Has Asia got the appetite for local currency CDS?

The development of a robust local currency credit default swap market in Asia has come a step closer following the first public won-denominated CDS trade in Korea late last year. Alice Hales looks at whether the ingredients are there for such a market to flourish

Large dealers are increasingly bullish about the likely development of a local currency credit default swap market in several Asian countries, including Korea, Malaysia and Taiwan. The current mood is a far cry from concerns reported five years ago that illiquid secondary bond markets, the absence of clear regulations and limited participation by foreign investors would prevent local currency CDS from gaining traction.

But industry stalwarts, notably JPMorgan - seen as the architect of the US and European CDS markets - reckon things are different now. The US bank is putting its money where its mouth is by setting up a local currency desk in Hong Kong focusing on bond and CDS trading. The desk conducted the first public Korean won-denominated CDS deal in December last year, with Korea Development Bank as the counterparty.

"Investors are flush with liquidity and are always searching for yield, especially on the back of credit spread tightening," says Terry Koh, who heads the new desk at JPMorgan. "So you need to package products in a form that investors are going to look at. This will drive activity on the trading side."

On the hedging side, adds Koh, local banks are looking at how they can transfer risk synthetically. Intermediaries can repackage those risks and sell them to investors, who have plenty of cash to put to work and are looking to diversify their investments.

Citigroup is another major dealer that sees potential in Asia. "There is sporadic activity among dealers," says David Rosa, co-head of Citigroup's emerging markets credit trading group in Hong Kong. "It's more of a 'tailor-made solution for end-users' type of market for the moment, with activity dominated by international banks with an onshore presence."

Rosa declined to provide estimates about the volume of transactions that have taken place or detail about deal sizes and the counterparties involved. But he says some activity among offshore dealers takes place in the form of US dollar-denominated, local currency-indexed CDS, which he calls non-deliverable CDS. "This is akin to how the non-deliverable forwards market works for foreign exchange contracts," adds Rosa. "Non-deliverable CDS can be transacted offshore with reference to any credits from any country."

Basel rules, OK

One of the critical changes in the market environment during the past four years has been the emergence of new Basel II banking regulatory capital rules that will require local banks to offload risk more effectively, especially exposures to lower-rated and unrated credits. Rosa says this will drive the supply side of the market.

Demand for credit, meanwhile, will come from foreign investors - asset managers, banks, real money managers and hedge funds - that are looking for higher and uncorrelated returns in local markets, he adds.

Both Asian and foreign investors have long been active traders of US dollar-denominated CDS linked to Asian credits, in particular those packaged in collateralised debt obligations. Consequently, the shift into local currency products should not be a major leap forward, say dealers. Moreover, cash CDOs are already commonplace in many Asian countries.

"As for local currency CDOs, we have seen plenty of activity in Korea, Taiwan and Malaysia but to date these have been cash deals, not synthetic," says Hong Kong-based Rachel Hardee, head of Asia-Pacific structured credit at Derivative Fitch. "We should see more local currency synthetic transactions as the regulatory environment evolves in each market. Of course, transaction volumes will also be dependent on spreads."

Local currency trades, within certain parameters, are possible in most Asian countries, says JPMorgan's Koh, with India being the main exception. "Korea is one market where I can see activity picking up in the short term. The markets in Thailand and Taiwan are also encouraging," he says. "From discussions with regulators in Malaysia, it is possible to conduct CDS purely from a hedging rather than trading perspective. In fact, the only country where it is not possible currently is India, because the central bank policy precludes any kind of credit derivatives."

Regulatory and government backing was a key driver in the advancement of the local bond markets: for example, Malaysia's so-called Capital Market Masterplan in 2001 helped that market expand. The volume of bonds outstanding in Asia excluding Japan was just under $3 trillion at the end of 2006, according to Asian Development Bank statistics. And some parties believe the same support is needed for CDS to take off.

Conversion rate

But, as was the case with bonds, regulators in different jurisdictions are moving at varying speeds. While Korea is considered to have one of the more advanced capital markets in Asia, its shift in regulatory attitude to credit derivatives is a recent phenomenon. For example, under Korean accounting rules, synthetic instruments are treated in the same way as guarantees or loans - accrual-based products that cannot be marked to market, which consequently restricts trading.

Yet market participants expect this to change in the first half of this year, and say the more positive approach is better late than never. "The authorities in Korea are trying to encourage the development of a domestic credit derivatives market," says Derivative Fitch's Hardee. "It is likely we will see activity from Korea this year."

Korea has a large domestic capital market, but has been behind the curve on credit derivatives. "We sense, however, the commitment of all parties to the development of this market generally in Korea, as well as to the development of a domestic CDS market," adds Hardee.

However, an official in the derivatives supervision team at Korea's financial regulator, the Financial Supervisory Service, says the slow progress in won-denominated CDS was not the result of any regulatory impediment. "The regulations permitting won-denominated CDS have been in place for a long time," says the official. "As to why activity has been limited, legally there are no restrictions, so the reason must be that there has been no real need or demand up until now. That said, we do expect this market to develop now that the JPMorgan-Korea Development Bank trade has taken place, but it is difficult to say how quickly at this point."

The lack of standardised documentation for local currency CDS from the International Swaps and Derivatives Association is not a major issue, with market participants drafting their own contracts, say dealers.

In other markets with a large potential, the regulatory barriers are more clear-cut. "India has a huge debt market, but on the credit derivatives side, it just needs that push from the regulators," says JPMorgan's Koh. "If that were to happen, though, the market would take off massively. It already has a developed overnight index swap market, so there is no reason why synthetic products would not see similar growth."

Koh also cites Thailand as a market with strong potential. "As a result of Basel II, we get requests from local banks on restructuring loans for capital relief," he says. "The only issue in Thailand is on the investor side, because of the recent capital controls, which is why many foreign investors are reluctant to dive in at the moment."

Currency risk

But some parties believe local currency CDS will only have limited appeal to most foreign buyers. "It's an issue of correlation," says a Singapore-based hedge fund manager. "If you own protection on a bunch of Korean names and they all go bust, the won will likely weaken against the dollar. So your payoff on the protection comes in the form of a devalued currency - that is not very attractive. Having a payoff in a hard currency that will not be impacted by local defaults is always more attractive. US-denominated protection on local names is likely to remain the dominant product."

The hedge fund manager believes local currency-denominated protection can represent better value. "If you are not worried about a broad set of defaults, but just one - say your primary supplier of raw materials - then local currency CDS will be cheaper and should be fine," he says. "I can see a bank with a lot of local clients being able to trade, but it still won't be a big business."

Another fundamental barrier to the creation of a liquid local currency CDS market is an active secondary bond market. And here, the problem seems further from resolution. Asian investors still often favour holding their investments until maturity. "For local currency CDS markets to develop, there needs to be more liquid trading in the secondary markets: this is vital for a vibrant CDS business," says JPMorgan's Koh. "We talk to investors in local markets, and this issue of illiquidity is often raised, but I am confident this will change in time."

Despite the limited number of trades completed to date, Koh does not believe JPMorgan has set up its trading desk too soon. He argues that investing time and energy educating institutions - ranging from regulators to local banks - is imperative if a bank wants to reap the rewards further down the line.

"We feel the market is ripe for this now, and it is important to note that the desk will trade bonds as well as CDS," he says. "To be able to trade CDS properly you need to fully understand the underlying credits. There is real momentum in the local currency debt markets, with suggestions that borrowers will increase their focus on local rather than offshore bond markets. Many hedge funds and asset managers are already starting to build up Asian bond funds. That will continue to grow, and CDS markets evolving from that would be a natural progression."

Koh anticipates the JPMorgan local currency CDS desk will handle one to two trades per day in the immediate future, although he envisages that figure could rise to between 10 and 20 within the next six months. He feels Korea is similar to Japan, where initial yen-denominated CDS trading - introduced in 2001 - took time to take off; once it did, momentum grew quickly.

Citigroup's Rosa is similarly confident. "One thing is for sure: local currency credit derivatives markets are set to grow at the same exponential pace as have external credit derivatives markets," he says. And he reckons the market will continue to develop even if there is deterioration in the credit environment. "Some market players are wary of a credit cycle downturn getting in the way of this market development. I actually think a bear market in credits would further compound demand for local currency products.

"This is not another 'bull market' type of derivative product," he adds. "It is a much-needed financial tool that is getting more and more acceptance amongst the local regulators around the region and the emerging markets world."