Capital Adequacy - CCR: Capital Treatment of Participating Margins for Swap Connect

Banking Policy Department
Our Ref: B1/15C
B9/75C
8 May 2023
The Chief Executive
All Locally Incorporated Authorized Institutions Dear Sir/Madam, Regulatory Capital Treatments in relation to Swap Connect In light of the coming launch of Swap Connect, I am writing to set out the relevant capital and reporting treatments applicable to assets posted by authorized institutions (“AIs”) for participating in Swap Connect (“participating margin”). With reference to the joint press release between the People’s Bank of China (“PBoC”), the Securities and Futures Commission of Hong Kong (“SFC”) and the Hong Kong Monetary Authority on 5 May 2023 1 , Swap Connect is an arrangement that enables overseas and Mainland investors to participate in the financial derivatives markets in the Mainland and Hong Kong through a connection between the infrastructure institutions in both places. Hong Kong Exchanges and Clearing Limited, through its clearing subsidiary OTC Clearing Hong Kong Limited (“OTC Clear”), has partnered with Shanghai Clearing House (“SHCH”) to provide clearing services under Swap Connect. OTC Clear and SHCH, as the qualifying central counterparties (“qualifying CCPs”) recognised by the SFC and PBoC respectively, have established a clearing link, with OTC Clear providing central clearing services for Hong Kong and international investors, and SHCH providing central clearing services for investors in the Mainland. OTC Clear and SHCH will face each other as principal and will pay variation margin and settlement payments daily, and have established an inter-CCP margin to manage the default risk to the other. 1 https://www.hkma.gov.hk/eng/news-and-media/press-releases/2023/05/20230505-4/

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In the initial stage, Northbound Trading will commence first, allowing overseas investors to participate in the Mainland interbank financial derivatives market through mutual access between Hong Kong and Mainland infrastructure institutions in respect of trading, clearing and settlement. Initially, interest rate swaps will be eligible with other products to be included in due course depending on market conditions. Regulatory capital and reporting treatments Having considered the nature of participating margins posted by AIs to OTC Clear in the latter’s loss-bearing waterfall structure, we believe that AIs should treat such margins in the same manner as default fund contributions under the Banking (Capital) Rules (“BCR”). It follows that—

• a separate capital charge should be calculated for the participating margin by
  using Formula 23K in section 226X(4) of the BCR; and
• the amount of the participating margin posted and its capital charge should be
  reported in Item 1 in Division A of Part IIIe of the Capital Adequacy Ratio return in the same manner as default fund contributions made to qualifying CCPs. Details of the above treatments are set out in the Annex to this letter. Yours faithfully, Daryl Ho Executive Director (Banking Policy) Encl cc: FSTB (Attn: Mr Justin To)

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Annex
Capital treatment of participating margins posted for the purposes of the Swap Connect

1. As discussed with the OTC Clearing Hong Kong Limited (“OTCC”), it is agreed that—
   (a) participating margins (“PMs”) posted by authorized institutions (“AIs”) that are OTCC’s clearing members (“CMs”) for the purposes of the Swap Connect will be treated in the same manner as default fund contributions under Division 4 of Part 6A of the Banking (Capital) Rules (“BCR”); and (b) the Shanghai Clearing House (“SHCH”) will be treated as if it were a CM of OTCC for the purpose of the calculation of the hypothetical capital (Kccp) under Basel Framework CRE54.28 to CRE54.351 .
2. Capital treatment of default fund contribution made by an AI to OTCC
   An AI, regardless of whether it has participated in the Swap Connect or not, must calculate the capital charge for its default fund contribution made to OTCC in accordance with Formula 23K in section 226X(4) of the BCR as set out below:
   (a) 𝐾𝐾𝐴𝐴𝐴𝐴𝐶𝐶𝐶𝐶𝐶𝐶 = 𝑚𝑚𝑚𝑚𝑚𝑚 �𝐾𝐾𝑐𝑐𝑐𝑐𝑐𝑐(𝐶𝐶𝐶𝐶) ∙ � 𝐷𝐷𝐷𝐷𝐴𝐴𝐴𝐴 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝐷𝐷𝐷𝐷𝐶𝐶𝐶𝐶𝑃𝑃+𝐷𝐷𝐷𝐷𝐶𝐶𝐶𝐶 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓� ; 8% ∙ 2% ∙ 𝐷𝐷𝐷𝐷𝐴𝐴𝐴𝐴 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓� (i) 𝐾𝐾𝐴𝐴𝐴𝐴𝐶𝐶𝐶𝐶𝐶𝐶 is the capital charge for an AI’s usual default fund contribution (i.e. excluding PM in cases where the AI has participated in the Swap Connect); (ii) 𝐾𝐾𝑐𝑐𝑐𝑐𝑐𝑐(𝐶𝐶𝐶𝐶) is the hypothetical capital for OTCC’s trade exposures to all its CMs (including those CMs that have participated in the Swap Connect). The value of 𝐾𝐾𝑐𝑐𝑐𝑐𝑐𝑐(𝐶𝐶𝐶𝐶) will be provided by OTCC; and (iii) 𝐷𝐷𝐷𝐷𝐶𝐶𝐶𝐶𝐶𝐶, 𝐷𝐷𝐷𝐷𝐴𝐴𝐴𝐴 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 and 𝐷𝐷𝐷𝐷𝐶𝐶𝐶𝐶 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 are as defined in section 226X(4). Any additional collateral or resources contributed by OTCC, the AI and other CMs for the purposes of the Swap Connect must be excluded as they will be accounted for in the calculation discussed below.
3. Capital treatment of participating margin posted by an AI to OTCC for the AI’s
   participation in the Swap Connect
   If an AI has participated in the Swap Connect, the AI must, in addition to the capital charge for its usual default fund contribution calculated under paragraph 2, calculate a capital charge for its PM made to OTCC in accordance with Formula 23K in section 226X(4) of the BCR as set out below:
   (a) 𝐾𝐾𝐴𝐴𝐴𝐴𝑆𝑆𝐻𝐻 𝐻𝐻 = 𝑚𝑚𝑚𝑚𝑚𝑚 �𝐾𝐾𝑐𝑐𝑐𝑐𝑐𝑐(𝑆𝑆𝑆𝑆 𝑆𝑆) ∙ � 𝐴𝐴𝐴𝐴 𝑂𝑂𝑂𝑂 + 𝑆𝑆 + 𝐶𝐶𝐶𝐶 � ; 8% ∙ 2% ∙ 𝑃𝑃𝑃𝑃𝐴𝐴𝐴𝐴� (i) 𝐾𝐾𝐴𝐴𝐴𝐴𝑆𝑆 is the capital charge for an AI’s PM;

1 https://www.bis.org/basel_framework/chapter/CRE/54.htm?inforce=20230101&published=20200327

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(ii) 𝐾𝐾𝑐𝑐𝑐𝑐𝑐𝑐(𝑆𝑆𝑆𝑆 𝑆𝑆) is the hypothetical capital for OTCC’s trade exposures to SHCH; (iii) ICMOTCC is OTCC’s own resources contributed to the inter-CCP margin. For application of Formula 23K, ICMOTCC will be treated as the DFCCP defined in paragraph (c) of Formula 23K; (iv) ICMSHCH is SHCH’s half of the inter-CCP margin. For application of Formula 23K, this will be treated as part of the 𝐷𝐷𝐷𝐷𝐶𝐶𝐶𝐶 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓defined in paragraph (d) of Formula 23K; (v) PMAI is the amount of PM contributed by the AI. For application of Formula 23K, this will be treated as the 𝐷𝐷𝐷𝐷𝐴𝐴𝐴𝐴 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 defined in paragraph (b) of Formula 23K; and (vi) PMCM is the total amount of PMs contributed by OTCC’s CMs. For application of Formula 23K, this will be treated as part of the 𝐷𝐷𝐷𝐷𝐶𝐶𝐶𝐶 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 defined in paragraph (d) of Formula 23K. (b) OTCC will disclose the value of a c-factor (“c”) to enable AIs to calculate the capital charges for their PMs in accordance with paragraph (a), where— 𝑐𝑐 = 𝐾𝐾𝑐𝑐𝑐𝑐𝑐𝑐(𝑆𝑆𝑆𝑆 𝑆𝑆) 𝐼𝐼𝐼𝐼 𝑂𝑂𝑂𝑂 + 𝐼𝐼𝐼𝐼 𝑆𝑆𝑆𝑆 𝑆𝑆 + 𝑃𝑃𝑃𝑃𝐶𝐶𝐶𝐶 (c) Currently under Basel Framework CRE54.29, the minimum risk-weight assigned to a qualifying CCP’s trade exposures to its CMs is 20%. In order to comply with the requirement set out in paragraph (a) of Formula 23K in section 226X(4) of the BCR, OTCC is required to apply a 20% risk-weight to its trade exposure to SHCH in calculating 𝐾𝐾𝑐𝑐𝑐𝑐𝑐𝑐(𝑆𝑆𝑆𝑆 𝑆𝑆) although this is not reflective of the lower credit risk of SHCH. As such, the HKMA will consider amending section 226X to allow for the application of a 2% risk￾weight by OTCC in calculating 𝐾𝐾𝑐𝑐𝑐𝑐𝑐𝑐(𝑆𝑆𝑆𝑆𝐶𝐶 ).
4. CAR return Part IIIe - reporting arrangement
An AI that is a CM of OTCC and has participated in the Swap Connect should report its default fund contribution and PM made to OTCC under item 1 in Division A of Part IIIe of the CAR return in the following manner—
Part IIIe: Risk-weighted Amount for Exposures to Central Counterparties (CCP) (in HK$'000)
Division A: Default Fund Contribution
Default fund contribution Capital Charge Risk-weight % Risk-weighted Amount (A1) (A2) (A3) (A4)

1. Qualifying CCPs
2. Non-qualifying CCPs 1250
   SUBTOTAL

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(a) Item 1 - Column (A1) - Default fund contribution The amount reported in respect of OTCC should be the sum of—

• 𝐷𝐷𝐷𝐷𝐴𝐴𝐴𝐴
  𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 (see paragraph 2(a)(iii) above); and
• 𝑃𝑃𝑃𝑃𝐴𝐴𝐴𝐴 (see paragraph 3(a)(v) above).
  (b) Item 1 - Column (A2) - Capital Charge
  The amount reported in respect of OTCC should be the sum of—
• 𝐾𝐾𝐴𝐴𝐴𝐴𝐶𝐶𝐶𝐶𝐶𝐶 (see paragraph 2(a)(i) above); and
• 𝐾𝐾𝐴𝐴𝐴𝐴𝑆𝑆 (see paragraph 3(a)(i) above).
  (c) Item 1 - Column (A4) – Risk-weighted Amount The AI should report the risk-weighted amount of its default fund contribution and PM made to OTCC in column (A4), which is calculated by multiplying the sum of the two capital charges reported in column (A2) by 12.5.