Brazilian derivatives: growing up fast

The jumbo merger between the Brazilian stock and derivatives markets earlier this year highlighted the growing power of Brazil’s capital markets: the new enterprise, BM&F Bovespa, is expected to be the world’s third-largest listed exchange. Innovative new products are bound to follow the tie-up, with equity derivatives and exotics catching up with the already liquid foreign exchange and interest rate vanilla markets. Yet the development of Brazilian derivatives continues to be hobbled by protectionist tax laws and the product range is, for now at least, basic. Trading in areas that should be Brazilian strengths – such as commodities – are taking place off shore, especially in the US. Moves are now afoot to stimulate markets and bring home this future bacon (or at least soya and sugar) from the gringos.

Exchange-traded Contracts
It has been hard to pick up a newspaper in Brazil without stumbling across the name of the futures market, Bolsa de Mercadorias & Futuros (BM&F), of late. An IPO that raised $3.4 billion at the end of last year followed up by a merger with the stock exchange Bovespa with the usual slew of promises of cost cutting, synergies, product launches and the like has hypnotized the media.

The move is crucial for the derivatives market. Unlike in most of the rest of the world, it is the exchange and not over the counter (OTC) contracts that dominate derivatives trading in Brazil. Some 80-90% of open interest-contracts are found on the BM&F, according to Luiz Fernando Figueiredo, founding partner of Mauá Investimentos and a member of the board of the BM&F exchange. That wasn’t the case just 10 years ago, he points out, when the OTC market dominated. The transition onto the exchange has been enormously helped because the BM&F takes on counterparty risk, he believes.

BM&F has not always been so prized. The exchange’s dominance of the derivatives markets stems from the take-over of a rag-tag of other, smaller exchanges, including a São Paulo commodities exchange and a Rio-based futures exchange in the 1990s which left the BM&F the last man standing. Since that sticky start, the BM&F has been working hard to professionalise and build a deep, liquid market.

The exchange now communicates well with market players and associations and has consequently proved astute at launching products the market really wants, says José Roberto Machado, executive director of the Treasury department at ABN Amro’s Banco Real in São Paulo.

And although the interest in Brazilian derivative markets is a relatively new phenomenon, fundamentals look solid because of strong underlying capital markets and the need to catch up with the rest of the world. The portfolio of OTC contracts is roughly 30% of Brazilian GDP, says Marcelo Maziero, managing director of derivatives at Banco Itaú’s investment banking arm in São Paulo. That’s tiny compared to the 10 times GDP seen in developed markets. As Brazil closes the gap, cash and derivative markets should experience a long period of growth, he reasons.

Indeed, markets for plain vanilla products in FX and interest rates have progressed very fast. In 2004, the exchange accounted for R$568 billion in contracts. By 2007, that had jumped to R$1,938 and if current trends for 2008 continue should end the year at some R$2,240 billion. That puts BM&F head and shoulders above any other exchange in Latin America.

The use of derivatives continues to receive a shot-in-the-arm because of laws restricting fund participation in cash markets. All securities purchases need to be registered with the country’s regulator and the central bank and investors also need a local account and a legal representative. That has seen many turn to derivatives to get round these restrictions.

Over the counter market
BM&F is responsible for exchange-traded and some OTC contracts, but the majority of OTC is handled through custody and settlement house, Cetip. The Brazilian OTC market can be surprising to outsiders as it has many idiosyncratic characteristics including high level of transparency and a sophisticated back office, including T+0. All trades, even OTC ones, must be registered with an authority, explains Jorge Sant’Anna, head of business development at Cetip. That allows access to much more information that is the case in most markets. This transparency is a product of Brazil’s hyperinflation at which time the market regulator, the CVM, decided it wanted to keep close tabs on banks’ exposures.

Cetip has emerged as the crucible for innovation in the derivatives market with exotic and bespoke derivatives trades. More elaborate contracts are growing fast. If you take a look at the derivatives market five years ago, it was dominated by futures, swaps and a timid number of options, mostly calls/puts and caps/floors, says Mr Maziero. Nowadays, exotic options are sold more actively. Clients have become more sophisticated and understand the risk/reward profile of derivatives better while underlying markets have become more stable making it safer to design and use more elaborate contracts, he adds.

Obstacles Abound
But the problem with developing Brazil’s promising derivatives markets are manifold. The short history of capital markets in Brazil means there is little historical data for equity and corporate bond market volatility. And while the use of derivatives as a hedging instrument thrives on some volatility, Brazil’s long-term history of macroeconomic instability has made pricing tricky.

Suspicion of the usefulness of hedging lingers, too. In the run-up to the first election of current president Luiz Inácio Lula da Silva, in 2002, there was a strong correlation between derivatives and the real economy with a spike in interest rates and rapid devalution of the currency reflected in very high hedging costs, points out Mr Sant’Anna. Fearing the worst and encouraged by banks, companies rushed to hedge FX and rate positions, paying a whacking premium. The expected crash in the currency and interest rate hike did not materialise and business managers repented having paid through the nose for the unnecessary protection while banks pocketed the profits. “That continues to rankle. It’s still difficult to explain the insurance role of derivatives,” says Mr Sant’Anna.

The lack of full convertibility of the Brazilian currency is a major impediment as well, says Mr Machado. While the April decision by Standard & Poor’s to raise Brazil to investment grade helps create the conditions for convertibility and the Central Bank would like to achieve this, there is strong government resistance because of the appreciation of the real.

And Brazil’s maddening tax regime is a double edged sword. It has driven foreigners into derivatives to avoid the headache of cash markets, but taxes applied on financial contracts are applied on a monthly basis, without any possibility of off-setting losses in one month against profits in another, for example. The tax regime is also unstable as the government’s recent moves to re-apply taxes on foreign investments in government bonds show.

Liquid established markets: FX and IR
Despite these hurdles, the juicy potential of the derivatives markets is clear and can most easily be seen in the FX and interest rate markets. In both cases, derivatives contracts far-outweigh spot market trading, a case of the tail wagging the dog. Trading in BRL/USD contracts is some five or six times that of the spot market thanks in part to restrictions on hedge and mutual funds in the cash markets, points out Mr Machado.

While liquidity is deep in the FX futures market, it only extends out to a couple of months, however. The length of contracts in the interest rate swap market have been extending out further and there’s good liquidity right up to five- to seven-years with the sweet spot concentrated at roughly two years, says Mr Machado.

The potential for further expansion remains strong. That’s particularly the case as Brazilian companies have been aggressive buyers of foreign assets, thanks to the strength of the real. Increasingly, they want to hedge future cash flows and debt payments. Indeed, the strong real has reversed the situation that prevailed between 1999-02, when the market was one sided with corporates clamouring for dollars, says Mr Maziero. Since 2003, the dollar has sunk from almost 4 to 1.67 to the real. That had driven the cost of protecting yourself against a dollar rise high. The futures market is now indicating that the real will probably retract with one-year contracts at 1.82 and that is leading to new products, including a call option that is free if the exchange rate is stable, but gets more expensive if the dollar passes certain thresholds, says Mr Maziero.

New markets: Equity derivatives and credit default swaps
While FX and rate contracts are common, Brazil is missing many of the more sophisticated capital markets derivatives products common in developed country markets because capital markets are so young.

The equity derivatives market is developing and the futures market for leading indices is sophisticated, but options have yet to develop critical mass, says Mr Figueiredo. The development of more diversified products, say futures on single shares, is constrained by a lack of liquidity. While the largest companies, such as Petrobras and Vale and to an extent telecom companies and some banks do have liquidity, most companies remain difficult to trade in size, making contracts expensive, he says.

“The equity market in Brazil was very marginal for 30 years, it’s only in the last five years that we have seen rapid development,” says Mr Figueiredo. That has seen daily liquidity spike from $300-500 million daily to today’s levels of more than $3 billion. In the next two years, liquidity should be strong enough to support more products, he predicts.

The liquidity of the equity markets has not yet been replicated in corporate bonds and the lack of credit default swap (CDS) products is a glaring example of a product hole. That will take time to change. The first step is to achieve more corporate bond issuance. It has been stymied because of high domestic interest rates and spreads. The S&P upgrade is raising hopes that both rates and spreads will fall and recently an issue by the Republic of Brazil priced inside triple-A rated General Electric. If S&P’s move is aped by another agency or agencies, which almost all Brazilian analysts expect before year-end, corporate bond issuance should grow and the CDS market will be ripe for take-off. Even then, a lot of new regulations need to be put in place to develop this market, cautions Mr Figueiredo.

Great expectations: the commodities market
The development of a commodities futures and options market in Brazil remains some way off, primarily thanks to low liquidity and ferocious competition. “It’s difficult to consider this a real market as it’s so small compared to Chicago, New York and London,” says Mr Maziero, who is one of the pioneers. “The BM&F has tried to develop agro contracts, but the market remains really small still and we don’t see any liquidity there,” adds Mr Figueiredo. The agricultural sector has been very informal with little access to capital or leverage with farmers selling straight to trading companies, such as Cargill, who hedge exposure in overseas markets, he adds.

The only contracts that have garnered volume on the BM&F are grains and cattle, adds Antonio Augusto Duva, manager of the soft commodities desk at BNP Paribas in São Paulo, adding that as contracts on cattle are non-deliverable, much of the interest is from speculators rather than producers. He adds that while soya and corn are starting to open up interest in sugar is negligible and appetite for ethanol is virtually nil. “Everyone trades abroad in these markets because of the liquidity there,” he notes.

There are efforts to stimulate the market in Brazil. The last couple of years has seen a growing volume of swaps concentrated in metals and in some agricultural products, particularly soya, says Mr Sant’Anna. And with commodity prices likely to face greater volatility in the short-term, now is a good time for development of the market, with growing interest from Brazilian producers, he points out. Mr Sant’Anna reasons that the OTC market will be the natural choice for Brazilian firms as funds are using exchanges to speculate on prices, distorting values. To get round the problem of low liquidity, in January a forward contract was launched that uses prices on the Chicago exchange as a benchmark, he adds.

Much of the effort by banks to generate interest is directed at packaging corporate loans with derivatives, but a lack of familiarity and some suspicion towards banks makes this an uphill battle. Itaú is working with sugar producers, seen as one of the most promising markets. The bank is testing out a number of products. It is keen to offer puts, which guarantee a minimum price to the producer, packaged with loans and Mr Maziero predicts that by year-end, he will have persuaded some of his clients to sign up. Other products clients might go for are commodity swaps into dollars or reais and products that offer lower interest rates if the price of sugar is low and higher rates if the price moves up, protecting producers on the downside and costing more only when profits are higher, he notes.

One of the difficulties is that responsibility for buying hedging protection typically lies with the sales and not the financial department at sugar producer, a department where financial sophistication typically remains more limited, Mr Maziero notes. Resistance from the sales area to yield responsibility to the financial division is a drag on interest overall, he notes.

“We think of ourselves as paediatricians. We have a customer base that doesn’t really understand the treatment they need. Our role is to explain it to them in a way they can understand,” says Mr Maziero. For all its vigour and progress, the Brazilian market has a lot of growing up to do.

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