Lending Vs Derivatives: tools for the trade
Being able to take risk on or off quickly can make the difference between banking alpha and taking a big hit. In the markets across Asia Pacific in 2017 – which will be characterised by “low returns and high volatility” according to asset manager Newton Investments – investment windows will be tight and speed is of the essence.
In many markets around Asia this can present
challenges. Limits on ownership of cash instruments, liquidity quality, market
maturity and local regulation all have a bearing on market accessibility.
“As
an investment professional you are always looking at the risks and the cost for
entry and exit of an investment, and the risk associated with sustaining an
investment in a specific market,” says Hong Kong-based hedge fund manager
Stephen Howard, who left Enhanced Investment Products on 27 February 2017. “Markets
with sufficiently liquid hedging solutions are going to be gravitated towards
by most institutional investors or investment firms because they need to have decent
two-way liquidity for the risk pricing of those hedging solutions.”
Given
the diversity of market structures and rules within local Asia Pacific
jurisdictions, portfolio managers and trading desks across institutional and
alternative investment firms need to be aware of the mechanisms available for
accessing liquidity quickly, for example using repos, listed derivatives or
exchange-traded funds in lieu of cash instruments.
“At
the individual security level, it really comes down to liquidity and cost,”
says Paul Solway, regional head of securities finance in Asia Pacific at BNY
Mellon. “Markets with good depth of inventory where borrowing fees are low
would suit borrowing, whereas markets that do not allow for or restrict
borrowing/lending or shorting in any way, such as India and Taiwan, presents access
to futures and options as useful alternatives.”
Among asset owners, as a consequence of the
low rate environment, there is growing interest in alternative routes of alpha
generation that can be used to help enhance performance.
“There
is a spotlight being shone on products such as securities lending, where there
can be opportunities for a stream of revenue that comes at relatively low risk,”
says Dane Fannin, head of capital markets at Northern Trust. “We are seeing
beneficial owners that previously had no interest in securities lending
suddenly now showing a lot of interest in it. That dynamic is probably going to
continue in the near term.”
The
volatility of emerging markets relative to developed ones can make trading them
as much an art as a science. The depth of lending liquidity can present
challenges, says Solway, noting that putting on a loan can be easier than
taking it off.
“That is where the skill comes in,” he says. “As
history has shown, some regional markets have resorted to short-sell bans in
times of extreme volatility. Fines or penalties, buy-ins, and trading restrictions
are all in play for failing trades
Regulators can impose hurdles for investors
that would not typically be a consideration in other markets, for example
relating to settlement.
“In some of the markets in Asia there are
punitive settlement structures, which can result in severe economic penalties
for investors,” Fannin says. “These drive non-standard requirements such as
pre-notification of sales, for example, or could affect the way you need to
structure operational support. While these might present barriers for some
investors initially entering the market, they also present an opportunity for
those who are able to navigate these complexities successfully with their
providers to achieve first-mover advantage.”
He
gives the example of Taiwan, where the settlement structure typically requires
pre-trade notification. Lenders or asset owners that were able to offer
pre-trade notification when the market opened were able to enter that market
with their providers, gaining greater advantage.
Local
cost drivers
Using
derivatives is equally dependent on local rules and there are clear cost
drivers for utilising them where the market allows it, says David Strachan,
head of clearing at UBS in Hong Kong.
“The
most notable shift in client behaviour has been the migration from bilateral
structures onto exchanges and into cleared structures, as clients’ bilateral
counterparties have been calling for greater capital contributions by way of
margins,” he says. “If you look at the transaction fees for creating equity
exposure via futures across the major markets in Asia you will find it averages
a quarter of the cost of gaining the same exposure through the swap market.”
Asia Pacific equity and equity derivative
markets saw a massive decline in trading volume in 2016 compared with the year
before, according to data from the World Federation of Exchanges, an industry
body. While cash equities fell by 26.1% year-on-year, stock options and single
stock futures declined by 10.66% and 16.88% respectively while index options
and futures saw falls of 43.11% and 49.57%. Interest rate options and futures
also fell 16.12% and 14.02%, although bond trading volume by value increased
51.9%.
Australia,
Hong Kong, Japan and Singapore, which all have mature capital market rules and infrastructure,
follow international best practice in terms of access, allowing omnibus
accounts, give-ups and post-trade allocation. Regulatory hurdles to trading
listed derivatives in other jurisdictions can mean that not much activity takes
place in the market.
Knowing in which markets specific instruments
work well can create a greater range of choices for buy-side investors.
Building the capacity to negotiate unique structures along with understanding client
demand can help investment managers support end-investors more effectively.
“The
big index futures markets attract great interest,” notes Kent Rossiter, head of
regional Asia Pacific trading at Allianz Global Investors Asia Pacific. “A lot
of clients don’t like buying the underlying if they just want broader index
level exposure. Korea and Taiwan for example have expensive 30 basis points (bps)
stamp duty on underlying share sales, so for some traders they’d be fine just
getting index exposure, which is much cheaper via futures.”
India
has one of the largest and most liquid single-stock futures markets globally,
largly as a result of investors wanting leverage and to save on security
transaction tax (STT), which with a couple of other fees adds up to a cost of
around 11bps each side of buying and selling single stock shares, plus
commissions.
“Indian
single-stock futures offer leveraged exposure, with only about 10% margin being
posted, and incur 1bp STT market charges each side versus 11bps on cash trades,”
says Rossiter. “So at only a tenth of the cost, and a tenth of the value needed
for margining, it’s an attractive proposition for short-term traders and
arbitragers.”
Around
90% of the approximately 240 Indian single-stock futures trade at premiums to
the local shares, but since the annual roll cost can often be 6% they are not
products for buy-and-hold investors, Rossiter notes. “Furthermore, the real
liquidity is still seen in the top 25–50 stocks, but for those investors
wanting to express and profit from negative views on stocks, the use of futures
is one route.”
Underlying liquidity
Keeping
on top of the liquidity of instruments and their underlying securities is
enormously important for investors. Getting under the skin of a market can
unearth risks that might not be apparent at first glance and ensure a fund is
picking its markets on a fully-informed basis.
“Listed
single-stock options are accessible in Hong Kong, however you are probably only
looking at maybe five underliers where you can get real two-way liquidity from
a broad enough range of market makers and liquidity providers to a reasonable
maturity profile – beyond three months,” says Howard. “This can be a ‘mouse
trap’ where the secondary liquidity for that option can be a real challenge to
source at a fair market price. As a market professional you have got to acknowledge
that there isn’t that liquidity, and therefore focus your asset allocation on
where you can find that two-way liquidity.”
He
notes that market structure and the architectural structure of prime brokers
are both very important in supporting alternative investment firms in using
these instruments. “Where they specialise in a discrete range of products – and
offer an open, transparent model for everything else – they are easy to work
with,” he says. “An investment theme will be correct periodically and, where
the market structure allows investors to asset allocate with ease, they will
take those periodic opportunities.”
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