential manner

ü Product Differentials – First mover on RMB denominated products to reinforce offshore RMB centre

ü Asian Centric Service – Customised on-boarding and training for local players

ü CPSS- IOSCO Compliance - Risk management framework to align with global standards

Harmonization of “Global” and “Local/Mainland” Needs

OTC Clear: Overview of Structure, Membership & Clearing Model

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n OTC Clearing Hong Kong Limited (香港場外結算有限公司) , a new subsidiary of Hong Kong Exchanges and Clearing Limited. It operates independently of HKEx’s existing clearing houses

n The Board and three key committees – Risk Management Committee, Default Management Group and User Committee

Ownership &Governance

Structure

n One class of clearing membership for both IRS and NDFn Must be an Authorized Institution (AI) licensed under the Banking Ordinance or

a corporation licensed under section 116(1) of the SFO or with equivalent regulatory authorizations or licenses in other jurisdiction in which it conducts business

Membership

Clearing Model

n Principal Clearing Model with client clearing featuresn Clear inter-dealer OTC trades initially, client clearing in 2013 latern Capture trades through Markitwire, DS Match and HKMA-TRn Money settlement through either RTGS or Direct Debit/Credit arrangementn Connect to the clearing house’s web portal through SDNetn Clearing House Opening Hours: 0830 – 1800 (Mon – Fri) Daily except 1 Jan

OTC Clear: Initial Product Coverage

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Interest Rate Swaps(IRS)

Non-Deliverable Forwards (NDF)

Note: HKEx OTC Clearing House will use a phased product rollout and cover more products/asset classes in due course

Currency Maximum Tenor

Single Currency Interest Rates Swaps

CNH 10 years

USD 10 years

EUR 10 years

HKD 10 years

Single Currency Basis SwapsUSD 10 years

EUR 10 years

Non-deliverable Interest Rate Swaps (CNY 7-day Repo) CNY 5 years

USD / CNY USD / TWD USD / KRWUSD / INR

OTC Clear: Trade Clearing Process Flow

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CM 1 CM 2

Approved Trade Registration

System (HKMA / Markit/

DSMatch)

OTC Clearing PlatformValidation of Product

Margin & Credit Check

Confirmation (accepted/pending/rejected)

Matched traderecord

SubmitTrade

Record

Confirmation (accepted/pending/rejected)

Confirmation (accepted/

pending/rejected)

Web portal Web

portal Web

portal Web

portal

CM1 initiates trade with CM2 (bilaterally)

CM1 & CM2 upload trade to the Approved Trade Registration System

The Approved Trade Registration System sends the matched record to HKEx

HKEx accepts/rejects the trade and sends confirmation to CM1 & CM2 via the

Approved Trade Registration System

After the trade is novated, HKEx steps in to become the counterparty to CM1 and CM2

respectively

HKEx performs daily risk management/ operation process

OTC Clear: Trades Novation Process

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New Trades are still pending (EOD)

Reject new trades

(EOD of next day)

Regularly re-submit during the day

Real-Time Novationor

Portfolio Novation

New Trades

New Trades

Existing PortfolioExisting Portfolio

110 HKD (Margin

Requirement)

Collateral Balance

>=110 HKD

Collateral Balance <110

HKD

New trades are

accepted

New trades are pending

IM HK$100

VM HK$3

IM HK$7

Credit & Margin Check

Process**

Credit & Margin Check

Process**

Pending Trades

Handling Process

Pending Trades

Handling Process

**Please note that only two parties pass the check can trade be accepted.

VaR approach to achieve 5-day 99% coverage*

OTC Clear: Margin Methodology

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* Subject to change

Margin is calculated on portfolio basis to achieve maximum netting efficiency

5 Days PnL Distribution 7 Days PnL Distribution

~99.9% threshold based on historical data

~99.9% threshold based on historical data

At least 99% threshold based on historical data

At least 99% threshold based on historical data

VaR approach to achieve 7-day ~99.9% coverage (allow for porting and lower

capital cost to members)*

For Members For Clients

OTC Clear: Risk Management Framework and Waterfall

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Defaulting Member’s Margin

Defaulting Member’s Guarantee Fund

CCP Contribution

Remaining Guarantee Fund

Assessments/LimitedReplenishment

Rights

CCP Contribution

n Fair and open clearing membership standardsn Reduced counter party exposure via Transparent Central Clearing – Potential to

Lower RWA & Free-up Credit Lines

Membership

n Independent, transparent mark to market methodologyn Work with the industry to develop enhancement valuation services.n Transparent, fully replicable model with margin simulator accessible for all clearing

participants

Mark to Market & Initial Margins

n Capped exposures for membersn Funded coverage and contingent unfunded coveragen Separate from Exchange Business with no recourse to or from other risk waterfalls

Risk Waterfall

OTC Clear: Clearing Rules

n Be supported by the Hong Kong legal frameworkØ Voluntary OTC derivatives clearing legislative framework effective as of 27 June 2012 pursuant to section

392 of the Securities and Futures Ordinance (“SFO”)Ø Opinion on enforceability of clearing rules under Hong Kong law

n Be consistent with industry practicesØ Take account of rules of existing clearing houses in Hong Kong and overseas CCPs clearing OTC

derivativesØ Market standard provisions for the relevant products (e.g. ISDA, EMTA)

n Meet international standards (e.g. principles published by CPSS-IOSCO)

n Seek the Recognized clearing house statusØ The Hong Kong OTC derivatives CCP will seek recognition as a “recognized clearing house” (“RCH”) under

section 37 of the SFO. As a result:Ø Its clearing rules will be subject to SFC approval under section 41 of the SFOØ Its clearing rules will have the benefit of insolvency protections under the SFO

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Proposed Regulatory Regime for OTC Derivatives Market in HK

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n List of “clearing eligible transactions” to be jointly determined by HKMA and SFC and prescribed by subsidiary legislation (for flexibility)

n Initially IRSs and NDFsØ Not FX forwards and swapsØ A “top-down” and “bottom-up” approach

What?

Who?

Exempted?

Which CCP?

n Apply to local AI, overseas AI (booked through its Hong Kong branch), LC or Hong Kong persons if:Ø It is a counterparty to a clearing eligible transaction;Ø Both counterparties have exceeded the specified clearing threshold; andØ Neither party is exempt from the clearing obligation

n Proposal for transactions "originated or executed" by Als or LCs to be mandatorily cleared has been removed

n Central banks, monetary authorities or public bodies from jurisdictions with reciprocal exemptionsn Global institutions (such as IMF and SIS)n Intra-group transactions (subject to as yet unspecified conditions)n Non-financial entities using derivatives to hedge commercial risksn Transactions involving "closed market" counterparties (where there are currency controls and other regulatory restrictions in

certain closed market jurisdictions)

n Transactions subject to mandatory clearing must be cleared through a designated CCPn Local CCPs may be designated under the RCH regimen Overseas CCPs may be designated under the RCH or the ATS regimesn SFC has indicated its intention to apply international standards (such as the CPSS-IOSCO principles) in determining whether or

not to grant approval

Timelinen Consultation of subsidiary legislation – Q4 2012n Relevant laws on mandatory clearing in place – Q3 2013

OTC Clear: Major Implementation Milestones

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Q3 2012 Q4 2012 Q1 2013 Mid-late 2013

Finalise Clearing House Rulebooks

On-boarding of clearing members

Launch of OTC Clear

Start of mandatory

clearing

Voluntary clearing

2nd consultation on sub-legislation and introduce

amendment bill to legislature

Relevant legislation in place

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