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Emerging Derivative Markets market development and risk management issues OECD- World Bank Annual Bond Market Forum 3. June 2003 Oliver Fratzscher The World Bank Page 1 Overview 500 BC Greece: Thales of Miletus – first option idea 1859 CBOT: first agricultural derivatives contract A. B. C. D. E. F. Risk and Rewards of Derivatives Relative Size of Derivative Markets Five Driving Factors of Derivatives Example Korea Example Brazil Selected Policy Issues Page 2 Confusion about D D are financial weapons of mass destruction (Buffet) D increase financial stability ; the more the better (Greenspan) D offer high leverage and cheap transaction costs (Financial Policy Forum) Notional values are not meaningful measures (FED) D make full disclosure even more difficult (World Bank) OTC regulation would stifle market creativity (SEC) D can avoid prudential safeguards, manipulate accounting, build leverage (IMF) Markets, not regulators should focus on risk management (Bankers) D are hugely profitable ; but each winner finds a dumb looser (Brookings) D are used by only 5% of large banks (Economist) Page 3 A. Risk and Rewards of D More leverage Less transparency Dubious accounting Regulatory arbitrage Rising CP exposure Hidden systemic risk Tail-risk future exposure Weak capital requirements Zero-sum transfer tools Market efficiency Risk sharing and transfer Low transaction costs Capital intermediation Liquidity enhancement Price discovery Cash market development Hedging tools Regulatory savings Page 4 Question Among the world’s 8 largest derivative exchanges, which countries do you think are represented ? A. B. C. D. Only G-7 countries Only OECD countries G-7 plus Korea and Singapore G-7 plus Korea, Singapore, Brazil, and Mexico Page 5 B. Size of Derivative Exchanges Top-8 Derivative Exchanges (volume) KSE: 855m (2001) ; 1930m (2002) Value $1,800 bn (#5) 900 800 9,000 BM&F: 101m (2002) Value $3,200 bn (#4) 700 600 billion US$ million contracts Top-8 Equity Index Futures (value) 500 400 8,000 KSE: market-cap $216 bn (#14 ; 10% Tokyo, 60% Sydney) 7,000 Cash trading $593 bn (#12 ; 40% Tokyo, 200% Sydney) 6,000 Futures trading $1680 bn (#3 ; 200% Nikkei) 5,000 4,000 300 3,000 200 2,000 100 1,000 0 0 KSE Eurex Euronext CME CBOE CBOT AMEX BM&F CME Eurex KSE CME Eurex Euronext Euronext Osaka S&P500 DAX KOSPI Nasdaq STOXX CAC40 FTSE Nikkei Top-8 Interest Rate Futures (volume) Top-8 Currency Futures Exchanges (value) 900 160 BM&F: DI-futures 44m (2001) ; 71m (2002) 800 KOFEX: $75 bn USD futures trading (#7) 140 Value $1,180 bn (DI) + $680 bn (DDI) 700 KTB futures trading $1,120 bn (#6) + OTC 120 + $850 bn (US$ futures) 600 KTB cash trading $39 bn (Israel, Ireland) 100 Brazil: government dom debt $180 bn 500 Korea: government dom debt $100 bn 80 60 billion US$ million contracts 180 400 300 40 200 20 100 0 0 CME Euronext BM&F Euronext SGX KOFEX Mexder BM&F Euro$ Euribor DI-future Sterling Euro$ KTB Interest DDI-$ BM&F US$ CME Euro CME Yen CME CHF CME CAD CME KOFEX GBP US$ CME MXP Sources: FIBV (2001) ; KSE, KOFEX, BM&F (2002) Page 6 Derivative Products OTC Derivative Markets Exchange Traded Derivatives $128 trn notional $ 5 trn market value $29 trn notional $700 trn turnover US: 35% EU: 34% JP Morgan Chase $ 27 trn 14% 70% Non-Financials $ 20 trn Chicago Eurex Euronext SGX BM&F KSE/KOFEX 28% Asia: 25% 62% (relative size may be misleading) Interest 40% annual growth rates Interest FX Equity Com Credit Other Key Driving Factors Capital flows Leverage Risk Management Liquidity Transaction Costs G-Debt Equity-Index Stocks Com FX Sources: BIS (June 2002) ; FIBV (Dec 2001) Page 7 C. Driving factor: capital flows Cross-border capital flows 24% 18% 2001 $21 trn 1997 $14 trn All countries 2001 23% 15% 2001 1997 11% 1997 34% 41% 57% 21% 25% 16% Developing countries Asia-Pacific countries 54% 64% 73% 23% 35% 14% Loans and deposits 52% Debt securities Equity securities Source: IMF (CPIS, 2002) Cross-border flows rise by 50% to $21 trn in 2001 Capital market flows double to $13 trn ; loans flat Trade integration complemented by capital flows EM private inflows declined to $120 bn annually versus $8,500 bn into G-7 economies in 2001. Page 8 Driving factor: leverage Institutional investor assets exceed 100% of GDP Investment bank leverage ø 30 times (LTCM 300 times) Capital incentives: discounts in Basle Capital Accord Enabling regulation: Futures Modernization Act (2000) deletion of real demand principle. Institutional Investor Assets 1998 G-7 1990 Japan 1980 US 1970 0% 50% 100% in percent of GDP 150% 200% Source: Davis and Steil “Institutional Investors” (2001) Page 9 Driving factor: risk management Seminal research on pricing models Immunization of portfolios through derivatives Dynamic hedging strategies Vehicle to reduce visibility and to smooth earnings Derivatives as risk transfer tools: example insurance sold $120 bn short credit derivatives (Fitch, 2003) Counter-party risk concerns during crises shift emphasis towards central counterparty Page 10 Driving factor: liquidity Liquidity premium: ST exchange vs. custom OTC Average annual turnover 25 times of underlying 95% of turnover accounted for by 5 MM futures 150 * turnover in Asian equity index options (KSE) Concentration among large banks, 5% non-financial Turnover of exchange-traded derivatives Turnover ratios (Quarterly BIS data, in US$ trillion) (times outstanding, 2001) Average Futures Options Interest Equity FX US EU Asia Asia Equity Opt Source: BIS Quarterly Review (March 2003) 25 46 11 25 25 30 22 31 38 150 Page 11 Driving factor: transaction costs Tax exemptions make derivatives cheap instrument Technological advances (internet, broadband,real-time) Competition of brokers (deep discounts, KOR 5 bp) Push by online & program-trading (retail participation) Clearing and settlement of standardized products Shift from physical to cash delivery Korea On-line Trading Share % 1997 1998 1999 2000 2001 Online share: 6% 25% 44% 53% Home Trading System 60 40 20 0 Korea US Canada France Sources: KSDA, Samsung Research (2001) Sweden Japan Web Trading System Regulatory approval IPO, mutual funds Content Tools English version Service Launch Fees 50 bp Broker deregulation Program trading 25 bp Online = offline Online fees cut Common Gateway Interface trading Delayed price quotes 15 bp 5 bp Competition Deep Discount brokers Java / Active-X based trading Real-time price quotes Page 12 D. Market overview for Korea D $630 bn = 130% of GDP ; tripled in two years KTB-futures: $5 bn daily; contract $87,000; OI $7 bn; 90% OTC KOSPI-futures: $7 bn daily; contract $38,000; OI $4 bn KOSPI-options: $0.5 bn daily; contract $50; OI $0.3 bn Exchange volumes top-1 ; equity volatility top-2 in world OTC Gross market value 3% [1%] ; FX swaps 13% [5%] Public banks very active in D ; 85% unrelated to loans 15% institutional investors ; tax incentives for D trading Questions on legal and counterparty risk ; 14% ø netting Questions on exchange margins ; trading collars ; cushions Page 13 Korean market growth OTC Derivatives Growth 800 400 Swaps (value outstanding) 700 350 OTC (value outstanding) 600 300 KRW trillion KRW trillion Commercial Banks' Leverage 500 400 300 200 250 200 150 100 100 50 0 2000 2001 2002-Sep Source : FSS response to questionnaire (December 2002) 0 1999 2000 2001 Source : FSS monthly statistics (table 13) 12 12 Derivatives (daily average) Derivatives (trading rev) 10 2002-Sep Equity Derivatives Trading Securities Firms Revenues 10 Cash (daily average) Commission (revenues) 8 KRW trillion KRW trillion Loans (outstanding) Derivatives (notional) Regulatory Capital 6 4 8 Open Interest (mill contracts) 6 4 2 2 0 1998 1999 2000 Source : FSS monthly statistics (table 25) 2001 2002-Sep annualized 0 1998 1999 2000 2001 2002Oct Source : KSE monthly statistics KOSPI200 futures & options Page 14 for illustration only Korean market assessment Notional size outstanding lower risk higher risk 130% of GDP [250%BIS] (% market cap, % GDP) Growth of leverage 200% growth in 24 months (OBS/assets, open interest) Gross market value Ø (% notional) Netting of credit exposure Ø 14% (%, legal issues, collateral) Concentration of credit risk Product characteristics 38% FX prod [14% BIS&JAP] (FX, equity, credit, duration) Exchange infrastructure Weak cushions (margins, cushions, insurance) Private sector risk mgmt Strong investment (staff, systems, disclosure) Supervision effectiveness Remaining challenges (analysis, frequency, arbitrage) Risk-based capital charges Low ratios (level, consistency, profits) JAP BIS [70%BIS, 52%JAP] 82% for top-5 banks (% top 5, credit quality) USA 3% value [1%US; 1.4%JAP] 1 2 3 4 5 Page 15 Korea: volatility and liquidity Equity Market Volatility 60% Futures Asian launched crisis 50% 50% Online Futures Regressions and Statistics KOR HKG AUS SAF POL 40% n 4 n Rt jRt j iDi jt j Ut . j 1 i 1 j 1 n 4 m n j 1 i 1 k 1 j 1 t jUt j iDi jAk jt j et Rt = daily return ; Di = dummy variable ; t-j= volatility 30% Ut = unexpected return ; Ak= volume activity (OI) 10% 0% Jan-96 Mar-96 May-96 Jul-96 Sep-96 Nov-96 Jan-97 Mar-97 May-97 Jul-97 Sep-97 Nov-97 Jan-98 Mar-98 May-98 Jul-98 Sep-98 Nov-98 Jan-99 Mar-99 May-99 Jul-99 Sep-99 Nov-99 Jan-00 Mar-00 May-00 Jul-00 Sep-00 Nov-00 Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01 Jan-02 Mar-02 May-02 Jul-02 Sep-02 20% Note: volatility is defined as 52-week standard deviation of weekly returns times √52. Vol(KOSPI) = 1.22*Vol (HKG) + 0.22*Vol (DOW) for entire period with R2 = 85%. Trading (2002, %) Foreign Institution Securities Retail Equity (value) 13.0% 16.0% 4.0% 67.0% Futures (value) 5.0% 9.0% 38.0% 48.0% Open-Int (short) 20.3% 11.9% 31.8% 32.2% Open-Int (long) 22.0% 4.6% 10.5% 61.2% Derivative markets have increased equity volatility Foreigners led the exit in late-1997 (40% of market) Securities firms are main contributor (90% D, 10% OI) Retail, online, program trading enhanced volatility Page 16 E. Market overview for Brazil D $160 bn at BM&F ; top-5, central clearing & counterparty DI-futures: $6bn daily; contract $27,000; OI $24bn (12m active) DDI-futures (local $-interest): $4bn daily; $47,000; OI $32 bn US$-futures: $3bn daily; contract $50,000; OI $20bn 80% of debt indexed to FX or I ; trading D parts separately Repo and D market liquidity is far larger than cash markets ON and D may be substitute for IB and cash bond markets Credit derivatives growing fast ; equity derivatives negligible BM&F established 3 guarantee funds ; seeks int’l insurance Strong margin systems ; but 90% collateral as Govt bonds Distortionary taxes: huge reserve requ , CPMF, D exempt BCB issuing FX swaps to meet bank & corp sector demand Page 17 Brazil’s debt indexation Absolute Levels (1994-2002) US$-Linked Nominal Zero-Duration Price-Level-Linked Others Duration Average remaining Life Jun-02 Mar-02 Dec-01 Jun-01 INFLATION Sep-01 Mar-01 Dec-00 Jun-00 FX-LINK Sep-00 Mar-00 NOMINAL Dec-99 Jun-99 Sep-99 Mar-99 Dec-98 Jun-98 Sep-98 Jul-01 Oct-01 Apr-01 Jan-01 Jul-00 Oct-00 Apr-00 Jan-00 Jul-99 Oct-99 Apr-99 Jan-99 Jul-98 Oct-98 Apr-98 Jan-98 Jul-97 Oct-97 Apr-97 Jan-97 Jul-96 Oct-96 Apr-96 Jan-96 Jul-95 Oct-95 Apr-95 Jul-94 Oct-94 0 Jan-95 100 SELIC Mar-98 200 Dec-97 300 Jun-97 400 Sep-97 500 Mar-97 100 bn BRL 600 Relative Shares (1996-2002) Dec-96 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 700 Sources: Garcia (2002) ; Brazil STN (2002) ; Deutsche Bank (2002). Real Interest Rate (%) 10 Brazil Turkey 9 Fiscal Deficit (% of GDP) Public Debt Stock (% of GDP) 8 7 Poland 6 Philippines Poland Hong Kong Philippines Hong Kong Russia Israel Israel Russia 5 South India Indonesia Colombia South Africa 4 Africa Colombia Indonesia Malaysia 3 Malaysia India Mexico Mexico 2 Chile Korea Korea China China Chile 1 Hungary Hungary Singapore Singapore % -6 -5 -4 -3 -2 -1 0 20 40 60 80 100 120 % Brazil Turkey Page 18 Risk management issues EM lessons (Mexico, Thailand, Russia): FX and Credit D may not be compatible with fixed FX and credit policies OTC risk concentration: Public banks’ transparency, weak best practices, trend to central counterparties Disclosure (IAS39) essential for insurance solvency, distinction between hedging and proprietary book Exchanges need better cushions (margins, insurance) Basle Capital Accord has fueled explosive D growth D may enhance volatility, may substitute cash market Page 19 F. Future challenges 1. Official regulation of rapidly expanding OTC derivative markets may need to be aligned across institutions to limit arbitrage and enhance transparency. 2. Prudential supervision of off-balance sheet exposure may need to be strengthened with reporting requirements and systemic risk analysis. 3. Derivatives exposure data may need to be considered in order to accurately assess BOP and reserve positions. 4. Proper valuation and full disclosure (strong IAS39) may reveal solvency issues of financial institutions. 5. Capital requirements for derivatives may need to be enhanced to limit regulatory arbitrage and leverage. 6. Derivatives as zero-sum risk-transfer tools may create conflict with managed FX and credit policies. 7. Derivatives driven by distortionary taxation and weak underlying issues may substitute for cash markets. 8. Management of counter-party risk may need to be enhanced (ISDA master, central clearing and counterparty). 9. Margin systems could be tightened for leveraged members (dynamic, insurance). Page 20 Thank you ! www.worldbank.org/finance Page 21