Good morning, ladies and gentlemen.
Welcome to another first brought to you by the SIDC -- a workshop on financial derivatives and risk management made possible through collaboration with the Options Clearing Corporation. Many of you are familiar with the SIDC by now --the Commission's brand name in bringing high quality, value-for-money educational products to the capital market. Permit me to say a few words on behalf of our venture partner.
In the United States, the OCC is recognized within the financial services industry for good risk management practices. It clears and settles all financial derivative trades for all -five national securities exchanges. Through its risk management practices built over many years of experience, and which I am told have sustained two market breaks in 1987 and 1989, as well as the insolvency of such former big names as Drexel, Burnham and Lambert, the OCC has received a Triple A rating from Standard and Poors, a rating more sound than you would find in many a money centre bank today. I can therefore think of no better partner for our educational effort in financial derivatives and risk management.
Recent losses in derivatives, and the apparent lack of risk management, have captured public attention all over the world. The cover of the March issue of Fortune Magazine this year was entitled, "Cracking the derivatives case" with the inside subtitle of "Untangling the derivatives mess". Almost a year ago, the same magazine came up with a piece entitled "The risk that wouldn't go away". As a subhead to that title, it said "Like alligators in a swamp, derivatives furl; in the global economy....".
A close reading of the two articles indicates a change of mood. Gone is the paranoia of imminent, albeit hidden danger. In its place is the felt need to bring order in the use of a group of products which per se are not risky. What more have we learnt in the one year between the two articles?
Fortune was right in at least one respect. Derivatives have not gone away, nor are they about to go away. They wouldn't go away because they are useful. They wouldn't go away because companies use them to reduce their cost of financing. They wouldn't go away because asset managers use them to improve portfolio returns, and reduce risk. They wouldn't go away because investors use them to hedge, and to change the risk-reward profile of their investments.
Indeed, it would be quite correct to say that derivatives have become a cornerstone of modern finance. In a world of volatile currency rates, interest rates as well as equity and commodity prices, banks, pension fund managers, mutual fund managers and insurance companies, as well as companies and individual investors would be deprived of important instruments to manage their market risks if all derivatives were made to disappear with the wave of a magic wand. So we're not only stuck with them, we would find it very difficult to progress in a sea of change without them.
Ah, but you say, have the risks gone away? No, they have not, nor are they about to. Risks arise from exposure to change, and as the world has always been changing since its inception, risk, too, is not about to go away. Indeed, if futurologists are to be believed, the pace of change facing the world has accelerated in recent years, and will accelerate even more in the years to come. The next generation will continue to need risk management tools, perhaps even more so than our own. Derivatives are risk management tools par excellence. As such, they very much a part of the fabric of our financial systems, as well as financial systems of the future.
Have we learnt a little more of how to manage risks using derivatives, or how to avert the losses arising from the abuse of derivatives? 1994 has been a year of great change for derivative markets. Perhaps we can look at development in these markets to see what they portend for the future.
Let us begin with exchange traded derivatives. For most exchanges, interest rate futures and options saw record trading volumes, especially in the first half of the year. This should come to no surprise. Within one year, the U.S. Federal Reserve Board increased Fed funds rate six times, from 3.25% on 4 February to 5.5% on 15 November. The entire term structure of interest rates changed as a result. At the 10 year point of the yield curve, yields rose from 5.9% to 7.9%. At the 3 month end of the curve, there was a 300 basis point change over the same period.
Consequently, the trading volume of interest rate products on derivative exchanges rose almost in tandem with the increase in rates. Topping the percentage increase in volumes of futures contracts was the 3 month Eurodollar contract on the Chicago Mercantile Exchange, which tends to trace the movements of short term spot rates -- a 63% increase for 1994 over the previous year. The 5 year Treasury note contract on the Chicago Board of Trade experienced a 53% increase over the same period, while the 10 and 30 Treasury bond contracts increased by 45% and 26% respectively. This pattern of increases in the volume of contracts is entirely logical and consistent since increase in the spot rate gave rise to expectations of change in expected future rates, albeit with different effects at different maturities, and the exposure to change is what is effectively exchanged through derivatives. Similar patterns can be detected in the European derivative exchanges, and I wouldn't bore you with the details. What has become clear is the direct relationship between the cash market and the derivative markets through the expression of market demand for derivative products to manage risks that have emerged in the cash market.
What about equity derivatives? For most stock markets, 1994 was a year of correction, conditioned by the increase in interest rates. Emerging markets were particularly affected, as they had performed particularly well the year before, and institutional investors generally felt it timely to take profits. Hong Kong, which is not considered an emerging market, but nevertheless embodies the market risks of its hinterland, corrected 31% measured by its Hang Seng index. Malaysia was not spared as the KLCI lost almost 24% in Ringgit terms.
One market that started the year full of promise, went to a peak in mid-June, and came back down by year end, albeit with a 13% increase over the beginning of the year, was Japan. Once again, in Japan, equity derivative markets mired changes on the cash market. Nikkei 225 contract on SIMEX showed a growth of trading volume of 12% in futures and 67% in options on the futures. The newly launched Nikkei 300 futures on the Osaka Stock Exchange reached almost 4.2 million contracts by year end, overtaking the Topix futures on Tokyo to become the second largest equity futures contract in Japan. The Nikkei 225 futures in Osaka remained the most liquid contract, but appeared to be losing ground as the Japanese Ministry of Finance required all equity linked products trading in Japan to be linked to the Nikkei 300.
Australia was yet another market where its benchmark equity index, the All Ordinaries, closed 12% higher year-on-year. The All Ordinaries futures consequently registered a 60% increase over the previous year. This shows, once again, that derivative markets grow out of the need to manage risks which have expressed themselves in cash markets.
How about derivative products traded "over-the-counter"? OTC products probably did not do so well as their exchange traded counterparts. While I have yet to see the final numbers for the year, I shall indeed be surprised if 1994 volumes have surpassed their 1993 levels. The reasons are also plain to see. While the volume of "plain vanilla", low leverage products probably increased over the year, the large spreads on interest rate products went away by comparison with 1993. Corporations and other users became more conservative in their risk management policies, particularly as some users suffered large losses on their leveraged, rates based derivative contacts.
I believe the lessons of 1994 for OTC derivative users, particularly the users of the more complex structured products, should be a sobering one. In the interest of chasing the few tens of basis points on the upside, some structured note users were faced with hundreds, and indeed, a thousand basis points losses on the downside --all premised on the assumption that rates would not move so far, so fast. This underscores the wisdom of using derivative products first and foremost as hedging tools, and the need to be extremely circumspect in using them as directional bets on rates, products or commodities.
Until the Baring incident, almost all publicized derivative losses took place with OTC products. As such, enormous pressure put on legislators and regulators in the United States to introduce more restrictive legislation. including an outright ban of OTC derivatives for certain types of users. These pieces of legislation did not get signed into law. But it is left to be seen if these pressures would not build up again, especially if more government agencies like Orange County and mutual funds continue to go belly-up. For the moment, regulators in the US have called for better disclosure, enhanced sales practices, better internal compliance and improved risk management as first steps before regulatory changes are contemplated.
In Malaysia, the Commission has called for all these changes in respect of both exchange traded and OTC products, as well as changes to the legal and regulatory framework. This is not a knee-jerk response to recent developments. Indeed, in its very first year of existence, the Commission undertook a thorough review of the Futures Industry Act which governs the trading of financial derivatives, and last year proposed amendments to cover identified loopholes, impediments, insufficiency of powers and regulatory deficiencies which will have to be addressed before trading starts. The proposed amendments, among others:
- facilitate the establishment of a common clearing house for both KLFM and KLOFFE;
- overcome the lack of statutory powers to deal with OTC derivatives;
- increase the flexibility of introducing new products;
- enable exchanges and clearing houses to deal with matters of a commercial nature through their rules, rather than through legislative amendment;
- facilitate the introduction of securities borrowing and lending, both to cover failed trades and enable the short side of a derivative transaction to be hedged; and
- clarify the powers of the Commission vis-a-vis the exchanges and clearing house in dealing with emergencies
The recent Barings affair has heightened concern over trading in derivatives. Both the Prime Minister and the Deputy Prime Minister, in his capacity as Minister of Finance, have recently underlined the need for caution and care in the introduction of trading in derivatives in this country. We must all take into account their concern and advice, and act in the spirit they have been given.
Two weeks ago at a Regulators' Conference on derivatives, I spoke of five elements of regulation and best practices that are necessary in developing a derivatives market. Some of you may have read them in the press already. Nevertheless two points are worth repeating here in the context of a workshop on risk management.
The first deals with promoting financial and market integrity through the operations of the clearing and settlement system. For exchange traded derivatives, the clearing house becomes a locus for risk management, and the Commission was concerned that an appropriate structure be found to implement clearing and settlement. especially since there will be two derivative exchanges. You may remember a series of press reports in 1993 and 1994 regarding the insistence of the Commission on the need for a common clearing house for better risk management. The Commission has also required that accounts be segregated up to the level of clearing house, and that proprietary and client positions be distinguished. It is also required the common clearing house to have facilities for inure-day margining, should they become necessary. The Barings experience bears out our concern of the significance of importance of the clearing house in managing risk and ensuring systemic stability.
The second point involves promoting market integrity through a series of measures including:
- Ensuring that only professional, ethical and well capitalized intermediaries with good track records are admitted to exchanges;
- Reducing the probability of manipulation of both cash and derivative markets through a series of measures, including removing barriers to arbitrage age between cash and derivative markets, as arbitrage is the best form of protection against manipulation;
- Establishing large position reporting requirements as a warning of potential manipulation;
- Considering the possibility of progressive margining for large positions; Facilitating the development of a payments system to collect margin; and
- Overseeing the implementation of appropriate "middle-office" software for brokers to manage operational risks.
These measures are both prudential and facilitative in content. Regulators must aim to attain both market development and integrity. The setting of margins provides one example of the tradeoffs that could arise from trying to attain both objectives simultaneously. High margins are prudential, but could reduce liquidity. Low margins facilitate trading, but may be inadequate to cover large market moves. However, the regulator cannot afford to choose one and ignore the other. He has to think creatively and address both concerns. One solution involves the use a risk based margining system, which calculates margins using a portfolio valuation model, and enables these margins to be stress tested.
The maintenance of market integrity depends on all parties performing their designated responsibilities well -- issuers, intermediaries, users, and regulators. The market cannot reasonably rely on the regulators alone. It is also not sufficient that we have all these responsibilities and undertakings on paper and embodied in the system, if everyone is not actually effecting them on a daily basis. A regulator can only do so much to reduce to the likelihood of abuse. Every participant in the market has to play his role.
In closing, I would like to thank:
- Senator Dato' Mustapa Mohamed, Deputy Minister of Finance, for gracing the occasion, and we all look forward to your address, Dato';
- Anne Fleming, our coordinator from the Options Clearing Corporation, for her effort making this workshop possible;
- Dr. Stephan Schoess who will be conducting the programme throughout the five days;
- Our guest speakers from American Stock Exchange, the Philadelphia Stock Exchange, the Chicago Board Options Exchange, the OCC itself as wel1 as derivative practitioners, who will be sharing with us their expertise;
- Kha Loon and his able team from the SIDC for the arrangements they have made; and
Finally, to you, ladies and gentlemen, for supporting this workshop with your attendance. We hope you will find it beneficial and educational, in the widest sense of the word.
Thank you.
