SINGAPORE (Feb 11): Global equity markets ended 2018 on a decidedly sour note. Once high-flying technology stocks were heavily sold off, and volatility across equity markets spiked, especially in October. The key reason was that the US Federal Reserve’s hawkishness was looking increasingly out of step with emerging signs that growth was slowing. The Fed has since adjusted its rhetoric, and the nervousness has subsided. But analysts are bracing for tougher and more volatile months ahead.
This is a very favourable backdrop for derivative instruments, as hedging activity is likely to increase. “When you’ve got increased volatility in the market — the underlying market, which is the equity market or interest rate market — people tend to hedge more,” says Andrew Gilder, EY Asia-Pacific banking and capital market leader.
Uncertainty over the future direction of global equity markets is also contributing to increased trading in derivative instruments, says Conrad Huber, head of trading solutions advisory and sales at Credit Suisse Private Banking Asia-Pacific. “If people don’t know where the market will go, this is one way to park your money, [and at the same time] hedge your returns. This is especially given the geopolitical uncertainty.”
Rohit Jaisingh, head of equity products advisory at DBS Wealth Management, tells The Edge Singapore that derivatives are also used to create financial structures that allow investors to enhance their yield-seeking strategies. For instance, in the private banking space, derivatives are usually structured together with other assets. This can be customised to suit the risk-and-return appetite of investors, who include high-net-worth individuals, family offices and other institutions, he says. “It’s about flexibility.”
Huber of Credit Suisse is of the same opinion. He points out that structured products that include derivatives are easier to construct to play on an investment theme. For instance, constructing an exchange- traded fund or mutual fund on the theme of 3D manufacturing will require a prospectus to be drawn up and regulatory approvals, unlike structured products that include derivatives. “It provides easy and fast access,” he says.
Not for retail investors
These instruments are controversial, though, with some experts warning that even relatively wealthy investors might not fully understand their risks. “My stance is this: Retail investors should not try to dabble in derivative and structured products because the risk is asymmetrical,” says Benny Koh, a partner at Deloitte. “They may not be trained to trade derivatives. They may not know as much as they should know.”
Whatever the case, the increased trading activity in derivatives could be a boon for financial market exchanges that have a foothold in this field. For instance, the Hong Kong Exchanges and Clearing’s volume for futures and options surged 20% m-o-m to 24.9 million contracts in October. In 4Q2018, volume was up 6.6% q-o-q to 75.8 million contracts. At the Intercontinental Exchange (ICE), which operates the New York Stock Exchange, the monthly average daily volume for futures and options leapt 33.2% m-o-m to 6.4 million contracts in September and crept higher to 6.6 million contracts in October. In 4Q2018, volume jumped 18.2% q-o-q to 18.6 million contracts.
Closer to home, the Singapore Exchange’s total derivatives volume rose 18.8% m-o-m to 22 million contracts in October. In 4Q2018, volume climbed 10.7% q-o-q to 60 million contracts. This helped SGX achieve its highest-ever revenue contribution from its derivatives business, comprising half of its total top line in its recent results. It is also the second time in a row that its derivatives business has overtaken its equities and fixed income business in terms of revenue contribution.
“We achieved a second consecutive quarter of record performance in our derivatives business, with robust institutional demand for our risk management and hedging tools, including our MSCI Net Total Return index futures and FX futures contracts,” says SGX CEO Loh Boon Chye. “Meanwhile, investor sentiment was dampened by concerns on slower global economic growth on escalating trade tensions, which led to lower activity in our securities business along with other regional markets. Notably, we are seeing increased interest in our securities products such as our new single stock daily leverage certificates, as investors seek out more investment opportunities,” he added.
For 2QFY2019 ended Dec 31, SGX reported earnings of $97 million, or nine cents per share, 9% higher than a year ago. Total revenue also rose 9% to $224 million from a year earlier. The board declared an interim dividend of 7.5 cents per share, up from five cents last year.
Most derivatives trade OTC
In the overall scheme of things, the likes of SGX, ICE and Hong Kong Exchanges are hardly leading players in the derivatives space. Most derivatives are not traded on financial exchanges but over-the-counter (OTC) by banks and financial institutions. Data on the total volume of OTC-traded derivatives is sparse, but the data that is available suggests the business is huge. According to the Bank for International Settlements, the notional value of outstanding OTC derivatives increased from US$532 trillion at end-2017 to US$595 trillion at end-June 2018. This increase in activity was driven largely by US dollar interest rate contracts, especially short-term contracts, it says.
As for DBS Wealth Management, 95% of derivative products transacted by its clients are OTC, according to a rough estimate by Jaisingh. The remainder comprises exchange-traded products. In Singapore, these are offered by SGX and two other derivatives exchanges: Chinese-backed Asia Pacific Exchange (Apex) and ICE. Apex entered the local market last year. It offers futures and options contracts covering both commodity and financial derivatives products, with underlying asset classes in agriculture, energy, petrochemical, metal, foreign exchange, interest rates, bonds and stock indices. In particular, it offers palm olein futures that will be dollar- denominated and physically delivered. ICE, on the other hand, offers derivatives products related to energy, metals, foreign exchange and equities.
Now, regulators have been trying to get a handle on the huge OTC derivatives market. One expert who declined to be named says regulation has increased sharply in the OTC space, following the US subprime crisis that led to the collapse of Lehman Brothers in 2008. In particular, bankers are required to be more stringent on their clients’ awareness of the risks of each transaction. Also, bankers have to keep better track of transactions, as regulators are demanding information more frequently. This is costly and time-consuming, he says.
On the other hand, with the encouragement of regulators, more derivatives are being traded on formal exchanges. “So, there is a push from regulators to [introduce] more OTC products — which I guess would have been less transparent — out into the open. That’s going through clearing houses,” says Gilder of EY.
Prospects mixed for SGX
What does all this mean for SGX? Over the last few years, its equities and fixed income business has been shrinking, no thanks to the dearth of large IPOs and dwindling investor participation in the local stock market.
The total securities market turnover value was $16.7 billion in December, down 22% m-o-m and 13% y-o-y, over 20 trading days. There were 21 trading days in November 2018 and 20 in December 2017. Securities daily average value (SDAV) was $837 million, down 19% m-o-m and 13% y-o-y. There were only three IPOs in 2QFY2019, compared with seven a year ago. Value of funds raised from IPOs plunged 98% y-o-y to $20 million.
Since taking the helm at SGX, Loh has been transforming the bourse operator into a multi-asset platform. The thriving derivatives business is one reflection of that. Its popular products, such as the SGX FTSE China A50 Index Futures, Japan Nikkei 225 Index Futures, iron ore derivatives and FX futures, have grown steadily in volume.
Can the derivatives business continue to drive the bourse operator’s fortunes ahead? “In the derivatives business we have formed and built a strong foundation. [Still], we can’t extrapolate the huge y-o-y increases, but it is a segment for which we have built a good foundation for further growth,” says Loh. “For the securities business, I would say that the last-quarter performance, in terms of volume and traded value, in the context of the regional markets, is comparable.”
Analysts have mixed views on SGX’s prospects. JPMorgan, which has an “overweight” rating and price target of $7.60 for the stock, says the medium-term investment case for SGX remains “intact”. “SGX offers a combination of dependable cash flows from the cash-equity business and likely upside from a derivative turnover increase. In some sense, SGX is a counter-volatility play, as the exchange has one of the largest equity derivative contracts in the region, which should benefit from an increased bout of volatility,” the bank says in a Jan 17 report.
Credit Suisse, however, is not too confident about SGX. “Despite a good momentum in derivatives, we expect the stock to trade rangebound near term on weak securities turnover and lack of strong upside catalysts,” the bank says in a Jan 24 report. Credit Suisse, which has a price target of $7.80, says it remains “neutral” on the stock, as it believes SGX remains a defensive stock and has good valuation and dividend support.
This story appears in The Edge Singapore (Issue 868, week of Feb 11) which is on sale now. Subscribe here
