Transcript Emerging Derivative Markets

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 $120 bn short credit derivatives (Fitch, 2003)
 Counter-party risk concerns during crises
shift emphasis towards central counterparty
Page 10
Driving factor: liquidity
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
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
Liquidity premium: ST exchange vs. custom OTC
Average annual turnover 25 times of underlying
95% of turnover accounted for by 5 MM futures
150 * turnover in Asian equity index options (KSE)
Concentration among large banks, 5% non-financial
Turnover of exchange-traded derivatives
Turnover ratios
(Quarterly BIS data, in US$ 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
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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   jt  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   jt  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
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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
Mar-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
Oct-97
Jan-98
Jul-97
Apr-97
Oct-96
Jan-97
Jul-96
Apr-96
Jan-96
Jul-95
Oct-95
Apr-95
Jul-94
0
Jan-95
100
SELIC
Dec-97
200
Jun-97
300
Sep-97
400
Mar-97
500
Oct-94
Sources: Garcia (2002) ; Brazil STN (2002) ; Deutsche Bank (2002).
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
Real Interest Rate (%)
100 bn BRL
600
Relative Shares (1996-2002)
Dec-96
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
700
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