Credit derivatives in Asia are growing in volume, sophistication and variety. Though still a small part of the global industry, they are increasing their impact on the world markets.
“A lot of people think of Asia as unsophisticated,” says Eric Slighton, head of credit derivatives in Asia Pacific for Barclays Capital. “It’s true that it’s much less liquid [than the US and Europe], but there’s a large body of investors that are technically quite sophisticated here.” In particular, Slighton notes a willingness to embrace the quantitative nature of these investments, since the region is home to many mathematically adept investors. “The region is receptive to technical complexity, and investors that have put a lot of time into understanding these structures are relatively good at making intelligent use of them.”
In terms of product, the derivatives that have been originated in London and New York are making their way east, especially through the structured product market. “Where default swaps were mostly on investment grade corporate credits, now we see them becoming more and more prominent across other asset classes: asset-backed securities, high yield, leveraged loans,” says Anirban Lahiri at Deutsche Bank. “All these asset classes are developing parallel synthetic markets together with the traditional cash market.”
Asia’s not driving a lot of this, but it is catching on. “Asia is more a recipient of innovation than a driver of it,” says Lahiri. But everything that exists elsewhere in the world is making its way here. Whereas the synthetic collateralized debt obligation (CDO) market in Asia was until recently limited to investment grade structures, it is soon likely to embrace synthetic loan structures, common in Europe and the US.
Unsound evidence
Precise numbers are difficult to come by in credit derivatives. For one thing, they’re unreliable: while derivatives are often held to maturity, people can change their positions around several times before that maturity is reached; different approaches to netting those positions in statistical research can skew the numbers dramatically. The British Bankers Association, which publishes benchmark research in this area, does so only occasionally, and the numbers it released in September 2005 in many cases only identified volumes applying at the end of 2003.
Nevertheless, it gives some guidance: it estimates the size of the global credit derivatives market will hit $8.2 trillion this year, and also suggests that the Asian percentage of that total, from 8% in 2003, will reach 10% in the course of 2006.
Bankers in the region say volumes are growing, as derivative desks move beyond an initial stage of building familiarity with products and begin selling structures other than the plain vanilla CDO and collateralized loan obligation (CLO) notes. “The main area of innovation among credit derivatives investors who’ve already made a number of investments is to find different assets or managers that can provide some variety, access to different markets,” says Slighton.
One distinctive trend in Asia is that structured products backed by credit derivatives have relatively higher volumes than the underlying derivatives themselves, in comparison to the US and Europe. “Structured products are bought by buy-and-hold investors, and the proportion of them in Asia is bigger than traders and high turnover groups like hedge funds,” says Lahiri.
Volumes will be helped by the fact that the list of names and credits upon which credit derivatives can be based is broadening. “It grows as the liquidity of the Asian bond market grows, and new issuers are added to the list,” says Slighton. “It also grows as credit improves among higher-yielding names.” Examples would be Indian companies entering the liquid market on the back of the many convertible bonds they have issued in the international debt markets over the last 12 months.
Indian support
The industry will be bolstered further if the regulatory regime relaxes in some of the larger domestic markets of the region. Credit derivatives are essentially illegal in India, in that there is no body of regulation allowing banks to do them, but when those regulations come through, India is considered a natural market for credit derivatives, given the depth of the rupee-denominated corporate and bank bond market.
The problem is that, for markets with regulators still trying to get to grips with their own domestic issues, credit derivatives create a problem. “It’s hard to mix a highly regulated market with derivative tools,” says one credit derivative expert. “Derivatives allow you to transform bonds. That’s hard to address from a prescriptive regulatory perspective.”
It will probably be resolved, though. “After the Asian debt crisis, countries in Asia began to realize how important it was to have a domestic bond market: it’s a national asset,” says another banker. “There is a fair amount of will to develop these things but regulators go at their own pace. Some time in future, in markets like India, Korea and Taiwan, we will see growth in derivative forms on debt and credit, and it’s going to be very interesting to follow.”