Hong Kong warrant market players bullish about 2015

Dealers are predicting up to a 50% spike in business next year but a repeat of the sector's 2005–07 bull run is unlikely

After a period of low volatility and a sustained pattern of banks exiting the Hong Kong warrants market, dealers are bullish that 2015 could see issuance increase by as much as 50% driven by increased liquidity after the launch of the Hong Kong-Shanghai stock connect.

As many as 29 banks have issued warrants on the Hong Kong market since 2005 but the exit of Barclays, Bank of America Merrill Lynch and Rabobank from the sector last year brought the number of active players down to 14. However, the remaining firms are expecting a spike in volumes next year as Chinese investors boost liquidity in the special administrative region's equity market after the stock connect goes live.

The stock connect is initially limited to cash equities but according to Johnny Yu, Asia head of public distribution equity derivatives sales for UBS in Hong Kong, there is a direct relationship between the level of activity on the Hong Kong Exchange (HKEx) and the amount of equity derivatives linked to the stocks issued.

"The turnover for warrants and CBBCs [callable bull/bear contracts – essentially a leveraged version of a warrant] accounts for 20%–25% of the equity market turnover. So if the stock connect increases equity market turnover it is fair to expect warrant and CBBC sales to increase by the same proportion," he says.

According to data from the World Federation of Exchanges, the Hong Kong listed warrant sector is the most active globally in dollar terms, with HKEx trading 10 times the amount of the next most successful bourse, the Tel Aviv-based Tase, so far this year. Despite this, volumes in Hong Kong of both equity warrants and CBBCs have remained roughly static over the past three years.

However, Yu is bullish that there will be a significant increase in issuance of both instruments in 2015.

"There will be an increase in equity market turnover in Hong Kong in 2015 and a 30%–50% increase in warrant and CBBC issuance is possible. But with the number of players in the market falling and the cost of issuance being so high it's unlikely that more instruments than that will be issued – unless the Hang Seng rallies by, say, 60% or 70% in 2015," says Yu.

Risk.net spoke to a number of the leading Hong Kong warrants dealers and all expressed optimism about the next 12 months – however, generally to a lower level than suggested by Yu. Indeed Ivan Ho, director of Hong Kong warrants sales at Credit Suisse, says that while 2015 will be a good year, investors have already bought warrants in anticipation of the stock connect's launch.

"We saw a 20% increase in warrant demand after the stock connect was announced in April and we are bullish that this trend will continue with another 20% rise in 2015," he says.

UBS and Credit Suisse are first and third in terms of market share of combined warrant and CBBC turnover in Hong Kong, according to figures from Bloomberg (see box at bottom of article). And while both expressed optimism for an increase in business next year, Cedric Cheung, head of warrants and CBBC sales and marketing Hong Kong for JP Morgan, the second largest player, says that success is by no means guaranteed.

"If Chinese investors participate in the Hong Kong market and drive up volatility as a number of market participants expect, this will be a favourable environment for the warrant investors but it is too early to say whether this will happen."

Hong Kong's equity market has been characterised by low volatility in 2014, with Hang Seng 90-day implied volatility touching just over 10% in September, close to the all-time low of 9.5% reached in 2005.

According to Venus Wong, Hong Kong-based head of warrants sales for Daiwa Capital Markets, this low volatility environment combined with the start of the stock connect and the potential for favourable macroeconomic headwinds could see at least a repeat of the 2005–07 boom cycle.

But Credit Suisse's Ho says that despite the positive momentum from the stock connect it is unlikely that there will be a repeat of the Hong Kong market's performance of a decade earlier.

"There are some superficial similarities to 2005: volatility is low and the market hasn't performed for several years, plus there are some parallels between the launch of the A and H shares and the stock connect. But a bull market needs more than that – stable or upward-trending economic conditions are key and there are still concerns over global economic recovery. This means that the conditions for a repeat of the 2005–07 bull run on the Hong Kong market are just not there."

Tight margins and increased Basel III capital costs for leveraged products such as warrants have driven a fall in the number of banks active in the Hong Kong warrants market, but Ho says it's unlikely that even an increase in profits in this sector will see new players enter the market – at least in the short term.

"I don't think that newcomers will suddenly participate in the warrants market in 2015 – this won't happen until 2016 at the earliest, because when firms start to earn money their competitors need to do their analysis and persuade themselves this is a good business to enter – and that process will take at least 12 months," he says.

Largest turnover for Hong Kong warrant & CBBC market

UBS – 15.5%
JPM – 14.5%
Credit Suisse – 13.6%
Societe Generale – 10.2%
Standard Chartered – 9.6%

Year-to-date 2014. Source: Bloomberg