Analysis of Brazil's Derivatives Market

Analysis of Brazils Derivatives Market Brazils derivative market has enormous contribution to the economy itself and the
central bank include it in making their macroeconomic policies. More than the sheer volume of transaction, the importance of any branch or economic activity depends on the economic function that this activity performs in the economy. Derivative market helps to achieve two functions ie price discovery and risk shifting also called hedging. Therefore economic function and impact of contribution is more important than size. This study identifies some important features of Brazils derivatives markets and how they were shaped by the regulatory framework. It thereby serves as policy advice to other countries who are grappling with the question of how to properly regulate these relatively new but increasingly important financial transactions. Some of these key features and their related policy measures include the following.
Improved transparency and greatly improved surveillance of OTC derivatives markets through the regulatory requirement to report all such transactions to designated regulatory authorities.
Many financial institutions that participate in the derivatives markets use modern risk management models to monitor their risk exposures. The central bank has been helpful in constructing such models and providing them for free to financial institutions. This especially helps the smaller financial institutions who have fewer resources to maintain their own research departments.
The inter-dealer market in derivatives transactions is conducted through the BMF instead of through OTC transactions. The consequence is to greatly reduce the interdependence of Brazils major financial institutions through inter-locking derivatives transactions and credit exposures. In its place are netted derivatives positions that offer AAA rated credit exposure through the exchange clearing house.
This study also provides a macroeconomic policy analysis of the key questions raised by derivatives markets for developing economies financial systems. One important question is whether the presence and significant use of derivatives markets, especially in exchange rate and interest rate derivatives, affects the stability of capital flows and the exchange rate. Another
important question is whether the central bank can, or should, use derivatives markets for the purpose of intervention as part of their exchange rate policy.
The conclusions from addressing the first policy question include the following.
Derivatives markets can facilitate international capital flows if they offer a dependable means of hedging unwanted aspects of the risky investment, such as currency risk or interest rate risk.
There are some pro-cyclical consequences of derivatives markets. This arises in part because of firms who wait until the economic situation begins to deteriorate before engaging in hedging strategies then sell in order to short-hedge. In this way a decline in the local currency can generate a spurt of short-selling in the derivatives market to hedge against further declines, and this additional selling will further lower the value of the currency on foreign exchange markets. Foreign investors conducting carry transactions can also add to pro-cyclical movements as they buy when the currency appreciates and unwind by selling when the currency weakens.
Given the important evidence that a stable and competitive exchange rate is one of the key variables determining growth, and given that derivatives seem to make Central Bank intervention in the foreign exchange market less effective, there is a strong case that regulation of derivatives should be done not just from a clearly important prudential perspective but also to keep open space for more effective Central Bank intervention, when this is desirable from a broader macro-economic and growth perspective.
Hedging international capital investments through derivatives markets can result in offsetting capital outflows, but this need not necessarily occur. If the local derivatives markets is two sided such that both long and short positions can be risk managed without offsetting cross-border transactions as is the case in Brazil and to a great extent in Chile then there will not be offsetting capital outflows. Similarly, central bank intervention into the foreign exchange derivatives markets can end up accommodating more speculative activity which would otherwise generate capital flows or in a balanced market be met with contrary interest in investing in the opposite position.
Derivatives market are used for speculation as well as hedging. In so far that they are used for hedging then there usually is a clear economic benefit (clearly so at the
microeconomic level, and at the macroeconomic level when they do not operate procyclically). The potential negative economic consequences of speculation depend largely on how it is conducted and whether it creates significant amounts of systemic risk, and whether large losses due to market risk or credit risk would have an impact on the overall economy.
In regards to the question of central bank intervention, including through the derivatives markets,
Central bank interventions can be effective, but there are limitations. It is difficult for interventions to successfully reverse a trend for a long period. However they can slow the trend for an intermediate-term and smooth short-term fluctuations along the path. For example, central bank interventions in Brazil during late 2006 and early 2007 served to slow the appreciation of the real and dampen the impact of large transactions crossing the spot currency market.
Central banks can be highly effective in providing hedging opportunities to financial and non-financial firms, thus protecting the economy from large exchange rate fluctuations. In doing so, the central bank needs to take steps to avoid creating greater speculative opportunities, thus reducing the cost and increasing the effectiveness of such interventions.. This can be achieved through changes in capital requirements (e.g. more restrictive limits on foreign exchange exposure as percentage of capital) and collateral (margin) requirements on outstanding foreign exchange position.

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Analysis of Brazils Derivatives Market Brazils derivative market has enormous contribution to the economy itself and the

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