1 Page 1 Oliver Fratzscher World Bank Emerging Derivatives Markets Risk Management Workshop Brazil São Paulo 11.–13. April 2006 Page 2 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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Page 1
Oliver FratzscherWorld Bank
Emerging Derivatives Markets
Risk Management Workshop BrazilSão Paulo
11.–13. April 2006
Page 2
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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Page 3
" 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
Page 4
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
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
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