Derivatives and Securitization: Risk Transfer Tools in East Asia

1. Derivatives and Securitization Both Derivatives and Securitization represent risk-transfer tools derived from underlying assets Asset Securitization in East Asia ASEAN+3 Workshop Shanghai National Accounting Institute Shanghai 9. November 2005 Oliver Fratzscher World Bank

2. Outline of Presentation • What are Securitization and Derivatives ? • How large are Asian derivative markets today ? • Which building blocks are necessary ? • What sequence is needed to develop derivatives ? • Which are key technical & prudential policy issues? • Conclusion and Discussion Hypothesis: OTC derivative markets are necessaryfor securitization to be sound and efficient (not sufficient, A+B+C also necessary)

3. B Banking Intermediate Products A Government Benchmark Bonds D DerivativesInterest Rate OTC C Legal & Collateral Framework Deposit → Loan → Mortgage → MBS What is Securitization ?A specialized OTC derivatives product • Securitization is a technique to standardize financial instruments for risk transfer from underlying assets; it is OTC derivative product structure through SPV • Derivative is a simple financial instrument for risk transfer from a single underlying asset (OTC/ETD) • MBS = package of assets linked to mortgages • CLO = collateralized package of loan obligations

4. Two perspectives " Although the benefits and costs of derivatives remain the subject of spirited debate, the performance of the economy and the financial system in recent years suggests that those benefits have materially exceeded the costs." Alan Greenspan “We view them as time bombs both for the parties that deal in them and the economic system. In our view derivatives are financial weapons of mass destruction (WMD), carrying dangers that, while now latent, are potentially lethal.” Warren Buffet

5. 2004 OTC Derivative Markets Exchange-Traded Derivatives US: 40% EU: 40% Asia: 20% ABS+MBS: 4% 12% 26% 65% 75% $53 trn notional $10trn mkt value $248 trn notional $9 trn mkt value FX Interest Gov-Debt OTC (bar) and Exchange-Traded (line) Derivatives (notional outstanding, in billions US$) Annual growth rates exceed 30% Equ-Index Stocks Comm Credit Sources: BIS (Dec 2004) ; FIBV (Jan 2005) 2. Global derivative marketsrapid OTC growth and increasing ETD products

6. Asian derivative marketsbanks in OTC FX and security firms in equity ETD Sources: Triennial Central Bank Survey (BIS, 2005) and World Federation of Exchanges (2005)

7. 3. Building blocks for DerivativesMBS requires similar components as derivatives Necessary components for MBS • Product Design • Push by originator for risk transfer tools • Pull by investors for yield and duration • Risk-based pricing, benchmark, corp bonds • System-wide stability without moral hazard • Regulation • Regulatory approval, product understanding • Legal clarity: default, repossession,enforcement • Accounting rules, transparency, disclosure • Clear tax treatment, level playing field • Infrastructure • Industry guide onstandardized products • Credit ratings industry and standards • Best practice risk management • Suitability criteria for investors, SRO

8. Building blocks for derivative markets • Product Design • Economic rationale for hedging needs • Liquid cash market, long and short positions • Market determined prices, interest/FX rates • System stability, no moral hazard risks • Regulation • Lead regulator, capital rules, reporting standards • Legal clarity: ISDA standards, enforceability • Accounting rules, transparency, disclosure • Level playing field, tax harmonized, integration • Infrastructure • CCP, ISDA master, close-out netting • Demut. exchanges, strong capital, margins • SRO rules enforcedwith limits, monitoring • Certified investors, code of conduct

9. Derivatives enhance financial developmentwin-win instruments for banks, corporations, investors • … beyond rice trading in Tokyo and tulip trading in Amsterdam • Commodity producers lock in future prices and reduce uncertainty • Corporations can close mismatch between assets and liabilities • Firms can hedge export receipts and seek cheapest funding abroad • Banks can share excessive or lumpy risks in capital markets • Investors gain access to new markets and broader asset classes • Pension funds can diversify exposure and enhance risk management • Retail receives better pricing for mortgages and securitized products • Foreign investment is facilitated by higher liquidity and hedging tools • Financial system enhances stability through new “spare tire”

10. Market efficiency Risk sharing and transfer Low transaction costs Capital intermediation Liquidity enhancement Price discovery Cash market development Hedging tools Regulatory savings More leverage Less transparency Dubious accounting Regulatory arbitrage Hidden systemic risk Counter-party risk Tail-risk future exposure Weak capital requirements Zero-sum transfer tools Rewards and risks of derivativesmarket development combined with prudential issues

11. Cash OTC Repo ETD 4. Schematic development of D marketscash liquidity+sound regulation+solid CCP infrastructure

12. 100,000 5 : 1 USA GER 1 : 1 10,000 KOR UK Derivatives Turnover JAP SIN HKG 1,000 ESP AUS IND 100 100 1,000 10,000 100,000 Cash Turnover Source: World Federation of Exchanges (Dec 2004) Link between cash and D turnoverliquidity corridor for emerging and developed markets

13. Australia China Hong Kong India Indonesia Japan Korea Malaysia Philippines Singapore Thailand Index Futures a r a a a a a a r a r Options a r a a r a a a r a r Options on futures a r r r r a r r r a r Stock Futures a r a a r r r r r a r Options a r a a r a a r r r r Currency Futures a r r r a a a r r r r Options r r r r r r a r r r r Interest rate Futures a r a a r a a a r a r Options on futures a r r r r a r r r a r Bonds Futures a r a r r a a a r a r Options on futures a r r r r a a r r a r Commodities Futures a a r r a a a a r a r Options on futures a r r r r r r r r r r # of products traded 12 1 6 5 3 10 9 5 0 9 0 Notes: Australia: Australian Stock Exchange (ASX) and Sydney Futures Exchange (SFE) China: Zhengzhou & Dalian Commodity Exchange, Shanghai Futures Exchange Hong Kong: HKEx India: National Stock Exchange of India (NSE) and Bombay Stock Exchange (BSE) Indonesia: Jakarta Futures Exchange (JFX), and Surabaya Stock Exchange Japan: TIFFE, Tokyo Stock Exchange (TSE), Osaka Securities Exchange, Tokyo Commodity Exchange Korea: Korea Stock Exchange (KSE) and Korea Futures Exchange (KOFEX) Malaysia: Malaysia Derivatives Exchange Philippines: Manila International Futures Exchange was closed Singapore: SGX-DT Thailand: Thailand Futures Exchange plans to open in 2006 Websites of regional exchanges, WFE, Futures Industry Association, and HK-SFC (2004). Sources: Derivative products in Asia three tiers of exchanges offer six product categories

14. Derivatives infrastructure in Asialiquidity indicators improve but regulation still evolving Notes:adenotes best practice ;q denotes progress on existing deficiencies ; and rdenotes major problems. 1./ Fixed income liquidity indicators and benchmarks are obtained from asianbondsonline.adb.org, which shows weaknesses in China (segmented markets), Hong Kong (small local currency issuance), Indonesia, Philippines, and Thailand (limited medium to long-term benchmark issues). 2./ Turnover ratios for fixed income instruments have also been obtained from HSBC (2004). 3./ Equity market liquidity indicators have been obtained from World Federation of Exchanges (2004), which revealed thin markets in Philippines, Indonesia, and Thailand. 4./ Information about laws on derivatives was obtained from individual country, with only Australia, Hong Kong, and India currently having distinct laws on derivatives. 5./ Securities lending data were obtained from Endo and Rhee (2005), showing restrictions in Malaysia and Philippines on short selling, with very little activity in Indonesia and Thailand. 6./ World Bank public documents on accounting standards (ROSC) and professional publications reveal adequate accounting standards aligned to IFRS standards only in Australia, Hong Kong, Indonesia, Malaysia, and Singapore, but major gaps exist in the Philippines. 7./ CCP information was obtained from industry sources and ADB, showing adequate functioning only in Hong Kong, Korea, and Singapore. 8./ ISDA netting opinions have been issued for all countries mentioned with the exception of China, but many countries have issues to resolve. 9./ Data from individual exchanges show their progress towards demutualization (2004). 10./ Data on taxation were obtained from PWC "Taxation on financial derivatives in Asia" (2003), which showed small stamp duties in effect in Hong Kong and Malaysia, and VAT being applied in China, Philippines and Thailand. 11./ Transaction costs for bond markets were obtained from ADB (2004) and additional market information on taxation. 12./ Institutional investor base and NBFI indicators are obtained from ADB, which shows weaknesses especially in Indonesia and Philippines.

15. 5. Technical issuescritical tools to increase netting and enhance cushions • Basics first: liquid and efficient cash markets allowing short positions • Legal framework: D law, SRO rules, licensing, ISDA documentation • Equal taxation: D may enhance volatility and substitute cash markets • Governance issues: accounting standards (IAS39), disclosure rules • Netting is critical: 85% risk reduction through close-out netting • Manage CP risk: Central clearing counterparty (CCP) is best practice • Modern exchange: demutualized, effective margins, strong buffers • Risk tools: dynamic margins, pos limits, reserves, capital, insurance • Product sequence: corporate hedging (interest rate futures) are more important than retail speculation (equity options) • Investor education: suitability, disclosure, monitoring, non-savings

16. Policy issuestransparency + monitoring + oversight enhance stability • ETD vs OTC: Investors prefer Exchanges – Banks prefer OTC Marketsshifting OTC products (interest futures) onto exchange enhances stability • Regulation: level playing field for ETD and OTC markets plus disclosure • Caution: D can undermine fixed prices, pegged FX regimes, credit policies • Monitoring: highly leveraged institutions, cross-border, FX and credit D • Capital: D require risk-based capital plus add-on cushions, beyond Basel-I • Public banks: bridge market failures but subsidies can create warehouses • Oversight: exchanges, SROs, rating agencies provide critical infrastructure • Enforcement: market surveillance, transparency, legal clarity, ISDA standards • Investor protection: rationale for new D products, standards for suitability

17. 6. Conclusion – main messages • Derivatives can enhance financial intermediation and economic growth but require efficient underlying cash markets and sound infrastructure • Modern exchanges with leading risk systems (CCP, dynamic margins, buffer) can enhance transparency, safety, and competitiveness of a financial system • Prudential supervision is critical for FX and credit derivatives which could undermine fixed prices, pegged FX regimes, and credit policies • Securitization products should be grounded on sound OTC derivative market structures.

18. www.worldbank.org/boards www.worldbank.org/finance www.financelearning.org 谢 谢 Thank You “An invasion of armies can be resisted, but not an idea whose time has come” Victor Hugo Discussion