Regulatory challenges for more competition in Brazilian capital markets

Capital markets have been showing extreme resilience worldwide in recent times. Particularly in Brazil, where interest rates are at a record-low level, retail investors are prone to acquiring riskier products compensated by long-term strategies.

This astonishing run for Brazilian capital markets is challenged by several regulatory issues that need to be addressed. These are currently under scrutiny in a public hearing conducted by the Brazilian Securities Commission (CVM) to amend CVM Instruction No. 461 of 2007, that regulates exchanges and entities that manage over-the-counter systems (OTC), among other rules.

One of the main issues under discussion is the lack of competition between exchanges and OTC, currently concentrated in a single corporation, the B3 S.A. – Brasil, Bolsa, Balcão (B3).

Some Brazilian brokers have expressed that one possible way of fostering competition is to allow internalization, a procedure in which the broker matches the buy and sell order flows within its own off-exchange trading systems.

Internalization is currently forbidden in Brazil, and CVM has decided to maintain this prohibition. According to the minutes of the public hearing, this decision was taken mostly due to the concern that internalization might make price discovery more difficult and may result in fragmentation of the market.

An important milestone which strikes the balance between brokers’ ability to match client order flow and the price discovery procedures was the recent implementation of a new trading tool created by B3, called Retail Liquidity Provider (RLP).

RLP allows brokers to order to the exchange a match between the aggressive orders from its customers with the proprietary account of the broker, or a wholesaler appointed by the broker. The match is made by the exchange’s system, pegged to the best bid and offer of the exchange’s books, or in a better price for the benefit of the investor.

The RLP brings significant advantages to the system. It maintains the price discovery structure of the exchange but improves the dynamic revenue model for brokers, potentially reducing costs for investors. It also avoids trading ahead of the broker’s own clients with pending orders, unless the client expressly agrees with deprecation.

In connection with the worldwide debate about pros and cons of market fragmentation, the regulatory challenge is to balance more competition with other relevant attributes, such as transparency, liquidity, market integrity and best execution for investors. Successful international experience might be a good reference in this context.

In the European Union, under the volume cap mechanism prescribed by the Markets in Financial Instruments Directive (MiFID), the volume of off-exchange trading in one single financial instrument is limited across the Union. This is a fragmentation policy as opposed to the system adopted in the United States where internalization is thought to account for almost 100% of all retail marketable order flow, and exchanges and regulators indicate growing concerns about price discovery.

In the United States, regulation prescribes transparency for Alternative Trading Systems (Regulation ATS) such as order displays and execution access. Financial Industry Regulatory Authority (FINRA) has made available for investors data regarding alternative trading systems’ activity, including the so-called dark pools, or off-exchange environments of large-scale trading for institutional investors.

Despite its many benefits, there is a limit to how much fragmentation can improve market quality. The International Organization of Securities Commission (IOSCO) has recently released a report appointing main concerns over market fragmentation worldwide and what regulators should consider in order to minimize potential adverse effects. One of the main concerns appointed in the report relates to fragmentation’s potential for hindring effective market oversight.

Whilst imported solutions are not necessarily adequate to solve local problems, these discussions may be a useful source of inspiration for local regulation.

In that sense, CVM’s proposal establishes a single self-regulatory entity to enforce the rules and supervise operations and market participants in a scenario of competition between exchanges and OTC, and a single investor protection fund.

Currently this role is played by BSM Market Supervision, an entity belonging to the B3 group. However, nothing prevents similar entities being formed in the future by competitors of B3. CVM’s proposal aims to avoid both a self-regulation overlap as well as a race to the bottom that could result in a scenario where each competiting entity developed its own self-regulation structure.

Since it is still uncertain how competition will play out, governance of the self-regulatory entities and of investor protection fund should be defined by market players and be subject to CVM approval and oversight only rather than be predefined in regulation.

In a nutshell, maximizing the advantages of competition in capital markets depends on transparency measures in price discovery, a single self-regulation structure and reasonable limits for off-exchange trading (if allowed by CVM).

Another important matter under scrutiny in the public hearing is the “best execution” concept, currently regulated by CVM Instruction No. 505 of 2011.

Even though traders can be counterparties to their clients or sell their orders to wholesalers for a fee, they must provide the best possible execution for client orders. In this scenario, conflicts of interest need to be carefully watched and adressed.

While the European standard of best execution is based on multiple criteria according to best execution policies agreed by brokers and investors, in the United States only favorable prices for investors shall be considered – even though investors can be awarded with “sub-penny executions”, where savings are only nominal.

The minutes presented by CVM shifts best execution regulation for retail investors from the current multiple criteria system – which consideres price, cost, speed, execution probability, volume, among other factors – towards a system where only price and cost matters, similar to the order protection rule of the United States.

Such an overturn might be a downgrade for an efficient market structure, because it rules out other relevant criteria for best execution that could be relevant for the retail investor, such as operational risks, liquidity and speed of execution.

The debate about market fragmentation in Brazil is still ongoing. Balancing reliable price discovery with more competition may result in positive outcomes, such as lowering transaction costs and enhancing quality of products and services in a fair market, thereby increasing overall investor confidence.

L&S Authors

Luiz Felipe Amaral Calabró

Luiz Felipe Amaral Calabró

Of Counsel
Rodrigo Dias

Rodrigo Dias

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