FTSE Global Markets by FTSE Global Markets

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ROUNDTABLE: HOW WILL SECURITIES LENDING WEATHER MARKET STORMS ISSUE 30 • NOVEMBER/DECEMBER 2008

FTSE updates its market classification US Treasuries: the only way is up Russia honeys up to western investors

APRÉS LE DELUGE

The search for stability SUPPLEMENT: RISK AND RETURN IN 130/30 INVESTMENT APPROACHES

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>> 5P ÂžOE PVU NPSF MPH PO UP KQNPSHBO DPN TFDVSJUJFTMFOEJOH PS DPOUBDU Western Hemisphere Europe, Middle East and Africa Australia/Japan Asia

William Smith at 212-623-5664 Michael Fox at 44-207-742-0256 Stewart Cowan at 61-2-9250-4647 Andrew Cheng at 85-2-2800-1809

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FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2008

IGHT NOW EQUITIES are the only asset that appear to be worth selling; and those in industrial quantities, if the continued trashing of any and all stock indices are anything to go by. In part, it is due to natural uncertainties about the depth and length of the impending recession. In part, it is the fear of aftershocks in the banking sector, which has taken the most consistent pounding. In most part, however, the thrashing of the equity markets must be firmly laid at the door of mark to market pricing and the different values ascribed by various banks to the assets on their books. The current trend of marking down to the lowest common denominator or zero in many cases, is having catastrophic consequences for both the short term and retail debt markets as well as equities. In times of such volatility holding on to cash is deemed safe, equities, even while falling, have at least a market price compared to asset backed securities right now. Vulture funds proliferate in these markets; witness the attention given to Berkshire Hathaway’s buying and selling sprees as a trend maker. Ultra low re-pricing across a slew of assets will mean that those with cash in hand will make more than a pretty penny over the coming months. We have devoted much of this issue, and the next two issues by the way, to a discussion of the outlook for the spectrum of asset classes that have been the darlings of institutional investors over the last three years; and those that will excite and stimulate investors through 2009. US treasuries, high yield debt, LBOs, and a regional report on Latin America make up this series. In future issues, we will tackle derivatives, structured products, hedge funds and Asia; as well as investor focused services, as all these sectors and market segments will undergo significant change. You will have noticed a supplement to this edition. It is hopefully the first of many, covering investment approaches, products and services. In this inaugural edition we look at the pros and cons of 130/30 investing in a volatile marketplace. Launched amid huge amounts of spin in the US, 130/30 investment funds have proliferated, though not evenly around the globe. Australia and the United States appear to have become the leading centres for the investment style; while Japanese fund managers still look askance at the approach and take up in Europe has been at best rather patchy. The investment approach has faced its first set of sustained and major challenges this year; even though quantitative investment methodology, which underpins more than 60% of 130/30 investment funds around the globe has been under strain since early 2007. More recently shorting, which is an important tool for 130/30 investing, has come under restrictions in several countries, such as the United States, Germany, France, and the United Kingdom in varying levels of intensity. Many 130/30 fund managers will have been minimally impacted by the restrictions, for a number of reasons: in all instances, restrictions were introduced only for short periods. In the US they expired early in October, though in Germany they remain until year end. Existing short positions were not restricted and a number of 130/30 fund managers carefully managed their holding period average, therefore rebalancing new positions will form only a small part of their total portfolio holdings. The supplement will hopefully provide readers with a comprehensive guide to 130/30 investing; asking important questions about the efficacy of the investment approach and testing the performance data provided by 130/30 fund managers to date.

Francesca Carnevale, Editorial Director November 2008

COVER PHOTO: Aprés le Deluge: Federal Reserve Board chairman Ben Bernanke (right) and Treasury Secretary Henry Paulson testify before the House Financial Services Committee on Capitol Hill in Washington on Wednesday, the 28th September. Photograph by Manuel Balce Ceneta, supplied by Associated Press/PA Photos, October 2008.

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Contents COVER STORY COVER STORY: AFTER THE FLOOD ..........................................................................Page 58

The long term consequences of the liquidity crisis that gained momentum through the autumn months are difficult to quantify. The gathering consensus is that more institutions will fail and radical changes to the structure of the global financial services industry are inevitable. We lead with a global round robin of the challenges and opportunities facing the banking markets on a global and regional basis.

DEPARTMENTS MARKET LEADER

..........................................Page 6 Vanja Dragomanovich on the resurgence of the disaster related asset class.

THE COMEBACK OF CATASTROPHE BONDS

WHY GERMANY STILL WORRIES ABOUT SOVEREIGN FUNDS ..Page 14 Dr Michael Fischer, partner, Reed Smith on the impact of impending legislation.

IN THE MARKETS

HOLDING THEIR OWN: FRENCH & GERMAN PRIVATE EQUITY ........Page 18 Graham Olive, head of Northern Europe Leveraged Finance at Natixis reports.

............................................Page 20 Anthony Riem, partner, PCB Litigation LLP explains the rights of asset owners

RECOVERING ASSETS IN CASES OF FRAUD

SECTOR REPORT

......................Page 24 Ian Williams on what is rocking the world of ImClone, Eli Lilly and Carl Icahn right now.

HIGH RISK/HIGH RETURN PHARMA STRATEGIES

....Page 28 Simon Denham, managing director, Capital Spreads, takes a bearish long view.

IS THERE ANYBODY OUT THERE WILLING TO TAKE A RISK?

INDEX REVIEW

..........................................................Page 29 South Korea is now developed; Saudi Arabia has a special category of its own, among a raft of changes.

MARKET CLASSIFICATION CHANGES

............................Page 31 Option traders thrive on volatility, how long can the good/bad times last? By Neil O’Hara.

INDEX OPTIONS: VOLUMES AT RECORD LEVELS

............................................Page 35 Why did the Russian government request a meeting with key western fund managers?

THAWING RUSSIA’S NEW COLD WAR

COUNTRY REPORT

..................................................Page 36 Yesterday the Ukraine was everyone’s favourite frontier market: what’s the problem now?

THE TROUBLE WITH THE UKRAINE

....................................Page 41 David Simons reports on the export of DMA into the emerging markets.

THE SLOW BUT STEADY EXPORT OF DMA

TRADING REPORT/DMA INVESTOR SERVICES DATA PAGES 2

............................................................................Page 45 Tim Wildenberg, managing director, head of direct execution services, Europe, UBS reports.

EUROPE HOT WIRES DMA

NORTHERN LIGHTS ..........................................................................................Page 83

Lynn Strongin Dodds on the fight for market share in the competitive Nordic custody market.

ETF Data, supplied by Barclays Global Investors ....................................................Page 87 Securities Lending Trends by Data Explorer ............................................................Page 91 Market Reports by FTSE Research ..............................................................................Page 92 Index Calendar ..............................................................................................................Page 96

NOVEMBER/DECEMBER 2008 • FTSE GLOBAL MARKETS

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Contents FEATURES SECURITIES LENDING ROUNDTABLE

SECURITIES LENDING: A BELLWETHER OF MARKET CHANGE ..........................................Page 49

“At a time like this, our absolute focus must be on risk management, and staying very close to our clients and explaining to them what is happening every step of the way; so that they can make appropriate choices about the assets they lend in this market. Right now, people are managing risk on a day to day basis, and obviously looking at how they may change their lending practices in future to take on board any lessons learned from current events.” So says Richard Steele, executive director, Financing & Market Products, JPMorgan Worldwide Securities Services. Find out what other participants had to say.

APRÉS LE DELUGE

US TREASURIES....................................................................................................Page 62

The US Treasury's funding activity indicates how intense investors' aversion to risk has become. Short term rates have plummeted even though the market has had to absorb unprecedented quantities of Treasury bills. The rate dipped briefly below zero at one point, which hasn't happened since the early 1930s. Neil O’Hara reports on the outlook for the asset class in 2009.

HIGH YIELD DEBT..............................................................................................Page 64

US high yield bonds got whacked as the credit markets unravelled this year. Even though the default rate for high yield bonds rated by Standard & Poor's has ticked up from a record low of less than 1% at the end of 2007 to 2.5% in August, current spreads suggest the market expects a much higher rate over the next couple of years. By Neil O’Hara.

PRIVATE EQUITY IN ASIA............................................................................Page 67

Asia was one of the jewels in the private equity crown. Record sums were raised to tap into the buoyant economies of India and China which were seemingly following their own and not Western path. The credit crunch was an issue but not a significant factor until this autumn when it erupted into a full blown major global financial crisis; and valuations and volumes are likely to fall further. Lynn Strongin Dodds reports.

THE OUTLOOK FOR LBOS ..........................................................................Page 71

"Anything with the word 'leverage' is sure to emote thoughts of the plague, or a nuclear spill,” says one New York based financial advisor. Others, luckily, are more sanguine. Preqin's Private Equity Report for the third quarter this year, however reports that there currently 284 buyout funds "on the road" trying to raise commitments of $310.4bn. Ian Williams reports on a sector that may defy expectations in 2009, as larger LBO houses find they have cash to burn.

LATIN AMERICA: IN THE WAKE OF THE STORM ..................Page 74

Almost unnoticed in the wider news, the World Bank slashed growth expectations for Latin America to between 2.5% and 3.5% for next year, down from 4.6% this year. The figures look provisional and could well be lowered again. Foreign-owned banks are holding back credit while domestic banks are facing tougher credit conditions from correspondent banks, are having to postpone capital raising plans, and have seen shares swoon. John Rumsey reports on the crisis now affecting South America.

COLLATERAL MANAGEMENT ................................................................Page 78

Collateral management has been gaining traction as a risk management tool but the recent tumultuous events has pushed it to a new level. The biggest fear of a counterparty default was realised when Lehman toppled, but the industry seems to have weathered the storm. The current crisis is only stoking the uncertainty and investors are increasingly running for cover under the collateral banner. Lynn Strongin Dodds reports.

NOVEMBER/DECEMBER 2008 • FTSE GLOBAL MARKETS

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Market Leader HURRICANE FUTURES & CATASTROPHE BONDS

CATBONDS IN THE EYE OF THE STORM E

Photograph © Elksister/Dreamstime.com, supplied October 2008.

Even while the financial markets remained storm-tossed through the autumn months downpours of a completely different style and magnitude created equal havoc elsewhere. In midSeptember hurricane Ike hit Houston, the fourth largest city in the United States, leaving behind a city without power supply, but with demolished roofs, torn trees and too liberal amounts of debris. Although badly hit, Houston, which is 50 miles inland, faired much better than Galveston on the coast. The hurricane came onshore at 110 miles per hour and with a 12-foot storm surge. Galveston was left uninhabitable. With natural disasters a fact of life in rather too many countries (rich and poor), Vanya Dragomanovich looks at the different ways that corporations and insurance companies transfer risk in the capital markets.

ARLY FORECASTS ESTIMATE that Hurricane Ike, which ripped through the state of Texas, in late September, triggered in excess of $27bn worth of damage, with Galveston and Houston taking the brunt of the storm’s ire. Hurricane Gustav, meanwhile, which surged through the Caribbean in August (the second major event of the 2008 Atlantic hurricane season) caused at least $15bn worth of damage in Haiti, the Dominican Republic, Jamaica, the Cayman Islands, Cuba and the US to boot. While neither storm resulted in the level of damage effected by Hurricane Katrina in 2005 (about $79bn worth); the harm is substantial indeed. These fierce displays of natural force invariably have a significant financial impact: not only on people whose homes were demolished; but also on a whole hosts of industries operating in affected areas. Municipalities, utilities and energy producers are high on that list, but the insurance industry is finding it particularly hard to cope with the aftermath of such events. Moreover, after Hurricane Katrina, the largest US insurers all but stopped selling insurance in hurricane prone states, such as Florida.

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Market Leader HURRICANE FUTURES & CATASTROPHE BONDS

Former President Bill Clinton looks on during the opening plenary of the Clinton Global Initiative annual meeting, held on Wednesday, September 24th this year in NewYork. Former President Clinton and former President George Bush are joining forces again to help victims of natural disaster.This time they are teaming up to help out the victims of Hurricane Ike.The former presidents previously worked together to raise $11m for tsunami victims, then worked to raise private money to help victims of hurricanes Katrina and Rita. Photograph by Jason DeCrow, supplied by AP Photos, October 2008.

With these issues in mind the Chicago Mercantile Exchange (CME) launched hurricane futures contracts last June. The derivatives are geared toward companies that want to transfer the risk of hurricanes to the capital markets and are based on specific indices maintained by reinsurance company Carvill, which calculate a storm’s damage potential by measuring its size and maximum winds. The Carvill Hurricane Index gives the market a numerical measure for a specific hurricane’s potential for damage. Hurricanes are typically classified according to the SaffirSimpson Hurricane Scale (SSHS) into categories one to five. However, according to Carvill, there are a number of features inherent in the

scale that make it less suitable to be used as a market index. For example, meteorologists have to quantify SSHS categories as either strong or weak in order to make a proper distinction of the storm. Hurricane Katrina, for instance, was described as a weak category four storm at the time of its landfall, but this description was far from providing a real estimate of the actual physical impact. The Carvill Hurricane Index incorporates additional factors, such as sustained wind speed and the radius of hurricane force winds, and represents a continuous measurement, rather than a discrete scale, starting from zero. Disturbingly, it has no maximum value, leaving scope for those record-breaking storms that occasionally wreak total

havoc with the US coast. Hurricane Wilma, in 2005, was the most intense hurricane ever recorded in the Atlantic basin, and at one point in its brief life, the strongest storm on record. Carvill argues that those with money on the line need to be able to make a more informed distinction between storms. According to back data, the CHI highlights that at its strongest, Katrina still had more potential to do damage than Wilma, despite its lower wind speed, as it was a far wider storm. The SSHS, by comparison, does not take this potential for destruction into consideration. Carvill tracks hurricanes using information from the National Weather Service’s hurricane centre and calculates activity affecting the US

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THE FTSE I WANT THE WORLD INDEX FTSE. It’s how the world says index. Global markets grow more complex and interconnected every day.To stay abreast, you need a comprehensive index that can slice and dice markets the way you do. The FTSE Global Equity Index Series was the first benchmark to cover the world seamlessly with a single consistent and transparent methodology. Because FTSE indices are independently verified by a panel of market practitioners, you can be sure that they will always be in line with investors’ needs. Wherever you invest, FTSE gives you the clearest view of how you are doing. www.ftse.com/invest_world

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

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Market Leader HURRICANE FUTURES & CATASTROPHE BONDS

coastline. Users include insurance is better for us to carry these risks There are also bonds that include risk from earthquakes and other companies, hedge funds, energy ourselves and are self-insured.” catastrophic events, Even so, this is not the whole potentially producers, pension funds, state governments, and utilities, either picture. During Hurricanes Ike and including terrorist attacks. Catastrophe bonds first appeared on looking to hedge their hurricane risk Gustav BP sustained minimal damage or attracted by its uncorrelated to all but one of its platforms (called the radar screens in the early 1990s, benefits. The front contract expires Mad Dog). However, BP says that after Hurricane Andrew left insurers when a hurricane makes landfall and although most of its crews returned to footing a bill for more than $23bn in damages. Total losses for is settle in 36 hours. The CME has developed three insurers after Hurricane types of contracts for Andrew exceeded all of the The Carvill Hurricane Index hurricane futures and insurance premiums ever incorporates additional factors, such as options in six defined areas – collected in Dade County, sustained wind speed and the radius of the Gulf Coast, Florida, the the worst hit part of the US, Southern Atlantic Coast, the forcing a number of hurricane force winds, and represents a Northern Atlantic Coast, the insurance companies into continuous measurement, rather than a bankruptcy. Overnight there Eastern US, and CHI-Catdiscrete scale, starting from zero. was intense awareness of In-A-Box-GalvestonDisturbingly, it has no maximum value, the possible affects of Mobile [sic]. The last covers leaving scope for those record-breaking climate change on swathes 90% of the vulnerable of US coast where a lot of offshore drilling areas and is storms that occasionally wreak total building had been done over geared towards attracting havoc with the US coast. Hurricane the last couple of decades energy companies. Wilma, in 2005, was the most intense and where a significant According to the CME hurricane ever recorded in the Atlantic portion of population was there has been steady basin, and at one point in its brief life, fairly affluent. growth in contracts traded the strongest storm on record. Although a number of since launch and this year financial instruments were 32,600 contracts exchanged hands. Although the CME developed since then, says it is happy with the speed at the platforms shortly after the including weather futures, as the which to contract is gathering hurricanes, much of its ability to memory of Andrew grew fainter, so momentum demand for these produce oil was affected by third-party did trading. However interest in instruments is still fairly thin compared pipeline operators that sustained weather-related instruments such as with some other futures contracts significant damage to their operations. cat bonds grew dramatically after the launched around the world in the last As a rough guideline, BP produces Hurricanes Katrina and Rita in 2005. That year there was a record 12 months, such as the London Metal 290m barrels of oil equivalent per day number of named storms, with four in the Gulf of Mexico. Exchange’s steel contract. State Farm Insurance, one of US’s major hurricanes making landfall in Part of the reason is that, while hedge funds such as Bermuda-based Nephila largest insurers, also opted for a the US. In the case of State Farm Capital, which has a strong focus on different route of hedging its Insurance, in 2007 the company sold weather instruments, have embraced exposure: catastrophe bonds. These $1.18bn of catastrophe bonds to the idea of hurricane futures the bonds are typically issued by various institutional investors. It is a industries it is aimed at are slow to get insurance companies which take the three-year deal using a certain level of involved. BP America, for instance, has premiums on property and casualty claims, which the company wouldn’t a significant number of oil platforms in policies, repackage them and then sell disclose, as a bond trigger. “We were the Gulf of Mexico but decided against the products to investors at attractive looking for ways to manage our risk,” using futures for insurance. interest rates. Most hurricane-related explains Dick Luedke, spokesman at Daren Beaudo at BP America says bonds are weighted to exposures in State Farm Insurance in South that “we have taken the judgment, Florida and Texas but there are also Caroline, and adds that the which is reviewed periodically, that it some with Gulf Coast exposures. catastrophe bond is“a deal that makes

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Market Leader HURRICANE FUTURES & CATASTROPHE BONDS

sense for insurers because we need total confidence that we will have enough finance to cover all claims. Another major US insurer, Allstate, was planning to issue $4bn worth of cat bonds this year. The difficulty for insurers comes mainly from the fact that they cannot predict hurricane losses and therefore find it hard to budget for them.“When our actuaries try and figure out how much we will pay in claims for auto accidents in a year they take a number of claims and they can come up with a pretty accurate estimate. When it comes to hurricanes in any one year there may be significant claims or there may be none,”says Luedke. The deal, though costly, makes sense for insurance companies. For investors, there is diversification, but on the down side there is a risk of loosing the entire principal of the bonds they have bought if the event is catastrophic enough to hit what is called a bond trigger. Risk is packaged into securities that are sold to investors at the beginning of the risk period, which effectively forms a kind of collateralized protection. Before rating agencies will rate the securities, the risk involved must be modeled by a third party. Depending on the structure of the particular

bond, trigger for payment can be proof of loss or only the event. The bonds set thresholds for claims or use factors such as wind speed at landfall to set the triggers. In practice then, a Category 4 or Category 5 hurricane reaching landfall in Texas would trigger a principle loss for investors. The current market volume for catastrophe bonds is over $15bn. Hedge funds dedicated to insurancelinked securities are estimated to hold over 40% of that, traditional funds account for some 20% and multistrategy hedge funds around 15%. The appeal is obvious particularly in current market conditions—a complete lack of correlation to other asset classes. Secondary trading of cat bonds remains an illiquid and not transparent market but is slowly picking up, particularly after events such as Ike and Gustav. In recognition of that, reinsurer Swiss Re last year launched a basket of catastrophe bond indices aimed at increasing the transparency of cat bond returns. The indices track the performance of the main basket, all outstanding dollardenominated catastrophe bonds, which include Single-Peril US Wind Cat Bonds, Single-Peril California Earthquake Cat Bonds and S&P-rated BB Cat Bonds.

Going forward trade in both catastrophe bonds and hurricane futures will be dominated by what happens with the weather. Between Andrew in 1992 and Katrina in 2005 there were a large number of hurricanes but none on the same scale as those two. After an initial flurry of activity after both event trading slowed down to a quieter pace. Trying to analyse what the weather will do next is as good as impossible. Looking at the last 20 years, which in terms of weather is not a long period, there was Andrew in 1992, Wilma in 2004 and Katrina in 2005. Two relatively calm seasons followed in 2006 and 2007 and then there were Gustav and Ike this year. It is because of this lack of predictability and the relative infrequent nature of major disasters that large companies such as BP feel they can carry the cost of the events themselves rather than opt for a financial hedge. Smaller and mediumsized firms may find it harder to protect themselves financially. But if, as climate change forecasters predict, hurricanes become more frequent then instruments such as hurricane futures and catastrophe bonds will come into their own. This is possibly little solace for those cleaning up the debris in Houston and Galveston.

EXPLAINING CAT BONDS atastrophe bonds (also known as cat bonds) are risk-linked securities that transfer a specified set of risks from a sponsor to investors. They are often structured as floating rate corporate bonds whose principal is forgiven if specified trigger conditions are met. Catastrophe bonds are used by insurers and reinsurers to spread the risk against high severity, low frequency events like natural disasters and even terror attacks. The issuer of a catastrophe bond, in consultation with an investment bank, typically sets up a special purpose vehicle and raises enough capital from investors to cover a defined event. That money is then reinvested into high quality assets. Bond holders get a periodic return from those investments, plus premiums from the insurance company’s customers. Generally, but not always, investors should expect a coupon of LIBOR plus a spread (anywhere between 3% and 20%). If the insured event happens, the insurance company pays out its customers from the catastrophe bonds funds. If it doesn’t, bond holders get their principal returned, along with earnings.

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

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In the Markets GERMANY: THE IMPACT OF CHANGES TO THE LAW ON FOREIGN TRADE & FDI

GERMANY RE-ACTS TO SOVEREIGN WEALTH FUNDS German Chancellor Angela Merkel’s ruling coalition unveiled farreaching rules in the late summer to head off powerful foreignowned state-controlled funds buying up key German industries, such as telecoms, banks and energy sectors, by cash-rich state funds from Russia, the Middle East and China. The proposals, which still need parliamentary approval, but has been approved by the Federal Cabinet, will mean that moves by non-European Union controlled investment groups or companies to buy a stake of 25% or more in strategic parts of German industry can and will be blocked. The draft bill has attracted much attention abroad as well as in Germany. Some commentators flatly regard it as an attempt to vest the ministry with powers to avert the exertion of political and economic influence on German key industries by foreign state investors. Dr Michael Fischer, partner, Reed Smith Germany comments on the impact of impending legislation. HE GERMAN FEDERAL Ministry of Economics and Technology has initiated changes to the law on foreign trade, which could have an impact on foreign investors’ investing in German companies. The bill, which has just been approved by the German Federal Cabinet, prescribes amendments to both the Foreign Trade and Payments Act (Außenwirtschaftsgesetz) as well as to the Foreign Trade and Payments Regulation (Außenwirtschaftsverordnung), and is expected to become effective this year after approval by the German Parliament. Sovereign wealth funds (SWF) are state-owned investment funds composed of financial assets or other financial instruments. They are created for a variety of purposes, ranging from purely economic roles (such as binding excess liquidity to reduce inflation or securing national wealth) to purely strategic aims (such as creating war chests for uncertain times). The number and wealth of these funds has increased dramatically over the last few years, making them a powerful tool in the

hands of foreign states; a fact which appears to have unnerved the German government somewhat. The legislation now in play aims to create a more flexible instrument governing foreign direct investment (FDI), and which, according to government blurb, “shall not serve the interests of security policy in the narrow sense of the word but protect the infrastructure and security of supply”. The draft bill therefore provides for the introduction of the criteria of public law and security of the Federal Republic of Germany into investment legislation; and the extent to which this will curtail foreign shareholding in key strategic sectors in the German economy is still open to question. “The majority of foreign investments won’t be affected by the draft law,” Economy minister Michael Glos told the German press when setting out details of the proposals. “Germany is and remains open to foreign investments.” The regulation is already contained in Section 52 of the Foreign Trade and Payments Regulation and is understood to be an elaboration of a general clause

Dr Michael Fischer, partner, Reed Smith Germany. Although the Federal Ministry of Economics and Technology emphasises that it will intervene in exceptional cases only, investors intending to acquire at least 25% of the voting rights in German companies operating in sensitive areas are now well advised to submit their potential investment plans to the ministry for review. Photograph © Ronald Hudson/Dreamstime.com, supplied October 2008.

and a rule example pursuant to Section 7 paragraph 2, number 5 of the Foreign Trade and Payments Act according to which any legal transactions the subject of which is the purchase of domestic companies or legal transactions on the acquisition of shares in domestic companies, which produce or develop military weapons or other military equipment or cryptographic systems may be restricted in order to guarantee the vital political and security interests of the Federal Republic of Germany. Moreover, up to now, the acquisition of 25% or more of the voting rights by a non-resident investor (that is, from outside the European Community) in a company whose prime business is the development or production of military weapons, related materials and crypto systems must be notified to, and can be outrightly prohibited, by the Federal Ministry of Economics and Technology. The application of that prohibition depends to what extent the government needs to take steps to guarantee or secure essential security interests of the Federal Republic. Although the Federal Ministry of Economics and Technology emphasises that it will intervene in exceptional cases only, investors

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In the Markets GERMANY: THE IMPACT OF CHANGES TO THE LAW ON FOREIGN TRADE & FDI

intending to acquire at least 25% of the voting rights in German companies operating in sensitive areas are now well advised to submit their potential investment plans to the ministry for review. Investors will need to submit the complete documentation before or immediately after signing a sale and purchase agreement, or in the case of a public take-over, the announcement of a take-over bid. Under the terms of the law, the ministry must provide feedback within one month of receiving the submission, otherwise the acquisition will become effective. However, any influence exerted by the state in this area can affect the freedom of capital movement according to Article 56 of the Treaty of the European Community (which is also open to third countries). Therefore, the entire regulation including the terms public law and security must be construed in this context and in line with the rulings and understanding of the European Court of Justice. For this reason the German legislator felt it encumbant to make the present legislation more precise and less discretionary. It is worth mentioning that indirect acquisitions by so-called European Community non-residents will also be covered by the legislation.Voting rights of other shareholders are legally attributed to the Community nonresident, provided that the Community non-resident holds 25% or more of the voting rights in the other shareholder. Voting rights of third parties are also legally attributed if they are subject to a voting agreement. Investments affected will be held as ‘pending’ for a three-month period after the signing/announcement of a take-over bid. Strictly speaking, only the contractual part of the acquisition, which is subject to the law of obligations, is pending. It is subject to

the will of the Ministry, which can prohibit the acquisition within the set three-month period. Only once this condition has been fulfilled will the mutual obligations of the parties under the acquisition agreement (i.e. essentially assignment and transfer of the object of the purchase—such as shares— against payment of the purchase price) be fulfilled. According to a German legal peculiarity called the principle of abstraction, the transfer and assignment of, for example, shares to fulfill the purchase agreement, is legally independent from the underlying obligation. Thus, the transfer and assignment agreement remains in effect even though the underlying (obligatory) relationship is not. As a consequence, once a share purchase agreement was implemented but later on prohibited, the agreement will have to be unwound. However, this is evidently difficult if not impossible in cases where 25% or more of the voting rights were not acquired as a whole but successively. Most of the former shareholders will not be known by name. It is also unclear whether it will be sufficient to reduce the shareholding to 24.99% in such cases to avoid any difficulty. Against this background, it is debatable whether or not the 25% threshold does make sense at all. On many occasions, possession of as little as 10% of the voting rights puts a shareholder in the position to block resolutions in a general shareholders’ meetings of listed corporations because decisions are taken on a majority basis. On average the attendance at shareholders’ meetings ranges between 50% and 80% of shareholders. German corporate law requires at least a 75% majority for the passing of special resolutions compared to a simple majority of

votes cast for ordinary resolutions. However, the required 75% majority relates to the share capital present at the shareholders’ meeting. In case the right to request documents within the three-month period is exercised, the purchaser must provide the Ministry with the complete documentation of the acquisition and the involved companies and their business activities. Only after the expiration of a further one-month period, and if no prohibition or limitation order is made, will the acquisition become effective. The acquisition can only be prohibited or limited or instructions be issued, if this measure is necessary to guarantee public law and security of the Federal Republic of Germany. However, in light of the referenced jurisdiction of the European Court of Justice, only direct and serious endangerment to the protection of the interests of the public in Germany will justify a prohibition or limitation. A prohibition of an acquisition can only serve as a last resort and the question will always arise as to whether the available mechanisms of market control under the existing competition law or according to the existing trade law are sufficient. As is increasingly stressed, a common European approach, ideally in common with the United States, would be desirable as a way forward. In this regard, a welcome step is action by the .International Monetary Fund (IMF) to encourage more transparency by foreign investors and has plans for a global code of conduct. Added to this, the International Working Group of Sovereign Wealth Funds has just reached preliminary agreement on draft set Generally Accepted Principles and Practices (often referred to as the Santiago Principles), setting out voluntary rules of engagement. We still have some way to go before clarity is achieved however.

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In the Markets OUTLOOK FOR FRENCH & GERMAN LBOS

HARDY PERENNIALS DEFY DOWNTURN The European leveraged finance market is clearly in a downturn, with the market largely frozen for large leveraged transactions. Moreover, the confidence of debt arrangers remains shaken and stirred. In recent weeks, a number of high profile large corporate sale processes have been postponed as sponsors struggle to find sufficient leverage to meet vendor expectations. However, both the French and German markets appear to show some signs of resilience in the face of the downturn. Graham Olive, head of Northern Europe Leveraged Finance at Natixis reports. RANCE AND GERMANY appear particularly resilient in the face of a general downturn in the European leveraged buy-out market, marginally increasing their share of the overall European market between June 2007 and June 2008 by 5% while the UK, Netherlands, Sweden and Spain have all registered declines. Recent estimates have it that France and Germany each enjoy a 20% share of the European private equity market right now. The hardiness of the French and German buyout markets is in part due the fact that both countries enjoy vibrant mid-market sectors, which continue to fuel acquisition activity. At the end of June this year, for instance, the number of buyouts with a debt value of over €500m had fallen by two thirds, while those with a value below €250m had reduced by significantly less. Even so, the largest LBO deals in each country this year indicate that there remains residual appetite for larger deals as well. Power group Converteam in France and construction materials provider Xella in Germany both sold for enterprise values of more than €1.5bn. Additionally, French and German borrowers have tended to be slower to embrace new pools of liquidity; and therefore are less dependent on jittery foreign institutional investors as limited partners. Moreover, French banks typically sustain long term relationships

with their clients, which to a certain extent stabilises the liquidity of France’s debt markets. The importance of these close banking relationships was underlined by the recent agreement of the four remaining book runners (HSBC, Natixis, RBS and Société Générale) to assume the underwriting obligations of Lehman Brothers in respect of the buyout of Converteam, France’s largest LBO so far this year. Equally, Germany’s industrial sector currently remains robust due to strong export markets in central Europe, Asia and the Middle East. Its flexible labour market continues to drive improved margins and growth in the corporate sector. As well, there is growing acceptance of private equity investment in the traditionally conservative German mid-market sector and also a gradually improving legal environment for business. These conditions have attracted new national and international lenders into Germany’s leveraged market over the last 18 months; in particular French banks. Debt multiples are, on the other hand, decreasing in Germany. At the half-year point leverage was over half a turn of earnings before interest, tax, depreciation and amortisation lower than at the same period in 2007, indicating that sponsor equity is providing the support for these higher purchase prices. A number of midmarket buyouts have recently closed

in the German industrial sector over the last few weeks, demonstrating the ability of private equity sponsors to successfully marry target investment returns and more cautious leveraged structures with vendor expectations. A common driver of the leveraged markets in both France and Germany is the relatively low level of private equity penetration. Private equity investment as a percentage of GDP is 1.7% in the UK but only 0.6% in France and 0.4% in Germany against a European average of 0.6%. A number of substantial, recently closed private equity fundraisings in both countries attest to the continued attraction of the asset class despite the more difficult near-term outlook. It is also widely acknowledged that the most attractive private equity returns have flowed from the fund vintages that invested after a market downturn. Economic visibility has deteriorated in both markets following recent more negative second quarter GDP figures and inflation pressures remain strong, albeit some commentators feel that they have now peaked. Indeed, surprisingly strong German retail sales in August and a fall in unemployment in September were attributed to falling energy costs, for instance. France meanwhile experienced a small upswing in consumer confidence in August. The consensus then, is that France and Germany are entering the slowdown with relatively robust economic fundamentals. Debt multiples are, however, decreasing in Germany— at the half-year point this year leverage was over half a turn of earnings before interest, tax, depreciation and amortisation lower than the same period in 2007, indicating that sponsor equity is providing the support for any higher purchase prices.

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In the Markets RECOVERY OF INTERNATIONAL ASSETS IN CASES OF FRAUD

The multi-jurisdictional nature of many hedge funds, their investors and the companies in which they invest, can make any associated litigation a daunting prospect. However, in the current financial climate, parties involved in or with hedge funds are increasingly looking to litigate in order to recoup funds lost to negligence, fraud or simply a falling market. A startling example of what can happen when things go wrong is the recent Hermitage Capital Management (HMC). This complex fraud involved three investment companies belonging to HMC which were allegedly re-registered by fraudsters. Bogus court claims were made against the companies who then claimed huge losses as a result of the litigation and themselves claimed $230m from Russian tax authorities. The Russian authorities have since raided the offices of several of HMC’s lawyers in an apparent attempt to link them to the fraud. By Anthony Riem, partner, PCB Litigation LLP.

Photograph © Boguslaw Mazur/Dreamstime.com, supplied October 2008.

RESPONSES TO FRAUD ONTRARY TO THE common perception that nothing can be done, Courts in a number of jurisdictions have developed a number of wide-ranging powers that are capable of international enforcement to enable victims of fraud and other wrongdoing recover their losses. In particular, the Courts recognise that fraud victims face a number of very specific hurdles that need to be overcome if they are to recover their losses.These losses include the fact that the fraudster will act covertly in committing the crime, concealing his identity and assets, the latter of which he will transfer internationally at a touch of a button. To overcome those hurdles, certain Courts have developed powers that enable the victim to establish the extent of the fraud and identity of the fraudster, his assets and freeze them, all without notifying him that these steps are being taken. To maximise the prospects of recovering assets, it is important to adopt the appropriate strategy which, in turn, requires the instruction of a specialist recovery team. The team should comprise a lawyer to formulate and execute the

strategy and to ensure compliance with local laws; an investigator to carry out enquiries; a digital forensic expert to investigate and preserve the integrity of electronic evidence and a forensic accountant to evaluate the extent of the fraud and losses. The first steps to take, even before issuing any claim, are to comply with any obligations such as to report the matter to insurers and to comply with any statutory or regulatory obligations. It is then to evaluate the extent of the fraud and the prospects of recovering any losses as this will assist in determining whether it is commercially worthwhile doing so.This will invariably involve consideration of considerable electronic documentation to determine whether the fraud is ongoing, the extent of the losses and whether the fraudster can be identified as well as the location of his assets and the stolen money. Given that about 80% of frauds are committed by or with the assistance of a director/senior manager or employee, it is important that any investigation is carried out without tipping off the fraudster or his accomplice and that the integrity of electronic evidence is

preserved. Investigations often need to be carried out in number of countries and it is important that they carried out in accordance with local laws. Where unusual steps are contemplated, then consideration should be given to whether there is a need to obtain the Court’s sanction beforehand. Investigations can often involve obtaining Court orders requiring third parties who have been unwittingly involved in the commission of the fraud or wrongdoing to disclose all information in their possession regarding it to the victim. This obligation extends to provide the victim information to enable him to formulate his claim. These orders are often obtained against banks and internet service providers. They are regularly combined with gagging orders that prevent the party against whom the order has been obtained from disclosing the existence of the order and the fact that information has been provided pursuant to it. A combination of disclosure orders and investigation will normally enable the victim to establish the extent of the fraud, the wrongdoer and the location

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In the Markets RECOVERY OF INTERNATIONAL ASSETS IN CASES OF FRAUD

of assets which the victim may be able to freeze. A decision can then be made at to whether it is commercially viable to bring proceedings. This will include consideration as to which country or countries it is most appropriate to bring proceedings and the legal policies within those countries. In England and a number of other countries, it may be possible to bring proceedings against not only the fraudster but also others who assisted in the commission of the fraud, such as recipients of the proceeds of the fraud. Widening the potential targets increases the prospects of recovering losses. English and other courts are willing to freeze assets held nationally and internationally and by individuals other than the defendant provided it is shown that they were obtained using the fraudster’s assets. At their most basic, the criteria for a freezing order are: a good arguable case, a real risk that the potential defendant will dissipate the assets, a connection with the jurisdiction and full disclosure by the applicant. These are strict requirements due to freezing orders being some of the more draconian orders which the court can make, breach of which may put the defendant at risk of criminal sanctions. There is also a requirement for the applicant to give a cross-undertaking in damages which could prove to be costly if it subsequently transpires that the defendant suffers loss as a result of the granting of a freezing order which should not have been granted. However, freezing orders are very effective remedies. They prohibit the defendant dealing with his assets, taking steps which will reduce the value of them or taking any steps to remove them from the jurisdiction. Where a claimant wishes to enforce a freezing order abroad, it must also obtain permission from the English Court to do so. In those circumstances, the court requires compliance with a

set of guidelines as set out in Dadourian Group Inc v Simms [2006] WLR 2499. These guidelines stipulate that for permission to be granted to enforce a worldwide freezing order abroad, it must be just, convenient and not oppressive. Additionally, consideration must be given to the grant of relief to compensate for the costs incurred and the proportionality of the proposed steps to be taken abroad. The penultimate guideline requires that the interests of all parties, including those likely to be joined to foreign proceedings must be balanced against each other. Finally permission will not normally be granted in terms which would enable the applicant to obtain relief in the foreign proceedings which is superior to the relief given by the worldwide freezing order. The US financial regulators are taking an increasingly proactive attitude to tackling business irregularity through the courts. The regulators’ reach extended even further into our to our shores in May when the US Securities and Exchange Commission (SEC) applied to the High Court to continue a worldwide freezing order against a defendant and to dispense with the need for a cross-undertaking. The second element was required partly because US law prohibits it from making an unlimited crossundertaking in damages. Briefly, the SEC alleged that Glenn Manterfield, a UK citizen and resident, was one of a group of people who created Lydia Capital, a hedge fund, which was a USbased and registered with the SEC [United States Securities and Exchange Commission v Manterfield (2008) All ER (D) 218 (May)].The SEC alleges that through Lydia, Manterfield and another, defrauded about 60 investors who had invested approximately $34m in the hedge fund between June 2006 and April 2007. It is alleged that Lydia defrauded investors by:

(1) materially overstating and in some instances completely fabricating the Fund’s performance; (2) inventing business partners, offices, and investors in an attempt to legitimatize the firm and concealing the truth as to why key vendors and banks ceased relationships with the defendants; (3) lying about Manterfield’s significant criminal history, and failing to disclose a February 2007 criminal asset freeze in England; (4) lying about the fund planned to address certain material risks and failing to disclose others; and (5) misstating the nature of the Fund’s assets and its investment process.” As if that were not enough, there are allegations of the misappropriation of millions of dollars of funds, wrongfully withdrawn by Manterfield and another. The High Court ruled that the freezing order should continue until the resolution of the SEC’s pending enforcement action in the US. The use of civil powers by regulators is a welcome development in assisting victims of fraud or financial mismanagement. In the recent past, hedge funds and the financial markets as a whole have enjoyed growing economies, banks which were only too willing to offer leverage and investors who were able to invest using readily available credit. One of the consequences of the credit crunch has been a reevaluation of those transactions and the discovery that collateral provided is either non-existent, suffers from undisclosed defects, or was never as valuable as originally represented. There may also be issues as to whether prospectuses and other financial advice given was misleading. It is important that those who have lost out are aware that there are effective legal weapons available on an international basis that, when properly exercised, can maximise the prospects of recovering losses that are suffered.

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Sector Report PHARMA: THE CHALLENGE FOR VENTURE CAPITAL

Pharma giants know that smaller, entrepreneurial companies can be more productive and inventive than corporate labs. They cover themselves by investing in start-ups and promising ventures so they are in a position to take some of the upside. On the other hand, the brightest ideas do not always translate easily into production and marketing, so larger companies do buy the smaller enterprises, whose eager entrepreneurs, in an ideal world, will rush off and invest their proven ingenuity and recently acquired cash in another start up. Whether selling or buying, the availability of capital is crucial. Photograph © Alinoughbigh/Dreamstime.com, supplied October 2008.

THE IMPORTANCE OF THE LONG VIEW The world of Pharma and Biotech often behaves like a Petrie dish, with seething cultures of competing growths. The medium that the organisms feed on and compete for is, of course capital. Robert Fleming may have discovered penicillin by accident, but most drugs and treatments are the product of long research, eliminated dead ends, intensive and extensive field trials and toxicity tests and all of these take a great deal of cash up front. It takes very adventurous venture capital. Of course, at the end of this cash-burning exercise, the lucky researchers – and their backers – might well hit the jackpot. However, the test for the nerve of backers is at what stage in the proceedings they come in with their cheque books. The earlier, the riskier it is, but the higher the payout if they stay the course. Ian Williams reports on the financing challenges in the high risk, sky high return, pharmaceutical sector. NCREASINGLY, WE LIVE in a globalised, highly interconnected, world and once the sub-prime crisis metastasised throughout the financial strata, its cancerous offshoots were bound to impinge on the pharmaceutical sector. Indeed the sector is talking about one New England entrepreneur who lost his entire stake in his own multi-billion company when the margin call came. Many observers had been watching, in the nature of a financial clinical trial to see whether giant Eli Lilly would complete its intended $6.5bn acquisition of ImClone System in the light of current credit conditions. It was managed and on October 6th, Eli

Lilly and ImClone Systems Inc. announced that the boards of directors of both companies have approved a definitive merger agreement. Under the terms of the agreement, Lilly (through a whollyowned subsidiary) will acquire ImClone through an all cash tender offer of $70.00 per share, followed by a merger of Lilly’s subsidiary with ImClone. Lilly is expected to commence the tender offer as soon as practicable, which represents a premium of 51% to ImClone’s closing stock price on July 30th 2008, the day before an acquisition offer for ImClone was made public. The transaction is conditioned upon at

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least a majority of the outstanding ImClone shares being tendered, as well as clearance under the HartScott-Rodino Antitrust Improvements Act, similar requirements outside the US, and other customary closing conditions. The company expects the transaction to be accretive to earnings on a cash basis in 2012 and on a GAAP basis in 2013. Additionally, certain entities associated with ImClone’s chairman, Carl C. Icahn, holding approximately 14% of ImClone’s outstanding common stock, have agreed to tender their shares in the tender offer. The combination will create one of the leading oncology franchises in the biopharmaceutical industry, offering both targeted therapies and oncolytic agents along with a pipeline spanning all phases of clinical development. The combined oncology portfolio will target a broader array of solid tumor types including lung, breast, ovarian, colorectal, head and neck, and pancreatic, positioning Lilly to pursue treatments of multiple cancers. Combining with ImClone will further strengthen Lilly’s growing portfolio of first-in-class and best-in-class pharmaceutical products. Importantly, the combination also expands Lilly’s biotechnology capabilities. ImClone’s state-of-theart development and commercial manufacturing facility will provide significant flexibility to develop and manufacture complex biomolecules. “We think very highly of ImClone’s ground-breaking work in oncology, particularly its success with ERBITUX®, a blockbuster targeted cancer therapy, and its ability to advance promising biotech molecules in its pipeline,”said John C Lechleiter, Eli Lilly’s president and chief executive officer, when the deal was announced.“We are excited about the possibilities of improving outcomes

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for individual patients and building value for shareholders. This transaction will broaden our portfolio of marketed cancer therapies and boost Lilly’s oncology pipeline with up to three promising targeted therapies in Phase III in 2009. By bringing together ImClone’s and Lilly’s marketed oncology products, pipelines, and biotech capabilities, we are taking a very important step forward in addressing the challenges of patent expirations we will face early in the next decade.” UBS Investment Bank is acting as lead financial advisor to Lilly and Deutsche Bank as financial advisor, while JPMorgan is acting as financial advisor to ImClone on the transaction. Earlier in the year, ImClone had been the subject of a bidding war with Bristol Myers Squibb and indeed, it was almost a secondary venture capital bid since major Lilly shareholder activist icon Carl Icahn was a proponent of the bid. However, a lot of stuff has flowed down the drip since then.“In 1987, a whole bunch of transactions were torpedoed by force majeure, so it will interesting to see if Lilly completes: if not then we need to worry about a whole bunch of transactions going forward,”says Garo Armen, chief executive officer (CEO) of Antigen and formerly of Elan. As befits a former scientist and financial analyst, Armen has tangled with Wall St before. He successfully took action against a finance house that allegedly dropped coverage on his company after he had failed to reengage their services for a secondary offering. It had previously put a“strong buy” on Antigen. The NASD fined the company $250,000 and its managing director, $50,000. It had clearly had not done its due diligence about its victim who, hardened by his experience remarks laconically, “I tell my son that the banks enriched

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themselves historically by encouraging acquisitions in the sector, until companies grew to an unmanageable size, and then came spin-offs, for which they got fees as well.” Of course, there are other reasons for the cycle apart from bankers’ admittedly voracious appetite for fees. Pharma giants know that smaller, entrepreneurial companies can be more productive and inventive than corporate labs. They cover themselves by investing in start-ups and promising ventures so they are in a position to take some of the upside. On the other hand, the brightest ideas do not always translate easily into production and marketing, so larger companies do buy the smaller enterprises, whose eager entrepreneurs, in an ideal world, will rush off and invest their proven ingenuity and recently acquired cash in another start up. Whether selling or buying, the availability of capital is crucial. So, is the current climate changing the speed or direction of this cycle? Sycamore Ventures is based in New Jersey“at the epicentre of biotech and pharma,” managing partner Peter Gerry says, and it is still in business— but careful. “The much diminished willingness of banks to lend money for leveraged transactions is making us more cautious in terms of investment, so private equity going to be on hold for some time, because many of the banks that leverage the deals have held on to that paper and could not syndicate and some of that paper is going to go sour.” “Pharma is our core focus,” Gerry says, adding that the company had hired two PhDs’ from Johnson & Johnson to make sure they got it right. The company is still pondering the impact on the sector of the September surprise in the capital markets. “It is generally recession proof, not entirely,

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Sector Report PHARMA: THE CHALLENGE FOR VENTURE CAPITAL

Carl Icahn. Earlier in the year, ImClone had been the subject of a bidding war with Bristol Myers Squibb and indeed, it was almost a secondary venture capital bid since major Lilly shareholder activist icon Carl Icahn was a proponent of the bid. However, a lot of stuff has flowed down the drip since then. Photograph provided by Starfire Holding Corporation, October 2005 and re-used in this edition.

but there is a continuum of growth. The issues that we face in other sectors don’t seem to be comparable, since while you won’t necessarily get year over year growth in healthcare, you probably won’t get a decline, so there is a certain element of built in stability.” Their portfolio includes stem cell research, prosthetic devices, and oncology. All are still in demand. In fact, he says, some of their portfolio companies making devices, prostheses, hip, knee and spinal chord devices,“are growing unabatedly. Some of those are discretionary, in the sense that they remove pain and improve mobility, but we don’t see it, in fact our portfolio companies have capacity problems dealing with the demand.”

Sycamore usually tends “to get in after startup, generally early stage or growth where there is already a revenue stream from the sale of product or services.” However, they have also mounted some investments “before there’s been a dollar of revenue, at a very early stage.” He instances a company focusing on a cure for cystic fibrosis. “Trials have been completed and now we are going into a phase three clinical trial before US Food & Drug Administration (FDA) approval.” He suggests that the likely exit is partnership with a major pharmaceutical company. Even so, he acknowledges the difficulties caused by what he calls the

sub-prime “Ponzi scheme.” Sycamore had to ride to the rescue of one of its portfolio companies that was, he said, “growing, earning money, totally in compliance with its covenants, cashflow- positive ahead of budget- and the bank refused to honour the credit line for the payroll. We had to get a court order.” His other worry is that the liquidity shortage will “extend the time from original investment to exit, and that is going to affect your total rate of return -that’s what you are measured on in this world. Since it is a function of gain and time, the longer the time, the lower the rate, which of course has an impact on our ability to raise additional funds. We have to work on that,” he admits, although counting his blessings that “we are compared with the vintage years of our funds, so we are being compared with 1999 rather than 2006!” Clearly there is cash available for likely prospects. For example in mid September Link Medicine Corporation based in Cambridge, Massachusetts announced a successful funding of an additional $40m for a promising Alzheimer’s cure. The cash will fund the pre-trial phase, but investors will have bought a share of the Elixir of Life if it is successful so the high stakes offer high rewards. A neighbouring company, Ironwood Pharmaceuticals Inc., working in antibacterial drugs for gastrointestinal disorders, successfully raised $50m in seventh-round funding this October, bringing its capital up to $250m since 1999, showing the time scale needed for the sector—and indeed the persistence of funders. Garo Armen, however, continues even more bearish “The biggest risk at the moment for healthcare is whether there is enough money to pay for it! There is a risk based on the credit crisis, since private equity typically relies on a debt and

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equity component. I have to imagine stream. There is indeed an imperative founders to realise some of their that in the current situation debt is very to find replacement products, and intellectual investment and to raise thus to fund the smaller more capital is of course an initial public difficult to come by.” Armen adds that the market itself entrepreneurial companies that could offering. Significantly, there have been none around for over a year, and some may become less congenial as well. produce the new golden egg-layer. Armen suggests“In this cycle we will companies that registered in “Typically, during a down-cycle healthcare has been assumed to be resilient, experience a very different sort of anticipation have withdrawn. The since there is indeed a non- dynamics that have so far spared the current state of markets is not discretionary component, but this is like healthcare companies: a difficult conducive to flotation. However, the no other down cycle. With the cost of environment, a slow down of M&A major companies are indeed the bailout, the government may have activity. In the past, bankers have tried desperate for new products and many less left for healthcare, unless it starts to solicit business by putting their own of them are cash-rich, so it is likely printing money.” He suggests, that those that have venture “Because of the severity, capital arms, such as Novartis, will find more willing healthcare may not follow the customers, while smaller previous resilience cycle.” companies will forfeit some Apart from revenue and degree of independence and demand implications, on the “We think very highly of ImCone’s move more towards capital supply side he groundbreaking work in oncology, partnerships and mergers and foresees “a very substantial particularly its success with acquisitions with their richer slow down of financial peer companies. activity, that will be ERBITUX®, a blockbuster targeted Another innovative way of compounded by the fact that cancer therapy, and its ability to raising capital is to monetise the regulatory authorities advance promising biotech have been very slow in present and future revenue molecules in its pipeline,” said John coming to decisions on new streams in return for C Lechleiter, Eli Lilly’s president and products, or reforming to development capital. The chief executive officer, when the accommodate new treatment continuing activity among paradigms. There have been a smaller and medium deal was announced. not insignificant number of companies combined with the trial failures by both small cash supplies and product and large companies a needs of the larger companies suggests that activity will because of the regulatory resume, but it may be in a environment, concerns about capital at risk, and we will see much different form, or with different toxicity and so forth.” Indeed those factors had pulled less of that, less bridge financing and so emphasis than before this year. When down the prices of some major stocks on.” He concludes, “Nothing is really it does, it will be taking into account, even before then. With the life-cycle clear under the circumstances. as never before, not just the risks of from patent to expiration, Pfizer for Transactions are difficult to complete. clinical trials, but anticipated example, has not has not so far Lack of debt, and secondarily, difficulties with exit strategies and of succeeded in replacing Viagra and budgetary constraints are likely to have rolling over credits. However, an Lipitor at the expiry of their patents. a very significant impact. Apart from industry on the cutting edge of dealing Lilly has been having difficulties as government’s willingness to reimburse with the failures of massively human well, hence its interest in ImClone for healthcare, it is highly likely that life systems shows every promise of which, apart from its ERBITUX®, government in the US, as they have showing equal ingenuity in coping approved for colon and head and done elsewhere, will use its bargaining with the ailing world financial system. neck cancers, with $1.3bn in sales last power to make sure get much better Along with death and taxes, sickness year, has three oncology products prices.” Better, that is for the and the drive for cures must be up there among the eternal verities that ready for into late-stage testing next government, not for the companies. During a bull market, one way for will always guarantee financial activity. year, giving Lilly a new revenue

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Index Review ANYONE OUT THERE PREPARED TO TAKE A RISK ANYMORE?

DRAGON DAYS The markets are so shot to pieces that it is tempting to try to ‘bottom pick’ as valuations reach ever lower levels. Unfortunately not all of us have the investment horizon of Warren Buffet. What might be a good bet over a fifteen years has a nasty habit of looking sick over six months. Then again, for all of the heroic efforts of central banks and treasuries of late, we are still a very long way away indeed from a solution to ever more arid liquidity. At best cash injections add stability in return for glacial growth and at worst contribute to the global slowdown by hamstringing banks from making ‘risky plays’. Simon Denham, managing director of spread betting firm Capital Spreads, lays out his bearish wares. T WAS THE propulsion of the hedge funds, private equity funds and investment banks that drove much of the growth in my life time. People risking money: to make money. It was only when the placid high street banks got involved in financial engineering models that things started to get out of hand. Jealously watching the huge returns from the likes of Merrill, Lehman and Goldman eventually tempted virtually everyone into taking a slice. Most business models work as long as it is only a minority actually using them. When the majority adopt them, then the model becomes ‘the market’ and vice-versa. In this circumstance there are no exit strategies as everyone who wants to play is in the same boat and there are no paddles. Unfortunately, at the moment, there is no credible alternative to the ‘capitalist’banking model. It has driven all before it for many, many decades. While France might like to talk up its cosy ‘social democratic capitalistic’ ideas, analysts invariably point to the huge entrenched unemployment levels in the country that successive administrations have been wholly unable to shift. The more regulators

strive to make things safer, more predictable and pliable to state control, the worse any outlook for growth will become. UK premier Gordon Brown’s insistence that banks taking the Queens Shilling should return to lending to small businesses and house buyers at 2007 levels typifies the problem. The dictat ignores the Financial Services Authority’s (FSA’s) effort to put an 8% to 9% Tier 1 capital ratio requirement on financial institutions (thereby putting something bit of a spanner in those proverbial lending multiples). Moreover, regulators are climbing all over “off-balance-sheet” mortgage/ credit backed securitisation (with a mind to restricting it). In tandem, it means banks will not have the room on their balance sheets to lend anything, even after huge capital injections. On the other hand, there is always the possibility for a year-end rally to brighten the outlook. Bear markets tend to manage a bit of fun towards the Yuletide season just to tempt the unwary into believing the turn might be upon us. With central banks now looking to cut rates aggressively companies with good margins but saddled with large debts might start to

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

look more positive than they did in the summer months. So will those companies paying a solid dividend. I can see a swift outflow of funds from cash if deposit returns start to become too miserly. Interbank markets are still some 2% to 3% above base rates (even with rate cutting on the agenda) and while liquidity is slowly returning, the days of LIBOR fixings straddling the official lending rates might be gone for good. If this does prove to be the final outcome then this will definitely put a brake on long term growth. However, real pain on the high street and in employment prospects has yet to filter through. Retail sales are actually still up on the year and debt levels in the UK continue to rise. It cannot be long before high street banks cut back on leeway spending over credit card usage; a fact concentrating the minds of investors in retail and discretionary spending stocks. Retailers work on very thin margins, even supermarkets. It would not take a large sea-change in spending habits to have a serious impact on the bottom line. While work (the service sector) in itself is of value, product creation is vital, otherwise all we are doing is funding today’s spending with yesterday’s savings and tomorrow’s growth. As ever place your bets ladies and gentlemen.

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CHANGES TO FTSE’S COUNTRY CLASSIFICATION MATRIX

Photograph © Saniphoto/Dreamstime.com, supplied October 2008.

REFINING DEFINITIONS OF MARKET CHANGE Global equity markets are in constant change; altering in terms of shape, structure, breadth and complexity. Logically then, benchmarks must undergo regular review and restructuring to make certain they more accurately reflect the investment opportunities available to global investors. In keeping with changes in the balance of liquidity flows (current market volatility aside), FTSE Group (FTSE), the global index provider, has introduced a series of substantive changes to its global country classification matrix. Among the key changes in this latest round: South Korea has been upgraded to developed country status while Red Chip stocks, which are currently included in the developed market of Hong Kong, will be moved to China, which is a secondary emerging market status. The changes will be effective in September 2009. UBSTANTIVE CHANGES TOFTSE Group’s country classification, which underlies the index provider’s global benchmark series, the FTSE Global Equity Index Series (GEIS) have been announced. FTSE applies its country classification framework to conduct an annual review of the market status of all countries into specific categories, namely: developed, advanced emerging, secondary emerging or frontier market. Changes to the status of individual countries are announced six months in advance of their application within a particular market classification. Among the criteria that are deciders of whether a country fits into any of its market categories are a nation’s market and regulatory environment, custody and settlement infrastructure, dealing

landscape and a functioning and deep derivatives market. FTSE is working with an expert committee of independent market practitioners, which advise on market conditions in specific countries, the operation of a country’s regulatory and capital markets infrastructure, and the free flow of capital. The review is conducted once a year in September. However, FTSE communicates an update on the progress made in March, in accordance with “an advanced, transparent and consistent methodology,”explains Imogen Dillon Hatcher, managing director, EMEA at FTSE Group. In this latest round of changes, South Korea has been moved from the advanced emerging segment into developed market status. South Korea

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has been on FTSE’s watch list for an upgrade to its historic status since 2004. As Dillon Hatcher has it, the “changes to South Korea’s country ranking is based on measures of good governance, transparency and country wealth.”The new rating will come into effect in September 2009. The Korea Exchange, the country’s primary stock and futures exchange, stated after the change was announced that it expected that the new rating could generate as much as $16bn of additional investment in the country’s stocks annually. Unfortunately, in the short term, the announcement of the changes has done little to lift the gloom currently dampening appetite for South Korean stocks, which had plunged in late trading (as this title went to press) 7.48% to a three-year low. The benchmark Korea Composite Stock Price Index (KOSPI) plummeted 84.88 points, to a yearly low of 1,049.71, the weakest since July 12, 2005. However, the KOSPI index remains the keystone Asian benchmark, particularly for options and futures written against the index; and will likely recover most of its power in 2009. The move is significant for the country in any case. An estimated $3trn worth of funds track the FTSE GEIS indices and the upgrade will likely encourage institutional investors

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Index Review CHANGES TO FTSE’S COUNTRY CLASSIFICATION MATRIX

to increase their country asset allocations for South Korea within and without relevant established indices. FTSE’s re-rating of the country might even tip rival MSCI to raise its own rating of the country. MSCI is reportedly due to review South Korea’s rating by next June. However, once a major powerhouse in the emerging markets context, South Korea’s market will now become a relative minnow in the GEIS indices. South Korean stocks will make up 2% of FTSE’s developed markets index, compared with its most recent 14.5% of the emerging market index. In this current round, FTSE has however kept Taiwan on a watch list to be considered for a possible promotion to developed market status (please refer to the box: FTSE Group’s Country Watch List, for more details) from advanced emerging. FTSE consistently engages with “representatives of the markets on its country watch list,” acknowledges Dillon Hatcher,“both to continue to outline the criteria required for countries to move from one segment to another, to discuss any

changes in market practice and understand their repercussions, and help those markets in communicating their progress in meeting established benchmarks in terms of market practice and report that back accurately to the investment community.” Among the most significant of the current batch of countries on the index provider’s Watch List, Pakistan has been removed from the list and will no longer be considered for possible demotion from secondary emerging to frontier status. In a significant departure from the normal categorisation of countries, this latest round of changes to FTSE’s country classification matrix now includes a new standalone index for those international investors wishing to add Saudi Arabia to their global portfolio. The move is in recognition of both the size and significance of the Saudi Arabian economy; a large Gulf Cooperation Council (GCC) country that does not currently meet the need for the inclusion in the FTSE GEIS, or even for FTSE Group’s country Watch List. It also marks FTSE Group’s

acknowledgement that markets do not always fit neatly into categories and that realism and flexibility, while maintaining internationally recognised standards, must now be taken into account. In addition, FTSE has extended its market categories to include frontier markets: an acknowledgement of the growing appeal of high growth markets such as Vietnam and Nigeria. According to Dillon Hatcher, “FTSE has developed a transparent and consistent approach to its country classification criteria, which helps both investors manage change and encourage new markets to adopt international standards in the development of the capital and investment market infrastructure. The extension of this process to include frontier markets is a logical extension of this duality: helping investors capture the opportunity in high growth markets and set out clear guidelines for frontier markets to progress through the various market categories. It is a timely and welcome development within FTSE’s country classification process.”

FTSE GROUP’s COUNTRY WATCH LIST (as of September 30th 2008) FTSE Group publishes a Watch List of countries that it actively monitors for possible promotion or demotion between developed, advanced emerging, secondary emerging and frontier market status. The following Watch List has been created from the September 2008 review.

TAIWAN: PROMOTION TO DEVELOPED STATUS Taiwan has substantially improved access to its market for foreign investors, but no change will be made to its status at this time. Taiwan will remain on the Watch List and will be considered for promotion again in September 2009 from advanced emerging to developed market status.

GREECE – DEMOTION TO ADVANCED EMERGING STATUS Changes recently announced by Greece to take into account the outstanding FTSE Quality of Markets criteria have yet to be adopted by the market. Greece will therefore remain a developed market, but will remain on the watch list and be reviewed again in September 2009.

ARGENTINA & COLOMBIA – DEMOTION TO FRONTIER STATUS Argentina and Colombia are being added to the Watch List and considered in September 2009 for possible demotion from secondary emerging to frontier status.

ICELAND – INCLUSION AS ADVANCED EMERGING STATUS Iceland will be added to the Watch List and considered next September for possible inclusion in the FTSE Global Equity Index Series in the advanced emerging segment.

CHINA A SHARES; KUWAIT & UNITED ARAB EMIRATES – INCLUSION AS SECONDARY EMERGING STATUS China A shares will remain on the Watch List and Kuwait and the United Arab Emirates will be added to the Watch List. All three markets will be considered next September for possible inclusion in the FTSE Global Equity Index Series.

KAZAKHSTAN, MALTA & THE UKRAINE – INCLUSION AS FRONTIER STATUS Following the introduction of the FTSE Frontier Markets Indices earlier in 2008, the Watch List will be extended to include frontier markets. Kazakhstan, Malta and the Ukraine will be added to the Watch List and considered for inclusion as frontier markets in September 2009. Source: FTSE Group, October 2008.

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Option traders thrive on volatility, so it is no surprise that the current market upheaval has driven index and ETF contract trading volumes on the major US exchanges to record levels. Although extraordinary volatility in the last year or so has helped push up average premiums per contract, dollar trading value has increased even faster. While the party will not last forever, advances in trading technology, the spread of multiple listings and a renewed emphasis on risk management may mitigate what could otherwise be a sharp drop in the volume and value of trading when calm returns to the financial markets. Neil O’Hara reports. HE CHICAGO BOARD Options Exchange (CBOE) Market Statistics for 2007 show a dramatic increase in the average premium for cash index options over the past five years. While call premiums shot up from $26 per contract in 2003 to $50 in 2007, put premiums rose even faster from $25 to $60 per contact. A bull run in the underlying indices raised the average strike price—the Standard & Poor’s 500 Index climbed 50% during that period— but not enough to account for the entire premium increase. Higher volatility played no role either, at least until 2007 when the long decline in volatility that began in 2003 finally reversed. If index values and volatility cannot explain a significant portion of the premium increase, market participants

must have altered the way they trade— and technological changes have given them every reason to do so. The spread of multiple listings, especially for options on exchange traded funds (ETFs), has driven innovation as the options exchanges fight to attract more volume to their particular venue. Will Easley, vice chairman of the Boston Options Exchange (BOX), points out that BOX set itself apart from the outset in 2004 by offering customers price and time priority rather than a trade matching protocol that favoured specialists. Indeed, BOX was the first exchange to forgo specialists altogether; it allows any participant to post markets and charges a fee only on executed trades. BOX has also taken the lead in penny increment trading with a price

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INDEX OPTIONS: VOLUMES AT RECORD LEVELS

Riding a volatile tide

The relentless growth in exchange traded funds (ETFs) that track market indices has ramped up option volumes as well. Arbitrage opportunities abound between index futures, ETFs, index options and options on ETFs. Nybo says the securities houses also use index and ETF options to manage exposure in their role as the authorised participants in ETFs who handle creations and redemptions of shares. In addition, when dealers trade baskets of stocks they often find the most economic hedge is an index or ETF option.“It is the electronic component that lets traders automatically hedge when it is cheaper to do it through an option rather than in the underlying cash instrument,” says Nybo. Photograph © Khwi/Dreamstime.com, supplied October 2008.

improvement auction, a segment in which Easley says it remains the market leader. Low cost access to the new exchange quickly attracted volume from retail players, who are still the core BOX customer base. At 18 contracts, the average trading ticket size is in line with the market as a whole but well below the level at exchanges that depend on institutional orders. “BOX’s primary target has never been the big institutional crossing business,” says Easley. “On BOX, a trade of 50,000 contracts is a big deal, whereas on some other exchanges that is fairly normal.” BOX capitalised on its initial success with a major technology upgrade about 18 months ago that slashed average execution times from between 150 and 200 milliseconds to less than one millisecond. For a capital outlay comparable to its initial system, BOX boosted capacity about 15-fold and cut latency to the point where Easley believes future decreases will offer diminishing returns. “The system sets alarms off if our response times go up to six or seven milliseconds,” he says, “That is a big deal for us today, but it is an execution speed unheard of two years ago.”

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Index Review INDEX OPTIONS: VOLUMES AT RECORD LEVELS

Tighter spreads and faster execution always improve market efficiency, which draws in new players and opens up trading strategies that were hitherto uneconomic or not feasible. Andy Nybo, a senior analyst at TABB Group, a New York-based market research and consulting firm that specialises in the capital markets, says options have emerged as an asset class in their own right through volatility arbitrage and dispersion arbitrage (trading index options against individual stock options on the underlying index constituents), strategies that rely on electronic execution driven by quantitative trading models. “They use computers to watch price relationships,” Nybo says,“When the stars are aligned they execute very quickly across different options classes to implement a profitable strategy.” The relentless growth in ETFs that track market indices has ramped up option volumes as well. Arbitrage opportunities abound between index futures, ETFs, index options and options on ETFs. Nybo says the securities houses also use index and ETF options to manage exposure in their role as the authorised participants in ETFs who handle creations and redemptions of shares. In addition, when dealers trade baskets of stocks they often find the most economic hedge is an index or ETF option.“It is the electronic component that lets traders automatically hedge when it is cheaper to do

Kris Monaco, director of new product development at the ISE. Quantitative strategies often demand complex option positions that have several “legs” to the trade, which can be hard to implement one trade at a time. In response, the International Securities Exchange (ISE) developed software that can handle up to four option legs in a single order. Traders set a limit price for the combination and let the computer execute the legs at whatever individual prices it takes to meet the limit.“It is a growing part of our business and we were the first ones to introduce electronic complex order capability,” says Monaco. Photograph kindly supplied by the ISE, October 2008.

BOX capitalised on its initial success with a major technology upgrade about 18 months ago that slashed average execution times from between 150 and 200 milliseconds to less than one millisecond. For a capital outlay comparable to its initial system, BOX boosted capacity about 15-fold and cut latency to the point where Easley believes future decreases will offer diminishing returns.

it through an option rather than in the underlying cash instrument,”says Nybo. Such technology has become widely available at relatively low cost in recent years. Proprietary trading firms and even modest-sized hedge funds can create quantitative strategies in next to no time using off the shelf software packages. “You take them out of the box, hook them up, build your strategy and start trading in a matter of days,” says Nybo, “Execution can be automated with the click of a button.” Quantitative strategies often demand complex option positions that have several “legs” to the trade, which can be hard to implement one trade at a time. In response, the International Securities Exchange (ISE) developed software that can handle up to four option legs in a single order. Traders set a limit price for the combination and let the computer execute the legs at whatever individual prices it takes to meet the limit.“It is a growing part of our business and we were the first ones to introduce electronic complex order capability,” says Kris Monaco, director of new product development at the ISE. The battle for market share spurs constant innovation to reduce latency, too. In November 2007, ISE introduced a service that permits members to colocate trading servers at ISE data centres, which cuts order routing times and speeds up execution.

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In the latest twist to the technology arms race, Ballista Securities is about to launch an electronic platform that will facilitate the direct negotiation of block option trades and complex combinations between institutional players. A trader who wants to put on a delta neutral hedge or a volatility spread today has to enlist help from a broker who specialises in the transaction to try to find the other side. Ballista’s platform will permit traders to tap liquidity from other participants, and if the bid and offer don’t fit exactly the parties closest to a match will be able to negotiate directly through the electronic interface. Once matched, Ballista will then automatically execute the transaction on the appropriate exchange platforms. Keith Landsberg, executive vice president of business development at Ballista Securities, attributes much of the recent growth in options volume to enhanced electronic access to the market. Hedge funds and mainstream institutions who were already using algorithmic trading techniques in the equity market have adapted them to options. “Any tick in the market or the underlying instrument automatically sends out an order to do something in the options,” says Landsberg, “That has created a large amount of the incremental volume.” Electronic access has slashed transaction costs and attracted more retail investors, too.

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Kelly Haughton, strategic director for Russell Indices, explains that while each futures exchange has different contracts and its own separate clearing house, the Securities and Exchange Commission (SEC) requires the options exchanges to use an industry-owned utility to clear all trades. Central clearing means that investors who buy options on one exchange are free to sell them on another.“For options, we believe the more exchanges the merrier because of contract fungibility,” says Haughton. Photograph kindly supplied by Russell Indices, October 2008.

Keith Landsberg, executive vice president of business development at Ballista Securities, attributes much of the recent growth in options volume to enhanced electronic access to the market. Hedge funds and mainstream institutions who were already using algorithmic trading techniques in the equity market have adapted them to options. “Any tick in the market or the underlying instrument automatically sends out an order to do something in the options,” he says.

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The positive feedback loop in which electronic trading boosts liquidity and brings in new players is a boon for the options exchanges, which levy a transaction fee on each contract traded. For an exchange, the average price per contract does not matter except to the extent that premiums are correlated to trading activity. In fact, ISE’s Monaco says the exchange doesn’t bother to track trading by value at all, only by volume. ISE launched the first allelectronic options exchange in May 2000. Just three years later it displaced the CBOE as market leader for individual equity options, a position it has retained ever since. CBOE is still the leading venue for cash index options, in large part because it has an exclusive licence to trade options on several popular indices including the Standard & Poor’s 500 Index and the Dow Jones Industrial Average Index. Options on the ETFs that track those indices do trade on the ISE, however, and the courts ruled about three years ago that exchanges do not have to seek a licence from the underlying index provider before they list ETF options. “We broke some new ground with options on SPDRs and DIAMONDS and other ETFs that were at one time considered to be out of reach,” says Monaco. ISE would like to trade cash options on these indices, too, but so far neither CBOE nor the index providers show any sign of giving up their exclusive arrangements.

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Index Review INDEX OPTIONS: VOLUMES AT RECORD LEVELS

volume in their own right. In Investors would almost fact, Haughton says volume certainly benefit from multiple has increased 10-fold since the listings, but the index switch to multiple listing. “We providers currently have the are in the same boat as an right to choose how to exchange. Multiple listing in maximise revenue from their options has generated much intellectual property and more volume and so has been exchange members who good for our revenues,” he benefit from an exclusive says, “It is also good for our licence have little incentive to clients in that contracts are surrender their privileged— much more liquid.” and profitable—position. Options on the ETF that ISE’s own experience with tracks the Russell 2000 (IWM) SPDR options suggests multiple listing would fuel went to multiple listing two volume in both the ETF years before the index options, options and the related cash an event that prompted a surge in ETF option volume relative index options. “You might to index options. Now that think one could cannibalise index options are multiple the other but we found that listed as well, volume in IWM volume increased for both,” options has flattened out. says Monaco, “You have two Haughton sees a time lag pools of liquidity with associated with multiple listing different market participants while traders recognise they trading each instrument and Andy Nybo, a senior analyst at TABB Group, a New Yorkcan trade the option in different using different strategies.” based market research and consulting firm that specialises in places and put the necessary Some investors prefer index the capital markets, says options have emerged as an asset infrastructure in place. options because they settle in class in their own right through volatility arbitrage and Increased volume in RUT may cash and are exercisable only dispersion arbitrage (trading index options against individual also reflect a preference at large at expiration, while others find stock options on the underlying index constituents), strategies the traditional physical institutions for the higher that rely on electronic execution driven by quantitative delivery settlement of ETF nominal value of RUT trading models.“They use computers to watch price options and American exercise contracts (five times IWM), relationships,” Nybo says,“When the stars are aligned they which allows them to get the execute very quickly across different options classes to terms more attractive. exposure they want with fewer Russell Investments, which implement a profitable strategy.” Photograph kindly supplied contracts—and therefore tried both exclusive and by the TABB Group, October 2008. lower transaction costs. multiple listing for options and Although S&P has not followed futures on its flagship Russell 2000 trades. Central clearing means that Index, settled on exclusive listing for investors who buy options on one Russell’s lead and the CBOE refuses to futures (now traded only on the exchange are free to sell them on give ground, the battle over multiple Intercontinental Exchange) but prefers another. “For options, we believe the listing for cash index options is not multiple listing for index and ETF more exchanges the merrier because over. ISE has sued both S&P and Dow options. Kelly Haughton, strategic of contract fungibility,”says Haughton. Jones in an attempt to force the index director for Russell Indices, explains When Russell switched from an providers to break the CBOE’s that while each futures exchange has exclusive listing on the CBOE to stranglehold. If multiple listing ever different contracts and its own multiple listing of index options on the does spread to the key cash index separate clearing house, the Securities Russell 2000 (RUT) about two years options, the incremental volume and Exchange Commission (SEC) ago, contract volume traded on the could be a welcome shot in the arm requires the options exchanges to use CBOE actually rose—even though when today’s frenzied trading is but a an industry-owned utility to clear all other exchanges attracted significant distant memory.

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Country Report

HONEYING UP TO INVESTORS T IS LITTLE wonder that when Lehman’s collapse triggered a massive outflow of money from Russian exchanges phones started ringing around Moscow. A highranking government official routinely meets top representatives of the foreign investment community in Moscow about once a year to talk shop. In September a special meeting was called that wasn’t routine at all; involving Russia’s first deputy prime minister Igor Shuvalov and a small number of top fund managers in Russia. Before the meeting even started, there were rumours of deep seated grudges on both sides. On the Russian side there were suspicions that recent cash outflows were politically motivated; that this was the West’s way of indirectly showing what it thought of Russia’s involvement in Georgia and that it was some cold-war type tit-for-tat. On the Western side the frustrations had to do with the fact that Russia’s exchanges are not functioning properly, that they lack depth because the only local players on the exchanges are brokers [and those are so heavily leveraged that it is

hard for them to survive if the market moves against them]; that long promised pension reform was never completed and that consequently there are only a couple of big local funds in the market rather than a wealth of investors to add depth. With that background in mind, proceeding began on an aggressive and almost arrogant note from the Russian side. However, through the course of the meeting the tone changed into a much more positive and cooperative one, with government officials asking what they can do to keep investors in the market. It was obvious they were willing to take on board any and all suggestions. Perhaps it became clear to them that politics had a lesser role to play in events than market psychology. Maybe it became clear just to what extent the global markets are interlinked and that there was nowhere to hide from what was happening on Wall Street. Granted, Russia’s risk profile has changed since the well publicised incident in Georgia and some funds began liquidating Russian assets before other emerging market assets.

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RUSSIA COMES TO ACCOMODATION WITH INVESTORS

When Russia’s two main stock indices collapsed after Lehman Brothers went bust and Moscow’s main boards had to close down. Stock market closures are bad news for a government that is promoting its exchanges as modern, Western-style markets and has plans to turn St Petersburg into an international finance centre to rival Moscow. In the downturn, Russia’s government became bearish in more ways than one: charging Western investors taking cover of political motivations; however it’s line is now softening. Vanja Dragomanovich reports from Moscow.

However, it was clear that what was happening was sheer market panic and the need to bring money home as quickly as possible. A breakdown of the Western banking system would not circumvent Russia or any other market on the planet unless that market was completely insulated from foreign investment. While Russian side made important moves towards Western investors [and later rescue packages were assigned to local banks and money was allocated to save domestic stocks proving that the government was serious about wanting to have an open market] there is no scope for investors to really claim victory. There is an acceptance among the Western investment community operating on the ground that they are playing on foreign turf, that the rulebook is different to the one at home and that they have little say in what gets decided. They are cautious of prodding the Russian bear too much lest it bite back, they are conscious of the fact that there is always the possibility of visas being denied and life being made difficult through red tape. Particularly now, when everybody is looking for a safe haven, or rather the market that will turn around the fastest, there is a belief that investors need Russia as much as Russia needs them. When the market was doing well it did spectacularly well and funds enjoyed some impressive returns. In the meantime all the main Russian stocks are down between 70% and 80% on the year. When they recover, and eventually they will, they will go a long way up. Despite all Russia’s faults, this will be a tempting prospect. Though it will be interesting to see whether either side’s commitment to a Russian free market is steady enough to weather further storms.

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Country Report UKRAINE: A COUNTRY ON THE VERGE OF A NERVOUS BREAKDOWN

LEFT HIGH & DRY? Size, they say, isn’t everything; though in the Ukraine, they may beg to differ. Kyiv, for example, does big really well. There is a big river—the Dnieper, which is three times as wide as the Thames in London. There are big monuments; the Monument of Motherland is taller then the Statue of Liberty. There are big roads; four-lanes in each direction run through the centre of the city. Then, suddenly, everything becomes small: those four lanes roads quickly get funneled into a single lane in each direction and there is a spectacular traffic jam. There’s a fractal quality in all of this: this big/small dynamic echoes throughout Ukraine’s political and business life. More latterly, all the big investments that were ready to be pushed into the country have all, suddenly become really small or have vanished altogether. Is the Ukraine now left high and dry? Vanya Dragomanovich reports on the very big problems now facing the market. HE UKRAINE HAS been in political turmoil for four solid years, ever since the Orange Revolution in 2004. Former allies President Viktor Yushchenko and premierYulia Timoshenko are now bitter enemies battling for power. In September, the latest governing coalition fell apart.Yushchenko called for early parliamentary elections only to revoke this decision as the country is heading for economic freefall. The domestic economy has been severely shaken by what has been happening in Western markets. The government has had to rescue the country’s two top banks, the value of the national currency has fallen by 12% and the stock market has effectively ceased up. The country is trying to raise a loan of $15bn from the International Monetary Fund (IMF) to help stabilise the financial sector and Tymoshenko recently warned Ukrainians that they are heading for tough times. As a portfolio investment, be it bonds or stocks, Ukraine was riddled with problems even before the financial turmoil. Although a large number of local companies are listed, the local

stock market is highly illiquid even at the best of times. Minority shareholder rights were non existent up until the failure of the coalition in September, and in the past foreign investors were hurt by heavy dilutions after local takeovers. Moreover, the bond market used to be in a better shape. It is twice the size of the stock market and bank bonds performed well up until the first half of 2008; however bond issuance is subject to the vagaries of government policy and the tactics of the central bank, which changed strategies in midstream from protecting the value of the hryivna (the local currency) to fighting off inflation. Then came the credit crunch. Last year Ukrainian stocks were the best performing in the world and were up 135%. This year they are the worst performing market and have lost most of their value. One of the country’s top companies, iron ore miner Ferrexpo, which was a FTSE100 company until it lost a large part of its market capitalisation, saw shares drop from around 425p in June to 167p in October as a global slowdown eroded demand for metals.

The local market’s moves up and down were vastly exaggerated because it is disproportionaly thin. According to Aivaras Abromavicious, partner at Swedish fund manager East Capital Group, this is the single biggest criticism foreign investors have of Ukraine: that the market is badly organised and that it does not reflect the size of the country. Local traders account for only around 20% of trade in stocks, the rest comes from foreign brokers. There are two pension funds operating in Ukraine, a large state pension fund and a much smaller private fund, both of which are only allowed to invest in investment grade bonds. In comparison, on Russia’s RTS exchange where stocks are traded in dollars the daily volume can reach up to $2.5bn. In June, before the credit crisis decimated trade, the total volume of contracts going through Ukraine’s stock exchange was around $19m over the month. By July trade had all but ceased and was down to $76,000 in the entire month. In fact, foreign investors wanting to trade Ukrainian stock frequently fall back on trading local shares in London, Warsaw and Frankfurt where there is sufficient liquidity for them. The initial public offering (IPO) market also dried up. In 2007 IPOs accounted for $3.1bn in new market capitalisation, in the first half this year, only $1.7bn of new equity had been issued. Moreover, Jacob Grapengiesser, an East Capital analyst, said he didn’t expect any more IPOs this year and in the early part of next year. The debt capital markets don’t look better. Grapengiesser says that debt issues are now far more expensive and available only to first tier companies. Even then, there are more fundamental issues in play.“Ukrainian companies like the idea of IPOs but what they don’t realise is how it works.They want to raise money

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but they don’t realise that once you are listed, it is for life. You have to do your accounts to international standards and you have to report regularly,” explains Olga Khoroshylova, partner and head of banking and finance at law firm Magisters in Kyiv. These requirements need a level of financial discipline most local companies don’t have and are not willing to commit to. It is still common practice to siphon earnings into private accounts or to barter for finance. Khoroshylova also points out that Ukrainian companies opt for issuing American Depositary Receipts (ADRs) or Global Depositary Receipts (GDRs), simply because they don’t come with the same level of scrutiny as regular shares. Then again, those industries that were the most successful up until recently, such as iron ore producers and steel makers, the companies were frequently making enough money not to be interested in listing, opting for private equity investment instead. For a period of time the bond market was in a slightly better state than stocks. Government bond issues were not large, but corporates, particularly retail banks, were prolific in their issuance in 2007 and early 2008. “The government was not willing to provide an interesting level of liquidity to the market. It was selling OVGZ bonds (bonds on an internal state loan) with a yield of 6%. This is too small a yield when banks [such as] Raiffeisen (Ukraine) offered bonds at 8%,” says Anastasia Golovach, analyst at Renaissance Capital. This year, for the sake of keeping the hryivna, stable, the central bank restricted its lending policy and the Ministry of Finance held back on releasing money from the budget, driving money market rates up to 26% when the central bank interest rate was 12%. All of that became completely academic the moment Western markets

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A key monument in Kyiv. Last year Ukrainian stocks were the best performing in the world and were up 135%. This year they are the worst performing market and have lost most of their value. One of the country’s top companies, iron ore miner Ferrexpo, which was a FTSE100 company until it lost a large part of its market capitalisation, saw shares drop from around 425p in June to 167p in October as a global slowdown eroded demand for metals. Photograph © Natalya Bratslavsky/ Dreamstime.com, supplied October 2008.

started crashing. Foreign traders started closing their positions at any price and fresh inflows of foreign money whittled down to zero. “Before the summer we had ten corporate bond issues in the pipeline. By the end of September this was down to zero,” says Magisters’ Khoroshylova. Although local banks held it together for longer than some of their Western peers (their growth has been between 40% and 80% in the early part of the year as they were isolated from the initial effects of the sub-prime crisis) eventually the credit crunch hit this sector too. Prominvestbank, the country’s sixth largest bank, ran into trouble because of large commitments in Ukraine’s metals

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and property industries, both of which were top earners until as late as last month but are now facing massive losses caused by falling metals prices and costly credit.The government moved to protect the bank by extending a loan and limiting withdrawals, but the move triggered a downgrade from Moody’s Investors Service for 12 domestic banks and a change in outlook. Global credit flows will have to settle at some point and at that stage Ukraine too will recover. And although it will have to work harder than some other Eastern European countries to attract back portfolio investors, in terms of direct investment the country has several

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Country Report UKRAINE: A COUNTRY ON THE VERGE OF A NERVOUS BREAKDOWN

Ukraine’s president Viktor Yushchenko, left, shakes hands with premier Yulia Tymoshenko during a ceremony at a monument to Ukraine’s 17th century leader Bohdan Khmelnitsky in Kyiv, Ukraine, Tuesday, October 14th this year. Ukraine was marking Cossack Day to honour the role of the Cossack movement in Ukraine’s history. Photograph by Olexander Prokopenko, for Associated Press/PA Photos, supplied October 2008.

strong industries that will make a good investment case. Agriculture is one of Ukraine’s strong points with a lot of potential for growth. The quality of land is extremely high—most of the soil does not need fertilising because it is already so rich—and fields are far larger than anywhere else in Europe. Because of large swings in grain prices, companies that are likely to do well medium to long term are those that not only grow grains but also farm animals and have milk production. The growth is likely to come from using better machinery, better seeds or animal breeds that produce more milk. Companies that will also do well in this sector are foreign agriculturerelated companies such as tractor makers or seed producers that will break into this large market. What is currently holding agriculture back, apart from the credit crunch, is a lack of land reform and bottle necks such as insufficient grain storage and port capacity. The former will depend on the political landscape in the country, the latter is already

being addressed by companies building additional ports. Companies related to infrastructure will also present a good investment as Ukraine, like neighbouring Russia and Kazakhstan, has plans for major road and railway upgrades. According to East Capital, one of the star picks in their investment portfolio is a company providing train signalling structures. Another interesting sector will be retailers, particularly those that manage to be first movers with a new trading idea. One such example is a company called Nova Linija, Ukraine’s answer to Ikea, which sells do it yourself (DIY) equipment in large out-of-town shops. This is a kind of shopping experience that Ukrainians did not have before and are taking to with gusto. It is completely different to the way that Ukrainians usually find shopping in towns: where customers are routinely intercepted by bulky security guards; where it is not unusual to be asked to put a handbag in a locker before going in to buy groceries; or to have to go to separate counters to buy bread, milk or vodka.

The sector to avoid is property, as a lot of developers are expected to go bankrupt, according to East Capital’s Abromavicious. A similar crisis has already engulfed property developers in Russia, Kazakhstan and the Baltic Republics. Going forward, much will depend on domestic politics settling down so that crucial regulation can be passed on to markets, landownership and corporate legislation. Ukraine is keen to catch up with the rest of Europe as a business environment, a sign of its eagerness a piece of crucial legislation which was passed after the governing coalition fell apart. Parliament voted through a joint stock company law sought for years by foreign and Ukrainian investors. The law will regulate the creation of joint stock companies, the rights and obligations of shareholders and management, the payment of dividends and access to information. It also ensures shareholder meetings can only take place at the premises of the company, avoiding situations seen in the past when control of a firm has been wrested by a few big shareholders through ad hoc votes. The country may need a boost from international institutions to keep on track to reform. For instance, negotiations with the World Trade Organisation which accepted Ukraine as a member has provided a necessary impetus to move regulation forward. Talking with the European Union (EU) is another motivator as the EU is seeking increasingly closer ties with Ukraine, although it is stopping short of offering full blown membership. This is not likely to change soon despite the fact that Ukraine wants to become a member country, as the EU is holding back for fear of being flooded with cheap labour and worries about the potential costs that such a large new member would bring.

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GM EDITORIAL 30.qxd:Issue 30

TRADING REPORT: DMA TAKES CENTRE STAGE 40

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DMA goes global The kind of access demanded by customers has changed. Increasingly, sophisticated buy side clients want more control over trade execution, more direct access to the markets, and less intervention by their brokers. Each market has a different way of applying this year, but the most widely used term is direct market access (DMA). Controlling order flow, promoting smarter trading, finding liquidity are but a few of DMA’s key attributes. Now, however, DMA is taking on additional significance. With the global markets moving in an increasingly transparent and restrictive direction, some say conditions have never been better for DMA’s long-term prospects. Moreover, the latest gig is eager adoption of DMA among more sophisticated traders in emerging markets. Dave Simons reports from Boston.

Looking ahead, all signs point to an increasingly transparent and restrictive market environment, requiring better planning and more sophisticated use of technology. Using DMA, clients can efficiently adjust portfolio management to account for added restrictions, as well as provide a transparent audit trail for review by regulators, says Loiseau. Along the way, DMA provides greater anonymity, thereby preventing additional information from being sent to a market already sensitive to any piece of news.“In short, the technology and the seamless service provided by DMA allows for a better workflow and therefore a better order flow, from the order creation by portfolio manager to the market execution and then straight through to settlement.” Photograph © Mike Monahan/Dreamstime.com, supplied October 2008.

Y ENABLING BUY-SIDE firms to execute with pronounced speed and efficiency, direct-market access (DMA), in conjunction with algorithmic trading mechanisms, continues to gain acceptance as a multi-faceted trading solution. In the United States, DMAbased trading is expected to reach 20% of equity share volume over the next two years. Significantly lower execution costs—averaging around a penny per share in the US, compared to upwards of six cents per share for a standard brokerage trade—remain one of the leading factors in the upward trend. However, there are a number of other benefits as well. “DMA started primarily as an effort to find a more costeffective way of trading, however, this is now no longer the only objective,” says Stephane Loiseau, head of execution services for Société Générale in London.“Today, DMA and its technological cousin, the algo, represent a quest that goes beyond mere cost saving. It’s about better control of the order flow, it’s about smarter trading, it’s also about finding liquidity. The benefits of DMA are numerous, and certainly include better transparency in the trading process, more discrete flows and faster point-to-point access to the various markets, including those of up-and-coming multilateral trading facilities (MTF’s).”

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“In my world, I need a broker that puts the control in my hands but won’t hesitate to pick up the phone.” UBS is a trading partner for your world. From intuitive algorithms like UBS Tap to advanced analytics like UBS Fusion, we are focused on providing the strongest trading tools and strategies in the industry. And we don’t stop there: our specialists help you use them to improve performance based on your objectives and current market activity – anytime, anywhere. We understand the world. Your world. It’s part of the powerful relationship we call “You & Us”. www.ubs.com/directexecution Europe: +44-20-7568 2436

In the U.S., securities underwriting, trading and brokerage activities and M&A advisor activities are provided by UBS Securities LLC, a registered broker-dealer that is a wholly owned subsidiary of UBS AG, a member of The New York Stock Exchange and other principal exchanges, and a member of SIPC. © UBS 2008. All rights reserved.

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occurrence, speed to market Though Europe currently lags becomes paramount, and DMA the US in terms of DMA can make it happen. “We have uptake, post-the Markets in seen extreme cases of stocks Financial Instruments Directive sometimes moving 40 percent in (MiFID) institutional direct15 minutes. Every minute of trading activity is expected to delay can result in a potential expand enormously over loss of several percentage coming years, reaching a points. However, by using possible 15% of traded value by DMA, an order can be 2011. With DMA activity on the generated and traded within a rise in Europe, high-touch equity trades, which currently very fast turnaround time, thus account for roughly two-thirds helping to provide a degree of of trading volume, will decrease price certainty despite the by 25% through the same prevailing high volatility.” period, according to a recent With demand for DMA on the poll by Stamford, Connecticutrise, efforts to improve its efficiency have picked up steam. based Greenwich Associates. Co-location (the situating of “The European equities trading systems adjacent to an marketplace is becoming more exchange’s data control center fragmented by the month and in order to improve execution the need for consolidation Stephane Loiseau, head of execution services for Société speeds) has gained favour in technology is now critical,” Générale in London, notes that “DMA started primarily as Australia, the United Kingdom argues Richard Hills, global an effort to find a more cost-effective way of trading, and other markets. MTFs such head of electronic services at however, this is now no longer the only objective. Today, as Project Turquoise and Chi-X Société Générale. DMA and its technological cousin, the algo, represent a According to Celent, during have already established coquest that goes beyond mere cost saving. It’s about better 2008 brokers such as Goldman location hosting services oncontrol of the order flow, it’s about smarter trading, it’s also Sachs and Morgan Stanley led site, and other exchanges are about finding liquidity. The benefits of DMA are numerous, the way for DMA among following suit. and certainly include better transparency in the trading brokerages with more than a According to Viraf Reporter, process, more discrete flows and faster point-to-point access quarter of the total market. The senior consultant with Bostonto the various markets, including those of up-and-coming departure of Lehman Brothers, based research firm TABB multilateral trading facilities (MTF’s).” Photograph kindly one of the leading providers of Group, tackling the issue of supplied by Société Générale, October 2008. latency—the time it takes for DMA to global hedge-fund firms, leaves a void in the market that could conceivably data to travel from source to destination, or for one part of be filled by the likes of Credit Suisse, JPMorgan, and the system to wait for another to catch up—remains an ongoing challenge in the quest to maximise DMA Merrill Lynch. efficiency. “Latency is often discussed, but not easily understood,”notes Reporter, author of TABB Group’s study Trading in the liquidity crunch As the markets swooned during the month of September, The Value of a Millisecond: Finding the Optimal Speed of a trading volume on US exchanges exceeded 5.3bn shares, Trading Infrastructure, “yet its impact on market risk and compared to 3.4bn shares during the year-ago period, operational risk is felt in quantitative terms.” Looking ahead, all signs point to an increasingly according to research and trading services provider Investment Technology Group. Such extreme conditions transparent and restrictive market environment, requiring have been a boon for DMA business.“Significant volatility better planning and more sophisticated use of technology. drove record volumes to our direct market access products,” Using DMA, clients can efficiently adjust portfolio remarks ITG chief financial officer Howard Naphtali. management to account for added restrictions, as well as Loiseau concurs that the current environment has helped provide a transparent audit trail for review by regulators, put DMA at the forefront of the dealer’s trading strategy. says Loiseau. Along the way, DMA provides greater Brokers with mature product offerings have been able to anonymity, thereby preventing additional information from provide dealers with the tools necessary to take advantage being sent to a market already sensitive to any piece of of the market volatility and also make them better equipped news. “In short, the technology and the seamless service to manage through these uncertain times, he says. provided by DMA allows for a better workflow and “Right now there is a need to act quickly, efficiently and therefore a better order flow, from the order creation by with the highest level of discretion,” says Loiseau. With portfolio manager to the market execution and then several hundred-point swings becoming a daily straight through to settlement.”

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Emerging markets now make their mark One clear indication of the success of DMA has been its gradual acceptance within the emerging markets. In April, the Securities and Exchange Board of India (SEBI) announced it would allow institutional investors to begin using DMA for trade executions on the National Stock Exchange of India and the Bombay Stock Exchange, currently the sixth- and eighth-largest Asian exchanges respectively. Improved regulatory conditions, including a liberalisation of authentication procedures, has set the stage for a DMA-friendly environment in the country, say observers. In a report entitled Impact of Direct Market Access in India, Sandeep Hebbar, senior analyst with Celent’s Banking group, says that factors that have made DMA popular in developed markets, including increased control, faster trade executions, and lowered costs, will have the same positive impact in India and other emerging areas. Demand for DMA in India is such that by 2010, 11% of total trade traffic will be facilitated through DMA, according to Celent.“Conditions in the market, especially some key market inefficiencies at the brokers’ end, are ripe for the adoption and usage of DMA channels,” says Hebbar. “Major brokerage houses are in a race with each other to enhance their trading Jarrod Yuster, head of global portfolio and electronic trading for Merrill Lynch in New York systems and be among the first to offer says that “Because there are so many different venues now that trade the same stock, these services.” directing access to a certain exchange isn’t necessarily guaranteeing you best execution. Indeed, a slew of global brokerages Professional or high-frequency traders will want to direct themselves--they incorporate all of have queued up to offer DMA services the exchange-order types, the cost rebates, and they have their own models that are specific to to India on behalf of foreign an exchange. However, in general the vanilla institutions want to have these smart routers or institutional investor clients (FII), algos in place that will allow them to successfully navigate through all these different among them Morgan Stanley as well as venues.” Photograph kindly supplied by Merrill Lynch, October 2008. UBS, which launched its UBS India DMA, a zero touch anonymous trading platform for India’s Additionally, hedge fund firms, which rely on sophisticated stock exchanges. Morgan Stanley executed the first Direct algorithmic programs for trade execution, have been drawn Market Access (DMA) trades in India through its electronic to the region as a result of the introduction of DMA. trading platform in mid July this year soon after receiving India joins a growing list of Asia-Pacific countries formal approval to deliver DMA to FII registered firms for offering DMA, among them Hong Kong, Taiwan, Korea both equities and listed derivatives on the National Stock and Singapore. Regional newcomers include Vietnam as Exchange, and for equities on the Bombay Stock Exchange. well as Malaysia, which began offering direct access last “The successful launch of DMA on India’s two major spring. Dato’Yusli MohamedYusoff, CEO of Bursa Malaysia exchanges is a culmination of the rapid development of Berhad, says that DMA“clearly puts us in a position on par India’s regulatory regime and UBS’s substantial and on- with international markets and increases our going investment into technology for its clients,” explains competitiveness, as it meets global investors’ demand for a Ranjit Hosangady, head of Indian equities for UBS. more efficient mode of trading.”

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“Emerging markets are the next frontier,”affirms Loiseau include rigorous back-testing and live-testing,“in the end of Société Générale.”Investors need to diversify and investors from London to Mexico to South Korea are become more global, which has led to greater demand for afforded the same seamless trading service,” says Loiseau. the kind of information and control that is provided on the This singular approach to meeting clients’ trading needs more mature developed markets. When investors are used means that they will be able to access a familiar system, to trading via DMA on Vodafone, it is only natural that even in new markets, with the same level of transparency, they’ll want to be able to do the same thing in Brazil on control and efficiency. Brasil Telecom or HFCL in India. The growth of the emerging markets and their increasing maturity when it Impact of alternative trading venues comes to technology and compliance, is allowing these While promoting competition with the traditional developments to become reality.” exchanges, the rise in alternative trading platforms DMA has made inroads in other markets as well. UBS nevertheless has the potential to muddy the waters for recently announced it would facilitate direct trading to institutional traders rushing to execute across direct-access Brazil over the Sao Paulo-based Bovespa, the world’s third systems. Particularly as the ranks of these venues grows, so largest stock exchange, on behalf of foreign clients. will the need for increasingly more sophisticated “International DMA is one milestone in providing technological solutions such as smart routers that can advanced electronic trading in this market, other tools and minimise costly execution errors and thereby enhance the strategies will follow very soon,”says Will Sterling, head of DMA execution experience. “Because there are so many different venues now that institutional electronic trade the same stock, trading at UBS. “Making directing access to a certain DMA available for clients exchange isn’t necessarily trading into Brazil is guaranteeing you best ex,” particularly exciting, given UBS recently announced it would says Jarrod Yuster, head of our global buy-side facilitate direct trading to Brazil over Sao global portfolio and clients’ increasing focus on electronic trading for this region.” Paulo-based Bovespa, on behalf of foreign Merrill Lynch in New York. The appeal of electronic clients. “International DMA is one “Professional or hightrading in emerging milestone in providing advanced frequency traders will want markets is obvious, as the electronic trading in this market, other to direct themselves—they general perception is that tools and strategies will follow very soon,” incorporate all of the technology progression says Will Sterling, head of institutional exchange-order types, the substantially reduces risk and, in particular, cost rebates, and they have electronic trading at the bank. execution risk; a residual their own models that are risk in many less specific to an exchange. However, in general the sophisticated markets. vanilla institutions want to Moreover, these benefits are further underscored as the concept of best execution have these smart routers or algos in place that will gradually becomes better defined, allowing buy-side clients allow them to successfully navigate through all these to more easily quantify and compare their brokers’ different venues.” Key to successful DMA usage, adds Yuster, is the right performance. Finally, from the point of view of many market practitioners, DMA and electronic trading add to amount of education, proper oversight, as well as sufficient liquidity, a key requirement if emerging market stock safeguards ensuring that orders that are not supposed to exchanges and alternative trading venues are to deepen make it through to the market do not.“Service and support product offerings. However, most trading operations is also key--if there’s a technology problem, for instance, agree, key to DMA developing as a ubiquitous feature of there should be a proper backup in place that allows you emerging market trading is the need for many emerging to get out of the market safely.” A proven source of market exchanges to improve performance, reduce fees liquidity, DMA is an essential part of any market that and encourage co-location. wants to grow its client base and increase transactional To the north, Canada, which has lagged other Western volume, says Loiseau. As such, DMA will in all likelihood countries in terms of streamlining the trading process, continue to meet or exceed growth expectations.“We will currently processes 20% of all institutional trades see more markets open to DMA, and more brokers electronically, a 45% year-over-year increase, notes offering these services in many more areas than ever Greenwich Associates. Regional adaptation is a key before,” says Loiseau. “The key, then, will be to compare challenge for DMA providers going forward, says Loiseau, the services that are provided along the way--and, most with the focus primarily on regulation and technology. importantly, to gauge the performance of these tools While the implementation process may be long and under various market scenarios.”

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Typically, trading firms now need the SOR tools that can source liquidity from all of the different potential venues and aggregation tools to present the liquidity sources and fragmented order flow in one screen. They are also looking for a range of tools to actually carry out their trading (including, execution management systems, trading algorithms, pre and post trade cost analysis). These demands have raised the stakes for direct execution providers once again, as clients have become more discerning about where they source their electronic trading services. In today’s market and the market of the foreseeable future, trading firms now need a provider that is continually investing in new technology and continually connecting to new liquidity sources. Photograph © Norebbo/Dreamstime.com, supplied October 2008.

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Direct market access (DMA) no longer refers to the simple provision of a direct trading link to a single execution venue. It has become a term used to summarise a variety of electronic trading tools/services; and in some cases is just another phrase for electronic trading. In its purest sense DMA is still the practice of enabling clients to directly access their chosen markets via a robust and low latency link to specific execution venues and exchanges. However, the market has evolved, liquidity has been dispersed to the point where these single venue links are becoming less relevant and brokers’ DMA offerings have grown to include a far more comprehensive suite of trading tools. Tim Wildenberg, managing director, head of direct execution services, Europe, UBS updates us on the latest developments in Europe.

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Hot wired DMA

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N ITS PUREST form DMA can still be viewed as an individual product in its own right (Pure DMA). Less than 20 years ago, DMA was a service provided by local brokers active in wholesale markets to their sell-side clients who where not exchange members and who would use this connectivity to offer execution services their own clients. This meant it was possible for, say, a London-based sell side firm to trade on the Paris exchange courtesy of the DMA link provided by their local French broker. Over time with the increasing sophistication of the buy side and the explosion of hedge funds, this sales model changed and consumers of DMA services widened from the sell side with no local presence to a wider community of clients. Typically this involved a buy side concerned with execution costs, lower commission rates and which was looking to take full control of its own order flow. Adoption of this direct form of trading however was still relatively slow. For some time its take up was limited to enthusiasts with specific trading styles or used alongside more traditional execution channels as a way of executing small orders or a way of getting rid of “nuisance” order flow. It wasn’t until the arrival of the trading algorithm that DMA in its widest sense (i.e. all self directed electronic trading; more commonly known as direct execution) started to become a mainstream execution channel in its own right. Initially, trading algorithms were delivered in the United States, alongside Smart Order Routing (SOR) technology to allow clients to re aggregate fragmented exchange liquidity and to better handle the increasing tendency to slice orders into ever smaller parts. The arrival of electronic communication networks (ECNs) in the US led to traders having to monitor prices across multiple exchanges or execution venues. Around the same time decimalisation (that is, the quoting of stock prices in smaller decimal units rather than the traditional fractions) accelerated the dispersion of orders away from telephone based block trading models towards central limit order books, where orders were broken into ever smaller parts in order to theoretically optimise execution. Algorithms enabled clients to take control of their order flow without having to worry about every single portion of their order. Clients let the algorithms and the Smart Routers take control of working out where and when to send the individual components of the order in order to achieve their execution benchmark using complex mathematical rules. When algorithms arrived in Europe, their focus was initially much more about optimising execution quality rather than re-fragmenting liquidity as the market fragmentation witnessed in the USA had not yet happened. SOR technology was initially not required in Europe and thus the focus was on optimising execution quality in a single venue. More recently, regulatory developments, such as Reg NMS in the US, and the Markets in Financial Instruments Directive (MiFID) in Europe, have tried to create truly open markets; where securities can be traded across

borders and on numerous venues. It is a regulatory ambition that has given a green light to the host of alternative venues, dark liquidity pools and crossing networks that had been operating on the fringes of the market. Although we are still in the early stages of this development there has been a clear change to the way the European markets operate. The incumbent exchanges that for so long held a domestic dominance are now facing competition from both the alternative venues and a wave of newly established multilateral trading facilities (MTFs) that have been specifically established to capitalise on the new market structure; with the Instinetowned Chi-X and the bank-backed Turquoise being two prime examples. These market developments have rendered the old concept of Pure DMA, with its high-speed link to single execution venues, of limited value to the majority. However there is still a strong specialist market for Pure DMA and this demand typically resides with specialist statistical or quantitative funds which look to take advantage of market anomalies and where the ability to execute in milli- (or indeed micro-) seconds is crucial to trading success. Pure DMA has become a game of technological prowess. The spoils falling to those with the fastest system helped by the right copper cable and even the availability of co-location services at the major exchanges. For the rest of the community a service that can provide a direct, high-speed link to the London Stock Exchange (LSE) has its benefits to those firms still focused on a single market, or with specific needs such as the low latency users. However, its relevance has generally been superseded by the market’s developments. Typically, trading firms now need the SOR tools that can source liquidity from all of the different potential venues and aggregation tools to present the liquidity sources and fragmented order flow in one screen. They are also looking for a range of tools to actually carry out their trading (including, execution management systems, trading algorithms, pre and post trade cost analysis). These demands have raised the stakes for direct execution providers once again, as clients have become more discerning about where they source their electronic trading services. In today’s market and the market of the foreseeable future, trading firms now need a provider that is continually investing in new technology and continually connecting to new liquidity sources.

Liquidity sources As the overall market and its clients become more comfortable with controlling their own order flow and the technology used to do this, they are becoming more ambitious in their trading strategies and more demanding of their DMA/direct execution providers; particularly in terms of the new markets they are looking to connect to. Aside from the established trading centres of London, Frankfurt, Paris, Madrid, Amsterdam, Brussels, Milan and Lisbon, firms are now looking at Europe’s new wave of

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Tim Wildenberg, managing director, head of direct execution services, Europe, UBS. Wildenberg writes that algorithms enabled clients to take control of their order flow without having to worry about every single portion of their order. Clients let the algorithms and the Smart Routers take control of working out where and when to send the individual components of the order in order to achieve their execution benchmark using complex mathematical rules. When algorithms arrived in Europe, their focus was initially much more about optimising execution quality rather than re-fragmenting liquidity as the market fragmentation witnessed in the USA had not yet happened. SOR technology was initially not required in Europe and thus the focus was on optimising execution quality in a single venue. Photograph supplied by Berlinguer Photo Archive, October 2008.

venues, such as Greece and Turkey, as well emerging markets further afield, such as Israel and the BRIC economies (Brazil, Russia, India and China). The type of client is also changing. In previous times the direct execution market was largely populated by cutting edge hedge funds while more institutional traders were beginning to embrace algorithmic trading. However, this generalisation is no longer applicable. Direct execution is clearly a mainstream product as is shown by our own trading statistics. Where direct execution accounted for between 15% and 20% of our daily trading volume a few years ago, this has now doubled and, on some days, reaches as high as 50% of our daily volume. We are also finding that firms that were previously our competitors are now our clients. Mid-tier brokers who are experts in specific markets are now hiring our direct execution services in order to expand into new markets, rather than investing in the resources and infrastructure themselves. The prohibitive front-office costs are such that many brokers see little point in investing large sums in areas that are not their core expertise so are happier to outsource the task of connecting to these markets to various direct execution providers. The range of electronic trading services on offer has similarly expanded to cover what is a far broader client base. Services now provide one-stop-shops for those firms with little or no technology resources. These services can provide risk management, news flows, trading algorithms, smart order routing, liquidity aggregation and the essential exchange membership. At the other end of the spectrum are the technology-proficient firms that just want an interface and little else.

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The exchanges A DMA service is dependant on the co-operation and continual development of the execution venues and we are seeing that the role of the exchanges in the DMA equation is changing as well. The onset of competition has lit a spark of innovation among the dominant exchanges, all of which have held a reputation for relative conservativeness over the years. The LSE, for instance, is investing in a dark pool; NYSE Euronext is launching its own multilateral trading facility; and Deutsche BĂśrse has also launched its own dark pool. Meanwhile Nasdaq OMX has launched a new order book with onward routing capabilities and Switzerland-based SWX has already gone live with its own dark pool. As a direct execution provider and a firm with strong relationships with all of these exchanges, it is important to remain neutral and to remain connected to as many venues as possible. In many ways, the role of direct execution providers is to consolidate fragmented markets. For buyside firms, this fragmentation of liquidity and the emergence of new liquidity venues is to be welcomed but also to be looked upon with some degree of caution. There is an optimum level of fragmentation, where there is enough of a sense of competition for innovation to be high and trading fees to be low. However, fragmentation can similarly become a disadvantage where the burden of connecting to a plethora of different execution venues outweighs the benefit of deregulated competition. What the market is now witnessing in Europe was preceded in the US. There the market was deregulated back in the late 1990s and led to the earlier emergence of alternative execution venues, dark pools, and crossing

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DMA IN EUROPE: A COMPREHENSIVE TRADING TOOLSET

networks. While there was an initial explosion of new venues and a violent dispersion of liquidity, this soon settled down as the number of venues consolidated to the point where accessing liquidity has become a more manageable task. I would expect a similar pattern to emerge in Europe—the current number of new execution venues will continue to grow in these initial stages before a wave of consolidation ensues as venues on both the alternative and traditional side struggle to survive in the new, competitive European securities market.

Current market conditions The struggle to survive will be exacerbated by the likelihood that Europe will enter an economic downturn for much of next year. Some legacy exchanges will be hardpushed to match the competitiveness of their new rivals, while some of the new entrants will struggle to find the extra investment they may need to fund their early attempts to gain liquidity and market penetration. The uncertainty surrounding economic prospects has led to enormous volatility in the securities markets as traders wait nervously for more news about government bail-outs

and Wall Street bankruptcies. While there are those firms that are comfortable with electronic trading and DMA and rely heavily on the technology to navigate their way through these markets, there are also those firms that have been cautious up to this point about how involved they become in DMA. It is a level of caution that will become more acute given the expected continuation of current conditions and the current appetite for investing in new projects and initiatives in the run up to 2009. Even so, the overall trend of market fragmentation will not disappear. Nor will the market’s governing bodies’ desire to see competition thrive in a deregulated securities landscape. Consequently firms will not be able to meet the regulatory requirement of providing best execution to their own clients if they are not using some form of electronic trading tools – be it DMA, smart order routing, liquidity aggregation or execution algorithms. Electronic trading is clearly here to stay and those firms that have acquainted themselves with what direct execution services have to offer will be able to better steer their way through the market’s current fragmentation and volatility.

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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2008 THOUGHT LEADERSHIP ROUNDTABLE SERIES

securities lending: the barometer of change

Participants:

Supported by:

Attendees: from left to right BRIAN LAMB, chief executive officer, Equilend FRANCESCA CARNEVALE, editor, FTSE Global Markets ROGER FISHWICK, director, Ratings, Thomas Murray DAVID RULE, chief executive, ISLA RICHARD STEELE, executive director, Financial & Market Products, JPMorgan SIMON LEE, senior vice president, Business Development, EMEA, eSecLending

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THE IMPACT OF THE CREDIT CRUNCH BRIAN LAMB: EQUILEND: I have been in this market for 21

years and I have never seen anything like this before; and I am not quite sure what to make of it. Having said that, with regard to EquiLend and its business; we are very much at the centre of the business from a trading and operational perspective a utility in the marketplace. In that regard we take a back seat to any of these issues. If anything, we have been trying to leave market participants alone while everyone deals with some of these very challenging issues. Having said that, we know our place and we, as ever, are striving to innovate and to give the market what it needs in order to evolve. As a consequence, I believe our services are stronger than ever. That is perhaps due to the fact that the people we serve are themselves striving to do the business more efficiently, in a cost-effective manner; and trying to scale their business globally. RICHARD STEELE, JPMORGAN: I would agree with Brian. Clearly, we are seeing unprecedented conditions in the global financial markets.You would almost have to go back to 1929 to find an event of similar magnitude. A number of us lived through the Barings crisis and the sterling exchange rate crisis and, you know, those were pretty minor skirmishes compared to what we are seeing today. Having said that, it is difficult to predict how deep and how long the downturn might be for the wider economy. At a time like this, our absolute focus must be on risk management, and staying very close to our clients and explaining to them what is happening every step of the way; so that they can make appropriate choices about the assets they lend in this market. Right now, people are managing risk on a day to day basis, and obviously looking at how they may change their lending practices in future to take on board any lessons learned from current events. However, with events moving so quickly at present, it is difficult to speculate on what markets might look like even months down the line. ROGER FISHWICK, THOMAS MURRAY: Have you seen any clients starting to withdraw their securities from lending because they perceive the risks to have gone up? RICHARD STEELE: We are not really seeing a notable move in that direction. Clients are dealing directly with the immediate issues and (quite rightly) looking at their risk management approach over the medium to longer term. We are having conversations with clients about making changes in lending parameters, however, and that is normal under current conditions. FRANCESCA CARNEVALE: Simon, how is eSeclending’s auction model bearing up in a market that is, frankly, confusing a lot of people? SIMON LEE, ESECLENDING: Very well actually. Obviously there is a degree of uncertainty in the market at present and at times like this there’s an increased level of focus on risk management. Particularly, lenders are being assiduous in assuring themselves that their lending agent has robust risk management procedures, as it pertains to collateral management, counterpart selection and so forth. When

BRIAN LAMB, chief executive officer, Equilend

you look at the bigger picture and look at eSecLending’s model, which primarily facilitates exclusive contracts through an auction, one advantage that emerges is the increased level of transparency it presents in regards to counterparty selection. This has always been a part of our business that our clients value. So in today’s market, where transparency is critical when considering a securities lending programme, eSecLending is well positioned and proving its worth. FRANCESCA CARNEVALE: David, there’s a lot of talk about risk management. Is it too little too late? Have the horses already bolted as we try to lock the stable door? DAVID RULE, ISLA: Securities lending is designed to be a low risk business. This has been the biggest test that that the market has ever had, both in terms of how lenders manage counterparty risks and the failure of a major dealer, which frankly, a lot of people probably thought was unthinkable. So, will people actually have adequate collateral? Will the close out mechanics work? Everyone is working through that at this very moment, and we will not know the outcome for a little while yet. The other side of it is the cash reinvestment business where we’ve had a huge movement in money market spreads. Investing at 12 months and borrowing overnight was not the greatest strategy to be in a year ago, albeit with hindsight; although it may be a good strategy to be in right now, if you are clever. So risks (even low risks) taken within this business have crystallised for the first time. Hopefully, we can come out of it stronger with the model tested and proven to be largely resilient. Hopefully, people will be more aware of the risks involved. For example, people will no longer look at cash reinvestment as something they can ignore. They will regard it as an integral part of their investment management business, if they

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choose to do it. The concern is that beneficial owners decide that securities lending is no longer core to their overall business and actually a bit more risky than they thought, and bale out. I hope that that will not happen to any great extent. I believe there are ways that most beneficial owners can run a securities lending business consistent within their overall risk appetite. Finally, one other concern I have is that some kind of regulatory backlash might emerge on the back of a popular outcry against short selling. We must avoid a misguided blame game. RICHARD STEELE: It is an important test for the industry and it is also about how well the industry performs as a whole in terms of making sure that its clients are looked after; that they don’t come away from this with a bad impression, or a bad experience. When you listen to commentators and read the news reports, people often overlook the fact that liquidity provided by securities lending is also important to the functioning of the money markets and the capital markets. Regulators and policymakers therefore should guard against throwing the baby out with the bath water. From JPMorgan’s perspective, the good news is that the legal contracts are working the way they were intended to and the collateralisation process has worked the way it was intended to. So those are some of the good things we can take away from our experience so far.

MANAGING THE IMAGE OF SECURITIES LENDING FRANCESCA CARNEVALE: Roger, rightly or wrongly, securities lending is an industry that suddenly has come into very sharp focus, for reasons not necessarily of its own making. How does it manage its PR now? ROGER FISHWICK: From where I sit, the biggest immediate danger is a kind of Maxwell effect. In the 1990s we saw a lot of UK pension funds withdraw from securities lending following the Maxwell scandal. The danger is that kind of reflex action again, where everybody says:“What on earth are we doing in this business?”Now, the onus is on the lending community to manage that process more carefully, manage the communication, both with individuals, individual lenders and borrowers, but also to manage the macro PR (as is being done at the moment) to try and make the case that, really, securities lending is part of efficient market operations. It is not there to provide a load of madcap speculators with easy pickings, which is, kind of, how the populace press seems to come over when it discusses all of these issues. So it is really time for the big players in the market to make the case very positively for what they’re doing and why they’re doing it. SIMON LEE: This increased focus on risk management within securities lending started when the credit crunch began last year and obviously it remains to be seen how far this current downturn will last. One benefit that does come out of this is that lenders have become far more educated through their efforts to understand where returns are being generated from and what risk are taken to achieve them.When the dust finally settles, lenders and agents will be much better for it.

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BRIAN LAMB: This situation is different. It was true with

Drexel Burnham Lambert which went out of business; it was true with the derivatives problems that we had in the early 1990s; it was true with the Russian debt crisis and the Latin American debt crisis, with the Malaysian crisis, and so on. However, this particular event – if you can even call it one event – is absolutely different. It will go to the core of what securities lending is all about. This roundtable will support talk about the things that we all know, that securities lending is good for liquidity and price stability in the market place, and that there are logical and good reasons for securities finance. However, there must be some fundamental changes in this business. For example, this whole general collateral or hot stock relationship that’s existed for years, may alter. The marketplace has benefited from the liquidity offered by lenders of general collateral. Perhaps, the margins on that collateral will widen. Perhaps general collateral shouldn’t trade at two basis points. Perhaps it should be much wider. I never thought that I would see the day when repo would trade at the spreads it has been trading at lately. Perhaps what is happening is a return to a more appropriate price point for those sorts of things. This is unprecedented. RICHARD STEELE: We can make some educated guesses but probably we will not know the end game players for some time. Some of the demand drivers will be different in future. You can also see it in the proposed merger of Lloyds Bank and HBOS, people are starting to say that those who stayed with the more traditional commercial banking model seem to be the smart guys, all of a sudden. I am not saying everybody will go back to that, but invariably we have got to look at what is going to happen with dealers who create a lot of the demand for this product. What will their management decide to do? What will their shareholders and regulators want them to do? It is a hard one to call: as there are many possible scenarios. SIMON LEE: It is commonly suggested that the market will continue to grow as more supply is made available by more investors making their assets available to lend, as more emerging markets remove lending restrictions, as sovereign wealth funds increase their lending activities, and on the demand side, an ever increasing number of hedge funds, hedge fund strategies, and 130/30 funds. That said, will that suggestion be realised? It’s clearly no longer easy to predict what this business will look like in the future or the timeframe for continued growth. DAVID RULE: I was just going to say that balance sheet is going to get more expensive. Regulators are going to have higher capital requirements on banks for a while. Investment banks, running on very high leverage, are, I suspect, history. Moreover, lenders may require higher returns for risk. So marginal trades are not going to happen. In that sense, activity in the market may fall. On the other side, particularly in bond lending, we are in a world where everything is going to be required to be collateralised and demand for collateral is going to go up, and dealers just don’t have large values of high quality bonds on their balance sheets. So they are going to have to borrow them. I predict bond borrowing demand will remain high, but equity borrowing demand may fall.

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BRIAN LAMB: Securities finance demand essentially touches

SIMON LEE, senior vice president, Business Development, EMEA, eSecLending

IS THERE A NEED FOR INCREASED REGULATION? FRANCESCA CARNEVALE: Is this the kind of perfect storm

where the markets now have become so complex that it is going to be quite difficult to unravel a lot of situations because of a lot of contradictory movements and exposure? Are investors going to be more reliant on professionals, such as yourselves, to create more transparent and rigorous investment and lending structures? Or, will existing structures and regulations, such as Basel II, come to the forefront? RICHARD STEELE: I can’t see the regulator giving the market more freedom at the moment. However, you are right; they have to decide where they want to focus. Taking your point about Basel II, it is part of the framework of managing risk, but it typically requires banks to set up their own value of risk model or use the regulator approved model. Obviously the regulator would have to approve the internal model, but any model is only as good as the assumptions that you plug into it. Given that the assumptions have changed along the line it is clear that the capital adequacy framework will have to be revisited. ROGER FISHWICK: Brian made a very important point at the beginning, which is all about the de-leveraging that is going on. There has been a push for the last year or so to deleverage the balance sheets of the investment banks because, basically, they have operated like macro hedge funds for a long time. My concern, for the medium term, is that securities financing has really grown very rapidly on the back of that increasing leverage we’ve seen over the last few years. In future, the market may well be smaller than at current in the medium term for the securities financing industry.

every part of the market place. Perhaps it is the broad ubiquitous nature of the business that makes it an easy target. While there are complexities at the very essence of securities finance in fact, they are actually not that complex. Rather, they are not fully understood either by the public or by regulators. It is also not very sexy or interesting. Instead, it is often rather mundane. Paradoxically, that is why it is a target right now. FRANCESCA CARNEVALE: Brian has highlighted the fact that maybe some areas need clarification and certainly some regulators may require help with understanding how, going forward, the business can work in what is looking to be the new world order. What role can you play in providing that education, in lobbying for the right kind of support rather than extra regulation? Moreover, how might you mobilise the industry to best leverage what’s happening now as opposed to being placed in a reactionary role because of this fear that people have? DAVID RULE: Well, that’s the role of ISLA. With our limited resources, we have done a reasonable job over the past couple of years of doing just that. The concern I have is that the regulators will not be able to take a dispassionate, consultative approach and they will be under pressure from politicians to act. Frankly, we have already seen that in the United States. Moreover, regarding your earlier point about Basel II and changing capital requirements, my interpretation is that a well-organised dealer that has all the information, would actually come out with lower capital requirements for this business from Basel II. Although that’s probably history now because, although Basel II may not be rewritten, there will be a kind of over-ride which says banks have to have higher overall capital requirements. ROGER FISHWICK: That’s one of the important things that the industry can influence. Securities lending and repo are very important providers of liquidity, and liquidity is a big issue for banks at the moment. It is a message for the politicians as well, but constricting securities lending drastically will constrict liquidity in the banks themselves, which impacts overall, delaying money flows to corporates, which oils the wheels of the economy. DAVID RULE: The best we can hope for is that the storm will pass in terms of banks failing and etc. The news story will be gone, and then the regulators will, maybe, be given enough space to come up with a measured response.

THAT’S THE BAD NEWS: NOW WHAT ABOUT THE GOOD? SIMON LEE: Taking an optimistic view of things, where do we see the industry going in the short to medium term? BRIAN LAMB: Historically, people have had lots of time to respond to change, but today, we have to manage change. Change happens at such an increasing rate every day. Moreover, it seems to me that is exactly what is happening here and it is not going to slow down. Additionally, we have got access to information unlike any other point in history. Is all that a good thing? Perhaps not. You know,

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transparency in the market sounds like a really good idea. However, everything has its limits, and I do not think that it is necessarily a good thing that people have access to such critical information on a minute by minute basis. Moreover, you don’t have time to really absorb it and understand what the larger implications are, and so things are more knee-jerk. I do not think that is a good thing. SIMON LEE: To pick up on that point made on transparency; that is the environment we are in and we have been going down that path for some time. However, it was not too long ago when transparency was not a primary concern and when there wasn’t clear information available to lenders to easily review the risk /return profile of their programme. This is means that there is still room for improvement in certain areas which could be a good thing for participants. DAVID RULE: We may come out of this crisis with a completely new order of big players in the industry, especially on the borrowing side. Moreover, that may mean that change in market structure is more feasible than maybe it was with the people who were dominating the market six months ago. Priorities may also change. For example, managing balance sheet and counterparty risk have become much more important. RICHARD STEELE: Obviously, the future for the securities lending industry will look a bit different, but then the market today looks different to how it was ten years ago, and part of that is down to technological change. I agree with Brian, perhaps there is too much information, but fortunately or not depending on your point of view, we are paying a lot of very clever people to keep churning out more and more products all the time and it seems to be the way that the market works nowadays. Looking to the future, securities lending will remain a value added product to most fund managers, and the industry needs to convince its customer base that the returns and the risks are still in alignment. We do have to make a case for this, but we can do that by reaffirming our core principles which are around risk management and being close to our clients, so that we can present them with options that fit best with their overall investment framework. However, collateral guidelines will likely change, and also the level of reporting which is required. I for one remained convinced however, that the securities lending industry will continue to add considerable value to its customer base, even in the new market conditions. FRANCESCA CARNEVALE: Do you think that clients will review how they get to market, how they achieve their securities lend out, provide, securities lending provider? Does it bring into focus the stability of their securities lending outlet? RICHARD STEELE: It does, but they already go through a rigorous review process. Roger’s firm contributes to that. Consultants go through a very detailed RFP process at the moment. Moreover, any securities lending provider at the moment has to be able to offer a full service to clients like JPMorgan can, whatever their route to market is. But it’s not just saying you can do it; it’s also about demonstrating that you’ve risk management expertise, as well as the capital base to support the indemnity.

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RICHARD STEELE, executive director, Financial & Market Products, JPMorgan ROGER FISHWICK: Clearly, consultants try to do as

thorough a job as possible to look at the lending component of the overall portfolio, what the custodian is offering, and to see how well risks are managed. Consultants do that because people find it very difficult to judge themselves. Independent advice does help people to understand the risks, understand the differences between different lending programmes and different lending agents. BRIAN LAMB: I am sure the five of us would be very good at describing why this market is efficient and a good idea, and how the risks are mitigated, but when we turn on the TV tonight, what people are talking about is short selling and why that is contributing to this calamity. So we get drawn into that because of our relationship with short selling, obviously. Therefore what we need to do is more than we have done in the past to describe and educate people about benefits of this business. This is hard because, for instance, I do interviews all the time with various publications and I will look at the results after the interview and sometimes, there’s been nothing that I’ve said that appears on the page. That is because what I’ve had to say might be uninteresting, or it is not going to sell a magazine. Good news, quite often, doesn’t really sell. I’m sorry, but that’s life. FRANCESCA CARNEVALE: Again, do you need to temporarily educate the retail market, or are you having to educate, what seems to an outsider, to be a sophisticated market that should understand the difference between speculative short selling, to drive down the value of a respective bank, and short selling in order to make a profit for your portfolio? BRIAN LAMB: I heard Greenspan on the weekend when he was being pressed quite aggressively about short selling. What I took away from the interview was that without short selling, you will have everybody on one side of the equation; you’ll have everybody whose self-interest is of supporting one another and you’ll have people who are weighting the value of what they own. Moreover, when the truth of the position is realised, the price collapse will be so dramatic because it has been too irrational on the upside. So obviously, there is absolutely some great rationale for short sellers to add value.

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SIMON LEE: We are getting to a point where regulators are

becoming better educated on the industry and beneficial owners are even more educated as well. Unfortunately, it seems as though the politicians and the mainstream press continue to misrepresent what is happening.

THE QUESTION OF COLLATERAL RICHARD STEELE: The challenge is one of providing appropriate returns, but also managing risk versus that return. I guess if the tide goes out, we will probably see who’s been managing that risk to the utmost. Managing the correlation between risk and return on your portfolio should always be part of the focus; not just in the last year during the credit crisis. Therefore, you need to be looking at your agent’s ability to manage cash on your behalf and looking at what sort of credit analysis they perform on those investments, and whether you are indemnified or not. On the non-cash, securities collateral side (and a lot of clients, frankly are still in government bonds when it comes to collateral), as long as those are seen to be diversified, it all comes back to best practice. I don’t think ideas about best practice will necessarily change, because diversification, looking at your liabilities, to your maturity date; all of these are still core principles. What people may do is just move their calibration of some of these things into an area where they feel they’re going to probably get maybe less return, but also less risk at the same time. SIMON LEE: The nature of collateral, if not its form, has changed over the years. Collateral is taken first and foremost to mitigate the risk of counterparty default. Over time, for some lenders collateral became a key component of securities lending revenue as additional returns can be generated through cash reinvestment. Since the Lehman collapse, the focus has reverted back to the ability of collateral to protect lenders in the event of counterparty default. Secondly, the management of cash collateral is now seen as an asset management function, with the attendant risks and rewards. Concerns over liquidity are at the forefront and understanding the relationship between lending activity and cash collateral management is paramount. For Lenders, collateral flexibility is key. When lenders review their cash collateral reinvestment program, they should undertake the same level of due diligence as they would when employing an equity or bond fund manager. ROGER FISHWICK: One of the things that has given me a bit of anxiety over the last couple of years has been the development of more aggressive cash management. We expected to see more aggressive cash funds being put out to certain sophisticated lenders, and you wonder what all of that means. Well, the consequence are losses in those that are publicly known about. BRIAN LAMB: Fundamental and simple point is that collateral is meant to be collateral. It is not meant to be a means to leverage. With regard to where we are today, absolutely, there’s only going to be less cash collateral in

this market going forward; there’s not going to be more. We can all agree on that point. How quickly we get there, I don’t know. The US market is probably, at least, 90% cash collateral and is challenged by these issues more so than probably the non-US market. How quickly that evolves to a non-cash model, I don’t know; but it’s headed in one direction, and one direction only. FRANCESCA CARNEVALE: Once collateral comes into the picture, then the securities lender uses that as a fund, as an asset manager. Cash collateral, has often been used as a selling point as to why you should use one securities lender over somebody else. DAVID RULE: That’s right. The industry however has been wrong to sell securities lending and cash reinvestment as a bundle product. They are actually two separate products that are related. You should be saying to your client, “By the way, off the back securities lending, you can get involved in the leveraged money market investment business with us, if you want to”. In Europe, you can unravel it in that way as well, because the client can say: “I don’t want to, thank you very much. I prefer to take non-cash collateral and not take the risk in the money markets.” In the US, ERISA guidelines mean that pension funds are drawn into cash reinvestment if they want to lend securities. The irony is that the regulators probably think the safest bet here is to just have cash collateral – that sounds really safe. It’s cash. The fact of course, is that it is potentially – potentially, but not necessarily –more risky than any form of non-cash collateral. ROGER FISHWICK: We get our clients to look very closely at the guidelines that they are prepared to put in place, and to compare them with their corporate treasury guidelines. The question we ask is: “Would you allow your corporate treasury to do some of the things that the money managers do with the cash?”We then find that they then start to cross certain instruments off because they know that their corporate side would not use them. RICHARD STEELE: The regulations come into this as well. If you look at UCITs regulations, it broadly states that any collateral should be held in accordance with the investment profile of the UCITs fund. On a very strict interpretation, that could lead to anomalies. An emerging markets fund, for example, might feel obliged to take emerging markets securities as collateral which could appear to be inherently more risky. BRIAN LAMB: I want to be clear: we should not throw the baby out with the bath water. Cash collateral in and of itself, is not a bad thing. What is wrong with cash? To the extent that it’s consistent with the investment objectives of the clients, then it is quite often, a very positive thing. To the extent that it is not, as Richard’s example illustrates, clients need to understand that even non-cash collateral needs to be well understood and managed. Back to the point, collateral is meant to be collateral. SIMON LEE: This goes back to the need for transparency. Lenders should be able to clearly understand program earnings and identify intrinsic versus reinvestment returns.

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FRANCESCA CARNEVALE: When

clients give you instruction on the use of collateral for reinvestment, are they equally concerned with overall risk and the compatibility of cash collateral reinvestment programmes with their overall investment approach; or are they simply looking to make an extra tip on return? SIMON LEE: Within our programme, we encourage lenders to first evaluate the intrinsic value of their portfolio. Reinvestment returns, then, are incremental. This results in increased transparency for the lender as they have a better understanding of the sources that revenue is derived from; whether it’s the intrinsic value of the loan or from the cash reinvestment. To underscore Richard’s point about agents managing cash, some lenders manage the cash themselves or use a third party investment manager. The cash collateral reinvestment is truly an investment management decision, and lenders should make their decisions based on the factors I have just described. ROGER FISHWICK: Is it the case, then, that in the last year or so, the cash crisis dog has been wagging the tail? It’s always been about cash and the returns on that, and very much less emphasis on the intrinsic value of the securities lending. SIMON LEE: I can only speak for our programme and the answer is no. Route to market for our clients is determined via an auction. The bids that are placed for exclusive arrangements are driven off the intrinsic value of the underlying portfolios. So, from our perspective, no. The decision that our lenders make is based on the revenues generated from the lending activity, and not the cash reinvestment process. However, it should be noted that over the last 12 months, within the industry as a whole, there’s been a shift away from the use of cash collateral with more focus on collateral flexibility and the use of noncash collateral.

DAVID RULE, chief executive, ISLA

THE TRADING EQUATION THE VIEW FROM A BRIDGE FRANCESCA CARNEVALE: When it comes to cash

collateral, reinvestment, gain returns from your portfolio, you all seem to have very well-informed customers. When it comes to securities finance, the issue of short selling and problems in the market, these very same customers aren’t as well informed. I don’t see the consistency in that. RICHARD STEELE: It’s an interesting point. I wouldn’t probably put it as black and white as that, but I see where you’re coming from.You know, managing cash is more often than not an integral part of the client’s business. Whatever cash guidelines they agree with the securities lending agent, will be a subset of their own treasury guidelines. that’s clear. So depending on where the securities lending activity touches the client, it may well be very close to their treasury function; it may be in their operations function, and they understand the business of managing cash on a day to day basis. Some of the other issues, Francesca, that you brought up are more overarching and I think this emphasises the importance of having regular dialogue with your clients.

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BRIAN LAMB: Electronic trading is here to stay and just

about every market in the world, and it’s here to stay in securities finance. And the definition of that… and the acceptance of that are things that will be debated. But in my view, a trade’s a trade, whether I pick up the phone to execute a trade with another person, or I set up an automated means to execute a hundred trades with that same person, regardless, those are trades. They were trades yesterday and they’re trades tomorrow. This industry will absolutely need more of that sort of a solution in order to prosper, especially in light of recent events and in order to manage programmes in the best interest of clients. RICHARD STEELE: There’s still a lot more to be done in all areas of the industry in order to leverage the capabilities of technology from electronic trading all the way through to back office efficiencies. It is kind of interesting because we have been going through this year by year and developing more products; Equilend, for example, has developed lots of products to help people manage their risk, their back

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office, and their front office, and there’s a lot being invested by firms in connectivity, but there’s still more to be done, frankly. When you are managing risk, you want to be able to get all the information you need to make a decision fast, and then be able to press the button to execute. Because when you’re trying to allocate collateral or close down a loan position, speed and accuracy are key. ROGER FISHWICK: It’s where the electronic transactions will come into their own. If you have a proper exchange and proper risk mitigation through the use of a central counterparty and efficient clearing, settlement and collateral management in the same way that the equity markets and so on work, where you’ve got intermediation of the post-trade risk by central counterparties.. BRIAN LAMB: In some respects,. yes, absolutely, there is a portion of the business that it would make sense for it to be that way, but this business is different; it’s different than the cash equity business. It’s different than the futures business. There’s a duration to a loan. It may be overnight or it may not be; it may be for a year or more, and because of that it creates subtleties that aren’t easily managed in a central counterparty model.

SAFEGUARDING LENDERS RIGHTS IN A VOLATILE OR UNCERTAIN MARKET: FRANCESCA CARNEVALE: In an insecure world – and we

do seem to be in an incredibly insecure world right now – is the message, the one message that has to go out is that lenders’ rights are safeguarded, or is there another more important message to go out in order to build on what’s been achieved in the securities lending market? RICHARD STEELE: Securities lending is a voluntary activity. It’s not the core activity of the investment manager of the fund, so it needs to be conducted in an environment that provides an incentive for them to do so. If that balance is tipped, then they will withdraw from that activity, voluntarily if you like. So it’s absolutely paramount that the industry is organised in such a way that clients’ rights, as beneficial owners, are protected. Nobody should lend shares without the assurance that they’re going to get back all the rights and entitlements, be it with dividends, corporate actions and obviously, ultimately, the return of the securities that they lent in the first place. Moreover, it is an ongoing process and it needs to be calibrated according to market conditions. The future of the industry and providers will be built around the fact that hopefully we have all demonstrated that we are up to those challenges and that we have managed the clients’ risks successfully, and that clients have actually been looked after during this period of market turbulence. FRANCESCA CARNEVALE: Simon, given the general gist of the conversation, do you think that, going forward, the securities lending industry will have to redefine what beneficial owners should expect from lending their assets? Will the expectations of beneficial owners of securities lending now change?

SIMON LEE: As an industry, we continue to improve our

communication about how the industry operates, ensuring that Lenders understand how their programme is managed, where their risks are and how those risks are mitigated. Securities lending is a risk/reward product and that doesn’t change, thus beneficial owners’ general expectations of the industry should not change. I don’t see the message changing much from where it is now. That said though, I expect beneficial owners to become more demanding of their providers around these points, requiring more detail around counterpart selection, collateral management and pricing. Also, it will become clearer to beneficial owners that they have a choice when it comes to accessing alternative routes to market. We were talking about technology earlier which has dramatically changed the landscape in recent years. From an operational perspective, technology has enabled third party programs to run efficiently which was less the case in years gone by. This results in more choices for lenders.

COMMODITISATION OR CUSTOMISATION? ROGER FISHWICK: One of the difficulties the industry has

is that everything is bespoke. It’s all based on bi-laterals, every borrower or lender relationship is different. The mechanics are, very often, different, the operation mechanics, cash reinvestment, guidelines are bespoke for everybody. It does need some standardisation. SIMON LEE: Is that not, though, indicative of a risk/reward product in much the same as asset management is? Wouldn’t every asset manager argue that they are providing a bespoke service based on their client’s ultimate investment guidelines and parameters? Securities lending is not dissimilar in that every beneficial owner will have different guidelines on risks, revenue, counterpart exposure, market exposure and so forth. ROGER FISHWICK: There are similarities, but coming back to Richard’s point, it’s not the same at all. Investment management is fundamental to the clients; that’s what they have to do to generate a better return, that they’re going to pay the members with. The securities lending is a kind of voluntary, they don’t have to do it and they would be marginally worse off if they didn’t, perhaps. The revenues that they’re earning are not the 18% annual returns that they’re seeking from investment managers and so on. They are very small returns. And to expect a huge amount of effort on behalf of each of these individual funds, to understand the risks at the levels that we’re describing them, to understand the different variants, is asking too much for too little return. That is why the future for the business is more standardisation, more standard components, and just certain negotiations around the edges of that, rather than everything is negotiable when you start the relationship. SIMON LEE: However, it very much depends on the lender and how they want to participate in the business.

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And whilst I agree with you that some beneficial owners would rather be in a standardised pool, which I would liken to an index fund, there will always be lenders that require more from their lending programme that wish to achieve optimal returns and want to be more actively involved. They will be the ones seeking customisation and going down the specialist route. They will view lending as an investment management decision and using the asset management analogy, will be active managers of their securities lending programme. So the question is, will the industry evolve to serve lenders in both camps? ROGER FISHWICK: So, people, who just want the standard return, could go into your index version, and people who are perhaps more sophisticated in their requirements … SIMON LEE: …would use a specialist agent. For lenders that want to go down a standardised route, it requires full standardisation of technology and infrastructure. BRIAN LAMB: Standardisation is the very premise on which EquiLend was founded. Our tagline is the global standard in securities lending. Applying standards, in my experience, to markets that are over the counter, is quite challenging. It’s not impossible, but it is very challenging. You need to get people to agree, to have the same standard, agree the same terminology. Even the terminology, especially in the global market, is a difficult thing to achieve. This is a market that is only going to need more standardisation in order for people to optimise their approaches to manage the business. In order for the ultimate consumer, the beneficial owner, to understand what they are getting themselves involved in; we are going to have to be able to describe it in standard terms that they can understand, and to accept or not accept, because it is a voluntary piece of business, as Richard said. In addition, it is my view that, the beneficial owner, is going to want to get paid more for it than they have been paid so far; regardless of what it is that he or she is agreeing to lend. RICHARD STEELE: Yes, lack of standardisation will just increase costs for the industry so whilst there will always be a requirement by some clients for a customised service you also need a baseline that you can work from. Sometimes, this will involve putting the information in the client’s hands, for instance, client reporting tools will deliver a standard set of data that they can then manipulate it themselves and feed it into their own applications. And that’s much better than the old days when you would actually create umpteen different permutations on a standard report because the client wanted it in green ink rather than black ink. ROGER FISHWICK: It sounds like there’s risks around standardisation as well. When we are going through these considerations for funds, we are looking at the securities lending parameters, we’re looking at the cash management guidelines and trying to knock out some of the instruments that perhaps are not required. If something gets standardised, this is the basic agreement. This is the basic, what you should do with the cash. Just get that in place,

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ROGER FISHWICK, director, Ratings, Thomas Murray

and then everybody would agree it, it would just mean that you were only then looking after the more, like the very sophisticated, very interested parties. SIMON LEE: I would argue, to an extent, that that scenario is already in place in the industry. Custodial discretionary programmes are that standard, vanilla programme that you are looking for. ROGER FISHWICK: But for each custodian separately, and they’re not the same for every custodian; each has his own bespoke client lending agreements, cash management guidelines etc. SIMON LEE: Again, to an extent, though I would argue that the custodial programmes aren’t overly dissimilar.You then have specialist providers, like eSecLending, and others who are delivering a more customised product that certain sophisticated investors will always require because they want to optimize their risk/return profile. They don’t necessarily want to accept the traditional custodial route. So, I agree with your point and believe that to an extent, the scenario you describe does exist already. Similarly, you could argue the same about the global custody business in that every custodian provides a different flavour of a standardised product. You already have an element of standardisation there, but you also have a number of specialist providers serving a specific client base.

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THE CHALLENGES FOR BANKS IN 2009 & BEYOND

BANKING AFTER THE FLOOD Federal Reserve Board chairman Ben Bernanke (right) and Treasury Secretary Henry Paulson testify before the House Financial Services Committee on Capitol Hill in Washington on Wednesday, the 28th September. Ben Bernanke’s announcement in late October to the Congress that: “With the economy likely to be weak for several quarters, and with some risk of a protracted slowdown, consideration of a fiscal package by the Congress at this juncture seems appropriate,” Bernanke told Congress in his first endorsement of a second US stimulus package. Bernanke also said he was encouraged by improvement in credit conditions, but it was too soon to draw conclusions. The White House said it was open to a stimulus plan and would look to Bernanke for guidance. Photograph by Manuel Balce Ceneta, supplied by Associated Press/PA Photos, October 2008.

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According to a recent survey by global law firm Norton & Rose, there is a gathering consensus that more institutions will fail and that radical changes to the structure of the global financial services industry are inevitable; natural consequences of the continued liquidity crisis. Over the next three editions, we look at what those changes might involve for the banking industry; the asset management industry; as well as the global debt and equity markets. We lead this issue with a round robin of the challenges and opportunities facing the banking, private equity, leveraged buyout, high yield and US treasury markets. EADERS FROM 20 advanced and emerging economies will meet in Washington in midNovember to thrash out issues around the continuing financial crisis. That China and other high growth markets will join with traditional debaters from the G10 economies is the clearest indication yet that, despite current market volatility which is trashing any and all markets that the league table of economic movers and shakers has now altered irrevocably. For one, the nature of the interaction between governments and what used to be private sector led banking has changed, perhaps for all time; blurring the distinction between what is public sector and private finance. What will certainly be on the discussion agenda is the continued vulnerability of banks, global, regional and national to market shocks. What that means is that at the very least over the coming two to five years, with the increasing involvement of politicians in the operation of the global banking system, via refinancings and equity stakes, the hitherto liberal and free-ranging nature of the banking system will be irrevocably changed, and perhaps muted. No one appears immune right now. In the last week of October, the truth of that statement was made plain, as Standard Chartered and HSBC, two financial institutions which until then had been the poster boys of financial circumspection came in for a mauling: with their supposed strengths (low exposure to toxic debt, an asset book that spanned key emerging as well as advanced markets) suddenly looked less attractive. American Express, one of the US’s top four credit-card issuers, reported a 23% decline in its third-quarter income from continuing operations as it set aside more money to cover credit losses; a clear indication of the spread of the crisis into the real economy. Other traditional darlings of the global economy were also trounced, albeit to varying degrees. In Asia, South Korea announced a $130bn rescue package, and China reported that economic growth eased in the third quarter and forecast a further slowing in the fourth quarter. In India, the central bank unexpectedly cut its key lending rate for the first time in more than four years. Looking at the continental regions, few indications are clear as to the ultimate structure or make-up of their respective banking sectors. In Latin America, however,

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developments are moving apace; for two reasons. One, the sub-continent is subject to massive swings in capital flight (domestic and international funds) and whatever happens there is an inevitable bellwether of longer term trends elsewhere. Already there are questions circulating over the commitment of Wall Street firms to the region. Perhaps the biggest source of speculation in Latin American financial circles is what will be the future of Merrill Lynch in Latin America since its incorporation into Bank of America. That bank had slowly been exiting the region, particularly with the key sale of BankBoston to Banco Itaú. The demise of Lehman Brothers has also given some pointers to how the new Latin American landscape might look in future. The firm’s burgeoning Brazilian business was bought by BTG, a start-up company run by Andre Esteves, the ex-head of fixed-income for UBS, who recently left to set up his own shop. Certainly, the rise of sovereign fund equity in many financial institutions in advanced and emerging markets is beginning to rewrite the power structures behind the financial system; the emergence of more corporate equity holders (increasingly common in the Middle East and Russia, for example) may start to be a feature elsewhere from 2009 onwards. In the medium term (at least through to the middle of next year) the markets globally will continue to be characterised by a chain of refinancing and rescues.The most obvious ones to date won’t be rehashed here. The latest casualty is Gulf Bank, Kuwait’s fifth largest bank, forcing the Kuwaiti government to guarantee the country’s bank deposits. The Kuwaiti central bank then stepped in to Gulf Bank itself, with governor Sheikh Salem Abdul-Aziz Al-Sabah appointing a supervisor for its treasury business and guaranteeing deposits, after the bank was hit by losses from currency derivative trades. Resignations were accepted from billionaire chairman Bassam al-Ghanim (who was rapidly replaced by his 61-year-old brother Kutayba al-Ghanim) and board member Abdul-Kareem al-Saeed. Chief executive Louis Myers affirmed he had not resigned.The lender posted two straight quarterly profit declines. “Things are now calming down,” general manager Fawzy Thunayan said, declining to say how much money clients had withdrawn since the bank unveiled the derivatives losses on Sunday. Gulf Bank shares were suspended pending an investigation by the central bank regarding the derivatives losses. There is a growing body of empirical evidence pointing to more bloodshed. The global financial crisis will lead to radical changes in the structure of the financial services industry with more financial institutions set to fail, according to a survey of financial institutions by international legal practice Norton Rose. According to Stephen Parish the law firm’s, global head of banking, “The credit crunch has entered a dramatic new phase. What started as a liquidity problem arising from writedowns of mortgage-backed securities has been transformed, into a much more serious financial problem. Intensive efforts are being made to rescue and reform financial institutions; many are questioning the viability of their business models.”

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The report Credit Crisis: The Long-Term Implications For A the rest of both the advanced and advanced emerging Turbulent Market is based on a survey of 195 respondents from economies. A prolonged overhaul of financial institutions financial institutions and mainstream corporate entities could leave consumption contracting in the west and between the 16th to the 25th September this year to canvass global fixed-asset investment slowing significantly, which the views of financial services professionals on the impact of would put pressure on commodities demand. The first the credit crunch on the industry and its effect on corporate fence to fall is invariably the syndicated loan market; which behaviour. Almost 80% of the survey respondents expect bankers report is enduring a complete slowdown. The more financial institutions to fail, with 91% predicting extent of the problem is highlighted by shipping increased consolidation and 38% expecting more state companies complaining that their business is stymied; but ownership of financial institutions. Moreover, 75% believe the it applies across the business spectrum. How quickly the rot spread to the direct investment effects of the credit crisis will take between one and five years to dissipate; 17% believe they will take over five years or will sector, again a bellwether of bank related activity, is noted in the latest issue of remain permanent and a Investment News published whopping 94% say radical changes to structure of by the Organisation for financial services industry Economic Co-operation “Cash is king right for the foreseeable are inevitable, with 85% of and Development future for corporates, consumers, respondents predicting (OECD), multinationals investors and banks. The second increased regulation. based in its thirty mostly problem facing governments in the wake Mercifully, perhaps, the industrialised member of their massive bailout is one of countries had investments tenor of responses was not worth over $1.8trn abroad unadulterated gloom. Just crowding out. According to Stuart in 2007, a record level. For under half of the Thomson, investment manager, at 2008, however, OECD respondents (47%) said Resolution Asset management, “This is predicts a sharp decline of they were actively clearly evident in the UK forward interest around 37%. Evidence to pursuing opportunities in rate market where short-dated real support this is the sharp new markets, especially in slowdown in cross border emerging economies (36% forward interest rates have risen sharply mergers and acquisitions, mentioned India, 47% the over the past few weeks.” which have been hit by the Middle East and 33% recent credit crunch. China) but also in Western Foreign direct investment Europe (31%) and in (FDI) flows to developing countries could decline by as North America (23%). According to James Bateson, head of financial much as 40% this year from their record level of nearly institutions, at Norton Rose:“Some economists believe that $500bn in 2007. growth in emerging markets could offset the slowdown in A number of trends in the bailout are emerging. One is the West, and investors from Asia and the Middle East are that a piecemeal strategy towards solving the banking crisis increasingly making strategic acquisitions of Western is unworkable and the likelihood is that nothing short of assets. Whatever course events take, the next few months full and unfettered bailout of the banking sector, backed by an uptick in government spending will be effective. The will be challenging and unpredictable.” The continuing crisis will invariably lead to continued de- British rule busting option of increasing borrowing to leveraging and re-capitalisation of banks’ balance sheets. revive flagging economies is being adopted globally; John Ultimately, as China discovered in 2002/2003 and 2004, Maynard Keynes is in, Milton Friedman and the Chicago there is no quick fix to the problem of banks that are over- Boys are definite out. extended in the wrong kind of debt. In China’s case that A critical measure of lending between banks, the threeinvolved the injection of more than $150bn into its leading month Libor rate, fell the most in a single day since January banks and ultimately, privatisation to general liquidity to in a sign that banks were regaining some confidence in refinance their balance sheets. Western institutions, unless dealing with each other. The markets appear sanguine, if able to find, as Barclays has done, significant equity inputs not comforted by this development. Following Ben from the Middle East or Asia, where sovereign funds have Bernanke’s announcement in late October to the Congress deep and ever deepening pockets (despite losing some 20% that: “With the economy likely to be weak for several of their overall value over the short term) then have to go quarters, and with some risk of a protracted slowdown, cap in hand either to their own governments (which has consideration of a fiscal package by the Congress at this sometimes involved wholly or part nationalization), multi- juncture seems appropriate,”Bernanke told Congress in his first endorsement of a second US stimulus package. lateral agencies, or been forced to succumb to a fire sale. While the bank’s have and continue to attempt to secure Bernanke also said he was encouraged by improvement in some sort of future, credit turmoil continues to spread to credit conditions, but it was too soon to draw conclusions.

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The White House said it was open to a stimulus plan and would look to Bernanke for guidance. The statement from the recent G7 Finance Ministers’ meeting laid out the guiding principles among developed economies of the key elements of a concerted and protracted commitment to Keynesian stimuli; namely, • Take decisive action and use all available tools to support systematically important financial institutions and prevent their failure. • Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding. • Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to reestablish confidence and permit them to continue lending to households and businesses. • Ensure that our respective national deposit insurance and guarantee programs are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits. • Take action, where appropriate, to restart the secondary markets for mortgages and other securitised assets. • Accurate valuation and transparent disclosure of assets and consistent implementation of high quality accounting standards are necessary.. more will be required, but the odds favour another round of cash injection into the banking sector next year. In the US, the Treasury is proceeding with its loose interpretation of its rescue plan to provide equity guarantees to the financial sector as well as the removal of toxic debt. New rules will place greater reliance upon management valuations of level two and level three banking assets. The general agreement is that what seemed a massive $700bn requirement for the rescue plan is still way low, and will not cover delinquency rates in the residential property market, which had an average 12% delinquency rate in the last major downturn in the early 1990s. Out of a current $14trn national residential property portfolio, if delinquency rates mirror those in 1990-1992, that’s a chunk of change. All in to date G7 governments have promised $3.3trn, to guarantee bank deposits, bankto-bank lending, and providing equity capital to banks with toxic assets. At least that again will be required to sustain the efforts to stabilise markets through at least the first half of 2009. Much will depend on the end of year bank results, and early indications are that some of the banks having received massive injections of state cash might still announce surprisingly high year end losses. What that means, as we keep saying throughout this edition, cash is king right for the foreseeable future for corporates, consumers, investors and banks. The second problem facing governments in the wake of their massive bailout is one of crowding out. According to Stuart Thomson, investment manager, at Resolution Asset management,“This is clearly evident in the UK forward interest rate market

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Us Treasury Department secretary Henry M Paulson Jr. The Treasury is proceeding with its loose interpretation of its rescue plan to provide equity guarantees to the financial sector as well as the removal of toxic debt. New rules will place greater reliance upon management valuations of level two and level three banking assets. The general agreement is that what seemed a massive $700bn requirement for the rescue plan is still way low, and will not cover delinquency rates in the residential property market, which had an average 12% delinquency rate in the last major downturn in the early 1990s. Photograph by Manuel Salazar, provided by Associated Press/PA Photos.com, October 2008.

where short-dated real forward interest rates have risen sharply over the past few weeks. Five year real yields deflated by forward inflation expectations are 3.5% more than productive economic potential and prospective economic growth. These are excess and reflects the DMO’s decision to begin funding the bank bailout in the current fiscal year.” At the same time long-dated nominal forward rates have fallen sharply, illustrating, according to Thomson that “investors’ expectations of future inflation in 20 years time has fallen sharply, indicating that they believe that longterm productive potential rates have fallen sharply.” Government debt managers are understandably nervous about the consequences of auction failure, while at the same time are keen to reassure voters that the crisis will be of short duration and that issuance costs will be minimised. “These base emotions should be resisted,” maintains Thomson.“The best way to avoid re-issuance risk and help bail out the banking sector is use the funding program to help steepen the yield curve. The resulting rise in longdated gilt yields will also help the equity market by raising the discount rate for pension funds.”

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US TREASURIES: A FLIGHT TO QUALITY

The US Treasury’s funding activity indicates how intense investors’ aversion to risk has become, too. William O’Donnell, head of rates strategy at UBS in New York, points out that short term rates have plummeted even though the market has had to absorb unprecedented quantities of Treasury bills. The rate dipped briefly below zero at one point, which hasn’t happened since the early 1930s.

MORE THAN DEATH & TAXES If Benjamin Franklin were alive today he might expand his famous declaration that “nothing is certain but death and taxes” to include the issuance of debt by the federal government. Franklin, whose portrait appears on the United States’ $100 bill, would surely understand that a pledge to buy up to $700bn of assets from beleaguered financial institutions ensures that the Treasury will be shovelling debt out the door at a brisk clip from here to eternity—or at least the foreseeable future. Neil O’Hara reports. OR NOW, THE financing cost of the banking sector bailout will be cheap as nervous investors shun everything except Uncle Sam’s IOUs. Payback will be a bitch, however. When banks resume lending to each other and investors recover their faith in private sector borrowers, the Treasury will have to pay higher interest rates to finance a ballooning federal deficit. The government bailout will help revive confidence in the banking system, but it will not relieve pressure on the money markets at a stroke. Short term funding rates tick up in the fourth quarter every year as banks hoard liquidity to flatter their published balance sheets, and this year will be no exception. In addition to regular seasonal influences, however, money market fund managers have become more selective in what they buy, according to James McDonald, vice

president and portfolio manager for taxable money market funds at Baltimore, Maryland-based money manager T Rowe Price Associates (TRP). For example, TRP’s credit analysts have dropped some names and lowered credit limits for others on the approved list of banks and corporations from which McDonald buys commercial paper and other short term debt instruments. As managers raise their credit standards, the higher cost of borrowing to the marginal money market participant pushes rates up for everyone else. Knock-on effects from the beginning of the credit crisis are coming home to roost, too. Extendible floating rate notes were an early casualty, but when the market dried up in August and September 2007 investors were left holding one year FRNs that are now maturing. McDonald says a few banks were able to sell new paper over the summer, albeit at higher spreads— 30 to 40 basis points (bps) instead of 1bps to 5bps over LIBOR last year, until the convulsions in September 2008 sent investors back into the bunker again. The Lehman Brothers bankruptcy in particular threw a curve ball at money market funds when losses on unsecured Lehman debt forced the Reserve Primary Fund to report a net asset value of 97 cents instead of $1, only the second time in history a money market fund has “broken the buck.”Panicked investors deserted money market funds in droves until the Treasury put up $50bn to insure their holdings. A $3.5trn industry lost 5% of its assets in just two

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weeks, and, although subsequent redemptions slowed, the flow of funds did not reverse. Ajay Rajadhyaksha, director and head of US fixed income and mortgage strategy at Barclays Capital in New York, says money market fund managers, a risk averse bunch by nature, have turned away from bank paper, which made up almost one third of money market fund assets. “The managers had a near brush with death,”he says,“It is not worth a few extra basis points in yield to stay in bank debt.” Most investors didn’t switch from money market funds to insured bank deposits, however. Instead, the money poured into Treasury bills, driving the yield on 3-month bills as low as 0.03% on September 17th, the day before rumours of a bailout package surfaced. Rajadhyaksha says money market fund managers joined the stampede into Treasuries, potentially cutting off $1trn of cheap funding for the banks. “The only reason to buy bank paper was because it was rock solid, just like Treasuries with a little more yield,” he says, “Once that illusion shatters you cannot put it back together again.” The flight to quality blew out the spread between LIBOR and overnight indexed swaps (OIS) to 200 bps, far beyond the high point reached in March when Bear Stearns collapsed, let alone the 8bps to 12 bps at which it traded in early 2007. Worse still, the two-year LIBOR-OIS spread, which had been trading at 50bps to 60bps, soared to 162bps. “In March, the two-year LIBOR-OIS basis was around 100 bps. People were convinced at some point liquidity would improve,” says Rajadhyaksha,“Now the market expects money will remain expensive for two years.”In effect, the spread widening offset 100 bps of easing by the Fed because most borrowing costs are tied to LIBOR rather than overnight interest rates. The US Treasury’s funding activity indicates how intense investors’ aversion to risk has become, too. William O’Donnell, head of rates strategy at UBS in New York, points out that short term rates have plummeted even though the market has had to absorb unprecedented quantities of Treasury bills. The rate dipped briefly below zero at one point, which hasn’t happened since the early 1930s. “They have been front-loading supply at the short end and yet bill rates are lower than they have been at any time since the Depression,” says O’Donnell. The Treasury has already signalled it plans to issue more 10-year and 30year bonds in the future, however. O’Donnell does not see LIBOR falling back to earth until the banks start making money again. The government bailout fund is critical to that process: Whether indirectly through buying assets at above-liquidation prices or directly through cash injections it will shore up bank capital.“You have to put a thumb in the dyke to stop bank losses,” says O’Donnell, “Once that happens banks may slowly loosen the purse strings and lend to consumers and other banks again.” It all takes time, however, not only to get controversial legislation passed during an election season but to get the new structure in place and to work through the inventory of unsold and foreclosed homes overhanging the housing market.

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James McDonald, vice president and portfolio manager for taxable money market funds at Baltimore, Maryland-based money manager T Rowe Price Associates (TRP). For example, TRP’s credit analysts have dropped some names and lowered credit limits for others on the approved list of banks and corporations from which McDonald buys commercial paper and other short term debt instruments. Photograph kindly supplied by T Rowe Price Associates, October 2008.

Contrary to conventional economic theory, O’Donnell says the supply of Treasury securities has historically exhibited little long term correlation to interest rates. In fact, supply is countercyclical; when the economy weakens tax receipts slow but mandated government expenditures are fixed so the deficit increases and the Treasury must borrow more to finance it. Treasury borrowing and deficit spending becomes a counter-cyclical shock absorber for the economy. In the long run, the public purse benefits; as the Fed cuts rates to stimulate the economy, the Treasury ramps up debt issuance. O’Donnell says supply changes correlate closely to swap spreads between Treasuries and LIBOR, although not in the way people expect. Increased supply does eventually drive up Treasury rates, but deficit spending fuels an economic recovery and credit conditions improve. Therefore, LIBOR does not move up as much. The swap spread gets compressed because the denominator is rising faster than the numerator.“When Treasury supply is falling swap spreads are widening, and when supply is rising swap spreads are narrowing,”O’Donnell says,“That relationship was cut in stone throughout time—at least until the recent breakdown between LIBOR and Treasury rates.”The spike in LIBOR during the past year has overwhelmed the usual effect of supply on swap spreads. Time lags in the system ensure that Treasury supply continues to rise long after the recession is over, too. For example, O’Donnell says Treasury issuance peaked in 2004, three years after the 2001 recession. Once the Fed has finished cutting rates, however, the market begins to anticipate the next move up and the yield curve flattens.“That’s when you see the pro-cyclical effect of supply,” O’Donnell says, “You have the lingering effect of weaker growth pushing supply up at a time when the economy is improving, which amplifies the shift to a higher rate structure.” The government bailout means the certainties in life are not just death and taxes any more.

BLOODIED, BUT NOT BOWED

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High yield bonds in the United States got whacked as the credit markets unravelled this year. In fact, the yield spread between the Merrill Lynch High Yield Masters Index and Treasuries soared to 983 basis points (bps) in late September, up from 240 bps in June 2007 and only 100 bps or so shy of its peak in 2002 during the last credit cycle. Even though the default rate for high yield bonds rated by Standard & Poor’s has ticked up from a record low of less than 1% at the end of 2007 to 2.5% in August, current spreads suggest the market expects a much higher rate over the next couple of years. Like so many other sectors of the credit markets, however, todays’ prices owe less to economic reality than technical selling pressure. In a fragile market, however, cheap assets often get cheaper. Neil O’Hara reports.

Photograph © Aloysius Patrimonio/Dreamstime.com, supplied October 2008.

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issues. Relatively few new bonds IANE VAZZA, earn a BB rating, which makes it MANAGING director and harder for high yield portfolio head of global fixed managers to move up the credit income research at Standard & quality spectrum, a classic defensive Poor’s (S&P), says the firm’s move during a bear market. “High baseline prediction calls for a 4.9% yield is really a mainstream B game default rate in high yield bonds now,”saysVazza. over the next 12 months through Supply may not have dropped to the middle of 2009. S&P as much as the issue calendar assigns a 60% probability to an suggests, however. Eric Tutterow, a underlying economic forecast that managing director in Fitch contemplates a mild recession in Ratings’ US leveraged finance late 2008 and early 2009, which team, says bridge loans that used will push unemployment up to to finance the 2007 leveraged 6.2%. Meanwhile, subject to buyout (LBO) boom were demand and any OPEC inspired designed to convert into high reduction in output, the yield bonds after 12 months if they consumer’s pocketbook will were not refinanced beforehand. remain under pressure from high In mid-September, for instance, oil prices as next year progresses. banks converted $980m of the If the economy turns weaker— Douglas Forsyth, head of income and growth strategies Clear Channel Communications S&P’s pessimistic case calls for a portfolio management and research at Nicholasbridge loan into 10.75% bonds long and deep recession, Applegate Capital Management, a simple comparison to rated CCC, but found no takers persistent financial gridlock, the past ignores fundamental changes in the composition when they offered the bonds at sharper falls in house prices, oil at of the high yield market since the last credit cycle. In 75% of face value. Just $228m sold $200 per barrel and 1999, media, telecommunications and technology at 70%, an effective yield to unemployment rising to 8.5% by companies accounted for 42% of the high yield market, maturity in excess of 18%. Shortly the end of 2009—Vazza says the many of which were losing money and ultimately failed. afterward, the underwriters of the default rate could hit 8.5%. Photograph kindly supplied by Nicholas-Applegate First Data buyout converted a The base case implies 81 Capital Management, October 2008. $7bn bridge loan into high yield defaults, up from 53 today, while bonds and never even tried to sell the pessimistic case requires 140 defaults. Vazza notes that S&P them. Although the banks kept “Would you rather own a the unsold bonds on their balance now has 135 US companies rated single-A credit at 900 bps sheets they still represent B- or lower on CreditWatch with potential future supply. negative implications or a negative over or a high yield bond at “The market has no appetite for outlook, the weakest constituency 1000 bps?” asks Tutterow. In lower quality high yield debt right in its corporate ratings universe. practice, he admits that is an now,”Tutterow says,“Investors can All those companies—or others unrealistic choice because get very good risk reward trade-offs that are not in that profile right few bonds trade at the in leveraged loans and investment now—would have to default if the average spread; it’s a barbell grade bonds.” Prices have dropped worst case comes to pass—a 20% to about 83 cents on the dollar in chance, in S&P’s view. market in which sound the leveraged loan market—for The sharp increase in spreads financial companies trade at senior floating rate paper that is reflects an aversion to credit risk perhaps 200 bps and those secured and has shorter duration among investors that has teetering on the brink may be decimated high yield bond than high yield bonds. The spread as high as 3000 bps. issuance. Through August 2008, on the Merrill Lynch BBB-A US Corporate Index hung around 500 volume amounted to just 35% of basis points (bps) over Treasuries in the prior year’s level. It is a tough comparison, according toVazza; noting that issuance in the late September, and for the financial services sector it was first half of 2007 was inflated by a slew of large private about 900 bps.“Would you rather own a single-A credit at 900 equity buyouts. “Deals are getting done at spreads 80% bps over or a high yield bond at 1000 bps?”asks Tutterow. In practice, he admits that is an unrealistic choice because few wider than they were a year ago,”she says. The high yield sector has slipped back below 50% of total bonds trade at the average spread; it’s a barbell market in US corporate bond issuance, although among non-financial which sound financial companies trade at perhaps 200 bps companies high yield bonds still account for two thirds of new and those teetering on the brink may be as high as 3000 bps.

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APRES LE DELUGE: THE OUTLOOK FOR HIGH YIELD BONDS

Default rates are a lagging indicator, of course, which explains why high yield investors also keep a close eye on the default ratio, the percentage of bonds in the Merrill Lynch High Yield Master II Index that trade at spreads over Treasuries in excess of 1000 bps. From a low last year below 2%, the default ratio has shot up over 36% in recent days. Tutterow says studies have shown roughly 22% of issues that trade over 1000 bps will end up in default within one year. Therefore, a 36% default ratio implies the default rate could rise above 8.5 Tutterow notes that Fitch believes the default rate could surpass the historical average of approximately 5% by year end 2008 even before taking Lehman Brothers, Washington Mutual and Wachovia into account. Moreover, it is likely to increase further in early 2009. While that would represent a big increase from current levels, Tutterow notes that Fitch’s default rate topped 17% in November 2002.“Is 810% a disaster?” he asks, “Not really. We have been there before and recovered from it.” To Douglas Forsyth, head of income and growth strategies portfolio management and research at NicholasApplegate Capital Management, a simple comparison to the past ignores fundamental changes in the composition of the high yield market since the last credit cycle. In 1999, media, telecommunications and technology companies accounted for 42% of the high yield market, many of which were losing money and ultimately failed. Today, Forsyth says the issuer base is more diversified (please refer to the diagram: High Yield: Industry Weights). The majority of companies are profitable and most were able to refinance their balance sheets before the credit crunch took hold at interest rates in the high single digits. Forsyth acknowledges that the default rate will increase over the next year or so but expects it to peak at 5% – 6%, well below the 11% – 12% seen in prior cycles. With spreads over Treasuries already at 1000 bps, he believes the market has already priced in almost all the likely deterioration in credit performance. “The risk-reward in

Diane Vazza, managing director and head of global fixed income research at Standard & Poor’s (S&P), says the firm’s baseline prediction calls for a 4.9% default rate in high yield bonds over the next 12 months through to the middle of 2009. S&P assigns a 60% probability to an underlying economic forecast that contemplates a mild recession in late 2008 and early 2009, which will push unemployment up to 6.2%. Photograph kindly supplied by Standard & Poor’s, October 2008.

high yield is bright regardless of the economic outcome,” he says, “Even in an extended recession high yield bonds have better protection than stocks.” Prices are likely to remain depressed while banks try to offload unwanted bonds; proprietary trading desks cut back leverage and hedge funds raise cash to meet redemption requests, but Forsyth is not worried. Coupons always contribute the lion’s share of the return in high yield, and with yields in the low teens investors are being paid to wait.“You can dip your toe in the water now or wait a couple of months,” he says, “Technical pressure has caused a massive spread widening without a commensurate increase in defaults.”

High Yield: Industry Weights Media, Telecom, and Technology 42%

Media 9.7%

Basic Materials Capital Goods 9.7% 6.1% Brokerage Banks 0.2% 2.4% Consumer Cyclical 12.4%

Consumer Non-Cyclical Co 5.5%

Telecom 8.6% Technology 4.4% Other Industries 58%

Energy 10.5%

Utilities 7.7%

December 1999*

Financ Financials 1.1% Insuran Insurance 0.7%

ces Non-Cyclical Services 6 8% 6.8% Services Cyclical 13.1%

*Based on the Merrill Lynch Highh Yield Master II Index, industry percent by market value

R l Estate Et t Real 1.2%

June 2008*

As of end of June 2008

*Source: Merrill Lynch, Bloomberg, Nicholas-Applegate. provided October 2008.

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Holding on, though feeling the strain In the past two years, Asia was seen as one of the jewels in the private equity crown. Record sums were raised to tap into the buoyant economies of India and China which were seemingly following their own and not Western path. The credit crunch was an issue but not a significant factor until this autumn when it erupted into a full blown major global financial crisis. The region is expected to more than hold its own but valuations and volumes are likely to fall further. Lynn Strongin Dodds reports.

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S JOHN SINGER, a London based managing partner of private equity firm Advent International, puts it, “Everyone will be cautious because it is uncertain how conditions will evolve. At the moment buyers are not only considering the price but also whether a company will be able to weather the storm. China and India may experience a significant slowdown but they should still generate reasonably robust growth.” The Asia Pacific private equity industry started to feel the strain in the first half of the year although China and India held their own, according to a report from the Asian Venture Capital Journal (AVCJ). Overall fundraising was down 21.5% to $19.2bn from $24.5bn in the same period last year. Australia and Japan experienced their biggest falls as investors realised the days of the large leveraged buyouts

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Chris Meads, a partner at private equity group Pantheon Ventures in Hong Kong notes,“The peak in fundraising was in 2007 reflecting the speed at which investments were realised but going forward, I expect there will be a significant slowdown over the next couple of years. However, I do not believe the region will experience the same downturn as in Europe and US. Private equity is a much more underdeveloped market in Asia with most of the deals being done in the mid-market. Also, leverage is not as much of a feature and most countries are in a more robust state in terms of their finances and fiscal policies.” Photograph kindly supplied Pantheon Ventures, October 2008.

were over for the foreseeable future. Australia suffered the most with a significant 75% drop to $775m from $3.08bn in the first six months of 2008 while fundraising in Japan slid 33% drop to $1.89bn from $2.85bn a year earlier. Singapore also lost its status as a major regional fundraising hub, with a 96% drop on the first half of 2007. Only $126m was raised versus over $3.4bn during the same period last year. The country is being usurped by China which saw Hong Kong-based regional funds record a sharp increase to over $7.24bn, compared to $3.3bn in the first half last year. India was also popular, attracting $3bn of funds, a 30% hike over $2.3bn. Not surprisingly, the number of buyouts in the region declined. They comprised just 31% of the region’s deals in the first half of 2008, down from 64% in the first half of 2007. By contrast, expansion capital deals, in which firms make minority investments, jumped to 24% of all investments, from 20% of deals a year earlier. Private investment in public equity financing deals, known as PIPE deals, also jumped, accounting for about 24% of investments, up from 13% last year, according to the AVCJ report.

Looking ahead, all market participants agree that China and India and to a lesser extent Japan will continue to be the region’s most active markets. All three countries, however, felt the impact of a series of body blows in early October. Despite governments’ best intentions, whether it is the bailout of Germany’s Hypo Real Estate, rescue of the Benelux’s Fortis or the privatisation of the UK’s Bradford & Bingley, share prices across the globe plummeted. Not even the US’s mammoth’s $700bn bailout package or UK’s $500bn bank lifeline could restore confidence. Kathleen Ng, managing director of the Centre for Asia Private Equity Research in Hong Kong comments, “Investors will be more cautious and growth will slow down but the majority of deals in the region are under $50m and they are pure equity plays. Qantas would have been the largest leveraged buyout (the A$11bn deal collapsed) but I do not think we will see any more of those in the foreseeable future.” Chris Meads, a partner at private equity group Pantheon Ventures in Hong Kong notes, “The peak in fundraising was in 2007 reflecting the speed at which investments were realised but going forward, I expect there will be a significant slowdown over the next couple of years. However, I do not believe the region will experience the same downturn as in Europe and US. Private equity is a much more underdeveloped market in Asia with most of the deals being done in the mid-market. Also, leverage is not as much of a feature and most countries are in a more robust state in terms of their finances and fiscal policies.” Pat Hedley, senior vice president of General Atlantic, which specialises in expansion capital deals, also notes, that “In general there will be a renewed discipline in terms of valuations but companies will still need funding. This is especially true in today’s markets because it will be harder to get financing through the public or credit markets. We look for companies that have a proven business model, have strong fundamentals in terms of performance and are looking for a capital partner with expertise to help them grow.” As in other regions, though, lending will remain tight and returns will not be as rewarding. Deals have already been scuppered or are in a holding pattern. For example, the biggest deal in the region – the $6bn plus buyout of Japanese real estate company Daito Trust Construction by local private equity group Unison Capital - has recently been shelved because Mizuho Corporate Bank would not lend the money. Daito issued a statement noting that it would be difficult to go through with the buyout because of ‘’dramatic changes in the economic environment.’’ There are also question marks over two of China’s headline grabbing multi-billion dollar deals; Huawei , the Chinese telecommunications equipment and PCCW, Hong Kong’s dominant fixed-line telecommunications operator. Both have seen several short-listed bidders abandon their interest due to the spiralling cost of credit and the dwindling prospects for the US economy. Huawei is currently mulling over bids from US private firms Bain Capital and Silver Lake, for a majority stake in its mobile handset division, which is valued at $3.5bn.

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Meanwhile, there are question marks as to whether PCCW, will go ahead with plans to fold most of its core fixed-line, broadband and television assets into a separate holding group, and to sell up to a 45% stake in the newly formed vehicle to investors. The deal was expected to raise up to $2.5bn but the stake is now hard to value with markets changing minute by minute. A recent report by Deloitte, which canvassed 30 private equity operators in China, confirms that the road ahead will be difficult. It said that falling returns and tougher exits will make the next 12 months the most challenging in recent times for the dealmakers in the country. However, the country has never been an easy market to crack mainly due to the regulatory issues and lack of financial transparency at many Chinese companies. This past summer, confusion reigned when the Anti-Monopoly Act was passed which calls for national security reviews for foreign investments, protects key Chinese industries and grants authorities substantial discretion. The problem is that the government has yet to say who will enforce the law, which covers mergers, price fixing and day-to-day business agreements. A number of buyout firms have already had problems. Last month, for example, Carlyle Group did not receive regulatory approval for its $375m (€255m) buyout of Chinese machinery manufacturer Xugong Group, despite having begun the deal process three years ago.

Nonetheless, private equity firms have not been deterred from putting down roots and working in the system. The growth story is too compelling. US private equity firm Blackstone Group recently signalled its commitment, by hiring a 12 strong advisory team. Last May, the heavy hitting group sold a 9.9% stake in its management vehicle to the Chinese government for $3bn (€2.1bn), a landmark investment at the time. Two months later, it won one of its largest mergers and acquisitions mandates from the Chinese government, advising China Development Bank on its investment in UK-headquartered Barclays Bank. Sam Robinson, director of SVG Capital’s fund advisory business, SVG Advisers, says, “One of the big questions that investors have to ask is whether they buy into the sustainable growth story. We do and are confident that China will remain the engine for growth. However, we are also aware that it will not be a smooth curve upwards.” Mounir Guen, founder of MVision, a private equity adviser. “The main difference with the emerging markets such as China, India as well as countries in the Middle East is that banks did not take on leverage. While their economies will be impacted by the global economic downturn, we are still looking at relatively strong growth rates of 5%, instead of perhaps 10%. In the long-term, though, the growth story in countries such as China is irreversible with its emerging middle class and easing of

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Ren Zhengfei, CEO and managing director of Huawei Technologies, right, and Chinese Premier Wen Jiabao, left, at the Huawei premises in Bangalore, India, Sunday, April 10, 2005. Others in the photo are unidentified. Huawei, China’s biggest maker of telecommunications equipment, is considering buying Britain’s Marconi Corp. PLC in the latest foreign takeover bid by a Chinese company, news reports said but a Huawei spokesman declined to comment Tuesday, Aug. 9, 2005. (AP Photo/ Huawei Technologies Ltd., HO)

regulations. There will be challenges but the path is set.” China’s burgeoning 250m strong middle class are only factor underpinning the long term health of the private equity industry in China. The other pillars include the global competitiveness of domestic Chinese firms that need expertise and capital to expand internationally, the tightening of credit from Chinese banks, and the decline of China’s stock market. According to Ng,“the hottest sectors for investment at the moment include internet and consumer related companies. Food is also strong although it has had negative publicity from the milk powder scares. The industries that will continue to be the hardest to invest in are those connected to national security such as defence. As for India, John Gripton, managing director and head of investment management Europe at Capital Dynamics, notes that it is easier to do business in India as the business has developed more in line with the UK and US private equity industries. “China has a completely different legal system which makes it harder but not impossible to do business. There is a lot of activity in Hong Kong and the most important thing is to identify the issues and know how to deal with them.” Although India has a thriving local private equity industry, it is by far the most internationalised private equity market in Asia. In the first seven months of the year, there were 47 fund allocations to Indian funds, and 64% of them had participations from foreign organisations, according to industry reports. Local and European players accounted for 36% each, followed by North America at 23% and the Middle East and Asia, with a respective 2% share. As in China, the most attractive sectors have been IT, healthcare and consumer related companies and most importantly of all, infrastructure. One of the reasons that private equity firms have flocked to India is the hope to tap into the Indian

government’s ambitious targets announced last year. It aims to almost double investment in the sector to 9% of gross domestic product a year over the next five years, or a total of $500bn. Projects range from modernising 35 secondary airports and adding 78,000 megawatts of electricity capacity (including nine so-called ultra-mega power plants with generating capacity of 4,000 megawatts each) to 387 ports-related developments. Real estate continues to be a key area of investment: with many private equity investors looking at the region in terms of short term buying opportunities and long term returns. LaSalle Investment Management, for instance, is targeting distressed sellers in Asia as it looks to invest its latest $3bn real estate opportunity fund. Some 80% of the fund is still uninvested and the firm believes that private equity investors now have the edge in local investment talks given the general uncertainties in the capital markets. LaSalle closed its Asia fund in August, at the time saying it was seeing“a lot of opportunity in Japan”as well as Korea, China and elsewhere in Asia Pacific. In a separate development, China’s sovereign wealth fund, the China Investment Corporation (CIC) has reported decided to increase its stake in the Blackstone Group, and the US buyout firm has notified the Securities and Exchange Commission (SEC) that it has raised the equity limit that CIC can own from just under 10% to 12.5%. Beijing Wonderful Investments, the investment vehicle CIC used to buy more than 100m non-voting units of Blackstone prior to the firm’s public float last year, was formerly prohibited from owning more than 9.99% of Blackstone. CIC paid roughly $3bn for the stake. In the wake of current equity market volatility shares in Blackstone are below the firm’s initial offering price of $31 per share. Blackstone shares ended trading in early October at $9.36, down 70% from the IPO highs.

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WHEN CASH IS KING N RECENT YEARS, a private equity and LBO’s became a larger and larger part of the financial scene both in terms of cash and media attention; and then came the fully fledged crisis of autumn, when banks began to fall, rather like the leaves from the trees. When the banks put the US’s biggest tobacco company, Altria’s $10.3bn bid for UST on hold, it was surely a sign that the times were a changing. Not only has the company been a completely reliable source of income, one would intuitively expect people to smoke more during the bad times threatening! Loans for previous buyouts are trading way below par in the secondary market despite their often preferred position. For example, media giant Univision’s loans are at 62 cents on the dollar. While many such companies remain profitable, the crisis of confidence indicated by discounted pricing like this makes it much more difficult to raise funding for new deals, not least since the overall credit crisis means that lenders are forced to seek exit strategies that offer liquidity in the face of difficulties raising cash elsewhere. “Anything with the word ‘leverage’ is sure to emote thoughts of the ‘plague, or ‘a nuclear spill’...a bit strong perhaps, but you get the picture,”said one financial advisor when asked, but others are more sanguine. Preqin’s Private Equity Report for the third quarter this year, noted that on the one hand, there was a notable slowdown in venture capital fundraising and on the other, there were some 284 buyout funds“on the road”trying to raise commitments in excess of $310bn. Not all, most likely, will be successful. However, for those asset owners and asset managers with cash, as Warren Buffet is happily demonstrating, these can be the best of times for astute investors. Buffet’s purchases of lucrative stakes in Goldman Sachs and GE demonstrate what the resourceful and resource rich can do.

Photograph © Alinougbigh/Dreamstime.com, supplied October 2008.

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APRÈS LE DELUGE: WILL THE US LBO MARKET GET BACK INTO GEAR?

“Anything with the word ‘leverage’ is sure to emote thoughts of the plague, or a nuclear spill; a bit strong perhaps, but you get the picture,” says one New York based financial advisor when asked to comment about the US leveraged buyout market. Others, luckily are more sanguine. Preqin’s Private Equity Report for the third quarter this year, however reports that there currently 284 buyout funds “on the road” trying to raise commitments of $310.4bn. Good luck to them. Ian Williams reports from the Big Apple on a sector that may defy expectations in 2009, as larger LBO houses find they have cash to burn.

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know when. But we’ve been preparing for it, so we have the process, procedure approach and strategy ready and we know the sectors that we want to invest in.” While there is a consensus that the large leveraged deals will be much less common—lack of leverage being, of course, the big issue, the medium to small range of deal seems to be a haven for investors. Carbone expands about RW Baird’s approach. “We have never leveraged our businesses highly and we have ten operating partners sitting next to us An archive photo of Berkshire Hathaway’s Warren Buffet participating in the Treasury with operating expertise, next to the Conference on US Capital Markets Competitiveness at Georgetown University in Washington in capital. There is a lot of private equity this March 13, 2007 file photo. The bond insurance industry, battered by fears of collapse, capital on the sidelines and in funds, received some validation at the end of last year as Warren Buffet’s Berkshire Hathaway opened waiting to be deployed,”he says.“On a business to guarantee municipal bonds. This year he staged a coup, ploughing more than $5bn the bank side, they are obviously into Goldman Sachs. A file photograph by Gerald Herbert for Associated Press/supplied by PA struggling with lots of issues, but they Photos, October 2008. are still deploying for good On a more predatory level KKR, the renowned inventors opportunities. They too are being very selective and picky of the leveraged buyout (LBO), have reputedly amassed a about what they do; but for the right companies, the right war chest of $58bn, which certainly equips it for bottom opportunities and the right long term partners [they will] feeding if they are so inclined. As Peter Gerry of Sycamore work with people they know and trust. Although larger deals Ventures points out “Some of those that have tremendous continue to be difficult to finance, there’s certainly capital out cash balances in their funds will do so without the leverage, there, particularly at the lower end of the market place. We and some of them have subordinated debt funds they can closed an investment last week and we feel good about it.” He adds “What is attractive about this class is that it is a wrap around transactions. Nevertheless, while using internal leveraging instead of from long term class. We are not looking for quarter on quarter other people has its benefits on the upside, it certainly does not performance, but for trading results over multiple years, on the downside. At the end of the day, if you can leverage it secondly, it’s an activist class, so it’s not like buying a stock with other people’s money (OPM), you can make a much better and crossing your fingers. We buy a company get our hands return for investors!”Which is why, of course, LBO’s typically round it, work closely with the management team, and we want to leverage their cash with debt. Firstly their available cash improve value – and all of us have different tools in our tool may have been tied up in fashionably disastrous forms of kit. We improve that value over multiple years and we muscle finance, previously liquid and now frozen or freezing, while the build companies and create returns. In these volatile markets, being an activist investor and not being subject to the whims credit crisis ends the easy loans once available. Private equity funds are also seeing renewed interest from and volatility of the public markets is a good thing.” However, Carbone cautions,“The tremendous tumult in major institutions with cash to spare and foresight to go with it, ranging from the New York State Teachers the financial world is going to have repercussions in the Retirement System (NYSTRS) fund to the Harvard real economy, and no one knows how far down it will go. Management Co, the $35bn endowment fund run by Jane We are going to be prudent, very selective, and look for Mendillo, its president and chief executive officer, who have the very interesting opportunities that will be in the both considerably increased their allocations to the sector. market place, but the issue is the price to earning (P/E) By the same token some of the larger buyout firms have also multiples. What may appear an attractive P now depends circling major companies including Iceland’s Baugur and on the E – if the earnings are uncertain, the P/E may be Spain’s Prisa, scrutinising opportunities offered by the high less attractive in six to twelve months.” Key questions, he opines, include: “where is the bottom? If you wait a profile war wounded in the current liquidity squeeze. In mid-October, as dead cats bounced only to fall even month the deals may be even better, so when do you lower, Patrick Carbone, managing partner at RW Baird in jump in to take advantage?” Chicago, averred“We fundamentally believe that there will On the reduction in exit strategies with the public be value out there. Down markets have proven to be very markets depressed now and likely to remain so for the attractive times to deploy capital, but you want to very foreseeable future. Carbone is reassuring. “There are selective, and not too early. We’ve been through cycles multiple ways out of the room. Be careful about lumping before, and we knew this one was coming, we just did not LBO’s into one big bucket. There are mega-funds, big finds,

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medium and small funds, all addressing different markets. the existing debt on its original terms, without triggering a We have used all doors out the room: we exit on the smaller debt refinancing.” The attraction for both parties is, he end through strategic buyers, sale to financial investors, or points out, that the incumbent firm, the counter-partner original owner, will have the ability to demonstrate public offerings.” Jacques Callaghan of Hawkpoint, is slightly more bearish objective value, and also get cash back through the deal about the prospects, “Fundraising is going to be a major while benefitting from any further upside.” consideration – it will be pretty tough over the next year or As for the sectors in Europe,“Clearly the financial sector so. With public equity markets coming down, the absolute has been battered, but there are local banks that do not amount available comes down, so there is less money for have the issues that others do, for example Scandinavia, private equity, and on top of that, the lack of exits clearly and of course oil will do well with the right financing,” has an effect as well. Fundraising is going to be difficult. So thinks Callaghan. To assess which way the wind will blow he is watching a number of private firms will be looking hard at their portfolios, although LPs do not necessarily want or need to with interest to see the completion of deals that were see exits from portfolio companies, it always helps to have struck during the summer.“Now those deals are just it will them. So some will be looking to see ‘what can I sell next be interesting to see if the banks actually complete them. year’ even if it is not an excellent time to sell. In terms of Are banks going to say they are open for business but deal flow, for buyouts, secondary buyouts, tertiary buyouts actually from now to the end of the year not really go forward with them but keep them on hold?” Clearly, in a will still be important in the future.” However, he also points to the ingenuity of the sector in panicky environment, banks have to be careful what signals they send about their rising to challenges.“At the capital availability, but as moment there is an the Altria deal slowdown enormous amount of suggests, the markets private equity available, expect and tolerate some and the public markets are caution. not really open, so if a We may even see a Darwinian company needs equity it is However, some of those struggle as the better capitalised, less more likely to go down the distressed companies may leveraged, or just more astute equity private route. The question include those bought out funds swoop on the failures in private is whether there will be the a year or two ago in highly returns with the reduced leveraged deals with sales on the verge of Chapter 11. amount of leverage favourable debt. If those available.” In the credits are due to roll over, meantime, he suggests, or the economic “Private equity firms are conditions squeeze profits over-equitising in the hope so that they cannot meet that in a year or two’s time they can get more debt in than contracted interest payment, this is not a good time to cash in the original deal, so they investing on the assumption in the public markets. We may even see a Darwinian struggle as the better capitalised, less leveraged, or just that the debt markets will recover by then.” Above all, he certainly does not see a complete end to more astute equity funds swoop on the failures in private the growing private equity sector. The capital is there, sales on the verge of Chapter 11. waiting for opportunities and even currently, “if anyone is There is money waiting, from pension funds, sovereign good at asset pricing - and only the really good are trading wealth funds and others that may be interested, but at at the moment. There is a scarcity value to deals at the current valuations, one cannot help thinking that the only moment, but for companies trading at relatively low companies prepared to sell will be under severe financial multiples, financing has been available, so the sector is still pressure – and certainly the Preqin report shows strong holding up relatively well, although obviously the debt interest in“Distressed Equity.” It is up to the private equity funds to decide whether component has been reduced quite a bit.”The money shops are not yet shuttered, so even at the height of the panic, he their potential acquisitions are distressed because of poor recounts,“we did one of the largest deals in Europe where management, short-term credit blips, or the longer-term we sold a business for a debt package €900 million. downward economic cycle, or whatever combination. The Lehman was one of the five. It could have fallen over, but point of a buyout is to make a company more profitable the other four banks took up the strain.” and thus more valuable, and in the current market The climate also suggests new entry strategies. Callaghan conditions, it takes a very high-resolution crystal ball to suggests, as has Henry Kravis of KKR, that there will a ascertain resale value in the near future. But the brave, and growing tendency to avoid taking complete control. Rather those houses with foresight, will continue, and will almost private equity will take a significant, and one presumes certainly reap rich rewards. It is, after all, the losers who influential, stake without taking control,“That would keeps make the winners, and pay for them.

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Fall-out Fears Ferment in Latin America Countries in Latin America with more orthodox policies are suffering greatly as well. In October, Chile saw its currency plunge the most in 19 years as copper prices stumbled. Then again, Brazilian stock market has plunged by more than 40% since a peak in May, with darlings of the market, such as Petrobras and Vale, particularly hard hit. Currencies across the board have slid and economic forecasts have been slashed. Photograph supplied by iStockphoto.com, October 2008.

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This year’s World Bank/International Monetary Fund shindig in Washington DC saw most attention focused on the plight of banks in the developed world. Yet, it is becoming increasingly evident that the crisis in infecting both the global real economy and that ripple effects on emerging markets will be severe. Almost unnoticed in the wider news, the World Bank slashed growth expectations for Latin America to between 2.5% and 3.5% for next year, down from 4.6% this year and 5.6% in 2007. Those figures look provisional and could well be lowered again. Foreign-owned banks are holding back credit while domestic banks are facing tougher credit conditions from correspondent banks, are having to postpone capital raising plans, and have seen shares swoon. John Rumsey reports on the crisis now affecting South America. HE BEGINNING OF the sub-prime crisis witnessed a touch of schadenfreude from Latin American pundits directed at the developed world, a sentiment which is only now fully dying out. It was rich countries’ overexposure to risky assets, a business area which Latin American banks were thankfully not involved in, that triggered the crisis and that would exempt Latin America from its after-effects went the argument. The attractiveness of that line of reasoning has faded as the focus of attention has turned from the banking system to the real economy. Indeed, many are more pessimistic than the World Bank on Latin America. JPMorgan Chase & Co. forecasts the Mexican economy will expand just 0.3% next year, down from 1.4% in 2008 and pegs Brazilian growth at 2.8% in 2009, down from 5.2% this year. The crisis is being transmitted to Latin America in three ways, according to Augusto de la Torre, the chief economist for Latin America’s office at the World Bank. The first is financial contagion with a slowdown in portfolio flows, large declines in stock price indices and significant currency adjustments. The second is a drop in demand that includes demand for exports, particularly commodities, and drops in remittances as well as higher borrowing costs and the impact of tight monetary policies. The last is changes in relative prices, especially in commodities. That is particularly key as over 90% of the region’s gross domestic product (GDP) and population reside in commodity exporting countries. The effects of this triple whammy are already coming home to roost. Much of Latin America’s boom during the last five years has stemmed from increases in commodity prices, attracting in foreign direct investment (FDI) and portfolio flows, cutting unemployment, driving up wages, and filling government coffers. Local currencies invariably appreciated against the dollar as balance of payments turned positive. The downturn in commodity prices has smashed those trends and hit currencies hard. The

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unwinding has been all the more brutal both because performance of commodities was so strong and thanks to a flight to US dollar assets. Chile, Brazil, Peru and Mexico have been hit hard. However, it is the effect on Venezuela in particular, with its heavy oil dependence and hollowed out agro-industrial economy, that threatens to be most severe. Venezuela remains an isolated case because of its dependence on one commodity, oil, and its unorthodox economic policies, largely supported on the back of these very oil revenues. It was only back in late summer that Venezuela’s oil giant PDVSA reported spectacular numbers: a 958% increase in net profits and revenues that had reached $72.42bn compared to $42.86bn compared to the same period last year. These huge increases were reached with just a 3.5% increase in production. PDVSA claimed that it would boost production substantially—to over 4.9 m barrels per day by 2013 and 6.5m by 2021. Many analysts were optimistic about the firm’s future. The situation has since changed dramatically as oil prices have tumbled nearly 50%. In a country with few other resources, the effect is magnified. JPMorgan Chase has cut its 2009 economic growth forecast for Venezuela next year to 2.5% from 3.5% on lower oil prices and expectations of a global recession. If oil prices remain below $90 in 2009, the current account surplus will be hit hard, according to analyst Ben Ramsey. It could even move into a deficit, compared to expectations of 14% of GDP, he predicts. That is likely to trigger a currency devaluation and Ramsey predicts that the bolivar will be moved down 30% from its current level of 2.15 to the US dollar. That will hurt in a country that imports some 60% of its goods and pays US dollars for them. Venezuela, which has long lived on the largesse of oil to fund extensive social programmes and more recently to embark on a comprehensive nationalisation programme, looks shaky. The country will pay close to $11.6bn for the nationalisations agreed to date, including those in the petroleum sector, according to paper Ecoanalitica. In a sign that the government is anxious, ministers have said that they will look to pass an austere budget. Countries with more orthodox policies are suffering greatly as well. In October, Chile saw its currency plunge the most in 19 years as copper prices stumbled. Then again, Brazilian stock market has plunged by more than 40% since a peak in May, with darlings of the market, such as Petrobras and Vale, particularly hard hit. Currencies across the board have slid and economic forecasts have been slashed. The severity of the crisis has, however, been mitigated thanks to at least some prudent policies. Across the region, debt levels have been falling and there have been moves to develop a local bond market. Total debt as a percentage of GDP in Western Hemisphere emerging market countries fell to 22.8% last year from 42% in 2003, according to the International Monetary Fund. Moreover, many countries have chosen to invest rather than spend all the revenues

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previous crises that destabilised Latin banking systems, have helped weather the storm. Strict rules, once seen as a straitjacket, have turned out to be a lifejacket. Stringent reserve requirements have particularly helped protect banks and furthermore given regulators the scope to ease such restrictions in a bid to defray the credit crunch. In Brazil, for example, Caixa Econômica Federal, the bank owned by the Brazilian government, announced plans in October to buy at least 20 credit portfolios from smaller lenders in a month after the central bank eased rules on reserve requirements. Latin banks tend to be conservatively managed as well. That has spared them from exposure to sub-prime assets and The effects of this triple whammy are CDOs, points out Jeanne Bank Policies already coming home to roost. Much of del Casino, vice president, The crisis has brought into Latin America’s boom during the last regional credit officer for focus the monetary policies Latin American banks, at of the region. Until it five years has stemmed from increases Moody’s. Even though struck, the main in commodity prices, attracting in Latin banks this time preoccupation had been foreign direct investment (FDI) and round look stronger and with fighting resurgent portfolio flows, cutting unemployment, more prudent that inflation. That had seen driving up wages, and filling developed market banks, almost all the major government coffers. Local currencies they may yet lose a chunk economies increase of their deposit base. interest rates. Brazil’s Selic invariably appreciated against the Local wealthy individuals rate stands at a hefty dollar as balance of payments turned have been selling local 13.75% and Mexico’s at positive. The downturn in commodity assets to buy the 8.25%. prices has smashed those trends and greenback, a reaction The dilemma is now hit currencies hard. The unwinding has honed over years of how monetary policy can dealing with crises. That be handled at a time that been all the more brutal both because looks astute given recent offers great uncertainty performance of commodities was so currency turbulence. and conflicting policy strong and thanks to a flight to US “Their risk appetite for priorities. The rapid rise in dollar assets. inflation in the first half of investment in their own the year may slow as home country has been commodity prices tumble, reduced,” said Javier Arus yet the recent sharp falls in Castillo, general manager currencies suggest that of Santander Private import prices will rise. Banking International, Governments want greater scope to loosen monetary which works in nine Latin American countries. policy to stimulate credit, but are nervous about looser Furthermore, the credit boom, that has been such a strong and region-wide phenomenon, looks overpolicies in case it exacerbates the run on currencies. The crisis also calls into question just how enduring stretched. The impact will be different in different reserves will prove as countries fight to protect their countries. In Brazil, which has one of the region’s last currency amid a massive flight to safety in US dollars. High mostly locally-owned banking systems, questions revolve levels of reserves are being eroded and the short-term around how banks will raise funds and what will happen to policy of selling dollars has had only limited success. credit lines between Brazilian banks and their Mexico’s central bank sold over 10% of its $84bn foreign correspondents. reserves in one week in October as the peso plunged 16.3% Larger banks have already seen significant drops in their against the dollar. Peru’s central bank sold $2.4bn in share prices. Itaú was down close to 40% over the 12 reserves in one day at the end of September to support the months to October 16 and Bradesco was down by just over sol. Chile’s central bank stepped up its offer of currency this amount over the same period. Although bad, it is the smaller banks that have been most hurt. Banco Daycoval is swaps to combat a sharp decline in its currency. In general, conservative bank regulations, imposed thanks to down by over 70% over the same period, for example.

from commodities. Chile has built up some $21bn in reserves from selling copper. Brazil’s international reserves are at record levels of $208bn. That will help soften the shocks in the short-term. Furthermore, support from an array of multilaterals has been forthcoming, concerted and rapid and should help to combat the liquidity crunch. Four multilaterals have pledged significant funds, including the Inter-American Development Bank (IDB) and Corporación Andina de Fomento (CAF), the Andean development bank. They accounted for close to $10bn in fresh credit and the IDB alone will provide $6bn in liquidity as well as accelerating specific loans next year.

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Rafael Ramirez, president of Petroleos de Venezuela, PDVSA, answers a question during a news conference in Caracas, back in March this year. At the time Ramirez said that PDVSA could launch a tender for a field in the Orinoco heavy oil basin in a matter of two months or sooner. Those now look like halcyon days for the oil major. It was only back in late summer that Venezuela’s oil giant PDVSA reported spectacular numbers: a 958% increase in net profits and revenues that had reached $72.42bn compared to $42.86bn compared to the same period last year. These huge increases were reached with just a 3.5% increase in production. PDVSA claimed that it would boost production substantially—to over 4.9 m barrels per day by 2013 and 6.5m by 2021. Many analysts were optimistic about the firm’s future. Now oil revenues are down by at least 50%. Photograph by Fernando Llano and supplied by Associated Press/PA Photos, October 2008.

These smaller banks had been seeking out niche areas in which to invest where they felt more shielded from competition. One area that may cause difficulties is US dollar-denominated agro loans, a hugely popular area in the last couple of years. Smaller banks are likely to face difficulties now in borrowing in dollars and with the sharp decline in the value of the real, the inability to roll over dollar debt by their customers could lead default rates to spike. Banks’ inability to tap markets is already starting to be seen with cancellations of debt and equity deals common. That means that local deposit capture will be the only way for many banks to raise capital in the short-term, for example, though emerging pension funds, says del Casino. All this has pressured ratings downwards. S&P revised the outlooks on Daycoval (BB-) and Banco Indusval (B+) to stable from positive on October 8 while Fitch trimmed positive outlooks for five banks too. S&P cited limited funding options as the largest challenge to banks rather than a fundamental weakening of operations while Fitch said its cuts came thanks to a fundamental change in the expectations for loan growth and business expansion, given the deteriorated world outlook. Most of the rest of Latin America, where international banks dominate the scene, faces different dilemmas. The question there is how much interest banks, that are facing severe turbulence at home, will have in funding continued growth in Latin America. Leaders in the region include Citigroup, HSBC and Santander. Moody’s has warned that Mexico faces some stress, for

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example. Foreign players have aggressively expanded loan books, both to individuals and companies with private lending up by as much as 50% in both 2005 and 2006. That growth has dropped precipitously to stand at some 11% annually today, but the risk is clearly strongly to the downside. Non-performing loans on credit card debt in Mexico have jumped to about 8% in recent months. Citigroup has been particularly badly affected by global conditions with third quarter results showed a quarterly loss of $2.82bn after write-downs (amazingly enough, that was actually better than many had feared). Key Latin markets were identified as showing weakening credit characteristics and chief financial officer (CFO) Gary Crittenden saying there is broad deterioration in consumer credit worldwide, particularly in Brazil, India and Mexico. The trouble for Latin banks has had little to do with the miscalculation of risk and aggressive lending to the unwashed of the credit era that banks in the developed world indulged in. Nonetheless, they are feeling the effects of these problems. Invariably, foreign-owned banks are already retrenching in Latin America, particularly in credit, the boom area of recent years. Their reticence will be encouraged as a slower macro scenario boosts delinquency rates. Sales by these banks of some Latin assets cannot be ruled out. Local banks, particularly those without big balance sheets to fund their business, face a huge funding drought that will oblige them to pick carefully what areas to emphasise. They will have to re-adjust to funding most of their business through deposits. The easy days for borrowers and bankers is over.

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Photograph © Ronald Hudson/Dreamstime.com, supplied October 2008.

LATIN FINANCIAL MARKETS: THE ROT SPREADS Latin equity and debt markets have been especially hard hit in the last few weeks by the generalised flight-to-quality and a growing sense that emerging markets are proving the last shoe to drop, compounded by dramatic currency volatility throughout the region. The rapid drops in commodity prices and fears of a global recession have seen Latin market falls accelerate and overall declines have now surpassed those of the developed world. More is likely to be on the way, before any rebound. ust six months ago, optimism reigned supreme in Latin America. Stock markets had taken off, investment banks were pouring into the region and scrapping for talent and forecasts were for continued sunny skies. Latin American funds lost 11.79% in the week that ended October 23rd and are down 56% year-todate while BRIC funds posted the 12th consecutive week of negative performance in the same week. Redemptions from Latin funds have reached close to $7bn since early June. Surprisingly, this is slightly better than the results for

all emerging markets which are down 12.51% over one week and 58.93% over the year, although this is small consolation for investors. Meanwhile, debt funds were down 9.73% in the same week. Not only are results worse than any expectations, but doommongers have replaced optimists throughout the region as analysts have torn up previous forecasts and many have simply given up trying to make predictions until clear trends on what are driving the market emerge. The brunt of the burden has been borne by the very stocks that

were the top performers a few months ago, particularly those in commodities. Investors have been focusing on the region’s heavy reliance on commodity exports and reinterpreting macroeconomics, seeing what was just months ago a robust macroeconomic picture as weak public finances. The gloom may now be overdone, but it is clear that Latin America will not reach the jubilant highs of the last 12 months for a long time. Latin markets had been in fashion for the last couple of years as heavy exposure to Asia was slowly reduced in the Americas’ favour, explains Brad Durham, managing director at EPFR Global in Boston. He adds that some Latin markets were overbought last year, with Brazil representing the single biggest overweight in the region. As managers have unwound positions, those markets that have enjoyed the fastest expansion in the last couple of years have fallen furthest. Two other factors have helped to destabilise Latin markets. In most countries of the region, precipitate and unclear public policy announcements have contributed to massive uncertainty. If this were not enough, foreign investors have seen losses compounded by steep declines in currencies versus the dollar. The Mexican peso, for example, plunged 18% against the US dollar in October. In recent history, that is comparable only to its monthly performance in December 1994, when the government devalued to staunch foreign reserves.

Market toxicity The rapidity and scale of the crisis have back-footed investors. A complication is that those economies which are likely to be most affected by the crisis have not had the worst equity market performance. It is likely that countries such as Chile, Brazil and Uruguay, which have pursued relatively prudent

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economic policies and have strong reserves, will be the least affected by the crisis. At the other end of the scale Argentina, Ecuador, Bolivia, Venezuela and parts of central America will suffer badly, thanks in large part to dotty policies and over-spending that leaves them particularly vulnerable to investor retraction. However, the transmission between economies and markets is patchy and often contradictory. Venezuela has, to date, proven one of the less awful performers, particularly for foreign investors. The index is down a relatively light 11.5% since highs as recently as late August. And because the Venezuelan currency is fixed to the US dollar, downside for foreign investors is limited. However, they are mostly absent: the tiny market is highly illiquid and a complete lack of transparency on corporate and government policy makes the market a crap-shoot. The main risk going forward for Venezuelan investors is the likelihood of a Venezuelan devaluation post elections. The parallel market has been showing the stresses of liberal spending and the bolivar had reached 5.45 against an official exchange rate of 2.15. If the Venezuelan market has been relatively immune, those stock markets that are more and more tied into the global economy, and were the strong performers of 200607, have been slammed. Brazil and Mexico are the prime examples. The Mexican market, as measured by the Bolsa index, was trading down 48% from last year’s highs on October 27th while the Brazilian market was down 58% from highs registered as recently as May on the same date. Recent currency movements have made market exposure to the two markets even more disastrous. In part, the dire performance of the Brazilian and Mexican exchanges reflects both their openness to

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investment and the number of ADRs listed in the US. American Depositary Receipts (ADRs) have tended to track broader indices faithfully and this has seen some of the largest, most liquid companies on both exchanges suffer. Currency weakness has made life more difficult. Mexico has been hard hit both by the likelihood of a US recession and its heavy reliance on petroleum as a foreign currency earner. Weakness forced the hand of the Banco de Mexico, which stepped in aggressively to contain the fall-out. The bank bought $13.1bn worth of pesos between October 8 and October 27. Commodity exporters including Chile and Peru have been hurt too. The Chilean market is down just over 33% since hitting highs in October last year. The Chilean peso has been trounced by fears of a global recession and falls in the price of copper, the country’s main export. The currency touched a five-year low in late October, dropping 19% to October 27. Peru’s Lima General Index losses have been catastrophic. The index is down 73% from highs last year with mining companies particularly hard hit. Peru’s securities exchange halted trading in October when the main index registered the greatest falls in at least 18 years. That day alone, the General Index plunged 11% before trading was suspended. It was the steepest drop since at least January 1990.

Policy responses and individual markets Policy responses to the crisis have varied widely throughout the region. After an initial bout of passivity, and in some cases the idea that this was a north American issue exclusively, most governments have rushed out responses. The problem is that the reactions have been mainly defensive and in some cases counter-productive.

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Argentina’s reaction has confirmed the country as the pariah of financial markets and investors. The decision to essentially nationalize the country’s pension funds under the guise of protecting pensioners, caused a rout in financial market. Details on the package were being discussed in Congress at the end of October with clarity on how funds would be administered still unclear. Meanwhile, investors ran for cover. The yield on Argentina’s benchmark 8.28% dollar bonds of 2033 rose 838 basis points to 28.8% and the Merval index fell 27% to 890.27 in one week. The market rout in Argentina has already put a bond deal by petrol giant YPF, one of the few strong names in the market, out of reach. The firm scrapped a planned $150m bond due 2018 because of weak market demand. In Brazil, President Luiz Inácio Lula da Silva was initially dismissive of the situation, referring to it as “Bush’s crisis”, but has since woken up to the gravity of the situation. A measure was rushed out with no public consultation to allow public sector banking giants, Banco do Brasil and Caixa Econômica Federal, to take over private sector banks. That has had the effect of triggering a sharp deterioration in the share prices of smaller Brazilian banks as investors assumed the government knew that there were banks that needed bailing out. More constructively, the Central Bank offered up to $50bn in FX swaps to the corporate market to help corporate hedge exposure to the US dollar. One of the exacerbating factors behind Brazil’s currency depreciation has been the rush to unwind derivative positions by companies, who have been trying to net out exposure through the futures market.

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COLLATERAL AS A RISK MANAGEMENT TOOL

A DELICATE

BALANCE The watershed moment this year, of course, was the Lehman collapse and the ensuing uncertainty surrounding other financial institutions. The bankruptcy meant the termination of thousands of derivatives contracts between Lehman and its many counterparties. As a result, the market value of the collateral backing contracts was tested against current market conditions plus there were concerns over funds ‘exposure to volatility due to the time lag before new contracts could be put in place. Photograph supplied by iStockphoto.com, October 2008.

Collateral management has been gaining traction as a risk management tool for the past few years but recent tumultuous events have pushed it to a new level. The biggest fear of a counterparty default was realised when Lehman toppled but the industry seems to have weathered the storm. The current crisis is only stoking the uncertainty and as a result, investors are increasingly running for cover under the collateral banner. Lynn Strongin Dodds reports. ARTICIPANTS HAVE NEVER been busier. JeanRobert Wilkin, executive director global securities financing and head of product management at Clearstream says, “Recent events have only reinforced the role of collateral management. For the past 15 years, it was seen as an obscure back office function but today it has

become a key front office function to maintain the liquidity of the banks and other institutions. One of our biggest challenges today is to cope with the demand and it is not just from financial institutions but also corporations.” While the financial meltdown in late September sharply focused the need for collateral, a raft of legislation over the past couple of years also started the ball rolling. Basel II, for example, set stringent capital adequacy guidelines that link effective risk management to lower capital management charges ,while the Undertakings for Collective Investment in Transferable Securities (UCITs) III, described collateral as a critical tool. It also broadened the kinds of securities that could be used as a guarantee on credit. In addition, the Markets in Financial Instruments Directive (MiFID), which was implemented last November, reaffirmed the importance of collateral management in the way institutions handle risk.

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These changes took place against a background of increasing instability and uncertainty of markets. Liquidity was growing scarce, fears grew over counterparty risk and lenders were becoming more discerning about the types of collateral they were willing to take on. In addition, the use of derivatives had mushroomed due to UCITs III as well as the fund management community’s push into liability driven investments. Mix all these ingredients in together and the use of collateral rose sharply in 2007, according to The International Swaps and Derivatives Association (ISDA) 2008 Margin Survey, which canvassed 85 banks or broker-dealers and 22 institutional investors and end users. The ISDA survey revealed that collateral employed in privately negotiated derivatives transactions last year soared almost 60% to an estimated $2.1trn of collateral in circulation from the approximate $1.335trn of collateral in the 2007 Survey. Meanwhile the number of collateral agreements in place jumped about 18% to over 149,000, with about 74% being two-way agreements. The margin survey also found that collateral coverage continued to grow, both in terms of trade volume subject to collateral agreements and of credit exposure covered by collateral. Breaking it down, 63% of all over-the-counter derivatives (OTC) transactions were subject to collateral agreements, while 65% of credit exposure for privately negotiated derivatives was covered by collateral. Last year, the figure was 59% for both categories. The watershed moment this year, of course, was the Lehman collapse and the ensuing uncertainty surrounding other financial institutions. The bankruptcy meant the termination of thousands of derivatives contracts between Lehman and its many counterparties. As a result, the market value of the collateral backing contracts was tested against current market conditions plus there were concerns over funds ‘exposure to volatility due to the time lag before new contracts could be put in place. While it is still too early to determine the full outcome, Ed Oliver, senior business consultant at Spitalfield Advisors notes,“In general, over the last few days, the industry has done quite well in using the necessary framework to liquidate collateral as a result of the default of Lehmans. It is the first time we have seen this process being really tested. I think going forward what this means, is that investors will pay more attention to the small print in their contracts. Many were written five to ten years ago and they will want to tighten the language to close any gaps.” Olivier Grimonpont, director and head of collateral services at Euroclear, agrees, adding“The wake-up call was last summer when investors realised that collaterising exposures were no longer an option but a necessity. In the past year, we have seen this appetite increase but no one actually expected a counterparty to default. However, the collateral was there and the system worked. Lessons, though, were learnt by all participants in the market place and I believe it will take time for everyone to adjust to the new reality. For now, market participants have become more cautious about collateral eligibility profiles and

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Jean-Robert Wilkin, executive director global securities financing and head of product management at Clearstream says,“Recent events have only reinforced the role of collateral management. For the past 15 years, it was seen as an obscure back office function but today it has become a key front office function to maintain the liquidity of the banks and other institutions. One of our biggest challenges today is to cope with the demand and it is not just from financial institutions but also corporations.” Photograph kindly supplied by Clearstream, October 2008.

certain assets may be excluded because they may be difficult to liquidate finance.” The ground rules covering a swap contract are set by the ISDA Master Agreement although the participants are able to customise the agreement through the schedule. This typically covers things such as termination and the credit support annex (CSA), which works to reduce the credit risk in a trade by enforcing collateral arrangements between counterparties. They are flexible, so they allow a firm to change the threshold at which collateral starts being collected according to how risky it thinks a counterparty is, for example, according to a corporation or institution’s credit rating. According to Robert Gardner, a founding partner of London-based Redington Partners that advises buyside investors and pension funds, “There has long been a framework (in the form of collateral) to protect investors and participants in derivative contracts to mitigate counterparty exposure. However, not all derivative contracts have collateral arrangements in place. A typical example is foreign exchange forwards which are used to hedge currency risk. I think we will see counterparties generally reviewing their terms and agreements and I think they will be tightened up.”

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The main items in the agreement typically include the (OTC) derivatives transactions but the use of acceptable types of collateral, frequency of margin calls, government securities has become much more haircuts, threshold level, close-out and termination clauses, commonplace. Cash is not only harder to get a hold of valuations and rehypothecation rights. This is the common because all the banks are hording their stockpiles but practice where the broker takes a client’s assets, posted investors have also become much more conservative. with the broker as collateral, in exchange for offering the “Cash is not always king because institutional clients are client easier credit terms. By lending out a clients’securities aware of the cost attached to it. The remuneration on or using them as collateral, typically for repurchase cash as collateral is often hard to earn in money markets. agreements, rehypothecation lets brokers enhance their Instead, liquid securities like government bonds can provide for a suitable own returns. substitute,”Verheijen says. The problems that came Grimonpont adds that to light in the Lehman case cash is expensive and risky. was that $22bn of the “If you are a lender today, $40bn held by Lehman’s then you do not European prime brokerage necessarily want cash as business had been collateral because of the rehypothecated, according risk of re-investment and to industry estimates. This changing prices. In places hedge funds trying Europe, securities have to reclaim their always been the rehypothecated assets in predominant collateral the same queue as general creditors. Moreover, hedge while the US has funds such as Amber and a traditionally used cash. small RAB Capital fund Europe has been evolving which allegedly claimed towards the US model, but the recent market turmoil they asked their assets not has reversed that trend, at to be rehypothecated, face a least for now.” long and potentially painful As for haircuts (the extra wait to get back securities cushion that cash held in segregated client providers demand to accounts. While this is protect themselves against mainly a hedge fund issue, Olivier Grimonpont, director and head of collateral services at a fall in the value of it does underscore the need Euroclear, explains that, “The wake-up call was last summer when collateral) there was a hike to pay closer attention to investors realised that collaterising exposures were no longer an in the run-up to the the details. option but a necessity. In the past year, we have seen this appetite Lehman situation, Another issue is increase but no one actually expected a counterparty to default. according to Oliver. “We valuations. Historically However, the collateral was there and the system worked. Lessons, have just completed a they were done on a though, were learnt by all participants in the market place and I study on collateral monthly basis but this has believe it will take time for everyone to adjust to the new reality. For management and have changed over the past year now, market participants have become more cautious about collateral reviewed changes over the as markets turned bearish. eligibility profiles and certain assets may be excluded because they past year. We have Today the regularity with may be difficult to liquidate finance.” Photograph kindly supplied by definitely seen a rise in which collateral is posted Euroclear, October 2008. has become crucial in haircuts during the events these fluctuating markets. Investors can lose money if the of recent days but it is difficult to predict whether this trend value of the swap increases since the last time the collateral will continue.” Wilkin of Clearstream believes it depends on the type of was posted, but new collateral has not been posted. Many, though, have already moved to daily and weekly valuations client and their risk profile. For our part, we have not seen which for those with exposures to Lehman held them in a rise in haircuts on government bonds. This is because good stead. Several contracts were settled on Friday, they are state guaranteed instruments and investors are September 13th before the bankruptcy was announced on comfortable with that. However, we have seen an increase in corporate bonds because they behave in the same way as the following Monday. Max Verheijen, managing director of Cardano, a risk equities in that there is more volatility. Also, while the and advisory firm, is also seeing a narrowing of the quality of the corporate bonds is there, the market has eligibility of assets. At one time, cash accounted for dried up and there is no way to realise value. No liquidity three-quarters of collateral used in over the counter means a higher haircut.”

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NORTHERN LIGHTS It is no surprise that global custodians have been making their mark in the Nordic region. The area houses some of the savviest investors and like many of their European contemporaries they are pushing the boundaries out in terms of alternative asset classes. Competition is fierce in the asset servicing world and not every domestic player will have the scale to be a contender, especially at the international level. Lynn Strongin Dodds reports.

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VER THE PAST few years, the changing nature of investment management has prompted domestic custodians to rethink their game plan. Their strategies differ across the Nordic region for despite the superficial homogeneity that it presents, each constituent country has its own legislation, culture and tax structure. For example, Denmark, Sweden, Norway and Finland all have different currencies, while Finland is the only one using the euro. Norway is not even a member of the European Union, while Sweden’s fund management community is considered to be a regional innovator. The common ground they share is a single regulation which has forced the region as a whole to strike a better match between liabilities and assets. This not only provides a link with each other, but also with other countries such as the UK and the Netherlands which are towing the same line.

GLOBAL CUSTODY FOCUSES ON NORDIC OPPORTUNITY

While Nordic institutions boast highly automated and efficient back and middle office functions many were not built with these more complex instruments in mind. As a result, they are increasingly turning to their local and global custodians for the answers. This means not only offering the core custody services but also products such as cash management, risk analytics, performance measurement, accounting, trade confirmation and state of the art technology across all asset classes. Photograph © Raimundas Gvildys/Dreamstime.com, supplied October 2008.

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The other big challenge facing them all is the current ability to drill down to the granular level using enhanced global economic downturn and volatile markets. In some performance and risk measurement analytics.” ways, this has accelerated the trend for institutions, The survey, which was published this past June and ranging from the large industry wide schemes to the conducted along with McKinsey & Co, canvassed middle smaller plans, to increase their use of over-the-counter and back office processes in 25 financial institutions across (OTC) derivatives as well as alternatives such as private the Nordic region, with aggregate assets of €560bn. High equity, hedge funds, commodities and currencies. The on the priority list was the reduction of risk, support for name of the game today is alpha generation but in a new products and managing the ever changing technology landscape. The White Paper also found that organisation tightly risk controlled environment. As Madeleine Senior, head of the Nordic relationship were concerned about coping with the expected increase in management team at Northern Trust, puts it,“The Nordic complexity and volumes as the focus in operations had region is one of the most sophisticated markets with a been predominantly on building rather than ‘optimising’ huge pool of assets. What has happened is that fund middle and back office processes. Equally as important for institutions is the ability to managers have been generating impressive investment returns but the question they face now is how are they attract and retain the best and the brightest. Less pressing going to replicate the performance as markets become concerns included cutting costs, improving client service more difficult. I think we will see an even greater push and generating additional revenue. Not surprisingly, into alternatives.” global custodians have been more than happy to step into While Nordic institutions boast highly automated and the breach when needed which has changed the efficient back and middle office functions many were not dynamics for the local players. Newby says,“The trend we are seeing is that top tier built with these more clients are using a global complex instruments in custodian for all their mind. As a result, they are needs. They want a increasingly turning to consolidated picture for their local and global their whole portfolio and custodians for the the services to match. We answers. This means not first came to the region in only offering the core While Nordic institutions boast highly 1917 and although we do custody services but also automated and efficient back and not have strategic alliance products such as cash middle office functions, many were not as such, we have built management, risk built with more complex instruments in strong relationships with analytics, performance measurement, accounting, institutional clients and mind. As a result, they are increasingly trade confirmation and banks. We have a deep turning to their local and global state of the art technology understanding of the custodians for answers. cultural and technical across all asset classes. issues and are able to Institutions are also meet all our clients’ needs exploring component or with our broad array of modular outsourcing. Sid products and services.” Newby, head of business By contrast, JPMorgan development for the Investor Services has gone Nordic region for The Bank of New York Mellon says,“We have not seen big asset down a different route and has been busy forging tactical management lift-outs in the region, mainly because fund relationships. Earlier in the year, the firm purchased the managers like to keep control over core middle office global custody division of Swedish based Nordea, the functions. Nordic institutions prefer a more modular and largest Nordic institutional global custodian, for €200bn. compartmentalised structure, and I do not see this Under the agreement, JPMorgan is the global custodian of changing in the foreseeable future.” assets managed by Nordea Funds and Nordea Life & The Bank of NewYork Mellon recently published a White Pensions, while Nordea retains its sub-custody business, Paper on the challenges and opportunities in the middle offering regional custodial services to international and back office of Nordic institutional investors and asset customers who invest in Nordic countries. Stuart Thompson, head of Nordic sales and relationship managers.“Our research validated the prevailing view that in general Nordic institutions are efficient in many back management at JPMorgan Investor Services explains,“We and middle office areas, managing high asset values and have been operating in the region for the past 15 years transactional volumes with relatively low staff numbers, and are the largest custodian in terms of assets under according to Newby. “However, what we did find is that custody which totalled about $415bn before the Nordea they are looking for value added products as well as the deal. They are now $700bn. We had a dedicated team that

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operated out of London and were covering the top tier clients but we decided to penetrate local mutual funds and the next level of size clients. In order to do that we needed much more of a local presence. The other attraction was that Nordea has a successful asset management business which needed the leading edge products and capabilities that a firm like JPMorgan can provide.” JPMorgan is also looking to strengthen its position through strategic alliances and last year solidified a longstanding relationship with Swedbank. Neal Meacham, head of custody at Swedbank comments, “We held a strategic review in which we asked our clients what they required. We decided that as a smaller local player it was better to enter into a strategic alliance with JPMorgan whereby we could offer the local understanding, expertise and relationships while they could provide the benefits of technology, products and knowledge of a global custodian. It has also extended our reach into the Baltics which we feel is becoming an important region in terms of assets. Going forward, we felt that our clients should have the whole package as custody has moved far Madeleine Senior, head of the Nordic relationship management team at Northern Trust, explains beyond safekeeping or assets and that,“The Nordic region is one of the most sophisticated markets with a huge pool of assets. What settlement. I think we will see more has happened is that fund managers have been generating impressive investment returns but the of these relationships occurring in question they face now is how are they going to replicate the performance as markets become more the future.” difficult. I think we will see an even greater push into alternatives.” Photograph kindly supplied by Senior notes,“We have seen several Northern Trust, October 2008. partnerships being formed over the past five years and I think this will continue. This is because custody and related services to a Swedish mutual fund. This a number of local players have realised it requires a past spring, the relationship was expanded with Northern significant commitment, resources and investment into Trust becoming Handelsbanken’s global custodian for its technology to keep pace with the diversification taking clients in Norway, Denmark and Finland investing outside place in the Nordic region. They are focusing on the of the Nordic region. domestic business while leveraging the services and Senior says, “Handelsbanken will be the preferred products of the global custodian such as securities lending, provider for local funds for our Nordic clients while we will cash management as well as tools around socially be used for global assets. The focus is on what each of us is responsible investing.” good at and this enables us to develop cutting edge services Northern Trust, which has been in the region for 17 to better align our products and services with where the years, was one of the pioneers having struck an alliance clients are going to. For example, socially responsible with Handelsbanken in 2003, whereby it appointed the investing is becoming increasingly popular and clients Swedish firm as its regional sub-custodian. The following want a holistic view of their portfolios. To this end, we are year, the two made headlines by winning the $17bn developing compliance and monitoring tools.” custody mandate from Swedish insurance giant Folksam, Not all regional firms are looking to join forces with a which marked the first time a non-Swedish bank provided larger counterpart. After a long and hard look at their

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2008

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GLOBAL CUSTODY FOCUSES ON NORDIC OPPORTUNITY

Leonhard, head of client relations and solutions at the Danish bank, explains, “The Nordea deal means that there will be increased competition by the presence of JPMorgan among top tier clients. We see this as an opportunity as a local provider to win more business from mid-tier banks. Being on our own means that we will have to make significant and continual investments in technology but we are a universal bank and are able to do that for now.” Looking ahead, Leonhard believes there will be repercussions from recent developments such as the European Central Bank’s Target 2 Securities, Euroclear’s Single Platform which this year acquired Finnish Suomen Arvopaperikeskus Oy (APK) and Swedish VPC central securities depositaries and the new Link-Up Markets initiative which Denmark’s VP Securities Services and Norway’s VPS have joined. “At the moment it is too early to tell what the exact impact will be but I think in a couple of years from now, people will not be talking about the Nordic region. It will be seen as a part of Europe,”she adds. The one thing that will not change, Sid Newby, head of business development for the Nordic region for The Bank of New York Mellon though, is the importance of says,“We have not seen big asset management lift-outs in the region, mainly because fund relationships. According to Thompson managers like to keep control over core middle office functions. Nordic institutions prefer a more “People in the Nordic region are not modular and compartmentalised structure, and I do not see this changing in the foreseeable future.” transactional. Clients want a strong Photograph kindly supplied by The Bank of New York Mellon, October 2008. track record, brand name and a broad business, SEB has decided to go it alone, for now, according array of products and services but they also greatly value to Göran Fors, global head of custody services, SEB, which you getting to know them, understanding their business operates in the Nordic and Baltic countries, Germany, and putting time and effort into the relationship. Poland, the Ukraine and Russia. “In the past we have Custodians will not succeed if they are half committed.” evaluated whether we should form a strategic alliance with a global custodian but decided against it and I cannot say if this will change in the future. We are one of the few local If you enjoyed this article, or any other in this banks providing global custody but we see it as part of our edition of FTSE Global Markets and would like overall offering which also includes cash management and reprints, please contact other similar products. We are in 10 countries but have an extensive knowledge Paul Spendiff, and believe that our local presence and relationships are Director, key advantages. The biggest challenges are to keep Berlinguer Ltd investing in the IT systems and developing the product Telephone: 00 44 207 680 5153 range. The large global custodians have been in the region Email: paul.spendiff@berlinguer.com for several years but we have a clear position among the Fax: 00 44 207 680 5155 top tier firms, such as large insurance companies and government pension funds and mutual funds.” Danske Bank is also following a solo route, preferring to target the smaller to mid sized institutions. Christel

We will be pleased to help you.

NOVEMBER/DECEMBER 2008 • FTSE GLOBAL MARKETS

Page 87 16:48 31/10/08 ETF Data 30.qxd:.

Ireland P Listings: T Listings: Managers: AUM:

Germany P Listings: T Listings: Managers: AUM:

Spain P Listings: T Listings: Managers: AUM:

Iceland

1 1 1 US$0.03 Bn

223 360 8 US$60.67 Bn

12 27 3 US$4.57 Bn

117 241 5 US$24.98 Bn

United Kingdom P Listings: T Listings: Managers: AUM:

Belgium P Listings: T Listings: Managers: AUM:

Portugal P Listings: T Listings: Managers: AUM:

1 1 1 US$0.06 Bn

1 1 1 US$0.00 Bn

13 233 5 US$1.06 Bn

5 61 3 US$0.23 Bn

Netherlands P Listings: T Listings: Managers: AUM:

South Africa

21 145 5 US$9.09 Bn

150 281 7 US$41.75 Bn

73 73 3 US$16.13 Bn

5 133 2 US$4.41 Bn

P Listings: T Listings: Managers: AUM:

15 15 4 US$1.52 Bn

Norway P Listings: T Listings: Managers: AUM:

Greece P Listings: T Listings: Managers: AUM:

Turkey P Listings: T Listings: Managers: AUM:

6 6 2 US$0.15 Bn

1 1 1 US$0.14Bn

6 6 2 US$0.15 Bn

1 1 1 US$0.00 Bn

Indonesia P Listings: T Listings: Managers: AUM:

Sweden P Listings: T Listings: Managers: AUM:

India P Listings: T Listings: Managers: AUM:

Australia P Listings: T Listings: Managers: AUM:

7 7 1 US$2.02 Bn

11 11 6 US$1.62 Bn

Finland P Listings: T Listings: Managers: AUM:

2 2 2 US$0.14 Bn

New Zealand P Listings: T Listings: Managers: AUM:

6 6 2 US$0.35 Bn

Hungary

P Listings: T Listings: Managers: AUM:

Austria

P Listings: T Listings: Managers: AUM:

Japan

P Listings: T Listings: Managers: AUM:

1 1 1 US$0.02 Bn

1 21 1 US$0.05 Bn

60 61 5 US$27.56 Bn

3 3 2 US$0.30 Bn

5 5 4 US$2.67 Bn

35 35 5 US$3.14 Bn

South Korea

P Listings: T Listings: Managers: AUM:

Malaysia

P Listings: T Listings: Managers: AUM:

5 18 4 US$1.10 Bn

Singapore

P Listings: T Listings: Managers: AUM:

2 2 2 US$0.10 Bn

11 11 2 US$1.83 Bn

11 23 5 US$13.24 Bn

Hong Kong

P Listings: T Listings: Managers: AUM:

Taiwan

P Listings: T Listings: Managers: AUM:

Thailand

P Listings: T Listings: Managers: AUM:

Source: ETF Research & Implementation Strategy, Barclays Global Investors, Bloomberg

4 18 2 US$1.17 Bn

P Listings: T Listings: Managers: AUM:

1 1 1 US$0.05 Bn

Italy P Listings: T Listings: Managers: AUM:

P Listings: T Listings: Managers: AUM:

1 1 1 US$0.01 Bn

China

Slovenia P Listings: T Listings: Managers: AUM:

Switzerland P Listings: T Listings: Managers: AUM:

France P Listings: T Listings: Managers: AUM:

Canada P Listings: T Listings: Managers: AUM:

Mexico P Listings: T Listings: Managers: AUM:

1 1 1 US$1.50 Bn

681 681 20 US$542.36Bn

United States P Listings: T Listings: Managers: AUM:

Brazil P Listings: T Listings: Managers: AUM:

FTSE GLOBAL MARKETS â&#x20AC;˘ NOVEMBER/DECEMBER 2008

EXCHANGE TRADED FUNDS: LISTING & DISTRIBUTION AS OF END Q3 2008

ETF Listings as of End Q3 2008

ETF Data 30.qxd:.

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1600

1800

1400

1600 1200 1400 1000

1200 1000

800

600

# ETFs

Assets USD Billions

EXCHANGE TRADED FUNDS: LISTING & DISTRIBUTION AS OF END Q3 2008

Worldwide ETF and ETP Growth

2000

400 400 200

200 0

ETF Assets USD Billions

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Sep-08

2009 Forecast

2012 Forecast

$0.81

$1.12

$2.30

$5.26

$8.23

$17.60

$39.61

$74.34

$104.80

$309.80

$412.09

$565.59

$796.70

$764.08

$1,000

$2,000

$141.62

$212.02

$0.04

$0.11

$0.32

$0.46

$1.20

$3.38

$6.32

$9.17

$0.12

$0.10

$3.97

$5.83

$23.05

$21.32

$35.75

$59.93

$90.77

$74.22

$104.66

$137.54

$205.87

$286.28

$389.57

$526.46

$729.89

$664.14

$15.58

$28.11

$45.87

$58.27

134

268

461

714

1171

1,499

ETF Commodity Assets USD Billions ETF Fixed Income Assets USD Billions ETF Equity Assets USD Billions

$0.81

$1.12

$2.30

$5.26

$8.23

$17.60

$39.61

ETP Assets USD Billions # ETPs # ETFs

202

280

282

336

Source: ETF Research & Implementation Strategy, Barclays Global Investors, Bloomberg

ETF Listings by Exchange as of End Q3 2008 Region

Country

# Primary ETF Listings

# Total ETF Listings

AUM (US$Bn)

20 Day ADV (US$Mn)

Australian Securities Exchange Shanghai Stock Exchange Shenzhen Stock Exchange Hong Kong Stock Exchange Bombay Stock Exchange National Stock Exchange Jakarta Stock Exchange Osaka Securities Exchange Tokyo Stock Exchange Bursa Malaysia Securities Berhad New Zealand Stock Exchange Singapore Stock Exchange Korea Stock Exchange Taiwan Stock Exchange Stock Exchange of Thailand

154 4 3 2 11 2 9 1 6 54 3 6 5 35 11 2

194 18 3 2 23 2 9 1 6 55 3 6 18 35 11 2

53.07 1.17 1.33 1.34 13.24 0.60 1.02 0.00 9.41 18.15 0.30 0.35 1.10 3.14 1.83 0.10

849.81 23.87 178.65 13.37 266.51 0.01 3.67 0.18 66.81 69.33 0.02 2.72 7.26 179.11 37.49 0.81

Sao Paulo Toronto Stock Exchange Mexican Stock Exchange AMEX Boston CBOE Chicago Cincinnati ISE FINRA ADF NASDAQ NYSE NYSE Arca Philadelphia

760 1 73 5 379 0 1 0 0 0 0 48 0 253 0

888 1 73 133 379 0 1 0 0 0 0 48 0 253 0

564.31 1.50 16.13 4.41 243.92 0.00 2.79 0.00 0.00 0.00 0.00 20.07 0.00 275.48 0.00

124,009.46 2.54 742.01 252.68 1,725.25 0.00 600.57 1,054.11 2,003.03 186.54 36,675.52 47,105.84 0.07 33,624.60 36.70

Wiener Borse Euronext Brussels Helsinki Stock Exchange Euronext Paris Deutsche Boerse Athens Exchange Budapest Stock Exchange Iceland Stock Exchange Irish Stock Exchange Borsa Italiana Euronext Amsterdam Oslo Stock Exchange Euronext Lisbon Ljubljana Stock Exchange Johannesburg Stock Exchange Bolsa de Madrid Stockholm Stock Exchange Swiss Exchange SWX Europe Istanbul Stock Exchange London Stock Exchange

585 1 1 2 150 223 1 1 1 1 13 5 6 1 1 15 12 7 21 0 6 117

1,412 21 1 2 281 360 1 1 1 1 233 61 6 1 1 15 27 7 126 19 6 241

146.69 0.05 0.06 0.14 41.75 60.67 0.14 0.02 0.05 0.03 1.06 0.23 0.15 0.00 0.01 1.52 4.57 2.02 9.09 0.00 0.15 24.98

2,404.20 0.63 0.82 6.37 592.78 843.49 0.67 0.03 0.29 1.00 282.07 50.99 61.63 0.00 0.00 9.38 15.90 157.82 109.52 7.08 29.25 234.47

1,499

2,494

764.08

127,263.47

Exchange

Asia Pacific Australia China Hong Kong India Indonesia Japan Malaysia New Zealand Singapore South Korea Taiwan Thailand Americas Brazil Canada Mexico US

EMEA (Europe, Middle East and Africa) Austria Belgium Finland France Germany Greece Hungary Iceland Ireland Italy Netherlands Norway Portugal Slovenia South Africa Spain Sweden Switzerland Turkey United Kingdom Grand Total

Source: ETF Research & Implementation Strategy, Barclays Global Investors, Bloomberg

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Global ETF Assets by Type of Exposure as of the end of Q3 2008 Region of Exposure

# ETFS

Total Listings

North America - Equity Fixed Income Emerging Markets - Equity Europe - Equity Asia Pacific - Equity Global (ex-US) - Equity Global - Equity Commodities Currency Total

481 154 216 320 126 58 92 46 6 1,499

628 286 423 632 196 65 186 72 6 2,494

Global Equity

Commodities

1.2%

1.5%

AUM (US$bn)

% TOTAL

$385.76 $90.77 $84.12 $82.05 $56.11 $44.73 $11.25 $9.17 $0.12 $764.08

50.5% 11.9% 11.0% 10.7% 7.3% 5.9% 1.5% 1.2% 0.0% 100.0%

Currency

Global (ex-US) Equity

5.9%

Asia Pacific Equity

7.3%

Europe Equity

10.7%

Emerging Markets Equity

North Americas Equity

11.0%

Fixed Income

50.5%

11.9%

Source: ETF Research & Implementation Strategy, Barclays Global Investors, Bloomberg

Top 20 ETF Asset Managers Around the World as of end Q3 2008 Year End 2007

Manager

Barclays Global Investors State Street Global Advisors Vanguard Lyxor Asset Management PowerShares DB X-Trackers ProShares Nomura Asset Management Bank of New York Daiwa Asset Management Nikko Asset Management AXA IM / BNP AM Credit Suisse Asset Management Van Eck Associates Corp WisdomTree Investments Nacional Financiera ETFlab Investment Hang Seng Investment Management BBVA Asset Management Commerzbank

End Q3 2008

Year to Date Change

# ETFs

AUM (USD Bn)

% Total

# ETFs

AUM (USD Bn)

% Total

# Planned

# ETFs

321 83 37 87 114 51 58 7 1 5 2 30 8 8 39 1 0 3 7 0

$402.61 $152.39 $41.97 $32.06 $38.02 $10.82 $9.70 $17.44 $10.15 $7.63 $9.08 $6.69 $4.97 $3.49 $4.52 $3.74 $0.00 $4.71 $1.18 $0.00

50.5% 19.1% 5.3% 4.0% 4.8% 1.4% 1.2% 2.2% 1.3% 1.0% 1.1% 0.8% 0.6% 0.4% 0.6% 0.5% 0.0% 0.6% 0.1% 0.0%

339 98 38 112 139 93 64 29 1 23 7 50 8 16 42 1 10 3 7 27

$350.29 $155.89 $46.95 $35.15 $31.09 $21.23 $19.57 $14.80 $8.22 $6.50 $6.21 $5.64 $4.89 $4.74 $3.71 $3.27 $3.16 $3.11 $2.98 $2.38

45.8% 20.4% 6.1% 4.6% 4.1% 2.8% 2.6% 1.9% 1.1% 0.9% 0.8% 0.7% 0.6% 0.6% 0.5% 0.4% 0.4% 0.4% 0.4% 0.3%

25 33 0 2 44 0 90 0 0 1 0 8 0 10 48 0 0 0 1 0

18 15 1 25 25 42 6 22 0 18 5 20 0 8 3 0 10 0 0 27

AUM % Change ETFs (USD Bn)

5.6% 18.1% 2.7% 28.7% 21.9% 82.4% 10.3% 314.3% 0.0% 360.0% 250.0% 66.7% 0.0% 100.0% 7.7% 0.0% 100.0% 0.0% 0.0% 100.0%

-$52.32 $3.49 $4.98 $3.09 -$6.93 $10.41 $9.87 -$2.64 -$1.93 -$1.13 -$2.86 -$1.05 -$0.08 $1.24 -$0.81 -$0.47 $3.16 -$1.59 $1.80 $2.38

% AUM Market % Share

-13.0% 2.3% 11.9% 9.6% -18.2% 96.2% 101.8% -15.2% -19.0% -14.8% -31.6% -15.7% -1.7% 35.6% -17.9% -12.7% 100.0% -33.8% 152.0% 100.0%

-4.7% 1.3% 0.9% 0.6% -0.7% 1.4% 1.3% -0.3% -0.2% -0.1% -0.3% -0.1% 0.0% 0.2% -0.1% 0.0% 0.4% -0.2% 0.2% 0.3%

Source: ETF Research & Implementation Strategy, Barclays Global Investors, Bloomberg

NOTES Worldwide at the end of Q3, there were 1,499 ETFs with 2,494 listings, assets of US$764.08 billion, managed by 86 managers on 43 exchanges. The US has the largest number of products and assets under management; 681 ETFs and US$542.26 billion, followed by Europe with 570 ETFs and US$145.17 billion and Japan with 60 ETFs and US$27.56 billion. Although ETF assets under management (AUM) worldwide decreased by 4.1% YTD this is significantly less than the decline in the “market” which, using MSCI World index as a proxy is down 25.58% in USD terms YTD. AUM in ETFs in the US declined by 6.6% and ETFs in Japan declined by 19.4% compared to the MSCI US (20.52%) and MSCI Japan (-22.86%) in USD terms. ETFs listed in Europe are one of the few bright spots in the financial markets; AUM has increased by 13.0% while the MSCI Europe Index is down 32.27% YTD. In Europe the net sales of ETFs in the first seven months of 2008 were USD 43.6 billion while European domiciled mutual funds (excluding ETFs) net sales were USD – 148.6 billion based on data from Lipper/Feri. There were 268 ETPs with 457 listings and assets of US$58.27 billion managed by 26 managers on 14 exchanges. Combining ETFs and other ETPs, there are currently 1,767 Exchange Traded Products (ETPs) with 3,015 listings and assets of US$822.34 billion managed by 100 managers on 44 exchanges with 716 new products planned.

*ETPs (Exchange Traded Products) include HOLDRs (Holding Company Depository Receipts), Exchange Traded Commodities, Exchange Traded Currency products, and Exchange Traded Notes. This document is an independent market commentary document based on publicly available information and is produced by the ETF Research & Implementation Strategy team. Specifically, this is not marketing nor is it an offer to buy or sell any security or to participate in any trading strategy. Although BGIL endeavours to update and ensure the accuracy of the content of this document, BGIL does not warrant or guarantee its accuracy or correctness. Despite the exercise of all due care, some information in this document may have changed since publication. Investors should obtain and read the ETF prospectuses from ETF managers and confirm any relevant information with ETF managers before investing. Neither BGIL, nor any affiliate, nor any of their respective officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. © 2008 Barclays Global Investors Limited. Registered Company No. 00796793. All rights reserved. Calls may be monitored or recorded. 709285 Contact info: For more information please contact Deborah Fuhr on +44 20 7668 4276 or Deborah.Fuhr@barclaysglobal.com. Comments and suggestions are welcome.

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2008

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SECURITIES LENDING DATA by DATA EXPLORERS

A SNAPSHOT OF THE SECURITIES LENDING MARKET as of 24 September 2008 Size isn’t everything, but the scale of activity in a security can be interesting, particularly if you hold that security.

Equities: Top 10 by Total Balance

Top 10 by Increase in Balance (Balance > 10 Mln USD)

Rank

Stock description

Rank

Stock description

Rank

Stock description

Rank

Stock description

Volkswagen Ag

Axa Sa

Astellas Pharma Inc

Bristol-Myers Squibb Co

Eni Spa

France Telecom Sa

Eni Spa

Intercontinentalexchange Inc

Bayer Ag

Wells Fargo & Co

Parmalat Spa

Denso Inc

Total Sa

Bhp Billiton Ltd

Itochu Corp

Steel Dynamics Inc

Toronto Dominion Bank

Bnp Paribas Sa

Takeda Pharmaceutical Co Ltd

Mitsubishi Corp

The amount of a security out on loan as a percentage of the amount available to lend is another useful indicator of which stocks are currently of interest to the Market. The following tables show the largest utilisations with the largest balance against securities held by Performance Explorer Lenders:

Equities:

Corporate Bonds

Top 10 By Utilisation and Lenders Balance Rank

Stock description

Alcan Inc

MidCap SPDR Trust;1

Gig Partners Inc

Top 10 by Utilisation and Balance

Change on Previous Mth (%)

Rank

Stock description

0.00

Italy, Republic Of (Government) (0% 15-Dec-2008)

-10.97

Westlb Ag (5.164% 18-Dec-2015)

-6.48

Cam Global Finance Sa Sociedad Unipersonal (5.083 14-Dec-2009)

Emcore Corp

6.53

Pfandbriefbank der schweizerischen Hypothekenbanken (2.03% 01-Mar-2012)

Matabolix Inc

7.91

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

American Italian Pasta Co

10.98

Enel Spa (5.622%18-Sep-2009)

Cabela’S Inc

21.08

Eurohypo Ag (3.611% 15-Jan-2009)

C&D Technologies Inc

-4.59

Danone Finance (5.029% 12-Dec-2008)

Builders Firstsource Inc

17.80

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

Euronext Nv

-0.81

3I Group Plc (5.1%23-Jan-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:

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

NOVEMBER/DECEMBER 2008 • FTSE GLOBAL MARKETS

GM EDITORIAL 30.qxd:Issue 30

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Thereâ&#x20AC;&#x2122;s the old fashioned way...

...and then thereâ&#x20AC;&#x2122;s our way

FTSE Global Markets gives you immediate access to 20,000 issuers, fund managers, pension plan sponsors, investment bankers, brokers, consultants, stock exchanges, and specialist data providers.

To discuss advertising insertions, tip-ons, supplements, sponsored sections, bookmarks or your own special requirements Contact: Paul Spendiff Tel: 44 [0] 20 7680 5153 Fax: 44 [0] 20 7680 5155 Email: paul.spendiff@berlinguer.com

MARKET REPORTS 30.qxd:MARKET REPORTS 30.qxd

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Index Level Rebased (30 September 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 08

8 M

Se p-

ar -0

07 Se p-

7 ar -0 M

06 Se p-

6 ar -0 M

05 Se p-

5 M

ar -0

04 Se p-

ar -0

Se p-

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

2,888

230.02

-16.1

-17.5

-26.2

-25.1

3.17

FTSE World Index

USD

2,438

543.88

-15.7

-17.0

-25.7

-24.3

3.20

FTSE Developed Index

USD

2,014

219.67

-14.8

-16.3

-25.4

-23.9

3.18

FTSE All-World Indices

FTSE Emerging Index

USD

874

486.18

-26.1

-26.9

-31.7

-34.3

3.16

FTSE Advanced Emerging Index

USD

424

453.99

-26.6

-25.7

-29.3

-29.8

3.53

FTSE Secondary Emerging Index

USD

450

567.32

-25.4

-28.4

-34.8

-39.9

2.60

3.10

FTSE Global Equity Indices FTSE Global All Cap Index

USD

7,841

366.98

-16.4

-17.8

-26.5

-25.3

FTSE Developed All Cap Index

USD

6,073

353.34

-15.1

-16.4

-25.7

-23.9

3.09

FTSE Emerging All Cap Index

USD

1,768

637.07

-26.4

-28.0

-33.3

-35.7

3.18

FTSE Advanced Emerging All Cap Index

USD

921

603.85

-27.1

-27.0

-31.3

-30.9

3.54

FTSE Secondary Emerging Index

USD

847

716.95

-25.4

-29.4

-35.8

-41.6

2.63

USD

712

164.81

-2.0

-6.6

8.9

4.1

3.23

Fixed Income FTSE Global Government Bond Index Real Estate FTSE EPRA/NAREIT Global Index

USD

283

2581.34

-10.4

-18.1

-30.6

-22.7

5.05

FTSE EPRA/NAREIT Global REITs Index

USD

186

966.78

-3.8

-11.6

-22.9

-12.4

5.69

FTSE EPRA/NAREIT Global Dividend+ Index

USD

250

1859.62

-7.6

-15.2

-26.0

-18.9

5.64

FTSE EPRA/NAREIT Global Rental Index

USD

231

1064.27

-5.0

-13.1

-23.9

-13.4

5.54

FTSE EPRA/NAREIT Global Non-Rental Index

USD

901.99

-25.7

-32.1

-47.0

-43.7

3.29

FTSE4Good Global Index

USD

689

5968.69

-13.7

-16.2

-26.9

-24.7

3.77

FTSE4Good Global 100 Index

USD

102

5201.82

-12.7

-14.6

-26.2

-24.4

3.87

FTSE GWA Developed Index

USD

2,014

3271.46

-14.9

-18.4

-28.5

-26.0

3.96

FTSE RAFI Developed ex US 1000 Index

USD

1,008

5448.17

-18.7

-21.8

-29.4

-28.7

4.69

FTSE RAFI Emerging Index

USD

360

5069.60

-23.8

-23.6

-28.5

-31.5

3.78

SRI

Investment Strategy

NOVEMBER/DECEMBER 2008 • FTSE GLOBAL MARKETS

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Americas Market Indices Index Level Rebased (30 September 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 USIndex 100

FTSE GWA US Index FTSE RAFI US 1000 Index 08

Se p-

ar -0 M

07 Se p-

7 ar -0 M

Se p-

6 ar -0 M

05 Se p-

5 ar -0 M

Se p-

4 ar -0 M

Se p-

Table of Total Returns Index Name

Currency

Constituents

Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%)

FTSE Americas Index

USD

856

733.75

-10.6

-11.3

-21.1

-19.2

2.39

FTSE North America Index

USD

717

809.70

-9.2

-10.5

-21.1

-18.8

2.36

FTSE Latin America Index

USD

139

872.63

-32.2

-24.7

-20.3

-25.6

2.94

FTSE Americas All Cap Index

USD

2,691

334.52

-11.1

-11.2

-21.1

-19.1

2.29

FTSE North America All Cap Index

USD

2,487

323.65

-9.7

-10.4

-21.1

-18.8

2.26

FTSE Latin America All Cap Index

USD

204

1215.46

-32.3

-25.0

-21.2

-26.1

2.94

FTSE Americas Government Bond Index

USD

151

178.13

2.6

0.5

8.8

4.9

3.55

FTSE USA Government Bond Index

USD

134

174.03

3.0

0.7

9.3

5.4

3.52

FTSE EPRA/NAREIT North America Index

USD

117

3481.24

3.2

-1.9

-13.9

-1.4

5.14

FTSE EPRA/NAREIT US Dividend+ Index

USD

1950.56

5.1

-0.6

-12.2

1.3

5.17

FTSE All-World Indices

FTSE Global Equity Indices

Fixed Income

Real Estate

FTSE EPRA/NAREIT North America Rental Index

USD

114

1152.19

4.6

-0.8

-12.6

0.2

5.14

FTSE EPRA/NAREIT North America Non-Rental Index

USD

926.42

-21.0

-23.6

-34.9

-26.2

5.15

FTSE NAREIT Composite Index

USD

135

3333.52

4.2

-1.0

-13.4

-1.6

5.84

FTSE NAREIT Equity REITs Index

USD

108

8329.68

5.6

0.4

-11.1

1.8

5.09

FTSE4Good US Index

USD

152

4846.37

-3.2

-8.5

-22.9

-19.6

2.61

FTSE4Good US 100 Index

USD

101

4669.18

-3.1

-8.5

-22.8

-19.6

2.63

FTSE GWA US Index

USD

661

3020.34

-7.8

-12.5

-25.1

-21.3

3.00

FTSE RAFI US 1000 Index

USD

998

4955.00

-6.2

-12.2

-24.3

-20.8

2.92

FTSE RAFI US Mid Small 1500 Index

USD

1,439

4608.28

-3.2

-5.6

-18.2

-13.8

1.89

SRI

Investment Strategy

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2008

MARKET REPORTS 30.qxd:MARKET REPORTS 30.qxd

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Page 94

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

8 M

Se p-

ar -0

07 Se p-

7 ar -0 M

06 Se p-

6 ar -0 M

05 Se p-

5 ar -0 M

Se p-

ar -0 M

FTSE GWA Developed Europe Index

Index Level Rebased (30 September 03=100)

5-Year Total Return Performance Graph

Se p-

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 (%)

4.58

FTSE All-World Indices FTSE Europe Index

EUR

561

220.96

-11.8

-14.2

-29.4

-27.7

FTSE Eurobloc Index

EUR

2,032

124.38

-11.4

-15.7

-29.6

-29.2

3.99

FTSE Developed Europe ex UK Index

EUR

383

222.28

-10.8

-14.9

-28.9

-27.4

4.61

FTSE Developed Europe Index

EUR

498

217.20

-11.0

-13.9

-29.3

-27.2

4.66

FTSE Global Equity Indices FTSE Europe All Cap Index

EUR

1,698

343.11

-12.2

-14.9

-30.2

-27.9

4.52

FTSE Eurobloc All Cap Index

EUR

836

365.62

-11.9

-16.2

-30.3

-29.3

4.78

FTSE Developed Europe ex UK All Cap Index

EUR

1,144

368.65

-11.5

-15.6

-29.7

-27.7

4.56

FTSE Developed Europe All Cap Index

EUR

1,578

339.51

-11.5

-14.6

-30.1

-27.5

4.59

Region Specific FTSE All-Share Index

GBP

669

3072.54

-12.2

-13.5

-22.3

-22.0

4.61

FTSE 100 Index

GBP

102

2943.26

-12.0

-12.3

-21.2

-21.5

4.68

FTSEurofirst 80 Index

EUR

4723.28

-9.5

-13.6

-27.7

-28.2

5.02

FTSEurofirst 100 Index

EUR

101

4179.73

-10.4

-12.2

-28.0

-27.1

5.00

FTSEurofirst 300 Index

EUR

312

1434.09

-11.0

-13.4

-28.8

-27.0

4.71

FTSE/JSE Top 40 Index

SAR

2382.48

-23.3

-19.2

-18.0

-15.1

3.48

FTSE/JSE All-Share Index

SAR

165

2591.85

-20.6

-17.9

-18.0

-15.5

3.67

FTSE Russia IOB Index

USD

834.85

-47.4

-39.0

-35.9

-42.6

2.11

FTSE Eurozone Government Bond Index

EUR

233

162.26

3.7

0.6

4.2

3.0

4.51

FTSE Pfandbrief Index

EUR

417

182.74

2.0

-0.5

2.2

1.4

5.28

FTSE Gilts Fixed All-Stocks Index

GBP

2099.54

4.7

0.9

6.8

2.3

4.56

FTSE EPRA/NAREIT Europe Index

EUR

2051.11

-4.7

-20.5

-33.7

-21.9

5.22

FTSE EPRA/NAREIT Europe REITs Index

EUR

762.38

1.1

-14.4

-26.5

-14.6

5.04

FTSE EPRA/NAREIT Europe ex UK Dividend+ Index

EUR

2135.59

-4.6

-17.8

-24.5

-14.9

6.09

FTSE EPRA/NAREIT Europe Rental Index

EUR

803.09

-3.8

-19.3

-32.0

-20.1

5.36

FTSE EPRA/NAREIT Europe Non-Rental Index

EUR

581.28

-21.7

-39.1

-56.9

-47.9

2.07

FTSE4Good Europe Index

EUR

275

4345.89

-9.3

-12.3

-29.3

-26.5

5.04

FTSE4Good Europe 50 Index

EUR

3889.72

-8.6

-9.4

-27.6

-25.1

5.09

FTSE GWA Developed Europe Index

EUR

498

2984.66

-10.2

-15.9

-32.4

-29.1

5.47

FTSE RAFI Europe Index

EUR

516

4625.67

-9.0

-14.9

-30.7

-28.6

5.51

Fixed Income

Real Estate

SRI

Investment Strategy

NOVEMBER/DECEMBER 2008 • FTSE GLOBAL MARKETS

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Asia Pacific Market Indices 1200

FTSE Asia Pacific Index

1000

FTSE/ASEAN 40 Index 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

Se p-

ar -0 M

07 Se p-

7 ar -0 M

Se p-

6 ar -0 M

05 Se p-

5 ar -0 M

Se p-

ar -0 M

Se p-

FTSE GWA Japan Index

Index Level Rebased (30 September 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 (%)

FTSE Asia Pacific Index

USD

1,319

236.30

-20.9

-22.3

-32.2

-30.8

3.07

FTSE Asia Pacific ex Japan Index

USD

860

417.43

-23.7

-27.4

-36.8

-37.1

3.90

FTSE Japan Index

USD

459

90.46

-17.3

-9.7

-31.7

-25.5

2.08

FTSE Asia Pacific All Cap Index

USD

3,242

396.80

-21.4

-23.2

-33.1

-31.7

3.11

FTSE Asia Pacific ex Japan All Cap Index

USD

1,965

512.94

-24.5

-28.6

-38.1

-38.5

3.95

FTSE Japan All Cap Index

USD

1,277

282.91

-17.2

-9.9

-31.7

-25.3

2.09

FTSE/ASEAN Index

USD

156

415.81

-22.2

-26.2

-27.0

-31.2

4.22

FTSE Bursa Malaysia 100 Index

MYR

100

7108.72

-13.7

-18.5

-22.0

-29.0

4.06

TSEC Taiwan 50 Index

TWD

5408.90

-18.0

-25.5

-31.8

-26.5

6.45

FTSE Xinhua All-Share Index

CNY

954

5465.39

-21.3

-42.6

-59.5

-57.6

1.48

FTSE/Xinhua China 25 Index

CNY

18317.46

-23.3

-24.5

-42.4

-41.1

3.00

USD

258

117.60

1.0

-6.6

16.4

9.8

1.50

FTSE EPRA/NAREIT Asia Index

USD

1803.66

-22.9

-28.8

-44.5

-40.4

4.84

FTSE EPRA/NAREIT Asia 33 Index

USD

1220.62

-19.1

-24.4

-39.7

-34.8

7.67

FTSE EPRA/NAREIT Asia Dividend+ Index

USD

1792.03

-23.1

-30.0

-43.0

-42.0

6.44

FTSE EPRA/NAREIT Asia Rental Index

USD

969.56

-18.4

-23.6

-39.2

-32.2

7.04

FTSE EPRA/NAREIT Asia Non-Rental Index

USD

909.84

-26.0

-32.4

-48.1

-45.6

3.14

FTSE All-World Indices

FTSE Global Equity Indices

Region Specific

Fixed Income FTSE Asia Pacific Government Bond Index Real Estate

Infrastructure FTSE IDFC India Infrastructure Index

IRP

825.92

-14.2

-34.6

-38.3

-54.6

0.80

FTSE IDFC India Infrastructure 30 Index

IRP

884.92

-12.2

-34.7

-37.0

-55.2

0.86

JPY

190

4439.49

-17.0

-9.0

-29.9

-24.7

2.17

FTSE SGX Shariah 100 Index

USD

100

4679.30

-21.2

-30.9

-27.4

2.86

FTSE Bursa Malaysia Hijrah Shariah Index

MYR

8366.35

-20.0

-22.0

-19.4

-32.5

3.21

JPY

100

1175.37

-20.2

-12.7

-36.0

-29.1

2.26

SRI FTSE4Good Japan Index Shariah

FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index

JPY

459

3040.78

-17.4

-9.2

-30.7

-24.9

2.18

FTSE GWA Australia Index

AUD

111

3708.29

-7.1

-11.5

-28.4

-24.9

6.35

FTSE RAFI Australia Index

AUD

5757.68

-3.7

-9.4

-23.1

-21.8

6.26

FTSE RAFI Singapore Index

SGD

6520.86

-14.7

-14.8

-27.2

-22.2

4.47

FTSE RAFI Japan Index

JPY

297

4308.84

-16.7

-8.4

-29.6

-24.0

2.16

FTSE RAFI Kaigai 1000 Index

JPY

1,014

4404.54

-12.3

-12.5

-33.1

-29.7

4.10

HKD

5370.41

-45.5

-19.9

-35.2

-35.9

3.45

FTSE RAFI China 50 Index

FTSE GLOBAL MARKETS • NOVEMBER/DECEMBER 2008

GM EDITORIAL 30.qxd:Issue 30

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15:51

Page 96

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

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

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

NOVEMBER/DECEMBER 2008 • FTSE GLOBAL MARKETS

GM EDITORIAL 30.qxd:Issue 30

3/11/08

15:51

Page IBC1

THE FTSE I WANT TO INVEST IN RESPONSIBLE BUSINESSES INDEX FTSE. It’s how the world says index. The FTSE4Good Index Series is the definitive benchmark for investors who care. Whether it’s climate change, human rights or supply chain labour standards that matter to you, you can be sure that the FTSE4Good Index Series includes only those companies that are committed to corporate social responsibility. And because FTSE cares, licensing revenues from FTSE4Good are contributed to UNICEF. www.ftse.com/invest_responsible

GM EDITORIAL 30.qxd:Issue 30

3/11/08

15:51

Page OBC1

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