Multiple factors including capital savings, access to liquidity and funding, operational resilience, transfer of risk and cost control are driving increased adoption of third-party clearing in the APAC region, found a recent GlobalTrading roundtable held in Hong Kong – with T+1 a key driver in the shift.
Titled ‘Shortening Settlement Cycles Amid Third-Party Clearing’ and hosted by the Hong Kong Stock Exchange (HKEX), the well-attended roundtable generated a detailed and diverse discussion around the market catalysts contributing to the growing adoption of (and interest in) the evolving third-party clearing model. Conducted under Chatham House Rules, the conversation was led by key speakers including Tae Yoo, Managing Director, Markets Division at HKEX; Clive Triance, Group Executive for Securities and Payments at the Australia Stock Exchange (ASX); Tom Jenkins, Head of Financial Risk Management at KPMG; and Kathy Ong, Regional Product Manager for Custody and Clearing Services at BNP Paribas.
A changing landscape
APAC has seen record trading volumes and increased volatility this year, and this has placed a strain on systems, creating a new need for third-party solutions to mitigate risk and reduce costs. Combined with a changing landscape of investors and new demands for brokers and banks to create intraday liquidity solutions to meet the evolving challenge of regional funding requirements, firms are keen to explore alternative options to self-clearing.
Cost efficiencies and operational resilience are important elements, and there has been a notable focus from regulators around the region in supporting this through post-trade initiatives such as clearing models – with third parties playing an important role, especially where institutions lack self-built scale.
A drive for stronger ROI is fueling the search for efficiency
Over the years, the combination of rising costs and smaller ticket sizes has not created the jaw effect that financial institutions had hoped for to create a sustainable operating model. This has accelerated the review of the operating model in order to seek significant efficiencies and savings. As one speaker noted, there are around 161 actions that need to take place in order for a trade to clear and settle – and most of it is just stuff that “has to happen” with little in the way of differentiation. So why not pay someone else a fraction of the price to do it for you?
The additional pressures raised by new regulatory standards on operational resilience were also a topic of discussion. Not only are regulators now expecting critical operations such as securities settlement and payments to be recoverable within a reasonable timeframe but at the same time the definition of what is considered to be a reasonable timeframe is changing as markets are moving to shorter settlement cycles and introduce T+1 (or even T+0) in some cases. This strengthens the case to engage service providers who can take over this burden, particularly in markets which are more challenging such as those moving to shorter settlement cycles.
“It’s a natural progression – you open up clearing to widen your markets,” said one speaker. Along with cost cutting, it can be seen as a way to expand activity in new markets whilst benefiting from lower entry costs by leveraging clearing and custody network of the provider.”
Outsourcing is on the up
The growing trend towards middle and back office outsourcing is also supporting the third-party clearing model, especially in Hong Kong, where the tradition has long been an account operator model. “What we have done over the last 10 years is really try to push to try and bring more efficiencies, to demonstrate that actually third-party clearing is a stronger model because it brings additional benefits that aren’t available with account operator,” said a speaker.
“And TPC adoption will become higher. We’re seeing other players enter the market, which grows it further. Now more than ever, because of the cost of capital, the increases in volume that need more collateral, more margining, more guaranteed contributions, all those things add to the cost of funding and liquidity. We are seeing a lot more pressure, and even though many of the drivers may be the same as last year, they are stronger this year because it is all more expensive.”
“As an industry, we’re facing a couple of challenges now,” agreed another speaker. “One is cost of operation. The other is the cost of funding different business activities, whether its operations or collateral or trading. And this can vary widely across jurisdictions.”
Hong Kong, for example, unlike the US, does not allow direct market access by exchange members’ direct clients, meaning that much of the buy-side has to use sponsored access through brokers that are providing trading and execution solutions – which can create further sensitivity around competition.
A new breed of investor
The APAC region provides unique, diverse and different challenges, but at the same time, it also has highly diverse liquidity profiles, depending on different jurisdictions, with their own set of eccentricities. We are now seeing these new types of investors studying it, learning it and developing investment strategies around it, which is where we’re starting to see growth.
But in addition, a new influx of quantitative clients (with higher volume and clearing thresholds) is driving demand yet further. To better service this growing market segment, exchanges and CCPs in the region are keen to develop their offerings.
These quant funds are “chomping at the bit” to pump more money into the market – but at the moment, many are shackled by their post-trade options.
“In Hong Kong, we’re seeing a new breed of investors coming to the market,” agreed Yoo. “That requires a higher degree of clearing services that are much more diversified in terms of the number of players, for the purposes of diversification away from concentration risk.”
One example of this is the upcoming rule change in Hong Kong to allow the appointment of multiple clearers in the cash and single stock options market, focused on servicing growing demand of clearer diversification for new and existing investors by allowing clearers and brokers to partner in servicing these clients and their increasingly sophisticated requirements. HKEX has announced plans to roll out a third-party clearing arrangement model to allow Non-Clearing Participants to appoint more than one General Clearing Participant for the clearing and settlement of trades. According to Yoo, the launch of the new third-party clearing model (now approved by the SEC) will provide greater incentive for clearing service providers to invest in their infrastructure and increase operational efficiency.
Shortening settlement cycles = greater synchronicity
Shortening settlement cycles is one of the key themes of the year for the custody market, and its impact on clearing is substantial. “It reduces credit risk, but it creates more operational risk for APAC, because of the time zones,” pointed out one speaker. It also places a squeeze on collateral – and some markets are finding it trickier than others. “The further east you fly, the harder it gets,” said one speaker. “By the time you get to Auckland, it’s a real challenge – and you’re a long way away from your investor in California.”
The concern is that customers, the end investors that effectively create the trading, or the institutional brokers, will spend a lot of money on fails and a lot of money on covering those fails or paying fines for those fails. “In some ways, atomic settlement is easier,” suggested one speaker. Hong Kong has T+0 settlement and the challenges of operational compression are similar, especially if the client or the client’s custodian is sitting in the US. “Eventually, as markets start to grow and the pressure on the amounts becomes larger, we’ll need to see some kind of synchronization between the banking system and the equities depositary and clearing house,” warned a speaker. “Currently they’re very disconnected, so you could have a situation where all the operations are functioning late into the night and we are operating in shifts because we are preparing for that sort of thing, to be able to send earlier settlements, but we don’t have the banks open late enough for the US to come in, reinstruct, and make those payments in HK dollars.”
Could this be an opportunity for third party clearers? Currently, if all margins are being squeezed by T+1, clearers could start charging for freebies. “If a bank is having to do T+1 settlement then they’ll have to margin call each day, and that creates a cost which they will have to pass down,” agreed a speaker. “
The ripple effect
However, the general consensus was that T+1 could increase correlated adoption of third party clearing in the region – as long as the clearers work to provide appropriate solutions.
“Every time we create an improvement in the lifecycle of the transaction it reduces capital, and it should allow more bandwidth to trade. I don’t think the move to T+1 will bring down costs entirely, because the shorter settlement cycle creates its own operational challenges, but theoretically the reduction of settlement risk could mean that velocity increases, which will be a positive step,” said Ong. “It will bring initial operational risk, but TPC (outsourcing) can help address that. In today’s environment, the front office should be chasing transformational deals and focusing on their core business, you don’t want to have your capital and your resources tied up in operations, so it’s easier to hand over to a third party to deal with those challenges.”
With shorter settlement cycles also comes the need to invest in technology to meet the new timelines, and here too, third party clearing can help, by providing a more efficient service that means clients do not have to make the investment (and outlay the effort) themselves. “As clearing becomes more popular, we will see more tech innovation,” predicted another speaker. “We’re having so many conversations right now with people on legacy models who are considering a move to TPC and that will automatically drive more competition, which will lead to more innovation.”
Exciting times ahead
With technology advancing, competition increasing and imperatives evolving, it’s an exciting time for clearing as the market grows and client demand grows with it.
“In the lifestyle of the transaction, third party clearing moves up the chain. It adds value, does things for you, produces what you do yourself, and creates capital efficiencies,” said Jenkins. “It can offer multi-asset class netting, it can offer multiple benefits. To be honest, I can’t see why more people aren’t taking it up, unless it’s just fear of change.”
And when it comes to shorter settlement cycles, all speakers agreed that no matter what challenges might arise, the market would adapt. “There will always be service providers who will find solutions,” confirmed Ong.
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