Default debate impacts Japan

Japan’s credit derivatives industry will closely watch the results of the first meeting of the International Swaps and Derivatives Association’s new credit derivatives committee on market practices, on March 12. Committee members will be groping for a solution to the most controversial issue to hit the industry in its short existence.

The emotive subject, which turns on whether corporate debt restructuring should trigger a swap default payout, erupted last September when a group of 10 major banks in New York arbitrarily changed the rules. This resulted in a two-tier US market, with higher prices for default swaps that include a debt restructuring clause.

Although Isda has an existing credit derivatives committee, this is chiefly comprised of lawyers dealing with documentation. The first meeting of the new committee, aimed at bringing together deal-makers and traders, will video-link London and New York. Market heavyweights will chair each end – Blythe Masters, head of JP Morgan’s structured credit products in New York, and Paul Varotsis, executive director for structured credit trading at Lehman Brothers in London.
In Japan, the level of corporate restructuring is making the issue especially significant. Under present Isda documentation, a debt restructuring is one of several credit events – along with bankruptcy, failure to pay and debt repudiation – which oblige the seller of protection in a credit default swap to pay out. But the Japanese big banks, which are often large sellers of protection, say that creditors and lenders (buyers of protection) often do not lose out when a company restructures its debt, and therefore receive a windfall gain from a default swap payout.

Among the possible solutions is a deletion of the restructuring clause from Isda documentation, or a new form of wording that draws much more tightly the
circumstances in which the clause is activated. Bank regulators are saying that if debt restructuring is not included in default swap contracts, there will have to be an increase in the amount of capital that banks must maintain against such deals.
For default swap traders in Japan, the problem is not just the high level of corporate restructuring, but also the lack of transparency surrounding such events and the close relationships between banks and their customers, says Terry Tanaka, head of legal and regulatory affairs in the international treasury department of the Industrial Bank of Japan, and an Isda board member. It is often very difficult for a protection seller to know what really goes on behind closed doors when one or two banks restructure their loans to a corporate customer. He cannot know which loans have been restructured, whether the creditors have actually lost any money, or whether they have received additional collateral. It creates the conditions for abuse, says Tanaka.

Whirlwind growth

Weather derivatives trading in Japan will see very rapid growth in 2001, with volumes tripling or quadrupling compared with activity over the past 18 months.
According to Jonathan Whitehead, vice-president for trading and origination at Enron Japan, a subsidiary of the Houston-based Enron energy group, the market in these products, although still in its infancy, is “moving very fast. We are starting to see the Japanese energy companies taking a lot of interest”.
Until now, the leading participants in this market have been financial institutions, such as reinsurance companies and banks. Although there have only been about 30 or 40 transactions since the market got going in the latter part of 1999, half of those have come in the last three months, says the Tokyo-based Whitehead. He predicts liquidity in the market will increase significantly in the coming months.

Jonathan Whitehead, Enron: “We are likely to begin getting linked deals”
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Big deals
At the moment, individual transactions are much bigger in Japan than in either the US or Europe, where a typical deal would mean having $1 million at risk. Japanese deals tend to be 10 or 20 times bigger, according to Whitehead. The reason is that many of these are undertaken by insurance companies, “which tend to be aggregators of much smaller risks. They then lay these risks off in one large transaction”, he says.
The chief forms of weather derivatives are heating or cooling degree-day swaps, which commonly use a reference temperature of 18°C (people tend to turn their heating on at temperatures below that level and the air conditioning on at temperatures above that level). The fixed leg of the swap is an agreed value, while the payout on the floating leg is determined, in the summer months for example, by the number of cooling degree-days during a specified period. However, in Japan, options on swaps are the most popular, partly because they are preferred by financial institutions.
Deregulation of the Japanese energy markets is set to give a big push to the expansion of weather derivatives. “As in the US and Europe, deregulation is the catalyst,” says Whitehead. Electricity deregulation is just getting underway, and foreign energy companies are now allowed to compete. The first phase came a year ago, when transmission grids were opened up to all electricity generators over a certain size.
“As we get a more liquid electricity market, and a greater acceptance of weather derivatives among other energy companies, such as the oil firms, we are likely to begin getting linked deals,” predicts Whitehead. This could mean, say, having weather derivatives embedded into electricity supply deals, where the amount provided is determined – on a sliding scale and at a pre-set price – according to the number of days the temperature is above or below a specified temperature. Such linked deals would be particularly applicable to the market in kerosene, which is widely used for heating in Japan. That would be an ideal commodity to link to weather derivatives, says Whitehead.

JapanRisk Comment

Japan seems poised between two paths. Option number one would mean that the nation achieves what it has not been able to do convincingly for nearly a decade now – reform the way it handles credit risk measurement and management throughout its entire economy. Option number two is to keep muddling along, with politicians implementing stop-gap measures designed to stave off the inevitable.
This is certainly a scenario where fortune would favour the bold. The right moves on the part of the Japanese government could avert disaster and put the country on the path to recovery. A failure to act could result in a repeat of the nation’s “lost decade” of the 1990s. Either way, the credit risk industry stands to profit – by playing a part in cleaning up credit messes, or helping implement new risk measurement and management systems.


In this special issue, JapanRisk, the staff of AsiaRisk look at the entire credit risk picture. Contributing editor Melvyn Westlake travelled to Tokyo to write a trilogy of articles on the subject. The first piece looks at the fundamentals that are driving the overall credit risk deterioration and how this could play out over the longer term. Then he turns his attention to the subjects of securitisation and credit derivatives, to examine how these tools are being used in Japan to help banks put their books to rights.
Furthermore, AsiaRisk deputy editor Nick Sawyer looks at the internet-based derivatives and foreign exchange trading platforms that are springing up across Tokyo, and how the unprecedented access and transparency that these will bring to the markets will help boost the use of those products.
The Risk Waters Group hopes that this will be the first of many new products – both from the editorial and the conference division – geared towards the needs of Japan’s risk management community.

Awaiting the bull’s return

Japan’s equity derivatives executives argue that the potential for growth in those instruments remains, in spite of near-term setbacks. Four bankers talk to JapanRisk about the prospects for these products
Equity derivatives have grown over the past year to be big business in Japan. Many firms launched operations, or expanded existing ones, on the back of hopes that a recovering Japanese economy would lead to a rising stock market. Unfortunately, the second half of 2000 and the first quarter of 2001 are proving to be a great deal bumpier a ride than expected. The Nikkei has continued its downward trend, while mark-to-market accounting rules are making many companies think twice about issuing equity derivatives and investors about buying them.

Paul Frost-Smith, JP Morgan: Expecting more product discrimination and less overall risk appetite
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Nevertheless, the four equity derivatives executives that JapanRisk spoke to agree that the second half of 2001 promises much for the sector. A recovery in the stock market is generally projected for the third quarter, which should lead to an overall demand for these products, especially from the retail side. In addition, internet distribution is making equity derivatives much more transparent and accessible. On top of this, it is unlikely that Japanese interest rates will rise much over the coming year, leaving the country’s investors hungry for returns – returns that equity derivatives can help provide.
Below, four executives from prominent equity derivatives operations in Tokyo discuss what they expect from the coming year, and how they are shaping their own businesses.
Last year was a very positive one for the Japanese equity derivatives market. What kind of a year do you think 2001 is shaping up to be?
Hiroshi Wakutsu, managing director and head of equity derivatives sales, Nikko Salomon Smith Barney: Well, if the Japanese market drops, no equity derivatives products will be popular. The markets will probably be quiet through the first quarter of the year. They will be quiet ahead of the year-end results at the end of March – especially so this year because of mark-to-market accounting. But once the market confirms the bottom, people will be very interested in participating in upside, and will be looking for products that will give them a lot of leverage to do so, unlike monetised coupons.
Jim Clark, managing director, head of equities trading, UBS Warburg (Japan): It has been a reasonably slow start to 2001 in Japan, with the Nikkei languishing in the 13,000-14,000 range. However, while we may not have the same market conditions as at the beginning of last year, there will inevitably be various opportunities that will present themselves as the year progresses. There is the potential for an increase in convertible bond issuance, flow and liquidity in the single-stock over-the-counter option market will hopefully increase, and there is potential to see an increase in business from the corporate sector.
Paul Frost-Smith, managing director, JP Morgan: We also think the climate will be more mixed. On the retail side, many investors have become more wary as they have seen stock and index levels slide through strike prices of options they have sold, realising losses. On the other hand, the asset management business is picking up and there is always room for risk management advice to the big institutional equity holders.

Turning on to the techno wave

Japan’s major banks have been reluctant to adopt electronic trading technologies, but the tide is turning as banks begin to recognise the potential of the internet. Nick Sawyer reports
A dizzying array of internet-based trading platforms for over-the-counter derivatives and foreign exchange have emerged in the past 12 months, but until recently most of the attention has focused on US and European financial institutions. Now that seems set to change. Over the past few months, a number of software companies have rolled into Japan in a sign that attitudes are shifting, and even the major banking behemoths now appear to be mulling over internet strategies.

Shinji Yamauchi, Cognotec: “2000 was the start of Japanese banks really starting to implement automated foreign exchange”
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Up until now, Japanese traders have relied, for the most part, on traditional domestic broking systems and their own internal data centres. Electronic trading for foreign exchange is nothing new in the Japanese market, but there has been a reluctance to embrace the internet for business purposes, and consequently Japanese banks have been slow to develop proprietary online trading platforms.
Meanwhile, a flood of third-party software vendors have developed online solutions, but have focused predominantly on marketing to US and European financial institutions.
Now, however, they view Japan – a country with a reputation for being technologically adaptive – as a potentially big market for their products.
“Here in Japan, we are still a bit behind the trends in Europe and North America, in the sense that everyone is talking about it [electronic trading] but the uptake has been slow,” says Jerome Kemp, Asia-Pacific head of futures and options and a managing director of JP Morgan, based in Tokyo. “That said, I think we are about to turn the corner in terms of clients seeking and demanding electronic access.”
The change in attitude among Japanese institutions is partly in response to the steady evolution of online platforms, and particularly the development of application service provider (ASP) technology. ASPs cut costs by hosting the trading software on a central internet platform, rather than on the banks’ individual servers. Indeed, the cost-efficiency appears to be a major driver, helping Japanese clients to overcome their initial scepticism of the internet.
As well as ASPs, there are a range of alternative online platforms available in the Japanese market, including: proprietary systems that are available only to dealers within a particular bank; dedicated private lines linking a financial institution to a central database run by a third party; and internet systems where the trading software resides on a client server within the bank.
JP Morgan’s futures and options brokerage is currently marketing a proprietary online system called ExtraTrade, which gives its clients access to global futures and options exchanges. The Tokyo Stock Exchange was added to the system last year, and it will soon be extended to include the Tokyo International Financial Futures Exchange. However, the system, which was developed using software from French company GL, is global and not specific to Japan.
Over the past year, JP Morgan has participated in the development of a number of online platforms, ranging from futures and bonds to credit derivatives. But Kemp adds that determining what products to make available via the Web is by no means an easy decision. “At JP Morgan, there are a number of discussions that are going on now with regards to what we can actually deliver via the internet to our clients,” he says. “Clients on the one hand don’t want to lose access to a multiplicity of price providers, but they want to gain, by the same token, the efficiencies in terms of the ergonomics and cost that the internet provides. So there’s a very interesting debate going on between clients and providers as to what the best solution is, and I think that the jury is still out.”
Merrill Lynch is also looking to add to its current electronic trading capabilitites, according to Paul Grotowski, Tokyo-based director of Pacific Rim debt markets and e-commerce. “An application called EOS [execution order system] delivered via dedicated lines has been marketed in Japan for more than five years and
covers futures, options and convertible bond executions on various exchanges,” he says. “EOS serves as the primary front end for in-house traders, as well as providing order management and back-office functions. This application was developed in-house and we are currently looking at EOS delivery via the internet,” he adds. In terms of foreign exchange, the bank uses a number of third-party vendors including EBS, Reuters Dealer 2000 and Fast Forwards, the Tullett & Tokyo/Bloomberg platform.
Bank of Tokyo-Mitsubishi (BTM) is currently working with electronic trading portal FXall for its online foreign exchange operations. Founded by six financial institutions, including JP Morgan, Morgan Stanley Dean Witter, Goldman Sachs and UBS Warburg, FXall now has a base of 31 banks, and offers straight-through processing (STP) for foreign exchange spot, forwards and options. FXall plans to create an open environment to automate foreign exchange transactions and allow dealers to have a single point of access to all participating dealers. Banks can access the platform over the internet or via a private network, although liquidity providers may be required to install software provided by FXall.

Escape route for troubled banks

Japan’s banks are starting to use credit derivatives to manage their balance sheets. The creation of synthetic portfolios as a way to reduce loan exposures should spur the credit derivatives market to new heights. Melvyn Westlake reports from Tokyo
Credit derivative specialists are sometimes viewed as medieval alchemists transmuting base metals into gold, complains a Tokyo-based practitioner of the most recent of the two recondite occupations. “Some creditors think that these derivative products will magically transform their bad loan books. Of course the alchemists didn’t have much success either,” he quips.

James Singh, UBS Warburg: Credit derivatives are now linked with other instruments to create credit solutions
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Magic may not be possible, but demand for credit derivative products is expanding very fast in a country where credit distinction was an alien concept until quite recently. Indeed, conditions in Japan are more favourable to growth and innovation in the credit industry than ever before, say deal arrangers and traders.
Not only is Japan’s investor base for credit risk products broadening, but there are the first signs that domestic creditors are beginning to hedge risk or consider shrinking their balance sheets, spurred on by corporate restructuring and merger activity. The credit derivatives business in Japan, which is really only four or five years old, has been growing at an annual rate of 100% since 1998, reckons Malcolm Perry, vice-president for credit derivatives trading at JP Morgan in Tokyo. This year should see a further 50% to 70% increase – off a larger base – he predicts. In trading volume terms, the equivalent of $1 billion to $1.5 billion of business was going through the market each month in 2000, Perry estimates. The figure for 2001 is likely to be around $2 billion.
Also changing is the character of the business. In the early days, the market was driven by participating Western banks hedging their own positions. “But in the past 12 or 18 months, these derivatives have become another investor product. And now the business is often driven by investors looking for assets, because if you can get an asset in derivative form, you will get a better yield than from a cash instrument. The problem today is often finding the risk exposure,” says Perry.
Japanese banks that are anxious to generate income are easily the largest investors, he says. By selling protection – that is, taking the credit risk on a particular debt through a default swap – these banks can often earn three times what they get from the loans they make to the same corporate debtors, Perry adds.
However, the Japanese banks, which hold huge credit exposure, have not tended to be buyers of such protection (sellers of risk). Not least of the reasons is that a premium of, say, 150 basis points, would in many cases be higher than the income from the loans (at perhaps 50bp).
Seeking exposures
As a result, the intermediary banks, chiefly the Western institutions, have spent a lot of time trawling the market for the kind of credit exposures that might interest investors. Foreign institutions holding Japanese debts have been one source. Repackaging Japanese convertible bonds (CBs) provides another. Such bonds are widely held. A derivatives house will typically seek out the holder of CBs, possibly a western hedge fund, and offer to strip out the equity, which the fund is happy to retain. The credit exposure in the bond will then be repackaged in a default swap and sold to Japanese investors, such as city banks, regional banks, life insurance companies and even some of the more cash-rich companies, explains Guillaume Barrier, head of credit derivatives at BNP Paribas in Tokyo.
But this pattern, where Japanese risk-takers are plentiful and risk-sellers scarce, is about to change, according to market participants.
In the US and Europe, according to Tokyo-based Jeffrey Zavattero, Deutsche Bank’s head of global credit derivatives – Japan, “banks are increasingly seeking to reduce their risk, particularly when it is highly concentrated. And they are starting to assign fair market values to this risk. In some cases, financial institutions are looking more closely at the levels of return on equity, in response to shareholder pressure. This is going to happen in Japan, too.” Deutsche Bank claims to be one of the two biggest players in the market, along with JP Morgan.
Now is the time when Japanese banks are most likely to go down this route, he says, because they are having so much trouble raising capital. It has been extremely expensive for them to do so. They have capital targets, which many of them cannot meet. “So instead of concentrating on the numerator in the equation [the level of capital], they should look at the denominator [the level of loans]. Credit derivatives provide a way for them to shrink the denominator,” argues Zavattero.
There are also other factors at work. Corporate restructuring and mergers, particularly in the banking industry, are resulting in concentrations of credit risk far higher than desired. The merger of Industrial Bank of Japan, Dai-ichi Kangyo and Fuji Bank – which is likely to be completed in April 2002, creating the huge Mizuho Financial Group, with assets of $1.4 trillion – is just the most glaring example of where high-risk concentrations seem inevitable.
As well as the long-term structural developments that are likely to drive the credit derivatives market, there are some shorter-term cyclical ones. A trader of these derivatives at one large US investment bank in Tokyo says that the development of the instrument’s usage in Japan follows the bear market cycle. “The more bearish people are, the more volume you see,” says the trader. “Credit derivative usage in Asia and Japan boomed in 1997 and 1998, as the financial situation deteriorated first outside Japan, and then in that country,” he says. “There was big speculative interest from banks wanting to ‘short’ credit spreads as they widened, as well as foreign institutions trying to hedge. After the crisis passed in 1999, things calmed down, credit spreads narrowed rapidly, and credit derivative trading volumes dropped as the fear factor declined. But since the final weeks of 2000, many negative factors have returned to the market. Foreigners are again looking for protection on an increasing scale,” the trader says. “And there are many betting on another crisis erupting in Japan in the coming months. They are ‘shorting’ Japan credit. If they are right and credit spreads widen out a lot further, they are going to make a lot of money,” he adds.
Zavattero adds in somewhat more muted terms: “The widening of Japanese credit spreads is causing a fair amount of volatility in them. This is creating trading opportunities that did not exist when everybody believed that companies in Japan had an implicit government guarantee and that their debt would trade at the same level as government bonds. Until the financial situation started to deteriorate ahead of the 1998 banking crisis, there was rarely any kind of credit spread movement or volatility at all.”