Dieter H' Wunder

1
OTC Markets The Chilean Experience Organized
by Asociación de Bancos de Colombia

• Dieter H. Wunder
• Cartagena de Indias, Septiembre 12, 2008

2
I Market Structure and Market
Depth. II Settlement Procedures and
Counterparty Risk Management III Regulatory
Issues IV Ongoing Reforms V SGC, the story
about how derivatives reach the medium and
small size firms. VI Challenges
ahead

• OTC Markets in Chile Outline

3
I Market Structure and Market
Depth. II Settlement Procedures and
Counterparty Risk Management III Regulatory
Issues IV Ongoing Reforms V SGC, the story
about how derivatives reach the medium and
small size firms. VI Challenges
ahead

• OTC Markets in Chile Outline

4
Market Structure

• All derivatives operations in Chile are
  organized as Over the Counter Agents
  are dealers, brokers and end users.

The ones that make the market, ready and
obliged to give puntas, a price to buy or sell.
Trades done mostly by phone, in a bilateral way.
Only part A and part B see the quotes. Between 15
to 20 actors.
Dealers
Intermediaries. They publish in an electronic
bulletin board, ask and bid prices from the
dealers. Dealers often use this boards to hide
their strategies and or positions. Tradition,
López León, among others.
Brokers
Are the final customers of the derivatives
markets, they look to enter into the derivatives
market to hedge (assets or liabilities) or to
speculate. Pension Funds, Hedge Funds, Mutual
Funds, Life Insurance Companies, Corporations
(large scale firms), private banking businesses,
and starting 2006, SMEs , and even the common
person.
End Users
Deals are mainly done between dealers, on the
phone or through the electronic bulletin
(broker), and between dealers and end users.
Rarely will you see a deal between two end users.
5
Derivative's Market Depth small relative to the
world
Source. J Selaive BCCH 2008
6
Derivatives Market Depth though deeper than
other Emerging Economies
Source. J Selaive BCCH 2008
7
Spot and Derivative's Market Depth including
spot does not change much
Chilean Spot and Derivatives (fx) (veces el PIB
en dólares nominales)
Source. J Selaive BCCH 2008
8
Spot and Derivative's Market Depth a comparison
for Emerging Economies
(veces del PIB en dólares nominales)
Includes Spot forwards and fx swaps. April
2007 Source Selaive 2008. Central Bank of Chile.
And BIS.
9
Spot and Derivative's Spreads
In Chile spreads are close to advanced economies,
thanks to the consolidation of the Banking Sector
Includes Spot forwards and fx swaps. Source
Selaive 2008. Central Bank of Chile.
10
I Market Structure and Market
Depth. II Settlement Procedures and
Counterparty Risk Management III Regulatory
Issues IV Ongoing Reforms V SGC, the story
about how derivatives reach the medium and
small size firms. VI Challenges
ahead

• OTC Markets in Chile Outline

11
Settlement Procedure and Counterparty Risk
Management
Counterparty A
Counterparty B

• Foreign Bank (Branch)
• Local Foreign Owned Bank
• Local Bank
• SPV

• Foreign Bank
• Foreign Bank (Branch)
• Local Foreign Owned Bank
• Local Bank
• SPV
• Corporative
• Institutional Investor
• SMEs
• Common person

Settlement requirements Depend upon who is the
counterparty
MTA
ISDA (netting)
CSA
MtM
Threshold
Collateral
Local ISDA
REC
Specific contract
Compliance
Confirm. fax
Note Early termination clauses rarely used.
12
Settlement Procedure and Counterparty Risk
Management an example
BSan Chile
Xerox
Local Foreign Owned Bank
SMEs
Settlement requirements
Local ISDA
REC
Compliance
Specific Contract
Confirm. fax




13
Settlement Procedure and Counterparty Risk
Management another example
BSan Chile
Standard Bank PLC.
Local Foreign Owned Bank
Foreign Bank
Settlement requirements
MTA
ISDA (netting)
CSA
MtM
Threshold
Collateral





14
Other Risks Involved

• Some products , ex CCS (UF fixed rate/TAB nominal
  variable rate) do not have a direct way to be
  hedged (TAB nominal is hedged against tasa
  Cámara, both highly but not perfectly
  correlated).
• Also the options market is underdeveloped in
  Chile , therefore in some circumstances the
  position remains open for a period of time,
  longer than desired.
• In some deals volumes are also a problem,
  though not very frequently. Ex long in IPSA
  options, short in UF forward.

Liquidity Risks

• Settlement is not an automatic process, neither
  are the clearing, nor the liquidation processes.
  Novations are also done manually.
• Many oh these types of risks are minimized by the
  use of systems like Murex. Even tough some
  remain
• Contracts signed come back with delay.
• Fax communications are imperfect and registration
  is not risk free.

Operational Risks
By the end of 2008 4 banks will be authorized
to sell options, and 6 by the end of 2009
15
Other Risks Involved continued

• Again, for some specific operations, REC (REC
  Equivalent Credit Risk has to be calculated
  manually.
• The calculation of the REC is a standard process
  for many underlying assets, but when it comes to
  the UF Curve we might have differences with our
  counterparties.

Credit Risk (REC)

• Appropriate understanding and translation (from
  ISDA) of special clauses, for example, early
  termination.
• Correct assessment of guarantees.

Legal Risks
16
I Market Structure and Market
Depth. II Settlement Procedures and
Counterparty Risk Management III Regulatory
Issues IV Ongoing Reforms V SGC, the story
about how derivatives reach the medium and
small size firms. VI Challenges
ahead

• OTC Markets in Chile Outline

17
Regulatory Issues

• Central Bank of Chile is extremely cautious
• Approves option s regulation, but the rules are
  very restrictive.
• Only for Banks with A level of solvency or
  higher .
• Allowed to sell only options for currency and for
  interest rates. Nor allowed for commoditties
  neither for stock, this can be done through a SPV
  like Santander Investment or Stock Brokers
  (unregulated).
• Explicitly prohibited structured deposits only
  structured notes are approved (Spains experience
  with structured deposits in BCCHs mind).
• Under study netting for derivatives among banks,
  considering the regulation of the G 7 countries.
  Need a local master agreement approved by BCCH
  (ISDA do not consider products in UF for example)
  and a special bankruptcy law.

18
Regulatory Issues continued
Supervisory Body (SBIF), in charge of the
options reglamento.

• Only Banks that have appropriate systems to
  manage the market risks involved.
• Only banks that have appropriate systems (Middle
  and Back office), to minimize operational and
  financial risks.
• Every new product should be approved by SBIF, and
  compliance is an issue.
• At BSAN a new product has to be approved by the
  Local Committee of New Products , the Global
  Committee of New Products (Madrid), and from the
  SBIF (Banks Supervisory Body).
• The first Bank to get the authorization to trade
  options was Banco Santander (2006).
• Tax system promotes hedge and/or discourage
  speculations.

19
Sub Prime Crises and the Chilean Derivatives
Market

• There seems to be no empirical evidence in favor
  or against for the hypothesis that more
  derivatives produce more volatility (Selaive,
  2006).
• Underlying assets are driven by fundamental
  factors. At most, derivatives could amplify the
  underlying asset's cycles.
• Sub prime crisis is a phenomena that does not
  exist in Chile. Only a few companies
  (institutional investors) have bought small
  pieces of structured notes with CDS included.
• The origins of the crises are not in the
  derivatives market, but in a lax practices to
  originate those credits. It is like to blame on
  the UF for the existence of inflation.

20
I Market Structure and Market
Depth. II Settlement Procedures and
Counterparty Risk Management III Regulatory
Issues IV Ongoing Reforms V SGC, the story
about how derivatives reach the medium and
small size firms. VI Challenges
ahead

• OTC Markets in Chile Outline

21
Ongoing Reforms

• There are a few number of reforms being
  discussed in Chile at the time.
• Pension Funds
• They would be allowed to buy options and futures
  for speculative (investment) purposes. Underlying
  assets interest rates, currencies and stock
  indices.
• For hedging purposes options, futures, forwards
  and swaps. Underlying assets interest rates,
  currencies and indices.
• Counterparties can be local or foreign entities.
• Limits apply
• CCP
• The Chilean government has presented a project to
  the Congress.
• New technologies like CCP (Central Counterparty
  Clearing) should improve the workings of the
  OTC derivatives market.

22
Impact of new technologies like CCP
Pros

• More transparency, and more uniformity.
• With respect to credit risk, a CCP allows members
  to achieve multilateral netting of credit
  exposures on the contracts cleared. For all
  products together?.
• Centralize and Standardize the counterparty risk.
  
• Global netting implies less Credit Lines
  (capital) requirements, which in turn reduces
  liquidity risks.
• There are no Mark to Market (MTM) differences
  between counterparties. Curves are unique and
  defined by CCP.
• Potential to diminish the legal risks. If default
  procedures are supported by specific provisions
  of national law.
• Lower operational risks if stringent operational
  requirements for back office operations.

23
Impact of new technologies like CCP continued
Cons ( thinking a a regulator)

• Risks gets concentrated on the CCP. How do they
  (re) insure themselves?. CME, BMF?..
• Eventual Contagion effects
• Too big to fall.
• Eventual Asymmetries of Information. CCP knows
  about a player's position, it might use it in its
  advantage (China Wall).
• Market Concentration.. In an extreme one actor
  control the CCP.
• Market size How to finance the costs of CCP.
• Competitiveness vs. Healthy Management. CCP might
  require too few collaterals in order to increase
  business volume.

24
CCP

• Are we prepared to have CCP in place like in
  Brasil and México?.., not sure Even more
  developed countries have not begun implementing
  them.
• From BIS 2007 (for G7 countries) The
  critical issue is how effectively a CCP for OTC
  derivatives can manage the risks to which it is
  exposed. CCPs for exchange-traded derivatives
  generally manage their risks quite effectively.
  The key question is whether the risk controls
  employed by CCPs for exchange traded derivatives
  would be equally effective when applied to OTC
  derivatives, which generally are less liquid and
  more difficult to value accurately than
  exchange-traded derivatives.

25
Customization compared to Standardized Products
Pros
Cons

• From a business standpoint Profits.
• It is like comparing commodities versus
  differentiated products.
• It is a natural process innovation-market-competi
  tion-commodity.
• Satisfy increasing customer needs.
• Incentives to innovation.

• Less liquid market
• Resources used to educate clients, employees.
• Complex structures are difficult to value, and
  monitor (sub prime crisis, Basilea increase K
  requirements).

26
I Market Structure and Market
Depth. II Settlement Procedures and
Counterparty Risk Management III Regulatory
Issues IV Ongoing Reforms V SGC, the story
about how derivatives reach the medium and
small size firms. VI Challenges
ahead

• OTC Markets in Chile Outline

27
SGC, the story about how derivatives reach the
small and medium size enterprises (SME)

• An idea developed originally by Bank Unicredito,
  Italy, 2000, and later on,2002, by Santander and
  BBVA in Spain.
• Business opportunity Selling derivatives to the
  Corporate and Institutional segment is extremely
  competitive, but not so in the SME enterprises
  firms.
• Santander Chile initiated this type of business
  in 2005, after the Central Bank authorized it to
  trade options, and after the SBIF approved the
  internal risk management procedures.
• The Players very few, mainly Santander Chile,
  Citibank (today Banco Chile, a big challenge ).
  More Banks are developing the resources to enter
  this so far profitable business (BCI, BBVA,
  Itaú, Scotia, Corp Banca). This is good news not
  only for the existing suppliers, but also to the
  system as a whole (liquidity issues).

BBVA not authorized yet. It is booking its
options operations either in Madrid or in
México. So it does work with a regular ISDA
translated.
28
SGC continued

• Requirements to hire the different products are
  to have a REC (credit equivalent risk) approved
  for the client, to have the General Conditions
  Contract signed (local ISDA), and to understand
  the products (compliance issues).
• The Banks lemma is each credit goes with its
  own derivative.
• There are just a few products made to speculate
  (ex super floater where the client pays a
  floating rate (tasa Cámara), and receives a fixed
  rate)
• The products pure options, options plus
  forwards, CCS IRS, and the like. Main purpose is
  to hedge firms liabilities .

29
SGC Products

• Insured Rate, CCS forward starting for financial
  leases (UF/TAB nominal).
• Rate Reducer, CCS spot starting for financial
  leases (UF/TAB nominal, or the opposite).
• Forward acotado (beneficio ó pérdida) for
  importers and exporters. A simple forward of Fx
  plus an Fx option.
• Nominalizador, protection against inflation
  increases, CCS UF Fixed rate, for Pesos fixed
  rate.
• Subsidized Credit for exporters (client sell to
  Bank a Fx call option out of the money) and
  importers (client sell to Bank a Fx put option
  out of the money)

30
SGC Products continued

• Wonder Swap, internally called Wunder Swap. A
  home builder knows well in advance the financial
  cost oh his development project (UF/TAB nominal
  180d).
• Put Spread, Call spread,
• Super floater (next slide)
• American Forward, Fx forward with the option to
  execute any amount ant any point in time (time
  limit, amount limits apply) (next slide).

31
Descripción
Es un producto que Intercambia flujos de una
Tasa de Interés fija a una variable en
Pesos. Permite al cliente disminuir su carga
financiera ya que éste se puede beneficiar ante
posibles variaciones en la Tasa de Interés. El
cliente acuerda con el Banco Santander una TI
fija, que dependiendo de cómo estén las
proyecciones de mercado, puede ser inferior o
superior a la Tasa de Cámara, TC. Luego se
calcula el promedio de las mediciones de la TC
durante 6 meses, si este promedio se encuentra
por debajo de la TI fija, el cliente es
compensado por el banco en el diferencial de
tasas por el monto contratado. En caso contrario,
es el cliente el que procederá a compensar al
Banco. Tasa Cámara Es aquella tasa a la cual
los bancos intercambian dinero. Su promedio está
representado por el ICP (Índice de Cámara
Promedio). Esta tasa se puede encontrar dentro
del rango comprendido entre TPM 25BP y TPM
-25BP.
Características
Plazo 4 o 5 Años Intereses Semestrales Se
considera capital y sólo se realizan intercambios
de flujos de intereses sobre un monto nominal
determinado.
Contratación
Para contratar la inversión se firmarán dos
documentos Un Anexo, donde se explica el
producto. Un contrato de Súper Flotador en
el que se especifican los siguientes aspectos

• Monto Contratado.
• Plazo.
• Tasa de Interés Fija.

1
32
Ejemplo
2
33
Descripción
Descripción Es un producto que permite asegurar
un tipo de cambio futuro a una fecha y un monto
de dólares predeterminado. A diferencia de un
seguro de cambio tradicional, el cliente puede ir
utilizando anticipadamente los montos en dólares
cuando lo requiera durante la vida del contrato,
las veces que lo necesite y al precio establecido
en el contrato, hasta completar el monto
contratado. Tipo de cambio Se establece al
momento de contratar el producto y se mantiene
fijo durante toda la vigencia del contrato para
todos los anticipos que se realicen. Plazo
Período por el cual se tiene cobertura en la
operación. Fecha de Vencimiento Fecha de
término del contrato en la que se liquida el
remanente (en caso que hubiese algún remanente en
dólares) al tipo de cambio fijado al inicio. En
este caso, se realiza una compensación respecto
al Tipo de Cambio Observado del día informado por
el Banco Central, la que puede ser a favor o en
contra del cliente. Nominal Monto a cubrir en
el contrato.
Características
Es un producto pensado para obtener cobertura de
tipo de cambio. Puede utilizarse para asegurar
un precio de compra o un precio de venta de
dólares a futuro. Los anticipos se realizan por
Entrega Física, es decir, hay intercambio de
monedas entre el Banco Santander y el cliente.
Sólo si queda algún remanente al vencimiento este
se liquida por compensación. Antes de cerrar un
seguro se deben firmar el contrato particular y
el cliente debe tener aprobada línea de crédito
especial para este producto con el Banco
Santander.
1
34
Ejemplo
Si al vencimiento no utilizó el 100 de los
US500.000, el saldo, será liquidado por
compensación entre el diferencial del precio del
Dólar Observado publicado ese día por el Banco
Central y el tipo de cambio contratado.
Un cliente abre una carta de crédito por US
500,000 a 9 meses plazo, pero no conoce con
exactitud las fechas de los embarques de la
mercadería. En el momento de la apertura de la
carta de crédito contrata con su Ejecutivo de
Cuentas un Forward Americano que le asegura el
tipo de cambio en 546 para todos los embarques
parciales que se produzcan durante los 9 meses de
la vigencia de la operación.
1º anticipo USD200.000
2º anticipo USD200.000
Vencimiento del contrato
Fecha de contratación
6 meses
2 meses
9 meses
- Dado que el cliente no ha utilizado la
totalidad de su nominal, llegada la fecha de
vencimiento se liquida el remanente de USD
100,000 al tipo de cambio pactado de 546. - Si
el Tipo de Cambio Observado se encuentra en
556, el Banco paga al Cliente una compensación
de 1,000,000 (556 - 546) 100,000
- El cliente solicita un 1º anticipo de USD
200,000 al cabo de 2 meses que se destinarán al
pago del primer embarque. -Ese día el cliente
pagará por esos dólares 109.200.000 (546
200.000)
-El cliente solicita un 2º anticipo de USD
200,000 al cabo de 6 meses que se destinarán al
pago del segundo embarque. -Ese día el cliente
pagará por esos dólares 109.200.000 (546
200.000)
Contratación
Para contratar este producto se firmarán dos
documentos Un Anexo, donde se explica
el producto. Un contrato de Forward
Americano en el que se especifican los
siguientes aspectos

• Nominal.
• Plazo.
• Niveles del Tipo de Cambio.
• Fecha de Vencimiento

2
35
SGC The Numbers in 2007
By number of operations (3600)
By notional (MM USD 2.900)
Medium size GGEE real state Small size BE
retail
36
SGC Profits in 2006-2007
2Q 2006 100

• YTD (July 2008) profits are the same that in all
  year 2007. It is expected to end year 2008,
  doubling the profits of year 2007.
• Also SGC is generating during year 2008 more
  profits than the Corporate and Institutionals
  segment.

37
Derivatives Business done by other end users

• Structures done by Mutual Funds. Structured
  Notes. A Simple deposit plus an option structure,
  as for example a simple call, a call spread.
  Maturity from 2 to 3 years, with/out cupon(s),
  capital (nominal) guaranteed (100, 90) at
  maturity.
• Tax benefits apply .15 of the savings goes as a
  credit against the income tax, with a ceiling lt
  min 30 income base65 UTA. If there is any
  excess, applies for the following year.
• 50 of these kind since the started in 2003.
  Notional total USD MM1.000
• BBVA (1015), Banco Chile (1043), BCI (615),
  Santander (1512), Security (4), Estado (1),
  Desarrollo(1).
• Average notional around US MM 20.
• Over all kind of equity indices IPSA, Bovespa
  BRIC (Brasil, Russia India and China), Nikkei
  225 Hang Seng SP CNX Nifty, equity mixed with
  fixed income, FTSE Xinhuá 25, CECEEUR index
  etc.. Also over Fx options.

38
I Market Structure and Market
Depth. II Settlement Procedures and
Counterparty Risk Management III Regulatory
Issues IV Ongoing Reforms V SGC, the story
about how derivatives reach the medium and
small size firms. VI Challenges
ahead

• OTC Markets in Chile Outline

39
Challenges Ahead

• Netting Regulation, coming out soon.
• CCP operation, timing uncertain.
• Liquidity issues. The market needs more players,
  particularly for Options and certain CCS (like UF
  fixed rate /Tab nominal variable rate).
• New regulation for the AFPs
• Electronic systems like CCP should help to make
  the market safer, more liquid and more efficient.
• Education culture for SMEs and natural people,
  for the IRS office, Banks supervisory body
  (SBIF), even for the Central Bank, and IRS?.

40
The End Further comments, questions or advice,
please contact Dieter H. Wunder Wunder
Asociados P.H. D c Economics dwunder_at_vtr.net (5
6 9) 827 7849 (56-2) 277 5524
41
Annex I Interest Rates Market Swap in Chile
quote against Tasa Cámara.
Garbans screen on Chilean swaps can be observed
on Bloomberg by typing ICLP ltGOgt. Alternatively
you have Traditions.
23
42
Annex II Closing Run (Tradition)