Junior Amaury

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Market Focus: Use of Derivatives in Brazil

Presenters: Amaury F. Junior Cesar Lauro Seminar on Fundamentals of ISDA Documentation

August 6, 2002

Discussion Points

I. Brazil Marketplaces

II. Brazil Markets by Numbers

III. Brazilian Underlying Prices

IV. Taxonomy of Derivatives Products in Brazil

V. Regulatory and Liquidity Issues

VI. Cross-border Constraints

VII. Client-Driven Transactions

VIII. New / Developing Products

IX. Conclusions / Looking Forward


I – Brazil Marketplaces
BM&F concentrates most listed products. CETIP concentrates most OTC derivatives

Brazilian Mercantile & Futures exchange Main products: DI futures; DDI futures; FX futures Daily turnover: USD 12 b Also, provides semi-standard contracts (swaps and flex options)


  

Clearing house where most of the OTC trades are registered and settled Does not guarantee any settlement: players bear the credit risk of their counterparts


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Daily turnover: USD 700mm
Provides semi-standard swap contracts

Bovespa (São Paulo stock Exchange): provides stock options contracts SISBEX (now part of BM&F): provides contracts on government bonds



II – Brazil Market by Numbers: Comparison with other Emerging Markets
Exchange-traded derivatives

Daily turnover Exchange-traded derivatives ( USD millions ) 14,000 12,000 10,000 8,000 6,000 4,000 2,000 Brazil Singapore Mexico Korea Poland


II – Brazil Market by Numbers: Comparison with other Emerging Markets
Swap transactions Monthly traded notional (USD millions)
30,000 25,000 20,000 15,000 10,000 5,000 12,000 10,000 8,000 6,000 4,000 2,000

Swap transactions Monthly number of swap trades (USD millions)

Czech Republic

Czech Republic

South Africa


South Africa













II – Brazil Market by Numbers: Derivatives
Daily Turnover (2002 average) (USD millions) Interest Rate futures (1) Open Interest (as of July 2002) (USD billions)

2,680 8 167 200

9 16 15 56

Other futures (2) BM&F

Listed options

Flex options



Swaps (3)




Listed Options



(1) (2) (3)

DI and DDI futures Mainly FX and Ibovespa futures FX NDFs are traded at CETIP, but with very low volume (open interest was USD 270mm in July 2002). FX forwards are usually traded as swaps


II – Brazil Market by Numbers: Cash Products
Daily Turnover (USD millions) Stock (July 2002) (USD billions)

Government bonds






Certificates of Deposit






Foreign Exchange




III – Brazil Underlying prices
Interest rate derivatives are based on the return of the O/N CDI rate

Stocks Commodities (gold, cotton, coffee, and others) Ibovespa stock index

Asset Prices

 

CDI is the average daily inter-bank overnight rate SELIC is the one-day repo rate of government bonds. IDI is the result of the accrued daily CDI, based on an initial amount of 100,000 on January 2nd 2000. The IDI basis is reset to 100,000 from time to time. Several derivatives are referenced to CDI, to the IDI index, or the accrued return of the daily CDI rate The CDI rate can be viewed as a daily Libor


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Physically-settled FX derivatives are rare or non-existent Most FX derivatives are cash settled in Reais, and the foreign FX return is generally calculated according to a fixing rate published by the Brazilian Central Bank (the “PTAX” rate)

FX Variation


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Several indexes were used as alternative currencies during the hyperinflation years IGP-M: inflation index TR, TJLP: interest rates indexes


IV – Taxonomy: Futures
Most traded futures are FX and Ibovespa futures

All futures are traded at BM&F Mainly dollar/real futures The fixing price is the PTAX rate published by the Central Bank on the business day prior to the contract expiration Standard swaps take as base FX rate the PTAX rate of the business day prior to the trade date, thus creating “dirty” and “clean” quotes:
 

FX Futures

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“dirty” quotes are based on previous day’s PTAX, and vary according to the spot FX “clean” quotes are based on spot FX

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EUR, ARS and JPY futures are available, but are not used Most of the volume on dollar/real futures is captured by USD-linked interest rate contracts (DDI and FRA). Hence, only the first future is generally traded Daily turnover: USD 2.4 b; Open interest: USD 8.3 b

Ibovespa Futures

Ibovespa is a stock index calculated by the São Paulo stock exchange and comprised of approximately 50 of the most liquid stocks (currently 57 stocks) The fixing price is the average Ibovespa price during the last half session of the expiration date Daily turnover: USD 245mm; Open interest: USD 309mm


IV – Taxonomy: Interest Rate Futures
The DI and DDI futures are settled according to creative formulas

The most traded future in Brazil. Daily turnover: USD 5.7b ; Open interest: USD 28 b. Underlying is not a forward rate. Underlying is the spot rate from trade date to expiration date. DI futures perform the same as a fixed-to-CDI swap Most liquidity for January, April, July, and October contracts, in addition to the next month contract. Currently, DI futures trade maturities up to 2005 Daily settlement formula makes the buyer pay a daily CDI rate to the seller, in addition to price variation. The final fixing price is 100,000 reais. So the price at which DI futures trade is equal to the present value of 100,000 Since January 2002, DI futures ceased to be traded in price and began to be traded in rates. The buyer of price became the seller of rate, and the seller of price became the buyer of rate

DI Futures

DDI Futures
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DDI futures trade the local synthetic dollar interest rate (the “cupom cambial”). They perform the same as a dollar-CDI swap Daily turnover: USD 2.9 b; Open interest: USD 27 b Most liquidity for January, April, July, and October contracts, in addition to the next month contract. Currently, DI futures trade maturities up to 2008

FRA Trading

FRA is not a future, but a mechanism of trading provided by BM&F where each trade is broken and registered as a pair of opposite DDI trades
Was created to avoid “dirty” rates (rates contaminated by the fluctuations of the spot FX rate) Practically all the DDI volume is originated from FRA transactions


IV – Taxonomy: Swaps
All swaps are semi-standard, index swaps

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All the swaps are index swaps. Interest rates and FX variation are represented by their returns from trade date to maturity date On CETIP: Daily turnover: USD 682 mm ; Open interest: USD 83 b On BM&F: Daily turnover: USD 200 mm ; Open interest: USD 56 b Traders can combine any two among 16 different indexes:
Reais fixed rate CDI rate TR interest rate TJLP interest rate SELIC rate ANBID rate Dollar variation Euro variation ARS variation JPY variation Floatng Dollar variation IGP-M IGP-DI IGP Ibovespa index Gold

All the indexes are calculated according to standard formulas. For instance, the “dollar” index is calculated as: [Final PTAX] / [Initial PTAX] * (1 + [coupon rate] * [tenor / 360] )

CETIP swaps can have optionality:
regret clause upper limit (cap) lower limit (floor) knock-in barrier knock-out barrier swaption compounded swaption forward start

Optionality Clauses

It is possible to map options to CETIP swaps using one or more optionality clauses

“Cash flow” swaps are a new product planned by CETIP (not delivered yet) “Cash flow” swaps correspond to the vanilla international interest-rate swap, or to the vanilla international cross-currency swap Additional rate indexes will be created, as Libor and Jibor

“Cash Flow Swaps”


IV – Taxonomy: Options
Listed and Flex options are offered by BM&F

Options listed at BM&F are:
  

Listed Options

Dollar / Real options (cash settled, fixing is the previous day PTAX) IDI options (cash settled, fixing is the value of the IDI index at expiration)

Other, illiquid options on: Ibovespa futures, gold, coffee (physically settled)

The São Paulo stock exchange provides listed options on stocks (physically settled) and on Ibovespa spot (cash settled)

BM&F Flex Options

Flex options are provided by BM&F. Market is OTC, but registration and clearing is exchange-based Traders may choose tenor, strike and fixing method. In some cases, optionality clauses (barrier) are allowed There are flex options on FX and Ibovespa spot Flex options may or may not be guaranteed by BM&F

 

CETIP swaps may replicate options, if optionality clauses are used In this case, great flexibility may be achieved. Possible products include vanilla European options, outperformers, barrier options and swaptions

CETIP Embedded Options


V – Regulatory and Liquidity Issues - Regulation
There are restrictions to OTC markets such as the international swap market
Registration Requirements

All swaps and “non-standard options” between financial institutions have to be “registered” with an exchange or with “other market organizers” such as CETIP (reg. 2873) There is a controversy about if non-registered derivatives contracts between non-financial institutions (corporates, individuals) are enforceable (anti-gambling laws)

Allowed Underlying Prices

The reference assets of swap transactions are: interest rates, FX rates, commodities, stocks and stock indexes (reg. 2873) In the case of commodities, stocks or stock indexes, any underlying price or calculation method not immediately available from a semi-standard contract has to be “authorized” by a regulator (reg. 2873) If an exchange or a “market organizer” creates a new underlying, it has to the “authorized” by a regulator (reg. 2873)


In any swap transaction, at least one party has to be a “market member” (a financial institution or institutional investor which has an account with CETIP) Non-market members may trade only through (or with) a market member, which is considered the non-market member “administrator” If two “market members” trade, settlement will be commanded by CETIP. If one non-market member trades with its administrator, the settlement is done through deposit in the bank account of the profitable party, executed by its counterpart. All trades between one non-market member and one market member have to be confirmed in writing. Transactions between two market members do not need to be confirmed in writing Confirmations may include additional clauses that “complement” the standard contract. However, clauses that are in conflict with the standard contract are void


V – Regulatory and Liquidity Issues - Liquidity
Lacking of netting regulation impairs swap liquidity and credit risk.
Netting and Collateral
  

In Brazil, netting is still not enforceable Article 30 of provisional measure 2139-67 provides for the netting, but it is not in effect yet. There are significant difficulties to secure control over pledged collateral

Exchange Guarantee and Margin

BM&F swaps and Flex options can be guaranteed (for one or both parties) or nonguaranteed BM&F margin call system considers the effect of offsetting positions CETIP swaps are always non-guaranteed Banks have included credit mitigators (reset, early termination) in the CETIP swaps contracts they trade with clients

  

BM&F made several efforts to move the swap contracts to contracts settled daily or monthly A pair of opposite swap transactions at BM&F, if both are exchange-guaranteed, counts as zero exposure for margin requirements A pair of opposite non-guaranteed swap transactions (BM&F non-guaranteed or CETIP) counts as double exposure



VI – Cross-Border Constraints
Restrictions to the participation of local players in the international derivatives markets
International Derivatives Transactions
  

A Brazilian resident may trade with non-residents in the international derivatives markets In this case, settlement occurs via “non-resident” (former CC-5) accounts As CC-5 accounts were heavily associated with money laundry in the past, most banks avoid using them, and the Central Bank maintains strict surveillance of all payments made through CC-5 accounts Income taxes are levied, either if the Brazilian party receives or if the Brazilian party pays (the last is considered a gain for the non-resident, subject to withholding tax)

International Hedge (reg. 2012)

According to reg. 2012, a Brazilian resident may trade derivatives with non-residents, effect payments through the free FX market (avoiding the CC-5 vehicle) and be exempt of income tax if the transaction is aimed at hedging cash flows commited in a foreign currency and / or foreign interest rate Central Bank maintains strict surveillance over the transactions done under reg. 2012

Access to Local Market (reg. 2689)

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Non-residents may trade in the local derivatives markets under the provisions of reg. 2689 Non-residents need a Brazilian financial institution to be the “administrator” of the 2689 account The same rules that apply to residents (including taxation) apply to non-residents trading through 2689. However, from time to time there may be exceptions regarding taxation (e.g. CPMF tax on equities). Tax rates are differentiated for investors based on countries considered “tax havens” Reg 2689 (from 1998) substituted the former “Annex” regulations, which specified the type of investment or trade the non-resident could do in the local markets. Before reg. 2689, there were six “Annex” regulations, each one regulating one type of investment

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VII – Client-Driven Transactions
The notional amount of outstanding FX hedge transactions is USD 68 billion notional (total CETIP FX swaps outstanding) 30% of the hedge transactions are non-standard (made possible by the CETIP “others” index) 2% of the FX hedge transactions are longer than 5 years 62% of the FX hedge transactions are 1 year or shorter Interest rate hedge is not widespread, given the lack of interest for locking (generally higher) fixed rates

FX Hedge Transactions

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FX options are generally traded for tenors up to 1 year


FX options are sometimes embedded in “best-of” products (e.g. best of a percentage of CDI or a dollar-linked return)

Structured Cash Products

In Brazil, debt instruments have to follow a very strict regulation. Structured notes and deposits are not allowed Hence, structured cash products are usually built as funds (principal protected, principal protected with knock-out, etc)


VIII – New / Developing Products: Interest Rate Derivatives
The vanilla type of international interest rate swap or cross-currency swap is only possible, in Brazil, through a series of index swaps. Usually, these swaps have non-standard underlying indexes, (e.g. Libor), and are registered at CETIP as “others” CETIP has proposed a “Cash Flow swap” that mimics the mechanics of international plain vanilla interest rate or cross-currency swaps However, implementation has been postponed due to the priority given to Credit Derivatives

“Cash Flow Swaps”

IDI options are traded at BM&F The reference asset of an IDI option is the IDI index

Interest Rate Options

   

Optionality clauses of CETIP contracts allow caps and floors
CETIP provides for swaptions, but no transactions of this type have been implemented yet Interest rate options are at a starting market stage in Brazil


VIII – New / Developing Products: Credit Derivatives - Regulation
Regulation on credit derivatives was issued April 2002

  

Reg. 2933 Resolution and Reg. Circular 3106 are the framework of credit derivatives transactions in Brazil Currently, only credit default swaps and credit default options are allowed Reg. Resolution 2921 provides for credit-linked deposits Have to be registered (CETIP already started the design of standard contract)

Only financial institutions may trade credit derivatives. However: Money-market funds regulated by the Central Bank (FIF funds) are considered financial institutions.


There is a controversy about if non-financial corporates, that are not regulated by the Central Bank, could or not trade credit derivatives (anti-gambling laws)
  

Only banks can sell protection Credit Events are:
bankruptcy default debt restructuring* bankruptcy protection acceleration capital restructuring * liquidation moratorium repudiation (*) only if they affect "negatively" the credit quality of debtor

Broad range of underlying assets are allowed, including derivatives and other credit derivatives. However, the protection buyer has to have an exposure on the underlying asset, or the underlying asset must be a “regularly traded” instrument Foreign participants and foreign reference assets are not allowed


VIII – New / Developing Products: Credit Derivatives – Preliminary Design
Preliminary design has been defined by the market

Four committees were created among industry members:
CDS on cash products CDS on contingent claims Legal and Tax Operations, Risk and Accounting

Market SelfRegulatory Effort
 

The objective is to develop market standard practices
CETIP has been an active participant of the committees’ meetings

Cash settled or Physically settled The committees are choosing the “regularly traded” securities (debentures) that better represent the debtor names, so that these become the benchmarks of CDS transactions Discussions with the Central Bank and CVM on accounting, operational and tax issues still have to take place

CDS on Cash Products

CDS on Contingent Claims

  

Cash settled (Swaps cannot be transferred without the consent of the counterpart) Three suggested protection types: a) Market Value; b) Accounting Value; c) Fixed Value

“Fixed Value” protection is controversial (legal opinions have been required)


IX – Conclusions / Looking Forward
Increasing demand for more flexibility and non-standard products are driven by: Change, from a market of small brokers to a market of qualified Banks (most of them international)

Current Needs and Trends

The need for new reference assets (e.g., market has rejected the “official” fixing prices for EUR, JPY or ARS, and has used the “Fedspot” rates to fix settlements in other currencies)
   

New complex products that are not easily standardized (e.g., “Cash flow swaps”) Increasing concern with credit risk and the need of provisions that could mitigate it.

Opposite trends: Additional efforts by regulators and exchanges have been taken to bring every initiative into the standardized regulatory framework (e.g., CETIP being the official calculator of mark-to-market and early termination amounts)
 

In contrast, market participants are asking for further de-regulation

Development of the credit derivatives business New, more flexible, contracts provided by CETIP Emphasis on credit risk mitigation

Future Developments

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