The Success of Derivatives Markets in Malaysia: Opportunities & Challenges Ahead

26 June 1996 | By : Dato' Dr. Mohd. Munir Abdul Majid, Chairman, Securities Commission, Malaysia

It is almost a year since financial futures were first introduced in Malaysia 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.

The introduction of exchange-traded derivatives serves a pressing need in our capital markets. This is the need for hedging and risk management for rates and exposure to the equity market. Those of you who have followed the development of these markets will recall there was some concern in the early '90s as to whether there was indeed a need for these markets. Indeed, it was the considered opinion of an international financial institution, which shall remain nameless, that these markets were not timely. The Minister of Finance and Deputy Prime Minister, in pressing ahead with the launch of these markets in the wake of the Barings debacle, indicated the importance of these markets in developing the Malaysian capital market, in line with the government's aspiration to promote Kuala Lumpur as a regional financial centre.

Clearly it is still too early to embark on a definitive analysis of the progress of these two markets. The first part of my luncheon talk this afternoon entitled "The Success of Derivatives Market in Malaysia:" is therefore somewhat premature. Having spoken to the industry recently, I think it would be fair to conclude on behalf of those who have been intimately involved in the introduction of the two markets that there is a feeling of cautious optimism: cautious because they know the introduction of any new product into the market place takes time. This is true all around the region -- in Simex in Singapore, in the Hong Kong Futures Exchange as well as in Sydney. Yes, some Exchanges have grown faster than others, but I need not remind you that the laws of physics seem to apply to the development of new exchanges as well, especially Newton's third law of momentum which postulates an equal and opposite reaction. This reaction, when the regulatory foundation is not properly in place, results in the need for a cleanup, which is wasteful in terms of lost time and lost opportunity.

So if you ask me whether I'm disappointed with the relatively slow start, and gradual increase in momentum of our exchanges, I would say a gradual start based on firm regulatory foundations is better than a quick up and quick down. Thus, I plan to spend more of the time allotted to me addressing the subtitle of the talk, and speak to the "Opportunities and Challenges Ahead", and in so doing, discuss the basis of the shared optimism that I sense.

As I have indicated earlier, building on feet of clay is not the Commission's view of a sound beginning. Together with the industry, we have worked long and hard to put in place the key elements that are necessary for derivatives trading to prosper. These include:

a sound regulatory framework that addresses market and financial integrity, systemic stability and investor protection;
an efficient and transparent trading infrastructure;
a secure clearing and risk management system; and
a nascent, but increasingly sophisticated investor base.

These key elements are necessary, but not sufficient conditions for the development of our markets. I shall return to these sufficient conditions later. Let me however take a few moments to review the progress thus far, and then proceed to discuss the opportunities and the challenges ahead.

Opportunities
Growth in the futures markets

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 is about 300 contracts a day while the volume of open interest as at 31 October 1996 stood at 2211 contracts. Over on the MME, trading activity has been slowly building up with trading volume on the 3-month KLIBOR futures averaging around 280 contracts a day since trading began. Open interest stood at 3341 contracts on 31 October 1996.

With the relatively slow start, and the modest volume of open interest, critics have been quick to cast doubts on the future of our futures market. However, by the same token, taking into account the growth and potential of the underlying cash markets, I prefer to view this modest start in relation to the growth potential that is possible. And to obtain a proper perspective, we need to take a quick look at the underlying cash markets as well.

Growth in the cash markets

In the equity market, demand from corporate institutions for funds to finance their activities has been increasing. In 1995, the amount of funds raised through various equity exercises was in excess of MR13 billion. The strong economic performance in recent years has also contributed to the growth on the KLSE. The KLSE currently is the second largest stock market in the Far-East, excluding Japan, and as at end of October 1996, its market capitalization stood at more than MR770 billion.

Our bond market pales by comparison to the equity market. As at end of 1995, the amount of bonds outstanding was about MR100 billion or a seventh of the equity market's capitalization. This comparison masks the underlying dynamics of the corporate bond markets. By 1995, it constituted about 28% of total outstanding bonds. Indeed, the SC has approved more fixed income related corporate proposals than their equity cousins in the last two years. With growing privatization, the projected high level of infrastructure spending and the need for corporations to achieve a more balanced capital structure, the ringgit corporate bond market has vast growth potential. With the recent announcement by the Minister of Finance on the government's proposal to issue benchmark papers, the bond market is expected to develop further. Thus, it is reasonable to expect the bond market to take its rightful place in Malaysia's capital market as we move into the next millennium.

The growth potential of large local institutional investors

Yet another way to view the growth potential of the cash markets is to understand the growth potential of domestic institutional investors. All over the world, institutions are managing more and more of the savings of households and the corporate sector. Malaysia is no different. The provident and pension funds, such as the Employees Provident Fund, The Government Pension Trust Fund, Social Security Organization, the Armed Forces Fund and others have continued to expand their activities. As at end of 1995, their total assets stood at about MR113 billion. The unit trust industry has also grown where their total net asset value has increased from MR36 billion in 1994 to MR44 billion in 1995. In the insurance sector, total asset of life and general insurance has increased from around MR21 billion in 1994 to MR25 billion in 1995. In the area of unit trusts, PNB's funds account for some 6% of market capitalization.

While these institutions are already substantial, their influence in the capital markets is just beginning to be felt. Today, an average of 70% of trading in the stock exchange results from the activities of retail investors. As more and more of assets become institutionalized, the trading activities of institutional investors will grow from their present 30% base. The nature of their activities and the size of the portfolios that are being managed by institutions will lead them to becoming natural participants in the derivatives market as well.

The need for risk management tools

Although the capital market has been enjoying continuous growth in recent years, there have been episodes of volatility in both the equity and interest rate markets. As an example, during the second half of 1990, the composite index dropped by more than 150 points. In late 1991, the composite index dropped by more than 100 points, and during the 1993 "super bull", the composite index reached a record high of 1314 points in the first quarter of 1994 before dropping to 928 points. There have also been periods of relatively high volatility in the local 3-month inter-bank rate, notably in April 1990 where there was a drop of about 120 basis points and in June 1994 where there was a drop of about 50 basis points.

These periods of uncertainty in the capital market are often exacerbated by a lack of hedging instruments. For institutional investors, a bearish market would mean getting out of their long position, or holding on to their position and absorb the losses, or divesting their investments in as many instruments at a cost to reduce the potential losses. With the size of funds that are being managed by these institutional investors getting larger, there is a need to have the ability to transfer risk in an efficient and cost effective manner, while remaining fully invested.

All these developments point to the increasing need for risk management tools. With growing institutionalization and sophistication, it is inevitable that there will be a growing demand for instruments to enable investors to:

deepen and broaden their trading activities by making portfolio adjustments less costly;
hedge, arbitrage and risk manage their positions;
obtain benefits from pricing efficiency through better price and volatility discovery;
employ more cost effective means to taking tactical positions in the market while remaining fully invested; and
increase the level of return and reduce risk simultaneously through greater diversification.

Having gone through the opportunities that exist in our market, let me turn now to the challenges that we will be encountering in the years to come.

Challenges

Despite having in place the necessary elements for trading in financial futures, and positive indications for growth, the immediate challenge for the regulators and market participants at the moment is to realize that potential. A key step involves improving the level of liquidity on both KLOFFE and MME.

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 stand in the way of attaining a higher level of liquidity. Since the SC Annual dialogue with industry earlier in the year, we have taken steps together with the Ministry of Finance to address many of these bottlenecks.

In the months ahead, we will be announcing the results of our efforts. In the meanwhile, let me make mention of five areas of policy changes. These relate to:

liberalizing the licensing scheme;
reducing supervisory overlap in emergencies;
consolidating the regulatory framework through the merger of the SC and the CTC;
introducing market making; and
stepping up education for investors and intermediaries.

Liberalizing the licensing scheme

As a result of our legal framework, 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 legislations needs improvement. In particular, the KLSE has within its rules a prohibition against dealers representatives taking on activities not related to stock broking. This effectively prohibits them from selling derivative products which are traded on KLOFFE. 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.
In discussions with industry, the Commission will be rationalizing its licensing scheme with the objective of liberalizing the dual licensing of securities dealers' representatives as futures brokers' representatives. Under the proposed changes to the licensing scheme;

a Dealer's Representative who is a Dual Licence holder will be allowed to perform the role and function of a Futures Broker's Representative, as provided under the Futures Industry Act 1993, at the premises of the stockbroking firm to which he is attached as a Dealer's Representative, notwithstanding that the stockbroking firm is located at different premises from that of the futures broker; and
a Dual Licence holder will be allowed to receive and execute orders to trade futures contracts on behalf of his clients.

With the liberalization of the licensing scheme, market participants will have better access to trading in the derivatives market and the necessary information with respect to the market. The conditions under which this liberalization is going to be implemented have already been discussed with industry. The ball is very much in industry's court. The Commission wishes the KLSE to act speedily to amend its rules, and hopes brokerage and futures firms that have been asking for this facilitation would move ahead with all speed to implement the changes to their compliance and control systems which are needed to make dual licensing possible.

Industry Committee

In an effort to strengthen the financial integrity of the derivative markets, KLOFFE, MME and the Malaysian Derivatives Clearing House ("MDCH") have proposed to set up an Industry Committee to deal with emergencies and situations which could lead to systemic instability of the financial system. The concept of Industry Committee was mooted by the two exchanges and the common clearing house early this year as a means of addressing the current overlap between the rules of the exchanges and the clearing house that deal with the handling of emergency situations. The existence of such overlap gives rise to the possibility that the exchanges and the clearing house may issue conflicting directives to members during an emergency.

To address the issue, an Industry Committee will be set up to achieve the following objectives:

to create certainty in the market and among market participants as to the type of action that will be taken by the exchanges and the clearing house in an emergency and/or in cases of undesirable situations; and
to provide greater efficiency in the decision making process.

The Commission has given its approval in principle to the proposed concept. The Industry Committee will be established once the necessary amendments to the business rules, and other arrangements and procedures have been put in place by the exchanges and clearing house. With this measure, the ability of supervisory authorities to take decisive action in the event of market emergencies would be strengthened.

Merger of CTC and SC

The recent Cabinet decision to merge the Commodities Trading Commission and the Securities Commission clearly indicates the government's desire to streamline the regulatory framework in the derivatives industry. With the merger, the regulatory framework for commodity and financial futures will be harmonized. 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. The merger will also provide a greater legal certainty to these market participants.

Amendments to the Futures Industry Act are expected to be tabled soon to make this merger possible. I would urge industry to take a hard look at the trading infrastructure, and the management of clearing and settlement, to see if greater economies could not be effected.

A single regulator makes possible the existence of a single exchange and a single clearing house. Perhaps the first step could be taken by members of the KLCE and the MME. Given a common membership, shared trading facilities and a related ownership structure, it makes good sense for explorations to begin soon to see if a rationalized institution could not be brought about, both in the trading and in the settlement area, to the benefit of all members.

Introducing market making

To further improve liquidity in the derivatives market, a proposal has been made by KLOFFE to introduce market making. This would not only apply to options contracts, both on the futures as well as on individual stocks, but would 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. In October 1996, trading of market makers accounted for about 51% of total trading in the 3-month KLIBOR futures contracts.

Let me return to what I call the two c's of market making: competitive and committed. It is important that market making should not be confined to one or two firms with the capital and expertise to take positions. Bid-ask spreads will only be narrow, and the market deep, if there is a community of market makers at work. Now, I fully recognize that market making is a relatively new skill not possessed by many Malaysian intermediaries. But it is a skill that has to be nurtured.

There is no short cut to this. You will need to hire the skills if you do not have them; obtain the pricing software needed, and integrate the price feeds with the software; put in place the controls in the back office as well as the middle office; and commit capital, on the full understanding that you will have to pay the price of learning.

Committed market making speaks to making markets within reasonable spreads when the going is good, and when it is not so good. For users of the market, there is nothing more irritating that being faced with impossibly wide bid-ask spreads, or calling around to find no market maker willing to return calls when the going gets rough. I put it to you that the hallmark of a market of integrity is not necessarily one where investors make money all the time -- investors recognize that they cannot be right about their positions all the time. Rather, it is one which allows them to exit relatively unscathed when the market moves against them. So let us start the market making tradition right in Malaysia. Fair weather market making adds no value to our market; committed market making on the other hand will speak volumes of the depth and integrity of our market.

Providing education for intermediaries and investors

Let me now address the issue of education.

It would seem not too long ago that a major concern of industry was the lack of personnel with the requisite MFORR qualifications. With hindsight, we now recognize that the examinations were necessary to ensure a minimum skill set for those trading in derivatives, and were by no means a deterrent to market growth and development.

Together with the Malaysian Institute of Futures and Options, the SC has streamlined the MFORR training materials, and developed a set of teaching materials that can be used in our universities and institutions of higher learning. Starting this year, a module on futures and options will be offered in the MARA advanced diploma of business and finance that will cover all the materials required for a student who has taken that module to sit for the MFORR exams. I understand from the Securities Industry Development Centre of the SC that a number of universities have expressed interest to adopt these materials for their own academic programmes as well.

Together with 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 cast 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 MFORR.

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. I understand both exchanges and the futures brokers have been undertaking courses in derivatives products to familiarize investors with derivative products. Thus far, the focus has been the retail segment of the industry, given the impending implementation of dual licensing.

Next step - encouraging institutional investors

However, 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 about 50% of the trades done on KLOFFE. Local institutions account for a mere 1%. Admittedly, the presence of the local banking community is higher on the MME, but the extent to which it has developed OTC products on the back of exchange traded derivatives has been slow.

I put it to you that we need the presence of our institutional investors in our 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 the supreme challenge in the years ahead. Together with the exchanges, the Commission is taking steps to address this challenge.

Conclusion
Ladies and gentlemen, I recognize the mark of an appropriate luncheon talk is to assist in the digestion of a sumptuous meal, and if I have inadvertently added to that digestive effort, I do apologize. However, I personally believe that the derivatives market in Malaysia has plenty of potential for growth and development, and the challenge is before us to exploit this potential and turn it to the advantage and benefit of our growing capital market.

Thank you.