FTSE Global Markets by FTSE Global Markets

ROUNDTABLE: FLEXIBLE INVESTMENT STRATEGIES BUOY COMMODITIES ISSUE 37 • OCTOBER 2009

IS BANK:

SUBTLE STRENGTH

Trading by stealth The low, slow return of the GCC’s banks Oyak bucks the trend Why US healthcare is so very scary

SPAIN’S REGIONAL BANKS FEEL THE PAIN

Outlook EDITORIAL DIRECTOR: Francesca Carnevale, tel: +44 [0]20 7680 5152, mob: 0795 855 5142; email: francesca@berlinguer.com, fax: +44 [0]20 7680 5155 SUB EDITOR: Roy Shipston, tel: +44 [0]20 7680 5154 email: roy.shipston@berlinguer.com CONTRIBUTING EDITORS: Art Detman, Neil O’Hara, David Simons. SPECIAL CORRESPONDENTS: Rodrigo Amaral (Emerging Markets); Andrew Cavenagh (Debt); Lynn Strongin Dodds (Securities Services); Vanja Dragomanovich (Commodities); Mark Faithfull (Real Estate); Ruth Hughes Liley (Trading Services, Europe); John Rumsey (Latin America); Ian Williams (US/Emerging Markets/Sector Analysis); Paul Whitfield (Asset Management/Europe). FTSE EDITORIAL BOARD: Mark Makepeace (CEO); Donald Keith; Imogen Dillon-Hatcher; Paul Hoff; Andrew Buckley; Jerry Moskowitz; Andy Harvell; Sandra Steel; Nigel Henderson. PUBLISHING & SALES DIRECTOR: Paul Spendiff, tel +44 [0]20 7680 5153 email: paul.spendiff@berlinguer.com EUROPEAN SALES MANAGER: Nicole Taylor, tel +44 [0]20 7680 5156 email: nicole.taylor@berlinguer.com OVERSEAS REPRESENTATION: Adil Jilla (Middle East & North Africa) Faredoon Kuka, Ronni Mystry Associates Pvt (India) Leddy & Associates (United States), Can Sonmez (Turkey) PUBLISHED BY: Berlinguer Ltd, 1st Floor, Rennie House, 57-60 Aldgate High Street, London EC3N 1AL Tel: +44 [0]20 7680 5151 www.berlinguer.com ART DIRECTION AND PRODUCTION: Russell Smith, IntuitiveDesign, 13 North St., Tolleshunt D’Arcy, Maldon, Essex CM9 8TF, email: russell@intuitive-design.co.uk PRINTED BY: Headley Brothers Ltd, The Invicta Press, Queens Road, Ashford, Kent TN24 8HH DISTRIBUTION: Air Business Ltd, 4 The Merlin Centre, Acrewood Way, St Albans, AL4 OJY. TO SECURE YOUR OWN SUBSCRIPTION: Please visit: www.berlinguer.com or Email: subscriptions@berlinguer.com Subscription price: £399 per annum (8 issues) FTSE Global Markets is published eight times a year. No part of this publication may be reproduced or used in any form of advertising without the express permission of Berlinguer Ltd. [Copyright © Berlinguer Ltd 2009. All rights reserved.] FTSE™ is a trademark of the London Stock Exchange plc and the Financial Times Limited and is used by Berlinguer Ltd under licence. FTSE International Limited would like to stress that the contents, opinions and sentiments expressed in the articles and features contained in FTSE Global Markets do not represent FTSE International Limited’s ideas and opinions. The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors. All information in this magazine is provided for information purposes only. Every effort is made to ensure that any and all information given in this publication is accurate, but not responsibility or liability can be accepted by FTSE International Limited and Berlinguer Ltd, for any errors, or omissions or for any loss arising from the use of this publication. All copyright and database rights in the FTSE Indices belong to FTSE International Limited or Berlinguer Ltd or its licensors. Reproduction of the data comprising the FTSE indices is not permitted. You agree to comply with any restrictions or conditions imposed upon the use, access, or storage of the data as may be notified to you by FTSE International Limited, or Berlinguer Ltd and you may be required to enter into a separate agreement with FTSE International Limited and Berlinguer Ltd.

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FTSE GLOBAL MARKETS • OCTOBER 2009

T APPEARS THAT the United State’s Securities and Exchange Commission (SEC) intends to establish a new Division of Risk, Strategy and Financial Innovation, which will track risks that develop as financial markets innovate and undergo rapid change. Early indications are that University of Texas law professor Henry TC Hu will head the division. While bringing the whole notion of risk centre stage, the new division will also crunch several previously separate SEC divisions into one: highlighting the current administration’s propensity to match the cutting of Gordian knots with ever cheaper blades. It looks like it will be a salient characteristic of the new puritan age which appears to be creeping upon us all, upon whichever side of the Atlantic you find yourself. “The derivatives revolution, the rise of hedge funds and institutional investors, technological change and other factors have transformed both capital markets and corporate governance,” Hu noted in a preliminary interview with US journalists. He might have well been talking about the key themes running through this edition. It is probably a bit too early to really get a strong sense of some of the drivers of the second decade of this century and read meaningful recovery into the occasional green shoot that springs up here and there. However, we examine some of the as yet immature pointers of tomorrow’s discussion points. Neil O’Hara was tasked with looking at some of those trends. In our Exchange Report, this month, he looks at the care with which derivatives exchanges are attempting to rebuild their franchises after a hair-raising and deep dip in trading volumes through the first half of 2009; and moves by the US government to encourage on-exchange trading. Market participants were quick to point out that hard limits would drive business away from the US exchanges to either foreign venues or the bilateral OTC market—a result that conflicts with the Obama administration’s stated desire to encourage trading of standardised OTC derivatives on an exchange. “Position limits won’t achieve the regulators’objective and it will reduce the market share of US entities,”Paul Shen, head trader at RG Niederhoffer Capital Management told Neil. “We know how hard it is to get market share back.”Can the exchanges do it? Then we asked him to review the securitisation market, which took the brunt of the pounding of the credit crunch. Can the segment return to full health? It’s still finely balanced, thinks O’Hara. Find out more on page 33. The other market division which is still in need of some TLC is obviously securities lending. Neil was joined in this exercise by Dave Simons. The focus on intrinsic value has changed the perception of securities lending from an operational function to a form of investment management—and requires a different approach to due diligence. Find out what that means in practice and whether this new approach has any meaning for those funds which withdrew from the segment in the first half of 2009. Might they be tempted back? Healthcare is obviously riveting and riling much of America right now; threatening to tear apart the fragile alliances of the left of centre political elite. Now that Edward Kennedy has moved to higher planes, there is no-one to steady the ship in the Democratic centre long enough for reasonable discussion of what must be one of the key challenges of the current US administration. Forget Central Asia: the real political battleground for hearts and minds over the coming decade will be between those who can and those who cannot can afford universal healthcare. Ian Williams discusses the salient points in our Market Leader.

Francesca Carnevale, Editorial Director September 2009 Cover photo: Photograph of Ersin Özince, chief executive officer of Iş Bankasi, and chairman of the board of The Banks Association of Turkey. Photograph taken on behalf of FTSE Global Markets by Yildirim Çelik, Turunco Foto, Istanbul, September 2009.

Contents COVER STORY THE QUIET APPEAL OF IS BANK ................................................................................Page 50 IS Bank’s hallowed position in the pantheon of Turkish banking is still intact, despite increased competition from private banking majors Akbank and Garanti. IS Bank chief executive Ersin Özince, explains the dynamics of the bank’s mid-term business growth plan and the strategic imperatives of a national banking segment that is in transition.

DEPARTMENTS MARKET LEADER

............................................................................Page 6 Ian Williams takes the pulse of the US healthcare debate.

BYE BYE MISS AMERICAN PIE?

IN THE MARKETS

THE IMPORTANCE OF THE CURRENT ACCOUNT ............................Page 14

INDEX REVIEW

CASTLES IN THE SKY ........................................................................................Page 20

FACE TO FACE

Private equity looks set to make a comeback—albeit a slow one. Neil O’Hara reports. Simon Denham, managing director, Capital Spreads, takes the bearish long view.

..........................................................................Page 22 Michael Krogmann, executive director, development and sales, Xetra, talks business growth.

XETRA HOGS THE HEADLINES

PROMISES, PROMISES – THE OUTLOOK FOR SUKUK ................Page 26

REGIONAL REVIEW DEBT REPORT

Will Islamic bonds finally achieve their true potential?

........................................................................................Page 31 Middle East banks are traditionally conservative lenders. Is it time to change?

TO STAND AND DELIVER

......................................Page 33 Neil O’Hara looks for signs of TLC in the still stretched securitisation markets.

SECURITISATION: STILL IN INTENSIVE CARE?

......................................Page 37 Vanya Dragomanovich reviews the challenges facing banks in Eastern Europe.

EASTERN EUROPE’S ROLLER-COASTER RIDE

....................Page 41 Rodrigo Amaral looks at the expected changes in Spain’s regional banking segment.

SPAIN’S REGIONAL BANKS FACE CONSOLIDATION

COUNTRY REPORTS

TURKISH BANK’S ENJOY FINER MARGINS ON LOANS ............Page 44

It’s halcyon days for Turkey’s banks and stock exchange. Can the economy sustain the trends?

....................................................Page 48 Turkey’s military pension fund sets a new benchmark.

OYAK: THE PENSIONERS’ POSTER BOY

EXCHANGE REPORT DATA PAGES 2

............Page 73 Neil O’Hara looks at the ways in which key derivatives exchanges have refocused services.

THE SLOW FIGHTBACK OF DERIVATIVES EXCHANGES

ETF Data, supplied by Barclays Global Investors ..........................................................Page 88 Fidessa Fragmentation Index ................................................................................................Page 90 Market Reports by FTSE Research ......................................................................................Page 92 Index Calendar............................................................................................................................Page 96

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Contents FEATURES TRADING REPORT

ANONYMITY: FOOTPRINTS IN THE SNOW..................................Page 53 Cees Vermaas, head of European cash markets, NYSE Euronext, thinks that anonymity leads to more efficient markets with tighter spreads, more volume and better price discovery mechanisms. “If you look at the history of anonymity, years ago you had to have ID if you wanted to trade—you could see your counterparties. We think anonymity has resulted in fairer markets because all participants have equal access to information regardless of whether they are big or small,” he says. Is he right? Ruth Hughes Liley reports.

COMMODITIES

ROUNDTABLE: COMMODITIES AS AN ALTERNATIVE INVESTMENT STRATEGY................................................Page 59

According to David Donora, head of commodities, Threadneedle Asset Management, says that, in general, “investors should become much more discerning about which commodities they invest in… investors will be looking at what they want to achieve with commodities and tailor their holdings. This raises the question: how best to invest in those commodities? What do the rest of the roundtable attendees think?

RISING DEMAND IMPACTS ON PLATINUM PRICES ......................Page 69 SWEET & SOUR: VOLATILITY IN DEMAND FOR SUGAR ..........Page 71 SECURITIES LENDING

GREEN SHOOTS – BLUE SKY ........................................................................Page 75

At first glance nothing seems different, but in fact, everything has changed. The securities lending business is now having to re-evaluate how it operates in the postcrisis quagmire. The focus on intrinsic value has changed the perception of securities lending from an operational function to a form of investment management—and requires a different approach to due diligence, reports Neil O’Hara.

THE DEVIL IN THE DETAIL ..............................................................................Page 81

Securities lending programmes acted as a reliable generator of revenue that tended to operate out of the spotlight. Since last autumn’s wake-up call, however, a vast majority of securities-lending clients have increased investment oversight while reducing or eliminating exposure to riskier products. For their part, agents have responded by adding tools of transparency and sharpening relationship-management capabilities as never before. Dave Simons reports from Boston.

ASSET MANAGEMENT

THE OMEGA EFFECT ..........................................................................................Page 83 Omega Analysis has created proprietary financial statistical techniques based on its expertise in Omega functions—an important innovation in the mathematics of probability and statistics the company pioneered. Omega says its methods would have warned banks and their shareholders of the economic downturn. Are they right? By Ana Cascon and William Shadwick.

MONEY MARKET FUNDS GO BACK TO BASICS ............................Page 85 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.

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Market Leader US HEALTHCARE REFORM: THE INVESTOR VIEW

AMERICAN PIE The proportion of GDP spent on healthcare in the United States, at 16.5%, is the highest in the world, double the OECD average. Costs are growing, even as the demands on it are about to escalate with an ageing population. In terms of longevity, despite the patriotic bluster, the US is not doing as well as many of its industrialised counterparts. The present system leaves 47m Americans uninsured, which is one reason why the US average life span of 77.9 is years below most other developed countries. Ian Williams reports.

President Barack Obama, flanked by Secretary of State Hillary Clinton, speaks during a meeting with members of the Cabinet in the Cabinet Room, September 10th 2009 in Washington, DC. During the meeting President Obama said he accepted the apology of Congressman Joe Wilson (Republican, South Carolina) for yelling out “You Lie” during Obama’s speech on healthcare reform to a joint session of Congress. Photograph by Olivier Douliery for ABACAUSA.COM. Photograph supplied by PA Photos, September 2009.

system as “a very high-tech industrial complex, built up over 50 years, developed in isolation, very top heavy, and very expensive”. It is a huge, growing industry grossing over $2.5trn a year. However, with the dubious reform battle in Washington, there is investor confusion about who gets the

opportunity and who gets the crisis out of President Obama’s reforms. Everyone agrees that something must change. The proportion of US GDP spent on healthcare, at 16.5%, is the highest in the world, double the OECD average. Its costs are growing, even as the demands on it are about to escalate with an ageing population. In

POCRYPHALLY, WHEN A lost traveller in Ireland asked for directions, he was told: “Well, if I was you, I wouldn’t start from here.” Most assessments of US healthcare would include that not very useful advice. Todd McCallister, codirector of Eagle Asset Management, dispassionately describes the present

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Market Leader US HEALTHCARE REFORM: THE INVESTOR VIEW

terms of outcomes such as longevity, despite the patriotic bluster, the US is not doing as well as many of its industrialised counterparts. The system leaves 47m Americans uninsured, which is one reason why the US average life span of 77.9 is years below most other developed countries. Anyone who doubts the ability of well-heeled interest groups to thwart the public good in Washington only has to look at how, over the years, the tobacco companies thwarted the one single measure most likely to improve overall American health figures—high Federal taxes on tobacco. Any reform has to stroke influential stakeholders, most notably the companies that provide the insurance, the drugs and the healthcare and, to a lesser extent, the people who actually use the service. The health insurance companies, by far the industry’s most profitable sector, have tried with some degree of success to confuse public insurance with public provision. In reality, between Medicare, Medicaid,Veterans, the military and tax exemptions for “charitable” care, the US government already covers more than private insurers and there is no suggestion of nationalising the private provision of medical care. The only question is who pays the private sector, and how much? So any reform offers a host of business opportunities. Industry in general, from Wal-Mart to General Motors, has been moving towards a public option as the healthcare costs they bear, uniquely in the industrialised world, press down on their bottom line. Health industry analyst Jack Plunkett assesses“private insurance companies would eventually suffer as their current clientele migrates to the public option for lower premiums.” Much-quoted research has estimated that 88m people, or 56% of those with employer-provided

Photograph © Andrey Folov/Dreamstime.com, supplied September 2009.

coverage, would desert private for a public option. Much less quoted was that United Healthcare, the biggest insurer with profit in 2008 of $5.3bn on $81.2bn revenue, actually owned the research group! That was intended to pressure legislators and it might even work in the USA, whereas in most countries it would reinforce the idea that the insurers are greedy dinosaurs getting their Darwinian comeuppance. Jeff Gold of pressure group Healthcare for All confesses to a sneaking admiration for the insurers’ business and lobbying acumen.“They control the data, and they’ve been able to slice and dice their clientele and tailor their policies so that none of their customers can be sure what they are insured for—but the shareholders can be very sure of benefiting.”In fact, between 2000 and 2007 the net profit of the ten biggest insurers soared by 428%, even as their premiums and copayments from the insured soared. That power over the data was reinforced when United Healthcare recently paid $400m in settlement to the State of NewYork for manipulating

the database that set the “customary” rates for reimbursement to doctors. “It’s the insurers’ statistics that have been accepted by many legislators as the basis for discussing the issues,” complains Gold. The insurer squeeze on doctors’ fees is why the medical profession has abandoned its former obdurate opposition to reform. The insurers have intensively lobbied the “Blue Dog Democrats,” who are always described as “fiscally conservative”, but who have benefited liberally from the insurers’ campaign contribution largesse. Recognising that withdrawing a public option is politically untenable for the administration unless there is universal, or near-universal coverage, the insurers offered a pragmatic and self-interested compromise. If the uninsured are legally required to buy insurance, the companies would drop many of their existing practices—such as exclusions for existing conditions— and presumably graciously accept the government subsidies for poorer clients’ premiums along with the 47m new clients.

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Market Leader US HEALTHCARE REFORM: THE INVESTOR VIEW

However, Mark Pauly, professor of health management at the Wharton Business School, cautions: “My Machiavellian suspicion is that the insurers are saying they will go along for universal coverage because they are confident it will not happen, so it is not that much of a deal. But it’s logical that if you can’t refuse to sell policies to a pre-existing condition, but you are forced to sell to everyone, then people will only buy when they become ill, which raises the price for everyone. So without mandatory coverage it is difficult to see the cost benefits.” Compulsory health insurance, whether public or private, would indeed reduce administrative costs considerably. Most of those costs go to selling, getting people to buy and persuading them to pay the premiums, Plunkett points out. However, he warns that the compromise could be a Trojan horse for the companies.“If Congress allows the legacy insurance companies to take up a lot of the new customers and if, as seems likely, the cost would be much higher than estimated, then the industry would face much more regulation and pressure on fees and profits later. If there is a universal care administered by the private companies, they’ll be squeezed, so it might not be such a great deal for them.” Similarly, he adds: “Pharma thinks it can partner with the government, but down the line government is going to come back and limit costs.” Plunkett gives the example of Medicare Advantage, which was a Republican attempt four years ago to “privatise” Medicaid by involving the private health insurers. Eight million people were enrolled, and he points out: “Congress approved it four years ago. Eight million people and now Congress wants to take it away—

Jack Plunkett, of Plunkett’s Health Report identifies the future winners as including “anything aimed at the 65+ segment of the population. Ageing baby boomers in the US are going to provide an incredible boost to healthcare revenues. By the year 2020, the over-65 population will grow to 54.8m from 40m today. That’s a 37% increase over ten years in the segment of the population that uses the most healthcare”. because insurance companies are making too much money out of it.”In fact it costs the government some 12% per head more. Pauly also sees trouble coming for the doctors. “They are trying to cut a deal so the government will try to pay at the usual level, but the government will need money to cover the uninsured and it won’t be paying high prices to doctors, so it’s a very delicate bargain, unlikely to be consummated.” He suggests the most lightly outcome “is that they will pay doctors less as a whole, but will pay more to the primary providers because they are the centerpieces. A central model will emphasise preventive and primary care, so even if the total pie does not grow so quickly, that part might.” But he allows that prompter, guaranteed payment systems could reduce doctors’ costs considerably compared with current serious collection problems. It follows, he reasons, that there will be investment opportunities in IT “since the administration believes that it will improve the quality of primary and preventive care and they have hopes it will save money overall—I’m much more sceptical about that”. However, he is much less optimistic about the success of IT designers who have to cope with a myriad of different providers and, in most reform packages, insurers.

Pauly suspects that the winners would be among firms that help with the co-ordination of primary care. “I have a soft spot in my heart for specially trained nurses to function in that role: the use of health professionals other than doctors offers the best chance to cut costs without quality, and to some extent hospitals may be able to organise that. But there may be a role for private companies to arrange co-ordinated primary care.” He is equally pessimistic about the prospects for making insurance mandatory for individuals. “There’s going to be real reluctance to making it compulsory because of budget constraints. In Massachusetts they waived it for lower middle income because there wasn’t enough money to subsidise them.” Jack Plunkett, of Plunkett’s Health Report, considers that despite costcutting pressures there are “huge opportunities in the sector”. He identifies the future winners as including “anything aimed at the 65+ segment of the population. Ageing baby boomers in the US are going to provide an incredible boost to healthcare revenues. By the year 2020, the over-65 population will grow to 54.8m from 40m today. That’s a 37% increase over ten years in the segment of the population that uses the most healthcare”. He singles out pharmaceuticals, e.g. drugs aimed at heart conditions, surgical specialties such as cataract

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Market Leader US HEALTHCARE REFORM: THE INVESTOR VIEW

surgery and appliances such as knee replacements designed primarily for ageing patients. Sadly he also adds products and services aimed at Alzheimer’s disease, dementia and other age-related diseases. However the American population is expanding physically as well, so he also identifies as winners “products and services aimed at controlling obesity and related diseases such as diabetes”. Finally, in the face of that demand and the expanding costs, he also foresees that, whatever option is chosen, there will be profits to be made in “services and technologies that provide cost control and efficiencies in healthcare delivery, payments, claims processing and the prevention of waste and fraud”. Plunkett instances HMS Holdings, a booming New York company whose business is helping providers ensure proper payment from Medicare, with its three-volume directory of billing codes. One does not have to give total credence of the omniscience of the market to consider that dispassionate investors may have some serious prognosis. Eagle Asset’s McCallister has been trawling companies that would win or lose as a result of reforms and reports. “If we do get a public option, some stocks such as the hospitals have already benefited from the perception of the possibility, so it’s already in the price. If we don’t get it they’ll fall.”

He explains: “They had a 13% bad debt ratio and the thinking was that the public coverage would bring that down to 7%. However, the investment community has a consensus that the public option is out of the window, which presents opportunities and pitfalls. We stayed away from things that could obviously be legislated out of business: HMOs, hospitals home health, Medicare. Orthopaedics has enjoyed big price increases for the past four or five years and so will be under scrutiny.” In contrast, he points to cardiology, “which has been living with 2% or 3% deflation,” and so might be due for a break. In similar vein, he advises investors: “If you are going to do Medicaid, stick with children”, since hard-pressed state governments will find it harder to make cuts there. “Short sellers will advise against stocks that depend on Medicare payments,” he assesses although he has hopes for Lincare, a provider of services like oxygen. “They’re a poster child with profitability five times their competitors. They could be the only one to survive the coming cuts, so it’s a Darwin story.” Based on the Massachusetts experiment in universal coverage, he sees investment in general practitioners and gynaecologists as winners. Where the insured previously went to emergency rooms, they would now go to more appropriate—and

cheaper—services. Pauly and Plunkett echo the advice that regardless of the politics, the best hope of mitigating runaway costs is by emphasis on primary care. Pauly advises investors to “look for innovative firms trying to get with the home and primary care or preventive model: they’re the places to prospect for gold.” On the face of it, any expansion of coverage should be good news for the drug-makers and the appliance makers as the newly insured rush with their prescriptions to the pharmacies. Pauly agrees: “Expansion of coverage could lead to expansion in primary prescription sales, blood pressure, diabetes etc but those are kind of where the blockbusters are going off patent.” Additionally, he cautions, whichever option wins, budget pressures will force the insurers, public or private to chisel down prices. He cautions: “There’s an administration reluctance to allow profit-seeking firms to play too large a role in this.” In the end, the professor cheerfully confesses to pessimism. “Somehow, we have to bend the curve and reduce the rate of increase of medical spending. I’m not very optimistic. Even if the government didn’t take action there was going to be pressure to reduce it.” Perversely, the greatest expectation for anyone who wants to make money is in helping the government, or the insurers, save it.

THE SIZE OF THE US HEALTHCARE BUSINESS otal US healthcare expenditures are projected to increase from $2.39trn in 2008 to $2.72trn in 2010, with annual increases averaging about 7%. The healthcare market in the US in 2008 was made up of hospital care (about $747.1bn), physician and clinical services ($501.7bn), prescription drugs

($247.0bn), nursing home and home health ($198.5bn), dental care ($102.4bn) and other items totalling $597.6bn. Registered hospitals totalled 5,747 properties in 2007, containing 947,417 beds serving 37m admitted patients. Source: Plunkett Health Almanac 2008

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In the Markets FOREIGN EXCHANGE TRADING: WHY THE CURRENT ACCOUNT IS SO VITAL

Uncertainty about US economic policies threatens to turn traditional thinking about currencies on its head. For years, the Federal Reserve’s embrace of inflation targets and sound money set an example to the world while countries including Brazil suffered hyperinflation and pursued inconsistent fiscal and monetary policies. Steven Englander, chief foreign exchange strategist for the Americas at Barclays Capital in New York, says today it’s Brazil that has a current account in balance, a modest fiscal deficit (less than 1% of GDP) and a financial system that came through the crisis in good shape. Meanwhile, observes Neil O’Hara, investors looking at the US see a gaping fiscal deficit for years to come and a banking system battered by credit losses. URRENCY VALUATION HAS been more art than science ever since the Bretton Woods agreement unravelled more than 35 years ago. Economists have created models based on purchasing power parity that purport to predict fair values, but in practice currencies trade far from those values for extended periods of time. Day to day, the exchange rate is nothing more than a clearing price for flows of funds attributable to trade, direct or portfolio investment and central bank reserve activities. The balance between those flows shifts over time, however, and in today’s foreign exchange markets the capital account has assumed greater importance. The financial crisis triggered a surge of foreign capital into US Treasuries and other low-risk US assets that propelled a huge rise in the dollar in the fourth quarter just as the real economy fell off a

Photograph © Guido Vrola/Dreamstime.com, September 2009.

CAPITAL IS KING OF CURRENCIES cliff. By the first quarter of 2009, the US current account deficit had plunged from 6% of gross domestic product in June 2008 to about 2%, which ought to have pushed the dollar higher if trade flows controlled exchange rates. It didn’t happen. “American consumers tightened their belts and the US trade deficit has shrunk, but the US dollar is weakening,” says Ashley Davies, a Singapore-based foreign exchange strategist at UBS. The dollar’s spike and retreat wasn’t entirely a foreign event, either. Steven Englander, chief foreign exchange strategist for the Americas at Barclays Capital in New York, says US investors repatriated money from abroad at a brisk clip late last year—$30bn to $40bn per month for a brief period. After the financial markets began to recover in March, the flow reversed; US investors sent $100bn abroad in the three months through July 2009. In effect, the

US went from a $40bn monthly trade deficit at the end of 2008, of which $10bn was financed by foreigners, to a $30bn trade deficit plus another $30bn exodus through the capital account—a $50bn swing in monthly demand for foreign capital. “That is a very potent combination,”says Englander. Foreigners are still looking to the US for safety rather than risk, however. They are buying a few equities and corporate bonds, but the overwhelming majority of purchases have been government bonds. Englander attributes the preference to a lack of leadership in US asset markets; US equity markets have risen and credit spreads have narrowed, but that has happened in every other major market, too. In contrast, when the dollar soared during the internet bubble, or in the Reagan era when real interest rates were high, US assets had unique attributes investors could find nowhere else.

OCTOBER 2009 • FTSE GLOBAL MARKETS

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In the Markets FOREIGN EXCHANGE TRADING: WHY THE CURRENT ACCOUNT IS SO VITAL

Now that trade flows have become less important, capital flows will dominate short-term currency valuations unless the central banks take steps to neutralise them. Uncertainty about US economic policies threatens to turn traditional thinking about currencies on its head. For years, the Federal Reserve’s embrace of inflation targets and sound money set an example to the world while countries including Brazil suffered hyperinflation and pursued inconsistent fiscal and monetary policies. Today, Englander says it is Brazil that has a current account in balance, a modest fiscal deficit (less than 1% of GDP) and a financial system that came through the crisis in good shape. Meanwhile, investors looking at the US see a gaping fiscal deficit for years to come and a banking system battered by credit losses. They worry about whether quantitative easing will work, how it will end and when the Fed will begin to raise interest rates.“Why should investors retain the traditional risk ranking of currencies?” Englander asks. “Brazil, Australia and Canada have all pursued conventional monetary policies, whereas the US has made a major deviation.” Now that trade flows have become less important, capital flows will dominate short-term currency valuations unless the central banks take steps to neutralise them. Daniel Tenengauzer, head of global foreign exchange strategy at Banc of America Securities, Merrill Lynch Research, points out that while emerging equity markets experienced big inflows during the first half of 2009, their currencies did not move as much because the local central banks were net sellers as they

piled up currency reserves. He says:“If a country has a large current account surplus and a large capital account surplus then the only way to avoid currency appreciation is by accumulating foreign currency reserves.” Tenengauzer uses a model based on the balance of payments rather than purchasing power parity to forecast currency movements. It tends to favour emerging markets currencies because developing countries typically run current account surpluses while most developed ones run deficits. At the moment, he says the Mexican and Argentine pesos offer the best value in Latin America while the Colombian peso is expensive. The Asian currencies all look undervalued, but the Korean won and Malaysian ringgit stand out. In EMEA, the Turkish lira and South African rand are overvalued while the Polish zloty and Russian rouble are cheap. Among the G10 industrialised nations, Tenengauzer favours the Norwegian krone and Swedish kronor over the Australian dollar and British pound. Reserve currencies, such as the dollar and euro, attract foreign capital inflows as a natural consequence of their special status, which enables the US and eurozone to run persistent current account deficits without undermining the value of their currencies. For other countries, trade deficits push the currency down, either immediately or at some future date when offsetting capital flows dry up. Tenengauzer says: “Every year foreign liabilities accumulate. Eventually the external debt becomes unsustainable and the currency needs to adjust.” Even a reserve currency won’t escape that fate forever, but the adjustment can be deferred as long as other countries are willing to accumulate reserves. Davies at UBS says central banks in general are overweight on the US dollar—65% of global foreign currency reserves,

Steven Englander, chief foreign exchange strategist for the Americas at Barclays Capital in New York, says today it’s Brazil that has a current account in balance, a modest fiscal deficit (less than 1% of GDP) and a financial system that came through the crisis in good shape. Photograph kindly supplied by Barclays Capital, September 2009.

according to the IMF—but face a conundrum: If they try to sell in size, it will depress the value of their remaining dollar holdings. He adds:“China may be in a ‘dollar trap’. Their current pace of reserve accumulation means that they will need to allow the renminbi to strengthen.”Davies expects the Chinese authorities to permit more rapid currency appreciation next year or in 2011. Although reserve accumulation does affect currency prices, it is a consequence of a country’s exchange rate policy rather than an underlying driver of fair value, according to Vassili Serebriakov, a currency strategist in Wells Fargo’s New York office. China is a perfect example; its growing dollar stash ($776bn in US Treasuries alone) is the direct result of its decision to keep the renminbi weaker than it would

OCTOBER 2009 • FTSE GLOBAL MARKETS

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In the Markets FOREIGN EXCHANGE TRADING: WHY THE CURRENT ACCOUNT IS SO VITAL

otherwise have been. Serebriakov says macro-economic factors such as interest rates, inflation, growth and productivity determine currency values over the long term, but real effective exchange rate models only indicate which currencies are out of line.“They don’t tell you when or how fast the convergence to equilibrium value will take place,”says Serebriakov.“They are not a practical guide to daily or even monthly exchange rate movements.” Exchange rates get pushed out of line by carry trades, too, another indication that capital flows have assumed greater importance in currency valuations. Traders borrow in a country where interest rates are low in order to invest in others where rates are high. The conversion money flows tend to depress the borrowed currency and inflate the recipient, which adds to the return as long as investors continue to favour the trade. Serebriakov says the strategy contributed to the strength of highyield commodity currencies including the New Zealand dollar and Australian dollar from 2005 through 2007, but it is not a free lunch.“It flies in the face of exchange rate theory,” says Serebriakov. “Interest rate parity tells you the currency with the high interest rate should fall, not rise.” The risk came home to roost with a vengeance when the financial crisis took hold last autumn. Plunging commodity prices undermined confidence in the high-yield currencies and carry trade investors headed for the exit—only to find that their own selling exacerbated the decline.“We saw very sharp downward moves in all those currencies,” says Serebriakov. “Depending when you got into the carry trade, you may have lost money on it.” It’s still a popular strategy, but not so attractive while interest rates are low almost everywhere and volatility is high.

Daniel Tenengauzer, head of global foreign exchange strategy at Banc of America Securities, Merrill Lynch Research, points out that while emerging equity markets experienced big inflows during the first half of 2009, their currencies did not move as much because the local central banks were net sellers as they piled up currency reserves. Photograph kindly supplied by Banc of America Securities, Merrill Lynch Research, September 2009.

A sudden reversal of capital flows can inflict serious damage on the real economy as Asian countries discovered to their cost during the currency crisis that devastated the region in 1998. Serebriakov says some central banks, including the Bank of Canada, now try to distinguish between exchange rate fluctuations that are consistent with economic conditions and more speculative movements. “When speculative moves persist, they are more likely to make a policy response,” he says. The Bank of Canada typically does not intervene in the currency market directly, but it may lower interest rates, for example. While currencies do tend toward an equilibrium value over time, that value is not set in stone. UBS’s Davies notes

that the Australian dollar, Canadian dollar and Norwegian krone are all trading above their long-term average values but he isn’t convinced they are expensive because strong economic fundamentals justify the higher rates. The same is true for developing nations. “Emerging markets currencies can exhibit a long-term upward trend without being overvalued so long as productivity growth outstrips the advanced economies,”says Davies. Trade flows still affect exchange rates, of course, but they had become less influential even before the financial crisis hit. Davies points out that the British pound and US dollar strengthened against the yen through mid-2008 even though both the UK and US current account deficits were expanding. Now that those deficits have plummeted, the capital account is the undisputed king of the currency markets. The reign could be short-lived, however. The Netherlands Bureau for Economic Policy Analysis reported a 2.5% increase in world trade in June 2009 and although the more reliable quarterly data showed a 0.7% decline in the second quarter, the rate of decline pales by comparison to the first quarter’s 11.2% drop. If these early signs of a recovery persist, trade flows may soon regain some influence in the currency markets. Kenneth Broux, market economist at Lloyds TSB Corporate Markets in London, points out that capital flows can be volatile and their current dominance has come about by default: It reflects the sharp drop in world trade rather than any underlying growth in international capital transactions. He says: “Dealers are closely tracking weekly portfolio flows from overseas into US Treasuries and equities to gauge any change in risk appetite for the US dollar, but the determinants of exchange rates today will not necessarily be the same tomorrow.”

OCTOBER 2009 • FTSE GLOBAL MARKETS

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Index Review THE WAY UP FOR THE NEXT DECADE WILL BE TOUGH GOING

Since we passed the 4250 mark in the FTSE, investors have consistently tried to call the top, only to be forced to cover (painfully) as the index has ground inexorably higher. Simon Denham, managing director of spread betting firm, Capital Spreads, appears to be left with the conclusion that, with this top picking scenario still the dominant one, the pressure will remain to the upside. At some point the general tone will become much more accepting of the levels we have reached and when this happens we might be ready for a fall. Before then the squeeze higher will probably win out. Is he right?

Simon Denham, managing director of spread betting firm, Capital Spreads, September 2009.

CASTLES IN THE SKY HE FTSE IS just off from its highs of around 5040 as the bull run pauses for breath and looks around for further reasons to be cheerful. Both bull and bear moves are often defined by the way in which economic data is read and, when we are in the midst of a strong trend in either direction, market participants have a habit of interpreting information to confirm the general trend. Right now, even bad data is being torn apart and made to fit a justification for an extension to the rally. Underpinning everything is the undeniable fact that equity is giving better returns than virtually any other asset class and it is difficult to argue the case for cash either, in the current low interest rate environment. The idea of equity out-yielding bonds etc, is a very old one, formed in the pre–inflationary era when price appreciation was virtually unknown and Treasury notes gave a respectable 2.5% (sound familiar?). Of course in those days, governments only increased state debt in times of war and, even then, seldom reached the levels prevalent today. Who can feasibly cut spending now? Unions are already threatening industrial action if public sector cuts

result in job losses. A bold move, given that this time around public opinion is not blowing their way. With everyone else’s pensions and salaries suffering in the downturn, the copper plating of state employees’ benefits rather grates on the private sector. Their emphasis on only doing their worst if the Tories gain power will likely work against the Labour Party as well, as nobody likes blackmail. Their argument, though, is not unreasonable: the depths of 3m-plus unemployment is not the time to cut budgets. Unfortunately, the UK is discovering that much of the past 12 years of “growth” has been illusory. Japan’s lost decade could well be an epithet for the past 12 years of the FTSE. The index is now almost exactly where it was when the Tories lost power all those years ago and while many will say“So what?”more will know that in a period of even minimal inflation as we have seen over this period, this represents a massive reduction in value—to the detriment of every worker with retirement in the hands of a managed pension pot (corporate or private). In real terms after costs, inflation and taxes, £1 invested 12 years ago is worth no more now than

it was then and in absolute terms a great deal less. With the governments (of what ever hue) desperate to raise revenue, it would be a brave man who would bet on the huge pension funds remaining any more inviolate than they did when Gordon Brown made his infamous raid back in 1997. The last saving generation is now retiring, so no matter how well the UK economy does from now onwards, redemptions may well outweigh new funding for some considerable time. Speak it quietly but the way up from here for the next decade will be tough going and possibly subject on a regular basis to morale-sapping bear shifts. Investors may start to worry about the “October effect” as analysts churn doom laden forecasts popular this time of year. The crash of 1987 and the crunch of 2008 will dominate headlines, most likely to no avail. However, I have to admit that the oldest market adage of them all (and my personal favourite) is still alive and well:“The markets will always move in the direction that causes the greatest amount of pain to the greatest number of people.” As ever ladies and gentlemen, place your bets…

OCTOBER 2009 • FTSE GLOBAL MARKETS

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Face to Face DEUTSCHE BÖRSE LAUNCHES PAN-EUROPEAN PLATFORM

Deutsche Börse seemed content to watch and wait during the rapid expansion and competition in pan-european stock exchanges sparked by the advent of Chi-x, which launched in 2007. Now the German Stock market has entered the fray with its own pan-European platform, Xetra, and is confident of its success. Paul Whitfield talks to Michael Krogmann, executive director for development and sales at Xetra.

Michael Krogmann, executive director for development and sales at Xetra. Photograph kindly supplied by Deutsche Börse, September 2009.

XETRA, XETRA—READ ALL ABOUT IT! EUTSCHE BÖRSE HAS been notable by its absence from the burgeoning competition among pan-European stock exchanges. The German heavyweight, the biggest stock market operator by market capitalisation in Europe, has appeared content, or at least unfazed, by the rapid growth of a handful of start-ups and new launches in the sector. These interlopers in the onceclosed European exchanges sector have proven the demand for pan-European share trading, and in doing so opened the European stock market sector to real competition for the first time. Deutsche Börse’s absence will be rectified on November 2nd this year, when it launches Xetra International Markets, a pan-European platform that will offer trading in French, Dutch, Finnish, Italian, Spanish and Belgian blue-chip equities, including those listed on the Dow Jones Euro Stoxx 50 index, and their corresponding equity and index derivatives. “The future of the cash equity sector is in having European scope,” says Michael Krogmann, executive director for development and sales at Xetra. “We want to be a part of that.” In fact, Deutsche Börse has some catching up to do. Chi-X, the biggest of the new operators, which have been dubbed multilateral trading facilities (MTFs), recorded a little over 12.6m trades in August, the last month for which statistics are available from the

Federation of European Securities Exchanges (FESE), an industry research group.The total is equal to about 16% of all trades in Europe. By comparison, Deutsche Börse recorded about 6.8m or 10% of trades on its Germany-focused Xetra platform, though the average value of the trades on the German exchange were significantly higher, meaning it had a higher turnover figure. Other MTFs, including the investment bank-backed Turquoise and BATS Europe, have also made significant inroads into the Europeanwide market, accounting for about 5% and 3.3% of the market respectively in August, according to FESE. The new MTFs have not only developed the European-wide market, they have taken market share from incumbent exchanges. Deutsche Börse’s share of the trade in German equities has slipped from near monopoly to closer to 75% in the past two and a half years, according to Thomson Reuters figures.The London Stock Exchange has seen its share of the trade in stocks listed on its own markets dip beneath 65% Deutsche Börse insists that its launch is not about clawing back market share. It claims that it hasn’t lost customers to the pan-European platforms but rather the total sector has grown, making room for the new entrants. David Easthope, a senior analyst at Celent, a research and consulting firm that follows the exchanges, says he is inclined to agree: “This is not purely

defensive. Exchanges and MTFs are all looking for ways to expand on a more pan-European basis and to allow domestic investors to trade easily and in a cost-effective manner across Europe. This [pan-Europe] market is still up for grabs, though it is very competitive.” If Xetra International is a little late to the European party, it has plans to quickly make up for lost time. The crux of the new exchange’s strategy is to leverage the muscle of its big brother, Xetra, to propel customers onto the new platform. Xetra is Deutsche Börse’s electronic trading platform for equities, warrants exchange-traded funds and subscription rights. Xetra International will initially be offered to Xetra’s existing customers, of which there are about 250. Many of those, whose interest extends only to German stock, won’t take up the invitation but others, including banks and arbitrage traders, have already signalled their interest. Xetra’s management is confident that the spin off will have the necessary support from launch to make it not only viable but to make it stand out from competitors. “You can’t compare our model with those of the MTFs,” says Krogmann. “We have a very heterogeneous membership base, not just high-speed traders but a mixture of banks and other institutions with different aims and goals. That is hugely important to create a good liquidity pool...that can’t be replicated by the MTFs.”

OCTOBER 2009 • FTSE GLOBAL MARKETS

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Face to Face DEUTSCHE BÖRSE LAUNCHES PAN-EUROPEAN PLATFORM

The premium that clients place on liquidity is going to be central to Xetra International’s chances of success. The exchange is not planning to compete directly on price with the cheapest of its MTF rivals, though it insists that pricing will be extremely competitive and will be significantly lower than on the main Xetra exchange.“That is normal as it is not a natural liquidity pool right from the beginning and we need to attract liquidity providers and order flow to the service,”says Krogmann. Deutsche Börse’s hopes of maintaining a pricing premium, relative to its MTF rivals, is premised on providing a customer experience closer to that of its Xetra market, in terms of liquidity, the ability to arbitrage against derivatives and the quality of its clearing services. Xetra International will function sideby-side with Deutsche Börse’s Eurex derivatives market (the two platforms use the same technical infrastructure), allowing customers to better implement arbitrage strategies, claims Deutsche Börse. It will also use the German group’s Eurex Clearing unit to provide post-trade services for the system, while settlement will be local.The hope is that better clearing will encourage high frequency institutional players to adopt the spin-off. Given that the new marketplace will leverage the existing goodwill of the main Xetra system, it makes sense that in the first instance the new panEuropean platform will be made available to Xetra’s customers. The opportunity to join Xetra International will eventually be rolled out to non-Xetra customers. The new exchange is targeting customers amongst the US arbitrage boutiques and large Russian traders, in particular. It is not only goodwill that will make the new platform easier to sell to current clients. Xetra International will use the same hardware and trading interface as

the current Xetra connection, meaning that adopting the new technology is both quick and inexpensive. “Clients, many of which say they have tailored their algorithms to work with Xetra and which have the hardware and connections already in place, don’t have to go through the trouble and expense of implementing new technology and signing up to a whole new service,”says Krogmann. An expansion of an existing Xetra account onto the new international platform could take as little as two days, including providing the necessary training to use the new system, Deutsche Börse estimates.

Low-cost access For Xetra clients, with many feeling the pinch following the recent market collapse, the attraction of a low-cost access to European-wide trading is evident. Yet expanding Xetra’s technology into the new market also makes a huge amount of sense for the German exchange operator itself. “The exchange business is an IT business so these exchanges are looking to transact in as many ways as possible using the same platform to become more efficient and drive scale,” says Celent’s Easthope. “The transactions can be across geographies and across product classes.” Deutsche Börse’s decision to piggyback Xetra International on its existing Xetra infrastructure sets it apart from its peers. Nasdaq OMX Europe, the pan-European offering of the American/Scandinavian exchange, chose to launch a separate Londonbased MTF for its assault on the European market. NYSE Euronext’s NYSE Arca Europe was also established out of London, though it operates across NYSE’s Universal Trading Platform, a new technology that allows customers to access the exchange operators stocks in both the US and Europe.

There is a lot riding on the launch and short-term success of Xetra International, which will need to quickly carve out its territory if it is to establish itself as a serious player in a crowded market. That will take time. There is little doubt that there are now too many participants competing for too few trades, a situation that has been exacerbated by 2008’s financial crisis and the ongoing economic woes which have hit both valuations and volumes. That will mean mergers, acquisitions and some failures. “There are definitely too many venues out there and many of them will not be profitable in the mediumterm,”says Krogmann.“Some of them won’t survive.” Of all the new ventures only Chi-X, which got the jump on its rivals when it launched in March 2007, already has established the necessary volume of trades to allow talk of breaking even in the coming year. The rest of the MTFs will remain lossmaking for the foreseeable future. Some have already pulled the plug.Turquoise’s investment bank owners put their platform up for sale in August this year, just one year after it was launched, sending sale documents to 18 possible bidders including Deutsche Börse, the LSE, NYSE Euronext and Chi-X. Xetra International’s management say that they have no interest in buying a rival MTF, noting that there is little of value in such a deal for the German platform. The focus in Frankfurt for the time being is on getting the launch right and then growing organically. Alongside plans to roll out Xetra International to non-members, the new platform will also be available to cover stocks in new countries.The UK and Switzerland, two of Europe’s most important financial markets, are the next destinations. Once more, Xetra will be late to join these markets—whether or not that will matter remains to be seen.

OCTOBER 2009 • FTSE GLOBAL MARKETS

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Regional Review SAUDI ARABIA: EVER DEEPER CAPITAL MARKETS

THE TEASING PROMISE OF SUKUK

Photograph © Scott Rothstein/Dreamstime.com, supplied September 2009.

The opening up and development of the Saudi Capital Markets has been a slow burn. The authorities appear to have opted for an evolutionary rather than a “big bang” approach to market expansion. While the equity market, (which was opened up last year to direct investment from non-Gulf Cooperation Council [GCC] investors for the first time has garnered most of the headlines), it is the potential for the expansion and deepening of Saudi Arabia’s bond market—both conventional and Islamic—that some market commentators believe will provide a better solution to any funding gap the Kingdom might experience in executing some $400bn-worth of capital projects over the next five years. Capital markets expansion also has the added benefit of providing international investors with less volatile exposure than can be achieved by investing in the Kingdom’s equity market. NE BIG DRAWBACK for international investors in Saudi Arabian new issues is the difficulties related to the pricing of some securities. There has been no significant new bond issuance from the Saudi government for many years and certainly not the long dated tenors that are traditionally used by the bond markets as a risk-free benchmark. This means that it is difficult to accurately price both new issues and for holders to be able to price their holdings and to guide prices in secondary trading.“While bond prices and yields of predominantly government-owned entities such as Saudi Basic Industries Corporation (SABIC) and the Saudi Electricity Company (SEC) do offer some guidance in terms of pricing, they are no substitute for long dated government paper on which to base a yield curve,” says Rajiv Shukla, managing director and head of

capital markets for the Middle East and North Africa at HSBC, which has been lead manager on a large number of issues in the Kingdom. In an effort to attract international investors and improve liquidity in the secondary trading in the Kingdom’s debt capital market, the Tadawul, the Saudi Stock Exchange, launched the Gulf’s third bond trading platform after Bahrain and NASDAQ Dubai in June this year. Levels of trading to date, however, have been disappointing with only 52 trades worth less than SR26m made between the platform’s launch on 13th June and the end of August. This is less than 0.1% of the SR33bnworth of Riyal priced bonds issued since 2006. Unfortunately the low levels of trading amply demonstrate the low levels of secondary market liquidity the trading platform has been introduced to overcome.

There are other factors in play. According to local commentators, Saudi Arabia’s corporate bond market is unlikely to become a success without a benchmark sovereign bond and the removal of legal obstacles. Then again, investors have been presented with too little choice. Relatively few issues are listed on the platform, and most of those are from state-owned companies, such as SABIC and Saudi Electricity Co. Moreover, the lack of trading is encouraging a higher yield expectation among investors to compensate them for the lack of liquidity and is inevitably lowering interest in subsequent issues. The pricing of a SR7bn ($1.87bn) Islamic bond issue by Saudi Electricity 160 basis points (bps) over the Saudi interbank rate (Saibor) in July typifies the situation. The pricing marked a sharp rise compared to Electricity’s maiden issue of 5bn riyals in 2007 which was priced at 45bps above Saibor as tight credit conditions also played their part. Equally, legal experts say that without an overhaul of the kingdom’s archaic laws requiring lengthy approvals, Saudi Arabia will continue to trail other Gulf states in this regard. Additionally, there is the withholding tax levied on overseas investors and the requirement for international investors to have their own, rather than a nominee, bank account in the Kingdom to undertake the purchase of securities. International investors therefore naturally have a

OCTOBER 2009 • FTSE GLOBAL MARKETS

Regional Review SAUDI ARABIA: EVER DEEPER CAPITAL MARKETS

preference for offshore issuances in major bond centres, such as London or Luxembourg, where liquidity is strong and where technical conditions do not impinge on investments in new issues. One way to improve liquidity is if the Saudi Arabian Monetary Authority (SAMA) introduced repo facilities, which are commonly found in other jurisdictions. Even if the facility were rarely put to use, it would provide comfort to investors during the placement of issues as they could rotate a portion or all of their holding out of a particular bond if necessary. In turn, this would encourage them to allocate significant capital to an issuance without the fear of being tied in.

Combined with action by the Capital Markets Authority (CMA) to incentivise local and international banks to act as market-makers, the move could energise trading levels. The quickest and easiest way to achieve this is to require firms licensed to act as arrangers to quote prices on all listed Sukuks. Alternatively SAMA could take on this role in the interim until it was felt the local banks were providing an adequate level of service to investors. Another concern is the level of corporate governance in the country. Some market commentators have suggested that international rating agencies allocate a lower rating for Saudi companies than their economic

fundamentals justify because of the lower levels of disclosure required in the Kingdom, particularly with regards to other borrowings and cash flow. Howard Handy, chief economist at SAMBA says this is being tackled: “In November 2006 the CMA issued a code of corporate governance which increased the level of Saudi compliance with the Institute of International Finance’s Code of Corporate Governance from around one half to slightly more than two thirds. As a code, adoption remains voluntary, but the CMA is actively encouraging listed firms to commit to its standards. Reporting (particularly in English) remains patchy, but the CMA’s efforts, in conjunction

ETFs: RED LIGHT, GREEN LIGHT? Eagerly anticipated, long expected (and some might say overdue) Exchange Traded Funds (ETFs) finally look set to make their debut on Gulf Cooperation Council (GCC) exchanges. Local banks have long had ambitions to launch ETFs. However, a lack of regulatory approval has, up to now, precluded them from realising their ambitions. Regulatory approval is imminent, say local commentators, led by the Saudi Capital Markets Authority (CMA) in Saudi Arabia and the UAE Central Bank, which are expected to give the green light to ETFs in the very near future. he announcement in early September by the National Bank of Abu Dhabi (NBAD), the second largest bank in the United Arab Emirates, with Dh5.15bn (around $1.5bn) of assets under management, that it intends to launch an ETF by the beginning of November has been welcomed by local investors, anxious to see a deepening of the Gulf Cooperation Council (GCC) investment product market. The Abu Dhabi Securities Exchange (ADX) is likely to be the first of the GCC exchanges to host the product. The bank is expecting a lot of demand for the ETF, which will track the Gulf’s biggest 50 stocks. They hope it will appeal both to local retail investors and international

institutional investors, many of whom are underweight in terms of their exposure to the region. The move is still dependent on regulatory approval, however. According to ADX chief executive officer, Tom Healey: “ETFs are ideally suited to this region and the trading and settlement platform we have developed here at the exchange. Hopefully this will be the first of many ETF applications from both NBAD and other financial institutions.” The benefits of ETFs are well known, adds Healey. Investors, both retail and institutional, are attracted to ETFs by their lower fees, and the ease with which they are traded; as they can be bought and sold like shares. Moreover, unlike most mutual funds, ETFs have no redemption charges other than brokerage fees. They are particularly suited therefore to the largely retail driven equity markets of the GCC where investors tend to prefer buying and selling shares than committing themselves to mutual funds which traditionally have higher charges and redemption fees. The launch of ETFs in the GCC markets is likely to attract substantial investment inflows, say local commentators. There is sizeable pent-up demand for exposure to broad based indices based on emerging markets, while many investors are anxious to leverage the recovery prospects of the region’s oil based economies.

OCTOBER 2009 • FTSE GLOBAL MARKETS

with a noticeably more vigorous crackdown on insider trading, suggest that transparency is improving.” In this vein, much depends on the ways and means applied to the debts of family firms, such as the Saad Group and Ahmad Hamad Algosaibi & Bros (AHAB). The central bank has categorically announced that it has no intention of bailing out the firms, which are in default and in discussions with creditors. The move by the central bank has been welcomed, as it signals a commitment by the authorities to adhere to good governance principles and in setting a precedent in that private sector firms cannot rely on the government to bail them out of tricky situations.

Ultimately, however, any deepening in the Kingdom’s capital markets will come from the adoption of new securities product. Handy believes that a more likely source of future issuance and liquidity in the short term may come from mortgage securitisations rather than corporate issues. “We are encouraged by the finance minister’s announcement in May this year that a new state-owned mortgage securities company will be established by the end of the year. The company will purchase mortgages from private or public-sector lenders and then securitise the loans into sukuk, tradable on a secondary debt market.The establishment of the new firm will be linked to the rollout of the long-awaited mortgage law.”

The region is not entirely inexperienced in the ETF concept. In March, NASDAQ Dubai, which is based at the DIFC and therefore regulated by the Dubai Fin2ancial Services Authority (DFSA), listed the Dubai Gold Securities (DGS), an exchange traded commodity (ETC). “The underlying concept is the same, except in this case the asset is based on gold rather than shares,” explained a spokesperson from NASDAQ Dubai. He adds that until now the exchange has not yet been approached to list an ETF but believes that is only a matter of time. “Ultimately we would examine each request on its merits and it would then be subject to the regulatory approval of the DFSA.” One of the factors restricting the development of ETFs in the region is due to the constituents of many of the local indices. While a large number of local firms are listed on national exchanges, few make the cut when it comes to selecting firms as constituents of the national or a regional benchmark index. Firms might not be selected for many reasons; such as low levels of freefloat, lack of tradability, or issues of poor corporate governance, or lack of adherence to international standard reporting requirements. In recent years improved market regulation governing list firms across the region has removed many of these obstacles and has encouraged the creation of broader-based regional indices, which are well suited to ETFs. The FTSE NASDAQ Dubai Index Series for example is designed to represent the performance of the largest and most GCC companies, initially in Kuwait, Qatar and UAE, though

FTSE GLOBAL MARKETS • OCTOBER 2009

While improved investor demand and secondary liquidity is likely to make local issues more attractive, it is unlikely to open the floodgates to new issues over the short term. Nonetheless, there are signs that many Saudi companies are feeling the financial pinch as local banks appear reluctant to kick start new lending on a grand scale. There are also regulatory limits in play. CMA regulations stipulate that only Saudi joint-stock companies which have operated for at least three years “under substantially the same management”can issue new securities in the public format. This appears to rule out sukuk issues from a large number of companies. Even so,

there are hopes to expand this to include other countries. The market with perhaps the biggest potential in terms of both international and local investors is Saudi Arabia’s Tadawul, thinks Howard Handy, chief economist at regional bank Samba. “ETFs are useful for their versatility and low operating and transaction costs. They might also provide a useful way for foreign investors to get a taste of the Saudi equity market.”

Pre-market feature Local players are already positioning themselves in preparation for any moves by the country’s Capital Markets Authority to support the launch of exchange traded investment products. Adeeb Sowalim, chief executive officer at investment bank Falcom, says the bank is keen to launch a number of Middle East and North African ETFs, some of which are linked to the bank’s own indices. “At the beginning of 2009 we launched the largest Islamic equity index in the GCC licensed by Tadawul.” Sowalim says that Falcom’s Shari’a Index is unique in that it has a pre-market feature; the only index to have this. According to Sowalim: “The feature allows investors to review the market position of their portfolios before the market opens. The index is calculated in real time and published in Saudi riyals.” Over time, he expects Falcom’s Shari’a index to be used as the basis for Shariah-compliant ETFs, both for over-the-counter products and index-linked equity funds.”

Regional Review SAUDI ARABIA: EVER DEEPER CAPITAL MARKETS

large private companies do have the option of issuing outside the Kingdom or issuing securities via private placements with local investors.

Islamic or conventional issues? There is an assumption among international investors that most if not all issues are sukuks i.e. Shari’a compliant and domestically listed. This isn’t necessarily so, says HSBC’s Shukla. “There are no specific rules from the Capital Markets Authority (CMA) and it is now generally accepted from an issuer’s viewpoint that if a bond issue is to be public and available to retail investors then it should be structured as a sukuk. If, however, it is a private placement targeting primarily institutional investors then there is no obligation to structure it either as a conventional or Islamic issue. The decision remains entirely with the issuer based on advice from their arranger.”

An alternative for Saudi corporates might be depositary receipts (DRs) thinks Hani Kablawi, regional head, Middle East and North Africa, BNY Mellon.“To date only eight companies in the GCC have listed DRs in either London or New York (compared to 12 from Egypt and 40 from Turkey) so on the issuing side there is a lot of potential.” At the moment companies in Saudi Arabia are prevented from listing their shares overseas but Kablawi is hopeful that these restrictions will be lifted in the not too distant future. “It’s a natural progression for a developing market and by allowing companies to list on exchanges in Europe and the US they gain access to a far wider pool of international institutional investors than they get through their local listing. These institutional investors also tend to take more of a long-term approach than can sometimes be the

case with retail investors who currently dominate the local exchanges.” Another benefit is that companies that offer DR programmes tend to improve their levels of corporate governance and reporting standards in order to comply with the international listing requirements. These improvements apply not only to investors in the DRs, but also to the underlying stock benefiting local or international investors who invest in the local listing.“Acting as a depositary receipt bank is not just about managing the logistics of the DR programme, but also about working with the companies to make sure they are structured in such a way and adopt levels of corporate governance that maximise their appeal to investors, explains Kablawi.“We are fortunate that as levels of corporate governance improve rapidly across the region, many companies are already above or at the level required for them to list DRs overseas.”

Bond Issuance in Saudi Arabia 2005-2009 Date

Issuer

Structure

Amount

Term

Arranger

Type

Distribution

2005 2005 2005 2006 2006 2006 2006 2006 2006 2007 2007 2007 2007 2007 2007

Saudi Hollandi SABB NCB SABIC SABIC Europe SABB SAMBA ANB Riyad Bank DAAR BNP Paribas DAAR SEC SABIC SABIC IP

Floating Rate Note Eurobond I Eurobond Sukuk I Al-Istithmar Eurobond Eurobond II Eurobond LT-2 Eurobond Eurobond Sukuk I Ijara Floating Rate Note Sukuk II Ijara Sukuk Al-Istithmar Sukuk II Al-Istithmar HY Bond

SR700m $600m $500m SR3bn EUR750m EUR325m $500m $500m $500m $600m SR1bn $1bn SR5bn SR8bn $1.5bn

7 years 5 years 5 years 5 years 7 years 5 years 5 years 10nc 5 years 5 years 3 years 5 years 5 years 5 years 5 years 8 years

SHB/ABN AMRO HSBC Deutsche Bank/UBS HSBC HSBC/JPM HSBC Citi HSBC/Citi JP Morgan ANB/ABC Islamic BNP Paribas ANB/ABC Islamic HSBC HSBC/Riyad Bank HSBC ++

Private

2008 2008 2008 2008 2008 2008 2008 2009 2009

Taajer Co SABB Saad Trading ME entity of International Bank SABIC Binladin Group Saudi Hollandi DAAR SEC

Sukuk Al-Istithmar Floating Rate Note Sukuk Al-Manfa’a Floating Rate Note Sukuk III Al-Istithmar Sukuk Mudaraba Sukuk Mudaraba Sukuk III Al-Istithmar Sukuk II Al-Istithmar

SR250m SR1.7bn $650m SR524m SR5bn SR1bn SR775m SR750m SR7bn

5 years 5 years 5 years 2 years 5 years 5 years 10 nc 5years 5 years 5 years

SHB SABB BNP Paribas HSBC HSBC/Calyon HSBC SHB HSBC/Samba HSBC/Samba

Local International International Local International International International International International International Local International Local Local International/ Local Local Local International Local Local Local Local Local Local

Public

Private Private Public Public

Private Private Public Private Private Private Public

Source: HSBC, September 2009

OCTOBER 2009 • FTSE GLOBAL MARKETS

ON GUARD

Despite a favourable long-term outlook, right now banks in the Middle East are stymied by the fear of asset quality weakening, say local commentators. Noted for conservative lending programmes in any case, most of the region’s banks are well able to stand up to inclement winds. Loan re-pricing and good cost control are countering muted lending growth and a steady increase in loan loss provisioning, to safeguard profitability. However, some green shoots of real recovery are beginning to be seen and all bank’s in the region are looking at last to leverage the demographic trends that favour the rise of Islamic financing. HE MIDDLE EAST banking segment by and large enjoys abundant liquidity and adequate and improving capitalisation. The region’s banks have so far been resilient to the unfavourable economic environment that is buffeting their near neighbours. Moreover, most banking commentators believe that the sector will be the primary beneficiary of an improvement in economic conditions, when lending resumes its natural growth trajectory and asset quality becomes less of a worry than it is right now. Furthermore, the significant amount of non-interestbearing deposits in many of the region’s financial institutions will tend to support interest margins and profitability, if interest rates start climbing from the current lows.

FTSE GLOBAL MARKETS • OCTOBER 2009

While on paper that sounds upbeat, the fear of asset quality deterioration still stalks the region’s leading banks. It has emerged as a top concern for Saudi banks as the financial troubles of two major Saudi groups have begun to impact on the market. Because of that fact, the primary focus of the banks according to Howard Handy, chief economist at SAMBA, is to bolster their balance sheets. In July, Bahrain’s Gulf Finance House, moved to raised up to $300m in fresh capital, designed to strengthen the balance sheet and enable the bank to engage in a number of high value investment opportunities presented by the global economic downturn. GFH chairman, Esam Janahi explains: “Our focus must be to adapt our approach to the markets we serve and our rights issue is a crucial and

MIDDLE EAST: BANKS STYMIED BY ASSET QUALITY FEARS

Photograph © Roman Smitko/Dreamstime.com, supplied September 2009.

positive first step in this process.” Recently appointed Gulf Finance House chief executive officer Ahmed Fahour adds:“We make no secret of our plan to establish GFH as the world’s leading Islamic investment bank and all our efforts will be driven towards this goal.” One unknown in the second half of 2009 will be the extent to which the region’s banks are forced to increased provisioning in order to combat market uncertainties. It is likely, that risk costs will rise and perhaps peak in the last quarter of 2009 and the first half of 2010. Inevitably, that means lending growth will remain weak for the remainder of this year. It seems likely therefore that a sustained increase in lending to the private sector might have to wait, thinks Handy, until international banks return in numbers to the region’s corporate finance market, providing a deeper capital pool. The paucity of lending over the immediate term may actually prove an opportunity for well capitalised, foreign banks, with access to external sources of funding. Standard Chartered, for one, is hoping to expand its their long standing banking operations in the region on the back of this opportunity. “The Middle East, and the GCC in particular, is a key region for the bank and somewhere where we are seeking to expand upon our already extensive operations. As primarily an emerging market bank we are uniquely placed to capitalise on the increasing trade flows between the Middle East and other high growth markets such as India and China;” believes Farooq Siddiqi, managing director, transaction banking, UAE, Standard Chartered. This is true also of local banks. Abdul Hamid Shoman, chairman and chief executive officer at regional powerhouse Arab Bank, says the bank remains steadfast in its approaches to the credit market. “We remain

Regional Review MIDDLE EAST: BANKS STYMIED BY ASSET QUALITY FEARS

committed to financing feasible projects in a way that serves the economies where the bank operates and contributing to enhancing the pace of economic and investment activities.” At the same time, Shoman says, the bank has lowered interest rates over the last 12 months to ease the burden on existing and potential customers. There are also sub-regional trends in play. While monetary union looks to be on hold for now there is a general expectation that the Gulf Cooperation Council (GCC) countries are likely to continue with economic integration, including a single currency, a single central bank and greater harmonisation of legal and regulatory environments. Banks based in the GCC are already ahead of the curve in terms of placing themselves to take advantage of this increasing integration, but as competition increases there is also a need to diversify their income away from their domestic markets as they being to suffer from greater competition from regional and international competitors.

Sub-regional trends Up to now, many of the region’s markets had a strong national focus, which precluded the need to step up services to compete with other banks, foreign or domestic. Traditionally, many Saudi banks, for instance, have expanded outside national confines, as they were already exposed to the largest economic and demographic market in the GCC. In recent years however a number of institutions have begun to reposition themselves as significant regional and international players. SAMBA, for instance, has already established operations in Dubai and further afield has acquired a majority shareholding in Crescent Commercial Bank in Pakistan. It has also received permission from the Qatar Financial Centre Regulatory Authority (QFCRA)

to commence operations in Doha. Those banks with smaller domestic markets have always had a greater incentive to look overseas for growth as their domestic markets eventually become saturated. National Bank of Kuwait (NBK) now operates out of 17 countries While Kuwait Finance House (KFH), one of the world’s largest Islamic institutions has fully licensed banks with retail branch networks in Malaysia, Bahrain and Turkey and is soon to launch five branches in Germany via its Turkish subsidiary. Ahli United Bank, one of Bahrain’s biggest banks, has turned itself into a regional player through acquisition. In addition to its operations in Bahrain it has a wholly-owned subsidiary in the UK and associates in Kuwait, Qatar, Oman, Egypt and Iraq in which it owns varying stakes. Overall, the AUB Group, through its subsidiaries and associates, now operates through a network of 93 branch offices and employs over 3,000 people. Part of the pressure for the banks to expand internationally was increased competition in their domestic markets following the opening up of the banking sector in the GCC. In Saudi the opening up of the banking sector, in part a result of admittance to the World Trade Organisation (WTO) and also linked to the move towards a common market within the GCC, led the Saudi Arabian Monetary Authority (SAMA), the central bank, and the Capital Markets Authority (CMA), the financial markets regulator, to issue a number of new banking and broking licences. While some banks such as Deutsche Bank and BNP Paribas do have a full banking license, it seems unlikely that they will target the already highly competitive retail banking market. It is the more lucrative investment banking, corporate banking, institutional asset management and private wealth management businesses which are

proving to be the primary target of the newly licensed firm, particularly as local banks remain inhibited in this regard. Even so, no one is standing still and, looking forward, the necessary deepening of financial services in the Middle East is a keystone of the forward strategy of many houses. NBK typifies the trend. A desire to diversify income streams is one motor behind NBK’s acquisition of 27.5% of Boubyan Bank a local Islamic Bank from the Kuwait Investment Authority’s (KIA) via auction in a transaction worth KD84.7m. According to Nasser Al Sayer, NBK’s vice chairman: “Our main goal is to stabilise Boubyan Bank, enhance its position in the local market and develop its various Islamic banking services.” With Shari’a compliant banking and investment products growing at more than twice the pace of conventional banking products in the region, it is a product gap NBK is keen to fill. The reason is clear.

Diversifying income According to research issued by Kuwait Finance House (KFH), one of the region’s largest Islamic financing houses, by the end of 2008 some $1trn in assets was held globally by Islamic financial institutions; a figure that had grown by 23.5% in each of the last five years. KFH predicts this total will reach $1.5trn by 2013 and $4trn in 2020, by which time, says the bank, the world’s Muslim population will have exceeded 2.5bn and Islamic banks are expected to manage between 40% and 50 % of their total savings. With banks now expected to rely less on external and wholesale funding markets the ability of Shari’a compliant banks to attract such significant deposits from both the Islamic and non-Islamic sector could provide them with a major funding advantage over their conventional competitors in the medium term.

OCTOBER 2009 • FTSE GLOBAL MARKETS

Debt Report REGULATORY REFORM COULD HINDER REVIVAL

SECURITISATION: STILL IN INTENSIVE CARE

Photograph © Dreamstime.com, supplied September 2009

Although nobody expects—and regulators don’t want—securitisation volumes to return to pre-crisis peaks, current levels leave a big hole in credit supply to the US economy. While Treasury and the Federal Reserve are making valiant efforts to revive the markets, administration plans for regulatory reform could have the opposite effect. Greater transparency should improve market efficiency and the elimination of gain on sale accounting removes one economic incentive for securitisation. In the longer term, proposals to diminish the role ratings play in financial regulation could undermine the ratings arbitrage on which securitisation depends, too. Neil O’Hara investigates. FFORTS TO RESUSCITATE the US securitisation markets are beginning to bear fruit. Although still far below pre-crisis levels, new issuance has picked up in consumeroriented asset-backed securities (ABS) backed by credit cards, auto loans and

FTSE GLOBAL MARKETS • OCTOBER 2009

student loans. Secondary market ABS spreads over Treasury securities of equivalent maturity have narrowed from stratospheric to merely elevated levels. Activity has been brisk in agency mortgage-backed securities (MBS), too. These encouraging signs that the

market is regaining its footing may be deceptive, however—and proposed regulatory reforms could stall the revival. For now, the securitisation markets depend on government support and are likely to stay that way for some time to come.

Debt Report REGULATORY REFORM COULD HINDER REVIVAL

Private sector investors have been snapping up new ABS issues that are eligible for the Term Asset-Backed Loan Facility (TALF), a Federal Reserve programme that offers relatively inexpensive financing for ABS portfolios. Initially intended to back only new issues, coverage was later extended to legacy assets on a limited basis. In effect, the Federal Reserve acts as the senior lender in new ABS securitisations on terms the private market would not match, leaving room for private investors to earn juicy returns on subordinated layers of the capital structure. It’s an offer many investors can’t refuse, including some who have never bought ABS in the past. “Issuance was definitely kickstarted by the TALF in ABS,” says Anthony Lembke, a co-head of investing and risk management at MKP Capital Management, a $2.5bn NewYork-based diversified alternative asset manager. “However, in some of the recent deals, most of the investment dollars are not related to TALF. It’s unlevered, real money.” In ABS deals, issuers have always retained the lowest tier in the capital structure exposed to first dollar loss. In effect, they are primarily financing transactions, unlike private label mortgage-backed securities (MBS) deals, which are a mechanism for risk transfer if, as is often the case, the issuer sells the entire capital structure. ABS issuers have also been willing to put up additional collateral to support deals that run into trouble. For example, in May, American Express augmented the credit enhancement in its Credit Account Master Trust and agreed to discount future receivables for a limited period in order to stave off ratings downgrades threatened by Moody’s and Standard & Poor’s. The banks’ moves have bolstered investor confidence in their ABS pools, but

Tad Philipp, chief risk officer at CW Capital, a leading CMBS servicer.“There were clearly alignment of interest issues.” An indirect subsidiary of Quebec’s Caisse des Dépôts et Consignations investment fund, CW Capital has about $180bn in its special servicing portfolio and is the second largest servicer of troubled CMBS. Photograph kindly supplied by CW Capital, September 2009.

they were able to step up in part because most had received capital under the Troubled Asset Relief Program (TARP)—another form of government support. Investors are happy to buy residential mortgage-backed securities (MBS) backed by Fannie Mae and Freddie Mac, too. These government-sponsored housing finance agencies have become wards of the state whose guarantees are underwritten by the Treasury and US taxpayers—and the Federal Reserve has committed to buy $1.25trn of these securities. “There are plenty of investors involved in that market, but if it were not for the governmental involvement, the bonds would be trading at a cheaper level,” says Lembke. “That would translate into a higher mortgage rate for borrowers.” Meanwhile, new private label

residential mortgage securitisation remains moribund, and the recent tightening of spreads for commercial MBS (CMBS) owes more to the extension of the TALF to cover new and legacy CMBS than a resurgence in investors’ appetite for commercial real estate loans. The only area in which the private label market has shown signs of life is in re-securitisation of existing residential MBS—the so-called real estate mortgage investment conduits (re-REMICs). In a reprise of the collateralised debt obligation structure, bankers are repackaging the super senior tranches of existing MBS deals into new special purpose vehicles that issue new AAA-rated super senior bonds supported by one or more subordinated layers. The deal works because the existing bonds trade well below par. If the bank pays 65 cents on the dollar and buyers of the new super senior bonds are content with a 20% subordination cushion, the bank has a 15% margin from which to sweeten the subordinated layers and take a hefty fee for its trouble. “Re-REMICs are the private market expression of the TALF,” says James Kane, co-founder and managing partner of The GreensLedge Group, a New York-based boutique advisory firm that focuses on structured credit. Just as the TALF has drawn new investors to the ABS market, reREMICs attract fresh money to the private label MBS arena. The concept has worked before, too. Kane recalls that when the technology bubble burst in 2001, primary securitisation issuance dwindled and only picked up after several months of re-REMIC activity enabled investors to recalibrate their assumptions about future default and recovery rates, two critical components in MBS valuations. In time, re-REMIC activity could help the

OCTOBER 2009 • FTSE GLOBAL MARKETS

The green shoots in the securitisation markets are still relatively weak. In the second quarter, US ABS issuance rebounded to $42bn from $14bn in the first quarter and a mere $3bn in the fourth quarter of 2008, according to figures compiled by Dealogic. It’s the highest volume since last year’s second quarter, but still less than 20% of the amount issued just before the credit crisis hit in the second quarter of 2007. government scale back its current support for the markets, but it won’t happen overnight. A chasm yawns between the return the government is willing to accept as a senior lender and what private senior lenders demand. Until that spread collapses, the government will likely continue to see the need for the TALF programme. Re-REMICs do create a real bid for structured debt, which is a big improvement from a few months ago when buyers were nowhere to be found.“You need a bid and an offer in order to have a spread to collapse,” observes Kane. The green shoots in the securitisation markets are still relatively weak, however. In the second quarter, US ABS issuance rebounded to $42bn from $14bn in the first quarter and a mere $3bn in the fourth quarter of 2008, according to figures compiled by Dealogic. It’s the highest volume since last year’s second quarter, but still less than 20% of the amount issued just before the credit crisis hit in the second quarter of 2007. MBS issuance is a little stronger: Buoyed by the agency market, the $81bn issued in this year’s second quarter exceeds any period since the third quarter of 2007 and represents 25% of the pre-crisis level. Although nobody expects—and regulators don’t want—securitisation volumes to return to pre-crisis peaks, current levels leave a big hole in credit supply to the economy. While

FTSE GLOBAL MARKETS • OCTOBER 2009

Treasury and the Federal Reserve are making valiant efforts to revive the markets, administration plans for regulatory reform could have the opposite effect, while greater transparency should improve market efficiency, the elimination of gain on sale accounting removes one economic incentive for securitisation. In the longer term, proposals to diminish the role ratings play in financial regulation could undermine the ratings arbitrage on which securitisation depends, too. However, the most immediate threat is a requirement that issuers retain 5% of the risk in securitisation deals, an attempt to combat conflicts of interest among investors, lenders who originate the underlying loans and securitised debt underwriters. Securitisation severs the ties that bind lenders and borrowers in conventional portfolio lending; instead of retaining risk for the duration of the loan, the lender sells its exposure and applies the proceeds to fund new loans. In this “originate and distribute” model, the lender has no continuing interest in how the loans perform, a risk that shifts to investors in the securitised debt. “The bankers were in the moving business and investors were in the storage business,” says Tad Philipp, chief risk officer at CW Capital, a leading CMBS servicer. “There were clearly alignment of interest issues.” An indirect subsidiary of Quebec’s

Anthony Lembke, a co-head of investing and risk management at MKP Capital Management, a $2.5bn New York-based diversified alternative asset manager. “However, in some of the recent deals, most of the investment dollars are not related to TALF. It’s unlevered [sic], real money.” Photograph kindly supplied by MKP Capital Management, September 2009.

Caisse des Dépôts et Consignations investment fund, CW Capital has about $180bn in its special servicing portfolio and is the second largest servicer of troubled CMBS. While investors, regulators and legislators like the idea that underwriters should have some skin in the game, bankers are implacably opposed. Under current accounting rules, retaining 5% of the risk would

Debt Report REGULATORY REFORM COULD HINDER REVIVAL

oblige banks to consolidate the transaction, so they would have to set aside regulatory capital against the entire asset pool. Bank balance sheets would bloat and quickly exhaust the capital available to support new transactions. The deals still look like originate and (mostly) distribute, but the accounting rules treat the banks as if they were portfolio lenders. “Everybody thinks risk retention works from an alignment of interests perspective, but I am not sure the accounting works for the Wall Street firms most likely to do securitisations,”says Philipp. He notes that a precedent already exists for retaining the bottom 5%. In a Fannie Mae programme designed to promote investment in affordable multifamily housing, CW Capital is one of 26 approved Delegated Underwriting and Servicing (DUS) firms that originate qualifying loans, sell them to Fannie Mae and receive a servicing fee. Phillip says: “We keep the first 5% loss, so we are really careful when we sell a loan to Fannie Mae. We pay attention to who the borrower is and what corner the property is on.” If, as seems likely, the authorities ignore bankers’objections and impose risk retention anyway, it will open up origination of securitised debt to a whole new cast of characters for whom securitisation serves to finance principal risk—firms like ICP Capital, a financial services boutique with offices in New York and London that manages $22bn in fixed income investments and provides advice on financing solutions. “We have always been an originator for the purpose of maintaining a principal position along with our investors,” says Tom Priore, ICP’s chief executive and chief investment officer. “Risk retention validates the merchant banking approach to investment banking.”

Tom Priore, ICP’s chief executive and chief investment officer.“Risk retention validates the merchant banking approach to investment banking.” Photograph kindly supplied by ICP, September 2009.

The administration has not specified how the 5% risk to be retained would be calculated yet. A horizontal layer at the bottom of the capital structure—the first loss piece—has very different implications from a vertical slice representing 5% of each tier. Banks often held on to the super senior tranches in their deals before the crisis, too. “They could claim they have massive alignment with other investors,” says Priore. “They don’t own the first loss but they own 100% of the biggest piece. It’s a tail risk, but it’s a pretty fat tail.” The status quo ante surely isn’t what the regulators have in mind, however. Priore believes it will take longer than most people expect to work out the details of risk retention. For example, if a bank buys a package of loans at par and sells them to a securitisation at a 5% premium in which it retains the bottom 5%, its net economic interest is zero. “How does the accounting work?” he asks. “They have to define economic interest

somehow.” The Street will adapt to whatever rules are imposed, of course, but if the banks don’t want or can’t afford to hold the risk and simply act as brokers, the playing field will open up to smaller players. “The banks were bringing balance sheet capacity to the issuers,” says Priore. “They are not doing that now and you are seeing new entrants like ICP expand.” ICP’s capital markets business has grown fourfold in the past year and now employs 45 people in New York, London, Chicago and Mexico City. It isn’t alone—and the risk retention securitisation model is likely to attract interest from large hedge funds, too. Bankers do have one argument against risk retention that may strike a chord among politicians: it carries a cost, which will show up in higher mortgage and credit card interest rates for consumers. It doesn’t guarantee that securitisation deals won’t go sour, either. MKP’s Lembke, who has been following the structured debt market since the mid-1980s, points out that some deals done by savings and loan companies in that era had as much as 10% retained risk yet third-party investors still suffered losses. He advocates a return to strong commitments from sellers to buy back loans that fail to meet pre-determined underwriting standards. Lembke says: “Strict and enforceable representations and warranties are an alternative way to have risk retention without having to post capital up front but there is no silver bullet.” Whatever the final shape of regulatory reform, securitisation will survive in some form. For now, the bloodied markets may be out of the operating room but they are still under intensive care. Says Lembke: “Even where the securitisation market has come somewhat back to life, the government’s hand is still pretty close by.”

OCTOBER 2009 • FTSE GLOBAL MARKETS

Country Report WESTERN BANKS HANG ON IN EASTERN EUROPE

Eastern Europe’s Roller-coaster Ride

Foreign banks will survive the recession in Eastern Europe by the skin of their teeth but still face a bumpy 12 months, which will result in disgruntled shareholders. With the worst of the economic crisis appearing to be over and the majority of local economies on the brink of a turnaround, for the banks involved it is a case of riding out the financial storm, writes Vanya Dragomanovich

UCH AS IN their own backyards, West European banks which operate in Eastern Europe are facing at least another 12 to 18 months of thin profits and increasing levels of bad debt. With the region already deeply in recession this year and only slight improvements forecast for 2010, all of the banks in Eastern Europe, not just the foreign institutions, will feel the delayed effects of the credit crisis on their 2009 results.

FTSE GLOBAL MARKETS • OCTOBER 2009

There are two major dangers on the horizon—the de-pegging of the Baltic currencies from the euro and the still rising levels of bad loans across the region, particularly to the corporate sector—but with the cavalry coming to the rescue in the shape of the IMF (International Monetary Fund), the World Bank and the home governments of foreign banks, there looks to be sufficient financial support to weather the problems that lie ahead. Also, all of the banks in the

Photograph © Gines Valera Marin/Dreamstime.com, supplied September 2009.

region have sharply increased their loan loss provisions and some now say they don’t expect to have to put even more money aside for bad loans. The financial injections that have already been authorised by the IMF and the World Bank are slowly filtering into the region and creating a sense of stability. Even though local economies are not doing well, the overall sense of panic that gripped the region is no longer present. On top of that increasing sense of calm, the

Country Report WESTERN BANKS HANG ON IN EASTERN EUROPE Sweden’s Prime Minister Fredrik Reinfeldt at the government chancellery in Stockholm, Sweden Tuesday August 11th 2009. Reinfeldt made clear Sweden would bail out the country’s banks if necessary while the Riksbank negotiated a swap agreement with the European Central Bank which gives it access to €3bn. The Swedish banks themselves have also been proactive. Swedbank multiplied its loan loss provisions—and said it lost $228m in the second quarter because of them—and decided to cut 3,600 jobs. Photograph provided by PA Photos, September 2009

credit crunch has not removed the fundamental motive which brought the banks into Eastern Europe in the first place. Charles Robertson, ING Wholesale Banking’s chief economist for EMEA (Europe, the Middle East and Africa), says Western banks are not now likely to pull out of the CEE (Central and Eastern Europe) countries because the main reason why they expanded in the region in the first place, the low level of debt and the high potential for

growth, is still there, despite the current economic outlook. “The average level of indebtedness is around 40-60% of GDP in CEE countries, which pales in comparison with West European countries, where it is typically over 100% and the UK where it is between 150% and 200%,” says Robertson. In the Baltic countries, for instance, mortgages are equivalent to around 40% of GDP, which is more than double the level of other CEE countries but well below

the 70-80% of GDP typically seen in Western Europe. In the 17 countries of Central and Eastern Europe, including Kazakhstan, Russia and Turkey, foreign banks control on average half of the banking sector. This level is closer to 90% in the Baltics, Croatia, the Czech Republic and Slovakia. At the end of 2008 foreign banks held €2.1trn in assets and €1.2trn in loans in the region, or the equivalent of 73% and 42%, respectively, of the

OCTOBER 2009 • FTSE GLOBAL MARKETS

region’s GDP. At home, those same banks extended €11.6trn in loans, equivalent to 127% of GDP of the countries involved. Although CEE is the smaller of the foreign banks’ markets, the profits are, or have been in the past, quiet considerable. When it presented its second quarter results this summer, UniCredit, Italy’s largest bank and the biggest foreign player in the region, said that Eastern Europe produced 30% of its commercial banking revenue last year and that the region was still the best contributor to the profit of the group. Some banks are more at risk from a potential CEE crisis than others. In the case of UniCredit, only 12% of the group’s assets are invested in CEE. Far more vulnerable are Hungary’s OTP bank, which only operates in Central and Eastern Europe, Swedish banks in the Baltic countries, and Austria’s Raiffeisen and Erste. Raiffeisen has 54% of its assets in the region, compared with 28% of Erste’s, and both have significant operations in Ukraine, the region’s most fragile economy. Belgium’s KBC and Dexia, France’s Société Générale and Germany’s Commerzbank also have operations in CEE but these are relatively small compared to the parent banks’ main operations. The Nordic banks operating in the Baltic region are facing one of the single biggest threats if either Latvia or Lithuania (Estonia seems less likely at this stage) decide to de-peg their currencies from the euro. If that happens the local currency will likely plunge and the value of the loans extended by Swedbank, SEB, Nordea, Danske Bank and DnB Nordbank would be wiped overnight. This could exacerbate the financial crisis in the region because the credit that is currently still being supplied would

FTSE GLOBAL MARKETS • OCTOBER 2009

Some banks are more at risk from a potential Central and East European crisis than others. In the case of UniCredit, only 12% of the group’s assets are invested in CEE. Far more vulnerable are Hungary’s OTP bank, which only operates in Central and Eastern Europe, Swedish banks in the Baltic countries, and Austria’s Raiffeisen and Erste. Raiffeisen has 54% of its assets in the region, compared with 28% of Erste’s, and both have significant operations in Ukraine, the region’s most fragile economy.

dry up and potentially leave some of the banks in question insolvent. All three Baltic countries are struggling to stay afloat after the credit crunch crippled their property sectors and their main export markets. Latvian GDP fell by 19.6% in the second quarter this year, Lithuania’s by an even worse 22.4% and Estonia’s by 16.1%. Before the credit crunch the three countries had been the closest to joining the euro after Slovenia and Slovakia and had set up a rigid peg against the euro in anticipation of joining the currency. Once the credit crunch hit, the peg behaved like a badly set sail as it kept forcing the countries to move in only one direction, not allowing any let up against the storm. They could no longer devalue to alleviate some of the financial pressures and local borrowers kept sinking deeper and deeper, not being able to repay highcost loans and mortgages. The autumn could bring fresh problems. Officially, Latvian unemployment is at 11.8%. Local unemployment benefits last only nine months and, given that a lot of people lost their jobs at the beginning of the year, there will be a large number of

jobless without state support in the last quarter of this year. This doesn’t bode well for the government as its predecessor’s budget cuts provoked street protests in Riga in January and eventually toppled it. In its CEE quarterly report, UniCredit Bank Austria says that “although devaluation (in Latvia) is not inevitable, it is our central scenario in the next 18 months given the scale of nominal GDP contraction, the level of lat overvaluation, the extent of private sector foreign currency short positions and 2010 parliamentary elections.” Ever pragmatic, the Swedes are braced for bad news. The country’s prime minister Fredrik Reinfeldt made clear Sweden would bail out the banks if necessary while the Riksbank negotiated a swap agreement with the European Central Bank which gives it access to €3bn. The Swedish banks themselves have also been proactive. Swedbank multiplied its loan loss provisions—and said it lost $228m in the second quarter because of them— and decided to cut 3,600 jobs. If the lat is devalued, the effects would not stop in the Baltic. “If the Baltics de-peg, we fear it would result in another year of recession for those

Country Report WESTERN BANKS HANG ON IN EASTERN EUROPE

countries as all those with foreign currency debt would face difficulty meeting those debts,” says ING’s Robertson. He adds: “The knock-on effect would be the growing fear that Bulgaria may also de-peg. That would hurt one of the biggest banks in Bulgaria, OTP”, and in a domino effect could lead to the weakening of the forint and the Polish zloty, the two biggest currencies in the region. While Poland is economically in good shape compared with the rest of the region—it is the only country in Europe that will not be in recession this year—Hungary is far from it. Hungary’s latest manufacturing index data shows its industry is recovering slower than its peers, its economy declined 7.6% in the second quarter and whenever there is negative news in the region the forint is sold more heavily than other regional currencies. However, analysts believe that this decline is reaching the end. “A slow and fragile recovery of the Hungarian economy awaits,” according to Stanislava Pravdova at Danske Bank. That recovery will in part be driven by the fact that Germany, the primary export market for CEE manufacturing, is getting back on its feet and is beginning to buy in products and parts from the region. On the back of that recovery Poland, the Czech Republic and some others are expected to demonstrate slight economic growth next year. Despite this growth. the level of bad loans is, worryingly, still on the rise. Like their Swedish peers, the two Austrian banks which seemed the most fragile earlier this year have been preparing for crisis. In the first half of 2009, Raiffeisen Zentralbank increased its loans loss provisions sixfold to €1.26bn and also finalised a deal to raise €1.75bn in capital and state aid to strengthen its core capital ratio. Erste received a state injection of €2.7bn late last year.

For both of the banks the weak spot will be Ukraine where bad loans have breached the double digit levels. The banks ran a fairly conservative lending strategy in the country with most loans collateralised with tangible assets. But Ukraine is a political powder keg and business and political decisions are made to score points against political enemies. One of the local political parties recently proposed sheltering people with mortgages who are not capable of repaying their debt by not allowing banks to secure the collateral, ie,

Société Générale and Raiffeisen. Dmitry Dmitriev, banking analysts for VTB Capital in Moscow, says that at the last count, bad loans in Russia stood at 7% of banks’ total debt portfolio but he estimates this is likely to rise to 10% before the end of this year and to 15% at some point in 2010. The loan defaults will come from companies, usually manufacturers, and here the situation should start improving next year. The IMF expects Russia’s economy to shrink by 6.5% this year but to start growing in 2010 by 1.5%.

“If the Baltics de-peg, we fear it would result in another year of recession for those countries as all those with foreign currency debt would face difficulty meeting those debts,” says ING’s Charles Robertson. He adds: “The knock-on effect would be the growing fear that Bulgaria may also de-peg. That would hurt one of the biggest banks in Bulgaria, OTP”, and in a domino effect could lead to the weakening of the forint and the Polish zloty, the two biggest currencies in the region.

allowing mortgage owners to keep their property regardless. “The proposal does not surprise me but what would surprise me if this passes as law because of implications it would have on banking in the country,”says Marcus Swedberg, chief economist at East Capital, a Swedish fund manager in the region. However, with an election due in January and the economy more fragile then its peers—the IMF expects Ukraine’s GDP to contract 14% this year and the budget deficit to rise to 6%—similar proposals may make it onto the table. Another country in which bad loans are still on the rise is Russia, where the top three players are UniCredit,

“Although high, this is not enough to bring any of the foreign banks down,” says Dimitriev. “Most of them have been increasing loan loss provisions and are likely to continue to do so. Also, as the overall banking situation in Europe eases and the access to credit is being re-established, banks will be able to carry this cost for a while.” The high level of bad loans will make it hard for foreign banks to create profits in the next year to 18 months and will mean a lot of unhappy shareholders. Nevertheless, now that the worst of the crisis seems to be over and the majority of local economies seem on the brink of a turnaround it will be a matter of riding out rather than pulling out.

OCTOBER 2009 • FTSE GLOBAL MARKETS

ISTORICALLY THE SPANISH banking industry has proved remarkably adept at dodging the kind of stresses endured by other banking groups in past global downturns. However, any complacency that that history might have engendered is up for grabs, as the sector looks set for a period of high drama. After years of strong growth and stellar performances, consolidation and restructuring are on the agenda of the Spanish government for financial entities as the banks suffer one of the most severe economic downturns in the European Union. The government’s hope is that the section can be scaled down to a more realistic size and that the remaining banks can work out rising rates of non-performing loans, which are now causing pain to in an already embattled economy. Most likely to go through a particularly emphatic round of changes are Spain’s regional savings banks, or cajas de ahorro. Many of the cajas are suffering from reckless lending policies during the economic boom of the 1990s and early 2000s. Most analysts agree that the cajas are something of a proverbial poison chalice; economic necessities in many cajas are often diluted by political interference. Even

FTSE GLOBAL MARKETS • OCTOBER 2009

SPANISH BANKING: STEADYING FOR CHANGE

Spanish banks have been among the least affected by the global financial crisis and for some time it looked as though they would be able to avoid the problems faced by many of their rivals in Europe and America. However, the sector is set for a period of high drama and the country’s regional savings banks, or cajas de ahorro, are most likely to have to face an emphatic round of changes as the banking system is reformed. Rodrigo Amaral reports from Madrid.

Photograph supplied by istockphoto.com, September 2009.

RAIN IN SPAIN so, the Spanish government appears to have tabled a plan which could very well trim the savings banks sector to a much more reasonable number than the current 47. In the process, it might also reduce the meddling of politicians in their boards. Up to now, Spanish banks are among the least affected by the global financial crisis, and for some time it looked as though they would be able to avoid the problems faced by many of their rivals in Europe and America. “At first, the global financial crisis [found the] Spanish banks in a very strong position,” says Joaquin Maudos, an economist at Ivie, a research institute based in Valencia. “By the end of 2007, growth rates were high and the ratio of nonperforming loans was very low. Provisions against non-performing loans were high, profit ratios were almost double the European average, and banks were highly efficient.”

Tough competition A number of factors have contributed to the state of play. Traditionally, Spain’s main retail banks have had to weather tough competition. They were also aided by the counter-cyclical policies of the Banco de España, the

central bank. It set stringent provision rules for the country’s banks, which were forced to lay aside robust financial cushions as a counterpoint to their lending operations and they were required to do so even when the economy was growing fast and revenues were booming. Spanish banks were also barred from adventuring into the murkiest corners of investment banking. The restrictions may have put a dent on bank’s profits for some years, but worked pretty well once those awful sub-prime mortgages began exert their poisonous influence. “Spanish banks have avoided the mistakes committed by other banks with investments in toxic assets such as structured investment vehicles [such as] collateralised debt obligations (CDOs),” says Santiago CarboValverde, a professor of economics at the University of Granada. “However, we have problems of our own.” Between 1997 and 2006, the Spanish economy grew at an annual average of 3.82%, outperforming the European Union average of 2.37% in the same period. Spanish banks savoured the ride and implemented aggressive expansion policies, particularly between 2002 and 2008,

Country Report SPANISH BANKING: STEADYING FOR CHANGE

when 7,000 new banking branches were opened in the country. With 45,000 branches, an average of one for less than 1,000 inhabitants, the sector consolidated an ultimately unenviable position of being the country with the most bank branches per head of population in Europe. Moreover, the bulk of its business was the provision of loans to home buyers, property developers and builders, the artisans of the property bubble that drove the economy forward at such a fast pace.

Bursting bubbles Spain’s particular problems started with the inevitable bursting of the bubble, which took place last year. The economy grew at a very modest 0.9% in 2008, in a sharp slowdown from the 3.6% posted the year before. Sales of new homes stalled, as both domestic and foreign buyers found themselves without access to new loans thanks to the global credit crunch. By mid-2008, the Spanish economy started to contract, and it is set to finish 2009 in recession. Unemployment has soared to more than 18.5% of the active population, property developers and builders have been going bust by the penny dozen and the ratio of nonperforming loans in the banks’ portfolios has begun to accelerate at a rather scary rate. Then there is the question of the assets held by Spanish banks in lieu of bad loans to the real estate segment. The banks ended up having to establish in-house real estate agencies to try to sell off tens of thousands of properties they had been forced to take over from bankrupt developers and homebuyers in exchange for their debts. DBK, a consultancy, estimates that in aggregate, Spain’s banks had €15.3bnworth of properties on their books at the end of the second quarter this year. Consequently, “Banks are too exposed to the domestic property

market,” Carbo-Valverde notes. Of all bank loans to the private sector in Spain, 60% are in the property sector. “The volume of mortgage loans has increased enormously, but the main concerns are loans to builders and developers,” highlights CarboValverde, adding “Non-performing loans on the rise put pressure on balance sheets at a moment where there is a lot of competition and revenues are slowing down.” The situation is particularly worrying among Spain’s many regional savings banks; those cajas mentioned earlier. With tight connections in their local communities and management boards that often make decisions based on political expediency rather than sound business principles, their exposure to the property market is considerably higher than commercial banks; totalling some 68% of their loan portfolios on average, says Maudos. The volume of non-performing loans among savings banks, notwithstanding wide variations among them, is high too. Few people were surprised, therefore, when Caja Castilla-La Manch (CCM), a regional savings bank, became the first Spanish bank in the current crisis to suffer an intervention from the central bank. CCM looks to be an extreme case: its ratio of non-performing loans reached more than 14% by the end of June, but the general trend is worrying nonetheless. Right now, according to DBK, non-performing loans linked to the property sector reach 8.43% among the savings banks and 5.98% among commercial banks. Maudos believes that the overall ratio could reach 9% or even 10% in 2010. The gloomy scenario looks far from exaggeration as Funcas, a foundation linked to the savings banks, has forecast that unemployment could next year reach a massive 20.5%.

It’s not all bad news however. Spanish banks have been“able to [rely upon] the cushion of generic provisions,” thereby mitigating the pain says Maudos. “They would have faced serious difficulties to set up specific provisions for the rise of nonperforming loans without those provisions,”he notes. However, the continuous deterioration of the economy has convinced the authorities that even the prudential policies of the past could prove insufficient to prevent a number of entities to go down, creating systemic risks for the banking sector. Therefore, in July, the Socialist government of José Luis Rodríguez Zapatero announced the launching of a plan to provide aid to struggling banks. The programme, the Fund for Ordered Bank Restructuring (FROB), could inject up to €90bn in the banking system if needed. Any funds disbursed must be matched by the transfer of preferred shares or participative quotas (in the case of the cajas) to the state, which will then give the government voting rights.

Huge implications The cajas are, in fact, private entities without shareholders which enjoy the status of foundations. Stakeholders such as regional governments or institutions including the Catholic Church have a decisive say in their management. Analysts think that mergers among the cajas is a good thing. The important regional governments of Catalonia and Andalusia think otherwise—an objection with huge implications in Spain’s highly decentralised political organisation. The FROB enables the central government to ignore such objections, if it has the political stomach for it. As soon as FROB was announced, a spate of merger negotiations started to be made public. Catalonia, which is

OCTOBER 2009 • FTSE GLOBAL MARKETS

Many of Spain’s regional banks (cajas) including those in Barcelona are suffering from reckless lending policies. Photograph © Lyupco Smokvski/Dreamstime.com, supplied September 2009.

crowded by ten savings banks, could see the number reduced to two. Deals are also under way in Andalusia and Castilla y León, and there is talk that CCM could be the first savings bank to be acquired by a firm from a different region of Spain. What is clear is that there is big changes afoot. A top official from Banco Popular, the third largest commercial bank, for instance, thinks the country will end up with only five or six savings banks. For the moment, it is unlikely that the large commercial banks will be allowed to join the party. They are legally barred from acquiring savings banks, but Miguel Martín, the president of the Asociación Española de Banca (AEB), the Spanish Banking Association, says that they might be participants in the process if invited. More urgently, he says that the FROB looks well-equipped to enable Spain not to repeat what he considers the mistakes made by other European countries in their plans to stabilise the banking sector.“The European market has been shattered as each country did what it wanted, and competition

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has been affected by the way aid has been given to some entities,” he says. “Entities that acted recklessly when the economy was growing and are struggling today have to be restructured and we believe restructuring means a merger with other entities. By their disappearance as individual entities, market discipline is reinforced and prevents moral hazard in the future [sic].” Everyone agrees that mistakes were made in the boom years that now perhaps weigh heavily on the industry, such as the over-expansion of branch networks. Thousands should and will be closed in the near future and a great number of employees are set to lose their jobs. Banks have also relied too much on the international interbank market as a source of liquidity, according to CarboValverde.“Such net interbank borrowing position reached 10% of the Spanish GDP,”he says. The closing of the tap of domestic credit once interbank markets went dry has, therefore, been a dramatic development for the Spanish economy. “I have no problem with the idea that there could have been more control of

risks in the banking sector. But risk analysis is conditioned by the macroeconomic situation and the monetary policy of the central bank,”Martín says. “If the central bank has a lax policy, it is almost an obligation to provide cheaper credit and, as a consequence, to create an excess of debt.” Maudos points out that banks were actually exposed to a drubbing by the markets if they tried to act more cautiously. “Bankinter was very cautious in its lending, thus posting modest rates of growth,”he recalls.“As a result, it was punished by the stock markets and found itself as the target of three unsuccessful hostile takeover attempts.”Today Bankinter boasts one of the lowest ratios of non-performing loans in Europe at 2% and is back in the market’s good graces. In September it became the first Spanish bank to tap the international institutional markets with an issue of subordinated debt, worth €250m. Then again, some Spanish banks remain in fine fettle. BBVA, the second largest bank, has taken advantage of the crisis to increase its presence in the American market with the acquisition of Guaranty, the Texasbased lender. Moreover, Banco Santander, the market leader, purchased Alliance & Leicester and the useful bits of Bradford & Bingley in the UK for a song and has just announced an ambitious plan to finance the expansion of its business in Brazil, and listing its local subsidiary on the Bovespa. Banco Sabadell meanwhile has acquired an American bank, and La Caixa, the largest caja, is making inroads in Morocco and China, among other places. In a crowded market and with economic perspectives in Spain looking dull for the foreseeable future, focusing on international market looks an increasingly attractive alternative for those healthier Spanish banks.

Country Report TURKEY: A NEW MOOD OF OPTIMISM

Change is in the air in Istanbul, as Turkey hosts the 2009 IMF meeting. There is a new mood of confidence on the streets and the country’s bankers face their counterparts head to head, as the country weathers the global credit crunch with aplomb. Ratings agency Moody’s Investors Service changed its outlook on the Turkish government’s Ba3 bond ratings from stable to positive, reflecting “the economy’s improved resilience … [and] its unassisted performance during the global crisis of the past two years”. Much of the credit for this turnaround, even while the country’s productive output has declined by as much as 9% this year, is due to the country’s central bank and its Capital Markets Board, which together have helped create a benign environment in which the country’s banks can prosper unhindered. HE POSITIVE OUTLOOK acknowledges that the Turkish economy was better prepared to face the credit crunch and the resulting global recession than would have seemed possible given its dependence on external capital,”says Kristin Lindow, regional credit officer for Europe and Africa in Moody’s Sovereign Risk Group.“Moreover, the government did not have to rely on external support from the IMF or other official sources as it had needed in past crises.” According to the Turkish Statistical Institute (TURKSTAT) the economy shrank by some 7% in the second quarter of this year, a substantive drop, yet lower than the massive 13.8% contraction suffered in the first quarter. The economy grew by an

Turkey’s central bank governor DurmuşYılmaz. Photograph supplied by PA Photos, September 2009.

ECONOMIC FLIP OR FILLIP? annual average 6.8% between 2002 and 2007, an unprecedented run for the country, though economic indicators began (as elsewhere) to turn negative in the third quarter of 2008. Lindow notes that although the contraction in Turkey’s GDP during the first half of 2009 was severe, the local financial market has “handled well the scarcity of external capital inflows and the tightening of credit conditions. This has been evidenced by the government’s ready access to both domestic and external credit and the rapid decline in market interest rates from their peak. Heavily indebted private sector companies were able to roll over or repay their own external obligations without government intervention.”

Central Bank governor Durmuş Yılmaz told reporters at the beginning of September that as long as the government keeps a grip on spending, the country can manage without having to borrow from the IMF. Moreover, he noted that the economy’s growth trend “is upwards and is improving”. Among the efforts to revive the flagging economy, the government has slashed taxes on cars and white goods and increased budget spending, while the central bank has consistently cut interest rates to a record low level; a move which has directly profited the country’s banking sector, which has tended not to decrease the cost of borrowing, either to consumers or to the SME and larger corporate sectors. The central bank has used interest rate

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Country Report TURKEY: A NEW MOOD OF OPTIMISM

policy as a key lever to kick start the economy and through the summer pressed on with a series of cuts to bring rates down from 8.75% to 7.75% and it is likely that it will continue in this vein through the third quarter if it deems that the recovery of the economy is not secure. Official figures released up to the end of August provided a mixed message, as consumer confidence grew in the second quarter and then proceeded to fall in July and August. At the heart of Turkey’s policies is the need to stabilise the economy over the medium term. Tax cuts combined with the burden of supporting more jobless people have forced the government to more than quadruple its budget deficit estimate for the year. The IMF has called on Turkey to reduce spending, should it intend to avail itself of the multi-lateral’s special drawing rights. In Lindow’s opinion, at Moody’s, in order for Turkey to regain fiscal credibility, “an ongoing commitment to low inflation will be crucial to avoid undermining the progress made earlier in this decade. For instance, the passage and implementation of supporting legislation for the proposed fiscal rule could be beneficial to improve debt affordability”.

Rising equity values In spite of some of the more obvious structural inconsistencies in the national economy, the country’s equity markets continue at a clip. Investors appear prone to believe that interests rates in Turkey will continue to fall and, in addition to a general upturn in global equity markets, the Istanbul Stock Exchange ( MKB) has steadily risen through the summer, though the market overall has remained volatile. Nonetheless, according to midSeptember figures issued by the exchange, the percentage share of foreign investors in Turkey’s main board has been pretty consistent through the

third quarter, at around 66% (equivalent to around TL72bn worth of indirect investment inflow). According to Ilhami Koç, general manager of Is Investment, the investment banking arm of IS Bank, the Turkish trading market has become increasingly sensitive to developments in Europe, and in particular the United States, “particularly as a growing number of international investors are utilising trading services. The front end of the trade might originate in Europe, but the back end is increasingly in the US,” he says. Koç further thinks that Turkey is increasingly the focus of foreign investor interest. At the beginning of July, Is Investment held a conference in London, organised around an Eastern Mediterranean theme. “We had expected 30, maybe 40 participants, but were pleasantly surprised to note more than 100 attendees; and that is a true reflection of the levels of interest we now handle in the country’s capital markets from foreign investors active in Turkey,”adds Koç. Koç is also buoyed by the outperformance of the equity markets. Moreover, he believes that a tipping point has been reached in the country’s capital markets.“Generally, I think foreign investors expect 2010 to be substantially better than this year,” he smiles. He also cites initiatives, such as the recent announcement by IMKB that it is planning to create a Turkeywide single trading platform, bringing together the Istanbul stock exchange and the country’s gold and derivatives trading markets. “If implemented, it will offer new opportunity to the country’s investment banking and brokerage segments, as brokers will be able to trade on three bourses through a single connection,”explains Koç. For its part, IMKB envisages the integration of the new platform with other key financial trading centres in London, Frankfurt and New York at some point in the near future.

Turkey’s banking sector continues to outstrip expectations in spite of its sometimes negative image in the global theatre. In mid-May this year, for instance, Turkish banks reported their first-quarter financials and most beat expectations. Profits at the top eight banks came in at TRY2bn (€940m) in the quarter, which was down only around 10% year-on-year. Of particular note was that non-performing loans (NPLs) accounted for between 3% to 5% of total bank lending (though this is expected to rise 6% by year end, according to a recent analysts report by Deutsche Bank) despite the downturn in the real economy, which is likely to see GDP contract in aggregate by over 6% in 2009.

The continuing importance of T-bills The banks have used their extra cash to invest in local treasury bonds (a long-standing strategy in the Turkish banking market), made more profitable by the central bank’s interest rate cuts. As a result, almost all Turkey’s banks put in strong bottom-line growth in the first quarter of this year compared with the same period a year earlier; particularly as few if any banks have reduced their on-lending rates, thereby boosting profits. Revenue has also increased as central bank rates have declined, while the bank’s own lending rates have remained stable. Akbank, the country’s largest private bank, reported net profits of TL1,309m over the half year, with the bulk (TL740m) in the second quarter. Overall, the Turkish banking segment increased its net profit by 33% in the second quarter, compared to the same period last year, according to figures prepared by the country’s Banking Regulation and Supervision Agency (BRSA).The sector raised its net profit to TL11bn in aggregate. The sector’s

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deposit, participation and loan credit customers also increased in the quarter, while the proportion of non-performing credit card customers to total credit card customers touched 8% over the period. As of June, the banking sector’s total assets reached TL768bn liras, however the BRSA anticipates a further slowdown in domestic demand and by extension new bank loans in the remainder of the year. Nonetheless, the sector’s total loans rose 7.4% in June over the corresponding period last year, to TL368bn. In line with the slow down of loans, the banks’tendency to increase their placements in securities has continued. Deposits, which constitute the sector’s most important foreign resource, reached TL468bn. The sector maintains its robust equity capital structure. In June, its aggregate equity capital reached TL98bn, while the sector’s equity capital was 18% and its return on assets 2.2%.

Bank funding strategies Changes in the way that Turkey’s leading banks raise finance, though, have been under way for some time. Over the last decade, syndications raised on behalf of Turkish banks were more scale affairs, with a large number of participating banks. Over the boom years this was replaced with an increasing number of club deals. That indicated that Turkey’s financial institutions were increasingly dealing with a specialist group of global banks or lenders that understood the market and could right sell down and price Turkish risk. “Two elements have changed the nature of the game as regards the sector’s reliance on foreign funding. One is that reliance on wholesale funding is now only 13% of the sector’s liabilities and, in that respect, Turkey is clearly differentiating itself from the rest of the emerging markets. Second, despite the crisis, the banking sector

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remains very price conscious of its borrowing. In the past, Turkey’s banks were renowned for being stingy. That is now paying off in spades,” explains Tansu Yuksel, vice president, at Vakifbank. Moreover, he notes that the exposure of the banking sector to foreign loans has also contracted: more a term trend, rather than an indication of the relative tightness in the syndication market for new capital raising. The amount that the sector has to repay over the coming year now in the Turkish banking sector’s total syndication repayment in the next 12 months is only $9.7bn, according to central bank figures, issued in July. In the second half of 2009, the trend is widening and syndications are increasingly popular, indicating that the country’s banking sector is garnering greater appeal. Even so, pricing on Turkish bank risk remains tighter and margins remain high.The pricing range is tending to hover between 200 basis points (bps) over LIBOR and 250bps for euro and dollar denominated deals. The increase in price since in the spring and summer of 2008 is dramatic however: before Lehman’s fall 67.5bps was the benchmark for most Turkish bank syndications. A further development, is that Turkish banks, such as Akbank and Garanti, are increasingly ending to be self-coordinated, garnering more control over the process. Technicalities aside, April and May consolidated return of Turkish banks to the capital markets for one year facilities on relatively favourable terms. In May, IS Bank secured a one-year $570m dualtranche term loan facility, funded in both euros and US dollars. The transaction was a club deal, with 28 banks from 14 countries participating. The US dollar tranche, worth $255m, came in at LIBOR plus 2.5% (typical for the times and Turkish risk right now). The €225.25m tranche,

meantime, has an extension option of a further one year and is priced at Euribor plus 2.5%. IS Bank is Turkey’s largest private bank in terms of total assets (worth $64bn at the end of last year) and is rated“BB-”by S&P’S and “B1”by Moody’s.Yapi ve Kredi Bankasi had entered the markets in April with a one-year benchmark dual tranche facility (worth $136m and €210.5m respectively) at 2.5% over LIBOR/EURIBOR. By mid September, another IS Bank dual tranche facility, originally signed in October 2008 was rolled over for a further year. The rollover involved two tranches, a $350m and €293.5m of a syndicated loan The loan was extended with the participation of 41 international banks and will be used for trade financing. The total cost of the loan for the banks which participated with the highest amounts, was realised at Libor+2.25% and Euribor+2.25%, respectively, a marginal tightening of rates. A couple of days later in mid September, Yapı Kredi successfully signed a one-year multi-currency club deal worth $985m.The club loan facility, raised by a syndicate of Yapı Kredi’s key relationship banks, is comprised of a US dollar tranche of $397.5m and a euro tranche of €399.5m. The all-in cost is LIBOR plus 2.25% per annum, illustrating that the marginal tightening looked likely to roll out across the market as a whole. Yapi ve Kredi’s club loan facility is a replacement of a $1bn of syndication loan maturing in September 2009. The proceeds of the loan will be used by the Bank to prefinance customer exports and export contracts. An oversubscription encouraged the bank to raise the amount borrowed from $800m to just under $1bn. UniCredit Bank Austria was coordinating bank and documentation agent and Commerzbank International acted as facility agent.

Country Report PENSION FUND PROFILE: OYAK – THE PENSIONS BENCHMARK

The industrial conglomerate Ordu Yardimlasma Kurumu Group, otherwise known as OYAK Group, is actually Turkey’s first and largest private pension fund. OYAK is an unusual hybrid: a military pension fund that acts in practice as a private equity investor, actively managing in-house an investment portfolio of leading companies which ultimately funds pensions for 240,000+ members, including officers and civilian workers of Turkey’s armed forces. The Group has consistently outperformed and has become a new template for pension funds elsewhere.

ASPIRATIONAL PENSION MANAGEMENT YAK GROUP CHIEF executive officer Coskun Ulusoy says the OYAK investment approach stems, historically, from the fact that Turkey’s capital markets were relatively underdeveloped. “The fund had to do something to make money, and so we invested in companies.” In doing so, over the last seven years, OYAK’s management has boosted the total assets almost eightfold (from just over $1bn in 2000 to more than $8bn today) and boosted the fund’s income beyond the 10% mandatory wage deduction levied on members.The pension fund returned 26.3% in 2008, while the benchmark ISE-100 index fell 52% over the same period, after the global credit crunch reduced demand for some emerging market assets. According to Ulusoy, the descriptions thrown at OYAK are often simplistic. “You can argue that when the fund was started in 1961, it was essentially a mutual assistance system, not a retirement fund as such. It was also designed to provide life insurance services and disability

insurance. This was quite revolutionary for its time; however insurance schemes have never really taken off in the country, as awareness of the product remains limited.” The pension system offered by OYAK now remains “straightforward,” holds Ulusoy. “It has many similarities with other direct contribution systems; you invest and receive a lump sum on retirement, with the option of cashing it all in or taking a portion of the cash up front and the rest in the form of regular payments,” he explains. On the management side, however, cedes Ulusoy,“that puts us under tremendous pressure to provide greater than market returns to ensure that our members receive an attractive pension. So in 2008, we made 26.3% and will pay that extra return to our members in quarterly instalments. That’s what drives our business strategy.”

No fees OYAK is unusual also in that it charges its members no fees: “just the operating costs of the overall

Oyak Group president and chief executive officer, Coskun Serif Ulusoy. Photograph kindly supplied by Oyak Group, September 2009.

management of the Group. When I started, 9 years ago, we had 200 people managing the scheme and we still have 200 people managing the scheme. We’ve kept costs relatively stable but managed to increase the members’ reserves, our assets, by a factor of 16, actually in US dollar terms it has increased eightfold,”he notes. OYAK is now one of Turkey’s largest and highly profitable and competitive industrial and services conglomerate. Just how competitive OYAK is, was demonstrated by its determination to secure control of Turkey’s Erdemir steel complex, a major producer of flat steel products for Turkey’s automotive industry. It fended off competition from both pre-merger Arcelor and Mittal for an aggressive $3bn bid for about 53% controlling stake of Erdemir back in 2005. The high bid paid off. Erdemir is currently said to be worth more than $8bn. It is also noted for having bought a group of failed banks under one name in the financial crisis in 2001, for $36,000, investing about $750m into it and

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selling it to ING for $2.7bn in 2007. Created in 1961, OYAK provides a supplementary pension for officers in the armed forces and some civilian military personnel, over and above the state pension. It has 240,000 + members and funds under management total about $8bn. Ulusoy stresses that OYAK is a purely commercial entity, interested only in returns for its members, who happen to be army officers. It has independent auditors and makes full disclosure of its activities. Given OYAK’s ambition to expand abroad, the fund is anxious to eliminate any ideas that it is a sovereign wealth fund, disguised as a pensions’ provider. Certainly, OYAK is not a passive portfolio investor. Ulusoy is proud of OYAK’s individuality; holding that it is a new model, a pension fund that conducts its business in the manner of a private equity firm. It has stakes, often majority holdings, directly, in about 30 companies, such as Erdemir. It has a bias towards infrastructure, such as OYAK Cement group for example, which controls 15% of the Turkish cement market, and it has a 49% stake in ISKEN, a power generator owned jointly with Evonik/Steag, of Germany, which enjoys 7% of the Turkish electricity market. In many ways OYAK typifies the grit and determination of its top management team, which includes Caner Oner, who has worked with Ulusoy on and off for more than 20 years, having run Turkey’s state banking giant Ziraat Bankasi together in the late 1980s. Ulusoy has consistently been a catalyst for change in the country. When Ulusoy took over the reins at Ziraat, at the invitation of then premier Turgut Ozal, the bank was a clunking state machine that grindingly processed salary payments for the country’s bloated civil service. Ulusoy and his team turned around

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the bank’s fortunes and its infrastructure, bringing the bank into ‘real time’ management and accounting and turning it to profit. After leaving Ziraat, during the premiership of Tansu Ciller, Ulusoy joined the Koç Group and established Koç Finance the first consumer finance operation in the country, creating a business template that was copied by virtually all of the country’s financial conglomerates. Just a clip less than a decade ago he joined OYAK and began to formulate a commercial funding model that would ensure that the group’s pensioners would enjoy “better than market returns.” Ulusoy regards it as a moral as well as a commercial obligation.

A global outlook Although a national pension institution, OYAK’s business outlook is global; “a necessity in a changing market environment,”he says. Even so, outsourcing of portions of the fund’s portfolio is not an option. Ulusoy and his team prefer direct stakes and management input into investments: “so that the business and growth imperative remain clear,” he stresses. “After all, why should a pension fund not manage another company? Who says it cannot or should not be done? Why hold to traditional investment approaches? My argument is: get in there and get involved.” OYAK’s strategy is now being actively expanded beyond Turkey’s borders, as cedes Ulusoy, the group needs to diversify beyond the domestic economy“to reduce risk and widen opportunity”. Nonetheless, the fund will stay with its commitment to investments in “basic industries and resources, which will take on increasing momentum as the global economy turns back to growth”, though he remains bearish and suggests that real recovery will not

take root until some time in 2011. Nonetheless, for OYAK it remains business as usual and the firm is looking for mineral supplies, mainly iron ore and coal, to supply Erdemir. Ulusoy says OYAK has a substantial cash pile, worth more than $3bn, to fund“the right investment.” Right now, the fund is planning to build a third turbine with a capacity of as much as 600 megawatts at a power plant in Iskenderun on the Mediterranean coast in 2010. The power plant’s current capacity is 1200 megawatts and it produces about 7% of Turkey electricity, Ulusoy says. Looking ahead, OYAK is unlikely to repeat the success of 2008 holds Ulusoy, “though the principal is still rising and better returns will found in subsequent years.” For the time being however, Ulusoy and his team have a two-fold mission. “The first is obviously that we are constantly looking for income.”That income will finance an immediate objective that OYAK now articulates to members: that after 30+ years of pension contributions, members of the fund should be able to expect an accumulation of funds in their pension sufficient to finance the purchase of both a home and a car.“It is a symbol, for sure,” says Ulusoy, “however it is a obligation on our part to deliver the best to our members, to help them articulate and achieve a dream perhaps.” The second is a new mission, to convert other pensions to new models of operating.“Perhaps now is the time to throw off the mantel of old style thinking and adopt different approaches to managing pension money.”Ulusoy believes that the OYAK model is a template for what can be achieved. Certainly, many pensioners might agree. After all, who would turn down a new house and a new car when your pension becomes due?

COVER STORY: A REGIONAL LEADERSHIP ROLE?

IS Bankasi (Isbank) has been a leading private bank in Turkey since its inception in the 1920s. Since then it is has been the quiet leader in the Turkish banking market. Isbank chief executive Ersin Özince, is a considered and erudite proponent of the view that Turkey’s banks, and Isbank in particular is well placed to take on a growing role in the immediate near East region. Is he right in thinking that the country’s banks now have a workable and exportable business template in train? Francesca Carnevale went to Istanbul to find out.

QUIET

ASPIRATIONS I

Isbank chief executive Ersin Özince. Photograph taken by Yildirim Celik, Turuncu Foto, Istanbul, September 2009.

S BANKASI (Isbank) traces its august beginnings back to 1924, when it was established by a special mandate from Atatürk, following the establishment of the Turkish republic. A publicly traded firm since its inception, since August 2005 41.5% of the bank’s shares are held by Isbank’s own private pension fund, 28.1 % are special Ataturk’s shares that are represented by Republican People’s Party and 30.4 % of the bank’s equity is in free float on the Istanbul Stock Exchange (IMKB). In May 1998, some 12.3% of the equity previously held by the Turkish Treasury were sold to national and international investors in a public offering. Now boasting 1074 branches and over 22,000 employees, the bank’s market capitalisation was valued at TL10.3bn at the end of March 2009. The bank is now the fourth largest by market cap of private corporations in Turkey, and is equivalent to 5.63% of the IMKB’s market cap. In August this year, ratings agency Moody’s Investor Services changed the outlook on the bank’s financial strength from stable to positive. The rating is based in large part on a substantive jump in profits for the first half year and a conservative provisioning policy, which involves 100% provisioning against non-performing loans, which grew by 12.5% over the first six months of this year. According to Ersin Özince, Isbank’s chief executive, the bank has, “strengthened its position as the largest private bank in Turkey in spite of the current economic contraction. This is due to its selected approach in asset creation.”

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Isbank posted TL1,471m net profit in the first half of this year, from total assets worth TL118,986m. Explains Özince, “on a consolidated basis, the bank increased its asset size by 7% and shareholder equity by 12.8% in the first half of this year, the highest profit among private banks in the country. Net profit was up by 20.8%, compared with the first half of 2008. Moreover, consolidated deposits continued to rise and are up by just over 5.4% over the period.”An extension of the bank’s branch network and a concerted push to broaden the bank’s appeal in its home market has been a keystone of the bank’s business build in the first half of the year. Isbank started the year with 1,039 branches and increased it to 1,074 branches by the end of June. “We also hired new staff numbers, which rose by more than 1,000 over the period,” says Özince. The move was motivated by 22% growth in the 2008 full year (with a TL1.8bn pre-tax profit). The main driver of the bank’s asset growth last year was a 40% expansion in the bank’s loan volume, with Turkish lira loans rising by 31% and foreign currency loans increasingly by 26% in US dollar terms. It was natural therefore to focus on expanding domestic market share. However, stresses Özince, it is not expansion for expansion’s sake. “The bank will make every effort to growth its activities in a profitable and healthy manner, without overlooking the prudency [sic] required in the crisis conditions. We have to marry the determination of our employees to succeed, the interest in the bank from our clients and customers and the trust of our shareholders. We are very aware of these three pillars in our growth strategy.”

A burgeoning banking segment However, as Özince illustrates, while Turkey enjoys a burgeoning banking segment, the country as a whole still remains under-banked compared to its near neighbours. Banking activity in the country remains at a ratio somewhere in the region of 1.5 times gross domestic product (GDP), compared to an average running between 2.5 to three times GDP in continental Europe. That means, he smiles, is that time is on the side of Turkey’s banking sector and Isbank in particular. Non-deposit sources of funding have also been key this year and most recently, in May this year, the bank secured a dual tranche syndicated loan, worth $225m and €225m, with a tenor of one year, with a further extension option for a further 12 months. The cost of the credit facility, which will be used to support Turkish trade, came in at Libor plus 2.5% for the dollar tranche and Euribor plus 2.5% for the euro tranche. “The credit was obtained with the participation of some 28 banks from 14 different countries, demonstrating the broadening appeal of the bank in particular and the Turkish market in general,”notes Özince. “It was particularly consoling for us in this period of market turbulence. To this, of course, we added a credit agreement, that we signed earlier this year with the European Investment Bank, which is worth €250m, which underscored our efforts to diversify the international

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However, as Özince illustrates, while Turkey enjoys a burgeoning banking segment, the country as a whole still remains under-banked compared to its near neighbours. position of the bank,” he explains. The bank followed this up with a further dual tranche currency term loan in late September, comprising a $484.5m tranche and a €236m tranche. Funds are believed to have cost 2.25% over Libor for the dollar tranche and 2.25% over Euribor for the euro tranche, indicating also the slight easing of margins for Turkish one year bank risk in the capital markets, which has been a feature of new loans signed at the end of the third quarter this year. Özince is also chairman of the board of Turkey’s banking association, a perch which invariably colours his world view. He believes that it is a pivotal period for both the country and the bank, offering opportunity for more leverage, both of inward direct and indirect investment and growth from within. In that context, Isbank and the country’s banking segment as a whole are poised for substantive growth. “Turkey is a senior player in the emerging market category,”he maintains.“This country has spent three decades, if not more, involving itself and refining open market practice. The cumulative benefit of that experience is now bearing fruit. Turkey is interpolated between the emerging and developing words and because of that we have witnessed unprecedented levels of foreign capital coming into the country to leverage that fact.” Özince believes the trend has reinforced the banking segment per se.“Almost all commercial Turkish banks have strategic shareholders and almost all the publicly held banks, including Isbank, have large percentages of their free float in the hands of major international investment firms, which has added to the strength of the banking community.” He points out that the country’s banks have been“more committed than other financial institutions,”to conforming to Basel II arrangements among emerging markets nations.“Not only the financial sector, but also the macro-economic indicators have been consistently improving and the country has outperformed many of the new European Union entrants.” In these circumstances, he notes,“the financial tsunami did not cause us a high season of concern. The banking segment had already made substantive reforming moves following the 2001 financial crisis and has been extremely cautious and conventional in its business behaviour and habits ever since. We have had no toxic debt and no Turkish institution has either serious exposure to toxic assets or direct exposure, though obviously we too have felt the impact, particularly in margins on foreign borrowings.” Even so, concedes Özince, “Turkey has always paid some serious margins in this regard.”

COVER STORY: A REGIONAL LEADERSHIP ROLE? 52

Isbank chief executive Ersin Özince. Photograph taken by Yildirim Celik, Turuncu Foto, Istanbul, September 2009.

The growth imperative “Growth is the biggest issue right now,”muses Özince. He is keen to highlight the regional template in which Turkey now operates.“The potential is enormous, both east and west, as we are located smack in the middle of a seriously growing sub-continental region,” he adds. In so far as there are vulnerabilities, Özince is aware of the downside. “Current macro-trends are mixed, creating perhaps the worst risk environment.“It is almost a year that the rapid growth of the last decade has dissipated and when it returns, it is unlikely to return ubiquitously,”he explains. This has lasting implications for the banking segment, he avers and sounds a note of natural caution.“Certainly, the banking sector’s growth during the first quarter of this year is still in double digits. However, we must be aware of the overarching trend that might push us towards decelerating growth rates,”he adds. Turkey’s new business hinterland, which encompasses much of eastern Europe, the Black Sea states and a growing list of CIS (Azerbaijan, Turkmenistan and Kazakhstan, eastern Mediterranean states (such as Syria and Israel), as well as Iraq and Iran will, hopes Özince, encourage Turkey’s banks to focus on the potential of developing Istanbul as a regional financial centre. Certainly, the notion has taken shape in Özince’s mind. “Isbank means customers are put first the bank has always tried to raise its game in this regard. The banking needs of these countries is still below the level of many large Turkish cities and in this regard, opportunity beckons. Should these countries commit themselves to the basics of open market practices and there is a peace window right now, we think it is our mission to spread our practice as far as we can in this zone.” Internally a number of dynamics are also taking shape. “The east of Turkey is in some respects another country, and the potential is still not fully realised. We have focused our efforts on this zone over recent years and now enjoy the single largest market share (around 25% of the total market) in Van province,”he notes. Then again, Özince points to the opportunities and problems in the make up of the Turkish small to mid-cap enterprise (SME) market segment, which he says is also “bringing pressure to bear on the banking sector”; and he maintains is a front line in Turkey’s efforts to become a regional

Turkey’s new business hinterland, which encompasses much of eastern Europe, the Black Sea states and a growing list of CIS (Azerbaijan, Turkmenistan and Kazakhstan, eastern Mediterranean states (such as Syria and Israel), as well as Iraq and Iran will, hopes Özince, encourage Turkey’s banks to focus on the potential of developing Istanbul as a regional financial centre.

business and financial hub. However, the benefits enjoyed by the segment are not always and everywhere the same. It is a question of differentiation, he posits.“Definitions in Turkey are a little bit different. In Turkey and in the markets at large, at least in most of the markets and especially in the Middle East and in the east of the country, actually the SME segment is doing rather fine. In industrial Turkey however, where the SMEs are connected to the European Union, there is something of a problem, particularly in the smaller market segment, where consolidation is inevitable.” Overall, Özince believes this to be a positive trend, “Actually we need more sizeable SMEs which can compete effectively in these regional markets,”he adds. Özince explains that the smaller market segment is a direct by-product of the high growth rates of the first decade of this century. “Add to this a substantive grey, unregistered market and you realise that a meaningful section of the economy has been operating outside usual business standards. Naturally, a priority in the banks has been to either encouraging regularisation of this segment, or to reduce their exposure to these firms,”he says.

Regional versus global? For all the promise of the near east Özince remains a committed globalist and posits a responsible and moral approach to modern banking, “if benefits, regulation and profits are to be universally enjoyed.”He believes the global markets should advance on the basis of a benign financial culture that is mutually supportive, rather than“beggar thy neighbour. Surely the experience of the last eighteen months has taught us the benefit and need for mutual support and the articulation of common goals in the raising of standards in the banking segment.” Optimistically perhaps, Özince firmly believes that modern Turkish banking now provides something of a marketable roadmap, as it “successfully meshes entrepreneurship with considered and cautious banking methods”. Moreover, he says, the country is ready to export its banking expertise, offering a substantial body of well trained and educated bankers. “This is still a young society, with new and radical ideas to offer the world. It is obvious that we have the potential to lead the region. Can we look even wider?

OCTOBER 2009 • FTSE GLOBAL MARKETS

ANONYMITY —A FIVE-CARD TRICK I

Photograph supplied by istockphoto.com, September 2009.

FTSE GLOBAL MARKETS • OCTOBER 2009

TRADING: WINNING STRATEGIES

Dark pools, which have sprung up in Europe since 2007 following the European Union’s Markets in Financial Instruments Directive (MiFID), have been used by traders in greater numbers largely because there is no requirement to display information on either your identity or the quantity or price of your intended trade. Ruth Hughes Liley reports on what UBS’s Owain Self describes as the balance between remaining anonymous and minimising opportunity cost.

N THE CARD game poker, players who keep their cards close to their chest and maintain an inscrutable expression on their face are most likely to keep their intentions and their hand secret. In today’s world of equities, traders have to use similar strategies if they want to win the game or try to outwit those who would outwit them. Anonymity in trading is crucial according to traders across the industry. If there is any information seepage while trading stock, the market moves against the trader with an opportunity cost which could be enormous. “It really comes down to a balance between remaining anonymous, and minimising your opportunity cost,” says Owain Self, UBS’s head of algorithmic trading, Americas and EMEA.“Are you willing to show your hand in order to get the trade done? The key to all types of trading is to minimise information leakage but also to maximise the opportunity to trade. The only way you don’t give anything away is if you don’t trade.” Anonymity levels vary, starting with very transparent markets, such as Spain, which offers very little anonymity and where the broker is visible both pre- and post-trade. Pre-trade anonymity is in the form of both nonattributable orders (“I want to trade but I don’t want anyone to know it is me”) and non-displayed orders (“I don’t want anyone to know I am ready to trade”). Posttrade anonymity is limited due to reporting rules, but key is whether the trade was attributable (“I don’t want anyone to know it was I who traded”).

TRADING: WINNING STRATEGIES 54

helped to improve volume growth, although the counter-side is that buyside traders are not happy to leave chunks of stock in an electronic market because they are worried about information leakage.” That in turn, believes Vermaas, has contributed to a rise in the popularity of dark pools as a place to trade larger orders.“People have gone to dark pools as they assume it is safe to find a counterparty and to avoid interruption in the price formation process. But now it appears that dark pools are not the most ideal solution either, because gaming can go on in there. With gaming, intelligent algos are able to determine depth behind a buy or sell order and this knowledge could be used to manipulate prices on the lit markets. There is always a counter-side to every development.” Dark pools, which have sprung up in Europe since 2007 following the European Union’s Markets in Financial Instruments Directive (MiFID), have been used by traders in greater numbers largely because there is no requirement to display information on either your identity or the quantity or price of your intended trade. Liquidnet Europe announced in its April 2009 Buy-Side Voice Survey that threequarters of buyside respondents were planning to increase their use of dark Owain Self, UBS’s head of algorithmic trading, Americas and EMEA.“Are you willing to pools. The firm itself, a dark buyside to show your hand in order to get the trade done? The key to all types of trading is to buyside crossing network, recently minimise information leakage but also to maximise the opportunity to trade. The only reported a new monthly record of principal way you don’t give anything away is if you don’t trade.” Photograph kindly supplied by trade of £5.1bn in August. Figures from UBS, September 2009. research agency Rosenblatt suggest that a Retaining anonymity can be tricky as Self points out:“As decline in volatility could be a reason for dark pools soon as you have traded, you have given away information: market-share gains, which they estimate went from 7.71% They don’t know how big or how aggressive, but they of consolidated US equity volume in May to 7.82% in June, know there is a buyer. Post-trade reporting is immediate although overall consolidated volume fell by 14%, giving dark pools a larger share of the market in June. but are there still shares to be traded? You don’t know.” Steve Brown, director of operations and IT at Liquidnet On 23rd April, 2001, Euronext Paris introduced anonymity to its limit order book and a study two years Europe, says:“With MiFID came a greater freedom to trade later by Foucault, Moinas and Theissen concluded that anywhere you want and a promise of greater post-trade transparency. But the problem is that the buyside may not anonymity had resulted in tighter spreads. Cees Vermaas, head of European cash markets, NYSE see the post-trade reports for two or three hours, and Euronext, agrees that anonymity leads to more efficient comparisons of pre- and post-trade reporting are showing markets with tighter spreads, more volume and better price up discrepancies in the reported volumes.” The rise of non-displayed liquidity venues has also seen discovery mechanisms: “If you look at the history of anonymity, years ago you had to have ID if you wanted to a rise in the amount of gaming, where unscrupulous trade—you could see your counterparties. We think traders take advantage of the anonymity to manipulate the anonymity has resulted in fairer markets because all price of a stock in a dark pool by putting up a small amount participants have equal access to information regardless of of stock to see if there are any takers and then posting a less favourable price to trade a larger part of the order. whether they are big or small. As electronic trading has developed, so has anti-gaming “The trend to electronic trading has led to fragmentation and smaller sized trading which has helped anonymity and technology, which aims to try to limit price movement.

OCTOBER 2009 • FTSE GLOBAL MARKETS

TABB Group estimates that Brown talks of “lifeguarding the larger sellside firms spent an pool” with three levels of estimated €714m on market data authentication before traders are and trading technology in 2008, allowed into Liquidnet: “We and Banneville is seeing more monitor what activity is taking and more smaller players giving place throughout the day. We up their expensive exchange have strict trading rules and we membership to put their trades closely monitor for system abuse. through larger brokers:“We have something suspect is If seen more brokers coming to us happening, we take action.” to provide SORs and algorithms. At Schroders Asset By concentrating the flows in Management, which manages fewer market participants it assets of £113.3bn annually, contributes to anonymity Steve Wood, global head of because it concentrates with a trading, says there’s more few brokers with enough slippage when interacting with technology to guarantee it. On the sellside: “You want to know the other hand you could argue what makes up a broker’s that technology has made internal pool—the Morgan trading less anonymous because Stanley, UBS, Goldman Sachs now people can reverse engineer joint pool for example—and who Cees Vermaas, head of European cash markets, NYSE a trading pattern and give the you might be crossing with. Is it Euronext, agrees that anonymity leads to more efficient game away.” client flow, the risk book, Delta markets with tighter spreads, more volume and better Brokers’ algorithms are also One, high frequency or stat arb price discovery mechanisms: “If you look at the history of being offered to buyside firms hedge funds making markets in anonymity, years ago you had to have ID if you wanted anonymously: in March, agencythe pool?” to trade—you could see your counterparties. We think brokerage execution allowed Schroders is not alone on the anonymity has resulted in fairer markets because all buyside clients anonymously to buyside in developing detailed participants have equal access to information regardless access the algorithms and questionnaires which enable of whether they are big or small. Photograph kindly electronic trading tools of four traders to check the quality of a supplied by NYSE Euronext, September 2009. global brokers. dark pool and even algorithms While sophisticated technology to detect trading and smart order routers, so they can trade anonymously with confidence. Wood says:“Low touch is the best way to patterns seems to have developed into an industry of its stay anonymous and to stay totally anonymous the best own, sometimes, methods are much more hands-on. It’s more difficult to hide in the less fragmented Asian way is to go to the exchange or MTF ourselves with DMA tools. We use the black box and smart order routers (SORs) markets, says Wood of Schroders. “In Korea everything is and we are segregated from the brokers. On the other traded on client identification codes, so you have to declare hand, SORs do leave a footprint, which can signal that we yourself and the local traders can see you coming. If you are doing something or at least that someone is trading use an international broker, they can read information into that and front-run you quite easily. An algo or DMA who is the same size and stature as us. “High-frequency traders have developed sniffer provider could use a local broker to try to avoid detection programmes to hunt out the wakes left by algorithms, and could even switch between local brokers within a day. particularly Volume Weighted Average Price (VWAP). You have to be more granular in formulating and creating They have it down to a fine art. To avoid detection, we are SOR and algo trading strategies.” Owain Self agrees: “In markets with member constantly adjusting strategies and switching between algos, working DMA and then switching back again, transparency, there is more information leakage and people sometimes in a single stock trade or a basket of trades as can spot patterns of trading based on what you have done. well. We have to use all our expertise to monitor and Patterns are less recognisable when there’s no transparency about who is trading. retain anonymity.” “Using minimum fill sizes is one technique used by the Francois Banneville, Société Générale’s global head of execution, sales and trading, agrees: “You have to be sellside: if you are going to give away information, the trade careful. You need technology to source liquidity for large- has to be worthwhile. Another is to be aware of the places cap stocks because they are very fragmented, so and likely people who are transacting on a particular fragmentation is increasing the level of technology. If you venue. What’s the quality of the liquidity pool? Who are the want to remain anonymous you need good SOR participants? What previous experiences have you had in technology and only the large players have enough that pool? Then you can set prices and limits and decide how much to trade,”says Self. financial stability to be able to invest.”

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TRADING: WINNING STRATEGIES

Clive Williams of T Rowe Price, head of European equity trading, says: “At the end of the day, everyone just wants one pool of liquidity so fragmentation gets in the way. People get more nervous and put trades in smaller and smaller amounts. It’s not necessarily a problem that I don’t know I am dealing. I just want liquidity.” Evidence suggests that liquidity is helped by anonymity. Post-trade anonymity via a central counterparty was introduced for German equities traded on Deutsche Börse’s electronic trading platform Xetra in March 2003. Even after transactions, the trades remained anonymous. A study by Hachmeister and Schiereck in March 2006 found that posttrade anonymity increased the level of liquidity on the exchange significantly and they concluded that “informed traders” provided liquidity more aggressively in an anonymous setting as it allowed“informed traders to profit from their private information without being detected”.

MATRIX REVOLUTIONS Recent years have seen a “perfect storm” where need has coincided with the development of new computer browser technologies, notably Rich Internet Applications (RIAs) such as Adobe Flash. RIAs are applications which offer a more sophisticated look and feel to web browsers. Ruth Hughes Liley explains how the advanced technology can make traders feel like Tom Cruise in the Spielberg-directed film, Minority Report. hile Steve Jobs, founder of Apple, turned mobile phone design on its head with the iPhone, the race was also on to bring the same ease of use and technology to trading floor screens. Morgan Stanley has launched a web-based application called Matrix, where traders can access research reports, chat with the authors in real time, see and send videos through their webcams and execute trades, all from the same browser. In development since January 2008 and introduced in June 2009, it offers fixed-income and foreign exchange trading, ideas, analytics and research, although Hishaam Mufti-Bey, Matrix founder and global director with Morgan Stanley, says the firm’s ambition is to add other asset classes to the platform. “Good design isn’t just about how good it looks but how well it works. Matrix provides a user experience that is intuitive and with no need for manuals,” says MuftiBey. “The web front-end masks the underlying complex technology. All transactions get straight-through processed. The ferocious nature of real-time pricing

However, when everything is dark, brokers have to work harder and smarter to try to find out where and what sort of liquidity is available to them. In the lit markets, iceberg orders have existed for many years, where a larger amount of stock is largely hidden from view while only a small portion of the liquidity is required to be displayed. However, under another trading practice a broker will electronically contact a number of counterparties to see if there is any interest in an order. These Indications of Interest (IOIs) are now appearing on Bloomberg and a new asset class of tradeable IOIs has begun to develop. “Once you have broadcast your interest, it is public knowledge,”says Banneville.“More clients are asking brokers to show only natural IOIs and are being very strict about it and tradeable IOIs make it harder to put in non-natural IOIs.There are very few IOIs on small- and mid-cap. In this instance you revert to calling clients to see if they are interested.”

updates for foreign exchange was one of the biggest challenges, so other asset classes will be less challenging to put online.” Recent years have seen a “perfect storm” where need has coincided with the development of new computer browser technologies, notably Rich Internet Applications (RIAs) such as Adobe Flash. RIAs are applications which offer more a sophisticated look and feel to web browsers. A March 2007 Forrester Research report explains: “Well-designed RIAs can produce eye-popping results that can help prove the value of current investments and make the case for future RIA projects.” Vivake Gupta, managing director of Lab49, technology consultants for the financial sector, says: “In the past few years, trading platforms have not been very exciting and simply delivered basic functionality. Now the pressure is on to bring the buyside back on board by providing them with better quality of service and that requires technology innovation.” Improving user experience with Web 2.0 technology is where the future lies. To understand the impact of Web 2.0 technology, think of the film Minority Report, directed by Steven Spielberg, in which Tom Cruise is surrounded by internet-enabled data and images from moving adverts on buses to holograms of sales assistants in Gap. Translate that to the trading floor and you have areas of the web that can be accessed by both researchers and buyside, allowing them to collaborate and edit from both sides. These types of applications can be accessed by a free simple plug-in such as Adobe Flash/Flex or Microsoft Silverlight 3, which launched in July to compete with Adobe for business users in the RIA space. Gupta of Lab49 sees a world where buyside and sellside could work together to structure a product: “You could do a video-post, a quick idea spoken into the webcam on your desk or you could have quick textual

OCTOBER 2009 • FTSE GLOBAL MARKETS

Steve Wood adds: “Brokers show us their inventory electronically via Indication of Interest either by FIX or Bloomberg; the quality of these IOIs can sometimes be questionable. There can be abuses: it might just be someone trying to flush you out. Credibility is nine-tenths of the law and one week of bad IOIs can take six months for a trader to recover his reputation. They can be filtered out electronically or you can just ring up the trader and tell him that you don’t like what he is doing and ask him to stop. You have to monitor and penalise it if the quality is not there.” IOIs vary from broker to broker, says Clive Williams. “Some can be useful, because if you have a small- or midcap it can help you identify where liquidity is. But they can also be unhelpful. A broker may put an IOI on Bloomberg, say for a large purchase of highly liquid stock, so you get on the phone, but it turns out they are a seller and they’ve just found you out.You have to be careful.”

Vivake Gupta, managing director of Lab49, technology consultants for the financial sector, says: “In the past few years, trading platforms have not been very exciting and simply delivered basic functionality. Now the pressure is on to bring the buyside back on board by providing them with better quality of service and that requires technology innovation.”

ideas through instant messaging. You could collaboratively structure that idea, see the price and trade there and then. Research and execution can now also be interlinked even though historically they have developed as two separate systems.” Mufti-Bey adds: “There’s no software for the client to install, so no troublesome large files to download. RIA has zero footprint. You just log on and go. RIA is a whole new world. It’s a real game-changer for the industry.” While Morgan Stanley says the feedback from clients has been phenomenal, it has attracted criticism from IT bloggers for its usability and content. Nonetheless, it seems to be a step forward in how traders will interact with their monitors in the future and other firms are following. In August, Barclays Capital completed the global roll-out of Barclays Capital Live, which leverages RIA, combining the legacy system of Lehman Live, acquired from Lehman Brothers in September 2008, with Barclays Capital’s own technology.

FTSE GLOBAL MARKETS • OCTOBER 2009

Recent months have seen a growth in the number of venues offering access to displayed liquidity from a dark platform. The New York Block Exchange (NYBX) launched in January 2009 reported a rise in trading volume of 181% in Q2 2009 compared with the first quarter. The platform, aimed at the block trading market, allows non-displayed liquidity on BIDS ATS to anonymously access both displayed and reserve liquidity of the NYSE order book. In July this year, Nasdaq OMX Europe began to route orders from its lit order book to dark venues, including its own NEURO Dark and in September 2009, ConvergEx launched TactEx Grey, which passively pegs the displayed market while simultaneously layering orders into selected dark pools as volume increases. As executions occur, Grey dynamically recalibrates between display and dark venues, capturing liquidity as it becomes available while ensuring measured participation and minimising information leakage.

Vivake Gupta, managing director of Lab49, technology consultants for the financial sector. Photograph kindly supplied by Lab49, September 2009.

Clients can read cross-asset class data, use real-time and historical analytical tools as well as prime services reporting tools. From Barclays Capital Live, they can launch the non-equity BARX electronic trading platforms (futures, fixed income, FX, money markets and commodities). For equities, clients have access to analytics and post-trade tools in Barclays Capital Live, but the electronic execution platforms are separate. Like Matrix, it aims to improve customer experience and provide visualisation tools to institutional clients, although at present it does not have chat or ideassharing facilities. Gupta says: “I wouldn’t go so far as to predict a downward trend in the number of flat-screen monitors but these traders do often have six different applications when there should be one. Matrix has set off an arms race in the industry; we will see a lot more functionality released to the public and each new system will be better than the one before.”

TRADING: WINNING STRATEGIES

Owain Self says: “For some, the information leakage on even the smallest order might be the difference between wanting to trade or not, whilst for others effectively managing their order between both the lit and dark markets allows them to get the best of both. One market model does not fit all execution objectives and advances in technology have allowed participants to control how and to whom they expose their orders, bringing additional liquidity to the market place.” Anonymity in trading aids price discovery by making markets less volatile and more liquid, according to Francois Banneville. In May 2009, Société Générale launched an internal crossing network, Alpha X, which executes at the mid-point of the best bid and offer, halving implicit transaction costs. Société Générale estimates this is a gain of 0.05% to 0.12% on the order depending on the stock. The crossing rate of 6%-7% of order processes is a good ratio, says Banneville, given that it is only client-to-client flow: “Internal crossing networks have an advantage over systematic internalisers, which can put their prop book in front of a client’s order.” Banneville concludes: “What it comes down to is the question of trust.Take mid-cap stocks or real estate.The client will call up a broker they trust and disclose their order. You don’t need technology for that.The three important words are professionalism, experience and trust. When you find a broker you trust, anonymity is preserved.”

Steve Wood, global head of trading at Schroders Asset Management. Wood says there’s more slippage when interacting with the sellside: “You want to know what makes up a broker’s internal pool—the Morgan Stanley, UBS, Goldman Sachs joint pool for example—and who you might be crossing with. Is it client flow, the risk book, Delta One, high frequency or stat arb hedge funds making markets in the pool?” Photograph kindly supplied by Schroders Asset Management, September 2009.

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

OCTOBER 2009 • FTSE GLOBAL MARKETS

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

Commodities: A hedge or diversification play?

Attendees

Supported by:

PATRICK ARMSTRONG, managing partner, Armstrong Investment Managers (AIM) ROZANNA WOZNIAK, investment research manager,World Gold Council DAVID DONORA, head of commodities,Threadneedle Asset Management JUDY SAUNDERS, chief investment officer,West Midlands Pension Fund FRANCISCO BLANCH, managing director, head of global commodities research, Bank of America-Merrill Lynch TOM ANDERSON, vice president, head of strategy and research, Intermediary Business Group, State Street Global Advisors FRANCESCA CARNEVALE, editor, FTSE Global Markets

FTSE GLOBAL MARKETS â&#x20AC;˘ OCTOBER 2009

THE 2009 COMMODITIES ROUNDTABLE

CURRENT TRENDS ROZANNA WOZNIAK, INVESTMENT MANAGER, WORLD GOLD COUNCIL:

RESEARCH

Investors and institutions found that they weren’t very well diversified when the financial crisis took hold. They are now looking for diversification that will help them prepare for the next crisis and for that reason they are looking at commodities. More importantly, since about October of last year, they are starting to consider gold as being not only part of the commodity bucket, but also as a unique asset class in its own right. As commodity indices started to decline and gold held its own, it became clear that gold has some unique attributes that a general commodity basket does not and offered a means to withstand those pressures in a way that a general commodity basket could not.

FRANCISCO BLANCH, MANAGING DIRECTOR, HEAD OF GLOBAL COMMODITIES RESEARCH, BANK OF AMERICAMERRILL LYNCH:

A number of trends are in play. In terms of the price drivers, the unprecedented expansion in monetary policy, not just in the United States and the United Kingdom, but also across the rest of the OECD economies and even the emerging market economies will have unintended consequences in the commodity markets; and that will surely become an area of focus for markets within the next year. On the more technical side, the CFTC hearings and moves by the FSA towards commodity regulation will have a significant impact in the market. While it is still not clear what the regulator is going to do with regards to investor activity in commodities; there is a clear risk of reduced positioning and reduced trading volumes. TOM ANDERSON, VICE PRESIDENT, HEAD OF STRATEGY AND RESEARCH, INTERMEDIARY BUSINESS GROUP, STATE STREET GLOBAL ADVISORS:

My perspective is largely based on exchange-traded products and in this context, exchange-traded gold. The desire for more effective diversification in an environment when correlations all went one way last year, has caused investors and advisers to turn to gold as a distinct asset class. Also tied into exchangetraded products in general is a greater desire and need for transparency and liquidity. We regularly fielded questions all through the fall and into this spring about what was in each portfolio and“can I see the holdings?”One of the key benefits of exchange-traded funds is that those holdings are posted every single day, and there is great liquidity; you can get in and out intraday. Moreover, these trends are increasingly driving institutions towards exchange-traded products.

PATRICK ARMSTRONG, MANAGING PARTNER, ARMSTRONG INVESTMENT MANAGERS (AIM):

Quantitative easing will translate into inflation and if you want to hedge against inflation, gold and other commodities are real goods and there is going to be a huge push on the real value or the nominal value of these things, because the real value of currencies are being destroyed. We think that will be a very favourable tailwind. Also, the trend for pension funds to get into commodities really started six years ago and they went from one extreme to the other.They went into

ROZANNA WOZNIAK, investment research manager, World Gold Council

CTAs, which are very active, opaque, or they went passive. We think the place in the middle is probably just even more efficient than either of the extremes: an index can be inefficient and a CTA can be inexpensive or very expensive indeed. Enhanced indices, actively managed, long beta is the place you want to play commodities. Commodity indices are structurally flawed; you don’t want to be there and you don’t want to pay the huge performance fees that come with CTAs. I think the present climate is particularly good for commodities: it is a very strong, long-term growth story regardless, but obviously with the world economies picking up, it will benefit from GDP coming back into positive territory. It is also an obvious hedge for inflation and it offers our fund further diversification. Having said that, I actually would not go via the ETF route; I want either enhanced passive or active. Right now, we have a balance between active managers and enhanced managers; because I think you will achieve returns, not just from beta, but from alpha out of commodities.

DAVID DONORA, HEAD OF COMMODITIES, THREADNEEDLE ASSET MANAGEMENT:

In general, investors should become much more discerning about which commodities they invest in. If we are coming out of this recession and the global economy is returning to growth, then more cyclical commodities, such as metals and energy, should perform well. Global economic recovery has little impact on what agricultural commodity prices will do; it certainly doesn’t say anything about what the price of cocoa is going to do in the short term. Therefore, investors will be looking at what they want to achieve with commodities and tailor their holdings. This raises the question: how best to invest in those commodities? Only a few years ago, the options in terms of how to invest and how to approach commodities were fairly limited. Today there is a wider range of instruments and vehicles available and clearly there is a lot more choice, but also more hazards.

OCTOBER 2009 • FTSE GLOBAL MARKETS

OBVIOUS BENEFITS JUDY SAUNDERS, CHIEF INVESTMENT OFFICER, WEST MIDLANDS PENSIONS FUND:

Over the very long term, commodities are a finite resource. Supposedly the world is getting wealthier; agricultural land is getting scarcer; we’ve got all sorts of climate changes going on; and so the industrial nations are going to want to secure access to commodities. You can easily issue stocks and shares, they are not finite; they are always going to be there. We will always need commodities, whether metals, agriculture or energy, and that is the strongest argument for keeping an allocation in diversification. It really is a strong long-term growth story. PATRICK ARMSTRONG: Commodities have many benefits. Indeed they are an asset class. They don’t produce cash flow, but they have provided a risk premium versus inflation versus cash over the very long term. Commodities are also ripe with potential for alpha. Allocating to commodities you get the beta, and you get compensated for that beta with the risk premium, but if you allocate to commodities efficiently, there is huge potential to outperform, because it is a structurally flawed benchmark, and you can outperform that without a great degree of sophistication. Investors generally have two objectives, no matter who they are, if they are retail, pension funds, high net worth – they really want to preserve their capital and they want to grow it in real terms. Commodities can help you do both of those things: diversify the risk in a portfolio and help you grow real returns. There is a lot of money in the sector. There is $100bn just tracking one index. The amount of gold ETFs is immense and it is relatively new. As regulations now allow people greater access to ETFs and commodities in general, more money is drawn to the segment. ROZANNA WOZNIAK: While there is potential for alpha in commodity space, we shouldn’t ignore beta. In other words, there are still a lot of asset managers, investors and particularly pension funds out there with quite restricted allocations that would benefit from having an allocation to commodities and to gold on top of that. I believe the focus needs to be more on restoring the risk return balance in asset management. We’ve gone through this period when a lot of the emphasis was put on return and people rode that wave, and it was easy to make money. Obviously, there will be times when some assets won’t particularly perform but there is a role for them in a portfolio and preparation for if something unexpected does happen. That is where gold fits in most specifically, its role as an insurance policy, because at the end of the day, there are not very many assets that can hold their own when things go particularly rough. TOM ANDERSON: Institutional investors, advisers and retail investors are benefiting from the ease with which you can access ETFs, their cost efficiency, and liquidity. The SPDR Gold Shares (GLD) has risen to over $33bn in assets this year, versus roughly $20bn at the end of 2008. A lot of that is, we believe, investors trying to tap into the benefits of preservation of capital, looking for a safe haven in a

FTSE GLOBAL MARKETS • OCTOBER 2009

volatile market, or increasing their exposure to uncorrelated assets. JUDY SAUNDERS: The fund uses ETFs quite a lot, but not for commodities, because I just feel that there is so much potential to be able to produce alpha on top of the beta, within the commodity arena. That is one of the areas I do believe that you should be able to get some alpha. I just have managers, and none of them are purely plain vanilla passive. TOM ANDERSON: A lot of times it depends on the manager selection. We are seeing insurance companies and some other institutional providers, not just in the commodity asset class but in general, looking at their asset allocations and pulling back on some of their active managers, probably because of underperformance, and at least blending those two things. They have a passive core, and then maybe an active satellite.

THE IMPORTANCE OF ETFs FRANCISCO BLANCH: One of the reasons why you may

want to consider a different instrument is the funded versus unfunded element of commodities. Differences in returns between ETFs and enhanced commodity indices are important, but should disappear over time. As arbitrageurs eliminate the inefficiencies embedded in the roll schedules of some of the ETF products, expected returns on ETFs and other similar instruments like enhanced swaps should converge. However, the benefits of holding a funded versus unfunded product are probably most relevant over the long run to the ETF debate. Some retail investors will always prefer to have a funded product, because of their concern about leverage or their fear of an unlimited loss in their portfolio. Others, such as a sophisticated pension fund investor or hedge fund investors will generally always prefer unfunded products. FRANCESCA CARNEVALE: Patrick, you mentioned you thought that indices were a very inefficient way of accessing returns in the commodities segment. However, a lot of ETFs are written against indices aren’t they? PATRICK ARMSTRONG: They are, and the vast majority of the indices are based in the near-month commodity future rolling into the next month, because that is where the bulk of the liquidity has been. However, there are just more efficient ways to invest, and you can create an index on that. ETFs have been launched on enhanced indices, better trading algorithms where you are not just rolling over the front month future every month and where you are doing seasonal rolls, or constant maturity rolls, things like that. There are relatively simple ways to do it, but that is also adjoined back by the fact that the liquidity dries up further down on the curve, so the most efficient roll is further down on the curve, but there may not be enough liquidity in that contract for large investors. However, that will not always be the case. As people invest in more efficient vehicles, the commodities market will become more efficient and that will create liquidity across the spectrum potentially.

THE 2009 COMMODITIES ROUNDTABLE

DAVID DONORA: The popularity of ETFs has greatly

contributed to widespread investment in commodities, which raises the issue of the impact on the finite supply of commodities coping with greater levels of investment. When investment type ownership, i.e. as a store of value or a longterm hold, is small in relation to the overall market, then it doesn’t significantly affect the overall marketplace and price. Higher levels of investment do not necessarily benefit a commodity the way equity investment expands market cap, rather the effect is that demand is rationed through higher prices. In some instances it motivates producers through higher prices, but sometimes investment reaches a place where it distorts the market and overwhelms fundamentals. In fact, I would add that index-based products make commodities trade much more like an asset class than they otherwise would and certainly more so than they did 10 or 15 years ago JUDY SAUNDERS: Beta is hugely important for us as a pension fund. My raison d’être is to produce 7.8% pa beta over 20 years, to meet our pension fund’s liabilities to pay pensions. Alpha to me is the most difficult thing in the world to actually achieve, but out of all the asset classes or sub sector of assets, I believe that commodities is one of the areas one should be able to achieve some alpha. I’ve almost given up trying to achieve alpha in long only equities, but I just think there are some asset classes, sub-sectors, whatever you like to call it, that you should be able to achieve alpha. And commodities is one of those. I have an overall target of just around 1% for the whole fund for alpha, so it is a very rare commodity.

CORRELATIONS BETWEEN COMMODITIES AND OTHER ASSET CLASSES JUDITH SAUNDERS: It depends very much how you

structure your portfolio. I have combined five different funds: two are enhanced beta and three are actively managed. Those funds are also managing against different benchmarks, different indices, and therefore the whole portfolio has less than a 50% exposure to energy. In 2008, the portfolio delivered minus 8%, but relatively speaking preserved most of the capital whilst UK equities returned minus 30%, emerging markets minus 37%. The overall volatility of the portfolio is actually lower than the individual indices, because we were very careful when we put those funds together. So our experience in 2008 was probably far less painful than other pension funds. But I wish I’d had far more of the fund in commodities than say global equities last year. FRANCISCO BLANCH: Commodities actually performed as they were expected to perform last year; they spiked into the end of the last business cycle and they collapsed when the business cycle came to an end. So from that standpoint, I don’t think anyone should be surprised that commodities rallied then they crashed. The surprise last year came from the fixed income markets, because we had been accumulating debt that happened to be worth a lot less than the market expected. That is really where the surprise

FRANCISCO BLANCH, managing director, head of global commodities research, Bank of America-Merrill Lynch

came in. Volatility last year really came from the credit markets, not from the commodity markets—that was the key driver of volatility. If you look at the differences in volatility, commodity volatility was high last year, no doubt, but volatility in other assets classes was even higher. In terms of correlation, I would say that commodities have a benefit in the sense that they provide diversification within themselves—a subtle but very important point. When you own ten stocks, whether it is BP or Unilever or another, correlation of those stocks is very high generally. In commodities, that is not true. Generally correlation across commodities tends to be quite low all the time. Why? Well, because corn has very different fundamentals than copper, and oil has a different fundamental from nickel. DAVID DONORA: A fair point, but I would just add two observations: first, within commodities, individual markets are becoming more correlated. For example, the US Renewable Fuels Act has created a link between commodities such as, crude oil, corn, raw sugar and soybeans. Second, the more commodities are traded as an“asset class”, the less diversified they become particularly in times of stress, because the index is traded as a block, irrespective of the individual markets’ underlying fundamentals. As commodity index investment continues to grow, there will be less diversification within commodities going forward. It also means that commodities will offer less diversification versus other asset classes than in the past. In the current environment it’s risk-on, risk-off, where investors are piling into and out of risk assets—equities and commodities together. The linkage is strongest now because commodities and equities have their highest correlation during a cyclical upswing. Also bear in mind that a number of long-term studies do not have the relevance they once had because of the degree to which commodities are used as an investible product now, and more current market data has taken on greater importance than it would have done, say 10, 15 or 20 years ago.

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FRANCISCO BLANCH: I disagree. The reason we saw correlations increasing is related to the points in the business cycle that we have just crossed. Correlations increased very much on the way down when all assets were sold off. If you believe the accounts, this is a one-in-80-year event, where all asset classes become correlated and go to one, and then portfolios break down. So it is a very rare event. Since commodity prices collapsed in October/November last year, we’ve seen correlations decline generally within commodities as an asset class and they’ve continued to decline. However, I don’t think it is the story of what’s going to happen for the next 12 months or the next five years, because ultimately commodities have a different pricing mechanism. I still believe that spot markets are the driver of commodity markets, which are driven primarily by supply and demand and inventories, and commodity prices very much reflect current supply and demand conditions. On the other hand, bonds and equities will always reflect future expectations. It means that, over time, that correlation will again break down, because the pricing dynamics of those instruments are so different: real time versus future expectations. PATRICK ARMSTRONG: You can make both points: there are reasons why it should be correlated because it is becoming an investment asset classes; equally, you can give reasons why it should be negatively correlated as well at times. If energy prices spike up for instance, it chokes off the economy, and kills off equities. Correlation isn’t stable; it varies throughout time but that is what makes it a diversifier, it does move to the beat of its own drum. In the energy crisis in the 1970s, if you had equities you lost 60% of your capital, but it is the energy that made it crash and that would have been a great diversifier. I don’t think correlation will remain perfect; it is only in times of extreme risk aversion or risk taking where everything will move either up and down together and that happens in the short term. However, most investors who are investing with the diversification principle are long-term investors. ROZANNA WOZNIAK: There are actually some quite significant differences in levels of volatility across the different commodities, and some of those differences can be knocked through to changes in trading and the way markets are interacting with each other. It can actually be due to very fundamental reasons. World Gold Council has done research into both the long term and short term over the period of the credit crisis, in terms of gold volatility versus other precious metals, other commodities and equity indices. Gold is in fact consistently less volatile in a commodity basket than the other precious metals, than oil and than most major equity indices. There is a very natural reason why. It is less vulnerable to supply shocks, because supply is diverse; it has got more than one demand base—consumer, industrial, and investment; and it has a natural market stabiliser in the role of scrap. Most of the gold ever mined still sits out there in a form that can be brought back to the market at the right price. While we do have price spikes and price drops; we do see changes in the amount of recycling activity going on, and this has helped reduce the volatility of the gold price.

FTSE GLOBAL MARKETS • OCTOBER 2009

PATRICK ARMSTRONG, managing partner, Armstrong Investment Managers (AIM)

THE IMPACT OF REGULATION DAVID DONORA: The commodity markets are heading towards greater oversight and regulation. I view this as part of the evolution. For the most part, commodities are relatively new to OTC trading within the financial markets, and are becoming more widely used by consumers, producers and intermediaries. The current moves between the US administration, CFTC and now the FSA are motivated by the need to have a better handle on what’s really happening in those markets. Whether or not they will create some bad regulation which impairs the flow or the price discovery process remains to be seen. In the end, whatever changes are imposed in the next months are unlikely to have a long-term negative impact. These markets will function and ultimately no regulation will stand in the way of that. FRANCISCO BLANCH: Clearly these markets are important to the normal course of economic activity. Their function is price discovery, but more importantly. Having said that, if the regulator is worried about there being so much alpha to be gained in commodity markets, what we need is more speculators not less. This is an argument I have made often in some of our research publications. We think there are not enough speculators in the commodity markets. So if the regulator decides to curb activity, there are real risks of impairing the normal development of these markets, and we could end up having higher volatility in the process. Having said that, we have run tests to study the relationship between prices and investments in commodity markets. When it comes to paper commodity investments, we’ve found that systematically it is always the investors that chase the price, and not the price that moves with investors.

THE 2009 COMMODITIES ROUNDTABLE

We find that when prices rise, that attracts investment. In contrast, we found that (perhaps going to the point of ETFs) physical investment in the commodity markets drives prices higher. This is a very natural result that comes from the way that the price discovery occurs in commodities, and it is something that the regulator hopefully will take into account. It is really the markets that are physically backed, for example investment in gold ETFs or in silver ETFs, that are having a big impact on commodity prices, not the markets or index investors that are purely based on futures and other derivative instruments which ultimately are just an exchange of paper between parties. FRANCESCA CARNEVALE: Is there a detailed intellectual debate happening? Or are the regulators pushing themselves because they perceive there is a problem? JUDITH SAUNDERS: Regulators are looking at all asset classes, not just commodities. And I possibly feel that they felt there was some sort of pressure on them to do so following 2008. I don’t think regulation will unduly affect the commodity market. As a pension fund, as long as you do your due diligence very thoroughly, then you should be okay, but you’d have to make sure that you understand what you are investing in. An example of that was a structured note based on trading strategies around the DJAIG index that worked very well, but the note was issued by a well-known US bank, and although it has actually now recovered its value, it was a very interesting learning curve, because the value of the note fell sharply, even though the trading strategy worked. That was all about the counterparty risk surrounding the note. One learns through experience. As I say, thankfully it has actually recovered its value, but it was an interesting scenario.

NEW PRODUCT DEVELOPMENT ROZANNA WOZNIAK: Over the medium and long term, there’ll be product development and market development and natural evolution taking place.The era that we are in now, it is not just the risk of regulation, it is also, to a degree, an issue of being consumer choice and being investor-led. In other words, investors are demanding and asking for products and preferring products that don’t have the counterparty risk and the default risk. Within the gold market, we have seen less demand for the leveraged-type products, and a move into either the exchange-traded funds or at the other extreme, right into the allocated gold accounts, and even a move from unallocated gold accounts into allocated gold accounts. So despite the fact that things are picking up and there is a perception that things are picking up, that counterparty risk still remains in the back of investor minds. FRANCESCA CARNEVALE: Will the ETF space benefit from increased regulation or re-regulation? TOM ANDERSON: Anything that drives investors toward transparency helps benefit exchange-traded products. Due diligence questions continued to arise throughout the spring and early summer. What’s actually in the portfolio? Is there a counterparty risk? Is there a credit risk? Even for ETFs

JUDY SAUNDERS, chief investment officer, West Midlands Pension Fund

unrelated to commodities we are still getting these questions because the fear is very real. Therefore, anything that brings transparency will benefit exchange-traded products. FRANCISCO BLANCH: We found the same relationship in silver, but again that is not to do with the fact that it is gold or copper or oil; it has to do with the fact that it is physically backed. Because when something is physically backed, you are taking raw material out of a market that has a certain supply and demand balance. And you are tightening that market out with something that is impacting the prices of those raw materials. PATRICK ARMSTRONG: The vehicles people are accessing commodities through are becoming more diverse: there are futures, indices, indices with derivatives attached and then you get into ancillary products. Instead of, say, buying agricultural commodities, you can access farmline funds, things like that. So there are always different ways to get exposure to commodities and the product set continues, gradually, to expand. ROZANNA WOZNIAK: There is a growing demand from investors for gold, and part of that natural evolution will be to find new ways for them to access the market. It is kind of a logical progression. At this point in time, I would have to say derivatives are not the buzzword, as there is a very clear preference by investors globally towards physical and physically-backed products. It is back to basics as far as gold is concerned and even the institutions that we have been talking to that are looking at products in that space, that tends to be where their focus has been. The priority from our point of view, in terms of gaining from the benefits of gold, is ensuring that you avoid counterparty risk and default risk and also benefit from the simplicity of the product.

OCTOBER 2009 • FTSE GLOBAL MARKETS

JUDY SAUNDERS: We have two managers who did perform

well last year, and one of them actually is a fund of hedge funds that is just purely 30 or so traders who do use derivatives, but it as a defensive fund and they actually all work within very strict risk parameters. DAVID DONORA: The Threadneedle commodity hedge fund is transacting much greater percentage of exchangecleared business than I would have predicted 18 months ago; this is consistent with the industry-wide trend towards greater transparency and liquidity. A number of exchanges are expanding the range of OTC-traded instruments that will be centrally cleared which eliminates, to a large extent, counterparty risk. TOM ANDERSON: From an exchange-traded products standpoint, there has to be liquidity in the underlying securities. There are asset classes we would love to deliver as exchange products, but the underlying securities don’t have enough liquidity or they don’t deliver in a traditional T+3 fashion. Transparency, simplicity, and liquidity are the keys to successful exchange-traded funds. Another key for success in ETFs is trading. If hedge funds and trading desks are using a product, it generates more liquidity, which benefits all investors in the ETF. FRANCESCA CARNEVALE: How much is collateral against contracts or commodities—how much is that used to generate alpha in the commodities segment, or is that not really an investment strategy? TOM ANDERSON: The indices you look at anyway are ungeared, so it is a fully funded with your catch as a margin, but anytime something works when you gear it up, it works a little bit better, but it blows up a little bit more when it doesn’t. So it works both ways. DAVID DONORA: If you are referring to the way in which collateral and repo are used in equity markets as a source of alpha, it is less prevalent in the commodity markets among financial participants. FRANCISCO BLANCH: There are a few funds out there that do try to use the collateral as a source of alpha. I’m thinking of a very big fund out there; I don’t want to necessarily publicise it, but there is a strategy out there with certain managers who believe in commodity performance with an alpha component on the collateral. This would typically involve fixed-income fund specialists.

NEW INVESTOR PROFILES TOM ANDERSON: Certainly in the last few years, the

demand for commodity products from institutions has broadened. Do people think this is a matter of institutions chasing what other people were doing in some cases? Or following the performance? JUDITH SAUNDERS: Certainly within the local authority pension fund world, I don’t believe there are many people with allocations to commodities. When we went into it two and a half years ago, we weren’t chasing performance but we were looking at diversification, and also, obviously, the hedge against inflation. Moreover, there is a very strong

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growth story and some products can be seen as falling within SRI but when we do any socially responsible investing, it is always bottom line that counts. DAVID DONORA: I would just add that the ETF phenomenon in commodities has enabled retail equity investors in North America to access commodities in a way that was not possible before 2005. The groundbreaking ETF was GLD in 2004. Now they are growing rapidly as it makes it easy for retail and institutional investors. One aspect that is good for the markets is that it speeds up the education process as more investors develop an awareness of commodities. Moreover, it will bring them up the curve towards using the more sophisticated forms of investment in commodities, such as actively managed funds. TOM ANDERSON: Most of the assets in the commodity ETFs are in focused products, not the ETFs that track broad-based commodity indices. ETFs do try to provide very specific exposure, the ones that gather assets and trade well in any case. So, as long as there are a lot of different options, it gives people the opportunity or choice. Not everyone’s piling into the same index; there is diversity and the ability to go long or sell short ETFs, so you can play both sides of the argument.

ECONOMIC INFLUENCES PATRICK ARMSTRONG: I’m quite cynical about people and

why they do things. When I talk to the pension fund investors and ask them why they are in leveraged loans, or structured credit or emerging markets, by and large they respond that that is where they will make the extra alpha or where they will make up their return. You get very articulate reasons why people are in commodities; it is not something they’ve rushed into; they understand the benefits. While there are a lot of people out there who do silly things, it is just surprising to me how well thought out the commodities decision has been made, when it is been made. Whereas in other alternative investment areas, the quick response is:“It will outperform.” FRANCESCA CARNEVALE: Is that because the market or segment is actually quite complex? PATRICK ARMSTRONG: Possibly. It is maybe because there is a sound argument for commodities, whereas the other ones you’d probably have to say, maybe that wasn’t such a good idea, but commodities, even when it doesn’t work, you can say, this is why it is in the portfolio; this is what... JUDITH SAUNDERS: I actually don’t think it is one of the more complex areas of investing. If you put a commodity fund in front of a board of trustees and there is somebody who presents well, it is an easier concept to understand than a lot of concepts that have been put in front of a board of trustees. FRANCISCO BLANCH: Commodities will be impacted primarily by physical demand, physical supply and money supply. I want to emphasise these three drivers, because a lot of people focus too much on the supply and demand balances of commodities without spending enough time thinking of the consequences of the large increases in

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money supply that have occurred since October. So as we move forward, clearly the demand element of commodities is going to be heavily supported by the emerging market growth story, which is still very powerful, and still very strong. On the supply side, we are still going to find some constraints, particularly for commodities such as copper and oil specifically where we think there are some longterm bottlenecks to expand capacity. I don’t think that every commodity will necessarily experience supply constraints; I don’t think every commodity’s necessarily scarce. There will be commodities that we won’t be running out of anytime soon. However, the supply picture for some key commodities like oil and copper, which are perhaps the most important ones in a diversified basket of commodities, will keep the pressure up on the rest. On the demand side, and particularly considering China or India, there is also the element of currency and how a weaker dollar will continue to support strong consumption of commodities in some of these markets. Just the sheer growth of these economies will surprise us in the same way that it has surprised us over the last ten years. We could very easily see China growing at 15% to 20% in nominal US dollar terms for the next ten years. How is that split? That is 5% currency appreciation, 5% inflation, and 7%, 8%, 9%, 10% real growth. So that is going to compare to 1%, 2%, 3%, 4% real growth in developed economies with what I believe will be generally relatively low core inflation, maybe 2%, taking some of the fixed income markets. PATRICK ARMSTRONG: The key determinant is the exploding population. When the baby boomers were born, there were 2bn people on the planet; when the last of the baby boomers die there is going to be over 9bn people and that is just one generation. They are all going to want to eat; they are all going to want to consume; the growth rates are very high in emerging markets; they are very energy intense in emerging markets—that is a very powerful tailwind, just the population explosion. Moreover, you have people in China who are making $320 a year right now. That is going to go up, and they are going to eat better, they are going to use more energy, all of those things are just a very powerful tailwind. On the money supply side, the destruction of the purchasing power of currencies means that you should be scared if you don’t have commodities, rather than why should I have a bit of commodities. JUDY SAUNDERS: I totally agree with Patrick, and I think that obviously the energy and the industrial metals areas are going to be particularly strong. However, I employ five specialist active managers to make those decisions on my behalf. ROZANNA WOZNIAK: In the case of gold, you have to look at the Western and traditional markets separately. The traditional markets, it is a case of sheer gravity and with these emerging markets—China, India and many others— there is a very strong natural affinity to gold. They save a lot of money, and when they do save, the first thing they tend to buy is gold. In Western markets, it is a little bit different. I personally still have some concerns about whether we are really in a solid recovery. The US economy has gone

through a period of adjustment and they can kind of almost see the end of it coming. I believe that, in the case of the UK and parts of Europe, that period of adjustment has been rather short and they haven’t gone through that adjustment that was necessary, that needed to take place. So, I have some worries on that front, but if and when it does take place, in the back of my mind like everybody else, I’ve got all those stimulus measures that are in place, and sooner or later they are going to kick in. So if things take a turn for the worse, then commodities and gold as your diversifier, and in the case of gold, it is your safe haven insurance policy and if things pick up it is your inflation hedge. That is the arguments both ways. TOM ANDERSON: Our research suggests that in periods in which we have a lot of stimulus going into the global economy, a lot of printing of money, when inflation rises, traditional asset classes, stocks and bonds tend to struggle. Real assets tend to do well in these environments, whether it is broad-based commodities, gold, real estate, or natural resources stocks. These are good things to have in a portfolio. We are seeing a lot of questions from our clients in terms of: “What can I do to protect my portfolio from future inflation?” ROZANNA WOZNIAK: If a central bank finds it difficult to manage a normal growth cycle where growth is between 2% and 4%, how on earth do you manage your way out of a recession where you’ve had -2%, -4% or -6% economic growth rates? That is just going to be horrendously difficult. TOM ANDERSON: Don’t you think they are going to err on the side of growth, right? As opposed to letting the economy sink back... ROZANNA WOZNIAK: They might be more concerned about things dipping down, so that by nature will make them err on that side, of letting things continue a while longer. They need to always be thinking 12 to 18 months ahead; how do you do that in a way that is not going to cause some problems at some stage? DAVID DONORA: China is trying to diversify some of its $800bn worth of US treasury bonds and nearly $2trn of reserves into hard assets and resources that they are going to need. So clearly there is a lot of resource investment going on, and there are quite a lot of investors and traders who follow this investment flow. Then again, a second point is the differentiation between significant devaluation of the dollar and inflation. A large part of the world probably won’t experience inflation the way that the US is going to, due to the fact that the dollar is likely to lose a lot of its value in the next few years. FRANCISCO BLANCH: I don’t necessarily agree with the idea that we’re going to see a lot of inflation. In fact, if you look at the inflation markets, they’ll tell you there is probably not going to be much more inflation than there has been for the last ten years. So if your concern is purely inflation, you are really better off by just owning inflation-linked bonds. It is very difficult to make a case for inflation across the economy when you have so much spare capacity in the industrial sector in the OECD countries, when the auto manufacturing sector is running at 40% utilisation rates, when computer

OCTOBER 2009 • FTSE GLOBAL MARKETS

DAVID DONARA, head of commodities,Threadneedle Asset Management

manufacturing is running at 50% utilisation rates, and unemployment is spiralling out of control. You cannot have inflation when people don’t have jobs, and when sectors are under-utilised. What you can have is a case for selective inflation, and this is where commodities come in. It is those sectors that have the tightest capacity utilisation of all, which are petroleum, metals, mining, crude processing and so on; that will experience the upside price pressures as this wall of money starts to seep through the economy. In the view of our research team, the source of this crisis is capital allocation; we’ve diverted too much of the Chinese savings into real estate as opposed to into energy. A savings glut effectively has to be mirrored by an investment shortage. I happen to believe that the savings glut that developed in Asia was the mirror image of the investment shortage that developed in the energy and commodity markets. As a result, as governments try to reflate asset values around the world, the biggest impact will end up being in those sectors that have the tightest capacity utilisation. ROZANNA WOZNIAK: When exactly does the inflation fever abate in developed markets and eventually things do start kicking out? You run the risk of that momentum gathering such a head of steam that it does cause inflation to take off. Short term we may see pockets of inflation, but the bigger fear is one of deflation, which is why we’ve got the policies that we’ve got in place. But if central banks are always thinking 12 to 18 months ahead and things are really easy now, is that recovery going to occur the beginning of next year or in the middle of next year? Or will it be by the end of next year, or the year after? Which means, do the central banks need to be rapidly unwinding at the end of this year or the beginning of next year? That

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timing issue is an extremely difficult one, so I don’t think you can ignore the fact that, regardless of whether the inflation surfaces at the beginning of 2010, the end of 2010, or not till 2011, there is a real risk that it will occur at some stage and that creates an environment of uncertainty and has implications for portfolios. JUDY SAUNDERS: To be honest, we take a 20-year view, a very long-term view, on our investments. Although commodities are a useful inflation hedge, it is also a very long-term growth story, so we will probably be gradually building up our allocation over the years. FRANCISCO BLANCH: Japan is a great example as to what might be in store for economies such as the US or some of the European economies. For the last 20 years, growth has been very hard to come by in Japan, and consumer prices have really struggled to push higher. In a regulated market where you have excess labour and you have spare capacity across many industries, it is really hard to get all prices in the economy to go higher, which is what inflation means. Nonetheless, the prices of raw materials in yen have gone up a lot over the last 20 years in Japan, because the Japanese economy has been getting smaller relative to other economies in the world. So this is what we’ll see for the next ten years. China and India will continue to become a little bigger and they will suck up all these commodities. At the same time more developed economies will face deflationary pressures from the overhang of labour and spare capacity across most industries. JUDY SAUNDERS: Just as an aside, I read somewhere that commodities perform more in line with the rate at which GDP is recovering, almost, rather than with the levels of GDP. I don’t know if that is right or if that is wrong, but bearing in mind that most of the Western world is supposedly coming slowly out of the recession, this is another factor behind why one should hold commodities. FRANCISCO BLANCH: This goes back to that discussion on decoupling. A lot of people believed that decoupling had to do with growth rates changing at different times. Decoupling never really happened in terms of rate of change; it happened on all levels, which means the levels of growth for emerging markets for the last ten years have been a lot, lot higher than developed markets. That will continue for the next ten years. So in that sense, the decoupling story is still intact. Now what hasn’t changed is that when the Western world sinks, emerging markets also sink—by a much less degree as we’ve seen with China, but they still sink. What matters in the long run for commodities is that growth in emerging markets continues at a fast pace. That will continue to be the case, because all the fundamental drivers of growth for emerging economies, capital, labour, productivity, are in place. In the West, however, our labour is getting older and productivity gets harder to come by, and to be honest, capital this time around is going to be flying East as opposed to be flying West as it has for the last ten years. All these drivers then are going to make it very hard for the UK, the US, Europe to post very strong GDP growth in the years ahead.

THE 2009 COMMODITIES ROUNDTABLE 68

TOM ANDERSON, vice president, head of strategy and research, Intermediary Business Group, State Street Global Advisors

THE WAY AHEAD PATRICK ARMSTRONG: The overarching reasons is diversification, the risk premium you get with commodities and the ability to outperform the indices. Commodities start to rally when you see a rate of change in growth. So when it is even deteriorating, or when it is moving not into a big recovery but just a slowdown in the recession, commodities start to rally. We’re pretty much out of that stage now. No one knows when we’re going to be out of the recession, but the slowdown doesn’t seem to be accelerating anymore. Emerging markets are glowing; they are not in recession; that is where the bulk of the people in the world are increasing their purchasing power; there is going to be big demand; and the deterioration of the dollar due to excessive money supply growth. For the last 15 years, M3 has been growing at 12% per annum, which is ridiculous. The US central bank stopped reporting M3 in 2005, because it was embarrassed how fast it was growing, but it is just gone up into hyperbole now, where the amount of money supply is ridiculous. It is been offset in the short term by banks not lending it out, but when you do see the multiplier effects start to come back as banks do lend, that will lead to destruction of the purchasing power of currencies, and real assets are a great place to be when that happens. ROZANNA WOZNIAK: I would like to think that investors and asset allocators are still thinking about the lessons that can be learned, given the period that we’ve been through. It is about risk return balance, about going back to basics and thinking more clearly about diversification and how assets fit together, how they perform differently at different parts of the cycle and perhaps when an asset isn’t necessarily going to perform in the next year, then there may still be a role for it over the long term. The basics of asset allocation, simplicity, transparency and liquidity are

now paramount. From the World Gold Council’s point of view it is about educating investors that there is a role for gold to play as a core strategic asset; and it is about why that holding is appropriate over the long run, regardless of conditions. DAVID DONORA: While the long-term argument and investment case for scarcity of these finite assets is ultimately valid, in the shorter term, it is going to be interesting to trade the two-way markets, recognising that higher commodity prices choke off demand and spur additional productivity. I like the aspect of discovering and extracting value out of these markets, trading both sides of them, while also being aware of the longer-term trends. Around this table we have talked about how people have invested recently into commodities, two and a half years for the pension fund, five years since the first commodity ETF was created—the changing nature of the commodity markets makes them interesting, dynamic and challenging to trade, but that is also where the opportunities can be uncovered. TOM ANDERSON: It is clear from what everyone’s said around the table today that there is continuing strong interest in the commodity markets and investing in those markets over the long or short term. Right now, there is a lot of need and interest in liquidity and transparency in investments. This transparency is one of the things we try to provide with exchange-traded funds and other exchange-traded products. When you put these factors together, I think you can make the statement that there will be more exchange-traded funds or exchange-traded products that provide liquidity, exposure, and transparency to different types of commodities. Whether it is as a way to get beta exposure or whether people are looking for alpha. JUDY SAUNDERS: Following 2008, we revised our benchmark in early 2009, basically to reduce our overreliance on quoted equities. The objective was to try and achieve the same level of return, but at a reduced overall volatility. So we now have a 35% allocation to alternatives and basically commodities just form an important part of these alternatives. FRANCISCO BLANCH: Perhaps just to highlight again that the constraints on the supply side for many of the commodity markets over the medium term will continue to create opportunities for investors; and that the long-term trend of demand seems in our view very robust. Also, while there are some elements of substitution and efficiency that will reduce usage of some commodities (efficient vehicles, cheaper sources of electricity generation, etc.), over the long term the underlying emerging market demand growth story remains very solid in our opinion. Large sovereign wealth funds, high FX reserves, and high savings rates will keep fuelling investment in emerging economies Strong domestic demand and high investment rates will create a tailwind to commodity demand. As well, I 100% agree with Patrick on the money issue; money supply has grown at too fast a rate and that unfortunately will have a lot of unintended consequences for markets in general, and for commodities in particular.

OCTOBER 2009 • FTSE GLOBAL MARKETS

ON THE RISE Photograph © Scott Rothstein/Dreamstime.com, supplied September 2009

FEW YEARS back, when talking about his working day in South Africa, Bobby Godsell, then chief executive of AngloGold, one of the world’s top gold producers, said: “In the evening when I get home and my wife asks me how was my day, I say: ‘I was not kidnapped, I was not shot, I still have all of my limbs, so it was a good day.’”This is a lot more than the unfortunate Piet Matosa might now say. The deputy president of South Africa’s National Union of Mineworkers lost an eye and had to have a nose operation this September after a pay increase offer from platinum miner Impala Platinum to the striking workers at the company’s Rustenberg plant was met with a stone in his face. South Africa’s bi-annual wage negotiations are typically heated affairs that end up in strikes and supply disruptions; a fact that is keenly felt in platinum prices given that the country produces close to 80% of the world’s platinum. During the last bout in 2007, prices rose over 30%. The upshot of this year’s negotiations was a 10% increase in miners’ pay against inflation in the country of close to 7% and demands for a 14% rise, and a $150 increase in global platinum prices to over $1,300/oz. Some 40,000 ounces of production is reckoned to have been lost at Impala Platinum, the world’s second largest platinum producer, and a lesser amount at Aquarius Platinum, a much smaller

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company. Meanwhile Anglo Platinum, the largest South African platinum miner, is able to claim no losses so far this year, but there’s a catch. Although the firm managed to agree a pay deal with its employees without them resorting to strike action, it is only valid for 12 months from 1st July 2009, meaning that new negotiations will have to start next summer rather than in 2011. Barclays Capital analyst Suki Cooper reckons that without the disruptions South Africa would have produced 2% more platinum this year than in 2008.“Most producers’ annual forecasts imply a pick up in supply in the second half of the year,” Cooper says, but adds that given the strikes the growth in output anticipated over the remainder of the year could quickly disperse.

PLATINUM: COPING WITH RISING DEMAND

South Africa’s wage disputes have provided a boost to platinum prices in the short term. A half world apart, Federal Reserve chairman Ben Bernanke’s “end-of-recession” comment in September will have the same effect in the longer term. Overall, the precious metal tends to closely follow economic indicators and, to some extent, the trend in gold prices. Platinum prices will also continue to depend on demand from the car industry [or indirectly on the overall state of the US and the global economies] and speculative interest from funds and other investors. Vanya Dragomanovich assesses its prospects.

Upmarket jewellery Despite the credit crunch, platinum prices were gradually see-sawing upwards this year as speculative investors and funds started returning to commodities. Although platinum’s image is typically associated with upmarket jewellery, actually twice as much metal is used in car catalysts to keep car emissions clean. According to Johnson Matthey, a specialist refiner of precious metals, demand from car catalysts in 2008 fell by 340,000 ounces or a multiple of what was lost this summer during the strikes in South Africa.

PLATINUM: COPING WITH RISING DEMAND 70

The demise of the US car industry might have spelt rock bottom prices for the metal had there not been a pick up in car demand in developing countries. Earlier this year when most countries were worried about the price of fuel and where the petrol would come from, China proudly bought the Hummer brand to meet demand from an increasingly affluent middle class. In the US however the slowdown in car buying was briefly reversed by the government’s “cash for clunkers”programme. The Obama administration made $1bn available for drivers to buy new cars in exchange for old ones, but had to double the funding after the first injection was used up within two weeks. Car sales rose in July and August but once the money was spent, demand went back to pre-summer levels. Going forward, prices will continue to depend on demand from the automobile industry—or indirectly on the overall state of the US and the global economies, and speculative interest from funds and other investors. According to commodities analyst James Steel at HSBC, stringent environmental legislation will assure “a baseline of demand”. He adds that there are signs Chinese demand for car catalysts is picking up and that the decline in the US may be moderating. On the downside, car owners are holding onto old vehicles for longer because of the credit crunch.

The move to green Some danger for long platinum investors comes from the fact that prices are relatively high compared to where they started a decade ago. The move towards greener transport has seen platinum move from $500 in 2001 to where it is today, causing car producers to look busily for substitutes. Catalyst producers have experimented with a number of base metals but the only metal that came close to displacing platinum has been palladium. Russia is by far the world’s largest producer of palladium but has in the past been notoriously unpredictable with supplies. Disruptions in 2000 have put catalysts producers off using the metal even though an ounce of platinum costs $1,000 more than an ounce of palladium. A compromise has been reached in an attempt to reduce overall cost in that some catalysts use a small proportion of palladium alongside platinum. Another aspect of the high cost of platinum is that a large proportion of old catalysts are recycled adding to overall levels of platinum supply. Most recently the UK government funded research into fuel cells, portable power generators that can be used in cars or to produce electricity with at least one project looking into developing a platinum-free cell. Nevertheless, tightening regulation on greener cars will work in support of platinum in the long run. According to Johnson Matthey, this will be particularly significant in Europe where around half of the cars run on diesel and require platinum-based catalysts. Barclay’s Cooper says: “Even though auto-catalyst demand could fall as the auto industry loses its boost, at least for now, current and potential supply disruptions

continue to provide support to prices. Should this support fade, prices could be susceptible to short-lived corrections, but as the auto sector slowly recovers we would expect precious metals prices to maintain their uptrend.” Demand for platinum as an investment is also on the rise, mainly fuelled by exchange-traded funds (ETFs) and bar and coin demand. Of the total annual demand for platinum which is around 6.3m ounces, some 425,000 ounces is form of investment products. The level of platinum in ETFs is at an all-time high. The precious metal is traded over-the-counter in London and as futures in New York. It is frequently trading in a much more volatile fashion then other precious metals with day swings of $50/oz not uncommon. Overall the precious metal tends to closely follow economic indicators and to some extent the trend in gold prices. Up until recently US economic data was all doom and gloom but statistics for July showed that the US unemployment rate dropped for the first time since April 2008. On top of that Federal Reserve chairman Ben Bernanke declared the US recession practically over and said he expected a very slow recovery throughout the rest of the year. This mostly bodes well for platinum but from a speculative prospective there could be some short-term pressure if speculators on Nymex who have built up record high long positions over the past months decide to close those positions. The tipping point for such a move could come if speculators decide to cash in on a rally in gold prices as long positions in this metal are now close to $30bn. UBS’s precious metals strategist John Reade says: “We are less concerned about positioning in platinum because net long positions, although at record levels in terms of equivalent ounces, are relatively small in absolute value.” “The value of the speculative positions, calculated by the equivalent ounces of the futures contract multiplied by the spot prices, is $1.2bn in platinum and $430m in palladium, both much less than the $28.9bn in gold.” He adds: “Also, the value of these positions is not yet at an all-time high.” In a recent note Investec Asset Managers also point to the link with gold and say that one of the catalysts for a recent $50/oz move upwards in gold and a rise in platinum could be from investors moving out from other commodities,“particular the shift from energy into precious metals, which have lower costs of physical storage”. Despite its violent nature, the effect of South African strikes on the platinum market will be fairly short lived. In the medium term, like a weather wane, platinum will continue to point the same way as the US economy— slowly, slowly upwards. How far up is another question. The metal has a long way to go until it reaches the highs of $2,000/oz seen at the end of 2007 and in early 2008. In the words of UBS’s Reade: “We continue to like the long-term fundamentals of platinum and look to buy a decent dip.”

OCTOBER 2009 • FTSE GLOBAL MARKETS

SWEET In August several big American food producers such as Kraft and Hershey wrote a dramatic letter to the US Secretary of Agriculture asking the government to ease import restrictions on the grounds that America was about to “run out of sugar supplies”. While the letter somewhat overstated the severity of the situation it was nevertheless indicative of the fact that a worldwide shortage has pushed sugar prices to the highest level in 30 years as heavy rains in Brazil and an usually dry monsoon season in India have resulted in lower than expected crops from the world’s top two producers. Vanja Dragomanovich describes the ever tightening sugar market. RICES HAVE REACTED to expectations that the global market will become even tighter than earlier predicted, given abnormally low rainfalls in India and high rainfalls in Brazil—both of which have worsened the supply outlook for 2009/2010,”says Kona Haque, analyst at Macquarie Bank in London.“While we expect a short-term retreat as prices consolidate amidst profit-taking, we also see plenty of support at such lofty price levels,”adds Haque. For a crop that is fundamentally a non-essential food, this year’s sugar shortage is causing political problems around the globe. Despite the dramatic letter by US food companies the government in Washington is unlikely to opt for easing import restrictions—above a certain level of imports higher tariffs kick in to protect domestic producers. Such a position would mean Washington would be siding with large companies at the expense of domestic sugar farmers; a move

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that is highly unlikely in the current political climate. On a different scale are problems in India and Pakistan where governments had to step in and subsidise imports to protect those below the poverty line who were no longer able to afford sugar. In Pakistan prices rose just before the month of Ramadan and in India before the festival season when demand is traditionally the highest. Ironically, until last year prices had been stagnant for years and for a lot of producers they were below the cost of production. India was on the other side of the supply equation. Several abundant crops resulted in the country exporting large quantities of domestic production and dampening prices both locally and globally. On top of high production levels, health consciousness in the West, a swing towards artificial sweeteners and cheaper alternatives such as corn syrup looked like they would sound the death knell for sugar. Had it not been for rising oil prices and increasing legislation on carbon emissions which prompted a swing to alternative fuels such as sugar-based ethanol, sugar prices would have remained low.

RECORD SUGAR PRICES CAUSE FRICTION

Photograph © Brian Calkins/Dreamstime.com, supplied September 2009.

The ethanol factor Rising oil prices have boosted the use of ethanol, particularly in countries that produce a lot of sugar, and have diverted some of the white stuff away from traditional food consumption. For roughly the last 20 years, the average cost of sugar production has been around 16 cents per pound while prices traded in the lower teens and occasionally even below that level. A lot of sugar producers were able to keep going only thanks to government subsidies and import restrictions.

RECORD SUGAR PRICES CAUSE FRICTION 72

The US still restricts imports from most countries except Mexico by imposing high tariffs above a certain level of imports. In India the government steps in when a high crop crashes domestic prices or when a low crop, like this season’s, pushes prices too high. In Europe producers had been protected by a system of subsidies which has been in place for over 30 years until complaints from Australia, Thailand and Brazil to the World Trade Organisation and the cost of the subsidies to the EU purse put an end to it. Now Europe is short of sugar and this year the EU has for the first time surpassed Russia as one of the largest importers.

High production One of a few producers that doesn’t need to protect its market is Brazil. Here producers invested in mills that can either produce sugar or ethanol from sugar cane and that flit between the two depending on the price of either commodity. The perfect-storm situation for sugar that came about this year was the result of several years of high production and low prices and weather. In India local producers have been barely able to make a profit over the last couple of years when crops were extremely abundant and have been switching to rice and wheat which are also subsidised by the government, and other crops such as bananas that bring higher profits. This coupled with the driest monsoon season in 83 years created such a shortage that India had to go out into the world markets to supply domestic sugar mills with raw sugar.“Indian stocks are some 60% lower that the 15m tonnes of stocks seen a year ago,”says Macquarie’s Haque. She expects that domestic stocks in the new season which starts at the beginning of October could fall to below three metric tonnes, in which case, and assuming production of 16m tonnes in the crop year 2009/2010, India will have to import at least 5m tonnes to make up for the second successive season of domestic shortfall. High prices will mean that Indian farmers will plant more sugar cane starting from October but as sugar cane remains economically less profitable than some other crops the increase is not likely to be high enough to cover all the shortfall. Of all of the almost 170m tonnes of sugar produced worldwide three quarters comes from sugar cane, which grows in the tropical climates of the southern hemisphere, the rest from sugar beet, which grows in Europe, North America and large parts of Russia. Both crops produce the same end product. Most of the sugar produced around the globe is consumed within the countries of origin with only one quarter making it onto the world markets. Sugar futures are traded on the NewYork Board of Trade, Euronext Liffe and the Brazilian Mercantile Exchange with the highest volumes seen on NYBOT. New York trades the cheaper raw sugar futures and London trades refined white sugar. Macquarie’s Haque says that some of the futures price spike came from speculators and index traders but the rest was from commercial buyers stocking up on sugar before an expected price increase. Luke

Chandler at Rabobank argues that although prices have eclipsed the highs reached in 2006 they remain well below previous two sugar highs in 1974 and 1980—both triggered by oil shocks—when sugar prices reached $0.66/lb and $0.45/lb respectively. “Looking at major historical sugar market events, prices have a tendency to revert to mean levels in around a 12-month window presumably as farmers respond to higher prices and larger new crop supplies ease any fundamental imbalance,” says Chandler. But the two main producing countries will both face problems when trying to increase production. Although there may not be another dry season in India next year some of the problems with water supply will remain in place. The irrigation system is old-fashioned and cannot cope with the rising level of crops being planted be it wheat, rice or sugar cane. On top of that, a recent study by NASA showed that ground water in northern India is disappearing because it is being used faster than it can be replenished. It is mainly pumped to irrigate cropland. On top of that plots of land planted in India are relatively small compared with those in Brazil making it hard to increase productivity by a significant margin. Brazil is facing a completely different set of problems. A lot of farmers took out large loans to expand their fields and invest in crushing plants that can convert the sugar cane into ethanol or sugar but with the credit crunch biting they are having difficulty repaying those debts and even more so raising money for further expansions. Although Brazil is also likely to increase the level of sugar cane that will be planted next season, the financial aspect will limit the level of that expansion.

Sugar substitute On the demand side, while diet consciousness in the West is still leading to a decline in demand for sugar and to consumers using sugar substitutes, the sweet tooth is proliferating in developing countries with the result that overall global demand is rising. The demand for ethanol is also not likely to abate. Sugar-based ethanol has similar characteristics to petrol and in Brazil is already used in the majority of cars. The US legislates that at least 10% of all the petrol sold in the country has to come from ethanol and the demand for ethanol is growing at a rate of well over one billion litres per year. The upshot is that despite already high prices sugar will likely become even more expensive in the short term. Nicholas Snowdon at Barclays Capital argues that the fundamental picture suggests that“the greatest gains from current levels will be seen in the March/May 2010 ICE sugar contracts, when the market will be at its tightest,”and adds that the fundamentals will remain tight until at least the third quarter of next year.“Any perceived cap on prices is purely psychological,” he adds. Sugar prices may still have some way to go. Compared with other commodities sugar is likely to remain the best performer this year.

OCTOBER 2009 • FTSE GLOBAL MARKETS

FUTURES PASS THE TEST ATS OFF TO the futures exchanges. The financial crisis battered the commercial banks, eviscerated the big independent investment banks and crippled some investors—but the futures exchanges never missed a beat. Even though volatility soared to unprecedented heights and a major Chicago Mercantile Exchange (CME) clearing member [Lehman Brothers] defaulted, the risk management regime held up. Margins proved adequate, the clearing guarantee funds were never touched, customers never lost access to their funds and nobody lost money due to counterparty risk. It is a striking contrast to the over-the-counter (OTC) derivatives market, where the Lehman bankruptcy sent counterparties into a frenzy as they tried to calculate their exposure, replace hedges and control losses that were all too real. “The futures exchanges passed the test with flying colours,” says Paul Shen, head trader at RG Niederhoffer Capital Management, a $900m money manager based in New York.“They have always adjusted their margins based on volatility. The whole mechanism really worked well.” Like most commodity trading advisers, RG Niederhoffer applies a systematic trading strategy; the firm is active in all the major financial and physical commodities futures markets as well as individual equities. Rapid-fire traders such as Shen gravitate to the futures contracts that have the greatest liquidity, which enables them to move large sums in and out of the market multiple times each day with minimal impact on prices. From their perspective, the recent consolidation of US futures exchanges ownership under one roof at CME Group, which in 2007 acquired the Chicago Board of Trade and

FTSE GLOBAL MARKETS • OCTOBER 2009

NYMEX last year, has made little difference. Shen applauds the introduction of CME’s Globex extended hours trading technology to contracts that trade on NYMEX, which has attracted more traders to the Globex platform and made the system more reliable and faster.“People go to where the liquidity is,” says Shen. “It’s a natural phenomenon in markets. There is usually a clear cut winner and that is where everyone goes.” Shen has one reservation about the CME’s dominant position: If it decides to increase clearing fees, market participants are at its mercy. The lack of competition prompted nine major securities houses, three trading firms and a technology provider to back ELX Futures, an electronic exchange that began trading financial futures contracts in July 2009. It is early days, but the new venue has yet to attract big volume even though it offers lower costs than the CME.“ELX has an uphill battle,”says Shen. “It is very difficult to take market share away from established contracts.” Richard Redding, managing director of products and services at Chicago-based CME Group, notes that history is littered with unsuccessful challenges to incumbent exchanges, which invariably fail if they compete only on price—as the CME knows to its cost. “We tried it many a time, even with the exchanges we have now merged with,” he says. “It has never worked out. Competing exchanges have been able to come in to liquid markets and be successful only where they have offered something different.” For example, an incumbent exchange may be vulnerable if it fails to adopt electronic trading or other new technology in a timely manner.

FUTURES EXCHANGES: RISK MANAGEMENT REGIME TRIUMPHS

The extreme market volatility last autumn caused the Chicago Mercantile Exchange (CME) to reassess and, in most cases, raise margins on their contracts, but underlying risk models never faltered. Investors are on notice that if volatility spikes, the margins move higher and vice versa when volatility comes down. While some investors no doubt received margin calls at an inopportune moment, the public interest in robust markets trumps the concerns of individual participants. Neil A O’Hara reports.

FUTURES EXCHANGES: RISK MANAGEMENT REGIME TRIUMPHS 74

streamline trade processing. Redding says: “There are numerous operational efficiencies and capital savings. They could not have come at a better time in the marketplace.” The extreme market volatility last autumn caused the CME’s exchanges to reassess and, in most cases, raise margins on their contracts, but underlying risk models never faltered. Investors are on notice that if volatility spikes, the margins move higher and vice versa when volatility comes down. While some investors no doubt received margin calls at an inopportune moment, the public interest in robust markets trumps the concerns of individual participants. “We have to protect the integrity of the market over anything else,” says Redding. “The margin system performed well in arguably one of the most stressful times in US economic history.” Success has not protected the futures exchanges from criticism, however. Politicians were quick to blame“speculators”when the price of oil soared to $147 per barrel in July 2008 and have called for position limits on energy products similar to those already applied to agricultural commodities. Gary Gensler, the new chairman of the Commodities Futures Trading Commission (CFTC), has disavowed a commission study last year that attributed high oil prices to fundamental supply and demand factors; he has decided to impose position limits on energy futures. Market participants were quick to point out that hard limits would drive business away from the US exchanges to either foreign venues or the bilateral OTC market—a result that conflicts with the Obama administration’s stated desire to encourage trading of standardised OTC derivatives on an exchange. “Position limits won’t achieve the regulators’objective and it will reduce the market share of US entities,” says Niederhoffer’s Shen. “We know how hard it is to get market share back.” CME’s Redding argues that the existing accountability regime, under which investors must advise the exchanges of positions beyond a certain size and may have to reduce them in certain circumstances, have proved effective in preventing market disruption during the delivery period. He notes that deliveries are rare on energy contracts, anyway— a “handful of contracts” in West Texas Intermediate Crude Oil, which typically has open interest in excess of 1m contracts. “Position limits don’t really have an impact on price,” says Redding. “The agricultural markets have those limits and yet you see quite a bit of price volatility.” The CFTC has its own agenda, however. In mid-August, the commission withdrew no action letters that permitted two commodity index tracking funds managed by Deutsche Bank to exceed speculative position limits in corn, wheat and soybeans futures. Chairman Gensler said at the time: “I believe that position limits should be consistently applied and vigorously enforced.” The outstanding performance of the futures exchanges through the financial crisis will not go unpunished.

RICHARD REDDING, managing director of products and services at Chicago-based CME Group

IntercontinentalExchange (ICE) demonstrated the importance of up-to-date technology when it acquired the New York Board of Trade (now called ICE Futures US) in 2007. Six weeks after the deal closed, ICE introduced electronic trading to the key markets and made a complete transition to electronic trading of futures in March 2008. “Volume increased virtually across the board as a result of these contracts being available to a wider global audience,” says Kelly Loeffler, a spokeswoman at ICE. The spike in US sugar prices has propelled further volume gains this year, more than offsetting lower volumes in other agricultural contracts. ICE has also benefited from trading in Russell 2000 mini futures and options, to which it acquired an exclusive licence in September 2008. ICE’s gains this year are the exception, however. CME has seen less trading in all its major physical and financial products groups except energy contracts. Most futures volumes were down 10%-15% (through August), but the drop in interest rate products was by far the most dramatic: almost 40%. Redding says:“US interest rate policy has taken short-term rates to near zero. It makes the need to hedge a lot less.” On a more positive note, the financial crisis underscored the risk management benefits of clearing, which has contributed to growth at CME Clearport Clearing. Started as a platform for clearing OTC derivatives on energy products, Clearport now accepts derivatives on other asset classes although energy still represents the majority of its business. “We have seen a movement towards bilateral contracts being cleared through Clearport,”says Redding.“I think you will see more asset classes move to a cleared environment in order for participants to use their capital more efficiently.” CME’s merger spree has enabled the group to offer crossmargin capability between products traded on the different exchanges. Redding estimates that market participants were able to cut their capital commitments by $1bn as a result of the CBOT deal alone. CME has also harmonised rules among the different exchanges as far as possible and introduced a single front end matching system to

OCTOBER 2009 • FTSE GLOBAL MARKETS

GREEN SHOOTS BLUE SKY

CHANGING PERCEPTIONS

At first glance nothing seems different, but in fact, everything has changed. The securities lending business is now having to re-evaluate how it operates in the post-crisis quagmire. The focus on intrinsic value has changed the perception of securities lending from an operational function to a form of investment management—and requires a different approach to due diligence, reports Neil O’Hara.

YEAR AGO politicians and executives of public companies were berating short sellers as devil’s spawn who were out to destroy the financial system. They claimed hedge funds and other shorts were undermining confidence in troubled financial companies in a deliberate attempt to push them over the edge and profit from their downfall. Regulators slapped restrictions on short selling, and several big players suspended their securities lending programmes. The panic didn’t last, however. The regulators backed off within a month, in the US, at least, and the critics turned their attention elsewhere as the credit crisis put the real economy into a tailspin. By the first quarter of 2009 most of the lenders were back— and coining money like never before from sky-high credit spreads. That game couldn’t last either and now the securities lending industry is going back to basics. Kathy Rulong, global head of securities lending at The Bank of New York Mellon, says that while the knee-jerk reaction among securities lenders last autumn was to pull back, they quickly discovered it would be an expensive proposition. Lenders take collateral against the securities they lend, usually cash, which they reinvest in the money markets to enhance the overall return on securities lending. At the time, a typical cash collateral reinvestment pool—whether co-mingled or separate—kept 10%-20% in short-term liquid instruments, but managers extended maturities on the rest in pursuit of higher returns.“The cash collateral pools had long-term-investments,” Rulong explains.“If lenders shut down they would have had to sell those into the weakest market in 80 years.”

Photograph © Photomyeye/Dreamstime.com, supplied September 2009.

FTSE GLOBAL MARKETS • OCTOBER 2009

CHANGING PERCEPTIONS 76

volume low margin segment of securities lending. Mark Payson, managing director and global head of trading and asset liability management at Brown Brothers Harriman (BBH), says that instead of 5-10 basis points (bps), general collateral lenders could make 75-100 bps even if the collateral pool was reinvested in conservative instruments like registered money market funds. He says: “It was a great opportunity. In spite of the market challenges, 2008 was a record year for beneficial owners that participated in securities lending programmes.” As fears that the financial system might collapse receded, LIBOR came down to earth and general collateral spreads settled back to 15-20 bps, still higher than the historical range but no longer a bonanza for lenders. The elevated returns reflect the need for some agent lenders to preserve their general collateral balances in order to avoid liquidating impaired collateral investments. Rather than take immediate losses on instruments that may still pay out in full at maturity, agents who manage these collateral pools have gone to extraordinary lengths to keep securities out on loan. For example, rebates related to general collateral lending have increased materially Kathy Rulong, global head of securities lending at The Bank of New York Mellon, says and been accepted in order to maintain cash that while the knee-jerk reaction among securities lenders last autumn was to pull back, levels and liquidity in collateral pools. they quickly discovered it would be an expensive proposition. Photograph kindly “Each day the liquidity in collateral pools is supplied by The Bank of New York Mellon, September 2009. becoming less of an issue as instruments in Relatively few lenders stopped lending altogether even the pools mature,” says Payson, “But they were an though some collateral pools suffered significant paper enormous factor for some lending agents to consider when losses on their holdings of asset-backed securities and pricing general collateral from August until May.” BBH other investments. The Bank of New York Mellon clients sidestepped the problem because its securities lending who dropped out had collateral guidelines that specified programme focuses on intrinsic value, the fees lenders overnight or very short-term duration instruments where extract for the use of their securities, rather than collateral the lending return depended on the intrinsic value of reinvestment returns. In July 2009 the securities lending market was valued at securities rather than a combination of intrinsic value and reinvestment returns. “They were mostly central banks or about $1.65trn, down from $3.9trn in June 2008, according financial institutions who had to use their lendable to Data Explorers, a London-based research and consulting securities for other purposes, like defending their firm that focuses on securities lending. Bonds account for currency,” says Rulong. A recent study conducted for The $1trn, about half the earlier level, but in an indication that Bank of New York Mellon by Finadium, a consulting firm some lenders have pulled out utilisation of the available that specialises in financial services, estimated that by supply has dropped only one third (from 30% to 20%). mid-year 90% of securities lenders active before the While equity balances dropped further, from $1.9trn to financial crisis were still in the game. The Bank of New $650bn, price declines clipped 35% off the principal value York Mellon clients who got out and stayed out were so underlying loan volume also fell by about half and smaller players who were either making little money from utilisation declined from 15% to 10%. The big securities borrowers are either hedge funds or securities lending or lacked the staff to monitor the proprietary trading desks at the major investment banks, programme effectively. Lenders who weathered the storm were well paid for both of which have faced severe capital constraints in the their trouble. As the premium of LIBOR, the basis for past year.“There are fewer hedge funds in existence,” says pricing cash reinvestment instruments, over Fed funds David Carruthers, head of quantitative services at Data soared, agent lenders were able to deliver outsized Explorers.“Those that still exist are either not being allowed returns on general collateral, traditionally the high as much leverage or are choosing to use less leverage.”The

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CHANGING PERCEPTIONS 78

ranks of the major securities houses have thinned as well: Bear Stearns was rescued by JP Morgan, Lehman Brothers died, Wachovia fell into Wells Fargo’s arms and Bank of America picked up Merrill Lynch. The surviving independent bulge bracket firms, Morgan Stanley and Goldman Sachs, became bank holding companies, which meant they had to cut their leverage and reduce proprietary trading, too. Carruthers attributes the decline in demand for bonds to a shift in financing priorities among financial institutions. The overwhelming majority of fixed income lending is in government bonds to support trades in the repo market, where activity has slumped in the past year. “People found they were too dependent on repo for short-term funding,” explains Carruthers. “They have issued longer-dated bonds. That’s why repo has come down and it’s one of the main drivers for lower bond utilisation.” The credit crunch also touched off a scramble among hedge funds to diversify their funding relationships. Funds that relied on a single prime broker for financing switched to a multi-prime model, while funds that already had multiple prime brokers added new ones. Demand for securities lending at each prime broker became less stable as balances shifted around, which made prime brokers reluctant to renew deals under which the lending agent pays a fee up front to lock up supply. “Some prime brokers don’t want to commit to pay a large revenue guarantee for exclusive rights to portfolios if they are not sure whether client demand will support the guarantee,”says

Andrew Clayton, global head of securities lending at Northern Trust. Principal lending still has a role to play, but Clayton expects future deals will focus on portfolios with high intrinsic value and only the most creditworthy counterparties. Photograph kindly supplied by Northern Trust, September 2009.

Kristen Doyle, a principal at Chicago-based investment consultants Ennis Knupp & Associates, says that US lending agents have already changed their collateral reinvestment guidelines to prohibit investments with a final maturity date longer than 13 months or otherwise not eligible for money market funds. Photograph kindly supplied by Ennis Knupp & Associates, September 2009.

Tredick McIntire, managing director and head of agency securities lending at Goldman Sachs. “Uncertain demand has introduced more volatility into the pricing of specials.” Beneficial owners aren’t so keen on lending exclusively through a principal in the current environment, either.“It exposes them to one or two counterparties as opposed to spreading that portfolio around a much bigger universe of borrowers,” explains Andrew Clayton, global head of securities lending at Northern Trust. Principal lending still has a role to play, but Clayton expects future deals will focus on portfolios with high intrinsic value and only the most creditworthy counterparties. As intrinsic value assumes greater importance, Clayton expects beneficial owners to use more third party agents. Instead of asking their custodian to manage the entire programme, owners parcel out assets to firms they believe can extract the greatest value for each piece, just as they pick different investment managers for bonds and equities. Custodians can’t pick and choose the assets that participate in their programmes, either; if someone walks in the door with a large Standard & Poor’s 500 index portfolio that has little value to borrowers, they are stuck with it, whereas third party agents can concentrate on small and mid-cap names that have higher intrinsic value. “Beneficial owners want the best in that field, the lender that provides them with value, robust risk management, transparency and on-line reporting,” says Clayton. “It’s not all about revenue these days.” Agency

OCTOBER 2009 • FTSE GLOBAL MARKETS

programmes offer lenders flexibility to set exposure limits for specified counterparties (borrowers), determine what securities they want to lend, and to recall securities that are on loan in order to exercise voting rights. Lending agents—whether third party or custodian—also offer borrower default indemnification in which the agent agrees that if the borrower fails to return the security, it will replace either the security or its cash value. The distinction is important to taxable investors, who will be deemed to have sold a security and owe tax on any gains unless it is replaced in kind.The US Internal Revenue Service let affected lenders off the hook after Lehman failed, but the experience served as a wake-up call. “Clients are focusing now on exactly what their indemnification provides,” says Michael McAuley, senior managing director, securities finance, at State Street, the Boston-based custody bank. A renewed attention to contingent risks has prompted more institutions to shift assets to custodians rather than leaving them with their prime brokers. State Street has seen an increase in demand for its enhanced custody service, which encompasses securities lending, as a result. “It’s a custodial alternative to a traditional prime brokerage arrangement,” says McAuley, adding: “It provides cost savings, risk reduction and operational efficiencies. There is no rehypothecation and all assets are held in the client’s custody account.” Securities that are hard to borrow—specials—attract premium lending rates that drive returns based on intrinsic value. Often associated with merger transactions or capital reorganisations that involve an exchange of securities, spreads can run to hundreds of bps over Fed funds in popular trades like the recent conversion of Citigroup preferred into common stock or the spread between Volkswagen preferred and ordinary shares. In the past year, specials have become more common, too: The Bank of New York Mellon/Finadium study found that 26 stocks in the Standard & Poor’s 500 were specials in March 2009 versus just five in March 2008. How expensive specials are may depend on whether the lending agent has impaired assets in its collateral pool. Agents who need to maintain big general collateral balances may be reluctant to charge full freight on specials in case the borrower goes elsewhere.“If a lender wants to re-rate an outstanding loan that has turned special, he may worry that the borrower will say: ‘Don’t push me, or I’ll return the general collateral balance,’” says McIntire at Goldman Sachs. “There was a transfer of pricing power between these lenders and borrowers because lenders couldn’t afford to lose the balance.” Much of the pressure on distressed collateral pools abated during the third quarter—and lenders who had liquid collateral pools were always able to charge market rates. The new emphasis on intrinsic value is likely to continue for some time. Kristen Doyle, a principal at Chicago-based investment consultants Ennis Knupp + Associates, says that US lending agents have already changed their collateral reinvestment guidelines to

FTSE GLOBAL MARKETS • OCTOBER 2009

Tredick McIntire, managing director and head of agency securities lending at Goldman Sachs.“Uncertain demand has introduced more volatility into the pricing of specials.” Photograph kindly supplied by Goldman Sachs, September 2009.

prohibit investments with a final maturity date longer than 13 months or otherwise not eligible for money market funds. Some clients have imposed even tighter restrictions, and others are likely to do so when the impaired collateral pools roll off the books, all of which reduces potential returns. “If lenders tighten up the reinvestment guidelines, it forces them to focus on intrinsic lending,” says Doyle. “They only lend out securities that bring a premium from the borrower.” The contribution to returns from intrinsic value is likely to increase in the coming months as legacy assets in reinvestment pools mature. Three-month LIBOR only fell below 1% in May but had drifted down to 39bps in late August, ensuring that replacement paper will generate lower yields. For lenders who have only large-cap equity and core-fixed income portfolios, Doyle says the low potential rewards in this environment may not outweigh the risk of lending their securities. The focus on intrinsic value has changed the perception of securities lending from an operational function to a form of investment management—and requires a different approach to due diligence. Says BBH’s Payson: “Beneficial owners want to ensure that their business objectives and risk tolerance for lending match those of the agent who is providing the service.”

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For years securities-lending programmes acted as a reliable generator of revenue that typically operated away from the spotlight. Since last autumn’s wake-up call, however, a vast majority of securities-lending clients have increased investment oversight while reducing or eliminating exposure to riskier products. For their part, agents have responded by adding tools of transparency and sharpening relationship-management capabilities as never before. Dave Simons reports from Boston. AVING BEEN IN the business for 22 years, Brian Lamb has seen a lot of ebbs and flows in the marketplace. From his vantage point as chief executive officer of EquiLend, a provider of trading and operations services for the securities finance industry, the current state of the securities lending industry (and the response from beneficial owners over the past 12 months) has a very familiar ring.“It is quite similar to the dynamics during the crash of the late 1980s, or the derivatives problems at the start of the 1990s,”says Lamb.“Those were also situations in which people did not fully understand some of their exposures, and there was a knee-jerk impulse to pull back. Even so, they then came back into the markets and I think we are seeing the same type of situation now.” For years, securities-lending programmes acted as a reliable generator of revenue that typically operated away from the spotlight. It is not surprising, then, that a level of complacency developed among many of its chief participants. Since the onset of the global credit crunch, however, securities-lending clients such as public pension plans have understandably clamoured for greater control of their assets and in some cases have withdrawn from the market in entirety. Many of those investment institutions that have seen the value of their assets under management reduce by a substantial amount—including beneficial owners who

FTSE GLOBAL MARKETS • OCTOBER 2009

experienced an unexpected interruption in liquidity or were unable to pull out of a plan immediately—have paused to assess the benefits of continuing in a securities lending programme. The California Public Employees Retirement System (CalPERS), for instance, which was the recipient of a $854m cash-collateral hit during the market plunge, has already considered a reconfiguration of its $182bn selfdirected programme. In some instances, owners have gone so far as to assume direct lending duties themselves. Though that is actually declining as an option.“After a few years there is suddenly the realisation that there is much more to it than meets the eye,” acknowledges Equilend’s Lamb, “and in reality it is a job that is better left to the experts.” The good news is that a majority of owners appear to be holding steady, and while trading volumes remain well below pre-crisis levels, the numbers are vastly improved from this time a year ago, notes Lamb. “My hope is that this ultimately brings about a greater understanding and appreciation of the entire process,”he says. For instance, any risks that a beneficial owner assumes as part of a sec-lend arrangement should be consistent with risks in other investment strategies, he adds. Many beneficial owners who suspended their programmes during the peak of the crisis in late 2008 have re-engaged in the business during 2009, particularly as market conditions have improved, highlights Chris Jaynes, president of Boston-based third-party lending agent eSecLending.“Similarly, beneficial owners are now taking steps to review their programmes and look at alternative providers and routes to market in recognition of the changing landscape in securities lending.” In any case, beneficial owners who historically have not reviewed or evaluated their securities lending programme are now more tuned in to the real dynamics of the business, explains Jaynes. It is a sea change, he cedes. “Going forward, we anticipate that more beneficial owners will view securities lending as an investment management function and will take a more proactive approach in the

SECURITIES LENDERS SHARPEN RELATIONSHIP MANAGEMENT

THE DEVIL IN THE DETAIL

SECURITIES LENDERS SHARPEN RELATIONSHIP MANAGEMENT 82

management of their programmes and in determining the optimal programme structure.“ The US in particular has seen a significant re-evaluation of exposures in cash reinvestment plans. Lamb, who served as portfolio manager and cash strategist while at Barclays Global Investors (BGI), understands first hand the nature of these cycles.“Ultimately this period will allow beneficial owners to reflect on their strategy and then come back into the business with eyes wide open,” he says, “or after gaining more insight, they may decide that they are better off focusing on other strategies.” Meanwhile, the ongoing shift from cash to non-cash collateral bears watching. Lamb says: “It is as if non-cash were some kind of utopia when in reality, non-cash has its own inherent risks, and you need to know what they are and whether or not the collateral you are taking is actually suitable. Not only that, but non-cash also has its own market volatility. So now you have the market volatility of the price of the underlying securities loan, against the market volatility of the collateral.” Should there suddenly be a need to raise cash in the event of a collapse or bankruptcy, the non-cash collateral must first be sold into the market. In a depressed environment, there are no guarantees that sufficient proceeds can be raised, acknowledges Lamb.

Staying informed As with many other segments of the investment market, current market conditions are fostering increased complexity around services. Like many of his colleagues, Jaynes sees greater demand for transparency and best execution in the securities lending market, fuelled by market turmoil, increased regulatory scrutiny and changing views and expectations of beneficial owners.“As beneficial owners increasingly view securities lending as an investment function, they expect to have better data available for reviewing returns, risk factors and relative performance information in order to more fully understand and monitor their programmes,”says Jaynes. “Clients are revaluating their credit-risk profile and considering what they want their programme to look like in the future,”says Kathy Rulong, executive vice-president, global securities lending, BNY Mellon Asset Servicing, “rather than saying they want to exit.” For their part, agents have responded to demands for tighter risk controls by focusing on their relationshipmanagement capabilities in an effort to improve transparency and, above all, maintain client confidence. “Whether it is securities lending, asset servicing or asset management, client-relationship management is paramount and our primary concern,”says Rulong. What is really required during this period, she says, is an increased level of communication, including providing information more frequently and with greater depth.“Rather than settle for a review of their lending programme on a monthly basis, many are now looking to have a regular snapshot or a more detailed look at these issues,” she adds. “Accordingly, we have ensured that all information is made

available on a daily basis, and also has the depth and clarity needed to provide adequate transparency.” As part of the overall effort to boost transparency, in August Chicago-based Northern Trust announced the launch of a specialised securities lending technology and reporting dashboard, designed to provide clients with continuous and up-to-date information on their lending programme. Data covering loan and collateral balances, earnings on loaned assets, credit ratings and other information is offered in snapshot form, and clients also receive commentary pertaining to the securities-lending market. With the rise of securities lending as an investment management and trading activity, beneficial owners are increasingly unbundling custody from securities lending, says Jaynes at eSecLending. “Unbundling allows for greater control and transparency in a lending programme. Beneficial owners are taking a more active role in the management of their programmes and are looking for providers with core competencies and expertise in the different functions for custody, securities lending and collateral management.” Thanks to advancements in technology and standardisation of operational procedures between industry participants, third-party lending has become far more efficient and widely accepted over the past decade, asserts Jaynes.“This is confirmed by custodians themselves who are now actively pitching third-party lending capabilities to non-custodial clients.” Jaynes believes the financial crisis has accelerated the trend of unbundling custody from lending, particularly as beneficial owners take a more active role in the management of their programmes. “Not only are they looking for diversification of borrowing counterparts, but also of agent providers to take advantage of the core competencies and strengths of different providers,” says Jaynes.“We have always viewed securities lending as an investment management and trading discipline and strongly believe in the merits of unbundling securities lending from custody to allow beneficial owners greater transparency and control over their programmes. The notion of selecting providers based on their core competencies and strengths is more important than ever in today’s environment.” In late September the Securities and Exchange Commission (SEC) hosted a roundtable to discuss in part securities-lending practices, addressing issues such as the availability of information concerning loaned investments, the cost of borrowing stock, and short-selling pre-borrowing requirements. Such events point to possible modifications of the current securities lending model. Before any re-tooling takes place, however, experts like Lamb believe it is necessary to determine the nature of any problems that may exist.“What exactly is it we are trying to fix? Do we want to ensure that cash reinvestment guidelines are such that lending programmes do not take an inordinate amount of risk? Or is it about better enforcement of existing rules? It isn’t clear to me that a problem really exists. Yes, there are people who would like to see things changed—and if that does happen, we would expect to be a part of whatever landscape is at the end of the rainbow.”

OCTOBER 2009 • FTSE GLOBAL MARKETS

THE OMEGA EFFECT Omega Analysis describes its business as the robust engineering development of solutions to practical problems in finance, backed by decades of experience in cutting-edge mathematical sciences research. It has created proprietary financial statistical techniques based on its expertise in Omega functions—an important innovation in the mathematics of probability and statistics the company pioneered. Omega says its methods would have warned banks and their shareholders of the economic downturn. Ana Cascon and William F Shadwick explain the dynamics. HE CREDIT CRISIS and its impact on world markets have prompted a great deal of discussion of risk management, and its absence. Most of the forecasting by financial institutions of the risk inherent in their businesses failed to avoid extreme and, in some cases, catastrophic losses. Institutional investors and other shareholders who failed to manage risk absorbed huge losses as equity markets plummeted. Regulators, bankers and investors are, as in the aftermath of every financial crisis, trying to determine what went wrong and how best to avoid a repetition. Improvements in the statistical technology employed by market participants and their regulators will be needed. In particular, appropriate use of existing statistical techniques for dealing with extreme values should play an important role. Share prices of major banks contain the information needed to predict the likelihood and severity of loss in advance of the major share price declines that rocked the world’s markets in 2007, 2008 and 2009. This information is invisible to naive statistical tools such as “Normal Value at Risk”(VaR) that are in widespread institutional use and are routinely employed in the calculation of bank regulatory capital. The relevant warning signs are, however, plainly

FTSE GLOBAL MARKETS • OCTOBER 2009

apparent through the use of the decades-old statistical technique known as Extreme Value Theory (EVT) to estimate the Expected Shortfall (ES), or Conditional Value at Risk (CVaR), commonly employed by the insurance industry. This technology both correctly predicts the expected level of losses and provides the means to control exposure to this risk for bank shareholders. Omega Analysis has compiled a history of its EVT-based 99% VaR and ES estimates for Citigroup, Lehman Brothers, Halifax Bank of Scotland (HBOS), the Royal Bank of Scotland (RBS), BNP Paribas and ING. Omega can illustrate the use of a simple risk control strategy for shareholdings in those companies, based on its ES risk estimates. The results are very encouraging: markets price the risk in shares efficiently and market data viewed through appropriate statistical tools provide the means for investors to control that risk. The 99% VaR is the maximum loss expected 99 times out of 100. It is therefore the minimum loss expected once in 100 times. It is immediately clear that VaR cannot be used to manage risk, even if the VaR estimate is reliable, because two assets which have the same VaR may be expected to produce completely different losses on the critical one day in 100. There is no justification for regarding two assets as equally risky simply because they have the same 99%VaR.

STATISTICS & HOW TO PREDICT THE FUTURE

Photograph © Dreamstime.com, supplied September 2009.

Severity of loss Aside from the unhelpful information that the one-day loss in a share price can’t exceed 100%, it is impossible to know what “worst case” one should prepare for on that critical one time in a hundred when the 99% VaR level is breached. However, it is possible to estimate how big this loss is on average. This is precisely the 99% Expected Shortfall (ES), as it is know in the insurance world. Unlike VaR, ES can be used to manage risk, provided it can be estimated reliably. It is perfectly sensible to regard two assets with the same ES as equally risky from a

STATISTICS & HOW TO PREDICT THE FUTURE 84

statistical point of view. The distribution of losses worse than the 99% VaR is not symmetric: losses which breach the 99%VaR level are more likely to be in the range from the 99% VaR to the 99% ES than they are to be below the 99% ES. As a result, the 99% ES can serve as an “approximate worst loss level”provided it can be estimated reliably. The question of the reliability of the ES in practice hinges on the accuracy with which your technology estimates the likelihood and severity of loss from historic data. EVT is the branch of probability and statistics which was created for cases where the frequency and severity of events cannot be predicted by a Gaussian (Normal) distribution. EVT is ideally suited to financial market data, using the observed data to model“fat tails”and to make predictions of large or even catastrophic losses. EVT may be thought of as a framework that tells you, under fairly general conditions, that using a distribution with the asymptotic behaviour of the generalised Pareto distribution to model extreme events is not only a reasonable choice, it is essentially the only choice. [The Pareto distribution, named after the Italian economist Vilfredo Pareto, is a power law probability distribution originally developed to describe the distribution of income, the basis being that a high proportion of a population has low income, while only a few people have very high incomes.]

Controlling risk Omega measured the historic 99% VaR and ES estimates for Citigroup, Lehman Brothers, HBOS, RBS, BNP Paribas and ING based on its EVT method, which is of the“peaks over threshold”type, from January 2004 to June 2009. In every case, the return series shows an explosion of volatility in 2008 , but prior to this, and in some cases much earlier, risk levels were high. The similarity of risk levels in commercial banks and investment banks would have been a warning sign to both investors and regulators. Figure 1 shows the day by day VaR and ES estimates for HBOS together with the returns on HBOS shares (blue). From January 2004 to June 2009 we now know EVT ES estimates could have been used to control risk by an investor in any of the banks considered. Omega’s risk control strategy is based on keeping expected losses bounded by a fixed Maximum Loss Level (MLL).“We use our EVT methods to estimate the one-day 99% VaR and ES for daily returns on bank share prices. We then use the ratio of a given MLL to the 99% ES to determine the proportion of shares in a portfolio of shares and cash that will maintain our risk budget at the MLL. In our examples, the MLL has been set to -4%. We are therefore treating the 99% ES as an approximation of the worst case loss. We increase or reduce exposure to shares as this rises above or falls below -4%. For the simulation, we considered a portfolio of shares and cash and assumed that cash is invested with an annual return of 3%. When the ES level indicates that average one day in 100 losses will not exceed 4%, the allocation to shares is allowed to increase by borrowing cash at the same interest rate. The portfolio’s exposure to shares is therefore

Figure 1: VAR Estimates for HBOS

Source: Omega Analysis, September 2009

Figure 2: HBOS NAV vs Risk Control Strategy 2,500

HOBS NAV

99% ES Risk Control

2,000

1,500

1,000

500

0 Jan-04

Jul-04

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Source: Omega Analysis, September 2009

always greater than zero. In the period in question, leverage never increased share exposure above 120% and the average exposures were much lower.” Figure 2 illustrates the impact of this risk control strategy on a £1m portfolio of cash and HBOS shares. The benchmark investment was entirely in HBOS shares.

In conclusion The EVT-based VaR and ES estimates performed as designed prior to and during the crisis. They provided what was so badly needed: advance warning of the potential for large losses in systemically important banks. This information would have alerted regulators to the serious threats to the international banking system that were developing and would have alerted shareholders to their increasing downside risk exposure. Omega says that, contrary to assertions in the popular press, these risks were not beyond the predictive capacity of modern statistics. Both the likelihood and severity revealed by the use of EVT would have raised serious concerns for investors and regulators in advance of the crisis. They were accurate enough that risk control based on the EVT 99% ES proved highly effective in reducing volatility and preserving value. Omega says:“We hope that these methods will be useful to both investors and regulators in future.”

OCTOBER 2009 • FTSE GLOBAL MARKETS

BACK TO BASICS 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

FTSE GLOBAL MARKETS • OCTOBER 2009

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 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 a push to generate additional return and deal up the risk on existing products. That is not the case now and investors are going

MONEY MARKET FUNDS: EMERGING REGULATIONS

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. Photograph © Fotolia.com, supplied September 2009.

MONEY MARKET FUNDS: EMERGING REGULATIONS 86

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, September 2009.

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

OCTOBER 2009 • FTSE GLOBAL MARKETS

By June 2012, if accepted by regulators, all funds that fall outside the proposed definition would no longer be classified as money market funds. 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.” 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

FTSE GLOBAL MARKETS • OCTOBER 2009

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.

Underlying assets 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 JPMorgan, 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.”

EXCHANGE TRADED FUNDS: LISTING & DISTRIBUTION

Assets US$ Bn

# ETFs

Worldwide ETF and ETP Growth

$1,000

2,000 1,800

$800

1,600 1,400

$600

1,200 1,000

$400

800 600

$200

400 200

$0 ETF Assets Total

0 1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Q1-09

Q2-09

Aug-09

$0.8

$1.1

$2.3

$5.3

$8.2

$17.6

$39.6

$74.3

$104.8

$141.6

$212.0

$309.8

$412.1

$565.6

$796.7

$710.9

$633.1

$789.0

$890.5

ETF Commodity Assets ETF Fixed Income Assets ETF Equity Assets

$0.8

$1.1

$2.3

$5.3

$8.2

$17.6

$39.6

$0.0

$0.1

$0.3

$0.5

$1.2

$3.4

$6.3

$9.9

$12.8

$16.4

$17.7

$0.1

$4.0

$5.8

$23.1

$21.3

$35.8

$59.9

$104.0

$116.4

$132.8

$144.9

$74.2

$104.7

$137.5

$205.9

$286.3

$389.6

$526.5

$729.9

$596.4

$503.3

$639.0

$726.9

$15.6

$28.1

$45.9

$54.4

$73.8

$85.5

$92.1

ETP Assets Total

# ETPs # ETFs

202

280

282

336

134

511

527

561

566

461

714

1,171

1,592

1,634

1,707

1,773

Source: ETF Research & Implementation Strategy Team, Barclays Global Investors, Bloomberg. Sept 2009

ETF LISTINGS BY EXCHANGE (as of end August 2009) Region Listed

Country

Exchange

Australia China

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

Asia Pacific

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

Sao Paulo Toronto Stock Exchange Mexican Stock Exchange BATS Boston CBOE Chicago Cincinnati FINRA-ADF ISE NASDAQ NYSE NYSE Alternext US NYSE Arca

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

Grand Total

Wiener Borse Euronext Brussels Helsinki Stock Exchange Euronext Paris Deutsche Boerse Boerse Stuttgart Athens Exchange Budapest Stock Exchange Iceland Stock Exchange Irish Stock Exchange Borsa Italiana Euronext Amsterdam Oslo Stock Exchange Ljubljana Stock Exchange Johannesburg Stock Exchange Bolsa de Madrid Stockholm Stock Exchange SIX Swiss Exchange Istanbul Stock Exchange London Stock Exchange Chi-X (not an official exchange) European Reported OTC

# Primary ETF

# Total ETF

AUM ($bn)

20 Day ADV ($m)

177

252

58.60

1,385

4 3 2 16 2 10 1 6 59 3 6 8 43 11 3

25 3 2 37 2 10 1 6 62 3 6 37 43 12 3

1.93 3.27 1.19 17.88 0.00 0.17 0.00 8.66 16.88 0.32 0.44 2.33 3.06 2.41 0.08

22.62 508.83 168.56 372.03 0.00 3.75 0.00 75.67 68.92 0.11 0.30 10.30 137.44 16.28 0.62

823

974

638.35

58,696.52

4 96 13 41 4 665

4 96 164 41 4 665

1.37 23.91 6.08 21.97 80.74 504.29

12.04 811.12 186.25 7,978.65 1,167.58 272.38 841.97 271.53 16,342.27 667.55 16,773.70 0.00 0.00 13,371.47

773

1,911

193.57

2,247.58

1 1 1 207 314 0 2 1 1 14 14 5 6 1 22 10 7 36 9 121

21 1 1 377 507 51 2 1 1 14 299 86 6 1 22 32 7 175 9 298

0.09 0.06 0.17 47.60 81.97 0.00 0.12 0.02 0.00 0.10 1.63 0.21 0.59 0.01 1.48 2.25 2.21 15.65 0.19 39.24

0.20 0.85 2.00 324.38 831.33 1.22 0.41 0.92 0.00 0.13 244.63 60.27 89.85 0.00 7.76 13.97 80.83 120.77 44.57 256.40 32.54 134.55

1,773

3,137

890.52

62,329.53

Source: ETF Research & Implementation Strategy Team, Barclays Global Investors, Bloomberg. Sept 2009

OCTOBER 2009 â&#x20AC;˘ FTSE GLOBAL MARKETS

Global ETF Assets by Type of Exposure, as at end August 2009 Global - Equity

1.7%

Number of ETFs

Total Listings

AUM ($bn)

% Total

North America - Equity 474 Fixed Income - All (ex-Cash) 215 Emerging Markets - Equity 259 400 Europe - Equity 144 Asia Pacific - Equity 62 Global (ex-US) - Equity 58 Commodities 100 Global - Equity Fixed Income - Cash (Money Market) 17 Currency 14 Mixed (Equity & Fixed Income) 28 Alternative 2 Total 1,773

650 384 522 841 234 68 118 243 33 14 28 2 3,137

$378.11 $135.98 $122.76 $98.88 $61.58 $50.13 $17.72 $15.45 $8.93 $0.52 $0.43 $0.05 $890.52

42.5% 15.3% 13.8% 11.1% 6.9% 5.6% 2.0% 1.7% 1.0% 0.1% 0.0% 0.0% 100.0%

Region of exposure

Fixed Income Cash (Money Market)

1.0%

Commodities

2.0%

Currency

Global (ex-US) Equity

0.1%

5.6%

Mixed (Equity & Fixed Income)

Asia Pacific Equity

6.9%

Alternative

Europe - Equity

11.1%

Emerging Markets - Equity

North Americas Equity

13.8%

42.5%

Fixed Income - All (ex-Cash)

15.3%

Source: ETF Research & Implementation Strategy Team, Barclays Global Investors, Bloomberg. Sept 2009

TOP 25 ETF PROVIDERS AROUND THE WORLD: ranked by AUM, as of end August 2009 Aug 2009 PROVIDER

iShares State Street Global Advisors Vanguard Lyxor Asset Management db x-trackers PowerShares ProShares Nomura Asset Management Van Eck Associates Corp Bank of New York Credit Suisse Asset Management Zurich Cantonal Bank Nikko Asset Management EasyETF WisdomTree Investments Daiwa Asset Management ETFlab Investment Hang Seng Investment Management Direxion Shares Commerzbank Claymore Securities Credit Agricole Structured AM China Asset Management UBS Global Asset Management Rydex

YTD Change

# ETFs

AUM ($bn)

% Total

# Planned

# ETFs

% ETFs

AUM ($bn)

391 104 40 102 110 124 78 29 21 1 24 4 9 59 51 23 30 3 22 51 57 53 2 8 31

$429.32 $139.33 $71.71 $40.78 $31.34 $30.74 $23.57 $14.36 $8.62 $7.47 $7.30 $5.75 $5.73 $5.08 $4.81 $4.79 $4.72 $4.69 $4.11 $4.02 $3.89 $3.85 $3.01 $2.81 $2.65

48.2% 15.6% 8.1% 4.6% 3.5% 3.5% 2.6% 1.6% 1.0% 0.8% 0.8% 0.6% 0.6% 0.6% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.4% 0.4% 0.3% 0.3% 0.3%

19 29 8 0 0 37 96 0 13 0 0 0 0 7 68 1 0 0 112 0 16 0 1 0 82

29 6 2 -13 12 -18 14 0 5 0 16 0 1 5 1 0 20 0 8 1 3 29 0 0 0

8.0% 6.1% 5.3% -11.3% 12.2% -12.7% 21.9% 0.0% 31.3% 0.0% 200.0% 0.0% 12.5% 9.3% 2.0% 0.0% 200.0% 0.0% 57.1% 2.0% 5.6% 120.8% 0.0% 0.0% 0.0%

$100.84 -$6.67 $26.55 $7.32 $7.27 $8.46 $3.25 -$0.58 $4.17 $0.78 $1.35 $2.45 -$0.46 $0.62 $1.58 -$1.27 $2.20 $1.87 $3.17 $1.43 $2.27 $1.99 $1.72 $1.41 $0.83

% % Market AUM Share

30.7% -4.6% 58.8% 21.9% 30.2% 38.0% 16.0% -3.9% 93.7% 11.7% 22.8% 74.1% -7.4% 13.8% 49.0% -20.9% 87.4% 66.5% 339.1% 55.2% 140.6% 107.2% 133.0% 100.8% 45.6%

2.0% -4.9% 1.7% -0.1% 0.1% 0.3% -0.2% -0.5% 0.3% -0.1% 0.0% 0.2% -0.2% -0.1% 0.1% -0.3% 0.2% 0.1% 0.3% 0.1% 0.2% 0.2% 0.2% 0.1% 0.0%

Source: ETF Research & Implementation Strategy, Barclays Global Investors, Bloomberg. All data supplied Sept 2009.

NOTES At the end of August 2009 the ETF industry had 1,773 ETFs with 3,137 listings, assets of $890.52 billion, from 95 providers on 41 exchanges around the world. YTD assets have grown by 25.3%, which is more than the 18.0% rise in the MSCI World index in USD terms. The number of ETFs has increased 11.4% YTD with 248 new ETFs launched, while 71 ETFs were closed. The average daily trading volume in US dollar has decreased by 22.7% to US$62.3 billion YTD. European ETF AUM has risen by 34.7% which is greater than the 21.6% rise in the MSCI Europe Index in USD terms. In Europe net sales of mutual funds (excluding ETFs) were positive $60.2 billion while net sales of ETFs domiciled in Europe were positive $15.2 billion during the first six months of 2009 according to Lipper FMI. Important Information Source: ETF Research & Implementation Strategy Team, Barclays Global Investors, Various ETF Managers, Bloomberg. Please contact Deborah Fuhr on +44 20 7668 4276 or email Deborah.Fuhr@barclaysglobal.com if you have any questions or comments. This communication is being made available to persons who are investment professionals as that term is defined in Article 19 of the Financial Services and Markets Act 2000 (Financial Promotion Order) 2005 or its equivalent under any other applicable law or regulation in the relevant jurisdiction. It is directed at persons who have professional experience in matters relating to investments. These materials are not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use is contrary to local law or regulation. Although Barclays Global Investors Limited (“BGIL”) endeavours to update and ensure the accuracy of the content of this document, BGIL does not warrant or guarantee its accuracy or correctness. Despite the exercise of all due care, some information in this document may have changed since publication. Investors should obtain and read the ETF prospectuses from ETF managers and confirm any relevant information with ETF managers before investing. Neither BGIL, nor any affiliate, nor any of their respective officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. © 2009 Barclays Global Investors. All rights reserved.

FTSE GLOBAL MARKETS • OCTOBER 2009

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.

European Top 20 Fragmented Stocks TW

-2

-1

-11

-3

-4

-6

-14

-25

-9

-12

-15

-74

-8

-63

-35

16 17

-52

-34

-39

-70

Description

FFI Across Major Indices

Wks

Stock

FFI

CPI.L

CAPITA GROUP ORD 2.066666P

3.06

SSE.L

SCOT.&STH.ENRGY ORD 50P

2.91

SGE.L

SAGE GRP. ORD 1P

2.82

BATS.L

BR.AMER.TOB. ORD 25P

2.73

CPG.L

COMPASS GROUP ORD 10P

2.72

ULVR.L

UNILEVER ORD 3 1/9P

DGE.L

DIAGEO ORD 28 101/108P

2.62

IMT.L

IMP.TOBACCO GRP ORD 10P

2.61

BG..L

BG GRP. ORD 10P

RSA.L

RSA INS. ORD 27.5P

2.59

EXPN.L

EXPERIAN ORD USD0.10

2.58

IPR.L

INTL POWER ORD 50P

2.58

STAN.L

STAND.CHART. ORD USD0.50

2.56

PRTY.L

PARTYGAMING ORD 0.015P

2.52

ABF.L

A.B.FOOD ORD 5 15/22P

2.52

HAS.L

HAYS ORD 1P

2.52

RB..L

RECKITT BEN. GP ORD 10P

JMAT.L

JOHNSON,MATTH. ORD #1

2.49

GSK.L

GLAXOSMITHKLINE ORD 25P

2.48

CNA.L

CENTRICA ORD 6 14/81P

2.46

2.7

2.5

2.0

2.6

1.5

1.0 Sep

Oct

Nov

Dec

Jan

Feb

Mar

Apr May Jun

Jul

Aug

2.5

Wks = Number of weeks in the top 20 over the last year. Week ending 11 Sep 2009

DAX

AEX

CAC 40

FTSE 100 August 2009

COMMENTARY By Steve Grob, Director of Strategy, Fidessa One of the most interesting trends that can be seen from the FFI graph above is how fragmentation in London seems to be accelerating whilst some trading in French and German stocks has reverted back to the primary exchange (NYSE Euronext). One of the reasons for this is that BATS Europe has moved the focus of its inverted pricing model that overly rebates makers of liquidity over takers of liquidity. This can be seen in the BATS market share of FTSE 100 stocks which has grown from around 4% in the middle of August to just under 7.5% by the middle of September. This raises the question as to what happens when these incentives are removed. In the case of BATS, some of the European liquidity it had previously gained on the back of its pricing promotions has indeed found its way back to NYSE Euronext but, significantly, not all. It will be interesting to see how the pricing war pans out. The primary exchanges have more variables to play with in terms of operating multiple venues and listing multiple asset classes. On the other hand, the MTFs are able to get away with pricing promotions that would be deemed as anti-competitive if the primaries were to adopt these same tactics. A second observation is that fragmentation is creeping up in Switzerland but remains stubbornly flat in places like Spain. Since May, the FFI of the major Swiss index (the SMI) has leapt by 30% with most of this volume being shared between Chi-X and Turquoise. In contrast, Madrid’s IBEX 35 has hardly fragmented at all. The causes of increased fragmentation in Switzerland are not easy to divine but the explanation for Spain is simple – they are playing by different rules. While MiFID provides one set of Europe-wide regulations they are, of course, subject to interpretation and enforcement by each of the domestic regulatory authorities. The situation in Spain seems hugely and unnecessarily complicated and although these reasons are sure to be genuine, it’s doubtful whether the same situation would have been allowed to persist for so long in London, Frankfurt or Paris. In any event, both trends highlight another dimension to the debate – the same set of rules apply differently to the players in the fragmentation arms race.

OCTOBER 2009 • FTSE GLOBAL MARKETS

Venue turnover in major stocks: January 2009 through August 2009 (Europe only). (€) January

February

March

April

BTE

4,785,896,896.00

5,608,054,977.00

8,293,478,409.00

11,760,455,327.00 12,273,094,621.00 19,819,573,785.00 17,136,125,014.00 14,571,686,219.00

May

June

CIX

46,834,544,047.00

44,478,000,689.00

57,302,171,842.00 64,890,793,940.00 67,426,563,518.00 76,420,127,929.00 73,902,822,016.00 71,551,307,518.00

CPH

6,122,089,395.00

6,065,736,542.00

5,769,670,820.00

ENA

28,628,617,634.00

28,155,384,745.00

33,344,383,457.00 33,930,334,077.00 32,867,006,758.00 30,976,601,902.00 31,385,199,230.00 30,691,910,028.00

ENL

1,942,925,835.00

1,699,902,475.00

2,192,516,989.00

ENX

67,347,958,250.00

62,176,825,878.00

71,521,595,572.00 72,615,015,403.00 64,756,243,571.00 65,114,762,913.00 60,333,614,213.00 59,636,097,679.00

GER

64,647,340,246.00

58,503,655,400.00

71,961,504,918.00 70,826,928,671.00 65,294,587,783.00 59,810,363,156.00 59,120,911,176.00 55,161,793,765.00

MAD

42,240,956,385.00

35,155,031,277.00

42,748,157,361.00 46,356,689,095.00 44,148,540,160.00 46,007,528,734.00 45,653,082,841.00 35,434,917,111.00

MIL

33,587,836,193.00

33,411,222,405.00

40,612,882,418.00 50,707,487,670.00 65,112,164,394.00 50,337,737,317.00 43,251,626,085.00 50,791,257,494.00

NEU

615,076,515.10

497,344,442.60

497,818,346.20

950,256,423.30

OSL

10,557,959,082.00

9,507,251,979.00

9,960,856,458.00

9,308,457,732.00 14,694,324,285.00 13,002,357,861.00 8,191,066,040.00

STO

19,083,973,240.00

21,156,243,299.00

22,366,913,852.00 24,478,052,974.00 21,101,128,524.00 19,326,314,013.00 18,390,750,978.00 20,842,988,551.00

TRQ

24,465,552,502.00

27,575,386,163.00

21,789,168,823.00 13,250,597,390.00 15,013,090,241.00 19,593,680,671.00 22,795,819,570.00 26,695,607,538.00

ENB

6,464,469,526.00

6,583,680,870.00

7,274,199,930.00

6,777,175,877.00 7,445,092,754.00

6,529,627,899.00

5,189,313,861.00

7,784,709,480.00

HEL

9,786,096,681.00

9,953,915,021.00

10,391,428,275.00 12,141,298,756.00 9,649,992,328.00

8,465,193,200.00

8,937,741,770.00

8,812,985,645.00

LSE

98,145,503,784.00

90,396,376,631.00

113,304,000,000.00 98,817,445,425.00 94,048,810,611.00 109,576,000,000.00 92,086,424,632.00 82,899,283,778.00

VTX

39,198,558,123.00

41,645,468,998.00

42,750,059,854.00 41,180,202,240.00 38,363,085,417.00 33,892,649,428.00 32,849,258,499.00 35,080,948,172.00

NAE

75,833,173.13

BRG

367,214,270.90

6,870,911,751.00 7,383,968,635.00

July

5,812,371,514.00

2,611,463,853.00 2,971,813,173.00

2,198,642,157.00

2,327,001,210.00

2,718,970,582.00

August

4,870,382,666.00

2,070,066,025.00

3,543,693,008.00

7,089,257,770.00

2,485,993,487.00

3,185,323,984.00 10,083,367,296.00

Index market share by venue: Week ending September 11, 2009 Primary

Alternative Venues

Index

Venue

Chi-X

Turquoise

Nasdaq OMX

BATS

Burgundy

Amst.

Paris

Xetra

Stockholm

AEX

Amsterdam

71.46%

15.56%

4.57%

0.60%

3.48%

4.83%

0.18%

BEL 20

Brussels

59.35%

14.55%

2.70%

0.47%

2.21%

19.40%

0.06%

CAC 40

Paris

68.14%

15.39%

4.80%

1.13%

4.06%

5.55%

0.19%

DAX

Xetra

74.94%

15.64%

4.18%

0.50%

3.57%

†

0.03%

FTSE 100

London

63.40%

19.93%

7.30%

1.92%

7.43%

FTSE 250

London

71.52%

18.70%

5.29%

0.33%

4.14%

IBEX 35

Madrid

99.54%

0.34%

0.02%

†

0.03%

FTSE MIB

Milan

92.91%

4.45%

0.73%

0.06%

1.79%

†

0.03%

PSI 20

Lisbon

97.76%

0.79%

1.35%

0.03%

0.05%

†

SMI

SWX

78.59%

12.96%

6.66%

0.96%

0.82%

OMX C20

Copenhagen

88.41%

9.50%

1.39%

0.19%

0.47%

†

OMX H25

Helsinki

81.20%

11.52%

4.33%

0.46%

0.82%

†

0.03%

1.41%

OMX S30

Stockholm

80.52%

13.20%

3.64%

0.55%

0.60%

1.40%

OSLO OBX

Oslo

93.97%

3.37%

0.38%

0.05%

0.12%

†

2.10%

Figures are compiled from order book trades only. Totals only include stocks contained within the major indices. † market share < 0.01%

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 • OCTOBER 2009

5-Year Total Return Performance Graph 600 500

FTSE All-World Index

400

FTSE Emerging Index

300

FTSE Global Government Bond Index

200

FTSE EPRA/NAREIT Global Index

100

FTSE4Good Global Index

Index Level Rebased (31 August 2009=100) Au g04

FTSE GWA Developed Index Au g09

Fe b09

Au g08

Fe b08

Au g07

Fe b07

Au g06

Fe b06

Au g05

Fe b05

MARKET DATA BY FTSE RESEARCH

Global Market Indices

FTSE RAFI Emerging Index

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

2,760

222.55

12.4

50.8

-15.1

24.4

2.66

FTSE World Index

USD

2,336

522.79

12.7

49.8

-15.4

23.1

2.69

FTSE Developed Index

USD

1,936

209.15

12.8

48.1

-15.9

21.3

2.68

FTSE All-World Indices

FTSE Emerging Index

USD

824

535.22

9.6

74.4

-8.8

53.5

2.50

FTSE Advanced Emerging Index

USD

400

496.97

10.8

75.4

-8.7

52.0

2.72

FTSE Secondary Emerging Index

USD

424

630.78

8.1

73.2

-8.7

56.0

2.20

FTSE Global All Cap Index

USD

7,373

355.47

12.7

51.6

-15.3

25.3

2.58

FTSE Developed All Cap Index

USD

5,727

336.60

13.0

48.9

-16.2

22.2

2.59

FTSE Emerging All Cap Index

USD

1,646

708.63

9.8

76.2

-8.2

55.4

2.46

FTSE Advanced Emerging All Cap Index

USD

863

668.79

10.5

76.6

-8.3

53.6

2.66

FTSE Secondary Emerging All Cap Index

USD

783

803.69

8.8

75.8

-8.0

58.2

2.19

USD

717

182.61

3.7

9.3

10.7

1.4

2.74

FTSE EPRA/NAREIT Developed Index

USD

260

2188.64

18.4

72.3

-23.1

25.4

4.65

FTSE EPRA/NAREIT Developed REITs Index

USD

178

720.97

23.6

66.2

-28.8

17.8

5.88

FTSE Global Equity Indices

Fixed Income FTSE Global Government Bond Index Real Estate

FTSE EPRA/NAREIT Developed Dividend+ Index

USD

228

1537.82

19.7

71.4

-23.9

25.7

5.22

FTSE EPRA/NAREIT Developed Rental Index

USD

216

817.77

23.3

66.6

-27.7

20.0

5.53

FTSE EPRA/NAREIT Developed Non-Rental Index

USD

1023.51

7.6

88.0

-8.8

40.7

2.41

FTSE4Good Global Index

USD

664

5784.64

15.1

54.3

-14.1

24.1

2.92

FTSE4Good Global 100 Index

USD

103

4900.02

13.8

50.1

-15.9

20.4

3.18

FTSE GWA Developed Index

USD

1,936

3297.53

14.4

66.1

-11.6

31.7

2.77

FTSE RAFI Developed ex US 1000 Index

USD

1,013

6002.67

19.5

75.5

-4.9

39.9

3.15

FTSE RAFI Emerging Index

USD

357

5816.33

10.8

79.8

-3.3

55.0

2.33

SRI

Investment Strategy

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

OCTOBER 2009 â&#x20AC;˘ FTSE GLOBAL MARKETS

Americas Market Indices 5-Year Total Return Performance Graph 300

FTSE Americas Index

Index Level Rebased (31 August 2009=100) Au g04

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 Au g09

Fe b09

Au g08

Fe b08

Au g07

Fe b07

Au g06

Fe b06

Au g05

Fe b05

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

792

668.02

11.0

43.3

-17.8

19.0

2.14

FTSE North America Index

USD

665

731.02

11.1

41.8

-18.0

17.2

2.07

FTSE Latin America Index

USD

127

937.75

8.7

71.9

-13.5

62.7

3.15

FTSE Global Equity Indices FTSE Americas All Cap Index

USD

2,561

304.85

11.4

44.4

-18.1

19.9

2.03

FTSE North America All Cap Index

USD

2,368

292.13

11.4

42.9

-18.4

18.0

1.97

FTSE Latin America All Cap Index

USD

193

1322.15

9.9

74.0

-12.8

64.7

3.07

FTSE Americas Government Bond Index

USD

164

186.26

0.9

0.7

5.8

-2.0

3.09

FTSE USA Government Bond Index

USD

149

182.63

1.0

0.3

6.3

-2.3

3.07

FTSE EPRA/NAREIT North America Index

USD

115

2371.82

22.3

70.8

-32.9

13.2

4.44

FTSE EPRA/NAREIT US Dividend+ Index

USD

1298.93

22.3

70.8

-33.6

10.0

4.31

FTSE EPRA/NAREIT North America Rental Index

USD

112

803.39

22.1

70.5

-31.3

14.0

4.41

FTSE EPRA/NAREIT North America Non-Rental Index

USD

290.85

28.9

84.6

-69.8

-16.7

5.26

FTSE NAREIT Composite Index

USD

113

2332.22

20.9

64.8

-30.4

10.8

5.18

FTSE NAREIT Equity REITs Index

USD

5605.49

20.6

68.0

-32.8

10.0

4.36

FTSE4Good US Index

USD

137

4481.07

15.7

49.9

-14.7

20.7

1.96

FTSE4Good US 100 Index

USD

101

4285.29

15.3

48.8

-15.2

19.8

1.96

FTSE GWA US Index

USD

613

2795.94

13.5

55.2

-16.0

22.6

2.06

FTSE RAFI US 1000 Index

USD

994

5057.34

21.5

70.8

-6.3

34.7

1.60

FTSE RAFI US Mid Small 1500 Index

USD

1,478

4637.50

23.0

80.9

-7.8

40.5

1.67

Fixed Income

Real Estate

SRI

Investment Strategy

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

FTSE GLOBAL MARKETS • OCTOBER 2009

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

400

Index Level Rebased (31 August 2009=100) Au g04

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

Au g09

Fe b09

Au g08

Fe b08

Au g07

Fe b07

Au g06

Fe b06

Au g05

FTSE GWA Developed Europe Index Fe b05

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 Europe Index

EUR

551

211.07

13.6

41.9

-15.0

23.9

3.50

FTSE Eurobloc Index

EUR

287

118.56

14.1

45.4

-15.3

20.5

3.87

FTSE Developed Europe ex UK Index

EUR

380

216.03

14.7

44.5

-13.4

21.9

3.51

FTSE Developed Europe Index

EUR

492

209.08

14.0

41.2

-14.2

23.2

3.55

FTSE Europe All Cap Index

EUR

1,614

328.79

13.8

42.6

-15.2

25.4

3.43

FTSE Eurobloc All Cap Index

EUR

802

349.68

14.2

45.6

-15.4

21.5

3.81

FTSE Developed Europe All Cap ex UK Index

EUR

1,093

358.68

14.8

44.9

-13.9

22.9

3.45

FTSE Developed Europe All Cap Index

EUR

1,494

327.58

14.1

41.8

-14.4

24.7

3.47

FTSE All-Share Index

GBP

622

3250.85

13.1

33.8

-8.2

17.8

3.48

FTSE 100 Index

GBP

102

3077.54

12.4

31.4

-8.9

14.5

3.62

FTSEurofirst 80 Index

EUR

4485.28

14.0

45.5

-14.4

18.1

4.17

FTSEurofirst 100 Index

EUR

3965.81

13.0

39.5

-14.8

19.9

4.00

FTSEurofirst 300 Index

EUR

311

1366.63

13.5

39.3

-15.0

21.1

3.65

FTSE/JSE Top 40 Index

SAR

2515.57

9.3

37.4

-9.5

17.3

3.04

FTSE/JSE All-Share Index

SAR

161

2784.50

10.2

37.1

-6.8

18.3

3.24

FTSE Russia IOB Index

USD

752.66

-4.5

78.1

-33.1

75.3

2.52

FTSE All-World Indices

FTSE Global Equity Indices

Region Specific

Fixed Income FTSE Eurozone Government Bond Index

EUR

234

168.31

3.4

3.8

10.5

3.5

3.60

FTSE Pfandbrief Index

EUR

375

202.73

4.3

5.3

10.8

6.0

3.83

FTSE Actuaries UK Conventional Gilts All Stocks Index

GBP

2330.86

3.9

4.1

11.1

0.7

3.75

FTSE EPRA/NAREIT Developed Europe Index

EUR

1747.73

26.2

48.7

-20.6

29.5

5.07

FTSE EPRA/NAREIT Developed Europe REITs Index

EUR

640.44

27.2

48.1

-17.9

28.4

5.62

FTSE EPRA/NAREIT Developed Europe ex UK Dividend+ Index

EUR

2102.36

22.8

41.4

-7.8

31.2

5.63

FTSE EPRA/NAREIT Developed Europe Rental Index

EUR

682.60

26.2

48.3

-20.3

28.5

5.20

FTSE EPRA/NAREIT Developed Europe Non-Rental Index

EUR

554.36

26.5

62.0

-21.7

66.0

1.35

FTSE4Good Europe Index

EUR

270

4195.78

14.2

41.4

-13.2

23.6

3.61

FTSE4Good Europe 50 Index

EUR

3632.86

12.2

37.2

-15.3

18.4

3.97

FTSE GWA Developed Europe Index

EUR

492

3077.81

15.8

62.6

-8.8

36.0

3.57

FTSE RAFI Europe Index

EUR

524

4946.24

20.2

63.5

-4.3

39.6

2.80

Real Estate

SRI

Investment Strategy

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

OCTOBER 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

Au g09

Fe b09

Au g08

Fe b08

Au g07

Fe b07

Au g06

Fe b06

Au g05

FTSE GWA Japan Index Fe b05

Au g04

Index Level Rebased (31 August 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

1,283

258.25

11.9

55.3

-6.2

31.1

2.62

FTSE Asia Pacific ex Japan Index

USD

826

482.65

13.0

72.5

-3.6

50.4

2.96

FTSE Japan Index

USD

457

80.17

7.2

29.3

-22.8

14.0

2.15

FTSE All-World Indices

FTSE Global Equity Indices FTSE Asia Pacific All Cap Index

USD

3,015

437.67

11.9

56.4

-5.6

32.1

2.61

FTSE Asia Pacific All Cap ex Japan Index

USD

1,777

595.76

12.8

74.5

-3.8

52.4

2.94

FTSE Japan All Cap Index

USD

1,238

254.45

7.7

29.6

-21.6

14.2

2.15

FTSE/ASEAN Index

USD

148

489.03

16.7

72.1

1.1

53.9

3.22

FTSE Bursa Malaysia 100 Index

MYR

100

8574.16

14.6

36.1

11.6

40.1

2.89

TSEC Taiwan 50 Index

TWD

6188.37

2.8

48.2

-3.4

47.4

3.32

FTSE Xinhua All-Share Index

CNY

1,001

7325.92

2.3

33.2

25.0

58.6

1.00

FTSE/Xinhua China 25 Index

CNY

21949.16

7.9

60.4

-5.1

40.3

2.59

USD

240

137.53

4.1

6.4

19.9

-2.0

1.29

FTSE EPRA/NAREIT Developed Asia Index

USD

1937.63

11.5

75.2

-11.5

34.6

4.67

FTSE EPRA/NAREIT Developed Asia 33 Index

USD

1244.28

11.7

67.7

-13.5

30.0

4.10

FTSE EPRA/NAREIT Developed Asia Dividend+ Index

USD

1932.93

12.3

74.3

-12.1

40.1

6.03

FTSE EPRA/NAREIT Developed Asia Rental Index

USD

849.85

21.0

56.5

-23.8

22.7

8.60

FTSE EPRA/NAREIT Developed Asia Non-Rental Index

USD

1119.74

6.5

88.3

-2.6

42.8

2.32

Region Specific

Fixed Income FTSE Asia Pacific Government Bond Index Real Estate

Infrastructure FTSE IDFC India Infrastructure Index

IRP

940.56

0.9

82.7

-5.6

54.8

0.68

FTSE IDFC India Infrastructure 30 Index

IRP

1061.79

0.1

86.1

-0.3

60.9

0.67

JPY

189

3893.30

6.3

30.4

-23.8

15.0

2.27

FTSE SGX Shariah 100 Index

USD

100

4930.68

11.2

43.3

-8.8

22.7

2.38

FTSE Bursa Malaysia Hijrah Shariah Index

MYR

9959.96

12.1

32.1

10.0

36.1

3.01

JPY

100

1072.05

8.0

30.0

-23.0

17.9

2.20

SRI FTSE4Good Japan Index Shariah

FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index

JPY

457

2859.52

7.2

36.2

-18.5

22.8

2.21

FTSE GWA Australia Index

AUD

102

3798.14

21.0

42.9

-5.4

27.1

4.90

FTSE RAFI Australia Index

AUD

6071.67

21.0

43.3

-0.4

27.6

8.63

FTSE RAFI Singapore Index

SGD

7390.39

10.0

68.2

-1.1

51.8

3.49

FTSE RAFI Japan Index

JPY

278

4013.06

7.0

34.7

-19.2

18.2

2.21

FTSE RAFI Kaigai 1000 Index

JPY

1,014

4043.90

17.8

67.1

-20.0

41.8

2.55

HKD

6401.52

7.0

62.8

-1.9

44.1

2.78

FTSE RAFI China 50 Index

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

FTSE GLOBAL MARKETS â&#x20AC;˘ OCTOBER 2009

INDEX CALENDAR

Index Reviews October – December 2009 Date

Index Series

Review Frequency/Type

Effective Data Cut-off (Close of business)

06-Oct 07-Oct 08-Oct Mid Oct Mid Oct 06-Nov 14-Nov 16-Nov Mid Nov Early Dec Early Dec Early Dec Early Dec Early Dec 03-Dec 03-Dec

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

Quarterly review Annual review (constituents) Quarterly review Quarterly review - share in issue Semi-annual review Annual review (constituents) Quarterly review Quarterly review Annual review Quarterly review Quarterly review Semi-annual review Semi-annual review Quarterly review Quarterly review

16-Oct 29-Oct 16-Oct 31-Oct 30-Nov 27-Nov 05-Dec 30-Nov 30-Nov 18-Dec 31-Dec 02-Jan 18-Dec 18-Dec 18-Dec

21-Sep 30-Sep 30-Sep 30 Sep 30-Sep 30-Oct 30-Sep 30-Oct 31-Oct 30-Nov 30-Nov 30-Nov 30-Nov 30-Nov 30-Nov

Annual review / North America Quarterly review Annual review (constituents) Quarterly review Annual review Quarterly review Quarterly review Quarterly review

19-Dec 18-Dec 30-Dec 18-Dec 18-Dec 18-Dec 18-Dec 18-Dec

30-Sep 18-Dec 30-Oct 30-Nov 08-Dec 30-Nov 30-Nov 30-Nov

Quarterly review Quarterly review Quarterly review Semi-annual review

18-Dec 18-Dec 18-Dec 31-Dec

30-Nov 30-Nov 30-Nov 30-Nov

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

19-Dec 19-Dec 18-Dec 18-Dec 18-Dec 18-Dec 18-Dec 18-Dec 18-Dec 18-Dec 18-Dec 18-Dec 18-Dec 31-Dec 18-Dec 31-Dec 18-Dec 18-Dec 18-Dec 27-Dec 31-Dec

28-Nov 28-Nov 30-Nov 20-Nov 04-Dec 04-Dec 04-Dec 04-Dec 04-Dec 04-Dec 04-Dec 30-Nov 30-Nov 30-Nov 30-Nov 30-Nov 30-Nov 24-Nov 30-Nov 17-Dec 30-Nov

05-Dec 07-Dec 09-Dec 09-Dec 09-Dec 09-Dec 09-Dec 09-Dec 09-Dec 09-Dec 10-Dec 11-Dec 11-Dec 11-Dec 12-Dec 12-Dec 12-Dec 12-Dec 12-Dec 12-Dec 12-Dec 12-Dec Mid Dec Mid Dec Mid Dec Mid Dec Mid Dec 11-Dec 11-Dec 14-Dec 18-Dec 24-Dec

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

OCTOBER 2009 • FTSE GLOBAL MARKETS