By Henry Davis
Latin America lags other regions when it comes to financial risk management practices – and it needs to change its ways. Only Mexico and Brazil stand out
Over the past decade, Mexico and Brazil, along with China and India, have established themselves as among the best-performing developing economies in the world – aided by relatively stable currencies, prudent monetary and fiscal policies and little threat of political disturbance.
It is therefore hardly surprising that Mexico and Brazil have led the rest of Latin America in developing their capital markets, risk management techniques, and derivative instruments. In these two countries, the combination of organized derivatives exchanges and robust over- the-counter (OTC) markets lets local banks and corporations satisfy a large part of their interest rate and currency hedging needs onshore, and institutional steps are being taken to broaden the markets by helping spread various market and credit risks to international investors.
Financial risk management practices in the rest of Latin America are less developed. Chile has a reasonably liquid interest rate market up to five years, including inflation-fixed and inflation-floating swaps, according to Diego Ferro, a managing director who runs local market Latin American trading for Morgan Stanley.
Also, corporations are starting to borrow abroad and, notes Thierry Wizman, emerging market strategist at Bear Stearns, more liberal regulations are allowing pension funds to direct more of their investments to international markets. But, Ferro says, Chile historically has not had a very active derivative market because it has been fairly hedged within itself.
Argentina has a history of trading in commodity derivatives that dates back to the early 20th century. It had an active financial derivatives market in the 1990s, but there has been little activity since the massive sovereign debt default and subsequent restructuring. Investors who got burned have yet to have their confidence restored, says Nikhil Bhandiwad, a vice-president responsible for structured products trading at Banco Santander in New York. In Peru, Colombia and other Latin American countries, there are OTC derivatives transactions “by appointment”, but there is not really what one would call a “market”, says Ferro.
Mexico
Among Latin American capital markets, Mexico is the most developed. Mexico has done a good job in developing its local capital markets since the 1994-5 Tequilla crisis, when the yield curve was much shorter than it is today, says Esteban Mofino, chief of funding at the IDB.
Mexico now has a 20-year bond, and a swap market has developed on the back of the bond market. Five years ago, regular 10-year quotes on Mexican interest rate and currency swaps would have seemed like “science fiction”, says Ferro, but now there is a liquid curve going out to 10 years, and 15- and 20-year prices can be obtained depending on circumstances. It is in this context that the IDB did its first-ever bond issue denominated in a Latin American currency in April 2004 by issuing a Mexican peso-denominated bond.
Credit risk remains an issue, says Ferro, but Mexico has a well-developed counter-party documentation system. Mexican participants have been proactive in making sure their collateral agreements are consistent with International Swaps and Derivatives Association (ISDA) practice, thereby helping the liquidity of the Mexican swap market.
While the great majority of wholesale derivatives activity in Mexico is OTC, Mexico also has an organized derivatives market known as the MexDer (Mercado Mexicano de Derivados), which began operations in late 1998. MexDer and its triple-A-rated clearing house are self-regulatory entities that operate under the supervision of the ministry of finance and public credit (SHCP), the Banco de Mexico, and the National Banking and Securities Commission (CNBV).
The financial products traded on the MexDer are Mexican peso/US dollar futures; Mexican stock exchange price and quotations Index (IPC) futures; debt futures (91-day Cetes, 28-day TIEE, three-year bond, ten-year bond, and inflation-linked investment units); individual stock futures; IPC options; and one individual stock option.
Today the peso is considered a convertible currency, and there is little separation between the Mexican onshore and offshore markets, says Dolores Lopez-Larroy, senior funding officer at the IDB. Mexican peso derivatives are traded on the Chicago Mercantile Exchange as well as the MexDer, and those markets are sufficiently liquid that there is little or no arbitrage between the two.
Brazil
In contrast to Mexico, most of Brazil’s derivatives activity is through the BM&F (Boisa de Mercadorias & Futuros). Launched in 1986, the BM&F is now the world’s 11th largest exchange. Its products include foreign currency futures (a $50,000 cash-settled dollar contract), futures on the Bovespa stock index, and interest rate futures (a one-day interbank deposit futures contract and a contract on the onshore US dollar interest rate called the Cupom Cambial).
BM&F’s success can be attributed not only to its products but also to the way it manages its credit risks, says Mark Yale, head of Latin America derivatives marketing and structuring at HSBC in New York. BM&F’s derivatives clearing house, similar to that of the MexDer, measures the risk of each member and customer throughout the day and can call for additional collateral when necessary.
International weaknesses
One of the BM&F’s strengths is also a weakness. A daily price-adjustment mechanism designed to cope with hyperinflation helped it survive different regimes of pegged currency, freely floating currency and high and low inflation, says Ferro. The exchange was already in position with the appropriate hedging instruments when the real began to float in 1999. However, that price-adjustment mechanism and other local margin-posting and settlement conventions are out of synch with international practice, cautions John Mathias, director of financial futures and options at Merrill Lynch in London.
For a listed derivatives market like the BM&F to grow and mature, says Mathias, it needs to be open to international players. To do that, however, Brazil has a few problems to solve. Because registration requirements to buy domestic Brazilian financial instruments are cumbersome and time consuming, international brokers and investors often postpone consideration of Brazil in favour of other markets. Other investors are put off by the relative complexity of transaction, cross-border profit-remittance, and dividend taxes.
And Mexico has its own problems catering to international investors, says Mathias. For example, because of problems related to an exchange-of-information clause in Mexico’s tax treaties with Germany and the UK, Mexican withholding taxes on derivatives instruments held by German and British investors are far higher than they should be. All of this is surmountable but takes time, he explains, and these markets are not yet sufficiently dominant in the world marketplace to be able to count on attracting investors.
One of the factors helping connect credit risk management in Latin American countries with the international markets is the fast-growing credit derivatives market. Alberto Agrest of Citigroup, for example, runs a group that focuses on structuring and credit default swaps and other credit derivatives on Latin American credits.
These products help Latin American and international financial institutions, institutional investors, corporations and hedge funds hedge their credit risks, make directional investments, acquire exposure in difficult-to-access markets, and do relative-value investing between different credits.
For Latin American institutions, says Yale, credit derivatives represent a pure expression of credit risk that is less affected by technical issues relating to the individual cash markets. In his opinion the development and growth of the credit derivative market has helped people understand how credit risk is priced in markets such as Latin America. An improved understanding of credit risk pricing is just one more factor that should broaden international participation in the credit, capital and derivatives markets in Latin America and thereby strengthen the practice of financial risk management.