DERIVATIVES have a bad reputation in international markets. If it is not Kidder Peabody losing millions in bond-linked trading then it is Salomon Brothers with a Hong Kong problem from losses suffered by clients who went into derivatives. The truth is, for any financial centre to even pretend to be at the edge of capital market development, a flourishing and innovative derivative market would be essential. Hong Kong has remained something of a leader in the region, outside of Japan, in equity-linked derivative trading. The high profile covered warrant business has provided many local merchant or investment banks with lucrative earnings and imposing profiles in the industry. Initially, local players, including Jardine Fleming and Peregrine, took the lion's share of the business. They were followed by some of the European players, including Barclays de Zoete Wedd and SBC Derivatives. The United States' investment banks came in afterwards. Over-the-counter business, local and regional, remains their bread and butter business and its importance has been growing. In foreign exchange, the sophistication of derivatives being offered in the territory is also improving. Even in the domestic retail market option-linked products are offered to clients via banks and, now, SBCI actually publicly quotes prices for investors interested in taking a view on foreign exchange trends. Retail investors could trade Hang Seng Index-linked options. However activity in this market has remained lacklustre. Next year, the stock exchange plans to launch stock options on key Hang Seng Index stocks. This will give investors better choices, but more importantly it will also offer the professional institutional investor an important series of tools with which to manage financial risk. Like a sports car, when in the hands of the uninitiated and unsupervised, derivatives can be dangerous. But this should not make local regulators oppose the products. Derivatives can stimulate liquidity and reduce overall risk from an exposure to equities or foreign exchange. As derivatives trading becomes more sophisticated, it also encourages improved trading in the equity market. Gone are the days when retail investors could find obvious anomalies in values of warrants or stocks from a cursory glance of financial newspaper pages. To date, turbulent capital market conditions around the world have tempered the vitality of the industry and the liquidity in these products. This ought to provide an opportunity for the market for equity-linked derivatives to be widened in Hong Kong. The Stock Exchange of Hong Kong has been keen to attract the quoting of debt-linked securities locally. Development of such a market in Hong Kong would improve attractiveness for institutional investors and also provide another avenue for mainland-linked operations to tap when raising capital. Attention at the exchange needs to also turn to equity-linked derivatives. The potential that exists for a regional hub to develop in such instruments is shown by the large volume of OTC business. The exchange has shown willingness to be flexible with rules regarding the listing of domestic covered warrants. So far, the exchange has twice waived its $10 billion market capitalisation rules to accommodate a covered warrant on Consolidated Electric Power Asia and Guangdong Investment. The stock market listed its first call-spread warrant in June. Local derivatives' practitioners would need to know whether such flexibility would be the rule when considering regional covered warrants. A fully-developed and buoyant market in regional covered warrants would be an asset to the local equity capital market, especially at a time when local and overseas institutions are looking for more investment opportunities in the region, away from Hong Kong. There are more technical difficulties listing such products away from the sight of the underlying stock listing base, compared with the listing of a local warrant on a local stock. However, there is a desire among many practitioners to see such a development occur in Hong Kong. The territory has managed to attract a fairly comprehensive clutch of expertise in derivatives, much of which transferred to Hong Kong from Tokyo over the past two years. Local regulators should consider measures to ensure they will stay in the territory. Otherwise, Singapore will likely lure them. In 1990, the local stock market had $13.97 billion of warrants listed or 1.9 per cent of market capitalisation. By March 1994, it reached $48.85 billion or 2.1 per cent of market capitalisation. The growth of derivative warrant listings has been more spectacular. In 1990, the total market capitalisation of this volatile instrument was $1.5 billion. By June this year it had reached $11.91 billion. Over the same period, the number of warrants listed in Hong Kong had risen from 120 to 271. In the exchange's annual report for the 12 months ending June 1994, chief executive Paul Chow said: 'These developments demonstrated the Hong Kong market's depth and liquidity as a listed derivative centre, providing investors with greater flexibility and risk management opportunities.