Taiwan takes the forward-thinking option

special report: asia

Driven by increasing cross-border investment activities and a dynamic economic climate, the global derivatives market has experienced a phenomenal growth during the past few years.

In the exchange-traded derivatives sector, global annual trading volume reached 9.8bn contracts in 2005, according to the Futures Industry Association (FIA). Among the global annual trading volume, Asia accounted for approximately 34% of global trading volume.

The major contracts in Asia include Kospi 200 Options of the Korea Exchange (2.5bn contracts), TAIEX Options of the Taiwan Futures Exchange (TAIFEX) (80m contracts) and TA-25 Index Options of the Tel-Aviv Stock Exchange (63m contracts).

In the OTC derivatives sector, the major instruments are FX- and interest rate-related, contracts. According to the BIS's Triennial Central Bank Survey (April 2004), global average daily turnover on OTC FX-related contracts and interest rate-related contracts reached $3trn. However, Asia plays a relatively minor role with market share of about 15%. Asia's main centres of OTC derivatives trading are Tokyo ($185bn per day), Singapore ($100bn per day), Hong Kong ($82bn per day) and Sydney ($73bn per day).

Derivatives markets in Asia are aware of the trend of cross-border investment and are gradually opening their arms to the global investment society. Taifex, for example, took liberalisation measures in March 2006 to encourage foreign participation, including allowing trading for non-hedging purposes by foreign investors, introducing omnibus accounts, accepting US dollars as margin deposit and launching dollar-denominated products.

Foreign participation in TAIFEX's products thus far remains low, at less than 5% in May, the main reason historically being attributable to the fact that, until recently, they could only participate in the TAIFEX market for hedging purposes. The total underlying value of open positions in all delivery month(s) held by a foreign investor could not exceed the total market value of underlying securities held by that investor, based on the previous trading day's closing prices.

TAIFEX moved to address this area in March and with efforts to further develop the TAIFEX by meeting international investors' needs, it is expected the percentage of foreign participation will increase in leaps and bounds in the near future. Foreign hedge funds taking an interest in Taiwan's derivatives market will not be lone institutional investors. In the past two years, the proportion of institutional investors on TAIFEX has gradually grown, and has surpassed that of individual investors - who historically were its major participants. Institutional investors' market share has grown to 61% (June 2006) from 5.6% (1999). Of this group, 58% are prop traders.

While TAIFEX's latest improvements are new, the Taiwan derivatives market is not, having entered its 14th year since the promulgation of The Foreign Futures Trading Law in July 1992.

From 1992-1997, domestic investors could only trade in contracts listed on foreign derivatives exchanges and approved by Taiwan's regulatory authority. The domestic derivatives market was first established after the setting up of TAIFEX in 1997 and its first product - TAIEX Futures - was launched in July 1998.

Although the Taiwan derivatives market was relatively young compared to those of other countries, TAIFEX was established with the ambition of becoming a key international derivatives marketplace. Thus the related regulations, market practices and operation systems are largely designed and implemented to align with those of major international derivatives exchanges.

Taiwan imposed a transaction tax on futures trading, different to other futures markets that adopted an income-tax scheme. This, coupled with the fact domestic investors were not familiar with derivatives products, meant annual trading volume of TAIFEX in 1998 was only 277,908 contracts (daily trading volume was 2,223 contracts).

To expand TAIFEX's scale and liquidity, Taiwan lowered the futures transaction tax rate from 0.05% to the statutory minimum, 0.025% in May 2000. Since then, TAIFEX has achieved significant growth.

The later launch of TAIEX Options in 2001 was welcomed by the market and ushered in an era of rapid growth in the TAIFEX market, putting it among the top 20 derivatives exchanges worldwide. In 2006, Taiwan further substantially lowered transaction-tax rates on derivatives trading on average by 60% for stock index futures, 20% for options contracts.

The reduced transaction tax has provided investors with a greater incentive to participate in the TAIFEX market and trading volume in 2006's first six months hit a new high of around 63.5m contracts. Currently, the instruments available in Taiwan's OTC derivatives market include contracts related to interest rates, to FX, to equities, to commodities and to credit.

According to the Central Bank of Taiwan, trading volume of OTC derivatives by notional amount was NT$53trn in 2005. Among the total trading volume, the FX-related contracts secured a share of 82.29%, followed by 17.26% of the interest rate-related contracts. In the first six months of 2006, the trading volume continued to grow and reached a new high of NT$33trn.

TAIFEX currently offers 14 products, including futures and options on major Taiwan stock indices, government bond futures, 30-day commercial paper interest rate futures, equity options and gold futures. Among these products, TAIEX Options is the flagship. In 2006's first six months, trading volume of TAIEX Options was 55m contracts - 85.9% of TAIFEX's trading volume. According to the FIA, the TAIEX Options is the world's third-most actively traded stock index options contract.

Success factors of TAIEX Options are:

1. The Taiwan derivatives market used to be comprised mainly of retail investors. The low multiplier (NT$50 per index point) and relatively low taxation basis compared with futures contracts gave retail investors easy access to the market;

2. High leverage. Investors could enter the market and not have to put up large capital amounts;

3. Domestic FCMs established a convenient and diverse range of online trading platforms providing easy accesses to market. Also, active promotion efforts by the domestic FCMs were important in encouraging market participation;

4. Implementing a market-maker mechanism.

With the market continuing to grow, the profile of market participants has gradually changed.

To attract international participation, TAIFEX applied to the US CFTC for no-action letters on its futures products and so far has been granted no-action letters on four: TAIEX Futures; Mini-TAIEX Futures; Electronic Sector Index Futures; and Finance Sector Index Futures. Together with the launch of the dollar-denominated products, TAIFEX also filed for a no-action letter for TAIFEX MSCI Taiwan IndexSM Futures.

To assist TAIFEX members access the US market, TAIFEX has applied to the CFTC for a Part 30 Exemption, which, if granted, would facilitate TAIFEX members to serve their US customers directly. Due to the reasons described above, foreign participation, especially by hedge funds in Taiwan's derivatives market is still in the embryonic stage. However, this also represents great potential for growth.

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