By Lawrence White
HONG KONG (Reuters) - Investment banks in Asia are taking advantage of a regulatory grey area to reap big returns from rising sales of equity derivatives, increasing the systematic risks to the financial system that regulators are trying to eradicate.
Derivatives are tempting for yield-hungry investors and banks facing a slowdown in their traditional deals and trading markets because of the higher returns they can offer both sides. But regulators and academics fear banks are using them to circumvent rules intended to stop them risking their own money to boost returns.
Banks have been preparing for the introduction of the "Volcker rule", a regulatory response to the global financial crisis that seeks to stop banks playing financial markets on their own account, a practice known as proprietary trading.
U.S. regulators are now concerned that banks are exploiting a grey area between "prop trading" and facilitating bets for clients, or market-making, under the guise of hedging risk.
"It's almost impossible to distinguish market-making and proprietary trading," said Professor Jin-Chuan Duan, director of the Risk Management Institute at the National University of Singapore. "But the Volcker rule is trying to do that because when prop trading fails banks need to get bailed out."
The worry is that the pick-up in such financial products in Asia exposes banks and investors to big volatility swings and stock market plunges, increasing systematic risks when the industry and regulators are trying to simplify the business.
Revenues from equity derivatives for top investment banks in Asia surged by 130 percent in the first half of this year to $3 billion, according to estimates from data provider Coalition. That is up from an average of $2.5 billion for the same period in 2009-11 and just $1.3 billion in the first half of last year.
Derivatives are bets linked to the movement of an underlying asset, whose engineered structures can produce a powerful multiplying effect on gains or losses.
Their popularity plummeted globally in the aftermath of the 2008/09 crisis, when that leveraged structure contributed to spiraling losses, but has recovered in the last few years as low interest rates have sent investors chasing better returns.
Banks do not typically disclose how much money their equity derivatives desks make, but traders in Asia told Reuters that the top firms will make more than $200 million each this year, with a second tier making $100-200 million.
French bank Societe Generale (GLE.PA) singled out "strong revenues on flow equity derivatives" in Asia in reporting a 42 percent year-on-year increase in net income at its equities division for the first half of this year.
The new breed of Asia equity derivatives, bankers in Asia say, forego the complex structuring of discredited crisis-era products in favor of simpler bets on stocks or indices.
"In the old days my boss used to say 'if you can't make 10 bps
But events in Japan in the last 18 months show how even simple derivatives products can exacerbate losses when markets move unpredictably.
The equity derivatives business in Japan is unusually concentrated - traders estimate some 75 percent of the market is Uridashi notes, bets on the movement of Japan's Nikkei 225 index or single stocks that are popular with retail investors.
Such notes are "autocallable", meaning they are repaid automatically if the underlying stock or index rises or falls too far.
Years of stagnation in the Nikkei meant those autocall limits were not reached, resulting in a massive accumulation of two-way bets with banks on one side and individual Japanese investors on the other.
Total "over the counter" equity derivatives contracts rose from just over 80,000 in June 2008 to 180,000 by June 2010 and 200,000 by June last year, Bank of Japan data shows.
When stock volatility spiked last year during both a May-June slump and a December recovery, those notes started to be repaid automatically, warping the risk profiles of the trading desks and forcing them to act in unison.
Banks typically offset the large exposure to volatility that selling big volumes of such products gives them by selling opposite bets to investors such as hedge funds.
Thus, they are merely making a market in that risk rather than taking a bet themselves. But it is impossible to perfectly balance those risks, as events in Japan showed, and therein lies the grey area between market-making and risk-taking.
"You had $25 billion worth of product that looked the same and the market moved 2 percent in one direction, so everyone went to hedge at the same place and trampled each other on the way out the door," said one trader who witnessed the ensuing losses.
U.S. regulators hope to vote in December on the Volcker rule, devised by former Federal Reserve Chairman Paul Volcker, that would prohibit proprietary trading in an effort to curb the systematic risks it poses.
"The former prop guys are hidden all over the
"If you can align risk-taking with a client in any way, make it shorter duration, you can get away with it and that's not really the point of Volcker."
Gary Gensler, chairman of the U.S. Commodity Futures Trading Commission, has acknowledged that distinguishing prop trading from market making is the biggest challenge in implementing the rule.
In Japan, investment banks' total losses were manageable, National University of Singapore's Duan said, but risks remain. Other equity-related products in the region such as synthetic exchange traded funds could pose risks to banks who sell them.
"If financial institutions are making commitments without fully funding them you have systemic risk and the danger of cascading losses," he said.
(Editing by Alex Richardson)