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ASSET SERVICING: Operational dilemmas

Buenos AiresArgentina illustrated just how risky things can get for asset servicers after custody bank Citi was dragged into a political and legal row. Nik Pratt considers whether Brazil and Uruguay might pose similar risks.

In September 2014, Funds Global – Latin America reported on the diminishing opportunities for distressed debt investors in Latin America following Argentina’s refusal to pay a small number of US hedge funds, led by NML Capital, that are holding out for full repayment of their government bonds. 

These so-called holdouts, which had purchased the distressed bonds after the last Argentinian default in 2001, were supported by the finding of US district judge Thomas Griesa, who awarded the funds full payment of their bonds and barred Argentina from restructuring their repayments until it settled with these select group of creditors. Argentina has refused to recognise this ruling.

A victim of this standoff has been the asset servicing industry. Citbank’s Argentina subsidiary, which acts as the custodian for some of the Argentine bonds, has been left in the crossfire – prohibited by Judge Griesa from making any payments to bondholders and threatened with the revoking of its banking licence by Argentina’s authorities if it abided by the US court’s ruling. 

Things came to a head in March 2015 when Citi attempted to reach a compromise with NML and the other creditors that would allow it to process two more coupon payments on Argentine debt while it extracted itself from Argentina’s securities market, a deal that was approved by the US courts. 

Instead, though, Citi found itself suspended from the capital markets, had its Argentine chief executive stripped of his authority, and its offices raided by Central Bank representatives. Argentina’s economy minister Axel Kiciloff accused Citi of “signing a deal with the devil… with the vulture funds to abandon Argentina”. 

The local securities depositary, Caja de Valores, has now taken over the processing of payments to Argentine bondholders and Citi has closed its Argentinian subsidiary, a decision the bank says was not taken lightly. It refers to its Argentine business as a “major international branch with thousands of employees and banking operations” – however, it was forced to withdraw from the custody business in Argentina because of the threat of “severe potential sanctions”. 

Presidential elections are due to take place in October and the elected government will be expected to try to negotiate an end to the standoff, which has effectively blocked Argentina from raising new funds from the international capital markets or from making any payments on existing obligations beyond its borders. 

While defaults are nothing new in Argentina – it has defaulted on its external debt seven times in its history and four times since 1982 – the situation with Citi and the holdout funds has highlighted the political risk that exists in the emerging markets of Latin America, especially for international service providers and investors. The question is whether these risks are confined to Argentina or can be found in neighbouring markets.

Whereas the economic woes of Argentina and the resulting political fallout have been serious for international asset servicers, the opposite appears to be the case in Brazil, where poor economic conditions have dampened the domestic investment market and led more investors to seek opportunities overseas.

Brazil is the largest and most liquid investment market in Latin America and consequently has the most active asset servicing market, with a combination of local and global custodians all vying for business. Incumbent global custodians such as Citi, Deutsche Bank and HSBC have been joined in more recent years by the likes of JP Morgan and BNP Paribas Securities Services (BNPP SS) looking to bolster their Brazilian offerings. 

In 2011, JP Morgan took its Brazilian sub-custody mandates back in-house and launched a direct custody service some 18 months later. And in February 2015, BNPP SS underlined its ambitions for the region with the hiring of Andrea Cattaneo as head of Brazil. 

The main catalyst for this activity has been a growth in appetite for overseas investment. International asset servicers are hoping that an offering that combines local and global custody will appeal to Brazilian investors. As Cattaneo stated on his appointment: “The need to diversify investment to boost returns means Brazilian investors are reaching out to global markets, which are eager to connect with them. This is the moment for us to bring our global reach and local expertise to bear and help connect Brazilian investors to markets worldwide.”

The Brazilian investment market has traditionally had a heavy domestic bias. In 2013, less than $3 billion of the $1 trillion mutual funds market was invested overseas. Despite a 2010 change in law that allowed for offshore investing, there appeared to be little appetite among Brazilian investors for offshore fund vehicles. This is changing, though. 

The drop in the Selic, the Brazilian benchmark interest rate, from 12.5% in mid-2011 to an all-time low of 7.25% in March 2013 (rates have since gone up again), coupled with the devaluation of the real led Brazilian pension fund managers to start looking overseas for higher yields. These conditions were also expected to persuade Brazilian asset managers to consider launching offshore fund vehicles for the first time. 

And changes announced by Brazil’s securities regulator in December 2014 will raise the limits on overseas investment. Under the rules, Brazilian retail funds will be allowed to allocate 20% of assets overseas while funds for clients with more than 1 million reals ($370 million) will be able to allocate 40% to foreign holdings. 

“There is a big need for diversification now that the Brazilian market has grown and is more open,” said Ana Novaes, director of the regulator, upon announcing the rule change. “If the country wants to be an important global player, it has to not only receive foreign investments but also to let its citizens invest abroad.”

This is not to say that Brazil is wholly without any political risk. President Dilma Rousseff was recently re-elected on a slender majority in what political risk research firm Eurasia Group describes as “a highly polarised political environment”. 

In its Top Risks 2015 report, Eurasia has grouped Brazil under “weak incumbents”, a category for emerging markets where the reduced incumbent support has produced risk-averse governments with weak mandates to tackle economic reforms or respond to external shocks. Furthermore, Brazil is still hampered by a reputation for poor governance and corruption. It stands 69th in Transparency International’s Corruption Perception index. 

However, the expectation is that a newly formed cabinet led by a new finance minister will introduce a series of credible economic reforms that will see off any danger of further sovereign downgrades and prevent any crises like the one seen in Argentina, while also hopefully setting a foundation for Brazil’s investment industry to capitalise on the more positive long-term economic outlook for Brazil, given that it is forecast to have the fifth-largest population in the world by 2025 – a demographic that will boost national savings and grow the mutual funds market both within and beyond Brazilian borders. 

The amounts involved in the Argentina/NLM case are a drop in the ocean compared to the size of Argentina’s domestic market. The political ramifications, however, far outweigh the money concerned and, given that there is a presidential election due in October, we will have to wait until then to see if the current standoff can be resolved, says Keith Mahon, managing director of Apex Fund Services Uruguay. 

“Most people expect there to be a change in government, but slogans saying ‘This government will not pay the vultures’ are still a feature,” he adds.

Will Uruguay, known as the Switzerland of South America for its banking secrecy and low risk of sovereign default, be one of the biggest beneficiaries from any uncertainty in Argentina that arises for international investors? There will be no significant change, says Mahon. “Whatever money has moved here from Argentina has been here since
the 1990s.”

Uruguay’s economics, including a cash real estate market, contrast with those of Argentina, which has currency controls and an overtly political banking system. Consequently, a lot of the money that has come into the country from Argentinian or Brazilian investors was looking for stability and low complexity, says Mahon.

The country is politically stable with a moderately left-wing party in power that wants to grow internationally, especially in servicing industries, from call centres to IT to financial services, and it has set up a number of free-trade zones where firms such as Apex can operate internationally as long as they employ locally. 

Apex set up its Uruguay office in 2012. Its strategy is to engage with asset managers and high-net-worth investors in Latin America and local broker dealers with asset management arms that want to set up offshore vehicles to invest internationally, says Mahon. 

 “There is a misguided mistrust of the offshore market among many investors in the region. They were ripped off in the past when these funds were not regulated, but people are becoming more aware of the safety of Cayman funds and Irish or Luxembourg Ucits funds.”

Despite having emerging market opportunities to rival Asia, and despite a vast improvement in political stability, the case of Citi in Argentina, though perhaps extreme, shows there are still significant political risks associated with Latin America investment that run beyond the front office and right into operations departments.

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