The search for efficiency

Financial derivatives are one of the most important tools in the capital markets, but in Latin America cumbersome regulations and inadequate technology have been stumbling blocks to the efficient use of derivatives to home in on true market prices and manage risk.

In spite of these challenges, the Brazilian Mercantile and Futures Exchange has recovered volume it lost in the wake of the emerging market crises in the late 1990s while streamlining its operations with a number of significant enhancements including a new payments system expected to be ready later this year. The BM&F is now on the verge of becoming one of the five largest derivatives markets in the world.

Efficiency has been the guiding principal behind the changes. Refinements have been made in the regulatory framework to accommodate foreign investor flows, which in turn have helped to develop new products and improved liquidity.

In the first half of this year, the futures exchange registered 24.3% growth in trading volume compared to last year. The notional financial volume went up by 28% from January to June, reaching $2.156 trillion compared with $1.681 trillion, in the first half last year. Through June this year, a total of 48.1 million contracts were traded, compared with 38.7 million last year, representing a daily average of 391,126 contracts in the first half of the current year.

If all goes according to plan, the average BM&F trading volume could well leap to above 700,000 contracts by year’s end, nearly matching that of the Chicago Board of Trade, which is the fourth-largest derivatives exchange in the world, says BM&F President Manoel Félix Cintra Neto.

Derivatives trading in Brazil has grown over the years. It began when stock options were first traded on the São Paulo Stock Exchange in 1979, then later included the launch of the BM&F in 1986 and the incorporation of the São Paulo commodities exchange in 1991. In 1994, with the advent of the new currency, the real, a series of modifications were implemented.

Catering To All
Today, the exchange includes all types of investors, from banks and corporations to brokerages and speculators, and trades a mix of traditional products including dollar, interest rate and commodity derivatives, alongside products tailored for the domestic market. Non-resident investors already can trade agricultural commodity futures, and the BM&F hopes to attract more foreign investment.

Pedro David Martinez, head of Latin American policy for the International Swaps and Derivatives Association, says that the BM&F is the largest trading center in Latin America. Since market participants view the over-the-counter (OTC) and exchange markets as tandem entities, and the OTC contracts are hedged by using standard, exchange-traded derivatives, this represents a positive sign for the continuing development of the over-the-counter derivatives market in Brazil, he says.

Martinez says that the OTC derivatives market continues to grow, not only in terms of products, but also by geographic region. In Latin America, Brazil is clearly the leader in terms of the development of new products such as credit derivatives, he says. “The Brazilian Central Bank has demonstrated interest in continuing to foster the appropriate regulatory framework for the development of over-the-counter derivatives in general, and most recently, for credit derivatives,” says Martinez.

In 1999, the central bank began a series of reforms in the way derivatives contracts are handled and liquidated upon maturity, aimed at reducing systemic risk in the Brazilian payment system. As part of the overhaul, in March 2001, Congress enacted legislation regulating the activities of clearing houses, which will have an important impact on multilateral netting of exchange-traded transactions by encouraging investment.

Although the legislation does not provide protection for enforceability after default of bilateral over-the-counter derivatives transactions, the new rules have created optimistic expectations for the adoption of close-out netting for OTC derivatives transactions in the near future, says Martinez. This form of netting, which has become the international standard, takes effect only in the event of default or other triggering event such as a downgrade in creditworthiness. For specific products, such as interest rate swaps, the positive contract values for a particular counter-party are netted against the contract values.

“Although a number of challenges remain ahead, these are very positive trends in terms of the development of the OTC derivatives market in Brazil,” he says. “The Brazilian authorities have made and continue to make important efforts in order to have an adequate infrastructure in place for the development of the OTC derivatives market.”

Throughout the year, Brazil has been implementing the new payments system, which is considered to be one of the most significant developments in the derivatives markets this year. The new payments system is a Central Bank project that has been embraced by the BM&F and private-sector participants, involving two areas of the clearinghouse structure.

New Payments System
According to the BM&F, the first area is adaptation of the derivatives clearinghouse to the new payment system. The second, which is currently in its initial phases, is to launch a clearinghouse for the interbank foreign exchange markets, aimed at decentralizing Brazil’s interbank settlement system. The benefits of the change include easing the burden of centralized settlement on the country’s risk rates and attract foreign direct investment, according to the BM&F. “The purpose of the project is to replace the Central Bank in certain areas in its role of primary guarantor,” says Cintra Neto.

Also this year, the BM&F adopted a new margin calculation system for its financial futures contracts, which reduced the requirements for collateral in preparation for the new payments system without implying any disruption in the security of the clearing division. Cintra Neto says this will lead to an improvement in the management of global margin levels within the financial system.

Judging by the increase in trading volume, the adaptations in the regulatory framework have strengthened investors’ confidence. While the rules governing the exchange have tended to depend on executive decrees, the approval in Congress of netting procedures led to greater developments in the market on several fronts since it provided more legal certainty and helped establish an appropriate environment for investment. Broad powers of decree are granted to the executive branch under the constitution, but full force of law is enacted only by Congressional approval of the decrees.

One element of the changes geared toward foreign investors has been the steady improvements in the electronic infrastructure of the BM&F, according to Cintra Neto. “We are ready to expand the electronic system, but the process requires a lot of observation until we know which contracts will maintain their liquidity outside of the traditional open-outcry system.” Electronic negotiation today accounts for less than 3% of the BM&F trading volume, but Cintra Neto says the exchange already has the structure to handle much larger volumes.

While the Brazilian derivatives market includes products found in any major market of the world such as commodities and dollar futures, there are also a few products considered unusual overseas such as inflation-indexed securities futures. “It is important to note that foreign investors are already authorized to operate in the agricultural commodities markets,” says Cintra Neto.”Non-residents already account for 22.7% of the open future contracts on the BM&F.”

Foreign Exchange Clearing House
There are a number of new products being developed, but the exchange’s priority is to implement the foreign exchange clearinghouse, which is considered fundamental for the Brazilian payment system. The exchange is also fine-tuning the rules and defining the products to be made available with the Globex Alliance, which unites the BM&F on the same operational trading platform with its counterpart markets in the United States, France, Spain, Canada and Singapore.

Carlos Santos, vice-president of foreign exchange and derivatives for J.P. Morgan in São Paulo, says the changes underway in Brazil are “very positive” from the point of view of the investors. “There is some concern about the flexibility of the rules regarding registration of transactions, but the central bank has demonstrated it wants to open the market and appears to be doing so in a controlled way,” he says.

He says both foreign investors and Brazilian authorities are exploring the opening of agricultural derivatives to non-residents as a kind of “test” of how the changes might develop in the future, but that the greatest interest continues to be for interest rate and foreign exchange derivatives, especially following Brazil’s devaluation. Santos says local investors are more interested in fixed income than exchange rate transactions. As well, he says, companies tend to prefer OTC because such transactions permit a “tailor-made” approach to what an individual company is seeking with regard to cash flow and financing needs. “The changes are certainly going in the right direction, but the timing will depend on the macroeconomic situation,” says Santos.