Market Focus:

1
Market Focus Use of Derivatives in Brazil
Presenters Amaury F. Junior Cesar
Lauro Seminar on Fundamentals of ISDA
Documentation August 6, 2002

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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
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I Brazil Marketplaces
BMF 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 Daily turnover USD
700mm Provides semi-standard swap
contracts Bovespa (São Paulo stock Exchange)
provides stock options contracts SISBEX (now part
of BMF) provides contracts on government bonds
BMF
CETIP
Others
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II Brazil Market by Numbers Comparison with
other Emerging Markets
Exchange-traded derivatives
( )
5
II Brazil Market by Numbers Comparison with
other Emerging Markets
Swaps
6
II Brazil Market by Numbers Derivatives
Daily Turnover (2002 average) (USD millions)
Open Interest (as of July 2002) (USD billions)
Interest Rate futures (1)
55
9,272
Other futures (2)
9
2,680
BMF
Listed options
16
8
Flex options
15
167
Swaps
56
200
Swaps (3)
CETIP
83
682
Listed Options
Others
N/A
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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
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II Brazil Market by Numbers Cash Products
Daily Turnover (USD millions)
Stock (July 2002) (USD billions)
Government bonds
3,300
217
Debentures
22
13
Certificates of Deposit
100
23
Stocks
237
145
Foreign Exchange
400
-
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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 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 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) Several indexes were used as
alternative currencies during the hyperinflation
years IGP-M inflation index TR, TJLP interest
rates indexes
Asset Prices
CDI and IDI
FX Variation
Others
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IV Taxonomy Futures
Most traded futures are FX and Ibovespa futures
All futures are traded at BMF 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 dirty
quotes are based on previous days PTAX, and vary
according to the spot FX clean quotes are
based on spot FX 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 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
FX Futures
Ibovespa Futures
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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 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 is not a future, but a mechanism
of trading provided by BMF 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
DI Futures
DDI Futures
FRA Trading
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IV Taxonomy Swaps
All swaps are semi-standard, index swaps
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 BMF Daily turnover USD 200 mm Open
interest USD 56 b Traders can combine any two
among 16 different indexes 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 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
Swaps
Optionality Clauses
Cash Flow Swaps
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IV Taxonomy Options
Listed and Flex options are offered by BMF
Options listed at BMF are 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) Flex options are provided by BMF.
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 BMF 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 nononononono
Listed Options
BMF Flex Options
CETIP Embedded Options
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V Regulatory and Liquidity Issues - Regulation
There are restrictions to OTC markets such as the
international swap market
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) 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
Registration Requirements
Allowed Underlying Prices
CETIP Rules
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V Regulatory and Liquidity Issues - Liquidity
Lacking of netting regulation impairs swap
liquidity and credit risk.
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 BMF
swaps and Flex options can be guaranteed (for one
or both parties) or non-guaranteed BMF 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 BMF made several efforts to move the
swap contracts to contracts settled daily or
monthly A pair of opposite swap transactions at
BMF, if both are exchange-guaranteed, counts as
zero exposure for margin requirements A pair of
opposite non-guaranteed swap transactions (BMF
non-guaranteed or CETIP) counts as double exposure
Netting and Collateral
Exchange Guarantee and Margin
Liquidity
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VI Cross-Border Constraints
Restrictions to the participation of local
players in the international derivatives markets
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) 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 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
International Derivatives Transactions
International Hedge (reg. 2012)
Access to Local Market (reg. 2689)
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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 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) 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)
FX Hedge Transactions
Options
Structured Cash Products
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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 IDI options are traded at BMF The
reference asset of an IDI option is the IDI
index 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
Cash Flow Swaps
Interest Rate Options
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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 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
Regulation
Concepts
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VIII New / Developing Products Credit
Derivatives Preliminary Design
Preliminary design has been defined by the market
Four committees were created among industry
members 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 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)
Market Self-Regulatory Effort
CDS on Cash Products
CDS on Contingent Claims
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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) 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
Current Needs and Trends
Future Developments