Developing the Asian bond markets Shanghai, 25-26 September 2007

Minimizing Foreign Exchange Settlement Risk in the ASEAN+3 Region

Alan Taylor, ADB Consultant 25 September 2007

2

Topics

3. Proposed settlement infrastructure

2. FX Settlements in Asia

1. Objectives and Progress

5. Proposals for further work

4. Feedback from the settlement conference

3

Topics

3. Proposed settlement infrastructure

2. FX Settlements in Asia

1. Objectives and Progress

5. Proposals for further work

4. Feedback from the settlement conference

4

Objectives of Study

Overall ABMI (Asian Bond Market Initiative) objectives• Development of local currency bond markets

– Alternative to bank and equity finance– Avoidance of maturity and currency mismatch– Deepening of liquidity, yield curve etc

Project objectives• Risk reduction in clearing and settlement• Removing the barriers to cross-border bond investment• Does Asia need a regional settlement intermediary

(RSI)?

5

Progress-to-DateInitial research:• Analysis of settlement risks, drawing on earlier studies • Market consultations May-August 2006

– Asia, Europe, US– Central banks, custodians, depositories, asset managers etc

Interim report:

• Market survey December 2006 - January 2007– financial institutions throughout ASEAN+3– 76 responses

• Development of further RSI Options• Asia Bond Clearing and Settlement Conference, April 2007

– Further feedback from attendees• Follow-on consultations with private sector

Final report:

6

ASEAN+3 bond markets size & growthUSD bn

0

500

1,000

1,500

2,000

2,500

27% average annual growth 2004 - 20062004

2006

7

Market survey / settlement risk (Q5)

0 20 40 60 80 100

Very concerned

Moderately concerned

Slightly concerned

Not concerned

57% are very / moderately concerned

"…concerned about the systemic risk given the high growth prospects of Asian bond markets" Central bank"…settlement and pre-settlement risks" Local custodian bank"…need to reduce principal risk and replacement cost risk, but cross-border investment in ASEAN+3 is small" Central bank

To what extent are you concerned about foreign exchange settlement risk for cross border bond transactions in ASEAN+3?

8

Market survey / settlement risk (Q6)

0 10 20 30 40 50 60 70 80 90 100

Big benefit

Moderate benefit

Slight benefit

No benefit

72% see big / moderate benefit

To what extent will it benefit your business if you can make payments and securities settlements in the same Asian time zone?

"…great benefit of reducing settlement risks. Ideally, PvP and DvP facilities should be introduced" Central bank"…free up credit line, maximize cash flow usage" Commercial bank"…cross-border transactions in Asian time zone will be stimulated" CSD

9

Topics

3. Proposed settlement infrastructure

2. FX Settlements in Asia

1. Objectives and Progress

5. Proposals for further work

4. Feedback from the settlement conference

10

FX settlements in ASEAN+3

1. Using correspondent banks

2. Using CLS Bank

3. Using local payment vs payment systems

FX settlement risk is borne by the banks, but the cost is passed on to the end investor

11

• Risk of counterparty default ('Herstatt risk')– AFTER paying currency A, and BEFORE receiving currency B– The exposure lasts from the time the payment instruction for

the currency sold becomes irrevocable until the time the receipt of currency purchased is confirmed.

FX settlement (1) using correspondent banks

Duration of Exposure

Source: “Settlement Risk in FX transactions", CPSS report, BIS (1996).

FX settlement 1: Correspondent banks

12

FX settlement 2: CLS Bank

• Assured payment vs payment– Established 2002– 15 eligible currencies– Owned by 72 member banks

• Benefits– Elimination of settlement risk– Operational efficiency

• Limitations– Only 4 Asian currencies eligible– Expensive to become a member– Settlement is late afternoon /evening Asian time

13

FX settlement 3: Local PvP systems

• Settlement of USD vs local currency– Payment vs payment– In local Asian time zone– Local currency settles via local RTGS, central bank money– USD settles via appointed settlement bank

• Existing systems– Hong Kong (HKD vs USD) – Hong Kong (HKD vs EUR)– Malaysia (MYR vs USD)– Philippines (PHP vs USD)

• Limitations– Participants must be local banks– Dependence on a single provider– Potential risk on commercial bank

Bank A

HKDRTGS

Bank B

USDRTGS

HKD RTGS USD RTGS

Bank B Bank A

HKMA HSBC

Payment flow Message flow

HKDCCPMP

USDCCPMP

Matching

14

Third Time Zone Problem

BRUSSELS

10/1 10/2 10/3

(time) 0 9 16 0 9 16 0 9 16 0

SEOUL

10/1 10/2 10/3

(time) 8 9 16 17 0 8 9 16 17 0 8 9 16 17 0

Investors in Asia must deposit money or securities a day before the settlement date

ICSDs & global custodians provides batch processing & intra-day line of credit

Investors bear the opportunity cost of losing liquidity for a day

8 hours of time difference Europe and Asia…

15

Topics

3. Proposed settlement infrastructure

2. FX Settlements in Asia

1. Objectives and Progress

5. Proposals for further work

4. Feedback from the settlement conference

16

What are the options?

• Option 1: Maintain the status quo

• Option 2: Set up a Regional Settlement Intermediary

17

Option 1: Status Quo

• = leave evolution to local initiatives and market forces

• Arguments for:– Market based solution– Existing global custodians are well capitalized and

regulated– Current low volumes in region

• Arguments against:– Existing settlement infrastructure focused on US /

Europe– Dependence on a few providers– Region should design its own infrastructure

18

Option 2: Regional Settlement Intermediary(summary of options)

• Option 2.1: Asian ICSD– Model A = Using Local Custodians– Model B = Direct Link to Local Settlement Systems– Model C = Direct Link to Local Settlement Systems & CLS Bank

• Option 2.2: Pan-Asian CSD• Option 2.3: Asian Payments Bank

All are aimed at reducing settlement risk and cost, harmonizing infrastructure, regional ownership of regional utilities

19

2.1 Asian ICSD

• Custody and settlement– 3 business lines

• ASEAN+3 investors investing in other ASEAN+3 bond markets• ASEAN+3 investors investing in US/European bond markets• US/European investors investing in ASEAN+3 bond markets

– US$ bonds issued by Asian governments can be 'seed' business• Direct users

– Banks and securities dealers• Bridge to both European ICSDs

– Book entry settlement, securities vs cash• Settlement geared to Asian time

– 3 possible mechanisms (described in Final Report): Model A; Using local custodiansModel B; Using direct links to local paymentsModel C; Direct links + special link to CLS

• Scope: only for bonds, or for equities too?

20

Option 2.1: Asian ICSD

Asian ICSD

CSDSingapore

CustodianBank

SecuritiesDealer

Euroclear /Clearstream

CSDChina

CustodianBank

SecuritiesDealer

Investor

DvP settlement bridge

Investor

etcCSDIndonesia

Settlement links(direct or via local custodians)

21

2.2 Pan-Asian CSD

• Depository for all debt securities issued in ASEAN+3– Existing national CSDs could be sub-depositories– Possible model: Euroclear Single Settlement Engine in Europe

• Direct users– Banks, securities dealers, possibly institutional investors

• Bridge to European ICSDs?• Link to local payments systems

– Settlement in central bank money

• Scope: only for bonds, or for equities too?

22

Option 2.2: Pan-Asian CSD

Pan-AsianCSD

Bond marketVietnam

Bond marketMalaysia

CustodianBank

SecuritiesDealer

Investor

Bond marketKorea

Bond marketIndonesia

etc

23

2.3 Asian Payments Bank

• Assured payments versus payments– PvP ASEAN+3 currencies vs US$– PvP ASEAN+3 vs ASEAN+3

• Final settlement of US$ in Asian time zone– Mechanism to be discussed - may involve consortium of leading

commercial banks, backed by central bank reserves?– Similar local systems in HK, Malaysia, Philippines - expand to regional

system• Direct users

– Banks• Link to ASEAN+3 local payments systems• Special link to CLS Bank

– Enables PvP with participants of CLS

• Scope - only for bond settlements, or for all FX payments?

24

Option 2.3: Asian Payments Bank

AsianPayments

Bank

Thai baht

Memberbank

Memberbank

CLS Bank

Phil peso

Memberbank

Memberbank

Investor

PvP settlement bridge

PvP Settlement links

Investor

Euro (ECB)USD (Fed)

"Asian time"USD

25

RSI - arguments for

• Reduce risks and costs of cross-border bond and FX settlement

• Single platform for whole region• Consolidated holdings of collateral will

help develop repo and derivatives market• Jump-start the integration of regional

markets• Local ownership of regional infrastructure• Catalyst for change?

26

RSI - arguments against

• Infrastructure is not the main barrier to development of bond markets– Lack of price transparency, lack of yield

curve, currency controls, withholding taxes…

• Current volumes low, can be handled by existing providers

• Is there a business case…?

27

Market survey / Need for an RSI?

(Q7a) Is it necessary to establish an RSI to improve the settlement risk on clearing and settlement of bond transactions?

(Q7b) Is it necessary to establish an RSI to improve the settlement risk on foreign exchange transactions?

Yes76%

No24%

Yes78%

No22%

over ¾ believe it is needed

28

Topics

3. Proposed settlement infrastructure

2. FX Settlements in Asia

1. Objectives and Progress

5. Proposals for further work

4. Feedback from the settlement conference

29

Clearing & Settlement conference (April 07)Summary of outcome

1. Rapid growth of the local bond markets, maturing as an independent asset class

2. Significant recent improvements in infrastructure3. Derivatives markets will also grow so also need

efficient settlement infrastructure4. European changes with Target2 Securities, requires

NCSDs to outsource settlement5. Need a regional not national perspective6. Importance of regional initiatives such as ASEAN+3

ABMI7. Broad study into cross-border settlement barriers is

needed for Asia (similar to 'Giovannini study' for EU)8. Need cost and benefit analysis for RSI

30

Topics

3. Proposed settlement infrastructure

2. FX Settlements in Asia

1. Objectives and Progress

5. Proposals for further work

4. Feedback from the settlement conference

31

GOE ProposalStage 1: Asian 'Giovannini' study

• Mandates: – Identify and prioritize the main barriers

(market practice / regulatory / tax / infrastructure) re cross border settlement

– Propose roadmap to remove the barriers– Estimate the costs (compared to domestic

settlement or US / Europe)

32

Setting up a Group of Experts…

In Europe, a Group of Experts successfully studied a number of EU-wide financial issues - Including cross-border clearing and settlement - Chaired by Dr Alberto Giovannini ("The Giovannini report“ (2001, 2003))

CoordinatingCommittee

Subcommittees

Steering & Monitoring Committee

Representatives from ASEAN+3

countries

Private sector professionals

(voluntary basis)

High-level private sector

professionals

ADB representative

Group of Experts

33

Setting up a Group of Experts

1. Strong and consistent (non-financial) sponsorship by EU government

2. Voluntary participation of private sector3. Advisory group, no policymaking power4. Group members selected on ability, experienced market

professionals5. Hands-on style, all members were assigned work!6. Chairman was an effective spokesman at government level7. TOR were clear but not too restrictive8. Lack of bureaucratic structure

Key message: Can rely on the private sector to provide resources, provided public sectors are supportive.

Success factors in Giovannini Group of Experts for EU:

34

GOE ProposalStage 2: RSI evaluation

• Based on Stage 1 findings

• Mandates: – Evaluate the need for an RSI, and if so…– Investigate the feasibility of the various RSI

options – Determine public and private sector roles– Analyze the business case

35

Further informationFor further information, please contact:

Asian Development Bank:Masato Miyachi, Senior Advisor, OREImmiyachi@adb.org

Chiemi-Jamie Kaneko, Senior Financial Market Specialist, OREIckaneko@adb.org

Consultant Team:Changyong Rhee (Seoul)rhee5@snu.ac.kr

Alan Taylor (Hong Kong)alan@atassociates.com.hk

Mariko Sawada (Tokyo)mariko.sawada@mizuho-ri.co.jp