Benign monetary policy in mature market countries and high liquidity-induced demand have put a premium on the risk diversification of alternative asset classes outside of conventional investment, such as emerging market equity. The development of derivative markets in emerging economies plays a special role in this context.
Derivatives offer gains from efficient price formation and risk shifting by providing low-cost arbitrage opportunities. They complete financial markets by facilitating the unbundling, transformation and diversification of financial risks, which can be customized to the risk preferences and tolerances of agents, improving the capacity of the financial system overall to bear risk and intermediate capital. Equity derivatives in particular convey benefits as means to reduce uncertainty about expected corporate performance, strengthen the liquidity and price discovery in equity markets, and lower the cost of equity listings for firms.
Equity Derivative Markets In Emerging Asia
Global trading in futures and options on equity derivatives exchanges almost doubled over the last three years from about USD56 trillion in 2002 to USD174.9 trillion in terms of notional amounts (on 7.3 billion contracts) by end-2006. By comparison, the U.S. GDP was about USD12.5 trillion for 2005. Measured by notional value, turnover in exchange-traded equity options and futures surged by 103.9% and 93.4% respectively since end-2004, while the combined figure for futures and options showed explosive growth at an annualized rate of more than 30% over the last five years. During the same time, the notional amount of over-the-counter equity derivatives increased only by 11% to USD5 trillion worldwide, whereas gross market values rose by one half to almost USD0.6 trillion, albeit from a low base. By comparison, the total size of outstanding OTC derivative contracts worldwide stood at about USD370 trillion at end-June 2006 according to the Bank for International Settlements' latest bi-annual survey released Nov. 17 this year.
Equity derivatives have flourished in a few markets in Asia, where they have witnessed the most rapid growth of all traded derivative products. As opposed to foreign exchange and interest rate derivatives, equity derivatives in emerging Asia are mainly traded on organized exchanges rather than OTC. Since 2002, exchange-traded volumes have mushroomed from USD16.9 million in 2002 to USD54.2 trillion in 2006 and now represent 31.0% and 38.9% of worldwide equity derivatives turnover by notional value and number of trades respectively (see chart below). Index derivatives are the most widely traded types of equity derivatives in emerging Asia at 82.4% and 15.9%. Recently, OTC derivatives have picked up momentum. The outstanding notional amount of OTC contracts on Asian equities excluding Japan rose by 38% to USD0.14 trillion from 2004 to 2005.
The high growth of equity derivatives trading in the region is due in part to the Korean derivatives market, where the trading on the Kospi equity index almost doubled over the last two years. Most of the growth, however, is due to valuation effects caused by rising stock prices. Although trading increased in notional terms, turnover measured by the number of contracts was sluggish (at a growth rate of less than 30% since 2003), which explains a doubling of average contract sizes worldwide over the last years. This valuation effect was so profound in emerging Asian countries that rising stock prices resulted in a larger increase of contract sizes than in other regions, even though regional derivative trading also gained global market share by number of traded contracts.
Nonetheless, contract sizes in emerging Asian countries have more than doubled from USD8,300 in 2003 to USD19,200 by October 2006. Besides Hong Kong, only equity derivatives in Korea are traded at contract sizes similar to mature market economies.
Challenges To Further Development
The impediments to the efficacy and further development of derivative markets in many emerging Asian economies include considerable shortcomings in cash market liquidity and trading infrastructure. There are also inadequate legal and regulatory frameworks for bankruptcy, tax, and corporate governance issues, as well as investor protection.
In general, equity derivative trading tends to be associated with high trading volumes in deep and wide cash markets to ensure efficient price formation. Low liquidity in some Asian equity markets may reflect issues of transparency and corporate governance. These issues generate information asymmetries, and accordingly foster high bid-ask spreads and limited trading activity. Thin equity market turnover remains an economic constraint on the introduction of derivative products in the Philippines and the expansion of the investor base of small equity derivative markets in Indonesia and Thailand.
Price discovery in derivative markets is most efficient if trading is motivated by a balanced mix of speculation and institutional hedging. Some Asian derivative markets, such as Korea and India, are actively sponsoring more domestic retail participation in order to compensate for the lack of genuine hedging demand by institutional investors. However, retail demand is mostly speculative in nature and could raise latent vulnerabilities unless sufficient investment by securities firms and other institutional investors limits the possibility of excessive speculation.
Since the impact of shocks to financial stability are generally deemed most pronounced and wide-spread where market forces and participants are left to their own devices, trading should preferably occur in regulated exchanges with centralized clearing and settlement and with multilateral close-out netting. There should also be risk mutualization and capital requirements in order to safeguard the collective interest of market participants. In some Asian countries without formal derivative exchanges, such as Thailand and the Philippines, OTC derivatives enjoy growing popularity. Since OTC trading is decentralized, and regulated only indirectly without full disclosure requirements, it entails greater emphasis on how market participants manage counterparty risks from confirmation backlogs, post-default settlement protocols and automated trade processing, and the prospect of market risk from multiple defaults that could overwhelm a settlement infrastructure that has not been tested under stress. OTC trading, however, can be augmented with transparency enhancing features normally found in exchange-based trading, such as registered market makers, circuit breakers, and generally agreed limits on transactions and positions.
Risk Management Measures Promote Growth
Orderly market rules, prudential regulation, and supervisory oversight through monitoring systems promote sound risk management that ensures the balanced growth of equity derivative markets. Statutory barriers and the absence of legal and accounting standards specific to derivatives seem to be lasting hindrances to further deepening of derivative markets in most of Emerging Asia. Leading derivative markets such as Korea and India have reliable tax regimes that ensure the equitable treatment of cash and derivatives trades and allow short selling, which facilitates hedging. Countries that are lagging have shortcomings in relevant laws that create uncertainty about whether derivative contracts can be enforced or even whether trading derivatives is permitted. Such countries also may have tax provisions that are unfriendly to derivatives, bans on short selling, and restrictions on investment by foreigners.
Conclusion
The further development of viable equity derivative markets in emerging Asian countries will crucially depend on financial sector initiatives, whose scope and intensity might be enhanced by coordinated policy efforts to improve market rules and trading standards with a view to enhance financial stability.
This week's Learning Curve was written by Andreas Alexander Jobst, economist at the monetary and capital markets department of the International Monetary Fundin Washington, D.C.
The views expressed in this article are those of the author and should not be attributed to the International Monetary Fund, its Executive Board, or its management.
