Reserve management at the BCB

Introduction

Over the last few years, the Central Bank of Brazil (BCB) has implemented important changes to its reserve management investment process, sustainability approach and asset allocation. The diversification among currencies, including Chinese government bonds managed in-house, was accompanied by new asset classes, such as US agency mortgages and investment grade corporates, and new tools, such as TBAs and ETFs. The active management framework was revised, and the achievements have been encouraging. Last, sustainability has become part of the official agenda for the bank, and the reserve management team, which has been trading green bonds for almost 10 years, managed to include ESG criteria on the evaluation process of its counterparts. On the local FX market, important enhancements were implemented as well, such as new types of auctions. Most of these changes were backed up by new modules of an in-house suite of systems for foreign reserves management and operation or by completely new systems that were developed from scratch by the team.

Organisational structure

The foreign reserves department is supported by six building blocks. The two largest areas, which comprise approximately 80% of the department´s staff, are the front and back offices. Each area is subdivided into three divisions, being responsible for the entire operational workstream into the department, from trading to payment, with successfully completed operations performed on a straight-through-processing basis reaching 99.71% throughout 2021 and, in 2022, reached more than 99.9%, having had only one operational incident in more than 8,000 operations.

The compliance division oversees all the department’s activities and ensures that operational procedures adhere to internal and external controls, reporting straight to the head of the department.

A financial adviser oversees negotiating all the agreements that establish the BCB’s relations with counterparties, brokers and service providers, thus providing agility to reduce legal risk and approving complex contracts governed by laws from a variety of different jurisdictions. This task is supported by external and internal lawyers. 

A senior adviser for reserve management performs studies and analysis aimed at supporting reserve management activities, and is involved in all high-level decision-making processes regarding the international reserves. Finally, a secretariat takes on the relevant administrative and secretarial duties.

Over the last few years, reserve management at the BCB has implemented important changes that were related to allocation choices made some time ago by the board and to operational decisions taken at a departmental level.

The board of governors¹ has made significant efforts to improve the efficiency of the reserves portfolio over the last decade, such as the reserve accumulation policy, a process that peaked around 10 years ago, which has guaranteed a healthy stock of excess reserves in relation to the sovereign’s external liabilities.

In this context, diversification has been one of the key areas of focus. Initially, the diversification process was concentrated on adding more currencies to the reserves portfolio, while also maintaining the existing broad asset class exposure mostly unchanged, which comprised low-duration and low-credit-risk sovereign bond portfolios. That effort was supported by the extensive experience the reserve management team had developed in managing government bond portfolios that, hitherto, were highly concentrated in US dollars and euros. 

As a direct result of such a diversification process, the back office had to provide custody solutions to the whole array of new investments. Although challenging, such responsibility was at the same time very enriching, since it expanded the relationship with previously existing custodians, made it possible to select new ones, and, foremost, also gave the opportunity to liaise with partner national central banks. If before the diversification process there was a single direct custody account with one national central bank, there are now seven in total.

Broadening diversification efforts and internal management scope

However, with the continued accumulation of reserves and with the central government having decided to pay down most of the foreign-currency-denominated debt, the BCB realised there was broader scope for diversification beyond high-quality, developed markets’ government sovereign bond portfolios.

With the main objective of gathering experience on non-traditional asset classes for reserve management, the BCB decided to test new asset classes in the broader reserve portfolio via external managers starting in 2012. The mandate that was implemented included asset classes, either as part of the reference portfolios or via tactical allocation strategies, in which the BCB had no previous experience managing internally. The main asset classes included (but were not limited to) US MBS, investment-grade corporate bonds, equities, commodities and, perhaps most importantly, the use of ETFs in asset allocation. In the case of corporate bonds and equities, managers were not allowed to gain exposure to the underlying assets, just to the broad indices.

Although the external management programme ended in 2018, it was considered a success, as it served as a vehicle to gain exposure to non-traditional asset classes and allowed the BCB to evaluate which asset classes could be added to the broader reserves portfolio, in light of the risk-and-return preferences of the board of governors. It also offered to the in-house reserves management staff (such as portfolio managers, operations and compliance officers and many others) comprehensive training opportunities and the possibility of accumulating invaluable experience in internally managing these new asset classes.

Furthermore, the know-how gathered during the external management programme has been instrumental over the last few years, especially during the Covid-19 pandemic shock, when the BCB incorporated the internal management of these new asset classes, which were already part of the reserves portfolios and started to be managed passively mostly via futures contracts (in the case of equity indices) and ETFs (corporate bonds, US agency MBS and equity indices). Besides these asset classes, the allocation to the onshore Chinese government bond portfolio, which has been partially managed internally, also increased.

The internalisation effort was made particularly challenging because of, on the one hand, the challenges related to the global pandemic – especially the need for staff to work remotely – and, on the other hand, because of the inherent challenges of the asset classes involved in the task, such as US MBS via TBAs, USD and EUR corporate bond portfolios via ETFs and, finally, onshoring part of the China government portfolio, which used to be fully outsourced via an open-ended fund structure.

Despite the challenges, in the last two years, the US MBS portfolio was migrated almost entirely from ETFs to TBAs. That shift involved not only the development of skills from the portfolio managers in the front office and operation officers in the back office, but significant changes in the IT systems that support reserve management in all phases. It is important to highlight that all IT systems currently in use in reserve management have been developed internally.

USD and EUR corporate bond portfolios were a new allocation, and entirely implemented by using ETFs. In this regard, the experience that was gained with the shift from futures contracts in equities to ETFs was very helpful in the process of implementation of the corporate bond portfolios, significantly shortening the implementation time, as the reserve management teams could choose between the primary market (creating new ETF shares) and secondary market (acquiring readily available ETF shares).

Finally, onshoring the CNY government bond portfolio also demanded a lot of effort from the BCB’s reserve management teams, since there was no operations infrastructure available previously that could be used to acquire securities, clear and custody them. The entire team was involved in that effort, but the operations team in particular had to set up the entire CNY infrastructure before the front office could start implementing the portfolio. That effort took close to – if not a bit more than – two years to be completed.² 

As sustainability became part of the official agenda of the BCB, that aspect was integrated into the counterpart evaluation framework. With that, the dealers’ ESG ranking contributes towards their annual scores.

Changes to the tactical asset allocation framework

In parallel to the asset allocation/implementation effort, there was a significant change in the tactical framework that took place just when the world was shutting down for the global pandemic.

The Investment Committee’s rules and guidelines were overhauled in January 2020. The Investment Committee oversees managing the tactical allocation process for reserve management. Historically, the committee met quarterly, and tactical allocation decisions were analysed, discussed and approved for implementation almost exclusively during the committee’s formal meetings. The Investment Committee is chaired by one of the board members, and all decisions needed to be approved by the supermajority of the committee’s voting members, requiring the vote of the chair. From a governance point of view, that framework was well established, and all stakeholders felt it was an important part of the investment process for reserve management. However, from a portfolio management point of view, it proved to be highly inefficient, since it significantly reduced the timeliness in which portfolio management tactical decisions could be implemented, which often meant the loss of an interesting investment opportunity. The result was that the former tactical management framework, while addressing governance concerns, resulted in a smaller number of tactical management decisions being made, which, in theory at least, meant that the ones that were made ended up being less important (smaller in size) and more concentrated (smaller in quality/diversification).

With that diagnosis, the task at hand was how to improve the tactical allocation process while maintaining (or even strengthening) the existing level of accountability and governance.

The answer to that question involved a complete change in the format of the formal meetings of the Investment Committee and a significant increase in the frequency of discussions and debates around tactical allocation decisions, making the process more dynamic.

The formal committee meetings now do not focus on macroeconomic scenario analysis and financial market dynamics. Instead, they now centre on accountability of performance (past performance is presented to the committee by the risk department, not by the portfolio managers themselves) and active risk allocation. 

The guidelines for active management are set by the board of governors, and cannot be changed by the Investment Committee. But the committee has the authority to allocate all the active risk budget set by the board of governors’ guidelines. In our case, the main number to keep in mind is 1% annualised differential value-at-risk (VAR) regarding the benchmark portfolio (roughly 6.3 basis points per day). Previously, the committee was presented with a basket of tactical allocation ideas, all of which had their own risk parameters, and had to decide (and often scale) each individual idea depending on scenario analyses or other subjective methods. Now, the committee has a simpler task, which is to decide the risk budget that each of three main risk-taking levels can use for tactical allocation purposes. Of course, it cannot breach the guidelines set by the board of governors – namely, the overall differential VAR limit.

Those three levels of active risk are:

• Level 1: Short-term tactical allocation and portfolio manager security selection level. To this level is assigned the smallest risk budget (presented as a percentage of the board-assigned VAR limit). The risk controls are done via VAR checks and maximum stop-loss levels that are done daily. Portfolio managers can use this level for short-term directional type tactical decisions and security selection. There is no need to submit any tactical decision to a formal vote.

• Level 2: Medium-term tactical allocation. Risk budget for level 2 is always larger than level 1, and is also presented as a percentage of the board-assigned VAR limit. Differently from level 1, at this level, all tactical ideas need to be approved either at the formal committee meeting, which is rare, or, which is generally the case, via email by a supermajority of the voting members of the committee requiring the head of the reserves department (the board member vote is not required). The vote of the chair of the committee is not needed at this level. Each individual tactical decision is parametrised with at least, but not limited to, daily VAR (in US dollars) and stop-loss levels. Once the tactical idea is approved, the trade can then be implemented by the appropriate investment desk. 

• Level 3: Medium- to long-term tactical ideas. The remaining risk budget is assigned to this level, and usually gets the largest share of the active budget. Similarly to level 2 tactical allocation ideas, all tactical ideas need to be approved either at the formal committee meeting or, more commonly, via email by a supermajority of the voting members of the committee requiring the approval of the chair. Each individual tactical decision is parametrised with at least, but not limited to, daily VAR (in US dollars) and stop-loss levels. Once the tactical idea is approved, the trade can then be implemented by the appropriate investment desk.

The Investment Committee meets, informally, at least every two weeks.

Voting members of the Investment Committee are:

• Chair (member of the board of governors)

• Head of the foreign reserves department

• Deputy head of the foreign reserves department

• Senior adviser of the foreign reserves department

• Head of the investment division

• Head of the money market and FX division

Participants also include members of the risk department, as well as members from the compliance and operations teams of the foreign reserves department. 

Tactical decisions are still an important part of the committee’s role, but these decisions are made significantly faster while maintaining control, governance and accountability.

FX intervention instruments

Over the last few years, the BCB has made several enhancements in its FX intervention toolkit by including new instruments as well as by making use of a combination of already-available ones.

Regarding spot interventions, the BCB has developed and implemented auctions referenced at the official exchange rate fixing (PTAX), where bids are placed as premium or discount points relative to that rate. This new type of spot intervention allows the BCB to provide dollar liquidity at a widespread reference rate for the Brazilian financial market and corporate sector.

The BCB has also innovated its toolkit by designing a USD repo facility to temporarily supply dollar liquidity to local banks, receiving as collateral dollar-denominated Brazilian sovereign bonds. This instrument was used in the aftermath of the pandemic to cope with the severe global dollar liquidity shortage, and has proved to be crucial in easing funding pressures in the local FX market.

Finally, another innovative initiative was the combination of deliverable and derivatives instruments to deal with a specific condition when the FX market was experiencing large spot outflows by local corporates while unwinding sizeable hedge positions. In response to these dual flows in opposite directions, simultaneous daily spot and FX-IR 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, supporting both market segments to keep them functioning well. 

Redesigning market data-gathering and -monitoring software

The process starts with reliable, clean and readily available structured data. So, regarding foreign reserves investment, we had a full redesign of the market data flow within the BCB. A couple of years ago, amid the Covid-19 crisis, the BCB launched a new market data capture and monitoring system to support decision-making for foreign reserves management. Before this, there was a plethora of different software responsible for gathering data and distributing it to other internal systems, such as accounting. This IT structure was difficult to maintain and guarantee that the data used in the systems was accurate and up to date.

With this new software, built with the idea of routines of data capture executed all day (and night) long, it is possible to check if all data requested was captured and transformed when necessary. Data that could be useful for other systems are also consolidated in a simple and smart way. It is also very easy to monitor all of this with a centralised custom dashboard of routine executions. Currently, there are 79 different routines and 421 automated executions of them throughout the day. 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.

Most of this data is fed into the risk-and-return in-house system, used to calculate portfolio positions, returns, VAR and other metrics. But it is available to be used by any other system within BCB, either passively (delivered by us in any format necessary, coded inside the routine) or actively (the other system obtains the data directly from the database using some ETL tool).

Final remarks

In a period marked by unprecedented economic and financial shocks, the BCB has managed to revamp its processes and to invest in new technologies that have strengthened its capacity to weather the growing challenges that reserve managers have been facing worldwide. Through its foreign reserves department, the BCB has consolidated its position as one of the most innovative and advanced central banks when it comes to managing international reserves and intervening in the domestic FX market. Having a sizeable cushion of foreign assets, as Brazil does, requires an ongoing systematic review of governance and operational structures and procedures, and this would be unfeasible without its staff’s high degree of responsibility and commitment that permanently seek to deliver excellent services to its society.

Notes

1. The Governance, Risk and Control Committee (GRC) – with the same composition as the board of governors – defines the guidelines and strategies related to corporate governance, risk management and internal control, embracing the guidelines for reserve management purposes. More on BCB’s integrated risk management can be found at: https://www.bcb.gov.br/en/about/integratedrisk.

2. BIS Investment Pool (BISIP CNY).