Hub hubbub

New rules coming into force in many jurisdictions in Asia are challenging the ability of global financial institutions to operate a hub-and-spoke business model for their derivatives businesses. By Jacqueline Low, Jing Gu and Keith Noyes

Given the size and jurisdictional complexity of Asia, global banks have generally preferred an over-the-counter derivatives coverage model in which their product specialists are based in either of the two main financial hubs, Hong Kong or Singapore. These product specialists travel to other Asian countries to work with on-the-ground relationship managers to jointly market deals to local counterparties. This was an efficient way to cover the region, as the domestic derivatives markets in most countries were too small to justify dedicated allocation of resources. Recent trends in regulation now put that business model under threat, with the cost of doing business likely to increase significantly.

This threat to the coverage business model has been exacerbated by losses suffered by local customers in intermediary trades, and by domestic investors in structured products issued by offshore issuers and sold by local banks and non-banking financial institutions.

Separate from the coverage model outlined above, some global banks did not have any local presence and their relationship managers and product specialists would market deals using local banks. Generally speaking, there was nothing wrong with the global bank dealing with the local bank as counterparty. But the local bank did not need to deal unless it had customers that would take the opposite side of the trade. So the global bank’s staff would talk to the local customer (with or without the local bank’s presence), then conduct the trade via a local bank. The local bank would book the transaction with the local customer and then book a back-to-back trade (with a spread differential) with the global bank. The intermediary trade had always been of concern as there was a fine line between acceptable onshore marketing efforts by the global bank’s staff and unacceptable efforts that would trigger onshore licensing requirements, as well as tax consequences for the global bank.

The idea of forcing business onshore is not completely new. Any bank wishing to transact equity derivatives onshore in South Korea will have gone through a lengthy application process and made significant commitments to obtain the relevant business licence. This would have included dedicated risk management personnel, traders and marketers employed exclusively in the onshore entity, and the setting up of onshore infrastructure such as dedicated computer servers.

The Financial Investment Services and Capital Markets Act, which came into effect in February 2009, made South Korea’s intention to bring business onshore even clearer. The act closed a loophole under which offshore energy companies could market their hedging products in South Korea without onshore licences. In its original form, the act also created a Chinese wall, stopping information flowing from a bank’s onshore business in Korea to its offshore parent. This would have prevented the sharing of important information, such as market and credit risk exposures. The act has been modified now to allow this sharing of information, although the need to maintain data on domestic servers and to manage the risks domestically remains.

There are many reasons for wanting to force a derivatives business onshore – a primary aim is the desire to license and regulate the business directly. Just as the US requires anyone selling securities to have passed the Series 7 exam, so Asian regulators want to ensure local professional standards are upheld. In the current environment, in which derivatives sales issues are very much in the public domain, regulators also want direct recourse to sanction the selling bank and the responsible individuals for any violations. It is hard to do that if the bank’s employee who sold the structure lives in a different country and works for a separate legal entity. It is even harder in the intermediary structure where regulators only have jurisdiction over the local intermediary bank and its employees (who would possibly allege they were as misled as the customer by the foreign bank). Similar conundrums arise in the case of offshore-issued structured products, where the regulators have no jurisdiction over the foreign issuer.

A good example of this is Taiwan. In an unusual sanction order issued in May 2009, the Financial Supervisory Commission (FSC) in Taiwan ordered Goldman Sachs (Asia), a foreign company located in Hong Kong, to fire two of its employees. According to the sanction order issued by the FSC, the two employees of the Hong Kong office marketed OTC foreign exchange derivatives products to a Taiwan company when travelling in Taiwan, notwithstanding that the Taipei branch of Goldman Sachs (Asia) did not have the appropriate licences to engage in OTC financial derivatives business.

This order shocked many banks conducting business in Taiwan, which previously operated on the understanding that certain limited marketing activities by offshore salespersons were permitted. Taiwanese law firms therefore had to rush to amend their legal opinions on cross-border marketing to reflect the tougher position of the FSC. Revised regulations for structured products sold in Taiwan have also created a new concept of a Taiwanese agent for the product manufacturer that will be held accountable for any problems with the products. Previously, many of the manufacturers did not have domestic legal entities in Taiwan, putting them out of reach of local regulators.

Similarly, after finding that many Chinese companies suffered significant losses from euro/US dollar swap curve-linked trades in 2008, the China Banking Regulatory Commission issued a circular at the end of July 2009 in which it put an end to the intermediary business model. The circular expressly prohibits marketers of offshore banks, alone or jointly, from marketing any derivatives products to end-users in China. It will force international banks to move derivatives marketers onshore if they wish to continue marketing to Chinese clients.

In Indonesia, both Bank Indonesia (BI) and Bapepam-LK, the local supervisory agency, have circulated draft regulations on offshore-issued products, which, if passed in their current form, would effectively mean issuers without an onshore branch would not be able to sell their products onshore. BI’s July 2009 structured products regulations (which extend to OTC derivatives falling within the definition of ‘structured products’) takes this even further by prohibiting onshore banks from using another onshore bank as a selling agent for its structured products. Indonesia also passed a law in July 2009 that requires all agreements involving an Indonesian party to be in the Indonesian language.

Meanwhile, the Reserve Bank of India released draft guidelines on OTC foreign exchange derivatives in November 2009, which constrain onshore banks to offer only those products they can price independently.

Another possible driver for encouraging derivatives businesses onshore is a desire to create domestic white-collar employment. A related consideration would be the desire to build up the domestic knowledge base and effect technology transfer.

That this onshoring trend is inefficient and expensive for global banks is evident. Whereas a bank might previously have had a couple of traders in their regional headquarters managing each of the country books for each asset class, and working with a regionally based structuring and marketing team, they will now be required to commit dedicated resources to individual Asian countries. This comes at an inopportune time, when many banks are already looking to merge their Asian and Japanese operations to reduce overheads, and begs the question of whether many Asian countries are big enough to justify increased resource commitments.

It is the understanding of the International Swaps and Derivatives Association that banks continue to believe in the potential of China as a market and are likely to make the necessary resource commitments. The South Korean market is probably just big enough during the good times to support the current level of resources, but we would be surprised to see much increased commitment. In Taiwan, banks are likely to meet the Taiwanese local agent requirement to participate in the structured products market. Given that India is already a significant market for foreign banks and its potential for growth, we think the banks will do what is needed. Meanwhile, we expect those foreign banks that already have a sizeable presence in Indonesia will increase resources, but expect that others may simply choose to pass.

Jacqueline Low is senior counsel, Asia, Jing Gu is assistant general counsel, Asia, and Keith Noyes is regional director, Asia Pacific, at the International Swaps and Derivatives Association