25.06.2012
By Simon Miller
When you think of markets, you generally think of those traditional powerhouses of New York, Tokyo and London.
But the global appetite for exchange traded derivatives (ETDs) has seen contracts grow from around nine billion in 2004 to 25 billion contracts according to the latest figures from the World Federation of Exchanges (WFE).
With ETDs heavily weighted in the Americas and Asia Pacific – 40 per cent and 39 per cent of volumes respectively – the global impact of exchange actions can be felt. For example, the 34 per cent decrease in commodity derivative trading volumes in China caused a global decrease of six per cent. To put it another way, if you took out the Chinese figures, commodity derivatives actually grew to 24 per cent.
The growing derivative and clearing markets in Asia are well-known with Singapore [see p30], Hong Kong and Malaysia making a splash in the finance pages. But what about another growth area, that of Latin America (LatAm)?
Emerging after years of financial and political turmoil, its derivative markets are growing benefitting from either scale – as is the case with Brazil – or, as with Mexico, a combination of geography and low-regulatory outlook.
It is easy to see the attractions to foreign investors. LatAm has large natural resources and benefit from increasing demand for oil from the US and China’s appetite for copper and iron ore through the area’s role as major commodity producers and exporters.
Brazil is the powerhouse of the region; with stock exchange activity double that of other LatAm countries. The stock market became the third largest exchange in the world in 2008 following the merger of the Sao Paul Stock Exchange and the Brazilian Mercantile and Futures Exchange and, as of 31 December 2011, it had a market capitalisation of $1.22trn (£0.78trn). BM&FBPVESAP (Bovespa) remains the biggest single stock option exchange in the world with 838 million of contracts traded with a notional value of $1.651 trillion.
Alice Botis, head of LatAm business at Fidessa commented: “Brazil is in a really good position because its market has developed a lot over the past few years, doing a lot to upgrade their technology and they’ve had the luxury of being able to take a look at much more advanced markets.”
However, it is not just Brazil’s exchanges that are growing. Both Chile and Mexico are increasing their offerings to the market. Indeed the Mexican derivatives exchange — MexDer — was the fastest growing exchange for the number of single stock futures traded in 2011, with a growth of 429 per cent according to figures from the WFE.
“The foreign players are key growth drivers and we are trying to leverage a very favourable legal and tax framework here in Mexico. So foreign players can play equities and fixed income, foreign exchange without any kind of restriction or holding tax or limitations on foreigners in terms of the need to register themselves separately,” says MexDer director general Jorge Alegría.
The one thing that links LatAm is the benefit of coming after the ‘western’ exchanges, tailoring their regulations and practices in the light of what has happened before such as the flash crash.
“The one thing that they benefit from is that they have been able to put in place the practices they want instead of tripping over the things we have had such as the flash crash. So, the Brazilian exchange, for example, has had a number of these risk checks in place for quite some time,” says Botis.
However, it is not simply learning from the western exchanges, it is also about learning from their own mistakes which, in itself brings its own challenges.
As Alegría explains, as regulation changes, there are some hurdles to face such as the conservatism within the authorities after the so-called Tequila crash and the impact of 2008 on corporates.
The tequila crash – where a loosening of currency controls led to the peso crashing through the floor against the dollar and a $50 billion loan guarantee intervention by the US – led to a tightening of banking control where banks had to reveal the measures they took for recapitalisation and the use of exotic derivatives
However, the tighter controls did not extend to corporate s which were hit when the financial crisis happened.
“The authorities are very conservative and quite concerned [about derivatives],” explains Alegría. “After the 1995 financial crisis and meltdown, the financial sector was heavily affected and the authorities responded with a very heavy and strong regulation that worked. And in 2008 and 2009 the banks were pretty much untouched. Although they suffered, and business was slow, the balance sheets are very strong.”
However, this was not the same for corporates which did some aggressive structure notes, basically trying to reuse their financing costs, interest rate swaps and some aggressive currency swaps with the Mexican peso and the Mexican interest rate tracking the US dollar. As a result, two or three very large corporations suffered heavy losses and at least two of them went bankrupt.
In addition, some private banking people and individuals also suffered losses from positioning and buying structured products. When the financial crisis occurred there were claims that they were not properly informed of the risks.
Alegría says that the reaction from the authorities was quite strong and that although their approach was “quite conservative”, it was a case of lessons learnt.
International regulation is also having its presence felt among LatAm exchanges.
“As Mexico is chairing the G20 at the moment, it is clear what impact some of these regulations are having as regulators try to figure out the implementation of global regulation in terms of bringing transparency to the over-the-counter (OTC) markets,” says Alegría.
However, he adds that certain criteria present in the G20 communiques and the European and US regulations had already been put in place in LatAm countries.
Botis agrees: “Certain exchanges had things in place for a long time that we are only now looking to implement in the States. They have had a more cautious approach and they continue to have a cautious approach so I don’t think global regulations have directly affected them.”
She adds: “It is complementing them and reaffirming that what they have had in place for a while are the right things to have had.”
Another hurdle that is being faced by emerging exchanges all over the world is technology. In South Africa for instance, the Johannesburg Exchange (JSE) cites technology as its biggest barrier to growth.
“Even if we double capacity, we are still behind other exchanges in terms of data and speed,” says Leanne Parson, director of equity markets at JSE. “The technology infrastructure and the pipe size are things that needs increasing.”
So with JSE, so with LatAm. However, the LatAm markets are increasing their investment in technology, aware of the need to compete with the speeds of New York, Chicago and London.
Botis comments: “I think all the Latin American exchanges have been doing an awful lot to upgrade their technology. Bovespa for example is introducing a new matching engine called Puma that they partnered with the Chicago Mercantile Exchange (CME) to employ. The Mexican exchange is bringing out a new matching engine later this year, and the Chilean stock exchange last year saw significant changes to increase the throughput lower latency in their market as well.”
“As the regulations change it is a relatively more expensive business to run compared to the OTC interdealer broker but it is important to invest in technology to attract that flow that is heavily growing in the OTC space and the customers you are trying to attract,” says Alegría.
However, it is not just the exchanges that have to improve their technology. Brokers also have to increase their use of electronic trading.
“If you take the OTC market, there is strong resistance from the bankers to take that to an electronic market,” says Alegría. “It is the way it has been done for the last ten years and there is resistance to change. And we need to break that.
“We are investing millions of dollars in technology to have a micro-second of timing in our trading engine. Investing millions in our clearing technology to have real-time risk management and the banks want to use the phone."
“From an exchange standpoint they’ve gone ahead and done their part, now it is up to the brokers to do their part,” says Botis. “I think in the past, a lot of the brokers in LatAm have depended on exchange technology to trade and I think that now volumes are increasing, and there is a quest for lower latency, brokers themselves are now making investments to build out their own technology and differentiate themselves to their clients and internationally.”
The last decade has seen mergers and acquisitions in the western exchanges as they positioning themselves in the global market and the oncoming global regulations.
However, in LatAm, it appears that partnerships and alliances are key to increase growth in the area and among international players.
In November, Chile, Columbia and Peru joined their exchanges together under the Integrated Latin American Market Agreement (MILA) which created the second largest LatAm bourse after Bovespa. The tying together of the security exchanges created a combined market capitalisation of nearly $720 billion as of December 2011 and a daily volume of around $300 million.
Chile currently has the largest participation in MILA with 48 per cent of all exchanges followed by 40 per cent from Columbia and 12 per cent from Peru. The alliance works by having complimentary investment niches such as Chile focusing on retail and services, Peru on mining and construction and Columbia on the financial and energy sectors.
In December, Mexico announced it was to join the alliance, which would almost double its size and is part of its on-going network of alliances.
“We have relationships in Columbia, Chile, Peru, Ecuador and the Dominican Republic for example but not as an exchange but through such things as interdealer brokerships,” says Alegría. “It is much better for us to do it that way through a product alliance or a joint venture rather than a full M&A at our size, especially going north or going east.
“Going South is an alternative and we are following that very closely and working very had to be a part of MILA.”
In addition, MexDer has an ongoing partnership with CME where the two exchanges have an equity stake in each other.
Meanwhile, Brazil has signed an alliance with Chile and is also part of a BRICS alliance that brings together Bovespa, MICEX from Russia, Hong Kong Exchanges and Clearing Limited and Johannesburg Stock Exchange (JSE) from South Africa while the National Stock Exchange of India and the BSE have signed letters of support and will join the alliance after finalising outstanding requirements.
At the first stage of this project the exchanges will begin cross-listing of financial derivatives on their benchmark equity indices. It is planned to launch cross-listed products by June 2012.
“In addition to measuring market performance, equity indices may be used as underlying assets to create new products, which can be the next step in the alliance development,” said Russell Loubser, CEO of the JSE at the launch.
“You see these exchanges joining to create a bigger force. So having that alliance does give them a competitive edge so you will see more inflow for example if someone in Mexico wanted to trade, the could go through the MILA route through Chile to get to Brazil,” says Botis.
The growth rate of these exchanges appears to be hype, but it is a justified hype with growing middle classes, to educate and woo, and investment in commodities and technology.
“Is it justified hype?” asks Botis. “Yes, because there are good solid reasons for trading in the market and building up the infrastructure.”
She adds: “So there is a risk in anything and a risk in investing in a new market. People are doing this in cautious, revenue-driven way. They are not just out there spending money or making investment because they think it’s right. There is definitely something behind it.”
Alegría adds: “Would we like to be the biggest exchange in LatAm? It would be nice. The way the Brazilian exchange grew was amazing and a great example of how to do things properly and how to take advantage of economic and political momentum."
