Strength in numbers

Asia Risk conference

With more than 200 delegates present, the 2006 Asia Risk conference was even better attended than the previous year's, and the bulk of the delegates were highly complimentary about the event, in terms of both general organisation and the content of the presentations. One described the event as a "beautiful symposium", while others were more prosaic - but equally lavish - in their praise. It was not hard to see why, given the impressive surroundings of Hong Kong's Island Shangri-La Hotel and the calibre of many of the speakers.

Bart Broadman, JPMorgan's former vice-chairman of Asia, opened the conference with a highly anticipated speech about the nascent credit derivatives market in Asia. Broadman is now managing director of Alphadyne Asset Management, a Singapore-based hedge fund focused on credit and interest rate arbitrage.

The debt market in Asia certainly seems big enough to support a strong CDS market, said Broadman, citing Monetary Authority of Singapore figures putting at $2.7 trillion the amount of bonds outstanding in the region. But until there is breadth and depth in the Asian credit default swap (CDS) and single-index markets, the region will always be a limited credit market, he said, pointing out that the Asian component of global credit portfolios or structures such as collateralised debt obligations tends to be very small.

Immature and illiquid

There are major barriers to using the same types of credit trading strategies in Asia as are employed in Europe and the US, mainly due to the market's immaturity and illiquidity, said Broadman. Commenting on the difficulties of executing even basic strategies like index arbitrage, he said: "The only credit index regularly quoted is iTraxx Asia, but only 70% of components are quoted on a regular basis, and to trade an index regularly you need them all to be quoted or you end up using a proxy-type basket, which is not so accurate."

Broadman summed up his views by saying: "It's only a slight exaggeration to say that the Asian CDS market is a virtual wasteland, and it will remain that way until meaningful liquidity enters the market."

Citing the illiquidity of Asia's credit markets, he said they would benefit from credit futures. "Something needs to happen with the help of an exchange, such as listed credit default swaps (CDSs) with simple binary-type payoffs. That would create a big risk pool and more transparency," said Broadman. "If a good exchange did this, hedge funds might become primary liquidity providers on such contracts."

His comments followed the Chicago Mercantile Exchange's early-November announcement that it intends to launch credit futures in the first quarter of 2007. The CME has thereby challenged Eurex - which itself plans to launch a CDS index - to become the first exchange to get a piece of what is now a $26 trillion over-the-counter market.

In response to questions from the audience, he highlighted several issues of concern in the credit derivatives market. One thing that needs tackling, said Broadman, is front-running - the practice of taking a position in the market with advance knowledge of a transaction that is likely to influence the market price. There may be "no Eliot Spitzer for the credit markets, no overarching regulator", he said "but front-running or potential insider trading is going to get a lot of scrutiny".

A Czech comparison

Another very interesting - and far-flung - speaker on the first day was Jan Barta, chief executive of CSOB Investment Co and CSOB Asset Management Group. He had made the trip from Prague to Hong Kong to speak on the structured product market in the Czech Republic, which is small, but, as in much of Asia and the rest of the world, growing very fast. For example, in 2005, around $20 billion Czech koruna ($949.5 billion) was invested in capital-guaranteed funds in the country - in the first half of 2006 alone, more than $30 billion had been invested in them.

"Interest rates were very low in 2003, so people were attracted by the good performance of the equity markets," said Barta. "Sterling or US dollar longer-tern rates exceeded Czrech koruna rates, so they offered a good environment for structured cap-guaranteed products."

He went on to say that the use of domestic currency in structured products offers diversification across asset classes. "Investors perceive diversification when using capital-protected structured products as well as bonds both psychologically and also from a purely technical point of view," said Barta. "These products can play the role of fixed income or close to fixed income within the investor's portfolio, as long as they are free of currency risk."

The first day continued with the theme of structured products - perhaps not surprisingly, given the explosive growth in volume of such investments in recent months. This time, it was a regulator's turn, when a senior official from Hong Kong's Securities and Futures Commission (SFC) had much to say on retail structured investments.

Alexa Lam, the SFC's executive director of intermediaries and investment, outlined her concerns on product misselling - particularly to retail investors - giving several examples of problems she had seen. She also highlighted that it is not just banks that are seeing major growth in the selling of investment products, but insurance firms are increasingly selling insurance-linked products.

"We have been getting a lot of complaints from investors and have conducted a survey into the issues we should be addressing," said Lam. "We asked a selection of investment advisers whether they are addressing those issues." She was referring to an SFC survey published in late November, which found that many investors who bought unlisted, retail structured products for their perceived higher returns did not fully understand the nature of these products (see page 8).

Several issues emerged, she said. One was that many advisers do not carry out proper know-your-client procedures; they should be doing this not only to combat money-laundering, but also so that they can provide the products that are suitable for their clients, she said. "Some seem to think having a copy of the customer's ID card is enough," added Lam. "But you need a proper client profile and an understanding of their investment objectives, time horizon and risk tolerance. How can you advise customers to buy products otherwise?"

Another concern was that some push just one type of product, to any risk profile of client profile - usually the product that provides the adviser with the biggest return.

Day two

One of the major themes of the second day of the conference was another very topical subject: the Basel II capital adequacy accord. The lack of data poses a huge challenge for banks trying to calculate credit risk under Basel II, said Harald Scheule, senior lecturer of finance at the University of Melbourne, in a panel discussion. This is particularly true for banks pursuing the internal ratings-based approach, because it requires fundamental changes in the way banks collect data and estimate and validate their models, he added.

Although banks started collecting data shortly after the Asian financial crisis in 1997/98, the data only covers a few years of economic growth, with limited numbers of credit loss events. "Statistical hypothesis tests for calibration and discrimination require sufficient number of credit loss events, which are often not available," said Scheule.

Christopher Laursen, director in capital markets and trading risk at the US Federal Reserve Board in Washington, DC, agreed. "In the wholesale area, many firms haven't collected data for long periods of time in the way that credits are broken out in their Basel II rating systems. With limited data, robust model validations aren't possible."

On the question of Basel II limitations, Scheule said current Basel II proposals are a compromise between accuracy and practicability. "For the first time, banks' capital will be based on the credit risk inherent in the loan books to absorb future credit losses. To relax difficulties to implement the new set of rules, the Basel committee on banking supervision had to make a number of simplifications with regard to the nature of the risks covered (credit, market and operational risk), the specification of correlations or the assumption of granular portfolios."

Laursen also commented on the question of limitations on models, saying it is difficult to have a perfect model, even if it is customised for a particular institution.

And neither is stress-testing foolproof, added Laursen. "Are you getting to a right capital number for the risk that you're under taking? You might get a number that complies with the rules and makes sense, but you always have to think a little further and consider what could happen if there is real concentrated stress," he said. "Stress-testing is always some kind of estimate and you may estimate too high and you may estimate too low versus what actually happens."

Meanwhile, in another Incisive Media conference that immediately followed the Asia Risk event - Structured Products Asia 2006 - there was another presentation of note: on the legal aspects of structured products. There has been an unprecedented growth in derivative and structured products in China over the last 18 months but there are also challenges, said Chin-Chong Liew, partner and head of derivatives and structured products Asia ex-Japan at law firm Linklaters, in his executive address.

Liew also raised the issue of whether the sale and distribution of offshore securities in China would comply with its securities law. The regulation defines securities as shares, corporate bonds and securities designated by the state council, although the body has not designated any so far for this purpose, said Liew. "Foreign issued securities are foreign-currency denominated debt securities, not shares or corporate bonds, so it is not clear whether the securities law applies," he said.

Offshore financial institutions have been selling notes to qualified domestic institutional investor (QDII) banks, and in turn these banks sell products that are linked to the notes, said Liew. China announced the QDII scheme in April, which allows banks and corporates to invest Chinese funds in overseas fixed-income products. The China Banking Regulatory Commission (CBRC) is amenable to this practice by offshore financial institutions, he said. The China Securities Regulatory Commission has not taken a view on this practice, because the QDII plan is believed to be regulated by the CBRC, said Liew.

Yet the regulators have not reacted as favourably to cross-border renminbi-denominated foreign exchange derivatives. In October, the State Administration of Foreign Exchange (Safe) issued a circular stating that no domestic institution and individual should participate in any overseas renminbi derivative transactions without Safe approval.

This means banks must stop cross-border non-deliverable forwards and swap transactions, said Liew. He added that the informal view from Safe is that the regulator will not be taking any action on existing deals.

Click here to view photos of the conference
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