Published October 12, 2009

No time to lose in arresting decline of warrants

By R SIVANITHY

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BY ANY standard, the performance of stocks over the past seven months has been spectacular, with the Straits Times Index (STI) having risen some 80 per cent in that time. And, in a rising and increasingly active market, it would be logical to expect leveraged plays like structured warrants to play a big part. Certainly, in the years following the 1999-2000 dotcom crash and the 2001/2002 recession when markets recovered strongly, turnover in warrants shot up exponentially - from $1.5 billion in 2004 to an all-time high of $28 billion in 2007.

This time around, however, although the market has once again been on a non-stop uptrend since March and investors are betting on a similar economic recovery taking grip, the warrants story is vastly different; volume is dwindling and if present trends continue the segment could find itself back at where it was in 2005 or 2006, with all the good work of the past 3-4 years wiped out.

According to figures provided by SG Securities last week, average daily third-quarter turnover in warrants was just $42 million, down 31 per cent from 2008's Q3 figure of $62 million. Average daily turnover in the underlying stock market in the meantime jumped 35 per cent to $1.73 billion.

Disappointing figures

The sequential comparison also isn't too encouraging. While the Q3 underlying market volume grew 2.7 per cent over Q2, warrants business plunged 28 per cent. For the first nine months of 2009, warrant turnover came to $9.2 billion - which, if we use a simple extrapolation, means the full-year figure would be in the region of $12 billion. That would be 43 per cent down from 2008 and in the region of 2006's $14 billion.

These are disappointing figures and speak of a once-promising segment that is now in decline. The loss of business has forced the exit of several issuers from the market, while other major players such as SG and Deutsche Bank have closed operations here and retreated to Hong Kong, leaving Macquarie the only big player with a local presence.

Since warrants play an important part in the financial landscape of any aspiring financial centre (in Asia, warrants are thriving in Hong Kong, Taiwan and South Korea), it's important that steps are taken to arrest this decline. In order to do so, it's essential to first understand why the business has been hit as badly as it has.

One reason is the emergence of seemingly more attractive alternatives such as Contracts for Differences (CFDs), an off-market leveraged product which resembles a futures contract that has reportedly enjoyed phenomenal growth this year. Similarly, anecdotal evidence is that although Hong Kong's warrants market hasn't suffered as badly as Singapore's, volume there has also dropped because of the introduction of a novel structured product known as 'callable bull-bear contracts' (CBBCs).

Problem is, while the appearance of CFDs here and CBBCs in Hong Kong could have played some part in cannibalising business from the warrants segment, neither instrument is directly comparable to warrants and both possess different features. Clearly, there must be deeper issues at work.

According to warrant experts, the main problem is increased risk aversion among retail brokers who, because their clients were badly hit when they traded warrants during the downturn last year, are now actively discouraging those clients from taking warrant positions any more. As one source said: 'You have to put up a margin to play CFDs, but you don't need any margin to play warrants. So if you're a broker looking to manage your client risk, you're better off recommending CFDs.'

This heightened risk aversion has also led many houses to deny Internet traders access to warrants; compare this to the situation in Hong Kong, where clients in China (a base that could run into the tens of millions) can trade Hong Kong warrants online. And the penny stock resurgence of the past 4-5 months meant that the relatively small number of risk-averse retail traders who ventured back into the market since March have preferred to punt these low-priced counters rather than equivalently priced warrants. We say 'relatively small number' because dealers and issuers have said that a significantly large part of daily volume over the past six months has come from house accounts, institutions and dealers trading among themselves, with retail players playing only a fringe role.

Contra trading

Finally, according to at least one senior warrants source, the contra trading system (which allows traders to offset their purchases and sales within three days without any initial outlay) presents a huge structural obstacle to the development of the segment. 'If retail traders can already enjoy leverage via the contra system, then what incentive is there for them to use warrants to gain leverage?' is the not unreasonable argument.

The good news is that the Singapore Exchange (SGX) is aware of these issues and is working hard with brokers and issuers to address them.

To be sure, it's a difficult task - how, for example, does one encourage remisiers to get their clients to take on more risk via warrants without asking those clients to pay an upfront margin? Or, for that matter, imagine the public outcry if contra trading were to be stopped. However, all concerned must press on and solutions must be quickly found.

The ultimate goal must be to restore the segment onto the growth trajectory it enjoyed before 2008's downturn because warrants are too important a feature of any advanced financial market for Singapore to lose.