The appetite for more diverse derivative products is growing and firms are seeking to expand into different markets. Market participants across Brazil are operating under new derivative regulations impacting how portfolios of fixed income, money market, and derivative instruments are fundamentally priced and risk managed.
Recent regulatory changes in Brazil have set into motion renewed interest in Certificados de Operações Estruturadas – COEs, as a new investment for individual investors and an alternative way to raise funds for Brazilian banks. They share a striking resemblance to the structured notes popular in the U.S. and Europe, and are intended to provide the investor diversification and access to new markets.
To introduce our readers to this new product, we sat down with our Numerix Latin Markets expert Luis Gustavo to provide a primer on COEs, their use, regulation and best uses for these products.
Q:
What are COEs?
A:
COEs are very similar to structured notes in the United States and Europe. We had structured notes in Brazil before the COE, but the difference now is that they can be registered as a single trade. Before COEs you had to register all the legs of an options trade individually – everything that was part of the structured note.
Now you don’t need to register all the legs separately, you can register them all at once. And with that feature it’s much cheaper, and more efficient to execute these types of structured notes, it is easier to monitor the performance, and also there will be a single taxation.
Q:
Who regulates COEs?
A:
The National Monetary Council (CMN) of the Brazilian Central Bank (Bacen) regulates this instrument. There are two places where you can register COEs – CETIP, the Brazilian market’s largest custodian for fixed income and OTC derivatives, and BM&F BOVESPA, the Brazilian Exchange.
Q:
Can you elaborate on how COEs work?
A:
This instrument can be issued as a capital guarantee or a face value at risk. Imagine the COE has an expiration date in two years, and at the end of those two years you can have one hundred percent of your money back without any gain. And, if the stock invested in increases 70% in the two years, you’re going to receive a return on this investment.
The underlying is open too, so it can be a stock or the Dollar/Real exchange rate, a commodity, or a basket, for example. What would follow at expiration is the payoff that was defined at the beginning of the trade. You can also change the parameters, like protect 90% of the capital, return on the participation can be 100% of the underline return capped on 30%. It’s up to the bank to decide how much they’re going to offer to the customer.
Q:
What type of market participants are using COEs?
A:
I’d say 90% of the volume is coming from individual investors. It has been reported that over $3 Bn of notes have been issued, and several significant issuers have entered the market with issuance set to rapidly increase to $20 Bn in the next two years. Additionally, a secondary market for these notes is expected to be in place by 2016. Institutional investor’s volume is still low, but it has been increasing over the past 6 months. Pension Funds are also a relevant player that has not started in this market yet.
Q:
Why are they so important to individual investors?
A:
Mainly because of the capital guarantee, or the maximum value at risk. Also, because there is such a high interest rate in Brazil, it’s easy to guarantee the capital. The interest rate in Brazil is currently around 11% to 12% per year. It means you have this advantage to buy an option, or enter into any other structured trade of your liking to ensure the maximum value of the investors return.
The Brazilian interest rate differs from the rate in the United States and Europe because in the U.S., the interest rate is close to zero, making it difficult to have short term structured notes with guarantee of capital. In Brazil, it encourages the investor to believe that they’re not going to lose money.
Q:
What changed in regulation to make COEs come to the forefront?
A:
Previously COEs were not regulated, and seen as just a structured note. It was difficult to have a structured note as a personal investor, there was significant paperwork and time that needed to be invested in at the bank, and there are taxation rules to consider. Now, it’s a product that’s easy to use compared to how it was in the past.
Before the COE, only well capitalized investors were buying structured notes in high volume. Now you can have a COE for much cheaper. In the U.S. you can have a structured note for $1,000, even though it’s not quite as low in Brazil just yet, some banks offering COEs starting from $25,000.
When the regulators issued COEs, they mandated new rules that had to be followed. For example, each month a risk scenario has to be initiated with all the COEs that are issued. You have to take into consideration: increases/decreases in the basis points on fixed income, increases/decreases in equities and take foreign exchange rates into account. It’s also required to send the mark-to-market from all the COEs that they carry. The Brazilian market is incredibly regulated, and both companies, CETIP and BM&F Bovespa have a Self-Regulation department where they check all trades that are being registered.
