"Derivatives and Macroeconomic Management in Post-Crisis Asia"
Speech by Dr Khor Hoe Ee, Assistant Managing Director (Economics), at the FOW Eight Asia-Pacific Derivatives Exhibition, Westin Hotel
Date : 25 Sep 2001
1.1 Good morning. I would like to share with you my views on derivatives markets from the perspective of a central banker in post-crisis Asia.
1.2 Recent years have seen phenomenal growth in global as well as regional financial derivatives markets. Prospects for derivatives in the Asian region have brightened considerably since the Asian crisis, particularly in light of efforts by governments to promote and develop the region's capital markets, and increased awareness by corporations and financial institutions of the need for better risk management. However, the rapid growth of the industry is also likely to pose major challenges to policy makers and regulators as they grapple with its implications for the maintenance of macroeconomic and financial stability.
Broad trends and developments in world and Asian derivatives markets
1.3 Whether measured in terms of turnover or contracts outstanding, the derivatives markets have grown at an explosive rate in the last two decades, and promises to continue their rapid growth in the coming years. Recent data by the BIS indicates that the total notional amount of outstanding derivative contracts worldwide stood at US$109 trillion at the end of 2000. Interest rate contracts formed the bulk of all derivatives contracts issued, followed by foreign exchange and equity-linked contracts. The most successful exchange-traded derivatives appear to be those that add liquidity to the underlying markets, while the most successful OTC derivatives are those that offer new configurations of risk and return, such as credit derivatives which have grown rapidly in the last few years. The bulk of derivatives trading and contracts issuance occurs in North America and Europe while Asia has lagged behind in market share. Although exchange traded derivatives in the region have grown rapidly in recent years, there remains a lot more room for growth in Asian derivatives markets, which represents a major opportunity for Singapore's financial services industry.
Role of Derivatives in Financial Crises
1.4 Derivatives have gained notoriety as instruments of speculation in recent financial crises. Derivatives played a key role in triggering the 1992 ERM crisis and the 1997 Asian financial crisis. In the latter case, speculative attacks were made on the Thai Baht through forward contracts and swaps, which depleted the foreign reserves of the central bank and led to the collapse of the pegged exchange rate regime, and triggered the Asian financial crisis.
1.5 The Long-Term Capital Management (LTCM) debacle, on the other hand, illustrates how a single financial institution can use derivatives to build up such a huge, highly leveraged position that its default would threaten to destabilise global financial markets. At the time of LTCM's collapse, the total notional amount of its outstanding derivatives contracts was estimated at a staggering US$1 trillion. Default by LTCM would have caused its counter-parties to try to liquidate their positions, possibly resulting in worldwide market disorder.
1.6 Finally, the 1994 Mexican peso crisis shows how derivatives can accelerate and deepen a financial crisis. According to the IMF, Mexican banks were holding US$16 billion in tesobonos total return swaps at the time of the Mexican crisis. The initial peso devaluation at the onset of the crisis depressed the tesobonos price substantially and exposed the markets to large next day collateral payments. This could have accounted for a major part of the loss in foreign reserves by the Mexican central bank the day after the devaluation. This shows how collateral or margin calls on derivatives can accelerate the pace of a financial crisis. The greater leverage that derivatives provide can also multiply the size of losses and thereby deepen a crisis.
1.7 Nevertheless, we must not confuse the instruments of speculation with the underlying causes of the financial crises. Derivatives by themselves cannot cause currencies to depreciate or firms to go bankrupt. Financial crises occur because of fundamental imbalances in the economy.
2 BENEFITS AND RISKS TO THE ECONOMY
2.1 There is agreement on the dangers of derivatives, partly from past painful experiences. However, their benefits to the economy need to be highlighted. Derivatives are an efficient way of transferring risks from those that do not want it to those that do and are better able to manage risk. While the underlying risk is not eliminated, the net consequence of such a redistribution of risk is greater robustness, if indeed the risk-takers are better qualified to handle risk. This should lead to an improvement in the ability of the economy to withstand shocks. Very broadly, I identify several specific ways that derivatives contribute to an economy's efficiency and robustness:
- Efficient Allocation of Risk
- Lower Cost of Hedging
- Improved Market Liquidity
- Source of Information on Market Expectations
- Improved Risk Management Practices
Efficient Allocation of Risk
2.2 Do derivatives benefit society? Some would argue that it does not, as risk is only redistributed but not eliminated. Take, for instance, the case of a wheat futures contract. Its availability does not in any way reduce the risk of adverse weather. However, because someone is willing to take the risk of lower wheat prices next year for whatever reason, the wheat farmer has an incentive to produce more wheat than he otherwise would. This demonstrates that the reallocation of risk results in a superior production outcome. In general, market participants for both corporate and retail markets are better able to manage financial risks using a wider range of financial products.
2.3 Derivatives allow different components of risk in a single product to be separated and traded, which results in better risk allocation. Therefore, derivatives empower end-users to manage and reduce their inherent risk exposures effectively, which permits them to focus on their core businesses. The ability to manage and reduce risks ultimately leads to stronger long-run economic performance. If there were no derivatives, economic agents would be more hesitant to make long-term investment and production decisions, as they would be unsure about future price movements.
Lower Cost to Hedging
2.4 Derivatives also provide a low-cost, effective method for end-users to hedge and manage their exposures to interest rates, exchange rates and commodity prices. Corporations, government agencies and financial institutions also benefit from derivatives through lower funding costs and more diversified funding sources. For example, currency and interest rate derivatives enable firms to borrow in the cheapest capital market, domestic or foreign, without regard to the currency in which the debt is denominated or the form in which interest is paid. This would have a positive effect on the economy as end-users of derivatives are able to achieve exposures in their financial transactions that are consistent with their overall business strategies, while being able to exploit a much wider range of funding sources. This promotes the financing of investment in physical assets through a lower cost of capital formation, and stimulates economic activity.
Improve Liquidity of Underlying Assets
2.5 Derivatives markets help to improve the liquidity in the underlying asset markets by bringing hedgers and speculators together. The ability to hedge encourages investors and traders to take bigger positions and be more active in the underlying markets. A more active market environment with high liquidity in turn facilitates price discovery, which promotes economic efficiency.
2.6 Derivatives are windows into market expectations, and could be exploited for information about future price expectations for various types of financial assets and important commodities. The forward-looking content is especially useful for regulators and policy makers in assessing the health of the financial system and the appropriateness of a monetary policy stance. For example, currency and interest rates swaps and futures prices contain valuable information about the outlook for the economy and the tightness of monetary conditions, which are very useful to central bankers when making monetary policy decisions.
Improved Risk Management Practices
2.7 In addition, there can be positive spillover effects from the derivatives markets in terms of better risk management. Improvements in risk management techniques that were first applied to derivatives trading can improve the management of risks in other, more traditional businesses such deposit taking and lending by banks, purchase and financing of securities positions by securities firms, or treasury management by corporations. The advances in risk management will enhance the stability and profitability of the institutions.
2.8 Taken as a whole, the growth in derivatives markets in Asia will yield substantial benefits for the regional economies by improving economic efficiency and robustness, despite being unable to eliminate the underlying risk. From a global perspective, derivatives strengthen the important linkages between global financial and commodities markets, increase market liquidity and efficiency, and facilitate the flow of trade and finance.
Risks of derivatives
2.9 Do derivatives make the world riskier? There are conflicting views on this question. It is true that some derivatives end-users have lost large sums of money. For example, Procter and Gamble, which lost heavily in 1994 by using complex interest rate swaps, and Barings Bank, in 1995, due to highly-leveraged trading in Japanese stock market futures and options by its Singapore based trader. However, what these examples really demonstrate is that derivatives are complex securities that can bring about huge losses if end-users are either ignorant of the risks involved or do not have an adequate risk management system.
2.10 The rapid proliferation of derivatives poses some major challenges to regulators and policy-makers. These include:
- Increase in moral hazard
- Facilitate efforts to undermine regulations
- Complicates risk assessment by regulators
- Increases market volatility.
2.11 The moral hazard problem of derivatives can be illustrated by using motor insurance as an example. Derivatives can be regarded as equivalent to an insurance product where a certain premium is paid for a certain amount of coverage in the event of an undesirable outcome. By pooling the risk, insurance lowers the cost to individual motorists of owning and operating a car, including the cost of being involved in an accident. However, the lower cost might induce some motorists to become more reckless in their driving and leads ultimately to more accidents.
2.12 Derivatives can also be used to exploit regulatory or tax loopholes. They can help firms avoid capital requirements, manipulate accounting rules and credit ratings, and evade taxes. They can also be used to raise the level of a firm's market risk exposure relative to its capital in pursuit of higher yielding and riskier investment strategies. In the event of a sharp correction in asset prices, large market exposures on the part of firms will hasten and intensify the adverse effects of the correction on the financial sector and general economy.
2.13 Furthermore, derivatives complicate the monitoring and assessment of the financial health of a firm or the financial system because they are off-balance sheet items. Derivatives introduce a wedge or discrepancy between the true risk exposure of a firm and what is reflected on its balance sheets. Off-balance sheet exposure through derivatives can easily reverse, exaggerate or overwhelm the risk exposure indicated by balance sheets.
2.14 Derivatives have also been blamed for intensifying the price volatility of the underlying assets in the presence of market imperfections. Mechanistic trading rules in the derivatives markets create more noise, and the specific technical construction of certain derivatives products increases price volatility and hence market instability. For example, knockout options, portfolio insurance, dynamic hedging are examples of derivatives products or strategies, which, from historical evidence, can increase price volatility - where an option seller can hedge by buying another option or by buying or selling shares. In the event that there is a major correction in prices, the market would be driven down further as the model would cause investors to sell even more. This effect was widely blamed for the severity of the US stock market crash in 1987 when investors with portfolio insurance sold into the selling wave as they attempted to replicate the Black-Scholes hedge ratio in a midst of a market sell-off.
3 MACROECONOMIC AND REGULATORY CHALLENGES
3.1 Derivatives are neither good nor bad intrinsically. From the lessons learnt in the numerous crises of the 1990s, it has become clear that the problem was not the usage of derivatives per se, but underlying weaknesses in the domestic and global financial systems, and shortcomings in the macroeconomic policy framework. There is a worrisome possibility that the rapid growth of the derivatives industry may outstrip developments in the supporting regulatory and policy framework. This is especially true for post-crisis Asia.
3.2 The main challenge for policy-makers here is to avert any dangers that may arise from the use of derivatives. Like typhoons, financial accidents are bound to happen sometimes. However, public policy can reduce the damage by establishing early warning systems and building more robust institutions that can withstand the inevitable storms.
3.3 It is important to point out that derivatives transfer but do not eliminate risk, that is, the risk still exists at the macro level. A question that needs to be addressed is, are the willing risk-takers able to carry the risk? In general, derivative traders are exposed to two main dangers: shortage of capital, and inadequate risk control and management systems. Sound macroeconomic policymaking and regulatory oversight are needed to mitigate these vulnerabilities.
3.4 Sound macroeconomic policies are necessary for the overall risk level to be kept at a low level. Since derivatives are complex instruments that can exacerbate the risk of contagion, policy makers need to improve their understanding and surveillance of the exposures and risks generated by these instruments. The problem of cross-border contagion requires better market intelligence and closer co-operation between national regulators and policy makers so as to enhance cross-border oversight.
3.5 The widespread use of derivatives may complicate the conduct of monetary policy, but should not affect the ability of central banks to establish a desired exchange rate or short-term interest rate level consistent with economic fundamentals.
3.6 Policy makers need to be aware that the monetary policy transmission mechanism may be affected by derivatives as they can modify economic agents' sensitivity to changes in interest rate or exchange rate. Derivatives thus can change the relative effectiveness of the various channels through which monetary policy operates and the speed and extent of the transmission of monetary policy to the economy. More importantly, derivatives enable economic agents to anticipate and partially insulate their existing investment or consumption plans from interest rate or exchange rate changes in the short-run. In the long-run, however, consumers and producers must align their economic decisions to changes in relative prices and monetary conditions brought about by monetary policy decisions.
3.7 It needs to be stressed that derivatives are merely instruments through which economic agents respond to risks and uncertainties in the physical, economic and policy environment. While they may enhance or reduce the transmission of monetary policy changes, derivatives do not exert an effect on the economy, independent of existing fundamentals and expectations. This implies that policymakers should focus more of their efforts on strengthening economic fundamentals and avoiding macroeconomic imbalances than on curbing speculative activity using derivatives. The existence of derivatives actually serves to discipline policymakers to pursue sound macroeconomic policies.
3.8 Continuous, smooth and safe functioning of the derivatives markets are needed for the benefits of derivatives to be fully realised. In this regard, the most important requirement is to strengthen the first line of defence, namely by enhancing the risk management capabilities of financial institutions and the risk assessment capabilities of regulators. As adequate capital to buffer against losses is another important line of defence to protect against derivatives-led market exposure, regulators need to address the optimal level of capital adequacy in the financial system, especially the risk-capital ratio.
3.9 Regulators must consequently maintain close supervision of financial institutions and, in the event of a financial failure, be ready to take decisive action to preserve financial stability. In addition, regulators need to foster transparency and prompt disclosure of relevant information in order that the full force of market discipline may be brought to bear on those institutions with derivatives exposures.
3.10 There is also a need to build up-to-date surveillance capability on derivative products in order to detect instruments that are specifically designed to outflank regulatory safeguards and undermine prudential controls. Regulators need to watch out for new and complex products created primarily to circumvent regulatory restrictions.
3.11 A well-functioning derivatives market facilitates the efficient allocation of risks between economic agents. However, derivatives are complex securities and not easily understood without specialised training, so it is imperative to improve investors' understanding of derivative products. This would help market participants from taking excessive risk without realising the potential repercussions on their balance sheets.
4.1 The derivatives industry clearly has a bright future in Asia and presents a major opportunity for the region's financial services sector. The growth of derivatives in Asia will be propelled by the rising demand for risk management, which will generate substantial positive externalities for the region's economies. In my view, the rewards of derivatives outweigh the risks. More importantly, the rewards are not merely restricted to end-users but encompass the wider economy. By facilitating a more efficient distribution of risks, derivatives render the economy more efficient, stable and robust. As for the risks involved in using derivatives, I am confident we can minimise them with the right framework and tools. The challenges to policymakers and regulators are significant, but not insurmountable.
4.2 We cannot eliminate the possibility of future financial crises, but we can certainly attempt to mitigate their damaging effects. In this regard, derivatives are valuable tools that can help firms, financial institutions, and governments in the region to protect against adverse financial shocks. However, we must make sure that adequate macroeconomic and regulatory safeguards are in place to control the risks arising from the use of derivatives.
4.3 For small open economies, the best defence is to practice sound macroeconomic policies, establish the proper regulatory framework, and maintain close prudential oversight of financial institutions. At the same time, we must permit the financial services sector enough freedom to innovate. Therefore, we must strike a balance between a single-minded policy agenda focused solely on crisis prevention at the expense of stifling financial innovation, and the other extreme of adopting policies aimed at promoting financial innovation at the cost of greater vulnerability to financial mishaps. Only by controlling the risks can we reap the full benefits of derivatives.
4.4 Thank you.