Rules of the game

Behind closed doors, senior traders in the Asian equity derivatives business sound pretty aggrieved these days. They are reeling from what one calls a “double regulatory whammy”. First, Hong Kong legislation, expected to take effect towards the end of the year, will mean that cash-settled equity derivatives transactions must – for the first time – be publicly disclosed in some circumstances. At the same time, in South Korea, some traders at major global firms are viewing a new law intended to liberalise the over-the-counter (OTC) derivatives market as a potential threat, bemoaning tough new operating requirements that could give domestic securities houses an edge over foreign rivals.

Hong Kong’s disclosure requirements are part of the Securities and Futures Bill, an omnibus piece of legislation that consolidates and amends a raft of existing securities laws. The full bill was passed by Hong Kong’s legislative council in mid-March following 10 years of debate and countless redrafts, and will be enacted later this year.

But the key concern for Hong Kong’s derivatives executives is the move to disclose cash-settled derivatives. Firms already have to disclose cash securities and physically settled derivatives over 10% of a company’s equity capital. Not only will cash-settled derivatives be included – along with some other transactions such as share lending – but the disclosure threshold will also be reduced from 10% of a company’s equity capital, to 5%.

In addition, short positions will have to be disclosed if there is a substantial long position outstanding. If the long position reaches 5% of the company’s equity capital and the short position amounts to 1%, both positions will have to be disclosed. Previously, it was not necessary to disclose short positions at all, whether physically settled or cash-settled (although it was never possible to net long and short positions).

The impact of these changes will be felt most strongly in the OTC market, say market participants. One senior executive at a US investment bank, who describes the disclosure regulations as “draconian”, says they could drive OTC derivative business away from Hong Kong. “[The new regulation] goes further than anywhere else in the world. The SFC [Securities and Futures Commission] seems to want this regulation because it is cutting edge,” the executive says.

Such criticism is strongly refuted by Mark Dickens, executive director of the SFC, Hong Kong’s regulator. Major shareholders have to disclose cash-settled long positions under US legislation, while much of Asia requires disclosure of physical shareholdings over 5%, he says.Dickens, who heads the SFC’s supervision of markets division, argues that the market effect of cash-settled transactions, and the relevance of information about such transactions, is no different to that of physically settled deals. While cash securities and physically settled derivatives positions have to be disclosed because they result in an actual registered change in ownership, cash-settled derivatives can be used to influence the share price, even if they do not give ownership of the share. And with the small public float required for listed shares in Hong Kong (only 25% of issued shares need to be tradable in the local market), there is the potential for price manipulation using cash-settled derivatives in a non-transparent market. “I can see no reason why the transaction should be transparent if physically settled, and non-transparent if cash-settled,” he says.

Equity derivatives traders do not dispute the good intention of disclosure, but are more concerned about the consequences, for their firms and their clients. Chin-chong Liew, a partner at law firm Allen & Overy in Hong Kong, criticises the complexity of the new disclosure regulations, noting that the resulting administrative burden and extraneous information will “stifle innovation and derivatives trading”.

The regulations will require that all positions across the firm will need to be aggregated, meaning that institutions will have to rapidly collect data across a range of separate business units. “The IT costs will be the real killer,” says one Hong Kong-based executive at a global bank. “If you tried to set up a full system to comply 100%, it could cost between $10 million and $20 million, as a rough estimate.”

And it is quite conceivable, adds Chi-Won Yoon, head of equity risk management at UBS Warburg in Hong Kong, that firms could inadvertently find they have crossed the 5% threshold, under certain circumstances such as client facilitation for agency transactions, or correction of error trades.

A big problem is that one transaction with a client can generate several internal transactions between different parts of a firm, perhaps involving the London-arm, and various offshore vehicles registered in say, Bermuda and Delaware, according to James Rodrigúez de Castro, head of equity trading at Merrill Lynch in Hong Kong. This represents an enormous data-gathering exercise, he says. “All these internal ‘hops’ need to be separately catalogued, aggregated and eventually disclosed. It may be that, in the interests of safety, some houses will simply disclose everything, whether the transactions exceed 5% or not.”

The SFC insists that transactions between wholly owned subsidiaries of a financial institution do not have to be individually disclosed under the new legislation, only the group-wide position. And Dickens does not believe the compliance costs will be particularly high. “All the houses should know their overall exposure, through cash equities and derivatives, to particular stocks. That is just good risk management.”

But whatever problems the new regulations cause for investment houses, it is the impact on corporate clients that causes the biggest concern. Many of Hong Kong’s companies are controlled by Chinese individuals or families, and these individuals have been among the biggest users of cash-settled OTC equity derivatives to reduce or increase an interest in their own companies, says the head of equity derivatives at one global institution. If these families buy and sell shares in their own companies, this sends a signal to the market and causes speculation, so they have used the OTC options market to hide their moves. “There is no doubt many transactions are driven by the ‘non-disclosure’ factor,” he says, adding that a lot of this business will now disappear.

Meanwhile, developments in South Korea are also being viewed with some disquiet. On the face of it, a presidential decree allowing foreign and local securities houses to freely trade won-denominated OTC equity derivatives from July 1 should be very welcome. The exchange-traded Kospi 200 options market is the most actively traded in the world, while turnover in the Kospi 200 futures is regularly between four and five times the turnover in the underlying cash market, according to the Korean Stock Exchange. In this light, the liberalisation of the OTC market is eagerly anticipated by both foreign and domestic houses.

What has stunned foreign securities firms, however, is the proposed high level of capital required for houses undertaking OTC derivatives business – 300 billion won ($226 million) and a 300% capital adequacy ratio proposed for transactions.

The precise requirements remain unclear, with the fine details still being worked out by the Ministry of Finance and Economics and the Financial Supervisory Service (FSS), the market regulator. But if the capital requirements remain at this level, it presents a huge obstacle for foreign firms, says Charles Kwak, legal counsel at Morgan Stanley in Hong Kong. “It probably means that most of them will not be able to participate” in the new OTC market, which includes equity swaps and options, as well as interest rate and forex derivatives (but not credit or commodity derivatives). The high capitalisation requirement is “unique in Asia”, Kwak adds.

Several foreign houses say they are considering whether to enter the OTC market, but view the capitalisation requirement as a major deterrent. The Seoul subsidiaries or branches of foreign firms will not be able to draw upon any part of their parent company’s balance sheet in reaching the capitalisation requirement. Foreign firms will therefore have to decide whether the potential for profits outweighs the extra cost of capital.

Some analysts suggest the requirement might yet be reduced because probably only six or seven of the 40 domestic securities houses – among them Samsung Securities, Daewoo Securities, LG Securities and Hyundai Securities – are believed to have capital of 300 billion won. But a reduction in the requirement seems unlikely for some time. “The regulators view OTC derivatives as a very risky kind of business, where firms can lose a lot of money. At the start, the regulators will be very cautious,” says Hochul Shin, supervisor of business conduct in the securities supervision division of the FSS.

Although the new decree allows securities houses to undertake OTC derivatives activities for the first time, it has always been possible for banks to undertake this type of business, with the prior approval of the country’s central bank, the Bank of Korea. In practice, though, domestic banks have not had the capability, in most cases, to provide this product. Consequently, much of the business has been conducted for local companies by foreign banks, using their offshore securities arms. There’s no doubt that this activity, chiefly in dollars, has been lucrative for foreign banks. But with the large and aggressive domestic securities firms expected to quickly capture much of the business that previously went offshore, deciding whether to compete is going to be “a tough call” for the foreign firms, says a local lawyer.

Dickens’ defence Hong Kong’s new disclosure provisions for cash-traded over-the-counter equity derivatives will not “significantly” reduce levels of market activity, predicts Securities and Futures Commission (SFC) executive director Mark Dickens, who has been heavily involved with the legislative proposals for five years. “We will lose – and would like to lose – those transactions that cannot bear the light of day, what you might call the dodgy transactions. Sunlight is the best disinfectant,” Dickens says. “We hope to limit the loss of legitimate business, which is why we have spent so much time listening to the concerns of the houses and modifying the legislation accordingly. All that the houses are being asked to disclose is the size and direction of a position – not the strike price, the premium or the period.” The only reason for treating cash-settled and physically settled derivatives differently, he argues, is historical. The need to disclose physical positions originally arose because of questions about voting rights and control of companies. But in the particular case of Hong Kong’s listed companies, with their small public floats, there is some scope for price manipulation. “There have been situations where particular stocks have been significantly affected by the use of cash-settled derivatives,” he says. Dickens also notes that the SFC has powers to make changes to the regulations in the future if they prove cumbersome in particular areas.