Outside the straightforward spot markets, an entire industry exists in building structured products to help clients hedge exposure, or simply to help them speculate. In Asia as elsewhere, the market is filled with innovation—occasionally to the point where one wonders whether it's all necessary.
The market for these products needs to be clearly defined. "Essentially there are two types of client out there who are players in foreign exchange," says Lutfey Siddiqi at Barclays Capital. "The active risk-takers, for example hedge-fund clients who are looking to exploit volatility to obtain superior returns; and risk managers or hedgers who are more into risk reduction, [and] are primarily passive players in the currency market."
Siddiqi argues that the approach for both types of client should be very different and, indeed, different products are emerging for each. The latter camp, typically, is interested in products that offer some enhancement over vanilla forwards. "The holy grail is protection with participation," Siddiqi says: "You're protected against adverse outcomes, but participate if the market moves in the other direction."
An example is a straightforward purchase option, giving the right but not the obligation to buy one currency against another, allowing the client to walk away from the position if it moves against them. That sort of rationale used to be enough for corporate clients. But in the past 12 to 18 months things have changed due to shifts in accounting treatment. Sellers have to be able to demonstrate that a hedging instrument is just that: for hedging, and not for speculation, to avoid the impact of new mark-to-market requirements flowing through to the company profit and loss (P&L) sheet. "Inexplicable P&L volatility is something that clients are clearly averse to," says Siddiqi.
This has caused many people to report less interest in innovative structures, instead opting for the familiar. Larry Hsu, who runs forex for Chinatrust Commercial Bank in Taiwan, sees that happening as a consequence of the new accounting rule 34 there, imposing definitions on fair market value and accounting requirements. "Given this transitional period, when you look at the growth percentage of foreign-exchange products, it's been getting more conservative," he says. "There's no particular structure getting more popular."
Yet some houses are reporting the reverse, Barclays included. "There is a noticeable increase in the use of currency derivatives," says Siddiqi. "And that is surprising to some people: they would have expected new accounting standards to put a brake on it." He notes that in the first year of similar standards being introduced in the US and Europe, people stopped doing transactions that would have made sense from an economic point of view because they weren't sure what the accounting treatment would be. "Then a lot realized that was the wrong way round, it was quite perverse to have reporting concerns driving economic decisions." So they came back to the markets, opting instead to calculate the impact of mark-to-market requirements and using simulations to see if products still make sense, which they often do.
Bringing in new ideas
And there are a variety of options for those who do want more exotic structures. Many bigger global houses have been trying to bring G7 technology to bear in local markets. One example is BNP Paribas, which has launched a product called the CMS spread range accrual, common in US dollars, in Korea. This product involves taking a view on the difference between the five- and two-year Korean won swap rates. It's a product that requires the investor to take a view on the shape of the yield curve.
BNP has also had success with a commodity-basket instrument, a five-year product giving investors exposure to metals such as gold and aluminium. The innovation here has been BNP Paribas launching quanto versions, meaning they make their payout in a local currency, such as Singapore dollars. Another example is Asian currency baskets. One such product pays out in Australian dollars based on the strengthening of Asian currencies against the US dollar.
On the forex derivative side, the bank has found its knock-out forward popular. Many banks offer knock-out products, in which a particular event changes the structure of the product. If the trigger is not hit, the investor gets an attractive strike rate compared to the forward rate. And, like other houses, BNP reports growth in yield-enhancement products, notably something called the rainbow basket, in which the coupon is based on the performance of a basket of currencies with more weighting given to those that perform best.
Calyon also reports yield enhancement as a key driver in Korea, where its products reach the retail level. Here, as in Japan, a low interest rate and an ageing population starting to think about income-generating pension products have prompted people to look for products giving yield. Calyon has structured several that offer 90% to 95% capital protection as well as yield enhancement. At an institutional level, Calyon reports the beginning of interest in synthetic collateralized debt obligation (CDO) structures.
Barclays, like BNP Paribas, reports success in structured forwards, particularly knock-outs; a buyer of dollars and seller of yen, for example, who gets a rate better than the vanilla forward rate by accepting a knock-out on the upside.
The mark-to-market implications are problematic as the forward rates move around, so Barclays has structured a product in which both the strike rate and barrier level reset as a result of spot movements. It can be structured to reset as a function of time, spot movements or both.
Another popular approach is where the strike or protection rate is a function not only of one spot price, but another index or currency as well. These are called multi-factor products.
But are banks not adding a layer of complexity that stops the customer fully understanding what they're buying? "Not necessarily," says Siddiqi. "Ultimately a forward is a forward."
Deutsche Bank has built a structured note like a fund of funds, only applied to currency managers. The investor is exposed to a portfolio of these managers and the return of the note is tied to the returns those managers achieve.
Another field in which Deutsche has been active is building products for firms such as insurers, whose returns are benchmarked in local currency but make investments overseas. Deutsche builds products designed to get efficient ways of minimizing the loss of carry when the insurers move from one currency to another.
Developing alongside all of this is an increasing interest in algorithmic trading, a form of program trading that uses advanced mathematical models to make transaction decisions. Algorithmic trading models exist in the equity markets too but are becoming popular in forex. Their arrival has real implications for electronic trading platforms and the banks that provide liquidity to them. But there's no question they're on the rise. Complex, controversial and mathematically adept: sounds perfect for Asia.