FTSE Global Markets

SECURITIES LENDING ROUNDTABLE: THE AFTERMATH OF THE CREDIT CRISIS ISSUE 29 • OCTOBER 2008

The appeal of biotech to Big Pharma Is there a road back for structured debt?

Yapi Kredi resurgent Saudi Arabia opens the door to investment inflows

CME & THE NEW

WORLD ORDER

THE BOVESPA/BM&F MERGER: SHOWY GLISTER OR PURE GOLD?

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This publication is issued in the United Kingdom by Société Générale. The information herein is based upon sources believed to be reliable but is not guaranteed as to accuracy or completeness. Copyright The Société Générale Group 2008. All rights reserved

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FTSE GLOBAL MARKETS • OCTOBER 2008

N A RECENT summer reader survey we asked questions about the magazine’s editorial and what topics you would like to see covered in FTSE Global Markets. Some 599 respondents to the questionnaire said they would like us to expand our coverage of company and banking profiles, commodities, alternative investments, private equity, emerging markets, structured products, derivates and ETFs, option strategies and indexation, regulations, trends in exchanges, comparisons of index providers, and details of new indices (from both FTSE Group and other index providers). So, that is what we will do. Moreover, we continue to want to improve the magazine so that it best meets your requirements. If you did not take part in the survey and have criticisms, suggestions or feedback on editorial issues, we will be pleased to hear from you.

By now you might be forgiven for thinking that you have escaped the ubiquitous hand wringing over the credit crisis.You’d be wrong. We have just interspersed it at strategic intervals throughout the issue. However, we think that the fin de siecle feel to the global markets offers as much hope right now as it does despond. In consequence, this issue is purposefully balanced towards the former, for two reasons. One to offer some respite to the endless yardage of doom. Two, because we also believe it might be quite a good thing in the long run. Irrespective of which institutions will or will not survive the credit crisis, a number of significant trends are in play right now. One is further consolidation of the banking sector. Whether marriages, mergers or acquisitions in the financial sector are borne out of strategic necessity or scarcity of funds, it seems we are in a period in which a tight knit group of global and regional super-banks (and super-exchanges for that matter) that will continue to find their feet in the new financial landscape. Acquisition opportunities will abound as it becomes clear that not all firms are adequately prepared for the new circumstances of the global markets in this century.

Two, tighter control on the global financial markets now seems likely, and assuming that most legislators will over-react rather than under-react, we can expect a relatively heavy hand from regulators. We for one, will opt for under-reaction. While the current carnage taps our sentiment and sympathy, it shows that if you mess with free markets, they bite you back with no small degree of ferocity. That should be encouragement enough to establish self-regulation and proper risk management controls in any and all financial institutions; without further political intervention in markets.

Equally, even with some rather pesky recessionary trends flowing through most economies (developed and emerging) globalisation will continue at an accelerating pace, ultimately changing the vocabulary of international financial and political relations. Reciprocity, sovereign integrity, interdependence, climate management, risk in all shapes and sizes, transparency and knowing your counterparty, will be among the key catchwords and phrases of the next decade. It should be real interesting.

In terms of asset classes, a number of issues are at the forefront.

Irrespective of the correction affecting most commodity markets right now, rising global demand over the coming years will keep them centre stage for some time to come. Moreover, the growth in derivatives trading (albeit growing challenges to the spread of the OTC market over the short term) and the increasing use of derivatives as a risk management as well as a speculative tool will mean that more institutional investors will adopt derivative instruments as an integral part of their overall asset allocation and risk management strategies.

I

Francesca Carnevale, Editorial Director October 2008

1

Contents COVER STORY COVER STORY: THE CME’S NEW WORLD ORDER ....................................Page 64 Few institutions appear ready to face the inevitable changes and swings of power and influence in the global financial markets as well as the Chicago Mercantile Exchange (CME) Group. Is this ability a happy accident? Or, is it instead a somewhat prescient growth strategy? Francesca Carnevale reports from Chicago.

DEPARTMENTS THE GATHERING STORM

MARKET LEADER

............................................................................................Page 6 Dave Simons and Francesca Carnevale review the state of the global financial markets.

THE HEDGE FUNDS FIGHT BACK

......................................................................Page 14 Has shorting of vulnerable stocks unravelled the financial order? The hedge funds say not.

STRUCTURED DEBT: WHAT NOW? ....................................................Page 15

IN THE MARKETS

Neil O’Hara asks when might the structured debt market return?

OTC DERIVATIVES: STRAIGHT THROUGH PROCESSING ........Page 18 The buy side is in this particular hot seat claims Neil O’Hara.

INDEX REVIEW INNOVATORS

OOPS! THEY’LL DO IT AGAIN

..................................................................Page 24 Simon Denham, managing director, Capital Spreads, on falling dominoes.

THE O’CONNOR APPROACH TO MANAGING RISK ..................Page 25 JPMorgan is on a roll; Sandra O’Connor is one of the reasons why.

SAUDI ARABIA & THE LIGHT OF LIBERAL MARKETS

..................Page 28 The Kingdom is liberalising its investment regime: what will be the impact?

MENA REPORT

THE SHAPE OF THINGS TO COME IN EGYPTIAN BANKING

....Page 34 Will the failure to sell off Banque du Caire have an adverse impact? Julia Grindell finds out.

KUWAIT’S BILLION DOLLAR BANKER

........................................................Page 38 What’s the secret of NBK’s Shaika Khalid Al Bahar’s success in the debt markets?

COUNTRY REPORT/TURKEY

WHAT DOES TURKEY KNOW THAT WE DON’T? ..................Page 41 Turkey’s real estate sector is on a roll, while everywhere else the sector is tanking. Why?

BANK PROFILE: YAPI KREDI RESURGENT ....................................Page 45 How Tayfun Bayazit, Yapi Kredi’s CEO, resurrected the bank’s fortunes.

EXCHANGE REPORT

MAKE OR BREAK FOR BOVESPA ............................................................Page 48 John Rumsey reports on the efficacy of Bovespa’s merger with BM&F.

TRADING VIEWS IN A FRAGMENTED MARKET ......................Page 72

TRADING REPORT

Société Générale’s Stephane Loiseau on the emerging European trading landscape.

WHAT’S A TRADE BETWEEN FRIENDS? ........................................Page 74 Why Anonimity is an increasingly utilised trading tool.

DATA PAGES 2

Securities Lending Trends by Data Explorer ............................................................Page 91 Market Reports by FTSE Research ..............................................................................Page 92 Index Calendar ..............................................................................................................Page 96

OCTOBER 2008 • FTSE GLOBAL MARKETS

Contents FEATURES INVESTMENT SERVICES

US SECURITIES LENDING: HANDLING VOLATILITY ..............Page 53 While politicians and market pundits have made pointed observations about the role of the securities lending markets in shorting, securities lending providers have been working hard to ensure that their clients properly manage their risk exposure in a hyper volatile market.

Dave Simons reports.

THE GROWING TUSSLE FOR BUSINESS IN EASTERN EUROPE....Page 60 It was only a matter of time before global custodians, anxious to expand their footprint, discovered the potential of local custody services in Eastern Europe. However, as Julia Grindell discovered, a whole host of other bankers got there before them. Who will win a growing tussle for business?

STRAIGHT THROUGH PROCESSING ..................................................Page 59 Uptake of corporate-actions messaging is ahead some 20% year-over-year, and has roughly tripled since SWIFT’s message system was first introduced some five years ago. That is the good news. However, for many other segments of the securities industry, data processing remains a problem, fraying nerves and eroding profits. What will it take to get everyone on?

David Simons reports from Boston.

DEBT REPORT

SOVEREIGN DEBT: EUROPE’S SOVEREIGN’S PILE IN............Page 77 In an otherwise rather moribund market, Europe’s sovereign issuers continue to increase their borrowing. Will it all end in tears?

THE LIFE & TIMES OF KFW ........................................................................Page 79 After recovering from the trauma of IKB, Germany’s development bank is back in the spotlight

PRIVATE EQUITY: THE APPEAL OF CALIFORNIA BIOTECH........Page 82 California now dominates the biotechnology industry, accounting for more than half of all biotech revenues. Its new companies soak up more than four of every ten dollars in US biotech venture capital. With the mix of an ideal climate, some of the world’s best universities and research institutes, and seasoned venture capitalists, what could go wrong? Big Pharma for one. Art Detman reports.

TEREX: WINNING AGAINST THE ODDS ..........................................Page 87 In a dozen years Ron DeFeo has changed Terex from a motley crew of troubled companies into the world’s third-largest construction equipment maker. Since 1997, sales have grown from $842m to $9.1bn, and DeFeo expects to reach $12bn by 2010. “Many people cannot fathom that we have got a $10bn company here—made out of ashes,” he says. Art Detman examines Terex’s successes and challenges.

4

OCTOBER 2008 • FTSE GLOBAL MARKETS

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Market Leader REPERCUSSIONS OF THE BANKING CRISIS

Photograph © Panagiotis Karapanagiotis/Dreamstime.com, supplied September 2008.

NO COUNTRY FOR OLD, FREE MARKETEERS Who would have thought it? The third week of September saw the low budget exhumation of the charred remains of Lehman Brothers and the emergence of Morgan Stanley and Goldman Sachs as licensed deposit takers. Another turn was the casting of US Treasury Secretary, Henry Paulson, as the saviour of the US banking system. While the global markets calmed over the weekend in response to the Paulson Plan and the temporary ban on shorting, ructions in money markets funds and continued equity market volatility signalled strongly that the cull is by no means over. It is clear now, that aside from those honoured names that have disappeared from the lexicons of banking and the fund industry, we have effectively kissed goodbye to the mechanics of the free market. David Simons and Francesca Carnevale mull over the philosophical, financial and human cost of the carnage.

HE EXTIRPATION OF Lehman Brothers, the bargain basement sell-off of Merrill Lynch, the assault on banking stocks around the world and insurer AIG, the shocking fall in the values of both sovereign wealth funds and high profile money market funds, and all in the third week of September. The melodrama is worthy of a Hollywood blockbuster.

Renaissance Capital, the flagship Russian bank/brokerage and the UK’s HBOS ended up as unwilling brides in shotgun marriages and even

T

6

Australia’s erstwhile banking star Macquarie, barely scraped through the week unscathed.

The madness was catching. High fallutin’ and ponderous commentary punctuated much of the daily and financial press, supported by phrases such as “new world order” and “Judgement Day”, giving its own special impetus to market uncertainties.

Equally, every man (and woman) on the Clapham Omnibus suddenly seemed to understand the mechanics of shorting. Finding a convenient

scapegoat, politicians and regulators from Saratoga to Sydney found themselves a Get out of Jail Free card and slammed down the breaks on short selling of financial stocks. That is when those in the know really knew the financial markets were in trouble and that politicians were taking over the asylum. Having dosed the markets (you know, those markets controlled by the daily press) with a weekend’s worth of valium, everyone settled down to begin wondering what really happened in those ten tumultuous days.

When Secretary Paulson unveiled plans to establish a government-backed facility reminiscent of the Savings & Loan-era Resolution Trust Corporation (RTC) and a suddenly assertive Securities and Exchange Commission (SEC) came in with a separate proposal, temporarily banning short-selling on 799 financial stocks and other commonly held issues, everyone reacted with unabated glee. Markets began to recoup most of the week’s losses, and then some. Even then, the euphoria lasted only over Saturday and Sunday, as by the Monday volatility was back

OCTOBER 2008 • FTSE GLOBAL MARKETS

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Market Leader REPERCUSSIONS OF THE BANKING CRISIS

with a vengeance, with oil prices rising on a projected uptick in demand (resulting from, yes you guessed it, Paulson’s Plan). If that wasn't enough, Republicans weighed in with their own amendments, wanting to turn Paulson's scheme into an insurance layer, rather than refinancing of toxic stock.

It is ironic though, isn’t it, that a Republican administration based its response to irresponsible market practices (albeit a year late) by an aggressive and total market bailout? It was only over that self-same weekend that some commentators began to understand the implications of Paulson’s package. Political veteran Newt Gringrich and a late but vociferous phalanx of ultra-right wing commentators cast the first stone against the efficacy of Paulson’s solution. Gringrich wrote in the influential National Review that “watching Washington rush to throw tax-payer money at Wall Street has been sobering and a little frightening,” while commentator Yuval Levin in another National Review article posited that noone could read about Paulson’s plan without concluding that “everyone in Washington has lost their minds.”

Worryingly perhaps, their opprobrium rested more on the “unfettered” powers that will accrue to Paulson and, presumably whoever succeeds him in the Treasury in a subsequent administration. It was left to the Democrats to fret over the small

print of the disbursement and management of the whopping $700bn to $1trn that will be used to buy up subprime debt (at what, if any, discount, noone is yet sure). Both sides of the political equation however appeared to focus on tax-payer rights and seemed to miss the fact that the Paulson Plan effectively gives banks—investment or commercial banks—carte blanche to run up another sack full of bad-ass debt at some indeterminate point in the future.

So much for rising and falling on economic merit.

No one should have been surprised at the extent of the Paulson package.

His lengthy paper, A blueprint for a stronger regulatory structure, issued in March this year, and which had been under formal consideration since 2007, hinted at a wider remit for supervisory agencies, particularly the Federal Reserve, which he underscored was the coordinator in the US markets in the management and resolution of central market and systemic financial risks. More ironically, it was the market (via the credit crunch) and not formal regulation that actually extended the role of the Fed by providing liquidity to non-deposit taking institutions and it will be interesting to see whether this role is formally encapsulated in any forthcoming legislation.

It is important. If nothing else, events in the UK, for instance, have highlighted the shortcomings of managing stability throughout the financial

markets when it is not the responsibility of any one single agency.

In America then, the debate will rest on whether the state apparatus will take on additional powers (already a sensitive issue in a post 9/11 world); which could mean (unless the Americans are extremely canny about it) it might miss an important opportunity to redefine the US’s role in an increasingly globalised marketplace. Paulson is keen on an objectives based regulatory approach; just how far that will be tempered by the market’s continued desire for light touch regulation (as the UK’s principle’s based approach) or an incoming new government anxious to show it’s testosterone fuelled power over the market has yet to be played. As the magazine went to press, US legislators had still not put a final face on the bailout plan.

Whatever one thinks about the need to address the causes of the current liquidity crisis, the fact remains that it occurred at an important tipping point in world affairs. The spectre of having to compete with an aggressive and competitive China, India and Brazil, might and should temper any excesses of regulation being dreamed up by politicians and regulators alike.Though any solution to seemingly unfettered borrowing by an over-extended retail sector is an obvious issue for any incoming US administration in 2009. If you think this is over-stating the case, remember than through the summer

Sovereign Wealth Fund Investment in Wall Street Country

Date of Deal

Amount (bn)

Company

Strike on Deal Date

Price on 15/09/2008

Change

Loss Amount (bn)

Kuwait Kuwait Singapore Singapore China Singapore United Arab Emirates Singapore China

25-Jan-08 25-Jan-08 16-Jan-08 24-Dec-07 20-Dec-07 07-Dec-07 26-Nov-07 23-July-07 23-July-07

3 2 6.88 4.4 5 9.75 7.5 2 3

Citigroup Merrill Lynch Citigroup Merrill Lynch Morgan Stanley UBS Citigroup Barclays Barclays

26.00 54.22 29.52 53.90 51.37 50.48 30.70 735.00 735.00

17.96 17.05 17.96 17.05 37.23 20.65 17.96 300 300

-30.92% -68.55% -39.16% -68.37 -27.53% -59.09% -41.50% -59.18% -59.18%

0.93 1.37 2.69 3.01 1.38 5.76 3.11 1.18 1.78

8 OCTOBER 2008 • FTSE GLOBAL MARKETS

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Market Leader REPERCUSSIONS OF THE BANKING CRISIS

months China’s consumer spending was rising at monthly rates ranging from 9% to 16% in real terms. That trend is likely to continue for some time and signals the future drift eastwards of at least one of the pillars of the global economy.

In Europe, there are equally important issues.The EU is introducing important harmonisation initiatives into a marketplace marked by an indifferent political class that does not really appreciate the significant of many post Lisbon Treaty directives. If you don’t believe that, remind yourselves that UK premier Gordon Brown turned up to sign the latest EU treaty a day late and after every other head of state had left the building.

Europe and Asia are inevitably affected by financial contagion (just ask RenCap, HBOS and Macquarie Bank).

In Europe a strengthening euro, a falloff in US imports, and high oil prices, will exacerbate a testing climate. Even those over-abundant sovereign wealth funds have been weakened (see box).

Having lost a substantial portion of their value (up to 30% in some instances), those funds with equity in US banks will be looking for some hefty returns to make up their losses and will not be shy about having their say in the way the banks are run. Make no mistake, they will be approached again and again for money: Britain’s high street banks, for instance, are reckoned to be around £38bn short of the capital they need to function properly, according to investment bank JPMorgan.

That’s an awful lot of money to find and it might not be easily forthcoming.

Kuwait Investment Authority’s managing director Bader al-Saad told Al Arabiya Television on September 23rd that the “Disasters in the United States, some European countries or Asian countries create opportunities in the real estate sector, the financial industry or other sectors,” he said,

10

though adding ominously:“We are not responsible for saving banks.”

Other sovereign funds, such as the Abu Dhabi Investment Authority, might take a more benign and long term approach to the problem, but there is no doubt that in the wealthy Gulf States things have also changed. Islamic Sukuk issuance has dropped off by at least 75% in value terms this year, for two reasons.

One is the credit crunch. Ironically the main investors in Islamic Sukuk were hedge funds and western asset management firms looking for exposure to the Gulf growth story; there is no such money spare to invest in those instruments right now. Two: is impact of the decision by Islamic Scholars at the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) earlier this year that mooted that more than 60% of issued Sukuk, were not in fact Islamic compliant. Most Gulf Sukuk were sold with a repurchase undertaking—a promise that the borrower will pay back their face value at maturity, or in the event of default, mirroring the structure of a conventional bond. A promise to pay back capital violates the principle of risk sharing and profit sharing on which such bonds should be based, noted Sheikh Muhammad Taqi Usmani, chairman of the AAOIFI board at the time.

The good news is that there are signs of pent up demand for debt in the Gulf: the question is, when (and it could be a long when) the market becomes more liquid, whether issuers plump for conventional bonds; Islamic structures that are really Islamic compliant and involve risk sharing and equity, or whether new instruments take their place. Whatever, the shape of those markets look set to change forever also.

Larry Tabb, CEO of Boston-based TABB Group, thinks recent days have done irreversible damage to the investment banking industry. “The days of the all-in-one global investment bank

Susan Chaplinsky, a professor at the University of Virginia’s Darden School of Business says,“We have never had a crisis in which literally all of the players were interconnected, affecting not only the investment community but the world at large. What started as a ‘credit problem’ has overtaken the entire global financial system.

Consequently, the typical self-correcting principals aren’t always sure if it’s the right time to make their move. Everyone has been singed by the same flame. I suspect we will see that the correlation is even more widespread than anyone had suspected.” Photograph kindly supplied by the University of Virginia, September 2008.

may be nearing an end,” surmises Tabb, “we are seeing a downsizing of industry capacity and we will absolutely see a movement away from risk toward transparency and liquidity.” Key to this transition, says Tabb, is that banks create separate subsidiaries for the sole purpose of housing risky assets, thereby preventing“clean”assets from becoming tainted and lessening the chances for the kind of debilitating contagion that has impacted today‘s markets. It’s a scenario that looks a lot like the banking system of old; that is, before every mortgage ever originated was sold off for the benefit of the investment community. No wonder Goldman Sachs and Morgan Stanley are lining up to attract depositor funds.

Equally, securitisation will remain a no-go area for some time to come as banks “begin to hold the loans they make,”says Tabb.“This will force them to really analyse credit instead of offering debt to anyone capable of fogging a mirror. We will also see more debt and derivatives products become simpler and easier to parse.These more vanilla products will be centrally

OCTOBER 2008 • FTSE GLOBAL MARKETS

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Market Leader REPERCUSSIONS OF THE BANKING CRISIS

banking and fund cleared and traded onmanagement communities exchange enabling greater must now come back into transparency and liquidity.” fashion. It is not enough that About time, perhaps. bankers are chastised for Then, there is the issue of introducing and buying continued contagion. The dodgy debt. Pension fund crisis is by no means over. trustees should also be Global Insight economist sufficiently au fait with the Howard Archer notes, “There workings of complex is obviously widespread financial instruments before concern about other banks’ their money is put into the exposure to Lehman Brothers, hands of asset managers with not only in the US but also in ‘high alpha return’ambitions.

Europe.” If more institutions Everyone might also want to fall and credit conditions US Treasury Department secretary Henry M. Paulson, Jr. delivers a think about aligning risk remain tighter for a longer speech on Open investment before the US/ UAE Business Council at management tools with areas period,“economic activity will Emirates Palace, in Abu Dhabi on Monday, June 2nd 2008. of high exposure. After all, it additionally weaken, thus Prophetically, Paulson noted that the Bear Stearns episode“raises makes sense. affecting the performance of significant policy considerations that need to be addressed.”The Regulators and national the rest of the world,”concurs collapse, said Paulson at the time, underscores the rapidly changing role treasurers must work more Alfredo Coutino, Moody’s of non-bank financial institutions as well as the interconnectedness closely with the management senior Latin American among all financial establishments. Photograph by Manuel Salazar, of financial institutions and economist in a research note. provided by the Associated Press/PA Photos.com, supplied June 2008. become an intrinsic part of As Susan Chaplinsky, a professor at the University of Virginia’s bill for the mistakes of Lehman et al. the financial markets; and not come Darden School of Business says, “We “This is a big moral hazard,” Diane into focus only when problems arise. have never had a crisis in which literally Garnick, investment strategist at The admission by UK Chancellor all of the players were interconnected, Invesco, says. “What are we teaching Alastair Darling that he was ‘surprised’ affecting not only the investment people about taking on levels of risk?” at the extent of the problem really cuts We should all spare a thought for no ice in this day of hyper-information community but the world at large. What started as a ‘credit problem’ has those bankers and ancilliary workers flows and telecommunications. Then overtaken the entire global financial who have lost (and will yet lose their again, banks could introduce tighter system. Consequently, the typical self- jobs) and whose savings, pensions and credit controls and watch what their correcting principals aren’t always sure if salaries have disappeared, as many financial alchemists are doing a tad it’s the right time to make their move. had used their supposedly gold plated more closely. Moreover, regulators Everyone has been singed by the same stock options as the basis of their short might want to review mark to market flame. I suspect we will see that the term borrowing and long term savings accounting. After all, if you cannot sell correlation is even more widespread plans. Add to that ordinary hard your house right away, does it mean it than anyone had suspected.” We think working people who trusted the has no intrinsic value?

Finally, for what its worth, it is also Fortis Bank, Washington Mutual, banking system to deliver returns on Wachovia, Bradford & Bingley and their investments and savings. Their useful to remember that (eventually) aspirations have been blasted into a things will get better. Says one London Glitnir Bank would agree.

There are other, human costs too. black hole as well. No more: “safe as based banker:“everyone seems to have forgotten that the value of shares can Borrowing costs will continue to rise houses”sales pitches to them then.

So what now? This is not a go up, as well as down.” In other for everyone, everywhere. At the retail level it will put a hammerlock on comprehensive list of do’s and dont’s; words, the bull will rear its head once consumer spending, as taxpayers who but we’ll put it out there for more. Us? Well, rather like the Sage of have watched home values plummet consideration with everyone else’s Omaha, we are waiting for the chance and credit lines collapse will two-penn’orth of comment. For one, to finally get our hands on a Goldman ultimately wind up footing most of the personal accountability, for both the Sachs chequebook and pen!

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OCTOBER 2008 • FTSE GLOBAL MARKETS

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Market Leader HEDGE FUND REACTION TO TEMPORARY STOP ON SHORTING

Securities lenders and short sellers have variously been cast as villains through shaky September as one financial stock after another tottered. Last July’s Securities and Exchange Commission restraining order barring shorts from touching 19 “systemically important” financials turned out to be just a warm-up. An even wider ban—this time affecting 799 financial companies, imposed on a temporary basis on September 19th. However, the mooted cure just might be more painful than the ailment. Dave Simons reports.

ON OR OFF A SHORT LEASH? ITH THIS CURRENT clamp on shorting, regulators face a daunting task: appease the chorus of traditionalists who believe you’re wrong if you’re not long; while at the same time acknowledging the many benefits that legitimate watchdog shorts have historically brought to the marketplace. While even the most ardent defenders of shorting do not deny the potential harmful effects of naked shorting (the practice of shorting a stock without first borrowing the shares) and other rogue activity, most are clearly alarmed at the regulatory rush to judgment, and warn of the potential long-term damage to the markets that could occur.

Richard Baker, president of the Managed Funds Association, which represents the alternative investment industry, acknowledges that members were troubled by clampdown.“We stand firm in opposing restrictions to short selling and maintain that short selling is an essential risk management tool and a critical component of ensuring market stability, not a contributor to market volatility,” said Baker. Baker told the press that it was unclear whether any of the 19 “protected” financial companies benefited from the short-selling restrictions by the SEC in July, as most had declined in value by the time the emergency order had expired.

Andrew Feldstein, CEO and chief investment officer of New York-based BlueMountain Capital Management, a

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$5.6bn global credit alternatives manager, says hedge fund and traditional money managers hedging their exposure to investment banking stocks had as much to do with the recent volatility as short sellers. “As they began to recognise the magnitude of their losses in connection with the Lehman bankruptcy, those who had never hedged that exposure decided they’d better do so, primarily by shorting stock,” says Feldstein. “In the rush to immunise their risk against the remaining dealers, they pushed stock prices down and credit spreads up.”

Feldstein also thinks current measures be counter-productive, should they be extended or adopted permanently.

Inhibiting participants’ ability to short will prevent them from hedging their large exposures to the dealers, which, in turn, will induce participants to take their positions elsewhere.“You have got people moving cash balances from the prime brokerages because they can’t hedge themselves,” says Feldstein.“The choice is clear—you can either move your balances, or you can hedge and if you can’t hedge, then you have to move.” Doing so, says Feldstein, will have an immediate impact on liquidity (something the market can ill afford at this juncture) and wind up hurting the same counterparties the government is trying to help.“In short, these restrictions on hedging will put a damper on activity.” In turn, any entity that is having trouble maintaining its

viability as a counterparty will see its compounded, says problems Feldstein, “because nobody will be willing to trade with them.”

Dick Del Bello, senior partner with hedge-fund service provider Conifer Securities in NewYork says,“[Politicians] see people who have made all this money, and they think there must be something very illegal and wrong with it, so they automatically make the assumption that this activity must be stopped.” The real mistake, says Del Bello, was the government’s scrapping of the uptick rule, which helped deter rapid downdrafts in stock prices incited by rampant short selling.

The clampdown on short selling not only impacts liquidity, but also removes a key component for price discovery, says Del Bello. “It’s just un-American to think you can only go one way in the market now, and that is, to bet on things going up. I just can’t fathom that.”

With a historic election looming, it is not surprising that politicians would make a move. “However, taking hundreds of stocks and saying you can’t short them is a knee-jerk reaction. There are a lot of players who have just been dealt out of the game as a result. It is going to make life very difficult for hedge funds if this stays in, and even worse, it is going to take away from the liquidity of the markets as well,”says Del Bello.

Anyone who is a proponent of free markets but says securities can’t be shorted when they appear overpriced is just being hypocritical, adds Feldstein. “Having a philosophical problem with short sellers is one thing—but we need to figure out solutions that are different from the extreme measures that have been taken. If the SEC thinks there has been market manipulation and that the law has been violated, they have the tools to go after the perpetrators.

But this approach is clearly different.”

OCTOBER 2008 • FTSE GLOBAL MARKETS

In the Markets

Everybody wants out. The major holders of structured debt instruments include structured investment vehicles (SIVs), conduits, banks and investment banks, all leveraged entities that have come under increasing pressure to sell assets since the credit crisis blew up last summer. It is no surprise then that prices have tumbled to unprecedented levels; when so many natural buyers have become forced sellers there is nobody left on the other side. Neil O’Hara reports.

HE DOWNWARD SPIRAL in structured debt may not end until real money investors who do not use leverage, such as pension funds, endowments, insurance companies, mutual funds and sovereign wealth funds, step up to the plate.

That however is easier said than done. Structured debt investors relied on leverage to juice their returns, so unleveraged players have neither the people nor the technology infrastructure needed to monitor a structured debt portfolio.

Money managers can not rely on bond analysts accustomed to corporate financial statements to do the work; it is a completely different game. The intricacies of contractual subordination and cash flow waterfalls have no counterpart in corporate financial statements. Unlike call provisions for conventional bonds, which occur on specified dates, mortgage backed securities (MBS) are subject to prepayment risk at the whim of the borrower at any time.

Even high yield and distressed debt analysts, who have a detailed grasp of corporate capital structures, have to learn a different landscape. “The traditional distressed corporate guy who looks at balance sheets and deals with companies in bankruptcies and restructurings is incapable of doing anything in structured finance,” says

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FTSE GLOBAL MARKETS • OCTOBER 2008

Steven Eisman, portfolio manager of the financial services team at New York-based FrontPoint Partners, a $10bn investment manager focused on absolute return strategies now owned by Morgan Stanley Investment Management.

For corporate bondholders, the outcome in a reorganisation is a continuum from par all the way down to pennies on the dollar but rarely zero. Not so in structured finance vehicles, for which even a modest deterioration in credit performance can mean the difference between par and zero for some tranches. The risk may be more prevalent than investors realized for collateralised debt obligations (CDOs) that go into default, affecting even the AAA senior tranches. If an event of default occurs, the super senior holders at the top of the capital structure have the right to preempt the cash flow from all other tranches in a so-called acceleration, or to force the CDO into liquidation whether or not the holders of other tranches object. “These instruments may have binary payout profiles,”says Christopher Crerend, executive vice president, chief investment officer (alternatives) and a portfolio manager at EACM Advisors, a $4bn fund of hedge funds based in Norwalk, Connecticut, “You purchase something that could appreciate

NO MORE ROOM FOR STRUCTURED DEBT?

THE NEW AGE STRUGGLES OF STRUCTURED DEBT Steven Meier, global cash chief investment officer at State Street Global Advisors, has first-hand experience of buying assets at an attractive middle market price only to find them marked down to the bid the very next day. Meier runs about $720bn invested at the short end of the market (five years or less to maturity), of which more than $100bn is in high quality asset backed securities (ABS) supported by credit card receivables, automobile loans, student loans and other obligations.“If I buy an asset at 100 basis points (bps) over LIBOR, it may price tomorrow at 120bps over and hit the net asset value,” he says,“You have to be willing to live with that.” Photograph kindly supplied by State Street Global Advisors, September 2008.

significantly but conversely you could be subject to a complete write off.”

Unleveraged investors can buy distressed structured debt instruments today that offer returns competitive to equities, but elevated yields are unlikely to last. In whatever form the structured debt market emerges from the crisis it will still be a substitute for fixed income with expected returns to match.

Investors have little incentive to build expensive infrastructure unless they expect to be long term participants in the market rather than taking advantage of a fleeting dislocation.

Unleveraged players may prefer to tap money managers who already have the necessary expertise instead.

Crerend says that although hedge funds are beginning to dip their toe in the water at current prices they are not ready to jump in the deep end. The carnage in the first half year was bad enough to cripple some hedge funds and managers do not want to risk

15

In the Markets NO MORE ROOM FOR STRUCTURED DEBT?

losses if they buy in ahead of a forced seller. “Hedge funds are cautious and watchful,” Crerend says, “They do not want some unknown liquidation to knock down the marks on something they put on their book.”

Investors already run the risk of unflattering marks due to a lack of liquidity that has pushed bid-offer spreads to unprecedented levels.

Steven Meier, global cash chief investment officer at State Street Global Advisors, has first-hand experience of buying assets at an attractive middle market price only to find them marked down to the bid the very next day. Meier runs about $720bn invested at the short end of the market (five years or less to maturity), of which more than $100bn is in high quality asset backed securities (ABS) supported by credit card receivables, automobile loans, student loans and other obligations. “If I buy an asset at 100 basis points (bps) over LIBOR, it may price tomorrow at 120bps over and hit the net asset value,” he says,“You have to be willing to live with that.”

For the short dated assets Meier traffics in he favours a buy and hold strategy that relies on payment at maturity rather than a market bid to exit positions.

Meier noticed an improvement in market conditions for credit card and student loan ABS early in the second quarter. New issue volume has been robust at spreads that are generous by historical standards but after several issues were oversubscribed up to four times over he hears talk that underwriters may try more aggressive pricing. If it does happen, a small move would not faze him. With leveraged players shut out of the market enhanced cash funds and cash collateral investors such as State Street can still demand high yields.“We want to make sure there is a depth of buyers

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Jeffrey Meli, head of US credit strategy at Barclays Capital in New York, expects the pace to pick up. "It is a finite source of risk," he says, "The phenomenon will feed on itself because the more it happens the less there is to move." Meli points out that the market will get additional relief when the SIVs have retired all their asset backed commercial paper.

Ever since the crisis broke SIVs have had to dump high quality assets—AAA rated CLO tranches, for example—to redeem outstanding liabilities, but even their extendible commercial paper will soon mature. "We think that process was mostly done by the middle of the summer," Meli says, "That flow of risk will get shut off." Photograph kindly supplied by Barclays Capital, September 2008.

for the new paper,” Meier says, “I do not think we have to chase anything at this point. The opportunities won’t go away tomorrow.”

Time is the great healer, of course.

The credit crunch put an end to large leveraged buyouts (LBOs) for the foreseeable future and the backlog of funded and unfunded LBO loans the banks were unable to package into collateralised loan obligations (CLOs) has dropped from $250bn last summer to perhaps $100bn in April. Some LBO transactions simply fell apart, but

banks have started to sell, too. Both Citi and Deutsche Bank sold large chunks ($12bn and at least $5bn respectively) of LBO debt in recent weeks and Jeffrey Meli, head of US credit strategy at Barclays Capital in NewYork, expects the pace to pick up.“It is a finite source of risk,”he says,“The phenomenon will feed on itself because the more it happens the less there is to move.”

Meli points out that the market will get additional relief when the SIVs have retired all their asset backed commercial paper. Ever since the crisis broke SIVs have had to dump high quality assets—AAA rated CLO tranches, for example—to redeem outstanding liabilities, but even their extendible commercial paper will soon mature. “We think that process will be mostly done by the middle of the summer,” Meli says, “That flow of risk will get shut off.”

The rating agencies play a part as well. Wholesale downgrades of structured debt have forced even real money investors to sell bonds that no longer meet minimum rating thresholds embedded in their investment guidelines. Sooner or later the agencies will run out of instruments to downgrade, and in the absence of new supply the market will begin to stabilise.

“The risk transfer is an ongoing process,” says Meli, “It’s likely to continue for the next couple of quarters at least, but it is already taking place.”

He says the buyers are mostly insurance companies, hedge funds and money managers buying on behalf of pension funds and other institutions.

Mutual funds most likely will not get involved; their strict investment guidelines leave little room for opportunistic trading in an unfamiliar asset class and the poor liquidity in structured debt does not match their obligation to meet redemption requests every day. Some money managers have launched new funds that aim to buy

OCTOBER 2008 • FTSE GLOBAL MARKETS

structured debt assets on the cheap targeted at investors who recognise the potential opportunity but lack the resources to dive in on their own.

Unleveraged buyers are demanding fat returns relative to conventional bonds or equities, however.“Credit spreads are substantially wider than they were this time last year and equities are a lot cheaper,” says Meli, “Investors need to get paid extra to take on risk with structural nuances.”

Buyers have good reason to be cautious. Anyone who put a toe in the water in September or December when the credit markets firmed a bit sank up to their neck when prices lurched down again in March. Some drowned,

including Peloton Partners, while Bear Stearns end up with a shotgun marriage to JPMorgan Chase. Investors have little incentive to wade in deeper while the macroeconomic outlook remains so uncertain right now.

One relatively encouraging area among the growing gloom is the Asia Pacific. The creditworthiness of structured debt securities across the Asia Pacific region is expected to remain stable in the next 12 to 18 months despite a likely deterioration in some assets, ratings agency Moody’s notes in a report issued in mid-September.

However, in Japan, the quality of real estate loans for small and medium enterprise (SME), consumer finance

loans, SME leases and commercial property loans was expected to deteriorate. Home loans were the most at risk of stress in Australia, because of economic pressures, while in Korea non-mortgage loans are the most likely to deteriorate due to high interest rates and high household indebtedness.

Even so, most of the credit ratings of the structured notes backed by these assets are expected to remain stable, according to Moody’s, as deal structures have enough protection to sustain a loan quality deterioration. The outlook of other asset classes including Japan’s home, credit card and auto loans, Korea’s home loans and Singapore’s commercial property loans, is stable.

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FTSE GLOBAL MARKETS • OCTOBER 2008

17

In the Markets OTC DERIVATIVES PROCESSING: BUYSIDE IN THE HOT SEAT

The credit crisis served as a wake-up call to asset managers, many of whom had paid scant attention to counterparty risk and collateral management. Cherie Graham, senior vice president and head of derivative products at Brown Brothers Harriman, says that until a year ago most of her clients only put up collateral when brokers asked for it, seldom bothered to ask for it back on time and never asked a broker to put up collateral when they were entitled to it.“They weren’t taking advantage of bilateral collateral arrangements,” she says,“That has all changed. Managers today know what their rights are under the credit support annex and pay more attention to collateral movements.” Photograph © /Dreamstime.com, supplied September 2008.

STILL A WAY TO GO

The OTC derivatives industry has been under relentless pressure to streamline trade processing ever since regulators sounded the alarm about paperwork backlogs in the credit default swaps market in 2005. The dealer community has made huge improvements in the electronic order capture rate, trade date affirmation and timely matching as the regulators keep raising the minimum acceptable standards. Buy side asset managers have lagged behind the dealers in automating their operations, but the latest targets will force them to upgrade their systems, too. Neil O’Hara reports from Boston.

HE CREDIT CRISIS has served as a wake-up call to asset managers, many of whom had paid scant attention to counterparty risk and collateral management.

Cherie Graham, senior vice president and head of derivative products at Brown Brothers Harriman, says that until a year ago most of her clients only put up collateral when brokers asked for it, seldom bothered to ask for it back on time and never asked a broker to put up collateral when they were entitled to it. “They were not taking advantage of bilateral collateral arrangements,” she says, “That has all changed. Managers today know what their rights are under the credit support annex and pay more attention to collateral movements.”

Her clients, all asset managers, are still scrambling to catch up with the dealers, however. In many cases they have only just implemented procedures to handle collateral management at all, never mind being able to resolve disputes over the amount of collateral demanded. The

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OCTOBER 2008 • FTSE GLOBAL MARKETS

The Creative Factory

more sophisticated clients who do manage their collateral proactively report that disputes most often revolve around position differences rather than valuations. For example, if the front office at one counterparty has not entered a trade into the back office system yet, the operations people who calculate the collateral amount at each firm will come up with a different answer. “You have a position that does not exist on one side or the other,”says Graham.

Graham applauds the industry’s initial focus on dealer to dealer transactions because those account for the biggest volume and yield the greatest benefit from netting settlements. However, in a July 31st 2008 letter to Timothy Geithner, president of the Federal Reserve Bank of New York, ISDA’s Operations Management Group (OMG) set aggressive year end targets to improve the timeliness and accuracy of confirms submitted to Depository Trust and Clearing Corporation (DTCC) for credit derivatives as well as other goals for equity, interest rate and commodity derivatives. OMG also agreed to present a road map to achieve electronic matching on trade date for credit derivatives. “The industry can’t meet those goals without including the buy side at this point,” says Graham, “No matter whether it’s confirmations, novations, collateral management or net payments.”

One obstacle to further automation is the lack of data standards. As part of its trade reconciliation service, BBH must reach out to dealers to get data files, which come in a variety of formats that not only differ by dealer but also among product lines at a single dealer. Although Graham expects the industry will eventually adopt a standard FpML format it has not happened yet and no deadline has been set. “It is a proprietary

FTSE GLOBAL MARKETS • OCTOBER 2008

data mapping exercise for each individual file,” says Graham.

A Closed User Group (CUG) administered by SWIFT began a pilot programme in early 2007 to exchange trade notifications relating to interest rate, equity and credit derivatives between asset managers and custodians in FpML format.

Christopher Richmond, vice president for global products at The Bank of New York Mellon (BNYM), a participant in the pilot, expects to see significant benefits when the FpML software is ready for prime time.

“Once you get accurate data in the door the other processes become much easier,” he says, “It lends itself to standardised instructions for settlement and calculation of expected payments. The whole value chain depends on the initial trade reference data.”

BNYM also participates in the custodian working group at Deriv/SERV, which is developing an interface into its credit default swaps trade information warehouse for custodians and fund administrators who are not party to the trades but need access to the data to perform reconciliations or valuations. Deriv/SERV is also working on a system to use data in the trade warehouse as the master copy for calculating

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In the Markets OTC DERIVATIVES PROCESSING: BUYSIDE IN THE HOT SEAT

Cherie Graham, senior vice president and head of derivative products at Brown Brothers Harriman, says that until a year ago most of her clients only put up collateral when brokers asked for it, seldom bothered to ask for it back on time and never asked a broker to put up collateral when they were entitled to it.“They were not taking advantage of bilateral collateral arrangements,” she says, adding,“That has all changed. Managers today know what their rights are under the credit support annex and pay more attention to collateral movements.” Photograph kindly supplied by Brown Brothers Harriman, September 2008.

payments that would flow through CLS Bank, the industry utility through which foreign exchange transactions already settle in close to real time. “It nets the amounts due to each counterparty for each client rather than having individual wires for each contract,”says Richmond.

Under traditional market practice, dealers base payment calculations on their internal records, not the trade information warehouse. Although these should be identical, differences

20

do occur. If the numbers of decimal places in a data field do not match it can cause a payment break even though the amount involved is trivial.

A central payment system for credit derivatives will be a huge improvement, but Richmond reckons it’s only the first step. Credit derivatives typically refer to a limited number of credits; have standardised terms and payment dates; and usually require a single fixed rate calculation for one leg of the trade.“Credit is fairly

straightforward,” Richmond says, “It’s a good start but there is more to follow.” Interest rate, equity or total return swaps require a calculation on the second leg of the trade as well, and the system will have to distinguish contracts that permit netting from those that do not.

Deriv/SERV isn’t the only player seeking to expand its role in OTC derivative settlements, of course. The Chicago Mercantile Exchange launched its CME Clearing360 service in 2006, which allows the parties to a limited number of standardised bilateral OTC contracts to substitute futures guaranteed by the exchange for the original deal. Liffe, a subsidiary of NYSE Euronext, plans to offer central clearing of OTC contracts based on the iTraxx European credit default swaps indices by the end of 2008, while Eurex will roll out a similar service in the first half of 2009.

The exchanges want to play in a fastgrowing segment of the financial markets, but Richmond is not convinced the new clearing services will attract big volumes. He points out that a central clearing house has to take collateral from market participants up front to underwrite its settlement guarantee, whereas most OTC swaps require either no money down or just a small amount at the outset and provide for subsequent collateral movements that reflect marks to market. “Central clearing does have value,” says Richmond, “However, there may be some resistance from the parties involved in the deals.”

Even so, there are signs that attitudes may be changing. Thomas Book, Eurex board member responsible for clearing, says market participants have become much more receptive to central clearing for OTC derivatives in the past year or so. A solution that eliminates counterparty credit risk has strong appeal at a time when turmoil in the

OCTOBER 2008 • FTSE GLOBAL MARKETS

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In the Markets OTC DERIVATIVES PROCESSING: BUYSIDE IN THE HOT SEAT

Although Neil Wright, credit markets has senior vice president of undermined confidence in Investor Services at State financial institutions across Street at State Street, the board, not to mention acknowledges that high the obvious benefit of central volume products must risk netting between take precedence in the counterparties.

Book quest for automated believes the key to success processing, he notes that lies in using the existing the weakest link in the OTC market infrastructure chain remains trades that so that participants do not are confirmed the oldhave to change the way they fashioned way—on paper. trade. “We are not trying to According to the June bring OTC business into the 2008 Markit Quarterly order book on the Trend Report, those trades exchange,”says Book,“It is a represent less than 10% of clearing service adapted to the volume in credit OTC conventions as far as default swaps, but while possible that provides electronically confirmed additional value in terms of equity derivatives trades risk management and jumped from 12% to 26% capital efficiency.” of total volume in the Although Eurex Clearing preceding year the other will handle only credit 74% are still handled in default swaps in the first hard copy. In interest rate phase, it harbours derivatives, half the ambitions to expand into volume is processed on other asset classes. Book paper even though 80% is emphasises that Eurex eligible for electronic Clearing retains a European Thomas Book, Eurex board member responsible for clearing, says market processing. The industry focus and complements participants have become much more receptive to central clearing for OTC still has a long way to go other initiatives in the derivatives in the past year or so. Book believes the key to success lies in to save the trees.

United States. He also using the existing OTC market infrastructure so that participants do not State Street has recently recognises that central have to change the way they trade.“We are not trying to bring OTC built a new platform to clearing does have its limits. business into the order book on the exchange,” says Book,“It is a clearing process OTC derivatives “We will focus on service adapted to OTC conventions as far as possible that provides based on FpML that covers standardised OTC additional value in terms of risk management and capital efficiency,” he the entire life cycle of the contracts, such as iTraxx notes. Photograph kindly supplied by Eurex, September 2008. products from trade products,”says Book,“Other segments are hard to clear because they through which users can not only capture through to final maturity, do not have standard terms and offer process OTC derivative transactions which is typically three to four years but also access ancillary services, but can be up to 30 years. Wright says limited netting efficiency.”

In another effort to streamline the including DTCC’s AffirmXpress, MCA it already has links to Deriv/SERV and market infrastructure, Markit and Xpress, and Novation Consent as well Markit as well as third party valuation DTCC have formed a joint venture to as Markit’s Trade Manager, Tie Out and services.“When new transactions types combine the MarkitWire (formerly Port Rec. The project moves the are expressed in FpML format we can SwapsWire) trade processing service industry closer to a single central utility roll them right out into our platform,” with Deriv/SERV’s post-trade for electronic matching of OTC Wright says,“It allows us to keep pace transactions booked with new products and ever increasing confirmation and matching derivative complexity as well as higher volumes.” capabilities. It will create a single portal anywhere in the world.

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OCTOBER 2008 • FTSE GLOBAL MARKETS

Despite the financial difficulties afflicting some major market participants, Wright and others see no sign that firms are balking at the cost of meeting the OMG commitments. To some extent the back offices are playing catch-up. Wright recalls that at the turn of the century infrastructure investment took a back seat to the front office, which had to cope with both Y2K and the adoption of the euro. “The industry is responding to the regulatory environment and the growth,” says Wright, “People recognise that the volumes warrant an investment in infrastructure.”

It is a big investment, of course, but State Street is not alone in making it.

Despite the financial difficulties afflicting some major market participants, Wright and others see no sign that firms are balking at the cost of meeting the OMG commitments. To some extent the back offices are playing catch-up. Wright recalls that at the turn of the century infrastructure investment took a back seat to the front office, which had to cope with bothY2K and the adoption of the euro.

“The industry is responding to the regulatory environment and the growth,” says Wright, “People recognise that the volumes warrant an investment in infrastructure.”

That is music to the ears of Mark Beeston, president of T-Zero, the leading affirmation service for credit default swaps. As the target for trades that match without correction inches closer to 100%, he believes market participants have no choice but to affirm trades or apply some other filter to catch errors before matching occurs. T-Zero’s clients include major dealers who track processing times and report that trades affirmed through T-Zero match three to four days faster than trades that go straight to Deriv/SERV. “You have to change

FTSE GLOBAL MARKETS • OCTOBER 2008

the game,” says Beeston,“That means better use of technology.You can’t win a formula one Grand Prix with a Ford Escort.You’ll get to the racetrack faster than on horseback but you are not going to win the race.”

He welcomes OMG’s focus on automating novations, a process that still involves too many manual steps.

From the beginning of 2009, the major dealers will no longer honour novation requests submitted via email for credit default swaps that are eligible for electronic platforms and must process requests on the day consent is granted.

That will speed things up, but Beeston sees a greater commitment than ever before on the part of regulators, asset managers, dealers and vendors to achieve same day confirmation for both trades and novations.“ The OMG has committed to get to a cleared solution for indices by year end,” he says, “In 12 months’ time you will see a very different market in settlements than the one you see today.”The technology honed on credit derivatives will then be available for export to equity, interest rate and other derivatives, which will open up new markets for T-Zero— especially on the buy side.

Mark Beeston, president of T-Zero, the leading affirmation service for credit default swaps. As the target for trades that match without correction inches closer to 100%, he believes market participants have no choice but to affirm trades or apply some other filter to catch errors before matching occurs. TZero’s clients include major dealers who track processing times and report that trades affirmed through T-Zero match three to four days faster than trades that go straight to Deriv/SERV.“You have to change the game,” says Beeston,“That means better use of technology.You can’t win a formula one Grand Prix with a Ford Escort.You’ll get to the racetrack faster than on horseback but you are not going to win the race,” he adds.

Photograph kindly supplied by T-Zero, September 2008.

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Index Review THE CREDIT CRISIS: A LULL IN THE STORM?

The idea of a ‘Bad Debt’ bank (based on the model of the Resolution Trust Corporation, established in the 1980s to work through the Savings & Loan exposure of the 747 firms wiped out in the S&L crisis) where all the toxic sub-prime securities can be placed is exciting investors right now. The idea seems to offer that most wonderful of things: a free lunch. However, the money needed to fund this huge undertaking is not disclosed and neither (and a much more tricky question) is where that money will come from. Even then, Simon Denham, managing director of spread betting firm Capital Spreads, thinks it might provide temporary relief.

HOLDING THE FORT: BUT FOR HOW LONG? HE DECISION BY the UK’s Financial Services Authority (FSA) and the US’s Securities and Exchange Commission (SEC) to temporarily ban short selling in financial stocks has also put a sort of prop under the stock market. Regulators now pray that it will dampen speculation and the less than helpful pronouncements from politicians and the press! Until mid September, the FSA had fought any suggestion of trading restrictions tooth and nail; but with the possibility that the Brown government’s orchestrated Lloyds/HBOS merger was going to be a disaster (Lloyds stock was coming under heavy attack on the day after the deal) a bit of political arm twisting seems to have taken place.

Not only has the competitions authority now been bypassed, but also a fundamental pillar of the free market philosophy has also been knocked away. Before we get all enthusiastic about the power of short selling restrictions it would be educational to remind ourselves that the SEC imposed just such a restriction a few months ago over in the US on financial stocks. Look what that led to.

In this brave new world of state intervention we now run the risk of the dead hand of government

T

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overseeing the City and, in the process, making the chances of the sort of growth seen across the planet over the past two decades recurring in the next a bet on slim odds. As I have noted in earlier columns, the real fear in the UK and Europe is that this financial tsunami seems to have gained destructive strength with very little impact on or from the rest of the economy. Yes, inflation is up a bit and unemployment is grinding higher but retail sales are still 3.3% up on last year and house prices (while weak) are still not showing the kind of pressures seen in the UK in the early 1990s. The fact is that unless unemployment starts to get considerably worse most people in the UK will happily sit in their negative equity abode until such time as things improve. The merger of Lloyds and HBOS is likely to lead to considerable synergies, which will mean large numbers of reasonably highly paid redundancies. Packages are likely to be generous, if only to avoid bad PR and lingering discontent.

If the rest of the UK and Euroland’s economic situation also goes the way of the banks then the consequences would be deeply harmful as a weakened financial system would be in

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

no position to aid in any recovery.

Assuming that worst of all cases/doomsday scenario and the full weight of restructuring spending might fall on the various state agencies. With public sector debt struggling under pressure it is not even certain whether we could expect much aid from this quarter. With several decades of extreme money supply growth combined with low inflation (leading to massive asset valuation growth) still to digest, ‘informed’ opinion seems to be that we are headed for a long period of very low growth, Possibly under 1% for several years. In truth it now seems that we will be lucky to get away with even this and with no end in sight to the banking liquidity crisis I fear that we are not even near to the end of the beginning let alone the beginning of the end.

Equity markets have now rejected the lows as violently as they did back in January and mid-March, the problem now though is that it this is taking ever more extreme intervention to achieve a braking effect. It raises the real spectre of what would happen if the next central bank move does not have the desired impact. These missives have, in the main, been unremittingly negative for the past year or more and unfortunately this one is no more encouraging. Markets are a long way from stability and we are likely to see more high profile victims before we can finally say “that was the turning point”.

As ever Ladies and Gentlemen, place your bets.

OCTOBER 2008 • FTSE GLOBAL MARKETS

Innovators

Sandra E O’Connor, managing director and business executive, Financing & Markets Products, Treasury & Securities Services, JPMorgan Chase & Co.

EFFECTIVE MANAGEMENT OF MARKET CYCLES

RISK MANAGEMENT ABOVE ALL

This department hones in on market professionals who set a blistering pace of change through innovation in their organisation; either in terms of new product development or in terms of new business or client approaches. In this regard, JPMorgan Chase & Co’s high achiever is Sandra O’Connor, managing director and business executive, Financing & Market Products, Treasury & Securities Services. O’Connor has long been an innovative manager. Among her career accomplishments, she was a prime driver in the radical concept of creating a centralised treasury function and a disciplined liquidity risk management framework for the bank. O’Connor brought a new focus to consolidating liquidity flows, understanding sources and uses of the balance sheet, which led to the development of liquidity risk measurement analytics. She has also brought new focus to redefining securities lending as a business focused on the distribution of securities within the context of risk management.

These innovations set a solid foundation for managing banking operations through market cycles and stresses; worthwhile now in the current market environment. Francesca Carnevale reports.

F EXECUTIVE OFFICES are totemic representations of their occupants then Sandra O’Connor’s 58th floor abode is powerful medicine. The Financing & Markets Products space has an ultra-enviable 360 degree vista spanning the East and Hudson Rivers, the Statue of Liberty and New York Bay beyond. Her own office is compact, bold,

I

FTSE GLOBAL MARKETS • OCTOBER 2008

25

Innovators EFFECTIVE MANAGEMENT OF MARKET CYCLES

functional and without ostentation.

Her ability to make something from nothing is clearly illustrated by the layout of the floor space outside.

“Actually, no one in the bank was really interested in this space. I said I would be interested in it, but with a budget to have things redone to create a great working environment,” smiles O’Connor. Everything is tailored to staff comfort; indicative of her overall business strategy, she says. There are hospitality points where many more sweeties, fresh fruit and drinks are on offer than the usual complement of coffee and indifferent cake. There are different desk alignments, across the floor“depending on the business being conducted,” she says; with different areas punctuated by strong colours and moods. Some areas are open plan; others allow more privacy.“People here work hard, so everything is designed to ensure comfort while facilitating maximum productivity,” she says. It combines to give an impression of focus, flexibility, transparency and the abundant provision of everything that is necessary to get the job done, all clear expressions of O’Connor’s management style and approach.

Moreover, the expanse of glass on one of the two interior walls in her own office is a nod to the staff beyond;“it is important that they see I’m working as hard as they are,”she notes.

O’Connor set down another business marker in 2006. Already a highly regarded 18-year JPMorgan Chase veteran, she took on the role of transmuting the bank’s base metal Financing & Markets Products business (FMP) —one of the major product companies within the bank’s Treasury & Securities Services (TSS) unit, with annual revenues near $7bn—into gold.

She refocused the business and worked to make the full value of the franchise – including securities lending, foreign exchange, transition management and

26

futures and options—accessible to clients. Over the last two years, FMP’s own revenue has grown almost 30% compounded annually and also enjoys an enhanced profile in the market; having benefited directly from O’Connor’s restructuring approach.

O’Connor is well established as the global head of FMP and is a member of the TSS Leadership Committee, a senior group which plays a key role in defining division strategy. While many a department head talks client focus, it is definitely the engine in O’Connor’s walk:“We had a number of investment banking products that could have been used more effectively by our clients, so we got to work on making that potential a reality,”explains O’Connor.“Once you define your business by providing optimal solutions for clients, the rest falls readily into place.”

Not surprisingly, O’Connor is a social multi-tasker and her reach extends far beyond her immediate professional concerns: she is a relentless advocate for women in the workplace and a member of the JPMorgan Executive Women’s Committee which was recognised at the Global Fund for Women’s 20th Anniversary Celebration. She sat on the Investment Banking Women’s Committee Advisory Board and has been a featured speaker at various events such as Women on Wall Street.

She is also a keen supporter of Sesame Workshop, Kids in Crisis and the Susan G. Komen Breast Cancer Foundation.

These active commitments are a signal indication of why O’Connor has been nominated for several business awards and industry recognition.

Within the immediate context of JPMorgan, O’Connor is a relentless advocate of risk-aware performance. A key tactic in this business outlook has been to build a strong and experienced team around her; with people who are capable of understanding market trends and “making decisions: I don’t

want to micro-manage,” she says. In keeping with her broad vision for the business, O’Connor has made critical hires from across many disciplines of finance, such as the prime brokerage business, investment bank and private equity. She has also brought new meaning to the term “customer relationship management,” having recently hired an executive from a client to join the firm. “JPMorgan is in the ideal position of being able to recruit and hire the best talent in the business.

It’s a goal of mine to add exceptional professionals to our team so that our clients and the franchise can benefit from their expertise,”adds O’Connor.

Evidenced by her career accomplishments, O’Connor embraces change and takes calculated risks of her own. As former head of Global Funding and Liquidity Management and chair of JPMorgan Chase’s Liquidity Risk Committee, she directed the focus on consolidating liquidity flows, understanding sources and uses of the balance sheet, and led the development of liquidity risk measurement analytics.

The foundation that O’Connor helped develop continues to be relevant in managing through market cycles and stresses.

In her current role, O’Connor is leveraging her past experience to drive change in the FMP business area. Her talents have again been put to the test by recent unprecedented market turmoil that has impacted the almost $2trn of clients’ securities in the securities lending business. It goes back to a sea-change, introduced by O’Connor which fine-tuned the bank’s securities lending service offering. “We were known as a custodial lender and we really wanted to redefine who we could be for our clients. While securities lending is still linked to our custody business, we now strive to be the best agent lender in the industry. Our strength is that we can leverage our

OCTOBER 2008 • FTSE GLOBAL MARKETS

O’Connor’s insistence on a rigorous, is a financial cost: without the context of expertise and global distribution channels to provide innovative conservative approach to risk risk adjusted returns, performance is not solutions for clients in areas such as management is now paying off in always obvious. However, it makes a big pooling, relaxed long strategies, and spades.“We have never seen times like difference to the business and to clients new markets—whatever it takes to this before. Every five to ten years we if you truly understand the risks that are consistently deliver value to clients.” witness a crisis of sorts. What is being taken. Securities lending is a risk The approach, notes O’Connor has different this time is that it is more management product, which requires strong operational expertise. been forged through a unique What clients are looking for understanding of client is a banking partner that dynamics: “what clients are “What clients are looking for is a manages risk well. We have looking for is a global global operating model and a always had a conservative operating model and a disciplined approach to managing risk risk management approach disciplined approach to when it comes to choosing a securities that gives us strength over managing risk when it comes lending partner. Sound risk the long term. It means a to choosing a securities management practice is fundamental sustained commitment to lending partner. Sound risk fundamentals with management practice is for the entire firm, not just the transparency, transparency fundamental for the entire securities lending business; that covers and more transparency.” firm, not just the securities credit, interest rate risk or liquidity risk Tough, incredibly bright, lending business; that covers management. We are able to leverage uncompromising and credit, interest rate risk or the entire JPMorgan franchise for the professional she may be, liquidity risk management. but O’Connor is equally We are able to leverage the client’s benefit,” says O’Connor. blessed with a sympathetic entire JPMorgan franchise for nature and consummate the client’s benefit.”

In this challenging business systemic. Other crises were country- charm. An unusual cocktail perhaps in environment, O’Connor notes dialogue based, name-based or product specific. the melee that is Wall Street. At the with clients and the rest of the industry Nowadays concerns are related to end of the day, O’Connor is a people is key. “On the risk adjusted front, we financial services institutions, which person; a facet of her approach that is have been working with clients on a are the key pipes for the flow of key to building sustained business variety of issues. Transparency is capital. Because of apprehension over relationships within the organisation essential in this regard as is risk certain aspects of those institutions we and without. Equally unusually, adjusted returns. We are committed to have witnessed an unprecedented O’Connor’s passion to drive success moving the industry to a better place, withdrawal of credit and higher for the organisation is matched by her markings, which has exacerbated the personal commitment to promote to everyone’s benefit,”she stresses. opportunities for others. “Rightly or O’Connor maintains that as the normal flow of business.”

O’Connor’s risk management wrongly,” she notes,“I have not spent bank navigates current market conditions, it is critical that they adhere strengths are regularly sought after a lot time thinking about the to disciplined practices that maximise within the firm. Her experience and endgame. Do I occasionally step back opportunities to capture alpha while treasury firm-wide perspective, for and check that I am on track? Of maintaining appropriate levels of example, gave her a key role in the course, but generally I focus on the liquidity. She is currently working on a merger with Chase Manhattan Bank client and the franchise and that helps dynamic new financing model as and more recently the absorption of Bear formulate my acumen as a business traditional mutual funds migrate to Stearns, with a particular lien in liquidity leader. I am always looking for new hedge fund strategies. “Obviously this risk evaluation. It was grist to her improvements and opportunities to is uncharted territory, but there are a proverbial mill; but it has not been move the business to a better place; rising number of variables at play in a without its price.“For the past few years and you can only do that if you have marketplace that currently offers room in securities lending,”she acknowledges, the right people working with you for comfort that the demand for this “you sometimes don’t get credit for who are equally as passionate about having a conservative risk profile. There what we have to do.” product will grow.”

FTSE GLOBAL MARKETS • OCTOBER 2008

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MENA Report SAUDI ARABIA MARKET LIBERALISATION

The newly liberalised Saudi Arabian securities market is under rising steam, say local banks. The Kingdom now allows foreign investors and traders full access to individual stocks listed on the Tawadul, the national stock exchange and the largest board in the Middle East.

Saudi authorities announced the policy in mid-August, but it was uncertain when trading would begin. In the event, foreign investors began trading local stocks less than a week later. Investors previously could invest in Saudi stocks only through locally run mutual funds; a restriction observers used to say limited outside investment in the kingdom; now they can gain exposure via equity swaps. With all the markets in the Gulf Cooperation Council (GCC) vying to secure trading flow, what are the prospects for the Saudi Arabian markets for the remainder of this year and next?

OPENING DOORS

By and large it is retail and in particular high net worth investors that tend to drive trading volumes and activity on the Tadawul. This has meant that the market has been susceptible to wild swings; and over the summer months, the overarching trend has shown no sign of abating.

According to sources at the Tawadul, some 90% of market activity over the summer is directly related to individual investors. The CMA hopes that attracting large foreign investment pools will increase trading volume and bring long-term and long hankered for stability to the Tawadul. Photograph Š Spectral-design/Dreamstime.com, supplied September 2008.

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N SPITE OF long term moves to establish a common currency, market harmonisation and interoperability in the GCC markets, individual countries are racing to establish competitive advantage by rolling out a series of market liberalisation programmes.

In fairness, the latest door opening to the Saudi Arabian equity markets to foreign investors by the Capital Market Authority of Saudi Arabia (CMA), the capital markets regulator, is a necessary development, given the increasing internationalisation of both developed and emerging markets; in particular a growing acknowledgement of the need to establish meaningful reciprocity in terms of market access. In the context of the GCC it is given added piquancy as Dubai, Bahrain and more latterly Qatar encourage fuller capital marketsâ&#x20AC;&#x2122; access to the global investment community.

The move was quickly pounced on by stock buyers, and the stock market shot up more by a tip over 5% on the first day of trading following the announcement.

Thereafter there was an uninterrupted run of nine sessions in which the Saudi market, continued to rise.

The move comes at a time when the CMA is making concerted efforts to introduce stability into the local stock market. In early summer, the regulator introduced a new law requiring stockholders with stakes of more than 5% in individual companies to disclose their positions. With this move, CMA has taken yet another investor friendly step. The CME started to roll the proverbial ball earlier this year as it opened up the investment sector to financial entities other than banks.

Moreover, in the interests of increasing market transparency and good corporate governance, the regulator has been strict in ensuring timely distribution of sensitive information and announcement of results by companies within a stipulated time frame.

I

OCTOBER 2008 â&#x20AC;˘ FTSE GLOBAL MARKETS

MENA Report SAUDI ARABIA MARKET LIBERALISATION

While still limiting full ownership of stocks on the Tawadul billions of dollars have flowed into the country as a result of high oil prices. ”We are confident that the interest is going to be quite significant,” says Adeeb Al Sowailim, Falcom’s chief executive officer.“The global investment community is gaining more and more confidence in the way the Saudi capital markets operate.” Photograph kindly supplied

by Falcom, September 2008.

The moves have been widely welcomed as a means of establishing investor confidence in the country’s capital markets in general and in the stock exchange in particular.

Ultimately, the move will attract huge interest from foreign investors looking to diversify their portfolios; particularly as the Saudi Arabian stock market is the most lucrative in the region because of its size and liquidity. The total market capitalisation of 126 listed companies on Tadawul is SR1,561.6bn ($416.4bn).

Certainly, while approaches to the market for foreign investors have been severely limited, the overall appetite for Saudi risk remains very strong, particularly while relatively high oil prices are the order of the day. Intentionally or not, foreign investment inflows will tend to coalesce around the stock exchange for years to come, fulfilling at least one of the CMA’s ambitions.

30

Under these latest regulations, foreign buyers to enter into swap agreements with local branches of investment banks in order to leverage access to price movements in the Saudi Arabian stock market.The swaps, which are being sold by a dozen or so banks in the country, including Goldman Sachs and Deutsche Bank, will be used to attract new investment into the stock market, while not actually ceding control or ownership over domestic shares and industry sectors. While the arrangement allows investors take advantage of movements in Saudi shares, they are still prohibited from owning them outright. International investors to pick and invest in a single stock or a couple of stocks as they please,”says a spokesman at Falcom, the Riyadh based investment bank.

Local investment banks/brokers will retain legal ownership of the shares while “transfering the economic

benefits of the Saudi companies listed on the stock exchange to non-resident foreigners,” explains the spokesman.

Some 60 companies are authorised to carry out swap trades on the Riyadhbased exchange, known as the Tadawul.

Most buyers are likely to be large institutional investors, with most fund managers looking to establish which stocks offer most value for money; though individual investors are also allowed to participate in the scheme.

The initiative comes at the right time, says a local banker, when sentiments in the local market are down and valuations are attractive.“This measure will cheer up investors who witnessed meltdown of the bull run in 2006 and fluctuating fortunes over next two years. Tadawul All Share Index (TASI), the market benchmark, has lost 23.3% up to the end of August 2008,” says a Falcom spokesman. Equity offerings on the exchange are also down. In 2007, 25

OCTOBER 2008 • FTSE GLOBAL MARKETS

MENA Report SAUDI ARABIA MARKET LIBERALISATION

new companies were listed whereas so far in 2008, 15 new companies are listed. “As a result, the trailing twelve month price earnings ratio has fallen to 15.6 whereas the average price to book value and dividend yield stand at 2.9% and 2.5% respectively for the whole market, he adds.

The move was also intended to encourage institutional investors to become active in the Saudi stock market. By and large it is retail and in particular high net worth investors that tend to drive trading volumes and activity on the Tadawul.This has meant that the market has been susceptible to wild swings; and over the summer months, the overarching trend has shown no sign of abating. According to sources at the Tawadul, some 90% of market activity over the summer is directly related to individual investors.

The CMA hopes that attracting large foreign investment pools will increase trading volume and bring long-term and long hankered for stability to the Tawadul. In the short term, this appears to have happened, but with wider market conditions in constant flux, it is likely that the upswing the exchange has experienced in the immediate aftermath of this latest liberalisation might not survive the next global equity market shock.

“Were are confident that the interest is going to be quite significant,” says Adeeb Al Sowailim, Falcom’s chief executive officer. “The global investment community is gaining more and more confidence in the way the Saudi capital markets operate.”

Bank profits up Against this background, Saudi Banks have been enjoying modest profits.

Gulf banks topped forecasts for second-quarter profit growth as a continuing regional economic boom fuelled by sustained oil prices and low

32

interest rates continue to drive demand for credit, even amidst the downturns elsewhere in the global markets. The top 20 banks in the GCC countries saw net profit grow overall by 22% to $8.68bn in the first-half of 2008, compared with the corresponding period a year earlier.

GCC governments and private investors continue to invest their money in infrastructure, real estate and industry across the world’s biggest oilexporting region, giving banks massive financing opportunities in corporate and retail banking. In Saudi Arabia, Riyad Bank and Al-Rajhi Bank kicked off the earnings season by topping most analysts’ expectations, shrugging off tighter bank lending curbs introduced by the central bank to stave off inflation. Even so, the overall Saudi banking index has enjoyed variable performance and is the least best performer in the region this year. In part this was due to continuing volatility in the Tawadul, as local investors went in and out of banking stocks with alacrity.

Moreover, compared with leading banks in other GCC countries, Saudi Arabian banks have not performed as well. SABB appears to have performed the best in percentage terms, recording a 24.2% net profit increase for the first half of the year. However, the relatively modest performance belies a significant switch by the banks to develop new revenue streams, to balance losses out of their brokerage services related to the stock market’s continued skittishness.

Additionally, the Saudi Arabian Monetary Agency (SAMA), the kingdom’s central bank, has been restricting credit growth in order to manage inflation. In consequence, most analysts says that the country’s banking stock is robust. Like the other GCC countries excluding Kuwait, the kingdom’s currency is linked to the US dollar, which forces the central bank to

mimic the US Federal Reserve’s interest rate policy. Increasing reserve requirements at commercial banks is one of the few monetary policy tools available to the central bank.

Riyad Bank additionally enjoyed the flip of both a Standard & Poor’s and Fitch ratings upgrade on its long term counterparty credit from an A+ from an A. Standard and Poor’s reasoning was based on Riyad Bank’s $3.5bn rights issue in June and the bank’s reportedly solid retail segment and strong corporate client base. As with all Saudi Arabia’s leading banking lights profitability has remained strong.

Moreover, like its counterparts Riyad Bank was able to put on year-on-year growth on its bottom-line profit due to a diligent lending policy, coupled with a lessening reliance on income from the stock market. Suliman Al-Gwaiz, Riyad Bank’s deputy chief executive officer notes that the ratings improve the bank’s ability to build market share at home and abroad. Rashed Abdul-Aziz Al-Rashed, the bank’s chairman says first half year profits are up by more than 6% compared with the first half of 2007. Al-Rashed points to a significant uplift in core banking profits.

The attraction of the Saudi market remains strong: enough to encourage Emirates NBD, the largest regional bank by assets in the GCC to start investment banking operations in Saudi Arabia, according to senior officials. Confirming that the bank has obtained a licence for investment banking operations in the Kingdom, Rick Pudner, Emirates NBD’s chief executive officer says the bank is planning to launch its Saudi Arabian operations by the last quarter of this year. Pudner says the bank is looking at both organic growth and expansion through acquisitions and says the bank has applied for more branch licences in the country.

OCTOBER 2008 • FTSE GLOBAL MARKETS

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MENA Report EGYPT’S BANKS: A CAPPED OPPORTUNITY?

THE SHAPE OF THINGS TO COME...

Investor sentiment in Egypt’s banking sector has been tested of late; not only by volatility in banking stocks in key developed and emerging markets; but also by the inability of the government to finalise the privatisation of Banque du Caire in the summer. Even so, writes Julia Grindell, the long term prospects for the sector remain good; though the government is treading an opaque path in selling off state-owned banks.

S ELSEWHERE, EGYPT’S bank stocks have endured bearish market conditions since the beginning of this year. Local and foreign investor sentiment towards the sector has remained lacklustre, not helped by the first-half year results of some loss-making banks, which were required to increase provisioning requirements for bad loans. Moreover, the cancellation of the merger talks between Commercial International Bank (CIB) and Arab African International Bank (AAIB), the deferment of the sale of a 67% per cent stake sale in Banque du Caire and a recently issued report by Moody’s rating agency revising the country’s bank deposit ratings in view of the rising inflation and interest rate conditions, have added to investor concerns. Nonetheless, says Moody’s, the long term earnings prospects for the sector remain good, with average return on aggregate assets of the country’s top ten banks, expected to rise from “0.6% in 2007 to 1.3%” this

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year. “Local banks are currently well capitalised on their excess liquidity while maintaining better credit quality standards,”the report adds.

“The sector is still dominated by the top three public banks in terms of assets,” explains Elena Sanchez, vice president of equity research at EFGHermes. National Bank of Egypt, Banque Misr and Banque du Caire account for 41% of the country’s E£1,083bn ($197.8bn) total banking assets. National Bank of Egypt makes up 21% of the national total; while Banque du Caire rests on 6%.

Long term optimism mainly rests on the projected growth of the Egyptian economy, which remains robust; with real gross domestic product (GDP) growth expected to average 6.3% over the next four years. This is a tip below growth rates in recent years, as this year’s slowdown in investment and export performance impacts the economy. While inflation is rampant, topping 22% in July, analysts expect it to fall significantly next year to between 9.7% and 10.5% in 2009 as the Central

Other untapped areas include mortgages and lending to small and medium enterprises (SMEs). Kypreos says the development of the mortgage market is hampered by long delays in making necessary adjustments to the mortgage law (passed back in June 2001).

However, the new government regulations concerning registration of housing units and SMEs, along with the establishment of a credit bureau are expected to give these segments a boost. Photograph (c) Jesse Lee Lang /Dreamstime.com, supplied September 2008.

Bank of Egypt (CBE) continues to raise interest rates (by 50bp increments through August to 13%) and utilises central bank deposits and treasury instruments to absorb surplus liquidity in the banking system. The cost of funding within Egypt’s banks is consequently expected to increase at a modest pace. However, credit quality is improving, after the CBE forced many of the small banks (including Export Development Bank, Faisal Islamic Bank, Suez Canal Bank and Egyptian Saudi Bank) to transfer 2007 year-end profits to cover any shortages in their provision accounts. The over-archingly positive climate is expected to spur foreign investment and local bank lending to local infrastructure, real estate and tourism projects.

Additionally, analysts point to the fact that annual lending by banks continues upwards (9% last year; 5% in 2006) and lending to households is growing as a proportion of total loans (now 19%, compared with 17.8% in 2007). Many banks are shifting to the lucrative but risky retail sector and expanding their branch networks, to tap into a business segment that is still, largely unexploited. Most of the 80m strong population does not have a bank account; and penetration of banking services in the country is only 10%. Pent up demand from this segment is huge though and expected to rise further.

OCTOBER 2008 • FTSE GLOBAL MARKETS

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MENA Report EGYPT’S BANKS: A CAPPED OPPORTUNITY?

“Expanding this retail base will enable banks to diversify their operations, risks and revenue streams,” says Constantinos Kypreos, vice president and senior analyst at Moody’s.

However, he cautions that it will take time to educate borrowers, enhance credit policies, controls and follow-up, and develop a delinquency track record.

“As a result, [while] these segments offer a lot of potential, they are likely to grow more in the medium term as opposed to right away,”he adds.

Other untapped areas include mortgages and lending to small and medium enterprises (SMEs). Kypreos says the development of the mortgage market is hampered by long delays in making necessary adjustments to the mortgage law (passed back in June 2001). However, the new government regulations concerning registration of housing units and SMEs, along with the establishment of a credit bureau are expected to give these segments a boost.

There are other issues. Hassan Abdalla, vice chairman and chief executive officer (CEO) of Arab African International Bank (AAIB) thinks that right now there is not a lot of differentiation between banks. Many are focused on investment banking services, with little real application and attention to the SME and retail segments. “Corporate banking still accounts for 80% of our total lending,” says Abdalla, adding that the figure correlates with the industry average in Egypt. Most recently the bank was instrumental in Egyptian steel giant Ezz Steel’s $1.1bn bond issue; reflecting the fact that much of the bank’s revenues are dependent on service and lending fees.“The Egyptian economy is quite well diversified and there is no one sector that dominates as such. However, sectors such as construction, tourism and infrastructure, as well as food and beverages and oil and gas have been

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issuing bonds lately to expand across the region,”he explains.

Consolidation has been the watchword in the sector over the last few years, following the implementation of reforms in the banking sector at the end of 2003.

Reforms included the introduction of minimum capital requirement for banks of E£500m ($91.2m) and capital adequacy ratios of at least 10% of riskweighted assets. Small banks and poor performers, which could not meet tougher operating benchmarks, were easy acquisition targets. Foreign banks took up the opportunity to buy into the market with alacrity.

However, it is now the only route to market entry, as the government strictly abides by its decision not to award any new banking licences.

Sanchez explains that “Following the reforms the market attracted significant interest from the major European banks as well as mid-sized Middle Eastern banks,” adding that out of the 41 banks still left in the market (out of 62 back in 2001), 75% are now owned by foreign players.

However, the last significant round of successful acquisitions largely took place in 2007, when a 51.3% stake in the National Bank for Development was taken up by Abu Dhabi Islamic Bank, and National Bank of Kuwait bought a 98.1% stake in Al-Watany Bank of Egypt. That is why so much store was set by the two major deals that had been expected this year.

The sell-off of Banque du Caire was one of the four jewels in the state owned banking sector’s crown and was expected (by local politicians at least) to command a premium price of the sort that saw Italy’s Sanpaolo IMI buy an 80% stake in Bank of Alexandria (the smallest of the country’s big stateowned banks) for $1.6bn. That sale set a benchmark in the government’s mind, as the sale price was a tip over six times

Constantinos Kypreos, vice president and senior analyst at Moody’s says that expanding Egypt’s retail base “will enable banks to diversify their operations, risks and revenue streams. ” However, he cautions that it will take time to educate borrowers, enhance credit policies, controls and followup, and develop a delinquency track record.

“As a result, [while] these segments offer a lot of potential, they are likely to grow more in the medium term as opposed to right away,” he adds. Photograph kindly supplied by Moody’s Investor Services, September 2008.

book value. First signs in the mooted sale of Banque du Caire were good. UKbased Standard Chartered and Saudi Arabia’s Samba were among five banks shortlisted to conduct due diligence on the bank in March. Other contenders included National Bank of Greece, Dubai’s Mashreqbank, and a consortium of Saudi Arabia’s Arab National Bank and its Jordanian affiliate, the Arab Bank Group. However, the highest bid ($1.36bn), which was submitted by the National Bank of Greece, fell well short of expectations.

The government thought Banque du Caire would command a premium as it is the third-largest state-owned bank with total assets of E£50.1bn ($9.36 billion) a year ago; a 6% market share in terms of total assets and deposits; is larger than Bank of Alexandria and (with the possible exception of Banque Misr, (which owns and effectively runs Banque du Caire) it is the last big bank available in the country for some time.

“The bank has some 250 branches and a huge client and correspondence base, as well as a sophisticated electronic system,”says one source close to Banque du Caire, arguing that the board had embarked on a solid restructuring programme well before the auction,

OCTOBER 2008 • FTSE GLOBAL MARKETS

which should have resulted in a bid/offer closer to the government’s estimates.

“Financially the bank was adequately capitalised, had good liquidity and had no non performing loan (NPL) issues,” notes Moody’s Kypreos. However, other analysts contend that Banque du Caire was not in fact as well primed as Bank of Alexandria prior to its sale and that explained the relatively miserly bids for the bank. Furthermore, bidders were not prepared to pay over the odds for a bank which will likely require substantial investment in order to leverage the opportunities it provided. Others argue that financially the bank is sound but that there were concerns surrounding the bank’s operations and (allegedly) the bank had, at times, suffered from a lack of strong management. Whatever the truth of the matter, Banque du Caire has signalled that it will revisit the auction process again at some (so far) indeterminate time, but not before ‘”market conditions improve”.

The failure to sell the bank was a set back; not least because it muted investor enthusiasm in the sector as a whole. It was also a supposed high point in a long-running $8.7bn financial sector reform programme, begun in 2003 and financed by the World Bank, the International Monetary Fund (IMF), the African Development Bank (AfDB) and the US Agency for International Development (USAID); more of which, later.

The privatisation debacle was added to by news that talks over a mooted merger between CIB, Egypt’s leading private bank and AAIB had terminated, and capped a disappointing summer for the sector.

AAIB is a joint-venture between Central Bank of Egypt (CBE) and the Kuwait Investment Authority.

Unconfirmed local press reports have it that a disagreement with the Kuwaiti authority over the terms of the deal resulted in the meltdown of the deal.

FTSE GLOBAL MARKETS • OCTOBER 2008

“From the Egyptian perspective, [had] the merger between CIB and AAIB gone through their expansion in the domestic market would have been accelerated. In addition, it could have helped produce a strong national champion which could [compete strongly] against foreign players,” purports Elena Sanchez, vice president of equity research at EFG-Hermes.

CIB, while remaining tight-lipped on the merger talks, remains buoyant.

“Our strategic direction poses no limits to alternative growth. We have looked at several prospects for M&A and greenfield opportunities, and we will keep looking for other opportunities as long as they will remain lucrative and rewarding to the company,”says a CIB spokesman, adding he is confident the company can keep growing organically for now. “We have been growing at a very fast pace and remain determined to become a national champion in the future,”he says.

In fact, CIB has a future of powerful consolation before it. It is the biggest private bank in Egypt and profitable.

Its first quarter performance was up 16% on the same period last year (but down 25% it acknowledges on an outstanding 2007 last quarter performance) though the bank benefitted from the reversal of some provisions and a E£50m gain for the sale of its stake in local firm, Contact Cars. Moreover, the bank intends to proceed with the acquisition of the outstanding 50% share in its subsidiary, CI-CH, which will boost the bank’s future earnings. The bank is also expected to expand its retail banking using excess liquidity; part of which will come from a one-for-two stock dividend distribution for shareholders that will increase its capital from E£1.95bn to E£2.93bn.

However the opportunity-cost is there also. AAIB has also been showing impressive results with profits of

$91.1m in June this year and has successively grown deposits by 46% and loans 96% between 2005 and 2007 to reach $5.7bn and $4bn respectively.

The question now is: what happens next? It looks like much of the drive towards the sell off of state owned banking assets has been driven by the multi-lateral lenders, such as the World Bank, the IMF and their agencies.

Multi-laterals are still highly active in the market. The International Finance Corporation (IFC), the private sector arm of the World Bank, for instance, has prioritised lending to commercial banks and financial institutions in the region. It says this is to increase available credit, particularly to small and medium-sized enterprises. MENA represents the fastest growing region in IFC’s investment portfolio; of which lending to Egyptian financial institutions is a key component.

Moreover, the World Bank and IMF provide significant funds to the country (combined in excess of $1bn) each year, some of which is provisional on the country raising a proportion of capital from asset sales. The failure of the Banque du Caire leaves the government in something of a pickle if it is to secure additional funding under the multi-lateral financing agreements.

The prime minister has already publicly discounted any sell off of Banque Misr or National Bank of Egypt and has refused to go on record as to its intentions to sell Banque du Caire in the immediate future.

Whichever way it falls, further consolidation is likely in the banking sector, thinks Sanchez, who says there is talk the CBE wants to reduce the number of banks operating in the country down to 25, though what the foreign banks think of that ambition is not on record. The pace of consolidation could, ultimately however rest in the hands of both the World Bank and the IMF.

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MENA Report MULTI-BILLION DEALS IN A DOWN MARKET

Shaikha Khalid Al Bahar, National Bank of Kuwait’s deputy chief executive officer, has earned the moniker “Billion Dollar Banker” this year, as she has equally garnered a series of multi-billion dollar deals in what has otherwise been a rather indifferent fund raising environment in the Gulf Cooperation Council (GCC) countries. Indicative of her growing clout in the region’s financial markets, Al Bahar is one of five senior executives that will participate in the upcoming Al Rouad (Pioneers) panel, at the Leaders in Dubai Business Forum in November. The business leaders are scheduled to discuss, among other issues, the future growth of the Middle East economy with a focus on how to deal with inflation and a surge in prices of primary commodities, including oil.

Shaikha Khalid Al Bahar, National Bank of Kuwait’s deputy chief executive officer. Al Bahar says she was pleased with the“remarkable success”of the Zain rights issue.“despite the recent gloomy situation and pressures dominating the local market, in addition to the decline in local liquidity and the unfavourable psychological circumstances of traders.”Despite difficult market conditions over the summer, NBK opened subscriptions to the rights issue in mid-August, closing it just over four weeks later.

“The speed of the deal took the market by surprise,”concedes Al Bahar, who acknowledges that Zain’s brand awareness helped.“Zain has, by any standards, become one of the world's largest and most prominent mobile operators,” she says. Photograph kindly supplied by National Bank of Kuwait, September 2008.

KUWAIT’S BILLION DOLLAR BANKER T IS NO small wonder that Shaikha Khalid Al Bahar is in demand right now. Since December last year, when she put the final touches to the $1.2bn acquisition of telecommunications provider Iraqna, by Kuwait’s own telecommunications major Zain from Egypt’s Orascom, Al Bahar has supervised a series of multi-billion dollar deals that have punctured an otherwise comatose local fund raising market in the Gulf this year. That deal raised $1.8bn in total from a syndicate of 12 regional and international banks, notes Al Bahar, well above the $1.2bn required

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for the discounting facility in favour of Orascom. Her most recent trophy is Zain’s $4.49bn rights issue, which closed in mid-September, the largest in the oil-rich Emirate's history, and was 99% subscribed.

On the way, Al Bahar has concluded, or is in the process of concluding, a series of breakthrough deals on her books for the 2008 financial year. The list includes Kuwait National Petroleum Company’s (KNPC’s) 4th refinery project, worth $15bn, and the second largest project financing in the country.

Contractors on the project include the

JCG/GS Engineering consortium (for work worth a tip under $4bn); SK Engineering & Construction (with over $2bn in contracts); Daelim Industrial Co ($1.18bn) and Hyundai Engineering & Construction, with $1.12bn in contracts. NBK also issued performance bonds for the contractors. Al Bahar is also involved associated pipeline contracts (worth KD250m) and a KNPC booster station project, worth KD79.4m. Italy’s Snamprogettii is the contractor, for which the bank also arranged the contractor’s performance bond. Added to this is a clean fuel project, involving the upgrading of the Shuaiba and Mena Abdulla refineries, supported by a transaction package worth between $10bn and $12bn. In addition, the bank has participated in a $2bn aromatics project and a further $2bn olefins project financing.

OCTOBER 2008 • FTSE GLOBAL MARKETS

CAN ZAIN RIGHTS ISSUE LIFT A MUTED MARKET? It has been a month of two halves for the Kuwaiti financial markets. On the one hand local telecoms giant Zain raised KD1.2bn ($4.49bn) in a rights issue which opened in mid August and closed on September 18th , which will help finance massive regional expansion plans. The other half was more mooted, as national sovereign fund, the Kuwait Investment Authority ploughed in more than KD100m into the Kuwait Stock Exchange to help shore up the domestic equity market, which has taken a pounding of late.

Zain chief executive officer Saad Al Barrak.

Proceeds from Zain’s $4.49bn rights issue will be used,“to finance future strategic expansion plans and meet financial commitments,” says Barrak.

ain’s rights issue was open only to existing shareholders, taking total subscribed shares in the company to 4.28bn, worth some $6.42bn. Funds raised will be used to finance the firm’s massive expansion programme that will take in frontier markets in Africa, as far distant as Rwanda. The amount raised is unprecedented in Kuwaiti's history, and exceeded market expectations, given the gloomy undertone that has dampened the Gulf Cooperation Council (GCC) fund raising markets this year. While it can be argued that Zain is also a special case: being one of the leading telecommunications companies in the wider Middle East and North African (MENA) region, the largest stock on the Kuwait Stock Exchange (KSE), with a market capitalisation of more than $27bn.

Zain was established in 1983 in Kuwait as the region’s first mobile operator. Since 2003, it has grown significantly becoming the fourth largest telecommunications company in the world in terms of geographic presence with a footprint in 22 countries spread across the Middle East and Africa providing mobile voice and data services to over more than 50m customers (as at the end of June this year). In the Middle East the company operates under the Zain brand name in Bahrain, Iraq, Jordan, Kuwait and Sudan. In Lebanon the company operates as mtctouch. Zain plans to commence operations in the Kingdom of Saudi Arabia in August 2008.

The issue was concluded with some rapidity in particularly dark and volatile market conditions between midAugust and mid-September. The deal got away with a substantial 50% discount, being offered to shareholders at Fils850 a share (half the price of the KSE, which has fallen off by more than 11% since the beginning of September. In addition to concerns over the global financial crisis, local press report Kuwait government officials expressing concern over an expected rush of substantially sized rights issues, which they claim will suck liquidity from the main bourse. Rights issues are common in Kuwait, as a means of raising cheap finance. A number of deals are in the market, including National Industries Holding, Kuwait’s largest construction materials firm (estimated to be worth KD265m, priced at Fils900 per share); and more are expected in the autumn, with logistics provider Agility, expected to raise more than KD120m in a rights issue that is expected to increase its capital by 25%.

It was inevitable that a deal of the size of Zain’s issue would elicit controversy. Even so, Zain’s chief executive maintained the subscription had exceeded expectations, considering volatile market conditions. The proceeds will be used, “to finance future strategic expansion plans and meet financial commitments," says Zain chief executive officer Saad Al Barrak. "The National Bank of Kuwait (NBK) through its local and international branches acted as the receiving bank for the capital increase. "NBK has always been our partner ever since we took our first expansionary step in Jordan way back in 2003. It has successfully managed several of Zain's acquisition transactions to date and exceptionally managed this and Zain's previous capital increase back in November 2005," adds Al Barrak (please see box: NBK’s Billion Dollar Banker).

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FTSE GLOBAL MARKETS • OCTOBER 2008

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MENA Report MULTI-BILLION DEALS IN A DOWN MARKET

Al Bahar says she was pleased with the “remarkable success” of the Zain rights issue.“despite the recent gloomy situation and pressures dominating the local market, in addition to the decline in local liquidity and the unfavourable psychological circumstances of traders.” Despite difficult market conditions over the summer, NBK opened subscriptions to the rights issue in mid-August, closing it just over four weeks later.“The speed of the deal took the market by surprise,” concedes Al Bahar, who acknowledges that Zain’s brand awareness helped.“Zain has, by any standards, become one of the world's largest and most prominent mobile operators,”she says.

Speed, tempered by eagle-eyed attention to detail, is a keynote of razorsharp Al Bahar’s business approach.

“Once you know what you have to do, you just do it,” she smiles. Other characteristics include working in the bank and outside with a contained coterie of experienced bankers that are regulars in Al Bahar’s deals: “that way everyone knows how you work, the detail we provide and they understand and have faith in the security packages and risk they are taking. In that case, participation becomes a relatively easy choice.”Second, the bank is consistent, says Al Bahar. “We have a consistent history of working on big syndications and financings, so we have experience of big ticket transactions. Second, we are consistent in that we work closely and often with the same clients,” she says.“NBK has been side by side with Zain, for example, over many years as the company has embarked on its international expansion programme,” she adds Most important, says Al Bahar is understanding what clients want and delivering services at an augmented level. This she says overlays the bank’s overarching strategy where,“we are keen to stamp our dominance on the Kuwaiti

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mega project and merger and acquisition segments, and in this regard, I would say we have been successful.”Then there is the international dimension,“where we also have clearly defined objectives, to focus on Kuwaiti companies working in specific markets overseas,”she adds.

Despite the current market gloom, the underlying fundamentals remain strong, notes Al Bahar. “The reality is that the whole area continues to boom because of oil, and over the medium to long term, that trend shows no sign of diminishing.

The GCC and wider Middle Eastern region offers massive opportunities even now, for the right projects and firms.”

Aside from obvious expansion in recent years in high growth markets such as Turkey and, most recently the opening of a new branch in Dubai, Egypt is a strong element in a broad brush strategy, and typifies the bank’s country by country growth tactics.

NBK purchased Cairo-based Al Watany Bank in 2007; and immediately began a process of building up business across the business spectrum.“We have 40 or so Kuwaiti clients that do substantial business in Egypt. We provide them with appropriate financing (a mix of private equity, mezzanine and traditional corporate lending). Remember also that there are more than 500,000 Egyptians living and working in Kuwait and we provide services to them also. The Al Watany acquisition gives us additional strength in the SME and retail segments in this regard.” Multiply that systematic approach across the Middle East and North African (MENA) region: “and I guess you have a pretty ambitious strategy,” agrees Al Bahar. The bank’s most recent expansion is the opening of a branch office in Dubai, she adds.

Right now, Al Bahar, like most senior banking executives in the Gulf is measuring the ability of the GCC states to withstand the seismic shifts in the global financial markets. Additionally,

there are specific regional issues to address. "The topic of double-digit inflation will be on high priority at the Al-Rouad debate.,” says Al Bahar.

Speakers are expected to highlight the appropriate monetary and exchange rate policies that will be implemented to maintain regional prosperity and address the possibility of opening new economic sectors in the Arab world for foreign investment beyond oil-related activities to strengthen the regional economy and enhance private sector participation. “In addition, the speaker line-up will share key insights into the overhauling of the regional educational system to meet the needs of the changing and increasingly globalised economy, with the purpose of ensuring regional employment for the next generation", Al Bahar says.

In a geo-political context, Al Bahar like NBK CEO Ibrahim Dabdoub and a goodly coterie of senior bankers in the GCC, is a broad brush, liberal thinker. Women’s rights, the expansion of education for all, the democratisation of the GCC via improved living standards, civil rights and a strong commitment to internationalism are hallmarks of her intellectual drive.

Right now, those issues are ultra-topical debates in the region. Not one to cross wide chasms with tiny steps, Al Bahar favours bold strides. “The GCC countries should work together for a greater integration of their economies”, thinks Al Bahar,“As we have seen [this year] the recession of the US dollar has reflected negatively on GCC currencies linked to it; therefore I believe that GCC countries should de-peg their currencies from the dollar to curb inflation, as we did in Kuwait. The introduction of a unified GCC currency could also be a positive resolution towards the betterment of the economic situation. We should work together to create a better future for new generations. This is our responsibility”.

OCTOBER 2008 • FTSE GLOBAL MARKETS

Country Report REAL ESTATE STILL ON THE UPSWING IN TURKEY

A geographical and cultural bridge between Europe and Asia, Turkey has enjoyed an enormous property boom in the past decade as it begins it long potential journey into the European Union.

Turkish property developers have been busy too, expanding in particular into Russia as they seek to grow their businesses outside of their home markets. However, in a country that has gained significantly from an increasingly affluent consumer base and a more confident business environment, potentially threatening legislative mistakes by the government has placed a continuing shadow on near term growth, notes Mark Faithfull.

Consumer boom keeps investors talking Turkey HERE IS, OF course, a lot going for Turkey. It has emerged as one of the key high-growth property development and investment markets and sustainable economic growth, greater political stability, wider investment in infrastructure and favourable demographics have all contributed to very positive market sentiment. Add to that its probable, albeit longwinded and possibly turbulent long term journey into the European Union and a large, growing and young population and the sum of the parts makes for a strong investment case. All of which makes it all the more astonishing that in April the government should throw a spanner in the works, leaving investors with the jitters.

More of that later. In its first report on the Turkish market agent King Sturge points to a number of the key positive drivers which have attracted so much interest in the country: Exponential growth has driven large transactions: Growth in the Turkish

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FTSE GLOBAL MARKETS • OCTOBER 2008

economy has led to greater demand for commercial property space, particularly in Istanbul. High demand for popular locations on the European side of Istanbul, such as Maslak and Şişli, has ensured that vacancy rates in these areas are virtually zero. Rents have correspondingly grown by as much as 25% over the last two years and prime monthly rents are as high as $30/sqm, with some asking prices already approaching $40.

The retail market continues to show major prospects: There is a very strong development pipeline of new retail space, with around 35 new shopping centres currently under construction in Istanbul and a further 30 modern schemes being built across the country.

Logistics and warehouse stock is on the increase: Warehouse and logistics stock in Istanbul and its suburbs currently totals about 1.2m sqm. Because of a significant new supply pipeline, this figure is expected to increase to 1.4m sqm over the next year.

The Diamond building in Istanbul.“Although major metropolitan cities such as Istanbul and Ankara still dominate the retail market, Turkey’s developing metropolitan areas, such as Antalya, Eskisehir and Mersin, are also attractive markets for new retail investments,” says Firuz Soyuer, managing partner of DTZ Pamir & Soyuer. Photograph supplied by Mark Faithfull, July 2008.

Yields compression is towards Western European levels: Only two to three years ago, all commercial property yields were in the order of 10% to 12%. Offices and industrial have since compressed to around 8%, with retail currently at around 7%. All well and good, but Turkey’s real estate market was thrown into jeopardy in April when the country’s Constitutional Court annulled a law allowing the sale of property to companies established by foreign investors or joint ventures involving foreign firms after the government missed a three-month deadline to

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Country Report REAL ESTATE STILL ON THE UPSWING IN TURKEY

amend the legislation. A freeze was slapped on more deals and the suspension came to end in May when parts of the legislation relating to foreign buyers were re-drafted.

However, the uncertainty prompted ING Real Estate to back out of bidding on a 50% stake in Renaissance Construction’s $1bn Turkish retail portfolio. The Russian developer has been looking for a joint venture partner since February.

Others are more bullish. The fund management arm of Savills is launching a €1bn opportunity fund to invest in retail and residential developments in Turkey. The Cordea Savills Turkish Property Ventures Fund will target an annual return of 20% and will have a five-year lifespan. The group said it would aim to raise €400m from investors which, with 60% leverage, would take the fund’s value to €1bn on completion of the schemes.

The controversy also brought into sharp relief some more fundamental issues about Turkish property. The real estate market is beset by complex zoning issues and a lack of transparency and the imminent risk of retail oversupply in Istanbul is compounded by the absence of a central zoning system, which makes it possible for new malls to be developed within close proximity of existing ones. Indeed, like most of the so-called emerging markets, much of the property development has been led out by retail. Kerim Cin, managing partner of Colliers International Turkey, points out that at the start of 2007 cumulative shopping centre space in Istanbul was just over 2m sqm. By the end of this year, that figure is expected to have almost doubled to 4.1m sqm. “The European side of Istanbul is still attractive for shopping centre investments,”Cin says, adding that 80% of the shopping-centre developments either under construction or in the planning stages are being built

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Is Bank real estate investment trust (REIT) recently sold its 50% stake in the 30,000 sqm Kanyon office tower in Levent to the Eczacıbas Group for $67.5m and Turkey posted the highest annual growth in global office rents last year, with Levent the country’s most expensive location, according to property consultancy Cushman & Wakefield. Top rents in this district increased by 95 % year-onyear in 2007 and now stand at $30 per sqm per month for those businesses which can actually find space. Photograph supplied by Mark Faithfull, July 2008.

on the European side of the city.

Consequently, Cin believes that investment opportunities now lie on the Asian side of the capital—especially in the fast developing residential regions, such as Tepeoren-Kurtkoy.

A number of other Turkish cities are also generating interest among investors. Yields compare well with other emerging markets, while annual shopping centre rents can top €1,000 per sqm. In 2007 over €370m of retail property changed hands, according to Jones Lang LaSalle. The majority of these deals were executed by Dutch investor Corio, an active player in the Turkish retail market. But the 2007 figure was down on the €770m spent on retail space in 2006, when international property investment,

development and asset management company St Martins’ purchase of the Cevahir mall in Istanbul for €495.4m accounted for almost 80% of that year’s figure. The $515.5m loan secured, which was oversubscribed, was hailed as the largest-ever loan agreed for Turkish real estate.

“Although major metropolitan cities such as Istanbul and Ankara still dominate the retail market, Turkey’s developing metropolitan areas, such as Antalya, Eskisehir and Mersin, are also attractive markets for new retail investments,” says Firuz Soyuer, managing partner of DTZ Pamir & Soyuer.

One of the key reasons for Turkey’s appeal is the country’s demographics.

Turkey’s population is around 75m but crucially half of those are under 25 – retailers are obsessed with youthful populations because of their high discretionary spend and such a bias is a common feature of emerging markets compared with the ageing populations of Western Europe and the United States. Richard Davies, country manager of Jones Lang LaSalle Turkey, says:“The huge potential in the Turkish market means that the country will remain among the top three emerging markets globally for foreign investors in the coming few years.”

Investors are finding that the best opportunities are often through forward-funding agreements with local partners. This type of deal accounted for more than 70% of total transactions in 2007. However, concerns are mounting about potential oversupply in the country’s shopping centre capital, Istanbul. As a result, the city is no longer an obvious investment target. Prices are high, development land is scarce and competition is fierce.

The city is home to 60 of the 183 shopping malls in Turkey, and a further 46 out of 72 under construction will be based there.

OCTOBER 2008 • FTSE GLOBAL MARKETS

Country Report REAL ESTATE STILL ON THE UPSWING IN TURKEY

One thing is clear: Istanbul is approaching its shopping centre capacity. In fact Turkey’s three largest cities (Istanbul, Ankara and Izmir) account for most of the country’s shopping mall floor space. “There are barely any opportunities left in Istanbul,” says Koray Ozgul, Corio’s chief executive officer.“It’s time to look at second-tier cities.” Smaller cities such as Antalya, Eskisehir and Mersin are now attracting investor interest.

Merrill Lynch and its local partner, Krea, have made retail investments in Eskisehir, Pendik and Esenyurt. GE Real Estate plans to focus on Turkey’s top 20 cities, where agent CBRE says yields can be up to 10 %. For the office market on the other hand a shortage of available land is keeping supply low and pushing up office rents in Istanbul, while the booming retail sector is prompting developers to build logistics space. With businesses pulled in by the country’s economic growth and improving market conditions, the existing office supply is unable to satisfy demand. The result is higher rents and in almost all locations, the average monthly cost of renting a top-grade office is above $15 per sqm.

Prime office yields are at around 7%.

Most of the office stock in Istanbul is of secondary-grade quality and is located on the European side of the city. The major business districts include Zincirlikuyu, Esentepe, Maslak and Levent, with the latter attracting the highest rents. Is Bank real estate investment trust (REIT) recently sold its 50% stake in the 30,000 sqm Kanyon office tower in Levent to the Eczacıbas Group for $67.5m and Turkey posted the highest annual growth in global office rents last year, with Levent the country’s most expensive location, according to property consultancy Cushman & Wakefield. Top rents in this district increased by 95% year-on-year in 2007 and now stand at $30 per sqm per month for those businesses which can actually find space.

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Meanwhile, new commercial districts are emerging on the Asian side of Istanbul as businesses relocate their operations to reduce overheads and meet space requirements through built-to-order schemes with land owners. This has pushed up rents in Kozyatagˇı, Kavacık, Ümraniye and Altunizade. Between 150,000 sqm and 200,000 sqm of office stock may hit the market within the next two years as developments complete, according to property adviser Colliers CRE. But even this will not have a dramatic impact on vacancy rates because demand for offices continues to outstrip supply— so rents are likely to keep rising.

Logistics is one of the fastestgrowing sectors in Turkey and offers plenty of investment and development opportunities. Expansion of the sector has been driven by strong economic growth and rising exports, as well as booming retail and manufacturing sectors. However, as with the office market, the supply of modern, highquality warehouse space is limited and demand exceeds supply. The shortage of standing investments has attracted foreign developers into the Turkish industrial market for the first time.

Industrial stock in Istanbul is expected to increase by 25% this year, according to CBRE. The logistics sector is concentrated around Sekerpinar and Gebze on the Asian side of Istanbul, and Hadimköy, Gunesli and Ikitelli on the European side, because of their proximity to both the E-5 and TEM highways. The total stock in Istanbul is around one million sqm, of which 60% is located on the Asian side. In Turkey as a whole, there is more than 700,000 sqm of logistics space in the pipeline due to complete during the next three to four years of which 250,000 sqm will be in the Istanbul area, says King Sturge.

Government efforts to improve Turkey’s transportation infrastructure

have also helped to expand the logistics industry. The development of new bridges and tunnels is underway.

Istanbul is served by two suspension bridges over the Bosporus but a third bridge is planned to the north of the other two to ease traffic congestion but its exact location is under wraps to deter property speculators. But its final completion is still years away.

Another major infrastructure project is the Marmaray rail tunnel passing under the Bosporus, which will be running by 2010. The $2.6bn project, financed mostly by the Japan Bank for International Cooperation and the Republic of Turkey, is part of an upgrade of the commuter rail system in Istanbul, and will connect Halkalı on the European side with Gebze on the Asian side. A 76km commuter rail system running through the tunnel will transport over a million passengers a day. The residential market also missed a beat while the Turkish government sorted out its self-made property crisis, but its swift resolution appears to have stabilised the situation. There are over 73,000 foreign-owned properties in the country, mainly in Istanbul and the coastal resorts, and nearly €2bn was invested in the Turkish residential real estate market by foreigners last year.

“The changes will have no effect on most foreign buyers and relate to the amount of land foreigners are entitled to buy,” explains Dominic Whiting, editor of residential guide Buying in Turkey.

Indeed, despite the self-engineered hiccup, it seems unlikely that Turkey’s appeal to property investors will diminish in the short term. GDP growth has slowed and the economy is not immune from the credit crunch but its relatively untapped potential remains a strong draw for money from The Netherlands, Germany and the UK plus Kuwait and Dubai and the legislative misstep is unlikely to be remembered as more than a blip on the radar.

OCTOBER 2008 • FTSE GLOBAL MARKETS

Bank Profile

Yapi Kredi has undertaken a high investment, high return growth strategy with the aim of becoming the leading bank in Turkey. Currently the fourth largest privately owned commercial bank in the country by asset size, Yapi Kredi firmly has its sights on the main chance. How far can the bank go under the leadership of its chief executive officer (CEO) Tayfun Bayazit?

URKEY’S BANKING SECTOR cis replete with turnaround stories. Battered by a series of banking crises in each of the last three decades, the country’s banking sector has been characterised by changing shareholdings, restructurings and mergers in an effort to survive in a highly competitive yet still discrete marketplace. Those that have survived into the 21st century are inured, experienced handlers of both difficult circumstances and change, and backed in many cases by substantial equity provided by foreign

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FTSE GLOBAL MARKETS • OCTOBER 2008

shareholders, readily placed to take advantage of the growing promise of the Turkish market. Among the most successful of these latter day banking businesses, isYapi Kredi, an institution which was one of a handful of private sector commercial entities that were established in the post Second World War period.

“The 2001 banking crisis in particular, taught us all a very good lesson,” notes Yapi Kredi chief executive officer Tayfun Bayazit. “Now when you look at the Turkish banking system, you see much improved risk

YAPI KREDI

THE PRIME OF YAPI KREDI

The tussle for market share in Turkey is easy to understand. Although replete with banking institutions, the country is by and large still under-banked, particularly in the regions and towns outside the hinterlands of the financial, industrial and tourist centres.

Moreover, right now, the vagaries that are buffeting the international financial markets have largely passed over Turkey, and its banking sector, which is getting on with business regardless. Photograph (c) Dreamstime.com, supplied September 2008.

management and supervisory controls. It has been important for us, as we embark on our own expansion programme, to have these new control systems in place. In the past, you will have seen banks aggressively investing funds in the pursuit of market share while compromising asset quality. This is no longer the case, particularly in this bank,”he affirms.

Yapi Kredi ve Kredi Bankasi AŞ, to give the bank its original full name, has seen a number of iterations. Originally established in 1944 as the country’s first privately held commercial bank by the Çukurova business family, it started to take on its current mantle via merger and acquisition. In October 2006, the bank merged with Koçbank AŞ, owned

by Koç Holding, one of the top industrial conglomerates in Turkey. The deal, one of the country’s largest M&A projects, involved Koç Financial Services (KFS), itself a 50/50 joint venture between Italy’s UniCredit and the Koç Group, which owned Koçbank back in 2005 and the Çukurova Group, together with the Saving Deposit Insurance Fund (SDIP), who together agreed a share purchase agreement for a 57.4% stake in the bank. Just over a year later, KFS upped its stake to 67.3% and shareholders of both Koçbank and Yapi ve Kredi approved the merger between the two banks in September 2006. Koçbank was dissolved and Yapi ve Kredi Bankasi and all its rights,

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Bank Profile YAPI KREDI

receivables, obligations and liabilities historically Yapi Kredi has enjoyed a largely passed over Turkey, and its were transferred toYapi Kredi. The new leading market share) and complex banking sector, which is getting on with combined legal entity retained the Yapi consumer banking services. The bank business regardless. To this end, in midKredi name. According to Bayazit, has also been a cultural touchstone in September, the bank successfully signed “2007 was a year of integration in the country, claims Bayazit,“not only is a one year dual tranche multi-currency which the final stages of the merger it a deep rooted institution with a loan facility worth $1bn, via a were implemented. It was also a year in strong retail franchise, but also the syndicated loan that replaces an $800m which the new strategic direction of the bank has been very committed to facility signed almost exactly a year Turkish culture and its overall earlier. The monies will be used to bank really took shape.” finance pre-export Pinpointing the retail contracts and exports. segment as continuing to Banks were invited to offer “real potential,” commit to the facility either according to Bayazit, Yapi in US dollars or in Euro and Kredi began a complex closed more than $200m growth programme that over-subscribed. Some 42 involved an aggressive banks participated in the branch expansion loan which is finely priced programme, involving the at LIBOR plus 0.75%. opening of some 340 new Largely, says Bayazit, “the branches throughout the success of the transaction country by the end of reflects our increasingly 2010. “Our projections strong performance as well show that the enhanced as long established banking network of over 1,000 relationships, which we branches will provide real have worked hard to value to the bank. The establish”. A group of lead strategy was essentially arrangers of the facility determined by our long Pinpointing the retail segment as continuing to offer “real potential,” include ABN AMRO, The term vision, or plan, to according to Bayazit,Yapi Kredi began a complex growth programme that Bank of New York Mellon, capture market share and involved an aggressive branch expansion programme, involving the opening Bank of Nova Scotia and a leadership position in of some 340 new branches throughout the country by the end of 2010.“Our Citi. WestLB acted as the sector,”says Bayazit. projections show that the enhanced branch network will provide real value coordinator, whileThe Bank Yapi began a dash for to the bank. The strategy was essentially determined by our long term vision, of New York Mellon acted growth, tempered by the or plan, to capture market share and a leadership position in the sector,” says as documentation and Koç Group’s conservative Bayazit. Photograph (c) Dreamstime.com, supplied September 2008. facility agent. business culture and Further, in August the bank held a Bayazit reputation for tough adherence contribution to Turkish intellectual to high standards of corporate thought.” He explains that the bank is rights issue on the Istanbul Stock governance and risk control. Moreover, one of the country’s largest book Exchange (ISE) which increased the the bank has been able through highly publishing entities in “support of bank’s capital fromYTL3,427bn toYTL 4,347bn, raising a tick over YTL920bn. targeted marketing campaigns and“on culture and the arts.”

The tussle for market share in Turkey The capital increase “was undertaken the ground footwork” says Bayazit, “working out from the bank’s rapidly is easy to understand. Although replete to support and help finance the bank’s expanding branch network to sell a with banking institutions, the country is long term growth plan, as well as growing array of banking product.” by and large still under-banked, strengthening its capital base and Although classed as an emerging particularly in the regions and towns providing additional cushion in light market, Turkey’s banking system has outside the hinterlands of the financial, of regulatory changes, such as Basel II always been sophisticated: the country industrial and tourist centres. Moreover, and financial volatility in the wider was an early adopter of electronic right now, the vagaries that are buffeting capital markets,” notes Bayazit.“We’re banking, credit cards (in which the international financial markets have taking a conservative risk position,”he

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OCTOBER 2008 • FTSE GLOBAL MARKETS

adds, “capital adequacy ratio (CAR) advisory work in Turkey, Bayazit ranks as 7th in terms of number of was at 13.17% at Group level and at boasts a “robust performance in fee cards and 10th in terms of total credit 14.96% at Bank level as of end of income, up 37% on the same period card issuing volume in Europe. The June”. Bayazit also points to the last year.”The increase in lending to agreement, which was finalised mid bank’s tight rein on costs, even with a the SME (up 72%) and the consumer year, allows 1m Fortis credit card customers to gain Worldcard’s benefits, massive nationwide expansion (up 83%) were also notable.

Moreover, the bank has successfully Fortis’ credit cards have been replaced programme in play.“Our cost/income ratio is around 51%, down from 57% leveraged two of its main business by new ones with the World logo. Yapi in 2007, as we continue to focus on pillars. One is the bank’s strength and will use the brand sharing agreement cost management and sustainable depth in the credit card business; the to leverage further card penetration at growth over the medium term. We are other is the bank’s commitment to home and abroad as well as strengthen keeping investments and spending asset quality. Bayazit says he is proud the World card brand, explains Bayazit.

Under Bayazit’s management, the under tight control. It’s not always an that in a period of change and focus bank has also been ruthless easy balancing act in these in cleaning out non circumstances,”he says. performing loans from the Even so, the positive balance sheet. In late March response to the bank’s fund “The 2001 banking crisis in the bank completed the sale raising exercises are also particular, taught us all a very good of YTL429m of corporate, explained by its consolidated lesson,” notes Yapi Kredi chief commercial, and SME related first half year results, issued executive officer Tayfun Bayazit. non-performing loans to LBT in early August, which “Now when you look at the Turkish Varlık Yönetimi (owned by reported YTL740bn (based banking system, you see much Lehman Brothers no less) in on Turkish accounting return for YTL60.5m, which standards [BRSA]), of improved risk management and enabled the bank to enjoy an consolidated net income, up supervisory controls.” uptick of YTL8.9m in its first 61% on the same period in quarter financials for this 2007, and “up 55% on a year and reducing the bank’s normalised basis,” says Bayazit, “the consequence of an on the branch network, that the bank non-performing loan ratio to a tip improved commercial focus coupled has “maintained its leadership under 4% at the end of March this year.

Bayazit’s enthusiasm for the task in with strong cost control. Accelerated position in credit cards in terms of branch opening has been progressing total outstanding volume, in which hand is hard to miss. “Like many above plan with 153 openings since the bank enjoys a 23% market share, Turkish financial institutions, we have launch of the plan last year,”he says. By total issuing volume (22.1% market been through tough times,” he muses. the end of June, the bank had share) and number of credit cards “But now I would venture that Turkey established the third largest branch (18% market share), preserving sound enjoys one of the healthiest banking despite margin systems in the world, having had to network in Turkey (up from 4th position profitability overcome crisis after crisis that were in March) with some 791 branches and compression,“he says.

Yapi Kredi has not been afraid to direct results of ineffective banking a 9.7% market share, he adds.

The results were particularly reach out to other institutions to help supervision. That is no longer the case. pleasing for Bayazit as he notes, “the add leverage to its card offering. Furthermore, we are in the lucky performance cuts to the heart of the Among the most notable initiatives in position of having supportive and efficacy of the strategy we are recent months is the “implementation strong shareholders, with good pursuing.”YKB Group posted of YKB’s brand sharing agreements business sense and an ability to YTL2,453m of revenues with a healthy with Fortis and Vakıfbank,” explains navigate effective growth in highly growth of 30% on a year on year basis, Bayazit, bring the total number of competitive business environments. driven by an uptick in lending to credit cards on the bank’s Worldcard Luckily for us, Turkey is a market that consumer, SME and business platform to over 10m and,“at the same still has room for us to show our segments. Moreover, in spite of a time, created the largest brand sharing banking skills. We are in an exciting general slowdown in corporate network in Turkey.” Yapi Kredi now period,”he concludes.

FTSE GLOBAL MARKETS • OCTOBER 2008

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Country Report THE MEDIUM TERM OUTLOOK FOR BM&F BOVESPA

THE GLOSS COMES OFF BRAZILIAN EXCHANGE MERGER The consummation of the marriage between Brazil’s stock market, Bovespa, and commodity and futures market, BM&F, to create BM&F Bovespa has brought into being a regional powerhouse. Long-term prospects for cost savings, new products, and capturing money from other Latin countries are exciting; although plans to leverage synergies and market opportunity will surely take longer to come to fruition than expected in the current economic climate. The short- to midterm is occluded by a rapid reversal in market sentiment which has led to a bear market, calling into question the sustainability of Brazil’s equity miracle. New rumblings over corporate governance are unlikely to help the market recover its glitter quickly. John Rumsey reports from São Paulo.

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International investors have been pulling out, selling almost $10bn of Brazilian stocks in June and July. That represents the fastest pace of withdrawals since 1994. Many foreign investors feel burned by many of the glossy presentations and over-optimistic forecasts that supported the wave of IPOs in 2006 and 2007.

“There was a lack of responsibility from both corporate and their advisers in producing estimates,” says Bernardo Parnes, chief executive officer (CEO) of Banco Bradesco BBI, the investment arm of the private domestic bank. Many companies that should have tapped a private equity (PE) investor instead prepared for a market launch, preferring to skip over a necessary transition, believes Antonio Félix, a partner at law firm Tozzini, Freire, Teixeira e Silva Advogados. That has left many investors resentful of pressure and suspicious of the Brazilian sell-side’s pushiness.

Photograph © Loveliestdreams/Dreamstime.com, supplied September 2008.

RAZIL’S OWN BEAR market has come on the back of a generalised withdrawal of foreign and local money as questions over valuations in Brazil’s commodityheavy equity markets emerge with the strength of the long cycle coming into question. Trading volumes have been slumping, with predictably dire effects on the new exchange’s shares. The retreat will likely set back the exchange’s ambitious plans to launch new products. If combined with further questions over corporate governance, it could more permanently damage Brazilian capital markets and bring into question the exchange’s business model.

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OCTOBER 2008 • FTSE GLOBAL MARKETS

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Country Report THE MEDIUM TERM OUTLOOK FOR BM&F BOVESPA

Certainly, the exchange needs to volumes continued to rise: the looking to sell itself more aggressively keep a close eye on expenditures for average was close to R$6 billion per to local investors. Some 500,000 now. Its first profit announcement day compared to R$4.9bn in the same Brazilians own equities and the revealed net profits of R$165.2m in the period of 2007. The problem is that exchange expects that figure to grow second quarter but also highlighted future predictions were extrapolated as it promotes itself. It intends to target how operational costs caused net from the past and more recent agriculture workers, which accounts income to fall 6.1% on a pro forma numbers are worrying: total volumes for 5% of the nation’s $1.2 trillion basis. That will need to be tightened in fell in July to R$125.2bn compared to economy.“We have this big project of R$132.5bn for June. Numbers for taking the Bovespa to the farmers,” these tougher markets.

CEO Edemir Pinto has announced.

Shares in the merged BM&F August are likely to be worse.

That is likely to happen slowly over International investors have been Bovespa had started auspiciously enough. On August 20th last year, pulling out, selling almost $10bn of time, but looks extremely difficult in the first day of trading, they jumped Brazilian stocks in June and July. That current markets. The tightening of the 7.5% to R$11.84, following the represents the fastest pace of interest rate cycle since April has already taken rates up to sizzling pattern of the 13% and most economists Brazilian initial public are predicting further offering (IPO) market of Certainly, the exchange needs to tightening to 14% or even 2007. That however was keep a close eye on expenditures for 15% before rates start to more of a technical bounce now. Its first profit announcement come back down. With and they came off the boil in revealed net profits of R$165.2m in some of the highest real the next couple of days. the second quarter but also highlighted rates in the world and lame Moreover, the leap came performance from the stock after shares in the how operational costs caused net market, there has been a individually traded income to fall 6.1% on a pro forma significant domestic move companies had provided basis. That will need to be tightened in out of equity funds and into dismal performance since these tougher markets. government bonds. their fêted IPOs late last Some investment year. Indeed, shares in Bovespa Holding peaked at R$37 on withdrawals since 1994. Many foreign management houses, most of which November 9th and came steadily investors feel burned by many of the had been moving into equities, have down to hit a low of R$14.25 on glossy presentations and over- seen their assets under management August 18th this year just before the optimistic forecasts that supported the drop by 50% or more as investors pile shares were converted into new wave of IPOs in 2006 and 2007.“There into bank certificates of deposit. That BM&F Bovespa shares. BM&F, which was a lack of responsibility from both has been the case even with very wellcarried out its IPO only in December corporate and their advisers in known houses including Mauá and Quest 2007, peaked at R$25 on December producing estimates,” says Bernardo Investimentos 28th and also hit a low on August Parnes, chief executive officer (CEO) of Investimentos, both in São Paulo.

Banco Bradesco BBI, the investment 18th; in its case of R$9.91.

Until recently, the business arm of the private domestic bank. Many Merger excitement numbers seemed to stack up. The companies that should have tapped a It wasn’t supposed to be this way. average daily trading volume on private equity (PE) investor instead Earlier this year, Brazil became the Bovespa more than doubled in each prepared for a market launch, preferring biggest single component of the MSCI of the last three years, reaching as to skip over a necessary transition, Emerging Market index and last year much as $3.7bn this year, up from believes Antonio Félix, a partner at law accounted for an outstanding 10% of $198m at the end of 2002. In that firm Tozzini, Freire, Teixeira e Silva all global IPOs with foreigners period, individual investors upped Advogados.That has left many investors representing 70% of the interest. The their presence on the exchange too resentful of pressure and suspicious of merger between the exchanges has and now account for 26% of trading the Brazilian sell-side’s pushiness. created the second largest stock The exchange is responding by exchange in the Americas and third compared with 22% in 2002.

Moreover, in the first quarter, trying to shift its investor base. It is largest in the world.

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The argument went that huge growth in foreign interest in Brazil’s economy and the rapid deepening of financial markets would continue to push demand for equities and the Brazilian real long-term. The exchange would be constantly able to increase volumes as markets deepened, launching new products together with partners and acting as the exchange of choice for other Latin companies, deterred from a US listing by the overzealousness of Sarbanes Oxley.

However, since June, the idea that Brazil could decouple from global market trends has proven hollow. The first leg down in the market came in the smaller company sector. Shares in this area, in house builders and property developers, small- and mid-sized banks and smaller clusters of listed companies in areas such as education and healthcare, were battered by the global rush to liquidity.

Volumes of trading dropped as investors moved into large-cap, appreciating commodity stocks. The second leg came as commodity prices started to fall in the late spring, with stalwarts of the exchange such as Petrobras and Vale losing more than 20%.

The selling point for the combined exchange was that the huge increase in trading is a longer-term, secular trend and that volume is the driver for profitability. Then, there is the real possibility that Bovespa can turn itself into a regional centre for companies seeking to raise capital. That is predicated on the liquidity that is attracted to São Paulo, a feature lacking from all other regional exchanges, with the possible exception of Mexico City.

Until the recent market drought, the Bovespa exchange had accounted for as much as 80% of the listings in Latin America and Argentina’s Banco Patagonia listed a concurrent Argentine, Brazilian and international offering of shares through Brazilian

FTSE GLOBAL MARKETS • OCTOBER 2008

Depository Receipts (BDRs), seeming to point the way to the emergence of São Paulo as the regional exchange of choice. Since the Patagonia deal, although there have been a number of BDR issues, there have been no other real foreign listings. Instead, most BDR issues have come from companies that are Brazilian businesses, typically using an offshore primary listing to raise foreign capital and minimize tax. There is unlikely to be more interest from overseas companies, which can easily tap New York or London, unless liquidity returns to the exchange in force.

There is also the possibility of further consolidation as exchanges globally join together to enjoy cost reductions. The Brazilian exchange already has two partnerships, one with the CME Group, which had a 10% stake in the BM&F, and the other with NYSE, which bought a 1% stake in Bovespa. It has not ruled out further or deeper partnerships. These relationships will help the Brazilian exchange upgrade its systems and gain more direct access to US investors. Pinto has said that the access to CME Group’s powerful Globex derivatives platform is going to boost its ability to offer new products substantially. Globex has more than 100,000 terminals worldwide, Pinto said, compared with the BM&F’s 750. That should help bring back liquidity.

The Bovespa-BM&F deal will position the new exchange in a number of new product lines. Brazil has been consolidating its position as one of the world’s powerhouses for agricultural products and management at the exchange are keenly aware that this could be a powerful driver of volumes.

The exchange has said it would like to rework its cotton futures to bring in worldwide investors. The future for

other commodities contracts, from soy to ethanol, looks bright. Brazil is a worldwide leader in ethanol and the Brazilian government would like to see the fuel commoditised to encourage global take-up.

The question is whether São Paulo will be the exchange of choice. It has proved difficult to get commodities contracts off the ground in Brazil and stiff competition exists from efficient, deeply liquid commodities exchanges, such as Chicago and London. Unlike local equities, where Bovespa has a clear advantage, there is no obvious draw for global commodity traders to come to Brazil.

Corporate governance The effect of the merger on corporate governance standards, a key area where Brazil has been showing leadership in the region, is not clear. It does seem likely that the merger will not great affect the management or oversight of markets, analysts believe. João Batista Fraga, listings and issuer relations executive officer at Bovespa, says he does not envisage changes to the structure of market monitoring and enforcement.

There continues to be progress in this area. The CVM, the market regulator, has been working hard to keep abreast of a market that until recently was growing fast. It recently created an enforcement division to streamline laws and bring more sophistication and, in May, started to work closely with the Federal Attorney, exchanging information and collaborating on research. The cementing of that relationship comes after the two worked together in 2007 on case involving market-listed companies, Ipiranga and Suzano, when the CVM was able to go to court and obtain an order freezing the accounts of traders involved after just three days, a record time in Brazil, points out Alexandre Pinheiro dos Santos, a senior attorney attached to the CVM.

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Country Report THE MEDIUM TERM OUTLOOK FOR BM&F BOVESPA

The CVM is also building on its track record in voluntary agreements, where a fine is paid but no admission of guilt is made. Such voluntary agreements will help remove cases that are clogging up the system, explains dos Santos.

Still, there are some red flags. While corporate governance standards have immeasurably improved, too many Brazilian companies respect the letter rather than the spirit of the law. Giant ethanol producer Cosan, once a darling of the exchange, moved its listing to Bermuda to enable the owner to keep control of the company with a 10% stake. That contributed to a collapse in the share price from which the firm is only just recovering.

Recently, UK fund manager F&C has been leading a fight against a

controversial proposed take-over bid.

The fund manager was joined by over a dozen leading UK, North American and European institutional investors in urging greater legal protections for minority shareholders. The action was triggered by the August bid by Votorantim Celulose e Papel (VCP) to control fellow pulp and paper producer Aracruz, in a deal which will hurt minority investors.

F&C says they raised concerns because of the possible damaging effect on their other Brazilian holdings and confidence in the market.“What is most important is that the CVM re-evaluate the existing regulatory framework so as to restore global investor confidence in the Brazilian capital markets,” said Karina Litvack, F&C’s head of governance and sustainable investment.

The start of trading of the new BM&F Bovespa has been a more muted affair than expected as the exchange deals with a sudden downdraft in interest in its product.

Shocks are hardly new in Brazil, which is used to seeing foreigners come and go and has equity markets that have rarely relied strongly on local investors who have typically preferred the safety of fixed-income.

Interest and liquidity will return, fed by the growing economy of Brazil, but the downturn has focused minds on just how many Brazilian companies currently have the heft to generate substantial enough liquidity to interest large foreign investors and where the exchange really has value added over deeper markets in other countries.

Don’t work in the dark, who knows what you might find Emerging Markets Report provides a comprehensive overview of the principal deals, trends, opportunities and challenges in fast-developing markets. For more information on how to order your individual copy of Emerging Markets Report please contact:

Paul Spendiff Tel:44 [0] 20 7680 5153 Fax:44 [0] 20 7680 5155 Email:paul.spendiff@berlinguer.com

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OCTOBER 2008 • FTSE GLOBAL MARKETS

SLOWDOWN?

Global securities on loan remain at suitably high levels, fattening revenues for leading lending agents. However, with liquidity in short supply and constraints laid down by the Federal Reserve (Fed) impacting broker-dealer activity, a slowdown in securities lending, however moderate, seems likely. Dave Simons reports from Boston.

S ONE OF the primary providers of liquidity to the marketplace, securities lending providers have enjoyed above-average growth in recent times. In fact, 2007 was a banner year. Moreover, even through the worst of the credit crisis, the trend continued unabated through the first half of 2008, and most of the industry’s leading players posted double-digit revenue gains. Global securities on loan were a tip above the $6trn mark. It appeared to be the best of times for at least this segment of the global markets.

It may be however, that these lambent times may have a sell-buy date. The ongoing shift in market dynamics— marked by continued liquidity issues, not to mention increased scrutiny of broker/dealers by the Fed, the US central bank, has already prompted a round of less-than-rosy forward-looking statements. Despite a 16% rise in securitiesfinance revenue from the previous quarter, during a second quarter (Q2) conference call Ron Logue, chairman and chief executive officer (CEO) of Boston-based State Street, nonetheless included the caveat that such “uncharacteristic growth”would likely moderate during the remainder of 2008.

“I caution…that you cannot extrapolate the strong results in securities finance revenue in forecasting the second half of 2008. Typically, we see a decline in securities finance revenue from the second quarter to the third quarter.”

Meanwhile lenders remain on tenterhooks; albeit more than a year after the first few tremors from the credit collapse were felt by the rest of the markets. Offering guidance—and tweaking programmes when needed— have, not surprisingly, become frontline strategies for major lending providers, who say they are holding an all-handson-deck posture as the year draws to a close.

A

INVESTMENT SERVICES: US SECURITIES LENDING

STEADYING FOR A

Lenders remain on tenterhooks; albeit more than a year after the first few tremors from the credit collapse were felt by the rest of the markets. Offering guidance—and tweaking programmes when needed—have, not surprisingly, become frontline strategies for major lending providers, who say they are holding an all-hands-on-deck posture as the year draws to a close.

Photograph © Mike Monahan/Dreamstime.com, supplied September 2008.

FTSE GLOBAL MARKETS • OCTOBER 2008

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INVESTMENT SERVICES: US SECURITIES LENDING 54

Lenders reassess Securities lending providers have spent a good portion of the past year honing their advisory skills, acknowledges William E Smith, managing director of Western Hemisphere new business development for JPMorgan’s Securities Lending and Execution Products unit, who joined the unit from Deutsche Bank in February of last year. “Due to the condition of the markets going back a year ago August, we have spent much more time doing relationship management than we had during the previous 18 to 24 months when the markets were relatively flat and there was not as much concern.” While this counseling has included helping clients reassess their risk appetite with respect to cash collateral management and affect any changes as necessary, JPMorgan has consistently operated at the lower end of the risk chain, notes Smith, and as a result such housekeeping has been fairly routine in nature. “I think clients recognise that risk management and access to risk credit analysis was part of the reason why they chose us in the first place. So I think this has been an opportunity for us to prove our worth during a difficult period. Or, as our clients have suggested, to put into Craig Starble, senior managing director, global head of securities finance at State Street action the type of sales pitch they heard Corporation in Boston, believes the department’s revenue growth to date is an indication prior to joining our lending programme.” that any necessary adjustments that have been made because of the credit crunch have Craig Starble, senior managing director, had a positive impact.“As investment managers, we have responded proactively by global head of securities finance at State becoming more conservative ourselves, raising available liquidity in the co-mingled cash Street Corporation in Boston, believes the collateral pools or reinvesting in shorter-term assets,” he maintains. Photograph kindly department’s revenue growth to date is an supplied by State Street, September 2008. indication that any necessary adjustments that have been made because of the credit crunch have had or eliminating exposure to opaque structured products. a positive impact. “As investment managers, we have The good news? Well, according to Greenwich: eight out responded proactively by becoming more conservative of ten beneficial lenders said they were pleased with the ourselves, raising available liquidity in the co-mingled cash measures taken by their custodian in dealing with the collateral pools or reinvesting in shorter-term assets,” he liquidity conundrum. That speaks well for the sector as a maintains.“[Therefore] despite the perception of increased whole, says JPMorgan’s Smith.

“This is a business that is supposed to be transparent,” risk, clients are receiving returns that are far outstripping offers Smith. “In reality, pension funds should always be that risk, in my opinion,”he adds.

A recent study by Stamford, Connecticut-based reviewing their [lending] programmes. What we found as a Greenwich Associates found that nearly one in every two result of the changing marketplace is that in some US pension funds have revisited their lending instances some dust had accumulated on the clients’overall programmes due to growing liquidity concerns. While understanding of the business, or their need to be fully only a few have suffered substantial losses, some engaged in reviewing the business. Securities lending is institutions have “experienced either an unexpected something that often takes place in the background and, as interruption in liquidity or unanticipated risks and credit a result, a certain comfort level can develop. That is why we exposures in securities lending pools and short-term view any adjustments that have been made along the way investment funds,” according to the report. The situation as quite positive,”he notes.

Acting in an advisory capacity is a necessary part of the has prompted lenders to re-evaluate the costs/benefits of their securities lending programmes, while at the same business, adds Smith.“When one of our clients comes to us time increasing investment oversight as well as reducing asking about the financial or risk-mitigating implications of

OCTOBER 2008 • FTSE GLOBAL MARKETS

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INVESTMENT SERVICES: US SECURITIES LENDING 56

William E Smith, managing director of Western Hemisphere new business development for JPMorgan’s Securities Lending and Execution Products unit.“Due to the condition of the markets going back a year ago August, we have spent much more time doing relationship management than we had during the previous 18 to 24 months when the markets were relatively flat and there was not as much concern. ”Photograph kindly supplied by JPMorgan, September 2008.

changing a specific portion of their programme, we are there to help them fine-tune and keep a dialogue going, if that is what is necessary,”he says.

Beneficial owners have generally expanded the depth of their due diligence to include more specific collateral portfolio reviews, holds Sandra Linn, chief operating officer, Global Securities Lending for Chicago-based Northern Trust. “In addition to providing clients with enhanced reporting, we have had many more opportunities for robust discussions with clients about the market environment and securities lending, which we have welcomed.”While a small number of clients have opted for a slightly more conservative approach, most have satisfactorily conducted their reviews and simply put in place more frequent and in-depth review practices, explains Linn.“Much of this has centered around providing greater transparency into collateral reinvestment, in addition to conducting more engaged dialogue regarding clients’ programs, including risks, risk management, indemnification, and drivers of revenue,”she says.

In its recently issued report The Impact of the Credit Crunch upon the Securities Lending Market, Spitalfields Advisors, the London-based securities lending consulting and database firm, states that all parties would greatly

Sandra Linn, chief operating officer, Global Securities Lending for Chicago-based Northern Trust.“In addition to providing clients with enhanced reporting, we have had many more opportunities for robust discussions with clients about the market environment and securities lending, which we have welcomed. ”Photograph kindly supplied by Northern Trust, September 2008.

benefit from the presence of an independent risk manager which would help agents match lenders with a programme appropriate for their level of risk tolerance. While agents have, in general, done a good job responding to the demands of the beneficial owner community for additional information, “The difficulty that beneficial owners have faced—particularly those with multiple agent lenders—is in receiving a consistent response that enables them to compare one programme with another,”says the report.

The hybrid hype Going forward, the popularity of so-called hybrid investments such as 130/30 funds could prove to be an important piece of the revenue pie for securities lenders.

Demand for these strategies among traditional long-only managers is expected to remain strong on balance, says Boston-based financial markets consulting firm,Tabb Group.

An estimated $2trn worth of investible dollars will be held in 130/30 assets by 2010, according to Tabb’s own forecasters, resulting in a potential $600bn in lendable assets.

The overarching growth of the 130/30 strategy is obviously a positive for securities lending, affirms JPMorgan’s Smith.“Anything that creates the potential for incremental demand for securities to be borrowed is good

OCTOBER 2008 • FTSE GLOBAL MARKETS

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eSecLending takes eSecLending takes a consultative, consultative, h highly ighly ccustomized ustomized aapproach pproach w when hen it it ccomes omes to to structuring securities lending nding programs for our clients. Unlike the traditional ional approach, where many grouped m any lenders’ lenders’ portfolios portfolios are are g rouped ttogether ogether wait bee b borrowed aand nd their their ssecurities ecurities w ait iin n line line tto ob orrowed on a best efforts basis, eSecLending structures programs sseparate eparate llending ending p rograms ffor or each each cclient lient aand nd utilizes u tilizes a competitive competitive aauction uction to to determine determine optimal market tthe he o ptimal rroute oute to to m arket for for their their lendable lendable assets. Based upon results ults from the auction, portfolios eeSecLending SecLending manages manages cclients’ lients’ p ortfolios eeither ither tthrough hrough exclusive exclusive aarrangements rrangements for for specified specified portfolio segments or on n a discretionary basis, where securities are lentt on an individual basis. eeSecLending’s SecLending’s model model enables enables clients clients to to benchmark measure b enchmark ttheir heir rreturns eturns and and m easure ttheir heir performance p erformance aagainst gainst the the market market ffor or ttheir heir given parameters, g iven aassets, ssets, p arameters, guidelines guidelines aand nd rrisk isk For tolerances. F or clients, eSecLending’s model has generated significantly ntly increased returns as while ccompared ompared to to ttraditional raditional llending ending programs programs w hile providing process. p roviding a ttransparent ransparent aand nd aauditable uditable p rocess.

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for us as an industry. I think it is also interesting that there disproportionate amount of the business. In fact, from our has been this dynamic convergence between what were current levels of 85/15 cash/non-cash business, we could traditionally hedge-fund roles and long-only asset see incremental growth to the point of it becoming closer managers, which will create opportunities for securities to 50/50. In other words, we believe our balances will lending just in terms of increasing volume coupled with the continue to grow over time, but that growth will include a need to borrow.”Additionally, this convergence of long and higher proportion of non-cash to cash collateral.”

With borrower balance-sheet constraints increasing, short strategies will allow institutions to blend and bundle services, many of which may include securities lending or non-cash collateral will be essential for the growth of the securities-lending business, says Northern Trust‘s Benner, sec-lend like products, notes Smith.

Despite some recent weakening as a result of the de- who considers non-cash collateral expansion a primary leveraging trend, alternative strategies continue to be a initiative. “Our product development and risk teams are focal point for Northern Trust. Jeff Benner, deputy head of modeling various loan and collateral combinations in our Securities Lending at the bank, sees renewed momentum value at risk model, identifying the collateral that will give our clients the best risk over the next several years based return. In addition which will in turn increase to the emerging markets, demand for borrowed we expect the expansion of securities.

Accordingly, the non-cash collateral “Northern Trust is A recent study by Stamford, market to contribute to the developing our product Connecticut-based Greenwich Associates continued growth of the offering to support active found that nearly one in every two US securities lending market.” extension from front office pension funds have revisited their Maintaining an to back office with extensive menu of securities lending being an lending programmes due to growing collateral options, important component,” liquidity concerns. including cash collateral says Benner. in both dollars and Euros, as well as non-cash Trouble ahead? lendables, will be While overall securities on necessary for agents to loan remain at historically remain on the fast track, high levels, demand for says Chris Jaynes, non-cash loans continues president of Boston-based to outpace cash. It is a It may be however, that these third-party lending agent situation that bears lambent times may have a sell-buy eSecLending. At the same watching, notes Jim date. The ongoing shift in market time, Jaynes agrees that Wilson, global head of dynamics—marked by continued bolstering relationship investment management liquidity issues, not to mention management is key to any for JPMorgan, who says shift in strategy. the pendulum is already in increased scrutiny of broker/dealers by “Transparency is motion. “It is simply too the Fed, the US central bank, has increasingly important for expensive for dealers to already prompted a round of less-thansenior management and pledge dollars given the rosy forward-looking statements. boards to ensure that consequential impact that their fund assets are would have on their earning the full and balance sheet. It is more appropriate returns for efficient for them to pledge any risks taken and to another security as collateral and pay a fee. As US dollars become a commodity ensure that objective criteria were used to award asset in shorter supply, it is more difficult to invest out on the mandates,”says Jaynes.

In its industry assessment, Spitalfields Advisors yield curve, and, as a result, everyone is squeezed.”

State Street’s Starble concurs that the shift from cash to concluded that “By taking a calm pragmatic position, non-cash is real.“There has been a move on the part of the leveraging detailed and relevant intelligence, lenders can broker/dealers to raise non-cash levels, in part because work with their agents to ensure that they factor risk they can control their balance sheets better, but also management appropriately into their thinking and still because obtaining cash has been expensive for them, remain capable of taking suitable opportunities as they therefore they would much rather exchange securities present themselves.” With the waters growing instead. This is important, because lenders who can increasingly choppy, both lender and agent would do well accommodate this kind of exchange will get a to heed such advice.

OCTOBER 2008 • FTSE GLOBAL MARKETS

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SUB-CUSTODY: CENTRAL & EASTERN EUROPE

The appeal of Eastern Europe to global custodian firms looking to expand their country and regional services and expertise is growing fast, having taken some time to attract their sustained attention.

Until this year, Eastern Europe was essentially the preserve of seasoned emerging markets specialist houses, such as Citi and local banks providing sub-custodian services to global providers, under the umbrella of an international grouping. Now though, global custodians are beginning to stir the regional pot, looking for new business opportunities at local level. However, the lack of a cohesive investment services infrastructure in the wider region may ultimately temper the ambitions of even the most experienced custodians. Julia Grindell reports.

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OCTOBER 2008 • FTSE GLOBAL MARKETS

THE INFRASTRUCTURE DIMENSION ENTRAL AND EASTERN EUROPE (CEE) and its surrounding markets “offer a huge and sustainable growth opportunity for global custodians,” offers Lilla Juranyi, global head custody at ING Securities Services, with $230bn in assets under custody (AUC) in the region. Following an expansion in the region that started back in the early 1990s, ING notes a steady and significant growth in business of some 18% over the last year.

BNP Paribas is another institution keen to deepen its reach in the region, having opened new offices in Hungary and Poland in May this year to provide custody and fund administration services. Philippe Kerdoncuff, head of new markets development, BNP Paribas Securities Services, says the bank reacted to a two pronged push: the first being that the bank was unable to ignore its clients’interest in the region any longer. “Given the development in local stock markets in these countries, our global clients are looking now for local custody and settlement and some are also looking for third-party clearing of stock exchange transactions due to their remote broker membership.”The second is an acknowledgement of changing local conditions. While Kerdoncuff agrees many Eastern European markets are still small, they are growing quickly, and an on-the-ground presence is a requisite if the bank is to remain a regional leader in the business.

C

Banks such as the UniCredit Group and Raffeissen International have essentially set the pace of foreign bank expansion in the wider CEE region, which increasingly encompasses the outlying CIS markets of Ukraine, Georgia, Russia and even Kazakhstan. Photograph (c) /Dreamstime.com, supplied September 2008.

Banks such as the UniCredit Group and Raffeissen International have essentially set the pace of foreign bank expansion in the wider CEE region, which increasingly encompasses the outlying CIS markets of Ukraine, Georgia, Russia and even Kazakhstan. UniCredit began with the establishment of a domestic custody business in Hungary in the early 1990s , which it has consequently expanded to encompass a presence in 15 countries across emerging Europe and administers assets worth €270bn. It won’t stop there. “There is an increasing interest from investors in markets such as Russia and Kazakhstan prompting us to expand further. We are seeing a lot of inbound business and believe these operations will be highly successful in the future,” says David Penstone, global head of sales and business development, Custody, at UniCredit Markets and Investment Banking.

UniCredit finalised the terms of its ownership of Russia’s Moscow Bank in May last year, upping its 63% stake in the company for a mere $400m. This was closely followed by a $2.2bn purchase of a 92% stake in one of Kazakhstan’s largest custodians ATF Bank in June the same year, one month before the credit crisis began its creeping paralysis of the global banking market. It more recently integrated the bank into the group, re-branding it as UniCredit in July this year.

Unicredit’s custody business in CEE is built on three pillars, says Penstone: “In addition to demand for our bread and butter services in providing sub custody to global custodians, there is also demand for provision of local fund administration to local pension funds, for example, as well as clearing services to remote exchanges.” He is confident in the sustainable future of investment services in the region, “given the added potential for growth in cross border flows and outward investment in the future. Hungary, for example is sitting on €60bn in cash savings so the next up kick we hope will come from cross border flows.” Slovenian banks, for instance, are highly active in Bosnia he says and Penstone believes his bank is poised to pick up business from crossborder flows. Additionally, custodians are hopeful that once the credit crunch eases local funds will start looking in other CEE countries for investment opportunities (either direct or indirect).“It’s like dropping a pebble into the water, it will take time,”he adds.

Even then, the CEE is not for the faint of heart.“One of the biggest challenges our regional operations face is harbouring an understanding of capital markets and custody in terms of the need to protect [shareholder] rights and collecting dividends, for example,” explains Penstone. He thinks there is still a requirement for custodians to educate clients in what is possible; to increase ‘bench strength’ in the market. “In Bosnia for example, only a handful of people fully understand the industry. Competition for good staff is intense and we have seen hyper inflation of salaries,” he says. Moreover, language barriers also make the CEE an especially hard market to navigate.

FTSE GLOBAL MARKETS • OCTOBER 2008

Martin Hofer, head of custody at Raffeisen Zentralbank Austria, points to some of the difficulties the bank faces from such extensive coverage.“Ukraine, Belarus, Kazakhstan and to some extent Russia have a complex registration process and there are a lot of barriers to entry there. It is often very difficult to get local currency out, which can be troublesome if you are trying to convert dividend payments for example,” he says. Photograph kindly supplied by Raffeissen Zentralbank Austria, September 2008.

Kerdoncuff points out that the level of development and practices followed are far from homogenous between each market. “Countries [such as] Poland and Hungary have made big steps towards harmonisation with international standards, but this is not the case in all Eastern European countries,” he says. He concedes it is one reason why the bank has preferred for now to stay in the relatively safer havens of these two markets for now.

Austria’s Raffeissen International however, has leveraged its proximity to CEE and pushed into 18 markets in the

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SUB-CUSTODY: CENTRAL & EASTERN EUROPE 62

on transaction volumes. “Because of the lack of support for foreign investment in these two countries in particular it is hard to encourage change in areas such as central securities depositories (CSDs), capital markets and tax regulations. This is not conducive to developing a strong regional custody business,”she avers.

Penstone agrees that Russia and Ukraine can often prove troublesome; particularly with regard to operational risk. “Bureaucracy is ingrained in every part of society and our greatest challenge in countries [such as the] Ukraine comes in protecting customers’ rights because there is no one regulator that overrides the others,”he says. He also mentions other tics, such as a law in the Ukraine that requires rights issues to take place at the share’s nominal rather than market value and (also in the Ukraine) where an over-emphasis on compliance is impeding outside investors from taking part in a transaction. The problem is as much cultural as systemic, says Juranyi who notes that “They just don’t have the enthusiasm David Penstone, global head of sales and business development, Custody, at UniCredit Markets and and will for change.”

Investment Banking.“There is an increasing interest from investors in markets such as Russia and However, mercifully, that Kazakhstan prompting us to expand further. We are seeing a lot of inbound business and believe approach is not ubiquitous these operations will be highly successful in the future,” says Penstone. Photograph kindly supplied throughout the CEE. “Some of the

by UniCredit, September 2008. smaller and medium sized countries region and now has €163bn worth of assets under custody. have been developing quite quickly in a lot of areas and Nevertheless, head of custody at the bank Martin Hofer are keen to embrace change,” says Juranyi. She says that points to some of the difficulties the bank faces from such some markets have been able to leapfrog the extensive coverage. “Ukraine, Belarus, Kazakhstan and to development process simply because they are starting some extent Russia have a complex registration process from scratch.“Countries such as Romania, Albania, Serbia and there are a lot of barriers to entry there. It is often very and Montenegro are eager to learn best practices, [so] difficult to get local currency out, which can be different from what we see with some of the larger troublesome if you are trying to convert dividend payments markets, such as Russia and [sometimes] even Poland,” says Raiffeisen’s Hofer. for example.”

Custodians commend Hungary, Poland and the Czech ING’s Juranyi also draws attention to the varying levels of infrastructure in place and cites Russia and Ukraine as Republic in getting most up to speed with international the most challenging of all CEE markets.“These markets do standards. Theofilos Mitsakos, head of location Hungary for not have homogenous central depositaries (CSDs), and BNP Paribas Securities Services explains the considerable although there is talk in Ukraine of one superseding the efforts instigated in there in recent years.“Hungary has worked others as early as next year,” she says, though she hard to improve its support systems and plans have now been acknowledges that current market conditions might delay announced for an independent central counterparty clearing this development for some time. “There is talk in Russia house (CCP), separating the CSD and CCP functions in an that this will not happen until as late as 2020,” she warns. effort to harmonise post-trade rules and infrastructure with Moreover, she cautions that such a restrictive marketplace, Western European markets,” he explains. Meanwhile, in with limited support systems and homogeneity makes it Poland there are plans to changes the CSD system to enhance hard for the wholesale custody business to evolve in the the efficiency of the settlement process, according to Andrzej region and in the short term, it is having a negative impact Szadkowski, head of location Poland at BNP Paribas.

OCTOBER 2008 • FTSE GLOBAL MARKETS

Some custodians contend that the lack of support services to clients,”says Hofer“We must also remain in the systems in some markets within CEE makes it difficult to driving seat for change to work towards harmonisation of provide clients with anything beyond core services and this processes with Western Europe through the development has implications for fee generation.“We have to look hard of local regulation, tax regimes and capital markets.”In this at STPs to develop value added services within this regard, providers have to be highly active in lobbying for market,” says Raiffeisen’s Hofer adding that “In some regulatory change to facilitate the development of their regional offer.“We take this countries you can’t make component of our business tax reclaims, carry out very seriously and it’s proxy voting or provide therefore integral we have delivery versus payment people on the ground and (DVP) settlement. It is ING’s Juranyi also draws attention to working on the relevant difficult therefore to the varying levels of infrastructure in boards to encourage provide regional clients place and cites Russia and Ukraine as development of the market with the service they are the most challenging of all CEE and improve our client used to in more offering, in turn this will developed markets.” markets. “These markets do not have facilitate market entry and Providers say that having homogenous central depositaries reduce investment risk,” operations on the ground (CSDs), and although there is talk in adds Unicredit’s Penstone. is integral to Ukraine of one superseding the others ING’s Juranyi says that understanding each as early as next year,” she says, challenges aside, CEE is an market to help tailor their though she acknowledges that current increasingly significant solutions accordingly. element in the bank’s Complexity is also an market conditions might delay this overall EMEA business. advantage, as ING’s development for some time.

“Although CEE is still Juranyi concedes. considered emerging in Heterogeneity offers terms of the growth custodians to set out potential it offers, its core their business expertise and local credentials to international investors keen to markets have a well established or at least improving leverage the CEE growth story, particularly if they have institutional and legal environment,”she says.“In addition, had on the ground operations for some time. However, although the operating environment in each country in the region can vary she does not undersell dramatically, each country the difficulties. “This is learning from another market is going to be and beginning to adopt tough not only because of universal systems; such as the challenges present Unicredit’s Penstone thinks there is still the mandatory pension but because foreign a requirement for custodians to educate fund systems in Hungary clients are asking for a clients in what is possible; to increase and Poland. I am confident higher level of service ‘bench strength’ in the market. “In that developments such as from their agents.” For Bosnia for example, only a handful of these will generate example, she points to business from the region the growing demand for people fully understand the industry. in years to come.” more in depth Competition for good staff is intense and Given the patchwork information and analysis we have seen hyper inflation of salaries,” quilt of regulatory on regulatory changes he says. Moreover, language barriers environments and varying and legal issues. also make the CEE an especially hard support systems sub “Providing this level of market to navigate. custodians are now all too service, although a big aware of the importance of opportunity, is also a big their presence on the challenge for agents frontline; and the revenue especially given increased competition and shrinking margins. In addition, these opportunities that complexity provides. No wonder that markets are complex so it’s often difficult to follow few providers are passing over the opportunity to get a slice exactly what’s going on making it difficult to mitigate the of the action. However, CEE is a long game and the immediate opportunities provided by the market may not risk for clients,” she says.

Nevertheless, to secure a sustainable future in this be enough to justify an increasing scramble for business. market custodians have to go beyond just providing direct Only time will tell.

FTSE GLOBAL MARKETS • OCTOBER 2008

63

COVER STORY: THE CME GROUP

CME GROUP

& THE NEW WORLD ORDER 64

Terrence Duffy, executive chairman of the CME Group and Craig Donohue, chief executive officer of the CME. Photograph kindly supplied by the CME Group, September 2008.

OCTOBER 2008 • FTSE GLOBAL MARKETS

If ever an institution is well placed to reap the whirlwind swirling through the global financial markets, it is the CME Group – CME, CBOT and NYMEX. CME chiefs have often told US regulators that competition in the futures world is global and that only a powerful US exchange can go head to head with foreign rivals.

Moreover, as internationalism and reciprocity become bi-words in the global financial markets, the CME has been careful to gain either full or partial ownership and/or influence in key exchanges at home and across the globe. It seems the exchange’s strategic pulse echoes the current techno-beat of the Zeitgeist. Having read the music so successfully to date, just how far can the CME go?

ERRENCE DUFFY, EXECUTIVE chairman of the CME Group is only momentarily non-plussed. He has just taken delivery of a gift of a six foot tall cigar store Indian carving. What to do? “I guess we find somewhere in the office for it,” he laughs, “It will remind me of the Wild West and will likely be a talking point for visitors.” Making something of something is illustrative of the CME; a kind of easy acceptance of the vagaries of business, meshed with an upbeat and can-do approach that permeates CME head offices at 20 South Whacker Drive. That and an overarching sense of history (or is it destiny?) that begins with the two friezes lining the entrance hall of the exchange; some of the few artefacts remaining from the now demolished 110 Franklin Street building that housed the original exchange between 1927 and 1972 and which are evocatively placed through and through the exchange’s HQ. It offers an easy traverse of the past and present.

Duffy is in an ebullient mood. Not only has his gift cheered him, but also the integration with the Chicago Board of Trade (CBOT), begun just over a year ago, is “basically complete,” he smiles, putting the merger between the city’s mega-derivatives exchanges in stark context:“We were standalone and successful for 101 years; so we had to ensure that the integration provided real synergies for investors.” Flawless, is a word used often in the CME to describe the speed and efficacy of the integration process with the CBOT. “We said when we began the process that it would take 12 to 18 months. It has been done in 10 months, exactly on track on cost synergy,” explains Duffy. A number of elements helped: the first was treating all parties on an equal footing, ensuring both party’s “core rights,” explains Duffy, “which we are now trying to harmonise some of the rules, concerning issues such as block trading, for example.”

Acknowledging that 80% of mergers are unsuccessful, and even given the happy confluence of product synergies, Duffy accedes that some cultural differences came into play. At which point Duffy credit’s Charles Carey,

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previously chairman of the CBOT and now vice chairman of the CME, with overcoming any residual issues. “His leadership was extraordinary, working on the merger, working on legal issues; he was critical to the success of the behind the scenes work. We were determined to be part of the 20% of mergers that worked well, and Charlie was the fulcrum for that ambition.”

The CME is the world’s largest future’s exchange, valued at approximately $37bn, just under double recent valuations of the merged and mighty New York Stock Exchange (NYSE) Euronext grouping. Moreover, as portfolio risk management tools increasingly take on board the use of futures and options, a wider range of institutional money is pouring into financial derivatives, a trend which the exchange is in a good position to leverage.

Additionally, the CME now has strength and depth in the increasingly lucrative market for derivatives based on commodities: which can only increase in demand over the coming decade. “The two domestic mergers (with the CBOT and NYMEX) have satisfied a strategic goal in diversifying asset classes in which CME offers benchmark product,”notes Bob Ray, global head of international sales.

For Ray, the commodities element is vital. “Putting all current financial and credit considerations aside, demand in the commodity sector is a tremendous long term movement that will not abate and I believe that the CME has been ahead of the curve in this regard.”

The merger between the Chicago exchanges was not without its detractors. Some commentators argued that they were already two of the largest futures exchanges in the US, representing over 85% of the domestic futures market. The Futures Industry Association (FIA) held that the merger would“concentrate significant market power in the new CME Group,” and that the combination would “substantially lessen competition among US futures exchanges, and raise even higher the barriers to entry for new competitors.”Industry watchers noted that the futures market walks to the beat of a different drum. Customers who buy Eurodollar contracts at the CME, for instance, can sell them only there and only by using the CME’s clearinghouse. While the cost of securities trading elsewhere in the US has fallen sharply, as a direct result of competition to the main boards, the cost of futures trading has moved only slowly. The CME has variously countered that clients have benefited from innovation in new products, a virtually 24-7 trading platform that is truly global and that trading costs have in fact fallen off as volumes inexorably rise. Moreover, the CME has up its sleeve the oft repeated chestnut that off exchange derivatives trading volumes far outweigh volumes onexchange (though as a result of the credit crunch, the excess of off-exchange or over the counter [OTC] markets must rise in consequence of a desire for more transparency and risk controls).

The CME has remained sanguine throughout. According to chief executive officer Craig Donohue, such criticism misses the point. “We take the long term view. While the

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COVER STORY: THE CME GROUP 66

CME has enjoyed robust growth rates; the reality is that we not averse to full acquisition,“as in the case of the NewYork have a mature market in the US and Europe. That is not the Mercantile Exchange (NYMEX),” he adds. That particular case in countries such as Brazil, Russia, India and China, deal works on many levels for the CME. The CME Group what we call the BRIC nations, though we add South Korea now enjoys a significant shareholding in the Dubai (hence BRICK) to that mix. To support clients working in Mercantile Exchange,“giving us important exposure to the those markets and others, we need a global presence. To Middle East,” underscores Donohue, and Norway’s this end we now distribute in 85 countries and trade in 24 International Maritime Exchange (IMAREX) Group, which has growing from being a small Norwegian freight of those.”

The CME’s expansion strategy is based on four supports: derivatives market to being a large diversified group, acting one is an understanding that you cannot cross huge as intermediary and clearer for physical and derivative chasms in tiny steps; a global infrastructure helps. In commodity transactions, now worth over $200bn a year. addition to its US network, it has placed Another jewel in the CME’s crown is its 10% shareholding telecommunication centres or hubs around the globe, in BM&F, which it acquired earlier this year in a crossseveral of which are in Europe and has recently added new equity deal that saw BM&F acquiring some 1.2m shares of CME Group common stock. In the summer, BM&F merged hubs in Sao Paulo, South Korea and China.

Two, it believes in the efficacy of local market-build with the Brazilian main board, thereby upping the CME’s reach in Brazil; one of its strategies. The CME has four key emerging had sales operations in markets.

Even so, Europe for over a decade; “the world is a big place,” and has steadily expanded The CME has been able to anticipate muses Donohue, “there is eastwards, with sales and leverage developments in the global still more to be done.” offices now established in financial markets. Its aim to offer financial According to Duffy, some Tokyo, Singapore, Hong products based on key indices and of that work involves Kong, Shanghai and depending and expanding Sydney. CME’s eastward investment benchmarks throughout the “our relationships: either current is not solely built developed and emerging markets, such as with customers or with on the promises of returns the hallowed Kospi index, on its Globex other exchanges. We are tomorrow, the markets platform is one cornerstone of the fortunate to be regarded as today are influencing new exchange's global expansion strategy. a good long term partner. business approaches: “In We have had close ties Asia, we’ve noted that the with the Singapore range of customers is very exchange for more than 30 large and that some of the barriers to trading in Europe and the United States are years; the Nikkei more than 15 years.”

Just how reliable a partner the CME can be was clearly simply not found in Asia.” Yet there are additional dimensions in play. As Ray notes: “52% of all US treasury illustrated earlier this year when the FIA wrote a letter to the bills are held in Asia; and with T-bills being a best bet flight Commodity Futures Trading Commission (CFTC) regarding to quality in this market, our on the ground sales effort and a petition filed by the CME. The petition requested that an local partnerships, mean we can leverage the volume. arm of China’s central bank, called the China Foreign Moreover, futures contracts tend to be dollar denominated, Exchange and Interbank Trading System, have access to and so one of our ambitions is to develop more local become“super clearing members”of the Chicago Mercantile product in local currencies; thereby eliminating price Exchange. CME asked the CFTC to allow the bank in China to clear foreign exchange and interest rate futures contracts discovery risk.”

The third support is the establishment of key strategic without having to register as futures commission merchants. relationships: an increasing feature of the CME’s global The FIA’s letter claimed that if CME’s petition was expansion strategy, enabling the exchange to carry more successful, it would reduce “fair competition” in the and more derivatives based on key national or regional marketplace. The FIA also took the position that this move benchmarks on its Globex (®) platform. Its latest coup is a would “adversely affect the ability of the Commission and new agreement with the Korea exchange to trade the CME to discharge their responsibilities.”The issue has derivatives based on the hallowed Kospi index on Globex, yet to be resolved, though both Duffy and Donohue remain which according to Donohue looks to be“the beginning of positive.“Actually, arguments like this ultimately help open up the market,”notes Duffy. The solution was obvious: if the a long term partnership”.

Last , but not least, is a commitment to spending money market would not come to the aid of the CME; the CME to offer clients the widest possible reach.“In which case we would come to the aid of the market. “Local brokers need will either establish joint ventures, a partnership or cross- international brokers to get access to key markets; therefore, equity shareholding to help penetration in local markets,” working with one of our international brokers gives the notes Donohue. Moreover, as with the CBOT, the CME is Chinese the same access,”adds Donohue.

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Moreover, as portfolio risk management tools increasingly take on board the use of futures and options, a wider range of institutional money is pouring into financial derivatives instead and as well as stocks and bonds, a trend which the exchange is in a good position to leverage. Photograph kindly supplied by istockphoto.com, September 2008.

Ultimately, believe Duffy and Donohue, words and phrases such as ‘internationalism’, ‘reciprocity’ and ‘level playing fields’ will lose their weasel word status and come to mean something really substantial. “You can be philosophical about it, or pragmatic and as we cast around and see the growth rates offered by some of these emerging markets, we chose to be pragmatic and we are oriented to the future,”explains Donohue.

More than internationalism is at play right now at the CME. A slice of the massive OTC derivatives market is another goal and one which might fall more readily into the CME’s lap than had been anticipated, say a couple of years ago. “Through our clearing facility,” notes Duffy, we bring the benefits of zero defaults, standardisation and transparency; all things which play to market requirements right now. If you are looking for validation of that tactic, look no further than the Depositary Trust and Clearing Corporation (DTCC), which has emulated the CME in many respects.”

Equally, exchange traded derivatives will also be on the uptick. “Certainly, the crisis must favour on exchange traded product,” notes Donohue. “Increased focus on the balance sheet strength of the banks and enhanced focus on the cost of capital across various businesses is inevitable. Of course, everyone in the derivatives market is very sensitive to counterparty credit risks. We believe the current situation plays to the strengths of our CCP, with its multilateral netting facilities and its elimination of counterparty credit risk.”

Additional aspirations include the maintenance of the status quo regarding regulation of the derivatives industry.

CME’s watchdog, the CTFC, rather like the UK’s Financial

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Services Authority (FSA) is a principle’s based regulator, rather than a directives based regulator. In part, the flexibility allowed by the CTFC has provided fertile ground for the CME to pursue both their global and domestic goals, without having too many barriers to growth placed in its path. If he has his way, Treasury Secretary Paulson would like a single regulator as a watchdog covering all the securities markets.“If they could revamp the Securities and Exchange Commission (SEC) to be principle’s based, then it might be a different matter. As things stand, we prefer the status quo,”acknowledges Duffy.

Right now, the CME is in its own sweet spot. Occasional assaults in the competitive space, from such as the Intercontinental Exchange (ICE) and Europe’s Eurex give it pause for thought; but not for long. It is hard to predict what competitors might do, accedes Duffy.“People are fond of giving us short odds. They gave us very short odds on the merger with CBOT. Right now, the game is about gaining efficiencies from market consolidation; it is a trend everywhere and will be a driver for some time to come. We still retain the capacity to do some different deals, but for now, we are focused on the integration process of both the CBOT and NYMEX. Suddenly, Duffy turns pensive: “You know, we meet a lot of people,”he says,“and every meeting influences our thinking and strategy doesn’t happen overnight. You could say that we undertake certain transactions and see the efficiencies that it brings.

Ultimately two things govern our approach: one is that we want as many countries’ benchmark product traded on Globex that we can have: and that is a global aspiration; which happily leads to the next goal, which is to conquer the world.”Duffy is smiling once more.

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CORPORATE ACTIONS MESSAGING 68

HOW NOW D STP?

Uptake of corporate-actions messaging is ahead some 20% year-over-year, and has roughly tripled since SWIFT’s message system was first introduced some five years ago. That is the good news. However, for many other segments of the securities industry, data processing remains a problem, fraying nerves and eroding profits. What will it take to get everyone on?

David Simons reports from Boston

Within the securities industry, the STP effort has been more “define and build” rather than implement, says Jeff Potter, product manager for Northern Trust Web Trade Services.“For the ‘vanilla’ asset classes such as equities and bonds, there has been little upward movement in the STP numbers,” says Potter.“Part of this is associated with the fact that most of the communications surrounding these asset classes are already highly STP, so it takes a lot of additional volume to move the needle up.”

ESPITE GREAT GAINS in automation technology, today too many firms still rely on systems that aren’t fast or flexible enough to achieve operational parity within the global marketplace. Manual processing, combined with a lack of uniform protocols and/or fully automated communications facilities, continues to result in costly errors affecting all parties along the data chain.

Partial or budget-based attempts to achieve straightthrough-processing, though a step in the right direction, may be much more costly in the long run: even when 95% of transactions are settled error-free, statistics show that the remaining 5% of non-straight through processing (STP) trades can strip away up to 25% of a firm’s transactional profits. So how has the effort to achieve industry-wide, all-encompassing STP progressed to date?

On the whole, not that bad, observes an upbeat Theodore Rothschild, executive director in JPMorgan’s Global Market Infrastructures business, who notes a number of STP successes over the past 12 months. “Uptake of corporateactions messaging is ahead 20% year-over-year, and has roughly tripled over the last several years since the messages were first introduced,”says Rothschild.

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According to Amy G Harkins, senior vice-president, BNY Mellon Asset Servicing, a consortium of groups that include the Asset Manager Forum (AMF), the Securities Market Practice Group (SMPG), the Securities Industry Association (SIFMA) and the Depository Trust & Clearing Corporation (DTCC) continue to work toward the goal of standardising event templates with defined data elements and option choices. A roll-out of proposed formats for industry review is scheduled for the end of this year.

“Additionally, many team members within the BNY Mellon Asset Servicing organisation have been active advocates for expansion of support for lottery processing and harmonisation of programming for SWIFT and DTCC coding efforts,”says Harkins.“These individuals have been leaders in the market to raise awareness as to what is needed and to help forge ahead the changes that are required for more effective handling of these events in an STP environment.”

Still, investors attempting to relay‘STP-able’instructions back to their agents continue to hit snags. “As we know, clients have had a hard time receiving consistent corporate-action announcements from their multiple suppliers, making it difficult for their system to send a single response message back. As a result, there hasn’t been great progress in this area.”According to Rothschild, cost continues to be a leading deterrent.“You have to start by making the right business case for this effort—there has to be a service level that you have already fleshed out with the industry before you can even get to the investment-council process in order to request the funds necessary to build this thing properly. Of course, given the current environment, it is even more difficult to push anything through an investment council because there are fewer dollars to spend. In turn, this may make the process a bit longer than we originally thought.”

Within the securities industry, the STP effort has been more “define and build” rather than implement, says Jeff Potter, product manager for Northern Trust Web Trade Services. “For the‘vanilla’asset classes such as equities and bonds, there has been little upward movement in the STP numbers,” says Potter. “Part of this is associated with the fact that most of the communications surrounding these asset classes is already highly STP, so it takes a lot of additional volume to move the needle up.”

Indeed, the rapidly shifting investment environment continues to underscore the need for the most efficient processing tools. In its report entitled IT Spending in Financial Services: A Global Perspective, Boston-based research group Celent argued that“STP is no longer about abstract T+0 goals…but a real need to increase operational efficiencies for a range of different asset classes.” Existing technology platforms are, in some instances, struggling to keep up in the face of increasing over the counter (OTC) derivatives volume and other complex investment products. As the number of traditional asset managers moving into complex instruments like derivatives, private equity and real estate increases, so too does the margin for

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Theodore Rothschild, executive director in JPMorgan’s Global Market Infrastructures business, who notes a number of STP successes over the past 12 months.“Uptake of corporate-actions messaging is ahead 20% year-over-year, and has roughly tripled over the last several years since the messages were first introduced,” says Rothschild. Photograph kindly supplied by JPMorgan, September 2008.

error. This has led to the kind of infrastructure capable of pulling together all the various pieces of data within the online informational mainframe, thereby allowing clients to see how everything interacts. Additionally, and most importantly, where the risk factors lie.

“For instance, we now have the ability to collect underlying private-equity information that can show the individual investments within the limited partnerships,” says Bill Pryor, senior vice-president of product and technology solutions at Boston-based State Street, as well as head of the newly launched State Street Investment Analytics group.“That way, not only can you drill down to the lowest level of detail, you also have the ability to see across the entire spectrum of investments, covering both traditional and alternative asset classes.”

Yet despite all good intentions, an initiative to increase efficiency through automated OTC derivatives processing using FpML (Financial products Markup Language) over SWIFTNet remains in the embryonic stages. “After two years there have been a whole two messages exchanged,” shrugs Rothschild. “On the one hand, a tremendous amount of work has gone into creating this capability and choreographing the messaging flows. But in reality, we obviously still have a long way to go.”

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Potter concurs that most of the STP effort on“new”asset classes like OTC derivatives has been focused on defining what needs to be communicated, when the communications can occur, and how this will be carried off.

“Many firms have been working on FpML messages and now are getting closer to a full pilot testing of the process.

Some communications have been established between firms, but not on a widespread basis across all counterparties or participants in the trade and settlement process.” Like others, Potter expects to see continued progress during 2009.

Getting the message across Speaking at the SWIFT-sponsored CorpActions 2008 conference held in New York last June, Harkins, while acknowledging the vast improvements in straight-through processing, maintained that there is little no room for complacency going forward. “Stay focused on standardisation,”she told the audience,“and keep the STP numbers going up.” JPMorgan’s Rothschild seconds that motion. To keep the momentum going, he says, clients must continue to put pressure on banks to continually improve their messaging systems.“Banks need to hear,‘The system still isn’t quite good enough for me, you need to keep making the messaging better.’ Pressure is really important.” So is patience, he adds. “We have to remind ourselves that, in the scheme of things, this is still a relatively new technology,” admits Rothschild. “The series of messages was implemented only five years ago, and it wasn’t until around 2005 that we actually had the bandwidth to make them work. We are still in the process of fixing newer messages as well.”

At the recent Sibos conference held inVienna, Rothschild addressed the need to take the end-to-end use of messages one step further—that is, to the issuers and their agents.

“This is crucial,”says Rothschild.“Right now, issuers are still producing 500-page legal prospectuses that we are all interpreting differently.” Once issuers can summarise their own prospectus into an ISO standard format, interpretation will become largely irrelevant. Says Rothschild, “In other words, we need to transform the process so that it is no longer a case of, ‘Here’s how I understand the event,’ or,‘Here is how I have scrubbed the event based on my 20 inputs of data vendors.’ That more than anything else will help with the consistency of corporate-actions messaging.”

Of course, the issuer issue has been a thorn in the industry’s side for years now, and may continue to be for years to come. “This is not a day-to-night thing,” says Rothschild,“because the fact of the matter is issuers don’t understand the problem clearly, and, more importantly, do not truly understand the benefit they will get from fixing this problem, and boy, there are some huge benefits for them once they finally get around to doing this! The good thing is the dialogue has begun, and it is my hope we can further the dialogue over the next couple of years through a number of different venues.”

Though custodian banks such as BNY Mellon support the current ISO 15022 standards, because it is not a sanctioned requirement participants may choose to follow the standard on their own merits—hence the inconsistencies which continue to plague the market.

“Currently, major global financial institutions are utilising the ISO messages,” says Harkins, “however, due to legacy technology applications, many of the major players may not be fully utilising the ISO 15022 standards.” Thus, the industry as a whole needs to continue to focus on working together to improve automating the corporate actions process, maintains Harkins.

Northern Trust’s Potter suggests that the low uptake of these messages relates to the lack of associated automation within the investment manager firms. “Many vendors are able to supply a good solution, but firms may not be investing because they do have a process, albeit manual, which supports corporate actions.” Potter also notes the prevalence of web-based corporate action tools, which many custodians have provided to investment managers for the purpose of sending and receiving information and decisions. For instance, Potter notes significantly more decisions being received via Northern Trust’s Corporate Action Delivery and Response tool (CDR), available through its Passport Portal, than through the SWIFT network. Equally important have been efforts within the industry to ensure that formats such as XBRL are properly synchronised with SWIFT’s messaging system. Through the planned introduction of the XBRL protocol into the Depository Trust and Clearing Corporation’s (DTCC’s) infrastructure, issuers and agents will be afforded greater scope and capability in transmitting data consistently, says Harkins. This effort, coupled with the ISO 15022 format that DTCC plans on rolling out to participants within a year or so, will help ensure that the appropriate format required by the standards of both messaging protocols is used, resulting in cleaner, less ambiguous data.

In terms of getting issuers on board, the key, says Rothschild, is getting XBRL to finally converge with ISO. “XBRL has already stated that it would like to see this convergence happen. With good reason. It is all the same data dictionary, the same standard, if not syntax. This could be a huge game changer, particularly in the US, as it will really help the issuers create these messages, because they are already very familiar with XBRL. When that happens, the deal is done.”

Additionally, efforts such as the Investment Roadmap project, which includes participation from FIX, FpML/ISDA, SWIFT, and ISITC, help firms understand which processes and messages correspond, as well as where there is overlap, says Potter.“Along with this, firms need to ensure SWIFT is aware of messaging needs whether through direct feedback as a SWIFT user, or through the service bureau they utilise for SWIFT connectivity.”

Despite great gains in the area of reconciliation, exception handling remains a trouble spot for many financial services firms and another impediment in the effort to achieve a

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long term, taking into higher level of STP. What account any funds that must kind of solutions can help be set aside for potential rectify this that are both losses resulting from errors effective and affordable? in manual processing.

“The most effective solution Another big challenge, would be conforming/ says Harkins, is the subscribing to industry perception that corporate standards such as SWIFT cannot be actions and ISITC formatting,” says automated.“This stems from Harkins. “Actively using the issue of late and these standards creates inconsistent data among the benefits of straightplayers, as well as the through-processing and offering agent and the greater efficiency. communication channels to Potter sees a multithe market place. Many tiered solution to the organisations will dual problem. “If messages are source the information not created properly, a received from the market firm can implement its place prior to the notification own middleware cycle in order to avoid reformatting solution or publishing inaccurate or use an outside vendor to unconfirmed data. The reformat. Both options can industry must strive to achieve better messagechange this perception to creation results and also move forward aggressively supplement messages towards automated with additional data that is processing.” not resident on the core processing system.”

Jeff Potter, product manager for Northern Trust Web Trade Services.

For its part, SWIFT Another way to combat itself has attempted to “Within the securities industry, the STP effort has been more “define and the problem is to develop mitigate such fears with build” rather than implement, says Potter,“For the ‘vanilla’ asset classes reports that identify and its Simulation Test and such as equities and bonds, there has been little upward movement in the group the reasons for Qualification Service STP numbers. Part of this is associated with the fact that most of the failure of STP—a process (STaQS), a corporatecommunications surrounding these asset classes is already highly STP, so that Northern Trust has actions message testing it takes a lot of additional volume to move the needle up.” Photograph used successfully for some program launched earlier kindly supplied by Northern Trust, September 2008. time, says Potter. “This this year that allows allows us to go back to the message originator with clients to gauge how their use of corporate-action details on non-STP messages, and help the firm identify messages compares to market practice guidelines. the message data that needs to change to allow for STP.” Despite such initiatives, observers such as Northern Trust’s Potter concede that getting everyone on board will undoubtedly be a long and gradual process. “These Cost versus benefits Companies that continue to rely on manual processes perceptions are difficult to break down,” he says. often cite the cost and length of implementation of “Through industry groups, firms are able to speak with automation platforms as leading deterrents. However, the other institutions in order to hear how they may have long-term benefits far outweigh any short-term solved similar issues. Also, industry associations provide discomfort, says Harkins. “For organisations who have exposure to vendors that may be able to assist. However, chosen to create technology solutions that utilise standard when trying to solve any problem, the solution for 80% market practice messaging such as SWIFT and bring them of the problem might be cheaper and easier to into their organisations to support the corporate action implement than the one that can solve 100% of the lifecycle, the clear benefit for straight-through-processing problem. So sometimes a firm must make the decision to is immediately felt and creates greater efficiency in the solve most of the problem and not all of it, realising that process while providing clear and timely handling of the they will then have 80% less work to do.” events to their clients.”

However, as we have seen, it only takes a wee bit of nonTo that end, Harkins strongly recommends that organisations STP delivery to eat into profits and logjam the data stream. review on a proactive basis the advantages of spending the No wonder, then, that for many automation proponents, technology dollars in the short term to realise the gain in the “total STP”remains the ultimate long-term goal.

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TRADING PROFILE & MARKET VIEWS

CONTINENTAL DRIFT

More pertinently Loiseau speaks to the emerging trading landscape.

Both sides of the Atlantic have undergone similar developments, he points out; namely challenges to the long held suzerainty of national exchanges through the emergence of alternative trading venues (ECNs in the US context; MTFs in the European). “At the end of the process you also have very different outcomes,” he notes. In the US context, you have a highly competitive trading landscape, with the national exchanges still with dominant roles, as they have acquired the ECNs established to compete with them. So there is less choice in the US, but a highly efficient and competitive process.” Photograph © Stasys Eidiejis/Dreamstime.com, supplied September 2008.

In response to the results of a recent reader survey, over the coming months we will be interviewing the heads of trading in key institutions to talk over the impact of some of the changes that are rolling through the global trading markets; in particular the changing exchange landscape and the impact of the emergence of alternative trading venues. First off is Stephane Loiseau, global head of equity program trading at Société Générale, who highlights the advantages of new trading venues in the European theatre. Loiseau has had extensive experience of working in both the European and US trading markets and is well placed to compare and contrast the regions.

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HE RUCTIONS IN the financial markets through the second half of September clearly brought into focus the front line role of securities trading operations. Most of the leading players have reported significant upticks in flow, as the buyside either sold off falling stock or tried to leverage the uptick from the trickle of conflicting news emerging out of the US congressional discussions on the efficacy of the Paulson Plan. As Loiseau says, however, “volatility does not always result in volume; having said that, if you want to do something in this market, you have to do it quickly and you have to have systems and relationships in place with your trading house that are top notch.”

It is a scenario that inevitably plays to the strengths of firms with a global reach and access to varied sources of liquidity:“With the markets so unforgiving, passive trading strategies, such as VWAP tend to be less effective. Speed to market is essential once a sell or buy decision is made. It is now about the infrastructure that the global houses provide, the quality of the order management system, for instance and the access to liquidity, to ensure that the client completes his trade in absolute safety,”stresses Loiseau.

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Irrespective of the immediate impact of the supercurrents buffeting the global equity markets, Loiseau increasingly notes substantive differences between the European and US trading environments. It is not just a question of culture, he acknowledges, though “that obviously plays its part.”

More pertinently Loiseau speaks to the emerging trading landscape. Eventhough for different reasons, both sides of the Atlantic have undergone similar developments, he points out; namely challenges to the long held suzerainty of national exchanges through the emergence of alternative trading venues (ECNs in the US context; MTFs in the European). “At the end of the process you also have very different outcomes,” he notes.

In the US context, the trading landscape has become more efficient and more competitive , with the national exchanges still with dominant roles, as they have eventually acquired some of the ECNs established to compete with them. Yet there is also the emergence of new sources of liquidity,namely the dark pools and other crossing networks. ” Compare and contrast that with the European experience, which he says is a direct result of the rolling out of the specific Market in Financial Instruments Directive (MiFID) and which is characterised by a growing number of smaller trading venues (which potentially will lead to a high level of market fragmentation). Despite the number of competitive venues, notes Loiseau it is only in selective cases that the costs of trading have been reduced and new liquidity has been created: “it is by no means universal,”which is, he says,“still a matter of concern and which must inevitably be addressed.” Even so, Loiseau acknowledges that the multiplication of new trading venues has had a beneficial effect on the“front-end costs” : “in a wider context the expansion of choice has been quantifiably beneficial, particularly with regard to execution costs. Yet, the impact on settlement costs hasn’t really materialised. And this contrasts with the US, where the existence of a centralized clearing and settlement system, has facilitated the proliferation of ECNs. If you look at overall transaction costs, the cost of trading is but a small portion of the whole.”

In consequence, thinks Loiseau, Europe would invariably benefit from a single settlement and clearing platform. As the new trading venues introduce additional liquidity into the market, the simplification of the “settlement process must be a priority, if only because the unnecessarily high costs involved right now restrict the development of new liquidity.”

Loiseau thinks it a particularly pressing issue as the rise of cross-border trading is still, with notable exceptions, largely defined by a regional rather than global movement.

In his ideal world, then Loiseau propones the ultimate emergence of three single settlement platforms: “one for the Americas; one for EMEA and one for Asia, in which case globalisation at the trading level really becomes a workable reality.”

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The challenge for the trading market is meeting the increasingly sophisticated trading requirements of a buy side which is, in some instances, taking on trading expertise and rolling it out in-house. “Inevitably that changes the nature of the relationship between the buy side and the sell side,” he acknowledges.“As the buy side expands the trading tools at their disposal, it has created a much healthier trading environment,” thinks Loiseau, “as it allows the sell side to concentrate on applying its wider market expertise to the specific market requirements of the buy side’s trading desk.” It is particularly acute in a regional or global trading dimension, he notes. “We can work and adapt the algorithmic trading tools, for example, to suit the particulars of a large cap stock such as Vodafone, but also to single markets such as Japan or Korea, and then to specific Emerging Market circumstances. It widens the possibilities for everyone,”he says.

He acknowledges however, that it is a two-way street and that the activities of asset management firms, particularly those “that have substantial global businesses, with tactical asset allocations, have encouraged the sell side to construct the infrastructure to handle opportunities arising in new markets, such as Latam and India, for instance.” Loiseau also gives a nod to the reality that it is not for everyone: “The US asset management firms are perhaps more advanced in this regard, but European funds are fast catching up : we have some firms that use all of our trading tools and services within a single day and on a global basis.”

Loiseau thinks that everyone now understands that the markets have changed irrevocably.“I do not think you can experience an event of this size without thinking that there will be significant short and medium term repercussions,” he cautions. However, he stresses that clients should keep their eye on the overall operational efficiency. “Going forward the leading trading houses will inevitably have a renewed commitment to improving the efficiency of the trading process, all the way to settlement,” he says. He also believes that the current level of market fragmentation will likely increase (as more MTFs come to the market in Europe) over the short term and that consolidation in the sector will be an inevitable consequence in the medium term: “just as it has been in the US, an event triggered by the acquisition of the most competitive ECNs by the NYSE and NASDAQ.” Irrespective, an increase in liquidity into the global equity markets will be a long term trend as the impact of the new trading venues, the rise of crossing networks and dark and light pools rolls eastward. “In tandem, new trading strategies will evolve to take into account a different trading landscape,” concludes Loiseau.“Today it is about implementation shortfall and best execution, tomorrow there will be other benchmarks. The overriding concern is to continue to improve the way we trade, while providing an operationally-strong trading environment for all participants.”

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If you thought that dark pools were only for ultra sophisticated traders; think again. They are rapidly growing in popularity and so called “dark liquidity” in European equities alone is estimated to account for around €12bn in value traded per day and is expected to grow rapidly in the coming years, according to recent figures issued by the London Stock Exchange. While dark pools have proliferated, and contribute in no small degree to that often used word “fragmentation” in the European trading theatre, the sell side or buy side trader rarely uses dark pools alone. Photograph © Madartist/Dreamstime.com, supplied September 2008.

TRADING ON THE QT

If information leakage is the bane of a trader’s working day; anonymity is his safeguard; ensuring that traders can undertake the acquisition or sales of a security without damaging either his client’s portfolio strategy or reducing signalling risks. The good news is that, partly as a result of best-execution regulation in Europe, hidden or dark liquidity pools are turning up in increasing numbers, providing clients with both the anonymity desired and liquidity required for block trade execution.

Increasingly anonymity is also spreading in the equity options market, particularly in the US. However, the real value of anonymity is the level of interaction and service that is required of the sell side traders and the way that it is changing the make-up of the relationship between the buy side and the sell side.

HE FIRST THING you learn about anonymity in the context of trading securities is that there are three main flavours. First, there is the increasing anonymity provided by mainstream exchanges as trades have dematerialised. Additionally, trading on exchanges provide further anonymity as trades are settled within clearing houses and buy side clients can act, comfortable in the knowledge that when trades settle, no one can see their actions.

The second flavour is related to the rise of so-called dark pools. The global trading market has been transformed by the rapid growth of dark pools, private, anonymous, offexchange stock trading venues where buyers and sellers anonymously match large orders but keep details about price and volume concealed. Dark pools are popular among investors who want to sell large amounts of shares (sometimes called block trades) without attracting notice or having an impact on price. There is an increasingly diverse array of dark pools in the market of which block-crossing networks are just one kind; and some multi-lateral trading facilities (MTFs) are dark pools.

If you thought that dark pools were only for ultra sophisticated traders; think again. They are rapidly growing in popularity and so called “dark liquidity” in European equities alone is estimated to account for around €12bn in value traded per day and is expected to grow rapidly in the coming years, according to recent figures issued by the London Stock Exchange. While dark pools have proliferated,

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OCTOBER 2008 • FTSE GLOBAL MARKETS

and contribute in no small degree to that often used word “fragmentation” in the European trading theatre, the sell side or buy side trader rarely uses dark pools alone. If there is no urgency around an order then both buy and sell side will most likely use dark pools on a regular basis. Equally, the converse is usually true and the share of trading in dark pools tends to fall off in times of rising volatility (such as right now) as volatility tends to be driven by high-frequency traders that favour faster execution in more public markets.

The buy side, depending on the portfolio investment strategies utilised, often waits out market volatility or will avoid dark pools in periods of market turbulence. What is equally true is that in turbulent periods, the buy side will inevitably lean more heavily on the expertise of their brokers; though over the long term, as the buy side imports more trading expertise from the sell side, even as trading algorithms and strategies become more sophisticated.

What appears to have happened in the run up to the frenzy of stock selling in September this year is that momentum in dark pools has been with the broker/dealers; particularly in the US. In Europe, the picture is a little more complex, as there has been a proliferation of new trading venues, some of which offer dark pool as well as light pool (that is, more transparent) trading features. Had all things been equal over the transit into autumn, then the London

Stock Exchange (LSE) and Lehman Brothers would have established the Baikal project, a dark pool aggregator, enabling both buyers and sellers to optimise anonymous trading strategies. However, there was something in the project for both of them: the LSE would have utilised the project as one means to tempt clients away from the growing number of independent trading venues and Lehman Brothers would have continued on its quest to provide clients with cheaper trading costs. It is not yet clear whether the LSE will continue with the Baikal project following the immediate demise of Lehman Brothers.

However, given the reverence given to the Lehman trading floor, the likelihood is that the individuals involved in the joint venture might resurrect the project from the trading floor of another firm at some point in the future.

The year has also seen movement by broker dealers to reach bilateral or trilateral agreements that give each bank’s algorithms access to each others’ dark pools. It appears to be a cheap and successful way of providing a low-risk method of tackling what appears to be a high degree of fragmentation in the block trading market.

Equally, anonymity is an increasing feature of the equity options market where traders have been looking for ways to trade that ape equity dark pools; thereby minimising impact while conducting large trades. This year, rising

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TRADING: THE GROWING APPEAL OF ANONYMITY 76

demand for the creation of hybrid or dark pools of liquidity for equity and index options have been provided in the US

by Ballista (an electronic pool for equity options) and 3D, a block options crossing network, that in the spring announced it was establishing a separate block trading network for equity options with the Chicago Board Options Exchange, in a deal signed at the end of May; though the network has yet to be operational.

The third flavour is the evolution in the relationship between the buy side client and the sell side broker/dealer.

In the recent past, this relationship developed over the provision by the sell side of direct execution business: either through providing the client with direct market access, or through the provision of specialist trading algorithms. As it takes some time for clients to become familiar with the

trading ethos and practices of different providers, it was typical for the buy side to have relationships with as many as four or five broker/dealers. Over time, this has reduced substantially, and the larger buy side clients, invariably those with well established trading desks of their own, tend to work with as few as one, two or maybe three providers now.

As the number of these relationships diminishes, this introduces the option of utilising specialist trading strategies that optimise the anonymity provided by the broker/dealer.

Of course, right now the market is experiences the kind of interesting times that only Chinese soothsayers can ponder with equanimity. Dark pools, goes the general thinking have temporarily taken something of a back seat, while experienced funds sit out the turbulence; or have already cashed out sensitive positions.

USEFUL TERMS IN THE TRADING LEXICON The financial exchanges sector is being comprehensively overhauled, as national exchanges face increasing competition from new trading venues, and alternative sources of market liquidity. Here are some useful terms for the beginner to get to grips with in the emerging trading landscape.

Alternative trading system (ATS): Often backed by broker-dealers, ATSs include electronic communication networks (ECNs) such as BATS Trading and block crossing networks such as Block Interest Discovery Service (BIDS).

Block crossing network: An ATS that handles large chunks of stock for institutions, which may be matched in a “dark pool”. One of the most established block crossing networks is private equity-backed Liquidnet.

Block Trade: A large order to buy or sell securities, usually 10,000 shares of stock or more. The average order size for equities on public exchanges is 250 shares.

Electronic communications network (ECN): An ATS that automatically matches buy and sell orders among subscribers. In America they are called ECNs; in Europe they are referred to as Multilateral Trading Facilities (MTFs).

Execution: The completion of a buy or sell order for a security.

Brokers operating on public exchanges are required by law to give investors the best execution price available.

Gaming: Manipulating the price of a stock to increase profits at the expense of the investor on the other side of the order in a dark pool. Common anti-gaming features offered by dark pools include setting minimum order sizes and pre-qualifying participants that meet a certain profile.

Indications of Interest (IOI): An IOI is an expression of interest in buying or selling a specific security sent electronically by a broker to a specific set of potential counterparties. After that, an interested counterparty negotiates and tries to complete the trade with a broker. Brokers feel this practice undermines the anonymity sought in dark pools by being a potential source of information leakage.

Internalisation: A process where broker-dealers use internal inventories to settle trades, sidestepping exchanges and saving on execution fees but potentially raising conflicts if brokers are pressured to execute in-house.

Liquidity: The widespread availability of a given security that makes finding buyers and sellers easier

without huge swings in security prices. Dark pools are called that because they offer pools of liquidity which facilitate matching of buyers and sellers while assuring anonymity.

MiFID: The European Union’s recently enacted Markets in Financial Instruments Directive is viewed by some analysts as the European equivalent of Reg NMS, likely resulting in greater competition for European exchanges. In response to MiFID, ECN’s, or more accurately MTFs have consequently begun to proliferate in the European market.

Ping: The most common way to glean information about an order in a dark pool. Often considered a type of gaming, an investor submits a small order to a dark pool to gauge liquidity. After determining there is liquidity, the pinger will drive the price of the stock up or down on the public exchange by buying or selling a few shares in the market. The pinger will then return to the pool to execute at the manipulated price.

Price Discovery: The ability to know what prices are available for a given security through order display books and other publicly available information.

OTC trading: Over the counter, or the trading of securities among a network of dealers rather than an organised exchange such as the London Stock Exchange or NYSE Euronext. Bonds and foreign currency are traded OTC among dealers.

OCTOBER 2008 • FTSE GLOBAL MARKETS

Inevitably, then the cost to hedge against losses on US government debt had already risen substantially after the Fed announced its intent to inject $85bn into insurance major, American International Group (AIG). Photograph (c) Tiong Ing Seng/Dreamstime.com, supplied September 2008

In the current credit crisis, it is inevitable that there are winners and losers: not least among sovereign debt issuers. While some of the frontier markets, such as the Philippines are announcing some trepidation in returning to the debt markets, European leading sovereigns have little choice. How much conditions changed over the summer are apparent, as economic fundamentals have clearly taken centre stage. Markets are increasingly distinguishing between high-debt Euro zone countries and the rest.

While the former suffer from the global appraisal of risk and are assessed according to their credit ratings, spreads of the latter are mainly determined by their economic outlook. Meanwhile, the price of US treasuries just keeps on going up, with much depending on the outcome of Congressional debate on the Paulson plan. Credit markets remained out of joint as investors shunned everything but government securities, thereby gradually pushing up premiums and keeping market interest rates high.

S ONE MIGHT expect, protracted arguments over the efficacy of the Paulson plan continued over the last weekend in September, on the basis that a deal ultimately would be thrashed out, and the announcement (as this edition went to press) that Washington Mutual would be absorbed by JPMorgan, helped ease some of the stress in the US short term funding market and curbed the dash to US treasuries as a relatively safer haven than the hyper volatile equity markets. US sovereign issuance has been rising to fund Treasury and the Federal Reserve Bank’s rescue efforts in support of the country’s financial institutions (AIG being a beneficiary of some $85bn), the US government has flooded the market with $224bn in Treasury bills and $58bn in coupon debt in the last week of September.

At the same time, investors have been scrambling to snap up shorter-dated US government paper as they shun riskier money market instruments issued by banks and companies.

Even if a deal is thrashed out that will satisfy both Treasury Secretary Paulson, law-makers and the US population, the likely outcome is that US treasuries will continue to gain from the systemic uncertainty in the

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financial markets. Certainly, renewed jitters in late September trading sparked market bets that the Federal Reserve may slash key interest rates by as much as half a percentage point from the current 2% as early as October, according to interest rate futures.

Unless the US Congress can deliver a rescue package for Wall Street, investors will continue to flock to the safe harbour of cash and US government securities. By the end of the last week in September, the price of US benchmark 10year notes rose 3/32 for a yield of 3.85%, against 3.87 % it had been mid-week, with the gap between two year and ten year notes widening from168 to 174 basis points (bps). Should the Congress not make significant progress by the beginning of October, undoubtedly short term money markets will suffer, with an expected rise of the London Interbank Offered Rate (LIBOR) to more than 4%. While the ability of sovereigns to raise finance will be largely unimpeded, short term corporate borrowing will be severely curtailed.

Inevitably, then the cost to hedge against losses on US government debt had already risen substantially after the Fed announced its intent to inject $85bn into insurance major,

SOVEREIGN DEBT: FLIGHT TO QUALITY IN EUROPE

FUNDAMENTALS RETURN IN SOVEREIGN ISSUES

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American International Group (AIG). Whether it was just the saving of AIG, or whether because it following rapidly upon the massive rescue of both Fannie Mae and Freddie Mac and projections that the US budget would balloon to $438bn next year, the figures were concerning enough to warrant the cost of benchmark 10-year credit-default swaps on Treasuries rising by 4bps to 30bps according to BNP Paribas SA prices in late September. This was well up on the 2bps of just over a year ago. [Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a country or company fail to adhere to its debt agreements. An increase therefore indicates deterioration in the perception of credit quality]. In comparison, credit default swaps on UK (at 31 bps) and German bunds (at 14 bps) are unchanged, according to figures issued by specialist market data provider CMA Datavision.

Even so, investors in European sovereigns are increasingly distinguishing between high-debt Euro zone countries and the rest. While the former suffer from the global appraisal of risk and are assessed according to their credit ratings, spreads of the latter are mainly determined by their economic outlook.

Although still at historically low levels, the dispersion of yield spreads in the European sovereign market has gradually increased since July 2007. Moreover, Euro zone spreads also stayed at their new levels even when risk appetite, at least temporarily, returned to other markets. The explanation for the widening spreads can be found in both credit risks and macroeconomic fundamentals, with much of that related to the ratio of sovereign borrowing to gross domestic product (GDP).

While Greece is the only country in the Euro zone with an A-rating, it’s national debt is not over-extended. No surprise then that Greece was in the happy position of having accepted €1.68bn out of a total of €6.34bn in bids for its reissued 5-year bond auction, the Greek Public Debt Management Agency (PDMA) in its official posting in the final week of September. The five-year bond has a fixed annual coupon of 4% and expires.

The German economy meantime, has proved to be remarkably resilient to the global turbulence for longer than expected, many of Europe’s AAA-rated countries (particularly Spain) have experienced a severe deterioration in their economic outlook since last year. For AA-rated Italy, the country with the sharpest deterioration of its economic outlook saw the strongest widening of the spread over treasuries. Italy is to offer a new 10-year bond in the fourth quarter, for a total amount of at least €12bin and with the coupon payment date changed to March and September, according to notes on the Italian Treasury website. The fixedrate BTP bond will have a maturity date of March 2019, it said.

The underperformance of Southern Europe not only reinforces the markets’ concerns about credit risk. The old spectre of whether some of these countries will remain within the Euro will inevitable rise out of the mists over coming months; though it is highly unlikely that it will result in the wholesale exit of one of the southern European economies within the foreseeable future.

Problems are not confined to Western Europe. The recent spike in commodity prices has “unleashed a surge in inflation when many countries were starting to run up against capacity constraints and overheat after years of rapid monetary and GDP growth,” notes a recent Fitch Ratings report on Eastern European sovereigns. Eastern European sovereign external bond issuance, which totalled $14.1bn to the end of July 2008, overtook 2007’s total annual borrowing. In comparison, private sector borrowing in the first half of this year in Eastern Europe tracked slightly ahead of 2008, but is still well below 2005 and 2006 levels.

Further afield, inflation has been highest in countries with fixed or managed exchange rates, including the Baltic states, Bulgaria, Kazakhstan Russia and Ukraine, and best contained in the inflation targeting central European economies, thereby putting pressure on exchange rates.

Moreover, current account deficits (CADs) are a concern across many Eastern European countries and one that is currently highlighted by the credit squeeze. Consequently a number of sovereigns are under credit watch by the ratings agencies: including Bulgaria, Estonia, Latvia, Lithuania and Romania. Fitch, for one, has constructed an index of countries that appear to be vulnerable to external financing pressures, based on their current account balance plus foreign direct investment inflows, external debt repayments due in 2008 and net external debt stocks. Latvia, Croatia, Lithuania, Turkey, Estonia, Bulgaria and Romania come out as most vulnerable. Fitch’s index does not however take political risks into account, and in a year in which a tussle over disputed territories in Georgia dominated headlines through to early September, the continuation of political risks in an expanded Eastern European context must be part and parcel of any risk assessment.

Over the medium term, further Euro adoption is a constant consideration within the Eastern European context.

However, the initial inflationary shock of adopting the Euro, particularly following the credit crunch will likely temper any ambitions for any country anxious to join the Euro-club. The impact of market conditions on sovereign issues in frontier markets has been much more acute. The Philippines is still studying whether to issue more sovereign debt this year and a final decision may come in late October as to whether the country will return to the debt markets, according to an official statement by treasury minister Robert Tan. Tan says the current crisis on Wall Street is a consideration but he also highlighted the fact that the country’s current budget deficit of Peso331.7bn (around $675m) for the first eight months of this year is still below expectations. The total deficit for 2008 is expected to top Peso60bn this year.“We are still observing the expenditure behaviour,” he noted. The Philippines had been planning to rise up to $750m through a sovereign debt issue, with the timing of any debt raising to depend on market conditions, according to Finance Secretary Margarito Teves. The amount raised will ultimately depend on how much revenue the government can raise from both taxation and the sale of 40% of its stake in the downstream oil refining company Petron later this year via auction.

OCTOBER 2008 • FTSE GLOBAL MARKETS

Frank Czichowski, KfW Treasurer, says the high premium reflected the current strength of demand for US Treasuries and maintained that the premium should still be considered “relatively low”, given that new-issue spreads of comparable issuers against American government securities had increased by considerably more.“In the context of the crisis in financial markets, KfW can be regarded as a beneficiary, which underlines the high credit quality of our bonds,” he adds.“Going forward we would expect new issue premiums to decrease again as soon as the market disruptions subside.” Photograph kindly supplied by Kreditanstalt für Wiederaufbau, September 2008.

Just when it thought it had shrugged off the last of the hot water drenched over Germany's development bank Kreditanstalt fuer Wiederaufbau, the bank was submerged by a gush of opprobrium following an 'accident' cash injection into a fast disappearing Lehman Brothers.

It hit the bank hard, particularly as it is rebounding from the turmoil it experienced in the wake of the near collapse last year of IKB Deutsche Industriebank, the private bank that was a very early casualty of the current credit crisis in July 2007.

Andrew Cavenagh looks at the repercussions of the collapse and the efforts of the development bank to re-establish its political and financial credentials.

LTHOUGH KFW OWNED only a 38% minority stake in IKB at the time of its near collapse, it was obliged to assume the lead role in a rescue operation to prevent the beleaguered bank going bankrupt. It did so with support of the government and and the country’s three banking associations, which feared that an IKB insolvency would precipitate a catastrophic loss of confidence in the entire German banking system.

However, the price of its intervention was high. By the end of 2007, shoring up IKB had put a €7.2bn hole in KfW’s balance sheet and (given the goverment guarantees its debt) brought the institution in for unprecedented political criticism over its handling of the crisis. Much of the censure focused on why KfW had allowed IKB to become so

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FTSE GLOBAL MARKETS • OCTOBER 2008

exposed to the dramatic change in the credit markets, through the two Rhinebridge structured investment vehicles (SIVs) that it had set up to invest in asset-backed securities. Like all other bank-sponsored SIVs, the Rhinebridge vehicles financed these investments through short-term borrowing in the commercial paper market and suddenly found they could no longer roll this CP over when the credit crunch took hold in July 2007.

The mounting criticism became too much for KfW’s chief executive Ingrid Matthaüs-Maier, who resigned on April 7th this year. As a former spokesperson on fiscal policy for the Social Democrat Party, Matthhaüs-Maier reportedly did not have formal banking qualifications and there was clearly diminishing confidence in both political and banking circles in her ability to resolve the crisis. Fellow board member Wolfgang Kroh temporarily replaced her and inherited the task of extricating KfW from its investment in IKB. By then, its investment had grown to a 90.8% majority stake—at the same time boosting the development bank’s issuance of capital market debt this year. For the cost of the IKB rescue obliged KfW to increase its financing requirement in 2008 from about €70bn to €75bn – a 16% increase over the €64.6bn that it had issued in 2007 (when the environment was far more friendly for the first six months of the year).

Within four months, Kroh was able to announce on August 22 that the KfW’s executive committee was recommending the sale of IKB – which focuses on lending to Germany’s small and medium-sized coporate sector (Mittelstand) – to Lone Star, the specialist US investor in distressed assets. While both parties agreed not to reveal

PROFILE: KFW REBOUNDS FROM IKB CRISIS

THE SLOW REBUILD OF KFW

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PROFILE: KFW REBOUNDS FROM IKB CRISIS 80

the price, it certainly fell well short of the the €800m that KfW and the government had been seeking. Kroh would only say that the additional charges to the KfW balance sheet arising from the shortfall would be less than 10% of the €7.2bn charge that the development bank had already incurred. This implied that reports of a purchase price around €100m might not to too wide of the mark.

Lone Star is certainly known to drive hard bargains. Earlier in the year it had bought $30bn of subprime-hit collateralised debt obligations (CDOs) from Merrill Lynch at 22 cents on the dollar. Nevertheless, KfW hailed the sale as a success. Not only did Lone Star assume over €3bn of the structured-finance securities remaining on the IKB balance sheet, but it also made a commitment that the German bank would continue to provide finance to the Mittelstand, whose companies are now starting to experience borrowing difficulties once more.“For us this means that KfW is now closing the chapter on IKB’s rescue,” maintained Kroh. “We can now go back fully to concentrating on our work as a promotional bank.”

The following month, KfW went a long way towards completing its own financing arrangements for 2008 with the successful launch of two large benchmark issues; one in euros the other in dollars, during the first 10 days of September. The first was a $4bn, three-year issue launched on September 2nd the institution’s third such benchmark dollar issue of 2008 – which had already filled its book by the time trading opened in New York. Orders totalled $4.8bn, with 80% of the commitments coming from central banks and a high percentage of European accounts. With a coupon of 3.25% and a re-offer price of 99.745%, the bond offered a yield of 3.338%, which corresponded to a pick-up of 106 basis points over the current 2-year US Treasury bond that matures in August 2010.

Frank Czichowski, KfW Treasurer, says the high premium reflected the current strength of demand for US Treasuries and maintained that the premium should still be considered “relatively low”, given that new-issue spreads of comparable issuers against American government securities had increased by considerably more.“In the context of the crisis in financial markets, KfW can be regarded as a beneficiary, which underlines the high credit quality of our bonds,”he adds.“Going forward we would expect new issue premiums to decrease again as soon as the market disruptions subside.”

The €5bn five-year euro bond launched a week later on September 10th was also significantly oversubscribed, with total orders reaching €6.3bn by the end of the day. It was the third benchmark issue of this size that KfW had launched in the currency this year; making it the only issuer in the SSA (Supra Sovereign Agency) segment to do so and Czichowski observed that the strength of demand for the issue underlined the continuing confidence of international investors in the institution’s debt.

European buyers accounted for 83% of the latest euro issue, led by the Scandinavians (20%), the UK (18%), France (17%) and Germany (10%). Asian investors bought 12% of the bonds and Americans a further 3%. Banks and central

banks were the biggest investors by category, accounting for 39% and 24% of the bonds respectively, followed by investment funds (17%), and insurance companies and pension funds (14%). The bonds pay a coupon of 4.375%, and their re-offer price of 99.82% means they offer a yield pick-up of 53.3bp over the comparable German sovereign bonds (bunds). The two September issues took KfW’s total issuance for the year to €61.4bn – over 80% of the €75bn target - with the benchmark programmes accounting for the bulk of the total. The three euro issues have raised €15bn, while eight issues out of the global dollar programme have accounted for a further $28bn.

While KfW will not announce its funding requirements for 2009 until December, Czichkowski suggested the total was unlikely to vary much from this year’s figure. “It has also always been a key value of our funding strategy to be a reliable partner for the global capital market community.

Therefore you should not expect a big change from this year’s volume,” he explained. As far as its investments for its liquidity portfolios are concerned, however, KfW started to apply to apply sustainability criteria in the first quarter of 2008. It had committed itself to applying such criteria back in 2006 when it signed up to the UN“Principles for Responsible Investment” initiative, which focuses on the environmental, social, and corporate governance (ESG) issues that can affect the performance of investment portfolios and their incorporation into investment analysis and decisions.

KfW has consequently developed a sustainable investment process for the liquidity portfolios, about €20bn of purely fixed-income investments— mainly covered bonds (pfandbriefe), and the bonds and debentures of public issuers—that are an important element in its liquidity management operations. It has commissioned the sustainable investment research firm Scoris to produce ratings against the PRI criteria for all issuers, which will enable it give preference to“particularly sustainable”issuers when making investments for the portfolios.

But while sustainability is now a further consideration in the choice of investment instrument - alongside the central criterion of credit quality – and the change will favour the more compliant issuers, Czichkowski says it would not result in the exclusion of any particular class of instrument.

Meanwhile, Czichkowski says the dramatic increase in energy prices this year would reinforce KfW’s commitment to support energy-efficient and energy-saving developments, such as its carbon fund that buys projectbased emission certificates under the Kyoto Protocol. “The current increase in energy prices will not change the emphasis of the projects we support but rather confirm our strategy,”he adds. The beginning of September also saw Dr Ulrich Schröder, the former chairman of the managing board at NRW.Bank, the development bank of the State of North Rhine-Westphalia based in Dortmund and Münster take over as permanent chief executive. The KfW supervisory board had appointed him to the post on June 25th, and his succession is seen as a further stabilising development. Kroh remains as his deputy.

OCTOBER 2008 • FTSE GLOBAL MARKETS

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SECTOR REPORT: BIOTECH – THE INVESTOR BATTLEGROUND 82

BIG PHARMA MUSCLES IN ON THE CALIFORNIA BIOTECH DREAM California now dominates the biotechnology industry not only in America but worldwide, accounting for more than half of all biotech revenues. Its new companies soak up more than four of every ten dollars in US biotech venture capital, and the California Institute for Regenerative Medicine (CIRM) promises to further cement the state’s lock on the sector.

With the mix of an ideal climate, some of the world’s best universities and research institutes, and seasoned venture capitalists, what could go wrong? Big Pharma for one. Art Detman reports.

California’s rise to world biotech powerhouse is a tale of happenstance.The state emerged from World War Two as America’s leader in manufacturing and applied engineering, both centered in Los Angeles. Meanwhile, the country’s medical research industry was based in the Northeast, primarily Massachusetts, New Jersey, Maryland and Pennsylvania (where much of the work was done that led to the polio vaccine). Among the leading research institutions were Harvard University, the Massachusetts Institute of Technology, and Johns Hopkins University and their affiliated hospitals.

The centre of gravity would shift westward across the continent because of controversy surrounding work on recombinant DNA, which involves the engineering of genes that do not occur in nature. Photograph © Eraxion/Dreamstime.com, supplied September 2008.

AY “CALIFORNIA” AND what comes to mind are beaches and palm trees, computers and semiconductors, the high-tech boom and the dotcom bust, Disneyland, Hollywood movies, Napa Valley wine, and succulent oranges. Fair enough, but what the casual observer might just overlook is that California has become the 600-pound gorilla of biomedicine; the technology that promises cures for diabetes, Alzheimer’s disease, liver failure, Lou Gehrig’s disease, cancers of all kinds, and much, much more.“California’s biotech industry is number one by far,” acknowledges David L Gollaher, president of the California Healthcare Institute.

Recent figures back him up. Last year, according to Ernst & Young, global revenues at publicly traded biotech companies totalled $84.8bn, of which $65.2bn (fully 77%) came from US companies. California accounted for more than $44bn, some 68% of America’s total and an astonishing 52% of the worldwide revenues for biotech companies. Just California’s Bay Area—which includes San Francisco, Berkeley and Silicon Valley to the south— accounted for $22bn in revenues, more than all of New England and, indeed, more than any other geographical unit in the Ernst & Young report Beyond Borders: Global biotechnology report 2008.

The story is the same for venture capital investments.

Last year, says specialist data provider Thomson Financial, part of Thomson Reuters, venture capitalists committed $1.66bn to California biotech firms. This was 42.3% of the $3.92bn total and exceeded the amount devoted to the next six states combined: Massachusetts, Washington, North Carolina, Pennsylvania, New Jersey and Connecticut.

Again, the Bay Area alone accounted for more dollars than all of New England, receiving $816m or 20.8% of all biotech venture capital. New England companies got $793m, 20.2% of the total. California’s San Diego County ranked third, at $646.6m and 16.5%. Through to early September

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of this year, the story is much the same. The state’s total venture capital investments came to $927m, 41.2% of the $2.25bn total and more than the next five states combined.

As usual, the Bay Area was number one by far, with $672m, or 29.8% of the total. New England ranked a distant second at $450m, a 20% share.

California’s rise to world biotech powerhouse is a tale of happenstance. The state emerged from World War Two as America’s leader in manufacturing and applied engineering, both centered in Los Angeles. Meanwhile, the country’s medical research industry was based in the Northeast, primarily Massachusetts, New Jersey, Maryland and Pennsylvania (where much of the work was done that led to the polio vaccine). Among the leading research institutions were Harvard University, the Massachusetts Institute of Technology, and Johns Hopkins University and their affiliated hospitals. The centre of gravity would shift westward across the continent because of controversy surrounding work on recombinant DNA, which involves the engineering of genes that do not occur in nature. In fact,“the greatest medical advance of the 1970s was recombinant DNA,” notes Robert N Klein, chairman of the Independent Citizens Oversight Committee for CIRM.“At that time, the people opposed to this research made the same claims and the same charges that they make today against stem cell research. Protesters actually shut down Harvard’s lab in Cambridge. [However,] Congress did not shut down recombinant DNA research. It increased funding.”

Some of the opposition to recombinant DNA research was based on the belief that it was a waste of money. More, perhaps most, was religious in origin. Man should not play God by mixing genes among species, went the thinking, even if the goal was to create pest-resistant crops or life saving drugs. Harvard’s labs remained closed, which spurred the University of California at San Francisco and the City of Hope National Medical Center in suburban Los Angeles to speed their collaborative work on developing a man-made insulin, based on recombinant DNA technology, for use by diabetics.“During the next decade,” says Klein, “they created within California 100 critical heart-enhancing drugs that have saved millions of lives.”

Since then, recombinant DNA technology enabled researchers to map the human genome, essential to identifying gene-related illnesses.

The rise of recombinant DNA research came at an opportune moment for California’s venture capital and high-tech support communities. During the 1950s and 1960s the electronics industry had taken root in California, nurtured by the aerospace/defense industry, Xerox Corporation’s Palo Alto Research Center [sic], and worldclass universities such as Stanford and the University of California at Berkeley, both in the Bay Area. A cadre of venture capitalists, many from the East Coast, arranged funding for startup high-tech companies, and soon an entire infrastructure of lawyers, accountants and marketers was in place to support new companies. That’s how the Santa Clara Valley became known as Silicon Valley.

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During the 1970s and 1980s, Silicon Valley’s venture capitalists discovered that their expertise was transferable to biotech companies. Soon they were arranging financing for startups launched throughout the state, from Sacramento in the north to San Diego at the Mexican border. Most of the biotech entrepreneurs located their companies in Silicon Valley, although a few remained in San Diego and fewer still stayed in Los Angeles and Orange counties. No protesters shut down startups such as Genentech in South San Francisco or Amgen just north of Los Angeles. The growth of biotech companies in California roared forward. “The whole idea of risk and reward was different in California than it was in the East, particularly during the 1960s and 1970s,” says Gollaher. In the East, a single failure was a stigma, often insurmountable. In Silicon Valley however, an entrepreneur could fail and still obtain funding for a second, third try, or even a fourth try. It was a mindset that made East Coast Americans uncomfortable and was virtually incomprehensible to Europeans.

This was just one aspect of the California business culture that was alien elsewhere in the US.“I grew up in California, went to school in the East, and now I’m back in California,” says Gollaher. “If you work in Boston or New York, the first thing anyone wants to know is where you went to school. If you work in San Diego or San Francisco, the first thing anyone wants to know is what you are doing.” It is a telling observation. The East Coast, like Europe, is fixated on credentials. California is focused on achievement.

Harvard’s hesitation in face of protests proved the turning point. “In 1977,” notes CIRM’s Bob Klein, “there were only about 17,000 jobs in biotech in California.” By 2006, it had risen to 276,000 jobs.“The industry went from virtually nonexistent to the second-largest employer in California in 30 years, and it was carried by the rising research in recombinant DNA therapies,” he adds. At the California Healthcare Institute, which is a trade association and a lobbying group, David Gollaher expects that a survey of California’s biomedical industry, now under way, will reveal an employment base of nearly 300,000 and revenues of $100bn; including not only biotech but diagnostics, medical devices and old-fashioned drugs.

Much of this activity will be in the Bay Area. Ernst & Young found that there are 77 public biotech companies there, with a market capitalisation of $146.6bn and revenues of $22.1bn. San Diego has 42 companies, valued at $23.7bn and with revenues of $3.2bn. Los Angeles and Orange counties, long seen as laggards in the state’s biotech industry, are home to 21 public biotech companies, with a worth of $58.2bn and revenues of $18.9bn. These figures however are distorted by Amgen, which alone accounted for roughly $50bn in market cap and $14.8bn in revenues.

“Biotech here is struggling,” admits Ahmed Enany, executive director of the Southern California Biomedical Council, a trade association headquartered in Los Angeles.

“We have not done a good job in tech transfer when the

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biotech revolution happened and new companies started popping up on the scene.” Indeed, many biotechs have emerged out of the three major research universities in Los Angeles—the University of California at Los Angeles (UCLA), the University of Southern California (USC), and the California Institute for Technology (Caltech)—only to migrate north.

For two decades this made little difference to Los Angeles County, a huge economic engine powered by aerospace, military, entertainment, fashion, finance, and world trade.The county’s economy was far larger than that of most countries, and its policymakers were content. The collapse of the Soviet Union changed things. As federal aerospace/defense spending was cut, Los Angeles fell into a severe recession in the early 1990s. The local economy was not as diversified as had been thought. Suddenly, local politicians and business leaders began lusting after biotech startups.

“Things started improving from 1995 on,” says Enany.

“We had more company formations and more technology spinoffs.” Because Amgen was the only biotech of importance in the region, nearly all of the new biotechs emerged out of research done at local universities, especially Caltech. “They have done a fantastic job since 1996 in their technology transfer effort,” says Enany.

Caltech has been a fountain of life sciences technology since 1928 but its biotech breakthroughs were overshadowed by its star physics professors, such as Richard Feynman and Murray Gell-Mann. For decades the biotech geniuses at Caltech frowned upon the vulgar marketplace. Their discoveries became important products, but their discoverers remained aloof and spinoffs headed out of town (among them Applied BioSystems, which is now based in Foster City, just south of San Francisco). It wasn’t until 1995 the Caltech began a concentrated effort to transfer laboratory breakthroughs into commercial products, an effort accelerated in 1997 when David Baltimore—a Nobel Prize winner in chemistry—became head of Caltech.

“He brought in a new team to manage technology transfer,” says Enany. “They turned Caltech around 180 degrees in terms of its attitude toward moving new ideas out into the marketplace, obtaining funding, and so forth.

Now practically every biotech company we have in Pasadena came out of Caltech.”

Baltimore’s initiatives helped create the Pasadena biotech corridor, an area in Pasadena (about 20 minutes away from downtown Los Angeles) that received zoning and other advantages from the city in order to attract biotech entrepreneurs. Meanwhile, both the county and the city of Los Angeles huffed and puffed to create local versions of Silicon Valley. The most ambitious of these proposals is a biomed research park that will be built along Valley Boulevard in Boyle Heights, a rundown area east of downtown. The corridor will stretch for 2.5 miles along Valley Boulevard from the California State University (USC) at Los Angeles, at the eastern end, to the Health Sciences Campus of USC at the western end.

As Enany envisions it, the USC biotech corridor would be not only grand but grandiose. Fully realised, it will occupy 2,000 acres and require $4bn to $6bn to build out and dwarf any biotech research park in the world, including those in Silicon Valley and San Diego. Tenants will receive below market rents, tax breaks, and employee training.

Thousands of high-paying jobs could be created, and a billion dollars or so in economic activity will be created.

Plus, of course, life-saving discoveries presumably will roll out on a regular basis.

Right now, the outlook for this biotech corridor isn’t good however. USC has started to master-plan the 16 acres it owns, but the balance of the plan is in jeopardy. One problem is that a juvenile detention hall is located on county-owned property in the proposed corridor. A far greater problem is that the Los Angeles political power structure has become too fragmented.Years ago a small cadre of businessmen, led by the owner of the Los Angeles Times, pretty much determined what would happen in Los Angeles. They brought water to the city, built a deepwater port, and in many other ways made Los Angeles into a world-class city. Those power structures however disappeared when the city’s major companies—Times-Mirror, Carnation, Douglas Aircraft, Lockheed, Security Pacific National Bank, Atlantic Richfield, Signal Oil and many others—were acquired by outsiders.

Today, Los Angeles is in the words of one columnist “a headless monster,” unable to chart a course in a rapidly changing world.

Even so, Enany is optimistic.“USC is spinning off biotech companies,”he says.“They are locating across the street from the campus. Some of them are leasing space in what used to be delicatessens. They are reconfiguring them, investing in tenant improvements.”Because biotechnology is a constantly changing industry, biotech companies prefer to locate near research university campuses. That enables them to keep up with the latest discoveries. For the universities, there are also advantages. Professors can more easily commercialise their work and obtain consulting commissions, and there are job opportunities for graduates and spouses of faculty.

Even so, Enany concedes that Los Angeles—like San Diego—is weak in venture capital. The two largest venture capital investors in the Los Angeles area are local offices of firms from far away: Versant Ventures, which is headquartered in Silicon Valley; and Prism Venture Management, based in Massachusetts. A representative local firm would be the Athenaeum Fund, a Pasadena venture capital fund that focuses on startups with initial capital needs of $250,000 or less.

Even so, as Los Angeles woke up to the need to attract biotech investments, California was moving ahead to the next level of technology, which is stem cell research. The polio vaccine was created using embryonic stem cells imported from Europe, and by the 1990s the biotech community had realized that future breakthroughs would be based on stem cell research, especially research using embryonic stem cells, which can be coaxed to develop into any kind of human cell.

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Franz Humer, chairman of the board for Swiss pharmaceutical giant Roche Holding AG, presents the figures of the half-year report offered $43.7bn to take over the remaining shares of US partner Genentech Inc. that same day. Photographer: Georgios Kefalas, Agency: Associated Press/Keystone/PA Photos, supplied September 2008.

Early on in his administration President Bush prohibited spending federal funds on any new embryonic stem cell lines, citing ethical reasons. Coincidentally, in California a movement got under way to form the CIRM, which would fund stem cell research throughout the state. The proposal—for $3bn in grants and $3bn more in interest— became an initiative for California voters in 2004.“Political experts said we would never get the necessary 600,000 signatures to qualify the initiative for the ballot,” says CIRM’s Klein. “They were right. We got 1.1m signatures.”

Even though California’s economy was weak and the state was having trouble meeting its expenses, the initiative passed with 59% of the voters favouring it.

Opponents—primarily religious conservatives—filed a lawsuit claiming that the initiative violated the state constitution. They lost in appeal court and then in the state supreme court. However, the process took 20 months. To keep stem cell research moving forward, Klein persuaded the state to issue $45m worth of bond anticipation notes.

“The offering memorandum carried a disclaimer that said if we lost the lawsuit the note holders had just made a $45m contribution to the state of California for medical research,” Klein recalls. The governor advanced $150m in state funds, so CIRM had $195m to launch its work. In addition, CIRM received gifts from individual donors to cover its administrative costs; for example, in 2005 Ray Dolby, the audio recording guru, and his wife donated $5m.

Klein believes that the lawsuit cost CIRM a year.

However, the grant program is now well under way, having given out more than $600m to California universities and research institutes. In September, CIRM launched a loan programme to fund for-profit companies. Actually, they are

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already eligible for grants but must agree to pay substantial royalties to the state. The loan programme, which will advance money at prevailing commercial rates, does not impose royalties, but it does require stock warrants in addition to interest payments.

The CIRM program promises to ensure California’s lead in biotech. No other state—indeed, no other country—has a comparable programme. Of course, now other nations are seeking to collaborate with California biotech researchers under the CIRM programme.“We just executed a memorandum of understanding with Canada regarding cancer stem cells,” says Klein,“and that country is putting up $100m for Canadian researchers who are collaborating with California researchers who have received grants from us.” All told, seven nations are working with CIRM currently, as are several research organizations within the US. “When I wrote the initiative,” says Klein, “I didn’t anticipate that nations would send essentially diplomatic missions to us in order to create collaborative relationships.

We already have had contact with 27 countries.”

In essence, California has taken over biotech research funding from a federal government that is hostile to genetic engineering. It may be the only of the 50 states able to do this. After all, if California were a separate nation it would rank among the world’s most powerful, with a population of 37m and a gross domestic product of $2trn, more than all but 11 countries. It is home to 13 research universities— ten in the University of California system plus Stanford, USC and Caltech—far more than any other US state or, for that matter, any country outside of America itself. In addition, California is home to scores of leading-edge research institutes, among them Salk, Scripps and

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Burnham.“I used to be a senior executive at Scripps,” says California, but also biotechs throughout the world.“As I’m Gollaher of the California Healthcare Institute (based in sure you heard a million times, the pharmaceutical industry San Diego’s La Jolla district, not far from Scripps). “We is desperate for new products,” says Yaron Werber, an would always try to recruit senior people in January, analyst with Citicorp Global Markets in New York. “Many February and March. We would bring them out from of their big products will go off patent soon.” What is Chicago or New York and they would look around and say, almost as bad is that most drugs are easily copied without violating patents, which is why, Werber notes, there are a ‘This is paradise.’”

California’s Mediterranean climate is still a selling point, lot of me-too products. However, biotech products, which but even the state’s most ardent supporters admit that the involve stringing together proteins and antibodies in state faces severe problems. At least a quarter, or perhaps a elaborate and very specific molecular chains, are virtually third, of all California children fails to obtain a high school impossible to knock off without violating the patent.

“Biotech is different,” diploma.

Taxes on Werber continues.“Biotech individuals and businesses products are innovative, are among the highest in they fetch price premiums, the nation. Despite the are massively profitable sharp drop in housing because you don’t need prices, homes are still very gigantic infrastructures to expensive.

Moreover, market them, they don’t traffic congestion is have a lot of competition, terrible; a 25-mile drive and they have a long can take an hour or more patent life.” No wonder during peak traffic periods. then, last year alone that at Even so, the growth of least 16 major biotech biotech in California seems companies were acquired; assured.

The state’s including seven in advantages—world-class California.

Currently, universities and research Switzerland-based Roche institutes, established is negotiating to acquire venture capital firms, and a the 44% of Genentech nurturing business service (Silicon Valley’s most environment—are deeply successful biotech) it rooted. “It is selfdoesn’t already own. reinforcing,” says Steve Werber believes Roche’s Krausz, a general partner at Three-dimensional photo of a virus. Some of the opposition to efforts will be successful.

U.S. Venture Partners in recombinant DNA research was based on the belief that it was a waste of “Biotech companies, by Silicon Valley.“You have the money. More, perhaps most, was religious in origin. Man should not play and large, don’t want to capital here. You have the God by mixing genes among species, went the thinking, even if the goal sell,” he says. “Unless,[of people who have been was to create pest-resistant crops or lifesaving drugs. Harvard’s labs course] the price is through startups and who remained closed, which spurred the University of California at San extremely attractive. That celebrate the Francisco and the City of Hope National Medical Center in suburban Los is a sweeping entrepreneurial ethic, so Angeles to speed their collaborative work on developing a man-made generalisation, but I think you have a lot of successful insulin, based on recombinant DNA technology, for use by diabetics.” that it does hold true.”The role models.

Another Photograph © Silverstore/Dreamstime.com, supplied September 2008. picking off of biotech important thing is that in California there is an incredibly diverse mixture of cultures. companies would fit a pattern long established in It is a very friendly place for smart entrepreneurial folks to California, which has lost iconic companies like Bank of come and be successful. So the number of companies that America, Atlantic Richfield, Lockheed and Douglas to outare started by people from India, China and elsewhere, who of-state acquirers. Venture capitalist Krausz however is not attended our universities and chose to stay after graduation, overly concerned. “Historically, when a biotech company has been acquired, after the entrepreneurs who started the is staggering. All this is a hard thing to replicate.”

He’s almost certainly right. The factors that make company do their time with the buyer, they go off and try California so attractive to biotech entrepreneurs are not to do something new again. So that intellectual easily replicated elsewhere and, in the case of the climate, horsepower is often returned to the startup market. simply can’t be duplicated.Yet, there is a villain in the form Acquisitions of biotechs by large pharmaceutical of Big Pharma, the major pharmaceutical companies based companies will not dampen down the creative juices of on the East Coast and in Europe. These giants are startups in California.” It is a comforting thought. For the increasingly investing in and acquiring not only biotechs in sake of medical advances, let us hope he’s right.

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Under DeFeo, Clark became profitable, going from losing $30m a year to earning $18m a year on the same revenues but with three fewer factories and 805 fewer employees. When he put it up for sale, Terex stock jumped to $6 from $4. DeFeo struck a deal to sell Clark for $135m but, as DeFeo tells the story, the buyers tried to get a price reduction of up to $20m.

DeFeo was outraged. He thought he had a firm deal and knew he needed every penny in order to pay down debt and acquire Simon Access, a UK maker of booms and related products. Photograph © Maaillustrations/Dreamstime.com, supplied August 2008.

Can a former Procter & Gamble marketer build a major multinational manufacturer of heavy equipment? You bet he can. In a dozen years Ron DeFeo has changed Terex from a motley crew of troubled companies into the world’s third-largest construction equipment maker.

Since 1997, sales have grown from $842m to $9.1bn, and DeFeo expects to reach $12bn by 2010. “Many people cannot fathom that we have got a $10bn company here—made out of ashes,” he says. Art Detman examines Terex’s successes and challenges.

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COMPANY PROFILE: TEREX

Demand pulls Terex’s turnaround

OST CHIEF EXECUTIVES would love to have the worries facing Ronald M. DeFeo, the 56-year-old chairman and chief executive officer (CEO) of Terex Corporation (TEX).“Our biggest problem right now is meeting demand, especially for cranes,” he says. At June 30th, his company’s backlog—firm orders that customers expect to be filled within 12 months—totalled $4.2bn, up 11% from the comparable figure in 2007. It is a problem nearly everyone serving the international construction industry faces; with commercial and infrastructure projects proceeding at a blistering pace in the Middle East, Africa, Europe, Russia, and China.

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For all its diversity, Terex is a five-cylinder engine firing on Headquartered in Westport, Connecticut, Terex is an unlikely survivor of the US government’s antitrust war with only three cylinders. Although the AWP business generated General Motors. DeFeo joined the company in 1992 as a only 25.6% of Terex’s revenues last year, it accounted for group president and in 1995 was appointed CEO. That year 47.1% of operating earnings. The crane business was 24.5% the company’s per-share loss was $1.69 and its book value of revenues and 26.7% of operating earnings. The mining was a negative $4.66. However, by 1997 Terex was in the equipment segment contributed 22.9% of revenues and black, and in 2007 it turned in its best ever performance. 25.6% of operating earnings. In contrast, the construction Worldwide revenues rose 19.5% to more than $9.1bn. segment produced 20.9% of Terex’s sales but only 5.8% of Operating income climbed 35.5% to $961.4m, and net operating profits. As for the road building and utilities income (fattened by sharply reduced interest costs) rocketed segment, its sales were only 7.4% of Terex’s total, and the 53.5% to $613.9m. The operating profit margin was 10.5%. business generated an operating loss for the year.

Clearly, the AWP business is Terex’s crown jewel. In 2002 Terex’s total assets rose 32% to $6.3bn, and the value of the DeFeo acquired Genie Industries, a California company, and company’s factories and equipment rose 24% to $419m.

Business was even better in 2008’s first half. Revenues rose applied the Genie name to all his company’s AWPs.“Genie is 21.7% to $5.3bn and net income climbed a breathtaking one of the best corporate acquisitions I’ve seen in my 25-year investment career,” says 38.6% to $400m. Per-share Robert Marcin, portfolio earnings surged 41%, to manager at Deflance Asset $3.89 despite the early Clearly, the AWP business is Terex’s Management, a money payoff of high-rate (9¼%) crown jewel. In 2002 DeFeo acquired management firm in notes, which nicked profit Genie Industries, a California company, Pennsylvania that has been by 8 cents a share. This and applied the Genie name to all his a long time Terex good news was not shareholder. anticipated by the market company’s AWPs. “Genie is one of the According to Andrew as recently as October last best corporate acquisitions I’ve seen in my Casey, a senior analyst at year, when TEX shares 25-year investment career,” says Robert Wachovia Capital Markets, went into a swoon.

Marcin, portfolio manager at Defiance Genie has 34% of the aerial Long-time Terex Asset Management, a Pennsylvania platform market, second watchers attributed the money-management firm that has been a only to the 46% market decline to a lack of share of JLG, recently understanding by long-time Terex shareholder. acquired by Oshkosh, the investors about the big manufacturer of fire company’s exposure to the U.S. housing market. “It has to do with the association in trucks and other specialty vehicles. DeFeo says that “JLG people’s minds with the housing slump because of Terex’s stands for Just Like Genie.” Wachovia’s Casey tops that aerial work platform business,” says Charlie Rentschler, an dismissal with this calculation: Genie’s operating profit analyst with the research firm of Wall Street Access. margin beats JLG’s by at least a half percentage point.

As for Terex’s under-performing segments, DeFeo has Rentschler, who has a Strong Buy rating on TEX, concedes that sales of aerial work platforms (AWPs) have been hurt faith in the long-term potential for both businesses. by the slowdown in US residential construction but However, he is not willing to take big risks to build either.

Last year when Ingersoll-Rand offered to sell Bobcat (a contends that investors over-reacted.

Indeed, DeFeo is quick to note that US housing major maker of skid-steer wheeled compact loaders that construction accounts for no more than 15% of Terex’s would have fit perfectly into Terex’s Construction segment) AWP business, and the AWP business in the US totals less DeFeo bid but lost to Doosan of South Korea, which paid than 4% of Terex’s revenues.“The product has a broad list $4.9bn. “I was not going to pay that much because to me of applications,” he says. AWPs are mechanised platforms the business was not worth that price. Instead, we paid that lift workers and materials to heights as great as 135 $450m for ASV,”explains DeFeo. A Minnesota manufacturer of track-driven vehicles feet; they have largely supplanted scaffolding and ladders (which differ from skid-steer wheeled vehicles), ASV is far in many uses.

Ironically, for a company born in the US, Terex has smaller than Bobcat and is expected to generate no more benefitted little from the decline in the US dollar. Its than $250m in sales this year. Even so, DeFeo thinks he got manufacturing centres for mining and construction a company with promising technology at a favourable price. equipment are largely in Europe. “Up to 40% of our The $488m purchase price works out to $18 a share; just construction segment equipment used to be imported,” over half of ASV’s high of $35 in 2007. “ASV’s compact says DeFeo.“Now it is down to only about 15%.”He is not tracked loaders will lead us to the skid-steer loader eager to build a new factory in the US, but hints that category, one of the largest individual product categories in Mexico—with its far lower labour costs—might be the our industry,”DeFeo says. “So we are going to have to build right place to expand the manufacture of heavy equipment. that business; in Europe, in Asia, and in the United States.”

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This past August, DeFeo made a much bigger acquisition, agreeing to purchase privately held Fantuzzi Industries for about €215m.The company, a leading manufacturer of gantry cranes, mobile harbor cranes and other seaport equipment, has factories in Italy, Germany and China. It posted 2007 revenues of €447m, and in 2009 is likely to boostTerex’s overall Crane segment revenues to well over $3.5bn.

As for Terex’s lagging road-building line, here DeFeo thinks the company was sandbagged by the attacks of September 11th in 2001. A month earlier he had agreed to acquire CMI, a manufacturer of road-building equipment based in Oklahoma City. One consequence of the federal government’s response to the 9-11 attacks was to shift spending from infrastructure to security. “The product category that CMI is in had to undergo some dramatic surgery,”says DeFeo.“It has been a real challenge, but I am committed to building that business.”

In hopes of drawing attention to the nation’s need for infrastructure spending, in February this year Terex hosted a symposium at DeFeo’s alma mater, Iona College. The theme was Infrastructure: A Pathway to Prosperity, and well-known Republicans and Democrats took part.“We are hoping to influence both sides of the aisle because this is an issue that should be apolitical,”DeFeo says.

That Terex is taking a leading role in this effort seems reasonable considering its size and product line. The fact is that Terex is a company that not only should not be number three in its industry, it shouldn’t even exist. Its origins date back to the 1920s, when the Euclid Crane and Hoist Company of Euclid, Ohio, introduced two earthmovers. By 1931 the company had a successful line of road-building products and formed the Euclid Road Machinery Company, a subsidiary that became independent in 1933.

Despite the Great Depression, Euclid prospered. Its 1951 introduction of the world’s largest rear-dump hauler, with a capacity of 50 tons, was emblematic of its success.

Euclid’s achievements caught the attention of General Motors, which acquired the company in 1954 and began broadening its product line to challenge Caterpillar Tractor, then as now the world’s largest construction equipment company. In 1959, fearing that GM might be too successful, the US government filed an antitrust lawsuit. GM’s Euclid Division continued to develop powerful crawler tractors and other new products, but it largely ignored the line of trucks it acquired when it bought Euclid. In the late 1960s, GM resolved its antitrust problem by selling the original Euclid line to White Motor Company of Cleveland. It was a terrible deal for White, which paid book value for a line of obsolescent off-road trucks even as its own line of heavyduty over-the-road trucks was losing market share (to GM and others). Within a few years, venerable White Motor fell into bankruptcy and disappeared.

Meanwhile, GM adopted the Terex name—from the Latin “terra” (earth) and “rex” (king)—and continued pursuing Caterpillar. Caterpillar however proved a formidable competitor, and during the 1981 recession GM sold its Terex Division to Germany’s IBH Group, which itself went bankrupt

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Ronald M. DeFeo, chairman and chief executive officer (CEO) of Terex Corporation (TEX).“Our biggest problem right now is meeting demand, especially for cranes,” he says. At June 30th, his company’s backlog—firm orders that customers expect to be filled within 12 months—totalled $4.2bn, up 11% from the comparable figure in 2007. It is a problem nearly everyone serving the international construction industry faces; with commercial and infrastructure projects proceeding at a blistering pace in the Middle East, Africa, Europe, Russia, and China. Photograph kindly supplied by Terex, September 2008.

in the 1983 recession. Terex was later bought by a Wisconsin firm, and then evolved into a holding company, acquiring such well-known businesses as Koehring cranes, Unit Rig mining trucks, Freuhauf trailers, and Clark forklifts. For a while, it appeared that Terex could make everything except money.

“It was a very interesting time,”says DeFeo, who arrived in 1992 as president of the Heavy Equipment Group (since disbanded) and became chief executive in 1995. “We ran the company with a daily cash call.” Terex had sold Freuhauf in 1993 and DeFeo wanted to sell Clark soon after he took over.“I concluded that the forklift business was a high-volume, low-margin business, and that Clark was a great brand in history but was going to be a difficult brand in the future. I examined the kinds of businesses I wanted to be in, and decided that Clark was not among them. I thought we could make a difference in the crane business in North America and a few other product categories.”

Under DeFeo, Clark became profitable, going from losing $30m a year to earning $18m a year on the same revenues but with three fewer factories and 805 fewer employees.

When he put it up for sale, Terex stock jumped to $6 from $4.

DeFeo struck a deal to sell Clark for $135m but, as DeFeo tells the story, the buyers tried to get a price reduction of up to $20m. DeFeo was outraged. He thought he had a firm deal and knew he needed every penny in order to pay down debt and acquire Simon Access, a UK maker of booms and related products. The buyers were convinced that Terex needed to make the sale, so DeFeo called their bluff with a news release announcing termination of negotiations. The stock promptly fell back to $4 (giving the company a market cap of $40m, compared with around $4.8bn now).

Undeterred, DeFeo pressed Clark management to find a buyer, which they did, for $139.5m. DeFeo bought the UK company, which gave it a line of cherry pickers and boomtrucks, both of which worked out well, and a line of aerial work platforms, which did not. “There were a lot of lessons

89

COMPANY PROFILE: TEREX 90

in the aerial platform business that I would apply to Genie when we had the opportunity to acquire Genie,”DeFeo says.

DeFeo came to Terex from JI Case, a big Wisconsin manufacturer of farm machinery that had successfully expanded into construction equipment. He had been a managing director of Case Construction Equipment in Europe, but perhaps equally influential to his management style were his 10 years in brand management at Procter & Gamble, one of the world’s premier consumer products companies. One key to P&G’s success is its utterly pragmatic, unsentimental approach to its brands. No matter how venerable, an under-performing P&G brand will be sold or killed, and it appears DeFeo learned well that lesson.

Freuhauf and Clark were both better known and more widely respected brands that Terex, but DeFeo determined that neither had the potential possessed by Terex.

As it turned out, both Freuhauf and Clark went bankrupt after being sold by Terex, something that DeFeo believes need not have occurred. “They both were fixable. But I could not have built Terex if I also had to build those other two brands. We made Terex stand for a whole bunch of things when people wouldn’t have given us a snowball’s chance in hell of surviving. But I’m used to that. Even today many people can’t fathom the fact that we’ve got a $10bn company here, made out of ashes.”

In seeking acquisitions, DeFeo looks for three things: a strong or at least promising product line, wide distribution (he calls this “geography”), and financial sense (at least a 20% return on invested capital). He also prefers to avoid going head-to-head with Caterpillar, Komatsu or other giant competitors.“We make a lot of products that are not made by those other companies that are perceived to be major players in our industry. That in part was my strategy: to build a company around the edges of what the big, major players had and then long-term to begin to encroach into the middle of the market.” Indeed, DeFeo proudly notes that Terex has achieved its size even though it competes directly with Caterpillar and Komatsu across only about 30% of Terex’s revenues. This is why Terex buys its diesel engines from Cummins, Caterpillar and 15 other suppliers instead of making them itself. It is also why DeFeo has no interest in resurrecting Terex’s line of bulldozers.“That is a business dominated by Caterpillar,”he says.“I believe I can compete in a lot of areas, but sticking my finger in a light socket is not what I want to do.”

Actually, DeFeo has plenty to do as it is. Even though his company ranks third in its industry, Terex is not T. rex. Cat’s construction equipment sales, not counting diesel engines, amounts to around $30bn, three times as much as Terex’s.

Japan’s Komatsu rings up $20bn in construction equipment, twice Terex’s total. The gap is slowly closing however, and maybe Caterpillar and Komatsu even look over their shoulders once in a while. As for DeFeo, he firmly believes Terex can increase both its sales and its profit margins. His goal is $12bn in revenues and an operating profit margin of 12% by 2010. How’s he doing? “On schedule or ahead of schedule,”he says. “That is the place I like to be.”

Photograph© Teacept/Dreamstime.com, supplied September 2008.

TEREX’S MAIN OPERATING SEGMENTS After a quarter century of acquisitions and divestitures, the company owns scores of brand names and manufactures in 15 countries, including the UK, Germany, France and China. Its many acquisitions have given Terex the widest range of products in the construction industry. These are grouped into five operating segments: Aerial Work Platforms: which reported $1.26bn in first-half sales, up 6%. All Terex AWPs are sold under the Genie name, a golden brand in construction equipment.

Cranes: $1.44bn in first-half sales, up 38%. The premier brand here is Demag of Germany; six other historic names are also in use. Whatever the brand, Terex cranes range from truck-mounted booms to giant cranes mounted on endless crawler treads and selferecting cranes used in high-rise construction. The Terex Demag C8800, a twin-boom crane on endless crawler treads that can hoist 32,000 tons, is the company’s most expensive product, with a list price of €23m.

Materials Processing & Mining: $1.25bn in firsthalf sales, up 37%. Powerscreen is Terex’s big brand here. Others include Reedrill tracked hole drillers, Cedarapids tracked crushing plants, Simplicity screening equipment, and two-storey tall Unit Rig mining trucks that can carry payloads of up to 400 tons. Mining equipment — which is used typically 24 hours a day, 365 days a year — can over their seven-year lifetime consume replacement parts worth 1.5 times the original cost of the equipment.

Construction: $1.07bn in first-half sales, up 17.5%.

This segment includes backhoes, front-end loaders, road graders and off-road dump trucks all bearing only the Terex name, plus products co-branded with the Atlas, Fuchs, Powertrain or Schaeff names.

Road Building, Utilities & Other: $360.5m in firsthalf sales, up only 3.7%, reflecting sluggish American sales. This is a catch-all segment that includes Terex portable asphalt plants, portable concrete plants, ready-mix trucks, landfill compactors, cable placers, and digger derricks, Cedarapids asphalt pavers, and Bid-Well roller pavers.

OCTOBER 2008 • FTSE GLOBAL MARKETS

The market reported 2,628,771 securities transactions, with 206,668 securities available for lending (down on the previous month, when 207,111 securities were available for lending), worth some $14,871bn (down from $15,035bn in July). Some 39,239 securities were out on loan, worth $3,983bn.

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 310 separate asset classes in the data set.

Security Type

Lendable Assets (M)

All Securities

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) 124

14,871,150

2,301,022

1,681,845

3,982,867

19.61

28.78

57.18

4.00

9.77

All Bonds

6,839,649

1,301,871

904,990

2,206,861

28.45

3.25

11.87

0.88

8.67

137

Corporate Bonds

3,583,202

244,515

127,654

372,168

8.49

-8.93

-57.71

-0.83

1.70

157

Government Bonds

3,069,410

1,047,046

774,563

1,821,609

53.13

5.71

19.17

2.92

17.20

132

All Equities

8,000,009

999,149

776,844

1,775,993

12.12

60.51

76.73

6.68

10.75

107

Americas Equities

4,560,363

709,375

205,171

914,545

11.68

73.42

73.55

7.65

12.95

113

838,653

65,176

126,379

191,555

13.29

65.42

85.14

7.26

9.87

104

2,215,393

124,794

424,468

549,262

12.35

38.77

85.23

4.39

6.06

110

222,011

48,885

7,690

56,575

13.83

57.35

68.03

5.80

12.67

60

93,334

44,339

7,037

51,376

16.34

45.06

73.31

10.28

19.31

49

Asian Equities European Equities Depository Receipts Exchange Traded Funds

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

Equities:

Corporate Bonds:

Top 10 by Utilisation and Lenders Balance Rank

Stock description

1

Microsoft Corp

2

Top 10 by Utilisation and Lenders Balance

Change on Previous Mth (%)

Rank

Stock description

N/A

1

Bbva Rmbs Li Fondo De Tituli (4.049% 17-Sep-2050)

Alcan Inc

-5.56

2

FN 07 15A GM

3

Barclays Bank Plc

6.59

3

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

4

Spdr S&P Retail

5.72

4

Ge Capital UK Funding (5.87% 01-Aug-2011)

5

North American Palladium Ltd

N/A

5

Pfandbriefbank der schweiz (2.03% 01-Mar-2012)

6

General Motors Corp

-21.88

6

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

7

Denison Mines Corp

N/A

7

Eurohypo Ag (3.611% 15-Jan-2009)

8

A Power Energy Generation Systems Ltd

-13.48

8

Landesbank Hessen-Thueringen Giro (4.125% 09-Jan-2009)

9

Thomson Reuters Corp

4.30

9

Danone Finance (5.03% 12-Dec-2008)

10

Park24 Co Ltd

1.86

10

Montes De Piedad Y Caja De (5.045% 28-Sep-2009)

Collateral management: This is central to the securities lending industry. The following charts detail the cash/non-cash split from a lenders and borrowers perspective.

Collateral Preferences from a Lenders and Borrowers Perspective:

SECURITIES LENDING DATA by DATA EXPLORERS

KEY PERFORMANCE EXPLORER STATISTICS as of 27 August 2008

Disclaimer and copyright notice The above data is provided by Data Explorers Limited and is underpinned by source data provided by Performance Explorer participants and also market data. However, because of the possibility of human or mechanical errors, neither Data Explorers Limited nor the providers of the source or market data can guarantee the accuracy, adequacy, or completeness of the information. This summary contains information that is confidential, and is the property of Data Explorers Limited. It may not be copied, published or used, in whole or in part, for any purpose other than expressly authorised by the owners. info@performanceexplorer.com www.performanceexplorer.com

FTSE GLOBAL MARKETS â&#x20AC;˘ OCTOBER 2008

Š Copyright Data Explorers Limited July 2008

91

Index Level Rebased (31 August 03=100)

5-Year Total Return Performance Graph 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

FTSE GWA Developed Index FTSE RAFI Emerging Index Au g08

Fe b08

Au g07

Fe b07

Au g06

Fe b06

Au g05

Fe b05

Au g04

Fe b04

0

Au g03

MARKET DATA BY FTSE RESEARCH

Global Market Indices

Table of Total Returns Index Name

Currency

Constituents

Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

FTSE All-World Index

USD

2,912

262.15

-12.5

-7.4

-11.3

-14.7

2.85

FTSE World Index

USD

2,445

617.94

-12.1

-6.7

-11.3

-14.0

2.87

FTSE Developed Index

USD

1,997

248.63

-11.4

-6.2

-11.6

-13.8

2.85

FTSE All-World Indices

FTSE Emerging Index

USD

915

586.61

-19.9

-16.1

-8.9

-20.7

2.86

FTSE Advanced Emerging Index

USD

448

544.18

-20.3

-14.2

-7.8

-15.9

3.14

FTSE Secondary Emerging Index

USD

467

690.85

-19.3

-18.6

-10.3

-26.9

2.46

FTSE Global Equity Indices FTSE Global All Cap Index

USD

7,879

419.84

-12.4

-7.3

-11.6

-14.5

2.76

FTSE Developed All Cap Index

USD

6,042

401.51

-11.4

-6.0

-11.7

-13.5

2.75

FTSE Emerging All Cap Index

USD

1,837

772.27

-20.1

-17.2

-10.8

-22.1

2.85

FTSE Advanced Emerging All Cap Index

USD

954

729.03

-20.5

-14.9

-10.0

-16.6

3.14

FTSE Secondary Emerging Index

USD

883

873.98

-19.5

-20.3

-11.7

-28.8

2.44

USD

713

164.89

-1.3

-2.7

11.4

4.1

3.29

FTSE EPRA/NAREIT Global Index

USD

286

2844.69

-12.9

-9.4

-19.0

-14.8

4.67

FTSE EPRA/NAREIT Global REITs Index

USD

188

1012.31

-9.7

-4.6

-15.3

-8.3

5.56

Fixed Income FTSE Global Government Bond Index Real Estate

FTSE EPRA/NAREIT Global Dividend + Index

USD

222

2020.55

-10.6

-6.6

-13.9

-11.8

5.41

FTSE EPRA/NAREIT Global Rental Index

USD

233

1130.94

-9.5

-5.4

-15.8

-8.0

5.32

FTSE EPRA/NAREIT Global Non-Rental Index

USD

53

1121.72

-21.9

-19.6

-27.2

-30.0

2.69

FTSE4Good Global Index

USD

703

6735.64

-11.6

-6.2

-13.8

-15.0

3.41

FTSE4Good Global 100 Index

USD

105

5827.48

-10.6

-4.8

-13.6

-15.3

3.62

FTSE GWA Developed Index

USD

1,997

3731.01

-12.3

-8.0

-14.8

-15.6

3.50

FTSE RAFI Developed ex US 1000 Index

USD

1,011

6313.56

-14.5

-10.6

-13.9

-17.4

4.15

FTSE RAFI Emerging Index

USD

361

6015.82

-18.5

-14.4

-5.3

-18.7

3.38

SRI

Investment Strategy

92

OCTOBER 2008 â&#x20AC;˘ FTSE GLOBAL MARKETS

Americas Market Indices Index Level Rebased (31 August 03=100)

5-Year Total Return Performance Graph 300

FTSE Americas Index

250

FTSE Americas Government Bond Index FTSE EPRA/NAREIT North America Index

200

FTSE EPRA/NAREIT US Dividend+ Index 150

FTSE4Good US Index 100

FTSE GWA US Index FTSE RAFI US 1000 Index Au g08

Fe b08

Au g07

Fe b07

Au g06

Fe b06

Au g05

Fe b05

Au g04

Fe b04

Au g03

50

Table of Total Returns Index Name

Currency

Constituents

Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

FTSE All-World Indices FTSE Americas Index

USD

861

812.76

-9.0

-2.8

-8.7

-10.5

2.17

FTSE North America Index

USD

722

891.18

-8.1

-2.4

-9.6

-10.6

2.14

FTSE Latin America Index

USD

139

1084.24

-22.0

-10.1

10.9

-7.6

2.73

FTSE Global Equity Indices FTSE Americas All Cap Index

USD

2,730

372.29

-8.8

-2.5

-8.4

-10.0

2.07

FTSE North America All Cap Index

USD

2,526

358.03

-8.0

-2.0

-9.2

-10.1

2.04

FTSE Latin America All Cap Index

USD

204

1515.49

-21.9

-10.2

9.8

-7.9

2.72

Fixed Income FTSE Americas Government Bond Index

USD

152

176.05

2.1

0.1

8.8

3.7

3.71

FTSE USA Government Bond Index

USD

134

171.83

2.5

0.5

8.7

4.1

3.70

FTSE EPRA/NAREIT North America Index

USD

117

3536.07

-6.3

5.0

-8.5

0.2

5.02

FTSE EPRA/NAREIT US Dividend+ Index

USD

93

1955.95

-6.2

6.1

-8.1

1.6

5.12

FTSE EPRA/NAREIT North America Rental Index

USD

114

1169.08

-5.0

6.0

-7.4

1.7

5.03

FTSE EPRA/NAREIT North America Non-Rental Index

USD

3

964.23

-27.1

-15.5

-27.9

-23.2

4.95

FTSE NAREIT Composite Index

USD

134

3350.69

-7.1

3.3

-9.3

-1.1

5.77

FTSE NAREIT Equity REITs Index

USD

108

8345.81

-5.7

6.8

-7.0

2.0

5.04

Real Estate

SRI FTSE4Good US Index

USD

146

5256.14

-6.1

-0.7

-14.0

-12.7

2.41

FTSE4Good US 100 Index

USD

101

5055.76

-6.1

-0.8

-13.8

-12.9

2.44

Investment Strategy FTSE GWA US Index

USD

666

3326.78

-8.8

-5.2

-14.7

-13.3

2.61

FTSE RAFI US 1000 Index

USD

1,003

5400.09

-8.9

-6.1

-14.9

-13.7

2.70

FTSE RAFI US Mid Small 1500 Index

USD

1,445

5028.71

-4.7

2.6

-9.4

-5.9

1.78

FTSE GLOBAL MARKETS • OCTOBER 2008

93

5-Year Total Return Performance Graph Index Level Rebased (31 August 03=100)

500

FTSE Europe Index FTSE All-Share Index

400

FTSEurofirst 80 Index 300

FTSE/JSE Top 40 Index FTSE Gilts Fixed All-Stocks Index

200

FTSE EPRA/NAREIT Europe Index 100

FTSE4Good Europe Index 0

Au g08

Fe b08

Au g07

Fe b07

Au g06

Fe b06

Au g05

Fe b05

Au g04

FTSE GWA Developed Europe Index Fe b04

Au g03

MARKET DATA BY FTSE RESEARCH

Europe, Middle East & Africa Indices

FTSE RAFI Europe Index

Table of Total Returns Index Name

Currency

Constituents

Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

FTSE All-World Indices FTSE Europe Index

EUR

574

248.41

-10.8

-7.2

-20.0

-18.7

4.02

FTSE Eurobloc Index

EUR

2,051

139.96

-11.9

-7.6

-19.7

-20.3

3.51

FTSE Developed Europe ex UK Index

EUR

381

249.57

-11.0

-6.9

-19.1

-18.5

4.05

FTSE Developed Europe Index

EUR

511

243.62

-10.2

-6.9

-20.2

-18.4

4.10

FTSE Europe All Cap Index

EUR

1,679

387.69

-10.7

-7.4

-20.7

-18.6

3.92

FTSE Eurobloc All Cap Index

EUR

816

413.26

-11.9

-7.6

-20.3

-20.1

4.12

FTSE Developed Europe ex UK All Cap Index

EUR

1,123

416.38

-11.0

-7.0

-19.7

-18.3

3.96

FTSE Developed Europe All Cap Index

EUR

1,559

382.90

-10.2

-7.1

-20.8

-18.2

3.99

4.01

FTSE Global Equity Indices

Region Specific FTSE All-Share Index

GBP

665

3541.35

-5.9

-2.3

-8.7

-10.1

FTSE 100 Index

GBP

102

3377.75

-5.8

-1.6

-7.1

-9.9

4.10

FTSEurofirst 80 Index

EUR

79

5240.37

-10.9

-7.0

-18.1

-20.4

4.44

FTSEurofirst 100 Index

EUR

99

4652.16

-9.6

-6.2

-18.6

-18.9

4.41

FTSEurofirst 300 Index

EUR

314

1608.67

-9.9

-6.5

-19.3

-18.1

4.12

FTSE/JSE Top 40 Index

SAR

41

2779.09

-14.1

-8.5

0.8

-0.9

2.70

FTSE/JSE All-Share Index

SAR

166

2987.36

-12.4

-8.2

-0.8

-2.6

2.89

FTSE Russia IOB Index

USD

15

1124.60

-33.0

-14.7

-5.0

-22.6

1.87

FTSE Eurozone Government Bond Index

EUR

233

161.15

1.9

-0.6

3.5

2.3

4.57

FTSE Pfandbrief Index

EUR

418

183.04

1.3

-1.0

2.4

1.6

5.14

FTSE Gilts Fixed All-Stocks Index

GBP

29

2097.54

3.9

1.5

6.7

2.2

4.77

FTSE EPRA/NAREIT Europe Index

EUR

93

2200.78

-10.3

-17.3

-32.6

-16.2

4.81

FTSE EPRA/NAREIT Europe REITs Index

EUR

39

780.00

-8.1

-14.6

-29.0

-12.6

4.86

FTSE EPRA/NAREIT Europe ex UK Dividend+ Index

EUR

45

2280.81

-10.8

-13.1

-19.2

-9.1

5.69

FTSE EPRA/NAREIT Europe Rental Index

EUR

79

856.46

-9.6

-16.7

-31.5

-14.8

4.98

FTSE EPRA/NAREIT Europe Non-Rental Index

EUR

14

707.72

-21.0

-27.2

-49.5

-36.6

1.65

FTSE4Good Europe Index

EUR

294

4832.60

-9.3

-6.2

-20.9

-18.3

4.46

FTSE4Good Europe 50 Index

EUR

55

4286.58

-7.7

-4.4

-19.2

-17.4

4.62

FTSE GWA Developed Europe Index

EUR

511

3374.96

-10.6

-7.9

-23.1

-19.8

4.85

FTSE RAFI Europe Index

EUR

519

5169.59

-10.4

-8.6

-22.0

-20.2

4.84

Fixed Income

Real Estate

SRI

Investment Strategy

94

OCTOBER 2008 • FTSE GLOBAL MARKETS

Asia Pacific Market Indices 1400

FTSE Asia Pacific Index

1200

FTSE/ASEAN 40 Index

1000

FTSE/Xinhua China 25 Index

800

FTSE Asia Pacific Government Bond Index

600

FTSE EPRA/NAREIT Asia Index

400

FTSE IDFC India Infrastructure Index

200

FTSE4Good Japan Index

0

Au g08

Fe b08

Au g07

Fe b07

Au g06

Fe b06

Au g05

Fe b05

Au g04

FTSE GWA Japan Index Fe b04

Au g03

Index Level Rebased (31 August 03=100)

5-Year Total Return Performance Graph

FTSE RAFI Kaigai 1000 Index

Table of Total Returns Index Name

Currency

Constituents

Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

2.69

FTSE All-World Indices FTSE Asia Pacific Index

USD

1,325

275.21

-16.2

-13.9

-14.8

-19.4

FTSE Asia Pacific ex Japan Index

USD

860

500.78

-18.2

-17.8

-14.4

-24.6

3.39

FTSE Japan Index

USD

465

103.88

-11.1

-4.6

-20.6

-14.4

1.81

FTSE Asia Pacific All Cap Index

USD

3,262

463.76

-16.5

-14.6

-15.7

-20.2

2.72

FTSE Asia Pacific ex Japan All Cap Index

USD

1,980

619.30

-18.8

-18.9

-15.9

-25.7

3.42

FTSE Japan All Cap Index

USD

1,282

324.61

-10.9

-4.5

-20.8

-14.3

1.82

FTSE Global Equity Indices

Region Specific FTSE/ASEAN Index

USD

156

483.86

-16.5

-17.7

-6.4

-19.9

3.7

FTSE Bursa Malaysia 100 Index

MYR

100

7684.44

-12.9

-19.3

-11.8

-23.3

3.78

TSEC Taiwan 50 Index

TWD

50

6404.50

-13.1

-11.3

-15.4

-12.9

5.35

FTSE Xinhua All-Share Index

CNY

954

5861.82

-34.4

-50.3

-54.3

-54.5

1.32

FTSE/Xinhua China 25 Index

CNY

25

23117.52

-15.6

-15.4

-13.5

-25.6

2.38

USD

258

114.71

-0.7

-3.1

14.7

7.1

1.44

FTSE EPRA/NAREIT Asia Index

USD

76

2190.53

-18.9

-17.7

-25.0

-27.7

4.18

FTSE EPRA/NAREIT Asia 33 Index

USD

38

1438.60

-16.7

-13.9

-21.0

-23.2

7.2

FTSE EPRA/NAREIT Asia Dividend+ Index

USD

51

2199.93

-16.4

-18.2

-20.3

-28.8

5.79

FTSE EPRA/NAREIT Asia Rental Index

USD

40

1115.58

-14.9

-13.5

-22.6

-22.0

6.53

FTSE EPRA/NAREIT Asia Non-Rental Index

USD

36

1149.85

-21.4

-20.4

-26.6

-31.3

2.53

FTSE IDFC India Infrastructure Index

IRP

85

996.20

-18.1

-29.0

-14.7

-45.2

0.65

FTSE IDFC India Infrastructure 30 Index

IRP

30

1065.26

-17.4

-29.8

-12.1

-46.1

0.73

JPY

193

5111.22

-11.3

-3.4

-18.4

-13.4

1.78

FTSE SGX Shariah 100 Index

USD

100

5407.78

-15.9

-12.0

-15.2

-16.1

2.47

FTSE Bursa Malaysia Hijrah Shariah Index

MYR

30

9050.90

-18.3

-24.8

-4.2

-27.0

2.93

JPY

100

1393.15

-10.9

-5.4

-22.6

-15.9

1.90

Fixed Income FTSE Asia Pacific Government Bond Index Real Estate

Infrastructure

SRI FTSE4Good Japan Index Shariah

FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index

JPY

465

3509.51

-10.9

-4.0

-19.2

-13.3

1.86

FTSE GWA Australia Index

AUD

111

4015.22

-8.1

-6.9

-18.5

-18.6

5.85

FTSE RAFI Australia Index

AUD

56

6095.68

-7.8

-7.1

-15.4

-17.2

5.90

FTSE RAFI Singapore Index

SGD

16

7469.67

-8.4

-1.4

-10.4

-10.8

3.92

FTSE RAFI Japan Index

JPY

297

4968.04

-9.8

-3.4

-17.5

-12.3

1.87

FTSE RAFI Kaigai 1000 Index

JPY

1,023

5053.88

-9.6

-5.4

-20.2

-19.4

3.73

HKD

50

6525.03

-36.8

-12.9

-6.4

-22.2

2.89

FTSE RAFI China 50 Index

FTSE GLOBAL MARKETS • OCTOBER 2008

95

CALENDAR

Index Reviews October – December 2008 Date

Index Series

Review Frequency/Type

Effective Data Cut-off (Close of business)

1-Oct 9-Oct 8-Oct Mid Oct Mid Oct 14-Nov 14-Nov Early Dec Early Dec Early Dec Early Dec Early Dec 3-Dec 4-Dec

TOPIX TSEC Taiwan 50 FTSE Xinhua Index Series OMX H25 FTSE / ATHEX 20 Hang Seng MSCI Standard Index Series CAC 40 ATX IBEX 35 OBX S&P / TSX DAX FTSE Global Equity Index Series (incl. FTSE All-World) S&P / ASX Indices OMX I15 FTSE/JSE Africa Index Series FTSE UK Index Series FTSE techMARK 100 FTSE Euromid FTSEurofirst 300 FTSE EPRA/NAREIT Global Real Estate Index Series FTSE eTX Index Series NZSX 50 S&P BRIC 40 S&P US Indices S&P Europe 350 / S&P Euro S&P Topix 150 S&P Asia 50 S&P Latin 40 S&P Global 1200 S&P Global 100 FTSE NAREIT US Real Estate Index Series FTSE NASDAQ Index Series NASDAQ 100 PSI 20 VINX 30 OMX C20 OMX S30 OMX N40 Baltic 10 S&P MIB FTSE Bursa Malaysia Index Series DJ STOXX Russell US Indices

Free float weight periodic review Quarterly review Quarterly review Quarterly review - share in issue Semi-annual review Quarterly review Quarterly review Quarterly review Quarterly review Semi-annual review Semi-annual review Quarterly review Quarterly review

30-Oct 17-Oct 17-Oct 31-Oct 28-Nov 5-Dec 28-Nov 19-Dec 31-Dec 2-Jan 19-Dec 19-Dec 19-Dec

30-Sep 30-Sep 31-Oct 28-Nov 30-Nov 30-Nov 30-Nov 28-Nov 30-Nov

Annual review / North America Quarterly review Semi-annual review Quarterly review Annual review Quarterly review Quarterly review Quarterly review

19-Dec 19-Dec 31-Dec 19-Dec 19-Dec 19-Dec 19-Dec 19-Dec

30-Sep 28-Dec 30-Nov 5-Dec 9-Dec 28-Nov 28-Nov 28-Nov

Quarterly review Quarterly review Quarterly review Annual review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review - shares & IWF

19-Dec 19-Dec 31-Dec 19-Dec 19-Dec 19-Dec 19-Dec 19-Dec 19-Dec 19-Dec 19-Dec

5-Dec 28-Nov 30-Nov 21-Nov 5-Dec 5-Dec 5-Dec 5-Dec 5-Dec 5-Dec 5-Dec

Annual review Annual review Annual review Semi-annual review Semi-annual review Semi-annual review Semi-annual review Semi-annual review Semi-annual review Quarterly review - shares & IWF Annual review Quarterly review Quarterly review - IPO additions only

19-Dec 19-Dec 19-Dec 2-Jan 31-Dec 19-Dec 31-Dec 19-Dec 31-Dec 27-Dec 19-Dec 19-Dec 31-Dec

28-Nov 28-Nov 30-Nov 30-Nov 30 Nov 28-Nov 28-Nov 30-Nov 30-Nov 17-Dec 28-Nov 18-Nov 30-Nov

5-Dec 10-Dec 10-Dec 10-Dec 10-Dec 10-Dec 10-Dec 10-Dec 10-Dec 11-Dec 12-Dec 12-Dec 12-Dec 12-Dec 12-Dec 12-Dec 12-Dec 12-Dec 12-Dec 12-Dec 12-Dec 15-Dec Mid Dec Mid Dec Mid Dec Mid Dec Mid Dec 18-Dec 11-Dec 17-Dec 19-Dec

30-Sep 19-Sep

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

96

OCTOBER 2008 • FTSE GLOBAL MARKETS

THE FTSE I WANT A CLEANER WORLD INDEX FTSE. It’s how the world says index.

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