Asian derivatives rebound but EMIR and Dodd-Frank cast long shadow
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Asian derivatives rebound but EMIR and Dodd-Frank cast long shadow

Derivatives traded on Asia’s exchanges are staging a recovery, with equity index futures leading the way – despite a looming threat from global regulation aimed at taming a sector widely blamed for the financial crisis.

Deepening local capital markets, the increasing complexity of corporates’ risk-management strategies and the growing sophistication of financial intermediaries have triggered year-on-year growth in the Asian derivatives market.

However, growth has not matched expectations while market participants are grappling with regulatory headwinds and fragmentation in the region’s budding market infrastructure.

On a cyclical basis, the Asian derivatives market is lagging behind North America and Europe, and Asian options growth has fallen year-on-year, though the growth in Asian futures has offset the latter.

Options turnover on Asian exchanges dropped to $48 trillion in 2012 from $103 trillion in 2011 and is likely to level off around the $34 trillion mark this year. Nearly all of this option turnover – more than 90% – came from trading in equity index options.

Nevertheless, Asian futures have seen across-the-board turnover increase in the first two quarters of this year, with interest rate, currency and equity index futures recording large rises.

Bank for International Settlements figures show equity index futures jumped 48% from $9.16 trillion in the third quarter of 2012 to $13.56 trillion in the second quarter of this year, overtaking North America. Currency futures surged 26% during the same period, while interest rate futures were up 23%.

Derivatives turnover fell sharply in 2012 across all markets but has rebounded strongly this year in contrast to lacklustre equities trading volumes. Globally, options and futures turnover are up 63% and 51% respectively this year and while Asian futures made a strong showing with a respectable 33% rise, options were virtually flat.

“The reason Asian derivatives have not performed quite as well is volatility in the commodities markets in Asia and a general sense that interest rates are going to be on the move,” says Steve Grob, director of group strategy at Fidessa, a provider of multi-asset trading and investment infrastructure.

“The futures markets in Asia are much more heavily weighted around commodities, so if you’re trying to find underlying causes you want to look at what’s going on in India and China. There’s a view that the seemingly never-ending commodities boom in Australia might be running out of steam.

“The US’s highly liquid, transparent equity options market has done well because of the buoyancy of the underlying cash equities marketplace. It’s a very easy place for the retail market to dive into when they want to take a bet on something and by comparison the Asian market is under-developed, certainly in the options space.”

Grob adds that upcoming regulation to bring the bulk of the global market onto exchanges presents an opportunity.

“There’s a definite sense that post Dodd-Frank and EMIR (European Market Infrastructure Regulation) will show a potential boost to futures markets but it’s way too early to point to any uplift in exchange volumes as being a direct result of that.”

Provisions of the Dodd-Frank Act and EMIR, which require almost all derivative contracts be cleared through central counterparties (CCPs), apply wherever US and EU institutions operate.

The problem is that the clearing houses they work with in Asia and elsewhere must be approved by the European Securities and Markets Authority (Esma) or the US’s Commodity Futures Trading Commission respectively – injecting uncertainty into the planning and future operations of leading western banks and brokerages.

Clearing houses have a nine-month grace period from the September 15 deadline for applying for Esma recognition, during which they can continue to service EU clearing members. Recognition is also dependent on the CCP’s home country having equivalent regulatory and supervision regimes, and anti-money laundering and terrorism financing systems.

The rules also apply east to west: Asian firms transacting with US or EU institutions must also comply – which could prove impossible if either their jurisdiction or clearing house has not been recognized.

CCPs’ status also determines capitalization exposures to clearing houses, with banks barred from applying the lowest risk weight – 2% – unless they are using an Esma-approved clearing house.

Until this summer, EU banking groups with Asian subsidiaries could avoid this potentially disruptive and costly regulation. However, the CRD IV – the fourth Capital Requirements Directive – unveiled in June extends the rules to banks accessing clearing through local subsidiaries as well as local branches.

The regulations will impact Asian exchanges because more derivatives trading will be through bourses whose clearing house is the CCP.

With derivative products and derivatives trading driving exchanges’ future growth, Singapore’s dominant SGX is leading the regional race but HKEx and KRX, already futures clearers, have catch-up central clearing operations in place, which are set to go live before year-end. All three have foreign-based clearing members.

China, Japan and India have all set up CCPs. Deutsche Börse recently announced plans to build a derivatives clearing house in Singapore, but as the number of clearing houses grows, it is unclear whether exchanges will be able to pull in sufficient volume to be profitable.

Most Asian jurisdictions are being considered for equivalence and have applied for CCP recognition but it is unclear whether Hong Kong, China, India and Australia met the September 15 deadline. Higher capital charges come into effect on January 1 for clearing houses that missed the deadline.

Neither China nor New Zealand is being considered for equivalence.

Competing CCPs across the region risk splitting liquidity. Leading banks and brokerages faced with joining costs – default pools, margin account and new technology – for multiple clearing houses might simply pull out of some markets, with consequences for derivatives volumes.

“Clearing houses out here have some very important western banks or subsidiaries as clearing members, and there are certain houses that are very dependent on these western banks for liquidity and market making,” says Paget Dare Bryan, Asia Pacific head of derivatives at Clifford Chance.

“It’s probably our biggest concern for the continuation of some of the larger regional futures or options businesses.”

The weak performance of Asian options, particularly equity index, ties in with relatively despondent equities markets last year, says Dare Bryan. The slowdown in China created a drag not just on equities markets and confidence there, but across the wider region.

“We had far less IPOs and at times quiet capital markets as well, so there was a period where there were little new assets coming to market, which clearly takes away some of heat from the exchange markets,” he says.

“The IPO market has still not recovered to the same levels of a few years ago but markets generally have been a lot more buoyant. We have seen more confidence this year, worries about China continue but perhaps have eased a bit, and we’ve seen a pick-up of business generally across the markets I cover.

“Banks out here this year have expressed with more confidence the sentiment that there are deals to be done, which could come in part from a thriving exchange-traded market.”

However, another risk lurks on the horizon: Singapore’s finance minister Tharman Shanmugaratnam warned in March that the proliferation of trading houses in the region could result in unchecked systemic risks, given the structural rise of the asset class in emerging Asia from a low base, notwithstanding EMIR and Dodd-Frank.

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