The Brazilian Electronic Landscape

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By Carlos Barros
At a time when the world is facing the prospect of severe change in its power relationships and the financial industry is under worldwide scrutiny, there are few places that inspire more confidence for long-term investments than the BRICs with Brazil probably presenting the most balanced profile of growth, democracy, economic stability and diversification. Carlos Barros of Agora CTVM explains.
After many years of doing their homework across the political and macro-economic spectrum, Brazil finally emerged from the recent turmoil as an interesting harbor for the highly demanding and sophisticated international investor, and is now set to become the access point for all Latin American markets.
Technological Evolution
The Brazilian market place is rapidly evolving and following many international best practices under a regulated environment, which definitely allows innovation but also aims to protect both the market and its participants’ integrity. Practices like ‘sponsored access’ and ‘co-location’ are already being used, while concepts like best execution is being discussed by the local regulators.
The basis of this development was created by the markets’ electronification. Bovespa, the equities market, ended its pit activities in 2005 and BM&F, the futures market, followed suit in 2009, almost a year after the two exchanges merged to form BM&FBovespa, the world’s 3rd largest exchange by market value.
To meet this challenge and be more cutting-edge, not only have the exchanges and the sell-side started to arm themselves with high-end technology, but the buy-side community is increasingly interested in high frequency algorithms, low latency EMS/OMS, Straight Through Processing (STP), risk systems, and all sorts of technology solutions that might impact their trading activity in this new environment.
Once the race started, the great majority of brokers, both local and foreign, began to look for some kind of electronic capabilities in the Brazilian market, creating an incredibly strong demand for specialized services and products within the electronic trading arena.
This trend was reinforced by the exchanges’ demutualization followed by their IPOs, which provided to brokers, who formerly owned the venues, sufficient capital to invest in infrastructure and technology, at the expense of losing the subsides that formerly kept some of them alive.
Without this steady inflow, players had to pursue other options to generate commission and their business models became increasingly linked to their choice of technology.
Their options were:

  1. Buying technology from an Independent Software Vendor (ISV), which creates dependency, but provides the assurance that the provider is fully focused on its core business;
  2. Acquiring and merging with an ISV or another broker, which might be more expensive, but provides the assurance that the firm is incorporating a proven and tested solution as well as the knowledge base;
  3. Developing the solution in-house, which might not be the quickest solution, but is definitely the option with the lowest cost prospects and highest knowledge aggregation rate.

In fact, the most appropriate model depends on a firm’s electronic business size, its technological maturity and its willingness to spend on both IT capital as well as personnel expenditure. However, it has been noticed that the most agile and sophisticated independent firms are being targeted by the bulge-bracket brokers and investment banks willing to increase their electronic operations.
The results of these unions are firms that evolve faster than independent ones, as they have more capital and more solid balance sheets. They are also faster than traditional full-service broker-dealers, since they are leaner with more specialized staff, and are focused on moving ahead of the market in identifying new trends.
As observed in more mature markets, it’s possible to foresee that with more fire power, large brokers will establish a technological barrier that will prevent mid-tier houses from effectively participating in the game, thus generating more consolidation and even the disappearance of some firms. Meanwhile, smaller and more specialized firms can focus on niche markets, thereby protecting themselves from being highly affected. 
Brokerage Model Changes
Along with the technological evolution, the brokerage model as a whole is starting to change in Brazil. While the retail client is attracted by low commissions and a wide range of services, products and a professional advisory, the institutional client is starting to assume responsibility for some of their executions, and is much more interested in state-of the-art technology, low latency infrastructure, access to algorithms, and selected liquidity.
The force driving these changes for the buy-side is the role played by automated algorithmic execution models in their strategies. Whether provided by brokers or developed in-house by the most sophisticated hedge-funds and proprietary desks, these models objectively analyze the determining factors, to slice and submit orders to the market in a fashion that no human trader can keep up with, while the execution performance is being measured in real time by sound TCA models.
As seen in the graph below, this trading style results in smaller tick sizes, forcing orders to shift from mere vanilla buy/sells to more sophisticated execution strategies, which is also changing the relationship between the buy-and sell-side.
Along with technology, this relationship is increasingly based on the broker’s ability to provide natural liquidity for higher-tier names, less information leakage and facilitation for large blocks.
In regards to the market structure, we notice that even though there are similarities, the evolution of the Brazilian marketplace is different from other countries. Let’s take for example, the U.S after the Order Handling Rule and Reg NMS, Europe after MiFID, and Asia after the adoption of best execution: all of them have seen a proliferation of ECNs, MTFs and Dark Pools. This has made the liquidity more fragmented and ‘darker’, creating a problem for price discovery and raising concerns in relation to practices that could be potentially hazardous for small or individual investors.
In contrast to other markets like US, Europe and Asia-Pac, there is not much room for market fragmentation in Brazil in the near future, given that the regulation by CVM in Brazil is more orthodox, with the exchange definitely playing a strong role in market development. In the meantime, brokers’ are motivated to in-house develop tools that will empower them to internally match natural liquidity, though they will still have to cross orders at the exchange. So, while there’s a growing interest in flow segmentation, it is probable that in Brazil, in contrast to foreign markets, brokers will develop internal tools that will help them segment, advertize and sell their liquidity by matching buyers and sellers in a scalable manner, but at least in the beginning, they need to start utilizing the established exchanges and not the private pools to cross its orders.
Due to the caliber of the infrastructure and its related gains, it is possible that in Brazil, the exchange, in conjunction with the largest brokers, will be responsible for the modernization of the market structure. But since in the U.S, new pools with segmented liquidity, are flourishing within venues that are being increasingly consolidated by the big players, it is possible that ultimately, the model adopted in Brazil will converge to the model present in other markets.