Synthetic finance is burgeoning as a service provided by prime brokers to hedge fund clients and in inter-dealer trading across Asia Pacific. 

An estimated 30% of tier one and tier two investment banks and asset managers in the region are currently booking synthetic financing transactions and a further 20% plan to in the near future, according to David Field, co-author of a 2015 synthetic finance whitepaper produced in partnership with 4sight. 

Banks report that revenue from their synthetic platforms is exploding and, while the biggest active books are typically Australia and Japan, there is particularly strong growth in China, Hong Kong and South East Asia. 

Nick Silver, head of synthetic equity sales for Asia at Deutsche Bank, says that over the last five years the bank’s revenue from synthetics in Asia has expanded in multiples, while JPMorgan is on record as stating it more than doubled its synthetic business during 2015. 

Use of synthetics is also relatively prominent in markets such as Korea, Taiwan, Malaysia and India where regulatory constraints make it easier for managers to implement swaps than cash transactions. 

The search for alpha 

One factor for the buy side is the challenge of finding alpha in current market conditions. “Global macro traders are widening the palette of companies they want to invest in,” says Jon Anderson, managing director, head of middle office at SS&C GlobeOp. 

“It’s been a tough year for hedge funds and their results are down, a rough year in commodities and fixed income and equities are not off to a blazing start. So the battle for alpha is heating up, and as there is no obvious winning asset class or strategy in the market, hedge funds are reacting by reaching further and wider into new markets. Increasing globalisation is also leading them to reach into markets they did not before.” 

Competition to find alpha has been exacerbated by the resurgence in hedge fund assets, which have now surpassed pre-crisis levels, and the trend for more funds to register as UCITS to access retail flows. As UCITS funds are only permitted to short sell using synthetic financing transaction methods, exposures have been boosted. 

In Hong Kong in particular there is huge demand from investment funds with increasingly broad or ambitious remits. 

“Hong Kong has seen more activity as locallydomiciled hedge funds have grown, plus there has been an increase in activity from greater China funds and Asia multi-strategy, particularly long/short equity quant funds with exposure to the region,” says Mr Silver. “More recently these funds have also been going into Korea and Taiwan in much greater size whereas previously the bid/offer spreads and lack of liquidity kept them out. Now quant models are active in these markets too.” 

Different funds have different dynamics. For example, access to a broad pool of borrow is particularly important for the quant funds. 

Operational efficiency 

Hedge funds are also looking for operational efficiency. “The flexibility of synthetics has improved significantly and operationally they are much more efficient for hedge funds than having to settle in different currencies and employ staff in another timezone,” adds Mr Silver. “ is effectively outsourced to the synthetic provider and appears as just a single item on the swap report.” 

In addition, the operational costs of traditional markets are still higher for external participants than for local investors. In terms of trading efficiency, they do not yet enjoy parity with domestic firms that trade that market day-in, day-out.

For the foreign asset manager, synthetic positions can therefore be relatively easy to take. “Equity markets are well regulated and efficient but the way they are designed is easier for people with expertise and domicile in those markets, so we are seeing a move towards using synthetics for both long and short exposure, as this is the most convenient way to do it,“ says Mr Anderson. 

In his experience, fund managers like the versatility of buying individual swaps and treat them just as any other position, adding or reducing on a trade-by-trade basis, which can appear straightforward, although of course from an operational point of view it is much more convoluted. Managers will use several equity prime brokers involving multiple positions and different financing rates, for example. 

“For example, one fund (which is actually both long/short and long only) trades in each equity swap position nine or ten times a month and has 1500 different equities in its portfolio – they are not just holding a few foreign equity stocks in swap form to tweak the makeup of their fund,” Mr Anderson explains. 

“A few years ago it had just 30 equity swaps in overseas stocks. They were holding in large companies and they would think twice before they re-positioned it because of the cost, drag and operational risk in trading it. But we are seeing this reluctance less and less.” 

Regulatory considerations 

Synthetic positions are also more private and hidden from view, which can be preferable to a traditional shareholder relationship. “An investment manager may use multiple counter parties for a cash trade and only one counter party for a synthetic trade,” explains Benjamin Low, investment director at Cambridge Associates, based in Singapore. 

“Whether to use synthetics to a degree depends on the individual manager and will mostly be a function of not wanting to leave a footprint. Some prefer swaps, for instance, especially for exposure to US ADRs, where with cash you would see a position under Section 13(f ) and might not want to be caught in a difficult conversation with company management.” 

While regulatory restrictions effectively forced managers to use synthetics in some markets, in others such as Hong Kong, Singapore and Australia, they have a real choice. 

“It is not a quickly changing landscape,” says Low. “The decision to use synthetics depends on factors such as operational efficiency, tax implications and whether it is cost-efficient. Operational efficiency might include for example the need for staff to write short reports for cash transactions, as they are required to in Hong Kong and Australia. 

In terms of costs, commissions charged for synthetics are relatively higher so a small-sized asset manager may prefer to use cash, while a bigger one might take cost into consideration, but may enjoy a better position with its prime brokers as part of their broader relationship.” 

In China, the Shanghai-Hong Kong Stock Connect has changed the model. Previously, the majority wishing to access the onshore Chinese market would typically trade via swaps as there was a limit to the amount of Qualified Foreign Institutional Investor (QFII) quota. 

With Stock Connect coming on line, the usage of the quota has evolved and the cost has come down. Firms are now using it for other asset classes such as fixed income and convertibles. Meanwhile, as cash borrowing is still hard to do in China, managers in the business of arbitrage are still using synthetics. 

Most of the products traded are swaps or CFDs. In recent times there has been increased use of index swaps as a hedging tool in emerging Asia owing to a lack of alternative hedging strategies. 

Few new or exotic products have been launched, but that does not indicate any lack of interest from prime brokers – indeed, they are pushing hard for broader synthetic usage because of the higher commissions. 

Basel III 

Basel III is creating additional cost pressures for the sell-side, including increased capital charges, liquidity costs, leverage restrictions and balance sheet scarcity. Synthetic trades are efficient from a balance sheet, liquidity and capital perspective. 

Some market participants operating in the more established markets are now integrating physical and synthetic financing with liquidity and collateral management and breaking down silos between desks and business lines. 

This helps to provide a more holistic view of the deployment of capital, liquidity and balance sheet across the firm and allows its leaders to achieve higher return on equity (RoE) targets. 

Some houses have been selective and off-boarded their least profitable clients or amended their contract terms. Over the years there has been a tendency to reduce the cost of these services, but in 2015 that trend slowed down and even reversed, owing to the increased balance sheet usage. 

Consultancy The Field Effect suggests the void will be plugged by a number of new entrants emerging to provide synthetic prime brokerage services. 

However, this business can be complex to process, often including multiple underlying instruments and thousands of trade events, and big investments are required in automated processing solutions and systems that optimise the use of balance sheet while reducing funding consumption. 

“Synthetic finance is complicated enough, but in Asia you also face restricted currency issues,” says David Field, managing director of The Field Effect. 

“In some jurisdictions such as Thailand and South Korea you are not allowed to short the currency. You could be fined or even go to jail. In some, you’re not even allowed to be long in the currency. So firms must design global operating models that address these risks.” 

Non-banks that are not subject to the same balance sheet constraints will also attract clients, especially as hedge funds still prefer to diversify counterparty risk. Establishing a synthetic service with a new prime broker is much simpler than the due diligence and systems involved in a full service cash relationship. 

The ‘give up’ process, whereby a hedge fund can trade derivatives with a range of counterparties and scour the market for the best price for each trade, also means brokers can specialise without needing the execution or stock-borrow capabilities to offer synthetic prime. 

This will emancipate the market to another level, as new entrants will not need access to large supplies of inventory or the relationships in the securities finance markets that brokers traditionally required.