Asia has about $2 trillion in local currency bonds while the global market in debt derivatives known as credit default swaps (CDS) is growing in leaps and bounds.
It would seem like a perfect combination: a huge local currency Asian CDS market. But bankers say it will be slow to grow. Regulatory hurdles are high, company disclosure standards are weak and local banks have few incentives to get involved.
The market for CDS - insurance-like contracts which protect against defaults and restructuring - has doubled each year since 2001, industry data shows.
Volume has now reached immense proportions: in 2005, CDS contracts accounted for some $17.4 trillion of notional principal. But nearly all of that was protection for debt denominated in dollars, euros, yen or sterling.
"In Asia, there are 15 different countries with as many currencies and regulations, as opposed to the relatively homogenous markets of the US and Europe," said Mark Brown, ABN Amro's Asian head for portfolio strategy and execution capital management group.
Still, progress is afoot and there are some who argue a local currency CDS market will become attractive. Traditional methods for hedging bond exposures will become outdated, they say, and new global banking guidelines will force banks to offload some of their risks.
Asian governments too are getting ready.
Regulators in China, South Korea, Taiwan, Thailand and Malaysia have all approved onshore CDS and issued related regulations over the past two years, while India drafted rules for the local CDS market four years ago.
Activity thus far has been restricted to a few private deals.
Hedge funds, which are traditional sellers of credit protection, are unable to get involved in many parts of Asia.
In countries such as South Korea, China and India, foreigners need to register or qualify as investors before they can buy bonds. Other countries limit repatriation of assets.
"The market needs to allow delivery of underlying assets in local currency. That can only happen if you allow foreign investors and remove currency restrictions," said Maurizio Raffone, Asia head of structured credit products at Dresdner Kleinwort Wasserstein.
There is also a paucity of buyers looking for protection.
"The market will develop only if you have local banks because they have the expertise on local credits more than foreign banks, and they have the exposure as well," said Cedric Podevin, BNP Paribas' head of credit derivatives structuring for Asia-Pacific.Domestic banks are the biggest investors in local bonds because of their familiarity with the borrowers, but for now they are not keen on taking the risk off their books despite pending changes to global accounting rules under the Basel II Accord.
"Investors are not ready to pay to protect themselves against default of local corporates and local debt because they are comfortable with the credit," said Pierre Trecourt, Calyon Corporate and Investment Bank's head of structured credit for Asia Pacific.
Even those banks that are keen on protecting themselves from default have chosen traditional methods to do it such as financial guarantees and letters of credit, said Vivek Mohindra, director of structured credit trading at Merrill Lynch.
"But credit derivatives are useful on account of assignability, standardisation and simplified settlement," said Mohindra.
"And as financial institutions here realise it is more efficient to have a credit derivative than a financial guarantee, you will see a greater demand for credit derivatives in Asia."
The growth of the European CDS market was in part triggered by banks looking to take credit risk off their balance sheets by buying protection against default, freeing up regulatory capital.
"A lot of them (Asian banks) have healthy capital ratios. They don't have a pressing need to rationalise their portfolios," said DKW's Raffone.
A Tokyo-based investment banker estimated 60 percent of the CDS volumes in Europe were driven by markets in synthetic collateralised debt obligations (CDOs).
Synthetic CDOs are portfolios of credit default swaps that can be divided into slices of risk offering investors varying exposures to defaults. A Barclays Capital report says synthetic CDO issuance volumes have grown by 50 percent each year since 2000.
"So by definition a lot of growth will come from Asian CDOs. The more all-Asian CDOs you see, more will be needed to be hedged out," the Tokyo-based banker said.
Some analysts say growth will be stoked by changes to bank capital standards via the Basel II Accord, which may force banks to offload some of their risk. "The Basel II changes will help," said Trecourt. "I don't have a crystal ball ... but I don't see the market flying right away."