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Emerging Derivative Markets market development and risk management issues. OECD- World Bank Annual Bond Market Forum 3. June 2003. Oliver Fratzscher The World Bank. Overview. 500 BC Greece: Thales of Miletus – first option idea 1859 CBOT: first agricultural derivatives contract.

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emerging derivative markets market development and risk management issues

Emerging Derivative Marketsmarket development and risk management issues

OECD- World Bank

Annual Bond Market Forum

3. June 2003

Oliver Fratzscher

The World Bank

overview
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
confusion about d
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)

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

A. Risk and Rewards of D
question
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 ?

b size of derivative exchanges

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
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%

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
c driving factor capital flows

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
driving factor leverage

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.
driving factor risk management
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
driving factor liquidity

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
driving factor transaction costs

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
d market overview for korea
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
korean market growth

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
korean market assessment

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)
korea volatility and liquidity

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
e market overview for brazil
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
brazil s debt indexation

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
risk management issues
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
f future challenges
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).

slide21

Thank you !

www.worldbank.org/finance