Brazil’s Derivatives Markets: Hedging, Central Bank Intervention and Regulation



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Brazil’s Derivatives Markets:

Hedging, Central Bank Intervention and Regulation


Randall Dodd

Stephany Griffith-Jones


Research Sponsored by ECLAC/CEPAL

Funding from the Ford Foundation1


December 19, 2007
Table of Contents

PART I


  1. Introduction: Overview of Brazil’s Markets: exemplary developments

  2. Importance and Size of Derivatives Markets

  3. Derivatives Instruments

  4. Market Structure

    1. Exchanges

    2. Over-the-Counter

a) Derivatives Dealers

b) Brokers in Derivatives Markets

c) Customers or End-Users in Derivatives Markets


  1. Key Features and Special Innovations in Brazil’s derivatives markets

  2. Overview of Regulatory Framework

PART II


  1. Derivatives in an open, developing economy

    1. Brazil’s history of high inflation, high interest rates and high fx volatility

    2. Derivatives as a means of hedging

    3. Derivatives as a focal point for exchange rate collapse

  2. Central Bank Intervention in Derivatives Markets

  3. Regulatory Proposals to Improve Derivatives Markets

a) Registration and Reporting Requirements

b) Capital and Collateral Requirements

c) Orderly Market Rules


  1. Concluding Remarks

1. INTRODUCTION

This report is a study of Brazil’s derivatives markets, the important role they play in the economy, and how they are used by the Brazilian Central Bank (BCB) in the conduct of macroeconomic policy. The first part of the report focuses on providing an analytical description of the derivatives markets in Brazil, how they operate and how they are regulated. Of special interest is the regulatory framework which has served to shape the development of the derivatives markets and continues to influence their stability and efficiency.


The second part of the report will focus on the role of derivatives markets in Brazil’s financial system and overall economy. This will consist, in large part, of a macroeconomic policy analysis of how the presence of derivatives markets affect the stability and efficiency of a large, open developing economy like Brazil. Of special interest will be the question of whether, and if so to what extent, the presence of derivatives markets result in pro-cyclical pressures on key variables such as the exchange rate. And it will also include an analysis of how derivatives markets are used by the BCB in its conduct of monetary and exchange rate policy.
The report addresses a subject matter that is challenging for usual research methods. The over-the-counter segment of the derivatives markets is not very transparent – due to there being only limited reporting and disclosure requirements; so, complete information on the size, volume and use of this market is difficult to obtain. Brazil, however, does uniquely offer a great deal more data on this part of the market than other countries. In order to augment the incomplete data, the authors conducted numerous lengthy interviews with representatives from all the major market participants in the derivatives markets and their key regulatory and supervisory institutions. While the report does not use direct quotes from any of these interviews, much of the description of OTC markets reflects what we learned from these many interviews and is then condensed into the descriptive analysis.

2. SIZE AND IMPORTANCE

a. OVERVIEW


The reason our overall markets are important for economies is not due merely to their size. Rather it arises mainly from the various economic functions they perform in the economy.
Derivatives markets serve two important economic purposes: risk shifting and price discovery. Risk shifting –commonly called hedging – is the transfer of risk from one entity who does not want it to another entity that is more willing or able to bear it. In doing so, derivatives can help discover the price of underlying assets, commodities, events or certain types of risk. Price discovery might not otherwise occur because of transactions costs, dispersion of the underlying item or the conglomeration of many values or risks into one whole thing. One of the most important price discovery functions is the price of the underlying item, e.g. an exchange rate, over time. In the case of Brazil, the futures traded on the BMF exchange are the point of price discovery for the real-dollar exchange rate. Also important is price discovery in the interest rate futures markets. They play a leading role in the fixed income market by preceding the government bank market in lengthening of maturities of fixed interest rate contracts.

Chart 1




* Data from BMF
Risk shifting is important for a variety of economic reasons. Importers and exporters hedge their foreign exchange exposure so that the local currency value of their importing costs and exporting revenues is less volatile. Firms borrowing in foreign markets hedge the local currency value of their foreign currency debt payments. There is also a large demand for hedging the fluctuations in domestic interest rates – Brazil’s history of high inflation and high nominal interest rates has left its credit markets with a concentration of short-term loans and debt instruments and the derivatives markets have served to hedge the fluctuations in these short-term interest rates. Even purely domestic enterprises face the risk of commodity price fluctuations and the indirect impact from exchange rate and interest rate
Box 1.

Comparison: Derivatives Market and Key Economic Variables

(some figures in US dollars and some in Reals)
Derivatives Amounts and Trading Volumes
CETIP{} (end of June 2007)

Outstanding amounts: Swaps - 209.9 billion reals

Options - - - 0.42 billion reals

NDF - - - 43.4 billion reals

Total - - - 253.7 billion reals
BMF{2}

Open Interest (July 2007)

Futures & Options - - 1,609 billion reals (69% of GDP)

Trading Volume

Futures & Options - - 32.34 trillion reals (1,392% of GDP)
Memo:

Total O.I. BMF + CETIP - 1,863 billion reals (80% of GDP)

Central Bank Exposure:

from swap with reset - - $23.3 billion



GDP figures (2006)

GDP - 2.323 trillion reals

Traded Goods: - $245 billion

Foreign Portfolio investment - $9 billion

(first 4 months of 2007) - $14.5 billion

DFI - $18.8 billion

(first 4 months of 2007) - $10 billion



Financial Measures (April 2007)

Market capitalization: - - 2,161 billion Reals

Public debt: - - 1,500 billion Reals



(1) CETIP defined in Appendix 2; (2) Brazilian Mercantile and Futures Exchange


variability. Also the cost of complying with environmental, climate change requirements can be hedged through futures and options on emission abatement permits (i.e. “carbon” trading). Lastly, some foreign investors – including hedge funds – have used derivatives markets for investment strategies such as capturing the large interest rate differential between Brazil and most developed economies, as we discuss in more detail below.
While they are not important merely because of their size, the significance of the economic functions they perform is reflected in the fact that Brazil’s derivatives markets are both large and growing rapidly. Their enormous size, and their size in comparison to some other familiar economic variables, is included in Box 1. Amongst other possible comparisons, the amount of derivatives outstanding on OTC markets registered at CETIP plus the open interest at BMF is greater than the market capitalization of listed corporations in Brazil and it is larger than the amount of outstanding public debt. In comparison to GDP, the amount outstanding of open interest is 80% of GDP. Trading volume at the BMF, on the other hand, is already 1,392% of GDP – and that does not include OTC trading reported to CETIP, options trading at BOVESPA2 and OTC trades with overseas entities that are not reported in Brazil.
The BMF derivatives exchange in Sao Paolo is the 5th largest futures exchange in the world.3 Trading volume totaled 248 million contracts in 2006, and it recently hit new records for daily trading volume on June 8th, 2007 – 3.88 million contracts with a notional value of $167.2 billion. This was lead by record high interest rate futures trading which hit a new record of 3.16 million. During January and February of 2007, BMF was the second fastest growing futures exchange in the world.4 Trading volume in the futures on overnight interest rates is one of the fastest growing in the world – 162 million in 2006 compared to 121 million in 2005 – and ranks 12th overall worldwide. The BMF maintains open-outcry or “pit” trading arrangements for many of its contracts. BMF was demutualized in 2007 and held an IPO in November of 2007.
In addition to the futures and options traded on BMF, Brazil’s stock exchange, the Bovespa, trades options at its location in Sao Paolo and is the 7th largest futures and options exchange in the world with a total of 288 million options contracts traded in 2006. Bovespa and BMF offer electronic trading.
Bovespa, which mostly trades options on stock indices and single stocks, is authorized under current law to trade forwards, futures, call and put options on single stocks and stock indices, stock future contracts, stock forward contracts, and warrants (non-standard options) issued according to CVM Instructions n° 223 and 328.5 Most of the options traded on Bovespa are call options with only a tiny fraction of trading volume conducted as put options.6 The volume of trading in options is concentrated in single stock options on just a few of the major Brazilian corporations listed on the Bovespa stock exchange.
b. OVER-THE-COUNTER MARKETS

Brazil’s OTC derivatives market is similarly large and fast growing. Like other countries with an established OTC derivatives market, it is dominated by a few large dealers. Unlike other countries, the majority of inter-dealer trading is conducted through exchange trading. Also, unlike OTC markets in other countries, it is made more transparent by reporting requirements.


Data on the OTC gathered from CETIP shows that

  • In 2006, 9.6 million OTC derivatives trades registered with CETIP, and that their notional value was 4.7 trillion reals.7

  • The outstanding amounts of OTC derivatives registered with CETIP at the end of 2006 was 1.48 trillion reals.

  • The trading volume of NDF in the real-US dollar OTC market in 2006 totaled 114 billion reals. (There were over 26,000 reported trades.)
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