Securities Board of India Guest Lecture Convergence of Derivative - - PowerPoint PPT Presentation

Securities Board of India Guest Lecture Convergence of Derivative and Cash Markets

Andrew Sheng Chairman Securities and Futures Commission Hong Kong 26 May 2005

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Table of Contents

• 1. Global Trend in Derivative Markets
• 2. Derivative Markets in Asia and Hong

Kong

• 3. Convergence of Derivative and Cash

Markets

• 4. Regulatory Implications
• 5. Conclusions

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Global Derivative Markets growing faster than Cash Markets

• BIS data on global derivative transactions:
• World Federation of Exchange (including 49 stock

exchanges) data:

12.0% 32,280 28,827 Market Cap

• 3.5%

3,354 3,476 Market Turnover Growth End June 2004 End June 2001 Stock Market (billion U.S. dollars)

54% 31,608 98 (0.3%) 31,510 (99.7%) 20,501 66 (0.3%) 20,435 (99.7%) Foreign Exchange 143% 226,842 49,385 (21.8%) 177,457 (78.2%) 93,328 17,515 (18.8%) 75,813 (81.2%) Interest Rates 113% 8,412 3,318 (39.4%) 5,094 (60.6%) 3,951 1,912 (48.4%) 2,039 (51.6%) Equity- linked 127% 266,862 52,801 214,061 117,780 19,493 98,287 Total Growth Rate for Total Total Exchange Traded OTC Total Exchange Traded OTC End June 2004 End June 2001 Notional Amount (billion U.S. dollars)

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Performance of the Global Derivative Markets

• Most derivative transactions in foreign exchange and

interest rate products take place in OTC markets, but 40% of equity-linked derivatives are transacted in regulated exchange markets.

• Growth of derivative markets outstripped that of the

stock markets (equity-linked derivative markets grew 113% from Jun 2001 to Jun 2004, but market cap only increased by 12%)

• In Hong Kong (no commodities exchange), growth in

derivative markets mostly in equity-related derivatives.

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International and Regional Trading of Stock Index Futures Contracts

Source: World Federation of Exchanges

• Asian region experienced the highest growth rate (15%) in 2004, compared

to Americas: 12% and EU: 1%.

• HK trading of stock index futures increased by 46% in 2004.

Number of Contracts traded

50,000,000 100,000,000 150,000,000 200,000,000 250,000,000 300,000,000 350,000,000

Chicago Mercantile Exchange (CME) Eurex Korea Exchange Euronext National Stock Exchange India Chicago Board

• f Trade

(CBOT) OMX Stockholm SE Singapore Exchange TAIF EX Osaka SE Hong Kong Exchanges and Clearing Toky o SE

2004 2003

Hong Kong is ranked 11th internationally and 6th regionally

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International and Regional Trading of Stock Options Contracts

Source: World Federation of Exchanges

• Growth rate in Asia (20%) in 2004 similar to EU (19%), but lower than

Americas (33%).

• HK trading of stock options increased by 33% in 2004.

Number of Contracts traded

50,000,000 100,000,000 150,000,000 200,000,000 250,000,000 300,000,000 350,000,000

International S ecurities E x change (IS E ) E uronex t S ao P aulo S E Chicago B

• ard

Options E x change (CB OE ) E urex A merican S E P hiladelphia S E B uenos A ires S E P acific S E OMX S tock holm S E A ustralian S E B

• rsa

Italiana B

• urse de

Montreal B ME S panish E x changes JS E S

• uth

A frica Hong K

• ng

E x changes and Clearing National S tock E x change India RTS S E

2004 2003

Hong Kong is ranked 16th internationally and 2nd regionally

7 2,000 4,000 6,000 8,000 10,000 12,000 14,000

Switzerland Hong Kong**** Spanish Exchanges (BME)*** Deutsche Börse Toronto** Euronext @* London Nasdaq Tokyo NYSE

Remarks:

* Comprises Euronext Amsterdam, Euronext Brussels, Euronext Lisbon and Euronext Paris ** Includes also TSX Venture *** Comprises Bolsa de Barcelona, Bolsa de Bilbao, Bolsa de Madrid and Bolsa de Valencia **** Includes GEM

Sources : WFE and HKEx

Ranking of Stock Markets by Market Cap (end Mar 2005, US$ billion)

• Hong Kong’s stock market is ranked 9th,,complementing trading of derivatives

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Hong Kong Derivative Markets

• Types of derivative products

– 4 types of Futures – 2 types of Options

• 4 types of Futures include :

– Index Futures (HSI Futures, Mini HSI Futures, H-shares Index Futures, MSCI China Free Index Futures*, Dow Jones Industrial Average Futures) – 11,805,613 contracts in 2004 – Stock Futures – 17,274 contracts in 2004 – HIBOR Futures (1-Month HIBOR and 3-Month HIBOR) – 59,040 contracts in 2004 – 3-Year Exchange Fund Note Futures – 2,225 contracts in 2004

• 2 types of Options include :

– Index Options (HSI Options, Mini HSI Options, H-shares Index Options**) – 2,133,708 contracts in 2004 – Stock Options – 5,611,832 contracts in 2004

Remarks: *Trading in MSCI China Free Index Futures was suspended with effect from 29 March 2004. **Trading in H-shares Index Options commenced on 14 June 2004.

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Growth of the Hong Kong Derivative Markets

0.2 0.5 1.1 2.7 4.8 5.6 7.2 9.7 10.1 8.5 9.3 10.5 11.0 14.5 19.6

5 10 15 20 25

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Total Turnover Volume of Futures and Options (million contracts)

Source: HKEx

Trading of derivatives in Hong Kong has recovered from Asian Financial Crisis

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HK’s Distribution of Derivative Trading by Participant Types (12 months ending Jun 2004, %)

Registered traders/ market makers 28% Local retail investors 29% Local institutional investors 10% Overseas institutional investors 22% Overseas retail investors 2% Proprietary trading 9%

Source: HKEx DTMS 2003/04

A healthy development of derivative trading requires a balanced mix of retail and institutional participants.

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Convergence of Derivative and Cash Markets in 2 Aspects

1. Products/Market Participants

• Derivative warrants
• Equity-linked structured products
• Decline of volatility
• Impact of hedge funds
• Issues to consider

2. Exchanges

• Demutualization facilitates convergence

Cash Market Derivative Market

Product lines, capital flows (participants), service providers (exchanges)

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• 1. Convergence in

Products/Market Participants

• Traditionally, products offered by stock exchanges and

derivative exchanges are quite distinct

• In recent years, new hybrid products like derivative

warrants and equity-linked structured products have become very popular in Hong Kong and some of the major European markets (e.g. Germany, Switzerland, Italy, France)

• Institutional players like hedge funds and investment firms

are looking for opportunities of mis-pricings between related products in different markets.

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What are Derivative Warrants?

• Warrants on blue chip stocks issued by third party

investment/commercial banks

• Listed on a stock exchange and traded like stocks (no

margining)

• Investors face the credit risk of issuers (no guarantee by

central clearing house)

• Popular among investors :

– Allow leveraged play on the underlying stocks – Required investment is small – Easy to understand and trade – Market information is transparent – Marketing efforts by issuers

• Most investors like call warrants

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Hong Kong’s Derivative Warrant Market

• Hong Kong was ranked first in terms of market

turnover in 2004, followed by Germany

• Total trading value in 2004 was about US$67 billion

(average daily turnover US$ 272 million, representing 13% of total daily market turnover)

• Total issue size in 2004 was about US$ 18 billion, and

accounted for about 27% of total funds raised in 2004

• Newly listed derivative warrants was 1,259 in 2004

(issued by 14 issuers)

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Hong Kong’s derivative warrant market was the most active in the world in 2004

Remarks: * Figures for Euronext are the aggregate figures from the exchanges of Amsterdam, Brussels, Lisbon and Paris. ^ Figures for Germany are the aggregate figures from all German Exchanges (Deustche Borse). Source: WFE Monthly Statistics, December 2004

Turnover of Derivative Warrants by Major Markets (US$ mn)

10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 Hong Kong Germany^ Euronext* Switzerland Italy 2001 2002 2003 2004

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Trading Activities of Derivative Warrants

100 200 300 400 500 600

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001* 2002 2003 2004

Trade Valule (HK$ bn)

• 1%

1% 3% 5% 7% 9% 11% 13% 15%

% to Total Market Turnover

Total Trade Value (HKD bn) %

• f Total Market Turnover

* : There was no new issuance of derivative warrants during the second half of 2001, pending the amendments of listing rules. Sources: Fact Books of HKEx, HKEx Securities and Derivatives Markets Quarterly Report

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Issuing Activities of Derivative Warrants

20 40 60 80 100 120 140 160

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001* 2002 2003 2004

Total Issue Size (HK$ bn)

200 400 600 800 1000 1200 1400

Number of Newly Issued Derivative Warrants

Total Issue Size Number of Newly Issued Derivative Warrants

* : There was no new issuance of derivative warrants during the second half of 2001, pending the amendments of listing rules. Sources: Fact Books of HKEx, HKEx Securities and Derivatives Markets Quarterly Report

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What are Equity-linked Structured Products?

• Short or medium dated notes with payout linked to

the performance of a blue chip stock, a stock index,

• r a basket of stocks
• Due to the low interest rate environment in the past

few years (i.e. lower US Fed rates since 2001 after the burst of the Tech bubble), they have been very popular among retail investors

• Investors will be paid relatively high interest rates. In

return, they will be required to purchase the linked stocks should their prices fall below a pre-determined level – they in effect sell put options to the issuers

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Development of Equity-linked Structured Products in Hong Kong

• The structured products were mostly transacted OTC

– not transparent to the public and regulators

• It has been estimated that the annual amount of

structured products sold in Hong Kong was about US$10 billion

• Retailization of the products in recent years:

– Moving from high networth and private banking clients to retail clients – Sell through commercial banks’ retail network

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Implications of Hybrid Products on Volatility and Liquidity

• Derivatives with option-like features (e.g. derivative

warrants, equity-linked structured products) are trading volatility.

• Issuers of these products need to use the underlying

cash market to hedge their positions. Whether the liquidity of the cash market is sufficient to accommodate such hedging activity is critical to the risk management of the products and market stability.

• Issuers of structured products (with embedded “short

put”) and derivative warrants (mainly “call warrants”) face opposite hedging risk, thereby helping stabilize the stock market volatility. This offsetting situation may disappear if structured products become less attractive to investors (e.g. when interest rates go up further).

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Declining Volatility in the Major Markets

10 20 30 40 50 60 70

Jan-00 Feb-00 Apr-00 May-00 Jul-00 Sep-00 Oct-00 Dec-00 Jan-01 Mar-01 May-01 Jun-01 Aug-01 Oct-01 Nov-01 Jan-02 Feb-02 Apr-02 Jun-02 Jul-02 Sep-02 Oct-02 Dec-02 Feb-03 Mar-03 May-03 Jun-03 Aug-03 Oct-03 Nov-03 Jan-04 Mar-04 Apr-04 Jun-04 Jul-04 Sep-04 Nov-04 Dec-04 Feb-05 Mar-05

%

Hang Seng Index S&P 500 Index Nikkei 225 Index FTSE 100 Index DAX Index

Implied volatilities

• f major markets

Source: Bloomberg

Since 2001, market volatility in the major markets (e.g. U.S., U.K., Germany, HK, etc) has been declining, from 30-40% to 12-15%.

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Possible Reasons for Lower Volatility

• The key macro driver is the low interest rate environment

created by the U.S. Fed since 2001. Low interest rates change investors’ investment behaviour and help improve corporate profitability.

• Offsetting impact of hedging activities for different

derivative products reduces market volatility.

• Traditionally, only financial institutions which issue

derivative products supply volatility to the market. Now investors also become the supplier of volatility. The abundant supply of volatility leads to the lowering of

• verall volatility in the market.
• The trading activities of hedge funds and investment firms

help reduce market volatility under certain circumstances (e.g. arbitrage away mis-pricings between derivative and cash markets).

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Risk Spreads are Declining

• Credit risk spreads on emerging markets are declining.
• When the risk spreads return to a wider level, hedge funds

and investment firms may be forced to sell their most liquid investments (e.g. equities) in major markets to cover their losses in illiquid lower-quality bonds.

• Market volatility may surge suddenly triggered by such

liquidation, thus creating high market risk to investors and issuers.

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Hedge Funds

• About 40% of the trading in New York and London is

related to hedge funds.

• Globally, there are about 8,000 hedge funds with assets

under management close to US$1 trillion. The market share for the U.S., Europe and Asia Pacific is about 75%, 20% and 5% respectively. The share for Asia Pacific is growing (some have estimated to be around 10% or US$100 billion by the end of 2005).

• With tremendous market power due to their ability and

preference to use leverage (normally, 2-3 times vs the extreme case of LTCM of 28 times).

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Prime Brokerage Services for Hedge Funds

• Hedge funds require services from prime brokers to

support their operations.

• Main prime brokerage services include:

– Trading, clearing and settlement – Securities lending – Position financing – Capital introduction – Other operational support (i.e. accounting, technology & administration)

• Large hedge funds typically maintain multiple prime

brokerage relationships, leading to an increase in their leverage.

• The growth of multiple prime brokerage relationships

implies that no one could effectively monitor the leverage

• f hedge funds.

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Issues to Consider

• The impact of hedge funds on the markets in time of

stress has not been tested in the major markets.

• The combination of low risk premiums (for inflation and

credit risks), complacency ( in good times ) and untested elements of risk management systems dealing with complex financial instruments could ultimately become hazardous to financial markets (IMF Global Financial Stability Report April 2005).

• As a regulator, we need to be mindful of the instability

which hedge funds and hybrid financial products could suddenly bring to the markets in time of crisis.

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• 2. Convergence in Exchanges
• Due to competition and changes in regulation, many

stock and derivative exchanges have been demutualised and become publicly listed companies.

• Changes in ownership and incentive structures have

lead to changes in mindset, becoming more commercially-oriented.

• Look for - growth opportunities, and
• diversified sources of revenues
• The businesses of stock and derivative exchanges

are complementary to each other. They are natural targets for merger.

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Examples of Mergers of the Cash and Derivative Markets

• Asia:

Hong Kong (HK Exchanges and Clearing), Singapore (Singapore Exchange), Korea (Korean Exchange), Malaysia (Bursa Malaysia Bhd)

• Europe:

Germany (Deutsche Borse/Eurex), UK and France (EurNext/Liffe)

• U.S.: Next?

Transformation is happening – the merger of NYSE and electronic-trading firm, Archipelago

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Regulatory Implications (1)

1. Moving to the creation of a single regulator for the stock and futures markets. This is driven by – The consolidation of stock exchanges and futures exchanges into single entities – Need for effective cross-market supervision and monitoring 2. Build better market infrastructure – Make trading and clearing in both cash and derivative markets equally easy to be conducted and being capable of accommodating increased volume – Allow better monitoring of risk concentrations and use

• f common collateral

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Regulatory Implications (2)

3. Establish compatible regulatory requirements for stock and derivative markets

– Reduce compliance costs and facilitate cross-market activities

4. Monitor cross-market impact of related products

– Evaluate liquidity and volatility implications to ensure the stability and orderly functioning of the markets

5. Investor education

– Given the complexities and the riskier nature of derivative products, it is important for regulators to step up investor education efforts

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Conclusions

• The trend of the convergence of the

derivative and cash markets will continue and intensify over time as it is a natural progress of market development

• As securities regulators, we need to be fully

aware of the benefits and risks which the convergence will bring to our markets and be prepared for it

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Thank you