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Mr David Setters,
industry friends, ladies and gentlemen. I am delighted to be
here, to deliver the opening address at this FOW's Asia-Pacific
Derivatives & Securities World Conference.
2 Let
me begin by saying some things about the exponential growth in
derivatives markets over the last few years.
3 To cite a
couple of statistics. Recent data by the Bank for
International Settlement (BIS) shows that the combined value of
exchange-traded financial derivatives contracts in interest rate,
stock index and currency contracts expanded strongly to 304 trillion
US Dollars. This represents a staggering 120% increase
compared to the previous survey figure in 2001 of about 140
trillion US Dollars.
4 Similarly,
the global average daily turnover in the OTC derivatives market
increased sharply to 1.2 trillion US Dollars, a rise of over 110%
compared to 2001.
5 Perhaps
not surprisingly, the surge in derivatives trading has resulted in
increased competition among exchanges. In the first half of 2004
alone, we saw several new exchanges operating in direct competition
with existing US derivatives exchanges. For example, Eurex US
launched Treasury futures in February while Euronext.liffe
introduced Eurodollar futures in March. The Boston Options
Exchange, a new all-electronic equity option exchange in the US also
began trading in February this year. Exchanges will have to find
ways to innovate and strengthen their competitive advantages to stay
ahead of the pack. This can only be good news for market
users.
6 The strong
global growth in derivatives transactions is also seen in this part
of the world. According to recent reports1 , in the
first half of 2004, the Asia-Pacific region including Australia and
New Zealand, accounted for about 40% of all exchange-traded futures
and options volume worldwide.
7 However,
if one were to strip out the more developed markets of Japan, Korea,
Australia and New Zealand, the derivatives markets in Asia are
actually not large. Part of this is obviously because many
markets in Asia are still relatively young. However, another
possible reason is that many in Asia -- regulators, investors,
corporate end-users - may still be viewing derivatives with a
degree of suspicion, perhaps due to a lack of understanding; or
perhaps a disdain for how speculators can use derivatives to create
financial havoc as in the Asian currency crisis.
8 Post-crisis,
many Asian governments have now recognized the need to develop and
deepen our capital markets. A number of regional collaborative
efforts have been launched; for example, many of you may be familiar
with the pooled investment in a US$ denominated Asian Bond Fund, by
11 Asia-Pacific central banks, including the MAS. Now, a local
currency denominated tranche called Asian Bond Fund 2 is being
worked on. Under the Asean+3 Finance process, 6 Working Groups
have been formed to consider various Asian Bond Market Initiatives
that will address a series of supply side issues. Within Asean,
an Exchange Linkage Task Force led by Singapore has been formed to
consider further strengthening alliances between our exchanges.
But efforts to develop the derivatives markets, whether OTC or
exchange-traded, have been far more tentative.
9 Why is
this so? One view may be that derivatives by definition will
naturally follow the growth of the underlying instruments and with
the demand for new financial products. But there may be another
reason why "derivatives" is not a common word one would
see, when it comes to regional development efforts.
Derivatives simply have had a lot of bad press. Many of you
would recall the enormous losses from use of derivatives by Gibson
Greetings, Orange County, Procter & Gamble, Sumitomo Bank, LTCM,
Enron and closer to home, Barings. So are derivatives
inherently a "bad thing", whose growing usage is something
we should frown upon? or is this yet another example of how
something good in the wrong hands can result in very bad outcomes.
10 The
debate on the cost and benefits of derivatives has gone on, and
probably will continue to go on for many years. Just a few
months ago, we heard an interesting exchange between Warren Buffett
and Alan Greenspan on this topic. You may all remember Mr
Buffett's reference to derivatives as "the financial weapons of
mass destruction", posing grave risks to financial markets.
Mr Greenspan in contrast, noted that derivatives actually helped to
spread risk, thereby stabilizing the financial system. These
remarks are especially interesting because we have arguably one of
the greatest investor of all times derogating the use of derivatives
and a central banker or regulator supporting it. One would
understandably expect the reverse.
11 Allow me
to share my own perspectives on this subject. I am from a
monetary authority, which sort of put me in the company of
regulators. At the same time, I oversee the reserve management
activities in the MAS and have been involved with financial
investments for some 18 years now, which sort of makes me an
investor.
12 And as an
investor, I would describe myself as a firm supporter of the use of
derivatives. The late Merton Miller wrote a wonderful book
called "Merton Miller on Derivatives", in which he argued
strongly the case for derivatives. Some of you may have read
the book within which he gave many arguments to support his stance.
I would just like to read a small excerpt. Prof. Miller posed
the question: "Did financial derivatives make us better or
worse off?" His own answer:
[Quote] "Free
market economists have a simple standard for judging whether a new
product has increased social welfare: Are people willing to pay
their hard-earned money for it? By this standard, these products
have proved their worth many times over. But why have they
been so successful? Where is their real ?value added"?
The answer, in large part, is that they have substantially lowered
the cost of carrying out many types of financial transactions."
[Unquote]
In other words, if I
were to crystallize that singular benefit of financial innovations
in the past 2 to 3 decades, it would be in the area of improved risk
allocation. And derivatives have allowed the transferring of
risks at significantly lower costs to those better able to bear
them.
13 In MAS'
own experience in the management of our reserves, and in our
discussions with many of our external fund managers, the value of
derivatives can be distilled into a single word:
"efficiency". And there can be
"efficiency" in 3 broad ways :
(a) Efficiency because
they allow an investment manager to keep less transactional cash in
his portfolio. And in these days of low interest rates, the
return drag from holding cash can be very high.
(b) Efficiency because
they help establish links between different markets, thereby
deepening liquidity. Asset swaps are an obvious example of
this.
(c) Efficiency because
they allow an investment manager to differentiate the distinct risk
components of an asset, and to value and trade each one separately;
thereby enabling the tailoring of an asset or a portfolio according
to one's needs.
14 So the
merits of derivatives usage would seem obvious. What then,
could some of the reservations be? I will highlight
three :
First, there is some
belief that derivatives can be used to destabilize exchange rates
and interest rates because they give speculators' access to greater
"fire power". Until a few years ago, MAS explicitly
disallowed S$ derivatives under our previous policy on the non-internationalisation
of the Singapore Dollar. But in 1999, we allowed S$ interest
rate products - interest rate swaps, FRAs, swaptions. Two
years later, we freed up restrictions on the S$ options market.
Our own experiences here reveal little evidence that derivatives in
S$ have added to volatility. Instead, we believed that
these instruments have helped to bring new participants and offshore
players into our markets and in turn, deepened market liquidity.
Indeed, there have been other studies done regarding the impact of
the introduction of derivatives, such as the research by Smithson,
Smith and Wilford in their book on "Managing Financial
Risk", and from empirical evidence, derivatives often reduce
price volatility and decrease bid-ask spreads in underlying markets.
A second reservation
perhaps, regards risk control and accounting. Enron clearly
demonstrated that accounting and risk controls can severely lag the
growing complexities of financial innovation. Back in 1992,
then-President of the New York Fed Jerry Corrigan issued a warning
at a meeting of the New York State Bankers Association. Mr
Corrigan said at that time that "the growth and complexity of
these activities and the nature of the credit, price and settlement
risk they entail should give us all cause for concern."
He added that these derivatives or off-balance sheet activities must
be managed and controlled carefully and that they must be understood
by top management as well as by traders and rocket scientists.
That warning 12 years ago sparked a series of new industry best
practices and the recognition for an independent risk management
function. And continued strides are being made in
the areas of financial risk control and accounting, including the
ongoing work of Basle 2.
A third related
reservation regards systemic risk. Because financial
derivatives involve future commitments, the issue of credit risk
always arises. For exchange-traded derivatives, the exchange
acts as a buffer for credit, legal and settlement risks. But
for OTC derivatives, there are no such buffers. When a market
player put on large leveraged transactions, and his positions turn
sour, there is the risk of a chain of defaults rippling throughout
the financial system. This may be exacerbated by the fact that
more and more derivatives are traded and priced by fewer and fewer
banks and investment banks - an outcome of global
consolidation. Some measures, such as ISDA agreements and
cross collateralization have helped to mitigate counterparty risks.
15
Notwithstanding the improvements in risk management and financial
oversight, some concerns about the growing use of derivatives will
remain, and rightly so. But the problem should not be seen as
one regarding the increased use of derivatives per se, but rather
how they are used and how they are managed. On balance,
the benefits of derivatives will outweigh the costs. I believe
that Asian capital markets will see greater vibrancy if the region
liberalize and allow the further development of our derivatives
markets.
16 And there
are some promising signs that this is happening. Most
encouraging are developments in the 2 Asian giants: China and India.
Interestingly, they have taken on slightly different paths in
developing the derivatives markets. China's liberalization is
mainly in the usage of OTC derivatives, marked by the introduction
of new derivatives rules in March this year. This allowed OTC
derivatives done for any commercially reasonable purposes and not
only for hedging; and the authorities there have granted derivatives
licenses to China's main commercial banks and several foreign banks.
India, on the other hand, has focused on developing exchange-traded
derivatives, marked by the launch of the Indian Rupee interest rate
futures last year. Both countries have seen strong growth
rates in derivatives activities -- China, up 38% from the first half
of 2003 and India, up 195% over the same period, although in
absolute terms, the market sizes are still small.
17 In my
view, there is a symbiotic relationship between OTC derivatives
activities and exchange markets. A good part of the growth in
global derivatives can be traced to end user demands for customised
needs and transactions. To meet these needs, derivatives
traders and dealers will always rely to some extent on
exchange-traded futures and options to hedge their net market risks.
A clear example is the relationship between the US interest rate
swap market and the Eurodollar futures contract. The
standardized terms of the futures contracts provided an efficient
means of price discovery while the IRS uses the price to tailor
solutions to individual contracts. And these same dynamics
will fuel a mutually reinforcing growth of derivatives and exchange
markets in Asia in years to come.
18 As
derivatives markets develop in the region, Singapore is well placed
to play an important role as a leading Asian centre. Both the
Monetary Authority of Singapore and the Singapore Exchange (SGX)
remain committed to developing the derivatives market here and have
worked closely with industry players to implement various measures
to encourage market growth. Mr Hsieh Fu Hua, the CEO of SGX,
will be able to share more details but I note that trading volume of
derivatives on SGX has been buoyant, reaching almost 17 million for
the first half of 2004. In particular, trading in the MSCI
Singapore Index Futures, which has been rising steadily over the
past years, has registered record-high open interest and volume in
the 2nd quarter of 2004.
19 In the
OTC derivatives market, Singapore has seen impressive growth with an
increase in market share of global OTC derivatives activities.
According to the recent BIS survey, daily average turnover for OTC
derivatives here rose almost three-fold from 6 billion US Dollars in
2001 to 17 billion US Dollars in 2004. Singapore is now the
12th largest OTC derivatives centre globally, further consolidating
our position as the second largest OTC derivatives centre in Asia.
20 We are
looking at further developing the derivatives markets in 3 ways.
Firstly on the regulatory front, we have taken steps to ease the
entry and compliance costs of firms engaging in financial and
commodity derivative activities. Currently, financial derivatives
fall under the purview of the Securities and Futures Act
administered by MAS, while most commodity derivatives are regulated
under the Commodities Trading Act administered by the International
Enterprise Singapore, or IE Singapore. Through a MAS-IE S'pore
initiative, the two regulators have agreed to provide a single
regulatory interface for corporations applying for authorisation as
markets, clearing houses, or licensing as futures brokers. So
interested corporations can now approach MAS directly for the
necessary authorisation if their financial products come under the
regulatory purview of both Acts.
21 For the
broader derivatives market in Singapore, we have also introduced
measures to enhance its development. For example, under the previous
legislative framework, a market operator is required to either apply
for an approved exchange status, with the attendant full set of
legal compliance requirements, or be exempted totally from our
regulatory ambit. In recognition of the rigidity of this
all-or-nothing model, we have introduced the Recognised Trading
Systems (or ReTS) provider regime in the Securities and Futures Act,
to give us the flexibility to apply regulatory requirements
consistent with the risk profile of an individual Recognised Trading
System provider. We will continue to refine our regulatory framework
to reduce regulatory burden so as to encourage new and innovative
trading platforms to take root in Singapore.
22 Secondly,
we are improving our trading infrastructure. Rapid technological
advancement is changing how derivatives products are traded and will
redefine the landscape of the derivatives marketplace.
Technology has not only opened the doors to new players through
greater accessibility, but also blurred the line between geographic
borders and between asset classes. Exchanges now have to be
able to offer trading in multiple asset types and to cater to the
growing sophistication of market participants, to compete more
effectively. I am happy to note that the Singapore Exchange
has introduced its new derivatives trading engine, SGX QUEST (which
stands for SGX Quotation and Executive System for Trading) in August
this year, to eventually lead to an integrated trading engine for
its securities and derivatives activities.
23 Thirdly,
we seek to broaden the instruments traded in Singapore. We
envisage strong growth in credit derivatives, driven by the
redistribution of risks from banks and insurance companies via the
capital markets. We are also promoting the commodity
derivatives market. Already well-positioned as an oil hub,
Singapore is a natural choice for financial institutions to set up
regional energy derivatives trading desks and more broadly, to
consolidate commodity derivatives operations here. The SGX is
currently in discussions with NYMEX, for the latter to consider
setting up a futures exchange here. Such a joint venture will be an
important first step towards developing strong exchange-related
trading and clearing facilities to service the regional markets.
24 In
conclusion, development of the derivatives market is important to
the growth of the financial markets in Asia. You will follow
from my remarks this morning that I am optimistic on the growth
prospects ahead. The MAS, whether in our regulatory, market
and investment, or development functions will also need to keep
ourselves updated and in tune with the latest developments and
trends of the industry. Conferences such as this can only be
beneficial, as there will be much to learn from one another.
25 I thank
FOW for organising this conference and I am sure it will be a
worthwhile and fruitful event to everyone here.
_____________________________
1
Source: Futures Industry Magazine
Source: Monetary
Authority of Singapore News Release 19 Oct 2004
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