Originally posted on TabbForum.com
Only the United States and Europe matter – at least that has been the view surrounding OTC derivatives reform. With CFTC Chairman Gary Gensler reiterating in a recent speech that a “significant majority” of OTC derivative trading is happening in the US and Europe, it is easy to see why Americans and Europeans have a narcissistic view.
If we closely regulate the majority of OTC derivative trading through only two major pieces of legislation, then little need exists to deal with the remainder – right? I can think of a number of governments, exchanges, clearinghouses and solution providers who would disagree.
Proposals currently in the works would create central clearing for interest rate swaps (IRS) in Japan, India and Korea and the same for credit default swaps (CDS) in Japan and Korea. Timetables are still to be determined. However, if thoughts have started to enter your head that Asia will simply wait to see what the West does before proceeding, you are dead wrong.
The Japanese House of Representatives on April 20 passed legislation that would modify the Financial Instruments and Exchange Law to enact mandates for central clearing, exchange execution and trade reporting. This only leaves a vote by the House of Councilors, one that many expect to happen by June 2010 to make the proposal law. Despite recent optimism from US lawmakers that they will have a bill passed before the end of spring 2010, it looks to me as if Japan may draw first blood in reforming the whipping boy of the credit crisis – the OTC derivative market.
Returning to my earlier point – that the amount of OTC derivative trading in Asia (and more specifically Japan) dwarfs that done in New York, London and other western financial centers – based on a recent report from the Bank of Japan, CDS outstanding notional in Japan is just over 1 trillion USD. That is only ~3% of the total market, and it is theoretically possible that a major swap dealer could have a larger position on its books, but $1 trillion is not to be ignored.
IRS outstanding notional in Japan is just under $30 trillion, a similar percentage of the total market as CDS. If we look at the total outstanding notional of IRS by currency, Yen-denominated IR derivatives account for 13% of the total. Based on that number alone, ignoring Japan when talking of global reform is shortsighted at best and quite possibly foolish.
First, there is the issue of systemic risk. The past few years have shown how interconnected the global financial markets are. If a major Japanese swap participant was to default, who is to say that the related counterparty risk might not bring down a major asset manager, pension fund or construction company?
Issues in Greece have demonstrated that actual money-at-risk does not have to be significant in relation to the size of the global economy to cause considerable disruption. Again, remember we are talking trillions – with a T. Once upon of time, that sounded like a lot of money.
Then there is the missed opportunity. In previous analysis of the OTC derivative market, TABB Group pointed out the huge revenue opportunity for everyone from clearinghouses to consultants. The same holds true in this case. Whether a market is $1 trillion or $300 trillion, infrastructure still needs to be built, legal documents created and signed, implementation plans made and contracts cleared. Competition is hot and heavy in the US and Europe, so looking East could very well provide substantial opportunities for those tuned-in enough to recognize them.
Some complications certainly do exist. Chief among them is the risk that liquidity in Japanese CDS contracts is too low for clearinghouses to accurately price and, therefore, risk manage the products. The inability to price derivatives contracts is likely what will keep many less standard products out of clearinghouse in the US and Europe, but Japan could face these problems on more vanilla index trades.
If a crisis was to erupt in Japan or other parts of Asia for that matter, it would impact the global economy as Japan is the third largest country in the world measured by GDP, behind only (you guessed it) the US and the European Union.
Question is, while all eyes are focused on Washington, D.C. and Brussels, who’s watching the Land of the Rising Sun?
Maybe it’s time we all were.
Standing Room Only in Hong Kong: Low Latency is High Priority
I created this video while I was in Hong Kong last week for Trading Architecture Asia. The audio isn’t that great unfortunately, so we’ve transcribed the commentary which you see below (its also on TabbFORUM).
…and the transcription:
This week I’m in Hong Kong for Trading Architecture Asia 2010.
If it’s a sign, almost every session in the morning has been standing room only, so there’s certainly a big focus from exchanges, buyside firms, sellside firms and technology providers all across Asia on low latency trading and low latency infrastructure.
One of the main focuses has been on the Singapore exchange. They’re building out a tremendous new co-lo facility and co-lo offering. They’re also in the midst of creating a matching engine that’s supposed to be one of the fastest in the world – down to 90 microseconds – to match an order. That rivals most of the exchanges in the U.S. and Europe.
Japan also continues to be a focus area in terms of low latency trading. The Tokyo Stock Exchange’s new Arrowhead trading platform has tightened spreads and driven up volumes – and has been quite successful. One interesting point: before Arrowhead, it would take 300 milliseconds to execute an order at the Tokyo stock exchange. If you were a trader in Tokyo, it was actually faster to send your orders over to New York through fiber optics and execute at a New York exchange than it was to execute locally in Tokyo because the matching engine was so slow. So clearly this development, this new matching engine at the TSE will help them considerably.
There’s also a lot of fragmentation talk going on in Tokyo and in Asia as a whole. Chi-X, among others is looking to create not only new liquidity pools in Tokyo but pan-Asian liquidity pools. So we’ll have to see. That’s early stages but certainly causing the incumbent exchanges to pay attention and increase their strategies.
Lastly there’s been quite a bit of discussion around the markets in India. Cleary this is a big, big economy with huge potential. Both the Bombay Stock Exchange and the National Stock Exchange of India were here at the conference talking about their offerings and their approaches.
The National Stock Exchange of India is the market leader right now but the BSE is coming up close and trying to take market share back from them. There was just an announcement from the regulators in India that smart order routing is allowed and now acceptable, so that’s a huge step forward. Algo trading will grow and both the NSE and BSE will allow colocation as well, so there’s considerable competition there.
One thing that I found interesting, one of the other rules that was just passed India is now retail investors are allowed to trade over mobile phones. So on one hand we have colocation and ultrafast trading by institutional traders in India and on the other hand we’ve got retail investors in remote villages trading on mobile handsets. They also mentioned there’s quite a bit of trading that goes on via satellite. Satellite is at the opposite end of the latency spectrum where we’re talking somewhere between 800 and 900 milliseconds to execute an order via satellite.
The week in Hong Kong has been quite eye opening. Clearly there’s a lot of opportunity here. The East has been able to learn from the process that’s gone on over the past decade both in the U.S. and in Europe. It’s likely the 10 years or more it took for the U.S. to get to where it is will be shrunk considerably in the Asian markets. So within two or three years, the amount of low latency trading happening in the region across listed cash equities, options and futures and other derivative products is definitely set to grow.