Supervision and Disclosure of Derivatives Trading in Hong Kong

Speeches

23 Jun 1998

Supervision and Disclosure of Derivatives Trading in Hong Kong

David Carse, Deputy Chief Executive, Hong Kong Monetary Authority

(Speech to the Hong Kong Financial Markets Association)

Ladies and Gentlemen

It is a pleasure to be here today to talk to you about the supervision and disclosure of derivatives in Hong Kong. In fact, it is a relief to be talking to you about something other than the financial crisis in Asia. Explaining how the crisis arose and why it has become so severe is now a major preoccupation of commentators around the world. Much of the explanation has centred on the weaknesses of banking systems in the region and the losses that they have suffered. The main cause of these losses has not been involvement in complicated financial instruments but straightforward bad lending, in particular to overheated property and stock markets and to over-leveraged and uncompetitive companies. Much of this lending was in turn financed by foreign banks who pumped short-term funding into the region, only to withdraw it when the going got rough. The Asian crisis has therefore reinforced the point that despite all the advances in financial engineering that have occurred in recent years, it is still poor lending that gets most banks into trouble. The main priority for banking supervisors must therefore be to encourage prudent lending policies and procedures.

Having said this, derivatives have figured at various stages in the Asian crisis and some of the risks that they pose have been demonstrated in particular episodes. We have seen for example in the forward sales by the Bank of Thailand of US$23 billion of its foreign currency reserves that lack of transparency can be a feature of off-balance sheet transactions, and that there will be an adverse market reaction when the truth becomes known. We have also seen in the dispute between a US investment bank and some Korean institutions that there is the risk that the losing parties in derivative transactions may claim that they were not fully informed about the risks, leading to a refusal to meet their obligations. Finally, it has become apparent that the on-balance sheet debt of the Indonesian companies, which is already large enough at US$80 billion, is likely to be swollen further by the off-balance sheet exposure that they have incurred from foreign currency and interest rate swaps.

Even in a sophisticated financial market like Hong Kong the role of derivatives over the last few months has been shrouded in some controversy. This centres particularly on the issues of whether derivatives make it easier to launch a speculative attack on the currency and whether they add to market volatility. It is certainly the case that the form of a currency attack in Hong Kong does typically does take place through a forward sale of the Hong Kong dollar using the TT swap market. Thus a speculator shorting the Hong Kong dollar does not really have to commit any resources other than the credibility of its name. The fact that the TT swap market is active, liquid and deep probably does make it easier for a speculator to go short on the Hong Kong dollar. However, in these circumstances we would expect the banks to be cautious not to inadvertently fund speculators, thereby exposing themselves to the risk of a liquidity squeeze. The correct response is therefore for the banks to widen the bid and offer spread of TT swaps thus raising the cost of taking up the speculative position. The banks are now alert to this and we see this reflected in the speed with which the prices of the TT swaps and the interbank interest rates for term money, move. This quickly helps to choke off speculative selling pressure on the Hong Kong dollar.

Of course, it has been suggested that the speculators are well aware that they cannot knock the Hong Kong dollar off the peg and that their real motive is to push up interest rates to benefit from short positions that they have taken in the Hang Seng Index futures market. While the possibility of such market manipulation cannot be ruled out, there is no evidence that it has actually occurred. It is however something that we need to be on the alert for and the HKMA accordingly maintains close liaison with the securities regulators on possible market irregularities.

There is also the concern that the equity derivative contracts can add volatility to the cash market and end up driving it. This can happen during periods of stress. It does seem to be the case in Hong Kong that the dynamic hedging activities of issuers of call warrants can help to exaggerate the fall in the cash market as the issuers offload their hedged positions in the underlying stocks. This is why the Stock Exchange is planning to tighten the rules and practices for derivative warrants. On the other hand, it is also the case that the existence of stock index futures can help to reduce market volatility - for example, by providing a mechanism whereby issuers of call warrants can hedge their risks without having to sell in an illiquid cash market.

Arbitrage activities between the futures and the cash market can also help to reduce volatility. When the stock market is falling sharply as it was about a week ago, the arbitrageurs will come in to buy the cash market and sell the relatively expensive stock index futures. This will help to break the fall in the cash market and help it to achieve a softer landing.

The stock index futures market, and the other derivatives markets in Hong Kong, can of course be a vehicle for outright speculation. But they are also a force for good in terms of redistributing risk and increasing market efficiency and liquidity. They are certainly an indispensable part of a modern financial system such as Hong Kong's. As a banking supervisor, I would certainly expect to see banks in Hong Kong using derivatives to reduce risk. An obvious example is that banks should be using interest rate futures, caps and swaps to protect them against the spikes in interest rates that are an occasional feature of Hong Kong's currency board system. I am glad to say that the HIBOR futures contract is currently achieving record highs in terms of daily volume and open interest and that the local banks are showing increased interest in the use of the contract as a hedging tool. Similarly, I can see great potential for banks to use credit derivatives such as credit default swaps to trade and insure against the risk that borrowers will not repay. As I pointed out earlier, credit risk is still the main risk faced by banks. Credit derivatives have the great advantage that banks can adjust the exposure to individual customers while retaining the business relationship with the customer. They also provide a means of unbundling the credit risk component in investments such as bonds, leaving only the market risk to be managed. Finally, of great significance for banks in Hong Kong is the ability to use credit derivatives to reduce portfolio risk, particularly in relation to property exposure.

The use of credit derivatives is still its infancy in Hong Kong, but the market is growing very rapidly elsewhere. According to a recent report, the total outstanding value worldwide for credit derivatives grew to US$170 billion at the end of 1997 from US$40-50 billion a year earlier. The figure is estimated to reach US$740 billion by the end of 2000. Much of the growth over the last year has been attributed to the desire of banks to transfer the credit risk on emerging market bonds as a result of the Asian crisis.

The size of derivative markets and the speed with which they grow help to explain some of the apprehension that surrounds derivatives. If something does go wrong at the market level or at the individual firm level there is a potential for it to go wrong in a big way. The collapse of Barings is the classic example of this. But this is only one example of a series of derivative-related problems that have emerged in recent years, even in supposedly sophisticated market participants. This has produced a sharp escalation in publicly disclosed derivatives losses from US$2.2 billion in 1992 to US$21.4 billion as at August 1997. The response to these kind of problems, and to the allegations that derivatives add to market volatility, cannot be to ban derivatives. That would be totally impractical in today's liberalized markets. The objective therefore must be to ensure that the risks are properly controlled at both the market and the individual participant levels.

I will now go to talk about how the HKMA, in its role of banking supervisor, tries to achieve this objective in respect of derivatives. Our focus of attention is on three main areas: the encouragement of sound risk management systems in banks; ensuring that banks have adequate capital to support the risks; and promoting greater transparency about the size and nature of the derivatives market and individual banks' participation in it.

As regards risk management systems, much of the focus on this issue by both banks and supervisors in recent years can be traced to the growth of derivatives. This is partly due to the complexity of some of the instruments, which increases the need for more sophisticated systems of control. But it also reflects the fact that the capacity of derivatives quickly to change the risk profile of a bank makes assessment of its financial condition at a particular point in time less meaningful. This has led to greater emphasis by supervisors on satisfying themselves that banks and other financial institutions have adequate systems in place for measuring, managing and controlling risk on an on-going basis. The new approach is essentially forward looking and shifts the focus of attention more to processes rather than historical financial performance.

The key elements of a sound risk management system have been spelt out in guidelines issued by the Basle Committee. In particular, there is emphasis on the role of the board of directors in setting the overall risk appetite of the bank and approving policies and procedures designed to ensure that the risk exposures incurred by the bank are consistent with that appetite. These policies and procedures must be designed to identify and measure the various types of risk that the bank is running across its various business units and to enable these risks to be monitored. This latter task should be fulfilled by an independent risk management unit that has a reporting line to senior management. At the operating level there must be basic controls in place such as segregation of duties to ensure that transactions are carried out in accordance with management's intentions.

The HKMA has issued two sets of guidelines on risk management of derivatives and we have formed a specialist team to conduct examinations of the systems used by those authorized institutions that are active in trading derivatives and other financial instruments. This has uncovered weaknesses in internal controls in a number of institutions, usually involving a basic lack of segregation of duties. In such cases, we require the institution concerned to undertake the necessary improvements in its systems.

However, risk management is not the whole story. Even in well-run trading operations it is possible that losses may occur as a result of unexpected market movements and it is thus necessary to ensure that banks have sufficient capital to be able to withstand such losses. The existing capital adequacy framework in Hong Kong is based on the 1988 Basle Capital Accord that almost exclusively deals with credit risk. In 1996, the Basle Committee amended the Accord to take account of market risk and we in turn amended our capital adequacy rules in Hong Kong to take account of this.

The effect of this is that banks that are involved in trading derivatives and securities have to calculate two capital ratios, before and after adjustment for market risk. In fact the difference between the two is not very great: on average the effect of the inclusion of market risk is to reduce capital ratios by only 0.13%. This reflects the fact that locally incorporated banks in Hong Kong are not in general incurring much market risk from their trading activities. Notwithstanding this, we are prepared to give institutions the opportunity to economize still further on the use of capital by allowing those who are qualified to do so the alternative of using their own internal statistical models to calculate the capital requirement. This is in keeping with the Basle Committee's objective of giving banks every opportunity to improve their own internal risk management. However, modelling is not an exact science. The model has to be right for the particular situation that is being modelled and the data that is fed into models obviously must be accurate. That is why the controls surrounding the use of models are extremely important and why models should be subject to rigorous backtesting to compare the expected changes in portfolio value generated by the model with the changes that actually occurred.

The final leg of our supervisory approach is increased disclosure about the risks being run by individual firms in their derivative activities and about the scale and nature of the derivatives market in Hong Kong.

On the first of these, it has been one of our main supervisory objectives in Hong Kong in recent years to increase the amount of information that banks disclose about their financial performance and risk exposures. The objective has been to allow market discipline to play a greater role in encouraging prudent conduct. The market can only fulfill this role if it is given sufficient information. As regards derivatives, banks in Hong Kong now provide in their annual reports a breakdown of the notional amounts by class of instrument and into those held for trading and hedging purposes. This is supplemented by figures for the credit risk weighted amounts and the replacement costs for those contracts that have a positive mark-to-market value. The banks also provide a qualitative description of the risk management policies which they use to control the various types of risk which they face as well as quantitative information, including value at risk, about the market risks which they incur from both on-balance sheet and off-balance sheet activities.

Market participants also need to know the size of the market within which they are operating, both nationally and globally, and how quickly that market is growing. A major source of such information comes from the survey that is conducted every three years by the Bank for International Settlements. The last such survey was conducted in 1995 covering 26 markets (including Hong Kong) and revealed that the notional value of outstanding over-the-counter foreign exchange, interest rate, equity and commodity derivative contracts was US$47.5 trillion at end-March 1995. Exchange rate contracts accounted for a further US$17 trillion. At that time Hong Kong was the seventh largest derivatives market in the world in terms of daily turnover. We are currently in the process of conducting the survey for 1998. This is likely to show further substantial growth in world-wide derivatives activities, although it is possible that the amount of business booked in Hong Kong may recently have suffered some decline due to the regional crisis.

In conclusion, let me repeat the point that derivatives are a vital tool for risk management. But they themselves need to be carefully handled. This requires sound management policy and control. It also requires sufficient capital to support unexpected losses if something does go wrong. The final point is that market participants need to have sufficient information about the size and growth of the derivatives market, and about the scale and nature of the risks being run by banks and securities companies in their derivative activities. This transparency complements the efforts of the supervisors to encourage sound risk management practices and promote the stability of the financial system.

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