The default of a Korean broker in December 2013 related to its erroneous trading of certain derivatives is not new news, but the reverberations from this default continue to echo loudly worldwide. This is because the default raises two very topical issues: (1) exchanges’ error policies and their response after direct access members’ algorithms go bad, and (2) the ability of clearing members meaningfully to impact publicly-traded clearing houses when they are the principal financial underwriters of clearing houses’ capability to address default situations. As a result, the following matters are all covered this week on Gary DeWaal’s Bridging the Week:
Korean Broker Default Raises Specter of Algorithmic Trades Gone Bad and Broker Liability for Fellow Brokers at Clearing Houses
Although the problem did not arise last week, the reverberations from the default of HanMag Securities Corporation during December 2013 as a result of erroneous trading of certain options on the Korea Exchange (KRX) continues to echo among brokers worldwide, raising concerns about error policies generally at exchanges, as well as reminding brokers about the potential losses they can sustain at clearing houses because of poor risk management policies of fellow clearing members. On December 12, 2013, HanMag, a KRX member, apparently entered over 36,000 orders involving Kospi 200 Index Options on the Exchange. However, it is believed that because of a wrong variable in a trading algorithm (i.e., coding the wrong number of days until option expiration), these orders were unintended. As a result HanMag sustained trading losses in excess of KRW 46 Billion (US $43.6 Million). At the time, KRX had no access to member kill switches, and had no error policy that invalidated trades outside of a prescribed band. On January 3, the KRX supposedly issued a notice to its members regarding the HanMag matter and asked counterparties voluntarily to return profits on the erroneous trades. Apparently a few counterparties returned profits from proprietary transactions, but the bulk of money remains unreturned outside of Korea, with the majority rumored to be in the United States. HanMag’s failure had a direct deleterious economic impact on other KRX members, because the Exchange covered from member deposits in the "Joint Compensation Fund" the amount HanMag failed to pay KRX as a result of the firm's default (KRW 42.5 Billion (US $39.6 Million)). The KRX recently amended its rules to permit member firms until the end of March 2014 to replenish this Fund. Apparently, KRX did not use any of its own resources prior to drawing on the Joint Compensation Fund. The principal Korean financial services regulator, the Financial Supervisory Service (FSS), is said to be investigating this matter. On January 16, the Financial Services Commission (FSC), the overseer of FSS, announced that by June 30, new regulations will be implemented that will give KRX the authority to cancel orders if the transactions are “deemed to pose threats to the security of trading settlement,” and that persons placing erroneous orders will be subject to punitive commissions. FSC also plans to introduce price-banding limits on futures and options trading, as well as to encourage securities firms voluntarily to enhance their internal control standards to preclude erroneous orders. The Kospi 200 Index Option is regarded as a security, not a futures contract, under US law. The Kospi 200 futures contract was approved by the Commodity Futures Trading Commission for trading by US persons in 2008. FSC estimates that 40% of the volume of Kospi 200 options trading on KRX is derived from algorithmic trading. Recently, during August 2013, the China Securities Regulatory Commission fined Everbright Securities RMB 523 Million (US $85 Million) after the firm’s algorithmic arbitrage trading system malfunctioned, causing a significant spike in the Shanghai Stock Exchange Composite Index.
My View: The recent events involving HanMag Securities present a real life study of two concerning matters: (1) an algorithmic trading system gone bad, with an exchange having few effective tools to manage the problem, and (2) a clearing house assessing clearing members as a result of the default of a fellow clearing member over which only the exchange and local regulator had oversight, not the other clearing members.
Without belaboring the point, it is critical by now for all exchanges worldwide to have transparent and predictable error policies with the ability to restrict access under certain circumstances. This has been a recommendation of IOSCO since October 2005 (see http://www.iosco.org/library/pubdocs/pdf/IOSCOPD208.pdf), and recently reiterated in the Futures Industry Association’s Market Access Risk Management Recommendations of April 2010 (http://www.futuresindustry.org/downloads/Market_Access-6.pdf).
Given the prominent importance of clearing in the current derivatives financial model, there needs to be reflection whether there is an adequate and meaningful representation of brokers in the governance of clearing houses now that most are de-mutualized publicly-traded entities. Brokers, who are principally obligated financially to support the clearing process, may no longer have adequate input to protect themselves against fellow clearing member risk now that the overwhelming majority of clearing houses are publicly traded and not mutualized organizations.
Compliance Weeds: The events at HanMag also provide US and non-US derivatives brokers an opportunity to refresh their recollection of the division authority between the Commodity Futures Trading Commission and the Securities and Exchange Commission related to certain non-US derivatives contracts. In general, the CFTC authorizes all US persons to trade non-US futures and options on futures products automatically except for futures and options on futures based on foreign security indices or foreign government debt products – which are subject to certain express pre-approvals by the CFTC and/or the SEC (the CFTC maintains a database of such approved products at: http://sirt.cftc.gov/sirt/sirt.aspx?Topic=ForeignOrganizationProducts). Also, some products that may trade as future options abroad, in fact would be regarded as a security in the US (under the exclusive jurisdiction of the SEC), because they are an option directly on a stock index (as opposed to a option on a futures based on a stock index, which would be under the jurisdiction of the CFTC); access to these products is governed by SEC rules. Finally, different rules apply entirely to foreign security futures contracts; both SEC and CFTC rules need to be consulted. For details, see: http://www.cftc.gov/International/ForeignMarketsandProducts/foreignproducts).
Federal Reserve Board Requires Establishment of an Intermediate Holding Company for Certain Large Foreign Banking Organizations The Board of Governors of the Federal Reserve System determined last week to impose a requirement on certain large foreign banking organizations to establish an intermediate holding company over their US subsidiaries and comply with the same risk-based and leverage capital standards to which US bank holding companies are subject. These requirements were adopted among a host of liquidity, risk management and capital measures adopted “to help increase the resiliency of” the operations of both certain US bank holding companies and foreign banking organizations. In general, the toughest requirements are imposed on domestic bank holding companies and foreign banking organizations with total consolidated assets of US $50 Billion or more (including non-branch assets only for foreign banking entities). In an earlier proposal, the FRB rules suggested triggering the tougher requirements for foreign banking organizations with consolidated assets of US $10 Billion. Relevant US bank holding companies will now be required to adhere to enhanced risk-management and liquidity risk management standards, conduct liquidity stress tests and maintain sufficient high liquid assets to cover their funding needs during a 30-day stress test. The objective in imposing these new requires, claims the FRB, is to have a “level playing field” and to “bolster the capital and liquidity positions of the US operations” of foreign banking organizations." Foreign bank intermediate holding companies will also be subject to FRB rules requiring regular capital plans and stress tests. The compliance date for US bank holding companies with these new rules is January 1, 2015. Foreign banking organizations have until January 1, 2016 to comply with the new requirements. According to a statement released by the European Banking Federation,
“We remain concerned with the negative impact the final rule will have on the presence in the US of European banks. …Indeed the obligation to establish an intermediate holding and to fulfill additional capital and liquidity requirements… will make the presence of European banks in the US more difficult and more expense and place them in a competitive disadvantage since US banks are not subject to comparable requirements in the EU. Continuous and in-depth cross-border cooperation with home regulators of [foreign banking organizations] would have been a better approach, more respectful of the international standards.”
Bloomberg News reported that Michel Barnier, the European Commission’s Financial Commissioner, appeared to threaten EU retaliation in response to the FRB’s new rules. “If we see unilateral measures in one direction,” Bloomberg News reported Mr. Barnier as saying, “there will be measures in the other direction.”
Compliance Weeds: The only reason I have reported on this matter is because it reminds me that, since 2010, there are now two items which futures contracts cannot be based on in the US: onions and motion picture box office receipts (or any index, measure, value or data related to such receipts; check out the definition of commodity at: http://www.law.cornell.edu/uscode/text/7/1a). Remember the Cantor Exchange’s proposed trading of Domestic Box Office Receipt contracts?
For more, see: Compulsory RMB IRS Clearing in China (translation available on request): http://www.pbc.gov.cn/publish/goutongjiaoliu/524/2014/20140220163044287403512/20140220163044287403512_.html.
ESMA AIFMD Q&As:
ESMA EBA Report on EBF Euribor Rate Setting Progress:
Federal Reserve Board New Capital and Liquidity Requirements:
General Press Release:
European Banking Federation Statement:
See: Bloomberg News Article:
Public articles on HanMag:
FSC Plan to Improve Security of Derivatives Transactions (scroll to find January 17 Release):
See: CSRC Release regarding Everbright Securities Corporation:
SEC v. Credit Suisse Group:
SEC Never Before Examined Initiative:
SEC v. Samuel Braslau et al:
See US Attorney’s Office (Central District of California) related criminal action:
The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of February 22, 2014, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.
Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office.
September 17, 2014
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March 13, 2014
February 25, 2014
November 15, 2013
June 25, 2013
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Gary DeWaal's Bridging the Week: February 17 to 21 and 24, 2014 (Korean Broker Default Reverberates Globally; Fed Tells Foreign Banks to Shape Up)Jump to: Bridging the Week Compliance Weeds My View