As a country that has seen frequent currency devaluations over time, Turkey has long had a thriving derivatives business, unsurprisingly revolving around FX and rates. But today’s investor has different concerns with capital protected products on the rise.
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Turkish investors have long sought protection from the vagaries of FX and inflation via the derivatives market, swapping local capital into US dollars. With strong historical trade ties to Europe, Turkey is no stranger to the risk posed by currency moves, and has long been comfortable with currency swaps.
“In such an environment, the FX market becomes a dominant front in the financial system,” said Fatih Keresteci, local head of treasury sales, Turkey at HSBC. And as the market has increasingly opened up in recent years, the importance of the FX market and the structures used within it has grown.
“Since currency substitution is very common and volatility in FX rates is sufficient to provide satisfactory rates of returns, the use of FX derivatives are very widespread among retail and individual investors,” said Keresteci.
Dual Currency Deposits are the most commonly used securities, with volumes very high, at more than US$1bn traded per week, he said.
Equity and commodity derivatives have taken much longer to gain traction. Such products have been permissible since 2008, according to the Capital Markets Board in Turkey, but only started to make a real impression as declining interest rates encouraged investors to consider alternative investments.
A capital idea
“A large proportion of derivatives bought by institutional Turkish clients are OTC options tailored for use in capital protected products,” said Chadi Semaan, responsible for financial institutions marketing at Commerzbank Corporates & Markets.
These capital protection products are often very simple structures, for example a bond with a call or put option, depending on the investor’s view, typically short-dated, out of the money with a 90%–95% strike on an ISE 30 stock.
“Capital guaranteed funds and notes were supplied by financial institutions in the previous years, but inconsistency in implied and actual volatilities, thanks to unanticipated events and unprecedented price moves, generally ended with zero return in six-month or a year tenor structures,” said Keresteci.
In light of these trades where investors failed to see any return, the preferred approach for Turkish private banking and asset management institutions is to take the capital guaranteed idea and apply it to the major index. Demand has since increased.
In all, the Turkish structured products market is believed to be worth about TL3bn (US$1.67bn).
“The use of structured equity derivatives through the launch of local currency-based capital protected notes or funds has increased over the past couple of years,” added Alain Alev, head of equity derivatives sales for EMEA at HSBC.
“Distributed by private banks and some retail distributors, these products are in general up to 2.5 years maturity, providing a simple or Asian type participation [average price over a pre-determined period] on an index, with a strong proportion of ISE 30 related products. Custom indices, including controlled equity volatility indices, have been quite fashionable with private banks over the past 18 months.”
Relatively sophisticated structures are also picking up. For example, Asian options mentioned by HSBC’s Alev derive their strike price from an average market price over a given period of time, and look-back options where the strike is determined by the optimal price over a pre-determined period, address the problem investors have timing their market entry point. Yet the complexity is deliberately limited as investors get used to these products.
“There always needs to be a balance with exotic structures, where a potentially interesting payoff has to be weighed against the ability of investors to understand it,” said Semaan.
Regulatory drag
The CMB, which is responsible for regulating derivatives, is a well respected regulator, its inherent conservatism winning it much admiration in recent years as other markets wrestled with increasingly complex products.
Capital protected funds have a strict investment structure to offset the lack of third-party guarantor, requiring resources be separated into two. One part of the portfolio must be invested in fixed income securities to achieve the required capital protection, while the other must be set aside for investment purposes, with investment in OTC derivatives tracking equity, FX, fixed income, commodity, economic indicators, or combination of these, permissible.
Structured funds must have a maturity of at least six months and there are about 105 capital protected funds and 30 guaranteed funds currently available in the Turkish capital markets, the CMB said.
But the CMB’s conservatism is also an obstacle for derivatives bankers in Turkey: it can take several months for products to be approved by the CMB, so it is difficult to design products to exploit current market conditions.
Banks and investors must therefore anticipate and exploit market conditions months in advance, an inexact science at best. A market that looks favourable for a call option on a given equity today might look very different by the time a product is approved.
Turkish derivatives users can find themselves locked into positions with unfavourable entry positions, making the business less efficient than in Western Europe.
It is not only regulation but Turkish accounting practices that need reform to make the use of derivatives easier, said one banker familiar with the Turkish market.
“The local regulatory framework is not very familiar with derivatives and watchdogs are not capable of handling them,” the banker said. “They unconsciously give harm to the use of derivatives and other structured products. The taxation and accounting barriers either resulted in a limited use of these products or encourage residents to deal with offshore financial institutions.”
However, ambitions to reinvent Turkey as a regional financial hub means there is hope the regulator will improve in this area.
“To reach this regional hub goal I hope the regulatory framework will be improved rapidly in the coming years, considering that the cost of offshore booking is very expensive in many aspects,” the banker said.
Another avenue of demand comes from Turkish corporates, who use derivatives to hedge, said Keresteci. “Although the conservative structure of Turkish corporations averts them from full hedging, the excess volatility in financial markets in the post-Lehman era directs them to hedge a part of their risks.”
However, it remains the financial players who are the principal driving force for derivatives in Turkey, according to an executive at Isbank in Turkey.
Expanding Turkish Funds
In the listed space, futures trading is gaining traction in Turkey, with volumes steadily increasing. Turkey is also host to a growing number of exchange-traded funds, allowing investors to gain exposure to a basket of equity positions via a single tradable security, for example via the Dow Jones Turkey Titans 20 Index or the Dow Jones Islamic Market ETF.
The regulation that paved the way for the emergence of ETFs was passed in 2004 and there are now 12 ETFs listed on the Istanbul Stock Exchange, according to the CMB, of which eight are equity tracking indices, two are fixed income tracking indices and two track gold.
ETFs have been very popular with investors around the world, and are an effective way for international investors to take exposure to Turkey’s equity market with Lyxor’s Turkey ETF, which is based on the Turkey Titans index, totalling assets under management of €191m.
On the whole, Turkey remains in the early stages of this development, with vanilla structures being the most popular and easiest to sell. “Three or four years is a short time,” said Semaan. “There is still plenty of scope for growth. A number of Turkish institutions aren’t yet in this business, and when they start offering them to their clients the size of the market will grow considerably.”
Turkish banks seem committed to developing their derivatives expertise, and are sophisticated enough to understand what is possible with derivatives, owing to their long experience in FX. But there is still a gap between the local players and the international banks.
“Local banks, while sophisticated in their approach, are some time away from having the capability to structure and price the derivatives underlying their products in house: for that they still rely on the international banks,” said Semaan.
“The derivatives business is very premature at the moment but there is a big growth potential,” agreed Keresteci.
“The outcome of the first investment is crucial in determining whether an investor will come back,” said Semaan.
