market in brazil - s3.amazonaws.coms3.amazonaws.com/zanran_storage/ · financial market - brazil....

Rio de Janeiro

2007

National Association ofFinancial Market Institutions

ANDIMA

Brazil

E c o n o m i c R E p o R t

OTC fixed incomemarket in Brazil

O87OTC fixed income market in Brazil/National Association of Financial Market Institutions - Rio de Janeiro: ANDIMA, 2007.78 p.; 25 cm. - (Economic report) ISBN 85-86500-41-1 1. Financial Market - Brazil. 2. Over-the-counter market. 3. Fixed Income. 4. Debt securities. I. National Association of Financial Market Institutions (Brazil). CDD-332.1140981

Published in 2007Total or partial reproduction of this book without quoting the source is prohibited.

PRODUCTION CREDITSTechnical Supervision - Valéria Arêas CoelhoTechnical Management - Sandro Baroni SelaimenEconomic and Tax Studies - Mary Carmen MendezEditor - Patrícia Fesch MenandroEconomists - Ana Lúcia Andrade dos Santos, Antônio Luís Filgueira, Berenice Ribeiro Fontes, Dalton Boechat, Demetrius Durante, Eduardo Norman Otero, Enilce Leite Melo, Glória Maria Medeiros Baptista, Marcelo Cidade, Marcelo Kucuruza Mehl, Nuno Miguel Conde, Patrícia Herculano and Vinícius Gomes Araújo. Trainee - Márcio Portugal MeligaCommunication Advisor - Cláudio AccioliCover, Publishing and Chart Production - Marcelo Paiva and Carlos Alberto V. JuniorProofreading - Renato MourãoCataloguing and Bibliographic Reference - Cláudia Kropf

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SummaRy

LIST OF CHARTS & TABLES .............................................................................................. 5

LIST OF ABBREVIATIONS .................................................................................................. 7

PRESENTATION..................................................................................................................... 9

1 - INTRODUCTION ............................................................................................................ 10

2 - RECENT CONCEPTS AND CHARACTERISTICS ...................................................... 12 Fixed income assets .......................................................................................................... 12 Trading characteristics ...................................................................................................... 13 Over-the-counter market ................................................................................................... 13 Why the discussion about transparency? .......................................................................... 14 Electronic systems ............................................................................................................ 15 Why is liquidity important? .............................................................................................. 17

3 - INTERNATIONAL MARKET – FIGURES AND DISCUSSIONS ............................... 20 General Overview ............................................................................................................ 20 Transparency in liquid fixed-income markets .................................................................. 21 The American experience ................................................................................................. 22 The debate in Europe ........................................................................................................ 26 The discussion in emerging economies ............................................................................ 27 The recent situation in Latin America .............................................................................. 29

4 - DOMESTIC MARKET: HISTORY, CONFIGURATION AND FIGURES; REGULATION AND SELF-REGULATION .................................................................. 32 Main characteristics ....................,,.................................................................................... 32 Brief history ..................................................................................................................... 35 The first measures designed to promote liquidity ............................................................ 38 Recent initiatives and advances ........................................................................................ 41 The market’s current configuration .................................................................................. 43 Trading in the secondary market ...................................................................................... 46 Electronic systems ........................................................................................................... 51 Transparency .................................................................................................................... 52 Liquidity ........................................................................................................................... 54

� OTC fixed income market in Brazil

5 - PROJECTS: A PROPOSED AGENDA FOR THE BRAZILIAN FIXED-INCOME MARKET ......................................................................................................................... 55 Macroeconomic issues ..................................................................................................... 55 Institutional and Microstructure Issues ............................................................................ 59 - Primary market and the actions of the authorities .................................................... 59 - Regulation of the secondary market of custody, depositary and settlement services ...................................................................................................................... 61 - Securities lending and short operations .................................................................... 65 - Taxation of fixed-income instruments ...................................................................... 66 - Investor base ............................................................................................................. 68 Conclusions on the agenda ............................................................................................... 69

6 - APPENDIXES ................................................................................................................. 71 Fixed-Income Market: Trading and Payment System ...................................................... 72 Fixed-Income Over-the-Counter Market – “Knowing the ropes” .................................... 73

7 – BIBLIOGRAPHY ............................................................................................................ 74

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Table 1 - Electronic Trading Systems in Europe/USA - December 2005 ...................................... 16

Table 2 – Stock of Bond Debt in Selected Countries ............................................................ 21

Chart 1 - U.S. Treasury Bonds ............................................................................................... 22

Chart 2 - U.S. Treasury Bond Holders ................................................................................... 23

Box 1 - The Trace Experience - Trade Reporting and Compliance Engine .......................... 25

Table 3 - Distribution of Corporate Bond Trading in the European Market ......................... 26

Chart 3 - Market Weights for the Pan-Asian Securities Fund ............................................... 29

Box 2 - Main Recent Features of Latin-American Bond Markets ........................................ 30

Chart 4 - Composition of the Brazilian Financial Market ..................................................... 32

Table 4 - Fixed-Income Market ............................................................................................. 33

Table 5 - Characteristics of the Main Fixed-Income Bonds and Securities .......................... 34

Chart 5 – Main Holders of Federal Government Bond Debt ................................................ 35

Chart 6 - Average Daily Volume x Stock of Federal Public Debt ......................................... 36

Chart 7 - Composition of the Federal Public Bond Debt by Type of Profitability ................ 37

Chart 8 - Maturity Structure of Outstanding Government Bonds ......................................... 37

Box 3 - Follow-up of the 21 Measures Proposed by the National Treasury/Brazilian Central Bank in 1999 in order to Expand Primary and Secondary Public Debt Markets Liquidity ............................................................................................ 38

Box 4 - Recent Measures Oriented Toward Liquidity and Transparency ............................. 42

Chart 9 - Stock and Traded Volume/Stock by Type of Bond ................................................. 44

liSt of chaRtS & tablES


Table 6 - Distribution of Trading in Federal Public Bond Debt - July/2006 ......................... 44

Chart 10 - Terms of Fixed Rate Government Bond Debt ...................................................... 45

Chart 11 - Forward Interest Rate Structure ............................................................................ 46

Box 5 - Main Features of Sisbex ........................................................................................... 48

Table 7 - Outstanding Stock, Traded Volume and Distribution of Trading in the Debentures Market ................................................................................................. 49

Box 6 - Main Features of CetipNet ....................................................................................... 50

Table 8 - Distribution of Trading in Government Bonds by Type of Operation and by Environment/Trading System ................................................................................. 51

Box 7 - Transparency in the Brazilian Fixed-Income Market - Information Availability in the Over-the-Counter Market ............................................................................... 53

Chart 12 - IMA versus Selic Rate versus DI Rate – Cumulative YTD Percentage Variation in 2006 ................................................................................................. 57

Box 8 - Over-the-Counter Fixed-Income Market Agenda – Outlook, Suggestions and Projects ................................................................................................................... 58

Table 9 - Number of Public Bond Maturities in the Market .................................................. 60

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Anbid .......................................................................................... Investment Bank Association

ANDIMA ............................................. National Association of Financial Market Institutions

BC ........................................................................................................ Brazilian Central Bank

BMA ..................................................................................... BM&F Securities Clearinghouse

BM&F ............................................................................. Futures and Commodities Exchange

BNDES ....................................................................................... Brazilian Development Bank

Bovespa .......................................................................................... São Paulo Stock Exchange

BovespaFix .................................. Electronic Trading Platform for Fixed Income Instruments

CBLC ............................................................. Brazilian Clearing and Depository Corporation

CDB ................................................................................................... Bank Deposit Certificate

CETIP .................................................................................. Custody and Settlement Clearing

CETIPNet .................................... Electronic Trading Platform for Fixed Income Instruments

CPF ............................................................................. Brazilian Individual Taxpayer Registry

CPMF ......................................................... Provisional Contribution on Financial Movement

CVM ..................................................................................... Brazilian Securities Commission

Demab ....................................................................... Central Bank Open Market Department

DI ................................................................................................................. Interbank Deposit

DPMF .............................................................................................. Federal Public Bond Debt

DVP .................................................................................................. Delivery versus Payment

FDIC ................................................................. Asset-Backed Receivables Investment Funds

FGV ............................................................................................... Getúlio Vargas Foundation

IBGE ............................................................... Brazilian Institute of Geography and Statistics

Ibovespa ............................................................................... São Paulo Stock Exchange Index

IRF-M ........................................... Fixed Income Market Index (LTN and NTN-F portfolios)

IGP-M ............................................................. General Price Index for the Financial Markets

IMA .................................................................................................... ANDIMA Market Index

IMA-B ................................................................. ANDIMA Market Index (NTN-B portfolio)

liSt of abbREviationS


IMA-C ................................................................. ANDIMA Market Index (NTN-C portfolio)

IMA-S ...................................................................... ANDIMA Market Index (LFT portfolio)

INSS .................................................................................... National Social Security Institute

IOF .............................................................................................. Tax on Financial Operations

IPCA ..................................................................................... Expanded Consumer Price Index

IR ........................................................................................................................... Income Tax

LBTR ............................................................................. Real Time Gross Settlement (RTGS)

LDL ....................................................................................... Deferred Net Settlement (DNS)

LFT ..................................................................................................... Treasury Financial Bills

LTN ...................................................................................................... National Treasury Bills

NTN ................................................................................................... National Treasury Notes

NTN-B ...................................................... National Treasury Notes – Series B (IPCA linked)

NTN-C ................................................... National Treasury Notes – Series C (IGP-M linked)

NTN-D ...................................... National Treasury Notes – Series D (Exchange Rate linked)

NTN-F ......................................................... National Treasury Notes – Series F (Fixed Rate)

PIB ......................................................................................... Gross Domestic Product (GDP)

PU ............................................................................................................................. Unit Price

SELIC ................................................................. Special System for Settlement and Custody

SISBEX ............................................................................................ BM&F Trading Platform

SFN ............................................................................................... Brazilian Financial System

SNA .......................................................................................... CETIP National Asset System

SND .............................................................................................. National Debenture System

SPB ................................................................................................ Brazilian Payment System

SPR ...................................................................................... Financial Risk Protection System

SRF .................................................................................................. Internal Revenue Service

STN ............................................................................................ National Treasury Secretariat

STP ................................................................................................... Straight Through Process

TJLP ................................................................................................... Long Term Interest Rate

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pRESEntation

The Economic Report – the OTC Fixed Income Market in Brazil sums up two of the

guidelines that we proposed to follow when we took over the Presidency of ANDIMA in

March 2005: the improvement of the secondary fixed income securities market, particularly in

relation to over-the-counter trades, and the production of technical studies showing the impact

on the financial sector. An analysis of the international literature in relation to transparency

and liquidity in this segment demonstrates that the trends and proposals which are being de-

bated in the domestic market are in line with the main discussions and initiatives observed in

consolidated bond markets as well as in those that are expanding. Therefore, what is the main

challenge facing the segment? In our view, one factor shows itself to be absolutely essential:

increasing the number of participants capable of operating in a competitive way. Nowadays,

trading in the fixed income secondary market is characterized by the prevalence of inter-fi-

nancial operations of high unit value, by assets with complex pricing and by specialized par-

ticipants, such as financial institutions and institutional investors, conditions that restrict the

presence of other potential interested parties eventual participants. There is a need to improve

the trading instruments that are available, amplify the disclosure and the discussion of the

operations carried out, by creating parameters and indicators of intent to trade, and reduce

transaction costs. We expect that this report, in which these and other issues are analyzed in-

depth in light of international experience, to be a catalyzing agent of transformations that will

benefit not just the market, but also the country as a whole.

Alfredo Neves Penteado Moraes

10 OTC fixed income market in Brazil

The macroeconomic stability that has been achieved in Brazil over the last few years, sup-ported by a fiscal discipline process, a system of targets for interest rates and inflation and a management of both foreign and domestic debt that is in line with what is deemed to be correct in international circles, produced positive effects in relation to the bond market and risk assess-ment of this indebtedness. The marked growth in the stock of bonds and the recent improve-ment in the profile of the debt have been occurring in a particularly favorable external context.

At the same time, and also in tandem with international trends, there was a restructuring in Brazil of the domestic payment system and an adaptation to fit in with the so-called Basel Rules, as well as recommendations for segregating the asset management area and mark to market of own portfolios. The activities and controls related to the management and settle-ment of assets were modernized. These changes, coupled with the marked strengthening of the investment fund industry, the consolidation of pension funds and insurance companies as institutional investors and the resurgence of the credit market, have helped to encourage par-ticipation by new customers together with product creation in the fixed income segment.

However, notwithstanding these advances, the existence of a consolidated derivatives market and a sophisticated recording and settlement structure, it can be observed that both the volume of trading in the secondary domestic debt market as well as the investor base are still restricted. Recently the debate on how to overcome these determining factors has found an excellent parallel in the discussions and initiatives observed in other countries that are directed towards increasing liquidity and transparency in the bond markets.

1intRoduction

11

The purpose of this study is to present the main characteristics and trends of the over-the-counter fixed income market in Brazil, using international experience as a backdrop. To this end, chapter II deals with the concepts and indicators used in worldwide literature and that is regarding as being important for the mapping of this experience, which is covered by chapter III. Meanwhile, chapter IV analyzes issues that are significant to the debate on transparency and liquidity in the domestic over-the-counter fixed income market. Last but not least, in the final chapter, initiatives and measures of a macroeconomic, institutional and microstructure nature are discussed, assembled in a proposed agenda, with a view to increasing the liquidity and transparency of the secondary market for Brazilian bond debt.


2REcEnt concEptS

and chaRactERiSticS

Fixed Income assetsIn the financial market, fixed income assets are bonds or securities1 which foresee the cor-

rection of their face value by a defined profitability or a previously established remuneration parameter. In the first case we have the fixed rate securities, and in the second, the floating-rate assets, which are adjusted by the variation in the prices indices or in the FX rate, or pegged to floating interest rates, obtained from the average rate of operations carried out in the financial market (SELIC Rate).

The differences between assets traded on the fixed income markets and shares begin with the price-setting process. The price of a share is the result of an agreement between centralized offers and bids in physical or electronic trading environments, which is redefined in a differ-entiated manner at any moment on account of the various events which affect these environ-ments and the respective issuers. The price of a fixed income security meanwhile depends on the implied profitability foreseen for the bond – and a rough idea of the bond’s present value can be obtained by discounting this remuneration from the payments. Factors such as market conditions and issuer risk may influence pricing, but the security’s main movements will be pegged to basic price references of the economy – which affect the present value of its remu-neration -, as well as its liquidity at any given moment.

1 According to the legislation, this definition may be more or less comprehensive. In Brazil, for taxation purposes, the Federal Revenue Service considers as fixed income any structure operations that ensure obtaining predetermined revenues, such as box operations.

1�Recent concepts and characteristics

Trading characteristicsAlso as far as trading is concerned, fixed income securities exhibit specific2 conditions,

which can be summarized as follows: due to their own characteristics, purchases and sales of bonds are not distributed proportionately over their useful life. Unlike the stock market, fixed income securities show periods when there is a higher level of trading – issue, payment of events, changes in the foreseen profitability of contracts or reference assets of equal term. Excluding these periods, - and except for changes related to the assessment of the issuer or the sector, in the case of corporate securities - , assets of this type exhibit a lower number of trades, and a relatively lower liquidity: discontinued trades over time, no trades at all for long periods or trading concentrated in the hands of just a few specialized participants3.

Furthermore, in contrast to the stock market, where a issuer usually accounts for a single share issue or a few, in the fixed income segment the same issuer may carry out various several issues, in accordance with funding conditions or requirements. Companies and governments, for example, issue securities with different terms, conditions and maturities, generating high issuing amounts and figures, but in a scenario of concentrated liquidity – in general, only a very low percentage of the total number of issues exhibit at least one trade a day, and this in-cludes markets (those of the USA and Europe)4, which are deemed to be more liquid.

Over-the-counter marketAnother characteristic that is common to this market refers to the trading environment.

According to international literature, over the counter trades are those that do not involve a stock exchange (centralized free trading environment) – with the participants trading di-rectly with each other, either by telephone or electronic systems. Due to the factors that were mentioned previously, this is the predominant trading format in the fixed income segment, in other words, that which involves government debt or corporate private debt securities, such as debentures, or bank funding instruments, such as certificates of deposit. This trait is also noted in American and European markets, just to mention better known examples, as well as in the Brazilian one.

2 FSA report – Financial Services Authority (United Kingdom) Discussion Paper No. 5/05 – Trading Transparency in the UK. Secondary Bond Market – December 2005 presents a detailed review of these specific characteristics, applied to the European and, especially, the United Kingdom market.

3 Further according to the FSA, government bonds present high liquidity periods related to their utilization as monetary policy instruments. Anyway, though with distinct frequency, they keep a liquidity concentration characteristics at localized times of their life cycle.

4 Differences could also be verified in the degree of tradability according to the type of profitability of these assets, which is not found in the stock market.

1� OTC fixed income market in Brazil

Because of the way it has been set up, the over-the-counter market is traditionally operated by specialists – financial institutions and institutional investors – and shows little dispersion. Due to the profile of its participants and to the afore-mentioned concentration of liquidity, there are long periods when there is little trading, but when trades take place they show a high unit value. Therefore, the pricing of the assets becomes more specific, with very little presence of commoditized trades outside the so-called turnover markets, and this explains why the seg-ment is still not really understood by retail investors.

Why the discussion about transparency?It was this recent increase in the participation of these investors that led the financial mar-

kets supervisory bodies to be concerned in connection with the presence of scattered agents in a segment with such peculiar characteristics. The expansion of managed portfolios, in the form of investment funds and pension funds, has also helped boost interest from individual investors in the segment, which is more representative in some countries than others, and that expanded following the stock exchange crises that were seen in the last decade.

The transparency of a market is related to the larger or smaller quantity of information available regarding the proposals made and the trades carried out – particularly regarding prices – and the access conditions and dissemination of this information. Specifically with regard to prices “transparency refers to the ability of participants in the market to get access to information about transactions carried out (post-trade transparency), price quotes (pre-trade transparency) and to price indications that help in the process of price-making”5. Taking into account the carrying out of operations in real time, and on an international scale, and the con-nection between the different markets, the recent emphasis by international entities on trans-parency also extends to the timeliness and consolidation of information.

In the stock markets, the disclosure of proposals and the obtaining of the actual prices are the counterpart of trades themselves. The results are continuous and made available in a timely fashion, reflecting multiple operations with standardized characteristics, and the clients, di-versified, including among others individuals, funds, companies and institutions, with access, therefore, to the figures. For its part, the consolidation of information is also made easier by the recent unification of the organizations and by the centralization of trading. As a result of this, the trends and initiatives capable of ensuring greater transparency for the different markets have been analyzed by the international entities and regulatory bodies with a special focus on the over-the-counter market.

5 TBMA – The Bond Market Association eCommerce in the Fixed-Income Market, December 2005, pg. 2. Indicative prices are price estimates for trading a certain bond, but not firm prices, quoted or executed.


In this segment, in addition to the expansion of the investor base to include retail investors6, the assets have become more complex and both investment decisions and market prices are increasing-ly influenced by an ever greater number of factors (in addition to interest rates and the benchmark represented by government bond prices). In segments where there is online availability of price information, but the trade is carried out either by telephone or voice systems, timeliness becomes an essential factor, because the published figures may not reflect market prices at a given time. Fragmentation is also a distinctive quality of the information in these markets, with trades not nor-mally being centralized in physical or electronic environments, and there is a great diversity in the systems used for supporting or carrying out trades (voice, screens or even platforms). Furthermore, depending upon the distribution of market members and the concentration of liquidity, the existing information may not be sufficient or accessible or constitute a suitable parameter for other trades.

Electronic systemsAmong the processes that have helped increase the level of transparency in this segment

are the electronic recordings or trading systems, which are able to consolidate and promptly disclose the characteristics of potential or actual trades. In more liquid and homogenous mar-kets, the introduction of electronic platforms (trading systems) was a natural result of the growing utilization of trading support systems – online quotation screens, information agen-cies and voice systems. Starting with the market globalization process, measures directed to-ward adopting STP – Straight Through Processing7, have gained strength, due to the reduction of costs and operating risks. The possibility of extending these measures to the trading stage resulted in a successful migration to electronic platforms, in these cases.

The predominance or high utilization of electronic trading systems in some segments has an effect on transparency, to the extent that it facilitates the creation and disclosure of informa-tion. A yearly survey regarding these systems in Europe and the USA that was carried out by the Bond Market Association states that, in 2005, 27 out of the 54 platforms surveyed allowed their users at least to check the most recent effective price of a given asset or operation; 20 of the platforms surveyed disclosed data regarding transactions that had taken place to non-us-ers; 26 made data available through vendors; 40 published quoted prices for the assets; and 23 allowed their users to access price indications.

6 In general, the greater number of retail participants are confirmed by statistics on the number of operations. When considering traded volume, this participation is quite reduced, although differentiated among markets. See, about it, note in Box 1 on Trace.

7 According to definitions used by BIS – Bank for International Settlement, STP – Straight Through Processing consist of “cap-turing trade details directly from front-end trading systems and complete automated processing of confirmations and settlement instructions without the need for rekeying or reformatting data”. In the case of systems involving asset settlement, it also refers to “fully performing pre-settlement and settlement processes from data on entered trades, manually, only once in a system”.


The increased presence of these agents in the European and, particularly the American market, has improved the situation in terms of operating costs and risks -related conditions, as well as the access of clients, both institutional ones as well as others, to the fixed-income seg-ment. It should be noted that, by providing greater transparency, the introduction of these sys-tems affected the configuration of these segments in relation to access and costs are concerned, but did not imply, either previously or subsequently, alterations to the original characteristics of the fixed-income market in which they operate. The trading systems implemented are de-signed to be flexible so they can incorporate different ways of trading, providing mechanisms that make it possible to choose counterparts, fractioned trades or firm offer conditions, more typical of an over-the-counter market, but also with risk controls or auction devices.

Indeed, in the survey that was previously mentioned four general pricing criteria in these en-vironments were mapped – auction, quotation, matched bid offers and matched firm orders (see

TABLE 1

Electronic Trading Systems in Europe/USA – December/2005Types of Platform by Trade, Participants and Services

Types No. of Systems

Surveyed universe ��

By type of participant/platform:

Financial institutions and brokers only (inter-dealer or B2B) 2�

Financial Institution/broker and custumer (dealer to custumer or B2C):

Single-dealer to customer 22

Multiple-dealer to customer 1�

Allow access to retail investors 12

New issue 12

By trading method:

Order driven (participants send proposals, which are centralized and may be seen or executed by all others) ��

Market-making/Cross-matching (participants send buy and sell quotes throughout the day; trades are executed when quotes and quantity coincide or when the participant accepts a quoted price)

2�

Request for quote (usually B2C: investors request quotes from institutions) 2�

Auction (usually used for new issues, allows participants to bid simultaneously for a securities offering) 11

Other characteristics:

Visibility to users of, at least, latest traded price 2�

Direct access to clearing and settlement systems 2�

Risk monitoring or management 1�

Extracted from “European Bond Pricing Sources and Services: Implications for Price Transparency in the European Bond Market”, April 2005 and “eCommerce in the Fixed-Income Markets – The 2005 Review of Electronic Transactions Systems”, December 2005, available at www.bondmarkets.com.


table on the previous page). Their distribution among the platforms that were surveyed demon-strates that a number of them offer more than one alternative. The systems may also be restricted to financial institutions or promote contact between a single institution and clients or various institutions and clients. Furthermore, out of 54 platforms that were surveyed, 29 offer links to clearing and settlement systems, and 14, to risk monitoring or risk management services.

Therefore, an important observation regarding the automation of processes and the ad-vance of electronic markets relates to the adjustments in the procedures seen in the Stock Ex-change and over-the-counter markets. The introduction of voice or trading systems8 multiplies the number of parties to a trade by comparison with the two-sided contracting by telephone, and trading screens or platforms increase client participation in trades and allow trading by best price criteria. At the same time, the utilization of these alternatives has been compatible with the existence of trading rounds, of firm orders or the use of fractioned trades In the over-the-counter market, these alternatives allow a better adaptation of the trading methods to the diversity of assets and operations that can be seen in the fixed-income segment9, which has also been observed in the case of derivatives.

Why is liquidity important?In segments with more heterogeneous assets and operations and where liquidity presents

the afore-mentioned unusual characteristics, electronic systems, even when present, are not generally the predominant means of trading, nor do they exhibit great degree of diversity or high level of specialization. In these cases, the introduction of electronic methods for the transmission of prices or the execution of trades has taken place in such a way as to enable the online disclosure of information or the register of bids to market participants, with dealers and specialists continuing to play a major role in the carrying out of operations.

Therefore, the typical fixed-income segment characteristics, such as the irregular distribu-tion of liquidity, the predominance of institutions and institutional clients and the existence

8 Voice systems allow a party to make or receive proposals from more than one counterpart through oral communication among several participants. Trades may be executed in this manner, as happens in the case of telephone, but, in order to be effectively executed, they require entering the operation in a trade system and/or record, Whereas in the electronic trading system, the command to execute an operation may result in, simultaneously, recording it and procedure for respective settlement; in Brazil, so-called “voice boxes” are used for calls made by brokers operating in the public security market.

9 As described in Chapter III, the presence of electronic trading systems in the American Treasuries market illustrates this observation; while in the on-the-run segment, with a high degree of non-differentiation, electronic platforms already account for practically the totality of trade, in off-the-run and primary segments, whose operations are heterogeneous, less frequent and require greater specification, trading by means of voice systems and using dealers prevail. As to the latter, the most active in this segment also control electronic platforms used in the other, which is to say, they alternate provided service to trading completion according to the characteristics of each segment. In the European market, according to ICMA – International Capital Market Association, it is also possible to use (or not) a central counterpart, on the same Euro MTS platform, and the parties may opt for anonymity or bilateral settlement.


of complex trading assets, may lead to situations in which the expansion of transparency is related to the consolidation and timeliness of information, without necessarily requiring any changes to the segment’s modus operandi. In such situations, the initiatives observed in terms of the international experience were along the lines of adopting– and this included making it compulsory to do so – of the recording of operations in centralized systems, with real time information reporting capability to a wide group of (potential) participants.

However, if we look at the bond markets in emerging economies countries, which are not yet consolidated, the discussion regarding liquidity takes on a distinct perspective to that ob-served in the case of American and European experiences. In these latter economies, the spe-cific characteristics of the fixed-income segment remain valid, but market liquidity as whole is relatively high, as is the number and absolute volume of transactions, the number of partici-pants and the depth of the secondary securities market.

Based on the international concept, the liquidity of a given market is related to its ability to execute transactions cheaply and quickly, without affecting prices. Liquid markets are impor-tant because they allow their participants to adjust their portfolios at the lowest possible costs. If this is not viable, the trend is for investors to charge a premium to compensate them for the lack of liquidity, which results in constant increases in the funding costs of the segment’s issu-ers10. The liquidity measures used to assess the secondary markets of these economies may be grouped into four most frequently used concepts:

• Market depth: usually related to the volume transacted and its impact on the prices prac-ticed in a segment, it is assessed in a simplified way, using the ratio between the volume traded and the outstanding debt stock.

• Size of the spreads: the difference between purchase prices and selling prices, which tend to present an inverse relation to the volume traded or the depth

• Concentration of the investor base: in this case, it is assumed that the greater the concen-tration of the entire debt in the hands of just a few holders, the lower liquidity will, and this is particularly so, if buy and hold type strategies are present.

• Market size: what is taken into account here, apart from the stocks involved, is the value of the individual issues in the primary market.

Moreover, according to the international literature, in unconsolidated shallow debt mar-kets, a series of macroeconomic, institutional and microstructure aspects may compete to re-strict liquidity in the segment. The macroeconomic determining factors refer to historical or market structure related reasons that help to explain the profile of indebtedness or its vulner-

10 Promoting Liquidity in Domestic Bond Market, speech given by BIS general manager, Mr. Malcolm Knight, in Saint Peter-sburg, in May 2006.


ability to external and internal factors. While the factors of an institutional and microstructure nature are related to market characteristics that might help (increase) liquidity, such as taxa-tion, controls on foreign capital, hedge market size, clearing and settlement structure, segment regulation and yield curve shape.

It is worth noting that, in markets which are considered to have restricted liquidity, infor-mation on actual trades, may be scarce and concentrated over time. It is possible that assets with a relevant participation in the market’s stock of debt stock will not be traded for a number of periods, and that trades, when executed, depending on the batch and conditions, will not provide representative prices for new future trades. So-called pre-trade information may also correspond to indicative spreads rather than firm trading intentions, bearing in mind the lack of market players who are capable of acting as market makers – in other words, willing to quote firm market prices at any given moment. Therefore, in these cases, the debate about transpar-ency is very closely linked to improving liquidity conditions. And, though essential to the effi-cient functioning of the markets, increasing transparency, in the situation under consideration, includes not only adopting initiatives or incorporating trends related to making information available, in a consolidated and timely fashion, but also the overcoming of factors which, by limiting liquidity, prevent the proper incorporation of these changes


General overview For the purpose of analysis, international academic articles on the subject of liquidity and

transparency in the fixed-income markets may be grouped into two main blocks. The first re-lates to the discussion about transparency in those countries that exhibit liquid fixed-income segments, with a great variety of private debt securities and active secondary markets. In these cases, the main issues revolve around increasing the amount and the timeliness of the informa-tion available, which may take place through changes in the nature of trading – for example, the expansion of electronic platforms or the participation of retail investors – or adoption of objective measures aimed toward this purpose.

The second block looks at the debate in relation to the context of the emerging coun-tries, of Asia and Latin America, along with those in the process of joining the European Union or getting closer. In these cases, the expansion in the debt markets has not been accompanied by a comparable growth in the level of liquidity. Due to the fact that we are dealing here with illiquid markets, the international prescription is to analyze the macro-economic, structural and microstructure factors that explain this context, but basically the discussion is focused on the initiatives that are capable of changing the scenario. In these economies, therefore, the debate on transparency, though important, is linked to improv-ing the liquidity conditions – and taking into account the above-mentioned factors, we can observe significant differences between among the various countries that are considered to make up this block.

3intERnational maRkEt

figuRES and diScuSSionS

21International market - data and characteristics

Transparency in liquid fixed-income marketsThe fixed income markets present significant figures on the European continent and in the

USA, with over-the-counter trading being the predominant form. They exhibit ample liquidity and have registered increasing transaction volumes over the last few years. In the USA, there is a significant stock of corporate bonds, and the other segments of municipal bonds have a high weight. In Europe, government bonds and those issued by financial institutions are pre-dominant, but there are distinctions. In Italy, government debt exceeds the sum of the remain-ing segments. The investor base and the distribution of private issuers show a high degree of diversification. In the American market, there is growing participation by retail customers, while on the European continent there are differences (it is higher in Germany and Italy and very low indeed in the United Kingdom).

High liquidity, however, does not prevent one from observing aspects that are typical of fixed income securities, which explains the growing emphasis on transparency in recent ac-tions and recommendations. It is interesting to note that, contrary to what was expected at the start, the main initiatives aimed at increasing transparency – such as the introduction of record-ing and/or trading systems and the spread and consolidation of the disclosure of quoted prices and actual trading prices– have not had a negative impact on liquidity, and there has even been an inflow of new investors to the segment. However, up to the present moment, there have not been any changes to differentiated pricing structures and performance by specialized entities, which show to be more suitable to the fixed-income segment.

TABLE 2

Stock of Bond Debt in Selected Countries - In US$ billion/March 2006

Countries

Domestic Debt Bonds StockInternational Debt Bonds

Stock

Total Government Financial Institutions Corporations Total

Germany 1,998.1 1,091.2 774.6 132.3 2,302.6

France 2,008.5 1,127.5 641.8 239.3 1,039.8

Italy 2,283.6 1,398.6 634.6 250.4 759.4

United Kingdom 1,069.5 715.7 331.4 22.3 1,649.9

Netherlands 696.5 265.5 373.9 57.0 780.5

United States 21,168.0 6,101.2 12,335.5 2,731.3 3,695.7

All Countries 46,510.7 22,781.8 18,475.6 5,253.3 15,495.6Source: BIS Quartely Review, September 2006. Preparation: ANDIMA.


The American experience In the USA, federal debt bonds (treasuries) are offered at regular primary auctions and

traded in the secondary market by financial institutions and institutional investors through inter dealer brokers – specialized brokers which have been presenting a marked process of concentration. A recent report released by the Fed11 estimates that virtually the entire segment is controlled by four major brokers, with just two of them – ICAP and Cantor Fitzgerald –ac-counting for an 88% share of the market. The report also confirms the growth of the electronic systems in this trading and recognizes the clear advantages of the process. Over the last few years, practically all trading in so-called on-the-run securities, which have more liquid and homogenous maturities and which account for 70% of the volume of treasuries trading, has migrated to electronic platforms, with a significant reduction in transaction costs (90% in the decade) and spreads (over 75% in the last five years) and an increase in the market depth.

Trades that require specification of amounts or terms of settlement still benefit from the presence of the traditional dealer, backed up by voice systems that increase telephone trading, but out-perform platforms when it is a question of dealing with complex informa-tion, illiquid assets and non-standard instruments. In the off-the-run segment, as well as in

11 Fed Working Paper 2006-012B, Research Division – Bruce Mizrach and Christopher Neely “The Transition to Electronic Communications Network in the Secondary Treasury Market” – revised April 2006.

CHART 1

U.S. Treasury Bonds - Daily Volume x Outstanding Stock*

* Up to June. Source: TBMA - The Bond Market Association. Preparation: ANDIMA.

0,0

1,0

2,0

3,0

4,0

5,0

2000 2001 2002 2003 2004 2005 2006*

Stock(US$ trillion)

0

100

200

300

400

500

600

Volume (US$ billion)

Stock Volume

2�International market - data and characteristics

primary market trading (including prior to auctions12), although operations exhibit lower volumes, they are predominantly carried out by means of voice systems made available by brokers.

One of the report’s conclusions is that the introduction of electronic systems has fa-cilitated portfolio management and information consolidation in the more liquid on-the-run segment, attracting new investors, including of retail investors. On the other hand, the report confirms the high concentration of specialized institutions operating in this market. The major electronic trading platforms (or ECN – Electronic Communications Networks), Bro-kerTec and eSpeed, which account for 61% and 39%, respectively, of the on-the-run market are controlled by the same dealers that have the largest share of the off-the-run segment (ICAP and Cantor). These brokers also trade other fixed income market-related instruments, by means of voice or electronic systems.

The gradual, but intensive move, towards electronic trading in the most liquid treasur-ies segments had already been preceded by the recording and consolidation of informa-tion regarding the market prices of American government bonds, which was initiated by GovPX13.

12 Operations known as when-if-issued, in Brazil, they are equivalent to forward operation using a bond offer in auction.

13 GovPx was the first consolidated system for reporting debt bond prices in the USA. Result of demands by the SEC – Secu-rities and Exchange Commission and treasuries market dealers for greater transparency, the system was created in 1991 by an Inter dealer brokers group to provide real time information on prices and traded volumes of these securities. Information is made available over the internet and distributed by vendors. In January 2005, ICAP Plc acquired GovPX Inc., but the system keeps operating as a separate company.

CHART 2

U.S. Treasury Bond Holders

Source: TBMA - The Bond Market Association. Preparation: ANDIMA.

51,0%

17,3%

7,1%5,2% 4,0%

1,1% 2,5%

5,9%5,9%

Non-residentsand international

organisms

MonetaryAuthority

Pensionsfunds

Investmentfunds/trusts

Individuals State andmunicipal

governments

Insurancecompanies

Financialsinstitutions

Others


Expanding this experience, the SEC – Securities and Exchange Commission – and Nasd - National Association of Securities Dealers designed Trace – Trade Reporting and Compli-ance Engine, making it compulsory to record in this system each and every trade made on the over-the-counter market with corporate securities in the USA. The implementation of the system followed a cautious strategy to measure the impact of information availability on illiquid segments. Initially, only investment grade securities and trades over and above a certain given value had their prices and amounts reported in a timely fashion (in real time, in relation to executed trades). Other segments were organized in order of their re-spective liquidity, with increasing lags in relation to the availability of information. This process was begun in 2002 with the last group of securities shifting to real-time reporting14 in 2005.

Among the impacts of the implementation of Trace, we can mention the reduction in transaction costs – with no significant effects on liquidity -, resulting from the reporting in a consolidated environment, of executed prices, on a trade by trade basis, most of them in real time. According to initial estimates, in addition to benefiting both large and small investors, the transparency achieved provided the segment’s regulators with new tools. Not-withstanding this, the specific characteristics related to liquidity distribution in the segment were maintained, with only 5% out of the 29 thousand (corporate) security issues that are subject to recording in Trace being traded five times or more a day. Out of this total, 4,700 (or 16.2%) exhibit at least one trade a day, with less than half (46%) being traded at least once a month.

Two observations are further drawn from the first official system assessments. The first one concerns growing transparency ensured by information, without necessarily having changes to segment structure – forcing it, for example, to resemble the stock market. Ac-cording to the SEC, “transparency changes the market structure because it results in subse-quent market initiatives”. As far as investor education is concerned, the finding is that by adopting auxiliary electronic tools to traditional supervising can improve regulation, but it should not replace prudential regulation, such as protection from bankruptcy and reporting of information on issuers15.

14 For a more detailed description of the Trace experience, see Edwards, Amy extracted from BIS Paper No. 26/2005 – US SEC Corporate bond market microstructure and transparency – the US experience and the following Box.

15 See reference in the preceding note.


BOX 1

The Trace Experience – Trade Reporting and Compliance Engine • Compulsory recording and reporting system of prices used in trades executed in the over-the-counter market, involving US corporate securities, taking into account the exceptions. • Information is reported in real time to Nasd affiliated institutions and information providers and with a lag time of at least four hours to the general public. Retail investors have access to information on retail operations and with investment grade bonds, as well as to selected databases and other information with a lag time of at least 1/2 hour, on the Nasd website (www.nasd.com) or www.investinginbonds.com.

• Introduced in July 2002 by Nasd – National Association of Securities Dealers, at the request of the SEC - Securities Exchange Commission, it was implemented in phases: - Regarding to register within the system: it was originally 75 minutes, dropping to 45 minutes, then to 30, and is now at 15;- With regards securities subject to enforcement and the reporting deadline: the sample of securities whose operations must be informed was gradually being extended, starting with investment grade securities with issues exceeding US$ 1 billion (50% of total) and selected high yield securities and going on to encompass securities with different ratings, issue size and trading frequency; - Due to liquidity concerns, up to Feb. 2005, infrequently traded high value operations with low rating securities and reduced liquidity (trades over US$ 1 million with BB securities (or less) and BBB securi-ties (or less) in the period immediately after their issuance) were not informed, which went on to be reported with a decreasing time lag.

• Securities universe:- In the first year of their implementation (2002), prices for 500 securities were reported. In April 2003, this figure increased to 4,600 and then to 17,000 in October 2004; - In 2005 this total was to reach 29,000, corresponding to 99% of the universe of corporate securities traded in the USA.

• About current exceptions:- Operations with asset backed securities and commercial papers are not reported; trades backed by Rule 144-A (private placements for qualified investors – QIB Qualified Institutional Buyers) must be reported, but not disclosed;- After market trades with BBB rating (or less) securities and of a high value with less active high yield securities are reported with up to a ten day lag time. The traded amount is “truncated” at US$ 1 million (or more) for high yield securities and at US$ 5 million (or more) for investment grade securities.

• Main effects of the introduction of Trace based on studies (2003 through 2005):- Transaction cost reduction, both for institutional and retail investors, and in spreads;- High participation of retail investors in the number of performed operations in the segment*; - Greater information available to relevant Authorities of the segment; - Conclusions on impacts in liquidity provision of institutions operating in the segment are not defini-tive;- Gradual implementation:- There was no negative effect of transparency on executed trades, neither was there a negative ef-fect in segments with a low number of transactions; traded volume did not increase either; - a drop in spreads was also seen, to a lesser degree, relative to those securities of the segment not reported to Trace.

* 2003/2004 Trace data show that while the average operation size is 788 securities, the median is 32, in other words, most trades involve small batches [commoditized trade size]; reported inter dealer trades were less than one half of the records. In a study by the Bond Market Association for 2005 surveying the electronic trading system it was found that transactions of amounts below US$ 100 million accounted for 65% of performed total, though they corresponded to just 1.8 % of their value. Source: European Pricing Sources and Services – TBMA, April 2005, NASD; Edwards, Amy – SEC, 2006; CEPR (ICMA & Others) European Corporate Bond Markets – May 2006.


The debate in EuropeIn Europe, taking into account the differences between the various countries, Eurobonds, -

for regulatory and fiscal reasons, are listed on the Stock Exchange, but most operations are carried out by financial institutions (dealers) who trade directly with clients using elec-tronic platforms. Governments bonds also exhibit the same characteristics, with a high par-ticipation of electronic over-the-counter trading systems (70%) and of institutional clients (60%). With regard to the distribution trades, a survey conducted on a random day showed that, out of 40 thousand fixed-income securities which are registered with TRAX16, 85% were not traded and, out of 15% that registered trades, less than one half showed more than two trades17.

In this case, the focus on transparency has been strengthened with the debated on im-plementation, in the European Union, of a new guidance for the financial market: MiFiD18, predicted to become mandatory in April 2007. The measure sets a series of requirements oriented toward reporting prices on stock mar-kets, such as disclosing prior and ac-tual information on trades as timely as possible in relation to their proposition or execution, ensuring broad access conditions and data availability. In the guiding text, the European Commis-sion predicts that: at the discretion of the UE member State, such measures may be extended to fixed income mar-ket, which is already being studied in Italy and Germany, possibly for already anticipated reasons. Such possibility,

16 TRAX – Trade Matching and Reporting System. Initiative of ICMA – International Capital Markets Association, self-regula-tory European market entity, is a quote and operation recording system, used by several institutions in the United Kingdom and the European Union.

17 Extracted from FSA Discussion Paper No. 5/05 – Financial Services Authority: Trading Transparency in the UK Secondary Bond Markets, November 2005.

18 The EU Directive on Markets in Financial Instruments (NiFID) was published on April 20, 2004 by the European Com-mission.

TABLE 3

Distribution of Corporate Bond Trading in the European Market*

No. of Trades on a Random Day

No. of Traded Maturities in Frequency Interval

�00+ 1

300-399 2

200-299 �

100-199 �

50-99 2�

10-49 ��

4-9 1.197

2-3 1.713

1 1.891

Total maturities 5.273* TRAX database data, excluding domestic governmental securi-ties and related repo operations, and taking as basis a typical June 2005 day. Extracted from FSA – “Trading Transparency in the UK Secondary bond Markets”.

- Discussion Paper No. 05/5, page 16, September 2005.


however, has brought about detailed assessments on transparency conditions and liquidity in this market19.

The discussion in emerging economies Concurrently with the literature on transparency, and largely due to the examination of the

points in common in relation to the consolidated corporate securities market given in the report by IOSCO (International Organization of Securities Commissions), the debate spread beyond the European and US borders, reaching the emerging economies, whose liquidity conditions are, in general terms very different. The main points at issue are the considerable growth ob-served in the bond markets of these economies since 1990s and the fact that this expansion has not been accompanied by a comparable increase in liquidity.

Recent data published by the BIS20 (Bank for International Settlements) shows that do-mestic debt in the Asian economies has raised from 20% of GDP in 1997 to 40% in 2005. In Latin America, there was a marked trend towards replacing external debt by domestic debt denominated in local currency: in the continent’s seven largest economies, issues of non-fi-nancial public and corporate bonds in local currency, increased by 337% between the end of 1995 and 2005, rising to a total sum of US$ 899 billion, which is equal to 40% of the combined GDP of these countries. According to Knight (2006), bond issues of foreign debt by these same borrowers rose by a mere 65% during the same period, registering a figure of US$ 264 billion, which meant that funding in domestic currency became the predominant format in both the public as well as and private sector.

This change is due, among other factors, to the strong demand by global investors for debt issued by the emerging economies – which is not restricted to dollar denominated debt – and to the efforts made by the local authorities themselves to encourage this trend. Taking advantage of improvements in the macroeconomic fundamentals, a number of countries have begun to enjoy the benefits resulting from a consolidation of their domestic bond market. In the Asian case, this fact made it possible for governments to raise funds for the purpose of financing their deficits, and restructuring their financial systems, following the crisis that occurred in the late 1990s. In Latin America, this was helped by the decentralization of banking activity risks and

19 More recent studies can be found in the BMA Europe websites; FSA (original and recent versions), in the United Kingdom, and ICMA. See complete references in the Bibliography. Studies attest to the existence of high pre-trade transparency in the Eu-ropean market and the growing presence of electronic platforms (with emphasis on Euro NTS, in the government segment) and information disclosure systems, which, though decentralized, have been expanded.

20 References on Asian economies were extracted from Knight (2006), Promoting Liquidity in Domestic Bond Markets, and regarding the Latin American economies from Tovar and Jeaunneau (2006) Domestic Bond Markets in Latin America: achieve-ments and challenges. The analysis also used quotations that were common to both texts.


the formation of a cost of money curve for the various maturities. In both cases, this led to an increase in the number of instruments available for the carrying out of monetary policy and helped bring about a decrease in the level of FX exposure.

From the figures collected by the BIS, it is also possible to confirm that there has been a decrease in the correlation between the profitability levels of the bonds issued by these coun-tries, and between these and those of the developed countries’, showing that internal factors have been assuming a more important role in the formation of the interest rates practiced in these economies. Nevertheless, low liquidity in these markets represents an obstacle to the as-similation of the positive consequences resulting from this process. As has already been noted, since in illiquid markets one cannot ensure that the reorganization of the portfolios occurs at the lowest possible costs, investors tend to charge a premium for this gap, which increases the cost of funding for local governments and private agents.

Based on the characteristics which are utilized to assess liquidity – the depth, base and profile of investors, the spreads practiced and the size of the market -, virtually all indicators reflect the relative lack of liquidity in these countries. According to the BIS, while the annual turnover/stock ratio in the USA is close to 22, in Korea it is 15, in Indonesia 0.5, in Mexico 5, in Venezuela 0,4, and in Brazil about 2. The spreads between the purchase and selling prices vary from 3 to 5 basis points in Mexico and Colombia, 7 in Indonesia, and from 10 to 20 in Peru, while on average in the USA and Germany they stand at around 1.

In terms of common factors, it is also worth mentioning a narrow investor base and the prevalence of buy and hold type strategies among the most active agents – in Asia, for ex-ample, 50% of the debt is held by banks exhibiting this profile. On the supply side, the issue amounts and average trade values are also lower.

There are other factors that influence this scenario, and which in emerging countries may take on a greater importance than usual, generally related to market micro structure and to macroeconomic and institutional factors. With regard to these last items, Knight lists for the case of the Asian markets, the main conditions for a favorable handling of economic policy – including control of government spending, of the fiscal result and the tax system – as well as the monetary policy objectives, with a focus on factors such as the full convertibility of the local currency. Among the suggestions that could be adopted in order to achieve an expansion of liquidity in these markets, the following items are con-sidered; the consolidation of various types of government debts into a single debtor; the concentration of bond maturities, the encouraging of short selling operations– assuming short positions in the spot market; and using securities with high values as guarantees in loan operations, including repo operations.


Still based on the Asian experience, Knight exemplifies the weight of these factors in fund allocation in these economies: in a pan-Asian fund21, the distribution of the portfolio by assets, which, purely based on profitability, would consist for the most part of securities from the Ko-rean and Chinese markets, allocates relevant fractions to securities from the Hong Kong and Singapore markets, due to the better conditions in terms of liquidity, market opening, taxation and hedge, as well as the clearing and settlement structure (see graph).

The recent situation in Latin AmericaSpecifically with regard to Latin America, it should be noted that, though they exhibit very

distinct conditions, the local markets exhibit similarities, such as a history of macroeconomic instability, institutional or regulatory controls that are inadequate for the regular development of bond markets and the absence of any solid, diversified investor base. As described in Jean-neau and Tovar (2006), these factors led to debt structures that were concentrated in the short terms and/or dollar-pegged that went hand in hand with the subsequent financial crises that occurred in the 90s and at the start of the following decade.

The significant growth of the local currency bond markets in the last few years – which was also made possible by the stability of macroeconomic policy and the favorable foreign context -, was in addition to movements such as the strengthening of institutional investors, the reduction of foreign capital controls and the efforts made by the authorities to reduce the FX exposure of the debt – and, as a balancing item, an increase in the degree of predictability

21 Information extracted from the report of The Asian Bond Fund 2 initiative, a regional fund set up by 11 Monetary Authorities of the EMEAP – Executive Meeting of the East Asia and Pacific group 1 initiative, oriented toward investing in eight exclusive regio-nal markets and a diversified Pan-Asian portfolio, also consisting of local currency securities of eight countries, in conjunction.

CHART �

Market Weights for the Pan-Asian Securities Fund

* They refer to four factors making up the “market opening” concept: capital controls, taxing at the source, hedge instruments and clearing and settlement structure. ** Consisting of Indonesia, Malaysia, the Philippines and Thailand.Extracted from: Knight, Malcolm “Promoting Liquidity in Domestic Bond Markets – BIS, May 2006.

Considering market profitability only

Korea China

SingaporeOthers**

Hong Kong

Considering market-related factors*

KoreaChina

Hong Kong

SingaporeOthers**

Considering market profitability only

Korea China

SingaporeOthers**

Hong Kong

Considering market-related factors*

KoreaChina

Hong Kong

SingaporeOthers**

�0 OTC fixed income market in Brazil

and transparency associated with its management. However, the profiles of the debt and low liquidity of their secondary markets still represents an obstacle to the consolidation of this seg-ment on the continent. Among the most significant characteristics in relation to the bloc’s bond markets that were pointed out (see box), are the differences between the countries: Brazil is an exception in terms of the size of its market and in relation to its derivatives market, where it exhibits differences to the other countries, followed by Mexico, but it shows much lower liquidity indices in its secondary market, with the result that its turnover/stock ratio, is lower than that registered by economies whose market debt is smaller, in absolute terms.

Also in relation to the recent processes in Latin America, factors were identified that tend to contribute to a continuation of the advances observed so far, such as the growing integration

BOX 2

Main Recent Features of Latin American Bond Markets1 Domestic debt markets vary widely in size

- Brazil has the largest stock in absolute terms and in GDP percentage.- Mexico holds second place in absolute values, but Argentina, Chile and Colombia have better positions in GDP %.

2 Public sector issuers dominate domestic securities markets- Corporate markets are less developed (they reach 40-50% of the government securities market in Chile and Peru)- An expansion of securitization in the region is being experienced.

� Short-term, floating rate and inflation-indexed securities continue to account for the largest share of the stock of domestic government securities- A change in the profile of the government is apparent, with a drop in the share of securities indexed to foreign exchange, with the exception of Argentina and Venezuela.- Fixed rate securities have increased in several countries.

� Gradual increase in the maturity of government debt in local currency- The lengthening of the terms of fixed rate security issuances, also relying on local currency issuing overseas. - Securities with longer-term have been contributing to a better use of the forward interest rate structure.

� Secondary market trading in domestic bonds has expanded in recent years, but it re-mains low relative to more mature markets - Indicators vary among countries: annual volume is five times the stock in Mexico, and re-mains below the unit in other cases, on average it is equivalent to 1.6*.- Low liquidity affects market efficiency: spreads are higher comparatively to USA, Europe and Asia markets.

� No actively traded derivative contracts on government bond benchmarks- Operations with short-term interest rate agreements and swaps are have been rapidly devel-oping in some countries. - They have contributed to the increase in the volume of trading on the stock exchange.

* In Brazil, considering only extra-group operations with government bonds (and excluding repo operations) the traded volume/turnover ratio in 2005 was 2.024 (Source: ANDIMA). Source: Jeanneau, Serge & Tovar, Camilo E. – Domestic Bond Markets in Latin America: achievements and challenges, NIS Quarterly Review, June 2006. Prepared by: ANDIMA.

�1International market - data and characteristics

of markets, the introduction of electronic trading processes and the lower correlation of the return on investments vis-à-vis the more developed economies, in addition to a healthy port-folio diversification process. However, analysis carried out by BIS, notes that notwithstanding despite these advances and the undeniable reduction in foreign vulnerability that has recently been achieved, there are still limitations to be overcome. The most significant ones are the high refinancing risk, which is still associated by domestic investors with securities that do not fit into a short-term public floating rate profile, making it harder to consolidate private debt markets, together with the previously mentioned restricted liquidity conditions and expansion of the investor base.

Therefore regarding the inclusion of the Brazilian fixed-income market into the recent debate over the change in the debt markets, it is not enough to simply look for factors that help increase its transparency, particularly in relation to the possibilities for transformation that arise in relation to trades carried out in the over the counter market. It is also necessary to iden-tify determining factors and actions that alter their liquidity conditions. In addition to making it harder to increase transparency, for macroeconomic and institutional reasons, restricted li-quidity in emerging markets requires the authorities and market players to take action so that it does not become a restricting factor on the expansion cycles of these markets.


Main characteristics Domestic federal public debt bonds are the predominant asset in the Brazilian fixed-income

market. Totaling R$ 1 trillion (which is equal to US$ 545 billion), the country’s stock of public debt is three times greater than the total amount in Mexico and more than four times the size of the combined debts of Argentina, Chile and Colombia. For purposes of comparison in the do-mestic market, the main non-bank private debt security stock – debentures – currently stands at a figure of R$ 95 billion, or one tenth of public debt, while the main instruments issued by the banks, such as CDBs and DIs show figures of R$ 330 billion and R$ 189 bil-lion, respectively.

As is the case in other emerging economies, the level of liquidity in the Bra-zilian secondary fixed-income market is sharply reduced. The volume of trading in the public debt segment came to

4domEStic maRkEt: hiStoRy, configuRation and figuRES;

REgulation and SElf-REgulation

CHART �

Composition of the Brazilian Financial Market R$ billion - June/2006

Sources: Brazilian Central Bank, BM&F, Bovespa and CETIP. Preparation: ANDIMA.

Corporate Securities

R$ 1113%

FinancialInstruments

R$ 53212%

FederalPublicBonds

R$ 1.01623%

EquitiesR$ 1.284

29%

DerivativesR$ 1.413

33%

��Domestic market: history, conformation and data; regulation and self-regulation

a total of R$ 40 trillion in 2005, with repo operations accounting for 91% of this amount. In yearly terms, the turnover in extra-group delivery operations is equal to twice the outstanding stock –, and therefore lower than the, figures observed in developed economies and a number of emerging countries. Nevertheless, in relative terms, government debt is the most liquid seg-ment, while debentures exhibit a volume of trading corresponding to 0.23 of the market total.

Despite the significant recent advances made, macroeconomic history is the most impor-tant factor in the formation of the highly concentrated, short-term profile of the debt market. A significant portion of the outstanding public debt is still composed of very short-term SELIC Rate-pegged securities (LFT) and is obtained based on the average rates of one-day repo oper-ations carried out executed between financial institutions. The high profitability and extremely low risk of these bonds reduces the attractiveness of fixed rate or inflation linked bonds and encourages hedging strategies aimed at reproducing these conditions in future settlement mar-kets. The significant share of total public debt that LFTs (Treasury Financial Bills) account for, as well as the high percentage (over 80%) of DI Rate-adjusted debentures are the other side of the high demand for investments in so-called DI funds, at the expense of options that combine a higher profitability with a certain degree of risk. Other institutional factors – mainly taxa-tion-related ones– help produce a reduced mobility between investment options, strengthening investor performance by means of buy and hold type strategies.

Regarding the microstructure factors that affect the liquidity and transparency of the sec-ondary fixed-income market, the particularly favorable conditions provided by the existing settlement and custody structure, together with the sophistication of the derivatives market, will be explained in detail further ahead.

TABLE 4

Fixed-Income Market - R$ million

YearCorporate Securities IF Securities/Financ. Inst. DPMF

Bonds Total In GDP %**Debentures Others Total CDB DI Others Total

2000 26,333 6,492 32,825 44,797 47,399 14,212 106,408 510,698 649,931 59.0

2001 37,892 3,405 41,297 62,945 43,950 11,878 118,773 624,084 784,154 65.4

2002 46,149 6,752 52,901 83,858 55,821 10,709 150,388 623,190 826,479 61.4

200� 42,744 4,173 46,917 154,865 74,065 12,162 241,092 731,426 1,019,435 65.5

200� 44,109 7,040 51,149 129,256 108,232 12,558 250,046 810,264 1,111,460 62.9

200� 85,007 14,966 99,973 286,529 177,002 9,735 473,265 979,662 1,552,901 80.1

200�* 95,277 15,485 110,762 334,530 189,533 7,985 532.048 1,016,100 1,658,910 82.6

In GDP % 4.7 0.8 5.5 16.7 9.4 0.4 26.5 50.6 82.6

% Particip. 5,7 0,9 6,7 20,2 11,4 0,5 32,1 61,3 100,0

* Position in June 2006. ** GDP of last 12 months (Sources: Note to Fiscal Political Press/BC).Sources: Central Bank and CETIP. Preparation: ANDIMA.

�� OTC fixed income market in Brazil

On the other hand, markets such as the securities lending one and spot market strategies such as short operations are still very much at the early stages in the fixed-income segment, though they exhibit a significant growth in stocks. With regard to the investor base, the main holders of public debt and debentures are the investment funds and the banks’ own portfolios (see graph on the next page).

In the case of investment funds, which carry roughly 50% of the stock, the substantial demand for DI-referenced portfolios favors the acquisition of securities that exhibit this profile – LFT (on a greater scale) or debentures, -, or even the search for hedge, in very liquid future settlement markets, in order to match fixed rate asset profitability to this spe-cific rate. It should be observed that the prevailing management strategy in these funds’ portfolios is fully compatible with the acquisition of securities held to maturity, which offer little risk, and, therefore, hardly make any contribution whatsoever to the liquidity of the secondary market.

TABLE 5

Characteristics of Main Fixed-Income Bonds and Securities

Assets Remuneration CharacteristicsAverage

Term(months)

Stock in % of GDP*

Federal Public Bonds

Compounded rates for 252 b.d.

29.22** 50.6**

LTN Fixed Rate No strip 9.37 15.1

NTN-F Fixed Rate With half-yearly strip 36.94 0.8

LFT SELIC Rate (floating) No strip 19.60 21.4

NTN-B IPCA Price Index With half-yearly strip 57.47 7.1

NTN-C IGP-M Price Index With half-yearly strip 78.51 3.2

NTN-D Exchange Rate Linear rates for 360 w.d.with half-yearly strip

9.24 0.2

CDB DI Rate (90%)Fixed Rate (6%),

TJLP, TR and IGP-M

May foresee advance redemption; repurchase; different remuneration

according to term

NA 16.7

Debentures DI Rate (88%), Price Index (9%), Exchange Rate (2%) and TJLP

May foresee periodic interest payments, amortizations,

repricing

9.75 years 4.7

* Position in June 2006. ** GDP of last 12 months (Sources: Note to Fiscal Press/BC). ** Refer to total federal public bonds and not only to bonds listed in the table. Sources: Central Bank, CETIP and SND. Preparation: ANDIMA.


Brief historyAs observed, the secondary fixed-income market in Brazil shows a low trading volume,

including as far as public bonds are concerned, which are generally characterized by a sub-stantial degree of liquidity and function as benchmarks for private sector operations. Nor do these bonds represent a significant portion of the fixed-income debt universe, which is directly reflected in the liquidity of the secondary market. Inflationary memory and the history of fis-cal policy leniency are partly responsible for this configuration. LFTs, with a reduced level of market risk, were created in a context where indexed currency protected a number of the market players who had access to the financial markets.

The prolonged co-existence with high levels of inflation also gave rise to specific charac-teristics in this segment: the registration and settlement systems were structured in such a way as to promote short settlement cycles (d0 or d+1) and enable the recording of the strategies that had already been adopted in the market, such as repurchase and resale, forward and inter-mediation operations. The registration of operations executed in the over the counter market by institutions’ own portfolios and by institutional investors has been mandatory for more than a decade, along with the individualization of these agents’ custody accounts in depositories. Also for reasons related to the indexation structure, the futures markets became sophisticated, and a diversified composition of hedge contracts for use with debt bonds, although with a sig-nificant wide advantage for floating rate ones.

After more than ten years of price stabilization, it would be logical to assume that in-vestors would feel more attracted to securities, whose market risk could guarantee a better

CHART �

Main Holders of Federal Government Bond Debt* **

* Position in August 2006. ** Interest in Closed Private Pension Entities: 15.32%, being 11.46% through investment funds and 3.86% in Non-Financial Legal Entity according to Pension Funds Secretariat estimate. Source: Brazilian Central Bank. Prepara-tion: ANDIMA.

49,7%

31,7%

11,1%6,4%

1,1%

Investment Funds Banks Portfolio Bonds andMandatory Deposits

Individual + Non-financialLegal Entity

Others


perception of the risk/return ratio. However, the recent monetary stabilization has not been accompanied by a marked reduction in the volatility of the economy’s basic prices – interest rates and FX rates -, which operated alternatively, at different times, as the anchors of the process, which led to shocks in these two variables during the period. This characteristic kept investors risk-averse, preventing the allocation of funds in longer term securities. On top of this there is the fact that Brazil’s yield curve has exhibited a continuous downward slope for prolonged periods.

Apart from the problems in relation to the handling of monetary policy, which resulted in the overexposure of issuers to market risk, it is also worth highlighting the narrow investor base as a factor restricting the volume of trading on the secondary market. The fiscal discour-agement of timely changes strategies in positions drove away a significant percentage of the potential creditors who, for individual motivations and expertise, might distribute the percep-tion of risk and reduce the asymmetry of information in price-setting. Examples of this were the obstacles to the entry of foreign investors in the fixed-income segment and the excessive taxation on financial transactions, in addition to other significant institutional factors.

Over the course of the last few years, the administrations of public debt and monetary policy have been converging upon international standards. The reduction of the public sector deficit, the concentration of maturity, with the decrease in the number of issues that compete with one another, the drastic drop in the level of dollar-denominated debt, and construction of a fixed rate interest curve indexed to the IPCA – Extended Consumer Price Index have

CHART �

Average Daily Volume* x Stock of Federal Public Debt

* Considering only extra-group for delivery operations. Source: Demab/BC. Preparation: ANDIMA.

-

0,10

0,20

0,30

0,40

0,500,60

0,70

0,80

0,90

1,00

2003 2004 2005 2006*

Stock (R$ trillion)

-

1,00

2,00

3,00

4,00

5,00

6,00

7,00

8,00

9,00

Volume (R$ billion)

Stock

Average DailyTraded Volume


leveraged secondary operations in public bonds, widening the degree of market information regarding inflationary lack of control risks and interest rate flow path. This initial movement is already being felt in trading records and in the stock composition.

CHART �

Maturity Structure of Outstanding Government Bonds

Source: Brazilian Central Bank. Preparation: ANDIMA.

-

0,20

0,40

0,60

0,80

1,00

1,20

Dec 99

Jun 00

Dec 00

Jun 01

Dec 01

Jun 02

Dec 02

Jun 03

Dec 03

Jun 04

Dec 04

Jun 05

Dec 05

Jun 06

R$ trillion

Up to 1 year All Other Maturities

CHART �

Composition of the Federal Public Bond Debt by Type of Profitability

Source: Brazilian Central Bank. Preparation: ANDIMA.

-

0,20

0,40

0,60

0,80

1,00

1,20

Dez99

Jun00

Dez00

Jun01

Dez01

Jun02

Dez02

Jun03

Dez03

Jun04

Dez04

Jun05

Dez05

Jun06

R$ trillion

SELIC Rate(floating)

Foreign Exchange All Other


The first measures designed to promote liquidityAs has been stated in the international literature, the consolidation of local currency bond

markets is not an overnight process, especially in emerging countries, where cultural issues and periods of turbulence generate backward steps and uncertainties about its materialization. In Brazil, the adoption of the inflation target system and complying with fiscal surplus targets have certainly increased the perception among market players of stability and transparency in relation to the use of monetary policy instruments.

The adoption of measures specifically directed towards the expansion of liquidity in the bond market is, therefore, relatively recent and, as mentioned, has been marked by periods of advances and retreats, in accordance with the volatility of the domestic economy and the reaction of the local market to foreign crises. The first measures formally announced by the National Treasury in connection with this topic date back to late 1999. They were assembled in a package of 21 measures, products and projects which ranged all the way from basic points covered treated in the international prescription – such as the concentration of bond maturi-ties and the increase in the amount of information made available by market entities and the issuer – up to specific determining factors related to the imperfections that were present at that time in the Brazilian experience, such as the absence of forward operation registration and the reduced leverage limit of institutions.

BOX 3

Follow-up of the 21 Measures Proposed by the National Treasury/Brazilian Central Bank in 1999 in order to

Expand Primary and Secondary Public Dept Market Liquidity Measures/Products/Projects Remarks

Implemented

1. A reduction in the number of outstanding public bond maturities, greater concentration of matu-rity of securities with fixed rate profitability and a reduction in public bid frequency.

The number of maturities was reduced from 260 in late 1999 to 99 in August 2006. LTNs present maturities concentrated in the beginning of each quarter (Jan, Apr. Jul, Oct), semes-ter or year. Regular security auctions were organized weekly by type of auction and offered security, but formal offers still exist in high numbers and several modalities.

2. Prior disclosure, by the NT, of security issuing schedules to be placed by public auctions.

Monthly, the National Treasury reports the month’s security issuing schedule through a Treasury Communication.

3. The National Treasury holds regular, predefined public bond purchasing auctions.

These have been held with relative regularity since Nov/99 (with exception of the period of Mar/01 to Sep/03). The Treasury holds LTN purchasing auctions periodically, in gen-eral aimed at decentralizing maturation in order to reduce financing risks, through public offers. NTN-F (public offers) and NTN-B (dealers only) purchasing auctions are also held in order to increase the liquidity of these bonds.

To be continued


Follow-up of 21 Measures Proposed by the National Treasury/Brazilian Central Bank in 1999 in order to

Expand Primary and Secondary Public Dept Market Liquidity4. Daily report by ANDIMA of outstanding fixed rate and exchange rate bonds.

ANDIMA started reporting indicative prices for these securi-ties and LFT in 2000, subsequently expanding the sample to inflation pegged bonds, hedged LTN and NTN-F.

5. Development of a system to register at SELIC forward operations with government bonds.

This was implemented in the SELIC system in Feb/2000 (Comm. No. 7282). Current Regulation is given by Circular Letter No. 3159/05.

6. The leveraging limit on operations with govern-ment bonds made flexible.

This was implemented with two significant reformulations in repo operation’s legislation, occurred in 2002 (Res. No. 2950) and 2006 (Res. No. 3339).

7. Alteration in the selection process of the Central Bank dealers in order to boost their capability of being market makers.

Several alterations were made to this regulation in order to strengthen: rights and obligations of these agents in the open market; diffusion provided by their performance and their participation in primary and for delivery operations. The function of specialist dealer and the possibility of non-bank-ing institutions participating in the group were also created (See Regulatory Act-Set No. 7 and 8/06).

8. Periodic Central Bank and National Treasury meetings with dealers, rating agencies, end custo-mers and class associations.

The Authorities have been promoting regular meetings with several representative groups of the segments of the finan-cial market, including videoconferencing.

9. Periodic release of a Note to the Press, contain-ing information and comments about the govern-ment bond market and liquidity conditions.

The Open Market Report was created in November 1999 and has been published on a monthly basis since then.

In implementation/partial implementation

10. Allowing separate trading of the principal and of the strips of exchange securities with term under 5 years.

This was regulated and made operable within the system, even for other securities not pegged to foreign exchange. The functionality, however, has not been used by the market.

11. The launch of securities at SELIC, with D+1 settlement.

This never got implemented, mainly due to the restructuring of the SPB (Brazilian Payment System), which changed the concept of the SELIC system to RTGS, but a when-if-issued settlement modality was created in this System.

12. Stimulation to increase transparency in trading government bonds on the secondary market, by, for example, using electronic systems.

Two electronic platforms were structured that allow for the quoting and trading of securities registered in the SELIC system (Sisbex and CetipNet) and several measures were adopted in order to increase the reporting of information on these trades (see text referring to the recent period).

13. Facilities for financial institutions to short posi-tions.

The possibility of assuming short positions is provided for in current legislation of repo operations (Res. No. 3339, article 4), since 2005, Operations, however, are seldom performed.

14.Fixed rate bond go-arounds with reverse repo for dealer institutions to cover short positions.

The Central Bank has been performing go-arounds of fixed rate securities with 3 to 5 month terms, in the form of sale and repurchase with free movement. It has also regulated combined operations performed on a daily basis in order to ensure liquidity in securities to institutions in short positions (see Appendix II for legal basis), but they are not demanded given the reduced number of short operations. The modality was recently extended to NTN-B.

To be continued

Continued


Follow-up of 21 Measures Proposed by the National Treasury/Brazilian Central Bank in 1999 in order to

Expand Primary and Secondary Public Dept Market Liquidity15. Purchase and final sale of short securities in supplementation to Banking Reserve go-arounds performed by the Central Bank.

The Central Bank seldom uses for delivery operations to level off liquidity, but began performing long repo operations (from 3 to 5 months) with fixed rate and free movement securities, with this objective. Since the instrument (repo) is different, objectives to reduce cash cost predictability and increase liquidity and secondary market depth are not being fully met.

16. Periodically holding of public bond purchase and sale go-arounds.

The Treasury hold security purchase and sale auctions for the decentralization of maturities and the increase in bond liquidity (see item 4). The holding of these events by the Central Bank, through for delivery operations in order to regularize prices or to alter the composition of outstanding securities, is, however, very rare (see item 16).

Implemented, but not continued

17. Public long-term bond auctions, with fixed rates of profitability, after receiving a request from financial institutions containing a firm buy proposal.

The firm bid auctions were held during the period from Janu-ary 2000 to December 2003.

Not implemented

18. Issuance of long securities with pre-fixed profit-ability and simultaneous competitive put option.

There has been a lot of discussion about the advantages and risks involved in using securities with a put clause by the Treasury. With the advances in improving the debt pro-file, exchange auctions and swap operations, the Treasury has enhanced the available instruments and this alternative was never implemented.

19. Incentive for the stock exchanges to create a derivative market for put options issued by Central Bank.

It lost its purpose as from the lack of put issuances.

20. Creation of zero coupon bond. Possibilities for defining the value of coupons upon issuance (Res. No. 2673/99 and Dec. No. 3540/00) and of exchange security strips (Comm. No. 7744/00) have been regulated but never used, since the Authority opted for holding inten-sive swaps and, subsequently, with the significant reduction in the amount of exchange securities on the market.

21. Overnight rate oscillation around the target for SELIC Rate.

In practice, oscillations are limited and the need for the Central Bank to be active in levelling liquidity practically eliminates significant variations to the SELIC Rate.

Sources: National Treasury and Brazilian Central Bank. Prepared by: ANDIMA.

Continued

The adoption of measures has moved forwards, with improvements in the availability of benchmarks and in the information utilized in the secondary market. In 2000, the Central Bank standardized expression of the interest rate, in an attempt to unify criteria for securities refer-enced in local currency, differentiating them from those adopted for securities indexed by the FX variation, which began to utilize linear rates calculated for 360 calendar days, in line with

�1Domestic market: history, conformation and data; regulation and self-regulation

the international standard. In the case of securities denominated in domestic currency (Real), compounded interest rates and the 252-business day period have been maintained, but the values switched to being expressed in percentages per year (instead of monthly or even daily rates). Additionally, the calculation criteria for updating the face values of securities has been consolidated into a single methodology.

The discontinuation of the strategy for managing the public debt imposed by shocks in the economy became obvious in 2002. The adoption of international mark-to-market accounting criteria and the restructuring of the Brazilian Payments System restructuring – projects that were relevant to the bond market – were implemented in a context of high volatility in terms of eco-nomic variables, as a result of the closeness to the election period and the resulting increase in the level of Brazil’s country-risk. The marking to market of securities belonging to institutional investors’ portfolios reflected the pronounced oscillations in prices that occurred during the pe-riod, which came on top of an already perceptible rejection of bonds maturing after the election. This process generated sharp drops in the asset values of these portfolios, resulting, for the first time, in accounting losses in the segment’s main investment modality: fixed-income funds.

The so-called “LFT crisis” is a good example in that it relates to the relative weight of the economic variables and the risk-aversion in the country: between April and December 2002, fixed rate securities’ percentage share of the debt dropped from 9.8% to 2.2%. The Treasury once again began to offer LFTs, acted in various ways in the sense of offering shorter term securities in exchange for long-term ones and began to offer the market hedge by means of security placement operations matched to FX swaps. The expansion of liquidity that characterized the implementa-tion period of new settlement systems, with real time operation, increased the undersold position resulting from redemptions and the shortening of bond lengths, necessitating the development of new forms of operation by the Monetary Authority in order to balance the System’s liquidity.

The process became smoother at the year end, and the implementation of the new pay-ments system proved to be less traumatic to liquidity and highly advantageous for the SFN’s (Brazilian Financial System) clearing and settlement structure. Initiatives in the mark-to-mar-ket process – including those contained in the Treasury’s proposal, which included ANDIMA’s pricing project –made a significant impact on the segment’s transparency, with the consolida-tion and disclosure of reference prices which were previously separately limited to each insti-tution or to the average prices generated by registration systems operating in the segment.

Recent initiatives and advancesThe recent period was marked by the coming to maturity of the first measures directed

towards expanding liquidity in the securities market and of a series of new initiatives ad-


opted in an environment of stability in terms of the monetary and fiscal policies, of inflation’s convergence upon the respective targets and of particularly favorable results in terms of the foreign accounts. In this context, in addition to the serious study of deepening microstructure measures, targets related to improving the profile of the public debt and reducing FX exposure were adopted, and these have proven to be particularly successful. On top of these steps of an institutional nature – mainly in the tax field – there were also others aimed at lengthening investment terms and expanding the segment’s investor base.

BOX 4

Recent Measures Oriented Toward Liquidity and Transparency - By NatureNature Measure-Event Purpose

Macroeconomic:

Domestic debt manage-ment

The treasury stopped placing exchange securities (2002); intensified LTN and NTN-B placement and reduced LFTs, which had not occurred between the months of Febru-ary to June 2006

Profile improvement and reduction of exchange exposure

LFT offers were reduced in volume and assi-duity. The 2006 PAF (Financing Annual Plan) has contemplated a drop in its share of over 10 percentage points over the debt total

Profile improvement and liquidity increase

Foreign debt management Swap, buyback operations and Brady Bonds cancellation and security issuing (even in reais) overseas.

Sovereign risk improvement and reduction of exchange exposure

Monetary Policy Interest rate reduction Profile improvement and term stretching

Monetary policy Credit market recovery with private security market strengthening and structuring of securitization operations.

Issuer and investor base diversifica-tion, liquidity increase

Institutional:

Taxation

Creation of the Investment Account, with CPMF (Provisional Contribution on Finan-cial Movement) being levied only on invest-ment applications or redemptions (2004)

Term lengthening

Income Tax Rates on fixed income start to be decreasing according to the investment term of each product of the segment

Term lengthening

Income Tax exemption for foreign investors buying federal public bonds

Investor base increase and term lengthening

Other

Simplification of available investment mo-dalities for non-residents (Res. No. 2689)


Term reduction for CPF (Brazilian Individu-al Taxpayer Registry) issuing for foreigners


To be continued


The culmination of these measures was the PAF – Annual Financing Plan for 2006, which was disclosed by the National Treasury. This plan’s targets contain indicative intervals regard-ing the percentage shares in the debt of the various types of securities, in addition to average terms and composition of the debt stock for the period. As in previous years, the Treasury is working with the objective of achieving a reduction of the percentage of debt represented by LFTs – Treasury Financial Bills pegged to the SELIC Rate (to a figure of below 50% of the debt) –. Inflation linked and fixed rate bonds take on a greater importance, with it being fore-seen that there will be a lengthening in the average term of their maturities in all cases. As for FX indexed debt, with the decrease in the percentage of the total stock of debt represented by these securities to a figure of between 3% and 4%, and taking into consideration swap posi-tions, the Central Bank and the Treasury, in conjunction, began to exhibit an active position in foreign exchange, thus reducing Brazil’s exposure to external shocks and improving the indebtedness profile even in situations of a deterioration in the international scenario.

The market’s current configuration The stability achieved on the macroeconomic front and the advances made in relation to the

debt profile have given rise to a scenario that is particularly favorable for the adoption of practices

Recent Measures Oriented Toward Liquidity and Transparency - By NatureMicrostructure:

Security loan The Central Bank included NTN-B among those securities that may be traded in com-bined operations and the CMN (National Monetary Council) authorized the perform-ance of loan operations and fixed-income security swaps.

Liquidity increase

Creation of referential alternatives

ANDIMA started reporting the family of IMA indices, referential alternatives to DI (Inter-banking Deposit) oriented toward portfolios consisting of government securities.

Term stretching

Pricing ANDIMA started pricing a representative debenture sample on a daily basis

An increase in transparency

Electronic systems Start of operation of CetipNet (April/2002) and Sisbex (May/2004)

An increase in liquidity and transpar-ency

Direct Treasury Program for the access of individuals to government debt bond buy and buyback over the Internet

An increase in investor base and transparency

1999 measures deepening (see previous box)

New upgrades in rules in force for repo, short operations, dealing rules, performing in the primary market and forward opera-tions by Central Bank and the increase of information on operations and events under the responsibility of the Treasury.

An increase in liquidity and transpar-ency

Prepared by: ANDIMA.

Continued


and tools that are typical in the case of a market where both liquidity and transparency show a po-tential for expansion. Two basic trends seem to have assumed a greater importance in this process up to the present moment: the growth in the relative share of fixed rate and inflation linked securi-ties in the make-up of the government’s bond debt and the growth in the stock of private securities, including expanding segments such as those of credit securities and receivables.

In the first case, the LTNs (National Treasury Bills) and NTN-Bs (National Treasury Notes - Series B), in addition to helping increase the debt’s duration22, by comparison with the LFTs, are much more liquid assets. Recent figures showing the distribution of trades by assets show that these securities (LTN and NTN-B) add a greater volume to the secondary bond market, in relative terms – in other words, ignoring the fact that the number of maturities of LFTs is still much greater than those exhibited by the former categories. Also, as far as spreads are

22 By considering LFT duration as close to zero, according to the Fiscal Policy Note, taking into account their high elasticity to short-term interest rate change.

CHART �

Stock and Traded Volume/Stock by Type of Bond

* Only for delivery extra-group operations considered. Source: Demab/BC. Preparation: ANDIMA.

Traded Volume*/Stock Ratio

-

1,00

2,00

3,00

4,00

5,00

6,00

LFT LTN NTN-B

Stock by Security (in R$ billion)

0

100

200

300

400

500

600

LFT LTN NTN-B

20051st semester 2006

20051st semester 2006

TABLE 6

Distribution of Trading in Federal Public Bond Debt - July/2006No. of Trades in One Month

No. of Traded Maturities in a Frequency Interval

No. of Traded Maturities

% Accum. %LFT LTN NTN-B�00+ � 1 2 1 � �

200-299 � 2 1 1 � 1�100-199 � � 2 1 1� ��

50-99 11 � 2 1 22 ��30-49 � - 1 2 � �210-29 � � - 2 1� ��

4-9 � � - 1 10 ��1-3 � 2 - - 12 100

Total traded maturities in the month �0 2� � �

Fonte: Brazilian Central Bank. Preparation: ANDIMA.


concerned, recent surveys of indicative bid/ask spreads have been showing a narrowing in the average value, as trades involving more liquid securities grow.

At a slower pace than that of the change in composition, this process has also been favoring the lengthening of terms, a fact which, coupled with the better macroeconomic conditions and the advances made on the pricing front, has allowed optimization of the slope enhancing inclina-tion and an increase in the number of the vortices of the economy’s yield curves vertexes. As a result of this there has been an increase in, the quantity and the quality of information obtained from the forward structure of nominal interest rates. The construction of a longer fixed rate yield curve has fueled the debate regarding the extraction of the implied inflation imbedded in the for-ward interest rate structure of inflation linked securities with payment of intermediate interest23.

With regard to the private securities market, the diversity of assets and issuers, as well as the increase in the number of issues (the stock, in the case of debentures, has increased by 151.5% since 2005), may become a key factor to the expansion of liquidity in the segment. In relation to the representative assets of receivables securitization operations, for example, the possibility of structuring portfolios with higher profitability and discriminated risks has led to a rapid growth in FIDCs – Credit Rights Investment Funds, with the value of quota offers ris-ing to R$ 15.3 billion over the past two years24.

23 The offset calculation for inflation imbedded in fixed rate interest rates is procedure performed in several countries where the government bond market records high liquidity and the yield curve is sufficiently long to extract important information on monetary policy conduction.

24 For a detailed description about the FIDC – Credit Rights Investment Funds, see the special study FIDC Funding Products, published in 2006 by ANDIMA, in partnership with CETIP.

CHART 10

Terms of Fixed Rate Government Bond Debt

Up to September 2006. Source: Brazilian Central Bank and National Treasury. Preparation: ANDIMA.

0

5

10

15

20

2001 2002 2003 2004 2005 2006

Years

Issuance term in Reais overseas (Global Bonds)Maximum issuance term in Reais in BrazilMinimum Issuance term in Reais in Brazil


This expansion, which has been important for the consolidation of the bond market as a whole as well as to the creation of dif-ferentiated risk structures, has gone hand in hand with the increased demand for diversification in the portfolios of institutional investors, who have al-ready caught a glimpse of the opportunity in a lower interest rate scenario to increase the percentage of private risk (and profit-ability) in the composition of their portfolios25.

Trading in the secondary marketWith regard to the configuration, the over-the-counter market is the prevalent format for

trades executed in the fixed-income segment, with a number of specific characteristics. Trans-actions involving government bonds and debentures, are for the most part executed by tele-phone and recorded in the segment’s registration and settlement systems26.

In the case of government bonds, trades are executed by financial institutions and insti-tutional investors, predominantly investment and pension funds, either using brokers or not. The level of broker activity in the segment remains significant, though the brokers and dealers who perform this function have been going through a noticeable concentration process over the last few years. Operations may be carried out over the telephone or by voice systems – the so-called daily calls, which were recently launched in the segment by more active brokers.

25 This process may suffer a significant revision, if the new investment fund regulation proposal is approved, which foresees res-triction to private securities in typically retail fund portfolio composition. See, about it, CVM Public Hearing Notice No. 3/06.

26 A detailed scheme of depositors and trading, clearing and settlement systems, by asset and trading environment can be found in Appendix I.

GRáFICO 11

Forward Interest Rate Structure*

* By considering LTN maturities on respective dates. Source and preparation: ANDIMA.

On 2/1/2001

15

15,5

16

16,5

17

17,5

1 21 40 66 85 110 130 151 196 239 263 384

Rate (% p.a.)/252

On 15/9/2006

13,5

13,75

14

14,25

10 71 133 195 260 321 383 445 575

Rate (% p.a.)/252


Trading via electronic platforms, although still at a low level, is more significant on Sis-bex, an environment where a collateral deposit is required and where the direct participants are banks and brokers. A second alternative, CetipNet, which is also available for private securi-ties, allows the utilization of the trading module used for government bonds, access by funds and other institutional investors and the choice of counterparts, with CetipNet not acting as the central counterpart for settlement purposes.

The SELIC (Special System for Settlement and Custody), in addition to performing the role of central depository for government bonds, acts as a financial registration and settlement system, operating in the RTGS27 modality, for operations executed over either the telephone or by voice system, or using the CetipNet trading module. The commands related to the reg-istration of operations are entered either by the participants themselves or by settlement banks or managers, in the case of institutional investors with individualized accounts. Trades made through Sisbex are settled at the BM&F’s Clearing Chamber, in net deferred settlement modal-ity. Funds and other institutions may take part in trades indirectly, by means of orders placed by participating institutions. Generally, operations are registered for settlement the following day, both in the SELIC system as well as in the Clearing Chamber, in the form of one-day for-ward repurchase and resale agreements, regulated for the fixed-income market.

Individual investors have also gained access to the government bond market through Di-rect Treasury. Made available over the internet, this system permits the simplified acquisition of securities, as long as a financial institution is appointed to be responsible for carrying out operations and bearing brokerage and custody costs which is the responsibility of the CBLC, the depository of the respective accounts. The participants have access to the weekly buyback operations of securities carried out by the Treasury, which are aimed at ensuring liquidity in this environment. Though it represents a reduced percentage of the total debt outstanding in the market, the stock of bonds in the hands of 65 thousand investors registered with Direct Treasury already stands at close to R$ 1 billion28.

As for the debentures market, the same rules apply to operations executed in the over-the-counter market, registered in CETIP, depository of over-the-counter private securities and derivatives and the registration and settlement system authorized by the Central Bank and the CVM (Brazilian Securities Commission). Debentures may also be traded in modalities made available by the Bovespa – using BovespaFix’s electronic platform or via SomaFix – and, in this case, the CBLC acts as a depository.

27 Gross Settlement on Real Time.

28 R$ 989 million, in 9/1/06 position. Further information on the Direct Treasury Program may be found at the address www.stn.fazenda.gov.br.


BOX 5

Main Sisbex Features• Electronic trading and registration system of operations with governments bonds and private fixed-income secu-rities issued by financial institutions. • For the purposes of federal public bond operations, it consists of two modules:- trading module: for securities trading, through bids, with subsequent registration of the operation;- registration module: for registering operations executed in trading environments external to Sisbex Trading.

• Dealer to Dealer System or B2B.• Participants: - Traders: banks, brokerage houses and distributors;- Any other market member: may only forward orders through a trader.• Institutional clients (investment funds and pension funds) may:- Have access to the terminal;- Send an electronic order through a participant (this order may not be modified); - Consult on the terminal his operations, market operations and the entire list of available bids; - Use the registration module;- Send an order by telephone to previously qualified trader as his representative. • Other clients: have no access to the terminal.• Approximately: 63 trading representatives and 12 already operational institutional clients, in addition to 41 institu-tional clients in the process of being qualified (September/2006).

• Standardization: organized in trading rounds:- by operation modality (for delivery, forward for delivery, when if issued, specific repo, generic repo and order driven repo); - by securities indexer type (Selic, fixed rate, price index, foreign exchange)- Standard commoditized trade size: for delivery (10,000 units), repo (R$ 100 million + R$ 1 million supplementary trades).- Small trades round (all operations/securities; smaller trades than standard commoditized trade size).

• Trading features:- Bids are organized by considering the best market price and chronological precedence, ensuring the best per-formance;- It is possible to enter buy bids, sell bids or spreads (the combination of a bid of each nature); - BM&F acts as a central counterpart: trades are closed with any counterparts, conditioned only to checking the operating limit generated by BM&F according to the prior provision of individual guarantees;- Anonymity: hybrid system, in which 8 participants (with the largest volume of operations for the quarter) may operate with anonymity. Others are identified on the screen.- Criticism mechanism: BM&F sets reference prices for all securities that are accepted for trading at least twice a day. Additionally, trading acceptance intervals are established:- Operating tunnel: an interval that stipulates bid acceptance limits. Any bids outside this interval will be rejected by the system;- Auction tunnel: a price interval that sets minimum and maximum prices for closing trades. Trades at prices outside this interval and that do not extrapolate the operating tunnel are immediately submitted, in auction, to the market referendum, and any participant may intervene in the trade and set a better price. If there is no interfer-ence, the original trade is accepted and a new reference price may be adopted by Clearing. - Operations run in the registration module are submitted to auction tunnel verification and are rejected if they exceed this interval;- It contributes to the timely registration of the operations and of the quality of the data generated by the System;- Loan program: loan and swap modality (which are not operational) driven repo (recently implemented).

• Settlement:by means of BM&F Asset Clearing, which acts as a central counterpart, in the LDL modality, with settlement between 1:30 p.m. and 3:30 p.m.

• Information:- Users with terminals have access to any and all prices, information on businesses and better bids;- Vendors: they receive, at a cost, information on best bids.

Sources: Sisbex and BM&F regulations. Prepared by: ANDIMA.


It is worth noting that volume traded in this segment in the period was equal to 7% of the stock at the end of the first half of 2006. Since the secondary market is still very limited and the bond indentures may contain various complex conditions, the majority of operations require the participation of specialized institutions, banks or brokers. The presence of retail investors is practically nonexistent, and the utilization of electronic trading platforms is still in the initial stages (1% of total), but is becoming increasingly common.

Initiatives in the sense of stimulating the secondary market of these assets, mainly by expanding the investor base and simplifying features, have been observed recently. Among these highlight should go to the self regulation initiatives, as well as to actions announced by the BNDES. In the first case, although the legislation proposed by the CVM for the issue of standardized debentures has not produced the expected results, the objec-tives that justified this measure have ended up guiding initiatives for the formalization of calculation criteria and the clauses that are common to the respective bond indentures in the operating codes of entities acting within the sector (ANDIMA and Anbid), which currently provide guidance for the issue and trading of debentures which are deemed to be simplified. In the case of the BNDES, in 2006 this entity announced a Debenture Investment Program that included channeling resources for purchasing and participating in primary placements, in addition to supporting the adoption of distribution and trading practices that favor the dispersion of bonds in the market, liquidity and the standardization of clauses.

TABLE 7

Outstanding Stock, Traded Volume and Distribution of Tradingin the Debentures Market

YearDebenture

Stock(R$ billion)

Total Traded Volume**

(R$ billion)

Traded Volume/ Stock

Trading Distribution (%)

SND CetipNet BovespaFix SomaFix

2002 46,1 21,5 0,46 98,27 0,15 1,58 -

200� 42,7 23,8 0,56 98,28 0,02 1,66 0,04

200� 44,1 14,1 0,32 89,87 0,10 10,02 -

200� 85,0 19,2 0,23 98,26 0,04 1,69 -

200�* 103,8 7,6 0,07 98,86 0,12 1,02 -

* Up to July/2006. ** Considers for delivery operations only. Sources: Bovespa and CETIP. Preparation: ANDIMA.


BOX 6

Main CetipNet Features• CETIP electronic trading platform• Module structure: auction, quotation, trading and bookbuilding (for debentures only)• Multi-dealer to customer or B2C system • Participants: approximately, 154 institutions and 600 funds

• Auction module features- secondary placement of fixed-income public or private bonds and securities, in CETIP custody or not); - operations have an appointed time, batch (participant defines whether he accepts a partial standard trade size or only full) and minimum price (PU or rate);- assessment: Dutch-type auction (payment by PU or cutoff rate) or competitive (payment according to contemplated bid)

• Quotation module features- Request for quote type: the customer or institution creates a group to receive quotes (fund borrower or donor);- primary or secondary markets (SELIC repo and, starting in August 2006, other operations); - receives proposals from all counterparts; one bidder does not see the other’s proposal;- it is not automatic closing;- institutional client may participate directly (no broker);- the outcome is released to all bidders.

• Trading module features - bid input (buy or sell): batch and PU;- blind screen (bidder is not identified) all participants see the proposal, but bidder may restrict counterparts (in other words, he may restrict whoever attacks the proposal);- cross matching system (it abides by the best price criteria); participant may define whether he wants to close total or partial amount: the bid choice will observe this option;- in homologation: if proposed price is off market (according to oscillation tunnels), the asset goes to auction – in this case, restrictions to counterparts are not valid, a minimum standard trade size for interfering is not stipulated;- the customer makes his bid through a financial broker, but the proposal terms are his own.

• Other remarks – participant has the possibility to create:- special screen (single dealer to customer) with his proposals.

• Settlement - operations with assets deposited with CETIP: through CETIP, in LBTR or LDL modality (primary quotation module market: issuer risk – with settlement between 11:25 a.m. and 12:45 p.m.); STP - Straight Through Process (trading module) or requiring registration (quotation/auction module); - when dealing with government bonds, in the SELIC system: it is not STP (SELIC registration must be made by participant, who may use information generated by CetipNet).

• Information- website (www.cetip.com.br): post-trades; minimum, maximum, medium and last trade; total amounts (trading); amounts for bids made (quotation).- participant has access to all information on his own operations.

Sources: Operating Manual and CETIP. Prepared by: ANDIMA.

�1Domestic market: history, conformation and data; regulation and self-regulation

Electronic systems Electronic systems are still not used very much in the fixed-income market, and there are

doubts as to about the scale and the changes that their adoption may lead to within the sector. It can be observed that the use of such systems has been gaining force in the fixed-income seg-ments where the concentration of information and of buying and selling agents increases leads to a direct increase in liquidity and transparency: this is the case, for example, with the quota-tions of CDBs by institutions, to customers providing funds, via CetipNET’s Request for Quote type module. It is also possible that the concentration and specialization of market makers in certain more liquid LTN maturities, together with the possibility of operating anonymously and the substantial access to hedge markets for their protection has contributed to the utilization of the Sisbex system by the predominant banks in this public bond market segment.

With both platforms, there is the possibility for trading by commoditized trade size or frac-tions thereof, and these trades will be concluded at the best possible price – with the exception being that, under the CetipNet system, the choice of counterparts may imply that this rule is not complied with. Sisbex counts on bid acceptance and rejection intervals, with adjustment throughout the course of the day, in order to prevent off-market trades or operating failures (two intervals). The projects that are on the agenda for these systems mirror the comments made at the start of this report, regarding the approach similarity to typical stock exchange or over-the-counter market procedures. While CetipNet is testing the implementation of float-ing intervals capable of detecting off-market bidding practices and determine the immediate auction of the asset, Sisbex, in addition to a highlighted registration module of the trade, is analyzing the incorporation of institutional investors, by means of electronic orders, and the conditions that are required in order to adjust the guarantee system to this integration.

TABLE 8

Distribution of Trading in Government Bonds by Type of Operation and by Environment/Trading System - in R$ million

Traded Volume By Trading SystemFor Delivery

RepoTotal TOTAL Sisbex

RegisterSisbexTrade CetipNet

Off ElectronicSystems

Extra-group Others Total

200� 1.037.322 1.233.056 2.270.378 31.334.858 33.605.235 0 0 0 33.605.235200� 2.039.972 1.105.317 3.145.289 35.648.287 38.793.576 25.214 1.308.837 1�� 37.262.262200� 1.920.347 1.559.331 3.479.657 36.545.140 40.024.797 38.540 1.143.096 10 38.833.289200�* 970.998 887.355 1.858.353 26.018.656 27.877.010 9.342 1.547.346 0 26.320.322

In Relation to Stock** Share %200� 1,4 1,7 3,1 42,8 45,9 0,0% 0,0 0,0 100,0200� 2,5 1,4 3,9 44,0 47,9 0,1% 3,4 0,0 96,5200� 2,0 1,6 3,6 37,3 40,9 0,1% 2,9 0,0 97,0200�* 1,0 0,9 1,8 25,7 27,5 0,0% 5,6*** 0,0 94,4

* Up to June. ** Ration between total traded volume in the period and government bond stock at period end. *** Only considering for delivery extra-group operations, this ratio goes up to 23% in 2006. Sources: Central Bank, BM&F and CETIP. Preparation: ANDIMA.


Transparency Electronic systems produce timely information regarding operations quoted and signed

in their environments, but only partially disclose this information to the public. In the case of Sisbex, computer monitor owners may check details of bids in terms of operations and prices including reference prices for “tunnels” –without identifying the counterparts. General information regarding about deals and best bids is disclosed to the public and disseminated by vendors. Meanwhile in the case of CetipNet, the trading module’s bids are disclosed, includ-ing over the internet, but details of operations signed are restricted to users. With regard to post-trade information, the main statistics are produced by the depositary systems on the day following that of the trade, and these include average, minimum and maximum prices and total amount traded, per asset29 – but do not yet meet timeliness criteria. The information generated by financial systems and institutions can also be found on the pages of communication sys-tems, such as those of the Reuters and Bloomberg agencies.

Recent projects involving SELIC, CETIP, BM&F and ANDIMA are aimed at expanding the range of this information, either in the sense of timeliness, such as the disclosure of actual prices in real time by SELIC, or by amplifying the collection universe over the course of the day, by including ANDIMA’s indicative prices, and the results of calls, etc. The consolidation of sources of information on the various segments is being looked at both by ANDIMA as well as by market members themselves.

It should be noted that, in the case of operations executed in non-electronic environ-ments, an additional effort should be made in relation to the timeliness of information: registration in the depositary systems will have to be made shortly after the trade is com-pleted, which is not currently the case with most entries made in gross settlement systems. For cultural, operating and scale reasons, the greater part of institutions’ entries, both their own as well as those of third parties, are concentrated in the day’s final period. Therefore, even if the information were to be disclosed in real time, it may not reflect the prices and amounts being negotiated at any given minute, and could even lead to produce inaccurate averages or benchmarks30.

29 In Table 7, available information about prior and subsequent prices and main indicators used in the Brazilian fixed-income market and projects aimed at expanding available data, are summarized.

30 In electronic trading environments, this problem tends to be avoided by the existence of tunnels: such as referential prices may change over the day, a participant who delays recording his operation may have his entry rejected, which stimulates prompt registration of transactions.


BOX 7

Transparency in the Brazilian Fixed-Income MarketInformation Availability in the Over-the-Counter Market

Pre-TradeInformation

Post-TradeInformation

Benchmarks/Other Indicators

TOD

AY

- Quotes made available on trading platforms (CetipNet, BovespaFix and Sisbex); BM&F trade screens; information report screens (Bloomberg, Reuters) – due to the absence of market makers it is generally a question of indicative quotes and not firm proposals.

Bloomberg Terminal ð MRKT <go> ð n°19 Títulos Públicos ð n° 8 Brasil.

Reuters Terminal ð BR/DEBT ð várias opções

- Quotes provided by institutions to their customers (exclusively) – in liquid markets and upon request only;

- Synthetic prices prepared and reported by ANDIMA at the end of the day, referring to the secon-dary government bond market (96 maturities) and debentures (48 maturities).

www.andima.com.br ð Technical Information.

- Mandatory registration of all operations with securities at SELIC (government bonds) and CETIP (private) systems: Infor-mation released on the following business day, without identifying the parties, containing minimum, average and maximum prices on each maturity, separated in total and extra-group (SELIC) and total amounts by maturity.

www.cetip.com.br ð Informativo Diário.

www.selichml.rtm ð Consultas.

- Trade results reported on online electronic platforms – still cor-respond to a very little significant portion of the market.

www.bmf.com.br ð Boletim ð Cotações e Volumes ð Sisbex.

- SELIC Rate (average rate prac-ticed in overnight repo opera-tions, with securities with SELIC or BMA used as guarantee).

www.bcb.gov.br ð Economia e Finanças ð SELIC – Mercado de Títulos Públicos.

- DI Rate (average interbank financing rate of one-business day term executed on CETIP). www.cetip.com.br.

- Interest rate forward structure, based on synthetic prices (ANDI-MA) and on DI swap curve rate x fixed rate (BM&F).

www.andima.com.br ð Informa-ções Técnicas ð Títulos Públi-cos ð Mercado Secundário ð Estrutura a Termo.

www.bmf.com.br ð boletim ð indicadores ðtaxas referenciais

- IMA rate family – released by ANDIMA: index representative of government bonds technical portfolio weighted by market amounts of each class of title (except exchange) and sub-indexes referring to each class separately – IRFM (fixed rate); IMA-B (IPCA); IMA-C (IGP-M) and IMA-S (SELIC Rate).

www.andima.com.br ð Infor-mações Técnicas ð Títulos Públicos ð IMA.

NE

W P

RO

PO

SA

LS

- Gathering and reporting of buy and sell quotes, more than once a day, obtained from specialist dealers (for a set of selected securities by the Treasuries) and financial brokers.

- The creation of a capture and report system of trades recorded at SELIC (government bonds), without identifying the parties, by trading and timely, organization by type of commoditized trade size, maturity, indexer, etc.

www.selichml.rtm ð Consultas.

www.bcb.gov.br ð Economia e Finanças ð SELIC – Mercado de Títulos Públicos.

- Extension of partnership to CE-TIP system (private securities) and to Sisbex (BM&F).

-- Assembly of an “environment” that allows the consolidated re-port of pre and post-trade prices, accompanied by other statistics and information to assist the user in interpreting the available information.

- The construction of a moni-toring tool of executable price behavior throughout the day.

- Follow-up/analysis of registe-red prices at SELIC and CETIP by ANDIMA’s Operational and Ethics Committee.

Prepared by: ANDIMA


Liquidity The projects related to expanding the range of information available on the bond market

should result in major advances in terms of the segment’s transparency in Brazil. Such initia-tives tend to imply changes in the market’s characteristics, but, as is shown by the international literature on this subject, liquidity conditions may have a significant impact on the extent of these changes. The comparison between synthetic rates and trade intentions (buy and sell bids) in the debenture market, for example, seems to indicate, in a number of periods, that the former provide a more consistent reference for agents to assess prices. Likewise, by observing the comparison between synthetic rates and trades executed, it can be concluded that they exhibit a closer correlation with each other, despite the existence of divergences– justifiable by the size of commoditized trades conjectural demand and supply behaviors or by deals that are part of a structured operation in distinct markets. Therefore, in these cases, information obtained prior to trades may not reflect fair prices for assets, and that produced by transaction records usually requires suitable statistical treatment.

It can be observed that, in the Brazilian experience, the trends have been diversified and, suitably, targeted toward an expansion of both transparency and liquidity. In this context, the expansion and consolidation of price information, including timely information, goes hand-in-hand with the eventual introduction of new registration rules or electronic systems capable of adding benefits to certain specific segments within this market. In other cases, it is possible to note that the efficiency of the secondary bonds market is more linked to structural precon-ditions related to the macroeconomic environment, to the concentration of operations in the near-term, to the low volatility of the financial assets and to the narrow investor base than it is to the existence of pre-registration or on screen trading.

Therefore, there are difficulties related to expanding the liquidity of the fixed-income mar-ket in Brazil, which it is vital to overcome in order to meet transparency requirements, do not require changes (in principle) to trading environments, as they involve questions of a mac-roeconomic, institutional and microstructure nature. Some themes related to these issues are analyzed in the next chapter, which also presents a proposed agenda designed to stimulate the growth of the domestic bond market.

��Projects: an agenda proposal for the brazilian fixed income market

The utilization of the international discussions as a backdrop for considering the liquidity and transparency in the Brazilian fixed-income market seems highly appropriate to outline the main characteristics, relative advantages and limitations of the segment. More than this, in light of recent experience and based on the international prescription, allows us to identify a proposed agenda that, though far from altering the determining macroeconomic factors, lists institutional actions and those directed at the segment’s microstructure, which are capable of contributing to the growth of the domestic securities market.

Apart from counting on an amplification of the advances obtained in the macroeconomic field – and therefore assuming continued positive scenarios for the monetary, fiscal and external areas – this agenda sought to bring together gather proposals and projects under discussion by ANDIMA’S Committees and workgroups or, separately, at the level of institutions, fund man-agers and regulators. It is not intended to cover all the alternatives for the expansion of transpar-ency and liquidity, or for the consolidation of the domestic bond market, but rather to encourage discussion of themes and obtain a consensus in relation to initiatives designed to overcome barriers, by clarifying doubts and improving rules capable of contributing to this process.

Macroeconomic issuesThe recent trends, in the financial market sphere, indicated by the current debt manage-

ment strategy and by the stability in the handling of monetary and fiscal policy may mean that three movements which are relevant to the domestic bond segment become increasingly

5pRoJEctS: a pRopoSEd

agEnda foR thE bRazilian fixEd-incomE maRkEt


evident: the change in the profile of the federal debt, the reduction in interest rates and the strengthening of the credit market.

The first of these resulted from a deliberate strategy on the part of the National Treasury, which was contained in the Annual Financing Plans of the last few years and, which became more evident, from 2004 onwards, in the sense of favoring the placement of fixed-rate and inflation-linked securities at the expense of those pegged to foreign currency and short-term interest rates. The decision is regarded as a deliberate strategy due to the fact that it implied higher costs in terms of financial charges for the Treasury and, during certain periods, back-ward steps in relation to the process of lengthening the average term of the debt.

For example, the decrease in the portion of the debt pegged to foreign currency to the cur-rent level of between 3% and 4% of the total stock of debt, has caused criticisms due to the fact that it has been implemented in a context of ample liquidity in the FX segment and of an appreciation in the Real. It is possible that indebtedness in FX-pegged securities would have implied relatively lower costs, by comparison with the rates being paid on other floating rate securities and, particularly, fixed rate bonds.

The same reasoning applies to the recent emphasis on offering LTNs and NTN-Bs, the primary placement of which was significantly affected by the volatility that was registered between May and June of 2006, a period in which LFTs would possibly have enjoyed a wide level of acceptance, leading to lower rollover costs. Though the Treasury still has some room – according to its schedule for the year – to place LFTs, it is perceived that this instrument has been used sparingly, with auctions of fixed rate and inflation linked assets having been re-sumed as soon as the context permitted it. For these reasons, it can be observed that this option gives priority to reducing the country’s exposure reduction to foreign shocks, whether direct ones – due to the repercussion regarding the FX rate – or indirect ones.

With respect to the reduction of the absolute interest rate levels, its effects are related to the current relevance of the portion of financial savings that are remunerated by the SELIC Rate or, equally, by the DI Rate. Since a large part of the public debt, of outstanding private securities, from the fund industry and other products offered by the banking network is remunerated by floating rates, the reduction in the level of interest rates should increasingly enable a comparison of the relative performance of these assets with those of fixed rate or mixed portfolios. This pro-cess is already visible, although only to a limited degree, from the structuring of multi-market funds, which has recently shown considerable growth, and from the increase in variable income investments. Added to the expansion in credit, the growth in the stock of funds and credit rights certificates also confirms the search for new sources of revenues that are not exclusively pegged to operations based on bonds remunerated by either the DI or the SELIC Rate.


The effects of these movements are obvious, but nevertheless important to the alteration of the current profile of the Brazilian debt market profile: in addition to contributing to asset di-versification in the segment, it should lead to an expansion in benchmark alternatives, includ-ing for the fund industry, which is compatible with the new conditions in terms of composition and demand. On the other hand, strengthening the portion of debt in securities with fixed rate profitability or which are pegged to other parameters tends to contributing to the formation of a yield curve that is capable of better reflecting the economy’s risk/return ratio.

By way of illustra-tion, the comparison be-tween the IMA and the SELIC and DI Rates during the recent period shows that, in 2006, the performance of the first of these has outstripped those of the referential rates (see chart).

The third trend reg-istered in the macro-economic plan – that of strengthening the credit market – has effects in common with the interest rate drop. Among these, there is the diversification of the assets of-fered in the market and of the investment fund industry – which in the latter case, is dependent upon the (re)discussion of the CVM’s proposals in the sense of restricting the presence of privately-issued securities in retail funds31. In addition to a series of other extremely relevant changes to the composition of assets and risks in the financial market, the development of structured operations and the resulting diversification in terms of issuers and investors– with-out mentioning the impact on the real economy – could also help aspects related to the per-formance of the rating agencies in Brazil, contributing to a necessary improvement in the evaluation processes of both issuers’ and issues, which still exhibit limited sophistication and use in the domestic market.

31 In Addition to CVM Public Hearing Notice No. 3, on the site of this Authority, see, in this respect, suggestions forwarded by ANDIMA (Letter Suger/Sutec No. 265/06), on the website www.andima.com.br.

CHART 12

IMA versus SELIC Rate versus DI RateCumulative YTD Percentage Variation in 2006*

* Up to August/2006. Sources: ANDIMA, Brazilian Central Bank and CETIP. Prepared by: ANDIMA.

10,38 10,4111,05

11,912,48

10,57

DI SELIC IMA Geral IRF - M IMA - B IMA - S


BOX 8

Over-the-Counter Fixed-Income Market Agenda Outlook, Suggestions and Projects

Macroeconomic Issues1 Continuity of the debt market profile change strategy

- Increase in liquidity associated with the LTN and NTN-B market- Average term lengthening.

2 Interest Rate Reduction- Increase in fixed-income asset demand/diversification- Investment fund industry diversification- Benchmark diversification.- Interest curve consolidation.

� Credit market strengthening - Increase in fixed-income asset demand/diversification- Investment fund industry diversification- Rating agent upgrading Institutional Issues

��

Tax-related- Extend non-resident income tax (IR) exemption to private securities - Correction of distortions broughton by periodic revenue IR taxation. - Extinction of the short-term IOF (Tax on Financial Operations)- Investment term, for IR tax rate purposes, measured by investment account, - CPMF (Provisional Contribution on Financial Movement) extinction

�

10

11

12

1�

Regulatory- Over-the-Counter: harmonize concepts applicable to the segment, clarifying the effects of this regulation on operating questions and tax-related issues related to settlement, registration and electronic trading systems. - Custodians and depositaries: clarify and consolidate the concept, rights and duties related to the rende-ring of custody services and to the relationship of these agents with depositary systems in the fixed-income market. - Loans: publish supplementary standards for securities loan and swap (Res. No. 3197/04), even with regard to program structuring by systems or custodians, to accounting and to taxation.- Settlement delay: redefine differences between forward market and deferred settlement and developments on registration and accounting systems. - Guarantees: definition of the legal role of guarantees in repo operations settled with or without central counterpart and escrow accounts in depositary systems.Microstructure Issues

1� Primary Market: Strengthening of the performance of the Central Bank by means of bond go-arounds (informal auctions) with for delivery operations. It helps the leveling of liquidity (supplementing the role of compulsories) and the correction of momentary pricing problems or maturity concentrations.

1�

1�

Transparency- Information: Timely dissemination and consolidation of executed prices (SELIC, CETIP, BM&F and ANDIMA projects) and of platforms, even for non-users; proximity between the trading occurrence and the effective recording in the systems; greater availability of pre-trade information (quotation modules, proposal screens).- Electronic systems: expand the utilization of quotation or trade systems, coordinated by specialized bro-kers or in segments whose utilization results in liquidity and counterpart concentration, especially institu-tional investors.

1�

1�

Investors Base- Pension Funds: increase participation in the secondary market, including, as the case may be, through supporting electronic systems and the professionalization of managers. - Investor Education: expansion of technical information and programs aimed at clarifying fixed-income investment features and respective assets.

1� Lengthening the term of Central Bank associated operations20 Adaptation of institutional investor’s internal systems oriented toward short and loan operations.Prepared by: ANDIMA.


Institutional and Microstructure Issues

Primary market and the actions of the authorities In Brazil, public debt bonds are issued by the National Treasury and placed in formal

public offer auctions held by the Central Bank, acting as an agent of the Treasury. The CB is responsible for the management of the monetary policy, including by means of informal auc-tions (go-around), selling or buying securities in a definitive manner, or via the carrying out of performing repo operations, in conjunction with institutions accredited as open market dealers. These same institutions have exclusive access to the so-called special Treasury operations: selling auctions established in public offering and purchase auctions at competitive prices.

Based on specific regulation, the accreditation process of the 22 open market dealers in-volves one-semester evaluation and validity periods. Since the adoption in 1999 of the first measures aimed at increasing the liquidity of the secondary market, and following debates with representative entities such as ANDIMA, the selection of these institutions has undergone various changes. The purpose was to attribute a greater value to liquidity operations and those institutions that exhibit a significant performance in the segment, contributing to the turnover and capillarity of the system. Currently, there are two groups of dealers: 12 primary dealers and ten specialists. Only four institutions, at most, are allowed to be present in both groups. Out of the specialist dealers, at least two must be brokers or dealers that do not belong to fi-nancial conglomerates. The selection criteria include the volume of operations in the primary and secondary markets and, more recently, a greater weight has been attached to delivery and auction operations, involving fixed rate and inflation linked securities (NTN-Bs).

Another measure adopted and originally foreseen in the 1999 proposals was the concen-tration of security maturities, which that year, registered a figure of 260 and which currently stands at around 9932. LTN maturities and regular securities auctions were also organized, with the latter occurring on a weekly frequency and being preceded by a monthly placement sched-ule. The Treasury also continues to hold purchase auctions, by means of public offerings, in the case of LTNs and NTN-Fs, and restricted auctions, in the case of NTN-Bs. The majority of LTN purchase operations are aimed at avoiding the concentration of maturities, while in the remaining cases they are focused on ensuring asset liquidity.

The Central Bank regularly acts by means of go-around, which are basically aimed at leveling the market’s liquidity. In the last few years, these operations involving buyback (or

32 In fact, the number of total public debt bond maturities is quite higher, if a security whose placement has not been made by public bidding is included, as is the case of LFT-A and B. By including these and other securities, which do not present frequent trading, total maturity number reaches 635.


sellback) agreements be-gan to adopt distinct guar-antees and longer terms – currently, the ones with the largest volume fluctuate be-tween three and five months and are carried out using either LTNs or NTN-Bs. The agreements involve the so-called free movement clause33, in other words, they allow the buyer to sell the bond that will be the object of resale, so as to stimulate the taking of short positions. It should be noted that it is rare for the CB to carry out delivery operations, which could help to bring about a more permanent leveling of liquidity (which currently requires a strong reserve requirement structure) or the correction of temporary pricing problems in the secondary secu-rities market. Therefore, if on one hand the operations carried out by the Treasury have been varied, but remain frequent34, the same thing cannot be said on the Monetary Authority front in relation to delivery operations.

As for the private securities market, primary issues, which may be registered in the depositary systems of either the Stock Exchange (CBLC) or the over-the-counter market (CETIP), already have rate building alternatives via electronic book-building. In spite of this option, which may re-sult in increased pricing transparency, the majority of primary debenture placements continue to be preceded by non-electronic book-building processes carried out by coordinating institutions. Although these processes are similar to closed auctions, taking place in isolated environments, with proposals received by fax in even conditions, in practice they permit greater selectivity than that offered by electronic systems. At CETIP, settlement occurs by means of transfer of the secu-rities from the SDT – Security Distribution System - to the investors’ custody account in the SND – National Debenture System, the depository of debentures in that Clearing House.

Other distribution processes in the fixed-income market, such as those of closed fund quo-tas and institutions’ financial instruments, rely on specific modules in the electronic systems or on simple recording in the case of over-the-counter and stock exchange systems. As men-

33 See related aspects to security loan and short market.

34 According to ANDIMA’s survey, between 2000 and 2006, the National Treasury held 1,099 auctions, being 380 LTN and 351 LFT.

TABLE 9

Number of Public Bond Maturities in the Market*Bond June/00 June/02 June/04 June/05 June/06

LTN 11 � � � �LFT 1�� 10� 100 �� NTN-B - 1 � � 1�NTN-C 2 � � 10 �NTN-D 2� 2� 1� � 2NTN-F - - 1 � �NBC-E �� 2� � � 2TOTAL 211 1�2 1�� 11� ��* Position on the last business day of the period. Note: Universe of priced bonds by ANDIMA. Source and preparation: ANDIMA.

�1Projects: an agenda proposal for the brazilian fixed income market

tioned, the raising or provision of funds via CDBs and DIs has been carried out by CetipNet’s quotation module, which does not imply simultaneous recording of the operation, and the uti-lization of which was due to the initiative of large institutional customers who were interested in expanding centralization and transparency. Fund quotas such as FIDC should be distributed with later recording in the CBLC or CETIP35, but may take utilize electronic options in related systems, including SomaFix. Since the primary placement process for private sector fixed-income securities does not offer any centralized environments and exhibits a high degree of specialization due to the diversity of the assets and the characteristics of the issues, incentives to the utilization of electronic quotation systems, book-building or auctions may in this case be important to organize segments, gather information and concentrate liquidity, providing more suitable conditions for issuers and investors.

Regulation of the secondary market, of custody, depositary and settlement services As demonstrated in the previous chapter, the clearing and settlement structure and the

depositary systems operating in the country date back to the creation of the secondary market itself, having been reformulated in 2002 in order to bring them into line with the recommenda-tions contained in the international prescription aimed at reducing credit, liquidity and operat-ing risks. As for custody risk and the disclosure of public information, the depositary systems adopted measures, which have been updated on a constant basis, that increase the transparency and regulatory capacity of the relevant authorities.

Specifically with regard to the fixed-income over-the-counter market, this background en-sured the recording of the universe of operations carried out in this environment and of assets that make up the portfolios of institutions and institutional investors, in a centralized way with SELIC or CETIP, making it possible for operations to have regulations in common and rules for the participation of financial institutions and brokers. The use of legal agreements, which are common in some countries for standardizing over the counter trades, has been restricted in the case of the domestic market to the relationship between institutions and clients whose positions have not been covered by individualization and, the same applies to retail products and complex operations. The rules that regulate the functioning of operations and assets in the Brazilian over-the-counter market are listed in the regulations issued by the CB and the CVM, or in the regulations of the registration and settlement systems, which are also approved by these authorities, in their respective areas of activity.

35 A detailed scheme of depositaries and trading, clearing and settlement systems, by asset and trading environment, can be found in Appendix 1.


The recent advances made in the regulation of the financial system in order to keep up with the changes that have occurred in the segment are remarkable, including in terms of compliance with issues discussed at the international level: public hearing processes have multiplied, both within the sphere of the CB as well as within that of the CVM; there has been an ample reformulation of investment fund legislation, by the CVM, and more recently new guidelines have been discussed; repo operations have undergone a similar process, within the sphere of the CB; and the basic rules for bank funding and securitization instruments are being debated at the present time. Thus, al-though the sophistication of products that are available within the sphere of the financial market, the changes in the distribution of tasks between the authorities and, in particular, the appearance of new modalities of services and activities by agents require constant improvements in regulations, this seems to be an auspicious moment for the consolidation of more conceptual rules.

This is the case, for example, with the treatment given to the over-the-counter market by the local regulations36: the CVM has established conditions for systems regarded as belong-ing to the” organized over-the-counter market”; the legislation on over the counter derivatives has only been partially defined up to now in the CB’s regulations, but the CVM has already been given this assignment legally; and although the Internal Revenue Service, differentiates taxation solely by criteria related to the definition of fixed and variable income, it maintains a number of rules in force that allow differentiated treatments according to whether the opera-tions are carried out on the Stock Exchange or at “similar” entities, as occurs, for example, in the case of foreign investors37. Given the growing sophistication of securitization operations and of the receivables segment, there is a need for the harmonization of the concepts that are applicable to the over-the-counter market and the electronic systems among other reasons in order to avoid legal risks that reduce the segment’s attractiveness.

Parallel to the act of defining the concept of the markets and to the conditions that these definitions imply for the agents acting in the trading and settlement stages, we need to stress other examples of concepts that deserve to be updated in the regulations that are currently in force. One of these is the differentiation between the functions of depositary and custodian, the definition of which is confused in the laws regulating the securities market and that, in the case of custodians, lays out rules just for the securities segment. The rights and duties of these agents and the conditions that are common to their supervision are not consolidated and, when they exist, they are differentiated according to the asset.

The relationship between the custodians – usually institutions which provide services to

36 A script with basic legal references in force for several assets, operations, systems and for the fixed-income over-the-counter market participants can be found in Appendix II.

37 See tax issue detailing in the Fixed-income market Taxation item, further ahead.


end investors and whose roles may or not include the tasks of portfolio management or admin-istration – and the depositaries – which are virtually nearly always systems or institutions that render services to issuers – is also covered by systems and asset indenture regulations, without any prior harmonization of concepts and establishment of mutual obligations. In addition to the difficulties pointed out, this situation complicates the simple compliance with other market rules, such as those regarding the identification of agents’ positions and the withholding of taxes, leading to doubts and uncertainties for the participants.

Difficulties are also created by a few specific points related to the definition of concepts, in the financial market sphere, of existing legal figures in other Law areas. An example of this situation is the functioning of escrow accounts in depositary systems, with the rules for these that are found in the regulations containing opening, closing and command forecasts, but whose actual functioning is based on private agreements governed by other legal codes. As other options of legal forms related to the exercise of guarantees are still being used in financial market agreements, and bearing in mind the growth in the product and receivables certificates’ market, these accounts could incorporate new functions or services – pursuant to the respective regulations, and in accordance with the specific legislation applicable – which would strengthen their role with depositors and depositaries.

A similar situation applies to the repo operations market with fixed-income securities. In the case of Brazil, these operations – purchases and sales tied to repurchase and resale agree-ments and forward purchase and sale operations - have not been regulated as loans. In other words, securities are actually sold or purchased and the “return” operation is entered into the books separately from the “outgoing” operation. On the other hand, the agreements are estab-lished by the entering of specific codes, in the sphere of the registration systems, and backed up by their own regulations as well as those of the system. Since the asset settlement systems work in the DVP modality – Delivery Upon Payment, there is no risk to the principal involved in these operations, but the securities utilized may not be considered as a guarantee – in other words, there is no way to ensure standardized behavior, in the event of an operation by an in-stitution that is under intervention in which the return agreement has not yet been entered.

The importance of repo operations to the secondary market becomes even clearer if these are compared to delivery operations (buy and sell trades): in the case of public debt, repo op-erations are almost 14 times larger than the second modality, while in the debenture segment they six times larger. It is observed that these operations, in Brazil, are essentially borrowers or providers of funds (cash-oriented)38: they represent the main way for the Central Bank to level

38 See next note.


liquidity and the overnight market for the swapping of funds between among the institutions of the financial system (with a guarantee in government bonds and a one-day term). These lat-ter ones, after statistical treatment, are used as a source for the calculation of the SELIC Rate, which is the main rate within the segment and the benchmark of the monetary policy.

It should be noted that, since the proposals made in 1999, the repo operation market has been deserving attention by the regulators. Among the measures adopted: highlight goes to the increase in the leverage limits, the regulation of recording of forward operations, the inclusion of private securities, from debentures to export notes, among the securities that can be used in repo operations; and the regulation of free movement operations (and the possibility of taking out short positions) in the segment – providing evidence of the willingness of the authorities to improve the applicable legislation. Furthermore, by means of back-to-back reverse repo and simultaneous operations between the same counterparts, the CB makes daily securities offer-ings from its portfolio in exchange for others offered as guarantees – the loan of CB securities. It may be that the purpose is to stimulate the carrying out of repo operations directed towards strategies involving securities that can be used in such operations and, thereby, short selling operations, which are virtually nonexistent in the domestic fixed-income segment.

Last but not least, a final aspect related to the systems and clearing houses that make up the payments system refers to the settlement delay offered to users in the securities market. Most of the operations executed in the segment are settled on the day after the operation is registered in the systems, coinciding, therefore, with the D+1 standard that is observed in other economies. To this end, operations are entered in the system as one day forward operations, reconciling the commands made at SELIC with the Asset Clearing House and, also with sales of - securities associated with auction purchases made on the same day – at auctions where settlement is carried out on the following day.

It so happens that cash operations settled on D+1 are traded at D+0 reference rates or prices, while the one day term would correspond to a future settlement operation, forming rates or prices that are related to the respective settlement date. In fact, although entered as forward operations, these operations are regarded as entailing lagged settlement, and are computed accordingly for pur-poses of the calculation of average rates or spot market prices. Although it does not seem to lead to any relevant operating differences, this distinction is reflected in the accounting of both institutions as well as investors, generating a concentration in the processing of operations at SELIC, from 9.30 a.m. onwards, when the forward operation settlement mechanism is initiated. The existence of a fixed timetable, in this situation, affects the conclusion of part of these operations, hinders the transfer of funds by foreign investors and, in some cases, requires the re-registration of the operation made the preceding day, and thus may help contribute to distort the average prices calculated on the day.


Securities lending and short operationsIn chapter III, a number of initiatives were listed that may help promote liquidity in second-

ary markets, and among them was the stimulation of lending and short selling operations, taking into account their positive effects on the volume of transactions and on asset pricing. The opera-tions may be complementary to each other, to the extent that, in order to revert a short position, agents choose between buying or borrowing the asset that is covered by the operation. In Brazil, short selling operations in the fixed-income market are practically nonexistent, though they are provided for in the regulations for repo operations – based on free movement operations – and may be carried out within the sphere of the clearing house that acts as a central counterpart or in the SELIC system, with this only being possible if it entails government bonds.

Several reasons help explain this situation. One of them is related to the regulation them-selves of the operations that may be carried out in order to borrow or lend securities, providing reversal conditions to eventual short selling39 strategies. As was previously noted, in Brazil repo operations have not been regulated in the form of loans. Even if in conceptual terms they represent an option for the segment, bearing in mind the very structure of the CB’s securities lending under this format, there are operating limits on its utilization. The structuring of a lending program in which a custodian seeks to bring together a pool of lenders and borrowers would run up against restrictions due to the fact that the agreements are made between pairs of counterparts, one on one.

The rule that entitles financial institutions to borrow securities, as well as to swap and lend securities that belong to their respective portfolios, including with individuals and non-financial corporations, as long as they are within the sphere of authorized systems or clearing houses, should overcome this difficulty. However, it still requires supplementary regulation, particularly in relation to the conditions for authorized agents to structure the aforementioned programs and in relation to the accounting and taxation of the operations. Other one-off measures could help the process, such as the carrying out of back-to-back operations by the CB with a term of more than one day and the adaptation of the internal systems of institutional investors who have not yet incorporated into their structures the possibility of acting as lenders.

At any rate, it is likely that the main justification for the fact that this segment’s short selling and lending market is still in its initial stages is the lack of demand for the aforementioned opera-

39 Taking as a basis the international market, securities loans may be structured based on several operations, the best-known ones being repurchase agreements and securities lending properly said. In several economies, the repo market is, usually cash oriented, where the security works as a collateral or operation guarantee. Whereas lending operations are used for supplementing the search for a certain asset covered by the loan – in other words, securities oriented. There are also mentions of sell back or sell buy back type transactions, whose contractual formality and terms would be distinct from the repo market, resembling even further to cash oriented operations and, therefore, to the Brazilian case.


tions. In fact, the main end-buyers of securities – fixed-income investment funds – do not exhibit any interest in this modality nor have they adopted strategies of this type, since their portfolios are concentrated in DI and LFT funds, and an eventual search for strategies that guarantee other assets floating rate profitability is easily remedied in very liquid futures market segments. In the case of Brazil, the sophistication and liquidity exhibited in certain agreements that are available in the future market “compete” with the development of typical cash market strategies.

In this sense, the diversification of options provided by the investment fund industry could also create different conditions for this segment. Stock lending, which has been regulated in Brazil for the last ten years, has posted excellent development in the recent period, to a great extent due to the expansion in terms of access to strategies and the diffusion of investment in these assets, including with regard to the proliferation of long-short funds. In the case of the fixed-income market, the diversification of benchmarks and of reference rates for institutional investors’ portfolios may reveal itself to be a development alternative for this market40.

Taxation of fixed-income instruments The taxation of financial operations in Brazil has been the theme of a great many discus-

sions, mainly due to the accumulation of rules and recurring changes that have taken place in the last few years. Recently, a number of measures were taken in order to accompany the ef-fort towards the consolidation of the local bond market, with highlight going to the following items: the creation of the Investment Account41, which has eliminated CPMF being charged on the migration of funds between financial investments; the use of decreasing rates of income tax on bond revenues earned in the fixed-income market, including investment funds, according to the term of the investment42; and exemption from Income Tax in the case of revenues gener-ated by securities issued by the National Treasury, purchased by non-resident investors.

A series of suggestions, which were made before and after the changes, remain on the dis-cussion agenda with the Federal Revenue Service. Among the most valid proposals, it is worth mentioning the extinction of the tax levied on fixed-income investments and funds when re-

40 In the case, for example, of IPCA remunerated Treasury bonds (NTN-B), for which sufficiently liquid future markets have not yet been built, growing demand for products linked to this inflation index could serve as the first step toward structuring short operations. The CB has recently included these securities among those offered at associated operations that it daily holds and has raised the weight in dealer evaluation for for delivery and auction operations having these securities as a basis.

41 The proposal for creating Investment Accounts was prepared by ANDIMA and is consolidated in a text contained in the Eco-nomic Report “Public Debt: proposals for expanding liquidity”, published by the Association in 2003.

42 This taxation modality by income tax – decreasing tax rates according to the investment terms – has also been extended to supplementary social security participants, as established by Law.


demption occurs less than 30 days after the initial investment (short-term IOF - Tax on Finan-cial Operations). Established in the initial stages of the effort aimed at lengthening terms, the effectiveness of the tax is currently heavily affected by the change in the profile of investments available, including by the better liquidity premium and the new way of assessing Income Tax, which also differentiates on the basis of investment term, but takes into account much longer periods (from up to six months to over two years)43. With regard to CPMF, it is known that even with the operation of Investment Accounts, this tax fuels the high cost of bank interme-diation in Brazil and should be reviewed, particularly in the context of growing participation by retail investors, especially non-resident ones.

With regard to the new rules that are in force for income tax, a number of points have been the subject of debate in the financial market sphere, with a view to improving them. As for the levying of decreasing rates of tax, since the measure was aimed at stimulating the lengthening the profile of investments, doubts have arisen in relation to the inclusion of the term of opera-tions (for delivery and repo operations) of the portfolios of funds among the variables taken into consideration when calculating their respective average term – bearing in mind that the purpose was to stimulate the purchase of long-term securities by these investors, instead of discouraging them from operating in the secondary market, and in relation to the extension of the general rule to include the payment of periodic revenues by fixed-income bonds and se-curities, which has led to distortions in their taxation, discouraging their purchase and trading, particularly when held by retail investors44.

Some market segments have also observed remarked that the decrease of tax rates after a period of remaining in certain investments may reduce competition between products, to the extent that it discourages migration to a new modality (which initially has a higher income tax rate). One possible solution would be to consider the movements on the Investment Account, for the purpose of determining the Income Tax calculation basis. Another alternative would be to measure the terms, for the purpose of determining the tax rate applicable, according to entry in the Investment Account and withdrawal from this account and transfer to the check-ing account, rewarding long-term investments, but making products indifferent with regard to Income Tax taxation.

As for the recent exemption granted to non-residents in the case of the purchase of gov-ernment debt bonds, in keeping with the objective of strengthening the domestic bond market,

43 The subject was covered by ANDIMA’s request to the Ministry of Finance, by Correspondence Suger/Sutec No. 514/04 dated 11/3/04.

44 The matter was covered by ANDIMA’s request forwarded to the Federal Revenue Service, by means of Correspondence Suger/Sutec No. 319~05, dated 7/20/05.


its extension to private fixed-income securities could also be looked into. If this measure were adopted it would ensure equal treatment for all local currency denominated securities and would encourage the expansion of both the investor base as well as the secondary market in this segment.

Lastly, and specifically in relation to the over-the-counter market and electronic systems, the lack of any harmonization in terms of concepts between regulators, as already mentioned, and of any consolidation of the more specific rules published over the last few years has led to gaps and doubts with regard to the treatment to be given to new assets and operations or those that are being developed in this segment, as is the case with FIDCs - Credit Rights Invest-ment Funds, agribusiness assets and derivatives agreements. Furthermore, the rules observing distinct criteria, such as those applicable to non–residents and to the “gain” earned on trading certain assets “off the Stock Exchange”, have been associated with the general rule that has always differentiated tax treatment by markets (fixed income, variable income or specific as-sets), regardless of the environment in which they are traded, generating uncertainties regard-ing the procedure to be adopted in each case.

Investor BaseWith regard to the expansion of the investor base, it can be noted that efforts aimed at

stimulating the presence of non-resident investors and retail investors in the local market are both recent, and in the latter case the effort has been a very modest one. In relation to non-resi-dents, in addition to the exemption from Income Tax on government bond revenues, a number of measures have been adopted with the aim of simplifying the procedures for investment in the country, such as reformulation and consolidation of the applicable rules and the reduction in the amount of time required to obtain the necessary documentation enabling such invest-ments to be made45.

As far as resident investors are concerned, the portfolios managed by closed pension funds were worth of R$ 297 billion in December 2005, and though it is not possible to calculate their share of the total public debt – because a significant percentage of their investments are carried out by means of exclusive funds -, it is estimated that fixed-income securities account for 50.6% of these portfolios, or R$ 150 billion. However, from the point of view of their contribution to the liquidity of the local markets, the funds managed by these entities still represent a potential market that has hardly been explored at all. Recently, their participation in the secondary market, which was still in the initial stages, was aggravated by the segment’s

45 With regard to this, see ANDIMA’S Technical Report “Public Debt – Foreign Investor Participation”, 2005.


reaction to charges relating to the use of ‘off-market’ prices in trades executed in the fixed in-come market, which ended up limiting purchases of purchase by these agents at the respective primary auctions.

Undoubtedly, measures designed to encourage participation on the part of pension funds in the secondary market involve the training of managers, which has already been occurring, but might get a boost from initiatives such as the adoption of continuous education programs, which have been successfully adopted in other financial market sectors. On another front, re-lated to their activity per se in the secondary market, these funds should have access to online information – in existing information, voice or quotation systems -, as well as using electronic quotation or trading systems. In this way, price execution would be ensured at market con-sidered intervals and, therefore, an efficient allocation of the savings deposited with these agents.

In addition to measures aimed at specific investors, initiatives related to investor education take on an increased importance. The expansion of technical information and programs de-signed to clarify the characteristics of fixed-income investments and respective assets not only attract new investors to the segment, but also contribute to more proactive behavior on the part of these participants. The diffusion of fixed- -income investments in Brazil would certainly yield advances in terms of the consolidation of the bond market, the management of public debt and the funding conditions of companies and other private sector entities.

Conclusions on the Agenda As previously stressed, the suggestions presented in this study do not intend to cover all

the measures directed towards toward expanding liquidity and transparency in the fixed-in-come over-the-counter market in Brazil. Their purpose is to get financial institutions, issuers, fund managers, regulators and depositary system managers involved in the debate regarding the implementation conditions and, when it is the case, the adoption of regulation or self-regu-lation measures aimed at the segment. In particular institutional issues directed toward market regulation, have been the subject of analysis by ANDIMA’s Monetary Policy Committee, for the forwarding of proposals, formal or informal, to the authorities, as well as matters related to taxation, discussed within the sphere of the Taxation and Standards Committee,. In addi-tion to the utilization of regular forums, such as committees and commissions, the Association resorts to the creation of workgroups for monitoring specific topics. A recent example was the creation of a Study Group, which brought together ANDIMA, Abrapp and other authorities to debate issues related to increasing the participation of institutional investors in the second-ary fixed-income market. With regard to transparency, ANDIMA is especially involved in the


project for the consolidation, disclosure and monitoring of prices in the secondary securities market, and continues to be active in relation to the question of investor education initiatives by means of the carrying out of workshops, studies, courses and material made available on its website (www.andima.com.br) and on the SND’s website (www.debentures.com.br).

�1

6appEndixES


TradingC

learingS

ettlement

CetipNet (Quotation;

Auction;Trading)

Brazilian Central Bank STRBanking Reserve

Accounts of Financial Institutions

SettlementAccounts

of Chambersand Systems

RTGSDNSGB - Government BondFI - Financial InstrumentsTDC - Corporate Debt Security

Fixed-Income Market: Trading and Payment System

GB;CB;FI GB GB;CB;FI CB

Depositaries

C E T I P**

CB FI

Sisbex (Trading

or Record)

Bilateral or Multilateral (by phone or voice

system)

BovespaFix (Trading)SomaFix(Record)

BM&F* Assets

Clearing

S E L I C

GB

C B L C*

CB

Reserve Transfer System(STR)

Record

* Central Counterpart. ** DNS for issuer’s risk operations only. Source and preparation: ANDIMA.

APPENDIX I

��

APPENDIX II

Fixed-Income Over-the-Counter Market“Knowing the ropes”

Subject Legal BasisGovernment Bonds Law No. 10.179/01 (amended by Provisional Measure No.

2.181);Decree No. 3.859/01 (Securities Feature);Adm. Rule STN 410/03 (Public Offering);Adm. Rule STN No. 554/01 and No. 44/02 (Direct Treasury);Communication No. 7.818/00 from CB (Rate calculation);

Debentures Law No. 6.404, art. 52;CVM Instructions No. 400 and 404;Joint Decision BC/CVM No. 13;

CDB – Bank Deposit Certificate CMN Resolutions No. 105 and 367;BC Circular No. 127;

DI – Interbank Deposit CMN Resolution No. 3.399/06;Investment Funds CVM Instruction No. 409/04;Repo Operations CMN Resolution No. 3.339/06;SELIC System BC Circular No. 3.316/06;Payment System Law No. 10.214; CMN Resolution No. 2.882;

BC Circular No. 3.057;Short Operations CMN Resolution No. 3.339, art. 4; BC Circular No. 3.252;Organized Over-the-Counter Market CVM Instructions No. 243, 289 and 343;Open Market Dealers Selection Joint BC/STN Regulatory Acts No. 9 and 10;Central Bank Loans(Back-to-Back operations)

BC Circular No. 3.316, RA section 7, items 26 & 26;BC Circular No. 3.107;BC Circular-Letter, No. 3.239 (BC website);

Bond Lending CMN Resolution No. 3.197 and BC Circular-Letter No. 3.225;Securities Lending CMN Resolution No. 3.278/05

Prepared by: ANDIMA.

Addresses for searching mentioned standards:Resolution; Circular; Circular-Letter; Communication – BC website (www.bcb.gov.br, option: Legislation and Standards; CMN and BC standards; :Search for Standards).Law; Decree – Planalto website - (www.planalto.gov.br , option: Legislation).Instruction; Joint Decision – CVM website (www.cvm.gov.br ; option: Legislation; CVM acts).STN Administrative Rule; Joint Regulatory Act – Treasury website - (www.tesouro.fazenda.gov.br / legislação/dívida).


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CENTRE FOR ECONOMIC POLICY RESEARCH et al. European Government Bond Markets: transparency, liquidity, efficiency. London: City of London, 2006. 88 p. This report has also been produced by the following institutions: ABI - the Association of British Insurers, the European High Yield Association, ICMA - the International Capital Market Association, IMA – the Investment Management Association e LIBA - the London Investment Banking Association. Writers of this report are: Peter Dunne, Michael Moore e Richard Portes.Available at: <http://www.icma-group.org/content/Advocacy/bond_market_transparency.Par.0003.ParDownLoadFile.tmp/TT%20GovernmentFULL.pdf>. Last access in: Sept. 2006.

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Consulted Websites:

Banco Central do Brasilhttp://www.bcb.gov.br BM&F – Bolsa de Mercadorias & Futuroshttp://www.bmf.com.br

The Bond Market Associationhttp://www.bondmarkets.com

��

Bovespa – Bolsa de Valores de São Paulohttp://www.bovespa.com.br

CETIP – Câmara de Custódia e Liquidaçãohttp://www.cetip.com.br

Comissão de Valores Mobiliários (Brasil)http://www.cvm.gov.br

CBLC – Companhia Brasileira de Liquidação e Custódiahttp://www.cblc.com.br

European Central Bankhttp://www.ecb.int/home/html/index.en.html

Financial Services Authorityhttp://www.fsa.gov.uk

International Organization of Securities Commissionshttp://www.iosco.org/about/

NASD - National Association of Securities Dealershttp://www.nasd.org

SELIC – Sistema Especial de Liquidação e de Custódiahttps://www.selic.rtm/extranet/Restricted Access to RTM – Market Telecommunications Network – users

SND – Sistema Nacional de Debêntureshttp://www.debentures.com.br/

Tesouro Nacional (Brasil)http://www.stn.fazenda.gov.br

U.S. Securities and Exchange Commissionhttp://www.sec.gov

Presidente

Alfredo Neves PeNteAdo MorAes

Vice-Presidentes

Aldo luiz MeNdes.

edgAr dA silvA rAMos

diretores

dANiel luiz gleizer

José roberto MAchAdo filho

MArco ANtoNio sudANo

MArcos AlbiNo frANcisco

regis leMos de Abreu filho

reiNAldo le grAzie

robert JohN vAN diJk

sAšA MArkus

sergio cutolo dos sANtos

suPerintendente geral

PAulo eduArdo de souzA sAMPAio

National Association ofFinancial Market Institutions

ANDIMA

Brazil

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