Published March 27, 2009

Don't be quick to pan SGX's ES contract

By R SIVANITHY

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THE Singapore Exchange (SGX) has had to deal with a bit of criticism in the local press over the past week for launching a new product known as an Extended Settlement (ES) contract, which is essentially an exchange- traded futures contract on an individual stock.

One critic asked if there was a need for the Singapore market to feature yet another set of derivatives that really only amount to gambling tools, while another warned of the similarities between ES and risky forward contracts that played a pivotal role in the Pan-Electric crisis of the mid-1980s.

Objectors in the industry, meanwhile, voiced fears as to whether a market as small as ours can support more of such instruments, especially one that is perceived as being difficult to understand.

While all of these concerns are valid and should not be understated (ES contracts are leveraged instruments, which means risks and losses are magnified), SGX realistically has no choice if it is to achieve its goal of being a top Asian financial centre. The alternative is to stand still and do nothing while competing exchanges forge ahead with new products of their own. Hong Kong, for example, last year launched its hugely successful 'callable bull/bear contracts' or CBBCs, which have complemented its already thriving structured warrants segment. In a bear market, where volume has dropped sharply, doing nothing would be tantamount to competitive suicide for a commercially driven exchange.

Moreover, claims of ES being difficult to understand are actually overstated. With a few differences, ES trading is similar to margin trading - something the majority of players here would already be familiar with. Essentially, investors take a view on where prices might head over the next 35 days, buy or sell accordingly and pay margins upfront, and again if prices move against them.

In the case of drastic movements, the margin calls can be substantial, so SGX provides guidelines on how much margin is needed. However, brokers will have to assess each client's creditworthiness before deciding on the actual margin amounts on a case-by-case basis.

When so doing, it is incumbent on brokers to check if clients have thoroughly familiarised themselves with the risks associated with ES because, like any leveraged product, losses can be large.

Has the ES launch been poorly timed? Maybe - even its most sympathetic critics have said introducing a new product in the depths of a bear market is bad timing because if interest in underlying stocks is already weak, then interest in new derivatives on those stocks would likely be non-existent.

As way of proof, they point to the present low daily volume in ES since its launch a few weeks ago. Had it been launched when the market was active and bullish, the chances of success would have been greater, or so it is believed.

While this sounds plausible, it has to be said that SGX is not in the business of timing the market and cannot afford to wait for an upturn before it offers new products. To elevate the local market's status as a financial centre, the exchange's role is to offer investors as wide a range of useful products as possible whenever it can, and to take all precautions to ensure no parties are unduly advantaged or disadvantaged. To achieve this, education and familiarisation are key so that risks are understood and factored in. Timing, however, cannot be an issue, at least not for the exchange.

Consider, for example, that when structured warrants were introduced back in 2002, annual turnover in the segment amounted to only $42 million. This was largely due to a post-dotcom crash bear market, uncertainty surrounding the US invasion of Iraq, a lack of understanding about the product among investors and the beginnings of the Sars epidemic - all factors that led to turnover dropping to a paltry $25 million in 2003.

Once the rebound started and familiarity with the instrument spread, turnover grew exponentially, hitting $28 billion in 2007. Note that this was slightly more than 1,000 times the business done in 2003 and today, even though volume has dropped because of the bear market, structured warrants are an established feature of our financial market.

Throughout the early years of the warrant segment's growth, concerns were raised similar to those now surrounding ES - namely, warrants are risky and difficult to understand, and since they are thinly disguised gambling tools, they increase risk in the market and therefore have no place here.

Those concerns have since been laid to rest; hopefully, in time, so will those surrounding ES - provided investors give the instrument the chance it deserves and take the time to study it thoroughly.