FTSE Global Markets by FTSE Global Markets

CAN THE US SAVE IT’S AUTO SECTOR? ISSUE 36 • SEPTEMBER 2009

The rise of the collateral manager The new gold bug Trading: the impact of fragmentation Spotlight on DTCC

WHAT FINK MIGHT DO WITH BGI ROUNDTABLE: DEFINING A NEW ASSET SERVICING MODEL

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FTSE GLOBAL MARKETS • SEPTEMBER 2009

T WAS INEVITABLE that in a protracted recessionary period there would be a tussle for supremacy between asset owners, fund managers and asset servicing providers in dictating terms of business. Right now there are conflicting signs as to who is winning this particular scrap. In the asset servicing segment, there are signs that providers are playing hardball. That’s because in the days before Lehman Brothers et al crashed and burned into crispy cinders, business was about volume and rarely about value. In a substantive turnaround, asset service providers are now more concerned about profit than rankings in an assets under custody league table. In consequence, their business approach has altered significantly. BNP Paribas for one has taken a blunt view: encouraging prospective clients to either put all their business through them or think again. Clients are feeling a tight pinch as a result: hence Paul Nathan, chief operating officer at Omam’s cri de cour in this issue’s asset servicing roundtable that many a firm’s star has waned in the eyes of their asset services providers just as rapidly as the net asset values of firms’ investment holdings have shrunk in recent months. It is a common complaint. Equally, transition managers report that among some asset owners, particularly sovereign and quasi sovereign wealth funds, the rapidity with which underperforming asset managers are dispensed with these days means that oft times transition managers are required to temporarily house large pools of capital and provide a return to their client, until a new asset manager is selected. It’s an ill wind, say the ancients, and so some transition teams have developed some rather innovative structures for these clients to benefit from. Among these various slings, private equity principals have also been punctured by flying arrows. Witness the pain of buyout firm Nordwind Capital, which was prevented from investing in Global Fertility AG, a start up in the German fertility business, by a group of limited partners including the Harvard and Yale endowments. With some brio the limited partners pushed back against a deal by the Munich-based private equity group which had raised a €300m ($423m) debut fund back in 2004. The deal fell through after Nordwind tried to draw down funds from its investors. Some had objected to the deal because of its heavy investment in US clinics did not match Nordwind’s strategy of investing in German, Swiss and Austrian turnarounds. Others because they did not want to invest in the segment. In the end Nordwind took the costly but honourable course of backing out of the deal, so as not to technically put its investors into default. While market uncertainties continue, this unedifying scrabble looks likely to ebb and flow. However, underpinning this froth is the damned reality of continued substantial declines in asset values in key investment institutions. Look what has happened at two of America’s largest pension pots. CalSTRS is likely to report a drop in the value of its asset by as much as 25% in the fiscal year ending June 30, 2009, with its market value of assets now worth $118.8bn. That much-vaunted bellwether, the California Public Employees' Retirement System (CalPERS) has reported a decline of roughly 23% for its latest fiscal year, the worst return in decades for the largest public pension fund in the US. The decline is equivalent to the loss of about $55bn in assets and while returns have improved somewhat since March, its assets remain buffeted by continued stock market turbulence, moribund credit markets and shrinking real-estate values. CalPERS is exposed to all those asset types, a fact which could ultimately impact on the firm’s credit rating.

Francesca Carnevale, Editorial Director August 2009

Cover photo: Laurence Fink, chairman and chief executive of global asset gatherer and manager BlackRock. Photograph kindly supplied by BlackRock, August 2009.

Contents COVER STORY THE IMPORTANCE OF BEING BGI ..............................................................................Page 67

Laurence Fink, chairman and chief executive of BlackRock, long coveted Barclays Global Investors and its iShares family of electronically-traded funds. Now he looks to have secured it. After the deal closes later this year, BlackRock will become the world’s largest manager of investment assets. Art Detman describes why BlackRock will likely grow and thrive, and how this acquisition may affect the money-management business.

DEPARTMENTS MARKET LEADER INDEX REVIEW

..................................Page 6 Ian Williams surveys the status of the US automotive landscape.

CAN THE US REALLY SAVE ITS AUTO SECTOR?

TURNING JAPANESE ......................................................................................................Page 12 Simon Denham, managing director, Capital Spreads, takes the bearish long view

................................................................................Page 14 FTSE Group’s tie-in with MCX-SX and the implications for Indian investors

ASIAN INDEX DREAMS

FAST AND LOOSE WITH PRIVATE EQUITY......................................Page 16 Private equity looks set to make a comeback – albeit a slow one. Neil O’Hara reports.

IN THE MARKETS

INTEREST RATES MAKE THE RUNNING ............................................Page 24

David Simons on the vagaries of interest rate management in a potentially deflationary arena

RISK MANAGEMENT IN HIGH-FREQUENCY TRADING ........Page 28 Dan Hubscher of Progress Apama looks at real-time risk management

REGIONAL REVIEW

NORTHERN LIGHTS: THE NORDIC WAY FORWARD ..............Page 32

FACE TO FACE

................................................Page 40 Tarek Anwar, Standard Chartered, explains the new business dynamics

Why Nordic markets are worth another look

NEW APPROACHES TO OLD PROBLEMS

COMMODITY REPORT

..................................................................................................Page 42 Jeff Singer, CEO of NASDAQ Dubai, on the promise of the near east.

THAT DUBAI FACTOR

................................................................................................................Page 70 Vanya Dragomanovich meets Aram Shishmanian, the new CEO of the World Gold Council

THE GOLD BUG

................................Page 75 Lynn Strongin Dodds reports on new approaches to money market funds

NEW APPROACHES TO CASH MANAGEMENT

..........................................Page 78 Neil O’Hara on the rising stars in collateral management following Lehman’s demise

THE RISE OF THE COLLATERAL MANAGER

SIBOS REPORT

..............................Page 82 David Simons reviews the DTCC’s new wave of business in clearing and settlement

DTCC HARNESSES A NEW WAVE OF BUSINESS

................................................................................................................Page 86 Lynn Strongin Dodds on the potential for a cross-Asian clearing and settlement platform

ASIAN DREAMS

DATA PAGES 2

Fidessa Fragmentation Index ......................................................................................Page 90 Market Reports by FTSE Research ..............................................................................Page 92 Index Calendar ..............................................................................................................Page 96

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

Contents FEATURES REAL ESTATE

AIN’T NOTHING GOING DOWN BUT THE RENT ....................Page 35

The real estate market is braced for a second wave of bad news as falling occupancy and rental levels replace the capital value crisis and real economy woes begin to bite. Much of the shock generated by price falls has been absorbed but now the pressure is on lease renewals, with tenants failing, downsizing or renegotiating terms as their leases expire. Direct investment has become a case of tactical chess between buyers and sellers while diversified vehicles are finding some favour. However, as Mark Faithfull reports, new breeds of investment platforms and investors are emerging to tackle the risk conundrum

TRADING REPORT

THE RISE OF TRADING SUPERMARKETS ..............................................Page 44

The divine right of stock exchanges to “own” the trading in their own country’s stocks is going to be a thing of the past, according to Steve Grob, director of strategy, Fidessa. “Fragmentation is on an inexorable rise,” he says. “One of the assumptions in the early post-MiFID days was that fragmentation would reach a certain level and then stabilise, but every week we are seeing more fragmentation and no signs yet of consolidation of venues.” Ruth Hughes Liley reports.

THE VALUE OF AGGRESSIVE PRICING....................................................Page 48 LIQUIDITY ISN’T WHAT IT USED TO BE ................................................Page 50 IS CONSOLIDATION THE ONLY ANSWER? ..........................................Page 53

Promising and offering lower latency and in some instances even free transactions, MTFs such as BATS Europe, an offspring of Kansas City-based BATS, Turquoise, a consortium-backed London-based venue and Nasdaq OMX Europe, all of which emerged one year ago, are still in business. Yet the talk of the demise of established exchanges such as the London Stock Exchange (LSE) and Frankfurt’s Deutsche Börse, has subsided with the all but near collapse of global financial markets. What role will technology play in determining the winners and the losers in the fragmented trading landscape? Dawn Kissi reports.

ASSET SERVICING

TOWARDS A NEW ASSET SERVICING MODEL ........................Page 57

According to Luc Leclercq, operations and IT director at Foreign & Colonial: “The landscape has certainly changed over the last 18 months, due in large part to changes in the segments of credit, counterparties, clients, regulators, cost, trustees, and control. Additionally, clients are becoming much more concerned about a relative performance into an absolute world, given the fact that last year we have seen quite a lot of people who lost money. The resulting paradigm shift has been quite enormous: moving from a relative world into an absolute world; from what was understood to be safe to what is not. Certainly, nothing will be taken at face value any more.” What now then for asset service providers? Our roundtable discussion gives some important pointers

DEBT REPORT

CORPORATE DEBT: AN OPTIMISTIC OUTLOOK? ....................Page 73 While credit fundamentals remain challenging for companies looking to crawl out from under the leverage wreckage, a mid-summer string of positive earnings reports has helped buoy the corporate bond markets, which have achieved a level of normalcy not seen since the pre-Lehman days. Dave Simons reports from Boston

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

Market Leader US AUTO SECTOR: CAN IT BE SAVED?

Chrysler, Ford and General Motors, the iconic Big Three automakers, account for just over half of all light vehicle production and slightly less than half of all light vehicle sales in the United States. Even so, they are in dire straits. The rest of the US auto industry— which includes Honda, Toyota, Nissan, Hyundai, BMW, and other foreign nameplate producers—have been making more products that Americans want to buy and will endure this recession without subsidies because they have more efficient cost structures. So why is the US government so intent on ploughing $25bn into the US auto majors? Ian Williams reports.

United States Department of Energy Secretary Steven Chu (right) talks with Ford Motor Company chief executive officer Alan Mulally during a news conference in Dearborn, Michigan, on Tuesday, 23rd June 2009. Chu announced the Energy Department will lend $5.9bn to Ford and provide about $2.1bn in loans to Nissan Motor Company and Tesla Motors Inc., making the three automakers the first beneficiaries of a $25bn fund to develop fuel-efficient vehicles. Photograph by Paul Sancya for Associated Press, supplied by PA Photos, August 2009.

CLUNKING SUBSIDIES ANY PEOPLE REMEMBER US president George HW Bush being sick over the leg of the Japanese premier Kiichi Miyazawa. Few, however, recall the occasion. President Bush was in Tokyo with the chiefs of the Big Three US automakers to plead for self-restraint from the Japanese auto manufacturers, which were roundly beating Detroit on its home turf. Robert Monks, of Lens Governance Advisors, a long-time scourge of auto executives, sees it as an iconic incident; the writing on the wall for potential investors in the Big Three: “There still isn’t full appreciation of how the Big Three have been subsidised and protected by the Federal political establishment—in both parties.” Monks points to Congressman John Dingell, the dean of the House of Representatives, who, he claims, has

helped at every stage to perpetuate US automakers’ inefficiencies, “whether it was stalling fuel efficiency measures or emission reduction rules”. Monks adds: “For years, almost the only people who bought American cars were the government and rental agencies— which were owned by the makers.Then they had to sell the car-hire companies and so people rented Toyotas. In the end they were destroyed by incest, as their ultra-cosy relationship with government protected their inefficiency. Talk about unions, legacy costs? It was just a fig leaf to cover bad managing and bad engineering.” It was far easier to hire lobbyists in Washington than to engineer lower emissions or more fuel efficiency. For decades, industry lobbyists successfully resisted stiffer Corporate Average Fuel Economy (CAFE)

standards for sedans and managed a complete runaround them anyway by getting tax breaks and complete exemptions for the SUV (Sport Utility Vehicles)—which are essentially heavy, lumbering trucks disguised as passenger vehicles. Detroit made much more money on the latter until rising oil prices brought them down to earth with a thump as heavy as the lead which, incidentally, they had also resisted removing from fuel. Consequently, in 2008 the Big Three fell below 50% market share for the first time in living memory, to 47.4%, losing primacy to imports and foreign transplants. Moreover, for the first time in almost a decade, “light truck” sales last year fell below the sales of higher miles per gallon (mpg) sedans, on which the US industry had all but given up. The credit crunch caused US sales to drop from 15 million vehicles a year to 9.5 million as the financial crisis dried up liquidity for consumers and companies alike.

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

Market Leader US AUTO SECTOR: CAN IT BE SAVED?

As July drew to a close,Washington had to add another $2bn to the oversubscribed billion dollar“Cash for Clunkers”scheme that had offered $4,500 for Americans trading in their old gas-guzzlers for more efficient models. It was small beer in proportion to the $80bn industry rescue package, though perhaps symbolic that the scheme appears to benefit the environment more than Detroit. As consumers traded in old, mostly US-made gas-guzzlers for new efficient cars, foreign companies (notably Hyundai) were major beneficiaries of the programme along with Ford, which recorded its first increase in sales in two years. Hyundai this July reported record quarterly profits. Long-time industry consultant Professor Barry Bluestone at Boston’s Northeastern University last year pointed out the stark realities in a memo to Representative Barney Frank, a key legislator in the Federal rescue programme for the industry. Using the oft-cited but, in Detroit, much-ignored market to make his case, he invokes the second-hand value of comparable 2003 model cars. “In late 2008, the Toyota Camry V6 had a Vehix.com value of $11,150 while a comparably-powered Honda Accord V6 is slightly higher at $11,225. In contrast, the trade-in values of the Chevrolet Impala V6 was only $6,850; the Chrysler Stratus $6,200, and the Ford Taurus $5,000.” Bluestone cites similar devastating figures from Consumer Reports for 2008 that show Big Three brands came in below 50 on the 0-100 satisfaction scale while the equivalent “import brand” models, as Detroit labels even US-built vehicles by foreign companies, won scores of 70s and even 80s. He concludes: “Automakers that provide their customers with quality that lasts, with a satisfying driving experience and a vehicle that meets their driving expectations, will make a profit and will not need Federal support.”

Bluestone recalls other missed opportunities. Around the time that Bush Senior was recycling his dinner menu in Japan, General Motors had tried to move forward with the Saturn, using the techniques that were propelling Japanese success. However, the good efforts came to little. No one now pretends that what’s good for General Motors is good for America. The contumely that greeted the Big Three executives in Washington when they turned up last year (cap in hand and on executive jets) marked the end of an era.

Political shift There has also been a political shift. As the Republican Party has become more intensely ideological, Detroit, with unions and workers “pampered” with health insurance, lay-off pay and pensions, looked dangerously “socialist” (an almost insulting jibe in US political circles) compared with the foreign transplants that had taken root in the Republican-voting Southern states with laws hostile to unionisation. That allowed the discussion to become obsessed and obscured by Monks’ “fig leaf,” the costs of union labour. In fact, there already was a convergence between labour costs in the old United Auto Workers (UAW) plants and the transplants, which suggests that it was not so much the cost of labour but, according to some analysts, the low quality of management and design that wasted the skills of the workforce. In fact, Professor Bluestone points out that many of the “import brand” transplants have had very successful union working agreements, and cites the Modern Operating Agreement of the Mazda plant in Michigan, the Toyota plant in California—and, significantly, the Ford plant in Cleveland, significant because, of all the US companies, Ford has weathered the crisis best.

In the face of Republican indifference and taxpayer revolt in the aftermath of banking bailouts, Detroit had to suffer tough love from Washington legislators who had previously been the political equivalent of a pushover. Congress forced it to commit to all the steps that it had helped them avert for all those decades. Washington acted quickly, allowing accelerated bankruptcy proceedings, helping shed many liabilities while backing-up corporate guarantees on vehicles, thus stopping even more precipitous erosion of the consumer base. Additionally, the industry had accelerated its long-procrastinated reforms with mandated cuts in staff, plants, marques, dealerships remuneration, an end to dividends, and with directives to invest in newer, more efficient models. Notably missing from the dole queue was Ford, which, Jack Plunkett of the annual Plunkett’s Automobile Industry Almanac points out, had “brought in a brilliant outsider”, former Boeing Commercial president Allan Mulally, to be president and chief executive officer, and so was in the right position to meet the crisis, amassing huge amounts of cash, creating efficiencies across the board, standardising designs and components across the product range. It had negotiated new union contracts, which reduced the labour force and cut wages and benefits for new employees. It cut its 97 marques to a manageable 20 or less. As a result, Ford could refuse offers of government money but did ask for a line of credit guarantee to maintain sales. In contrast with its beleaguered compatriot firms, it recorded a second-quarter $2.3bn net profit. However, even if Ford was prepared to bounce off the rocks that almost crushed GM and Chrysler, it is still in a hard place: the faltering global and US economy.

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

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Market Leader US AUTO SECTOR: CAN IT BE SAVED?

Plunkett commiserates that the “global auto industry has been evolving out of control, with massive overcapacity, but in the European Union and US it hasn’t really evolved to take advantage of the market. Toyota has been able to give the customers an SUV with low petrol consumption as the US carried on making the big Chevrolet Tahoe and Hummer, while Hyundai’s quality is outstanding.”He concludes that “even if the financial crisis had not happened, there was still an auto crisis in the making”. So is there any light at the end of this very gloomy tunnel for US automakers in a world with global overcapacity, a credit squeeze, rising unemployment—and more efficient competition at home and abroad? Actually, there is. Professor John Paul MacDuffie and his colleagues at the International Motor Vehicle Program (IMVP) argue that demand will return to near-complete levels in the developed world and in particular in the US, and even without “Cash for Clunkers” four million more cars a year hit the scrapheap than are being sold, so upwards is the only way. The $64,000 question is: how many of those vehicles will Detroit make? The answer is, almost inevitably, many fewer. Slimmed down as they will be, with fewer models, many fewer dealers and without the credit to offer the cutthroat incentives and discounts they have used to maintain sales, there are few grounds for great expectations. It will take time for them to tool up to build their new, efficient models with their new, cheaper workforce. Indeed, their fire sale of overseas assets may be assisting yet another rival just over the horizon. Chinese companies are hovering around and make little secret that they want the technology as much as the physical assets. Ironically, GM is very

successful in China, but Plunkett points out: “The Chinese are developing some impressive technologies, and as soon as American consumers decide they trust the quality and like the styling of Chinese models (which is based on US cars anyway) they will buy.” There is only a narrow window of opportunity for the US companies to turn themselves around before taxpayer indulgence attenuates, the market revives and their rivals move into the vacuum the Big Three’s nearcollapse created. The one step Congress could take that would allow—or rather force—the US industry to compete, Plunkett suggests, is what Big Three executives also seem to favour: that is to incrementally increase fuel prices to developed world levels to force efficiencies and confirm a market for the low-emission, high efficiency vehicles they are now committed to build as a condition for the Federal aid. He points out: “The CAFE fleet standards are just absurd, an evadable abyss of regulation. The intelligent way to control fuel use is price: I wish Congress were that smart.”

Massive savings Sadly, Capitol Hill, which only occasionally exhibits courage, is unlikely to increase the cost of fuel in the face of combined consumer and oil company resistance which may thwart the industry’s belatedly adopted reforms. Detroit’s reforms were predicted to offer massive savings (in 2010). Already, for example, GM’s hourly manufacturing costs have dropped from $18.4bn in 2003 to an estimated $8.1bn in 2008, somewhere around 10% of the cost per car. The IMVP echoes Bluestone that all three US automakers now have some sites that are “true knowledge-driven

workplaces, delivering world-class performance on safety, quality, cost, and other indicators,” while Ford’s resilience and those Modern Operating Agreement plants shows what can be done. The question is whether those examples can be replicated at GM and Chrysler and whether managerial conservatism and the credit squeeze will allow investment in new, and sellable, technologies. The dangers are that they only learn half the model. While Toyota, for example, is keeping redundant workers on the books of its California truck plant to maintain their skill base for the upturn, Detroit’s rush to shed workers on the older union contracts to hire novices may be pithing its technological abilities. Professor James Jacobs of Macomb College in Michigan points out: “Any future of the auto industry rests upon highlyskilled workers willing to be flexible. But will such workers be attracted to the auto industry when wages are being lowered? Currently, nursing assistants get $9 to $50 per hour, while starting wages in auto-unionised jobs are not much more at $14 to $50.” Similar traditional short-termism may inhibit the industry’s preparation for an upturn. Indeed, the crisis effect on industry liquidity has already postponed the launch of several fuelefficient vehicles such as GM’sVolt and Cruze, while US carmakers have been reluctant to adapt clean-diesel engines, which account for half of sales in Europe. In the end, there is a real-time experiment. The transplant companies have shown there is nothing inherently untenable about making desirable and profitable vehicles in the US, even in unionised plants. In the wake of the crisis, Detroit’s management has no more excuses left. It would be a bold investor though who bought stock in them.

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

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Index Review AVOIDING THE WORST EFFECTS OF DEFLATION

The summer is drawing to a close and markets have continued to be reasonably friendly with the FTSE nestling comfortably around 4700 and the various economic data releases giving hope that the worst of the current downturn might now be over. The fact that the German and French economies grew in the second quarter came as something of a surprise to the markets, though this might have more to do with the very high levels of personal state aid available in both nations than with an actual turnaround in the economy. Simon Denham, managing director of spread betting firm Capital Spreads, calls the odds.

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

TURNING JAPANESE? N THE UNITED Kingdom the vast sums added via banking support, quantitative easing and general state spending seem to be holding back the worst (for the time being) but it must be admitted that the general outlook once the purse strings start to be tightened is rather harder to estimate. Economists seem to fall into two camps, with the apocalyptic grabbing the headlines and the more generally neutral bringing up the rear; after all, middle of the road forecasts do not make for good copy. Inflation in the US and Europe, or rather deflation, is causing considerable concerns, especially as the massive increase in money supply would normally have been expected to have the opposite effect—especially across the Atlantic. One wonders what the CPI number in the States (currently -2.1%) would have been had the Fed not spent the trillion plus dollars on its various policy initiatives over the last year. Europe meanwhile (when compared to the UK and US) has, in the main, kept its powder dry. The economies are not so heavily weighted towards the service sector and levels of personal debt are way below those prevalent in the Anglo Saxon economies. Their capacity to

maintain domestic demand levels without state aid has therefore been that much greater. If growth in the West flags once again eyes will be turned rather more aggressively on the Northern European Bloc to open the floodgates to aid expansion. Above everything is the fear of the “ghost at the feast”. Japan’s lost decade (actually nearer two decades now) is a spectre that nobody wants to contemplate, though for high inflation, high personal expenditure, nations such as the UK it has always seemed most unlikely. Even with the vast sums being expended, the sad fact is that the money supply data is still falling (M4 growth in the UK is now dipping sharply) as banks retrench into their domestic economies. Japan has shown that even extreme levels of state funding can have little impact once the effects of deflation become endemic. Japan’s public debt is now 200% of GDP but nobody seriously expects hyper-inflation to rear its head in the land of the rising sun. In fact the deflationary aspect of Japan’s economy means the real value of its debt keeps increasing year on year. In Europe we have become used to governments inflating their way out of a poor debt situation (if inflation is 5% then the absolute value of

£1,000,000 debt is just £950,000 next year, £902,500 the next, etc). Imagine the effect of consumer confidence and expenditure if personal debts (mortgages, credit cards, etc) were greater in terms of salary and income next year even though they had not increased at all. Actually we do not need to imagine as we have the case study of the effect in Japan to show us. The weak pound means inflation has continued in positive territory in the UK but the recent strength of sterling means that this effect is being whittled away. By mid-October, if the pound remains where it is now, inflationary impulses will have largely worked its way through the system. Compounding this export growth has been in fact export contraction and the trade balance has fallen as import levels have reduced even further. If entrenched deflation takes a hand, investors will experience the Japanese effect of waning stock valuations. However, if inflation spirals out of control, rates will have to be hiked and money and bonds may well regain their attraction over equities. A continuation of the current equity rally will rely on reasonable, noninflationary growth, but this is a rather narrow path to tread. As ever ladies and gentlemen, place your bets.

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

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Index Review FTSE GROUP TIE UP WITH MCX-SX

Index provider FTSE Group is developing and refining its approaches to emerging markets investing through innovative agreements with established and emerging stock exchanges and trading venues in a move to create both investible products and investment benchmarks in selected countries. Following on from its extensive agreements and ventures with the JSE in South Africa, FTSE Group has tied up with India’s MCX Stock Exchange (MCX-SX), to create new investment products for investors in the Indian subcontinent, which are based around indices and investment benchmarks and which will be listed and traded on the Indian exchange. FTSE will also extend co-operation to MCX-SX parent Financial Technologies Group’s exchange network in India, Singapore and Bahrain, and facilitate creation of international investment products to be listed on the MCX Stock Exchange.

DEEPENING THE INVESTMENT MIX P TO NOW, the Bombay Stock Exchange’s (BSE’s) Sensex and the National Stock Exchange (NSE) Nifty indices have dominated the Indian domestic equity markets. Global index provider FTSE Group instead chose to work with MCX-SX, a relatively new six-year-old exchange active in currency trading. Under the terms of the agreement, MCX-SX and FTSE will work together to create new domestic index products for India, as well as bring a set of international FTSE indices to MCX-SX, which will facilitate the creation of international investment products, including index futures, exchange traded funds and cash-based products, to be listed on the MCX-SX in India, after completion of regulatory compliances. By combining FTSE’s indexing heritage with MCX-SX’s deep local knowledge, both organisations are confident. “We can add value to international and domestic investors seeking to capture the investment opportunities in India’s markets,” says Donald Keith, FTSE Group’s deputy

chief executive. “Our interest in India goes back some years, though we realised that to gain meaningful access and build a position in the market we needed a partner. MCX-SX think there is room to compete with both the BSE and NSE and I think they are right. India is still relatively underdeveloped from an index point of view.” The venture will begin market research to conduct a wide market consultation over the requirements for a new domestic index, says Keith, “and we hope to have something ready for investors by the end of this year”. According to Joseph Massey, managing director and chief executive officer of MCX-SX, the partners will “jointly design and introduce a range of indices which will meet the needs of the market participants. These indices will allow the market participants to take a view on global growth, manage sectoral as well as global risks. We are delighted to be working with FTSE on this important development. Through our deep domain knowledge of Indian financial markets and FTSE’s expertise

Donald Keith, deputy chief executive, FTSE Group. Photograph kindly supplied by FTSE Group, August 2009.

in creating global indices, we aim to help Indian investors make informed decisions through efficient and global benchmarked products.” The venture’s goal is to bring a broad range of domestic and international index products to the Indian financial services sector, which can then be used as performance benchmarks and as a basis for financial products such as institutional and retail funds, exchange traded funds, and derivative contracts. Going forward, FTSE and MCX-SX will agree to create a set of FTSE global indices which will be licensed to become the basis for futures contracts on MCXSX in India subject to regulatory clearances. The partnership will also create a new jointly developed index series which will offer domestic as well as global investors new opportunities to “track, analyse and invest in India’s dynamic financial markets,”says Keith. MCX-SX already provides a highliquidity platform for hedging against the effects of unfavourable fluctuations in foreign exchange rates. Banks, importers, exporters and corporates can hedge on MCX-SX at low entry and exit costs. The exchange is now awaiting regulatory approval to commence equity trading. According to Keith:“MCX-SX is the right partner. The exchange has a long-term strategy, good technology and is poised for better growth. Today’s

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

stock exchanges globally to design and calculate a range of domestic, as well as global, indices. These exchanges include Singapore, Malaysia, Thailand, Johannesburg, Italy and London. Equally, the index provider is keen to get a foothold into the relatively prosperous Indian market. According to last year’s International Monetary Fund (IMF) economic outlook, the Indian economy, though stymied by the global financial crisis, is still expected to put in growth by some 6.9% this year, though it is still down on the peak of 9.3% registered in 2007. “There are limits, however, on how much Indian investors can invest overseas. That is why part of the plan is to bring a range of products to the Indian market, listed in India and based on FTSE Indices created globally, thereby precluding Indian investors of the need to go overseas,”explains Keith. FTSE is also expanding its products and partnerships in the wider Australasian region to include the FTSE Australia Index Series—designed to address Australia’s unique tax application. Other recent initiatives include a new FTSE Currency Forward Rate Bias Index Series as well as the FTSE Environmental Markets Classification System and the extension to the FTSE Environmental Opportunities Index Series. However, the Asian continent remains key for FTSE Group, acknowledges Keith, who points to a number of new index based initiatives, with the Bursa Malaysia and the Singapore Stock Exchange which have involved upgrades to each market’s respective benchmark indices.

FTSE GLOBAL MARKETS • SEPTEMBER 2009

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co-operation announcement marks an important step towards establishing FTSE in India, the world’s fastest-growing market, after China.” MCX-SX is a subsidiary of Multi Commodity Exchange of India Ltd (MCX), part of the Financial Technologies Group owned by Jignesh Shah, and operates under the regulatory framework of the Securities and Exchange Board of India (SEBI) and Reserve Bank of India (RBI). MCX-SX was inaugurated on 6th October 2008 and went live the next day. According to Keith, MCX ranked among the world top 10 commodity futures exchange in 2007 and ranks number one in silver, number two in natural gas, and three in gold, crude oil and copper futures trading globally. MCX has helped redefine the Indian commodity market and is among the fastest growing exchanges in the world, boasting strategic alliances with NYMEX, the London Metals Exchange, TOCOM, NYSE Euronext, CCX, SHFE, and others. As a 51% stakeholder in MCXSX, MCX will add value to the business of MCX-SX by bringing in the actual users of commodities to hedge their currency exposure on MCX-SX’s nationwide electronic trading platform. For its part, Financial Technologies Group is the promoter of nine other commodity and financial exchanges—six in India including Multi Commodity Exchange of India and three outside India, including the Dubai Gold and Commodities Exchange, The Singapore Mercantile Exchange and the Global Board of Trade, Mauritius and Bourse Africa. The venture builds on FTSE’s experience in partnering with

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In the Markets PRIVATE EQUITY: IMPROVING OUTLOOK

Photograph supplied by istockphotos.com, supplied August 2009.

EVERY WHICH P WAY BUT LOOSE Undoubtedly private equity is a tough place to be these days. However, despite the current difficulties, most private equity professionals expect conditions to improve towards the end of 2010. According to Brian Livingston, head of private equity at Smith & Williamson, the accountancy and financial services firm in the United Kingdom: “The debt-fuelled frenzy is over, and financial engineering can no longer be relied on to generate equity returns. Private equity will have to go back to fundamentals— concentrating on old fashioned, solid businesses with strong management in attractive sectors. With returns based on business, rather than banking, we see a further move to more realistic pricing … Some have claimed that the private equity market is dead. The love affair with debt may be over but private equity will survive and adapt—this is the age of equity investment.” Is Livingstone right? Neil O’Hara assesses the industry outlook.

RIVATE EQUITY INVESTORS worldwide expect 10% of limited partners to default on their capital commitments in the next two years, according to a summer 2009 survey conducted by Coller Capital, a boutique securities house based in London that specialises in secondary transactions in private equity interests. Investors in the United States are even more pessimistic: they expect a 13% default rate. The potential shortfall exceeds $80bn in the US alone, where private equity firms raised an aggregate $630bn in 2007 and 2008. Although many investors ended up overexposed to private equity after the market meltdown (which played havoc with target asset allocations) they haven’t yet defaulted in droves—and may never do so.

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

In the Markets PRIVATE EQUITY: IMPROVING OUTLOOK

Relations between private equity firms and their investors could turn ugly if limited partners do start to default. In early March, CapGen, a New York-based private equity shop, filed a complaint in Delaware Chancery Court against two of its limited partners whom it claimed had defaulted on capital calls due on 31st December, 2008.

Christian Oberbeck, a founding partner of Saratoga Partners, a New York-based private equity firm that manages $250m. Oberbeck says: “All of a sudden you stop getting liquidity flows from prior investments …You have to tap into other investments in the rest of the portfolio to fund the call.” Photograph kindly supplied by Saratoga Partners, August 2009.

Serial investors in private equity have undrawn commitments to newer funds while older ones throw off cash as the sponsor liquidates successful investments; in effect, returns from older funds provide a significant portion of the cash needed to finance future commitments. The amount invested at any one time may be no more than 50%-60% of the nominal exposure, so investors often sign up for higher commitments to keep the average amount invested close to their goal. The market crash eliminated the customary exit strategies for fund sponsors. However, it decimated merger activity, undermined the economics of recapitalisations and shut down initial public offerings altogether. Investors who have no cash coming in but still have to fund capital calls are now struggling to meet their obligations. “All of a sudden you stop getting liquidity

flows from prior investments,” says Christian Oberbeck, a founding partner of Saratoga Partners, a New York-based private equity firm that manages $250m.“You have to tap into other investments in the rest of the portfolio to fund the call.” Suppose a $1bn pension fund had 10% committed to private equity before the crash; if the portfolio also included $500m in equities whose value tumbled 50%, it became a $750m fund—and the $100m in private equity represents 13.3%, way above target. For high net worth individuals who used leverage to fund their private equity commitments, allocations got even more out of whack. Relations between private equity firms and their investors could turn ugly if limited partners do start to default. In early March, CapGen, a New York-based private equity shop, filed a complaint in Delaware

Chancery Court against two of its limited partners whom it claimed had defaulted on capital calls due on 31st December, 2008. CapGen’s funds had $500m committed in total but the alleged defaulters were bit players: Chalice Fund was on the hook for $3.5m and WK GG Investment for $1m—and the missed call was for less than 25% of those amounts. Frank Morgan, president of Coller Capital in the US, points out that partnership documents typically permit the general partner to call on other limited partners to make up any defaulted amount, but CapGen chose to take legal action against two high net worth individuals instead. “It was a warning to other larger investors not to try this,” he says, “I do not think a lot of defaults have occurred.” In a slow deal market, Morgan says private equity firms haven’t been making many capital calls except for follow-on commitments to existing investments anyway. At some point that will change—probably sooner rather than later. Private equity funds have “use it or lose it” provisions that

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

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In the Markets PRIVATE EQUITY: IMPROVING OUTLOOK

require general partners to cancel commitments if the money is not invested within the investment period, which is typically five years. The clock is ticking, and firms don’t want to lose the management fees they charge even on uninvested funds.“If there are still economic pressures when activity picks up, you will start to see defaults or more product trading in the secondary market,”says Morgan. Investors in private equity funds make firm capital commitments at the outset, but the sponsor does not draw money down until needed to finance a particular investment. For their own protection in this deferred funding model, general partners have long insisted on draconian penalties to discourage limited partner default. Paul Ellis, a partner in the restructuring and recovery services practice at PricewaterhouseCoopers, says every fund is different, but limited partners in default always lose their voting rights and typically forfeit 25%50% of future fund distributions. They may be liable for future management fees on the amount of their original commitment (including the defaulted amount), too.“Those penalties are pretty significant and they affect the reputation of the investor,” says Ellis.“We have not seen any significant volume of threatened or actual defaults.” Saratoga’s Oberbeck points out that the severity of the penalties depends on where the fund is in its lifecycle and how the early investments have performed. Investors will be loath to give up future gains from a successful fund, but if a fund made its initial investments in 2006 or the first half of 2007 it may well be under water.“If you have invested $40m out of $100m but you think that $40m is worth zero, what do you lose by walking away?” asks Oberbeck. “Do you want to be in the back end of a fund that has lost money? The carried interest incentives for the fund manager are not there either.”

Saratoga has not experienced any limited partner defaults itself although Oberbeck has heard talk of the phenomenon. Like Ellis, he suggests that investors and private equity firms are talking to each other to work out a solution acceptable to both. General partners have to be careful, however; whatever they do to accommodate one limited partner will set a precedent other investors may try to follow. Notwithstanding the CapGen case, Oberbeck doesn’t expect sponsors to resort to litigation. “You don’t bite the hand that feeds you,“ he says. “If you sue an endowment or a pension fund it will be all over the press. It doesn’t look good.” Ellis says private equity firms have become more willing to exchange information with limited partners, particularly about valuations and potential changes to the general partner’s investment strategy. For example, in the current environment many sponsors see opportunities to buy companies out of bankruptcy, which may not have been contemplated when a fund was first launched. “The underlying concept is understated value. It happens to reside in the bankruptcy world at the moment,”says Ellis. “Limited partners who have not been involved before are concerned enough to ask more questions about why sponsors are doing this and what the implications are.” While Ellis acknowledges that general partners may shy away from capital calls if they believe limited partners will default, he has not encountered any reticence among his clients. Quite the opposite, in fact: limited partners are pressing sponsors to deploy money—they don’t like to pay fees on unfunded capital commitments. Nevertheless, sponsors won’t go out of their way to antagonise limited partners by investing in troubled industries such

Frank Morgan, president of Coller Capital in the US, points out that partnership documents typically permit the general partner to call on other limited partners to make up any defaulted amount, but CapGen chose to take legal action against two high net worth individuals instead.“It was a warning to other larger investors not to try this,” he says,“I don’t think a lot of defaults have occurred.” Photograph kindly provided by Coller Capital, August 2009.

Paul Ellis, a partner in the restructuring and recovery services practice at PricewaterhouseCoopers, says every fund is different, but limited partners in default always lose their voting rights and typically forfeit 25%-50% of future fund distributions. Photograph kindly supplied by PricewaterhouseCoopers, August 2009.

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

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In the Markets PRIVATE EQUITY: IMPROVING OUTLOOK

as auto parts, for example. “It would be reasonable to expect general partner reluctance to call capital without a significant amount of limited partner support,” says Ellis. “[However,] we are not seeing defaults or threats of default.” Kathy Jeramaz-Larson, executive director of the Institutional Limited Partners Association, a Toronto-based association dedicated to private equity investors around the globe, wonders whether the talk of limited partner default is real or if it is simply an urban legend. “I have not heard from either limited partners or general partners of any limited partner defaults,”she says.

“That’s not to say they aren’t happening—it’s just that I am not aware of any specific instances.” Jeramaz-Larson has heard of situations where investors have made hard decisions not to reinvest in the next fund offered by a particular sponsor, however. That’s consistent with Coller Capital’s finding that 31% of limited partners plan to reduce the number of general partner relationships they have, and that 20% intend to cut their allocation to private equity in the next two years. Investors also expect that 25% of private equity sponsors will be unable to raise new funds, effectively putting those firms out of business

when their existing funds liquidate. If investors can afford to wait, a combination of future distributions and passing up opportunities to reinvest with some managers will get their allocation back on target. The secondary market is always an option for those under immediate pressure, too. “Not only do they get some consideration for what they invested in the fund but they get relieved of the ongoing commitment,” says Coller Capital’s Morgan. “I expect people to find that attractive.”For most investors under pressure from excess exposure to private equity, default on capital calls is likely to be a last resort.

UK SURVEY CHARTS UPS & DOWNS OF PRIVATE EQUITY he number of private equity houses is expected to fall significantly over the next 24 months, according to a recent survey carried out by the UK accounting and financial services firm Smith & Williamson. The survey of 136 private equity senior executives was conducted between 10th June and 3rd July 2009. Some 75 different mid-market (£5m-£50m) PE houses responded, between them representing more than two-thirds of all UK mid-market PE transactions. According to Brian Livingston, head of private equity at the firm, some two-thirds of the 136 senior private equity executives across the 75 firms polled shared the gloomy prediction for the industry. “Recent poor performance has meant many private equity houses are being squeezed: they cannot raise new equity funds and cannot raise bank finance either, since the banks are increasingly focusing on investors’ track records before committing finance for deals. As a result, many firms are effectively unable to make investments and may have little choice but to merge or shut down,” notes Livingston. While respondents overwhelmingly stated that entry multiples on new investments have fallen since

2007, so far lower prices have not resulted in more deals. Some 82% of the survey respondents agreed that over the last two years it has become much harder for companies to raise finance from private equity investors. Moreover, 93% believe that more private equity-backed businesses will breach banking covenants in the year ahead. The private equity community does not expect to get much help from the government either. Only 12% believe government policies will help to ease problems in the private equity industry. Livingston adds: “Even with lower entry multiples, the lack of bank funding makes it difficult to structure deals in a way which will generate satisfactory returns. Instead, we are seeing more and more private equity houses shifting their focus from making new investments to preserving the value of their existing portfolios.” However, the outlook is brighter. Some 68% of survey respondents think investor confidence will begin to return, while half believe bank finance will become more readily available in coming months and 57% expect the current recession in the UK to end by 2010.

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

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In the Markets INTEREST RATE OUTLOOK: STEADY AS SHE GOES

Dollar Down But Not Out In an effort to keep the economic recovery on track, the Federal Reserve Board has made clear its intention to hold rates at their current bottom-scrapping levels well into next year. Meanwhile, the dollar, having closed the gap against numerous international currencies during the first part of the year, is once again back down—but not out, according to most observers. From Boston, David Simons reports. N ITS MOST recent monetary policy statement issued in late June, the Federal Open Market Committee indicated a willingness to maintain a target range of 0%-0.25% for Federal funds as part of the overall effort to “employ all available tools to promote economic recovery and to preserve price stability”. With rates skimming zero, the Fed’s focus in 2009 has shifted to quantitative easing measures to help stimulate the economy and the functioning of financial markets, including substantial purchases of Treasuries and mortgage securities, says John Beggs, chief economist, AIB Global Treasury. “Given the very weak economic conditions, with the unemployment rate set to soon breach 10%, as well as very subdued inflation, the current exceptionally low level of the Fed funds rate can be expected to remain in place well into 2010 at least.” Richard B Hoey, chief economist for Dreyfus Funds, believes that policymakers have correctly diagnosed the current financial and economic risks and have taken the proper steps to keep the situation under control. Along with a gradual recuperation of the financial

Photograph supplied by istockphotos.com, August 2009.

sector as it moves from “semi-orderly deleveraging to orderly deleveraging,” Hoey also sees the continuation of extremely low interest rates worldwide for an extended period. Of course, it wasn’t all that long ago that the Federal Reserve Board went on a similar rate-slashing campaign, chopping the Federal funds rate from 6.5% to 1% during 2001-2003. Many observers still believe that the Fed’s subsequent about face, which took the rate from 1% to 5.25% during 2004-06, effectively punched a hole in the realestate bubble the Fed helped create.

Technology solutions Conditions are markedly different this time around, however, and strategists such as Nick Colas, chief market strategist for New York-based ConvergEx Group, an institutional agency brokerage and investment technology solutions provider, aren’t concerned about a repeat scenario based on current monetary policy. Still, the quantitative easing trend does bear watching, he says. “For instance, our offshore trading partners worry that we are basically monetising

the debt, and the Fed is just printing money to buy treasuries, which may be perceived as a breach between the separation of the central banks and fiscal policy. The Chinese in particular are concerned about the notion of quantitative easing as a way of monetising debt, because obviously if this really were the case, the dollar would weaken considerably—and that would be a major problem.” Hans Redeker, global head of foreign exchange strategy at BNP Paribas, says that the worldwide belief the worst is over has furthered optimism over the recovery process, which in turn has provided support for asset markets, as well as allowing currencies to extend their rebound against the dollar and yen. Indeed, the perception that the market has bottomed has negatively impacted the dollar, as investors abandon cash positions in favour of higher yielding instruments. After staging a powerful rally during the mass flight to quality beginning late last year, the dollar has since given back a good portion of its gains. The British pound, which hit a seven-year low of $1.35 against the dollar in March, vaulted ahead of the

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

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In the Markets INTEREST RATE OUTLOOK: STEADY AS SHE GOES

greenback some 25% by midsummer. Meanwhile, a string of better-than-expected earnings reports by US companies helped drop the dollar to its lowest level against the euro since early June. By August, the euro had risen above the $1.40 mark, its highest position this year. Speaking on behalf of Dreyfus, Hoey said that it was not surprising that the dollar would hit a wall once the financial crisis began showing signs of improvement. Contrary to some opinions, Hoey doesn’t believe the dollar is overvalued in comparison to other industrial currencies. Relative short-term interest rate spreads shifted against the dollar as countries such as Japan had less room to reduce their rates, or, in the case of Europe, refrained from lowering their policy rates to the same degree. “However, the effect of the more aggressive stimulus in the US is that the [domestic] economic recovery is likely to lead the European recovery and economic activity is likely to remain at a less depressed level in the US than in Japan.” Sterling may also endure periods of turbulence over the near term. In a recent report, the International Monetary Fund (IMF) inferred that additional injections of capital may be required in the UK due to the continuation of challenging economic conditions, stating: “Substantial further writedowns would result in an erosion of capital buffers and might lead to renewed doubts about the capital adequacy of individual banks.” The UK is expected to round out 2009 with a negative growth rate of -4.2%, improving to near 0.2% next year. Despite some improvement of late, the world’s leading economies still find themselves combating a slew of negatives, not the least of which is the continuation of extremely tight credit conditions. In its recent Global Credit

Market Outlook, State Street Global Advisors suggested that a global recovery“ seems to be dependent upon a genuine improvement in the US, and this, in turn, depends critically upon effective economic policy”. On that point, SSgA expects global growth to reach -1.1% this year (from 3.2% in 2008), reflecting both a lock-step contraction of the advanced economies as well as a slowing of growth within emerging markets. While growth is expected to reach positive territory in the coming year, it will more than likely track at the recession-level rate of less than 2.5%. Economic sluggishness will all but ensure a continuation of slack monetary policy, says SSgA. “Renormalisation of policy rates is not likely to begin anywhere until late 2010 and in most places not until 2011.”

Positive indicator Though on the one hand the greenback pullback may be viewed as a positive indicator—i.e., increased global investor risk tolerance—some are worried about its impact on the US economic recovery. “The central issue is that crude oil is predominantly priced in dollars, so a softer dollar increases energy prices, such as what Americans pay for gasoline,” notes Colas. “The average household buys some 100 gallons a month, so as gasoline prices rise, their overall discretionary income falls. That makes a consumer-led recovery much more difficult.” At the same, says Colas, fears of inflation are unwarranted. “Capacity utilisation is still so slack, and unemployment is still rising, that it just doesn’t seem there is any kind of inflationary risk for at least the next 12 months,” says Colas.“There have been worries over this raw flood of money that has just been issued because to many people it seems inflationary. The reality is that people don’t have the

means to go hog-wild on spending, and from a producer standpoint, why would you try to raise prices when you’re just happy to have the capacity?” Comments made by Fed chairman Ben Bernanke have underscored the uneasiness many feel over the ability of the Fed to take action without any kind of third-party oversight.“Inadvertently, quantitative easing has become a lightning rod in terms of what the role of the Fed should be during this time,” says Colas. In a recent market commentary, Colas suggested that efforts to “intrude on the Fed’s independence will likely accelerate”the longer the US and global economies remain under pressure. Colas believes the Fed has done a good job under difficult conditions, and therefore “any successful effort to undermine its independence will only exacerbate weakness in the dollar and prolong domestic economic underperformance. “Hopefully the political rankling that we’ve seen is nothing more than theatre, but there are still a lot of people who legitimately believe that the Fed has too much power. I do not believe efforts to change that independence are constructive at all.” The great irony, says Colas, is that the US, the country that started the implosion, should be considered the safest haven in the midst of the implosion. “Fair or not, that is exactly what has happened, and I don’t anticipate that changing to any great degree. We might continue to see some devaluing of the dollar as money moves into more speculative investments, but in general, I think everyone is looking at the US economy as the place that has to start picking up steam in order for the rest of the world to move forward. If that is the case, why wouldn’t you want to be involved in US securities? So for that reason alone I believe the dollar is safe for the time being.”

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

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In the Markets RISK MANAGEMENT IN HIGH-FREQUENCY TRADING

What you see is what you risk

Photograph © Irina Petrenko/Fotolia.com, supplied August 2009.

The past 12 months have changed the game for how risk is viewed and managed. Such has been the extreme level of volatility at times that only the most highly equipped firms have felt safe they can avoid sudden losses. In the face of such extreme conditions, the parameters for “conventional” risk management, understandably, have also had to change. Companies need much better access to information in real time if they are to stand a chance of coping under a new financial landscape. Dan Hubscher of Progress Apama looks at real-time risk management in the context of high-frequency trading and aggressive algos. IGH-FREQUENCY TRADING these days is a serious market tool and risk management in trading is now more important than ever. Managing risk is not just about preventing loss; it is also about making money. It is about knowing, across traders, desks and asset classes, what the entire firm’s exposure is, at any point in time. It is also being able to do something about it (automatically) in real time. With the confidence to sense and respond immediately, it is about trading responsibly and without fear. With both trade generation and execution growing ever faster and more automated, an awareness of risk is also growing. There has been an increase in the requirement for the real-time risk management aspects of algorithmic trading as people learn to use algorithms to capitalise on opportunities faster than they

otherwise could manually. In the past, some firms have been relatively relaxed about the risks, arguing that if they had one bad trading day, the profits from the rest of the year would make up for it. In this recessionary climate, that attitude has changed significantly. Now everybody is interested in what their level of exposure is at any given point in time, all the time, and what the safeguards are. This is a major focus. Many are finding that as trading velocity increases, it is no longer acceptable to assess risk at the end of the day. In these straightened times, highfrequency trading is an essential tool for traders seeking liquidity. Moreover, the growth in electronic communication networks (ECNs), FIX adoption, direct market access (DMA) and the increase in electronic trading tools have created a fertile environment for the

exponential growth of the highfrequency trading community. High-frequency players have undoubtedly increased volume on markets. The effect of such trading strategies is improved market quality, but market participants have also had to increase their IT spend and improve in-house systems to cope with rising trading volume. While these are necessary advancements and mark a natural evolutionary step within capital markets, the key trend is to turn real-time risk management from the exception to the norm. Pre-trade checks are one way of offering this real-time risk protection. Broker-dealers often wrestle with how to offer it, particularly within the context of providing DMA. Generally you see it in the form of a sponsored-access service through which the broker lends its clients its identification to access securities exchanges directly. While realising the benefits of giving its clients direct access, brokers are keenly aware of the risks associated with this practice. Ultimately, many have taken the view— most notably and recently Goldman Sachs—that there is a need for pretrade checks before orders are placed.

Real-time view Futures clearing firms equally demand a view of the risk stemming from proprietary trading desks’ order flow to access futures markets via DMA. This requires a real-time view on the desks’ positions and the ability to place and enforce limits on that order flow. This practice is becoming increasing popular (particularly in the current climate of high-frequency trading) as a safeguard against technology failures, oversized orders and other situations where there is a potential for systematic market impact. Drop-copies from the exchanges are no longer seen as an acceptable or quick enough method.

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

In response to numerous requests from our loyal delegate base, we have scheduled IMN’s Fourteenth Annual European Beneficial Owners’ Securities Lending Summit for 22-23 September 2009 in London as a matter of convenience. In September 2008, as credit markets seized-up and global markets plunged, IMN’s Thirteenth Annual European Beneficial Owners’ Securities Lending Summit forged ahead. Despite the unprecedented market conditions, leading European Securities Lending decision-makers made it a priority to attend the event, and were rewarded with real-time content and discussion about the profound issues confronting Beneficial Owners and the industry. As always, the Summit agenda is being developed after extensive consultation with industry leaders and with significant input by leading Beneficial Owners. Programme Session Highlights: U *À }À> i , Ã > >}i i Ì E >ÌiÀ> > >}i i Ì U i ÌÀ> Õ ÌiÀ«>ÀÌ iÃ\ Û ÕÌ "À ,iÛ ÕÌ ¶ U / i ÕÌÕÀi v `i wV>Ì \ 7 >Ì i iwV > "Ü iÀÃ ii` Ì Ü Now U *À }À> i -ÕÃ«i Ã Ã] /iÀ >Ì Ã ` i ` } *À }À> i ÌiÀ>Ì Ã U L> - ÀÌ -> i ,i}Õ >Ì Ã\ «>VÌ ` « V>Ì Ã À / i `ÕÃÌÀÞ U Unique Opportunity For Beneficial Owners To Meet Privately; Two Special Closed-Door Roundtable Sessions For Beneficial Owners Only

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In the Markets RISK MANAGEMENT IN HIGH-FREQUENCY TRADING

One sector of the market that really needs to wake up to the issue of realtime risk management is the hedge fund community. The Obama administration has already begun to take steps by reforming the regulatory environment in the United States. The government in the United Kingdom has announced, meantime, its intent to effect sweeping reforms of the Financial Services Authority. While it might not be crystal clear how these reforms are going to affect hedge funds, what is clear is that (like it or not) hedge funds will be next in the line of fire for regulators. There is a groundswell of opinion that an essential task for the regulation of hedge funds is to source and aggregate data on leverage and positions. For the regulation of hedge funds to stand a chance of being successful, regulators will need to be able to track the concentration of hedge funds by assets and by strategies, and to understand how the failure of one firm might affect others. Real-time risk management through the pre-trade checking therefore is critical. Even so, there are a number of issues to consider for hedge funds and institutions. Pre-trade risk management is perceived to add latency to the process. Moreover, the issue of how a broker’s handling of buyside order flow impacts anonymity also has to be tackled. Having visibility into the fund’s trading patterns could potentially provide the broker the ability to frontrun the orders and reverse-engineer the algorithms, among other things. So how do you solve the latency and anonymity problems and still control the risk? Some look to broker neutral real-time systems, while others employ the trick of abstracting the positions/exposure in real-time from the details of the order flow that pushed the exposure to that level in the first place. Either way, it is important to note that minimising the latency impact of pre-trade risk

checking is not only essential, but also achievable through event driven, realtime approaches, as compared to the other traditional methods of checking trades before being placed. In addition, real-time risk management does not have to impact anonymity if handled well. It’s generally accepted that the buyside’s way around this issue is via the DMA route. The best systems for doing this are those that have no knowledge of the trading algorithm and do not deduce the algorithm from seeing the order flow; they only care about issues such as instantaneous perorder risks or total position/exposure over time, regardless of how it got there.

Impact of algorithms The advantages of real-time risk management are crystal clear. It allows traders to benefit from more aggressive limits, which safely increases trading volumes and thereby increases profitably from high-frequency trading strategies. It preserves the buyside/sellside relationship when used in conjunction with DMA or any other instance where the broker must otherwise either overly constrain or blindly trust the trading activities of its client.Another plus point for the buyside is that direct adoption empowers it to be more broker-neutral and, as many will find out, hold off the regulators if implemented widely enough. Within all this talk of real-time risk management and high-frequency trading, it is critical not to forget the role and impact of algorithms. While the earthquake that shook the markets last year undoubtedly drove computerorientated investors temporarily back to more traditional methods and trading styles, many brokers expect the growth curve in electronic trading to continue. To this end, there is still a strong appetite for algorithms which aggressively complete transactions with as little latency and as unobtrusively as possible.

According to Sang Lee, a managing partner at Aite Group, the first iteration of aggressive algorithms were more about looking for liquidity in the displayed market, but now algorithms have evolved to the point where aggressive algorithms seeking liquidity can operate simultaneously in both dark and displayed venues, allowing for greater efficiency and speed of execution. Aite Group research has also highlighted the fact that leading algorithms in the “aggressive-algo” category have grown significantly in the past year. Those trading in foreign exchange can testify to this trend. Despite the downturn in equities, many brokers trading FX benefited as long as the algorithms they used could accommodate attendant larger spreads and higher volatility. Some had to customise their algorithms to do so; but once done, the new algorithms worked well and to quote a trader were“making money hand over fist”. There have been cases of buyside firms trading primarily in equities prior to the market meltdown at the end of 2008 that then wanted to start trading foreign exchange with algorithms as quickly as possible because of the opportunities to capture gains on new volatility, which was not expected to last very long. Ultimately all this points to a shift in the landscape bought about by volatility, regulation and competition. Traders and investors are constantly looking at ways to forge ahead of competitors while trying to not to fall foul of the regulator and an industry stung by events of the last year. Traders eventually and often reluctantly adhere to the old saying in racing: “Never drive faster than your guardian angel can fly.” Adopting real-time risk management is a step in the right direction, helping the guardian angel fly at the speed the traders need to drive in order to win their race in high-frequency trading.

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

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Regional Review NORDIC ZONE MOVES TO UPGRADE PAYMENTS INFRASTRUCTURE

EUROPEAN PAYMENTS SYSTEMS UPGRADED IN NORDIC ZONE The Payment Services Directive (PSD) aims to make payments within the European market easier and more cost efficient. All European banks in the European Union group and within the wider European Economic Area (EEA) countries must comply by the beginning of November this year. WEDISH PSD LEGISLATION is expected to be ready during the spring of 2010, though Skandinaviska Enskilda Banken AB (SEB) says its adherence to the directive will be ready from November 1. David Teare, global head of customer relationship management at the bank, says:“For clients, the PSD will entail two major changes in terms of payments. Transferred amounts shall reach the receiver intact; no deductions may be made from the payment amounts, as previously occurred. Instead, any fees must be reported separately. In addition, the amount will be available to the recipient the same day as the receiving bank is credited.” PSD is an important building block in creating a single European payment market and aims to equalise legal conditions governing payment services

throughout Europe for both individuals and enterprises. PSD also creates the necessary legal platform for the Single Euro Payments Area (SEPA). Together, the PSD and SEPA will reduce national divergences and harmonise payment instruments, technical standards and information on payments. JP Morgan’s Treasury Services business, full-service providers of cash management, trade finance and treasury solutions, recently announced its new payables and receivables capabilities in the Baltic and Nordic regions through both urgent payments and non-urgent local automated clearing house (ACH) channels. Corporates with customers or suppliers in these markets can now initiate and receive payments in seven additional countries. The move brings the total number of European countries in

which JP Morgan clients can transact in the domestic clearing to 20, in addition to SEPA and multi-currency transaction services. Alex Caviezel, head of Treasury Services in Europe, Middle East and Africa, explains: “The model is ideal for larger organisations based outside the Baltics or Nordics which actively trade there. The solution simplifies the task of managing multiple bank accounts and bank relationships, enabling clients to manage their funds conveniently on a London-based account.” Additionally, Caviezel says that the bank continues to invest in its global payments platform, “enhancing local payments and receivables services in Italy, Switzerland and the UK”. He adds: “These enhancements include improved reporting, later cut-off times and enhanced local ACH connectivity.”

TESTING TIMES FOR NORDIC BANKS Nordic banks have substantial exposure in the Baltic region after lending heavily in Latvia, Lithuania and Estonia during several years of booming growth. As the Baltics continue to exert a drag effect in the Nordic markets, foreign banks are looking at the potential to expand their business lines. WEDEN’S CENTRAL BANK in June noted that loan losses this year and next among the country’s leading banks could reach as much as $23bn, as the economies of Latvia, Lithuania and Estonia continue to contract at double-digit rates this year. The situation is not helped by the fact that the Baltic countries are hanging on to their currency pegs, thereby making

recovery a lot more difficult. Although the temptation and encouragement for the Baltic states to devalue is rising, it would have the double whammy of stymieing their desire to be part of the EU currency union, and also spiral more borrowers into default. Either scenario does not bode well for the Nordic banks. Nordea Bank AB and Svenska Handelsbanken AB, two of the region’s

larger banks, have reported forecastbeating second-quarter earnings after taking much smaller provisions than rivals for potential losses on bad loans. However, Nordea and Svenska Handelsbanken may be the exceptions that prove the rule, as Swedbank AB and Skandinaviska Enskilda Banken AB, which have expanded aggressively into the Baltic countries, will impact on

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

Global solutions, delivered locally For two decades, J.P. Morganâ&#x20AC;&#x2122;s mission has been to serve as a trusted partner for our clients in the Nordic region. Our locally based experts, backed by our global team, are ready to discuss an array of securities services and related solutions with you. We are committed to helping you and your clients achieve future success. To learn more about how J.P. Morgan can help your company succeed, please contact: Copenhagen Allan Nedergaard +45-3344-9200

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Regional Review NORDIC ZONE MOVES TO UPGRADE PAYMENTS INFRASTRUCTURE

earnings. Nordea’s exposure to the Baltics is relatively small (accounting for only 3% of total lending) while Handelsbanken has been reticent about the opportunities provided by its near neighbours and reports no exposure to the economy-torn states. Swedbank and SEB, meantime, report exposure totalling 17% and 13% of their total lending in the Baltics respectively, with related net losses of SKR2.01bn ($280m) for Swedbank and losses of SKR193m for SEB. The biggest Nordic banking group had $10.4bn of loans to the region by the end of this year, of which the biggest portion (around a third), was in

Latvia and the rest evenly split between Estonia and Lithuania. Norway’s top bank, DnB NOR, has a Baltic exposure through its DnB NORD unit headquartered in Copenhagen, a joint venture with Norddeutsche Landesbank. DnB NORD operates in Estonia, Latvia, Lithuania, Denmark, Finland and Poland. Nordea expects that rising bankruptcies in the Nordic countries will continue to exert pressure on the balance sheets of local banks for some time. Nordea’s second-quarter 2009 (Q2 2009) net profit fell 11% to €616m from €692m over the same period last year, beating analyst expectations. Nordea

chief executive Christian Clausen maintains that the region’s banks have yet to reach the bottom of their bad-debt problems. He notes that Nordea’s loan losses swelled for the sixth consecutive quarter to €425m in the quarter ending June 30th, well up on Q2 2008, when the bank’s loan losses touched €36m. Handelsbanken meantime reported net profit of SKR2.53bn, up 2% on the same quarter in 2008, but also reported a 64% increase in loan losses to SKR939m over the same period, with the lion’s share originating in export-dependent Sweden. The losses were offset by a stronger-than-expected 25% jump in net interest income to SKR5.64bn.

KAS BANK UPGRADES POST TRADE SERVICES Nordic custody major KAS BANK has added the alternative trading platform Equiduct to its European network of direct exchange links. Adding Equiduct means KAS BANK is currently linked to 25 regulated and alternative markets across Europe. ITH THE ADDITION of Equiduct, KAS BANK is currently linked to seven Multi-Trading Facilities (MTFs). In total, 18 regulated exchanges and these seven MTF’s are directly connected to the Single Platform of KAS BANK in Amsterdam.This platform processes our client transactions in a uniform manner, with a single collateral and margin arrangement for all markets. Equiduct Trading provides a Markets in Financial Instruments Directive (MiFID) compliant, integrated pan-European single point of connectivity for trading services in most liquid equity instruments listed on the European Economic Area Regulated Markets through the Regulated Market operated by Börse Berlin in Germany. Equiduct’s market is divided into several geographical segments, each following the trading schedule and characteristics of their

home market. For the settlement of transactions in securities listed on the NYSE Euronext markets and the London Stock Exchange (LSE)— including SIX Swiss Exchange’s Swiss Blue Chip Segment markets— LCH.Clearnet will provide its central counterparty services. KAS BANK will provide clearing and settlement services to its clients for their transactions through Equiduct in its capacity as General Clearing Member of LCH.Clearnet SA (NYSE Euronext) and LCH.Clearnet (LSE, including SIX Swiss Exchange Swiss Blue-Chip Segment). KAS BANK already provides clearing and settlement services to NYSE Arca Europe and SmartPool, moves finalised in March this year. Most recently, the bank has extended its reach to offer integrated clearing, settlement and custody services for transactions executed on NASDAQ

OMX and relevant MTFs. With the addition of the Nordic Exchanges, KAS BANK strengthens its European strategy and offers its post-trade securities services and solutions linked to 22 regulated exchanges and seven MTFs in the European market place. The bank’s Single Processing Platform processes clients’ transactions in a uniform way, with a single collateral and margin arrangement for all markets, through expert management and mitigation of relevant risks on behalf of Trading Member Firms, creating a unified market for its clients. According to Albert Röell, chairman of the managing board of KAS BANK: “In line with our European strategy, KAS BANK’s commitment to the Nordic region is very strong. Our highly-sophisticated equities platform will be directly connected to the Nordic infrastructure.

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

Real Estate Report REAL ESTATE: NEW INVESTMENT PLATFORMS

Richard Holberton, director, EMEA research at agent CBRE, supports the view that more buyers are beginning to circle and points out: “The downturn in real estate values across Europe has so far been predominantly driven by increases in yields. However, we have now clearly entered a period in which rents are the driving force behind the property value corrections. While investment turnover remains relatively low, there appears to be growing interest in several areas of the market, supported by the re-pricing that has already taken place.” Photograph kindly supplied by CBRE, August 2009.

AIN’T NOTHING GOING DOWN BUT THE RENT FTSE GLOBAL MARKETS • SEPTEMBER 2009

HE PAST 18 months could not have been much tougher for European real estate and with rental income streams in decline as leases come up for renegotiation, combined with further falls in capital values, 2010 promises another rocky ride. Some of those at the heart of the current malaise—notably investment and retail banks—remain in the process of dismantling much of their exposure to a real estate industry still damaged by the mega-deals they helped finance. The impact, especially in transactional volumes, is there for all to see. Direct investment in commercial real estate in Europe stood at just €24bn in the first half of 2009 according to agent Jones Lang LaSalle (JLL), down 42% on the second half of 2008 (€41.5bn). With restrictive new lending conditions during the second quarter, there were few transactions over €100m, with the majority of trading in lot sizes between €20-50m.

Real Estate Report REAL ESTATE: NEW INVESTMENT PLATFORMS

However, Tony Horrell, head of European capital markets at JLL, believes volumes may have bottomed out: “We believe that the European market has now reached a floor in transaction volumes. Prime office yields were largely stable in Q2 for the first time since mid-2007. Volumes have remained low because the bid offer spread remains wide in some markets. At the same time, falls in capital values have made pricing attractive for those investors with equity or buyers who are not highly leveraged.” That makes the market interesting for those in a position to buy, reckons Nigel Roberts, chairman of European research at JLL.“Attractive investment opportunities—often assets which rarely come to the market—have appeared,”he reflects. Richard Holberton, director, EMEA research at agent CBRE, supports the view that more buyers are beginning

to circle and points out: “The downturn in real estate values across Europe has so far been predominantly driven by increases in yields. However, we have now clearly entered a period in which rents are the driving force behind the property value corrections. While investment turnover remains relatively low, there appears to be growing interest in several areas of the market, supported by the re-pricing that has already taken place.”

Glimmers of hope That does not hide the fact that while there may be glimmers of hope, transaction volumes have fallen off a cliff since their peak. With direct investment opportunities either rare or perceived as high risk, investors have instead been reconsidering the vehicles to market and with that there are changes afoot, says Roger Cooke, chairman of the EMEA capital markets

board, managing partner Spain, Cushman & Wakefield. He says: “The dominance of the real estate private equity closed-end funds model is likely to see a reduced appeal, while we may see the increasing importance of public markets in real estate— specialised REITs—as well as joint ventures with a small number of institutions with operating partner management in a form of privatelyheld operating company. “Investors are likely to be either more sector or geographic specific when selecting vehicles and more general platforms will not be so attractive,” Cooke notes. “While there is a clear role for REIT-type vehicles, they should not be viewed as tax efficient vehicles for bundling together toxic assets.” There is a subtle shift back to institutional investment. Cooke says: “We foresee a steady return to real estate through 2010—mainly focused

SIX TO WATCH IN EUROPE IN 2010 THIBAULT DE VALENCE, executive managing director, CBRE Investors Established in 1972, CBRE Investors has £21bn in assets under management, with the UK as the hub of its European operations. A penchant for long-term relationships means CBRE Investors has developed a strategy to match long-term, sustainable growth objectives. Valence is presiding over continental Europe.

BILL BENJAMIN, managing partner, Europe, AREA Property Partners AREA Property Partners—formerly Apollo Real Estate Advisors—closed out a $1.4bn European fund in 2008, some of which has been spent on stakes in Capital & Regional’s German and UK operations and on the £600m joint-venture acquisition of Dawnay Day’s portfolio. Bill Benjamin is widening the opportunity search to countries such as Turkey and Ukraine and to Africa.

GUILLAUME POITRINAL, chairman and chief executive officer, Unibail-Rodamco Unibail and Rodamco were already massive players in the European retail and office real estate markets before they merged in 2007. Since then the company has been rebalancing its €26.1bn European portfolio, selling €741m of Dutch high street property and buying retail centres in Austria and Spain. Poitrinal is keen to bolster its position as a retail powerhouse.

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

interests (with general partner and coinvestors) and, of course, gearing. To get round this, new vehicle structures may be needed plus refinement of existing ones. “To raise finance for larger schemes, we may see a vehicle to allow more building specific securitisations coming forward, possibly on the public market. We may also see more interest in strata-title type deals allowing smaller investors or occupiers a stake in larger buildings.” Indeed, there is a perceptible shift towards “club style” investment schemes as disenchantment about fund performance intensifies in the wake of a long series of loss-making quarters. For example, Goldman Sachs was heavily criticised recently for its dual role in property transactions and debt renegotiation in deals where different arms of the investment bank had a stake in both positions, leading Nori Gerardo Lietz,

on more core markets and better quality product. At the moment, the lack of institutional interest has created an opening for opportunity funds. However, they will need to be careful that their pricing requirements do not lead to deals escaping them before they have established significant positions.” David Hutchings, head of research, EMEA at Cushman Wakefield, reflects: “For many investors in the market, collective vehicles must be the way forward since this spreads risk, delivers diversification and accesses the market for a smaller cost. It may also fit more generally in a market with lower gearing, meaning the financial reach of each investor is lower than it was. A number of facets of existing collective routes have, however, been discredited or called into question in the downturn: namely fee levels, liquidity, management expertise, alignment of

chief investment strategist for real estate for Swiss investment firm Partners Group, to declare: “The investment banking model is broken in real estate private equity.” Lietz was referencing “Whitehall” funds such as Whitehall Street Global Real Estate Limited Partnership 2007, which despite losing billions still made Goldman Sachs millions in transaction advisory and management fees. Having a foot in both camps is becoming increasingly contentious for investors burnt by capital value falls.

EU regulations threat Meanwhile, real estate investment funds could be caught out by prospective European Union investment regulations designed to curb the activities of hedge funds. The European Parliament is discussing changes to the Directive on Alternative Investment Fund Managers, which could be implemented as early as

ERIC SASSON, managing director, Carlyle Group If real estate investment is out of favour then clearly someone forgot to tell Carlyle Group. The giant American private equity house raised $3.4bn with its third European-focused fund in the middle of 2008 and has set about spending that money pretty quickly, with Portugal Sasson’s latest target.

CHAD PIKE and JONATHAN GRAY, senior managing directors and co-heads, real estate, Blackstone It’s hard to argue with a business which has just raised €2.5bn in this market, and this US colossus is determined to make sure that size matters. It is using debt purchase as one of its big gateway strategies but its Blackstone Real Estate Partners Europe III fund will be spent “cautiously”, say co-heads Pike and Gray.

MARK HUTCHINSON, president, GE Capital Real Estate With more than $81bn in assets and a presence in 31 countries, the company has made a speciality of buying pan-European loan books from the likes of Bradford & Bingley, Capmark Europe and Credit Suisse. Hutchinson, appointed president in 2008, is focusing activity on more debt business and increased exposure to Asia.

FTSE GLOBAL MARKETS • SEPTEMBER 2009

Real Estate Report REAL ESTATE: NEW INVESTMENT PLATFORMS

2011. It aims to standardise investment products to make it easier to market them throughout the EU and to tighten regulations. The directive applies to all alternative investment fund managers managing more than €100m in assets, or €500m where they do not use leverage and have a lock-in period of five years or more. The aim of the legislation is to standardise fund products to make it easier to market them to professional investors throughout Europe. The European Commission also proposes to centralise regulation within the EU with the establishment of the European Systemic Risk Council and the European System of Financial Supervisors, which were announced in May and for which consultation ended in July. The Directive on Alternative Investment Fund Managers is further down the line. Nevertheless, critics say regulating property funds in the same way as hedge funds and private equity would make property fund management more difficult. Industry bodies are being galvanised into response. The European Association for Investors in Non-listed Real Estate Vehicles (INREV) convened a meeting with members in London to discuss the impact of the directive and the Investment Property Forum is also looking at its response. John Forbes, EMEA real estate industry leader at PricewaterhouseCoopers, suggests EU property funds could also lose out because the draft directive suggests that insurance companies and sovereign wealth vehicles would be exempt, even if they were managing funds. Forbes believes the effect of the regulation will be to make every EU country heavily regulated—currently, investors can choose lightly-regulated

“The expectation of large sales of distress real estate has proved wrong and banks generally seem to be holding on. That means distress sales are still ‘situational’; specific to a certain building or portfolio.”

markets, such as the UK, or heavily regulated environments, such as France or Germany. With so many cul-de-sacs for investors, alternative means of accessing the real estate market have begun to emerge and, in what could be a prelude to greater consolidation, BlackRock recently confirmed it was buying Barclays Global Investors, notably including its iShares exchange traded fund (ETF) business, for $13.5bn. The transaction is expected to close in the fourth quarter. BlackRock chief executive Laurence Fink expects a wave of consolidation to sharpen the split between large and small asset management firms and the distinction to harden between giant and boutique firms. He says:“I believe we’ll wind up with a basket of small managers and a basket of big ones.” For property, ETFs are one means of investing in real estate investment trusts (REITs)—the much heralded but spectacularly under-performing tax efficient models under which many of Europe’s biggest property developers and owners trade. ETFs should offer a counterbalanced risk profile for investors and could become a route into a REIT market some analysts believe may be bottoming out. However, weak economic fundamentals are likely to

hamper REIT performance and most still have massive amounts of debt they need to roll over or refinance looming. That said, it is possible an acquisition boom in REITs may materialise, similar to what happened in the US in the 1990s. Investors will be looking for any news on the deleveraging process and economic trends when REITs begin reporting second-quarter results. Whatever investment platform an investor chooses, general economic woes are likely to challenge returns, adds Van Stults, a founding partner and managing director of Orion Capital Managers. “We are moving from problem banks to problem borrowers. The financial crisis that has gripped us from 2007 is now shifting to the real economy and how that affects buildings, declining rents and less tenants,” he says. “On today’s terms, just about everything has to be considered over-rented so we’re not talking about loan-to-value issues, or anything like that, we’re talking about the danger of companies running out of cash.” In response, he believes there will be a shift away from financial mechanics towards operational expertise and investment with experienced real estate management teams, with good buildings and good tenants. “This will overlay financial sophistication. Before, it was perhaps the other way round,”he reflects. “The expectation of large sales of distress real estate has proved wrong and banks generally seem to be holding on. That means distress sales are still ‘situational’; specific to a certain building or portfolio. People ask: ‘Will it be like France in 1995 or the US in 1990?’ I think not because this time the situation is too big for companies to sell out of it. Besides, even if they do, where do they put their money?”

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

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Face to Face TAREK ANWAR, GLOBAL HEAD OF SALES, TRANSACTION BANKING, STANDARD CHARTERED

Tarek Anwar, global head of sales, Transaction Banking, Standard Chartered. Photograph kindly supplied by Standard Chartered. August 2009.

THE PRIME OF TRANSACTION BANKING RANSACTION BANKING IS coming into its own, holds Tarek Anwar, global head of sales, Transaction Banking at Standard Chartered in Singapore. It is not just Anwar’s view. The quality of transaction banking delivery is playing a greater role than ever in determining which banks are chosen by corporates as their primary relationship banker, according to new research from banking analyst firm

East & Partners. In the East & Partners May 2009 survey of Asia’s top 1,000 institutions, Standard Chartered garnered one of the biggest gains in primary and secondary transaction bank recognition, rising from 31% from 28.5%. Anwar professes no surprise at the surge of interest by banks in the segment “as it encompasses the backbone of institutional and corporate banking relationships. It is important

Standard Chartered continues to refine its Transaction Banking business to better align the bank with its intention of becoming a global leader in cross-border as well as domestic transaction banking. As the bank's ambitious transformation continues, it could become the dominant emerging market bank for years to come, believes Tarek Anwar, global head of sales for transacton banking at the bank. to define what might be the future of the transaction banking industry and refine the industry outlook”. He adds: “There is no doubt that transaction banking is growing, but is this growth straightforward and all-round? Or are we responding adequately to the currents in the market?” According to Anwar, the market has already undergone substantive change since the pre-September 2008 period. Despite interest margin compression and some US competitors dumping pricing, clients are showing a strong preference to transaction banks that help them create value. Moreover, he explains, change in the way they view counterparty demonstrates that corporations and institutional investors have sought fewer solid but more comprehensive relationships with their bankers. At the same time, he notes the barriers to entry in the business have meant that long-term providers, “who have shown commitment to regional markets, have seen a gravitation of business towards them. Commitment is key and clients recognise that”. Anwar says there are three main drivers of the business: “Getting deeper with the clients, creating a

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

bigger wallet and improved crossselling. That in a nutshell is the overarching tactics with the overall strategy of being the leading bank in the segment.” In addition, he stresses the following qualifiers: “Balance the dash for growth with vigilance on risk and ensuring the quality of operations matches the quality of service that is offered to clients. “Transaction banking—defined as cash management, trade finance, clearing and securities services—makes up over 45% of client revenue globally,” says Anwar. “We have a lot of momentum in this business and we are positioned in those areas of the world with fastest growth. Our aspiration is to become a top provider of transaction banking services in all the key countries of our regions.” For banks that can succeed in growing and retaining market share, transaction banking is a very attractive business. It attracts liabilities, has low capital usage, earnings stability and return on equity—all valuable characteristics for banks today that are refocusing on more stable business areas to deal with the current downturn in the financial industry, highlights Anwar. For him, the business“is about evolutionary patterns, among industries and among regions. It has become a cultural interaction, as we are dealing with people influenced by their corporate culture and their demands are similar around the world, irrespective of their market.” Even so, the emerging markets bank differs in many ways, different from its European or American peers. Standard Chartered derives over 90% of its profits from Asia, Africa and the Middle East. Serving both consumer and wholesale banking customers, the bank combines deep local knowledge with global capability to offer a wide range of financial products and service solutions. Anwar explains that Standard Chartered had been focused

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on building the franchise for at least 150 years, and, for transaction banking, can now leverage extensive networks with deep expertise and capabilities in Asia, Africa and the Middle East. “We have witnessed a substantive evolution as corporates expand their geographic spread. Take a large Chinese corporate: they are as concerned with supply chain issues, working capital, risk and the introduction of efficiencies as any large corporation.” Moreover, he states:“The supply chain and working capital finance is the backbone of a company. So any changes you make can easily enhance the performance of the company. It creates a completely different level of relationship with a bank, one of a partner and adviser.”

Responsibility Anwar works out of the bank’s Singapore office and reports directly to Karen Fawcett, Standard Chartered’s Singapore-based group head of transaction banking. Since arriving at Standard Chartered three years ago, Anwar has had responsibility for the bank’s cash management, trade, clearing and securities services sales globally. All of Standard Chartered’s regional transaction banking heads, located throughout its network in Asia, Africa and the Middle East, report directly into him. Throughout his 28-year career, Anwar has worked with clients across all aspects of clearing, cash, trade and treasury management, including reengineering projects, treasury centralisation programmes and shared services centres. His experience also extends to advising on change management, complex implementations and project management, skills he has subsequently brought to bear in his current role. The impact has been substantive. He notes: “We are much

more client centric today. We no longer work in product or geographic silos, a malaise some competitors suffer from. We aggressively encourage leveraging of the bank’s extensive network. We no longer measure people by revenue generated just in their own country. Our sales teams follow an origination model tagged to their clients, irrespective of where they act, and this works really well for our clients as we help them grow cross-border.” In addition to Asia, Anwar stresses the equal importance of the Middle East and Africa region to Standard Chartered’s recent and future growth. He says: “The focus for the bank is on maximising its network, focusing on its people and products and services to create value, and also focusing on segmenting services for specific industries and clients in different stages of evolution.” Anwar adds: “For example, small and mid-market companies are no longer just locally focused, but the local banks can’t truly help them with their new international opportunities or cross-border suppliers or buyers. The local banks don’t have the same ‘reach’ power of a bank like Standard Chartered.” Anwar thinks that the financial crisis has created a new mood of realism in the markets:“The few banks like us that continued to be ‘open for business’ during the crisis, were able to have positive dialogue with clients about balancing the risk and the nonrisk business. People are much clearer these days about what is key.” “Part of it is that people are reviewing the basics more frequently these days. But some part of it is also a greater realism on what can be done by the bank to help create value. It is safe to say though that paramount in all this, the equation still tends towards the client and we tell our teams: ‘Don’t compete on price, compete on value.’”

Innovators THE NASDAQ DUBAI EXCHANGE: AIMING FOR EXPANSION 42

The NASDAQ Dubai exchange’s home region includes the United Arab Emirates and the rest of the Gulf Cooperation Council (GCC) countries, the wider Middle East and North Africa. Armed with a broad hinterland, the exchange has great expectations. Can chief executive officer Jeff Singer lead it to a bright future?

Jeff Singer, chief executive, NASDAQ Dubai. Photograph kindly supplied by NASDAQ Dubai, August 2009

GREAT EXPECTATIONS N LATE NOVEMBER last year, the Dubai International Financial Exchange (DIFX) was rebranded as NASDAQ Dubai. The exchange has close links to The NASDAQ OMX Group, which stakes a claim to being the world’s largest exchange company. NASDAQ OMX had acquired a onethird stake in NASDAQ Dubai in February 2008. The other two-thirds shareholding continues to be owned by holding company Borse Dubai, which also runs the Dubai Financial Market. At the time, Soud Ba’alawy, chairman of NASDAQ Dubai and a Director of The NASDAQ OMX Group, noted that the exchange’s “growing ties to NASDAQ OMX exchanges in the US and Europe in listings, marketing, technology and management expertise will support its continuing expansion”. According to Jeff Singer, chief executive of NASDAQ Dubai: “The exchange moved quickly once the new

branding was implemented, taking active steps to further develop its market, such as extending opening hours, including opening on Sundays, and allowing listings in UAE dirhams. We will continue to develop new asset classes as well as seek further primary and secondary equity listings.” “The opportunities for Borse Dubai and NASDAQ OMX to further develop and link mature and emerging markets through our new combination remains significant,” adds Singer, who stresses continued interconnectivity in the global markets. His own exchange, he concedes, has not been immune from the global downturn. “There is no question what happened in the US and elsewhere impacted on the United Arab Emirates (UAE).” Singer expresses surprise at the degree of interconnectivity and the extent of the exposure in the region to toxic assets: “Many of the funds carried these assets in their books.” The region was also

adversely impacted in August last year by the movement of “hot money”, which, says Singer, “panicked local investors as well”. It is a sensitive time for the exchange. Dubai itself is anxious to establish its credentials as a stable and substantive regional financing hub, with the Dubai International Finance Centre (DIFC), a huge development in the centre of Dubai with its own independent legal regulatory system, and NASDAQ OMX as cornerstones of this strategy. Dubai’s strategy has been all encompassing, as it has involved a stake in the London Stock Exchange (LSE) as well as in Deutsche Bank, HSBC and Standard Chartered Bank. The link-up between NASDAQ OMX and Dubai was meant to secure Dubai as a sustainable force in global finance. Not only that, the link-up means that Dubai benefits from the operating technology available at NASDAQ OMX, which puts it on a level playing field with some 60 or so global exchanges. Finally, despite moves within the GCC countries to achieve harmonisation across the financial and currency markets, the reality is that Dubai is working hard to compete with much naturally-richer Emirates, such as Qatar, which are racing ahead with financial market initiatives of their own. The DIFX had been slow to get off the ground, mainly because its huge launch ambitions were immediately

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frustrated by the collapse of share prices on the local Dubai Financial Market (DFM) exchange, which is also suffering in the current global economic downturn, and Singer realises the fine balance between opportunity and the realities of current market limitations. Key to the realisation of these goals is the deepening of the exchange’s products and listings and efforts to promote stability. In terms of new product diversification, Singer points to a number of business drivers. The first is to expand the exchange’s derivatives offerings. NASDAQ Dubai is the only United Arab Emirates exchange that trades equity derivatives. It launched the market in November 2008 by listing futures on the broadly based FTSE NASDAQ Dubai UAE 20 index and on 20 individual stocks listed on NASDAQ Dubai, the Dubai Financial Market and the Abu Dhabi Securities Exchange. The index calculated by FTSE Group is the only one of its kind within the UAE providing stocks listed on all three exchanges which allows investors to benefit from the optimum investment opportunity across the Emirates. In April 2009, NASDAQ Dubai added an equity options service. Members are now able to report, trade and clear user-defined option contracts on NASDAQ Dubai, with the price and expiry date agreed by the parties to the contracts. Singer says: “Trading in equity derivatives increased rapidly soon after inception. In January, equity futures contracts traded, rising to 6,816 in March and 8,945 in July. However, while we are pleased with the growth to date, we need to increase volume dramatically. Derivatives trading provides investors with price insurance and creates liquidity and stability in the underlying shares; an important attribute in volatile markets,” The exchange plans to expand its

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derivatives market in due course by listing options on equity indices and individual equities. The exchange also plans to clearly define its remit. “If you are a local investor, you look at locally-based exchanges including NASDAQ Dubai,” says Singer. “If on the other hand you are a global or regional player, then it is NASDAQ Dubai that is the obvious market. That is for many reasons, not least the quality of the investible products on offer, technology and infrastructure, regulatory excellence and relationships with leading brokers.” He adds that NASDAQ Dubai offers unique advantages to issuers both from the region and outside it. These include bookbuild IPOs, which allow issuers to receive the market value of their shares, while other regional exchanges tend to require a lower issue price. Another advantage is over the counter (OTC) trading, which other UAE exchanges do not allow. A third point is fixed income. NASDAQ Dubai has a higher value of listed Sukuk (Sharia-compliant bonds) than any other exchange in the world, with listings worth a total of $16.4bn. “We naturally want to expand that track record and encourage further listings of corporate and other debt issues and other fixed income products,”says Singer. In terms of innovation, Singer points to the success of the exchange’s Dubai Gold Securities (DGS), which are designed to track the spot price of gold. The DGS listing was the first listing on any stock exchange in the GCC in the first quarter of 2009; breaking a psychological barrier of sorts. DGS is an initiative of the World Gold Council (WGC) and the Dubai Multi Commodities Centre. Similar gold securities have been listed through WGC initiatives on 12 other international exchanges, with gold in

trust exceeding 1,200 tonnes. DGS has the only ones listed in the Middle East to have been declared Sharia-compliant. Says Singer:“As a traditional trading hub for gold in the Middle East, Dubai is a natural venue for listing innovative Sharia-compliant gold products. DGS offers investors an alternative to physical gold and gold futures.” He adds that NASDAQ Dubai is keen to encourage listings of other innovative products such as exchange traded funds. In a move that underscores Singer’s commitment to good market practice and market stability, NASDAQ Dubai and the Middle East Investor Relations Society signed a memorandum of understanding in July to work together to provide educational seminars and initiatives for issuers, potential issuers and their advisers, as well as enhance understanding of how listed companies can communicate most effectively with the public. Singer states: “Transparency and timely delivery of accurate information are key to promoting investor confidence in listed companies.” Singer now has great expectations for his exchange. “We are well positioned both geographically and in terms of product and ideas to take us forward. Moreover, we have an excellent regulatory environment that has a common denominator with other leading markets. Best practice is the basic standard that we adhere to and we have an excellent ownership structure that we can leverage to best effect for our stakeholders and investors.” The road ahead is not easy, he acknowledges. “There are 18 other exchanges in the Middle East and we are number 19. Unless we distinguish ourselves, we will face rising competition. However, I believe that fundamentally we have a strong market and a strong infrastructure and we are we placed to leverage these as financial markets recover.”

THE RISE OF TRADING SUPERMARKETS

Photograph © Sdmix/Dreamstime.com, supplied August 2009.

TRADING PLACES “Fragmentation is on an inexorable rise,” says Steve Grob, director of strategy, Fidessa Fragmentation Index. “One of the assumptions in the early days of the MiFID was that fragmentation would reach a certain level and then stabilise, but every week we are seeing more fragmentation and no signs yet of consolidation of venues.” He foresees a group of pan-European “supermarkets” offering a complete range of asset classes that can be accessed by both lit and dark order types, sitting alongside smaller MTFs and niche exchanges offering specialist services, either in terms of their stock exchange coverage or in the trading styles they support. The national exchanges are doing their best to keep their heads above water and Michael Krogmann, head of Xetra sales, Deutsche Börse, says: “Everybody has to aim at a more efficient market structure no matter whether they are regulated markets or MTFs. There will definitely be fewer MTFs and dark pools in the next three to five years.” Ruth Hughes Liley assesses the developments and implications. N THE SECOND week of July 2009, the FTSE 100 index broke through 2.0 on the Fidessa Fragmentation Index (FFI), which monitors fragmentation in markets across Europe. It was a significant moment as it meant average stocks in the index had to be traded on more than two venues to complete and no longer “belonged” to the original venue. For the FTSE 100 index on the London Stock Exchange (LSE), fragmentation became official. The divine right of stock exchanges to“own”the trading in their

own country’s stocks is going to be a thing of the past, according to Steve Grob, director of strategy, Fidessa. “Fragmentation is on an inexorable rise,” he says.“One of the assumptions in the early days of the Markets in Financial Instruments Directive [MiFID] was that fragmentation would reach a certain level and then stabilise, but every week we are seeing more fragmentation and no signs yet of consolidation of venues.” Towards the end of July, the LSE’s overall market share of trade in FTSE 100 stocks was 67.7%, with multilateral trading facilities (MTFs) Chi-X at 18.9% and Turquoise at 7.1%. At that time, the FFI shows that all of the top 10 fragmented stocks on the FTSE 100 were above 2.33 with the most fragmented stock, Bunzl, reaching 2.6. In fact, the first time the 2.0 barrier was broken in the FTSE 100 was last October when five stocks showed as having to trade on more than two venues. Trade sizes too are down an estimated 75% in the past five years due to fragmentation and competition and still falling between 5% and 10% a month. Thomson Reuters estimates the average electronic transaction size on the LSE in the FTSE 100 during July 2009 was 2,434 shares per trade, worth just under €10,000. The largest number of shares per trade on the MTFs hover around the 1,000 mark, worth between €3,800 (on Nasdaq OMX) and €5,225 (on Chi-X). “It was the adoption of algorithmic trading which started the decline in size of trades, because the machines cut an order into more granular sizes,”says Ashok Krishnan, head of execution services EMEA, Bank of America Merrill Lynch.“However, it is the adoption of algorithmic trading now by the client base and the recent increases in speed which have led to the dramatic decline in sizes. This is further exacerbated because there are multiple venues to take the same order to.”

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In the United States, where high-speed trading has existed for longer and where there is a regulatory obligation to pass on trades to find the best price, an estimated 75% of all share trading is undertaken by high-frequency trading firms. Ian Peacock, CA Cheuvreux’s global head of execution service, estimates that in Europe this figure is 40% and increasing, with much of the new flow arising from arbitragers taking advantage of fragmentation. These high-frequency firms are also known as market makers, liquidity providers, systematic traders or statistical arbitrage traders. They post liquidity and make money on rebates offered by MTFs. One such firm, Getco, is a founding investor in Chi-X and BATS Exchange, the American sister company of BATS Europe. Richard Balarkas, chief executive officer of agency broker Instinet, goes further: “Every significant change in market structure we have seen in the past three years is as a result of the high-frequency market makers. The maker-taker model, fragmentation, high-speed trading, all are responses to the needs and buying power of these firms. “It’s as if you order 20 boxes of photocopy paper. Unknown to you, each sheet is being Steve Grob, director of strategy, Fidessa Fragmentation Index. “Fragmentation is on bought and sold individually before being an inexorable rise,” he says. “One of the assumptions in the early days of the put into the boxes. There’s no delay in the Markets in Financial Instruments Directive [MiFID] was that fragmentation would delivery of your order and no obvious reach a certain level and then stabilise, but every week we are seeing more adverse change in the market price, but the fragmentation and no signs yet of consolidation of venues.” Photograph kindly market maker could have taken a cheque for supplied by Fidessa, August 2009. two passive orders on the MTF. Clients are Charles-Albert Lehalle of agency broker CA Cheuvreux oblivious to this, but people are funding these companies is head of quantitative research and has written papers on through the MTF structure and they are massive optimising intra-day trading in fragmented markets. He operations,”adds Balarkas. says people need to look back over the past 20 years to see that the drop in execution size follows the development of Focus on technology electronic capabilities. Lehalle says:“Now fragmentation is Peacock agrees: “People are posting orders and arbitraging not only about execution size but the way an order is them. As long as their systems are co-located and fast, they updated on the order book. Some orders are never can make money. It can be good because it adds liquidity to executed. Some are put in and cancelled and then put in the market and tightens spreads which benefits the end again. These orders have dramatically increased in number investor. [However,] from a best execution perspective, it is in the past two years. Now that the capability of electronic putting more focus on technology because you cannot trading is high, trades can be computed in a few operate in these markets without heavy investment and this milliseconds and captured very fast. Also, because of fragmentation could price some of the niche brokers out of fragmentation, decisions about which MTF to trade on are the market. Fragmentation is favouring the bigger houses, taken very rapidly if you want to cancel your order and because you need good connections to different markets, update it on another destination.” regulatory departments and SORs and technology.” CA A CA Cheuvreux report points out that Chi-X has Cheuvreux, for instance, is connected to all European venues captured significant share of the market (almost 20% of the because of its best execution responsibility and trades in 60 FTSE 100), and that investors have to use smart order markets globally, says Lehalle. routers (SORs) to find the best place to execute. “The more Geographically, European fragmentation began in London investors use SORs, the easier for newcomers such as BATS largely because Chi-X and Turquoise both set up there in to obtain market share as they offer similar fee policies and 2008, but it is now moving steadily across the region. Grob of efficient market-making,” says the report. Fidessa says France and Germany are only three to four

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THE RISE OF TRADING SUPERMARKETS 48

months behind with the Nordic countries four months later still.“Spain is the last bastion,”he says.“It has seen near-zero fragmentation because of complexities in their clearing and settlement regulations, but this will no doubt change when these issues have been addressed by Spanish regulators.” News that the Spanish stock market regulator, CNMV, has approved the first MTF in Spain, appears to show that the bastion is being stormed, particularly as Chi-X, Turquoise and NASDAQ OMX have all been offering trading in certain Spanish stocks since early this year, via Spanish exchange members. Other exchanges have not been far behind. Deutsche Börse has been in discussion with the Spanish market to develop a trading solution via its new Xetra International Market, a regulated market, which will start trading Euro Stoxx 50 companies in November. The Euro Stoxx 50 index contains five of the most liquid companies in Spain.

The tentacles of the MTFs are spreading through Europe: Liquidnet is soon to launch in Turkey, Poland and Slovenia and has already seen regular trading on its platform from the Czech Republic and Hungary. Chi-X is moving into Irish stocks. Hungary will be the base for Quote, an MTF backed by Canadian firm BRMS Holdings; operating out of Budapest, it claims it will offer the cheapest trading in Europe after launch in September this year. Burgundy launched on 12th June, 2009, offering trading in almost 600 Swedish, Norwegian, Finnish and Danish securities. Owned by the leading Nordic banks and securities trading firms, it claims it will offer cost effective securities trading and “strengthen the Nordic region as a financial hub”. As early as July, it claimed an average of 4.5% of the primary market, with a one-day peak of 12.1%. It is in discussion with marketmaking firms attracted by Burgundy’s maker-taker pricing structure and is expecting to connect some this autumn.

THE VALUE OF AGGRESSIVE PRICING ggressive pricing policies and price improvement have been a hallmark of the new trading structure in Europe as MTFs have competed with the incumbent exchanges. BATS Europe, for instance, recently extended an “inverted” pricing model on its main order book, giving away more money in rebates to those posting liquidity than it took in fees from those taking liquidity. It hopes to mirror the success of two similar schemes in the US by BATS Exchange when it drew market share. On the other hand, in September, the London Stock Exchange (LSE) will abandon its maker-taker pricing model introduced a year ago to attract high-speed stat arb trading, in favour of balanced charges for each side of a transaction. It will lower the threshold for volume discounts, reduce the minimum charge per execution and introduce new incentives for trading in small-cap securities. The aim, says the LSE, is to encourage a return to the long-term trend of volume growth on the markets and to give savings in small-cap trading where liquidity has been most affected by the financial crisis. Maker-taker pricing models attract the high velocity stat arb traders who can make money by arbitraging higher rebates and cut-price fees for liquidity; they also seem to influence where brokers trade. In June BATS Europe recorded one-day overall market share of €1.24bn traded and a 4.02% share of the European market. Richard Balarkas, chief executive officer at Instinet, says: “When BATS increased its rebates in

Photograph © Konstantinos Kokkinis/Dreamstime.com, supplied August 2009

Euronext shares, its market share roughly doubled overnight, showing that brokers are routing to where the best rebates are.” Balarkas also urges caution on price improvement: “You might buy at 19 when you were expecting 20, but you might have been able to get 17 if the broker had looked at all external venues. You may have price improvement, but there’s still a big opportunity cost.” Not everyone is confident that the buyside sees the benefit of lower fees and higher rebates as Miranda Mizen, principal with TABB Group points out: “Price is important, but it is not everything. For someone [such as] a stat arb trader it is very important, but for a buyside client, which is often not set up to cope with rebates and the maker-taker pricing system, they won’t immediately benefit from this downward pricing trend. However, overall, when prices come down across the market, it is a good thing.” AXA Investment Managers pays a standard commission rate to brokers regardless of the venue they ultimately

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

Just as Burgundy is competing with NASDAQ OMX, which operates seven stock exchanges in the Nordic and Baltic regions, other primary exchanges have felt the heat from the new MTFs and their market share has shrunk. This trend is expected to continue: Aite Group estimates that in the first four months of 2009, 15% of European equity orders were traded on MTFs and the group estimates this will increase to 20% by the end of the year and to 50% by 2013. Mark Howarth, chief executive officer of Chi-X, expects to see exchanges move to around 40% of market share.“In European markets, we have seen the same trend as in the US, where the New York Stock Exchange fell from 100% of the market to under 40% in six or seven years. I see the same drivers and the same reasons in Europe. It’s an unstoppable trend.” Grob foresees a group of panEuropean “supermarkets” offering a complete range of

Charles-Albert Lehalle of agency broker CA Cheuvreux is head of quantitative research and has written papers on optimising intra-day trading in fragmented markets. He says people need to look back over the past 20 years to see that the drop in execution size follows the development of electronic capabilities. Photograph kindly supplied by CA Cheuvreux, August 2009.

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trade on. “The brokers won’t pass on a rebate,” says Paul Squires, head of trading at the asset management firm. He adds: “So they are incentivised to post liquidity to certain venues, whereas administratively it’s difficult for us to accommodate adjusted commission rates to reflect those rebates. We, the clients, are all different and have different commission tariffs for different types of trade. And the commission rate reflects a level of research as well. It’s not a precise science. We rely on the relationship with the broker and agree a tariff.” Thomson Reuters MiFID solutions business manager Andy Allwright recognises buyside concerns over the cost of data: “Before MiFID, primary exchanges represented nearly 100% of data in a stock. Now they account for 60%-70% so the buyside have queries why they are still being charged the same amount. These are the kinds of issues we should be talking about.” Beyond the question of rebates and fees, lies the issue of price formation. Currently, an MTF does not have to post pre-trade information for a dark book if it adheres to certain criteria, one of which is to take its price formation from an external source, usually the primary exchange. However, as MTFs grow market share to take what Aite Group estimates will be 50% of market share by 2013 and settle down at around 40% as many estimate, the primary market will no longer be the primary market and the point of reference for pricing. One alternative point of reference under discussion is a European best bid and offer (EBBO) based on the US national best bid and offer, which guarantees the best available bid and offer prices. This system is already creeping into the market as regulators approve use of an EBBO on different MTFs. In June, Turquoise was granted approval to use an EBBO as its reference price for its mid-point non-displayed book.

FTSE GLOBAL MARKETS • SEPTEMBER 2009

NASDAQ OMX Europe’s NEURO Dark will use an EBBO and Chi-Delta, Chi-X’s dark pool, which launched in May, is hoping to switch to EBBO in the future. Broker Bank of America Merrill Lynch created its own EBBO after MiFID, taking a range of prices from various MTFs and exchanges. Ian Peacock, global head of execution services, CA Cheuvreux, says: “We will have an EBBO in Europe and it will have an important implication because market data will be split between trading venues so Chi-X, Turquoise and BATS will in the future have a share of tape revenue coming from resulting trades. It will change the landscape for exchanges in Europe because BATS and Chi-X etc will participate in market data revenues that today they don’t see. It’s all about liquidity. The new investors have a lot more to gain under EBBO.” From the buyside’s perspective, Paul Squires says an EBBO would help if it was based on accessible liquidity, not just on an amalgamation of prices on order books. He believes that the primary exchanges have an important role to play. “The primary exchange is still crucial to the whole market structure. When the LSE’s systems went down, pricing transparency disappeared from the MTFs as well, as they often reference the primary exchange for pricing formation.” Head of Xetra sales at primary exchange Deutsche Börse, Michael Krogmann, agrees: “It’s important for Deutsche Börse to preserve price discovery and remain the reference market. In the long run it might harm price discovery which would not be so efficient—and efficiency was a major aim of MiFID.” However, Mark Howarth, chief executive officer at Chi-X, believes there is no good answer to where price reference will come from: “It’s important for net asset management, but it’s a technology question and national exchanges are not wanting to get involved. It’s possible that this issue could drag out quite a long time.”

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asset classes that can be accessed by both lit and dark order types, sitting alongside smaller MTFs and niche exchanges offering specialist services, either in terms of their stock exchange coverage or in the trading styles they support.“Of the large regulated markets, we need two, but whether we need three is open to question,”he says. The national exchanges are doing their best to keep their heads above water and Michael Krogmann, head of Xetra sales, Deutsche Börse, says the exchange is in a

TO BE, OR NOT TO BE LIQUID n the fast-changing world of European markets, the new multi-lateral trading facilities (MTFs) live or die by their access to liquidity. Indeed, as each MTF has come on stream, liquidity has been the draw to its success. “Liquidity begets liquidity and traders are moving towards those centres that offer the best pricing and technology,” confirms a report from Aite Group called European Multilateral Trading Facilities: The Post-MiFID Exchange Landscape. “Venues that are able to offer deeper liquidity, along with lower costs, will be the successful ones.” Turquoise, an MTF which began trading in August 2008, had the backing of nine major investment banks, all with a contract to pump in liquidity to the platform. It was feared that when the backers’ contract ended in March 2009, Turquoise would slump. Its overall market share did fall—from more than 5% to around 2.5%—but by April Turquoise was on the rise again in most European indices and on 21st July it recorded a trading share high of 11% in UK and Swiss shares. It aims to reach over 6% by year end. All the MTFs have adopted a plethora of aggressive pricing policies to draw liquidity to their platform: giving data away for free, increasing payment to firms which post liquidity, enhancing the rebate for larger volumes and reducing charges for firms taking liquidity. Even the time of day of a trade has a bearing on whether execution will be successful. The primary markets have most liquidity and activity early in the day as they deal with retail flow; Turquoise has most liquidity in the morning and BATS and Chi-X which are more heavily influenced by US liquidity, in the afternoon.

strong position, and has invested in a strong, sub millisecond, high frequency trade capacity and intends to be a survivor. “Everybody has to aim at a more efficient market structure no matter whether they are regulated markets or MTFs. Given current volumes, the question is if we need so many trading venues, lit and dark, as well as the MTFs? It’s probably not good for the market. There will definitely be fewer MTFs and dark pools in the next three to five years.”

Photograph © Maciej Frolow/Dreamstime.com, supplied August 2009

However, some of this drive to draw liquidity can be attributed to recent economic conditions as Michael Krogmann, Deutsche Börse, points out: “It is difficult to isolate the MiFID effect from the effect of the economic crisis. Turnover was down and order sizes came down and some buyside traders have had a hard time finding liquidity.” An April 2009 report by CA Cheuvreux found that the more liquidity a destination captures on market moves, the better for liquidity providers. They identified a “market maker threshold”, the point at which a venue mainly hosting flow from market makers would stop capturing flow after a certain level of volatility. “Having liquidity is the biggest issue,” says Miranda Mizen, principal with TABB Group. “It’s harder to draw if you don’t have it and it’s important to bring in the stat arb traders so that it feeds on itself. But liquidity tends to be fickle and it doesn’t mean it will stick to a particular venue.” Steve Grob, director of strategy, Fidessa, adds: “There has been a huge rise in high velocity algo traders taking advantage of maker-taker pricing models. They are making money through the maker-taker rebates but this distorts the markets. A lot of shares are being traded on arbitrage. The firms can make money if they are fast enough by moving liquidity between venues. Will it last? It’s established in the US and it’s now de facto for the MTFs in Europe.” Some MTFs are having to widen their operating model to ensure they retain liquidity. Brokerage firm Liquidnet, which operates as a dark pool MTF—one without any pre-trade information—is launching

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Miranda Mizen, principal with TABB Group, has not seen any signs of consolidation yet, but does not doubt that it will come. “There will be more contenders on the scene before it comes. It’s still very much a market structure in motion and, as such, a constant level of innovation is the key to survival. It’s not a given who the strongest players are yet.” She also sees differentiation as a key determinant: “Those who survive will offer a level of service to the

buyside with new order types and constant innovation as the key to survival.”Out of more than 120 MTFs registered, Howarth says around 10 or 11 have the same kind of business model.“Not all are going to survive. People can’t connect to all those. They might connect to four, but not 10. New ideas are still being tried out and tested, so it won’t happen for 12 months.“ The announcement that Citadel had bought a controlling stake in Equiduct, the exchange launched by Turn to page 52

Liquidnet Supernatural for block trading in Q4 2009 in Europe which will allow the firm’s 580 buyside clients access to liquidity from 26 “streaming liquidity partners” on the sellside. “It is a separate channel and a different type of liquidity, adding extra depth. As much as 70% of flow could be latent during a day,” says Steve Brown, director of operations and IT, Liquidnet. “Provided the trader is logged into the system, the ability to get at that flow is there.” Liquidnet’s sweet spot is small and mid-cap stocks, in which liquidity is harder to find in the visible markets where traders are more afraid of moving the market. On the other hand most MTFs have visible order books and began life by trading a limited number of the most liquid blue-chip stocks. However, there are signs that they are extending their model to cover small and mid-cap stocks as well. For example, Chi-X now trades 14 main indices and five second and third-tier indices. Many MTFs are focused on liquidity aggregation to assess multiple venues and put all executions on one order, saving time and lowering transaction and trading and settlement costs. Turquoise’s newly-branded liquidity aggregator, TQ Lens, was launched at the beginning of August. Taking orders from clients, and using liquidityseeking algorithms, it aggregates non-displayed liquidity by trading into its own dark pool and assessing the liquidity of six brokers (CA Cheuvreux, Citadel, Citi, Deutsche Bank, Bank of America Merrill Lynch and Nomura) with more liquidity partners to be announced this year. It will sit alongside the existing integrated order book (where light and dark orders interact) and the midpoint service (where non-displayed order types execute at the mid-point of bid/offer spread). Not to be outdone, the London Stock Exchange in its fightback against the MTFs, has launched dark pool Baikal, also providing liquidity aggregation. Given regulatory approval in June 2009, it first launched a smart order routing service to navigate fragmented liquidity across 17 European equity trading venues in 14 countries. By launching this first, Baikal claims it will have the time to set up the linkages needed for liquidity aggregation for its MTF, which will launch in autumn 2009. Paul Squires, head of trading, AXA Investment Managers, says the whole dark pool discussion is on

FTSE GLOBAL MARKETS • SEPTEMBER 2009

another level of complexity. “We generally like them if they add liquidity that is easily accessible. Liquidnet, for example, is a standalone crossing network and at the moment buyside only. It supplements the liquidity that the brokers might have but bigger brokers have their own dark pools as well, which can become unhelpful. We might like to access the liquidity in Baikal and Smartpool as aggregators, but we as a buyside institution aren’t members and can only access through the broker or broker algo. Proprietary dark pools do complicate matters and guides our decision as to who we transact with. You have to do more due diligence, because by definition dark pools can only be ‘illuminated’ by revealing your own trading intentions.”

Name of the game While proliferation of venues and low volumes of trade have spread liquidity thinly, that does not always mean that it is harder to find, as Ashok Krishnan, head of execution services, EMEA at Bank of America Merrill Lynch, points out: “If the liquidity is out there, we know where it is. We have created a synthetic consolidated tape and have good technology. It’s just a question of routing to the right destination.” Agency broker Instinet’s chief executive officer Richard Balarkas adds: “A good smart order router is the name of the game and all our efforts are focused on upgrading almost by the hour based on where the liquidity is. It’s even more important in finding dark liquidity. We connect to everything and on that basis we don’t care if a venue is empty 364 days of the year. On the one occasion we find something there, it makes connecting worthwhile especially as most dark liquidity is priced mid-spread. There are no massive overheads or costs in connecting so we just don’t buy other brokers’ arguments that ‘we’ll wait and see if any liquidity turns up there before connecting’.” The cost of the smarter, faster order routers themselves, on the other hand, is not cheap and brokers spent an estimated €714m on market data and trading technology in 2008. This is expected to rise in the next two years as brokers maintain and update systems to seek out liquidity and capture the best prices in a millisecond.

THE RISE OF TRADING SUPERMARKETS 52

Börse Berlin, was seen by some as the first sign of consolidation and by others as a move to a more retail-style type of trade. From the buyside perspective, Paul Squires, head of trading, AXA Investment Managers, says: “The punchy tariffs will run out after a certain period of time. I think venues need to do something to draw flow to them if they are going to be a longterm proposition. There is a sense that as a couple of MTFs fall by the wayside, there will be a couple of new entrants to replace them. We are not going to get back to a very small number of venues.” One way in which the MTFs are attempting to differentiate is by moving into the smaller and mid-cap stocks and fragmentation has followed. The Fidessa Fragmentation Index website, set up in November 2008, now drills down in to the FTSE 250, which has risen steadily on the index throughout 2009 and now sits at just under 1.9 on the index. It shows Chi-X’s share of trading in the FTSE 250 has grown from 6% in January 2009 to nearly 18% in July this year. Nonetheless, Krogmann does not believe the MTFs will be as successful in mid-cap stocks and points out that Deutsche Börse’s Xetra International Market will itself trade in highly liquid European stocks. “The vast majority of turnover is in these stocks,”he points out. Andrew Allwright, Thomson Reuters’ MiFID solutions business manager, says the MTF model is getting more varied: “Some have included dark pool orders and some have period auctions, although at the moment most are in the transparent order book.” NASDAQ OMX Europe has NEURO dark, Turquoise has a mid-point dark book and Chi-X is launching dark pool

Ian Peacock, CA Cheuvreux’s global head of execution service. Peacock says: “People are posting orders and arbitraging them. As long as their systems are co-located and fast, they can make money. It can be good because it adds liquidity to the market and tightens spreads which benefits the end investor. But from a best execution perspective, it is putting more focus on technology because you can’t operate in these markets without heavy investment and this fragmentation could price some of the niche brokers out of the market. Fragmentation is favouring the bigger houses.” Photograph kindly supplied by CA Cheuvreux, August 2009.

Richard Balarkas, chief executive officer of agency broker Instinet.“Every significant change in market structure we have seen in the past three years is as a result of the high-frequency market makers. The makertaker model, fragmentation, high-speed trading, all are responses to the needs and buying power of these firms,” says Balarkas. Photograph kindly supplied by Instinet, August 2009.

Chi-Delta. BATS Europe launched its Europe Dark Pool in August 2009. It will operate a maker-taker pricing model and will be separate from BATS Europe’s current integrated book, which combines visible and hidden order types. Rob Tarr, director of execution services, Bank of America Merrill Lynch, agrees: “Dark pools are attracting a great deal of attention, but they are embryonic in Europe and there’s not a lot of liquidity in those venues in comparison to the overall European liquidity pool.” TABB Group’s Mizen urges caution however:“Dark pools only make up a small percentage of market share, and we have to be very careful when we talk about ‘dark’. There are MTF dark pools, broker internal pools, dark trading on lit venues, OTC trading.” When an order is traded on multiple venues, particularly dark venues, anonymity is one concern, as Squires points out: “I’m sure there is leakage of information and I am sure there are some very advanced gaming strategies out there. You would be naïve if you didn’t pay attention to them. However, generally in the last two years, the problem has been the dispersal of the client base. “In the old days, if you were trying to buy a stake in a FTSE 250 company, there would be six or seven significant shareholders and if a big print went through you would have a reasonable guess as to who you were dealing with and would have an idea of how they would be likely to react. Now, there are hundreds of thousands of different clients and you don’t know who is on the other end of your trade so you have no idea what the likelihood of you being able to cross up a block with them might be. It isn’t a problem. Rather it’s just a different skill set required.”

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

FTSE GLOBAL MARKETS • SEPTEMBER 2009

Part of the stated objective of MiFID was to encourage competition within the European market structure. In less than 18 months the multilateral trading facilities claim up to 20% market share of the pan-European market, while certain markets are closer, hovering near 25%. Other markets continue to have challenges to encourage competition. Today, if one compares this to the listed markets in the United States, it probably took a few years for the electronic crossing networks to become a true viable alternative to the New York Stock Exchange. All have felt the impact of the downturn. Dawn Kissi examines how the MTFs in Europe are affecting the traditional exchanges. financial markets, talk of the demise of established exchanges such as the London Stock Exchange (LSE) and Frankfurt’s Deutsche Böerse has subsided. Part of the stated objective of MiFID was to encourage competition within the European market structure. In less than 18 months, the MTFs claim up to 20% market share of the pan-European market, while certain markets are closer, hovering near 25%. Other markets continue to have challenges to encourage competition. Today, if you compares this to the listed markets in the US, it probably took a few years for the electronic crossing networks (ECNs) to become a true viable alternative to the New York Stock Exchange (NYSE). In 2002, NYSE market share was most likely around 85%.

TRADING: NEW TECHNOLOGY MEANS NEW RULES

O MARKET PLAYER today will question that change has taken place across the European trading environment, change that compares easily to what its counterparts in the US experienced with the onset of the Regulation National Market System (Reg NMS) rules and even the Penny Quoting Pilot Programme (Penny Pilot), which to date are both significantly impacting market participants. Two years into Europe’s Markets in Financial Instruments Directive (MiFID), the change has not only been dramatic, but has readily transformed the environment for the buying and selling of a security across the United Kingdom and Western Europe. In taking advantage of the new rules, a number of trading venues, both“lit”and“dark”, have sprung up and unleashed two weapons—lower price and speed— which has hit incumbent exchanges and forced their hands at lowering their pricing and offering incentives for those bringing “liquidity” to their venues. Yet while technology has proven exponential and offered more choice than some traders may even need at a particular given moment, the global economic downturn has not spared the new venues, known as multilateral trading facilities (MTFs). Promising and offering speed, lower latency and in some instances even free transactions, MTFs such as BATS Europe, an offspring of Kansas City-based BATS, Turquoise, a consortium-backed London-based venue, and Nasdaq OMX Europe, all of which emerged one year ago, are still in business. However, with the near collapse of global

TRADING: NEW TECHNOLOGY MEANS NEW RULES 54

on how each broker handles best execution, centering on the MTFs that they access—not every broker connects to every MTF.” Not all market participants have access to the same pools of liquidity, according to research, market and securities industry observers. George Hessler, executive vice president of NewYork-based Lime Brokerage, points to “varying access” to liquidity pools. He states: “Some have extensive routing capability to source liquidity, while others have limited capability and rely on access to other brokers.”

Crossing platforms Technically, as long as brokers can create and maintain the connectivity to platforms that others typically would not have access to, even as firms link up with other broker-owned crossing platforms, a certain level of access is being generated. “The only difference is that the broker-owned crossing platforms would typically get priority over other venues out there,” notes Sang Lee, co-founder and managing partner at US-based research consultancy Aite Group. “They would presumably cross internally prior to sending the order out to other dark pools or displayed pools.” So how does the buyside choose which venue to place an order on, given the maker/taker model that many of the MTFs employ? Gallagher says: “The question is are the broker’s placing their economic benefit Owain Self, head of algorithmic trading for UBS in the Americas and EMEA. Self over the higher likelihood of a fill at the says that today traders have high expectations of the strategies and platforms at their primary exchange? If MTF market share is fingertips. Aside from access, smart-order routers and algorithms, and best-in-breed around 25% and on average a broker comes tools such as “really good and transparent Transaction Cost Analysis (TCA), are key,” back with 10% of your orders fills from an MTF, comments Self, adding: “Plus, interaction with experienced execution consultants who maybe their ‘smart router’ is not as smart as can help clients utilise—in real time—the best tools in an optimal way.” Photograph they say. But on the other hand, if more than kindly supplied by UBS, August 2009. 40% of their fills are from the MTFs then more In late 2006 it was placed at around 70% but by early than likely they are trying to lower their cost to execute in the 2008, market share for NYSE was 40%. Market structure market at the clients’ expense.” Today, there are a number of firms coming to market in Europe is at a very interesting point today; in fairness, all of the incumbent exchanges are much more aware of with, or enhancing, their current technology, all promising competition now than the NYSE had been. But liquidity to present the best in terms of latency, anti-leakage and decisions become easier when the MTFs garnered nearly more. Along with the major brokers, Lime Brokerage (in 40% market share. the US), FTEN and SunGard have offerings. Most of these With major sellside market participants still promising players would also include co-location as part of the the best level of execution and pricing transparency, the package. Some of the traditional players, including burden has never been greater, as proven by how quickly Thomson Reuters, BT Radianz, and Savvis, also fall into this liquidity is today moving across markets. “It will be niche of those trying to capitalise on the new trading incumbent on the sellside to become extremely environment. Not to be left out, incumbents have caught transparent and educate the buyside on their specific on as well. Lee notes: “In recent years, we have also seen liquidity strategy and venue discretion that they exact on exchanges more aggressively offer their trading their clients order flow,” notes Brian Gallagher, executive infrastructure to other exchanges and trading firms.” director and head of electronic trading for Morgan Stanley Depending on the type of business a broker-dealer is in Europe. “There is a tremendous amount of variability conducting, they may or may not be allowed to trade in a

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

particular dark pool and the risks remain for those on both sides of the trade. “This depends on how [the banks] are internalising the business,”says Ralston Roberts, senior vice president, product management of Assent Liquidity Services at SunGard Trading. “If the bank is internalising against a prop order, then the bank is taking on market risk. If the bank is operating a crossing system internalising two customer orders, they are increasing their settlement exposure.” There is no question customers are also at risk of not achieving the best possible execution in the marketplace. As liquidity continues to fragment across dark pools, it has become very difficult to ensure that an order is accessing all available liquidity.“Brokers and technology providers are in a position to help buyside clients navigate a dark fragmented market place,”says Roberts.“Leveraging more sophisticated smart-routing technology enables customers to help ensure that they have probed dark markets for liquidity priced [in the US] between the NBBO prior to routing to the best displayed market.” SunGard’s Assent Liquidity Services provides customers with solutions that incorporate low latent dark and displayed routing strategies. In the US, solving the fragmentation issue has found its way to the exchange level. Direct Edge, an ECN in the process of converting to exchange status, offers its Enhanced Liquidity Provider (ELP) Programme to firms looking for a re-aggregator of dark liquidity. Bryan Harkins, head of sales and strategy for Direct Edge, says: “We have about 30 firms, including the major dark pools, participating as ELPs. On an opt-in basis, customers can choose to route an order to our book and then, if not completely filled, have their order exposed to these ELPs before routing out to other market centres.” Although Direct Edge has been offering ELPs since June 2006, its success in the last year, “has been a major reason Direct Edge has grown to become the third largest equities marketplace in the United States,”Harkins adds. Traders today have high expectations of the strategies and platforms at their fingertips. Aside from access, smartorder routers and algorithms, and best-in-breed tools such as “really good and transparent Transaction Cost Analysis (TCA), are key,”comments Owain Self, head of algorithmic trading for UBS in the Americas and EMEA, adding:“Plus, interaction with experienced execution consultants who can help clients utilise—in real time—the best tools in an optimal way,” In May 2008, UBS, Morgan Stanley and Goldman Sachs—three of the market’s major liquidity providers— agreed to offer clients reciprocal access to their respective non-displayed liquidity pools for US shares. In an effort to address market fragmentation (which is on the rise in the US) the arrangement allows their clients’ algorithmic trading orders for US equities to interact across their nondisplayed, or “dark”, pools, which include UBS’s PIN ATS, Morgan Stanley’s MS POOL and Goldman’s SIGMA X, respectively. Similarly, a set of algorithmic access agreements for European equity trading was announced by the three firms in May of this year.

FTSE GLOBAL MARKETS • SEPTEMBER 2009

New-generation smart routers and algorithms are today more intelligent about sourcing liquidity in a fragmented market. The dynamic adjustment and intelligent use of both light and dark liquidity, and anti-gaming technology, is built into the current technology.

Navigation of the “pools”, depending on the algorithm, can differ. Traders are seeking access to a wide array of liquidity, but it’s important that the sources of liquidity and the means of interaction result in quality execution. This requires direct market data feeds, advanced, reliable routing and price discovery logic. “Enhanced crossing opportunities should maximise quality executions while minimising visibility and information leakage whenever possible.”Self adds. Navigation of the “pools” can also differ depending on software. Traders are seeking access to a wide array of liquidity, direct market data feeds and advanced and reliable routing and price discovery logic—”Enhanced crossing opportunities to maximise quality executions while minimising visibility and information leakage whenever possible,”says Self. New-generation smart routers and algorithms are today more intelligent about sourcing liquidity in a fragmented market. The dynamic adjustment and intelligent use of both light and dark liquidity, and antigaming technology, is built into the current technology. “The challenge still falls on the trader to use the tools properly,”Hessler points out.“Traders have morphed from tactical execution experts into liquidity strategists, with many weapons at their disposal.” Portware, a New York-based financial technology firm whose clients span the globe, offers sophisticated tools for the high-frequency trader. According to Harrell Smith, head of product strategy at Portware, sellside market participants are increasingly reliant on independent technology vendors such as Portware (for users with complex trading and integration requirements) and Bloomberg, for users with basic trading needs. “Single-dealer systems simply do not provide larger, more advanced firms with the kind of functionality and broker neutrality they are looking for, nor do they make sense for clients who have basic trading needs but still want access to multiple brokers on a single platform.”says Smith, adding: “At the end of the day brokers do not care where client flow comes from and they no longer want to devote significant resources to maintaining and developing their own systems.”

TRADING: NEW TECHNOLOGY MEANS NEW RULES 56

the latent liquidity which cannot be traded in the market for fear of the inherent signalling risk and information leakage which occurs when instructions are given to brokers and orders sent into the market infrastructure.” MiFID was conceived, designed and implemented to create competition and execution performance improvement for the end investors. Yet the reality of MiFID is that even if a new exchange were to launch tomorrow, that was even faster, cheaper and smarter than all the other exchanges and MTFs and offered even better prices and deeper liquidity than any other venue and was 100% transparent, there would still be no guarantee it would see any business. Why? “Because brokers are not obliged to use it, and it is still the case today that few brokers have the required technical ability to trade the same equity on more than one venue,” says Balarkas.

Increased regulation In the US, Reg NMS, through the Order Protection Rule, is aimed at providing equal access to all market participants in regard to pricing. However, it appears not all“access”is even across the board. Increased regulation may be key, but how much interference is the market willing to tolerate? “The regulatory framework for dark pools is, as we’ve seen, a subject of major discussion among regulators at this time. While we aren’t sure what the outcomes of these discussions may entail, we fully support regulation which aims to increase transparency and make trading more accessible,” says Dave Johnsen, head of SIGMA X Business Development at Goldman Sachs.“To that end, we support the recent suggestion of more disclosure with Bryan Harkins, head of sales and strategy for Direct Edge.“We have about 30 firms, regards to where transactions have taken including the major dark pools, participating as ELPs. On an opt-in basis, customers can place, as well as a move to a standardised choose to route an order to our book and then, if not completely filled, have their order volume reporting regime.” exposed to these ELPs before routing out to other market centres.,“ says Harkins. This, Johnsen says, will then make it easier Photograph kindly supplied by Direct Edge, August 2009. to compare market venues and understand The likely impact of regulation on these pools in Europe the true relative size of each liquidity pool. “More and the US is of concern, given recent market events. While specifically, we support the reporting of ‘single-counted’ Reg NMS is in place in the US and MiFID came to market and ‘matched-only’ volume as a standard, similar to what to harmonise the European markets with the intention of exchanges have followed for some time,” Johnsen adds. every broker having to describe its best execution policy, “We believe these suggestions will go a long way to regularly review as well as publish its performance.“As far increase transparency, confidence in our industry, and the as we can see,” we [Instinet] are the only broker to have understanding of our complex market structure.” done this,” Richard Balarkas, chief executive and president On 17th June of this year, Goldman Sachs began of Instinet Europe, points out. reporting all SIGMA X volumes on the basis of a singleRegulators are looking very closely at dark pools with count of customer-to-customer shares executed within the some degree of caution, but Balarkas notes:“If properly run SIGMA X ATS.“It is our hope that the industry will adopt a and managed, dark pools will be able to unlock much of similar reporting practice as soon as practically possible.”

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

T H E 2 0 0 9 S E C U R I T I E S S E RV I C E S R O U N D TA B L E

Defining a New Model of Securities Services

Attendees

GORAN FORS, global head of custody services at SEB

Supported by:

LUC LECLERCQ, global head of operations, IT and projects at F&C Asset Management PAUL NATHAN, chief operating officer, OMAM

CHRIS SIMS, head of investment operations, Gartmore Investment Management SONJA SPINNER, senior associate at Mercer Investment Consulting

PAUL STILLABOWER, global head of business development fund services at HSBC Securities Services FRANCESCA CARNEVALE, editor, FTSE Global Markets

FTSE GLOBAL MARKETS â&#x20AC;˘ SEPTEMBER 2009

THE 2009 SECURITIES SERVICES ROUNDTABLE

altered states SONJA SPINNER, SENIOR ASSOCIATE AT MERCER INVESTMENT CONSULTING:

Pension funds, even small ones with assets of only half a billion pounds, are now increasingly using derivatives in their portfolios. Whereas before only a subset of large clients required derivatives capabilities from their accounting and outsource administration providers, we now see that requirement trickling through into even smaller client relationships. I’m seeing a lot of pension scheme sponsors starting to drive the RFP process. These pension scheme sponsors, frequently multi-nationals, are under a lot of cost pressure and whereas before they would perhaps have left that work to the individual pension trustee boards, these days they consider taking it in hand themselves. Multinational pension plan sponsors now want to bundle all of their custody and fund administration services with a single provider to leverage any potential economies of staff. In the hedge fund space, outsourced fund administration service providers are under increasing pressure to improve services. With the move towards UCITs IV, more and more funds and funds of hedge fund managers want to get to the point where hedge funds price daily, almost like a daily NAV mutual fund. The industry hasn’t really seen this before. LUC LECLERCQ, GLOBAL HEAD OF OPERATIONS, IT AND PROJECTS AT F&C ASSET MANAGEMENT:

The landscape has certainly changed over the last 18 months, due to changes in credit, counterparties, clients, regulators, cost, trustees, and control.The resulting paradigm shift has been quite enormous, moving from a relative world into an absolute world; from what was understood to be safe to what is not. Certainly, nothing will be taken at face value any more. All these changes will have an impact. For example, the fiduciary responsibility of the asset manager is heightened or at least under high scrutiny, either from the client, the trustees, or even the consultants. Moreover, aside from new products that help investors hedge their exposure, we are noting a heightened risk consciousness of the end client—be they pension holder or the trustee. PAUL NATHAN, CHIEF OPERATING OFFICER, OMAM:

If there is one seismic change since the credit crunch, it is that risk aversion and risk awareness is spreading through our industry.This is manifest in a number of ways. We see far more care being taken by clients in doing due diligence. In our hedge fund business we see a lot of changes to the whole prime brokerage model because pre-Lehman Brothers’collapse hedge funds were very likely to have a sole prime broker, who also has custody of your assets, and is busy re-hypothecating them. That is not a terribly comfortable model in difficult times. We also see an increased level of interest in moving absolute return strategies into UCITS or other regulated fund structures. While there will always be a role for lightly regulated Cayman hedge funds, I doubt the segment will show the same breakneck rate of growth again. We are also dealing with the consequences of heightened risk aversion,

STANDING: GORAN FORS, global head of custody services at SEB PAUL NATHAN, chief operating officer, OMAM; CHRIS SIMS, head of investment operations, Gartmore Investment Management; LUC LECLERCQ, global head of operations, IT and projects at F&C Asset Management; FRANCESCA CARNEVALE, editor, FTSE Global Markets FRONT ROW: SONJA SPINNER, senior Associate at Mercer Investment Consulting; PAUL STILLABOWER, global head of business development fund services at HSBC Securities Services

combined with a reduced asset base and reduced revenues in the way our relationships with our outsourced service providers now work. The very can-do enabling attitude that was facilitated by growing revenue streams has gone. Outsourced partners are behaving much more like suppliers. I might well do the same in their position, but they are much more risk averse and one sometimes feels that they are being led by their legal and risk departments rather than by their commercial people. An investment manager whose asset base has shrunk, with uncertain growth prospects, is not quite such an interesting client any more.

PAUL STILLABOWER, GLOBAL HEAD OF BUSINESS DEVELOPMENT FUND SERVICES AT HSBC SECURITIES SERVICES

Very interesting comments, in particular how they relate to securities services—an industry which has been in turmoil over the last 18 months. Largely born out of the 1980s mutual fund boom, the industry has now been exposed as having a flawed business model, poor correlation between industry benchmarks (such as assets under custody) and profitability, which is obviously the key driver in any business. Moreover, banks such as HSBC that have tried to evolve the model have been held back by competitors that are unwilling to change. If you look at the core revenue pillars of the business, three of the four pillars are problem areas now. Markets, which drive the ad valorem fee, have fallen as indices have fallen, clients have taken money out of funds and, more significantly, leverage has shrunk dramatically. Moreover, for many banks, cash collateral-led securities lending programmes have been exposed as a disaster, given the re-investments that have gone into illiquid funds. In addition, net interest income has suffered in a low interest rate environment. Only foreign exchange revenue is hanging on as a revenue stream. So, revenues are a problem. Costs can be reduced to a certain

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extent but certainly not to the level that revenues have been impacted and counterparty risk is now first and foremost in customers’ minds, which drives costs up. You now hear questions such as: “What happens if the global custodian fails? What happens if the exchange has a problem? What happens if a large client fails?”Finally, clients and regulators are questioning the pooling of assets (post-Lehman), and whether that exposes clients unnecessarily. On top of that, regulation has changed and is continuing to change with consultation papers on hedge fund servicing, retail servicing and everything in between pushing for more independence and transparency. So there is a lot of pressure to bring the business model into the 21st century. GORAN FORS, GLOBAL HEAD OF CUSTODY SERVICES AT SEB:

If you go back more than a couple of years, the big shift in the industry as a global custodian and sub-custodian, was the enormous growth in different products and in various investment areas. Then, when we were in the middle of developing all these services and products around derivatives and other types of investments, we were hit by the worst crisis we have had for, oh I don’t know, probably ever. Right now, there is a notable drawback from the clients in investing in new products and markets. That puts an additional burden on our own development needs in order to cope with servicing investors as custodians. In my view, being a custodian today is not the simplest or easiest part of the banking industry. It used to be and it still is a wonderful industry, but it has become a bit of a minefield. As a result of the crisis, we have seen a huge change in our working environment, and have had to reassess the different risks that we actually face as a custodian and that includes market risk and client risk. While we have processes in place to handle these risks, we are not always aware of the consequences of these risks—the legal implications, for example.The Lehman Brothers case might highlight some of them: and in five years time we will look back and see how valid the claims of plaintiffs actually were, for example. In the immediate term though, we are now facing some huge regulatory initiatives that are being knocked by regulatory bodies such as the FSA. The European authorities appear to be on a crusade, creating so many initiatives, especially for the European environment. Over the last two years it seems the world has become extremely complicated. In part, that is also because we now need to service clients in more complicated areas of business and at the same time take into account all changing risk and regulatory aspects. CHRIS SIMS, HEAD OF INVESTMENT OPERATIONS, GARTMORE INVESTMENT MANGEMENT:

From a Gartmore perspective, on the back of Madoff, there is an awful lot of interest in having separate managed accounts. Once you start actually having the conversation about separate managed accounts the client then starts to realise that he is taking on responsibilities that service providers used to give them, such as cash management, hedging and continued oversight of the outsourced third party relationships that had been built. They then had to

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take these jobs on themselves. From the asset management side, because of the drop in assets, either through the drop in the markets as a whole, or in Gartmore’s specific case, because we had hedge fund investments where we weren’t gated, our funds were used almost as a cash machine because one could get funds out of us. That, in turn, led to heavy cost control, which brings its own charges. Other comments on counterparty risk side: there is more client interest in it, but some of it is ill-informed. In the alternative space, there is an increasingly short list of prime brokers you can actually deal with these days. Then, on the regulatory side, having read the proposed European directive on hedge funds, there are a number of quite good points in there, particularly to do with sub-custodians and responsibilities. Obviously however, there is still a lot of emotive stuff in there right now.

POST MADOFF DUE DILIGENCE CHRIS SIMS: There is a lot more focus on due diligence.

Equally, I have had senior management tell me they have just spent two hours in a due diligence meeting with 10 people in the room from a client with five consultants on the phone and not one sensible question coming from any of them. It is actually frighteningly difficult to find people with the experience to ask the right questions. PAUL STILLABOWER: It is a tricky question because we had been scaling up for a new level of complexity of investment instruments. Now we are starting to scale back towards more vanilla products of a lesser complexity as client boards shy away from products they don’t fully understand. Whether that continues indefinitely is a factor of the way in which the financial services community evolves over the coming months. The amount of work done around the remaining complex instruments and, indeed, vanilla instruments, however, has increased, including regulatory oversight and due diligence, and therefore a new level of cost has been added. One interesting point in the securities services industry is a trend towards increased pricing to cover risk, for example pricing of illiquid instruments or processing of non-STP instruments. Because the pricing model had been so opaque, clients are saying:“So, let me just get this straight, we have had 20 years of bull market and everything was fine, and now, when we are on our knees you want to change the pricing model?”For those providers that had offered services for free because they were earning undisclosed revenues in other areas, I am sure those conversations are unpopular. Another element revolves around regulation and oversight. Goran mentioned Europe. There are some governments suggesting that the custodian or the depository is on the hook for any underlying loss. If that were to happen then you would have to recapitalise the securities services industry. Trust banks wouldn’t be able to participate in the industry because they don’t have the capital, and universal banks would either choose to leave the industry or re-price services to such an extent that the retail investor would be better off putting cash under the mattress.

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PAUL NATHAN: From the investment manager’s perspective, the securities services industry has failed to deliver the economies of scope and the economies of scale that it promised us five years ago. Complexity has been a problem for all of us. In an ideal world, a small or mediumsized investment manager would probably like to have one strategic outsource partner, managing an integrated service spanning investment operations, fund accounting, custody, transfer agency and so on. In the real world, the component outsourcing route is more common because no one company, quite frankly, can provide both adequate breadth and quality of service. PAUL STILLABOWER: I completely understand that. In part it results from an industry that presented itself and in which customers buy, on the basis that assets under custody are representative of capability. It is a flawed indicator, but clients have accepted it. A provider can have trillions of dollars of T-bills and yet that offers no scale synergies in processing Malaysian corporate actions. LUC LECLERCQ: Yes, the services industry might have done better. I’m not sure I agree with your statement Paul that I would like to have one provider doing everything because I think it is difficult for one organisation to be good at everything. Secondly, it doesn’t give me the option just to benchmark which firm is doing better. Thirdly, if that party is not really as good as they should be, I have a better opportunity to move. Regarding contractual agreements, some of the industry-wide agreements need to be overhauled. The Lehman collapse highlighted the complexity and difficulty of implementation of some legal structures/contracts in case of default. However, we see some positive moves, such as the Big Bang approach in the CDS market, which makes the auction process transparent and uniform. I think it is a very positive move because ultimately there is one standard, take it or leave it. Asking someone to watch the watcher, where does it end? We already pay an external auditor every year to look at our books and make sure that we have more than adequate risk assessments. Secondly, every firm has an internal audit and a compliance department and thirdly the board/chief executive officer sign off the books and records of their company. So the question is, shouldn’t we work on the first three rather than just adding extra resources at the problem? SONJA SPINNER: I’m definitely seeing cost pressures within the servicing industry. The days when you did a fee review and you assumed that your fees were going to go down have now ended. Many service providers are economically trying to call the bottom of the market and things like minimum fee relationships are coming in to place. This is fair. It is unreasonable for some clients to be subsidised by others. When times were good people just tolerated some of these loss-making relationships but the trend now is for all clients to have to pay their way. In the hedge fund space, one thing that I’m definitely seeing, particularly with hedge fund-of-funds, is increasing demand for managers to have the transparency of the underlying asset holdings that their hedge fund managers

are investing in. The days where people would just beg to give a hedge fund manager money are long gone. I have been into quite a few hedge fund-of-funds managers recently where assets are held in segregated accounts so that the hedge fund-of-funds manager has full transparency to the underlying asset positions. GORAN FORS: Being a mid-size European bank operating in the northern regions of the continent, I have always been a target for American banks saying:“You’re too small to be in this industry, you should get out because you can’t deliver all the products clients want. You are not big enough.”In some countries we have seen the result of a lot of banks getting out of the custody industry and leaving a client base to transfer to a provider which might not know that client as well as the bank that originally serviced them. I’m still in the industry and I’m looking forward to being in this industry for many more years. Maybe there are institutions that want to have one provider and who can enter into a full service relationship, but equally many institutions will go and buy the services for specific areas from specific providers that can do it better. Also, a lot of providers will be more willing to offer services if they can also have a better control of the client and know the specific requirements for a specific product and control the risks involved. I think we will see both of these developments evolve in tandem. On the regulatory side, I was talking to a colleague from a bank in Paris about what did really happen and how could it go so wrong, specifically in the Madoff case and a couple of others. We have seen the most rigorous and most extensive control bodies established in the United States, which have been extremely hard on everyone and still they can miss a thing like Madoff … PAUL NATHAN: We are all tarnished as an industry by Madoff. I would never dare tempt fate by saying it could never happen here. Even so, the hedge fund scandals that we have seen have generally been where managers have been valuing their own assets and that is still quite prevalent in the US. It’s absolutely not the model among European managers. I won’t say it can never happen but the risk of it happening is much, much lower in Europe. SONJA SPINNER: The average pension trustee doesn’t, with all due respect, always have the capability to go in and undertake a review of a hedge fund’s investment operations. When we do go in on their behalf, we absolutely look for total segregation between the manager and the administrator. It is just a red line for us if this fundamental control is not in place. We look for independent valuation of assets and are very interested in the pricing of hard to value assets. We aim to get a good understanding of their business model, the level of commitment to safe and sound operations and the quality of the staff working in the back and middle office as well as in support functions such as human resources and compliance. We also find out whether or not the manager can override administrator valuations. It’s key that there is that segregation there.

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EUROPE’S URGE TO LEGISLATE PAUL STILLABOWER: The million euro question is what

ends up getting enacted? We are in an environment now where there is still a lot of political capital in gunning for particular participants. There is concern about where this all ends up. I do not think we are going to know the extent of incoming legislation for some time. We have mentioned the initiatives regarding the responsibilities of the depositary custodian. There is also certainly political capital in going after hedge funds for various uninformed reasons. For example, the industry is being attacked for gating (wealthy) investors and yet there is a trillion dollar gate on the poor pension community from securities lending, which frankly, no one’s talking about. I think you’re going to continue to see both politicians and regulators working together on legislation and one critical factor will be what is happening in the economy. If we are to come out of the recession quickly then things will probably revert to the old norm. If the recession is drawn out or growth is slow, then there will continue to be pressure to find someone to pin the blame on. GORAN FORS: The European market is partly driven by the US, trying to compete with the US, and the creation of a single market. However, none of the regulatory initiatives will help create this one market. To some extent, that is not possible because Europe is still a collection of independent areas where you will not achieve harmonisation. If we look at this as a competitive issue, that is more or less going to be dampened a bit. Whether the risk situation or the crisis situation has created these manifold ideas from the authorities is debatable. However, who is actually going to monitor and implement these initiatives and how we are going to follow them through? Are they wise enough? Do they actually have enough knowledge to implement regulatory set ups that are good for the industry? Maybe there should be someone who stops a bit and asks:“Well, what do we actually want?”How should the long-term savings industry look, for example? Do we want to have a situation where people are so afraid of investing because of the risks involved but which does have a lot of cash in the system? This, of course, is the Japanese situation. Or do we want to have a market where the capital savings industry can contribute to our growth in the future in a good way? Maybe regulation is moving too quickly and too extensively for the good of the industry. Which institutions should set the pace in this splurge of new regulation? Perhaps the industry should be more involved in establishing this regulation. LUC LECLERCQ: I totally agree, and basically, there is a bit of, for lack of a better word, over-zealousness in the proceedings, to catch up on whatever it is they think they lost time on. By the same token however, let us not forget we went through a huge exercise called MiFID. We also spent a lot of time on that and ... GORAN FORS: And still do.

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GORAN FORS, global head of custody services at SEB LUC LECLERCQ: … and still do, exactly. Regulators are

under pressure and have learned some tough lessons. Public/political opinion pushes towards more action and control. We will see more intervention and requests coming from the law makers and the regulators in the foreseeable future. GORAN FORS: MiFID is a very good example of a thing that probably has a very, very worthy underlying principle in trying to introduce cost efficiencies for the investor. At the same time though, it is creating an enormous number of marketplaces, a complex structure in the way, which actually does add a lot of cost to the industry instead of savings and in the long run adding cost to the investor. So it’s an initiative that cuts both ways.

TRADING PLACES FRANCESCA CARNEVALE: There seems to be a blurring at

the edges in this new financial order. Prime brokers and custodians are increasingly taking on each other’s work and roles. Even the DTCC is looking increasingly like a custodian. Where will it end? CHRIS SIMS: From the point of view of custodians taking on elements of the prime brokerage business, that is a good thing from our point of view. We are heavily involved with HSBC and we are moving to use services from HSBC that we would have taken from—or we still do take—but would have taken more of from what you’d refer to as investment banks. Equally, you’ve got investment banks trying to convince you that they’re now proper banks and aren’t going to fall over and they’ve all got the concept of being bankruptcy remote. So yes, this bit can fall over but it won’t affect our overall business. So, some of these developments are a good thing. PAUL STILLABOWER: I would say that the getting into other people’s space, that was the bull market model. Now, everyone is trying to figure out which space they can actually excel in. Prime brokerage is a good example where the economics of the model have changed. For example, because 50% of the revenue was built off the leverage, and

THE 2009 SECURITIES SERVICES ROUNDTABLE

now financing is far less available. How much will return? We don’t know, but it certainly is lower and therefore generating much lower earnings. However, the prime brokers want to preserve their business as much as possible, so they are reinventing themselves (post-Lehman as Chris said) with new models, such as the bankruptcy remote model. So far, those models are not well understood and not tested and therefore we don’t see a lot of client comfort in the new models. We come back to a lot of questions around capitalisation and segregation. Where, for example, is the balance sheet support in a bankruptcy remote model? Securities lending is another example. Where is the balance sheet to support the programme? Indemnities that are based on insurance policies are probably not valued as highly as a balance sheet indemnity programme. To do a balance sheet indemnity you have to have capital. CSDs moving up the chain? Same question. Where’s the capital? If you do not have any capital how are you going to move into the custody space? The thin veneer firms with no capital, whether that is in insurance, securities services, or prime brokerage, that model is the one that is under the most severe threat and will struggle to find a space in the future. LUC LECLERCQ: Every change in the industry forces us to ask: what’s the impact on us? We have a constant push/pull situation. The pull comes from service providers, they come up with new ideas, new products, new services, and new service providers enter into the fray. The push is coming from clients or regulators. Service providers have been reviewing their service provisions and their client base. Services thought to be“risk free”are under review. A brilliant example is CLS, FX Clearing. Service providers are changing the contractual arrangements with their clients and adding new clauses like“right of sales”, others simply stop offering CLS clearing to new clients. There is a tendency towards risk sharing with the client whereby the latter is asked to take up his part of the risk, explicitly or implicitly.

TOWARDS TRUE PRICING OF SERVICES CHRIS SIMS: It is complicated, but you have to have a sensible conversation about what should be charged for what, and obviously, a service provider wants to cover itself against a certain amount of risk. You do get to the point where in order to provide that service provider X wants to get paid a certain amount in order to cover themselves against the risk. So you’re having to then make a judgment call as to whether you retain the risk yourself and rely on your years of expertise and the quality of staff that you’ve got and live with that, or you pay through the nose for it (relative to what it’s actually costing you today). The same balance exists when you are having conversations with your prime brokers right now. These days they have more dictates from their legal departments that they can’t override. Then it comes back to what risk do you want to take on using a different prime broker? It’s complicated, together with a lot

LUC LECLERCQ, global head of operations, IT and projects at F&C Asset Management

of administrative effort, to move from using service provider A to service provider B knowing that the market can change again in three or four months time and everything is swapped around. It’s very, very tricky indeed. PAUL NATHAN: Do you think there is a possibility that the market will turn around? Or, do you think we are seeing a more fundamental re-pricing of risk to its true levels and actually we need to get used to the reality? I suspect it’s the latter. CHRIS SIMS: Some of the firms I’m referring to have got a slightly extremist approach at the moment. They’ve taken the ability away from the front office to price the risk and actually put it into the legal team which is telling them what they can and cannot do. However, I agree with you that there has been a fundamental change, but there are still too many outliers at the moment. PAUL STILLABOWER: The supplier side needs to focus very hard on the space that they want to occupy, whether it’s a very broad space or whether it’s a very specific niche. It will be difficult to be all things to all people. At HSBC we emphasise our emerging market capability, our balance sheet, our funds administration and custody capability. Moreover, the regulatory side is having more impact in this space as well, pushing up the cost of both on-boarding and maintaining. So what you’re hearing now, and this is not specific to our industry, this is across financial services as a whole, is that the benchmark of minimum revenue that will be required to be earned, just to be able to wash your face, is increasing. That is impacting the customer side of the industry as well.You can’t just spring up with a hedge fund any more because the financing support from the supply side has dropped out of the equation. All that is happening concurrently and where we end up is still to be determined

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GORAN FORS: We are also living in a bit of an old fashioned type of environment. We’ve been reluctant to change fee models and the basis points to top it. Over time we will see a breakdown in this type of pricing for services and whether we do it for all or some clients straightaway, the underlying trend is that service providers will invariably become more selective. This is in part because the investment that we need to put into this is going to be enormous. Actually, it is probably one of the largest threats to this part of the industry, because if this cost situation continues it is going to be an industry where we will see difficult to mobilise investments coming into the business. The custody industry is something that is not the sexiest thing among the top management. They might want to put their money somewhere else, which I believe could and will create problems in other areas for asset managers and the wealth industry in general. I can see us probably getting into a different type of fee model and also being very pretty sure to invest in infrastructure to make the overall offering efficient. SONJA SPINNER: People are going to have to pay more for receiving more. When I send RFPs out, banks now sometimes decline to respond because the business doesn’t fit with their business model; this is an increasing trend. I haven’t got any industry statistics but I’m seeing quite a swing towards pooled fund investments. When funds move towards pooled funds they still want a value add service from the custodian. Historically, when a segregated account was in place, custodians were receiving income from safe keeping fees, transactions fees, earnings on cash and foreign exchange flows to support the provision of value add services such as fund accounting; services were being provided effectively, almost for free. Now, custodians, quite rightly actually, say: “Well, there is a cost to your fund accounting.” I actually think that is a healthier approach. I prefer custodians to charge people for the services that they’re receiving discreetly so that they can provide the transparency around fees, and so that clients can pick services from different providers. Bundled relationships just prevent clients from understanding the true cost of their actions. PAUL STILLABOWER: I would say that the industry hasn’t covered itself in glory here and the clients have believed that there is such a thing as a free lunch. The securities services industry is simple. Fund administration and investor services are very difficult to scale but are very sticky services. Global custody is a commodity but because it is where the assets are held it generates a lot of profit from high margin ancillary services. The HSBC model is quite transparent with respect to pricing. We want our customers to understand that there is a cost associated to providing services and this drives that cost. We have had numerous conversations on bids where clients buy a lower cost model because another provider can offer a service for free. How can a service be offered for free? Scale doesn’t enable that. Not even in global custody where there are transaction costs, sub-custody

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PAUL NATHAN, chief operating officer, OMAM

costs etc. If the face value price is free then there have to be hidden costs elsewhere and those hidden costs tend to be in the ancillary services. Now that the ancillary revenues are under pressure, it is hard for providers to go back to clients and say, “Actually, I can’t provide that service for free any more”, because the implication is that it was never about scale in the first place. PAUL NATHAN: Interesting comments and it harks back to my comment about one stop shop versus component outsourcing. It’s about scale and it’s about honesty and openness in pricing. For example, at my firm, we manage £3.5bn and I am not convinced that the revenue that we can generate makes us such an appealing client if we parcel it up into say four different chunks. I do not want to be a bronze client; I want to be a gold client. An integrated service would make a lot of sense. In a larger firm you will drive better value for money through component outsourcing, but you do need honest conversations about the costs and the risks being taken for each and every part of the service. So I do see a lot of unbundling going on in those pricing conversations. However, I suspect that as markets normalise, those elements will get re-bundled into package deals again. On the supply side, there is overcapacity in securities services, so there must be further opportunities for industry consolidation. However, it’s not until you start breaking the cost of that service into realistic units that you can understand where those scale and scope benefits are going to come from.

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FRANCESCA CARNEVALE:

CHRIS SIMS: If you say, is

the service that is provided to Gartmore the same from an HSBC point of view—if we were talking about something like unit pricing—exactly the same that is provided to another HSBC client? No, it’s not PAUL STILLABOWER: exactly the same. Probably Certainly what we have because HSBC has had to done at HSBC is present an turn round and unbundled price per accommodate the client service. What has changed because of limitations in in the credit crunch is that the client’s middle office it’s become less likely that services or custody we would provide a service arrangements for in isolation. Largely it is example. I’m sure HSBC because we can optimise would love to turn round profit by bundling and we and say: “Yes, same reduce risk for both the service.” But not all clients client and ourselves and are the same. They’ve got we lock in sticky services SONJA SPINNER, senior Associate at Mercer Investment Consulting IT systems that have, shall that underpin a stable, we say, matured over time. long-term relationship. SONJA SPINNER: I have definitely been speaking with some One of the biggest problems we see with what you’d call fund managers wanting to do custodian and administrative customisation, is actually the need put to absolute return selections. When we are working on these selections, to be funds under a UCITS III wrapper, where you’re doing quite honest, it’s not normally price which has driven the synthetics because you’re not allowed to do physical shorts. client’s desire to go back to the market. Quite a few of the The way that that ends up getting done varies drastically operations heads that I’m speaking with are really looking for from asset management firm to asset management firm. If the right service provider. If you’re a fund manager and you’re then, the asset servicing firm wishes to have this business running a very thin structure and just running a trading it has to accommodate the custodian. It can’t say, especially platform with outsource investment operations and at the moment, go away, spend two or three million quid accounting, what really kills you is when your on all the old systems and come back when you can deal custodian/administrator can’t service your account. For with it in the way that we’d most like it to work. example, I have had conversations with managers that have GORAN FORS: In the past we were probably more flexible had to use members of their quants team to price hard to in doing things and that is going to continue being the value assets because they can’t place reliance on the case; but we want to work towards controlled outsource service provider’s asset valuations. Clients prefer to customisations, if I can put it that way. pay more for the administration and have the right firm with SONJA SPINNER: At the heart of everybody’s operations is the right capabilities doing it. So cost is a driver, obviously, but a securities master file. Some things are the backbone of really people want the best value service provider. the operations and if you start tinkering with the LUC LECLERCQ: What we seem to forget is that when you fundamentals you create a lot of operational risk outsource something you will have to create something downstream. Then, there are other things where you can else, in the form of a middle office, for example. If you look overlay a customer friendly layer on the top of core at all the technology that you outsource, for example, systems. Securities processing and reconciliations need to software provision, you need to have people looking after operate smoothly. The reasons why we have seen the your software licence. Equally, you need to have a economies of scale we see in the industry is because that is relationship manager facing off the outsourcer. Cost is so highly automated. Custodians and administrators can important but you need to think about a cost price model only keep costs as low as they are by working purely on an whereby you take into consideration the totality of what exception basis. There are elements of the service which the new cost will be, the cost of the service provider plus can be customised and bits that can’t. your internal costs. Cost is not the driver per se for PAUL NATHAN: Wouldn’t it be nice to extend those outsourcing, it is the total service provision which counts. economies of scale further up the value chain into FRANCESCA CARNEVALE: As costs come into play, is accounting, for example, which we all find difficult? service customisation a thing of the past? Or will Wouldn’t it be good if there was an absolutely standardised customised services exact a high toll? way in UCITS III funds of accounting for synthetic shorts

Yet, you’ve got some custodians that are now insisting that you bundle all your products into them and you’ve got to take the whole package otherwise they’re just not interested.

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and supporting collateral management? The TPA could come to us with a standard operating model and we’d sign up to it so that we could concentrate on managing our client’s money, which is actually what we are being paid to do. Virtue is being made out of customisation because it’s “client friendly”, but actually, a bit more standardisation wouldn’t be a bad thing for us as an industry, otherwise we will never get scale. LUC LECLERCQ: Yes, absolutely, the market will change and the buyside will change as much as service providers will change over time. I also think, due to the fact that everybody is becoming cost conscious and price conscious and what they have to pay or what they want to be paid for will in itself bring a number of dynamics into place. Some institutions will want to keep things in-house and others outsource. Moreover, it will create increased demand for transparency around the entire service offering and, at the same time, there will be increasing awareness of risk and the need to mitigate it. Those trends will undoubtedly force change.

NEW MARKETS, NEW TERRITORIES PAUL NATHAN: I see two interesting trends: globalisation and complex instruments. Aside from a new wave of protectionism, which is always politically possible, globalisation feels like an unstoppable trend so we will see service providers and asset managers become more rather than less global in their business models. On complex instruments (synthetics and derivatives) the jury is out, really, on the benefits of those to investors. Certainly it is possible to realise returns only through some sort of particular derivative structure but there is often scope to express the portfolio view through traditional vanilla instruments. The business case for doing that through derivatives, if you look at the full cost end to end, is not proven and it would be very interesting to see more research on that. Yes, they certainly do have a place in investors’ portfolios but it would be helpful to see the full cost of support factored into that equation. GORAN FORS: Maybe a bit of back to basics will drive our industry a bit going forward. We will see a slowdown in the creation of new derivative instruments or type of innovations, but it will come back again slowly over time. For the time being there will be a bit of back to basics driven by cost efficiency and risk mitigation. SONJA SPINNER: I have an increasing number of clients wanting to hedge exposures. For example passive currency overlays or interest/inflation hedges, which can be achieved with synthetics. I do not see the use of derivatives to control particular portfolio risks stopping. What I do think is that the era of the CDO squared is definitely passed. The creation of derivative contracts, which cannot be effectively valued, is dead. The usage of quite simple derivatives is rising substantially. In terms of globalisation it’s very interesting; I have got clients in the Nordic countries and in Europe, say for the example the Dutch and

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PAUL STILLABOWER, global head of business development fund services at HSBC Securities Services

the German markets, where they have extensive derivative portfolios and quite specific needs. Some of the global custodians are not very well placed to service those specific client needs. Global custodians may not have experience producing specialised regulatory reporting or may not have the appropriate depot bank licences to support some regional clients. Equally, some of the global custodians are really investing in global capabilities so that they can actually start winning business from some of the niche market providers, which are second-tier banks in terms of size. It’s very difficult for local market providers to give global custodians a good run for their money economically. Local market providers may not have the scale to invest in systems to support value add services such as derivative administration, performance and attribution reporting. It will be interesting to see how the market plays out! PAUL STILLABOWER: The big change is not, as I keep reading in the paper, going to be the demise of the smaller European custodian banks. Change is coming at the purer custodian banks. We will see them link up with commercial banks because of the importance of having balance sheet increases. If you really want to be a global player then you have to have people on the ground in the markets you are servicing. If you are not already there, however, it is unlikely that you will get sign off in 2009, by the board, to massively increase costs for local banking licences, local fund administration, local premises and operations that do not pay right away. Between now and the next 15 or 20 years—when the bigger threat will probably come from the Chinese banks that plan to move into the global custody business and that will have a huge domestic asset pool to pump up their assets under custody—the local bank will be very difficult to dislodge from the customer base. That is because they’re the ones that are able and willing to do financing, they support distribution, things that are actually at the most important end of the customer’s businesses. GORAN FORS: Local banks and knowledge about the clients is going to become more important. I see reluctance from some of the larger, global custodians to enter into

THE 2009 SECURITIES SERVICES ROUNDTABLE

CHRIS SIMS, head of investment operations, Gartmore Investment Management

discussions with smaller institutions in my own home markets because they do not know enough about the client. They cannot motivate to have the amount of staff you require for that type of client base. At the same I see that there are some custodians that will be part of the custody industry where you have a huge need of size and sheer critical mass. That will, of course, encourage different types of corporations in different parts of this industry. So we will see, maybe, a shift in the custody industry over the coming decade, well, in sub-custody definitely, especially in the European market.

ANY HOPE OF AN UPTURN? SONJA SPINNER: The securities lending market needs to totally change. If any client came to me now—and I would never have advised them to do it before—and asks,“Should I go into a pooled cash reinvestment fund, accept the reinvestment risk on cash collateral and lose the right to control my lending programme?” The answer is just, no. Securities lending against cash is still happening in the US but my clients here are just asking:“Why would I do that? I might lend against gilts at a 1% or 2% haircut, but I’m not going to lend against cash or investment.” The industry made a mistake. A lot of people in the securities lending industry just didn’t realise that, if you’re a long-only pension investor, you’re not looking to take risk and you’re not looking to gear your portfolio via lending. It can be argued that trustees should have been more aware; it can be argued

that consultants should have educated more. Securities lending is an investment decision but it is a secondary investment decision to asset allocation and manager selection; securities lending should be near invisible and should not control the ability of funds to make other investment decisions. Beneficial owners are just not going to go back to programmes which expose them to the risks that crystallised from 2008. I’m not telling clients not to lend securities, I do not want to give that impression. I’m telling clients that securities lending can be a very helpful addition to portfolio revenues. Securities lending should be tackled like any other investment decision; have credit limits with your counterparties, ensure that collateral haircuts are reasonable and that the appropriate indemnities are in place. Do not lend against cash unless you really know what you’re doing. For some of my very big clients, who are very sophisticated, lend against cash in a knowing and controlled manner. If they want to do so, with the right governance structures, it is fine but most asset owners do not want to suffer the required oversight burden associated with more sophisticated lending programmes. CHRIS SIMS: They shouldn’t go there, at all. I can’t remember when we did the first one, back in 2000/2001, I think, something like that, and it’s fairly stringent. It is a worry that people ever signed up to securities lending agreements that were quite so cavalier, for want of a better word. PAUL STILLABOWER: At HSBC, we spent years having to defend a model that we fervently believed in, that is of client segregation and transparency. I would go back to the notion that the custody model that runs off pooled accounts is flawed, because the very large clients that make up X% of a pooled account are the ones whose assets are at risk. So if you think you’re not taking any risk in the pooled account, you are wrong. We’ve been told it’s too expensive to not run pooled custody, which we do not believe. So our agency securities lending programme is segregated customer by customer, we know who each borrower links to, and we indemnify on our balance sheet if customers want this. Moreover, our custody is segregated from proprietary assets and from other client assets. In dealing with today’s issues, we have a much better starting point. PAUL NATHAN: I will be interested to see over the next three to five years the extent of consolidation across the securities services industry because we have recognised how fragmented the industry is. Certainly, big chunks of it are at scale but there are still lots of providers or service elements that are sub-scale. If you look at the first wave of outsourcing investment operations, there were a lot of lift outs that are taking three, four, even five years to migrate onto the providers’ strategic platforms. If consolidation happens—and economically it must—and you apply those kind of timescales to merger activity, the industry is in for a good few years of pain and costly systems integration. That will affect us on the buyside too as a client of the securities services industry. It will be an interesting few years.

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Archive photo of Laurence Fink, chairman and chief executive of BlackRock, speaking to reporters during a news conference following a meeting of the Governor’s Commission to modernise the regulation of financial services Friday, January 18th 2008 in New York. Photograph by Mary Altaffer, for the Associated Press, supplied by PA Photos, August 2009.

Laurence Fink, chairman and chief executive of BlackRock, long coveted Barclays Global Investors and its iShares family of exchangetraded funds. When the financial storm of the past year threatened Barclays PLC, Fink bid $13.5bn for BGI, an offer the bank could not refuse. After the deal closes later this year, BlackRock will become the world’s largest manager of investment assets. Art Detman describes why BlackRock will likely grow and thrive, and how this acquisition may affect the money-management business. ARRY FINK IS a man in a hurry. When, in 1988, he founded what today is BlackRock, it was a money management operation that occupied a single room in New York City. In less than 10 years he had more than $100bn under management, mostly fixed-income securities. In 2005 Fink bought State Street Research Management, which put BlackRock deeply into equities. A

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year later the acquisition of Merrill Lynch Investment Managers pushed BlackRock’s assets under management over the trillion-dollar mark. And when BlackRock completes its acquisition of Barclay Global Investors, it will have $2.8trn under management, as much as the next two largest US firms—State Street and Vanguard—combined. By one estimate, BlackRock Global Investors (as it will be named) will have more than 3% of the world’s investable assets under management. In most industries, a 3% market share would be unremarkable; in the money-management business, it is breathtaking. “Astounding, isn’t it?” comments John Dutton, head of GHS-Dutton, a wealth adviser in Northern California. “I used to run an investment management firm back in the 1980s and we charged a fee of six-tenths of 1%. Imagine that fee on $2.8trn.”As for Fink, we can assume he long ago computed the potential income from the combined asset base. In any event, his media people say he’s not talking to the press until after the acquisition closes, which might not be until nearly the year’s end.

BLACKROCK WINS RACE FOR BARCLAYS GLOBAL INVESTORS

WHY FINK WILL TRIUMPH WITH BGI

BLACKROCK WINS RACE FOR BARCLAYS GLOBAL INVESTORS 68

By itself, San Francisco-based Barclays Global Investors is one of the larger money managers. At 30th June it had £1.02trn under management, about $1.7trn, even more than BlackRock’s $1.37trn (which, tellingly, grew by $15.2bn in net new money in the second quarter alone). For the six months to end-June, BGI had pre-tax profits of £276m, about $469m. BlackRock’s after-tax income was $349m for the same period. BGI contributed about 15% of last year’s pre-tax income at fabled Barclays, the eminently British bank that has operations worldwide and assets of £1.5trn ($2.6trn). When the global financial meltdown began last year, Barclays twice refused government aid and was told by the UK’s Financial Services Authority that it must improve its Core Tier 1 ratio, which was an anaemic 5.6% at year’s end. Six months later—thanks to the turnaround in the banking industry—it was 7.1%. Once the BGI sale is completed, it will be 8.8%, perhaps not robust but high enough to satisfy the regulators. Because BGI is carried on Barclays’ balance sheet at only £1.5bn, roughly $2.6bn, everything above this amount flows through to its paid-in capital. BGI has three main lines of business—indexed accounts (64% of assets under management), iShares (23%), and actively managed accounts (13%)—and selling all of them wasn’t the bank’s first choice. Barclays chief executive John Varley and president Robert Diamond (who also is chairman of the executive committee of BGI, which is managed as a standalone business) reluctantly concluded that the best way to raise capital was to sell the iShares operation. It was not a core business of Barclays, which Varley and Diamond ambitiously intend to build into the world’s pre-eminent investment bank. Serendipitously, iShares is a highly profitable operation, generating 44% of BGI’s operating profit in 2008. As the industry’s most successful family of exchange-traded funds (ETFs), iShares accounts for 54% of ETF sales to the world’s 100 largest pension plans, 47% of all US ETF volume, and 39% of European volume. Little wonder that Barclays soon had a reported 27 inquiries. Some experts expected bids from the likes of Fidelity, the big mutual fund company, Northern Trust, and even Charles Schwab Corporation (whose headquarters is within walking distance of BGI’s). Instead, the interested parties were firms such as Goldman Sachs, Bank of New York Mellon, Bain Capital, Colony Capital, BC Partners, and Apax Partners. In the end, Barclays accepted a bid from CVC Capital Partners, a private equity firm. The amount was $4.2bn, much less than the $6.5-$7bn some observers had expected. Did the low price mean that Varley and Diamond were growing a bit desperate? Perhaps so, but they had given themselves a second chance by insisting on a 45-day go-shop clause. Armed with a firm price from CVC, they looked for someone to top it. That someone was Larry Fink, who had long admired BGI and very much wanted it. But Fink wanted not just iShares but nearly all of BGI (except for one small, money-losing operation). He reportedly

With the clock ticking, Fink rounded up the money from PNC Financial Services Group (a long-time BlackRock investor); sovereignwealth funds from Singapore, China and Kuwait; and Highfields Capital Management, a hedge fund. He did this within a 24-hour period, a classic demonstration of Fink’s clout and determination.

offered $12bn. When negotiations ended, the price was $13.5bn—13 times BGI’s projected 2009 earnings before interest, taxes, depreciation and amortization. “BlackRock paid a generous price,”says Kim Arthur, president of Main Management in San Francisco and a long-time user of iShare ETFs, who adds:“But it is buying the market leader, and typically you do have to pay a premium for that, especially in a fast-growing market.” As for CVC, it will have to content itself with a break-up fee from Barclays of $175m, a tidy sum for being a stalking horse. Fink is paying $6.6bn in borrowed cash, which includes $3.8bn from Barclays, and the balance in stock. When the deal goes through, Barclays will own 19.9% of BlackRock and Varley and Diamond will be board members. For a while, it appeared that Fink wouldn’t be able to raise the remaining $2.8bn in cash. He had engaged PCP Capital Partners, which has a track record of raising money from Middle Eastern investors, including a $5.77bn investment last year by Abu Dhabi in Barclays itself. But, according to press reports, as the deal was ready to go down, Amanda Staveley, head of PCP, did not produce commitment letters from the actual investors themselves but rather from a special-purpose vehicle she managed. Fink and his advisers at Citigroup felt this wasn’t good enough. With the clock ticking, Fink rounded up the money from PNC Financial Services Group (a long-time BlackRock investor); sovereign-wealth funds from Singapore, China and Kuwait; and Highfields Capital Management, a hedge fund. He did this within a 24-hour period, a classic demonstration of Fink’s clout and determination. Although the object of Fink’s ambitions is the largest sponsor of ETFs—funds comprising of a basket of securities that trade throughout the day like individual stocks—BGI was not the first to offer them. In fact, it wasn’t until 1996 that it created some ETFs which were strictly for institutional investors. This was three years after State Street Global Advisors and the American Stock Exchange had created the first ETF, the Standard & Poor’s Depository Receipt, known as SPDR. State Street and Amex followed up with an S&P mid-cap index fund and then another to track the Dow Jones 30 Industrials. Sales were modest until the introduction of the ETF that tracks the Nasdaq 100, the famous QQQQ. It was tech-heavy and highly volatile, just what many investors wanted in the go-go 1990s.

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Lee Kranefuss, who joined BGI in 1997 from the Boston Consulting Group, was eventually put in charge of BGI’s small and struggling band of ETFs, all country funds then known as World Equity Benchmark Shares (WEBS). He simplified the technical aspects of managing them, rebranded them as iShares, made them exchange-listed, and began marketing them to institutional investors as well as individuals. In May 2000, BGI had only 17 iShares ETFs, accounting for less than $2bn in assets and perhaps 3% of the market. Today, BGI has more than 380 ETFs with a market value of roughly $425bn. (See“BGI: The Dominator Factor,”FTSE Global Markets, March/April 2007.) Notably, all iShares ETFs track established, third-party indices. Some, like those for an emerging market country, might be obscure but they are legitimate, recognised indices, not one contrived by BGI for marketing purposes. Nor does BGI sponsor any leveraged ETFs or inverse ETFs, both of which have come under increasing criticism recently. “I think they’re very dangerous,” says Mark Wilson, a vice president at The Tarbox Group, which manages just over $300m from its office in Newport Beach, California.“Leveraged ETFs allow you to make a good call and still end up with bad performance.” The reason, as Wilson notes, is the ratchet effect. If a fund drops in value by 1%, it has to gain 1.11% to break even. In a fund leveraged three times, that 1% loss requires a 3.33% offsetting gain. “On a daily basis, this dynamic gets really bad. The fund is doing exactly what the sponsor said it would. It’s just that when things go up and down again, you can have negative performance.” Inverse funds, which are designed to rise in a falling market, can also be treacherous. “Real estate ETFs are a perfect example,” Wilson says. “On a daily basis, one leveraged fund did exactly what the sponsor said. So you would expect an 80% return because that’s two times the inverse of the underlying index, which went down 40%. But instead the ETF was down something like 20% and that’s why I worry about these leveraged and inverse funds. They are very dangerous to people’s financial health.” True enough, but with payments due on $6.6bn in loans, will Fink be tempted to offer leveraged and inverse ETFs? What about tweaking some indices to soften or eliminate their bias towards big-cap funds? Some sponsors offer funds whose indices are weighted by dividends or even revenue growth rates. Here Fink might find some support among professional investors. “A given ETF may not be as diversified as investors might think,” explains Jim Tierney, head of Argus Investors’ Counsel of Stamford, Connecticut. He notes that in some industries the top one or two companies dominate an index weighted by market capitalisation. Thus, an investment in an index comprising a dozen or more stocks is essentially an investment in just one or two stocks. Another problem Fink faces is growing competition. At one time, iShares had 70% of the market. That’s below 50% now, and it’s almost certain to continue to fall as existing sponsors introduce new ETFs and newcomers enter the

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market. For example, Pacific Investment Management, which managed about $760bn and is a unit of Allianz SE, is launching a family of fixed-income ETFs. The first is the Pimco 1-3 Year US Treasure Index Fund, which competes directly with a $71bn iShares ETF. The Pimco fund has an annual expense ratio of 0.09% of assets compared with 0.15% for the iShares fund. Fink can expect many more new competitors like this simply because the demand for ETFs is growing, evidently at the expense of traditional mutual funds. Although mutual funds are still far larger than ETFs—$10trn in combined assets at 20th June versus only $590bn for ETFs—the flow of funds pattern is clear. Mutual fund assets are declining and ETF assets are rising, and in some months it appears to be a roughly one-to-one ratio. It’s too soon to say that this indicates the ascendancy of indexing. But a definite trend is under way, although most professional investors warn against overstating the case. “The purchase of BGI by BlackRock is not a validation that passive investing has trumped active investing,” says Dennis Clark, president of Advisor Partners, a San Francisco firm that manages $250m. ”The validation is really threefold. One is that indexing will likely remain a key component of portfolios in the wealth-management arena as well as for large institutional accounts. Two, ETFs are a superior indexing vehicle. That’s a huge trend and it will continue. Three, BlackRock with BGI will become a serious, dominant player with scale.” Chances are Fink would agree with all three points. He’s already said that he doesn’t believe indexing will supplant active management. Instead of managing a portfolio of 200 or 300 stocks, managers will limit themselves to fewer than 100 individual issues and use ETFs as a foundation—the beta, if you will, for their value-added alpha. That ETFs are a superior indexing vehicle is still debatable. Some managers use indexed mutual funds for certain asset classes because they are cheaper, and some institutional investors, such as the giant California Public Employees’ Pension System (CalPERS), create their own basket of stocks to track specific indices. As for BlackRock Global Investors becoming “a serious, dominant player with scale”, well, that will happen the day BlackRock folds BGI into its operations. Despite the debt burden and the growing competition, as long as Larry Fink is running BlackRock it will grow and prosper. `

If a fund drops in value by 1%, it has to gain 1.11% to break even. In a fund leveraged three times, that 1% loss requires a 3.33% offsetting gain. On a daily basis, this dynamic gets really bad. The fund is doing exactly what the sponsor said it would. It’s just that when things go up and down again, you can have negative performance.

GOLD’S NEW ROLE IN CHANGING MARKETS

Photograph © Dreamstime.com, supplied August 2009.

The last two years have changed the world’s financial architecture for good and the thinking about investing in gold, which, for a long time had an almost old-fashioned status, is changing. As a luxury good it has to compete with platinum, spa breaks, Gucci bags and iPhones, a battle it sometimes loses. As a financial investment however it is hard to beat. Endless references have been made to its glitter and shine, but in today’s uncertain markets it is solidity that has become its main allure. Vanja Dragomanovich reports. HERE IS AN increasing need to have an asset type in portfolios that helps overall diversification and provides stability against market spikes in equities, currencies and other more volatile assets. Equally, this is balanced by a move towards more basic, perhaps simpler, or at least more transparent financial instruments to invest in. Then again, there is a strong desire to replace the dollar as the world’s reserve currency with a currency that would not be as dependent on the economic fortunes of a single country.

In all of these aspects gold is playing a role. Working away quietly behind gold’s fortunes is the World Gold Council [WGC], an organisation representing the gold mining industry, and its new chief executive, Aram Shishmanian. “The nature of the gold market is changing rapidly, [and] investment attitudes are changing. It seemed like a good time to review what we do,”says the 58-year old who took over at the helm of the council at the end of last year. Until fairly recently the biggest demand for gold came from the jewellery sector, with demand for coins, bars and gold ETFs playing a proportionally smaller role. Geographically, India, China and the Middle East have always been the biggest buyers of jewellery, but with gold prices shooting up to above $1,000 earlier this year a lot of that buying slowed. At the same time, gold jewellery in the West is losing its status among top end buyers with platinum and diamonds stealing some of its market share. Even so, a notable increase in investment demand is more than making up for the loss of gold’s traditional markets. In this regard, the WGC pulled a particular stroke of genius; in that it has launched gold exchange traded funds (ETFs). These securities offer investors an innovative, and relatively cost efficient and secure way to access the gold

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market. All of the securities are backed by allocated gold held in a vault on behalf of investors. They are intended to offer investors a means of participating in the gold bullion market without the necessity of taking physical delivery of gold. Up until the point when ETFs were introduced gold as a paper investment was bought either in the shape of futures, something that pension funds and insurance companies were not able to invest in because of strict regulation on risk; or physical gold, which for smaller scale private investors was either too expensive or to complicated to buy. ETFs filled a void that allowed for gold to be bought at a press of a button. Gold ETFs shot to prominence over a relatively short period of time: the world’s largest ETF, SPDR Gold Shares, was launched in New York only five years ago. There is now,“$37bn held in WGC-backed gold ETFs. That’s more than the national reserve of many countries,” says Shishmanian. Although the first gold ETF was set up by Graham Tuckwell in Australia and then a year later ETF Securities launched them in London, it was the US market that really run away with ETFs. The SPDR Gold Trust is the word’s biggest gold ETF by a safe margin.

Investment products “ETFs have been a resounding success in the US,”explains Shishmanian. Unlike in Europe where gold ETFs are still mostly held by large institutional investors, in the US 70% of all the gold ETFs are held by individual investors.” US retail investors are comfortable dealing with shares and that ease was applied to gold ETFs too. In comparison,“to invest here (in the United Kingdom) you usually have to be a high net worth individual and have a broker. We have not been able to penetrate this market as much as the US but we plan to market ETFs more aggressively both here and in Europe through our partners,” explains Shishmanian. He expects gold ETFs to continue going from strength to strength and continue attracting significant inflows. “We are only at the beginning of this investment cycle,”he says. After the success of ETFs, WGC is looking at new ways to open up access to the gold market via new channels and products. Shishmanian said he couldn’t disclose the type of the product the council is developing at present, but that it will be bringing them to the market as soon as possible. Looking at the broader financial universe, one of the upshots of the financial turmoil has been that groups of institutions such as sovereign wealth funds, central banks and large institutional investors are revisiting their view on gold. “In the last nine months we have seen a significant change in attitudes towards gold across the board. Sovereign wealth funds have in the past avoided gold in favour of large equity stakes but are now looking to buy it to balance their portfolios,”says Shishmanian. While mature economies have held a high percentage of gold in their reserves for many decades and have been sellers of the precious metal over the last 10, 15 years, in rising economies—particularly in Russia, China and Korea—central banks are looking to increase the portion

FTSE GLOBAL MARKETS • SEPTEMBER 2009

World Gold Council chief executive officer Aram Shishmanian. Photograph kindly supplied by the World Gold Council, August 2009.

assigned to gold. The European Central Bank [ECB] chose to hold 15% of its own reserves in gold when it was first established. Shishmanian points out that China holds 1,054 tonnes of gold, which accounts for only a small percentile of its total reserves, and that that stake may well be increased.

New limits on gold sales On 7th August, the Central Bank Gold Agreement was renewed to limit the sale of gold over the five year period to 2,000 tonnes. There is a reduction in the annual ceiling on sales from 500 tonnes in the current agreement to 400 tonnes a year starting on 27th September this year. “[The move] reflects an acknowledgment of the fact that the central banks’ appetite for sales is diminishing. This is evident in the way that total sales under the second CBGA look set to fall well short of the ceiling the signatories set for themselves in 2004,” explains Shishmanian. The decision to allow room under the agreed ceiling to incorporate the International Monetary Fund’s (IMF’s) proposed sale of 403 tonnes of gold demonstrates a willingness to help the IMF comply with the recommendations of the Crockett Report: namely, that IMF sales should represent no net addition to the quantity of gold the market is expecting from the official sector. A shift in thinking about gold has also occurred within pension funds and insurance companies; two sets of large and conservative investors which traditionally have

GOLD’S NEW ROLE IN CHANGING MARKETS 72

avoided gold derivatives because of their high risk nature. Here the WGC’s negotiations with regulators about finding ways to include gold in a muli-asset investment strategy, or within a pension fund’s asset mix, has coincided with pension funds losing money on equities and wanting to invest in an asset that could provide some future protection. The effects started being felt since the beginning of the year. A further “discontinuity” as Shishmanian describes it, has been the weakening of the dollar during the financial crisis which hit the value of national reserves around the globe. Those countries that have been hit the most are now pushing for a viable alternative to the dollar as the world’s reserve currency. Russia, China and France have been at the forefront of this discussion and the Gulf Cooperation Council (GCC) countries are also working on a new currency in order to get away from a dependence on the dollar. However, GCC moves to establish both currency conversion and a common market are heavily dependent on the goodwill of Saudi Arabia, which is not always a given in this regard. Even so, “They (several G20 members) are saying we should consider the world monetary system and are asking what is the right currency to hold. We don’t suggest we go back to the gold standard but the mere fact that gold is being introduced into the vocabulary and into the thinking has given it a new relevance,”adds Shishmanian.

Consumer demand Despite wider global developments, the jewellery market continues to offer substantial opportunity to the WGC. Two markets to address are younger buyers—a youth market as good as didn’t exist in major gold buying hubs until recently—and the mid-range market in the West which Shishmanian says has been “tarnished”.“We need to find ways to entice the younger market and engage them in the unique attributes of gold and to encourage an increase in the quality and appeal of the mid market”, says Shishmanian. WGC claims to have managed to crack the youth market in India and China by working with local retailers to create the brands Farfasha and K-Gold, respectively. Both proved a runaway success. In the West however, “we have a problem with the mass market, [though not at] the high end of the market, the Bulgaris, the Tiffanys. We need to encourage greater innovation in the gold jewellery market and to develop retailers and consumers’ perception of the true value of high quality product,” acknowledges Shishmanian. Given that it is usually women who buy jewellery, Shishmanian has determined the perfect person to test his theories on—his wife.“My wife is symbolic of what I mean. Like most women she finds luxury goods attractive. She saw [the luxury in] platinum and diamonds but didn’t find gold as desirable,” says Shishmanian. However, when presented with it in“the right way, she became a convert,” he smiles.

In terms of geographical spread, potential in China is huge. It has the lowest per capita spend on gold of all the key gold regions and with a growing middle class and a natural affinity for gold the future looks very promising. Chinese demand makes up 9% of total world demand but if its current rate of growth is continued it could easily reach 20%.

Looking ahead, Shishmanian believes that at the current price of gold jewellery as a proportion of total demand will drop if prices remain high but that the investment market will not be hindered by high prices. Then again, the outlook for investment remains positive. Investors remain concerned about future inflation, as government efforts to stimulate economies through quantitative easing continue to steer their particular course, with gold the obvious choice as an inflation hedge. In terms of geographical spread, potential in China is huge. It has the lowest per capita spend on gold of all the key gold regions and with a growing middle class and a natural affinity for gold the future looks very promising. Chinese demand makes up 9% of total world demand but if its current rate of growth is continued it could easily reach 20%, he suggests. On a personal note, the 58-year old, who came to the council after a 33-year career in business consulting, most of which were spent in Accenture, says that what appeals to him about his new post is the broad range of activities involved. Possibly even more than his career, what makes Shishmanian suitable to head WGC is his background which is as eclectic as the gold market itself.

Opulent presents Armenian by descent, he grew up and was educated in Britain and later lived in the US, Switzerland, Iran and Kuwait. In Switzerland mature investors buy gold or coins, he muses, for a rainy day. In Eastern Europe children are given gold coins at birth with a “for good luck” whispered into their ears. In the Middle East at big family events opulent presents of gold are a must. In the US retail buyers allot a portion of their wage to trade gold ETFs. To be able to market in such diverse regions requires understanding different cultural affinities, something Shishmanian does probably better than most.“ I was initially sceptical that this was the role for me but the spectrum of activities and the influence of WGC grabbed my imagination. You engage central bankers, regulators …,”he says. “I am loving every minute of it.”

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ONWARDS AND UPWARDS? While credit fundamentals remain challenging for companies looking to crawl out from under the leverage wreckage, a mid-summer string of positive earnings reports has helped buoy the corporate bond markets, which have achieved a level of normalcy not seen since the pre-Lehman days. David Simons reports from Boston. UNNY HOW A few months and a few thousand points on the Dow can alter the global market psyche. After hitting bottom at 6547 in early March, by early August the Dow Jones Industrial Average (DJIA) had vaulted ahead some 40%, helped in no small part by a set of monetary measures aimed at reducing the scope of the US recession. “This has helped spur some return of risk appetite and a decline in volatilities, with investors moving into risk assets from safe havens,” observed the International Monetary Fund (IMF) in its Global Financial Stability Report, issued in July. The signs of relief are clearly evident within the corporate bond markets, which, reports the IMF, have achieved a level of normalcy not seen since the pre-Lehman days. “Corporate credit and asset-backed spreads have tightened significantly and issuance has risen, as firms seek alternatives to scarce bank credit,”says the IMF in its report. As of summer 2009, data from Russell Financial Services indicated that the option-adjusted spread (OAS) on

FTSE GLOBAL MARKETS • SEPTEMBER 2009

investment-grade corporate debt stood at 3.06%, a significant drop from the November 2008 peak of 6.07%. (The OAS is used to evaluate yield differences between similar-maturity fixed-income products with different embedded options; higher OAS readings indicate increased default risk, while lower numbers are associated with satisfactory credit availability and greater operational flexibility.) Though still at historically high levels (nominal month-end OAS values typically range between 0.51% and 1.87%), the current OAS reading seems to indicate greater willingness among investors to increase portfolio risk. While the perception of credit risk may have improved since earlier this year (as evidenced by tighter spreads and lower projected default rates), it is still far from a full-fledged recovery. According to the IMF, high-yield issuance, though on the rise, has been mainly confined to higher quality credit, and spreads continue to be historically wide. Bank lending remains restricted, despite the imposition of unorthodox policies aimed at reviving credit to end users, while overall bank credit growth continues to diminish, as de-leveraging pressures persist. Securitisation markets continue to be impaired, except for those directly supported by government programmes or central bank facilities. “With the rally in credit spreads, the market is now pricing in lower expected default rates than earlier this year,”reports Mark Kiesel, a managing director for global investment management firm PIMCO.“Is that a sign that we are coming

CORPORATE DEBT OUTLOOK: CAUSE FOR OPTIMISM

Lead photograph © Scott Maxwell/Dreamstime.com, supplied August 2009.

CORPORATE DEBT OUTLOOK: CAUSE FOR OPTIMISM 74

into a safe harbour? Just because we have seen a sharp tightening in credit spreads and a rally in the equity market does not mean that the economy is in calm waters.” Nick Colas, chief market strategist for New York-based ConvergEx Group, an institutional agency brokerage and investment technology solutions provider, also believes that the markets still have a long way to go.“On a scale of 1 to 10 where 10 is very open and 1 is very tight, I’d say we’re currently at 2 to maybe 3,” says Colas. “Banks still aren’t lending any tremendous amounts. If you’re a highquality issuer with a single-A rating and you’re not a financial company, you can probably get some corporate bonds issued. But it is still an extremely narrow window. I think the way it is going to play out is that second- and third-tier companies with very bad balance sheets will eventually file for bankruptcy—and we’re already seeing a lot of that—and you’ll see a lot of companies get taken out once the M&A wave starts to arrive during the last quarter of this year and the first half of next year.” On the positive side, the amount of cash flow that many companies have been able to generate in recent months has been impressive, says Colas. “These are companies that are building cash in their balance sheets and they’re improving their competitive positions. Of course, they’ve also been laying off a lot of people, which isn’t good for the economy. Still, by cutting back, saving money and raising cash, corporations are the one major component of capitalism that is still working correctly—and they’ll be around to scoop up some of their less-fortunate competitors once things properly stabilize.”

Reversing the credit curse Unlike downturns of the past, companies attempting to crawl out from under the wreckage have been hampered by the extraordinary amount of debt collectively accumulated in the years leading up to the credit-market implosion of 2007. Standard & Poor’s has estimated that domestic firms currently shoulder upwards of $1.4trn in loans and highyield bonds (by comparison, the debt load for US companies during the downturn of 2001 was roughly $500bn). Furthermore, companies hoping to raise cash through the sale of once-valuable subsidiaries and other assets have been stymied by consistently weak demand. As those firms struggle to make payments on their credit obligations, defaults have skyrocketed. According to Moody’s, to date the US default rate exceeds 11%, or more than four times the number of defaults a year ago. Though policy stimulus has had the effect of deferring refinancing risk—the ability for companies to replace maturing debt obligations with more favorable credit terms—it has not been eliminated entirely, says PIMCO’s Kiesel. “Credit fundamentals are still going to be challenging, especially for companies with significant leverage. It is important to note that for every security that Moody’s upgraded this year, they have downgraded seven.” While some companies have been able to boost liquidity through the credit markets, for many others the taps are still turned off. If companies aren’t able to restructure their

maturing debt obligations, a default rate in excess of 12% isn’t out of the question, say analysts. Some fear this could lead to a widening of high-yield spreads, and, in turn, touch off another round of equity selling on high-flying Wall Street. In addition to a potential rise in default rates, PIMCO foresees lower recovery rates for unsecured bondholders given high leverage, weak economic growth and higher levels of senior secured debt in the capital structure of many high yield companies.“The recovery rate so far this year has been about 20% based on 76 high yield companies that defaulted,” says Kiesel. “Meanwhile, high yield remains a risky bet. Today’s 11% default rate for high yield issuers is over 27 times the 0.4% default rate for investment grade issuers.”

Cause for optimism In order to ensure that the recovery proceeds on schedule, banks must be able to provide support where needed, notes the IMF.“In spite of recent capital raisings by banks, there is a need to ensure adequate capital levels going forward as default rates increase, and to promote restructuring where needed. Moreover, actions continue to be needed to help banks deal effectively with troubled assets. Only then will they be in a position to support the real economy going forward. Parallel to this, finding ways to reopen the securitization market by placing it on a sounder footing will be of particular importance, as it serves as a significant conduit of credit provision.” Despite the ongoing concerns, many analysts are heartened by recent market trends. Gavan Nolan, credit analyst for London-based information services provider Markit, believes that recent market data supports President Obama’s mid-summer assertion that the US economy has “stepped away from a precipice” and is on a path towards stronger growth during the remainder of 2009. “Second-quarter US GDP figures showed the economy contracting by 1%, a sharp improvement from the revised 6.4% contraction in the first-quarter,”notes Nolan.“The US housing market, the cancer at the heart of the global recession, is also showing signs of stabilisation,” he says. The credit and equity markets have certainly bought into the scenario of an imminent recovery, adds Nolan.“Spreads have rallied to pre-Lehman levels, while the major stock indices are at record highs for the year.” The momentum has been fueled by a slew of better-thanexpected earnings reports from a wide variety of sectors including high-tech, retail and telecommunications. As Colas points out, the ratio of positive to negative earnings reports was an impressive 3-to-1 during July.“I do not think people have really focused on just how well these highquality companies have been able to manage their balance sheets during this crisis. They are adding to cash, preserving liquidity, and they understand that it could be a long time until they once again have full and free access to the debt markets. At the same time, they’re also beginning to think that things are improving. Once chief executive officers are convinced that the turnaround is at hand, that’s when they are going to start thinking about buying up the competition. And that moment isn’t too far off.”

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A raft of regulation in Europe and the US is expected in the near future to keep money market providers on the proverbial straight and narrow path. This past summer the European Fund and Asset Management Association (Efama) and the Institutional Money Market Fund Association (IMMFA) issued proposals to better clarify the definition of a money market fund, a long running source of debate in the industry. Lynn Strongin Dodds explains the issues. HE FINANCIAL CRISIS may have highlighted some of the dangers lurking in money market funds but institutions continue to view them as safe harbours. The difference now is that investors are not only more discerning but have lowered their expectations in this nominal interest rate environment. Plain vanilla triple-A rated funds that do not have an edge are currently all the rage. Breaking it down, this means investments into treasuries, supra-nationals and highly rated, government backed financials with 60 to 90 day maturities. This is expected to remain the case in the near and medium term despite the easing of LIBOR levels. Bid/offer spreads remain wide across most asset classes causing funds to be cautious about investing further out on the yield curve. As Robin Creswell, managing principal at Payden & Rygel Global in London, comments: “The wish list has changed from two years ago. Back then, the priorities and in this order were achieving a return over LIBOR or bank account returns, liquidity and capital preservation. Today, it

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is the reverse with capital preservation at the top followed by liquidity and beating LIBOR. These three objectives are not mutually compatible but investors have become much more conservative. David Rothon, senior investment strategist at Northern Trust, agrees, adding: “In the past, there was push to generate additional return and deal up the risk on existing products. That is not the case now and investors are going back to basics with safety being one of the main priorities. What we witnessed last year was a perfect risk storm of interest rate and credit spread widening coupled with a sharp reduction in liquidity. To counteract these risks and maintain the core objectives of capital preservation and maintenance of liquidity, many fund managers kept investments short to reduce interest rate risk and to improve the maturity profile. About 30% to 40% of our funds are invested in overnight investments, 25% are in one month and 25% are in three months.” There has also definitely been a flight to quality and safety, according to Gail Le Coz, chief executive of The Institutional Money Market Funds Association (IMMFA), the trade association for providers of triple-A rated money market funds, which covers nearly all of the major providers of this type of fund outside the US. “There was a steady demand for our product over the past ten years. Since the financial crisis broke last year, we have seen tremendous interest, with assets of our funds increasing by €60bn to about €400bn. Investors were looking for a conservative framework which we provide with our Code of Practice.” While the inflows may have slowed in the past few

MONEY MARKET FUNDS: EMERGING REGULATIONS

A SLOW RETURN

Photograph © Fotolia.com, supplied August 2009.

MONEY MARKET FUNDS: EMERGING REGULATIONS 76

months, a hint of trouble will send investors running for cash cover if the latest monthly Bank of America Merrill Lynch poll is anything to go by. The survey, which canvassed 221 fund managers overseeing a total of $635bn (€452bn), found nervousness over equity prices in June pushed the average level of their cash balances to 4.7% from 4.2%. The trend also marked a reversal from the growing tide of confidence seen in the first half of the year, when managers whittled their cash balances down to the long-term average level of about 4% from the peak of 5.5% reached last December. The cautious tone is not surprising given the magnitude of the financial crisis and the fears of counterparty risk triggered by the collapse of Lehman Brothers and Bear Stearns. Investors were also spooked by the losses in the socalled enhanced or dynamic money market funds which were filled with longer dated maturities and asset-backed securities. They not only failed to deliver the promised returns but they also quickly lost their lustre, not to mention liquidity when the credit was crunched. The ensuing maelstrom broke the buck of some high profile players, most notably Reserve Primary Fund, the US money market mutual fund, while others had to suspend redemptions. Andrew Jones, money markets client service manager at Insight Investment, notes: “Throughout 2008, there was a lot of uncertainty in the financial sector with money market rates being extremely volatile, especially in the third quarter which was notable for the collapse and nationalisation or merger of a number of institutions. The effect of this panic was a substantial widening of spreads. Floating rate notes (FRN) short dated yields were significantly higher, as collateral holders of FRNs effectively became forced sellers. Pooled money market funds with a higher return objective are typically variable net asset value funds (NAV), i.e. the principal is subject to changes in the mark-tomarket valuation of the underlying investments. Over the last 18 months, there has been considerable movement in the value of some of these funds due to the volatility caused by illiquidity in the market.”

Turning tide It is unlikely that these enhanced funds will make a comeback any time soon and if they do they probably will be rebranded with a different label. For now, though, investors are expected to walk the traditional line.There is too much uncertainty over the direction of the global economy with some industry experts predicting a turning tide while others foresee the spectre of a double dip recession. As Tony Andrews, money market fund manager of Henderson Global Investors, says:“Equity markets may be moving upwards daily but I do not expect to see any major outflows to fund purchases. I think people are happy to wait for the green shoots to blossom before jumping fully on the stock market bandwagon.“ Jones adds:“Market volatility and falling asset values has been driving risk aversion although institutional investors have been reluctant to sell certain asset classes at what is perceived to be a trough in the market. Where assets have

Steven Meier, executive vice president of State Street Global Advisors and global cash chief investment officer.“We are in several discussions with clients who manage their cash in-house but are looking to put it in the hands of a professional manager. This is because of the high cost of the infrastructure and credit analysis that is and will be required going forward.” Photograph kindly supplied by State Street Global Advisors, August 2009.

been liquidated, investors have been seeking low risk havens for their capital which for sometime has been pointing in one direction—cash.”

Coming regulation Regulation is also expected to keep money market providers on the proverbial straight and narrow path. This past summer the European Fund and Asset Management Association (Efama) and the Institutional Money Market Fund Association (IMMFA) issued proposals to better clarify the definition of a money market fund, a long running source of debate in the industry. According to Rothon: “The definition of money market funds in Europe has often been misleading. There have been instances, for example, of short duration bond funds and enhanced cash funds being termed money market funds, when in reality they are distinctly different from AAA-rated treasury style MMFs. The definition provided by the IMMFA defines MMFs as: ‘Mutual funds that invest in short-term debt instruments.’ They provide the benefits of pooled investment, as investors can participate in a more diverse and high-quality portfolio than they otherwise could individually. Money market funds are actively managed within rigid and transparent guidelines to offer safety of principal, liquidity and competitive sector related returns. Moreover, IMMFA implicitly distinguishes between treasury-style products such as constant NAV MMFs and investment style funds with a variable NAV.” The IMMFA and Efama recommendations aim to make this delineation even clearer by having investment funds follow clear-cut rules in order to be allowed to carry the label “money market”. The report states: “the proposed restrictions on maximum interest rate risk at both portfolio and individual instrument level, as well as the limit set on the weighted average life, will limit the exposure of money market funds to interest rate and credit/credit spread risks.”

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

This includes putting constraints on the average maturity of the portfolio holdings of “short-term” money market funds to 60 days and having a limit of one year for“regular”money market funds. By June 2012, if accepted by regulators, all funds that fall outside the proposed definition would no longer be classified as money market funds, The boards of Efama and IMMFA have unanimously endorsed the proposals and are now seeking the support of fund managers, regulatory authorities and performance measurement agencies to ensure the definition is used across Europe. Peter De Proft, director general of Efama, also stressed the importance of working towards a European classification, which was outlined in the de Larosière Report, the European Union publication on the current financial crisis. It suggested a common EU definition for money market funds and “a stricter codification of the assets in which they can invest to limit exposure to credit, market and liquidity risks”. In the US, the Securities and Exchange Commission (SEC) recently issued its own roadmap to amend Rule 2a7, the principal rule governing money market funds. The proposals cover seven areas but the main thrust is to establish new liquidity requirements for funds to hold a certain percentage of their assets in cash or highly liquid securities. This would put funds in a better position to redeem investors’ shares on a short-term basis. The proposals are also designed to enhance the quality of money market fund investments by strengthening the credit quality and portfolio maturity requirements. This includes shortening the average maturity limits for money market fund portfolios from 90 days to 60 days. In addition, money market funds would be prevented from investing in Tier 2 securities plus they would be required to stress test their portfolios periodically to determine whether they can withstand market turbulence. Institutional money market

funds, which have been harder hit than retail funds, would have to have at least 10% in assets that could be liquidated within one day, and at least 30% within one week. Laurie Carroll, global investment strategist, of BNY Mellon Cash Investment Strategies, says:“By and large I think these regulations are good for the industry. However, it does not take away from the fact that investors need to look at the underlying assets in much greater detail than in the past.They also need to do more forward planning and to tier their cash. This used to be done in the 1980s and 1990s, but people stopped doing it in the past few years. However, it is a good way for institutions to better match their requirements and more effectively mitigate their risks.” “Institutions are monitoring their portfolios on a more regular basis and are drilling down in much greater detail into the quality of underlying assets as well as credit and risk profiles,” according to Steven Meier, executive vice president of State Street Global Advisors and global cash chief investment officer.“We are in several discussions with clients who manage their cash in-house but are looking to put it in the hands of a professional manager. This is because of the high cost of the infrastructure and credit analysis that is and will be required going forward.” Tristan Attenborough, managing director and regional executive for treasury, liquidity and investment products at JP Morgan, adds: “Many lessons have been learnt from the financial crisis and investors are paying more attention to transparency and that their parameters are being met. They are also overlaying the rating agency reports with their own due diligence to ensure that all the i's are dotted and t's crossed. We are also seeing a trend towards outsourcing the cash management function to specialists like ourselves, which can help remove operating risk, increase scale, improve returns and reduce costs.”

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

FTSE GLOBAL MARKETS • SEPTEMBER 2009

COLLATERAL MANAGEMENT: THE ART OF RISK MITIGATION 78

KEEPING CONTROL OF ASSETS Asset managers who want to improve their collateral management practices can either buy a software package and run it in-house or hire third-party service providers such as JP Morgan, BNYM or State Street to handle it for them but the buyside's new-found enthusiasm for collateral management owes at least as much to pressure from investors as to enlightened self-interest. State of the art collateral management requires robust information technology but it takes good people to make it work properly. Neil O’Hara reports. UYSIDE FIRMS CHANGED their tune towards collateral management overnight after Lehman Brothers’ bankruptcy exploded the myth that a major securities house could never fail. Many institutional investors had been slow to enforce their rights under collateral agreements—or even ignored them altogether— which left them nursing larger than necessary losses when Lehman bit the dust. It was also a wake-up call to other dealers, who had to consult their collateral management desks to find out what their exposures were. As a result, third-party collateral managers and software vendors have seen a surge in demand for their services that shows no sign of abating. “Everyone has realised how collateral works as a risk mitigation technique,” says Mark Higgins, vice president, global clearing and collateral management at The Bank of New York Mellon (BNYM). “They understand how they can apply it and what options are available to them.” Collateral provides critical protection against counterparty credit risk in the repo, securities lending and OTC derivatives markets. For technical legal reasons, the major dealers still operate these businesses independently even though all three are often linked in trades customers want to execute.“The buyside doesn’t look at a complex position or their portfolio with respect to how it gets manufactured by the sellside,” says David Wechter, senior director, collateral product management at Algorithmics, a Toronto-based vendor of enterprise risk management software.“Customers just want the simplicity of a single margin number.” Time was, customers were happy to accept what the dealers told them. But the Lehman bankruptcy revealed that the prices dealers use in valuations sometimes left

Photograph © Oxlock/Dreamstime.com, supplied August 2009.

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customers over-collateralised. In addition, buyside shops that didn’t take or call back collateral when they could, built up excess exposure to Lehman. Most customers agreed to re-hypothecation, which meant any collateral posted at Lehman was pooled with the firm’s own capital and reinvested to enhance its returns. When the venerable securities house failed, customers lost access to any rehypothecated collateral, which became an unsecured creditors’ claim against the bankruptcy estate. The experience sparked new interest in collateral management among buyside firms eager to have more control over their assets and the collateral process. While dealers were perceived as invulnerable credits, customers often did not object if initial margin deposits intended to protect dealers against customer default were co-mingled with variation margin, which compensated dealers for mark-to-market movements in collateralised positions. In the Lehman bankruptcy, customers lost not only variation margin to which Lehman was properly entitled but also access to their initial margin. “We are seeing more interest from the buyside in validating and calculating margin requirements,” says Wechter. “Having initial margin segregated from variation margin has grown in importance, too. Investors want to make sure they can get that initial margin back.” The demand for segregation has sparked innovation at custodial banks. Earlier this year, BNYM introduced Margin Direct, a service that holds investors’ initial margin in a tripartite custody structure. “A hedge fund can pledge the asset but title does not transfer,” explains Higgins. “The prime broker can only get its hands on the collateral if the hedge fund defaults.” The arrangement comes at a cost: prime brokers will charge more if they no longer have access to cheap funding at the customer’s expense and the custodian bank charges a fee as well. It’s a small price to pay to avoid the losses and disruption—fatal in some cases—that hedge funds and other investors experienced last autumn, however.

Robust operations The buyside’s new-found enthusiasm for collateral management owes at least as much to pressure from investors as to enlightened self-interest, according to John Wisbey, chairman and group chief executive officer at Lombard Risk Management, a London-based vendor of collateral management and compliance software. “Investors want to make sure their asset manager or hedge fund has sophisticated risk systems in place,”he says.“The industry must demonstrate robust operations and segregated compliance. Collateral management plays a huge role in that area.” In the over-the-counter (OTC) derivatives market, both buy and sellside participants have ratcheted up efforts to eliminate trade population differences, a notorious source of disputes over collateral calls. In the past, parties typically did not try to reconcile their positions until a dispute arose, according to Raf Pritchard, chief executive officer for North

FTSE GLOBAL MARKETS • SEPTEMBER 2009

David Wechter, senior director, collateral product management at Algorithmics, a Toronto-based vendor of enterprise risk management software. "Customers just want the simplicity of a single margin number,” says Wechter. Photograph kindly supplied by Algorithmics, August 2009.

America at Stockholm-based TriOptima, a vendor of posttrade services to the OTC derivatives market. Investors and dealers would exchange incompatible spreadsheets that might contain tens of thousands of trades and work through line by line to find errors. Not infrequently, the market moved before they completed the exercise and the collateral call changed—or even switched to the other party’s benefit. “People were just trying to agree the margin call,” says Simon Lillystone, business development director at Omgeo, a post-trade service provider headquartered in London. “That is very different from trying to work out whether you have exactly the same portfolio as somebody else.” TriOptima’s triResolve product transformed the reconciliation process. First introduced in 2007, it replaced the exchange of spreadsheets with a common web interface where both parties can view each other’s trades side-by-side based on normalised data inputs. The system shows trades that match, identifies mismatches and offers powerful search and reporting capabilities which allow customers to see, for example, aggregate exposures by counterparty or by product type. An electronic messaging capability keeps all communications related to a disputed position in the same place and available to anyone who views the file, too. Take-up among dealers was slow at first, but Bear Stearns’ near death showed the potential: a few mouse clicks enabled triResolve customers to generate reports that displayed their exposure to each counterparty. Lehman’s

COLLATERAL MANAGEMENT: THE ART OF RISK MITIGATION 80

demise swept away any lingering doubts. “TriResolve has now been taken up by all 16 major swaps dealers,” says Pritchard. “They have gone from reconciling reactively in response to a dispute to doing it daily and proactively.” The dramatic improvement in market practice happened fast, too. In a 2nd June letter to William Dudley, president of the Federal Reserve Bank of New York, ISDA’s Operations Management Group noted that between October 2008 and June 2009, the OTC derivatives market “progressed from a state where there was no well-defined standard for reconciling portfolios to one where 70% of the outstanding transactions across all derivative asset classes are reconciled frequently”. TriOptima is focusing its marketing efforts on the buyside now that the dealers are all on board. “Anything you might do under an ISDA master agreement is included,” says Pritchard. “It covers all your trades in all asset classes, not just the standard ones that go into central clearing or a trade warehouse.” Derivatives reconciliation tools, including triResolve, have been so successful that Kelly Mathieson, global head of clearance and collateral management at JP Morgan Worldwide Securities Services, says disputes over collateral calls now tend to involve discrepancies in pricing rather than trade populations. She adds: “The ability to continue to make strategic investments in collateral management functionality is key.” Other collateral management processes could use a similar technological shot in the arm. Omgeo’s Lillystone explains that when one party makes a collateral call today, it usually emails the counterparty and attaches a spreadsheet to support the claim. The counterparty may reply by either phone or email in an unspecified timeframe and, on the sellside, delivery is often to a generic email address.“There is no resilience to it,”Lillystone complains. “If you were using proper messaging you would get acknowledgement and confirmation that the message had been received.” Lillystone came to Omgeo from Allustra, a collateral management software vendor the company bought in 2008. Demand for its AllustraMargin product has soared in the past year, particularly from buyside firms that find it no longer feasible to monitor their collateral exposure on spreadsheets. Lillystone says one potential asset management client that used to make or receive about eight margin calls per day saw that number leap 25-fold to 150 calls per day in the nine months after Lehman failed. He can’t tell how much is attributable to heightened attention to collateral management by the asset manager and its counterparties versus more calls triggered by a volatile market, but the effect is the same: an overwhelming increase in volume. “It’s impossible to keep track of that activity on the back of a cigarette packet,” Lillystone says.“In addition to asset managers and hedge funds, we are getting requests from large corporations and even local governments that have treasury desks trading derivatives.”

Kelly Mathieson, global head of clearance and collateral management at JP Morgan Worldwide Securities Services. Mathieson says disputes over collateral calls now tend to involve discrepancies in pricing rather than trade populations. She adds: "The ability to continue to make strategic investments in collateral management functionality is key.” Photograph kindly supplied by JP Morgan, August 2009.

In an environment where some firms have disputed margin calls to deflect a demand for cash rather than in good faith, the primitive messaging system exposes the calling party to incremental risk. ISDA has begun work on a dispute resolution protocol in an attempt to streamline what remains essentially a manual process. It is trying to promote electronic messaging, too, an effort Algorithmics will support through its Collateral Connectivity solution, an industry electronic messaging platform which is under development. Technology upgrades are symptomatic of a broad move in collateral management towards more real-time data. JP Morgan’s Mathieson says market participants who take collateral also pay greater attention to what collateral is eligible, where it is located, how quickly they could take possession and what it would fetch in a liquidation sale. “It’s not enough in the current market just to have collateral,”she says.“My sense is that corporate governance has changed. Risk management now has a seat at the table when investing, trading and counterparty decisions are being made.” Mathieson says providers of collateral in derivatives trading relationships must adapt now that counterparties have become more finicky about what they will accept. That has prompted many hedge funds to initiate multiple prime broker relationships or add new names to their existing stable. She says:“Borrowers who use tri-party repo to finance their positions or securities lending and OTC derivatives for risk mitigation need to have more counterparties. They need more options to get the financing or execute their trades.” A year before Lehman failed, JP Morgan recognised an emerging need for a global collateral platform that would permit clients to view their collateral positions in near-realtime consolidated across multiple geographic regions and legal entities—and possibly transact as well. In early 2008, the firm began work on a multi-million-dollar new global collateral engine, which is being rolled out over three years. The early improvements affected internal systems, but

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

clients began to see the benefits in August 2009 through enhanced re-hypothecation capabilities on the securities collateral management side; further upgrades will follow. Market participants recognise that straight through processing of collateral calls would be desirable but Lombard Risk’s Wisbey says technical obstacles remain. Although the firm’s collateral management tool, Colline, automates the entire process, legacy systems at the major dealers often cannot handle margin calls through their trade settlement platforms without manual intervention. Automation requires both sides to accept the prices used to calculate the margin call, too, although disputes may become less common when the market adopts International Swaps and Derivatives Association ISDA’s proposed dispute resolution protocol.

Better option Asset managers who want to improve their collateral management practices can either buy a software package and run it in-house or hire third-party service providers such as JP Morgan, BNYM or State Street to handle it for them. Theodore Leveroni, vice president, global product management at State Street Corporation, says a service provider is often the better option for buyside firms. He says: “The industry keeps advancing. Keeping up can be difficult, especially if your core competency is money management, not running an operations centre.” Leveroni expects collateral use will spread to other instruments with long settlement periods, including master forward financing agreements and TBAs (forward trades in agency mortgage-backed securities for which the bonds to be delivered upon settlement are not specified on the trade date). While State Street can already handle these instruments, he says it has not yet become common market practice to collateralise them. Leveroni anticipates more frequent position reconciliations, too. Although daily reconciliations have become standard among dealers, once a week would now be considered best practice for the buyside. “We believe that daily reconciliations will be seen regularly for all market participants in the not-too-distant future,”he says. “In addition, proactive reconciliations of the collateral itself will become the norm.” State Street has experienced rapid growth in demand for its collateral management services as escalating operational needs put more pressure on buyside firms to outsource an increasingly important function. State of the art collateral management requires robust information technology but it takes good people to make it work properly, a point BNYM’s Higgins says firms new to the game sometimes overlook. A buyside firm that enters into a collateral agreement but does not keep track to ensure that prices used to calculate margin calls are accurate and excess collateral does not accumulate at the counterparty, may end up more exposed than if it never posted collateral. Higgins says: “You can buy the very best technology but if you don’t have the right people to run it it’s pointless. Collateral management done badly can be worse than not doing it at all.”

FTSE GLOBAL MARKETS • SEPTEMBER 2009

Simon Lilleystone, business development director at Omgeo, a posttrade service provider headquartered in London. "That is very different from trying to work out whether you have exactly the same portfolio as somebody else," says Lilleystone. Photograph kindly supplied by Omgeo, August 2009.

Raf Pritchard, chief executive officer for North America at Stockholmbased TriOptima, a vendor of post-trade services to the OTC derivatives market. Investors and dealers would exchange incompatible spreadsheets that might contain tens of thousands of trades and work through line by line to find errors. Not infrequently, the market moved before they completed the exercise and the collateral call changed—or even switched to the other party's benefit. Photograph kindly supplied by TriOptima, August 2009.

DTCC EXPANDS CLEARING CAPABILITIES

The New Wave During a conference call involving some 300 broker/dealers, the FICC was implored to test-fire its CCP engine in order to “net out” as many of the trades as possible. When the dust had settled, the company had transformed an estimated $329bn in uncleared trades into a significantly more manageable $30bn, which was subsequently liquidated in orderly fashion with no loss to member participants. Photograph © Strizh/Dreamstime.com, supplied August 2009.

Faced with the enormous task of winding down hundreds of billions of dollars in Lehman trade securities last autumn, the Depository Trust and Clearing Corporation responded by rushreleasing a major new initiative: a central counterparty (CCP) platform capable of “netting out” as many of the trades as possible. It turned out to be a smashing success. Now, what does the DTCC do for an encore? From Boston, David Simons reports. S DEMAND INCREASES for over-the-counter (OTC) derivatives, the industry will require more consistent trade-cycle data, more stringent pricing standards and, above all, increased risk-management tools. Working in consort with regulators, industry leaders have to date made significant commitments of time and capital with the goal of bolstering the infrastructure and the processes around servicing derivatives and related products, including trade confirmation, investment compliance, cash-flow calculation and settlement, as well as independent pricing and collateral management.

Such are the challenges facing the Depository Trust and Clearing Corporation (DTCC), whose fortunes may have been permanently shaped by the events of Monday, 15th September 2008, the day Lehman Brothers Holdings, one of the most powerful financial institutions and a major cog in the mortgage-backed securities pipeline, suddenly slipped into the abyss. Faced with the seemingly impossible—and enormously dangerous—task of winding down hundreds of billions of dollars in trade securities, the DTCC managed to see the trades through to completion by spontaneously bringing to market a major new initiative on behalf of its Fixed Income Clearing Corporation subsidiary (FICC): a central counterparty (CCP) capable of netting and guaranteeing trades in the mortgage-backed securities (MBS) market. During a conference call involving some 300 broker/dealers, the FICC was implored to test-fire its CCP engine in order to “net out” as many of the trades as possible. When the dust had settled, the company had transformed an estimated $329bn in uncleared trades into a significantly more manageable $30bn, which was subsequently liquidated in orderly fashion with no loss to member participants.

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

“That series of events really showed that we were moving in the right direction in terms of creating a central counterparty for this product,” says Murray Pozmanter, DTCC managing director of fixed income and product development. “Clearly, that kind of mass liquidation hitting the market all at once, on top of the various other events that were going on at the time, would have been a very destabilising force, to say the least. By acting as CCP for a day, we basically accelerated many of the processes that we had been building for the eventual CCP migration. And it worked amazingly well.” Moreover, the validation of the DTCC’s liquidation model was enough to convince previously sceptical buyside firms that the time had come to rethink the traditional approach to clearing.“That event was really the genesis of this effort to get buyside firms into the clearing environment,” says Pozmanter. “Prior to Lehman, money managers were often loath to relinquish collateral to a clearing corporation, because, in essence, that was money that would have to be parked on the sidelines instead of in the market.” Since last autumn, however, the idea of posting margins, rather than liquidating one’s own positions should another Lehmantype scenario occur, has become far more palatable.

Systemic risk “There had been this misconception that joining a CCP would be cost prohibitive or would be burdensome in some way,” says Michael C Bodson, executive managing director of DTCC Business Management and Strategy, and chairman-designate of MarkitSERV. “But one of the lessons learned from the Lehman experience was the benefit of having a CCP on board, particularly since there were a lot of buyside firms involved during the event. The point is, it opened everyone’s eyes to the fact that no one is completely immune to this kind of systemic risk—particularly when you saw the kinds of firms that were on the ropes during that period—and it really drove home the notion that a CCP provides both transparency and a level of credit control that isn’t always available in a pure bilateral marketplace.” Giving buyside as well as non-US firms the opportunity to participate in centralised clearing not only reduces the risk factor for all involved, but also greatly expands the DTCC’s clearing market share. “Non-US firms need our participant criteria,”says Bodson.“Though ideally we’d like there to be a completely holistic marketplace, we also understand that the more participants there are, the more holistic and balanced your view of the market becomes.” In the aftermath of Lehman, the DTCC has kept up the momentum by bringing forth a number of programmes aimed at refining and expanding its clearing capabilities. Topping the list is the effort to establish daily trade netting for MBS transactions. Using the FICC as the clearing counterparty, the initiative will seek to address trade costs while at the same time boost risk controls. Also included is a pool netting arrangement, with the FICC serving as trade guarantor on all matched trades and the novated counterparty on eligible pool obligations. A pilot

FTSE GLOBAL MARKETS • SEPTEMBER 2009

Murray Pozmanter, DTCC managing director of fixed income and product development.“[On Lehman’s fall] By acting as CCP for a day, we basically accelerated many of the processes that we had been building for the eventual CCP migration. It worked amazingly well,” says Pozmanter. Photograph kindly supplied by the DTCC, August 2009.

programme comprised of a select group of trading firms is due to launch in September. The realigning of services under the mortgage-backed securities division of FICC within a CCP model is key to the netting programme, says Pozmanter. “Despite having a 95% netting rate in the mortgage-backed securities market, the programme had never served as a trade guarantor or a central counterparty.You have to realise that historically there had been a much greater emphasis on having operational efficiencies, whereas risk management was considered more of a luxury. And that model worked very well for a number of years.” Even before the onset of the credit crisis, the model had already begun to evolve. With the establishment of the FICC in 2003, the effort to move all fixed-income products into a central-counterparty environment in order to boost risk-management capabilities became a possibility. The mortgage-backed securities (MBS) market initiative has paved the way for various other products. One of them is portfolio margining (also known as “common” margining), which makes it possible for FICC member firms to margin assets across both the FICC’s Mortgage Backed

DTCC EXPANDS CLEARING CAPABILITIES 84

the downstream processing and Government Securities of OTC derivatives. Divisions. Holding both “It is imperative that long and short positions there be one central within two separate repository of information markets provides clients so that regulators and with a natural hedge market participants can opportunity, says have a single-snapshot, Pozmanter. Meanwhile, the holistic view of the DTCC has also proposed markets,” affirms Bodson. moving the US trade “That is what our trade guarantee from its current information warehouse is position of midnight doing for the creditbetween T1 and T2 to the derivatives world. What point of trade validation, or we really don’t want to see roughly seconds following happen is the appearance trade execution. of multiple warehouses all “Again, this was over the globe, which something that was made Michael Bodson, executive managing director for business management could really add to the apparent during the and strategy for DTCC.“One of the lessons learned from the Lehman confusion.” Lehman crisis,” says experience was the benefit of having a CCP on board, particularly since According to Peter Bodson. “Because our there were a lot of buyside firms involved during the event,” notes Axilrod, head of guarantee was two days Bodson. Photograph kindly supplied by the DTCC, August 2009 DerivSERV and business later, there was a period of time when theoretically we could have had the option to development for the DTCC, the rapid proliferation of these reject trades and push them back into the marketplace, or global CCPs might not have been possible without the basically settled on a trade-for-trade basis bilaterally presence of DTCC’s warehouse. “Not only from a amongst the different firms.” A good concept on paper, fragmentation standpoint but in order to clear these trades perhaps, but it was nearly useless from a practical effectively, it is necessary to have a standardised automated standpoint.“ It just couldn’t be done—you’re talking about process in place covering successor events, credit events— millions of trades that would have to be reversed, it would anything that could impact the underlying issuer on a clear be impossible to properly configure. By contrast, going to trade. By having all of the CCPs leverage our business, a trade-date guarantee first and foremost allows us to users can be assured that everything is uniformly processed collect the right margin from the moment of trade receipt across cleared as well as non-cleared bilateral trades.” The demand for trade repositories in both the US and and validation—because, after all, we are taking the Europe has furthered the development of even more exposure from that point forward.” robust downstream processing covering multiple asset classes. Under certain circumstances—for instance, Expanding the warehouse As part of US Treasury Secretary Timothy Geithner’s instruments that are derivatives on corporate issuers— objective to “bring unparalleled transparency to the over- various corporate action-type events can often impact the-counter derivatives markets,” the industry has forged the contracts themselves. “Given these situations, one ahead with the establishment of multiple clearing cannot act as a credible repository without having the initiatives. Earlier this year, the Securities and Exchange ability to process these downstream events,”says Axilrod. Commission (SEC) granted conditional exemptions “For derivatives on underlying corporate issuers such as allowing both the Chicago Mercantile Exchange (CME) credit and equities, you can’t really be a repository unless and ICE US Trust to operate as a central counterparty you have some kind of downstream post-trade clearing house for credit default swaps. LCH.Clearnet, processing infrastructure in place to deal with those which won approval from the SEC last December, has kinds of events.” In a speech to the US Chamber of Commerce in July, enlisted the support of HSBC and JP Morgan as shareholders in its OTCDerivNet platform, which oversees Donald Donahue, chairman and chief executive officer of the DTCC, underscored the remarkable growth of the OTC the company’s SwapClear worldwide clearing service. The sheer number of global counterparties and their derivatives market over the past several years—as well as the affiliated regulatory agencies, however, raises concerns about opacity of certain credit-derivatives products that ultimately fragmentation. In an effort to provide independent support, contributed to the market’s unraveling last autumn. Were it earlier this year the DTCC filed applications for the not for the safeguards provided by DTCC’s Deriv/SERV establishment of a limited purpose trust company to facilitate automated matching service, as well as the housing and the functions of its Trade Information Warehouse, a servicing of CDS contracts under the trade information centralised, automated trade information support system for warehouse, things could have been much worse.

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

“The market for credit derivatives was in many ways vastly misunderstood—there was very little transparency into the marketplace prior to the events of last autumn,”says Bodson. “That said, through our Deriv/SERV business, roughly 95% of all derivatives were confirmed and located within our trade-information warehouse. In other words, the information was available, trades were being captured—it was mainly a question of properly accessing the information in the warehouse and using it in the best way possible.” More than anything else, the Lehman event revealed the need for better disclosure and heightened transparency within the credit-derivatives market. To that end, DTCC has worked to provide regulators with vastly improved data and market analytics, making sure that even one-sided or “bronze”records are maintained in the warehouse in order to provide a much broader view of the global marketplace. In the weeks following the 17th July regulatory deadline for all OTC products to be listed within a global repository, DTCC announced that global OTC participants had registered over 216,765 CDS contracts with a notional value of approximately $5.7trn.

Joining forces In June, DTCC announced a joint venture with NYSE Euronext for the purpose of clearing domestic fixed-income derivatives, under the heading New York Portfolio Clearing (NYPC). Set to launch during the second quarter of 2010, the new clearing house, which combines Euronext’s futures exchange with DTCC’s FICC, it will offer participants risk management, clearing and settlement efficiencies covering both fixed-income securities and derivatives. Partnering with Euronext allows DTCC to“hit the ground running,” says Bodson. ”They [Euronext] already had the clearing technology, which makes it that much easier to get the process going. Obviously this is a company that we have a lot of respect for, has a proven track record of success, and also brings to the table some very strong relationships, which will enable us to get through any initial problems very quickly.” Says Pozmanter: “We were already working on a portfolio risk-margining system that combines multiple asset classes, however, we lacked the ability to handle futures clearing should we want to move into that segment of the market. NYSE brought to the table its Liffe Connect and futures back-office system, which it had acquired through its merger with Liffe several years ago. At the same time, NYSE was looking to bring new products to market, and we already had the risk-management technology available. So, as it turns out, it was a very natural fit, one that enabled us to do this kind of mutually beneficial portfolio clearing.” In a separate arrangement one year in the making, DTCC has joined forces with Markit, combining the backoffice post-trade confirmation and matching services of DerivSERV with the front- and middle-office trade processing services offered by the London-based financial information services provider. The new venture will provide customers with a single efficient gateway for the

FTSE GLOBAL MARKETS • SEPTEMBER 2009

confirmation of OTC derivatives transactions on a worldwide basis, a new company that will combine the two organisations’ electronic trade confirmation and workflow platforms to provide a single gateway for over-the-counter (OTC) derivative trade processing. The strategic partnership was first announced in July last year, subject to completion of due diligence, regulatory filings and approval by relevant global regulators. Due diligence is now complete and MarkitSERV has received regulatory approval from the United Kingdom Financial Services Authority and the Department of Justice in the United States. Jointly-owned by DTCC and Markit, MarkitSERV will combine the DTCC Deriv/SERV and Markit Wire trade confirmation platforms to cover all major asset classes including credit, interest rate, equity and commodity derivatives. It will connect multiple market participants and execution venues to downstream processing platforms such as DTCC’s Trade Information Warehouse. It will also connect to various central counterparty platforms for interest rate swaps and CDS, in collaboration with the DTCC Trade Information Warehouse. “Our shared vision is to provide the industry with a more secure, reliable and streamlined operational environment for confirming OTC derivative transactions globally,” says Bodson. “Each of our firms has been independently successful, and this joint company will now leverage our combined expertise to extend benefits to a wider user base and across a more diverse range of financial instruments. This is certainly in keeping with DTCC’s desire to pursue partnering opportunities that reduce risk and serve the industry as a whole.” “This is something we’re very excited about,”says Axilrod. “The industry has been looking for this kind of offering for a very long time, because it creates a number of different efficiencies within the trade-processing business.” Downstream processing for the credit-derivatives market has become developed to the point that credit events which would have been considered daunting only a year ago can now be handled routinely and relatively risk free, he adds. Having a robust downstream operational infrastructure that includes such benefits as net-cash settlements will bring additional value to the OTC market, says Axilrod. Pozmanter says: “We really look at all of these developments as one stepping stone leading to the next. The idea behind putting all of the mortgages and government securities into a single portfolio was to create a natural hedging opportunity through trade margining. Getting derivatives listed was the next logical step in the effort to have more of the risk management and portfolio consolidated within a centralised clearing environment in order to provide us with a more accurate view of our member firms’ risk exposure, and from there we began our discussions with NYSE, which was in the process of trying to launch a new marketplace for fixed-income derivatives. So it really has been a very natural evolution of bringing new products to market based on the single premise of mitigating risk, while significantly enhancing transparency.”

TOWARDS A REGIONAL CLEARING PLATFORM

Picking Up

Steam Photograph ÂŠ Andrea Dante/Dreamstime.com, supplied August 2009.

The Asian Development Banks is at the forefront of developing a fully integrated Association of Southeast Asian Nations (ASEAN) capital markets by 2015. The bank has recently undertaken two studies as part of the Asian Bond Markets Initiative (ABMI), launched by ASEAN+3 (China, Japan and the Republic of Korea). The first report due next March is expected to make recommendations on the most effective ways to harmonise the various regulations and practices to facilitate crossborder trading and investment in Asian government and corporate bonds. The bank will explore, for example, the options of establishing a regional bond forum and suggest measures to strengthen self regulatory bond organisations in the region. The second report, due to be published in December, is looking at ways to improve the bond settlement and clearing landscape and the cross-border arrangements currently in place. It is also considering the effectiveness of a regional settlement body. Lynn Strongin Dodds reports. T FIRST GLANCE a pan-Asian clearing and settlement platform may seem like a pipe dream but a closer look reveals several initiatives are on the table that could kick-start the process. Views are mixed as to their success rates but all agree that, like the European experience, it will take several years of debate, discussion, not to mention patience. The difference is the challenges will be greater. The region is not only far more heterogeneous, but there is also no single currency acting as a unifying force.

As a result, few expect a big bang-type of regulation but instead see a slow and steady progression towards integration that is unlikely to follow a smooth path. Currently, each country has its own systems and processes and there are nuances within the confines of these local arrangements. On the settlement front, for example, Hong Kong, Singapore and India have different cycles, and none of them support T+1 for equities and corporate bonds. Drilling down further, the settlement cycle in Singapore is T+1 for government bonds, but T+3 for all other securities.

SEPTEMBER 2009 â&#x20AC;˘ FTSE GLOBAL MARKETS

Overall, in terms of market infrastructure, Hong Kong and Singapore have three organisations with very similar roles to support the entire trading cycle, while India is much more fragmented, with eight providers. The first pieces of the puzzle likely to be sorted are the cross border trading of bonds and equities with clearing and settlement farther down the priority list. In many ways this sounds like the European model, which focused on developing pan-European equities platforms, but Asia is expected to devise its own solutions. Philip Reichardt, director, international co-operation, at Euroclear, says: “There are lessons to be learnt from Europe but it is important to remember that the developments on the European clearing and settlement front were triggered by the introduction of the euro. Asia is very different in that it is not a common market nor does it have regulations such as Markets in Financial Instruments Directive (MiFID) which stimulated activity in European financial services. “It is also important to remember the way markets have evolved in Asia. Exchanges have high profiles and they are linked to clearing and settlement platforms in their own domestic markets. Many see them as silos that they control and each has its own regulatory and liquidity

differences. There is little cross-border trading in Asia compared to other regions, but we are seeing local and international clients who want to invest in the region looking at how these markets can be more efficient and liquid through co-operation.” Karin Quek, regional manager, global network management, The Bank of New York Mellon, also notes there is a higher degree of collaboration but does “not expect a unified market like Europe for the short or medium term”. This is because countries are at different stages in economic growth and infrastructure plus they each have their own cultures, languages and religions. The lack of homogeneous regulatory and operational environment resulted in a wide range of different market practices and domestic models. In addition, no one country has assumed the key leadership role in Asia. Considering the current constraints, it would be beneficial for Asia to move towards a gradual rationalisation of the domestic and regional infrastructure. The political drivers also vary and there are question marks as to whether the momentum is there to create a more harmonised financial services industry with the clearing and settlement industry as one of the main

“As well as the tools we provide for our clients, we have the structures to support their international development every step of the way. In fact, our organisation is our strength. Our centres of expertise are distributed throughout the world via international platforms. No matter which country my clients are based in, I can offer them a complete range of services that best meets their expectations.” Massimo Cotella, CEO, SGSS S.p.A. www.sg-securities-services.com

Massimo Cotella SGSS Milano

FROM MILAN TO HONG KONG, WE STAND BY YOU WITH AN INTERNATIONAL SERVICE PLATFORM.

We stand by you

FTSE GLOBAL MARKETS • SEPTEMBER 2009

TOWARDS A REGIONAL CLEARING PLATFORM 88

the requirement for US components. As Evan dollar clearing systems to Goldstein, product head of be built locally. Japan has securities services of several brands that are Standard Chartered, says: household names around “It is a consensus building the world and these process and to get the companies demand the different countries to agree best technology and on a standard set of systems to be able to principles across the board operate internationally takes a lot of will given the and in the most efficient political and self interest way.” involved.” Latiff notes though, that Barnaby Nelson, head of “at the same time, the business development for impact of these Asia, BNP Paribas developments would Securities Services, depend on how long they questions in whose interest take to be adopted. He a regional facility would be. believes CLS, the largest “At a market level, a multi-currency FX number of smaller Asian settlement system, could markets potentially have a eventually provide a lot to lose from a single Lisa Robins, treasury and securities services China executive at JP blueprint. “Geography is pan-Asian facility. Today, Morgan, says: “Shanghai has the potential to be a major financial less of an issue. The CLS businesses are spread centre. In reality, I believe we could see different operating platforms Bank, which looks after across multiple Asian from North Asia (which includes China, Hong Kong and Japan) be the the settlement process, is centres but regionalisation first to develop a common exchange gateway that can add value, based in New York but the would probably see because within the Asia Pacific region, North Asia has the most administration is done in businesses move towards experience and the most sophisticated systems and best practices in London. Although it the larger centres such as this area.” Photograph kindly supplied by JP Morgan, August 2009. would depend on how it is Singapore and Hong Kong. At a market participant level, current providers have designed in Asia, one would expect that the countries with already made significant investments to be present across the best practices around clearing and settlement processes the region and so they are unlikely to want to then make it would have the greatest opportunity to host it.” Philippe Metoudi, head of Clearstream in Asia, also easier and cheaper for new entrants.” Currently, the main contenders for regional hubs which notes that Manila could emerge as a clearing and would include clearing and settlement are Hong Kong, settlement centre. “It is the home of the Asian Singapore, and Japan. Shanghai is also hoping to muscle Development Bank (ADB) and would not pose a threat to in as China has plans to transform the city into a major any other major financial centre in the region. It could global financial centre by 2020. Many believe, though, that benefit from its neutrality.” The ADB is at the forefront of developing a fully integrated this will not happen until the Chinese government provides more scope for capital to easily move in and out Association of Southeast Asian Nations (ASEAN) capital markets by 2015. The bank has recently undertaken two of the country. Lisa Robins, treasury and securities services China studies as part of the Asian Bond Markets Initiative (ABMI), executive at JP Morgan, says:“Shanghai has the potential to launched by ASEAN+3 (China, Japan and the Republic of be a major financial centre. In reality, I believe we could see Korea). The first report due next March is expected to make different operating platforms from North Asia (which recommendations on the most effective ways to harmonise includes China, Hong Kong and Japan) be the first to the various regulations and practices to facilitate cross-border develop a common exchange gateway that can add value, trading and investment in Asian government and corporate because within the Asia Pacific region, North Asia has the bonds. ADB will explore, for example, the options of most experience and the most sophisticated systems and establishing a regional bond forum and suggest measures to strengthen self regulatory bond organisations in the region. best practices in this area.” Robins’ colleague, Raof Latiff, head of treasury services This could include setting up new ones such as the clearing and foreign exchange, Asia at JP Morgan, adds:“An International Capital Market Association in Europe. The example from Asia would be Bank of Japan—Japan was one second, due to be published in December, is looking at ways of the first countries to set up the Real-Time Gross to improve the bond settlement and clearing landscape and Settlement (RTGS) system and it was the first in the Asia the cross-border arrangements currently in place. It is also region to have active flows with the US. Japan stimulated considering the effectiveness of a regional settlement body.

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

This is not the first time a venture of this kind has been mooted. As Goldstein notes: “It has been a stop and start process. The idea of an integrated bond market in the region was first introduced in 2001 but it petered out in 2005. It has come back on the table and if there was ever a time for discussion and debate it is now, given what has happened in the financial markets and the need for greater efficiency.” In addition, bond markets in Asia have expanded rapidly in recent years. Between the end of 2007 and end2008, for example, total outstanding bonds in ASEAN, People’s Republic of China, Hong Kong, and Republic of Korea grew a healthy 14.9% to $3.7trn. However, regional cross-border issuance and investment is low with ASEAN+3 countries allocating only 2% of their bond investment to paper denominated in other regional currencies. This is mainly due to the expense of dealing with the accounting, tax and national legal systems. There is a view that the new yuan trade settlement, which allows yuan business, including the issue of bonds in Hong Kong, could be a harbinger for China’s remninbi to become the pan-Asian currency but all agree that is several years away. On the equity front, ASEAN has launched the Common Exchange Gateway alliance, which is expected to help pave the way for the future development of backend linkages involving clearing, settlement, and depositary arrangements. The goal is to link ASEAN capital markets by way of a single access point for investors and issuers to any of the exchanges. The agreement initially involves five countries—Indonesia, Malaysia, Philippines, Singapore and Thailand—each of which will list their top 30 stocks on a single computer screen, known as the ASEAN Bulletin Board. Quek of BNY Mellon says: “The ASEAN Common Exchange Gateway is a good starting point. The first phase is expected to go live in 2010 starting with Malaysia, Singapore and Thailand as these three markets account for over 60% of the region’s total market capitalisation, to be followed by the rest of the participating ASEAN countries, depending on their system readiness. The challenge, though, will be how to make it cost effective given the different technology systems and pricing structure.” There has also been movement on the technology front with 10 major fund managers working closely together via the Asian Funds Automation Consortium (AFAC), which has been leading the drive for straight-through processing `

Philippe Metoudi, head of Clearstream in Asia, notes that Manila could emerge as a clearing and settlement centre. “It is the home of the Asian Development Bank and would not pose a threat to any other major financial centre in the region. It could benefit from its neutrality.”

FTSE GLOBAL MARKETS • SEPTEMBER 2009

Raof Latiff, head of treasury services clearing and foreign exchange, Asia at JP Morgan, adds: "An example from Asia would be Bank of Japan—Japan was one of the first countries to set up the Real-Time Gross Settlement (RTGS) system and it was the first in the Asia region to have active flows with the US. Japan stimulated the requirement for US dollar clearing systems to be built locally. Japan has several brands that are household names around the world and these companies demand the best technology and systems to be able to operate internationally and in the most efficient way." Photograph kindly supplied by JPMorgan, August 2009.

initiatives in the region, including recommending the use of SWIFT’s ISO 20022 compliant funds messages. The group of 10 is developing a set of common templates to make it easier for distributors to test and automate. They are also conferring with counterparties on best business practices and looking to eliminate issues that impede the industry from moving forward. While each of these initiatives is not specifically geared towards clearing and settlement, the general consensus is that together they will precipitate changes in the industry over the long term. Metoudi of Clearstream also would not be surprised to see a pan-Asian system based on the LinkUp model in Europe. The group is spearheading this joint venture by eight central securities depositories (CSDs) which establishes a common infrastructure linking each national CSD. Metoudi says: “The main challenge today is the developmental cost of setting up a pan-Asian platform and where the headquarters should be based. A Link-Up-type of initiative that included major markets such as China, Hong Kong, Singapore, Malaysia and Japan makes sense. We are getting good feedback because it would make use of existing infrastructure, be more cost effective and lessen the head office issue.”

EUROPEAN TRADING STATISTICS

THE FIDESSA FRAGMENTATION INDEX (FFI) The Fidessa Fragmentation Index (FFI) was designed to provide the trading community with an accurate, unbiased measurement of the state of liquidity fragmentation across the order driven markets in Europe. Liquidity is fragmenting rapidly as new MTFs have unveiled a range of low-cost alternative trading platforms. It is essential for both the buy and the sellside to understand how different stocks are fragmenting across the new venues. To make it easy to measure and compare fragmentation across Europe, the Fragmentation Index provides a single number to show how a stock or index is fragmenting. It is calculated using proven mathematical principles and shows the average number of venues that should be visited to achieve best execution when completing an order. An FFI value of 1 therefore means that the stock is still traded at a primary exchange. An FFI value of 2 or more shows that the stock has been fragmented significantly and can no longer be regarded as having a primary exchange. The FFI is calculated daily across all the constituents of the major European indices, which illustrates how many stocks are fragmenting and the rate at which they are doing so.

Venue turnover in major stocks: January 2009 through August 2009 (Europe only). (â&#x201A;Ź) January

February

March

April

May

June

July

August (to 10th)

BTE/BATs

4,790,110,404

5,600,695,181

8,284,331,344

11,739,665,480

12,301,809,608

19,789,185,173

17,117,749,560

5,457,889,847

CIX/Chi-X

46,712,279,892

44,287,264,624

57,055,170,476

64,549,417,670

67,015,814,749

75,466,606,317

73,025,101,945

24,873,688,770

CPH/Copenhagen

4,658,766,694

4,781,868,780

4,172,100,968

5,376,242,856

5,436,958,049

4,226,938,742

3,555,493,183

1,504,516,203

ENA/Amsterdam

28,998,109,764

28,228,747,464

33,374,484,823

33,930,345,328

33,811,464,108

30,976,601,902

31,385,199,230

10,327,976,294

ENB/Brussels

6,557,604,579

6,677,562,065

7,285,738,551

6,777,175,877

7,445,092,754

6,529,627,899

5,189,313,861

2,703,427,446

ENL/Lisbon

1,942,925,835

1,699,902,475

2,192,516,989

2,611,463,853

2,971,813,173

2,198,642,157

2,070,066,025

837,573,491

ENX/Paris

68,569,494,159

62,176,825,878

71,521,595,572

72,615,015,403

64,756,243,571

65,114,762,913

60,333,614,213

20,886,035,426

GER/Xetra

65,531,679,523

58,938,123,381

72,362,496,131

70,827,752,529

65,295,346,642

59,810,289,687

59,120,851,769

19,504,463,459

HEL/Helsinki

8,018,556,502

7,630,785,531

8,002,261,708

9,739,066,277

7,404,697,792

6,622,939,852

7,515,516,012

1,844,596,973

LSE/London

98,676,987,434

90,529,113,476

113,505,101,306

98,894,191,343

94,113,001,150

109,629,000,000

92,115,865,780

31,234,251,466

MAD/Madrid

33,878,620,775

33,642,167,059

40,867,417,146

51,081,732,593

65,550,350,346

50,238,349,906

43,251,626,085

17,930,082,964

MIL/Milan

43,520,648,521

37,123,194,201

45,141,078,254

47,509,757,990

44,325,704,359

46,007,528,734

45,653,082,841

12,076,296,260-

25,742,380

NAE/Nasdaq Arca Europe NEU/Nasdaq-OMX

603,441,883

487,436,557

489,152,477

938,987,188

2,333,459,443

2,705,245,354

3,524,274,483

1,048,784,715

STO/Stockholm

18,432,301,605

20,449,832,829

21,258,141,925

23,114,786,824

19,718,479,803

17,681,366,625

16,615,639,023

5,518,073,887

TRQ/Turquoise

26,311,426,009

29,084,346,493

23,016,525,997

13,975,420,771

15,796,021,315

19,858,562,643

22,652,941,465

9,771,437,534

VTX/SWX

39,198,800,982

41,645,468,998

42,750,059,854

41,180,202,240

38,363,085,417

33,892,649,428

32,849,258,499

10,330,324,734

Monthly Total

496,401,754,564

472,983,334,994

551,278,173,520

554,861,224,224

546,639,342,279

550,748,297,332

515,975,593,974

175,875,161,849

Market share by venue in electronic order book trades in major stocks: January 2009 through August 2009 (as a percentage) (Europe only) January

February

March

April

May

June

July

August (to 10th)

BTE/BATs

0.96%

1.18%

1.50%

2.12%

2.25%

3.59%

3.32%

3.10%

CIX/Chi-X

9.41%

9.36%

10.35%

11.63%

12.26%

13.70%

14.15%

14.14%

CPH/Copenhagen

0.94%

1.01%

0.76%

0.97%

0.99%

0.77%

0.69%

0.86%

ENA/Amsterdam

5.84%

5.97%

6.05%

6.12%

6.19%

5.62%

6.08%

5.87%

ENB/Brussels

1.32%

1.41%

1.32%

1.22%

1.36%

1.19%

1.01%

1.54%

ENL/Lisbon

0.39%

0.36%

0.40%

0.47%

0.54%

0.40%

0.48%

ENX/Paris

13.81%

13.15%

12.97%

13.09%

11.85%

11.82%

11.69%

11.88%

GER/Xetra

13.20%

12.46%

13.13%

12.76%

11.94%

10.86%

11.46%

11.09%

HEL/Helsinki

1.62%

1.61%

1.45%

1.76%

1.35%

1.20%

1.46%

1.05%

LSE/London

19.88%

19.14%

20.59%

17.82%

17.22%

19.91%

17.85%

17.76%

MAD/Madrid

8.77%

7.85%

8.19%

8.56%

8.11%

8.35%

8.85%

6.87%

MIL/Milan

6.82%

7.11%

7.41%

9.21%

11.99%

9.12%

8.38%

10.19%

0.01%

NAE/Nasdaq Arca Europe

NEU/Nasdaq-OMX

0.12%

0.10%

0.09%

0.17%

0.43%

0.49%

0.68%

0.60%

STO/Stockholm

3.71%

4.32%

3.86%

4.17%

3.61%

3.21%

3.22%

3.14%

TRQ/Turquoise

5.30%

6.15%

4.18%

2.52%

2.89%

3.61%

4.39%

5.56%

VTX/SWX

7.90%

8.80%

7.75%

7.42%

7.02%

6.15%

6.37%

5.87%

Monthly Total

100.00%

SEPTEMBER 2009 â&#x20AC;˘ FTSE GLOBAL MARKETS

INDEX MARKET SHARE BY VENUE FOR THE WEEK ENDING 7TH AUGUST (EUROPE ONLY)

Index market share by venue for the week ending 7th August 2009 Primary

Alternative Venues

Index

Venue

Chi-X

Turquoise

Nasdaq OMX

BATS

Copen.

Amst.

Paris

Xetra

Helsinki

AEX

Amsterdam

66.80%

17.55%

6.49%

0.51%

3.52%

4.83%

0.20%

BEL 20

Brussels

64.80%

9.44%

3.17%

0.28%

2.57%

19.40%

0.06%

CAC 40

Paris

67.59%

15.36%

5.70%

0.80%

4.39%

5.14%

0.16%

DAX

Xetra

73.90%

15.50%

5.08%

0.55%

3.98%

†

0.03%

FTSE 100

London

66.23%

19.65%

8.83%

1.09%

4.19%

FTSE 250

London

70.41%

20.36%

4.84%

0.31%

4.08%

IBEX 35

Madrid

99.35%

0.52%

0.02%

†

0.03%

FTSE MIB

Milan

90.28%

6.00%

0.85%

0.07%

2.68%

†

0.08%

NORDIC 40

Stockholm

47.94%

16.17%

3.95%

0.72%

0.57%

13.83%

†

0.28%

16.36%

PSI 20

Lisbon

98.64%

0.08%

1.23%

†

SMI

SWX

82.43%

9.25%

7.22%

0.47%

0.63%

† market share < 0.01%

COMMENTARY

2.1

Last month we looked at how the rest of Europe was catching up with London in terms of fragmentation. This trend seems to be continuing although London seems to have opened up “a lead” over its European rivals. This is further illustrated if you look at the top 20 most fragmented stocks in Europe—available at http://fragmentation.fidessa.com/stats/—as all of these are London based stocks.

1.8 1.6 1.3 1 Aug

Sep

Oct

Nov

DAX

Dec

Jan

AEX

Feb

Mar

CAC 40

Apr

May

Jun

Jul

FTSE 100

European Top 20 Fragmented Stocks TW

-46

-53

-93

4 5

-2

-4

-91

-61

-11

-67

-25

-69

-3

Wks

Stock

Description

IMT.L

IMP.TOBACCO GRP ORD 10P

2.67

ISYS.L

INVENSYS ORD 10P

2.62

NFDS.L

NTHN.FOODS ORD 25P

2.62

LAND.L

LAND SECS. ORD 10P

2.56

BLND.L

BR.LAND ORD 25P

2.53

TOMK.L

TOMKINS ORD USD0.09

2.52

AU..L

AUTONOMY ORD SHS 1/3P

2.52

SSE.L

SCOT.&STH.ENRGY ORD 50P

2.51

MRW.L

MORRISON (WM) ORD 10P

2.48

CCL.L

CARNIVAL ORD USD 1.66

2.46

DGE.L

DIAGEO ORD 28 101/108P

2.46

HMV.L

HMV GRP ORD 1P

2.45

CBRY.L

CADBURY ORD 10P

2.45

NXT.L

NEXT ORD 10P

2.44

COB.L

COBHAM ORD 2.5P

2.44

ANTO.L

ANTOFAGASTA ORD 5P

2.43

SN..L

SMITH&NEPHEW ORD USD0.20

2.43 2.42

-26

-78

-63

-83

-9

FFI

MKS.L

MARKS & SP. ORD 25P

BA..L

BAE SYS. ORD 2.5P

2.4

CPI.L

CAPITA GROUP ORD 2.066666P

2.4

Wks = Number of weeks in the top 20 over the last year.

2.1 1.8 1.6 1.3 1 Aug

Sep

Oct

Nov

DAX

Dec

AEX

Jan

Feb

CAC 40

Mar

Apr

May

Jun

Jul

FTSE 100

Stocks that comprise the IBEX 35 have resolutely refused to move onto the new MTF platforms. Even Chi-X, which has successfully garnered nearly 14% of all European trading, barely registers more than one half of one per cent of Spanish equities trading. The reason that this is so is that, despite the MiFID directive, there are a number of technical obstacles in terms of clearing and settlement that exist in Spain that make trading on MTFs unattractive and cumbersome. The other national exchanges are becoming more pan-European in response to the competitive threat and so it seems likely that the local regulators in Spain will, in time, be forced to open up their market too.

Having said this, it is worthwhile looking at those markets where fragmentation is not following the general trend. One of the most obvious examples of this is Spain.

All data © Fidessa Group plc. All opinions and data here are entirely the responsibility of Fidessa Group plc. If you require more information on the data provided here or about FFI, please contact: fragmentation@fidessa.com.

FTSE GLOBAL MARKETS • SEPTEMBER 2009

5-Year Total Return Performance Graph 500

FTSE All-World Index

400

FTSE Emerging Index

300

FTSE Global Government Bond Index

200

FTSE EPRA/NAREIT Global Index

100

FTSE4Good Global Index FTSE GWA Developed Index -0 9

FTSE RAFI Emerging Index

Ju ly

Ja n09

-0 8 Ju ly

Ja n08

-0 7 Ju ly

Ja n07

-0 6 Ju ly

Ja n06

-0 5 Ju ly

Ja n05

-0 4

Index Level Rebased (31 July 2009=100)

600

Ju ly

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 (%pa)

FTSE All-World Index

USD

2,762

214.53

19.4

31.3

-19.9

19.9

2.82

FTSE World Index

USD

2,339

502.50

18.8

29.8

-20.2

18.4

2.85

FTSE Developed Index

USD

1,937

200.68

18.3

27.8

-20.4

16.4

2.85

FTSE All-World Indices

FTSE Emerging Index

USD

825

533.55

28.2

63.5

-16.1

53.0

2.60

FTSE Advanced Emerging Index

USD

402

488.18

24.4

59.4

-17.0

49.3

2.90

FTSE Secondary Emerging Index

USD

423

641.70

33.9

69.7

-14.6

58.7

2.20

FTSE Global All Cap Index

USD

7,382

342.31

19.5

31.9

-20.1

20.7

2.73

FTSE Developed All Cap Index

USD

5,734

322.71

18.4

28.5

-20.7

17.2

2.76

FTSE Emerging All Cap Index

USD

1,648

705.51

28.8

65.2

-15.8

54.7

2.57

FTSE Advanced Emerging All Cap Index

USD

865

658.09

24.8

61.4

-16.6

51.2

2.84

FTSE Secondary Emerging Index

USD

783

813.39

35.0

71.1

-14.4

60.1

2.19

USD

714

179.07

4.7

3.4

6.5

-0.5

2.83

FTSE Global Equity Indices

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

USD

261

2033.10

23.9

33.7

-30.0

16.5

4.95

FTSE EPRA/NAREIT Global REITs Index

USD

179

635.60

15.7

20.9

-37.1

3.9

6.58

FTSE EPRA/NAREIT Global Dividend+ Index

USD

229

1413.08

21.9

32.1

-30.4

15.5

5.62

FTSE EPRA/NAREIT Global Rental Index

USD

217

722.77

16.6

23.2

-36.0

6.1

6.18

FTSE EPRA/NAREIT Global Non-Rental Index

USD

1068.72

43.1

63.1

-12.7

47.0

2.29

FTSE4Good Global Index

USD

664

5521.33

20.8

32.7

-19.5

18.5

3.16

FTSE4Good Global 100 Index

USD

103

4714.46

20.7

30.1

-20.6

15.8

3.39

SRI

Investment Strategy FTSE4Good Global Index

USD

664

5521.33

20.8

32.7

-19.5

18.5

3.16

FTSE RAFI Developed ex US 1000 Index

USD

1,015

5536.19

25.2

44.1

-15.1

29.1

3.59

FTSE RAFI Emerging Index

USD

359

5800.25

28.3

67.9

-10.8

54.5

2.46

SOURCE: FTSE Group and Thomson Datastream, data as at 31 July 2009

SEPTEMBER 2009 â&#x20AC;˘ FTSE GLOBAL MARKETS

Americas Market Indices 5-Year Total Return Performance Graph 300

FTSE Americas Index

Index Level Rebased (31 July 2009=100) Ju ly04

250

FTSE Americas Government Bond Index

200

FTSE EPRA/NAREIT North America Index

150

FTSE EPRA/NAREIT US Dividend+ Index

100

FTSE4Good USIndex FTSE GWA US Index 9 Ju ly0

Ja n09

8 Ju ly0

Ja n08

7 Ju ly0

Ja n07

6 Ju ly0

Ja n06

5 Ju ly0

Ja n05

FTSE RAFI US 1000 Index

Table of Total Returns Index Name

Currency

Constituents

Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%pa)

FTSE All-World Indices FTSE Americas Index

USD

793

647.47

15.5

25.0

-19.8

15.4

2.22

FTSE North America Index

USD

666

708.42

14.8

23.4

-19.5

13.5

2.15

FTSE Latin America Index

USD

127

915.86

28.9

58.8

-22.2

58.9

3.20

FTSE Global Equity Indices FTSE Americas All Cap Index

USD

2,566

295.43

15.7

25.9

-20.1

16.2

2.11

FTSE North America All Cap Index

USD

2,373

283.03

14.9

24.3

-19.9

14.3

2.05

FTSE Latin America All Cap Index

USD

193

1287.47

29.9

60.5

-21.8

60.4

3.14

FTSE Americas Government Bond Index

USD

162

185.07

-0.7

-0.5

6.4

-2.6

3.20

FTSE USA Government Bond Index

USD

147

181.16

-1.1

7.0

-3.1

3.17

FTSE EPRA/NAREIT North America Index

USD

115

2085.22

11.4

19.6

-39.6

-0.5

5.04

FTSE EPRA/NAREIT US Dividend+ Index

USD

1136.23

9.4

17.2

-40.6

-3.7

4.91

FTSE EPRA/NAREIT North America Rental Index

USD

112

708.01

11.8

20.3

-37.6

0.4

5.01

FTSE EPRA/NAREIT North America Non-Rental Index

USD

232.27

-1.6

-8.0

-78.1

-33.5

6.51

FTSE NAREIT Composite Index

USD

113

2072.83

9.6

17.8

-37.0

-1.5

5.86

FTSE NAREIT Equity REITs Index

USD

4943.57

8.6

17.3

-39.5

-3.0

4.92

FTSE4Good US Index

USD

137

4299.06

16.8

29.8

-16.1

15.8

2.05

FTSE4Good US 100 Index

USD

101

4122.30

16.6

29.2

-16.4

15.3

2.05

FTSE GWA US Index

USD

613

2648.92

16.3

29.1

-19.2

16.1

2.20

FTSE RAFI US 1000 Index

USD

996

4599.28

19.6

37.0

-13.2

22.5

1.83

FTSE RAFI US Mid Small 1500 Index

USD

1,479

4305.09

21.1

47.8

-11.3

30.5

2.13

Fixed Income

Real Estate

SRI

Investment Strategy

SOURCE: FTSE Group and Thomson Datastream, data as at 31 July 2009

FTSE GLOBAL MARKETS • SEPTEMBER 2009

5-Year Total Return Performance Graph FTSE Europe Index FTSE All-Share Index

400

Index Level Rebased (31 July 2009=100) Ju ly04

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

Ju ly09

Ja n09

Ju ly08

Ja n08

Ju ly07

Ja n07

Ju ly06

Ja n06

Ju ly05

FTSE GWA Developed Europe Index Ja n05

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 (%pa)

FTSE All-World Indices FTSE Europe Index

EUR

551

200.61

14.1

22.6

-18.3

17.8

3.85

FTSE Eurobloc Index

EUR

1,969

111.90

13.3

22.3

-19.1

13.7

3.36

FTSE Developed Europe ex UK Index

EUR

380

204.17

13.6

22.6

-17.0

15.2

3.71

FTSE Developed Europe Index

EUR

492

198.53

14.0

21.6

-17.1

17.0

3.90

FTSE Europe All Cap Index

EUR

1,616

311.76

14.1

23.2

-18.5

18.9

3.77

FTSE Eurobloc All Cap Index

EUR

803

329.45

13.4

22.6

-19.1

14.4

4.06

FTSE Developed Europe All Cap ex UK Index

EUR

1,094

338.44

13.7

23.0

-17.4

16.0

3.66

FTSE Developed Europe All Cap Index

EUR

1,496

310.39

13.9

22.2

-17.4

18.1

3.82

FTSE All-Share Index

GBP

623

3018.41

9.4

16.1

-10.5

9.4

4.11

FTSE 100 Index

GBP

102

2871.51

9.8

14.1

-10.9

6.8

4.27

FTSEurofirst 80 Index

EUR

4248.13

13.9

22.4

-18.4

11.8

4.39

FTSEurofirst 100 Index

EUR

3784.07

14.5

20.2

-17.6

14.4

4.42

FTSEurofirst 300 Index

EUR

311

1302.30

13.9

20.3

-17.8

15.4

3.98

FTSE/JSE Top 40 Index

SAR

2444.07

18.2

19.6

-12.5

14.0

3.28

FTSE/JSE All-Share Index

SAR

165

2698.16

17.8

19.7

-9.4

14.6

3.48

FTSE Russia IOB Index

USD

724.21

18.9

82.7

-45.7

68.7

2.62

FTSE Global Equity Indices

Region Specific

Fixed Income FTSE Eurozone Government Bond Index

EUR

232

167.54

1.5

4.2

11.4

3.0

3.62

FTSE Pfandbrief Index

EUR

376

199.89

3.3

4.3

10.2

4.5

4.06

FTSE Actuaries UK Conventional Gilts All Stocks Index

GBP

2248.29

-0.8

1.8

9.4

-2.9

4.13

FTSE EPRA/NAREIT Europe Index

EUR

1513.48

10.4

18.3

-30.1

12.2

6.07

FTSE EPRA/NAREIT Europe REITs Index

EUR

558.82

11.8

18.3

-27.2

12.0

6.71

FTSE EPRA/NAREIT Europe ex UK Dividend+ Index

EUR

1829.55

10.7

14.4

-18.8

14.2

6.45

FTSE EPRA/NAREIT Europe Rental Index

EUR

592.09

10.4

18.2

-29.6

11.4

6.22

FTSE EPRA/NAREIT Europe Non-Rental Index

EUR

457.64

12.2

21.5

-36.8

37.0

1.64

FTSE4Good Europe Index

EUR

270

3985.16

14.4

22.0

-15.8

17.4

4.01

FTSE4Good Europe 50 Index

EUR

3485.14

14.5

18.5

-17.4

13.6

4.34

FTSE GWA Developed Europe Index

EUR

492

2883.09

16.3

34.5

-12.6

27.4

4.00

FTSE RAFI Europe Index

EUR

524

4521.77

17.3

34.0

-10.2

27.6

3.34

Real Estate

SRI

Investment Strategy

SOURCE: FTSE Group and Thomson Datastream, data as at 31 July 2009

SEPTEMBER 2009 â&#x20AC;˘ FTSE GLOBAL MARKETS

Asia Pacific Market Indices 5-Year Total Return Performance Graph

FTSE Asia Pacific 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

Ju ly09

Ja n09

Ju ly08

Ja n08

Ju ly07

Ja n07

Ju ly06

Ja n06

Ju ly05

FTSE GWA Japan Index Ja n05

Ju ly04

Index Level Rebased (31 July 2009=100)

FTSE/ASEAN 40 Index

FTSE RAFI Kaigai 1000 Index

Table of Total Returns Index Name

Currency

Constituents

Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%pa)

FTSE Asia Pacific Index

USD

1,282

254.59

24.7

39.2

-12.3

29.2

2.71

FTSE Asia Pacific ex Japan Index

USD

825

484.30

30.6

62.9

-9.3

50.9

3.06

FTSE Japan Index

USD

457

79.08

13.2

22.0

-26.6

12.4

2.18

FTSE All-World Indices

FTSE Global Equity Indices FTSE Asia Pacific All Cap Index

USD

3,015

431.01

25.4

40.1

-12.1

30.1

2.71

FTSE Asia Pacific All Cap ex Japan Index

USD

1,777

597.46

31.4

65.1

-9.8

52.9

3.07

FTSE Japan All Cap Index

USD

1,238

250.51

13.6

21.8

-25.6

12.4

2.19

FTSE/ASEAN Index

USD

148

492.70

37.9

62.2

-5.4

55.0

3.26

FTSE Bursa Malaysia 100 Index

MYR

100

8542.45

21.4

37.8

5.8

39.6

3.05

TSEC Taiwan 50 Index

TWD

6279.38

17.7

62.4

0.4

49.6

3.62

FTSE Xinhua All-Share Index

CNY

1,001

9395.10

38.0

80.6

32.9

103.4

0.85

FTSE/Xinhua China 25 Index

CNY

23521.21

33.9

66.4

-5.7

50.4

2.45

USD

241

133.20

3.7

-5.3

15.9

-5.1

1.37

FTSE EPRA/NAREIT Asia Index

USD

1952.15

38.7

48.7

-16.3

35.6

4.45

FTSE EPRA/NAREIT Asia 33 Index

USD

1255.06

35.4

42.4

-16.6

31.1

9.80

FTSE EPRA/NAREIT Asia Dividend+ Index

USD

1943.15

37.9

49.6

-14.8

40.8

5.76

FTSE EPRA/NAREIT Asia Rental Index

USD

782.69

27.2

22.6

-31.6

13.0

8.83

FTSE EPRA/NAREIT Asia Non-Rental Index

USD

1185.84

45.5

66.8

-5.5

51.2

2.18

Region Specific

Fixed Income FTSE Asia Pacific Government Bond Index Real Estate

Infrastructure FTSE IDFC India Infrastructure Index

IRP

942.14

43.8

70.4

-9.9

55.1

0.68

FTSE IDFC India Infrastructure 30 Index

IRP

1072.78

46.4

75.4

-3.2

62.6

0.68

JPY

189

3855.14

12.9

23.4

-27.6

13.9

2.30

FTSE SGX Shariah 100 Index

USD

100

4876.44

19.7

29.6

-14.2

21.4

2.40

FTSE Bursa Malaysia Hijrah Shariah Index

MYR

9868.21

16.4

31.5

1.8

34.9

3.04

JPY

100

1057.92

13.5

26.0

-25.7

16.4

2.23

SRI FTSE4Good Japan Index Shariah

FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index

JPY

457

2817.31

14.1

29.6

-22.5

21.0

2.24

FTSE GWA Australia Index

AUD

102

3528.16

13.4

24.4

-8.2

18.1

5.64

FTSE RAFI Australia Index

AUD

5669.81

12.2

27.3

-2.8

19.1

9.52

FTSE RAFI Singapore Index

SGD

7616.03

42.9

58.2

-1.8

56.4

3.44

FTSE RAFI Japan Index

JPY

278

3950.49

13.5

26.4

-23.0

16.4

2.25

FTSE RAFI Kaigai 1000 Index

JPY

1,016

3786.63

19.2

51.1

-25.3

32.8

2.97

HKD

6832.46

34.7

68.5

-1.8

53.8

2.65

FTSE RAFI China 50 Index

SOURCE: FTSE Group and Thomson Datastream, data as at 31 July 2009

FTSE GLOBAL MARKETS â&#x20AC;˘ SEPTEMBER 2009

INDEX CALENDAR

Index Reviews September – October 2009 Date

Index Series

Review Frequency/Type

Effective Data Cut-off (Close of business)

Early Sep Early Sep

ATX CAC 40

30-Sep

31-Aug

18-Sep

31-Aug

Early Sep

S&P / TSX

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

18-Sep

28-Aug

01-Sep 03-Sep 04-Sep

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

18-Sep 18-Sep

30-Jun 31-Aug

07-Sep

TOPIX

08-Sep 09-Sep 09-Sep 09-Sep 09-Sep

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

09-Sep 09-Sep 09-Sep 09-Sep 09-Sep 09-Sep 09-Sep 09-Sep 09-Sep 09-Sep 11-Sep 11-Sep 11-Sep 11-Sep 11-Sep 11-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 15-Sep 15-Sep 16-Sep 23-Sep 06-Oct 07-Oct 08-Oct Mid Oct Mid Oct

Annual review / Japan Quarterly review/ Ordinary adjustment Quarterly review - shares, S&P / ASX 300 consituents Monthly review - additions & free float adjustment Semi-annual constiuents review Quarterly review Quarterly review Semi-annual review

18-Sep

28-Aug

29-Sep 18-Sep 18-Sep 18-Sep 18-Sep

31-Aug 31-Aug 08-Sep 31-Aug 31-Aug

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

18-Sep 18-Sep 18-Sep 18-Sep 18-Sep 18-Sep 18-Sep 18-Sep

30-Jun 31-Aug 31-Aug 31-Aug 31-Aug 31-Aug 30-Jun 31-Aug

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

18-Sep 18-Sep 18-Sep 18-Sep 18-Sep

07-Sep 31-Aug 31-Aug 31-Aug 04-Sep

Quarterly review Quarterly review Quarterly review (components) Style review Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review - IPO additions only Blue chip (annual review) Quarterly review Quarterly review Annual review (constituents) Quarterly review Quarterly review - share in issue Semi-annual review

18-Sep 18-Sep 18-Sep 18-Sep 18-Sep 18-Sep 18-Sep 18-Sep 18-Sep 18-Sep 18-Sep 30-Sep 18-Sep 30-Sep 16-Oct 29-Oct 16-Oct 31-Oct 30-Nov

31-Aug 31-Aug 25-Aug 07-Sep 04-Sep 04-Sep 04-Sep 04-Sep 04-Sep 04-Sep 14-Sep 31-Aug 01-Sep 31-Aug 21-Sep 30-Sep 30-Sep 30 Sep 30-Sep

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

SEPTEMBER 2009 • FTSE GLOBAL MARKETS

GM EDITORIAL 36.qxd:.

21/8/09

12:48

Page IBC1

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