Derivatives 2005 - Asia surmounts hurdles
The contribution to global bank profits from Asia's structured product markets has grown dramatically over the last five years. There are plenty of hurdles to building sustainable businesses, however. Nick Herbert reports.
Asian structured product growth has come from the opening up of new markets and growing familiarity with new investment techniques. The development of any new market comes with its share of risks, however, as some international banks discovered this year.
In global terms, Asia represents a fraction of the financial markets, which is always going to act as an effective revenue cap on any product line in the region; it is no different for structured products. Yet the numbers are already good enough for banks – and head-hunters – to see further opportunities in this area.
From a liability management perspective, Asian structured product activity is tiny in worldwide terms. Yet, although the contribution to the overall business from the Asian market is constrained by the size and nature of its companies, the margins are good.
"Asian companies tend to have pro-active treasurers," said Mahesh Bulchandani, head of structuring and solutions at JPMorgan. "They are much more accepting of complex structured solutions, whereas in the US, the market is bigger but more commoditised.”
Volumes on the investment side constitute a more significant component of world-wide volumes and profitability. Here, the placement of CDOs has been a major factor in Asia's increasing importance, but there has also been healthy interest in structured notes – notably before the flattening in the US interest rate curve.
The retail sector is also taking off in the more developed markets of Hong Kong, Singapore, Taiwan and Korea.
Great hopes are pinned on regional profits increasing, and these hopes are likely to be fulfilled but it will not necessarily come easy, particularly as the market pushes into new territories. In these frontier markets, supervisors have a lot of catching up to do before there is a level regulatory playing field throughout the region. This is where banks can get caught out.
Running foul of the regulator can impact a bank both from a financial and, even more importantly for some, a reputational viewpoint. Incidents in India and Korea this year highlight this threat.
India has two financial markets regulators, both admirably protective when it comes to the domestic investor. There is a level of opaqueness when it comes to derivatives in India that periodically leaves room for error – and recrimination.
In April, for instance, the Reserve Bank of India (RBI) put a stop to a developing flow of quanto swap deals, while in May UBS was reprimanded by the Securities and Exchange Board of India (SEBI) for equity derivative transactions.
While the RBI curtailed the sale of quanto products, it did not enforce unwinding of existing trades and no punishment was meted out. But SEBI banned UBS for one year from selling offshore derivative instruments with Indian securities as the underlying instrument.
Clarity, or the lack of it, was an issue in both cases. Without explicit guidelines as to what is expressly permitted, retrograde action is inevitable but worrying. The Indian Securities Appellate Tribunal itself highlighted a lack of clarity in SEBI's "know your client" requirement in its September ruling in favour of UBS's appeal against its ban.
Even in the more developed markets, banks are open to regulatory risk. In Korea, for instance, Deutsche Bank and BNP Paribas were rapped on the knuckles by the regulator for supposedly mis-selling derivative products to quasi-sovereign companies.
"That decision has made it difficult for foreign banks, but it will hurt the development of the market in Korea more," said one structurer. Following the reprimand, bankers say that deals with government-linked companies require several banks to price the deal.
"Having 10 banks bidding on a deal is OK in normal markets, but that is not Korea," said a banker. "What is the point of doing loads of work for only a 10% chance of getting the business?"
The rewards from structuring in Asia are evident but the risks less tangible, yet with the market leaning towards further deregulation, banks feel impelled to participate.
They are pragmatic about the risks involved, as even if all the bases are covered, there is always the chance of being unlucky and that kind of exposure cannot be hedged. Best practice can decrease the probability of something going wrong.
"You need to work with the regulators and create a dialogue," said Balchandani. "Banks need flexibility to drive innovation but the regulators are there to protect the market."