Use of OTC Derivatives by Asian Corporates
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25 November 2013Arin Ray
Asia accounts for less than 10% of notional outstanding of the global OTC derivative market. Even within Asia, trading activity is primarily dominated by the four advanced countries Japan, Singapore, Hong Kong and Australia. Most of the OTC products in Asia are plain vanilla in nature, and as a result the OTC markets emerging Asian countries are at a very early stage of development. Corporates in Asia primarily use OTC derivatives to satisfy their need for customization. Foreign Exchange (FX) derivatives are the most popular OTC instruments used by Asian corporates. Many corporates have regional or international operations; they use cross currency swaps as net investment hedges for foreign currency exchange risk of international operations. In addition, corporates engaged in significant imports and exports use forward foreign exchange contracts as cash flow hedges for exposure to foreign currency exchange risks arising from forecasted or committed expenditure. Interest rate instruments are also popular among Asian corporates. Many Asian corporates have issued foreign currency denominated debt and therefore use cross currency interest rate swaps to hedge interest rate risk and cash flow hedges to hedge currency risk arising from issued bonds. In addition, corporates also engage in OTC commodity derivatives. Commodity derivatives, particularly those involving palm oil and rubber, are in demand from Southeast Asian corporates. Moreover, corporates in the energy and manufacturing sectors use them to hedge against price fluctuations in the underlying commodities. Emerging Asian countries lack necessary infrastructure for onshore OTC commodity derivatives trading. Corporates in those countries therefore have to deal with international exchanges or with international counterparties. Asian corporates typically engage in OTC derivatives for hedging, and not for trading purposes. Therefore many of them have not set up infrastructure for exchange trading. Small percentage of them is using centrally cleared derivatives at present. However, this is likely to change in the future since regulators are now encouraging and incentivizing central clearing of standardized OTC derivatives as part of the OTC derivative market reform process. While reducing counterparty risk is an obvious benefit of using central clearing, CCP also reduces clearing costs, as without central clearing one has to pay higher margins up front. With requirements of central clearing and other associated reforms, it is argued that the use of OTC derivatives may decline. If that happens, it will be mostly limited to financial institutions’ use of these instruments who engage in them for trading purposes; the need for OTC derivatives for hedging purpose is likely to increase. Non-financial corporates accounted for around 20% of OTC derivative trading in the emerging Asian economies, while they accounted for only 6% in the four advanced countries. This indicates the involvement of real economic actors and trade related activities are higher in the emerging country OTC markets. This is also due to the fact that in advanced countries large dealers and other financial institutions engage in significant trading and market making activities in the OTC space. Corporates’ high share in emerging country OTC market is likely to continue or even increase as the real economic output of the countries grows. This will be driven by economic growth, growing international operations and trading activity of local firms, liberalization of financial markets and regulatory initiatives facilitating more cross border trading. The developments in the emerging economies will also contribute to the growth of OTC activity in the advanced countries, particularly in Hong Kong and Singapore, as a significant proportion of activity in those markets comes from investors in the neighbouring countries who cannot meet their demand in local markets. However, this process is likely to evolve slowly as regulators in the region are traditionally conservative in nature.