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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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