Lending Vs Derivatives: tools for the trade

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 timely short-reporting across many markets – so you need to do your homework.”

 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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