YBhg Datin Zarinah Anwar
Deputy Chief Executive, Securities Commission
CIMB Conference on Derivatives and Structured Products
“Towards Alternative Investment in Malaysia”
18 March 2004
Mandarin Oriental, Kuala Lumpur
I am delighted to be here today to share with you my views on one of the fastest growing areas in the global financial world – alternative investments. I would like to thank CIMB not only for inviting me to deliver the keynote address at this conference but also for their initiatives to promote innovation in the Malaysian capital market. I believe that their efforts are well recognized and that this is reflected by the premium value attached to the CIMB brand.
“Alternative investments” is a term that covers quite a wide and diverse range of products. A leading international pension fund defines it as investment products that are “privately negotiated, illiquid and include investment styles (i.e. venture capital, buyout) that are not available in publicly-traded markets – typically hybrid investment vehicles and hedge funds typically offered in a limited partnership or limited liability form.”
Within the context of today’s conference, I am looking at alternative investments in terms of the role of derivatives in helping to create structured assets and liabilities which are able to generate highly customized exposures for investors consistent with their nominated investment objectives.Product innovation critical for Malaysia’s capital market development
The drive to adapt to the specific needs of clients have led to the exponential growth of the OTC derivatives and structured products markets. Derivatives and structured products provide a liquid and efficient way of distributing financial risks to third parties who are more willing to assume such risks either because it provides a hedge for their exposure or because they are willing to speculate.
Through embedding derivatives in conventional asset and liability products, risk and return characteristics can be altered. These products therefore provide an efficient mechanism for risk allocation from those who wish to avoid risk to those who are more willing to assume it. The ability to re-engineer risk and return characteristics with greater precision enlarges the base of potential customers who would be interested in these products and, in the process, enhances the liquidity of the instrument while the option-like pricing features reduces the transaction costs of managing risks.
From the view-point of the investor, investment vehicles based on such products have the flexibility to pursue a varied range of strategies to either achieve positive returns in rising and falling markets while generally attempting to protect investment principal. Hence, it is possible to package structured products with a view to meeting yield enhancement or risk management objectives.
In Malaysia, the SC recognizes the need to facilitate the industry to find innovative solutions to meet the growing needs of customers. Product innovation is an integral part of the process of deepening and broadening the capital markets and is thus a critical factor in the development of Malaysia’s capital market.
The Capital Market Masterplan (CMP) recognizes that the cost-effective hedging and risk management facilities provided by instruments such as derivatives and structured products in the market will enhance the ability of investors and businesses to effectively manage the risks associated with their investment and business exposures. Thus the CMP advocates that derivatives industry look closely at where it can provide the most value and that it make concerted efforts to expedite its development.
The other motivation is that Malaysia is at the forefront of developing Islamic finance. Structured products can provide a useful way of constructing many Islamic financial products and can facilitate further product innovation in the Islamic Capital Market (ICM). At the moment, the range of structured products on ICM is limited to the more conventional instruments such as call warrants but there is a lot of potential here to be tapped.Global regulatory trends
On the global front, regulators maintain a strong interest in alternative investment products, focusing on public interest issues such as investor protection and financial stability.
In the past, the global markets for derivatives and structured products have tended to be Over-The-Counter (OTC). It has been allowed to operate largely on its own as it was deemed that these products were used by high net-worth, corporate or institutional clients capable of looking after their own interests.
In recent years however, alternative investments have increasingly started to cross the boundary into the realm of public interests and publicly-traded markets. This is an outcome of two developments. First, this is a sign of the increasing maturity of derivatives and structured products. Second, technological advancement, as personified by the internet, is enabling the distribution of such complex products to the retail market.
As a result, regulators in many jurisdictions have started to scrutinize the alternative investment industry more closely. The flexibility offered by derivatives and structured products represents a challenge for regulators the world over. Let me briefly review some of these challenges:
- The first is that while structured transactions have valid business objectives such as managing risk exposures, they can sometimes be used to disguise these exposures or their accounting effects. This results in the risk that these instruments may be used to undertake market manipulation in a variety of guises or to perpetuate fraud and abuse arising from conflicts of interest.
A prime example of this was Enron which employed a range of vehicles to help finance the rapid expansion of the group, including limited partnerships that kept billions of debt off its balance sheet as well as the use of a structured private equity fund that invested in Enron’s new ventures and allowed it to book income. In essence, these “sales” were transacted for the benefit of the company often without a genuine buyer on the other side of the table. The collapse of Enron in 2001, as we know, led to a sweeping review of accounting rules – and financial disclosure requirements for off-balance sheet transactions have since been tightened considerably.
More recently, Parmalat made use of its complex group structure as well as structured products and special purpose vehicles in lightly-regulated offshore centres to allegedly conceal borrowings and liquidity shortfalls. Like Enron, the failure by the gatekeepers of the financial system to curb fraud resulted in the transfer of risks to end-clients without their knowledge.
As a result of these scandals, regulators worldwide can be expected to exercise greater vigilance in their efforts to enhance standards to ensure that the reporting system on structured products is transparent so as to reinforce the integrity of financial markets. In particular, the role of the global investment banks in facilitating structured products and special purpose vehicles registered in lightly-regulated jurisdictions will come under closer scrutiny.
In this regard, the International Organisation of Securities Commissions (IOSCO) has set up a special task force to draw lessons from and to co-ordinate the global response of regulators to the Parmalat scandal.
- Second, there is also concern over the market impact of these instruments. Since 1987, when there was substantial debate over the role of portfolio insurance in the US stockmarket crash, regulators have kept a keen eye on the impact of alternative investment products.
Complaints from Asian governments over the role of highly leveraged funds in de-stabilising their economies were brushed aside during the Asian crisis in 1997 but the thinking has certainly changed following the collapse of the Long-Term Capital Management (LTCM). The hedge fund industry now promotes itself as responsible capital market players focusing on managing absolute returns through diversifying risks through a variety of strategies.
- Third, both the Financial Services Authority (FSA) in the UK and the Securities Exchange Commission (SEC) in the US have launched recent initiatives to review the regulatory structure for hedge funds – the trigger being an increase in hedge fund enforcement cases
The Malaysian regulatory perspective
The recent US SEC review highlighted that the hedge funds, in particular, tend to be unregistered and private, operate without proper governance controls and did not report their results in a standardized format. Generally, they are not registered with the regulators. Most regulators realize that they have limited ability to obtain basic information from hedge funds and this limits their ability to detect problems before they result in harm to investors or to the capital market. Among the measures being considered by the US SEC, for example, is mandating the registration of hedge fund investment advisers as a means of providing the SEC with examination authority and to foster strong compliance practices. This is a stepping stone towards enhancing transparency and disclosure in the industry.
Worldwide, it can be expected that the alternative investment industry is likely to become more closely regulated. While the need to provide greater availability of investment choices for consumers is acknowledged, regulators are taking further steps to secure investor protection eg by securing more prominent disclosure in the prospectus of the special risks associated with these investments. These regulatory developments are an outcome of the growth and success of the industry itself. Greater regulation and product standardisation however are factors that will instill greater public confidence in alternative investment products and will fuel the growth of the industry even more.
The Malaysian regulators have generally adopted a consistent approach on the regulation of products and markets. We place substantial emphasis on transparency and disclosure as a means of achieving fair markets. Our formula is for the Malaysian markets to be like our weather – lots of sunshine.
In this regard, the structures for alternative investments can be highly complex. The more complex the structure, the harder for regulators and investors alike to fully understand and control the consequences from such products. This may result in the transfer of risks without the full knowledge of the investor or a build-up in risk to financial stability without sufficient warning especially when some modern structures are utilized as a complex basis for transference of risk through an often long chain of transactions.
The onus is on the industry to continue with their efforts to educate capital market stakeholders and to work closely with the regulators in constructing a facilitative framework which can find the right balance between enhancing the growth of the industry while ensuring ample safeguards to protect the interest of investors.
In this regard, the development of the Guidelines on the offering of Structured Products is a case in point. These guidelines were developed by the SC based on requests from industry and were formulated after extensive consultation with industry associations, professional bodies and experts. These guidelines introduce an avenue for the issuance of tailor-made yield enhanced financial solutions to be offered to sophisticated clients.Challenges ahead for the industry
There are several challenges ahead for industry to build this market segment; many of which the SC has clearly identified in the CMP.
The first challenge is to promote a culture of risk management, particularly among institutional investors. Domestic institutional investors, due to their fiduciary responsibilities, often tend to adopt conservative investment mandates. The task is for industry to continue with their efforts to encourage these institutions to liberalise their mandates.
The next is to enhance investor awareness and knowledge. With the exception of industry professionals, the truth is that the capacity or capability to manage the risks of structured products is still lacking. Structured products provide access to a range of assets and facilitate creative construction of risk/reward patterns. But the financial engineering behind these products is often complex and can affect the final returns in unexpected ways. For investors therefore, understanding the factors that influence returns is critical. Perhaps, there is a need to move beyond education and seminars and perhaps to create some pilot projects where investors can get real hands-on experience and where the risks of using such products can be tightly controlled.
From a broader structural perspective, there is still a lack of critical mass and this translates into poor liquidity. Poor liquidity hampers the effective ability to hedge and this in turn prevents the efficient pricing of risk. Greater efforts must be made to attract more players and expand the range of instruments.Concluding Remarks
In this context, our approach is to foster a market-driven approach towards the development of new products. We, therefore, welcome the initiatives and efforts put in by those involved in this growing segment of the capital market.
The SC will provide industry the support its needs to innovate. We are more than willing to engage with you at the earliest opportunity if you want to do so in order to shorten your product development cycle.
However, the onus remains with the industry to develop the market. As with all new products, it is a hard plod for the pioneers as they blaze the trail but the rewards that come with success are equally high. And I wish you the best for all your efforts.