Distinguished guests,
Ladies and gentlemen,
1. Good morning. On behalf of the Singapore Exchange, I am delighted that FOW has brought the Derivatives World exhibition to Singapore for the 15th consecutive year. It is always a pleasure to see our partners and customers from around the world congregated here. I would also like to extend a warm welcome to those of you here who are visiting Singapore for the first time.
2. The talk in the financial markets over the last 12 months has mainly been about the global credit crisis. Coupled with high commodity prices amid a gloomy economic outlook, it is not surprising for derivatives to once again be in the spotlight – particularly the role it plays in the financial ecosystem. Today, I propose to cover in this address the various facets of derivatives – the good, the bad and the ugly. Let’s talk about the bad and the ugly first, then perhaps we can celebrate the good!
- The “bad”
4. Since then, conditions may have grown more challenging. Following the near-collapse of Bear Stearns, questions have been raised as to the solvency of several other major financial institutions. The Chinese and Indian stock markets, after years of stellar performance, have also undergone a period of correction. And soaring commodity prices have pushed Asian inflation rates to levels not seen since the mid-1990s.
5. The derivatives markets, and in particular credit and commodity derivatives, have attracted regulatory attention against the backdrop of the current crisis. But this should be no surprise, if history is anything to go by. Derivatives were also blamed for, among others, triggering the Asian financial crisis of 1997, and even the 1987 US stock market crash before that. And let’s not forget Orange County.
6. If I may term it so, this is the “bad” side of derivatives – the potential for over-leveraging and concentration of risks within the financial system that are especially vulnerable to a sudden evaporation of market liquidity, and the consequent potential for messy unwinding of positions. Or, if I may borrow Warren Buffett’s words, derivatives may be seen as “financial weapons of mass destruction” if risks are not properly understood or managed.
- The “ugly”
8. The role of derivatives in the recent commodity price spirals has also been hotly debated. In the crude oil market in particular, the West Texas Intermediate price rose to a record high of more than US$147 a barrel on 11 July this year. This is a dozen-fold jump from less than US$12 a barrel in the space of 10 years. It has been attributed more to financial speculators than to demand and supply fundamentals, and has even prompted lawmakers to consider placing restrictions on energy trading in the US and Europe.
9. Similarly, debate has been heated on whether record high futures prices, caused by inflows of institutional investment funds, is the main factor behind the substantial increases in food prices. The price of rice, for example, more than doubled from April last year to this April. Bowing to public and political pressure, governments also shut down commodities trading in some emerging economies.
10. This lack of understanding of derivatives markets and over-dramatisation of events even among some members of the media, as well as the over-reaction by politicians, is what I would call the “ugly” side of derivatives.
- The “good”
12. First, derivatives facilitate risk transfer, enabling corporates and financial institutions to hedge against changes in raw material prices, and exchange and interest rates, among others. As financial institutions focus on de-leveraging and rebuilding their balance sheets, there is increased recognition of the need for more efficient and effective risk management. This can be made possible through the use of derivative instruments.
13. Second, rather than distorting prices, derivatives actually play a central role in price discovery. They allow investors to take short positions and to engage in arbitrage, thereby reducing the mis-pricing of assets. By providing better information, derivatives can help promote greater liquidity and efficiency in the underlying cash or physical markets.
14. It is worth reiterating and reminding ourselves in these interesting times, that the path to the “good” side of derivatives – that is, free capital market access and transparency – needs to be promoted and encouraged, not restrained.
- Role of futures markets in cash market development
16. SGX’s provision of a one-stop, pan-Asian equity derivatives platform increases trading in these products through the capital efficiency offered through margin efficiencies at one exchange. In turn, our offshore centre plays a part in boosting liquidity and efficiency of the underlying cash markets around the region to the benefit of all, as arbitrage opportunities stimulate additional activity.
17. In May this year, we launched the unique MSCI Asia APEX 50 futures contract that tracks the global MSCI Asia Ex Japan Benchmark for portfolio managers. As the first pan-Asian contract listed in this region, investors can now effectively tap into fast-growing Asian economies without having to trade into multiple markets individually – just by using one contract. It really complements our existing SGX Nikkei 225 and recently-successful SGX Nifty contracts, and allows for strategy and risk arbitrage trading with SiMSCI and MSCI Taiwan futures contracts here. It also allows for trading with contracts in other markets, growing liquidity for all.
18. Looking ahead, we will soon launch a single stock derivative product on our cash market. We hope this will allow for greater hedging, trading and arbitraging opportunities in our domestic market.
OTC vs exchange platforms
20. In many instances, concerns about derivatives and their potential systemic risks stem from a lack of transparency in the OTC derivatives market and, consequently, a lack of transparency on the concentration of risks in the financial system – that is, the “bad” fuelling the “ugly”.
21. Without a doubt, the OTC derivatives market plays an important role in enabling the innovation of new instruments and the customisation of contracts. But increasingly, the “good” or benefits of exchange trading and clearing services for derivatives contracts are being recognised. The latest and most prominent regulator to touch on this was US Federal Reserve chairman Ben Bernanke. He said that the “migration of derivatives trading toward more standardised instruments and the use of well-managed central counterparties” could have a “systemic benefit”.
22. Apart from being more liquid, offering equal access and public disclosure of prices, exchange trading and clearing also enable reduced risks in three areas.
23. First, counterparty risk. The use of central counterparties in exchange-cleared contracts provides multilateral netting across all trading parties. This significantly reduces the amount of regulatory capital required and helps financial institutions free up their balance sheets.
24. Second, operational risk. Exchange trading and post-trade processes lower operational risk by minimising manual handling.
25. Third, legal risk. For example, exchanges offer the benefit of standardised derivatives contracts without the need for the bilateral negotiation of ISDA and other complex legal agreements.
26. SGX has made some progress in offering post-trade services for OTC-traded products, and hopes to expand its current offerings. In 2006, we set up SGX AsiaClear, Asia's first and only OTC clearing service for oil swaps and forward freight agreements. Since then, the pool of trading counterparties has grown substantially to 221 as of end-June this year, with many of these being Asia-based. We are also beginning to see more interest from European players who are keen to trade with Asian counterparties and partners. AsiaClear’s unique suite of products, such as Balance-of-Month contracts on Fuel Oil, Gasoil and Kerosene, has also contributed to the rising market interest. We look forward to your continued support and participation.
- Final note
28. Overall, the developments in the derivatives market have contributed to more complete financial markets. They have improved market liquidity and increased the capacity of the financial system to more effectively price and bear risk.
29. With their greater operational efficiency and use of a central counterparty to spread credit risks, on-exchange traded and cleared derivatives have a critical role to play in the financial ecosystem. There are opportunities for exchanges and market participants to work together to collectively better manage risks in the financial system. With an expanded role in derivatives trading and clearing, exchanges too can help bring this important class of instruments further into the mainstream of financial markets.
30. If we, as an industry, continue on the path to greater transparency, product innovation and fostering freer access to global liquidity and participation, the ugly duckling called derivatives, will properly be recognised as a beautiful swan and have its proper and rightful place in the sun.
31. On that note, I would like to thank the organisers for hosting this event. I wish all of you a fruitful and interesting exhibition.
32. Thank you.
