Asian Derivative Markets

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Derivatives and Securitization
Both Derivatives and Securitization represent
risk-transfer tools derived from underlying
assets
Asset Securitization in East Asia ASEAN3
Workshop Shanghai National Accounting
Institute Shanghai 9. November 2005
Oliver Fratzscher World Bank
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Outline of Presentation
Hypothesis OTC derivative markets are necessary
for securitization to be sound and efficient
(not sufficient, ABC also necessary)

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

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What is Securitization ?A specialized OTC
derivatives product

• Securitization is a technique to standardize
  financial instruments for risk transfer from
  underlying assets it is OTC derivative product
  structure through SPV
• Derivative is a simple financial instrument for
  risk transfer from a single underlying asset
  (OTC/ETD)
• MBS package of assets linked to mortgages
• CLO collateralized package of loan obligations

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Two perspectives
" Although the benefits and costs of derivatives
remain the subject of spirited debate, the
performance of the economy and the financial
system in recent years suggests that those
benefits have materially exceeded the costs."
Alan Greenspan

• We view them as time bombs both for the parties
  that deal in them and the economic system. In our
  view derivatives are financial weapons of mass
  destruction (WMD), carrying dangers that, while
  now latent, are potentially lethal.

Warren Buffet
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2. Global derivative marketsrapid OTC growth and
increasing ETD products
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Asian derivative marketsbanks in OTC FX and
security firms in equity ETD
Sources Triennial Central Bank Survey (BIS,
2005) and World Federation of Exchanges (2005)
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3. Building blocks for DerivativesMBS requires
similar components as derivatives
Necessary components for MBS

• Product Design
• Push by originator for risk transfer tools
• Pull by investors for yield and duration
• Risk-based pricing, benchmark, corp bonds
• System-wide stability without moral hazard

• Regulation
•   Regulatory approval, product understanding
• Legal clarity default, repossession,
  enforcement
• Accounting rules, transparency, disclosure
• Clear tax treatment, level playing field

• Infrastructure
• Industry guide onstandardized products
• Credit ratings industry and standards
• Best practice risk management
• Suitability criteria for investors, SRO

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Building blocks for derivative markets

• Product Design
• Economic rationale for hedging needs
• Liquid cash market, long and short positions
• Market determined prices, interest/FX rates
• System stability, no moral hazard risks

• Regulation
•   Lead regulator, capital rules, reporting
  standards
• Legal clarity ISDA standards, enforceability
• Accounting rules, transparency, disclosure
• Level playing field, tax harmonized, integration

• Infrastructure
• CCP, ISDA master, close-out netting
• Demut. exchanges, strong capital, margins
• SRO rules enforcedwith limits, monitoring
• Certified investors, code of conduct

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Derivatives enhance financial 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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Rewards and risks of derivativesmarket
development combined with prudential issues

• Market 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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4. Schematic development of D marketscash
liquidity sound regulation solid CCP
infrastructure
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Link between cash and D turnoverliquidity
corridor for emerging and developed markets
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Derivative products in Asia three tiers of
exchanges offer six product categories
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Derivatives infrastructure in Asialiquidity
indicators improve but regulation still evolving

• Notes a denotes best practice q
  denotes progress on existing deficiencies and r
  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./ Turnover ratios for fixed
  income instruments have also been obtained from
  HSBC (2004). 3./ Equity market liquidity
  indicators have been obtained from World
  Federation of Exchanges (2004), which revealed
  thin markets in Philippines, Indonesia, and
  Thailand. 4./ Information about laws on
  derivatives was obtained from individual country,
  with only Australia, Hong Kong, and India
  currently having distinct laws on derivatives.
  5./ Securities lending data were obtained from
  Endo and Rhee (2005), showing restrictions in
  Malaysia and Philippines on short selling, with
  very little activity in Indonesia and Thailand.
  6./ World Bank public documents on accounting
  standards (ROSC) and professional publications
  reveal adequate accounting standards aligned to
  IFRS standards only in Australia, Hong Kong,
  Indonesia, Malaysia, and Singapore, but major
  gaps exist in the Philippines. 7./ CCP
  information was obtained from industry sources
  and ADB, showing adequate functioning only in
  Hong Kong, Korea, and Singapore. 8./ ISDA
  netting opinions have been issued for all
  countries mentioned with 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 Hong Kong
  and Malaysia, and VAT being applied in China,
  Philippines and Thailand. 11./ Transaction costs
  for bond markets were obtained from ADB (2004)
  and additional market information on taxation.
  12./ Institutional investor base and NBFI
  indicators are obtained from ADB, which shows
  weaknesses especially in Indonesia and
  Philippines.

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5. Technical issuescritical 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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Policy issuestransparency 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

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6. Conclusion main messages

1. Derivatives can enhance financial intermediation
   and economic growth but require efficient
   underlying cash markets 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
   credit derivatives which could undermine fixed
   prices, pegged FX regimes, and credit policies
4. Securitization products should be grounded on
   sound OTC derivative market structures.

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Discussion