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Page 1
Emerging Derivative Marketsmarket development and risk management issues
Oliver FratzscherThe World Bank
OECD- World Bank
Annual Bond Market Forum
3. June 2003
Page 2
Overview
A. Risk and Rewards of DerivativesB. Relative Size of Derivative MarketsC. Five Driving Factors of DerivativesD. Example KoreaE. Example BrazilF. Selected Policy Issues
500 BC Greece: Thales of Miletus – first option idea
1859 CBOT: first agricultural derivatives contract
Page 3
Confusion about D
D are hugely profitable ; but each winner finds a dumb looser (Brookings)
OTC regulation would stifle market creativity (SEC)
Notional values are not meaningful measures (FED)
Markets, not regulators should focus on risk management (Bankers)
D make full disclosure even more difficult (World Bank)
D can avoid prudential safeguards, manipulate accounting, build leverage (IMF)
D offer high leverage and cheap transaction costs (Financial Policy Forum)
D are used by only 5% of large banks (Economist)
D are financial weapons of mass destruction (Buffet)
D increase financial stability ; the more the better (Greenspan)
Page 4
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 5
Question
A. Only G-7 countriesB. Only OECD countriesC. G-7 plus Korea and SingaporeD. G-7 plus Korea, Singapore, Brazil,
and Mexico
Among the world’s 8 largest derivative Among the world’s 8 largest derivative exchanges,exchanges,
which countries do you think are which countries do you think are represented ?represented ?
Page 6
B. Size of Derivative Exchanges
0
100
200
300
400
500
600
700
800
900
mill
ion
co
ntra
cts
Eurex Euronext CME CBOE CBOT AMEX
Top-8 Derivative Exchanges (volume)
KSE: 855m (2001) ; 1930m (2002)Value $1,800 bn (#5)
KSE BM&F
BM&F: 101m (2002)Value $3,200 bn (#4)
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
CME S&P500
EurexDAX
CME Nasdaq
EurexSTOXX
EuronextCAC40
EuronextFTSE
OsakaNikkei
Top-8 Equity Index Futures (value)
bill
ion
US
$
KSE KOSPI
KSE: market-cap $216 bn (#14 ; 10% Tokyo, 60% Sydney)
Cash trading $593 bn (#12 ; 40% Tokyo, 200% Sydney)
Futures trading $1680 bn (#3 ; 200% Nikkei)
0
20
40
60
80
100
120
140
160
180
mill
ion
co
ntra
cts
CMEEuro$
EuronextEuribor
EuronextSterling
SGXEuro$
KOFEXKTB
MexderInterest
Top-8 Interest Rate Futures (volume)
BM&FDI-future
BM&F: DI-futures 44m (2001) ; 71m (2002)
Value $1,180 bn (DI) + $680 bn (DDI)
+ $850 bn (US$ futures)
Brazil: government dom debt $180 bn
BM&FDDI-$
0
100
200
300
400
500
600
700
800
900
bill
ion
US
$
BM&FUS$
CME Euro
CMEYen
CMECHF
CMECAD
CMEGBP
CMEMXP
Top-8 Currency Futures Exchanges (value)
Sources: FIBV (2001) ; KSE, KOFEX, BM&F (2002)
KOFEXUS$
KOFEX: $75 bn USD futures trading (#7)
KTB futures trading $1,120 bn (#6) + OTC
KTB cash trading $39 bn (Israel, Ireland)
Korea: government dom debt $100 bn
Page 7
Derivative Products
Key Driving Factors Capital flows Leverage Risk Management Liquidity Transaction Costs
JP Morgan Chase$ 27 trn
Non-Financials$ 20 trn
ChicagoEurexEuronextSGXBM&FKSE/KOFEX
Sources: BIS (June 2002) ; FIBV (Dec 2001)
(relative size may be misleading)40% annual growth rates
US: 35%
EU: 34%
Asia: 25%
OTC Derivative Markets
Interest
FX
Equity
Com
Credit
Other
$128 trn notional$ 5 trn market value
70%
14%
Exchange Traded Derivatives
Interest
G-Debt
Stocks
Com
FX
$29 trn notional$700 trn turnover
28%
62%
Equity-Index
Page 8
C. Driving factor: capital flows
57%25%
18%
41%
35%
24%
All countries
1997$14 trn
2001$21 trn
Cross-border capital flows
64%
21%
15%
54%
23%
23%
Developing countries
1997
2001
73%
16%
11%
52%
14%
34%
Asia-Pacific countries
1997
2001
Loans and deposits 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 9
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.
0% 50% 100% 150% 200%in percent of GDP
1970
1980
1990
1998
Institutional Investor Assets
G-7
Japan
US
Source: Davis and Steil “Institutional Investors” (2001)
Page 10
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
insurancesold $120 bn short credit derivatives (Fitch, 2003)
Counter-party risk concerns during crisesshift emphasis towards central counterparty
Page 11
Driving factor: liquidity
Liquidity premium: ST exchange vs. custom OTC Average annual turnover 25 times of underlying 95% of turnover accounted for by 5 MM futures 150 * turnover in Asian equity index options (KSE) Concentration among large banks, 5% non-financial
Turnover of exchange-traded derivatives(Quarterly BIS data, in US$ trillion)
Average 25Futures 46Options 11Interest 25Equity 25FX 30US 22EU 31Asia 38
Asia Equity Opt 150
Turnover ratios(times outstanding, 2001)
Source: BIS Quarterly Review (March 2003)
Page 12
Driving factor: transaction costs
0
20
40
60
%
Korea US Canada France Sweden Japan
On-line Trading Share
Sources: KSDA, Samsung Research (2001)
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
1997 1998 1999 2000 2001
HomeTradingSystem
WebTradingSystem
Korea
ServiceLaunch
Regulatory approval
Brokerderegulation Common Gateway
Interface trading
Delayed price quotes
Java / Active-Xbased trading
Real-time price quotes
Online share: 6% 25% 44% 53%
Fees
50 bpOnline = offline
25 bpOnline fees cut
15 bpCompetition
5 bpDeep Discount brokers
ContentTools
IPO, mutual funds
English version Program trading
1997 1998 1999 2000 2001
HomeTradingSystem
WebTradingSystem
Korea
ServiceLaunch
Regulatory approval
Brokerderegulation Common Gateway
Interface trading
Delayed price quotes
Java / Active-Xbased trading
Real-time price quotes
Online share: 6% 25% 44% 53%
Fees
50 bpOnline = offline
25 bpOnline fees cut
15 bpCompetition
5 bpDeep Discount brokers
ContentTools
IPO, mutual funds
English version Program trading
Page 13
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 14
Korean market growth
0
50
100
150
200
250
300
350
400
KR
W t
rill
ion
1999 2000 2001 2002-Sep
Commercial Banks' Leverage
Loans (outstanding)
Derivatives (notional)Regulatory Capital
Source : FSS monthly statistics (table 13)
0
2
4
6
8
10
12
KR
W t
rill
ion
1998 1999 2000 2001 2002-Sepannualized
Securities Firms Revenues
Derivatives (trading rev)
Commission (revenues)
Source : FSS monthly statistics (table 25)
0
2
4
6
8
10
12
KR
W t
rill
ion
1998 1999 2000 2001 2002Oct
Equity Derivatives Trading
Derivatives (daily average)
Cash (daily average)
Open Interest (mill contracts)
Source : KSE monthly statistics KOSPI200 futures & options
0
100
200
300
400
500
600
700
800
KR
W t
rill
ion
2000 2001 2002-Sep
OTC Derivatives Growth
Swaps (value outstanding)
OTC (value outstanding)
Source : FSS response to questionnaire (December 2002)
Page 15
Korean market assessment Notional size
outstanding(% market cap, % GDP)
Growth of leverage(OBS/assets, open interest)
Gross market value(% notional)
Netting of credit exposure(%, legal issues, collateral)
Concentration of credit risk(% top 5, credit quality)
Product characteristics(FX, equity, credit, duration)
Exchange infrastructure(margins, cushions, insurance)
Private sector risk mgmt(staff, systems, disclosure)
Supervision effectiveness(analysis, frequency, arbitrage)
Risk-based capital charges(level, consistency, profits)
USA JAP BIS 1 2 3 4 5
130% of GDP
[250%BIS]
200% growth in 24
months
Ø 3% value [1%US;
1.4%JAP]
Ø 14% [70%BIS,
52%JAP]
82% for top-5 banks
38% FX prod [14%
BIS&JAP]
Weak cushions
Strong investment
Remaining challenges
Low ratios
lower risk higher risk
for illustration only
Page 16
Korea: volatility and liquidity
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
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%.
Equity Market Volatility
0%
10%
20%
30%
40%
50%
60%
Jan
-96
Ma
r-9
6M
ay-
96
Jul-9
6S
ep
-96
No
v-9
6Ja
n-9
7M
ar-
97
Ma
y-9
7Ju
l-97
Se
p-9
7N
ov-
97
Jan
-98
Ma
r-9
8M
ay-
98
Jul-9
8S
ep
-98
No
v-9
8Ja
n-9
9M
ar-
99
Ma
y-9
9Ju
l-99
Se
p-9
9N
ov-
99
Jan
-00
Ma
r-0
0M
ay-
00
Jul-0
0S
ep
-00
No
v-0
0Ja
n-0
1M
ar-
01
Ma
y-0
1Ju
l-01
Se
p-0
1N
ov-
01
Jan
-02
Ma
r-0
2M
ay-
02
Jul-0
2S
ep
-02
KOR
HKGAUSSAFPOL
Futureslaunched
Asiancrisis
50% OnlineFutures
0%
10%
20%
30%
40%
50%
60%
Jan
-96
Ma
r-9
6M
ay-
96
Jul-9
6S
ep
-96
No
v-9
6Ja
n-9
7M
ar-
97
Ma
y-9
7Ju
l-97
Se
p-9
7N
ov-
97
Jan
-98
Ma
r-9
8M
ay-
98
Jul-9
8S
ep
-98
No
v-9
8Ja
n-9
9M
ar-
99
Ma
y-9
9Ju
l-99
Se
p-9
9N
ov-
99
Jan
-00
Ma
r-0
0M
ay-
00
Jul-0
0S
ep
-00
No
v-0
0Ja
n-0
1M
ar-
01
Ma
y-0
1Ju
l-01
Se
p-0
1N
ov-
01
Jan
-02
Ma
r-0
2M
ay-
02
Jul-0
2S
ep
-02
KOR
HKGAUSSAFPOL
0%
10%
20%
30%
40%
50%
60%
Jan
-96
Ma
r-9
6M
ay-
96
Jul-9
6S
ep
-96
No
v-9
6Ja
n-9
7M
ar-
97
Ma
y-9
7Ju
l-97
Se
p-9
7N
ov-
97
Jan
-98
Ma
r-9
8M
ay-
98
Jul-9
8S
ep
-98
No
v-9
8Ja
n-9
9M
ar-
99
Ma
y-9
9Ju
l-99
Se
p-9
9N
ov-
99
Jan
-00
Ma
r-0
0M
ay-
00
Jul-0
0S
ep
-00
No
v-0
0Ja
n-0
1M
ar-
01
Ma
y-0
1Ju
l-01
Se
p-0
1N
ov-
01
Jan
-02
Ma
r-0
2M
ay-
02
Jul-0
2S
ep
-02
KOR
HKGAUSSAFPOL
Futureslaunched
Asiancrisis
50% OnlineFutures .
1
4
11
D t
n
j
jtj
i
ii
n
j
jtjt URR
tjt
n
j
j
m
k
kj
i
ii
n
j
jtjt eAU
11
4
11
D
R t = d a i l y r e t u r n ; D i = d u m m y v a r i a b l e ; t - j = v o l a t i l i t y
U t = u n e x p e c t e d r e t u r n ; A k = v o l u m e a c t i v i t y ( O I )
.
1
4
11
D t
n
j
jtj
i
ii
n
j
jtjt URR
tjt
n
j
j
m
k
kj
i
ii
n
j
jtjt eAU
11
4
11
D
R t = d a i l y r e t u r n ; D i = d u m m y v a r i a b l e ; t - j = v o l a t i l i t y
U t = u n e x p e c t e d r e t u r n ; A k = v o l u m e a c t i v i t y ( O I )
Trading Equity Futures Open-Int Open-Int(2002, %) (value) (value) (short) (long)
Foreign 13.0% 5.0% 20.3% 22.0%Institution 16.0% 9.0% 11.9% 4.6%Securities 4.0% 38.0% 31.8% 10.5%Retail 67.0% 48.0% 32.2% 61.2%
Regressions and Statistics
Page 17
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 $20bn 80% of debt indexed to FX or I ; trading D parts separately Repo and D market liquidity is far larger than cash markets ON and D may be substitute for IB and cash bond markets Credit derivatives growing fast ; equity derivatives negligible BM&F established 3 guarantee funds ; seeks int’l insurance Strong margin systems ; but 90% collateral as Govt bonds Distortionary taxes: huge reserve requ , CPMF, D exempt BCB issuing FX swaps to meet bank & corp sector demand
Page 18
Brazil’s debt indexation
123456789
10
0 20 40 60 80 100 120 %
Public Debt Stock (% of GDP)R
eal I
nter
est
Rat
e (%
)Brazil
Chile
Colombia
Mexico
Hungary
Israel
PolandRussia
South Africa
Turkey
China
Hong Kong
IndiaIndonesiaMalaysia
Philippines
Singapore
Korea
% -6 -5 -4 -3 -2 -1
Fiscal Deficit (% of GDP)Brazil
Chile
Colombia
Mexico
Hungary
Israel
Poland
Russia
South Africa
Turkey
China
Hong Kong
India Indonesia
Malaysia
Philippines
Singapore
Korea
Absolute Levels (1994-2002)
0
100
200
300
400
500
600
700
Jul-9
4
Oct
-94
Jan
-95
Ap
r-9
5
Jul-9
5
Oct
-95
Jan
-96
Ap
r-9
6
Jul-9
6
Oct
-96
Jan
-97
Ap
r-9
7
Jul-9
7
Oct
-97
Jan
-98
Ap
r-9
8
Jul-9
8
Oct
-98
Jan
-99
Ap
r-9
9
Jul-9
9
Oct
-99
Jan
-00
Ap
r-0
0
Jul-0
0
Oct
-00
Jan
-01
Ap
r-0
1
Jul-0
1
Oct
-01
US$-Linked Nominal Zero-Duration Price-Level-Linked Others Duration Average remaining Life
0
100
200
300
400
500
600
700
Jul-9
4
Oct
-94
Jan
-95
Ap
r-9
5
Jul-9
5
Oct
-95
Jan
-96
Ap
r-9
6
Jul-9
6
Oct
-96
Jan
-97
Ap
r-9
7
Jul-9
7
Oct
-97
Jan
-98
Ap
r-9
8
Jul-9
8
Oct
-98
Jan
-99
Ap
r-9
9
Jul-9
9
Oct
-99
Jan
-00
Ap
r-0
0
Jul-0
0
Oct
-00
Jan
-01
Ap
r-0
1
Jul-0
1
Oct
-01
US$-Linked Nominal Zero-Duration Price-Level-Linked Others Duration Average remaining Life
100
bn
BR
L
Relative Shares (1996-2002)
Sources: Garcia (2002) ; Brazil STN (2002) ; Deutsche Bank (2002).
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
De
c-9
6
Ma
r-9
7
Jun
-97
Se
p-9
7
De
c-9
7
Ma
r-9
8
Jun
-98
Se
p-9
8
De
c-9
8
Ma
r -9
9
Jun
-99
Se
p-9
9
De
c-9
9
Ma
r -0
0
Jun
-00
Se
p-0
0
De
c-0
0
Ma
r -0
1
Jun
-01
Se
p-0
1
De
c-0
1
Ma
r-0
2
Jun
-02
SELIC NOMINAL FX-LINK INFLATION
Page 19
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 20
F. Future challenges1. 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).