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Brazil: Cleared for take off

Published in Automated Trader Magazine Issue 35 Winter 2015

The heart of Latin America skipped a beat this year as Brazil, the world's seventh-largest economy, fell into recession. But the financial system that underpins the beleaguered economy is undergoing changes which could help bolster growth. Sophie Lewisohn reports.

Nils-Robert Persson, Chairman, Cinnober

Unlike its northern neighbour the US, which boasts more than a dozen stock exchanges, Brazil has only one: BM&F Bovespa. It launched a new clearing house in August, bringing improved speed and safety to investors. Meanwhile, competitor exchanges in Brazil are inching towards launching bourses of their own, which would inject some much-needed competition into the market. Funds which have cautiously awaited election results see Brazil becoming increasingly attractive for investment.


When the futures exchange BM&F merged with the
stock exchange Bovespa in 2008, they ran four separate clearing houses: one each for derivatives, equities, bonds and foreign exchange.

The tumult of 2008 spurred on plans to integrate the clearing houses, with reduced risk at the forefront of developers' minds.

"After the crisis, there was recognition around the world that more effective regulation and better clearing systems were needed," says Nils-Robert Persson, chairman of Cinnober, which provides the technology for Brazil's new clearing house. "Here in Europe, we've talked about it for five years. In Brazil, they've taken action."

In Brazil, every single market participant now has its own account with the clearing house rather than passing their trades through a few big banks. While clearing houses in western Europe and the US handle a few hundred accounts, Brazil's handles several million separate clients, with the capacity to serve 12 million simultaneously.

Importantly, the risk represented by each market participant is now assessed by the clearing house, rather than by the banks. The immediate effect is that collateral is calculated in an entirely new way: on an individual client basis, and across all different asset classes at once.

The way it used to work was that a bank might receive instructions from one client to buy a hundred stocks of a company, and instructions from another to sell a hundred of the same. The orders would cancel each other out, and so the bank would not be asked to post any collateral by the clearing house.

If one of those parties defaulted, the bank took the hit. "This set-up might allow crises to occur," says Persson. "We've seen crises before arising when no one knew what was going on behind the front presented by the bank."

Not content with traditional methods of calculating collateral, BM&FBovespa created a new model with the assistance of internationally recognised quants and risk experts. After four years in development, the result is an integrated risk calculation system called Closeout Risk Evaluation, or CORE.

When the new clearing house went live on a Monday morning in late August, BM&FBOVESPA was asking its traders for $8.8bn less collateral than the week before.

"Risk in a market must be accompanied by a fair amount of collateral - that's the first rule," says Persson. "By asking for more information from each participant, the clearing house can calculate the amount of collateral they need from clients far more accurately. In other words, they can lower collateral requirements without adding risk to the market. And everything happens in real time - clearing and risk calculations are near-instant, improving safety."

Exchange-traded and over-the- counter derivatives have been cleared through the new house since August, to be followed by equities and fixed income next year.

Still, some market participants are less dramatic in their estimation of the benefits. "From a practical investor's perspective, there is no difference in the way business takes place," says Rodrigo Svirsky of Squanto Invest.

What would really enliven the market would be competition among stock exchanges: a missing element in Brazil's financial landscape.


Alan Gandelman, CEO, ATS Brasil

The Comissão de Valores Mobiliários - Brazil's version of the Securities and Exchange Commission - conducted research on the matter of competition in 2012 alongside consultancy group Oxera. Their conclusion: it would spur growth and bring liquidity.

But offers by BVMF's competitors to open stock exchanges have yet to be approved. "It's hard to say when other exchanges might open - there have been several cancellations," says Svirsky.

Direct Edge, a US exchange acquired by BATS, wants to launch an electronic trading platform in Rio de Janeiro to "foster competition and encourage innovation". They announced their intentions in November 2011, but have yet to file formally with the regulator.

"There is no time frame," said Jim Gorman, vice-president of corporate communications at BATS. "My understanding is that CVM is still considering rules to safely bring competition to Brazil."

Another hopeful is ATS Brasil, the joint venture of stock exchange NYSE Euronext (now owned by ICE) and electronic trading specialist Americas Trading Group. It applied to the
CVM in June 2013 for permission to open a trading platform linking Latin America, and hopes to claim a 10- 15% share of equities trading - but is still awaiting permission to open.

"The approval time for a highly complex project is understandable," says Alan Gandelman, CEO of ATS Brasil. "We believe we will have legal authorisation from the regulator in 2015."

As well as forming a competitor exchange focused on the cash and exchange traded fund markets, ATS Group would create a clearing house of its own. Its authorisation application is soon to be formalised with the central bank.

"The entry of ATS Brasil will represent a new paradigm for the Brazilian capital markets," says Gandelman. "Competition improves efficiency, transparency and increases market liquidity."

The exchange itself would run on NYSE's Universal Trading Platform, which can receive "intense data traffic at extremely high speeds and low latency, enabling a thousand orders to be sent per second. We will offer lower spreads and lower costs."

This, Gandelman says, will open Brazil to large global investors, including those using high frequency trading strategies.


"Despite constant efforts at growth, the Brazilian market is still extremely illiquid in large and medium companies, and a market for 'small caps' and 'middle caps' is absent," says Gandelman.

Only 365 companies are listed on Brazil's stock market, a number not much higher than in the 1970s. And of these 365, just 10% represent more than half of the exchange's trading volume. In the futures market, 90% of the trading volume is concentrated on just five contracts.

"With only 30 stocks with significant market capitalisation and volume, the development of algorithmic trading is limited," says Svirsky. High frequency trading accounts for only 12-15% of trading on BM&F Bovespa.

Competitor exchanges could make a difference, and BVMF itself is making efforts to attract more traders.

The exchange offers discounts to "day traders" - those speculative investors buying and selling a stock on the same day. Among this group are algo traders. Though they have gained a bad name for shaving the returns off the rest of the market, they can also be regarded as volatility shock absorbers, and their many trades add liquidity to a market - plus fees for the exchange.

To further encourage high frequency traders, BVMF allows colocation, and has since 2009. For a fee, traders can site their machines right next to the stock exchange, shaving crucial milliseconds off the time it takes for orders to reach the exchange.

The conditions at the Brazilian exchange are ripe for automated trading. Investors are now considering two things: when liquidity and trading volumes will be sufficient to make their strategies viable; and regulation.

The level of accountability and transparency expected of Brazilian funds is extremely high. "Funds must report daily to the regulator, disclosing not only net asset value but also their positions," says an economist at one of Brazil's largest private equity groups.

As a result of this strict supervision, the regulator can boast that not one Brazilian fund collapsed during the subprime crisis.

At the same time, Brazil's reporting requirements can dissuade funds from placing

big bets in the open. "There are two ways around this," says the private equity firm economist. "Hedge funds can take a synthetic position, such as buying options on the stocks they are interested in. Or they can go offshore."

A large amount of trading on Brazil's markets comes from overseas. The international make-up of the Brazilian market can be glimpsed in the fact that trading is usually down by around 40% on American public holidays.


Brazil took off at the new millennium. Rising incomes and record exports helped the Bovespa index rise 16% a year, and the country's debt was decreed investment-grade for the first time in 2009, boosting government bonds.

In the boom years a straightforward strategy known as the Brazil Kit developed. Long on the Bovespa stock index, receiving favourable local interest rates, and short on the US dollar-Brazilian real exchange rate, it was a winner.

But the days of the "Brazil Kit" have petered out, and many investors are waiting on the sidelines until election results are in. "Due to the new economic picture and the uncertainty around the election, investors are running less risk and waiting for a clearer picture on the political front," says Svirsky.

"The preference at the moment is for less sophisticated, less volatile investments," says a trader at one of Brazil's largest private equity groups. "They just have to be tied into the nominal interest rate."

Inflation has risen to a three-year high of 6.75%, according to Trading Economics, so linking into Brazil's 11% interest rate is crucial for investors.

Alongside the challenge of inflation, investors
are aware that several much-needed structural adjustments have been postponed until after the elections. These include improving infrastructure, which needs investment; labour market reforms; central bank independence and increased foreign direct investment. 2015 is likely to be a year of change.

Some elements are in Brazil's favour: it has a youthful population, and unusually, incomes are rising at the same time that inequality is falling. Budget surpluses have reduced the government's deficit, and GDP is expected to pick up to 1.6%
for 2014 and 1.8% for 2015. Moreover, companies which held off from going public until after the election are likely to launch IPOs next year, bringing renewed investor interest to Brazil.

"On a relative basis, Brazil is not as interesting as it used to be," said the private equity firm's economist. "But it remains a driver of the region and of emerging markets. When it is more efficient in terms of its labour market and infrastructure, it will be better for everyone."

A robust financial system underlying the economy will support these reforms. "Developed capital markets are the key to economic growth in a country: They help companies raise money to finance their projects," says Gandelman. "The Brazilian capital market is significantly behind the size and dynamics of the country's economy."

When it catches up, the potential for growth is great.