Derivatives markets in Brazil
(Extract from page 75 of BIS Quarterly Review, December 2016)
Virtually alone among emerging economies, Brazil boasts relatively large and well developed onshore derivatives exchanges that trade FX and interest rate contracts in addition to stock and commodity instruments. Brazilian FX futures and options are non-deliverable, in that they are settled in domestic currency. A particular combination of factors gave rise to such a large derivatives market, where exchange-traded, both onshore and non-deliverable, transactions predominate.
The instability of the Brazilian economy has created strong demand for hedging instruments, contributing to the development of a large derivatives market. High and volatile inflation, in particular at the end of the 1980s and beginning of the 1990s, led to widespread inflation-indexing and volatile real interest rates, which fostered the demand for instruments to manage inflation and interest rate risks. In the second half of the 1990s, after the "Real Plan" succeeded in reducing inflation and stabilising the exchange rate, the private sector made greater use of lower-cost foreign currency borrowing. The resulting exposure to foreign debt incentivised the use of FX futures for hedging.
The Brazilian legal and regulatory framework puts constraints on over-the-counter (OTC) trading, thus encouraging the migration of trading to exchanges. Taxes levied on revenues and cash flows rather than income or value added create a bias towards a system in which profits and losses of individual contracts can be netted, thus reducing the tax burden.
This is the case on exchanges, where purchases and sales of the same contract can be offset against each other, but not in most OTC markets, where positions are closed by offsetting outstanding trades.
Restrictions on the use and trading of foreign currencies provide a further incentive for the use of derivatives as a substitute for cash transactions, while also explaining the preference for non-deliverable instruments settled in local currency. Access to the FX spot market is highly restricted, since only chartered banks have such authorisation. Also, local banks are not allowed to take deposits in foreign currency. In addition, the Brazilian real is not fully convertible and cannot be delivered outside the country, which precludes the development of a liquid (deliverable) offshore market.
Given its high liquidity, the FX futures market in Brazil is considered more developed than the spot market. The demand for hedges against exchange rate exposures is concentrated in the futures market, which in effect provides price discovery for the spot exchange rate.
The link between those two markets is established via "synthetic" operations, known as "casado" or "differential" transactions, which are used to match positions between them. In such operations, it is possible to buy or sell dollars in the spot market while simultaneously selling or buying the same amount of dollar/real futures.
The liquidity of FX derivatives markets has encouraged central bank intervention in these markets, which has in turn spurred further development of these markets. During the 1990s, when the real followed a crawling peg, the central bank intervened by selling US dollar futures through state-owned commercial banks as intermediaries.
Since 1999, when the floating regime was introduced, auctions of domestic non-deliverable currency swaps (the "swap cambial") to dealer banks have been very prominent. Another important intervention instrument has been the FX repo, which has been used to deal with liquidity shortages of FX cash, for example after the Great Financial Crisis. Derivatives-based interventions aim at providing liquidity in FX cash (eg repo) or a hedge (eg non-deliverable currency swap) to the private sector, without drawing, at least not definitively, on official FX reserves.
Owing to its depth and high level of development, the Brazilian derivatives market has been innovative and resilient to financial distress. During many episodes of financial turbulence, including the East Asian financial crisis (1997), the Russian debt moratorium (1998), the abandonment of the real peg (1999), the Argentine default (2001), the Great Financial Crisis (2007-09) and the recent fiscal and political crisis in Brazil (2015), the Brazilian derivatives market arguably helped prevent more serious financial distress or a credit crunch. It did so by providing low-cost, transparent and liquid trading vehicles for a wide range of customers (Dodd and Griffith-Jones (2007)). In particular, dealers, rather than taking market and counterparty risks on their own balance sheets, have been using the exchanges. The exchanges have maintained their prominent role by investing in efficiency improvements and have endeavoured to adopt international best practices. For example, they recently implemented a multimarket architecture that allows integrated risk management across a range of asset classes and contracts, as well as a post-trade integrated clearing house framework. This improves the netting of market risks and reduces the need for dealers to provide guarantees.
For more details, see Kohlscheen and Andrade (2014). Or are terminated; see Ehlers and Eren (2016). For details about price discovery in Brazilian FX markets, see Garcia, Medeiros and Santos (2014). For more about FX interventions in Brazil, see Garcia and Volpon (2014).