Use of OTC Derivatives by Asian Corporates

Asia accounts for less than 10% of notional outstanding of the global OTC derivative market. Even within Asia, trading activity is primarily dominated by the four advanced countries Japan, Singapore, Hong Kong and Australia. Most of the OTC products in Asia are plain vanilla in nature, and as a result the OTC markets emerging Asian countries are at a very early stage of development. Corporates in Asia primarily use OTC derivatives to satisfy their need for customization. Foreign Exchange (FX) derivatives are the most popular OTC instruments used by Asian corporates. Many corporates have regional or international operations; they use cross currency swaps as net investment hedges for foreign currency exchange risk of international operations. In addition, corporates engaged in significant imports and exports use forward foreign exchange contracts as cash flow hedges for exposure to foreign currency exchange risks arising from forecasted or committed expenditure. Interest rate instruments are also popular among Asian corporates. Many Asian corporates have issued foreign currency denominated debt and therefore use cross currency interest rate swaps to hedge interest rate risk and cash flow hedges to hedge currency risk arising from issued bonds. In addition, corporates also engage in OTC commodity derivatives.  Commodity derivatives, particularly those involving palm oil and rubber, are in demand from Southeast Asian corporates. Moreover, corporates in the energy and manufacturing sectors use them to hedge against price fluctuations in the underlying commodities. Emerging Asian countries lack necessary infrastructure for onshore OTC commodity derivatives trading. Corporates in those countries therefore have to deal with international exchanges or with international counterparties.  Asian corporates typically engage in OTC derivatives for hedging, and not for trading purposes. Therefore many of them have not set up infrastructure for exchange trading. Small percentage of them is using centrally cleared derivatives at present. However, this is likely to change in the future since regulators are now encouraging and incentivizing central clearing of standardized OTC derivatives as part of the OTC derivative market reform process. While reducing counterparty risk is an obvious benefit of using central clearing, CCP also reduces clearing costs, as without central clearing one has to pay higher margins up front. With requirements of central clearing and other associated reforms, it is argued that the use of OTC derivatives may decline. If that happens, it will be mostly limited to financial institutions’ use of these instruments who engage in them for trading purposes; the need for OTC derivatives for hedging purpose is likely to increase. Non-financial corporates accounted for around 20% of OTC derivative trading in the emerging Asian economies, while they accounted for only 6% in the four advanced countries. This indicates the involvement of real economic actors and trade related activities are higher in the emerging country OTC markets. This is also due to the fact that in advanced countries large dealers and other financial institutions engage in significant trading and market making activities in the OTC space. Corporates’ high share in emerging country OTC market is likely to continue or even increase as the real economic output of the countries grows.  This will be driven by economic growth, growing international operations and trading activity of local firms, liberalization of financial markets and regulatory initiatives facilitating more cross border trading. The developments in the emerging economies will also contribute to the growth of OTC activity in the advanced countries, particularly in Hong Kong and Singapore, as a significant proportion of activity in those markets comes from investors in the neighbouring countries who cannot meet their demand in local markets. However, this process is likely to evolve slowly as regulators in the region are traditionally conservative in nature.

China’s road towards Currency Internationalization

China is the world’s second biggest economy, largest exporter and second largest importer. Yet China’s currency, the Renminbi (RMB), accounts for less than 1% of global FX turnover. The Chinese authorities have been making concerted efforts since late 2008 to internationalize the Renminbi by trying to increase its use in international trade and investments. Their efforts are paying off as RMB settled trade has grown since late 2010 and accounts for 8-10% of all international trades at present. The following highlights some major successes of their efforts: •    From October 2010 to June 2012 value of RMB payments grew by 17 times. Currently 91 countries are processing renminbi payments. •    Hong Kong is the dominant offshore centre for RMB trading accounting for around 80% of all renminbi payments; share of Singapore, Taiwan are also significant. UK is positioning itself as a major offshore trading centre for renminbi. •    RMB is among world’s top ten currencies traded. Three FX markets exist for RMB: onshore CNY market which is tightly controlled, offshore CNH market in Hong Kong which is relatively free, and USD denominated non-deliverable forward market. The currency sometimes trades at different rates in the CNY and CNH markets and many firms, especially large ones with subsidiaries outside borders, use it to conduct exchange rate arbitrage in these two markets. Given that China’s currency is not fully liberalized, this arbitrage sometimes is not settled by market forces and it creates pressure on the currency, as was evident late last year. Some therefore argue that significant proportion of RMB settlement comes from speculation in the two markets while imports are still invoiced and mostly settled in US dollar. Bank of China Hong Kong (BOCHK) and Bank of China, Macau, are the only two entities approved to clear offshore RMB transactions. Other banks can engage in offshore RMB business through agreement with BOCHK, or through relationship with other banks which have existing agreement with BOCHK. This presents an opportunity for many regional and international banks to tap into this burgeoning market of RMB clearing and trade related services. Moreover, two of the world’s biggest exchanges, the Hong Kong Exchange (HKEx) and the CME Group, recently announced plans to launch offshore yuan futures in Hong Kong by the end of 2012. This is likely to facilitate exporters and importers hedge their currency risks, especially now that the currency is showing some volatility. The forwards market at present is very efficient with tailor made contracts; therefore some think currency futures may not gain traction immediately among traders. However, along with importers and exporters who use currency futures and forwards to hedge exposure, this will also attract asset managers and other financial institutions as the contracts will be standardized and tradable at the exchanges. The outcome of these initiatives remains to be seen, but these moves are likely to further strengthen China’s efforts towards Renminbi internationalization. It must be mentioned that in spite of these developments, there are challenges with China’s efforts to internationalize the RMB. At a broad level, RMB is mostly used to settle imports, but not exports. Even in imports, invoicing is often done in US dollars while settlement happens in RMB. It is argued many Chinese corporations use the different currency markets (CNH-CNY) to engage in speculative activities and not that much for pure trade purposes. This effectively allows for interest rate speculation between the two markets as well. Many of these problems are intertwined as China has traditionally had very strict capital control, and the internationalization of renminbi is taking place before fully liberalizing its interest rate, exchange rate or capital account. Therefore how China attempts to internationalize its currency and manages its key rates at the same time will be closely watched.