A Report on Taiwan’s Financial Sector
Emerging vs. Developed Market
BY TIMOTHY FERRY
Taiwan’s Bond Rates Among World’s Lowest
BY PHILIP LIU
Acceptance Growing for Futures Products
BY PHILIP LIU
Emerging vs. Developed Market
Industry members weigh the pros and cons of moving up the classification ladder.
BY TIMOTHY FERRY
In recent years, Taiwan has taken significant steps towards integrating its financial markets with the world by relaxing foreign investment limits, signing MOUs with foreign jurisdictions, and aligning regulations and standards with global norms.
To many, the next logical step is for the Taiwan Stock Exchange Corp. (TWSE) to gain an upgrading in its country classification from the current emerging market status to that of developed market by the FTSE and MSCI – the world’s leading two market indexes. Proponents see such a move as vital if Taiwan is to attain its longstanding goal of becoming a regional financial center, especially for fund-raising and asset management.
Among industry players, however, some stark differences of opinion remain as to whether that upgrading would really be to Taiwan’s, and investors’, advantage. In part, the debate is over whether it is better to be a big fish in a small pond or vice versa. Shifts in the world economy have also had an impact. A year ago, when investors were looking primarily for stability in the wake of the global financial tsunami, the advantages of developed-market status seemed paramount. But now interest is swinging toward emerging markets where opportunities for profits are higher (though some question whether Taiwan, at its current level of development, can achieve high enough growth rates to attract those kinds of investors).
Ian Cole, president of Genesis Capital, a New York-based investment firm with significant holdings in emerging markets, said in a telephone interview that “the appeal to invest in emerging markets is really aggressive growth” and their resultant profits. Otherwise, they would lose their appeal, as they are generally considered riskier than developed markets. Without an “extra premium,” gained by exploiting gaps in transparency in emerging markets, he says, there is little advantage to investing in them.
In financial markets, the term “transparency” refers to the amount of information investors have access to, including price levels and audited financial reports, and is seen as vital to preventing insider trading and other forms of corruption. Cole notes that Taiwan is “trying to make it as fair as possible,” but adds that “the fairer it is, the more transparency there is, the less opportunity there is to make money.”
The perception of irregularities in emerging markets is perhaps one reason why the TWSE lists “Upgrading the Taiwan capital market into developed country status” as the third of four long-term goals posted on its website. The other objectives are promoting listings on the exchange by overseas enterprises, developing new financial products and boosting service levels, and strengthening Taiwan’s international competitiveness. These goals are all intended to facilitate what AmCham refers to in its 2009 Taiwan White Paper as the transformation of the island into a “robust regional financial services center.”
Eric Lee, director of the Chartered Financial Analysts Association of Taiwan, notes that although these aims have all been stated goals for at least 10 years, “there are still many hurdles the Taiwan government needs to overcome.” He cites four key obstacles: a) the complexity of the domestic legal system with regard to financial transactions, b) the lack of sufficient government support for the financial industry, c) the underdeveloped talent pool for financial-sector personnel, and d) over-regulation and the relatively unsophisticated financial services infrastructure.
While Hong Kong and Singapore both have very positive legal and regulatory systems that encourage financial-service companies to set up shop in their jurisdictions, Taiwan has been very slow to adapt its laws and regulations to the changes occurring in financial markets, Lee says. Particularly in the banking sector, he notes, that situation has led to very low margins and a fragmented market. He likens Taiwan’s financial-services industry to commodity trading in that it is “only price driven.”
This price-based competition leads to the further issue of lack of global scale. Lee notes that the average size of a mutual fund in Taiwan is NT$1 billion (US$33 million), compared with China’s average of US$1 billion. He observes that in the China market, a fund valued at around US$500 million is considered the minimum, and that Taiwan’s lesser scale leads to lower management fees and profits for financial-services providers, and therefore to lower salary levels. That in turn impacts Taiwan’s ability to attract top-level talent and take advantage of their insight on global financial markets.
The relatively small scale of the Taiwan funds also means that the fund managers lack the opportunity found in China to rub shoulders with top global industry insiders. “Although we try to be international, if you look at the truth, we are really quite local,” Lee concludes.
Cole notes that “the main reason any country want to gain developed market status is the prestige.” On the other hand, gaining developed-market status entails many of the same qualifications as becoming a financial center: “standards are a lot higher.” Besides a highly developed financial infrastructure, he says, another requirement is the existence of “regulatory authorities that actually monitor what’s going on.” These qualities are found in Hong Kong and Singapore, and improvements are visible in South Korea, but less so in Taiwan, says Cole. South Korea is already considered a developed market by FTSE, and its status will be reviewed by MSCI – along with Taiwan’s – in the next few months.
As Taiwan’s financial market evolves, its elevation to developed status is undoubtedly only a question of time, although currently it is unclear whether it will be a matter of months or of years. A Taiwan-based foreign market analyst compares the process to Taiwan’s political development. “Vote buying, kickbacks, and bribery were [previously] just commonplace and considered a normal part of the election process,” he says. “Similarly, a decade ago insider trading was considered normal, and investigations into such activity didn’t have teeth. But that’s changing.”
He observes that the primary regulatory agency – the Securities and Futures Bureau (SFB) under the Financial Supervisory Commission (FSC) – is ramping up its investigatory efforts and forwarding its findings to prosecutors. “People are not only getting fined but are put in prison for insider trading,” whereas a decade or two ago “that just didn’t happen.”
Eric Lee is less convinced. He concedes that the government now has “very strict regulations on financial reporting,” including requirements that financial institutions report on monthly sales and quarterly financial results, as well as on major events and activities by the company. But despite the regulations, he believes “there’s still some room to play around.” He suspects the existence of insider trading and other market manipulation, while noting that these are “hard to prove, hard to convict.” Cole concurs, saying “I would argue there’s still a lot of corruption in trading” in Taiwan.
Still, the question remains whether attaining developed market status is a desirable goal, and whether it would do much to further Taiwan’s ambition of becoming a regional powerhouse in capital markets. The previously quoted market analyst, taking one side of that argument, asserts that if Taiwan were granted developed-market status, “billions of dollars would come in.” Developed status would reduce Taiwan’s risk metric, he says, making asset allocators more inclined to include Taiwan in their allocations. That impact is well-documented, since “every country that has gone from emerging market to developed market has seen an inflow,” he maintains.
Cole agrees in principle that developed status “moves you down the risk index,” so that “from a certain perspective, investment is more attractive.”
But the opposite point of view also has its adherents. “Emerging markets are very attractive right now,” notes a trader for a major international brokerage who requested anonymity. “We have high growth, high valuation – we can make money easier.” She feels that by reducing market volatility, instituting the regulatory changes required to meet developed-market status would make the market “boring” and less profitable.
Lee shares that position, noting that “in terms of fund flow, most funds right now are tracking MSCI Asia Pacific Emerging Markets,” which includes Taiwan.
Less risk adverse
As the financial tsunami subsides and people see less risk in the markets, “people are moving away from developed markets such as the United States,” Cole explains. “If you’re an investor, you want to put your money where it’s going to grow the fastest; you want to invest in emerging markets because they’re going to grow faster. It’s all about risk and reward.”
Taiwan occupies an unusual position among global financial markets. According to MSCI weightings, Taiwan’s percentage of global market cap is 1.2%. That pales in comparison to Australia’s 3.45% or Britain’s 7.43%, let alone the commanding 41.83% of the United States. But this weighting in fact exceeds that of two of the four BRIC nations (Russia’s 0.85% and India’s 0.98%) and is only slightly behind the other two (China’s 1.58% and Brazil’s 2.15%). Closer to home, Hong Kong’s market weighting of 1.72% and South Korea’s 1.65% both narrowly surpass Taiwan’s, but Singapore trails with only 0.58%.
It might seem odd that with this weighting and large economy (ranked 20th in the world by the CIA Factbook), Taiwan is not already considered a developed market. In a press release issued last summer, MSCI noted that “under the current MSCI market classification framework for Developed Markets, Taiwan meets the economic development as well as the size and liquidity requirements,” and that “the overall market accessibility of Taiwan is comparable to that of Korea.” Taiwan’s continued placement in the emerging market indexes is attributed to overregulation, currency issues related to lack of NT-dollar convertibility and fund size, and questions of tax policy.
A case in point is the newly instituted Alternative Minimum Tax, which allows the government to tax earnings on income derived from outside the country. Few countries (the United States is one) have such a global tax system. AmCham’s 2009 White Paper warned that this new tax could have dire consequences for Taiwan’s financial market, as massive outflows preceded the tax’s introduction this January. So far this year, however, the effects appear to be muted. Lee’s explanation is that the rich already removed their money a long time ago, or have their assets protected in institutional investments that are exempt under the new law. While he predicts that only unsophisticated investors will actually pay this tax, he agrees that it suggests an overly onerous tax regime.
The market analyst cautions that “it’s very important to have a well-thought-out tax system,” as “money moves to avoid taxes.” He notes that capital markets throughout the world – including many in Asia – are competing for funds and for listings. Elements affecting this decision may include tax systems, listing requirements, and other risk factors. “In the end, you’re going to list where it’s the most friendly,” he says.
Taiwan has made some significant strides towards attracting foreign investment capital, particularly from China. Lee notes that while smaller-holding retail investors account for nearly 40% of the market activity on the TAIEX, they are losing ground to FINIs (Foreign Institutional Investors), particularly in Taiwan’s blue chip stocks, such as Hon Hai and TSMC.
Recent legal changes laws allowing China’s Qualified Domestic Institutional Investors (QDII) to invest in Taiwan enterprises have created another significant source of investment capital in Taiwan. These institutions are limited to investing a total of US$500 million each, however, and face further restrictions on the types of investments they may make. Another source of money flowing into the market is Taiwanese entrepreneurs who have done well in China and are now seeking to reinvest in Taiwan.
Ultimately, in Lee’s view, Taiwan has little chance of becoming a regional financial services center, and so should feel little pressure to upgrade to developed-market status. “We already meet the minimum requirements (for developed market status), but from a professional point of view,” Taiwan cannot match sophisticated financial markets like Hong Kong and Singapore. Further, Taiwan’s neighborhood is becoming increasingly crowded with Chinese competitors, including Beijing, Shanghai, and Shenzhen.
“The government has high goals,” he says, but if it cannot improve the regulatory environment and the quality of talent and financial infrastructure, the notion of becoming a regional center will remain “just a slogan.”
Taiwan’s Bond Rates Among World’s Lowest
But the market still faces a challenge in enhancing its attractiveness to domestic investors.
BY PHILIP LIU
Thanks to the Central Bank’s loose monetary policy and the existence of abundant domestic idle funds, interest rates on Taiwan’s bond market have plunged to a level that is among the lowest worldwide. In order to secure low-cost long-term funds, that phenomenon has prompted the government and large domestic companies to issue new bonds. In general, however, Taiwan’s bond market remains an under-developed fund-raising channel for domestic enterprises.
When the Ministry of Finance (MOF) held a public bidding on January 25 for NT$30 billion (US$937.5 million) worth of 30-year government bonds, the first issuance in six years for such long-term government bonds, it attracted the enthusiastic participation of domestic institutional investors. The interest rate offered by the winning bidders for the bonds was only 2.294% per annum, much lower than the market expectation – and 1.716 percentage points less than the interest rate of 4.01% for the last previous issuance of 30-year government bonds on May 27, 2004. It is even 31 basis points (one basis point equals 0.01 percentage point) lower than the 20-year government bonds issued last May.
Similarly, thanks to fierce competition among institutional investors, the interest rate for NT$40 billion (US$1.25 billion) in 20-year government bonds was set at 1.95% per annum during public bidding on February 10, the second lowest ever for such bonds.
The government stands to enjoy low interest rates for its plan to issue NT$514.7 billion (US$16 billion) in government bonds throughout 2010, compared with the average level over the past five or six years of NT$400 billion-$450 billion (US$12.5 billion-$14 billion). These new bonds, with terms ranging from two to 30 years, will be used to cover the government’s budgetary shortfall and to fund major infrastructure projects, notably the 12 i-Taiwan (Love Taiwan) projects. Due to the economic downturn, the central government’s tax revenue in 2009 was NT$250 billion (US$7.8 billion) less than the targeted amount.
The low interest rates are attributable in part to the abundant idle funds in the hands of domestic institutional investors. A major buyer of the NT$30 billion in 30-year government bonds, for instance, was the Chunghwa Post Co., which absorbed about one-third of the amount. Life insurance firms were also major buyers, taking some NT$10 billion-$15 billion (US$313 million-$469 million) worth, although interest income from the bonds is even lower than the actuarial-assumption interest rates for their insurance policies, which average 2.75%. Market players note that with the decline of investment-link insurance policies, traditional insurance products have re-emerged as the mainstream business item of life insurance companies, forcing them to find outlets for the huge funds they generate. The third major buying force was domestic banks.
The low interest rates for government bonds have also pushed interest rates for corporate bonds and financial bonds to a very low level. Last November, Fubon Financial Holding, for instance, received full subscription to its NT$6 billion (US$190 million) seven-year subordinated corporate bonds within a short time, although the issuance only generates interest of 2.6% per annum, even lower than the previous record low of 2.65% for the NT$20 billion (US$625 million) in subordinated corporate bonds issued by Cathay Financial Holding last October. The interest rate is expected to be even lower for a NT$5 billion primary-lien bond that Fubon is due to issue soon. Fubon plans to use the funds to pay off in advance the US$300 million overseas subordinated bonds issued in February 2008 for the acquisition of ING Antai Life Insurance. As the existing bonds carry an interest rate of 6% per annum, the refinancing will enable Fubon to save NT$300 million-$400 million (US$9.4 million-$12.5 million) in interest payment a year.
Nan Ya Plastics, part of the Formosa Plastics Group, issued NT$4.8 billion (US$150 million) worth of five-year unsecured corporate bonds last October at an interest rate of only 1.49% per annum. That approached the group’s previous record low of 1.48% issued by Formosa Plastics Corp. in 2003 during the period of the SARS (severe acute respiratory syndrome) epidemic.
Last October when Uni-President Enterprises, Taiwan’s leading food company, issued NT$3 billion (US$94 million) in unsecured corporate bonds – half with a three-year term and the rest with a five-year term – demand was so high that it was over-subscribed by 5.5 times. The interest rates were only 1.23% for the three-year bonds and 1.59% for the five-year.
State-owned corporations enjoy even lower interest rates on the bond market. Last October, Taiwan Power’s bond issuance received such a warm reception in public bidding that the interest rates were driven down to only 0.85%, 1.26%, 1.55%, and 1.78% for bonds with three-, five-, seven-, and 10-year terms. In view of the strong demand, the company expanded the scale of the issuance from the original NT$12 billion (US$375 million) to NT$15.7 billion (US$490 million). In 2009, the company carried out five bond issuances, raising NT$63 billion (US$2 billion) in funds, the largest amount for any issuer.
Many banks are rushing to jump onto the bond bandwagon, in order to strengthen their financial structure. These include Taiwan Business Bank, which plans to issue NT$12 billion (US$375 million) in seven-year subordinate financial bonds; Hua Nan Commercial Bank, with a plan to issue NT$3 billion (US$93.8 million) in subordinated financial bonds without fixed term; and E. Sun Commercial Bank with NT$1.5 billion (US$47 million) in seven-year subordinated financial bonds.
Even foreign banks are joining the fray, as Standard Chartered Taiwan plans to issue NT$10 billion (US$313 million) in 10-year subordinated financial bonds and BNP Paribas Taiwan has applied with the regulator to issue US$1 billion (NT$32.2 billion) in financial bonds, the fourth largest foreign currency-denominated bond issuance in the history of the local market.
The MOF has encouraged state-owned banks to issue subordinated bonds without fixed term, which can be treated as first-category capital, to help them raise their first-category capital-adequacy ratio (first-category capital divided by risk assets) to 8%. That is the minimum requirement for domestic banks to set up subsidiaries in China, according to the regulation formulated by the Financial Supervisory Commission (FSC).
In addition to the impact on the market from government bonds, another major reason for the low interest rates for corporate bonds is the reduction in supply, as investors have become even more cautious about the credit standing of bond issuers in the wake of the recent financial crisis. Securities firms estimate that the total amount of corporate bonds and financial bonds issued in Taiwan in 2009 reached NT$250 billion (US$7.8 billion), NT$100 billion (US$3.1 billion) less than in 2008.
New bonds issued on the local market have been purchased mainly by big institutional investors – particularly by Chunghwa Post, banks, and life insurance companies – which have been plagued with huge amounts of idle funds over the past few years due to changes in the domestic investment environment. These major buyers have had a dominating presence, especially for government bonds. They account for over 80% of the outstanding government bonds, worth some NT$3.5 trillion (US$109 billion) in value.
Most of the government bonds are kept in the safes of the major buyers, leaving only limited amounts for trading on the secondary market. Average daily trading volume for government bonds last October, for instance, reached only NT$50 billion (US$1.6 billion), just one-tenth of the NT$500 billion (US$16 billion) figure in 2005, which was then the second highest in Asia, trailing only Japan.
“Government bonds have become a haven for the huge idle funds of major financial institutions, including government-owned ones, which have shied away from overseas markets due to their substantial losses, especially during the financial tsunami,” explains Lee Shyan-yuan, professor of finance at National Taiwan University and a former member of the Financial Supervisory Commission.
The limited supply, plus the Central Bank’s loose monetary policy, has also driven the yield rates of government bonds on the secondary market to extremely low levels. On January 26, for instance, the yield rate on the second batch of 30-year government bonds issued in 2009 dropped to only 2.23%. That was the lowest worldwide, even lower than the yield rate of similar Japanese-government bonds, which stood at 2.29%. The major buying force was life insurance firms, which bought up the long-term bonds, driving up prices while dampening the yield rates.
Last October, the yield rate of two-year government bonds at one point even dropped to virtually zero (0.02%), due to massive purchases by foreign-currency speculators for parking their hot money temporarily. Intervention by the Central Bank then brought the rate back up.
The supply of government bonds on the domestic market is set to remain limited in the coming years, since the central government’s outstanding debt has topped 34.68% of GDP. That level of debt leaves only about a 5% leeway for new bond issuance, amounting to around NT$600 billion (US$18.8 billion) worth, before reaching the 40% legal ceiling.
In addition to limited supply, the development of the domestic bond market is also being hampered by a number of other factors, including the underdevelopment of the domestic bond futures business and the limited scale of domestic bond mutual funds, now amounting to only NT$10 billion (US$313 million). In addition, interest income from bonds is subject to a 20% withholding tax, dampening the interest of foreign investors in the domestic market. Such income is free of tax in Japan and subject to only 10% tax in Singapore. Currently, foreign traders account for only 2% of the trading volume on the domestic bond market.
Due to the absence of an active domestic bond market, local investors – both institutional and individual – have switched their investments to overseas bond markets, which have enjoyed a booming business during the economic downturn.
Liu Yi-cheng, vice president of Cathay Financial Holding, notes that local life insurance firms have invested around NT$3 trillion (US$94 billion) overseas, around two-thirds of the funds under their management, with a large portion of it going into bonds. The phenomenon differs from the situation in developed countries, where life insurance firms generally invest 80% of their funds on domestic products with fixed yield.
As of the end of 2009, Taiwanese had invested NT$773 billion (US$24.2 billion) in overseas bond funds, including those issued by domestic fund managers and overseas funds, almost double the amount a year earlier. Of that amount, according to the Securities Investment Trust and Consulting Association of the ROC, high-yield bond funds accounted for the largest portion at NT$363 billion (US$11.3 billion). A category labeled “others” – including government bonds, investment-grade corporate bonds, treasury inflation protection securities (TIPS), and convertible corporate bonds – was next with NT$227 billion (US$7 billion), followed by emerging-market bond funds with NT$144 billion (US$4.5 billion), and common bond funds with NT$39 billion (US$1.2 billion).
To facilitate investments by Taiwan investors in overseas bonds, the GreTai Securities Market (the over-the-counter market) joined hands last November with ICAP, a leading international securities broker, to launch a “trading platform for foreign government bonds.” The purpose is to enable domestic traders to deal directly in U.S. government bonds, without need for the mediation of foreign counterparts, greatly enhancing efficiency and lowering cost. The platform will be extended to other foreign bonds, including those from Japan and Europe, at a later date.
Market players note that in view of the existence of huge domestic low-cost funds, Taiwan’s bond market has the potential of developing into a regional fund-raising center, but how to invigorate the domestic market and enhance its appeal to investors will be a major challenge for the government and related parties in the years to come.
Acceptance Growing for Futures Products
The introduction this year of individual stock futures has invigorated the market.
BY PHILIP LIU
The Taiwan Futures Exchange rolled out individual stock futures on January 25 this year, which is expected to further enliven stock trading on both the spot and futures markets, thanks to its advantages of low trading cost and precise risk-hedging function.
Taiwan is the 23rd market worldwide to offer individual stock futures, a fast-developing futures product on the global market. Compared with the 13% trading-volume growth rate for the overall global futures market, it underwent 60% growth to reach 1.15 billion contracts in 2008 (the most recent statistic available).
Currently available on the Taiwan market are 34 individual stock futures, all for large-cap stocks and mainly in the fields of electronics, finance, and traditional industries. Among them are China Steel, Nan Ya Plastics, United Microelectronics (UMC), Taiwan Semiconductor Manufacturing (TSMC), Fubon Financial Holding, AU Optronics, Cathay Financial Holding, Chinatrust Financial Holding, Compal, and Uni-President. All of them are constituent stocks of the Taiwan Top 50 Tracker Fund, an exchange-traded fund.
Anyone can open a trading account at a futures firm, pay a margin amounting to 13.5% of the contract’s market value – around NT$10,000 (US$313) per contract on average – and then place orders for either a long or short position. One contract equals 2,000 spot shares. The trading time is similar to that of the spot market, but the matching between buying and selling orders is carried out continuously, achieving much higher efficiency compared with the once every 25 seconds for the spot market.
Contracts expire on the third Wednesday of February, March, June, September, and December, and investors can close their positions before the deadlines. Investors can extend their contracts upon the deadline; otherwise, the futures exchange will automatically clear their positions on the expiration day, with investors having to pay extra money for their loss or receiving money for their profit, all in cash, without the need to deliver physical share certificates.
Although the futures exchange has set the targeted daily trading volume for stock futures at only 4,000 contracts this year, it is upbeat about the market potential for the new product because of its advantages of low trading cost and fund requirement, as well as its flexibility and precision in risk hedging.
Buyers and sellers of stock futures, for instance, are both subject to the 0.004% futures transaction tax, while margin traders and short sellers on the spot stock market have to pay a 0.3% securities transaction tax when selling their holdings, on top of the cost of interest (currently 4.5-6.5% per annum) for their borrowing. Meanwhile, the funding requirement for stock-futures investors is only one-third the level for margin traders and one-sixth that of short sellers, allowing for much higher leverage for investments. Moreover, short sellers currently cannot sell stocks at prices lower the closing prices of the stocks on the previous trading session.
Due to the low trading cost, investors may utilize the product for intraday trading (buying and selling the product within the same trading session) or arbitrage (seeking to profit from the price differential between spot and futures market for the same stock).
Bearish investors can conveniently build up short positions for stock futures without the difficulty of borrowing stocks for short selling when the market goes down.
In addition, stock futures offer full protection for the stock holdings of investors, whereas existing stock index futures, such as the Taiwan Index Futures and MSCI Taiwan Futures, can only provide limited protection. As a result, foreign investors, who may not engage in margin trading or short selling on the spot market, may switch to the new product, so as to better protect their stock holdings.
Many investors are expected to convert their stock holdings into stock futures during the second quarter, the season for the issuance of stock dividends, in order to gain some tax advantage.
With the aim of enhancing the trading volume of stock futures, the futures exchange plans to issue stock futures for the remaining constituent stocks of the Taiwan Top 50 at a later date. It is even considering issuing stock futures for foreign stocks, notably from China, since these do not involve any problem of licensing.
In view of the experience in foreign markets, market players believe that the trading volume for stock futures – which will be the key to the product’s success – will gradually pick up, as investors become increasingly familiar with its operation, despite the absence of a market maker for the system. After referring to South Korea’s experience, the futures exchange decided not to institute market makers for the new product, in view of the difference in the trading speed between the stock spot and futures markets.
Charles Lui, head of the Taiwan office of Optiver, a leading global futures firm headquartered in Holland, says he is upbeat about the outlook for stock futures, adding that it is a product suited to individual investors, the main participants in both the futures and spot stock markets in Taiwan.
But he worries that securities firms, many of which are the parent companies of local futures firms, may be reluctant to promote the stock futures business for fear of affecting their spot-market business. At present, about half of the business on the futures market comes from the recommendation of securities firms in fulfilling their function as introducing brokers (IB). He therefore urges the futures exchange to step up efforts to educate local investors about the advantages of the new product.
Stock futures are joining other stock derivatives now available on the market, including stock price index futures, options, and warrants, further widening the choices for investment portfolios and enhancing investors’ profit opportunities.
Along with the launch of stock futures, the futures exchange in January also rolled out 13 new stock options, increasing the total number of options to 39. An option is the right to buy (call option) or sell (put option) a designated stock at a designated price, also known as the strike price, at a designated time. Moreover, in a bid to reverse the 8% decline in the option business to 90 million contracts in 2009, the exchange cut the handling fee for five major option products, including the Taiwan stock price index option, electronic index option, financial index option, non-financial and-electronic index option, and over-the-counter market index option. The fee was reduced by one-third to NT$10 per contract, from the previous NT$15, effective January 4.
Interest in warrants
Local investors began to show strong interest in stock warrants last year, due in part to the vigorous promotion of the 20 warrant issuing institutions, fulfilling the role of market makers. The number of warrants on the market shot up 62% to over 6,000 in 2009. To further expand the market, the Taiwan Stock Exchange, the regulator for stock warrants, plans to allow the launch this year of callable bull/bear contracts (CBBC) and warrants based on overseas stock price indices. CBBCs are a very popular warrant in some overseas markets such as Hong Kong.
A warrant is the right to buy (call warrant) or sell (put warrant) a certain amount of designated shares at designated prices on designated dates. It is quite similar to an option, but the contract is of longer duration. In addition, warrants are issued by securities firms and are listed and traded on the stock market, while options are issued by the Taiwan Futures Exchange and are listed and traded on the futures market.
Following the rollout of stock futures, the futures exchange plans to launch Chinese stock price index futures in the second quarter, further enriching the product lineup on the local futures market. That lineup now includes eight stock price index futures, six stock price index options, 39 stock options, 34 stock futures, and two gold futures (one dominated in NT dollars and the other in U.S. dollars). In addition, the futures exchange is actively advocating a change in policy to allow China’s QDII (qualified domestic institutional investors) to engage in futures trading in Taiwan for risk hedging of their stock holdings on the spot market. Three QDIIs have already opened accounts with local securities firms to invest in Taiwanese stocks, following the coming into effect in January of the Memorandum of Understanding negotiated last year for cross-Taiwan Strait cooperation in financial supervision.
As a result, during a press conference on February 1, Tsai Ching-nien, chairman of the Taiwan Futures Exchange, expressed confidence that the trading volume on the Taiwan futures market this year will increase by more than 10% to reach 149 million contracts, for a daily average of 600,000 contracts.
In comparison, the futures trading volume reached 135 million contracts in 2009, down by a slight 1.17% from the peak level in 2008. In 2008, the volume jumped by 18.7% to 136.7 million contracts, as investors flocked to the futures market for risk-hedging purpose in the midst of the global financial tsunami. Daily trading volume in 2009 stood at 548,000 contracts.
Thanks to the reduction in the futures transaction tax, the average daily trading volume of index futures leapt 18% to 179,000 contracts in 2009, while the volume of stock options declined 9.6% to 352,000 contracts. Stock price index futures and stock price index options were the two mainstream products of the market, accounting for over 90% of the total trading.
The scale of the market in 2009 was 485 times that of 1998, which reached only 277,000 contracts, underscoring the vigorous expansion of the market over the years as products on the market have become increasingly diversified and local investors have become increasingly aware of the advantages of futures products for risk hedging and profit making. As of the end of November 2009, the number of individual futures trading accounts had topped 1.25 million, according to the Securities and Futures Bureau of the Financial Supervisory Commission (FSC). The futures market is also proud of its trading efficiency, as 80% of the trading orders are placed online, compared with 50% on the stock market.
“Taiwan leads neighboring markets in the trading volume of its mainstream products: stock price index futures and stock price index option,” notes Charles Lui of Optiver. “In addition, the Taiwanese futures market boasts high trading efficiency, thanks to the heavy IT investments by the futures exchange and futures firms in recent years.”
Lui attributes the vigorous development of the market in recent years partly to the participation of foreign futures firms, which were allowed to enter the market in 2005. Foreign futures firms, for instance, have been instrumental in introducing advanced market-maker mechanisms to the market, greatly expanding trading volume.
Market-making functions as a lubricant for the market, putting forth bid prices (buying prices) and offer prices (selling prices) for futures products, facilitating transaction settlement. “The role of market maker is similar to a money changer, which offers buying and selling rates for conversion of one currency to another,” explains Lui.
The participation of foreign firms has considerably narrowed the spread between bid and offer prices, thereby greatly cutting the trading cost for investors, according to Lui. At present, 40-45% of trading volume on the market is carried out via the market-maker mechanism.
Foreign firms, says Lui, also helped the futures exchange set up the SPAN (Standard Portfolio Analysis of Risk) one year ago, which accurately calculates the risk level of a trading account, thereby lowering the margin required of investors by 80% on average.
Trading volume has also been stimulated by the continuous reduction of the futures transaction tax rate over the past years. Now 0.004%, the rate was 0.05% in 1998 before being cut to 0.025% in 2000 and 0.01% in 2006.
Thanks to the large scale of trading volume, the Taiwan Futures Exchange garnered after-tax revenue of NT$1.3 billion (US$40.6 million) in 2009, NT$200 million (US$6.3 million) more than the previous year, with EPS (earnings per share) reaching a handsome NT$5.39 per share.
Due to the plunge in time-deposit interest rates and a less satisfactory performance in investments, however, the 19 specialized futures firms saw their profits drop by 50% from the 2008 peak level, when they achieved EPS of NT$2.33.
Futures firms say they are confident about scoring a better performance in 2010, as the rollout of stock futures and the decrease in handling fees for five options products is likely to expand trading volumes. Starting this year, in addition, the futures firms will be able to accept orders not only for futures trading but also for trading on the spot securities market, undertaking the role of IB.
Market players are also upbeat about the market potential related to the huge Chinese market. The Taiwan Futures Exchange is currently probing opportunities for local futures firms to trade in China’s merchandise futures market, including metals and bulk commodities. “Taiwan firms boast strong advantages – in management, product development, and staff expertise – to tap the Chinese market,” says Charles Lui. “However, they will have to step up their pace, since the window of opportunity will be closed in a few years.”
In another new development, the Taiwan Futures Exchange this year plans to open up the leverage transaction merchant business, which involves brokerage for or dealing in leverage contracts. “Until now, Taiwan’s futures market has been subordinate to the spot stock market,” says Lui. “But thanks to the leverage effect, the futures market will eventually surpass the spot stock market in trading volume,” he predicts, citing the experience of industrially developed nations.