Emerging Derivative Markets market development and risk management issues

1. Emerging Derivative Marketsmarket development and risk management issues OECD- World Bank Annual Bond Market Forum 3. June 2003 Oliver Fratzscher The World Bank

2. Overview 500 BC Greece: Thales of Miletus – first option idea 1859 CBOT: first agricultural derivatives contract • Risk and Rewards of Derivatives • Relative Size of Derivative Markets • Five Driving Factors of Derivatives • Example Korea • Example Brazil • Selected Policy Issues

3. 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)

4. 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 A. Risk and Rewards of D

5. Question • Only G-7 countries • Only OECD countries • G-7 plus Korea and Singapore • G-7 plus Korea, Singapore, Brazil, and Mexico Among the world’s 8 largest derivative exchanges, which countries do you think are represented ?

6. Top-8 Derivative Exchanges (volume) Top-8 Equity Index Futures (value) KSE: 855m (2001) ; 1930m (2002) Value $1,800 bn (#5) 9,000 900 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) 8,000 800 BM&F: 101m (2002) Value $3,200 bn (#4) 7,000 700 6,000 600 5,000 500 billion US$ million contracts 4,000 400 3,000 300 2,000 200 1,000 100 0 0 KSE Eurex Euronext CME CBOE CBOT AMEX BM&F CME S&P500 Eurex DAX KSE KOSPI CME Nasdaq Eurex STOXX Euronext CAC40 Euronext FTSE Osaka Nikkei Top-8 Interest Rate Futures (volume) Top-8 Currency Futures Exchanges (value) 180 900 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 160 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 $100 bn 800 140 700 120 600 100 500 million contracts billion US$ 80 400 60 300 40 200 20 100 0 0 CME Euro$ Euronext Euribor BM&F DI-future Euronext Sterling SGX Euro$ KOFEX KTB Mexder Interest BM&F DDI-$ BM&F US$ CME Euro CME Yen CME CHF CME CAD CME GBP CME MXP KOFEX US$ Sources: FIBV (2001) ; KSE, KOFEX, BM&F (2002) B. Size of Derivative Exchanges

7. OTC Derivative Markets Exchange Traded Derivatives $128 trn notional $ 5 trn market value $29 trn notional $700 trn turnover US: 35% EU: 34% Asia: 25% JP Morgan Chase $ 27 trn Non-Financials $ 20 trn Chicago Eurex Euronext SGX BM&F KSE/KOFEX 28% 14% 70% 62% (relative size may be misleading) 40% annual growth rates Interest Interest FX G-Debt Key Driving Factors • Capital flows • Leverage • Risk Management • Liquidity • Transaction Costs Equity Equity-Index Com Stocks Credit Com Other FX Sources: BIS (June 2002) ; FIBV (Dec 2001) Derivative Products

8. Cross-border capital flows 2001 $21 trn 2001 2001 1997 $14 trn 23% 24% 1997 11% 1997 15% 18% 34% 41% 16% All Developing Asia-Pacific countries 52% 21% countries countries 57% 54% 25% 64% 73% 23% 35% 14% 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. C. Driving factor: capital flows

9. Institutional Investor Assets 1998 G-7 1990 Japan 1980 US 1970 0% 50% 100% 150% 200% in percent of GDP Source: Davis and Steil “Institutional Investors” (2001) Driving factor: leverage • Institutional investor assets exceed 100% of GDP • Investment bank leverage ø30 times (LTCM 300 times) • Capital incentives: discounts in Basle Capital Accord • Enabling regulation: FuturesModernizationAct (2000)deletion of real demand principle.

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

11. Turnover of exchange-traded derivatives (Quarterly BIS data, in US$ trillion) Turnover ratios (times outstanding, 2001) Average 25 Futures 46 Options 11 Interest 25 Equity 25 FX 30 US 22 EU 31 Asia 38 Asia Equity Opt 150 Source: BIS Quarterly Review (March 2003) 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

12. Korea Korea 1997 1998 1999 2000 2001 1997 1998 1999 2000 2001 On-line Trading Share Online share: 6% 25% 44% 53% Online share: 6% 25% 44% 53% % Regulatory approval Regulatory approval IPO, mutual funds IPO, mutual funds Home Trading System Home Trading System Content Tools Content Tools 60 English version English version 40 Program trading Program trading Service Launch Service Launch Fees Fees 20 5 bp Deep Discount brokers 5 bp Deep Discount brokers 15 bp Competition 15 bp Competition 50 bp Online = offline 50 bp Online = offline 25 bp Online fees cut 25 bp Online fees cut Web Trading System Web Trading System Broker deregulation Broker deregulation 0 Java / Active-X based trading Java / Active-X based trading Common Gateway Interface trading Common Gateway Interface trading Korea US Canada France Sweden Japan Sources: KSDA, Samsung Research (2001) Real-time price quotes Real-time price quotes Delayed price quotes Delayed price quotes 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

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

14. OTC Derivatives Growth Commercial Banks' Leverage 800 400 Swaps (value outstanding) Loans (outstanding) 700 350 Derivatives (notional) OTC (value outstanding) Regulatory Capital 600 300 500 250 KRW trillion KRW trillion 400 200 300 150 200 100 100 50 0 0 2000 2001 2002-Sep 1999 2000 2001 2002-Sep Source : FSS response to questionnaire (December 2002) Source : FSS monthly statistics (table 13) Equity Derivatives Trading Securities Firms Revenues 12 12 Derivatives (daily average) Derivatives (trading rev) 10 10 Cash (daily average) Commission (revenues) 8 8 Open Interest (mill contracts) KRW trillion KRW trillion 6 6 4 4 2 2 0 0 1998 1999 2000 2001 2002-Sep 1998 1999 2000 2001 2002Oct annualized Source : KSE monthly statistics KOSPI200 futures & options Source : FSS monthly statistics (table 25) Korean market growth

15. for illustration only lower risk higher risk 130% of GDP [250%BIS] 200% growth in 24 months Ø 3% value [1%US; 1.4%JAP] Ø14% [70%BIS, 52%JAP] 82% for top-5 banks 38% FX prod[14% BIS&JAP] Weak cushions Strong investment Remaining challenges Low ratios JAP BIS USA 1 2 3 4 5 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)

16. Equity Market Volatility Regressions and Statistics 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 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% 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

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

18. Absolute Levels (1994-2002) Relative Shares (1996-2002) 10 Brazil Turkey Brazil 9 Turkey Fiscal Deficit (% of GDP) Public Debt Stock (% of GDP) 8 Real Interest Rate (%) 7 Poland 6 Philippines Poland Philippines Hong Kong Hong Kong Russia 5 Israel Israel Russia South Africa India Indonesia 4 Colombia South Africa Colombia Indonesia Malaysia 3 Malaysia India Sources: Garcia (2002) ; Brazil STN (2002) ; Deutsche Bank (2002). 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’s debt indexation

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

20. 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 aszero-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 riskmay need to be enhanced (ISDA master, central clearing and counterparty). 9. Marginsystems could be tightened for leveraged members (dynamic, insurance).

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