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Oliver FratzscherWorld Bank
Emerging Derivatives Markets
Risk Management Workshop BrazilSão Paulo
11.–13. April 2006
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Outline of Presentation
1. Two perspectives on derivatives and risk sharing
2. Size of global and Latin derivative markets
3. Building blocks for derivatives
4. Sequencing cash & derivative market development
5. Brazil specific issues
6. Conclusion and Discussion
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" Although the benefits and costs of derivativesremain the subject of spirited debate, theperformance of the economy and the financialsystem in recent years suggests that those benefitshave materially exceeded the costs."
“We view them as time bombs both for the partiesthat deal in them and the economic system. In ourview derivatives are financial weapons of massdestruction (WMD), carrying dangers that, whilenow latent, are potentially lethal.”
Alan Greenspan
Warren Buffet
1. Two perspectives
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Risk Sharing across Financial Systemrisk diversification does not eliminate counterparty risk
CallOption
RetailInvestor
Deposit
BankSecurities
StructuredNote
OTCInstruments
DepositsTo Stocks
CounterpartyCredit Risk
PutOption
Insurance
StockHedgingCall with Put
Put-Call ParityI + C = X + P
YieldEnhancement
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Goldilocks or Mispriced Risk ?financial conditions should translate into higher growth
Strong private capital flows to EM Rising commodity prices
Record low spreads for EMBI LAC investment & growth lagging
Source: World Bank GDF (2006)
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Emerging Market Banks profitabilityhow can Brazilian banks generate 30% ROE ?
0
20
40
60
80
100
120
140
160
Bra
zil
Ba
Bra
zil
Bra
des
co
Ba
ncoI
tau
Mex
ico
SA
fric
a
Tu
rke
y
Cz
ech
Hu
ngar
y
Po
land
Ru
ssia
Chi
na
Ko
rea
Mal
ays
ia
Tha
iland
EM Banks Loans (%of GDP)
0
5
10
15
20
25
30
35
Bra
zil
Ba
Bra
zil
Bra
de
sco
Ba
nco
Itau
Me
xico
SA
frica
Turk
ey
Cze
ch
Hu
nga
ry
Po
land
Ru
ssia
Ch
ina
Kor
ea
Mal
ays
ia
Tha
iland
EM Banks Return on Equity (%)
0
5
10
15
20
25
Bra
zil
BaB
razi
l
Bra
des
co
Ba
ncoI
tau
Mex
ico
SA
fric
a
Tur
key
Cz
ech
Hun
gar
y
Po
lan
d
Ru
ssia
Chi
na
Ko
rea
Ma
lays
iaTh
aila
nd
EM Banks CAR Ratio (%)
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Bra
zil
BaB
razi
l
Bra
des
co
Ba
ncoI
tau
Mex
ico
SA
fric
a
Tur
key
Cz
ech
Hun
gar
y
Po
lan
d
Ru
ssia
Chi
na
Ko
rea
Ma
lays
ia
Tha
ilan
d
EM Banks P/B Ratio (%)
Source: UBS Global Banks Perspectives, 2005
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Real Interest Ratesdeclining volatility, inflation targeting, yet high rates
Source: Muinhos and Nakane (BCB), 2005
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2. Global derivative marketsrapid OTC growth and increasing ETD products
Sources: BIS (Dec 2004) ; FIBV (Jan 2005)
0
50,000
100,000
150,000
200,000
250,000
1991 1993 1995 1997 1999 2001 20030
10,000
20,000
30,000
40,000
50,000
60,000
OTC (bar) and Exchange-Traded (line) Derivatives(notional outstanding, in billions US$)
CAGR exceed 30%
76%
12%
$270 trn notional$11 trn mkt value
US: 40%
EU: 40%
Credit
Interest
Gov-Debt
Stocks
Comm
Equ-Index
FX
2005OTC Derivative Markets Exchange-Traded Derivatives
65% 26%
$59 trn notional$10 trn mkt value
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Growth of futures and optionsexponential growth in stock options in Asia
Sources: World Federation of Exchanges (2005), BM&F (2005) and MexDer (2005)
0
50
100
150
200
250
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
BM&F Trading Volume 1990-2005
CAGR 16% to 22%
Global Notional Value Outstanding (bn $) Open Interest (mill contracts)
CAGR 12% futuresCAGR 24% options
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BM&F / MexDer derivative marketsextreme specialization in short-term interest rate products
Credit
Interest
Gov-Debt
Stocks
Comm
Equ-Index
FX
2005
65%22%
1day DI future
199 mio contracts
BM&F Contracts
92%
3%
28day TIIE future
108 mio contracts
MexDer Contracts
Stock Index Options
2593 mio contracts
KoreaStockExchange
Stock Futures
132 mio contracts
NationalStock
ExchangeIndia
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Leading Exchangesemerging markets leap-frog on derivatives
1.1%108Mexican Derivatives Exchange15
1.3%132National StockExchange India14
1.5%145Pacific Exchange13
1.6%163Philadelphia Stock Exchange12
2.0%199BM&F Brazil11
2.0%202American Stock Exchange10
2.1%205New York Mercantile Exchange9
2.7%269Bovespa Brazil8
4.5%449International Securities Exchange7
4.7%468ChicagoBoard Options Exchange6
6.8%675Chicago Board of Trade5
7.7%758Euronext Liffe4
11.0%1,090Chicago Mercantile Exchange3
12.6%1,249Eurex2
26.2%2,593Korea Stock Exchange1
% ofglobal
Volume(2005)
Derivatives ExchangeRank
1.1%1.1%585TaiwanStockExchange15
0.2%1.2%608AMEX14
2.0%1.3%673ASX13
3.7%1.8%904TSX Group12
2.0%1.9%951OMX11
2.3%1.9%976Swiss Exchange10
1.7%2.4%1,204Korea Stock Exchange9
2.0%2.6%1,300Borsa Italiana8
2.5%3.1%1,568BME Spanish Exchanges7
3.2%3.8%1,912Deutsche Boerse6
6.8%5.7%2,901Euronext5
10.7%8.7%4,427Tokyo4
7.5%11.1%5,674London Stock Exchange3
8.6%19.8%10,087NASDAQ2
31.9%27.7%14,125NY Stock Exchange1
% globalmarkcap
% globaltrading
Value(2005)
Stock ExchangeRank
Stock Exchanges universe (bill of US$ traded, 2005) Derivative Exchanges (mil of contracts, 2005)
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Product Design
Economic rationalefor hedging needs
Liquid cash market,long and short positions
Market determinedprices, interest/FX rates
System stability,no moral hazard risks
Regulation
Lead regulator, capitalrules, reporting standards
Legal clarity: ISDAstandards, enforceability
Accounting rules,transparency, disclosure
Level playing field, taxharmonized, integration
Infrastructure
CCP, ISDA master,close-out netting
Demut. exchanges,strong capital, margins
SRO rules enforcedwith limits, monitoring
Certified investors,code of conduct
3. Building blocks for derivatives
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Derivatives enhance financial developmentwin-win instruments for banks, corporations, investors
… beyond rice trading in Tokyo and tulip trading in AmsterdamCommodity producers lock in future prices and reduce uncertainty
Corporations can close mismatch between assets and liabilities
Firms can hedge export receipts and seek cheapest funding abroad
Banks can share excessive or lumpy risks in capital markets Investors gain access to new markets and broader asset classes
Pension funds can diversify exposure and enhance risk management
Retail receives better pricing for mortgages and securitized productsForeign investment is facilitated by higher liquidity and hedging tools
Financial system enhances stability through new “spare tire”
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Rewards and risks of derivativesmarket development combined with prudential issues
Market efficiencyRisk sharing and transferLow transaction costsCapital intermediationLiquidity enhancementPrice discoveryCash market developmentHedging toolsRegulatory savings
More leverage Less transparencyDubious accounting Regulatory arbitrageHidden systemic risk Counter-party risk Tail-risk future exposureWeak capital requirements Zero-sum transfer tools
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4. Schematic development of D marketscash liquidity +sound regulation+solid CCP infrastructure
Investor Basehedging needs,products, IT,lower costs
Investor Basehedging needs,products, IT,lower costs
OTC Licensereg approval,
CP credit risk,swaps IR &FX
OTC Licensereg approval,
CP credit risk,swaps IR &FX
Accountingadopt IFRS,
MTM, IAS39,full disclosure
Accountingadopt IFRS,
MTM, IAS39,full disclosure
Design CCPclose-out net,ISDA master,enforcement
Design CCPclose-out net,ISDA master,enforcement
Exchangeplatform, links,capital,margins,
first futures
Exchangeplatform, links,capital,margins,
first futures
Taxes levelplaying field
cash=repo=D,avoid trans tax
Taxes levelplaying field
cash=repo=D,avoid trans tax
IntermediaryLicensing
qual. investors,training
IntermediaryLicensing
qual. investors,training
Repo Marketseffective short,margin trading;secur. lending
Repo Marketseffective short,margin trading;secur. lending
Regul & LegalFramework
derivatives law,SRO function
Regul & LegalFramework
derivatives law,SRO function
Cash Marketsliquid,efficient,
integrated;benchmarks
Cash Marketsliquid,efficient,
integrated;benchmarks
DerivativeMarket
BuildingBlocks
DerivativeMarket
BuildingBlocks
Cash
Repo
ETD
OTC
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Link between cash and D turnoverliquidity corridor for emerging and developed markets
Equity and DerivativesTrading Volumes (Index)
100
1,000
10,000
100,000
100 1,000 10,000 100,000Cash Turnover
Der
iva
tives
Tur
no
ver GER
BRA
KOR
1 : 1
5 : 1
Source: World Federation of Exchanges (Dec 2004)
Ratio of Derivatives to CashTurnover on Log-Log Scale
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Derivatives infrastructureliquidity indicators improve but regulation still evolving
Notes: denotes best practice ; denotes progress on existing deficiencies ; and denotes major problems.1./ Fixed income liquidity indicators and benchmarks are obtained from asianbondsonline.adb.org, which shows weaknesses in China (segmented markets), HongKong (small local currency issuance), Indonesia, Philippines, and Thailand (limited medium to long-term benchmark issues). 2./ Turnover ratios for fixed incomeinstruments have also been obtained from HSBC (2004). 3./ Equity market liquidity indicators have been obtained from World Federation of Exchanges (2004), whichrevealed thin markets in Philippines, Indonesia, and Thailand. 4./ Information about laws on derivatives was obtained from indi vidual country, with only Australia,Hong Kong, and India currently having distinct laws on derivatives. 5./ Securities lending data were obtained from Endo and Rhee (2005), showing restrictions inMalaysia and Philippines on short selling, with very little activity in Indonesia and Thailand. 6./ World Bank public documents on accounting standards (ROSC) andprofessional publications reveal adequate accounting standards aligned to IFRS standards only in Australia, Hong Kong, Indonesia, Malaysia, and Singapore, but majorgaps exist in the Philippines. 7./ CCP information was obtained from industry sources and ADB, showing adequate functioning only in Hong Kong, Korea, andSingapore. 8./ ISDA netting opinions have been issued for all countries mentioned with the exception of China, but many countries have issues to resolve. 9./ Datafrom individual exchanges show their progress towards demutualization (2004). 10./ Data on taxation were obtained from PWC "Taxation on financial derivatives inAsia" (2003), which showed small stamp duties in effect in Hong Kong and Malaysia, and VAT being applied in China, Philippines and Thailand. 11./ Transactioncosts for bond markets were obtained from ADB (2004) and additional market information on taxation. 12./ Institutional investor base and NBFI indicators areobtained from ADB, which shows weaknesses especially in Indonesia and Philippines.
Brazil Mexico Korea India Australia China Hong Kong Japan Malaysia Singapore
LiquidityFixed income benchmarks a a a a a q q a a aFixed income liquidity a a a q a q a a q aEquity market liquidity a a a a a a a a a aRegulationDerivatives law a a q a a r a q q qSecurities lending a a a a a q a a r aAccounting standards q q q q a q a q a aExchanges
Clearing and settlement CCP a a a a a r a q q aISDA netting opinion a a a a a r a a a aDemutualized exchange a a a a a r a q q aTaxesTax harmonization q a a a a r q q q aTransaction costs and IT a a a a a q a a a aInvestor base and NBFI a a a a a q a q q a
# best practice components 10 11 10 10 12 1 10 7 5 11
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Derivative productsthree tiers of exchanges offer six product categories
Notes:
Sources:
Australia: Australian Stock Exchange (ASX) and Sydney Futures Exchange (SFE)China: Zhengzhou & Dalian Commodity Exchange, Shanghai Futures Exchange Hong Kong: HKExIndia: National Stock Exchange of India (NSE) and Bombay Stock Exchange (BSE)Indonesia: Jakarta Futures Exchange (JFX), and Surabaya Stock E xchangeJapan: TIFFE, Tokyo Stock Exchange (TSE), Osaka Securities Exchange, Tokyo Commodity ExchangeKorea: Korea Stock Exchange (KSE) and Korea Futures Exchange (KOFEX)Malaysia: Malaysia Derivatives Exchange Philippines: Manila International Futures Exchange was closedSingapore: SGX-DT Thailand: Thailand Futures Exchange plans to open in 2006
Websites of regional exchanges, WFE, Futures Industry Association, and HK -SFC (2004).
Brazil Mexico Korea India Australia China Hong Kong Japan Malaysia Singapore
IndexFutures r a a a a r a a a aOptions a a a a a r a a a aOptions on futures r r r r a r r a r aStock
Futures r a r a a r a r r aOptions a a a a a r a a r rCurrencyFutures a a a r a r r a r rOptions r r a r r r r r r rInterest rate
Futures a a a a a r a a a aOptions on futures a r r r a r r a r aBonds
Futures a a a r a r a a a aOptions on futures r r a r a r r a r aCommoditiesFutures a r a r a a r a a aOptions on futures a r r r a r r r r r
# of products traded 8 7 9 5 12 1 6 10 5 9
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5. Brazil specific issuesconcentration on DI-futures and few risk takers
Excellent infrastructure, BM&F CCP also for OTC
Product variety, commodities, equity, FX plus DIConcentration on DI-future as sole benchmarkWeak underlying cash and interbank marketsPublic sector remains ultimate risk-takerTax issues, foreign participation, LT inst investorsExchange links abroad, risk diversification, synergyCounterparty concentration risk
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Technical issuescritical tools to increase netting and enhance cushions
Basics first: liquid and efficient cash markets allowing short positionsLegal framework: D law, SRO rules, licensing, ISDA documentationEqual taxation: D may enhance volatility and substitute cash marketsGovernance issues: accounting standards (IAS39), disclosure rulesNetting is critical: 85% risk reduction through close-out nettingManage CP risk: Central clearing counterparty (CCP) is best practiceModern exchange: demutualized, effective margins, strong buffersRisk tools: dynamic margins, pos limits, reserves, capital, insuranceProduct sequence: corporate hedging (interest rate futures)
are more important than retail speculation (equity options) Investor education: suitability, disclosure, monitoring, non-savings
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Consolidation of Exchanges
Increasing trend among leading exchanges16 publicly traded exchanges worldwide ($35 bn)
Creates deeper liquidity poolRevenue and cost synergiesUnified and efficient platformsIntegrated clearing and settlementFurther risk diversificationConcerns about competition
and national policies
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Policy issuestransparency + monitoring + oversight enhance stability
ETD vs OTC: Investors prefer Exchanges – Banks prefer OTC Marketsshifting OTC products (interest futures) onto exchange enhances stability
Regulation: level playing field for ETD and OTC markets plus disclosure
Caution: D can undermine fixed prices, pegged FX regimes, credit policies
Monitoring: highly leveraged institutions, cross-border, FX and credit D
Capital: D require risk-based capital plus add-on cushions, beyond Basel-I
Public banks: bridge market failures but subsidies can create warehouses
Oversight: exchanges, SROs, rating agencies provide critical infrastructure
Enforcement: market surveillance, transparency, legal clarity, ISDA standards
Investor protection: rationale for new D products, standards for suitability
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6. Concluding thoughts Derivatives can enhance financial intermediation BUT
require efficient cash markets and sound infrastructure Modern exchanges (CCP, dynamic margins, buffer) can
enhance transparency, safety, and competitiveness Prudential supervision is critical for all financial institutions
to avoid undisclosed exposure to the public sector Valuation and accounting standards should meet best
international practice and avoid regulatory arbitrage Successful financial stabilization would support benchmark
moving from DI-futures to intermediate-term bond futures Listing exchanges and exploring synergies from mergers
can reduce concentration risk (instrument, counterparty).
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