THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL

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1 THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL 1

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4 Summary 06 Executive Summary The Brazilian Financial System - Structure And Governance The Brazilian Payment Systems - Adherent To International Standards Legal And Regulatory Basis The Structure Of The Brazilian Payments System Brazilian Payments System Building Blocks 19 The Central Bank Money System (STR) 20 Clearinghouses And Securities Settlement Systems With Direct Access To The STR - Certainty Of Settlement In Central Bank Money 20 Mechanisms For Risk Mitigation And Safeguard Structures 21 A Wide Ranging Communication Network 22 Fund Transfers For Retail Payments The Brazilian Financial Market Infrastructure - Best Practices In Practice Electronic Trading Systems And Centralized Registration Electronic Trading Systems Mandatory Centralized Registration - Beyond The Trade Repository 28 Cetip Otc Derivatives Registration System 29 Bm&Fbovespa Otc Derivatives Registration System Clearing And Settlement - Delivery versus Payment In Central Bank Money 31 Bm&Fbovespa 32 Cetip 33 Selic Central Counterparty - A Comprehensive Approach Legal Basis Bm&Fbovespa - The Central Counterparty For The Brazilian Market Taking On The Role Of Central Counterparty In Real Time Risk Management At Bm&Fbovespa 37 Chain Of Responsibility 37 Safeguards Structure 38 Risk Calculation Methodology 39 Bm&Fbovespa Risks And Mitigation Mechanisms - Summary Bm&Fbovespa Projects: The Integration Of Its Clearinghouses And A New Risk System The Cetip Ccp Project For Derivatives And Corporate Fixed Income Securities Lending

5 THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL Brazilian Leadership In Collateral Management 44 Bm&Fbovespa 45 Cetip Why Is It That Settlement In Brazil Almost Never Fails? Yes, We Have Securities Lending Securities Lending For Equities And Corporate Bonds Forward Market For Government And Corporate Fixed Income Securities Why Did The Brazilian Regulators Decide Against Banning Short Selling? Central Securities Depositories - Beneficial Owner Account Holding System Protecting Issuers And Investors Dematerialization And Book-Entry Recordkeeping The Advantages Of Beneficial Owner Over Omnibus Account Holding Systems Securities Integrity - Daily Reconciliation With Issuers Asset Servicing - Payments In Central Bank Money Why Is It Better To Trade Brazilian Securities In Brazil Than Drs Abroad? A Broader Array Of Securities Available Deeper Liquidity Shareholder Rights Better Investor Protection - Again The Beneficial Owner Advantages Pre-Release - Risks Of Adrs Issued Without The Underlying Securities Why Invest In Synthetic Adrs And Etfs? The Brazilian Investment Fund Industry - Relevant, Sophisticated And Well Regulated Instrument Size And Sophistication Regulation - Broad And Transparent Tax Advantages For International Investors In Brazil Income Tax Tax On Credit, Foreign Exchange And Insurance Financial Transactions (IOF) 78 Glossary 3

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7 ACKNOWLEDGEMENTS We would like to thank the members of the working group that organized and produced this document, which addresses for the first time the main features and benefits of the Brazilian financial market. ÁLVARO TAIAR JR. AMARILIS PRADO SARDENBERG JOAQUIM KAVAKAMA LUIS GUSTAVO DA MATTA MACHADO MARCELO FLEURY MARCIO VERONESE PEDRO LUIZ GUERRA (COORDINATOR) RADJALMA COSTA SIMONE ACIOLI BRAiN Team: JOSÉ MOULIN NETTO DANIEL P. ROSENFELD Elaboration and revision: MONIQUE MOURA DE ALMEIDA This publication is available on the BEST website ( 5

8 Executive Summary The Brazilian financial system is increasingly recognized worldwide for the scope and sophistication of the products it offers, the efficiency and safety of its infrastructure, and the mature and wide-ranging regulation it is subject to. Evidence of such recognition is widespread. About 40% of all stock investments are made by international investors, who also account for about 25% of the investments in the listed derivatives market. When it comes to initial public offerings (IPOs), international investors account for 60 to 70% of the total distributed locally. Nevertheless, there is a set of investors that chooses to invest in Brazil indirectly, in the form of instruments such as depository receipts (DRs), or synthetic securities representing Brazilian securities, exchange traded funds (ETFs) or indices. This document targets precisely these investors, as well as others who may not yet have invested in Brazil, perhaps because they are unaware of the characteristics of this market. The goal of this document is to show global investors that investing directly in Brazil offers a number of advantages compared to investments made through DRs and synthetic instruments in international markets. Below is a summary of the reasons why investing in the local market is more attractive. Each topic is developed fully in the body of this document. A state-of-the-art payments system The Brazilian Payments System (SPB) was revamped in 2002, resulting in a financial system and capital markets with characteristics that make them international examples of security and sophistication. This became very clear, for instance, in the way the nation successfully pulled through the recent international financial crises, in particular the 2008 crisis, and the recent assessment by the World Bank and the International Monetary Fund within the scope of an initiative entitled the Financial Sector Assessment Program, according to which the nation was considered adherent to international standards. The building blocks of the Brazilian Payments System are: A solid and ample legal basis; 6

9 THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL The mandatory use of central counterparties for transactions subject to multilateral netting in systemically important systems; Settlement irrevocability and finality; The certainty of settlement offered by the central counterparty, based on risk management mechanisms and safeguards created to address situations where one of the parties in the system may become insolvent; The National Financial System Network (Rede do Sistema Financeiro Nacional - RSFN), which connects all of the institutions that have been authorized by the Brazilian Central Bank to operate, the clearinghouses 1 and securities settlement systems and the STR, BCB s large value transfer system, enabling ample access to settlement in Central Bank money. Mandatory registration of transactions, including OTC derivatives One of the building blocks of Brazil s financial market infrastructure is that all transactions involving fixed income securities and bank debt, as well as all derivative contracts, including OTC derivatives, must go through an exchange or be registered in a centralized registration system authorized by the regulators. Trading or registration systems must include sufficient data to clearly characterize the type of contract or security, the nature of the transaction, the parties and the amount involved. In Brazil, all equities are exchange traded, and settlement is ensured by a central counterparty. This also applies to 80% of all derivative transactions. Regulations require that all OTC trades be registered in a system authorized by the Brazilian Central Bank (BCB). While mandatory registration of OTC derivatives is a proposal that has been gaining momentum in international discussions, it is still rare in international marketplaces. The registration systems used in Brazil are not only highly customizable, enabling participants to record detailed descriptions of complex, customized derivatives, but they go far beyond the functions of a simple trade repository, with functions that automatically update positions and settle payments. Securities Settlement Systems - Delivery versus Payment in central bank money Securities settlement systems (SSS) abide by strict delivery versus payment (DvP) principles. In addition to simultaneous DvP, settlement is final and there is no possibility that settled funds or securities will be unwound. 1 In the present document, clearinghouse is used to refer to organizations that are securities settlement systems acting also as central counterparties. 7

10 Furthermore, all transactions in the Brazilian capital market are settled in central bank money, eliminating the credit and liquidity risks inherent to payments made via a network of banking institutions. The world recently realized that no bank is above suspicion, thus the use of central bank money is a relevant element of a system s security. In order to make payments in central bank money, Brazilian clearinghouses and securities settlement systems have settlement accounts directly with the BCB, and also direct access to the STR. It should also be mentioned that the low settlement failure rate is the result of robust procedures for handling failures, such as compulsory securities lending and buy-in at the expense of the defaulting party, in addition to punitive fines. A comprehensive central counterparty and a lead role in collateral management Brazil has a comprehensive central counterparty structure that serves multiple markets - equities, derivatives, fixed income securities, corporate and government bonds and Forex transactions. The central counterparty s role in the Brazilian market has a number of important distinctions compared to other markets: A solid legal basis that ensures it has priority over fiscal and labor debts to execute collateral posted by the participants should one of them fail to fulfill its settlement obligations; The role of central counterparty is assumed immediately after the transaction is closed in the trading systems; Multilateral netting of obligations and direct settlement with the BCB within previously defined settlement windows; A clearly defined chain of responsibilities; A risk model for calculating exposure at the level of the beneficial owner using a portfolio approach; A hybrid structure of safeguards with individual collateralization by the players (defaulters pay) and mutualized settlement funds (survivors pay); Management of the collateral posted by participants segregated into accounts, marked-to-market, with the possibility of intraday margin calls and haircuts proportional to liquidity. In addition to collateral management by the central counterparty, the Brazilian market offers bilateral collateral management services for OTC transactions. The bilateral collateral management service enables establishing the parameters of the eligible securities and the applicable haircuts, collateral marking-tomarket and automatic calls as a function of parameters agreed beforehand by the parties. In addition to improving the mechanisms to manage bilateral risks 8

11 THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL and reduce the operating costs associated with collateral management, the bilateral collateral management service enables more efficient management of the collateral available, within the specific requirements of the parties involved. One of the important characteristics of the collateral management system in Brazil is that positions and collateral are controlled at the level of the beneficial owner, and totally segregated from the financial intermediary and other investors. Thus the collateral used for one investor may not be used for another, adding a layer of security to the system so that even if one of the intermediaries should become insolvent, the investor s collateral are protected. Securities lending with central counterparties One of the distinctions of Brazil s securities lending market is that it is also guaranteed by the central counterparty, which provides certainty of settlement to the contracts. Lender and borrower offers must register with a centralized system that provides total transparency in terms of rates and maximum limits for rate variations (tunnel), and where all market players can track the offers added and the deals being closed in real time. The central counterparty measures participant and investor risk and manages the collateral they submit. The level of collateralization is monitored in real time and, should it be necessary, the BM&FBOVESPA has the power to demand additional collateral, including intraday. Central Securities Depositories as instruments to protect investors and issuers. Central Securities Depositories (CSDs) in Brazil play a fundamental role in protecting investors and issuers: Dematerialization (complete for equities and bonds) and immobilization (for some other financial equities); A structure of individual accounts in the name of the beneficial owner (BM&FBOVESPA); Proprietary accounts segregated from client accounts, with individual accounts for institutional investors (Cetip and Selic); Asset integrity by reconciling with the issuer; Corporate actions and payments in central bank money. It is also worth pointing out that the advantages of a model based on individual accounts rather than on omnibus accounts are numerous. First of all the legal certainty of ownership of the securities - a structure of individual accounts ensures that the ownership rights over a security can be fully identified at any 9

12 time. Identification of the final investor at the level of the CSD also contributes to the quality of regulatory oversight. Crimes such as money laundering and terrorist funding, the use of privileged information, and fraud in general can be identified by the regulators very quickly and accurately. In markets that use the traditional model of omnibus accounts, positions are registered in the CSD in the name of the custodian financial institution, and the custodian in turn has control of the individual positions. In case the custodian becomes insolvent, even though client positions are kept separate from their proprietary position, there is reasonable legal uncertainty regarding ownership of the securities, and investors may suffer significant losses due to the risk of poorly managed custody. Regulators and self-regulatory organizations (SROs) in countries that use an omnibus account model do not have access to centralized information which makes market oversight more difficult and increases the investor s custody risk. Comparison with DRs Wider scope Investors [residing abroad] who wish to invest in stock issued by Brazilian companies in their local markets can only do so by purchasing a DR (Depositary Receipt). The range of securities available to investors is therefore limited to companies with a CVM (Brazilian Securities and Exchange Comission) authorized DR program. However, international investors have unlimited access to any shares listed on Brazilian exchanges, and their derivatives. Data published by the Brazilian Financial and Capital Markets Association (ANBIMA) shows that the volume of securities under custody that underlies the ADRs of Brazilian companies represent around 30% of all the securities held in custody for international investors in Brazil. Increased liquidity The Brazilian equities traded in Brazil are not only more liquid, but also the daily volume traded as ADRs has been steadily decreasing over time. According to data published by the MSCI (Morgan Stanley Capital Index), the ATVR (Annualized Traded Value Ratio) of Brazilian stock ADRs is high, around 50%. However, the ATVR for stock traded in local markets is 104%. Moreover, in 2012 the average daily trading volume of the 32 most liquid Brazilian ADRs dropped 27% compared to the previous year, reaching US$ 2 billion. In 2010 this volume was US$ 3.2 billion, and in 2008 US$ 3.5 billion. Handling of investor rights 10

13 THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL In the case of payment of corporate actions such as cash dividends and interest on equity, it can take several days for the owners of DRs to receive these amounts, whereas in Brazil the cash is available to the custodian on the same day it is paid by the issuer of the assets. This represents an opportunity cost since investors give up liquidity for a period of time unnecessarily, as they could invest directly in the local market. In the case of so-called voluntary rights, where investors must state their desire to exercise a right, the situation may be even worse for those who invest in DRs, as it is almost impossible to exercise these rights from abroad. Investors often ignore these for a variety of reasons. While on the one hand investors may be simply unaware of how the process works in the local market and therefore are unable to compare the two options, on the other, the cost is almost always included in a package of custodian services that makes any comparison difficult. Investor protection DRs traded abroad must abide by the rules of the market in which they are traded, and the transactions do not have the same level of protection that Brazilian legislation offers. In Brazil, listed company stocks can only be traded in an exchange, where there are a number of rules designed to preserve suitable pricing and ensure market transparency. As mentioned, these transactions are settled by a central counterparty that offers certainty of settlement. Furthermore, investor positions are registered in individual accounts in the name of the final investor. This is different from DR positions held by investors in markets that work with the concept of omnibus accounts. Although omnibus accounts normally segregate client ownership positions, it is impossible to identify individual investor positions using this system. A record of individual positions is kept exclusively at the participant level, and this is the only way to identify investor rights. Custody risk could be quite significant should the participant fail. The risks of pre-released ADRs In the US, financial institutions often issue pre-release ADRs, a mechanism whereby the institution issues an ADR based on collateral or availabilities the investor has in the financial institution of which it is a client. Pre-release issues are in fact credit in the form of stock that has no legal basis in Brazil, as these ADRs have no underlying equities in custody bank in Brazil. The risk to the investor is clear. As the ADR was issued based on the investor s 11

14 position and collateral with the financial institution, depending on how the market behaves, these funds may not be sufficient to actually purchase the actual ADRs. In a more extreme case, such as the insolvency of the financial institution that issued the pre-release, the investor s market risk may become a principal risk, as the only record of the ADR is held by the financial institution with no correspondence in Brazil, and thus no legal validity. This type of transaction has other collateral effects such as legal distortions and uncertainties related to the exercise of rights and the taxation of corporate actions. There are other opportunity costs such as late payments or the loss of rights that lapse. The risks involved in purchasing pre-release ADRs may also lead to significant losses and legal costs. Risks and costs of synthetic instruments The purchase of synthetic instruments representing Brazilian securities brings with it a number of risks. The first is related to the credit risk of the financial institution that issued the synthetic security. As this issue exists only on the books of the financial institution, should it fail, the investor has no legal backing to ensure its ownership rights. Another source of uncertainty is related to the integrity of the synthetic security relative to the security it represents. Depending on how a synthetic security is structured, it may not correspond perfectly to the underlying security. It is also not clear that synthetics are more attractive from an economic point of view. As in principle there is price parity between a security and its synthetic, part of the investment profitability is being used to bear the cost of issuing the synthetic. A sophisticated investment funds industry Investment funds are an attractive option for international investors in general, and are especially attractive for those who are just now venturing into the Brazilian market. The Brazilian funds industry is particularly interesting for its size, the number of qualified fund managers, the diversity of instruments available to investors and a broad and very effective regulatory framework. The Brazilian asset management industry is currently ranked 6 th in the world, with US$ 1.1 trillion in assets under management (AUM) at the end of 2012, a 16% year-over-year growth. The aggregate net inflow of the almost 13 thousand funds that make up the industry was US$ 50 billion in The investment 12

15 THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL funds existing in Brazil are also quite diverse in nature, and are managed by around 450 independent asset-managing firms registered with the CVM. In Brazil, the regulation and oversight of investment funds is quite comprehensive, and covers all sorts of funds, including the so-called multimarket funds, which are the closest to hedge funds. Brazil s regulators have full and regular visibility of how leveraged each fund is, and are thus fully aware of the industry s aggregate risk. All funds in Brazil, including exclusive funds with a single quota holder, must register with the CVM. The Brazilian funds industry also stands out for its high level of transparency. All fund transactions must necessarily be registered in a centralized system. Brazilian funds are also obliged to disclose a significant amount of data, either through the CVM or directly to the public at large. Tax advantages International investors who invest in Brazil through National Monetary Council regulation 2,689/2000 are taxed differently. In this sense, tax rates are lower or reduced to zero for almost all types of investments. Basically there are two types of taxes on financial investments: income tax (IT) on capital gains and earnings in general, and a tax on credit, foreign exchange and insurance financial transactions (IOF). In this case the IOF that affects international investors directly is primarily the IOF associated with foreign exchange transactions to bring funds into the country

16 THE BRAZILIAN FINANCIAL SYSTEM STRUCTURE AND 1GOVERNANCE In order to make this document easier to understand, the first topic is a summary of the structure and governance of Brazil s National Financial System (SFN). The SFN is comprised of financial institutions and oversight bodies that operate in different markets, in particular the capital, monetary, credit and exchange markets. The building blocks of the SFN as it stands today were created by Law 4,595/1964, also known as the bank reform law, and by Law 6,385/1976, which created the nation s capital markets. From the structural point of view, the oversight bodies and the institutions that operate under the umbrella of the SFN are guided by three normative agencies: the National Monetary Council (CMN), the National Private Insurance Council and the Supplemental Pensions Management Council. This document covers institutions, markets and transactions that are under the regulatory umbrella of the CMN and its subordinate oversight bodies. The National Monetary Council (CMN) is comprised of the Minister of the Finance, the Minister of Planning and the President of Brazil s Central Bank. It is the highest authority within the SFN, and responsible for formulating monetary and credit policies in general. The main SFN oversight bodies, the 14

17 THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL Brazilian Central Bank and the Securities and Exchange Commission, are both subordinate to the CMN. The Brazilian Central Bank (BCB) is responsible for enforcing monetary policy, for managing international reserves and overseeing foreign capital and credit. The BCB enforces prudential regulations and also acts as a monetary authority. As a prudential regulator, the BCB is responsible for ensuring systemic stability as the lender of last resort to financial institutions, and the administrator of the payments system. The Securities and Exchange Commission (CVM) is responsible for regulating and overseeing the capital markets, including securities issuers, exchanges and OTC markets, and the institutions that are part of the system to distribute securities. The CVM aims to keep the market efficient and foster development, and also strives to protect investors and maintain equitative practices in the securities market, enforcing the rules regarding information disclosure and transparency. From an operational point of view the SFN is made up of a large set of financial institutions - banking and non-banking, that act directly in the capital, monetary, credit and exchange markets, as well as all of the support entities such as the stock exchanges, the environments where transactions are registered and recorded, the clearinghouses and the CSDs, among others. The following chart shows the main components of this structure 3 : National Monetary Council (CMN) Central Bank (BCB) Securities and Exchange Commission (CVM) Cash and Futures Exchanges (BM&FBOVESPA) OTC and registration systems (Cetip and Selic*) Securities Settlement Systems* Central Counterparties* Central Securities Depositories** Multiple banks* Securities brokers Exchange brokers Mutual funds Investment banks* Securities dealers Independent agents Investment clubs** *Subject to the BCB oversight only **Subject to the CVM oversight only 3 The purpose of this illustration is to help readers become familiar with the structure of the SFN as it applies to this document. However, it is not exhaustive and does not include all of the elements that comprise the SFN. For further details please go to 15

18 THE BRAZILIAN PAYMENT SYSTEMS adherent to international 2standards The payments system is a key element of the financial system in any country. 4 The 2002 reform of the Brazilian Payments System (SPB) catalyzed a series of changes and improvements that transformed Brazil s financial system and capital markets, making the SPB an international example of security and sophistication. This became very clear, for instance, in the way the nation successfully pulled through the recent international financial crises, in particular the 2008 crisis. The Brazilian Payments System is made up of a number of building blocks, which are described further along in this document. These are: A solid and comprehensive legal basis; Mandatory use of central counterparties for transactions subject to multilateral netting in systemically important systems; The certainty of settlement offered by the central counterparty, based on risk management mechanisms and safeguards created to address situations where one of the parties in the system may become insolvent; The irrevocability and finality of the settlements; The National Financial System Network (Rede do Sistema Financeiro Nacional - RSFN), which connects all of the institutions authorized by the BCB to operate, the Brazilian clearinghouses and securities settlement systems and the STR, the Brazilian Central Bank (BCB) s large value transfer system, enabling ample access to settlement in Central Bank money. 4 The payments system is understood as the set of rules, systems and procedures used to transfer funds and to settle nation s obligations. 16

19 THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL It is fair to state that the SPB stands out for the efficiency and security it offers institutions and the public in general. This has been further underscored by a recent assessment conducted by the World Bank and the International Monetary Fund (IMF) within the scope of a joint initiative entitled Financial Sector Assessment Program, which found that Brazil s payments system adheres to international standards, based on the Principles for Financial Market Infrastructures (PFMI) Legal and regulatory basis One of the building blocks of the Brazilian Payments System is its solid legal basis. Law 10,214/2001 determines that clearinghouses that settle transactions using multilateral netting in systemically important markets act as central counterparties and ensure the certainty of settlement. To support the role of clearinghouses as central counterparties, current legislation allows multilateral netting of obligations within the same clearinghouse. To ensure the certainty of settlement even if one party should become insolvent, it also requires that the clearinghouses create adequate safeguards and ensure priority enforcement of the securities received as collateral, thus mitigating the risk that the calculated multilateral positions will be unwound. Another fundamental element of the SPB s regulatory framework is Resolution 2,882 issued by the Brazilian National Monetary Council (CMN), which defines the overall principles that all fund transfer systems and clearinghouses/securities settlement systems must abide by. Resolution 2,282 reflects the general principles of the Bank for International Settlements (BIS) Committee on Payment and Settlement Systems (CPSS). The document entitled Core Principles for Systemically Important Payment Systems was published by the CPSS in 2001, and lists ten basic principles it recommends be followed by systemically important fund transfer systems. 5 In April the CPSS-IOSCO published the final version of the Principles for Financial Market Infrastructures (PFMI). The PFMIs harmonize and, where appropriate, make existing international standards more demanding, incorporating new principles and stipulating the minimum requirements to ensure a basic common level of risk management across different infrastructures and countries, providing more detailed guidance and broadening the scope of the standards to cover new risk-management areas and new types of FMIs. 17

20 BCB Circular 3,057 complements the regulatory structure, as it defines guidelines for the regulation of clearinghouses/securities settlement systems. Before becoming operational a clearinghouse must submit its regulations to the BCB for approval. The operating procedures and regulations of these clearinghouses/securities settlement systems completes the regulatory framework, to the extent that they detail mechanisms for risk management and the safeguard structures used by systemically important clearinghouses. 2.2 The Structure of the Brazilian Payments System The SPB is characterized by the co-existence of real time gross settlement systems (RTGS) and clearinghouses that settle transactions using multilateral netting and act as central counterparties. Gross settlement systems include the system for real time large value transfer system (STR) and the system for settling government bonds (Selic), both managed by the BCB, as Cetip, responsible for fixed income securities and banking debt instruments. For clearinghouses that use multilateral netting for settlement and act as central counterparties we have the BM&FBOVESPA, which has four different environments for transaction clearing and settlement. The four BM&FBOVESPA clearing and settlement environments 6 handle numerous market segments: (i) equities - cash, derivatives and securities lending, (ii) corporate fixed income; (iii) financial and commodity derivatives; (iv) federal government bonds; (v) FOREX spot interbank transactions. There are also systems that process the settlement of the net positions related to events involving issuer risk and therefore do not require a central counterparty. Cetip is an example of this, as it settles transactions based on the multilateral netting of obligations originating in the issuer of fixed income securities and banking debt instruments. BM&FBOVESPA settles corporate actions based on their gross amount. Brazil s infrastructure for retail payments is quite comprehensive and includes, for example, the Interbank Payments Clearinghouse (Câmara Interbancária de Pagamentos - CIP) for clearing and settling systemically important interbank fund transfers, and the central check clearing system (COMPE) BM&FBOVESPA is in the process of consolidating its four clearinghouses into a single central counterparty and settlement structure in order to promote synergies that are important for market players and their clients.

21 THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL With the growing use of electronic payment means, the companies responsible for payment card schemes have taken on a more important role within the payment system, in particular Visa, Mastercard, American Express and Hipercard. 2.3 Brazilian Payments System Building Blocks The SPB has two very important general axes. Firstly, the SPB is based on international recommendations and best practices, as well as the experience of other markets, including their mistakes and what they got right, and did not hesitate to seek for the best solution for each aspect involved. Secondly, although the system is managed by the BCB, it has the continuous cooperation of all of the regulated institutions. The outcome of this is a system designed with absolute care and precision. In fact, the Brazilian payments structure is an international reference and living example of a walking best practice. The Central Bank Money System (STR) The STR is a large value transfer system that is owned and managed by the BCB, which processes payment instructions one by one, in real time. Institutions authorized to operate by the BCB have direct access to the STR. The STR only processes credit instructions. In other words, funds will only be moved if the owner of the debited settlement account instructs the payment to another settlement account. Fund transfers processed by the STR are irrevocable and final 7, and the transferred funds are immediately available to the credited account. However, the payment instructions are structured in such a way that the credited party of the STR will only be informed of the credit when it is irrevocable and final, thus discouraging the risk that credit will be granted based on funds not yet received. The STR uses the following mechanisms to manage system liquidity: Granting intraday credit in real time using repo transactions involving government bonds registered and settled via Selic; Scheduling payment orders, including time-scheduled, for up to 3 days from the date of the order; The possibility of holding back payment orders until such a time as there 7 International recommendations are that the system be able to ensure settlement during the course of the day - intraday finality. It is also essential that the system be able to ensure that, once settlement is complete, it becomes irreversible or irrevocable - certainty of settlement. These concepts are intrinsically linked to systemic risk, which may originate from any source of disruptive behavior along the large value payment flow. 19

22 are sufficient funds in the remitting institution s account; Optimized queuing of pending payment instructions to prevent the possibility of liquidity pooling due to a gridlock situation. Clearinghouses and Securities Settlement Systems with direct access to the STR - certainty of settlement in central bank money In Brazil, clearinghouses that operate systemically important systems have settlement accounts directly with the BCB, and must necessarily use these accounts to settle the financial results from multilateral netting of participant obligations. Settlements in central bank money eliminate the credit risk inherent to settlements intermediated by banking institutions, which is the case in several countries. In periods such as those experienced in 2008, transaction settlements were exposed to the credit risk of quite a large set of banks previously held to be too big to fail, doubtless a significant source of apprehension and concern among investors at the time. In Brazil, the use of central bank money to settle transactions is not subject to the credit risk of any single financial institution. The fact that clearinghouses have direct access to the BCB payments infrastructure and to central bank money, without any other intervening financial institution, is extremely important for the security and reliability of transaction settlements in Brazil. In all market segments in Brazil, funds transferred by financial institutions to clearinghouses/ securities settlement systems to settle transactions are processed in real time and are irrevocable and final, and any credits or debits are made to settlement accounts designed specifically for this purpose. The structure of the STR and the ample access it enables are therefore essential elements that allow the infrastructure that supports transaction settlement in Brazil to guarantee the irrevocability, certainty and finality of settlements. Mechanisms for risk mitigation and safeguard structures Systemically important Brazilian clearinghouses must necessarily have risk management models capable of measuring the risk at each moment in time with a great degree of reliability. Clearinghouses must also develop a structure of safeguards based on this risk assessment so as to ensure the continuity of settlements even in the event of default by the system s largest net debtor. 20

23 THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL Before addressing the mechanisms and safeguards currently in operation, it is worthwhile remembering that although Brazilian legislation requires that the central counterparty be able to ensure transaction settlement in the event of default by the largest net debtor, in practice central counterparties in Brazil have safeguards of a size sufficient to support the system even if its two largest net debtors default. Such safeguards may combine, for example, elements of individual collateralization, where each participant covers the risks it generates for the system (defaulters pay), with a mutualized settlement fund created by system participants (survivors pay). The proportion of individual collateralization and the mutualized settlement funds to the percentage of covered risk, including in stress scenarios, is continuously monitored by the BCB, which applies back tests to the clearinghouses and has done so since they were authorized to operate. The BCB has direct, real time access to settlement data for all market players, as it is able to view the clearinghouse settlement accounts and the flow of messages regarding the daily settlement of the transactions carried out by all financial institutions with accounts in the STR. Under stress, such as the scenario in 2008, this becomes an essential element that allows the BCB to immediately identify potential problems and take whatever measures it deems necessary. For institutions with BCB authorization to hold accounts in the STR, the intraday credit mechanism provides an efficient and agile layer to liquidity management. Financial institutions may execute intraday repo transactions in Selic at no cost. A wide ranging communication network The National Financial System Network (Rede do Sistema Financeiro Nacional RSFN) links the BCB to all institutions with accounts in the STR - institutions authorized by the BCB, clearinghouses/securities settlement systems. The RSFN uses standardized messages that are ISO 15,022 compliant, ensuring a high level of information security and agile data exchange and instruction processing. The intense use of messaging and the fact that all of the institutions in the SPB are connected enable a high level of straight through processing (STP) for all transactions in the STR, as well as the easy exchange of information within this environment. The agility, centralization and security of payment processes are important contributions to risk mitigation. 21

24 In addition, to complement the RSFN, in 2010 a new mechanism for online access to the STR was created, designed for smaller institutions such as brokers, securities dealers and credit cooperatives, among others. These players use STR-Web, an application developed by the BCB to use and manage their accounts online. Fund transfers for retail payments In the Americas, Brazil is second only 8 to the United States in the volume of non-cash payments, which in 2010 added up to US$ 110 trillion. In Latin America it is by far the largest payment market, accounting for 52% of all payments in the region. 9 The Interbank Payments Clearinghouse (Câmara Interbancária de Pagamentos - CIP) was created in It is a private clearinghouse 10 owned by Brazil's banks, and settles over US$ 2 billion a year in credit orders in real time. It was included in a comparative study of 26 retail payment systems around the world. According to this study CIP's systems have been classified as a "rich & in real time system". 11 In Brazil, in addition to traditional payments using cash or checks, electronic fund transfers also deserve special mention. Technically, a TED (available electronic transfer) can be classified as settlement in D+0, but in fact it is much more than that, as funds transferred via TED are available to the credited party in real time, and may be withdrawn at a teller window or ATM immediately after the destination bank is informed of the settlement. This rapid payment is unique among similar settlement systems used by the nation members of the CPSS. This speed is possible due to the technology involved and regulations that require a short settlement cycle, which starts when the client issues the transfer order and ends when the funds are available to the beneficiary, no more than ninety minutes later. This is the time it takes to go through the bank's security processes such as fraud and money laundering prevention. However, in the majority of the cases funds transferred via TED are available in a matter of only a few minutes. A TED may be issued using any of the means of access provided by the bank, from a branch through smartphone apps Boston Consulting Group Feb. 2011: Report Global Payments 2011: Winning After the Storm ( 9 Boston Consulting Group Feb. 2011: Report Global Payments 2011: Winning After the Storm ( 10 In some markets this type of organization is known as an ACH or Automated Clearing House. 11 Lipis & Lipis GmbH - Global Payment Systems Analysis, final report, version 2.0, published in October 2012 (

25 THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL This mechanism to transfer funds allows CPSS participating institutions to use a high degree of automation (straight through processing - STP), and allows investors to streamline processes and lower their costs. For foreign investors, real time funds availability contributes to more efficient cash flow management and lower risk, and helps shorten the time it takes to settle the exchange transactions involved in bringing in and taking out funds from Brazil. 23

26 THE BRAZILIAN FINANCIAL MARKET INFRASTRUCTURE BEST PRACTICES 3IN PRACTICE Following the efforts made by the Financial Stability Board (FSB) to strengthen the main financial market infrastructures, in April 2012 the CPSS-IOSCO published a document entitled Principles for Financial Market Infrastructures - FMIs, which brings a set of recommendations for a broad set of institutions that make up the Brazilian financial system. The principles for FMIs consolidated and revisited the recommendations issued by CPSS-IOSCO 12 since 2001, covering payment systems (or PS), securities settlement systems or SSS, and central counterparties (or CCPs), including for derivatives, central securities depositories or CSDs and trade repositories (or TRs). The principles for FMIs are currently an international reference in terms of best practices. The infrastructure of Brazil s financial system is fully adherent to international recommendations for FMIs. In fact, in many cases its business models exceed recommendations, with characteristics that provide value, promoting system stability, security and efficiency. In addition to the payments system itself (SPB), this infrastructure includes securities settlement systems, which may or may not also act as central In February 2010 CPSS-IOSCO embarked on a comprehensive review of the three sets of recommendations for FMIs: Core Principles for Systemically Important Payment Systems (Jan. 2001), Recommendations for Securities Settlement Systems (Nov. 2001) and Recommendations for Central Counterparties (Nov. 2004).

27 THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL counterparties and CSDs. These institutions also act as central trade repositories for different markets, providing functions that go beyond mere registration of transactions, positions and contracts. This infrastructure also handles primary security offerings and secondary trading of securities and both exchange-traded and OTC derivatives, and the payment of obligations originating from the issuer of the securities or derivatives, such as dividends, interest, amortization, premiums, redemptions, etc. The following chart summarizes the structure of the Brazilian market: Trading Registration Securities Settlement Systems (SSS) Central Counterparty (CCP) Central Securities Depository (CSD) Equities FOREX Derivatives BVMF BVMF BVMF CETIP CETIP BVMF Corporate bonds BVMF CETIP Government bonds SELIC SELIC BVMF BVMF SELIC CETIP Banking Debt CETIP CETIP BVMF = BM&FBOVESPA 25

28 ELECTRONIC TRADING SYSTEMS AND CENTRALIZED 4REGISTRATION One of the building blocks of the Brazilian financial market infrastructure is that all transactions involving fixed income securities and bank debt, as well as all derivative contracts, including OTC trades, are legally required to go through an exchange or be registered in a centralized registration system authorized by the regulators (trade repository). Trading and registration systems must include sufficient data to clearly characterize the type of contract or security, the nature of the transaction, the parties and the amount involved. 4.1ELECTRONIC TRADING SYSTEMS In the case of exchange-traded securities, the electronic trading systems themselves record the trades and their characteristics as soon as they process the offers and close a deal. In the case of equities, cash transactions normally go through BM&FBOVESPA 13 and settlement is guaranteed by a central counterparty as we will see below. In the case the of derivatives market, 80% of the transactions also go through BM&FBOVESPA and enjoy the same type of central counterparty guarantee. Cetip also provides trading platforms for government bonds registered with Selic, and for fixed income securities registered in the system, although most are traded over the counter. In the case of fixed income securities, the trading platform and the registration and settlement systems are linked CVM Instruction 461/2007, Article 57, paragraphs 3 and 4 prohibits the simultaneous trading of stock on an exchange and organized OTC, but does allow simultaneous trading of securities other than stock in an organized securities market other than the one in which the issuer s securities are traded (...).

29 THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL 4.2 MANDATORY CENTRALIZED REGISTRATION - BEYOND THE TRADE REPOSITORY For fixed income securities in general, primary and secondary distributions may be registered in an exchange or in a so-called organized OTC market. In the latter situation, which is the case for most securities of this type, securities are registered with Cetip. As mentioned above, the majority (80%) of the derivative transactions go through an exchange, with settlement being guaranteed by the central counterparty. For derivatives traded in OTC markets, regulations 14 determine not only that they be registered with an exchange or organized OTC market, but also that they be approved by this entity to avoid artificial price formation and fraud in general. Regulations also require that all of the data regarding registered contracts be permanently available to the regulators, the CVM and BCB. While mandatory registration of OTC derivatives is a proposal that has been gaining favor in international discussions, it is still rare in international marketplaces. The same is true for sharing data about registered contracts. In Brazil, data on registered OTC derivatives is shared through the Derivatives Exposure Center (Central de Exposição a Derivativos - CED), an initiative led by the Brazilian Bank Federation (Federação Brasileira de Bancos - Febraban), which has 13 member financial institutions. Within the limitations imposed by secrecy laws, the CED lists the positions of companies that are registered with Cetip or BM&FBOVESPA, and have voluntarily adhered to the system. It is worthwhile noting that only the regulators have access to the data in the system, and although participation is voluntary, CED records cover 90% of the registered contracts in Brazil. Transparency is thus one of the characteristics of the handling of OTC derivatives in Brazil. During the 2008 crisis, in a number of international systems the lack of transparency contributed to expand the crisis in confidence established at the time, as nobody knew for sure the actual extension of the problem. To a large extent, the roots of the crisis were found to be in markets and products that were not regulated in some countries, with OTC derivatives being one of the primary culprits. This finding kicked-off a comprehensive discussion in numerous international forums about the best way to regulate and track such markets. 14 CVM Resolution 2,042/1994 states that derivative contracts that are traded or registered with an exchange or organized OTC market must be approved by such markets. This is regulated by CVM 467/