Latin America’s MILA: Solving Settlement Quagmire

Mercado Integrado Latinoamericano, or MILA, sounded like a great idea.

Announced in September 2009 and launched in May 2011, the initiative was supposed to bolster trading volumes in three stock markets, which historically languished in the shadows of Brazil and Mexico. The exchanges of Colombia, Chile and Peru would become the new Euronext. Or so they hoped.

Fast forward, and MILA is still in operation, but with less lustre than envisioned. The talk has now turned to just how to plug the risky holes in the back-office settlement plumbing, which could attract more trading volume going into the pipes. The three exchanges and their respective depositories have finally created a committee to discuss post-trade settlement issues and none too soon.

“We were eager to launch MILA as quickly as possible, but realized that we would eventually have to tackle settlement issues,” says Fernando Yanez, general manager of Chile’s Deposito Central de Valores. “They were always on the agenda.”

The depositories and exchanges aren’t the only ones eager for progress: the higher the trading volumes, the more custodian banks will financially benefit from settlement and other fees.

“For now it has been an entirely trading-driven initiative and settlement procedures took a back-burner,” explains Claudia Calderon, head of sales and relationship management for Northern Latin America at BNP Paribas Securities Services, which offers local custody in Colombia. “We are encouraged that settlement is now being addressed.”

The current cumbersome and risky settlement procedure is just one of three shortcomings stifling trading volumes on MILA. Two others: differences in how investors are treated when it comes to capital gains taxes and restrictions on how currency conversions are to be conducted, according to Alejandro Berney, director of securities and fund services for Citi in Latin America. The custody giant could benefit the most from MILA correcting settlement deficiencies, because it has a presence in all three markets.

Foreign investors aren’t particularly interested in participating in the MILA initiative as they can still rely on the status quo. They can access each market through local custodians and local broker-dealers who will settle their trades on a delivery versus payment basis. Such a scenario allows for far tighter foreign exchange spreads when currency must be converted, explains Berney.

It is the local institutional investment community that MILA really hopes to win over. With investment restrictions loosening, the three exchanges want their shares to appear as a more attractive alternative to depository receipts and exchange-traded funds. So far, that’s what most local pension plans wanting to invest in neighboring countries have favored.

Liability on Broker-Dealers

Although details of just how cross-border settlement procedures will work are still at a high level, the primary goal of the depositories and exchanges appears to be how to reduce the counterparty risk now carried by broker-dealers when settling cross-border trades. Of the three markets, only Chile has a central clearinghouse. Colombia and Peru don’t. Just who will assume counterparty risk is a tall task to solve because of the multiple parties which are party to the decision — broker-dealers, custodians, exchanges, and their depositories alike.

Here is how MILA currently works: Brokers in each of the markets have access to all of the three equity markets through local brokers in the other markets. The trading and post-trade procedures are conducted according to the rules of the exchange and market that lists the instrument in question. Of the five hundred fifty equity issuers affected, about 282 are from Peru, 227 from Chile and 81 from Colombia.

From a trading perspective, it sounds like an ideal scenario for local investors. They don’t need to track down a broker in a neighboring country to do the trade. They can just rely on the broker in their home market to send an order to a broker in the neighboring country and ¡hey presto! the trade is executed. And that’s just what the exchanges wanted to do to shore up trading volumes and compete with the likes of the far larger markets of Brazil and Mexico. Power in numbers is their motto.

But that’s where the simplicity begins and ends. The post-trade settlement of the cross-border trades — those between investors in one country buying securities listed in another — relies on the local broker and the local custodian of the investor and the broker in the neighboring country and its custodian bank to complete. The trade is settled only on the books of the depository in the market in which the issuer is listed, not in the country in which the investor is located.

Now for the clincher: the settlement process is conducted on a free of payment basis; the cash and securities do not simultaneously move on settlement date — typically three days after the trade is executed. Rather, cash moves ahead of securities and, although no one would disclose just what the timing difference is, one thing is certain. The investor could lose out big time if a broker-dealer in another country goes bust. That is unless its own broker-dealer bails it out which is exactly what would happen today. Say a Colombian broker buys a Peruvian equity for its Colombian investor through a Peruvian broker and the Peruvian broker goes broke and doesn’t deliver the securities. The Colombian broker will end up on the hook to make its investor whole.

No one is willing to estimate just how many times broker-dealers have faced that prospect or if any have been forced to make their investors whole. Broker-dealers in the three countries are relying on the sound financial status of the other to keep them safe and sound. This is small comfort to investors who prefer delivery-versus-payment settlement. 

While the exchanges in Colombia, Peru and Chile are spearheading the MILA initiative, their silence on the issue of settlement is deafening. When asked about the matter in an emailed request for comment, the Bolsa de Valores de Lima (BVL), referred the question to each of the depositories. Officials at Colombia’s depository, Deceval, were unavailable for comment, while officials at Peru’s depository, Cavali, referred all questions to the local exchange, which only briefly acknowledged any problems existed.

“The main challenges for this integrated market is to promote MILA among foreign investors, increase and consolidate its presence in Latin America, work towards an efficient and competitive infrastructure and develop a multilateral process for settling trades between brokers,” says the BVL, in a statement to FinOps on behalf of the three exchanges. The statement suggests that broker-dealers are more concerned about questions of currency conversion than the counterparty risk they bear.

Juggling the Options

But the depositories and exchanges know they need to come up with a better settlement gameplan. One option, building a single regional clearinghouse for all three markets, isn’t in the cards. Two other options are: allow broker-dealers in each market to “give up” the trades to their local custodians which would settle the trades on a delivery-versus payment basis; or have the local broker settle the trade with the depository of the security sold in the neighboring country acting as the counterparty. In the second case, settlement would still take place on a free of payment basis, but the depository would guarantee the settlement.

The first alternative under consideration implies that custodians would be on the hook for any financial losses incurred, should the local broker dealer representing the investor default on payment. It’s a scenario custodians clearly want to avoid. “There is some discussion as to whether the custodian could offload the risk to the local exchange of the security where the asset was issued,” explains Berney. “It is certainly a viable alternative.”

But depositories appear willing to take on counterparty risk so the second alternative looks more promising. “We aren’t going to build a single central clearinghouse, but in the meantime will study an alternative providing central securities depositories with a different role in the settlement process,” says Yanez. “The depository would guarantee a transaction through a local broker-dealer receiving cash before delivering the securities and vice-versa.”

Regardless of which alternative is selected, time isn’t on the side of the exchanges or depositories. With Bolsa Mexicana de Valores expected to finally join the MILA initiative, the market infrastructures in Colombia, Chile and Peru have little choice but to come up with a better settlement gameplan.

“It’s a chicken and egg scenario,” says one US fund manager on the East Coast. “If they don’t fix the settlement quagmire, the counterparty risk for brokers — and their investors — could increase if trading volumes increase. Alternatively, if improvements aren’t made they might not get the trading volume after all.”