Issuance process

11. The regulatory framework for the issuance of fixed-income products does not appear to present major impediments to the development of the market. The framework provides sufficient flexibility to issuers in terms of issuance size, structure, and characteristics. Public offering requirements are reasonable and in line with international standards.

12. Corporate debt issuance is relatively easy for large corporates, but small corporates face significant hurdles. The problems for smaller issuers seem to arise primarily from their credit quality and size. In practice, they are often unlikely to obtain the credit rating required for private pension fund investments. Also, the generally smaller size of issuance tends to deter private pension funds and other major institutional investors. Altogether, this has led to a compartmentalized capital market, with reduced opportunities for smaller issuers.

13. The length of the registration process for new bond issuance does act as an impediment to the development of the market, particularly for smaller issuers. Issuers and banking sources report that it takes a minimum of 90 days to issue a corporate bond, even for large corporates. This includes 30–40 days to register with the Superintendencia de Valores y Seguros(SVS) and an additional period of at least 30 days to complete the registration process with the Comision Clasificadora de Riesgo (CCR). These delays tend to be longer for smaller and lower credit grade corporates. Although the SVS has taken several positive steps to reduce the burden for issuance of new tranches of pre-registered bonds, the regulatory authorities should explore ways to reduce the approval process further. In particular, given that local credit rating agencies are now well established, the authorities could consider streamlining the role of the CCR, refocusing its activities on the areas where it can add most value.

14. The stamp tax adds to the cost of issuance, particularly for shorter tenors. The stamp tax is applied as a flat rate tax (of 1.6 percent) on all financing activities. Consequently, its cost impact on long-term financing is significantly lower than on short-term financing. For example, assuming a general level of interest rates of 5 percent, the stamp tax adds 172 basis points to the cost of a one-year instrument, 38 basis points a year to a 5–year instrument, and 21 basis points a year to a 10–year instrument.⁸ This structure tends to impact small and medium-sized enterprises (SMEs) more significantly, given their relatively volatile and uncertain financing needs. This may also encourage them to favor bank lending over capital market financing, as banks may be able to offer more flexibility in the type of instruments provided. The stamp tax also hinders competition in the provision of financing, as the relief available on rolled-over debt is restricted to roll-over with the same lender.

15. The authorities could consider equating the incidence of the stamp tax across maturities, reducing current distortions. Ideally, a comprehensive review of the taxation of financial instruments would be undertaken to allow an assessment of the overall cost-benefit impact of the stamp tax. Reducing or eliminating the tax could be considered within an overall framework that would take account the impact on fiscal revenue as well as agents’ behavior in the market.

Foreign issuers

16. Recent regulatory changes have opened up the possibility for foreign corporate debt issuers to tap the domestic Chilean market. Recently-issued SVS regulations facilitate the issuance of debt by non-resident corporates. Although these regulations have only been in place for a few months, there are some encouraging signs of interest from Latin American corporates. Likely barriers include the stamp tax and the requirement that the issuer be approved by the CCR to ensure that it can access the pool of liquidity held by pension funds. Whilst it would be surprising if non-resident issuance grew to a significant share of the market quickly, the SVS and other market participants could advertise this facility internationally to help enhance its development.

Securitization market

17. Although the market for mortgage-related bonds functions well, securitization is still modest. The market combines both mortgage-backed securities (letras hipotecarias) and endorsable mortgage loans (mutuos hipotecarios). While the securitization of mutuos hipotecarios has virtually disappeared, following the decline in interest rates in recent years, securitization of letras hipotecarias continues at a steady pace. More recently, other assets have been securitized, mainly related to department store credit cards and leasing associated with housing and car loans. Complex forms of securitization are almost non existent.

18. Securitization could be enhanced as a useful mechanism to provide SME access to capital. Given the importance of small and medium sized enterprises (SMEs) for the growth of the economy, many countries have developed programs to help improve their access to credit through securitization. The Chilean authorities could explore ways to link guarantees issued by the Fondo de Garantia para Pequeñas Empresas (FOGAPE) to securitization schemes (Box 1 outlines a potential framework, based on the experience of Spain).⁹

Domestic Investors

21. The Chilean pension system is highly concentrated, with no significant cross-fund variation in portfolio asset allocations. There are 6 private pension funds in Chile, with the largest 3 managing more than 70 percent of total assets. The high elasticity of substitution between pension funds due to minor differences in performance, coupled with asymmetric penalties for under-performance relative to the industry average, has led to funds achieving almost identical returns. As a result, they hold similar asset allocations, a lack of diversity which generates inertia and low liquidity in the secondary market.

22. Greater competition in the provision of private pension funds management services might lead to an increase in diversity of views, generating greater activity. Achieving this increase in competition will not be straightforward. One approach that could be considered would be to split the administration business from asset management, allowing firms to specialize in the provision of those services where they have the greatest comparative advantage. As economies of scale considerations are likely to be relatively less important on the asset management side, such a split might encourage new entrants.

23. The tight regulatory framework imposes strict limits on private pension fund investment opportunities. An important quantitative restriction is that funds cannot invest more than 30 percent of their assets in foreign issues, and this allowance is fully utilized (Table 3). As noted, investment restrictions on pension funds result in holdings of cash that are significantly higher than in other developed systems, thus reducing the returns to contributors.

24. Relaxing the restrictions on holdings of foreign assets appears desirable. This would allow private pension funds to transfer much of their cash holdings into foreign equity and fixed income, which would help increase the expected return to contributors. In many small developed countries, large private pension funds not subject to binding foreign investment limits do invest a significantly larger share of their assets abroad. For example, pension funds in Ireland and the Netherlands invest over 60 percent of their assets abroad, in part because of the lack of suitable liquid instruments domestically. The increasing availability and liquidity of foreign exchange forwards means that the resultant foreign exchange exposure could be effectively hedged.

25. The development of the derivatives market is also hampered by existing restrictions on private pension fund activities. At present, private pension funds are only permitted to use derivatives to hedge an exposure, which in effect means hedging a currency exposure. While new regulations might allow private pension funds to participate in the interest rate derivatives markets, current restrictions limit their ability to actively manage their duration and/or take strategic views on interest rate developments. It also limits activity in the derivatives markets, reducing liquidity and the effectiveness of that market.

26. Life insurance companies tend to hold long-dated inflation-indexed securities, which are scarce. Insurance companies represent the second largest buy-and-hold investor class in the fixed-income market, with life insurance accounting for 70 percent of total insurance business. In 2005, total investments of insurance companies amounted to US$22.1 billion, with 15 percent of total held in public sector debt, 21 percent in mortgage-related debt, and 34 percent in corporate debt. As the pension fund system matures and more annuities are required when contributors retire, there will be added pressure for the life insurance sector to acquire inflation-indexed long-dated debt. In the absence of significant new public sector issuance, the majority of such debt will need to come from the corporate sector. To the extent that such supply will not be forthcoming, there could be an increasing mismatch between the assets and liabilities of the life insurance sector, with unwanted consequences for the provision of annuities.

27. The mutual fund industry has grown steadily over the last 10 years, resulting in a new source of demand for fixed-income assets. At end-2005, the mutual fund industry managed US$13.7 billion in assets, up from US$2.5 billion in 1995. During 2005, the net value of funds under investment grew by 5 percent, with a 17 percent increase in the number of participants (Table 4). Since only 3 percent of the population presently holds such a fund, there seems to be significant scope for this industry to experience continued growth. Mutual funds are increasingly active in the public sector and corporate debt markets, providing much needed competition and alternative investment perspectives to the pension and insurance sectors. They also tend to hold longer-dated paper than in the past and now participate directly in the primary debt issuance of both government and corporate paper.

Table 4:

Developments in Mutual Fund Industry, by Type

Source: SVS.

Table 4:

Developments in Mutual Fund Industry, by Type

	Net Value of Fund (CLP ‘000s)			Number of participants
	Dec-04	Dec-05	Mar-06	Dec-04	Dec-05	Mar-06
Type 1	2,709	3,295	3,945	124,191	187,551	203,006
Type 2	406	314	389	72,038	64,041	66,589
Type 3	2,397	1,582	1,693	233,347	193,328	189,934
Type 4	195	213	270	32,690	36,599	41,581
Type 5	444	847	962	58,059	106,649	112,647
Type 6	293	408	470	22,799	36,471	39,172
Type 7	164	266	281	16,302	30,004	31,887
Type 8	13	53	53	150	1,232	1,394
Total	6,622	6,978	8,063	559,576	655,875	686,210

Source: SVS.

View Table

Table 4:

Developments in Mutual Fund Industry, by Type

	Net Value of Fund (CLP ‘000s)			Number of participants
	Dec-04	Dec-05	Mar-06	Dec-04	Dec-05	Mar-06
Type 1	2,709	3,295	3,945	124,191	187,551	203,006
Type 2	406	314	389	72,038	64,041	66,589
Type 3	2,397	1,582	1,693	233,347	193,328	189,934
Type 4	195	213	270	32,690	36,599	41,581
Type 5	444	847	962	58,059	106,649	112,647
Type 6	293	408	470	22,799	36,471	39,172
Type 7	164	266	281	16,302	30,004	31,887
Type 8	13	53	53	150	1,232	1,394
Total	6,622	6,978	8,063	559,576	655,875	686,210

Source: SVS.

28. The growth of a high-yield market in Chile may be determined by developments in the mutual fund industry. Investment restrictions prevent private pension funds from playing a significant role in the development of a high-yield sector in Chile.¹⁰ Even if some additional flexibility were granted to invest in sub-investment grade bonds, it should only be marginal, given that the private pension funds are the main pillar of the social security system, requiring a high degree of conservatism in determining investment parameters. As Table 4 suggests, there appears to be an increase in the risk appetite of mutual fund investors, with a significant increase in the numbers of participants in the more flexible and exotic funds—types 5 (capital instruments), 6 (free investment), 7 (structured) and 8 (qualified investors). This could provide a basis for development of the high-yield market, with mutual funds providing a source of funding for corporates unable to access other investor segments.

29. Broad financial literacy programs would foster the development of a healthy market. As markets develop, the need for more informed investors increases. However, financial literacy often lags the development of financial products. A broad financial literacy program could help relax the strong conservative culture that prevails in the Chilean financial market, further facilitating the development of a high-yield market and enhancing SME access to credit. Programs such as those developed by Singapore and Australia could serve as a reference for the Chilean authorities.

Foreign investors

30. Foreign investor activity in the Chilean fixed-income markets is very limited. In the equity market, the removal of tax impediments in 2001 led to a significant increase in foreign investor participation. In the fixed-income market, although provisions exist to exempt foreign institutional investors from the capital gains tax, the registration process is still cumbersome and some uncertainties continue to exist about the application of these provisions. Improving the operational effectiveness of these provisions, through clear regulations, and simplifying the registration process, by relying to a greater extent on the exchange of information provisions in existing double tax agreements, could increase foreign investor participation. Their presence would add liquidity to the fixed-income market, given likely differences in the risk appetite of foreign investors relative to domestic investors.

31. The lack of information on trading conditions in the Chilean fixed-income market also acts as a deterrent to prospective foreign investors. Some market participants commented that more efforts should be devoted to promoting Chile among foreign investors. They noted the contrast with the situation in Brazil, where the authorities work closely with the Brazilian Mercantile and Futures Exchange and the Brazilian Clearing and Depository Corporation to promote the market to foreign investors through the BEST—Brazil Excellence in Securities Transactions—initiative.

Market makers and intermediaries

36. A tailored system of specialists in public debt could add value. It is not clear that a traditional market making system could be supported, given the limited supply of public debt. Neither Australia nor New Zealand, two countries which only have a limited supply of government debt, possesses such a system. Given the dominant position of the pension funds and life insurance companies in the market, a traditional market making arrangement requiring market makers to make firm two-way prices to clients would expose them to an unacceptable level of risk. However, establishing less traditional arrangements would be feasible:

• Requirements. In Chile, the main purpose of specialists could be to actively promote the development of fixed-income securities to new market participants by providing price information and market analysis. Success could then be determined by increased turnover. This would be similar to the approach in Brazil, where market makers are required to achieve certain turnover requirements in a small selection of designated bonds.

• Privileges. In return for providing enhanced services to prospective participants, specialists could be given certain privileges in the auctions of public debt—for instance, access to a non-competitive bidding facility—but they would not be given exclusive access to the primary market (Box 3).

• Meetings. Other benefits might include participation at regular meetings with the authorities to discuss market development issues and issuance plans. Such a regular dialog between key market participants is common in the European and U.S. markets.

37. Market intermediaries should be subject to a robust risk-based supervisory framework, with adequate enforcement mechanisms. Current capital requirements are insufficient, and there are no “fit and proper” requirements in place for securities intermediaries. Although the draft Capital Market II law contains provisions for the development of such requirements, the authorities should consider a more comprehensive review of the licensing requirements applicable to securities intermediaries. With respect to market conduct rules, it would be important to impose symmetric requirements across all intermediaries, including dealers. The BCS has recently constituted a regulatory committee, composed of independent members, to enhance its enforcement capabilities. Close coordination of BCS and SVS efforts should be ensured.

General Regulatory Framework

38. The authorities will need to evaluate how best to address deficiencies in the legal framework for clearing, settlement, and custody. Beyond approval of the draft Capital Market II law, which contains key provisions in the areas of netting and movable collateral, reforms are needed to incorporate the concepts of finality and novation. The draft law would also strengthen custody arrangements. However, the authorities will need to evaluate whether additional provisions should be included to clearly address the status of assets held in custody in the event of insolvency.

39. Risk management arrangements for the clearance and settlement of BCS trades should continue to be overseen by the SVS. Operational improvements have taken place in this area: the central bank has recently implemented RTGS, while the BCS has introduced multilateral netting, accompanied by a set of mechanisms to manage settlement risk. It is important, however, that the SVS continue to keep the adequacy of these mechanisms under review and assess whether additional mechanisms, such as a settlement fund or a central counterparty, are needed.

40. Additional changes at an operational level could improve the services provided by the DCV. In particular, if the number of foreign investors increases, the DCV should actively seek arrangements with other central securities depositories abroad, which could generate additional activity by foreign investors at the margin. However, given the presence of foreign banks in Chile, the current arrangements are unlikely to represent a significant impediment to foreign investor activity.