On the cusp: regional integration in Asia

It’s 2015, the mid-point of the decade and a good time to start looking at major trends in Asian financial services over the next five to ten years. One of the major themes will be regional integration, which is another way of saying the development of cross-border markets. There are at least two important threads here: the ongoing internationalization of China’s currency, and the development of the ASEAN Economic Community (AEC) in Southeast Asia. RMB internalization is really about the loosening of China’s capital controls and its full-fledged integration into the world economy. And everyone seems to want a piece of this action, including near neighbors such as Singapore who are vying with Hong Kong to be the world’s financial gateway to China. The AEC is well on its way to becoming a reality in 2015, with far-reaching trade agreements designed to facilitate cross-border expansion of dozens of services industries, including financial sectors. While AEC is not grabbing global headlines the way China does, we see increasing interest in Southeast Asia among our FSI and technology vendor clients. From Celent’s point of view, both trends will open significant opportunities across financial services. In banking, common payments platforms and cross-border clearing. In capital markets, cross-border trading platforms for listed and even OTC products. In insurance, the continued development of regional markets. Financial institutions will be challenged to create new business models and technology strategies to extract the opportunities offered by regional integration. It’s the mid-point of the decade, and the beginning of something very big.

Challenges with China’s RMB Internationalization Process

Chinese authorities have been making concerted efforts of late to internationalize its currency (renminbi, RMB) by trying to increase its use in international trade settlement and investment. Their efforts are paying off as international RMB payments and trade settlement have grown rapidly since 2010. The whole process consists of three broad steps beginning with the use of RMB in trade settlement, then investment and then as a global reserve currency. The first step is well underway and has received the most traction of the three – around 10-15% of China’s international trade is settled in RMB at present. China has currency swap agreements with 24 central banks allowing them to directly settle international RMB trade. Use of RMB for investment purposes is still limited due to lack of development of the Chinese capital markets and strict controls imposed by the Chinese authorities. Use of RMB as a global reserve currency is the most ambitious step and likely to take the longest time. At present several central banks have expressed interest for increasing RMB holding as part of their reserve. However, the quantum of holding is small at present and primarily geared towards diversification of foreign assets.

In spite of these developments, there are challenges with China’s efforts to internationalize the RMB. Even though the Chinese currency recently broke into the list of top ten currencies globally, its share is still miniscule (~1%) in total global payments. At a broad level, RMB is mostly used to settle imports, but not exports – roughly a third of imports and less than 5% of exports are settled in RMB at present. Even in imports, invoicing is often done in US dollars while settlement happens in RMB.

A necessary requirement for RMB internationalization is to first make it fully convertible. China is planning to do this first through the offshore markets. Doing the same in the onshore market by opening capital account and liberalizing interest rate regime will be more challenging.

Then there are operational challenges for banks that need to be addressed. New systems and processes will be required to support clearing and settlement of payments in real time by domestic and international players. They also need to support different languages including Chinese, English and other regional ones and to accommodate working hours in different time zones to bring about a truly international system of operations.

These will also require strengthening of China’s anti-money laundering (AML) framework. AML practices in China have been in development for over 15 years, however, the AML regulations were largely inadequate until as late as 2006-07. As a result the internal control systems and company culture at banks in China tend to be inadequate, and they do not go beyond meeting basic regulatory requirements at present.

Given the rapid developments in the RMB internationalization process over the last three years, there has been a lot of enthusiasm and optimism expressed by several players regarding its potential to bring in major changes in the immediate future. However, it is safe to assume from past experiences that China will follow a planned, controlled, and slow but steady path in trying to raise the importance of its currency at a global level. True internationalization of RMB will require fundamental changes on many fronts including regulatory, market infrastructure, political and geopolitical aspects. An intermediate step in realizing the ultimate goal may be to first make RMB a dominant currency at a regional level (ASEAN/Asian). The extent of its adoption at a global level will however be long drawn and closely watched.

Electronic and cross-border trading in Asia

I recently participated as a moderator in two panel discussions on the South East Asian markets in the SunGard City Day held in Singapore on 14th July, the topics being electronic trading and cross-border trading respectively. An important point that came out of the discussions was that Asia-Pacific cannot be seen as one market, unlike the European Union. It comprises of various national markets at different stages of development. Japan, Australia, Singapore and Hong Kong are the leading markets in the region. By comparison, markets such as Indonesia, Malaysia and China are lagging behind. The difference can be seen in terms of infrastructure, e.g., the differences in the latency of the exchanges, as well as the number of products that can be traded on them. In the leading markets, the circumstances are becoming more conducive to high-frequency trading and the operation of alternative trading systems, including dark pools. Co-location services are being provided by the exchanges and the regulators are reducing the barriers on off-exchange transactions, such as the limits on the size of transactions and the time limit within which a transaction has to be reported. A crucial factor in the adoption of greater electronic and algorithmic trading will be the willingness of the buy-side to develop the infrastructure for the same. An interesting example that was quoted in the event was that a buy-side trading desk took three months just to fine-tune the latency of their connectivity to the exchange. What this highlights is the fact that while many in the local sell-side and increasingly the buy-side are convinced of the need to have algorithmic trading, it will take time to put the necessary systems in place. Also, the local players are not sure about whether they can afford the level of investment (and the time taken) required to create the trading infrastructure. Hence, the barriers to adoption of technology are more practical than theoretical, unlike earlier. In fact, most of the panelists stressed that there has been a sea-change in the mindset of the domestic market participants in the last 2-3 years and they are much more open to having algorithmic trading and dark pools now. It is further expected that once ADR/GDRs can be traded in these exchanges, the level of algorithmic trading will go up, with the greater presence of exchange-traded funds also playing a similar role. However, the level of off-exchange trading in the next 3-4 years is expected to go up to 5% at the most, up from the current 1% but much below the 30% levels seen in Europe. Cross-border trading in the ASEAN region has picked up in the last few years. Regulation has also paved the way for this, e.g., in Malaysia, regulation has recently allowed up to 30% of the NAV of a firm to be used in trading assets abroad. Even before the recent ASEAN linkage between six countries was announced, cross-border trading was a prevalent phenomenon. The linkage is expected to increase the level of electronic trading and also make it cheaper and more efficient. The next step should be to develop the post-trading infrastructure and linkages between the central securities depositories.