Welcome to Futures Industry
Frederick Grede
Published 2/6/2006

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During the 15th century, Portuguese ships, sailing off the southeast coast of China, came across a neighboring island. The sailors called the island "Ilha Formosa" which in Portuguese means "beautiful island." Six centuries later, Taiwan still casts a siren spell on foreign visitors, but the sailors of old have been replaced by international financiers from London, New York, Amsterdam and Chicago.

Over the past two years, Taiwan has been one of the rising stars of the international derivatives business. Despite having a population of only 23 million, Taiwan has a remarkably active securities market and very high levels of participation by domestic investors. Last year, more than 2.5 million investors actively traded on the local market, according to stock exchange statistics. Increasingly this appetite for trading has spilled over into the equity derivatives traded at the Taiwan Futures Exchange.

Even though Taifex is just seven years old, it has grown so rapidly that it ranks among the top 20 derivatives exchanges in the world in terms of the volume of contracts traded. Taifex volume jumped from 31.87 million contracts in 2003 to 92.66 million contracts in 2005, making it one of the fastest growing derivatives exchanges in the world and the fourth largest in the Asia- Pacific region.

Despite this remarkable success, Taiwanese government and exchange officials recognize that they must look beyond the island's boundaries for new sources of growth. They realize they must act quickly and decisively if they want to increase Taiwan's influence among the major markets in the region, and make sure that it is not displaced by regional alternatives.

According to the most recent figures, retail investors comprise about 45% of Taifex volume. Taiwanese institutional investors and proprietary traders comprise most of the remainder. Less than 5% of the volume comes from foreign investors, far short of the potential for such a dynamic market.

In the last year or so, Taiwan has taken a number of actions to encourage greater participation in its securities and derivatives markets by both institutional investors and foreign institutions. Some of these actions are especially important to the futures industry, such as the pending creation of omnibus accounts, the abolition of the restrictions on speculative and arbitrage trading, and the drastic reduction of transaction taxes.

These actions are contributing to increased awareness of the Taiwanese market among global futures brokers. In the last 12 months, at least seven foreign firms have become members of Taifex, and at least one more is actively applying for membership. These brokers are welcoming the exchange's efforts to harmonize its rules and regulations with international practices, and say Taifex is becoming a much more favorable and less expensive place to do business. Access remains challenging, however, and on the horizon is a merger with the Taiwan Securities Exchange, which could impact the pace of liberalization.

The principal catalyst for the phenomenal growth of Taifex has been retail interest in Taiex stock index options. Last year more than 80 million Taiex options changed hands, an increase of 83% from 2004. Although it only began trading in late 2001, this contract now accounts for 86% of total Taifex volume and ranks as the third most actively traded equity index options contract in the world.

Open interest in the Taiex options, on the other hand, was just 774,202 contracts at the end of December. Like the even more popular Kospi 200 stock index option in Korea, the Taiex option attracts large numbers of retail speculators who see this contract as a relatively low-cost and low-risk way to take a position on the direction of the stock market. The contracts are cash-settled with European-style exercise, meaning that the options are exercised only at expiration. The notional value of each option is based on a multiplier of NT$50 (US$1.57) per index point. In addition, the tax on options transactions is based on premium value not notional value, making options much cheaper to trade than futures.

Taifex has a portfolio of other products as well. Taiex stock index futures rank second in popularity, with 6.9 million contracts traded in 2005 and open interest of 41,870 at year-end. Taifex also lists futures on electronic and finance sector indices, the Taiwan 50 stock index, government bonds and shortterm interest rates, as well as a mini Taiex futures contract. On the options side, the exchange lists options on the electronic and finance sector indices and on various individual stocks.

Encouraging Cross-Border Trading

The exchange has a two-pronged strategy for encouraging greater foreign interest. First, it is developing several U.S. dollar-denominated products to attract overseas Chinese and foreign investors. Gold futures, denominated in U.S. dollars, are expected in the near future, and a U.S.-dollar denominated stock index contract is also being planned.

Second, the exchange is working closely with the government to reduce legal barriers and other obstacles to cross-border trading and investment. In late 2003, Taiwan eliminated a burdensome requirement that foreign investors had to register under a "qualified foreign institutional investor" program. The QFII permit system was replaced with an "ID registration" system, which greatly simplified the process for foreign investors to participate in Taiwanese markets. This was part of an overall effort by the government and financial regulators to meet international standards and make the Taiwanese financial markets more "institution- friendly."

Up to now, however, foreign investors could only participate in Taiwan's futures and options markets if their transactions were for hedging purposes. In practical terms, this meant that foreign investors seeking to take positions in Taifex products were required to hold a position in the underlying securities in Taiwan's domestic market.

Last year the government agreed to abolish this hedging restriction. Foreign institutions will soon be permitted to trade futures and options for both arbitrage and speculative purposes. This should significantly increase the amount of foreign participation in Taiwan's derivative markets. This change is tentatively scheduled to take effect in March.

Taifex also has applied to the Commodity Futures Trading Commission for a Part 30.10 exemption. If granted, this would open the door for Taiwanese brokers to hold positions for U.S. customers and would allow them to market their services directly to U.S. customers. It should be noted, however, that local brokers seeking to take advantage of this are required to meet certain conditions set by the U.S. authorities, including applying to the National Futures Association.

Another change, smaller in importance but still significant, is an increase in position limits. In the Taiex futures contracts, individuals can now hold up to 2,500 contracts and institutions can hold up to 5,000 contracts. In the Taiex options contract, individuals can now hold up to 10,000 contracts and institutions can hold up to 20,000 contracts. In addition, institutional investors can apply for exemptions from the position limits for hedging purposes. These limits will apply to both domestic and foreign market participants.

Omnibus Accounts

Another crucial change coming in the near future is the introduction of omnibus accounts, whereby a foreign broker conducts business on behalf of multiple customers through a single account with a local broker without disclosing the identity of the customers to that broker. Omnibus accounts are widely used in international trading because they allow customers to consolidate their business at a single global broker, and give the global brokers an efficient way to provide access to a large number of futures and options markets.

The introduction of omnibus accounts is expected in March, but exchange officials caution that this date is tentative and subject to approval. Once the new rules take effect, foreign brokers will be able to open omnibus accounts with different local brokers, or multiple accounts with one broker. The broker or brokers holding these accounts must be clearing members of Taifex. Currently the exchange has approximately two dozen general clearing members authorized to clear trades for the customers of other futures brokers as well as their own customers.

To qualify for permission to hold an omnibus account with a Taifex clearing member, the foreign broker must be a member of a recognized foreign exchange. In addition, the firm must have a clean disciplinary record in Taiwan and its home country.

The foreign broker is not required to disclose to the local broker the identities of individual customers behind the omnibus account or information about the customers' trading strategies. The exchange, on the other hand, does require that every foreign customer obtain a unique ID code before trading, and requires their open positions to be reported to the exchange on a daily basis. The ID codes are obtained through custodian banks, if the foreign customer is offshore, and a local broker if onshore. This ID registration system enables the exchange to monitor compliance with position limits.

For some brokers, omnibus accounts will be the most effective way to gain access to Taifex. Others will prefer to go through the more difficult and time-consuming process to become clearing members, in part because they anticipate significant customer business coming out of Taiwan as well as going in.

These reforms are encouraging foreign brokers, many of which are already active in local securities markets, to sign up for membership on Taifex through local subsidiaries. In the past 12 months, Optiver and Société Générale have joined as market makers (i.e., for the purpose of engaging in proprietary trading), while Credit Suisse, Fimat and JP Morgan have become members for the purpose of handling customer business on the exchange. The most recent to join was Merrill Lynch Futures Asia and Citigroup Global Markets, both of which began operating as members of Taifex in December. [Editors Note: UBS Securities began operating as a Taifex member on Jan. 10.]

It should be noted, however, that a broker— foreign or otherwise—cannot become a clearing member of Taifex until it has been a member for at least 12 months. This means that these foreign brokers will have to rely on local houses to clear their trades on Taifex until that first year expires.

[Editors Note: Another foreign broker, Refco, set up a joint venture in Taiwan in 2003 with Polaris Financial Group, a leading local brokerage house. According to a spokesperson for the joint venture firm, Polaris Refco ranks as the largest futures broker in Taiwan, with more than 11% of the domestic market and 40% of domestic trading on foreign futures exchanges. Following the bankruptcy of Refco's parent in October 2005, Man Financial acquired Refco's futures brokerage business, including its 20% stake in the joint venture with Polaris.]

Reducing Taxes

The Taiwan government is also doing its part to stimulate trading in Taiwan's financial markets. Previously, the Taiwan government imposed a significant transaction tax on equity derivatives. Taxes were assessed at .025% of the contract value on each stock index futures transaction. Combined with broker commissions and exchange service fees, this made Taiwan one of the most expensive places in the world to trade futures contracts, and encouraged some Taiwanese investors to take their business to Singapore's SGX. It has been estimated that as much as one third of the turnover in the MSCI Taiwan futures contract at SGX comes from Taiwanese investors.

Last November, the Taiwanese legislature passed a bill that significantly reduced the tax burden on futures and options. First, the bill lowered the transaction tax on equity-related index futures to .01% of the value of the transaction. That translates into a reduction of 60%. Second, the bill cut the transaction tax on options to .1%, which translates into a reduction of 20%. Thirdly, the bill changed the taxation of interest rate futures so that taxes are assessed on a pertransaction basis, rather than on capital gains. These changes to the tax code, which took effect at the beginning of January, will reduce transaction costs and provide another major boost to future growth in Taiwan's derivative markets.

Taifex is also making its margining requirements more efficient by implementing better netting mechanisms and providing for ways for customers to take advantage of those mechanisms. Individual clients can apply for position offsets, option combinations and reduced margins for the positions they hold.

Pending Merger with Stock Exchange

One of the biggest issues on the horizon for Taifex is the government's desire to consolidate the securities market infrastructure. Last November, the Financial Supervisory Commission, Taiwan's principal financial regulator, announced plans for a merger of Taifex, the Taiwan Stock Exchange, and the Taiwan Central Depository Company, the nation's main securities custodian. The proposed merger follows similar trends in the neighboring Asian countries of Singapore, Hong Kong, Malaysia and Korea as well as in Europe.

Details have not been announced yet, but the FSC said the three entities would merge into a holding company "in order to become more efficient and to increase competitiveness." The FSC added that it would set up a task force to draft a plan and timetable for the merger.

Clearly, Taiwan is taking numerous steps to improve upon its record of success. Time will tell, how well Taifex can continue to flourish under a new organizational structure.

Frederick Grede is chairman of Vega Financial Engineering Limited, a consultancy specializing in international derivative markets. Clients of Vega include the Agricultural Futures Exchange of Thailand and the Thailand Futures Exchange. Prior to Vega, Grede was chief operating officer of Hong Kong Exchanges and Clearing Limited and chief executive of the Hong Kong Futures Exchange.
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