Indonesia’s future derivatives market

Those who have watched The Big Short, a comedy-drama film about the crash of the United States market in 2008, may be rather skeptical, or frightened by financial derivatives. The movie presented the innovative credit default swaps (CDSs) and collateralized debt obligations (CDOs) that became the seeds of the US financial market turmoil.

The takeaway of the movie was that the haphazardly crafted financial derivatives instruments ended up endangering the whole system. Many scholars have similarly voiced post-2008 crisis precautions about the derivatives market regulations.

The late Prof. Lynn Stout of Cornell University argued that changes to the law had caused the market to crash. Stout identified a series of dynamics that removed legal constraints on speculative trading in over-the-counter (OTC) derivatives. The dynamics hence provided leeway for private actors to privately arrange OTC trading, which then became a catalyst for the capitalism beast of speculation.

The mixed feelings about derivatives are part of an overdue discourse. Derivatives are so lucrative they can engender Keynesian animal-spirited whims of the capitalist wallet, but the 2008 experience highlighted contusion in the derivatives. Despite this, derivatives have still proven useful for hedging (not speculations).

John Finnerty of Fordham University has acknowledged the proper use of derivatives for improving economic efficiency and managing unwanted risk exposure. J.M. Keynes himself recognized that the market could provide benefits to societies that help facilitate investment, despite his seminal warning of “liquidity illusion” (that no such thing as market liquidity for everyone).

For emerging markets like Indonesia, derivatives market development is important. When the onshore derivatives market gets more lucrative, market participants will more actively hedge their financial position, thereby developing more efficient risk management and providing a space for market expansions. The derivatives market bestows liquidity, which opens alternative funding sources. By the same token, the domestic derivatives market could contribute to efficient price discovery.

Some market participants might use derivatives for leverage, sometimes with speculative motives, i.e betting. Along with the market deepening, this indeed requires a more careful approach as not to fabricate a “casino” for derivatives speculators.

Many economists would agree that financial market development is necessary because Indonesia needs more relative market depth to support further economic growth. After all, most industrial advanced countries are investment-dependent economies. But Indonesia’s financial market is still relatively shallow, which only means there is a great opportunity to develop it.

There are at least five immediate tasks.

The first is structuring the market. A more-structured derivatives market could facilitate businesses to efficiently hedge against future risks, just like an insurance contract. The job is to induce more industry-friendly market venues, either for the existing exchanges such as Indonesia Commodity Derivatives Exchange (ICDX), Indonesia Stock Exchange (IDX) and alternative trading venue (PPA) or other future competitive exchanges, including exchange(s) for money market derivatives.

Structuring OTC derivatives is also urgent despite its more-unregulated market attribution. Credible infrastructure for OTC trading must be available. The momentousness of the 2022 Group of 20 presidency should motivate Indonesia to accelerate the implementation of the G20 recommendation on OTC derivatives reform. The early stage of centrally cleared standardized OTC derivatives contracts through a central counterparty (CCP) should at least be started this year.

Second, market innovations. On the foreign exchange (FX) market, the domestic non-deliverable forward (DNDF) instrument is consistently developing. Bank Indonesia (BI) uses DNDF to manage exchange rate stability. Not only that, the strategy has successfully constructed a more conducive FX environment, facilitated demand redistribution from the spot market and encouraged banks to hedge their FX exposure. It is about time the DNDFs market became mature.

The products, however, must still be expanded. Credit derivatives such as CDSs, securities derivatives, interest rates products and commodities derivatives should be accessible in the market. Because the underlying coverage is extensive (from commodities to financial ones), there should be cross-market coordination to make them all work properly. All policymakers and private associations must work in collaboration.

Third, closeout netting implementation. Derivative transactions are delicate, complex and rattled not only by their value but also by the dynamics of the underlying assets. Closeout netting offers legal protection against the receiver in bankruptcy to “cherry-pick” contracts which can be adversarial for derivatives counterparties. Indonesia needs to implement this framework with a proper design. That would require national legislative reform.

Closeout netting should not necessarily give priority for derivatives parties over other secured creditors. Katharina Pistor of Columbia University issued a precaution on how it could facilitate derivatives traders to get out faster, which could deepen the problem. But if efficiency and the “cherry-picking” constraint are the summum bonum, then closeout netting steps should simply be an early termination, outstanding valuation and rendering a single amount under one master agreement that should be legally upheld. The payment priority should still be on the question of the collateral quality and not solely because of the derivative trader’s status.

Fourth, developing an efficient legal framework for collateral or security interest. Property and transactional laws in Indonesia still contain great leniency within the colonial-inherited Civil and Commercial Code, which may no longer be suitable for the modern market practice. A comprehensive review of the practicability of the law in today’s market is necessary. The renewal of the law, including on the ease of asset securitization could provoke the derivatives supply-side.

Lastly, uniformity. The International Swaps and Derivatives Association (ISDA), a global focal point for derivatives transactions, is exemplary for standardizing OTC derivatives. Promoting the use of the ISDA or ISDA-like master contracts would help achieve uniformity in the derivatives market to simplify the naturally complex transactions.

While most seem to be legally dominant, there are other determining factors. Top-notch know-how of financial engineering, market-wide literacy and sociomarket ethics and culture are some key extralegal concerns. The derivatives market is a gateway toward overall financial market deepening. With all the risks and opportunities associated, the job must be done step-by-step in an eclectic yet accelerative way.

The future is ahead.