All stock options contracts traded on the Exchange are cleared through a central clearing house - The SEHK Options Clearing House Ltd (SEOCH), a wholly owned member of the Hong Kong Exchanges and Clearing Limited Group. It becomes the central counterparty to every validly executed trades through the process of novation.
Risk management is the primary function of SEOCH safeguard system. The System is to provide the highest level of safety and the early detection of unsound financial practices. Its purpose is to protect all SEOCH Participants and their customers against the consequences of a default by a participant in the clearing structure. The system is constantly being reviewed and modified to reflect the most advanced risk management techniques.
Clearing Participantship Standard
Participantship standard is the first line of defense in the risk management system. There are two categories of the clearing participantship, namely, Direct Clearing Participantship and General Clearing Participantship.
Direct Clearing Participants should have minimum liquid capital of HK$5 million and General Clearing Participants should have at least liquid capital of HK$20 million. In addition to the financial requirement, SEOCH also considers the other factors including (1) the company background, (2) financial conditions, (3) the experience of the company’s directors and key personnel and (4) the risk management system employed by the company.
The Derivatives Clearing and Settlement System (DCASS) is an integrated clearing and settlement system for the derivative markets covering futures and options products of HKEX. It is a fully electronic and automated clearing and settlement system capable of supporting many types of derivatives products. It also provides a seamless interface for derivatives trading and clearing, which reduces cost through common hardware, software and communication links. DCASS enables Participants to establish and maintain positions in either the house or the client accounts. Stock transactions as a result of exercise and assignment are settled under the Continuous Net Settlement System (CNS) in Central Clearing and Settlement System (CCASS).
Margin requirements are good faith deposits to guarantee the performance of the contracts. Clearing House and Client margin levels for all products traded in HKFE are established with reference to historical price volatilities, current and anticipated market conditions, and other relevant information. SEOCH calculate the margin requirements of their participants at the end of each trading day using PRiME, (Portfolio Risk Margining System of HKEX), a SPAN compatible margining algorithm that underpins the margining engine of DCASS. PRiME determines the margin requirements based on its assessment of the maximum potential risk exposure of a portfolio over a one-day period under different realistically simulated market scenarios. It takes into consideration of the major risk factors, such as the movement in the prices and volatilities of underlying assets, the time until expiration and the risk-free interest rate when assessing the potential loss (risk) of the portfolio’s value. Margin levels are routinely reviewed and will be revised should market conditions change.
SEOCH performs regular backtesting to evaluate the margin coverage and regular sensitivity analysis to test the sensitivity of the margin model coverage. The latest results as of March 2017 reveal that the model performance is satisfactory. The margin coverage for major products and all Clearing Participants’ portfolios can achieve single-tailed confidence level of at least 99%.
Daily Mark-To-Market Margin
Each day, after the close of trading, SEOCH marks the marginable positions to market with the fixing price of each option series determined by SEOCH. The resulting amount is called Mark-to-Market margin. Collections from Clearing Participants are processed by the Direct Margin Debiting System (“DMDS”) through which SEOCH instructs its settlement banks to direct debit the Clearing Participant’s bank account. Money settlement conducted by settlement banks should be confirmed before 9:15 a.m. to assure that all open positions are fully margined before the opening of Markets.
Intra-day Margin Call
During periods of high market volatility, SEOCH conducts intra-day margin call on real-time open positions using the prevailing market prices. All intra-day margin calls should be met by Clearing Participants within one hour after the notification. Generally, a margin erosion of 50% in the margin interval of any one of the option classes automatically triggers the intra-day margin call. With the capacity to conduct intra-day margin calls, SEOCH is not forced to wait until the settlement on the next day and margins for those contracts whose prices have changed significantly can be restored immediately.
Capital Based Position Limit
SEOCH assigns Gross, Net and Total position limits to each Clearing Participant on the basis of its apportioned Liquid Capital (“LC”). It is a measure which seeks to ensure that the risk exposures of participant commensurate with their financial strength in terms of LC. Should an SEOCH Participant's Gross, Net and/or Total position exposure exceed the assigned limits, the Participant can extend the limit by increasing its liquid capital.
Additional Margin on Concentrated Positions
To minimize the risk arising from the over-concentration of open option positions and pending stock positions on one Participant, SEOCH has the authority to impose additional margins on individual Participants. If the projected aggregate loss (less any margin) based on the Reserve Fund stress assumptions arising from such open options positions and pending stock positions (‘Net Projected Loss”) held by a Participant is greater than 30% of total Net Projected Loss of all Participants and the total Net Projected Loss of all Participants exceeds HK$500 million, SEOCH will increase the margin requirement by 20% or more# (depends on its concentration level) on that Participant.
#Tiered Margin Rate
Above 30% and at or below 40%
Above 40% and at or below 50%
Above 50% and at or below 60%
Above 60% and at or below 80%
##Applicable on the sixth consecutive Business Days and onwards, before which 40% would be applied, to allow 5 days for CPs to transfer or close out concentrated positions and/or arrange funding.
Holiday Margin Arrangement
SEOCH has put in place a set of holiday margin arrangements to mitigate the potential market risk on the reopening of the Hong Kong markets after the holiday break arising from significant overseas market movements during the holiday period. Currently, when there is one calendar day, excluding Saturdays and Sundays, in the Hong Kong holiday period, SEOCH makes a mandatory intra-day margin call on its participants on the trade day prior to the holiday period to mitigate the potential market risk. When there are more than one calendar day, excluding Saturdays and Sundays, in the Hong Kong holiday period, in addition to the mandatory intra-day margin call, SEOCH also raises the margin intervals for each of the option classes based on the historical price movement with reference to the number of calendar days, excluding Saturdays and Sundays, in the holiday period and collects the margin requirements of open positions based on such increased margin intervals from the participants before the holiday.
SEOCH has established a Reserve Fund for the purpose of meeting its obligations as the counterparty in circumstances that the losses arising from one or more Clearing Participants’ default cannot be fully covered by the defaulting Participant’s margin. The resources available to the Reserve Fund comprise Initial Contribution and Variable Contributions made by Participants, interest income earned on the cash deposits of the Reserve Fund, and other resources as arranged by SEOCH from time to time.
The size of the Reserve Fund is monitored on a daily basis by stress testing and the Clearing House shall require Participants to pay such amounts by way of Variable Contributions for the purpose of providing further additional resources to the Reserve Fund.
Key stress testing assumptions are:
- Market movement assumptions: ±22% of stock options market
- Counterparty default assumptions: default of the single largest Participant plus the fifth largest Participant
Level of Variable Contributions required = (Projected Loss from stress testing – Defaulting participants’ Margin and collateral*) ÷ 90% – Basic Elements of the Reserve Fund**
* Collateral includes mark-to-market margin, risk margin and surplus funds
** Denotes the existing aggregate value of the Reserve Fund less the total Variable Contributions
SEOCH will re-calculate the Variable Contributions of each Participant on the 1st business day of every month and ad hoc recalculation may be made from time to time.
SEOCH Participants will be required to pay Variable Contributions under either of the following conditions:
- Under the regular monthly assessment where the actual Variable Contributions on hand is lower than the required level; or
- Daily risk exposure exceeds 90% of the existing Reserve Fund size for one business day
If Variable Contributions are required, each Participant's share of the Variable Contribution will be equal to that Participant's share of the average total margin requirement and net premium paid over the most recent 60 business days. Any Variable Contributions payable by SEOCH Participant will be debited from its House CCMS Collateral Account via the Direct Margin Debiting System by 4:00 p.m. of the 1st business day after the recalculation, unless otherwise specified by the Clearing House.
Variable Contributions may be made in the form of non-cash collateral such as Exchange Fund Bills and Notes provided prior approval is obtained from the Clearing House.
For more details, please refer to Chapter 4 – SEOCH Participant’s Obligation of the Options Clearing Rules of SEOCH and Chapter 11 – Reserve Fund of the Operational Procedures for Options Trading Exchange Participants of SEOCH by the hyperlinks below:
Participants' margin deposits must be in the form of cash, Exchange Fund Bills/Notes, US Treasury Bills/Notes or other acceptable collateral types as prescribed from time to time. If a participant does not have sufficient margin collateral on deposit with SEOCH to satisfy the margin requirements calculated, a direct debit instruction will be sent to the participant's designated bank to collect the shortfall. All margin calls must be met before the stipulated time.
Segregation of Customer Monies
Participants are also required to separate their customer positions and monies from their own positions. The regulations are designed to protect customers in the event of the insolvency of financial instability of the SEOCH Participant through which they conduct business. Based on specific written instructions from a SEOCH Participant, SEOCH maintains separate accounting of the aggregate positions and monies of the SEOCH Participant's customers.
SEOCH Participant's Default
While the risk management techniques at SEOCH are specifically designed to prevent an SEOCH Participant from defaulting on its obligations, the Clearing House, by rule and by operational practice, has prepared contingencies to deal with such an event. The following summarizes the steps that would be taken in the event an SEOCH Participant failed to meet its financial obligations to SEOCH.
The SEOCH managed Reserve Fund provides instant liquidity to the market in the event that the SEOCH Participant cannot meet margin calls and his margin monies have been exhausted. When an SEOCH Participant defaults, customer positions are netted against each other and the SEOCH Participant's margin money is applied to any deficits after netting. If the deficit exceeds funds available in the SEOCH Participant's margin deposits, the balance is withdrawn from the Reserve Fund in layers. Under no circumstances will customer segregated margin deposits held by the Clearing House for one SEOCH Participant be used to cover either a house or customer default of another SEOCH Participant.
The safeguard system of the SEOCH provides a unique blend of risk management and financial surveillance techniques designed for the protection of the Clearing Participants and its customers. As the Clearing House strives to become more responsive to the demands of a sophisticated financial marketplace, it will continue to improve and strengthen its financial safeguard system. This article has been compiled by the SEOCH for general information purposes only. Although every attempt has been made to ensure the accuracy of the information, the SEOCH assumes no responsibility for any error or omission. All matters pertaining to rules and procedures herein are made subject to and are superseded by the official SEOCH Rules and Procedures.
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