As memories of Barings and other debacles fade, the Far East derivatives business is coming back to life.

By Simon Boughey

Twelve months ago, the future for derivatives in the developing countries of the Asia/Pacific area did not look bright. The collapse of Barings in early 1995 had left a nasty taste in the mouths of Asian regulators. In the wake of the debacle, monetary authorities in most countries introduced guidelines that threatened to curtail growth in the region drastically. Derivative instruments, and their Western practitioners, had earned a bad name.

Since then, however, the derivatives industry has tried to smooth out relations with the regulators, and the impediments to continuing growth in the region are disappearing. Although Korea remains an unreconstructed enemy of derivatives, and negotiations in Singapore are at a very delicate stage, the International Swaps and Derivatives Association and other groups have made considerable progress in taming the regulators' ire.

Regulators who favor a crackdown have plenty of examples to point to. Barings, after all, wasn't the only company that got burned in Asian derivatives. There is a long and lamentable list of firms that suffered big losses in various structured derivatives products, including Dharmala, Sinar Mas, Nippon Sanso, TPI Polene, Salim Group, Berjaya International, Citic, Unipec, Minmet and OCBC. "The regulatory concerns about derivatives are quite widespread due to the previous derivatives losses by major corporations in each respective country in Asia," notes Ralph Liu, president of Advanced Risk Management Solutions, a Singapore-based derivatives consultancy.

Some Asian regulators fear that complex derivatives products are being introduced into a region where capital markets knowledge and expertise does not match that found in developed financial centres. As one Western banker put it, "They are worried that nasty foreign banks will prey on the locals."

Their fears have been exacerbated by a new development: Asian companies that suffer losses have little recourse in the international courts. Early last year, the U.K. High Court rejected Dharmala's suit against Bankers Trust for losses incurred in structured derivatives transactions.

Quentin Hills, Citibank's head of derivatives marketing in Asia and cochairman of ISDA's Regional Committee for Southeast Asia and Hong Kong, admits that Asian countries "come from a position of not being used to derivatives legislation or banks that are proactive." Nonetheless, most are trying to head in the right direction and do not want their regulations to stifle competitiveness with their neighbors. As countries throughout the region are at different stages of development, the picture currently presented is a patchwork with little uniformity. During the past year, however, a greater consistency has begun to emerge, and ISDA officials are confident that convergence will continue.

Singapore

The Monetary Authority of Singapore (MAS) was one of the first regulators off the mark with a draft set of guidelines that it dispatched to banks in 1996. In keeping with the somewhat secretive and authoritarian nature of the MAS, it intended that these should be confidential and was annoyed when ISDA got hold of a copy and forwarded a reply late last year.

What really troubled the industry was that the proposed rules talked of a disclosure rule that, if imposed, would have required banks to inform the client if the transaction was suitable for their requirements or not. This implies a fiduciary relationship between bank and client-something the industry has fought hard to avoid all over the globe in the last few years.

Though the original guidelines indicated that the disclosure rule was optional, industry officials were worried that there would be a difference between what was in the document and what was actually enforced. The audit process in Singapore is "very hands on," according to a banker who has worked there for several years, and no banker wanted to leave any room for doubt.

ISDA was well aware that it would have to proceed carefully in its dealings with the MAS. It is known to be prickly, and would bridle if it felt it was pushed around by arrogant Western bankers. And it would be largely Western bankers with which the MAS would be dealing. Local Singaporean banks did not see the implications of the proposed rules as clearly as overseas shops because they are not major derivatives players and because they don't stand up to the MAS. ISDA "has worked hard to be accepted by the MAS," says Hills.

On July 21, 1996, ISDA and the Hong Kong Monetary Authority cohosted a closed-door roundtable in Hong Kong with regulators from Japan, Australia, South Korea, Hong Kong, the Philippines, Indonesia, Malaysia, Singapore and Thailand. It was one part in a process by which ISDA hopes to establish its profile in the region and encourage harmony of regulatory response. "One consequence of the meeting has been the development of a dialogue with regulators in the region, including the MAS," says Hills. "We believe this serves a useful purpose as Singapore's regulators continue framing the guidelines for derivatives activities."

For the time being, the MAS is redrafting its original guidelines and has invited ISDA to comment whenever they appear. Though no exact date has been disclosed, ISDA expects they will appear in the next few months. In the mean time, the draft guidelines are still in force and the MAS expects them to be obeyed. ISDA's objective is to see that counterparty relationships are clearly understood. It wants to ensure that relationships are understood to be "arms length" and that disclosure should not be mandated.

Malaysia

The recent changes to regulation in Malaysia represent the derivatives industry's most spectacular success in the region to date. On July 27, 1996, Bank Negara Indonesia, in a most dramatic reversal of previous hostility, rescinded rules introduced earlier last year that required that banks seek its approval before entering into every derivatives transaction. This deal-by-deal approval structure threatened to stifle the nascent derivatives business in the region. The bank's new policy document, Risk Management Practices for Derivatives, rely instead on strong internal controls, in the spirit of the G30 report of 1993 and recent BIS rules. Hills calls this a "complete about-face."

Hong Kong

Hong Kong has a much longer history as a financial center than its neighbors. As a result, it's not surprising that the approach taken by the Hong Kong Monetary Authority (HKMA) is often cited as a model to other regulatory authorities in the region.

The HKMA sent out guidelines for comment early last year, and was prepared to redraft them substantially in light of the feedback. Once again, ISDA was particularly concerned that the nature of the counterparty relationship should be clearly understood as nonfiduciary.

The authority's subsequent Guidelines on Risk Management of Derivatives and Other Traded Instruments embraced global standards. One standard was the BIS's Risk Management Guidelines for Derivatives issued by the Subcommittee for Banking Supervision released in July 1994. Another was the International Organization of Securities Commission's Operational and Risk Management Mechanisms for OTC Derivatives Dealing of Registered Securities Firms, issued by its technical subcommittee also in July 1994. These sets of guidelines echo each other, and are quite clear about the arm's-length nature of the counterparty relationship. ISDA would be quite happy if all regimes throughout the region incorporated its precepts into their own regulations, as the HKMA has done.

Philippines

The regulatory record in the Philippines represents something of a mixed success for the derivatives industry. On the one hand, Bangko Sentral ng Pilipinas, the country's chief financial regulator, approved in May risk management of derivatives guidelines that closely match the BIS rules. On the other hand, it still requires all banks that use derivatives to obtain licenses from the central bank. Only four banks currently have licenses: Citibank, the first to be approved; Bank of America; Hong Kong Shanghai Bank; and Far East Bank, a local institution.

Indonesia

Tight guidelines are still in force in Indonesia, according Hills. Bank Indonesia has imposed heavy, prescriptive regulation for all local banks and local subsidiaries of overseas institutions, leaving only offshore banks exempt. This has forced most derivatives business out of the country. Negotiations between ISDA and Bank Indonesia, however, are in the "follow-up phase," says Hills, and he hopes that these restrictions will be relaxed.

Thailand

The Thai baht market is one of the fastest-growing markets in the entire region. Maturities are quoted out to 10 years, although liquidity drops after five. Although Thailand's regulatory framework incorporates BIS standards, a cloud looms in the form of Thailand's draconian taxation of gambling. If a derivatives trade involves a mathematical formula, it is possible that it will be deemed a bet, and therefore subject to the gambling tax.

Taiwan

Taiwan had one of the most restrictive regimes, but things are changing rapidly. Although it is currently illegal to trade options of the Taiwanese dollar, this restriction will be abolished on June 30. There is also a thriving currency swap market in Taiwanese dollars. In fact, the Asian Development Bank, in an attempt to popularize the market, has issued several bonds in this currency and swapped the proceeds back to floating U.S. dollars.

As might have been expected, South Korea is the most intractable of all regimes. Its tight controls have stifled the development of even the most rudimentary capital markets instruments, let alone derivatives.

China

There is little derivatives activity in China today, but bankers are sure that it is only a matter of time before things change in one of the world's biggest and fastest-growing economies. Much of China's external debt is denominated in U.S. dollars and yen, yet it has only certain windows through which it can access international borrowing and only a few counterparties with which it can deal.

Banks are new to this market and the regulatory regimes are not used to dealing with assertive Western financiers. "Regulators here are very happy to have liquid and deep derivatives markets, but they want that to happen in an environment in which there are appropriate levels of expertise and appropriate controls," says Hills. In fact, he claims that negotiations have been mercifully free of the acrimony that characterized the dissension surrounding derivatives in the United States in 1994.

Ralph Liu of Advanced Risk Management Solutions, a Singapore-based derivatives consultancy, says that in the early 1990s some Asian dealers were as cavalier about selling complex products as their colleagues were in the United States and Europe. Liu is fond of using a hypothetical example to illustrate what he's seen: A $500-million one-year U.S. dollar/yen call option, used by a company that imports from Japan and wishes to guard against an increase in the value of the yen.

The true value of the option is U.S. $5 million, but an aggressive banker who wanted to make an additional U.S. $3 million might try sell it for U.S. $8 million. The Asian buyer might be put off by the cost, or call up other banks to get a more competitive cost.

But if the banker suggests a more structured transaction in which the company would sell an option and be paid $2 million up front, the whole transaction begins to look more attractive. Liu notes that treasury officials often don't need to seek approval to complete a transaction that results in an upfront payment, and no one questions it closely. What the treasurer may not notice is that he has sold a U.S. $5 million option for U.S. $3 million-rewarding the banker with the required profit margin-and taken on quite a bit of additional risk. Liu says that in the early 1990s, when banks needed strong revenue streams to justify development costs in new markets, transactions such as these were quite common.