The Central Bank of Brazil (BCB) has implemented a significant overhaul of the management of its $330 billion in foreign exchange reserves during the past few years – a period marked by acute economic and financial shocks. The Brazilian central bank revamped its processes; improved its organisational structure; changed its asset allocations, instruments and tactical investment rules; and invested in new in-house technologies.
Most recently, the BCB has implemented additional changes related to its investment process, sustainability approach and asset allocation. It has diversified into new currencies, including in-house investments into Chinese bonds, and added new credit classes, such as mortgages and corporate bonds – again managed in-house. It also introduced new investment tools, such as ‘to-be-announced’ (TBA) mortgage instruments – where the seller of a mortgage-backed security agrees a sale price but does not specify the particular securities that will be delivered on settlement – and the use of exchange-traded funds (ETFs).
Its active management framework rules were revised and the reserve management team, which has been buying green bonds for almost 10 years, now considers sustainability as part of its counterparty evaluation process. In the local FX market, important enhancements were introduced, such as the introduction of new types of auctions.
Most of these changes were supported by the development of new modules to the central bank’s in-house suite of systems for the foreign reserves management – or by completely new systems that were developed in-house from scratch.
The BCB’s foreign reserves department includes six sections. The two largest, comprising about 80% of staff, are the front and back offices. Both areas are subdivided into three divisions, and are responsible for all operations, from trading to payment (straight-through processing hit 99.99% in 2021. Meanwhile, the compliance division ensures adherence to internal and external controls; the financial consultancy handles contract signing that enables trading and settlement; a senior adviser analyses reserves activities and is involved in all high-level decision-making processes; and the secretariat addresses administrative and secretary duties.
The earliest part of the diversification process involved the BCB investing in currencies beyond US dollar and euro holdings, which required liaising with partner national central banks, and establishing new custody accounts, while maintaining low duration and credit risk sovereign bond portfolios. However, by 2012, with the continued accumulation of reserves, the BCB started to invest in new asset classes using external asset managers. This offered practical experience related to investments in US agency mortgage-backed securities (MBSs), investment-grade corporate bonds, equities, commodities and ETFs – investments could only be made in equity and corporate bond indexes rather than individual instruments.
After the external manager programme ended in 2018, the training and investing experiences in non-traditional assets enabled the BCB to start to manage new asset classes internally. These investments tended to be passive, mostly via futures contracts (in the case of equity indexes) and ETFs (for corporate bonds, US agency MBSs and equity indexes). The allocation to the onshore Chinese government bonds, also increased.
More recently still, the US agency MBS portfolio of close to $2 billion was migrated almost entirely from ETFs to TBAs. TBAs are viewed as far more liquid than ETFs – an instrument that is also constrained by a ceiling at the BCB – and are viewed as the best mechanism to access the MBS market short of direct access to individual pools, which would require a larger staff and new technological resources. Equity investments of approximate $3.8 billion were also shifted from futures contracts to ETFs. The preference for ETFs instead of futures in the strategic portfolio is due to them being less operationally intensive over the long run. But futures are still used for tactical allocations, as they are more flexible and can fit better for short-term investments.
The new dollar and euro corporate bond portfolios were entirely implemented by using ETFs, drawing on lessons learned from equities, including whether to create new ETF shares or acquire them on the secondary markets. Onshoring the renminbi bond portfolio also took about two years as there was no operational infrastructure to drawn on to acquire, clear and custody onshore Chinese government bonds. Overall, the effort required support via significant internal IT systems development.
“The internalisation effort was made particularly challenging because of, on the one hand, the challenges related to the global pandemic – especially the need to migrate the staff to remote work – and, on the other hand, because of the inherent challenges of the asset classes involved in the task, such as US Agency MBSs via TBAs, US dollar and euro corporate bond portfolios via ETFs and, finally, onshoring the CNY China government portfolio,” says Alan da Silva Andrade Mendes, head of the international reserves department.
Tactically more nimble
The BCB also changed the rules and guidelines governing its ‘investment committee’, which oversees tactical allocations, meaning opportunistic investment decisions are now made significantly faster while still ensuring there are strong controls and accountability.
Historically, the investment committee met quarterly and tactical decisions largely were analysed during these formal meetings. Decisions required a supermajority of the committee’s voting members, including from the committee’s chair (a member of the board). While the structure offered sound governance, it often resulted in lost opportunities due to the slow speed of decision-making – and tactical allocations that did make it through were often smaller and more concentrated as a result.
The BCB changed the format of the investment committee’s formal meetings in 2020 and increased the frequency of discussions around tactical allocation decisions. The formal committee meetings now focus less on scenario analysis and more on ‘accountability of performance’ – with the risk department presenting details about past performance and active risk allocations. The guidelines for active management are now set by the board.
Previously, the committee was presented with a basket of tactical allocation ideas, all of which had their own risk parameters. It then had to decide – and sometimes scale – each individual idea depending on scenario analyses or other subjective methods. “The investment committee now has a simpler task which is just distributing risk allocations to each of the three main risk-taking levels for tactical allocation purposes while still respecting the guidelines set forth by the board of directors, namely, the overall differential value-at-risk limit of 1% annualised (approximately 6.3 basis points per day). We judge that this framework increases the flexibility of tactical risk-taking by the portfolio management team without sacrificing governance,” says Mendes.
The BCB’s three levels of active risk, some of which require approval by the investment committee, whose voting members include a chair (member of the board); the head, deputy head and senior adviser in the foreign reserves department; the head of the investment division; and the head of the money market and FX division, are defined as follows:
Level 1 covers short-term tactical allocation and portfolio manager security selection. It has the smallest risk budget – a percentage of the board-assigned VAR limit. There is no need to submit any tactical decision to a formal vote, and risk controls are made via VAR checks and maximum stop-loss levels conducted daily. Level 2 covers medium-term tactical allocation. The risk budget is always greater than for level 1 and is also represented as a percentage of the VAR limit. All tactical ideas need to be approved either at the formal committee meeting or via email by a supermajority of the voting members of the committee, including the head of the reserves department (the board member vote is no longer required). Each tactical decision is parametrised with at least daily VAR (in US dollars) and stop-loss levels. Level 3 include medium- to long-term tactical ideas. The remaining risk budget is assigned to this level, and it usually gets the largest share of the active budget. All tactical ideas need to be approved either at the formal committee or via an emailed supermajority, this time, requiring the approval of the chair. Each individual tactical decision is also parametrised with at least, but not limited to, daily VAR (in US dollars) and stop-loss levels.
In general, portfolio managers have benefitted greatly from the more flexible approach, placing a larger number of ‘bets’, with officials saying the new approach has proven itself in all circumstances, on all risk levels.
The BCB has also made several enhancements to its FX intervention toolkit. For spot interventions, the central bank developed and implemented auctions referenced at the official US dollar FX purchase rate (PTax) fixing, where bids are placed at a premium or discount relative to that rate. This new type of intervention allows the BCB to provide liquidity to primary dealers when it is scarce without causing spikes in the exchange rate when compared with spot auctions at market prices. As a result, the BCB to provide dollar liquidity at a widespread reference rate for the Brazilian financial that trickles down to the corporate sector.
The BCB also enhanced its toolkit by designing a US dollar repo facility, where the central bank received dollar-denominated Brazilian sovereign bonds as collateral, to temporarily supply dollar liquidity to local banks when there was a severe global US dollar liquidity shortage in the aftermath of the Covid-19 pandemic. At the time, the squeeze in global credit markets meant local financial institutions faced prohibitively high costs in repo markets to fund their holdings in Brazilian sovereign bonds. The BCB facility helped these institutions to maintain their bond holdings by offering alternative funding at a more reasonable repo rate, so preventing banks from disposing of their bond holdings, which, in turn, would have resulted in greater pressure in US dollar funding conditions, domestically.
Another important element was the use of a combination of deliverable and derivatives instruments to address a specific condition when the FX market was experiencing large spot outflows by local corporates engaging in hard currency debt buy-backs while they were also unwinding sizable FX hedge positions associated with the debt that were no longer necessary. In response to these dual flows, simultaneous daily spot and FX-interest rate swaps (non-deliverable futures) auctions were conducted, in which, for a few months, the BCB sold dollar spot and repurchased swaps in the same amounts, ensuring both market segments kept functioning well.
Data and monitoring overhaul
The BCB has also redesigned its market data-gathering and monitoring software in-house.
A new market data capture and monitoring system was launched at the height of the Covid-19 pandemic to secure clean, reliable and readily available structured data to support decision-making for foreign reserves management.
The integrated approach marked a shift away from the fragmented use of multiple software tools for data-gathering and distribution. Data that could be useful for other systems are also consolidated and the central bank has a centralised custom dashboard of routine executions, with 79 different routines and 421 automated executions taking place throughout the day. The BCB says more than 31,000 data points are gathered daily for securities alone, which are then consolidated into almost 20,000 daily ready-to-use data points.
Much of the data is fed into the BCB’s in-house risk-and-return system to calculate portfolio positions, returns, VAR and other metrics. But it is available to be used by any other system within the BCB, either passively (delivered in a specified format and coded inside the routine) or actively (other system receives the data directly from the database using extract, transform, loan tools).
Overall, the revamped reserve capabilities at the BCB put it in a strong position to manage the assets of Brazilians moving forward.
The Central Banking Awards 2023 were written by Christopher Jeffery, Daniel Hinge, Dan Hardie, Joasia Popowicz, Ben Margulies, Riley Steward, Jimmy Choi and Blake Evans-Pritchard.
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