## cr18345

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### Executive summary — market structure and liquidity
- Brazil’s financial markets are generally liquid and sophisticated with a wide array of instruments to manage and hedge interest rate and FX risks.
- Large structural liquidity surplus (around 20 percent of GDP in the Executive Summary; ≈ 25 percent of GDP in chapter detail).
- Brazil’s substantial FX reserves underpin resiliency; investors hold ample cash reserves as a buffer against liquidity shocks.
- Preference for high quality short term liquid investments: overnight repos and short-term government bonds.
- Government bonds are the centerpiece of the securities markets and the lynchpin of the repo market.
- Market concentration is high: the top 6 asset managers/banks control over 60 percent of assets under management and 80 percent of banking system assets respectively.
- Interest rate and FX derivatives markets are well-developed and cleared through CCPs, while the cash instruments that underlie derivatives are often much less liquid.
- Interest rate derivatives predominantly use the overnight unsecured interbank CDI rate as benchmark, a market that is very lightly traded compared with the SELIC repo market.
- FX spot market is relatively small and access is limited to 189 authorized bank FX dealers, impeding development of a more representative spot market.

### Money and fixed income market structure — selected statistics and characteristics (2017)
- Dominance of overnight instruments: SELIC repo market is the deepest and most actively traded money market segment; onshore FX swaps and unsecured CDI markets are much smaller.
- Selected figures (2017, BRL):
  - Outstanding issuance (2017, BRL):
    - SELIC Repo 1,273 billion
    - Interbank Unsecured CDI 52.7 billion
    - Certificates of Deposits 198 billion
    - Commercial Paper and Asset backed securities 254.8 billion
    - Federal Government 3,187 billion
  - Average maturity (2017):
    - SELIC Repo 1.3 days
    - Interbank Unsecured CDI 1 day
    - Certificates of Deposits 83 days
    - Commercial Paper and Asset backed securities 225 days
    - Federal Government 4.4 years
  - Daily traded volume (2017):
    - SELIC Repo 1,289 billion
    - Interbank Unsecured CDI 2,634 million
    - FX Swaps 4,574 million
    - Certificates of Deposits 687 million
    - Federal Government 28,789 million
  - Turnover ratio (2017):
    - SELIC Repo 281
    - Interbank Unsecured CDI 12
    - Certificates of Deposits 0.5
    - Commercial Paper and Asset backed securities 0.6
    - Federal Government 2.2
- Indexation (December 2017, BRL Millions; percent of total):
  - instruments indexed to interbank unsecured CDI 76.5 percent
  - SELIC repo 10.9 percent
  - fixed rate 12.2 percent
  - inflation indexed 0.3 percent
  - others 0.1 percent

### Issues with key benchmarks: SELIC versus CDI
- Both overnight benchmarks are based on interbank trades: SELIC calculated by the BCB based on repo trades captured in SELIC; CDI calculated by the B3 exchange.
- SELIC comprehensively reflects market trades; CDI captures few overnight interbank transactions.
- Trade volumes underlying SELIC are significantly greater—almost 150 times in 2017—than for CDI.
- CDI can only be calculated if more than ten trades are available; this criterion was not met on around 92 percent of occasions in the first half of 2017, leading to frequent use of a fall-back rule that bases CDI on SELIC less a margin.
- CDI transactions tend to be from smaller banks with excess funds and therefore CDI tends to lie below SELIC and is not representative of large banks’ funding costs.
- SELIC repo rate is a superior indicator of short-term funding costs compared to CDI.

### FX market characteristics, liquidity, and regulatory constraints
- Brazil’s FX swaps market is very small in absolute size and relative to peers; FX spot market is relatively small and constrained by regulations limiting deliverable FX transactions to 189 authorized bank FX dealers.
- FX derivatives markets provide price discovery and hedging and are much more actively traded than spot FX; price discovery often occurs in derivatives markets rather than the spot market.
- Key FX hedging instrument: the DOL US dollar futures on B3 — a BRL settled futures contract based on a notional USD 50,000 investment in Real earning the overnight CDI rate and paying the onshore USD Cupom Cambial interest rate.
  - Turnover in 2017 for the DOL futures instrument averaged around 15.7 billion USD per day.
- Exchange traded FX derivatives are cleared through the B3 CCP; OTC derivatives such as onshore NDFs and BRL settled FX swaps are registered with B3.
- B3 determines margins for exchange traded derivatives; margins are conservatively set, re-margined once a day and need to cover FX risks for two days once margin is received.
- Interbank spot FX transactions can settle through the B3 CCP; the Real is not part of the Continuous Linked System (CLS).
- Market participants face settlement limits through B3: around USD 1 billion per counterparty per day; larger transactions must be split or settled bilaterally.
- The DOL futures instrument is more heavily traded in the nearest maturing contract, typically maturing within 2 months; other OTC instruments have longer tenors but are much smaller.
- Long-term FX hedges can be achieved by rolling dollar futures with the CDI and Cupom Cambial USD futures curves, which are deep and liquid for long tenors.
- Regulatory constraint: Brazil’s FX regulations do not allow some domestic market participants to enter into any contract settled in FX; importers, exporters and banks have differing access and end-users must trade with one of the 189 authorized FX dealers.
- Recommendation: Update FX regulations to reflect market development and to allow a wider range of participants to trade contracts that are deliverable in FX (¶ 43–47).

### BCB liquidity management, sterilization, and balance sheet
- BCB operates a mid-corridor interest rate implementation framework; operational target is the overnight SELIC repo rate.
- The BCB accepts that the market overnight SELIC rate can remain around 10 basis points below the policy target rate.
- Two-day standing lending and deposit facilities priced at 80 basis points around the market SELIC rate.
- Structural liquidity overhang ≈ 25 percent of GDP, mainly reflecting BCB’s significant FX reserves; liquidity sterilization is BCB’s main liquidity management objective.
- Sterilization composition:
  - Reserve requirements are very high (40 percent for demand deposits) and account for around 25 percent of total sterilization.
  - Around 75 percent of total sterilization occurs using repo (or around 19 percent of GDP).
  - Most liquidity sterilization uses 45-day repo operations that span the time between MPC meetings.
  - Average maturity of BCB repos is around 20 days.
- Legal and operational constraints:
  - BCB is not permitted by law to issue its own securities but can conduct outright government bond sales from its portfolio (not done in practice).
  - BCB regularly receives government securities from the MOF when valuation losses accrue on the BCB’s foreign reserves; regulations allow further securities if unencumbered holdings fall below 20 billion BRL.
  - FX losses—realized or unrealized—are covered by the MOF on a semiannual basis through injections of government bonds to the BCB balance sheet.
- Treasury Single Account (TSA):
  - Around 33 percent of BCB assets.
  - Around 15 percent of GDP.
  - TSA is remunerated based on the average accrued yield the BCB earns on the government securities it holds; interest is paid every ten days.
- Proposed changes to distribution and capital policies:
  - Current practice: net income transferred to the government’s TSA every six months; losses returned to the BCB as government securities (Provisional Measure N° 2.179-36, August 24, 2001 and Law N° 11.803, November 5, 2008).
  - Proposed change: future FX gains and losses would accrue to the BCB’s capital reserves; recapitalization if reserves fall too low; flows to the TSA if reserves grow too large.
  - Potential implication: reduced flows to/from TSA and reduced buildup of BCB government bond holdings; BCB may need other instruments to sterilize liquidity.
  - Proposal under consideration to authorize the BCB to accept term deposits as an alternative sterilization tool; BCB securities would be a superior alternative but require changes to the Fiscal Responsibility Law.
  - The proposed 4 percent minimum threshold for unencumbered BCB government bond holdings is an effective increase relative to the existing minimum threshold of 20 billion Reals; proposal allows emergency injections of bonds if serious liquidity management pressures emerge.

### FX intervention instruments, approach, and market effects
- Intervention choice reflects relative liquidity of markets; price discovery and liquidity centered on the futures market, so intervention mainly occurs there.
- Repo lines of credit used for temporary FX funding shortages; Brazilian FX swaps used when hedging or outflow pressures are predominant.
- BCB intervention history:
  - Discretionary approach until 2013.
  - From 2013 until March 2015 switched to a preannounced regular program using FX repo lines of credit and Brazilian FX swaps.
  - From 2013-2015 BCB sold Brazilian swaps around USD 115 billion (around 20 percent of BCB FX reserves).
- Auctions and transparency:
  - Preannounced multiple price auctions used for FX spot and FC repos; single-priced auctions for Brazilian FX swaps.
  - Volume offered in FX swap auctions is announced; BCB can allot less than the amount offered.
  - Volume offered in spot FX auctions is not fixed in advance.
  - Auctions are preannounced and results released immediately after the auction; volumes transacted and outstanding of intervention instruments published weekly.
- Market intermediation:
  - Banks intermediate BCB’s derivatives interventions to end users, repackaging FX hedges across spot, outright forward, futures and OTC markets and retaining modest net FX exposure.

### Debt management framework and Market Maker of Last Resort (MOF and BCB roles)
- Debt management:
  - Directed by the MOF and implemented through the BCB’s SELIC system; national treasury publishes an annual borrowing plan and monthly auction schedule.
  - MOF focuses issuance on maturities longer than a year to reduce refinancing risk and lengthen maturities while meeting market demand (increased volumes of floating rate and inflation linked bonds).
  - MOF can adjust issuance strategy monthly, including exchange and buyback operations.
- Market Maker of Last Resort (MMLR) operations:
  - MOF uses changes to scheduled auctions and outright sales, purchases and switch operations to preserve price discovery and liquidity.
  - Interventions focus on benchmark actively issued securities during periods of unusual volatility and illiquidity and are often two-way operations to support price discovery while minimizing net supply changes.
  - BCB offers a securities lending facility twice daily to dealers; lending limit set at 25 percent of BCB holdings and lending fee is a 15-basis point net fee on a security for security basis, with the fee set through competitive auctions.

### Operational reforms and introducing new instruments
- Current OMO practice:
  - BCB invites banks to first suggest an interest rate for overnight and 45-day repo operations; once the interest rate is set, volumes are bid and allocated.
  - Strength: works well in a large liquidity surplus where banks expect full allocation.
  - Limitation: no direct link between volumes bid and prices; difficult to introduce and discriminate between new instruments or maturities.
- Recommended operational change:
  - Move to fixed volume—variable price OMO auctions.
  - Alternative in volatility: fixed rate–full allotment operations for short-term repo auctions.
  - The Fund could offer technical assistance to develop a new operational approach.
- Related adjustment:
  - Link interest paid on the TSA to SELIC rather than the return on the BCB’s government bond portfolio.
- SELIC alignment:
  - A 10-basis point gap between policy rate and SELIC is meaningful at current low rates; recommendation to align SELIC closer to the BCB policy rate (i.e., 10 basis points higher than currently) to erase communications concerns.
- Reserve requirements:
  - BCB plans to simplify and reduce reserve requirements and consider widening the reserves base by including public sector deposits.

### Term deposits, BCB securities, and alternative sterilization instruments
- International context: 54 out of 121 (45 percent) central banks reported use of term deposits in some form (2013 ISIMP survey).
- Term deposits characteristics and limits:
  - Typically used for shorter terms; maximum maturities of one month and less are most common.
  - Early redemption can be allowed to encourage longer maturities; US Federal Reserve example allows early termination for a fee (forfeiture of accrued interest plus 0.75% per annum).
  - Term deposits useful for short-term fine tuning but may not be suitable or cost effective for structural sterilization.
  - End-users of BCB OMOs—banks and investment funds—have limited capacity to place term deposits at the BCB; banks more able than investment funds.
  - BCB likely to need to offer higher interest rates to entice participation, increasing policy implementation costs.
  - Term deposits would need frequent roll-over to achieve structural sterilization objectives (current main instrument: 45-day repos).
- BCB securities as preferable structural instrument:
  - BCB securities would be ideal back-up structural sterilization instrument; historically sterilization met by government bonds but future needs may grow beyond available bonds.
  - Fiscal Responsibility Law adjustments required to allow BCB to issue securities.
  - BCB securities would be more liquid than term deposits and fit naturally into investor portfolios; issuance would need coordination with MOF to avoid market segmentation.
  - Given government does not issue securities at the very short end (less than six months), there is a market gap the BCB could fill.
- Policy-relevant conclusions:
  - BCB request to the Senate for authority to offer term deposits has merit to allow overnight and very short-term deposit facilities.
  - Term deposits could support fine-tuning liquidity and place a floor on interest rates as part of a corridor system, but are not ideal for structural sterilization where BCB securities would be superior.

### Representativeness of money market benchmarks and transition guidance
- Assessment:
  - SELIC is a far superior and robust benchmark compared to CDI and should replace CDI.
  - CDI falls short of FSB/IOSCO principles: lacks an underlying market reflective of funding costs of large banks and often relies on a fall-back rule tying CDI to SELIC.
- Transition role of authorities:
  - BCB should work with CVM, ANBIMA and B3 to transition away from CDI.
  - Regulators can indicate a date after which CDI use won’t be suitable from a regulatory perspective.
  - Adjust the fall-back rule so CDI is fixed to SELIC to eliminate financial differences and facilitate novation of existing derivative contracts from CDI to SELIC.
- Implementation guidance: an adequate transition plan and period is required to prevent disruption risks; FSB principles require clear, carefully planned and communicated transitions.

### Key recommendations (summary)
- Monetary Policy Operations and Liquidity Management:
  - BCB to seek authority to issue term deposits for short-term sterilization purposes and to seek authority to issue its own securities for monetary policy purposes if an additional structural tool is required (¶ 40). Responsible: BCB and MOF. Time: I
  - BCB to develop an operating approach that incorporates variable rate auctions of term deposits and eventually BCB securities (¶ 41). Responsible: BCB. Time: I
  - BCB to reform its operational target to better align OMOs with the SELIC policy target rate (¶ 42). Responsible: BCB. Time: I
  - BCB to set the interest rate on the TSA equal to SELIC (¶ 41). Responsible: BCB and MOF. Time: NT
- Improving resilience of money, bond and FX markets:
  - Replace the CDI benchmark with the overnight SELIC benchmark (¶ 48–50). Responsible: B3, BCB and ANBIMA. Time: NT
  - Review the regulatory framework governing the spot FX market to allow a wider range of participants to trade contracts that are deliverable in FX (¶ 43–47). Responsible: BCB and MOF. Time: NT
- Sequencing and safeguards:
  - Ease access to deliverable FX instruments should be carefully sequenced and conditioned on a supportive macro-financial backdrop and robust alternative tools (for example macro-prudential policies).
  - Consider Fund technical assistance for designing a transition path and operational reforms.

*Source: cr18345 — IMF country report chapter content provided in the content unit.*

### EXECUTIVE SUMMARY __________________________________________________________________________ 4

### EXECUTIVE SUMMARY

### Key findings on market structure and liquidity
- Brazil’s financial markets are generally liquid and sophisticated with a wide array of instruments to manage and hedge interest rate and FX risks.
- A key foundation of resiliency is the large structural liquidity surplus (around 20 percent of GDP) and Brazil’s substantial FX reserves.
- Investors hold ample cash reserves that provide a key buffer against liquidity shocks.
- Investors prefer high quality short term liquid investments (overnight repos and short-term government bonds); dollarization is low but FX hedges are widely available.
- Government bonds are the centerpiece of the securities markets and are the lynchpin of the repo market.
- Market concentration is high: the top 6 asset managers/banks control over 60 percent of assets under management and 80 percent of banking system assets respectively.
- Well-developed interest rate and FX derivatives markets are sophisticated, deep, liquid and have Central Counterparties (CCPs) to clear transactions, but the cash instruments that underlie derivatives are often much less liquid.
- Interest rate derivatives predominantly use the overnight unsecured interbank CDI rate as benchmark, a market that is very lightly traded and not generally perceived to be representative of large banks’ funding costs compared with the much more active SELIC repo market.
- The FX spot market is relatively small and constrained by regulations that limit deliverable FX transactions to 189 authorized bank FX dealers, which impedes development of a more representative spot market.

### Money and fixed income market structure (selected statistics and characteristics)
- Dominance of overnight instruments: the SELIC repo market is the deepest and most actively traded money market segment; the onshore FX swaps and unsecured CDI markets are much smaller.
- Table 2 (selected figures, 2017):
  - Outstanding issuance (2017, BRL): SELIC Repo 1,273 billion; Interbank Unsecured CDI 52.7 billion; Certificates of Deposits 198 billion; Commercial Paper and Asset backed securities 254.8 billion; Federal Government 3,187 billion.
  - Average maturity (2017): SELIC Repo 1.3 days; Interbank Unsecured CDI 1 day; Certificates of Deposits 83 days; Commercial Paper and Asset backed securities 225 days; Federal Government 4.4 years.
  - Daily traded volume (2017): SELIC Repo 1,289 billion; Interbank Unsecured CDI 2,634 million; FX Swaps 4,574 million; Certificates of Deposits 687 million; Federal Government 28,789 million.
  - Turnover ratio (2017): SELIC Repo 281; Interbank Unsecured CDI 12; Certificates of Deposits 0.5; Commercial Paper and Asset backed securities 0.6; Federal Government 2.2.
- Indexation (December 2017, BRL Millions; percent of total): instruments indexed to interbank unsecured CDI 76.5 percent; SELIC repo 10.9 percent; fixed rate 12.2 percent; inflation indexed 0.3 percent; others 0.1 percent.

### Issues with key benchmarks: SELIC versus CDI
- Both overnight benchmarks are based on interbank trades: SELIC is calculated by the BCB based on repo trades captured in SELIC; CDI is calculated by the B3 exchange.
- SELIC comprehensively reflects market trades; CDI captures few overnight interbank transactions.
- Trade volumes underlying SELIC are significantly greater—almost 150 times in 2017—than for CDI.
- CDI can only be calculated if more than ten trades are available; this criterion was not met on around 92 percent of occasions in the first half of 2017, resulting in frequent use of a fall-back rule that bases CDI on SELIC less a margin.
- CDI transactions tend to be from smaller banks with excess funds; CDI therefore tends to lie below SELIC and is not representative of large banks’ funding costs.
- SELIC is actively traded and more representative of bank short term cost of funds; SELIC repo rate is a superior indicator of short-term funding costs compared to CDI.

### FX market characteristics and regulatory constraints
- FX derivatives markets provide price discovery and hedging, but the deliverable spot FX market is small and access is limited to 189 authorized bank FX dealers.
- Price discovery often occurs in derivatives markets rather than the spot market; when derivative markets become illiquid or close (for example when daily circuit breaker limits are reached on the B3 exchange), end-users have limited alternatives to trade and manage FX risk.
- The FX regulatory regime should be updated to reflect market development and to allow a wider range of participants to trade contracts that are deliverable in FX.

### Authorities’ roles and operational framework issues
- The BCB is a major supplier of high quality liquid assets through large OMO repo operations; the MOF is active in debt issuance and uses reverse auctions to provide liquidity in the bond market during periods of high volatility.
- Authorities’ interventions (BCB in OMOs and FX futures; MOF in debt issuance) and coordination between BCB and MOF provide market comfort, but high reliance on the authorities may discourage markets from developing capacity to manage risks independently.
- Planned legislative changes to reduce variability of transfers between BCB and MOF could mean the BCB has fewer government bonds to use in OMOs over time.
- The BCB plans to introduce term deposits as an alternative sterilization tool; challenges include:
  - Term deposits do not currently fit within some asset managers’ investment mandates.
  - Deposits may be costlier for the BCB due to lower liquidity.
  - Using BCB-issued securities would be preferable; the BCB should pursue legislative changes to issue its own securities (¶ 40).
- The BCB should review and reform its operational framework to accommodate new instruments and better align operations with policy settings:
  - Reform OMO approach to incorporate more conventional fixed volume, variable priced auctions targeted at keeping rates close to the SELIC target rate (¶ 41–42).
  - Set the interest rate paid on the Treasury Single Account (TSA) equal to SELIC as a better benchmark for a short-term risk-free deposit (¶ 41).

### Financial stability relevance and market resilience
- Markets are interconnected and concentrated; banks and asset managers are parts of conglomerates doing substantial business with each other.
- Repo market foundation is tied to BCB OMOs which channel government bonds to asset managers.
- Derivatives markets are deep while cash markets for underlying instruments are thin, causing reliance on derivatives to manage or take risk.

### Key recommendations (Table 1: Brazil FSAP—Systemic Liquidity—Key Recommendations)
- Monetary Policy Operations and Liquidity Management
  - BCB to seek authority to issue term deposits for short-term sterilization purposes and to seek authority to issue its own securities for monetary policy purposes if an additional structural tool is required (¶ 40). Responsible: BCB and MOF. Time: I
  - BCB to develop an operating approach that incorporates variable rate auctions of term deposits and eventually BCB securities (¶ 41). Responsible: BCB. Time: I
  - BCB to reform its operational target to better align OMOs with the SELIC policy target rate (¶ 42). Responsible: BCB. Time: I
  - BCB to set the interest rate on the TSA equal to SELIC (¶ 41). Responsible: BCB and MOF. Time: NT
- Improving the resilience of money, bond and FX markets
  - Replace the CDI benchmark with the overnight SELIC benchmark (¶ 48–50). Responsible: B3, BCB and ANBIMA. Time: NT
  - Review the regulatory framework governing the spot FX market to allow a wider range of participants to trade contracts that are deliverable in FX (¶ 43–47). Responsible: BCB and MOF. Time: NT
- Time coding: “I (immediate)” is within one year; “NT (near-term)” is one–three years; “MT (medium-term)” is three–five years.

### Policy implications and near-term priorities
- Urgent reform of the CDI benchmark is needed; replacement with SELIC is widely preferred but requires leadership from authorities and coordination with market participants (¶ 48–50).
- Update FX regulations to broaden access to deliverable FX contracts and deepen the spot FX market (¶ 43–47).
- Pursue legislative changes to enable BCB issuance of its own securities to preserve OMO capacity and consider term deposits only as a supplement if necessary (¶ 40–41).
- Reform OMOs and operational targets to align liquidity operations with the SELIC policy rate and to accommodate variable-rate auction instruments (¶ 41–42).

*Source: EXECUTIVE SUMMARY, Brazil FSAP—Technical Note on Systemic Liquidity (IMF).*

### 6.      Most participants cannot or choose not to use the FX swap market for liquidity

### 6.      Most participants cannot or choose not to use the FX swap market for liquidity management

### FX swap market limitations and market structure
- Brazil’s FX swaps market is very small, both in absolute size, and relative to peer countries.
- Small FX swap market implies market participants cannot easily use foreign exchange to meet Brazilian Real liquidity needs on a hedged basis without resort to the derivative markets; the deep SELIC repo market is a more preferred liquidity management instrument.
- The small size reflects Brazil’s FX restrictions that prohibit many domestic market participants from participating in any deliverable FX denominated contract onshore.
- Brazil’s FX regulations do not allow some domestic market participants to enter into any contract settled in FX. Importers, exporters and banks have differing access; end-users must trade with one of the 189 authorized FX dealers.

### Interest rate derivatives market (Table 4, December 2017)
- CDI futures: Traded Volumes (Daily Avg, 2017, BRL billions) 144.6; Open Interest (Daily Avg, 2017, BRL billions) 2031.9
- SELIC futures: Traded Volumes 0.008; Open Interest 1.7
- CDI Interest rate swaps:
  - < 30 days: 3.7
  - 30 to 365 days: 35%
  - 1 to 5 years: 29%
  - 5 years and longer: 31%
  - (additional line) 4%
- SELIC swaps: Traded Volumes 0.0; Open Interest N/A
- Source: BCB (as presented in the table)

### FX market liquidity, derivatives centrality, and instruments
- Brazil’s FX market ranks in the top 20 largest markets globally; small compared to advanced economies but around the median in turnover-to-GDP among BRICS peers once FX derivatives are considered.
- FX spot market is relatively small, partially reflecting regulatory constraints and limited access for some domestic participants.
- FX derivatives are much more widely accessible and much more actively traded; they are the center of price discovery, trading and hedging.
- The key FX hedging market is the DOL US dollar futures instrument listed on the B3 exchange: a BRL settled futures contract based on a notional USD 50,000 investment in Real earning the overnight CDI rate and paying the onshore USD Cupom Cambial interest rate.
- Turnover in 2017 for the DOL futures instrument averaged around 15.7 billion USD per day.
- The bulk of FX contracts are cleared or registered with the B3 exchange:
  - Exchange traded FX derivatives are cleared through the B3 central counterparty (CCP).
  - OTC derivatives such as onshore NDFs and BRL settled FX swaps are registered with the exchange; all domestic entities are required to register OTC derivatives with B3.
  - B3 determines margins for exchange traded derivatives settled through its CCP; margins are conservatively set, vary with market conditions, and are re-margined once a day (margins need to cover FX risks for two days once margin is received).
- Interbank spot FX transactions can settle through the B3 CCP, reducing settlement risk for deliverable FX transactions; the Real is not part of the Continuous Linked System (CLS).
- Market participants face limits on the volume of spot FX transactions that can be settled through B3 in a day (around USD 1 billion per counterparty); larger transactions must be split or settled bilaterally.

### FX hedging tenor and capabilities
- The DOL futures instrument is much more heavily traded in the nearest maturing contract, typically maturing within 2 months.
- Other OTC instruments have longer tenors but are much smaller.
- Investors can achieve long-term FX hedges by combining rolling dollar futures contracts with the CDI and Cupom Cambial USD futures curves, which are deep and liquid for long tenors.

### BCB liquidity management and sterilization
- The BCB operates a mid-corridor interest rate implementation framework; operational target is the overnight SELIC repo rate.
- The BCB accepts that the market overnight SELIC rate can remain around 10 basis points below the policy target rate.
- The BCB has two-day standing lending and deposit facilities priced at 80 basis points around the market SELIC rate.
- Brazil has a large structural liquidity surplus at around 25 percent of GDP, mainly reflecting the BCB’s significant FX reserves; liquidity sterilization is the BCB’s main liquidity management objective.
- Structural liquidity is absorbed using high reserve requirements and repo operations:
  - Reserve requirements are very high (40 percent for demand deposits) and account for around 25 percent of total sterilization.
  - The balance of sterilization occurs using repos with maturities from overnight to 6 months.
  - Most liquidity is sterilized using 45-day repo operations that span the time between MPC meetings.
  - The average maturity of BCB repos is around 20 days.
- The BCB is not permitted by law to issue its own securities but can conduct outright government bond sales from its portfolio (not done in practice).
- The BCB’s capacity to sterilize using repo operations is underpinned by the MOF:
  - The BCB regularly receives government securities from the MOF when valuation losses accrue on the BCB’s foreign reserves.
  - Regulations allow the BCB to receive further government securities from the MOF if unencumbered holdings fall below 20 billion BRL.
  - FX losses—realized or unrealized—are covered by the MOF on a semiannual basis through injections of government bonds to the BCB balance sheet.

### BCB balance sheet and sterilization composition
- Composition notes and figures (as described):
  - Structural liquidity overhang ≈ 25 percent of GDP.
  - Reserve requirements contribute around 25 percent of total sterilization.
  - Around 75 percent of total sterilization occurs using repo (or around 19 percent of GDP).

### Proposed changes to BCB distribution and capital policies (Box 2)
- Current practice: net income is transferred to the government’s TSA every six months; losses are returned to the BCB as government securities (rules established in Provisional Measure N° 2.179-36, August 24, 2001 and Law N° 11.803, November 5, 2008).
- Proposed change: future FX gains and losses would accrue to the BCB’s capital reserves; recapitalization would occur if capital reserves fall too low, and funds would flow to the TSA if reserves grow too large.
- Potential implications:
  - Reduced flows to/from TSA and reduced buildup of BCB government bond holdings.
  - The BCB’s government bond portfolio might not grow over time in line with the structural liquidity surplus; BCB may need other instruments to sterilize liquidity.
  - Proposal under consideration to authorize the BCB to accept term deposits as an alternative sterilization tool; BCB securities would be a superior alternative but would require changes to the Fiscal Responsibility Law.
- The proposed 4 percent minimum threshold for unencumbered BCB government bond holdings is an effective increase relative to the existing minimum threshold of 20 billion Reals; the proposal allows emergency injections of bonds if serious liquidity management pressures emerge.

### Treasury Single Account and potential operational shifts
- The government’s balance in the Treasury Single Account (TSA) is large:
  - Around 33 percent of BCB assets.
  - Around 15 percent of GDP.
- The TSA is remunerated based on the average accrued yield the BCB earns on the government securities it holds; interest is paid every ten days.
- Legislative proposals (Senate draft law) would allow the BCB to accept remunerated sight or term deposits as substitutes for repo transactions of government securities, with potential to change composition of sterilization instruments (currently around 75 percent of total sterilization via repo, or around 19 percent of GDP).

### FX intervention approach and recent activity
- The BCB has an active FX intervention approach without a formal written FX intervention policy; objectives have varied historically.
- Recent focus has been on leaning against exchange rate volatility rather than the level of the exchange rate.
- The BCB’s interventions have been frequent and at times relatively large:
  - From 2013-2015 the BCB sold FX in the form of Brazilian swaps of around USD 115 billion or around 20 percent of BCB FX reserves.
- The BCB can intervene in spot and derivatives markets but mainly intervenes in the futures market.
- Since mid-2012 the BCB has used FX derivatives for intervention in the form of FX repo lines of credit (equivalent to standard FX swaps) and sales of “Brazilian FX Swaps” (cash-settled contracts for difference based on change in USD/BRL and accrued SELIC over the life of the swap).
- Intervention operations:
  - Preannounced multiple price auctions used for FX spot and FC repos.
  - Single-priced auctions for Brazilian FX swaps.
  - Volume offered in FX swap auctions is announced and BCB can allot less than the amount offered depending on bids received.
  - Volume offered in spot FX auctions is not fixed in advance.

_Italic: Source — content from the IMF country report chapter provided in the content unit._

### 22.      The choice of intervention instrument reflects the relative liquidity of markets and the

### 22.      The choice of intervention instrument reflects the relative liquidity of markets and the

### FX intervention instruments and market liquidity
- Price discovery and liquidity are centered on the Brazilian futures market, so intervention mainly occurs there.
- Spot market intervention would be more likely if convertibility risks emerge to the extent that the onshore US dollar interbank rate—the Cupom Cambial—rises relative to offshore US interest rates.
- Repo lines of credit are used where FX demand stems from temporary FX funding shortages.
- Brazilian FX swaps are used when hedging or outflow pressures are predominant.
- Banks intermediate the BCB’s derivatives interventions to end users by trading with the BCB and then selling and re-packaging FX hedges with their customers (corporates, foreign investors) using the spot, outright forward, futures and OTC derivatives markets, leaving banks with a modest net FX exposure.

### BCB intervention approaches, scale, and transparency
- The BCB used a discretionary approach up until 2013.
- From 2013 until March 2015 the BCB switched to a preannounced regular program of interventions using FX repo lines of credit and Brazilian FX swaps.
- Rationale for the rules based approach: exchange rate pressure was viewed as being driven by hedging demand from corporates and households best met with a more predictable and transparent approach.
- The BCB has at times been a large part of the futures market and a key hedging counterpart; when the BCB FX swap program was at its peak in late 2014:
  - Brazilian banks accounted for around half of the BCB’s outstanding swaps,
  - institutional investors around 45 percent,
  - foreign investors around 5 percent.
- Communications protocols:
  - Auctions are preannounced and results released by communique immediately after the conclusion of the auction.
  - Volumes transacted and outstanding of intervention instruments are published weekly, allowing full transparency of the BCB’s intervention ex-post.

### Debt management framework and Market Maker of Last Resort (MOF and BCB roles)
- Debt management strategy:
  - Directed by the MOF and operations implemented through the BCB’s SELIC system.
  - The national treasury publishes an annual borrowing plan and a monthly auction schedule; the MOF determines debt management strategy and auction composition/results.
  - MOF government bond issuance is focused on maturities longer than a year to reduce refinancing risk while minimizing costs by lengthening maturities and focusing on market segments with greatest demand (increased volumes of floating rate and inflation linked bonds).
  - The MOF can adjust issuance strategy monthly via its auction schedule and can change composition, offer exchange and buyback operations.
- Market Maker of Last Resort:
  - The MOF conducts MMLR operations via changes to scheduled auction programs and outright sales, purchases and switch operations to preserve price discovery and liquidity.
  - Interventions focus on benchmark actively issued securities during periods of unusual volatility and illiquidity and occur infrequently—often when there are large changes in government bond yields.
  - Most bond market support operations are two-way operations (purchases partially balanced with bond sales) to support price discovery while minimizing net supply changes; nonetheless, most operations result in net purchases consistent with a stabilizing role.
  - The MOF offers a buy back facility to retail investors via the “Treasury Direct” program.
  - The BCB offers a securities lending facility twice daily to dealers; lending limit set at 25 percent of BCB holdings and the BCB lends securities for a 15-basis point net fee on a security for security basis, with the fee set through competitive auctions.

### Key issues of relevance to financial stability — Reliance of markets on the BCB
- The BCB supplies HQLA to the financial system; banks and asset managers prefer overnight repo investments provided by the BCB via its sterilization operations.
- Banks act as conduits for funds from investment funds, performing maturity transformation (placing funds and repo government bonds from the BCB for maturities longer than overnight—average maturity around 20 days—and then taking funds from and supplying government bond collateral to investment funds on an overnight basis).
- The current model may be challenged if the BCB’s bond holdings do not grow in line with the structural liquidity surplus:
  - Changes in the BCB distribution model have the side effect of reducing inflow of government bonds to the BCB balance sheet.
  - New legislation provides mechanisms for the BCB to continue to receive bonds for use in OMOs, but if insufficient bonds are provided or there is a desire for fewer government bonds to be used in OMOs then alternative instruments will be required.
  - The proposal to introduce term deposits to the BCB tool-kit is designed to fill any gap that might arise; a key issue is the degree to which new BCB tools fit with the existing market structure.

### Term deposits, BCB securities, and alternative sterilization instruments
- International experience (2013 ISIMP survey):
  - 54 out of 121 (45 percent) central banks said they were using term deposits in some form.
  - Reported maximum maturity distribution and pricing formats were summarized in the source.
- Characteristics and limitations of term deposits:
  - Term deposits are typically used for shorter terms due to their illiquid characteristics; maximum maturities of one month and less are most common.
  - It is possible to allow early redemption to encourage longer maturities; example provided where the US Federal Reserve allows early termination for a fee (forfeiture of accrued interest plus 0.75% per annum).
  - Term deposits may be useful for short-term fine tuning but may not be suitable or cost effective for structural sterilization.
  - End-users of BCB OMOs—banks and investment funds—have limited capacity to place term deposits at the BCB; banks have more capacity while investment funds do not currently have direct access to the BCB’s OMOs.
  - Banks indicated some capacity to invest in very short-term deposits (for example overnight or less than one week) though total volume might be relatively small; reduced reserve requirements could increase banks’ capacity to invest in term deposits.
  - The BCB would likely need to offer higher interest rates to entice banks and asset managers to place term deposits, increasing the costs of implementing monetary policy.
  - Term deposits tend to be used for maturities commonly less than a month; the BCB would need to roll over significant volumes frequently to achieve structural sterilization objectives (the main sterilization instrument currently is 45-day repos offered between Copom meetings).
- BCB securities as preferable back-up structural sterilization instrument:
  - Historically, growth in the BCB’s sterilization need has been met by government bonds; future sterilization needs will likely grow but sufficient bonds may not be available.
  - BCB securities would be ideal if a back-up structural sterilization instrument is required.
  - Fiscal Responsibility Law adjustments would be required to allow the BCB to issue securities.
  - BCB securities would fit naturally into investor portfolios, be more liquid than term deposits, and could be used at a lower cost.
  - Issuance of BCB securities would need coordination with the MOF to avoid segmentation in securities markets.
  - Given the government does not issue securities at the very short end of the yield curve (less than six months) there is a market gap the BCB could fill.
  - Introducing BCB securities would not undermine the existing approach of using government bond repo for structural sterilization; if sufficient bonds are available to the BCB then there would be no need for BCB securities.
- Policy-relevant conclusions from the report:
  - The BCB’s request to the Senate for authority to offer term deposits has merit as it would give the BCB the option to implement an overnight deposit facility and short-term deposits for fine-tuning liquidity.
  - Term deposits could be a useful addition for some sterilization purposes and for placing a floor on interest rates as part of an interest rate corridor system, but are not ideal for structural sterilization where central bank securities would be superior.

*IMF staff summary of the content unit.*

### 41.      Introducing new instruments will be easier if the BCB reforms its operational

### Introducing new instruments will be easier if the BCB reforms its operational approach

### Operational approach to OMOs and introducing new instruments
- Current practice: BCB invites banks to first suggest an interest rate for overnight and 45-day repo operations; once the interest rate is set, volumes are bid and allocated.
- Strengths of current practice:
  - Works well in a large liquidity surplus because banks can be sure they will receive their full desired allocation.
- Limitations for new instruments:
  - No easy way to discriminate between competing instruments or instrument maturities.
  - No direct link between volumes bid and prices.
  - Introducing term deposits or BCB securities into current auctions would be problematic under the existing approach.
- Recommended operational change:
  - Move to fixed volume—variable price OMO auctions.
  - Alternative if volatility arises: fixed rate–full allotment operations for short-term repo auctions.
- Implementation support:
  - The Fund could offer the BCB technical assistance to develop a new operational approach.
- Related operational adjustment:
  - The current practice of linking interest paid on the TSA to the return on the BCB’s government bond portfolio should be adjusted given the changed distribution framework; SELIC would be a more natural interest rate to pay on the TSA.

### SELIC alignment with the policy rate
- Communication and operational challenge:
  - A 10-basis point gap between the policy rate and SELIC is now more meaningful than historically when interest rates were much higher.
  - The gap represents a meaningful deviation of the de-facto policy stance from the de-jure stance.
- Risk with new instruments:
  - Introducing short-term deposits could complicate policy communication (is the stance the policy rate or the rate paid on short-term deposits?).
- Recommendation:
  - Adjust the operational target to achieve a SELIC rate in line with the BCB policy rate (i.e., 10 basis points higher than currently) to erase communications concerns.

### Reserve requirements
- BCB plans:
  - Simplify and reduce reserve requirements.
  - Consider widening the reserves base by including public sector deposits.
- Assessment:
  - Reducing reserve requirements is very desirable and a good initiative; widening the base would make lowering the rate possible.

### Development of the FX spot market
- Current state:
  - Brazil’s FX market compares well with Latin American markets; derivatives market is well developed compared with most advanced economy markets.
  - In normal conditions the FX market is liquid; in stress it generally performs well but derivatives can freeze when volatility is very high.
  - The spot FX market is small relative to peers and constrains capacity when derivatives markets are unavailable.
- Key impediment:
  - Legal restrictions on who can use deliverable FX instruments (spot, outright forwards and FX swaps) unless accompanied by an economic interest.
  - By contrast, there are no significant limitations on non-deliverable FX hedging instruments.
- Market structure details:
  - 13 banks are eligible to participate in the BCB’s FX spot market intervention auctions.
  - A larger group of 189 financial institutions can trade in deliverable instruments such as spot FX including banks, brokers and money changers.
  - On May 18, 2017, turnover in the spot market increased by around 30 percent as some activity moved from the unavailable derivatives market to the spot market.
- Benefits of opening deliverable instruments:
  - Could grow the spot market and derivatives, attract investors not comfortable with derivatives, and improve money market liquidity by facilitating use of global money markets while remaining hedged.
- Counterparty risk management:
  - Counterparty risks from spot FX can be managed similarly to derivatives (e.g., Brazil could become a member of CLS bank to manage settlement risks).
  - The B3 exchange has limitations on the volume of transactions that can be settled without additional counterparty risk; enhancing settlement capacity would be beneficial.
- Sequencing and safeguards:
  - Changes to the FX regulatory regime need careful consideration and timing per the IMF’s “Institutional View”.
  - Key considerations: supportive macro-financial backdrop and robust alternative tools (for example macro-prudential policies).
  - The BCB could seek Fund technical assistance to design a robust alternative regime and transition path.

### Representativeness of key money market benchmarks (SELIC vs CDI)
- Assessment:
  - SELIC is a far superior and robust benchmark compared to CDI and should replace CDI.
  - CDI falls short of properties required by the FSB/IOSCO principles: lacks an underlying market reflective of funding costs of large banks; often relies on a fall-back rule tying CDI to SELIC.
  - Market participants agree SELIC should replace CDI, but significant operational work across banks, investment funds and markets is required.
- Transition role of authorities:
  - The BCB needs to work with CVM, ANBIMA and the B3 exchange to transition away from CDI.
  - Regulators can indicate a date after which CDI use won’t be suitable from a regulatory perspective.
  - Adjust the fall-back rule so CDI is fixed to SELIC, eliminating financial differences and facilitating novation of existing derivative contracts from CDI to SELIC.
- Implementation guidance:
  - An adequate transition plan and period should be allowed to prevent disruption risks; FSB principles require clear, carefully planned and communicated transitions.

### Market maker of last resort and crisis response
- Past coordination:
  - MOF and BCB coordinated effectively to manage bond market liquidity pressures (example: May 2017 episode).
  - Tools used: BCB FX intervention for hedging and MOF cancellation of bond auctions followed by reverse auctions of government bonds.
- Operational approach:
  - Authorities target the most systemically important securities market—the government bond market.
  - Approach aligns with best practices: transparent, focused on price discovery and liquidity, enabling market adjustment.

### Summary and concise recommendations
- Market resilience and buffers:
  - Brazilian markets have been resilient through frequent political and macroeconomic shocks; market participants exhibit strong risk management culture.
  - Authorities have significant buffers (structural liquidity and BCB FX reserves) and well-defined targeted policies to mitigate market stress.
- Priority reforms and recommendations:
  - Replace CDI benchmark with SELIC across markets and contracts; plan and coordinate transition with CVM, ANBIMA and B3.
  - Seek authority for the BCB to issue its own securities for liquidity sterilization as superior to relying solely on government bond repo.
  - Enhance the BCB’s monetary policy operational framework to:
    - Accommodate multiple instruments (including term deposits or BCB securities).
    - Operate in more variable liquidity conditions rather than relying on a large liquidity surplus and a single instrument.
    - Consider technical assistance for redesigning operations.
    - Align the operational target for SELIC closer to the BCB policy rate.
  - Ease access to deliverable FX instruments to grow and strengthen the spot FX market, sequenced after ensuring macro-financial robustness and alternative tools are in place.
- Final assessment:
  - Easing FX access should be carefully sequenced; the BCB believes the spot FX market is adequately developed at present, but the IMF view emphasizes potential benefits from cautious liberalization.

*Source: cr18345 - 41.      Introducing new instruments will be easier if the BCB reforms its operational*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18345.pdf_