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Developments in commodity and derivatives exchanges in Latin America

Date 20/08/2007

Leonela Santana-Boado and Adam Gross
United Nations Conference on Trade and Development (UNCTAD)

Introduction

The United Nations Conference on Trade and Development (UNCTAD) has been closely involved with Latin American commodity and derivatives exchanges for the best part of two decades. This article reviews the recent performance of these exchanges and their efforts at regional cooperation, and examines an enduring strength of Latin American exchanges – their capacity to innovate in a way that has seen exchange mechanisms applied effectively to address key challenges in these rapidly growing emerging markets.

Recent performance

Since the crisis years of the early 2000s, the performance of derivatives exchanges in Latin America has accelerated well (see figure 1 below), growing at a rate that has been more than double the world average.

Figure 1: Growth of Latin American derivatives markets

UNCTAD analysis based on FIA and exchange data

Source: UNCTAD analysis based on FIA and exchange data

Note: 2006 volumes sourced from exchanges, and total 2006 world volume extrapolated from FIA Jan-Oct 2006 volume data

Between 2002 and 2006, these markets have grown at a vigorous compound annual growth rate (CAGR) of 32%, compared with the world average CAGR during the same period of 15%. This rapid growth has led to a significant rise in Latin America's share of world derivatives volume from 4% in 2002 to 7% in 2006. 2006 saw another impressive year of growth, with the Latin American rate outstripping the world average by 44% to 20%. Three exchanges dominate the Latin American derivatives markets (see Figure 2) – the Mexican Derivatives Exchange (MexDer) and the two Brazilian exchanges, the Brazilian Mercantile & Futures Exchange (BM&F) and the São Paolo Stock Exchange (Bovespa). Two smaller Argentinean exchanges, the Rosario Futures Exchange (ROFEX) and the Mercado a Término de Buenos Aires (MATba), also feature.

Figure 2: Exchange growth

FIA and exchange data

Source: FIA and exchange data

Note: Bovespa 2006 volume is extrapolated from FIA Jan-Oct 2006 data on the basis of the annual growth rate to October

Over the period, each of these exchanges has contributed to the overall growth surge, with ROFEX particularly impressive at a sustained average 158% year-on-year increase since 2002 (albeit from a relatively low base). Figure 2 also shows that the apparent blip in 2005 – an annual volume decrease by 7% – was a reflection of events at one of the region's largest exchanges, MexDer, which will be addressed further below. The other exchanges continued to grow during this year.

BM&F in Brazil is one of Latin America’s largest and most important futures exchanges. Although created only in 1985, some 284m contracts were traded by 2006 – a volume growth of 42% over 2005 in which it ranked as the world’s 11th largest futures exchange. This ranking was actually low compared with previous years – in 1997, BM&F had been the 4th largest derivatives exchange in the world – but the Brazilian devaluation severely impacted trading volumes in the intervening period.

The vast majority of BM&F's trading is in financial derivatives – mainly interest rate and US dollar futures, as well as providing registration for over-the-counter transactions. However, the exchange also offers a range of commodity derivatives contracts, with Arabica coffee and live cattle being the most liquid. Outside of derivatives trading, BM&F is heavily engaged in other dimensions of commodity market activity through the Brazilian Commodities Exchange (discussed further below). The exchange also launched in 2005 the BM&F Carbon Facility, an electronic trading system for the generation and trading of carbon credits under the Kyoto Protocol's Clean Development Mechanism.

Growth at BM&F has been driven by the progressive engagement in the markets of Brazilian industry and foreign investors, the latter now accounting for about 20% of liquidity on the exchange, as well as the upgrade in ratings of Brazil's sovereign debt. The exchange is well on the road to demutualisation with authorisation being given by the BM&F Board of Governors in 2006. 2007 is therefore likely to see further significant developments at the exchange.

Founded in 1890, but trading under its current name since 1967, Bovespa is Latin America's largest stock exchange and the only centre in Brazil for trading equity and private fixed-income securities. Bovespa was the first exchange to launch derivatives in Brazil when it launched options on stocks in 1979. Alongside equity cash and derivatives contracts, Bovespa offers trade in indices, corporate bonds, subscription warrants and Brazilian Depository Receipts (BDRs) which are certificates representative of stocks issued by foreign companies. Bovespa was the world's eighth largest derivatives exchange in both 2004 and 2005. However, for the first 10 months of 2006, growth was a somewhat sluggish 2% over a similar period in the previous year, making it unlikely to hold that position given the fast growth of other derivatives exchanges around the world.

In Brazil, there are a further 29 commodity exchanges operating across the country. They trade largely in commodities for immediate or forward delivery, but an electronic network which links most of the country’s exchanges also makes it possible to trade in futures contracts.

Although Mexico is Latin America’s second biggest economy, it only introduced a futures exchange comparatively recently in 1998. The Mexican Derivatives Exchange (MexDer), which trades financial futures only, has experienced rapid but volatile growth.

With 210m contracts traded in 2004, MexDer had become the world's ninth largest futures exchange. However, 2005 proved catastrophic for MexDer – a near 50% decline in volume reduced MexDer to 108m contracts and fifteenth position. Its TIIE 28-day Interbank Rate Futures, the world's fourth most traded derivatives contract in 2004 and accounting for 98% of exchange volume, experienced in 2005 the largest decline – 52% – of any derivatives contract in the world. This was the result of a combination of factors – greater stability in interest and exchange rates, the imposition of higher margin and capital adequacy requirements by the Central Bank, and an increase in the withholding tax on foreign investors.

If the decline was precipitous, so has been the recovery. In 2006, the TIIE 28 contract grew by 165% and overall exchange volume by 154%. This was driven by the relaxation of the withholding tax, introduction of the FIX protocol and the implementation of several regulatory reforms. As a result, MexDer shot up again to claim eighth ranking among the world's derivatives exchanges with the TIIE 28 contract becoming the world's third most traded after the CME Eurodollar and the Eurex Euro-Bund contracts (as of October 2006).

Argentina has a long tradition in futures markets, but their activities have from time to time been circumscribed by detailed government regulation which has limited the use of exchange services. The national exchange network consists of 11 markets, which trade mostly in agricultural commodities, including one of the world’s oldest commodity futures exchanges, the Bolsa de Cereales dating back to 1854. Its futures market, MATba, which was founded in 1907, temporarily suspended operations during the 2002 Argentinean economic crisis. Having achieved a volume of 246,000 contracts in 2000, MATba's 2006 turnover stood at 158,000 – annual growth of 16% for 2006 following a 59% annual rise the previous year. The larger ROFEX traded 18.2m contracts in 2006 – also a significant rise on the previous year of 36%. The vast majority of ROFEX volume is in financial futures, specifically US dollar futures, though it did trade a few hundred thousand agricultural derivatives contracts in maize, soybeans and wheat.

A major private sector group in Chile proposed the creation of a commodity futures exchange in the late 1980s. The proposed exchange would trade in domestic food grains and fishmeal. In 1993, the Government included the establishment of an exchange in its programme (and adopted a law to make it possible), but a significant step forward was only made in 2003, when an Argentinean consultancy firm was recruited by the Ministry of Agriculture to do a feasibility study. Following this study, an exchange, Bolas de Products de Chile, was formally established in March 2005 and trades wheat, corn and wine.

There are also established commodity exchanges in Bolivia, Colombia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Honduras, Nicaragua, Panama, Peru and Venezuela. These were created mostly in response to the liberalisation of domestic trade as a mechanism for the organisation of domestic agricultural trade flows. The oldest of these, in Colombia, dates from 1973, and the Ecuador exchange dates from 1986, while all the others have been established since 1992. Most of the products traded are agricultural (with some processed products traded in a few countries), but the Government of Colombia has been examining the possibility of introducing a commodity exchange for emeralds. The trading possibilities offered by the exchanges vary widely. Most provide a forum for trade in physical commodities but some, such as the Agricultural Exchange of Venezuela, also enable forward trading. In Colombia and Venezuela, the exchanges also trade the ‘credit’ part of warehouse receipts and have arranged livestock securitisations to improve rural financing (see below).

Regional co-operation

The Association of Latin American Exchanges (APBP) was created in October 1994 in Buenos Aires during the Second Regional Meeting of Commodity Exchanges. (The first meeting had taken place in Guayaquil, Ecuador in the previous year.) Since then, annual regional meetings have been held in various Latin American capitals, the last being in the Dominican Republic in 2005. (The 2006 meeting, scheduled for Venezuela, was postponed.) The objective of the Association is to increase the exchange of information between national exchanges on issues related to best practice, innovative mechanisms, regulation, etc.

In the long-term, the Association is viewed as a tool for regional integration. Some attempts have been undertaken in this direction, including the Central America Regional Commodity Exchange project, a joint partnership between the Inter-American Institute for Cooperation on Agriculture (IICA) and the Canadian consortium, Agriteam Canada Consulting Ltd in 1996. There has been some discussion on the subject lately in the framework of MERCOSUR and the Andean Pact. However, the idea of the creation of a pan-American commodity exchange remains a dream for the time being.

Innovative application of exchange mechanisms

In the course of fulfilling UNCTAD's role to facilitate the sharing of experience and best practice across emerging commodity exchanges in various regions of the world, Latin American exchanges have become noted for their innovative application of exchange mechanisms to address challenges in the underlying markets.

Three particular sets of innovative mechanisms will be discussed below: financing mechanisms, as operated by exchanges in Colombia and Venezuela; mechanisms for quota and import allocation, as operated by exchanges in Honduras and Panama; and mechanisms for upgrading the underlying physical markets, as illustrated by the BM&F's Brazilian Commodity Exchange initiative.

Financing mechanisms

In many developing countries, banks are not very interested in exposing their own capital to agricultural credit risks. However, an exchange can provide a mechanism that meets an important market gaps allowing the commodity sector to bypass banks and tap directly into local capital markets. The mechanism is the trade of farmer repurchase agreements, or 'repos'. In this structure, the exchange provides an innovative product to capital market investors that offers a valuable addition to the existing range of money market instruments; and it attracts a large and relatively organised part of the commodity sector which is looking for relatively cheap sources of capital. In the process, the exchange, by arranging the transactions, can benefit from high arrangement and other fees.

Colombia’s National Agricultural and Livestock Exchange (BNA) has developed a whole range of instruments of this nature, with not only agricultural commodities as the underlying but also poultry and live cattle. This has also been done in Venezuela, where a private company (Induservices) developed a system under which it provided capital enhancement to warehouse receipt paper on seasonal maize stocks. This paper was put into a Special Purpose Vehicle, which was backed by financial guarantees of Induservices, and issued securities.

How do these instruments work? For commodities that have already been produced, they can be stored either in a warehouse recognised by an exchange, or put under the control of a collateral manager approved by the exchange. The warrant/warehouse receipt is then transferred to an exchange broker, and the owner of the commodities signs an agreement to buy it back at a given price (say, USD1,000) after a certain period (say, three months). The broker posts this ‘package’ on the exchange network, and investors can bid on it. Investors know that after three months, they will receive USD1,000. The higher they bid, the lower the interest rate they receive. The payment is guaranteed by the broker, and further underwritten by the physical goods in the warehouse, so the risks for the investor are very low. At the end, investors can expect to receive a somewhat higher return than what they could get on other, equally risky investments; and the commodity firm will have cheaper working capital (see Figure 3).

Figure 3: Exchange-traded agricultural repos

Exchange-traded agricultural repos

The exchange can be more proactive and structure repos around future receivables rather than existing stocks. For example, Colombia’s BNA introduced an innovative livestock securitisation programme in 2000, and a similar programme for poultry in 2002. The programme has made it possible for cattlemen to obtain tens of millions of USD in financing for the feeding of their cattle – at rates that were determined through competition among institutional investors on the country’s stock and commodity exchanges.

Under the programme, funds for the feeding of beef cattle were raised from local institutional investors, through livestock-backed securities offered and traded on the BNA and the country’s securities exchanges. The securitisation, arranged under the overall supervision of BNA, was highly structured with risk mitigation through insurance, high levels of overcollateralisation and independent quality control of the underlying commodity throughout the process. Several series of securities were successfully issued under the programme, with strong interest from both cattlemen and investors – BNA expects to issue securities worth some USD4-5m each 45 days. The benefits of the programme for the cattlemen were clear: more financing at better terms. For institutional investors, the programme provided a new investment tool giving an attractive rate at a low risk. (Note that these instruments are fully compatible with Islamic principles, and can thus be successfully marketed to Islamic funds.)

Mechanisms for Quota and Import Allocation

In countries in which efficient or transparent markets for international or domestic trade have not yet fully formed, an exchange is an essential intermediary for bringing together interested transactional counterparties within a rule-based framework. Trade in cash and derivatives contracts are the standard contracts offered, but other types of less conventional transaction can also be handled where an exchange mechanism offers the possibility of promoting broader participation and increased transparency. Two examples are discussed below.

The National Commodities Exchange, Panama (BAISA) utilises its commodity exchange for distributing tariff packages negotiated as part of Panama's WTO accession agreement. One of Panama's accession conditions is a commitment to import eight sensitive agricultural and agro-industrial products. These tariff packages are imported through a commodity exchange mechanism to bring about greater participation and transparency in the process. Between June 1999 and June 2006, BAISA had negotiated over USD40m in these tariff packages.

Two separate processes exist for exchange allocation – one for tariff packages constituting commodities classified to be in raw material form, and another for processed commodities or finished products.

The former is the most straightforward. Amongst the interested foreign suppliers, there is an auction in which the supplier that offers the lowest price gains the right to supply the whole package. Among the Panamanian importers, there is no auction. Instead, the government allocates the right to buy a part of the package to interested processors of the imported commodity in proportion to the installed capacity each processor has. The price is set in the auctions amongst suppliers.

The process for processed commodities or finished products is more complicated. Here, an auction takes place among the interested suppliers and a separate auction also takes place among the interested importers – mostly consisting of retailers, wholesalers and resellers. In the latter, the bidding is no longer for the entire package, but on a lot by lot basis with the highest offered price winning the lot. For that reason, there is not one single auction but several. The purpose of dividing the package into lots is that a larger number of importers have the possibility to acquire a part of the package.

Given that buyer and seller are not brought together in one auction, no price is actually set. Instead, the suppliers receive the price at which they won the auction, and each importer pay the price at which they won the right to purchase each lot. The importers pay in two instalments. One instalment is the amount due to the supplier. The second is any surplus, sometimes quite a significant amount, which will be deposited with BAISA. The exchange then has the formal obligation, agreed with the Panamanian State, to distribute the surplus to charitable institutions within a month. Through this mechanism, BAISA donated in 2002 the sum of USD1.6m merely from the negotiation of one part of a rice tariff package classified as a finished product.

The philosophy is that, even though the second auction increases the price to the consumer (importers typically transfer their higher costs to consumers), by donating the differential between the buyers' and sellers' prices, the most destitute segment of consumers are the ultimate beneficiaries. Typically, these would be children and the elderly who depend for their livelihood on charitable institutions. A second reason is to ensure a certain level of stability in consumer prices, since the buyers’ bids tend to come close to the price of the domestic product, something that would not happen if they paid only the sellers’ price which is usually far lower. Over time, however, it is noted that the number of products classified as finished goods has been reduced leading to reduced charitable donations.

The Honduras Commodities and Services Exchange (AGROBOLSA) registers and processes Honduran import transactions as part of its operations. The exchange was registered with the purpose of serving the commercialisation of products, goods or services from or for agriculture and livestock by facilitating transactions.

In particular, AGROBOLSA registers transactions within the Granza Rice Agreement, a scheme that enables rice mills to import, duty-free, the deficits of grain that are not produced domestically (provided they buy the whole bulk of the national crop at a guaranteed price). Since 2002, the exchange has been registering transactions and generating the support required by the Government to issue import licenses. The exchange also generates process information such as follow-up to commercial agreements and reports on quality discrepancies. The participation of AGROBOLSA in the Agreement has contributed to its acceptance by the producer community, which increased crop production by 600% after the Agreement first came into force in 1999. The exchange envisages expanding its role in these transactions through enabling trade finance and working with other Central American exchanges to integrate a regional dimension into its services.

It should be noted that the Colombian and Ecuadorian commodity exchanges have also conducted auctions to allocate permits and licenses for the import/export of Ecuadorian rice to Colombia in years when Colombia has not been able to produce sufficient to meet its domestic requirements.

Mechanisms for upgrading the underlying physical markets

In fragmented and underdeveloped physical commodity markets, the absence of efficient price discovery and reliable trading mechanisms sustains inefficiencies and can promote anti-competitive practices. Farmers are often the biggest losers from this set-up as intermediaries can exploit information asymmetries to offer sub-optimal prices and conditions of purchase.

In 2002, BM&F launched the Brazilian Commodities Exchange (abbreviated to ‘BBM’ from the Portuguese), pitched as a dedicated agribusiness exchange that would create a link between agriculture, commerce, industry, finance and government. The objectives of the BBM are to upgrade and commercialise the agricultural sector and to provide a reliable and transparent mechanism for the exercise of government agricultural policy.

BBM united the previously separate exchanges from the states of Goiás, Mato Grosso do Sul, Minas Gerais, Paraná and Rio Grande do Sul, and from the city of Uberlândia. A further exchange from Ceará was integrated into the system in 2004. In the new structure, these exchanges became regional operation centres whose members trade on an electronic platform accessible via the internet with BM&F providing the clearing and settlement functions.

Services offered by BBM include trading in physical commodities, rural product notes (rural securities, also known as CPRs) and agribusiness letters of credit (LCAs), auctions of government inventories, and a secondary market for securities, public tenders and private acquisitions.

The result has been an integrated domestic market for agricultural commodities. Modern price discovery mechanisms deliver transparent and neutral reference prices, and an organised marketing structure brings together different stakeholders on an accessible and open platform. Upgrading of sectoral infrastructure has taken place in terms of enhanced warehousing and logistics. Finally, the registering of transactions and the BBM's rule-based framework, including arbitration mechanisms, have enabled greater confidence among counterparties to enter transactions, stimulating liquidity and new trading possibilities.

As has been discussed above, when such trading mechanisms are in place, innovative applications of those mechanisms can be developed. Thus, in 2004, the BBM took part in auctions for the purchase of products in support of the Brazilian Government's Zero Hunger Program, a hunger relief campaign, in conjunction with the National Food Supply Company (CONAB), the public agricultural distribution agency.

Leonela Santana-Boado (leonela.santana-boado@unctad.org) is Co-ordinator, Commodity Exchanges and Adam Gross (adam.gross@unctad.org) is Associate Economic Affairs Officer in the Commodities Branch of the United Nations Conference on Trade and Development (UNCTAD). Acknowledgement is also made to Abelardo Carles and Andrés Carías, general managers of the Panama and Honduras exchanges respectively.