BM&FBOVESPA's Post-Trade Infrastructure

BM&FBOVESPA’s Post-Trade Infrastructure Integration Opportunities and Challenges This White Paper was prepared by the Clearing, Risk Management and Central Depository Executive Officer team of BM&FBOVESPA working in collaboration with Bruce Butterill, an Independent Capital Markets Infrastructure Consultant.

January 2010 BM&FBOVESPA’s Post-Trade Infrastructure Integration Opportunities and Challenges

Integration Opportunities and Challenges

CONTENTS

EXECUTIVE SUMMARY...... 9 INTRODUCTION...... 17 PART I – ENVIRONMENTAL REVIEW...... 21 1..The Brazilian Marketplace...... 21 2..BM&FBOVESPA in a Snapshot...... 23 PART II – CORE POST-TRADE INFRASTRUCTURE – THE BASIC BUILDING BLOCKS...... 29 1. BM&FBOVESPA Central Securities Depository...... 29 2. BM&FBOVESPA Securities Settlement Systems...... 31 3. BM&FBOVESPA Central Counterparty Services...... 35 4. Central Securities Depository, Settlement System and Central Counterparty - Best Practices...... 39 PART III – INTERNATIONAL EXPERIENCES IN POST-TRADE OPERATIONS INTEGRATION.. 45 1. Australian Stock Exchange (ASX) Integration Case Study...... 45 2. Depository Trust and Clearing Corporation (DTCC) Integration Case Study...... 48 3. Hong Kong Exchanges and Clearing Limited (HKEx) Integration Case Study...... 51 4. Main Conclusions of the International Experiences in Post-Trade Operations Integration...... 53 PART IV – INTEGRATION OPPORTUNITIES...... 57 1. Creation of a unified vision for portfolio risk to enhance participants’ and investors’ risk monitoring and management...... 58 2. Adoption of common risk management for all systems, combining two or more Central Counterparties (CCPs) with a common margin calculation, adopting a common loss sharing approach and integration of different financial instruments across CCPs...... 59 3. More efficient use of collateral, with the introduction of a collateral pool...... 59 4. Improved liquidity and cash management with netting of payment obligations, fostering harmonization of settlement processes during the day...... 60 5. Availability of a more diversified suite of products and services to a broader range of potential customers...... 61 6. Provision of a financial information hub and electronic platforms, facilitating the delivery of information in a standardized manner through a single portal to support a variety of traded products and services.... 61 PART V – INTEGRATION OPPORTUNITY CONSIDERATIONS...... 69 1..Need for Consensus...... 69 2..Market and Functional Segmentation...... 69 3..Risk and Collateral Management Considerations...... 70 4..Changes in the Participants’ “modus operandi”...... 71 5..Regulatory Models and Risks...... 71 6..The Stakeholders’ Equation...... 71 APPENDIX...... 75

EXECUTIVE SUMMARY

Integration Opportunities and Challenges

EXECUTIVE SUMMARY Introduction

It is our hope and expectation that the development of this “White Paper” will prompt an active and informed dialogue among our stakeholders regarding both the opportunities and challenges associated with an increased level of integration of BM&FBOVESPA ´s post-trade infrastructure.

Much has happened in the months since the merger of BM&F with Bovespa in May of 2008. During this time the management team at BM&FBOVESPA has focused its energies on bringing about the smooth and effective amalgamation of the two organizations into one that provides an integrated group of services, ranging from listing services through trading, clearing, risk management, depository and other support services.

Over the past year we have done a great deal to enhance and streamline our operations, and during the latter half of 2008 we faced the added challenge of managing the impact of the financial crisis.

Following the second quarter of 2009 we turned our attention to examining how a greater integration of our post-trade systems environments and processes could benefit BM&FBOVESPA, our participants and the Brazilian market as a whole. Up until now there has been a great deal of internal discussion on this subject, but we feel the time is right to move the discussion of how we can bring about the achievement of a more efficient post-trade environment to the broader public forum.

Although integration opportunities might exist within BM&FBOVESPA’s different business lines, this White Paper will focus only on those related to the post-trade environment; more specifically the integration opportunities related to central depository, clearing and settlement and risk management systems, processes and procedures.

Through this White Paper we strive to:

1. Present to our various stakeholder groups the opportunities which are believed to exist from the further integration of post-trade systems and operational activities; 2. Assist in furthering the knowledge of stakeholders regarding our business model; 3. Stimulate informed discussion on the subject; 4. Act as a catalyst for action; 5. Provide a framework for any integration actions that are undertaken; 6. Outline what we believe to be viable options for integration.

The Brazilian Capital Market and BM&FBOVESPA

In order to better understand the integration opportunities we foresee in BM&FBOVESPA’s post-trade infrastructure, it is important to understand the context in which these changes might take place. Over the past two decades, we were witness to a dramatic evolution of the Brazilian economic, regulatory and market environments that has had, and will have, an impact on the discussion of integration opportunities and options.

Brazil has evolved into a very important financial and capital market, both in terms of its size and level of sophistication. The Brazilian financial and capital markets have a high quality and prudent regulatory

9 BM&FBOVESPA’s Post-Trade Infrastructure environment, and the changes that were implemented in the payments infrastructure were absolutely crucial in achieving the current level of excellence in the clearing and settlement process.

The Brazilian capital market has also seen the consolidation of the exchanges, in a process that began with the demutualization of Bovespa and BM&F in 2007, followed by each company going public and listing their shares on Bovespa, and then ultimately, to the merger of the two organizations resulting in the establishment of BM&FBOVESPA in May of 2008.

In this sense, it is important to bear in mind that BM&FBOVESPA is a vertically integrated exchange providing the Brazilian capital market and its participants with a wide range of services:

• Listing services for local and international issuers with differentiated levels of corporate governance (Novo Mercado); • Electronic trading solutions for intermediaries and Direct Market Access (DMA) for local and international investors, including co-location connectivity; • Electronic registration environment for OTC derivatives, with or without the interposition of the Central Counterparties (CCP); • Central counterparty clearing and DVP settlement: • A Central Securities Depository (CSD) platform with a beneficial owner account structure; • Securities lending services where BM&FBOVESPA acts as the central counterparty to borrowers and lenders; • Banking infrastructure – BM&F Bank offers settlement bank and custodial services to market intermediaries and provides the Clearinghouses access to the Brazilian Central Bank rediscount; and • Integrated and modular IT solutions for intermediaries’ front, middle and back office activities (Sinacor).

BM&FBOVESPA is also a multi-asset class exchange, offering a wide array of products in the various markets and presenting solid growth in the number of trades and overall volumes during recent years. It should also be mentioned that BM&FBOVESPA provides the infrastructure and systems that make up the foundation of the post-trade processing environment in Brazil.

Post-Trade Core Infrastructures – The Basic Building Blocks

BM&FBOVESPA’s post-trade infrastructure can be divided functionally into three core units: a Cen- tral Securities Depository (CSD), Securities Settlement Systems (SSS) and Central Counterparties (CCP). We consider these units to be the “building blocks” upon which BM&FBOVESPA will further develop its post-trade infrastructure. They will serve as the foundation for future advancements as part of our committed efforts to meet the continually evolving needs of our market.

Here at BM&FBOVESPA we operate a world class Central Securities Depository (CSD) that services the full breadth of the Brazilian securities markets. We have implemented a holding model where the custody records are maintained based upon beneficial owner registration, representing the official record of ownership as prescribed under Brazilian Regulation. Securities held within our custody have been completely dematerialized (where no physical certificates exist) for holdings of equities, corporate bonds, mutual fund units, exchange-traded funds, agri-business bonds and mortgage-backed securities. This efficient Central Securities Depository (CSD) infrastructure provides the foundation upon which it is possible for market participants to initiate and complete large volumes of transactions that would not otherwise be operationally feasible.

10 Integration Opportunities and Challenges

Within the post-merger organization we are currently operating four distinct settlement processes as well as four distinct Central Counterparties (CCPs) in support of the equity, corporate bonds and stock derivatives, financial derivatives, government bonds and foreign exchange markets. BM&FBOVESPA has put in place settlement systems and processes of the highest caliber, compliant with prevailing international standards and thus provide market participants with reliable and secure transaction settlement. For example, we directly control both the movement of funds and related securities without the use of intermediaries in the process1.

We have also put in place sophisticated risk management systems and processes which are designed to effectively safeguard each of the CCPs (Central Counterparties) against the risks associated with the default of a participant. The Central Counterparties (CCPs) have mechanisms for managing market risk, liquidity risk, credit risk, legal risk and operational risk. The varying structures of our systems reflect the nature of the markets they serve, providing participants with efficient risk management tools. The various Central Counterparty (CCP) risk models within BM&FBOVESPA, while differing in their underlying structure, share a common philosophy of providing BM&FBOVESPA and our participants with an extremely high level of confidence that the risks inherent in the clearing and settlement processes are effectively managed.

BM&FBOVESPA’s Central Securities Depository, Settlement Systems and Central Counterparties have been strongly influenced by the recommendations issued by a number of organizations, such as The Group of Thirty, International Organization of Securities Commissions (IOSCO) and Bank for International Settlements (BIS). BM&FBOVESPA’s compliance with these recommendations is de- scribed in the Appendix of this White Paper.

International Experiences in Post-Trade Integration

Stemming from the strong belief that there is a much to be learned from the experiences of other coun tries, we included in the White Paper a set of “case studies” which illustrate how some other markets have gone about the process of integration. These case studies were developed in consultation with our peers in the respective markets and provide some valuable insights into their experiences, particularly in relation to:

• What extent these organizations have integrated processing for various instrument types or markets serviced by their organizations; • What were their motivations were in pursuing an increased level of integration; • What challenges they experienced along the way; • How the benefits they realized compared with those they envisioned at the outset.

The analysis of these markets illustrates that, as their infrastructures pursued an increased level of in tegration of their operations, a variety of challenges were encountered which needed to be addressed. From a very general perspective, the most relevant challenges faced by the infrastructures in their inter action with market participants related to one or more of the following aspects:

1 The only exception is the Foreign Exchange Clearinghouse that settles USD through settlement banks in the USA.

11 BM&FBOVESPA’s Post-Trade Infrastructure

• There was a marked difference in the perception of various participant groups with respect to initiatives being considered. • Differences and issues tended to grow through analysis, rather than getting smaller. • The market view was at times different than that of the infrastructure with respect to the potential benefits of various initiatives. • In some situations the complications and risks associated with integration of systems outweighed the potential benefits. • Integration of legacy market systems was a highly complex undertaking as it involved not only technical preparation and migration, but also operations integration, rules and operational procedures changes, market readiness, a period of parallel processing and fallback arrangements, etc.

Integration Opportunities

Immediately following the merger of BM&F and Bovespa, we embarked on our path towards ever- increasing levels of integration. The company has now been organized within a single legal entity and operating units across the various markets have been consolidated, generating synergies and providing the foundation upon which we will achieve greater levels of integration and efficiency.

A more advanced degree of integration of the post-trade environments across the various BM&FBOVESPA markets presents the opportunity to build a business and service center for the Bra- zilian and international markets with greater opportunities for:

• Creation of a unified vision for portfolio risk to enhance participants’ and investors’ risk monitoring and management activities; • Adoption of common risk management for all systems, combining two or more CCPs (Central Counterparties) with a common margin calculation, adopting a common loss sharing approach and integration of different financial instruments across CCPs; • More efficient use of collateral, with the introduction of a collateral pool; • Improved liquidity and cash management with the unification of two or more settlement windows (specific time during the day to arrange the DVP); • Availability of a more diversified suite of products and services; e • Improvements in the operating efficiency of participants, through the harmonization and standardization of BM&FBOVESPA´s information and process.

These opportunities comprise a set of initiatives that can be classified as actions; that are currently -un derway, planned, and actions being considered..

Integration Opportunities Considerations

There are some elements of the integration opportunities presented in the previous section that are a natural byproduct of combining our infra-structure, such as the construction of a unique portal for ac- cessing BM&FBOVESPA’s services, as well as the potential to combine existing tools and products to better serve our customers.

There are other elements, however, that require a deep understanding of our market’s functioning as well as a thorough analysis of the changes being contemplated in order to ensure that the outcomes will be beneficial for the various categories of market participants and stakeholders.

12 Integration Opportunities and Challenges

Those potentially more controversial aspects of integration will probably require deeper reflection and consultation in order to build an appropriate level consensus on the best way forward with the various integration opportunities.

Among these considerations are:

• Need for Consensus among stakeholder groups on the best approach to adopt regarding the integration opportunities. • Market and Functional Segmentation necessitates consideration of the differences in the various markets and market participants. While there is a substantial level of overlap, participation in each of the different markets is not identical. • Risk and Collateral Management Considerations will raise important questions as we examine the various integration options. • Changes in the Participants’ “modus operandi” which might be required as a result of various integration opportunities. Careful consideration will need to be given to the potential impacts on participant operational processes, whether they are expected to be potentially positive or negative. • Regulatory Models and Risks, because the market segments supported by BM&FBOVESPA operate under a variety of regulatory frameworks.

The goal behind all of the integration opportunities we have outlined is to create value for all stakeholders in a balanced way. BM&FBOVESPA has the responsibility to seek technical solutions considering, at the same time:

• improvements in service quality, • excellence in risk management, • cost-efficiency for market participants, • regulatory reliability, and, • returns to shareholders.

The considerations identified are aimed at encouraging stakeholders to take a broad market view in building an ever more efficient post-trade infrastructure in support of advancing the attractiveness and competitiveness of the Brazilian capital market.

Next Steps

Based upon the input received from stakeholders following review of the material in this White Paper and the ensuing exchange of ideas, BM&FBOVESPA will formalize a plan of action that will likely include an examination of one or more of the integration options outlined within this paper, or possibly another variation which emerges from the dialogue.

13 BM&FBOVESPA’s Post-Trade Infrastructure

14 Integration Opportunities and Challenges

INTRODUCTION

15 BM&FBOVESPA’s Post-Trade Infrastructure

16 Integration Opportunities and Challenges

INTRODUCTION

Much has happened in the months since the merger of BM&F with Bovespa in May of 2008. During this time the management team at BM&FBOVESPA has focused its energies on bringing about the smooth and effective amalgamation of the two organizations into one that provides an integrated group of services ranging from listing services through trading, clearing, risk management, depository and other support services.

Over the past year we have done a great deal to enhance and streamline our operations, and during the latter half of 2008 we faced the added challenge of managing the impact of the financial crisis.

Through this White Paper we strive to:

• Present to our various stakeholder groups the opportunities which are believed to exist from the further integration of post-trade systems and operational activities; • Assist in furthering the knowledge of stakeholders regarding our business model; • Stimulate informed discussion on the subject; • Act as a catalyst for action; • Provide a framework for any integration actions that are undertaken; • Outline what we believe to be viable options for integration.

In order to discuss the future design of BM&FBOVESPA’s post-trade infrastructure, we believe it is essential to begin by building a comprehensive understanding of the context in which these changes might take place. For this reason Part I of the White Paper addresses our perceptions on the Brazilian capital market’s current stage of evolution.

After having provided an overview of the Brazilian market place and BMF&BOVESPA’s role in it, we proceed to Part II which presents an outline of the “building blocks” that make up the foundation of our post-trade infrastructure: Central Securities Depository (CSD), Securities Settlement Systems (SSS) and Central Counterparties (CCP). Part II also presents a general overview of the relevant international best practices that have heavily influenced the development of BM&BOVESPA’s current model.

Part III explores some “case studies” of international infrastructures that undertook integration initia tives in their post-trade environments and the results they obtained. The “case studies” cover the mar kets of Australia, United States and Hong Kong.

17 After providing a picture by detailing the aspects of the post-trade basic “building blocks”, an overview of the prevailing international standards, and an analysis of international experiences regarding post-trade operations integration, Part IV addresses a variety of possible post-trade integration options within BM&FBOVESPA.

Finally, Part V explores some aspects of the integration that would likely require deeper reflection and consultation with our stakeholders in order to build an appropriate level of consensus on the best way forward with the various integration opportunities. PART I THE BRAZILIAN MARKET PLACE AND BM&FBOVESPA

Integration Opportunities and Challenges

PART I – THE BRAZILIAN MARKET PLACE AND BM&FBOVESPA

In order to better understand the integration opportunities we foresee in BM&FBOVESPA’s post-trade infrastructure, it is important to understand the context in which these changes might take place. Over the past two decades, we were witness to a dramatic evolution of the Brazilian economic, regulatory and market environments, which has had and will have an impact on the discussion that will follow.

This section of the White Paper will present a view of this evolutionary road and highlight the accom- plishments that were significant in contributing to the transformation of our market. We are especially interested that our readers reach a common understanding that:

• Brazil is now a very important financial and capital market, both in terms of its size and level of sophistication. • The Brazilian financial and capital markets have a high-quality regulatory environment. • The changes that were implemented in the payments infrastructure were absolutely crucial in achieving the current level of excellence in the clearing and settlement process.

In this context, BM&FBOVESPA has followed its own evolutionary pathway and this section of the paper also aims to provide a brief overview of BM&FBOVESPA before going on to a more detailed discussion of the post-trade infrastructure.

1. The Brazilian Marketplace

Throughout the latest decades, Brazil underwent a period of inflation stabilization. The stability which was achieved, coupled with the opening of Brazil’s economy strengthened its financial sector, providing the catalyst for greater integration with the international financial system, and positioning Brazil as a much more attractive market for foreign direct and portfolio investment. During this same period, Brazilian regulatory authorities became more actively engaged in the international debate on the for- mulation of best practices for the world’s financial and capital markets.

Over the past 15 years, the Brazilian financial system has also brought about substantial improvements in its operational efficiency, and even more so in the soundness of its macroeconomic fundamentals. The transformation of the Brazilian financial system has included the important following developments:

• The end of the inflationary period with the implementation of Plano Real in 1994; • The Central Bank of Brazil adopted the Basel Accord with capital requirements that were more con- servative than the international standard (11% instead of 8%); • Adoption of professional conduct rules which included a requirement for asset management firms and bank divisions to observe Chinese Wall principles; • Development of innovative and diversified financial products and banking services, as financial institutions sought to establish new sources of revenue; • Growth in foreign investment in the capital and financial derivatives markets; • Development of a domestic investment fund industry; • Reform of the Brazilian Payment System; and, • Investment grade credit rating granted by the Standard & Poor, Fitch Ratings and Moody’s in 2008 and 2009.

At Basel financial forums, the Central Bank of Brazil has emerged as an active participant on a number of fronts, including; as a member or participant of the Global Economy Meeting, the BIS Markets

21 BM&FBOVESPA’s Post-Trade Infrastructure

Committee and the BIS Committee on the Global Financial Stability. More recently, Brazil has become a member of the Financial Stability Board, which now includes all the G20 countries. These entities comprise the principal forums for advancing in-depth understanding of the structural underpinnings and evolution of financial markets and for initiating improvements to their functioning and stability. In 2009 the Brazilian Securities Commission (CVM) also became a member of the Technical Committee of the International Organization of Securities Commissions (IOSCO).

Brazil’s increasingly important position on the global economic landscape is clearly related to the market’s relevance. Not only is Brazil a large country in geographical and demographic terms, but it also represents the 8th largest economy in the world. GDP growth has increased from 0.5% in 2003 to 5.4% in 2007 and now, despite global turmoil the economy is forecasted for 2010 to grow at a rate of 4.5%. Similarly, the per capita GDP has grown from USD2940 in 2003 to USD6680 in 2007 and is now ap- proaching USD7350. Reserve balances have grown from USD 17 billion in 2003 to USD 189 billion in 2007 and in September of 2009 reached USD 224 billion. As the largest fund industry in Latin America, representing 85% of the entire region, assets under management reached USD 455 billion in 2007 and now, with clear signs of recovery in sight following the 2008 crisis, they amount to USD621 billion.

Another aspect of great importance that is contributing to the positive attention the Brazilian financial markets have been receiving from the international community relates the quality of Brazilian regulation and the scope of regulatory oversight.

The Brazilian financial and capital markets do not allow unregulated institutions or instruments regardless of their nature or size. All institutions operating in the financial sector fall under the supervision of the Brazilian Central Bank, the CVM or, in some specific cases such as BM&FBOVESPA, both. It is also mandatory that all transactions, including those involving OTC derivatives, be registered in centralized systems that provide full disclosure of information to both regulators1. The regulations also apply where conglomerates use a holding company approach, requiring all entities within the structure to be included within the regulatory perimeter. Also of considerable importance is that capital and liquidity requirements have been applied more conservatively than in most other markets, and immo- bilization limits and diversification credit risk rules are further inhibitors to over-leveraging behavior.

The Brazilian Payment System, which was implemented in April 2002, represents one of the corner- stones of our country’s financial system. In July 1999, when the Central Bank announced the new model for the Payment System, one of the primary drivers for this initiative was the desire on their part to lay a foundation that would underpin the development and strengthening of both the domestic financial system and the Brazilian capital markets.

A solid and reliable legal and regulatory framework was then established which allowed for the operation of Clearinghouses as integral and interacting parts of the Brazilian Payment System. Accordingly, the legislation recognized that Clearinghouses perform multilateral settlements, requiring every systemically important Clearinghouse to act as a central counterparty (CCP). This legislation also established mechanisms to ensure that the insolvency, restructuring procedures, bankruptcy, or extrajudicial settlement of a market participant would not affect the outcome of transactions within the clearing and settlement system.

All systemically important Clearinghouses in Brazil were given settlement accounts at the Central Bank and direct access to the Reserve Transfer System in order to manage payments related to the settlement of transactions in Central Bank funds. This feature has allowed Clearinghouses to eliminate credit risk in the payment leg and to settle transactions on a delivery-versus-payment (DVP) basis, resulting in final and irrevocable exchange of assets versus payment.

2 The level of disclosure depends on the regulator’s mandate.

22 Integration Opportunities and Challenges

2. BM&FBOVESPA in a Snapshot

Over the past decade, the Brazilian capital market has seen the consolidation of the exchanges, in a process eventually leading to the demutualization of Bovespa and BM&F in 2007, followed by each company going public and listing their shares on Bovespa, and then ultimately, to the merger of the two organizations resulting in the establishment of BM&FBOVESPA in May of 2008.

BM&FBOVESPA is a vertically integrated exchange, which acts as a central securities depository, securities settlement system and central counterparty, providing the Brazilian capital market and its participants with a wide range of services:

• Listing services for local and international issuers with differentiated levels of corporate governance (Novo Mercado); • Electronic trading solutions for local and international market intermediaries, including Direct Mar- ket Access (DMA) and co-location connectivity; • Electronic registration environment for OTC derivatives, with or without the interposition of the Central Counterparties (CCP); • Central counterparty clearing and DVP settlement: • A Central Securities Depository (CSD) platform with a beneficial owner account structure; • Securities lending services where BM&FBOVESPA acts as the central counterparty to borrowers and lenders; • Banking infrastructure – BM&F Bank offers settlement bank and custodial services to market intermediaries and provides the Clearinghouses access to the Brazilian Central Bank rediscount window ; and • Integrated and modular IT solutions for intermediaries’ front, middle and back office activities (Sina- cor).

BM&FBOVESPA

Securities, Broker Commodities a nd Issuer Futures Exchange

Clearing Investors Central Counterparty Member (CCP) Register

Securities Custodian Settlement System (SSS)

Bank

Central Securities Depository (CSD)

Fig. 1: BM&FBOVESPA Trading environment, post-trade building blocks and main external relationships

23 BM&FBOVESPA’s Post-Trade Infrastructure

BM&FBOVESPA is also a multi-asset class exchange, offering a wide array of products in different markets that have been showing solid growth in terms of the number of trades and volumes lasting recent years. Bovespa Segment Product Grid

CASH EQUITY DERIVATIVES CORPORATE BONDS

Stocks Stocks options Debentures

Brazilian depository receipts (BDR) Index options (Ibovespa and IBRX) Commercial paper

Real estate investment funds Forward contracts Mortgage-backed securities

Exchange traded funds Protected and participative investment Asset-backed securities

Securities lending

BM&F Segment Product Grid

COMMODITY FINANCIAL DERIVATIVES OTC DERIVATIVES SPOT MARKET DERIVATIVES

Futures & Options Structured Products Swaps & Forwards Futures & Options

Stock index Spread strategies Interest rate Arabica coffee Gold

U. S. dollar Interest rate Volatilities trading: Exchange rate Sugar exchange rate Federal government Exchange rate – Stock index Price index Ethanol bonds Dollar denominated – Interest rate Stock index Corn domestic yield curve

PPI/CPI spread – Exchange rate Metals Soybean

Forward rate Price index Flexible Options Live cattle agreements

Sovereign debt swaps – Stock index

Credit default swaps – Exchange rate

Interest rate versus Price – Interest rate index

24 Integration Opportunities and Challenges

2.500.000

2.000.000

1.500.000

1.000.000 Number of contracts

500.000

Fig. 2: volume of traded contracts in the financial and commodity derivatives market since Jan/2000.

450.000

400.000

350.000

300.000

250.000

200.000 number of trades

150.000

100.000

50.000

Fig. 3: number of trades in the equities and equities derivatives market since Jan/2000.

25 BM&FBOVESPA’s Post-Trade Infrastructure

In February 2008, BM&FBOVESPA and the CME Group (Chicago Mercantile Exchange Group) established a strategic partnership which included a commercial agreement, a cross investment program and other initiatives. The commercial agreement underpins the order routing system, whereby CME is able to offer access to BM&FBOVESPA products using its Globex electronic trading platform and BM&FBOVESPA is able to offer access to CME products using its GTS electronic trading platform. Being CME Globex the largest global derivatives trading network, the order routing agreement allows BM&FBOVESPA to distribute its derivatives products to a very large and diverse base of international investors. On October 2, 2009, 205,637 BM&FBOVESPA derivatives contracts were traded in a total of 33,595 transactions using the order routing system, establishing a new peak in daily transaction volumes.

This cross investment program has established the basis for a long-term partnership between both companies. The cross investment consists of an exchange of shares between CME Group and BM&FBOVESPA, complemented by investments with lock-ups and exclusivity clauses. Other initiatives are also being put into place, such as a joint product development program.

In August 2009, BM&FBOVESPA announced that it has initiated discussions with the NASDAQ OMX Group with the purpose of establishing a strategic, commercial and technological partnership.

BM&FBOVESPA at a glance:

• Largest stock and derivatives exchange in Latin America • 3rd largest listed exchange in the world by market value (Jan10) • 6th largest derivatives exchange by trading volume in the world (Jan-Jun09) • 12th largest stock exchange by market capitalization in the world (Sep09)

• 3rd largest options market in the world (Nov09) • 5th largest capital raising market in the world (Nov09) • Largest IPO Market in the world (Jan-Oct09)

• Top exchange traded options contract on individual equity in the world (2008) • Top exchange traded currency futures contract in the world (Jan-Jun09) • 5th most exchange traded interest rate futures contract in the world (Jan-Jun09)

It is also important to bear in mind that BM&FBOVESPA provides the infrastructure and systems that make up the foundation of the post-trade processing environment in Brazil.

The following section presents an outline of the “building blocks” that make up the foundation of this post-trade infrastructure.

26 PART II CORE POST-TRADE INFRASTRUCTURE – THE BASIC BUILDING BLOCKS

Integration Opportunities and Challenges

PART II – CORE POST-TRADE INFRASTRUCTURE – THE BASIC BUILDING BLOCKS

In order to better assess our needs and priorities going forward, it is essential for us to take inventory of what we already have in place. With this in mind, this section of the White Paper will focus on the critical elements that we currently have in place at BM&FBOVESPA.

BM&FBOVESPA’s post-trade infrastructure can be divided functionally into three core units: a Cen- tral Securities Depository (CSD), Securities Settlement Systems (SSS) and Central Counterparties (CCP). We consider these business lines to be the “building blocks” upon which BM&FBOVESPA will further develop its post-trade infrastructure. They serve as the foundation for future advancements as part of our committed efforts to meet or exceed the continually evolving needs of our market.

Therefore, we will spend the upcoming pages examining the current post-trade infrastructure by detailing the main features of the “building blocks” – CSD (Central Securities Depository), SSS (Securities Settlement Systems) and CCP (Central Counterparties).

1. BM&FBOVESPA Central Securities Depository (CSD)

Central Securities Depository (CSD) is a facility or an institution for holding securities, thus enabling securities transactions to be processed in a book entry environment. The depository may immobilize physical securities or securities may be dematerialized, so that they exist only as electronic records. In addition to safekeeping and the associated support services such as entitlement processing, a central securities depository may incorporate trade comparison, clearing and settlement functions.

In 1989 the G30 issued a paper entitled, “Clearance and Settlement Systems in the World’s Securities Markets”2. The paper offered nine recommendations to alleviate risks associated with deficiencies in clearance and settlement of securities transactions.

Recommendation number 3 suggests: “each country should have an effective and fully developed central securities, organized and managed to encourage the broadest possible industry participation (directly and indi- rectly)”

The report also states that the CSD (Central Securities Depository) may have the capability to support trade clearance, safe custody, and settlement/post-settlement processing of securities and information, such as corporate actions and dividend/interest processing.

Here at BM&FBOVESPA we operate a world class CSD (Central Securities Depository) that services the full breadth of the Brazilian securities markets. We have implemented a holding model where the custody records are maintained based upon beneficial owner registration, representing the official record of ownership as prescribed under Brazilian Regulation. Securities held within our custody are completely dematerialized (where no physical certificates exist) for holdings of equities, corporate bonds, mutual fund units, exchange-traded funds, agri-business bonds and mortgage-backed securities.

Daily reconciliation processes carried out with the issuers, coupled with rigorous internal controls and safeguards, effectively ensure the integrity of our records. In addition, investors receive a monthly statement listing all their holdings and also can take further comfort from their ability to access the records of their holdings with us directly via the Internet.

2 “Clearance and Settlement Systems in the World’s Securities Markets” – 1989 – Group of Thirty (see Page 31).

29 BM&FBOVESPA’s Post-Trade Infrastructure

The beneficial holding model utilized within BM&FBOVESPA’s CSD (Central Securities Depository) provides the capability to deliver a wide array of services, including the ability to:

• Provide the issuers with an up to-date record of shareholders on a daily basis, adding, for instance, integrity of shareholder representation for General and other Shareholder Meetings; • Facilitate timely and accurate entitlement processing, at the investor level including tax calcula- tions; • Deliver to all participants and investors an Internet based facility that provides information on asset holdings, corporate actions, derivatives, lending and borrowing positions, asset movements, and, • Efficiently communicate with regulatory authorities regarding matters related to beneficial ownership.

Issuer W Issuer X Issuer Y Issuer Z ...

BM&FBOVESPA Central Securities Depository ...

Custodian 1 Custodian 2 ......

Investidor Investidor Investidor Investidor Investidor Investidor account A account B account C account D account E account F

Fig. 4: BM&FBOVESPA’s Central Securities Depository beneficial holding model.

This CSD (Central Securities Depository) infrastructure enables BM&FBOVESPA to provide a wide array of support services to the market, which include:

• Streamlined standard trade and settlement communication (Straight Through Processing - STP); • Securities lending and borrowing services; • Pledge facilities; • International custody; • Electronic collateral management.

This efficient CSD infrastructure provides the foundation upon which it is possible for market participants to initiate and complete large volumes of transactions that would not otherwise be operationally feasible.

30 Integration Opportunities and Challenges

2. BM&FBOVESPA Securities Settlement Systems (SSS)

Securities Settlement System (SSS)is a system that permits the transfer of securities: either free of payment or against payment. Settlement of securities occurs through securities deposit accounts held by the CSD (Cen- tral Securities Depository). Settlement of the associated funds typically occurs within an interbank funds transfer system, which is often associated with the central bank.

In the 2001 paper, entitled, “Recommendations for Securities Settlement Systems”3, the Committee on Payment and Settlement Systems of the Bank for International Settlements (BIS), wrote;

“Securities settlement systems (SSSs) are a critical component of the infrastructure of global financial markets (…). Weaknesses in SSSs can be a source of systemic disturbances to securities markets and to other payment and settlement systems. A financial or operational problem at any of the institutions that perform critical functions in the settlement process or at a major user of an SSS could result in significant liquidity pressures or credit losses for other participants. Any disruption of securities settlements has the potential to spill over to any payment systems used by the SSS (…) (…) Market liquidity is critically dependent on confidence in the safety and reliability of the settlement arrangements .”

In relation to these recommendations BM&FBOVESPA has put in place settlement systems and processes of the highest caliber, compliant with prevailing international standards and thus providing market participants with reliable and secure transaction settlement. BM&FBOVESPA directly controls both the movement of funds and related securities without the use of intermediaries in the process4.

At the present time, BM&FBOVESPA operates four separate and distinct settlement systems:

• Equity, equity derivatives and corporate bonds; • Financial and commodity derivatives; • Foreign exchange; • Government bond markets.

In each system, trade capture occurs on a real-time basis from the various trading platforms. The payments associated with all settlement transactions within BM&FBOVESPA are completed in Central Bank funds. In this connection, BM&FBOVESPA currently maintains four settlement accounts with the Central Bank. Payments to and from these accounts are for immediate value, and are final and irrevocable.

Each settlement system managed by BM&FBOVESPA must conform to a specific time frame. Through- out the settlement day, BM&FBOVESPA interacts with the market participants, who in turn interact between each other and their clients, in order to satisfy their settlements obligations. Deadlines can vary greatly between the various settlement systems due to external factors related to this interrelation- ship between financial institutions in the various markets supported by the Clearinghouses. The payment deadline for the Foreign Exchange Settlement System, for example, is subject to the schedule of international settlement banks in the New York time zone.

Each market also maintains different timing between the settlement of debit and credit positions. This time period is used by the CCP to activate its failure mechanisms, if necessary.

3 “Recomendations for Securities Settlement Systems” – 2001 – BIS - Committee on Payment and Settlement Systems. 4 The only exception is the Foreign Exchange Clearinghouse which settles USD through settlement banks in the USA.

31 BM&FBOVESPA’s Post-Trade Infrastructure

These external factors and other characteristics inherent in each market, such as: market dynamics; operation allocation; collaterization model; and retail clients’ payment by the institutions affect the settlement schedules in BM&FBOVESPA’s Clearinghouses.

AM PM

Equities & Participants Clearinginform Clearing Payments Simultaneous Equities deliver participant s informs nal to Clearing cash and Derivatives securities to provisional settlement deadline securities Clearing settlement obligations settlement obligations

Financial & Clearinginforms Participants Payments Settlement to Clearing Commodities participant s receive nal payments to deadline Derivatives provisional settlement participants settlement obligations obligations

Clearing informs Participants Payments Simultaneous Government participant s receive nal andDelivery cash and Bonds provisional settlement to Clearing securities settlement obligations deadline settlement obligations

Clearinginforms Clearing Payments Settlement Foreign participant s informs nal to Clearing paymentsto Exchange provisional settlement deadline participants settlement obligations obligations

Fig. 5: Main events making up the settlement day and their respective time schedules.

During the first six months of 2009, BM&FBOVESPA settled an average of almost 400,000 trades per day across the 4 settlement environments.

2.1 BM&FBOVESPA Securities Settlement System for Equities, Equity Derivatives and Corporate Bonds

Equity, equity derivatives and corporate bond trades are received from the trading systems (MegaBolsa and Sisbex) on a real-time, locked-in basis and come to value on T+3, T+1, T+0 or T+1 respectively, in accordance with a delivery-versus-payment (DVP) BIS Model5 2 at the participant level and BIS Model 3 at the investor account level.

5 The Bank for International Settlements (BIS) defines 3 settlement models: a) Model 1: Gross settlement for cash and securities b) Model 2: net cash and gross securities c) Model 3: net cash and securities A full description of the various models can be found on the BIS website at www.bis.org.

32 Integration Opportunities and Challenges

All trades captured by these post-trade systems already contain the required data related to the transaction and do not require additional confirmation from the participants, thus ensuring extremely high levels of STP. The majority of trades have already been allocated at this point, and contain the necessary information regarding the buyers and sellers, at the beneficial owner level. In some cases the trade information needs to be supplemented with details related to the final investor and their custodian. In these cases, BM&FBOVESPA request authorization from the custodian to receive or deliver the related securities. In situations where the settlement involves Delivery-Versus-Payment (DVP), such as in the case of equities, the securities are delivered directly to the account of the ultimate owner.

A facility for automatic securities lending is also in place supporting the settlement of equities and has had the effect of reducing value date settlement failure rates by approximately 50%.

Derivatives transactions on equities, similarly, are reported to the post-trade systems in real-time on trade date, however, they settle on a T+1 basis. The resulting obligation for equity derivative transactions is netted with the obligation for the equity and corporate bonds cash market.

The close link between the trading and clearing systems also allows for the exchange of information on positions in the options market. During the maturity period, and on the exercise date, for example, the clearing system sends the trading system information regarding option holders and writers. The trading system is therefore able to identify; (i) if a certain investor holds an American or European-style option and if they are able to exercise their right before, or only at expiry, (ii) who are the writers, and (iii) the underlying securities, strike prices and exercise dates. As a result of this information exchange, the trading system can match purchases and sales resulting from exercised options.

In the same environment, BM&FBOVESPA provides a gross settlement system for equities and corporate bonds. This facility is used for some operations, such as IPOs, follow-ons and other special operations. In this respect, BM&FBOVESPA provides a service for IPOs that comprises not only settlement, but also distribution pool organization, allocation and reporting. The services are currently used by issuers for the vast majority of IPOs and follow-ons in the Brazilian equity market.

2.2 BM&FBOVESPA Settlement System for Financial and Commodity Derivatives

BM&FBOVESPA maintains a separate settlement system for the processing of financial and commodity derivatives trades. These trades, similarly, are received from the trading system (GTS) on a real-time, locked-in basis.

Payment obligations related to financial and commodity derivatives trades are settled on T+1. In over- night processing, BM&FBOVESPA calculates at the level of the individual client accounts, what, if any; additional margin or collateral is required to support their outstanding position, not covered by assets already posted. During the day, the investor has the opportunity, through its broker dealer, to post additional non-cash assets accepted by CCP as collateral in order to avoid additional payment obligations or to realize the return of cash being held to cover a requirement for collateral.

The Derivatives Settlement System contains functionality that enables brokers to “give-up” a trade to another broker, in which case the system requires the receiving broker to accept the trade. This capability is used primarily where an investor uses more than one executing broker in combination with a carrying broker and provides for a consolidated settlement of their activity.

Another feature of this environment is the ability for the broker to allocate the trade to the final investor or to the master account of a fund manager pending further reallocation within the fund. The

33 BM&FBOVESPA’s Post-Trade Infrastructure same fund manager then has until the end of the day to inform the ultimate account to the broker that is responsible for allocating the trade. In the allocation process, brokers can also pass trades to a Direct Settlement Participant (PLD), which is a participant able to settle operations directly with BM&FBOVESPA on their own behalf. Once the PLD has accepted a trade, they replace the executing broker as the counterparty to the Clearinghouse for the transaction.

Settlements resulting from OTC derivative transactions, whenever BM&FBOVESPA acts as the central counterparty, are settled on a net basis with listed financial derivatives.

2.3 BM&FBOVESPA Settlement System for Foreign Exchange

BM&FBOVESPA’s settlement system for foreign exchange settles inter-bank transactions executed -ei ther through BM&FBOVESPA’s electronic platform (GTS) or OTC. The resulting balances from both entries are settled on a net basis. In the FOREX market, trades are executed directly by the final benefi- ciary. This market does not have an allocation process.

Foreign exchange transactions settle on a T+0, T+1 or T+2 basis depending upon the requirements of the parties to the transaction. The BRL leg of the transactions are settled in Brazilian Central Bank funds, as previously mentioned, while the USD leg is settled via Fed Funds through four settlement banks in New York. BM&FBOVESPA makes settlement possible through several banks in order to spread bank risk and to provide participants with multiple options with respect to their service provider.

BM&FBOVESPA receives USD in those accounts corresponding to the delivery obligations of the net debtors in USD. In its settlement account at the BCB, BM&FBOVESPA receives the corresponding BRL. BM&FBOVESPA then effects the settlement employing a Payment-Versus-Payment (PVP) mechanism .

All foreign exchange operations, whether traded electronically or OTC, must be registered with the Central Bank.

2.4 BM&FBOVESPA Securities Settlement System for Government Bonds

BM&FBOVESPA’s securities settlement system for government bonds, like other BM&FBOVESPA settlement systems, receives trade information from the SISBEX trading system , on a real-time, locked- in basis, that is, with all the necessary information for the settlement process. In this environment, brokers can also allocate trades to the final investor. Government bond transactions within BM&FBOVESPA settle on a T+0 – T+n basis in accordance with Delivery-Versus-Payment (DVP) BIS Model 2. Participants in the system have the ability to contract a settlement date for bond transactions as many as 23 days in the future. The cash leg of government bond transactions is settled through the Central Bank, while the securities leg is settled through a settlement account in the name of BM&FBOVESPA at SELIC (Special System for Settlement and Custody), the Central Bank depository for federal government bonds. The Clearinghouse receives the government bonds in this latter account from the net debtors and, once the corresponding cash has been received in the cash settlement account at the BCB, BM&FBOVESPA coordinates the delivery of government bonds to the net creditors’ account in SELIC against the payment to the reserve accounts of the net creditors in cash.

34 Integration Opportunities and Challenges

3. BM&FBOVESPA Central Counterparty (CCP)

Central Counterparty (CCP) is an entity that interposes itself on a transaction, becoming the buyer to every seller and seller to every buyer of a specified set of transactions or contracts, such as those executed on a particular securities exchange or exchanges. The process by which this is achieved is generally referred to as “novation”.

BM&FBOVESPA operates four individual CCPs (Central Counterparties) in support of the:

• Equity, equity derivatives and corporate bonds; • Financial and commodity derivatives; • Foreign exchange; • Government bond markets.

In a paper prepared by CPSS-IOSCO in 20046, markets were reminded of both the benefits and risks associated with central counterparty systems:

“Central Counterparties (CCPs) hold important role on the Securities Settlement Systems (SSS). CCP places itself between the counterparties on financial transactions, becoming buyer for the sellers and seller for the buyers. A well designed CCP, with appropriate risk management arrangement, reduces the risk from the settlement system participants and contributes to the achievement of financial stability. CCPs (Central Counterparties) have long been used by derivatives exchanges and a few securities exchanges. In recent years, they have been introduced into many more securities markets, including cash markets and over- the-counter markets. Although a CCP (Central Counterparty) has the potential to reduce risks to market participants significantly, it also concentrates risks and responsibilities for risk management. Therefore, the effectiveness of a CCP’s Central( Counterparties) risk control and the adequacy of its financial resources are critical aspects of the infrastructure of the markets it serves.”

BM&FBOVESPA has put in place sophisticated risk management systems and processes designed to effectively safeguard each of the CCPs against the risks associated with the default of its participants. In accordance with the best international practices, the four CCPs have put in place mechanisms to mitigate credit risk, market risk, liquidity risk, legal risk and operational risk.

The varying structures of our systems reflect the nature of the markets they serve, providing participants with efficient risk management tools. For the spot markets (corporate bonds, government bonds, equities and FX), risk is calculated and collateral is posted at the clearing member level, although risk can also be viewed in different levels (e.g. intermediary). Since the settlement cycle for spot transactions is typically very short, collateralization at the beneficial owner level would be an inefficient option.

Conversely, for the derivatives market (financial, commodities and equity derivatives), risk is calculated and collateral is posted at the beneficial owner level, although risk can also be viewed at different levels, such as the broker and clearing member. In this case, since positions tend to be open for an extended period of time, collateralization at the beneficial owner level yields the best results in terms of efficiency and safety. In fact, some efficiency features are only meaningful when risk is managed at the beneficial owner level (e.g. risk offsets between derivatives contracts and assets posted as collateral).

BM&FBOVESPA participants and their clients take additional comfort from the knowledge that all collateral is held in completely separate accounts with no commingling of assets.

6 CPSS-IOSCO Recommendations for Central Counterparties (2004).

35 BM&FBOVESPA’s Post-Trade Infrastructure

The various CCP risk models within BM&FBOVESPA, while differing in their underlying structure, share a common philosophy of providing BM&FBOVESPA and its participants with an extremely high level of confidence that the risks inherent in the clearing and settlement processes are effectively managed. Underpinning this confidence is a rigorous and structured process of stress testing in each of the individual environments

3.1 BM&FBOVESPA Central Counterparty for Equities, Equity Derivatives and Corporate Bonds

BM&FBOVESPA’s CCP for the Equities, Equity Derivatives and Corporate Bonds, novates trades in real-time, at the moment they are received from the trading system (Megabolsa and Sisbex) by the Clearinghouse. Risk monitoring begins immediately upon receipt and novation of the individual trades.

For equity, equity derivatives and corporate bond transactions, collateral requirements are calculated on a real-time basis. In the case of a shortfall in collateral results, such as, from new trades, BM&FBOVESPA instructs participants to post additional collateral.

For open derivative positions, collateral requirements are calculated on a daily basis based, at the level of the beneficial owner, upon current market conditions and predefined stress scenarios.

In addition to the collateral posted by participants and their clients, any residual risk is supported by a mutualized clearing fund comprised of contributions from each participant based upon the level of risk they bring individually to the CCP. These clearing fund requirements are recalculated on a daily basis.

The CCP for equities, equity derivatives and corporate bond does not incur principal risk, since it employs a DVP (Delivery-Versus-Payment) settlement model.

3.2 BM&FBOVESPA Central Counterparty for Financial and Commodity Derivatives

The Financial and Commodity Derivatives CCP novates trades in real-time at the moment they are received by the Clearinghouse from the trading system (GTS). The only exception to this practice is for OTC trades, which are novated only after both parties have posted collateral sufficient to cover the incremental risk associated with the new transaction. New trades accepted by the CCP are immediately incorporated into the risk monitoring process.

For financial and commodity derivatives transactions, collateral requirements are calculated on a near- time basis (every 10 -15 minutes) based upon open positions, new trades and underlying price movements. When a related shortfall in collateral occurs, BM&FBOVESPA requires participants to post additional collateral.

The collateral of participants and their clients, which is on deposit with BM&FBOVESPA, also underpins the safeguard structure for the Financial and Commodity Derivatives CCP. Any residual risk is supported by participant minimum collateral requirements, specific funds comprised of BM&FBOVESPA capital, and a clearing fund. This clearing fund is comprised of contributions from each participant based upon their functional profile, and is mutualized in its structure.

36 Integration Opportunities and Challenges

3.3 BM&FBOVESPA Central Counterparty for Foreign Exchange

The Foreign Exchange CCP covers exclusively interbank transactions and therefore has only one clas- sification of participant - clearing members. All transactions accepted by the Clearinghouse are novated immediately since risk management is based upon a pre-margin approach. New trades are accepted by the CCP whenever the participant has sufficient collateral on deposit to cover the incremental risk associated with the new transaction.

For the Foreign Exchange CCP the risk management system incorporates a mark-to-market process for all open transactions. The mark-to-market re-calculation occurs throughout the day at varying fre- quencies based upon the prevailing level of market volatility. This mark-to-market recalculation takes place no less frequently than once per hour and can be initiated whenever deemed necessary. Should the mark-to-market recalculation result in a collateral shortfall, the participant is immediately notified by BM&FBOVESPA of the requirement to post additional collateral. The collateral of participants, which is on deposit with BM&FBOVESPA, underpins the safeguard structure for the FX Clearinghouse. Any existing residual risk is supported by a loss sharing mechanism among the system participants.

The Foreign Exchange CCP does not incur principal risk as it employees a Payment-Versus-Payment (PVP) settlement model.

3.4 BM&FBOVESPA Central Counterparty for Government Bonds

The Government Bonds CCP handles transactions executed in the Sisbex electronic trading system or in the OTC market using a pre-margin approach. The risk is calculated at the moment of trade execution or registration (OTC) in the Sisbex electronic trading system, when they are accepted by the Clearinghouse and immediately novated.

The Government Bonds CCP incorporates a mark-to-market process very similar in structure to the Foreign Exchange CCP. The principal differences relate to the number of assets which need to be re- priced given movements in the underlying yield curves and the generally lower level of volatility inherent to interest rates versus foreign exchange rates.

The collateral participants have lodged with BM&FBOVESPA underpins the CCP safeguard structure. Furthermore, the Government Bonds Clearinghouse does not incur with principal risk as it employs a DVP (Delivery-Versus-Payment) settlement model.

3.5 The Value Proposition of CCPs (Central Counterparties) - CCP12 Considerations

In March 2009, CCP127 issued a discussion paper entitled ‘The Value proposition of CCPs”8 , in which it is highlighted the key benefits to the market of the existence of an effectively managed CCP (Central Counterparty).

The paper explains the role of central counterparties and the significant contribution they make to the efficiency of financial markets, as well as highlighting thirteen specific benefits derived from CCPs

7 CCP12 (Central Counterparty 12) was formed in 2001 and works to further the industry’s dialogue on the adoption of best clearing and risk management practices, and supports strategic progress on regulatory harmonization and the enhancement of global standards. CCP12 is a not-for-profit informal association, with membership encompassing over 30 individual CCPs from around the globe. 8 The entire paper ‘The Value proposition of CCPs” can be viewed on the CCP12 website at www.ccp12.org.

37 BM&FBOVESPA’s Post-Trade Infrastructure

In this White Paper we will highlight four of these observations that have particular relevance to BM&FBOVESPA and our participants. i. Mitigate against counterparty credit risk and facilitate multilateral netting of exposures through the legal or technical substitution of one high quality counterparty (the CCP) for many, potentially lower quality, bilateral counterparties; this also has the effect of reducing the need for credit analysis.

All transactions within BM&FBOVESPA markets are novated immediately following trade execution in order that the counterparties are locked-in and protected. The only exception to this practice is within the derivatives OTC market where the transactions novate only after both parties to the transaction have posted the required collateral with the exchange. ii. Reduce the potential systemic impact of a default by undertaking to maintain adequate combinations of margin, liquidity, capital or other financial resources to deal with such an event without impacting other participants.

BM&FBOVESPA has developed “state of the art9” risk management systems that effectively and efficiently protect the markets that we serve. Furthermore, because all collateral that underpins our safeguard structure is readily available for use in the case of a default, and liquidity facilities in place in order to monetize those assets, the potential market impact of such events is negligible. The effectiveness of these mechanisms is assessed on a daily basis via backtesting. iii. Increase the effective capacity, volume, liquidity and product innovation of the marketplace through netting exposures and reducing the capital required and balance sheet used to support participants’ trading activity.

Our CCP for the equities and derivatives markets reduces the funds required for settlement by 91% and 65%10 respectively of the value of the original contracted amounts.

Since it provides for an efficient way for offsetting risks among different counterparties, our CCP sub- stantially reduces the use of collateral that would otherwise be greater or equivalent, at best, in the case of bilateral arrangements. As a result, liquidity providers can conduct their activities in a very dynamic way.

Overall volumes benefit from the fact that the system is able to absorb large trades due to the homoge- neous credit worthiness provided within the CCP environment - i.e., the system is very “elastic” given its ability to spread liquidity. iv. Reduce spreads since anonymity reduces the market impact of position unwinds, while reduced balanced sheet, capital and credit line usage will also be reflected in execution.

The leveling effect of credit worthiness provided by the CCP makes trading between various participants (large and small) viable when the individual credit risk is replaced by the CCP. This allows for a great number and variety of market participants in the trading venue, maximizing the presence of liquidity providers that, in turn, reduces the potential market price impact of taking a position.

During the tremendous market volatility of the later part of 2008, these structures (the Central Securi- ties Depository (CSD), Securities Settlement Systems (SSS) and Central Counterparties (CCP)) were instrumental in shepherding the BM&FBOVESPA markets safely through this complicated and perilous period.

9 International Monetary Fund, “Emerging Local Securities and Derivatives Markets”, pp 73, 2004. 10 Figures based on the daily average of the first half of 2009.

38 Integration Opportunities and Challenges

4. Central Securities Depository, Settlement System and Central Counterparty - Best Practices

BM&FBOVESPA’s Central Securities Depository, Settlement System and Central Counterparty have been strongly influenced by the recommendations issued by a number of organizations that provide guidance or prescription to capital markets and market infrastructures with respect to how they should operate in order to maximize efficiency and minimize risk. From the numerous recommendations that have been issued over the years we have selected a group of the most relevant to highlight within the White Paper. These recommendations have been extracted from reports issued by;

4.1 The Group of Thirty

The Group of Thirty (G-30), established in 1978, is a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia.

The G-30 aims to deepen understanding of international economic and financial issues, to explore the international repercussions of decisions taken in the public and private sectors, and to examine the choices available to market practitioners and policymakers.

Main G-30 reports:

• G-30 (1989) – Recommendations for Securities Clearance and Settlement • G-30 (2003) - Global Clearing and Settlement – A Plan of Action • G-30 (2008) - Lessons Learned from the 2008 Financial Crisis

4.2 BIS - CPSS (Committee on Payment on Settlement Systems)

The Committee on Payment and Settlement Systems (CPSS), within the Bank for International -Set tlements (BIS), contributes to strengthening the financial market infrastructure through promoting sound and efficient payment and settlement systems.

The Committee serves as a forum for central banks to monitor and analyze developments in domestic payment, settlement and clearing systems as well as in cross-border and multicurrency settlement schemes.

The CPSS undertakes specific studies in the field of payment and settlement systems at its own discre- tion or at the request of the G10 Governors. Working groups are set up as required. In recent years the Committee has developed relationships with other central banks, particularly those of emerging market economies, in order to extend its work outside the G10.

Through the publication of theCore “ principles for systemically important payment systems”, the CPSS/IOSCO “Recommendations for securities settlement systems” and the CPSS/IOSCO “Recom- mendations for central counterparties”11, the Committee has contributed to the set of standards, codes and best practices that are deemed essential for strengthening the financial architecture worldwide.

11 Publications can be found at www.bis.org/publ.

39 BM&FBOVESPA’s Post-Trade Infrastructure

4.3 IOSCO (International Organization of Securities Commissions)

The International Organization of Securities Commissions – IOSCO, established in 1983, is the most relevant international forum for securities and futures markets regulatory authorities.

The member agencies currently assembled together in the International Organization of Securities Commissions have resolved, through its permanent structures:

• To cooperate together to promote high standards of regulation in order to maintain just, efficient and sound markets; • To exchange information on their respective experiences in order to promote the development of domestic markets; • To unite their efforts to establish standards and an effective surveillance of international securities transactions; • To provide mutual assistance to promote the integrity of the markets by a rigorous application of the standards and by effective enforcement against offenses

CPSS-IOSCO main reports:

• CPSS-IOSCO – SSS (2001) - Recommendations for Securities Settlement Systems • CPSS-IOSCO – CCP (2004) - Recommendations for Central Counterparties • CPSS-IOSCO – OTC (2007) - New Developments in Clearing and Settlement Arrangements for OTC Derivatives

4.4 Recommendations

The achievement of an extremely high level of compliance with the most relevant recommendations put forward by the aforementioned organizations over the past two decades has contributed positively to the high regard in which BM&FBOVESPA and the Brazilian Capital Market are held internationally. The following recommendations, which have been extracted from various reports, are considered to be the most relevant guidelines for BM&FBOVESPA’s central securities depository, settlement system and central counterparty structures. In the Appendix of this White Paper these recommendations are put into greater context with a brief commentary on how BM&FBOVESPA’s structure and operations relates to them.

40 Integration Opportunities and Challenges

Recommendation Description

A CCP (Central Counterparty) should have a well-founded, transparent and CPSS-IOSCO – CCP (2004) – Recommendation 1 enforceable legal framework for each aspect of its activities and in all relevant jurisdictions.

Confirmation of trades between direct market participants should occur as soon as possible after trade execution, but no later than trade date (T+0). Where confir- CPSS-IOSCO – SSS (2001) – Recommendation 2 mation of trades by indirect market participants (such as institutional investors) is required, it should occur as soon as possible after trade execution, preferably on T+0, but no later than T+1.

CSD (Central Securities Depository) should eliminate principal risk by linking CPSS-IOSCO – SSS (2001) – Recommendation 7 securities transfers to funds transfers in a way that achieves delivery versus payment.

Payments associated with securities transactions should be made in same-day G-30 (1989) – Recommendation 6 funds.

G-30 (2003) – Recommendation 11 Ensure final, simultaneous transfer and availability of assets.

A CCP (Central Counterparty) should employ money settlement arrangements that eliminate or strictly limits its settlement bank risks, that is, its credit and li- CPSS-IOSCO – CCP (2004) – Recommendation 9 quidity risks from the use of banks to effect money settlements with its participants. Funds transfers to a CCP (Central Counterparty) should be final when affected. A CCP (Central Counterparty) should require participants to have sufficient financial resources and robust operational capacity to meet obligations arising from participation in the CCP Central ( Counterparty). A CCP should have CPSS-IOSCO – CCP (2004) – Recommendation 2 procedures in place to monitor that the participation requirements are met on an ongoing basis. A CCP’s participation requirements should be objective, publicly disclosed, and permit fair and open access. A CCP (Central Counterparty) should measure its credit exposures to its participants at least once a day. Through margin requirements, other risk control mechanisms or a combination of both, a CCP (Central Counterparty) should limit its CPSS-IOSCO – CCP (2004) – Recommendation 3 exposures to potential losses from defaults by its participants in normal market conditions so that the operations of a CCP (Central Counterparty) would not be disrupted and non-defaulting participants would not be exposed to losses that they cannot anticipate or control. If a CCP (Central Counterparty) relies on margin requirements to limit its credit exposures to participants, those requirements should be sufficient to cover potential CPSS-IOSCO – CCP (2004) – Recommendation 4 exposures in normal market conditions. The models and parameters used in setting margin requirements should be risk-based and reviewed regularly.

A CCP (Central Counterparty) should maintain sufficient financial resources to CPSS-IOSCO – CCP (2004) – Recommendation 5 withstand, at a minimum, a default by the participant to which it has the largest exposure in extreme but plausible market conditions.

A CCP’s (Central Counterparties) default procedures should be clearly stated, and they should ensure that the CCP can take timely action to contain losses and CPSS-IOSCO – CCP (2004) – Recommendation 6 liquidity pressures and to continue meeting its obligations. Key aspects of the default procedures should be publicly available.

The next section contains three “case studies” of international infrastructures which undertook integration initiatives in their post-trade environments, allowing us to benefit from their experiences.

PART III INTERNATIONAL EXPERIENCES IN POST-TRADE OPERATIONS INTEGRATION

Integration Opportunities and Challenges

PART III - INTERNATIONAL EXPERIENCES IN POST-TRADE OPERATIONS INTEGRATION

Stemming from the strong belief that there is a much to be learned from the experiences of other coun tries regarding projects of infrastructure integration, we have included in this section a set of “case stud ies” which illustrate how some other markets have gone about the process of integration. These case studies were developed in consultation with our contacts in the respective markets and provide some valuable insights into their experiences, particularly in relation to:

• What extent these organizations have integrated processing for various instrument types or markets; • What were their motivations in pursuing an increased level of integration; • What challenges they experienced along the way; • How the benefits they realized compared with those they envisioned at the outset.

Among the developed case studies, we detail: • Australia – ASX • USA – DTCC • Hong Kong - HKEx

1. Australian Stock Exchange (ASX) Integration Case Study

Background The ASX Group, (which is currently one of the world’s top ten listed exchange groups as measured by its market capitalization) was formed in July 2006 through the merger of the Australian Stock Exchange (ASX) with the Sydney Futures Exchange Corporation (SFE). The merger brought together the trading, clearing and settlement operations of the Australian Cash Equity and Equity Derivatives market with the Australian Financial/Commodities Futures and Options market.

In the post-trade processing environment, each market had a dedicated CCP (Central Counterparty) for risk management as well as a CSD (Central Securities Depository) environment for settlement. At the time of the merger, the new ASX/SFE group had a combined staffing level in excess of 650 people.

Investors in the Australian cash equity market hold securities within issuer sponsored registers (the default option) or may hold securities at their choice within CHESS (the depository custody system for the ASX cash equity market) registered in their name through a sub-account held with a sponsoring financial institution in a manner similar to the Brazilian custody model.

Integration Goals Shortly following the completion of the merger, the newly formed entity (the Australian Securities Exchange Group – ASX) embarked upon an initiative focused on achieving synergies in the post-trade operating environment, both for the ASX and for market participants. This was in addition to the overall business integration effort which focussed on streamlining each business function to achieve efficiencies (including cost savings), and lay the foundation for longer-term strategic growth.

The principal objectives of the post-trade initiative were to determine the feasibility and potential benefits that might be derived from the harmonisation and ultimately, the potential integration of the two

45 BM&FBOVESPA’s Post-Trade Infrastructure

CCPs, and of the systems supporting both settlement engines and both markets, as well as to deliver a processing environment that provided capital usage and operating cost efficiencies to the market as a whole.

ASX had a stated objective of implementing “best of breed” solutions for the market.

Process

In order to initiate the process, the ASX formed an internal project and incorporated targeted consultation with participants, regulators and technology partners. Their objective was to undertake a comprehensive review of the combined organization’s processes and strategic systems in order to determine the possible integration alternatives for subsequent discussion with the Board of Directors.

This process took approximately nine months to complete and arrived at the conclusion that there were insufficient drivers and/or benefits in the current environment to be derived from the integration of the systems supporting each of the markets’ CCPs or settlement facilities, either for the ASX or the market participants generally. This strategy group concluded, however, that there was the prospect of major synergies to be derived from the harmonization/integration of key aspects of the two CCPs’ operations, particularly through the standardization and/or harmonization of rules, policies and risk management methodologies supporting each of the CCPs’ activities, notwithstanding the differences in participant populations, legacy systems, environments and products cleared.

In support of this conclusion, the ASX went on to establish an industry working-group (referred to as the Clearing Participant Strategic Forum) that included senior staff representation from industry participants. Its objectives were to:

• Inform clearing participants of progress on ASX strategic and policy developments relating to central counterparty harmonization and integration; and • Facilitate feedback from a representative range of both Australian Clearing House (ACH) and Sydney Futures Exchange Clearing Corporation (SFECC) clearing participants in order to: • Improve solution design and delivery; • Clarify and enhance understanding of customer priorities; and • Provide clearing participants with the opportunity to raise and discuss high-level issues.

Over a period of approximately eight months this group, led by ASX executives through regular meetings and correspondence, explored and provided feedback to help enhance the ASX’s strategic plan to harmonize/integrate its two CCPs. Work has since progressed and completed a number of capital management and risk-control policy harmonization initiatives that have provided benefits to the ASX and its Participants, as well as the market generally.

A process of ongoing industry consultation has further assisted the ASX in determining the way forward and prioritization of the next set of initiatives to be addressed.

In order to garner industry feedback and ultimately a level of consensus and support for the various initiatives being considered, the ASX developed a series of very subject focused “White Papers” for review and discussion among industry stakeholders.

The ASX established an incremental approach to the process of integration. A series of projects were created in agreement with the major stakeholders, including milestones that could be closely managed in terms of scope and timing in order to provide regular delivery of enhanced and harmonized functionality.

46 Integration Opportunities and Challenges

The consideration and approval of initiatives by the ASX Board of Directors was not necessarily driven by a financial business case, given the regulatory and operational context in which CCPs operate as systemically important infrastructure within the Australian financial markets. For example, the benefits from initiatives being undertaken for purposes of risk reduction could not always be defined strictly in financial terms, but rather, approval was driven by the overriding objective of prudent and best practice risk management practices, contributing to the reduction of systemic risk across the market as a whole.

Results

Over the course of the post-merger business integration process, which has now been underway for slightly more than 3 years, the ASX has delivered results in relation to its CCPs that include:

• Merger of each CCP’s risk management policies and operational functions into a single cohesive unit with improved depth of knowledge, skills transfer and efficient delivery of business objectives (in the context of staff and cost reductions within the overall ASX Group of in excess of 16% and 18% respectively since merger, while delivering revenue growth of 19.5%), • Implementation of a dedicated and complementary business development team focussing on strategic clearing and settlement service development and customer management; • Harmonization of risk principles and policies across both CCPs; • Increased the overall size and quality of CCP financial resources, including additional capital injec- tions by the ASX Group; • Systems upgrades/enhancements around cash equities risk measurement and reporting, collateral management and treasury management; • Enhanced default management procedures; • Standardization of margin rate setting; • Adoption of uniform and enhanced capital and liquidity stress testing and enhanced collateralisa- tion of stress testing exposures beyond the CCPs’ risk appetite; and • Selection of a single strategic, harmonised margining engine to replace existing legacy engines used by each of the CCPs (implementation has commenced) and facilitate cross-CCP margin offsets.

Experiences

Through the execution of the CCP harmonization and integration process, a number of realities became clear or were strongly reinforced. In a few cases they may seem quite obvious, but are still worth stating due to their importance to the overall outcomes.

• Engagement at the appropriately senior staff levels among market participants is critical to ensuring that the process maintains a strategic focus and that sufficient understanding of the market-wide drivers, benefits and need (if not necessarily consensus) and support for the initiatives is obtained.

• Differences and issues tended to grow through analysis, rather than getting smaller. What sometimes began being perceived as relatively minor differences in market practices (collateral management processes for example), tended to become more significant or complex through more in depth understanding of the rationale for the adoption of certain legacy practices. Adaptability and robustness of the project management framework proved important to providing the flexibility needed to incorporate and oversee thorough identification and analysis of issues and impacts early in the project process.

• Remaining focused on, and continually challenging the risk/return associated with taking the next step forward, since most of the benefits could at times be gained prior to full completion of the entire

47 BM&FBOVESPA’s Post-Trade Infrastructure

strategy (80:20 rule). Constantly examining whether achieving harmonization of policies, processes, interfaces etc., without necessarily achieving full integration (single Rulebook, single system) might provide the vast majority of benefits without the costs and time that full integration might entail.

• Given the diverse user population,, big differences in participant knowledge levels in relation to clearing and settlement principles and processes existed, and as a result, in their perceptions with respect to the ASX initiatives. Not surprisingly, at times there was a marked difference in the perception of various participant sub-groups with respect to initiatives being considered.

• The market view was at times different than that of the ASX with respect to the potential benefits of various initiatives – e.g. the perceived value to be derived from establishing a common collateral pool versus the perceived value of equity index/derivative margin offsets.

• Related to the previous points, initiatives frequently took longer to conclude than originally envisioned. For example, there was greater need than expected to educate participants on the benefits and criticality of CCP clearing. Furthermore, building a level of consensus took time. There was also recognition that consensus would not always be achievable and as a result, that some ASX decisions might be unpopular, but nonetheless needed to be taken and implemented for the overall/longer- term good of the market.

• The global financial crisis has delayed progress. In the latter part of 2008 and early 2009, the priority of managing CCP risks relating to significantly increased market volatility necessarily deflected energy, resources and focus from the harmonization/integration effort. The residual impact has been some temporary slowing of the overall project programme in order to respond to market and regulatory reac- tions, and to lesson the burden on market players who have been hurt by the financial downturn.

• The effective management of market and regulatory expectations was critical to the process. Clear and timely communication of the game plan was critical to ensuring regulators were aware of progress and any issues, as well as keeping the market in lockstep with the change timetable.

• Effective project management proved extremely valuable in keeping initiatives on track and scope under control. The delivery approach included breaking the overall strategy into manageable component parts (including sub-projects) in order that incremental progress could be accurately reported on, measured, and future steps continually re-assessed as the strategic, market and regulatory drivers for change evolve.

2. Depository Trust and Clearing Corporation (DTCC) Integration Case Study

Background

DTCC was established in 1999 when the holding company was formed by the bringing together of the Depository Trust Company (DTC) and the National Securities Clearing Corporation (NSCC).

The Depository Trust and Clearing Corporation (DTCC) through its subsidiary companies provide CCP clearing & settlement, and central securities depository services, both in the USA and abroad. DTCC is the largest provider of capital market post-trade services in the world.

DTCC provides the clearing and settlement for each of the US stock exchanges and about 50 alternative trading systems and electronic communications networks.

48 Integration Opportunities and Challenges

The company operates domestic market CCPs through its subsidiaries:

National Securities Clearing Corporation (NSCC) supporting equities, corporate and municipal debt, American Depository Receipts (ADRs), exchange traded funds (ETFs), etc., and,

Fixed Income Clearing Corporation (FICC) where they handle processing for US government debt and money market issues and US government agency mortgage-backed securities.

Integration Goals

DTCC’s practice has been to integrate businesses and processes where there have been compelling reasons to do so, considering the benefits, risks and inherent complexity associated with a particular business or process integration being considered.

Process

By examining the history of how DTCC has evolved as an organization, it is illustrative of the fact that they have not chosen a single integration path, but have chosen their direction by weighing the relevant factors, and by engaging in extensive consultation with their market participants and stakeholders.

DTCC has used White Papers and industry working groups extensively as part of the consultation process. DTCC also has a Board of Directors comprised of users, supplemented by specialized business and operations committees.

Results

DTCC has made a priority of pursuing integration opportunities where the potential benefits were greatest, and the nature of the business was complementary.

FICC - FICC was created in 2003, when the Government Securities Clearing Corporation (GSCC), which had been affiliated with NSCC since being founded in 1986, and the Mortgage-Backed Securi- ties Clearing Corporation (MBSCC) were integrated under a single legal entity.

With the formation of FICC, the processing of government debt and mortgage-backed securities were brought together under a single legal entity. The businesses continue to be run as separate divisions with separate operating rules. A notable difference in the environments is that the Mortgage-Backed Securities Division does not act as a central counterparty, and therefore does not guarantee the settlement of transactions. Collateral pools for the two divisions are managed separately, although they continue to move towards standardization of the eligible collateral and the near-term goal is for the two divisions of FICC to be brought together under common rules, including margining rules and collateral requirements.

Now under way is an initiative linking FICC’s clearing of government bonds with a new system, jointly developed by DTCC and NYSE Euronext, called New York Portfolio Clearing. This new system will integrate FICC´s clearing system with NYSE Euronext Liffe’s US government bond futures clearing system, and it will use LIFFE1 software.

1 LIFFE (London International Financial Futures and Options Exchange) is NYSE Euronext´s derivatives and commodities market

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NSCC and FICC –The merger of NSCC and FICC was contemplated by DTCC, but was ultimately not pursued because of the extent of the differences in the business needs of the two markets.

DTC, NSCC, Omgeo – DTC and NSCC have consolidated their settlement systems into a single platform, merging and streamlining the end-of-day money settlement process for bank and broker dual participants. With Omgeo, NSCC and DTC are now offering ID Net, an opportunity for brokers to net their CCP obligations against their own obligations to institutional clients, while the clients’ settlements are still settled on a gross basis.

Risk Management – DTCC has a centralized risk management function in support of its various subsidiaries. Although each clearing entity is still risk-managed separately, unifying risk management re- mains a goal. For a number of years each of the DTCC subsidiaries have had cross-collateralization lien arrangements which allow any excess capital of a failing participant to be applied first to its obligations to another registered clearing agency. In terms of integration, the principal agenda is, as noted above, to unify the two FICC divisions. They have concluded that it makes more sense to unify related trading, such as cash, options, futures of government securities than to attempt to integrate equities and fixed income cash markets.

Data Centers and Systems – DTCC’s subsidiaries share centralized data processing, which includes three data centers, two local centers required to ensure immediate replication, and one located hun- dreds of miles away from their headquarters. Similarly, DTCC subsidiaries share two major operating sites, one located in New York City and a second in Tampa, Florida. Centralizing the processing facilities, while also distributing them across various locations, has enabled best capabilities at lower cost. DTCC has also encouraged and achieved a degree of harmonization within the systems area where it made business sense to do so.

Experiences

The examination of integration opportunities at DTCC seems to be constant process. Based upon DTCC´s experience to date, there are some clear realities stemming from their approach to the integration process.

• The difficulties in changing established market practice has likely been one of the biggest challenges to achieving increased levels of business or systems integration. In situations such as equities and fixed income, where participants typically manage their lines of business separately, integration of clearing processes would require a wholesale simultaneous re-engineering in participants’ operations, and thus far, there has not been a business case for this undertaking.

• In some situations the complexity and risks associated with integration of systems outweighed the potential benefits. For example, future systems changes would become more complex in some in- stances with an integrated system, and the potential implications of a system’s outage would be mag- nified by use of a single platform.

• Participation requirements are not uniform. There are higher capital requirements for participation in the clearing of government securities than for equities. This would have implications for the integration of NSCC and FICC.

• Collateral pools and the associated cost of collateral are managed separately for the various business lines within many of DTCC’s participants. Integrating collateral pools would have consequences for the way in which participants manage collateral within the clearing corporations, and when ap- proached, participants have been somewhat wary of having competing businesses (within a given legal entity) contribute to and share common collateral pools, even if this would be a somewhat less capital intensive alternative.

50 Integration Opportunities and Challenges

• Beyond this, DTCC emphasizes that it, and the rest of the US market infrastructure, have not seen wholesale CCP integration across diverse products as necessarily the best use of industry resources. Rather, DTCC’s vision is that, through the flexibility of its holding company structure, it has been able to provide an agile portfolio of services, and extend its processing capabilities and low costs to new market segments and new instrument types. This includes leveraging its experience and technology to rapidly build Deriv/SERV to automate and lower risk for the growing global market in credit default swaps and other OTC derivative instruments, as well as launching its EuroCCP subsidiary, a pan-Eu- ropean equity clearing platform. DTCC also forged a partnership between FICC and NYSE Euronext in a new cross-market CCP called New York Portfolio Clearing (NYPC) showing that DTCC is always alert to new synergies and ready to pursue them directly or in partnership with others.

3. Hong Kong Exchanges and Clearing Limited (HKEx) Integration Case Study

Background

HKEx is the holding company of The Stock Exchange of Hong Kong Limited (SEHK), Hong Kong Futures Exchange Limited (HKFE) and Hong Kong Securities Clearing Company Limited (HKSCC). Market reforms announced in 1999 allowed the two exchanges to demutualize and the companies to merge under a single holding company, HKEx.

The merger took operational effect on 6 March 2000, and HKEx listed itself on SEHK on 27 June 2000. The merger consolidated the exchanges and the associated clearing houses within a single group, and brought together the trading, clearing (including central counterparty) and settlement operations of the Hong Kong cash and derivatives markets.

Integration Goals

Integration was undertaken with a view to aim to streamlining operations, maximizing efficiency and cost savings, and creating a structure that would provide for long-term business growth.

Initial Integration Process

HKEx engaged the services of external consultants during the initial integration process to study the company structure and make recommendations taking into consideration the integration goals. An integration Steering Committee was also established to review recommendations and monitor various integration initiatives.

Results

All support services (e.g., human resources, legal services, corporate communications, etc.) have been integrated. At the time of the merger the organizations had total staff levels of approximately 1050 people. That number has been reduced to approximately 830 through a process of integration and rationalization as at end of 2001.

On the clearing operations side, a single division (Clearing Division) was established to operate three

51 BM&FBOVESPA’s Post-Trade Infrastructure

Clearinghouses (i.e. HKSCC for the cash market, HKFE Clearing Corporation Limited or HKCC for the futures and options market (except stock options), and The SEHK Options Clearing House Lim- ited or SEOCH for the stock options market).

At the time of the merger, the three Clearinghouses were running three different market systems, which were on different technical platforms. HKEx initiated a study regarding the possibility of integrating the clearing systems for the derivatives markets operated by HKCC and SEOCH. The systems were integrated into a single derivatives clearing system (referred to as DCASS) in 2004 which shares the same technical platform as the derivatives trading system.

In 2002, two years following the merger, HKEx implemented its Common Collateral Management System (CCMS) for use by clearing participants of both the cash and derivatives markets. The CCMS provides a common platform for participants of the three Clearinghouses to manage their collateral electronically through a single system. The system was built internally and designed with the view to support future developments such as cross-collateralization between the three Clearinghouses.

The CCMS application resides on the clearing platform for the cash market (CCASS), and has linkages with both CCASS and DCASS to support their respective collateralization processes. Prior to the development of CCMS, the three Clearinghouses used different satellite systems to manage participants’ collateral.

One of the challenges HKEx faced in establishing CCMS was in designing an infrastructure to fit the specific requirements of three Clearinghouses while at the same time deliver one that could provide for future integration requirements.

The risk management functions of the clearinghouses were spun off from the Clearing Division and merged under a separate division (Risk Management Division) in mid-year 2007. The revamped division provides risk management for cash and derivatives markets clearing, market surveillance, participant surveillance, as well as enterprise wide risk management.

A single system provided by a leading technology vendor to the exchange and clearinghouse industry is used to calculate margin requirements for SEOCH and HKCC participants; however, the three Clear- inghouses (including HKSCC) are also using in-house developed risk management systems to support their clearing risk management operations and related risk management requirements.

Within the Clearing Division, hotline, training, and product development services are provided through a single department, which covers participants in both the cash and derivatives clearing. While the three Clearinghouses have separate participant groups, a number of firms are participants in more than one Clearinghouse. By centralizing the hotline and training support within a single team, HKEx has found that they can better serve their clearing participants since they have an overall view of each of their participants’ clearing business. Furthermore, they have realized synergies in using a single team to support product development for both markets, and in particular for those initiatives with cross- market impacts.

Communications networks have been consolidated allowing both exchange and clearing participants to connect with the respective market systems via a single network. Prior to the network consolidation, which began in January 2005, HKEx was maintaining four separate networks. The consolidation of networks has resulted in a $20 million reduction per year in network costs for participants and provides greater bandwidth and scalability to better support increased order flow and market data traffic. This initiative was completed in July 2007.

52 Integration Opportunities and Challenges

The six different data centers for different market systems of HKEx are being consolidated in phases, with the first phase of consolidation being completed in 2009.

Experiences

• Integration of market systems was a complex undertaking as it involved not only technical preparation and migration, but also operations integration, rules and operational procedures changes, market readiness, a period of parallel processing and fallback arrangements, etc.

• The integration of derivatives clearing systems was managed as a separate project, and took almost three years to complete. This was quite a bit longer than originally anticipated due to a number of reasons such as the degree of customization undertaken, communications between the Clearing- houses and the system vendor, and the quality of technical deliverables.

• As is the case with almost any integration, it was challenging to HKEx to deal with the streamlining of resources, accommodation of the different company cultures and getting buy-in of stakeholders.

• HKEx has found that with listing, trading and clearing in both cash and derivatives markets running under one roof implementation of market initiatives is more efficient. Having all within one organization has streamlined the decision-making and priority setting processes.

4. Main Conclusions of the International Experiences in Post- Trade Operations Integration

The analysis of these markets illustrates that, as their infrastructures pursued an increased level of integration of their operations, a variety of challenges were encountered which needed to be addressed. From a very general perspective, the most relevant challenges faced by the infrastructures in their inter- action with market participants related to one or more of the following aspects:

• Frequently, there was a marked difference in the perception of various participant groups with respect to initiatives being considered. • Those differences and issues tended to grow through analysis, rather than getting smaller. • The market view was at times different than that of the infrastructure with respect to the potential benefits of various initiatives. • In some situations the complications and risks associated with integration of systems outweighed the potential benefits. • Acknowledgement that integration of market systems can prove to be a complex undertaking as it often involves, not only technical preparation and migration, but also operations integration, rules and operational procedures changes, market readiness, a period of parallel processing and fallback arrangements to safeguard against risk of system problems arising during migration.

Having established a general picture by detailing the aspects of the post-trade basic “building blocks”, reviewing the prevailing international standards and analyzing international experiences on the subject, we move now to the section of the paper that addresses various potential BM&FBOVESPA´s post-trade integration options.

PART IV INTEGRATION OPPORTUNITIES

Integration Opportunities and Challenges

PART IV - INTEGRATION OPPORTUNITIES

Immediately following the merger of BM&F and Bovespa, we embarked on our path towards ever-increasing levels of integration. We did so with the help of internationally recognized external consultants who were engaged to provide advice on the definition of the organizational structure. The company has now been organized within a single legal entity and operating units across the various markets have been consolidated, generating synergies and permitting us to more efficiently and effectively serve our- mar kets and to provide the foundation upon which we will achieve greater and greater levels of integration.

Executive e Officer

•BM&FBOVESPA Bank Officer •Research and BusinessProjectsOfficer Clearinghouse, Financial, Corporate Business Operating Depository and Products E xecutive •Audit Officer Affairs and IR Development Executive Officer Risk M anagement Officer •Human ResourcesOfficer Executive Officer Executive Officer Executive Officer •Sustentability Officer

RISK •CENTRAL SETTLEMENT MANAGEMENT SECURITIES OFFICER OFFICER DEPOSITORY

PARTICIPANT REGISTRATION ACTIVITIES • Risk Modeling • Allocation Process • Centralized • Credit and Market • Failures Safekeeping of E quities, Risk Administration • Multilatera lNet Fixed Income, Gold a nd Settlement Agribusiness s ecurities • Intraday R isk • GrossSettlement Administration • Corporate Actions • Commodities control and payment • Margin C alculation Settlement • Daily Reconciliation • Collateral • Specia lOpera tion • BM&FBOVESPA Administration Settlement and • Certificate I ssuing and Participants Sctructu ring Canceling Registration and • Default Access Control management (IPO/OPA/Auctions) • International Programs • OTCRegistration • Te souroDireto • Investors • Contracts and Registration Equities Evaluation • Depository I nformation (Depository Statement • Centralized • Securities Lending Invertors Registration Program (BTC) and Investor E lectronic Channel –CEI) (CCI)

Fig. 6: BM&FBOVESPA´s current structure, highlighting post-trade units

The merger has provided the opportunity to have a much more comprehensive picture of the risks presented by each market participant across a broader range of their business. Previously, the risks were measured separately by each of the companies but it is now possible to design a single view integrating the trades and business of each participant. Even though there is not a unique risk management system, the picture of the risks presented by each market participant across a broader range of their business had proven especially valuable during the period of extreme market volatility experienced during the second half of 2008.

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• Creation of a unified vision for portfolio risk to enhance participants’ and investors’ risk monitoring and management activities; • Adoption of common risk management for all systems, combining two or more CCPs (Central Counterparties) with a common margin calculation, adopting a common loss sharing approach and integration of different financial instruments across CCPs; • More efficient use of collateral, with the introduction of a collateral pool; • Improved liquidity and cash management with netting of two or more settlement windows (specific time during the day to arrange the DVP); • Availability of a more diversified suite of products and services ; and • Substantial improvements in operating efficiency of the participants, through the harmonization and standardization of BM&FBOVESPA´s information and processes.

This section of the White Paper it is intended to advance the discussion of many of these ideas.

This section of the White Paper intends to stimulate the discussion regarding several of these ideas.

For each identified opportunity, there is a separate discussion of one or more of:

• Projects currently underway; • Actions planned; • Actions being considered.

1. Creation of a unified vision for portfolio risk to enhance participants’ and investors’ risk monitoring and management activities

As mentioned in the introduction to this section, the merger has provided BM&FBOVESPA with a much more comprehensive picture of the risks presented by each market participant across a broader range of their business.

1.1. Unified Vision for Portfolio Risk

Actions planned

While there is value to the information that is currently available, the opportunity exists for an augmented view of the participants’ risk profile.

Achievement of an augmented view entails; the development and implementation of improved information gathering and handling techniques in order to increase the speed, malleability and overall confidence related to the data, as well as flexible tools that provide the capability to carry out various types of analysis quickly and reliably. These tools should enable, at a minimum, exposure and gap reports, in addition to, “what if” and risk factor sensitivity analysis, which will enhance the overall risk management and the related decision making processes.

58 Integration Opportunities and Challenges

2. Adoption of common risk management for all systems, combining two or more Central Counterparties (CCPs) with a common margin calculation, adopting a common loss sharing approach and integration of different financial instruments across CCPs

There is a clear opportunity for the development of a single risk management system that could span the breadth of Clearinghouses managed by BM&FBOVESPA. This common risk management system would simplify the implementation of the Consolidated View of Risk previously discussed. It would also make possible the integration of two or more CCPs, potentially reducing collateral requirements. The common risk management system would also result in a more harmonized environment for both internal and external risk management processes.

Although combining all Clearinghouses into a single CCP might prove to be an extremely challenging task, and perhaps an economically inefficient one, there is still the possibility of combining only CCPs that share a number of common features. This option could potentially represent a more appropriate balance between costs and benefits for both BM&FBOVESPA and market participants.

2.1. Common Risk Management System

Actions planned

We are currently analyzing the possibility of developing (or licensing) a risk management system that would have the capability to support all four of BM&FBOVESPA’s Clearinghouses. We expect to le- verage this investigation by taking into account the international experience regarding this matter, as previously discussed in this White Paper.

2.2. Combining Two or More Central Counterparties (CCPs)

Actions planned

The possibility of combining two or more CCPs is already under examination as a part of the process of developing a common risk management system.

3. More efficient use of collateral, with the introduction of a collateral pool

BM&FBOVESPA currently maintains four separate collateral management facilities supporting the activity within its 4 markets and Clearinghouses using approaches that have not yet been harmonized. In that connection, there are differing haircuts applied, distinct sets of eligible collateral, and varying concentration limits for each.

We believe substantial opportunities exist to bring about greater levels of standardization and harmonization between the various environments. Providing participants with more efficient means to manage their collateral is a priority for BM&FBOVESPA, as is engaging in the analysis and discussion of how we can achieve standardization across the various risk models.

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3.1. Unified Collateral Management Capability

Actions planned

BM&FBOVESPA is currently analyzing the requirements for the creation of a unified collateral management system. The objective is to provide a single electronic facility that would allow participants to manage their collaterization activities across the entire breadth of their business with BM&FBOVESPA through a consolidated interface. This interface would streamline the process for the allocation or reallocation of collateral to and between the various markets.

In line with BM&FBOVESPA’s objective to implement systems that are more agile and efficient, modi- fications to the risk management systems are already being analyzed in order to provide for the harmonization of collateral eligibility, haircuts and concentration limits.

Actions being considered

In some specific situations there is a natural market risk offset between derivatives positions and the collateral posted at the Clearinghouse. This is often the case when the position being hedged using a derivatives contract (either listed or OTC) is posted as collateral. Although applying these kinds of risk offsets is not a trivial task - poorly implemented it could expose the Clearinghouse to other types of risk (e.g. liquidity, credit/issuer) - we believe that in some circumstances this practice could be put in place for the benefit of market participants.

3.2. Bi-Lateral Collateral Facility

Projects currently underway

BM&FBOVESPA is currently developing the capability for the management of bilateral collateral arrangements between participants related to their activity in the derivatives OTC market. It should be pointed out that the development of bi-lateral collateral facilities is a project independent from any other integration plans that might be decided upon.

4. Improved liquidity and cash management with netting of payment obligations, fostering harmonization of settlement processes during the day

4.1. Netting of Final Payment Obligations

Actions being considered

An initiative is underway with the objective of examining the potential benefits and implications of netting the final payment obligations across two (or more) settlement systems. One of the approaches being examined is predicated on combining the cash leg of settlements while retaining the separate central counterparties. The achievement of the netting of the final payment obligations will involve the harmonization of timeframes for settlement across the systems involved, in addition to some level of rule changes and procedure harmonization.

60 Integration Opportunities and Challenges

5. Availability of a more diversified suite of products and services

The merger has brought together staff from the two organizations with complementary skills and -ex perience. The resultant synergies have provided BM&FBOVESPA with an enhanced capability to develop new services by leveraging the unique backgrounds within the combined group.

5.1. Combo-products

Actions planned

Being a multi-asset class and a vertically integrated infrastructure allows BM&FBOVESPA to integrate different financial instruments not only in, but also across different Clearinghouses. Thus, it is possible to have combo-products traded electronically that would represent two or more products that would be settled in different Clearinghouses. There are also opportunities to reallocate products from one Clearinghouse to the other, offering more efficiency to market participants. This is particularly relevant the case of derivatives contracts, which are currently cleared in two different CCPs.

The studies concerning the creation of combo-products and the possibility of reallocating products between Clearinghouses are already under way.

6. Substantial improvements in operating efficiency of participants, through the harmonization and standardization of BM&FBOVESPA´s information and process

BM&FBOVESPA maintains for its four Clearinghouses and Central Depository, several processes with similar purposes, such as, systems access, functionalities for trade allocation, information and financial settlement controls, holdings control and derivatives contracts positions, as well as others. Fur- thermore, there are currently differing communication protocols between BM&FBOVESPA and its participants.. While the range of functionality and usage varies from system to system, they essentially include; terminal access, XML and FIX messaging as well as file transfer capability.

The goal of BM&FBOVESPA with respect to the functionality and electronic communications is to advance harmonization and use increasingly modern and internationally adherent standards that facilitate STP (Straight Through Processing) for participants. In this connection, the dynamic of each process will determine the best path to harmonization as well as the communication standard to be designed: online communications using messages and the exchange of large volumes of information using files.

6.1. Consolidated Reporting of Holdings

Actions planned

Our participants maintain investment portfolios with BM&FBOVESPA that include a wide range of instruments, such as;

61 BM&FBOVESPA’s Post-Trade Infrastructure

• Equities, • Fixed income, • Gold, • Futures and derivatives contracts, and • Agribusiness-related securities.

Today, while this portfolio information is presented in high quality, secure and efficient systems, it originates from multiple systems and in varying formats, each of which requires a separate log-on and password. This clearly needs to change in order to provide participants and investors with an integrated, accessible summary of their holdings.

We are examining the requirements for the establishment of a flexible structure for a wide range of instruments to enable consolidated reporting of holdings regardless of instrument type. This will provide participants with centralized control of all assets and contract positions for BM&FBOVESPA products. This consolidation will be supported by a standardization of processes related to the administration of holdings, such as, the adoption of a common process for asset transfers, deposits, balance inquiries, etc.

The provision of all information for participants regarding position and historical transaction activity will be available through a single access. This unique portal will enable BM&FBOVESPA participants to view individual account holdings (equities, fixed income, gold, agri-business, futures and derivatives contracts.) as well as account activity (e.g. movements, entitlements) within a single screen, or from a single standardized message or file.

Reporting to individual investors will be consolidated in a similar manner, thus simplifying communications between BM&FBOVESPA participants and their clients.

6.2. Centralized Management of Custody Positions

Actions being considered

An examination of the cost and benefits of consolidating the underlying systems that support holdings administration of various instruments registered and deposited at BM&FBOVESPA, as well as instruments maintained in accounts of BM&FBOVESPA in local and foreign depositories is already under way.

The establishment of this centralized multi asset management capability has the potential to enhance settlement and collateral management processes, allowing participants to manage the various assets of their clients through a centralized and secure function.

6.3. Account Administration

Actions being considered

Two distinct account administration processes exist today; one for the former Bovespa markets and another for the former BM&F markets. The adoption of a single, standardized system for account set-up and administration, including client information updates will simplify participants’ procedures regarding those activities. The establishment of standardized account identifiers is also underway.

62 Integration Opportunities and Challenges

6.4. Trade Allocation

Projects currently underway

A project is nearing completion that will result in the standardization of the allocation process, particularly for equity, equity derivatives and financial and commodity derivatives. Through a single system it will be possible to handle allocations for all post-trade environments. This standardization will reduce future technology and development costs both for BM&FBOVESPA and our participants. Ultimately, it is our goal to bring about a standardization of the rules surrounding the allocation processes in the various environments. Achievement of rules standardization would present opportunities for further reductions in operating costs and operational risks associated with the use of different processes in the different markets.

Actions planned

BM&FBOVESPA is working on an initiative to bring about the inclusion of fund and asset managers in the communications/allocation process in order to enhance the overall level of STP for all concerned parties.

6.5. Unified Financial Information Flow

Projects currently underway

Today, BM&FBOVESPA maintains four separate financial information systems, and work is underway to consolidate three of these (excluding Foreign Exchange) into a single system. These financial systems provide the complete range of information related to the financial rights and obligations participants have before the Exchange, as well as the timing of those rights and obligations. The consolidated system will provide, through standardized messaging, information related to: variation margin, margin calls, purchases and sales, corporate actions payments, among others. This will allow for the reduction of ongoing operational costs and risks through the provision of streamlined, less complicated processes for BM&FBOVESPA, and our participants.

6.6. Unified Messaging System – IMercado

Projects currently underway

The concept behind iMercado involves the creation of a secure and standardized communication hub for all market participants.

63 BM&FBOVESPA’s Post-Trade Infrastructure

PRE-TRADETRADE POST-TRADE Market Portfolio Order Allocation Clearing / Collateral Auxiliary Access Trade Custody Analysis Management Settlement services

BM&FBOVESPA

BROKER BROKER ASSET MANAGER CUSTODIAN ADMINISTRATOR OTHERS (EXECUTOR) (CARRYING)

Fig. 6- Before iMercado

PRE-TRADETRADE POST-TRADE Marke t Portfolio Order Clearing / Auxiliary Access Trade Allocation Collateral Custody Analysis Management Settlement services

BM&FBOVESPA

BROKER BROKER ASSET MANAGER CUSTODIAN ADMINISTRATOR OTHERS (EXECUTOR) (CARRYING)

Fig. 7 –iMercado Project

Phase 1 of this initiative involves the creation of a network hub to which the financial marketplace can connect in order to facilitate the exchange of standardized information in electronic format. The hub will replace the need for the current uses of fax, email and phone for much of the communication that takes place between market participants today.

Phase 2 will enable the transfer of qualified information related to activity within all the products of BM&FBOVESPA, such as, trade related information, entitlements, positions, allocations etc., with the

64 Integration Opportunities and Challenges

“certification” of BM&FBOVESPA attesting to the legitimacy of the information. iMercado will facilitate communications using multiple protocols (SPB2, FIX and ISO 20022) and will provide a translation capability eliminating the necessity for users of the network to translate messages or develop a single communication protocol.

Actions planned

BM&FBOVESPA plans to extend (or link) iMercado with other networks both domestically and internationally in order to provide expanded reach for our participants in support of greater STP levels for cross border transactions and post-trade activities. BM&FBOVESPA will initiate studies related to this topic after the second quarter of 2010.

Actions being considered

Opportunities may exist to extend the network to support activity beyond BM&FBOVESPA markets thus enhancing its utility to our participants.

6.7. SINACOR+

Projects currently underway

Sinacor is a complete solution for the back, middle and front offices. It consists of several modules which can be fully integrated with each other and with other systems. The system allows process automation and improvement for user participants’ processes, especially those related to BM&FBOVESPA, saving resources and time, besides reducing operational risks. In addition, Sinacor handles BM&FBOVESPA information in efficient and real-time basis.

The platform supports participants in their relationship with the negotiation and clearing environments, as well as with other financial institutions. Its services are currently used by 95% of BM&FBOVESPA brokers.

The project currently underway, named Sinacor+, is the adaptation of the platform in accordance with the integration of the BM&FBOVESPA’s post-trade infrastructure and other technology advances.

Phase 1, completed in August of 2009, allows users to more efficiently administer orders and trades executed through the equities and the financial derivatives electronic trading platforms. In addition to other improvements, the new system allows brokers to track their clients’ positions and trades in both markets,.

Sinacor’s enhancement is also focused on preparing the system to adapt with agility to new products and innovations that BM&FBOVESPA delivers.

The goal is to complete the entire project in 2010 by launching new modules and updates on a quarterly basis.

2 Communication protocol based on XML used on the Brazilian National System Network

65 BM&FBOVESPA’s Post-Trade Infrastructure

6.8. Harmonization of Operating Procedures

Actions being considered

BM&FBOVESPA wishes to bring about the harmonization of operating procedures where it is deemed practical, and where there are tangible benefits in doing so.

6.9. Single Log-on and Terminal Based Functionality

Projects currently underway

BM&FBOVESPA has a project underway to enable access to the terminal screen environment for all post-trade services by way of a single log-on and password, and to allow participants to control access for their users (environments and functions) according to their specific needs.

Work is also underway to harmonize the screen look and navigation for each environment, and to offer a consistent breadth of terminal based functionality across all environments, supported by increased standardization of operating processes.

6.10. Harmonization of Participant Structure

Actions being considered

BM&FBOVESPA is considering the possibility of further harmonizing and where possible, simplifying the participant structure. As integration opportunities are identified and specific plans are defined, it will be necessary to reflect the infrastructure evolution in the participant categories and requirements.

This next section concerns an analysis of post-trade integration considerations in relation to various market scenarios.

66 PART V INTEGRATION OPPORTUNITY CONSIDERATIONS

Integration Opportunities and Challenges

PART V – INTEGRATION OPPORTUNITY CONSIDERATIONS

This section will explore those potentially more controversial aspects of integration, which will probably require deeper reflection and consultation in order to build an appropriate level consensus on the best way forward with the various integration opportunities.

An important characteristic of the intermediation industry, which underpins of our market functioning, is its diversity. Participants differ in their size, their role in the market, the products and services they provide, in their governance, in the location of their major decision making, whether domestic or foreign, and, in the type of customers they serve, to mention just some of the key aspects.

1. Need for Consensus

In our participants’ ideal world all solutions would be customized according to their individual needs and best interests. The resulting proliferation of solutions, however, would involve costs that they would certainly not be inclined to bear. Thus, to state the obvious, the solutions we develop need to balance the at times diverse needs of our participants and the associated costs.

Achievement of this “balance” leads us to the need for consensus on the best approach to adopt regarding the integration opportunities. When fragmentation among stakeholder groups emerges, progress is stalled or stopped completely. Should this happen, we, participants in the Brazilian market have the most to loose. The gains to be achieved arising from a greater standardization and/or centralization of processes and information could be stifled should a group or groups of market participants resolve to maintain the status quo with processes and information in individualized and segregated form. The maintenance of duplicate systems, reports, interfaces and communication tools runs counter to the goal of optimizing our market efficiency, burdening all with potentially unnecessary or unproductive expenditures.

2. Market and Functional Segmentation

Although there is a substantial level of overlap, participation in each of the different markets is not identical. Notably, the institutions operating in the equity and derivatives markets are not all active players in the government bonds and foreign exchange segments. These latter markets have participation which is much more concentrated within banking institutions.

Even within the brokerage community, the firms are generally split between those with a greater pen- etration in the derivatives market and those with an equities market focus. This of course is not an issue limited to the independent brokerage firms. Segregation of business activities within large institutions has similar implications. Large institutions are often active participants in each of the markets, but often separate operating departments that have responsibility for different market segments.

69 BM&FBOVESPA’s Post-Trade Infrastructure

We must therefore give careful consideration to the implications of the various options in order to achieve the best collective solution or solutions. We must also keep in mind that some level of segregation might be desired as a safety measure protecting against undesired disclosure of investor information, or as an element contributing to the effective functioning of the “Chinese Wall” between departments. There are design choices that can and should be made in order to mitigate this type of risk, but the options and associated costs need to be thoroughly analyzed and understood.

The regulators’ perspective also needs to be carefully considered throughout the integration process. At each stage we need to ensure that the regulators are engaged and fully understand the implications of changes that are being contemplated.

For these reasons, all stakeholders involved in the process need to have a clear understanding of the actual institutional arrangements in the intermediation industry in order to prevent the construction of economically or functionally inefficient solutions.

3. Risk and Collateral Management Considerations

Some of the integration opportunities raise important questions in terms of risk and collateral management.

A subject that will require very careful examination relates to the balance between the different loss sharing models (defaulter pays versus survivors pay). In the equities and derivatives clearing systems there is a combination of approaches in a hybrid model in which participants collateralize their risk directly, and residually contribute to settlement funds. This model, on the other hand, is not employed in either the Forex and government bond clearinghouses. We will need to consider the reasons for these differences, such as the type of investors operating in each market, the characteristics of the security or instrument, as well as potentially others.

We will also need to consider the possibility that participants are prepared to accept some level of loss sharing in the markets in which they operate but, conversely, may not wish to engage in arrangements for sharing potential losses in markets they do not take part.

Another aspect to be considered relates to the methodologies used in calculating individual participant risk. Although methodologies that identify and offset opposite exposures related to positively correlated risks - or, conversely, directional exposures related to negatively correlated risks – have the potential to reduce the required levels of collateralization, those methodologies are generally based upon a sim- plified view of the actual market dynamics. Since the main principal concerning central counterparty risk management is connected to the assessment of the potential losses related to the close out of a portfolio of assets under adverse market conditions, friction factors such as correlation misalignments during high volatility periods, different liquidity profiles related to different assets and markets and different settlement structures, must be considered. Therefore, the offset mechanisms should ensure a minimum level of sophistication in order to incorporate those friction factors, otherwise, it is likely that the participant’s portfolio real risk would be underestimated.

The standardization of eligible collateral and haircuts also requires careful consideration. For instance, in a situation where we have two or more Clearinghouses with differing risk models, then the differences in the defaulter pays and survivors pay balance would also result in different haircuts for the same collateral, as would be the case for the margin requirements related to equivalent instruments settled through these clearinghouses. Furthermore, the ability to offset risks between positions and collateral would also influence the set of eligible collateral that the Clearinghouse could accept.

70 Integration Opportunities and Challenges

4. Changes in the Participants’ “modus operandi”

Some of the integration opportunities have the potential to impact participant operational processes. A single netting, for example, instead of as many as four, would certainly impact each participating institutions’ cash and liquidity management procedures.

One of the motivations for netting the settlement from transactions is to reduce liquidity demands through the reduction of cash amounts that institutions have to provide in order to settle its obligations. However, the procedures in place in all clearing members, including their relationship with clients, currently consider the existing settlement schedules. With clearing members that are not banks, this may have implications for their contractual relationship with the settlement bank as well.

A change in payment timeframes, while seemingly a simple matter of communicating with customers, could have far reaching operational implications for operational environments that are beyond participants’ direct influence or control. Participants doing business with non-resident investors will almost certainly face barriers in changing the current payment timetable beyond certain parameters.

5. Regulatory Models and Risks

The different markets supported by BM&FBOVESPA rely upon a variety of regulatory frameworks. The Brazilian Central Bank, in what concerns BM&FBOVESPA’s activities, establishes the rules and policies pertaining the central counterparty and settlement functions, whereas the Brazilian Securities Commission focuses on the regulation and oversight of central depository and trading activities.

The Brazilian Central Bank regulates the government bond and the Forex markets and both segments are considered essential tools for implementing macroeconomic policy. The liquidity in these markets is concentrated within large financial institutions and most transactions take place over-the-counter with the Central Bank playing an important and direct role in the markets. Within the Brazilian regulatory structure, the Central Bank is responsible for the prudential regulation of the market and for taking the necessary measures to ensure financial stability.

The equity and derivatives markets are regulated by the Brazilian Securities Commission (CVM) whose role in the country’s regulatory structure is principally related to investor protection and enforcement of market rules related to intermediaries. The role of self-regulation in these segments is much more important than in the government bonds and foreign exchange markets, and as a conse- quence, BM&FBOVESPA’s rules and procedures are the main regulatory instrument used in address- ing some aspects of the functioning of the equity and derivatives markets.

These differences in the regulatory approach must be given appropriate consideration in the evaluation of integration opportunities. In considering combining the central counterparty and settlement infrastructure for the different segments, we must reflect on the resultant potential for regulatory changes that go beyond BM&FBOVESPA’s direct influence and the impact they might have on the markets’ functioning.

6. The Stakeholders’ Equation

Finally, the goal behind all the integration opportunities we have outlined is to create value for all stakeholders in a balanced way. BM&FBOVESPA has the responsibility to seek technical solutions considering, at the same time:

71 BM&FBOVESPA’s Post-Trade Infrastructure

• improvements in service quality, • excellence in risk management; • cost-efficiency for market participants; • regulatory reliability, and • returns to shareholders.

Any imbalance in this rather complex equation has the potential to compromise the entire process.

The case studies included in this White Paper illustrate how some other market infrastructures have dealt with similar integration challenges. Their experiences seem to illustrate that this equilibrium is not always easy to achieve.

The considerations identified in this section are aimed at encouraging stakeholders to take a broad market view in building an ever more efficient post-trade infrastructure in support of advancing the attractiveness and competitiveness of the Brazilian capital market.

Next Steps

72 APPENDIX

Integration Opportunities and Challenges

APPENDIX BM&FBOVESPA Compliance to Best Practice Recommendations – Central Securities Depository, Settlement System and Central Counterparty

The recommendations that have been put forward by international organizations, such as, The Group of Thirty, International Organization of Securities Commissions (IOSCO) and Bank for International Settlements (BIS), have had a great influence on the decisions made by BM&FBOVESPA with respect to its post-trade operations. The achievement of an extremely high level of compliance with the most relevant recommendations has contributed positively to the high regard in which BM&FBOVESPA and the Brazilian Capital Market is held internationally.

The following recommendations have been extracted from the various reports published by those international organizations. Each is followed by a summarized commentary of how BM&FBOVESPA’s structure and operations relate to the recommendation.

A.1 CPSS-IOSCO – CCP (2004) – Recommendation. 1

A CCP (Central Counterparty) should have a well-founded, transparent and enforceable legal framework for each aspect of its activities and in all relevant jurisdictions.

The legal basis underlying the infrastructure of clearing and settlement in the Brazilian capital markets is composed of (i) laws and rules of the Monetary Council (CMN) and the Brazilian Central Bank (BCB), and (ii) the Clearinghouses’ rules and procedures.

Laws and rules of the CMN and BCB

The Brazilian “New Payment System” (SPB), implemented in 2002, promoted the construction of a sound legal basis underlying not only the functioning of the Real Time Gross Settlement (RTGS) transfer system, managed by the BCB, but also the functioning of the systemically important Clearing- houses.

The Law 10.214 (2001) defined the concepts of multilateral netting and novation of contracts, thus introducing the need for the systemically important Clearinghouses to act as central counterparties. The Law recognizes the finality and irrevocability of settlements in both Real Time Gross Settlement (RTGS) and Deferred Net Settlement (DNS) systems, and also assures to the Clearinghouses priority over any securities posted as collateral, in case of a participant default, thus enabling the continuance of the settlement process and the settlement certainty.

Rule CMN 2.882 from 2001 on the payment systems and the Clearinghouses establishes the principles to be observed by direct participants of the Brazilian Central Bank Large Value Transfer System (STR), including the Clearinghouses. The principles basically reproduce the Core Principles published in prior months by the CPSS (BIS):

Rule 2.882 - Article 3. In the payments system, it should be observed the general rules listed below, applied by Brazilian Central Bank which will consider the particularities of each system:

I – the participants should have access to clear and objective information, allowing the identification of

75 BM&FBOVESPA’s Post-Trade Infrastructure the risks involved in the systems they use (core principle 2)

II – the rules and procedures should allow and promote the management and mitigation of credit risks and liquidity risks, as well as establish clearly, for this purpose, the obligations of the Clearinghouses and the providers of clearing and settlement services and those of the participants (core principle 3);

III – the unconditional and irrevocable settlement of an obligation, in account maintained at the Brazil- ian Central Bank, should take place as soon as possible in the settlement date (core principle 4);

IV – the delivery of the traded security and the corresponding payment should be mutually dependent (DVP);

V – the Clearinghouses and clearing and settlement providers should, at a minimum, be capable of ensuring, in case of a participants’ default, the timely settlement of obligations equivalent to the largest net debt position, not considering the issuer risk (core principle 5);

VI – the Clearinghouses and clearing and settlement providers’ operational infrastructure should have the adequate level of safety and reliability, including the contingency and recovery plans able to ensure the processing within the settlement cycle (core principle 7);

VII – the means and procedures for the settlement of obligations should satisfy the needs of users and be economically efficient (core principle 8);

VIII – the access criteria should be publicly disclosed, clear and objective, permitting broad participation. Restrictions related mainly to risk mitigation are allowed (core principle 9); and

IX – the Clearinghouses and clearing and settlement providers’ organizational and administrative structure should be effective and transparent in order to allow the evaluation of the management and contemplate the interests of stakeholders (core principle 10).

Circular 3.057 of Brazilian Central Bank from 2001 complements the regulatory structure establishing guidelines for the Clearinghouses’ rules and procedures that should be submitted for the approval of the BCB. This circular essentially replicates the principles of Rule 2882, incorporating a greater level of detail.

Clearinghouse Rules and Procedures

The Clearinghouse rules and operational procedures detail the risk management mechanisms adopted and the safeguards composed by individual collateralizations and/or mutualized settlement funds (core principle 2).

A.2 CPSS-IOSCO – SSS (2001) – Recommendation 2

Confirmation of trades between direct market participants should occur as soon as possible after trade execution, but no later than trade date (T+0). Where confirmation of trades by indirect market participants (such as institutional investors) is required, it should occur as soon as possible after trade execution, preferably on T+0, but no later than T+1.

The trades settled by BM&FBOVESPA’s Clearinghouses are captured from the trading systems auto- matically, not only on T+0 as recommended, but in real-time, assuring a high degree of STP. The trades

76 Integration Opportunities and Challenges accepted by the Clearinghouses already have a status of compared, confirmed/affirmed and matched and are locked-in, that is, with every necessary information for settlement. Once trades are captured no information will be modified by any of the counterparties; there will only be enriching of information regarding the allocation of trades to the final beneficial owners and their custodians.

A.3 CPSS-IOSCO – SSS (2001) – Recommendation. 7

Central Securities Depositories (CSP) should eliminate principal risk by linking securities transfers to funds transfers in a way that achieves delivery versus payment. BM&FBOVESPA´s Clearinghouses for equities and government bonds have adopted the strictest principles of simultaneous, irrevocable and final DVP. The operational infrastructure in place allows the elimination of principal risk and the achievement of true DVP. This infrastructure is comprised of the following elements: a) For the receipt of securities, the Clearinghouses maintain securities transitory accounts within the respective CSDs (BM&FBOVESPA for equities and corporate bonds and SELIC (the Brazilian Cen- tral Bank CSD) for government bonds. b) For the receipt and transfer of funds from and to settlement banks: all Clearinghouses have a Central Bank money settlement account at the Brazilian Central Bank and direct access to the Central Bank large value transfer system (STR). All transfers of funds in STR, once confirmed by the Central Bank, are final and irrevocable.

According to a predefined schedule, known as “settlement windows”, BM&BOVESPA´s Clearinghous- es receive (i) securities in the securities transitory accounts; and (ii) funds in the Central Bank settlement account from the net debtors in cash. Once this transfers are confirmed, Clearinghouses instruct the simultaneous delivery of securities to the creditors in securities against the payment of funds to the net creditors in cash.

Payment obligations arising from the settlement of derivatives transactions are also made through the Central Bank settlement account.

In the case of the Foreign Exchange Clearinghouse BM&FBOVESPA coordinates the payment-versus- payment process by the transfer of Fed Funds through settlement banks in New York and BRL in a settlement account within the Brazilian Central Bank.

A.4 G-30 (1989) – Recommendation. 6

Payments associated with securities transactions should be made in same-day funds.

Within BM&FBOVESPA’s Clearinghouses, all payments related to the settlement of securities transactions are carried out in Central Bank money to and from the Clearinghouses’ settlement accounts at the Central Bank on real time basis.

A.5 G-30 (2003) – Recommendation. 11

Ensure final, simultaneous transfer and availability of assets.

As explained previously, BM&FBOVESPA’s Clearinghouses employ true DVP standards for the settlement of transactions. No securities are delivered without the corresponding payment, and no payment

77 BM&FBOVESPA’s Post-Trade Infrastructure takes place without the corresponding delivery of securities. Every payment is made simultaneously to the delivery in a final and irrevocable basis.

A.6 CPSS-IOSCO – CCP (2004) – Recommendation. 9

A CCP (Central Counterparty) should employ money settlement arrangements that eliminate or strictly limits its settlement bank risks, that is, its credit and liquidity risks from the use of banks to effect money settlements with its participants. Funds transfers to a CCP (Central Counterparty) should be final when affected.

The account structure maintained by the Clearinghouses within the Brazilian Central Bank and the direct access to the large Value Transfer System (STR) are the fundamental elements ensuring the elimination of credit and liquidity risks in money settlements between the BM&FBOVESPA Clearing- houses and their participants.

All funds transfers within the STR environment are final and irrevocable when effected, as are the funds transferred to and from the BM&FBOVESPA Clearinghouses. All payment instructions sent to the Central Bank through the STR are executed by the Central Bank only if the submitter has a sufficient reserve account balance. Once completed, the movements are confirmed both to the sender and the receiver. Securities and cash are available immediately upon completion of DVP for re-use.

A.7 CPSS-IOSCO – CCP (2004) – Recommendation. 2

A CCP (Central Counterparty) should require participants to have sufficient financial resources and robust operational capacity to meet obligations arising from participation in the CCP (Central Counterparty). A CCP should have procedures in place to monitor that the participation requirements are met on an ongoing basis. A CCP’s participation requirements should be objective, publicly disclosed, and permit fair and open access.

BM&FBOVESPA has established objective participation criteria, which are publicly disclosed. In relation to the clearing members, BM&FBOVESPA’s capital requirements vary according to:

(i) The participant’s category – e.g. If they settle only proprietary and clients’ transactions or if they settle for third parties; (ii) The type of service rendered – e.g. non-guaranteed gross settlement or net guaranteed settlement; and (iii) The type of financial institution – banking vs. non-banking.

BM&FBOVESPA’s access conditions define the participation criteria and the requirements for each type of participant.

The Operational Rules, in turn, determine the ongoing requirements for participants and also establish the monitoring procedures and process for their periodic revision. Compliance with these rules is assessed on a monthly basis by BM&FBOVESPA.

78 Integration Opportunities and Challenges

A.8 CPSS-IOSCO – CCP (2004) – Recommendation. 3

A CCP (Central Counterparty) should measure its credit exposures to its participants at least once a day. Through margin requirements, other risk control mechanisms or a combination of both, a CCP Central( Counterparty) should limit its exposures to potential losses from defaults by its participants in normal market conditions so that the operations of a CCP (Central Counterparty) would not be disrupted and non- defaulting participants would not be exposed to losses that they cannot anticipate or control.

A.9 CPSS-IOSCO – CCP (2004) – Recommendation. 4

If a CCP (Central Counterparty) relies on margin requirements to limit its credit exposures to participants, those requirements should be sufficient to cover potential exposures in normal market conditions. The models and parameters used in setting margin requirements should be risk-based and reviewed regularly.

All BM&FBOVESPA Clearinghouses have well-established risk management systems that measure their credit exposure to their participants. The risk assessment cycle depends upon the Clearinghouses’ collateralization model and market dynamics, but can be divided essentially into three groups, namely;

Assessment Frequency Clearinghouse Market

Government Bonds All

Foreign Exchange All Real-Time/Pre-Margin Cash and Derivatives Settlement; Equities and Equities Derivatives Securities Lending

Derivatives OTC Derivatives

Near-Time Derivatives Listed Derivatives

Equities and Equities Derivatives Derivatives Open Positions Daily

In the Equity, Equity Derivatives and Corporate Bonds Clearinghouse, the risk management system calculates the individual risk that each clearing member represents to the system, considering every transactions under the clearing member’s responsibility that are not yet settled. The risk for each clearing member is calculated using a 95% level of confidence considering 252 different historical scenarios. For open positions in the derivatives and securities lending markets, the risk is calculated at the level of the beneficial owner using the derivatives risk management system. In this case, BM&FBOVESPA employs a set of stress scenarios. In addition, each clearing member’s contribution to the settlement fund is determined by the individual member’s residual risk given a set of historical stress scenarios and a 99% level of confidence.

In the Derivatives Clearinghouse, the risk associated with open positions is similarly calculated at the level of the beneficial owner using a proprietary system based upon a risk factor stress-testing framework. The risk associated with each derivative portfolio is defined as the most adverse possible financial result given the set of stress scenarios related to the underlying risk factors of the derivatives contracts. The system is also structured in components that are specific to the various classes of instruments, in order that risks of a similar nature can be offset.

79 BM&FBOVESPA’s Post-Trade Infrastructure

The Government Bonds and Foreign Exchange Clearinghouses also use proprietary systems based upon a risk factor stress-testing framework. Even though the systems used are very similar to the one used by the Derivatives Clearinghouse, specific market characteristics are taken into account in each risk management system.

A.10 CPSS-IOSCO – CCP (2004) – Recommendation. 5

A CCP (Central Counterparty) should maintain sufficient financial resources to withstand, at a minimum, a default by the participant to which it has the largest exposure in extreme but plausible market conditions.

For each of the Clearinghouses, with the exception of Foreign Exchange, BM&FBOVESPA maintains collateral levels sufficient to cover the obligations of the two largest participants with supporting liquidity facilities that can be used to ensure the completion of settlement in the event of a default. This approach is consistent with the Lamfalussy-Plus standards,3 where a Clearinghouse should, at minimum, have sufficient resources to withstand a default by the participants to which the CCP has the two largest exposures in extreme but plausible conditions. In the Foreign Exchange Clearinghouse, participants are not permitted to have net debt balances in excess of the Clearinghouse’s maximum liquidity line in USD. As a result, the Clearinghouse ensures, each day, the continuance of the settlement process even in case of default of the largest debit position in accordance with Lamfalussy standards.

A.11 CPSS-IOSCO – CCP (2004) – Recommendation. 6

A CCP’s (Central Counterparties) default procedures should be clearly stated, and they should ensure that the CCP can take timely action to contain losses and liquidity pressures and to continue meeting its obligations. Key aspects of the default procedures should be publicly available.

The BM&FBOVESPA Clearinghouses make full disclosure of the default procedures in their rules and operational procedures, in compliance with regulatory requirements.

There are two key aspects of the default procedures related to ensuring the Clearinghouses’ capacity to continue to meet their obligations:

Central CounterpartyCredit Exposure Management

In case of a clearing member default, the Clearinghouses will execute the collateral posted by the participant in order to provide continuity to the settlement process. In cases where there is a settlement fund, the defaulter’s collateral will be executed next and the survivors’ collateral subsequently, should it be required.

BM&FBOVESPA has the ability, in the event of a default, to utilize collateral deposited by clearing member and the securities involved in the day’s settlement.

3 Lamfalussy Standards, defined by BIS on Report of the Committee on Interbank Netting Schemes of the central banks of the Group of Ten countries (Lamfalussy Report) in 1990 as: “Multilateral netting systems should, at minimum, be capable of ensuring the timely completion of daily settlements in the events of an inability to settle by the participant with largest single net-debit position.” Lamfalussy Plus Standard, specifies that : “a netting system must be able to withstand the failure of the two largest net debtors to the system”

80 Integration Opportunities and Challenges

Liquidity Management

Each of the Clearinghouses maintains credit lines with a pool of banks that are able to extend immediate liquidity.

In the case of the Foreign Exchange Clearinghouse credit lines are maintained in both BRL and USD. It is worth to mention the liquidity lines are divided into two categories: (i) uncollateralized (credit facilities) and, (ii) collateralized (BRL, USD, government bonds and equities).

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