by Dan Shirai


A tectonic shift is happening in Brazil that should help crack open still immature capital markets. Barriers that have kept global investors away from LatAm’s biggest derivatives marketplace are being bashed down by a high-tech initiative to link Brazil’s BM&FBovespa with the world’s largest exchange by market cap, the Chicago Mercantile Exchange (CME).

Both exchanges are working to bring investors around the globe unprecedented access to Brazil’s domestic futures, options, equity and fixed income markets. The pact, which involves cross-listing contracts and direct order routing across a shared network, could unleash a wave of trading.

Some large US funds that employ quantitative models for high-volume trading are already waiting to pounce, and investors predict that the CME-BM&FBovespa agreement will triple – or even quadruple – BM&F trading volume in the coming year. The Brazilian exchange traded 426 million futures and options contracts with a notional value of $16.6 trillion in 2007, up from 284 million contracts worth $10.6 trillion in 2006, according to the Futures Industry Association (FIA) and BM&F. The CME meanwhile traded 2.8 billion contracts, worth a notional value of $1.2 quadrillion in 2007.

“There’s a lot of optimism over what’s going to happen over next six months with regards to the market’s efficiency,” says Matthew Andresen, co-head of Citadel Derivatives Group in Chicago, whose parent Citadel Group, manages over $20 billion. “These markets are poised for significant growth,” he adds, referring to Brazil’s derivatives trading.

“We have a lot of interest from non-Brazilian overseas investors to trade Brazilian products,” says Paul Maggio, head of LatAm business at Chicago-based trading house Newedge Group. “There are many funds that just like to have access to all different kinds of markets and interest in Brazil is big.” They are mainly looking at equities, equity index futures, FX, rates and commodities, adds Maggio. Newedge is a joint venture between Calyon and Société Générale’s Fimat, with $27 billion under management for US clients alone.

Bulls note that similar transitions, such as the Bovespa’s 2004 change from a predominantly open outcry system to its Mega Bolsa electronic trading platform, have led to increases measured in multiples. “The liquidity impact is going to be very big,” says Cicero Augusto Vieira Neto, COO of the BM&FBovespa.

The plan, set to go live in the last week of September, is to permit global investors to view prices of contracts that today are offered solely on the BM&FBovespa. For users of CME’s Globex system, orders and trades are routed directly across Globex, while a direct market access (DMA) system will provide other investors with a link to BM&FBovespa once they have registered with a local brokerage.

Benefits to the Brazil market will be muted at first as participants assess their options. But the initiative will expand the pool of investors in the country, bringing important tenor extensions for rates futures and FX futures contracts. That in turn improves borrowing conditions for bond issuers including the government.

“If this event increases the local market’s exposure to a broader investor base, it will also increase liquidity,” says Ugo Panizza, head of debt and finance analysis at the UN and a former debt markets analyst at the IDB.
 
Volume Bonanza
In February, CME exchanged 2.13% of its equity for a 10% stake in the BM&F. After the merger of Bovespa and BM&F in June, the CME retains a 5% stake in the combined entity. The share swap ensures mutual interest in projects to enhance trading activity and develop new contracts.

The chief joint initiative of the US and Brazilian exchanges is cross-listing of proprietary products, slated to begin in the last week September. Equity analysts covering the Brazilian exchange say this is a novel event, since most global exchanges compete with each other.

Under the plan, global investors will be able to view and trade BM&FBovespa products on screens either through DMA or by using Globex, without having to call a broker. Starting at the end of October, users of the BM&F, today mostly Brazilian, will have direct access to CME-listed products through their own so-called GTS terminals.

“The CME [trades] 95% of [total volume] in the US exchange-traded derivatives market,” says Edemir Pinto, CEO of the BM&FBovespa, noting his exchange seeks immediate insertion into global markets.

Based on 2008 figures through June, BM&F volume is on track to match 2007, according to the FIA. But if predictions on the routing initiative prove true, those numbers will be dwarfed in the next few years.

In the first half of 2008, roughly 15% of trading volume on the BM&F was attributed to offshore accounts, says Pinto. “Any estimate on growth of this number would probably be conservative,” says Pinto. “Today there are 760 BM&F terminals in Brazil, and non-residents have to hire these guys to trade there. Starting in late September, you’ll have the same products displayed on 100,000 terminals around the world,” he says.

For the Brazilian exchange, which now answers to a broad shareholder base of its own, the initiative is a fee-enhancing bonanza. CME’s clients meanwhile gain direct access to this increasingly popular BRIC market.

Risks to the bullish forecast are mainly technological, says Jason Mollin, Goldman Sachs’ São Paulo-based analyst for exchanges, financials and real estate. Full implementation of systems and IT procedures remains to be tested, but having CME as a sponsor adds credibility, he adds.

Plug and Play
The linkup between the two exchanges presents local and offshore investors with several opportunities, though some, including big global trading houses, stand to benefit more rapidly than others. Hedge funds with dedicated EM strategies, especially in rates and FX, as well as financial institution and corporate treasury desks, should increase participation in Brazilian futures and options, says Vieira.

“Established hedge funds and institutional investors are increasingly looking at global markets and there are still many barriers,” says CME CEO Craig Donohue. Conducting business over the phone and manually reconciling trades at the end of the day is time consuming, to say the least, adds another market participant away from the process.

But global investors will soon be able to purchase BM&F-listed contracts, such as FX and rates futures, with little more than a few clicks of a mouse. This circumvents a host of regulatory, clearing, and timing issues that so far have provided disincentives for active participation in LatAm local markets.

In late July, BM&FBovespa ran a successful mock trading session to test DMA, says Vieira, with all 23 participating institutions conducting some 52,000 trades. A second dummy run was scheduled to test the BM&F’s linkup to Globex.

Here Come the Quants
One group of investors in particular hopes to make a killing by entering the Brazilian market with scale and speed never before witnessed. Algorithmic – or high-frequency – traders are some of the CME’s biggest clients, and a new breed for LatAm.

Using high speed programs to crunch raw data directly from exchange servers, they scoop up small spreads generated from inefficiencies inherent in markets dominated by humans. “When you look at the efficiency of the actual market, that’s where Brazil still lags,” says a US-based high-frequency investor eyeing LatAm trading opportunities in Brazil, who asked not to be identified.

This elite group of high-tech funds employs algorithmic models and sophisticated trading programs to squeeze out returns, and some are expected to set up shop on day one. Among Citadel’s rumored initiatives is establishing a co-location, a process whereby a trading shop installs its own servers in the BM&FBovespa’s server room to hasten data transfer back to US offices. Citadel’s Andresen declines to comment on his fund’s plans for Brazil. Other CME customers who engage in high-volume proprietary trading include Moore Capital, Drawbridge Global, Wolverine, Susquehanna and Tudor.

Brazil is, however, well equipped to catch up to US and European quant funds, says Ricardo Sant’Anna, business development director for LatAm at the CME. He notes a large base of IT professionals and strong academic record in financial engineering that should aid creation of homegrown high-velocity shops.

Meanwhile, Brazilian BM&F traders are preparing for changes that will accompany the arrival of new investors. “This will impact certain kinds of trades and people will have to rethink how they play this market,” says Wagner Murgel, founding partner of São Paulo-based hedge fund NEO Investimentos, referring especially to trades that rely on technical market analysis.

He adds that volatility will also increase with the new linkup, which will change market dynamics. “Increased liquidity will help people build up new kinds of positions in the market,” adds Murgel, noting the development is ultimately very positive for Brazil.

Secondary Shock Therapy
Plugging Brazil’s derivatives and equities markets into a global network is sure to yield enormous local markets benefits in the long run. “Foreign participation will be very good for the FX market,” says Alexandre Soares, head trader at Brascan Corretora in Rio de Janeiro. “Today we only have two real maturities [for the BRL-USD] – the one-month and the two-month – and only the one month is really liquid,” he adds. Soares is hopeful that greater participation from accounts accustomed to taking duration will boost liquidity down the yield curve.

This should benefit the sovereign and ultimately make it easier for local corporates to raise long term funding in reais. “An increase in liquidity in the derivatives market can benefit the government’s issuance of fixed-rate notes,” says BM&FBovespa’s Vieira. He adds that an extension of maturities for DI futures contracts, used as a hedge by holders of the sovereign’s local BRL-denominated LTN notes, can increase demand for this type of debt issuance and help the government achieve better pricing and duration. LTNs accounted for 21% of total sovereign public debt in June.

“Demand for hedgeable instruments rises with the availability of a hedging option,” says Vieira, referring to the short term zero-coupon LTN notes, which carry a fixed rate over Selic. The yield curve for corporates, which takes its lead from the sovereign, would benefit by association.

Brazil’s real economy could also prosper from a sustained pickup in trading activity, says Sergio Foldes, head of structured transactions at the BNDES, Brazil’s development bank. “Many of Brazil’s exporters will benefit by having better access to FX hedges,” be notes. Companies like Vale, Suzano, Aracruz and Petrobras have significant exposure to currency fluctuations and could see increased ability to lock in longer-dated currency.

Commodities contracts could also see a jump in interest. “Only four tenths of 1% of the BM&F’s volume is in commodities – primarily soy and corn,” says Donohue at the CME, which claims to be the single largest agricultural commodities market. “There’s a tremendous opportunity there,” he adds.

“Interest in commodities contracts will be enormous,” chimes in Fernando Cardoso, a director at São Paulo-based Interfloat Corretora, whose Brazilian clients trade equity indexes, FX and agricultural contracts.

Meanwhile, Brazilian derivatives investors are also assessing the opportunity. “Being connected to the CME will be a big benefit,” says Soares, who looks forward to having access to US exchange-traded funds, including S&P Depository Receipt shares.

When the anticipated wave hits, it should consolidate Brazil’s position as LatAm’s tallest conducting rod for global capital.

BM&FBovespa has made no secret of its plan to court other bourses in the region. “We’re growing through partnerships with other markets and will initiate a strategy to set up agreements with all the other exchanges in Latin America,” says Pinto.

“Colombia, Peru, Chile, Argentina, Mexico are countries that interest us,” he adds, noting the goal is not to buy exchanges outright, which Pinto acknowledges is a thorny issue, complicated by nationalism. “The alternative is to arrive and do commercial agreements and look to develop that market in conjunction with them.”

Agreements around the region are cropping up already. Mexico’s floundering Bolsa has been in contact with counterparts in Brazil and Colombia on various initiatives. This includes clearing, says Guillermo Prieto, CEO of the Mexican exchange, which went public in June. Meanwhile, Nasdaq OMX has helped Colombia’s BVC set up a futures market, launched in July.

“We’re very oriented towards globalization and the BRICs,” says CME CEO Craig Donohue, who is on the board of BM&FBovespa. “Brazil was best positioned of all the BRIC countries,” he adds.

Donohue, who has overseen acquisitions by his exchange in developed markets, says more LatAm bolsa consolidation is likely. “The trend to demutualization and the follow on to M&A activity is inevitable. We’re very far down that road globally,” he adds, referring to partnerships with Chicago Board of Trade and Nymex, that turned into acquisitions.
BM&FBovespa could one day itself be a target, although investors, who assign lofty valuations to the combined entity based on a steep growth curve, may be reluctant to part with the upside in the short term.

A sting in the tail for BM&FBovespa is that a deluge of international capital inevitably fuels volatility, posing a temporary threat to stability. This kind of turbulence, however, is seen as a necessary step on the road towards deeper more sophisticated markets. If it can kick start trading and increase the global bid for Brazilian assets, this could prove a watershed event for LatAm. LF