Author: Luke Clancy
Source: Hedge Funds Review | 12 Jun 2014
Asia-Pacific posited as an attractive location for OTC derivatives as the costs of doing business in the US and Europe begin to mount following regulatory intervention
Is Asia-Pacific the new breeding ground for hedge funds? Asia-Pacific-based firms represent approximately 13% of all hedge fund managers tracked by data provider Preqin, although these firms represent less than 4% of total industry capital, largely due to the fact that funds within Asia-Pacific are both newer and smaller than those in the established regions of North America and Europe.
But the region does present advantages over its more established counterparts, according to some. Zohar Hod, global head of sales and support at derivatives technology and data provider SuperDerivatives, tells Hedge Funds Review that regulatory disincentives imposed by Dodd-Frank and the European Market Infrastructure Regulation make over-the-counter derivatives trading too expensive in the US and Europe; buy-side sources report the cost of posting collateral can be 10–20% lower when done with a less-regulated entity.
The use of OTC derivatives is clearly here to stay as the instruments hold an advantage over the partial hedges achieved with plain vanilla, centrally cleared products. In the US, meanwhile, derivatives users are attempting to avoid regulatory requirements to trade on swap execution facilities.
OTC derivatives markets continued to expand in the second half of 2013, according to the Bank for International Settlements. The notional amount of outstanding contracts totalled $710 trillion at the end of 2013, up from $693 trillion at the end of June 2013 and $633 trillion in 2012.
Banks, asset managers and large dealers are keen to take on more risk and structure or deal with more complex instruments – the increase in notionals shows where money can be made, as the market is tougher following reductions in volatilities and insufficient margins in plain vanilla products. Last month, Royal Bank of Scotland announced that it is winding down its rates prime brokerage and rates OTC clearing businesses as a result of the increasing level of capital, operating costs and investment required in a market with extremely thin margins. Further regulation-derived costs are also on the horizon in Europe, with some voicing concerns that the Markets in Financial Instruments Directive II could lead many OTC derivatives players to withdraw altogether.
If there is a need to maximise the money made per trade then the place to possibly do that is where there is less regulation, more freedom of trading and relaxation in terms of the amount of collateral that needs to be put in place. Could more favourable rules in markets such as Singapore, as well as the growing strength and financial sophistication of China, create a perfect storm for intercontinental regulatory arbitrage? Hod is one who believes so and cites several large hedge funds, traditional asset managers and global bank dealers looking to add to or centralise operations in Asia in the past year, including “a very large publicly traded hedge fund company with dozens of funds under its umbrella that has moved trading operations to Singapore”. But the biggest elephant in the room is China, he says, as it is adhering less to global regulatory reform and is increasing its offering of exchanges to attract more business, including derivatives.
In mainland China, in June 2013, hedge funds were first recognised under changes to the Securities Investment Funds Law, allowing them to raise funds legitimately where previously only regulated mutual funds were permitted to do so. From an admittedly low base – zero, in fact – there has been rapid expansion. Firms are required to register with the Asset Management Association of China and the hedge fund and private equity/venture capital firms listed as members on its site currently number more than 80.
There is more anticipated development in the Shanghai and Qianhai (Shenzhen) free trade zones where foreign companies can set up with looser capital controls, tax rebates and special quotas for foreign exchange. Six hedge funds have been granted licences with a combined quota of $300 million. Canyon Partners, Citadel, Man, Oaktree, Och-Ziff and Winton are taking advantage of the new regime, although a lawyer tells Hedge Funds Review he has heard only two of the firms have so far managed to raise the $50 million allotted.
It should be recognised of course that although regulations in Europe and the US are at a more advanced stage, OTC participants in Asia are already moving in a similar direction, while BIS/International Organization of Securities Commissions rules in 2015 will significantly increase the collateral associated with non-cleared OTC positions. Nevertheless, others also anticipate a shift in the centre of gravity towards Asia. Ken Heinz, president of Hedge Fund Research, agrees over the long term that regulatory disincentives to global trading in the US and Europe could outweigh those faced in Asia. He points to a universe of nearly 1,200 Asian-focused hedge funds, 34% of which are now located in China including Hong Kong.
The future looks bright for doing business in Asia-Pacific. China itself has a virtually untapped $6.6 trillion retail savings market, while there is noted interest from Asian investors in diversifying their high beta holdings into less volatile hedge fund strategies; at the same time, global investors are increasingly seeking growth via sophisticated hedge fund strategies applied to Asian markets.
