Transcript Total Return Swap

Market Focus:
Use of Derivatives in Brazil
Presenters: Amaury F. Junior
Cesar Lauro
Seminar on Fundamentals of ISDA Documentation
August 6, 2002
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
2
I – Brazil Marketplaces
BM&F concentrates most listed products. CETIP concentrates most OTC derivatives
BM&F
CETIP
Others

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 BM&F): provides contracts on government bonds
3
II – Brazil Market by Numbers:
Comparison with other Emerging Markets
Exchange-traded derivatives
Daily turnover
Exchange-traded derivatives
( USD millions )
14,000
12,000
10,000
8,000
6,000
4,000
2,000
Brazil
Singapore
Mexico
Korea
Poland
4
II – Brazil Market by Numbers:
Comparison with other Emerging Markets
Swaps
8,000
15,000
6,000
10,000
4,000
5,000
2,000
N/A
N/A
Mexico
Korea
Singapore
-
Brazil
South Africa
Poland
Mexico
Korea
Singapore
Brazil
-
N/A
N/A
Hungary
20,000
Czech Republic
10,000
South Africa
25,000
Hungary
12,000
Czech Republic
30,000
Poland
Swap transactions
Monthly number of swap trades
(USD millions)
Swap transactions
Monthly traded notional
(USD millions)
5
II – Brazil Market by Numbers: Derivatives
Interest Rate futures (1)
9,272
55
Other futures (2)
2,680
9
Listed options
8
16
Flex options
167
15
Swaps
200
56
CETIP
Swaps (3)
682
83
Listed Options
6
N/A
BM&F
(1)
(2)
(3)
Open Interest
(as of July 2002)
(USD billions)
Others
Daily Turnover
(2002 average)
(USD millions)
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
6
II – Brazil Market by Numbers: Cash Products
Daily Turnover
(USD millions)
Stock (July 2002)
(USD billions)
3,300
217
22
13
Certificates of Deposit
100
23
Stocks
237
145
Foreign Exchange
400
-
Government bonds
Debentures
7
III – Brazil Underlying prices
Interest rate derivatives are based on the return of the O/N CDI rate
Asset Prices
CDI and IDI
FX Variation
Others

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
8
IV – Taxonomy: Futures
Most traded futures are FX and Ibovespa futures
FX Futures

All futures are traded at BM&F

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 day’s 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
Ibovespa Futures
9
IV – Taxonomy: Interest Rate Futures
The DI and DDI futures are settled according to creative formulas
DI Futures

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 BM&F 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
DDI Futures
FRA Trading
10
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 BM&F: Daily turnover: USD 200 mm ; Open interest: USD 56 b

Traders can combine any two among 16 different indexes:
Swaps
Reais fixed rate
CDI rate
TR interest rate
TJLP interest rate
SELIC rate
ANBID rate
IGP-M
IGP-DI
IGP
Ibovespa index
Gold

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:
Optionality Clauses
“Cash Flow Swaps”
Dollar variation
Euro variation
ARS variation
JPY variation
Floatng Dollar variation
regret clause
upper limit (cap)
lower limit (floor)
knock-in barrier
knock-out barrier
swaption
compounded swaption
forward start

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
11
IV – Taxonomy: Options
Listed and Flex options are offered by BM&F

Listed Options

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 BM&F. 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 BM&F

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
BM&F Flex Options
CETIP Embedded
Options
Options listed at BM&F are:
12
V – Regulatory and Liquidity Issues - Regulation
There are restrictions to OTC markets such as the international swap market
Registration
Requirements
Allowed Underlying
Prices

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
CETIP Rules
13
V – Regulatory and Liquidity Issues - Liquidity
Lacking of netting regulation impairs swap liquidity and credit risk.
Netting and
Collateral
Exchange Guarantee
and Margin
Liquidity

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

BM&F swaps and Flex options can be guaranteed (for one or both parties) or nonguaranteed

BM&F 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

BM&F made several efforts to move the swap contracts to contracts settled daily or monthly

A pair of opposite swap transactions at BM&F, if both are exchange-guaranteed, counts as
zero exposure for margin requirements

A pair of opposite non-guaranteed swap transactions (BM&F non-guaranteed or CETIP)
counts as double exposure
14
VI – Cross-Border Constraints
Restrictions to the participation of local players in the international derivatives markets
International
Derivatives
Transactions

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 Hedge
(reg. 2012)
Access to Local
Market
(reg. 2689)
15
VII – Client-Driven Transactions
FX Hedge
Transactions
Options

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)
Structured Cash
Products
16
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 BM&F

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
17
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:
Regulation
Concepts
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:
bankruptcy
default
debt restructuring*
bankruptcy protection
acceleration
capital restructuring *
liquidation
moratorium
repudiation
(*) only if they affect "negatively" the credit quality of debtor

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
18
VIII – New / Developing Products:
Credit Derivatives – Preliminary Design
Preliminary design has been defined by the market

Market SelfRegulatory Effort
CDS on Cash
Products
CDS on Contingent
Claims
Four committees were created among industry members:
CDS on cash products
CDS on contingent claims
Legal and Tax
Operations, Risk and Accounting

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)
19
IX – Conclusions / Looking Forward

Current Needs and
Trends
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)


Future
Developments
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
20