Tagged on the end of a proposal to issue ETFs in Taiwan was a hidden gem. The Securities and Futures Commission (SFC) for the first time indicated that they would examine and hopefully implement institutional stock lending and possibly borrowing through a yet-to-be-established clearing house. This change would be enacted through administrative amendments and not be required to touch the floor of the divided Legislative Yuan. The Ministry of Finance (MoF) would simply convene a committee to debate the changes and the SFC would announce the conclusion in the form of an amendment to the appropriate securities law.
Currently, institutions investing in Taiwan equities have limited options for hedging their positions. Local institutions, such as securities investment trust companies (SITEs), insurance companies, proprietary desks, trust companies, the stabilization fund, the so-called "Big Four Funds" and banks, cannot short the shares of Taiwan listed companies. However, local and foreign institutions, as well as the proprietary desks of local securities brokers can short the TAIEX index futures. For foreign institutions it is even more limited, with only SIMEX and TAIEX-traded index futures contracts and offshore swaps providing a means to hedge positions, and these very often being imperfect. Arbitrage funds capturing the opportunities between Taiwan's cash market and derivatives (ECBs, DRs, etc.) have been actively using swaps and also nominee accounts. Whilst the move will be welcomed by these funds, it is also possible that the advent of a central clearing house could bring efficiency into the arbitrage market, thereby helping narrow some of the more interesting spreads.
There are only two ways one can currently short individual stocks without going via a swap. The first is if you are a local Taiwanese individual or corporate client of a local broker, where the short position per account per broker is limited to NT$15m (US$440,000). And the second route is for foreign clients using multiple nominee accounts with local brokers controlled by a central local broker willing to perform these transactions for a fee (1% in and 1% out + interest). The credit risk is one deterrent to employing this method for foreign institutions, and the narrow but obvious regulatory risk is another.
Taiwan is not only trying to catch up with its neighbors such as Hong Kong and Korea on liberalization measures and the opening up of its capital markets, but now also trying to keep a step ahead of China, which has just initiated a QFII (Qualified Foreign Institutional Investor) system very similar to that first employed by Taiwan in the mid 90's. In January 2003 alone, Taiwan's exchange has allowed the trading of options for five names, proposed to lift the minimum 70% equity holding "guidance" for SITEs, and also reinstated the ability to short below the previous day's closing price on the local exchange. In Taiwan, though, without a lender of last resort such as the IMF, the Central Bank of China plays a prominent role in decisions, which would have an impact on the currency, however minor.
The benefits to the borrower are obvious and clear, but the other side of the coin is even more interesting. Lending stocks would allow local institutions with long-term holdings to improve their cash yield. It might also reduce the selling pressure from the stabilization fund by allowing it to trickle shares out through the clearing house as a lender, thus removing some of the potential selling pressure currently perceived to sit atop the index. Most importantly though, it would give the market a more natural balancing mechanism, where bottlenecks and blocks were reduced. Transparency would improve markedly from the current mix of local official short positions and offshore swaps.
There are potential risks and problems embedded within the proposed structure however. Currently securities laws and regulations are not supportive of hedge funds operating in Taiwan, in particular allowing for shorting of stock by foreign institutional investors. The absence of hedge funds operating openly in Taiwan and the similarity of most SITE portfolios means that there is relatively little local expertise in the area of derivatives and hedging. The effectiveness of the clearing house will only be maximized with the presence of a large number of sophisticated lenders and borrowers.
The proposal, which specifically relates to the shorting of listed companies, suggests that a clearing house handle stock borrowing and lending activities. The SFC is determined to meet the deadline of June 2003 by which to make all these changes. But a good deal of work will have to be done before then to make sure that it does not turn out to be a car without an engine. Several bodies may be able to hasten the process however. As we said earlier, the Central Bank is one of them. Without their blessing and seal of approval, nothing changes. The second is the committee that the SFC will likely form under the instruction of the MoF. This committee will invite key industry players, regulatory bodies (including the Central Bank, legislators and the MoF), and possibly some industry associations (i.e. Securities Investment Trust Companies Association) and chamber members. The American Chamber and European Chamber of Commerce have been extremely effective participants in these committees before now, and can lay claim to some credit for the recent liberalization measures for QFIIs & GFIs (General Foreign Investor). I suspect they will be invited to play a role this time as well, keeping the door open for constructive and progressive recommendations from industry experts. All this will ensure that the amendments are practical, useful and above all, permanent.
Peter Kurz is CEO of Insight Pacific, and head of the Capital Markets Committee of the American Chamber of Commerce:
Ralph Dixon is head of institutional sales at Insight Pacific: