Chapter 6. Barriers to Integration in Capital Markets
- Charles Enoch, Wouter Bossu, Carlos Caceres, and Diva Singh
- Published Date:
- April 2017
Market capitalizations in the LA-7 (Brazil, Chile, Colombia, Mexico, Panama, Peru, and Uruguay) are moderate in size by emerging market standards; however, continued growth and development will depend on improving liquidity conditions across the region. At the end of 2015, capitalization of LA-7 equity markets was 32 percent of regional GDP, while the value of domestically traded bonds outstanding was about 62 percent of GDP (Figure 6.1). In dollar terms, the largest bond and equity markets are in Brazil and Mexico. Despite solid market capitalizations, low trading volumes are a growing concern. Shrinking liquidity is attributed to deteriorating macroeconomic conditions, high transaction costs, and the outsized role of institutional investors and their buy-and-hold strategies.
Figure 6.1Indicators of Capital Market Growth and Size
Sources: Bank for International Settlements; Federation of Ibero-American Exchanges; and Haver Analytics.
Though most LA-7 exchanges are well-established institutions that predate the Great Depression of the 1930s, their size and importance have waxed and waned along with the macroeconomic prospects of the region. Since financial liberalization in the mid-1990s, equity markets have deepened, whether measured by capitalization, number of issuers, or types of securities traded. However, concerns remain as financial development has not kept pace with the size and activity of comparator markets in emerging Asia and Europe. Moreover, capital raised in Latin American equity markets has been somewhat limited, trading volumes are compressed, markets tend to be dominated by certain sectors, and the underdevelopment of currency and derivatives markets means that domestic instruments are mostly traded offshore (see Annexes 6.1 and 6.2). Ananchotikul and Eichengreen (2008) cite a number of factors that impair regional equity market development, including a history of high inflation, financial crises, corporate and sovereign defaults, and frequent infringement/weakening of creditor and investor rights. Financial deepening has advanced on the back of improved policy and regulatory frameworks and (more slowly) legal reforms, but the history of volatility still weighs on corporate and sovereign financing. The dominance of debt (banks, bonds, and supplier credit) and internal financing over equity reflects high direct and implicit costs of equity issuance. A World Bank study (Zervos 2004) found that in Brazil and Mexico, issuing equity was more expensive than selling domestic bonds (200 and 275 basis points, respectively) or international bonds (217 and 170 basis points). Investors are also thought to prefer holding debt over equity holdings because of the prevalence of family and conglomerate ownership, both of which exert strong management control with less regard for the interests of minority shareholders. Latin American bond markets also bear the cost of previous profligacy. Sovereigns and corporates that issue in foreign markets generally garner larger amounts and often with lower yields or longer maturities than can be had on domestic markets. The bulk of paper in local markets is sold by sovereigns and corporations (particularly financials) with local currency assets and revenues. During the commodity boom, many producers issued internationally to take advantage of better terms and minimize currency mismatches.
State of Play
As in other sectors of the financial system, regional financial integration among capital markets is observed in two dimensions: intraregional securities flows and the expansion of business operations across borders. With regard to the first measure, the question is to what degree are residents of the LA-7 countries buying and selling each other’s financial securities? The IMF’s Coordinated Portfolio Investment Survey indicates that the countries of the region are increasingly open to financial opportunities (Figure 6.2, panel 1) in neighboring states. Between 2003 and 2014, five of the seven countries increased their intraregional liability financing shares, while four increased their asset exposure (although aggregate regional asset position declined on account of the drastic reallocation in Uruguay).1 Brazil is the largest destination for intraregional assets, attracting 45 percent of investments, followed by Mexico (19 percent) and Peru (12 percent). Chile is the largest provider of regional financing, accounting for 47 percent of liabilities, with Mexico and Panama, respectively, supplying 19 percent and 16 percent of funds. Figure 6.2, panel 2 shows the bilateral relationships between the reporting country on the horizontal axis and its regional partners.
Figure 6.2Regional and Global Integration of LA-7 Securities Markets
Source: IMF, Coordinated Portfolio Investment Survey.
1 Liability data derived from partner asset positions.
2 Derived liabilities only; asset data not available.
Regional capital markets are also integrating along the operational dimension. This integration can take many forms; for example, securities exchanges reaching collaborative agreements on mutual trading rights, agreeing on post-trade clearing procedures, or adopting the same electronic trading platform. Operational integration also increases when broker-dealers purchase or establish operations abroad, facilitating the foreign trading activity of clients in both countries. Capital markets become more synergistic when they harmonize trading hours, tax treatments, supervisory practices, and international payment and settlement arrangements. Additionally, there is scope for peer reviews to assess central counterparties’ (CCPs’) compliance with regulatory frameworks, as well as the safety and soundness of individual CCPs, including their use of CPMI-IOSCO PFMI.2 All these elements combined could lead to the mutual recognition of regional clearinghouses as qualified CCPs.
LA-7 exchanges are modernizing their organizational structures, trading, and settlement systems. Over the past decade the BM&F Bovespa, Bolsa Mexicana, and Bolsa de Santiago stock exchanges have fully demutualized.3 Demutualizing increases the transparency under which exchanges are managed, because ownership stakes of the brokers in the exchange are converted into shares that are publicly traded and subject to the same reporting requirements as listed firms. Also, the right to join and trade as a broker becomes a matter of application and process rather than merely the consent of the owning brokers. Other exchanges continue to have mutualized ownership structures, though Bolsa de Lima and Bolsa de Colombia have publicly traded floats and thus must comply with financial reporting requirements that provide greater transparency of operations. The major exchanges have adopted electronic trading platforms that facilitate more cost-effective back-office support in brokerages than when over-the-counter negotiations dominate trading. Exchanges in Brazil, Chile, and Mexico have instituted independent CCP entities that settle and clear trades in all markets (stocks, bonds, foreign exchange, and derivatives), as well as maintaining broker collateral against default. On the Colombian, Panamanian, Peruvian, and Uruguayan stock exchanges, stock and bond trades clear through the exchange itself. Bolsa de Colombia also operates a CCP for derivative and foreign exchange trades.
The global trend for stock exchanges to build strategic alliances through ownership stakes in each other is also occurring in Latin America. These alliances are entered into with the intention of facilitating cross-border transactions that will mobilize larger pools of savings to increase market size and trading activity and cut costs through scales of operation and back-office synergies. Many global banks and exchanges have stakes in Latin American stock exchanges, but regional cross-ownership is also on the rise. In early 2015, BM&F Bovespa purchased an 8 percent stake in the Santiago exchange and is working with it to set up an electronic derivatives market in Chile. In April 2016, BM&F also secured a 4.1 percent stake in the Mexican stock exchange BVM,4 and it is said to be interested in acquiring stakes in the other Latin American Integrated Market (MILA) exchanges as well as the Bolsa de Buenos Aires. The acquisition in 2013 that gave the BVM an 8 percent stake in the Lima exchange was significant not only because it became the largest independent shareholder of the Peruvian Bolsa but also because it signaled BMV’s commitment to join the MILA initiative. Regionalization is also expanding at the broker level. Several brokerages have obtained seats or licenses to be broker-dealers in other LA-7 markets. While their motivations could vary substantially, likely benefits would include reducing transaction costs for regional trades (compared with trades via correspondent brokers), broadening client bases, and increasing transaction volumes, which in turn could drive down average costs of back-office support. BTG Pactual has brokerages on the most dynamic regional exchanges, including Brazil, Chile, Colombia, Mexico, and Peru. Other investment banks and brokerages with intraregional operations include Itaú (Brazil), Sura (Colombia), Credicorp (Peru), GNB Sudameris (Colombia), and LarrainVial (Chile).
The concern regarding the withdrawal of global institutions from Latin America is much less pronounced for capital markets than it is for the banking sector. First, majority control of exchanges lies with domestic entities, while many of the foreign stakeholders are in fact other regional exchanges, not advanced economy entities looking to exit the region. At the brokerage level, while many brokers are subsidiaries of global banks from advanced countries, divestiture of operations has not occurred widely. Even when global banks leave a market (mainly retail banking), they often keep their brokerage operations open as, for example, HSBC has done in Colombia and Citibank in Chile. Retaining brokerage operations can help banks access fixed income and currency markets more efficiently. Brokerages may also signal sophistication of operations to large clients in advanced and emerging markets. Finally, the global regulatory agenda is not generating divestiture pressures for brokerages, given the substantial capital they must maintain with exchanges and the limited amount of lending they do to clients.
For regional capital markets, financial integration could facilitate financial deepening and development. Markets would especially like to see integration drive greater equity trading activity and liquidity conditions. Figure 6.3 shows that since 2013 liquidity measured as growth in value traded has declined for the smaller equity markets (Chile, Colombia, and Peru) and remained largely flat for Brazil and Mexico. The drop in trading activity is likely tied to slowing macroeconomic prospects as the commodity super-cycle ended. This has raised concerns about a vicious circle in which lower trade volumes raise the cost of buying and selling large blocks, which further reduces market liquidity. Also, Latin American exchanges, noted for their high commission and settlement costs, need higher volumes of trades to push down per-trade transaction costs.
Figure 6.3Value Traded in Equities
Source: World Federation of Exchanges.
1 Selected emerging market (EM) exchanges in Argentina, Bermuda, Chile, China, Colombia, Cyprus, Egypt, Indonesia, India, Iran, Israel, Malaysia, Malta, Mauritius, Mexico, Panama, Peru, Philippines, Poland, Slovenia, Sri Lanka, South Africa, Taiwan, Thailand, and Turkey.
Experience with the MILA initiative has shown a demand for cross holdings of regional assets. However trading on the MILA exchange has not met expectations, with volumes averaging only about 260 trades per month at an average value of about $7 million since 2011. Several factors are cited as impediments to more robust trading on the MILA exchange in particular and among the LA-7 countries in general. These include the following:
- Higher costs to trade in regional markets compared with trading in advanced exchanges. Issues of high commission costs,5 large bid/ask spreads in the region, and the fact that many shares trade only sporadically should be addressed to attract more regional participation.
- Operating in the cross-currency markets adds costs to transactions. If brokers, bankers, and institutional investors want to buy a foreign (regional) security and do not have internal access to foreign currency, they must first sell local currency for dollars (usually through New York), then buy the foreign currency (again through New York) before buying the asset. Both foreign exchange transactions incur charges and then they are charged again when they sell the position and repatriate the receipts. Capital controls in Brazil raise costs further for investors looking to enter the largest capital market in the region.
- Variance in tax rates/rules and administrative procedures. The opportunity exists to standardize and coordinate clearing and depository practices across the region.
- Poor sectoral diversity across some markets. The largest and most liquid debt and equity issuers in Chilean, Colombian, and Peruvian markets tend to be natural resource (mining) related firms which, over the past decade, have experienced highly correlated business cycles. Equity markets in Brazil and Mexico offer investors a variety of more diversified sectors from which to choose.
Broker-dealers should be permitted to operate across borders. They should be subject to supervision by both the home and host country regulatory agencies but should receive the same regulatory treatment as domestic firms.
Financial infrastructure should be harmonized across the region, including trading hours and interoperability of trading and settlement platforms. This would facilitate higher trading volumes, lower commission/settlement costs, and reduce reliance on more expensive correspondent brokerage services.
A special “bucket” should be introduced that would allow pension funds to hold regional securities that do not count against foreign securities asset class limits. As described in the recommendations for pension fund integration (Chapter 5), this bucket should have a small cap of 5 percent of assets and would apply only to countries that meet agreed-upon regulatory standards. This recommendation is motivated by the expectation that pension funds would be among the most active participants in regional capital markets if their holdings were not counted against the general foreign asset cap.
International Financial Reporting Standards should be used throughout the region. Countries that have not yet done so should adopt the multilateral memorandum of observance of principles and practices as set out by the Bank for International Settlements and IOSCO related to governance, monitoring, mitigating financial and operational risk, and exchanging information. Also, where they are not yet in effect, double taxation avoidance treaties should be signed and, over time, countries should seek convergence in their tax rates.
Offshore trading continues to dominate turnover rates of Latin American currencies, with the majority of transactions taking place in the United States and the United Kingdom.6 Foreign exchange turnover of emerging market currencies has been predominantly driven by the offshore component in many regions (Annex Figure 6.1.1), which testifies to the growing internationalization of currency, particularly as foreign exchange turnover expansion outpaces trade growth. Latin America continues to have the largest share of offshore currency trading among emerging markets, closely followed by central and eastern Europe (CEE), and well above emerging markets in Asia. The market patterns of offshore turnover of the currencies of Latin America, emerging Asia, and CEE appear to vary in response to geographic proximity as well as trade and financial linkages with offshore jurisdictions. Emerging Asian currencies, for example, have the lowest share of offshore trading, and nearly half of their offshore transactions occur in the regional financial centers: Hong Kong SAR and Singapore. Offshore trades of Latin American and CEE currencies, on the other hand, are largely concentrated in extraregional financial centers, given the absence of sufficiently large financial centers in the region. Although the majority of offshore turnover of CEE currencies occurs in the United Kingdom, financial centers in the United States constitute the largest markets for trading Latin American currencies, accounting for more than half of the offshore turnover.
Annex Figure 6.1.1Offshore Trading of Emerging Market Currencies
(Percent of total onshore and offshore over-the-counter foreign exchange market turnover1)
Sources: Bank for International Settlements (BIS), Triennial Central Bank Survey, and BIS staff calculations; and IMF staff calculations.
1 Daily average in April 2013. Adjusted for local and cross-border inter-dealer double-counting (that is, net-net basis). Latin American currencies (LA) = Argentine peso, Brazilian real, Chilean peso, Colombian peso, Mexican peso, and Peruvian nuevo sol. Weighted averages based on foreign exchange turnover. Central and eastern European (CEE) currencies = Bulgarian lev, Czech koruna, Hungarian forint, Latvian lats, Lithuanian lats, Polish zloty, Romanian leu, Russian rouble, and Turkish lira. Emerging Asian (EM Asia) currencies = Chinese renminbi, Hong Kong dollar, Indian rupee, Indonesian rupiah, Korean won, Malaysian ringgit, New Taiwan dollar, Philippine peso, Singapore dollar, and Thai baht. All emerging market (All EM) currencies = Asia, Bahrain dinar, CEE, Israeli new shekel, LA, Saudi riyal, and South African rand.
2Intraregional is defined as all offshore trades within the respective EM region.
3Regional centers: Hong Kong SAR and Singapore for EM Asia; Brazil and Mexico for Latin America; and Turkey and Russia for CEE.
Global turnover of Latin American currencies is dominated by the Mexican peso (about 65 percent of offshore turnover), followed by the Brazilian real. In 2013, the Mexican peso joined the ranks of the 10 most traded currencies, largely against the U.S. dollar and in the form of foreign exchange swaps and spot transactions (Annex Figure 6.1.2). In turnover ranking, the Mexican peso trails only the national currencies of the United States, the European Union, Japan, the United Kingdom, Australia, Switzerland, and Canada. The Mexican peso is fully convertible, free-floating, without any exchange controls, and widely accepted around the world. It experienced one of the biggest increases among the major emerging market currencies in market share up to 2013, when its turnover reached $135 billion, raising its market share in global foreign exchange trading to 2.5 percent (from 1.3 percent in 20107) and significantly lifting Mexican peso turnover in the domestic market and in offshore jurisdictions. At 80 percent, the Mexican peso’s share of offshore trading is among the highest among emerging markets, trailing only the Polish zloty and the Turkish lira.
Annex Figure 6.1.2Global Foreign Exchange Market Turnover by Currency
Sources: Bank for International Settlements (BIS), Triennial Central Bank Survey, 2013; BIS staff calculations; and IMF staff estimates and calculations.
1 Percentage shares of average daily turnover in April.
2Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200 percent instead of 100 percent.
3Turnover for years prior to 2013 may be underestimated owing to incomplete reporting of offshore trading in previous surveys. AUD = Australian dollar; CAD = Canadian dollar; CHF = Swiss franc; CNY = renminbi; EUR = euro; GBP = pound sterling; JPY = yen; MXN = Mexican peso; NZD = New Zealand dollar; USD = U.S. dollar.
Turnover in the Mexican peso increased largely as a result of increasing investor confidence and growing market liquidity. Unrestricted access (the Mexican peso trades globally 24 hours a day) plays a fundamental role in its rising popularity. The high liquidity of Mexican assets also stimulates turnover of the domestic currency. Its popularity received a boost after the size of the Mexican bond market led Citigroup to add Mexican peso-denominated debt to its World Government Bond Index in late 2010, making Mexico the first Latin American country in the benchmark.
The bulk of the interest rate derivatives denominated in Mexican pesos are traded predominantly in the offshore markets, mainly in the United States. Mexico’s vibrant interest rate derivatives market is composed primarily of TIIE (Tasa de Interes Interbancaria de Equilibio, the equilibrium interbank interest rate) interest rate swaps, with an overwhelming share of trading taking place outside of platforms via the over-the-counter (OTC) market. OTC turnover of single currency interest rate derivatives denominated in the Mexican peso stood at US$12.3 billion in April 2013,8 representing about 0.4 percent of the global OTC single currency interest rate derivatives market, trailing only the OTC interest rate market denominated in the Brazilian real (Annex Figure 6.2.1).9 However, less than a fifth (US$2.4 billion) of the Mexican peso turnover is cleared in Mexico, while the remaining 82 percent clears through offshore markets, mainly in the United States (Annex Figure 6.2.2).
Annex Figure 6.2.1Over-the-Counter Interest Rate Derivative Turnover Composition
Sources: Bank for International Settlements (BIS), Triennial Survey 2013; and IMF staff estimates and calculations.
Note: ARS = Argentine peso; BRL = Brazilian real; CLP = Chilean peso; COP = Colombian peso; MXN = Mexican peso; PEN = Peruvian nuevo sol; TOT = all currencies.
Annex Figure 6.2.2Over-the-Counter Interest Rate Derivative Turnover Country and Currency
(Percent, single currency, April 20131)
Sources: Bank for International Settlements, Triennial Survey 2013; and IMF staff estimates and calculations.
1 ARS = Argentine peso; BRL = Brazilian real; CLP = Chilean peso; COP = Colombian peso; MXN = Mexican peso; PEN = Peruvian new sol. Forward rate agreements, swaps, options and other products. Adjusted for local inter-dealer double-counting (that is, “net-gross” basis).
2All Latin American currencies in the sample.
A number of factors have accounted for the burgeoning offshore OTC market, including Mexico’s close ties with the United States, delay in establishing a well-functioning trading platform, and lower costs of OTC transactions. Although it was established in the late 1990s, the Mexican derivatives platform MexDer (Mercado Mexicano de derivados) did not become an important financial player until a few years ago. Thus, until recently, in the absence of a well-functioning platform, interest rate hedging needs were predominantly met through the OTC market. Higher fees, associated largely with the technological and technical costs of the trading platform, continue to contribute to the general preference for the OTC market.
Recent regulatory adjustments in the European Union and the United States call for the trading of standardized OTC derivative contracts on exchanges or electronic platforms, and for their clearance through a recognized central counterparty (CCP), while non-centrally-cleared contracts would be subject to higher capital requirements. In the spirit of alignment with global standards, the Mexican authorities have introduced a new regulation, scheduled for gradual implementation, that will require OTC derivative trades to take place on exchanges or through interdealer brokers and that provides for a mandatory clearing of standardized derivatives through a CCP—Mexican (if established in Mexico and authorized by the Secretariat of Finance and Public Credit) or foreign (if recognized by Banco de Mexico). Since April 2016 compliance with the new regulation is required for transactions between Mexican entities; November 2016 marked the start date for transactions involving foreign financial institutions.
In addition to making derivatives markets safer, the new Mexican regulation is expected to improve competition between domestic and foreign clearinghouses. Over the medium term, the regulation is expected to increase the volume of contracts traded through MexDer and cleared through Asigna, the Mexican central clearinghouse for derivatives. However, given the large presence of foreign institutions, Asigna is likely to continue facing strong competition from offshore CCPs—such as Chicago Mercantile Exchange and LHC. Clearnet Ltd. (a European clearinghouse)—as foreign institutions are expected to continue clearing their derivatives offshore. By clearing through a CCP in the parent country, multinational entities can consolidate their operations by netting their derivative positions vis-à-vis the positions of the parent and other subsidiaries, thereby decreasing capital requirements. The operations of MexDer and Asigna are likely to continue expanding largely through the derivative trading businesses of Mexican institutional investors, such as pension funds. While the new regulatory changes constitute a welcome step toward market transparency and lower risk, additional technical and technological improvements are needed to boost Asigna’s and MexDer’s competitiveness.
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