Over-the-counter derivatives allow investors and lenders to price and structure tailor-made funding arrangements to promote long-term infrastructure finance.
Official institutions have long pursued the goal of tapping the power of the bond markets for infrastructure finance, but except for a handful of success stories, project bonds have never really taken off. This is overwhelmingly because bonds are by definition boxy, rigid structures that are easily understood and traded. Incorporating amortizing structures, complex financial covenants, onerous safeguards and governance language into a fixed income security is like trying to fit round pegs into square holes.
This is not to deny that sterling work has been achieved across many jurisdictions in building local currency bond markets. However, whilst these markets contribute much to financial and economic stability, they leave the question of project bonds unanswered. In many cases, local currency bond markets have also not developed beyond the government securities market, leaving the private sector with the perennial Achilles Heel of reliance on foreign currency markets for term funding.
Enter center-stage the derivatives market. Exchange traded derivatives are certainly part of the solution - futures and options provide essential hedging tools for currency, commodity and interest rate risks but again, these are standardized contracts and like fixed income securities, rigid and inflexible in their structure. On the other hand, over-the-counter (OTC) derivatives are bespoke financial instruments that offer almost indefinite flexibility to accommodate accreting or amortizing cashflows of any tenor, pay-off or dimension. In real terms this means that investors and lenders can price and structure tailor-made funding arrangements to promote long-term infrastructure finance.
One of our recent energy sector successes was the Nam Ngiep 290 megawatt hydro-power project in the Lao People’s Democratic Republic, which was funded with a series of 22 and 23-year US dollar/Thai baht cross currency swaps over 2015-2017. Such ultra-long dated borrowings would be challenging to structure as project bonds. Add in the semi-annual amortizing nature of the cashflows and tranching via multiple disbursements over an extended availability period and you have a non-starter.
Unfortunately, there is no low-hanging fruit for the successful development of derivatives markets, but a critical step lies in early adoption of legislation to allow clean netting of claims between parties in the event of bankruptcy. The effect of netting is to allow banks, brokers and investors to offset claims against each other: I owe you 100 and you owe me 60 - therefore I owe you 40 net. Without this clean netting arrangement, usually recognized through an Opinion issued by the International Swaps and Derivatives Association (ISDA), there is a risk of “cherry-picking” by a bankruptcy administrator during insolvency proceedings. This not only places connectivity to international markets in jeopardy, but more dramatically means that risk exposures are considered on a gross basis and hence consume more limits and capital.
Other key measures for regulators to consider include clarity on taxation; customer protection measures; availability of collateral; trade reporting conventions and adequate clearing and settlement systems. All told, these are complex and demanding requirements which demand time and resources to establish.
The more developed Asian markets as well as Indonesia, Malaysia and Philippines have passed this litmus test, and India and Thailand have excelled in promoting liquid over-the-counter derivatives markets. There do remain some outstanding legal and enforcement issues in these markets, but ADB takes an inclusive view and largely considers them to be “clean netting environments”.
In the People’s Republic of China (PRC) in 2015, the China Foreign Exchange Trade System granted foreign central banks and official institutions access to the domestic derivatives markets and People’s Bank of China promptly normalized the onshore use of ISDA contracts. Subsequently ADB has relied on US dollar/Chinese yuan cross currency swaps to fund loans in the micro-credit, small business and agri-finance sectors. However, the concept of netting is not yet enshrined in the Enterprise Bankruptcy Law. Accordingly, ADB ring-fences its renminbi trades by documenting standalone ISDA agreements (supplemented by Credit Support Annexes) with PRC counterparties. This impacts the pricing of derivatives since there is no offsetting portfolio benefit from the broader international business relationship.
Within Asia, the same constraints face other non-netting markets including Bangladesh, Sri Lanka, Viet Nam and central Asian countries although progress is reported by ISDA in markets as diverse as Armenia and Pakistan. This work must continue, as it is important that developing countries consider derivative instruments as a force for good in their financial markets’ infrastructure – and a real alternative to those elusive project bonds.