Just off Lan Kwai Fong in the Central district of Hong Kong is a bar called Midnight Express. Its yellow canopy sports the words: "Sponsored by MeesPierson Derivatives Clearing". It's an unusual piece of advertising for an investment bank, and only serves to reinforce the impression that Asia's derivatives business is faced with bottlenecks.
All the main western banks are in town now; some indeed are concerned there are too many for current conditions. Regulations in some countries restrict or prohibit derivative use. And, says a Hong Kong-based banker: "There are only so many companies out there which can benefit from using derivatives. There can't be more than 10 or 20 per country over here, and certainly no more than 200 throughout the region [excluding Japan]. That's not much business for all of us to be chasing."
Asia's popularity with big foreign banks is based on a widely held belief that the region will be the next big market. But some fear that a combination of low interest rates and an oversupply of investment banks in Asia is having a negative effect on the derivatives business. Competition between the foreign investment banks here is seen as being so advanced that it's driving margins down. "That's no bad thing in itself, but the margins are sometimes too tight considering the risks that are being run," says Quentin Hills, head of marketing, Asia, at Citibank, and co-chair for Asia of the International Swaps and Derivatives Association (Isda).
The flip side of the argument is that having so much competition can only be a good thing. "Having so many players helps to develop the use and reach of derivatives, and increases the liquidity of the products," says Jonathan Chung, managing director for global equity derivatives in UBS's Hong Kong office. "Only as a result of this do margins tighten." But as a Singapore-based trader points out, this too has its dangers: "The interbank market in Asian derivatives is huge. Banks, especially foreign banks, are providing liquidity only in that they're quoting prices at one another, especially in local-currency products where end-user demand is small. And so, as soon as there is a crisis, liquidity will dry up immediately."
This is not a remote concern for Asian economies. One derivatives trader admitted that his bank expected a mini-crisis in Indonesia every four to six months. Another gave this example of how precarious the business can be: "Our CEO went to Thailand towards the end of last year, and while there he rang us up and told us to dump all our Thai basket positions because the country was in such a mess." In the event, Thailand avoided the predicted crisis. Had it not, the consequences for the region could have been immense.
Concerns about competition, tight margins and potential liquidity problems are, however, subordinated to a generally bullish outlook on derivatives. "We are over-investment-banked in Asia, but there are so many potential developments in the area of derivatives that the future looks bright," says Gustiaman Deru, assistant director, Asian local markets, at ING Baring's Hong Kong office.
After the losses and lawsuits attributed to derivatives worldwide in 1994 and 1995, some may find this hard to believe; it is tempting to speculate that MeesPierson's advertising represents last-ditch attempts to try to salvage business from an otherwise uninterested and distrustful world. This may have been true not so long ago: "If you used the d-word in connection with a deal, you could be sure of a frosty reception from Asian clients until early last year," says a derivatives trader in Hong Kong.
In through the back door
But the use of derivatives is picking up again, just as it is elsewhere. Not that clients haven't learnt a lesson or two: "Now we often have to explain doubly hard to our clients why particular instruments might be good for them," says UBS's Chung.
And attempts are already being made to ease bottlenecks. The use of derivatives to gain exposure to markets that restrict direct foreign access is a small but important development. Non-convertible currencies, punitive withholding-tax requirements or restrictions on foreign ownership all foster the need for access to Asia via derivatives. Or investors might simply be uncomfortable with local settlement systems. The main markets at present are for China, India, the Philippines, South Korea and Taiwan, as well as Singapore, which still holds strong views about the use of its currency in international capital markets.
There are two reasons why companies might want to gain exposure to these surrogate markets. First, the need for risks to be hedged has grown as more and more foreign capital is invested in Asian countries. Second, as margins have narrowed in those onshore Asian markets that are open, investors have come to look to the offshore derivatives market as the place to gain the higher yields they crave.
This market is usually referred to as the non-deliverable forward market: participants set up deals offshore that track the performance of the relevant domestic indices and usually settle accounts in US dollars. Although most trades are plain-vanilla swaps, currency plays and equity-index tracking, more complex derivatives are increasingly being used. These can be simple knock-in floors and caps, positions based on differentials between US and specific Asian interest rates, or more complex products that enable firms to use swaps to take synthetic positions that combine an equity and currency view.
Not all the banks are involved in this part of the market or at least will not admit to it claiming either that they do not want the expense of waiting for the market to develop or that they do not want to upset the authorities.
Those who do admit to involvement in the offshore markets usually do so privately, and play it down: "We do trades in Chinese renminbi and Korean won, but it's not a very big market, and we normally only do it at the request of our clients," says a Hong Kong-based derivatives trader.
Not all are convinced of the usefulness of the offshore markets. David Wong, executive director, fixed income, at Morgan Stanley in Hong Kong, says "It's just an intermediate step; the offshore markets are small and illiquid a large trade for a non-convertible currency is just $30 million, and no more than $100 million for convertibles." And for some currencies trades are not always immediately profitable. According to David Worth, head of the financial engineering group, capital markets, at Standard Chartered in Singapore: "For some currencies in the non-deliverable forward markets the spreads can be so wide that a two-way flow is needed to make any money on the deal."