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Risk Transfer

Risk transfer is the process by which a financial institution operating in foreign exchange passes its exposure to exchange rate fluctuations to the financial market, protecting its capital. This is done using a set of tools and mechanisms from the organized market, mainly from B3.

Operations Book (Booking)

The "book" is the consolidation of all foreign exchange operations carried out by the institution. It determines the institution's final net exposure, which can be:

  • Long Position: The institution bought more foreign currency than it sold - profits from a rise in the exchange rate.
  • Short Position: The institution sold more foreign currency than it bought - profits from a fall in the exchange rate.

The book is the starting point for risk management, as it quantifies the size and direction of the risk to be managed.

Role of B3

B3 (the Brazilian Stock Exchange) acts as a central guarantor for all futures operations. Instead of trading with an unknown participant, the institution trades directly with B3, which is responsible for ensuring that the contract will be fulfilled. In practice, this eliminates the risk of counterparty default, bringing security to all involved.

This security offered by B3 attracts many traders, which creates high liquidity in the market. Liquidity is the ability to buy or sell large volumes quickly, without affecting the asset's price. This liquidity is actively maintained by Liquidity Providers, institutions that continuously offer buy and sell orders. Their presence ensures that a bank can execute its hedge of millions of dollars instantly and at a fair price.

Futures Contract as a Hedge Tool

The dollar futures contract, traded on B3, is the main tool that the institution uses to hedge its risk. As a standardized, liquid, and transparent instrument, it allows the institution to quickly and efficiently create a position opposite to its book. If the book is long in dollars, the institution sells futures; if the book is short, the institution buys futures, thus neutralizing its directional exposure to exchange rates.

Collateral System

To trade futures contracts, B3 requires the institution (and all participants) to deposit a margin. This margin is collateral (in cash or government bonds) that acts as a guarantee, ensuring that the participant can cover any losses. It is a fundamental pillar to mitigate credit risk among participants and ensure market integrity.

Security Mechanisms

These are the dynamic components that make the collateral system effective in real time:

  • Daily Adjustment: Every day, B3 calculates the gains or losses of each futures position and credits or debits these amounts directly to the participants' margin accounts. This prevents the accumulation of large unrealized losses, forcing the financial settlement of positions day by day.

  • Margin Call: If the daily adjustment debits bring a participant's margin account below the required minimum level, B3 issues a "call." This is an order for the participant to deposit new collateral to cover the loss and restore their margin. It is the enforcement mechanism that ensures the system always remains secure and capitalized.

Use Case - Banco Alfa

It is complex to imagine the scenario where all the above topics are put into practice in a sequence of actions correlated to events within the financial institution. So, observe a use case of a fictitious foreign exchange bank:

  • Participant: Banco Alfa
  • Date: Friday, March 20, 2024.
  • Bank's Risk Policy: Maximum foreign exchange exposure limit of US$ 5 million.
  • B3 Parameters: Requirement of 10% initial margin; maintenance margin level at 75% of the initial margin.

Consolidation of Risk in the Operations Book

At the end of Friday, adding up all operations, Banco Alfa finds that it bought a total of US$ 52 million and sold a total of US$ 32 million. That is, it has a long position of US$ 20 million.

Thus, the bank is above its risk limit (US$ 5M) by US$ 15 million and needs to neutralize this excess risk.

Neutralization via Futures Contracts

Banco Alfa's Trading Desk receives the order to reduce exposure.

  • Action: The trader executes a sell order for dollar futures contracts on B3 in the amount of US$ 15 million.
  • Result: The bank's net exposure becomes US$ 20M (physical) - US$ 15M (futures) = US$ 5M, staying within the allowed limit.

Margin Deposit

However, to validate the futures sale operation from the previous section, the treasury needs to allocate the required margin (10%) demanded by B3.

  • Calculation: With an exchange rate of R$ 5.00, the contract value is R$ 75 million (15M * 5.00) and the initial margin of 10% corresponds to R$ 7.5 million.
  • Action: Banco Alfa allocates R$ 7.5 million in Federal Government Bonds in its B3 account.

Position Management and Daily Adjustment

On the following Monday, the dollar rises 2% above R$ 5.00, and the bank's short position in the futures market generates a loss.

  • Loss Calculation: 2% of R$ 75 million = R$ 1,500,000.
  • B3 Action: At the end of the day, B3 debits R$ 1,500,000 from the bank's margin account - the collateral balance drops to R$ 6.00 million.

Margin Call Execution

On Tuesday, the dollar rises another 2%, generating a new loss of R$ 1,500,000.

  • New Margin Balance: R$ 6,000,000 - R$ 1,500,000 = R$ 4,500,000.

  • Trigger Check: B3 calculates the minimum maintenance level: 75% of R$ 7.5 million = R$ 5,625,000.

  • Margin Call: Since the current balance (R$ 4.5M) is below the maintenance level (R$ 5.625M), B3 issues the call and Banco Alfa needs to deposit the total accumulated loss, which is R$ 3,000,000 (1.5M + 1.5M), to restore the margin to its initial value (7.5M). The treasury executes the transfer, and the bank's hedge position remains safe and valid.

Final Result

  • What happened in the market? The dollar rose sharply.

  • What happened to the Hedge on B3? The bank was short in dollar futures, so as the dollar rose, this position generated a real loss of R$ 3 million that was taken from its cash.

  • What happened to the Bank's Book? The bank was long US$ 20 million and, as the dollar rose, this position appreciated greatly. The value in Reais of those 20 million dollars on the bank's balance sheet increased, generating a profit of equivalent value (R$ 3 million) to the loss on the Hedge at B3; although not realized, since the bank did not sell the foreign currency.

The conclusion is as expected, the hedge worked perfectly, the bank was immune to exchange rate fluctuations, and the daily adjustment cash flow is just the mechanism that makes this immunity financially tangible day after day.