Asian Derivative Market

8/8/2019 Asian Derivative Market

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Oliver FratzscherWorld Bank

Asset Securitization in East Asia

ASEAN+3 WorkshopShanghai National Accounting Institute

Shanghai

9. November 2005

Both Derivatives and Securitizationrepresentrisk-transfer tools derived from

underlying assets

Derivatives and Securitization


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Outline of Presentation

1. What are Securitization and Derivatives ?

2. How large are Asian derivative markets today ?

3. Which building blocks are necessary ?

4. What sequence is needed to develop derivatives ?

5. Which are key technical & prudential policy issues?6. Conclusion and Discussion

Hypothesis: OTC derivative markets are necessary

for securitization to be sound and efficient (not

sufficient, A+B+C also necessary)


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. a s ecur za onA specialized OTC derivatives

product Securitization is a technique to standardize financial instruments for

risk transfer from underlying assets; it is OTC derivative productstructure through SPV

Derivative is a simple financial instrument for risk transfer from asingle underlying asset (OTC/ETD)

MBS = package of assets linked to mortgages

CLO = collateralized package of loan obligations

Deposit Loan Mortgage

AGovernm

entBenchma

rk

Bonds

BBankingIntermed

iateProducts

CLegal &Collater

alFramew

ork

DDerivativ

esInterest

Rate

OTC


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" Although the benefits and costs ofderivatives remain the subject of

spirited debate, the performance of theeconomy and the financial system inrecent years suggests that thosebenefits have materially exceeded the

costs."

We view them as time bombs both forthe parties that deal in them and theeconomic system. In our view

derivatives are financial weapons ofmass destruction (WMD), carryingdangers that, while now latent, arepotentially lethal.

Alan

Greenspan

WarrenBuffet

Two perspectives


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. o a er vat ve mar etsrapid OTC growth and increasing ETD

products

Sources: BIS (Dec 2004) ; FIBV (Jan 2005)

0

50,000

100,000

150,000

200,000

250,000

1991 1993 1995 1997 1999 2001 2003

0

10,000

20,000

30,000

40,000

50,000

60,000

OTC (bar) and Exchange-Traded (line) Derivatives

(notional outstanding, in billions US$)

Annual growth rates exceed 30%

75%

12%

$248 trn notional$9 trn mkt value

US: 40%

EU: 40%

Asia: 20%

ABS+MBS: 4%

Credit

Interest

Gov-Debt

StocksComm

Equ-Index

FX

2004OTC Derivative Markets Exchange-Traded Derivatives

65% 26%

$53 trn notional$10trn mkt value


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s an er va ve mar e sbanks in OTC FX and security firms in

equity ETD

Daily Turno

Japan

Singapore

urces: Triennial Central Bank Survey (BIS, 2005) and World Federation of Exchanges (20

0% 20% 40% 60% 80% 100%

HKG Equity Index Futures

Korea Equity Index Futures

HKG Equity Index Options

Korea Equity Index Options

HKG Equity Options

Korea Bond Futures

Korea FX Futures

Banks

Securities

Institutions

Retail

Foreign


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ProductDesign

Push byoriginator for risktransfer tools

Pull by

investors foryield and duration

Risk-basedpricing,benchmark, corp

bonds

Regulation

Regulatoryapproval, productunderstanding

Legal clarity:default,

repossession,

enforcement

Accountingrules, transparency,disclosure

Clear tax

Infrastructure

Industry guideonstandardizedproducts

Credit ratings

industry andstandards

Best practicerisk management

Suitabilitycriteria for

Necessary components forMBS

. DerivativesMBS requires similar components as

derivatives


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ProductDesign

Economicrationale forhedging needs

Liquid cash

market, long andshort positions

Marketdetermined prices,interest/FX rates

System

Regulation

Lead regulator,capital rules,reporting standards

Legal clarity:ISDA standards,

enforceability Accountingrules, transparency,disclosure

Level playingfield, tax

Infrastructure

CCP, ISDAmaster, close-outnetting

Demut.exchanges,

strong capital,margins

SRO rulesenforcedwith limits,

monitoring

Building blocksfor derivative markets


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developmentwin-win instruments for banks,

corporations, investors beyond rice trading in Tokyo and tulip trading in Amsterdam

Commodity producers lock in future prices and reduce uncertainty Corporations can close mismatch between assets and liabilities

Firms can hedge export receipts and seek cheapest funding abroad

Banks can share excessive or lumpy risks in capital markets

Investors gain access to new markets and broader asset classes

Pension funds can diversify exposure and enhance risk management

Retail receives better pricing for mortgages and securitized products

Foreign investment is facilitated by higher liquidity and hedging tools

Financial system enhances stability through new spare tire


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derivativesmarket development combined with

prudential issuesMarket efficiency

Risk sharing and transfer

Low transaction costs

Capital intermediation

Liquidity enhancement

Price discovery

Cash market development

Hedging tools

Regulatory savings

More leverage

Less transparency

Dubious accounting

Regulatory arbitrage

Hidden systemic risk

Counter-party risk

Tail-risk future exposure

Weak capital requirements

Zero-sum transfer tools


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. marketscash liquidity+sound regulation+solid CCP

infrastructure

Investor Basehedging needs,

products, IT,lower costs

Investor Basehedging needs,

products, IT,lower costs

OTC License

reg approval,CP credit risk,swaps IR&FX

OTC Licensereg approval,

CP credit risk,swaps IR&FX

Accountingadopt IFRS,

MTM, IAS39,full disclosure

Accountingadopt IFRS,MTM, IAS39,

full disclosure

Design CCPclose-out net,ISDA master,enforcement

Design CCPclose-out net,ISDA master,enforcement

Exchangeplatform, links,

capital,

margins,first futures

Exchangeplatform, links,capital,margins,

first futures

Taxes levelplaying fieldcash=repo=D,avoid trans tax

Taxes levelplaying fieldcash=repo=D,avoid trans tax

IntermediaryLicensing

qual. investors,training

IntermediaryLicensing

qual. investors,training

Repo Markets

effective short,margin trading;secur. lending

Repo Marketseffective short,

margin trading;secur. lending

Regul&LegalFramework

derivatives law,SRO function

Regul&LegalFramework

derivatives law,SRO function

Cash Markets

liquid,

efficient,integrated;benchmarks

Cash Marketsliquid,efficient,

integrated;benchmarks

DerivativeMarketBuildingBlocks

DerivativeMarketBuildingBlocks

Cash

Re

po

ETD

OT

C


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turnoverliquidity corridor for emerging and developed

markets

100

1,000

10,000

100,000

100 1,000 10,000 100,000

Cash Turnover

Deriv

atives

Tur

nover

USA

UKJAP

GER

ESP

KOR

HKG

AUSIND

SIN

1 : 1

5 : 1

Source: World Federation of Exchanges (Dec 2004)


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three tiers of exchanges offer six

product categories

Notes:

Sources:

Australia: Australian Stock Exchange (ASX) and Sydney Futures Exchange (SFE)

China: Zhengzhou & Dalian Commodity Exchange, Shanghai Futures Exchange Hong Kong: HKExIndia: National Stock Exchange of India (NSE) and Bombay Stock Exchange (BSE)

Indonesia: Jakarta Futures Exchange (JFX), and Surabaya Stock Exchange

Japan: TIFFE, Tokyo Stock Exchange (TSE), Osaka Securities Exchange, Tokyo Commodity Exchange

Korea: Korea Stock Exchange (KSE) and Korea Futures Exchange (KOFEX)

Malaysia: Malaysia Derivatives Exchange Philippines: Manila International Futures Exchange was closed

Singapore: SGX-DT Thailand: Thailand Futures Exchange plans to open in 2006

Websites of regional exchanges, WFE, Futures Industry Association, and HK-SFC (2004).

Australia China Hong Kong India Indonesia Japan Korea MalaysiaPhilippinesSingapore ThailandIndex

Futures Options Options on futures Stock

Futures Options Currency

Futures Options Interest rate

Futures Options on futures Bonds

Futures Options on futures Commodities

Futures Options on futures # of products traded 12 1 6 5 3 10 9 5 0 9 0


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in Asialiquidity indicators improve but

regulation still evolving

Notes: denotes best practice ; denotes progress on existing deficiencies ; and denotes major problems.1./ Fixed income liquidity indicators and benchmarks are obtained from asianbondsonline.adb.org, which shows weaknesses in China (segmented

markets), Hong Kong (small local currency issuance), Indonesia, Philippines, and Thailand (limited medium to long-term benchmark issues). 2./ Turnoverratios for fixed income instruments have also been obtained from HSBC (2004). 3./ Equity market liquidity indicators have been obtained from WorldFederation of Exchanges (2004), which revealed thin markets in Philippines, Indonesia, and Thailand. 4./ Information about laws on derivatives was obtainedfrom individual country, with only Australia, Hong Kong, and India currently having distinct laws on derivatives. 5./ Securities lending data were obtainedfrom Endo and Rhee (2005), showing restrictions in Malaysia and Philippines on short selling, with very little activity in Indonesia and Thailand. 6./ WorldBank public documents on accounting standards (ROSC) and professional publications reveal adequate accounting standards aligned to IFRS standards onlyin Australia, Hong Kong, Indonesia, Malaysia, and Singapore, but major gaps exist in the Philippines. 7./ CCP information was obtained from industry sourcesand ADB, showing adequate functioning only in Hong Kong, Korea, and Singapore. 8./ ISDA netting opinions have been issued for all countries mentionedwith the exception of China, but many countries have issues to resolve. 9./ Data from individual exchanges show their progress towards demutualization(2004). 10./ Data on taxation were obtained from PWC "Taxation on financial derivatives in Asia" (2003), which showed small stamp duties in effect in HongKong and Malaysia, and VAT being applied in China, Philippines and Thailand. 11./ Transaction costs for bond markets were obtained from ADB (2004) andadditional market information on taxation. 12./ Institutional investor base and NBFI indicators are obtained from ADB, which shows weaknesses especially in

Indonesia and Philippines.

Liquidity

Fixed income benchm

Fixed income liquidity


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. ec n ca ssuescritical tools to increase netting and

enhance cushions

Basics first: liquid and efficient cash markets allowing short positions

Legal framework: D law, SRO rules, licensing, ISDA documentation

Equal taxation: D may enhance volatility and substitute cash markets

Governance issues: accounting standards (IAS39), disclosure rules

Netting is critical: 85% risk reduction through close-out netting

Manage CP risk: Central clearing counterparty (CCP) is best practice

Modern exchange: demutualized, effective margins, strong buffers

Risk tools: dynamic margins, pos limits, reserves, capital, insurance Product sequence: corporate hedging (interest rate futures)

are more important than retail speculation (equity options)

Investor education: suitability, disclosure, monitoring, non-savings


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o cy ssuestransparency + monitoring + oversight

enhance stability

ETD vs OTC: Investors prefer Exchanges Banks prefer OTC Marketsshifting OTC products (interest futures) onto exchange enhances stability

Regulation: level playing field for ETD and OTC markets plus disclosure

Caution: D can undermine fixed prices, pegged FX regimes, credit policies

Monitoring: highly leveraged institutions, cross-border, FX and credit D

Capital: D require risk-based capital plus add-on cushions, beyond Basel-I

Public banks: bridge market failures but subsidies can create warehouses

Oversight: exchanges, SROs, rating agencies provide critical infrastructure

Enforcement: market surveillance, transparency, legal clarity, ISDA standards

Investor protection: rationale for new D products, standards for suitability

6 C l i i


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6. Conclusion mainmessages

1. Derivatives can enhance financial intermediation and

economic growth but require efficient underlying cashmarkets and sound infrastructure

2. Modern exchanges with leading risk systems (CCP,dynamic margins, buffer) can enhance transparency,safety, and competitiveness of a financial system

3. Prudential supervision is critical for FX and creditderivatives which could undermine fixed prices, peggedFX regimes, and credit policies

4. Securitization products should be grounded on sound

OTC derivative market structures.


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Thank You

www.worldbank.org/boardswww.worldbank.org/financewww.financelearning.org

An invasion of armies can be resisted, but not an

idea whose time has comeVictor Hugo

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