Latin America
With Europe in a spiraling debt mess, the US hugely overdrawn and even China slowing down, investors have had to look away from traditional markets. Latin America was plagued during the last century with a combination of political instability and runaway inflation which made it a difficult region to invest in. However, the years ahead may be called “Latin America’s decade,” a phrase coined by the Inter-American Development Bank in early 2011 and although varying levels of economic sophistication remain in the region, securities lending and hedge fund activity is most certainly on the rise.

Brazil is the economic powerhouse of the region, part of the formidable BRIC (Brazil, Russia, India, China), which some commentators believe could overtake the G8 economies by 2027. In fact, Brazil has recently overtaken the UK to become the world’s sixth-largest economy. The country has made staggering economic advances in the last decade, in one symptom of this the merger of Bovespa and the Brazilian Mercantile and Futures Exchange (BM&F) created the world’s third largest exchange. In the same year the BM&FBovespa was created, the country received investment-grade status for its sovereign debt, attracting investment funds from China, Singapore and Japan.

To CBLC or not to CBLC

In Brazil, securities lending transactions are governed by CBLC, the central counterparty (CCP) owned by BM&FBovespa, which accepts collateral from the borrower and holds it centrally. This differs from most other markets which use a bilateral OTC arrangement. This has caused some anxiety. “It can be hard to understand what the duty is between CBLC and the client. It puts some clients off as they don’t want the risk with their collateral [In case Brazil defaults],” says one source.

Other commentators are aware of the reluctance of using clearing houses. “There is growing fear that clearing houses within an exchange can dominate a market and some would like things to be separate,” says Jane Fuller, co-head of financial think tank Centre for the Study of Financial Innovation (CSFI)

Fuller believes that the use of CCPs is part of a global shift away from the bilateral arrangement. “There has been more movement from bilateral OTC derivatives to central clearing houses as seen in reform legislation like Dodd Frank. The idea is to have more and better capital and keep tabs on it. It’s hard to keep tabs on a bilateral agreement. Quite often emerging markets have more conservative rules although advanced economies seemed to be going down the same route.” she said.

Carey Chamberlain, head of equity finance trading and a director with HSBC who is based in Rio, also sees this trend. “At HSBC we are fortunate enough to know the industry infrastructure very well, and if you look at it from more of a macro level I think it’s very important to be involved in markets that could shape the way stock lending is executed globally in the future. Regulators across the world are promoting the use of central counterparty type risk models that will in some ways emulate the Bovespa,” he explains.

But firms acting as brokers in Brazil have been able to attract clients with their knowledge of using the CBLC. “Lenders want to partner with Merrill Lynch due to our market knowledge and strong presence in the region. There are great opportunities for growth in Brazil and lenders are looking for ways to break into the market,”said Courtney Campbell, director in synthetic products and securities lending at Merrill Lynch.

The growth of securities lending in Brazil was illustrated by last year’s figures. In 2011, securities lending transactions at BM&FBovespa reached a new high point with a financial volume of BRL732.75 billion ($407.4 billion) and 1,417,787 trades, surpassing 2010’s financial volume of BRL465.6 billion ($258.8 billion) and 971,558 trades.

“When I started the market was much smaller but has exploded in the last 4-5 years,” says Marina Leite, formerly of Itau Securities and now at Merrill Lynch.

Barriers to market

Despite the size of the Brazilian securities lending market, the CBLC does present some problems for foreign investors. Although the CBLC may need some locally based expertise to navigate, it does give the Brazilian market security. However, the Brazilian government seems to be in constant flux regarding the “IOF” tax, essentially a tax on foreign loans. The government plans to extend the tax to longer maturities, signalling the second change to the tax in two weeks. There have been calls to abolish the tax amongst economists but it doesn’t seem to adversely affect securities lending.

“Our view is that [the IOF] is a way to stabilise the currency. For clients, the IOF becomes relevant when they want access to Brazil via synthetic products such as swaps and certificates. It’s not relevant in the stock loan world as money does not leave the country.” says Campbell.

A more pressing concern for the Brazilian market is how to cope with the increase in demand. “It is a very manual process. You do have to go through operational issues and the CBLC might have to add more technology as the market grows. The plan is to work directly with hedge funds in Europe, the CBLC want to do it but it’s not a priority at the moment. We have to cross all info from the lender, broker and custodian relationship in a manual way which is very time consuming.” says a source.

In stark contrast, a region that seems to have the least barriers to its securities lending market is Mexico. This is reflected by its larger percentage of foreign investors compared to Brazil, where domestic funds seem to dominate. According to Alejandro Berney, managing director - Latam business head GTS - Securities and Fund Services at Citibank, this is due to foreign investors largely not using the CBLC programme.

Chamberlain believes that the reason Mexico is the easiest market for international lenders to get involved in is due to the Mexican ADR market. “[The ADR market is] trading at parity to the locals, or very close to it. Investors tend to favour the US way of beta in that market, making it difficult to lend any real volume in locals.” he says.

Also in Mexico, there are no locally domiciled hedge funds. “[Instead,] most of the demand comes from local managers looking for arbitrage opportunities by looking at the local underlying security and comparing it to the ADR in New York.” says Berney.

Pension schemes

Although a major participant in securities lending markets such as the US, in Latin America pension schemes are not a major presence yet. According to Carlos Barrios, Director of Investor Relations and Corporate Matters at the Bolsa de Valores de Colombia, pension schemes were completely absent in Colombian securities lending in 2011. This is hardly surprising as the sec lending market is in its infancy, starting in January 2011 and only allowing set guarantees with cash. Only this month, after a regulation change in December 2011, is it now allowed to set up guarantees with securities.

But Barrios does have hopes that the market will develop and the pension schemes will have a presence. “We are expecting an increase of the operation’s level in 2012 and strengthening of the legal entities participation including foreign investment funds, mutual funds and pension funds,” he says.

Even in the comparatively more mature market of Brazil, pension funds have only recently been getting involved in securities lending. “In the last three years pension schemes have been getting involved in the market. There are no external regulatory issues but the schemes have their own internal rules and controls concerning things like how much in percentage terms can be lent out,” said Leite.

In Brazil pension funds are suppliers of assets. “When pension funds participate, it’s external asset managers who are doing the loans. Asset managers only lend out what they weren’t considering selling in the next months,” says Berney.

However the position is very different in Mexico because they are not allowed to lend their equity holding. They can only lend their fixed income, “which due to the large supply means very small returns,” says Berney.

There is a feeling that pension funds are still a somewhat untapped resource in the region. “There is a substantial amount of inventory sitting dormant right now,” says Chamberlain.

Major Players

In Brazil the securities lending market is dominated by two companies, mining company Vale and the oil business, Petrobras. The reason for this dominance is due to the liquidity of the securities which means a lower spread and higher demand. In Mexico, AMX and Walmex dominate and make up 50 per cent of the index.

In terms of those involved in facilitating sec lending an industry insider gave his opinion on the pecking order in the region. He says the market in Brazil is currently dominated locally by Itau and offshore by J.P. Morgan. HSBC and Merrill Lynch are both significant players making it into the top 10. In Chile, Larrian is the dominant force and in Colombia, the Interbolsa group are leading. He also views that the biggest player in Mexico is currently Citi.

The Latin American market is clearly a diverse one with differing models and investment types. For instance Brazil and Chile use a CCP model, as opposed to a bilateral OTC model favoured by the rest of the region and Brazilian sec lending is largely domestic whereas foreign investors favour Mexico. Although a diverse region, there was universal optimism for sec lending in the area, it could well be “Latin America’s decade”
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