FTSE Global Markets by FTSE Global Markets

SIBOS REPORT: MOUNTING COMPLEXITY IN FINANCIAL MARKETS ISSUE 28 • SEPTEMBER 2008

Why gold has lost some lustre The new maturity of transition management The slow defrosting of Iceland's banks US steps up the pace of regulatory reform

AHLI UNITED:

SETTING A NEW

PACE OF CHANGE

ROUNDTABLE: THE FUTURE OF INVESTMENT SERVICES

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A borderless ‘domestic market for Europe’ with harmonised market practices will soon become a reality. Together with your active participation, Euroclear is on the way towards delivering a single, multimarket processing platform. A choice of services and service levels will meet your domestic and cross-border settlement needs. Take a front-row seat and enjoy the benefits.

DELIVERING A DOMESTIC MARKET FOR EUROPE

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FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

HIS IS TURNING out to be a year of substantive change in the global financial markets. The repercussions of regulation, such as Basel II are increasingly felt. The impact of EU market directives, such as the Undertakings for Collective Investment in Transferable Securities (UCITS; now on their third iteration, with a fourth pending) and the Markets in Financial Instruments Directive (MiFID) are creating storms of activity in the derivatives and securities trading markets respectively. Also, the clearing and settlement industry increasingly looks to be redefining its remit and relationships in a global context. Add it all together and the resulting Big Bang Mark II is recreating the financial universe as we now understand it. Moreover, these are but three of seeming countless regulatory business drivers, new liquid products, exchanges and markets that are emerging and criss-crossing the global markets. We make no claim to being able to predict the ultimate shape of this unfolding cosmos. All we know for sure is that it will be replete with challenges and new opportunities; all we can offer is tantalising glimpses of an exciting and profitable future, in spite of the current grind of recessionary trends haunting most (but not all) markets right now. A number of threads in this evolutionary process are brought together in this issue. At its core is a roundtable discussion on the future of investment services in the light of so much change. The image of the investor services industry is that it is led by giants. It is reassuring therefore, to hear from market specialists that the heartbeat of the business going forward is the national, rather than the international cross-border level. Smaller and medium sized funds rejoice; the giants are now looking at you! This edition is also about competition as a business enhancer. We look at this from a number of angles: Ian Williams tackles the thorny question of US regulatory reform; how much is needed and now much is not if markets are to work unimpeded at optimal levels. We also look at the impact of increasing competition in the clearing and settlement landscape, mainly in Europe, it has to be said. What’s surprising here is that the debate is no longer about a panEuropean solution (perhaps someone should tell the EU regulators about that); but the emergence of global platforms. In an changing and credit crisis riven landscape, it is inevitable that investors will fly to quality, in the search for security and returns. That has repercussions in all service areas: we highlight transition management and prime broking in this edition. Commodities took centre stage in the first half of this year, as high prices in both metals and agricultural commodities took their toll on economies, wallets and even human lives.The scramble for metals, oil and cereals looked likely to escalate beyond reason through the spring, though signs are that panic buying has all but stopped: with attendant falls in key commodity prices. That will not, in the short term, help the estimated 14m people near starvation in eastern Africa; but it will ease nerves in a global economy already straining to contain inflationary trends.Vanja Dragomanovich looks, in separate articles, at the key trends in the bellwether commodities of gold and oil. Our country coverage meanwhile is firmly rooted in emerging markets, which continue to set the pace of growth in and among the doldrums-beset developed markets. We highlight the ways in which frontier markets are gradually rebuilding after a difficult 2007. Kazakhstan and Iceland, though widely different, share many of the difficulties of being faddish markets: all the rage one year; forgotten the next. Find out how they have overcome their difficulties, beginning on page 33.

Francesca Carnevale, Editorial Director September 2008

Contents COVER STORY COVER STORY: AHLI UNITED SETS THE PACE OF CHANGE..............Page 47 Ahli United has been the quiet performer in the Gulf Cooperation Council (GCC) countries of late, racking up a stack of publishing industry awards. In a region where all that glisters is not necessarily gold, Ahli United’s considered, risk averse yet innovative approach to business development means it has become a valuable nugget.

DEPARTMENTS MARKET LEADER

PRICE RICE LEADS TO A GOLD RUSH

............................................................Page 6 Gold is off its glittering high, but is still riding high. Vanja Dragomanovich reports

CHANGING PLACES: REGULATORS VIE FOR CONTROL....Page 10

IN THE MARKETS

Ian Williams explains why US financial markets reform is way overdue

THE PROBLEM WITH BYPASSING THE MIDDLEMEN................Page 16 Dave Simons wonders whether disintermediation has gone too far

CAN UK plc PULL ITSELF OUT OF THE DOLDRUMS?

INDEX REVIEW

............Page 22 Simon Denham, managing director, Capital Spreads, looks at the effects of indecision

ALTERNATIVES

......Page 24 Ian Williams reports on the best and worst in the fast growing carbon trading market

COMMODITIES

........Page 29 Oil prices are falling right now, but not for long, writes Vanja Dragomanovich

ETFS

MOVING IN ON A $1TRN CARBON TRADING MARKET LONG TERM OUTLOOK SUGGESTS HIGHER OIL PRICES

THE LONG AND WINDING ROAD OF ETFS ................................Page 33 Neil O’Hara explains why ETFs have a future of powerful prosperity before them

WHAT’S RIGHT, WHAT’S WRONG WITH ICELAND? ..................Page 36

COUNTRY REPORTS

Julia Grindell looks at the ways Icelandic banks have rebuilt investor confidence

THE COMEBACK KIDS ......................................................................................Page 40 Kazakh issues are making tentative forays into the capital markets once more

COMPANY PROFILE DATA PAGES 2

TESTING TIMES FOR MMX’S EIKE BATISTA ................................Page 43 After a super-confident start to the year, Brazil’s big entrepreneur is in the spotlight Securities Lending Trends by Data Explorer ............................................................Page 91 Market Reports by FTSE Research ..............................................................................Page 92 Index Calendar ............................................................................................................Page 100

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

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Contents FEATURES TRANSITION MANAGEMENT

THE BREAKAWAY PACK ..............................................................................Page 51 Europe’s transition management teams that have stayed the course after an eventful first half year, have never had it so good—or quite so bad—all at the same time. Francesca Carnevale explains why

ASSET OWNERS LOOK TO A SMOOTH TRANSITION ........Page 55 In an increasingly competitive US market, mitigating risk and maintaining portfolio value while offering an ever-expanding menu of services are the driving forces behind today’s leading transition specialists. Dave Simons

ROUNDTABLE

THE FUTURE OF INVESTOR SERVICES ..............................................Page 59 According to Paul Stillabower, global head of business development, Fund Services, HSBC Securities Services, a key question for everyone right now is whether the global markets are in a V-shaped downturn with more volatility and therefore trading revenues or in a Ushaped downturn, where clients tend to trade less and move to less lucrative instruments. Our panel of experts discuss the impact of the credit crisis on the provision of investor services over the coming decade

THE SIBOS REPORT

THE CHANGING GAME OF EUROPEAN CLEARING AND SETTLEMENT ............................................................................................Page 70 In an increasingly fragmented post-MiFID European trading landscape, clearing and settlement arrangements are in flux. It is prompting the principal clearing and settlement firms to look further afield for opportunity

PROFILE: EUROCLEAR & THE SINGLE PLATFORM ................Page 75 “We believe the Single Platform is the most ambitious and deepest project in Europe in terms of technology and market-practice harmonisation. We will process all types of transactions in multiple currencies and not just settlement services like T2S,” says Euroclear CEO Pierre Francotte. Lynn Strongin Dodds profiles Euroclear.

TOWARDS BEST PRACTICE IN HEDGE FUNDS ..........................Page 78 José Santamaria, director, RBC Dexia Investor Services, argues that hedge funds will gain a competitive edge if they improve pricing and valuation methodologies

FAIR VALUE HEDGE ACCOUNTING ....................................................Page 81 Financial institutions and non-financial institutions should adopt fair value reporting to improve their understanding of risk exposures and the effectiveness of risk management systems, writes Vincent Papa, senior policy analyst at the Chartered Financial Analyst (CFA) Institute.

PRIME BROKING AT THE CROSSROADS ........................................Page 85 Spooked by the near-collapse of Bear Stearns, institutional investors and fund managers are insisting that hedge funds diversify their sources of financing through multiple prime broker relationships. For smaller firms in a business still dominated by Morgan Stanley and Goldman Sachs, it is a heaven-sent opportunity to grab market share. Neil O’Hara reports.

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

Market Leader GOLD SHINES IN TIMES OF CRISIS

Although commodities have been riding a high wave of investment since the beginning of the year, the correction across this asset class that started in mid-July also brought down gold, with prices falling to around $860/oz. Two major factors were the strengthening of the dollar and a significant drop in oil.“A stronger dollar is contributing to pressure on commodities,” explains John Reade, commodities analyst at UBS, adding that the dollar is hitting gold particularly hard, despite strong jewellery demand, because the metal is traded in the US currency. Photograph © Roberto Giovannini/Dreamstime.com, supplied August 2008.

PRICE RISE LEADS TO A GOLD RUSH Gold’s long term price should be some $200 an ounce lower than where it is now, say analysts. That counts for very little however at times of financial or political crisis. Gold prices are already off by some 15% from this year’s high as commodities prices corrected across the board through July and August. Even so, with Russia in serious conflict with Georgia and large Wall Street banks continuing to grapple with the after-effects of the sub prime mortgage problem, there are still crises aplenty to help support the price of the precious metal. By Vanya Dragomanovich. OLD PRICES REACHED their highest level ever this March, coming in at just above $1,000 a troy ($1,000/oz) as details began to emerge about how badly large banks were hit by exposure to the sub-prime crisis in the United States. This compares with $840/oz at the start of the year and up from $670/oz in 2007.

When presenting precious metals consultancy GFMS’s annual Gold Survey, the industry bible, in April this year, Phillip Klapwijk, executive chairman of GFMS, says that gold prices would turn only once the worst of the credit crisis was over. In other words, once the US dollar stopped going down and interest rates started going up. At the beginning of August at least the dollar seemed to have turned the corner and rates in Europe were higher. “Eventually, gold will come down to around $600, but not for a good while yet,” thinks Philip Newman, research director at GFMS. The crunch is far from resolved. Economic news from the US is still persistently negative and inflation remains high, even as economic growth is slowing. There is also evidence that domestic mortgages one level above sub-prime have also been impacted; particularly those issued in early 2007, as mortgage lenders did not tighten lending standards until the summer of 2007 when the credit crisis began to have an impact on the equities markets.

Big banks are not out of the woods yet, despite large capital-raising exercises. Moreover, threats of legal action nudged Citigroup and Merrill Lynch into saying that they would buy back a billion dollars worth of auction-rate papers. In equity markets, the FTSE 100 is down 15% since the beginning of the year and the Dow Jones Industrial Average is down 12%. In this environment investors will continue to look for alternative havens for their money, preferably those that are not correlated to either stocks or bonds. Gold fulfils both criteria. “The liquidity crisis has forced leveraged investors and companies to unload assets across the board to comply with new US accounting rules and this has created a domino effect as investors panic,” says Frank Holmes, chief executive officer (CEO) of mutual fund company US Global Investors. An estimated $15bn was pulled out of US stock funds in July, about four times more than in June. For the first seven months of 2008, those outflows totalled $52.4bn, an all-time high.

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

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Market Leader GOLD SHINES IN TIMES OF CRISIS

Although commodities have been riding a high wave of investment since the beginning of the year, the correction across this asset class that started in mid-July also brought down gold, with prices falling to around $860/oz. Two major factors were the strengthening of the dollar and a significant drop in oil prices.“A stronger dollar is contributing to pressure on commodities,” explains John Reade, commodities analyst at UBS, adding that the dollar is hitting gold particularly hard, despite strong jewellery demand, because the metal is traded in the US currency. Reade says he would advise buying

gold if jewellery demand continued to consistent strength, if show speculators cut long positions in the over-the-counter market and on the COMEX division of NYMEX and the dollar strength ran out of steam, although the latter did not seem likely in the short term. The link with oil, however, may not remain in place, despite the fact that the two commodities have travelled in tandem for the better part of this year. If oil moves higher for political reasons, such as the conflict between Russia and Georgia—a likely scenario as a major pipeline that carries oil from the Caspian to Turkey runs not

far from Georgia’s capital Tbilisi—gold will also move up. Another thing gold and oil have in common is that commodity index funds invest in both simultaneously as they buy into indices such as the FTSE Gold Mines Index or the DJIA Commodity Index. According to research by Lehman Brothers, allocations in commodities from index investors—who hold almost exclusively long positions— rose from negligible size in 2003 to an estimated $76.7bn in January 2006, only to balloon to $297bn by June 2008. Of the increase since 2006, $98.1bn has been new financial inflow, with the remainder due to the

HOW GOLD IS TRADED The gold market functions slightly differently from other commodities. The benchmark futures contract is traded on the COMEX division of the New York Mercantile Exchange (NYMEX), but there is also active futures trading in Tokyo, Shanghai, Dubai and Mumbai. In London, however, all trade is over the counter (OTC). Here the price is set through the London Gold Fixing (LGF) mechanism, an old fashioned procedure in which five member banks of the LGF twice daily agree on the price of gold. In the past the five LGF members had to be in the same room, these days the fixing is done on a conference call. At the start of each fixing, the LGF chairman states an opening price to the other four members, who relay this price to their customers and who then have to say if they are buyers or sellers at that price and, if so, how many bars they want to trade. If the trade is not agreed the price is moved until there is consensus. The majority of central banks that hold gold—producers, refiners, fabricators and traders —trade gold OTC. Like other commodities gold is also traded as an Exchange Traded Commodity (ETC), spread bets, covered warrants and structured products. However, unlike oil, corn or metal it is also invested in in the form of bars and coins; gold accounts, which are effectively safe deposit boxes for gold, frequently provided by Swiss banks; and gold certificates, issued by banks which confirm that investors hold gold while the bank stores it, thus bypassing issues of storage or security. The fastest rising segment of investment are gold ETCs. ETCs took two of the top four spots in terms of trading volumes in June 2008 on the LSE’s ETC/ETF trading platform, of which gold ETCs accounted for $1.3bn of trade. ETF Securities, a big provider of ETCs, saw its total assets grow 30%, or $1.7bn, over three months to mid-July to $6.6bn, with the five physical precious metal ETCs contributing more than 50% of inflows.

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

The Creative Factory

appreciation of the underlying commodities. However, looking at the underlying physical commodities, gold and oil are driven by fundamentally different factors. Oil is fundamentally pushed higher because people drive more cars and industries use more oil, while at the same time supply from existing fields is declining and new finds are becoming increasingly rare. Gold, on the other hand, is as good as indestructible and a large portion of all the gold that has ever been mined still exists above ground. The biggest demand by far comes from jewellery. If prices are close to $1,000/oz that demand tends to dry up, while at the same time old jewellery and gold scrap find their way back into the market. Also, central banks no longer build their reserves in gold and, if anything, are sellers of gold stocks. There is one new source of demand that works in gold’s favour—demand created by gold Exchange Traded Funds (ETFs). These trade like shares on major stock exchanges and issuers of these papers have to hedge against their counterparty position. According to GFMS, the ETFS Physical Gold launched by ETF Securities had 20 tonnes of gold in trust by the end of 2007. Looking at the long term outlook for gold, UBS’s John Reade believes that fundamental support for the precious metal lies between $700/oz and $750/oz, based on long term contracts in the physical market, although he adds that fund investment has become a huge contributing factor in keeping prices higher. GFMS’s Klapwijk has an even lower long term forecast, at $600/oz, but says that prices would not fall below that level because of high production costs. So what will happen between the

current $860/oz and the long term gold price? If recent price moves are anything to go by, probably large swings. According to ScotiaMoccatta, the precious metals trading arm of Scotia Bank, wild swings in the market can be traced back to 1990 when the global economy started being pumped full of money. “The process really started in the late 1990’s when Japan spent vast sums of money on public works projects. The impact was not restricted to Japan as financial institutions put on carry trades whereby investors borrowed yen and converted these into dollars to then invest in dollar-based assets,”says a ScotiaMocatta spokesman. This way Japan’s abundant liquidity was used in other markets and contributed to the rapid expansion of the hedge fund industry. The second source of liquidity came from the US itself. All this has kept global growth running at a fast pace, but the excess liquidity has created various bubbles along the way. This is why, perhaps, it is no longer unusual to see gold move up or down almost $200 in a space of two months and the situation is not likely to change going forward. In the meantime, gold may not be a good long term bet, but in the short term it will take a brave man to bet against it.

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

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In the Markets US REGULATORS MULL MARKET REFORMS

From left, Treasury Secretary Henry Paulson; Richard Shelby, Democratic senator for Alabama, the ranking member on the Senate Banking Committee; committee chairman Christopher Dodd, Democratic senator for Connecticut, and Securities and Exchange Commission (SEC) chairman Christopher Cox gather on Capitol Hill in Washington, Tuesday, July 15th 2008, during the committee's hearing on the economy. Photograph by J Scott Applewhite, supplied by Associated Press/PA Photos, August 2008.

CHANGING PLACES: modifying the regulatory landscape Will the almost certain incoming Democratic Congressional majority—which may even be veto proof—overcome its attachment to financial industry campaign donations enough to attempt a root and branch reform of finance and securities industry regulation? A Wall St Journal/NBC News poll released in July shows that by a 53% to 42% margin, Americans want government to do more to solve problems, which suggests that the high tide of Reagan’s neo-liberal era is definitely ebbing. Ian Williams reports from Washington. T IS LIKELY that the crises that beset sub-prime, collateralised debt obligations (CDOs), Bear Sterns, Fannie Mae and Freddie Mac, will provoke the incoming US

I 10

Congress to indulge in a noisy exercise of slamming the stable door shut after all the horses have bolted. However, since the crisis involved commercial banks, investment banks,

rating agencies, and listed and private companies (thereby cutting across the territories of the different regulatory agencies), the size of the door, the form of the lock, and the identity of the gatekeepers are all undetermined. So far, the election campaign has overshadowed rational discussion of alternatives, while diverting public attention from the details. Even the Wall Street Journal asked in July “Where’s the outrage?” about the shortage of visible public concern over successive financial scandals. Harvard Professor Ken Rogoff, collaborating

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

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In the Markets US REGULATORS MULL MARKET REFORMS

on a book This Time is Different: Eight Fed’s) expansion into providing life had kept their rates low. At the same Centuries of Financial Folly, who thinks support systems for investment time however, it defeated a proposal to this is more a 1932 denouement than banking, capped by the Fed's and stop the lenders lobbying Congress, a Sarbanes-Oxley moment, explains Treasury's transfusion for the where they have traditionally been the lack of audible indignation: “It is nominally independent Fannie Mae major writers of cheques. Moreover, the SEC’s decision to ban because the costs are concealed in a and Freddie Mac, all encroach to some lot of off-the-book complex liabilities. degree on the US Securities and “naked”short-selling in some financial If they were sold at market the Exchange Commission’s (SEC) home stocks may be a harbinger of the type taxpayer could see what they were patch. That patch has already been of same “do something” imperatives getting, but they aren’t, so the public expanded by the SEC’s new mandate that may govern the shape of future to monitor the rating agencies that regulation. Naked short-selling means does not appreciate the cost.” Rogoff describes the Fannie Mae had koshered the CDOs at the root of short-selling stock that you do not necessarily have, so banning it is an and Freddie Mac rescue as “really the global crisis. understandable attempt to appalling. There is no quid put some brakes on market pro quo; for example, no volatility. But the underlying restriction on dividend premise that rumourpayments,” and estimates enhanced short-selling the bill for the bailout caused the problems in the somewhere between “The rapidly metastasising crisis has sector is far from proven. $100bn and $200bn, adding, spread so widely that would-be financial Adding to the temptation “it could come in even oncologists are having to draw on to take some politically higher. It is very difficult for different specialisations. And lurking in visible action, no matter the watchdog agencies to the background are the unregulated what, is the absence of any come up with concrete blueprint for how to control numbers, so it makes them private equity/hedge funds who are the exuberant innovation of less resistant to political being blamed for much of the crisis.” the financial sector. Chicago pressures to understate the Professor Raghuram Rajan true cost.” candidly confesses that“it is That typifies the swings of a big concern when you the regulatory pendulum— have the privatisation of between desperate attempts Introducing its first report, SEC gains and the socialisation of losses to show activity for the voters after a crisis, and the more customary chairman Christopher Cox berated the with Fannie Mae and Freddie Mac, acquiescence to political pressure. “It ratings agencies (without whom the against a background of growing is very difficult to cry wolf during good CDOs and sub primes would not have inequality. There are a lot of questions times. The regulated industry can so been possible) for serious shortcomings; that need to be asked, but I am not easily get the politicians to call the including a lack of disclosure to sure there are that many answers!” agency and ask ‘What are you doing?’ investors and the public, a lack of Indeed, he asks another fundamental We can look at the pattern but it is policies and procedures to manage the question:“Whether we can move from very hard for a regulator to resist,” rating process, and insufficient attention a rules based structure to one that asks questions that boards should Rogoff explains. “The rapidly to conflicts of interest. In the July Housing Bill, in the same traditionally be asking but don't seem metastasising crisis has spread so widely that would-be financial reactive rush to “do something,” to have bothered.” Rajan suggests that it could go oncologists are having to draw on Congress established a new Federal different specialisations. Lurking in Housing Finance Agency to regulate several ways: one would be very the background are the unregulated Fannie Mae, Freddie Mac and the interventionist, involving regulating private equity/hedge funds who are Federal Home Loan Banks. This was more carefully and increasing capital introduced, along with an effective standards. The danger with this is that being blamed for much of the crisis.” The involvement of the Treasury, Federal guarantee for the agencies, it could shut off the kind of innovation and the Federal Reserve Bank’s (the replacing the previous implicit one that that has driven the financial sector

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

In the Markets US REGULATORS MULL MARKET REFORMS

over the last few years, which would put us back a fair bit in terms of the sector’s contributions to growth. Unless the intervention is really heavy-handed, it may not help that much in terms of stability.” The second option, he says, is to do very little, other than shutting the stable door, in which case the financial sector would find different ways to get into trouble in seven or eight years from now. It won't be sub prime again—but it will be something else. His preferred option is recognising these things will happen and that we can’t completely eliminate them, but that we can improve regulation here and there a little bit, while taking steps so that, when the inevitable troubles do come, we can insulate the real economy a little more from the financial sector. He explains:“You have to ask why all these smart guys who get paid millions loaded up their balance sheets with this stuff (CDOs)?” Rajan maintains that stricter rulesbased regulation of the banks may not have averted it. “For example, when the CDOs had a triple A rating, with extra returns compared with normal Triple A corporate securities, banks like UBS just loaded up on them, to the hilt. A regulator works to the letter of the law and accepts how much cash those CLOs represented, so UBS did not break the rules by buying them. But shouldn't they really have taken a step back to look at the bigger picture? That kind of risk concentration does not make sense from the standpoint of a well managed firm, whatever the rules say.” “In this environment, where we are dealing with a tremendous amount of innovation, it makes sense not to enact more regulation but more thoughtful regulation. Simply laying down the rules gives a lot of scope for arbitrage as opposed to a principles based discussion,”he says.

Professor Rogoff takes a different tack. Regulators should let the markets take their course rather than rescue those who stray. Instead, “if they are going to be bailed out by the taxpayer then they do need more regulation earlier on, but it is precisely now we could move to a more solid system by letting firms go instead of bailing them out. That's why you need more discipline during the downtimes because we are not prepared to regulate too much during the good times, and it is not clear that we know how to regulate the financial industry very well either. Those seriously interested in wider regulation should want to let financial firms fail, to let executives, shareholders and bondholders know that their money is at risk, and that the taxpayer will not always be there to bail them out,”he says. Rogoff does not buy the 'too big to fail' argument; dismissing its relevance to Bear Sterns. “The bondholders wanted everyone to think that. But if they lose a ton of money then they should fail,”he says. Quite apart from the “what” of any regulation, is the“how and who.”At the end of July, the Federal Reserve (the Fed) and the US Securities and Exchange Commission (SEC) were engaged in a pre-emptive public turf war before the Congressional banking subcommittee about which agency would lead the regulation of investment banking. In response to demands by the Fed for an enhanced role, SEC chair Cox called for his agency to remain in charge, and to expand its role to include establishing risk management systems and the application of “progressively more significant restrictions on operations if capital or liquidity adequacy fails, including requiring divestiture of lines of business.” The problem is that Americans have traditionally underpaid their public servants, and anyone who knows the

markets well enough to regulate them effectively could equally well be making a personal fortune in them. Effective regulation, Rajan points out, “needs regulators who understand what is going on, with the capacity to second guess and third guess these traders who make millions and billions. With a financial system that has such a tremendous amount of raw talent and incentives to get itself into trouble, how much can regulators do? Think of Robert Rubin. Few are so experienced in macro-finance, understanding microstructure, and yet Citibank went where it did,” Rajan concludes ominously. Professor Rogoff considers the Fed “the premier agency in terms of the quality of its staff and the consistency of its analysis. From an outsider’s point of view you'd like the Fed doing everything. On the other hand, its narrow focus is part of the reason for its success. So, if you expand its responsibilities, it will be very hard to maintain its quality. Congress and Treasury want the Fed to do more.” Former SEC chair Arthur Levitt remains loyal to his former agency. “There is a massive loss of public confidence in our management and in our regulatory system, but the Federal Reserve Board has acted in the past more like the bankers’ protection association than the bankers' regulator [sic], and I have difficulty in allowing the subsuming of the regulatory authority of the SEC to an expanded regulatory power of the Federal Reserve.” He sees profound contradictions between SEC oversight and investment banks’ access to the Fed’s window. He would prefer a closer working relationship between the SEC and the Fed, with continuing principal responsibility for overseeing both the investment bank and the investment arms of the commercial banks.

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

Others doubt that the SEC actually has the teeth to regulate effectively. Robert Monks, author of Corpocracy, and long time corporate governance activist, says: “You could almost say that if the SEC is providing an answer to a question, then the question is not important. If it is important then someone other than the SEC provides the answer.” Levitt points to the threats from Congress to cut funding for the SEC when it first raised the issue of “costing” stock options, when Congressmen succumbed to the lobbying power of the Investment Company Institute, the US association of national mutual funds. Because of that pressure, he maintains, the SEC is

quite clearly on a leash, adducing the fact that “the people who run mutual funds are the richest people in the country, and the people who buy them are getting very mediocre products heavily loaded with fees.” Since then, Levitt says the SEC has been under pressure from the White House and from the Washington DC Circuit Federal Appeals Court. The Appeals Court consistently takes a minimalist view of the Agency’s powers between them, consistently stopping the SEC’s, admittedly not very vigorous, defence of shareholder rights. One of the differences is that the Fed’s extended appointments to its boards guarantee it far more

independence, for better or worse, than the SEC. Levitt argues that “the SEC needs greater independence and importance, but I think we are about to enter an era of greater transparency and the SEC is going to be seen as a vehicle for ensuring that transparency. The SEC must be given the powers for greater understanding of positions, a day-by-day ability to evaluate risk. A strong working relationship with international counterparts. This is not something that can be done in the US alone.”Somewhat critical of the SEC’s lack of power and ambition, when asked if he felt that the SEC could rise to the challenge, he chuckles. “If you tell me who the leadership will be, I will answer.”

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In the Markets RESEARCH & TRADING POST-DISINTERMEDIATION: WHAT’S NEXT?

Clients on the buy-side are seeing more choice than ever before as a result of higher competition among the venues, and this will ultimately affect the cost of trading, notes Will Sterling, head of institutional electronic trading at UBS. “They will experience a significantly heightened ability to manage price impact and information leakage,” says Sterling. “Trading infrastructure has to not only keep up, but stay ahead of this evolution.” Photograph © Bram Janssens/Dreamstime.com, supplied August 2008.

THE PROBLEM WITH BYPASSING THE MIDDLEMAN Broker free research, in a perpetual state of evolution since the start of the broadband era some 10 years ago, has today reached its zenith, as investors increasingly receive their information directly from the source. Meanwhile, disintermediation continues to have a pronounced effect on the trading process, resulting in an explosion of alternative exchanges as traders increasingly bypass the middle man. But is going direct really as infallible as it seems? Dave Simons reports from Boston. EGULATORY INITIATIVES SUCH as RegNMS in the United States and the Markets in Financial Instruments Directive (MiFID) in Europe have only quickened the pace of high-speed alternative trading systems (ATS) designed to help traders meet the various requirements of best execution. With disintermediation continuing to shape the global marketplace, advanced mechanisms such as direct market access (DMA), algorithmic trading and smart-order

routing technology appear to have irrevocably altered the link between the buy side and the broker-dealer, as investors increasingly find ways to bypass the intermediaries. Meanwhile, digital technology continues to minimise the spread between content and consumer, making equity data of all forms increasingly accessible and giving rise to a whole new fleet of third-party research firms. “Innovation and adaptation will determine the success of service providers in Europe as they

respond to the challenges posed by venue pricing, next generation smart routing, cost of access to hidden liquidity, and algorithmic trading growth,” says Lee Hodgkinson, chief executive officer of SWX Europe. Not least among these challenges is increased disintermediation as the buyside seeks out alternative sources of liquidity and different ways of accessing the available pools of liquidity, adds Hodgkinson. “Regulatory liberalisation and rapidly developing technology have also transformed the market to date, with previously unachievable business activity now being executed at the touch of a button. Stock exchanges must respond appropriately to this convergence of powerful forces. It will be crucial for exchanges to offer the innovative services demanded by today’s sophisticated investor, such as combined dark and light liquidity, in order to survive.” Clients on the buy side are seeing more choice than ever before as a result of higher competition among the venues, and this will ultimately affect the cost of trading, notes Will Sterling, head of institutional electronic trading at UBS. “They will experience a significantly heightened ability to manage price impact and information leakage,” says Sterling. “Trading infrastructure has to not only keep up, but stay ahead of this evolution.”

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In the Markets RESEARCH & TRADING POST-DISINTERMEDIATION: WHAT’S NEXT?

More choice for traders

these are largely driven by technology,” continues Bruner, who foresees massive has had a Disintermediation and continuous investments in trading pronounced effect on the growth of technology going forward. For investors, equity trading platforms of late. Today one major byproduct of the post-MiFID there are more than 55 different venues exchange explosion is the potential for in the US alone, according to a recent more efficient and increasingly coststudy from Boston-based TABB Group effective trading. Alain Lesjongard, head entitled US Equity Market Structure: of international compliance at the Bank Driving Change in Global Financial of New York Mellon, says the increased Markets. “With these millisecondcompetition with upstart alternative matching US equity trading platforms venues forces traditional brokers/dealers competing against each other, and new to justify best execution standards for electronic strategies enabling brokers, their retail and professional clients. “In investors and markets themselves to the longer term, this will result in further connect and trade, the way traders now Robert Bruner, dean of the Darden Graduate efforts by the exchanges and other access the financial markets has School of Business Administration at the venues to reduce trading costs, and this changed radically,” says TABB Group University of Virginia.“It paves the way for will make Europe a more attractive place chief executive officer Larry Tabb, greater competition, and in turn will lower in which to perform business,”he adds. author of the study. trading costs,” says Bruner. Given the intense MiFID and RegNMS has already According to TABB, the proliferation competition among the alternative venues, initiated a palpable evolution in market of equity execution venues, ongoing however, it is unlikely that all newcomers will structure, says Sterling of UBS. “This capital expenditures in scheduling and be able to sustain profitability unless they can has impacted the way exchanges do smart-order routing logic, along with differentiate themselves from the incumbent business both individually and with improvements in market-data exchanges. Photograph kindly supplied by the each other, and has facilitated the infrastructure and millisecond speeds University of Virginia, August 2008. entrée of newer alternative necessary to read and analyse trading venues,”he says.“We trading opportunities “has are moving to a marketplace made the old-school method “Innovation and adaptation will that is more ‘venue-neutral’ of phoning a stock exchange determine the success of service than we have ever seen.” floor broker for a trade providers in Europe as they respond to Adam Sussman, senior execution as ludicrous as a the challenges posed by venue pricing, research analyst for TABB horse and buggy competing next generation smart routing, cost of Group, agrees that the in the Daytona 500. Not only access to hidden liquidity, and algorithmic continued disintermediation can they not win, but they of equity trading will not only have a greater chance of trading growth,” says Lee Hodgkinson, lead to lower-cost trade harming everyone around chief executive officer of SWX Europe. executions, but will also them.” Though the trend promote the quest for greater towards disintermediation has its roots in the US, the improved of Business Administration at the efficiency—which, in effect, is the trading infrastructure that is an offshoot University of Virginia. “It paves the overreaching theme of MiFID. “These of the trend has already spread to way for greater competition, and in trends position Europe for rapid growth markets around the world, says Tabb, turn will lower trading costs,”he says. in electronic trading as we see both “and once the genie is out of the bottle, Given the intense competition among direct market access and algorithmic the alternative venues, however, it is trading flow growing at an approximate it is impossible to re-cork.” The ability for investors to choose unlikely that all newcomers will be compound annual growth rate of 50% where they can trade irrespective of able to sustain profitability unless they through 2009,”says Sussman in a recent geographic location is an enormous can differentiate themselves from the report on European buy-side trends in institutional equity trading. In Europe benefit for both traders as well as incumbent exchanges. “There are huge economies of scale to post-MiFID, direct-to-market (DMA) retail customers, says Robert Bruner, dean of the Darden Graduate School be harvested in the field of trading, and access is expected to nearly double over

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In the Markets RESEARCH & TRADING POST-DISINTERMEDIATION: WHAT’S NEXT?

the next three years, reaching an estimated 15% of traded value, fueled by the advancement of alternative trading systems and multilateral trading facilities (MTFs), as well as the need for faster execution and compliance.

Third-party research

Disintermediation has also led to a wealth of opportunity for independent providers in a market once monopolised by the largest data aggregators. Broker free research, in a perpetual state of evolution since the initial ramp-up of broadband-based communications some 10 years ago, has today reached its zenith, as investors increasingly receive their information directly from the source. Mutual-fund analysts in particular are expected to decrease their use of full-service broker research in favour of third-party services, according to a recent report from Stamford, Connecticut-based Greenwich Associates. Like all shared and open-sourced research providers, in all probability the generators of new insights will find it increasingly beneficial to share their insights with large aggregators, who themselves are in very direct contact with the ultimate users, says Bruner. “Increasingly, there will be an atomisation of research houses whereby small teams, and even individual researchers known for their excellence, will once again rise in prominence as they feed their research to the aggregators,”he notes. The disintermediation of equity research, however, has put downward pressure on fee-based revenues. Independent firms are finding the going much tougher than previously expected, as commissions paid by buy-side analysts continue to fall, according to Greenwich. Meanwhile,“bulge bracket”

maintain the clearing, settlement and connectivity requirements necessary to realistically compete. The adoption of smart-order routing technology, for instance, is one area that may determine who survives and who does not, according to research entitled Surviving or Thriving after MiFID from Paris-based Atos Consulting. While smart order routing and algo-based processing have substantially reduced the margin for error, direct access does not always guarantee best execution. In order to use DMA efficiently, clients need to be able to understand how to manage their order flow properly, and without the traditional broker acting as a safety net. Therefore, the main issue with DMA is not so much how to use it, but when to use it, argues UBS’s Sterling. Because orders are visible to the general market, traders need to understand the perils of information leakage. “Most medium and large buy-side institutions have been using DMA for a very long time, and are thoroughly experienced at training their new traders. Potentially, in smaller practices, there is a risk that a new trader may not have a full appreciation of the potential impact of a DMA order,”he says. This need for transactional handholding—combined with the slower growth of alternative exchanges in certain markets—means that disintermediation probably will not disenfranchise the incumbent providers anytime soon. Says SWX’s Hodgkinson: “Incumbent exchanges are best placed to develop the services that market participants will demand in an environment where the need to be agile and adaptive has never been greater.” However he warns, “only if they embrace, rather than oppose, innovation.”

“Increasingly, there will be an atomisation of research houses whereby small teams, and even individual researchers known for their excellence, will once again rise in prominence as they feed their research to the aggregators,” notes Robert Bruner, dean of the Darden Graduate School of Business Administration at the University of Virginia.” firms, having ceded market share to independent providers since 2004, finally reversed the trend last year, registering a slightly higher portion of the research business. Consequently, says Bruner, smaller independents will be forced to make serious investments in information technology and either sink or swim based on the franchise they have created. Bruner believes that there will, in all likelihood, be a fairly high rate of turnover.“It is a very different world from the large integrated trading, brokerage and research houses,” he adds. As information technology continues to fracture the bundling of services, the going certainly will not get any easier for those without the wherewithal to keep up, says Bruner.

Cutting out the safety net? Despite the many positives of trading and research disintermediation, eliminating the middle man will not be a complete cakewalk. Alternative trading platforms have been hampered by continued off-exchange restrictions in various European localities, and may struggle to find a foothold going forward, perhaps gaining as little as 5% of market share over the next three years, according to estimates from Boston-based research group Celent. While increased visibility and, in turn, higher levels of liquidity will enable select providers to outperform the market, others may find it difficult to

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Index Review UK: THE SPECTRE OF STAGFLATION

Comments last time out that there were reasons to be cheerful had the good fortune to be published just as the markets enjoyed their little bounce. Any mention that the near-destruction of building stocks had lessened any downside risk did not anticipate anywhere near the resulting quadrupling of some construction stocks— particularly Barratts! However, the real test for the United Kingdom’s economy is yet to come. The current administration has failed to take a single hard decision for more than ten years on virtually any subject, let alone a financial one, and is now faced with a possible rising public sector pay dispute this autumn/winter. Simon Denham, managing director of specialist spread betting firm Capital Spreads, looks at the inevitable consequences of indecision.

CAN UK Plc PULL ITSELF OUT OF THE DOLDRUMS? HE BROAD UK economic situation does not appear to have lightened in the least. While there are still buying opportunities out there, they are much harder to find. Moreover, it could be argued that neither the credit crunch nor any attendant economic woes have yet to exert an impact on the general population. Inflation is bad and worsening. House prices continue to fall but, wage growth is (just) keeping pace with rising prices. Only those who bought or refinanced their homes in the last two years are suffering. After a period of prolonged indecision, it would be a leap of faith to believe that the UK government will start playing hardball now. The Labour Party, itself, is virtually bankrupt and remains vulnerable to pressure from its union paymasters. This raises the spectre of an inflationary wage spiral setting in, causing the Bank of England (BoE) some sleepless nights over rate expectations for the remainder of 2008 and going into 2009. Governor Mervyn King’s recent comments on the inflationary and growth outlook for the UK are stark. Investors fear few words more than stagflation, but King seems

to be preparing us for the fact that this is indeed our future. The UK Treasury is also struggling to balance the books with various areas of revenue stream now as good as gone. Those rich tax revenues from the banks and the Square Mile that fed a grasping public sector now looks to be over: at least for the foreseeable future. This year is a busted flush for banking profits and if mortgage write downs continue to deteriorate, next year might be the same. In fact, with the UK’s corporate tax in arrears system the Treasury is almost certainly repaying banking receipts for the remainder of 2008. Inevitably, this will blow a hole in the government’s revenue models. Add to this an expected dive in income from Stamp Duty (expected to more than halve), falls in death duty income (as property asset values decline) and a drop in income tax revenue as unemployment rises. On the reverse side, outgoings will increase as Social Security payments balloon. The pressure on prices and tax revenues, coupled with the possibility of increased gilt issuance could mean that the UK Treasury yield curve might well start to reverse its current one to five year inversion, thereby increasing borrowing

Simon Denham, managing director of spread betting firm, Capital Spreads, April 2008.

costs. If this happens then the equity markets may start to look expensive in comparison to gilt yields and the momentum, once again, switches to the down side. Moreover, this outcome could be played out across the global market place if the spectre of entrenched inflation takes solid form. It is an extreme and doom-laden outlook, but the possibility of a worldwide reaction to the current credit crunch is not one that can be, nor should be, underestimated. Of course, as with all speculative situations, there is always an opposite. With growth beginning to slow, commodity prices have already begun to buckle. Additionally, the dollar is resurging (at last!) as investors start to pull out of Greenback shorts. This might relieve pressure on producer prices which could trickle into the Retail Price Index (RPI) data, therefore coming to the aid of the central banks. Inflation projections for the first half of 2009 are already beginning to factor in softer commodities, but if we are hoping for a near recession to fight inflation then the BoE and European Central Bank may be tempted to take the Federal Reserve and the Bank of Japan route of weaker rates to bolster the economy. Fears over job prospects can also have a salutary effect on wage demands (although generally not in the public sector, of course) which should favourably impact final awards. The fear for everyone is that the solution appears almost worse than the problem. As ever, Ladies and Gentleman, place your bets!

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

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Alternatives CARBON TRADING: SET TO BECOME BIG BUSINESS

Moving in on a $1trn Carbon Trading Market

Photograph © Rolffimages/Dreamstime.com, supplied July 2008.

It is the best of times and the worst of times for carbon trading in the United States, where the issue of combating climate change is in an indeterminate state. There have been almost seismic shifts in carbon usage over the past year. It seems Americans are using more public transport, driving less, and buying smaller cars. They are shifting back from the exurbs (where house prices are falling) to city centres and their suburbs (where they have been relatively stable). However, it is not carbon caps that led to this outbreak of virtue, rather the impact of energy pricing. So what now? Ian Williams supplies his own prognosis. AP AND TRADE involves voluntary, governmental or internationally enforced limits on carbon emissions. The trading element rewards the virtuous by allowing them to derive revenue from a reduction in emissions. However, it is a slapdash method that rewards the

indolent and the lucky: those countries and companies dropping out of rustbelt technologies who have no further need to pollute. Even while the White House issued a report contradicting its own Environmental Protection Agency (EPA) on the harm of greenhouse

gases (GHG) and President Bush fought a rearguard action against hardening Kyoto emission controls, several things happened in July that could, finally, spark some definitive legislative reaction in the US. For one, both Barack Obama and John McCain, the rival senators up for election as president this autumn, have repudiated much of Bush’s hard line stance and promised some effective action against GHG emissions. Additionally, after years of legislative inaction on the issue, the Warner-Lieberman bill on carbon cap and trade was debated in the Senate, with much more seriousness and science than before. The word is out that voters are worried about climate

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

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Alternatives CARBON TRADING: SET TO BECOME BIG BUSINESS

The Warner-Lieberman bill has suggested that the US should auction 25% of permits in

change, even if some oil and coal 2012, when the programme starts and gradually raise the proportion to 70%. Photograph companies feign indifference. © Robert Adrian Hillman/Dreamstime.com, supplied August 2008. The bill’s sponsors have been looking hard at the European experience and to avoid the EU’s initial problem of overgenerous free permits and consequent minimal effect on emissions, the Warner-Lieberman bill has suggested that the US should auction 25% of permits in 2012, when the programme starts, and gradually raise the proportion towards 70%. It is a process, maintain senators Warner and Lieberman, that will give a serious incentive to emissions reduction. Some senators in the debate talked about imposing a ceiling on the price to avoid damaging industry. However, Milo Sjardin, US head of New Carbon Finance, the consultancy providing fundamental analysis of the European, Washington consensus that the free tax. The Warner-Lieberman debate, he North American and global carbon market could solve everything. Cap says, did everyone a favour by markets, notes that any problems and trade was a hybrid of revealing how complex a cap and trade concern and system has to be. “You would have to looming in the EU are certainly not a environmental realpolitik, designed to overcome the open up the hood of the US economy product of carbon trading. Although the bill was kicked out, toxic shock that any hint of new taxes and change everything else inside to produce a Frankenstein’s Sjardin says it was what monster,” says Komanoff. everyone expected. It was He cites a Washington purely as a placeholder for lobbyist who suggested that Congress to look at the “The whole market and any companies many of the big issue. “The whole market that could be involved are waiting for environmental groups that and any companies that 2009 and the new administration to had backed cap and trade could be involved are come into office for this topic to be reare suffering from buyer’s waiting for 2009 and the addressed. Then, hopefully, there will be remorse, the feeling that new administration to come they have backed the wrong into office for this topic to a push for some far-reaching legislation plan.“We think that a carbon be re-addressed. Then, to be put in place.” cap and trade is never going hopefully, there will be a to be implemented in the push for some far-reaching US and the sooner we face legislation to be put in induced in many politicians. It offered up to this, the sooner we can move to place,”says Sjardin. While financial institutions, for a way out that negotiators hoped the gold standard… the carbon tax,” obvious reasons, are looking forward would help get the US and its says Komanoff. Although this view may be to profiting from the potential vociferous special interests on board, multibillion-dollar market, the and it did offer a means of transferring unpopular among all the traders proponents of a carbon tax also took funding from the developed to the waiting to move in, it has some respectable supporters including Alan renewed heart from the Warner- developing world. However, Charles Komanoff, of Greenspan. Indeed, British Columbia Lieberman debate. When diplomats negotiated the Kyoto protocols it was Komanoff Energy Associates, claims has just introduced a carbon tax, even at the height of the neo-liberal that support is growing for a carbon as it moves to cap and trade. However,

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

Alternatives CARBON TRADING: SET TO BECOME BIG BUSINESS

the host of financial institutions that would trade (and profit) from trading are proceeding on the assumption that cap and trade in one form or another will be coming soon. They will use their political clout to make it so, not least in view of the potential size of the market which, says Sjardin,“we envisage to be around $1trn by 2020.” There are many players positioning themselves to take part in the market, presumably because they share Sjardin’s estimate. The intense hype surrounding the global carbon market, already worth $60bn in the first half of this year alone, has benefited Chicago Climate Exchange (CCX), which operates the leading markets for carbon trading in Europe and the US. The first half of this year alone saw 61,786,300 metric tons traded in the Windy City, a significant figure which is indicative of the political pressures building up since its clientele are demonstrating good corporate citizenship, not coerced legal compliance. However, the company, which generates its revenue from trading and membership fees, is yet to produce a profit. Listed on the London AIM with a market capitalisation over £800m, its revenues were just £13.8m and its losses £8.3m in 2007. This is futures trading with a vengeance. Neil Eckert, chief executive officer of Climate Exchange, refers to the continuing maturity of the European market, coupled with the favourable political climate in the US as key factors for promising growth. The valuation certainly suggests the potential that investors see in carbon trading, both for the CCX itself, and for the sector, since there is anticipation that the New York Mercantile Exchange (NYMEX) or someone similar will try to lock up the market with a takeover bid. Equally indicative is the range of sponsors behind NYMEX’s new

venture, the Green Exchange, set up last year by heavy-weight sponsors like Morgan Stanley, Credit Suisse, JPMorgan, Merrill Lynch, Goldman Sachs, Tudor Investment and Constellation Energy. The Green Exchange begins with a mandatory product from the North Eastern states and Canadian provinces which have been establishing cap and trade systems in the Regional Greenhouse Gas Initiative to form RGGI (Reggie). The first auction in September 2008 will see 12.6m Regional Greenhouse Gas Allowances (RGAs) under the hammer from Connecticut, Maine, Maryland, Massachusetts, Rhode Island and Vermont. The RGGI regime is limited to fossilfuel-using electricity generators of 25 Megawatts in the North East, and does not include offsets, so it does not have the range of clientele of CCX, but will more than make up for that in volume. Recent over-the-counter forward trades have been brokered at as high as $8.45 per ton. However, the second auction, due in December, should be more indicative, since by then the two biggest emitters, New York and New Jersey, should be involved. Combining both volume and breadth will be the Western Climate Initiative, with California at the core, stretching from Mexico northwards to Canada, where Ontario has just joined Quebec as a member. In endorsing the Western states’ initiative, due to start in 2012, governor Arnold Schwarzenegger of California explicitly repudiated the Bush administration resistance to climate change as a concept, and California is leading the WCI towards a composite of mandatory caps and offsets. California is also a leading force in the Climate Registry, which is establishing the framework for a reporting methodology in the context of both voluntary and mandatory emission controls, which most states

and provinces across North America have adopted. The states’ activism on the issue is another reason why more and more people anticipate a mandatory Federal scheme soon. Founding Editor of the Forum for Atlantic Climate & Energy Talks (FACET), Alexander Ochs, says he would be surprised if within the next two years there is not a national carbon trade system in the US. “It is very difficult to predict what form it will take,”says Ochs.“There are many open ends. I’d be surprised if anyone knew what it would look like in the end, and the same goes for the carbon price. It depends on the design.” Ochs gives as an example the European carbon market that dropped to almost zero per ton but has now, in the second phase, reached €20/€30 a ton, “which is now a significant price signal, so you will see political and economic results from that.” From his European experience, he also confesses that the trading venue, whether NYMEX’s new Green Exchange, or a revamped Chicago Exchange, is difficult to predict. Adam Raphaely, of TFS Energy (one of the founding partner companies of the Green Exchange), said that under a new administration some rendition of Warner-Lieberman will be proposed and it will have a stronger chance of getting through. Equally up in the air is the eventual price range. Sjardin points out valuation depends on the stringency of the caps, and on how many offset credits are allowed from outside the programme. “According to our projections it is likely to range from $20 to $50 per ton,” he said. In comparison, he points out, the European price is currently $40, which he expects to double by 2015/2020.“The world market is $64bn, of which 80% is in Europe, and that has had triple digit growth,” said Raphaely. Hence his trillion dollar prediction for 2020.

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Commodities There is no definitive estimate on how much of oil’s move higher can be attributed to speculation, but analysts and fund managers believe that speculative investment could have temporarily added up to $20 a barrel to the realistic price of oil.The rest of the increase came about because of a genuine tightness in the market. Photograph © Rolffimages/Dreamstime.com, supplied August 2008.

OIL: LONG TERM DEMAND REMAINS HIGH

Oil traders will spend this autumn glued to their screens tracking US economic indicators. They will try to gauge how badly the United States economy is faring and how this will affect energy demand. However, while the level of oil stocks held in the US, domestic retail sales, car sales and mortgage approvals will give an indication on how the biggest global consumer of oil will weather the rest of the year, the full picture, particularly a more medium or long term one, is a bit more complicated. It includes Chinese demand, Saudi supplies, hurricanes, and, for good measure, geopolitics.

LONG TERM OUTLOOK SUGGESTS HIGHER PRICES IL STAGED SOME spectacular moves this year. The New York Mercantile Exchange (NYMEX) oil futures started the year at under $90 a barrel. It then shot to $147 in July, only to crash back to $118 in the space of a matter of weeks. Although analysts say that the long term price ultimately reflects the balance of supply and demand, in the cold light of day it seems obvious that such a quick rise and fall could not have come about just because of a shortage or surplus of oil. A report by Lehman Brothers explains why oil prices reached record highs despite the fact that there probably was enough oil in the global system at the time.“The shortage of information (on key aspects of the fundamental balance, such as the amount of Saudi Arabian spare capacity, or the size of Chinese inventories) leads market observers to focus inordinately on the handful of available signals, such as weekly changes in US inventories. Markets may interpret a sharp drop in US crude inventories as a bullish statement, lending more credence to theories of supply shortages and peak oil, even though the reality may be

that global inventories are rising in places where we cannot measure them,”the report says. It adds that because of the relative illiquidity of commodity markets compared with other financial markets, large traders can create significant intraday price effects. At the same time “the anonymity of markets allows participants to potentially misinterpret an uninformed investment as a bullish move by a trader with superior information. If participants then “herd” around this investment, prices can shift to a new non-equilibrium level based on market reactions to an invalid signal,” concludes the Lehman report.

Long term demand to stay high There is no definitive estimate on how much of oil’s move higher can be attributed to speculation, but analysts and fund managers believe that speculative investment could have temporarily added up to $20 a barrel to the realistic price of oil. The rest of the increase came about because of a genuine tightness in the market. Every year, global demand for oil, steel, water and all other commodities rises by a small percentage just by

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

Commodities OIL: LONG TERM DEMAND REMAINS HIGH

Simon Derrick, head of currency virtue of the world developing further. Asian countries recently removed However, in the last few years this subsidies on oil imports which had research at Bank of New York Mellon, pace of industrial development has sheltered local prices from the moves says that “although this is still very accelerated as some of the bigger on global markets and kept them early days, there does appear to be emerging economies, such as China, artificially low. This growth will growing evidence that global India and parts of Latin America, partially offset the falling demand in inflationary pressures may be starting to abate. If this is true then this might picked up speed and became more the US, Europe and the Pacific. US demand, of which roughly 70% provide the first building blocks for a significant consumers, creating a tightness in a market in which comes from transport and about 30% more sustained recovery in the dollar from industry, has fallen markedly in the months ahead.” supplies have reached a plateau. Going forward, China and other since prices reached their recent large developing economies will heights. The Federal Highway Little new oil is coming on-line continue to be voracious users of Administration said that in May this On the supply side, increases in commodities. Economic demand are normally met by growth is a good proxy for more drilling and the oil demand growth and, developing of new fields, but according to estimates by such activity coincided with “A report by Lehman Brothers explains the Organisation of faster declines in older oil why oil prices reached record highs Petroleum Exporting fields in the North Sea and Countries (OPEC), the Russia and delays in despite the fact that there probably was economies of China and expansion projects. The enough oil in the global system at the India are expected to grow decline rate for existing fields time. “Markets may interpret a sharp by 9.7% and 7.6%, is around 20% per year, drop in US crude inventories as a bullish respectively, this year. This according to Mark Lacey, costatement, lending more credence to compares with the US portfolio manager of the theories of supply shortages and peak economy growing at 1.2%— Investec Global Energy a slowdown but not the Fund.“We are not finding the oil, even though the reality may be that recession touted by some oil any more. (Brazil’s) global inventories are rising in places market watchers—and Petrobras announced a new where we cannot measure them,” the 1.7% growth in the Eurofind, but this is nothing report says.” zone. These projections are compared with those of the roughly in line with 1960s,”says Lacey. forecasts from the In this tight global oil International Monetary market, OPEC countries Fund, which also estimates that year the number of cars on US roads have faced delays in bringing new growth in the global economy will dropped by 3.6% compared with last capacity on-line, particularly in slow down to 4.1% this year, and to year. Americans are also beginning to Algeria and in Saudi Arabia, where a use more public transport and are large project has been pushed back to 3.9% in 2009 from 5% last year. OPEC has adjusted its expectations shunning moves to the leafy suburbs the end of 2008. Also, non-OPEC slightly downward for this year’s to avoid crippling commuting costs. producers, such as the UK, Australia, The drumbeat of economic data Sudan and Kazakhstan have consumption after high oil prices started having an effect on how much from the US continues to sound a produced less than expected this year. oil is being used, particularly in the negative note, showing that the In trying to alleviate some of the US, but it still expects world demand numbers of jobless are rising, that tightness in supplies, and responding to grow by 1.1m barrels a day to defaults on mortgages one level above to political pressure from the US, average 86.88m barrels a day. China, subprime are on the rise and that the Saudi Arabia agreed in June this year the Middle East, Latin America, and economy is struggling. But there is to raise production to the highest India are likely to increase their oil one factor that will work in favour of level in 27 years, to 9.7m barrels a day. demand for the rest of this year, the US consumer, and that is the While this seemed good news at the despite the fact that a number of potential strengthening of the dollar. time (although it failed to curb prices

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

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Commodities OIL: LONG TERM DEMAND REMAINS HIGH

on the day), it put the oil industry into a fragile position. It left very little spare capacity in the system, all of which is concentrated in Saudi Arabia, the world’s largest producer. “Any industry operating at close to 99% of capacity will remain vulnerable to surprises that either boost consumption or disrupt production. Such surprises would place additional upward pressure on prices and contribute to oil price volatility,” observes the Energy Information Administration, a US government group. There is plenty of scope for surprises. August is the beginning of the hurricane season in the Gulf of Mexico, which will go on until October or early November; production in Nigeria continues to totter in and out of a crisis, with frequent rebel attacks on infrastructure and the kidnapping of oil companies’ staff; sabre-rattling between Iran and Israel and potential sanctions over Iran’s nuclear programme could also lead to reduced exports from Iranian fields. Of these, unrest in Nigeria will trump events elsewhere because Nigerian oil is a light, high quality crude which refiners prefer. Although oil companies are busy drilling for new oil across the globe, there is no quick supply solution on the horizon. If anything, they have to find ways to resolve existing problems such as rusty infrastructure and the shortage of skilled staff. “The big spending has yet to come in the industry, and big spending will be necessary to see some excess capacity in the system,”says Lacey.

Short term prices likely to decline So where do we go from here? Most analysts believe that the correction that started playing out in mid-July

still has some way to go and that oil prices will fall a little further in the near term. Again, a substantial portion of this will be speculative. The wild swings in the oil market had a not entirely unexpected side effect—they became a domestic political problem in the US and, with this being an election year, Congress started applying pressure on commodity market regulators to find ways to curb price rises. A number of hearings and proposed bills, which were mostly rejected, led to fairly small changes in market regulation, but nevertheless created the desired effect: concerns about political interference in commodity investment triggered heavy outflows from commodity index players.“In the near term it seems likely that crude oil is set to head lower and index money will probably continue to flee commodity markets. Accordingly, it will be hard for the commodity complex to prosper in the short term,” says John Reade, a commodities analyst at integrated investment services firm UBS. Also, as market players become aware that large amounts of Saudi oil will start hitting the market at the same time as the US driving season enters a slow patch, NYMEX crude speculators have positioned themselves to sell oil for the first time since February 1999. Investors in Exchange Traded Commodities (ETC) are also getting ready for a further decline in oil prices, at least short term. ETC provider ETF Securities says that total assets in its ETFS Short Crude Oil contract rose to $245m in the first week of August to one and a half times the size of the largest long energy ETC, ETFS Brent Crude. Investec’s Jonathan Waghorn and Mark Lacey, co-portfolio managers of the Global Energy Fund, say that the crude price could test levels closer to

$110 or below in the near term, but that this level will provide a natural long term price floor because the most expensive oil currently produced has a marginal cost of production of $107. It constitutes only about 2% to 3% of the total global output but if prices fall to that level, that production would be closed down. For comparison, oil can cost as little as $4 to $6 to lift out of the ground, but exploration and other costs will add anything between an additional $5 and $70 to the total expense. Medium to long term, however, oil prices are likely to continue to move higher. As oil prices decline, some of the demand in Western economies will come back on-line, consumption per capita is expected to rise in China and India, and there will be a supply requirement which will be impossible to meet over the next three to five years. This will create an investment opportunity not only in long term oil—futures, or ETCs—but also in oil equities. Oil stocks have significantly underperformed commodities, rising about 25% less than oil futures, according to Investec’s Waghorn and Lacey. They believe that some of the most interesting investments could be smaller and medium sized companies involved in various stages of the production chain, such as service providers in deep water drilling, floating storage companies and directional drilling companies. Among the big integrated producers they single out are Brazil’s Petrobras, France’s Total and Italy’s Eni. The current vogue for commodities is likely to mean that more speculative investment and commercial hedging will become a permanent fixture in these markets, giving them better efficiency and diminishing distortions. Before that happens however, oil trading will be anything but dull.

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ETFs US ETFS: DEEPENING THE US PRODUCT RANGE

Surprising though the thought might seem, exchange traded funds (ETFs) are still in their infancy, even in the United States. Institutions nurtured the US ETFs industry through its infancy and they remain big players, accounting for the lion's share of trading volume. Measured by assets under management, however, retail investors have elbowed aside the institutions in recent years. Manufacturers, financial advisors and distributors have latched on to the seemingly never ending potential of ETFs as never before. Neil O’Hara reports on a continuing trend that could feed the US investor market for years to come.

THE ENDLESS POTENTIAL OF ETFs T

HE SPREAD OF fee-based financial advice, whether from independent financial advisors or retail brokers, has fostered the use of asset allocation models to construct portfolios tailored to a particular client's needs. Financial advisors then look for the appropriate investment vehicle to deliver the desired exposure, which often includes ETFs. Retail brokers are also rolling out unified managed accounts (UMAs), which allow investors to hold mutual funds, ETFs, individual stocks, bonds, commodities and other asset classes in a single account, a powerful combination that could sustain growth in the US ETF market for years to come. It's hard to separate cause and effect, of course. The major US ETF sponsors, such as Barclays Global Investors (BGI), State Street Global Advisors (SSgA) and Vanguard, have built up sales forces dedicated to selling ETFs through financial advisors and brokers, in effect co-opting the intermediaries as a distribution channel. At the same time, the major wire houses—Merrill Lynch, Morgan Stanley, Smith Barney, Wachovia and UBS—and independent brokerdealers—Charles Schwab, Fidelity and others—have developed fee-based

platforms for financial advisors that incorporate ETFs alongside their existing mutual fund wrap accounts. The broker-dealers do not favour ETFs over mutual funds or vice versa; but by putting ETFs on their platform they allow financial advisors to choose whichever vehicle they prefer. Meanwhile, new ETF sponsors have emerged, some of which have tried to grab market share by launching products designed specifically to meet the needs of retail rather than institutional investors. The ETF market has splintered into two tiers: the broad-based products that appeal to all investors and narrower funds that track a single sector or even subsector. Of the new entrants, ProShares has attracted the most assets based on the popularity of its leveraged and inverse (i.e. short) products. Paul Mazzilli, an executive director in Morgan Stanley's global wealth management group, estimates that ProShares has captured 3.6% of US ETF assets, although it is still far behind the market leaders, BGI (51%), SSgA (23%) and Vanguard (8.3%). The quest for market share among new entrants has cluttered the ETF market with funds that have failed to

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James Ross, senior managing director at SSgA, "I put myself on a 10-year time line," he says. Photograph kindly supplied by SSgA, August 2008.

attract significant assets. Mazzilli reckons about 125 US ETFs have less than $10m in assets, far less than the $50m to $75m needed for an ETF to be profitable on a standalone basis before marketing expenses. "A couple of years ago people were just throwing anything against the wall to see what would stick," he says. The first mover always has a huge advantage in the ETF market, which encourages new sponsors to launch products whether or not investors want them. The potential payoff is enormous. "Sponsors that are first to market where there is investor demand can raise $1bn in six months," says Mazzilli. The established sponsors do extensive market research before they create a new product to ensure it fulfills an unmet need. For example, SSgA hit a home run when it launched the first global non-US real estate ETF in December 2006, the SPDR DJ Wilshire International Real Estate Fund, which attracted $993m in its first year. "If I launch a new ETF my goal is to make sure I do not have to close it," says James Ross, senior managing director at SSgA, "I put myself on a 10-year time line."

ETFs US ETFS: DEEPENING THE US PRODUCT RANGE

He also listens to feedback from investors: SSgA introduced a range of narrow sector ETFs at the request of institutional clients who wanted to break down a broad-based financials index into banking, insurance and capital markets components. Ross says SSgA has no plans to offer inverse or leveraged ETF products, which do not meet the needs of its institutional clients and could damage its brand. As a leading manager of passive investment products, SSgA takes pride in its ability to minimise tracking error. Leverage within an ETF can compound any tracking error, which accumulates over time and tends to worsen in volatile markets. "The ETF structure is not ideally suited for a leveraged investment vehicle," Ross says, "If the market goes down 10% over three months a double-long ETF is not necessarily down 20%." He notes that so far no major sponsor has offered leveraged ETFs, leaving that segment to boutiques that have less to lose if a fund does not perform as advertised. While smaller players are sometimes quick to pull the plug on products that fail to attract assets, the major sponsors will bide their time as long as they see potential for future asset growth. In June 2006, SSgA launched the KBW Regional Banking ETF, which attracted $270m by the end of that year. Assets ebbed as the credit crisis took hold in 2007, reaching a low point of just $12m before rebounding to $57m by year end, but Ross never considered closing the fund. He was right, too: Six months later, assets had soared to $600m. Despite the broad range of ETFs now available in the US, sponsors continue to find new product opportunities. Northern Trust kicked off its ETF business in April with six single country Northern Exchange

Richard Genoni, ETF product manager at Vanguard. Photograph kindly supplied by Vanguard, August 2008.

Peter Ewing, managing director of the ETF group at Northern Trust Global Investments (NTGI). Photograph kindly supplied by NTGI, August 2008.

Traded Shares (NETS) funds tied to the most widely recognised equity index in each market, such as the FTSE 100 in the United Kingdom, the FTSE/JSE Top 40 in South Africa and the DAX in Germany. Subsequent launches added another nine country funds by mid-June and the products had attracted $55m by mid-August, according to Peter Ewing, managing

director of the ETF group at Northern Trust Global Investments (NTGI). NTGI has hired experienced sales and marketing staff to get word of the NETS products out to existing and potential clients. Ewing says education is critical to success. His team has already encountered people who still don't know what ETFs are as well as established users interested in new products. As a relative latecomer to the ETF party, Northern Trust has made a big commitment in order to elbow its way into the crowd. "We believe ETFs are most often not merely bought but also sold and distributed," says Ewing, "Our ETF business is aimed not just at the captive audience of Northern Trust's existing clients but to earn the business of outside financial intermediaries." Established sponsors are not standing still, of course. In May, PowerShares introduced an ETF of ETFs, bringing the fund of funds concept to the ETF market for the first time in balanced investment vehicles designed to offer specific levels of risk. Ross sees potential for adapting the structure to target date ETFs, a product SSgA is already working on. In a similar vein, BGI has teamed up with Upromise Investments, a leading administrator of tax-advantaged college savings plans, to offer the iShares 529 Plan, which uses iShares ETFs to create portfolios based on either a child's prospective year of enrollment, a desired risk profile, or a customised option that lets investors pick their own allocations among domestic and international equities; real estate; and fixed income. If BGI's move into college savings accounts succeeds it could be a harbinger for the broader tax-deferred retirement savings market, including individual retirement accounts and 401(k) plans, a goal that has long eluded ETF sponsors. Obstacles abound, however, and Richard Genoni,

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ETF product manager at Vanguard, remains sceptical. "Bid-ask spreads and commissions on nominal investments that happen on a frequent basis will eat away at the returns," he says, "ETFs are generally less appropriate for 401(k) plans than traditional mutual funds." In addition, the entire infrastructure of 401(k) plan administrators was built around mutual funds that trade once a day; it cannot handle continuously traded products like ETFsâ&#x20AC;&#x201D;and low-cost ETFs don't generate a revenue stream to pay for the technology upgrade required. Genoni sees a more promising future market in direct retail investors who buy ETFs for their own account without the assistance of a financial advisor. Relentless media coverage combined with sponsors' efforts to educate investors about the merits of asset allocation using ETFs are beginning to bear fruit, although Genoni cautions that investors need to consider the risks, especially if they are buying narrowly-based products. "Niche ETFs are typically used to make tactical bets in the market, so client portfolio turnover is likely to increase," he says, "This can lead to both higher capital gains and increased trading costs." As a low-cost provider of mutual funds, both active and passive, direct retail has long been a core constituency for Vanguard. The firm has a structural advantage in the ETF market, too. Its products are a separate share class of existing mutual funds, so new ETFs have an established track record when they are launched. "We can show investors how well we have performed against the underlying index," says Genoni, "But that needs to be followed up. It's about bringing a great product to market and supporting it with education." Vanguard has no plans to introduce niche products but will look

Bruce Bond, chief executive office of InvescoPowerShares, agrees that retail investors will drive ETF asset growth for the next few years, but he expects the predominant inflows to come through financial advisors as UMAs are rolled out in the US and elsewhere. Photograph kindly supplied by Invesco, August 2008.

for opportunities to launch additional broad-based core ETFs that appeal to a wide range of investors. Bruce Bond, chief executive office of InvescoPowerShares, agrees that retail investors will drive ETF asset growth for the next few years, but he expects the predominant inflows to come through financial advisors as UMAs are rolled out in the US and elsewhere. The UMA structure means investors no longer need separate accounts if they want to own both ETFs and mutual funds in their portfolio. Although ETFs and mutual funds are often portrayed as rivals for the same investment dollar, Bond believes they complement each other. "We believe that a significant amount of the assets we see are not coming from mutual funds or separately managed accounts (SMAs)," he says, "People who would normally acquire a portfolio of individual securities in order to gain

FTSE GLOBAL MARKETS â&#x20AC;˘ SEPTEMBER/OCTOBER 2008

exposure are just buying the ETF, especially in the narrower segments." The mutual fund industry is not about to disappear, after all. The Investment Company Institute reports mutual funds had $11.7trn in assets under management in June 2008, 20 times the $578bn in US ETFs. The ratio is falling because ETF assets are growing rapidly from a low base, but BGI isn't about to put Fidelity or American Funds out of business. Nevertheless, the traditional mutual fund managers are no doubt aware that among the five asset managers who attracted the largest net inflows in 2007, three had ETF businesses: BGI, SSgA andVanguard. "The mutual fund managers face a conundrum," says Bond, "ETFs are attracting significant assets, but if they offer these products their ETFs might compete directly with what they already have." Bond believes that in the next few years inflows to ETFs could exceed the amount gathered by mutual funds, a development likely to prompt a response from mutual fund managers. If Fidelity and others do decide to offer ETFs, their formidable marketing muscle could ratchet up the growth in ETF assets another notch. One mutual fund manager, Vanguard, has already demonstrated the potential; it is already the third largest sponsor ETFs in the US. Morgan Stanley's Mazzilli notes that while ETFs may have cannibalised part of Vanguard's traditional business, the products have opened up new distribution channels through broker-dealers and other intermediaries who had not used Vanguard mutual funds before. "Compared to the mutual funds business ETFs are only in the third inning," says Mazzilli. The US may have more experience with ETFs than any other country but even there it is still early in the game.

Country Report IS ICELAND’S RISK OVERBLOWN?

BANKS NOW EQUIPPED TO WEATHER ANY STORM With the turbulence in global markets, regional risk profiles on all but the safest of assets have heightened. Iceland is no exception. This has been reflected in the cost of insuring Icelandic bank debt against default which reached near record levels this year. Moreover, a number of ratings agencies have gradually adjusted the credit ratings on Iceland’s banks downwards. Market analysts cite Iceland’s exposure to long term debt in external markets, large macroeconomic fluctuations and the potential onset of recession to justify the rise in the sector’s risk profile. Nevertheless, an increasing number of Icelandic and international analysts now contend that Iceland’s risk perception has been overblown. From the banking sector’s perspective, they argue that on top of well diversified funding they also exhibit strong liquidity, sound profitability and robust asset quality, meaning default is very unlikely in the near future. Has Iceland therefore become the victim of a speculative run; or are markets fair to caution investors? Julia Grindell reports.

Following consolidation in the sector throughout the 1990s it made sense for Iceland’s banks to go abroad to maintain growth trajectories,” explains Kristjansson, who’s Landsbanki now operates in more than 17 countries, predominantly in northern Europe.“Although we have embarked on a number of albeit small acquisitions, we have then been successful in growing these operations organically,” he says, adding that Iceland has benefited from the availability of affordable funding over the last few years to ramp up expansion plans. Photograph © Bram Janssens/Dreamstime.com, supplied August 2008.

a reflection of credit risk. The high spreads mean traders were paying €1m per year to insure €10m of each bank’s debt over five years, more than double the price two months ago. A year ago, they paid €30,000. “Credit default swaps as high as these

would suggest a very high probability of default and seem somewhat exaggerated,” says Louise Lundberg, credit analyst at Standard and Poor’s, referring to the low level of defaults within Iceland’s banking system. “It seems to be more of a question of

REDIT DEFAULT SWAPS (CDS), contracts between two parties to insure debt against default, hit 1,000 basis points on two of the major Icelandic banks Kaupthing and Glitnir in July this year. Investors follow CDS spreads as

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perception,” adds Halldor Kristjansson, of the negative backlash such fast Iceland an obvious target for market chief executive officer of Landsbanki growth has had on the sector and watchers to hike its risk profile during and chairman of the Icelandic Financial market perceptions. “Iceland’s banks global market turmoil. “[However] I Services Association.“For some reason, have been particularly aggressive with think Iceland should in fact be markets see that Iceland is somehow their growth when compared with complimented on how well [it is] more risky than its peers in the Nordic their Nordic counterparts. Such rapid standing up to the challenges in the region,”he says.“It could be to do with expansion by such a small nation global market,” he adds, citing the the size of the banking system relative means Iceland has been heavily sector’s strong liquidity position as a to Gross Domestic Product (GDP), but reliant on external funding to support result of a mini crisis back in 2006. Kristjansson explains how the mini there is a perception that there is too this growth,” she says. Thordur crisis came about, following much reliance on the banking a sovereign ratings fall to system in the economy.” outlook negative early in The nation of a mere “For some reason, markets see that 2006. “During this period, 300,000 is home to a highly ratings agencies claimed concentrated banking market, Iceland is somehow more risky than its Iceland was suffering from a with Kaupthing, Glitnir and peers in the Nordic region,” says high level of debt and Landsbanki controlling about Halldor Kristjansson, chief executive warned of the impact this 90% between them. These officer of Landsbanki and chairman of may have if there was no banks have a strong focus on the Icelandic Financial Services contraction in capital flows investment banking and to the Icelandic banking capital markets related Association. “It could be to do with the system,” he says. “In earnings, although they all size of the banking system relative to addition, there were also offer universal banking Gross Domestic Product (GDP), but fears about the increased products and services. there is a perception that there is too leverage of Iceland’s system “Following consolidation in much reliance on the banking system as a whole and international the sector throughout the in the economy.” critics were worried about 1990s it made sense for the high levels of Iceland’s banks to go abroad dependence on foreign to maintain growth trajectories,”explains Kristjansson, who’s Palsson, managing director of credit and its low levels of deposits. Landsbanki now operates in more than business development at Kaupthing, The crisis of 2006 therefore triggered a 17 countries, predominantly in northern the seventh largest Nordic bank, adds number of discussions on growth and Europe. “Although we have embarked how “one of the reasons people are funding from international capital on a number of albeit small acquisitions, sceptical about this is because they see markets which led us to strengthen, we have then been successful in growing this fast growth and consider these and in some cases amend, our these operations organically,” he says, loans to be unseasoned and therefore business models.” Kristjansson explains that the talks adding that Iceland has benefited from more risky. They wonder whether it is the availability of affordable funding possible to grow so quickly without prompted Iceland’s banks to diversify over the last few years to ramp up increasing risk too.” He points out, their funding, shifting from capital expansion plans. “The number of however, that a large part of the markets to focusing on deposit operating units run by Icelandic financial banks’ asset growth has been through growth, as well as adopting more companies has more than doubled to 60 acquiring well seasoned operations in liquidity in order to reduce their northern Europe and the UK. overall market risk. “We also realised units since 2005,”he explains. As a result, the financial sector has Nevertheless, the extent of borrowing we had to work harder to better grown more than any other sector in has left the nation the most leveraged communicate our liquidity position and increase transparency,”he says. Iceland over the past decade. In terms in Nordic Europe. “This really was a fire drill for the Stefan Sigurdsson, managing of the banks’ total assets, these represented 96% of GDP in 2006 and director of strategic development at situation today,” adds Glitnir’s today represent around nine times Iceland’s Glitnir bank, comments how Sigurdsson. “In fact, we believe that GDP. Nevertheless, Lundberg warns this high leverage position made compared to other countries, Iceland

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

Country Report IS ICELAND’S RISK OVERBLOWN? Stefan Sigurdsson, managing director of strategic development at Iceland’s Glitnir Bank, comments how this high leverage position made Iceland an obvious target for market watchers to hike its risk profile during global market turmoil.“[However] I think Iceland should in fact be complimented on how well [it is] standing up to the challenges in the global market,” he adds, citing the sector’s strong liquidity position as a result of a mini crisis back in 2006. Photograph kindly supplied by Glitnir Bank, August 2008.

is very well prepared when it comes to dealing with the credit crunch because of the turbulence in 2006. We were also fortunate enough to have no direct exposure to sub prime or any related products.” As a result of this increased liquidity position, the banks claim they have enough equity to survive the next 12 months without the need for external funding. In addition, Iceland’s banks have reduced short term growth ambitions, which will likely reduce funding needs

and support their strong liquidity position. This was reflected in Kaupthing’s recent withdrawal from an acquisition of the Netherland’s merchant bank NIBC in January. “As market conditions deteriorated we changed our minds on the acquisition of NIBC. We came to a decision for both parties to relinquish the prior acquisition agreement,” explains Kaupthing’s Palsson. “This was a positive decision considering market conditions, and it helped boost our

liquidity position given that this capital had already been freed up for the deal.” Kristjansson adds how Landsbanki will also refrain from making big acquisitions for now and instead concentrate on consolidating operations across the region and increase cross-selling activities this year and next. “We won’t grow more until the turmoil in capital markets calms down,”he says, adding how the bank has also been working to diversify its funding needs to support liquidity and reduce their reliance on external funding. “There has been an increased emphasis on deposits, particularly outside of Iceland, and these yielded good results in 2007 and substantially boosted our liquidity position,” says Kristjansson, citing the success of its Icesave high interest savings product which was launched into the retail market towards the end of 2006. Second quarter results revealed the bank’s strong liquidity position with liquid assets amounting to €7.8bn at the end of June 2008. In addition, like Landsbanki, Glitnir has been boosting its deposits with the launch of an online savings platform for its clients across Europe. Nevertheless, despite aggressive growth and strong liquidity positions within the banking sector, analysts are predicting a rapid slowdown in Iceland’s economy and its impact on the sector. In addition, Iceland suffers from vast fluctuations within the market and this poses a challenge for any business operating in the country. “Although Icelandic financial institutions benefit from operating in a flexible, highincome, rapid-growth economy with favourable demographics, they have to cope with unusually large swings in economic growth, exchange rates, and interest rates. Following a vigorous upturn between 2004 and 2007 we now see growth to remain negative until

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

2010,” says Standard and Poor’s the future. The International Monetary that a major challenge will be Lundberg, citing the Icelandic Kroner’s Fund, for example, has concluded that refinancing Iceland’s long term debt, depreciation of almost 30% since the the long term economic prospects of “nevertheless, we have been dealing beginning of the year and inflation which the Icelandic economy remain enviable. with that in various ways in terms of “And after all, Icelandic banks still increasing deposits and asset backed now stands around 12%. However, Sigurdsson says:“There is remain profitable,” notes Sigurdsson. borrowing, as well as slowed growth, a higher tolerance for currency “The results for the banking sector for and as we go through this adjustment fluctuations and inflation in Iceland 2007 and the first quarter of 2008 were period we have to reassure investors,” because we are a small open economy good even in comparison to their he adds. A number of ratings agencies have which has historically demanded Nordic counterparts, despite worsening flexibility.”In addition, Iceland’s banks conditions on international financial carried out a series of stress tests on have mitigated the risks arising from markets,” he says. Landsbanki, for Iceland’s banking sector that show volatility at home by continuing to example, posted a pre-tax profit for the that, although it faces challenges, it diversify revenue streams first six months of this year of IK31.1bn will likely stand up to the turmoil in geographically. “What is often (€285m) and an after tax profit of global markets. Kimmo Rama, a senior analyst from overlooked in Iceland is that Moody’s EMEA banking around 60% of our banking team, comments:“Although business is outside of the “There is a higher tolerance for Icelandic banks have had home economy. Therefore, no direct exposure to the although the banking system currency fluctuations and inflation in sub prime market, their is relatively large in Iceland, Iceland because we are a small open rapid loan growth, resulting the majority of this is economy which has historically in unseasoned loan operated abroad,” says demanded flexibility,” says Stefan portfolios and loan Kristjansson. Landsbanki’s Sigurdsson, managing director of concentrations, is still a core income from operations strategic development at Iceland’s concern.”However, he goes outside of Iceland amounted on to add that after carrying to IK33.9bn (€310m) during Glitnir bank. out comprehensive stress the first half of 2008, which is tests, the three commercial equivalent to 59% of group core income. Similar trends are seen in IK29.5bn (€270), up 12% from the same banks’ liquidity profiles are sound to both Glitnir and Kaupthing, the latter period last year. In addition, return on strong, thanks to which they have of which derived 65% of its €451m in equity remains high across the three been able to withstand volatility in the operating income from outside of banks, ranging between 19-27% in international capital markets over the Iceland in the first quarter of 2008, 2007. There has also been a shift away last several months. “Slower growth from capital markets-related operations ambitions this year will also likely with 32% coming from the UK. In addition, Iceland will be sheltered towards core operations.“Over the past reduce their funding needs,”he adds. Lundberg contends that CDS values to some extent by the external market year, Iceland’s banks have increased downturn because its economy is their focus on core operations and attributed to Iceland’s banks were hiked anchored in some sectors which have reduced the percentage of non-core up as a result of investor sensitivity not been negatively impacted, explains income in their results,” explains during the current climate. “This Kristjansson. “Iceland is focused on Kristjansson, and this was represented sensitivity could partly reflect a country food production, in the way of marine in the bank’s core income which was up risk premium, than an indication of the products such as fish, and technology 32% from the same period a year earlier. economic and financial fundamentals of “As for almost every bank in the the banking sector,” she says. All in all, and environmentally sustainable power however, the current defaults were at an all time low at the generation. New power intensive world, projects have increased Iceland’s export environment is still challenging,”adds beginning of the year, adds capacity and will facilitate ongoing Sigurdsson. “However, we have put Kristjansson. “The fundamentals of the economic adjustment,” he says, adding several proactive initiatives in place to Icelandic banking system are sound and how both industries also offer strong manage through the current market well equipped to meet turbulence on growth potentials in global markets in environment.” Kristjansson supports the financial markets,”he concludes.

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

Country Report CAN KAZAKH ISSUERS MAKE A COMEBACK?

Joint Stock Company Halyk Savings Bank of Kazakhstan came to the market in late August with a $200m syndicated term loan facility, which according to market watchers was oversubscribed. The facility will be used for general financing purposes, including mainly trade finance business underwritten by Halyk Bank. In reality though, the deal signifies so much more. After a prolonged period in the financial wilderness, issuers have been testing investor appetite for Kazakh risk since April, with success. Is it now time for Kazakh issuers to come into their own once more?

THE BOYS ARE BACK IN TOWN RRANGED BY BNP Paribas, ING Wholesale Banking (ING), Landesbank Berlin AG (LBB), Standard Bank, UniCredit Markets & Investment Banking and WestLB AG, London Branch, Halyk Bank’s $200m syndicated loan facility in late August appears to have marked a watershed for Kazakh issuers. The facility is structured as a one-year term loan with an extension option for another one-year period with a bullet repayment, carrying a margin of 1% each year and builds on Halyk Bank’s re-emergence in the global capital markets. Once the darling of the Eurobond and syndicated loan market, Kazakh issuers hit a wall in 2007 as Moody’s downgraded the country’s risk and adverse perception of local banking liquidity almost crippled the country’s banking sector. The three largest banks, Kazkommertsbank, BTA Bank and Halyk Bank, account for more than 60% of assets. The sector however, depended heavily on international borrowing at low rates to finance exports and a local consumer and housing boom. Once

Fitch downgraded the country’s banks, having questioned the quality of bank lending, the industry dipped temporarily into a spiral, as nervous depositors moved substantial funds out of the main banks. The slide was stopped only with decisive central bank intervention; ploughing funds into each of the main banks and gradually restoring confidence in the sector. Kazakh banks too were quick to respond, in some cases overhauling and rebranding their franchises and introducing tighter credit controls. However, with problems at home coinciding with the emergence of a world wide credit squeeze in the summer of 2007, Kazakh banks faced severe difficulties accessing the international capital markets for well over a year. The worst is now over, with the growth in bank deposits resuming steadily since November last year, and even accelerating as of March this year, according to local bank reports. In the event, just over one year later, a number of issues in early April began to set a new pace of investor interest.

Photograph © Vassily Mikhailin/Dreamstime.com, supplied August 2008.

Halyk Bank’s London-based subsidiary HSBK (Europe) B.V., cautiously led the way, placing a $500m benchmark bond offering, available to institutional investors both inside the United States (in accordance with Rule 144A) and internationally. The bond, which was guaranteed by Halyk has a bullet maturity on the 16th October, 2013 and bears a coupon of 9.25% pa. The bond was priced at 98.948% to yield 9.5% pa and was in line with initial price guidance. Either illustrating the paucity of returns of this magnitude elsewhere in the market, or whether there is sustainable and renewed appetite for Kazakh risk, given the level of its hydrocarbon resources, the deal was well received in the market. The bond was sold mostly to investors in the US (65%), the UK (24%), Europe (8%), Asia (2%), and Switzerland (1%), with the largest portion being taken by asset managers (84%). The offering was the first public Eurobond from a bank in Kazakhstan and it the first public transaction for a private sector CIS bank since July, 2007. JPMorgan

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

Country Report CAN KAZAKH ISSUERS MAKE A COMEBACK?

and UBS were joint lead managers and bookrunners. In the same month, a marker of sorts was also set down by BTA Bank, now Kazakhstan’s largest bank, which repaid a $100m bond at the request of its holder, which exercised a put option. BTA Bank then immediately issued a new bond for the same value, in a transaction managed by Barclays Bank. In July, BTA Bank paid off a second tranche worth $63m of a $200m Islamic loan, issued in 2006, at a margin of 70bp. Calyon Bank and Abu Dhabi Islamic Bank acted as mandated lead arrangers of the deal and consulted BTA Bank on Shariah and Mudarabah principles. The first tranche, worth $137m, carrying a margin of 40 bp was repaid in July 2007. In a further positive move, in July Fitch Ratings announced an uplift in the long-term issuer default rating (IDR) of OOO BTA Bank, a JSC BTA Bank Russian subsidiary, from B- to B+. At the same time, the issuer’s sovereign rating has been upped toAwith a stable outlook. The bank’s other ratings have been affirmed at B for the short-term IDR and at D/E for the individual rating. The ratings agency says the two-notch uplift has been due to the successful completion of the purchase by BTA Bank Kazakhstan of more than 52% of shares in BTA Bank Russia. The previously assigned “no support” rating of the long-term IDR support has been withdrawn now that BTA Bank Russia is majority-owned by BTA Bank Kazakhstan, is about to become fully consolidated into the latter’s reports and may count on full support from its institutional owner. The tentative steps appear to be paying off. At the end of August, banks were set to ink a three year, $2.5bn facility for KazMunayGas (KMG), which opened in late June and closed at the end of July. The deal was

oversubscribed, but will be signed for the launched amount, following scalebacks. ABN Amro, Bank of Tokyo Mitsubishi UFJ, Barclays Capital, Credit Suisse, Deutsche Bank, SMBC, Société Générale and WestLB are mandated lead arrangers. The facility amortises in two years and pays a margin of 155 basis points (bp) over Libor and lenders were offered tickets of $200m for 100bp, $100m for 85bp, $50m for 70bp and $25m for 60bp. The proceeds will be used for refinancing purposes. The issuer is rated Baa1 by Moody’s and already has two debt issues outstanding worth a combined $3bn. Such a renewal of confidence in the risk rating of Kazakh issuers is not surprising. The country is one of Central Asia’s rising stars: mineral rich, and benefiting from rising commodity prices. Annual economic growth is on or near 10% and has been consistently so for the last decade. Gross domestic product (GDP) rose by almost 500% between 2001 and 2007, by far outpacing the growth rates of its Central Asian neighbours. While the economy has benefited from rising commodity prices, the global credit crunch and the prolonged stop in lending to the country’s bank’s through 2007, adversely impacted local infrastructure growth; with the construction and manufacturing sectors affected the most. As a consequence, GDP growth is likely to slow to 5% this year, before rising to 6.3% or above next year. The Kazakh economy has benefited from the rising oil, gas, zinc and gold prices; allowing the government some degree of intervention in the economy. Using central bank reserves, the government injected some $4bn in the construction industry and small businesses to provide a fillip to business growth and encourage diversification in the local economy.

At the end of the day, however, foreign investor interest in the country remains firmly set in the energy sector, particularly in the eastern oil fields. Kazakhstan has the largest oil reserves outside the Middle East, projected at about 100bn barrels, according to government estimates. Proven oil reserves stand at 32.5bn barrels, with the Tengiz oil field being the country’s largest. It is however the Kashagan oil field in the Caspian Sea that attracts most investor attention, as it is the largest deposit discovered in the past 30 years with a projected output almost as large as that of Saudi Arabia’s Ghawar field. Production was scheduled to begin in 2005, but has been delayed to end 2011 as the international consortium led by ENI, which operates the field, has faced various technical problems in opening it up. Frustrated by the delays, the government came down hard on the consortium, requiring it to pay $5bn in compensation to cover cost overruns and project delays. Moreover, local press reports say that the consortium has also had to stump up 5% of profits, even while costs incurred by the exploration teams have yet to be recovered. Moreover, the government has doubled its equity stake in the project to 16.8%. In spite of the lashing the consortium has suffered, it remains consoled by the potential of the field. Kashagan’s peak output is estimated at 1.5m barrels per day; well above the country’s current production volume. Kazakhstan’s gas reserves are also impressive, with proven reserves of 3trn cubic meters and projected reserves estimated at 5trn cubic meters, according to government data. Kazakhstan is also among the world’s largest uranium producers, with a yearly production rate of more than 5000 tonnes.

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

Company Report

HAS MIDAS LOST THE GOLDEN TOUCH? Eike Batista rapidly turned himself into one of the most respected and feared entrepreneurs in Brazil. He sealed this reputation when he listed OGX, his energy business, in what was Brazil’s largest ever initial public offering (IPO) in January this year. His sprawling commercial empire is starting to compete head-on with some of Brazil’s best established companies, including giant mining company Vale and oil firm Petrobras, and Batista is not short of further big plans. However, the emergence of recent allegations of corruption threaten to undermine his reputation, have hit shares and may limit growth. Meanwhile, longer-term government intervention in oil and gas and mining is stoking further investor uncertainty. John Rumsey reports.

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

EIKE BATISTA FIGHTS TO CLEAR HIS NAME

Brazilian billionaire Eike Batista smiles during a news conference in Rio de Janeiro, Brazil in February this year. At the time the photo was taken, MPX Energia SA, the energy company controlled by Batista, was seeking to develop solar energy projects in Brazil and other Latin American countries. Photographer: Douglas Engle/Bloomberg News /Landov; supplied by PA Photos, August 2008.

N UNKNOWN COMMODITY outside of his homeland until recently, Brazilians have long known Eike Batista. He was first noted in circles as the playboy son of a famous businessman (his wellrespected father had been at the helm of what was then a state-owned company, the miner Vale do Rio Doce) and an entrepreneur with a colourful history. Later, a far-wider public became familiar with him when he married telenovela star Luma de Oliveira and many closely followed the subsequent divorce. More recently, he has been enjoying his moment in the sun with papers dubbing him the man with the Midas touch. However, recent allegations may have taken the sheen off his golden reputation and questioned his past track record as a businessman. Batista is, if nothing else, prolific and having seen more than his fair share of both success and failure. Past ventures include a cosmetics company and a start-up jeep manufacturer. Between 1986 and 2001, he held senior positions at TVX Gold Inc., as well as some 10% of the stock. Shares more than tripled in value under his management, but the Greek high court forced TVX to close mines, after villagers near the mine rioted and the court ruled the mines were environmentally unsustainable. Shares in TVX consequently collapsed and Batista resigned. The memory of TVX has long been relegated to the distant past and Batista has proved highly successful in subsequent ventures, proving himself both as a serious operator with a sure entrepreneurial touch. Supporters see him as an audacious success and a symbol of an emerging, confident Brazil. They say that by implementing his ideas, he is shaking up the cosy world of Brazilian business and giving opportunities for the very best staff; a meritocracy in action.

Company Report EIKE BATISTA FIGHTS TO CLEAR HIS NAME

His business model of dangling huge remuneration packages for executives who perform well has seen him attract many of Brazil’s best and brightest from stodgier state companies. He certainly has a knack of spotting and selling ideas in natural resources and doing so in an impressively short timetable. Investors signed up for shares in his OGX business before it brought up a drop of oil. However, success breeds resentments and Batista is admired and disliked in equal measure. Critics say investors have been fooled by his effortless selfconfidence and that his empire has done so well only because it is focused in fashionable sectors such as oil and gas and commodities that have taken off globally. His companies lack any track records, and are being sold before there is any proof they can perform. It is only a question of time before the Emperor is found to have no clothes, they allege. Furthermore, they say initial success came in large part from his advantages in having a father who could cut through Brazilian red-tape, particularly in obtaining licenses. There are also allegations of shoddy work on environmental licensing and indigenous rights; points yet to be proven. Critics now have a further stick with which to beat the entrepeneur. Allegations of corruption (also as yet unproven) have emerged. July proved a tough month for him. The Federal police announced that they raided the offices of his mining company MMX in

company OGX, which raised $4bn when it was launched as an IPO on the local stock market and briefly flew, has since nosedived. Shares were up over 8% on the day and at one point OGX reached a total valuation that made it worth close to as much as 8% of Petrobras. Since then they have fallen off by more than 50%. There are signals that things may get trickier for Batista over the long term too. The government is contemplating new legislation in a number of areas that have the potential to hurt his businesses, including tighter environmental legislation for the development of ports and changes to the oil and mineral tax regimes. One of the key difficulties for Batista is the inter-relation between his businesses and their dependence on his oversight. His holding company, EBX, holds shares in a number of subsidiaries which he has been rapidly taking public. OGX may be a stand-alone business, but Batista’s mining firm, MMX, which mines principally for iron, has power supplied by his energy company MPX, and is partly helped to reach its destination through LLX, his logistics business. The power and logistics businesses have been bolted on to compensate for Brazil’s notoriously poor supporting infrastructure, with Batista recognising that it is better to generate your own power and ship out through your own ports than rely on Brazil’s erratic and over-burdened systems. His business model, too, looks more difficult to pull off in current riskaverse conditions. Typically, he uses his own capital to get a business off

One of the key difficulties for Batista is the inter-relation between his businesses and their dependence on his oversight. His holding company, EBX, holds shares in a number of subsidiaries which he has been rapidly taking public. OGX may be a stand-alone business, but Batista’s mining firm, MMX, which mines principally for iron, has power supplied by his energy company MPX, and is partly helped to reach its destination through LLX, his logistics business. Photograph © Oxlock/Dreamstime.com, supplied August 2008.

the states of Amapá and Rio de Janeiro with warrants to search the premises and take away documents related to alleged fraud. The police operation, dubbed Midas, alleged illegal activity related to a contract for the licensing and concession of a railway contract in the state of Amapá. MMX strenuously denies any wrongdoing related to this or a further accusation concerning unlicensed gold mining activities in the state. The firm has promised to cooperate fully with any future police investigation and with the Federal judge of the region and up to now there have been no criminal proceedings against executives of the group. However, since the raid a slew of other allegations have been swirling in the media, including charges of bribery and even a connection with Brazilian banker Daniel Dantas, who currently faces charges of alleged corruption and attempts to divert the course of justice. The police raid and rumours have hit the share prices of Batista’s companies hard. The share price of MMX’s sister

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

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Company Report EIKE BATISTA FIGHTS TO CLEAR HIS NAME

the ground and then sells it on to may award licenses to explore only business MMX with some of its key investors, either in the form of an IPO, on a shared basis, where the state mining assets (a 51% interest in the when markets permit, or to strategic continues to be the owner of the Minas-Rio iron ore project and 70% investors when that is more attractive, resources and the exploring oil interest in the Amapá iron ore project). and in some cases both. In addition to company is awarded a cut of The problem is that the recent brouhaha selling a stake in OGX, he has brought revenues. The minister of mines, over the Federal police investigation MMX public with an IPO and sold Edison Lobão, is producing a report into the MMX railroad has spooked parts of the same business to Anglo on the matter soon. The moves are Anglo, which has been seeking to delay American for $5.5bn. Batista was unlikely to alter current contracts, but the deal until there is more legal clarity on the issue of the railroad concession recently planning to launch IPOs for could hurt expansion plans by OGX. and how it might affect MMX IronX, part of the MMX business in Amapá. business which is being Finally, Batista’s logistics dismembered after the OGX may be a stand-alone business, business LLX faces the Anglo American deal, and but Batista’s mining firm, MMX, which possibility that even privatehis logistics business LLX. sector operators will need to Batista constituted OGX mines principally for iron, has power apply for licenses. Batista has in July 2007 and brought it supplied by his energy company MPX, protested vociferously against to the capital markets a and is partly helped to reach its this measure. That is partly year later. As with most of destination through LLX, his logistics because environmentalists and his ideas, it was a business. The power and logistics indigenous rights’ groups have recognition that the time been fighting hard against his was right for an oil businesses have been bolted on to development plans for a port business in Brazil and the compensate for Brazil’s notoriously poor on the coast of Rio de Janeiro hunch proved correct. supporting infrastructure, with Batista state which threaten to displace With oil prices heading recognising that it is better to generate Indian settlements and are through the roof as a your own power and ship out through located near a marine park. secular change in the your own ports than rely on Brazil’s All this negative news flow supply-demand balance could jeopardise what is said takes place, investors were erratic and over-burdened systems. to be one of Batista’s more prepared to pay a large cherished plans, the premium to get their It also seems clear that OGX will not launching of a fund to invest in hands even on the promise of oil. At the same time, Brazil has woken up to be able to compete with Petrobras in natural resources, which may be paid find itself the holder of massive oil what promises to be the holy grail of for through an IPO of the holding reserves, drawing massive investor Brazil’s oil business, the deep water company, EBX, whose value is hard to interest in the country. Once he had reserves. These are buried under a salt measure. EBX has grown through an decided to start up an oil company, layer and require some of the most opportunistic assessment of where Batista went about assembling the best advanced extraction techniques in the Brazil’s best next opportunities will possible team he could and took an world. Petrobras was taken by surprise in emerge and any offering would be ex-president of Petrobras as well as the last bidding round in shallow waters highly contingent on his reputation. There is plenty to play for as Brazil’s when OGX walked away with the lion’s key geologists and engineers. However, things have quickly gone share of licenses, however the state giant commodities and oil boom continues sour. It is by no means all Batista’s will be better prepared in future rounds. to gather ground and a possible IPO of Batista’s other cornerstone business, Batista’s holding company might elicit fault. The price of oil has shuddered into reverse for now with the global minerals, is also being undermined. The massive interest. However, Batista will economy rapidly slowing. The threat sale of a $5.5bn stake to Anglo need to clear his name thoroughly for of government tax increases is American has been hanging in the foreign investors to return with the hurting the sector too. It is possible balance. Anglo had offered $5.5bn for a same appetite to his businesses. For that royalties will simply be 63.6% shareholding in a new company now, he is struggling to maintain the increased. Alternatively, the state that was to be de-merged from mining disparate parts of his empire.

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

IN THE MIDST OF PLENTY Adel El-Labban, group chief executive officer and managing director, Ahli United Bank. Photograph kindly supplied by Ahli United Bank, August 2008.

Shares of Ahli United Bank made their biggest one-day gain in more than three months in early August on media reports the Bahraini bank was in merger talks with National Bank of Abu Dhabi. In the event, Ahli United made a formal statement to the Bahrain bourse that the speculation was unfounded. Nonetheless, rumours tapped into the banking sector zeitgeist in the Gulf Cooperation Council (GCC) region: namely that the region’s major houses are on the acquisition trail and two that Ahli United has been making a bigger splash in the wider region. Francesca Carnevale went to Manama to find out the drivers behind the bank’s business strategy.

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

HE OUTWARD APPEAL of Ahli United Bank (AUB) and its peers in the world’s biggest oil-exporting region is obvious: having benefited from a sixfold rise in oil prices since 2002 an expansion of business confidence, geographic spread, new product development and lending is a given. In similar vein to its peers, Ahli United has also emerged relatively unscathed from the rough winds shaking the darling banks of western economies.“Relatively is the operative word,”cautions Ahli United’s Adel El-Labban, group chief executive officer and the bank’s managing director.“It is not accurate to assume the GCC works only to its own dynamics. Clearly we are influenced by what is happening in the broader world and by the global nature of the banking industry. While we have perhaps felt a lesser impact because of the high tide of oil prices and infrastructure spending, we have not been immune to the liquidity situation elsewhere. Spreads have widened across a wide berth of activity and most obviously our cost of funding has been affected by events.” Even making banking profits in the midst of plenty, according to El-Labban, has its own peculiar challenges; he claims it is a business not for the fainthearted. Is it not a given that banks in the GCC are enjoying plentiful and equal opportunity to leverage the region’s growth? It is, holds ElLabban something that you have to work at. He cites the example of a typical blue chip GCC corporate, for which the cost of finance has now tripled. “Before the crisis top

COVER STORY: AHLI UNITED: A BIGGER SPLASH

PROFITS

COVER STORY: AHLI UNITED: A BIGGER SPLASH 48

corporations were looking at funding costs of around 40 to 50 basis points (bps) at senior level; now it is 120bps to 180bps or higher.”Ahli United itself has not been immune.“Spreads have widened considerably for leading international banks, larger in size than AUB or as any other regional banks. Has our credit risk widened to the same extent? Absolutely not; however, because we have a similar rating we also pay a higher costs for our money. Moreover, the liquidity crisis has impacted the depth and duration of the interbank market.” Equally, assumptions that the GCC infrastructure is awash with liquidity and therefore local banks are enjoying a project financing bonanza are somewhat wide of the mark.“Countries in the grouping receive approximately $2.5bn in hydrocarbon revenues per day. While there are massive infrastructure and industrial projects in the pipeline, and leaving aside regional financial resources, the financial planning behind the projects always assumed a level of foreign bank intervention, in terms of project financing expertise and funding capacity,”notes ElLabban. With the reduced appetite for risk among global banks, he says:“the implications are that either, governments inject more equity for projects; or the project will be phased over a longer period.” There are other dynamics at play, with long term consequences for the structure of the local banking community. “Incoming energy receipts are not being deposited regionally. Revenues and accumulated reserves are at staggering levels, but the impact on the region itself is not proportionate,”explains El-Labban. He cites the example of a hypothetical $1bn power station. “Invariably, capital goods are imported, which will eat up close to 60% of that spend. Construction workers tend to be foreign and some 35% to 50% of their remuneration is repatriated to their own countries. At the end of the day you can effectively be looking at between $100m and $150m of that billion dollars staying in the region. It is a different order of business entirely.” Given then that there is not the direct correlation between high levels of liquidity in the region resulting from higher energy prices and outperformance and liquidity amid the region’s banks, banks themselves have had to adopt complex strategies to leverage new business opportunities. For some that has meant expansion in the wider region, as far as North Africa and the Levant. For others, it has meant diversifying their service range out of the usual wholesale and retail metier to include investment banking, Islamic finance, asset management and private banking. In October last year Ahli United launched Islamic banking services in Bahrain, with the opening of its first Islamic banking branch in Arad, to which is gradually being added a comprehensive Islamic banking network throughout the Kingdom under the brand name of Al Hilal Islamic Banking Services.“With the growth of Islamic financing at a rate of more than 15% a year, the move made clear sense,”he says.“The evolution of technology has opened new doors and the development of Shari’a compliant programmes and systems has enabled Al Hilal Islamic Banking Services to make use of state-of-theart technology to facilitate and accommodate a wide range of client needs across retail, treasury and corporate services.”

Among the bank’s more recent initiative are the expansion of its investment and financial advisory business, working through KMEFIC, a Kuwait based brokerage and asset management operation, 75% owned by Ahli United and Bank of Kuwait and Middle East (BKME), AUB’s Kuwaiti subsidiary. The business now manages some $6.5bn of regional and non-regional investment funds; though some investment mandates are outsourced, notes El-Labban. Then, “In April, we signalled our intention to enter the insurance industry with the signing of a memorandum of understanding with the UK-based Legal & General Group,” says El-Labban. The joint venture, with authorised capital of $200m in which Ahli United and Legal & General both initially hold a 50% stake, will be headquartered in Bahrain and regulated by the Central Bank of Bahrain. $25m in capital will be initially issued and paid up and once fully operational, venture will offer a comprehensive range of Islamic compliant or takaful insurance products to customers throughout the Gulf region,“in a phased manner, under Legal & General management and subject to necessary regulatory approvals,”says El-Labban.“Our role is to assist through our distribution channels across the Gulf.” Diversification is a necessity as, explains El-Labban, “an important dynamic in Gulf banking has occurred. Increased regulation by the region’s central banks has essentially reduced the expansion and profitability of retail banking. Therefore it is incumbent upon us to rebalance our product range to give greater emphasis to new products, such as corporate finance, investment banking and bank assurance.The search continues for alternative sources of new revenues”. Additionally, mergers and acquisitions in the region are integral to any meaningful expansion strategy; particularly as foreign banks are increasingly a ubiquitous presence in many countries. Among the most prominent merger deals of recent times is the combination of Emirates Bank International Ltd and National Bank of Dubai to create the Gulf region’s biggest bank by assets. However, Ahli United is a perennial favourite among merger rumour mongers. The bank was reportedly courted last summer by International Bank of Qatar, an affiliate of National Bank of Kuwait, which reputedly made a $6.1bn offer to take over the Bahraini bank. The deal came to nought however, after AUB’s major shareholders turned down the offer. Ahli United’s appeal is obvious: its shares are generally deemed to be fairly, or under-valued. It has a growing spread of business throughout the profitable Gulf region and it is widely held to be well-managed. Ahli United itself has not been deficient in this regard. After acquiring a 48% stake in Kuwait-based Bank of Kuwait and Middle East (BKME), Ahli United Bank acquired a 40% stake in Qatar-based Ahli Bank of Qatar. Later, in August 2005 Ahli United increased its stake in BKME to 75%. El-Labban notes: “Focused regional expansion through mergers and acquisitions followed by organic growth and cross border synergies are the key pillars of the bank’s growth strategy. Our initial creation, for example, was through a share swap business combination between United Bank of Kuwait, the oldest Gulf-owned UK bank, and

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COVER STORY: AHLI UNITED: A BIGGER SPLASH 50

Al Ahli Commercial Bank and Grindlays Bank [Bahrain] BSC, two leading Bahraini commercial banks of the time”. The acquisition of BKME represented a second key milestone in AUB’s strategy to become a major regional bank in the Gulf by securing a significant presence in Kuwait, to complement its existing large operations in Bahrain and in Qatar through AUB and Ahli Bank QSC (formerly Al-Ahli Bank of Qatar), respectively,”explains El-Labban. Ahli United recently acquired a 35% stake in Alliance Housing Bank (AHB), Oman together with a technical services and management agreement (TSMA).“The Omani economy has tremendous, untapped potential and we are confident that our banking experience across the region will help AHB, after its re-branding as Ahli Bank, gain a significant share in the banking sector.”Now he says “Our goal is meaningful market presence in all our markets, with at least a 10% market share in our targeted countries. AUB seeks to service its local clients in each market as an experienced, established local player with a regional and UK dimension provided through its other group banks. Our path to date has involved the successful challenging of much conventional wisdoms regarding barriers to change and cross-border banking in the region.” Certainly, Ahli United has enjoyed a cracking start to the year, announcing a 40.5% rise in net profits for the first half of 2008 of $ 211.7m, compared with the same period in 2007. “Despite what the wider markets regard as a highly liquid and

easily profitable regional banking sector, our half year result reflects increasing profitability in very competitive and challenging market conditions,”notes El-Labban.“It has been achieved through a judicious mix of diversified and sustainable revenue streams within a prudent risk framework,”he adds. The Group, having made a strong start in the first, continued its growth momentum posting a record operating income for the first half of this year of $461m, compared with $313.1m in the same period a year earlier and an increase of 47.2% over the same period last year, supported by a strong underlying growth in core earnings.“The growth achieved in core earnings was mainly due to higher net interest margins earned on a conservatively managed asset profile, supplemented by the accretive fee and commission income generated by wealth management and investment banking,” notes El-Labban. Moreover, the Group’s strategic investments, “have all contributed very positively taking advantage of the cross-border deal flow opportunities and the synergies accruing from a diversified regional presence in five Gulf countries with linkages to UK and Egypt,” adds ElLabban. He notes, however that containing operating costs remains challenging in a double digit inflationary environment. “Overall the cost to income ratio improved to 32.4%, mainly through investments in technology and the leveraging of cross-group synergies,”he adds. It’s a satisfying period for a bank, which was only established in its present corporate form in 2000 through a visionary strategy adopted by its major shareholders. ElLabban has managed Ahli United since its launch and has been closely involved in its strategic development. During a distinguished career, he has been chief executive officer of the United Bank of Kuwait PLC, London, managing director of Commercial International Bank (CIB) in Cairo, chairman of the Commercial International Investment Company in Cairo and vice president of Corporate Finance for Morgan Stanley, Investment Banking Division in New York. “Most banks start in the region and then establish subsidiaries or branches in London and Paris and NewYork. In our case, it was the reverse. We had a large subsidiary in the UK and we needed to establish ourselves in the Gulf. Bahrain had an established market that enabled us at the time to retain our investment grade rating. Second, it had a recognised, cutting edge regulator. This facilitated the shift of the business in terms of credibility of the new bank vis-avis its counterparties and its UK regulators. From honing in on Bahrain in its early beginnings, Ahli United is now establishing a solid international footprint. For the time being, Ahli United will focus on the region. “Irrespective of regulatory or inflationary challenges, there is substantive hydrocarbon wealth in the region which gradually cascades down to expand the middle class. Add to that an upward demographic trend, with a large percentage of young, educated people coming into the working market and it means for the medium term that we have not had to look too hard outside our core markets,” notes El-Labban. “Whatever barriers exist to growth are basically short term. Barriers, after all are only a state of mind for the weak.”

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TRANSITION MANAGEMENT – EMEA – A TIME OF CHANGE 52

The With markets remaining turbulent and the global investment management industry sitting at an inflection point, the role of transition managers (particularly in Europe) is under scrutiny. Internally, transition managers are having to justify themselves not only in terms of flow into trading desks but also (increasingly) as standalone, profitable businesses. Externally, with markets changing around them and asset managers and beneficial owners switching in rapid succession between alpha, beta and combined alpha/beta strategies, looking for returns in a difficult market; transition management teams that have stayed the course have never had it so good—or quite so bad—all at the same time. Francesca Carnevale reports. RADITIONALLY, EARLY SUMMER has, in the past, been a good time to write about transition management. In the past, there was a notable lull in volumes, giving transition managers time to mull over business trends and plan the autumn’s new business development plans. Not so this year. This summer is about volume business for transition teams that have survived an autumn, winter and early spring of discontent. The transition management business in London has undergone substantive change. One, the number of firms offering transition management on a permanent (rather than ad hoc basis) has declined. This is for two reasons: one, transition management, while handling substantive volumes of business (the latest estimate is that $2trn worth of investment assets are transitioned globally), has not often enjoyed a profile within a large investment bank commensurate with its market expertise and reach. Two, there is sometimes a blurring at the edges between portfolio trading services and transition management (albeit they are

Pack two very different skill sets). It is ironic then, that as the industry has reached maturity, it has still to achieve high standing within an investment banking structure. According to John Minderides, global head of transition management at JPMorgan,“there’s still a lot of low margin business in the transition management industry, with in many instances, clients paying execution fees only. The question is how sustainable is that over the long term for some houses?” As a consequence, some houses have felt able to melt away from the mainstream of transition management, either focusing on a specific region (as in the case of UBS, which still operates a transition management business in Asia, but no longer in Europe), or provide the service on a selective basis (as Instinet and ITG have done). In consequence, those houses that have remained in the business are finding that they are enjoying a concentration of new business opportunity that is revitalising the industry; albeit at a rather testing time of significant market change. Moreover, pension funds and beneficial owners have found that in challenging markets, the service of experienced transition management, with advanced risk management capabilities and understanding, are an increasing and welcome support when they need to make significant changes to their investment arrangements. Whether prompted by performance issues, actuarial advice, sponsor changes, new regulatory requirements or new investment opportunities, transition managers are now a key element in managing the change in portfolio mandates. Moreover, advancements in technology and the expansion into new segments of its traditional client base have combined to expand the traditional paradigms of the transition management offering; a trend that is particularly acute in today’s volatile markets.

Photograph © Maharand Kulkarni/Dreamstime.com, supplied August 2008.

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

TRANSITION MANAGEMENT – EMEA – A TIME OF CHANGE 54

According to TABB Group, the Ironically, for those transition introduction of new trading houses that have survived the technologies, such as dark pools turmoil and market consolidation and crossing systems, have of the past year, business has helped to minimise the execution never been so buoyant. Morgan risks associated with information Stanley typifies some of the leakage and opportunity cost. In trends. A transition management addition, they cite the agencyhouse that has worked only on a only brokerage model as being ‘selective’ basis in the past, “on the cutting edge of trading “looking after the interests of its technology,” because of the need key clients,” explains Gary to be efficient at finding liquidity. Spreadbury, Morgan Stanley’s Based on a survey of 15 beneficial head of transition management, owners, transition managers “the bank now thinks that the now receive about 45% of all time is ripe to invest in the Gary Spreadbury, vice president, transition management, mandates to mitigate the risks business and we are looking to Morgan Stanley. Photograph kindly supplied by Morgan associated with increasingly expand the transition team.” Stanley, August 2008. complex, global, multi-asset Morgan Stanley’s move is a signal indication of the level of new business that is emerging out portfolios for institutional investors. Twenty years ago, the of key markets in Europe – Scandinavia, the Netherlands, transition management industry focused its efforts on the UK, the Mediterranean states and, increasingly, the protecting the value of transitioning assets against Middle East. There is a “lot of activity right now,” concurs operational risks. Currently, writes Schulz, “It focuses on Tim Wilkinson, managing director, transition management mitigating opportunity cost, market impact and other at Citi:“A variety of elements are in play, some of which are investment and trading risks.” Transition management related to sub prime. We have seen some clients with firms utilise risk analytics to schedule orders according to a trigger levels based on asset or liability valuation points variety of factors. In addition, transition managers are which have been the catalyst to transition them into developing algorithm technology that interacts with pools of liquidity to complete orders as efficiently as possible. defensive strategies.” Schulz also points out that the number of transition Moreover, advancements in technology and the expansion into new segments of its traditional client base managers who actively pursue transition mandates is have combined to expand the traditional paradigms of the expected to drop over the next two years, especially among transition management offering; a trend that is particularly investment bank providers. “Given the Street's current acute in today’s volatile markets. According to Minderides, cost-cutting environment, along with the transition at JPMorgan, transitions are often manager “performance business’s relatively slim margins, as compared to those of driven. A lot of cash is being invested in assets valued lower programme trading, TABB Group expects that several of the current investment bank players will make a soft exit from than they were a year ago.” That is not the only change however, “The evolution of the business,”she writes. Whether the industry will survive unscathed through the trading and risk management technology has shifted the primary focus of transition management from operations to current crisis is not in doubt: the question surely rests on how risk management, with the preservation of the value of a it will adapt to changing circumstances. Increasingly, for client’s assets the most important aspect of the transition,” instance,“the business is lumpy,”notes Minderides. Strategies notes Struan Malcolm, head of transition management at will be required to handle periodic concentrations of RBS. “The decision to change an investment strategy is a transitions and relatively quieter periods, in an investment significant event for asset owners, because of its long-term banking or asset management environment in which impact on investment performance, therefore it is constant flow and business growth are required. Two, the incumbent on the transition manager to be involved in that business is becoming increasingly global, with leading houses risk management process, ensuring that risks throughout operating out of one or more financial centre to handle regional business flow. Third, each region has its own quirks: the transition are minimised at all points.” In a recent report on transition management by TABB fewer transitions, larger transitions and longer lead times in Group, analyst Monica Schulz has drawn similar Europe, for instance, compared with fast flow small transitions conclusions. The report, titled The Optimal Transition: that often characterise the US market. What will be significant Mitigating Risk and Minimizing Market Impact, explores the is the growing impact of Asia as more local beneficial owners current state of the transition management industry. The begin to tap the professional transition management market. report analyses the major components of the portfolio Finally, questions will increasingly arise over the specialist transitioning process, including trends in transition capability of individual transition management houses, as management usage, differentiators between providers, and investment portfolios become more complex, more expected future demand of transition management services. concentrated and include alternative asset classes.

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

Opportunity cost, market impact, bid/ask spreads and operational risks are all magnified when carrying out transition trades on behalf of clients such as defined-benefit and definedcontribution plan sponsors and, to a lesser extent, sovereign wealth funds, endowments, trusts and high net-worth investors, says Schulz. As a result of this increased complexity, asset owners are more inclined to seek the expertise of a seasoned transition manager, not only for shuttling equity portfolios, but for fixed income and foreign currency movements as well. Photograph © Rolffimages/Dreamstime.com, supplied August 2008.

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

ARKET TURBULENCE IS not always a bad thing—just ask those in the business of shuttling pension fund assets from one portfolio to the next. In today’s topsy-turvy environment, transition managers have been busier than ever meeting the demands of an increasingly alpha hungry clientele that seeks the very best returns at minimal cost. “Because transitions are significant, complex and lengthy affairs, they are subject to an exceptional number of risks,“ says Monica Schulz, TABB analyst and author of the report The Optimal Transition: Mitigating Risk and Minimising Market Impact. Opportunity cost, market impact, bid/ask spreads and operational risks are all magnified when carrying out transition trades on behalf of clients such as definedbenefit and defined-contribution plan sponsors and, to a

CLIENTS ASK FOR AN EXPANDING MENU OF SERVICES

THE NEW M DEAL

Transition management continues in a secular uptrend, as asset owners seek out wellpositioned providers for a much broader range of transitions than ever before. In an increasingly competitive market, mitigating risk and maintaining portfolio value while offering an ever-expanding menu of services are the driving forces behind today’s leading transition specialists. From Boston, Dave Simons reports.

CLIENTS ASK FOR AN EXPANDING MENU OF SERVICES 56

global, multi-asset and multicurrency presence in an effort to provide a more stable and sizable transition environment. This trend is still present today, says Stush, with some notable differences, including type of client, volume of transition and duration of project. “Users are more diversified today, from pension funds and endowments and foundations to investment managers, mutual funds, insurance funds and private clients,”he says.“Additionally, the volume of fixed income transitions and requests for information has increased significantly and the projects are longer and often include temporary investment management oversight,” adds Stush. Like others in the field, over the past several years Dan Verrastro, director of United States transition management at UBS, has witnessed a significant increase in the number of agency bids, whereby the transition manager acts as broker and attempts to sell a fund’s assets at the best available price on transition events. “The need for transparency around the cost of trading continues to be an Bill Stush, North American head of transition management at Merrill Lynch, despite the faster important issue for plans and growth in defined contribution assets and alternative investments by defined benefit plans.“This consultants involved in transitions,” is primarily because asset owners are looking to use transition managers for a broader range of he explains. “In particular, we have assets than in the past,” says Stush. Photograph kindly supplied by Merrill Lynch, August 2008. seen more drive in the fixed-income lesser extent, sovereign wealth funds, endowments, trusts world for agency trades and explicit costs.” The US has a and high net-worth investors, says Schulz. As a result of unique set of rules defining what fiduciaries can and this increased complexity, asset owners are more inclined cannot do, particularly with respect to Employment to seek the expertise of a seasoned transition manager, not Retirement Income Security Act (ERISA)-type plans. only for shuttling equity portfolios, but for fixed income Accordingly, fiduciary responsibility is perhaps the single greatest differentiator between EU and US-based and foreign currency movements as well. The trend has had a pronounced impact on transition transition management providers, says Grant Johnsey, management growth. Globally, transition management head of transition management-North America for currently trades in excess of $2trn in assets, according to Northern Trust Global Investments (NTGI), the asset TABB, the Boston based financial markets' research and management arm of Northern Trust. “The investment strategic advisory firm. At present, transition managers are committees for such plans are actually co-fiduciaries in awarded some 45% of all mandates, with the goal of conjunction with fiduciaries that they hire. Should they minimising risk and maintaining value for multi-asset decide to terminate their current investment manager and go out on their own without any fiduciary oversight, they institutional investor portfolio holders. Transition management continues in a secular uptrend, become sole fiduciaries until a replacement manager can notes Bill Stush, North American head of transition be found,” says Johnsey. To mitigate risk, many seek the management at Merrill Lynch, despite the faster growth in assistance of a transition manager who can oversee the defined contribution assets and alternative investments by event, thereby plugging the gap between outgoing and defined benefit plans. “This is primarily because asset incoming managers. The fiduciary issue is foremost on the minds of most owners are looking to use transition managers for a broader range of assets than in the past,”says Stush. From plan sponsors and consultants in the industry, says UBS’s the outset, transition managers have sought clients with a Verrastro. “Almost all requests for proposals (RFP’s) in

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

Accordingly, we’ve seen a which we participate have greater acceptance of questions that revolve what transition managers around the fiduciary status can do for these plans,” of the transition manager. says Johnsey. This being the case, we To maintain their will continue to see asset competitive edge in an managers and brokers increasingly tight market, who will configure US transition managers arrangements to address continue to focus on being a fiduciary for the controlling the implicit transition event.” costs of trading via Ross McLellan, senior crossing and other managing director and algorithmic capabilities, head of North American says Verrastro. According transition management for to Johnsey, there are two Boston-based State Street, types of firms offering agrees that ERISA transition management at continues to be the guiding present: those looking for principle of the fiduciary a way to capitalise on the relationship with US-based growing industry and clients. “Most clients have leveraging the systems long since mandated that they already have in place; their transition manager and those who are truly act as fiduciary,” says committed to transition McLellan, “which, of management and will be course, is a bit problematic Grant Johnsey, head of transition management-North America for at it 10 years from now, no for firms that have any kind Northern Trust Global Investments (NTGI), the asset management arm of matter what changes of proprietary trading—you Northern Trust.“The investment committees for such plans are actually cooccur.“While we saw a fair can’t make money fiduciaries in conjunction with fiduciaries that they hire. Should they amount of turnover implicitly off your client’s decide to terminate their current investment manager and go out on their several years ago when the funds, everything has to be own without any fiduciary oversight, they become sole fiduciaries until a industry was still young, I above board. Whereas in replacement manager can be found,” says Johnsey. Photograph kindly think the really dedicated Europe, that kind of supplied by NTGI, August 2008. firms are committed to definition doesn’t exist— building a strong which is mainly why a lot organisation with the goal of investment banks have a of retention,”says Johnsey. large presence over there.” “While we saw a fair amount of turnover Not surprisingly, Growth of transition companies that have management has been several years ago when the industry was attempted to ride on the fuelled in part by the need still young, I think the really dedicated coat-tails of transition for providers to firms are committed to building a strong managers have not fared implement plan changes organisation with the goal of retention,” nearly as well as more as swiftly and effectively says Grant Johnsey, head of transition entrenched providers, says as possible, whether in McLellan. “To have the response to fluctuating management, NTGI. breadth and scale that you market conditions or need to compete in this perhaps the emergence of business requires a lot more alternative new asset classes. This is particularly relevant in the US, where than simply recruiting a handful of people from other firms plans tend to make smaller changes and with greater and trying to generate trading. Which is the approach that frequency than their European counterparts. Johnsey many newer firms have taken, and they have not been able to cites the connection between plans administrators build any kind of credible market share. Given the current state growing more comfortable moving assets as needed in of the markets, when a group is under-producing, obviously order to meet their goals, and the rise of transition they become expendable. I think the firms that have a large management to help facilitate such changes. “The global presence, don’t have significant conflict-of-interest transition manager is helping clients manage costs and issues, and can also handle transitions of any size and scale are risk, while at the same time coordinating the event. the ones that will still be competing 10 years from now.”

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

CLIENTS ASK FOR AN EXPANDING MENU OF SERVICES 58

widespread,” says Stush. In her report, TABB’s “As clients implement Schulz estimates that the fixed-income transitions, number of transition utilise transition managers actively pursuing managers on an interim transition mandates will asset management basis drop significantly through and incorporate overlay 2010, particularly among mandates into their funds, investment-bank providers. we would expect more “Given the Street’s current mandates to move to the cost-cutting environment, asset management side of along with the transition the industry.” business’ relatively slim Another prominent margins, as compared to trend among transition those of program trading, management of late has TABB Group expects that been the elimination of several of the current home-country biases, says investment-bank players Ross McLellan. “We have will make a soft exit from seen this occur in Canada, the business,”writes Schulz. for instance, with the Pro-active transition removal of the foreign managers are finding it content rule. In the US advantageous to expand there have been large their scope to include reallocations of assets into advising, planning and global equities, and there other fiduciary functions, has been a similar particularly with regard to response from our defined-contribution plan European and Asian transitions, which by clients, who at one point nature are time, and labour had upwards of 80% of intensive endeavours. their assets in domestic “There has been a greater stocks and have since emphasis on service Ross McLellan, senior managing director and head of North American reallocated to the point of among the very dedicated transition management for Boston-based State Street, agrees that bringing the homeproviders,” says Johnsey. ERISA continues to be the guiding principle of the fiduciary country bias down to a “You’re also seeing a lot relationship with US-based clients.“Most clients have long since more manageable level.” more interim or overlay mandated that their transition manager act as fiduciary,” says With the markets in a type service—for instance, McLellan. Photograph kindly supplied by State Street, August 2008. constant state of flux and if a client has had an underperforming manager, quite often they may hire a technology making transitions much more feasible, experts transition manager not only to liquidate the account, but to like UBS’s Verrastro believe that the current rate of growth also make recommendations and ultimately manage the for transition management is easily sustainable. assets on an interim basis until they can go through a six- “Investment products that plan sponsors are willing to month RFP process and hire a new manager. That is consider within their mandates are now more diverse than something that rarely happened five years ago, but is much ever before,” says Verrastro. With this diversity comes a more common today. So I think that the transition greater need for transition management involvement in managers that will ultimately survive are those firms that order to facilitate cost-efficient transfers of assets from can help in a number of different categories, not just legacy managers to the new managers. Addressing the specific needs of the client remains a transition management.” The combining or bundling of services, such as asset top priority for transition managers going forward, says management and transition management, more emphasis Merrill‘s Stush.“As with any environment, we continue to on risk management, as well as an increased focus on the focus on providing solutions for the challenges facing our breadth of trading strengths to address the most difficult customers. We listen to their goals and objectives of the and costly portions of the transition, is also paramount, event and deliver a bespoke solution that matches their adds Merrill Lynch’s Bill Stush. “While growth on the needs. To ensure that we maintain our competitive product side of transition management has largely been in position, we constantly evaluate our capabilities and fixed income, the practice of employing the transition personnel to ensure our product offering and service is manager as a 1940 Act Investment Advisor has become the best that it can be.”

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

THOUGHT LEADERSHIP ROUNDTABLE

THE FUTURE OF INVESTOR SERVICES

ATTENDEES:

Supported by:

Attendees: from left to right TIM REUCROFT: director, research, Thomas Murray Ltd TIM KEANEY: co-chief executive officer, The Bank of New York Mellon Asset Servicing FRANCESCA CARNEVALE: editor, FTSE Global Markets LUC LECLERCQ: head of IT and operations, Foreign & Colonial PAUL STILLABOWER: global head of business development, Fund Services, HSBC Securities Services ERIK GORIS: managing director, Goris & Partners BV RONALD WUIJSTER: head of strategy & research, APG [via phone]

FTSE GLOBAL MARKETS â&#x20AC;˘ SEPTEMBER/OCTOBER 2008

INVESTMENT SERVICES ROUNDTABLE 60

PROFITS: EVEN IN CHALLENGING TIMES TIM KEANEY: The year began with a credit crisis, which

quickly escalated into a liquidity crisis. This resulted in a lot of change, largely driven by clients. There has been a fair degree of growth in terms of transaction volumes, a flight to quality and clients have been putting more money into cash and keeping it on the sidelines. The march away from equity markets into non-traditional investments continues to gather pace. It has been particularly interesting to see how investment trends have shifted. From an operational perspective, the bar has been raised. We are clearly in a period of zero tolerance. for a defect environment; especially these days, when everyone is broadcasting net asset values (NAVs), accounting and performance and risk data on a daily basis— indeed throughout the day. In terms of errors, there is nowhere to hide, as many investors and clients are basing important investment decisions on the information we provide them. Financially, we have enjoyed outsized earnings over the last 12 months: in part, because of the impact of the credit crisis; the impact a lack of liquidity has had on foreign exchange volatility; and what has happened in areas such as securities lending. Oddly enough, it has been a rather good environment for making money. LUC LECLERCQ: Clients are reassessing what is happening in the markets. We see a flight towards different asset classes, compared to say 12 or more months ago. There is higher demand for protection; to secure returns. Therefore, while clients are increasingly interested in a higher level of sophistication, particularly instruments in the derivatives space, they are also more demanding and require better and quicker results in terms of performance or risk measurement. There has been a shift whereby clients no longer have traditional benchmarks as their main objectives. Moreover, they have a variety of requirements . PAUL STILLABOWER: A key question for securities services businesses is whether we are in a V-shaped downturn with more volatility, and therefore trading revenues, or in a U-shaped downturn, where clients tend to trade less and move to less lucrative instruments. Right now, we continue to see trading activity. We see a lot of activity from hedge funds that are dealing with institutional investors that demand industrial strength administration services. As institutional investors push more money in that direction we see an increase in complexity of investments. It is also visible on the traditional side with UCITs III type vehicles, where there is more use of derivatives and sophisticated instruments. These developments are straining those businesses supporting these trends; either because the activity is happening in full employment markets, or because it is difficult to find people with the skill sets to deal with that increasing complexity. Therefore, the people side has become quite important for our businesses. Asset servicers and asset managers, prime brokers and investment banks are all looking for the same type of talent. Additionally, we

still see a lot of interest (driven by macro demographic trends) in Asia and the Middle East, in spite of the market downturn. Because we have such a strong fund administration business and we have people and a bank support network in these markets, we have been growing quite quickly in that space. Again, it has not been without its challenges—given the difficulty finding staff to deal with the growth. Finally, post Bear Stearns, hedge funds specifically have been looking at de-risking their pure prime broker relationships. This has resulted in an opportunity, given the flight to quality, for asset servicing providers that are not prime brokers. Our ability to segregate their assets and not rehypothecate are advantages that hedge funds are starting to look at very seriously. RONALD WUIJSTER: What has been important for us is that we cannot force a different pace from the long term horizon that our pension fund clients have. And we do mean long term. It does not only refer to the investment horizon, but also the ability to stay in deals and to make a liquid investment. Also, we have tried to become, as others are doing, more absolute return oriented. We have succeeded in that (partially, at least) though we need to go further. We still however, have a large equity exposure risk, which means that we suffer from declines in the equity markets. Consequently, we have tried to diversify our systematic risk a little bit. We have increased our investments in areas where we can earn a liquidity premium, and this in some instances has involved buying distressed risk. Moreover, we are exploring other, alternative risk factors that are of interest for long term investors. Of course, at the same time, the only short term factor that we have to take into account is corporate ratios because of our central bank, which is the regulator of the benchmarks that we manage money for. Up to now though, we still appear to be in safe territory, so we can keep our focus on our longer term investments. TIM REUCROFT: There has been a major collision between two very interesting trends. The first is that everyone is moving into alpha, away from beta. Beta is so cheap these days. You can buy ETFs and get beta for virtually nothing. Everyone is going for absolute returns. Institutional investors are coming to us and saying:“Our fund managers now are into all sorts of funky products, OTC derivatives, and new asset classes. Our custodians cannot handle them and we are being forced into the prime broker solution and we don’t know what we are doing either.”There have been a lot of cries for help. That trend then collided with the credit crunch. This was extremely interesting, because there was a credit bubble, where people could not quite price credit correctly. When they found that they could not price it, there was suddenly a massive freeze on liquidity and the central banks’ response to that was to pump loads and loads of money into the system. That did nothing to help those people who had sub prime mortgages in the United States. All it did was bail out their own church—the broker/dealers and the investment banks. The result? When you pump loads of money into the system, interest

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rates go down. When interest rates go down (and this is where the problem starts), commodity prices go up. What you have done is transfer one asset bubble (the credit bubble) into another asset bubble (which is now the commodities bubble).The trouble is that it is not a temporary bubble; it is a Pandora’s Box! Once opened, it will not go away. So what we now have is two crises, where previously we had one. That has also exacerbated the fact that there is a lot of alpha in commodities, so people have been encouraged to chase that because it is a win/win game and it is going up and up. ERIK GORIS: The last twelve months have put most investment strategies and models to the test. Many institutional investors made significant changes to their investment portfolios in search of alpha, diversifying further into alternative investment classes and increasing their use of derivatives and other complex instruments. These posed new challenges for asset servicing companies. Certain investors, in particular the small to mid-sized pension funds, tried to regain control of their asset management function after the dotcom crisis in the early 2000s. In an environment of increased regulation and financial requirements, they looked for new models to structure their asset management organisation and operations, as well as increase returns. For example, the concept of fiduciary management strongly emerged in the Netherlands and is still growing in importance. However, these models are now being put to the test and they are showing very mixed results. The Holy Grail of fiduciary management embraced by a significant number of pension funds ultimately still depends on the quality of the underlying asset managers—something that people may have forgotten. Additionally, certain legislation by regulators designed to increase focus on sound governance and operations may have had the opposite effect and increased the complexity of pension fund operations. It will be interesting to see how these new models and organisational structures emerge from the current turmoil.

… WE ARE ALL IN THIS TOGETHER, TO GET IT RIGHT FRANCESCA: Do you think that the change is of a degree that it will redefine the relationship between investment service providers and their clients? PAUL STILLABOWER: There has to be a sufficient amount of investment, not just in technology, but in people, which I have already noted. I guess one of the factors is that we are all in this together.There is a vested interest in everyone getting this right. It is not just about an ability to process a derivative. It is a market issue and it involves standardisation of products, the paperwork, legal contracts, and there needs to be a change in taking some of the operational risk out of the market. Certainly, asset servicing firms are well placed. We spend a lot of money on technology. It is a very difficult business to get into if you have not already made the investment in the infrastructure. One of the areas we are focusing on is our core

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TIM KEANEY, co-chief executive officer, The Bank of New York Mellon Asset Servicing

clients. We are spending a lot of time ensuring that we meet the needs of our existing clients since client retention is a key driver of profitability. Fund administration is a particular product that scales almost imperceptively, and it is extremely sticky; whereas custody tends to be a more commoditised product, and where the profit in the industry is generated. Balancing all that is a challenge.You cannot just give away all of the hard products without any return, and that probably comes to Erik’s point, where customers need convincing that the price of processing some of these instruments is, and should be, higher. Moreover, there is a higher risk of error in processing complex instruments. Service providers cannot do these things for free and take all the risk, so there has to be some sort of balancing act. Perhaps re-pricing of risk servicing in the industry is coming. TIM REUCROFT: In fact, the industry has changed already and gone through a paradigm shift. We cannot go back to how it used to be. Some custodians have systems that are hard coded, so that they cannot hold short positions, because in the traditional world you were never allowed to have short positions. However, that simply does not work anymore. These days you are running extension strategies and involved in stock lending and borrowing, and thereby running short positions. The game has changed completely. If I can pick up on what Paul says on taking operational risk out of the system. This is fascinating because, if you look at the history of regulation, there was an almighty crash in the 1980s and, at the time, regulators said that you had to put capital aside against market risk. People did that and realised they could use exchange rate derivatives and hedge against their market risk.Then the regulators said:“We don’t like counterparty risk and we think you should put some capital aside to mitigate it.” Then some bright spark came up with credit default swaps, and we know what happened then. Subsequently, it

INVESTMENT SERVICES ROUNDTABLE 62

LUC LECLERCQ, head of IT and operations, Foreign & Colonial

got out of control and there was a glut of operational risk, resulting in a nightmare. What are the regulators saying now? They are saying: “We don’t like all the operational risks”. Invariably then, some bright spark will figure out a way to transfer operational risk through the system and we will be back to where we were before. In fact, it is the regulator who is driving half the problems we are facing in the first place. Actually, you do need to take operational risk out of the system, but the regulator will put it back in again. TIM KEANEY: Step back 10 years and 100% of our profit in asset servicing came from custody, whereas today only a modest amount is derived from custody. If I look at the paradigm shift that has taken place, it has demanded a substantial transformation in the knowledge-base of the people in this business. Some of our smartest people can today be found in the new business development and client relationship areas. Why is that? Because they are at the sharp end, dealing with clients who are evolving their investment models. They understand the nature of these changes and can help position our company to ensure we have the right technology and processes at the right time to better support clients’changing needs. This is a knowledge worker business because it is now a front office business. Asset servicing is accorded the same stature in our company as asset management. This year we will spend around 15% of our top line revenue on technology: the equivalent of a drug company’s spending on research and development, and that is a statistic that still grabs my attention to this day. About a third of that I would characterise as keeping the lights on and keeping the factory running; another third is spent to address regulatory requirements and other duties I am compelled to carry out.The final third is spent on developing new products and services, which ties back into changing client needs.

RONALD WUIJSTER: Technology, processes and services have become more important for us as well. As an organisation we are moving in the direction of a true multiclient environment for the first time. We did manage smaller pension funds before, but now we are moving towards a more open market environment and we do feel that our processes, technology and IT are playing a crucial role in our service range. We want to be the best pension fund investor in the world and we think that if you look at our investment process and our portfolio construction, the way we manage assets, we are already there or almost there. We also have an innovative approach to investment, which generally needs little additional work. However, our processes and technology need to be flexible and adapt to change, so there is a lot we still have to do in that space. Also our asset service suppliers play a crucial role in this regard. What we do now more than before is partnering. I heard the example earlier of complex products, and I can provide as an example of this in action. Our back office is partnering with a service supplier to deliver a better quality product to the front office. It is not that we want to be the best in everything ourselves, simply that we are taking more of a partnering approach to our growing requirements. LUC LECLERCQ: Our business depends on a number of service providers. Each of them now faces very different challenges. Firstly, the broker community is facing liquidity constraints and is constantly reviewing counterparty risk, which has an effect on trading and the turnaround of legal documents such as ISDAs. Secondly, data service providers also face difficulties regarding the services they offer. Everyone has seen the problems with asset backed securities prices. Therefore, finding the right data provider is not only difficult, but also it has become (sometimes) very costly. Thirdly, custodians have always faced demand for change, but the speed of execution demanded now is higher than twelve months ago and some are struggling to come up with the right expertise and knowledge required by the market. Fourthly, the software providers are under pressure to keep up with the pace of change. There is not one provider who is capable of giving us a complete solution for most of the asset classes we are active in. Moreover, the speed of software release is becoming much longer and the cost of release is increasing. Bringing all these strands together, we all see that things are becoming much more complicated. ERIK GORIS: We have noted two issues. One is that most institutional clients that we represent in custody searches do not recognise the intricacy and complexity of the structures that asset service companies have to provide a solution for. So from the client side there often is less appreciation of the processes and issues that are brought up during the selection process and the implementation phase thereafter. This has implications for the pricing of these services, both for core custody services as well as valueadded services. Looking at that aspect of the custody business, the front office function has become more important for asset servicing companies. Their job is to

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create both awareness with clients as well as establish a working relationship. This is particularly important for the less sophisticated investor. Of course, investors such as APG know what they are looking at. But there is a vast group of institutional investors that is not as familiar with the level of complexity of asset servicing. The other issue is technology spending. Looking at custody searches we performed over the past five years, the group of global custody providers has shrunk immensely. Other than through consolidation in the sector, one of the key factors is the vast amount of technology spending that the leading companies have continuously invested in infrastructure and processes. As a result, the leading global custody providers have widened the gap with the rest of the competition.

very small innovators tend over time to be either acquired, partnered, or replicated by competitors. There are few successful strategies that are not quickly replicated by large managers with deep resources, expertise and capital to buy in expertise to do this. So, small innovators might occasionally hit a home run, but on balance stay small, or specialised, and therefore it is uneconomic to just focus on small, innovative clients.

DIVERGING DEMANDS

changing constantly. There are a handful of providers who can say they are truly global. But in the main it is a national industry—not global. There are national banks who provide these services all over the world. This is the change from a custody industry to a fund administration and middle office services industry, which are very intensive and hard to scale services—whether in Europe, where there are a couple of huge offshore centres, and certainly in Asia and the Middle East, where for the most part you have to be on the ground with local employees. If you look ahead, say ten or 15 years, the Chinese banks will be large players in the industry; much like the Japanese banks were in the 1980s, driven by their massive national stock market. One of the things to consider, and we have seen this in Europe, is that local banks are very hard to dislodge from local customers, because they lend money, they offer distribution and provide other banking services. That strength at the grass roots therefore that you find in Europe, or Middle East or in Asia, means that there are local banks to contend with. It is a challenge for a foreign firm, for example, to provide services for a South Korean fund that in local terms is huge, but in global terms is not: being local in faster growth markets is an important objective for service providers right now. TIM KEANEY: Paul makes an excellent point. If you take the investible assets around the world, somewhere around $120trn, only about a third are in the United States. And what you see as you travel around the world is that 80% to 85% of the assets stay local. For example, French investors invest primarily in the French mutual fund market and only about 15% to 20% of assets are cross-border. It is those cross-border flows that the global custodians are competing for. As the conditions change for global custodians, the scale model that we have seen emerge in the market will give rise to opportunities for the global players to encroach more and more into the local frame. For our part, BNY Mellon is already local in a number of key markets —the US, the UK, the Netherlands—and we are looking to expand into certain markets with strong growth characteristics, and our ambition to do so is increasing. PAUL STILLABOWER: And there really is only a handful of banks that can do that.

FRANCESCA: Do you get a sense that the market is

dividing into the “über funds” with sophisticated requirements and are ahead of the curve, and they are straining at the limits of investor services provision? Then there are small and mid sized funds that are aiming for sophistication and then those funds with more traditional custody requirements? Is it the need to service such a wide spectrum of requirements nowadays that is straining the provision of investor services? TIM KEANEY: Larger organisations tend to be the ones pushing the envelope in respect of sophistication and complexity. Yes, that is a very fair point and this has been driven in part by the under-funded nature of the pension systems in certain markets, such as the United States and the United Kingdom. That scenario has been pushing investors to diversify their assets in their constant search for alpha. It has been interesting though to see the growing level of sophistication among investors, with alternative fund managers grabbing a larger share of wallet as a result of changing investor trends. So whether it is real estate, private equity, 130/30 funds, venture capital or derivatives from alternative asset managers, they have been hugely innovative. So, on the one hand, yes, you see investors, the owners of the assets, diversifying into higher returning asset classes. On the other side are the fund management communities, which have been very quick to innovate and come up with new products, and which continue to impel asset servicers to expand the boundaries of our own product range. So, to summarise, the larger funds and alternative asset managers in general have been driving product innovation. PAUL STILLABOWER: That’s right. Everyone has their anchor clients—their über clients—who keep the lights on in the business by eating up fixed costs. However, über clients have pricing power and therefore it is generally the middle client segment that tends to be more profitable. As Tim says, in particular product areas you need innovative clients to drive forward your product development. But it is a balancing act, because you cannot do that for every client because of the cost of constantly developing product. Those

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THAT NATIONAL/INTERNATIONAL DYNAMIC FRANCESCA: Is investor services today a game best played

by giants?

PAUL STILLABOWER: It is a game of giants, though it is still

INVESTMENT SERVICES ROUNDTABLE 64

TIM REUCROFT: The outbound business from a lot of these emerging markets is only just starting. You have QDII which is taking off in China and the sovereign funds setting up in Russia. That money is just starting to move abroad. At the moment the only candidates who can handle that are one or two American and European global custodians. But it will not be long before you see VTB and Sberbank become global custodians, and it won’t be long before you see China Construction Bank become a global custodian. They will start to carry a lot of this outbound business. Clearly they will come up against some of the same problems that other global custodians have got in handling all these varied asset classes. TIM KEANEY: There has been a generational change in the leadership running many of the large financial institutions across Europe. Historically, firms have taken a more localised approach to the asset servicing business, and we now see chief executive officers and their executive boards seeking greater transparency and pulling businesses apart to better understand them. It has been interesting to observe one of the bigger players in Italy exiting a couple of years ago and to see a couple of German players exit for exactly the reasons that you have described,Tim.They are feeling the same pressure as their own asset management businesses and their underlying clients—they are utilising and having to support derivatives and are having to figure out ways to invest in the technology that they require to do that. Everyone is feeling the same pressure, whether you are on a small patch or a big patch. ERIK GORIS: Clients are looking for this global solution, which means that they are currently looking at a group of global custodians that has become smaller over the past years because of market consolidation and exiting providers. The issue is, however, that because core custody services do not yield as much income as they used to, asset service providers have developed a range of value added services. A lot of our clients, though, are just looking for one point of contact for asset servicing in a global solution and a limited use of value added services. They do not run sophisticated investment portfolios to the extent other investors and asset management firms do. So our clients often, as we phrase it, are offered a Ferrari to do their groceries! It is a state-of-theart service offfering, but too complex for the client. This is where it becomes difficult since choices for a one-stop global solution are limited, but these service providers actually only thrive on income from value added services. RONALD WUIJSTER: What we are trying to do, which is related, is to offer a unique and integrated solution to our pension fund clients. So we offer pension fund administration, communication and asset management and that all in one go as an integrated solution to them. We try to have everything in range, but also be innovative in all aspects of this. We try to offer them something unique, so in that sense we are different. Our main focus is on the benefits to clients and our approach is that they should take our full proposition so that there is no cherry picking. It is not the most commercial approach maybe, but it is the approach that we think will work for us.

NEW ROLES, NEW PLAYERS FRANCESCA: Are large fund management firms assuming some of the work and characteristics of investor services providers, perhaps because there is less choice out in the marketplace? LUC LECLERCQ: I do think there are less players, but in contrast to five or ten years ago we can change some service providers quite easily, particularly in the custody space. This added flexibility compensates the fact there are less players in the market. We see that the big providers are increasing their service offerings in line with demand of the client/market. However, the increasing customisation of services and the shortening of the lead time to bring a product to market puts the providers under extra strain. This can lead to an increase of costs charged to the clients and will trigger the clients to look for alternatives, such as doing it in-house or looking for an alternative kind of provider. As such, we see that in the derivatives space the traditional providers are ‘complemented’, or in some cases replaced, by new players such as central clearing parties and clearing houses. Let’s not forget that ten or fifteen years ago, the clearing houses themselves were not capable of doing a third of what they do now. So you are right, the number of players are reducing, but there are a number of other players coming along. TIM REUCROFT: Going back to the question directly, what is happening is fascinating and what we see is that a lot of what are traditional institutional investors are now behaving like traders. They have recruited people in investment banks who trade by nature, and they have put 5% of their portfolio into hedge funds. You buy a hedge fund and you have no idea what is inside it. It could be completely toxic, right? So actually, some say that they don’t like doing that, so what they do is begin to replicate what the hedge funds are doing. They hire a trader and he can represent or replicate whatever arbitrage strategy the hedge fund was doing in-house. That has taken them right down the trading end of the spectrum. As a consequence, the custodian, who used to provide back office services for the traditional long-only positions, is having to change, because the trader wants middle office. A lot of the custodians, I would argue, are not in that space. Or have not been in that space and are now scrambling to get there. That is creating all sorts of issues, and there are a lot of acquisitions going on and they have to integrate all sorts of different platforms and it is a bit of a mess. Nobody has succeeded in doing that. There is not a single provider out there who has solved this. I challenge anybody around the table to come up with a name, but you are not allowed to nominate your own bank, who has really solved this problem. PAUL STILLABOWER: Providing investor services is like building a spaceship! It is complex. It is not something that just comes out of a box on the shelf. It requires investment in complex products: it is the data warehouse; it is the independent pricing engine, corporate actions, trade

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matching in the middle office services, etc. It takes time to get new products right. I do think there is an element of fund managers starting some things in-house, and the question is: is that where they intend them to be forever? Probably not. But products have to become replicable and scalable if providers are to make them industrial strength. At the side of all this, of course, is the question of risk management. We have chief executives asking whether there is a $5bn fraud in here somewhere, or is someone mispricing investments or holding illiquid products. So there is an element, of course, of wanting to have some control over new products, and a feeling that providers are not fully ready for some products. It is clear though that providers will spend to develop in products. It is just a question of how quickly you can make the right investment and implement the right technology and get the right people. LUC LECLERCQ: Custodial activity generates extra income from stock lending and FX and might make the custody business model self-sufficient. If you are moving towards the middle office space, you are moving away from standardisation and are confronted with a high level of sophistication and customisation. On top of this, you are taking more risk. A good example of increased risk is the treasury function in the middle office segment. It would be interesting to learn how you cope with this because, for us being on the receiving side, your business model is not always clear. TIM KEANEY: Let me zero in on the middle office as an example. If I took my shirt off, you would see the scars on my back from my past dealings in the middle office arena! Back in the day it was the bigger asset managers that outsourced the middle office. Organisations ran into problems in a bear market, there was a profit challenge in the fund management industry and consequently we saw a mushrooming in middle office outsourcing among asset managers. As they tended to be the bigger guys, they had the pricing power and were demanding about just how they wanted their middle office to work. As an industry we were very quick to recognise that this could be a big business opportunity, and so we took out our hammers and our screwdrivers and bent our plumbing to support these clients – but in hindsight maybe we were a little naïve about just how that would work out in reality, given the inherently bespoke nature of many of those mandates. Interestingly, the market that has quietly developed almost unnoticed is the mid and small sized fund manager segment, and they have been very, very open to taking a standardised approach and in recognising the trade-off between costs and customisation. As our industry matures and we get a more scalable model, I am starting to see more and more of the big managers saying: “Look, I don’t want to put a large round peg in a square hole. If you can articulate how your middle office works and demonstrate it to me, I am much more willing today to consider a standardised process than I might have been four or five years ago.” So watch this space: middle office outsourcing is going to come back on the upswing.

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PAUL STILLABOWER, global head of business development, Fund Services, HSBC Securities Services TIM REUCROFT: There is a lot of convergence going on. I

mean, you would not dream of settling Crest transactions bilaterally would you? So you have a utility in the middle there, that makes standardised straight through processing and everything a lot, lot easier. Now what we are seeing is that those utilities are now emerging in the OTC derivatives space.To a certain extent, you can say they were forced upon us by the regulators when the credit default swaps crisis blew up. But those utilities solutions, such as Deriv/SERV and SwapsWire etc, were designed by investment banks and the problem is that the custodians have been slow to join. What you have to do is batter the door down, really get to the table and make sure those utilities are run in your own interests as well as everybody else’s. If you can do that and achieve functional convergence, so that exchange trading derivatives, cash markets and OTC derivatives all look pretty much the same, then it becomes much easier for you: same model, but you just plug it in different product lines. Life then becomes a lot easier, particularly if you are running IT. So there are solutions out there. FRANCESCA: Has the custodian side has been a bit slow off the mark in this regard? Is it the investment banking side of the business that might now set the pace of change? TIM REUCROFT: Yes, because the investment banks have had to become involved to support their own prime broking operations. We are extremely fortunate that there are no prime brokers in the global custody space, because

INVESTMENT SERVICES ROUNDTABLE

ERIK GORIS, managing director, Goris & Partners BV

they mainly pulled out a few years ago. There are one or two that have still got prime brokerage operations and there are one or two that still have custody operations: Citi and JPMorgan spring to mind. They have been threatening to put them together, but never succeeded. I presume they are still working on it. It comes back to my earlier point that there is nobody out there who has been able to combine all these asset classes and products.

TOWARDS UCITs IV FRANCESCA: I believe that in the last few months the

European Commission has said it wants to move ahead with UCITs IV, once it comes into play and you have a true European passport. What impact do you think that will have on the provision of services to the investment industry? TIM KEANEY: It is good for investors, it is good for the industry. It is going to lower the cost of providing fund administration when you can develop one investment strategy and market it to 11 different markets. Generally, anything that is good for investors is good for asset servicing providers like ourselves. UCITs IV certainly raises the level of sophistication, and that sophistication will only continue to increase – and as it does, institutions will be driven to assess their own core competencies.“Am I going to be a distributor of investment product? Am I going to be a manufacturer of investment product?”One example that sticks with me is Pioneer Asset Management: it closed down $10bn of Italian domiciled funds and transferred them to Luxembourg to sell them back into Italy. In the process it lowered the cost of administration, it improved the after-fee performance of its funds, and it created a tax

advantage for the investor. That is a very good example of the power of UCITs. I believe it is terrific and will lead to significant growth in the choices open to investors. LUC LECLERCQ: What you forgot to say is that you will lower your costs as well! TIM KEANEY: Yes, that is true, because we clearly have a scale model. I would say that every two or three years it leads to our clients coming back to the table, wanting us to share the benefits of our scale with them through a lower rate card. It is a key element of our business today. TIM REUCROFT: If you look back, you used to be able to buy indices and buy unit trusts to invest in certain countries and you could buy into the beta of certain markets fairly easily as an individual investor. But nowadays you can buy ETFs and have done. I am looking for the time when hedge funds effectively go on exchange. UCITs IV is essentially going to take us in that direction. With these things people are going to get used to effectively investing in alpha. Now you get beta through an ETF, if you buy into UCITs IV you buy alpha, so then it is only a question of time before that itself goes on to the exchange and then people can buy and sell them. Obviously that will improve the volumes. But what it does for the custody business, I am not quite sure. I have not figured that out yet. But for the end investor it is fantastic as you can choose how much beta or alpha you want.You can do your global asset allocations. It is fantastic. TIM KEANEY: The other interesting variant on this theme is ETFs. I may be a little off on my timeframe, but as I recall a little over a year ago I hardly noticed any ETFs listed on the London Stock Exchange. The last time I took a peek, the total stood at over 120 or so. Regarding the point you were making earlier Tim, about the separation of alpha and beta, one of the spaces to watch is what is going to happen to ETFs. They are very cost-effective, and I know that in the US the regulators have said they will speed up the approval process for ETFs. There are actively traded ETFs now, commodity ETFs, there are tax-efficient ETFs. So from my perch as a custodian/asset servicer, it will be fascinating to see just how big a global phenomenon ETFs become. LUC LECLERCQ: What is the impact on your business model? With the introduction of these products, there are a lot of transactions that you will not see going through your books, since they are cleared and settled elsewhere. PAUL STILLABOWER: ETFs are quite interesting. We support a lot of ETFs in Asia and you are kind of getting three or four bites of the cherry, as service providers. For example, we get fees for transfer agency, for fund administration, for global custody, the sub-custody. As a universal bank, the interesting thing is that there are three more bites of the cherry: there is the asset management fee, the structuring fee and the equity financing fee. As products they are very interesting and certainly we see an opportunity to put, for example, an HSBC brand on an emerging market ETF which would provide a group-wide product benefitting multiple divisions. LUC LECLERCQ: So that goes outside of your classical view of custodian/asset management provider? The structuring would be done by other parts of your bank’s business.

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PAUL STILLABOWER: Yes, it is other parts of the organisation, but that is one of the benefits of a universal bank model, or providers that have the multiple components. As well, regarding internalisation where you have different parts of one organisation that require securities services and they are pushing boundaries and you co-develop together, it is one of the exciting elements for a universal bank. TIM REUCROFT: The old transaction banking model is pretty much broken. The idea of putting cash and custody together worked great for ten or fifteen years, but now it is all changed because you have all these new products and asset classes. One of the things that HSBC, for instance, has been successful at is that they do run a separate network management for exchange traded derivatives. You cannot always go to the traditional custody providers for exchange traded derivatives, because it is a completely different network, with different providers, so you have to run it separately, and you are going to have to run different networks for prime brokers and OTC derivatives and many other asset classes. The transaction banking model is holed and is now sinking underwater, and you have to start looking at these new models.

RISK MANAGEMENT LUC LECLERCQ: You have to distinguish between risk management and risk measurement. Around the table we all do risk measurement, but few do risk management, which is a front office function. Given the volatile markets, the requests from the fund managers, the sophistication of our clients, the demands from regulators and external advisors, risk measurement becomes more and more important next to risk management. PAUL STILLABOWER: The very last thing anyone would do today is to go into their board and to say that a new product is risk free. That is probably the fastest ticket out of the boardroom with zero dollars to spend! ERIK GORIS: Our clients are looking at their custody provider to monitor investment guidelines and restrictions as well as provide risk measurement. The service level required for these services is also becoming more intricate. In terms of risk management, parties are looking to unload these activities either to an asset manager or to the asset service provider. On another level, looking at counterparty risk, investors are increasingly questioning asset service providers about risk management at the service provider itself. Previously clients would look at e.g. financial robustness, management and people. Currently we review all aspects of asset service providers ranging from core processes to disaster back-up procedures, as well as how risk management as a firm is being conducted by service providers. TIM KEANEY: We are being invited in more frequently by financial institutions that are looking at launching new products. And we are now being brought in earlier in the process, because once a decision is made to alter an investment style or launch a new product, the length of time from formulation of the idea to new product launch is about

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half of what it was just a few years ago. As a result, and I kind of like this, we have the opportunity to understand early on the scope of the operational and risk implications in supporting that change. When you are our size and you put it in the context of us custodising 9% of General Motors shares, for instance, then if we make a mistake on a corporate action for General Motors, or an income item—and imagine overpaying investors when you custodise and process 9% of General Motors— then that is measured in earnings per share. It is on the front of the Wall Street Journal and the front page of the FT.That harsh reality will drive the industry to the faster adaptation of standards ( notably in respect of derivatives) but it will also drive people down into the engine room together to figure out the best ways of launching the product quickly and with the least possible amount of risk. PAUL STILLABOWER: There are a couple of good examples of change, in the area of risk management, which have always been there, but had kind of been forgotten about. Two examples have come up really over the last two years. One is where the institutional investors are directing a lot of money into alternative investments and they are asking questions about the back office, the administrator, the custodian, the support mechanisms. If they are going to invest $500m into a fund, they want to have some understanding of who is doing the back end processing. Then secondly, specifically out of, or just after Bear Stearns’collapse, you have hedge funds starting to ask about the pooled account model of prime brokers and what happens around rehypothecation of assets, or what happens if another hedge fund goes down the tubes and assets are in a pooled account and get frozen until an administration company sorts out the ownership issue. The threat of not being able to trade for a period of time scares hedge funds. So they are starting to move assets not required as collateral from the prime brokers. Then it is not a big reach to move the financing to say a professional custody bank that will properly segregate their assets. And then, one step further, if the hedge funds don’t really require the financing for leverage, or they are funded by institutional investors instead of a prime broker, do they really need to be a prime broker at all?

THE FUTURE? FRANCESCA: What will be the important influences on your

businesses over the next five years, how are you preparing for it and what might the future of investment services be? PAUL STILLABOWER: The $64m question! At HSBC we are sticking to the roots of the organisation. The securities services business is following the bank footprint. We believe in the universal bank model and we have moved a lot closer to joining up the bank in the last few years, for example, with the investment management business, the global markets division and private banking. In macro terms, we like the long term demographics, which indicate continued faster growth in the investor base in Asia and the Middle East and in parts of Europe.That trend favours HSBC because we have a strong brand (we have a retail and bricks and mortar in those markets) and balance sheet in those markets. We are

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investing heavily in the two trends that we talked a lot about today, which centre around the convergence of traditional and alternative managers and the increase in complex investments. We are focused in our spend, on reusing our technology dollars, attracting people that have different talents, that as Tim said are really required in today’s business. So it is and will continue to be—in spite of the immediate downturn, which is perhaps starting to look more U-shaped than perhaps we would like—a good long term growth business. We are also investing heavily in the business because it is one of the fastest growing parts of HSBC. ERIK GORIS: Looking from the investor side again, as was mentioned earlier, there is a need for increased flexibility in supporting alternative investments because clients want to invest in these products and need somebody to service those assets. It becomes important for the industry to provide a sophisticated level of reporting and risk measurement because we see a lot of demand there from our clients. This is also driven by improved supervision and scrutiny regarding pension funds on those issues, on understanding what actually is in their portfolio and the inherent risk level. They are important elements of the service provision that clients will look for and that will be high on the list for selecting and choosing service providers. TIM KEANEY: From our perspective, we are going to step out from being just a global house and supporting cross-border investors. We want to take our game, our intellectual capital and apply that to local markets where we can help and drive change in a competitive landscape in a selective fashion. One of the big changes I know I am bracing for is when clients start to bind asset servicers to a hook. Fiduciaries and fund managers are going to say:“If you give me a calculation, you will have to put your imprimatur, your guarantee, on that.”No get out of jail free card. They will expect us to be comfortable with putting a valuation on their assets because they will be acting on that valuation. It is a game change. It is now all about those companies who put the capital investment, the people and the expertise behind their brand and who are prepared to put a ‘Good Housekeeping’ seal of approval on valuations of assets that are fluctuating quite rapidly. LUC LECLERCQ: One of the main drivers to make the industry successful is standardisation, but unfortunately this is lacking. We had some great successes such as Swift but we need more in order to push the industry and technology forward. Transactions could be processed so much easier if clear industry standards would be available and applied. The technology will enable us in the future to track transactions from inception to settlement across providers. This will not only enable us to better understand the status of each event but also reduce potential errors. FRANCESCA: Tim, obviously the clearing and settlement landscape is undergoing massive change, with DTCC coming into Europe and this ambivalent relationship between Euroclear and Clearstream and now the rise of the new trading venues with their own clearing and settlement arrangements. It is an increasingly fragmented landscape. What are the key issues that have to be addressed for you?

TIM REUCROFT: There was a metaphysical debate a few years ago, asking should we have competition or consolidation in the post trade landscape? The debate was won in favour of consolidation and Europe has set out to do that. I take my hat off to Euroclear (though I do not agree about the way that they went about it). They were open and said they were going to consolidate the CSDs. However, they are also an ICSD—effectively a global custodian—and they used that position to compete with the global custodians in Europe. Quite rightly Citi, BNP Paribas and a few others under the Fair & Clear banner said: “No, that’s not right. You have access to CSDs and we don’t; you also have direct access to central bank funds via the integrated model which none of the other clearing banks in Europe have either. This cannot be fair.” However, Euroclear’s justification is that the only way to reduce the cost of crossborder settlement in Europe is by taking out the cost of the agent banks (which is where the majority of the cost is). So, the Euroclear business model is good, but the way they went about is (perhaps) bad. Fair and Clear fought back and whispered in the ear of the ECB saying “Wouldn’t it be better if you came up with a pan-European solution called Target 2 Securities (T2S)?”Now I do not think that this is the solution to Euroclear, because T2S will not work. It does not have a financial justification. Central banks are not in the business of clearing and settlement (they do not provide uncollateralised lending, so cannot oil the wheels of settlement); T2S does not deal with the retail model (that is a whole separate argument) and there is no belief that the ECB will deliver what they say they will deliver. The main problem is however, that it effectively puts Europe on hold until 2013, because one of the basics of their financial case is that there are no more changes made by CSDs. We are not going to do any Giovannini work anymore because the ECB says we can’t, otherwise it destroys its business case for T2S. So that sets back the agenda for everybody. Now, that might suit some of the custodian banks, because it means that CSDs are no longer in a position to really compete with them, but the problem is if the CSDs see themselves as being nationalised by the ECB. That is essentially what the ECB is doing, taking this money away from the CSDs and the CSDs are saying:“Naturally we want to survive and the only way we can do that is by going up the value chain and taking on the business of the global custodians.” Then you are back to where you were before, with everyone objecting to what Euroclear was doing and going up the value chain and competing with the global custodians. And you have just recreated that by threatening all the CSDs in Europe. It is a very scary landscape. FRANCESCA: Tim, do you find it a lot easier in the US, where you have this rolled up system, compared with Europe where it is very fragmented and where you have the vertical system and the horizontal system or the bank system to deal with? TIM KEANEY: We like the DTCC model. It is scalable and the people that bring volume to it have a say in its governance. That is one of the things that has to be looked

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at quite carefully in the European context, and in a few years we will have moved on to talking about the AsiaPacific infrastructure. So yes, when you look at what T2S is costing, at what Clearstream and Euroclear are spending, it is unsustainable. That is one of the reasons why it costs eight times more to process equity trades in Europe than it does in the US, and that has got to change. I also think that a lot of volume should be pumping through this, but I worry about a for-profit infrastructure. Whether that infrastructure is vertical or horizontal, the industry—and global custodians—need to be more forceful when it comes to driving that change onto the agenda in Europe, where it is a more user-oriented model and where the people that are bringing the volume have a major say in the governance model. So yes, it is calling out for more scale, everyone cannot continue spending hundreds of millions of euros and not expect to see cost efficiencies in respect of equity trades over here. It simply has to change. PAUL STILLABOWER: The more infrastructure consolidates, the more there is standardisation in the infrastructure, the more comfortable citizens will be to invest more in the market. And that should benefit investors and that therefore benefits us. That eventually will happen, whether that has to be prescribed by government or not, it is inevitable. It is clear that there is enough vested interest in continuing to make money that slows the whole consolidation and standardisation process down, which is why it is something that may have to be prescribed, but certainly trends like UCITs IV and the passport plan in Europe, mean that eventually standardisation will come. It is unfortunate that in the meantime it is so painful to get there. But certainly if you made it easier and more transparent in the processing you would have much more investment, and that would mean a larger and healthier industry. FRANCESCA: With no immediate resolution in sight, do you see more or less pain? TIM REUCROFT: It has gotten worse because of the MTFs, because you now have EuroCCP, Citibank is the settlement agent for Turquoise, you have EMCF and Fortis acting as settlement agent for ChiX, so that has confused everybody. You have the PEP market opening up in NASDAQ/OMX, and they are going to use the EMCF solution, you have Burgundy threatening up in the Nordics and they have not yet announced what their post trade solution is going to be. So the whole thing is getting really confused and getting confused at the exchange end, as well as at the settlement end. All the MTFs are taking liquidity off the exchanges; MiFID just missed the target completely. It went for best execution when really it should have gone for price discovery. TIM KEANEY: Complexity is not just down to infrastructure, it is also a function of the diversity of tax rules within Europe. Look at the tax rules in places such as France. Furthermore, when do you own a stock and when do you not own a stock? Is it trade date or is it settlement date? The exchanges are one aspect of all this, sure, but the regulators also need to sit down and demonstrate a greater sense of urgency when it comes to harmonisation efforts.

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TIM REUCROFT, director, research, Thomas Murray Ltd ERIK GORIS: It is a step too far, maybe even for us, to try to

fully understand how this element of the business works, but it is at least important to know the level of knowledge of the provider, for example with respect to tax regimes. This is especially important for pension funds because they are not subject to taxes and look to avoid taxes to any extent. It often remains enormously confusing, however, to explain to clients that e.g., in transferring assets from one custodian to another you can (albeit temporarily) lose the beneficial or legal holding of your asset for tax purposes in some jurisdictions. On the one hand they maybe don’t even want to know, but on the other hand they need to acquire more knowledge as it is one of the key selection criteria for core services. It would be nice if on the pan European side there would be a more harmonised solution somewhere. PAUL STILLABOWER: The crux is that it is not a United States of Europe. It is fragmented and Asia is the same, where there are 14 or 15 meaningful markets. The tax status is complex depending on your domicile, and the products you are investing in. So it is very, very complicated. LUC LECLERCQ: It seems to me we are consolidating, and by the same token we are propagating. I strongly believe that if transactions cannot be done in the physical world, it will be done in the synthetic world and it will happen more and more. If I go synthetic I can get exactly the same as in the physical world without having to care for some of the inefficiencies of the physical world. FRANCESCA: Thank you very much for a very interesting discussion.

THE QUEST FOR INTEROPERABILITY

Photographer © Leo Blanchette, Dreamstime.com, supplied August 2008.

EVOLVING CLEARING REQUIREMENTS

With so much in flux at the continental European level, you could be forgiven for wondering what the future structure of clearing and settlement in Europe will look like over the coming decade. There is a spectrum of views, particularly in the area of clearing, where clearing options for traders still remain limited. Some years ago, questions centred on the possibility of a single pan-European clearing entity, but that solution is increasingly looking outdated as questions of competition, price efficiency and interoperability swirl the markets. As the European theatre becomes increasingly fragmented, new solutions must be found. One thing is clear however, pretty soon Europe will have to look for more than just regional solutions. The playing ground for clearing (and inevitably settlement) services is increasingly global. HE EVOLUTION OF post-trading clearing and settlement in the European single market is driven by a slew of initiatives, including the voluntary Code of Conduct for Clearing and Settlement, CESR/ESCB, the European Central Bank’s (ECB’s) Target2Securities, CPSS/IOSCO, ISD, G30 and the Giovannini accords. What they have in common is a desire to create a fully harmonised single, efficient European theatre in both clearing and settlement. The general thinking is that while some progress has been achieved in the settlement space, though clearing remains fragmented. Clearing (and settlement) remains organised largely on national lines; and deep-seated regulatory, legal, fiscal and market practice barriers make it difficult to move quickly to a panEuropean framework. Right now, the clearing infrastructure in Europe is becoming more not less fragmented. the emergence of new trading venues is encouraging a raft of new CCPs as there is a perception that existing central counterparties (CCPs) do not meet their pan-European coverage requirements. Second, the cost of cross border clearance and settlement remains

unacceptably high across Europe; “What needs to happen is the simplification of the European clearing and settlement franchise,”maintains Paul Bodart, executive vice president, The Bank of NewYork Mellon, for global custody excepting the United States. For Bodart, the imperative for change is straightforward: “People increasingly invest cross-border and because of the way that the European clearing and settlement market is structured (with 23 Central Securities Depositaries-CSDs) it is 10 to 15 times more expensive than a domestic transaction. Clearly there is a need for a simplified structure, though I am not convinced that Europe requires a single entity.” Moreover, as new trading venues come on stream with their own clearing counterparty arrangements over the short term, solutions to key questions such as competition and interoperability appear as far away as ever. According to Diana Chan, chief executive officer at European Central Counterparty Ltd. (EuroCCP), the London-based subsidiary of The Depository Trust & Clearing Corporation (DTCC) formed to provide clearing and settlement services in Europe, the key is the Code of Conduct for Clearing and Settlement,

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THE QUEST FOR INTEROPERABILITY 72

initiated back in June 2006 by the European Commission.“The fees in an effort to hang on to market share. LCH.Clearnet, Commission has been supported in its push by large for example, announced wide-ranging fee reductions last investment banks, concerned about the high costs of cross- year that have effectively halved the cost of clearing in the border clearing and settlement,”explains Chan.“The intent is London equity markets. There are also plans to extend its to create competitiveness and freedom of choice,” she services to new markets including Germany and Italy, which explains; “though we are yet some way from that. There are should help reduce unit costs and make further fee eight CCPs operating in Europe right now. Most have multi- reductions possible. Meanwhile Eurex Clearing, the clearing market capability; and we cover some 13 markets. All new and house of Deutsche Börse, also reduced its clearing fees for existing trading platforms need a clearing solution, but what is equity transactions earlier this year on its main order book lacking is a free choice for the trading community. A platform’s and the floor of the Frankfurt Stock Exchange by 25%. It is perhaps another outward sign of efforts by existing economic considerations, might not necessarily work to the advantage of traders. A platform will obviously favour their national CCPs to fend off change. Swiss CCP SIS x-clear, for example, was forced to delay the launch of its UK equity own CCP, but traders do not have that same choice.” clearing service in the early EuroCCP was provided part of this year after its own boost in the refused to allow it free continental European access to the LSE’s equity markets by Turquoise, a business, as required by the pan-European multilateral As new trading venues come on stream Code of Conduct. trading facility (MTF) with their own clearing counterparty LCH.Clearnet reportedly backed by a consortium of arrangements over the short term, imposed a charge to access nine investment banks, solutions to key questions such as business on the exchange, which began limited competition and interoperability appear which stymied the launch. operations at in London LCH.Clearnet has on August 15th. The as far away as ever. consistently supported the venue, first announced in Code of Conduct tried to November 2006, will block SIS x-clear in protest become fully operational at barriers it is facing itself in by September 5th. American alternative trading systems operators such as Europe, particularly Germany and Italy. Last year NyFIX, Liquidnet and the Investment Technology Group LCH.Clearnet issued formal requests to Deutsche Börse and (ITG) have already established platforms in Europe. Chi-X Borsa Italiana for full interoperability with Eurex Clearing and Europe, operated and majority owned by New York-based Cassa di Compensazione e Garanzia respectively. The link ups would enable market participants to agency brokerage Instinet, itself owned by Nomura, began operations back in March 2007. SmartPool, a dark book consolidate clearing of cash equities traded on four owned by NYSE Euronext, HSBC and BNP Paribas, is separate European markets (LSE, SWX-Europe, Deutsche expected to roll out later this year, as are Börse Berlin’s Börse and Borsa Italiana) at LCH.Clearnet. LCH.Clearnet Equiduct Trading and a pan-European venue from reportedly hit a stumbling block as regulations in Germany NASDAQ OMX Group. More venues, including Baikal, a and Italy are thought to require the London clearing house dark point aggregator, which is a joint venture of the to set up a local bank in order gain access to local markets. London Stock Exchange (LSE) and Lehman Brothers, are In the end LCH.Clearnet backed down in its stand off with slated for next year. Baikal has not yet announced which SIS-x but subsequently criticised European rivals for failing firm will provide clearing counterparty services for the to cooperate. Since then the Intercontinental Exchange venture: but it is likely to be an institution linked to the LSE. (ICE) has unveiled plans to establish a new London based While traders are not enjoying a free competitive European clearing house, which is expected to be landscape, against the background of the proliferation of operational by the end of the year. ICE has already secured new trading platforms, CCPs have been aggressive in their approval from the UK’s Financial Services Authority to efforts to either develop or keep market share. The Code of establish ICE Clear Europe. This prompted the UK’s Office Conduct on Clearing and Settlement, introduced in of Fair Trading (OFT) to call for feedback from "interested November 2006, has exposed clearing houses to the parties" on whether it should launch a competition prospect of real competition from rival service providers for investigation into clearing and settlement in the derivatives the first time. It is too early to say how successful this market. Although the competition watchdog approved competition will be, over the short term, in taking market ICE’s clearing house plans, the OFT said that "some share from existing providers; or as a method of providing competition concerns have been expressed about clearing and settlement". The major concern is that the incoming true interoperability. In the short term, the most immediate effect of increased clearing operations are expanding the so-called "vertical competition and the operation of free market dynamics is silo" model of clearing in Europe, whereby exchanges own encourage existing clearing operations to start reducing their their post-trade operations, thereby ensuring user lock-in

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from execution to settlement. The resulting question being, what is the point if there is a spreading anti-competitive behaviour in the exchange clearing business? “The introduction of the EU’s Markets in Financial Instruments Directive (MiFID) and the creation of a panEuropean securities market in November last year launched a paradigm shift in Europe’s equities markets,” notes Jeff King, director, product development EMEA on Exchange Services at Citi. “At the trading level, MiFID encourages the development of a pan-European market enabling the portability of trading markets across the continent. MiFID is less clear, however, on whether the more geographically restrictive clearing and settlement boundaries will remain, and if these boundaries are not diminished, how the goals of MiFID will be achieved.” The key going forward is interoperability, stresses King, “If you could openly choose whether EuroCCP or EMCF was better than the LCH.Clearnet and Eurex, then that is true interoperability,”he notes. Ultimately, it may the US Depository Trust & Clearing Corporation (DTCC) that sets the pace of change. In April, rumours surfaced of a possible link up with LCH.Clearnet, to facilitate transatlantic post-trade services. To date, nothing has

THE DOWN AND DIRTY GUIDE TO EUROPEAN HARMONISATION INITIATIVES The path of the search for harmonisation, market efficiencies and interoperability in the European clearing and settlement space has been marked by a series of mouth-contorting acronyms and initiatives. For the faint hearted, we provide a ready reckoner of the main institutions, joint ventures, directives and initiatives that have been strewn across the path of CCPS, CSDs and ICSDs aside from the more obviously understood institutions and initiatives, such as the Code of Conduct and Target2Securities. CESAME: The EC is assisted by the Clearing and Settlement Advisory and Monitoring Expert group (CESAME group) which is composed of around 20 high level representatives of various mainly private bodies involved in clearing and settlement, along with four observers from public authorities including the ECB. The group advises the Commission on marketled initiatives to bring down barriers to integration, ensures wide dissemination of all necessary information on the state of reform, and contributes to building awareness of the importance of the project for the success of the EU’s financial markets and for attaining the overall economic objectives incorporated in the Lisbon agenda.

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happened and both sides remain tight-lipped on the question, neither confirming nor denying that regular talks took place. It may be that the launch of EuroCCCP provides it with what it wants over the longer term in any case and if Turquoise is successful, the balance of power in DTCC’s favour in any case. That is important, not for the sake of the DTCC necessarily, but simply that it raises the stakes once more and Europe’s regional aspirations will begin to be super-ceded by global relationships. In a recent report by the Boston-based TABB Group on European clearing and settlement in Europe, Breaking Barriers-Building Alliances, its analysts think that “both the Code of Conduct as well as TARGET2-Securities will be challenged. The Code of Conduct, while critical, is reliant on institutions that may have no vested interest in facilitating interoperability; and TARGET2-Securities, while its merits may be debated, is a significant undertaking that will not be implemented until at least 2012.“ Over the medium term TABB Group believes the EU Commission will be prepared to intervene in support of interoperability under the Code of Conduct. In the longer term, competition will drive consolidation among clearing and settlement providers, leading to the emergence of a handful of efficient pan-European providers.

FSAP: Financial Services Action Plan (FSAP) was devised by the EC as far back as 1999. The plan is a key driver in working towards a single market for financial services. The measures in the FSAP have worked towards filling the gaps in legislation and removing the barriers between EU member states. Important regulation for financial services was passed under the FSAP, i.e. the Settlement Finality Directive (SFD), the Collateral Directive (CD), and the new Investment Services Directive (ISD). This has substantially improved the certainty and safety of operations involving collateral. CESR/ESCB: The Committee of European Securities Regulators (CESR) and the European System of Central Banks (ESCB) published two documents entitled Standards for securities clearing and settlement systems in the European Union. This document contains 19 standards which aim to increase the safety, soundness and efficiency of securities clearing and settlement systems in the European Union. The standards were based on International Organisation of Securities Commissions and the Committee on Payment and Settlement Systems (IOSCO/CPSS) recommendations for securities settlement systems of November 2001 issued by the Technical Committee of IOSCO/CPSS back in November 2001. The scope of application of the CESR/ESCB standards for public consultation related to the joint work being done by CESR/ESCB in applying certain specific standards to major custodian banks that provide securities clearing and settlement services. From this early template, the work of CESR/ESCB continues to strive for increased market efficiencies.

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After decades of debate and discussion, there is finally movement on the European post trading scene. A raft of regulations has started the ball rolling and there are now different solutions on the table. Ironically, they lead to the path of both fragmentation and consolidation but whatever the outcome, Euroclear is determined to remain a dominant force. Lynn Strongin Dodds reports.

VER THE PAST few years Europe has been seemingly inundated with legislation ranging from the Markets in Financial Instruments Directive (MiFID) to the European Commission’s code of conduct, Basle II requirements on capital adequacy and the European Central Bank’s (ECB’s) Target2Securities (T2S). Together they aim to transform every aspect of the European securities landscape with the common goal of integrating Europe’s financial markets, increasing efficiency and lowering costs. Although it might seem like there has been a recent flurry of activity, behind the scenes painful negotiations have been taking place between the stakeholders for years. They are far from over.

“We believe the Single Platform is the most ambitious and deepest project in Europe in terms of technology and market-practice harmonisation. We will process all types of transactions in multiple currencies and not just settlement services like T2S,” says Euroclear CEO Pierre Francotte. Photograph © Joshua Resnick/Dreamstime.com, supplied August 2008.

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Pierre Francotte, the chief executive officer of Brusselsbased Euroclear, notes that “undercurrents of change have been around for many years, such as deregulation in the financial markets, the launch of the euro and globalisation. For example, investment banks have looked outside their home markets and have considered these operations, not only in Europe but increasingly in Asia, as an integral part of their business. This was not the case ten years ago. Progress may be slow but these are significant trends involving technological decisions, and it takes time. The train, though, has definitely left the station and it will not stop in the middle of the countryside.” One of the prevailing questions, though, is whether Europe will ever emulate the United States and have its own Depository Trust & Clearing Corporation (DTCC), which clears and settles US cash equities, municipal bonds, mortgage-backed securities and OTC derivatives. The problems are obvious. The US is a homogenous country in terms of currency, regulations and culture whereas Europe is riddled with different cultures, legal and tax structures. National European exchanges use either inhouse or third-party clearance and settlement providers, which is an expensive proposition; facts that help explain why untangling this morass is a slow burn.

PROFILE: EUROCLEAR’S FORWARD GROWTH STRATEGY

EUROCLEAR STAYS THE PATH WITH A SINGLE PLATFORM

PROFILE: EUROCLEAR’S FORWARD GROWTH STRATEGY 76

serving seven EU markets and the “For many people, creating a international markets served by DTCC structure in Europe is the Euroclear Bank, will cover more ultimate solution. I do not see this than 50% of Europe’s domestic happening in the short term,”says bonds, about two thirds of its blue Francotte.“In effect, each country chip stocks and 60% of in Europe is already operating its Eurobonds. The eventual goal is own DTCC.The main objective of to serve 75% to 85% of the EU regulations and codes of European settlement market’s conduct recently introduced is to needs. We are not necessarily reduce trading, settlement and looking for 100% because the clearing costs in Europe. In a first incremental benefit of adding a phase, this will be achieved Pierre Francotte, the chief executive officer of Brusselslarge number of smaller pieces of through greater competition, and based Euroclear, notes that “undercurrents of change have business may not be worth it.” will lead to more consolidation been around for many years, such as deregulation in the Euroclear plans to continue and innovation. financial markets, the launch of the euro and globalisation. expanding the breadth and “We are already seeing a For example, investment banks have looked outside their reach of the platform, although it number of parallel, home markets and have considered these operations, not may not be through the complementary initiatives that are only in Europe but increasingly in Asia, as an integral traditional route. Moreover, says delivering, or have the potential to part of their business. This was not the case ten years ago. Francotte,“the Central Securities deliver, real benefits. A champion Progress may be slow but these are significant trends Depository (CSD) consolidation could eventually emerge, but the involving technological decisions, and it takes time. The effort has been accelerated by key to success will be the ability to train, though, has definitely left the station and it will not the planned acquisition of the attract critical mass, which is stop in the middle of the countryside.” Photograph kindly Nordic CSD. We are also looking necessary to generate the supplied by Euroclear, August 2008. at other types of partnership necessary cost savings,”he says. Not surprisingly, perhaps, Euroclear—one of the largest arrangements, so it is certainly not necessary to be a formal providers of domestic and cross border settlement and acquisition on every occasion. We are open to strategic related services for bond, equity, derivatives and fund partnerships, mergers or cooperation in the form of transactions—believes it is at the forefront with the technological alliances. The more volumes we attract on development of its Single Platform initiative. Launched in the Single Platform, the greater reduction in cost we can 2004, it is due to be completed in 2011. It has spent the past deliver to clients, which is our main goal.” The group also plans to target different user groups such as few years laboriously negotiating legal and fiscal practices in each country in order to harmonise the various practices the new crop of multi-lateral trading facilities (MTFs) that are expected to mushroom thanks to MiFID. So far, Chi-X is the for settlement, custody, payments, reference data and tax. The Single Platform aims to create a unified securities’ only real contender, although expectations for Turquoise, processing system and depository across its five markets— which is set to launch in September, are running high. Both UK, Ireland, France, the Netherlands and Belgium—as well have raised eyebrows in bypassing the big European operators, as the Finnish Suomen Arvopaperikeskus Oy (APK) and such as LCH.Clearnet and Euroclear. Chi-X employs Fortis’ Swedish VPC central securities depositaries that it recently European Multilateral Clearing Facility (EMCF) entity for its acquired for €470m. It has been designed as a multi- clearing and settlement needs, while Turquoise has chosen jurisdictional and multi-currency solution that will enable EuroCCP, the subsidiary of DTCC, for its clearing, settlement clients to settle securities transactions in central bank or and risk management services. Citi’s global transaction services commercial bank money, depending on their requirements. business will serve as EuroCCP’s settlement agent. Francotte is not put off and welcomes the contest. It will offer the gamut of processing services including corporate-action, collateral management and securities “Competition between settlement systems will, over time, lead to further consolidation as business volumes move towards the lending and borrowing transactions. Once the platform is fully functional, Euroclear predicts most efficient settlement systems. We are open to work with that users could pocket annual cost savings of about €350m MTFs such as Chi-X and Turquoise, the latter having selected by mitigating the expense caused by the current Citigroup as an agent to connect to CSDs that are part of fragmentation of processing platforms and disparate Euroclear. We are actively talking to other MTFs about our market practices. If the approach were to be extended offering and, while they may rely on a ready-made solution across Europe, the savings could grow to €700m to €800m. that is already functioning in the local marketplace, that does “We believe the Single Platform is the most ambitious and not mean the local CSD will be their only choice. The deepest project in Europe in terms of technology and market- advantage we have is that we are a neutral provider and are not practice harmonisation,” says Francotte.“We will process all part of a vertical silo associated with a specific exchange.” The fruits of Euroclear’s labour on the single platform are types of transactions in multiple currencies and not just settlement services [such as] T2S. The Single Platform, expected to be seen at the end of the year with the launch

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of an interim platform for all Belgian, Dutch and French securities transactions.“What this means,”says Fracotte,“is that these three markets will operate no differently than if they were a single market, as in the US. A Belgian bank can sell any domestic securities from these three markets to a Dutch firm which, in turn, can sell to a French firm in the same way that firms in Philadelphia, Boston and San Francisco settle trades. The complexity of cross-border transactions is removed and the cost is reduced.” Francotte also does not see the other offerings, such as the ECB’s T2S or Link-Up Markets spearheaded by rival Clearstream, as major threats. After a lengthy consultation process, the ECB’s governing council gave the green light to plans to build the pan-European integrated settlement system. The project, which will not encompass custody, collateral management, corporate actions processing or securities lending, will service the national CSDs and be run by the Eurosystem, the network of European central banks including the ECB. It will initially cover only euro traded securities, although other currencies are expected to be included in the future. The ECB invited all European CSDs to join T2S and asked them for feedback on the project’s viability. Euroclear, as well as Clearstream, which is part of Deutsche Börse, both had reservations over the cost, legal and governance structure of the project. “T2S definitely fits into our picture and we see the platform more as a complementary offering. We have given our support to the objectives of T2S, but it is conditional on certain requirements being met,”says Francotte.“Issues will have to be clarified. This is not surprising given that the project is not due to be launched for another five years and we did not expect the ECB to have all the answers now.” The main sticking points relate to the legal and contractual framework “governing the ECB/CSD supplier/outsourcing relationship”, the governance structure safeguarding CSD interests and user choice between T2S and Euroclear’s single platform.“The bottom line is whether the ECB will complete the project on time, at a reasonable cost and with all the benefits that have been promised. User choice, we believe, is very important. Each user should decide individually which settlement model they wish to use and when to use it. This will allow users to make any investments related to T2S according to their own preferred timetable,”added Francotte. As for Link-Up Markets, Francotte believes it is a different proposition altogether. The joint venture between Greece’s Hellenic Exchanges, Spain’s Iberclear, Austria’s Oesterreichische Kontrollbank, Switzerland’s SIS SegaInterSettle, Denmar’s VP Securities Services and Norway’s VPS seeks to create a common infrastructure by the first half of 2009 that will absorb the differences in communication standards currently existing between the CSDs. It will facilitate links between CSD markets and introduce efficient cross-border processing capabilities. According to Clearstream, customers will benefit from a single access to almost 50% of the European securities

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market and receive consistent best-in-class CSD settlement and custody services. The firm claims this should reduce costs by up to 80%, while fees on existing CSD links have potential for reduction, albeit at a lower level than 80%. “We see Link-Up Markets as a positive but more modest step that focuses on standardisation and communication, although we already have these features as part of our Single Platform. I do not see Link-Up Markets reducing the costs of settlement in a meaningful way, but it might make sense for us to link up with them in the future as a way to communicate with other CSDs that are not part of our platform,”says Francotte. Looking ahead, Euroclear is also casting its net wider than Europe and has signed memorandum of understandings (MOU) with different CSDs in Brazil, Russia, India and China [BRIC markets]. In 2007, Euroclear, which has an office in Brazil, signed an MOU with Latin American securities depository Camara de Custodia e Liquidacao (CETIP), which provides for cross-training programs, information exchanges, joint studies and regular meetings between the senior management of both settlement houses. Earlier this year, Euroclear Bank opened an operations centre in Hong Kong and an office in Beijing in order to boost its presence in the Asia-Pacific region. The bank has hired 25 operations staff while several senior operations and legal experts relocated from the bank’s Brussels-based headquarters in order to beef up its team in the territory. Domestic securities from eight Asia-Pacific markets are currently eligible for settlement, custody and related services at Euroclear Bank. “The BRIC markets are growing and are looking towards the international capital markets to raise capital,” says Francotte. “At the same time, we are seeing institutional investors increasingly investing in these markets. Although these markets may not be fully open as yet, we want to position ourselves as the international securities depository with which to work over the long term in order to settle cross-border trades and provide custody services for the domestic securities of these markets when settled outside the home markets.” Closer to home, there has been some movement in the management ranks with Tim May, currently chief executive of Euroclear UK & Ireland (EUI), taking over from Francotte as chairman of EUI. May will retain his position as executive director of Euroclear at group level and chairman of EMXCo. Yannic Weber, currently managing director and head of the commercial division at Euroclear. will become chief executive officer of EUI, while Pierre Yves Goemans, currently managing director and head of product management at Euroclear, will step into Weber’s shoes. These changes are par for the course, according to Francotte, who remains chief executive of the group.“It is part of our philosophy to rotate senior people every three to four years so that they can better understand and gain experience working in different facets of the company. It is part of their career evolution and has proven to be a good way to retain people as they are regularly being challenged. Take me, I joined Euroclear’s legal division in 1993 and am still here.”

TOWARDS BEST PRACTICE IN HEDGE FUNDS

HEDGE FUNDS RAISE THEIR OPERATIONAL GAME

In April 2008, the Asset Managers’ Committee of the President’s Working Group on Financial Markets issued a report, Best Practices for the Hedge Fund Industry. The committee identified five areas where it wanted managers to implement a best practice framework: disclosure, valuation, risk management, operations and compliance and conflicts. While the report does not have the force of regulation to back it up, it certainly fired a warning shot across the bows of the industry.

In a flat market, the rules change. Since the onset of the credit crunch, investors have struggled to find a sustainable balance between cheap beta and profitable alpha. With many alternative investment products now failing to deliver alpha [July 2008 was widely reported as the worst month for hedge funds since 2000], both institutional investors and market regulators are beginning to demand new levels of transparency and standards from alternative investment managers. As always, there is an element of carrot and stick to these demands. Specialist fund managers are keenly aware of the opportunities to tap into the deep global pools of institutional money, with the rapidly growing resources of sovereign wealth funds being just the latest example. José Santamaria, director, RBC Dexia Investor Services, argues that hedge funds will gain a competitive edge if they improve pricing and valuation methodologies.

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OR HEDGE FUND managers to stand a chance of winning significant mandates right now, they need to demonstrate that they operate to the highest industry standards. This is not only about the business of asset allocation and selection. Investors and regulators are naturally concerned that the manager has an effective operational and risk management infrastructure, with proper controls, robust technology and suitably qualified staff. In April 2008, the Asset Managers’ Committee of the President’s Working Group on Financial Markets issued a report, Best Practices for the Hedge Fund Industry. The committee identified five areas where it wanted managers to implement a best practice framework: disclosure, valuation, risk management, operations and compliance and conflicts. While the report does not have the force of regulation to back it up, it certainly fired a warning shot across the bows of the industry. In fact, many hedge fund managers have already started work on improving practice in these areas, backed by two earlier initiatives. In 2007, for instance, the Alternative Investment Management Association (AIMA) published 15 recommendations for hedge fund valuation, while the Hedge Fund Working Group, a UK-based committee of 14 major hedge funds, has published a comprehensive set of standards that will be monitored and maintained by the newly-created Hedge Fund Standards Board. The formalisation of best practice standards is clearly a positive step forward for the industry. With regulators and practitioners working co-operatively, the industry will be much better placed to satisfy the demands of institutional investors. That said, participation in these industry initiatives should not be used by managers as an excuse to avoid implementation of better operational and risk management processes within their own middle and back offices. Managers need to be able to demonstrate that their procedures are transparent, robust and subject to rigorous internal and external audit. There is growing evidence that alternative investment management houses are taking notice and are upgrading their infrastructure.

Setting the pricing parameters Yet the fact remains that much more needs to be done. Nowhere are the key issues of transparency and standards more pressing than in the process of valuations. Investors and regulators have set the industry a challenge: to implement and deliver a consistent, transparent and fair pricing methodology across all alternative investment classes and markets. This goal is the ultimate test for the industry as it seeks to gather more assets from institutional investors that have demanded and received these standards in the traditional long-only sector. Despite the fact that alternative and structured assets are, by their very nature, more difficult to price accurately, institutions expect greater consistency and transparency.

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Paladyne Systems, a technology solutions provider to the hedge fund industry, summed up the reasons for this increased focus on pricing transparency in its 2008 white paper Hedge Fund Portfolio Pricing Best Practices. It noted that: “The pricing initiative will become more pressing as investors demand greater transparency in light of the recent market volatility. Traditionally, investors have accepted a lack of operational and pricing transparency, taking comfort that the hedge fund principals and partners have significant equity and personal deferred compensation at risk. However, as more funds have announced negative returns and closings, both investors and regulators are urgently addressing this pricing and valuation issue.” For managers and their service providers, standardising the pricing model will be a tough assignment. The seemingly inexhaustible institutional appetite for absolute return products has encouraged managers to expand their investment parameters well beyond financial markets. Infrastructure projects, carbon emissions, methane recapture and weather futures are just a few of the new asset classes attracting the attention of the alternatives sector, while specialists can offer investment in areas such as fine art, antiques, wine, stamps, coins and rare gems.

The outsourcing alternative One inevitable consequence of complexity is that the managers gravitate towards external centres of excellence. This is not only a practical solution: it also satisfies the institutional and regulatory demand for more independence in the pricing and valuation processes. For long-only managers that are moving into the alternative space, the decision to outsource administration is relatively straightforward. They have neither the time nor the resources to build new systems and operations to handle, say, long/short funds or structured products. Outsourcing has long been an accepted practice in the traditional fund management space. Now that practice is becoming more widespread within the alternative management community. Specialist managers with highly complex investment strategies that encompass a broad range of illiquid or hard-to-price instruments are increasingly turning to third-party administrators for help. Acting independently from the manager, their counterparties and prime brokers, it is the role of properly qualified third-party administrators to deliver the professional pricing standards sought by investors and regulators. The key to effective pricing and valuation is consistency. Whether working within the terms of a private placement memorandum, or on behalf of a managed account, it is vital that the administrator clearly understands, documents and agrees with the investment manager the processes that will be used to calculate and provide an independent valuation. This may be a combination of mark-to-market, mark-tomarket-maker or model-based pricing. The overriding pricing principle should always be to act in accordance with

TOWARDS BEST PRACTICE IN HEDGE FUNDS 80

the agreed pricing methodology, based on the best information available at the time and to demonstrate good faith, effort and total transparency in the valuation process. Not all administrators are equal when it comes to their capability to value and account for complex instruments. Most third-party administrators can reliably administer exchange-traded and liquid instruments. The technology platforms required to service long/short funds are now widely deployed (as opposed to the former solution of manual spreadsheets), with administration delivered by experienced fund accountants. However, that technology and expertise cannot be seamlessly transferred or leveraged for complex over the counter (OTC) derivatives and modelbased pricing. These require the combination of specialist technology platforms and highly-skilled staff. The larger administrators are now looking at acquiring and building the same levels of market expertise as their clients, so that they can deliver a service that is underpinned with a true understanding of the behaviour of complex instruments and markets. That type of expertise has not historically been available from smaller administrators, which have tended to rely on a combination of graduate and accountant recruitment. As a result, some smaller administrators may deliver what might be referred to as a ‘pricing/NAV lite’ service, where only a limited amount of work is put into pricing the investments and all liability for errors is transferred back to the investment manager. Additionally, the service provider community varies widely in its capabilities to value and administer OTC derivatives.

A new investment model Derivatives represent possibly the biggest current challenge to the administration industry. The scale of that challenge was identified in a 2007 report published by Celent, OTC Derivatives: The Post-Trade Landscape for Hedge Funds and Asset Managers. Celent forecast that technology expenditure globally on third-party solutions for automating OTC derivatives support in the post-trade/pre-settlement area would increase from $187.8m in 2007 to $232.5m by 2011. The report suggests that: “Some fund managers are willing to cope with manual processes on small amounts of trading; others rely on services provided by prime brokers. For some firms, the complexity is so challenging that outsourcing to fund administrators is the ideal approach.” As the Celent report shows, the overall cost of setting up a middle and back office infrastructure for OTC derivatives in today's environment can run into millions, leading many firms, including mainstream traditional investment management groups, to view outsourcing as the only viable option. However, while there is a lot of interest in outsourcing the derivatives middle and back office, there are few providers in the market who can provide a truly integrated offering. Current service providers fit into two broad categories: the global custodians, and niche fund administrators, that are developing the technical capabilities, and the sell-side institutions that are still trying

to come up with a service model that works for the institutional investment manager. Servicing the lifecycle and date requirements of the constantly widening OTC product market is an ongoing challenge. The challenges confronting the industry are no longer confined to the relatively small alternative management sector. Traditional managers are busily expanding their product offerings so that they can capture better market share and fulfil client expectations. In Europe, the UCITS III Directive has considerably expanded the range of eligible instruments that can be deployed by managers, enabling them to replicate hedge fund activities. Mutual fund managers are now using long/short strategies and structured products as part of their overall offering for mainstream retail funds. New products, such as the 130/30 fund, are evidence of the ambitions of traditional managers, as is the significant growth in the use of OTC derivatives. This, in turn, has changed the way in which investors think about their portfolios. We no longer live in the monthly or quarterly world. Institutional and retail investors want portfolio data much more quickly, especially during periods of high volatility, as we witnessed in the first half of 2008. Fund managers can struggle to provide these on-demand indicative asset values, giving further impetus to the outsourcing of such vital processes.

Taking the next step No one ever believed that the wholesale shift of institutional money into alternative assets would be straightforward. Specialist managers have understandably focused their attention on investment performance rather than operational excellence. Yet the way in which the middle and back offices are structured and managed can have a significant positive—or negative—effect on overall fund performance. Those managers that have already recognised this fact have restructured themselves with a combination of higher internal operating standards and the deployment of best-of-breed external providers. Investment managers want to be free to pursue business without undue regulatory burdens. To ensure the regulators continue to operate a light touch regime, the managers themselves have to prove that they consistently adhere to best practice and industry codes of conduct. In the key area of pricing and valuation, that means the standardisation of pricing methodologies across all asset classes, supported by mutually-agreed policies on valuation procedures and, critically, ultimate ownership of responsibility and liability for errors. A well-documented and understood operational and pricing methodology, supported by best in class infrastructure and operational process, will greatly benefit hedge fund managers and the alternative investment industry at large. Working under this transparent backdrop, investors will continue to allocate more capital to hedge funds and the alternatives industry will benefit as a whole. That is the golden goal for an industry that is still learning the values of transparency, consistency and standardisation.

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Financial institutions and non-financial institutions should adopt fair value reporting to improve their understanding of risk exposures and the effectiveness of risk management systems, writes Vincent Papa, senior policy analyst at the Chartered Financial Analyst (CFA) Institute. He explains that adopting fair value for financial instruments can significantly reduce the complexities of existing financial reporting practices, such as hedge accounting.

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NVESTORS SEEK TO understand the overall business risk profile of their current and potential investments. Anticipating the potential volatility of future business performance is an integral part of understanding the overall business risk profile of companies. This means getting answers to several questions including: what is the risk exposure of reporting companies? There is also the question of whether the reporting companies fully or partially hedge their risk exposures and whether the hedges applied are effective. Derivative instruments can be used to manage corporate risk exposures. They can also be used for speculative purposes in which corporate managers can make bets on interest rate trends, shifts in the yield curve or other risk factors. Corporate use of derivatives for risk management and speculative purposes is widespread. The latest Bank of International Settlements (BIS) shows that, as of December 2007, there was $597trn of outstanding derivative contracts, including foreign currency, interest rate, commodity, credit and equity-linked derivatives.

FAIR VALUE ACCOUNTING

Improving Investors Understanding of Risk

FAIR VALUE ACCOUNTING 82

financial instrument complexity. It is also due to the shortfalls in the financial reporting of derivatives. The motivation behind the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) decision to introduce fair value accounting for derivative instruments was to make transparent the risks associated with these and other Derivative Transparency Notwithstanding the improvements in the financial financial instruments. Under FASB Statement No 157, Fair reporting for derivatives in recent years, there remain gaps Value Measurements, fair value is defined as the price that in the disclosure about risk management activities in would be received to sell an asset or paid to transfer a liability financial reports. Investment professionals are often in an orderly transaction between market participants at the measurement date. Sources befuddled and of fair value include quoted overwhelmed by the (unadjusted) market prices general complexity of Survey studies of financial reporting for highly liquid financial financial reports and the disclosure requirements of Chartered instruments. For less liquid particular complexity of financial instruments, fair derivative accounting. Financial Analyst (CFA) Institute value can be determined by One equity analyst says membership, conducted by the Centre for the use of indirect market that reporting on the use Financial Market Integrity, show that proxies, adjusted for factors of derivatives seems to there is a significant deficit in the quality specific to the asset or only be of interest to of disclosure about the nature of a firm’s liability such as condition treasury professionals. He and location and activity implied that current risks and its use of derivatives and level of the market. derivative accounting was hedging strategies. In the absence of not making his job of observable market or understanding the effects market-based inputs, fair value can be determined based on of derivative use on operating performance any easier. Survey studies of financial reporting disclosure management estimates using unobservable inputs. Fair value requirements of the CFA Institute membership, conducted measurement provides an updated assessment of the value of by the Centre for Financial Market Integrity, show there is assets and liabilities held. The use of fair value as an exit, a significant deficit in the quality of disclosure about the market exchange price is predicated on the market price being nature of a firm’s risks and its use of derivatives and seen as an objective arbiter of the value of assets and liabilities. The use of fair value hedging strategies. The accounting has wide deficit is measured as the support among investors. A difference in quality and monthly survey of CFA importance attached to Findings show the lack of derivative Institute membership these components. The conducted in March 2008 opacity of risks associated expertise could be a constraining factor had 2006 responses. The with derivative use is not on the worth of an independent board in results showed 79% of confined to firm outsiders. their oversight and monitoring function. respondents believe fair A study (Buckley and van value improves financial Der Nat (2003)‚ Derivatives institution transparency, and the Non executive directors, European Management Journal, Vol 21, No.3, pp while 74% believe it improves the market integrity. Similarly, 389-397) conducted by academics of a sample of quoted a survey study carried out by the European Federation of UK companies, found two thirds of directors said they had Financial Analysts (EFFAS) found a majority of respondents had a favourable general attitude towards fair value. an inadequate knowledge of derivatives. Relative to the application of amortised cost for financial These findings show the lack of derivative expertise could be a constraining factor on the effectiveness of an instruments, fair value accounting provides a better starting independent board in their oversight and monitoring point to conduct investment analysis. For financial function. Board members may have the right incentives instruments, fair value accounting enables the ongoing and willingness to act in the best interest of shareholders, tracking of risk factors that affect the value of financial yet they may simply lack the knowledge to effectively do instruments, for example, the interest rate and yield curve so. The situation of where even well-meaning, trends, prepayment rates, default rates, recovery rates, and independent directors appear to have ‘fallen asleep at the the volatility of these risk factors. Ongoing tracking of wheel’ due to inadequate understanding of derivative these risk factors enhances the ability to develop related exposures, could be a by-product of derivative expectations about the changes in future values of assets The challenge of understanding derivative associated risks and opportunities is compounded by the fact that even though derivative contracts may help to offset particular risk exposures, such contracts can introduce new ones, such as counterparty risk.

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and liabilities. The idea behind fair value accounting is to help obtain decision useful information, as opposed to providing precise but economically meaningless information with little predictive abilities. Some critics of fair value often raise questions about the reliability of fair value, for example in illiquid markets. However, those critics overlook the fact that liquidity risk is a critical one to be considered when valuing a specific instrument just as interest rate risk, market risk or credit risk. Getting a meaningful value for illiquid financial instruments can pose formidable challenges, especially for those without observable inputs. However, on what basis are managers making buy, sell or hold decisions? Are investors to assume that because trading activity has dried up for certain kinds of instruments that estimating fair values is impossible? On the contrary, there has to be an up-to-date basis of assessment to ensure the adequacy of a firm’s financial flexibility, which managers should be able to convey to those providing capital to their firms. The ongoing credit crisis has vindicated the role of fair value accounting treatment as a decision useful approach. Fair value accounting has clearly had a role in the restoration of trust between counterparties holding inventories of hard to value financial instruments. It is also becoming more evident, even to doubters, that the fair value write-downs undertaken by many of the large banks represent economic reality and is a correction of excessive risk bearing. The recent move by Merrill Lynch to sell its Collateralised Debt Obligation (CDO) portfolio at 22 cents on the dollar just shows the sheer folly of assuming that the signals provided by the marketplace are nothing more than a temporary aberration.

Resolving hedge accounting complexity and anomalies Apart from increasing transparency of derivative use, the application of fair value measurement for all financial instruments can simplify the accounting for derivative instruments tha occurs through hedge accounting methods. During the introduction of fair value accounting for derivatives, concerns that recognition and measurement inconsistencies between the hedging instrument and hedged items could trigger artificial earnings volatility were raised. To address these concerns, the accounting standard setters introduced hedge accounting as a means of alleviating ‘artificial’ earning volatility. However, the application of hedge accounting has contributed to the extraneous complexity and reduced the overall transparency of financial reporting information. In part this is because hedge accounting is essentially an exceptional treatment that can be optionally applied to the general requirement of having to fair value derivatives. Within the exception, multiple sub exceptions have been built in. The multi-layered exceptional treatment with optional choice makes accounting more of a reflection of managerial intent. Managerial intent is often not observable or accessible to investors. Besides, managerial

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

intent of holding derivative instruments is not always consistent with their fundamental economic reality. The two primary forms of hedge accounting are fair value hedge accounting and cash flow hedge accounting. Fair value hedge accounting adjusts the accounting treatment of the hedged item to that of the derivative instrument. It is applied to recognised assets and liabilities and unrecognised firm commitments. Cash flow hedge accounting is aimed at future cash flow transactions, such as sales, purchases and interest rate payments. The accounting treatment works in the opposite direction of fair value hedge accounting as far as income statement treatment is concerned. This is because it requires the deferral of derivative gains and losses as a component of other comprehensive income. For example, an airline company based in Canada could make orders for several A380 carriers from a manufacturer such as EADS, invoiced in euros and due for delivery in five years. This airline company could decide to hedge the effect of potential exchange rate volatility on the cost of this acquisition, using a call option or forward currency derivative contract. The airline company could use cash flow hedge accounting for the future payments. The distinction between a cash flow hedge and a fair value hedge lies in the hedged item, not in the derivative itself. A fair value hedge is designed to hedge changes in market value, whereas a cash flow hedge is intended for situations where market value is not at risk, but the level of cash flow is. (White, Sondhi, Fried: The Analysis and Use of Financial Statements Third Edition).

Consequences of hedge accounting The application of hedge accounting had a range of unintended consequences including: imposing significant interpretation and implementation obstacles; suboptimal instrument selection; income volatility due to deferred and recycled hedges and increased earnings management opportunities

Interpretation and implementation complexity The question of whether and how a derivative can qualify for hedge accounting treatment is one that has triggered the need for frequent discussion by, and massive amounts of interpretative guidance from, the FASB and its Emerging Issues Task Force and the International Financial Reporting Interpretations Committee. This is a by-product of derivative product complexity and the variety of derivative instruments available. The implementation requirements are communicated through volumes of rules. The documentation of eligibility for hedge accounting is onerous. It requires the execution of a range of prospective and ongoing, quantitative tests in order to prove that a hedge is effective. This imposes significant interpretation hurdles for both financial statement preparers and users. The multi-layered complexity arising from hedge accounting leaves investors with the burden of deciphering the managerial intent underpinning the accounting for each derivative instrument. For example, a

FAIR VALUE ACCOUNTING

problem with recycled hedge accounting adjustments is that they effectively represent gains and losses relating to earlier reporting periods and their inclusion can create unforeseen and significant fluctuations in current period earnings. The deferral is a distortion of economic reality, as it is premised on locking in risk factors. For example, the Canadian airline acquiring an A380 in euros will be Sub-optimal instrument locking in the exchange rate selection available at inception of the The imposition of onerous hedge derivative contract. It may appear accounting eligibility tests was that the recognition of the based on the assumption that derivative gain or loss at the time preparers would prefer to of the purchase in five yearsâ&#x20AC;&#x2122; time account for derivative Survey studies of financial reporting disclosure would then accurately present the instruments using hedge requirements of the CFA Institute membership, economic cost of sales. However, accounting. Onerous hedge conducted by the Centre for Financial Market Integrity, this is only true if the derivative accounting requirements show there is a significant deficit in the quality of maturity matches the hedged inherently make it difficult for disclosure about the nature of a firmâ&#x20AC;&#x2122;s risks and its use transaction holding period and if certain types of derivative of derivatives and hedging strategies. Photograph there is no basis risk due to instruments to qualify for hedge supplied by istockphotos.com, August 2008. hedging amount or underlying accounting, regardless of their actual economic hedge effectiveness. Options in particular risk factor. In reality there is often a maturity mismatch often fail to meet requisite hedge effectiveness tests and between the derivative and the hedged item. Besides, the can only qualify for hedge accounting to the extent of hedging gains and losses can be monetised during the changes in intrinsic value but not to time value changes. holding period of the hedged item, and the reporting firm Interest rate swaps also fail to qualify as they often do not may decide to replace the derivative instrument with other match up properly (with hedged items) for hedge hedging instruments. Hence it is misleading to implicitly accounting. These onerous requirements of hedge assume that they will be held to maturity. Overall, the accounting can have the unintended consequence of interplay of deferral and recycled cash flow hedge accounting policy choices effectively dictating risk accounting gains and losses makes it difficult to interpret their economic meaning. management choices in certain instances.

receive fixed, pay floating rate interest rate swap would be accounted for differently if it were designated as a fair value hedge used to hedge a fixed rate debt obligation, compared to how it would be accounted for if it were designated as a cash flow hedge used to hedge the interest rate variability of a floating rate debt exposure.

Distortions from cash flow hedge accounting Cash flow hedge accounting requires the deferral of derivative gains and losses in relation to future anticipated transactions. In general, hedge accounting must be discontinued when the hedges are ineffective, sold, terminated or exercised. However, hedge termination does not always result in recognition of gains and losses on derivatives. Accumulated gains and losses on forecasted transactions are recognised in income when that transaction affects reported income. However, when the hedge is terminated because the forecasted transaction takes place, accumulated gains and losses are recognised over the life of the forecasted transaction. (White, Sondhi, Fried: The Analysis and Use of Financial Statements Third Edition). The rules of determining ineffectiveness can be described as mysterious at best. For example the current rules, have an asymmetrical treatment of gains and losses, only allowing the adjustment of over-hedging but not allowing the adjustment of under-hedging. Another

Fair value: best solution to hedge accounting complexity As described in the article, hedge accounting is complex, and often unwieldy in its implementation requirements. The most effective way of eliminating measurement mismatches would be the application of full fair value across all financial instruments. The use of fair value for all financial instruments would eliminate the need for hedge accounting and significantly reduce the complexity associated with financial reporting. Admittedly there are hurdles that exist before financial reporting can be executed on a single, fair value basis for all financial instruments. Some critics of fair value highlight the difficulties in getting fair value of illiquid instruments. Given the benefits of fair value on transparency, the challenge should be to try and improve the valuation methods and markets that enable price discovery. It should also be to improve disclosure in a manner that enables the easy understanding of the range of likely outcomes associated with assets and liabilities held.

SEPTEMBER/OCTOBER 2008 â&#x20AC;˘ FTSE GLOBAL MARKETS

fund distribution & the evolving role of administrators

Photograph © Norma Cornes/Dreamstime.com, supplied August 2008.

A newly released report by CREATE-Research, sponsored by RBC Dexia Global Funds Distribution; Bridging new frontiers, looks at the way that Undertakings for Collective Investments in Transferable Securities (UCITs) is globalising the funds business, at the same time driving out systemic inefficiencies in the funds business. Report director, Professor Amin Rajan, the chief executive officer of CREATE-Research looks at the benefits so far of UCITs III for clients and their managers and highlights the factors that will accelerate the take up of the investment vehicle in coming years. ACK IN 1985, when the European Commission set out to create a single market in fund management across Europe, few people could have anticipated its three notable outcomes. The first is the scale of recognition now accorded to UCITs, the legal vehicle chosen by the European Commission (EU), which has now become the kite mark of quality inside and outside Europe. The second is the emergence of Luxembourg and Dublin as key centres from which fund managers now engage in cross-border sales. Both have incorporated the relevant directives into their national laws with an unusual degree of common sense. Third is the growing role of third party administrators which now offer a variety of low, medium and high valueadded activities under outsourcing deals. Starting from scratch in Dublin and Luxembourg has enabled external service providers to use state of the art systems with a marked unit cost advantage over the legacy systems, which many fund managers and their distributors continue to use in their home jurisdictions. These are some of the findings from the CREATEResearch survey, involving some 110 fund managers from 23 countries with funds under management of a combined

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

€15,746bn. Focusing on UCITS, the survey sought the opinions of these funds on the past impact of the investment vehicle and its future challenges. According to the participants, administrators are directly adding value to their clients’ businesses by delivering: cost savings in operations that are scalable; time-savings in fund registrations; faster time-to-market in product launches; independent valuation of investments; and modularisation of services that clients prefer on an à la carte basis. Indirectly, their value-added is also notable in three areas. First, as hubs they are delivering operational excellence in activities as diverse as income collection, asset reporting and securities pricing; thus aligning the front and back office at fund manager end. Second, they are helping fund managers to extract maximum operating leverage in cross-border export of funds; thus offering a more cost-effective route to globalisation. Third, they are venturing into an increasing number of middle office functionalities e.g. trade reconciliations, performance reporting, performance attribution analysis, risk analysis, simulation models, stress testing, data management; thereby emerging as significant partners in innovation. In the process, administrators are now increasingly equipping themselves to venture into back office processing at the distribution end, in ways that can promote a seamless alignment between manufacturing and distribution. Over time, they also expect to provide introductory services that promote alliances between fund managers and their potential distribution partners, thereby bringing yet more players to the UCITS space. Global head of sales and relationship management at RBC Dexia, Tony Johnson, says: “This is rapidly becoming a critical area for the investment business and we have recently boosted distribution support capabilities via our Funds Hub platform—connecting distributors and manufacturers, providing key data on areas such as settlement and custody activity and employing extremely robust management information systems.”

DISTRIBUTION SERVICES AT THE FOREFRONT

Business Darwinism:

DISTRIBUTION SERVICES AT THE FOREFRONT 86

A new web of alliances Globalisation of funds began in the 1960s, but it is only in this decade that it gathered momentum, when large fund managers increasingly ventured abroad as growth in their home markets slowed down due to rising penetration. With the growth of UCITS funds, globalisation has received an added fillip, boosted by the fact that their exports from Luxembourg or Dublin do not require a physical presence on the ground in the jurisdictions where the funds are sold. What they require are alliances with third party distributors in countries, where fund managers do not have proprietary sales channels. Under UCITS, such alliances have grown rapidly inside and outside Europe, thereby reinforcing another trend unleashed by new regulation in this decade: namely, the separation of manufacturing and distribution. Since the start of this decade, regulators inside Europe have been increasingly wary of large distributors that also offered in-house fund managers, who ended up managing the lion’s share of the money irrespective of their track record and needs of end-clients. At the EU level, such managers are now enjoined to reduce conflicts of interest via the recent introduction of the Markets in Financial Instruments Directive (MiFID) rules, which require full transparency around total expense ratios and value-added at each stage of the food chain. National regulators, too, are applying direct pressures, the degree of which has varied between the member states. Directly, these devices seek to protect the client interests. Indirectly, they aim to encourage fund managers to focus on their core competencies and increasingly outsource non core activities such as distribution and administration to third party specialist providers. However, for fund managers, finding good distribution partners is not easy. Outside the United States and the United Kingdom, distribution in many other markets is controlled by banks, which hold a strong sway over their clients. Furthermore, contradictions have long characterised the retail fund market in Europe. Outwardly, Joe Public has never had it so good. With around 38,000 share classes on offer, he has nearly four times as much choice as his peer in the US. However, more does not always mean better. Moreover, the average assets in each class are four times less, raising unit costs. Finally, distribution has hitherto been dominated by banks that offer little advice and place funds automatically with in-house fund managers, or those offering highest front-end commissions, irrespective of client needs. Sales commissions have invariably driven the choice of products and providers. That such practices are attracting increasing regulatory scrutiny is not in doubt. Nor is there any doubt that distributors are being forced to put client interests first. Under UCITS, the winds of change are evident. According to the survey, one in every two fund managers has alliances with their third party distributors and one in four has joint ventures. The former are more prevalent inside and outside Europe; the latter are more prevalent outside Europe. Either way, the fund business is becoming more networked. Old

style cosy relationships are being replaced by new style mandated transparency. Currently, the balance of power in the evolving networks lies decidedly with distributors who ‘own’ the end-clients and are incentivised to deliver better returns. For fund managers, the best way to retain their market leverage is by delivering them. For their part, administrators in Dublin and Luxembourg are responding by making the necessary investments that will equip them to go well beyond their traditional role and become conduits between fund managers and their distributors. Many leading asset servicing providers are investing heavily in this area. As Johnson explains: “Sheer market growth in the UCITS space has encouraged us to make significant new investments in both Luxembourg and Dublin to support expansion of the business. “In addition we now offer a single transfer agency model across multiple geographies, dealing with distributors on the ground in a wide number of jurisdictions and offering local language, presence, expertise and understanding. This is important, as all of our clients are trying to work out how they play on a global stage. It is up to companies such as ourselves to help facilitate that process via new investment and the introduction of new technologies.“ The development of such services may well bring new players into the UCITS framework that have so far stayed out because of lack of access to sales channels and lack of information on new opportunities under UCITS. Survey participants have underlined the important role played by administrators as transfer agent, registrar, administrative agent, legal adviser or paying agent; both in Luxembourg and Dublin. There are further two areas, however, where fund managers want third party administrators to go much further. First, they need to develop a more robust management information system which can serve as a dashboard that gives accurate and timely readings on the number of new funds, new business, attrition, revenues, profits and loss. The dashboard also needs to provide ‘heat maps’ on service quality, accuracy and timeliness – especially for premier division clients who are becoming ever more demanding. Second, as manufacturing and distribution are being decoupled, there is a need for administrators to provide functionalities that connect the two. The necessary platforms are emerging, albeit gradually. Most bankowned distributors prefer to do their own administration currently, in order to enhance their share of the wallet. However, as the industry becomes more horizontally integrated via new alliances, administrators are well placed to evolve common standards as well as effect introductions between manufacturers and distributors in different jurisdictions In response, a new generation of administrators are emerging with a strong professional overlay - of skills and infrastructure – as the fund business continues to go global. The report Global Funds Distribution – Bridging New Frontiers, is available for free from www.rbcdexia.com

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

THE SCUFFLE FOR MARKET SHARE The credit crunch threatens to shake up the pecking order among prime brokers, the banks and broker dealers who provide clearing, financing, stock lending and other services to hedge funds. The turmoil has nothing to do with financing costs, however. Spooked by the near-collapse of Bear Stearns, institutional investors and fund managers are insisting that hedge funds diversify their sources of financing through multiple prime broker relationships. For smaller firms in a business still dominated by Morgan Stanley and Goldman Sachs, it is a heaven-sent opportunity to grab market share.

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

PRIME BROKING: A FLIGHT TO QUALITY

Photograph © Tadija Savic/Dreamstime.com, supplied August 2008.

ANY LARGE HEDGE funds already use more than one prime broker. Although risk management concerns may have contributed to the decision, access to multiple stock lending networks, the ability to manage financing costs by playing one firm against another and the desire to prevent a single firm from seeing a fund’s entire book were the driving forces. Even before the credit crunch, the proliferation of relationships as well as aggressive expansion by smaller firms had pared back the leading duo’s edge and undermined the once unassailable claim Bear Stearns had to be the third largest prime broker. The new pressure from investors just turned up the heat on the leaders another notch. “By all measures—the number of clients, the balances, and revenues—we continue to take market share,” says Jeffrey

PRIME BROKING: A FLIGHT TO QUALITY 88

Penney, co-head of prime brokerage at Merrill Lynch, who says his firm has displaced Bear Stearns as number three, although he acknowledges it is a tight race between Merrill Lynch, UBS, Deutsche Bank and Credit Suisse for that slot. No matter how fierce the battle for market share, Penney says the core prime broking business— secured lending against high quality liquid collateral—has come through the credit crunch largely unscathed. Merrill Lynch has not changed its margin policy for two years, although Penney concedes that certain assets no longer qualify as eligible collateral. Haircuts for different types of collateral depend on liquidity and volatility, but Merrill Lynch set prudent levels based on years of experience in pricing eligible assets. “Clients do not want their margin to change continuously,” says Penney, “Margin calls are driven by changes in market price, not because we have been caught off guard by liquidity or volatility.” Penney says Merrill Lynch’s prime broker clients are mostly multi-strategy hedge funds that trade various assets across the entire corporate capital structure. Diversification reduces the portfolio risk, therefore as long as the liquid assets can support the outstanding loan balance he is not too worried about whatever else is in the portfolio.“We look at the composition and overall characteristics of the portfolio to determine a loan to value ratio,” Penney says. “It is less appealing to us to rip it apart and cherry pick the assets we will finance.” Once a hedge fund decides to add another prime broker, Merrill Lynch is a top contender based on its global reach, enviable securities lending capability and its ability to offer margin across multiple asset classes. The move toward multiple prime brokers has allowed the firm to get its foot in the door at some large hedge

Jeffrey Penney, co-head of prime brokerage at Merrill Lynch. Penney says his firm has displaced Bear Stearns as number three, although he acknowledges it is a tight race between Merrill Lynch, UBS, Deutsche Bank and Credit Suisse for that slot. Photograph kindly supplied by Merrill Lynch, August 2008.

Martin Malloy, head of prime brokerage at Barclays Capital. The bank has a strong presence in fixed income, has seen an influx of assets, cash and new clients in the past six months, too, according to Malloy. Barclays has focused on the largest funds, a strategy that has paid off as the big get bigger. Photograph kindly supplied by Barclays Capital, August 2008.

funds where Penney sees an opportunity to win additional business in the future. He is less enthusiastic about start ups at a time when capital is scarce, but he will take them on if the principals have solid pedigrees and he is convinced they will succeed. “It is not an absolute hurdle in asset size start ups have to clear,” says Penney, “We evaluate clients in terms of their overall profitability and allocate our resources accordingly.” Merrill Lynch is not the only firm picking up new business, of course. Barclays Capital, which has a strong presence in fixed income, has seen an influx of assets, cash and new clients in the past six months, too, according to Martin Malloy, head of prime brokerage. Barclays has focused on the largest funds, a strategy that has paid off as the big get bigger. As a fixed income specialist, Barclays has been at the centre of the maelstrom that has roiled the markets since August 2007. Haircuts on many assets have gone up, in some instances all the way to 100%. For sub prime mortgage backed securities and certain tranches of collateralised debt obligations (CDOs) financing is no longer available at any price. As secured lenders, prime brokers have always worried about how much an asset price could move if they had to sell it to cover their loans, but liquidity and volatility has assumed even greater importance since the credit crunch took hold. For years, fierce competition among prime brokers permitted hedge funds to borrow at the same rate regardless of the leverage they used or the volatility of the assets they owned. Now, however, a renewed focus on counterparty risk has emboldened prime brokers to differentiate their pricing based on customer credit quality. Hedge funds have become more discriminating, too, which

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

gives banks such as Barclays an edge. At a time when balance sheet capacity is limited, the extra financial muscle a bank brings to the table appeals to hedge funds, especially if their existing prime broker is a broker dealer. Funds often come to Barclays for fixed income in the first instance, but the firm offers a complete prime broker service for equities, foreign exchange, credit default swaps, interest rate swaps and commodities as well. As the fixed income relationship grows, Barclays often captures additional business in other asset classes.“It is a natural process,” says Malloy, “Once they have a good experience with one product we can leverage on that.” Although prime brokers can now charge more for their balance sheet capacity, the credit crunch has squeezed margins in other ways. Matt Pecot, head of prime brokerage at UBS in the United States, points out that hedge funds were among the first players to slash their leverage, which cut the outstanding loan balances from which prime brokers generate their revenues. The disconnect between the overnight federal funds interest rate and LIBOR has put US prime brokers in a bind, too. Brokers typically charge clients a margin over federal funds, whereas much of their financing is tied to LIBOR. The mismatch did not matter as long as the two rates moved together just a few basis points apart, but one month LIBOR blew out from 7 basis points (bps) over federal funds in July 2007 to more than 50bps, and brokers could not pass on the cost. The flight to quality has driven up funding costs on the asset side of the balance sheet as well. Pecot explains that US broker dealers are required to buy Treasury bills every week to cover their outstanding net credit balances to customers, who receive interest at the federal funds rate less a

Matt Pecot, head of prime brokerage at UBS in the United States, points out that hedge funds were among the first players to slash their leverage, which cut the outstanding loan balances from which prime brokers generate their revenues. Photograph kindly supplied by UBS, August 2008.

James Lafaman, head of North American sales and relationship management for prime services, Credit Suisse. The bank which came through the credit crunch relatively unscathed, has captured new prime broking business, although, says it has not changed its historical focus on bespoke service tailored to the needs of the largest 300 to 500 hedge funds. Photograph kindly supplied by Credit Suisse, August 2008.

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

margin. Under normal market conditions, the two rates fluctuate in tandem, but panicky investors have pushed Treasury bill rates well below federal funds. “It has become significantly more expensive to do the required lockup,” Pecot says, “We have to eat the cost because it is just part of doing business.” The well-publicised losses UBS suffered on sub-prime mortgagebacked securities and collateralised debt obligations have not affected the bank’s ability to attract new prime broker clients. Pecot notes that UBS now has a Tier 1 capital ratio of 11.9%, one of the highest in the world, having taken its lumps early on and raised new capital. “We have been a beneficiary of the turmoil within the broker dealer community over the past six months,” he says.“We are picking up business because we are a bank and not a broker dealer.” The bank’s global reach has proved a big advantage at a time when US hedge funds are increasing their investments in international markets. Arch-rival Credit Suisse, which came through the credit crunch relatively unscathed, has captured new business, too, although James Lafaman, head of North American sales and relationship management for prime services, says it has not changed its historical focus on bespoke service tailored to the needs of the largest 300 to 500 hedge funds. Banks are better positioned than broker dealers to win new business, but foreign banks have an extra edge because they are not subject to US regulations that restrict transactions between a US bank and its broker dealer subsidiary, a factor that may have played a part when Bank of America agreed to sell its prime broker business to BNP Paribas. “Counterparty risk, balance sheet capacity and capital adequacy has become the primary concern of investors as well as fund

PRIME BROKING: A FLIGHT TO QUALITY 90

managers. The distinction between a US broker dealer, a US bank with a US broker dealer and a non-US bank and how they fund themselves has become of paramount concern to counterparties,” says Lafaman. “As a conservative Swiss bank, we have benefited.” Shawn Sullivan, head of prime services trading at Credit Suisse in New York, says prime brokers pay far more attention to the assets they are financing than they did before the crisis. In keeping with its aim to foster a long term partnership with hedge funds, Credit Suisse has grandfathered margin requirements for existing clients even though it applies tighter terms to new accounts. It will also finance positions other prime brokers may turn down. “Assets which are not‘vanilla’have become more difficult to finance, but that is where some of the best returns are,”says Sullivan.“We try to get a fatter share of the wallet from our accounts.” The near collapse of Bear Stearns delivered a wake up call to hedge funds that sent them scrambling both to diversify their financing sources and to lock in credit terms for longer periods. It also focused attention on counterparty credit risk, which has favoured Credit Suisse. “We have been well positioned to benefit from the flight to quality,” says Sullivan. “Hedge funds want to be sure that a prime broker is not going to pull the rug out from under them.” The quest for stable financing has created an opportunity for smaller players who have strong balance sheets to compete for prime broker business. Christopher Barrow, international head of sales, global prime services at Nomura International in London, says that Nomura was “conspicuously absent” from some hedge funds’ broker lists until they started looking for healthy prime brokers that had an appetite to expand.

Shawn Sullivan, head of prime services trading at Credit Suisse in New York, says prime brokers pay far more attention to the assets they are financing than they did before the crisis. In keeping with its aim to foster a long term partnership with hedge funds, Credit Suisse has grandfathered margin requirements for existing clients even though it applies tighter terms to new accounts. It will also finance positions other prime brokers may turn down. Photograph kindly supplied by Credit Suisse, August 2008.

Jonathan Cossey, global head of equity finance and head of prime services for Nomura in Europe. “Nomura targets accounts where the broadest relationships exist with touch points throughout, where we have products and services aligned to their strategies,” says Cossey. Photograph kindly supplied by Nomura, August 2008.

Loan balances increased sixfold in the four months after the Bear Stearns meltdown, but despite the rapid growth Nomura takes a selective approach to new clients. “It is about picking strategic clients who want to work in partnership with us,” says Barrow. “If we finance relatively illiquid assets, then we want to see significant flow business too.” Nomura has capitalised on its strengths in Japan, convertible bonds and emerging markets in Asia—a hot area for hedge funds at the moment. The firm has also focused on institutional managers running 130/30 short extension funds qualified for pan European distribution under the UCITS III directive. “Nomura targets accounts where the broadest relationships exist with touch points throughout, where we have products and services aligned to their strategies,” says Jonathan Cossey, global head of equity finance and head of prime services for Nomura in Europe. Nomura’s clients are an eclectic bunch, ranging from small start ups to large hedge funds and institutional money managers who offer alternative investment products. Its partnership model resonates with hedge funds who received short shrift from their existing prime brokers when the credit crunch took hold. “We have heard from disgruntled hedge funds that were well treated in the good times but were re-margined or even cut off in the not so good times,”says Cossey. The prime broker business has become a two way street in which both sides are re-evaluating the quality of their counterparties. A world where financial strength and multiple funding sources are of paramount importance to hedge funds has ignited a battle for market share that will change the pecking order among prime brokers and could threaten the long time dominance of Morgan Stanley and Goldman Sachs.

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

The market reported 2,603,771 securities transactions, with 207,111 securities available for lending, worth just over $15,035bn; while 38,949 securities were out on loan, worth $4,122bn.

Group Results (USD): The following table details the aggregated group results for all Performance Explorer participants and provides a high level summary of the activity in particular assets. This table represents a summary of the 313 separate asset classes in the data set. Security Type

All Securities

Lendable Assets (M)

Balance vs Cash (M)

Balance vs Non Cash (M)

Total Balance (M)

Utilisation (%)

SL Fee (Bp)

Revenue SL Return to Share f rom Lendable SL (%) Assets (Bp)

Total Return Lendable Assets (Bp)

SL Tenure (days) 119

15,034,596

2,332,603

1,789,539

4,122,142

19.85

33.31

70.11

4.80

8.69

All Bonds

6,877,147

1,281,178

975,804

2,256,982

28.76

7.38

30.81

2.12

7.57

132

Corporate Bonds

3,627,228

242,577

148,680

391,257

8.90

-3.64

-23.33

-0.41

1.66

153

Government Bonds

3,093,867

1,027,150

823,981

1,851,131

53.09

9.65

37.64

5.15

14.72

127

All Equities

8,129,566

1,051,423

813,480

1,864,903

12.39

64.69

85.10

7.08

9.68

103

Americas Equities

4,535,038

742,790

205,315

948,105

12.15

75.78

82.48

7.72

11.08

109

891,487

66,440

118,194

184,633

11.67

70.47

90.11

6.96

8.56

110

2,292,603

138,883

465,546

604,429

12.91

44.87

91.25

5.6

6.78

100

Depository Receipts

233,213

52,435

8,563

60,999

13.86

67.71

81.66

6.98

10.96

Exchange Traded Funds

102,865

47,600

8,967

56,567

18.64

69.56

83.10

14.72

22.50

Asian Equities European Equities

The following tables show the largest utilizations with the largest balance against securities held by Performance Explorer lenders.

Equities:

Corporate Bonds:

Top 10 by Utilisation and Lenders Balance

Rank

Stock description

Rank

Stock description

Proex Energy Ltd

BBVA Rmbs II Fondo De Titul. De Act. (4.049% 17-Sep-2050)

Alcan Inc

3i Group Plc (5.1% 23-Jan-2009)

Cedar Fair

FN 07 15A GM

Thomson Reuters Corp

GE Capital UK Funding (5.918% 01-Aug-2011)

Teppco Partners LP

Pfandbriefbank der Schweiz. Hypo. (2.03% 01-Mar-2012)

General Motors Corp

Banque PSA Finance Sa (5.046% 06-Oct-2008)

Sierra Wireless Inc

Eurohypo Ag (3.611% 12-Jan-2013)

Star Bulk Carriers Corp

Blue City Investments Ltd (6.96% 07-Nov-2013)

Mxi Inc

Landesbank Hessen Thueringen Gir (4.15% 09-Jan-2009)

Euronext NV

Danone Finance (5.03% 12-Dec-2008)

The total income generated by lending a security can be split into two: the amount generated from the fee charged and the amount generated by reinvesting any cash which is received back as collateral. The following tables detail the securities generating the largest income through a combination of these two components.

Equities:

Corporate Bonds:

Top 10 Securities by Total Return

Rank

Stock description

Rank

Stock description

Interoil Corp

Sally Holdings Llc (10.5% 15-Nov-2016)

Conn’S Inc

Burlington Coat Factory Warehouse Corp (11.125% 15-Apr-2014)

Redwood Trust Inc

Cch I Holdings Llc (13.5% 15-Jan-2014)

Osiris Therapeutics Inc

Freescale Semiconductor Inc (10.125% 15-Dec-2016)

Nutrisystem Inc

Ply Gem Industries Inc (9% 15-Feb-2012)

Usana Health Sciences Inc

Spectrum Brands Inc (11.25% 02-Oct-2013)

Corus Bankshares Inc

Rr Donnelley & Sons Co (3.75% 01-Apr-2009)

Lululemon Athletica Inc

Yankee Acquisition Corp/MA (9.75% 15-Feb-2017)

Valence Technology Inc

Rexnord Llc (11.75% 01-Aug-2016)

Cal-Maine Foods Inc

Mohegan Tribal Gaming Authority (7.125% 15-Aug-2014)

SECURITIES LENDING DATA by DATA EXPLORERS

KEY PERFORMANCE EXPLORER STATISTICS as of July 30th 2008

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FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

Al lF Wo FT TSE rld SE W Ind FT or D ex SE FT eve ld FT Ad SE lop Ind SE va Em ed ex In e Se nce co d E rgin de x nd g m FT ary erg Ind F T SE Em ing ex SE G In e FT De lob rgin de al SE x F g v In Ad TSE elo All de C va E pe x nc me d A ap In ed rg ll F Ca de FT TSE Em ing x p SE In Se erg All c Ca de Gl i x ob ond ng p A FT al G ary ll C Ind F ov Em ap ex FT TSE SE e E SE In rn er E P EP PRA RA me gin dex RA /N /N nt g I AR nd A / B F FT TSE NAR REI EIT ond ex SE In EP EIT T G Gl d o EP lo R RA A/N Glo ba bal ex In /N A ba l R AR RE l D EIT de M x M acq EIT IT G ivid s I ac lo en nde G qu uar ba d+ x ar ie lob lR In a G ie Gl lob l No ent de x a ob al n In -R l In al In fra ent de x fra st al st ruc In ru F tu de x FT TSE ctu re In re 4 SE FT G SE FT 4G oo 100 dex RA SE ood d G In FI GW G lob de x De A lob al In ve De al lo ve 10 dex p 0 l FT ed opm In de SE e x e RA US nt I x FI 10 nd Em 00 ex I er gi nde ng x In de x

FT SE

% Change

Al lF Wo FT TSE rld SE W Ind FT or D ex SE FT eve ld I S A FT dv E lop nde SE Em e d x a In e Se nce co d E rgin de x nd g m FT ary erg Ind F T SE Em ing ex SE G In e FT D lob rgin de SE x FT eve al g A I Ad SE lo n ll va Em ped Cap dex nc In ed erg All F Ca de FT TSE Em ing x p SE In Se erg All c Ca de Gl i x ob ond ng p A FT al G ary ll C Ind F ov Em ap ex FT TSE SE SE EP EP ern erg Ind EP RA RA me in ex g R n /N /N FT A/N AR AR t Bo Ind E A FT S E IT nd ex SE E E REI IT I G EP PR T G Glo lob nde x al RA A/N lo ba l b I /N A R n a AR RE l D EIT de M x I i M acq EIT T G vid s I ac lo en nde G qu uar ba d+ x ar ie lob al l Re In Gl ie No nt de Gl ob x a ob al n In -R l In al In fra ent de x fra st al st ruc In ru F tu de x FT TSE ctu re In SE 4G re FT SE FT 4G oo 100 dex RA SE ood d G In FI GW G lob de x De A lob al In ve De al d 1 lo v pe elo 00 ex FT d In p de SE ex me RA US nt I x FI 10 nd Em 00 ex I er gi nde ng x In de x

FT SE % Change

Ju l-0 8

Ja n08

Ju l-0 7

Ja n07

Ju l-0 6

Ja n06

Ju l-0 5

Ja n05

Ju l-0 4

Ja n04

Ju l-0 3

Index Level Rebased (31 July 03=100)

MARKET DATA BY FTSE RESEARCH

Global Market Indices

5-Year Total Return Performance Graph 700

600

FTSE All-World Index

500

FTSE Emerging Index

400

FTSE Global Government Bond Index

300

FTSE EPRA/NAREIT Global Index

200

FTSE4Good Global Index

100

Macquarie Global Infrastructure Index

FTSE GWA Developed Index

FTSE RAFI Emerging Index

2-Month Performance

-4

-8

Capital return

Total return

-12

-16

1-Year Performance

-10

Capital return

Total return

-20

-30

SEPTEMBER/OCTOBER 2008 â&#x20AC;˘ FTSE GLOBAL MARKETS

Table of Capital Returns Index Name

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

FTSE All-World Indices FTSE All-World Index FTSE World Index FTSE Developed Index FTSE Emerging Index FTSE Advanced Emerging Index FTSE Secondary Emerging Index

USD USD USD USD USD USD

2,913 2,446 1,997 916 449 467

225.97 395.69 213.05 517.00 474.46 618.37

-10.8 -10.7 -10.4 -13.8 -14.6 -12.7

-6.6 -6.5 -6.9 -4.2 -0.8 -8.6

-11.8 -12.1 -12.5 -6.0 -5.7 -6.1

-14.3 -13.9 -14.1 -15.6 -10.7 -21.6

2.89 2.92 2.92 2.69 2.95 2.32

FTSE Global Equity Indices FTSE Global All Cap Index FTSE Developed All Cap Index FTSE Emerging All Cap Index FTSE Advanced Emerging All Cap Index FTSE Secondary Emerging

USD USD USD USD USD

7,900 6,061 1,839 955 884

378.90 360.14 723.10 674.99 833.10

-10.8 -10.4 -14.0 -14.7 -12.9

-6.4 -6.6 -5.2 -0.9 -10.7

-12.3 -12.8 -8.1 -8.2 -7.8

-14.2 -13.9 -16.9 -11.4 -23.7

2.80 2.82 2.67 2.95 2.28

Fixed Income FTSE Global Government Bond Index

USD

720

121.08

0.1

0.5

12.1

4.1

3.47

Real Estate FTSE EPRA/NAREIT Global Index FTSE EPRA/NAREIT Global REITs Index FTSE EPRA/NAREIT Global Dividend+ Index FTSE EPRA/NAREIT Global Rental Index FTSE EPRA/NAREIT Global Non-Rental Index

USD USD USD USD USD

286 188 222 233 53

1998.36 905.33 1861.65 1013.64 1164.74

-11.7 -10.8 -11.0 -10.5 -15.0

-11.2 -8.4 -10.1 -8.2 -18.2

-18.2 -15.9 -14.6 -16.9 -21.5

-15.1 -11.2 -14.0 -10.9 -24.5

4.69 5.73 5.52 5.47 2.48

Infrastructure Macquarie Global Infrastructure Index Macquarie Global Infrastructure 100 Index

USD USD

239 100

9898.66 9722.20

-7.8 -8.0

-3.2 -3.3

1.4 1.9

-10.6 -10.4

3.42 3.40

SRI FTSE4Good Global Index FTSE4Good Global 100 Index

USD USD

703 105

5824.38 5003.43

-10.2 -9.1

-7.9 -7.7

-14.9 -14.4

-15.3 -15.6

3.53 3.75

Investment Strategy FTSE GWA Developed Index FTSE RAFI Developed ex US 1000 Index FTSE RAFI Emerging Index

USD USD USD

1,997 1,011 360

3503.37 6005.35 6240.22

-11.3 -11.9 -12.7

-9.5 -8.4 -1.2

-16.3 -15.0 -2.6

-16.1 -16.9 -13.9

3.63 4.29 3.32

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

FTSE All-World Indices FTSE All-World Index FTSE World Index FTSE Developed Index FTSE Emerging Index FTSE Advanced Emerging Index FTSE Secondary Emerging Index

USD USD USD USD USD USD

2,913 2,446 1,997 916 449 467

267.94 629.64 252.21 635.89 588.33 751.69

-10.5 -10.4 -10.2 -13.2 -13.9 -12.2

-5.0 -4.9 -5.3 -2.7 0.8 -7.2

-9.6 -9.8 -10.3 -3.7 -3.2 -4.3

-12.8 -12.4 -12.6 -14.1 -9.0 -20.4

2.89 2.92 2.92 2.69 2.95 2.32

FTSE Global Equity Indices FTSE Global All Cap Index FTSE Developed All Cap Index FTSE Emerging All Cap Index FTSE Advanced Emerging All Cap Index FTSE Secondary Emerging

USD USD USD USD USD

7,900 6,061 1,839 955 884

428.64 406.86 837.69 789.36 950.39

-10.5 -10.2 -13.4 -14.0 -12.5

-4.9 -5.1 -3.7 0.8 -9.4

-10.1 -10.6 -5.9 -5.7 -6.1

-12.7 -12.4 -15.5 -9.7 -22.6

2.80 2.82 2.67 2.95 2.28

Fixed Income FTSE Global Government Bond Index

USD

720

168.16

0.6

2.2

15.8

6.2

3.47

Real Estate FTSE EPRA/NAREIT Global Index FTSE EPRA/NAREIT Global REITs Index FTSE EPRA/NAREIT Global Dividend+ Index FTSE EPRA/NAREIT Global Rental Index FTSE EPRA/NAREIT Global Non-Rental Index

USD USD USD USD USD

286 188 222 233 53

2904.87 1010.05 2029.93 1128.98 1224.71

-11.1 -9.9 -10.2 -9.6 -14.7

-9.1 -5.8 -7.6 -5.6 -17.3

-14.8 -11.6 -10.4 -12.8 -19.8

-13.0 -8.5 -11.4 -8.2 -23.6

4.69 5.73 5.52 5.47 2.48

Infrastructure Macquarie Global Infrastructure Index Macquarie Global Infrastructure 100 Index

USD USD

239 100

11577.55 11403.64

-7.2 -7.4

-1.1 -1.2

4.7 5.2

-8.6 -8.3

3.42 3.40

SRI FTSE4Good Global Index FTSE4Good Global 100 Index

USD USD

703 105

6860.01 5939.41

-9.9 -8.9

-5.9 -5.6

-12.2 -11.5

-13.5 -13.6

3.53 3.75

Investment Strategy FTSE GWA Developed Index FTSE RAFI Developed ex US 1000 Index FTSE RAFI Emerging Index

USD USD USD

1,997 1,011 360

3787.45 6523.25 6500.52

-11.0 -11.6 -12.0

-7.7 -6.0 0.6

-13.8 -12.1 0.2

-14.3 -14.7 -12.1

3.63 4.29 3.32

Table of Total Returns Index Name

FTSE GLOBAL MARKETS â&#x20AC;˘ SEPTEMBER/OCTOBER 2008

F FT TS SE E A m N FT ort eric h a Am s I F T SE La n FT S SE E A tin eric dex a m A N FT ort eri me Ind ca r ex SE h s ica A La Am I tin eri ll C nde ap ca FT x SE Am Al In LA eric l Ca de x TI a p A B I FT FT EX ll C nde SE ap S A x In Am F E LA ll-S er TSE TI har dex B e ic In FT FTS as LAT EX Go IB TO de SE E x EP US ver EX P I F n B FT n R A FT TS SE A/N Go me ras dex E SE nt il E A ve E EP PR PR RE rnm Bo Ind IT RA A/N A/ en nd ex N N /N AR A I t AR E RE orth Bo nde n I x EI IT No T U Am d In T er No rt S d rth h A Div ica ex A m ide In M FT me eric nd dex ac + SE ric a qu Re In ar FT N a SE AR No nta dex ie n No l N E rth AR IT C Ren Ind ta ex o A EI M ac me T E mp l In os qu q d r ar ica uity ite ex ie I I US nfra REI nde T s x A In tru s In fra ctu d ex r s F T t ru e I FT SE ctu nde SE 4G re x 4G oo In oo d U de x d S FT U F In SE FT TS S d RA SE E G 100 ex FI RA W I n US FI A U de x S U M id S 1 Ind Sm 00 ex 0 al l 1 Ind 50 ex 0 In de x

% Change

F FT TS SE E A m N FT ort eric h a Am s I F T SE La n FT S SE E A tin eric dex m Am a I No e nd FT ric e r ex SE t h as ric A aI La Am tin eri ll C nde a c FT x a p SE Am A In LA eric ll Ca de x TI a A pI B FT FT EX ll C nde SE SE Al ap x l In Am F LA -S er TSE TI har dex B e i c In FT FTS as LAT EX Go IB TO de SE E x EP US ver EX P I FT A Br nd FT RA G nm FT S a ex S SE E E E E /NA ove ent sil PR RE rn B In EP P R IT me ond dex RA A/N A/ No nt /N AR NA I rth Bo nde AR E RE n I x EI I T No T U Am d In T er No rt S d rth h A Div ica ex In A m ide M FT me eric nd dex ac + SE ric a qu ar FT NA a N Ren Ind S ie e o t No E N REI n-R al I x rth AR T C en nd e E ta o x I A M ac me T E mp l In os qu q d r ar ica uity ite ex ie I I US nfra REI nde T s x A In tru s In fra ctu d ex r s e t FT ru I FT SE ctu nde SE 4G re x 4G oo In oo d U de x d FT U S In F SE FT TS S d RA SE E G 100 ex FI RA W In A US FI US dex U M id S 1 Ind Sm 00 ex 0 al l 1 Ind 50 ex 0 In de x

% Change

Ju l-0 8

Ja n08

Ju l-0 7

Ja n07

Ju l-0 6

Ja n06

Ju l-0 5

Ja n05

Ju l-0 4

Ja n04

Ju l-0 3

Index Level Rebased (31 July 03=100)

MARKET DATA BY FTSE RESEARCH

Americas Market Indices

5-Year Total Return Performance Graph 300

FTSE Americas Index

250

FTSE Americas Government Bond Index

200

FTSE EPRA/NAREIT North America Index

150

FTSE EPRA/NAREIT US Dividend+ Index

FTSE4Good USIndex

100

FTSE GWA US Index

FTSE RAFI US 1000 Index

2-Month Performance

-5

-10

Capital return

-15

Total return

-20

-25

1-Year Performance

Capital return

-10

Total return

-20

-30

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

Table of Capital Returns Index Name

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

FTSE All-World Indices FTSE Americas Index FTSE North America Index FTSE Latin America Index

USD USD USD

862 721 141

524.96 540.31 928.65

-9.9 -9.5 -15.5

-6.4 -7.0 5.0

-9.9 -11.1 14.1

-12.1 -12.7 -1.2

2.20 2.18 2.52

FTSE Global Equity Indices FTSE Americas All Cap Index FTSE North America All Cap Index FTSE Latin America All Cap Index

USD USD USD

2,742 2,536 206

335.05 321.06 1390.68

-9.8 -9.4 -15.2

-5.9 -6.4 5.0

-9.7 -10.8 12.9

-11.7 -12.2 -1.3

2.10 2.08 2.51

Region Specific FTSE LATIBEX All-Share Index FTSE LATIBEX TOP Index FTSE LATIBEX Brasil Index

USD USD USD

37 16 12

3356.60 5276.60 14220.00

-18.0 -12.8 -15.5

2.1 16.0 15.3

9.4 9.6 19.5

-8.2 4.4 0.8

na na na

Fixed Income FTSE Americas Government Bond Index FTSE USA Government Bond Index

USD USD

152 134

113.61 111.12

0.1 0.3

-2.3 -2.3

4.7 4.4

-0.2 0.0

3.92 3.92

Real Estate FTSE EPRA/NAREIT North America Index FTSE EPRA/NAREIT US Dividend+ Index FTSE EPRA/NAREIT North America Rental Index FTSE EPRA/NAREIT North America Non-Rental Index FTSE NAREIT Composite Index FTSE NAREIT Equity REITs Index

USD USD USD USD USD USD

117 93 114 3 133 108

2201.84 1755.61 1017.81 972.70 146.64 471.05

-9.3 -9.1 -8.6 -19.8 -9.8 -8.6

-3.2 -2.5 -2.3 -15.7 -5.1 -1.7

-9.6 -8.7 -8.9 -20.6 -10.9 -7.6

-4.8 -3.3 -3.9 -17.2 -5.8 -2.9

5.14 5.22 5.17 4.45 5.9 5.1

Infrastructure Macquarie North America Infrastructure Index Macquarie USA Infrastructure Index

USD USD

96 89

8366.26 8233.94

-7.4 -7.9

-2.0 -2.5

1.0 0.1

-9.0 -9.6

3.08 3.06

SRI FTSE4Good US Index FTSE4Good US 100 Index

USD USD

146 101

4530.94 4346.48

-8.8 -8.7

-9.9 -9.9

-16.0 -15.6

-16.1 -16.2

2.54 2.57

Investment Strategy FTSE GWA US Index FTSE RAFI US 1000 Index FTSE RAFI US Mid Small 1500 Index

USD USD USD

665 1,001 1,458

3076.74 4978.43 4696.48

-10.4 -11.0 -8.3

-11.6 -12.2 -4.0

-16.7 -17.8 -12.7

-15.6 -16.5 -10.1

2.71 2.81 1.87

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

FTSE All-World Indices FTSE Americas Index FTSE North America Index FTSE Latin America Index

USD USD USD

862 721 141

807.06 880.30 1176.58

-9.6 -9.2 -15.3

-5.5 -6.1 6.3

-8.1 -9.3 16.8

-11.1 -11.7 0.3

2.20 2.18 2.52

FTSE Global Equity Indices FTSE Americas All Cap Index FTSE North America All Cap Index FTSE Latin America All Cap Index

USD USD USD

2,742 2,536 206

369.59 353.56 1647.33

-9.5 -9.1 -15.1

-4.9 -5.5 6.4

-8.0 -9.1 15.5

-10.7 -11.2 0.1

2.10 2.08 2.51

Region Specific FTSE LATIBEX All-Share Index FTSE LATIBEX TOP Index FTSE LATIBEX Brasil Index

EUR EUR EUR

36 15 13

na na na

Fixed Income FTSE Americas Government Bond Index FTSE USA Government Bond Index

USD USD

152 134

173.86 169.36

0.9 1.1

-0.1 -0.2

9.4 9.1

2.4 2.6

3.92 3.92

USD USD USD USD USD USD

117 93 114 3 133 108

3453.52 1912.97 1135.37 1061.06 3288.95 8165.42

-8.5 -8.3 -7.8 -19.8 -8.8 -7.8

-0.8 0.0 0.1 -14.4 -2.5 0.8

-5.3 -4.2 -4.4 -17.7 -6.1 -3.1

-2.1 -0.6 -1.2 -15.5 -2.9 -0.2

5.14 5.22 5.17 4.45 5.86 5.13

Infrastructure Macquarie North America Infrastructure Index Macquarie USA Infrastructure Index

USD USD

96 89

9690.75 9528.15

-7.0 -7.5

-0.6 -1.0

4.0 3.0

-7.5 -8.2

3.08 3.06

SRI FTSE4Good US Index FTSE4Good US 100 Index

USD USD

146 101

5123.75 4933.38

-8.5 -8.3

-8.8 -8.8

-14.1 -13.6

-14.9 -15.0

2.54 2.57

Investment Strategy FTSE GWA US Index FTSE RAFI US 1000 Index FTSE RAFI US Mid Small 1500 Index

USD USD USD

665 1,001 1,458

3279.06 5297.76 4851.50

-10.1 -10.6 -8.1

-10.6 -11.0 -3.3

-14.8 -15.8 -11.5

-14.5 -15.3 -9.3

2.71 2.81 1.87

Table of Total Returns Index Name

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

FT ve S l F E FT ope TS Eu E ro S d FT E E p De Eur uro e I SE De FT vel ope blo nde SE op ex c I x ve F n e FT lope TS Eu d E UK de SE d E E rop ur In x De Eur uro e A ope de ve op blo ll I x lo e A c Ca nde pe l A p x d l C ll C In Eu ap a de ro e p I x x n p FT e U de SE All S I x Al Ca nde l-S p x FT FT ha Ind SE SE re ex In FT u SE rof 100 de x FT uro irst In SE fir 80 de FT uro st 1 In x FT d SE FT SE/ firs 00 ex SE JS t 3 In Eu /J E T 00 de ro S zo F E op In x ne TS A 4 d Go E R ll-S 0 I ex FT ve us har nd FT s SE r n ia e ex S EP FT FT E G FT me IO Ind RA SE SE ilt SE nt B ex s /N EP E F Pf Bo Ind AR R PR ixe an nd ex A A d d FT FTS EIT /NA /N Al bri Ind SE E E RE AR l-S ef ex u EP EPR ro IT EIT toc Ind RA A pe Eu E ks ex I / /N e r u M NA AR x U ope rop nde ac R E K e x qu EI IT D RE In ar T E Eu ivi ITs de ie u ro de I x Eu rop pe nd nd + e ro e pe No Ren In x I n t de FT F FTS nfr -Re al I x SE TS E4 ast nt nd GW E4 Go ruc al I ex G o n A oo d E ture de x De d u ve Eu rop Ind FT lop rop e I ex SE ed e 5 nd RA Eu 0 I ex FI rop nd Eu e e x ro Ind pe e In x de x

FT SE

% Change

FT ve S l F E FT ope TS Eu SE d E E rop FT De Eur uro e I SE De FT vel ope blo nde c x S o ve F E pe ex In FT lope TS Eu d E UK de E r SE d op ur In x E o De Eur uro e A pe de ve op blo ll I x lo e A c Ca nde pe l A p x d l C ll C In Eu ap a de ro e p I x x n FT pe U d SE All S I ex Al Ca nde l-S p x FT FT ha Ind S S re ex FT Eu E 1 In SE rof 00 de x FT uro irst In SE fir 80 de x st u I F FT T ro 1 nd SE FT SE/ firs 00 ex SE JS t 3 In Eu 0 de / E ro zo F JSE Top 0 In x ne TS A 40 de l l E Go R S I x FT ve us har nd FT SE rn sia e ex SE EP FT FT G FT me IO Ind RA SE SE ilt SE nt B ex /N EP E s F Pf Bo Ind AR RA PR ixe an nd ex A d d FT FTS EIT /NA /N Al bri Ind SE E E RE AR l-S ef ex ur E EP PR o IT EIT toc Ind RA A pe Eu E ks ex I / /N e r u M NA AR x U ope rop nde ac R E K e x qu EI IT D RE In T I i ar E v T d ie Eu uro ide s I ex r n n Eu op pe d d + e ro e pe No Ren In x n- ta de I F n FT F TS fr Re l I x SE TS E4 ast nt nd GW E4 Go ruc al I ex G o n A oo d E ture de x De d u ve Eu rop Ind FT lop rop e I ex SE ed e 5 nd RA Eu 0 I ex FI rop nd Eu e e x ro Ind pe e In x de x

FT SE

% Change

Ju l-0 8

Ja n08

Ju l-0 7

Ja n07

Ju l-0 6

Ja n06

Ju l-0 5

Ja n05

Ju l-0 4

Ja n04

Ju l-0 3

Index Level Rebased (31 July 03=100)

MARKET DATA BY FTSE RESEARCH

Europe, Middle East & Africa Indices

5-Year Total Return Performance Graph 500

FTSE Europe Index

400

FTSE All-Share Index

300

FTSEurofirst 80 Index

FTSE/JSE Top 40 Index

200

FTSE Gilts Fixed All-Stocks Index

100

FTSE EPRA/NAREIT Europe Index

FTSE4Good Europe Index

FTSE GWA Developed Europe Index

-10

-15

-20

-30

FTSE RAFI Europe Index

2-Month Performance

-5

Capital return

-20

Total return

-25

-30

1-Year Performance

-10 0

Capital return

-40

Total return

-50

-60

SEPTEMBER/OCTOBER 2008 â&#x20AC;˘ FTSE GLOBAL MARKETS

Table of Capital Returns Index Name

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

FTSE All-World Indices FTSE Europe Index FTSE Eurobloc Index FTSE Developed Europe ex UK Index FTSE Developed Europe Index

EUR EUR EUR EUR

574 2,051 381 511

194.00 105.35 196.99 188.74

-12.1 -13.3 -12.5 -12.0

-11.3 -12.4 -11.2 -11.8

-24.3 -23.9 -23.6 -24.9

-21.9 -23.8 -22.1 -22.1

4.11 3.53 4.09 4.21

FTSE Global Equity Indices FTSE Europe All Cap Index FTSE Eurobloc All Cap Index FTSE Developed Europe All Cap ex UK Index FTSE Developed Europe All Cap Index

EUR EUR EUR EUR

1,684 819 1,128 1,564

321.51 341.71 346.91 315.33

-12.2 -13.4 -12.7 -12.1

-11.3 -12.3 -11.0 -11.8

-25.3 -24.9 -24.5 -25.8

-21.9 -23.6 -22.0 -22.0

4.01 4.17 4.01 4.10

Region Specific FTSE All-Share Index FTSE 100 Index FTSEurofirst 80 Index FTSEurofirst 100 Index FTSEurofirst 300 Index FTSE/JSE Top 40 Index FTSE/JSE All-Share Index FTSE Russia IOB Index

GBP GBP EUR EUR EUR ZAR ZAR USD

666 102 79 99 314 41 165 15

2749.21 5411.90 4302.46 3773.51 1180.04 25779.21 27719.67 1306.24

-10.8 -10.6 -11.8 -11.1 -11.6 -13.9 -12.9 -20.7

-8.4 -8.0 -11.9 -11.4 -11.2 2.6 1.5 11.4

-16.4 -14.9 -21.8 -23.1 -23.9 -0.3 -2.9 7.1

-16.4 -16.2 -23.5 -22.3 -21.7 -1.8 -4.3 -9.0

4.26 4.35 4.44 4.50 4.21 2.61 2.83 1.52

EUR EUR GBP

239 420 29

96.15 103.12 146.08

0.0 -0.5 1.6

-3.3 -3.5 -2.8

-1.1 -1.9 0.8

-1.4 -1.8 -2.5

4.73 5.27 4.91

EUR EUR EUR EUR EUR

93 39 45 79 14

1586.80 692.10 1991.00 769.40 695.55

-12.3 -10.1 -12.6 -11.9 -19.6

-20.1 -18.6 -13.5 -19.6 -28.8

-35.1 -30.1 -23.2 -34.0 -50.4

-20.1 -16.7 -14.0 -19.0 -36.1

4.91 4.95 5.74 5.09 1.63

USD

12776.66

-10.8

-5.0

2.2

-13.7

3.76

EUR EUR

294 55

3799.58 3352.94

-11.4 -9.4

-12.2 -10.6

-26.1 -24.4

-22.3 -21.2

4.59 4.75

EUR EUR

511 519

2975.07 4592.82

-12.9 -12.9

-13.9 -14.3

-28.5 -27.2

-24.2 -24.5

5.04 5.05

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

FTSE All-World Indices FTSE Europe Index FTSE Eurobloc Index FTSE Developed Europe ex UK Index FTSE Developed Europe Index

EUR EUR EUR EUR

574 2,051 381 511

245.46 138.27 246.00 239.38

-11.8 -13.0 -12.2 -11.7

-8.8 -9.7 -8.5 -9.3

-21.6 -21.1 -20.9 -22.1

-19.6 -21.3 -19.7 -19.8

4.11 3.53 4.09 4.21

FTSE Global Equity Indices FTSE Europe All Cap Index FTSE Eurobloc All Cap Index FTSE Developed Europe ex UK All Cap Index FTSE Developed Europe All Cap Index

EUR EUR EUR EUR

1,684 819 1,128 1,564

382.38 407.43 409.71 375.70

-11.9 -13.1 -12.4 -11.8

-8.9 -9.6 -8.4 -9.3

-22.7 -22.2 -22.0 -23.1

-19.7 -21.2 -19.6 -19.8

4.01 4.17 4.01 4.10

Region Specific FTSE All-Share Index FTSE 100 Index FTSEurofirst 80 Index FTSEurofirst 100 Index FTSEurofirst 300 Index FTSE/JSE Top 40 Index FTSE/JSE All-Share Index FTSE Russia IOB Index

GBP GBP EUR EUR EUR SAR SAR USD

666 102 79 99 314 41 165 15

3372.86 3221.09 5207.56 4594.27 1584.21 2792.16 2978.06 1300.70

-10.4 -10.2 -11.5 -10.8 -11.3 -13.7 -12.7 -22.5

-6.2 -5.7 -9.0 -8.7 -8.7 4.0 2.9 9.1

-13.3 -11.6 -18.8 -20.0 -21.1 2.2 -0.4 6.0

-14.4 -14.1 -20.9 -19.9 -19.3 -0.5 -2.9 -10.5

4.26 4.35 4.44 4.50 4.21 2.61 2.83 1.52

EUR EUR GBP

239 420 29

159.04 181.31 2054.34

0.6 0.3 1.7

-1.3 -1.5 -0.3

3.2 2.3 6.1

1.0 0.6 0.1

4.73 5.27 4.91

EUR EUR EUR EUR EUR

93 39 45 79 14

2164.89 767.47 2253.73 840.79 723.55

-11.7 -9.5 -11.9 -11.3 -19.2

-17.8 -16.3 -10.0 -17.2 -27.7

-32.4 -27.1 -19.4 -31.1 -49.5

-17.5 -14.0 -10.2 -16.3 -35.1

4.91 4.95 5.74 5.09 1.63

USD

15263.62

-10.0

-2.4

5.8

-11.2

3.76

EUR EUR

294 55

4734.40 4218.53

-11.1 -9.1

-9.6 -7.8

-23.2 -21.3

-19.9 -18.7

4.59 4.75

EUR EUR

511 519

3300.15 5043.01

-12.6 -12.6

-11.1 -11.7

-25.6 -24.4

-21.6 -22.1

5.04 5.05

Fixed Income FTSE Eurozone Government Bond Index FTSE Pfandbrief Index FTSE Gilts Fixed All-Stocks Index Real Estate FTSE EPRA/NAREIT Europe Index FTSE EPRA/NAREIT Europe REITs Index FTSE EPRA/NAREIT Europe ex UK Dividend+ Index FTSE EPRA/NAREIT Europe Rental Index FTSE EPRA/NAREIT Europe Non-Rental Index Infrastructure Macquarie Europe Infrastructure Index SRI FTSE4Good Europe Index FTSE4Good Europe 50 Index Investment Strategy FTSE GWA Developed Europe Index FTSE RAFI Europe Index

Table of Total Returns Index Name

FTSE GLOBAL MARKETS â&#x20AC;˘ SEPTEMBER/OCTOBER 2008

FT SE

F As TS ia E Pa As cif ia F As TS ic Pa ia E e c Pa As F x J ific cif ia TS ap In ic Pa E an de ex cif Ja I x FT Ja ic A pan nde SE pa ll I x Ja n A Cap nde pa ll x I n Ca nd FT SE F FTS All p I ex n C T E Bu S /A ap de rs E/A SE I x n a FT M SE A d FT T al AN N I ex SE ay 4 nd S S E As E s e ia FT Xi C T ia 0 In x Pa SE nh aiw 10 de cif /X ua a 0 I x n n i F ic G nh All 5 de FT SE FT TSE ov ua -Sh 0 In x EP SE EP ern Chi are de R E R m n I x FT FT A/ PR A/ en a 2 nd SE SE NA A/N NA t B 5 I ex EP EP REI AR REI on nde R RA T E T d x F A/ /N As IT As Ind FT TSE NAR AR ia As ia ex i I D a SE I E EI iv 3 nd ID DFC IT A T A ide 3 I ex FC I si sia nd nd In ndia a N Re + I ex o di n FT a In n-R nta de In fra e l I x SE fra st nt nd Bu F s r a e rs FTS TS tru uct l In x u E a M E S 4G ctu re dex al G oo re In FT ays X S d 30 de J i SE a ha ap In x Sh Hijr ria an de ar ah h 1 In x ia 0 d F h Sha 0 ex FT TSE Jap ria Ind SE G an h I ex FT G WA 10 nd S W 0 e FT E R A Jap In x SE AF Au an de s RA I A tra In x d FT FT FI iust lia I ex SE SE Sin ra nd l RA R ga ia I ex FT FI AF por nd SE K I J e e x a RA aiga pa Ind FI i 1 n I ex Ch 00 nd in 0 I ex a n 50 de In x de x

FT SE

% Change

F As TS ia E Pa As cif ia F As TS ic Pa E ia e c A Pa s F x J ific cif ia TS ap In P ic a E an de c e if Ja I x FT x Ja ic A pan nde SE pa ll I x Ja n A Cap nde pa ll In x C n FT a d SE F FTS All p I ex Bu TS E/A Cap nde r s E/ A S E I x n a FT M SE A d FT T al AN N I ex SE SE SE ays 4 nd As e ia FT Xi C T ia 0 In x Pa SE nh aiw 10 de cif /X ua a 0 I x n n i F ic G nh All 5 de FT SE FT TSE ov ua -Sh 0 In x EP SE EP ern Chi are de R E R m n I x FT FT A/ PR A/ en a 2 nd SE SE NA A/N NA t B 5 I ex R R EP EP EI AR EI on nde R RA T E T d x FT A/N /N As IT A Asi Ind FT SE AR AR ia s a ex SE I E EI Div ia 3 Ind ID DFC IT A T A ide 3 I ex FC I si sia nd nd In ndia a N Re + I ex o di n FT a In n-R nta de In fra e l I x SE fra st nt nd Bu a r F s e rs FTS TS tru uct l In x u E a M E S 4G ctu re dex al G oo re In FT ays X S d 30 de SE ia ha Jap In x Sh Hijr ria an de ar ah h 1 In x ia 0 d FT h J Sha 0 I ex FT SE ap ria nd SE G an h I ex FT G WA 10 nd S W 0 e FT E R A Jap In x SE AF Au an de s I t RA A ra In x d FT FT FI iust lia I ex SE SE Sin ral nd i ex g a R R a FT AFI AF por Ind SE K I J e e x a RA aiga pa Ind FI i 1 n I ex Ch 00 nd in 0 I ex a n 50 de In x de x FT SE

FT SE

% Change

Ju l-0 8

Ja n08

Ju l-0 7

Ja n07

Ju l-0 6

Ja n06

Ju l-0 5

Ja n05

Ju l-0 4

Ja n04

Ju l-0 3

Index Level Rebased (31 July 03=100)

MARKET DATA BY FTSE RESEARCH

Asia Pacific Market Indices

5-Year Total Return Performance Graph 1600

1400

FTSE Asia Pacific Index

1200

FTSE/ASEAN 40 Index

1000

FTSE/Xinhua China 25 Index

800

600

FTSE Asia Pacific Government Bond Inde

400

FTSE IDFC India Infrastructure Index

200

2-Month Performance

-5

Capital return

-10

Total return

-15

-20

1-Year Performance

Capital return

-10

-20

Total return

-30

-40

SEPTEMBER/OCTOBER 2008 â&#x20AC;˘ FTSE GLOBAL MARKETS

Table of Capital Returns Index Name FTSE All-World Indices FTSE Asia Pacific Index FTSE Asia Pacific ex Japan Index FTSE Japan Index FTSE Global Equity Indices FTSE Asia Pacific All Cap Index FTSE Asia Pacific ex Japan All Cap Index FTSE Japan All Cap Index Region Specific FTSE/ASEAN Index FTSE/ASEAN 40 Index FTSE Bursa Malaysia 100 Index TSEC Taiwan 50 Index FTSE Xinhua All-Share Index FTSE/Xinhua China 25 Index Fixed Income FTSE Asia Pacific Government Bond Index Real Estate FTSE EPRA/NAREIT Asia Index FTSE EPRA/NAREIT Asia 33 Index FTSE EPRA/NAREIT Asia Dividend+ Index FTSE EPRA/NAREIT Asia Rental Index FTSE EPRA/NAREIT Asia Non-Rental Index Infrastructure FTSE IDFC India Infrastructure Index FTSE IDFC India Infrastructure 30 Index SRI FTSE4Good Japan Index Shariah FTSE SGX Shariah 100 Index FTSE Bursa Malaysia Hijrah Shariah Index FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index FTSE GWA Australia Index FTSE RAFI Australia Index FTSE RAFI Singapore Index FTSE RAFI Japan Index FTSE RAFI Kaigai 1000 Index FTSE RAFI China 50 Index

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

USD USD USD USD USD USD USD

1,326 860 466

249.78 421.15 89.21

-11.9 -13.3 -7.9

-7.9 -9.9 -3.6

-14.1 -12.7 -23.5

-16.2 -21.1 -12.1

2.61 3.27 1.75

3,267 1,981 1,286

437.43 558.49 315.16

-12.1 -13.8 -7.7

-8.2 -10.5 -3.4

-15.3 -14.5 -23.8

-16.9 -22.1 -12.0

2.62 3.27 1.75

USD USD MYR TWD CNY HKD

156 40 100 50 954 25

416.16 8469.93 7505.82 5063.57 6687.33 20039.83

-10.7 -10.4 -9.2 -18.0 -19.0 -10.1

-9.4 -7.6 -18.5 -8.1 -36.9 -1.8

-8.1 -6.3 -16.7 -21.4 -34.9 -4.1

-15.6 -13.3 -21.0 -17.8 -44.0 -21.4

3.43 3.33 3.27 5.37 1.09 2.21

USD

258

97.31

-0.8

0.8

17.4

6.4

1.53

USD USD USD USD USD

76 38 51 40 36

1736.30 1343.21 2090.31 1007.12 1202.12

-14.2 -13.6 -14.2 -13.7 -14.6

-16.7 -14.8 -19.2 -13.1 -18.9

-22.5 -18.7 -20.9 -24.7 -20.9

-24.5 -21.2 -28.1 -22.4 -25.8

4.09 7.6 5.84 6.70 2.34

IRP IRP

85 30

1045.80 1106.15

-13.6 -13.7

-29.3 -30.9

-12.3 -10.0

-42.3 -43.8

0.59 0.65

JPY

193

4940.69

-7.6

-2.1

-20.8

-10.5

1.71

USD MYR JPY

100 30 100

5401.18 8946.44 1341.87

-12.1 -13.4 -9.1

-5.9 -21.1 -5.2

-12.8 -6.6 -25.0

-13.2 -23.3 -15.0

2.34 2.61 1.87

JPY AUD AUD SGD JPY JPY HKD

466 111 56 16 297 1,021 50

3494.57 3383.57 5136.80 7078.99 4944.28 4724.42 6679.11

-7.8 -12.4 -12.2 -5.3 -6.9 -9.7 -8.1

-3.1 -15.2 -14.6 3.7 -1.8 -9.7 -1.1

-22.2 -23.1 -20.6 -13.5 -20.6 -24.5 1.8

-11.1 -24.0 -22.9 -9.5 -10.4 -20.9 -18.4

1.80 6.01 6.11 3.65 1.81 3.90 2.83

Currency

Constituents

Value

2 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

USD USD USD USD USD USD USD

1,326 860 466

290.43 534.15 107.71

-11.5 -12.7 -7.8

-6.6 -8.3 -2.7

-12.1 -10.1 -22.2

-14.9 -19.5 -11.2

2.61 3.27 1.75

3,267 1,981 1,286

490.25 662.21 336.69

-11.7 -13.1 -7.6

-6.8 -8.9 -2.5

-13.3 -12.0 -22.6

-15.6 -20.6 -11.1

2.62 3.27 1.75

USD USD MYR TWD CNY CNY

156 40 100 50 954 25

520.61 9464.83 8039.99 6271.92 7281.96 24785.70

-10.2 -10.0 -8.8 -14.9 -18.6 -9.5

-7.6 -6.0 -17.2 -4.6 -36.4 -0.4

-4.9 -3.0 -14.2 -17.7 -34.3 -2.1

-13.9 -11.7 -19.8 -14.7 -43.5 -20.3

3.43 3.33 3.27 5.37 1.09 2.21

USD

258

114.94

-0.5

1.5

19.2

7.4

1.53

USD USD USD USD USD

76 38 51 40 36

2331.32 1504.82 2280.02 1144.65 1255.04

-13.6 -12.9 -13.3 -12.7 -14.3

-15.1 -13.1 -17.1 -10.4 -18.0

-19.9 -15.8 -17.3 -20.6 -19.4

-23.0 -19.6 -26.2 -19.9 -25.0

4.09 7.6 5.84 6.70 2.34

IRP IRP

85 30

1051.88 1113.43

-13.5 -13.6

-29.1 -30.7

-11.9 -9.6

-42.1 -43.7

0.59 0.65

JPY

193

5326.52

-7.5

-1.2

-19.6

-9.7

1.71

USD MYR JPY

100 30 100

5685.38 9646.24 1423.35

-11.6 -13.0 -9.0

-4.6 -20.0 -4.2

-10.8 -4.1 -23.7

-11.8 -22.2 -14.1

2.34 2.61 1.87

JPY AUD AUD SGD JPY JPY HKD

466 111 56 16 297 1,021 50

3635.64 3844.62 5830.86 7753.87 5129.63 5068.17 8951.07

-7.7 -12.0 -11.8 -4.9 -6.8 -9.3 -13.3

-2.1 -13.1 -12.2 6.1 -0.8 -7.8 29.4

-20.9 -19.5 -16.5 -9.6 -19.3 -22.1 34.3

-10.1 -22.1 -20.8 -7.4 -9.5 -19.1 6.8

1.80 6.01 6.11 3.65 1.81 3.90 2.83

Table of Total Returns Index Name FTSE All-World Indices FTSE Asia Pacific Index FTSE Asia Pacific ex Japan Index FTSE Japan Index FTSE Global Equity Indices FTSE Asia Pacific All Cap Index FTSE Asia Pacific ex Japan All Cap Index FTSE Japan All Cap Index Region Specific FTSE/ASEAN Index FTSE/ASEAN 40 Index FTSE Bursa Malaysia 100 Index TSEC Taiwan 50 Index FTSE Xinhua All-Share Index FTSE/Xinhua China 25 Index Fixed Income FTSE Asia Pacific Government Bond Index Real Estate FTSE EPRA/NAREIT Asia Index FTSE EPRA/NAREIT Asia 33 Index FTSE EPRA/NAREIT Asia Dividend+ Index FTSE EPRA/NAREIT Asia Rental Index FTSE EPRA/NAREIT Asia Non-Rental Index Infrastructure FTSE IDFC India Infrastructure Index FTSE IDFC India Infrastructure 30 Index SRI FTSE4Good Japan Index Shariah FTSE SGX Shariah 100 Index FTSE Bursa Malaysia Hijrah Shariah Index FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index FTSE GWA Australia Index FTSE RAFI Australia Index FTSE RAFI Singapore Index FTSE RAFI Japan Index FTSE RAFI Kaigai 1000 Index FTSE RAFI China 50 Index

FTSE GLOBAL MARKETS • SEPTEMBER/OCTOBER 2008

CALENDAR

Index Reviews September – November 2008 Date

Index Series

Review Frequency/Type

Effective Data Cut-off (Close of business)

Early Sep Early Sep

ATX CAC 40

30-Sep

31-Aug

19-Sep

29-Aug

Early Sep

S&P / TSX

Semi-annual review / number of shares Annual review of free float & Quarterly Review Quarterly review - constiuents, shares & IWF

19-Sep

29-Aug

2-Sep

FTSE Global Equity Index Series (incl. FTSE All-World) DAX S&P / ASX Indices

Annual Review / Japan Quarterly review/ Ordinary adjustment Quarterly review - shares, S&P / ASX 300 consituents Semi-annual constiuents review Quarterly review Quarterly review Quarterly review Semi-annual review

19-Sep 19-Sep

30-Jun 31-Aug

19-Sep 24-Sep 30-Sep 19-Sep 19-Sep 19-Sep

29-Aug 17-Sep 31-Aug 9-Sep 5-Sep 29-Aug

Annual review / Developed Europe Quarterly review Annual Review Quarterly review Quarterly review Quarterly review Annual review Quarterly review

19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep

30-Jun 29-Aug 29-Aug 29-Aug 29-Aug 29-Aug 30-Jun 29-Aug

Quarterly review Semi-annual review Quarterly review / Shares adjustment Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review - shares & IWF

19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep

5-Sep 29-Aug 31-Aug 5-Sep 5-Sep 5-Sep 5-Sep 5-Sep 5-Sep 5-Sep

Quarterly review Quarterly review Quarterly review - shares & IWF Quarterly review Style Review Annual review Quarterly review - IPO additions only Free float weight periodic review Quarterly review Quarterly review Quarterly review - share in issue Semi-annual review Quarterly review Quarterly review

19-Sep 19-Sep 24-Sep 19-Sep 19-Sep 19-Sep 30-Sep 30-Oct 17-Oct 17-Oct 31-Oct 28-Nov 5-Dec 28-Nov

29-Aug 29-Aug 17-Sep 19-Aug 1-Sep 1-Sep 31-Aug

3-Sep 5-Sep 7-Sep 10-Sep 10-Sep 10-Sep 10-Sep 10-Sep 10-Sep 10-Sep 10-Sep 10-Sep 10-Sep 10-Sep 10-Sep 12-Sep 11-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 17-Sep 17-Sep 17-Sep 17-Sep 19-Sep 1-Oct 9-Oct 8-Oct Mid Oct Mid Oct 14-Nov 14-Nov

S&P MIB NZSX 50 FTSE UK Index Series FTSE / JSE Africa Index Series FTSE Asiatop / Asian Sectors FTSE Global Equity Index Series (incl. FTSE All-World) FTSE techMARK 100 FTSEurofirst 80 & 100 FTSEurofirst 300 FTSE Euromid FTSE eTX Index Series FTSE Multinational FTSE Global 100 FTSE EPRA/NAREIT Global Real Estate Index Series FTSE4Good Index Series NASDAQ 100 S&P US Indices S&P Europe 350 / S&P Euro S&P Topix 150 S&P Latin 40 S&P Asia 50 S&P Global 1200 S&P Global 100 FTSE NAREIT US Real Estate Index Series FTSE NASDAQ Index Series S&P MIB DJ STOXX DJ STOXX DJ STOXX Blue-Chip Russell US Indices TOPIX TSEC Taiwan 50 FTSE Xinhua Index Series OMX H25 FTSE / ATHEX 20 Hang Seng MSCI Standard Index Series

30-Sep 19-Sep 30-Sep 30-Sep 31-Oct

Sources: Berlinguer, FTSE, JP Morgan, Standard & Poors, STOXX

100

SEPTEMBER/OCTOBER 2008 • FTSE GLOBAL MARKETS

THE FTSE I WANT A CLEANER WORLD INDEX FTSE. It’s how the world says index. The FTSE Environmental Technology Index Series is the definitive benchmark for investors who want to be at the forefront of environmental markets. With the inclusion of alternative energy, water treatment and waste management companies, the FTSE Environmental Technology Index Series focuses on the companies that are shaping our future. www.ftse.com/ET

© FTSE International Limited (‘FTSE’) 2008. All rights reserved. FTSE ® is a trade mark jointly owned by the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE under licence.

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