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AmericasJune 30 2008

Equity derivatives in Latin America pick up pace

No longer lurching from crisis to crisis, the major Latin American economies have won credibility. For equity derivatives bankers, that means business, writes Natasha de Terán.
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President Luiz Inácio Lula da Silva famously called it a “magic moment” when Standard & Poor’s raised Brazil’s credit rating to ‘investment grade’ status in April. President Lula’s ‘moment’ became even better when Japan’s R&I, Canada’s DBRS and Fitch Ratings followed, awarding Brazil its second, third and fourth investment grade ratings.

Brazil’s rise out of junk or speculative status is important for more than the government’s credibility: it allows some of the biggest overseas pension and insurance funds to invest in the country.

If they do, they will find plenty to choose from, for the country is fast adopting an equity culture. Last year, no less than 64 companies went public on the São Paulo Stock Exchange (the Bovespa) including two of the largest 10 initial public offerings globally: the $3.7bn flotation of Bovespa, and the $3.4bn offering from the local derivatives exchange, Bolsa de Mercadorias e Futuros.

Nor should they be disappointed by performance. The Bovespa index had risen by about 15% in the five months to the end of May; the Brazilian economy is growing at about 4% to 5% a year; its trade surpluses have been bolstered by commodity exports and its external debt continues to decline.

Perhaps unsurprisingly, Simon Yates, head of global equity derivatives at Credit Suisse, says that of all Latin American economies, Brazil offers the most near-term potential for his business: “Equity issuance has expanded dramatically, the economy is in great shape and there is a burgeoning onshore investment market,” he explains.

Adrian Valenzuela, global head of investor sales for equity derivatives at JPMorgan, echoes this opinion, adding: “Activity in Latin America is very concentrated. The only onshore market that has real depth and sophistication is Brazil, where there is an established hedge fund community, a growing local retail investor base and a fast-expanding equity market.”

For Julien Lascar, co-head of Latin America structured products coverage at Société Générale (SG), the Brazilian corporate sector has provided a perhaps unexpected source of business. Brazilian corporates, being both sophisticated and cash-rich, have been investing their surplus in hedge funds. Similar to anyone else that makes direct investments in hedge funds, they were aware of the downside: the lack of transparency and liquidity, plus the high management fees – but saw little alternative.

Mr Lascar’s team immediately spotted an opportunity; it would promote SG’s Lyxor range of managed funds to them as alternatives. His team spent a considerable amount of time explaining Lyxor products and why these could offer useful alternatives with quite unique benefits. “They have been receptive to the offering, liking the returns, the quality of the managers on the platform and the transparency of the Lyxor products,” he says. “However, the liquidity provided by the platform remains the stronger argument.”

SG initially offered these products offshore in US dollars but a recent change to Brazil’s Fundo MultiMercado regulation will allow them to do it onshore in real. “This is a real bonus as they largely want to keep their assets in local currency,” adds Mr Lascar.

Not just about Brazil

It is, of course, not just Brazil that is storming ahead. Todd Steinberg, head of equities and derivatives for the Americas at BNP Paribas, says: “Most of the Latin American economies are growing at 5% per annum or more; they have largely been able to control inflation; have ­benefited from the commodities boom; reinvested in real estate and infrastructure and sought to diversify their economies.”

Furthermore, as the local economies have improved, the wealth effects have trickled down fast; companies are cash-rich and are no longer beholden to foreign investors. “There is a fast-growing private wealth market developing onshore; pension fund assets are accumulating fast; and the political and social climates are stable in many cases. In all, the outlook is extremely good for the region and presents lots of opportunities from a commercial and investment banking perspective.”

After Brazil, it is Mexico that equity derivatives specialists are targeting for growth. Similar to his colleagues at rival firms, Mr Valenzuela hopes that the recent lifting of restrictions on derivatives usage will lead to growth in the sector, along with structured products.

Relaxation of regulations are coming in thick and fast, affecting all sectors of the market. A law was passed at the end of 2007 in Mexico allowing pension funds to buy options, structured notes and futures. “First, the funds will need to ensure they are familiar with the products, then they need to get the appropriate support and risk processes and the regulatory authorisation in place, but we are already seeing the effects of this change unfold,” says Francisco Hervella, head of equity derivatives structured products sales for Latin America at BNP.

Insurance companies were previously unable to invest in structured notes but recent changes in regulation mean they now can, and Mr Lascar says that they have since started to contemplate buying principal-protected notes linked to offshore underlying assets.

Finally, there is potential for change on the high-net-worth individuals (HNW) side of the business. Mr Hervella says that two-thirds of BNP’s HNW-related business in Mexico is still carried out offshore, but as regulations are eased, he is seeing more and more interest in onshore products delivered in local currency. “At present everything has to be structured on a principal-protected basis but there is strong demand for non-PP investments and the regulator is understood to be considering allowing these to be sold domestically.”

Out of some of the regulations, bankers have managed to extract opportunities. On targeting the country as one of its main Latam franchises, Mr Lascar spent two months living there, working with lawyers and the exchange to find ways of offering products locally. He found out the bank could raise assets in Mexico only by listing debt instruments – and quickly went on to get approval to list locally a euro medium-term note programme that the bank already had in Luxembourg.

SG quickly found out that its local distributors wanted to compete against each other with their own-branded version of the products and has since gone down the white-labelling route with the programme, issuing 35 notes and raising approximately $6bn Mexican pesos ($576m) through local partners.

Mr Lascar adds: “We are now also seeing new client segments open up to these products. For instance, institutional investors were not attracted to the products during the first phase but are now starting to look at them.” Tax rules have also thrown up some interesting opportunities. For instance, equity investments in Mexico are free of capital gains tax but only if the investments are made onshore. Under the rule, local investments made in foreign equity underlyings would also qualify. “To help investors benefit from this, we plan to list exchange traded funds [ETF] linked to a range of international underlyings,” says Mr Lascar.

Markets jostle for attention

After Brazil and Mexico, bankers are divided about whether Chile or Argentina offer the next best opportunities. Credit Suisse’s Mr Yates believes that in the short to medium term, Chile will prove the ripest area for growth, but for BNP’s Mr Steinberg, the next priority is Argentina – followed by Chile, Peru, Ecuador and Colombia.

What most seem to agree on is that Chile is the most sophisticated of all the Latin American markets. “Regulation in Chile is the most favourable for structured investments, and investors are familiar with products,” says Mr Lascar. “They are allowed to invest offshore – and they know how to do it.”

He says that the first major growth area in the local market is in structured guaranteed funds linked to offshore equity indexes for retail investors. “We have closed deals with 100% of the local funds and, as of today, we keep an 80% market share of the new funds launched this year. We are regularly developing new offerings for them to take to a market that is constantly on the look out for new assets.”

The second area he identifies is the private banking business, where an active market in structured notes has already developed, and the third is the ETF market. Mr Lascar says: “Chilean investors already invest quite substantially in ETFs but the activity is all offshore and mostly done through Luxembourg, where Lyxor has been able to tap into this interest.”

Corporate usage of equity derivatives has not yet been a key driver of activity in Latin America but Dixit Joshi, head of global equities at Barclays Capital, believes that this too will provide ample room for growth. “In Latin America, we expect that acquisitive cash-rich local firms will increase usage of the instruments to access offshore investments and in financing stake-building, and that international firms will leverage these instruments to access the domestic markets.”

Not all of the banks boast the sort of local footprints that the Spanish or North American giants possess but they do not seem to be deterred. Mr Lascar admits that it has been challenging not having local branches in every country in the region, but says SG has been able to grow the business quite substantially by approa­ching each country individually and finding ways of offering products, both on and offshore. Of SG’s particular mode of entry, he says “we started filling the gap in services and products provided by other banks”.

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