Brazil
22 January 2013
Could Brazil’s CCP-designed lending market foreshadow how the industry conducts business across the globe? SLT takes a look
Image: Shutterstock
Brazil’s securities lending industry has a slightly peculiar make up, at least in the eyes of European or American citizens. The Brazilian Clearing and Depository Company (CBLC), the central counterparty (CCP) of stock exchange BM&FBovespa, accepts collateral from the borrower and holds it centrally.
“The central counterparty design of the Brazilian lending market does pose a challenge for some—the exchange retains control of the collateral posted by borrowers which can unnerve some lenders,” says David Lewis, senior vice president at Astec Analytics, SunGard’s capital markets business.
“In more European style markets, such collateral is controlled by the lender or more commonly their agent. This allows quick access to the collateral in the event of a borrower default. In Brazil, some fear that not controlling the collateral directly adds risk; however, it could be said this risk is no greater than any other investment/long position in this market, which is also held and controlled by the Brazilian exchange. This ‘quirk’ does potentially squeeze supply; some funds do not like the perceived risk whilst others (such as ERISA and Mutual Funds in the US) are restricted by regulations over collateral control. On the positive side, restricted supply means that those lending in this market can enjoy higher rewards in return.”
“The Brazil lending market is generally a ‘specials market’, where the average fee is over 100 basis points. As such, the need for bilateral control of collateral for reinvestment purposes to achieve alpha is not as economically important in this market,” adds Gregory Wagner, managing director and global head of prime services at Itaú BBA.
“It is a question as to whether market participants are comfortable or legally capable of dealing in a mature CCP venue that does not provide for possession and control of collateral and where they cannot control the type of collateral that the CCP holds on their behalf.”
“The eligible assets allowed include Brazil currency are pretty broad—Brazil government bonds, gold, ETFs (exchange-trade funds), LOCs (letters of credit), securities traded in the international markets for non-resident investors, and so on—but the international market needs to look at the CBLC/CCP structure in a more holistic way.
When one looks at the eligible collateral allowed by the CBLC and then compares it to the position limits, the settlement fund and the margin calculation structure that the CBLC uses (CM-TIMS system), the risk profile is reduced: the CBLC uses a volatility based margining structure that requires a minimum of about 115 percent in collateral on easy names and can go as high as 180 percent (in today’s market) for more volatile stocks. By comparison, the international markets charge 102 to 105 percent in collateral for ‘purpose’ lending. Also, generally, there are no margining distinctions between liquid and illiquid names in the international market between counterparties (HF margining will be more dynamic than broker to broker margining).”
The CCP has two distinct disadvantages. In the event of Brazil defaulting, collateral that is held in the CBLC is put at risk, and it puts off global custodians that are accustomed to managing their own collateral pools in finance centres such New York or London from doing business in the country. Even though Brazil has the largest equity market capitalisation, global custodians such as State Street do not offer securities lending services to local investors there.
But in conferences worldwide, regulators endlessly promote the use of CCP-type risk models that seem to emulate the CBLC—despite accusations of it failing to encourage foreign participation.
Representatives of the BM&F Bovespa have done an excellent job in educating foreign participants on the policies and procedures of Brazil securities lending, argues Wagner.
“The exchange has been criticised in the past for not opening up to foreign participants, but there is no way that can be said now. They have been extremely proactive in reaching out to the wider market as of late.”
“As recently as last December, representatives from the exchange went on a road show in Europe to educate and encourage foreign custodial banks (which represent pension funds and the like) and other institutions to work toward distributing their Brazil equity assets through the CBLC.”
“The BM&F Bovespa representatives are implementing a follow up/action plan to the meetings to further address the questions raised during their road show. It’s clear that the local exchange is serious about bridging the gap between home market policies and foreign participation in securities lending.”
Their efforts have paid off, with foreign investors representing the largest part of the equities lending pool at 36 percent of the total wallet, says Wagner. “For the borrowing pool, they represent the second largest share of the of the wallet at 19 percent of market share. Since there are more Brazil assets sitting idly at US and European custodial banks than all of the loans outstanding in the CBLC, it is conceivable that the foreign investor category will continue to increase its market presence in Brazil securities lending.”
Despite this, Wagner predicts that the future for domestic participation is still sunny. “For example, the current structure is setup to ensure some domestic participation—a local broker is required to access the settlement system (BTC) to facilitate local and foreign investor trades. This is not dissimilar to how US registered broker-dealers are used to access US markets. So while the foreign participants will continue grow its share, the domestic providers will always have a place in the market.”
Lewis adds that his gut feeling is that domestic players will always have a place in their own markets. “They have the connections and experience that the foreign investors and market players will, at the very least, want to align themselves with in the longer term.”
“Whilst many international banks and custodians are active in Brazil, they cannot cater for every style of investor and there will always be a demand for domestic participants from certain areas of the market.”
The tax system is another suspected downside to the system, and is often accused of driving up securities lending costs for international players.
Lewis says: “The tax system in Brazil is a little complicated, particularly for those participants domiciled outside the country. However, the income levels are relatively high and as such, tax simply becomes a cost of doing the business that has to be met.”
“Like the taxes, structural differences in the Brazilian lending market also add friction compared to the more mature European countries, however, securities lenders looking for developing markets with good yields will overcome these difficulties.”
The slashing of the Selic
Local asset managers (hedge funds and mutual funds, not including pension funds) represent the biggest borrowers of Brazil assets by a large margin, with close to 70 percent of securities being borrowed for these funds. “Conversely, the funds represent a significant part of the lending pool as well,” adds Wagner.
Wagner says that multi-strategy or ‘multimercado’ funds dominate. They represent almost 50 percent of all strategies.
“These funds employ multi asset investment vehicles—which almost always involved a much more healthy dose of fixed income assets and a smaller portion dedicated to equities and generally long/short bias. This strategy—along with the high Selic benchmark rate—allowed for investors to achieve high fixed income investment yield with little volatility.”
Now the Selic has been cut by about 500 basis points—with Brazil’s Central Bank Monetary Policy Committee (Copom) cutting its overnight rate by another 25 basis points to 7.25 percent and hinting strongly that its easing cycle has now ended—things have changed for the multimercado funds.
“Multimercado funds are now required to find alternative ways to achieve returns,” says Wagner. “This includes increasing leverage (ie, trading in options markets) and tapping into the local and global equity markets. Appetite for risk in these funds must increase to achieve the same benchmark returns previously earned in a higher interest rate environment.”
And tapping into equity markets is what these funds have done, with securities lending in Brazil confined to equities despite local investors’ preference for fixed-income instruments.
“High local interest rates and strong demand makes borrowing Brazilian fixed income securities extremely expensive, driving investors towards a burgeoning synthetic fixed income market instead,” says Lewis.
“Fixed income securities finance transactions are generally governed under repo arrangements,” adds Wagner. “Repo arrangements are monitored by the Brazil Monetary Council (CMN). There are a number of rules that apply to trading fixed income repo in Brazil, but for financial institutions it does not require clearing through a CCP (as it does for equities).”
But securities lending is not completely confined to equities. Wagner says: “There is another lending platform called SISBEX but it is significantly smaller than the equities lending platform (BTC).”
In January of 2012, mining company Vale and oil business Petrobras were dominating, together making up almost 20 percent of the market. Minerals and oil firms, along with banking, are the biggest securities, reflecting their positions within the investment markets. Currently, the top equities assets on loan in order of value are Ambev (brewing company), Vale, Bradesco (banking) and BRF Foods.
“Borrowers, in the form of both local and international hedge funds, tend to concentrate on the larger more liquid securities especially those that trade as ADRs (American depository receipts) in the US,” states Lewis. “As such, both Vale and Petrobras are popular securities to borrow, but as more investors become active lenders then I would expect interest levels to widen to other less liquid securities.”
It seems as though the current Brazilian securities lending model could be the precedent for regulators to stir up lending transactions across the globe. This is a world in which there are no bilateral trades, cash collateral reinvestments are not allowed, fees are transparent, and authorised investment funds are permitted to act as both lenders and borrowers. But criticism over tax and the level of control that is wielded by the CCP means that it could be a while before the model takes hold elsewhere.
“The central counterparty design of the Brazilian lending market does pose a challenge for some—the exchange retains control of the collateral posted by borrowers which can unnerve some lenders,” says David Lewis, senior vice president at Astec Analytics, SunGard’s capital markets business.
“In more European style markets, such collateral is controlled by the lender or more commonly their agent. This allows quick access to the collateral in the event of a borrower default. In Brazil, some fear that not controlling the collateral directly adds risk; however, it could be said this risk is no greater than any other investment/long position in this market, which is also held and controlled by the Brazilian exchange. This ‘quirk’ does potentially squeeze supply; some funds do not like the perceived risk whilst others (such as ERISA and Mutual Funds in the US) are restricted by regulations over collateral control. On the positive side, restricted supply means that those lending in this market can enjoy higher rewards in return.”
“The Brazil lending market is generally a ‘specials market’, where the average fee is over 100 basis points. As such, the need for bilateral control of collateral for reinvestment purposes to achieve alpha is not as economically important in this market,” adds Gregory Wagner, managing director and global head of prime services at Itaú BBA.
“It is a question as to whether market participants are comfortable or legally capable of dealing in a mature CCP venue that does not provide for possession and control of collateral and where they cannot control the type of collateral that the CCP holds on their behalf.”
“The eligible assets allowed include Brazil currency are pretty broad—Brazil government bonds, gold, ETFs (exchange-trade funds), LOCs (letters of credit), securities traded in the international markets for non-resident investors, and so on—but the international market needs to look at the CBLC/CCP structure in a more holistic way.
When one looks at the eligible collateral allowed by the CBLC and then compares it to the position limits, the settlement fund and the margin calculation structure that the CBLC uses (CM-TIMS system), the risk profile is reduced: the CBLC uses a volatility based margining structure that requires a minimum of about 115 percent in collateral on easy names and can go as high as 180 percent (in today’s market) for more volatile stocks. By comparison, the international markets charge 102 to 105 percent in collateral for ‘purpose’ lending. Also, generally, there are no margining distinctions between liquid and illiquid names in the international market between counterparties (HF margining will be more dynamic than broker to broker margining).”
The CCP has two distinct disadvantages. In the event of Brazil defaulting, collateral that is held in the CBLC is put at risk, and it puts off global custodians that are accustomed to managing their own collateral pools in finance centres such New York or London from doing business in the country. Even though Brazil has the largest equity market capitalisation, global custodians such as State Street do not offer securities lending services to local investors there.
But in conferences worldwide, regulators endlessly promote the use of CCP-type risk models that seem to emulate the CBLC—despite accusations of it failing to encourage foreign participation.
Representatives of the BM&F Bovespa have done an excellent job in educating foreign participants on the policies and procedures of Brazil securities lending, argues Wagner.
“The exchange has been criticised in the past for not opening up to foreign participants, but there is no way that can be said now. They have been extremely proactive in reaching out to the wider market as of late.”
“As recently as last December, representatives from the exchange went on a road show in Europe to educate and encourage foreign custodial banks (which represent pension funds and the like) and other institutions to work toward distributing their Brazil equity assets through the CBLC.”
“The BM&F Bovespa representatives are implementing a follow up/action plan to the meetings to further address the questions raised during their road show. It’s clear that the local exchange is serious about bridging the gap between home market policies and foreign participation in securities lending.”
Their efforts have paid off, with foreign investors representing the largest part of the equities lending pool at 36 percent of the total wallet, says Wagner. “For the borrowing pool, they represent the second largest share of the of the wallet at 19 percent of market share. Since there are more Brazil assets sitting idly at US and European custodial banks than all of the loans outstanding in the CBLC, it is conceivable that the foreign investor category will continue to increase its market presence in Brazil securities lending.”
Despite this, Wagner predicts that the future for domestic participation is still sunny. “For example, the current structure is setup to ensure some domestic participation—a local broker is required to access the settlement system (BTC) to facilitate local and foreign investor trades. This is not dissimilar to how US registered broker-dealers are used to access US markets. So while the foreign participants will continue grow its share, the domestic providers will always have a place in the market.”
Lewis adds that his gut feeling is that domestic players will always have a place in their own markets. “They have the connections and experience that the foreign investors and market players will, at the very least, want to align themselves with in the longer term.”
“Whilst many international banks and custodians are active in Brazil, they cannot cater for every style of investor and there will always be a demand for domestic participants from certain areas of the market.”
The tax system is another suspected downside to the system, and is often accused of driving up securities lending costs for international players.
Lewis says: “The tax system in Brazil is a little complicated, particularly for those participants domiciled outside the country. However, the income levels are relatively high and as such, tax simply becomes a cost of doing the business that has to be met.”
“Like the taxes, structural differences in the Brazilian lending market also add friction compared to the more mature European countries, however, securities lenders looking for developing markets with good yields will overcome these difficulties.”
The slashing of the Selic
Local asset managers (hedge funds and mutual funds, not including pension funds) represent the biggest borrowers of Brazil assets by a large margin, with close to 70 percent of securities being borrowed for these funds. “Conversely, the funds represent a significant part of the lending pool as well,” adds Wagner.
Wagner says that multi-strategy or ‘multimercado’ funds dominate. They represent almost 50 percent of all strategies.
“These funds employ multi asset investment vehicles—which almost always involved a much more healthy dose of fixed income assets and a smaller portion dedicated to equities and generally long/short bias. This strategy—along with the high Selic benchmark rate—allowed for investors to achieve high fixed income investment yield with little volatility.”
Now the Selic has been cut by about 500 basis points—with Brazil’s Central Bank Monetary Policy Committee (Copom) cutting its overnight rate by another 25 basis points to 7.25 percent and hinting strongly that its easing cycle has now ended—things have changed for the multimercado funds.
“Multimercado funds are now required to find alternative ways to achieve returns,” says Wagner. “This includes increasing leverage (ie, trading in options markets) and tapping into the local and global equity markets. Appetite for risk in these funds must increase to achieve the same benchmark returns previously earned in a higher interest rate environment.”
And tapping into equity markets is what these funds have done, with securities lending in Brazil confined to equities despite local investors’ preference for fixed-income instruments.
“High local interest rates and strong demand makes borrowing Brazilian fixed income securities extremely expensive, driving investors towards a burgeoning synthetic fixed income market instead,” says Lewis.
“Fixed income securities finance transactions are generally governed under repo arrangements,” adds Wagner. “Repo arrangements are monitored by the Brazil Monetary Council (CMN). There are a number of rules that apply to trading fixed income repo in Brazil, but for financial institutions it does not require clearing through a CCP (as it does for equities).”
But securities lending is not completely confined to equities. Wagner says: “There is another lending platform called SISBEX but it is significantly smaller than the equities lending platform (BTC).”
In January of 2012, mining company Vale and oil business Petrobras were dominating, together making up almost 20 percent of the market. Minerals and oil firms, along with banking, are the biggest securities, reflecting their positions within the investment markets. Currently, the top equities assets on loan in order of value are Ambev (brewing company), Vale, Bradesco (banking) and BRF Foods.
“Borrowers, in the form of both local and international hedge funds, tend to concentrate on the larger more liquid securities especially those that trade as ADRs (American depository receipts) in the US,” states Lewis. “As such, both Vale and Petrobras are popular securities to borrow, but as more investors become active lenders then I would expect interest levels to widen to other less liquid securities.”
It seems as though the current Brazilian securities lending model could be the precedent for regulators to stir up lending transactions across the globe. This is a world in which there are no bilateral trades, cash collateral reinvestments are not allowed, fees are transparent, and authorised investment funds are permitted to act as both lenders and borrowers. But criticism over tax and the level of control that is wielded by the CCP means that it could be a while before the model takes hold elsewhere.
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