FTSE Global Markets by FTSE Global Markets

WITH THIS ISSUE: THE 2010 INVESTMENT STRATEGIES HANDBOOK ISSUE 39 • JANUARY/FEBRUARY 2010

Kuwait in the spotlight India & China spur securities services The issue with CVAs The changing face of fund administration

JAY HOOLEY & THE NEW WORLD OF STATE STREET THE TRADING VENUES ROUNDTABLE: THE RISE & RISE OF DARK TRADING

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Outlook EDITORIAL DIRECTOR: Francesca Carnevale, tel: +44 [0]20 7680 5152, 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. CORRESPONDENTS: Rodrigo Amaral (Emerging Markets); Andrew Cavenagh (Debt); Lynn Strongin Dodds (Securities Services); Vanja Dragomanovich (Commodities); Mark Faithfull (Real Estate); Richard Hemming (FX & Derivatives); Ruth Hughes Liley (Trading Services, Europe); John Rumsey (Latin America); Paul Whitfield (Asset Management/Europe); Ian Williams (US/Emerging Markets/Sector Analysis). FTSE EDITORIAL BOARD: Mark Makepeace (CEO); Donald Keith; Imogen Dillon-Hatcher; Paul Hoff; Andrew Buckley; Jerry Moskowitz; Andy Harvell. PUBLISHING & SALES DIRECTOR: Paul Spendiff, tel +44 [0]20 7680 5153 email: paul.spendiff@berlinguer.com AMERICAS, AFRICA & RUSSIA SALES MANAGER: James Ikonen, tel +44 [0]20 7680 5158 email: james.Ikonen@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), Can Sonmez (Turkey) SUBSCRIPTION SALES: Carol Cremin, tel: +44 [0]20 7680 5154 email: carol.cremin@berlinguer.com DATABASE MANAGEMENT: Emrah Yalcinkaya, tel: +44 [0]20 7680 5157 email: mandates@berlinguer.com 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 Subscription price: £497 each year (9 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 2010. 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.

ISSN: 1742-6650 Journalistic code set by the Munich Declaration.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

ITH THE OPENING edition of 2010 we’ve added a special supplement, The Investment Strategies Handbook, which we hope will become an annual event. While the distribution is contained to outside the United States (for SEC regulatory reasons), our regular US readers will be able to access the individual articles on our website at www.berlinguer.com. We hope it provides some food for thought on the key investment themes for the year ahead. In this edition we have tried to provide you with a broad brush of investible instruments and one of our regular reviews of the asset servicing industry.This time we have singled out the burgeoning sub custody markets in Asia and Latin America. Lynn Strongin Dodds reports on the growing preference for India by subcustodians over the Chinese market.The country not only has fewer restrictions but also the markets are more liquid and advanced. Its trading system is fully computerised, paperless and has a T+2 settlement system, plus the regulator has raised the level of disclosures, transparency and accountability to global levels. John Rumsey meantime looks at the problems facing the asset servicing industry in the Latin American sub-continent. The pattern of market growth is very uneven across the region with individual circumstances dictating how much interest investors have in each country. Some countries have even been going backwards, note market commentators. While several Latin custody markets are looking attractive as asset bases grow in size and diversity, the question is whether custodians, already traumatised by the financial crisis and subsequent litigation, are now able to take full advantage of the opportunities on offer? Elsewhere we write about the struggles of America’s five biggest publicly-held insurance brokerages, which are battling a continuing weak economy and a benign loss environment. The former naturally hurts. However only a year or so ago, common wisdom was that the economy didn’t much affect insurance revenues. After all, good times or bad, companies needed to be insured against a variety of risks, ranging from fires and floods to theft and libel.The recession put the lie to that thinking. As companies outsourced work, closed facilities, laid off employees and shrank inventories, there’s been much less to insure. Moreover, as, many companies went out of business and some of the survivors have reduced their coverage below prudent levels to help cut costs. The benign loss environment meanwhile encourages insurance companies to continually reduce their rates and thus broker commissions. Relief, suggests Art Detman, may be years away Our cover story this issue is focused on State Street Corporation, which is about to undergo a leadership change. Incoming chief executive Jay Hooley has a daunting agenda. Rebuilding the trust of custodial clients, addressing revenue gaps in trading services and securities finance, boosting capital reserves for potential acquisition targets, and shoring up investor confidence: these just a few of the items on Hooley’s immediate to-do list. Hooley talks to Dave Simons about the way that he will tackle these issues and more, and provides insight into the ongoing tussle between State Street, and ex-California governor Jerry Brown. Last but not least is our continuing series of articles and roundtables on the trading markets. In this issue we look at the implications for the trading community of the plethora of new trading venues, lit and dark. The Markets in Financial Instruments Directive (MiFID) has had a number of unintended consequences. Among them, the efforts of the directive to increase transparency along the trading spectrum has actually encouraged the proliferation of dark venues; a trend which continues to gain currency. Moreover, as Ruth Hughes Liley reports, accurate measure of trading performance post MiFID is a responsibility that few institutions want to shoulder. Exchanges think regulators should do it and that the buyside should be clearer as to their trading objectives. Equally, the buyside thinks the sellside and the independent data providers should fulfil this still opaque role.These dilemmas and others are also discussed at length in this edition’s roundtable. Read and join in the debates.

Francesca Carnevale, Editorial Director January 2010

Contents COVER STORY A NEW HEAD OF STATE ......................................................................................................Page 69

Rebuilding the trust of custodial clients, addressing revenue gaps in trading services and securities finance, boosting capital reserves for potential acquisition targets, and shoring up investor confidence. These are just a few items on incoming CEO Jay Hooley’s Herculean labour list. What will the affable Hooley prioritise? David Simons reports

DEPARTMENTS MARKET LEADER

COUNTDOWN FROM COPENHAGEN ............................................................Page 6 FTSE, THE ENVIRONMENT & THE INVESTOR ......................................Page 10 BBH’S UCITS MASTERCLASS ..................................................................................Page 12

A STEADY UPTICK IN ETF TRADING VOLUMES ................................Page 16

IN THE MARKETS

HIRTH PARTNERS: WHY THE UK TOUGHENED UP ON TAX......Page 20

UTILITIES: THE DEFENSIVE PLAY ......................................................................Page 22

A BRAND NEW SOMBRERO: US/MEXICO RELATIONS ..............Page 24 THE NEW LOOK OF FOREX ....................................................................................Page 27

HOW MTM EVALUATES TRANSITIONS ......................................................Page 29

DEBT REPORT

THE ROAD TO RECOVERY FOR EUROPEAN COVERED BONDS ..Page 31 ON THE UPSIDE IN SOUTH KOREA ..............................................................Page 34

COUNTRY REPORT

INDIA: STRUCTURED PRODUCTS & DERIVATIVES TRADING ..Page 37

INDIA: THE BATTLE TO SUSTAIN GROWTH ..........................................Page 40 KUWAIT: A RETURN TO OPTIMISM

............................................................Page 46

REAL ESTATE

CVAs OR THE HIGHWAY..........................................................................................Page 42

INDEX REVIEW

LET THEM EAT CAKE! ................................................................................................Page 49

COMMODITY REPORT

OILING THE WHEEL OF GROWTH..................................................................Page 50 JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

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Contents FEATURES US INSURANCE

THE BIG FIVE SEARCH FOR GROWTH..............................................Page 53

The five largest publicly held insurance brokers are struggling with two problems, writes Art Detman. The first is a weak US economy; the second is a benign loss environment. Neither is good for business. While the former hurts as customers slink away, the second encourages insurance firms to continually reduce their rates and broker commissions. Is relief in sight?

SECURITIES SERVICES

TAKING ON A NEW SHAPE ......................................................................Page 58

The economic downturn and a new raft of regulation have provided onerous challenges to the fund administration industry. Even so, fund administrators have responded proactively and positively. For their part, institutional investors have become more demanding, requiring a deeper service range. So far, providers have delivered, constantly enhancing their product array. Lynn Strongin Dodds reports on the main trends.

THE SEC SERVICES UPTICK IN INDIA & CHINA ........................Page 62

It is easy to see why India and China are attractive destinations for sub-custodians. Despite tough regulatory restrictions, both countries are regarded as fertile areas for overseas investors, creating new opportunities for service providers. Lynn Strongin Dodds reports.

LATIN CUSTODY: UNPLUCKED ..............................................................Page 66

Several Latin American custody markets now look more attractive. Asset bases in individual countries are growing in size and diversity. Can global custodians now take full advantage of the available opportunities? Do they really want to? John Rumsey reports.

TRADING VENUES ROUNDTABLE

THE QUEST FOR LIQUIDITY & CONSOLIDATED DATA ......Page 74

According to Tony Whalley, investment director at Scottish Widows, “The rise of MTFs has had quite a dramatic influence on what we’re doing. The next trend is volume business transacted within dark pools. Whether that is to the good or bad, we are yet to find out. ... Additionally, there are issues surrounding market transparency. As market fragmentation continues, there are concerns about the effect that has on the way the whole market is seen. A key requirement now, to mitigate some of the detrimental effects of market fragmentation, is to have consolidated market data; on both a pre- and post-trade basis. Without it our job is increasingly difficult.” Did everyone else on the panel agree?

TRADING

POST-TRADE REPORTING: IS MIFID UP TO IT? ........................Page 83

Clearing the fog which characterises much of today’s measurement of trading performance is a responsibility few seem to want to shoulder, writes Ruth Hughes Liley. Exchanges think it is the regulator’s responsibility and that the buyside should speak out more. The buyside meanwhile believes the sellside and data providers should do more. Everyone though, blames the confusion on MiFID.

NEW PLAYERS SHAKE UP HIGH-YIELD BONDS ......................Page 87

DATA PAGES 4

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

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

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Market Leader COPENHAGEN: ANY MOMENTUM WILL BENEFIT GREEN INDUSTRIES

COUNTDOWN FROM COPENHAGEN

Photograph © Iqoncept/Dreamstime.com, supplied December 2009.

Copenhagen hosted the biggest political get together of 2009. On the top line, US president Barack Obama, Chinese premier Wen Jiabao, Japan’s prime minister Yukio Hatoyama, UK prime minister Gordon Brown, German chancellor Angela Merkel and 60 other heads of state failed to confront key reduction targets in carbon production. Nonetheless, most countries now agree the world is on the brink of widespread climatic change. Vanja Dragomanovich reports on the repercussions of the conference. HE COPENHAGEN CONFERENCE closed with a whimper rather than a bang. Since it takes several years from agreement to ratification there is now a risk that there will be a sustained period post Copenhagen without meaningful and binding rules on tackling carbon emissions and climate change. While it is still possible to just extend Kyoto rules for a year or two if necessary, industries that are affected and investors will want the guidance of a firm blueprint of a new regime tackling climate change. What made it so hard to reach a deal is the cost any meaningful agreement represents to governments in terms of new infrastructure and technologies. Added to that are the implications it will have for big industry. Oil refineries, cement and steel makers are among the top polluters and the single biggest emitters of carbon dioxide are power companies; the life blood of all manufacturing. For developed countries reaching a deal is a balancing act between being seen to want to address climate issues and trying to protect domestic industries at a time when their economies are still struggling to get back on track. If we take the US steel industry as an example, higher electricity costs and costs of new technologies that reduce emissions will

undermine US steel makers’capacity to compete with Chinese producers. “For governments frequently the climate change issues are a matter of window dressing. What they are really interested in is energy independence and being less dependant on oil,” says one oil industry executive. After last year’s sky high oil prices governments around the world are looking for alternative sources of energy, preferably such that can be found domestically. For developing nations it is a different issue. To provide its mushrooming industry with energy China is building on average two coal-based power plants a week. For it to slow down would mean that its economy and GDP would grow at a slower pace and that the rate at which it is catching up with the West would slow down. The same goes for India and other developing nations. The two sides are locked in an ideological and economic tug of war. Developing nations, lead by China, are asking for developed countries to cut emissions by between 25% and 40% arguing that the largest portion of all the greenhouse emissions ever produced has been generated by the US and the EU and that it is unfair on developing nations to ask them to stop now when they are in the process of growth and expansion. China is also asking for developed countries [read the US] to

contribute up to 1% of their GDP to help developing nations carry the cost of reducing emissions. The US, EU, Australia and other big economies argued that China is now the single biggest polluter and that at its current rate of expansion the country will continue adding the most to the world’s greenhouse gases over the coming years. Based on 2007 data, China produced around eight gigatonnes of CO² per year followed by the US with around six gigatonnes. However, on a per capita basis, the US produces 20 tonnes of CO² per year compared with China’s six. Both of those are surpassed by the per capita output in the Gulf states which is between 25 and 30 tonnes per person.

Numbers and tables The main players are all bringing some numbers to the table. Barack Obama is pledging to cut emissions by 17% from their 2005 levels by 2020, the European Union is saying that if there is a legally binding agreement to cut emissions by 20% by 2020 it will go one better and set its own target at 30% less emissions. Industry watchers say that while China is reluctant to commit any targets to paper, possibly because it would involve some international monitoring, the country is taking emissions seriously and is working hard on reducing them by pushing energy efficiency, solar and

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

Market Leader COPENHAGEN: ANY MOMENTUM WILL BENEFIT GREEN INDUSTRIES

wind power generation. Just before the summit China said it would aim to reduce its “carbon intensity”, or carbon dioxide emitted per unit of GDP, by 40% and 45% by the year 2020. Australia and Japan are committing to reduce their emissions by 25%. Most analysts were right about the final outcome: a political agreement on very broad principles but nothing that is legally binding. Dr. Samuel Fankhauser, principal fellow at the Grantham Research Insititute at the London School of Economics is not unduly depressed at the result.“Negotiators can translate that into legal text later,” he notes. However, he remains unimpressed by the unilateral numbers issued, which amount to an overall reduction of between 13% and 19%; well below the 25%-40% range recommended by the Intergovernmental Panel on Climate Change required to stop the temperature from rising by more than 2 degrees. The next step would be either a special conference in the summer of 2010 or after that at the regular conference of the parties in December 2010, probably in Mexico. “We have, incidentally, been there before. The Kyoto Conference in 1997 was moved from spring to December to give negotiators more time and The Hague meeting in 2000 did not come to an agreement on the“secondary legislation”of Kyoto”, notes Frankhauser. In the end it took about six years for all countries to ratify the Kyoto treaty with Russia dragging its feet the longest and only approving it in September 2004. Any agreement going forward will have an effect on a broad range of industries. The bulk of the world’s electricity is generated using coal and the coal industry will be in a fragile position as cutting the use of coal for power generation is the core of any climate strategy, particularly in the UK.“There is no role for unabated coal (coal without capturing CO² emissions) in the UK power sector from the 2020s and other

industrial countries will find the same. Even so, the renewable energy sectors are the big winners, and so, to a lesser extent, might be nuclear,”says Frankhauser.

Which firms benefit? Bozena Jankowska, portfolio manager of the Allianz-dit Global EcoTrends fund, says a broad range of technology companies will benefit from Copenhagen. “These companies cover the spectrum of environmental technology products which will be adopted over time including battery technologies for electric vehicles, systems to support smart grids for improved efficiency and functionality, energy efficient light emitting diode (LED) products, second generation biofuels, as well as carbon capture and storage.“ She singled out wind turbine maker Gamesa which has significant exposure to the US and Chinese wind markets, and Andritz, the world’s second largest supplier of hydropower technology. Although solar, wind power, wasteto-energy and biofuels industries will all benefit from the Copenhagen talks, all these industries contribute only a small fraction to the overall electricity that is produced around the world. At best they make up around 5% of total electricity and in some countries they are closer to around 1%. Yet for industries to expand and for governments to achieve the discussed targets there has to be much more electricity generated with less emissions.

Reducing consumption Massive reductions in power consumption can be achieved through energy efficiency and technologies, such as smart grids that channel electricity to different users at different times of the day depending on hot points of demand.They can have a bigger impact than several wind farms. Companies such as US-based Silver Spring Networks are hooking up 10,000 homes per week to smart grids and

seeing a reduction in the use of electricity of between 10% and 15%. Similarly, carbon capture and storage (CCS), a technology that almost completely cuts emissions from power plants using coal, could potentially be fitted on existing plants making them practically pollution free. Alstom, Siemens and the smaller Norwegian company Sargas are all developing technologies that, if successful, could be used on plants around the world. Support companies such as Londonlisted Costain, which provides engineering services to a broad range of industries will also be kept busy over the coming years by the need to have new types of infrastructure such as pipelines to transport the captured CO². The nuclear sector will also benefit as it has a much larger capacity then solar or wind. When squeezed between a rock and a hard place — the negative public image of nuclear on the one hand and the need to have a lot more electricity while reaching ambitious emissions reductions on the other — governments are increasingly opting for nuclear. At this stage, gas is one of the cleanest power generating options and would deliver electricity fast, but going forward might come under pressure if coal power generation becomes clean. Allianz’s Jankowska notes that “certain ‘low hanging fruit’ also stand to benefit irrespective of the outcome of Copenhagen. These companies include those that deal in energy efficiency, such as better insulation in homes e.g. Kingspan and energy efficient motors for heating, ventilating and air conditioning (HVAC) systems.” She concludes: “whether Copenhagen lived up to expectations or not, over the longer term, we see sufficient momentum at the national level to ensure commitment to the development of clean technologies and efforts to phase out over-reliance on carbon dioxide intensive fossil fuels.”

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

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In the Markets CLIMATE CHANGE: THE INVESTMENT OPPORTUNITY

Environmental technology

The impact of climate change is set to alter the shape of the global economy over the next few years and as a result, there is an expectation that the environmental technologies sector will benefit and grow, providing both attractive and long-term investment opportunities for investors worldwide. Photograph © Hypermania/Dreamstime.com, supplied December 2009.

The environment and the investor The impact of climate change is set to alter the shape of the global economy over the coming years and, as a result, there is an expectation that the environmental technologies sector will benefit and grow, providing both attractive and long-term investment opportunities for investors worldwide. A report by FTSE Group HE FOCUS ON climate change and its implications in terms of assessing economic cost and investment portfolio risks are increasingly being highlighted by political and industry commentators across the globe, including two of the world’s most powerful economies, the USA and China. Their pledges in this field have made it clear that addressing the impacts of climate change are critical to economic growth and prosperity despite current market conditions. In addition, the United Nations conference on climate change in Copenhagen in December should have proved pivotal in gaining consensus from political leaders around the world to a successor to the Kyoto Protocol. In the event, it was something of a stalemate.

Nonetheless, the impact of climate change is set to alter the shape of the global economy over the next few years and as a result, there is an expectation that the environmental technologies sector will benefit and grow, providing both attractive and long-term investment opportunities for investors worldwide. However, it is important to note that it is not only the renewable energy sector which will benefit from the changes required to deliver a lowcarbon economy. Companies from sectors such as energy efficiency, water infrastructure and pollution and waste control have important contributions to make in addressing not only climate change, but the inter-related wider environmental threats facing society. Growth in this sector will in part be dependent on access to capital by companies emerging in all of these areas.

A decade ago very few environmental technology investment opportunities were available other than those from a small number of pioneers specialising in this area such as Impax Asset Management. Today, however, it is a very different story with institutional and retail investors having access to a wide range of environmental and climate change investment options, with an estimated $50bn invested in environmental market funds. These opportunities have become an important tool for investors in the early stages of environmental technology investment. Furthermore, industry players such as index providers have also entered the field to provide investors with much-needed visibility to the performance of environmental markets, through both tradable and benchmark indices. Environmental indices such as the FTSE ET50 Index and the WilderHill Clean Energy Index have successfully provided index funds and exchange traded funds (ETFs) with low-cost exposure to this exciting sector, while also providing transparency of performance. Until now, strategies within this investment theme have tended to focus on pure play technology companies—which derive the majority of their business from environmental technology—and have primarily been in private equity, venture capital or small-cap investment. However, there has been little in the way of products and services which enable investors to invest in the larger listed equities arena. Now, with industry innovation and investor demand, interest in this area is no longer limited to smaller-cap pure play environmental technology companies. Exciting investment opportunities are also emerging with larger companies that are transitioning their business models to exploit the path to a decarbonised economy.

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

Indexation and classification In 2007, FTSE Group undertook the calculation and management of the ET50 Index, with Impax Asset Management continuing to provide research for the index. FTSE improved the investability of the index by adding liquidity screens and introducing freefloat adjustments to constituent weights. There is also an independent committee to direct the ongoing management of the index, chaired by Winston Hickox, the architect of the California Public Employees’ Retirement System (CalPERS)“GreenWave”investment strategy. Since then, FTSE has expanded its environmental technology offering to include 18 indices within the Environmental Markets Index Series. This includes the development of indices that measure the performance of global companies with a significant involvement in environmental business activities, including

renewable and alternative energy, energy efficiency, water technology and waste and pollution control. As more interest develops within this opportunity, a major hurdle has been how to identify or classify the activities of companies active in environmental markets on a global scale. In response to this, FTSE has developed a pioneering and comprehensive global classification system which underpins the indices called the FTSE Environmental Markets Classification System (EMCS). This allows companies to be classified according to the environmental products and services they provide.

Environmental markets As many of the drivers of environmental markets, such as energy security and supply, water scarcity and disruptive weather patterns, continue to catch political

and public attention, the interest in those companies and sectors providing solutions to these issues will increasingly attract the interest of global investors. As a result, it will become clear that attractive returns may be achieved from the investment opportunities emerging from the leading companies in these sectors. This increased investor interest will challenge the industry and index providers to continue to develop a range of investment tools to reflect this growth and suit the needs of a variety of investment strategies. The challenge for the next decade is to continue to build on these many successes. Global investors will have a key role to play in decarbonising economies, rewarding companies that adopt sustainable and responsible business practices, and creating a sustainable global financial market system—the latter being the biggest challenge of all.

Don’t work in the dark, who knows what you might find Emerging Markets Report provides a comprehensive overview of the principal deals, trends, opportunities and challenges in fast-developing markets. For more information on how to order your individual copy of Emerging Markets Report please contact: Paul Spendiff Tel:44 [0] 20 7680 5153 Fax:44 [0] 20 7680 5155 Email:paul.spendiff@berlinguer.com

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

In the Markets UCITS IV: UNDERSTANDING THE MASTER/FEEDER FRAMEWORK

Masterclass Photograph © Iqoncept/Dreamstime.com, supplied December 2009.

The reformed UCITS Directive proposed by the European Commission is expected to simplify the regulatory environment by reducing administrative barriers for cross-border trading of funds. Among the key proposals is the creation of a framework for mergers between UCITS funds. Moreover, the directive allows the use of master/feeder structures to accommodate the cultural preference for domestic funds. Seán Páircéir, managing director of fund services at Brown Brothers Harriman (Dublin) looks at the implications. ASTER/FEEDER INVESTMENT structures could be represented graphically as the perfectly interconnected moving parts of a clock. At the core the asset pool would manage streams of liquidity driven to (or drawn from) multiple jurisdictions. A single core investment outcome could be repackaged by jurisdiction, by distribution channels, by brand, or alternately adjusted for hedging strategies, derivative overlays or co-mingled with other asset classes, or core-satellite investment approaches.The interoperability of each of the component parts would be perfection itself. Regulatory interchange between countries would function on an exact equivalence basis. The original objective of

creating economic efficiencies through globalisation techniques would stand realised. In the European context intense periods of regulatory consultation are followed by what feels like an interminably long implementation cycles. In previous periods this might have facilitated a somewhat calmer consideration of product manufacturing opportunities which could be delivered in July 2011, the date by which the implementation measures need to be in place in local legislation across the community. However the clamour of regulatory debate over the course of this summer may result in a substantially altered distribution landscape by then. Before considering the likely

impact of this continuing debate it is worth considering the original parameters presented back in 2007. The original consultation on UCITS IV recognised that the fragmentation of the marketplace was ultimately bad news for investors. Despite the astonishing growth and success of the UCITS regime, viewed in aggregate UCITS funds are still, in the main, less efficient than they should be. For example, approximately 65% of UCITS have less than €50m in assets under management (AUM), and some 30% have less than €10m AUM. This inefficiency creates a situation where the average running costs of UCITS funds are twice that of their US counterparts. Given that UCITS have become the pre-eminent global crossborder investment vehicle, distributed in over 50 countries, this inefficiency needed to be addressed. When the European Commission drafted the UCITS IV regulations, one of the key goals was to find ways for the EU fund industry to consolidate assets and to take advantage of economies of scale. The first strands of discussion centered on globalisation

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

Master/feeder definition The master/feeder structure is sometimes referred to as “entity pooling”. This is because the assets are “pooled”together in a master fund, in which the feeder funds invest. The feeder funds do not hold the assets directly, instead they hold units in the master fund. In effect, UCITS IV will open the door for basic fund of fund structuring. Most importantly, the UCITS framework will allow for crossborder master/feeder structures. This greatly increases the potential of the master/feeder arrangement. The concept of a master/feeder structure is not new. Such structures have been in existence, outside the UCITS framework, for years. However,

by enshrining the concept the UCITS within framework the investment management community has been given a useful tool for consolidating assets and increasing efficiency. At its core, what the master/feeder regime allows is for the consolidation of assets into a single pool. This consolidation, presents many benefits for both the promoter and the investor alike. The most obvious benefit of the regime is the ability of funds to achieve economies of scale by consolidating assets into a single pool. The economies of scale, experienced at the master fund, can be passed on to the feeder funds Another issue that has bedevilled the asset management industry is the issue of rationalising fund ranges across jurisdictions. Here once again, the master/feeder regime can play a role in helping solve this problem. The regime allows for the master and feeders to be in different domiciles, provided that all domiciles are within the EU. This means that a promoter who is operating similar funds in multiple jurisdictions can consolidate the assets of these funds by transforming one of the funds into a master fund and the other into a Feeder fund. Rationalising funds through the master/feeder regime may prove easier to implement and more cost effective than undertaking a fund merger.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

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techniques such as pooling or virtual pooling. Indeed, the Irish regulator among others, contributed significantly to the public consultation discussion based on their understanding and expertise in dealing with virtual pooling structures in the context of the Irish marketplace. There was some disappointment in the industry, particularly among practitioners (such as ourselves) which were operating virtual pooling platforms on behalf of clients in both Ireland and Luxembourg, that the debate had moved on to the more narrow confines of a master/feeder regime which offered a more limited vision of cross-border globalisation than might have been the case. Nonetheless, an important conceptual point is enshrined in the creation of the master/feeder regime; the idea of a fund domiciled in one jurisdiction transferring its diversification to another investment vehicle based in the same or another jurisdiction. In an era where the argument in favour of diversified investment vehicles is stronger than ever this is a significant recognition by regulators.

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In the Markets UCITS IV: UNDERSTANDING THE MASTER/FEEDER FRAMEWORK

By allowing a master/feeder arrangement, promoters can link onshore products to offshore expertise. Say a promoter has a successful offshore US small-cap fund, which it wants to replicate in a UK onshore product. Under the master/feeder arrangement, the onshore product can be a feeder and access the successful offshore strategy. This reduces the need to build out further infrastructure on the promoter’s end. Moreover, by maintaining the assets in one pool, the investment manager can more efficiently manage the portfolios of the various funds. In turn, this means the investment manager will only need to trade once, as opposed to enacting the same trade across multiple funds Therefore, by centralising the asset management, the performance of all participating funds will be brought into line. This structure then eliminates anomalies that occur due to multiple portfolios being maintained. It also permits the retention of performance histories for marketing purposes and allows for the establishment of the record of the core target fund in a new vehicle. By centralising the assets, redundancy is reduced in the oversight and compliance function of the funds.

Regulatory repercussions To some degree, the original objectives of addressing the inefficiencies of the UCITS market can be met in the context of what is likely to be enacted on local books. However it is worth revisiting what the potential impact of other discussions is likely to be on the market by the time the summer of 2011 comes around. The Alternative Investment Fund Management Directive (AIFMD) has demonstrated how the increasingly robust interplay between regulation and politics is

likely to have an impact on manager and promoters vehicle and domicile choice. Looking at the discussions around the AIFMD, one cannot help but conclude that there is still much work to be done to bring all EU jurisdictions into a truly common regulatory framework. Looking into the future, clearly the decision on where to domicile master funds will be an important one. The choice of domicile for master funds is linked to the decision on where the domicile of the Passportable Management Company [sic] is domiciled. In fact, no one considering a master/feeder structure should contemplate one without the other. When considering a domicile, clearly jurisdictions where complex globalisation techniques have been supported as a standard for a number of years have an advantage. Beyond the considerations for the domicile of funds, promoters need to consider a number of other elements when constructing a master/feeder structure. As much as pooling the assets in master fund provides scale, having feeder funds adds unavoidable costs as well. The cost of establishing and running local feeder funds should be weighed against the benefits. Focusing too closely on launching local feeder funds could lead to increased costs. In this regard, promoters should consider whether disturbing existing crossborder products makes sense. Using feeder funds adds an additional layer of cash management: that is, the investors to the feeder and then the feeders to the master. Aligning and monitoring the cash movement and projection throughout the master/feeder structure should be considered. Although feeder funds are part of a larger structure, they remain independent legal entities. Therefore, local boards will remain an important constituency of the product.

Seán Páircéir, managing director of fund services at Brown Brothers Harriman (Dublin). Photograph kindly supplied by Brown Brothers Harriman, December 2009.

In addition, local auditors and accounting regulations need to be considered. Complex flow and allocation models which are currently deployed to support globalisation techniques have a direct role to play here. Due to the cascading nature of a master/feeder product, the valuation timeline of the complete structure must be contemplated. Co-ordination and flexibility of local rules with the master domicile rules will influence the viability of the proposed model. So where does that leave us? Clearly the debates of the summer and the legal outcomes of the winter will have an influence on the attractiveness of the product set.The industry’s instinct is that the secular trend toward the highest regulatory standards will place UCITS as a more generally accepted regulatory brand. The debate around AIFMD may drive better product clarity into UCITS versus alternative classes. Domiciles where the expertise resides in navigating these complex issues will benefit disproportionately in product location. Ironically, rather than product rationalisation, master/feeder is likely to add to the total number of funds in the short term. However, the important conceptual movements in the legislation holds out hope that once the clamour recedes, the framework for even broader interpretation of diversification sharing between legal entities will take place. The clock and time ticks on.

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

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In the Markets EVOLVING STRATEGIES IN TRADING ETFS

“

global head of ETF research TFS ARE STILL quite and implementation strategy new to institutional at Barclays Global Investors investors,” says (BGI). The strategy is popular Thorsten Michalik, global with stock pickers who can head of db x-trackers, a unit gain a short-term exposure to of Deutsche Bank and a region or sector while they Europe’s number three ETF research companies, avoiding manager by assets under so-called cash-drag on their management. “They know returns. about the FTSE or DAX Until recently, the use of products but are still ETFs by European institutional becoming aware of the Photograph © Paha-1/Dreamstime.com, supplied December 2009. investors has remained options in fixed income, relatively straightforward. foreign exchange and ETFs However, the recent change in of hedge funds and how they approaches to ETFs has been can be used.” fueled by the expansion of ETFs are open-ended European-listed ETFs into index funds that are listed new markets, including and traded on exchanges like farther-flung emerging stocks. That affords them a markets, niche and sectornumber of advantages over specific equity indices, bonds, more traditional pooled real estate and commodities. funds: notably ETFs enjoy It is 16 years since the first exchange traded The list is quickly expanding. real-time pricing allowing fund (ETF) made its debut on the US markets In November, ETF Securities, a for inter-day trading and like in 1993. Like most 16 year olds, ETFs are only London-based issuer of stocks, they can also be now coming of age. Proof of that is partly in exchange traded products, traded on margin and are their undoubted popularity. Assets invested announced that it would lendable. For much of the in global ETFs hit an all-time high of $933bn launch Europe’s first exchange relatively brief history of at the end of the third quarter, according to traded currency platform, ETFs, investment institutions figures collated by Barclays Global Investors. covering 18 currencies. have principally used them A more telling sign of their maturity The growing range of ETF as cheap and flexible however is to be found in their burgeoning and similar products has substitutes for tracker funds. complexity and the increasingly diverse allowed institutional That strategy typically manner in which they are being employed. investors cheap and liquid involved ETFs being That trend is, not surprisingly, coinciding access to markets that had employed as part of a with increased interest in the possibilities previously been beyond their core/satellite, buy-and-hold inherent in ETF trading amongst institutional reach for regulatory, technical strategy. In that role an investors. By Paul Whitfield. or cost reasons. It has also equity-index ETF or government-bond ETF would be gain short-term exposure to the made ETFs a ready substitute for a host purchased within a core holding. At markets. In this role, active fund of derivatives.That makes ETFs a viable the same time, a more niche ETF, such managers will buy an ETF as an alternative for investors barred from as an emerging market fund or a alternative to short-term cash futures markets because of either sector-specific fund, might be acquired instruments, such as overnight accounts. internal or external regulation. Skirting “Many institutional investors, the rules is not the only reason for as part of a satellite holding, to diversify away from the index and intermediaries, family offices and self- ETFs’popularity as a futures-substitute, provide so-called beta returns. The directed retail investors have embraced according to Michalik. “ETFs have ease of entering and exiting an ETF the idea that ETFs are tools that can become a substitute for futures on position has also made them popular help them to equitise cash,” says emerging markets especially amongst instruments in which to park cash to Deborah Fuhr, managing director, hedge funds.” The reason, says

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JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

Spotlight on International REITs: A Q&A Session with iShares’ Head of Product Research and Development, Noel Archard, CFA What are Real Estate Investment Trusts (REITs) and how can they be utilized in portfolio construction? Real estate investment trusts (REITs) are companies that own and manage income producing commercial real estate. REITs can play an important role in a portfolio by adding diversity to the overall asset allocation. The international real estate market typically has a lower historical correlation to both the U.S. REIT market and to traditional equity and bond assets. Because they are more impacted by localized supply and demand factors, international REITs can further diversify a portfolio that otherwise holds only U.S. REIT investment.

Index Correlations GEOGRAPHICAL SEGMENT Index

U.S. REITS NAREIT Index

NAREIT Index

INTERNATIONAL DEVELOPED EXCLUDING U.S. FTSE EPRA/NAREIT Developed ex-US TR

DEVELOPED ASIA

DEVELOPED EUROPE

U.S. EQUITY

FTSE EPRA/NAREIT Developed Asia TR

FTSE EPRA/NAREIT Developed Europe TR

S&P 500

–

76.35%

64.42%

84.76%

83.23%

76.35%

–

96.81%

85.18%

89.45%

FTSE EPRA/NAREIT Developed Asia TR

64.42%

96.81%

–

69.60%

85.41%

FTSE EPRA/NAREIT Developed Europe TR

84.76%

85.18%

69.60%

–

77.68%

S&P 500

83.23%

89.45%

85.41%

77.68%

–

FTSE EPRA/NAREIT Developed ex-US TR

Source: NAREIT analysis of data from Ineractive Data Pricing accessed through FactSet. Correlation based on monthly total returns from November 2006 - November 2009. Correlation describes the historical strength of the relationship between the indexes, and range from -100% (perfect negative relationship) to +100% (perfect positive relationship).

How are REITs accessible to investors? REITs are traded on exchanges like any other publicly traded company. ETFs are one of the most efficient and effective ways to gain access to REITs because they have the trading flexibility of stocks, but give full exposure to a basket of REITs in one tradeable vehicle. iShares REIT ETFs offer investors a low cost, tax efficient and transparent way to gain exposure to underlying REITs. The funds are benchmarked to FTSE EPRA/NAREIT Global Real Estate Indexes and FTSE NAREIT US Real Estate Indexes, which are designed to represent the performance of real estate equities worldwide.

Are international REITs available to US investors? Yes. iShares ETFs allow investors to invest in both broad international (ex-U.S.) and regional markets including Asia, Europe, and North America. They also offer investors diversified exposure to different segments of the U.S. commercial real estate market. Investors should also be aware of principal risks, such as volatility, associated with international and regional REIT markets.

What are names and tickers of iShares international REIT ETFs? IFGL: iShares FTSE EPRA/NAREIT Developed Real Estate ex-U.S. Index Fund IFAS: iShares FTSE EPRA/NAREIT Developed Asia Index Fund IFEU: iShares FTSE EPRA/NAREIT Developed Europe Index Fund IFNA: iShares FTSE EPRA/NAREIT North America Index Fund Call 1-800-iShares to request a prospectus, which includes investment objectives, risks, fees, expenses and other information that you should read and consider carefully before investing. Investing involves risk, including possible loss of principal. In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. REIT investments are subject to changes in economic conditions, credit risk and interest rate fluctuations. International real estate is subject to the status of its local economy. Asset allocation and diversification may not protect against market risk. Shares of the iShares Funds may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from a Fund by Authorized Participants, in very large creation/redemption units. There can be no assurance that an active trading market for such shares will develop or be maintained. Transactions in shares of the iShares Funds will result in brokerage commissions and will generate tax consequences. iShares Funds are obliged to distribute portfolio gains to shareholders. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. The iShares Funds (“Funds”) are distributed by SEI Investments Distribution Co. (“SEI”) and advised by BlackRock Fund Advisors (“BFA”). BlackRock Fund Distribution Company (“BFDC”) assists in the marketing of the Funds. BFA and BFDC are affiliates of BlackRock, Inc., none of which is affiliated with SEI. The iShares Funds are not sponsored, endorsed, issued, sold or promoted by European Public Real Estate Association ("EPRA®"), FTSE International Limited ("FTSE"), or National Association of Real Estate Investment Trusts ("NAREIT"). None of these companies make any representation regarding the advisability of investing in the Funds. Neither SEI, nor BlackRock, Inc., nor any of their affiliates, are affiliated with the companies listed above. iShares® is a registered trademark of BlackRock Institutional Trust Company, N.A. All other trademarks, servicemarks or registered trademarks are the property of their respective owners. iS-1945-1209.

THE FTSE HOW DO I GET INTO REAL ESTATE INDEX FTSE. It’s how the world says index. Real estate has outperformed both equities and bonds over the last 10 years. But getting into real estate hasn’t always been easy. That’s changed. Whether you are looking at REITS or want direct exposure to commercial property, FTSE has the world’s leading range of Real Estate Indices, helping you measure the performance of global real estate markets and invest more easily. www.ftse.com/invest_real_estate © FTSE International Limited (‘FTSE’) 2009. All rights reserved. FTSE ® is a trade mark owned by the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE under licence.

In the Markets EVOLVING STRATEGIES IN TRADING ETFS

Michalik, is that futures in niche markets can suffer from acute illiquidity problems and thus high tracking error. It is not just obscure equity-market ETFs that have attracted investors to them because of their liquidity. Illiquidity in the bond market in late 2008, for example, led many institutions to turn to ETFs for exposure to assets such as inflation linked bonds as the primary market dried up during the crisis. ETFs providing exposure to fixed-income were the most popular instrument in Europe at the end of the third-quarter of 2009, accounting for about 24% of all ETF assets under management, according to BGI.

Accessing liquidity ETFs draw their liquidity from two sources. The first is the liquidity of the underlying assets, which is accessed by a creation and redemption process managed by the ETF issuer. This route sees the ETF investor trade directly with the issuer, buying newly created units or selling units back to the ETF issuer. Trades made in this way tend to be small, typically a maximum of about $500,000, making them of limited use for institutional investors. The second source of liquidity is the off-exchange or over-the-counter (OTC) market, where investors trade ETF units between themselves through brokers. It is estimated that at least half of all European ETF trading takes place in this way, though some of the issuers insist that in excess of two-thirds of their ETFs change hands in this way. Those figures are, by necessity, estimates. ETFs were not included in the European Commission’s Markets in Financial Instruments Directive (MiFID) so their market is not subject to the same levels of transparency as other stocks. That tends to work against the

funds, giving the impression that the market is less liquid than it is, according to many issuers. Yet, what little can be gleaned from the trading figures available suggests that the ETF market in Europe may not be quite as liquid as issuers might suggest. At the end of September, official average daily trading volumes accounted for only 1.3% of total European ETF assets.That compares poorly to the figure in the United States, which includes all trades, and stands at about 27%, suggesting high frequency trading in the US remains far more common than in Europe. That is slowly changing as Europe catches up, according to industry insiders. Not the least of the reasons for that is the growing popularity of newly introduced leveraged and short ETFs, which cater primarily to investors which hold short-term positions. Investors have had the ability to short ETFs for some time, but the advent of short funds, in which investors take long positions in order to reap returns in a falling market are new. The first European short-funds, also known as inversefunds, were launched a little under two years ago. Their impact and adoption since then has been hugely impressive. Trading in short-ETFs accounts for 15% to 20% of the daily volume of European ETF trades, according to data collated by db x-trackers. The shortDAX ETF is Europe’s second most actively traded fund, according to db xtrackers, behind the long Dax ETF. Leveraged ETFs, which can provide returns of up to 300% of the returns of the underlying index, also tends to lend themselves to adoption by highfrequency traders such as hedge funds. A leveraged Dax ETF, launched by Lyxor, was one of the top ten traded ETFs as at the end of the third quarter, according to BGI.

Leveraged and inverse ETFs are funds that aim to magnify the daily moves of the market. In a short double-leveraged fund, for instance, if the index goes up, then the fund goes down twice that amount. In a long leveraged fund, if the index goes up, the fund doubles that. The same principle applies when you’re talking about triple-leveraged ETFs, too. The popularity of inverse and leveraged ETFs has seen their numbers grow rapidly but not everyone is comfortable with the new direction that the market has taken. “Our view on short ETFs is that they should be more carefully supervised,” says Charles Morris, head of absolute return at HSBC Global Asset Management (UK) Ltd. “To short sell a long ETF is one thing, but the problem with going short a long ETF is that the returns don’t reflect the negative equivalent of the underlying index.” The return variation arises because inverse-ETFs are settled at the end of each trading day, when the funds are effectively realigned with their underlying assets. That means that if an investor holds a long position in a short ETF for a period of longer than one day their returns will be accumulative rather than reflecting the simple movement in the market. There is also some concern that short ETFs are opening up the shortmarket to investors who are otherwise barred. They can do this because investors actually buy the investment; so as far as regulators are concerned they are taking a long position. “Enabling market participants to access short selling or leverage who are not normally entitled to do so…smells like regulatory arbitrage,” says HSBC’s Morris. “These products are misleading and the world would be better off without them.”

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

In the Markets UK TAX: THE CURIOUS CASE OF LYLE DICKER GRACE

Illustration © Caraman/Dreamstime.com, supplied December 2009.

UK TOUGHENS UP ON TAX Managers of hedge funds with operations based in the UK are increasingly concerned changes to the UK tax rules for high earners (a 50% tax band will be introduced in April 2010), combined with European Economic Area (EEA) restrictions on pay, which will make it harder to retain and attract the best talent. Switzerland in particular is gaining popularity as a possible destination for the emigration or part-relocation of hedge fund resources. Naturally, becoming nonresident for UK tax purposes enters the conscience of mobile senior employees and high net worth individuals planning. Achieving this where employment and other ties remain here is more difficult than ever, but not impossible with the right fact pattern and careful planning. By Mark Walters and Frank Hirth, partners at Frank Hirth, the specialist taxation and accounting practice. UST HOW DIFFICULT it can be to interpret the rules on loss of UK tax residency was most recently illustrated in the case of Grace versus The Commissioners for Her Majesty’s Revenue and Customs on October 28th 2009.The case concerned whether Lyle Dicker Grace was resident in the United Kingdom for tax purposes and has once again highlighted that there is no statutory definition of residence for tax

purposes. In the absence of a statutory residence test, there is an increasing need for greater clarity and certainty around the non-statutory residence tests used by the courts to develop a series of guiding factors when considering tax residence. The Inland Revenue’s practice notes have been reinterpreted by them with a succession of cases seeking to challenge any established understanding.

The background to this particular case makes for curious reading and illustrates the challenges. At the heart of the case is the question of in what circumstances (when a long-standing UK tax resident moves abroad) can they be certain they have, in effect, achieved a clean break from being resident for UK tax purposes? In examples that can be traced back over the last 100 years, the courts have sometimes discouraged the legal profession from trying to find specific pointers such as“the right fact pattern” that might drive careful legitimate planning. Instead, the judiciary has insisted that there is a need to take into account, weigh-up, and balance all relevant factors in each case. Actually, Lyle Dicker Grace is a long-haul pilot for British Airways who claimed, after a period of living in the UK, that he had relocated to his native South Africa and was now commuting to the UK for his work. He claims that he only visited the UK in this way because each of his long-haul flights started and ended here. A closer look at the facts of the case quickly reveals that matters were complicated because Mr Grace had lived in the UK for ten years until 1997 when he moved back to Cape Town. Therefore the enquiry had to assess the nature of the visits to the UK, including the duration of his presence in the country and also the regularity and frequency of his visits. Equally, the enquiry had to take into account his continuing links to the United Kingdom and his particular connection with South Africa, including his ownership and use of a house there, and his activities, ties and other connections there. His ownership and use of a house in South Africa was not considered conclusive that he did not reside in the UK, but it was a relevant factor to be taken into account along with, in this case, the following list of factors about his UK ties. Dicker Grace

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

retained a house in the UK and was on the electoral roll in the UK as a resident. Moreover, post was sent to him at his UK address and he kept a car in the UK. He had a bank account in the UK into which his salary from British Airways was paid and was registered with a dentist in the UK.Then again, he had no relatives in the UK and while his ex-wife and daughters lived in the UK he had had no contact with his children for over 30 years; and finally, he was a member of the professional body of the British Airline Pilots Association. HM Revenue & Customs have argued that Lyle Dicker Grace did not break his UK residency at any stage given the

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extent of his visits to the UK and the nature of his continuing links to this country. Indeed the many volumes of case law support the idea that a UK tax resident is unlikely to have left the UK unless there has been a definite break in his pattern of life. In the absence of a statutory residence test (along the lines of the USA and Ireland) planning to make a definite break requires careful consideration of non-statutory residence factors as outlined above. In the case of an individual then who has been resident in the UK, the making of a “distinct break” in his pattern of life, including establishing a residence elsewhere, may mean that

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even lengthy or regular visits to this country may not amount to continued or resumed residence. What is clear in this case, and one or two others, is that established practice is no longer as clear and distinct as it may have appeared for many years. The lack of a statutory residence test makes planning for nonresidency status more challenging. Bankers, hedge fund managers, asset gatherers, private equity partners and any other rich and disillusioned high net worth individuals who intend to either cut and run and/or claim non-domicile status, in light of the UK’s increasingly draconian tax regime, please take note!

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In the Markets EUROPEAN UTILITIES: €1TRN NEEDED IN NEXT DECADE

Even in times of crisis people need electricity, gas, water and sewage. That’s good news for those planning on investing in utilities. Utility bonds are regarded as one of the safest and most defensive instruments; they were certainly a favourite for conservative investors in the first part of 2009. Even so, as markets turned north through 2009 investors began seeking out the higher returns provided by equities and commodities. Vanya Dragomanovich reports.

A DEFENSIVE PLAY? REDIT ANALYSTS NOW say asset allocations should be underweight in utility bonds as a sector; yet highlight a handful of stars that are worth a second look. While yields on some of the top names such as France’s GDF Suez and Germany’s E.ON and RWE appear to offer very little upside, France’s water company Veolia Environnement, Spain’s Gas Natural, UK’s National Grid and Portugal’s Energias de Portugal are all tipped as companies to watch. As a segment, the European utilities sector is under massive financial pressure. Its networks are old and power fleets need replacing. The situation is exacerbated by the proliferation of alternative energy which generate electricity in bursts, instead of the continuous supply offered by coal and gas. The sector will need to spend close to €1trn over the next decade to update or replace ageing networks and comply with ever more demanding governmentdriven environmental targets. Utilities in the five largest EU countries face a capital expenditure bill of up to €800bn over the next ten years with €470bn of that having to be spent on replacing or refurbishing existing infrastructure and another €330bn on environmental issues. With banks holding on tightly to their purse strings after losing some $1.7trn during the credit crunch,

utilities, like most corporates, are increasingly turning to the capital markets for financing. Corporate bond sales since the beginning of 2009 are estimated to have reached close to €1trn, the highest level ever. Of that, utility companies are estimated to have issued between €80bn and €100bn in new bonds. Although this volume will decrease in 2010, low interest rates, low yields on government bonds and difficulty accessing large loans over long maturities will keep the new issuance market busy. Neil Beddall, director of credit research at Barclays Capital, estimates that new corporate issuance in Europe through 2010 could top €50bn. For utilities, one of the attractions of issuing bonds instead of procuring a bank loan is that while banks will typically grant loans for between two to five years, the capital markets will provide financing for anywhere between five and 15 years. The UK’s National Grid (rated A3 by Moody’s Investors Service and A- by Standard & Poor’s) went one step further, issuing a 22-year fixed-rate sterling bond in 2009. So did Veolia, which issued €750m of 6.75% ten-year bonds and another €1.25bn of 5.25% five year notes to finance existing debt. This compares with a 3.48% yield on ten-year treasuries and 2.24% yield on five-year treasuries.

Companies doing well in the secondary bond markets include Gas Natural, EDP, Iberdrola, National Grid and Enel. Analysts note that these companies carry a certain amount of perceived risk but are working hard to reduce their debt and have a recovery story behind them. In the case of Spain’s Gas Natural however, the company struggled as demand in its domestic market weakened and power prices came down because of the economic crisis. Even so, situation is slowly recovering. Barclays’ Neil Beddall says Gas Natural has made progress on its planned asset disposal programme, having divested 80% of the total scheduled for sale. The company is hoping for a BBB+ rating in 2010. Meanwhile, BNP Paribas’ Richard Birrer tips Veolia as one of his top choices in the sector. “Veolia’s industrial demand has been hit hard but the company is making progress on cost efficiency. Also on the upside, if they run into issues with their rating they would look to raise money in equity markets,” he notes. Since the situation in equities markets has improved this would work well for Veolia. Given how far and how fast equities travelled in 2009 it is plausible that a stagnation or a dip is around the corner. In that case, exposure to some defensive investment could make sense.

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

measure it understand it apply it sĂZ ƌĞŵĂŝŶƐ Ăƚ ƚŚĞ ŚĞĂƌƚ ŽĨ ƌŝƐŬ ĞƐƟŵĂƟŽŶ ĨŽƌ ďĂŶŬƐ ĂŶĚ ĂƐƐĞƚ ŵĂŶĂŐĞƌƐ But a single VaR number is not the whole story D ƉƉůŝĐĂƟŽŶƐ Excerpt ĚĞůŝǀĞƌƐ͗ ^ŚŽƌƚͲƚĞƌŵ ĂŶĚ ůŽŶŐͲƚĞƌŵ sĂZ hƐĞƌ ĚĞĮŶĞĚ ƌŝƐŬ ĂƩƌŝďƵƟŽŶ ŽŵƉƌĞŚĞŶƐŝǀĞ ŝŶƐƚƌƵŵĞŶƚ ĐŽǀĞƌĂŐĞ ƌŽďƵƐƚ ƐƚĂƟƐƟĐĂů ŵŽĚĞů ĂƐǇ ŝŶƚĞŐƌĂƟŽŶ ŝŶƚŽ ǇŽƵƌ ŝŶǀĞƐƚŵĞŶƚ ƉƌŽĐĞƐƐ

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ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟŽŶ ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

In the Markets US-MEXICO RELATIONS: OBAMA WEARS ANOTHER HAT

A brand new sombrero? President Obama takes relations between the US and Mexico much more seriously than the previous administration and the nomination of Carlos Pascual as US ambassador to Mexico underlined the change in policy. US officials have publicly acknowledged for the first time that the smuggling of firearms purchased north of the border has contributed to escalating violence in Mexico involving the powerful local drug cartels. They also recognised that the enormous demand for drugs in the US sustains trafficking and exacerbates the bribery, extortion and violence associated with illicit markets. Immigration is another major issue. With Washington paying more attention to Mexico City, the two countries could even develop a stronger bond, reports Neil O’Hara. VEN BEFORE PRESIDENT Barack Obama visited Mexico City in April last year, the new administration had signalled that relations with Uncle Sam’s southern neighbour would be a higher priority than during the Bush years. Three US cabinet officials—secretary of state Hillary Clinton, attorney general Eric Holder and department of homeland security secretary Janet Napolitano— had already flown south for talks with their counterparts in the Calderon government. Obama was all business,

too. “There was very little pomp and ceremony when he came,” says David Robillard, deputy regional managing director for Latin America at Kroll, a leading security consulting firm, “It was a working visit.” The August nomination of Carlos Pascual as US ambassador to Mexico only reinforced the message. Pascual is bilingual and considered an expert on failed states after earlier stints in developing countries riven by internal strife. Talk that Mexico may become a failed state is overblown in Robillard’s

Demonstrators shout slogans as they protest the Mexican government’s decision to disband the electricity company Luz y Fuerza del Centro in Mexico City on Friday, December 4th 2009. Mexico’s President Felipe Calderon shut down the state-run utility citing a gaping budget and operational inefficiencies. Photograph by Marco Uguarte, for AP Photos. Supplied by PA Photos, December 2009.

view, but the selection of a respected career diplomat rather than a patronage candidate underscores the importance Obama attaches to relations with Mexico. In a break with the past, US officials have publicly acknowledged for the first time that the smuggling of firearms purchased north of the border has contributed to escalating violence in Mexico involving the powerful local drug cartels. They also recognised that the enormous demand for drugs in the US sustains trafficking and exacerbates the bribery, extortion and violence associated with illicit markets that cannot settle disputes through the courts.

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

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In the Markets US-MEXICO RELATIONS: OBAMA WEARS ANOTHER HAT

Robillard says stepped-up border security since the 9/11 attacks, more resources devoted to the Border Patrol and the construction of a security fence, has made it harder to get drugs into the US. As a result, supply has built up in Mexico, which has encouraged the Mexican cartels to develop local distribution, and brought crime along with it. In addition, President Felipe Calderon’s campaign to stamp out corruption, including deployment of the army and federal police against the drug cartels, has upset the cosy relationships between government officials and the cartels that past administrations tolerated. Arrests and assassinations have triggered battles for control both within cartels and between competing organisations as they try to seize control of drug shipment corridors. “There were power vacuums and greater rivalry for territory, which led to more violence”says Robillard.

Tighter border controls To a limited extent, tighter border security may also have curbed illegal immigration from Mexico into the US— a perennial concern for both countries—but the recession has had a far bigger impact, according to Shannon O’Neil, an expert on Latin America at the Council on Foreign Relations, a New York-based research organisation and think tank. The estimated annual influx has fallen from 500,000 to 600,000 in the decade through 2006 to about 150,000 to 200,000 in the last two years. “In most cases, people who leave Mexico are going to a particular place in the US where they already have a job waiting for them or a community network that will help them get a job,” says O’Neil. “Fewer jobs in the US means that fewer people are coming.” The construction and services sectors that often employ Mexican migrants have been particularly hard hit in the economic downturn, too.

The recession was no picnic in the US, but it has been much worse for Mexico: O’Neil expects Mexican GDP this year to drop even more than it did after the 1995 peso crisis. That is why migration has not stopped altogether or reversed. Nevertheless, reduced numbers of migrants and lower income for those already in the US have cut remittances—a significant component of Mexican GDP—by 15%-20% so far this year. The recession may not be the only explanation, however. O’Neil notes that the number of children stopped at the US border has increased in recent years, which suggests that tight border security has had the perverse effect of encouraging migrants to move to the US permanently and bring their families north. “Migrants won’t be returning to Mexico,”she says. “That cuts remittances because they are not sending money back to their families any more.” About 85% of Mexican exports go to the US, leaving its economy inextricably linked to its northern neighbour. Allyson Benton, an analyst on Latin America at Eurasia Group, a leading political risk research and consulting firm, says the Mexican government talks about diversifying the country’s export markets, but she sees few viable options. Although Mexico has entered into a plethora of bilateral free trade agreements, gaining market access does not guarantee that demand for Mexican goods will develop.“It’s hard for them to export to countries they are competing with,” says Benton, “Their awareness of their dependence on the US is heightened, but they have to compete with other developing countries for access to larger markets.” Geographic proximity ensures that Mexico has an edge in trade with the US it cannot match anywhere else. Mexico’s dependence on the US stems in part from the North American

Free Trade Agreement (NAFTA), a treaty between Mexico, Canada and the US that took effect in 1993. NAFTA boosted trade among all three countries, and most disputes have been resolved by mid-level bureaucrats before they escalated into major conflicts. A notable exception is a longrunning clash over Mexican trucks, which are supposed to be able to deliver their loads anywhere in the US. Under pressure from labour unions and consumer safety groups, the US has never lived up to its treaty obligation, although the Bush administration did set up a pilot programme.

Obama under pressure “Obama has been pressured by US labour unions and consumer groups to stop spending on the truck access programme,” says Corina Monaghan, a vice president in the trade credit and political risk practice at Chicago-based insurance broker Aon. After congress blocked funding for the pilot, Mexico slapped retaliatory tariffs on US imports valued at $2.4bn, carefully selected to spread the pain across multiple US states while minimising the affect on Mexican consumers and manufacturers. While the truck spat is a distraction, Eurasia’s Benton points out that the USMexican relationship operates at many levels and through multiple channels. Although the Obama administration is trying to co-ordinate US policy toward Mexico—the multi-level approach has led to policy confusion in the past—the Mexicans see no need for change to a system that tends to ring fence diplomatic disputes.“If there is friction on a security issue, all the trade, immigration and other relationships go along as normal,”says Benton,“You can’t ever fully derail US-Mexico relations when things are so decentralised.” Now that Washington is paying more attention to Mexico City, the two countries could even develop a stronger bond.

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

While large institutional players experienced declines in foreigncurrency revenues during 2009, retail foreign exchange (FX) activity continued to accelerate, led by more powerful research tools as well as stronger demand for currency exchange traded fund (ETF) products. Such factors have enabled the FX market to grow in ways that institutions could not have foreseen. From Boston, David Simons reports. FTER A PROLONGED period of record profitability, major institutional banks saw a palpable decline in foreign exchange revenues as volumes returned to more normalised levels during 2009. While trends remain historically positive, firms such as JPMorgan and Deutsche Bank— two of the biggest generators of foreigncurrency revenue over the past several years—say that reduced volatility will likely continue to impact forex revenues over the near-term. In many instances, the pullback has been unusually pronounced; in October, State Street Corporation reported that third-quarter FX revenues were off 41% year-overyear, while at BNY Mellon, foreign exchange and other trading activities revenue fell to $246m, compared to $385m in the third quarter of 2008.

While the major institutional players account for more than half of the estimated $3.2trn in daily FX trading volume, during 2009 retail FX activity continued to accelerate, fuelled by more powerful research and trading tools and making FX an increasingly viable asset class for hedge funds, individual traders and other market participants. “These days you can’t surf a financial website for more than two minutes without getting some kind of pop-up ad for currency trading,” says Nicholas Colas, chief market strategist at New York’s BNY ConvergEx. “For one thing, it is a very high-margin form of trading. There is also a built-in stop-loss system—while in theory you could very well lose more than your principal, in practical terms most

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

FOREIGN EXCHANGE: RETAIL FX ACTIVITY ON THE UP

THE NEW LOOK OF FOREX

brokers today would cut off your account beforehand. It is a highly attractive feature—you start with $2000, and you can trade that money like a banshee and never lose more than $2000.” Gone is the freewheeling, highgrowth style of FX investment management that was so prevalent pre-crisis. During 2009, transaction costs rose dramatically and bid-ask spreads widened as well.“The lack of liquidity, extreme volatility and an unwillingness among counterparties to support previous levels of exposure has led to a number of different approaches,” says David Nichols, managing director and head of product management, BNY Mellon Global Markets. Capitalising on the new market psyche, last spring New York-based FX settlement services provider CLS Group announced a joint venture with UK inter-dealer broker ICAP to provide FX trade aggregation services in an effort to mitigate operational risk and lower posttrade costs within the expanding global FX marketplace. Currency ETFs, which track any number of foreign currencies in relation to the dollar (including dollar/euro, dollar/pound and dollar/yen), continue to gain favour among investors. “Anything that provides diversification in correlation to the existing asset classes is a good thing for your portfolio, and ETFs are quite useful in that regard,”says Colas. Unlike more conventional FX trading vehicles, currency ETFs are typically very low-leverage products and also have relatively low volatility. “You don’t get the kind of pop for your capital base,” says Colas. “It is a very different kind of approach—it gives you a slow, creeping method of protecting yourself against fluctuations in the dollar.”

In the Markets FOREIGN EXCHANGE: RETAIL FX ACTIVITY ON THE UP

Such factors have enabled the FX market to grow in ways that institutions could not have foreseen. Rather than allowing institutions to continue to develop lower-correlated investment classes, currencies are now providing a convenient avenue for retail investors to generate some leverage—and, in the process, help offset recent losses. Colas says: “With the old currency plays there was a greater need for hedging, greater interest in the various currencies, but that has all changed. In the last month alone, the correlation for nearly any asset class imaginable increased versus the S&P. Now when the dollar goes down, the stock markets immediately go up.” It works in reverse as well. Throughout 2009, low interest rates continued to weigh on the US dollar, allowing domestic investors to scoop up attractive, higheryielding foreign currencies with relative ease.Then in late November the dollar began a sustained rally against the world’s major currencies, aided by stronger-than-expected US jobs figures and increased consumer spending—fuelling speculation that the Federal Reserve Board could change its tune and begin raising interest rates sooner rather than later. The dollar’s sudden about-face not only prompted a pullback in equities but also caused investors to exit numerous foreign currency ETFs in favour of those more bullish on the dollar. “On the surface, it may sound silly,” remarks Gary Gordon, president of California-based Pacific Park Financial, a registered investment advisory firm. “Wouldn’t investors want to see strong evidence of a true rebound in the largest economy in the world?”

David Nichols, managing director and head of product management, BNY Mellon Global Markets. Photograph kindly supplied by The Bank of New York Mellon, December 2009.

Nicholas Colas, chief market strategist, BNY ConvergEx. Photograph kindly supplied by BNY Convergex, December 2009.

Nevertheless, he adds, current stock prices are largely being driven by what had seemed like a sure thing— a weaker dollar linked to the Fed’s unwillingness to raise rates. The potential for central bank intervention at home and abroad bears some watching.“There are only a limited number of countries that have the facility to do an intervention in the first place, relative to how they’ve stretched their balance sheets,” says Colas. “Given that the US is already playing with $2trn and has promised to buy another $250bn in mortgage-backed bonds between now and March, the notion of the Fed doing an intervention on behalf of the dollar seems incredibly remote—mainly because the size of the balance sheet is so large already.” Whereas, the opposite holds true for a country like Australia, says Colas. “They have tremendous resources and there has been slow and steady growth the entire way through, largely because the country has benefited so strongly from the Chinese export market. So structural intervention really is very much on a case-by-case basis.” Is the greenback on the verge of a comeback? To some observers, the dollar’s recent rise (and concurrent sell-off in competing currencies such as the euro and Australian dollar) merely suggests that FX investors are looking to lock-in gains. According to a Credit Suisse team of analysts led by global equity strategist Andrew Garthwaite, the December jobs report will not “mark a broader turning point for the US currency, and that risks will rise again early in the new year.” Should the opposite occur, however, 2010 could turn out to be a very different kind of year for those on the forex frontlines.

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

PERFORMANCE MANAGEMENT FOR TRANSITIONS

Photograph © Fstok1156/ Dreamstime.com, supplied December 2009.

EVALUATING THE TRANSITION & THE TRANSITION MANAGER The effectiveness of a transition manager is the key to ensuring that the three distinct components of risk within a transition (execution, exposure and operational risk) are harnessed and woven together to create the most effective transition strategy. Within this, full account must be taken of relative contribution to the total of each risk component, and, crucially, these three risk factors must be managed in tandem. It is the in-tandem nature with which these distinct risks present within a transition that sharply distinguishes transition management from the more traditional services of asset management and broker-dealer execution. By Tim Wilkinson, managing director for Europe, the Middle East and Africa at Mellon Transition Management (MTM). N ORDER TO evaluate the success of a transition, and the performance of the transition manager, it is constructive to distinguish between quantitative and qualitative criteria. At the same time, it is important to recognise that these two metrics are inextricably linked and inter-related. The overall result, expressed as the total performance impact cost of the transition versus the projected cost estimates, neatly captures the

quantitative component of the evaluation process. Given that it is rarely possible to eliminate all of the impact cost risk however, a single performance number in isolation does not tell the whole story. It is therefore necessary to “dis-aggregate” the headline result. For example, as between any performance slippage occurring overnight between the “previous close” benchmark prices and the market open (called gap) versus the impact cost accruing during

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

the actual trading day measured from the market open (typically called direction or drift). While this decomposition of the result should not be taken to such an extreme as to lose sight of the total performance impact number (being the ultimate cost to the fund) the degree of detail provided by the transition manager, and the clarity with which variance between estimated cost and realised result is explained forms a pivotally important part of the evaluation exercise. Note also that it is here where the quantitative and qualitative most overlap. A post-trade impact cost snapshot highlights the degree of detail which ought to be delivered immediately trading is completed. Where a transition is traded over several days, similar information should be made available on a daily, end-of-day basis. This furnishes the client with an ability to assess the progress of trading

In the Markets PERFORMANCE MANAGEMENT FOR TRANSITIONS

as well as the impact cost result multiple different against benchmarks. It also serves to decompose the total impact cost as between the different countries and different sectors involved. Note as well that the objective here is to provide a breakdown of the implicit costs. This not a decomposition of the full implementation shortfall; that should also be provided, but ideally within the broader post-trade report, so as to reflect the higher level split between explicit and implicit costs. Additional qualitative criteria to deploy alongside“clarity of reporting” and “quality and frequency of communication”are: the robustness of the transition strategy; the degree of transparency of the event and also of the provider’s total remuneration; the smoothness of the transition process; the adherence or otherwise to the projected timelines; the post-trade settlement rate and, perhaps most importantly of all, the all-round “comfort factor” experienced by the client—i.e. the extent to which the client had a clear prior and real-time understanding of all aspects of the event and a strong sense of the provider having demonstrated (and thereby also imparted to the client) full and effective control of all stages of the transition process. In terms of attributing a hierarchy to the various qualitative criteria outlined above, and identifying the single most important factor to focus upon within the evaluation process, the author believes that clear and effective communication stands head and shoulders above its peers. For it is the degree and efficacy of communication, before, during and after the transition; and also with all related parties to the transition (not just the client) that will almost certainly have the greatest bearing

The transition manager’s effective captaincy of the broader team on the field is the key to ensuring that the three distinct components of risk within a transition are harnessed and woven together to create the most effective transition strategy.

upon the outcome and the overall success or otherwise of the event. In this regard, it is imperative that the transition manager establishes itself, at the earliest opportunity, as the epicentre of all transition-related communication and all transitionrelated activity. Central to this is the need to stress to all parties the utmost importance of absolute confidentiality of information and timelines at all stages of the transition. The chart shows the typical parties to a transition, and the optimal communication structure, with the transition manager the nucleus of all transition-related activity. Ultimately, the transition manager’s effective captaincy of the broader

team on the field is the key to ensuring that the three distinct components of risk within a transition (execution, exposure and operational risk) are harnessed and woven together to create the most effective transition strategy. Within this, full account must be taken of relative contribution to the total of each component of risk, and, crucially, these three risk factors must be managed in tandem. It is the in-tandem nature with which these distinct risks present within a transition that sharply distinguishes transition management from the more traditional services of asset management and broker-dealer execution.

Epicentre Chart

Source: Mellon Transition Management (MTM), December 2009

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

Debt Report

THE ROAD TO RECOVERY? The European market for covered bonds staged a dramatic recovery last year, ever since the European Central Bank (ECB) launched a €60bn purchase programme for the instruments in July. The initiative, which will run until the end of June 2010, has spurred new issuance across most of the established jurisdictions and seen secondary-market spreads come in sharply from the unprecedented levels they reached in the first quarter of 2009. Despite predictable optimism from market practitioners, however, there is still a question as to whether the ECB’s short-term support for the eurodenominated market will restore it to the point where it can stand on its own once again by the middle of this year. Andrew Cavenagh looks at the factors that will determine the answer. HERE ARE CERTAINLY some grounds for confidence. Primary issuance in the oldest and most robust of European covered-bond markets—German pfandbriefe and French obligations foncières—had already resumed before the European Central Bank (ECB) announced its programme, albeit at prices that were an order of magnitude higher than in the pre-crash era (up to 100 basis points over the mid-swaps benchmark). Since the ECB began buying bonds (and it had acquired more than €25bn of the instruments under the programme by mid-December), there have also been new issues out of the more recent covered-bond jurisdictions—Spain, Italy, Ireland, the Netherlands and the

UK—as well as the first publicly marketed bond from Greece. Spain’s Caja Madrid brought two jumbo issues of €1.75bn and €1bn to the market within two months, in September and November, and by December 15th total new issuance across Europe was on course to exceed €120bn for the year. Although the vast majority of it came in the second half, few would have forecast such a volume back in March. So what are the drivers to keep this primary market going? One is that as banks in Europe and elsewhere look to wean themselves off various forms of government life-support—particularly the guaranteed debt in the senior unsecured bond market that provided

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

COVERED BONDS: CAN EUROPEAN MARKET REGAIN ITS STRENGTH?

Photograph © Clarens55/Dreamstime.com, supplied December 2009.

them with critical liquidity at the height of the crisis—covered bonds are likely to emerge as a bigger source of their funding in percentage terms over the coming months and years future than they were in the past. With the credit ratings (and in some cases reputations) of European banks at an all-time low, there must be doubts as to how easy, and affordable, it will be for many to finance themselves heavily in the senior unsecured markets (at least in the near term) once the guarantees disappear. Covered bonds are also more likely to appeal to investors with residual concerns over bank names, offering as they do a claim against the issuer first and then, if the issuer defaults, on the ring-fenced assets in the cover pool. From the issuer’s perspective, this enhanced security should translate into significantly tighter pricing than institutions with single-A and triple-B corporate ratings will be able to find in the unsecured markets. Furthermore, spreads on covered bonds will certainly be more than 100 basis points (bps) inside what they would be able to achieve through securitisation in the near-to-medium future. While this market may have begun to flicker back to life over the past three months or so, it remains tarnished in the eyes of many by the wilder excesses of the originateto-distribute model, which led some originators to pay scant attention to the credit quality of mortgages they were originating because they knew they would soon be offloading the entire risk. A further selling point for covered bonds is that they offer what are still predominantly triple-A rated investments—in an environment where less and less sovereign debt looks likely to retain such top billing in the months and years ahead—with an attractive yield pick-up. For although the average spreads on French, German and Spanish

Debt Report COVERED BONDS: CAN EUROPEAN MARKET REGAIN ITS STRENGTH?

jumbo issues (over €1bn) have come in by 45pbs, 28bps and 57bps respectively since the ECB began buying bonds in July, and they remain significantly wider than in preLehman days. Caja Madrid priced its November offering at 70bps to 75bps over mid-swaps, while new German pfandbriefe issues backed by mortgage pools are still pricing in the mid-to-high teens over mid-swaps, as opposed to the single figures of yesteryear.“It’s a safe asset class, and it offers a bit more yield than it used to,” observes Tim Skeet, head of coveredbond origination at Bank of America Merrill Lynch in London.

Liquidity buffers For bank buyers—who remain the largest single class of investor in covered bonds—the instruments should also offer a viable means of providing the “liquidity buffers” that they will required to hold to mitigate the impact of any future crisis; covered bonds will continue to attract relatively low regulatory capital charges under the revised Basel II accords and the European Capital Markets Directive. “Really quite small banks can buy a big slug of covered bonds and not take a big capital hit against it,”explains Skeet. Greek banks certainly view covered bonds as the way forward for mortgage funding, despite their limited experience with the instruments relative to residential mortgage-backed securities (RMBS), which they began issuing in 2003. They launched three issues of covered bonds last year, the first two of which were not sold publicly. This was evident at a recent panel discussion in Athens. National Bank of Greece, which successfully launched the country’s first public covered bond in September (the €1.5bn issued was four times over subscribed), confirmed

A further selling point for covered bonds is that they offer what are still predominantly triple-A rated investments—in an environment where less and less sovereign debt looks likely to retain such top billing in the months and years ahead—with an attractive yield pick-up. that it would be looking to this market to meet its mortgage-funding requirements in the medium term. “Covered bonds are definitely the flavour of the month here,”says one of the bankers who attended the discussion. “Their risk profile is that much more clear to the investor.” If there are compelling macroarguments for banks in Europe and elsewhere to make more use of covered bonds for their funding needs, however, they will need to appreciate that the market is now more discerning. Increasingly, creditconscious investors will no longer view issues out of any given jurisdiction as the almost-uniform risk that they did before, and issuers with lower credit ratings and reputational issues will have to be prepared to pay a commensurate premium. There is now obviously also considerable variation in the credit quality of cover pools as well, with those that have high exposures to the distressed housing markets of the UK, Spain and Ireland, or the commercial property markets, looking especially vulnerable. Investors will consequently look at both issuers and cover pools on a case by case basis, rather than base their decision on the legal framework in question, which was often almost the sole reason behind investments in the past. “Now you’ve got something that starts off with the credit,”maintains Skeet. This discrimination between issuers is likely to be most marked in Spain, where the big established issuers such

as Caja Madrid and Santander should be able to continue issuing at viable cost (despite the difficulties being experienced by some of their RMBS issues) but some of the smaller savings banks (cajas) may struggle. “Where there are pressures and concerns is in the small regional cajas,”says Skeet.

Ratings downgrades Another consideration for the market in the coming months will be the potential for widespread ratings downgrades, as the three main agencies complete changes to their methodology for rating the instruments to take account of heightened liquidity risk—the mismatches that can arise between the future cash flows from the underlying collateral and the couponpayment obligations on the bonds— in stressed market conditions Standard & Poor’s (S&P’s) put €1,460bn of covered bonds on rating watch negative on December 16th, when it finally published its new rating criteria for covered bonds, which also link the rating of the bonds more closely to that of the issuer in the event the covered bond programme develops am asset-liability mismatch. The 96 affected programmes have 90 days to introduce further“structural features”to address this risk or face downgrades. Fitch and Moody’s made similar revisions to their criteria earlier this year. In Fitch’s case, the changes in its liquidity-risk assumptions, both qualitative and quantitative, had a

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detrimental impact on 73 of the 99 rated programmes that have publicly available “D factors”; the relationship between the rating of the bond and that of its issuer (the closer the two ratings become, the worse the D factor). The agency moves have led some sector analysts to predict a torrid time for the market this year. “In 2010, we expect covered-bond ratings to come under pressure on account of potential collateral quality deteriorations, the sensitivity of certain covered bonds to counterparty risk, and the implementation of S&P’s new covered-bond rating criteria,” concludes Sabine Winkler, covered bond analyst, at Bank of America Merrill Lynch. Bankers are not convinced, however, that investors will take too much notice of what the rating agencies do, as from now on they will be carrying out their own credit analysis to a far greater extent than before. “I think investors are pretty sanguine about that,” says Skeet. “A lot of them have become fed up with the rating agencies.”Another banker concurred:“The question will be how much importance investors put on ratings versus their own analysis.” Nevertheless, widespread downgrades will not help the coveredbond market to meet another of its challenges over the next six months— to restore some meaningful liquidity. For despite the surge in primary issuance, secondary trading remains at an extremely low ebb, and until that attains something approaching its former level investors will continue to demand an“illiquidity”premium. In the medium term, perhaps the most encouraging signal for covered bonds is the apparent determination

Tim Skeet, head of covered-bond origination at Bank of America Merrill Lynch in London. Photograph kindly supplied by Bank of America Merrill Lynch, December 2009.

to develop a significant market for the instruments in the US. After two unsuccessful attempts to introduce structured versions of the securities in 2007 and 2008 (admittedly blighted by unfortunate timing), the US congress is now considering a specific legal framework for the instruments. Introduced by Scott Garrett, a Republican representative from New Jersey, the measure has strong crossparty support and a genuine chance of making it on to the statute book before the end of the current congressional session.“We really must look for new and innovative ways to provide funding to out credit markets and I really believe we must set up a system here that allows covered bonds to flourish,”insists Garrett Skeet maintains that a special legal framework would be a pre-requisite for the development of a meaningful US market and points to the experience in Europe, where the two countries that began with structured

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bonds, the UK and the Netherlands, both subsequently introduced legal frameworks. “I believe that it will be third time lucky for the US,”he says. Garrett’s bill circumvents the difficulties that obstructed acceptance of covered bonds in the past. Chief among these was the Federal Deposit Insurance Act, which did not recognise the instruments as a financial contract (and protect their underlying assets from the claims of general creditors in a bank insolvency). It also allows for a wide range of assets to be used as collateral for bonds—including auto and small-business loans, as well as residential and commercial mortgages and public-sector debt. Bert Ely, the head of the specialist Virginia-based financial consultancy of the same name who has been one of Garrett’s key advisers on the bill, points out that the total outstanding volume of such assets in the US was $20trn. The Garrett bill secured a hearing before the full House Financial Services Committee on December 15th, and, although there was some controversy over its proposals for a Federal backstop to enable the bond trustee to maintain payments in the event of an issuer insolvency, its proponents hope it will now be tacked on to the Financial Services Reform Act when that goes to the Senate in the coming weeks. This would give it a serious chance of becoming law in the first half of 2010. It goes without saying that the emergence of a true investor base for covered bonds in the US would also be a massive boost for the European market, as it would open up the largest bond-buying jurisdiction in the world to their offerings.

SOUTH KOREA SET FOR FURTHER GROWTH

Governor of the Bank Of Korea Lee Seongtae gestures during a press conference to announce the benchmark call rate at the headquarters of the Bank of Korea in Seoul, South Korea, Thursday, December 10th 2009. South Korea’s central bank left its key interest rate at a record low for a 10th straight month that day amid increasing signs of recovery in Asia’s fourth-largest economy. Photograph by Ahn Young-joon for Associated Press. Photograph supplied by PA Photos, December 2009.

ON THE UPSIDE All the signs are that South Korea’s relative position in the global economy will be even stronger as a result of the crisis. Of course, heavily tied into world trade, it had also been hit by the downturn, but the government’s prompt huge and growing stimulus package seems to have averted the worst effects with a success that surprised even the authorities themselves, writes Ian Williams

Korea’s success is in some ways even more remarkable—its manufactured exports to China, whose domestic boom has helped insulate Asia from the American chill. Korea’s exports to China grew 4%. It doubtless helps that unlike the US and UK, the Asian tigers have huge reserves to back up their stimulus package rather than massive debts.

Cost effective producer T WAS SAID that South Korea’s economic development was held back by its relatively inflexible capital markets with intertwined holdings dominated by the dominant conglomerates, the chaebols; that it was too reliant on manufacturing, and had an inadequate service sector and inflexible labour supply. Totally un-American, was the gist of the complaints. However, as South Korea’s economic output surged 2.9% in the third quarter of last year, many in the West would have been wishing they shared those perceived problems, not least in view of a sudden affection from British and American leaders to what they used to disdain as passé rustbelt manufacturing. Much of Korea’s growth was in industrial output, not least the country’s thriving automobile industry, where Hyundai, for example, was taking market share in the US from declining Detroit. It added to 2.6% growth in the second

quarter (Q2) 2009—the highest in the Organisation for Economic Cooperation and Development (OECD). All the signs are that South Korea’s relative position in the global economy will be even stronger as a result of the crisis. Of course, heavily tied into world trade, it had also been hit by the downturn, but the government’s prompt huge and growing stimulus package seems to have averted the worst effects with a success that surprised even the authorities themselves. Almost a year later, in October last year, the finance ministry revised its initial estimate of a 1.5% decline over the year to an actual annual increase over the previous year. The stock market is already above preLehman crash levels. In addition to new money, the government had front-loaded its annual spending for the earlier part of the year. It also avoided a fire sale by delaying its planned privatisations of state assets until market conditions approved. However, another factor in South

HSBC senior analyst Frederic Neumann adds: “It was not just from China: the primary driver was the won’s depreciating exchange rate that enhanced their existing advantage as cost-effective producers for China and other emerging markets. But that highlights their unique position. They have been exporting to China for consumption, not for re-export like some other Asian economies.” That lower cost is important, but it does not make them “cheap” in the derogatory sense. Neumann points out:“Even Hyundai’s success in US was partly driven by cost consciousness. However, the success of their export drive has given them a cash flow for investment and research and development [R&D] that neighbouring rivals did not have. They have been moving up the value chain. Their shipyards have big sales of vessels to China, but now they are also moving into much more sophisticated sectors like gas exploration drilling vessels.”

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Country Report Michael Ranieri of the Korea Center for International Finance adds: “We sometimes overlook the real Korean success story—this is not a government-cosseted sector. These companies are big, very successful. Companies such as Samsung, LG and Hyundai are good at sales, development, marketing and advertising. They’re very well managed even with their size, they’re very nimble and respond very flexibly to very adverse market conditions.” South Korea’s conclusion of a Free Trade Agreement with the European Union, the biggest free trade deal since the North American Free Trade Agreement (NAFTA) in 1994, promises even more growth from manufacturing, as well as the prospect of further decoupling from a struggling US economy. However, that does not ease Seoul’s disappointment at the US Congress’s failure to finalise the Free Trade Agreement, although it upsets many in the American business community who claim that the European agreement is in effect a photocopy of the stalled Korea/US pact and see European companies jumping into the vacuum congress has created. Lamenting the US congress’s failure to sign the agreement, Ranieri points to one of the major grounds for legislators’ opposition: “They want more access for US autos—as if Koreans are dying to buy American cars!” In contrast he points out: “Hyundai is a good product,” as its rising sales during the US cash for clunkers programme indicates. Fuel economy was one of Hyundai’s most desirable features and the government in Seoul is encouraging industry to break the stereotype of high pollution emerging industry with a strong emphasis on the energy and green sectors. The pro-business government does not imply laisserfaire but harnesses government efforts

to coordinate the direction of corporate enterprise. According to a recent survey of multinationals in Korea, one in four considered the energy and green industries the most promising sectors which, admittedly could be a response to the promised flow of government funds.

A green outlook Unlike the US stimulus package, which draped some green tinsel about what was in some ways an expanded pork barrel, Seoul has committed up to $80bn for green industries and technology such as electric and hybrid cars. Neumann comments that so far the green-ness is “by and large an aspiration—but of course they are not alone on putting a green mantle on their stimulus package”. He adds: “They have moved into early stages, such as solar cells, but have a way to go to compete, for example, with the Japanese in hybrid and electric cars or fuel cells.” Even so, with the combination of government encouragement and their own proven resourcefulness, they are almost certain to be players in the global markets. However, while investors might be attracted to green wons from the government, they found that Korea’s investment environment lagged behind Taiwan, Singapore and Hong Kong, though ahead of China. Despite an increase of 32% in foreign investment drawn in by the depreciating won and relative economic stability, the government is taking note and finance minister Yoon Jeung-hyun recently announced more incentives for foreign investment, including full exemption for rent on land in foreign investment zones exclusively for parts and materials production. He can deliver on that, but whether the government can deliver on its promises for increased labour market flexibility and the

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removal of “inconveniences” for foreign investors is another story. The Korean labour force is well educated, militant and well-organised and with the growth figures now recorded is less likely to be amenable to worsening conditions than it was a year ago. Even so, perceptions of and prejudices about Korea should change as a result of the crisis elsewhere, not least government involvement in industry, until recently anathema in Washington and Wall Street alike. One example could be the now battered GM that took a huge stake in Daewoo when it was the chaebol that lived down to western expectations by failing. Daewoo is now one of GM’s major producers, making and exporting GM’s small and medium range—precisely those now encouraged by Washington and in demand globally. However, it is debarred from getting any US bailout money despite its strategic position for the currently US governmentowned parent company. GM has just increased its stake in Daewoo as part of its bargaining with the Korean government-owned Korean Development Bank. The bank which is insisting on production guarantees and technology transfers before putting any more money into the unit, thus joining many other nations to which Detroit had outsourced production but are now bidding for a position higher up the auto drive-chain. It is difficult for the Americans to complain about government involvement as it used to.

Great expectations So what are the prospects for Korea, and for putative foreign investors? One question that arises is miscategorisation of the country as an “emerging economy”. Actually the country was awarded“developed”status

Country Report SOUTH KOREA SET FOR FURTHER GROWTH

by FTSE Group, enabling its stock market to attract more of the estimated $3trn in funds that track the group’s global benchmark indices in September 2008. The move to developed status came into effect in September 2009. FTSE had previously classed the Seoul exchange as an“advanced emerging”. Neumann confesses some degree of bewilderment at the confusion: “It’s been in the OECD since 1997, has sophisticated financial markets, marketing, R&D and production by a well-educated skilled and productive workforce. One reason [for the confusion] advanced was the alleged lack of transparency in corporate governance, but looking at what has happened recently in the West, it’s difficult to hold that against them.” Even allowing that the country’s emphasis on manufacturing has served it well through the crisis he identifies one challenge as “the need to develop a more mature service sector. The chaebols are very good at big capital intensive projects, but conglomerates of that size rarely succeed in creating a vigorous services.” Obviously the government shares some of his concern. The finance minister is calling for foreign investors to be allowed to take a bigger stake in the services sector.

RCM’s Korea fund manager San Won Kim also thinks that that structural changes will drive Korea more towards a service-orientation, but as an addition to the strong export culture led by improved product quality and brand images. With the opening out to foreign investors the less intensive service sector offers attractive opportunities not least because the depreciation still offers what he calls the “Korea discount”, which allows his fund, and other portfolio investors “to buy world class companies at a reduced price”. Ranieri says: “Portfolio investment in Korea is not so difficult: the stock market is up, there’s a current account surplus, growing foreign exchange reserves… It is just that foreign direct investment [FDI] is not as attractive as the Koreans would like. But attracting FDI has never been easy. There are lots of reasons given but the main one is China. The looming presence of China has made it difficult to come up with a rationale for investment in Korea. If a company wants to be in Asia, then China, just next door, is the place they want to be.” KWR International’s Keith Rabin warns that Korea’s current attractiveness to foreign investors might pose problems. “The

CME GROUP & KRX INITIATE AFTERHOURS ACCESS TO KOSPI 200 FUTURES n mid-November last year the CME Group and the Korea Exchange Inc. (KRX), launched the first phase of a programme to provide customers with afterhours access to KOSPI 200 Futures hosted on the CME Globex electronic trading platform. Once this phase is completed, KRX clearing members will have access to the

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fundamentals are clear but everything is so highly leveraged with speculators and fund guys bid up. In some ways Korea is like a highly leveraged ETF. People have very high expectations and pour money into it, but the slightest hiccough and it goes down.” He cautions: “It’s basically an export economy, so growth depends on global recovery. Its ability to rely on the US, still its number one trading partner, as a source of demand is lessening. Switching the emphasis significantly to China, or the EU, or the developing world is a challenge. Overall, Koreans do things fast, in an accelerated fashion, but they can’t change the trading patterns overnight.” However, observers agree that the effect of the crisis is that Korea will be looking more pragmatically at what it has done that worked rather than listening to ideologically tinged advice from abroad. Since what it has done has worked rather well, not least considering the geopolitical situation with North Korea within artillery range of its capital, that should ensure future growth with a growing decoupling from a USA that may be turning from the locomotive to the brake-van of the global economy.

KOSPI 200 Futures market via the USG. Direct access through global CME Globex connections is subject to regulatory approvals. The exchanges say they are also committed to providing in due course a bi-directional order routing initiative, based on the model CME Group has implemented with BM&FBOVESPA in Brazil. The KOSPI 200 comprises the 200 largest publiclytraded companies on the Korean Exchange and is widely regarded as the barometer of the overall movements of the Korean stock market. According to the Futures Industry Association, in the first half of 2009, KOSPI 200 Futures were the sixth most traded index futures in the world in terms of trading volume, with 43.9m contracts.

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INDIA: STRUCTURED PRODUCTS & DERIVATIVES TRADING

Despite improvements, reservations about structured products and derivatives trading in India continue. In large part, this is because of the strict regulatory regime, fears over the introduction of additional regulations, the lack of transparency and a lack of understanding about the calculation of return on investment. The Reserve Bank of India (RBI) believes such regulation has been necessitated by poor investor understanding of products as well as the lack of transparency in the products themselves. Shaneen Parikh, partner, Amarchand & Mangaldas & Suresh A Shroff & Co., Mumbai, and Alan Meehan, associate, Reed Smith LLP, London, assess the situation. Additional reporting by Dharam Jumani and Rishab Bailey associates (dispute resolution) at Amarchand & Mangaldas & Suresh A Shroff & Co.

A number of problems have bedevilled the industry of late. The 2007/2008 financial crisis and steady devaluation of the US dollar and several other major currencies, has resulted in substantial losses for many investors, as they marked to market the asset values. Inevitably, this induced a spate of litigation in which several banks’ customers sought to challenge the transactions, including the contention that they were void or unenforceable. Photograph © Kashman/Dreamstime.com, supplied December 2009.

GRADUATED OPPORTUNITY N SEPTEMBER 1993, the Reserve Bank of India (RBI) permitted foreign currency options on an over-the-counter (OTC) basis; in 2000, the Foreign Exchange Management Act (FEMA) regulations allowed OTC foreign exchange derivative transactions, and in 2006, the Reserve Bank of India Act was amended to recognise the validity of derivative transactions and grant retrospective approval to them, thereby removing any ambiguity as to the legality of OTC derivatives which were cash settled. Today, trading in equity derivatives is allowed only on an exchange and not on an OTC basis. Equally, OTC derivatives

such as foreign currency options, forwards and interest rate/currency swaps can be entered into only with a scheduled bank/authorised dealer and only then to hedge any underlying exposure, and not for portfolio management, investment or speculative purposes. Many of these transactions are deemed to be exotic, with a series of complicated options, range accruals, swaps etc, built into one structure. A number of problems have bedevilled the industry of late. The 2007/2008 financial crisis and steady devaluation of the US dollar and several other major currencies, has resulted in substantial losses for many investors, as

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they marked to market the asset values. Inevitably, this induced a spate of litigation in which several banks’ customers sought to challenge the transactions, including the contention that they were void or unenforceable. Right now, only standard US dollar–Indian rupee futures and options contracts tend to be traded on the exchanges, although there is hope that euro-rupee trading will soon follow. The combined daily turnover across exchanges in currency futures totals more than $2bn. Presently, SEBI permits trading inter alia in index options, stock options, stock futures, sectoral indices, mini derivative (futures and options)

Country Report INDIA: STRUCTURED PRODUCTS & DERIVATIVES TRADING

contracts, volatility index, bond index and exchange traded currency derivatives, which provides hope for the future expansion in the markets.

Interest rate futures Of late, there have been a number of moves to open up the market.The NSE, for instance, became the first stock exchange to get approval for interest rate futures and on August 31st, 2009, launched a futures contract of INR200,000 (£2,638), each based on 7% ten year government of India (GOI) bond (notional), with quarterly maturities. Overall, the newly-launched derivatives clocked trading volumes of INR276m in their very first day of trade.The BSE is also expected to launch its own scheme in the next few months, while the Multi Commodity Exchange (MCE) is also awaiting regulatory approval to launch interest rate futures trading. Interest rate futures are the first major product to be re-introduced in India after the launch of currency futures in August 2008. Dealers say the market has priced the futures in such a way that there is little opportunity for arbitrage. Other initiatives have included ETFs, which were launched with the Nifty Benchmark Exchange Traded Scheme in 2001 and mutual funds have since launched gold, silver and equity ETFs. ETFs combine the valuation feature of a mutual fund by holding assets and trading at approximately the same price as the net asset value of their underlying assets. They have been regarded as attractive investment opportunities because of their low costs, tax efficiency, and stock-like features. ETFs initially received a fairly lukewarm welcome in the market, with analysts citing lack of awareness on the working of ETFs, complicated investment norms, high entry loads (and in relation to gold ETFs, an Indian propensity to hold gold in physical form), as reasons for them not picking up in earnest.

Equity ETFs were initially more popular that gold ETFs but, even then, they were vastly outperformed by active funds. However, following volatility in the stock market and the fluctuating US dollar-Indian rupee rate in 2008, ETFs became more attractive to investors. Gold ETFs in fact have now become a popular portfolio management tool, particularly since they all have similar returns (as they are tracking the same commodity), averaging about 38% returns over the past year, as opposed to other fund categories where there is considerable divergence. Foreign institutional investors (FIIs) have invested around $1.5bn via ETFs in the past six months. Industry analysts continue to expect this section of the derivatives market to expand significantly in coming years with greater investor knowledge and a wider range of products being made available.

Structured products Structured products (pre-packaged investment strategies based on the performance of underlying instruments or markets) in India are commonly regarded as falling within the definition of a “debenture” under the Indian Companies Act 1956, as they are not “shares”, and acknowledge the debt of the principal amount invested and provide for payment of that amount, along with interest or other periodic payment which is linked to any of a variety of underlying benchmarks. Any structured product, irrespective of whether it is being offered to the public (i.e., to more than 50 people) or by way of “private placement” (less than 50 people) is required to be traded on a stock exchange. This is because the SCRA provides that contracts in derivatives shall be valid if they are traded on a stock exchange and settled on its clearing house, and equity derivatives are not permitted on an OTC basis.

Such structured products are typically listed on the wholesale debt market, even though they usually have one or more embedded options or may employ other derivatives strategies as principal is “protected”. The derivatives market deals in only straightforward and standard futures and options contracts. However, the requirement for listing brings with it the corollary obligation of complying with the relevant listing of debt security regulations and listing agreements. One of these obligations includes obtaining a credit rating for the product from a recognised credit rating agency. While this requirement is for the benefit of the investor, the value of the credit rating actually assigned to a particular product remains questionable, particularly in the aftermath of the 2008 financial crisis. The perceived lack of objectivity of credit rating agencies has recently prompted the High Level Coordination Committee on Financial Markets (HLCCFM), which deals with inter-regulatory issues in the Indian financial and capital markets, to debate doing away with mandatory ratings for financial products.

Capital protection schemes Products featuring a “principal protection” or capital protection function, if the product is held to maturity, have been permitted following the introduction to a 2006 amendment to the SEBI (Mutual Funds) Regulations, 1996. SEBI requires mutual funds to disclose that “the scheme offered is ‘oriented towards protection of capital’ and ‘not with guaranteed returns’. It should also be indicated that the orientation towards protection of the capital originates from the portfolio structure of the scheme and not from any bank guarantee, insurance cover etc”. The promise of capital protection is the obvious attraction to investors and growth has been rapid. Although the returns are on

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average much lower than in direct equity investments. Market sources place the current value of the issued and outstanding structured products to be in excess of INR150bn. Franklin Templeton and UTI Mutual Fund were the first to offer schemes, based on a constant proportion portfolio insurance (CPPI) strategy, designed to offer investors with protection of their capital plus participation in any appreciation of the underlying portfolio. The fundamentals of CPPI are the determination of the cushion and the multiplier. The cushion is the value of assets in the portfolio in excess of the present value of the liability to return investors capital at maturity (known as the floor). The multiplier is based on a determination of maximum possible loss in the portfolio’s risky assets during an observation period. The portfolio is constituted of risk-free

assets and risky assets where the value of the risky assets equals the exposure (the product of the cushion and multiplier), and provides the basis for the investor’s participation in appreciation of the portfolio. The idea being that even if the worst fears upon which the multiplier was based are realised, the loss will not exceed the cushion and the value of the portfolio won’t fall below the floor. If the worst fears are exceeded and losses exceed the cushion—a situation known as a “gap event”—the portfolio may prove insufficient to return investors capital. Alternatives structures to CPPI have included structures based on cliquet payments and chooser options. Nonetheless, reservations continue, in view of the strict regulatory regime, which does not permit issuers to guarantee return of capital but only to structure the portfolio in a manner so as to protect

THE CONVOLUTED HISTORY OF INDIAN DERIVATIVES India began trading in derivatives as early as 1875, when the Bombay Cotton Trade Association permitted futures trading, and by the early 20th century, the country’s futures market was one of the largest in the world. However, after independence in 1947 the government clamped down on futures and options trading in several commodities. ollowing the opening of the Indian economy and the deregulation/full convertibility of the Indian rupee in 1993/1994, domestic and international markets were integrated, leading to a need to manage currency risks. Indian financial regulations were gradually subject to a series of progressive amendments, which began to be implemented in the second half of the 1990s. The prohibition of options trading was lifted in 1995. Four years later, an amendment to the 1956 Securities

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capital; the close ended schemes requiring the investors to stay locked in for a period of three to five years; the lack of transparency in relation to the structuring and working of the schemes and management fee being levied by the issuer; and the consequential lack of understanding about the calculation of return on investment. Reports suggest that the structured products market has also attracted the glare of the RBI, which recently issued a communiqué and asked issuers to disclose the details of the products issued and outstanding. It is widely anticipated that the RBI’s intervention is a precursor of further and stringent regulation of structured products and arises out of the RBI’s view that such regulation has been necessitated by poor investor understanding of the products as well as the lack of transparency in the products themselves.

Contract (Regulation) Act (SCRA) paved the way for trading of derivatives on the stock exchange by including “derivatives” within the definition of “securities”, and also including a specific provision that contracts in derivatives were legal and valid so long as such contracts were traded on a stock exchange and settled on the clearing house of the stock exchange. Subsequently, the Securities and Exchange Board of India (SEBI) permitted the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) to commence trading in approved derivative contracts and index futures and options. The types of such instruments and their uses were fairly restricted in the initial years though the market witnessed a steady increase in trading volumes. Following investor sophistication and increasing interest in the stock market, mutual funds—initially formed to enable small investors to participate in the equities market—introduced innovative products, investment techniques and investor-servicing technology, including capital protection oriented schemes and other exchange traded funds (ETFs). Indian appetite for derivatives grew exponentially, the main reason being the intrinsic nature of a derivative contract which enables transfer of risk (for a fee) from those who are unwilling to bear it.

Country Report INDIA: PREMIER SINGH COMMITS TO REFORM

THE SEARCH FOR SUSTAINED GROWTH Comments from Prime Minister Manmohan Singh in early November last year would seem to indicate that, after many half-hearted attempts, genuine economic reform is finally on the agenda in India. At the heart of this is Singh’s desire to propel Asia’s third-largest economy towards 9% annual GDP growth through a combination of economic modernisation, infrastructure spending, and the corollary attracting of new foreign capital inflows, a programme that has impressed the World Bank’s International Finance Corporation (IFC) sufficiently to make it place India as its biggest single investment portfolio, ahead of Russia. Simon Watkins reports. ESPITE THE PLEDGES for widescale capital markets reform, adjunct infrastructure development, and the apparent confidence implied in premier Singh’s statement that India will be among the first of the G20 nations to begin winding back on fiscal stimulus measures, the question remains to what degree such efforts will actually be sustainable. Some 800m Indian still live on less than $2 per day, while the country’s seven poorest states, which hold about 40% of the population, attract only around 1% of its direct foreign investment inflows. That means the immediate focus of the government will be on boosting infrastructure development in these areas, thinks Sonal Varma, senior economist for Nomura Securities, in Mumbai. “A cornerstone of this project is to coax some of the $400bn or so currently held in domestic savings accounts into the capital markets, and entice more foreign investment,” she says, “which will also allow the government to borrow less from the debt markets, and so ease pressure on bond yields.” A major development in this respect, she says, is the November announcement by the government that

all profit-making, listed, state-run companies will be obliged to float at least 10% of their shares to private investors. That would open up holdings in MMTC (the country’s biggest stateowned trading company), NMDC (its largest iron ore producer), and Hindustan Copper (its leading copper miner), among others; all of which would be of particular interest to Chinese acquisition-hungry firms. This move alone, Varma thinks, could well generate share sales of around $50bn over the next three years, reducing the budget deficit by around four percentage points, and still leaving another $375bn or so at current market capitalisation of state-run stock to sell off down the line. “Prior to this,” she says,“the rules required that all proceeds from such asset sales be credited to the National Investment Fund in the first instance, with only three quarters of the total finally making its way into financing education, health, and employment programmes, so this is a major step forward from Singh.” This said, with the government having stated that it needs to spend $500bn on infrastructure projects in order to reach its 9% GDP annual growth target, clearly more will need to

Photograph © RolffImages/Dreamstime.com, supplied December 2009.

be done, states Tarun Kataria, head of global markets and banking for HSBC, in Mumbai, which is where ongoing reforms to India’s bond markets come in.“In the current environment in which bank loan rates are higher than bond rates [India’s biggest bank, ICICI Bank, charges around 16.75% to its best customers for rolling loans at the moment, while State Bank of India recently offered 10-year bonds paying just 8.6%], so the decision in June of this year to increase the limit on the level of ownership of Indian corporate bonds by foreign investors to $15bn, from $6bn, can only be positive,”he says. Given the difficulty that the country’s firms have in raising capital from domestic banks, from share sales ,which are down around 60% in the year to date (YTD), and from syndicated loans (lower by about 10% YTD, it is highly likely that the government will seek in its next budget, due next February, to further broaden and deepen the country’s bond markets. “At the moment, corporate bonds are basically a buy and hold market,” Kataria says,“as there is an absence of pricing spreads against an adequate benchmark, and a broadly flat yield curve too boot, so the necessity for new government issues of a good size, and in longer tenors, is paramount in their development.”

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In this respect, he adds, the recent initiative from India’s regulators to introduce a formal clearing mechanism should serve to increase liquidity, reduce counterparty risk, and improve transparency and efficiency. “The scheme sees bonds traded through recognised clearing houses, with support from the central bank, which is marked improvement on the previous method whereby trading was conducted on a largely bilateral basis, increasing the risk that one party might default before payment,”he underlines. Indeed, not only is there provision for an escrow account in which payments for bonds are deposited with the central bank prior to the handover of the security, but also there are further moves afoot to bring more trading onto a realtime trading platform in which the prices of trades are made known to the rest of the market, and the regulators alike.

The promise of insurance Similarly full of potential, thinks Tapen Sinha, ING Commercial America professor of risk management and insurance, ITAM, Mexico City, is India’s insurance market. “Its current premium volume of around $18bn has the opportunity to increase to $90bn or so within the next decade,”he says,“and, in particular, life insurance, which currently makes up about 80% of total premiums, is likely to lead this growth.”Since 2000, he adds, when the government eased entry restrictions on private sector investors and foreign investors coming into the market, the premium income from life insurance has grown at an annual average rate of around 20%, but this is likely to increase further, he thinks, as restrictions are relaxed more.“Further liberalisation of investment regulations on insurers that strike a proper balance between insurance solvency and investment flexibility are envisioned,”he says, “as is the replacement of some obsolete regulations on insurance pricing

that will be replaced by riskdifferentiated pricing structures.” An additional challenge, he highlights, lies within the non-life insurance sector’s tariff structure, which is till, by international standards at least, heavily regulated, with pricing often below market-clearing levels, and the state-owned Life Insurance Corporation (LIC) still dominating around 75% of the market, and laying down government guidelines.“It is the responsibility of non-life insurers to help manage India’s high degree of exposure to natural catastrophes,” he says,“and to do this, boosting the level of technical know-how and financial capability from international reinsurance companies is essential.” To this effect, he expects more initiatives to be announced that recognise the necessity of de-linking reinsurance operations from direct insurance ones, by, for example, allowing the branching out of foreign insurance firms. As an adjunct to this, he underlines, India’s pension fund market is also likely to grow at an annual average rate of around 40% through to 2013, against a backdrop of extended life expectancy, and anticipated government reforms. In this respect, the New Pension Scheme, brought into effect on May 1 of this year, and open to all workers with a minimum annual investment of INR6,000, is likely to become increasingly popular, he thinks, given that it allows for up to 50% investment in potentially high-return stock markets, whilst after the participant reaches the age of 60, 90% of his total savings would be placed in less volatile government bonds. “At present, the LIC dominates the pension industry, while private life insurers contributed only 7.5% of India’s total insurance premium last year, “he says,“but this figure is expected to rise, in line with increasing unemployment levels in the private sector, and rising healthcare costs.”

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Sustainability Even so, significant questions remain over the sustainability of the country’s overall economic recovery beyond the 6% GDP growth targeted this year, particularly if, as Singh has suggested, fiscal stimulus measures are wound down at the end of the first quarter of next year. Here, highlights Kunal Kundu, principal financial research consultant for Infosys Technologies, in Mumbai, an analysis of India’s GDP growth number over the previous two quarters clearly reveals that with domestic demand still stagnating, it was the high level of government spending (about 12% of GDP in the past 12 months) that saved the country from a much worse decline than many other countries endured. Going forward, though, he adds, with the key agricultural sector having been badly affected by severe droughts in the north of India, and by severe floods in the south, uncertainty revolves around whether industry can pick up the slack in generating growth. “Although the Index of Industrial Production [IIP], which started tapering off from August 2008, has shown signs of rebounding since June of this year, this was largely due to increased demand resulting from increased government spending in the rural segment, the recent INR475bn payment arrears received by government employees in line with recommendations made by the Sixth Pay Commission, and inventory buildup ahead of the traditional Diwali celebrations. Similarly disappointing, he highlights, has been the swathe of corporate results announced in the last couple of quarters: “While the nonfinancial companies have, on average, been able to show improved profitability—mainly due to stringent cost-cutting measures, and falling commodities prices and interest rates, their revenue growth has virtually ground to a standstill.”

Real Estate UK RETAIL: CVAs ALARM INSTITUTIONAL INVESTORS

While UK retailers struggled with the consumer downturn and a series of high profile business failures during the past year, most notably the demise of high street perennial Woolworths and Virgin reincarnate Zavvi, another raft of administrations is expected in 2010. For shopping centre owners and real estate funds, the fear is that pre-pack administrations and new kid on the block corporate voluntary arrangements (CVAs) have become too convenient as a way for retailers to divest themselves of the bits of their business they no longer want. Two test cases could determine which way the industry turns, reports Mark Faithfull.

Photograph © Urose/Dreamstime.com, supplied December 2009.

CVA or the highway? ORPORATE VOLUNTARY ARRANGEMENTS (CVAs) have blown up a storm of controversy within the UK retail real estate industry as a series of embattled retailers have sought to secure their survival by means of this once comparatively unheard of acronym. CVAs have become the buzz term of the past 12 months—sharply dividing those who believe they are a credible damage limitation exercise and those who see them as a cheap and convenient way for an ailing retailer to walk away from its commitments and some of its leases with little responsibility either for the mess left behind or competitors who continue to“do the right thing”. Tighter regulation means that in mainland Europe the practice is

nowhere near as widespread. In Britain however CVAs are sounding alarm bells for institutional investors of high street and, particularly, shopping centre stock. Already the market is being forced to come to terms with downward movement in renegotiated rents—after years of upward-only rent reviews—and unpredictable void (empty shop) levels. In turn, the trend is making investment performance far harder to predict, and investors are now seeing incumbent tenants at the table looking for exit deals across their store chains. The real estate sector was braced for a second surge in administrations, liquidations and CVAs in the postChristmas wash-up. The festive season is vital for the retail industry,

accounting typically for 40% of annual sales and as much as 60% for some retail operations. Those retailers beholden to their banks went into the holiday season wondering whether their financial backers had a premeditated plan to wait for optimum cash flow before pulling the plug or knowing that if they failed to perform during the peak retail season they would probably lose investor confidence. As the tinsel came down, so inevitably would the retail empires of more UK retailers. A CVA is a formal procedure under Part I of the Insolvency Act 1986, which enables a company to agree with its creditors how its debts should be paid and in what proportions, without resorting to administration. The CVA

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terms must comply with the Insolvency Rules 1986 and creditors vote on the proposals, which must be approved by at least 75% of creditors present in person or by proxy at the meeting. They can be challenged in the 28-day period following. It is not only landlords and property owners who have been put out by the practice. Focus DIY is one of the latest retailers to make use of the procedure to offload non-trading stores—38 in its case—and set itself on a firmer financial footing by moving from quarterly to monthly rents. Focus told creditors this was necessary if its banks were to renew its two-year revolving credit facility. However, Kingfisher, owner of rival DIY chain B&Q, was furious and Kingfisher group chief executive Ian Cheshire wrote to those landlords the retailer shares with Focus demanding similar concessions as a result of the CVA.

Unwanted stores B&Q itself has 15 to 20 unwanted stores, and Cheshire points out: “I think CVAs and pre-packs are an example of where a good idea has ended up getting turned into a way of being able to dump the bits of the business you don’t want, having left a bunch of creditors behind. “The problem is, you end up with a completely uneven playing field. The strong are effectively crosssubsidising the weak,”he claims. Property industry chiefs including Westfield’s Peter Miller have also slammed CVAs and rumoured plans to introduce US-style Chapter 11 bankruptcy protection to the UK. Miller believes that CVAs “set a very negative precedent for the market”. Even so, not everyone is against CVAs and sports retailer JJB Sports is held as a model example of when they do work. JJB’s sales had plummeted, continued support from its banks was

in jeopardy and its chief executive had left, embroiled in scandal. The CVA gave the retailer a new lease of life, allowing it to reduce its oversized store portfolio, save jobs and ultimately secure new funding. Without the CVA—which allowed JJB to rid itself of the £17.3m burden of 140 non-trading stores—it would have collapsed. JJB went on a roadshow to see its top 15 landlords. The retailer explained its position, gauged opinion on a CVA and won overwhelming creditors’ support. Land Securities commercial director Ronan Faherty commends JJB’s “open and honest approach”, but adds: “Retailers negotiate deals and make the decisions to go into those properties. Then they decide that all of a sudden the terms are unacceptable.” “A lot of it is how the deal comes to market,” says Davies Arnold Cooper (DAC) partner Ken Smith.“JJB met with its landlords and creditors with a clear plan to move the business forward and with a strategy which shared the pain among the interested partners. I think landlords were able to step back and consider it as a fair proposition that also gave them a fair chance of keeping JJB going, even if that meant losing some stores and reducing rents.” Smith points out that, in the current climate, accepting such a deal may be more preferable for a shopping centre owner than holding on to a void—especially in malls struggling with empty space—or being forced to offer significant rentfree periods to new retailers. Liz Peace, chief executive of the British Property Federation (BPF), adds: “In all the CVAs we have seen, the driver behind them has been the banks who have demanded that the retailers shed under-performing stores if they wish to continue. However, what this means is that CVAs will only

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be a way of maximising someone’s investment rather than be a fair way of sharing the pain.” Peace warns that while the banks funding the retailer may get their money back, those funds invested in the properties from which they operate are unlikely to be so lucky. Citing yet another CVA case, that of upscale fashion mini-chain Flannels, she points out: “While this CVA has been transparent and covered landlords’ empty rates payments on closed stores, it has not taken any bite out of shareholders’or other creditors’pockets. Landlords have borne all the pain, and, when you consider that many of our pension funds are invested with them, it is clear that this is not fair.”

New challenges Land Securities is challenging a restaurant operator in one of two potentially landmark insolvency cases heading towards the courts. In the Land Securities case, all-you-can-eat buffet chain Water Margin carried out a pre-pack administration in the autumn. The new phoenix company hopes to continue to trade in its three restaurants by taking assignment of their leases. However, at the highly successful Gunwharf Quays in Portsmouth, landlord Land Securities has challenged a request to assign the lease to the new company and the case is due to be heard early in 2010. It is thought to want to forfeit the lease—even with the loss of the rent arrears due—and re-let the unit to a new operator. To forfeit, it needs the approval of the courts. Guy Hollander, an insolvency practitioner at administrator Mazars, says: “In most cases, landlords do agree to the new company assigning the lease of the old company in administration. However, in all cases, to assign a lease the administrator needs the consent of the landlord.”

Real Estate UK RETAIL: CVAs ALARM INSTITUTIONAL INVESTORS

Land Securities’ decision is a sign of an improving lettings market but this is still the case only for prime locations, and landlords in more secondary locations may not feel so bullish. The second test case centres on fashion retailer Miss Sixty. This is the first major challenge after the doomed CVA attempt by Powerhouse, the electrical chain, some two years ago. It is attempting to exit three leases as part of a CVA agreed in April but landlord Mourant, which is being represented by DAC, has challenged a lease which had a parent company guarantee. The outcome will have an impact on how easily retailers can exit leases if they go into some form of administration, especially where leases have a guarantor. Similarly, the most notable CVA failure has been footwear retailer Stylo, which was not supported, it would seem, because the retailer attempted to “renegotiate unrealistic terms,” says Faherty. Smith concurs. He believes that landlords and mall owners saw the proposed deal as too one-sided and could not see enough benefit in it for them. “There have been cases where agents and representatives just present the deal to landlords without any liaison. It is not the way forward,”he says. Richard Fleming, partner at KPMG’s corporate recovery practice, worked on JJB’s CVA. He believes CVAs represent a fair option for retailers on the brink.“The suggestion that a CVA in some way gives an underperforming business a competitive advantage is factually incorrect. A CVA gives all stakeholders the opportunity to discuss the best compromise in an open and collaborative manner,” he says. “By contrast, a company that goes into administration leaves landlords and trade creditors in a

Kingfisher Group chief executive Ian Cheshire points out: “I think CVAs and pre-packs are an example of where a good idea has ended up getting turned into a way of being able to dump the bits of the business you don’t want, having left a bunch of creditors behind. The problem is, you end up with a completely uneven playing field. The strong are effectively crosssubsidising the weak,” he claims. Photograph kindly supplied by Kingfisher Group, December 2009.

worse position, with this group having little say in the process.” However, the BPF has dismissed plans to introduce American-style Chapter 11 bankruptcy protection for UK firms as “misguided” because the British legal system is, the BPF counters, not geared up to oversee it. The Insolvency Service is consulting at present, looking at the way CVAs and pre-packs are run. The government is specifically looking at giving moratorium powers of protection to large companies during the CVA process, without them having to apply for an administration order as they do at the moment. Only small companies have that benefit now. In the US, Chapter 11 protects businesses from their creditors under the supervision of a court.The idea is to allow a company to restructure, protecting jobs and the value of business assets. The process has allowed many big US firms to maintain their market position despite a failing business while new financing is found. “Some of it is psychological,” adds Smith.“In the US there is more society acceptance that entrepreneurs will take risks and consequently will sometimes fail. In the UK there is still a stigma, a sense that it doesn’t feel quite right.”

Ian Fletcher, BPF policy director, reflects: “Now is not the best time for reform because emotions are running high and we need to evaluate how the 2002 reforms have performed during the recession. Property companies and competing retailers have had concerns with aspects of the current system, which seems to place undue weight on propping up failing businesses and not enough on the consequences for healthy creditors and competitors.” DTZ head of retail Martyn Chase calls CVAs “an absolute disaster for the industry”. He believes they are a “blatant abuse in terms of the retailers getting off the hook in terms of their property commitments”. He says: “The Stylo Barrett one was a classic. They were going to halve the portfolio and the CVA was just a way of walking away from rental obligations. Luckily it got voted down and they had to do the decent thing.” Chase says that the situation in mainland Europe is very different. “European countries look on us in complete wonderment. Abroad, they have to face up to reality, they don’t just get a CVA and walk away from obligations.You either keep trading or you go bust, that’s the reality of life.”

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Country Report KUWAIT: A RETURN TO OPTIMISM

discovery and development T’S BEEN A bruiser of a costs as their leading year for the Kuwaiti business concern, adds the business and banking Dun & Bradstreet survey. segments, though by Responding, Sami alOctober 2009, the economy Rasheed, chairman of began to show signs of Kuwait Gulf Oil Co (KGOC), improvement, driven in part says a number of upgrade by resurgent oil prices. projects have enabled the Kuwait's finance ministry company to raise its oil says the country's budget production capacity to recorded a budget surplus of around 3.13m barrels per KD6.32bn in the first eight day (bpd). More than half of months of its 2009/2010 the capacity comes from the fiscal year on higher than Great Burgan, the world's forecast oil revenue. Revenue second largest oilfield after stood at KD11.17bn at the Saudi Ghawar, whose end of November last year, output capabilities have nearly 138% of the total been raised from 1.5m to revenue budgeted for the 1.7m bpd. whole fiscal year, according Moreover, in midto the ministry’s recently December Kuwait's oil posted figures. minister, Sheikh Ahmad AlOptimism is also reflected Abdullah Al-Sabah, told in higher sales volumes and journalists at the opening of net profits expectations by the Kuwait Oil Expo 2009 the business community that close to KD25bn will be during the fourth quarter of spent on oil sector capitalist 2009, says the Dun & projects, in addition to Bradstreet report. Not quite the worst of times and not quite annual spending on Nonetheless, Kuwaiti the best, sums up the curate’s egg that has maintenance and services. consumers and businesses been the Kuwaiti economy over the last The financial contribution find credit difficult to secure eighteen months. According to the Dun & of the country's private as local banks remain risk Bradstreet South Asia Middle East Ltd’s sector in the plan is averse, evinced by Business Optimism Index, Kuwait’s economy expected to amount to continuing provisions. It’s a is expected to post a growth rate of 3.3% in KD5bn, the minister added. trend that concerns Kuwait's 2010 as compared to earlier estimates of KGOC plans to spend about non-hydrocarbon sector in 2.4% growth. Additionally, the government KD328m (about $1.14bn) particular; with Dun & is spearheading a massive $130bn on oil and gas projects in Bradstreet claiming some infrastructure investment programme that 2010, according to the 44% of non-hydrocarbon encompasses both hydrocarbons and noncompany's managing business units polled in its energy segments. Will that combination be director, Bader al-Khashti. Q4 2009 survey, are worried enough to salve a somewhat bruised The budget allocated for about the availability of banking sector? Francesca Carnevale reports. capital and operational finance; a figure only marginally lower than that polled in recovery. Meanwhile 84% of local projects is about KD1.21bn, to be respondents think oil prices will not spent over the span of the five-year the Q3 2009 survey. Significantly, 54% of the improve significantly in the near term. plan 2009-2013. However, in the At the same time, a substantial 38% immediate term, only KD328m will respondents do not have plans to invest in business expansion despite of the respondents from the be spent on oil and gas projects the sector identified financial year. current signs of global economic hydrocarbon

A RETURN TO OPTIMISM

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The capital goods segment is expected to enjoy something of a revival in the country as part of the government’s efforts to kick start a strong recovery through direct investment projects. As the year closed, the government announced plans to float five tenders for key projects in 2010, as the first step towards the implementation of the government's five-year plan. The total cost of the projects is estimated to be around KD49bn, with Kuwait's private sector reportedly set to play a major role in their implementation. Kuwait's public works ministry is set to present the KD700m Jaber Bridge tender shortly. The tender will last for six months to settle on the qualifiers, while the design and the execution of the project is due to complete in five months. The ministry reportedly has pre-qualified eight groups, each comprising three to four contractors. In a wider, regional context, the Gulf Cooperation Council (GCC) is due to float a public tender for the strategic $25bn GCC joint railway network in the first quarter of the current year. The secretariat general of the council will reportedly assess bidding companies and shortlist the number of potential winners to three or five. The joint GCC 2,117km long rail network will be built according to a timetable to be set by the member states, with the aim of operating it as of 2017. The network is planned to start in Kuwait and Saudi Arabia before construction of the lines linking up Bahrain, Qatar and the UAE. Again in the capital goods segment, in October National Bank of Kuwait (NBK) signed a KD80m ($279m) five year loan agreement with the Kuwaiti Projects Company (KIPCO) to fund company projects. NBK deputy chief executive officer, Shaikha Khalid Al Bahar explains: “This financing is in line with NBK's strategy in Kuwait, which aims at supporting the local

economy and [working] with the most and prominent prestigious corporations in Kuwait, with respect to long-term strategic funding.” Al Bahar adds:“The loan, which matures in July 2014, precedes [a] $500m seven year international bond issue which KIPCO concluded earlier in the month which was the first international bond issue by a private sector corporate in the MENA region this year. Moreover, KIPCO holds almost $1bn in cash with the bulk of its liabilities maturing in the next five and seven years.” The return of the local and regional project market will mark a watershed for Kuwaiti banks, which have been hunkering down through the recession, battered by the impact of high profile defaults, such as that of Investment Dar, which have yet to be fully worked through as restructurings. Although local bank exposure to some of the larger debt defaults is minimal, Kuwaiti banks have nonetheless felt the consequences.

The ratings conundrum Even though traditionally, Kuwaiti banks have demonstrated a structurally strong operating performance, it has not inured them to Spartan market conditions. Their historic strength is derived in some part from the concentration of business among a handful of banks. Kuwait has seven conventional banks and one Islamic bank. Elsewhere, Kuwaiti banks have benefitted from their protected local franchises and efforts to introduce day to day efficiencies. The sector’s performance is boosted however, by gains made through proprietary investments, and for some banks by the government’s capacity to support the Kuwaiti banking system if and when required. Even so, though through the recent crisis, while the government made substantial funds

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available, few Kuwaiti banks have dipped meaningfully into state coffers. Moreover, most, including NBK and KFH have reported substantive third quarter profits in 2009. It came as something of a surprise therefore when Standard & Poor's Ratings Services announced in midDecember 2009 that it revised its Banking Industry Country Risk Assessment (BICRA) for Kuwait (AA/Stable/A-1+) to Group 5 from Group 4. At the same time, Standard & Poor's confirmed its 15% to 30% estimate of the potential level of gross problematic assets (GPAs) expressed as a percentage of domestic privatesector credit over the full course of an economic recession in Kuwait. “The BICRA change reflects our view that economic risks in Kuwait have increased,” wrote the ratings agency, highlighting “especially those banks that are vulnerable to price volatility in the real estate (including commercial properties and offices) and equity markets. The Kuwaiti economy's limited diversification led to rapid growth of banks' credit facilities during the oil boom years, until mid-2008, with a notable concentration in loans to local property companies and investment companies—the latter, owing to their involvement in the real estate and equity markets.” Even so, notes Standard & Poor’s: “strong ongoing funding support from the Kuwaiti authorities and customer deposits from Kuwait's public sector entities have, at least temporarily, helped alleviate pressure on the availability and cost of funding. Nevertheless, we anticipate that the banks will eventually have to reduce current mismatches in their balance sheet, lengthen the maturity of their liabilities, and prepare for a reduction in the availability of government funding.”

Country Report KUWAIT: A RETURN TO OPTIMISM

KUWAITI BANKS LOOK OVERSEAS FOR GROWTH One of the strengths of the Kuwaiti banking sector, the high concentration of business in the hands of a few leading banks, is also its weakness. Inevitably then, Kuwaiti banks have been keen to expand overseas to grow new business. Three new initiatives took place as 2009 drew to a close. ational Bank of Kuwait (NBK) subsidiary, Al Watany Bank of Egypt (AWB), which opened a new branch at Sharm El Sheikh. The new Sharm El Sheikh office is the 36th branch for the AWB network in Egypt. The new office reflects NBK’s commitment to a wider MENA regional expansion strategy and in particular reflects NBK’s increasing interest in the growing Egyptian banking sector. NBK believes that the Egyptian economy will continue its strong growth over the long term, according to NBK deputy chief executive officer & AWB chairman Shaikha Al Bahar. Al Bahar says that the new full-service branch has been designed to accommodate greatest possible number of visitors, staffed with AWB’s “bankers and equipped with the latest banking services to better serve our increasing number of customers.” Islamic financing specialist Kuwait Finance House (KFH) has meantime expanded its international real estate portfolio, recently signing a direct residential real estate investment deal in Chicago with a total cost of $242m. The compound, in Michigan Street, includes 40 floors and more than 80 flats. Despite the fact that the project is currently under construction and will be ready by the end of 2011, more than 40% of it was marketed, says a KFH spokesman. The International Real Estate Department Manager Ali AlGhannam says that KFH owns 95% of the project, while Prism Company for real estate development owns the remaining 5%. Ritz Carlton, will be the

operator manager of the project, and that this investment comes as part of KFH’s strategy in investing in real economic projects, in addition to expanding and diversifying its fields of work, which guarantees best returns with minimal risks, and benefiting from its success in the United States through its Dana Real Estate Fund that has been operated in US since the early 1990s. Bader Abdul-Muhsen Al-Mukhaizeem, chairman and managing director of KFH explains that the bank has recently obtained a business license in Germany and intends to open its first branch there shortly. KFH has increased its branches in the Malaysian market for Islamic finance services. Closer to home, Kuwait Turkish Participation Bank (Dubai) says it has received a licence from the Dubai Financial Services Authority (DFSA) to operate out of the Dubai International Financial Centre. Kuwait Finance House is a majority shareholder of the bank, while other shareholders include General Directorate of Foundations (Turkey), Public Institution for Social Security (Kuwait) and Islamic Development Bank. The move outlines the continuing importance of the GCC zone to its member states, particularly as currency union takes shape.

Photograph © Appler/Dreamstime.com, supplied December 2009.

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

Index Review THE UK GOVERNMENT’S MANANA SYNDROME

LET THEM EAT CAKE! At the end of October, I hypothesised a previously undescribed political landscape where the UK’s two leading political parties could try to outdo each other on whose policies proposed the most uncomfortable ‘hair shirt’ for both tax payers and the public sector. It would have raised the possibility of the next election being fought on the grounds of who is the meanest ‘hood on the block’. After the publication of the UK’s pre-budget report. That looks increasingly unlikely. What now? Simon Denham, managing director of spread betting firm Capital Spreads, takes the bearish view. S UK CHANCELLOR Alistair Darling ducked and pushed budget cuts into the back end of 2010, he appears to have ignored the precedent set by Ireland’s emergency budget, which had been announced the day before his own. Ireland’s finance minister had announced a sharp axe to the public purse (involving actual pay cuts ranging from 5% to 15% for public sector employees). Arguably Ireland’s economic circumstance is worse than the UK’s; but the principle is sound. The chancellor should perhaps take note. Oddly enough, the UK’s gargantuan budget deficit might not do too much damage to the FTSE 350, as an absolute number. Over 60% of the revenue of its constituent parts come from overseas business. Moreover, as long as corporation tax levels remain sacrosanct, margins could remain buoyant. Equity markets may also gain traction from a falling pound, as revenue is earned in stronger currencies and costs paid in a weakening one. This does not necessarily mean that the ‘global’ basket value of UK equities will remain stable as the conversion into euros, yen or dollars will be impacted by the falling pound. The reduction in purchasing power of UK plc and its population will be a burden for years to come, on top of an expanding government debt pile. While in theory,

exports should gain, there’s precious little evidence of this to date, even with an already weakened sterling. In fact, the weakening industrial production numbers of recent months indicate the reverse is occurring. Therefore, the pressure from the twin fiscal deficits will almost certainly fall on the debt markets and sterling where values are inextricably linked. Sterling bond markets (corporate and gilt) were already anxiously watching the Bank of England’s quantative easing. Right now, prices are still high because the Treasury continues to buy in a range of maturities and no-one is looking to aggressively short—just yet (and just in case the programme is increased one more time, forcing an expensive buy back). However, the omen’s aren’t good. The Treasury will at some point not only stop buying; but more disastrously, it will have to start selling all of its expensively purchased assets. This commentator will not be surprised if it loses up to 20p in the pound on the longer dated issuance. It is at this point that the true problems for the UK may well surface. Long dated debt (ten years and more) is currently yielding around 3.8% even though inflation is dormant and base rates are at just 0.5% (giving a three month to 10 year yield gap of 3.3%). The government has a shortfall in 2009 of £180bn, the

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

same next year and by the end of January will have bought some £200bn of debt to keep the financial sector fluid. If the pound starts to crumble inflation (long dormant) will be in danger of reigniting and, anyway, the yield curve may possibly start to resemble a mountain side. The cost of funding the UK’s various deficits would then soar, requiring action of the type currently being implemented by the Irish. The cost to the UK of the 12-year New Labour project is only now beginning to surface, but the real problem will be if the current administration manages to keep the situation out of the consciousness of the electorate before the polls next year.There is a strong chance that there will be a hung parliament as the Tories (themselves not exactly an encouraging mob) are nowhere near in sight of a clear election win. How can they be, when their opposition to the government has been so ambivalent. The consequences if the market begins to suspect another Labour administration or (even worse) an inert, cobbled-together Tory/Liberal Democrat pact may be fearsome. Confidence in the ability of either to make the serious (and deeply unpopular) decisions that will be required may well start to fade and sterling and the UK debt market will probably suffer accordingly. It is not a happy prospect. As ever ladies and gentlemen ‘place your bets’.

Commodity Report GOLD STILL THE HOT FAVOURITE

Oil will remain another market favourite. Analysts expect crude to trend higher rather than spike because fundamental demand has not yet returned. There is still a lot of oil stored around the world but this excess stock will be vacuumed up by the market once demand increases, which is expected to take place in the second half of 2010. Photograph © Ilterriorm/Dreamstime.com, supplied December 2009

OILING THE WHEEL OF GROWTH As the global economy improves and the siege mentality in the financial markets turns into, at times, over-optimistic exuberance, other instruments in commodities are also receiving more interest. The growth of exchange traded commodities is slowing down but the overall trend of growth is continuing. Commodity investors are becoming increasingly sophisticated and while there is currently plenty of interest in beta type investments such as index funds, investors are expected to employ more alpha strategies—investments in spreads and swaps—this year. At the same time, because of a better understanding of commodities, there are fewer large arbitrage opportunities on the scale that has been seen in the past. By Vanya Dragomanovich OMMODITIES HAVE PERFORMED exceedingly well in the past 12 months. Copper rose 130% on the year, while aluminium rallied ‘only’ 44%; the kind of return that would have had investors whooping with joy in a normal year. If the question is can commodities repeat this kind of performance next year, for most of them the answer is not to the same

degree, but then neither will other assets that rallied on a comparable level in 2009, such as emerging market equities. If the question though is: are they likely to continue rising? The answer is definitely yes. The biggest driver behind the recovery of commodities had less to do with genuine demand than with the easy availability of cash provided by central banks. The world economy,

though improving, is far from being back in full growth mode, which is the pre-requisite for a fundamental improvement in demand for oils, metals and agricultural commodities. A clear sign that demand is not back yet is the fact that exchange warehouses are full of metal and one in 12 of the world’s crude oil tankers are being used to store oil rather than move it from place to place. However, because the central banks have made money easily available, speculators can borrow short-term dollars at nearzero interest rates and buy assets that provide much higher returns. This trend will change slowly. Central banks will start tightening the supply of money but they will be keen to do it in baby steps to avoid disrupting the markets. Here are the first signs: the New York Federal Reserve carried out a small reverse repurchase agreement transaction in

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

Given the high early December to test amount of financial how the market would products linked to these respond to the withdrawal indices and managed of liquidity. At the same products closely tracking time, European Central these benchmarks, the Bank president Jeanrebalancing can have a Claude Trichet proposed a significant impact on package of decisions to individual commodities. tighten up liquidity. The Comex copper stands to markets took both in their be the most affected by stride, signalling that the trade as the expected investors will stick to their net sale corresponds to newly regained appetite for riskier investments. There could be a soft patch for gold in the middle of 2010 when the dollar is almost 20% of current “Commodities seem to expected to rebound but any drop towards $1,000 will likely be bought into open interest. Zinc, be able to do no wrong at by investors. Merrill Lynch expects that gold prices will move above natural gas, wheat and present. There is a wall of $1,500/oz particularly as emerging market central banks increase their corn could also see money coming in and we allocation into the commodity. Photograph © Krot2/Dreamstime.com, significant price moves. Jennie Byun of don’t expect that to supplied December 2009. JPMorgan estimates that change. The dollar is currently a carry trade, it is a no brainer. say it is probably closer to between the re-weighting of the S&P GSCI and DJ-UBS indices could result in the You can borrow dollars and invest in $150bn and $170bn. January will be particularly active sale of roughly 19,000 of Comex commodities,” says Robin Bhar, metals for index investors as the two copper March 2010 contracts, the commodities analyst at Calyon. “What we have seen this year is that commodity indices undertake the selling of 8,000 LME zinc March 2010 rebalancing of their futures and the buying of around when there has been a fair amount of annual selling in metals it was quickly commodities baskets. The rebalancing 35,000 of March 2010 natural gas absorbed. You had such a situation of the S&P GCSI has typically less of futures. She notes that these estimates with nickel and zinc and the metals an impact on the market because the are based on prices as of December were eagerly bought. The market is index bases the weight of individual 1st and that the actual numbers will bullish bordering on rampant,” adds commodities on the last five years of change based on price levels during Bhar.The non-speculative logic behind production and those levels change the January rebalancing. Although the new weights had commodity investment is that they can only by a small percentage from year be used for diversification, as a hedge to year. The DJ-UBS index, however, been announced in November, the bases the weight of each commodity actual rebalancing will happen against inflation and a weaker dollar. For passive investors such as large on the price on the fourth business between January 8th and 14th. Byun pension funds and insurance funds, day in January which means that the notes that in past years, the market commodity index investment remains composition of the index can vary has witnessed some pre-rolling of positions and bilateral swap one of the preferred options. Although significantly from year to year. returns are typically lower from commodity-based indices and baskets than from individual commodities, the For passive investors such as large pension funds and risk involved is also lower than being insurance funds, commodity index investment remains one exposed to a single commodity of the preferred options. Although returns are typically market. Merrill Lynch estimates that lower from commodity-based indices and baskets than from total investment value allocated to two of the main commodity indices— individual commodities, the risk involved is also lower than the DJ-UBS Commodity Index and being exposed to a single commodity market. the S&P GSCI Commodity Index—is more than $120bn but some analysts `

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

Commodity Report GOLD STILL THE HOT FAVOURITE

agreements as investors prepared for the move. Institutional funds are more likely to buy S&P GSCI index swaps than the actual underlying commodity futures, leaving the risk management to commodity market makers. As the global economy improves and the siege mentality in the financial markets turns into, at times, overoptimistic exuberance, other instruments in commodities are also receiving more interest. The growth of exchange traded commodities is slowing down but the overall trend of growth is continuing. Commodity investors are becoming increasingly sophisticated and while there is currently plenty of interest in beta type investments such as index funds, investors are expected to employ more alpha strategies—investments in spreads and swaps—this year. At the same time, because of a better understanding of commodities, there are fewer large arbitrage opportunities on the scale that has been seen in the past. This leaves the question: which commodity to invest in? With inflation issues and the question mark over the strength, or the lack thereof, of the dollar, gold continues to be a hot favourite as a form of alternative currency. Throughout December gold was hitting record highs and this trend is likely to continue until the second and third quarter of 2010. The continued weakness in real interest rates—the yield on the 10-year US inflationlinked bond remains under 1.5%—will continue to provide strong support to gold prices over the medium term. Analysts forecast prices to average anywhere between $1,300 an ounce and $2,000/oz throughout this year although most agree that once inflationary and economic pressures ease gold is likely to come back to a level closer to $1,000/oz, possibly in late 2011 and 2012. Daniel Sacks, co-portfolio manager of the Investec Global Gold Fund, says

that gold has finally broken clear of the $700/oz–$1,000/oz range that has dominated the last two years and that the level of investment demand will force a peak that is nearer $1,300/oz over the next six months, with $1,000/oz now becoming the long-term floor. There could be a soft patch for gold in the middle of 2010 when the dollar is expected to rebound but any drop towards $1,000 will likely be bought into by investors. Merrill Lynch expects that gold prices will move above $1,500/oz particularly as emerging market central banks increase their allocation into the commodity. Oil will remain another market favourite. Analysts expect crude to trend higher rather than spike because fundamental demand has not yet returned. There is still a lot of oil stored around the world but this excess stock will be vacuumed up by the market once demand increases, which is expected to take place in the second half of 2010. BNP Paribas’ analyst Harry Tchilinguirian expects the oil price to average $81 a barrel this year.“Oil will most likely trade within a wide band over the next six months, checked on the upside by bearish short-term fundamentals, but finding a support above a fundamental equilibrium level as liquidity remains loose. Our 2010 view retains a strong second half,” Tchilinguirian notes. Base metals will also continue to do well although some of the most

interesting strategies could be to play one metal against another. For example, Société Générale suggests selling three month aluminium and buying three month lead.“We anticipate that the lead market will move into deficit next year as constrained supply fails to keep pace with growing Chinese demand,” the bank said. In contrast, aluminium fundamentals remain poor with massive oversupply continuing and warehouse stocks at record highs. Copper might correct lower in January because of the rebalancing of the commodities indices and because it rose sharply in the fourth quarter of last year but the increase in demand expected from emerging markets in the latter part of 2010 will continue to support prices. In contrast, soybeans, which rallied 50% since the beginning of 2009, are heading for a serious correction as major producers Argentina and Brazil are set to harvest record amounts this year.“This rally looks set to change in 2010 with a burdensome balance sheet looming for the global soybean market, which should see a 12% fall in average price levels and the lowest average prices in three seasons,” say Luke Chandler and Dough Whitehead of Rabobank. The speculative money is likely to stay with commodities this year. The fact that the global economy is set to rise by between 3% and 4% in 2010 will provide a good backdrop for investing in the complex.

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

TO AVOID ‘FATAL ERRORS’

Photograph © Prawny/Dreamstime.com, supplied December 2009.

America’s five biggest publicly held insurance brokers are struggling with two problems: a weak economy and a benign loss environment. The former hurts as brokerage customers shrink or even disappear. The latter encourages insurance companies to continually reduce their rates and thus broker commissions. Relief may be years away, reports Art Detman. IRTUALLY EVERYONE IN the insurance brokerage business would agree with this warning from Gregory C Case: “Misunderstanding risk can be a fatal mistake.”Case, president and chief executive officer of Aon Corporation, the world’s largest insurance brokerage firm in terms of commission revenues, is a former McKinsey partner who brought a management consultant’s sensibility with him when he joined Aon in 2005. He cites a McKinsey study that said the true economic impact on a company of a major catastrophe can be nearly 12 times the actual dollar

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

cost of the event itself, once factors such as reduced market capitalisation become evident. What’s more, says Case, the magnitude and complexity of risk are going up. Here again he would find virtually unanimous agreement throughout the brokerage business. Joseph Plumeri, head of Willis Group Holdings, notes that owners of companies face risks today that essentially didn’t exist when they were children. For all that, there is little evidence business executives are particularly focused on insurable risks these days (please refer to the box: Ten threats to worry about on page 56). In one important sense, they can hardly be blamed. If prices are a signalling mechanism, the prices of property and liability insurance almost shout that there is little to worry about. Over the past three years, rates have fallen between 10% and 20%, depending on the type of coverage. In 2009, rates were down 5%. Because a brokerage firm’s commissions are based on the gross premiums it generates for insurance companies, this means that most brokerage

US INSURANCE BROKERS BATTLE TWO MAJOR SNAGS

BIG FIVE AIMING

US INSURANCE BROKERS BATTLE TWO MAJOR SNAGS

firms have suffered from declining commissions, once the effect of same-year acquisitions is removed. As a consequence, the 2009 financial results of the leading publicly-traded brokers will be mostly lacklustre (please refer to box: America’s Big Five publicly held insurance brokers). Third-quarter results well illustrated the bind that the brokerage business finds itself in. The two largest brokers— Aon and Marsh—suffered declines in organic growth (net of newly acquired business) of 3% and 2% respectively.The two smallest brokers suffered most; Gallagher was down 5.5% and Brown was down 5.2%. Only Willis, much larger than either, and with a big book of overseas business, was able to show organic growth, up 4%.“Because Aon, Marsh and Willis are global, they have benefited from stronger growth in certain emerging economies, especially some countries in Asia and South America,” says Mark Lane, an analyst at William Blair & Company.“While they’re not huge businesses for any of these companies, they are growing at much faster rates, which has mitigated some of the weakness in developed markets, particularly the US and Europe,”he adds. Most of the brokers also have profitable consulting operations, primarily in employee benefits. Marsh, in fact, derives roughly half of its revenues from outside the brokerage arena, mainly from its Mercer, Oliver Wyman Group and Kroll subsidiaries. Marsh even owns a design firm that creates corporate logos and packaging. Aon, too, has major consulting practices in such areas as employee benefits, compensation and communications. At Gallagher and Brown, fee-based consulting is restricted almost entirely to employee benefits. The rationale for consulting is that it provides a steady source of fee income. However, as client companies have downsized and economised, even employee benefit consulting has been hurt, and many other consulting practices have been severely impacted. Lane says: “The consulting business is more economically sensitive than insurance and, in many instances, it is a discretionary expense.” One broker definitely against consulting is Willis. Chief executive officer Plumeri says: “I think consultation is part of the process of getting to the transaction, of selling the insurance policy. So why have a separate consulting operation when you should be consulting and advising as part of the process to making the ultimate transaction in a way that the transaction makes sense?” Until just a year or so ago, common wisdom was that the economy didn’t much affect insurance revenues. After all, good times or bad, companies needed to be insured against a variety of risks, ranging from fires and floods to theft and libel. The recession put the lie to that thinking. As companies

outsourced work, closed facilities, laid off employees and shrank inventories, there was less to insure. In addition, many companies simply went out of business and some of the survivors even reduced their coverage below prudent levels. Meanwhile, the loss experiences of carriers continued to decline from the fearful days of the September 11th attacks in 2001. Even Hurricane Katrina—the single biggest insurance loss ever, according to Mark Shields of Stifel Nicolaus—didn’t change the downward trend in losses. “Insurance is a backward product,” says Shields.“Typically, you sell the insurance years before you pay any claim. Because of that you tend to have a little more competition than you should have, because it is not difficult for an aggressive insurance company to justify to itself the charging of a little lower rate than the guy down the street. As long as that is the case, you will see rate competition and a focus on premium volume that ultimately is not helpful.” Are rates already unrealistically low?“Only time will tell,” says Cory T Walker, treasurer and chief financial officer of Brown & Brown.“For 2009, their combined loss ratios look like they could be slightly better than the prior year.”Plumeri of Willis is likewise unwilling to publicly condemn the price competition:“We’re in the business of not only analysing risk but getting the best possible price for our clients.”However, he worries that a few major catastrophes could deplete the carriers’ reserves: “Then the rates spiral up, and the result may be that some of our client can’t afford those rates.” The US economy appears to be recovering only slowly and the insurance companies—thanks to the strong rebound in the stock market last year—appear to be well capitalised. In other words, the outlook for the Big Five over the next few years is for only slow growth, and most of that will likely come from acquiring smaller firms. The double whammy of a weak economy and falling rates has hurt not only the brokerage firms’ bottom lines but their ability to grow through acquisition.“We make acquisitions as part of our business, just like selling insurance,” says Walker of Brown & Brown, itself perhaps the industry’s best example of the importance of growth through acquisition. The firm was started by Adrian Brown in 1939 in Florida. It was closely held and indistinguishable from the thousands of other small agencies and brokers across the country. In 1961 Adrian sold his business, which had roughly $61,000 in commission revenues, to his son, J Hyatt Brown. Over the next 48 years, the younger Brown built the firm into a billion dollar, publicly traded company. In fact, it went public through a 1993 acquisition, when it combined with Poe & Associates, a publicly traded company. Even

America’s Big Five publicly held insurance brokers Company

Ticker

Headquarters

Revenues1

Change2

Market Cap3

Aon Corp Arthur J Gallagher Brown & Brown Marsh & McLennan Willis Group Holdings

AON AJG BRO MMC WSH

Chicago Itasca IL Daytona Beach FL New York London, New York

$7.552bn $1.718bn $978m $10.373bn $3.259bn

–1.0% +4.4% +0.1% –9.9% +15.0%

$ 10.37bn $2.26bn $2.55bn $ 11.41bn $4.47bn

1/Stifel Nicolaus estimates; 2/Includes acquisitions made during year; 3/ December 10th; Source: Data compiled from various broker reports Dec 2009.

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

though Poe had $52m in revenues to Brown’s $36m, Hyatt was able to get five of the board’s nine seats for his people. The resulting company, Poe & Brown, became Brown & Brown in 1998. Last July, Hyatt turned over the reins to his son, J Powell Brown. Brown & Brown has made more than 330 acquisitions since 1992 but only six in 2009, reflecting a widespread reluctance of owners of small brokers to sell into a weak market. Probably no more than 125 acquisitions were made during the year throughout the industry, down by half from 2008 and far below the blistering pace of the late 1990s.“Aon and Marsh were almost tit for tat in making large acquisitions,”says Regis Coccia, editor of Business Insurance. Gregory C Case, president and chief executive officer of Aon Corporation, the world’s largest “Between them, they were snapping insurance brokerage firm in terms of commission revenues, is a former McKinsey partner who up a lot of significant players. Aon brought a management consultant’s sensibility with him when he joined Aon in 2005. He cites a alone had probably 400 acquisitions McKinsey study that said the true economic impact on a company of a major catastrophe can be in the past 20 years or so.” nearly 12 times the actual dollar cost of the event itself, once factors such as reduced market Although the pace of acquisitions capitalisation become evident. Photograph kindly supplied by Aon, December 2009. has slowed, some important deals have taken place in the past year or two. Willis acquired formation of the Marsh & McLennan Agency, which will Hilb Rogal & Hobbs for $2bn, the largest acquisition in the focus strictly on small and mid-sized accounts. Acquiring business during the past decade. Plumeri says his company brokers that serve these companies is the only practical way is concentrating on integrating HRH into its operations to enter the field, and Duperreault says that Aon last year and until that is completed won’t seek additional spent building a pipeline of potential acquisition candidates. Gallagher and Brown are now the brokers most focused acquisitions. In 2008 Aon acquired Benfield Group, a London-based reinsurance broker that is the largest of its on this market, which is intensely relationship oriented. A type in the world. Last year Aon bought ten brokerage single satisfactory claims settlement can cement a clientfirms, including Allied North America, a specialist in broker relationship for years and years. J Patrick Gallagher construction and surety. (Typically, big firms gobble up Jr—grandson of Gallagher’s founder—professes not to be small ones to either fill a geographic area or, as in the case worried. “We’ve been in the acquisition mode for 20-plus years,” says Gallagher, who serves as chairman, president of Allied, an insurance specialty.) Two important transactions were sales, not purchases. In and chief executive officer. He notes that there are 15,000 early 2008 Aon sold its Combined Insurance Company of to 18,000 firms in the country that do personal and America and Sterling Life Insurance Company for nearly commercial insurance.“Most of these firms are run by baby $3bn. These were health and life carriers, so they did not boomers,” he says, which means a wave of owners who compete with the property and liability companies with soon will be ready to sell out and retire. “The nice thing which Aon places insurance. However, as carriers, they about the brokerage business is that the numbers are very were capital intensive and really did not fit within a simple.Very few lines on the profit and loss statement, and very few on the balance sheet. So 99% of our due diligence brokerage operation. Marsh—which has been undergoing a thorough is on the culture. We are very particular about the people rebuilding under its new boss Brian Duperreault, who joined we want to bring aboard.” This sentiment is shared by all the big brokers. Each has in January 2008 as president and chief executive officer in the aftermath of a 2004 bid-rigging scandal—has been cautious a unique corporate culture and seeks principals who would in its acquisition programme. It acquired the balance of fit in well, stay for several years, and earn out their selling DeLima Marsh, a Colombian broker; bought Collins, the price. “It’s not really buying a book of business,” says seventh largest reinsurance brokerage firm in the world, and Brown’s Walker. “It’s attracting high-quality people.” As in September acquired International Advisory Services, the time passes, more and more small brokers are likely to world’s largest independent manager of captive (self- conclude that the high prices of ten and 12 years ago are insurance) companies. Perhaps its most significant unlikely to return. Thanks to lowered expectations, the acquisition programme lies ahead now that it has announced acquisition binge will again resume.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

US INSURANCE BROKERS BATTLE TWO MAJOR SNAGS

TEN THREATS TO WORRY ABOUT Regulation and compliance: “Compliance risk has the potential to damage your reputation, diminish your franchise value, and undermine your competitiveness when it comes to hiring and keeping talent.”

Corporate reputation: “Anyone can start a Facebook group attacking your company and it can become a tipping point before you know it. How many of your companies are actively monitoring blogs and other social media?”

Pandemics: “I hope you’re prepared to protect your business against the impact of a pandemic with a robust continuity plan. Many small and mid-tier businesses don’t [have such plans]—and [these companies are] the lifeblood of our economy.”

Supply chain integrity: “You just have to think of toys, toothpaste or drywall from China to know what I’m talking about here. When they aren’t up to standard because the product safety mechanisms are lacking, the liability may rest with the importing companies.”

Terrorism: “People like to believe that because we’ve not been attacked since 9/11, it won’t happen again. Unfortunately, we are still vulnerable to an attack in this country.”

Piracy on the high seas: “Our experts say it could get much worse in the waters off Somalia. Piracy could spread to Yemen and choke off access to the Suez Canal. Just think of the risk to global trade and the cost of doing business.” Cyber security: “A recent Ernst & Young survey of senior executives found that 75% were concerned about possible IT-related reprisals from departing employees— yet only 26% were doing anything about it.” Globalisation: “The interconnected nature of business … brings great benefits but it’s also a major new risk, [as was] underscored by the financial meltdown. Many economists were surprised by what a house of cards the worldwide financial system had become.”

Cost and availability of credit: “So many businesses … rely on being able to secure credit at a reasonable cost. That certainty has vanished in this marketplace.”

nsurance brokers know just how frustrated Cassandra must have felt. They warn of risks that their customers (worried about fires and lawsuits from discharged employees) hardly acknowledge. In a speech before business people in Los Angeles in December, Joseph Plumeri of Willis Group Holdings described his own Top 10 Risk List.

Climate change: This is Plumeri’s number one risk. To illustrate the possible effects, he tells the story of the winter of 1861-62, when the worst storms in the recorded history of California struck the northern and southern parts of the state just days apart. “Lakes formed in the LA basin and, yes, in the Mojave Desert … Governor Leland Stanford left his home in Sacramento through a second floor window and had to be taken to the [inauguration] ceremony by rowboat … Scientists say another storm like this one … is inevitable. Is everyone here ready for this? No. In fact, most Californians seem to be unaware of this risk.” Indeed—and this is the point made again and again by Plumeri and the chief executive offers at the other brokerage firms— people in general seem unwilling to recognise risks, even when they are pointed out to them. Cassandra should have been in the insurance business.

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

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FUND ADMINISTRATION: ENHANCED SERVICES

Photograph © John247/Dreamstime.com, supplied December 2009.

TAKING ON A

NEW SHAPE While the overall business and regulatory environments have provided more than their fair share of challenges to the fund administration industry, it has responded proactively and positively and come into its own over the last 18 months. It is no bad thing, given that many institutional investment firms have not waited for the ink to dry on the rafts of proposed regulation but have already turned to their administrators requiring a deeper service range. Providers up to now have been more than keen to oblige and have wasted no time in expanding and enhancing their array of products. Lynn Strongin Dodds reports on an industry in transition.

HIBAUD DE MAINTENANT, head of domestic custody services, Asia Pacific at Deutsche Bank, says, “There is no doubt that the asset management industry has gone through one of its most testing times ever. There has been much more scrutiny from investors as well as regulators and fund managers needing to rebuild their portfolios. It is a question of cost and they are leveraging the infrastructure of global custodians for their back- and middle-offices. Fund managers are also looking for third party valuation to help restore investor confidence in their products.” According to Paul Rowady, senior analyst at consultancy TABB Group who co-authored the report, (Hedge) Fund Administration: The Selection Criteria for a New Market

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

Reality, in general, fund administrators are playing a larger role in a fund managers’ operational infrastructure.“It is no longer just about back-office functions dealing with accounting, valuation and share registration, but covers everything after the trade. In fact, the list of services firms cover has become so exhaustive that it is suffice to say that the only things administrators do not cover are fundraising and asset management,”he says. Fund managers are looking more to fund administrators to become an extension to their back and middle office and provide help in addressing the new demands of the market holds Jonathan Bowler, head of business development, BNY Mellon Asset Servicing, noting that “The key areas include transparency, risk management and reporting, operational efficiency, independent valuations for non vanilla products such as private equity funds, hedge funds, funds of hedge funds. We are also seeing clients want to get more involved in the process. We provide the investment analytics tools which allow them to do their own value at risk calculations and back testing.” Clients are also becoming more selective. Susan Ebenston, head of global fund services at JPMorgan Worldwide Securities Services, says, “We are definitely seeing a greater demand for outsourcing but I am not talking about wholesale outsourcing. Clients are looking at the different regulations that are pending and thinking about the support that they will need for their investment funds. What we have seen after the financial crisis, is that fund managers are adopting a hub and spoke approach with core products at the heart and the higher margin products at the edge, depending on a clients’ risk appetite. It is important that administrators have the flexibility and ability to support them as they move into different asset classes and vehicles.” Institutions are also taking the time to review their existing arrangements, according to Hilary Martin, consultant at investment consultancy Investit. “We are at the end of a cycle that started about five to seven years ago when we saw a saturation of outsourcing deals. Fund managers are now looking at their contracts and clarifying whether they received the services and products they signed up to and whether they want to change providers.” It is not just a long only phenomenon. The pressure on hedge funds to show clients that their governance structures are up to scratch is prompting managers to examine what is on offer and with whom. Dermot Butler, chairman of Custom House Fund Services, says, “The Madoff scandal forced investors to conduct more rigorous due diligence and we have definitely seen hedge funds move from self administration to appointing a third party for independent valuation. We have also seen a shift in requests from weekly and monthly reporting to daily reporting and soon I anticipate some clients will want real time reporting.” Ian Headon, senior vice president at Northern Trust, also notes that hedge fund clients are focusing more on the “ability to measure liquidity and counterparty exposures in more granular detail. They want to be able to know how

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

Susan Ebenston, head of global fund services at JPMorgan Worldwide Securities Services, says,“We are definitely seeing a greater demand for outsourcing but I am not talking about wholesale outsourcing. Clients are looking at the different regulations that are pending and thinking about the support that they will need for their investment funds. Photograph kindly supplied by JPMorgan, December 2009.

many assets are exposed to a particular counterparty or strategy.”The firm recently launched a new compliance tool that enables clients to monitor their investments in real time according to their own investment guideline criteria. It looks at the level of portfolio diversification, liquidity risk in the fund, investment strategy and performance attribution.” While the roster of new products may have grown longer since the financial crisis, the main players such as Bank of New York Mellon, JPMorgan Securities Services, BNP Paribas, State Street, Deutsche Bank, Northern Trust, Custom House and GlobeOp Financial Services raised their game a few years ago in response to liability driven investment, new accounting standards and UCITS III. The resulting increase use of derivatives as well as alternative asset classes led to a investor calls for greater transparency, performance measurement, daily reporting as well as increased standardisation and more accurate valuation for OTC instruments as well as illiquid asset classes.

FUND ADMINISTRATION: ENHANCED SERVICES 60

Ian Headon, senior vice president at Northern Trust. Headon says, hedge fund clients are focusing more on the “ability to measure liquidity and counterparty exposures in more granular detail. They want to be able to know how many assets are exposed to a particular counterparty or strategy.”The firm recently launched a new compliance tool that enables clients to monitor their investments in real time according to their own investment guideline criteria. It looks at the level of portfolio diversification, liquidity risk in the fund, investment strategy and performance attribution.” Photograph kindly supplied by Northern Trust, December 2009.

Bill Tomko, managing director and head of operations at Spectrum Global Fund Administration, a Chicago-based hedge-fund and fund-of-funds administrator, says,“I think investors have been driving the changes in fund administration and are ahead of the regulation. The fund industry is definitely gearing up in anticipation of the new rules but independent administrators were already developing many of these services such as independent pricing, reconciliation and daily reporting in response to investor demands.” The collapse of Lehman Brothers investment bank and the Madoff Ponzi-style fraud have only served to accelerate these trends, according to Vernon Barback, president and chief operating officer of GlobeOp. “There is pending regulation but it will take time to be decided and finalised. I believe the financial crisis has forced investors to ask much tougher questions. We have seen an increase in the demand for much more detailed information and risk reporting at the operational and portfolio level. For example, clients want information about construction of the portfolio, the exposures to counterparties investment such as private placements as well independent valuations around the more illiquid asset classes.” As for the regulation itself, there are various drafts at different stages on the table but the fund administration industry is particularly interested in proposals for the

$450trn over the counter (OTC) derivative market, the European Directive on Alternative Investment Fund Managers (AIFM) and UCITS IV. On the first issue, US and European regulators may differ on some of the finer points in their impending regulations but the main focus of their proposals is broadly the same. The thrust is to try to shift as many OTC derivatives as possible onto exchanges, where it is deemed that there is more transparency. Moreover, settlement of OTC derivatives trades is to be processed through clearing houses. For those derivatives that are not centrally cleared, there is likely to be a charge and they must be reported to a trade repository. The result will be that central data repositories, extension of central counterparty (CCP) clearing, contract standardisation, broader authority for the regulators and investor protection through tighter controls on OTC trading eligibility, will take centre stage, says Derek Adler, co-founder and director in charge of business development at the UK-based International Financial Administration Group Ltd (IFINA). The AIFM, on the other hand, says Adler, is very much a work in progress and is not expected to see the light of day before the end of 2011 or even the year after. It was floated as part of a general effort to tighten up regulation of the financial services sector in the wake of the crisis but has caused uproar in many quarters of the financial services industry. In its latest incarnation, Sweden, the holder of the EU’s six-month rotating presidency, recommended removing two of the most contentious aspects of the directive—the leverage cap and the ban on hedge funds domiciled outside the EU, marketing to investors in the region. The one controversial issue that does remain is the article that requires custodians as European depositaries to take on the liability for situations should sub-custodians, to whom they have delegated, fail to deliver securities owned by investors. In other words, according to the proposal, they would have to reimburse a fund’s investors for “any loss of financial instruments” (either the actual securities or the value of the assets lost) unless the custodian can prove that “it could not have avoided the loss.” It is a clause that is too rich for most market practitioners. Most market participants believe this proposal will be diluted because providers would either have to substantially increase their fees to cover the additional liability or they would withdraw from providing the services. Geoff Cook, partner at Brown Brothers Harriman & Co, based in the bank’s Luxembourg office, explains: “There is much nervousness about the AIFMD and the final outcome. There have been major changes since the initial draft in April but nonetheless, there has not been the typical consultative approach with the industry. One consequence we are seeing is a number of hedge fund managers creating products under the UCITS banner- that can’t be the political intention, surely?” Cook also believes that UCITS IV will create further opportunities on the new management company passport front, once of course a number of open tax issues have been

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

resolved. This will enable companies to manage better crossborder fund ranges by not having to appoint service providers in a fund’s domicile, apart from the custodian bank. “It will improve the ability for administrators to record assets on a single technology platform less driven by different jurisdictions. Administrators will be better able to help aggregate data across multiple fund ranges; a particular benefit in reporting on shareholder subscription and redemption activity.” Looking ahead, there is no doubt that fund administrators have their tasks cut out, as they battle with supranational regulators that appear to have only a superficial understanding of the nuances within the complex asset management segment. Gavin Nangle, head of business development at State Street, believes they are more than up for the challenge.“The industry is definitely rising to the challenge and has invested in infrastructure to service more complex instruments. If you look back five to six years, funds might have turned to a specialist provider but today they want the scale and breadth of product offering of a larger player.” William Keunen, director of the Citco Group’s Fund Services division, adds, “The top administrators see fund administration as a core business so the continuously invest in the business to meet the new challenge. Prime examples are derivative processing and pricing capabilities, annual financial and tax reporting capabilities.” Some may not though have the resources to stay in the game according to Philippe Rozental, head of asset servicing at Société Générale Securities Services. “Several boutiques have appeared in the past two years in the valuation areas. However they do not have the global platform and reach to support client requirements today. I believe we will see consolidation in the near future and several niche players will disappear.You need to be able to invest on a continuous basis in the products and resources. For example, on the valuation front, at SGSS we own the process from beginning to end with state-of-the-art IT platform, valuation models and dedicated market data warehouse.” Chris Adams, global product head for alternative funds at BNP Paribas Securities also emphasises the importance of having a uniform approach, regardless of the regulatory climate.“Whether a fund is based in Dublin, Luxembourg or the Caymans, the most important factor to a fund manager is a consistency of approach.You need to comply with local laws but where a fund is domiciled is arbitrary. They want the same level of support and attention to detail.” Fund administrators also have had to become much more bottom line oriented which might explain why some are looking to extract value from their relationship and not necessarily from the higher margin products. In other words, off the shelf products with more style and service instead of a tailored offering are the order of the day. As Sarah-Jane Dennis, consultant, operations and systems at investment management consultancy Investit, puts it, There is no doubt that cost has become a big issue. There has been increasing pressure on asset managers to become more transparent and step up their client servicing, which

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

Geoff Cook, partner at Brown Brothers Harriman & Co, based in the Luxembourg office explains: “There is much nervousness about the AIFMD and the final outcome. There have been major changes since the initial draft in April but nonetheless, there has not been the typical consultative approach with the industry. One consequence we are seeing is a number of hedge fund managers creating products under the UCITS banner- that can’t be the political intention, surely?” Photograph kindly supplied by Brown Brothers Harriman & Co, December 2009.

costs more, at the same time that their assets under management have fallen, leading to a reduction in fees. They may be looking more at their fund administrators for solutions but they don’t want to pay high costs.” Giles Elliott, global product head, securities services at Standard Chartered Bank, adds,“To a certain degree, clients want to expand the list of services but they are also conscious of the cost. It is quite a competitive market and we think one of the best ways to compete is to strengthen the relationship with a select group of key clients.” Ebenston echoes these sentiments. “We have definitely deepened our relationship with our clients in the past two years. We realise that their margins have been squeezed and that they are much more focused on cost. We have a standardised offering which covers about 90% to 95% of a clients’ requirements. We can customise the remaining 5% to 10%, but customisation has a different cost. We are finding that clients are often now deciding that they do not need that extra 5% to 10%.” There are exceptions, of course. Bowler at BNY Mellon, says“In the more complicated OTC and central party worlds clients are prepared to pay to a certain extent. However, they expect the transparency and counterparty exposure reporting as included as part of the standard package.”

SECURITIES SERVICES UPTICK IN BOTH CHINA & INDIA 62

Despite challenges which include tough regulatory restrictions, China and India, with their expanding local markets, are seen as fertile areas for investors from overseas. The governments of both countries see the advantages of foreign investment, and disadvantages, but the potential in the region is pulling in sub-custodians, reports Lynn Strongin Dodds.

DUALHANDED GROWTH T IS EASY to see why China and India are attractive destinations for sub-custodians. The growing interest of overseas investors coupled with burgeoning local markets is a breeding ground for opportunities. Each country, though, has its own challenges and successful firms have to be well versed in the rules and regulations of both to help investors navigate their way. Colin Brooks, the global head of sub-custody and clearing at HSBC Securities Services, says: “There are differences and similarities in both countries, the most common being the foreign institutional investor concept. Investors cannot just enter these markets; they have to go through a stringent process to get approval and this defines the services that we provide.” Giles Elliott, global product head, securities services at Standard Chartered Bank, agrees, adding: “There are definitely challenges investing in both countries. The Chinese and Indian governments recognise the benefits and drawbacks of having foreign investors. One shared main concern is the potential withdrawal of foreign money and the impact that might have on markets. They also do not want to have speculators coming in and, as a result, are careful to examine what the investment remit is.” Despite both countries imposing strict controls, there are major differences in terms of levels of bureaucracy. Obtaining the necessary documentation for foreign banks and investors to operate in India is a far less time consuming and laborious process than in China. In fact it only takes about a week or two to obtain a Foreign Institutional Investor (FII) license from the State Exchange Board of India (SEBI) whereas in China it typically takes

roughly a year or longer to get a Qualified Foreign Institutional Investor (QFII) licence from the State Administration of Foreign Exchange (SAFE). In addition, the Chinese financial markets are more fragmented, with a distinct separation between foreign and domestic investors. The QFII scheme was introduced in 2006 to allow foreign institutions to invest in the A-share market, (denominated and traded in renminbi) under certain foreign exchange flow and disclosure requirements. The total quota that has been granted so far is $30bn, or about 1%, of the A-share market capitalisation. The programme is expected to expand in line with China’s growing standing in the global economic order and there have been reforms in recent months. For example, the government recently raised the maximum sum a single QFII could invest to $1bn from $800m as well as shortened the lock-up period for insurers and pension funds to three months from a year. In addition, it lowered the minimum quota application from $50m to $20m, a move designed to diversify the QFII investor base and encourage smaller long-term asset managers to invest in Chinese stocks. Foreign investors can also invest in the B-share market, which was launched in 1992 and home to Chinese incorporated companies, denominated and traded in US dollars. There are no market entry restrictions except that foreign investors must open an account and obtain an investor code from the central depository. On the domestic front, there is the Qualified Domestic Institutional Investor (QDII) scheme, which made its debut three years ago to allow local investors such as

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SECURITIES SERVICES UPTICK IN BOTH CHINA & INDIA 64

banks, insurance companies, asset management houses and securities firms to invest money into overseas markets. While these institutions can cast their nets wide, the main beneficiary at the moment seems to be the Hong Kong market. Chinese fund managers are most familiar with Hong Kong stocks, and Hshares (Chinese companies incorporated on the mainland but traded on the Hong Kong Exchange) which frequently trade at a discount to their Ashare counterparts. Under the QDII scheme, global custodians have to partner with a local bank because incorporated foreignowned banks are currently not approved to act as a custodian bank to locally-registered funds for both domestic and overseas markets investment. Given the different structures, it is no wonder that, for now, many sub-custodians see more opportunities in India. The country not only has fewer restrictions but also the markets are more liquid and advanced. Its trading system is fully computerised, paperless and has a T+2 settlement system, plus the regulator has raised the level of disclosures, transparency and accountability to global levels. It is also a liquid market due to the increasing size of the domestic mutual fund and industries. It is home to more than 5,000 listed companies, boasts a market capitalisation of more than $1trn, with foreign institutional ownership accounting for around 20%. While the financial crisis took its toll and there was a sharp decline in new FII registrations— a 70% drop from last year— existing FIIs continued to pump in money. As of December 1st, inflows reached $15.27bn, the second-highest total of annual investments since the record $17.66bn in 2007, according to data from SEBI.

Colin Brooks, the global head of sub-custody and clearing at HSBC Securities Services, says: “There are differences and similarities in both countries, the most common being the foreign institutional investor concept. Investors cannot just enter these markets; they have to go through a stringent process to get approval and this defines the services that we provide.” Photograph kindly supplied by HSBC, December 2009.

Andrew Osborne, global head of network management at Northern Trust, also points out: “The Indian markets recognise the sub-custody industry and that is really not the case in China. A QFII pension fund would be less likely to require a local bank to act as custodian than a QFII investment fund, which is more likely to utilise the distribution capabilities and expertise to service the fund.” Photograph kindly supplied by Northern Trust, December 2009.

Kevin Smith, managing director, global network management, BNY Mellon, says: “Indian regulators will continue to work towards enhancing market stability through reforms and guidelines. We see increased focus towards risk management, building the right infrastructure and lowering costs, evidenced through measures such as margin implementation, introducing permanent registration, lowering registration costs, uplifting debt/equity allocation requirements and mandating corporate bonds to be settled through clearing corporations.” Equally as important, subcustodians can set up shop without having to partner with a domestic firm. Andrew Osborne, global head of network management at Northern Trust, also points out: “The Indian markets recognise the subcustody industry and that is really not the case in China. A QFII pension fund would be less likely to require a local bank to act as custodian than a QFII investment fund, which is more likely to utilise the distribution capabilities and expertise to service the fund.” The main exceptions include HSBC and Standard Chartered, both of whom are long established players in the country and region. The products and services for QFII funds in China are the standard range of sub-custody, which includes reporting, securities settlement, cash, clearing and safekeeping of securities, monitoring actions for corporate events and proxy voting. Also on the list are regulatory, portfolio and cash reporting, foreign exchange, compliance and regulatory reporting as well as customised reporting. Brooks of HSBC, which has a 33% market share, servicing 29 out of 88 QFIIs, says: “In China and India, the service provided is not just about your areas of core expertise, such as processing of

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

settlements and corporate action, but the quality of advice our sub-custodian capabilities in India because of the to clients and the relationship with the regulators—they significant amount of inbound investment and are the main differentiators. Clients want to apply or sophistication of investors. We provide the full range of back increase their quotas and our job is to make the process as and middle office services such as safe keeping, settlement painless as possible. We have to ensure that we are and fund accounting as well as services around corporate monitoring their applications and that they are well- actions, foreign exchange and cash management.” Société Générale Securities Services, on the other hand, positioned to obtain their quota in a timely manner.” Elliott agrees, adding: “We see one of our roles as a is in the process of forging a joint venture with State Bank of India to offer a range of market advocator and we work services to foreign and domestic closely with the local regulators investors, including custody, to make them aware of the fund administration and major themes in the transfer agency. The new marketplace. India, though, is a company—SBI SG Custodial much more sophisticated and Services—will be based in developed market. The country Mumbai and be 65%-owned by already has a fast moving the Indian firm and 35% by the derivatives market, a growing French group. securities lending market and Ramy Bourgi, head of an overall broader product emerging markets at the France range. China is far more nascent based group, says: “India has a at this point and I think it will number of foreign banks and we take many years before the decided that the best way to market will see the volumes and service both outbound and breadth of products.” inbound clients was to enter into Thibaud de Maintenant, head a joint venture with a major local of domestic custody services, player such as SBI. For foreign Asia Pacific at Deutsche Bank, funds looking to launch into the echoes these sentiments: “Both country, we intend to offer a countries offer opportunities but broad range of services such as they are at different stages of safekeeping and settlement, development. We offer the same cash management, foreign basic sub-custody services in all exchange, fund administration the 13 countries we cover in and distribution support.” Asia, but in China there is more There are, of course, consultative work to be done. It challenges. Smith notes: “India, is a step by step process between Giles Elliott, global product head, securities services at being a relatively complex the regulator and fund manager Standard Chartered Bank, agrees, adding: “There are market, requires a lot of to facilitate the approval of the definitely challenges investing in both countries. The customisation for clients and quota under the QFII scheme.” Chinese and Indian governments recognise the benefits hence a lot of flexibility at both and drawbacks of having foreign investors. One shared a local and global custodian main concern is the potential withdrawal of foreign money Foreign sub-custodians level. At times this results in and the impact that might have on markets. They also do Not surprisingly, foreign subvery different approaches by custodians have been much not want to have speculators coming in and, as a result, local custodians when more successful in India. Smith are careful to examine what the investment remit is.” transposing market changes, of BNY Mellon, points out: “While serviced by some of the local Indian banks, we have and global custodians and/or foreign investors have to cope seen the sub-custody business in India dominated by several with these differences.” Another hurdle, according to Smith, Osborne and of the largest non-Indian institutions such as Citi, Deutsche Bank, HSBC and Standard Chartered. Although some of the others, is the circular on Irrevocable Payment foreign institutions are also offering sub-custody services for Commitments (IPC) from the Reserve Bank of India (RBI). China, we see the PRC (Peoples Republic of China) firms It requires foreign investors to fund trades before custodians can send a confirmation to the exchange, which clearly very present and active in this area as well.” The reigning firms in India, though, are not complacent may be tantamount to the need to pre-fund. Osborne says: as their competitors such as JP Morgan Securities Services “Sub-custodians could facilitate the process but this may and Société Générale Securities Services are deepening be a massive challenge for international investors as it their footprint. Laurence Bailey, Asia Pacific chief executive would require them to put money into the country in officer of the US-based firm, says:“We decided to build out advance of trading in order to support the process.”

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

LATIN AMERICA ON THE BACK BURNER

Latin custody: low fruit not for the picking? Several Latin American custody markets now look more attractive. Asset bases in individual countries are growing in size and diversity. Can global custodians now take full adavantage of the available opportunities? John Rumsey reports. ARGE GLOBAL CUSTODIANS working in Latin America are not having the best of times. The wider banking crisis has trickled down and affected even healthy custody businesses as parent banks have had to wield the axe across the board. Custodian clients are proving parsimonious, too, as they look to bring down costs that were considered peanuts in the glory days. Custodians admit their clients are putting pressure on them and scrutinising their bills. “Significant pressure on fees is coming both through lower market valuation of

Photograph © Rjmiz/Dreamstime.com, supplied December 2009.

assets and from clients themselves as they look to reduce their cost base in these difficult markets,” admits Drew Douglas, global head of custody at HSBC. Given the squeeze, custodians need to carefully consider whether their core businesses are solid before they make any plans to grow their business in emerging markets. Already, many clients have been unhappy with the service that they have been getting and many are keen to change their custodian. “Many of our clients are extremely unhappy with their custodians.They have not been able to get basic services,” says Stacy Scapino, global director, Mercer Sentinel Group, which advises investors on asset servicing arrangements. She says clients have expressed dissatisfaction in areas such as their service provider’s inability to reconcile positions, pricing and valuing of alternatives, typically less liquid assets; as well as practices in security lending programmes.

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A wave of litigation is further complicating matters for custodians, making future strategic planning fraught with uncertainty and compelling them to increase the level of reserves in case of the unexpected. Events at the global level are clouding the picture for their regional businesses and inducing a caution-aboveall approach. Scapino says that given the lack of clarity surrounding the possible outcome of litigation on each particular institution, she is generally advising her clients to sit tight. Her best guess is that there will be more clarity by the end of 2010 on which institutions have come out the other end most strongly, allowing clients to pick new custodians with more confidence. These global uncertainties are leading to a fortress, battendown-the-hatches mentality and ensuring that what investments there are stay focused on improving existing services to clients, rather than opening up new fronts. The global context means that Latin America is often on the back burner. Returns on investment are under the microscope and Latin America has to compete with more urgent projects such as improving the lousy service provided on over-the-counter (OTC) derivatives, says Scapino. She predicts that the gunpowder will be reserved for alternative investment platforms, which may represent a better return than regional plays.

emphasise foreign direct investment over portfolio flows and has imposed many limitations on equity and fixedincome investment with strict rules covering vehicles for investment, notes Kalavritinos. The positive news is that foreign money has flowed heavily into the markets of Peru and Brazil, which both provided sterling performances last year. That was down largely to more orthodox macro-economic policies than those practiced by Argentina and Venezuela. A decrease in interest rates has helped markets grow as investors seek higher returns. This is particularly marked in Brazil which is enjoying an interbank rate of 8.75%, a single-digit rate for the first time in many years. The Brazilian fund market is already worth $700bn with some $200bn to $300bn in pension funds assets. Moreover, foreign investors already hold some BRL410bn in assets, bonds and equities in Brazil, according to the Brazilian Financial and Capital Markets Association (ANBIMA). Colombia and Mexico lie more in the middle. Colombia is attracting more foreign interest though not at the same furious pace as Brazil and Peru. The Mexican markets continue to interest foreigners because of their size but performance has suffered because of the proximity to the United States and the country’s inability to pursue macroeconomic reforms.

Latin asset growth

Up for grabs?

The gloomy global backdrop for the custody business and the possibility for providers to bolt on complementary businesses comes at a time when a number of markets in Latin America are looking highly attractive. An improved regulatory environment for local funds, as well as more foreign investments heading into emerging markets, means fund managers can now look for more attractive returns. The pattern of market growth is very uneven across the region with individual circumstances dictating how much interest investors have in each country. Some countries have even been going backwards, notes Mike Kalavritinos, managing director at BNY Mellon Asset Servicing in New York. Interest in the equity and debt markets of Argentina, South America’s second largest economy, has ebbed quite substantially, for example, he says. Policies there, including the nationalisation of pension funds last year and the removal of the last Argentine stock from the MSCI Emerging Markets Indices, have accelerated the decline in foreign investor interest and Argentine equity markets are today considered frontier and irrelevant to all but intrepid foreign investors. Equally, Venezuela, which used to be an attractive equity market, has also gone backwards. The privatisations of the early 1990s, including telecoms company CANTV, have been reversed under Hugo Chávez and his extensive nationalisation programme. At the other end of the interest spectrum lies Chile. Long a magnet for foreign money, the government has sought to

Traditionally, custodians in the region have focused on the foreign portion of government funds, typically those of central bank and central securities depositories. These are still the core of custodians’ portfolios although currency and asset bases are undergoing significant diversification, explains Kalavritinos. JPMorgan has been active in pursuing such clients and last year won the mandate tendered by Peru’s Central Securities Depository, Cavali, to provide custody and asset administration services. That win came hot on the heels of the US bank winning the custody business of the Central Securities Depository of El Salvador. “JPMorgan is well positioned to become the securities service partner of choice for Latin America,” says Chris Lynch, head of western hemisphere sales for JPMorgan Securities Company. These funds are very conservatively invested, with very high allocations to fixed-income, Kalavritinos says. The interest rate environment is pushing them to diversify into higher yielding instruments while regulations are allowing them to look overseas, he notes. Government funds are becoming more interesting thanks to wider investment mandates as well. Kalavritinos adds: “We are seeing segmentation of these funds’ portfolios. Regulatory changes that enable them to make more foreign investments are coming at the same time as the decline in interest rates. That is making diversification a necessity not a luxury.”Commodities and corporate bonds are two areas into which such funds are moving, he adds.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

LATIN AMERICA ON THE BACK BURNER

These funds are increasingly diversifying foreign currency holdings. Here, in the backyard of the US, the greenback has held sway of portfolios. The dominance of the US dollar has been eroding with long-term concerns over its store of value. The presence of European and Asian currencies is still small but growing. Kalavritinos is beadily eyeing developments in Brazil. Royalties and taxes from the pre-salt oil discoveries, with estimated reserves between 25bn and 100bn barrels, are destined for a new fund, loosely modelled on Norway’s sovereign petroleum fund. Moreover, Brazil’s sovereign wealth fund, funded by the primary fiscal surplus, may get permission to invest outside the country in 2010, making part of its $8bn assets available for global custodians. Other trends are underpinning the interest of custodians in Latin America. A liberalisation of regulations is increasing the pool of foreign assets in other fund types. The next stage of growth is set to be the battle for these new investors and their assets. Kalavritinos is already working hard to win the global business of pension funds in the region and, in particular, would like to win insurance company business. The custodian is also looking for private client businesses and at independent asset managers that are looking to expand. The strong performance out of the region would usually be triggering a wave of investments by global custodians. With caution as the watchword for most banks, there has been more retrenchment than commitments of new money, however.

Local custody trends One area that continues to prove elusive is securing local custody. The rigidity of regulations and requirements for a bank charter and a physical presence have deterred banks from competing for this business. Regulations usually mean they have to front operations through a local presence, notes Scapino. The need for a physical presence is a particular problem in heavily-regulated Brazil.“Brazilian regulators really promote the domestic business,”says Scapino.“They keep developed countries’ banks at arm’s length and only use them when needed. It’s a very consolidated market and the big family banks are very well connected, making it hard to get in.” Given the general absence of custodians, local Brazilian banks are consolidating in their home market and starting to eye foreign clients. Itaú-Unibanco is vying to become a significant sub-custodian and Bradesco would like to build on its very large, local custody platform to woo foreign clients. Not all foreign banks are waiting for the global environment to improve either. BNP Paribas is already custodian to its own funds and has some foreign clients. It is now keen to set up a business to provide services to other foreigners. Even so, companies that are looking to grow are exceptions rather than the rule and most custodians are not spending substantially to build their presence in the region. The traditional approach to Latin America by banks and custodians has been gung-ho in the good times and they back away as the next crisis hits, an expensive and counter-productive approach. This time round, the opportunity may be missed altogether.

ADVENT AND CETIP In recognition of the growing opportunities for custodians available, private equity giant Advent International bought a 30% stake in CETIP in May last year. CETIP is the leading custodian of OTC derivatives and corporate bonds in Brazil. he value of Advent’s investment could be as high as some BRL360m ($171m), provided CETIP meets certain targets. CETIP is Brazil’s undisputed market leader in custody and settlement activities, with BRL2.6trn ($1trn) assets under custody, an average daily trading volume of over BRL50bn and an average settlement volume of BRL30bn. Growth trends for the fixed-income and OTC derivatives markets in Brazil remain positive as most Brazilian companies operate with an under-leveraged structure. The average net debt-to-EBITDA ratio of approximately 0.7 times in 2008 highlights the potential for increased issuance of corporate fixed-income securities in the medium term.

Cityscape Sao Paulo. Photograph © Satori13/Dreamstime.com, supplied December 2009.

Advent’s plans include broadening the range of offerings, particularly in fixed-income. The potential for growth in the fixed-income markets is enormous, particularly when the very low consumer debt-to-GDP ratios are considered, say managers.

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

Rebuilding the trust of custodial clients, addressing revenue gaps in trading services and securities finance, boosting capital reserves for potential acquisition targets, and shoring up investor confidence: just a few of the items on the to-do list of State Street’s incoming chief executive officer Jay Hooley. From Boston, Dave Simons reports. EARLY EVERY OTHER week, it seems, another group of battle-scarred institutional clients is nipping at the heels of some suspected wrongdoer, seeking retribution. To date, some of the most vocal—and litigious—members of the investment community have been large pension plans that incurred substantial losses on assets held in securities lending pools, short-term collateral funds and other programmes established through custodial agreements. In an atmosphere this tense, nothing is sacred; even the most historically profitable custodial relationships have come under fire since the onset of the financial crisis. Just ask Jay Hooley, president and chief operating officer for Boston-based financial services giant State Street Corporation, who, on March 1st, assumes the mantle of chief executive officer, replacing Ronald Logue, who will stay on as a non-executive chairman until January 1st 2011. For Hooley and fellow State Street executives, 2009 ranks among the most gut-wrenching 12 months in the company’s recent history. Last January State Street’s stock plummeted nearly 60% in a single day—hitting a 13-year low of $14.43—as investors bailed out over fears that the

Jay Hooley, president and chief operating officer for Boston-based financial services giant State Street Corporation. Hooley will assume the mantle of the corporation’s chief executive officer on March 1st 2010. Photograph kindly supplied by State Street, December 2009.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

COVER STORY: STATE STREET, NEW REGIME OR REGIMEN?

A NEW HEAD OF STATE

COVER STORY: STATE STREET, NEW REGIME OR REGIMEN? 70

company would be required to raise additional capital in order to remain in the black. All that changed in May, however, when the bank passed the US treasury’s stress test with style, earning the highest tier-1 capital ratio (at more than 15%), and sending shares of State Street soaring to near $50. However, like other global financial companies, State Street was forced to spend much of the year defending itself against accusations of custodial mismanagement from an array of tempestuous institutional clients. In November, State Street announced it would pay $89.75m to settle a class-action lawsuit filed by a consortium of employee benefit plans that had invested in fixed-income strategies managed by State Street’s Global Advisors unit (SSgA). Also, in one of the most eyebrow-raising stories of the year, in October, State Street was named in a lawsuit filed by California attorney general Jerry Brown on behalf of the country’s two largest pension funds, California Public Employees’ Retirement System (CalPERS) and California State Teachers Retirement System (CalSTRS), claiming massive fee overcharges on foreign currency trades dating back to 2001. Unsealed the same day as State Street’s thirdquarter (Q3) earnings announcement, the CalPERS suit, along with a guarded Q4 outlook, helped shave more than 20% off State Street’s share price by year’s end. From his perch high above downtown Boston’s Lincoln Street, the affable Hooley remains philosophical about such sensitive subjects. “Unfortunately, the CalPERS incident is a sign of the times,”shrugs the 23-year company veteran who has served as State Street’s second in command since April 2008.“Being associated with a major bank has taken on a whole new meaning—it is now fair game to criticise financial institutions, and there are a lot of things that have become highly politicised. Partially as a result of our earlier Troubled Asset Relief Programme (TARP) involvement, lately it seems that we have been lumped in with the investment banks and large universal banks. In reality, we are a very different, specialised kind of institution. We have always placed a tremendous emphasis on our long-term client relationships and, as we have done in the past, I think we need to address these issues headon in order to maintain the faith that our customers have placed in us. During any given year, approximately 70% of our incremental revenue comes from our existing customers. So treating our customers properly and finding the best way to service them really is our lifeblood. If we continue to do so, I feel that this kind of market noise can be mitigated.” Despite the events of the past year and a half, Hooley remains focused on the job at hand—that is, building upon the proven strengths of State Street’s asset-servicing business.“Through the course of this disruption, the core business has performed extremely well. As the pressure on asset managers, pension funds, and sovereign wealth funds mounted, there became a much greater need for the kinds of services we have to offer, including both riskmanagement and collateral-management solutions. We’ve

seen a pick up in middle-office outsourcing as well,” he says. In November, State Street agreed to provide Morgan Stanley’s Investment Management division with global outsourcing services, including portfolio administration, reporting and reconciliation, covering some $300bn in assets under management.

Undervalued target Things could be a lot worse. Though five cents lower than the year-ago quarter, during Q3, State Street posted earnings per share (EPS) of $1.04, ahead of market expectations. Overall profits for the quarter rose 8% to $516m and net interest revenue on an operating basis increased 18% year-over-year to $754m. Full-year operating EPS stands at $4.13-$4.17, and with a forward price/earnings (P/E) multiple of nine, State Street appears to be one of the most conspicuous of undervalued investment targets. Running a multi-tiered custody business isn’t always a bed of roses, however, particularly when the markets aren’t cooperating. During 2009, State Street, like other major custodians, was hampered by the underperformance of such normally reliable revenue generators as trading services (off 26% year-over-year) and securities finance (less than half of 2008’s third-quarter $246m), which were both severely impacted by constrained market conditions. “The lending industry as a whole came under a lot of pressure, particularly as collateral pools were forced to stick to their dollar commitments,” says Hooley. While some clients elected to withdraw from State Street’s lending programme in the wake of the crisis, many have already returned, says Hooley, and on-loan balances have since stabilised in the $400m range. However, the reduced risk appetite has been keenly felt.“Customers are proceeding with caution, which translates into lower revenue all around,”says Hooley.“Over time, however, we believe this cautiousness will subside, and the revenue stream will pick up accordingly.” `

“Even before the stress test, we had to make sure that our boundaries were protected from the standpoint of having adequate capital,” says Hooley. “It was evident at the start of last year’s first quarter that the playing field was going to be disrupted, and that the strongest companies had the opportunity to get even stronger if they were able to execute properly. We feel that our current position is testament to our demonstrated competency in making successful acquisitions, and we continue to maintain a position of strength due to our capital reserves.”

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

In this February 11th 2009 archive file photo, outgoing State Street Corporation chief executive officer Ronald E Logue, left, and Morgan Stanley chairman and chief executive officer John Mack, testify on Capitol Hill in Washington, before the House Financial Services Committee. Photograph by Manuel Balce Ceneta, for the Associated Press. Photograph supplied by PA photos, December 2009.

The long-term prospects for foreign-exchange revenue growth remain strong, says Hooley, with numerous opportunities in areas such as Europe as well as Asia, China and other emerging markets. “Even though Europe has been flat or down from a GDP perspective, because of the way the market is constructed, we’re still seeing solid growth potential.” As such, Hooley believes that State Street’s long-held goal of garnering 50% of its revenue from non-US sources is still attainable. More than onethird of the company’s employee base resides outside of the US in over 30 markets, giving State Street a very decentralised business platform. “We continue to work these non-US markets from the bottom up in order to create opportunities and organically grow the footprint,” says Hooley. “These are markets with generally greater growth characteristics, either because they haven’t yet been through the full cycle of pension and retirement, or the growth in a particular country leads to bigger reserves in the central banks or the sovereign wealth funds, which in turn creates more opportunity. So we remain very bullish on non-US prospects, which we believe will continue to outpace the US in growth and present more fertile opportunities. We were extremely wellpositioned to capitalise on those prospects.”

Pocket change Acquisitions have been a significant part of State Street’s growth strategy since the start of the decade. Capitalising on the rapidly evolving alternative space, in 2002, State Street purchased International Fund Services (IFS), a provider of fund accounting and administration as well as

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

“Customers are proceeding with caution, which translates into lower revenue all around,” says Hooley. “Over time, however, we believe this cautiousness will subside, and the revenue stream will pick up accordingly.” trade support and middle office services for alternative investment portfolios. Similar opportunities in the world of private-equity led to the 2007 acquisition of New-Jersey based Palmeri Fund Administrators (PFA). In an effort to gain a foothold in the burgeoning electronic foreignexchange marketplace, the same year State Street paid $564m in cash for Currenex, the London-based online foreign exchange trading platform. That was just pocket change compared to State Street’s mammoth $4.5bn purchase of Boston-based Investors Financial Services (the holding company for Investors Bank & Trust), the largest expenditure by the company since its $1.5bn acquisition of Deutsche Bank AG’s record-keeping and securitieslending business five years earlier. Though times have become tighter, State Street remains committed to additional strategic acquisitions as it sees fit. Tougher regulatory conditions have prompted many hedge-fund managers to rethink self-administration altogether, leading to tremendously increased opportunities in the alternative-investment space. In its most recent move announced in early December, State Street agreed to acquire offshore administration leader

COVER STORY: STATE STREET, NEW REGIME OR REGIMEN? 72

Mourant International Finance Administration as part of its ongoing effort to expand global fund administration, private equity and alternative servicing capabilities (as of end-September, State Street had more than $420bn in alternative assets under administration). The all-cash deal is expected to close during the first quarter of 2010. State Street considers its acquisition targets from a number of angles, says Hooley. “Some are market-share oriented—IBT is a prime example. Another strategy focuses on geographic expansion—our acquisition of the Deutsche Bank [business], for instance, helped plant us in seven different European markets and also gave our Asian business a boost. Then there is a third subset, which is largely about product extensions.”All of these acquisitions have met or exceeded management’s expectations, adds Hooley, and were also quickly accretive to the company

financials: “So I believe that we have an enormous opportunity to use acquisitions as a key driver of growth over the long haul.” Of course, consistent earnings are needed in order to provide the capital to fund such acquisitions.“Even before the stress test, we had to make sure that our boundaries were protected from the standpoint of having adequate capital. It was evident at the start of last year’s first quarter that the playing field was going to be disrupted, and that the strongest companies had the opportunity to get even stronger if they were able to execute properly. We feel that our current position is testament to our demonstrated competency in making successful acquisitions, and we continue to maintain a position of strength due to our capital reserves.” State Street has long been a frontrunner in the exchange-traded funds (ETFs) market, and observers see

BROWN BASHES BANK It was Valentine’s Day 2006 when the California Public Employees’ Retirement System (CalPERS) reaffirmed its love for State Street Corporation by announcing its intentions to re-sign the Boston-based financial firm to serve as its master custodian, a position State Street had held since 1992. “The financial future of our members and retirees rests in good hands,” remarked a confident Charles Valdes, a veteran CalPERS board member. Since then, the sweet relationship has turned sour. hen the credit crisis took hold and double-digit returns turned into losses, CalPERS, like many others, suddenly assumed the role of spurned suitor. With a history of utilising the legal system to settle its scores, in 2009, the pension fund first took aim at the nation’s top three ratings agencies—Moody’s Investors Service, Standard & Poor’s and Fitch—with a lawsuit claiming “wildly inaccurate and unreasonably high” credit ratings that CalPERS says contributed to $1bn in losses from its investments in various structured credit products. Heading the probe was state attorney general Jerry Brown, the veteran political icon and former governor of California, who had already announced his plans to enter the state’s gubernatorial race in 2010. There was more to come. On October 20th, Brown held a news conference revealing a major lawsuit against State Street, alleging that CalPERS and its sister fund California State Teachers Retirement System (CalSTRS) had been overcharged some $56m in foreign exchange trading fees over an eight-year period. In a Huffington Post blog posted the same day, Brown claimed that State

California Attorney General Jerry Brown speaks at the Bryant Temple AME Church Friday November 20th, 2009 to announce his office is beginning an investigation into a nationwide scam that has defrauded more than 30 Southern California-based African churches. At right is senior Pastor Rev, Dr. Clyde Oden Jr. More pertinently for State Street, on October 20th, Brown held a news conference revealing a major lawsuit against State Street, alleging that CalPERS and its sister fund California State Teachers Retirement System (CalSTRS) had been overcharged some $56m in foreign exchange trading fees over an eight-year period. It is a charge contested by the banking group. Photograph by Nick Ut, for Associated Press. Photograph supplied by PA Photos, December 2009.

Street had “systematically ripped off CalPERS and CalSTRS,” and, referring to a contentious interview with financial news network CNBC hours earlier, added a regional subtext by suggesting that State Street’s actions (and CNBC’s apparent defense of the company) were “symptomatic of the eastern financial elite.”

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continued brisk investment in this arena, particularly as institutional investors continue to gravitate toward passive and quantitative asset-management strategies in general, and ETFs in particular. According to State Street’s own research, at year’s end the US exchange-traded fund industry had a record $739bn in assets under management. With $174bn in ETF assets, State Street Global Advisors ranks second only to Barclays Global Investors (BGI), which was acquired by BlackRock in 2009. “In terms of portfolio asset allocation, we have seen a gradual trend towards beta strategies, along with an increased use in hedge funds in order to achieve alpha. Assuming these trends are sustainable, then I believe that IFS, our hedge fund service provider, as well as our passive and ETF business on the beta side, will keep us extraordinarily well positioned.”

Nicholas Colas, chief market strategist at New York’s BNY ConvergEx, says the CalPERS suit is the latest example of the new intersection of politics and commerce. He adds: “There is the adage, ‘In politics, never let a good crisis go to waste’. Also, if part of that is having the ability to needle the private sector for your own political purposes, then that’s a valid outcome. There are many different parallels to this situation—from what happened between [former treasury secretary Henry] Paulson and Wall Street during the last administration, to the fact that the current chairman of the New York Fed [Denis Hughes] is a regional labour-union president, and we’re talking about Jerry Brown, who is about as skilled a political operator as you’re going to find.” Colas says that the timing of the CalPERS announcement—on the same day as State Street’s quarterly earnings report—was likely more than coincidental. “You have to believe that there is a good reason why he chose that particular moment to drop the bomb. The fact that the announcement had such a dramatic impact on State Street’s share price gives Brown a huge bargaining chip—in other words: ‘Do the right thing, and your stock price will go right back up again.’” While some have argued that the calculated nature of Brown’s actions weakens his case, Colas isn’t so sure. “The political winds are certainly blowing in his favour right now. I’m sure he senses that; it’s a very good time to make this kind of move. Politicians aren’t all that different from traders in that they like to work the odds—cut your losses early when you’ve blown a trade, but press your bets when you know you’re winning.” Could the CalPERS case help raise the due-diligence antennae at other pension funds? Michael Travaglini, head of Massachusetts’ Pension Reserves Investment Management board (PRIM), which oversees the state’s pension fund, says that the allegations are to some degree specific to the CalPERS-State Street agreement.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

Excellent relationship As he prepares to take the reigns as State Street’s new frontman, Hooley is candid about the turbulence that marked the outgoing year.“I’d be kidding if I said the wild swings in share price didn’t really have an emotional impact,”he says bluntly.“Yet I never lost sight of the fact that we have a sound business model, that we’ve maintained an excellent relationship with our clients, particularly through the tough times. During the first part of last year we were able address the concerns of our shareholders by taking the proper steps to consolidate the conduits and raise capital. Since that time the focus has been on real earnings, and I feel quite positive about our earnings potential and our forward momentum, particularly given our current standing in the marketplace and the strides we’ve made during the past year. To put it mildly, it really is ours to lose.”

For example, PRIM’s custodial arrangement with BNY Mellon does not take into account rates, nor does it compel PRIM’s managers to use Mellon to do currency trading. “In other words, our managers are at their own discretion,” says Travaglini. “So it really is about the contractual arrangement—and whether or not CalPERS was being charged in excess of the listed contractual rate—which is not something that we have to deal with.” Nevertheless, news of the lawsuit was enough to prompt Travaglini and board members to get on the squawk box with BNY Mellon in order to review PRIM’s custodial agreement. “Much of how we operate is based on reacting to this kind of news and then applying it to our own situation. So yes, we wanted to know right away that we didn’t have a similar due-diligence problem, and I assume that many of our peers did the same thing once the news broke, particularly those who use State Street as a custodian.” An industry spokesperson who wishes to remain anonymous says that the CalPERS suit is consistent with the fund’s long history of activism. “CalPERS and CalSTRS have a reputation for being very politically involved, and of course Brown’s methods certainly seem designed to raise his political profile, a la Cuomo or Spitzer. If in fact it is a contractual claim, the allegations should be easily provable, and yes, perhaps there is something to it. However, the fact of the matter is that when you have an elected official making this sort of pronouncement, you kind of have to take it with a grain of salt.” Oddly enough, CalPERS apparently knew for years that it wasn’t getting the very best deal on FX trading fees. According to a Wall Street Journal report filed just weeks after the suit was announced, in 2003 CalPERS retained a consultant to review its contract with State Street, who subsequently confirmed the status of the fee structure. “That certainly does raise additional questions as to how much of this is actually about State Street and how much of it is political posturing,” says the source.

FTSE GLOBAL MARKETS TRADING VENUES ROUNDTABLE:

THE QUEST FOR BEST PRICES, LIQUIDITY & CONSOLIDATED DATA

Attendees

First row: left to right

Supported by:

MARTIN EKERS – European head of trading at Northern Trust Global Investments PETER JOHANSSON – global head of equities at Neonet

MICHAEL KROGMANN – executive director, Deutsche Börse Second row: left to right

LARRY TABB – founder and chief executive officer of the TABB GROUP TIM WILDENBERG – head of direct execution, EMEA, at UBS TONY WHALLEY – investment director at Scottish Widows

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TONY WHALLEY – investment director, Scottish Widows:

Most notable is the speed of change, both to market structures and liquidity, so much so that we need to adapt and modify our trading strategy on a far more regular basis than ever before. Post-Lehman Brothers’ collapse there’s been a significant impact on the liquidity that’s made available to us. Moreover, the rise of MTFs has had quite a dramatic influence on what we’re doing. The next trend is volume business transacted within dark pools. Whether that is to the good or bad, we are yet to find out. There are obvious benefits. Even so, it is imperative that we secure access to those dark pools in a way that is beneficial to us. Additionally, there are issues surrounding market transparency. As market fragmentation continues, there are concerns about the effect that has on the way the whole market is seen. A key requirement now, to mitigate some of the detrimental effects of market fragmentation, is to have consolidated market data; on both a pre- and post-trade basis. Without it our job is increasingly difficult. LARRY TABB – founder and ceo of Tabb Group: MiFID has changed the ground rules of how the European markets work. We are in a process of fragmentation and increased competition within the marketplace, which is changing how the buyside and the sellside interact. New liquidity providers are moving into the market, increasing liquidity within certain MTFs. Meanwhile, the buyside needs a wider range of tools to be able to trade against a fragmented infrastructure as well as protect trading flow from possibly predatory liquidity providers and high frequency traders. Moreover, US and European regulators are looking at the new players, technologies and market centres, trying to determine the right market structure and how we should be operating, and that will then change the landscape again. MICHAEL KROGMANN – executive director, Deutsche Börse:

An important observation is that the algorithms implemented on our central platform worked well, even with a decrease in volumes and increasing volatility during the crisis. It is vital for us to confirm this fact. When the algorithms were first implemented (and we can actually track them back on our platform to 2002) we recognised that they provided significant liquidity to the market. However, that was in the good times, when volumes and turnover were on an upward trajectory. Over the last year, we saw that our major market participants and liquidity providers kept on providing liquidity and the market share of algo flow on the central platform remained constant. Elsewhere, customers who are very active today in the US markets have set up subsidiaries and entities within the European Union and have started trading and implementing their algorithms over here and now provide additional liquidity into the market. We think the game is now a European one. Moreover, crossborder trading, clearing and settlement continue to be very important. Finally, consolidation has to occur. We need it, because there are too many platforms out there.

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TONY WHALLEY – investment director, Scottish Widows PETER JOHANSSON – global head of equities, Neonet: From

the brokerage viewpoint, the market provides ample opportunities. As fragmentation continues we interact in a different way with our clients and the dynamics of buyside/sellside client interaction nowadays focuses more on service solutions. Overall, the biggest change is the level of innovation and roll out of technology. However, the big challenge this year has been finding liquidity; and it has been hard, for both the buyside and sellside. I’m not as bearish perhaps on the fragmentation issue. Yes, consolidation is needed, but we need to find the right solutions to a market which in the near term looks to be continuing to fragment. MiFID has been good. It has brought competition, it has brought more liquidity into the marketplace. We could argue is it good liquidity for the buyside, for end clients? Nevertheless, it has encouraged technology innovation in terms of market interaction, which by the end of the day will affect transactions costs in a positive way.

MARTIN EKERS – European head of trading, Northern Trust Global Investments: Just to get a bit controversial, I slightly

disagree with Larry. I don’t think the buyside is going to have this huge IT challenge that you kind of imply and that’s really because, as Peter intimated, of the service solutions that are being provided by the brokerage side. I share his view about fragmentation too. Everyone says the US is always big: big numbers, big Macs, and there are so many different venues. Actually, there aren’t. Even at a recent presentation at the White House the claim that there were 42 separate trading venues in the US was knocked back to 32!. So, there’s a bit of puff here. It can be very scary when you’re faced with supposedly all these venues, supposedly new entrants and supposedly new liquidity. Really, how meaningful is that to the buyside? It’s probably noise to Tony [Whalley] and I. It’s the white noise that you want to somehow exploit and the sellside has been pretty good so far at clearing our TV screens for us. The two big issues that will help us significantly are market data and inter-operable clearing systems.You’ve got to have that open up and once that’s opened up, the issues aren’t as scary as they seem today.

FTSE GLOBAL MARKETS TRADING VENUES ROUNDTABLE

MARKET STRUCTURES & THE SPEED OF CHANGE

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TIM WILDENBERG – head of direct execution, EMEA, UBS:

brokers that are able to innovate and connect will over the longterm do better. The buyside I think there are three things: the meanwhile is asking, on a first is competition, which seems monthly/quarterly basis, for to get harder every year. You destination reports, to check that think you’re getting better at making good use of all the what you do but, sadly, your different forms of liquidity out competitor seems to be doing there. However, as Martin will the same, which is always a testify, 20 years ago if we were slight frustration. The second is looking for, let’s say, 50m Tescos, fragmentation; MiFID is a work you’d ring up a trusted broker in progress, if you like. Definitely and you’d tell him: “I’m looking some good things have come for 50m Tescos. Don’t take them, out of it. However, there has also LARRY TABB – founder and chief executive officer,TABB GROUP but if you see anything, make been some unintended consequences that people may not have anticipated. Tony sure we don’t get overlooked.”The broker would sit there and Whalley’s point about transparency and market data is say nothing. Two, even four days later someone in the trading pertinent in this regard. Third: the“dark pool”debate is raging room shouts:“I’m a seller of 20m Tescos!”The broker says,“I’ll in the regulatory world and it’s an important one.The thing we buy those, thank you very much”. That was your original dark can ask from regulators is to help us get clean and accurate data. pool. Now that happens electronically. Also, we need to put this so-called problem in perspective, for PETER JOHANSSON: Tony, do you feel more secure about the market and for regulators, as there is a danger that it is being the old dark pool or the new dark pool? What’s the overall inflated out of proportion. There are a number of post-MiFID buyside feeling? issues and they all need to be addressed. While the dark pool TONY WHALLEY: The buyside has become immensely more issue is one of them, it is not the biggest. professional and more diligent than it was 20 years ago and cognisant of what is going on in the market in terms of structure, pricing, volumes.Today’s good buyside trader is much TRADING PLACES: THE NEW better equipped than the buyside trader of 20/30 years ago. BUYSIDE/SELL SIDE RAPPORT PETER JOHANSSON: I do believe we’ve seen that TIM WILDENBERG: There’s an extra dimension now to transformation on the sellside too, i.e. in the way in which our stockbroking. In reality it’s become a kind of technology and traders interact with clients and their overall approach to service provision role that, 15 years ago, wasn’t the case. Then, trading. Now we’re just moving into hybrid areas, in between, it was about being able to find liquidity; advising clients with low touch and high touch service. I believe you have to utilise regard to the market; and making recommendations on stocks. all of the technology and innovation and market access There’s a wider range of things that brokers do nowadays, together with the old school personal approach to trading, driven by an evolution of the stock market itself as it has because it is still a relationship business. moved from the floor to an electronic model. In consequence, TONY WHALLEY: Yes. It’s about prioritising your order brokers have had to compete more as technologists. The flow, isn’t it? As you say, high touch, low touch. You now question now is: when does that stop? Actually, I’m not sure it have systems whereby any order which is worth less than, stops any time soon. It will continue to get busier and tougher let’s say, £5,000 is automatically routed somewhere and and harder. As long as there are competitors in the executed and comes back and you don’t even need to see marketplace, there will always be somebody trying to invent a it. It is not only low touch, it’s no touch. better mousetrap or a faster service. Competition drives that LARRY TABB: It isn’t that the buy side’s going to develop and will continue to, but we must face that it is a new an entire suite of algos and build their infrastructures. dimension to brokerage that wasn’t there before. However, they will need more order management technology. Eventually, you will wind up with a whole suite TONY WHALLEY: Brokers are constantly coming up and saying: “We’ve got a new this and that, which does this quicker than of really good algorithms provided by brokers. To some everyone else’s.” By the time we’ve tested it, checked degree, we’re seeing this in the States, where even those connectivity issues and installed it, someone else comes along buyside firms that you would think wouldn’t have and says they’ve got something faster and better. From a buyside independent execution management tools are perspective, long-term relationships are paramount.You go with implementing them to take a little bit more control of the people you know can deliver. Brokers are now putting in front of execution process, and not necessarily putting everything us a lot more products that we can use, and it is down to us to through a broker — whether to hide strategy or take more choose which products we think are most suitable. There is a control of it. Now, you’re not going to be building those fairly substantial technology cost to the buyside of all this, as we platforms from the ground up, instead implementing have to test them and ensure they are compatible with our vendor-based platforms and some canned outsidelegacy systems and that can be time and cost consuming.Those algorithms, but it’s more than you had in the past.

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CROSSING & DARK LIQUIDITY TIM WILDENBERG: No question, MiFID has enabled new trading venues. Now we have the arrival of dark MTFs, which are publicly accessible non-displayed pools. We’ve always had crossing services that brokers were operating solely because we were trading for our clients. We know that we’ve got a buyer of Alcatel and we’ve got a seller of Alcatel, so we’re going to try, if it makes sense from a best execution standpoint, to cross them. That is exactly what we’ve always done as stockbrokers. We are obliged to look after our clients’interests. To whom we might – or might not — show bits of their order rests on our understanding of our clients’requirements. One thing that brokers, with hindsight, have perhaps done badly is that we’ve allowed the perception to develop over time that crossing services offered by brokers are the equivalent of dark pools that are public MTFs. Actually, they are quite different. It goes to the point mentioned earlier: about the importance of knowing whom you trust. MICHAEL KROGMANN: Being progressive and considering that there is crossing and liquidity, it is vital in an efficient market that we strengthen the elements of transparency and price formation. Nevertheless, big investment firms must be able to cross large-in-scale orders on the basis of public information and price. We should consider in order to account for economic necessities and existing trading practices, MiFID originally allowed few exemptions from the strict transparency regime. Again: the basis for the waivers was to avoid“excessive transparency” for large-in-scale orders, and this is the very area waivers should be restricted to, besides the other waivers that are already in place. If they are, they might indeed support a transparent and efficient market structure. LARRY TABB: The problem is, when you’re looking at blocks that are large in scale, a lot of the blocks that wind up getting executed in the broker dark pools look a lot like small little pieces. The issue then becomes that sometimes there is only one side of the order that’s block and what winds up crossing against it is lots of small orders or an algorithm, and if you start banning dark pools or putting too many restrictions on dark pools, investment managers aren’t going to put a million shares into a pool. They’re just going to leave it on their desk or put it into an algorithm or give it to a broker over a period of time.You wind up moving that liquidity out of the market completely and it makes it just more difficult for the buy side. TIM WILDENBERG: There needs to be more granularity and transparency. To Larry’s point: in reality the crossing executions that are happening are not always traditional “blocks.” There are many reasons for that. The nature of the instructions we get from a client varies. He may want to trade discretely throughout the day, so executions are done in micro-portions. We need to be transparent about where we’re printing those executions. Do we print them today instantly? Yes, and we print them at the midpoint. While improved transparency has a positive impact, there also need to be protections in place when crossing with nondisplayed flow to ensure that people are not trading outside

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of the spread or at bad prices. One of the points that Tony raised about seeing more free trade could actually be a problem. The trader is our client, but some fund managers are looking at their dealing desk, saying:“Well, I know that the crossing pools might be trading at a different price, but I’m measuring you on the primary.” Therefore, though an algorithm can manage multiple curves across multiple markets in order to achieve price improvement, brokers may be compelled to “dumb them down”, providing our clients with a benchmark primary because that’s what they themselves are being benchmarked against. This tells us that if there was actually one consolidated tape, they wouldn’t be having that conversation because everyone would be looking in the right place for the market data. TONY WHALLEY: The big worry with dark pools is if, for example, and I’m using Tesco again, I’m looking to buy 5m Tesco through UBS’s dark pool and Martin is looking to sell 5m Tesco through Merrill Lynch’s dark pool, they’ll sit there all day and nothing happens. TIM WILDENBERG: That would have also happened before in your old floor based system. You would have talked to only one broker. TONY WHALLEY: Yes, but wouldn’t it be so much better and so much more advantageous to our side of the fence not necessarily your side of the fence because there’s a vested interest here if dark pools were consolidated and everything came together? TIM WILDENBERG: Then they would all be public open pools. In the same way you’ve talked us through your Tesco example, there are going to be certain times where you’re not going to want anybody else to know about your order. So, the problem is that this is a bit like the indications of interest (IOI) debate. TONY WHALLEY: Absolutely. It’s protectionism. MARTIN EKERS: Do buyside desks prefer the old dark pools or the new dark pools? My reply to that is that you can walk into a very nasty pool in both the old or the new style pools or, equally, you can decide to swim very badly with your eyes shut. Either way, you will end up damaged. Dark pools have always been there and our biggest risk as an industry is that the regulators don’t understand that dark pools have always been there. This isn’t some nasty new plague that’s suddenly coming across the industry for which they prescribe some prohibitive regulation. They often use a sledgehammer to crack a nut, and it’s a hell of a way back once they’ve done that. It is our duty as industry professionals to ask everyone else who’s involved to guide regulators towards a sensible solution. As we’ve discussed, technology has only enhanced what was already there. TIM WILDENBERG: In non-displayed liquidity, everyone wants to see your IOIs, and not show their own. The problem rests in certain types of orders. When you give us an order, we will put it in some of the public dark pools. We will also allow some of our other clients’ orders to match against it because we know it’s usually good for them and you. The problem with a dark pool is implicit. If it’s a public dark pool, then in reality it’s not that dark, because you just

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you start getting into the broker don’t know who’s going into it dark pools that bring in different or what they are doing with types of liquidity. I’ve been on the information they are desks where they’re starting to getting from their interactions. get fills and, yes, they’re getting You don’t know that Martin 100 and 200 share fills but Ekers has been sitting there they’re getting a huge number of thinking: “There’s a buyer on them, really filling quickly. The Tesco, I’ll just wait.” What’s the question then is: is that, for fine line between someone example, Martin or is that Tony being a great trader and on the other side with an someone gaming a dark pool? algorithm feeding into the other It’s a very subtle difference. side of that? Or is it Mr. Get Go MARTIN EKERS: I was reading taking the other side and laying this morning about a major US PETER JOHANSSON – global head of equities , Neonet it off heaven knows where? company that’s launching in Unfortunately, it’s hard to tell. If London very soon and their you look at the numbers of average trade size in the States Credit Suisse, Sigma-X or UBS, is 415 shares. I’m not sure that even though they don’t tell us that’s of any benefit to my order their numbers, they’re actually book or Tony’s order book and doing far more volume than the yet this is a major headline and big block dark pools. there’s a big fanfare. TIM WILDENBERG: To be fair, TIM WILDENBERG: Ultimately, though, there is an intellectual dark liquidity is one part of a debate that says if new people larger function. It’s a tool. There come to the market with are times where you need a volume each day, but leave the visible and public market, and market at the end of every night often most of the time, you need flat, have they brought liquidity to advertise you’re a buyer or or have they not? In aggregate, you’re a seller. You want to be you’re right, 415 shares isn’t sitting on the best bid and you going to make a difference. want to be visible, because you However, if every time you trade need to find the other side of the you manage to trade that 415 order. There are many times, shares with half a basis point however, where you don’t want price improvement, that over this visibility. There is also time is going to make a pretty sometimes an unhealthy blur MARTIN EKERS – European head of trading, Northern major difference to you. If, as between what is over the Trust Global Investments you say, all this frequency trader counter (OTC), or off exchange, does is take money out of the business, then that will stimulate and what is dark. There is a misplaced perception that all OTC a debate around: have you brought a new buyer to the market? is dark or non displayed liquidity, which is not the case. The I don’t know the answer, but I can see that there actually is percentage of orders that are truly dark is probably 5% in more turnover, there is some more liquidity been brought into Europe, compared to the 40% that is OTC. As an industry we play. Is liquidity all about institutional long only clients buying need to be more transparent around that OTC number, because stocks, keeping them and selling them to another long only an OTC trade report might for example just be relating to some guy? I don’t know, but the accumulation of good 415 share swap or give-up going on behind the scenes, or a risk trade, or executions adds up. all sorts of other things that (chances are) have actually been through the public lit market first, anyway. LARRY TABB: In the US,TABB Group counts all the dark pools through our LiquidityMatrix. We gather the information that MICHAEL KROGMANN: If you want to get fills in small providers give us and if you look at the dark pools that have sizes, you can just send a certain proportion of your big large-in-size trades — such as Liquidnet — the amount of their order to the order book and get executed against 260 liquidity is much more limited than if you look at the ones that market participants to execute against you fully and are trading 100, 200 and 400 shares. Therefore, if you’ve got anonymously. If it comes to execution of small proportions your 5m Tescos, you’re going to put that in a Liquidnet. If of a big order, it should be distributed in the price discovery somebody else is in Liquidnet and you can match that off, that’s process that is publicly available. We have a big conflict great, no leakage. The question then becomes, if everybody’s here, because no individual is interested in sending his buying Tesco, who is going to take the other side? That’s when order to the public order book. However, everybody is

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interested, of course, in high quality price discovery that he can read as an indication for all kinds of executions. LARRY TABB: In the US, the public markets have been very open to the high frequency set and to a lesser extent, the dark books, or at least certain dark books. When we talk with institutional traders, there’s a much greater desire to keep things, even if they’re getting 100 to 200 share fills and they’re dark. That’s because they feel that when they get to the lit markets they’re absolutely playing with the Mr GetGos. Sometimes, when you need to get filled, you need that, but they want a little bit more shelter. PETER JOHANSSON: There will always be different types of vendors, there will always be different types of brokers. There will always be different types of algos, dark pools, marketplaces. I just think that we need to take one step back and understand, specifically from the buy side’s perspective: what is the investment decision behind this trade? Where shall I go? Who shall I interact with? You should keep close interaction and notes and make sure that you get all of the information you require. Where did I trade it? How did I trade it? Where was the EBBO? It is also vital to measure your execution quality, because there’s always going to be different venues to choose from.

BUYSIDE APPROACHES TO TRADING TONY WHALLEY: Our fund managers are supposed to be

taking a three-year view.The high frequency traders are taking a three nanosecond view. Now, as far as I’m concerned, there has always been a fear in the market as to who you’re trading against. It used to be: am I trading against natural on the other side or am I trading against the market maker? Then it became: am I trading against a hedge fund? Now it’s become: am I trading against a high frequency trader? Well, actually, provided I’m fulfilling my objective, which is buying or selling the shares that the fund manager wants to buy and sell on a three, four, five-year view, I’m doing my job. In any case, this fear about who we’re trading against actually shouldn’t matter. These guys are providing liquidity and our job, as much as anything else, is to find that liquidity. MARTIN EKERS: I’m glad Peter has posed the questions, it’s better coming from the sell side. At what point does the buyside and the whole variety of buyside desks that there are become accountable? I fully acknowledge that you and Tim and all the other brokers have got orders but I do not know any other transaction that you would make that you’d be prepared to complete based on a future price. For example, Larry, have you flown over here only to find out how much your flight will cost you when you get home? Of course you haven’t. None of us would do that and the justifications given for those sorts of instructions concern me. We’ve got a huge core business and if the benchmark is the closing auction, I fully understand why we’re going into the close, even though we could have traded at four o’clock. We’re going to trade at the auction at 4:35 and that is absolutely crystal clear and fully defendable. For example, if my equity manager has made a decision to buy 50m Tescos based on the price at 25 past one,

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then it’s my job to get that done as quickly as possible with as little impact as possible with whoever else is out there. PETER JOHANSSON: The buyside trading desk is now also asking for help with alpha from the sellside. Therefore, I do believe there’s an interaction between them, however, with the options available today, you should feel fully secure that giving out the trades that Martin is talking about, that you are sure about the added value in just giving out straight benchmark. I cannot agree more with you. MICHAEL KROGMANN: There has always been a demand for crossing of big orders outside the order book, as we’ve discussed. Xetra MidPoint allows trading members to trade stocks without disclosing the volume and the limit of their order. The functionality thereby enables market participants to execute market neutral orders of greater volume. The orders are entered into a closed order book and executed at midpoint between the best bid and ask price of the open Xetra order book. Therefore the Xetra MidPoint, is not a dark pool, it is a reference pricematching. However due to the execution at midpoint between the best bid and ask price, implicit transaction costs for investors are reduced. Xetra MidPoint thereby not only ensures full transparency concerning price determination but also enables trading members to minimise their trading costs. Additionally, as Larry mentioned before, all the public dark pools are not as successful as the broker-owned dark pools. As far as I know, there has not been a single public or exchangeowned dark pool in Europe that has been successful.

GROWING TRANSPARENCY LARRY TABB: What Tony and Martin were saying earlier

about pre-and post-trade market transparency, that tends to be the biggest challenge we hear from European buyside traders; that it’s very difficult to get a complete view of what’s happening in the market. Hand in hand with that is clearing and settlement. Pre- and post-trade transparency will be a challenge but it’s more easily solved than the posttrade clearing issue with five or six CCPs and a significant number of depositories to take into account. MARTIN EKERS: Condition codes are fairly boring, yet crucial. There is a whole swathe of data out there that we’re all trying to decipher and if we can get a very clear common set of condition codes across Europe, then it just becomes so much easier for everyone. Any agency transaction, any OTC cross should be printed, reported and published immediately and marked as such. For example, if I decide to buy 5m Tescos from Tim on writ, that should not print. That should be privileged information for Tim and me to know. When he unwinds it in the marketplace or from the high frequency trade or from Tony, then that should print, and I don’t think there’d be anyone on the sellside or the buyside who would argue against a very commonsense solution. PETER JOHANSSON: We spoke about the old days previously. Wasn’t there some kind of gentleman’s agreement in between buyside and sellside of unwinding the position?

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mandated by the regulators, it TIM WILDENBERG: MiFID has simply will not happen. That is actually, though many don’t because there is a certain wish to admit it, made the world amount of vested interest in the more transparent. However, if mix, where transparency is not a you were a London stock big thing. You ask anyone and market operator, either on the they will say:“I want everyone’s buyside or the sellside, the new, business to be 100% transparent more transparent rules of MiFID except mine.” However, it are actually a step backwards doesn’t work that way. Even so, from what was visible in if you have a greater degree of London before. In aggregate transparency in markets, it there is more visibility, there is encourages liquidity, which is more trade reporting and there’s what we all want. more detail because actually anything that traded in MICHAEL KROGMANN – executive director, Deutsche Börse LARRY TABB: I had a Germany could have been discussion recently here in traded OTC almost anywhere on the planet and was just London with a market operator who was also very sceptical getting booked and not shown. Now we’re in a scenario where of getting complete pre-and post-trade transparency. He felt all of these OTC executions are actually visible. People don’t yet that if there was complete pre-and post-trade transparency, a have the tools, although they’re starting to build them and lot of the liquidity from Europe would wind up in London, understand how to drive them, to do that. However, to mostly because more of the trading venues are there and that Martin’s point, there is a debate in the market about the value it would disadvantage a lot of the smaller countries trying to of MiFID. Some of Michael’s colleagues, I’m sure, in the legacy build up their own bourses. Now, that might not necessarily exchange world are facing intense competition and may find affect Xetra because that’s a big market centre, but it might some of the developments in the OTC space rather affect some of the smaller countries, and they would never go threatening. In reality, though, at a granular level, we discover for it. That’s only one market operator’s viewpoint but... that the dark liquidity that everybody’s so very worried about is TIM WILDENBERG: We’ve seen recently in the US the SEC only 5% or 6% of all the aggregate, tradable volume. What is discussing the“Fair Access”point, saying basically that they’re displayed remains a massive proportion. For example, if you considering changing the threshold at which the dark pools look on the Fidessa website today, they’ve got a thing called that publish IOIs will need to display prices more visibly. “The Fragulator,”where you can see how much is trading dark, Moreover, the SEC is also talking about a tape where people how much is lit, and on which venues. There is a big chunk would have to immediately declare where a non-displayed that is OTC and that needs to be flagged in a way that explains trade happens. So, rather than just take an execution report that this is a client to client cross, this is a client to book cross that says IBM just traded at ten, it will say IBM traded at ten or whatever. in Sigma-X or in UBS PIN or New York Stock Exchange or Xetra, for instance. In Europe if we cross something today, for MICHAEL KROGMANN: If I look at the whole proportion of OTC trading, in some months it is near 45%. Even so, there instance, we put it in BOAT in real time, so it is already being is no formal and publicly available information that says how published in real time and we are happy to do it. The much is going on in broker internal dark pools. Therefore, all interesting feedback I’m getting from my US colleagues is that the figures, even the figures that Larry is providing, are just a the US client base does not want that level of granularity to go good guess about what’s going on in these dark pools. So, on a public tape, as the SEC are proposing. That is, information that shows a block go through and who traded it. we need some more transparency there. TONY WHALLEY: On a European basis we are far more TONY WHALLEY: You’ve got to give it a bit of time where transparent than we were pre-MiFID and the issue that we people actually see the benefit of having full transparency. As have is very much one that we have on all European long as the client name isn’t shown, I don’t have a problem. legislation, not just in the financial sector, where you’re trying In the old days in the market where a broker just crossed up to get lots of different shaped things all to fit in the same hole stock, if you had business to do in that stock, you gave that and, actually, it doesn’t always work for me. Ironically, the particular broker a call, knowing where the business was transparency we enjoyed in the UK market pre-MiFID was going on, meaning that they get more business and we end actually far greater than the level of transparency we now have. up getting our business executed with less market impact. People are pushing back to a certain extent and slightly TIM WILDENBERG: Except there is a general trend concerned that what they used to be able to see and what used throughout Europe and around the world to “anonymise” to enable them to do their job is now no longer available and the public markets (i.e. hide the broker codes) , because the that is a big concern. I also think that if you look at what is information leakage is viewed as detrimental to the players going to happen in MiFID Stage 2, if such a thing does go in the market. ahead, which I believe it will, then you’re going to find that PETER JOHANSSON: I’ve been involved in those discussions unless the transparency/consolidated tape argument is regarding anonymity on the exchanges. There has been, and

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I do believe there still is, a strong resistance among Scandinavians, both buyside and sellside, to go completely anonymous on the post-trade scenario. So, how does that affect the market? I’m a strong believer that we should become totally anonymous because I’ve seen some patterns within the markets where orders get shuffled around and you have some front-running. I’m not saying that I could point it out precisely, but you can have a good guess at it. The execution performance in anonymous markets versus nonanonymous markets tells us that all markets should embrace total anonymity. However, the debate is still raging. MICHAEL KROGMANN: The market needs to be fully anonymous because otherwise all the market participants might have a problem with the counterparty risk when they see small broker names in the book. All trades should be fully anonymous and fully secured by CCP afterwards. TIM WILDENBERG: Well, that’s contrary to what is being asked for in the dark pool debate by the SEC. In that debate we are being asked to print in real time and put our name on it. So, to some extent there’s a conflict. Maybe a solution is we publish it in real time and later on we tell you this was our total number and we mark it in someway or something. I absolutely agree with you. Transparency, in my view, takes the debate away because the dark pool debate, in my view, has become too big unnecessarily. MICHAEL KROGMANN: However, your internal dark pool is obviously not a public marketplace and not everybody can have access. On an exchange, actually, everybody can have access. That is for me a totally different discussion. TIM WILDENBERG: Nevertheless, the risks around anonymity remain. MARTIN EKERS: There was question a little while ago about whether we feel there’s a reluctance to publicise the venue, where the things trade. If there is, its very misguided. I would fully, fully support it and I don’t really get Michael’s difference here because we’re in a public market and a Sigma-X or UBS PIN. If the trade’s going on in the public market, then all market participants are going to get there. They’re going to know very quickly. If all the volume of Siemens is on Xetra, they’re going to trade it on Xetra, there’s no doubt about that. If Tim is putting up crosses after crosses after crosses and you can see it going though real time on the tape and it’s all got his little flag on it, then it’s quite right that I get hold of Tim and he rings up Tony and he does a huge great cross and we’re both happy. MICHAEL KROGMANN: I’m not. MARTIN EKERS: That’s competition, right? One of the biggest threats to us as an industry is lack of trust in the price formation process, lack of reliability about the tape, which is why it’s so important to consolidate it, misunderstanding about what is real volume and what isn’t real volume and how much is going on where and what and it’s within our grasp as practitioners to help solve that problem. We should be publishing. You’ll all have your different ways of advertising it. People will have it on the tape Neonet just crossed this and I’ve got an interest in the name and I’m going to be calling you up. That’s the way it should be.

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LARRY TABB: Some of the debate in the United States is

not necessarily about larger mid-cap and large cap names but some of the smaller cap names. These smaller cap names are easier to game and traders are worried that realtime printing of smaller cap names, especially in the dark, may help facilitate the gaming of these names. Now, I don’t know whether that’s right or not. MARTIN EKERS: Because it’s a trade and it’s complete, the gaming risk, and this is to Larry’s point, really, about the small cap, is no greater or less than any other scenario. It’s no different in 25,000 little shares with a small company and a 50m Tesco. The chance of that being gained after the trade has hit the tape is exactly the same. LARRY TABB: That’s the issue: when you wind up with one after another print of 200 share prints in a dark pool of a smaller cap stock that trades over a period of time. It’s not when you’re done all at once. TONY WHALLEY: There’s no doubt at all that the fund management industry is becoming more and more global and will continue to do so. However, I do think, like all things, it is very, very important that we get what’s going on our own doorstep correct before we start trying to branch out. If we try and branch out before we’ve got the stuff close to home working properly, all that’s going to happen is that a lot of the problems we have close to home we will export to the other markets and make them worse than they are right now. So, we’ve got to be very, very careful about that. The trend itself is to move to a global basis in terms of fund management, in terms of analysis and probably in terms of trading from a fund management perspective as well. You see more and more desks starting to split their order flow, not so much on a geographical basis but on a sectoral basis and that is probably going to continue as time goes on. However, please, please can we concentrate on getting what’s at home right before we try and move overseas? LARRY TABB: Also, the issue is that Europe through the EU process and Brussels is coming together while at the same time Asia is really fragmented and not coming together. You have the Asian markets with some linkages but those markets are really very different.

THE VERDICT ON MiFID MARTIN EKERS: I’d give MiFID six or seven out of ten. It hasn’t quite achieved what they wanted it to but it has been a wake-up call for the industry. The first words in this roundtable were about change being continuous and ongoing. That sounds good and that continues to be the case. I don’t think you ever get to a point in this industry where everything is sorted and we stop developing or stop innovating and changing. I’m reasonably optimistic that the market fragmentation will, in the short term, worsen but in the medium term improve. I share Tony’s reflection that the quality of buyside has improved and continues to do so. FRANCESCA CARNEVALE: Do you think the buyside of the sellside has benefited most from a post-MiFID world?

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TIM WILDENBERG: At first

books, it looks like we don’t have the same proportion that glance, the perception will be we had probably two years that the sell side has benefited ago, but I’m not so sure more, especially if your business whether that would have been is selling technology that routed to our platform even aggregates fragmented markets. before MiFID. However when somebody does some qualitative work around PETER JOHANSSON: There’s the liquidity of the market, I been great opportunities and believe we’ll actually discover there’s been some great issues that the buyside and some of as well. We’ve seen their clients have also benefited. fragmentation. It is here to I’m not sure that’s clear yet stay. One could debate because there is scant research whether it will continue. There in the marketplace that will be consolidation on the TIM WILDENBERG – head of direct execution, EMEA, UBS demonstrates how spreads are trading venue side, but also in tighter, liquidity has become easier, and the cost of trading has the asset management space. You might see it also on the dramatically changed. I think trading costs have come down; brokerage side. We might see some more consolidation on but we need empirical proof. the sellside because, with this fragmentation, there’s a lot of brokers out there that do not have the capability or the MARTIN EKERS: Just a PS on that. The problem, as we already mentioned, is about the quality of the data but also infrastructure or the money to actually invest in what’s you have to accept from any position that 2008 was an needed to actually reach all the different liquidity pools. extraordinary year and you’ve almost got to lift it out of the Moreover, on the other side of consolidation, which we equation. You’ve got to go back to 2007 and you’ve got to haven’t spoken about, I’m actually in a market where compare 2009 and 2007 and just say, right, 2008 was a real suddenly exchanges are starting to compete with me on aberration, an outlier that’s going to make a mess of any stats. out-routing, forward-routing. I’m just starting to see the TIM WILDENBERG: Have you thought of doing some of whole map, defining a new but still exciting market. The buyside has benefited from MiFID in the changing way that that work, Larry? LARRY TABB: Yes, we’re actually in the process of looking it now needs to utilise the sellside more as a consultancy for at the last four years, the two pre-MiFID and two years solutions, and to actually reach the market in a more post-MiFID, analysing effective spreads not across the technological way. The old relationship will still stand whole market but a tier of, say, 30 stocks. That includes top however, and I do believe that’s one of the core things tier as well as mid tier and small tier, across the FTSE, the within our business. Going forward there’s still opportunities out there and we just have to embrace them CAC and the DAX. MICHAEL KROGMANN: Of course, there have been a lot of and finally, liquidity will continue to move into market. changes in the last two years but at Deutsche Börse and TONY WHALLEY: I wouldn’t say it’s much improved, I Xetra we were always in the position where we had to would say it’s different. MiFID was there primarily as a driver compete with the markets. Compared to other European for change and to ask questions and there is no doubt markets we did not have a concentration rule in Germany, whatsoever we have seen some change and there’s still a so it was always possible for retail as well as institutional certain amount of change to come and it will possibly be in investors to trade OTC off the markets. Then we have the areas where we don’t expect to see that change. The peculiarity in Germany that we still have seven regional discussions we’ve had over the previous hour and a half exchanges that are, of course, not a competitor on an show that there’s still some questions which definitely need institutional scale, but which are certainly competitive on to be answered. So, from that point of view MiFID has done the retail scale and we have had to innovate all the time. We a very good job. In terms of exchanges, in terms of ECNs, in have implemented around two releases of Xetra every year terms of MTFs, the question is whether we’ve actually even before the implementation of MiFID. So, we have reached the stage where fragmentation is going to continue listened to the market, have been innovative and so on, but, or start to consolidate. If we look at the example of the LSE of course, the dynamics increased as regulatory changes with Baikal, and potential take-over of Turquoise, we’re have been implemented but at the same time technology starting to see the consolidation starting to take place. What implementation on the customer side also increased, so we the marketplace will look like longer term, I’m not sure, but have really had to adapt our business model to new market I do believe that it’s given us and it’s also given the sellside a conditions.That is why we are launching Xetra International huge amount more choice as to how we execute that Market, a dedicated segment for trading of European Blue business and choice is good. Choice in itself allows you to Chip equities with an efficient home market settlement use a little bit more discretion, to add a little value to the way process. In terms of a market share comparison of what was trades are executed and that in itself has led to a higher traded in German instruments and in the transparent order quality of people on both sides of the fence.

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

Clearing the fog which characterises much of today’s measurement of trading performance is a responsibility few seem to want to shoulder. Exchanges think it’s the regulators’ responsibility and that the buyside should speak out more; the buyside believes the sellside and data providers should do more; almost everyone blames the Markets in Financial Instruments Directive (MiFID). Ruth Hughes Liley reports.

Says Deutsche Bank’s McGoldrick.“A consolidated tape is an easy label to use but it is a broad topic and means different things to different people. At the first meeting we identified a wide range of concerns but agreed our initial focus should be to identify the issues in post-trade data for cash equities in the major EU markets.” Photograph © Kgtoh/Dreamstime.com, supplied December 2009.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

WOYEARS DOWN the line, the Markets in Financial Instruments Directive (MiFID), the European Union directive which standardised the regulation of investment services, has certainly been found wanting in the area of post-trade reporting. MiFID did not make it mandatory to publish the venue where shares were traded, even though the directive allowed for creation of a raft of new exchanges. The directive said transactions had to be made public, but did not insist on how those trades should be made public. Moves are afoot to ensure that the next iteration of the directive, MiFID 2, as it is known, addresses these outstanding issues. “It is not necessarily the regulators’ fault,” says Clive Williams, T Rowe Price’s head of trading, Europe. “If you look at the growth of trading over the last two years, I do not think many people could have foreseen how the current situation has developed.” MiFID allowed the creation of multi-lateral panEuropean exchanges in direct competition with the traditional exchanges. It also promoted competition between the exchanges and new reporting venues such as Markit BOAT. Lower fees allowed more frequent trading, as costs per fill came down, explains Andrew Morgan, Deutsche Bank’s European head of electronic trading.“The sheer quantity of data to run post-trade reports pulling in all quotes and trades is huge,”he says.“For customers who are more active, the number of prints has increased as the cost of trading has come down. We are getting smaller and smaller trades from cost-sensitive, high-frequency

POST-TRADE REPORTING: IS MIFID UP TO IT?

MiFID MAKES END INVESTOR MISS OUT

POST-TRADE REPORTING: IS MIFID UP TO IT? 84

Morgan Stanley, together with representatives from the UK’s Financial Services Authority (FSA), the Investment Management Association (IMA), the Association for Financial Markets in Europe as well as representatives from Reuters, Bloomberg and Markit BOAT. “Trade reporting has been a hot topic for some time and our original aim was to hear what the buyside had to say to us,” says McGoldrick. “A consolidated tape is an easy label to use but it is a broad topic and means different things to different people. At the first meeting we identified a wide range of concerns but agreed our initial focus should be to identify the issues in post-trade data for cash equities in the major EU markets.” Meanwhile, CESR’s overall review of MiFID will continue throughout 2010 and will be fed through to the European Commission for probable implementation in 2011. George Andreadis, head of AES liquidity strategy, Europe, Credit Suisse, has been involved in discussions with the commission and CESR. He says accurate and reliable post-trade reporting is vital for an efficiently functioning market. “If a stock is trading 30% off-exchange and I didn’t know that, I would be assuming 100% is on-exchange or on an MTF, but I would be wrong. I wouldn’t have the full picture to Andrew Morgan, Deutsche Bank’s European head of electronic trading.“The sheer inform me what price to trade at, who’s quantity of data to run post-trade reports pulling in all quotes and trades is huge,” he trading and so on. That’s fundamental for says.“For customers who are more active, the number of prints has increased as the cost when I come to try and buy or sell a stock. It’s of trading has come down. We are getting smaller and smaller trades from cost-sensitive, also important for measurement. If I am high-frequency participants, plus the increased use of algorithms, slicing large orders into missing 30% when I am doing TCA on the smaller sizes, is increasing the data needed to run post-trade reports.” Photograph kindly trade in that stock or if clients are measuring supplied by Deutsche Bank, December 2009. me, how can they measure me if they miss the participants, plus the increased use of algorithms, slicing 30?You don’t know whether you are getting best execution.” large orders into smaller sizes, is increasing the data needed to run post-trade reports.” Consolidated tape Miranda Mizen, a principal with TABB Group, calls trade While the accuracy of data from displayed, on-exchange reporting “a missing piece of the jigsaw puzzle that needs transactions is not an issue for the sellside, which can see data to be addressed”. For her, poor quality data is a risk issue: from all the venues via Reuters and Bloomberg; Thomson “In our view, questionable quality of data adds Reuters launched its own consolidated tape for post-trade unacceptable risk to the market and should be addressed reporting in January 2009. However, it is more of a problem for with a level of public urgency. Post-trade data is incredibly the buyside. Many rely on their brokers pulling reports important because it builds a story of the market and forms together and the data from the main exchanges is expensive. part of the future and the way people make trading Olof Neiglick is chief executive officer of Burgundy, decisions. That people can see the trading story is which launched as an MTF in June 2009 and offers data important to the ability to manage risk in the market.” free, as do most of the MTFs. He says: “There are absurd Various industry initiatives are under way to see how to prices for data and you even have a situation where you make trade reporting work more effectively in Europe, need to source data from different venues and then pay including a general consultation from the Committee of each venue a distribution fee. That’s expensive. I don’t European Securities Regulators (CESR). In one forum, Stephen think all data will end up free, but you can get a lot of McGoldrick, director of market structure at Deutsche Bank, information without exchange fees. However, someone has convened a meeting in October 2009 and again in December, to pull it together and you will always have to pay the attended by heads of dealing from the buyside and the four aggregator something, but not necessarily five or six sellside firms of Deutsche Bank, UBS, Goldman Sachs and exchange fees plus distribution.”

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

Williams at T Rowe Price asks: “Why should we pay for our own data? MiFID was introduced to encourage competition because the cost of fees was too high but we have told the exchanges that the only way you’ll get rid of the trade reporting mess is to get back to regulated utilities.” The quality of available data is also clouded by delays in reporting.Williams says:“Some people interpret the rules more aggressively than others and take advantage of the three-day delay which is allowed for larger trades. That’s information which can be used proprietarily before it’s public.” Neiglick estimates that more than 95% of trades are reported in real-time, but agrees with Williams:“Professional customers can see trades in real time but the delayed reporting rule doesn’t help to improve the quality of markets.”

Multiple reporting In addition to delays and the high cost, another problem has been multiple reporting, where a client might sell 100,000 shares to an inter-dealer broker (one report), who then sells 100,000 shares to another broker (second report), who might even then sell to a third, generating a third report. Guidelines from the FSA in June 2009 laid down that“where shares pass from one investor to another via a chain of investment firms but the movement is economically a single transaction, the ideal outcome should be the publication of a single trade report.” It also set out guidance for agency trading, risk trades and combination of agency/principle trades. “The guidelines are working to a point,” says Richard Semark, managing director, client execution relationships at UBS, but he adds:“I doubt everybody is following them and clients are saying that there needs to be some policing of them.” In July 2009 the FSA also published guidelines for investment firms using Trade Data Monitors (TDM). Having TDM status means that the firm has post-trade reporting arrangements in place which have been confirmed either by the FSA or an external auditor as enabling them to meet the guidelines. It is a voluntary benchmark scheme and lists six TDMs: BOAT, Chi-X Europe, Deutsche Börse, LSE, Plus Markets and Reuters. While the Financial Services Authority (FSA) can set standards in the UK, Williams points out:“There are different regulators and different parties. France’s regulator is different from the FSA or from Germany. Everyone is trying to protect their own corner and it’s difficult to get it sorted out. Meanwhile, it’s not helping the markets.”Neiglick adds: “It’s no good if France has one set of rules and Germany another. This has to work cross-border. They managed to do it in the telecoms industry with cross-border agreements and they’ve done it with tick-sizes. The systems are already in place in our industry, so it should be possible.” Not being able to see detail in the data is a further obstacle to transparent trading, especially in off-exchange or over-the-counter (OTC) trades and in dark pools. Andrew Allwright, MiFID solutions business manager at Thomson Reuters, recalls that pre-MiFID, when the

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

majority of trades were reported through the LSE, they were classified into different trade types within the LSE data. “Now there is no obligation to classify and there is a lack of granularity, especially regarding off-exchange trades, so you don’t know whether it’s VWAP [a trading benchmark based on volume and the average price], a capital commitment trade, option expiry or an internal order book cross.” With the proportion of business reported on Markit BOAT and others accounting for up to 40% of total turnover in EU equities, with about 1% of that attributed to dark pools, Allwright estimates around 39% of trades are reported without any kind of useful classification. “If we knew and had classification, that 40% would get a lot less scary.” McGoldrick agrees: “Different markets grew up with different conventions. Now that we need to see data from multiple venues in a consolidated view, the variations in flagging, formats, distribution and value for money makes the aggregation difficult and expensive yet ultimately subjective. This impacts the efficiency and accuracy of algos and smart order routers as well as traders needing market colour. “They can see trades printing but if they can’t act on the flow or if the trades should have no influence on price formation then, from their perspective, it is just ‘polluting’ the tape and should be filtered out.There’s poor feel for the relevant volume in the market and it makes transaction cost analysis very hard because transaction cost analysis (TCA) involves comparing order size to relevant market volume, so your analysis changes depending on your view as to which orders you include. If it’s not clear which flows are relevant, it’s hard to do TCA.”

Opaque market Cees Vermaas, executive vice president and head of cash equities at NYSE Euronext, says that while the regulated markets are fully transparent, the OTC market is much more opaque, where trades have to be reported to the regulator, but don’t always have to be published to the market, unlike on exchanges and other platforms with public order books where prices are displayed. Where trades are“internalised”the situation is worse. He says:“Crossing networks, internal dark pools operated by banks, are not subject to the same reporting requirements as the lit markets.This is a problem for European markets because we lack an overview of what is really going on in certain stocks and it is particularly unhelpful for the end investor. “How can the cost of trading be calculated accurately if there are no accurate measurements? Best execution means best price, the tightest spreads in the book as well as speed, likelihood of execution and settlement—as well as other factors. However, if you don’t know what these elements look like, how do you know whether best execution was achieved?” Semark says buyside clients are more focused on analysing their own trading data than historically.“Use of electronic management systems has increased their appetite. They’re dissatisfied with TCA providers so they are asking us more and more to analyse their trading. We take direct feeds from all execution venues as well as Markit BOAT OTC data and provide customised analysis.

POST-TRADE REPORTING: IS MIFID UP TO IT? 86

stuff. There’s a lot of misinformation out there and you have to be able to trust the data. We rely on brokers to a large extent and ask them a set of questions such as where did we trade, what amount and type of flow is in the dark pool, how much is high-frequency and so on. We are starting to accumulate that information and put it all together at head office in Baltimore. Bloomberg and Reuters are also trying to bring data together and simplify it, but it’s a struggle.” Many believe that the responsibility lies with the regulators to enforce rules.Vermaas says:“As part of the forthcoming MiFID review, we advocate the commission perform an holistic review, to include an assessment of the impact of MiFID more broadly on the quality of European markets and the needs of the end investor. We would like to see the differences in regulatory treatment between the regulated exchanges, MTFs and intermediaries resolved. We want to encourage a level playing field which should include an obligation for brokers to identify OTC and dark pool orders, as they do in the lit books and devise a standard way of reporting.” Andreadis agrees: “It is important to make the trade reporting environment more reliable and consistent. It will give the market the Miranda Mizen, a principal with TABB Group, calls trade reporting “a missing piece of transparency and clarity it needs to function the jigsaw puzzle that needs to be addressed”. For her, poor quality data is a risk issue: “In more efficiently on a post-trade basis. We need our view, questionable quality of data adds unacceptable risk to the market and should be a set of defined trade reporting rules.” addressed with a level of public urgency. Post-trade data is incredibly important because Nonetheless, Neiglick, who worked on the it builds a story of the market and forms part of the future and the way people make buy and sellside for 20 years, believes the trading decisions. That people can see the trading story is important to the ability to buyside are in the driving seat when it comes manage risk in the market.” Photograph kindly supplied by TABB Group, December 2009. to change:“They need to make a consolidated “The aim of a buyside trader is to review what liquidity is feed demand across Europe. The more that buyside available to them and compare their execution against the customers put business on MTFs, the faster the good changes market price. The market structure is changing quite will come. The main issue is that stock exchanges are owned rapidly so if you don’t analyse your trading, it’s difficult to by financial investors who are reluctant to do anything that will reduce their income. The systems are there, it’s just evolve your approach.” VWAP depends on being able to make accurate prohibitively expensive for the majority of investors.” TABB Group interviewed 53 buyside head equity traders predictions of volume, something which is difficult to do if it is based on dubious historical data. Historical data is also in Europe for a report by Mizen. She says:“They bemoaned used as the basis of calibration for many algorithms and a worsened visibility in the marketplace compared with smart order routers, so accurate trade reports are needed pre-MiFID and are calling for comprehensive, reliable trade for informed decisions about where to trade.VWAP fell out data at affordable cost. The importance of quality trade data of favour when volatility was high at the end of 2008 and is fundamental. Without comprehensive trade data across earlier this year, and, although there is evidence of its the board, how can the quality of market surveillance, risk return to favour, Williams says that if a large trade prints, management or best execution be assured?” Vermaas concludes: “MiFID has introduced increased traders have to“play catch-up”in order to make up some of the volume they may have been left behind on. He believes competition and choice to the market, both in terms of trading venues and increased choice of European clearing it contributes to volatility in the market. In dark pools, the difficulty is compounded, although houses together with lower transaction costs. However, Williams believes the dark pool issue is overblown. “Dark MiFID has led to significant fragmentation of liquidity pools didn’t cause this problem. If we put something into a across the many trading venues, creating new costs, raising dark pool, we’re not doing it arbitrarily. We choose issues about best execution and transparency, which means parameters and limits and so on. It’s not cloak and dagger the end investor has missed out.”

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

The credit crisis has transformed the high-yield bonds market. High-yield bonds are “the most illiquid of the illiquid” in a notoriously illiquid corporate bond market. The buyside complains about the lack of liquidity, but investors know that in a volatile market electronic execution doesn’t always work in their favour. Neil O’Hara reports. N DAYS OF yore—i.e. more than two years ago— anyone who wanted to trade high-yield bonds would pick up the phone to get a quote from one or more of the major dealers such as Credit Suisse, Morgan Stanley or Goldman Sachs. It was a clubby world dominated by a few big players who often had a near monopoly of the order flow in issues they had brought to market. The dealers had to pay to play—the buyside expected them to commit their capital to facilitate customer trades—but fat bid-offer spreads rewarded them handsomely for their trouble. The credit crisis changed all that. Under intense pressure to conserve their dwindling capital, the major dealers were no longer prepared to take on risk they could not immediately lay off on the other side. The demise of Lehman Brothers, the near death of Bear

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

Stearns and the shotgun marriage of Merrill Lynch and Bank of America also disrupted long-standing cosy relationships between dealers and their customers. The combination opened the door to new players, who could compete on an equal footing. Regional firms, including Raymond James, Morgan Keegan and Stifel Nicolaus, beefed-up their high-yield businesses, as did second-tier national players, including Cantor Fitzgerald and Jefferies. The latter has been particularly aggressive, hiring traders and sales people from bulge bracket firms in a major expansion that bulked-up its high-yield team to more than 50 professionals. The new environment also attracted boutiques like SAMCO Capital Markets and Libertas that try to match up buyers and sellers but never commit capital to a trade. “We saw a shift in liquidity from the bulge bracket to the regional dealers and the smaller brokers where they were speaking to end clients who had an interest in high-yield bonds,” says Jason Lenzo, head of trading, equities and fixed income at Russell Investments. The migration began in mid-2007 and continued through early 2009, although Lenzo has noticed the bulge bracket firms starting to flex their muscles again in the last six months now that their balance sheets have stabilised.

TRADING HIGH YIELD DEBT: OPPORTUNITY COST

New Players Shake up High-Yield Bonds

TRADING HIGH YIELD DEBT: OPPORTUNITY COST 88

“the buying opportunity of a decade” when spreads were at their widest. “People are looking for yield,”says Trani.“They are going into the more esoteric junk bonds. The fallen angels add more flavour because they were at one point decent quality and maybe they will be again.” The high-yield market consists of two segments: bonds that were speculative grade at the time they were issued, and crossover bonds, the fallen angels that started out as investment grade but were later downgraded when the issuers fell on hard times. Not surprisingly, the fallen angels trade more actively than original issue high-yield bonds; the issuers are established companies with a wider following than the fledgling upstarts—which may not even have publicly traded equity—that dominate the original issue market. Crossover bonds go through a comprehensive change in ownership when they drop below investment grade. They are ejected from standard benchmarks such as the Barclays Aggregate Bond Index—and many investors are not permitted to hold speculative grade bonds under any circumstances. Regulated entities face higher capital charges if they retain these bonds, too. A flurry of activity inevitably follows a downgrade, but the redistributed bonds then settle down to a more sustainable trading pattern. Original issue high-yield bonds trade actively for a few weeks after they are issued, but in time they typically migrate to longterm holders and volume dries up. The lead underwriter usually knows better than Sandy White, high yield and emerging markets product manager at Market Axess, says anyone where the bonds come to rest, which that while the average ticket size traded in high yield is smaller than on a typical gives that firm a huge advantage in handling institutional desk, it has gone up in the past couple of years due to the influx of fallen subsequent order flow. It becomes the “axe” angels like AIG and CIT Group, which have numerous large bond issues outstanding. in the security, privy to the associated story Photograph kindly supplied by Market Axess, December 2009. and best placed to locate a natural investor to Market Axess, the leading electronic trading platform for take the other side of a trade. “The investment bank that US high-yield bonds, has made inroads, too, although the brought a bond to market works closely with the issuer,” high-yield bond market remains a bastion of traditional says Andy Nybo, principal and head of the derivatives voice-based execution.“There is always a story attached to practice at TABB Group, a New York-based research and high-yield bonds,”says Salvatore Trani, executive managing advisory firm that specialises in the financial markets. “It director at BGC, a leading inter-dealer broker. “It’s not a will make a market in the issuer’s bonds not only for profit vanilla product like Treasuries or even agencies. They trade but also to ensure the relationship persists.” Once the bonds find a semi-permanent home, Nybo by appointment—and you can’t put the story on a screen.” The veteran trader sees no chance that electronic trading says it often takes a corporate event to dislodge them: a will ever displace voice broking in illiquid asset classes like merger, a bankruptcy filing or a new debt issuance, for example. Under normal circumstances, however, the bonds high-yield bonds. The crisis shook up the buyside as well as the dealer hardly ever trade, which leaves dealers other than the community, but to nowhere near the same extent. Hedge underwriter little incentive to make a market. As a result, these bonds are not well suited to electronic funds that suffered redemptions have scaled back, while other investors who had not been active in high-yield trading, which requires multiple market participants that bonds jumped in to take advantage of what one trader calls are willing to quote the majority of the time to create a

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

consistent and accurate market. “Some of these issues are traded so infrequently that there just isn’t a good market,” says Russell’s Lenzo. Although he sees scope for aggregators like Market Axess that allow investors to get quotes from multiple dealers, he expects much of the fixed income market—and high yield in particular—to stick with traditional voice execution. A human trader will always be the better bet if an investor wants to buy or sell a big position anyway. If word gets out that a $20m chunk of a $200m bond issue is for sale, all the bids vanish and the trade will go through at a price several points worse than the market quote. “You want to speak directly to someone with whom you have a solid relationship to minimise the information leakage,” says Lenzo.“If you have dealers who are willing to represent the customer’s best interest you can get a very sensitive issue traded with little or no market impact.” It’s a different story for small orders, for which voice execution is time consuming and expensive. That’s where Market Axess has discovered fertile ground for its electronic platform, which allows investors to solicit quotes from multiple dealers at the same time. Sandy White, high yield and emerging markets product manager at Market Axess, says that while the average ticket size traded in high yield is smaller than on a typical institutional desk, it has gone up in the past couple of years due to the influx of fallen angels like AIG and CIT Group, which have numerous large bond issues outstanding. The squeeze on the major dealers has also helped Market Axess boost its share of trades. “From September 2008 our

Andy Nybo, principal and head of the derivatives practice at TABB Group, a New York-based research and advisory firm that specialises in the financial markets. "It will make a market in the issuer's bonds not only for profit but also to ensure the relationship persists,” says Nybo. Photograph kindly supplied by TABB Group, December 2009.

Salvatore Trani, executive managing director at BGC, a leading inter-dealer broker. The veteran trader sees no chance that electronic trading will ever displace voice broking in illiquid asset classes like high-yield bonds. Photograph kindly supplied by BGC, December 2009.

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

volumes just took off,” says White.“People were looking for other ways to find liquidity, and we were one of the best tools out there.” Although Market Axess still accounts for less than 5% of secondary market activity in high yield bonds, White says trading volume has grown faster in the last year than in any other sector of the fixed income market that trades on its platform. The firm has signed up more than 700 buyside investors, who can now request quotes from 35 high yield bond dealers, a number that doubled in the 12 months after Lehman collapsed, adding a raft of regional and smaller firms. White wonders whether all the new participants will stay in the game for the long haul, however. He expects the major dealers will use their balance sheet strength to win back market share in the next 12 months at the expense of firms that do not commit capital, a view shared by Trani at BGC. Says White: “Risk free orders are going to become harder to come by in the future.” To David Easthope, a senior analyst in the securities and investments practice at Celent, a Boston-based financial services research firm, highyield bonds are “the most illiquid of the illiquid” in a notoriously illiquid corporate bond market. The buyside complains about the lack of liquidity, but investors know that in a volatile market electronic execution doesn’t always work in their favour. “The liquidity is really in the credit default swaps market,” says Easthope. “If a pension fund is looking to trade cash high-yield bonds, the traders are going to pick up the phone and call their best relationships. It is still very much a phone and Bloomberg based system.”

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

-38

Stock

CPI.L

CAPITA GROUP ORD 2.066666P

3.16

PFG.L

PROVIDENT FIN. ORD 20 8/11P

2.97

CCL.L

CARNIVAL ORD USD 1.66

2.97

BLND.L

BR.LAND ORD 25P

2.91

DGE.L

DIAGEO ORD 28 101/108P

2.84

RR..L

ROLLS-ROYCE ORD 20P

2.82

KGF.L

KINGFISHER ORD 15 5/7P

2.81

COB.L

COBHAM ORD 2.5P

2.79

RDSA.L

RDS ‘A’ ‘A’ ORD EUR0.07

2.78

BG..L

BG GRP. ORD 10P

2.73

RDSB.L

RDS ‘B’ ‘B’ ORD EUR0.07

2.72

PFC.L

PETROFAC ORD USD0.025

2.71

HAYS ORD 1P

2.71

Description

FFI Across Major Indices

Wks

FFI

-5

-16

-12

-36

-4

-19

-22

-9

-23

-50

-6

4 4

HAS.L HFD.L

HALFORDS ORD 1P

2.71

-68

MKS.L

MARKS & SP. ORD 25P

2.68

-17

SSE.L

SCOT.&STH.ENRGY ORD 50P

2.68

-2

RSA.L

RSA INS. ORD 27.5P

2.68

-13

MRW.L

MORRISON (WM) ORD 10P

2.68

-33

BSY.L

BSKYB ORD 50P

2.66

-14

GSK.L

GLAXOSMITHKLINE ORD 25P

2.65

2.5

2.0

1.5

1.0 Oct

Nov Dec

DAX

Jan

Feb

AEX

Mar Apr

May Jun

CAC 40

Jul

Aug Sep

FTSE 100 October 2009

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

COMMENTARY By Steve Grob, Director of Strategy, Fidessa Last month we commented on the gulf between the London Stock Exchange (LSE) and the other primary markets. In the past three months this gap has only widened although the FFI for indices such as the CAC40 and the DAX has increased, too (only slower than for the FTSE 100 and 250 stocks). This helps to highlight just how high the stakes are in the battle for liquidity between the primary exchanges and the MTF community. One event that helped to crystallise this issue was the outage at the LSE on the 26th November. During the outage, and contrary to expectations, traders didn’t divert their orders to the MTFs but, in fact, stopped trading altogether. This shows that, in London at least, traders are still reluctant to use the MTFs without the comfort of knowing that the primary market is open at the same time. Market makers, too, are reluctant to make prices when the primary market is down and so this further encouraged traders to stay at home rather than go and play on the MTFs. Another factor in play this time, though, was technology. The majority of smart routers are (correctly) configured so as to direct all orders to a primary market when it is in auction. Normally, when an exchange has a problem it suspends trading on its platform altogether. However, on this occasion, the LSE put its market into auction which had the effect of creating an ‘artificial’ auction that sucked up available liquidity from smart routers. This then led to the huge spike in trading on the LSE when it reopened at 2 pm. The net result was that the LSE’s market share jumped by 7% compared with its daily average for the rest of November. This last point highlights, yet again, the ironic interplay in the post-MiFID world whereby the MTF community is still dependent on the LSE being open in order to try and increase its own share of UK stock trading.

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

Venue turnover in major stocks: April - November 2009 (Europe only). (€) April

May

June

July

October

November

BTE

11,760,455,327.00

12,273,094,621.00

19,819,573,785.00

17,136,125,014.00

August 14,571,686,219.00

September 22,569,010,036.90

27,644,041,971.79

23,573,463,734.99

CIX

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

84,046,791,321.19

106,697,966,298.67

90,039,160,470.86

CPH

6,870,911,751.00

7,383,968,635.00

5,812,371,514.00

4,870,382,666.00

7,089,257,770.00

7,147,826,212.47

7,580,961,264.52

5,706,863,159.57

ENA

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

37,393,454,265.25

44,333,181,213.17

32,257,175,002.36

ENL

2,611,463,853.00

2,971,813,173.00

2,198,642,157.00

2,070,066,025.00

2,485,993,487.00

4,261,559,944.59

3,485,422,128.23

2,219,360,066.21

ENX

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

77,685,773,333.81

81,861,726,196.95

65,433,199,147.49

GER

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

69,515,848,590.13

74,419,073,211.90

60,908,552,433.56

LSE

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

96,477,697,345.69

100,753,579,612.36

88,751,421,724.55

MAD

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

47,318,951,034.98

56,848,573,772.28

42,670,316,078.54

MIL

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

78,086,217,226.28

65,232,722,070.55

58,890,245,107.45

NEU

950,256,423.30

2,327,001,210.00

2,718,970,582.00

3,543,693,008.00

3,185,323,984.00

4,413,980,819.97

6,508,249,441.66

7,449,995,153.50

OSL

9,308,457,732.00

14,694,324,285.00

13,002,357,861.00

8,191,066,040.00

10,083,367,296.00

13,222,554,868.00

16,695,154,952.77

13,184,181,892.72

STO

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

23,529,554,732.68

25,928,648,845.75

20,898,321,966.79

TRQ

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

26,106,162,960.16

28,005,208,583.96

22,895,687,295.59

VTX

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

37,499,163,419.18

39,772,295,992.78

37,198,627,753.77

HEL

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

10,016,921,672.01

11,276,385,550.29

7,451,015,808.21

ENB

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

10,086,003,222.10

8,942,068,143.91

6,366,264,426.48

NAE

75,833,173.13

65,079,038.29

188,509,367.45

286,391,174.03

BRG

367,214,270.90

622,622,788.02

559,921,470.34

362,494,501.08

BER

11,198,473.01

DUS

41,944,732.75

Index market share by venue: Week ending December 11th 2009 Primary

Alternative Venues

Index

Venue

Chi-X

Turquoise

Nasdaq OMX

BATS

Burgundy

Amst.

Paris

Xetra

Stockholm

AEX

Amsterdam

72.81%

16.21%

3.56%

1.11%

3.28%

2.73%

0.17%

BEL 20

Brussels

52.91%

15.81%

2.76%

0.98%

2.62%

24.65%

0.04%

CAC 40

Paris

64.20%

18.69%

3.79%

1.80%

3.94%

7.01%

0.15%

DAX

Xetra

69.93%

20.14%

4.03%

1.03%

3.95%

†

FTSE 100

London

58.64%

25.53%

5.53%

1.57%

8.35%

FTSE 250

London

69.41%

17.90%

6.03%

1.71%

4.93%

IBEX 35

Madrid

99.58%

0.32%

0.03%

†

0.02%

FTSE MIB

Milan

82.96%

9.49%

1.62%

0.42%

5.40%

†

0.04%

PSI 20

Lisbon

92.25%

3.00%

4.34%

0.12%

0.24%

0.02%

SMI

SIX Swiss

83.50%

10.25%

3.03%

1.04%

2.15%

88.97%

6.59%

3.15%

0.38%

0.90%

†

OMX C20 Copenhagen OMX H25

Helsinki

81.01%

10.35%

4.34%

0.85%

2.10%

†

0.03%

1.05%

OMX S30

Stockholm

80.17%

10.77%

4.52%

1.11%

2.31%

1.10%

OSLO OBX

Oslo

92.81%

2.41%

0.81%

0.09%

0.38%

0.09%

3.41%

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 • JANUARY/FEBRUARY 2010

5-Year Performance Graph (USD Total Return) Index Level Rebased (30 November 2009=100) No v04 500

FTSE All-World Index

400

FTSE Emerging Index

300

FTSE Global Government Bond Index

200

FTSE EPRA/NAREIT Developed Index

100

FTSE4Good Global Index FTSE GWA Developed Index No v0

9 ay -0 M

8 No v0

8 ay -0 M

7 No v0

ay -0 7 M

v06 No

ay -0 6 M

v05 No

ay -0 5

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

2,757

238.70

7.3

20.6

38.5

33.4

2.52

FTSE World Index

USD

2,306

559.05

6.9

20.5

36.6

31.7

2.55

FTSE Developed Index

USD

2,014

222.13

6.2

19.8

33.3

28.9

2.55

FTSE All-World Indices

FTSE Emerging Index

USD

743

617.84

15.4

26.5

90.7

77.2

2.30

FTSE Advanced Emerging Index

USD

292

584.85

17.7

30.4

95.5

78.8

2.64

FTSE Secondary Emerging Index

USD

451

714.41

13.3

22.4

85.9

76.7

1.97

FTSE Global All Cap Index

USD

7,312

380.94

7.2

20.7

39.7

34.3

2.44

FTSE Developed All Cap Index

USD

5,860

357.29

6.1

20.0

34.5

29.7

2.46

FTSE Emerging All Cap Index

USD

1,452

817.94

15.4

26.7

93.5

79.4

2.26

FTSE Advanced Emerging All Cap Index

USD

622

787.11

17.7

30.1

98.1

80.8

2.57

FTSE Secondary Emerging All Cap Index

USD

830

909.53

13.2

23.1

88.8

79.1

1.95

USD

713

192.76

5.6

9.4

14.9

7.1

2.65

FTSE EPRA/NAREIT Developed Index

USD

259

2329.15

6.4

26.0

46.3

33.4

4.41

FTSE EPRA/NAREIT Developed REITs Index

USD

177

774.96

7.5

32.8

39.6

26.7

5.50

FTSE Global Equity Indices

Fixed Income FTSE Global Government Bond Index Real Estate

FTSE EPRA/NAREIT Developed Dividend+ Index

USD

202

1663.76

8.2

29.5

50.2

36.0

5.18

FTSE EPRA/NAREIT Developed Rental Index

USD

214

876.49

7.2

32.1

40.4

28.7

5.18

FTSE EPRA/NAREIT Developed Non-Rental Index

USD

1069.19

4.5

12.4

63.6

47.0

2.38

FTSE4Good Global Index

USD

657

6124.30

5.9

21.8

36.4

31.4

2.82

FTSE4Good Global 100 Index

USD

103

5234.67

6.8

21.5

31.8

28.6

2.96

FTSE GWA Developed Index

USD

2,014

3466.54

5.1

20.2

43.3

38.4

2.70

FTSE RAFI Developed ex US 1000 Index

USD

1,002

6111.71

1.8

21.6

49.9

42.5

3.00

FTSE RAFI Emerging Index

USD

355

6512.79

12.0

24.1

85.2

73.5

2.03

SRI

Investment Strategy

SOURCE: FTSE Group and Thomson Datastream, data as at 30 November 2009

JANUARY/FEBRUARY 2010 â&#x20AC;˘ FTSE GLOBAL MARKETS

Americas Market Indices Index Level Rebased (30 November 2009=100)

5-Year Performance Graph (USD Total Return) 300

FTSE Americas Index

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 No v09

-0 9 ay M

No v08

-0 8 ay M

No v07

-0 7 ay M

v06 No

-0 6 ay M

v05

-0 5 ay M

v04

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

785

726.34

8.7

20.7

30.8

29.4

2.02

FTSE North America Index

USD

661

788.19

7.8

19.8

27.6

26.3

1.97

FTSE Latin America Index

USD

124

1158.94

23.6

34.3

107.2

101.0

2.63

FTSE Global Equity Indices FTSE Americas All Cap Index

USD

2,528

330.85

8.5

20.9

32.3

30.2

1.92

FTSE North America All Cap Index

USD

2,339

314.40

7.6

19.9

29.0

27.0

1.87

FTSE Latin America All Cap Index

USD

189

1634.99

23.7

35.9

110.2

103.7

2.56

FTSE Americas Government Bond Index

USD

170

190.84

2.5

3.4

4.3

0.4

2.81

FTSE USA Government Bond Index

USD

156

186.89

2.3

3.4

3.7

0.0

2.78

FTSE EPRA/NAREIT North America Index

USD

114

2587.53

9.1

33.4

42.6

23.5

3.97

FTSE EPRA/NAREIT US Dividend+ Index

USD

1413.09

8.8

33.1

40.9

19.7

3.91

FTSE EPRA/NAREIT North America Rental Index

USD

111

875.31

9.0

33.0

41.2

24.2

3.95

FTSE EPRA/NAREIT North America Non-Rental Index

USD

331.66

14.0

47.0

169.0

-5.0

4.36

FTSE NAREIT Composite Index

USD

117

2526.31

8.3

30.9

39.2

20.0

4.79

FTSE NAREIT Equity REITs Index

USD

6088.91

8.6

31.0

39.0

19.4

3.88

FTSE4Good US Index

USD

137

4809.15

7.3

24.1

31.1

29.6

1.85

FTSE4Good US 100 Index

USD

102

4598.11

7.3

23.8

29.7

28.6

1.87

FTSE GWA US Index

USD

609

2977.38

6.5

20.8

31.7

30.5

2.07

FTSE RAFI US 1000 Index

USD

987

5230.90

3.4

25.6

41.4

39.3

1.52

FTSE RAFI US Mid Small 1500 Index

USD

1,453

4720.53

1.8

25.2

50.9

43.1

1.24

Fixed Income

Real Estate

SRI

Investment Strategy

SOURCE: FTSE Group and Thomson Datastream, data as at 30 November 2009

FTSE GLOBAL MARKETS • JANUARY/FEBRUARY 2010

5-Year Total Return Performance Graph FTSE Europe Index (EUR) Index Level Rebased (30 November 2009=100) No v04

FTSE All-Share Index (GBP)

400

FTSEurofirst 80 Index (EUR)

300

FTSE/JSE Top 40 Index (SAR)

200

FTSE Gilts Actuaries UK Conventional Fixed All-Stocks Index (GBP) FTSE EPRA/NAREIT Developed Europe Index (EUR)

100

FTSE4Good Europe Index (EUR) FTSE GWA Developed Europe Index (EUR)

No v09

ay -0 9 M

No v08

ay -0 8 M

No v07

M ay -0 7

-0 6 No v

M ay -0 6

No v05

M ay -0 5

MARKET DATA BY FTSE RESEARCH

Europe, Middle East & Africa Indices

FTSE RAFI Europe Index (EUR)

Table of Total Returns Index Name

Currency

Constituents

Value

3 M (%)

6 M (%)

FTSE Europe Index

EUR

550

FTSE Eurobloc Index

EUR

285

FTSE Developed Europe ex UK Index

EUR

FTSE Developed Europe Index

EUR

FTSE Europe All Cap Index FTSE Eurobloc All Cap Index

12 M (%)

YTD (%)

Actual Div Yld (%pa)

215.32

2.0

15.9

21.2

26.4

3.37

119.94

1.2

15.4

22.3

21.9

3.77

375

218.92

1.3

16.3

23.2

23.5

3.40

490

212.56

1.7

15.9

20.6

25.2

3.42

EUR

1,578

335.36

2.0

16.1

22.6

28.0

3.28

EUR

778

354.51

1.4

15.8

23.6

23.1

3.68

FTSE Developed Europe All Cap ex UK Index

EUR

1,061

364.36

1.6

16.6

24.6

24.9

3.31

FTSE Developed Europe All Cap Index

EUR

1,457

333.10

1.7

16.0

22.0

26.8

3.33

FTSE All-Share Index

GBP

618

3441.30

5.9

19.7

29.3

24.7

3.35

FTSE 100 Index

GBP

102

3279.49

6.6

19.8

26.3

22.0

3.45

FTSEurofirst 80 Index

EUR

4559.92

1.7

15.9

21.1

20.0

3.99

FTSEurofirst 100 Index

EUR

100

4049.28

2.1

15.4

17.5

22.5

3.81

FTSEurofirst 300 Index

EUR

311

1391.95

1.9

15.6

19.1

23.3

3.48

FTSE/JSE Top 40 Index

SAR

2750.98

9.4

19.5

29.0

28.3

2.02

FTSE/JSE All-Share Index

SAR

161

3022.43

8.5

19.6

30.3

28.4

2.28

FTSE Russia IOB Index

USD

882.79

17.3

12.1

86.6

105.6

2.34

FTSE All-World Indices

FTSE Global Equity Indices

Region Specific

Fixed Income FTSE Eurozone Government Bond Index

EUR

233

170.93

1.6

5.1

6.2

5.1

3.52

FTSE Pfandbrief Index

EUR

382

206.89

2.1

6.5

9.0

8.2

3.59

FTSE Actuaries UK Conventional Gilts All Stocks Index

GBP

2349.41

0.8

4.7

6.8

1.5

3.76

FTSE EPRA/NAREIT Developed Europe Index

EUR

1740.84

-0.4

25.7

26.8

29.0

4.72

FTSE EPRA/NAREIT Developed Europe REITs Index

EUR

639.60

-0.1

27.0

23.4

28.2

5.24

FTSE EPRA/NAREIT Developed Europe ex UK Dividend+ Index

EUR

2161.20

2.8

26.2

43.3

34.9

5.42

FTSE EPRA/NAREIT Developed Europe Rental Index

EUR

682.00

-0.1

26.1

26.6

28.4

4.84

FTSE EPRA/NAREIT Developed Europe Non-Rental Index

EUR

502.55

-9.3

14.7

34.6

50.5

1.34

FTSE4Good Europe Index

EUR

264

4256.82

1.5

15.9

20.0

25.4

3.50

FTSE4Good Europe 50 Index

EUR

3696.11

1.7

14.2

14.3

20.5

3.70

FTSE GWA Developed Europe Index

EUR

490

3090.48

0.4

16.3

31.5

36.6

3.53

FTSE RAFI Europe Index

EUR

516

4803.14

-2.9

16.7

29.7

35.5

2.74

Real Estate

SRI

Investment Strategy

SOURCE: FTSE Group and Thomson Datastream, data as at 30 November 2009

JANUARY/FEBRUARY 2010 â&#x20AC;˘ FTSE GLOBAL MARKETS

Asia Pacific Market Indices FTSE Asia Pacific Index (USD) FTSE/ASEAN Index (USD) FTSE/Xinhua China 25 Index (CNY)

800

FTSE Asia Pacific Government Bond Index (USD)

600

FTSE EPRA/NAREIT Developed Asia Index (USD) 400

FTSE IDFC India Infrastructure Index (IRP) 200

FTSE4Good Japan Index (JPY)

No v

-0 9

ay -0 9 M

-0 8 No v

ay -0 8 M

No v07

M ay -0 7

No v06

M ay -0 6

No v

-0 5

FTSE GWA Japan Index (JPY) M ay -0 5

-0 4

No v

Index Level Rebased (30 November 2009=100)

5-Year Total Return Performance Graph

FTSE RAFI Kaigai 1000 Index (JPY)

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

1,288

FTSE Asia Pacific ex Japan Index

USD

829

270.52

4.8

17.2

49.2

37.3

2.44

540.96

12.1

26.7

84.2

68.5

FTSE Japan Index

USD

2.58

459

70.35

-12.2

-5.9

2.8

0.0

2.21

FTSE All-World Indices

FTSE Global Equity Indices FTSE Asia Pacific All Cap Index

USD

3,023

458.64

4.8

17.3

50.7

38.5

2.44

FTSE Asia Pacific All Cap ex Japan Index

USD

1,776

668.75

12.3

26.6

87.6

71.1

2.56

FTSE Japan All Cap Index

USD

1,247

222.78

-12.4

-5.7

2.9

0.0

2.23

FTSE/ASEAN Index

USD

149

539.45

10.3

28.7

86.2

69.7

2.90

FTSE Bursa Malaysia 100 Index

MYR

100

9154.57

6.8

22.3

51.7

49.6

2.47

TSEC Taiwan 50 Index

TWD

6818.34

10.2

13.3

67.5

62.4

2.87

FTSE Xinhua All-Share Index

CNY

1,008

9247.08

26.2

29.1

102.5

100.2

0.77

FTSE/Xinhua China 25 Index

CNY

24402.11

11.2

19.9

68.3

56.0

1.94

USD

231

148.60

8.0

12.5

13.5

5.9

1.25

FTSE EPRA/NAREIT Developed Asia Index

USD

2033.10

4.9

17.0

48.1

41.3

4.70

FTSE EPRA/NAREIT Developed Asia 33 Index

USD

1317.45

5.9

18.3

41.3

37.6

3.88

FTSE EPRA/NAREIT Developed Asia Dividend+ Index

USD

2114.06

9.4

22.8

60.1

53.2

6.54

FTSE EPRA/NAREIT Developed Asia Rental Index

USD

900.68

6.0

28.2

29.2

30.0

8.64

FTSE EPRA/NAREIT Developed Asia Non-Rental Index

USD

1167.99

4.3

11.1

61.9

48.9

2.32

Region Specific

Fixed Income FTSE Asia Pacific Government Bond Index Real Estate

Infrastructure FTSE IDFC India Infrastructure Index

IRP

928.08

-1.3

-0.5

75.1

52.8

0.72

FTSE IDFC India Infrastructure 30 Index

IRP

1048.86

-1.2

-1.1

83.2

59.0

0.72

JPY

185

3397.81

-12.7

-7.2

3.6

0.4

2.38

FTSE SGX Shariah 100 Index

USD

100

4995.38

1.3

12.7

34.5

24.4

2.26

FTSE Bursa Malaysia Hijrah Shariah Index

MYR

10440.32

4.8

17.5

44.1

42.7

2.52

JPY

100

954.11

-11.0

-3.9

7.5

5.0

2.23

SRI FTSE4Good Japan Index Shariah

FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index

JPY

459

2521.13

-11.8

-5.5

11.2

8.3

2.32

FTSE GWA Australia Index

AUD

101

4002.53

5.4

27.5

32.2

33.9

4.31

FTSE RAFI Australia Index

AUD

6457.30

6.4

28.7

33.0

35.7

6.68

FTSE RAFI Singapore Index

SGD

7988.97

8.1

18.9

67.0

64.1

3.15

FTSE RAFI Japan Index

JPY

278

3432.62

-14.5

-8.4

4.2

1.1

2.27

FTSE RAFI Kaigai 1000 Index

JPY

1,006

3879.51

-4.1

13.0

32.8

36.1

2.41

HKD

7094.63

10.8

18.6

65.9

59.7

2.38

FTSE RAFI China 50 Index

SOURCE: FTSE Group and Thomson Datastream, data as at 30 November 2009

FTSE GLOBAL MARKETS â&#x20AC;˘ JANUARY/FEBRUARY 2010

INDEX CALENDAR

Index Reviews January – April 2010 Date

Index Series

Review Frequency/Type

Effective Data Cut-off (Close of business)

05-Jan

FTSE/Xinhua Index Series

Quarterly review

18-Jan

17-Dec

07-Jan

TSEC Taiwan 50

Quarterly review

18-Jan

31-Dec

07-Jan

TOPIX

Monthly review - additions & free float adjustment

25-Feb

29-Jan

Mid Jan

OMX H25

Semi-annual review consitutents

01-Feb

29-Jan

Late Jan/ Early Feb

PSI 20

Annual review

02-Mar

02-Jan

Early Feb

BEL 20

Annual review

02-Mar

01-Mar

Early Feb

AEX

Annual review

02-Mar

01-Mar

05-Feb

TOPIX

Monthly review - additions & free float adjustment

30-Mar

26-Feb

10-Feb

Hang Seng

Quarterly review

02-Mar

31-Dec

12-Feb

MSCI Standard Index Series

Quarterly review

26-Feb

31-Jan

02-Mar

FTSE All-World

Annual review Asia Pacific ex Japan

19-Mar

26-Feb

Early Mar

ATX

Semi-annual review / number of shares

31-Mar

28-Feb

Early Mar

CAC 40

Quarterly review

19-Mar

17-Mar

Early Mar

S&P / TSX

Quarterly review

19-Mar

26-Feb

03-Mar

DAX

Quarterly review

19-Mar

26-Feb

05-Mar

S&P / ASX Indices

Annual / Quarterly review

19-Mar

26-Feb

05-Mar

TOPIX

Monthly review - additions & free float adjustment

29-Apr

31-Mar

09-Mar

FTSE MIB

Semi-annual review

19-Mar

26-Feb

10-Mar

FTSE Asiatop / Asian Sectors

Semi-annual review

19-Mar

26-Feb

10-Mar

FTSE/ASEAN 40 Index

Annual review

19-Mar

26-Feb

10-Mar

FTSE UK

Quarterly review

19-Mar

09-Mar

10-Mar

FTSEurofirst 300

Quarterly review

19-Mar

26-Feb

10-Mar

FTSE techMARK 100

Quarterly review

19-Mar

26-Feb

10-Mar

FTSE Italia Index Series

Quarterly review

19-Mar

26-Feb

10-Mar

FTSE/JSE Africa Index Series

Quarterly review

19-Mar

26-Feb

12-Feb

FTSE4Good Index Series

Semi-annual review

19-Mar

26-Feb

13-Mar

FTSE EPRA/NAREIT Global Real Estate Index Series

Quarterly review

19-Mar

26-Feb

13-Mar

S&P Asia 50

Quarterly review

20-Mar

06-Mar

13-Mar

DJ STOXX

Quarterly review

20-Mar

06-Mar

13-Mar

Russell US/Global Indices

Quarterly review - IPO additions only

31-Mar

28-Feb

14-Mar

S&P US Indices

Quarterly review

20-Mar

06-Mar

14-Mar

S&P Europe 350 / S&P Euro

Quarterly review

20-Mar

06-Mar

14-Mar

S&P Global 1200

Quarterly review

20-Mar

06-Mar

14-Mar

S&P Global 100

Quarterly review

20-Mar

06-Mar

14-Mar

S&P Latin 40

Quarterly review

20-Mar

06-Mar

15-Mar

S&P Topix 150

Quarterly review

19-Mar

05-Mar

17-Mar

BNY Mellon DR Indices

Quarterly review

22-Mar

26-Feb

24-Mar

NZX 50

Quarterly review

31-Mar

28-Feb

06-Apr

FTSE/Xinhua Index Series

Quarterly review

16-Apr

19-Mar

07-Apr

TOPIX

Monthly review - additions & free float adjustment

28-May

30-Apr

08-Apr

TSEC Taiwan 50

Quarterly review

19-Apr

31-Mar

Late April

FTSE / ATHEX

Semi-annual review

31-May

31-Mar

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

JANUARY/FEBRUARY 2010 • FTSE GLOBAL MARKETS

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