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Tenors too have expanded, with swaps of key
currencies such as the South African rand
and Mexican peso even going as far out as 30
years. This was unfathomable at the beginning
of the millennium.
Gains in product breadth have been equally
impressive. Most large- and medium-size
emerging markets have evolved beyond
currency forwards and swaps to include exotic
foreign exchange (FX) options. What’s more,
EM currency derivatives have showcased
sophistication at par with those of the G-10
currencies and include products as cancelable
cross-currency swaps, quanto credit default
swaps, and synthetic on-shore swaps, in other
words off-shore swaps that reference an on-
shore swap market.
Regulations temper expansion
Generally speaking, currency convertibility
and the easing of FX and capital controls
are key drivers of EM derivatives growth.
As a result, “open” jurisdictions that enjoy
these conditions, such as South Africa and
Mexico, have experienced the biggest bump in
derivatives activity. At the same time, around
three-quarters of emerging markets still
have currencies that are not fully convertible.
Extreme examples include countries such
as Argentina and Venezuela that, through
staggering exchange controls, have entirely
obliterated their own currency derivative
markets.
Other factors that fuel EM derivative growth
include sound legal and regulatory trading
frameworks, robust bankruptcy laws, viable
bond markets and the existence of yield curves
and interest rate benchmarks. Still, a large
number of EMs do not possess LIBOR-like
benchmarks, which has hampered the evolution
of derivative buildings block such as basic swaps
and interest options for those markets. In these
cases, local institutional investors – mainly
pension funds and insurance companies – serve
as catalysts for development. As such investors
seek long-duration local currency assets, either
directly or synthetically, they promote the
extension of yield curves and development of
benchmarks for interest rate swaps.
Balance sheets are transformed
Many EM governments with established
risk management frameworks have used
derivatives over the past decade to
fundamentally transform their balance
sheets. Today, emerging market debt
is preponderantly denominated in local
currencies, a significant swing from the pre-
2000 years when approximately 90 percent
of that debt was US dollar-denominated and
vulnerable to both FX and systemic EM risks.
A change in mindset and the pursuit of local
currency-denominated debt by EM borrowers,
sovereigns in particular, evolved in part as a
response to the Latin American, Russian and
Asian debt crises of the 1990s that triggered
maxi-devaluations and sovereign defaults.
Multilaterals, and institutions
such as Citi, bring to the table
a wealth of experience and
expertise that can help public
sector entities take advantage
of opportunities in the EM
derivatives.