BM&F Bovespa : BM&FBOVESPA Clearinghouse starts operating

Cícero Augusto Vieira Neto

As of today, Brazil's financial and capital market infrastructure is unparalleled worldwide in terms of risk management. The first phase of BM&FBOVESPA's clearinghouse integration project goes live today, together with its new risk management system. This change can only be compared to the implementation of the new Brazilian Payment System (SPB) in 2002, a project led by the Central Bank of Brazil that modernised and enhanced the security of the nation's market infrastructure. The new integrated system for risk calculation, known as CORE - one of the most advanced and secure in the world - enables investors to allocate capital more efficiently, with an immediate benefit on the order of R$20 billion. Unification of the clearinghouses' settlement processes guarantees greater efficiency of cash management by institutions, generating daily savings of some R$500 million. Increased process standardization and automation will cut recurring costs for the entire market. The new IT infrastructure reduces operating risks and is prepared to support volume growth for the next 20 years. The nation's markets will benefit in terms of robustness and competitiveness.

The key role of a clearinghouse is to assure correct settlement of all the transactions executed in the relevant trading environment. Substantive economic benefits are associated with the activities of clearinghouses: mitigation of systemic risk; increased liquidity and democratization of market access; facilitation of multilateral netting (in the presence of a clearinghouse, debits and credits can be settled by means of multilateral netting so that only the net debit or credit balance for each participant is transferred by the clearinghouse); and transparency.

While on one hand clearinghouses mitigate counterparty risks and generate significant benefits for the market, on the other hand they concentrate risk for the entire system, so that efficient and effective clearinghouse operation is a necessary condition for preservation of financial system stability, especially at times of crisis. For this reason, clearinghouses require well-designed, sound and constantly tested management systems, as well as appropriate regulation and supervision by regulators.

Brazil's regulatory framework and BM&FBOVESPA's clearinghouse and central securities depository (CSD) systems stand out on the international scene thanks to the adoption of the final beneficial owner model, which is the most robust in terms of risk management and fraud prevention. Despite the intermediation performed by brokerage houses, the contracts and securities traded and held by investors, as well as the collateral posted to guarantee settlement, are segregated and identified individually, i.e. by investor, in the clearinghouse and CSD systems. The existence of complete information on the ownership of securities and positions makes risk management, monitoring of leverage in the system and control of prudential limits more robust. It also facilitates the treatment of default by intermediaries, in which customers' securities, positions and collateral must be transferred to the responsibility of other institutions. Last but not least, it hugely mitigates the risk of custody fraud.

Most of the world's clearinghouse and CSD systems do not use the final beneficial owner model in use in Brazil. In such systems each intermediary has a "customer account" with the clearinghouse and CSD, pooling investors' transactions without segregation or identification of final beneficiaries. Lack of information on final beneficiaries limits the ability of clearinghouses and CSDs internationally to manage risk and prevent financial fraud, besides making it more complex to monitor risk and harder for regulators to obtain information.

When the Brazilian stock exchange (BOVESPA) and derivatives exchange (BM&F) merged in 2008, BM&FBOVESPA became responsible for managing four clearinghouses considered systemically important by the Central Bank of Brazil: (i) the clearinghouse for equities and corporate bonds (formerly CBLC); (ii) the clearinghouse for financial derivatives and commodities; (iii) the clearinghouse for the spot foreign exchange interbank market; and (iv) the clearinghouse for federal government bonds.

Shortly after the merger, the new exchange realized that its clearinghouses needed to be integrated in regulatory, operational, technological and risk management terms. It also realized that this was a major opportunity to develop the infrastructure of the nation's financial and capital markets, preserving their security and enhancing their competitiveness. It was not until 2010, when initial studies were released to specialists, that the project really began to take shape. Some 300 professionals have worked exclusively on the project for four years, with the participation of international consultants and technology companies.

One of the project's key challenges was the development of the new risk calculation system. First, the new system had to be capable of handling a long list of heterogeneous securities, contracts and collaterals: equities, ETFs, DRs, listed funds, gold, securities lending (which are centrally cleared in Brazil), financial futures, commodity futures, options on futures, over-the-counter derivatives, corporate bonds, government bonds and spot US dollar transactions, among others. Second, in order to enhance market efficiency the new system had to be sufficiently intelligent to calculate risk for an entire portfolio, rather than its parts in isolation, taking into account the effects of diversification and offsetting the different kinds of risk in each investor's portfolio. Third, the system had to be industrial scale and high performance in terms of computation, given the need to calculate quasi-real time estimates of risk for more than 50,000 investor portfolios with positions in derivatives. Above all, the new system had to be extremely reliable and secure so as to preserve the solidity of BM&FBOVESPA's clearinghouse environment.

BM&FBOVESPA's new risk calculation model, called CORE, short for Closeout Risk Evaluation, was developed by a multidisciplinary team of professionals who specialize in risk management, statistics, mathematics and computing, with the support of front-ranking international consultants. BM&FBOVESPA's risk management culture, developed during several decades of responsibility for systemically important clearinghouses in a highly volatile environment, was also fundamental to the definition of the model's key parameters.

In CORE, the manner in which a defaulting investor's positions and collateral are closed out in the market is termed the "portfolio closeout strategy". A good closeout strategy must respect two conditions. First, positions must be closed out in an orderly way to avoid exacerbating market volatility. This means the amounts of each security, contract or collateral bought and sold must be compatible with the liquidity of the respective instrument to avoid having a very strong impact on prices. Second, any hedging relationships in the portfolio must be preserved to avoid increasing its exposure to risk unnecessarily. For example, if a futures contract is used to hedge an option with the same underlying, both should be closed out simultaneously to preserve the hedge, even though futures can usually be settled more quickly than options.

CORE offers a robust solution for the calculation of portfolio closeout risk in markets in which portfolios typically hold a heterogeneous mixture of securities, contracts and collaterals. Unlike most risk models, CORE takes into account not only market risk but also liquidity risk (market depth) and cash flow risk (when flows of payables and receivables mismatch intertemporally). All these types of risk are inherent in the process of closing out a portfolio in the market. CORE uses a conditional optimization algorithm to determine the "optimal portfolio closeout strategy", which must respect the liquidity conditions prevailing in the market and preserve any hedging relationships between contracts and securities. To model the possible future price trajectories that may affect the financial result of portfolio closeout, CORE works with tens of thousands of stress scenarios based on historical simulations for a period of more than ten years, statistical simulations using the best econometric models available, and prospective stress scenarios designed to reflect the risk of material economic and political events, including the risk that the historical correlations between returns on different instruments could break down. The amount of collateral CORE requires from an investor is equal to the financial result of the process of closing out the investor's portfolio considering execution of the "optimal closeout strategy" and the occurrence of the worst possible stress scenario of all those used by the model. The financial result considers not only the "permanent loss" obtained at the end of the closeout process after all debits and credits are settled, but also the "temporary loss" equivalent to the extra funds required to cover any transient deficits during the closeout process.

From the technical standpoint, it is probable that no clearinghouse risk system in the world can be said to rival CORE. It is both highly robust and capable of calculating risk for a complete portfolio, including securities, contracts and collaterals, thereby enhancing the efficiency of capital allocation by investors. CORE's combination of robustness and enhanced capital allocation efficiency puts BM&FBOVESPA in the forefront of global risk management.