Opening Address by Mr Ong Chong Tee, Assistant Managing Director, Monetary Authority of Singapore, at FOW's 11th Asia-Pacific Derivatives & Securities World Conference, 19 October 2004, Singapore
Mr David Setters, industry friends, ladies and gentlemen. I am delighted to be here, to deliver the opening address at this FOW's Asia-Pacific Derivatives & Securities World Conference.
2 Let me begin by saying some things about the exponential growth in derivatives markets over the last few years.
3 To cite a couple of statistics. Recent data by the Bank for International Settlement (BIS) shows that the combined value of exchange-traded financial derivatives contracts in interest rate, stock index and currency contracts expanded strongly to 304 trillion US Dollars. This represents a staggering 120% increase compared to the previous survey figure in 2001 of about 140 trillion US Dollars.
4 Similarly, the global average daily turnover in the OTC derivatives market increased sharply to 1.2 trillion US Dollars, a rise of over 110% compared to 2001.
5 Perhaps not surprisingly, the surge in derivatives trading has resulted in increased competition among exchanges. In the first half of 2004 alone, we saw several new exchanges operating in direct competition with existing US derivatives exchanges. For example, Eurex US launched Treasury futures in February while Euronext.liffe introduced Eurodollar futures in March. The Boston Options Exchange, a new all-electronic equity option exchange in the US also began trading in February this year. Exchanges will have to find ways to innovate and strengthen their competitive advantages to stay ahead of the pack. This can only be good news for market users.
6 The strong global growth in derivatives transactions is also seen in this part of the world. According to recent reports1, in the first half of 2004, the Asia-Pacific region including Australia and New Zealand, accounted for about 40% of all exchange-traded futures and options volume worldwide.
7 However, if one were to strip out the more developed markets of Japan, Korea, Australia and New Zealand, the derivatives markets in Asia are actually not large. Part of this is obviously because many markets in Asia are still relatively young. However, another possible reason is that many in Asia -- regulators, investors, corporate end-users - may still be viewing derivatives with a degree of suspicion, perhaps due to a lack of understanding; or perhaps a disdain for how speculators can use derivatives to create financial havoc as in the Asian currency crisis.
8 Post-crisis, many Asian governments have now recognized the need to develop and deepen our capital markets. A number of regional collaborative efforts have been launched; for example, many of you may be familiar with the pooled investment in a US$ denominated Asian Bond Fund, by 11 Asia-Pacific central banks, including the MAS. Now, a local currency denominated tranche called Asian Bond Fund 2 is being worked on. Under the Asean+3 Finance process, 6 Working Groups have been formed to consider various Asian Bond Market Initiatives that will address a series of supply side issues. Within Asean, an Exchange Linkage Task Force led by Singapore has been formed to consider further strengthening alliances between our exchanges. But efforts to develop the derivatives markets, whether OTC or exchange-traded, have been far more tentative.
9 Why is this so? One view may be that derivatives by definition will naturally follow the growth of the underlying instruments and with the demand for new financial products. But there may be another reason why "derivatives" is not a common word one would see, when it comes to regional development efforts. Derivatives simply have had a lot of bad press. Many of you would recall the enormous losses from use of derivatives by Gibson Greetings, Orange County, Procter & Gamble, Sumitomo Bank, LTCM, Enron and closer to home, Barings. So are derivatives inherently a "bad thing", whose growing usage is something we should frown upon? or is this yet another example of how something good in the wrong hands can result in very bad outcomes.
10 The debate on the cost and benefits of derivatives has gone on, and probably will continue to go on for many years. Just a few months ago, we heard an interesting exchange between Warren Buffett and Alan Greenspan on this topic. You may all remember Mr Buffett's reference to derivatives as "the financial weapons of mass destruction", posing grave risks to financial markets. Mr Greenspan in contrast, noted that derivatives actually helped to spread risk, thereby stabilizing the financial system. These remarks are especially interesting because we have arguably one of the greatest investor of all times derogating the use of derivatives and a central banker or regulator supporting it. One would understandably expect the reverse.
11 Allow me to share my own perspectives on this subject. I am from a monetary authority, which sort of put me in the company of regulators. At the same time, I oversee the reserve management activities in the MAS and have been involved with financial investments for some 18 years now, which sort of makes me an investor.
12 And as an investor, I would describe myself as a firm supporter of the use of derivatives. The late Merton Miller wrote a wonderful book called "Merton Miller on Derivatives", in which he argued strongly the case for derivatives. Some of you may have read the book within which he gave many arguments to support his stance. I would just like to read a small excerpt. Prof. Miller posed the question: "Did financial derivatives make us better or worse off?" His own answer:[Quote]
"Free market economists have a simple standard for judging whether a new product has increased social welfare: Are people willing to pay their hard-earned money for it? By this standard, these products have proved their worth many times over. But why have they been so successful? Where is their real ?value added"? The answer, in large part, is that they have substantially lowered the cost of carrying out many types of financial transactions." [Unquote]
In other words, if I were to crystallize that singular benefit of financial innovations in the past 2 to 3 decades, it would be in the area of improved risk allocation. And derivatives have allowed the transferring of risks at significantly lower costs to those better able to bear them.
13 In MAS' own experience in the management of our reserves, and in our discussions with many of our external fund managers, the value of derivatives can be distilled into a single word: "efficiency". And there can be "efficiency" in 3 broad ways :
(a) Efficiency because they allow an investment manager to keep less transactional cash in his portfolio. And in these days of low interest rates, the return drag from holding cash can be very high.
(b) Efficiency because they help establish links between different markets, thereby deepening liquidity. Asset swaps are an obvious example of this.
(c) Efficiency because they allow an investment manager to differentiate the distinct risk components of an asset, and to value and trade each one separately; thereby enabling the tailoring of an asset or a portfolio according to one's needs.
14 So the merits of derivatives usage would seem obvious. What then, could some of the reservations be? I will highlight three :
First, there is some belief that derivatives can be used to destabilize exchange rates and interest rates because they give speculators' access to greater "fire power". Until a few years ago, MAS explicitly disallowed S$ derivatives under our previous policy on the non-internationalisation of the Singapore Dollar. But in 1999, we allowed S$ interest rate products - interest rate swaps, FRAs, swaptions. Two years later, we freed up restrictions on the S$ options market. Our own experiences here reveal little evidence that derivatives in S$ have added to volatility. Instead, we believed that these instruments have helped to bring new participants and offshore players into our markets and in turn, deepened market liquidity. Indeed, there have been other studies done regarding the impact of the introduction of derivatives, such as the research by Smithson, Smith and Wilford in their book on "Managing Financial Risk", and from empirical evidence, derivatives often reduce price volatility and decrease bid-ask spreads in underlying markets.
A second reservation perhaps, regards risk control and accounting. Enron clearly demonstrated that accounting and risk controls can severely lag the growing complexities of financial innovation. Back in 1992, then-President of the New York Fed Jerry Corrigan issued a warning at a meeting of the New York State Bankers Association. Mr Corrigan said at that time that "the growth and complexity of these activities and the nature of the credit, price and settlement risk they entail should give us all cause for concern." He added that these derivatives or off-balance sheet activities must be managed and controlled carefully and that they must be understood by top management as well as by traders and rocket scientists. That warning 12 years ago sparked a series of new industry best practices and the recognition for an independent risk management function. And continued strides are being made in the areas of financial risk control and accounting, including the ongoing work of Basel 2.
A third related reservation regards systemic risk. Because financial derivatives involve future commitments, the issue of credit risk always arises. For exchange-traded derivatives, the exchange acts as a buffer for credit, legal and settlement risks. But for OTC derivatives, there are no such buffers. When a market player put on large leveraged transactions, and his positions turn sour, there is the risk of a chain of defaults rippling throughout the financial system. This may be exacerbated by the fact that more and more derivatives are traded and priced by fewer and fewer banks and investment banks - an outcome of global consolidation. Some measures, such as ISDA agreements and cross collateralization have helped to mitigate counterparty risks.
15 Notwithstanding the improvements in risk management and financial oversight, some concerns about the growing use of derivatives will remain, and rightly so. But the problem should not be seen as one regarding the increased use of derivatives per se, but rather how they are used and how they are managed. On balance, the benefits of derivatives will outweigh the costs. I believe that Asian capital markets will see greater vibrancy if the region liberalize and allow the further development of our derivatives markets.
16 And there are some promising signs that this is happening. Most encouraging are developments in the 2 Asian giants: China and India. Interestingly, they have taken on slightly different paths in developing the derivatives markets. China's liberalization is mainly in the usage of OTC derivatives, marked by the introduction of new derivatives rules in March this year. This allowed OTC derivatives done for any commercially reasonable purposes and not only for hedging; and the authorities there have granted derivatives licenses to China's main commercial banks and several foreign banks. India, on the other hand, has focused on developing exchange-traded derivatives, marked by the launch of the Indian Rupee interest rate futures last year. Both countries have seen strong growth rates in derivatives activities -- China, up 38% from the first half of 2003 and India, up 195% over the same period, although in absolute terms, the market sizes are still small.
17 In my view, there is a symbiotic relationship between OTC derivatives activities and exchange markets. A good part of the growth in global derivatives can be traced to end user demands for customised needs and transactions. To meet these needs, derivatives traders and dealers will always rely to some extent on exchange-traded futures and options to hedge their net market risks. A clear example is the relationship between the US interest rate swap market and the Eurodollar futures contract. The standardized terms of the futures contracts provided an efficient means of price discovery while the IRS uses the price to tailor solutions to individual contracts. And these same dynamics will fuel a mutually reinforcing growth of derivatives and exchange markets in Asia in years to come.
18 As derivatives markets develop in the region, Singapore is well placed to play an important role as a leading Asian centre. Both the Monetary Authority of Singapore and the Singapore Exchange (SGX) remain committed to developing the derivatives market here and have worked closely with industry players to implement various measures to encourage market growth. Mr Hsieh Fu Hua, the CEO of SGX, will be able to share more details but I note that trading volume of derivatives on SGX has been buoyant, reaching almost 17 million for the first half of 2004. In particular, trading in the MSCI Singapore Index Futures, which has been rising steadily over the past years, has registered record-high open interest and volume in the 2nd quarter of 2004.
19 In the OTC derivatives market, Singapore has seen impressive growth with an increase in market share of global OTC derivatives activities. According to the recent BIS survey, daily average turnover for OTC derivatives here rose almost three-fold from 6 billion US Dollars in 2001 to 17 billion US Dollars in 2004. Singapore is now the 12th largest OTC derivatives centre globally, further consolidating our position as the second largest OTC derivatives centre in Asia.
20 We are looking at further developing the derivatives markets in 3 ways. Firstly on the regulatory front, we have taken steps to ease the entry and compliance costs of firms engaging in financial and commodity derivative activities. Currently, financial derivatives fall under the purview of the Securities and Futures Act administered by MAS, while most commodity derivatives are regulated under the Commodities Trading Act administered by the International Enterprise Singapore, or IE Singapore. Through a MAS-IE S'pore initiative, the two regulators have agreed to provide a single regulatory interface for corporations applying for authorisation as markets, clearing houses, or licensing as futures brokers. So interested corporations can now approach MAS directly for the necessary authorisation if their financial products come under the regulatory purview of both Acts.
21 For the broader derivatives market in Singapore, we have also introduced measures to enhance its development. For example, under the previous legislative framework, a market operator is required to either apply for an approved exchange status, with the attendant full set of legal compliance requirements, or be exempted totally from our regulatory ambit. In recognition of the rigidity of this all-or-nothing model, we have introduced the Recognised Trading Systems (or ReTS) provider regime in the Securities and Futures Act, to give us the flexibility to apply regulatory requirements consistent with the risk profile of an individual Recognised Trading System provider. We will continue to refine our regulatory framework to reduce regulatory burden so as to encourage new and innovative trading platforms to take root in Singapore.
22 Secondly, we are improving our trading infrastructure. Rapid technological advancement is changing how derivatives products are traded and will redefine the landscape of the derivatives marketplace. Technology has not only opened the doors to new players through greater accessibility, but also blurred the line between geographic borders and between asset classes. Exchanges now have to be able to offer trading in multiple asset types and to cater to the growing sophistication of market participants, to compete more effectively. I am happy to note that the Singapore Exchange has introduced its new derivatives trading engine, SGX QUEST (which stands for SGX Quotation and Executive System for Trading) in August this year, to eventually lead to an integrated trading engine for its securities and derivatives activities.
23 Thirdly, we seek to broaden the instruments traded in Singapore. We envisage strong growth in credit derivatives, driven by the redistribution of risks from banks and insurance companies via the capital markets. We are also promoting the commodity derivatives market. Already well-positioned as an oil hub, Singapore is a natural choice for financial institutions to set up regional energy derivatives trading desks and more broadly, to consolidate commodity derivatives operations here. The SGX is currently in discussions with NYMEX, for the latter to consider setting up a futures exchange here. Such a joint venture will be an important first step towards developing strong exchange-related trading and clearing facilities to service the regional markets.
24 In conclusion, development of the derivatives market is important to the growth of the financial markets in Asia. You will follow from my remarks this morning that I am optimistic on the growth prospects ahead. The MAS, whether in our regulatory, market and investment, or development functions will also need to keep ourselves updated and in tune with the latest developments and trends of the industry. Conferences such as this can only be beneficial, as there will be much to learn from one another.
25 I thank FOW for organising this conference and I am sure it will be a worthwhile and fruitful event to everyone here.
1 Source: Futures Industry Magazine