Can domestic non-deliverable forwards replace the sale of international reserves? An analysis of the Brazilian experience

In the 2010s, the Brazilian Central Bank (BCB) intervened massively with domestic non-deliverable forwards (DNDFS) to offset the reversal of the global financial cycle. This article aims to investigate why the BCB used these derivatives instead of selling its international reserves, how they affected the markets, and the limits of these interventions. The main benefit of DNDFs is that they preserve the international reserves of the central bank. Since market makers use these DNDFs to hedge their supply of foreign currencies in the foreign exchange markets, the central bank can affect these markets without spending a dollar. We present evidence that DNDFs were associated with an expansion of market makers’ short dollar positions. DNDFs were also used to limit excessive currency volatility. We identified a subset of interventions aimed at offsetting excessive volatility and present evidence that the BCB could stabilize the markets on these occasions. However, DNDFs are not a panacea. If coupled with deregulated foreign exchange markets, frequent interventions may stimulate speculative activity against the domestic currency. Furthermore, they can be costly, and these costs increase the interest-bearing liabilities of the central bank, constraining the domestic policy space of the monetary authority.