U.S. regulators are pushing to move much of the $693 trillion over-the-counter derivatives market to new electronic platforms known as Swap Execution Facilities (SEF), which will increase transparency and help prevent the recurrence of the 2008 crisis. The SEFs started trading on Oct 2.
But dealers estimate only 10 to 20 percent of Asia's daily market turnover in currency and interest rate derivatives - estimated by derivatives traders in the region at about $20 billion - has moved to the SEFs with the rest being settled in the wider market or bilaterally. The fragmentation of liquidity has made it difficult for investors to hedge portfolio risk, especially for large trades.
Asian participants say they are not legally bound by the rules drawn up by the Commodities Futures Trading Commission (CFTC), the main U.S. derivatives regulator. But any trades with U.S. counterparties will have to be on SEFs if their deals with American entities exceed $8 billion over the preceding 12 months.
"We have shifted away from dealing with U.S. persons although we have not forbidden our staff to trade with them altogether - if you have to do it you have to do it, but if you have an alternative then go for that as we would like to keep under the CFTC minimum threshold," said Frederick Shen, head of global treasury business management at Oversea-Chinese Banking Corp Ltd (OCBC) in Singapore.
Trading on the SEFs will mean more disclosure and other regulatory requirements in addition to more costs. So many Asian banks now prefer to trade derivatives with non-U.S. counterparties, or look to settle trades bilaterally.
"One of the issues with SEFs is because you are going through a broker, they are likely going to charge you more on a SEF because they've got additional reporting requirements. They typically have to outsource that work, so they pass on the additional cost," Shen said.
U.S. banks, worried they may be shut out of the growing Asian swaps and derivatives market, are employing methods that will avoid the rules but are legal.
LONDON SUBSIDIARIES
Citigroup, Goldman Sachs and Morgan Stanley are offering their London subsidiaries for Asian counterparts to settle trades, said derivatives dealers in Singapore, Hong Kong and Seoul who are involved in the trades.
JP Morgan is taking advantage of a carve out that allows it to route trades with non-U.S. counterparties via its Singapore branch and still not be caught by the rules, they said.
Goldman Sachs, Citigroup, Morgan Stanley and JP Morgan all declined to comment for this article.
Late last year, Reuters reported that U.S. banks such as Morgan Stanley and Goldman Sachs were explaining to their foreign customers that they could avoid the rules by routing trades via the banks' non-U.S. units, according to industry sources and presentation materials.
"Some U.S. banks have restructured and set up London offices and asking us to go through them," said OCBC's Shen.
While these patchwork solutions have kept the mammoth derivative markets working for now, market watchers say they have kept them vulnerable to a sharp selloff - the very outcome regulators are trying to prevent.
"Splintering market liquidity has made markets more vulnerable and we are deeply concerned with these developments," said Mark Austen, CEO at Asian Securities Industry and Financial Markets Association (ASIFMA), an industry body. "We wish regulators could have taken a more coordinated global approach on this issue."
Europe is not expected to implement rules forcing trades on to electronic platforms until 2015 at the earliest while Asian regulators have not set out any immediate plans to bring in such regulation.
Regulators fear a "Balkanization" of the market and the likelihood that more transactions will be done outside of SEFs will undermine the transparency that the rules were supposed to achieve.
While routing trades through U.S. banks' offshore offices have worked for now, traders in South Korea said different interpretations of the overseas subsidiaries of these banks have raised uncertainty and damaged market liquidity.
Asian markets have already had a whiff of things to come.
When the CFTC began implementing the new rules on October 2, Korean and Indian offshore derivatives markets, where U.S. banks have a sizeable presence, wobbled.
Earlier in the year, concerns that the U.S. Federal Reserve would hike interest rates sent Asian markets skidding even though net outflows were only about $85 billion according to Thomson Reuters data, a fraction of the trillions of dollars that have gone into Asian markets since 2009.
A source at a U.S. bank in Seoul said that half of its existing counterparties label U.S. banks as "bad names" or not appropriate for trading. As long as uncertainty remains about implementing these rules on a global basis, local counterparties will shun these banks, the source said.
"One of the things that has happened in Asia is liquidity in these products has shifted to the London opening hours than in the Asian time zone as market participants expect European-based entities to step in provide more liquidity " said Keith Noyes, regional director of International Swaps and Derivatives Association, a derivatives body, for Asia in Hong Kong.
"We are going to end up with bifurcated markets with the U.S. and the non-U.S. market."
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