Johannesburg Stock Exchange: New Rules Launched For New Derivatives Market Default Fund

Safcom - the clearing house for the JSE’s derivatives market – today announced the promulgation of the rules enabling the establishment of a default fund intended to add another layer of investor protection in the exchange traded derivative market. The need for the fund arises from the financial crisis of 2008, which prompted coordinated efforts to improve global market stability. Internationally, derivatives markets must now have prefunded resources to provide capital (in addition to the collateral posted by participants) in case a clearing member defaults. The fund aims to reduce the impact of this risk and thus limit the liability for Safcom’s clearing members, most of whom are banks. Safcom calls for approximately R14billion in margin to cover trading valued at R350 billion per day.
 
The proclamation of the new rules follows the recent signing of a temporary legal agreement by all clearing members and paves the way for a new best of breed risk management process for the SA derivatives market, one which is aligned to global guidelines set by the International Organisation of Securities Commission (IOSCO) and compliant with Basel III requirements.
The structure of the new fund works on the basis that the nine clearing members, together with the JSE on behalf of Safcom, will pay collateral into the default fund (a legally separate entity) and invested as per an investment mandate agreed by Safcom. Each clearing member’s contribution to the fund is calculated according to the risk that each member brings to the central counterparty (CCP). The size of the fund and proportional contributions will be recalculated by Safcom quarterly and the total size of the fund will be disclosed to the market.
 
Under the new rules of the pre-funded limited liability default fund, Safcom now has a clearly defined and transparent full risk waterfall with four layers of defence built into the system for default purposes; namely initial margin of the defaulting clearing member, the defaulting clearing member’s contribution to the default fund, SAFCOM’s contribution to the fund and lastly, non-defaulting members’ contributions to the fund.
 
This replaces the previous model whereby Safcom’s members where liable for all losses incurred in the default of another clearing member. If the losses depleted the defaulter’s initial margin contributions, then the other members were obliged to step in to support the CCP with their capital to the very last cent if required.
 
“For the JSE, this is a big step towards overhauling the risk process in the SA exchange traded derivatives market and raising the profile and credibility of this market, particularly given that trading decisions are increasingly being made based on the costs of doing that trade,” says Leila Fourie, director of post-trade services at the JSE.  “For the first time, Safcom effectively has “skin in the game” as it is now legally bound (as are other clearing members) to contribute to reducing the impact of the risks faced by clearing members. This ultimately adds additional layers of protection for both its members and ultimately investors.”
 
The new fund reduces systemic risk as well as clearing members’ exposure to counterparty credit risk when clearing through Safcom. As a result, clearing members will need to hold less capital for centrally cleared exposures in terms of Basel III. The Basel Committee on Banking Supervision allows banks to apply a lower risk weight to trades cleared through a CCP that complies with the  IOSCO best practice guidelines.  IOSCO recommends that clearing houses should hold the necessary financial reserves, such as additional collateral or a pre-funded default arrangement to cover credit exposures from participant defaults in extreme but credible market conditions.
 
The new rules govern the use of the fund, the calculation of the required size of each member’s contribution and the investment and maintenance and governance of the fund itself.
 
The default fund applies to all markets for which Safcom provides a clearing service and hence default in one market will consequently be funded by clearing members across all markets. Due to the size of the different markets and trading profile of clearing members, this was considered appropriate and more capital efficient than having a separate fund for each market.
Following on from Safcom becoming the first CCP in the world to qualify for IOSCO compliance in November last year, the new default fund is another big step towards the JSE’s plans to launch its own onshore OTC clearing service later this year.