THEORETICAL FRAMEWORK ABOUT DERIVATIVES
THEORETICAL FRAMEWORK ABOUT DERIVATIVES
Derivatives are financial contracts whose value is determined by the performance of underlying assets, financial bases, indices, or other investment instruments, as defined by John Downes and Jordan Elliot Goodman.
The book "Options, Futures and Other Derivatives" by John Hull defines derivatives as financial instruments whose value is derived from underlying variables, typically the prices of traded assets For instance, a stock option's value hinges on the stock's price, but derivatives can also depend on a wide range of variables, including commodity prices and even weather conditions.
The Securities Institute of Australia defines derivatives as contracts that stipulate a specific timeframe for the purchase or sale of commodities, such as wheat or wool, as well as financial instruments, including stocks or indices.
Derivatives are contracts between buyers and sellers that establish terms for a future transaction, such as exchanging a specified amount of US dollars at a predetermined USD-EUR exchange rate The value of these derivatives fluctuates based on the price of the underlying asset throughout the contract's duration, which can extend beyond ten years Due to the potential price volatility of the underlying asset and the derivatives contract itself, effective risk management is crucial.
Derivatives securities are financial instruments derived from underlying assets like stocks, bonds, commodities, currencies, interest rates, and market indexes They serve various purposes, including risk diversification, profit generation, and profit protection By leveraging these instruments, investors can amplify their exposure to the value of the underlying assets, ensuring that any fluctuations in the prices of stocks and bonds are managed effectively, thereby maintaining the initial value of the derivative instruments.
Derivatives transactions include an assortment of financial contracts, including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations thereof
A contract between two parties outlines specific conditions, including dates, values, definitions of underlying variables, contractual obligations, and the notional amount for payments Common underlying assets in such contracts encompass commodities, stocks, bonds, interest rates, and currencies.
Derivatives differ from traditional stocks as they do not grant ownership rights or claims to a company's capital Instead, these financial instruments involve obligations tied to interest rates, foreign exchange, commodity prices, or stock prices Essentially, derivatives represent the rights and responsibilities of participants, including priority rights, put or call options, and the obligations to fulfill specific commitments.
In broad terms, there are two groups of derivatives contracts, which are distinguished by the way they are traded in the market:
Over-the-counter (OTC) derivatives are privately negotiated contracts traded directly between two parties, bypassing exchanges or intermediaries Common products in this market include swaps, forward rate agreements, and exotic options As the largest and largely unregulated derivatives market, OTC trading primarily involves sophisticated entities like banks and hedge funds, leading to minimal information disclosure between parties This market serves as a crucial alternative to traditional exchanges and has significantly outgrown the exchange-traded market in terms of total trading volume.
Exchange-traded derivatives (ETDs) are financial instruments traded on specialized derivatives exchanges, where standardized contracts are defined and facilitated These exchanges serve as intermediaries for transactions, requiring both parties to deposit an initial margin as a guarantee for the trade.
Derivatives differ from securities in that transactions for securities are completed within a few days While some securities exhibit characteristics similar to derivatives, such as certificates, warrants, or structured credit-linked securities, they are not classified as derivatives.
Derivatives markets have achieved remarkable success due to their ability to attract a diverse range of traders and substantial equity This high level of participation ensures that when an investor seeks to enter a contract, they can easily find a counterparty willing to take the opposite position.
There are three categories of traders: hedgers, speculators, and arbitrageurs
Hedgers utilize derivatives to mitigate the risks posed by potential future fluctuations in market variables By employing these financial instruments, they safeguard themselves against the uncertainties related to asset pricing.
Traders monitor market prices closely and sell futures contracts when they find a favorable price that meets their needs Hedgers, including businesses and individuals, are typically involved in the underlying cash commodity at some stage, using futures contracts to manage price risk effectively.
Speculators play a crucial role in the financial markets by taking positions to profit from anticipated price movements, unlike hedgers who seek to mitigate risks associated with asset price fluctuations Acting as intermediaries, speculators do not intend to own the commodities themselves; instead, they buy and sell assets, capitalizing on market trends and future price directions Their primary goal is to bet on the future price movements of various assets, contributing to market liquidity and efficiency.
Arbitrageurs play a crucial role in futures, forward, and options markets by capitalizing on price discrepancies across different markets They engage in arbitrage, which allows them to secure riskless profits by simultaneously executing transactions in multiple markets For instance, when they identify a divergence between the futures price and the cash price of an asset, they take offsetting positions in various instruments to ensure a guaranteed profit.
There are many types of derivatives, but in general, those can be classified into 4 main instruments: Forwards, futures, options and swaps
RISKS IN THE PERFORMANCE OF COMMERCIAL BANKS
1.2.1 Definition and business nature of commercial banks
A commercial bank is a financial institution that offers a range of services to businesses, organizations, and individuals, including accepting deposits, providing loans for business and mortgage needs, and offering basic investment products like savings accounts and certificates of deposit.
Commercial banks generate profits by converting small, short-term deposits into larger, long-term loans, a process known as asset transformation that yields net income Additionally, while investment banking activities are not the primary focus, many commercial banks also engage in this sector.
Commercial banks are essential financial institutions that fulfill a variety of functions to meet the financial needs of sectors such as agriculture, industry, and trade They play a crucial role in addressing economic and social requirements As time progresses, the functions of banks are evolving, with a growing focus on customer-centric services and an expansion of their roles Generally, the functions of commercial banks can be categorized into two main types: primary functions, which include accepting deposits, making advances, and credit creation, and secondary functions, which encompass cheque clearance, the sale and purchase of shares and bonds, money transfers, acting as trustees, and serving as representatives.
To give/accept money, To provide letter of credit)
1.2.2 Main risks in the business of commercial banks
Risk is unwanted event leading to losses on the bank's assets, the lower actual profit than expected or an additional cost to complete a certain financial profession
Commercial banks operate as businesses that face significant financial risks while delivering their services The concept of "risk" primarily refers to the potential for financial loss or uncertainty When assessing risk, we can view it on a spectrum, ranging from certainty of occurrence to certainty of non-occurrence The highest level of risk occurs when the likelihood of an event happening is equal to the likelihood of it not happening.
Over the past ten years, the banking industry has experienced significant financial setbacks, with previously successful firms reporting substantial losses attributed to deteriorating credit exposures, unfavorable interest rate positions, and uncertain derivatives strategies In light of these challenges, commercial banks have collectively prioritized the enhancement of their risk management and control systems to better navigate potential future risks.
1.2.3 Types and reasons for risks in banking business
1.2.3.1 Types of risks in banking business
Banking services carry varying risks depending on the specific services offered Overall, these risks can be categorized into two primary types: systematic risk and unsystematic risk.
Systematic risk, often referred to as market risk, is the potential change in asset value due to broad economic factors, which cannot be completely diversified away All investors face this risk whenever their assets or issued claims fluctuate in value due to these overarching influences In the banking sector, the most significant forms of systematic risk include fluctuations in interest rates and changes in currency values.
Credit risk refers to the possibility that a borrower or counterparty fails to fulfill their financial obligations as agreed, which can lead to potential losses for banks This risk may manifest as outright default or through a decline in the value of a bank's portfolio due to perceived or actual deterioration in credit quality Since credit risk is an inherent aspect of lending, closely tied to market risk variables, effective credit risk management aims to minimize potential losses while maximizing the bank's risk-adjusted returns by carefully managing credit exposure within acceptable limits.
Interest rate risk is a significant concern for commercial banks, which typically manage this risk effectively within their investment portfolios However, since interest rates are largely influenced by the Federal Reserve, banks must take precautions to hedge their loans against fluctuations in the overall interest rate environment For instance, if a bank issues a business loan at a 5 percent interest rate while the prevailing rate is 2 percent, it stands to gain a 3 percent profit if the rate remains stable Conversely, an increase in general interest rates could jeopardize this profit margin.
3 percent, the bank's profit will decline to 2 percent
Foreign exchange risk refers to the potential losses a bank may incur due to unfavorable movements in exchange rates while holding open positions in foreign currencies, whether spot or forward Even when individual currency positions are balanced, discrepancies in the maturity patterns of forward transactions can create mismatches Additionally, banks face settlement risk from counterparty defaults and time lags in settling transactions across different time zones Furthermore, banks are also vulnerable to interest rate risk stemming from the maturity mismatches of their foreign currency positions.
- Legal risk is risk from uncertainty due to legal actions or uncertainty in the applicability or interpretation of contracts, laws or regulations
Unsystematic risk is risk occurs in a business that is independent of factors such as economic and political conditions or systematic factors
Liquidity risk is primarily the risk of a funding crisis, often triggered by unexpected events like significant charge-offs, loss of confidence, or national crises such as currency devaluation Effective risk management focuses on liquidity facilities and portfolio structure, highlighting the importance of viewing liquidity as a valuable asset Consequently, banks must design their portfolios to address concerns related to illiquidity, making it a critical challenge in financial planning.
Operational risk pertains to challenges in accurately processing, settling, and executing trades for cash, as well as issues related to record keeping, system failures, and regulatory compliance While these individual operational issues are typically low-probability events for well-managed organizations, they can lead to significant financial consequences for the firm.
1.2.3.2 Reasons for risks in banking business
There are three main reasons triggering risk in banking system
Ineffective bank management can lead to significant risks, including liquidity issues that hinder debt repayment and excessive loans or investments in high-risk sectors A lack of market understanding, inadequate information, and careless analysis may prompt banks to make hasty lending or investment decisions Additionally, internal fraud, such as bribery and unprofessional practices, further exacerbates these risks within the banking system.
Customers may face various challenges that hinder their financial stability, including legal incapacity, misallocation of capital, liquidity issues stemming from poor capital management, and internal conflicts within the Board of Directors.
- External reasons related to business environment: instable political situations, economic crisis or degradation, natural disasters or unfavorable legal framework
1.2.4 The use of derivatives in risk hedging in commercial banks
The financial futures market allows risk-averse investors, like banks and insurance companies, to transfer interest-rate fluctuation risks to speculators The current selling price of a futures contract reflects market expectations of future cash prices at the time of delivery To hedge against interest rate changes, financial institutions typically take an opposite position in the futures market compared to their cash market positions For example, a firm intending to buy bonds in the cash market may sell bond contracts in the futures market to protect against potential declines in bond prices This strategy can offset losses in the cash market with gains in the futures market Financial institutions extensively utilize futures contracts not only for security dealer operations and bond portfolio management but also to safeguard returns and costs associated with loans, deposits, money market borrowing, and other financial assets.
In general, there are three most typical interest-rate hedging problems most financial face
Protecting the value of securities and fixed-rate loans from losses due to rising interest rates
Avoiding a rise in the borrowing costs
Avoiding a fall in the interest returns expected from loans and security holdings
SITUATION IN USING DERIVATIVES IN RISK HEDGING
AN OVERVIEW OF COMMERCIAL BANKS AND DERIVATIVES
2.1.1 An overview of Viet Nam commercial banks
Over the past decade, the number of banks in Vietnam has remained relatively stable This consistency can be attributed to government policies that prohibited the establishment of new joint stock commercial banks, particularly in response to the vulnerabilities faced by the commercial banking system during the 1997 financial crisis.
Table 2.1: Number of commercial banks through years (1997-2012)
The data indicates significant fluctuations in the banking sector over the years As of May 2008, there were 4 state-owned banks, 36 joint stock banks, and 44 branches of foreign and venture banks However, the joint stock banks saw a notable decline due to bankruptcies and operational issues, while the other bank types experienced growth By August 2010, the figures reflected 5 state-owned banks, 39 joint stock banks, and a decrease in foreign and venture bank branches to just 17 This suggests a slight recovery in joint stock banks, contrasted by a sharp decline in foreign bank branches from 44 to 11 In 2012, the overall number of banks remained relatively stable, showing no significant changes.
International economic integration has significantly benefited Vietnam's commercial banks, enabling them to expand their branch networks and customer bases while effectively promoting economic growth Key factors contributing to their success include a deep understanding of the domestic market, skilled banking personnel, a favorable legal environment, and strong support from the Central Bank However, joining the WTO has introduced challenges, such as increased competition from international banks, limited technological capabilities, and a lack of diverse banking products As a result, restructuring within the banking system has become a priority Additionally, external factors like global financial crises and traditional business practices have created further obstacles for these banks to navigate.
2.2.2 An overview of the performances of Viet Nam banking system
Banking system can be considered the arterial of the whole economy Till
Since 2008, Vietnam's banking system has significantly contributed to the economy, providing 16% of annual GDP and nearly 50% of total investment capital This demonstrates the banking sector's remarkable development and its effective role as an intermediary in connecting production, consumption, and savings.
Diagram 2: Charter Capital of Commercial Banks in 2012
Banking system has been financially restructured and dealt with bad debt since 1990s In 2007, bad debt rates made up below 2% on the total credit balance
Rapid economic growth has outpaced the economy's absorption capacity, resulting in significant inflation and the emergence of stock and real estate bubbles This situation has created an imbalance in the capital-asset structure, causing serious liquidity issues for banks By the first quarter of 2008, both inflation and the trade deficit were under severe threat.
In the second quarter of 2012, under the context of decreasing inflation rate, negative credit growth, the central bank decided to cut down interest rates again to stimulate economic growth
From July 1, 2012, to the end of 2012, the base interest rate was held steady at 9%, while the cap on short-term lending rates was set at 13%, and medium to long-term loans over 12 months were subject to floating interest rates On May 3, 2012, the central bank implemented a reduction in interest rates, lowering the ceiling from 8% to 7.5% and reducing short-term interest rates in VND for priority sectors from 12% to 11% Additionally, credit growth during this period remained significantly low compared to the previous year.
The process of restructuring the banking system continues after the plan was first announced at the end of 2011and approved in 3/2012 In the first quarter of
2012, restructuring rate is rather slow In 2011, there were three banks merged: SCB ( Sai Gon Commercial Bank) , FCB ( Ficombank) and TinNghia Bank In
In August 2012, Habubank successfully merged with SHB, marking a significant development in the banking sector By the end of the first quarter of 2013, the merger between PVFC and Western Bank was officially announced Notably, Western Bank was one of the nine banks identified for restructuring due to its low liquidity and high levels of bad debt.
The restructuring process faces ongoing challenges with bad debt, which remains a significant concern due to the lack of official data on its level In the first nine months of 2012, the growth rate of bad debt surged by 66% compared to the end of 2011, with fluctuations ranging between 8.5% and 10%.
2.2.3 An overview of Viet Nam derivatives market
Since the 1990s, derivatives financial transactions have been introduced in Vietnam, primarily within banking operations involving foreign banks Major institutions like Vietcombank and BIDV have engaged in foreign currency futures, swaps, and futures contracts to assist businesses in international payments Despite the introduction of a pilot program by the State Bank, derivatives transactions have not received significant attention While many banks in Vietnam now offer these services, the range of complex derivative products remains limited, with most activities conducted by foreign banks operating in the country.
Table 2.2: Overview of derivatives operations in some Viet Nam commercial banks
Foreign exchange Gold Foreign currency Currency Gold Currency Interest rate Gold
Despite the potential of derivative products, their adoption by businesses within the banking system remains low, resulting in a minimal contribution to overall bank income For instance, current data from two leading commercial banks highlights the limited revenue and profits generated from derivatives, underscoring their underutilization in the financial sector.
Table 2.3: The proportion of derivatives in income and profit in BIDV and
Year Criteria BIDV Vietinbank million VND % million
The income and profit generated from derivatives at BIDV remain minimal in comparison to the bank's overall financial performance In 2009, revenue from derivatives was 91.272 million, representing just 0.94% of total income This figure rose to 152.482 million in 2010, accounting for 1.34% of total income, but peaked in 2011 at 190.383 million, which constituted only 1.24% of the total.
In general, it is clear that derivatives market has still been rather limited and freshly new for commercial banks in Viet Nam.
IDENTIFYING MAIN RISKS IN THE PERFROMANCE OF VIET
Credit risk is a significant concern for banks, as it represents the potential loss associated with issued credits Lenders anticipate profits from the credits they extend, but there is a substantial risk that these amounts may be partially or entirely lost.
Credit activities in Vietnamese commercial banks have been characterized by low quality and efficiency, with overdue debts averaging around 5% and significant potential credit risks For instance, in 2012, several banks in Ho Chi Minh City reported lending amounts exceeding 10% of their equity, with Eximbank at 74%, Sacombank at 48%, and SaiGon Bank at 33%.
Commercial banks are currently encountering significant credit risk due to the potential bankruptcy of their customers To mitigate this risk, they can utilize credit derivatives contracts available in the over-the-counter (OTC) market.
Interest rate risk and foreign exchange risk:
Two significant risks in banking are interest rate risk and exchange rate risk, both of which can impact loan costs and bank profitability Rising interest rates or unfavorable exchange rates can lead to increased loan expenses, while declining rates or exchange rates can diminish a bank's operating results.
VP Bank primarily holds short positions in foreign currencies, exposing it to significant foreign exchange risk In the current Vietnamese Forex market, where the domestic currency is overvalued against the dollar and supply consistently exceeds demand, VP Bank is particularly vulnerable to exchange rate fluctuations This situation is not unique to VP Bank; many banks in Vietnam face similar risks in this challenging economic environment.
Mr Trinh Quang Anh, Manager of Maritime Bank’s Economic Center, states that while the USD/VND exchange rate is expected to remain stable in the short term, long-term devaluation of the VND is inevitable and will increase pressure on the economy Additionally, even strong currencies like the USD and EUR can experience significant fluctuations, posing challenges for projects that rely on foreign loans or investments without corresponding cash flow As a result, the foreign exchange rate presents substantial potential risks.
Interest rate risk is a significant concern for businesses, as they typically prefer fixed-rate loans to minimize capital costs and enhance project efficiency In contrast, banks favor floating-rate loans, which allow them to better manage capital with short-term rates This divergence in preferences arises from the inherent volatility of currency values; for instance, the U.S dollar has fluctuated from 7.5% per year down to as low as 1% per year, with peaks reaching 5.25% per year.
Derivatives, therefore, is an effective tool to prevent the two types of risk
To mitigate interest rate risk, banks often utilize derivatives like forward contracts, futures contracts, options, and swaps, with forward rate agreements (FRAs) and interest rate swaps (IRS) being the most prevalent These instruments enable banks to manage interest rate fluctuations without the need for simultaneous asset transfers, thereby reducing transaction costs This cost-saving allows banks to reinvest the saved funds into loan activities, enhancing their operational efficiency.
Banks frequently utilize derivative contracts to mitigate exchange rate risks and capitalize on currency fluctuations These derivatives provide banks with substantial foreign currency reserves, aiding in liquidity management Common derivative instruments employed include options, futures, and currency swaps, which serve as effective tools for safeguarding against exchange rate volatility.
Derivatives provide banks with enhanced options for risk hedging, allowing them to effectively manage interest rate and foreign exchange risks By strategically combining derivative contracts, banks can mitigate these risks at a reasonable cost.
SITUATIONS OF USING DERIVATIVES IN RISK HEDGING AT
Foreign currency forward contracts, introduced in Vietnam in 1998 during a period of significant economic growth and successful integration policies, have seen a rising demand for hedging foreign exchange among enterprises and banks Despite this increase, the volume of foreign currency forward transactions at commercial banks remains a small fraction compared to spot transactions According to BIS statistics, the global proportion of futures trading rose from 4.58% in 1989 to 12.08% in 2009, yet Vietnam's commercial banks experienced only a minimal increase in forward transaction volume alongside substantial growth in foreign exchange sales, resulting in a relatively stable percentage of forward transaction sales.
Table 2.4: The proportion of forward transactions in VinaForex
Over the past five years, the proportion of forward sales in total forward trading has remained relatively stable, fluctuating between 5.5% and 6.0% While the rates of forward buying and selling have evolved, a significant gap persists between them Notably, from 2001 to 2004, forward selling transactions were four times greater than forward buying Additionally, in the years 2009 through 2012, forward selling accounted for only about 30% of total transactions at VinaForex.
Foreign currency forward operations are widely conducted by major commercial banks in Vietnam, including Agribank, Eximbank, Techcombank, Vietcombank, BIDV, HSBC, Sacombank, Vietinbank, and MB These banks utilize automated accounting and processing systems for foreign exchange trading Customers facilitate payments through Nostro accounts in foreign banks or at the central bank's exchange, utilizing various methods such as Reuters, phone, and fax Transactions encompass all major currencies, including USD, EUR, CAD, GBP, JPY, SGD, AUD, HKD, CHF, CNY, and offer currency conversions tailored to customer needs.
The implementation of foreign currency forward transactions in Vietnamese commercial banks remains limited, as evidenced by Vietinbank's minimal development in this area The value of currency forward contracts has been relatively low, with an accounting book value of just 15,354 million VND in 2008, increasing slightly to 19,165 million VND in the first quarter of 2010, and showing no significant change by 2012 Most of these contracts were primarily signed with local partners.
However, in some banks, foreign currency forward operation has achieved certain successes Recently, the total value of forward contracts in Sacombank increased about 30 %/year
In general, futures contracts are relatively new in Vietnam; future forex trading has not been actually deployed as expected
Foreign currency futures contracts are not yet available in Vietnam Presently, commercial banks can trade futures contracts on the commodities market, focusing on agricultural products like coffee, tea, soy, and rubber, among others However, these banks primarily serve as intermediaries, assisting businesses in executing commodity futures contracts in foreign exchange.
Since the 2006 Trade Act officially takes effect and Decree No 158/2006
Several prestigious banks, including BIDV, Vietcombank, VIB, Asia Commercial Bank, Techcombank, MB, Citibank Branch, Standard Chartered Bank, and HSBC, have been authorized to operate as brokers in commodity futures trading Following this, VCB, VIB, BIDV, and Maritime Bank have introduced two types of licensed commodity futures contracts, with commercial banks serving as brokerage intermediaries.
Futures trading in Vietnam has seen limited growth, primarily due to their lower usage in risk hedging compared to other derivatives by commercial banks Currently, futures operations are predominantly conducted as commodity futures trading, with commercial banks serving primarily as intermediaries in these transactions.
In September 2004, the Central Bank authorized Techcombank to trade futures contracts on the commodities market, making it the first bank in Vietnam to offer this service aimed at enhancing clients' risk management and minimizing potential losses By late 2004, Techcombank began providing commodity futures contracts, partnering with businesses in sectors like steel and oil Initial successes were noted in major markets such as London, New York, Chicago, and Tokyo by 2005 However, the subsequent decline in contract value indicated a lack of acceptance of futures contracts in Vietnam, as customers favored forward contracts for risk management and speculation Over time, the use of futures contracts has grown, leading to significant successes in recent years.
Table 2.5: Value of commodity future contracts in Techcombank from 2008-2012
According to the table, a clear upward trend can be observed From 2008 to
Since 2009, the value of signed futures contracts has significantly increased and has continued on an upward trajectory Commodity futures contracts have become traditional products for Techcombank, gaining widespread recognition across the country.
BIDV, alongside Techcombank, is one of the few banks permitted to implement a pilot program for futures contracts, although this initiative remains relatively new and is developing slowly at the bank.
The first option transaction in Vietnam is the currency option which began in
In 2004, the Governor of the State Bank of Vietnam issued Decision 1452/2004/QD-NHNN, which regulates currency option transactions exclusively involving foreign currencies, excluding the USD Participants in these transactions include authorized credit institutions, international organizations, and individuals, alongside the State Bank of Vietnam Notably, credit institutions are prohibited from purchasing options from economic entities or individuals, allowing them only to sell options to these parties The duration of the option agreements is flexible and based solely on the mutual agreement of the involved parties.
Only banks are allowed to maintain total value of option contract with no reciprocal transactions up to 10% compared to their equity
In October 2005, currency option transactions were initiated at several banks, including VCB, VIB, Eximbank, and Citibank, followed by BIDV, Techcombank, MB, ACB, and Agribank in December 2005 However, foreign currency options remain less prevalent in Vietnam compared to other foreign currency derivatives and are not widely adopted by businesses for risk hedging Additionally, banks are restricted to purchasing options solely from local businesses and must collaborate with foreign partners for reinsurance This process incurs a 10% value-added tax on fees from domestic partners, which is non-deductible when dealing with foreign partners, resulting in an immediate 10% loss for banks.
Table 2.6: Sales of currency option contracts in ACB and Eximbank (2009-2012)
(Source: ACB’s and Eximbank’s annual reports)
ACB, Eximbank, and VCB were pioneers in introducing options contracts in foreign currency trading While the volume of these contracts remains a small fraction of overall trading, it has shown consistent growth over the years Other banks, including Sacombank and Techcombank, have also adopted this innovative trading option.
Eximbank has become the first bank in Vietnam to pilot foreign currency option transactions, as authorized by the NHNN-QLNH Following this initiative, the State Bank has permitted additional banks, including Citibank, HSBC, BIDV, ACB, VCB, ICB, and Agribank, to also pilot this innovative service.
As of May 6/2004, 50 option contracts were signed with sales of more than
Eximbank generated 50 million USD from currency option transactions, while seven other banks failed to sign any contracts From 2004 to 2007, despite the absence of restrictions on the number of participating banks in these transactions, interest remained low, primarily involving branches of foreign banks like HSBC and Citibank, along with a few Vietnamese banks such as Eximbank and Techcombank.
SOLUTIONS TO THE DEVELOPMENT OF DERIVATIVES
EXPERIENTIAL LESSONS IN SOME COUNTRIES IN THE
3.3.1 Lessons from some countries in the world
The derivatives market boasts a rich history spanning over 160 years, with the U.S Securities and Exchange Commission (SEC) currently overseeing six options markets and twelve registered futures markets This market is characterized by a wide array of commodities that are increasingly innovative and complex Initially, forward contracts and options were based on tangible goods, including agricultural products like butter and rice, as well as raw commodities such as crude oil and precious metals like gold and silver Over time, this has evolved to include financial products such as stocks, bonds, interest rates, and currencies The Chicago Board Options Exchange (CBOE) remains the leading exchange in terms of market share within this sector.
Derivatives market in the Central and Eastern Europe - CEESEG
Derivatives market in Central and Eastern Europe have one characteristic in common That is the presence of an exchange management company
Quality characteristics of electronic exchanges, such as Eurex, include fully electronic operations, standardized contract terms, and daily-calculated deposits, ensuring payments align with international practices (CCP.A) Furthermore, all derivatives on the Central and Eastern European (CEE) market can be traded using a unified trading system, featuring a common currency and centralized payment center.
The history of derivatives in India is marked by several government bans, but significant progress was made with the establishment of the Securities and Exchange Board of India (Sebi) in 1988, which regulated financial asset transactions in the country.
The issuance of India's amended Edict of financial assets in 1995 marked a pivotal moment in the evolution of derivatives transactions, as it lifted the ban on option trading and established a robust legal framework by December 1999 This development allowed derivatives instruments like options and futures to be recognized as tradable financial assets In the early 2000s, significant restrictions on commodity futures transactions were eliminated, leading to the establishment of electronic commodity exchanges nationwide By 2001, a variety of derivatives products, including BSE Sensex options, stock options, and futures contracts, became available, with both the National Stock Exchange (NSE) and Mumbai Stock Exchange (BSE) facilitating trading in index futures, stock futures, index options, and stock options Additionally, the over-the-counter (OTC) market provided considerable flexibility, particularly for swap products and interest rate swaps.
Since its launch in 2000, India's currency derivatives market has experienced significant growth in transaction volume and contracts, with the National Stock Exchange (NSE) accounting for 99% of the market's transactions Derivatives have gained widespread acceptance among market participants, leading to periods where revenue from the NSE's derivatives market surpassed that of the cash market For instance, in 2008, the market value of derivatives reached 13,090,477.75 NSE Rs.Cr, compared to the money market's value of approximately 3,551,038 Rs.Cr.
3.3.2 Experiential Lesson for Viet Nam
Some experiential lessons can be withdrawn from examining practical experience in derivatives market management and development in some countries all over the world
The government is essential in enhancing the development of the derivatives market by implementing macroeconomic policies tailored to the overall economic conditions and the specific circumstances of the derivatives market in each country.
The derivatives market has experienced significant growth globally, primarily serving the economic function of transferring risk from those unwilling to assume it to those who are, in exchange for compensation While the primary role of this market is price hedging, most transactions are driven by speculation, which, despite its connotations, actually enhances market liquidity and facilitates risk transfer In the early stages of its development, many investors believed that speculating in the derivatives market would yield substantial benefits, potentially leading to market chaos.
To foster the effective development and growth of the derivatives market, it is essential to establish a comprehensive legal and management framework Additionally, prioritizing the strengthening and establishment of adequate institutions across the stock, bond, and derivatives markets is crucial for ensuring their proper functioning.
The rapid increase in the number of banks and brokers in the derivatives market has raised concerns about potential massive losses that could threaten the stability of the financial system To ensure the effectiveness and safety of the derivatives market, it is essential for all participants—policymakers, brokers, and investors alike—to receive thorough training in technical knowledge.
A management model that combines government oversight with autonomy mechanisms is widely adopted across various countries However, the chosen approach for each nation must be carefully evaluated, taking into account its unique legal framework and socio-economic conditions.
A key advantage of a Stock Exchange in the derivatives market is its role as a catalyst for emerging businesses To foster a robust derivatives market, it is crucial to enhance the institutions associated with the Stock Exchange, as this significantly contributes to the market's development.
OPPORTUNITIES AND THREATS IN DERIVATIVES
The derivatives market in Vietnam, while relatively new, is not unfamiliar to the banking system and is poised to offer significant business opportunities for investors and securities companies, ultimately aiding in the development of the Vietnamese securities market Many commercial banks have utilized derivatives for over a decade, and with the foundation laid by Vietnam’s 2006 Securities Law, which draws from the advancements in American and European markets, the timing is ideal for implementing derivatives tools in alignment with global trends Despite concerns regarding the transparency and complexity of these instruments, derivatives can provide substantial benefits to both investors and banks by mitigating risks For instance, futures contracts can safeguard against fluctuations in product prices or exchange rates However, investors must be cautious, as failing to manage their positions effectively could lead to significant financial losses.
Commercial banks in Vietnam are experiencing rapid development, characterized by a modern banking system and professional staff The government, along with domestic and neighboring businesses, has shown significant interest in these banks, providing valuable support This backing is crucial for the success of commercial banks as they utilize derivatives for risk hedging.
The recent financial crisis has significantly impacted businesses across various sectors, leading to closures and severe hardships In Vietnam, commercial banks are grappling with numerous challenges, including liquidity issues, capital constraints, and regulatory hurdles As a result, risks have become a major concern for these banks Additionally, the derivatives market presents a nascent opportunity for growth, yet the lack of adequate development conditions and a robust legal framework poses substantial challenges.
International economic integration presents both opportunities and challenges for Vietnam's commercial banks While it facilitates the entry of foreign banks into the Vietnamese market, bringing with them substantial financial resources and expertise, it also intensifies competition These foreign banks, with their experienced teams and adeptness in derivatives, are likely to attract a significant customer base, posing a threat to domestic banks Consequently, the derivatives market in Vietnam is expected to become increasingly competitive.
Vietnamese commercial banks encounter significant legal challenges when engaging in derivatives contracts with foreign banks, as there is no established legal framework governing financial derivatives in Vietnam In contrast, developed countries have well-defined regulations that ensure coherence among participants in these transactions This lack of legal protection and guidelines for Vietnamese banks can place them at a disadvantage, particularly in the event of disputes with foreign partners.
The commodity and financial markets in Vietnam are underdeveloped and inefficient, fostering a herd mentality among participants who tend to react similarly Additionally, frequent changes in policies and regulations complicate the situation, making it challenging for banks to accurately assess contract values.
Commercial banks face significant challenges in developing uniform derivatives services, with current usage limited to a few banks Additionally, domestic banks lack comprehensive campaign services for businesses and organizations, raising concerns about their effectiveness in promoting risk prevention and profit generation for companies and individuals.
Derivatives instruments have a long history of nearly four centuries globally, but they have only been present in the Vietnamese market for just over a decade This limited exposure presents a significant challenge for Vietnamese commercial banks, as they strive to enhance their understanding of derivatives and financial markets to compete with established global banks Expanding knowledge on trading derivatives contracts is essential for Vietnam's financial institutions to elevate their standing in the international banking landscape.
In Vietnam's relatively stable and state-controlled financial market, banks face challenges in rapidly integrating with global trends The underdeveloped environment for derivatives instruments in Vietnam necessitates that local banks adapt and learn from the practices of major global banks By doing so, they can enhance the growth and development of derivatives within the country's commercial banking sector.
SOLUTIONS TO INCREASING THE USE OF DERIVATIVES IN
Improving the legal system relating to derivatives instruments
The legal framework for financial instruments must be clearly defined in official legal documents rather than relying solely on guidance documents Establishing widely recognized official legal documents will enhance market operations and regulate derivatives, leading to greater efficiency and broader acceptance in the financial sector.
The State must prioritize the creation of dedicated legislation to address the complexities surrounding derivatives, particularly as Vietnam experiences increased foreign transactions following its initial international integration This law is essential for facilitating hedging and profit generation from derivative operations A structured 5-year roadmap should be established to draft and implement this legislation, ensuring that it clearly outlines specific regulations regarding derivatives.
To participate in the derivatives market for risk hedging, speculation, and arbitrage, individuals and legal entities must meet standard legal status requirements, maintain a certain credit rating, provide necessary documentation, and adhere to a minimum capital amount.
- The derivatives allowed to be circulated on the derivatives market, the standard of value and duration of these instruments
- The basic content of derivatives contract accompanied with the requirements of this content
- Transaction process of each type of derivatives instruments, the rights and obligations of the parties in relation to the transaction, trading, brokerage of all kinds of derivatives instruments
Future and options exchanges are actively working towards establishing a centralized platform for these financial instruments, aligning with emerging trends and ensuring compliance with evolving regulations This initiative aims to foster a more integrated market environment, positioning the exchanges to adapt to legal frameworks that support innovation in trading practices.
- International exchange on derivatives instruments
To enhance participation in the derivatives market, it is crucial to relax regulations surrounding their use, enabling investors to engage in speculation and arbitrage beyond mere hedging This approach would make the derivatives market more appealing, as businesses could simultaneously generate profits while mitigating risks To facilitate responsible speculative activities without disrupting pricing, legislation could introduce options with defined ceiling and floor price conditions.
Capital requirements for brokers in derivatives contracts are crucial for minimizing risks within Vietnam's commercial banking system, preventing broker defaults To enhance the sustainability of the derivatives market, mandatory re-hedging in the international market is essential, ensuring that the domestic banking system is not burdened by risks associated with option or futures contracts.
Vietnam's legal framework for financial institutions should comprehensively address derivative instruments as essential components of risk management in banks This would facilitate better organization and management of derivatives within these institutions Furthermore, legal documents must enable financial institutions to engage in profitable trading of derivatives It is crucial to establish official standards for options, swaps, and futures, allowing commercial banks to utilize these tools beyond mere pilot programs.
Amending Civil Law, Commercial Law, and Investment Law is essential to align contractual relationships, including commercial and import-export contracts, with international standards, thereby attracting increased foreign investment.
To enhance the stock market's efficiency and transparency, the State and relevant authorities must develop and enforce clear guidelines and bylaws The Securities Commission should specifically evaluate the possibility of banning short-selling while establishing acceptable limits for its practice, as short-selling plays a crucial role in the functioning of the futures market.
Improve and develop commodity market and financial market
Promoting import and export activities is essential for the development of commodity derivatives, as it indirectly boosts the derivatives market To accelerate this market's growth, there is a significant demand for goods that are heavily exported, experience price volatility, and originate from unstable sources, including rice, coffee, cashew nuts, high rubber, and pepper.
To enhance the quality and reputation of Vietnam's exports in both regional and international markets, enterprises must prioritize branding and standardization This approach will facilitate product evaluation and pricing through commodity derivatives contracts Additionally, establishing a centralized commodity exchange is essential to prevent trading fragmentation, ensuring that Vietnamese commodities secure a strong position and voice in the global market.
There should be some solutions to making Vietnam stock market modern, transparent, well organized and be consistent with international standards
To enhance the efficiency of the securities depository center, it is essential to implement depository operations, establish centralized securities settlement, and prioritize risk management Standardizing all activities within the center will ensure consistency and reliability Additionally, a gradual development and improvement of operations in alignment with international standards will foster growth and enhance the center's credibility in the global market.
To enhance the efficiency of state enterprises, it is essential to expedite their equitization and public share issuance Additionally, offering tax incentives will motivate issuers and boost the volume of original and derivative securities available in the market.
To combat insider trading and prevent the misuse of sensitive information within enterprises, it is proposed that the Securities Commission be transformed into an independent state agency Additionally, the Securities Exchange should be separated from the Securities Commission to enhance regulatory effectiveness and integrity in the financial markets.
Government bonds remain the primary focus for investors, necessitating diversification to align with various investment goals, including hedging strategies Additionally, the advancement of interest rate hedging derivatives based on bonds is crucial Developing a secondary market for bonds is essential to enhance their liquidity and accessibility for investors.