OTC derivatives have been a focus of discussion in the
aftermath of the global financial crisis of 2008. The OTC derivatives market
had been growing at a rapid pace leading up to the crisis, helped in part by
low operating and regulatory cost, technology advancement, product innovation
OTC derivative instruments serve a different
purpose from their exchange-traded counterparts. While the derivatives traded
at exchanges are standardised, OTC derivative contracts are customised and
primarily designed to suit the specific needs of the counterparties involved.
OTC derivatives therefore allow participants to hedge firm specific risks that
would otherwise be difficult to manage using only exchange-traded derivatives.
The global OTC derivative market is dominated by the US and Europe,
with Asia accounting for less than 10% of notional outstanding. Even within
Asia, trading activity is primarily dominated by the four advanced countries of
Japan, Singapore, Hong Kong and Australia, which together account for over 90%
of derivative trading volume in Asia. The OTC markets in the emerging Asian
economies are not only small in size, but they are also less developed. Most of
the products are ‘plain vanilla’ in nature and, as a result, the OTC markets in
these countries are at a very early stage of development.
Conservative regulations, lack of investor awareness, a limited product
universe and the largely domestic nature of the financial markets have meant
the link between economic and financial activities is relatively low in these
emerging economies, particularly in the area of OTC derivatives. Some of it was
the result of the Asian financial crisis of 1997. In its aftermath, regional
regulators took note of the risks associated with certain aspects of financial
markets and instruments, and also the process of internationalisation of
markets. While this largely helped these countries in limiting the contagion of
the financial crisis of 2008, the situation is slowly changing.
Asia still represents a
region of high economic growth. When coupled with increasing global integration
this often results in high growth in international trade, in turn giving rise
to demand for instruments for risk management. Moreover, many of the emerging
Asian countries are in the process of liberalising their financial markets. For
example, China is taking measures to internationalise its currency, which
should pave the way for liberalising interest rates. Other countries too are at
different stages of economic and financial liberalisation. As trade increases
and financial markets become more open, there will be a need for hedging
instruments to hedge against currency, interest rate and other risks. This
should give rise to the growth of the OTC derivative markets. However, this
process is likely to evolve slowly as regulators in the region are
traditionally conservative in nature.
Corporates in Asia primarily
use OTC derivatives to satisfy their need for customisation. Foreign exchange
(FX) derivatives are the most popular OTC instruments used by Asian corporates.
Many corporates have regional or international operations; they use cross
currency swaps as net investment hedges for foreign currency exchange risk of
international operations. In addition, corporates engaged in significant
imports and exports use forward FX contracts as cash flow hedges for exposure
to foreign currency exchange risks arising from forecasted or committed
Interest rate instruments are also popular among Asian
corporate and many have issued foreign currency denominated debt and therefore
use cross currency interest rate swaps to hedge interest rate risk and cash
flow hedges to hedge currency risk arising from issued bonds. In addition,
corporates also engage in OTC commodity derivatives. Commodity derivatives,
particularly those involving palm oil and rubber, are in demand from Southeast
Asian corporates. Moreover, corporates in the energy and manufacturing sectors
use them to hedge against price fluctuations in the underlying commodities.
Emerging Asian countries lack the necessary infrastructure for onshore
OTC commodity derivatives trading. Corporates in those countries therefore have
to deal with international exchanges or with international counterparties.
Asian corporates typically engage in OTC derivatives for hedging, and not for
trading purposes. Therefore many of them have not yet set up the infrastructure
for exchange trading. A small percentage are using centrally cleared
derivatives at present. However, this is likely to change in the future since
regulators are now encouraging and incentivising central clearing of
standardized OTC derivatives as part of the OTC derivative market reform
While reducing counterparty risk is an obvious benefit of
using central clearing, a central counterparty (CCP) also reduces clearing
costs, as without central clearing one has to pay higher margins upfront. With
the requirements of central clearing and other associated reforms, it is argued
that the use of OTC derivatives may decline. If that happens, it will be mostly
limited to financial institutions’ use of these instruments who engage in them
for trading purposes. A Celent survey earlier this year of Asian corporates
found that the need for OTC derivatives for hedging purposes is likely to
increase. This is not surprising, since the primary objective of some of recent
regulatory changes is to discourage speculation in this segment and encourage
Non-financial corporates accounted for around 20% of OTC derivative trading
in the emerging Asian economies, while they accounted for only 6% in the four
advanced countries. This indicates the involvement of real economic factors and
trade related activities are higher in the emerging country OTC markets. It
also reflects the fact that in advanced countries large dealers and other
financial institutions (FIs) engage in significant trading and market-making
activities in the OTC space.
Corporates’ high share in the emerging
countries OTC market is likely to continue or even increase as the real
economic output of these countries grows. This will be driven by economic
growth, more international operations and trading activity of local firms,
liberalisation of financial markets and regulatory initiatives facilitating
more cross border trading. The developments in the emerging economies will also
contribute to the growth of OTC activity in the advanced countries,
particularly in Hong Kong and Singapore, as a significant proportion of
activity in those markets comes from investors in the neighbouring countries
who cannot meet their demand in local markets.
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