Changes afoot at Brazilian depository

The move by private equity firm Advent International to take a stake in Brazilian central depository Cetip looks like a shrewd move from the Boston-based group. Cetip enjoys a dominant position in its field in fixed-income and over-the-counter (OTC) derivatives, two markets with plenty of potential for growth in Brazil, and the US firm brings needed resources and expertise to an exchange traditionally too influenced by user-owners and dependent on their largesse to roll out innovative products.

Advent’s May 8 announcement that it was set to take a 30% share of Cetip, the largest central depository for fixed-income securities by private issuers and OTC derivatives in Latin America, should lay the ground for the Brazilian exchange to consolidate its leading hold in these two areas and invest in new, value-added offerings so that it can offer clients a broader array of products.

The Boston-based firm has just four core areas of operation, one of which is investments in financial markets. The ethos is that by confining yourself to a limited number of areas, you get to know the industry profoundly and can add value, according to Martin Escobari, lead partner of the US firm in the deal.

Cetip was particularly attractive to Advent thanks to the very low penetration of fixed-income instruments in Brazil’s financial markets and thus its scope for growth. Globally, Brazil is one of the only large economies that is substantially under-leveraged, says Escobari.

The potential for growth in the fixed-income markets can be seen when comparing Brazil’s low debt to GDP figures. Mortgages represent less than 2% of GDP for example and growth is in triple digits, says Escobari. The Brazilian derivative markets are similarly under-developed: such markets in Brazil represent just 0.4 times GDP. That compares to four times GDP in Mexcio and 26 times in the US, he notes.

For Cetip, the transaction immediately provides a simpler, more coherent ownership structure. Like many of its peers, Cetip has been mutually-owned. Small- and medium-sized banks and brokerage houses possessed 103 million of the 221.9 million shares with small distributors holding close to another 35 million, leading to a highly fragmented ownership.

As other exchanges have found, the interests of such owners can often be short-term and they can be reluctant to embrace change. Even where that is not the case, the parsimony f such a shareholder base does not typically provide a conducive atmosphere for long-term projects.

And in the case of Cetip, many of the owner-users had ceased to have an active role on the market, explains Jorge Sant’Anna, head of business development for the exchange. Many such shareholders have proven reluctant to provide enough cash to develop the exchange, he notes. The arrival of Advent allows these parties to monetize their shares and should remove the dead wood from the exchange.

The new owners will usher in some new management. Escobari will be one of two Advent professionals to gain a seat on the board and a new CFO, Francisco Gomez, has already been appointed, hired for his depth of experience, and as a recognized, respected name in the market place. The company was set to appoint a new CEO, who Escobari declined to name, as FTSE Global Markets went to press.

Overall, Escobari does not see the need for substantive changes. Managers at Cetip have emphasised the development of technology and have worked well with the resources that they enjoyed over the last 10 years, he says. In fact, he would like to see a beefing up of human resources.

The focus for capital investment will be technology in the short-term and processes and IT over the medium-term, says Escobari. Advent aims to extract efficiencies through this tactic, and provide the platform for providing a broader set of services, as well as improving internal controls and enhance real time reporting as well as the accuracy of calculating market values for clients.

Cetip will need to be brought up to date and made more business oriented, believes Escobari. The exchange has had a not-for-profit mentality and Advent will be able to help in the transformation to a stronger business focus through new systems, alignment of management and shareholder interests. That does not mean the exchange will forget its public mission of helping develop capital markets, he says.

Why now?

The slowdown of the global economy as well as the tarnished reputation of derivatives and home grown derivatives scandals may make this seem an inauspicious moment to be purchasing an exchange, specializing in financial instruments that incorporate a big slug of derivatives.

Some of Brazil’s top companies have been embroiled in scandals that have been costly, both to the bottom line and reputation, including food processor Sadia and paper and pulp company Aracruz. Sadia shareholders announced in April that they would sue Adriano Lima Ferreira, former CFO, who they accuse of having a role in a BRL760 million loss. Shareholders in Aracruz, which settled a $2.13 billion derivatives loss with banks in a deal that stretches repayment out to nine years, voted last November to sue former CFO Isac Zagury.

The worst moment has passed and the media exaggerated the possible extent of the derivatives scandals, says Sant’Anna. He saw estimates of potential losses quoted in the media of as much as $80 billion whereas his expectations are that $15 billion. Moreover, most of the derivatives trading was used for hedging currency positions by exporters, with only a small minority of firms using contracts in asymmetrical derivatives to make significant bets on the direction of currency movements. Furthermore, the market regulator is now insisting on greater transparency from listed companies on their derivatives exposure, he notes.

Globally, there remains a lot of work to be done in qualifying derivatives and understanding their systemic risk profile, admits Escobari. He predicts that in the short-term there will be higher demand for simpler derivative products.

And in this area, the Brazilian exchange has some significant advantages over others. The regulatory structure of the market is different from most of the rest of the world. Registration of trades at a central custodian is mandatory under Brazilian legislation. That gives complete accountability and the regulator an almost real-time snapshot of the exposure of the economy to derivatives, says Escobari. This level of informational capture doesn’t exist in either the US or European Union and regulators are working towards the kind of greater transparency already to be found in Brazil, he notes.

Cetip is, anyway, not dependent on derivatives. It operates across the public and private fixed-income space, OTC derivatives and commodity derivatives, in custody and settlement and offers trading platforms in government and private bonds. Although, it dominates Brazilian derivates trading, by acting as depository in 80% of trades, it is even more dominant in fixed-income transactions, accounting for 98% of trades. And often when one of the markets it operates in is weak, another one picks up the slack, says Sant’Anna.

Indeed, despite the various crises suffered by Brazil since 1999, revenues have displayed low volatility. For example, Cetip’s revenues were relatively little affected when the dollar spiked and bond yield spiked in the run up to president Lula’s first election in 2002. It is Cetip’s range across different markets that smoothes out revenues, points out Sant’Anna. Indeed, revenues grew 89% between the first quarter of last year and the first quarter of this year despite the market downturn, he notes.

And the fixed-income markets should provide plenty of growth for Cetip. The Brazilian government traditionally crowded out private sector borrowers who were further deterred from issuance thanks to high interest rates. The dynamics both in crowding out and rates are improving as the government’s debt burden slowly falls and the Central Bank cautiously top slices interest rates, a trend hastened by the global downturn. The Selic rate has been cut to 10.25% on April 29 with the rate widely seen as falling to between 8.5%-9.5% by year end.

Just how fast the private fixed-income market will grow in the near-term is hard to predict thanks to the global recession. “We don’t have lots of visibility in credit over the next six months, but we do have confidence in long-term trends”, says Escobari. In the meantime, the transition from floating-rate to more fixed-rate issuance by the private sector creates derivative demand, adds Escobari. As fixed- and floating-rate issuance increasingly co-exist, opportunities for derivatives to match differing liabilities is opened up.

New products

It is not only the organic growth of the fixed-income and derivative markets that attracted Advent to the Brazilian market. There exist many opportunities in product development and value-added products that will allow premium pricing.

One of the most exciting areas for new opportunities lies in the development of collateral management products. Federal legislation dating back to 2004 has clarified creditors’ rights and made it easier to enforce claims against borrowers when they stop repayments.

That clarity in legislation is allowing Cetip, with its established role as a depository, to develop a more significant role. Over time, the exchange will look to enhance services, for example, with more automated calculations which allow the amount of collateral to be adjusted in line with changes in underlying prices as securities are marked to market.

Developing more elaborate collateral management systems will require innovation, notes Sant’Anna. For users, the benefits are clear and include reductions to the amounts of capital tied up and lower costs, while more efficient management of collateral also cuts systemic risk, adds Escobari. Securities lending is another area of possible opportunity in the future.

In the fixed-income market, development will be focused on the breadth of products. Secondary market trading in Brazil has remained under-developed; as the whole market grows, that should start to change. There are also new areas of operation. For example, there are new types of agricultural lending that allows different types of collateral to be pledged.

There is also the possibility that Cetip could get involved in equity markets in the future, says Sant’Anna. Currently, Brazilian legislation restricts companies from listing shares both on exchanges and OTC markets. Changes in legislation might enable Cetip to offer electronic trading platforms for equities, he notes.

Escobari declines to be drawn on what Advent is anticipating for future revenues from Cetip. When asked whether Advent would like to list its stake on the stock market in the future, he replies that it is too early to talk about the firm’s eventual exit from its investment and says that there is plenty of time to ponder strategies as the company has a typical time horizon of four to seven years. Advent uses both strategic sales and listings as exit strategies.

The conclusion of the acquisition by Advent of Cetip’s business comes just as financial markets are showing a rapid recuperation. Even if there is no repeat of the run-away markets of just a couple of years ago, the foundations for Brazil’s fixed-income market are solid and the volatility of the foreign exchange market means that, even if companies restrict themselves to plain vanilla instruments, they are not going to forsake the protection of derivative contracts altogether.

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