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spell on foreign visitors, but the sailors of old have been replaced by international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.
