Alan Taylor, ADB Consultant 25 September 2007

Developing the Asian bond marketsShanghai, 25-26 September 2007Minimizing Foreign Exchange Settlement Risk in the ASEAN+3 Region Alan Taylor, ADB Consultant25 September 2007

Topics 1. Objectives and Progress 2. FX Settlements in Asia 3. Proposed settlement infrastructure 4. Feedback from the settlement conference 5. Proposals for further work

Objectives of Study Overall ABMI (Asian Bond Market Initiative) objectives • Development of local currency bond markets • Alternative to bank and equity finance • Avoidance of maturity and currency mismatch • Deepening of liquidity, yield curve etc Project objectives • Risk reduction in clearing and settlement • Removing the barriers to cross-border bond investment • Does Asia need a regional settlement intermediary (RSI)?

Progress-to-Date Initial research: • Analysis of settlement risks, drawing on earlier studies • Market consultations May-August 2006 • Asia, Europe, US • Central banks, custodians, depositories, asset managers etc Interim report: • Market survey December 2006 - January 2007 • financial institutions throughout ASEAN+3 • 76 responses • Development of further RSI Options • Asia Bond Clearing and Settlement Conference, April 2007 • Further feedback from attendees • Follow-on consultations with private sector Final report:

ASEAN+3 bond markets size & growth USD bn 2004 27% average annual growth 2004 - 2006 2006

Market survey / settlement risk (Q5) To what extent are you concerned about foreign exchange settlement risk for cross border bond transactions in ASEAN+3? 57% are very / moderately concerned "…concerned about the systemic risk given the high growth prospects of Asian bond markets" Central bank "…settlement and pre-settlement risks" Local custodian bank "…need to reduce principal risk and replacement cost risk, but cross-border investment in ASEAN+3 is small" Central bank

Market survey / settlement risk (Q6) To what extent will it benefit your business if you can make payments and securities settlements in the same Asian time zone? 72% see big / moderate benefit "…great benefit of reducing settlement risks. Ideally, PvP and DvP facilities should be introduced" Central bank "…free up credit line, maximize cash flow usage" Commercial bank "…cross-border transactions in Asian time zone will be stimulated" CSD

FX settlements in ASEAN+3 • Using correspondent banks • Using CLS Bank • Using local payment vs payment systems FX settlement risk is borne by the banks, but the cost is passed on to the end investor

FX settlement (1) using correspondent banks FX settlement 1: Correspondent banks • Risk of counterparty default ('Herstatt risk') • AFTER paying currency A, and BEFORE receiving currency B • The exposure lasts from the time the payment instruction for the currency sold becomes irrevocable until the time the receipt of currency purchased is confirmed. Duration of Exposure Source: “Settlement Risk in FX transactions", CPSS report, BIS (1996).

FX settlement 2: CLS Bank • Assured payment vs payment • Established 2002 • 15 eligible currencies • Owned by 72 member banks • Benefits • Elimination of settlement risk • Operational efficiency • Limitations • Only 4 Asian currencies eligible • Expensive to become a member • Settlement is late afternoon /evening Asian time

FX settlement 3: Local PvP systems • Settlement of USD vs local currency • Payment vs payment • In local Asian time zone • Local currency settles via local RTGS, central bank money • USD settles via appointed settlement bank • Existing systems • Hong Kong (HKD vs USD) • Hong Kong (HKD vs EUR) • Malaysia (MYR vs USD) • Philippines (PHP vs USD) • Limitations • Participants must be local banks • Dependence on a single provider • Potential risk on commercial bank

Third Time Zone Problem 8 hours of time difference Europe and Asia… Investors in Asia must deposit money or securities a day before the settlement date ICSDs & global custodians provides batch processing & intra-day line of credit Investors bear the opportunity cost of losing liquidity for a day

What are the options? • Option 1: Maintain the status quo • Option 2: Set up a Regional Settlement Intermediary

Option 1: Status Quo • = leave evolution to local initiatives and market forces • Arguments for: • Market based solution • Existing global custodians are well capitalized and regulated • Current low volumes in region • Arguments against: • Existing settlement infrastructure focused on US / Europe • Dependence on a few providers • Region should design its own infrastructure

Option 2: Regional Settlement Intermediary(summary of options) • Option 2.1: Asian ICSD • Model A = Using Local Custodians • Model B = Direct Link to Local Settlement Systems • Model C = Direct Link to Local Settlement Systems & CLS Bank • Option 2.2: Pan-Asian CSD • Option 2.3: Asian Payments Bank  All are aimed at reducing settlement risk and cost, harmonizing infrastructure, regional ownership of regional utilities

2.1 Asian ICSD • Custody and settlement • 3 business lines • ASEAN+3 investors investing in other ASEAN+3 bond markets • ASEAN+3 investors investing in US/European bond markets • US/European investors investing in ASEAN+3 bond markets • US$ bonds issued by Asian governments can be 'seed' business • Direct users • Banks and securities dealers • Bridge to both European ICSDs • Book entry settlement, securities vs cash • Settlement geared to Asian time • 3 possible mechanisms (described in Final Report): Model A; Using local custodians Model B; Using direct links to local payments Model C; Direct links + special link to CLS • Scope: only for bonds, or for equities too?

Option 2.1: Asian ICSD Investor Custodian Bank Euroclear / Clearstream Securities Dealer DvP settlement bridge Asian ICSD Investor Custodian Bank Securities Dealer Settlement links (direct or via local custodians) CSD China CSD Indonesia CSD Singapore etc

2.2 Pan-Asian CSD • Depository for all debt securities issued in ASEAN+3 • Existing national CSDs could be sub-depositories • Possible model: Euroclear Single Settlement Engine in Europe • Direct users • Banks, securities dealers, possibly institutional investors • Bridge to European ICSDs? • Link to local payments systems • Settlement in central bank money • Scope: only for bonds, or for equities too?

Option 2.2: Pan-Asian CSD Bond market Indonesia Bond market Korea Pan-Asian CSD Investor Custodian Bank Securities Dealer Bond market Malaysia Bond market Vietnam etc

2.3 Asian Payments Bank • Assured payments versus payments • PvP ASEAN+3 currencies vs US$ • PvP ASEAN+3 vs ASEAN+3 • Final settlement of US$ in Asian time zone • Mechanism to be discussed - may involve consortium of leading commercial banks, backed by central bank reserves? • Similar local systems in HK, Malaysia, Philippines - expand to regional system • Direct users • Banks • Link to ASEAN+3 local payments systems • Special link to CLS Bank • Enables PvP with participants of CLS • Scope - only for bond settlements, or for all FX payments?

Option 2.3: Asian Payments Bank USD (Fed) Euro (ECB) Investor Member bank CLS Bank Member bank PvP settlement bridge Asian Payments Bank Investor Member bank Member bank PvP Settlement links Phil peso Thai baht "Asian time" USD

RSI - arguments for • Reduce risks and costs of cross-border bond and FX settlement • Single platform for whole region • Consolidated holdings of collateral will help develop repo and derivatives market • Jump-start the integration of regional markets • Local ownership of regional infrastructure • Catalyst for change?

RSI - arguments against • Infrastructure is not the main barrier to development of bond markets • Lack of price transparency, lack of yield curve, currency controls, withholding taxes… • Current volumes low, can be handled by existing providers • Is there a business case…?

Market survey / Need for an RSI? (Q7a) Is it necessary to establish an RSI to improve the settlement risk on clearing and settlement of bond transactions? (Q7b) Is it necessary to establish an RSI to improve the settlement risk on foreign exchange transactions?  over ¾ believe it is needed

Clearing & Settlement conference (April 07)Summary of outcome • Rapid growth of the local bond markets, maturing as an independent asset class • Significant recent improvements in infrastructure • Derivatives markets will also grow so also need efficient settlement infrastructure • European changes with Target2Securities, requires NCSDs to outsource settlement • Need a regional not national perspective • Importance of regional initiatives such as ASEAN+3 ABMI • Broad study into cross-border settlement barriers is needed for Asia (similar to 'Giovannini study' for EU) • Need cost and benefit analysis for RSI

GOE ProposalStage 1: Asian 'Giovannini' study • Mandates: • Identify and prioritize the main barriers (market practice / regulatory / tax / infrastructure) re cross border settlement • Propose roadmap to remove the barriers • Estimate the costs (compared to domestic settlement or US / Europe)

Setting up a Group of Experts… Group of Experts High-level private sector professionals ADB representative Steering & Monitoring Committee Coordinating Committee Representatives from ASEAN+3 countries Private sector professionals (voluntary basis) Subcommittees In Europe, a Group of Experts successfully studied a number of EU-wide financial issues - Including cross-border clearing and settlement - Chaired by Dr Alberto Giovannini ("The Giovannini report“ (2001, 2003))

Setting up a Group of Experts Success factors in Giovannini Group of Experts for EU: • Strong and consistent (non-financial) sponsorship by EU government • Voluntary participation of private sector • Advisory group, no policymaking power • Group members selected on ability, experienced market professionals • Hands-on style, all members were assigned work! • Chairman was an effective spokesman at government level • TOR were clear but not too restrictive • Lack of bureaucratic structure Key message: Can rely on the private sector to provide resources, provided public sectors are supportive.

GOE ProposalStage 2: RSI evaluation • Based on Stage 1 findings • Mandates: • Evaluate the need for an RSI, and if so… • Investigate the feasibility of the various RSI options • Determine public and private sector roles • Analyze the business case

Further information • For further information, please contact: • Asian Development Bank: • Masato Miyachi, Senior Advisor, OREI • mmiyachi@adb.org • Chiemi-Jamie Kaneko, Senior Financial Market Specialist, OREI • ckaneko@adb.org • Consultant Team: • Changyong Rhee (Seoul) • rhee5@snu.ac.kr • Alan Taylor (Hong Kong) • alan@atassociates.com.hk • Mariko Sawada (Tokyo) • mariko.sawada@mizuho-ri.co.jp

Alan Taylor, ADB Consultant 25 September 2007