What does the future hold for the Brazilian stock market?

A modernised market structure will help Brazil match the economic expectations the world has placed on it

 
Author: Arthur Pinheiro Machado
January 10, 2014

For years, Brazilian capital markets have lagged behind the domestic economy in terms of size and growth potential, and have struggled to keep up with a number of international markets. As one of the world’s most significant growth economies, it is essential for Brazil to develop a market structure more in line with those found in the world’s leading financial centres, such as New York and London. A closer look at the market in Brazil reveals the obvious need for competition in order to stimulate growth and facilitate investor access to global investment opportunities.

A closer look at the market in Brazil reveals the obvious need for competition in order to stimulate growth and facilitate investor access to global investment opportunities

Global investors have long desired access to Brazil, only to be stifled by the monopoly that BM&FBovespa has had on equities and derivatives trading since 2008, when a merger between the country’s Bovespa stock exchange and the BM&F futures exchange was created. In the years that have followed, the group has criticised market fragmentation and promoted its own self-interest, to the detriment of the broader Brazilian economy. But change is in the air.

Market opportunity
In order to better comprehend the Brazilian economy today, it’s important to understand how the market has developed and modernised. As recently as the 1990s, the Brazilian capital market was struggling and losing ground to others due to the lack of protection for shareholders, uncertainties regarding investments, and lack of technological enhancements. With the lack of management transparency and adequate instruments to monitor companies, it gave off an impression of risk, which consequently increased the cost of company capital. In fact, between 1995 and 2003, there were only six initial public offerings in Brazil. Consequently, the Brazilian Stock Exchange was not used by companies to source funds and many Brazilian companies began to go to foreign markets, through American Depositary Receipts (ADRs).

Figure 1

Then in 2000, the Brazilian stock exchange system began to unify and consolidate, led by Bovespa and eight other Brazilian stock exchanges. The capital markets recovered as a result of a series of very favourable macroeconomic events for the Brazilian economy. The number of IPOs rose dramatically, with over 100 IPOs between 2003 and 2011. During this timeframe, the merger of BM&FBovespa occurred, liquidity levels improved and stock prices rallied, prompting the market to embrace the self-deceiving belief that this exchange consolidation was allowing Brazilian equities markets to inch closer to major international markets in terms of performance.

In the last few years, however, new investment alternatives have been few and the economy has suffered without any real growth in retail investing. Despite a growing middle class in Brazil that is consuming more goods than ever before, the domestic capital markets are not representative of the economy as a whole. The number of listed issuers compared to overall GDP is also not a clear representation of the whole picture (see Fig. 1). When compared to other exchanges, the monthly trading volume as a percentage of GDP of Brazil’s stock exchange is 2.4 percent, considerably below the 12.4 percent of key US markets such as NYSE and NASDAQ, and roughly three percent for key European markets (see Fig. 2). When broken down even further, approximately 50 percent of the volume traded is concentrated in only 10 companies in the Bovespa segment, and in the futures market almost 90 percent of the volume is concentrated in only five types of contracts. In addition, the Brazilian markets also have also had some of the largest bid-ask spreads worldwide.

New exchanges
Interest from foreign exchange operators led the Securities and Exchange Commission of Brazil (CVM) to announce in June 2012 that it was working with Oxera, an independent economic consultancy, to weigh up the benefits of allowing new exchanges to operate in the country. What resulted was a surprise to no one that follows the Brazilian markets. The overarching message was that competition would spur economic growth and enhance the economy by bringing in additional liquidity, benefiting a greater number of market participants investing in Brazil.

Figure-2

While the need for liquidity providers is essential for growing the economy, it is just as important to have a liquidity aggregator with efficient technology that meets international standards. By creating an additional stock exchange, a number of additional benefits would include:

  • Improved price formation and smaller bid-ask spreads;
  • Higher trading volumes;
  • Heightened liquidity for small and medium enterprises;
  • Rebalancing of the financial equation for investment services firms and technology providers;
  • Improved savings and liquidity formation conditions.

Another key component to improving Brazil’s financial structure is to develop current technology to increase the volume of trading on electronic platforms. When electronic trading was first introduced in Latin America with the launch of Globex (CME Group’s electronic trading platform) in 1992, the market was slow-moving. However, over the past few years the region has evolved and electronic trading is now growing in Brazil, Mexico and Chile. With that said, there is still a lot of room for expansion; there are many buy-side firms in Brazil that have been slow to adopt electronic trading order routing. Expanding electronic trading in Brazil will allow the order process to be speedier and more efficient while reducing the cost of transactions and increasing transparency.

Competing equities platforms
Recognising the opportunity and demand for a new exchange, NYSE Euronext announced it would partner with Americas Trading Group (ATG) to create a new equities platform to compete with BM&FBovespa. The new exchange, named Americas Trading System Brasil (ATS Brasil), will offer the Brazilian market an opportunity for significant growth and will seek to secure a share of approximately 10-15 percent in equities trading by the end of 2014.

This aggressive goal is based on ATG and NYSE Euronext’s established infrastructure and experience in the electronic trading and stock exchange business. For those not familiar with ATG, it is an electronic trading company that emerged as a result of the lack of development in the capital markets and the need for enhanced technology platforms and modernised access to the broader markets. ATG consolidates and manages connections between brokers, end users and stock exchanges in Latin America. The company also offers the buy- and sell-side firms support in electronic trading and a diverse array of products and services to ensure best order execution and control.

NYSE Euronext saw the opportunity to increase its exposure to the Latin American markets and partnered with ATG to become the exclusive liquidity hub in the region. ATG has invested heavily in technology infrastructure and in trading, monitoring and support systems to build a state-of-the-art, multi-asset, broker-neutral trading platform that connects to the principal economies in the Americas. NYSE Euronext also brings its sophisticated technology to the partnership and will be actively involved with the planning and implementation of this new market in Brazil. ATS Brasil will help remove capital market barriers, providing investors better access to companies and investment instruments.

A growing project
In June 2013, ATS filed a request with the CVM for approval to launch the new exchange. Three months later, ATS Brasil removed the largest barrier for the new stock exchange’s formation by partnering with the Risk Office to create a new clearinghouse in Brazil. The joint venture will provide the full range of clearing and settlement services for transactions in the Brazilian capital market. While the Risk Office and ATG will be the initial investors in the new clearing entity, there are other investors in advanced negotiations to become partners in the project.

With the new clearinghouse in place, ATS Brasil is continuing to move forward with its plan to open the Brazilian stock market for the overall betterment of Brazil and its economy. The new exchange is currently securing liquidity partners and is seeking final approval from CVM. The opportunity for a new modernised market structure in Brazil is on the horizon and when it becomes a reality, domestic and international investors will benefit greatly from increased competition.