Banks in Asia profiting from derivative plays that put financial system at risk
Investment banks in Asia are taking advantage of a regulatory grey area to reap big returns from rising sales of equity derivatives, increasing the systematic risks to the financial system that regulators are trying to eradicate.
Derivatives are tempting for yield-hungry investors and banks facing a slowdown in their traditional deals and trading markets because of the higher returns they can offer both sides.
But regulators and academics fear banks are using them to circumvent rules intended to stop them risking their own money to boost returns.
Banks have been preparing for the introduction of the “Volcker rule”, a US regulatory response to the global financial crisis that seeks to stop banks playing financial markets on their own account, a practice known as proprietary trading.
US regulators are now concerned that banks are exploiting a grey area between “prop trading” and facilitating bets for clients, or market-making, under the guise of hedging risk.
“It’s almost impossible to distinguish market-making and proprietary trading,” Professor Duan Jin-chuan, director of the National University of Singapore’s Risk Management Institute, said.
“But the Volcker rule is trying to do that, because when prop trading fails, banks need to get bailed out.”
The worry is that the pick-up in such financial products in Asia exposes banks and investors to big volatility swings and stock market plunges.
Revenues from equity derivatives for top investment banks in Asia surged 130 per cent in the first half of this year to US$3 billion, according to estimates from data provider Coalition.
Derivatives are bets linked to the movement of an underlying asset, the engineered structures of which can produce a powerful multiplying effect on gains or losses.
Their popularity plummeted globally in the aftermath of the 2008-09 crisis, when those leveraged structures contributed to spiralling losses, but has recovered in the last few years as low interest rates have sent investors chasing better returns.
Banks do not typically disclose how much money their equity derivatives desks make, but traders in Asia said the top firms will make more than US$200 million each this year, with a second tier making US$100-200 million.
French bank Societe Generale singled out “strong revenues on flow equity derivatives” in Asia in reporting a 42 per cent year-on-year increase in net income at its equities division for the first half of this year.
The new breed of Asia equity derivatives, bankers in Asia say, forgo the complex structuring of discredited crisis-era products in favour of simpler bets on stocks or indices.
But events in Japan in the last 18 months show how even simple derivatives products can exacerbate losses when markets move unpredictably.
The equity derivatives business in Japan is unusually concentrated – traders estimate 75 per cent of the market is Uridashi notes, bets on the movement of Japan’s Nikkei 225 index or single stocks that are popular with retail investors.
Such notes are “autocallable”, meaning they are repaid automatically if the underlying stock or index rises or falls too far.
Years of stagnation in the Nikkei meant those autocall limits were not reached, resulting in a massive accumulation of two-way bets with banks on one side and individual Japanese investors on the other.
When stock volatility spiked last year during both a May-June slump and a December recovery, those notes started to be repaid automatically, warping the risk profiles of the trading desks and forcing them to act in unison.
“You had US$25 billion worth of product that looked the same, and the market moved 2 per cent in one direction, so everyone went to hedge at the same place and trampled each other on the way out the door,” said a trader who witnessed the ensuing losses.