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April 2011

New Amsterdam Advisory Services

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Brazil's Clearing Processes: A Developed Infrastructure in an Emerging Market

As is often the case, the lure of emerging markets for institutional investors frequently gets countered with an apprehension of the unknown. This relates to the culture, the business conventions, the trustworthiness of local counterparties, the reliability of local technology and a host of other factors. All of them issues which, in the normal course of business in established markets, are always of some concern, but usually have established benchmarks, references and information available to provide ways to effectively monitor and manage these risks. In emerging markets, however, these are areas where the "emerging" aspect rears its head prominently. In relation to the operations aspect of the market, these concerns are often magnified many times over. Because all the great investment ideas, local insights and other competitive advantages an investor might have in an emerging market will remain just that, and won't be able to be executed against if the local clearing infrastructure is such that the uncertainty and perceived risks of executing a trade far outweigh the potential economic gains of the trade itself. One only has to think about the need to make payment for settlement, the safekeeping services needed to maintain a position, the accessibility of one's money and securities, etc. And that is not even taking into account the more technical issues of dealing with taxation, corporate actions and other operational aspects related to trading in any investment arena. Of course some of these fears are being alleviated by global service providers operating in these markets. Clearly a custodian operating in 100+ countries around the world will have the wherewithal to function as effectively in an emerging market as most local players. Moreover, because of its global operations, it can often leverage its technology solutions to provide service levels that exceed that of the local competition. And with its overall expertise in other emerging markets it operates in, the custodian will typically be able to at least partially use previously developed solutions for such thorny issues as compliance with local rules & regulation, currency conversions, reporting and other standard operational processes. However, regardless of how well any clearing service provider can cope with the demands of an emerging market, it will always have to operate within the framework such a market provides. That, in turn, will always have some degree of what I would call "systematic risk" in it: for instance, the risk the market's clearing process is not robust enough, that its banking system might be vulnerable or its

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April 2011

New Amsterdam Advisory Services

International Operations & Prime Brokerage

+1(312)212-3630 www.NewAmsterdamAdvisory.com

regulatory environment might be fraught with uncertainty. Any of these risks would apply largely to any player in this market, regardless of its background. But in this area of risk, I think Brazil distinguishes itself from its peers in a significant way. Its current clearing infrastructure, although somewhat fragmented, clearly has incorporated "lessons learned" from other, more developed markets. And it did so because of acute pains it experienced in an earlier era that left a lot to be desired in this respect. In the late 90s, Brazil encountered many of the same problems its neighbors were facing: runaway inflation, unstable infrastructure, corruption in government and private business and many related ills. However, in contrast with how some of those neighbors approached this, essentially looking for incremental improvements in existing processes, Brazil decided to make a clean break with the past and effectively start from scratch. Maybe one of the most visible elements of this, although more symbolic in nature than anything else, was the move over the last decade of many of the financial institutions from Rio de Janeiro, which until that time had been the financial center of the country, to São Paulo. However, a much more significant change was the development of new clearing systems, reporting requirements and other control aspects. First and foremost in this was the development of a new payment system for financial institutions, the "Sistema de Pagamentos Brasileiro", or SPB. This system provides real-time processing of payments between financial institutions, similar to for instance, the Fedwire system in the U.S. Its functionality extends into settlement payments for trades in different asset classes (equities, fixed income, derivatives, foreign exchange and lending products). From an operational perspective, the system provides users with extensive real-time liquidity management functionality as well as a medium to exchange messages with other participants. Secondly, a new regulatory regime was implemented that relied heavily on electronic submission of information. Although many foreign investors complain about the impact these requirements have on their business, it is important to remember this process was put in place to lessen the "systematic risk" in this market that drove away those same foreign investors just over a decade ago. A good example of this is the recognition of "beneficial ownership" in the market, which means at any one time regulators have the ability to determine which parties are holding what positions, information that is available to them because it travels with an order for the length of the life cycle of that order: from submission to execution, onwards to clearing, settlement and any other post-trade events that take place. Again, something that is often raised by foreign investors as a hindrance to doing business in Brazil, but

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April 2011

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effectively, helps these same investors by creating a more robust market environment to operate in. Local authorities often cite this beneficial ownership approach as one of the reason why a financial meltdown as was experienced in the US, Europe and other regions could not have happened in Brazil, or at least would have been addressed early enough to significantly lessen its impact. The reasoning behind this thinking it that, to use the U.S. situation as an example, regulators would have spotted overleveraged institutions , like AIG, much earlier, and would have been able to take corrective measures well before the blow-up of such a critical institution within the financial market. A third aspect of this revamping of the market infrastructure, and the leveraging of "best practices" from other markets, is the presence of central counterparty (CCP) clearing in several markets. Within the BM&FBOVESPA, for instance, CCPs are in place for equities, derivatives, foreign exchange and government bonds. And although a CCP system is only as strong as its participants, it obviously does eliminate a degree of systematic risk in the system. A final example of the current regulatory regime in the Brazil can be found in the treatment of foreign investors. And although a lot has been said, often in a negative sense, about the reflection of this in the recent changes in the so-called IOF tax (a tax levied on money brought into Brazil by foreign investors), from a macro perspective, the reason behind all this is to create a longer term level of stability in the marketplace that will make it an attractive venue for international investors (see also: "Changes in Brazil's IOF tax: Why it Matters (But Not in the Way You Think)", New Amsterdam Advisory Services, Jan. '11; http://www.newamsterdamadvisory.com/Brazil.php). The above doesn't mean Brazil has overcome all its infrastructural clearing challenges. A lot of work is still ahead in a number of areas. For instance, the vertical silos of the four CCPs within the BM&F BOVESPA prevent a lot of cross-connection from happening, some of which still a legacy of the merging of the BM&F and BOVESPA operations in 2008. Not only does that limit the benefit to investors in relation to such topics as netting and cross-margining, but it also creates a lot of duplication of processes. In the fixed income area, a similar vertical integration separates the clearing processes for corporate bonds, cleared mainly at the CETIP clearing house, and government bonds, cleared through SELIC. And when it comes to the hot topic of clearing OTC derivatives, both the BM&FBOVESPA and CETIP are vying to become the main provider of these services, something that still has to completely crystallize in the market.

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April 2011

New Amsterdam Advisory Services

International Operations & Prime Brokerage

+1(312)212-3630 www.NewAmsterdamAdvisory.com

However, in all of these areas, recent developments would indicate these issues, just as the ones that initiated the market infrastructure reform over a decade ago, are well on their way to resolution, or at least further clarification. The BM&FBOVESPA has made it clear it sees the importance of further integration of its clearing processes, and is in the implementation stage of some its plans around this, focusing on single-view portfolio risk management, netting and the introduction of collateral pools for a more efficient use of participants' collateral. In the fixed income arena, some cross-connectivity between CETIP and SELIC allows for certain government bonds to be traded on CETIP's automated Negociação platform but settled in the participant's SELIC account. In addition, CETIP is looking to implement a tri-party collateral management platform over the course of 2011, further eliminating some of the silo barriers from the past. And with regard to the OTC derivatives clearing debate, Brazil is clearly not far behind similar developments in Europe and North America, which also still need to get their final form in the months and years to come All of the above are examples reflecting Brazil's unique status as an emerging market: it certainly has a lot of the economic risks inherent in such a market, but at the same time, has created an infrastructure around it that should provide investors a lot higher degree of confidence in matters related to the market's "systematic risk" than most of its peers. And although, as described above, there are certainly more hurdles to be cleared, Brazil seems to be well on its way to maintain its unique status of having a developed market's infrastructure supporting an emerging market.

Rob Philippa is founder and principal of New Amsterdam Advisory Services, an international operations consulting firm, with a special focus on Brazil and the rest of the LatAm region. More information can be found at www.NewAmsterdamAdvisory.com.

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