General Overview of the Structured Warrant Market

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Growing like Wild Fire : The structured warrant markets in Asia underwent a huge metamorphosis in 2006. The success was partly attributed to the buoyant regional stock market, and partly to the growing familiarity of the momentum instrument. With a furious bullish undertone, turnover in warrant trading now accounts for nearly 30% of Hong Kong's total turnover compared with just 7-9% a few years ago. In Singapore, it contributes to 5-10% of total daily turnover. In Korea, where structured warrants are known as equity-linked warrants (ELWs), the turnover now comprises 10% of overall market turnover since inception in December 2005.

 

Such appetite to consume volatility is evident in Malaysia, despite its slow growth momentum since the new guidelines from the Securities Commission (SC) came into effect in May 2003. Bursa Malaysia shifted gear in the second half of 2006 - we saw CIMB accelerated its warrants issuance program, while AMMB and OSK Securities followed in tandem. Still, the warrant market over here is relatively small and inactive - from 12 call warrants at the end of 2005 to 35 currently.

 

So what is to be expected in 2007?

 

Planting the Seeds: Expect to see further relaxation of the listing requirement. The current placement methodology (new issues need to be placed to 100 holders, or 50 holders each subscribing to a minimum value of MYR100,000) is a barrier to expand the warrant market. Hong Kong and Singapore have abandoned such pre-placement regulations in 2001 and 2004 respectively, and have since replaced it by the "warrant supermarket" approach ¨C where issuers can list all sorts of warrants and "shelf" them for public consumption. Risk management takes effect not until the warrants are consumed in the secondary market. The result is a heavy influx of warrant launches. Listing fees were lowered and made competitive as an effect (not a cause) of the huge supply of issuance.

 

Such supply-driven dimension has serious connotations in fuelling the popularity of structured warrants. Currently, there are 20 and 13 issuers in Hong Kong and Singapore respectively, although only a handful accounts for market dominance. They compete to issue or roll-over new warrants with relevant strike levels as the market trended upwards throughout 2006. As it stands, there are 550 structured warrants listed on SGX, compared to 35 on Bursa Malaysia (note that both SGX and SC revised guidelines in 2003). The other implication is that the breadth of the issuers and the warrant issues will inevitably translate to the depth and market making efficiency on the warrant market.

 

Keeping it Fair, Tight and Liquid: Prior to the current market making system, daily prices of structured warrants were based strictly on forces of supply and demand. There was simply no guarantee of ample liquidity on a day-to-day basis. Nonetheless, the existing market making system has not eradicated the legacy of doubt and suspicion. Recent examples were the quotations of two call warrants - Resorts-CA and Genting-CA, which traded in opposite directions to their respective underlying stocks. Issuers' goodwill is thus eroding fast.

 

The challenge for Bursa Malaysia is to induce inter-warrant competition from foreign issuers running on a global platform to improve the overall market making efficiency. Reputational risks will increase with more issuers competing on a selective group of stocks. Any inconsistency in pricing from volatility manipulation or failure to maintain a tight bid-offer spread will be fast acknowledged by the demand side. While the appetite to consume volatility can become more than manageable on the delta- and gamma-hedging fronts for some issuers, a more competitive supply side will evolve in the hedging front and collectively adopt less defensive market-making techniques.

 

Teach and Reap : Bursa Malaysia, the issuers, and the distributing brokers are obviously anxious to keep the local warrant market moving, and thus need investors to understand structured warrants, trade skilfully and profit from it. In Hong Kong and Singapore, warrant issuers actively provide data on warrants indicators and conduct (sometimes joint) product seminars on warrant trading. Websites with tools and simulators of prices based on different pricing parameters are clearly lacking here.

 

Final Thoughts: There is definitely more scope for growth in the structured warrant market in Malaysia. As the above-mentioned changes are foreseen, so would the trading mentality evolved. The typical buy-and-hold warrant trading strategy will only succeed with efficient market makers from a breadth of issuers. High delta in-the-money warrants will be replaced and rolled over fast with relevant strike levels, and issuers need not resort to defensive market making tactics (e.g. widening the spreads) and rapid implied volatility adjustments. Else, investors and traders will adopt a shorter holding period for structured warrants upon closer scrutiny of the various market-making mechanisms employed by the issuers. In markets like Singapore and Hong Kong, about 90-95% of total turnover on structured warrants were contributed by day-trades on average. This is a natural evolution after 3-4 years of product adoption. The Malaysian warrant market cannot afford to undergo this chicken-and-egg syndrome at such infancy stage, where overwhelming participation from the day-traders prevails over the actual retail clients.

 

In the next issue, we will discuss the basics of structured warrants.