THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL 1

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Summary 06 Executive Summary 14 1. The Brazilian Financial System - Structure And Governance 16 2. The Brazilian Payment Systems - Adherent To International Standards 17 2.1. Legal And Regulatory Basis 18 2.2. The Structure Of The Brazilian Payments System 19 2.3. 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 24 3. The Brazilian Financial Market Infrastructure - Best Practices In Practice 26 4. Electronic Trading Systems And Centralized Registration 26 4.1. Electronic Trading Systems 27 4.2. Mandatory Centralized Registration - Beyond The Trade Repository 28 Cetip Otc Derivatives Registration System 29 Bm&Fbovespa Otc Derivatives Registration System 30 5. Clearing And Settlement - Delivery versus Payment In Central Bank Money 31 Bm&Fbovespa 32 Cetip 33 Selic 2 34 6. Central Counterparty - A Comprehensive Approach 35 6.1. Legal Basis 35 6.2. Bm&Fbovespa - The Central Counterparty For The Brazilian Market 36 6.3. Taking On The Role Of Central Counterparty In Real Time 36 6.4. Risk Management At Bm&Fbovespa 37 Chain Of Responsibility 37 Safeguards Structure 38 Risk Calculation Methodology 39 Bm&Fbovespa Risks And Mitigation Mechanisms - Summary 41 6.5. Bm&Fbovespa Projects: The Integration Of Its Clearinghouses And A New Risk System 43 6.6. The Cetip Ccp Project For Derivatives And Corporate Fixed Income Securities Lending

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL 44 7. Brazilian Leadership In Collateral Management 44 Bm&Fbovespa 45 Cetip 46 8. Why Is It That Settlement In Brazil Almost Never Fails? 50 9. Yes, We Have Securities Lending 50 9.1. Securities Lending For Equities And Corporate Bonds 51 9.2. Forward Market For Government And Corporate Fixed Income Securities 52 10. Why Did The Brazilian Regulators Decide Against Banning Short Selling? 54 11. Central Securities Depositories - Beneficial Owner Account Holding System Protecting Issuers And Investors 55 11.1. Dematerialization And Book-Entry Recordkeeping 55 11.2. The Advantages Of Beneficial Owner Over Omnibus Account Holding Systems 57 11.3. Securities Integrity - Daily Reconciliation With Issuers 58 11.4. Asset Servicing - Payments In Central Bank Money 60 12. Why Is It Better To Trade Brazilian Securities In Brazil Than Drs Abroad? 61 12.1. A Broader Array Of Securities Available 62 12.2. Deeper Liquidity 63 12.3. Shareholder Rights 65 12.4. Better Investor Protection - Again The Beneficial Owner Advantages 66 13. Pre-Release - Risks Of Adrs Issued Without The Underlying Securities 68 14. Why Invest In Synthetic Adrs And Etfs? 70 15. The Brazilian Investment Fund Industry - Relevant, Sophisticated And Well Regulated 70 15.1. Instrument Size And Sophistication 71 15.2. Regulation - Broad And Transparent 74 16. Tax Advantages For International Investors In Brazil 74 16.1. Income Tax 77 16.2. Tax On Credit, Foreign Exchange And Insurance Financial Transactions (IOF) 78 Glossary 3

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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 (www.bestbrazil.org.br). 5

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

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

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

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

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

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

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 2012 2. The investment 12

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. 2 www.anbima.com.br. 13

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

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 www.bcb.gov.br. 15

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

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). 5 2.1 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

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). 18 6 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.

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

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

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

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 2002. 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. 22 8 Boston Consulting Group Feb. 2011: Report Global Payments 2011: Winning After the Storm (www.bcg.com). 9 Boston Consulting Group Feb. 2011: Report Global Payments 2011: Winning After the Storm (www.bcg.com). 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 (www.lipis.net).

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

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 24 12 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).

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

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. 26 13 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 (...).

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 467/2008. 27

In Brazil, the fact that the "phantom" of an information gap simply did not exist had a very positive influence, quickly restoring any confidence in the nation's systems that may have been lost. In 2008, at the height of the turmoil in international markets, Brazilian regulators tracked the exposure of a wide range of institutions, including some non-banking organizations such as security brokers and dealers 15. In fact, the measures that international markets resorted to as solutions for problems linked to the absence of transparency are already consolidated in the Brazilian market. Cetip OTC derivatives registration system Cetip manages a centralized system that registers OTC derivatives. This system stores contract information under the international concept of a trade repository or warehouse, but goes beyond this to provide a broader range of services. Cetip's registration system enables registration of all sorts of OTC derivatives, regardless of their specific characteristics. The system is highly customizable, enabling participants to include detailed descriptions of complex, customized derivatives. CVM regulations 16 require that prior to registration contracts must be approved by Cetip, which has a team of experts dedicated to this activity. The system already includes parameters for a large portion of the customized derivatives, and registration is immediate. Even in the case of very complex structures, the analysis, approval and development of the specific fields required for full registration takes only an average of 7 days, given the detailed information that must be submitted ahead of time. Cetip's role however, extends far beyond mere registration. It automatically updates registered derivatives for all contracts that use the indices calculated by Cetip, which covers about 85% of the total number of registered contracts. This is possible because the information required for the calculations are part of the parameters that must be submitted for contract registration. In the case of contracts that use indices that Cetip does not calculate, participants are required to report their calculations. In such cases a monitoring team continuously checks that the contracts are at market price and, if any suspicious situation is found it immediately demands an explanation. All payments, including premiums and early settlement ordered by the parties go through Cetip in its role as a securities and settlement system. Once the counterparty that is anticipating payment credits the amount in the Cetip settlement account, instructions are issued to transfer the amount to the 28 15 Data is available to the regulators quite quickly or in real time, in the case of BM&FBOVESPA. 16 CVM Instruction 486/2010.

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL creditor's settlement account and at the same time updates the contract's remaining notional value. In short, in addition to registration, Cetip services enable controlling all registered contracts based on the reference indices, the anticipated flow of payments and even early settlement. Finally, all of the data on registered contracts is provided to the regulators on a daily basis. BM&FBOVESPA OTC derivatives registration system BM&FBOVESPA also offers its members central registration services for forward contracts, swaps and flexible option contracts. These instruments are quite customized and the BM&FBOVESPA system allows the registration of contract specificities, and provides an automated system to control positions. The system offers numerous functionalities related to the life cycle of derivatives, and processes to make it easier for participants to use the system, such as unified queries for all of the transactions completed that day as well as open positions, helping to manage and control client positions. When entering a derivative contract, participants can choose whether or not to use central counterparty collateral. Settlement amounts are financially handled on the date the contract matures as follows: If both parties opted for central counterparty guaranteed settlement, the amount to be settled shall be the result of multilateral netting of the clearing members of both parties, and will be settled in BM&FBOVESPA's settlement window in the Central Bank Transfer System STR; If the creditor has opted for central counterparty guaranteed settlement and the counterparty debtor has opted for a non-guaranteed settlement, the amount to be settled shall be the multilateral balance of the creditor clearing member, and the counterparty debtor shall settle the amounts directly with BM&FBOVESPA by deposit in its settlement account; If both parties choose to settle without a central counterparty guarantee, BM&FBOVESPA will inform the parties of the amount to be settled, and settlement will take place directly between the parties involved. 29

CLEARING AND SETTLEMENT DVP IN CENTRAL 5BANK MONEY In Brazil, transaction clearing and settlement is handled by the securities settlement systems, which may or may not act as central counterparties. Regardless of whether settlement takes place in a guaranteed environment with the support of a central counterparty, or in a non-guaranteed environment, the settlement model used in Brazil ensures the use of the strictest principles of delivery versus payment - DvP. The use of DvP for transaction settlement is essential to eliminate the principal risk, thus avoiding the possibility that any of the parties involved in the transaction might be at risk of, having fulfilled its obligations, being deprived of the acquired right as a result of the counterparty having failed to meet its own. In addition to simultaneous DvP, the transaction settlement is final and there is no possibility that settled funds or securities will be reversed by the securities settlement systems. Funds credited in a settlement account are specifically confirmed by the Brazilian Central Bank (BCB) to make sure they are available with no conditions or restrictions. In the same way, the transfer of securities to an investor's account in the Central Securities Depositories (CSD) as part of a settlement process is final, and they become immediately available. In no situation are unconfirmed provisions made so that the party receiving the funds or securities will not pass them along. 30

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL In Brazil, all of the payments related to the settlement of securities transactions are made using central bank money, eliminating the credit and liquidity risks inherent to payments made via a network of banking institutions. We recently saw that there are no banks "above suspicion" and considering the volume of funds involved in the daily settlement of securities transactions, the ability to use central bank money becomes even more relevant 17. Although DvP and settlement in central bank money are common features shared by all of the securities settlement systems in Brazil, there are differences in the settlement model used by BM&FBOVESPA, Cetip and Selic clearinghouses. BM&FBOVESPA BM&FBOVESPA captures transactions directly from the electronic trading systems and these have already been compared and matched or, in other words, are locked-in for settlement. It is worth mentioning that these steps are completed not only at D+0, as recommended by CPSS-IOSCO, but in real time, ensuring high levels of straight through processing (STP). 18 For transactions where there is a central counterparty, once BM&FBOVESPA has captured the transactions from the trading systems it proceeds with multilateral netting of the obligations, resulting in a net debit or net credit for each of the participants involved in the clearing process. Multilateral netting shall be settled in a specific settlement window by debit or credit (i) in the settlement accounts held in the BCB by the participants and the central counterparty for payment purposes, and (ii) in the accounts held by BM&FBOVESPA and the participants in CSDs for delivery purposes. Also contributing to the efficiency of the settlement process as it reduces the settlement lag is the fact that settlement systems are linked to the CSDs (the Brazilian Clearing and Depository Corporation CBLC): BM&FBOVESPA for equities and corporate bonds securities, Cetip for corporate bonds, and Selic for government bonds. Public offerings of eligible securities by BM&FBOVESPA are registered in a proprietary system that allocates rights based on both data received from the 17 In numerous international markets settlement funds are still moved through one or more commercial banks, which may pose a great systemic risk that could even extend as far as the global level. 18 The concept of straight through processing or STP is a continuous chain of processes that take place automatically and sequentially without the need for re-keying or manual intervention. Designing processes with high levels of STP is an important element in reducing operating risks and therefore best practices. 31

participants and the parameters set by the issuer. The payment obligations this generates are settled using the same payments infrastructure the Central Bank Transfer System (STR) and settlement accounts, and the distributed securities are segregated in an account specific for that transaction until such a time as BM&FBOVESPA coordinates DvP, delivering the securities to the investors and the funds to the issuer. Cetip In Cetip, the characteristics of the trade are inserted into the system bilaterally, and are subsequently compared, confirmed and matched for settlement. Transactions completed using the trading platforms provided by Cetip (CetipTrader and CetipNet) are assumed to be confirmed, matched and ready for settlement, thus ensuring high levels of straight through processing (STP). The settlement process, the simultaneous transfer of securities and funds, also uses the payments infrastructure, the STR, and the settlement accounts. The securities in these transactions are segregated until Cetip can coordinate DvP, delivering the securities to the investors and the funds to the issuer/seller. It is worthwhile pointing out that Cetip also completes these steps not only in D+0, as recommended by CPSS-IOSCO, but immediately upon settlement. Cetip currently uses three settlement models: i. Real time gross settlement (RGTS) for secondary OTC transactions involving corporate fixed income securities and banking debt instruments, as well as OTC derivatives; ii. Multilateral netting of new issues 19 and obligations of issuers of corporate fixed income securities and banking debt instruments, such as the payment of earnings, interest, amortization and redemptions; iii. Bilateral net settlement is available only for derivative transactions, as an operational facility. In the case of corporate fixed income securities in general, primary and secondary market OTC transactions are registered with Cetip. The system matches the data provided by the parties and, after the balance is checked by the seller, the trade is forwarded for financial settlement in central bank money. As soon as the buy side settlement agent transfers the funds to Cetip's settlement account in the BCB, Cetip pays the sell side settlement agent and simultaneously transfers the security to the buyer's position, thus ensuring DvP. In none of these models does Cetip act as a central counterparty, and settlement is not guaranteed. Multilateral netting for new issues and issuer obligations, as well as bilateral netting of derivatives is automatic and takes 32 19 In the case of new issues, which are eligible for both multilateral netting and for settlement using the real time gross module, the parties involved select the type of settlement. Issuer obligations must necessarily be settled multilaterally.

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL place in specific windows determined by the BCB, using real time gross settlement soon after the data inserted by the participants has been matched. Selic One of Selic's main functions is to make the National Treasury Department (STN) government bond auctions operational; it is also the securities settlement system for repo OTC transactions registered by its members. Just as in the case of Cetip, the counterparties input the transaction characteristics into the system, and the data is then compared, confirmed and matched for settlement. The settlement system coordinates DvP immediately after matching. Selic will process the transfer of the bonds subject to the transfer of the related funds. Here again all steps are completed in a simultaneous and final way, and almost in real time, abiding by the principles of DvP. 33

CENTRAL COUNTERPARTY A COMPREHENSIVE 6APPROACH Central counterparties acquired a much more important role in international financial markets following the 2008 crisis, when their span of action, and in some cases their very absence, came under scrutiny. Central counterparties however, have existed for a few decades, and are the result of market development and sophistication. 20 Brazil has a comprehensive central counterparty structure that serves multiple markets - equities, derivatives, fixed income securities, government bonds and interbank FOREX trading. The Securities and Exchange Commission (CVM) and the Brazilian Central Bank (BCB) regulations require that all equities be exchange traded and be settled using a central counterparty. The use of a central counterparty is not mandatory for derivatives, but about 80% of the transactions go through an exchange and are settled using a central counterparty. By and large, the settlement of corporate and government bonds is not guaranteed. 34 20 The initial concept of a central counterparty was analyzed in the works of the Bank for International Settlements (BIS) in the nineties. BIS analyzed the numerous risks involved in the settlement process, and identified two types of risk assessment, control and mitigation. In the first type, risk management is decentralized and market players analyze their risk exposure to each of their counterparties on an individual basis, and define the guarantees required to safeguard their position and the position of their clients should any of the counterparties fail. The second model is decentralized and handled by a neutral institution that is not itself a market player, but is positioned between the players to enable centralized calculation of risk exposures. By positioning itself between the contracting parties it becomes the single and central counterparty to all players (seller to all buyers and buyer to all sellers). In this model the collateral required to safeguard the system in the event of participant default are also centrally calculated using standard criteria for calculation and eligibility of accepted assets. In some cases, such as BM&FBOVESPA, collateral is managed directly by the central counterparty and not by system participants.

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL 6.1Legal basis One of the building blocks for the role of central counterparties is a solid legal basis. In Brazil, clearing and settlement are governed by Law 10,214, signed in April 2001. This law stipulates that clearinghouses considered to be systemically important and that settle transactions using multilateral netting must act as central counterparties and ensure the certainty of settlement of all obligations it handles. To support the role of a central counterparty, the law defines the concept of multilateral netting and ensures that the central counterparties have priority in the foreclosure of collateral should any of the participants fail to meet its obligations, even over tax and labor debts. However, the law does not require that the settlement of issuer obligations, such as the payment of corporate actions, use a central counterparty. Regulations also require that all payments made through securities settlement systems use central bank money and settlement accounts held directly in the BCB. 6.2 BM&FBOVESPA - the central counterparty for the Brazilian market Central counterparties are sophisticated structures that handle a significant number of transactions and large volumes of funds to enable more efficient risk management. Financial Market Infrastructures - FMIs - in general, and central counterparties in particular, face numerous risks. The central counterparty will formulate its risk management model and its safeguards structure based on these risks. Since the 2008 merger of BOVESPA, the stock exchange, with BM&F, the futures and commodities exchange, BM&FBOVESPA is the only central counterparty organization in Brazil, combining all of the secondary markets considered to be systemically important. BM&FBOVESPA manages four central counterparties: 35

CBLC (Brazilian Clearing and Depository Corporation) Derivatives and Commodities Clearinghouse Government Bonds Clearinghouse FOREX Clearinghouse Equities, equity derivatives, corporate securities and equities securities lending Financial derivatives and commodities Government bonds Spot interbank FOREX 6.3 Taking on the role of central counterparty in real time BM&FBOVESPA trading systems are linked to the settlement systems, so all transactions are automatically registered in both systems in real time. This means BM&FBOVESPA can develop mechanisms that allow it to accept a transaction and play the role of central counterparty not only at D+0, as recommended by international standards, but as soon as a transaction is captured. This places Brazil's central counterparty at a level that is above that of many mature markets. It is worthwhile remembering that the time elapsed between the moment the trade is closed and the central counterparty intervenes is a period during which risks are bilateral and are not covered by any collateral other than the asset itself or the negotiated contract. Thus the shorter this period of time, the smaller the risk to which intermediaries and investors are exposed. Ideally the counterparty will intervene in real time, which is the case in Brazil. 6.4 Risk management at BM&FBOVESPA The risk management model used by BM&FBOVESPA includes a range of elements or layers of protection that act simultaneously to ensure the central counterparty is able to finalize the settlement of transactions even should one of its participants default. Following we explore some of the characteristics and describe how these layers work. 36

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL Chain of responsibility The chain of responsibility defines the settlement responsibilities of the different classes of participants and the central counterparty. The following figure is a generic illustration of the clearinghouse settlement chain of responsibility. CHAIN OF RESPONSIBILITY BM&FBOVESPA Clearing Member Clearing Member Intermediary Intermediary Investor Investor Clients are responsible to their intermediaries for settling their transactions. These in turn are responsible for settling transactions with their clients and the clearing members. Clearing members are responsible for settling with the intermediaries, their customers, and the central counterparty. The chain of responsibility is defined in a set of regulations to which the participants must adhere. Clear responsibility for meeting obligations is one of the central counterparty's layers of defense. Safeguards structure Default or failure of one or more participants in the chain of responsibility may expose the central counterparty to market and liquidity risk, as the clearinghouse must ensure the timely settlement of all of the trades it guarantees. In this case, market risk is the potential difference in value between the rights and obligations of the defaulting participant, given prevailing market conditions at the time of failure. Liquidity risk, on the other hand, results from the potential timing mismatch between financial rights and obligations, from the point of view of both the originally contracted transactions and the collateral execution flow. 37

To mitigate the risks to which it is exposed, BM&FBOVESPA uses safeguard structures that combine the classic models of defaulters pay and survivors pay. In the defaulters pay model, risk is mitigated directly by the party that generated the risk by handing over collateral. In the survivors pay model, risk is mitigated in the form of mutualized fund composed by participants contributions. Regarding the individual safeguards provided by the participant (defaulters pay), BM&FBOVESPA uses collateralization procedures and sets operational limits that participants must abide by. Operating limits are monitored in real time and are only extended if additional collateral is posted. This collateral is managed by BM&FBOVESPA at the level of the final investor, and marked-tomarket on a daily basis. In the case of mutualized losses or survivors pay, settlement funds are the main mechanism used by BM&FBOVESPA. Although there are differences in the methods used by the four clearinghouses to calculate contributions to the settlement funds, these funds meet at least the international standard known as Lamfalussy plus 21, which recommends that funds have sufficient resources to cover the two largest net debtors of the system on any given day. It is worth pointing out that although the legal requirement in Brazil is Lamfalussy, all BM&FBOVESPA funds comply with Lamfalussy plus 22. In addition to the safeguards listed above, clearinghouses need special arrangements to manage liquidity risk, given the short period of time between the moment the funds are received from the net debtors and payment is made to the net creditors. This period is known as the settlement window, and normally lasts around 30 minutes. Should a participant fail to make a payment that is due, the clearinghouse must be able not only to proceed with the settlement, but have these funds available in time so as not to delay the process. In order to face the liquidity pressures that may arise should any of the participants default, BM&FBOVESPA has lines of credit with a group of banks so that they may obtain liquidity immediately. Risk calculation methodology Regarding the process used to measure risk, the Brazilian Clearing and Depository Corporation - CBLC - calculates the individual risk each participant presents to the system in real time and over the settlement period 23. This risk 38 21 The Lamfalussy Report, which is BIS document on central bank netting schemes published in 1990, stipulates that central counterparty safeguards must be able to withstand failure by the largest net debtor in the system on any given day. 22 The concept of Lamfalussy plus corresponds to safeguards that are sufficient to bear the failure of the two largest net debtors in the system. 23 For stock market settlements, which are the largest component, this time period is 3 business days (D+3).

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL determines the operating limit the clearinghouse is willing to extend to the participant. The clearinghouse uses final investor positions to calculate the risk associated with equity derivatives and securities lending transactions. In the Derivatives and Commodities Clearinghouse, the risk of open positions is calculated at the level of the final investor using a proprietary system that applies stress testing methodology to risk factors. The system is segmented into modules by type of instrument, and risks of a similar nature may be compared within a given model. For intraday exposure the clearinghouse analyzes investor portfolios at time intervals shorter than 10 minutes. The Government Bond and FOREX clearinghouses also use proprietary systems and stress testing methodology that calculates risk exposure in real time. BM&FBOVESPA risks and mitigation mechanisms - summary The risk management model focuses largely on the risks involved directly in the central counterparty settlement process. However, BM&FBOVESPA's risk management model attempts to cover a larger set of risks of a diverse nature that can also compromise system safety and soundness. The following boxes define the risks faced and summarize the mitigating measures used by BM&FBOVESPA: Credit risk Credit risk is the risk that a given party in the transaction will be unable to meet its obligation on time or at any point in future. Credit risk may take the form of market risk or principal risk. Mitigating mechanisms Participant credit analyses Concentration limits Individual collateralization at the level of the clearing member Settlement funds Calls for additional collateral, including intraday 39

Market risk The market risk component of credit risk is the risk that gains will not be realized if a transaction is not settled, for example. It is the risk of having to replace a given position at a new market cost. Mitigating mechanisms A system to calculate and manage intraday risk Submitting portfolios to stress tests Monthly analysis of the domestic and international macroeconomic and political scenarios Use of Extreme Value Theory (EVT models) Market risk collateralization Principal risk Principal risk is the risk that the principal in the transaction will be lost when amounts are paid or securities delivered without receiving the counterparty securities or funds. Mitigating mechanisms Delivery versus payment or payment versus payment Liquidity Risk Liquidity risk is the risk that a given party in the transaction will be unable to meet its obligation on time, but may meet it at some time in future. This can happen on the payment side as well as on the delivery side, and normally requires that the participant settle other positions or take out loans to meet the expectation of delivery and/or payment. Liquidity risk has the potential to cause important systemic risk as systemic problems are normally preceded or accompanied by a run to liquid assets, which become increasingly scarce. Mitigating mechanisms BCB intraday credit window based on repo transactions handled by the BM&F bank. Levels of collateralization and settlement funds that meet Lamfalussy plus criteria Liquidity risk collateralization 40

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL Operating risk Operational risk is the risk associated with inefficiencies in internal processes and information systems, human error, management failures or even discontinuities due to external events that might imply in a reduction, deterioration or interruption of the services provided. These problems may lead to delays, losses, liquidity issues and, in more serious cases, systemic risk. Operating risks may also compromise the efficiency of the risk management mechanisms, as they can make it impossible to complete settlement. Mitigating mechanisms Business recovery plan Contingency site Internal and external auditing Legal risk This is the risk of changes in relevant laws and regulations governing the operation of central counterparties or other system elements that may, in general, lead to financial losses. Mitigating mechanisms Law # 10,214 BCB and CVM regulations Clearinghouse statutes, regulations and procedures 6.5 BM&FBOVESPA projects: the integration of its clearinghouses and a new risk system BM&FBOVESPA is currently working on an ambitious project to integrate its four clearinghouses. Combining the four clearinghouses operating within BM&FBOVESPA will require changes in the technology infrastructure and modus operandi of each one of them. The overall goal of the new model is to improve conditions for the different types of participants, either by simplifying day-to-day operating routines, or optimizing the use of liquidity to meet different types of requirements these clearinghouses may have. In short, the project will include: A single clearinghouse; 41

Standardized participant structure; Rights and obligations consolidated into a single multilateral netting; A single settlement window for settling transactions in the STR; New methodology to calculate and manage risk. The new model to calculate risk, known as CORE (Closeout Risk Evaluation), takes into consideration all of the segments in which a participant is active simultaneously in a multi-market and multi-asset approach. Based on increasing stress scenarios, CORE calculates participant risk based on the potential need to closeout a client's portfolio. CORE will be used to determine how much collateral must be posted by each participant individually, or by third parties on their behalf, and also to determine how much they should contribute to mutualized funds. BM&FBOVESPA believes CORE methodology offers important advantages for members and regulators, and will contribute to its internal processes as it integrates its clearinghouses. The new model offers participants the following advantages, among others: More efficient use of capital posted as collateral, thanks to a new way of calculating margins, which allows risk to be offset across different classes of assets and between open positions and pledged collateral, while preserving the security of the system. More efficient use of capital to meet intraday liquidity requirements due to the implementation of a single settlement window, and the calculation of consolidated multilateral netting; Lower risk and increased operational efficiency thanks to significant simplification of operational processes, eliminating redundancies, standardizing processes, reducing the number of human interventions and the need for information exchange in a single, integrated clearinghouse; Real-time information on open positions, marked-to-market and risk, thanks to faster data processing and event-driven architecture. BM&FBOVESPA also sees advantages for the regulators, the BCB and CVM, as an integrated clearinghouse enables a simpler business model. These include: Simpler oversight models and routines, thanks to a consolidated participant structure and forms of access, the consolidation of market information into a single structure and the streamlining of BM&FBOVESPA's operating processes and routines; Greater operational efficiency in the use of the STR, reducing the number of transfers required to settle transactions performed in BM&FBOVESPA s markets. 42

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL Clearly integrating the after-trade infrastructure will offer significant benefits for BM&FBOVESPA, among them: Enhanced efficiency and lower operating risk due to streamlined internal processes; An opportunity to improve its operating model, in particular its risk model, already considered to be among the best in the world. Greater speed and processing capacity, enabling the growth of Brazil's capital market; Increased agility and flexibility to launch new products and potential innovations as a function of the simpler, modularized technological solution used, which itself may generate advantages for participants. The single clearinghouse will be implemented in phases, and should be complete in 2015. 6.6 The CETIP CCP project for derivatives and corporate fixed income securities lending Cetip is currently developing a central counterparty infrastructure for OTC derivatives with a greater degree of standardization as well as for corporate securities lending, starting with debentures. This solution should be implemented in the second half of 2013. Cetip will also use a hybrid central counterparty model, with risk collateralization by each party individually (defaulters pay) and a mutualized settlement fund (survivors pay). The settlement fund will also abide by Lamfalussy plus, meaning that it will have safeguards that are sufficient to bear the failure of the two largest net debtors in the system. Registration systems will also be linked to the settlement systems, so that all transactions will be captured automatically and in real time. This will allow Cetip to accept a transaction and play the role of central counterparty at the same time as the transactions are being registered. 43

BRAZILIAN LEADERSHIP IN COLLATERAL 7MANAGEMENT Providing collateral to support all sorts of credit transactions is an inherent part of any financial system. Collateral posted by participants in favor of the central counterparty help safeguard it from any default situation where it might find itself forced to proceed normally with the settlement of the obligations for which it is responsible. More than this, in many cases the collateral posted must be sufficiently liquid to protect the clearinghouse from liquidity risk and enable ready foreclosure. In a similar way, in bilateral collateral management models the collateral posted by the parties serves to safeguard both of them in the event of counterparty failure, thus mitigating the risk incurred by the transactions covered. BM&FBOVESPA BM&FBOVESPA is very conservative in terms of defining the eligible collateral, preferring highly liquid securities such as government bonds. For all other securities BM&FBOVESPA applies progressive haircuts as liquidity decreases, and has limits on the concentration of certain types of securities. The securities posted as collateral are marked-to-market on a daily basis, so that their sufficiency for covering the participant's risk is continuously checked. BM&FBOVESPA may make intraday calls for additional collateral if the 44

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL participant's risk position exceeds, or even comes close to the value secured by the collateral posted. It is worth mentioning the requirement that one of the central counterparty's participants post collateral is similar in nature to settling a transaction. Thus failure by a participant to post required collateral is automatically converted into a debit that is added to the multilateral net balance, which the participant will have to settle with the clearinghouse, and may increase the amount it must pay or reduce the amount it will receive, depending on its net position vis-à-vis the central counterparty. Cetip The parties of OTC derivative transactions not guaranteed by a central counterparty, such as the transactions registered in the Cetip, may opt to use Cetip's collateral management services. Cetip's derivatives collateral management service, available since July 2011, was created as a joint effort with Clearstream and uses its automated collateral management model. It is also worth mentioning that centralized management of collateral for OTC derivative transactions enables mitigating the risks that became more evident following the 2008 crisis. Cetip's collateral management service is highly customizable and flexible, so that the counterparties in the transaction can define the characteristics of the collateral accepted, such as eligible securities and applicable haircuts. Securities are marked-to-market daily, and calls for additional collateral are automatic according to previously defined parameters. To make sure that the collateral posted is sufficient, Cetip will analyze the portfolio considering on the one hand the marked-to-market collateral and, on the other, the risk one party poses to another. In addition to improving the mechanisms to manage bilateral risks and reduce the operating costs associated with collateral management, the Cetip service enables more efficient management of the collateral available, given the specific requirements of the parties involved. One of the important characteristics of the collateral management systems used in Brazil, be they in the BM&FBOVESPA central counterparty system or the Cetip collateral management system, 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 is protected. 45

WHY IS IT THAT SETTLEMENT IN BRAZIL ALMOST 8NEVER FAILS? As in any other country, settlement in Brazil can fail. In the case of gross settlements not guaranteed by a central counterparty, such as the settlements coordinated by Selic or Cetip, if securities or funds are not available the transaction is cancelled, so that one counterparty need not to meet its delivery or payment obligations unless the other counterparty has also done so. In the case of Cetip, a non-payment of an obligation that is part of the multilateral netting shall imply in the cherry-piking of the obligation and the calculation of new multilateral netting. The Brazilian Central Bank - BCB - is immediately informed of this procedure and issues a warning to the participant that failed to honor its obligations. Regulators are also informed in the event of default in the payment related to the derivatives market. In the case of Selic, if securities are not available by the end of the day 24 the transaction is considered not authorized and the instructions submitted by the participants are cancelled. If there is a failure in a repo transaction, Selic monitors the participants who must provide formal justification. Furthermore, information about any failures remains available for BCB's oversight area, which may take further measures. In the case of settlements guaranteed by BM&FBOVESPA central counterparties, delivery failure is a much more complex process and varies based on the nature of the securities involved. However, settlement failure 46 24 The Selic system searches for securities for settlement immediately after matching the instruction, and if the securities are not available the system has a routine that searches the system every few minutes until the close of the Central Bank Money System - STR.

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL accounts for less than 0.5% of the total volume of the equity market, for example. Before we explore the different mechanisms available for the various types of securities, it is important to point out that one of the important distinctions of Brazil's central counterparty system is that it admits delays, but not failure in the sense of a participant never meeting its obligations. Furthermore, as even delays are penalized, participants are not encouraged to intentionally consider not settling a transaction. In the stock market, if a participant fails to deliver securities within the stipulated deadline, BM&FBOVESPA sets in motion a sequence of events that ensures that the settlement process can be completed as soon as possible. Firstly, the settlement system is linked to the securities lending system so that any failure in delivery immediately and automatically triggers a check of the availability of the non-delivered security in the securities lending system. If the security is available, the system automatically registers a borrower position on behalf of the defaulting intermediary/investor. Thus borrowing will take place regardless of any order from the defaulting investor/intermediary. If there are no lending offers for the non-delivered security, BM&FBOVESPA imposes a punitive fine on the defaulting party and starts a buy-in process to acquire the securities in the market. Securities will be bought under prevailing market conditions at the expense of the defaulting party. Delivery failures in the stock market are less than 1% of the volume settled, and this percentage is cut in half after the automatic securities lending system is triggered. The fact that this type of event is so rare is mostly because the seller cannot completely control the delivery process - there is a relatively high probability that failure to deliver will be resolved through lending and, should this fail, the securities will be bought back. In other words, failure to deliver is taken to be merely a temporary situation, as one way or the other delivery will be made. In order to further discourage this type of behavior, BM&FBOVESPA applies a daily fine of 0.2% of the traded volume. Attention is called to this point in particular as in a number of international markets non delivery of securities is not subject to penalties or buy-in procedures, and transactions remain open for up to 30 days. The time between a trade and actual settlement is a risk generating element. The longer the time gap, the greater the settlement uncertainty and the larger the market risk, especially in situations of higher volatility. 47

Thus the compulsory nature of settlement in the BM&FBOVESPA business model contributes very positively to mitigating risks, as would be expected from a central counterparty. In the derivatives market, failure to post sufficient collateral implies in adding to defaulting institution s multilateral netting balance the due amount to be settled in the settlement window. Nonpayment is considered a situation of insolvency on the part of the defaulting participant, which triggers an immediate notice sent to the BCB that will independently monitor the process through the Central Bank Money System - STR; at the same time the central counterparty will apply its own mechanisms for handling insolvency. In the government bond market, settled at D+0, failure to deliver securities will create a borrow position in the name of the defaulting party. If the security is not available in the securities lending system, BM&FBOVESPA will start a buy-in process to buy back the security at market prices at the expense of the defaulting party. Here again, if the security is not available, a substitute security may be offered, if the counterparty agrees. Otherwise, financial settlement takes place and the funds are returned, plus 50% of the fined levied by BM&FBOVESPA against the defaulting party. In the FOREX market, which consists essentially of interbank FOREX trading, BM&FBOVESPA has credit lines in both US Dollars and Brazilian Reals to a pool of banks in Brazil and the US, to secure the funds to proceed with settlement should one of the participants default or delay in meetings its obligations. 48

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YES, WE HAVE SECURITIES 9LENDING There are two types of securities lending in Brazil. In one there is both a lender and a borrower, and applies to equities and securities that, in general, are regulated by the Brazilian Securities and Exchange Comission - CVM. The other model applies to government bonds and specific types of fixed income securities, and enables the borrowing of securities for a specific period in time using forward transactions similar to the repo transactions used in international markets. This type of transaction and the securities involved are regulated by the Brazilian Central Bank - BCB. 9.1Securities lending for equities and corporate bonds In the Brazilian model, securities lending agreements are not traded over the counter, but must involve a central counterparty, BM&FBOVESPA 25. As the unique central counterparty in Brazil, BM&FBOVESPA s securities lending service covers equities and corporate bonds. According to CVM Instruction 441/2006, Article 2: "Only securities clearinghouses authorized by the CVM to provide custody services may offer securities lending services." Lender and borrower offers are registered in a centralized system that is fully transparent in terms of rates, maximum limits for rate variations (tunnel) and where all market players may track the offers made and transactions closed in real time. 50 25 As mentioned in chapter 6, Cetip is creating a central counterparty that will enable the rendering of securities lending services as well.

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL The central counterparty, on the other hand, guarantees the settlement of loan agreements. For this purpose BM&FBOVESPA conducts a centralized risk assessment of the participants and investors and manages the collateral they post to cover their risk. Collateral sufficiency is monitored in real time and, if necessary, BM&FBOVESPA can call for additional collateral, including intraday. BM&FBOVESPA's securities lending service was created in 1997, and since 2002 has grown at a rather fast pace. This fast paced growth reflects the widespread acceptance of its business model, making it an instrument used extensively by market participants. As discussed above, the integration between the securities lending service and the settlement system is important to the handling of delivery failures in the cash and forward markets. 9.2 Forward market for government and corporate fixed income securities The forward transactions in Brazil, which are similar to repo transactions in international markets, are transactions where the seller commits to buying a security back from the buyer at a designated future date. Although the sale is linked to buying back securities, normally the price negotiated by the parties is an interest rate paid by the seller to the buyer. Over the counter forward transactions are registered with Selic when they involve government bonds, and with Cetip when they involve corporate fixed income securities. As the providers of non-guaranteed settlement services, Selic and Cetip compare and match the two ends and confirm settlement to the participants. The most common term for government bond forward transactions is one day. Government bond forward transactions typically involve financial institutions and are quite liquid in Brazil for a variety of reasons. One reason is that this type of transaction is used extensively by the BCB as part of its monetary policy, adding or removing market liquidity depending on its strategy. Another reason is that these transactions are also used to provide financial institutions with intraday liquidity so they can manage adequately their payments in the payments system. This mechanism is also used to reallocate liquidity among the financial institutions themselves, which use these transactions to finance their portfolio and intermediate investment fund transactions, for example. 51

WHY DID THE BRAZILIAN REGULATORS DECIDE AGAINST BANNING 10SHORT SELLING? Early in the second half of 2008, when markets all over the world were extraordinarily volatile and on an almost unstoppable downward trend, most markets around the world were concerned with putting a stop to the speculative behavior associated with the manipulation of asset prices. A number of markets displayed behaviors that associated naked short sales with asset depreciation. Thus short sales became one of the great villains, and the securities lending market a tool to enable this harmful strategy. Naked short selling is the practice of selling an asset without ever owning it or using it to settle a transaction. In other words, it involves intentional failure to deliver an asset for settlement, the only goal being to depreciate the price of a security. In this case, in the securities lending market there is no borrower position and there is no exchange of securities and cash, only the loan rates are traded. As a result, most markets have taken measures to severely restrict short-selling and the securities lending market. In Brazil, naked short selling transactions are impossible due to (i) the difference between the Brazilian model for securities lending and the international model, and (ii) the specific procedures enforced by BM&FBOVESPA in its role as the central counterparty to address failure to deliver securities for settling transactions. In other words, the Brazilian market has structural characteristics that, while not making it completely impossible, make it extremely difficult to use short sales combined with securities lending to manipulate the price of securities. 52

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL The first characteristic has to do with mechanisms that ensure certainty of settlement. As explained when we addressed delivery failures, the settlement system is linked to the securities lending system so that, if securities are unavailable for lending, the system automatically registers a borrower position in the name of the defaulting intermediary/investor, and arranges for the delivery of the securities for settlement within the settlement cycle. The lending transaction proceeds regardless of the defaulting investor, making it impossible for a participant to plan failure to deliver, which is typical behavior in naked short selling. It is worth mentioning that the settlement of securities lending transactions is also guaranteed by the BM&FBOVESPA central counterparty, based on the collateral posted by the intermediary/investor. If the investor fails to deliver the securities for settling the securities lending transaction, the collateral posted shall be foreclosed to recover the securities. This makes it impossible for investors to transform failure to deliver into failure to settle a securities lending agreement. If securities for settlement cannot be borrowed as none are available for lending, BM&FBOVESPA starts a buy-in process at the expense of the seller. Here again the process proceeds regardless of any order from the seller, and can only be suspended by the actual delivery of the securities for settlement. It is also important to remember that the seller is also liable for a pecuniary fine taken directly from its financial earnings from multilateral netting. Thus in the Brazilian market the practice of naked short-selling to manipulate market prices is uncertain and extremely costly. Failure to deliver is extremely rare due to the combination of the preventive and punitive measures enforced in Brazil. The lending business model also works to inhibit attempts to use short selling to manipulate market prices by failure to deliver. In its role as the central counterparty, BM&FBOVESPA requires the actual delivery of the securities, which creates demand for purchasing the securities, putting pressure on prices in a direction that is opposite to the pressure created by short selling. As a result, it is very unlikely that the seller could fail to deliver; in fact failure to deliver is not the seller s decision. 53

Central Securities Depositories beneficial owner account holding system protecting 11issuers and investors Central Securities Depositories - CSDs - are responsible for the centralized safekeeping of the securities and processing the corporate actions. CSDs play a key role in preserving the integrity of the securities, and protecting investors with respect to ownership of these securities and the associated rights. In Brazil, BM&FBOVESPA, Cetip and Selic act as the CSD for a number of instruments: BM&FBOVESPA for equities, corporate bonds, real estate securities, gold and agribusiness securities; Cetip for corporate fixed income and banking debt instruments, as well as real estate securities; Selic for government bonds. Distinctive characteristics to the Brazilian CSD business model provide investors and issuers with a safe and efficient environment. 54

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL 11.1Dematerialization and book-entry recordkeeping Most securities in Brazil have been fully dematerialized since the nineties. Custody positions are registered in book-entry format, as are relevant updates of corporate actions. Reconciliation mechanisms and controls involve automated electronic procedures and are completed in a centralized way and over short intervals of time. To enable this, Brazilian legislation recognizes CSD records as being legally valid. The issuance of physical certificates is rare and not mandatory. In these cases, regulations require that certificates be immobilized and registered in centralized systems authorized by the Brazilian Central Bank - BCB - and the Brazilian Securities and Exchange Comission - CVM. 11.2 The advantages of beneficial owner over omnibus account holding systems Brazilian regulations require that all securities be registered in individual depository accounts held by the intermediary institution with the CSD, in the name of the beneficial owner. BM&FBOVESPA and Cetip keep individual accounts to segregate investor positions from custodians positions, the proprietary position of the CSD and that of any other investors. Exchangetraded derivatives positions are also kept in the name of the beneficial owner. This account holding system, also known as the transparent system, is considered the most advanced for CSDs under CPSS-IOSCO recommendations. According to these recommendations, CSDs must be capable of segregating investor positions from their own proprietary positions and the positions of their participants, the custodians. In exceptional situations and as permitted by the legal framework, CSDs must segregate investor positions from each other. In the case of corporate fixed income securities, the law determines that the position of investors be held separate from the proprietary positions of the participants and of the CSD itself. Identification of the beneficial owner is mandatory for institutional investors and for investors with positions that exceed R$ 1 million (about US$ 500 thousand) 26. However, the financial instruments recently authorized, such as financial bills, for example, also require that the beneficial owner be identified in any situation. In Cetip, while participants may demand this level of segregation, a practice that is becoming increasingly frequent, this is not required by law or regulation. 26 BCB Circular 3282/2005. 55

In the case of government bonds, Selic necessarily segregates investor positions from the proprietary positions of the participants and of the CSD. Identification of the beneficial owner is mandatory for institutional investors and optional for the other categories of investors, depending on the policy of each participant. In the Selic environment individualized accounts are also being increasingly used. The advantages of a model based on individual accounts rather than an omnibus accounts are numerous. The first is the legal certainty of asset ownership, which is essential from the point of view of protecting investors. This structure of individualized accounts enables CSDs, the BCB and the CVM to perfectly identify the ownership rights associated with any asset at any moment in 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. There have been cases in which suspicions regarding the use of proprietary information allowed regulators to identify the transactions even before settlement on D+3. This model also enhances the role of CSDs as self-regulatory organizations - SROs. Situations in which the market is manipulated, prices are artificially set or ownership concentration exceeds legal limits may be quickly mapped. In markets that use the more common model of omnibus accounts, positions are registered in the CSD in the name of the custodian bank who 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 asset ownership, and investors may sustain significant losses due to the risk of poorly managed custody risk. The fact that the regulators and self-regulators in countries that use an omnibus model do not have access to centralized information makes market oversight more difficult and increases investor custody risk. The advantages of the beneficial owner account model extend to other institutions that make up the financial market infrastructure. Counterparty risk, for example, may be calculated at the level of the final investors and collateral, even if under the responsibility of the clearing member, may also be managed on an individual basis. Furthermore, the information on segregated positions on the level of the beneficial owner is available to the clearing members, 56

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL the central counterparty and the regulators. Thus investor activities may be comprehensively monitored, even if the investor works through numerous intermediaries, allowing the identification of leverage and risk situations that would likely not be clear in omnibus account systems. 11.3 Securities integrity - daily reconciliation with issuers Another important element to ensure the security of issuers and investors is the integrity of the securities safekept in the CSD. Accurate record-keeping must mitigate the risk that securities will be created or disappear. At any time the total volume of securities issued less the number of securities registered on the issuer books must equal the number of securities deposited at the CSD. The appearance or disappearance of a security without a corresponding issuance or redemption cannot happen in Brazil. For this, BM&FBOVESPA reconciles the securities deposited at the CSD with the issuer records, as recommended by CPSS-IOSCO. This reconciliation is automatic and based on the daily exchange of electronic files between the CSD and the issuers. BM&FBOVESPA also reconciles its records with those kept by the custodians on a daily basis, bearing in mind not only the balance but also any movements between accounts. The entire reconciliation process happens at the level of the individual accounts. Cetip conducts daily reconciliation of its debenture and closed fund positions. For all other instruments Cetip sends information to issuers on the consolidated position of the investors on a daily basis, but they need not confirm this data. Regarding the physical custody of certificates by participants, such as in the case of real estate credit bonds, Cetip requires that the providers of such services complete a qualification process that involves a minimum standard of security and is valid for 2 years. The fulfillment of these requirements is checked from time to time by Cetip SRO department and an independent auditor. The reconciliation process used by Selic is simpler, to the extent that only one issuer is involved, the National Treasury. In addition to the specific files exchanged with the National Treasury, Selic also makes available online data on the total number of each government bond issued. 57

Brazilian regulators also pay close attention to make sure that the positions registered in CSDs match the information provided by the financial institutions. The BCB, for instance, reconciles data on the stock of banks Certificates of Deposit CDs. It receives from Cetip with the positions reported by the banks through its own proprietary systems. 11.4 Asset servicing - payments in central bank money A core element of the CSD's activities is the servicing of payment flows associated with the security or, in the case of equities, corporate actions announced subsequently by the issuers. Although each instrument and corporate action requires a specific treatment, two overall aspects should be mentioned. Firstly, the BM&FBOVESPA CSD updates investor positions for all of the deposited securities, and makes payments at the level of the beneficial owner. Thus not only the securities are held under individual deposit accounts, but the rights associated with them are handled in the same way. In the case of Cetip and Selic, updating and payment of corporate actions segregate proprietary from client accounts. The second aspect is related to corporate actions involving the cash payments. As seen, the payments carried out by BM&FBOVESPA, Cetip and Selic CSDs go through the Central Bank Transfer System (STR) and are made in central bank money, thus funds are immediately available to the settling banks. These may credit the funds to the custodians in only a few minutes, and the transfer to the beneficial owner can also be completed on the same day. 58

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WHY IS IT BETTER TO TRADE BRAZILIAN SECURITIES IN BRAZIL 12THAN DRs ABROAD? The issuance of depository receipts (DRs) by Brazilian companies is governed by the Brazilian Securities and Exchange Comission - CVM - Instruction 317/1999, which requires that before a Brazilian company can have a DR program in a given country the Brazilian Exchange must have signed an agreement with the Exchange in the other country. The Exchanges agreement must be submitted to the CVM. International investors who wish to invest in DRs are subject to the regulations of the market where the DR was issued with regards to the rules for trading, settlement, registration and custody. International investors wishing to purchase stock of Brazilian companies in Brazil are subject to National Monetary Council (CMN) Resolution 2,689/2000. This requires that the investor appoint a legal representative in Brazil and retain the services of a local custodian, who will be responsible for registering the investor with the CVM and for managing the securities under its custody with regards to the Central Securities Depositary (CSD). The local custodian is also responsible for registering the inflow and outflow of funds related to the portfolio investments in the Brazilian Central Bank - BCB - systems. Resolution 2,689/2000 also requires that the local custodian identify positions at the level of the beneficial owner. Investor identification and registration are governed by CVM Instruction 505/2011, which requires that investors be identified in both the custodian 60

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL and the CSD systems. Furthermore, the custodian must adopt best practices in Know Your Client (KYC), and keep up-to-date information about the investment profile of international investors. If the custodian does not have a direct relationship with the investor, CVM Instruction 419/2005 allows the custodian to sign an agreement with an intermediating institution abroad, which will be responsible for the final investor KYC procedures. Once registered in Brazil, which typically takes 1 business day from the moment the local custodian receives the instruction from the global custodian, the investor will be able to use all of the infrastructure offered by the Brazilian financial system, which has been amply described in this document, and will enjoy important tax benefits that we will address further along. 12.1A broader array of securities available International investors wishing to invest in stock issued by Brazilian companies in their local markets can only do so by purchasing a DR. The array of securities available to investors is therefore limited to companies with a CVM authorized DR program. Even though Brazilian blue-chips typically have DRs, many companies in Brazil, in particular the smaller ones, are not available to investors abroad. Alternatively, international investors have unlimited access to any shares listed on Brazilian exchanges, and their derivatives. Ample access to the Brazilian market provides international investors with additional business opportunities and more flexible investment strategies, often more sophisticated than those available in DR markets. An investor who decides to invest in a given economic sector will have available an array of securities in the local market that would be hard to match using DRs. International investors have increasingly recognized the advantages of investing directly in the local market. It is interesting to compare the stock of American Depositary Receipts - ADRs - to the volume held by international investors in Brazil. Data published by the Brazilian Financial and Capital Markets Association 27 (ANBIMA), shows that the volume of securities underlying ADRs amounts to around 30% of all the securities held in custody by international investors in Brazil (Res. 2,689/2000). 28 27 Anbima Data - custody ranking, January 2013 28 As of January 2013 there were some R$ 260 million backing ADRs, compared to almost R$ 720 million held in custody for international investors investing directly in Brazil under Resolution 2,689. This estimates assumes 25% in fixed income securities, leaving some R$ 530 million invested in stock. 61

12.2 Deeper liquidity Another advantage of trading directly in Brazil is that investors can benefit from deeper liquidity. Not only are Brazilian equities traded in local markets more liquid, but the daily volume traded as ADRs has been decreasing over time. According to data published by the MSCI 29, the ATVR (Annualized Traded Value Ratio) of Brazilian ADRs is high, or around 50%. However, the annualized traded value ratio for stock traded in local markets is 104%. The following table lists the traded value ratio of stock traded in Brazil and through ADRs respectively. Stock Brazil 12 M ATVR ADR 12 M ATVR Petrobras PN 117% 24% Vale PNA 195% 32% Itaú Unibanco PN 90% 52% Petrobras ON 44% 67% Ambev 45% 22% Banco Bradesco PN 75% 32% Vale ON 75% 86% Brasil Foods ON 81% 21% Cemig PN 89% 58% Telefônica Brasil PN 72% 32% Gerdau PN 212% 83% Banco Santander Brasil Unit 97% 69% CSN ON 120% 57% Pão de Açúcar PN 128% 48% TIM Part. ON 110% 94% Embraer 66% 64% Sabesp ON 54% 45% Oi PN 194% 26% CPFL Energia ON 74% 46% COPEL PNB 142% 47% Eletrobrás ON 83% 32% 62 29 ATVR data on April 30, 2012 considering its share of the MSCI Brazil index.

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL Fibria Celulose ON 191% 62% TAM PN 143% 73% Oi ON 152% 15% Braskem PNA 221% 51% Gol PN 460% 143% Mean 104% 50% Source: MSCI The ADRs trading volume has also been falling over time. In 2012 the average daily trading volume of the 32 most liquid Brazilian ADRs dropped 226.68% compared to the previous year, reaching US$ 1.99 billion. In 2010 this volume was US$ 3.2 billion, and in 2008 US$ 3.5 billion. 12.3 Shareholder rights In theory, stockholders in Brazil and investors in DRs should have the same rights inherent to ownership of these securities. Although conceptually and legally true, in practice there is an appreciable difference in how these rights are handled under the two scenarios. In the case of corporate actions paid in cash, such as cash dividends and interest on equity, the owners of DRs receive these amounts at least two days after international investors in Brazil. On the date of payment, the issuer of the securities in Brazil transfers funds to the CSD, which runs a series of reconciliations and transfers the amount to the investor s custodian. Having received the funds on the same day they were paid by the issuer, the custodian can credit these funds to the accounts of their investors. Thus international investors receive funds on the same date as the securities issuer made the payment. The custodians of DR programs however need to execute a FOREX transaction for the funds to be transferred to the program's bank abroad. The spot FOREX market has a settlement cycle of D+2, meaning that the funds will only be available for a depositary bank abroad two days after being received by the custodian in Brazil. While it is possible for the Brazilian custodian to complete a D+0 FOREX transaction, this is considered a special transaction and, by 63

and large, is subject to a larger fee. While the funds will be available to the DR depositary bank abroad on D+2, there is no guarantee that they will be credited to the final investor on that same day. Thus cash payment of corporate actions can take several days for the owners of DRs, whereas in Brazil the cash can be available on the same day it is paid by the issuer of the securities. This represents an opportunity cost as investors abroad 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 rather difficult to exercise these rights from abroad. International investors in Brazil are told by their custodians of subscription rights and the deadline for exercising such rights. Investors may negotiate these rights in the market if they have no interest in exercising them. As a rule, depositary banks do not offer such services, in other words investors are not informed of these rights nor do they exercise them. The recommendation, when asked, is that investors convert these DRs into stocks in Brazil in order to exercise their rights or sell them on the local market. To the investor this poses a cost that goes beyond mere opportunity cost, but primarily it costs the investor a right that oftentimes is simply lost. Investors often ignore the costs associated with holding DRs instead of stocks in Brazil for a variety of reasons. On the one hand, investors may be simply unaware of how the process works in the local market and therefore cannot compare the two options, and on the other, the cost is almost always included in a package of services that makes any comparison difficult. Payment of corporate actions in Brazil is an efficient process and funds are normally available to the investor on the same day they are paid by the issuer, while the payment of cash dividends on DRs held abroad requires first contracting a FOREX transaction through the custodian bank for the program in Brazil, which will transfer funds to the depositary bank abroad who in turn credits the investor's account. In addition to the costs associated with the required exchange transaction, investors bear an opportunity cost because of the time it takes for funds to become available for use. 64

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL 12.4 Better investor protection - again the beneficial owner advantages 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 exchange-traded, thus subject to a set 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, as Brazil is a country that requires beneficial owner identification, all investor positions are registered in individual accounts in the CSD, held in the name of the final investor, and are not mixed with the positions of the participants or the CSD itself. This is an important distinction compared to DR positions held by investors in markets that work with the concept of omnibus accounts, where positions are registered in the CSD in the name of the market participants. Although omnibus accounts normally segregate client ownership positions, it is impossible to identify individual client positions using this system. A record of individual positions is kept exclusively by the participant and this is the only way of identify investor rights. Custody risk could be quite significant should the participant fail. 65

PRE-RELEASE RISKS OF ADRs ISSUED WITHOUT THE UNDERLYING 13SECURITIES In the US, oftentimes financial institutions issue so called pre-release American Depositary Receipts - 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. One justification for these transactions is that these are an advance or loan of ADRs whose underlying equities have already been purchased in Brazil, but where the transaction has not yet been settled; in other words a means to accelerate the process for the investor. Some institutions require that the client submit a statement that it owns the underlying stock. In practice however, there is no check that the investor actually owns the equities in Brazil. Furthermore, if a pre-release is a type of advance, one would expect the position to be undone at most within a few days, when the underlying equities are deposited with the program's custodian bank in Brazil and the actual ADR issued. As a rule this is not what happens, and pre-releases are held for unreasonably long periods of time. The correct and legally valid mechanism for issuing a DR is to transfer the underlying security to the program's custodian bank in Brazil, and the subsequent issue of the DR by the depositary bank abroad. The underlying equity is frozen for as long as the DR exists and cannot be traded in the local market. This ensures that the volume of equities traded does not exceed the total volume issued. 66

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL Pre-release issues are in fact credit in the form of securities that has no legal basis in Brazil, as these ADRs have no underlying equities in the custodian bank in Brazil. The risk to the investor is clear. Above all else, investors who purchase an ADR from a financial institution do not necessarily know or understand that their ADR is different from any other and may have no underlying security. As the ADR was issued based on the investor's position and collateral with the financial institution, depending on how the market behaves, these funds may not be sufficient to 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. The exercise of investor rights is also a source of uncertainty. Should the holder of the ADR issued as a pre-release desire to vote at a general shareholder's assembly of the Brazilian issuer, it is quite likely that this would result in a mismatch between the number of shares issued and the number of votes received by the issuer. This is an important source of risk for the issuer. Taxation of corporate actions cash payments may also be a source of legal risk. According to US legislation, earnings paid by a foreign issuer in the US, as in the case of legitimately issued ADRs, are not taxed. In pre-release transactions however, the ADR is issued by a US based financial institution and earnings would therefore be taxable. Thus it is possible that the owners of ADR equivalents would be taxed differently. The main idea to be retained from this section is that there are numerous costs and risks associated with investing in DRs that investors may not be aware of. In fact, they are not easy to see as the amount of information investors ultimately receive is normally not enough to enable a fair comparison between the terms for investing in both markets. There are other opportunity costs such as late payments or the loss of rights that lapse. The risks involved in purchasing prerelease ADRs may also lead to significant losses and legal costs. 67

WHY INVEST IN SYNTHETIC ADRs 14AND ETFs? The issue of securities representative of other securities is a normal and perfectly legal and legitimate process. Thus the issue of synthetic American Depositary Receipts - ADRs - and Exchange Traded Funds - ETFs - does not, in and of itself, pose any legal issues, such as could be the case of the prereleases discussed above. Nevertheless, investing in ADR or ETF synthetic instrument abroad adds elements of risk that do not exist for investors who choose to invest directly in Brazilian stock or ETFs. 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 issuing financial institution, should it fail, the investor has no legal backing that ensures 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 with the underlying securities. Furthermore, there are no mechanisms to enable checking the compatibility between synthetics and their underlying securities from time to time. Even more so in the case of ETFs, which themselves represent a basket of securities. Not only there are added risks, but it is also not clear that synthetics are any more attractive from a financial point of view. The issue of synthetics by financial 68

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL institutions is not cost exempt, a cost investors do not bear if they purchase securities directly in Brazil. As in principle there is price parity between an asset and its synthetic, part of the investment profitability is being used to bear the cost of issuing the synthetic. Once they are aware of the additional risks of synthetics, as well as the cost of purchasing such instruments, there must be other stimuli such as regulatory limitations for example, to opt to purchase synthetic abroad, as otherwise the purchase of the underlying securities themselves in the local market is certainly the best option. 69

THE BRAZILIAN INVESTMENT FUND INDUSTRY RELEVANT, SOPHISTICATED 15AND WELL REGULATED 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 investment fund industry is particularly attractive for its size, the number of qualified asset-managing firms, the diversity of instruments available to investors and a comprehensive and very effective regulatory framework. 15.1Instrument size and sophistication The Brazilian asset management industry is currently ranked 6 th in the world, with more than of 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 2012 30. The investment funds existing in Brazil are also quite diverse in nature: fixed income, equity, money market DI (Interbank Deposit) referenced, pension, structured (receivable investment funds, real estate and private equity), 30 www.anbima.com.br. 70

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL currency, external debt, close and exclusive funds. The industry has around 450 independent asset-managing firms registered with the Brazilian Securities and Exchange Comission - CVM. The breakdown of funds among the different types of investors shows that almost 40% corresponds to institutional investors, while private (14.7%), corporate (14.1%) and retail (15.1% each) are more evenly distributed. 31 Compared to the rest of the world, the Brazilian investment fund industry is still quite concentrated in government bonds. However, funds are increasingly diversifying into other instruments and there are major opportunities in corporate equities and fixed income securities. 15.2 Regulation - broad and transparent The regulatory framework for the Brazilian investment fund industry offers investors a high degree of security 32 since it stands out for its broad scope and transparency. In Brazil, the regulation and oversight of investment funds is quite broad and comprehensive, and covers all sorts of funds, including the so-called multimarket funds, which are the closest to hedge funds. Hedge funds in Brazil originated from mutual funds, and consequently emerged within the regulatory scope of such funds and are required to exhibit the same level of transparency. Brazil's regulators have full and periodic visibility of how leveraged each fund is, and are thus fully aware of the industry's aggregate risk. 33 Still regarding the scope of regulation, all funds in Brazil, even exclusive funds with a single quota holder, must register with the CVM. In Brazil there are no cut-off rules that stipulate that funds with less than a certain number of quota holders need not to be registered. The Brazilian funds industry also stands out for its high level of transparency. Firstly, as mentioned before, all fund transactions, including OTC trades, must necessarily be registered with a centralized system (BM&FBOVESPA, Selic or Cetip). Thus all OTC transactions take place in an environment to which the regulator has access. 31 ANBIMA Bulletin Investment Funds (May/2013). 32 The main standard governing investment funds is CVM Instruction 409/2004. 33 In the US, hedge funds are legally non-financial institutions (corporations), and thus are not subject to the rules governing the financial system. Thus they can be as transparent as they choose regarding the market, as financial industry regulations do not apply. The rationale behind this is that investors in this segment are qualified to judge the level of risk they are willing to bear. 71

Brazilian funds are also obliged to disclose a significant amount of data, either through periodic disclosure to the CVM or directly to the public at large. Once a month, asset managers submit the full breakdown of the portfolio of funds they manage to the CVM 34. Thus the CVM can monitor the exposure of a specific asset, derivative, fund or the industry as a whole. Fund administrators are required to disclose the following on a daily basis: the fund's net worth, the value of each quota, redemptions and new investments. In this way investors have all the information about their investment and the CVM can track unusual changes and even question the administrator. The feeling is that daily sensitivity helps flag problems to the regulator and the public at large. Furthermore, the funds industry is closely monitored by the Brazilian Financial and Capital Markets Association (ANBIMA), a self-regulated entity that also requires that its members who signed their self-regulation code submit daily information that is quite similar to that submitted to the CVM. Daily disclosures also require daily marking-to-market. In Brazil, the pricing process is well organized and regulated 35. The ANBIMA Code of Regulation and Best Practices for Investment Funds require that fund administrators keep a Marking-to-market Handbook describing the criteria used to price the securities that make up the portfolio of assets under management. The criteria must have a consistent theoretical basis and must be verifiable 36. Another distinction has to do with the segregation of functions between the asset manager, the fund administrator and the custodian, the last acting as the verifying element. The CVM requires that securities composing investment funds be held by a CVM authorized custodian. Although not mandatory, the most common model of fund management used in Brazil is comprised of three independent figures: a asset manager, who makes investment decisions; a fundadministrator, who handles back office operations, in particular those related to quota pricing, and a custodian, who holds the securities that make up the investment fund. This tripod structure contributes positively to the governance, to the extent that the person making investment decisions is usually not the person pricing quotas or holding the securities. There are also specific rules for closing funds 37. Closing a fund for redemption 72 34 In case of a strategically justified motivation, a fund administrator can keep a specific transaction hidden for up to 90 days (CVM Instruction 409/2004). 35 Compliance with the ANBIMA Code of Regulations and Best Practices for investment funds is voluntary, but almost all investment funds and asset managers in Brazil adhere to the code. The main reason for this is that the ANBIMA seal granted to adhering institutions has become a reference in the funds industry. 36 CVM Instruction 438/2006, which approves investment fund accounting plans and determines the mandatory mark to market of the securities in investment fund portfolios. 37 CVM Instruction 409/2004.

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL requires that the fund administrator call for a General Quota-holder Assembly. This provides important protection for investors, in particular retail investors who have less access to information. This makes sure that all quota-holders have equal exit conditions. Furthermore, in Brazil there is a culture of good management of portfolio liquidity that comes from those times when inflation in the country was extremely high, so administrators do not have trouble honoring their commitments, such as quota-holder redemption. 73

TAX ADVANTAGES FOR INTERNATIONAL 16INVESTORS IN BRAZIL In Brazil, international investors who invest in the country through the National Monetary Council - CMN - regulation 2,689/2000 38 are taxed differently. Federal law grants advantages to these investors, either by waving taxes or reducing the tax rate on their investments. There are basically two types of taxes levied on financial investments: income tax (IR) and IOF - a tax on credit, insurance, foreign exchange or securities transactions. 16.1Income Tax In theory, income tax on international investor earnings results from two generating facts: earnings from investments held and capital gains from selling investments. More specifically, international investors who are not domiciled in tax havens 39 are subject to a special, more favorable regime compared to local investors: There is no income tax on capital gains from transactions carried out in 38 CMN Resolution 2,689/2000 governs investments made by international investors in the financial and capital markets. 39 The list of tax havens may be found in Article 1 of Brazilian Secretariat of the Federal Revenue Normative Instruction #1,037/2010. 74

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL stock, commodities, futures and similar exchanges (Brazilian Secretariat of the Federal Revenue Normative Instruction SFR NI #1,022/2010, Article 69). The income tax rate on earnings from equity funds (FIP), FIP quota investment funds and emerging business investment funds (FIEE) is reduced to zero, so long no more than 5% of the fund portfolio is made up of non-convertible debt securities, and the investor has no participation nor receives earnings proportional to more than 40% of the quotas issued (Law 11,312/2006, Article 3). The income tax rate on earnings from government bonds purchased after February 16, 2006, or from quotas in investment funds exclusively for international investors who have at least 98% invested in government bonds is reduced to zero (Law 11,312, 2006, Article 1) 40. The Income tax on earnings from equities or securities purchased as of January 1 2011, that were the object of a public offering or issued by a non-financial legal entity, as well as real estate receivables certificates (CRI), issued to raise funds for investment projects, including research, development and innovation is reduced to zero, so long as: such equities or securities are remunerated based on (i) a pre-determined interest rate linked to the price index or the reference rate (TR), and the parties have not agreed in full or in part to use post-fixed rates, or (ii) equity funds that have at least 85% invested in such securities (or 67% in the first two years) 41 (Law 12,341/2011, Article 1). The tax rate on earnings from credit rights investment funds (FIDC) constituted as a closed condominium and regulated by the Brazilian Securities and Exchange Comission - CVM - is reduced to zero, so long as the credit rights portfolio originator or assignor is not a financial institution and funds are allocated to investment projects, including research, development and innovation. Furthermore the expected profitability of the FDIC funds must be referenced to a fixed interest rate that in turn is linked to the price index or reference rate (TR) 42 (Law 12,431/2011, Article 1). The income tax on earnings from quotas in funds with at least 85% of their net equity (67% in the first two years) invested in debentures issued by a special purpose entity focused on investments in infrastructure and research and development is reduced to zero 43 (Law 12,431, Article 3, header). 40 These advantages do not apply to government bonds forward and securities lending transactions. 41 Some additional terms apply to the term, the prohibition on buy-back and resell commitments, registration and resource allocation. 42 Additional conditions regarding the term, the allocation of fund resources, related parties, registration, resource allocation and minimum information to be disclosed to investors apply. 43 More specifically, the law states that the purpose of the debentures must be to raise funds to implement investment projects in infrastructure and intensive economic production in research, development and innovation that are considered to be a priority by the Federal Executive Power. 75

The zero income tax rate on the earnings from investments in government bonds is relatively recent (2006) and an example of improving the tax legislation, to the extent that it benefits international investors directly, and has a positive impact on the cost of Brazil's government debt. Investors consider net (after tax) returns on their investment. By waiving income tax on interest paid, the Brazilian government in effect reduced the interest rate demanded by international investors, decreasing the overall cost of the nation's public debt. Regarding the benefits granted to debenture funds that focus on infrastructure, it is worth mentioning that if the debenture issuer fails to invest the amounts in the issue deed, or does not invest in the projects listed, international investors are not subject to any sanctions and their exemption rights are protected. The issuer of the security and the FIDC/CRI assignor will be penalized, but the legal security of the investment and the tax regime to which it is subject are assured (Law 12,431/2011, Article 1, Paragraph 8). Rates for international investors are also better than those offered to local investors in the following situations: Income from equity investment funds, swap transactions, whether or not these are exchange registered, and non-exchange futures markets, where they are charged a 10% income tax rate, as opposed to the 15% investors residing in Brazil are charged (SFR NI #1,022/2010, Article 68, item I). All other earnings, including those from fixed income exchange or OTC transactions pay 15% income tax, regardless of the term (SFR NI #1,022/2010, Article 68, item II). Regarding this last item, it is important to point out that investors domiciled in Brazil are taxed at a decreasing rate, depending on how long the investment is held: 22.5% if less than 180 days, 20% between 180 and 360 days, 17.5% between 360 and 720 days, and 15% for investments that remain for more than 720 days. It is also interesting to note that although equity funds (FIPs) focus on equity investments, they are also authorized to invest in convertible debt securities, and the income from these is also tax exempt if they are distributed by FIPs that meet the requirements listed above. Income tax is waived for corporate dividends paid to both international investors and those domiciled in Brazil. 76

THE BENEFITS OF INVESTING DIRECTLY IN BRAZIL In a more general way, it is also worth remembering that for investors not residing in a tax haven, income tax on earnings from investment funds is levied only when funds are redeemed. 16.2 Tax on credit, foreign exchange and insurance financial transactions (IOF) Regarding the IOF tax, it primarily affects international investors in what it is related to the foreign exchange transactions required to bring funds into the country. IOF is governed by Law 8,894/1994 and Decree 6,306/2007. IOF on foreign exchange transactions is the main tax that directly affects investments made by international investors. This is a non-fiscal tax. In other words, it is used not to raise funds but as a Brazilian Central Bank - BCB - tool to manage monetary policy. Legislation enables reducing the IOF rate to zero for foreign exchange transactions of international investors who will: Invest in exchange traded variable yield instruments; Purchase publicly offered stock that is registered with the CVM or exempt from such registration, or to subscribe to stock issued by companies whose stock is registered for trade in an exchange; Invest in equity investment funds (FIP), or in FIP quota investment funds or emerging business investment funds (FIEE); Invest in equity or securities, credit rights investment funds (FIDCs) and debenture funds set up to raise funds for investment projects, including those that focus on research, development and innovation as stipulated in Articles 1 and 3 of Law 12,431 (mentioned under income tax before); Invest in real estate investment funds (FII); Foreign exchange transactions to remit abroad any interest on equity or dividends received by an international investor Finally, another tax item that should be mentioned is that the Brazilian Secretariat of the Federal Revenue (Receita Federal do Brasil - RFB) does not require that international investors file a tax return. In this case the entity with tax responsibility for the investor in Brazil need only provide information when asked to do so. 77

Glossary: 1. BM&FBOVESPA is the second largest exchange in the Americas, the fourth largest listed exchange group in the world and the leading market in Latin America. As a vertically integrated multi-asset class exchange, BM&FBOVESPA offers a full range of services and products for the sophisticated global investor. 2. Cetip is currently the largest custodian of corporate fixed income securities in Latin America. It ensures the support required for the entire cycle of operations for fixed income securities and OTC derivatives. It was created in 1986 by financial institutions and the Central Bank of Brazil to provide more safety and efficiency to operations in the Brazilian financial market. 3. Selic (Special Clearance and Escrow System) is the Brazilian Central Bank s system for performing open market operations in execution of monetary policy. The Selic rate is the Bank s overnight rate. 4. ANBIMA is the Brazilian Financial and Capital Markets Association. ANBIMA acts as a private regulator agent, creating and supervising rules according to its Regulation and Best Practice Codes and works together with the Brazilian authorities and public institutions aiming to regulate the activities performed in Brazil s financial and capital markets. 78

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