In order to strengthen the stability of the financial market and gear to international regulatory standards, Taiwan Futures Exchange (TAIFEX) launched the OTC central clearing business on July 25, 2022.
OTC derivatives are transactions that do not trade on an exchange, usually executed through negotiation between financial institutions, or by brokers as intermediaries, using the telephone or Internet to request quotations and reach a consensus on the terms of the transaction. In general, OTC derivative products are more complex, with greater financial leverage, and market participants are interconnected with each other. When one market participant defaults, it may trigger a chain reaction and affect the stability of the financial market, just like what happened in the 2008 financial crisis.
Through central clearing, market participants can transfer the default risk to TAIFEX. The original obligation between the buyer and seller will become obligations between TAIFEX and the buyer, and TAIFEX and the seller. Participants no longer have to face multiple counterparties with different risk profiles. They can just deal with one single counterparty – the TAIFEX. Thus their risk management operations can be simplified and costs can be reduced.
The payment of profit and loss and the risk management are handled according to the mark-to-market value of each cleared transaction. Thus TAIFEX can have real-time control over the risk profile of each participant and issue the warning in advance. The financial safeguard system of TAIFEX can support its role to act as a shock absorber in a default event and avoid the continuous expansion of risk which might further trigger a financial crisis.
According to the regulations of the banking bureau, a risk weight of 2% can be applied to a financial institution’s trade exposure to TAIFEX when calculating the capital charge for counterparty credit risk, which can effectively reduce their capital requirement and increase their capital efficiency. Furthermore, in the past, financial institutions have to pay a considerable expense to submit their transactions for central clearing at foreign central counterparties, such as the LCH. The opening of the TAIFEX OTC derivatives clearing business allows financial institutions in Taiwan to clear their transactions domestically, realize the localization of finance services, improve the convenience of central clearing and reduce clearing costs.
The central clearing mechanism is like the central nervous system of the financial system. Only by ensuring the smooth operation of the clearing system can enhance the confidence in trading and allow the market to flourish. In addition to ensuring the safety of participants’ transactions and reducing the cost of financial institutions, the TAIFEX OTC derivatives clearing service can create a favorable trading and hedging environment, which is expected to further attract foreign investment into the Taiwan futures market and enhance its international visibility.
