Page 1

Emerging Derivative Marketsmarket development and risk management issues

Oliver FratzscherThe World Bank

OECD- World Bank

Annual Bond Market Forum

3. June 2003

Page 2

Overview

A. Risk and Rewards of DerivativesB. Relative Size of Derivative MarketsC. Five Driving Factors of DerivativesD. Example KoreaE. Example BrazilF. Selected Policy Issues

500 BC Greece: Thales of Miletus – first option idea

1859 CBOT: first agricultural derivatives contract

Page 3

Confusion about D

D are hugely profitable ; but each winner finds a dumb looser (Brookings)

OTC regulation would stifle market creativity (SEC)

Notional values are not meaningful measures (FED)

Markets, not regulators should focus on risk management (Bankers)

D make full disclosure even more difficult (World Bank)

D can avoid prudential safeguards, manipulate accounting, build leverage (IMF)

D offer high leverage and cheap transaction costs (Financial Policy Forum)

D are used by only 5% of large banks (Economist)

D are financial weapons of mass destruction (Buffet)

D increase financial stability ; the more the better (Greenspan)

Page 4

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

Page 5

Question

A. Only G-7 countriesB. Only OECD countriesC. G-7 plus Korea and SingaporeD. G-7 plus Korea, Singapore, Brazil,

and Mexico

Among the world’s 8 largest derivative Among the world’s 8 largest derivative exchanges,exchanges,

which countries do you think are which countries do you think are represented ?represented ?

Page 6

B. Size of Derivative Exchanges

0

100

200

300

400

500

600

700

800

900

mill

ion

co

ntra

cts

Eurex Euronext CME CBOE CBOT AMEX

Top-8 Derivative Exchanges (volume)

KSE: 855m (2001) ; 1930m (2002)Value $1,800 bn (#5)

KSE BM&F

BM&F: 101m (2002)Value $3,200 bn (#4)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

CME S&P500

EurexDAX

CME Nasdaq

EurexSTOXX

EuronextCAC40

EuronextFTSE

OsakaNikkei

Top-8 Equity Index Futures (value)

bill

ion

US

$

KSE KOSPI

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)

0

20

40

60

80

100

120

140

160

180

mill

ion

co

ntra

cts

CMEEuro$

EuronextEuribor

EuronextSterling

SGXEuro$

KOFEXKTB

MexderInterest

Top-8 Interest Rate Futures (volume)

BM&FDI-future

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

BM&FDDI-$

0

100

200

300

400

500

600

700

800

900

bill

ion

US

$

BM&FUS$

CME Euro

CMEYen

CMECHF

CMECAD

CMEGBP

CMEMXP

Top-8 Currency Futures Exchanges (value)

Sources: FIBV (2001) ; KSE, KOFEX, BM&F (2002)

KOFEXUS$

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

Page 7

Derivative Products

Key Driving Factors Capital flows Leverage Risk Management Liquidity Transaction Costs

JP Morgan Chase$ 27 trn

Non-Financials$ 20 trn

ChicagoEurexEuronextSGXBM&FKSE/KOFEX

Sources: BIS (June 2002) ; FIBV (Dec 2001)

(relative size may be misleading)40% annual growth rates

US: 35%

EU: 34%

Asia: 25%

OTC Derivative Markets

Interest

FX

Equity

Com

Credit

Other

$128 trn notional$ 5 trn market value

70%

14%

Exchange Traded Derivatives

Interest

G-Debt

Stocks

Com

FX

$29 trn notional$700 trn turnover

28%

62%

Equity-Index

Page 8

C. Driving factor: capital flows

57%25%

18%

41%

35%

24%

All countries

1997$14 trn

2001$21 trn

Cross-border capital flows

64%

21%

15%

54%

23%

23%

Developing countries

1997

2001

73%

16%

11%

52%

14%

34%

Asia-Pacific countries

1997

2001

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.

Page 9

Driving factor: leverage

Institutional investor assets exceed 100% of GDP Investment bank leverage ø 30 times (LTCM 300 times)

Capital incentives: discounts in Basle Capital Accord

Enabling regulation: Futures Modernization Act (2000)deletion of real demand principle.

0% 50% 100% 150% 200%in percent of GDP

1970

1980

1990

1998

Institutional Investor Assets

G-7

Japan

US

Source: Davis and Steil “Institutional Investors” (2001)

Page 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

Page 11

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

Turnover of exchange-traded derivatives(Quarterly BIS data, in US$ trillion)

Average 25Futures 46Options 11Interest 25Equity 25FX 30US 22EU 31Asia 38

Asia Equity Opt 150

Turnover ratios(times outstanding, 2001)

Source: BIS Quarterly Review (March 2003)

Page 12

Driving factor: transaction costs

0

20

40

60

%

Korea US Canada France Sweden Japan

On-line Trading Share

Sources: KSDA, Samsung Research (2001)

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

1997 1998 1999 2000 2001

HomeTradingSystem

WebTradingSystem

Korea

ServiceLaunch

Regulatory approval

Brokerderegulation Common Gateway

Interface trading

Delayed price quotes

Java / Active-Xbased trading

Real-time price quotes

Online share: 6% 25% 44% 53%

Fees

50 bpOnline = offline

25 bpOnline fees cut

15 bpCompetition

5 bpDeep Discount brokers

ContentTools

IPO, mutual funds

English version Program trading

1997 1998 1999 2000 2001

HomeTradingSystem

WebTradingSystem

Korea

ServiceLaunch

Regulatory approval

Brokerderegulation Common Gateway

Interface trading

Delayed price quotes

Java / Active-Xbased trading

Real-time price quotes

Online share: 6% 25% 44% 53%

Fees

50 bpOnline = offline

25 bpOnline fees cut

15 bpCompetition

5 bpDeep Discount brokers

ContentTools

IPO, mutual funds

English version Program trading

Page 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

Page 14

Korean market growth

0

50

100

150

200

250

300

350

400

KR

W t

rill

ion

1999 2000 2001 2002-Sep

Commercial Banks' Leverage

Loans (outstanding)

Derivatives (notional)Regulatory Capital

Source : FSS monthly statistics (table 13)

0

2

4

6

8

10

12

KR

W t

rill

ion

1998 1999 2000 2001 2002-Sepannualized

Securities Firms Revenues

Derivatives (trading rev)

Commission (revenues)

Source : FSS monthly statistics (table 25)

0

2

4

6

8

10

12

KR

W t

rill

ion

1998 1999 2000 2001 2002Oct

Equity Derivatives Trading

Derivatives (daily average)

Cash (daily average)

Open Interest (mill contracts)

Source : KSE monthly statistics KOSPI200 futures & options

0

100

200

300

400

500

600

700

800

KR

W t

rill

ion

2000 2001 2002-Sep

OTC Derivatives Growth

Swaps (value outstanding)

OTC (value outstanding)

Source : FSS response to questionnaire (December 2002)

Page 15

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)

USA JAP BIS 1 2 3 4 5

130% of GDP

[250%BIS]

200% growth in 24

months

Ø 3% value [1%US;

1.4%JAP]

Ø 14% [70%BIS,

52%JAP]

82% for top-5 banks

38% FX prod [14%

BIS&JAP]

Weak cushions

Strong investment

Remaining challenges

Low ratios

lower risk higher risk

for illustration only

Page 16

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

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%.

Equity Market Volatility

0%

10%

20%

30%

40%

50%

60%

Jan

-96

Ma

r-9

6M

ay-

96

Jul-9

6S

ep

-96

No

v-9

6Ja

n-9

7M

ar-

97

Ma

y-9

7Ju

l-97

Se

p-9

7N

ov-

97

Jan

-98

Ma

r-9

8M

ay-

98

Jul-9

8S

ep

-98

No

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8Ja

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9M

ar-

99

Ma

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Jan

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Jul-0

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Jan

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Ma

r-0

2M

ay-

02

Jul-0

2S

ep

-02

KOR

HKGAUSSAFPOL

Futureslaunched

Asiancrisis

50% OnlineFutures

0%

10%

20%

30%

40%

50%

60%

Jan

-96

Ma

r-9

6M

ay-

96

Jul-9

6S

ep

-96

No

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n-9

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Ma

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Jan

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No

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Jan

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Jul-0

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No

v-0

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ar-

01

Ma

y-0

1Ju

l-01

Se

p-0

1N

ov-

01

Jan

-02

Ma

r-0

2M

ay-

02

Jul-0

2S

ep

-02

KOR

HKGAUSSAFPOL

0%

10%

20%

30%

40%

50%

60%

Jan

-96

Ma

r-9

6M

ay-

96

Jul-9

6S

ep

-96

No

v-9

6Ja

n-9

7M

ar-

97

Ma

y-9

7Ju

l-97

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97

Jan

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8M

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Jul-9

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No

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Ma

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Jul-0

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-00

No

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01

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01

Jan

-02

Ma

r-0

2M

ay-

02

Jul-0

2S

ep

-02

KOR

HKGAUSSAFPOL

Futureslaunched

Asiancrisis

50% OnlineFutures .

1

4

11

D t

n

j

jtj

i

ii

n

j

jtjt URR

tjt

n

j

j

m

k

kj

i

ii

n

j

jtjt eAU

11

4

11

D

R t = d a i l y r e t u r n ; D i = d u m m y v a r i a b l e ; t - j = v o l a t i l i t y

U t = u n e x p e c t e d r e t u r n ; A k = v o l u m e a c t i v i t y ( O I )

.

1

4

11

D t

n

j

jtj

i

ii

n

j

jtjt URR

tjt

n

j

j

m

k

kj

i

ii

n

j

jtjt eAU

11

4

11

D

R t = d a i l y r e t u r n ; D i = d u m m y v a r i a b l e ; t - j = v o l a t i l i t y

U t = u n e x p e c t e d r e t u r n ; A k = v o l u m e a c t i v i t y ( O I )

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%

Regressions and Statistics

Page 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

Page 18

Brazil’s debt indexation

123456789

10

0 20 40 60 80 100 120 %

Public Debt Stock (% of GDP)R

eal I

nter

est

Rat

e (%

)Brazil

Chile

Colombia

Mexico

Hungary

Israel

PolandRussia

South Africa

Turkey

China

Hong Kong

IndiaIndonesiaMalaysia

Philippines

Singapore

Korea

% -6 -5 -4 -3 -2 -1

Fiscal Deficit (% of GDP)Brazil

Chile

Colombia

Mexico

Hungary

Israel

Poland

Russia

South Africa

Turkey

China

Hong Kong

India Indonesia

Malaysia

Philippines

Singapore

Korea

Absolute Levels (1994-2002)

0

100

200

300

400

500

600

700

Jul-9

4

Oct

-94

Jan

-95

Ap

r-9

5

Jul-9

5

Oct

-95

Jan

-96

Ap

r-9

6

Jul-9

6

Oct

-96

Jan

-97

Ap

r-9

7

Jul-9

7

Oct

-97

Jan

-98

Ap

r-9

8

Jul-9

8

Oct

-98

Jan

-99

Ap

r-9

9

Jul-9

9

Oct

-99

Jan

-00

Ap

r-0

0

Jul-0

0

Oct

-00

Jan

-01

Ap

r-0

1

Jul-0

1

Oct

-01

US$-Linked Nominal Zero-Duration Price-Level-Linked Others Duration Average remaining Life

0

100

200

300

400

500

600

700

Jul-9

4

Oct

-94

Jan

-95

Ap

r-9

5

Jul-9

5

Oct

-95

Jan

-96

Ap

r-9

6

Jul-9

6

Oct

-96

Jan

-97

Ap

r-9

7

Jul-9

7

Oct

-97

Jan

-98

Ap

r-9

8

Jul-9

8

Oct

-98

Jan

-99

Ap

r-9

9

Jul-9

9

Oct

-99

Jan

-00

Ap

r-0

0

Jul-0

0

Oct

-00

Jan

-01

Ap

r-0

1

Jul-0

1

Oct

-01

US$-Linked Nominal Zero-Duration Price-Level-Linked Others Duration Average remaining Life

100

bn

BR

L

Relative Shares (1996-2002)

Sources: Garcia (2002) ; Brazil STN (2002) ; Deutsche Bank (2002).

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

De

c-9

6

Ma

r-9

7

Jun

-97

Se

p-9

7

De

c-9

7

Ma

r-9

8

Jun

-98

Se

p-9

8

De

c-9

8

Ma

r -9

9

Jun

-99

Se

p-9

9

De

c-9

9

Ma

r -0

0

Jun

-00

Se

p-0

0

De

c-0

0

Ma

r -0

1

Jun

-01

Se

p-0

1

De

c-0

1

Ma

r-0

2

Jun

-02

SELIC NOMINAL FX-LINK INFLATION

Page 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

Page 20

F. Future challenges1. 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 as zero-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 risk may need to be enhanced (ISDA master, central clearing and counterparty).

9. Margin systems could be tightened for leveraged members (dynamic, insurance).

Page 21

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