The Market structure debate in Asian context

The recent debate about the impact of High Frequency Trading (HFT) and on the issue of market structure in general is no more confined within the US market. Regulators and market participants worldwide are discussing this issue seriously. The chairman of the Australian Securities and Investment Commission (ASIC) recently detailed the position of the Australian authorities in this regard. Incidentally Australia, along with Japan, is one of the few Asian countries that have multiple trading venues, a necessary condition for the growth of advanced trading and order routing capabilities, including HFT. It is worthwhile to look at the state of adoption of the Asian region in terms of adoption of advanced trading tools, and the role of the Asian exchanges in that regard. The different Asian markets are at different levels of maturity, and therefore it is difficult to analyse the region as a single homogenous entity; rather the Asian markets can be grouped into two broad categories. The first category belongs to the advanced economies like Australia, Hong Kong, Japan and Singapore which have well developed capital markets. Exchanges in these countries are at par with western competitors in terms of latency and adoption of advanced trading technologies. The second category consists of exchanges in emerging economies like India, China, Malaysia, Korea which are somewhat lagging their Asian counterparts in the first category. However, there is a common factor that runs across the two categories of exchanges – lack of competition from alternative trading venues. This means that most of the Asian exchanges are largely national monopolies without significant competition from alternative providers, though the situation is slowly changing in some markets (e.g., Australia, Japan). This is one aspect which distinguishes Asia from the western markets where the competition among exchanges and alternative trading venues is severe. Another key challenge in Asia is the fragmentation of markets and lack of harmonization – regulatory, economic, monetary and technological – in trading and settlement practices. This restricts the growth of cross border trading volumes and greater regional integration at an Asian level. The ASEAN initiative is a move in that direction, but it is still early days to judge its potential for achieving regional integration. Asia has also lagged the western markets in terms of adoption of advanced trading tools and technologies (like DMA, algorithmic trading, high frequency trading etc). Some of the Asian exchanges, particularly the ones in the advanced economies, have adopted latest technologies with low latency and colocation offerings, but some of the above mentioned factors still present challenges. For example, lack of multiple trading venues limits arbitrage opportunities. Lack of regional integration means cross border flows have yet to realize its full potential. These prevent growth of trading volumes, need for advanced trading tools and technologies, and participation of foreign players in domestic markets. Regulators in Asia are traditionally very conservative. Therefore decision making for significant changes in market structure and practices takes time. In a rapidly evolving trading world, this means Asian exchanges find hard to stay abreast with global trends. Also because domestic exchanges are perceived more as national utilities, any proposal that threatens the position of incumbent exchanges is met with resistance and difficult to implement. Some of the Asian exchanges have been very aggressive in exploring newer avenues beyond the traditional revenue sources. The Singapore exchange is a good example of that. It started offering clearing services for commodity derivatives through its AsiaClear offering a few years ago. In addition to providing CCP services as mandated for OTC derivatives under the proposed reforms, the SGX is collaborating with the Korea Exchange to develop the latters’ OTC clearing capabilities. Therefore in some markets (like Singapore) the incumbent exchanges are taking a leading role in clearing of OTC derivatives as proposed by new regulations. It will be interesting to see if new players will be able to enter and succeed in this business. Low volumes in the Asian markets, proliferation of CCPs, and competition from international ones may result in each CCP specializing in specific niches along product lines or local currency instruments.

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.

OTC Market Reforms in Asia: Presenting New Opportunities

In another blog we discussed the issues that will have serious implications for different market participants in the OTC derivative market reform process in Asia.  Here we look at its impact on different market participants. The move towards central clearing is likely to create more demand for clearing services. Currently a small number of brokers offer clearing service in this space, and they may not be able to handle the sudden rise in demand. Some of the major international clearing firms are in the process of scaling up their operations in the region. Even though the volumes in the OTC segment are low at present, the growth prospects of the Asian economies in general, and niche areas (e.g., NDF clearing) make the region strategically important for many of these firms. However, some participants are wary about the costs of having to join many clearing houses and the issue of assuming unlimited liability in case of default. International banks have significant share in the OTC derivatives space in Asia; if these issues are not sorted out, some western banks may withdraw from some markets, or even the whole region, which would likely have an adverse impact on liquidity. Regulations mandating central clearing will create business opportunities for centralized clearing. In some markets like Singapore, the incumbent exchanges are taking a leading role in this regard. It will be interesting to see if new players will be able to enter and succeed in this business. Low volumes in the Asian markets, proliferation of CCPs and competition from international ones may result in each CCP specializing in specific niches along product lines or local currency instruments. The business models of new CCPs will come under heavy scrutiny from regulators, breaking trends from the past. As large number of OTC trades move to the CCPs, the concentration risk at some of them would be significant and national regulators would want to make sure those risks are adequately managed on a continuous basis. As CCPs replace bilateral trading, and market participants face the choice of executing trades at different CCPs, they will also need tools for managing and optimizing the use of collateral. This represents an opportunity for some market players who specialize in providing collateral management solutions. Needless to say, the kind of solutions needed and offered in this space will depend largely on the maturity of specific markets and market participants. Thus, while Credit Support Annexes (CSAs) may be sufficient for emerging countries of the region, advanced services (like collateral transformation, outsourcing of collateral management) would gain traction in the leading countries like Australia, Hong Kong and Singapore. Reporting banks would come under greater regulatory scrutiny and will have to run stress tests and ensure capital requirements on an ongoing basis.

OTC Derivatives in Asia

Over-the-counter (OTC) derivatives have come under scrutiny since the Global Financial Crisis (GFC) of 2008. The global OTC derivative market is primarily dominated by the US and Europe, with Asia accounting for less than 10% of notional outstanding. The Asian financial market, unlike its western counterparts, is not a homogeneous entity. Rather, the countries in the region are divided along jurisdictional lines with limited regional integration. Thus Asia not only consists of a large number of countries with each at different level of economic development, they also have different regulatory and monetary regimes. This has resulted in a number of highly localized markets with the exception of a few, notably Hong Kong and Singapore. In two new reports Celent discusses the development in the OTC markets in 11 Asian countries, divided into two groups. The first report looks at the advanced economies and includes Australia, Hong Kong, Japan, New Zealand, and Singapore. The second report covers the emerging economies of China, India, Indonesia, Malaysia, South Korea and Taiwan. It is interesting to note that the emerging countries account for only 9% of total OTC turnover in these countries, even though there share is much higher on other economic and financial