Derivatives are financial instruments that are derived from an underlying asset, such as a stock, an exchange index, bonds, currency, interest rates and raw materials, among other things. There are two categories of derivatives: standardised, which are traded through a stock exchange such as the Colombia Stock Exchange (Bolsa de Valores de Colombia, BVC); and non-standardised, which are tailor-made products traded outside a formal exchange on an over-the-counter (OTC) basis. As well as developing broad and deep spot markets, the addition of a sophisticated derivatives market can give players in the industry a more complete range of investment opportunities while allowing financial and real economy companies alike to hedge against risks arising from their investments or in the course of their usual business activities. A Colombian firm borrowing in US dollars, for example, may wish to be able to hedge against both a change in interest rates and the exchange rate. In theory, standardised derivatives have the advantage of removing counterparty risk while ensuring a secondary market.
The BVC first dipped its toes in the standardised derivatives market with the September 2008 listing of a future contract based on a basket of government bonds. In the intervening eight years, the range of products available on the Colombian market has gradually expanded, while trading volumes have picked up substantially. What were once seen as exotic investment instruments have become more mainstream and key component of Colombian firms’ hedging strategies. Indeed, derivatives have come into their own since market volatility and macroeconomic uncertainty spiked in 2014, leading to further increases in traded volumes. Jaime Humberto López Mesa, president of the Colombian Association of Exchange Commission Agents, told OBG, “The derivatives market is still not huge, but it has been developing rapidly. Products are available on foreign exchange, interest rates and shares, and nearly all activity relates to hedging rather than speculation.”
Building on the initial success with the 2008 launch of futures on Treasury bonds, 2009 saw the addition of exchange rate futures. Each successive year saw the addition of a new futures products: shares in 2010, the Colombian capitalisation index Colcap in 2011, inflation in 2012, specific Treasury bond tenors in 2013 and overnight indexed swaps (OIS) in 2014. While all of the above products had already existed in non-standardised OTC form, the introduction of standardised derivative contracts allowed more players to enter the market, notably broker-dealers. It also extended opportunities for hedging to smaller and less sophisticated firms and investors who may not have previously had the wherewithal to use the OTC market.
Traded volumes were relatively small in 2008 and 2009, but jumped significantly during the 2010/11 period in terms of both the number of contracts and total volumes, whether measured in Colombian pesos or US dollars. All three dipped slightly in 2012, before regaining their upward march. From their fourth quarter 2012 low of COP13trn ($3.9bn), a level posted again in the third and fourth quarters of 2014, volumes tripled to reach a peak of COP39trn ($11.7bn) by the second quarter of 2016, according to BVC figures. The main drivers of volume have been foreign exchange futures and, increasingly, equity futures. However, prevailing macroeconomic trends have tended to have a big influence on investors’ use of derivatives. For example, periods of extreme foreign exchange rate volatility in recent years, spurred by the decline in oil prices, coincided with peaks in traded volumes for foreign exchange futures. Similarly, the central bank’s interest rate tightening cycle from late 2015 to mid-2016 coincided with increased trade in interest rate futures and swaps.
At the end of 2016 the total national equivalent value of all outstanding standardised derivative contracts stood at COP10.1trn($3bn), of which COP1.8trn($540m) related to interest rate products, COP100bn ($30m) to equity products, COP360bn ($108m) to foreign exchange and COP7.9trn ($2.4bn) to OIS. As reported in the March 2016 issue of PostTrade from the World Federation of Exchanges (WFE), by that month the BVC boasted: 27 derivative instruments across foreign exchange, including two peso and dollars products; equity, which covered 12 single stock futures in addition to the Colcap future; interest rates, of which nine were single Treasury bond futures and three bond basket futures, one of which is inflation-linked; and swaps, including two OIS products. The WFE also noted that Colombia’s derivatives market consisted of 33 members, comprising 15 broker-dealers, 13 banks, three trusts and two pension funds, which together accounted for some 5000 accounts.
While there was a major increase in standardised derivative products traded during the 2010/11 period, even at their peak they accounted for less than a fifth of the total trade in derivatives, the vast bulk still being made up of non-standardised OTC products. Notwithstanding continued growth in traded volumes of standardised derivatives from late 2012 onwards, this was more than matched by the increase in OTC trading, meaning that during the 2015/16 period the share of standardised derivatives in the overall derivative market was still only 10.1%. Traded volume in standardised foreign exchange futures is dwarfed by its OTC counterparts, with the former’s share falling from 5% in mid-2015 to less than 2% by late 2016. Similarly, BVC’s 3% market share in the $3bn OIS market also signals significant scope for growth in the years to come.
While broker dealers are restricted to trade only in standardised products, banks are permitted to also trade in OTC products. According to the WFE, broker-dealers have rapidly gained market share since 2013, now accounting for three-quarters of traded volume in standardised derivatives. The WFE also highlighted another important trend since 2013, namely, the consolidation of third-party participation in the futures market, accounting for a high of 34% of traded volume in 2015.
The Next Frontier
The BVC’s big project for 2017 is to add options to the suite of standardised derivative products on offer. Once this latest range of options has come on-line, the BVC will have a total of 11 standardised derivative products on offer, which is more than 10 on offer at the Chicago Mercantile Exchange, for example. Initially, options are to be offered on the Colcap index, as well as on the three most liquid equities in the spot market: the preferential shares of Bancolombia and Grupo Aval Acciones y Valores, and ordinary shares in Ecopetrol. Options are also to be offered on the futures for Treasury bonds maturing in 2018, 2024 and 2030, and on the spot peso/dollar exchange rate. According to the WFE, other instruments that may be added to the BVC’s offering include long-term and inflation-linked swaps, which would help further eat into OTC market share.
As in many emerging markets, and despite recent progress on this front, lack of liquidity is a constant challenge. Leonardo Mila Torres, director of investment strategy at pension fund Porvenir, told OBG, “The derivatives market has come a long way in recent years, but it is still developing and needs far more depth, as even some of the fixed-income futures have very limited liquidity.”
The WFE also flagged barriers to increased liquidity as including consolidation in both the banking and broker-dealer sectors, as well as tougher capital requirements and tighter regulation. The WFE added that the introduction of local custody to Colombia in 2014 was an important step towards making the BVC derivatives market more attractive to international players, which could be another source of increased liquidity. López Mesa told OBG, “Financial education is also critical for derivatives as much as for other investment products. It is important that the public is well informed as to all the possible alternatives to putting their savings in a bank account.”
Increased global economic uncertainty, with bouts of extreme market volatility which particularly impact emerging markets, would suggest that the immediate future for the development of the Colombian derivatives market is bright. While traded volumes are likely to continue to ebb and flow the overarching trend is likely to continue upwards as the country’s capital markets become increasingly sophisticated and a wider range of derivative products are available. At only 10% of the total derivatives market, and far less in the foreign exchange and OIS segments, there is significant scope for BVC’s standardised products to gain even more of a market share from the OTC market.