Applying Platform and Ecosystem Thought to the Internet of Things

Why isn’t one dominant platform like Windows emerging in the internet of smart, connected things [IoT]?  The main reason is that IoT is a far more complex market than those that came before, and a single platform won’t be enough to meet a wider variety of user demands.

In previous eras, like PC and Mobile, there was only one core technology for operating systems to harness.  In contrast, IoT is only a convenient blanket term that actually includes many different vertical markets (e.g. enterprise, consumer, wearables, gateway, healthcare, transportation, etc.), and encompasses a myriad of different devices, user experiences, and input methods.  Microsoft/Windows dominated horizontally when there were only PCs, and was able to insist on one experience no matter the hardware; but IoT platforms face a multitude of user experiences.  Instead of a single platform achieving dominance in IoT, it could take multiple platforms to reach those needs.

Underlying Market Dynamics

Additionally, IoT’s underlying market dynamics differ from those of the PC/Windows era.  The market fit and network effects that led to Windows’ dominance at the time no longer carry over or accrue to IoT platforms in the same way.  PCs/Windows achieved dominance based upon securing sales and distribution relationships with enterprise customers, but the internet has since opened up new customers (by reaching large groups of individual consumers).  These new consumer markets reward companies very differently from enterprise markets, rewarding them instead based upon the quality of the user experience.

The PC/Windows market primarily began as an enterprise market, meaning that those in charge of purchasing decisions were not always the primary users, and that the quality of the user experience was not often the highest priority in those decisions.  Rather, the enterprise market wanted open, generic commodities in bulk, and rewarded companies with the greatest product fit and the strongest distribution relationships.  This happened to be Microsoft.

In contrast, neither mobile nor IoT have had one single dominant OS emerge yet.  With the new consumer markets opened up by the internet giants, it is now crucial to deliver superior user experiences to attract users, rather than to just control sales, distribution, and access to enterprise customers.  Given these new ground rules, OS wars are currently at an equilibrium (e.g. iOS vs. Android), and there will likely continue to be multiple winners in IoT (e.g. Homekit, Brillo, IoTivity, AllJoyn) as well.

The Powers that Be in IoT

IoT is composed of various consumer and enterprise markets.  On the consumer side, Google and Apple will continue fighting into the IoT era, one that is nearly as large as both previous eras combined (~4 billion PCs/smartphones vs. ~5 billion IoT devices in 2015).  Google and Apple have already acquired the biggest developer and user platforms and are well-positioned to control the home vertical.

Google's Brillo/Weave is an open system that may unite a universe of differing devices, varying inputs, constraints, and uses.  A customizable and interoperable platform, where information is aggregated in an intelligent hub, and combined with a conditional rule-set that is dependent upon a user's needs would be powerful.  On the other hand, Apple/HomeKit's vertical integration and possession of one the most powerful iOT gateways, the iPhone, will help it to keep delivering a complete, albeit closed, user experience.  Apple's integrated approach towards software, hardware, and design thinking--designing wearables and IoT devices from the ground up, rather than based upon physical interfaces--will also help it to continue capturing high-end users.

Other companies (e.g. Intel’s IoTivity, Qualcomm’s AllJoyn, etc.) that might understand IoT very well, but haven’t aggregated users like Apple and Google have, could yet still succeed by going into enterprise vertical markets, or industrial application spheres.

The Internet's Ripple Effects upon Consumer Firms

Why do flat organizational structures and digitization matter so much for innovation?  The public eye is fixated upon startups, but massive change is also happening within incumbent corporations.  Since corporations are contemplating this question, we should retrace just how we got from the internet, to startups taking advantage of changing business economics and models, to enterprises now responding by prioritizing flatter hierarchies and digitization.

The internet prizes users

The internet has changed how companies grow and stay competitive (i.e. generate outsized or monopoly profits).  To paraphrase the peerless Ben Thompson, it used to be that a company either had to 1) gain a horizontal monopoly in one of the three primary parts of the consumer market value chain (suppliers, distributors, and consumers/users), or 2) integrate two of the parts so as to have a competitive advantage in delivering a vertical solution.  To achieve the latter, delivering a vertical solution, it was common to integrate supply and distribution.

Now, by making the distribution of goods and content free, the Internet has modularized suppliers, and rendered supplier-distributor relationships and integration less valuable.  Also, by reducing transaction costs to zero, the Internet allows distributors to reach or integrate with consumers/end users at scale.  All this is to say that the balance of power has tipped towards consumers.  Therefore, distributors no longer compete based upon exclusive supplier relationships, but rather now compete for consumers and users.

One example of where this has played out is with enterprise software vendors and systems integrators, whose businesses have suffered at the hands of Software as a Service (SaaS) and freemium.  Their business models revolved around selling all sorts of services through the exclusive sales team-customer relationships, and were such that as long as they had the best distribution or relationships, they would win regardless of how good the products were.  Now, in contrast, the most successful companies aggregate suppliers—meaning the suppliers come to them—and connect them to the consumers/users with whom they have developed an exclusive relationship at scale.  The perfect example of this is Facebook, which has achieved the historic task of monetizing a staggering 1.5 billion monthly active users.

Digitization and flat hierarchies are bridges to users

And that's precisely why flat organizational structures and digitization matter for innovation, because they both enable you to get closer to the customer or user, which in turn allows you to use data to adjust your strategy more quickly and make better decisions.

Digitization achieves this by integrating the practices of looking at data to learn more about the customer, and of using those insights to design better customer interactions and products, into one continuously improving and iterative process.  Because of the way that the internet has elevated the consumer and user, user experience has become the most important factor in determining success.  Companies that design the best user experience will gain the most consumers and users, and in turn attract the most suppliers.

The other element of digitization is reconfiguring organizational structures so that they can take better advantage of analytics.  Flat organizational structures, in particular, enable those with their ears closest to the customer data to be decision-makers.  At a corporation, the most valuable resource is people’s labor and time (what they work on, etc.), but it is often allocated by plan and command, non-price mechanisms (i.e. by hierarchy).  Ironically, free markets are generally seen as good, and corporations are themselves the emblem and engine of free enterprise, but the market for people's time at those places is an area that is relatively resistant to that principle.  Meanwhile, startups are often considered more nimble, “entrepreneurial,” closer to the pulse of the customer, and capable of identifying real issues quickly; all because they are flatter, and decentralize and individualize time and team allocations.

Yet flat hierarchies and democratization may not always suit every organization.  As an extreme example, you wouldn't want the military to be run that way.  Flat hierarchies still involve their own trade-offs, as they can still be subject to power politics, and can hide power structures and shield individuals from accountability, leading to abuse or dysfunction.

Digitization and reconfiguring structures is more broadly about getting all of the siloed data and putting it in front of the people who can make use of it, or putting those people in power to act upon those insights—and flatter structures are just one method of doing so.  Sometimes, this can entail ring-fencing certain initiatives or projects within a company so that they can grow and develop independently.  Other times, it can involve finding out where the silos of experts and dispersed talent are, and integrating them better.  Or, it can involve simplifying lines of accountability and empowering those further down the hierarchy with decision-making rights (i.e. having fewer cooks in the kitchen when it comes to making decisions so you can get things done).

Building a Durable Product in Marketplace Lending

It’s been fascinating to follow the marketplace lending space over the past year.  The creation of different classes of marketplace loans (whole vs. fractional) has materially improved capital access by shortening the amount of time it takes for borrowers to secure funding.

In the early days, when borrower demand still outpaced lender supply, it could take up to a few days to fill a loan.  Lenders consisted of small retail investors with limited capital, so platforms would split loans into fractions to make it easier for investors to participate.  Since then, large institutional investors (i.e. hedge funds, pension funds, insurance companies, banks, HNW individuals, etc.) have joined the marketplace.  For instance, Blackrock was responsible for funding 17% of loans on Prosper last year, while Santander backed 25% of whole loans on Lending Club.

Unlike retail investors, though, institutional investors are capable of investing at scale.  To accommodate this, platforms reserve blocks of loans on their marketplace as whole loans that can only be bought or matched in full.  With the substantial growth in whole loan pools, institutional investors are able to attain the legal advantages of investing in whole loans in large volume.  At the same time, platforms with an eye towards sound market structure and participation, have implemented measures to keep large institutions from crowding out retail investors (e.g. random loan assignment to pools to prevent bias in loan quality).

All the institutional investors entering the market are giving the entire funding process a shot in the arm.  Whereas it used to take several days for a borrower to get funded, it now averages less than a day*.  Furthermore, portfolio managers commonly employ purchasing algorithms through platform APIs, so many loans are in fact snapped up within just a matter of seconds.

While there are other issues involved in building a dominant business in this space (e.g. partnering to get products in front of more consumers), measures like these that maintain a competitive and diverse market are also key for building a lasting, durable product.  The bifurcation of marketplace loans, along with the measures taken to maintain a healthy balance in supply and demand, have been great developments in financial technology.  The next step in that regard may be to implement more secondary marketplaces for loans, where investors can exit investments by offloading them to other willing buyers.

*It may take several more days for loans to review and originate, and for borrowers to receive money.

Latin America’s Position in Global Leverage

Although U.S. financial and household sectors have deleveraged following the 2008 crisis, overall global leverage has actually increased.  One surprise has been the rise in Latin American issuance of international corporate debt.  Latin America’s share of global issuance has been surprisingly high, and all this increased leverage comes with greater risk.  An important question, then, is whether LatAm companies are properly mitigated or prepared for these risks?

The growth in LatAm international corporate debt (issued in foreign currency, or FX) is a result of greater financial integration, low interest rates, and low term premia.  Financial integration has meant greater access to international capital markets.  Being able to borrow in FX, particularly the dollar, has enabled LatAm corporations to take advantage of low rates and thereby make more long-term investments such as capital expenditures.

At the same time, this increased exposure to the dollar, which is experiencing an extended period of strength, raises the cost of dollar-denominated liabilities relative to assets. It also increases interest rate risk: Should U.S. monetary policy tighten, borrowing costs would climb. Further, it could damage companies’ creditworthiness. These risks could spill over into the domestic banks that house LatAm corporate deposits, the global banks and asset managers that have invested in LatAm corporate debt, and the real economy.

Governments have reserves for dealing with these situations, but how do companies prepare?  Corporations mitigate these risks in a couple of ways: they can ensure that their FX liabilities are naturally hedged by matching their FX asset returns and revenue, or they can use financial derivatives to hedge FX exposure.  Since exact firm-level hedging data are not available, issuer-sector exposure and volume of derivative transactions can serve as proxy indicators.

As it turns out, the largest issuers are companies in financially integrated commodity producing nations[1] such as Brazil, Chile, Colombia, Mexico, Peru, and Uruguay.  Their private sectors issue the most debt and have the greatest foreign liabilities.  They also have a higher proportion of commodities and energy exporters.  Such firms are more accustomed to dealing with FX risk and are therefore more likely to have partially matched their FX assets and liabilities.

Furthermore, the volume of FX and interest rate derivatives transactions has increased in Latin America.  Among Brazil, Chile, Colombia, Mexico, and Peru,[2] transactional turnover rose between 2007 and 2013, from $28 billion to $67 billion for OTC FX derivatives and from $3 billion to $6 billion for OTC interest rate derivatives.

Overseas borrowing and leverage pose risk to financial stability all over the world. However, there are indications that indebted LatAm corporates, especially those in the sectors and countries that are most vulnerable, are a little less vulnerable than they might appear.

How Yu'e Bao Arbitrages Financial Repression

In China, the government’s policy of capping deposit interest rates has set off a competition for the savings of the nation’s growing consumer base, spurring product innovation that takes advantage of regulatory conditions. Tech companies, well-positioned because of their strong presence in payments, e-commerce, and social networks, have entered the fray with online money market funds (MMFs). Leading the charge is Yu’e Bao, the fund created by ecommerce giant Alibaba’s payments arm, Alipay. As funds like Yu’e Bao navigate a new field, they are certain to face mounting business, liquidity, and regulatory risk.

How policy led to arbitrage and innovation

The government’s policy has traditionally been to set deposit yields instead of letting the market decide them to lock in the profits of state-owned banks and lower their funding costs. As a result of such financial repression and the added burden of inflation, savers often have to accept negative real returns on deposits, incentivizing them to seek other vehicles offering higher returns.

Consequently, many investors eschew bank deposits and even equity markets in favor of bank wealth management products (WMPs) and now online funds such as Yu’e Bao. WMPs are offered by banks, which pool the cash and deploy it into stocks and debt to generate higher yields than conventional deposits. Huaxia Bank introduced the first WMP in 2004, but the real prelude to this showdown occurred in June 2013, when Alibaba launched Yu’e Bao. The competition escalated this year, when Alibaba, Tencent, and eight other companies acquired licenses to jointly establish and operate five private banks (separate from the online MMFs).

China wants to gradually liberalize deposit rates and make them more competitive, but Yu’e Bao and other online MMFs have taken the initiative in providing higher returns. They have done so by letting savers put their money in funds that invest in the interbank market, where rates are driven by market forces—a form of regulatory arbitrage.

At this juncture, Yu’e bao has amassed upward of RMB ¥535 billion ($87 billion) since it launched last June. Though that represents only 0.5 percent of the RMB ¥113 trillion in total deposits, China’s increasingly diversified tech giants,[1] along with six other companies, have also launched online MMFs. This has in turn has triggered banks to counter with their own online funds, provoking a broad grassroots liberalization of interest rates.

Business and liquidity risks loom

As competitors and regulators have adjusted, challenges have emerged to tech MMFs’ business models and the liquidity of their holdings. This year, China’s central bank (the PBOC) eased credit conditions, slashing the interbank interest rates and consequently the returns that had made Yu’e Bao so attractive relative to bank deposits. To maintain its competitive yields, Yu’e Bao has allocated more assets to repurchase agreements and products with longer maturities, resulting in a maturity mismatch on its balance sheet.

This mismatch risk and the ability of Yu’e Bao investors to make withdrawals on the day of the request (in banking terms, a T+0 settlement basis) pose a serious problem: If a large number were to quickly withdraw their money, Yu’e Bao would face a classic bank run situation. It would be forced to sell assets at fire-sale prices to generate liquidity and cash. Losses would likely mount.

Chart 1: Yu'e Bao Returns vs. China Benchmark Deposit Rate, percent

Chart 2: Yu'e Bao Assets by Duration, percent

Sources: Alipay, Tianhong.

Notes: "Repo agreements" means assets held under resale agreements, and "bank deposits" refers to bank deposits and settlement reserves.  Alibaba for e-commerce, Tencent and Sina for social media, and Baidu for search.

Assessing the regulatory reaction and landscape

Like other regulatory arbitrageurs that are not disruptors in the strictest sense, Yu’e Bao and other online funds may face mounting regulation in addition to those risks as officials concerned about financial stability rein in their growth to a more temperate pace. As they act, regulators will have to juggle concerns that include continued rate reform, opposition from the banking industry, and the risk of stifling innovation in the tech sector.

So far, the PBOC seems to have taken the lead in regulating these MMFs, just as it has with WMPs and the broader shadow banking sector. Other agencies are also involved. For example, the PBOC oversees Alipay, which owns Yu’e Bao; securities regulator CSRC supervises Tianhong Asset Management, which manages Yu’e Bao’s assets; and the banking regulator, CBRC, is concerned with the banks in which those assets are invested.

Potential PBOC moves include requiring online MMFs to hold minimum reserves on their deposits. The PBOC is also considering placing limits on online consumer spending, which would affect how much cash flows into online funds. The central bank has already temporarily halted the use of virtual credit cards and QR codes for online shopping. While this does not directly affect online funds, it signals a desire to manage the pace of growth in such platforms.

To discern regulators’ general disposition toward online MMFs, one could also look to their stance on WMPs, which play a similar role in China’s markets. Regulators view WMPs as useful vehicles for advancing rate liberalization, providing savers with competitive returns, and preparing banks for change—but also as an experiment to be watched closely.

China has further to go in reforming its capital markets, and the path it takes could shape the future of online finance. Regulators are allowing the field to expand and pushing commercial banks to change as well, but they are likely to clamp down if risks to financial stability arise.

The Trade Finance Gap

The use of trade finance is an important funding method in Asia, one of the most vibrant, influential regions of the world. However, due to regulatory and other barriers, there is a large gap between supply and demand. Currently, the industry is being transformed by an increasing desire to marry trade finance with the wider capital markets, as well as by the internationalization of the renminbi (RMB).

Trade finance uses traded goods as collateral, unlike traditional lending, which lends against balance sheet or assets. As a result, a key component is the ability for banks to set up safeguards to take possession and sell the goods and commodities themselves. Bank-intermediated trade financing is also short-term in nature, with about $6.5 trillion to $8 trillion in short-term annual trade finance flows versus just $175 billion in medium- to long-term trade finance exposures.

Driving force: Regional risks and attributes

Trade finance is a hallmark of emerging Asia, with almost half of global bank-intermediated trade finance devoted to firms in that region. Its popularity there is due to the heightened risk that comes with such factors as: longer trade routes between Asia and its trade partners, product types, less established trade partnerships, weaker contract enforcement, lower degree of financial development and higher political risk. Europe, in contrast, has shorter trade distances and better established institutions that insure trade credits and discount trade receivables.
image

Chart 1: Trade finance, trade credit insurance, and trade by geography

Sources: BIS.

Trade financing is thus able to come in with more complex, sometimes syndicated structures that shift the risk burden to banks, which can then monitor the transactions and exert greater control over the flow and receipt of funds. This is especially useful in situations where there is a lack of mutual understanding between parties.

Differences in regulations and legal frameworks have also created arbitrage opportunities and played a role in the regional popularization of trade finance. For example, in China, the degree of interest rate liberalization varies between RMB loans and trade finance. Also, the discount rates of RMB and foreign-currency letters of credit (L/Cs) were at times lower in offshore than onshore markets. These various reasons conspired to make trade finance instruments like L/Cs relatively cheap and popular instruments to finance working capital.

Barriers to trade finance

Despite the importance of trade finance in supporting production, job creation and economic growth, there is currently a funding shortfall of $1.6 trillion globally, and $425 billion in developing Asia alone. Based on the volume of rejected loan requests, there exists a substantial amount of unmet demand for import and export finance.

Ongoing regulatory change is one major barrier for trade finance. Basel III requirements have increased operating costs and capital allocation to trade loans, making profitability more difficult, and possibly increasing pricing and decreasing liquidity. Under Basel III, credit risk conversion factors increased from 20 percent (under Basel I and II) to 100 percent, and other elements like the liquidity coverage ratio, the net stable funding ratio, and the asset value correlation multiplier have contributed to hiking capital requirements.

Other barriers that have created a trade finance gap include: banks’ poor payment records, low credit ratings, weak capacity, unsatisfactory performance, lack of dollar liquidity, weak overall banking systems and low country ratings.

Recent developments

There has been a surge in securitization deals backed by trade finance loans, as banks look to divvy up risk and offset trade finance capital requirements. Trade finance assets are mainly generated by banks and were traditionally traded only in the interbank market, but a recent spate of issuances has increased non-bank investors’ (i.e. capital markets) access to trade-finance assets.

Standard Chartered led the way in 2007 with Sealane I, a special-purpose vehicle (SPV) set up to sell protection against the portfolio to the bank and to issue securities to the public. Banks can ordinarily distribute and offset trade finance risks by directly selling their loans or through credit insurance. In the past two years, though, six large public issuances have followed, indicating that outright and synthetic securitizations for investors might become a more frequent path for banks. One caveat is that different regulatory and tax regimes may make this pursuit complicated in Asia.

Chart 2: Trade finance securitization deals.

Source: Company press releases.

Another change is the increased use of RMB in payments and trade financing. With more companies considering the practice, more banks are developing their own RMB trade finance capabilities to meet those needs. Though the figure is purported to be inflated by shadow lending practices, the RMB recently replaced the euro for the No. 2 spot in terms of world usage in trade finance. This represents a growth opportunity for financial institutions, as China continues to liberalize its capital account.

On the other hand, the effect upon the trade finance business will be limited until more commodities start to be priced in RMB. Though commodities trade will gradually convert to RMB settlement in some areas, much of it is still denominated in U.S. dollars. Asian and European banks in particular are well-positioned to adapt to the change, due to offshore centers and hubs in Hong Kong, London and Singapore.

Chart 3: Trade finance currency usage

Source: SWIFT.

Untangling China's Shadow Banking and Real Estate Issues

Real estate is an engine of the Chinese economy, but many experts believe the possibility of overinvestment in the sector poses serious systemic risk. Shadow banking and local government debt are the other massive, interwoven financial issues, but property could be the one that triggers distress in the others.

In 2012, the government embarked on numerous financial reforms. They included liberalizing interest rates, clamping down on property price increases, limiting government agency spending, and imposing new rules on lending. These narrowed bank lending margins, so money flowed instead into retail trusts and wealth management products (i.e., shadow banking) through which banks could continue to invest in real estate and chase yield.

Nevertheless, a large portion of official lending in China is still aimed at the real estate sector. By some measures, housing absorbed up to one-third of total lending in 2013. Furthermore, maturity peaks are coming, with more than 60 percent of all loans due in Q2 2014, and almost 45 percent of those in Q1 2015, being in the real estate sector. The impact is felt even beyond official loan channels because property is often used as collateral to support billions of dollars in corporate borrowing.

Chart 1 & 2: China's real estate is a crucial part of its economy

Sources: Bloomberg, Nomura, Milken Institute.

Notes: Loans from large and middle-market banks, including ICBC, Bank of China, BoAg, BoCom, China Construction Bank, China Merchants, Minsheng, Everbright, and Citic. "Gov’t" refers to regional and local government, while "M&M" stands for metals and mining.

Now, housing inventory is overflowing, and it's not limited to first-tier cities like Beijing, Shanghai, Guangzhou, and Shenzhen. In fact, second-, third,- and fourth-tier cities account for 95 percent of housing under construction. In the same way that infrastructure development (e.g., subway projects) in many small cities has overshot their actual needs, the supply of real estate has far outstripped demand in recent years.

Because of this structural overbuilding, the market has displayed cracks. For example, Zhejiang Xingrun Real Estate, a major property developer, defaulted this year on $567 million in debt owed to more than 15 banks. Li Ka-shing, a real estate investor and the richest man in Asia, sold nearly $3 billion in Chinese property in the past year.

As these fissures appear more frequently, the government has two policy choices: Embrace reform by letting companies default and trusts fail, or continue to bail them out. The more likely route, in our view, is continuing bailouts because so much of investors’ wealth depends on growth targets remaining high, which in turn relies on the continual expansion of real estate. There’s just too much at stake for the leadership to do otherwise.

South Korea's Notoriously Stringent Financial Sector

At the moment, policies meant to deal with South Korea’s slowing economy and high level of household debt are putting pressure on its already-weakened banking sector. Banks operating in Korea have struggled with profitability, causing many to restructure and downsize. For instance, foreign banks such as Standard Chartered, HSBC and Citibank have trimmed headcount, sold business operations or closed retail units.

The slow economy and weak business sentiment have resulted in slower loan growth, and have also prompted the Bank of Korea (BOK) to respond with monetary easing, which naturally squeezes bank margins. There have already been several rate cuts in the last couple of years, but in August the BOK cut the policy rate again in order to restore confidence and boost the economy. As a result of falling net interest spreads and bank lending rates, bank returns on assets and equity have suffered, and margins will continue to be pressed until the central bank raises rates.

Chart 1

President Park Geun-hye’s plans to tackle high household debt are also pressuring banks. Park’s efforts to relieve heavily indebted households have resulted in the implementation of a debt write-off program called the personal debt rehabilitation scheme (PDRS, aka the Happiness Fund). Because banks must sell their loans at a loss to the state fund when borrowers apply successfully for the scheme, this has resulted in a rise in loan impairments and a general deterioration of asset quality.

The majority of household debt is made up of mortgages, so prudential regulators are also trying to strengthen the resilience of mortgage loans to credit risk. While this should stabilize the banking system, it will also further hamper bank profits. Specifically, regulators are encouraging a shift from floating rates and bullet payments toward fixed rates and amortizing mortgages. As a result, bank-funding costs have risen and net-interest margins have been constrained, as banks have sought to attract borrowers by offering lower rates on fixed-rate loans. Banks must also match the increasing amount of fixed-rate loan assets with similarly long-term debt financing, which tends to be more expensive than short-term funding. Prepayment risk, or the risk of borrowers refinancing at lower rates, may also bite into profits.

These issues are often cyclical, but they are also indicative of a broader struggle in South Korea’s financial services sector. The government is stringent in regulating the safety of the financial sector, but at the same time domestic banks find it difficult to compete internationally and foreign banks struggle to make a profit in Korea due to the culture of intervention and protectionism.

Chart 2 & 3

Sources: Bank of Korea, Bloomberg. 

Securities Exchanges, Part I: Global Proliferation

The securities exchange industry has grown prolifically behind globalization for nearly four decades, but industry-specific challenges are now clouding its future.  

Each link in the globalization chain tells of a need for risk and capital intermediation, and loosely illustrates why securities exchanges have boomed.  With trade liberalization, trade agreements are inked or restrictions are lifted, and trade routes open up; meaning more exchange of commodities like raw and primary materials, finished goods, currencies, and cross-border payments.  

With financial liberalization, corporations that grow into MNCs with greater global profiles can attempt to access and raise money from new, foreign equity or bond markets; and investors can simultaneously better channel their savings towards those very cross-border investments.  As a result, both corporations and investors also become exposed to more global risk, and need to offset those risks with hedges (see Chart 1 for an example of derivatives exchange growth).  

Chart 1

Notes: The chart starts in 1970 because globalization accelerated in the following decades.  The net number of operational exchanges is shown, with growth indicating more being established than defunct or merged. 

Sources: WFE, FIA, Numa, AFM, IOS, CFTC.

It’s easy to forget that exchanges are living, breathing firms like any other.  After all, the Intercontinental Exchange (parent of NYSE Euronext) and the NASDAQ OMX Group are publicly traded alongside the very thousands of companies that are listed on their own exchanges.  They deal in products and services, and are constantly trying to grow.

The most important business activity of an exchange is providing a place for investors to trade (derivatives, equities, fixed income, commodities), and a place for corporations to list and raise money (cash equities).  Ancillary services often include the provision of market data and analytics to corporations, or of technology to exchanges or clearinghouses in other parts of the world.

For exchanges, organic growth might come in the form of expanding their product lines (e.g., developing faster trading platforms, and innovating new trading products), or expanding whole business segments (e.g., an equities exchange developing its derivatives business).  On the other hand, inorganic growth involving M&A is also a popular route.

The securities exchange industry is always a flurry of activity: international exchanges seeking to expand aggressively by acquiring or merging with smaller, regional operations; smaller exchanges going defunct due to lack of liquidity (i.e., a lack of buyers and sellers or trading activity); and new alternative exchanges being launched all the time to provide liquidity and offer new trading products.  The industry is also intensely competitive.  Not only must exchanges out-price and out-innovate one another, but also they have to fend off other competitors, such as OTC markets run by broker-dealers, and ATNs (which include ECNs, MTFs, dark pools, and matching networks).

Presently, a number of headwinds are engulfing the industry, but there are tailwinds waiting in the wings as well.  In the past few years, low growth, customers deleveraging, and extraordinarily low interest rates all contributed to poor business and low trading volumes.  But developed economies are beginning to reverse zero-interest rate monetary policies, which is a boon for exchanges, as rising rates should bring back fundamentals and trading volume.  The global regulatory overhaul of derivatives (i.e., Basel III worldwide, Dodd Frank in the U.S., MIFID II in Europe, etc.), also, is shifting the market in favor of clearinghouses and exchanges.

Illiquidity in Fixed Income Markets, Part I: Death of the Dealer Model

U.S. fixed-income markets are in transition because of new regulations and Federal Reserve policy. The decline of the broker-dealer market-making model is causing a shortage of liquidity, which would pose risk to investors should the great bull run in bond markets come to an end. Deep, liquid markets are important for financial stability and expand access to capital for individuals and corporations.

Select banks called primary dealers, among them J.P. Morgan, Goldman Sachs, and Citigroup, traditionally played an important role in “making” bond markets by providing liquidity, holding inventory of their own, and acting as the counterparty for trades by quoting bid and offer prices. Because bonds have unique durations, covenants, and rates, and are overall less standardized than equities, they are less frequently traded and have fewer investors, making intermediaries such as dealers necessary.

Two factors have caused institutional investor bond holdings to rise substantially and dealer inventories to fall. Basel III’s higher capital requirements and supplementary leverage ratios, and Dodd-Frank’s Volcker Rule, have decreased the profitability of dealers who trade and carry bonds on their balance sheets, prompting them to retreat from the traditional dealer model and focus on their core businesses. At the same time, years of quantitative easing by the Fed have caused investors to leave government fixed-income securities for high-yield and investment-grade corporate bonds (and equities) in pursuit of bigger returns.

Chart 1

Source: Bloomberg, ICI, NY Fed, SIFMA.

The confluence of these factors has constricted the supply of fixed income to investors on the secondary market, while demand has risen. Dealer holdings of bonds have fallen to an all-time low, down 89 percent from their 2007 peak, while mutual fund holdings of bonds more than doubled in the same period. This means the amount of mutual fund credit assets susceptible to declines in liquidity equals nearly $870 billion versus $300 billion during the credit crisis in 2008.

With the inclusion in those assets of exchange-traded funds that track corporate debt, buy side bond holdings further exceed dealer inventories. In part, the huge resurgence in the issuance of traditionally illiquid securities in 2013 (i.e., leveraged loans, CDOs, CLOs, corporate hybrids, and convertible bonds) stems from attempts to satisfy the supply-demand mismatch in fixed-income markets.

On the surface, market liquidity seems to be healthy, but closer inspection reveals that is not the case. Despite high trading volumes, other aspects of liquidity have suffered: bid-offer spreads that spike when liquidity is needed; less diverse market participation and a concentration in fewer bond categories; weaker dealer participation in Treasury auctions; and thin trading in older and smaller bonds in secondary markets. Because of the issuance boom, investors mainly are buying new bond issues and have not needed to rotate into other portfolios.

Furthermore, large block trade volume has waned over the past eight years. Block trades worth more than $5 million have decreased, and those in the $1 million to $5 million range have increased. The average trade size has declined due to more dealers splitting up large orders to find buyers and sellers. In retrenching, dealers are focusing on their largest clients, often leaving smaller funds struggling to complete trades affordably and further narrowing market participation and the strategies used for trading. Financial institutions are trying to remedy these issues by developing electronic bond trading platforms to facilitate liquidity.

Illiquid markets present both volatility and risk to investors. Unlike the dealers, institutional investors cannot act as liquidity stabilizers, risk warehouses, or pressure release valves. When the corporate bond bull market ends, investors, not dealers, would bear the brunt of losses as the latter are no longer positioned to take on all the bonds investors would want to offload.

Funds have built up big positions in corporate debt and taken on less liquid securities with higher yields to help meet expected returns or actuarial assumptions. If those funds should need liquidity stemming from a jump in nonperforming loans or market volatility, the door under the Exit sign would quickly become very crowded. Numerous factors could trigger this, including rising interest rates, deflation, an international financial crisis—anything that affects credit or causes defaults to multiply. It would inflict massive stress on those funds and a jarring impact on the economy, undermining the financial futures of pensioners and annuity holders.

China Reading List

Some time ago, I put together a condensed reading list of things that have most shaped my understanding of China. My hope is that this can help others who are similarly interested, or are just setting out in understanding the language, trajectory, systems, and culture of China. Help me add to it in Google, and read my additional thoughts (some of which may be dated) after the jump:

News: 
Sinocism 
zgbriefs 
Tea Leaf Nation 
Chinese Media Project 
Danwei 
Chinafile 
Truth About China 
China Digital Times 
South China Morning Post 
Haohao Report History & Politics: Patrick Chovanec - Primer on China's Leadership Transition*** Congressional Research Service - Understanding China's Political System*** Jonathan Spence - The Search for Modern China Fox Butterfield - Alive in a Bitter Sea Richard McGregor - The Party James Fallows - Postcards from Tomorrow Square Peter Hessler - River Town, Oracle Bones, Country Driving Leslie Chang - Factory Girls (Hessler’s wife, also very good writer) Jung Chang - Wild Swans Evan Osnos - The New Yorker Nicholas Kristof - China Wakes (NYT correspondent, 1980s) Dan Harris - China Law Blog Carl Walter - Red Capitalism Henry Kissinger - On China Seeing Red in China Geopolitics & Security: The Diplomat Department of Defense - Military and Security Developments Involving the People’s Republic of China Foreign Policy Foreign Affairs Center for Strategic & International Studies Strategic Studies Institute Council on Foreign Relations European Council on Foreign Relations ... this section needs some work (more experts and specific works) Economics & Finance: Michael Pettis - Peking University*** Patrick Chovanec - Tsinghua University Richard Wong - University of Hong Kong Nicholas Lardy - Peterson Institute for International Economics Minxin Pei - Carnegie Endowment for International Peace Cheng Li - Brookings Institution Andy Xie - Caixin Matt Dale - Mao Money Mao Problems Greg Canavan - Daily Reckoning Also Sprach Analyst*** Stephen Green - Standard Chartered Global Research Zhang Zhiwei - Nomura Global Research Stephen King - HSBC Global Research
Charlene Chu - Fitch Ratings (formerly) Pranab Bardhan - Awakening Giants, Feet of Clay Netizen Sentiment: Chinasmack Shanghaiist Beijing Cream Language: Skritter MDBG NCIKU Pleco ICIBA

Some basic thoughts (a snapshot of present-day China): Economics & Finance:

• National accounting identities and how they explain the China and Asian growth model and its need to re-balance, as well as why growth will inevitably slow to a much more reasonable pace.
• Low interest rates --> favor (subsidize) manufacturers and infrastructure as a driver of the economy through easy borrowing, but penalize (tax) households through low wages.
• Easy borrowing (= low interest rates) --> leads to massive hidden debt, non-performing loans in the banking sector, and fraud in investment.
• Easy borrowing + lack of retail investment options (closed capital account) --> lead to makings of a real estate bubble --> as well as a huge shadow banking sector.
• Tax on households --> leads to low consumption and an economy that heavily leans upon investment, rather than consumption --> as well as leads to financial repression
• Undervalued currency --> favors exporters as a driver of the economy.
• Balance of payments surplus --> extra capital exported abroad to fund foreign debt --> enables persistent foreign fiscal deficits.
• Domestic stability above all else, and the importance of employment (and thus the economic growth model) in safeguarding that goal.
• The internationalization of the RMB, and how the mechanics (e.g. the need for capital account reform and governance) dictate the likelihood and desirability of that happening (bilateral agreements, etc).
• The degree of accounting irregularities, misrepresentations, scandals, and fraud (also read point 3 in this article) in China that accompany its overabundance of credit.
• The influence China exerts on global commodity markets and commodity-rich nations because of its major contributions to global demand (i.e. growth, building, etc. must be fed by raw materials), and the impact rebalancing will have upon these relationships (e.g. Australia).
• The relatively cash-rich position of Chinese companies and the Chinese sovereign wealth fund, how it has lead them to seek increasing amounts of foreign acquisitions in recent years, and the political resistance they have met.
• The old story about intellectual property theft, forced technology transfers, etc. What’s ironic is that IP theft is just as much an obstacle to domestic Chinese entrepreneurs as it is to Western corporations.:
• As for innovation, I do believe there is talent here but the local governments are the biggest obstacles. I've heard from and seen too many entrepreneurs complaining about IP theft from entities controlled by local governments. If you are doing a startup and have good tech, there is a 75% chance you will somehow have a competitor that's more well-financed from the local banks and have almost the identical IP in six months. It's a tale that's told again and again. So you have this disconnect: the central government wants China to stop being the world's workshop and become an innovator, thus giving all these tax breaks and incentives; but when a local guy or an overseas returnee builds up a credible product/service, it'll be stolen from right under them by the local government. What, then, is the incentive for innovation for the little guys? -- Lloyd
• The lack of a good social safety net, which generates incentives to save, rather than to consume, further exacerbating the imbalanced economy
• China and India's linked stories on their path to economic power, and the vastly contrasting models they use to get there.
• The role of Taiwanese companies and employers in China, and the importance of China-Taiwan economic integration, especially to Taiwan.
• China's urbanization, differently tiered cities, and special economic zones.
• Poor performance of Chinese capital markets linked to a general lack of profitability

Politics & Society:

• The domestic political landscape: the obstacle that the existing landed interests, stakeholders, and lobby represent to future reform (i.e. manufacturers, exporters, owners, and those who benefited from its 1979-current growth policies).
• The influence of the Guangdong vs Chongqing development models and how they have traditionally vied with each other within Chinese policy circles (also, how the Bo Xilai incident changed the balance of power).
• China's relative attractiveness and cultural influence (soft power), or lack thereof, and how various factors conspire to send a flight of capital and emigration abroad.
• The state of education, and how it prioritizes test-taking skills, rather than inspiring innovation.
• The state of pollution
• The Party's fixation upon stability above all else, and the ways it protects that interest.
• Factors that affect the Party’s stability
• The use of employment*, as previously mentioned.
• The potential for inflation to unite key constituencies
• The party’s procedures for reporting corruption and removal of officials
• China's views towards religious freedom, and its toleration of Christianity only insofar as it counters other religions (i.e. Buddhism, Falungong).
• China's fourth estate and censorship.
• Instability in China's western provinces, and growing inequality in spite of a growing middle class.
• The tension in policymaking between the central government and local government; how incentives at the local government level causes them to constantly frustrate central government objectives
• Local government debt
• Entrepreneurial incentives (central gov’t gives tax breaks and subsidies to foster innovation, but local governments steal startup ideas)
• Housing market (central gov’t wants to curb housing prices, but local governments have a monopoly on land)
• How interwoven corruption is into the status quo (e.g. Xi Jinping's assets, the Immortal 8 families, and the Bo Xilai corruption scandal).

Geopolitics & Security (hard power):

• Japanese aggression and Chinese concessions to Western nations in the past 200 years, and their importance to understanding the aggressiveness of Chinese security policy.
• String of Pearls strategy: China's energy security concerns, and how it informs their actions and diplomacy across ASEAN, and Africa. aligning the islands, etc against or with U.S.
• The importance of the Malacca strait in establishing energy security and independence.
• Strategic investments in Africa infrastructure:
• Korean Peninsula issue: the South Korea-North Korea-China-U.S.-Japan-Russia configuration.
• Indo-Pakistani nuclear issue: the China-India-Pakistan-U.S. relationship.
• Sino-Indian relations: the Sino-Indian war over contested territory near the McMahon Line and the Himalayas.
• U.S. pivot issue: U.S. → Japan, Korea, Taiwan, Australia, ASEAN (Philippines, Vietnam, Brunei, Malaysia, Singapore, Thailand, Indonesia) somewhere in between → China; or is it not that simple?
• Island issues: the source of island conflicts in energy exploration rights
• Korea-Japan-China-Taiwan: Senkaku/Diaoyu, etc (e.g. natural gas)
• Philippines-Vietnam--Malaysia-Taiwan-China - Spratlys and Paracels
• Indian Ocean and South China Sea disputes, legal bases, and the future importance of international arbitration.
• ASEAN issues: U.S.-Australia, island alignments, Taiwan, etc.
• China's increased role in providing global security and patrolling shipping lanes.
• Comparative military strength:
• China-Japan: Shinzo Abe and the expansion of the JDF; the Japanese Navy and submarine fleet as a relative strength compared to China's; and how its demographics subtract from the effectiveness of its Army, and any potential projection of power on land.
• China-U.S.: China's (now) two aircraft carriers, development of anti-carrier missiles, its own drone technology.
• China-India: mutual assured destruction as a stabilizing factor to the region?
• China as an originator of cyber attacks, espionage, and intellectual property theft; and Western corporations encountering failed joint ventures, and forced technology transfers (e.g. Huawei and ZTE)
• China's Taiwan strategy, which involves militarily deterring the U.S., and gradual economic integration with Taiwan. The CPC is patient.

California's Biggest Issues

California Pension Funds

One of the greatest challenges is that some of California’s pension funds are structurally underfunded and short millions of dollars per year, based upon their current set of assumptions (e.g., the number of workers and retirees, average retirement age, life span, rate of wage growth, and the investment returns offered to employees).  What this shortfall means is that California’s pension systems have promised retirees more than what they are currently able to pay. 

If the California pensions funding gap does not work mathematically, how can it be resolved?  Will the promise of employee pensions simply disappear?  After all, even if total contributions increase (from employers and employees), funds would still be severely underfunded.  One possible change, lowering assumptions from 7 ¼ to 6 ¼ percent, would conceivably bring contributions up over a 10 year horizon.  In the end, whatever the State takes to fund the teachers' pension funds, for example, will likely have to come out of the classroom—specifically, teachers’ take home pay. 

Demographics and State Politics

One of the broader underlying issues is the aging population.  The growing pool of retirees and shrinking work force at national and state levels means lessening revenues and increasing fiscal burdens for governments, which provide services to retirees.  This strain on the system means that immigration, particularly of young people, will likely play an important role in California’s future.  

If a public servant wishes to be elected in California today, she is confronted with the demographic reality that the real decision makers in the state are minorities from Latin America and Asia.  Minority groups are equipped to determine their future for themselves. 

As a result, the political power struggle between certain groups (e.g., Latinos and African Americans) occurs at the lowest levels, such as school systems, often determining who gets what.  Furthermore, California’s union membership has increased in part because Latino leaders see unions (not the mayor or governorship) as their bases of power, just as African Americans did twenty years ago. 

Education

Perhaps the single biggest issue in California, related to both the pension and political demography issues mentioned above, is the school problem.  If graduation rates do not improve, L.A. risks becoming a less attractive place to live and raise a family. 

Charter schools have been a great source of improvement.  For example, half of the schools in Washington D.C. are now public charter schools.  One charter school in California implements double math and English into its 9^th grade curriculum in order to bring students, who are often three years behind at that point, up to speed.  However, they alone are not enough.

Charter schools also have untold effects on communities.  Magnet and charter school bussing often means children don’t go to school with peers from their own neighborhood anymore.  This depresses real estate prices in those areas, whereas places with their own school systems have stronger pricing, forcing parents to decide whether to send their children to charter schools, or to stay and fight.

Though other occupations are more sheltered, teachers are often the closest to the ground.  In a sense, schools feel society and determine what society is, so fixing the schools means fixing society.  The family must be the unit that sees the value in education.  If not, then there is little the government can do about it.  

Credit Ratings vs. CDS Spreads, and Which Measure is More Responsive

During the past decade, the United States suffered the worst financial crisis and the most severe recession since the Great Depression.  In response to this dire situation, the federal government took action in October 2008 to inject capital into some of the biggest financial institutions in the country.  Some individuals believe that credit rating agencies failed to adequately assess the creditworthiness of many of these institutions in a timely manner.  In short, the contention is that ratings were kept too high for too long.  As a result, investors may have relied too heavily on the ratings, and thereby suffered losses before the large institutions were downgraded.

To assess this belief, I look at the credit ratings that Fitch assigned to eight of our largest financial institutions prior to the government bailout in October 2008.  Specifically, I compare the credit ratings assigned to these institutions in 2004, 2005, and 2007, a period before the full emergence of the financial crisis and before the Great Recession.  This will enable us to determine the extent to which the each of the institutions was downgraded, depending upon the degree to which each was leveraged (i.e., the total assets per each dollar of equity capital).  Clearly, the more leveraged an institution, the greater the likelihood an institution will become insolvent for any given amount of losses.  One would therefore expect the credit ratings to decline with substantial increases in leverage.

Chart 1 shows the relationship between credit ratings and leverage for our sample of eight institutions.  Over the period examined, only two institutions were downgraded, Citigroup and Merrill Lynch, three institutions received the same rating, Bear Stearns, Goldman Sachs, and Morgan Stanley, and three institutions were upgraded, Bank of America, JPMorgan Chase, and Lehman Brothers.  In the case of the two institutions that were downgraded, Citigroup was downgraded from AA+ to AA and Merrill Lynch from AA to A+, which still were investment grade ratings.  And the other cases, all the ratings were A+ or higher.  As we eventually learned, however, Lehman Brothers failed despite its upgrade in rating after 2005, and Bear Stearns with its investment grade rating was acquired by JPMorgan Chase.

Chart 1

Source: Bloomberg.

In contrast to credit ratings, there is other information about the financial condition of big financial institutions.  In particular, credit default swap premiums (i.e., the price one pays to essentially insure against losses on investments) provide indications of the financial condition of institutions.  The higher the credit default swap premium, the greater the cost of protecting one’s investment against losses.  Chart 2 shows the average credit default swap premiums along with the leverage ratios for the same eight large financial isntitutions shown in Chart 1.  In contrast to the lack of any significant relationship between credit ratings and leverage, there is a significant positive relationship between CDS premiums and leverage.  Specifically, the CDS premiums increased to a high of nearly 80 (indicating investors would have had to pay, on average, $80,000 a year to insure $10 million against losses) from a low of just under 20 basis points (indicating investors would have had to pay, on average, $20,000 a year to insure $10 million against losses), a roughly four fold increase over the period.  Notice that the CDS premiums for both Bear Stearns and Lehman Brothers increased the most, and they were among the most highly leveraged institutions, and, as already noted, one of which failed and the other acquired by another large institution.

Chart 2

Source: Bloomberg.


The bottom line is that the CDS premiums were a much better indicator of the financial condition of big financial institutions insofar as there is a significant positive relationship between the premiums and the degree of leverage.  And it was the highly leveraged institutions that suffered the most as a result of the recent financial crisis and severe recession, with most bailed out by the government and only one institution allowed to fail.  To this extent, credit default premiums, if not a replacement for ratings, should surely be used in addition to such ratings when assessing the financial condition of large financial institutions.  The benefit of also using publicly available CDS premiums is that they are market-based measures, unlike publicly available, but yet based upon proprietary information, credit ratings.  

Collateral is the Linchpin of Modern Finance, Part I: The Shift from Retail Banking to Wholesale Banking

Over the last forty years, the banking industry has dramatically changed the way it funds itself.  At one time, banks relied almost entirely upon retail deposit funding. Under this traditional funding model, banks offer deposits to customers in exchange for interest rate payments. Banks then turn around and use the deposits to extend loans to businesses and consumers, earning profits by charging them higher interest rates than what they pay depositors.

However, this model’s weakness was its susceptibility to “bank runs” on deposits.  Whenever depositors believed that banks were in deep trouble, they would panic and “run” to the banks to withdraw their deposits.  The runs would often even affect healthy institutions, resulting in cascades of insolvencies, as banks sold assets at “fire sale” prices to meet the deposit withdrawals.  This problem was largely resolved by the establishment of the Federal Deposit Insurance Company (FDIC) in 1933.  Should banks fail, depositors are now insured against losses by the FDIC up to $250,000 per account.

Beginning in the 1970s, banks began to modify their traditional funding model by expanding their funding sources to include the wholesale markets, as shown in Figure 1.  More specifically, banks began relying more heavily on issuing short and long-term debt to other financial institutions.  This enabled banks to grow larger without relying as heavily on retail deposits. Furthermore, it enabled banks to leverage to a greater degree, and thereby potentially increase their return on equity.

Wholesale funding instruments, also known as non-core or non-deposit liabilities, include repurchase agreements, foreign currency debt, commercial paper, large-denomination certificates of deposits (CDs), federal funds, and brokered deposits.  The purchasers of such instruments are large institutions such as hedge funds, private equity firms, insurance companies, ultra-high net worth individuals, and corporations.

Figure 1 & 2

Source: Federal Deposit Insurance Corporation. 

Since wholesale funds in the form of debt are generally not insured like retail deposits, large institutions in the wholesale market attempt to achieve a comparable degree of security and safety by putting their money into high-quality collateral, such as mortgage-backed securities and government treasuries.

A problem that arises with this newer funding model is that to the extent a bank cannot roll over its short-term debt, it may have to sell off assets if it cannot obtain additional deposits or issue additional equity.  In short, if purchasers of short-term debt believe that banks are in deep trouble or collateral is impaired, they may decide to “run” away from such debt, which creates a problem somewhat similar to that which existed before the establishment of the FDIC’s deposit insurance scheme.

Ironically, this means that the modern banking system still faces runs, but no longer on just retail deposits.  Instead, as shown in the financial crisis that fully emerged in September 2008, banks are now vulnerable to runs by participants in the wholesale funding market.  In 2008, the world watched as the wholesale market seized up, and banks could not rely upon this market funding.  Banks’ ability to roll over their debt and uninsured liabilities disappeared overnight along with their ability to use repurchase agreements. As a result, the government created the Troubled Asset Relief Program (TARP) to provide funding to banks, and the Federal Reserve engaged in three quantitative easing programs.

In the course of the evolution of the banking system, the government solved one problem early on, but a new one arose in its place.  Since the modern banking model is now more dependent upon wholesale funding, high-quality collateral will likely be instrumental to finding a solution that both emulates the earlier solution provided by a federal deposit insurance system, and helps prevent runs on the wholesale market. Whatever steps regulators take next will have landmark consequences for preventing or reducing the severity of future financial crises, just as the FDIC’s introduction of retail deposit insurance did.

How the Korea Exchange Vaulted to Top, a Case Study

How did the Korea Exchange come to be amongst the world's largest derivatives exchanges?  The main factors in its strong growth were 1) the strength of its equity derivatives market, 2) the role domestic retail investors played during its early years, 3) the lifting of the cap on investment for foreign investors in 1992, and 4) the more recent rise of institutional investors.

Korea Exchange's rise to the top is due disproportionately to domestic retail (and later, foreign investor and institutional) participation in its equity derivatives market (specifically, its Kospi 200 options, which were until recently the most actively traded derivatives contract in the world), rather than due to any outstanding strength in its exchange-traded T-bond, currency, or commodity derivative markets.

In 2011, the Korea Exchange was at the top of the rankings in contract volume, with 3.748 billion, 93% of which was equity index options.  In 2012, the Korea Exchange fell a little in the rankings, but still fully 86% of the 1.835 billion in volume that year was equity index options.  Of those equity index options, roughly 28% could be attributed to retail traders, while 42.3% could be attributed to foreign entities, and 29.7% to institutional investors (as of April, 2012; 27% retail and 43% foreign in 2011).

• As a developing country, Korea initially lacked institutional investors (hedging demand), but developed strong retail (speculative) demand.  Developing markets often lack natural hedging demand, as they do not yet have enough institutional investors who can make long-term investments and manage their risk.  Retail investors originally comprised 2/3 of the equity derivatives market, driving its growth and making Korea stand out (along with India and Taiwan) from most other developing markets, which have weak equity derivative markets.  Since then, institutional players have steadily increased their presence in the derivatives market.

• Until recently, it was relatively cheap for retail investors to buy options on the index, making the equity options index key to the exchange’s rise, and key to its recent dip.  The index multiplier was low ever since the contract launched in 1997, making it cheap for retail speculative investors to trade.  The main reason the Korea Exchange recently dropped in the rankings is because regulators quintupled the nominal size of their Kospi equity index contracts, making them more expensive and damping excessive retail speculation.  Korean exchange-traded derivatives also tend to be concentrated in short-term contracts.  Long-term contracts are not even listed, meaning it is difficult to manage risk and hedge in the long-term. 

• Furthermore, widely available internet (94% of people have high-speed connections) made it easier and cheaper for retail investors to participate in the markets.  Combine that with online broker competition, low transaction costs and commission fees, the proliferation of market research sites, and a cultural enthusiasm for trading like that in Japan, and you have the makings for very active retail investor participation (and in seeking opportunities for arbitrage or speculation).

• Capital control liberalization also lifted the investment ceiling for foreign investors, enabling them to be the contributors to Korea’s capital markets that they are today.

• Fourth, consolidation and partnerships played a role in Korea Exchange’s growth, as it often does in the wider industry.  As a product of the Korean Stock and Futures Exchange Act, three markets merged to form the Korea Exchange in 2005, accelerating the growth of Korean capital markets.  Then, in 2009, Korea Exchange partnered with Eurex, enabling its contracts to be traded in Europe and the U.S., when the Korean market is closed. 

• The growth in Korea’s economic fundamentals, its integration into the global community, and value as a high beta investment play has been an underlying driver for its capital markets.