At a Glance
- Heightened volatility, central bank rate moves, and presidential elections in Brazil and Mexico increased investor interest and trading activity.
- Over $30 billion per day was cleared in Latin American rate swaps in 2018, a record high.
2018 was a record-setting year for the clearing of interest rate swaps of Latin American countries, as global investment managers were drawn to these markets for interest rate exposure.
Volatility was heightened throughout 2018 due to presidential elections in Mexico and Brazil, significant central bank rate changes, and escalating trade tensions.
“Risk managers had to cope with Presidential elections in both Mexico and Brazil in 2019 which had big impact on both interest and exchange rates,” said Blu Putnam CME Group Chief Economist.
In addition to the elections, both countries’ central banks were active with Mexico’s central bank raising its overnight rate from 7.25 to 8.25 percent, and Brazil’s central bank moving in the opposite direction by dropping the overnight Selic rate from 7 to 6.5 percent.
For Mexico, the renegotiation of the North American Free Trade Agreement morphed into the U.S.- Mexico-Canada Agreement and allowed markets to breathe a sigh of relief that trade tensions with their biggest partner has eased.
The trade war story for Brazil was all about agriculture. The US-China trade tensions resulted in China curtailing buying of U.S. soybeans and starting to import more from Brazil. “In essence, Brazil was the big winner in the US-China dispute,” said Putnam.
Enter Interest Rate Swaps
“All of the above factors generated significant market uncertainty, changed economic outlooks, and drove risk managers to use interest rate swaps,” said Putnam. Interest rate swaps are used by market participants to hedge against movements in the interest rates of a specific currency, and the usage of these products generally increases when there is greater uncertainty about economic and monetary conditions.
This translated to over $30 billion per day cleared in Latin American currencies of rate swaps in 2018, a new record high and a 34 percent increase over 2017.
Of the 219 total market participants that are clearing these Latin American swaps at CME, the lion’s share (180) fall into the investment manager category, including hedge funds, asset managers and pensions. The remaining 39 include the global swap dealers and regional banks who provide liquidity in these markets.
Chilean Peso and Colombian Peso Hit The Ground Running
One other factor driving this increase is the addition of two new products which provide market participants with additional clearing opportunities, as well as margin offsets when they have risk reductions from offsetting positions in other products.
In May 2018, CME Group launched Chilean Peso and Colombian Peso rate swap clearing. The demand for these products was greater than I can remember for any other product, and it helped that some of the biggest users had long been clearing Mexican peso and Brazilian real swaps. The new products scaled quickly because these market participants were already fully connected to CME and familiar with the benefits of voluntary clearing.
Chile and Colombia were our best OTC product launches of all time, and the graph below shows how quickly they scaled to over 50 market participants globally clearing each one. It took Chile seven months and Colombia eight months, and this compares to twelve months for Brazil after it launched in 2015 and twenty months for Mexico after it launched in 2013.
Prior to our launch, market participants could only execute these swaps with counterparties where they had an International Swaps and Derivatives Association (ISDA) legal agreement and available credit lines setup. This limited the number of potential trading partners and required these managers to take additional credit risk of each counterparty they faced in a bilateral, off-exchange environment.
While Mexican swaps have been mandatory to clear for most Mexican and U.S. participants since 2017, the clearing of other Latin American currencies of rate swaps is completely voluntary. The reasons why clients want to voluntarily clear were evident when I was speaking to investment managers who were asking us to launch Chile and Colombia.
Managers said they liked better execution pricing and access to more liquidity providers that they get from clearing. Many of these participants have already been clearing their other rate swaps positions. Having everything cleared together on one exchange creates operational efficiencies by establishing one set of processes for all rates products and the margin efficiencies of risk offsets within a single account. With uncleared margin rules impacting approximately 50 market participants in 2019 and potentially thousands of accounts in 2020, investment managers are striving to free up their bilateral credit lines while also reducing counterparty credit risk.
That’s to be expected. As risk managers face another year with potential rate changes from central banks, political change and trade uncertainty with no end in sight, hedging interest rate risks will be paramount to their success.