Asian Regulators loosen up
As memories of Barings and other debacles fade, the Far
East derivatives business is coming back to life.
By Simon Boughey
Twelve months ago, the future for derivatives in the developing countries
of the Asia/Pacific area did not look bright. The collapse of Barings in
early 1995 had left a nasty taste in the mouths of Asian regulators. In
the wake of the debacle, monetary authorities in most countries introduced
guidelines that threatened to curtail growth in the region drastically.
Derivative instruments, and their Western practitioners, had earned a bad
Since then, however, the derivatives industry has tried to smooth out
relations with the regulators, and the impediments to continuing growth
in the region are disappearing. Although Korea remains an unreconstructed
enemy of derivatives, and negotiations in Singapore are at a very delicate
stage, the International Swaps and Derivatives Association and other groups
have made considerable progress in taming the regulators' ire.
Regulators who favor a crackdown have plenty of examples to point to.
Barings, after all, wasn't the only company that got burned in Asian derivatives.
There is a long and lamentable list of firms that suffered big losses in
various structured derivatives products, including Dharmala, Sinar Mas,
Nippon Sanso, TPI Polene, Salim Group, Berjaya International, Citic, Unipec,
Minmet and OCBC. "The regulatory concerns about derivatives are quite
widespread due to the previous derivatives losses by major corporations
in each respective country in Asia," notes Ralph Liu, president of
Advanced Risk Management Solutions, a Singapore-based derivatives consultancy.
Some Asian regulators fear that complex derivatives products are being
introduced into a region where capital markets knowledge and expertise does
not match that found in developed financial centres. As one Western banker
put it, "They are worried that nasty foreign banks will prey on the
Their fears have been exacerbated by a new development: Asian companies
that suffer losses have little recourse in the international courts. Early
last year, the U.K. High Court rejected Dharmala's suit against Bankers
Trust for losses incurred in structured derivatives transactions.
Quentin Hills, Citibank's head of derivatives marketing in Asia and cochairman
of ISDA's Regional Committee for Southeast Asia and Hong Kong, admits that
Asian countries "come from a position of not being used to derivatives
legislation or banks that are proactive." Nonetheless, most are trying
to head in the right direction and do not want their regulations to stifle
competitiveness with their neighbors. As countries throughout the region
are at different stages of development, the picture currently presented
is a patchwork with little uniformity. During the past year, however, a
greater consistency has begun to emerge, and ISDA officials are confident
that convergence will continue.
The Monetary Authority of Singapore (MAS) was one of the first regulators
off the mark with a draft set of guidelines that it dispatched to banks
in 1996. In keeping with the somewhat secretive and authoritarian nature
of the MAS, it intended that these should be confidential and was annoyed
when ISDA got hold of a copy and forwarded a reply late last year.
What really troubled the industry was that the proposed rules talked
of a disclosure rule that, if imposed, would have required banks to inform
the client if the transaction was suitable for their requirements or not.
This implies a fiduciary relationship between bank and client-something
the industry has fought hard to avoid all over the globe in the last few
Though the original guidelines indicated that the disclosure rule was
optional, industry officials were worried that there would be a difference
between what was in the document and what was actually enforced. The audit
process in Singapore is "very hands on," according to a banker
who has worked there for several years, and no banker wanted to leave any
room for doubt.
ISDA was well aware that it would have to proceed carefully in its dealings
with the MAS. It is known to be prickly, and would bridle if it felt it
was pushed around by arrogant Western bankers. And it would be largely Western
bankers with which the MAS would be dealing. Local Singaporean banks did
not see the implications of the proposed rules as clearly as overseas shops
because they are not major derivatives players and because they don't stand
up to the MAS. ISDA "has worked hard to be accepted by the MAS,"
On July 21, 1996, ISDA and the Hong Kong Monetary Authority cohosted
a closed-door roundtable in Hong Kong with regulators from Japan, Australia,
South Korea, Hong Kong, the Philippines, Indonesia, Malaysia, Singapore
and Thailand. It was one part in a process by which ISDA hopes to establish
its profile in the region and encourage harmony of regulatory response.
"One consequence of the meeting has been the development of a dialogue
with regulators in the region, including the MAS," says Hills. "We
believe this serves a useful purpose as Singapore's regulators continue
framing the guidelines for derivatives activities."
For the time being, the MAS is redrafting its original guidelines and
has invited ISDA to comment whenever they appear. Though no exact date has
been disclosed, ISDA expects they will appear in the next few months. In
the mean time, the draft guidelines are still in force and the MAS expects
them to be obeyed. ISDA's objective is to see that counterparty relationships
are clearly understood. It wants to ensure that relationships are understood
to be "arms length" and that disclosure should not be mandated.
The recent changes to regulation in Malaysia represent the derivatives
industry's most spectacular success in the region to date. On July 27, 1996,
Bank Negara Indonesia, in a most dramatic reversal of previous hostility,
rescinded rules introduced earlier last year that required that banks seek
its approval before entering into every derivatives transaction. This deal-by-deal
approval structure threatened to stifle the nascent derivatives business
in the region. The bank's new policy document, Risk Management Practices
for Derivatives, rely instead on strong internal controls, in the spirit
of the G30 report of 1993 and recent BIS rules. Hills calls this a "complete
Hong Kong has a much longer history as a financial center than its neighbors.
As a result, it's not surprising that the approach taken by the Hong Kong
Monetary Authority (HKMA) is often cited as a model to other regulatory
authorities in the region.
The HKMA sent out guidelines for comment early last year, and was prepared
to redraft them substantially in light of the feedback. Once again, ISDA
was particularly concerned that the nature of the counterparty relationship
should be clearly understood as nonfiduciary.
The authority's subsequent Guidelines on Risk Management of Derivatives
and Other Traded Instruments embraced global standards. One standard was
the BIS's Risk Management Guidelines for Derivatives issued by the Subcommittee
for Banking Supervision released in July 1994. Another was the International
Organization of Securities Commission's Operational and Risk Management
Mechanisms for OTC Derivatives Dealing of Registered Securities Firms, issued
by its technical subcommittee also in July 1994. These sets of guidelines
echo each other, and are quite clear about the arm's-length nature of the
counterparty relationship. ISDA would be quite happy if all regimes throughout
the region incorporated its precepts into their own regulations, as the
HKMA has done.
The regulatory record in the Philippines represents something of a mixed
success for the derivatives industry. On the one hand, Bangko Sentral ng
Pilipinas, the country's chief financial regulator, approved in May risk
management of derivatives guidelines that closely match the BIS rules. On
the other hand, it still requires all banks that use derivatives to obtain
licenses from the central bank. Only four banks currently have licenses:
Citibank, the first to be approved; Bank of America; Hong Kong Shanghai
Bank; and Far East Bank, a local institution.
Tight guidelines are still in force in Indonesia, according Hills. Bank
Indonesia has imposed heavy, prescriptive regulation for all local banks
and local subsidiaries of overseas institutions, leaving only offshore banks
exempt. This has forced most derivatives business out of the country. Negotiations
between ISDA and Bank Indonesia, however, are in the "follow-up phase,"
says Hills, and he hopes that these restrictions will be relaxed.
The Thai baht market is one of the fastest-growing markets in the entire
region. Maturities are quoted out to 10 years, although liquidity drops
after five. Although Thailand's regulatory framework incorporates BIS standards,
a cloud looms in the form of Thailand's draconian taxation of gambling.
If a derivatives trade involves a mathematical formula, it is possible that
it will be deemed a bet, and therefore subject to the gambling tax.
Taiwan had one of the most restrictive regimes, but things are changing
rapidly. Although it is currently illegal to trade options of the Taiwanese
dollar, this restriction will be abolished on June 30. There is also a thriving
currency swap market in Taiwanese dollars. In fact, the Asian Development
Bank, in an attempt to popularize the market, has issued several bonds in
this currency and swapped the proceeds back to floating U.S. dollars.
As might have been expected, South Korea is the most intractable of all
regimes. Its tight controls have stifled the development of even the most
rudimentary capital markets instruments, let alone derivatives.
There is little derivatives activity in China today, but bankers are
sure that it is only a matter of time before things change in one of the
world's biggest and fastest-growing economies. Much of China's external
debt is denominated in U.S. dollars and yen, yet it has only certain windows
through which it can access international borrowing and only a few counterparties
with which it can deal.
Banks are new to this market and the regulatory regimes are not used
to dealing with assertive Western financiers. "Regulators here are
very happy to have liquid and deep derivatives markets, but they want that
to happen in an environment in which there are appropriate levels of expertise
and appropriate controls," says Hills. In fact, he claims that negotiations
have been mercifully free of the acrimony that characterized the dissension
surrounding derivatives in the United States in 1994.
What Regulators Fear Most
Ralph Liu of Advanced Risk Management Solutions, a Singapore-based derivatives
consultancy, says that in the early 1990s some Asian dealers were as cavalier
about selling complex products as their colleagues were in the United States
and Europe. Liu is fond of using a hypothetical example to illustrate what
he's seen: A $500-million one-year U.S. dollar/yen call option, used by
a company that imports from Japan and wishes to guard against an increase
in the value of the yen.
The true value of the option is U.S. $5 million, but an aggressive banker
who wanted to make an additional U.S. $3 million might try sell it for U.S.
$8 million. The Asian buyer might be put off by the cost, or call up other
banks to get a more competitive cost.
But if the banker suggests a more structured transaction in which the
company would sell an option and be paid $2 million up front, the whole
transaction begins to look more attractive. Liu notes that treasury officials
often don't need to seek approval to complete a transaction that results
in an upfront payment, and no one questions it closely. What the treasurer
may not notice is that he has sold a U.S. $5 million option for U.S. $3
million-rewarding the banker with the required profit margin-and taken on
quite a bit of additional risk. Liu says that in the early 1990s, when banks
needed strong revenue streams to justify development costs in new markets,
transactions such as these were quite common.