Latin America has long been hailed as a future destination of choice for investors, innovators and everyone in between. Markets such as Brazil and Mexico are often thought of as emerged, while their Latin American cousins, such as Chile, Argentina and Colombia, are on their way. But for securities lending, all in Latin America may not be as cozy as it once seemed.
Latin America has long been hailed as a future destination of choice for investors, innovators and everyone in between. Markets such as Brazil and Mexico are often thought of as emerged, while their Latin American cousins, such as Chile, Argentina and Colombia, are on their way. But for securities lending, all in Latin America may not be as cozy as it once seemed.
According to a Markit Securities Finance’s Long Short Ratio for Latin America, which tracks market sentiment, longs outnumber shorts by 42 times in a region where the value of stock on loan is $944 million against a lendable supply of $40 billion.
Judy Polzer, global head of securities lending product at J.P. Morgan, which executed and settled a securities lending transaction in the Brazilian market in May 2011 to become the first non-domestic agent lender to complete a loan transaction in Brazil, says that “securities lending throughout Latin America has been developing at a relatively slow pace”.
She explains: “The Brazilian financial market has good liquidity and well-defined policies, procedures, and infrastructure. However, securities lending transactions are executed through the CBLC (Brazilian Clearing and Depository Corporation), which acts as a central counterparty (CCP). This CCP model has historically limited participation to onshore institutions only. Offshore lenders are slowly warming to the idea of accepting the CBLC model with certain modifications or concessions. Borrowers are generally averse to making such concessions, as their needs can often be satisfied locally through the CBLC.”
“Mexico, which embraced securities lending years ago, is a specials market with few stocks that contribute significantly to revenue. Interest in other markets (eg, Chile) is limited (ie, one-off opportunities), making these lower priority markets for our due diligence reviews.”
A friend in CBLC
The CBLC was created in 1997 and was charged with providing an integrated and national depository clearing, settlement, CCP and risk management solution for the Brazilian securities market.
Today, the CBLC is focused on its CCP role when it comes to securities lending. Clearing agents participating in securities lending must satisfy a minimum set of conditions—proving their operational and financial capacity—before they can trade.
The CBLC marks to market daily the collateral that is required to cover investor liabilities in markets with either future settlement or securities lending. The CLBC uses OCC’s Clearing Members-Theoretical Intermarket Margin System for this purpose.
This system calculates the collateral that must be posted with a 95 percent confidence level. Operational limits for each participant are defined according to the amount of collateral that has been posted, while clearing agents define limits for their clients. Broker-dealers can only operate within these limits, which are controlled in real time.
Polzer says: “As the CBLC clears all trading activity, not just securities lending, local market participants are comfortable with the system and consider it part of the normal course of dealing. An appropriate level of due diligence is necessary to make sure that the operating model is well understood and can be explained to clients in a comprehensive manner.”
The possibility of this CCP model being adopted regionally or even internationally is difficult to judge, but Polzer does not think that Brazil’s way of doing securities lending business is a sign of things to come.
She says: “The CBLC model, whereby all collateral is held by the exchange, is not a sustainable model for agent lenders to manage on a large scale. Brazil’s market is currently a specials only market; consequently, reasonable returns can be earned with relatively small on-loan balances. If this model were applied to markets with much higher utilisation, I think it would be difficult to manage. We have looked at other CCP models outside of Brazil and it is still not clear that there is a net economic benefit for the client.”
Gregory Wagner, global head of prime services at Itaú BBA, says that it is true that the CCP securities lending model at the CBLC takes collateral out of the market.
“This effectively makes the collateral unavailable for reinvest strategies, which is an important part of the revenue for ‘volume’ lending activities. However, we should remember that it was the reinvest strategies themselves that caused significant problems over the years.”
“As such, perhaps the argument can be made that the CCP lending model encourages ‘value’ lending strategies (which doesn’t necessarily require a bolt on reinvest strategy). The question is whether this also encourages good trading behaviour, bringing focus back to simpler, less risky lending strategies.”
Ones to watch
A successful securities lending market requires sufficient depth and breadth of liquidity in the primary financial markets, according to Polzer.
“In this regard, Brazil has been the most successful. Some countries such as Mexico have established securities lending models but lack sufficient primary liquidity to support much volume in lending. Other countries, such as Chile and Peru, continue to elicit interest, but require higher liquidity and market capitalisation levels to become viable.”
“Securities lending will continue to develop slowly in other Latin American markets as participants seek further development of the current operating models, regulations and securities laws.”
