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.”
Yet there appears to be a growing demand for offshore market products, and banks are becoming increasingly proactive some even quote prices on the Vietnamese dong, though they admit they have never actually done a trade on it.
Officially many Asian regulatory authorities take a dim view of offshore trading in their currencies, but in practice their response to it varies. South Korea, for example, knows it exists but pretends it doesn’t. Singapore is not at all happy about it. Taiwan is usually comfortable with offshore OTC trades, but was not impressed when the Singapore International Monetary Exchange (Simex) and the Chicago Mercantile Exchange launched Taiwan equity index futures last month. Taiwan’s regulatory commission had planned to launch its own futures, but not until the end of the year. It is now said by a Hong Kong-based trader to be under pressure to launch by March.
Mayur Ghelani, director, foreign exchange, at Salomon Brothers Singapore, explains why some regulators are more upbeat than others: “I’m told that some governments actually encourage the non-deliverable forward market. The line they take is that it serves as a good way to develop the products before they’re brought onshore after all, these markets are simply a temporary transition until the currencies in question become fully convertible.”
Indeed, some central banks have been known to ring up traders in the region to see how derivatives products in their currency are trading offshore.
At present the governments have little to fear from the offshore market. Only the risks are being sent abroad, the underlying assets remain onshore, so there is no effect on domestic money supply. Only if companies began to borrow offshore might regulatory authorities take action.
In Asian markets that have a relatively liberal regulatory regime there is a distinct new trend in the use of derivatives.Products are no longer simply churned out by rocket scientists sitting in front of supercomputers before being marketed to clients regardless of whether they suit their needs or not: exotic products are no longer being used purely because they are exotic or highly leveraged.
Instead, as virtually all the institutions Euromoney spoke to were at pains to point out, derivatives are increasingly being marketed as corporate finance tools and used as a means of solving particular problems. Jonathan Fox, managing director at Credit Suisse First Boston’s Hong Kong office says that “We might spend six to 12 months introducing appropriate derivatives products to restructure a firm’s balance sheet.”
The message being put across is that derivatives have matured from being products for risky short-term leverage and speculation to more rational, sensible systems of effective risk management. This, says Mark Ramsay, head of regional treasury for HSBC Markets, explains the overwhelming use of plain-vanilla instruments in the last two years: “95% of customers in Asia are looking for liquidity and transparency first. Only then do they move on to second- and third-generation derivatives.”
Structuring growth
There is, however, some use of more complex derivatives. In the past nine months both interest rates and volatility have been low, forcing investors to look beyond plain-vanilla products in order to get better yields. But the high-risk hedging of the early 1990s is not being repeated. “A lot of asset buyers are coming back to the derivatives market,” explains Foong Hock Meng, managing director, financing and risk management products, at UBS in Singapore. “And increasingly they’re looking at more structured products, only this time round they want principal protection and minimum yield floors factored in. Floors are big business now everyone wants to know what their downside is.”
Some of the larger corporates in the region have a mixture of derivative requirements, says Peter Coad, managing director, international capital markets, at Chase Manhattan in Hong Kong: “Some companies here have a need for both complex US dollar and Japanese yen hedging structures, as well as plain-vanilla local instruments.” Some of the more complex structures these firms use include strikes with compound features that are very far from the money and trades that involve big discontinuity risks.
A prime example of a thriving plain-vanilla product is Hong Kong’s covered warrants. Issued by third parties, these are securitized options on either a single stock or a basket of stocks whose use has grown rapidly recently. Five years ago there were three covered warrant issuers in Hong Kong; now there are 25, most of them foreign investment banks. But there appears to be room for all, at least for the moment. “It’s very popular in the retail market, so you can’t turn it into too esoteric a product,” says Raphael Blot, head of equity derivatives at SocGen-Crosby, which issued its first Hong Kong covered warrant just last year. “And it still has huge potential. We issued two this week one a call warrant on First Pacific stock, the other linked to a basket of stocks.”
One week last month there were 20 separate covered warrant issues, eight of them on one day, and four on a single stock. With such a level of activity, and the expected increase in funding requirements from mainland Chinese companies tapping the Hong Kong market (the so-called red chip firms), last year’s total of 170 covered warrant issues could easily be surpassed this year.
A recent development has been the growth of the swaps market, previously something of a lame duck in Asia. Of the currencies in the region, though, only three are regarded as being at all advanced when it comes to trading them. The baht is the most developed of the three, both in the underlying and the derivatives markets, followed by the Malaysian ringgit and the Indonesian rupiah. “In interest rate and currency swaps all three currencies are liquid, all the way up the curve to 10 years,” says Citibank’s Hills. “But the baht is the most liquid and has seen a very quick tightening of spreads.”
Chase Manhattan’s Coad believes this trend will continue: “The next 10 years will see a huge demand for capital in Asia, something which the traditionally favoured equity market won’t be able to meet on its own.” The resulting increase in debt issuance that he and others forecast bodes well for fixed-income derivatives. In fact, the derivatives market already leads the way. “The development of debt markets in Asia has been completely different to that of the US and Europe,” says Coad. “There the money markets developed first, followed by the bond markets and then derivatives. Here it’s virtually the opposite the most liquid interest rate market in Asia is in the derivatives market.”
The reason for this is the lack of suitable government benchmarks. Hong Kong has issued virtually no debt, for example, and in Malaysia oil company Petronas’s issues of five-10-, 20- and 30-year bonds in the last two years became quasi-government benchmarks. So the interest rate swaps market is used as a means of establishing where benchmarks would be trading if they existed.
Cross-currency swaps are also a driving force: “A lot of currency swaps are done by supranationals such as the Asian Development Bank,” says Citibank’s Hills. “They issue in local currencies and swap into US dollars. It improves the prestige of the swaps market.” Deru at ING Barings agrees: “Cross-currency swaps are developing fast. Last year it was difficult to swap beyond three to five years, now we can go up to seven years quite easily.” This growth has had a knock-on effect on the underlying market, says Deru, with issuance moving away from one-year maturities into two, three and even five years.
Coming up fast on interest rate swaps are credit derivatives. “In a region such as Asia, where investors’ funding costs can be high, and markets are not all that efficient, using derivatives to carve up credit products makes good sense,” says Eric Slighton, head of global relative value at Deutsche Morgan Grenfell. “It allows different investor classes to buy the cheapest form of a given credit, or to isolate the part of credit exposure they are particularly interested in, be it the spread tightening, default risk, country risk, currency risk, or whatever.” Products such as these are well suited to buyers that are balance-sheet-sensitive, mark-to-market-sensitive or have a high cost of funds. The risk, once decomposed, can easily be distributed globally to investors with the strongest natural interest in each component: “Credit-enhanced products generally go to Europe, while leveraged spreads go to investors in Asia,” says Slighton.
Success by default
According to Wong at Morgan Stanley, there is a noticeable trend: “North Asia effectively Japan, Taiwan and Korea has started to look at ways to buy credits more efficiently. So they’re starting to use credit derivatives, and the best way to do this in Asia is by default derivatives there’s not enough liquidity for spread derivatives.”
Investors can choose from a variety of options in default derivatives. For example, they can get exposure to several credits held in a basket, but limit that exposure to just one credit in the event of a default; or they can create a very safe, high-yielding asset that is exposed only if two companies default. Deutsche’s Slighton explains the benefits of these: “If a company has an appetite for credit but has a high cost of funds, it’s uneconomic to position high-grade credits. So it makes sense to leverage one’s credit view. If an investor takes the view that none of a basket of high-grade credits will default, this produces a wide spread with downside no worse than any one of the credits. On the other hand, investors who have cash or cheap funding and who are able to evaluate complex exposures can get good returns for joint credit risk products. Since the investor is protected unless two credits default, the risk is remote, but the positions are often by-products of credit structuring so they are cheap.”
Although many of the end users of such products are western and Japanese investors, there is growing sophistication in the application and acceptance of derivatives by domestic Asian clients. Yet for companies and investors alike to benefit from a more fully developed range of products, much more will have to be done. The local futures market, for example, is underdeveloped, with only Simex and the Hong Kong Futures Exchange offering well-established equity index futures. Because of the relative paucity of debt issuance, the interest rate futures market is very small, although the Hong Kong Futures Exchange announced last month that it plans to revamp the three-month Hibor (Hong Kong interbank offered rate) contract later this year. The general consensus on Thailand is that it will be another two or three years before a futures market will be viable. Malaysia opened Kloffe (the Kuala Lumpur Options and Financial Futures Exchange) at the end of 1995, and according to one trader its Klibor future was launched too early: “They’ve set up a market for a need which doesn’t exist, and it’s withering. By the time they sort out the onerous regulations tying down the basic swaps market, Klibor could well be a non-factor.”
Progress is gradually being made on overcoming regulatory hindrances to derivatives, which many attribute both to regulators’ lack of knowledge and their fear of losing control of the market. At the forefront of these efforts is Isda, which has been active in Asia since May 1995. Citibank’s Hills, its local co-chair, says: “We’re concentrating on establishing good relations between the bankers and the regulators with the aim of making a combined positive input into the development of the derivatives market.” The first steps were taken last July when Isda’s Asian-based representatives met most of the region’s regulators at a one-day conference in Hong Kong. “Initially we were worried that no-one would speak,” says Hills. “But by the end of the day each side had a good feeling for what the other’s main concerns were.” A follow-up conference is planned for later this year.
Derivatives traders are generally upbeat about the path Isda is following and appreciate that the situation won’t change overnight. But some are concerned at how some countries still seem reluctant to allow foreign banks much access: “If regulators remain determined to build up domestic derivatives using local brokers and institutions then they’ll be setting themselves up for a string of disasters,” says an equity trader in Hong Kong. “They don’t have the experience necessary for risk management. At some point a securities house will take a big punt and get it wrong.” With this in mind, Isda is planning to extend its Asian committee to include representatives from some of the local banks.
