Brazil
24 January 2012
As Brazil鈥檚 investment community adopts more complex trading
strategies, securities lending demand is booming
Image: Shutterstock
Brazil鈥檚 exchange, BM&FBovespa (BVMF), has been investing heavily in technology in order to attract more volumes and it鈥檚 working. Investment managers implementing long/short strategies and high frequency traders are moving in and consequently, have pushed the demand for securities lending services to record highs.
Volumes of registered securities lending contracts at BTC, the securities lending programme of the Brazilian Clearing and Depository Corporation (CBLC), have been increasing exponentially - exceeding 57 per cent in 2011 compared with 2010. Meanwhile the quantity of registered contracts showed over 46 per cent growth. In December, the market reached a new record of BRL 35.9 billion ($20.1bn) in financial volume of outstanding positions.
鈥淭he ongoing maturity of the market for securities lending is being pushed by an increase of long/short investment funds. A lot of investors, if they have their equity deposited and wish to see an increase of income are also getting used to having a position with BTC,鈥� says Daniel Granja, central counterparty risk manager at BVMF. 鈥淭here is also growth of high frequency trading and if they want to arbitrage between markets they tend to seek a securities lending position鈥 expect to see continued growth, the securities lending programme is a good tool for hedging equities and for trading as well.鈥�
Acting as the CCP, CBLC is responsible for the settlement of all securities lending transactions and collateral remains under the fiduciary ownership of the clearing house with all trades registered. The country鈥檚 securities lending model is fully integrated into the CCP environment, there is no bilateral trade.
In an environment of diminished returns, some market participants have noted that the registration fees are high, borrowers pay to register a transaction at 25 basis points per year (pro-rata equivalent to the contract maturity) while lenders pay a 15 per cent tax. However, Daniel Granja, is quick to point out how transparent the fee model is.
Though only authorised institutions can access the system, all users can see updated daily data which shows open positions, total lending volumes of each asset, compulsory loans registered over a month and other key statistics - all important factors to ensure fair pricing and to track trends in the market.
An important difference in the BTC model that foreign investors should be aware of, Granja says, is the lack of cash collateral reinvestment, an activity that is currently being scrutinised heavily by supranational regulators such as the Financial Stability Board.
At the same time, authorised investment funds are permitted to act as both lenders and borrowers. Granja explains that this is so that if a specific stock price drops, the investment fund can borrow it, sell it to the market and then buy it back. In addition, securities lending positions can be used as collateral for other transactions since it is held by the CCP. Another advantage of BTC includes the processing of significant corporate events in the lifecycle of transactions for lenders, such as dividends.
Mutual funds by and large dominate the borrowing market, representing some 73.9 per cent of the market, although foreign investors also show significant activity, composing 15.6 per cent. Still, this is an incipient market in many ways. Only last year, J.P. Morgan Worldwide 麻豆传媒 Services (WSS) became the first non-domestic agent lender to successfully execute and settle a securities lending transaction.
At the time, Ricardo Nascimento, head of WSS business for Brazil, said in a statement that 鈥渢he ability to offer securities lending services in the Brazilian market is part of our strategy to offer our global and Brazilian clients a broad range of local services to support their investment strategies鈥�.
Foreign investors now represent some 29.3 per cent of the lending market as well though individuals with holdings comprise the largest portion at 43.1 per cent with mutual funds at 18.7 per cent. Pension funds are heavily regulated but are becoming increasingly important as well. At present, this group represents just under two per cent of the lending market.
Though Granja doesn鈥檛 see any regulation specific to the securities lending market on the horizon, there may be some risks if the government was to intervene with policies to slow down investment. Last year, the Brazilian economy was at most risk of overheating in Latin America and the local currency, the real, was appreciating beyond comfortable levels. To prevent further foreign investment inflows, the government enforced a financial transaction tax, but this has since been repealed. Market observers with knowledge of the matter express divergent opinions over how great this risk is, yet it remains.
鈥淭here is still plenty of space for growth, as foreign investors become more familiar with the way in which BTC is different than foreign models, we will likely see an increase for these market players as well,鈥� Granja says.
High frequency upgrade
Analysts agree that one of the most important factors driving securities lending is the modernisation of the Exchange after its demutualisation and active courting of electronic and high frequency trading and thus, investors interested in shorting.
Bernardo Mariano, analyst at Equity Research Desk, says that since 2008 investment in technology is putting Brazil鈥檚 capital market closer to being on par with more developed exchanges.
鈥淩ight now the Exchange is implementing a technology developed together with CME, called PUMA, which will really put the Exchange, in terms of latency, at the level of US or European exchanges, but throughput, which is basically how many orders you can fit per second, will still be lagging,鈥� he says.
Despite the increase in volumes that technology will bring, for brokers engaged in securities lending, the fact that CBLC acts as the counterparty also has other implications. Since the services offered by brokers are all the same, competition for business focuses on price and squeezes margins.
鈥淎t the beginning, there were a couple of brokers which jumped into it because it was profitable, there was very little competition. Then, when the market started to develop, competition heated up and since the Exchange was demutualised, margins became smaller and smaller,鈥� Mariano says.
It all started in Rio...
Alvaro Vidigal鈥檚 grandfather loved keeping equities in his family-owned insurance company鈥檚 portfolio but ran into regulatory compliance issues. Those limitations were the inspiration to create a stock loaning business within insurance companies all over the country to reconcile the books.
鈥淚t all started in Rio as a family business, not for trading purposes either...but before CBLC it was difficult, with the clearing, for example...then Sao Paulo bought the Exchange and all the stock lending moved there, even still my trading desk remains in Rio,鈥� says Vidigal.
When securities lending began officially through CBLC in 1996, Vidigal founded the Socopa stock loaning desk, which had some 70 per cent market share by 2000 and, even since the arrival of large custodians such as J.P. Morgan, remains one of the top five independent brokers in the securities lending space.
He readily admits that the business is not what it used to be on its own, rather it has become an integral part of a broker鈥檚 service package.
鈥淵ou need a stock loaning business and a trading desk in order to provide your clients liquidity for short sales, if you don鈥檛 have this liquidity, you may lose clients that want to trade with you, stock loaning has become a provider of other business rather than a business itself,鈥� Vidigal says.
He applauds the development of the market since CBLC has been involved, noting in particular the system鈥檚 safety but also flexibility.
鈥淢any foreign investors are using the CBLC system to borrow stocks, selling short in Brazil but depositing collateral in Euroclear. And this has been happening for a while, so, for example, a borrower deposits German sovereign bonds in Euroclear, Socopa provides leverage in Brazil and then they can borrow and sell stocks,鈥� he notes. The CCP also has agreements with DTCC for US securities collateral.
He adds that there is a misconception that foreign investors cannot use the securities lending market, but that has more to do with hedge funds using swaps as an alternative rather than any formal barrier to entry - foreign investors have all the same rights as domestic investors.
鈥淚 think the securities lending market is very well developed now, Brazil鈥檚 system is one of the safest in the world. Since 1996, there is not one bankruptcy related to a short sale...brokers and banks are working in a safe, secured lending environment. When there is a crisis, many people try to blame securities lending but my point of view is that the tail does not chew the dog...stock borrowing and lending provides liquidity to the market. You should have seen the market before 1996.鈥�
Volumes of registered securities lending contracts at BTC, the securities lending programme of the Brazilian Clearing and Depository Corporation (CBLC), have been increasing exponentially - exceeding 57 per cent in 2011 compared with 2010. Meanwhile the quantity of registered contracts showed over 46 per cent growth. In December, the market reached a new record of BRL 35.9 billion ($20.1bn) in financial volume of outstanding positions.
鈥淭he ongoing maturity of the market for securities lending is being pushed by an increase of long/short investment funds. A lot of investors, if they have their equity deposited and wish to see an increase of income are also getting used to having a position with BTC,鈥� says Daniel Granja, central counterparty risk manager at BVMF. 鈥淭here is also growth of high frequency trading and if they want to arbitrage between markets they tend to seek a securities lending position鈥 expect to see continued growth, the securities lending programme is a good tool for hedging equities and for trading as well.鈥�
Acting as the CCP, CBLC is responsible for the settlement of all securities lending transactions and collateral remains under the fiduciary ownership of the clearing house with all trades registered. The country鈥檚 securities lending model is fully integrated into the CCP environment, there is no bilateral trade.
In an environment of diminished returns, some market participants have noted that the registration fees are high, borrowers pay to register a transaction at 25 basis points per year (pro-rata equivalent to the contract maturity) while lenders pay a 15 per cent tax. However, Daniel Granja, is quick to point out how transparent the fee model is.
Though only authorised institutions can access the system, all users can see updated daily data which shows open positions, total lending volumes of each asset, compulsory loans registered over a month and other key statistics - all important factors to ensure fair pricing and to track trends in the market.
An important difference in the BTC model that foreign investors should be aware of, Granja says, is the lack of cash collateral reinvestment, an activity that is currently being scrutinised heavily by supranational regulators such as the Financial Stability Board.
At the same time, authorised investment funds are permitted to act as both lenders and borrowers. Granja explains that this is so that if a specific stock price drops, the investment fund can borrow it, sell it to the market and then buy it back. In addition, securities lending positions can be used as collateral for other transactions since it is held by the CCP. Another advantage of BTC includes the processing of significant corporate events in the lifecycle of transactions for lenders, such as dividends.
Mutual funds by and large dominate the borrowing market, representing some 73.9 per cent of the market, although foreign investors also show significant activity, composing 15.6 per cent. Still, this is an incipient market in many ways. Only last year, J.P. Morgan Worldwide 麻豆传媒 Services (WSS) became the first non-domestic agent lender to successfully execute and settle a securities lending transaction.
At the time, Ricardo Nascimento, head of WSS business for Brazil, said in a statement that 鈥渢he ability to offer securities lending services in the Brazilian market is part of our strategy to offer our global and Brazilian clients a broad range of local services to support their investment strategies鈥�.
Foreign investors now represent some 29.3 per cent of the lending market as well though individuals with holdings comprise the largest portion at 43.1 per cent with mutual funds at 18.7 per cent. Pension funds are heavily regulated but are becoming increasingly important as well. At present, this group represents just under two per cent of the lending market.
Though Granja doesn鈥檛 see any regulation specific to the securities lending market on the horizon, there may be some risks if the government was to intervene with policies to slow down investment. Last year, the Brazilian economy was at most risk of overheating in Latin America and the local currency, the real, was appreciating beyond comfortable levels. To prevent further foreign investment inflows, the government enforced a financial transaction tax, but this has since been repealed. Market observers with knowledge of the matter express divergent opinions over how great this risk is, yet it remains.
鈥淭here is still plenty of space for growth, as foreign investors become more familiar with the way in which BTC is different than foreign models, we will likely see an increase for these market players as well,鈥� Granja says.
High frequency upgrade
Analysts agree that one of the most important factors driving securities lending is the modernisation of the Exchange after its demutualisation and active courting of electronic and high frequency trading and thus, investors interested in shorting.
Bernardo Mariano, analyst at Equity Research Desk, says that since 2008 investment in technology is putting Brazil鈥檚 capital market closer to being on par with more developed exchanges.
鈥淩ight now the Exchange is implementing a technology developed together with CME, called PUMA, which will really put the Exchange, in terms of latency, at the level of US or European exchanges, but throughput, which is basically how many orders you can fit per second, will still be lagging,鈥� he says.
Despite the increase in volumes that technology will bring, for brokers engaged in securities lending, the fact that CBLC acts as the counterparty also has other implications. Since the services offered by brokers are all the same, competition for business focuses on price and squeezes margins.
鈥淎t the beginning, there were a couple of brokers which jumped into it because it was profitable, there was very little competition. Then, when the market started to develop, competition heated up and since the Exchange was demutualised, margins became smaller and smaller,鈥� Mariano says.
It all started in Rio...
Alvaro Vidigal鈥檚 grandfather loved keeping equities in his family-owned insurance company鈥檚 portfolio but ran into regulatory compliance issues. Those limitations were the inspiration to create a stock loaning business within insurance companies all over the country to reconcile the books.
鈥淚t all started in Rio as a family business, not for trading purposes either...but before CBLC it was difficult, with the clearing, for example...then Sao Paulo bought the Exchange and all the stock lending moved there, even still my trading desk remains in Rio,鈥� says Vidigal.
When securities lending began officially through CBLC in 1996, Vidigal founded the Socopa stock loaning desk, which had some 70 per cent market share by 2000 and, even since the arrival of large custodians such as J.P. Morgan, remains one of the top five independent brokers in the securities lending space.
He readily admits that the business is not what it used to be on its own, rather it has become an integral part of a broker鈥檚 service package.
鈥淵ou need a stock loaning business and a trading desk in order to provide your clients liquidity for short sales, if you don鈥檛 have this liquidity, you may lose clients that want to trade with you, stock loaning has become a provider of other business rather than a business itself,鈥� Vidigal says.
He applauds the development of the market since CBLC has been involved, noting in particular the system鈥檚 safety but also flexibility.
鈥淢any foreign investors are using the CBLC system to borrow stocks, selling short in Brazil but depositing collateral in Euroclear. And this has been happening for a while, so, for example, a borrower deposits German sovereign bonds in Euroclear, Socopa provides leverage in Brazil and then they can borrow and sell stocks,鈥� he notes. The CCP also has agreements with DTCC for US securities collateral.
He adds that there is a misconception that foreign investors cannot use the securities lending market, but that has more to do with hedge funds using swaps as an alternative rather than any formal barrier to entry - foreign investors have all the same rights as domestic investors.
鈥淚 think the securities lending market is very well developed now, Brazil鈥檚 system is one of the safest in the world. Since 1996, there is not one bankruptcy related to a short sale...brokers and banks are working in a safe, secured lending environment. When there is a crisis, many people try to blame securities lending but my point of view is that the tail does not chew the dog...stock borrowing and lending provides liquidity to the market. You should have seen the market before 1996.鈥�
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