It was not too long ago that terms emerging markets and derivative exchanges were not exactly conjunctive with one another. Yes, commodity exchanges were established in emerging markets in the early part of the 20th century, but derivative exchanges which traded financial futures and options were relatively rare in the '80's. There were a few exceptions. In Brazil, the Bolsa Brasileira de Futuros was incorporated in Rio towards the end of 1983, while in Sao Paulo, the Brazilian Mercantile and Futures Exchange (BM&F) was established out of the merger of two exchanges in early 1986. In Asia, SIMEX was inaugurated in September 1984 as the first financial futures exchange in Asia, albeit trading in contracts with an international underlying, within an Asian time-zone.
All that has changed in ten years. Since the start of this decade, derivatives exchanges have been springing up all over in the emerging markets. In Malaysia, financial futures were first introduced when the Kuala Lumpur Composite Index Futures Contract was launched by the Kuala Lumpur Options and Financial Futures Exchange ("KLOFFE") on 15 December 1995. This was followed by the 3-month KLIBOR Futures Contract which was launched by the Malaysia Monetary Exchange ("MME") on 28 May 1996. In Korea, the Korean Stock Price Index ("Kospi") 200 Futures began trading on the Korea Stock Exchange ("KSE") on 3 May 1996. In Hong Kong, the Futures Exchange was given a new lease of life, while options on individual stocks began trading on the Stock Exchange last year. On the African continent, the South African Futures Exchange ("SAFEX") commenced operations on 30 April 1990. One hears of plans in the pipeline for the introduction of exchange traded derivatives in many other emerging markets before the close of the century, including such markets as Taiwan, India, Thailand and Mexico.
The reason for this recent surge of activities is not difficult to discern. A number of emerging markets have become index markets in their own right, offering a risk/reward profile which draws an increasing stream of portfolio investors to trade in them. These markets are relatively less correlated with the advanced markets, and therefore offer diversification opportunities in addition to growth. As fund management becomes increasingly cross border, so does risk management take on a wider geographical dimension. Hedge funds, global banks, emerging market funds all seek means of managing their increasing exposure to the equity and interest and exchange rates of emerging markets. Derivative exchanges offer them a means of managing their exposure.
But futures and options exchanges and over-the-counter derivative markets meet the needs of not only foreign investors; first and foremost, they cater to the increasing financial sophistication of investors, issuers and intermediaries of emerging markets themselves. Indeed, it would appear that derivatives are part and parcel of the financial deepening process of all economies which have reached a certain level of economic development. Given the role that derivatives play in our markets today, and the role they will have in the future, I can foresee that these markets will play an important role for many other economies that are in the process of development.
For the purpose of my talk this afternoon, I will draw upon our own experience in the development of the Malaysian derivatives market, and to share with you the challenges and problems that we have faced and are facing at the moment. Some of the problems may be unique to Malaysia, but I believe that many of the broader issues are also faced by other emerging markets.
With its background as a leading commodity producer in the '70's, it is not surprising to see the establishment of a commodity futures exchange in Malaysia in 1980. Its crude palm oil contract has been the mainstay of the Kuala Lumpur Commodity Exchange ("KLCE"), and accords with the important role of Malaysia in the export of palm based products, which in turn accounts for some 40% of exports of vegetable oils.
Towards the end of the '80's, it was felt that financial derivatives should be pioneered. The Government took steps to encourage the startup of two exchanges; the Kuala Lumpur Options and Financial Futures Exchange ("KLOFFE"), a for-profit exchange trading equity based products in an electronic environment; and the Malaysian Monetary Exchange ("MME"), a member-owned exchange trading rate based products using the open outcry facilities of the KLCE, and owned by it. From the point of view of market architecture, you might say we are perfectly hedged!
It might be added that the decision to establish the two exchanges was deemed to have been somewhat courageous at that time; indeed, had the Government taken the advice of an international organization, which shall remain nameless, we would have been two exchanges less. With the benefit of hindsight, and the super bull-run that lifted emerging markets all over the world in 1993, the decision was indeed a timely one.
I recall the formative years of KLOFFE and MME with some fondness now, but there were challenges aplenty at every turn. I reckon the three main challenges facing any jurisdiction contemplating setting up derivatives exchanges in the emerging markets are:
- garnering the necessary support and commitment all the way from the policy makers to the investors;
- building market foundation, including establishing proper regulatory and market framework; and
- facilitating further development of the market.
Allow me to elaborate further on each of these points.
Commitment and support
While the government was committed to the establishment of the two derivative exchanges, this commitment had to withstand the testing times following the Barings affair. This occurred while the policy makers were busy finalizing the regulatory framework, and the market preparing for the launching of KLOFFE. There were views expressed concerning the desirability of introducing financial futures in the country, or at least the propitiousness of the timing.
Despite this unfavourable turn of events, the leadership, in particular the Deputy Prime Minster and Minister of Finance, offered support and industry remained committed. On our part, we pointed out to the difference between the instrument per se, and management of the instrument, or the lack thereof.
Every cloud has its silver lining. Barings had two.
First, it served to bring regional regulators closer together. Despite a sizable exposure of Barings Securities in the KLSE, there were no settlement failures, and no threat of systemic disruption. Working hand-in-hand with our colleagues in Singapore and Hong Kong, the Commission managed to prevent a gridlock situation from developing.
There was one more upside. You may recall that we were in the midst of proposing substantial legal reform to enable the two derivative exchanges to be established. There was considerable resistance to the widespread changes that were proposed, as the ink was hardly dried on the Futures Industry Act of 1993. In the event, Barings proved that the proposed reforms was were not only justifiable but prescient. What was described to us as the most comprehensive amendment bill ever tabled before the Malaysian Parliament, all one and a half inches of it, finally received ringing endorsements, even from members of the Opposition.
Which brings me very naturally to the second challenge of foundation building.
Building market foundation
Prior to the slew of well publicized losses involving OTC derivative products in 1994, the largest derivative loss involved the Borough of Hammersmith and Fulham in London. A somewhat controversial judgment of the British House of Lords, which failed to draw a distinction between derivative contracts and wagering, brought home to us the importance of basing the regulation of these new markets upon clear statutory provisions. Fundamental to the introduction of any new market is the existence of a sound and comprehensive regulatory framework, and market infrastructure that goes along with it. As financial derivatives are introduced for the first time, the market would look to the regulatory framework for consistency and certainty to give participants confidence that they are involved in lawful trading activities, and that their rights are well protected.
In building this basic foundation, the Commission is guided by three principles:p>
- maintaining market and financial integrity;
- promoting systemic stability; and
- ensuring investor protection.
Allow me to touch on each point briefly.
Market integrity
Derivatives exchanges serve three important economic purposes: risk shifting, price discovery, and enhancing efficiency by providing a focal point where buyers and sellers can easily meet. None of these purposes can be properly served if prices on the exchanges do not accurately reflect the forces of supply and demand. Nor can they be served if buyers or sellers do not have confidence that prices do reflect these forces. That is, investors will be unlikely to use the market and its contracts if they do not believe their integrity.
The Commission has worked towards creating an efficient and transparent market. This has been done by requiring prompt and widely disseminated price reporting, promoting fair, open and competitive order execution, requiring the maintenance of an audit trail, prohibiting fraud and manipulation activities, instituting an audit and examination programme, and ensuring sufficient operational capacity.
Financial integrity
One of the distinctive features of a centralized derivatives market is that the clearing house acts as a counterparty to every trade. This eliminates counter-party credit risk as the clearing house becomes the central risk taker. In order to fulfill its responsibilities as a counterparty, the clearing house must establish a system for financial integrity and other means for guaranteeing trades. As in the case of market integrity, it is clearly in the market's interest to establish a reputation for financial integrity.
In achieving this goal, the Commission ensured minimum capital requirements for market intermediaries, a daily marking-to-market of all open positions and capital charges on certain assets of the intermediaries. In addition to the Commission's initiatives, the clearing house has adopted an internationally recognized risk-based margining system and a layered capital structure to ensure that it is able to fulfill its obligations, even in times of crisis.
Systemic stability
To ensure systemic stability in the market, the Commission called for the establishment of a common clearing house to provide clearing facilities for KLOFFE and MME. When you have two new exchanges in the market, the last thing they would expect is some of their business being taken away from them. I can tell you that it was not an easy task, and it took a lot of patience and persuasion from our part to convince them of the importance of ensuring systemic stability in the market. I am very glad that they have come around to our point of view.
In addition to the establishment of a common clearing house for the purpose of maintaining systemic stability, the Commission has required that large concentrations of positions among end users be monitored closely and intermarket-surveillance activities be stepped up. The clearing house, in its contribution towards this objective, has adopted progressive margining practices and carefully monitors the capital adequacy of its members.
Investor protection
Investors trading on derivatives exchanges entrust their funds to financial intermediaries and they receive information about the nature of the risks of these transactions from those with an interest in inducing them to engage in such transactions. Appropriate mechanisms must be established to address investor protection and fairness.
Among the mechanisms that have been put in place are licensing of market intermediaries, providing appropriate disclosures to customers, documentation requirement to ensure customer authorization for transactions, sales practice intended to prohibit misleading sales conduct, segregation requirement that separates customer funds from the funds of the firm and the requirements for record-keeping and that customers' orders get priority over firm orders, and the establishment of a fidelity fund.
Given the very large proportion of retail involvement on the Kuala Lumpur Stock Exchange, the Commission was particularly concerned that derivatives be marketed to suitable customers. As a result, it is one of the few jurisdictions where broad suitability requirements are incorporated into statute, and further fleshed out in the sales practices of futures broking firms.
As an aside, these principles relating to integrity, systemic stability and investor protection have since been endorsed by the International Organization of Securities Commissions or IOSCO. A report on the legal and regulatory framework for exchange traded derivatives in emerging markets was drafted by the Working Group on the Regulation of secondary markets which Malaysia is privileged to chair, and published by IOSCO at its last Annual Meeting in Montreal.
Building a solid and sound market foundation is a necessary, but not sufficient condition for the success of the derivatives markets. The third challenge is to continuously facilitate the further development of these markets.
Facilitate further development
The Malaysian derivatives market currently lacks depth and liquidity. Since the start of trading activities on KLOFFE and MME, the growth of open interest and trading volume have been modest. On average, trading volume on the KLCI futures at KLOFFE has been in excess of 300 contracts a day while the volume of open interest as at 31 January 1997 stood at 1348 contracts. As a percentage of the cash market, both in terms of trading value and market capitalization, this represents about 5% of the cash market, a long way away from the point where we, as a Commission, would be satisfied. Over on the MME, trading activity has been slowly building up with trading volume on the 3-month KLIBOR futures averaging about 270 contracts a day since trading began. Open interest stood at 2452 contracts on 31 January 1997.
Liquidity in a new exchange is very much a Catch 22 problem. Without liquidity, investors, particularly institutional investors, are reluctant to use the exchange. Without the participation of large investors, the exchange will not grow. It is imperative that both MME and KLOFFE overcome this vicious circle, and move on to greater volumes of trading and higher levels of open interest.
It has been represented to the Commission that a number of regulatory and institutional bottlenecks are among some of the constraints that stand in the way of attaining a higher level of liquidity. In response, we have taken steps together with the Ministry of Finance and in consultation with the industry, to address many of these bottlenecks. They include:
- Rationalizing the regulatory framework;
- Introducing market making; and
- Stepping up education for investors and intermediaries.
Rationalizing the regulatory framework
For purely historical reasons, the cash and futures markets are regulated separately by the Futures Industry Act and the Securities Industry Act. While this legal framework was necessitated by the startup of the derivatives industry, and follows the regulatory framework used by other advanced jurisdictions, the administrative interworking of the two pieces of legislation needs improvement. Due to technical constraints arising from two laws, and from the bye-laws of the stock exchange, securities dealers are not permitted to take on activities that are not related to stock broking. This effectively prohibits them from selling derivative products. This prohibition is not only inefficient in terms of the use of the sales force of the industry, but also stands in the way of making the benefits of exchange traded derivatives more readily available to the retail market.
After discussions with industry, it was agreed that this obstacle should be removed. The new process of providing dual licenses to trade in securities and futures, in my own view, is still not ideal. Perhaps a unified piece of legislation covering all investment contracts would be the way to go in the future. Most importantly, we should be able to cater flexibly to the need of the industry with the ultimate objective of facilitating further development in the market.
The Government, too, has inclined towards regulatory rationalization as well. Its recent decision to merge the Commodities Trading Commission, which currently oversees trading in commodity futures, with the Securities Commission clearly indicates its desire to streamline the regulatory framework in the derivatives industry. With the merger, the Commodity Trading Act will be repealed, and only one Act, the Futures Industry Act, will govern all futures markets. For market participants that are currently involved in both the commodity and financial futures markets, this would mean a reduction in regulatory costs as they would be subject to the same regulatory regime and clearly the merger will also provide greater legal certainty to all market participants.
Introducing market making
To further improve liquidity in the derivatives market, a proposal has been made by KLOFFE to introduce market making. This will apply to options contracts, both on the futures as well as on individual stocks, and will have a salutary effect on the liquidity of futures contracts as well.
Market making is expected not only to improve liquidity, but also to make for greater efficiency in the market. Competitive and committed market making will enable institutions to have the confidence to enter into, and take offsetting positions at will.
Discussions have taken place between the Commission and KLOFFE with respect to the proposal, and a final proposal is expected to be submitted to the Commission soon. Already, on the MME, market making activities have been encouraging. For last year, trading of market makers accounted for about 46% of total trading in the 3-month KLIBOR futures contracts.
Providing education for intermediaries and investors
Let me now address the issue of education, a never ending task.
A major constraint to the growth of any new market is the lack of competent personnel, and the derivatives market is no exception. The problem is not made easier by the need to ensure that only fit and proper persons be allowed to operate in these markets.
At the start of the two exchanges, the Commission required all futures representatives to undergo the Malaysian equivalent of the Series 3 examinations. The syllabi for these examinations were drawn up in consulation with representatives of the Chicago Mercantile Exchange and the Chicago Board Options Exchange. An industry organization, the Malaysian Institute of Futures and Options ("MIFO") administers the examinations, but the Commission took upon itself a quality assurance role.
Through its training arm, the Securities Industry Development Centre ("SIDC"), it has streamlined training materials, and developed a set of teaching materials that can be used in our universities and institutions of higher learning. With the development of these teaching materials, the SIDC has conducted a series of "training the trainer" programmes for institutions of higher learning with a view that more and more of their teaching staff would be in a position to offer courses related to futures and options, thus casting the training net wider.
At the same time, the SIDC is repackaging the materials it has developed into distance learning course manuals so that professionals who do not have the luxury of taking time off their work to attend courses would be able to review the materials in the comfort of their own homes, and be better prepared to attend prep courses for the entrace examinations.
Together with industry, the effort to provide education to the investing public on derivatives is proceeding apace. Among the programmes conducted by the SIDC is the annual Risk Management Workshop with the Options and Clearing Corporation, a workshop for directors and senior management on risk management, and many other courses for the benefit of training financial professionals to be more proficient in derivatives.
The way ahead
The success of exchange traded derivatives in Malaysia is critically dependent on the participation of domestic institutions. They are the natural hedgers in any market. Despite the sizable presence of large institutional investors in the cash market, their participation in derivatives has been disappointing. For example, foreign institutions account for more than half of the trades done on KLOFFE. Local institutions account for a mere one per cent.
The presence of local institutional investors is clearly needed in the derivatives exchanges. Unless they are actively participating, foreign institutions would not feel comfortable to be involved, not with the present levels of volume and open interest. While every contribution to the level of trading activity would help, be it from retail investors or market makers, the key has to be to make the exchanges attractive to pension funds, mutual funds and insurance funds, both local and foreign. This, to my mind, remains a major challenge for KLOFFE in the years ahead. In this effort, we are not alone. South Korea, despite its slightly larger volume on the Kospi 200 futures contracts, has about a 6% of institutional trading volume.
Not only must derivative exchanges of emerging markets grow in depth and liquidity, they must also respond to the competitive pressures of similar contracts traded on established exchanges in advanced markets. The Chicago Mercantile Exchange's Growth and Emerging Markets Division has introduced currency contracts based on the Mexican Peso and the Brazilian Real, Index products based on the Mexican IPC index and the Dow Jones Taiwan Stock Index, as well as rate contracts based on Mexican, Argentine and Brazilian Brady bonds. The Chicago Board Options Exchange trades options on stock and ADRs of emerging markets, including bellwether stocks such as Telmex.
As a regulator, I regard such competition between markets as healthy, but the cross border regulatory framework should not be left behind of market developments. We have all seen how Barings and Sumitomo have brought to light the need for co-operation and information sharing agreements that must be put in place before more cross border problems befall us all. The Malaysian Commission is delighted to add its name to the information sharing arrangements called for by the Windsor Declaration, and to honour its obligations as a member of IOSCO.
To the extent that regulatory efforts are being harmonized, market development efforts should likewise be co-ordinated on a cross border basis. Too often are derivative contracts, and the trading of such contracts, characterized as zero sum games. One cannot forget that the risks that are represented by these contracts may not be symmetric to the two parties that enter into them.
There is therefore plenty of opportunity for exchanges to co-operate, not only to extend trading hours and to realize the possibility of a 24 hour trading book, but to optimize risk management on a global basis. This could mean joint clearing and common settlement arrangements, as well as mutual offset trading for new products.
At the end of the day, it is important that overall liquidity develops, but where that liquidity will move to will depend entirely on market forces, and on the comfort of investors with the transparency and integrity of the regulatory framework.
Conclusion
Ladies and gentlemen, I have taken the liberty of addressing the challenges faced by derivatives exchanges in the emerging markets by drawing on my experiences as a regulator in Malaysia, rather than putting on my IOSCO hat. Nevertheless, I believe they are just as relevant to countries that have just introduced derivative exchanges, or are in the process of introducing them.
Thank you.
