Philip Tsao, UBS Investment Bank's managing director, joint head of debt capital markets and risk management, is expansive about the derivatives business. Indeed, he jokes that most of his colleagues in the segment have either cashed out or moved on.
But he says he loves the challenge. Here, he talks about his bank's derivatives business.
Tell us about UBS' derivatives business market in China?
Tsao: Now that the renminbi fluctuates, clients think twice about which currency they should use to hedge. The US dollar used to be the proxy for the renminbi.
Is it still a good proxy? Probably "yes" for the short term, especially for clients who receive renminbi revenues and want to hedge against the appreciation risk of the US dollar against other currencies.
Until derivatives denominated in renminbi become available, the US dollar will remain a good bet, as liability hedgers will have the benefit of any further renminbi appreciation against the US currency by using US dollars as the proxy. China has been a rich source of both asset and liability derivatives. Cash-rich individuals and companies have around $120 billion of deposits in the banking system and, increasingly, are seeking higher yields and diversification by converting into US dollars. Derivatives are a natural solution.
There is also approximately $210 billion of foreign currency liability outstanding in China, most of which is booked at historical cost. It is becoming more and more commonplace for clients to look for alternatives to either reduce or lock-in the cost.
But isn't the government looking into offering RMB derivatives?
Regulators in China are seeking to understand how a government can regulate the market efficiently but, at the same time, ensure a platform exists for RMB derivatives to develop further. UBS has been working closely with the Chinese authorities to develop the initiative.
What about Hong Kong? Is the Hong Kong derivatives market going to change much due to the appreciation of the yuan?
Following the revaluation of the RMB, Hong Kong is in a transition phase. In the past, some Hong Kong-based fund managers adopted the US dollar as a proxy because the US dollar interest rate is slightly higher than that for HK dollars.
This strategy may become obsolete should the Hong Kong dollar appreciate in line with the RMB. Should this occur, investors in Hong Kong are likely to refocus on Hong Kong dollar assets at the expense of assets denominated in US dollars. As a result, we would expect volumes in the Hong Kong dollar-denominated derivatives market to increase.
What about other regions?
Well starting from the north, there's Korea. Korea is kind of different because of the FSS (Financial Supervisory Service) situation. (background: The Financial Supervisory Commission announced on July 22 that the Seoul branch of Deutsche Bank and the Seoul branch of BNP Paribas would be issued a disciplinary warning for engaging in improper non-standardized OTC derivatives contracts with state-owned companies.)
We cooperate fully with the regulators and have ourselves been audited. I am happy to report that we came out with a clean bill of health. We run a tight ship and apply stringent controls to our derivatives business to ensure it remains sustainable and profitable.
Our clients are pretty much the same as those of all our competitors. And though we sell structured-products, as clients demand them, we go to great efforts to ensure our clients really understand the risks; that the products genuinely meet their requirements; and that our presentations, term sheets and other marketing material are all devised to ensure they are fully protected.
What about Japan?
Our business model in Japan is different to that of most of our competitors. Most blue-chips and government agencies in Japan are all subject to very strict government-mandated accounting disclosure reporting rules. As a result, activity is mainly confined to general hedging although we are also investigating how best to develop the commodities segment.
There is also significant potential for growth driven by medium and small corporate clients who, by and large, are not subject to the same accounting requirements. In addition, they tend to be cash rich, and - in a low yen interest-rate environment - are attracted by the potentially high yields.
Now Taiwan?
Taiwan is exciting. For the past two years, the Taiwan dollar structured-bond market has grown very quickly with around $15 billion in new issues each year. While UBS is a major player - having started the business from scratch around two years ago, we now have a market share of around one third - we do not underwrite the bonds but simply provide the structures.
Our strategic partners underwrite the bonds and find the issuers - or being the issuers themselves - sell to investors. Almost all of our competitors operate a Taiwan-dollar underwriting business, as well as a local-underwriting business. As a result, local underwriters or banks with underwriting licenses entering the business, tend to view them as competitors rather than as partners.
By contrast, UBS has made it clear from the outset that it does not underwrite the bonds and so is viewed as a genuine partner - a provider of ideas, pricing and research. However, at the end of last year, the regulators deemed that many bond funds were over laden with structured bonds and, furthermore, that most were not properly marked to market.
As a result, the sale of structured bonds to bond funds was halted and the business quickly dried up. However, asset-backed securities (ABS) are poised to fill the gap and the regulators are encouraging ABS originators to buy the structured bonds, unwind the structure and then reissue as an asset-backed security.
Alternatively, local banks have the option to offload assets, such as cash-card or credit-card receivables, to improve capital ratio and asset efficiency. We are targeting onshore assets to be packaged and sold offshore where we have a competitive strength and less potential for conflict with our local partners.
What about Southeast Asia?
In terms of revenue composition, Northeast Asia - China, Japan, Korea, Taiwan and Hong Kong - will probably make up more than 70% of the P&L annually, but Southeast Asia is catching up quickly. And revenues from India, Malaysia, Thailand, Indonesia and the Philippines have all increased on last year.
In the Philippines, political instability and the limited number of products available has driven local banks to look offshore for investment opportunities. On the other hand, Thailand has started to manage its foreign-currency borrowing risks more aggressively in the private and public sector, while Indonesia and Malaysia, are looking at ways to manage risk more aggressively on both the asset and the liability side.
