Derivatives Regulation In Brazil

The Brazilian monetary authorities are known worldwide to regulate and supervise the financial sector tightly and unlike other jurisdictions Brazil always adopted a very restrictive approach in the derivatives market. After the global financial crisis of 2007, several prudential initiatives have been taken in our jurisdiction to monitor and control the risks assumed by the participants of the Brazilian financial system and of all derivatives transactions entered into by Brazilian companies.

The applicable rules are set forth by the Brazilian Monetary Council (Conselho Monetário Nacional – CMN) and the regulators in charge to monitor and supervise the enforcement of such rules are the Central Bank of Brazil (Banco Central do Brasil – Bacen) and, insofar the securities market is concerned, the Brazilian Securities and Exchange Commission (Comissão de Valores Mobiliários – CVM). The current regulations which govern this matter are outlined below1.

For the purpose of this analysis, the following topics will be covered herein: I. Credit Derivatives Transactions; II. Swap Transactions; III. International Hedging Transactions; IV. The Position of CVM regarding Derivatives; V. Multilateral Netting; and VI. Conclusion.

1. CREDIT DERIVATIVES TRANSACTIONS

   CMN Resolution No. 2,933, of February 28, 2002, authorized financial institutions and other entities accredited by Bacen to perform credit derivatives transactions. The only institutions authorized by CMN to bear the credit risk in a transaction are multiservice, commercial and investment banks; the Federal Savings Bank (Caixa Econômica Federal – CEF); loan, finance and investment companies; real estate loan and leasing companies. In the specific case of leasing companies, the transaction may only occur if the underlying asset relates to credits deriving from leasing transactions.

   In this regard, "credit derivatives" is a contract where the credit risk of the transaction is negotiated without the transfer of the respective underlying asset(s). Underlying asset is any credit deriving from loan, financing and leasing transactions; credit instruments; securities; guarantees; sureties; credit derivatives and other instruments and financial or commercial agreements that are subject to credit risk and negotiated and performed in the domestic market.

   Bacen Circular No. 3,106, of April 10, 2002, establishes two modalities of credit derivatives: (i) credit default swap (swap de crédito), when a party (the buyer) buys the credit risk from the other party (the seller), the remuneration is based on a predetermined protection fee. In case of default of the debtor of the underlying asset, the buyer of the risk is liable for the payment obligations of the debtor before the seller. However, if the underlying asset is duly paid up, the buyer earns the protection fee; and (ii) full return swap (swap de taxa de retorno total), when both the credit risk and the credit remuneration are assumed by the buyer. In this modality, the remuneration is based on the flow of payments, comprising interest and other charges received in connection with the underlying asset.

   The following transactions are expressly forbidden: (a) options linked to any of the above-mentioned modalities; (b) credit derivatives between related parties, comprising individuals or legal entities which are controllers, affiliates or controlled companies2; (c) any assumption of risk of these related parties; and (d) credit derivatives whose flow of payments in connection with the underlying asset is not in the same currency or index of such asset.

   Swap transactions are the trades between a protection buyer and a protection seller for settlement on a future date, which result, upon the occurrence of one or more credit events, in full or partial recovery of the reference value set out in the contract by the protection buyer.

   Credit events are the events defined between the parties in the contract and connected with the underlying asset or its obligors, and which, independently of any reason, cause the payment by the protection seller of the protection contracted by the protection buyer.

   The contract must establish at least the following situations as credit events: (a) bankruptcy or civil insolvency, as well as company's recovery plan and liquidation, judicial or extrajudicial, or moratorium of the obligors of the underlying asset; (b) restructuring of the obligors' debts, and change of control, consolidation or merger of the obligors, when any such situation represents a loss or credit downgrade affecting the underlying asset; (c) default on the underlying asset; (d) compulsory advance payment of the underlying asset, in the event of a contractual provision in this regard; and (e) repudiation or challenging in court of the underlying asset.

   As to the liability for the risk, the transferor of the risk is the party acquiring, under a credit derivatives contract, the protective right against a given credit risk by making the mutually agreed payment. On the other hand, the bearer of the risk is the party assuming, under the same kind of contract, the credit risk related to a given underlying asset and undertaking to compensate, as agreed, the party transferring the risk upon occurrence of a given event.

   Transfer of the credit risk of the underlying asset is considered effective when: (i) the contract contemplates the above-listed credit events; (ii) the underlying asset is legally transferable, if the credit derivatives contract so stipulates upon the occurrence of a credit event. (iii) there is no co-obligation on the part of the protection buyer in relation to the portion of the underlying asset contemplated by the transaction; (iv) there is no clause allowing for unilateral cancellation of the contract by the protection seller, except in the event of nonpayment by the protection buyer of the protection fee; and (v) there is no clause allowing the protection seller to default on the obligation to make prompt payment of the amount due to the protection buyer upon the occurrence of a credit event.

   Credit derivatives transactions may be performed on two occasions: (i) if and when the underlying asset credit risk is effectively held by the party transferring it at the time of contracting; or (ii) the underlying asset is regularly traded on the organized market3 and whose price can be confirmed.

   The party transferring the risk is required, in the case of underlying asset existing in portfolio, to make available to Bacen adequate records evidencing that the underlying asset risk existed at the time of contracting, being it understood that the amount of risk transfer is limited to the underlying asset value. Additionally, no direct or indirect assignment, transfer or disposal of the underlying asset during the term of the credit derivate contract is allowed.

   The performance of such transactions is conditioned upon the designation by each of the authorized institutions of a director (a technically qualified officer) to be the contact person with Bacen. Institutions shall maintain, at the disposal of Bacen, proper documents regarding their policy and procedures for credit derivatives transactions, as well as the exposure limits established, irrespective of acting as protection buyer or protection seller.

   In addition, information containing at least the following aspects of credit derivatives transactions shall be disclosed in the explanatory notes to the institution's financial statements: (i) the institution's policy, objectives and strategies; (ii) the credit risk received and transferred (book and market values), specifying the overall volume and during the respective period; (iii) effect (increase/reduction) on the capital adequacy requirements (Patrimônio Líquido Exigido – PLE) calculation; (iv) amount and characteristics of the credit transactions transferred or received during the period as a result of the triggering events stipulated in the contract; and (v) breakdown per type (credit...