The JSE Securities Exchange in South Africa aims to give a boost to a lifeless exchange-traded derivatives market by trading the underlying cash instruments and derivatives side by side. Edward Russell-Walling reports.

The South African bond market – at least, the government bond market – is one of the most liquid in the world. So it is hardly in need of competition to pep it up. Yet competition is what it is about to get – not because of any shortcomings in the bond trade itself, rather as an attempt to waken a lifeless exchange-traded derivatives market.

JSE Securities Exchange – the former Johannesburg Stock Exchange – plans to light a fire under the bond business by opening up a new marketplace where interest rate derivatives and the underlying cash instruments will trade side by side. It believes that this will make Yield-X, as the new exchange will be called, the first such market in the world.

“The aim,” says Allan Thomson, JSE director of equity and derivatives, “is to create a one-stop yield shop for a whole range of interest rate products.”

Trading foundations

Until now, organised bond trading has been the sole preserve of the Bond Exchange of South Africa (Besa), first licensed as an exchange in 1996. It has some 55 members, including 10 banking institutions that act as primary dealers in government bonds. Last year, government bonds accounted for 94% of turnover and 72% of maturities.

Besa introduced an (optional) automated trading system in 2000, although most dealers stuck to the phone and interdealer broker screens. It has since been replaced by a new trade capture system that can also capture and match derivatives. There is no central counterparty. There is, however, a central depository within which more than 70% of the bonds listed on the exchange have been dematerialised. What is more, the market has so far never had to face a settlement default.

In the past, issuers have overwhelmingly been either government or the so-called ‘parastatal’ utilities. South African corporates have traditionally borrowed in the money markets or from banks which, eager for market share and hungry for assets, have lent at keen rates. High price-earnings ratios have made equity funding more alluring for finance directors than debt issues. A few large corporates, such as SA Breweries, listed their paper; however, this was invariably bought and held, so there has been no secondary market to speak of.

Shifting landscape

Things are changing, albeit slowly, and today Besa lists a growing number of bonds issued by banks and large industrials. Besa chief executive Tom Lawless attributes the shift to various factors that include growing demand from buyside institutions that are under-invested in bonds. “The arrival of international banks has also influenced the attitudes of corporates wishing to borrow, in that they are more focused on fee income,” Mr Lawless says.

Growing appreciation of the speed and ease of medium-term note programmes has helped, and corporates are beginning to remember that debt is cheaper than equity. What is more, some bank loans are being priced at more realistic levels. “Banks are reassessing their returns on equity and the capital requirements needed for loans, particularly in the light of the changes flowing from Basel II,” Mr Lawless points out.

Government is trying to encourage a revival in the municipal bond market, moribund since the apartheid era. The City of Johannesburg recently listed two issues and is planning a third. Only a handful of cities have the size and credit quality to list their own paper, but Mr Lawless argues that consolidating the requirements of low-credit municipalities could make them more attractive to investors – as has been done in Australia.

What’s on offer?

So what does JSE think it can bring to the party? After all, Yield-X will compete head-on with Besa, though only in the secondary government bond market, at least to begin with. In fact, JSE’s move is prompted less by ambitions in the spot bond market per se and more by a desire to put interest rate derivatives – so successful in so many other national markets – on a commercial footing.

“JSE purchased Safex [SA Futures Exchange] in August 2001,” explains Mr Thomson. “It’s a derivatives exchange, but the bulk of its business is in equity and index derivatives. Safex is very large and growing in single stock futures – the third largest in the world after India and Spain.”

When it comes to exchange-traded interest rate derivatives, however, the story is rather different. Safex lists two and they don’t trade at all. One reason is regulatory capital requirements. Derivatives margin is charged against capital at a rate of 100%, although the SA Reserve Bank assured Mr Thomson that this would be reduced. Another reason is that Safex’s trading system was essentially designed for equity products. “Interest rate products don’t enjoy their own focus,” Mr Thomson says.

A third reason, and for buyside institutions the most important reason, is a perceived lack of price discovery in the underlying spot market. “There has always been a problem unwinding Safex derivatives positions into the spot market, without seeing a major movement in spot prices,” notes Stuart Yates, a strategist and industry specialist at Rand Merchant Bank.

Yield-X solution

Yield-X hopes to address these shortcomings with anonymous, automated trade matching through a central order book. This will involve a central counterparty with guaranteed settlement and multilateral netting for all products. As well as spot and forward bonds, those products will include interest rate futures and options, carries (buy/sell-back transactions), swaps and futures on notional swaps.

The result, JSE says, will be clear transparency of prices and market depth and, so it follows, efficient price discovery. Another objective is to broaden market access for smaller players. “Margining will make it possible for anyone to come into the market,” says Mr Thomson. “Now you need a huge balance sheet before anyone will trade with you.”

Mixed reaction

System roll-out was scheduled for mid-November, and Yield-X hopes to open for trading in “early 2005”, perhaps as soon as late January. Out in the marketplace opinions are mixed; at the extremes, institutional investors are much in favour, while certain broker dealers and even some big issuers are very dubious.

Graham Smale, a risk manager at investment banking boutique Decillion Capital, likes the concept. “Yield-X will allow us to replace cash-intensive margining relationships involving multiple counterparties with a single relationship into the exchange,” he says. “We think that’s an efficient way of expanding our business model.”

Rand Merchant Bank’s Mr Yates is also broadly in favour, although he thinks that the new exchange may have a polarising effect on the market. “I think Yield-X does tackle the worst of the price discovery problem,” he says. “Design-wise, it’s quite a clever idea.”

Mr Yates acknowledges the concerns of those worried that, if instruments are being traded in two places, some liquidity will be destroyed. “I don’t buy that,” he says. “On the Yield-X plan, most trades will be in small sizes – perhaps R1m ($165,000) to R10m or R20m. The big bulk trades tend to be R100m–R500m, which is not the same product as R1m. And the price is not the same.”

He points out that many people who trade big blocks do not want to put them into an order entry system for fear that they will just get nibbled at, which can result in part execution. “Let’s get it started and see how it goes,” Mr Yates concludes. “The JSE has the wherewithal to support it for a number of years before they decide whether it’s working or not.”

However, in the view of the head of capital and markets at one major corporate issuer, it will not work. “The market can’t run on two exchanges,” insists the official. “More likely, this will get Besa up and running faster to give us what we need – a derivatives-inclusive package. The fact that swaps are still not exchange-traded, for example, is quite shocking. There should be one exchange where the whole package is traded together.

“We should also get proper credit in the market – and netting – so as to open opportunities to the smaller guys – the ones who contribute more to liquidity than the bigger guys.”

Some interdealer brokers are surprised that regulators will allow Yield-X to price their products on a separate platform. They say that the Financial Services Board has applied strong pressure to them through Besa in order to improve transparency and centralise price discovery. “And now they let the JSE start a market that will recreate what they asked us to undo,” says one broker. “It’s a confusing message.”

Wayne Rosenberg, chairman of interdealer broker TTSA Securities, says that Yield-X will pit an automated margining business model against a centralised, yet transparent, bilateral credit model. “I believe it will fragment liquidity,” he maintains. “Certain people prefer to trade in different environments, but that environment must offer liquidity [in order] to enable effective and efficient trading. The market will follow liquidity, and the success or failure of margining will determine where the liquidity will be.”

If Yield-X can stay the initial course, it hopes to list corporate bonds as a second phase. Getting into the primary government bond market would need the authorities’ active co-operation, in face of hugely intensified resistance from Besa’s primary dealers. So, one step at a time, perhaps.

Future competition

Competition of this kind will proliferate in the years ahead as exchanges seek to leverage their existing trading platforms across new products. The New York Stock Exchange has applied to US regulators for approval to expand the range of bonds traded on its Automated Bond System, which it clearly intends to put more weight behind.

While it says merely that this is “a good business opportunity”, it might be seeking to pre-empt the big Chicago derivatives exchanges, before they in turn decide to list cash bonds themselves.

It is difficult to call the outcome of these contests in advance. As Besa’s Mr Lawless says of the imminent battle with Yield-X: “You don’t know what the impact of competition is until you have got into competition. It may be to the benefit or the detriment of both. But the market will decide.”

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