Brazil: The Brazilian Structured Operations Certificate (COE)

On September 5, 2013, the Brazilian Monetary Council (Conselho Monetário Nacional – CMN) approved CMN Resolution No. 4,623 (CMN Res. 4,623/2013), which regulates the conditions for the issuance of Structured Operations Certificates (Certificados de Operações Estruturadas – COEs), created by Law No. 12,249, of June 11, 2010.

The COE is similar to the structured note as adopted in the international market, which is a hybrid security that includes several financial products, typically a stock or bond plus a derivative, and allows to offer different investments to the client who seeks a mix between fixed income and variable income within a single instrument.

I. General Features and Authorized Issuers

Pursuant to CMN Res. 4,623/2013, the COE is a certificate issued against an initial investment, representative of a single and indivisible set of rights and obligations, with profitability structure that has characteristics of derivative financial instruments. This initial investment should be significantly superior to most likely results of the certificate at the time of its issue, according to and in the form of the criteria established by the Central Bank of Brazil (Banco Central do Brasil – Bacen).

Only multiple banks, commercial banks, investment banks and savings banks are authorized to issue COEs. These institutions must indicate a Director responsible for issuing, distribution or negotiation trading of the COE. For purposes of this responsibility, the appointed Director may play other roles in the institution, except those relating to third-party resources administration and risk management, which will have to be completely segregated.

II. Registration

This certificate must be issued exclusively in book-entry form, through the registration in a registry and financial settlement of assets system authorized by Bacen or CVM (the "Authorized System")1. This registration must allow the calculation and parameterization of the income structure and flow of payments of the COE, containing at least the following information: (i) the name in Portuguese Certificado de Operações Estruturadas; (ii) the name of the issuer (i.e. the financial institution issuing the certificate); (iii) the name of the holder; (iv) the order number and the place and date of issuance; (v) the par value; (vi) the initial date of its remuneration; (vii) the maturity dates; (viii) the date for early settlement or the conditions for its occurrence, if applicable; (ix) the underlying assets used as benchmarks; (x) the conditions for its remuneration; (xi) the rights and obligations of the holder and the issuer which can influence the conditions of remuneration must be specified; (xii) the conditions of the periodic payment of the income, if any; (xiii) the COE mode, including the portion of the protected par value; (xiv) the prediction of physical delivery of the underlying asset, if applicable; (xv) the registration code in the Authorized System; and (xvi) the conditions for repurchase or redemption before the agreed maturity.

The transfer of ownership of the COE is effective through the Authorized System, which shall keep record of the historical sequence of the negotiations, including the identification of the holders of the certificate.

The issuing institution must report monthly to the Authorized System´s administrator the following values with reference to the last business day of the previous month: (i) the marked market value of the certificate; and (ii) the certificate values resulting from the sensitivity analysis performed as per the methodology to be released by Bacen. The Authorized System`s administrator must keep record of the historical sequence of all the information provided.

III. Underlying Assets

Regarding the underlying assets, the COE can be referenced in price indices, bond indexes, securities indexes, interest rates, exchange rates, securities and other underlying assets. For this purpose, at least the following criteria shall be observed: (a) price indices, bond indexes, securities indexes, interest rates and exchange rates used as benchmarks must be regularly calculated series and subject to public disclosure; and (b) securities and other underlying assets used as benchmarks must present quotations regularly disclosed by stock exchanges, commodities and futures exchanges, organized over-the-counter (OTC) markets or by managing entities of clearing, settlement and registry of assets system authorized by Bacen or CVM2. It is possible to use underlying assets calculated by using a methodology that combines the benchmarks referred to in items (a) and (b), provided that it is consistent and verifiable, but the use of this methodology is of exclusive responsibility of the issuing institution. The values and quotations of the underlying assets must be independent of the parameters relating to specific operations carried out by the issuing institution.

The COE can be referenced in underlying assets disclosed or traded abroad, with due observance of the same requirements for assets in Brazil, including regarding exchanges and OTC markets, which must be regulated by the competent foreign authorities.

The issuance of COE referenced in credit operations, credit instruments, and securitization and derivatives instruments of credit is expressly prohibited. This prohibition shall not apply to the following assets, provided they are object of public offering and negotiated actively and frequently: (i) debentures; (ii) private debt securities issued in the international market; and (iii) domestic or international public debt securities issued by the Brazilian Treasure (Tesouro Nacional).

IV. Modes of COE

There are two modes of COE, classified according to their profitability structure: (i) protected par-valued investment (investimento com valor nominal protegido) - investment whose total value of minimum payments due to the investor is equal to or greater than the initial investment; or (ii) investment with par value at risk (investimento com valor nominal em risco) - investment whose total value of minimum payments due to the investor is equal to or greater than a previously defined portion of the initial investment. In both cases, the par value of the certificate in the issued date must be equal to the initial investment.

The public distribution of the COE will be permitted under the terms of specific regulation to be enacted in due course.

V. Responsibilities and Controls

The issuing institution and the institutions that participate in the process of distribution, placement or negotiation of the COE (accredited entities) must implement policies and procedures to ensure the adequacy of the certificates to the investor profile, observing the needs, interests and goals of the investors. These policies and procedures must be based on consistent and verifiable criteria.

The policies shall consider at least the following: (i) the mode, level of risk and complexity of the COE; (ii) the amount to be invested; (iii) the assets and liabilities and financial situation of the investor; (iv) the investor experience and his/her ability to understand the risks of the investment; (v) declared preferences of the investor regarding assumption of risk; and (vi) the procedures used in the negotiation of the COE.

The accredited entities must ensure that the information concerning the COE are provided by means of documents made available to the investors, which must written in a clear, objective and appropriate language according to their nature and complexity, in order to allow comprehensive understanding on the conditions of operation, payment flows and incurred risks of the investment. This information shall make it clear that the receipt of payments is subject to the credit risk of the issuer of the certificate.

The issuing institutions must ensure that their operational controls and risk management processes are appropriate to the complexity and the volume of certificates in circulation. The operational controls must at least comply with the following requirements: (i) allow for the calculation of the marked market value of the certificates individually on daily bases; (ii) be based on clearly defined criteria and procedures and documented; (iii) allow the continuous control of verification of the operational limits established by the institution; (iv) ensure consistency of the information contained in the record of the Authorized System; and (v) contain systematic prevention controls against operational failures and issuances that are incompatible with market prices.

The risk management processes shall at least: (i) observe proper decomposition of exhibitions of certificates in risk factors of market and credit risk, if any; (ii) consider exposures arising from non-linearity and asymmetries generated by the profitability of the certificate; (iii) assess liquidity risk exposure arising from the issuance of the licenses; (iv) measure exposures and risks both in an integrated manner, involving all exposures, as by product, by risk factor and other dimensions considered relevant; and (v) provide for the completion of stress tests, as indicated below.

The risks of stress must be carried out with sufficient frequency and breadth to assess at least: (a) the effect of concentrations in risk factors, counterparties or segments; (b) the breakdown of correlations and other assumptions of risk measurement models; (c) the effect of non-linearity and asymmetries; and (d) the effect of adverse scenarios on the liquidity conditions.

All the activities described above must be linked to the risk management structure of the institution, and the unit responsible for these activities must be segregated from those that conduct the issuance, distribution or negotiation of the COE.

VI. Authorized Transactions

The issuing institutions can purchase at any time certificates of its own issue through exchanges or organized OTC markets to be held in Treasury and for subsequent sale in the amount of up to 40% of the balance of the issued COE. Certificates acquired from third parties by institutions of the same economic conglomerate of the issuer should be considered in the calculation of this limit of 40%.

The financial institutions are prohibited from issuing derivatives financial instruments with the same features of the COE, except as expressly permitted under CMN Res. 4,263/2013.

VII. Other Obligations

The Authorized System´s administrator shall maintain available to Bacen and CVM database containing information about the records held in the form of CMN Res. 4,263/2013 for a minimum term of ten years counted from the maturity date of the COE, without prejudice to the supply of any specific information requested by Bacen and CVM.

The information, documentation and methodology relating to operations carried out in accordance with CMN Res. 4,263/2013 must also remain at the disposal of Bacen for the same period of time, i.e. a minimum term of ten years counted from the maturity date of the COE.

CMN Res. 4,263/2013 will come into force 120 days after the date of its publication in the Official Gazette of the Union (Diário Oficial da União – DOU), which occurred on September 6, 2013.

The derivative financial instruments with features of COE not yet redeemed, contracted as from September 6, 2013, shall be registered by the issuing institutions until 30 days after the date of the entry into force of CMN Res. 4,263/2013.

Within their respective spheres of competence, Bacen and CVM are authorized to establish criteria and adopt additional measures necessary for the implementation of the provisions of CMN Res. 4,263/2013.

VIII. Final Considerations

According to Bacen, the COE is an instrument of raising funds for banks because the issuing institution receives money from the investors and makes applications that will result in a return over a given period of time. It is important to note that the investor who acquires a COE runs the risk of the issuing institution.

The creation of the COE is inserted in a context of maturity and sophistication of the Brazilian capital market. Endowed with great versatility, this certificate creates the possibility of financial institutions and investors to access a much larger variety of investments in the search for appropriate strategies to their business profile and enables the diversification of its business strategies.

The regulation of the COE through CMN Res. 4,263/2013 aims to discipline certain operations already existing in the Brazilian market that combine characteristics of investment with profitability typical of derivative financial instruments, traded in a dispersed form through derivative contracts, and it contributes to greater transparency of these operations, favoring also the monitoring and supervision procedures.

CMN Res. 4,263/2013 also presents a series of provisions designed to ensure the adequacy of the product to its target audience and the broad understanding on the part of the investors, as well as minimum requirements additional to the operational controls and risk management processes of the issuing institutions.

At least for now, this is not a product to the general public and businesses should focus on bilateral operations involving banks and institutional clients such as pension funds, for example.

Although the entry into force of CMN Res. 4,263/2013 is scheduled for January 2014, from now on any structured operation is subject to the new rules.


1 At the moment, the only entities authorized by Bacen and CVM are CETIP OTC Clearing House (CETIP S.A. - Balcão Organizado de Ativos e Derivativos - CETIP), which is the leading clearing house and central securities depository and derivatives registrar for operations carried out in the over-the-counter (OTC) market and the Derivatives Clearing House (Câmara de Derivativos) of the Brazilian Securities, Commodities and Futures Exchange (BM&FBOVESPA S.A. – Bolsa de Valores, Mercadorias e Futuros - BM&FBovespa).

2 Please refer to footnote 1 above.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Walter Stuber
Adriana Maria Gödel Stuber
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