Derivatives and Securitization

Both Derivatives and Securitization

represent
risk-transfer tools derived from
Asset Securitization in East Asia
underlying assets
ASEAN+3 Workshop
Shanghai National Accounting Institute

Shanghai
9. November 2005
Oliver Fratzscher
World Bank

Page 1
 Outline of Presentation

Hypothesis: OTC derivative markets are necessary

for securitization to be sound and efficient (not
sufficient, A+B+C also necessary)
1. What are Securitization and Derivatives ?
2. How large are Asian derivative markets today ?
3. Which building blocks are necessary ?
4. What sequence is needed to develop derivatives ?
5. Which are key technical & prudential policy issues?
6. Conclusion and Discussion

Page 2
 1. 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

A B C D
Governm Banking Legal & Derivativ
ent Intermed Collater es
Benchma iate al Interest
rk Products Framew Rate
Bonds ork OTC
Deposit → Loan → Mortgage → Page 3
 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
Alan
costs." 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
Warren
potentially lethal.” Buffet
Page 4
2. Global derivative markets
rapid OTC growth and increasing ETD
products
OTC Derivative Markets 2004 Exchange-Traded Derivatives

FX
US: 40%
Interest
EU: 40%
12% Gov-Debt 26%
Asia: 20% 65%
Equ-Index
75%
ABS+MBS: 4% Stocks
$53 trn notional
$248 trn notional Comm $10 trn mkt value
$9 trn mkt value Credit
250,000 60,000

200,000 OTC (bar) and Exchange-Traded (line) Derivatives

50,000

40,000
150,000 (notional outstanding, in billions US$)
30,000
100,000
20,000

50,000 Annual growth rates exceed 30% 10,000

0 0
1991 1993 1995 1997 1999 2001 2003

Sources: BIS (Dec 2004) ; FIBV (Jan 2005) Page 5

 Asian derivative markets
banks in OTC FX and security firms in
equity ETD

Daily Turnov
Japan
ources: Triennial Central Bank Survey (BIS, 2005) and World Federation of Exchanges (200

Korea FXFutures
Korea Bond Futures
HKGEquity Options
Banks

Singapore
Securities
Korea Equity Index Options Institutions
HKGEquity Index Options Retail
Foreign
Korea Equity Index Futures
HKGEquity Index Futures

0% 20% 40% 60% 80% 100%

Page 6
 3. Building blocks for
Derivatives
MBS requires similar components as
derivatives
Necessary components for
MBS
Product Regulation Infrastructure
Design
  Regulatory  Industry guide
 Push by approval, product on
originator for risk understanding standardized
transfer tools products
 Legal clarity:
 Pull by default,  Credit ratings
investors for repossession, industry and
yield and duration enforcement standards

 Risk-based  Accounting  Best practice

pricing, rules, transparency, risk management
benchmark, corp disclosure
bonds  Suitability
 Clear tax criteria for
Page 7
 Building blocks
for derivative markets
Product Regulation Infrastructure
Design
  Lead regulator,  CCP, ISDA
 Economic capital rules, master, close-out
rationale for reporting standards netting
hedging needs
 Legal clarity:  Demut.
 Liquid cash ISDA standards, exchanges,
market, long and enforceability strong capital,
short positions margins
 Accounting
 Market rules, transparency,  SRO rules
determined prices, disclosure enforced
interest/FX rates with limits,
 Level playing monitoring
 System field, tax
Page 8
 Derivatives enhance financial
development
win-win instruments for banks,

corporations,
… beyond rice trading in Tokyo and tulip trading investors
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”

Page 9
 Rewards and risks of
derivatives
market development combined with
prudential issues
 Market efficiency  More leverage
 Risk sharing and transfer  Less transparency
 Low transaction costs  Dubious accounting
 Capital intermediation  Regulatory arbitrage
 Liquidity enhancement  Hidden systemic risk
 Price discovery  Counter-party risk
 Cash market development  Tail-risk future exposure
 Hedging tools  Weak capital requirements
 Regulatory savings  Zero-sum transfer tools

Page 10
4. Schematic development of D
markets
cash liquidity + sound regulation + solid CCP
infrastructure
Cash MarketsCash Markets
liquid, efficient,
liquid, efficient,
Investor Base integrated; Regul
Investor Base integrated; Regul&& Legal
Legal
hedging
hedgingneeds, benchmarks Framework
needs, benchmarks Framework
products, IT,
products, IT, derivatives
derivativeslaw,
law,
lower
lowercosts
costs SRO
SROfunction
function
Cash
OTC
OTCLicense
License Repo
RepoMarkets
Markets
reg approval,
reg approval, effective
effectiveshort,
short,
CP
CPcredit
creditrisk,
risk, margin trading;
margin trading;
OTC

Repo
swaps
swaps IR &FX
IR & FX Derivative
Derivative secur.
secur.lending
lending
Market
Market
Building
Building
Accounting
Accounting Blocks
Blocks Intermediary
Intermediary
adopt
adoptIFRS,
IFRS, Licensing
Licensing
MTM, IAS39,
MTM, IAS39, qual.
qual.investors,
investors,
full
fulldisclosure
disclosure training
training
ETD
Design
DesignCCP
CCP Taxes
Taxeslevel
level
close-out net,
close-out net, playing field
playing field
ISDA
ISDAmaster,
master, Exchange
Exchange cash=repo=D,
cash=repo=D,
enforcement platform, links,
enforcement platform, links, avoidtrans
avoid transtax
tax
capital, margins,
capital,margins,
first
firstfutures
futures
Page 11
 Link between cash and D
turnover
liquidity corridor for emerging and developed
markets

100,000
5:1
Derivatives Turnover

USA

10,000 GER 1:1

KOR UK
JAP
1,000 SIN HKG
AUS ESP
IND
100
100 1,000 10,000 100,000
Cash Turnover
Source: World Federation of Exchanges (Dec 2004)

Page 12
 Derivative products in Asia
three tiers of exchanges offer six
product categories
Australia China Hong Kong India Indonesia Japan Korea MalaysiaPhilippinesSingapore Thailand
Index
Futures           
Options           
Options on futures           
Stock
Futures           
Options           
Currency
Futures           
Options           
Interest rate
Futures           
Options on futures           
Bonds
Futures           
Options on futures           
Commodities
Futures           
Options on futures           
# 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
Sources: Websites of regional exchanges, WFE, Futures Industry Association, and HK-SFC (2004).

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 Derivatives infrastructure
in Asia
liquidity indicators improve but
regulation still evolving

Liquidity
Fixed incom e benchm
Notes: denotes best practice ; denotes progress on existing deficiencies ; and denotes 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

Fixed incom e liquidity

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.

Page 14
 5. Technical issues
critical 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

Page 15
 Policy issues
transparency + monitoring + oversight
enhance stability
 ETD vs OTC: Investors prefer Exchanges – Banks prefer OTC Markets
shifting 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

Page 16
 6. Conclusion – main
messages
1. Derivatives can enhance financial intermediation and
economic growth but require efficient underlying cash
markets and sound infrastructure
2. Modern exchanges with leading risk systems (CCP,
dynamic margins, buffer) can enhance transparency,
safety, and competitiveness of a financial system
3. Prudential supervision is critical for FX and credit
derivatives which could undermine fixed prices, pegged
FX regimes, and credit policies
4. Securitization products should be grounded on sound
OTC derivative market structures.

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 Discussion

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