Recent trends and challenges in OTC derivatives in

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• Recent trends and challenges in OTC derivatives
  in
• emerging market countries
• XI Treasury Congress - OTC Derivatives and
  agenda for development
• September 11-12, 2008
• Cartagena de Indias, Colombia
• Zsófia Árvai
• International Monetary Fund
• Monetary and Capital Markets Department

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Disclaimer

• The views expressed herein are those of the
  author and should not be attributed to the IMF,
  its Executive Board, or its management.

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Outline

• I. Recent developments in emerging market OTC
  derivative markets
• II. Key factors behind the growth of emerging
  derivative markets
• Global integration
• Local factors
• III. Challenges and obstacles to sound
  derivatives market development in emerging market
  countries (EM)

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I. Recent developments in emerging market OTC
derivative markets
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Main features of EM OTC derivatives markets

• With some notable exceptions such as Korea,
  Brazil, OTC derivatives markets are more
  developed than exchange-traded derivatives in
  most EM countries
• Spectacular growth over the past decade
• US625 trillion (trade volume) at end-2007 vs.
  US6,150 trillion in mature markets
• Composition of OTC derivatives different in
  emerging market and mature market (MM) countries
  (2007 BIS data)
• EM interest rate 9 and FX products 81 swaps
• Japan, UK, US interest rate 51 and FX 49 -
  swaps

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OTC FX derivatives EM Positive correlation
between FX OTC derivatives market turnover and
economy size, as well as income level
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OTC FX derivatives - swaps
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OTC FX derivatives Regional differences

• Latin America FX forwards with local
  counterparties dominate in most countries, FX
  swap activity low (Mexico accounts for almost
  all)
• Emerging Europe FX swaps dominate (used for
  liquidity management by banks and for taking
  positions in local bonds by foreign investors)
  high global integration through the London market
• Emerging Asia more balanced (does not include
  Korea)

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FX Derivatives Latin America

• longer history of FX derivatives than in other EM
  regions, significant exchange-based trading
  (Mexico and Brazil)
• increasing volatility of exchange rates
• gradual relaxation of regulatory restrictions on
  products and investors (pension funds use of
  derivatives in Chile and Mexico)
• large share of foreign investors in local capital
  markets in Brazil and Mexico

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FX Derivatives Emerging Asia

• negligible share of exchange-based trading
• more flexible exchange rates following the
  1997/98 financial crisis, and gradual dismantling
  of FX restrictions and capital controls
• very high growth Korea, India, and Taiwan POC
• volumes are similar to that of small and
  medium-sized European economies suggesting
  further large growth potential for emerging Asian
  markets

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FX Derivatives Emerging Europe

• increasing exchange rate flexibility since
  end-1990s
• EU membership elimination of capital account
  restrictions
• very high share of foreign ownership in banking
  sectors facilitates global integration
• deepening of local capital markets
• very high growth of turnover everywhere, esp. in
  Russia and Turkey in recent years

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Colombias OTC FX forward turnover is relatively
high in its peer group...
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...however, it ranks very low in terms of FX swap
turnover as do other Latin American countries
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OTC cross-currency swaps
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Interest Rate Derivatives

• Much smaller share of OTC trading than FX
  derivatives (different from MM), but very high
  growth. Reasons
• gradually deepening EM underlying money and bond
  markets, but still only a handful of EM countries
  have deep and liquid secondary bond markets
• significant extension of yield curves
• higher domestic interest rate variability related
  to more active interest rate policies, such as
  inflation-targeting regimes

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OTC interest rate derivatives Regional
differences

• IR derivatives have been growing rapidly in
  recent years
• Emerging Asia IR swaps dominate (India and
  Taiwan)
• Emerging Europe more balanced, higher FRAs
  (Czech Republic, Hungary, Poland), very high
  share of cross-border transactions
• Latin America Predominantly IR swaps (Mexico
  accounts for nearly all)
• Other EMEA Very similar to EME (South Africa,
  same foreign investors)

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OTC interest rate derivatives - swaps
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Latin American countries generally have less
developed OTC interest rate derivatives markets
compared to their EM peers
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II. Key factors behind the growth of emerging
derivative markets

• Global integration
• Local factors

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Key common driving forces increasing integration
of emerging markets into the global financial
system and local capital market deepening

• Derivative markets play a very important role in
  deepening the various segments of emerging local
  capital markets by attracting foreign investors
  and enabling them to hedge and take speculative
  FX, interest rate and stock market positions in
  the local market.
• Growth of EM derivatives markets is due to
  mutually reinforcing effects of
• increased foreign participation in local capital
  markets emerging market countries
• rising foreign asset holdings of emerging market
  investors
• and the deepening of emerging derivative and
  underlying capital markets

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The role of global integration in EM derivatives
market development I

• International diversification of portfolios of
  both mature and emerging market investors
• relaxation of investment restrictions on
  institutional investors
• low interest rate environment in MM
• ? increased the need for hedging
• ? intensified investors speculative activity
  both in underlying markets and through
  derivatives as access instruments to gain
  exposure to emerging markets
• Rising foreign ownership in emerging market
  banking systems
• brought financial innovation and more
  sophisticated risk management techniques
• strengthened the link between offshore and
  onshore markets through subsidiaries or branches
  of foreign banks

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The role of global integration in EM derivatives
market development II

• Major financial centers such as London, New York,
  Hong Kong and Singapore have played a major role
  in fostering the global integration of emerging
  derivatives and capital markets
• centralized resources, market makers and research
  in emerging market derivatives worked towards
  multiplying liquidity in these derivatives
• Increasing international trade contributed
  significantly to emerging derivative market
  development through the rising demand for hedging
  

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As a result, global integration of EM OTC markets
is now relatively high

• Same foreign market makers (on-/off-shore) ?
  share of cross-border trading approaching that in
  MM, though cross-border OTC trading in Latin
  America is lower than EMEA and most of Emerging
  Asia.
• FX Trading Activity with Foreign Dealers

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The role of local factors in EM derivatives
market development I

• Major progress in developing underlying local
  bond and equity markets in EM countries
• improved macroeconomic management and
  fundamentals
• lengthening of yield curves
• higher growth rates encouraging firms raise
  capital in the local equity market
• Improved corporate governance and securities
  regulation and supervision

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The role of local factors in EM derivatives
market development II

• Relaxation of foreign exchange and capital
  account restrictions in many EM countries
• nevertheless, a number countries continue to
  maintain capital account restrictions and
  administrative or taxation barriers to capital
  inflows, or restrictions on nonresidents
  transactions in the local currency
• Higher volatility of exchange rates and interest
  rates due to more flexible exchange rate
  frameworks and more active monetary policies
• rise of hedging demand against volatility and
  rising speculative activity on the back of
  volatility

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The role of local factors in EM derivatives
market development III

• Foreign investments by the growing institutional
  investor base in emerging countries
• increased their demand for hedging and provided
  derivatives dealers with counterparties to
  offload their exposures incurred with other
  customers
• Emerging market derivative market legal
  framework, regulation and supervision
  significant improvements have been made, but much
  remains to be done
• legal certainty related to contract
  enforceability
• regulatory measures to curb counterparty risk
  and overall improved bankruptcy procedures

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III. Challenges and obstacles to sound
derivatives market development in EM

• Transparency
• Legal and regulatory framework
• Operational and credit risk

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Transparency

• Timely and detailed information on off-shore
  trading of EM derivatives is seriously lacking,
  with potential negative implications for
• global and local financial stability and the
  supervision of domestic financial entities
• making informed monetary and exchange rate policy
  decisions
• Transparency of trading by domestic entities is
  easier to enforce, but it is usually a smaller
  share of overall trading

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Legal and regulatory framework

• Derivatives market development has been set back
  in several EM countries by
• lack of a clear legal environment for derivative
  contracts
• bankruptcy laws that do not allow netting
• strict limits on derivative use by institutional
  investors
• confining the use derivatives to hedging of
  actual exposures and strict restrictions on
  speculative activity
• foreign exchange and capital account restrictions

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Operational and credit risk

• A robust and regulated infrastructure is
  essential
• transparent accounting standards aligned with
  international accounting standards
• reliable tax regimes that ensure the equitable
  treatment of cash and derivatives trades
• Many exchange-based mechanisms now used in OTC
  derivative markets
• requiring collateral and margins, and allowing
  only highly rated entities to engage in OTC
  transactions
• using OTC trading platforms to display price
  information (and centralized clearing in some
  instances), requiring market makers to provide
  two-way quotes continuously
• copying disclosure practices used for futures
  markets

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Thank you for your attention!