FTSE Global Markets

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FACE TO FACE WITH EAST CAPITAL ISSUE 40 • MARCH/APRIL 2010

The promise of Asian securities lending The return of Middle East real estate How to best regulate derivatives The beef with offshore markets

CAN CARL ICAHN HELP SAVE LAS VEGAS? ROUNDTABLE: THE COMPETITIVE CHALLENGE IN ASIAN SECURITIES SERVICES

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As a partnership for more than 190 years, Brown Brothers Harriman (BBH) applies the principles of partnership to everything we do. Each client relationship benefits directly from our relationship excellence, trust, and long-term commitment. With offices worldwide and a network covering

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close to 100 markets, we leverage our global reach, leading-edge technology, and

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Learn more about our unique approach at www.bbh.com.

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Custody Accounting Fund Administration Securities Lending Fund Distribution Outsourcing Foreign Exchange Consulting Offshore Services Brokerage

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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.

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FTSE GLOBAL MARKETS • MARCH/APRIL 2010

HERE’S A VERITABLE sea change afoot in the global markets and it is it being driven by a political elite that has not yet properly articulated (or proved for that matter) whether what is good for banks is not necessarily what is good for the financial markets at large. Until someone can square that particular circle the flurry of polemical moves to curtail the size and profits of the banking sector looks like wielding a heavy hammer to fillet a fish; an inappropriate exercise with inadequate tools.

In part, in a still arid economic climate, the propensity to rugby-tackle anything that looks like it is making a profit just because it might have popular appeal seems an ill-judged exercise from people who should know better.

Moreover, while the global financial markets are in flux and with the rapid rise of Asia as a new financial axis, the global markets are best served by lawmakers who understand concepts such as global competitiveness, financial diversity, investor protection and adequate risk-return management rather than punitive assaults on the earning power of a relative few in the financial segment.

If you think that is overstating the case, I would point you to Bibby Financial Services’ most recent trading report, which reveals that 48% of surveyed firms in the UK feel their business is experiencing the same conditions as six months ago, while 33% of businesses do not expect trading conditions to improve for at least a year (up from 19% last year). Worse, one in ten businesses surveyed think trading conditions will not improve for another two years, and 10% of firms surveyed think the markets will remain in recession for three years or more. The markets are looking for visionary leadership and economic stimuli; not outdated rivalries around Napoleonic versus “Anglo-Saxon” market approaches, feudal levels of taxation and market-inhibiting regulation. Cover and eliminate fraudulent excesses by all means; but do not hamper economic prospects by making it difficult for financial institutions to want to continue to conduct business in their traditional market strongholds; for if you do, they will only seek out new ones. You have only to look at the escalating demand for office space in Singapore to understand the dynamics of that particular play.

Polemics aside, we’re offering a job lot of analysis covering a broad range of financial services in this edition. Ian Williams analyses the outlook for private equity, which appears to be making something of a gradual return to normalcy.

Andrew Cavenagh meantime tests the waters for the pfandbrief and European covered bond markets; important bellwethers for a welcome return of the asset backed segment in continental Europe. In related editorial, we look at the testing time for airline financing and the Middle East real estate sector, each having been stymied by the fallout in the availability of credit.

In turbulent times one looks for clear signs of hope. In that regard our cover story focuses on Las Vegas as a microcosm of the US economy at large. Gaming central has endured poor pickings of late; despite the $1k a pop slot machines.

Fontainebleau, for instance, a 68-floor hotel-casino that, after $2bn in construction costs, went into bankruptcy, requires perhaps a billion dollars more to be built out. It looks like legendary investor Carl Icahn believes it is worth the money. His bid of $156.2m—about 8 cents on the dollar—has been accepted by the bankruptcy court. When our East Coast editor Art Detman descended on a rainy Las Vegas to research the story, he found out that actually, the famous strip is not in the City of Las Vegas, but in an unincorporated town named Paradise.You couldn’t make this stuff up really. There are obvious puns, but I won’t stretch your patience with them.

T

Francesca Carnevale, Editorial Director March 2010

Cover photo: Archive photo of billionaire investors and financier Carl Icahn attending a news conference about Time Warner Inc. On Tuesday, February 7th, 2006 in New York. At the time the photo was taken, Icahn led a group of investors who asked for a shake-up at Time Warner.

Icahn's demands included larger share buybacks and a complete spinoff of Time Warner's cable TV division. Photograph by Shiho Fukada for Associated Press. Photograph supplied by PA Photos, January 2009.

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Contents COVER STORY CAN CARL ICAHN SAVE LAS VEGAS? ....................................................................Page 67 Gambling central, Las Vegas has lost substantially more than sheen over the last few years. Can its fortunes be resurrected? Carl Icahn thinks he can make something of the Fontainbleu hotel complex. Historically a canny investor, what does he see that others don’t? Art Detman visited Las Vegas to find out.

DEPARTMENTS MARKET LEADER

WILL PRIVATE EQUITY RISE OUT OF THE ASHES?..................Page 6 Ian Williams surveys the status of a bruised US buyout and venture capital markets.

BACK TO THE FUTURE ..................................................................................Page 10 Private equity looks set to make a comeback – albeit a slow one. Neil O’Hara reports.

IN THE MARKETS

GROUNDHOG DAY ..........................................................................................Page 18 Ian Williams asks how long the airline industry can fly in the doldrums.

..............................................Page 22 Vanja Dragomanovich looks at the impact of Russian firms opting to list in Asia.

UC RUSAL OPTS FOR HONG KONG

FACE TO FACE

EAST CAPITAL: THE RUSSIA HOUSE ..................................................Page 28 Vanja Dragomanovich reports on the outstanding performance of the investment firm.

PFANDBRIEF: THE STEADY COMEBACK ........................................Page 34 Andrew Cavenagh reports on the prospects for the German pfandbrief market.

DEBT REPORT

SPANISH COVERED BONDS IN THE BULLRING ........................Page 38 Andrew Cavenagh reports on a market under duress.

CREDIT SPREADS & GOVERNMENT BOND YIELDS ..............Page 41

By Jamie Stuttard, head of European & UK fixed income and Sarang Kukarni, fixed income fund manager at Schroders.

EVOLUTIONARY INDEXING ......................................................................Page 43

INDEX REVIEW

FTSE Group’s teams with EDHEC-Risk Institute to redraw the way indices are constructed.

DOOMSDAY DOMINOES ............................................................................Page 45 Simon Denham, managing director, Capital Spreads, takes the bearish long view.

CRY FOR ME NOW, ARGENTINA ........................................................Page 46

COUNTRY REPORT

John Rumsey on the impact of the ousting of Argentina’s central bank governor.

........................................................................Page 48 John Rumsey assesses the economic policies of Brazil’s presidential election candidates.

GOODBYE TO ALL THAT?

REAL ESTATE

AFTER THE STORM ..........................................................................................Page 50

SECTOR REPORT

OIL: FLATTENING DEMAND......................................................................Page 53

Mark Faithfull on new approaches to investment in the real estate segment in the GCC region.

Vanja Dragomanovich on the investment outlook for oil in 2010.

Fidessa Fragmentation Index ................................................................................................Page 94 Market Reports by FTSE Research ......................................................................................Page 96 Index Calendar..........................................................................................................................Page 100

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MARCH/APRIL 2010 • FTSE GLOBAL MARKETS

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Contents FEATURES THE ASIA REPORT

THE GROWING PROMISE OF ASIAN SECURITIES LENDING......Page 56

An increased requirement for transparency, the ability to control investment guidelines and a growing awareness of risk mitigation tools are cornerstones of today’s securities lending business, states Robert Lees, vice president, head of Securities Lending Trading in Asia for Brown Brothers Harriman (BBH).

THE SECURITIES LENDING REGULATOR ROUSTABOUT ........Page 62 ROUNDTABLE

LEVERAGING OPPORTUNITY IN HIGH GROWTH MARKETS ....Page 63

According to Soon Kian Lee, principal and head of ASEAN investment consulting business at Mercer, “The last 18 months have been a huge wake up call for all participants in the global capital markets. Asset managers have been under pressure for failing to produce the expected alpha during this period.” How has this impacted on the provision of asset services in an otherwise growth-led region? The attendees of our annual Asian Asset Servicing Roundtable discuss the key trends.

ASSET SERVICING

US CUSTODY: IT IS IN THE GENES ......................................................Page 78

Coming off a gruelling year of stress tests and other trials, US-based custodian banks entered 2010 in remarkable shape, evidenced by a uniform rise in assets under custody.

Fees remain the key revenue driver, compelling many asset servicing providers to make fresh securities servicing acquisitions while at the same time bringing a new array of tools to the market. However, with margins constantly under pressure and demands for capital on the increase, custodians have little time to rest on their laurels.

OFFSHORE EXCHANGES

BSX AND THE IMPORTANCE OF CATASTROPHE BONDS ....Page 82

With an insurance market comprising nearly 1,400 companies, total assets of $442bn and gross premiums of $142bn, Bermuda boasts the third largest insurance market in the world. Listed insurance companies and insurance-linked securities have a combined market capitalisation of some $39bn on the Bermuda Stock Exchange (BSX).

In October last year, the new Insurance Amendment Act 2008 came into effect, under the auspices of the Bermuda Monetary Authority (BMA). The Act is intended to cement Bermuda’s role as a rising insurance hub and spur innovation of new insurance product, with particular regard of late to catastrophe bonds.

THE ME TOO COMPLEX ..............................................................................Page 85 DERIVATIVES

THE DRIVE FOR TRANSPARENCY AND REGULATION........Page 88

Regulators continue to push for reform of the over the counter (OTC) derivatives market. In early February, European member of parliament, Werner Langen published a draft report on OTC derivatives reforms to be considered by the European Parliament’s Economic and Monetary Affairs Committee in its decision on how the European derivatives markets should be regulated going forward. The United States is also in the process of clarifying approaches to OTC derivatives products. Will Europe end up with a draconian regime? Or will pragmatism win the day? Richard Hemming explains some of the dynamics.

LIFE THROUGH A LENS? ..............................................................................Page 91

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MARCH/APRIL 2010 • FTSE GLOBAL MARKETS

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Market Leader PRIVATE EQUITY: LIVING IN THE AFTERMATH

It’s a battlefield The private equity sector’s fundraising last year had its worst 12 months since 2004, with just $246bn raised by 482 funds worldwide. That is more than 60% down on the $636bn raised in 2008, and 62% lower than the record $646bn raised in 2007. The fourth quarter (Q4) in 2009 represents a low point for the year, with only $35bn raised by 75 funds—the lowest quarterly total since Q3 2003. In contrast, this year, due to a return to visibility and the resumed availability of some leverage, there will be more deals completed. Even so, there is evident caution, but the time will come to throw money at PE funds, writes Ian Williams.

Photograph © Dreamstime.com, supplied February 2010.

global private equity, confirms that in 2009 the sector’s fundraising had its worst year since 2004, with just $246bn raised by 482 funds worldwide. That is more than 60% down on the $636bn raised in 2008, and 62% lower than the record $646bn raised in 2007. In 2009, Q4 represents a low point for the year, with only $35bn raised by 75 funds— the lowest quarterly total since Q3 2003. Venture capital (VC) was hit even worse. For example, in the US only $17.7bn was ventured in 2009, the lowest level since 1997 according to the US National Venture Capital Association (NVCA). Start-ups raised 37 % less than in 2008.

The missing link was, of course, leverage.

Preqin’s head of communications Tim Friedman explains: “If you look at 2002/2003, there was some availability of debt, but what’s really characterised 2008-2009 is that there really has been no finance available, which has really hampered the ability of the industry to get many deals done.”

A year ago, it seemed to some observers that private equity was poised to gorge itself with bottom feeding.

Potential acquisitions were hurting, with low valuations, the credit markets battened down and sales falling. In contrast, private equity was awash with liquidity, what the trade calls “dry powder”—more than $200bn worth.

Only a year later it is apparent that managers have decided to keep the powder very dry indeed, despite what Andrea Auerbach, Cambridge Associates’ private equity expert dubs “a buy-low moment”. That is when valuations give the impression of a buyers’market.

Says Auerbach:“There are a couple of factors why it was not as aggressively deployed, despite an apparently very nice buyers’ market. In early 2009, especially, there just wasn’t much visibility about how a company was going to do on a forward basis. So how could you estimate how much you should pay for a company? Forecasting what profitability would be for the rest of 2009 was an exercise in impossibility, so it was difficult for buyers and sellers to agree valuations with the uncertainty of the market.”

Even so, there is evident caution and investment managers complain constantly that it is very hard to “time the bottom”. In contrast, this year Auerbach deduces from a return to visibility, and the resumed availability of some leverage, that there will be more deals completed. “While valuations in the public markets have come up, the multiples at which deals are being done are quite low compared with historical highs, so it is not going to put as much of a damper on mergers and acquisitions (M&A) activity for private equity as one might think,”she says.

WO YEARS AGO, investors were queuing up to put their money into private equity funds based on the sector’s previous stellar performance, which had consistently outperformed public markets over medium and long-term periods. While the sector has not sunk as low in esteem as Madoff’s funds, investors are much less trusting now, especially those who bought in at the high valuations just before the market meltdown. New Dawn Advisors chief executive officer Luc de Clapiers sums up the approach: “The private equity field is littered with corpses of former giants. Investors have been badly burned. The big guys have done poorly because so many of their big plays tanked.”

At the same time, private equity managers have hoarded the cash they amassed in the glory days of 2007 and the first half of 2008. De Clapiers says the industry complains that “prices in terms of earnings before interest, tax, depreciation and amortisation (EBITDA) multiples and book value ratios are still too pricy to offer meaningful opportunities in a still uncertain economy”. He adds:“If the 2003 pattern repeats itself, it is when prices do break down that the best opportunities present themselves to the fortunate private equity funds that hoarded cash.”

Preqin, the assiduous monitor of

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MARCH/APRIL 2010 • FTSE GLOBAL MARKETS

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Market Leader PRIVATE EQUITY: LIVING IN THE AFTERMATH

Friedman agrees: “Investors are very uncertain about how it is going in private equity and how it has been performing. They’ve seen their holdings’ value fall dramatically, especially the big buyouts.”

While private equity has picked up, it has not recovered as much as the public markets. Friedman explains the reasons: for example, in real estate, private equity suffered from a series of highly leveraged deals at the peak of the market, which consequently suffered with the real estate disaster that was, after all, at the heart of crisis.

Moreover, a year ago there were fears that institutions would not be able to meet their commitments on capital raising, not least as the equity side of the portfolios plummeted and they found themselves proportionally overpledged to alternative assets such as private and equity capital.

In the event, those fears were groundless.“Across our client basis we’re not aware of any who defaulted on a capital commitment,” says Auerbach.

“The denominator effect could stop you making a new commitment, but you are certainly going to honour your existing commitments.They went to great efforts to raise capital and there was lot of activity in the secondary market. If they wanted to get their allocations back in line they could sell their limited partnership (LP) interest,”she adds.

Cambridge Associates’venture capital research managing director Peter Mooradian says that despite“a lot of fuss in early 2009”there was not the investor fallout feared. He says:“The industry has a long memory so they were loath to default on their commitments”. Even so, he suggests that some major institutions let it be known that they would be less than ecstatic at calls for new capital.“VC investors did not know how long they would have to hold the companies for. So they conserved cash for existing investments rather than put

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it into new ventures, so it’s been hard for new groups coming to market, although in some cases companies that had dry powder could come in and recap some existingVC-backed companies,”he says.

In fact, the Cambridge duo takes some satisfaction from the shakeout of the industry. The lemming-like flow of investors waving cheque books had distorted the market. The reduction in funding could be better for the overall industry, says Auerbach, and Mooradian concurs for venture capital,

`

Cambridge Associates’ venture capital research managing director Peter Mooradian says that despite “a lot of fuss in early 2009” there was not the investor fallout feared. where he points out that the actual demand for capital is relatively stable, so the excess funding led to overvaluations.“This way only the best companies will get the investment.”

So what are the prospects for this year year? Auerbach confesses surprise: “Coming into the NewYear, I thought it would be hard, but it isn’t so bad.

Leverage is available! True, in 2007, the average debt/EBITDA leverage ratio was six times, and now it is available at two to 2.5 times EBITDA, which seems to be enough to get things rolling.”

Friedman reports that Preqin’s latest investor survey shows that while in December 2008 21% of investors found themselves over-allocated to PE, a year later that proportion had shrunk to 13%, and more than half of those surveyed intended to commit more to the sector this year.

Indeed, there is enough movement to detect trends in the direction of the

investment flows—into PE, financial services, consumer and retail and energy and media. He says: “Sponsors are finding things to purchase”, even if there are fewer deals.

Some almost seem counterintuitive.

“There’s a huge amount of dry powder in infrastructure but very little activity, with low deal prices and the slowest fundraising since 2004”, which makes one wonder about government stimulus deals. Although emerging economies have weathered the recession better the OECD countries, private equity in emerging markets has been hit really hard. Friedman comments: “We haven’t really seen investors prepared to invest in these far flung funds the same way they used to”, but he adds that the latest survey shows that two-thirds of them were considering going that way.

De Clapiers also sees those trends:“If the 2003 pattern repeats itself, it is when prices do break down that the best opportunities present themselves to the fortunate [firms] that have hoarded cash; in this case not the big well known names (KKR, Blackstone, Thomas Lee Partners or Carlyle), but some of the second tier, smaller firms, or the funds of funds of private equity because they do provide risk diversity.”It is still too early, he says, to commit to uncertain valuations:“Maybe in late 2010 or 2011?

Certainly the time will come to throw money at private equity!”

However, the money will have strings attached. Chastened investors are now wary about overweening managements with vaulting ambitions. They prefer smaller, more focused funds, and, says Friedman, insist on more say in what happens to their investment, looking all the while more closely at the terms of limited partnerships. Private equity might not be outstanding in that respect. Throughout the world of finance, all investors not afflicted with amnesia will be scrutinising money managers with renewed attention.

MARCH/APRIL 2010 • FTSE GLOBAL MARKETS

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In the Markets DEPOSITARY RECEIPTS: UPTICK IN NEW ISSUES & TRADING

BACK TO BUILDING

BLOCKS

Photograph © Norrebbo/Dreamstime.com, supplied February 2010.

Despite one of the most challenging market environments in recent memory, depositary receipts have performed admirably over the past 12 months, with total DR trading volume inching upwards and new issuance easily trumping cancellations, particularly in the second half of the year. While DR programme establishment and capital raisings remained off historical highs, in terms of new issuance 2009 was much stronger than 2008. Overall DR performance, as tracked by the BNY Mellon ADR IndexSM, finished the year 36% higher, while total DR trading volume reached record levels, up 2% from 2008, even with declining equity values. Meanwhile, the emerging markets continue to present the greatest potential for growth opportunity for investors, particularly as sources of liquidity become increasingly transparent and strategies less complex. From Boston, David Simons reports.

LAUDINE GALLAGHER, GLOBAL head of JPMorgan’s depositary receipt business, recalls the moment early last October when the Brazilian division of Banco Santander, the third-ranked privatesector bank in Brazil, debuted its $4.5bn Depositary Receipts (DRs), the single largest initial public offering of its kind ever issued from Brazil. “I couldn’t believe the energy on the floor that day. We were actually getting pushed aside by the traders, the media was there, photographers were crowding around—I’d never seen anything like it. Granted, part of it was because there had been so little capital raising activity prior to Banco Santander’s announcement— but just having that kind of interest in a DR issuance once again was pretty amazing.”

Last year was something of a banner event for the bank’s DR team.

In the Asia-Pacific, JPMorgan acted as the depositary bank for three of the

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five largest American Depositary Receipt (ADR) IPOs in 2009, including the $1bn IPO of Shanda Games.

Comfort levels are once again on the rise, says Gallagher. “It is a sign that confidence in pricing has returned and investors are able to absorb much larger IPOs.” In what Gallagher describes as a strong start to the 2010 issuance calendar, in the first few weeks of the year, the bank was selected as depositary bank by IFM Investments Limited and Insprit.

In the first 11 months of 2009, IPO capital raisings through DRs increased 68% over the prior year, with 22 new issuers raising almost $8bn, as compared to 30 issuers raising a relatively measly $4.7bn in 2008.

Additionally, DR liquidity maintained close to the unprecedented levels witnessed in 2008, only marginally declining from 131bn DR shares traded globally during the first 11 months of 2008 compared to 124bn DRs traded during the same period in 2009.

Despite one of the most challenging market environments in recent memory, DRs performed remarkably well during 2009, ending the year 36% higher than in 2008, according to BNY Mellon’s ADR Index, one of four indices listed under the company’s new “umbrella” Composite Depositary Receipts Index that tracks ADRs and global depositary receipts (GDRs). The bank launched the new index in November last year. The BNY Mellon Composite Depositary Receipt Index comprises all American depositary receipts, New York Shares, and Global Registered Shares that trade on the NYSE, NYSE Amex, NASDAQ and OTC, as well as GDRs that trade on the LSE. By year end, the Composite Depositary Receipt Index had more than 870 constituents and a free-float market capitalisation as defined by Dow Jones of $10.2trn. Some 34 of the 35 BNY Mellon ADR country indices posted higher returns in 2009, with the Argentina, Brazil and India indices

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The world’s capital markets have a V.I.P. entrance.

Depositary Receipts. Connecting issuers to investors and brokers is critical to the success of every depositary receipt program.

BNY Mellon’s specialised expertise and outreach initiatives are central to this connection. We open a world of opportunities for investors — which is why issuers have made us the world’s leading depositary bank. Working together, we can help you reach your highest goals.

For more information on Depositary Receipts, please contact: Western Europe: Marianne Erlandsen +1 212 815 4747 Asia-Pacific: Chris Kearns +852 2840 9875 Middle East: Mahmoud Salem +1 212 815 2248 Central Eastern Europe and Africa: Anthony Moro +1 212 815 5838 Latin America: Nuno da Silva +1 212 815 2233 bnymellon.com/dr ©2010 The Bank of New York Mellon Corporation. This information is provided for general purposes only and is not investing advice. The Bank of New York Mellon Corporation provides no advice nor recommendations or endorsement with respect to any company or security. Nothing herein shall be deemed to constitute an offer to sell or a solicitation of an offer to buy securities. Depositary Receipts: NOT FDIC, STATE, OR FEDERAL AGENCY INSURED. MAY LOSE VALUE. NO BANK, STATE, OR FEDERAL AGENCY GUARANTEE. Products and services are provided by various subsidiaries of The Bank of New York Mellon Corporation.

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In the Markets DEPOSITARY RECEIPTS: UPTICK IN NEW ISSUES & TRADING

each posting returns above 100%.

However, the BNY Mellon Finland ADR Index was the sole decliner, falling nearly 15% last year.

This latest upward trend has substance, holds BNY Mellon. In their search for new investment opportunities, investors are increasingly choosing DRs as a pipeline to global equities, says Michael Cole-Fontayn, chief executive officer of BNY Mellon’s depositary receipts business. Cole-Fontayn sees “great opportunities from the emerging markets in the coming year,” as evidenced by the continued flow of funds from the developed markets to the BRIC countries (Brazil, Russia, India and China) in particular.

Valuations/trading Though valuations remained generally weak, total DR trading volume moved ahead fractionally, up 2% from 2008, says BNY Mellon in a year-end report. Net issuance trumped net cancellations, particularly during the second half of last year, a sign of renewed faith in DRs as an investment alternative.

From a price perspective, DRs remain well off the mark set in 2007.

While it is unlikely that DRs will return to their stratospheric pre-crisis levels any time soon, experts like Gallagher believe that the current momentum is easily sustainable at least through the first half of this year.

The pipeline of forthcoming IPOs will likely continue around such nascent industries as alternative energy, online education and medical-services outsourcing, mainly from China and other emerging economies.

Russia, once a major force in the DR arena, has remained conspicuously absent of late, says Gallagher. “There really weren’t any major deals out of Russia throughout all of last year, which was due in part to the difficulties

12

Michael Cole-Fontayn, chief executive officer of BNY Mellon’s depositary receipts business.

Cole-Fontayn sees “great opportunities from the emerging markets in the coming year,” as evidenced by the continued flow of funds from the developed markets to the BRIC countries (Brazil, Russia, India and China) in particular. Photograph kindly supplied by BNY Mellon, February 2010.

we saw in sectors like commodities and banking.”However, in January Russia’s UC Rusal, the producer of aluminium, raised $2.2bn in an IPO offered on Hong Kong’s stock exchange (in the process becoming the first non-Asian firm to have a primary listing in Hong Kong: please refer to page 22). Though liquidity remains strong, the number of new sponsored programmes continues to fall, as it has done over the last several years.

Not that this is necessarily a bad thing, says Gallagher. “Having fewer but more meaningful issuances is more aligned with the original intent of the depositary receipt—a depositary is better able to leverage the benefits of DRs much more effectively than you would with a wider pool of much smaller deals. Our strategy has always been to focus on a select group of issuers who firmly believe that the DR has strategic value

for their business and for their international profile. So obviously, the larger the issuance, the more the issuer is likely to be focused on their DR programme. The greater liquidity of large issuances makes is that much easier for a depositary to manage the programme and promote its growth.”

For now, sponsorship remains predominantly retail in nature, and as a result investment-manager created products continue to account for the lion’s share of DR capital. “For instance, we have had a number of ETF sponsors request that parts of our index be tailored to their own specific benchmarking requirements,” says Cole-Fontayn. By continuing to attract larger institutional players, DRs have helped foster a more stable investment climate, particularly in markets with a high number of retail participants, he adds. “The vast majority of DRs outstanding are held by institutional investors who are benchmarking against the various DR-related indices, and they are typically longer-term holders. That can certainly help offset some of the volatility that can be found in predominantly retail markets.”

In the developed markets, blue-chip companies such as UK-based pharmaceutical GlaxoSmithKline and mobile network operator Vodafone consistently rank top in DR valuation.

However, the emerging markets will continue to present the greatest potential for growth opportunity for investors, particularly as sources of liquidity become increasingly transparent and strategies easier to understand, says Cole-Fontayn. In 2009, nearly 70% of total capital raisings came from the emerging markets, with BRIC countries topping the list of new DR issuers.

Recent capital-flow patterns underscore the growing significance of these foreign players in the DR domain. According to fund tracking

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In the Markets DEPOSITARY RECEIPTS: UPTICK IN NEW ISSUES & TRADING

service provider EPFR Global, aggregate fund flows to the emerging markets reached $80bn during 2009, led by $61bn in total outflows from developed market equity funds, including $89bn from US funds alone.

That trend is likely to continue, according to a survey from BNY Mellon, which found that 60% of respondents expect to increase their exposure to emerging markets to overweight in the months ahead.

There continued to be a rapid increase in unsponsored ADR programmes in 2009, as global depositary banks continued to create ADR programmes, often without investor interest or issuer consent.

Even so, more than 50 unsponsored programmes, mostly from Japan, have been terminated as issuers expressed discontent on depositary banks’ establishment of such programmes without their consent.

Offsetting uncertainty Helping to further offset uncertainties were the revisions to the Securities and Exchange Commission’s Rule 12g32(b), instituted in late 2008, which simplified the process for establishing un-sponsored over-the-counter programmes for non-registered US companies, while making it easier for non-US companies to establish Level I programmes stateside. Despite the SEC’s good intentions, companies need to be kept in the loop with regard to the arrangement and ongoing performance of unsponsored programmes (unlike sponsored ADRs that benefit investor and issuer equally, investors stand to gain the most from an unsponsored programme).

Like others in the business, Deutsche Bank, which offers services covering the administration for both American and global depositary receipts, maintains a rigid set of guidelines for keeping issuers apprised of unsponsored

14

programme information. At the same time, Edwin Reyes, Deutsche Bank managing director, underscores the benefits of the unsponsored DR influx, foremost of which is the ability for a company to easily exit a listing should the need arise. Removing this and other deterrents has the potential to attract new business, thereby stimulating DR volume and, in the process, creating a more stable environment for all involved, says Reyes.

Though the highly liquid and established markets of New York and London still account for the majority of new DR listings, other exchanges may begin to make inroads. “It is possible, for instance, that Hong Kong’s exchange could garner some issuer interest in the coming years, particularly in light of China’s rapidly growing capital base,” says Gallagher.

While Hong Kong’s rules and costs are similar to those found on the NYSE or LSE, companies that are heavy exporters to the region or already have a local footprint may consider using that exchange in an effort to attract new investors. “Certainly Hong Kong stock is a market that has sought to attract international investors,” concurs ColeFontayn, referring to the precedentsetting Rusal listing.

The emergence of alternative trading venues, which offer investors the potential for cost savings and less stringent regulatory measures, could also have an impact. OTCQX, the over-the-counter marketplace that allows high-quality issuers to list securities within a transparent environment, is among the recent crop of newcomers that has secured its share of DR listings and liquidity. In January, pharmaceutical manufacturer Shandong Luoxin became the first Chinese company to establish an OTCQX-traded DR programme, using BNY Mellon as its depositary bank and principal American liaison (PAL).

Claudine Gallagher, global head of JPMorgan’s depositary receipt business. Last year was something of a banner event for the bank’s DR team. In the Asia-Pacific, JPMorgan acted as the depositary bank for three of the five largest American Depositary Receipt (ADR) IPOs in 2009, including the $1bn IPO of Shanda Games. Comfort levels are once again on the rise, says Gallagher.“It is a sign that confidence in pricing has returned and investors are able to absorb much larger IPOs.” In what Gallagher describes as a strong start to the 2010 issuance calendar, in the first few weeks of the year, the bank was selected as depositary bank by IFM Investments Limited and Insprit. Photograph kindly supplied by JPMorgan, February 2010.

The proliferation of alternative venues could be highly beneficial for the DR industry as a whole, says Gallagher, particular when one considers the vast number of potential issuers who are put off by existing regulations.“If these venues can make it easier for companies to list, it could help expand the DR marketplace in general. It is similar to the relaxation of 12g3-2(b)—the amended rule has benefited issuers, while keeping reasonable investor protections in place. If the new trading venues operate judiciously, I think they could create an entirely new tier of issuers who would otherwise stay on the sidelines.”

Though the industry still has a way to go on a relative basis, DR volumes remain in record territory, and capital flows continue to increase. Says

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In the Markets DEPOSITARY RECEIPTS: UPTICK IN NEW ISSUES & TRADING

Gallagher:“Investors are viewing DRs as a very easy way to diversify, one that allows them to avoid the usual difficulties of investing directly in foreign companies, including language barriers, time-zone issues as well as regulatory concerns. We take into account all of these things on the investor’s behalf and the result is a very efficient gateway into some very vibrant equity markets.”

Trends to watch Given the current upward trajectory of DR issuance, it looks likely a number of trends will govern issuance patterns and levels going forward. Most obviously perhaps, is that issuers from emerging markets will increasingly

use DRs to raise capital, with the Asia Pacific zone expected to be the most active region. China and India will invariably be at the forefront of this wave of capital raisings, followed by Taiwan. Newer markets, such as Vietnam, will also likely emerge in the next 18 to 24 months.

Russia is expected to lead DR capital raisings in the Eastern Europe, Middle East and Africa (EEMEA) region, although new regulations may set tight limits on capital raising from that market. New Russian regulation makes it possible for Russian companies to establish Level 1 OTC ADR programmes. The previous regulation required Russian issuers to raise capital when circulating their

DRs offshore. Additionally, the government of India is examining a proposal to amend its existing rules governing ADRs to allow Indian companies easier access to the US market through Level 1 programmes.

The EEMEA region’s DR trading reached a value of $382bn at year-end, according to BNY Mellon’s year end 2009 report. Russia’s Gazprom was the region’s most actively traded DR, with trading value of nearly $66bn DRs globally. The region’s top five most actively traded DRs also included Israel’s Teva Pharmaceuticals, Russia’s Lukoil and Rosneft, and South Africa’s AngloGold Ashanti, with a further uptick expected across these DRs through 2010.

DR CAPITAL RAISINGS IN ASIA-PAC ON THE RISE n a year of gradual economic recovery, the issuance and trading of depositary receipts (DR) in 2009 remained strong in the Asia-Pacific (APAC) region, especially in key markets such as China, India and Taiwan, according to JPMorgan’s inaugural Depositary Receipt APAC Year in Review 2009. Last year, says the review, IPO capital raising in the region through DRs was four times higher than in the previous year, as 26 new issuers raised over $4bn, compared with 18 issuers raising $871m in 2008. DR liquidity also remained extremely high, with 36bn DR shares traded on APAC DR programmes in 2009, close to the record 38bn shares traded in 2008.

The majority of DR IPO capital raisings in 2009 were from APAC, with 26 issuers from the region overall, compared to 28 globally. “The depositary receipt has proven its resilience as a cross border capital raising instrument in a volatile market,” says Kenneth Tse, Asia Pacific head of JPMorgan’s DR business. “As the global financial crisis subsides, the depositary receipt will play an even bigger role as a capital raising tool in funding the growth of the emerging APAC economies.”

Unsurprisingly perhaps, New York-listed American Depositary Receipts (ADR) continued to dominate DR IPO capital raisings by APAC issuers, driven primarily by Chinese issuers. The Shanda Games NASDAQ $1bn IPO was the standout deal of the year, since it was the largest

I

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ever DR single listed IPO offering from China. Other significant DR offerings included the IPOs of three companies within India’s Tata Group—Tata Steel, Tata Motors and Tata Power—as well as Taiwan’s Tatung, which raised $197m on the Luxembourg Stock Exchange.

Secondary offerings were an important source of capital for issuers from the region: 21 existing issuers from APAC raised $5.2bn in the US, Europe and Asia through follow-ons in 2009, compared to $2.2bn raised by 16 issuers in 2008.

As relations between mainland China and Taiwan have continued to improve, four new issuers from Hong Kong, listed on the Taiwan Stock Exchange in the form of Taiwan Depositary Receipts (TDR) in 2009. Meantime, several major Asian issuers delisted and deregistered from the NYSE or NASDAQ in 2009 to trade OTC. According to the BNY Mellon’s 2009 DR report, trading from Asia-Pacific issuers totalled $760bn, representing more than 35bn DRs. The most actively traded DR in the region was Taiwan Semiconductor Manufacturing, which traded nearly $47bn in DRs last year. The other top-traded DR programmes in the region were JA Solar Holdings, Yingli Green Energy, Suntech Power Holdings and United Microelectronics, all of which traded more than one billion DRs in 2009.

The region’s largest DR programme as measured by DR value was Baidu, with more than $10.2bn in DRs.

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Introducing Schwab’s International Equity ETFs: A Q&A Session with the Senior Vice President of Schwab Investment Management Services, Peter Crawford In November 2009, Schwab announced that it was rolling out a suite of eight ETFs. Why did Schwab decide to enter the ETF space?

Investors look to Schwab to provide products that offer exceptional value, and our clients are increasingly looking at ETFs as a way to invest in and trade entire segments of the market. As a result, we decided the time was right to launch low-cost ETFs that individual investors and advisors alike could use as core building blocks of a diversified portfolio for themselves or their clients.

Our initial offering includes eight equity ETFs: 5 domestic and 3 international.

Schwab elected to partner with FTSE on its international ETF line-up. Why is that and which funds are available?

We chose FTSE indexes for our international equity ETFs because their indexes met our key criteria. FTSE indexes provide broad exposure, with the Global Equity Index Series (GEIS) covering 98% of the world's investable market capitalization. Further, the FTSE indexes are rules based, each one is mutually exclusive; and FTSE uses an objective, criteria-based approach to country classification. Lastly, we like that FTSE has a deep experience in indexing.

Schwab International ETFs FUND

INDEX

Schwab International Equity ETFTM (launched 11/3/2009)

FTSE Developed ex-US Index

TM

OER

TICKER

0.15%

SCHF

Schwab International Small-Cap Equity ETF (launched 1/14/2010)

FTSE Developed Small Cap ex-US Liquid Index

0.35%

SCHC

Schwab Emerging Markets Equity ETFTM (launched 1/14/2010)

FTSE All-Emerging Index

0.35%

SCHE

What distinguishes the Schwab ETFs from the competition?

The high quality products combined with competitive pricing clearly differentiate the Schwab ETFs from the crowd. The new Schwab ETFs have some of the lowest expense ratios in the industry—the Schwab International Equity ETF and the Schwab International Small-Cap Equity ETF are the low-cost leaders in their respective categories, and the Schwab Emerging Markets Equity ETF is priced well below most of its peers. In addition, all Schwab ETFs can be bought and sold commission-free online in Schwab accounts, making them an even more cost-effective investment.

Has the launch been a success?

Yes. The launch has been very successful. The compelling value proposition combined with the steady trading volumes and relatively tight bid/ask spreads have resulted in strong investor adoption. We remain committed to supporting and growing these new products.

Investors should read and consider carefully information contained in the prospectus, including investment objectives, risks, charges, and expenses. Obtain a prospectus by visiting www.schwabetfs.com.

Online trades of The Schwab Exchange-Traded Funds™ (Schwab ETFs) are commission-free at Schwab, while trades of third-party ETFs are subject to commissions. Broker-assisted and Automated Phone trades subject to service charges.

Minimum $1,000 deposit required to open most Schwab brokerage accounts. Waivers may apply. See the Charles Schwab Pricing Guide for details. ETFs are subject to management fees and expenses.

ETFs are subject to risks similar to those of stocks, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Diversification does not eliminate the risk of loss. International investing involves risk from unfavorable fluctuation in currency vales, differences in accounting principals, or economic or political instability in other nations.

Emerging markets involve these and other risks.

Schwab ETFs are distributed by SEI Investments Distribution Co. (SIDCO). SIDCO is not affiliated with The Charles Schwab Corporation. Charles Schwab Investment Management, Inc. (CSIM) serves as the registered investment adviser to Schwab ETFs.

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

Global markets grow more complex and interconnected every day. To stay abreast, you need a comprehensive index that can slice and dice markets the way you do. The FTSE Global Equity Index Series was the first benchmark to cover the world seamlessly with a single consistent and transparent methodology. Because FTSE indices are independently verified by a panel of market practitioners, you can be sure that they will always be in line with investors’ needs. Wherever you invest, FTSE gives you the clearest view of how you are doing. www.ftse.com/invest_world © FTSE International Limited (‘FTSE’) 2010. 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.

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In the Markets AIRCRAFT MANUFACTURERS WORTH A FLYER

GROUNDHOG DAY Engines on the Boeing 747-8 Freighter are started just prior to the plane’s first flight, Monday, February 8th 2010, in Everett, Washington. Photograph by Ted S Warren for Associated Press. This photo supplied by Press Association Images, February 2010.

Any investor who takes a ride on airline stock “would be well advised to open their parachutes once they have reached high altitude on this stock recovery play”, according to industry analyst Bob Hirst. Operators worldwide are experiencing their worst slump. Because of that, the shares should take off again one day. In the meantime, planemakers are a better bet. Ian Williams reports.

OME PHYSICISTS ARE still arguing about how an aircraft wing works, but that is almost easy compared to working out how the airline industry stays in the air. In the US as elsewhere, air transport is an industry deeply wrapped up in national pride and economic development. Worldwide, millions of workers make the planes, maintain them, fly them and harness the passengers and freight to fill them. Yet this huge economic apparatus is caught in turbulence. Airlines are afflicted by cut-throat competition; fuel price volatility that tends

S

18

inexorably upwards; terrorism and fear of terrorism, and regular economic recessions, now compounded by legislative pressure on carbon usage.

Questions have become even more critical as the industry limps out of the worst ever slump it has experienced, worse even perhaps than in the 100 days after 9-11 when the industry lost $13bn. Last year, the airlines saw a stunning $80bn revenue decline, which would probably have been even worse had fuel prices not also plummeted from their previous heights. The International Air Transport Association reports that last year passenger miles,

the usual measure for global traffic, fell 3.5%, the highest decline in modern times. Indeed, in the recession-hit European, North American and Asia Pacific regions, passenger mileage fell more than 5%. Air freight, a growing proportion of the industry, suffered even more but is recovering, especially in Asia where it can account for 40% of traffic.

Passenger traffic increased 4.5% in December compared with a year earlier, led by gains of 19% in the Middle East and 8% in Asia. Even so, air fares have yet to recover from the discounting that kept the planes filled during the bad year. As Giovanni Bisignani, chief executive officer of the International Air Transport Association (IATA), reported: “Profitability will be even slower to recover.”

So, while British Airways and Continental both recently reported profits for the first time since the financial crash, they have by no means recouped their previous year’s losses.

Japan Airlines (JAL) for instance filed for bankruptcy protection in midJanuary. The crisis raises fundamental questions about the airline industry. If such an essential component of the modern world economy, depending on heavy capital investment and maintenance, cannot show a profit, then how and why does anyone invest in it? Jesup Lambert, an analyst at Helane Becker, notes: “I’ve put that question to people in the industry and

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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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In the Markets AIRCRAFT MANUFACTURERS WORTH A FLYER

I’ve never really had an answer. On the equity side, I don’t think people really think of it as ‘investing’ in the industry, it’s trading. You can make a lot of money with the volatility in the industry.”She adds:“The money really comes from the debt side of the equation more than the equity side.”

IATA chief economist Brian Pearce reinforces that view, comparing airline equity investors with media and sports investors who do it for“factors beyond finance”. After all, he says:“The return on invested capital for airlines is very low, lower than the weighted average cost of capital, so even in a good year, there’s not enough return for an equity investor. Overall, the industry is a value destroyer.” However, he admits there are airlines that do create shareholder value.

`

Air freight, a growing proportion of the industry, suffered even more but is recovering, especially in Asia where it can account for 40% of traffic.

Even so, the industry raised no less than $25bn last year, mostly in debt, and he explains that the secret is the collateral.“The aircraft which are seen as highly liquid assets that can be seized and promptly flown off to another market,” he says. Indeed, the national element intrudes here as well, as Airbus and Boeing in particular are trying to secure more governmental export credit guarantees that would allow purchasers even easier and cheaper access to finance for their products.

National (in the case of Boeing) and continental (in the case of Airbus) interests must feature among the

20

“factors beyond finance”. Even here, the national are regional loyalties spread globally, the supply chain of airframes, engines, and other parts spans continents, so while governments might be inhibited about too overt favouring of one competitor, the industry as a whole has enough clout to ensure that it is too big to fail, whatever the mysteries of finance.

Pearce reports that IATA “looked at returns on capital some ago, and the people making good returns were the rest of the value chain, the lessors, fuel suppliers, freight forwarders, and the manufacturers,” who, he admits, “had problems in the crisis but they have full order books for years ahead”.

In addition, the banks should be added to the beneficiaries of the industry. Pearce says the capital markets were falling over themselves to provide cash to airlines to the extent that when asked about the possibility of an airframe debt bubble, he had to pause and think it through. “Some would argue that’s the case at least in part. In Europe, there are many outstanding orders for narrow-bodied single-aisled aircraft and no one is sure that there is the capacity or demand unless the economy improves.”

In fact with credit available, reequipment has been an essential economy measure even during the crisis. As fuel prices quadrupled from their 2002 levels, even the US airlines with notoriously vintage fleets began to scrap them for more modern aircraft, although Becker also points out that as soon as oil dropped, some older planes were brought back out of mothballs. Even so, she adds:“A lot of the lines are re-fleeting, getting new, more efficient aircraft, which is a positive for them and makes a lot of sense, not least because you can sell carbon credits to your customers.”

Pearce also points out that while airlines have to take into account

carbon costs when they begin trading, it will take a long time before their cost anywhere near matches the impact of rising fuel prices.

Industry analyst Bob Hirst wisely forebears comment on individual stocks but agrees “airlines aren’t good long-term investments”. However, he joins the consensus: “Historically, airline stocks have significant up-anddown patterns that can be used for shorter-term trading. In addition, many exchange-traded funds (ETFs) and mutual funds have a requirement to own airline stocks, providing pressure on the buyside.”

Luc de Clapiers of New Dawn Advisors is very slightly more optimistic: “There’s only one good reason to invest in airlines: and it is that, if—a big if—they can one day regain their profitability of 2007, then they are dirt cheap today. I’d favour Continental Airlines since they seem to have improved their metrics more than other US carriers, and passengers seem to like their quality of service improvements, particularly on international routes. Southwest could be a second-best choice but with more limited upside potential as it is already an investor’s favourite because of its low-cost features and better survival potential.”

He adds:“There’s a huge oversupply of planes in the US market and just too many carriers in a shrinking market which could take years to recover.” His conclusion is that any investor who takes a ride on airline stock “would be well advised to open their parachutes once they have reached high altitude on this stock recovery play”. Hirst is also cautious, even about Continental: “Accepting the last few months are looking more positive, Continental lost close to $900m over the past two years (including $230m in special charges).”

So where does it go from here?

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Hirst measures his words carefully: “I’m confident the industry won’t disappear, but most airlines have significant financial problems. Until long-term solutions to these problems are resolved, airlines will continue to be a high-risk investment. Most legacy airlines have an ageing fuelinefficient fleet.” Companies have been filling more seats and boosting their load factors, as cramped and uncomfortable passengers can testify, but they have not increased air fares.

Air fares have, on average, not increased for over 20 years—with inflation since 1982 they would be double what they are now.

There is not much more to squeeze in that way, Hirst suggests. “Recent data shows they’ve all but maxed out filling seats with record load factors.

Now, in order to cover increasing costs, air fares will have to increase before balance sheets can improve and old aircraft can be replaced.”

As for the airlines themselves, the problem is simply too much capacity.

The solutions are, of course, complex.

Becker points out the cyclical nature of responses, for example British Airways’emphasis on“premium traffic and almost anywhere non-stop from Heathrow left them with little interest in connecting traffic. Now the new management is definitely interested, which leans them to more leisure, which they can always manipulate by discounting”. Now premium traffic is rising, and leisure fares will too!

Some of the changes might become permanent. For example, one of Air France’s responses to the fuel crisis was to reconsider long-haul, non-stop flights when they calculated how much fuel they were burning to carry the fuel needed.

Hirst believes:“If, and it’s a big if, the industry can forego adding capacity, supply and demand would push air fares higher and provide the

Page 21

Photograph © Kiosk88/Dreamstime.com, supplied February 2010.

increased revenue required to make the industry healthy again.”

Internationally, he sees the process of consolidation. “The foreign carriers face many of the same problems as US carriers. The industry is going to be consolidated and I fully expect most major airlines around the world will become part of the three global alliances. The next economic downturn will force consolidation and/or elimination of the weakest carriers.”

Pearce suggests any fix has to address the paradoxically imperfect globalisation of what must be the world’s most global industry.“Outside Europe and North America, there are still many state-owned airlines,” he points out, and even the corporate owned sectors are hampered by national ownership rules, which only allow cross-border mergers at the cost of losing treaty privileges to fly between different countries.

The patchwork of deregulation and national regulation has increased competition and driven down fares while making it more difficult to get the greater efficiencies that other industries have achieved through global rationalisation. There are some moves: there was a recent meeting of

FTSE GLOBAL MARKETS • MARCH/APRIL 2010

governments to liberalise ownership requirements on a bilateral basis.

In the absence of such agreements, the three big alliances retain their importance, explaining why, for example, Delta and American are vying with such fervour for the limp hand of JAL. Pearce points out: “It does help but it still does not address the need to reduce capacity,” Pearce points out”, adding that national ownership restrictions are yet another brake on the airlines’ capacity to raise equity finance.

Is there a way out? Well that depends if you are investing or flying.

The sensible way to make money is to invest in the manufacturers, not only Boeing and Airbus, which Becker suggests “must be licking their lips”, but also Embraer, Bombardier and the aspirant Chinese makers who sense a market gap as the big duopoly struggle so hard to cope with their existing backlog. In particular, Pearce points to Bombardier, whose 150-seat single-aisle aeroplane is filling the market niche left by Boeing and Airbus’s delay in launching their competition. “It’s a big opportunity and the Chinese are certainly looking to take the opportunity.”

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In the Markets ALUMINIUM GIANT’S HONG KONG IPO IN SOFT SPOT

Oleg Deripaska, left, chief executive officer of UC Rusal, talks to Ronald Arculli, chairman of the Hong Kong Stock Exchange during the debut of the company in Hong Kong Wednesday, January 27th 2010. Photograph

by Vincent Yu for the Associated Press and supplied by Press Association Images, January 2010.

RUSAL’S HONG KONG PAYLOAD Russian mining giant Rusal, the world’s largest aluminium company, opened the initial public offering (IPO) season in Hong Kong in late January. Despite the hype surrounding the IPO, the company’s shares dropped 11% on its first trading day. All in all, this was less of a surprise than the fact that it managed to list in the first place. Vanya Dragomanovich reports from Hong Kong.

C RUSAL, RUSSIA’S aluminium giant, was badly hit by the credit crunch; not only did the price for a tonne of aluminium drop in 2008 to about a third of what it traded at its peak that year, but financing dried out for the company whose ambitious acquisition and expansion plans included buying a 25% stake in another Russian mining behemoth, nickel producer Norilsk Nickel. By the end of 2009 the company was suffocating under the burden of $16.8bn worth of debt owed to both Russian and international institutions.

U

22

Looking for additional ways to raise finance it unsuccessfully tried to list in London. Then the Hong Kong Stock Exchange reportedly said no to a listing by the Russian firm, before changing its mind and admitting the company to the exchange. Those institutions which decided to invest in the company had to accept from the outset that it would be a high risk proposition. Rusal itself was scrupulous in outlining the potential downside. On page three of Rusal’s 1,000-page investment prospectus, emblazoned in bright red letters, is the following warning: “An

investment in shares in United Company RUSAL Limited involves significant risk. Investors may lose part or all of the value of their investment.

Subscription for shares in the company is being limited to potential investors who are professional investors or who are willing to subscribe for or purchase at least HK$1m ($128,500) worth of shares.”

The warning stretches over a whole page and explains that the company did not meet the profit test to qualify to list on the main board of the Hong Kong stock exchange. It was allowed to list anyway on the grounds of its large market capitalisation, revenue and positive cash flows from operating activities.

It also added that a massive $4.5bn repayment obligation to Russian state-owned Vneshkombank (VEB) falls due in ten months time. “. If the company should be unable to extend or refinance or repay the VEB loan as and when it falls due the group may cease to continue as a goingconcern,” says the not-so-small print.

Despite this cheerful warning Rusal’s order book was covered just three days after book building started on January 12th and eventually the group raised around $2.6bn for a stake of just over 10%. Around 40% of the total money raised from the IPO in Hong Kong and a simultaneous listing in Paris reportedly came from four investors: Malaysian tycoon Robert Kuok; the afore-mentioned Russian state development bank VEB; NR

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In the Markets ALUMINIUM GIANT’S HONG KONG IPO IN SOFT SPOT

Investment Ltd, the investment vehicle of Nathaniel Rothschild; and investment company Paulson & Co., the hedge fund run by John Paulson.

In the IPO shares were priced at HK$10.80, in the middle of the stock’s indicated price range, but on the first day of trading they dropped 11%. On the same day, shares in its main rival, China’s aluminium company Chalco, rose by 0.5%.

As if the red-letter warning and the fact that the Hong Kong listing authority effectively excluded retail investors from trading the stock were not enough, the timing of the listing contributed to the stock’s decline in the immediate IPO aftermarket. Over the same week that it took Rusal’s advisors to price its shares to the day of the IPO, Asian stock markets kept on falling, because of China’s announcement that it intended to tighten lending requirements for its banks, sending ripples of market uncertainty across the wider region.

Even so, there were other reasons for the softening of Rusal’s share price. “The starkness of the warning from the exchange was unusual, the discount at which Rusal was priced compared to Chalco, the other aluminium company traded on the exchange, was too small. Moreover, trading was restricted to a narrow pool of institutional investors. In that kind of environment investors looked at it and thought—do I really need this risk?” holds Chris Weafer, analyst at UralSib bank in Moscow.

The listing also provoked a lot of soul searching in London as the preferred choice for Russian companies. Notwithstanding the fact that Rusal came to London first there may be little the City will be able to do about the fact that Russia and China are growing closer together in business terms and that this trend will only accelerate.

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Russia and China are growing closer together in business terms and that this trend will only accelerate. Photograph © Hypermania37/Dreamstime.com, supplied January 2010.

Russia is not oblivious to China’s appeal as a massive market and Rusal pitched its IPO idea on the grounds of China becoming an increasingly important market for its metal. The company wants to double its market share in China over the next several years and its Siberian production units are conveniently located to supply this market. There are numerous other levels on which the cooperation between the two countries has been increasing. In January the DauletabadSarakhs-Khangiran pipeline was inaugurated, connecting Iran’s Caspian region with Turkmenistan’s vast gas field. Turkmenistan has committed its entire gas exports to China, Russia and Iran which eliminates any need for Turkmenistan to have pipelines supplying gas to Europe or the US. Last year China signed a deal to lend $25bn to two Russian energy companies in exchange for enough oil to cover 10% of all China’s domestic consumption. The deal was part of a broader Sino-Russian energy cooperation pact in which China

invested $50bn into several resource deals. Vladimir Putin has recently talked up the importance for Russia of the ASEAN summit which will see the leaders in the Asia Pacific region congregate in Vladivostok in 2012.

UralSib’s Weafer says that Rosneft may be another candidate for a Hong Kong listing, given that it needs to reduce debt after its credit-for-oil deal with China last year. Other potential applicants are the gas giant Gazprom and state-owned bank VTB. However, Weafer adds that for the bulk of Russian companies considering an IPO or secondary public offerings (SPO), the natural location is still London or a European bourse.

Even so, the Hong Kong stock exchange was the single most active exchange in terms of IPOs last year and is keen to maintain this momentum, particularly when it comes to foreign listings. The exchange listed 68 companies in 2009, with some $24.1bn raised through IPOs during the year.

Of that, 83% were companies defined as mainland enterprises, or companies based in China, and nearly all of the remaining companies were local Hong Kong companies. Having a couple of big Russian names on the list would add to its international credibility to Hong Kong’s ambitions to broaden its listings base.

Despite the softening of the share price in the immediate IPO aftermarket, Rusal’s chief executive Oleg Deripaska is also likely to be pleased with the sale process overall. No matter what happens next with its shares, Rusal has a fresh $2.6bn in its pocket, which will go some way to alleviating the company’s considerable debt burden and soothe nerves after the company lost $868m in the first half of 2009.

Rusal is far from being out of the woods yet however. In December it restructured its debt and agreed to split the $7.4bn it owes to international

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In the Markets ALUMINIUM GIANT’S HONG KONG IPO IN SOFT SPOT

lenders into two phases. It said that in the initial four year period, principal repayments will be made on a “pay-ifyou-can” basis which will depend on the performance of the business.

Interest will be paid partly in cash, at a rate ranging from LIBOR + 1.75% to 3.5% depending on the debt level. The second phase of the restructuring will involve the refinancing of the remaining debt by for another three years.

The company agreed to similar terms with its Russian lenders VTB bank, Gazprombank and Sberbank.

Rusal owes them a total of $2.1bn and will be repaying those over four years with an annual interest of between 8% and 9%.

For those banks the investment will work whether Rusal’s shares go up or down. Analysts believe that Russia wants to create a large national mining champion on the scale of the

gas company Gazprom and that rather than overly buying or nationalising mining companies it will go about it more subtly. At present the two biggest mining companies Rusal and Norilsk are privately owned but during the credit crunch state banks got hold of a stake in Norilsk by converting the company’s debt into equity. A similar thing could happen with Rusal, which not only has its own appealing aluminium assets but also holds a 25% stake in Norilsk.

The main question asked now by investors is how well Rusal can manage its business and accounts over the next 12 months, when so much of its performance is due to external trends. The company’s profits, for instance, are closely linked to aluminium prices and forecasts for the metal are not promising over the immediate term. While prices for

copper, zinc, tin and nickel have all roared higher in the last six months aluminium prices have moved at a much more sedate pace. Its two main end users, construction and car manufacturing, have not recovered yet and global production levels remain high.

Metal trading company Sucden expects aluminium to trade at between $1,900 and $2,500 a tonne in the coming quarter—on the day of Rusal’s debut in Hong Kong it was at $2,200—but adds that the high of that range may have already been reached. Looking beyond the immediate future it stands to reason that Rusal should be financially viable and successful. Commodities are predicted to be in demand over the coming years as the global economy recovers and metals will be on the forefront of that demand.

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Face to Face EAST CAPITAL PARTNERS: THE RUSSIA HOUSE

THE FUND THAT RETURNED OVER 1,500% IN A DECADE Just as the financial crisis in Asia 13 years ago started to spill over into Russia, three people launched a fund to invest in Russia, the old Soviet states and Eastern Europe. After the stock market crash and economic meltdown in Russia, East Capital Partners failed to make a profit for five years. They have made up for it since with Russia’s RTS stock exchange substantially outperforming the Dow Jones and the FTSE 100 over the past ten years. Vanya Dragomanovich reports.

N 1997, TEN years after Perestroika was introduced by Russia President Mikhail Gorbachev, a Swede, a French woman and a Lithuanian with a background in Nordic financial institutions set up East Capital Partners. Their idea was to invest in Russia, the former Soviet states and Eastern Europe. In May 1998 they set up their first Russia fund.

The strategy was sound but the timing was less then fortunate. It didn’t start as a bed of roses. In July 1997 the Thai baht had de-pegged from the dollar and Asia had sunk into a financial quagmire. At the time of the launch it seemed as if the crisis would be contained to the Asian continent but

by August the rouble was devalued and Russia was plunging headlong into an economic meltdown.

After Russia’s stock market crashed, the fund went down 60%; by October it had lost more than 80%. In fact, the company didn’t make any profit for the

I

28

first five years. So how did they stay afloat?“We took out bigger and bigger mortgages,” says Peter Elam Hakansson, the chairman of East Capital and the brains behind the company’s investment strategy who laughs as he reminisces. What kept them going through the years when returns were barely enough to cover expenses? “Ever since we started the fund we had the intention of being focused on one area only, on investment in Eastern Europe. We have to be good at what we were doing because there is nowhere else that we will be making money,”he says.

Elam Hakansson and his cofounders—Karin Hirn, a French woman with finance experience on the ground in Moscow, Nizhny Novgorod and Helsinki, and Kestutis Sasnauskas, a Lithuanian with intimate knowledge of the Baltic states who, like Elam Hakansson, had come from Enskilda Securities—were

Photograph © Areo17/Dreamstime.com, supplied February 2010.

convinced that as Russia and the other former Eastern bloc states transitioned from state-run to market economies, people in those countries would look West and want to catch up.

They would want to drive flashier cars, own better television sets, wear more fashionable clothes. There would be a consumer boom driven by the middle classes of New Europe on an unprecedented scale and the fund had to position itself in sectors that would benefit from that.

The persistence paid off in multiples. In a Morningstar poll, East Capital’s Russia fund came out as the Noughties’ top-performing fund. (The comparison doesn’t cover offshore funds.) It returned 1,524% in dollar terms to investors.

This in itself is achievement enough but on top of that the fund’s performance is far above the next fund on Morningstar’s list, also a Russia fund, which has returned 962% and more than double the 724% rise in Russia’s leading Russian Trading System (RTS) index for the same period. Although the idea of investing in Russia was not unique—the top four funds on Morningstar’s top

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Face to Face EAST CAPITAL PARTNERS: THE RUSSIA HOUSE

performing list are all Russia funds— East Capital worked several things to its advantage. Firstly, the company didn’t invest in local indices, which are all heavily weighed towards natural resources. While the region is certainly rich in oil, gas and metals, the fastest growth happened in banking, telecoms and retail consumption.“You can’t really avoid investing in big oil and gas companies because if you look at the stock exchanges in Russia these companies have the biggest liquidity.

The RTS index is some 70% resourcebased while we have only 45% in resources and the rest in domestic consumption,”says Elam Hakansson.

Scandinavian investors The other advantage was that East Capital started off with an investor base that was mainly Scandinavian retail investors, who at times of crisis proved far more resilient than large scale investors.

“In 1998 we lost all of our institutional clients but our retail money remained stable. Here were people who invested their pension money and thought, ‘I will need this money in 20 years time, if I stick with it, it will come good’,”Elam Hakansson explains. They understood from the beginning that there would be bumpy patches, they understood the region fairly well and were happy to wait it out, he notes. “Even during the worst stretch in 2008 and 2009 we only lost about 10% of our investment money, there were only 10% of redemptions.”

It has very much to do with what people believe, adds Elam Hakansson.

What also worked in favour of East Capital was that, unlike some of its competitors who were Luxembourg or Guernsey-based, the company operated from Stockholm and didn’t face restrictions on what it could invest in in Russia. East Capital’s fundamental strategy served the

30

company in good stead and by the end of 2009 it had €35bn under management, a long way away from the early days when it managed €2m.

The composition of investors has changed and almost a third of them are now institutional investors.

Of the total portfolio the company manages, some 60% is invested in Russia.

The company runs 19 funds and although two thirds of its investment remains in publicly-traded shares, it has increasingly Peter Elam Hakansson, the chairman of East Capital and the moved to holding private brains behind the company’s investment strategy who laughs equity in companies, as he reminisces. What kept them going through the years typically a 20% to 25% when returns were barely enough to cover expenses? “Ever since stake. Elam Hakansson we started the fund we had the intention of being focused on cites the Russian banking one area only, on investment in Eastern Europe. We have to be sector as a classic case of good at what we were doing because there is nowhere else that why foreign investors we will be making money,” he says. Photograph kindly supplied might chose private equity

by East Capital, February 2010. over shares.

“When we started the banking stores across the Ukraine in the space sector fund in Russia at the end of of a few years, and Chumack, the 2005, early 2006, there were—and still largest ketchup producer in Ukraine are—only a few banks listed and and a local brewer. those are large and typically state owned like Sberbank,” he says. “We Coping with the credit crunch wanted to get access to the growth How did the company cope with the story that would come from middle credit crunch when countries like class consumers and it is difficult to Ukraine and the Baltic states sailed get exposure to that only through close to complete financial collapse and shares traded on stock exchanges. Our only survived because of injections idea has been that if you can’t find the from the International Monetary Fund share on the stock exchange we go for (IMF)? “We survived 2008 and 2009 direct investment in the company,” relatively well. The key was not to have explains Elam Hakansson. too much debt. Most of the companies The list of such companies includes we are involved in were not too some smaller Russian banks, Russian exposed. The DIY company Nova retail fashion group Melon, which has Liniya, for instance, managed to survive some 200 stores across the country, or well because they were so fast in the case of Ukraine the local DIY growing,” says Elam Hakansson. He company Nova Liniya, which grew proudly stresses that the managing from nothing to having a chain of team has not changed since the

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Face to Face EAST CAPITAL PARTNERS: THE RUSSIA HOUSE

company’s inception—the lead three have picked up two more partners along the way: Swede Jacob Grapengiesser and another Lithuanian, Aivaras Abromavicious, who now lead their investment strategy alongside Elam Hakansson. The whole team puts an admirable amount of international legwork in to keep up with the companies they invest in.

The partnership’s Russia fund’s return in the past decade has been more than impressive and the question now is: can it replicate this performance over the next decade?

As the investment small print these days is so fond of pointing out:

Hakansson remains bullish about the region, not only Russia but also the Baltic States and the Balkan countries.

As countries get ready to join the European Union they will become a particularly good investment case once they start going through the convergence process like their central European peers before them.

Ukraine remains a difficult place to invest in because of the seemingly perpetual political turbulence, which makes it difficult to judge how investments will fare. Elsewhere, the Baltic States are showing signs that the worst is over. Given how relatively small and flexible their economies are they

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The other advantage was that East Capital started off with an investor base that was mainly Scandinavian retail investors, who at times of crisis proved far more resilient than large scale investors.”In 1998 we lost all of our institutional clients but our retail money remained stable.

Here were people who invested their pension money and thought, ‘I will need this money in 20 years time, if I stick with it, it will come good’,” Elam Hakansson explains.

previous fund performance is no guarantee of future returns, but what the company will always have going for it is its accumulated knowledge about the region and the understanding of how it operates.

A print ad for East Capital shows photographs of four mildly dishevelled desks with the usual trappings— computers, telephones, but no people.

‘Where is everybody,’the caption asks?

The answer: Tallin, Riga, Kiev or Moscow. Even more likely, the team is visiting a dairy farm in Ukraine, or a Russian company that produces rail equipment, or a bank in Georgia. After a decade of investing, Elam

32

could recover in a relatively short period of time. “There is a strong sense of entrepreneurship in the region and the beauty of a small country is that they have to be export-orientated. They have good managers and good companies there,” and will be able to turn around quickly, says Elam Hakansson.

The appeal of Russia Russia remains the most interesting case for investment. Despite a domestic economic crisis, Russia did much better during the credit crunch than some other European countries because of the large financial cushion it built up while oil and gas prices were

high. In Russia, Elam Hakansson is positive about the banking sector in particular, where debt levels ended up being less than expected. In a lot of cases local banks overestimated what the losses would be and have built up large loan-loss provisions which they will likely cut over the coming months.

Another sector that is likely to do well this year is telecommunications, which will strengthen as consumer demand picks up and on the back of the strong rouble. Power utilities are also tipped by Elam Hakansson, who says the sector has been “extremely misunderstood because for years they (power companies) were run as cost plus operations.” This has changed with sweeping reforms brought in during the last few years that included a sell-off of generation capacity to big foreign buyers.

Equally, most emerging market analysts believe that Russia will do well this year. The country’s lead RTS index is expected to rise from around 1440 in January to 1900 or 2000 by the end of this year and economic forecasts for the country are all for positive growth, particularly further out.

Russia still trades at a 25% discount to other emerging markets. Because of the infamous volatility of its market, investors continue to treat it with scepticism and although funds are rediscovering their appetite for emerging markets, the bulk of fresh investments still go to Brazil and China.

While Russia is appealing, it is certainly not the investment arena for the fainthearted. Local stock markets are capable of losing 75% in the space of 12 months, but they tend to regain the same amount over a similar time frame.

To put this into perspective, the Dow Jones Industrial Average started the last decade at 11700 and ended it at 10400. The FTSE 100 dropped from 6268 to 5412. The RTS rose 724%. The numbers speak for themselves.

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Debt Report PFANDBRIEF: INVESTORS STILL CAUTIOUS

Photograph © Romeo1232/ Dreamstime.com, supplied February 2010.

A NEW ERA DAWNS Investors may still view German pfandbriefe as the most secure covered-bond market in Europe—their spread levels relative to the those on issues from other countries certainly imply that is the case—but in the world post the banking crisis, investors are nevertheless adopting a more holistic, and in some ways more cautious, approach to the instruments than was certainly the case two years ago. Andrew Cavenagh reports.

HE MOST OBVIOUS change in the pfandbrief market is that investor credit analysis now focuses heavily on the underlying credit quality (as distinct from rating) of the issuers.“We always spent much time on credit research, but senior credit analysis plays an even more prominent role today,” says Timo Böhm, portfolio manager and member of the covered bond team at Allianz Global Investors’ Pimco in Munich.“It is no longer a market where investors just look into the cover pool.”

Böhm explains that the strength of institutions’ capitalisation (including their reliance of the various forms of government support), their systemic importance to the banking system (whether they are too big to fail or

T

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not) and their perceived ability to continue financing their operations profitably were now dominant considerations in Allianz Global Investors’Pimco’s investment strategy.

“We try to focus on issuers who we think have a sustainable size in terms of their business,” he adds. “As a consequence, we are looking more at the bigger players in the market.”

Tim Skeet, head of covered-bond origination at Bank of America Merrill Lynch in London, says the trend these days simply reflected the dominance of credit assessments across the investment spectrum. “The nature of the risk has changed, and pfandbrief investors—along with all others—are far more name conscious now.” This switch in emphasis has been reinforced

by changes in the methodology of the rating agencies towards all European covered bonds, which broadly link the ratings of instruments more closely to those of their issuers and also penalise asset-liability mismatches, which produce potential refinancing risk.

“Their approach makes absolute sense,”said Böhm.

Differences in approach between the three rating agencies, however, have caused some consternation among issuers. Although the Association of Pfandbrief Banks (Verband Deutscher Pfandbriefbanken, VDP) is reasonably comfortable with the revised criteria that Standard & Poor’s (S&P) finally published on December 17th. At the time the agency warned that €1,460bn of predominantly European issues could face downgrades as a consequence), though not all pfandbrief issuers accepted the outcome.

Landesbank Baden Würtemburg asked S&P to withdraw its senior unsecured ratings on the bank in January. The move came after S&P confirmed LBBW’s long-term issuer

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rating at single-A minus but on negative outlook, and as a consequence the agency will no longer rate any of the bank’s debt.

Most of the VDP’s membership appears to be drawing comfort from the fact the pfandbrief are in the lowestrisk of the three jurisdictional categories in S&P’s revised criteria, which allow the ratings of covered bonds issued out of Germany, France, Denmark and Spain to achieve ratings up to seven notches higher than the underlying ratings of their issuers. “If you’re in category one or two, you should still be able to attain a triple-A rating for your covered bonds,”confirmed one issuer.

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The VDP reacted angrily, however, to Fitch’s decision on January 20th to place the mortgage-backed pfandbriefe of eight German banks on rating watch negative after subjecting them to further analysis since October. Henning Rasche, the VDP’s president, described the timing of the action as “incomprehensible”, given the agency had not yet presented the issuers in question with its final model for analysing the additional information that it had requested from them. He pointed out that the decision in no way reflected a decline in the underlying quality of the instruments and was simply based on

Fitch’s review of its own models, assumptions and assessments of commercial real-estate loans in the cover pools.”Even though Fitch says that the conservative determination of the mortgage lending value provides adequate protection against expected losses—even in higher stress scenarios—this rating action could cause unnecessary uncertainty in the markets and thus compromise the highly important stabilisation of the financial markets,”Rasche confirms.

Differences in the approaches of the three rating agencies have produced some curious anomalies in the ratings of some pfandbriefe already, but there

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Debt Report PFANDBRIEF: INVESTORS STILL CAUTIOUS

is broad acceptance in the market that the revised criteria will inevitably mean a considerable volume of outstanding pfandbrief issues will see their ratings lowered at some point this year from the triple-A level that has characterised the vast majority of the market since ratings began. A significant proportion seems likely to end the year in the double-A range.

Although this will force some central banks and other investors who are restricted to triple-A investments to offload their holdings, there appears to be little fear that a sudden rush of such enforced sales will have a dramatic impact on the stability of the market. “Spread-wise the influence is likely to be very, very limited,” maintains Böhm.

He points out that, up to the end of June at least, there would still be plenty of capacity in the European Central Bank’s €60bn repurchase programme for covered bonds to sweep up any potential overhang from these disposals. A further factor that should limit the impact of rating downgrades on most pfandbrief spreads is lower level of primary issuance that will come to the market this year relative to 2009, as most of the established issuers continue to shrink their balance sheets and focus on core activities.

This trend will be particularly noticeable at the state-owned landesbanks, several of which have suffered heavy losses on structuredfinance investments since 2007 and have consequently required substantial injections of state aid to keep them afloat. As with the privatesector banks that were large-scale recipients of such support, the price that the European Commission will demand for approving the lifeline will be significant reductions in balance sheets and withdrawal from higherrisk areas of activity.

36

Jens Tolckmitt, executive director of Verband Deutscher Pfandbriefbanken (VDP).“Investors do look increasingly at issuers and do their own credit analysis. This is not surprising given the issuer universe in pfandbriefe and also the fact that the rating agencies are now linking all pfandbrief issuers to the issuer.”Tolckmitt adds, however, that he still believes that any differentiation in the market will be “limited to relatively small dimensions, given the strong legal basis the pfandbrief can build on”. Photograph kindly supplied by VDP, February 2010.

LBBW, Bayerische Landesbank, West LB and HSH Nordbank, for example, have submitted plans to the commission that will reduce the size of their balance sheets by 40%-50% compared with their levels at the end of 2008. With much of the huge volume of pre-funding they put in place still invested in impaired and illiquid asset-backed securities—and losses on their loan books expected to increase this year—their ability to participate in the primary pfandbrief market looks to be negligible for the foreseeable future.

Despite the €3bn of new pfandbrief issues that came to the market in January (from Dexia, Deutsche Pfandbrief Bank, Aareal and a Eurohypo tap), the overall market for jumbo transactions is unlikely to exceed €10bn-€15bn in 2010. This compares with a forecast for the overall European market of between €150bn and €160bn, notwithstanding a high level of redemptions from maturing bonds, estimated to be around €60bn.

“We expect to issue less than in past years and less than we have maturing,”confirms Marcel Kullmann, deputy head of covered bond funding at leading issuer Eurohypo and its parent Commerzbank. “Through the low issuer needs, the pfandbrief market is in a different situation from the rest of the European coveredbond market.”

The Commerzbank group announced that it will raise €20bn from the bond markets this year, about two-thirds of which will be in the form of pfandbriefe or lettre de gage (covered bonds issued out of Luxembourg). This compares with the bank’s €11.2bn of pfandbrief issuance in the first nine months of 2009, when the market was virtually non-existent in the first quarter and touch-and-go in the second three month period until the European Central Bank launched its purchase programme.

Kullmann points to the relatively small primary market pipeline this year, holding that the strong

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redemption schedule should support outstanding pfandbrief issues at their current tighter spread levels. “From that point of view it’s very positive for pfandbrief investors,”he says.

What has not been so positive for pfandbrief investors is the increasing migration of cover pools away from portfolios of purely residential mortgages with the inclusion of more commercial-property loans. Many of these now look vulnerable as valuations in the sector have dived and the prospects of refinancing the loans when they mature looks increasingly slim. Investors clearly share the rating agencies’ concerns that the performance of some collateral pools will deteriorate as a consequence. “That is a question to which investors have to find an answer,” said Böhm at Pimco. “The quality of the cover pool may well weaken over time.”

It will also prove difficult in many cases for issuers to satisfy ratingagency demands for more information on the borrowers involved, and the performance of much of this commercial-property lending. The loan contracts often prevent banks from disclosing such details to third parties.“It’s not really a practical thing to do,”explained one banker.

Failure to do so, however, will clearly place more outstanding issues at risk of—possibly significant—downgrades, and this seems likely to lead to more tiering of both ratings and spreads in the market than has been the case historically. This concern over the underlying collateral has led Allianz Global Investors’ Pimco and other investors to view the pfandbrief market as too tightly priced at present relative to some of the other European covered-bond jurisdictions. They consider that the French, Dutch and Nordic markets now offer better value.

The VDP acknowledges that there

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will be more distinction between issuers in future.“We will see a certain level of credit differentiation going forward—as has been observed for a number of years now,” said Jens Tolckmitt, the organisation’s executive director.“Investors do look increasingly at issuers and do their own credit analysis. This is not surprising given the issuer universe in pfandbriefe and also the fact that the rating agencies are now linking all pfandbrief issuers to the issuer,”Tolckmitt adds. However, he still believes that any differentiation in the market will be “limited to relatively small dimensions, given the strong legal basis the pfandbrief can build on”.

A final consideration for pfandbrief investors is the heightened awareness of sovereign risk, as governments across Europe face the prospect of issuing debt on an unprecedented scale to finance their bail-outs of the banking system. As the focus of concern on this score shifted from Greece to Spain and Portugal at the end of January, spreads on Spanish and Portuguese covered bonds predictably widened.

Movement was unrelated to any change in the credit risk of instruments however. Covered bonds—along with all other capital-market debt issued out of countries perceived to be vulnerable to worsening sovereign risk—will always suffer from such contagion as portfolio managers are suddenly required to re-justify any holdings in the jurisdictions. “The last thing you want to have to do as an investment manager is constantly defend your decision to invest in this or that type of asset to your superiors because of adverse headlines about national finances in the newspapers,” explains Kullmann at Eurohypo.

This should strengthen investor perception of the pfandbrief over its counterparts—certainly Spanish, Italian, UK and Irish covered bonds—

FTSE GLOBAL MARKETS • MARCH/APRIL 2010

Tim Skeet, head of covered-bond origination at Bank of America Merrill Lynch in London, said the trend these days simply reflected the dominance of credit assessments across the investment spectrum.“The nature of the risk has changed, and pfandbriefe investors—along with all others—are far more name conscious now.” Photograph kindly supplied by Bank of America Merrill Lynch, February 2010.

in the near term given the bund remains the most tightly priced sovereign debt in Europe.

Nevertheless, German government debt as a percentage of national GDP is higher than in many European countries and the market may not be as immune from such risk as it has been in the past.

Tolckmitt at the VDP certainly remains confident that pfandbriefe will retain its status as the most stable, secure (and tightly priced) covered bonds in the Europe. “The pfandbrief was the banks’last funding market to be affected by the turmoil and the first market segment to return to functioning properly. We understand that this is something investors are well aware of and value strongly,”he concludes. There can be little doubt, however, that the market is entering a new era.

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Debt Report SPANISH COVERED BONDS: SHAKEN NOT STIRRED

Spain looks fragile in the economic bullring Spanish banks may have started to issue Spanish covered bonds again since the European Central Bank (ECB) launched its $60bn purchase programme for the instruments in June 2009, but serious doubts hang over the market this year as the scale of Spain’s property crisis—and its impact on the country’s banking sector—become increasingly apparent. Andrew Cavenagh reports.

UST HOW FRAGILE the cedulas market remains was evident towards the end of January, as bond spreads widened significantly on renewed concerns about Spain’s sovereign debt and a big increase in bad-debt provisions at the country’s second largest bank. Banco Bilbao Vizcaya Argentaria (BBVA) disclosed on January 27th that bad debts had increased from 2.3% of its total lending a year ago to 4.3%, while “doubtful risks”on the bank’s books had risen to €15.6bn from €8.6bn over the period.

By the end of the month, spreads on Spanish covered bonds had widened to around 60 basis points (bps) over mid-swaps. This was double the level at which BBVA priced its €1bn, fiveyear mortgage-backed (cedulas hipotecarias) bond in September and 5bps to 10bps wider than the pricing on bonds issued in the first half of January. The retrenchment was also no doubt in part a reaction to the glut of primary issuance of covered bonds across Europe in the first half of the month, with over €22bn of new bonds sold into the market.

Santander, the country’s leading bank, also pulled a planned covered bond for

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its UK subsidiary (the former Abbey National) in mid-January, apparently because there was insufficient investor appetite for the 40bps-50bps over midswaps at which it was looking to price the instrument. Even so, it issued a €1bn bond out of Spain priced at 50bp over the benchmark the following week on January 19th.

Massimo Carocci, head of capital markets at the fourth-ranking cedulas issuer Caja Madrid, acknowledged that investor appetite had weakened since the final quarter of last year, largely over the growing fears about the Spanish government’s financial position. He maintains that the revival of the primary market in the second half of 2009 is clear evidence that there was still belief in the product.

“That confirmed the interest that we had at that point,” he says. “It’s still triple-A paper, backed by the total mortgage portfolio of the banks.”

Carocci adds that the recent spread widening meant that was now a“lot of value”in the cedulas market.

Several financial analysts question whether this would have much of a market at all, were it not for the huge level of European Central Bank (ECB)

support: not only through the purchase programme, but also central bank’s expanded repo programme that has enabled Spanish banks and others to use their cedulas holdings to access liquidity that some would otherwise have struggled to find.

“That is the only way many Spanish banks have any semblance of liquidity right now,” insists Jonathan Tepper, a London-based partner at the economic research firm Variant Perception. “Without the ECB, some Spanish banks would have the same liquidity problems that US sub-prime mortgage originators had. The ECB is a mega-warehouse, effectively, for the Spanish banking system.”

There can certainly be little argument over the scale of the Spanish housing bubble. The country accounts for about 10% of the European Union’s GDP yet managed to build 30% of all new homes in the region between 2000 and 2008. Over that period, the value of outstanding loans to property developers rose from €33.5bn to €318bn. Add in loans to the construction sector, and the total comes to €470bn—about 50% of the national GDP. The country has the distinction of

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Debt Report SPANISH COVERED BONDS: SHAKEN NOT STIRRED

having as many vacant properties as the US, around one million, with a population one-fifth of the size.

What is more contentious is the extent to which Spanish banks have been concealing the true extent of their losses on this lending. Tepper believes that the total is probably at least three times as much as the €12.3bn of excess provisions that Spain’s banks had made up to end-2008. BBVA’s recent disclosure would tend to support the view that this figure is woefully inadequate. Moreover, there is ample evidence that they have been hiding the real numbers of non-performing loans (NPLs) on their books.

The Spanish Banking consumer watchdog, Adicae, last year claimed that banks were resorting to all sorts of “tricks and cons” to reduce the number NPLs they had to declare— such as buying back properties before the loans on them defaulted and debtfor-equity swaps. The organisation warned that the Bank of Spain’s data on delinquencies was consequently “very distant”from the reality. Some of these disguised NPLs have been wrapped up in cedulas issues that have been parked with the ECB.“The clear indication is that things are getting worse on the ground in Spain in terms of delinquencies,”concludes Tepper.

The Spanish Mortgage Association confirmed the parlous state of affairs at the beginning of February. Then, its president, Santos Gonzalez Sanchez, declared that the real estate sector was “bankrupt”. He told the Spanish press that Spanish developers had invested 50% of the €324bn of debt they had incurred by the third quarter of 2009 to buy land for which there was now no market and that the situation was putting the banking system at risk. The viability of the property sector is in question and it is putting the financial sector in danger,”he added.

Gonzalez says that the government

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or Bank of Spain needs to take a lead in tackling the problem instead of “looking the other way”—possibly through the creation of a “bad bank” into which all toxic real-estate loans could be dumped—to enable banks to start lending again to the sector of the economy that needed it.

It is hard to see how this dire situation can fail to feed through into much of the cedulas market before too long. Investors in Spanish mortgage securitisations (which have specific pools of loans assigned to each transaction) are already suffering losses.

Bad debts of this magnitude, allied to declines of up to 50% in property prices, threaten to undermine the one great structural strength of cedulas programmes: that bond investors ultimately have recourse to the originators entire mortgage portfolio.

Revised ratings Against this background, the rating agencies’ revised criteria for European covered bonds—all of which link the ratings of the instruments more closely to that of their issuers than before and discriminate against the Mediterranean euro countries—seem certain to result in further multiple downgrades this year. Moody’s in mid-December dropped its ratings on a third of all the cedulas hipotecarias it rates from triple-A to double-A plus (Aa1), while Standard & Poor’s placed €1,460bn of European covered bonds on negative watch about the same time.

Despite the grim outlook, however, widespread downgrades will not shut the market for new issuance entirely.

BBVA and Santander, with their strong double-A ratings, will continue to find ample investor appetite for their covered bonds, along with their senior unsecured offerings (there is little spread distinction between the two).

The instruments should also remain a cost-effective source of funding for

second-tier Spanish banks such as Caja Madrid and Banesto, but most of the multi-seller programmes, which pool together the mortgage portfolios of the smaller Spanish savings banks, seem certain to struggle.

Not only did these cajas advance the most risky property lending in terms of high loan-to-value percentages, which the Bank of Spain’s regulations prevented the larger institutions from undertaking. They are also a relatively unappealing proposition for an investor base that is much more attuned to carrying out its own risk assessments than two years ago.

“It’s a lot more difficult for investors to go through the analysis with 10 players,” explained Carocci. “That’s where the spreads have widened the most.” The outstanding bonds of the largest of the multi-seller programme, AyT, are currently trading in the 110bps to 150bps range and it is hard to imagine any of the programmes attempting to launch new issues at those levels.

Consolidation Carocci thinks that their situation should improve, however, once the second phase of consolidation of Spain’s sector gets under way this year and mergers concentrated the sector into fewer, larger and stronger cajas.

The government has set up a €9bn fund to facilitate the process, with a commitment to borrow a further €90bn to support the programme if necessary. Given the one bank it has been to the rescue of so far—Caja Castilla La Mancha (CCM) in March 2009—required a recapitalisation of €2.7bn, it is optimistic to believe a lot of this borrowing will not be needed, and that may have further damaging implications for the sovereign rating.

PricewatehouseCoopers recently estimated that the Spanish banking system will need between €25bn and €75bn of fresh capital.

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Debt Report

Photograph © Blitzkrieg/Dreamstime.com, supplied February 2010.

In a study using data from the US Federal Reserve between 1920 and 2009 conclude that spreads and yields generally have a negative correlation, outside of the long secular period of the rise in inflationary/government bond-based stress and its subsequent resolution. That of course raises the one million dollar question: how probable it is that 2010-11 sees 10%–plus higher government bond yields? Moreover, what can investors do to protect portfolios against such a negative scenario? By Jamie Stuttard, head of European and UK fixed income and Sarang Kukarni, fixed income fund manager at Schroders. sing data from the US Federal Reserve find that over the very long term (1920 to 2009) the correlation between changes in credit spreads and government bond yields is almost zero. This finding however masks a number of periods when the correlation is either clearly negative or clearly positive. In particular, they note a 15 year period from 1968 to 1982 when the correlation between yields and spreads was much higher and generally bearish for both.

Subsequently, in the great moderation which ensued, there is market data in the early 1990s illustrating that US spreads and US government yields can also at times be positively correlated.

There are other drivers of credit spreads which exhibit a much closer longer-term relationship—with credit lending standards, industrial production cycles, the proportion of

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CCC issuance in high yield and the shape of yield curves all much more consistent longer-term indicators.

Overwhelmingly, credit spreads are driven by cyclical growth phenomena, as the ability of corporations to generate cash flow to meet their debt obligations is the over-riding driver of price, both at an idiosyncratic, and at a market level. These drivers are beyond the scope of this short piece, where we focus solely on the relationship between US credit spreads and yields.

The lack of long-term correlation, however, masks the fact that within the last 90 years, there have been quite strong relationships, periods of a decade or more, where outright positive or negative correlations have been seen. In fact in the post-war period, we can break down the relationship between government yields and credit spreads into four distinct periods.

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CREDIT SPREADS & GOVT BOND YIELDS

THE LONG RUN

In the 1950s and 1960s, credit spreads were generally tight. There were fairly regular recessions, but inflation was low and stable throughout. During this time, when government bond yields rose, credit spreads typically tightened. When yields fell those same spreads widened.

As such, credit spreads behaved as a cyclical asset and government bonds behaved as a counter-cyclical asset. This is intuitively and empirically what market participants expect of the two markets. We might call this the normal cyclical relationship.

In the second period, from the mid1960s to the early 1980s, inflation rose above 10% twice due to the oil shocks and the associated macroeconomic chain of events that followed. CPI has only risen above 10% in two decades in the data since 1930 (the 1940s and the 1970s). Both times were due to geopolitics (something of a euphemism in the first case) and external shocks.

Importantly for today’s context, the aftermath of the Depression in the early 1930s, or indeed the recessionary relapse in 1937-8, was not followed by rate-induced credit blow-up. The credit risks of the 1930s—a very relevant precursor for the extreme market movements in credit spreads in 2008 were overwhelmingly driven by cyclical macroeconomic data, not changes in government yields. In the second of these periods, the impact on credit spreads (and indeed many financial and cyclical assets) was severe and negative.

This suggests to us there may be something of a breakpoint in government yields/inflation, whereby modest yield rises and inflation can be tolerated, but double digit yields/inflation have historically been enough to reach a tipping point, which then leads to wider spreads.Throughout the 1970s, transmission mechanism from high government yields to wider spreads was over-tightening of monetary policy and recession as the

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requirement to tackle inflation led to economic contraction and therefore wider spreads. It should be noted that periods of increased inflation fear over the last ten years (1999 through to the second quarter of 2008) have been nowhere near high enough to concern credit spreads at the time.

The third period, in the early 1990s, saw a higher correlation in both spreads and yields. This was during the “Great Moderation” Greenspan era when for a number of years in the 1990s, following the junk bond and savings and loan (S&L) crisis of 19891990, flows into US assets caused a synchronous and secular rally in all major US asset classes. This period is arguably the flipside of the secular increase in risk premia in the 1970s, in that it was the high government yields of that period which provided the market starting point and policy response that began the 20-year period of secular decline in both inflation premia and risk premia in the 1980s and 1990s. This secular decline was powerful enough to ensure a positive correlation between yields and spreads in the early 1990s in particular.

The fourth period (from the late 1990s

onwards), has exhibited a negative correlation, very similar to the first period in the 1950s and 1960s. The normal cyclical relations have reasserted.

The negative correlation between yields and spreads has been at its most powerful in the 2008-2009 period, at a time when the magnitude of cyclical moves in credit spreads and government bonds has been very extreme.

Capturing trends In conclusion, the data suggests there are clearly ‘regime switches’ over time, when the dominance of particular macroeconomic themes (such as war, 1950s/1960s ‘normal cycles’, 1970s inflation shocks, 1980s/1990s moderation and then the 2000s ‘deep cycle’) have moved the correlation between government bond yields and spreads from negative, to positive and back to negative again.

It appears there are also secular themes whereby yields and spreads move in the same direction concurrently can occur if external shocks are sufficient to dominate the market landscape. Clearly with the deterioration in budget deficits in 2009 and further deterioration

forecast for 2010—for the US, UK and peripheral European issuers, this needs to be closely watched.

Government yields above 10% have historically been enough to hurt credit spreads. We are a long way from that point, but the rapidity of government bond debt accumulation in 2009 suggests vigilance is needed.

The most direct way to capture this trend, for those investors that perceive a government bond crisis is likely, is to sell government bonds and government bond futures. Given the disparity in government borrower fundamentals, there is an intrinsic need to focus on government bond country allocation as part of this process. For example, Japanese government debt trends are very different to those in Germany. In many bearish government bond scenarios (especially cyclical economic rebound), credit spreads will tighten. Seeking second order effects in the impact on investment grade from government bonds does seem a somewhat contorted strategy. Rather, the relative outperformance of corporations over governments seems well-supported by fundamentals as well as by much of the historical data.

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

Paul Spendiff Tel:44 [0] 20 7680 5153

Fax: 44 [0] 20 7680 5155

Email:paul.spendiff@berlinguer.com

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Index Review

In a fast moving post-recessionary market there appears to be growing diversity in investment approaches. Long regarded as a staid segment within the investment industry, actually index providers have in recent years been at the vanguard of change, providing invaluable backing to new investment styles (such as strategic investing) and new product, such as exchange traded funds. Now the industry threatens even more revolutionary, or should that be evolutionary, change. The standard practice of constructing stock market indices based on capitalisation weighting is now under sustained scrutiny. FTSE Group and EDHEC-Risk Institute, an institute for applied asset and risk management research, have launched new risk efficient indices, based on a risk adjusted investment strategy to deliver investors with an optimal risk to return ratio, which they now suggest, can provide consistently improved returns.

TSE Group and EDHEC-Risk Institute have launched an index series which uses a risk-adjusted strategy to that of traditional market capitalisation-weighted indices, to deliver investors with an optimal risk return ratio. The FTSE EDHEC-Risk Index Series aims at improving the socalled risk/reward efficiency of market capitalisation (often called capweighted) indices by applying an optimal weighting scheme to the constituents of the index. According to EDHEC-Risk Institute’s research, cap-weighted equity indices have a lower reward to risk ratio compare to what it believes can be achieved by carefully constructed and well-diversified portfolios that invest in the same constituents.

The launch of the new index series heralds a new approach to index construction and comes at a pivotal time in the global investment markets, as investors seek increasing diversity in investment approaches as a risk

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management tool. It is in that light that the initiative has been launched, rather than any intention to replace market capitalisation based indices with so-called characteristics based indexing approaches.

At present almost all investment dollars benchmarked against equity indices worldwide are based on market-cap weighted indices, such as the FTSE 100 and shifting that preference would be a Herculean task.

According to Andrew Buckley, executive director, strategy, at FTSE Group, the index business will continue to evolve and adopt ever more efficient methodologies and approaches and that this latest initiative is one among many being considered by the index provider. “I think a lot of money will remain in market cap-weighted indices,” adds Buckley, “however, I would anticipate that investors will use an ever wider range of benchmarks going forward as index providers bring

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THE EMERGENCE OF NEW INDEX CONSTRUCTION STYLES

EVOLUTIONARY INDEXING

new products into the market. The increasing use these days of indices that are weighted by fundamental factors, for instance, shows that investors are increasingly willing to work with diverse index products to achieve their investment goals.”

Even so, as this new index appears to maximise the risk/reward relationship within index-based investment approaches, it speaks to the Zeitgeist: where a current preference for long only strategies can be married to improved returns. As Mark Makepeace, chief executive FTSE Group explains: “Increasingly, investors are looking to diversify their core passive funds across a range of benchmarks weighted by market cap and other weighting schemes. The weighting methodology developed by the EDHEC-Risk Institute provides a robust and transparent approach to constructing a benchmark seeking to achieve an efficient risk return.”

According to the EDHEC-Risk Institute, the new weighting methodology indices serve a different purpose to traditional market capitalisation-weighted indices, which are created to track the performance of the market. It minimises excessive concentration of risk and gives investors the ability to benefit from the maximum Sharpe ratio portfolio, which measures the relationship between the risk of a stock and its return. According to the blurb provided by both FTSE Group and the EDHEC-Risk Institute: “This efficiency is achieved by maximising the Sharpe ratio, by weighting the constituents of the indices accordingly. This enhanced methodology, combined with a constituent base deriving from the FTSE All World Index Series, allows investors to develop new passive investment strategies.”

In other words, cap-weighted indices weigh stocks by the footprint a company leaves on the stock market

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and that is reflected in its market capitalisation. Characteristics-based indices, on the other hand, weight stocks according to company characteristics, such as earnings or book value, to obtain what FTSE Group refers to as an “economic measure”.

Professor Noël Amenc, director of EDHEC-Risk Institute, says: “Overall, traditional commercial capitalisation weighted indices are not designed to be at the pinnacle of efficiency or provide well-diversified portfolios, as they principally track the market. EDHEC-

Risk Institute has therefore undertaken major research in a methodology that minimises excessive concentration of risk and affords investors the ability to benefit from the maximum Sharpe ratio portfolio. This simple concept is primarily based on the concept of a positive and robust long-term relationship between the risk of a stock and its return and we are pleased to have partnered with FTSE Group, an authority in the field of indexing, to achieve this within an innovative index series.”

FTSE Group has now launched the index series called the FTSE EDHECRisk Efficiency Index Series, of which the initial regional/country indices will cover the developed Asia-Pacific countries (excluding Japan); the Euro bloc, Japan, the United Kingdom and the United States. These new indices are based on the constituents of the corresponding FTSE All World Index Series.

According to Buckley, FTSE will also use the weighting scheme of the index series on customised versions.

ARE MARKET CAPITALISATION-BASED INDICES OLD HAT? ccording to the EDHEC-Risk Institute the standard practice of constructing stock market indices, based o capitalisation weighting has faced ‘criticism’ for some time. More than 15 years ago, says the Institute, a number of academic papers offered empirical evidence that cap-weighted indices provide an efficient risk-return trade-off.

The main objective of indices is to provide a representation of the stock market and therein lays the problem, suggests the Institute, as they neglect the need for the most efficient risk-return trade-off. In other words, cap-weighted indices are not efficient or well diversified portfolios because they were never meant to be. These indices focus on improving representation, says the Institute, and do not explicitly aim at improving the reward to risk ratio.

Characteristics-based indices on the other hand try to be more representative by weighting stocks according to their economic footprint.

Moreover, holds the Institute, cap-weighting leads to a high concentration of stocks. If one examines the

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constituents of the leading cap-weighted indices, it immediately becomes apparent that a relatively minor percentage of the index exerts a powerful influence on the remaining firms in the index; these powerful stocks are called ‘effective’ stocks. If one stock, for example, makes up the entire index, the effective number of stocks equals one: if the index is equally weighted, it is equal to the nominal number.

The Institute’s own research, married with the back history of the index series now launched by FTSE and EDHEC-Risk, shows that the new characteristics-based indices have outperformed relevant cap-weighted indices since 2002, by approximately 200 basis points annually, while also lowering volatility. (Please refer to the tables below.) However, in extreme bull markets, such as that between 1996 and 1999, capweighted indices appear to come in to their own, obtaining higher returns than efficiently weighted indices. However, says EDHEC-Risk, efficiently weighted indices still continued to have lower volatility during this period.

LONG TERM RESULTS OF THE EFFICIENT INDEXATION METHOD The table below shows risk and return statistics for efficient indexation portfolios constructed with using the same set of constituents as the cap-weighted S&P500 index. Rebalancing is quarterly and the results are based on weekly return data from 01/1959 to 12/2008.

Index

Annual Average Return

Annual Standard Deviation

Sharpe Ratio

Information Ratio

Tracking Error

Efficient Index Cap-weighted index

11.63% 9.23%

14.65% 15.20%

0.41 0.24

0.52 n.a.

4.65% n.a.

Source: EDHEC-Risk Institute & FTSE Group, February 2010.

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Index Review EU: WEAKER ECONOMIES PUT PRESSURE ON BOND YIELDS

DOOMSDAY DOMINOES? There have been comments concerning the possibility that the rally of 2009 was built on the back of the easy money being poured into the system by central banks. The removal of this crutch has led to the market reacting like a drug addict forced into “cold turkey” by the sudden cessation of its free money fix. We may yet be heading into the perfect storm of weak economies, weak banks and weak governments leading to yet another financial tsunami but, in all likelihood, not just yet. In reality, the latest crisis will almost certainly result in yet another stickingplaster solution with the Northern European states extracting some penalty from the South in return for a more solid guarantee over EU sovereign nation debt. The whole merry-go-round will start up again for just one more ride thinks Simon Denham, managing director of spread betting firm Capital Spreads.

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

towards a corrective budgetary stance; and at least they were able to do this from the position of having a reasonably robust employment. Spain, Portugal and Greece have huge unemployment and the sudden removal of state spending may cause social unrest as well as economic misery.

How will this affect the FTSE? The prospect of chaos in one financial market tends to cause mayhem in others. Moreover, the recent slowdown has highlighted actual tax revenues for the UK over the past 12 years. While we have been under the impression that the country has been in economic growth from 1997 to 2007 the actual total tax take for the Inland Revenue hardly moved in all that time. Indeed, it actually peaked in 2001. The huge spending increases of the Blair years appear to have been built on sand. It wouldn’t be a problem if money had been spent on roads, rail, or power. Instead it has been focused on health, social welfare and education, creating structural spending liabilities that will be almost impossible to unwind.

If the financial probity of deficit hung European economies continues

to be tested to breaking point, then yields across the globe in the bond markets may well come in for some heavy weather. Into this mix strides quantative easing, which seems to have been designed to push nasty decisions further into the future; a sort of central bank collusion in wishful thinking that something good might eventually turn up and pull our nuts out of the fire.

Unfortunately, just as quantative easing is being pulled back, the UK will not only have to issue gilts into a weakened market, it might also have to offload the expensively bought quantative easing portfolio. Minds will reel and more if the UK Treasury is forced into a sale just as the world appetite for sovereign debt hits a nadir. If the problems in the weaker EU economies grow, then longer dated gilt debt could reach yields of 2% to 3% higher than the current 4.0% to 4.5%, leaving equity returns of 3% over sovereigns offering 6%. This is obviously not sustainable, which is why the markets have been in a tailspin since early January.

As ever, ladies and gentlemen, place your bets.

HE VAGUE SENSE of doom across dealing floors is laid at the door of the “sudden” realisation that much of southern Europe is technically busted. In the face of tightening belts, rising unemployment and burgeoning state debt, no political leader is willing to burden domestic voters with further spending. The need to show EU solidarity is wilting under the glare of self interest. Germany in particular is digging its heels in and we are left with the awareness that this time they might really be serious when they talk of kicking out one of the weaker states. In times of plenty it suited everyone’s purposes to turn a blind eye to endemic corruption and soft accounting practices, but the New Austerity may well engulf a few nation states rather than the handful of bankers it has caught up to date.

One problem might be the return of the old domino theory (oft mentioned in the crisis of 12 to 18 months ago) where the contagion of one sovereign default leads to another and another until even solid countries are dragged down into the mire. Only Ireland has actually made even the slightest shift

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Country Report ARGENTINA’S ELECTIONS HAMPERING ECONOMIC RECOVERY

Cry now Argentina?

Argentina’s latest attempt to get its hands on more cash through the desperate measure of purloining central bank reserves and firing its president has both emasculated the bank and alienated investors. While diehard optimists hold that the move might provide some coherence to economic policies, it has removed a vital check on the government’s expansionary policies. It also underscores the sometimes skittish decision-making style of president Christina Kirchner, who continues to alienate Argentina from the mainstream. The government is likely to blow the country’s reserves by distributing political largesse and as giveaways to obedient provinces ahead of next October’s presidential elections. To what end? John Rumsey reports.

HE FIRING OF Brazil’s excentral bank chief Martín Redrado and his replacement by Mercedes Marcó del Pont was initiated in January and only completed in February. Kirchner’s decision to remove Redrado from the post came after he declined to implement her decision to take $6.5bn from the central bank’s $48bn reserves and inject it into the new Bicentennial Fund. That fund is widely seen as a piggy bank to ensure the government can up its spending while meeting debt obligations.

Redrado’s dismissal was the death of a thousand cuts. He was fired by decree on January 7th this year, but swiftly reinstated by court order, which pointed out that a special congressional committee should have been convened

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to ratify the presidential decision.

Redrado’s vice-president Miguel Pesce then became interim president after January 24th as the government physically prevented Redrado from reentering his offices, leading to a furious war of words. A committee was then put together, with members from both congress and the senate, and headed by the vice-president Julio Cobos, and which finally lanced a festering boil and voted by a majority of two to one to support Redrado’s dismissal.

The new central bank president, formerly the president of the stateowned Banco de la Nación, is an altogether more pliable figure and has been heard to make emollient sounds.

Del Pont pays lip service to independence but has stated that the central bank needs to follow the

Argentina’s president Cristina Fernandez Kirchner, right, Argentina’s economy minister Amado Boudou, left, and Daniel Scioli, governor of the Argentina’s Province Buenos Aires, attend a press conference in Buenos Aires, Monday, January 11th 2010, in which new economic measure were announced for wheat traders.

On the Friday before the photograph was taken, a judge reinstated Argentina’s central bank chief Martin Redrado, a day after President Fernandes-Kirchner fired him by emergency decree in a bitter fight over control of the bank’s reserves. Photograph by Eduardo Di Baia for Associated Press.This photograph was supplied

by Press Association Images, February 2010.

government’s domestic agenda.

Moreover, she holds that while the bank might have operational autonomy, it cannot operate independently of the nation’s economic policies. She also added that the bank might need to take a softer line with inflation, spooking local economists and analysts.

Local analysts have been scouring her past to make predictions about the likely policy shift at the bank. In her time in the lower house of congress, del Pont supported a number of suggested changes to the central bank, including the idea that it should not merely target inflation but alter its charter to actively support generating jobs and sustaining growth. One economist wryly noted: “She believes the central bank should be more of a development bank.”Del Pont has also in the past argued for a devaluation of the peso to ensure competitiveness in the economy.

Del Pont was quick to add that she did not intend to change radically the foreign exchange policy in order to assuage markets. Although the peso did fall, the move was muted as jaded markets increasingly take the twists and turns of the Kirchner government for granted and the only investors in debt markets are deep discount and vulture buyers.

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The Bicentennial Fund now needs to garner the support of congress. To drum up that support, the government has been negotiating with cash-strapped provinces. A“yes” vote will therefore likely be sealed only after further financial goodies are lined up for the regions.

Since his ousting, Redrado has been sniping from the sidelines, warning of “the government’s hunger for raising expenditure” and revealing that the central bank has stopped paying heed to national inflation statistics prepared

by Indec two years ago, saying that there was an extremely significant credibility gap in the data.

Macro story A host of other issues continue to dog the economy as well and could be worsened by the new appointee and changes in policy direction. The latest manoeuvres come at a time of recovery in Argentina, although growth predictions for this year are anaemic.

GDP growth was a negative 2.52% last year and is predicted to reach a sluggish positive 1.5% this year, according to the International Monetary Fund (IMF).

Argentina’s numbers compare poorly with other key economies in Latin America, which are also more investor friendly. Peru is predicted to grow at a healthy clip of 5.8%; Chile at 4%; Brazil at 3.5%; and Colombia at 2.5% by the IMF. Of the larger Latin economies, only Venezuela will do worse, with expected negative GDP of 0.4%.

There are growing concerns too, that the government’s voracious spending appetite will further unleash inflation, which is already the highest in the region outside of Venezuela. Meantime, the controversy over unreliable inflation data has been given fresh support by Redrado’s statements.

It’s not as if the official numbers on inflation are flattering. They are acceptable, if poor. Official data claim

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that consumer prices increased by 7.7% in 2009, itself an increase from the year before at 7.2%. This year’s budget makes predictions that inflation will decline to 6.1% this year.

The central bank has already been proving more mealy-mouthed. The latest inflation report under interim president Pesce was slimmed down, confining its statements on inflation to a one-page summary. Market watchers have found the official data risible.

Private-sector economists say inflation has been close to 20% for the past four years. This year is a tester, with inflation estimated by independent economists at 2% in January alone. Moreover, some commentators fear the appointment of del Pont at the bank will stoke further inflationary pressures.

The government has been increasing its inflation-adjusted spending by 15% per year, notes economist Miguel Ángel Broda. Its primary surplus has been shrinking fast as increased tax collection is not keeping up with spending plans. Some local analysts believe that growth in government spending could spike to 30% this year as elections draw near. Unions already sense more spending leeway and are pressing the government to increase salaries of public employees. The teachers’union has been pushing for an increase of some 25% and has been threatening to strike.

These additional spending pressures come as the country’s finances are deteriorating. The total for the primary surplus came in at ARS17.27bn ($4.49bn) in 2009, down significantly from ARS32.5bn ($8.45bn) a year earlier. The overall fiscal deficit after interest payments was ARS7.1bn ($1.85bn). Moreover, last year’s figures were flattering, showing the impact of both payments that will not be repeated as well as the effects of nationalisation. The government counted not only a one-off payment

FTSE GLOBAL MARKETS • MARCH/APRIL 2010

from the IMF but also investment profits from the social security agency ANSES and counted contributions to the social security system, which when combined, total $5.85bn.

Senior Argentine economists have lined up to condemn the government’s spending plans, according to local media. Claudio Loser, ex-director of the IMF, called the government’s action very myopic, adding that it was spending the family jewels. His interpretation of the creation of the Bicentennial Fund was that the government was looking for more resources to spend as the budget had already included provisions for the payment of bondholder debt, he said.

Former economy minister Roberto Lavagna added that the possible creation of the fund added to measures taken in the previous three months were leading to higher indebtedness, more public spending and higher inflation. Since 2006, the government had spent its entire fiscal surplus and continued to be in the red. With the elections, it would enter into a new cycle of debt, he noted.

Another issue is the policy direction that the Central Bank will take on the exchange rate. The Central Bank report issued under Pesce’s interim management displayed only one, slightly controversial aspect. It said that it “wouldn’t be advisable to use the exchange rate as the only tool against inflation”, fearing that such a move would negatively affect competitiveness.

“The perception that interest rates are going down and inflation up is worrying. This positions the dollar as an alternative,” says Ricardo Delgado, director of the consulting firm Analytica. The peso tumbled 9.2% over the 12 months to the end of January and some analysts see the currency falling to 4.2 to the dollar by year-end. It was worth 3.84 to the dollar in early February.

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Country Report BRAZIL: THE IMPACT OF PRESIDENTIAL ELECTIONS

Goodbye to all that?

The last two Brazilian elections could hardly have been more different. In 2002, Brazilian markets went haywire. With the real and equity values tumbling, Brazil went cap-in-hand to the International Monetary Fund (IMF) to seek a bailout to the tune of $30bn. In 2006, markets remained preternaturally calm. Analysts think that this year’s election should not repeat the crisis scenario of 2002, but it will perhaps be trickier than in 2006. Crucially, they will usher in a new president as incumbent Luiz Inácio Lula da Silva has run through the constitutionally-permitted two consecutive terms. What now? John Rumsey reports.

N THIS YEAR’S elections in Brazil, voters will probably be choosing between two candidates with much in common: they are from the centre left and are likely to have similar policies in key areas. The first election round will be held October 3rd and will likely pit Dilma Rousseff, frontrunner for the incumbent Workers’Party (PT), against José Serra, likely candidate for the opposition centrist Brazilian Social Democracy Party (PSDB) party. Rousseff is widely seen as authoritarian with a fiery temper and Serra is known as the kind of tough negotiator who gets just what he wants.

Even if Brazil’s presidential elections don’t have a high probability of tension, they will be an important event, holds Rafael Cortez, political scientist at São Paulo-based consultancy Tendências. The elections are likely to be close and the outcome cannot be predicted, he notes.

Although the PT as a party tacks well left of the PSDB, which has moved to the centre in recent years, the two leaders are also similar in how they view the role of the government, says Mauro Cunha, head of equity at local asset manager Mauá Investimentos, based in São Paulo. Both candidates are likely to respect orthodox macro-economic policies, with some different leanings.

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Brazil has learned the importance of implementing reasonable monetary and fiscal policies and that is not likely to be jeopardised, market watchers say.

Moreover, the candidates are by instinct tied to the role of the state in development. Both would likely pursue a policy of big government and an activist industrial policy, which is likely to include the promotion of Brazilian “champions”in key industries, nurtured in the hope that they will become global players. This has been a pet project of outgoing president Luiz Inácio Lula da Silva and it is probable that the policy would be more actively pursued by Rousseff than by Serra.

Financing mix The activist stance of both candidates will probably be good news for the country’s powerful national development bank (BNDES), which lent more money than the World Bank last year and received a R$100bn loan from the government to beef-up operations.

As the recession wanes, the bank may lose some of its enormous clout but it will still be a very significant part of the financing mix for Brazilian companies under either presidential candidate.

Another institution that is likely to benefit is the ministry of planning, budget and management. The ministry will be strengthened and enter new

Outgoing president Luiz Inácio Lula da Silva.

Photograph by Ed Ferreira for the Agencia Estado in Brazil, for AP Images. This image was provided to Berlinguer by Associated Press Images, February 2010.

areas, says Cortez. The statist thrust of industrial policy is likely to mean privatisation plans take a back seat, says David Fleischer, professor of political science at the University of Brasilia, and a political consultant at consultancy Brazil Focus. Discussions over the privatisation of electricity giant Eletrobras and the sale of more of Petrobras to the private sector are likely to be off the table, he believes. Serra did attempt to sell São Paulo’s state energy body, CESP, but backed off when no willing investors were found and seems to have little genuine appetite for selling crown jewels.

If the perceived role of the state under both has similar stripes, divergences are likely to appear in how fiscal and monetary policy is undertaken. Rousseff is widely seen as continuing Lula’s policies which is likely to mean a relaxed fiscal stance, predicts Fleischer. Under Lula, current spending of the government has grown substantially thanks to a combination of hires, increases in wages for federal employees and inflation-busting increases in the minimum wage.

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Cunha agrees that Rousseff would likely continue with the PT’s lax policies, which have involved using loopholes and accounting tricks to disguise the impact of spending on government finances. Last year, for example, the BNDES received a R$100bn loan from the government, which does not count as part of the country’s net debt. This sleight-of-hand keeps the most commonly looked at debt-to-GDP ratios down.

Meanwhile, Serra has built a reputation in his current position as governor of São Paulo state, the country’s most populous and wealthiest, as a fiscal hawk and parsimonious in hiring.This has allowed him to boost the state’s investment budget and leads analysts to believe he will be more fiscally cautious.

Even these differences in the area of fiscal policy may be less than thought, speculate some analysts. Recently, Rousseff has appointed Antonio Palocci to head her campaign. He was Lula’s first minister of finance and steered Brazil through the turbulent waters of the 2002 post-election period with surprisingly tough fiscal policies before losing his job in the 2005 Mensalão payment-for-votes scandal. His appointment could mean Rousseff will prove tougher on fiscal policy than expected, says Cortez.

On the flip side, Rousseff may prove to be tougher in monetary policy and maintaining a hands-off attitude to the country’s central bank, as Lula has done.

Serra, who is seen as being in hock to the São Paulo industrial base, has been a fierce critic of the central bank’s tight monetary policy, believing it to be a cause of the high valuation of the real, which is seen by many industrialists as stifling Brazilian competitiveness.

The impact of elections is likely to be muted in the long term as the main planks of both candidates are similar.

However, in the short term, the elections could cause spikes in volatility,

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especially if candidates present more populist ideas on the campaign trail.

Cortez thinks that Brazil country risk could spike up to 300 basis points on an EMBI basis and might even reach 420 points with the dollar gaining to a maximum of 2.06. He sees inflation subdued at 4.2%, comfortably inside the official target rate of 4.5%, and growth at 5.2%.

For capital markets, the effects are also likely to lead to some wobbles this year, although most investment banks still see upside for the Bovespa. Citigroup and HSBC Asset Management have an 80,000 target for the Bovespa index and Goldman and Itaú BBA have 85,000 with the index closing at the end of play on January 29th at 65401. Many are more concerned by external events.

Global uncertainties and commodity price weakness stemming from the decision by Chinese authorities to put a brake on growth through tighter credit and higher banking reserve requirements contributed to a terrible first month of the year. In January, the Bovespa index fell 4.6% and the real tumbled 7.9% against the US dollar.

Consumer market Most investment bankers remain hopeful, however. There is still the warm glow of 2009’s excellent performance, when the Bovespa index leaped 148% in US dollar terms.

Moreover, a growing number of global and Asian funds are eyeing Brazil for its relatively strong economic growth and consumer market. For Latin American funds, the country has become pivotal.“Whenever we talk to anyone, they just want to talk about Brazil. It’s just Brazil, Brazil, Brazil,” says Nicolas Aguzin, chief executive officer, Latin America at JPMorgan.

These investors are scouring the market for domestic consumer stories as the theme of an emergent middle class comes to dominate thinking on

FTSE GLOBAL MARKETS • MARCH/APRIL 2010

Brazil. Higher salaries and easier access to credit are particularly helping the low-to-middle-income class C and D consumers up their spending.

The focus may be on those sectors, but the wider market should benefit, partly as there are so few consumer plays to be had. Commodity stocks still represent some 40% of the total index and retail names just 4%, although the retail sector accounts for 13% of GDP. That is seeing banks emerge as proxies for the consumer story, for example.

For some investors, however, there are questions about current valuations.

There is less room for capital gains than there were in the past. Pedro Bastos, chief executive officer at HSBC Asset Management, thinks that the fast growth in earnings will quickly reduce multiples to more reasonable levels. His own estimate is for an increase of earnings of 28% this year.“History does not reflect what this country is about to experience in terms of growth and formation of the middle class,”he says.

Others, however, are tapping on the brakes. Markets such as Mexico are looking more attractive, not because economic growth will be as high as Brazil, but because Mexico is now deeply discounted and a seemingly-fast US recovery should help the country.

It’s not just Brazil’s elections that are worrying the market. Economic growth is likely to put pressure back on interest rates, which are likely to trend up this year with the market predicting a 200 to 300 basis point increase, from current levels of 8.75%.

That may not be enough to completely rattle the stock market and cause an exodus into fixed-income markets. After all, Brazil has gone through periods of much higher rates. It may, however, give food for thought to investors interested in buying consumer stocks and real estate companies, where mortgages are just starting to become more popular.

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Real Estate GULF REAL ESTATE: A NEW PATCHWORK

After the Storm Dubai’s eventual admission that its real estate boom had run out of cash forced an embarrassing bail-out late last year by neighbour Abu Dhabi. However, despite the fact that Dubai is far from a bellwether of the robustness of the Gulf’s property market, in a part of the world that suffers from generalisations there is a danger that the emirate’s high-profile problems could impact the entire Gulf region, warns Mark Faithfull.

UBAI HAS REFUSED to go down without a fight. The crown prince told investors a few days before the debt revelation last November that Dubai’s economy was “humming along nicely” and the chairman of one of Dubai’s biggest property developers claimed that the emirate would still enjoy a growth rate of 5% this year. On November 25th however, an announcement painting a decidedly different picture rocked world markets as Dubai World, the emirate’s port operator, requested a sixmonth debt moratorium and sparked global fears of a Dubai debt default.

Five days later Dubai World pledged to restructure ten firms in the group, crucially including construction and development arm Nakheel, and to renegotiate a little under half of its $59bn debts. Neighbour Abu Dhabi then agreed an 11th-hour $10bn deal to meet debt obligations, enabling Nakheel to honour a $4.1bn Islamic bond that fell due that week.

While Dubai World seeks to reorganise its businesses—and to deny claims spawning from an aerial photo of its iconic The World islands scheme that the project is sinking (physically rather than metaphorically), opinion on prospects for 2010 differ markedly, with local media and analysts generally far more positive than their international counterparts.

EFG-Hermes, the

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regional investment bank, says in its 2010 UAE Yearbook, published in January: “The total debt held by Dubai Inc could well be in the range of $130 to $170bn”, based on $96.6bn of capital market debt, including bonds and syndicated loans, plus upside risk.

As well as the uncertainty surrounding Dubai World, the standstill could also affect other listed developers such as Emaar Properties, the UAE’s largest, Union Properties and Deyaar Development. “Should they effectively default, it could become one of the biggest sovereign defaults since the Argentinean crisis,” says Marina Akopian, partner at London-based emerging markets fund specialist HEXAM Capital.

However, while Dubai attracts headlines for the spectacular collapse of its real estate-driven economy, the situation around the Gulf nations is far from homogenous. Qatar and Saudi Arabia, both rich in natural resources, have, or are expected to introduce, further fiscal stimulus packages and have the depth of resources and latent demand to increase property investment.

Bahrain, rocked by the banking crisis as it is heavily financial services dependent, has been less hit by the real estate downturn, but major infrastructure investment to link it with neighbour Qatar looks set to

provide longer-term economic stimulus. Closer to the heart of the crisis, however, Dubai’s neighbour Downtown Dubai. Photograph (c) Browny.hu/Dreamstime.com, supplied February 2010.

and benefactor Abu Dhabi has been more deeply impacted by the recession. Despite bailing out Dubai to the tune of $10bn and with substantial energy reserves to its name, 2010 looks likely to be a difficult year for the emirate.

For now, however, the international focus remains on Dubai. Even there, the picture is more complex than it at first appears. For tenants, the Dubai office market is becoming increasingly favourable as it is witnessing a significant demand-supply mismatch along with falling rentals and increased vacancies, says agent Jones Lang LaSalle. While demand levels are increasing, as both existing and new tenants seek to consolidate and take advantage of the availability of better quality space on more competitive terms, there is not likely to be enough demand to meet the high level of new supply entering the market this year, says JLL. Average vacancies across the city are therefore likely to increase from their current level of around 33%

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during 2010. One reason is that much of this space is contained in non-core locations that international and regional tenants will not consider, which is leading to a two-tier market.

“The headlines do not necessarily tell the full story,” says CBRE managing director for the Middle East, Nicholas Maclean. “By our estimates, 90% of international corporations coming into the Middle East are still looking to set up in Dubai as a base for their regional activities. Ironically, there is a lack of grade-A, single-ownership office space available. That’s attracting investors interested in buying distressed developments and completing and marketing them to the international community.”

Rental adjustments have been more modest in the Dubai retail market.

Average rentals have declined by around 29% from the fourth quarter of 2008 to the same period in 2009 on the back of a 15% to 20% decline in retail sales in 2009. Blair Hagkull, managing director of JLL MENA region, says:“In spite of the cutback in future supply levels we expect to see an increase in shorter leases, break clauses and rentfree periods as we go through this tectonic shift in the market. We are also seeing the emergence of a two-tier retail market as occupancy rates in super regional and regional malls remain above 90% as opposed to older shopping centres.”

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Maclean stresses that transparency—an issue before the crisis—has become even more important. “Direct international investment in Dubai and the GCC is quite small both in actual and proportional terms, yet it is clear that both global international investment and real estate’s weighting within that will increase over the next decade,”he says. “However, transparency is essential. It’s up to the GCC to remove any barriers to that investment; otherwise it will pass us by.”

Nearby, last year was also tough for Abu Dhabi’s real estate sector which felt the impact of the global financial crisis, although the residential market is showing signs of stabilising, says the latest report from CBRE. At the end of 2009 the market continued to experience declining rental rates, albeit at a slower rate than in the previous four quarters. More affordable rental rates and better quality alternatives in Dubai were among the key factors influencing weaker residential demand, the agent says.

A substantial portion of planned residential stock was temporarily put on hold with delays at Ream Island, specifically Marina Square, Sun Tower and Sky Tower, and Al Raha Beach. In the office market, prime rents continued to slide and are down 45% from peak prices achieved in 2008.

Despite the comparatively low rents,

finding tenants remains a challenge for both owners and agents, CBRE says. Increased availability is providing end users with more choice and improved bargaining power.

Overall demand remains weighted towards smaller office units. While vacancy rates for office accommodation during the third quarter of 2009 remained low at around 2%, the impact of new upcoming stock and weaker demand for office accommodation could see this rate increase during the course of 2010. “Abu Dhabi is too far behind Dubai to be a serious competitor at the moment and with the pipeline schedule I can’t see that changing until the end of next year,” says CBRE’s Nicholas Maclean.

Energy wealth helps Qatar’s energy wealth has enabled it to spend its way out of the global downturn and the government has hinted that it may move to prop up real estate operators after bailing out its banks. Qatar’s economy is expected to grow 16% thanks to new energy projects and its status as the world’s biggest producer of liquefied natural gas.

The government’s help for banks in 2009 included taking $3.96bn in real estate loans off their books to spur more lending. However, more direct help for real estate firms may be needed.

With so many projects nearing completion in Doha, Qatar’s booming

KUWAIT: REAL ESTATE SALES INCREASE UWAITI REAL ESTATE sales rose 41% in the year to November, on high sales of residential and commercial property. Sales rose to $672.6m, with residential property deals the biggest portion of total real estate transactions, up 36%.

Kuwait’s parliament has approved a $104.3bn, fouryear development plan aimed at decreasing the Gulf Arab state’s dependence on oil, and boosting private sector participation in projects. The plan, which runs to

K

FTSE GLOBAL MARKETS • MARCH/APRIL 2010

2014, also includes investment on raising oil and natural gas production. The package is also designed to attract more investment into Kuwait.

The residential segment in Kuwait is expected to pick up as it continues to witness supply shortages.

The latest legal amendments and permission for construction in new areas should increase activity in the market. Moreover, extended credit for the segment is expected to pick up in the medium term.

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capital, prices are set to fall further after an already steep decline last year.

House prices, off some 30%, are expected to drop a further 15% in 2010, investment bank The First Investor Asset Management predicts.

George Nasra, managing director of the International Bank of Qatar, says: “There is already oversupply in real estate, particularly in office buildings, but we are starting to see it in residential buildings as well.” Patrick Rahal, senior analyst, asset management, at The First Investor, comments:“The government is already an equity investor through Qatari Diar, the property arm of Qatar’s sovereign wealth fund.”

Qatari Diar is a major shareholder in several listed real estate firms and will own at least 45% of new Barwa group,

formed after Barwa Real Estate’s planned takeover of Qatar Real Estate Investments, which is widely regarded as an implicit signal of the government’s support for the real estate market. JLL MENA’s Hagkull says: “The role the government plays here is really important. The government can play a larger role in the roll-out than in Dubai.”

World’s longest causeway Construction on the world’s longest causeway, which will link Qatar with Bahrain, is expected to start before the middle of this year after spending a decade in planning. The 40km road and rail crossing first unveiled in 1999 will eventually connect to the planned GCC rail network.

SAUDI ARABIA: INVESTMENT ON THE RISE NVESTMENT IN SAUDI Arabia’s real estate market is likely to top $129bn in the next three years, according to the head of the kingdom’s chambers of commerce, Fahad Al Sultan, secretary general of the Council of Saudi Chambers. He cites the real estate sector as the kingdom’s most important after oil. Real estate GDP rose by 50% from 1999 to 2008, with an average annual growth of 5%.

Forecasters expect construction sector growth to average 5%-6% this year, with Riyad Bank predicting spending in construction projects at $195bn for 2009 and $90bn this year. A new mortgage law is expected to give a further boost to the country’s residential sector.

Government spending continues to drive construction, with the building and expansion of ambitious economic cities as the centrepiece of the infrastructure programme. The cities will aim to utilise the kingdom’s comparative advantage in low-cost fuel to develop the petrochemicals, aluminium, steel and fertiliser sectors, which will in turn generate spin-off service industries.

Saudi Arabia is also on a charm offensive to encourage inward investment and Western business; although cultural challenges mean that many

The crossing, which will cut the trip between Bahrain and Qatar from five hours to 30 minutes, is expected to strengthen trade ties and lift economic expansion and, adds agency CBRE, will give Bahrain’s real estate economy a huge boost.

The Qatar Bahrain Causeway Foundation, set up to oversee and fund the project, hopes to save 20% on construction costs as it renegotiates a price with the contractors building the crossing.

Office rents in Bahrain declined by around 20% last year, according to CBRE. The fall steepened during the summer months and Ramadan, and enquiries declined significantly between the third and the first quarter, the real estate consultancy adds.

Downtown Riyadh. Photograph (c) Mstreckiw/Dreamstime.com, supplied February 2010.

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companies continue to prefer to base their regional headquarters elsewhere.

Saudi Prince Al-Waleed bin Talal is planning to build a 1.1km tower to usurp Dubai’s Burj Khalifa as the world’s tallest building. US architect Skidmore, Owings and Merrill, which designed the Burj Khalifa, is hoping to secure the multi-billion-dollar contract on Kingdom Tower.

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Sector Report OIL PRICE AND SHARES STATIC FOR FIRST HALF

GOING NOWHERE, FAST Oil is likely to trade rangebound in the first half of 2010. Barring extreme weather or a war, the upside potential for oil will be limited. Various analysts’ predictions are very close to one another for the next six months, pegging oil at between $75 and $78 a barrel. The forecasts further out are better: prices are expected to rise to between $90 and $100 in 2011 and even higher in the years ahead, depending on the speed at which the global economy returns to its pre-crunch levels and continues to expand. In the meantime, base metals or agricultural goods may be a better bet. Vanya Dragomanovich reports.

HE NEXT SIX months may not be the time to invest in oil. Since October, prices for oil have been at their most stable in a long while, trading in a roughly $10 per barrel range rather than swinging wildly up and down as they did in the past year and a half.

Still, they have doubled from the levels where they were at the beginning of last year, which is more than the global economy can say for itself.

Commodities have traditionally been seen as a good proxy for the state of the world economy but all the financial engineering indulged in by the various central banks during the credit crunch created a disconnect, an over-inflating process for commodities. In major economies, the cost of money has been reduced to virtually zero, large sums of money have been pumped into the system, creating unrealistically high levels of liquidity and generating masses of unleveraged cash which is seeking returns.

In an environment in which volatility has come down, the dollar is weak and the cost of money is very low, commodities have attracted fresh inflows from investors across the board, according to Harry Tchilinguirian, head of research in London for BNP Paribas. “There is a

T

Photograph (c) Leoblanchette/ Dreamstime.com, supplied February 2010.

lot of unleveraged cash looking for yield”, and that money is being channelled into commodities, he says.

A rush to the long side Anecdotal evidence of a rush to the long side of the oil market has been confirmed by the Commodities Futures Trading Commission’s (CFTC’s) data, showing that long positions by noncommercial holders—market participants who are not involved in oil production—have risen to the fourthhighest level on record. Net exposure in both heating oil and gasoline is also at a record high. The high liquidity bonanza will slowly peter out during this year as central banks start tightening supply and raising interest rates to counter inflationary pressures.

In January, China decided to raise the proportion of deposits that banks must set aside as reserves to curb some of the excessive lending that happened in 2009. Banks there lent a record $1.3trn in the first 11 months of 2009. In the US, the members of the Federal Reserve’s rate setting committee have spoken out against leaving rates too low for too long.

This does not need to translate into a plunge in commodities prices but it will mean that, barring extreme weather or a war, the upside potential for oil will

FTSE GLOBAL MARKETS • MARCH/APRIL 2010

be limited.Various analysts’ predictions are very close to one another for the next six months, pegging oil at between $75 and $78 a barrel.“Despite the strong technicals, the weaker dollar, renewed fund interest on the long side and colder weather in the US, energy’s underlying fundamentals remain weak,” says Edward Meir, senior commodity analyst at oil trading firm MF Global.

The forecasts further out are better: prices are expected to rise to between $90 and $100 in 2011 and even higher in the years ahead, depending on the speed at which the global economy returns to its pre-crunch levels and continues to expand. However, the recovery in Western economies continues two steps forward, one step back. What analysts describe as soft sentiment data such as business

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Sector Report OIL PRICE AND SHARES STATIC FOR FIRST HALF

confidence, consumer and investor confidence have been steadily improving over the past few months although hard economic data such as manufacturing figures has yet to provide proof of a significant turnaround.

Unemployment in the US remains at around 10% and analysts say that the actual figure is more likely around 17%.

Retail sales in Europe were below expectations in November, so were German new manufacturing orders, a key indicator. In Japan, the third-largest oil market in the world, the industrial recovery continues at a faster pace then elsewhere but some sectors such as construction are slow to catch up.

China remains one of a few bright lights with its economy growing 8.9% in the third quarter of 2009 from a year earlier, the fastest pace in a year.

Growth forecasts According to a report by Bank of America Merrill Lynch: “Leading indicators suggest that global economy will continue to improve, but this is not yet fully reflected across the board in power generation, travel or manufacturing data.

Likewise, evidence of a turnaround in oil demand data is patchy at best. Demand growth has moved into positive territory for many petroleum products, but the positive year-on-year comparison is mostly supported by the collapse in demand experienced in the fourth quarter of 2008.”

The bank adds, however, that the real economic data, which has lagged so far, could now be close to an inflection point: “There are signs that the manufacturing sector—the sector hit hardest during the crisis—is emerging from recession in the United States and Europe. The progress is particularly impressive in the US where the manufacturing sector seems to be undergoing a pretty robust recovery led by a turnaround in durable goods spending.”

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The UA Energy Information Administration expects the US economy to grow about 2% this year and close to 2.7% in 2011, which could translate into an increase in demand of about 200,000 barrels per day, far below the 400,000bpd growth seen in the past. BNP Paribas’ Tchilinguirian says that 95% of demand growth for oil this year will come from emerging economies, China in particular. The latest Chinese trade data showed the country in December imported more than 5m barrels a day of crude oil, a record high, while overall exports turned upward after 13 months of declines. Higher exports could mean a stronger yuan, which would make oil cheaper in the local currency and encourage more buying.

According to the International Energy Agency, China’s oil demand at the end of 2009 was estimated at an average of 8.3m barrels a day, or 5.7% more than in 2008. The agency had adjusted its forecasts slightly upwards recently but added that question marks over China’s economic stimulus programme meant the outlook for next year was highly uncertain.

On the supply side, producing countries are pumping oil out at a regular rate, land-bound inventories are high and there is sufficient of both crude oil and oil products floating around in tankers in various ports around the world. OPEC has pledged that it would remove a total of 4.2m barrels of oil per day to stop the decline in prices last year but while cartel members initially complied with its decision, the compliance rate has slipped to 59% in recent months. In January, the cartel said it was comfortable with current price levels and that it had no intention of changing output. On top of that, however, non-OPEC countries, notably Russia and Brazil, have been pumping more and more oil, Some

genuine additional demand for oil was created around the turn of the year as a cold spell gripped Europe, North America and parts of Asia. “From an oil market perspective, the cold weather could not have come at a better time.

Despite the bearish US stock build in early January, largely driven by holiday factors, the cold snap could result in large inventory draws going forward,” says Francisco Blanch, commodity strategist at Bank of America Merrill Lynch. The cold weather reduced inventories for heating oil and other crude oil distillates.

From a trading perspective oil prices typically slide by the end of March when the weather gets warmer and refineries start shutting down for a brief period of maintenance works.

“Stripping out the temporary demand impact of the colder weather and the supportive influence of the wobbly dollar, which seems to have lost its mid-December thrust of late, energy’s supply demand balances look very comfortable,”says MF Global’s Meir.

Unpredictable weather The weather will remain one of the unpredictables for oil. There was no significant hurricane season in the US in 2009, which meant that some of the production that would have typically been lost because the extreme weather would have forced refiners in the southern part of the States to close down has instead remained on the table.

November was particularly mild, again causing stocks to build up. The arctic spell in December and January changed that but all bets are off on what the weather will do for the rest of the year.

The second unpredictable is geopolitics, with tensions surrounding Iran andYemen being the biggest factors to watch. Forecasters say that even if there is a disruption of supplies from Iran there are some other countries getting ready to step into the vacuum.

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7 Asian

th Annual PASLA/RMA

Conference on

Securities Lending

2-4 March 2010

| JW Marriott Hotel Hong Kong

Co-sponsored by the Pan Asia Securities Lending Association (H.K.) and the Risk Management Association (USA), the first industry-wide co-sponsored conference in Asia developed by securities lending and borrowing professionals for securities lending and borrowing professionals.

PASLA and RMA are pleased to announce Dr. Marc Faber as this year’s Conference keynote speaker. Dr. Faber publishes a widely read monthly investment newsletter “The Gloom Boom & Doom Report” that highlights unusual investment opportunities; and he is the author of several books including Tomorrow’s Gold - Asia’s Age of Discover

The business program will include an Introductory Securities Lending Tutorial and panel discussion on: t Issues with Tri-party Arrangements Panel t Global/Developed Market Update: Australia, Japan, Hong Kong and South Korea t The growing importance of ETF’s t Emerging Market Update: China, India, Malaysia, Taiwan

Conference Co-Chairs Larry Komo PASLA Chairman & Conference Co-chair Citi Singapore Mark Payson Conference Co-Chair Brown Brothers Harriman & Co Boston, MA

Interested in Event Sponsorship: Email Loretta Spingler at lspingler@rmahq.org

For more information about the conference or to register visit the RMA Website at www.rmahq.org/RMA/SecuritiesLending/ or email Kimberly Gordon at KGordon@rmahq.org

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According to London-based securities lending analyst Data Explorers’ 2009-10 Securities Lending Yearbook, the second and third quarters of 2009 saw a return of funds flow into Asian equities, closely followed by lenders. Data Explorers says that between January and December 2009, Asian lendable balances rose by 40% from over $500bn to approximately $700bn by the end of the year; though the total was still 30% below the lendable balance in December 2007. The last two quarters of 2009 showed signs of an uptick, not only in terms of volumes, but also in terms of investment by securities lending houses, both in terms of new product and expanding business reach. What will it all mean for business levels in the Asian market in 2010?

A GRADUAL RETURN Photograph © Rolf Images/Dreamstime.com, supplied February 2010.

ISELLE AWAD, SENIOR vice president, eSecLending, based in Sydney, has witnessed a discernible uptick in confidence and securities lending business volumes in the Asian region through 2009. Awad has noted “a number of beneficial owners reentered the market in 2009 after having temporarily suspended programs following the Lehman default. In addition, the lifting of short sale bans, improved liquidity, declines in volatility and the rally in world equity markets have contributed the improvement. “ As for eSecLending itself, the nature of the game was particularly specialised, given that the bulk of the $200bn in assets auctioned globally last year was allocated to agency exclusives, with the balance transacted on a more traditional agency basis.

While the market rejoices in a renewed lending volume as last year closed, the outlook for 2010 is positive, notes Awad, given that eSecLending was appointed lending agent for funds new to lending and also on behalf of funds looking to diversify providers and/or utilize different routes to market.

Scotia Bank notably expanded its securities lending capability through the hiring of a specialist team from Wells Fargo to beef up its Asian operations in September of 2009.

Elsewhere, JPMorgan Worldwide Securities Services expanded its securities lending capabilities in the region to take in Taiwan in late November of last year. In the Asia

G

Pacific zone, JPMorgan offers securities lending services in Australia, Hong Kong, Japan, New Zealand, Singapore, South Korea, Taiwan and the Philippines, “some fourteen markets now,”notes Andrew Cheng, executive director and head of clients sales management for JPMorgan’s securities lending business in Asia ex-Japan ,“with the possibility of others coming on stream as well.”

Elsewhere, Clearstream opened a new branch in Singapore, run by Robert Tabet, previously head of Clearstream’s Dubai office in October last year. According to Philippe Metoudi, head of Clearstream for the AsiaPacific region, Clearstream’s automated securities lending and borrowing services (ASL), and ASL-plus, where Clearstream is the principal borrower and lending and the firm’s case by case lending operations, remain cornerstones of its Asia-Pacific business growth strategy. “Over the last five years,” acknowledges Metoudi, “overall the Asian region has grown in significance for Clearstream per se, now accounting for almost 20% of its business lines. In the context of securities lending, there are many more conversations around global securities financing, and we find an increasing sophistication among our Asian clients.”

Those clients are perforce broker/dealers and central banks. “The pick-up of late has been immense notes Metoudi, with “70% of ASL-plus business located in the Asia-Pacific region.”ASL lies at the heart of Clearstream’s

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We focus on maximizing intrinsic returns in accordance with each clientâ&#x20AC;&#x2122;s specific risk tolerances. Having built the program to incorporate investment practices such as the use of specialists, multiple-managers, unbundling, price transparency and competition, our approach enables best execution and also provides clients with greater control over their programs, allowing them to more effectively monitor and mitigate risks and counterparty relationships. eSecLending provides services only to institutional investors and other persons who have professional investment experience. Neither the services offered by eSecLending nor this advertisement are directed at persons not possessing such experience. Securities Finance Trust Company, an eSecLending company, and/or eSecLending (Europe) Ltd., authorised and regulated by the Financial Services Authority, performs all regulated business activities. Past performance is no guarantee of future results. Our services may not be suitable for all lenders.

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settlement engine and acts as lender of last resort, explains Metoudi, preventing failures and enhancing the settlement efficiency through automated loans. “With just one contract, borrowers gain access to a large pool of undisclosed lenders, speeding the reception of the proceeds from counterparties. Once the securities are on the account, the loan closes. The ASL Guarantee reduces the counterparty risk for lenders. Lenders can advise Clearstream of the positions available for lending via the lender download facility. This is of particular use to lenders with mixed assets,”he says.

Risk management is fundamental to today’s business, concedes JP Morgan’s Cheng.“Our approach is to give our clients access to risk-adjusted returns. This has always been a focus for us, and it has become a priority for clients.”The bank, he says, works closely with clients to reduce as far as possible, the interest rate and credit risk from reinvestment of cash collateral.“What we find in Asia is that Asian asset managers and institutional investors are looking at reducing the risk that they take in a lending programme,” highlights Cheng.“Those institutions in co-mingled funds, for instance, which used to take riskier investments, are long gone now. We are telling our clients that our focus is on helping them extract intrinsic value and that risks should be minimised.”

That likely involves running segregated cash collateral accounts: “JPMorgan operates with separately managed accounts, which is an unusual model. 100% of our customers in the region utilise them.” concedes Cheng.

Moreover, he adds,“lenders can adjust the guidelines very easily and we are in a position to react very quickly to changes.” Having the ability to control the eligibility of counterparties helps clients mitigate risk more efficiently, he adds, explaining that the bank also provides a robust indemnification programme against borrower defaults, supported by the bank’s strong balance sheet”. Cheng sees agent lender indemnification (the protection agent lenders provide to beneficial owners against counterparty default) has real value in today’s market,”he says.

An increased requirement for transparency, the ability to control investment guidelines and a growing awareness of risk mitigation tools are cornerstones of today’s securities lending business, states Robert Lees, vice president, head of Securities Lending Trading in Asia for Brown Brothers Harriman (BBH). As regulators become more involved and clients become more demanding, the current requirements are increasingly challenging. Lees highlights that, “The appropriate mix of revenue generation, understanding the underlying client strategy and maximising opportunities in the market against a risk-averse backdrop, has never been more important.” He adds that achieving the right mix has been the focus of BBH’s program since its inception.’

Changing requirements mean the market must constantly adapt to meet market developments and that encourages further product development. Among the prime movers in this space, in early February EquiLend announced that it intended to expand its services in the

Pertamina Towers, Kuala Lumpur. The Malaysian Securities Commission and Bursa Malaysia spurred SBL based securities lending in the autumn of 2009. Photograph © Szefei/Dreamstime.com, supplied February 2010.

securities lending marketplace by including the ability to borrow and lend ETFs via Trade2O, a service that facilitates the interactive trading of non-GC securities, specials as well as a host of other security types. The initiative “continues to emphasize the flexibility of the platform and highlights its instrument agnostic feature’ says Sharon Walker, managing director at Equilend. The move speaks to a variable trend in the region (in fact across the globe) for lending and borrowing ETFs. It is a sign of the times.

According to eSecLending’s Awad, “there is certainly demand for ETFs in the Asian securities lending landscape, with levels fluctuating on a regular basis.“ While Asia remains a growth market, securities lending facilitators are under the cosh to keep up with new product.

Some have an immediate advantage: eSeclending, Clearstream and Equilend have clear niches. However, it is not always so easy these days in the global facilitator space.

Large houses such as JPMorgan offer their clients a broad array of services, including fund administration, collateral management and depositary receipts, among other services. However, these days not everyone is selling a combined package. Disintermediation is a key trend in Asia, as it is elsewhere. Lees agrees stating that BBH has seen great interest in its third party (non-custodial) lending services. According to eSecLending’s Awad, there is a distinct preference for best in class services. “At one time custodian lenders could bank on the fact that their clients regarded securities lending as an ancillary service to custody,” she notes. “Now institutions and funds are looking for best in breed providers and will mix and match their mandates accordingly; often separating custody, collateral management and securities lending. It is a different ball game entirely.”

It’s a view endorsed by JPMorgan’s Cheng. “What made sense in 2007 no longer makes sense today. For example, more lenders have brought cash collateral right into the front office; which forces service providers such as ourselves, to

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Photograph of Taipei. Taiwan has been more accommodating of securities lending of late. Phtoograph © Rademakerfotografie/Dreamstime.com, supplied February 2010.

become much more focused on liquidity and the maturity of collateral reinvestments. It has ratcheted up the business to a much more sophisticated level and brought us closer to the client in that there is much more discussion these days on the way that collateral is reinvested.”

That means constantly pushing the boundaries. In early February EquiLend announced that it will expand its services in the securities lending marketplace by including the ability to borrow and lend ETFs via Trade2O, a service that facilitates the interactive trading of non-GC securities, specials as well as a host of other security types. The initiative“continues to emphasize the flexibility of the platform and highlights its instrument agnostic feature’ says Sharon Walker, managing director at Equilend. The move speaks to a variable trend in the region (in fact across the globe) for lending and borrowing ETFs. According to eSecLending’s Awad, “ETFs come in and out of focus on a regular basis through the Asian securities lending landscape.”

As for JPMorgan’s view, Cheng says:“What made sense in 2007 no longer makes sense today. For example, more

`

eSecLending’s Awad remains buoyant: “The region has transitioned. The dramatic market events of 2008 caused many funds to seek more information about their securities lending programmes. What became apparent is that securities lending is an alpha generating activity and should be treated with the same level of due diligence as any other investment decision.

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lenders have brought cash collateral right into the front office; which forces some service providers to become much more focused on liquidity and the maturity of collateral reinvestments. It has ratcheted up the business to a much more sophisticated level and brought us closer to the client in that there is much more discussion these days on the way that collateral is reinvested.”

Perhaps because of the willingness of securities services providers to go the extra mile to leverage the business potential of Asia, the upward drive in the market as a whole has buoyed the gradual, yet sustained return of business levels. Equally, there is a growing drive

by Asian capital markets to encourage securities lending, or at least allow shorting of stock, in an effort to deepen the region’s capital and money markets. Right now, the Asian stock markets have been buffeted by volatility; perhaps not really surprising in this jittery, post recessionary period. eSecLending’s Awad remains buoyant: “The region has transitioned. The dramatic market events of 2008 caused many funds to seek more information about their securities lending programmes. What became apparent is that securities lending is an alpha generating activity and should be treated with the same level of due diligence as any other investment decision. As such, funds should have a comprehensive understanding of the risks and rewards inherent in their programs and feel confident about proper oversight and controls. In addition, there has been an increased amount of independent support for the practice of securities lending from both regulators and academics who view it as an effective mechanism for bringing liquidity and efficiency to the market. It is an important step and the evolution is positive for the industry.”

Clearstream’s Metoudi is equally upbeat about the region’s prospects. By nature the market is volatile in Asia, states Clearstream’s Metoudi. Nonetheless, despite temporary market volatility, “I have no doubt the overall trend is upward,”he states.

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A BIGGER PIE Two important developments have helped sustain the optimism in the Asian securities lending market. One: short selling restrictions introduced around the region through 2008 at the height of the global liquidity crisis, were gradually withdrawn as regulators have begun to appreciate the benefits of securities lending and short selling to the efficient operation of the capital and money markets; helping provide market liquidity and encouraging efficient price discovery. The lifting of short selling bans in Australia and South Korea were instrumental in this regard through 2009. Two: is the promise provided by new markets to securities lending, such as China and the Philippines.

N EARLY JANUARY this year, the China Securities Regulatory Commission (CSRC) announced a number of regulatory reforms, which included the news that it was ready to launch margin financing and securities lending on a trial basis. According to the CSRC statement, the regulator will soon select a first batch of securities companies to participate in the pilot scheme by considering their scale of net capital, compliance track record, net assets risk control indicators, and their readiness for conducting such business.

China’s move towards opening up to securities lending has been a long time in coming. As far back as 2008, the CSRC picked 11 top brokerages for test runs of the trading network, including CITIC Securities, Haitong Securities, Guotai Junan, Shenyin Wanguo and Everbright Securities. It was reported that the CSRC would pick six to seven domestic brokerages from the 11 candidates for the initial phase of a trial programme. However, the rapid onset of the global liquidity crisis, coupled with moves by key securities lending markets in the Asia-Pacific region, such as Australia, encouraged the Chinese authorities to postpone the efforts to open up to securities lending.

By late January, the regulator began to unveil regulations on the pilot programs for soon to be launched margin trading and short selling. According to a January 24th release, securities firms must have at least Yuan5bn in net assets and be rated as A-class in order to be qualified to enter the agency lending business. The regulator also requires securities firms to have sufficient capital holdings and stocks of their own and have completed test runs of the trading network in order to conduct securities lending. The regulator also asked qualified securities firms to choose clients wishing to access the securities lending market carefully, based on the review of their financial status, trading experience and risk preference.

The regulator is reportedly anxious to deter investors with a low tolerance to market risk, low levels of experience in the trading of securities, and which lack sufficient financial resources to become involved in the securities lending markets on a sustainable basis.The CSRC did not reveal what stocks would be the target for margin trading and short

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margin trading. However it hopes that the introduction of short selling will allow investors to borrow money to buy securities or borrow securities to sell. However, foreigninvested securities companies will unlikely be able to participate at this stage, think local law firms.

Also couched in the regulator’s original statement was a note that the State Council has approved the launch of stock index futures; with CSI300 futures stated as the first to be introduced. The regulator expected that the launch of the futures product should be completed in the next three months. During this period, the CSRC and the China Financial Futures Exchange (CFFE) will promulgate various implementing rules in respect of suitability of investors, account opening requirements. It is still not clear however whether a foreign invested enterprise (FIE) will be allowed to open an account with the CFFE. If an FIE can open an account with the CFFE, it may be possible for a foreign investor to trade stock index futures through its FIE. While the Asian equity markets have been volatile of late, it is likely that China will continue with its efforts to continue to deepen the operation of the capital and money markets.

Other markets in the region are looking now to emulate the success of South Korea, which used to have a restrictive regime in securities lending but has steadily opened up to increased stock lending activity. Taiwan recently liberalized its market, as has the Philippines, while India, which has had a lending market for some time, is trying to make it easier to operate in the market by simplifying regulations and tax treatment related to the exchange of ownership.

Malaysia has also made significant strides, having introduced an securities borrowing and lending (SBL) Negotiated Transaction (NT) model in October last year; a preference already established by the South Korean and Taiwanese markets. The Malaysian securities markets have been marked by a steady process of liberalisation, as the government aims to compete with the still stronger Singaporean market. The third quarter of last year encouraged the government’s efforts to establish a broader and deeper capital markets regime, particularly as equity markets appeared to rally generally around the world in the second half of last year, with most markets registering a 17% uptick, at least. Malaysia’s own capital markets broadly reflected this performance with the FTSE Bursa Malaysia KLCI Index gaining around 34% over the year.

The Malaysian Securities Commission, and Bursa Malaysia introduced the SBLNT, in September last year, an enhanced (SBL) model that offers an option to borrow and lend on an over-the-counter (OTC) basis. The Securities Commission released the revised SBL Guidelines while Bursa Malaysia issued the relevant rules, procedures and guidelines. Under the framework, lender and borrower can enter into SBL agreements, but any transactions must be reported via onshore borrowing and lending representatives and facilitated through Bursa Malaysia Securities Clearing as the approved clearing house.

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THE 2010 ASIAN SECURITIES SERVICES ROUNDTABLE:

LEVERAGING OPPORTUNITY IN HIGH GROWTH MARKETS

Attendees

Supported by:

Left to right

SOON KIAN LEE – principal, head of ASEAN investing consulting business, Mercer WILLIAM (BILL) ROSENSWEIG – managing director, investor services and markets, Brown Brothers Harriman (HK) Ltd

ELIZABETH CHIA – head of global custody solutions, Asia-Pacific, BNP Paribas Securities Services

ALASTAIR POW – director, global head of product, fund services, transaction banking, Standard Chartered Bank DR AU KING-LUN – chief executive officer, FRM Hong Kong Ltd

COLIN LUNN – head of business development, Asia-Pacific Fund Services, HSBC Securities Services CHOU YOON CHONG – investment director, Aberdeen Asset Management Asia Ltd

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THE 2010 ASIAN SECURITIES SERVICES ROUNDTABLE

FACTORS INFLUENCING THE 2010 BUSINESS OUTLOOK SOON KIAN LEE, PRINCIPAL, HEAD OF ASEAN INVESTMENT CONSULTING BUSINESS, MERCER: The last

18 months have been a huge wake up call for all participants in the global capital markets. Asset managers have been under pressure for failing to produce the expected alpha throughout this period. Despite this failure, they are still earning quite“good”fee income. Institutional investors, our primary client base, are examining asset managers’ alpha generation capabilities more closely now.

They are prepared to terminate these managers and to engage those, who have been able to add value.

Alternatively, we have also seen some clients seeking pure beta play, i.e., seeking passive mandates to avoid paying active fee with negative value add. On the regulatory side, in Singapore as well as in Hong Kong, regulators are still dealing with the fallout of the failure of some of the more complex structured products. We expect some new regulations beside those introduced recently to further tighten the selling process to safeguard retail investors. In general, we noted that asset owners have become more conservative in their investment approaches. They prefer to adopt a more prudent approach to strategic asset allocation, giving due regard to their liability stream, as they review their investment programme. De-risking seems to be an emerging trend among more conservative investors and those with shorter time horizon, i.e., less than seven years. In this regard, we do expect more inflows into defensive assets and a correspondent outflow from growth assets in the short to possibly medium term.

ELIZABETH CHIA, HEAD OF GLOBAL CUSTODY SOLUTIONS, ASIA-PACIFIC, BNP PARIBAS SECURITIES SERVICES: Outsourcing is one area that clients are

considering. It has been under way as a trend for some time, with questions as to why they should outsource and what and how much they should outsource. Equally, post the financial crisis, there is heightened awareness of the need to consolidate data collation. As data is consolidated in one house, it allows the client greater control of their overall asset portfolio and simultaneously allows them to supplement their compliance monitoring and improve their risk management, irrespective of where that fund manager is located: in Hong Kong, Japan, Australia, Thailand and Singapore. In addition, it encourages more informed decisions about investment and financial actions.

Moreover, clients are requesting a wider range of services as they focus on new fund launches in both global and local jurisdiction. It is no longer just about providing global or master custody; these days, clients require local expertise to deliver a full suite of services to also support local funds set-up. Therefore, providers like ourselves are challenged to provide a diverse range of both global and local solutions.

ALASTAIR POW, DIRECTOR, GLOBAL HEAD OF PRODUCT, FUND SERVICES, TRANSACTION BANKING, STANDARD CHARTERED BANK: Obviously, trust and

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ELIZABETH CHIA, head of global custody solutions, Asia-Pacific, BNP Paribas Securities Services

confidence is something that has impacted our industry.

Banks in particular have come in for some fairly hard knocks. Investors lost some confidence and trust in their fund managers, in terms of performance, transparency and so forth. That trust and confidence factor has taken a bit of a rollercoaster ride; it has plummeted to fairly severe depths but come back to an extent on the back of a postcrisis rally. Businesses have become more conservative during the last 18 months in terms of their willingness to fund new initiatives. Market share is an issue because it is relevant to how firms expect to grow in the near term.

Profitability is an issue facing many organisations. As a service provider, a lot of our profit is driven by volumes, which fell fairly significantly through the recession, with market volatility sometimes offering temporary uplifts.

Everyone now has to look at generating more value for clients with less resource. Concentration and counterparty exposure are also hot topics. Within banking/financial services, businesses are concerned about their concentration with counterparties so they will monitor this more systematically at an enterprise level. The buyside is also looking at the concentration they have with certain service providers. For example, global asset managers typically bought custody coverage from one or more global custodians. What is becoming more prevalent is procurement of this coverage via separate regional relationships. It has the added benefit of partially addressing the buyside’s current cost imperative.

COLIN LUNN: HEAD OF BUSINESS DEVELOPMENT, ASIA-PACIFIC FUND SERVICES, HSBC SECURITIES SERVICES: Expanding on the point about profitability,

there are various factors that are increasing our costs. We are seeing increasing levels of self-regulation. This means more due diligence for us and investors. There is much more transparency demanded of us and managers are

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therefore demanding more enhanced and frequent reporting for their investors. Additionally, as managers are increasing the number of counterparties they transact with, it has multiplied and intensified requirements in areas such as reconciliations. Obviously you can automate to an extent, but even then volumes have increased substantially, which in turn means we have to continually invest in our technology offering. We also need to throw the risk factor into the equation, particularly as service providers. Are we effectively pricing the risk in our business correctly? It has particular relevance, given our role as a fiduciary in most markets in Asia. It is a big question, particularly in this business environment. It is imperative that we keep on top of automation; focus on the outsourced business that more managers are keen to give us, and ensure that our compliance procedures are top-notch and are inline with the regulation that is continually coming through. It is complex and demanding but necessary to provide comfort to clients and regulators.

WILLIAM (BILL) ROSENSWEIG, MANAGING DIRECTOR, INVESTOR SERVICES, BROWN BROTHERS HARRIMAN (HK) LTD: The industry has definitely been shaken up in the

past 18 months. This creates both opportunities and challenges for existing business models that up until now may have been on autopilot. Prior to the crisis, the core business of Global Custodians of safekeeping client assets had become increasingly commoditised and therefore less valued. However, in the post-Madoff, post-Lehman world, institutional investors are probing into the safekeeping arrangements, which they had taken for granted previously.

Clients now ask: are our assets segregated from the service provider or prime brokers? Are they segregated from the assets of other clients? What would happen in a default scenario? Prior to the crisis some institutions had been advertising “custody for free” when actually, it wasn’t custody at all as assets were frequently on the balance sheet of prime brokers and re-hypothecated. We found that quite frustrating at the time; but then as problems such as Madoff came out, clients suddenly wanted to verify where their assets were and were suddenly appreciative of the concept of old-fashioned asset safe-keeping. So in many ways we see a “back to basics” dynamic as investors have de-risked and deleveraged. As for asset management product trends, we see a lot of asset managers shifting to or adding passive ETFs and index-type products. Although this creates a new opportunity, it unfortunately is an indication that the investing community is losing confidence in the ability of active managers to really add value. We also see many global fund managers looking to Asia as a distribution area given its relatively high growth rates and that’s bringing in business as global fund managers define and implement their distribution strategies.

DR AU KING-LUN, CHIEF EXECUTIVE OFFICER, FRM HONG KONG LTD: FRM is a global fund of hedge funds

group. As you all know the hedge fund industry went through a near-death experience in Asia in 2009. There was the combination of losses, the Madoff incident, and the

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sudden withdrawal of liquidity during the credit crisis, which caused many hedge funds to suspend or gate their funds. Not surprisingly, this has led clients to focus very much on due diligence, transparency, liquidity and best practices, and this has an impact on how hedge fund managers manage assets. For service providers, these trends favour them. For example, in the past some hedge fund managers preferred to have administration in-house, particularly because not all their assets were listed and some of the illiquid positions were priced to models. Now, investors increasingly demand independent administrators. As another example, from the manager side, they are concerned about counterparty risks and so they are diversifying those relationships, for example, by appointing a number of prime brokers rather than just one.

THE CHANGING DYNAMIC BETWEEN THE BUYSIDE AND THE SELLSIDE CHOU YOON CHONG, INVESTMENT DIRECTOR, ABERDEEN ASSET MANAGEMENT ASIA LTD: We are

traditional long-only fund managers. Over the past two decades we’ve been through a substantial process of reformation and seen one or more financial crises.Therefore, a crisis of the magnitude of the last 12 to 18 months has not held too many surprises; perhaps a sense of déjà vu instead.

However, there is a lot of soul searching under way over the complexity of some investment products, particularly over cross-hedging products and complex derivatives. Going far deeper than that, there have been important questions as to the concept of alpha portability, alpha generation, and all the complex stuff that was popular in the mid 2000s. While it all started to unravel, I have to say I wonder if people are now beginning to forget; particularly as money is coming back into the system and you are seeing the signs of bad habits returning once more. While we would like to say we’ve come out of this period a new person and learned our lesson, I suspect if not this year probably in the next two years lessons will be have to learned all over again. On the industry side and related more closely to asset servicing, in the traditional sub-business you’ve also seen, after 20 years of reformation and competition, you are seeing increasing consolidation in traditional long-only pension systems and fund management firms like ours in this industry. It’s not surprising that in Aberdeen we’ve undertaken in the last five or six years quite a few consolidation exercises related to various mergers and acquisitions here in Asia. In that process we’ve become even closer to our asset servicing side, obviously, because one sole reason for consolidation in the active market is trying to save money, to outsource more, to protect the margins that we have against a very competitive market. The buyside today has many more avenues to invest in, from ETFs to private equity and commodities, and fees are continuously under pressure and therefore it’s all passed right up the supply chain.

COLIN LUNN: The days of “lift and shift” are over. Over the years, particularly in the West, service providers have inherited

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ALASTAIR POW: On the one hand you’ve got asset

CHOU YOON CHONG, investment director, Aberdeen Asset Management Asia Ltd

multiple infrastructures that have yet to be integrated. Every manager is different and has different requirements. The trick is to standardise the key processes and focus on information delivery as that is what is unique to each manager. The future is the buyside and the sellside working together in partnership—managers and service providers effectively becoming part of each others infrastructure.

AU KING-LUN: That’s very relevant, especially to the hedge fund industry. Managers used to perform a lot of administration in-house mainly because of the complexity of their investment strategies. However, this is changing and in order for managers to outsource their administration, especially the valuation of illiquid asset or complex strategies, managers will have to share their valuation methodologies with their service providers.

Although some managers might not be comfortable paying their administrators for their learning, a close partnership will develop over time between the two parties. The outsourcing trend is here to stay and the industry will benefit from such knowledge sharing over time between managers and their service providers. Cost is a key consideration but communication and partnership is really the key for successful outsourcing.

CHOU YOON CHONG: If you jump back 20 years ago, the buyside literally owned the asset servicing side. I remember when I first joined the industry 17 years ago, we were considered a bit different because we outsourced administration. Over the past ten years you’ve seen cost margin pressure split the industry apart, asset managers divesting it incrementally out of their business. Moreover, we’ve seen that increasing complexity has meant full outsourcing and so it becomes more a partnership, based on market expertise. Capex requirements to service just one client with $2bn under management can cost you $50m or more; so it is not sensible to go it alone; therefore partnership with service providers makes real sense.

managers that need to differentiate themselves in order to capture more investor flows. If asset management products were homogenised and no innovation was allowed, investors would be less inclined to move their money. On the other hand, the service provider side wants to standardise everything as much as possible because their margins aren’t high. Standardisation helps achieve economies of scale. While the buyside might be happy to have certain services standardised, they also need to differentiate themselves from their competition. They will therefore continue to require customised service elements within their value chain which will include certain activities provided by their service providers. This is the dichotomy that is unlikely to go away. This need for differentiation on the buyside results in differentiation on the sellside. The challenge for the sellside is how to address this level of differentiation without creating an unwieldy operating model or an imbalanced risk/reward proposition. As Colin noted, when a service provider takes on services whether by design or regulatory default, they ought to appropriately price for the risk and/or effort assumed. The challenge for service providers is the buy side’s willingness to pay! In some respects this dynamic is shifting for certain services.

Be it a regulatory, cost or best practice requirement, the buyside in Asia are leveraging their supply chain more expansively to provide greater independence, for example outsourcing compliance and performance/risk services; to gain access, for example distribution; and to seek higher asset performance, for example notional cash aggregation.

BILL ROSENSWEIG: For the buyside to remain competitive and add value it has to develop new products that meet client requirements. That in turn creates challenges downstream; both for the buyside middle office and for service providers. So there are competing influences at work. Realistically there’s always going to be a gap between the most innovative new product and a middle office or service provider’s system’s ability to efficiently process it in an STP manner by the very nature of the fact that it’s new, it’s different; and that’s what makes it attractive to investors. Hopefully, our industry will continue to come up with ways of innovating and creating products that reduce risk and increase return but there will always be that lag time before it’s something that’s truly scalable. As a product matures, the cost and therefore price that one can charge for servicing those assets goes down as the standardisation increases. After a while, what used to be cutting edge and innovative, and for which you could charge a premium price for servicing because it was difficult, becomes commoditised. It’s an ongoing cycle.

ELIZABETH CHIA: The key here is to leverage the activities of the buy and sellside to benefit both parties. When looking at the rapidly changing landscape of the asset management segment, involving M&A for instance, the ability to connect them with the structuring expertise of the sellside is a value enhancer. As an asset services provider, the ability to seamlessly connect the buy and sellside,

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automating processes using robust infrastructure to process high volumes and deliver efficiency, is vital. The current challenge is moving away from servicing fragmented local systems geared to support local solutions into providing really global integrated systems. They must be effective and sustainable to provide clients with a single viewpoint of all the investment positions of a global asset manager. These challenges arise as more fund managers are linked globally.

SOON KIAN LEE: I would like to highlight the importance of differentiating a service that is essentially possessing data for clients and one that evaluates data for clients.

There seems to be some confusion here. A typical asset service provider is a processor of information through the use of computing resources and well written code to generate the requested information in various report formats for clients to analyse and act on. If evaluating data is not their core competencies, they should not be asked, nor should they even attempt, to perform the function of evaluating data to formulate conclusions or recommendations for clients to use. I bring this differentiation up because of comments being made about seeking asset service providers to help valuing assets, especially those that are not publicly traded. If there is a need for a third party independent assessment of valuations of non-publicly trade assets, it is better to seek a specialist with specific asset pricing expertise. In this manner, you provide investors, who invest into a specialist hedge fund with non-traditional, highly-specialised strategy investing largely into non-publicly traded assets, the transparency of your valuations and performance.

COLIN LUNN: This is where the challenge lies and what makes the market tick. As a service provider, you can have two managers holding the same or similar type of investments and they will have a completely different view on how that asset should be priced. So, you can have two debates as an asset servicer on effectively the same instrument. Now the solution might be dictated by documentation, what’s agreed in the prospectus upfront, what’s transparent to the investor, but at the end of the day, you will still have two views on how a holding is valued.

There needs to be transparency in the process.

AU KING-LUN: You need a specialist administrator to evaluate alternative assets. Moreover, with hedge funds, you have to take leverage into account as it is a key difference between hedge funds and traditional investment management. Because of the importance of leverage to hedge funds, their banking relationships are more important, and thus they will tend to also use the administration services provided by their lenders. Some administrators may also offer risk management tools to managers as part of their overall service proposition, but I think one has to be very careful in deciding what they want from their administrators. In my opinion, risk management is more of a front office issue and I am not convinced that a back office asset service provider can be relied upon for a total solution to this issue.

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SOON KIAN LEE, principal, head of ASEAN investing consulting business, Mercer

DEFINING THE ROLE OF THE CUSTODIAN PROVIDER FRANCESCA CARNEVALE: Can custodians truly be all things to all men anymore in this modern age? Will Asia instigate a change in this regard?

ELIZABETH CHIA: In this business landscape you cannot be everything to everybody.You’ve got to choose your strengths, identify your domain specialty and develop your strategy to focus on the target of your choice. When talking to asset manager and asset owners, their requirement is to get more out of one provider. Clients are no longer asking for plain “vanilla” services, in the new age, it’s about providing customised solutions and end-to-end value added services from fund administration to transfer agency to custody to risk and performance management. To design your services to meet such dynamic needs, scale is critical. Thus, asset servicing providers will be challenged beyond standard offering to deliver customised, dedicated, committed solution offered to the target client of their choice.

BILL ROSENSWEIG: Some people use the value of assets under custody as a means of ranking custodians; I think that is a pretty meaningless way of ranking providers for any given fund manager. Obviously you need someone who has adequate scale but, to our conversation before about partnership and the asset manager/custodian value chain, the real way an asset manager should evaluate custodian providers is quality of service and alignment with one’s strategy. It’s difficult to be all things to all organisations and I believe there’s a strong correlation

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between those that try to do so and those who have the largest asset depots. Although being biggest may be best for the custodian, is it a good model for an asset manager with unique requirements? Will a scale-driven model be flexible enough to support their requirements or will the asset manager be forced to adapt to fit their provider’s model? That said, I do believe most asset servicing providers would like to take on a more complex processing role for their clients to add more value, assuming of course an appropriate balance of risk and reward.

CHOU YOON CHONG: The past 18 months or so was quite a watershed on the asset servicing side because up to then in the chase for business they tried to do everything that the client wants. With the problem with CDOs and the kinds of scandals that appeared, I gather now from dealing with custodians, there’s a clearer attempt to say I can’t do this, I’m sorry, because it’s out of my scope and because of the risk to our reputation.You don’t want to risk your reputation because you’ve got other important customers. The landscape is changing, for example, China is opening up to futures trading and margin trading; we believe Asia will become one of the biggest pools of hedge funds within the next five years; perhaps even sooner.

Investors are buying into the Asian emerging markets story and assets are building up very quickly. Whether the economic power will shift from the States to Asia is still unclear. What is happening for sure is that we’ll have more funds domiciled in Asia set-up by Asian based managers to cater for Asian clients. I wonder how that will impact on the nature of the relationship between buy and sellsides, if it should happen.

SOON KIAN LEE: I do not think that the gravity of importance will shift from US to Asia just because China is opening up and more hedge funds can be expected to be established in Asia than in US. I think that the challenges posed by the emergence of Asia are quite different. The growth of Asia will pose a challenge on the availability of necessary investment skill sets; but this is not going to pose a problem for asset service providers. In the foreseeable future, the problem of complexity in structuring investment products can still be expected to come out of developed markets. Their more advanced regulatory framework and more sophisticated investors’ base provide the necessary conditions to promote innovations in product design. In Asia, the emergence of China is more likely to be volume and size-driven than in innovations. Most global asset service providers have got the algorithms to deal with it.

But when you’ve got the next new thing in product design, other than swaps, you would need more than just pure computing power to support your client.

COLIN LUNN: Complexity in Asia is due to lack of availability of market data. Liquidity and the availability of market data makes the valuation of assets a challenge; that’s where the complexity comes into what we’re doing here.

AU KING-LUN: I would add technology and innovation, which is what drives the market, but that goes with volume. That explains why the US has been so dominant in

the financial industry because they have the market size and volume; but maybe that is changing.

BILL ROSENSWEIG: And leverage, yes?

EVOLUTION OF THE ASIAN ASSET MANAGEMENT SEGMENT CHOU YOON CHONG: In the last 16 years I’ve seen three

bubbles in China blow up; even so, China will be the next place to drive the capital markets. However, the rate of growth in Asia is always very interesting: wealth is growing very quickly, but it may be growing far ahead of the client maturity profile most of the time. So you might say China’s growing lots of wealth, surely the fund industry will grow in tandem in the republic; but you know, they have only just started to learn about investing in property, let alone the concept of buy and hold. You try to explain let’s say a semi-corporate institution, the concept of three-year track record, they don’t absorb the concept. They just want to have the flavour of the month. Now, this might be generalising a little, as there are certainly quite professional people around and, funnily enough, it’s actually some of the older established markets, in places like Singapore, for instance, where the sophisticated discussions take place.

Malaysia too is coming close in trying to move up the chain in professional investment.

COLIN LUNN: That will come with the maturing pension markets in Asia, in markets such as Singapore, and Hong Kong. Obviously Thailand’s going to be launching initiatives this year and South Korea’s not far off. People are beginning to look at their long-term savings and are asking questions such as“how do I allocate my portfolio?”

AU KING-LUN: I still think size matters. The mutual fund market in Asia has been dominated by European domiciled funds. Many of these European domiciled funds are designed for the European markets, for example, by complying with UCIT regulations. Now the game is changing with Chinese domestic fund managers capable of raising ten of billions of US dollars for their new funds in a single day. Size means demand and demand will drive innovation.

BILL ROSENSWEIG: Although the Asian asset management market has and will continue to enjoy strong growth, it is likely to evolve on a market-by-market basis as opposed to in a coordinated regional manner. The European Union, almost by mistake, created the UCITS framework, expecting that it would facilitate pan-European harmonisation and distribution of funds. As things have evolved, UCITS has emerged as a very good regulatory framework to facilitate global distribution including into Asia. Given the efficiency for fund managers of distributing a single cross border product range, I believe it is unlikely that an Asian equivalent will emerge, especially given the competition between different markets and their respective regulators to become the definitive financial centre for Asia. China, however, is positioned to evolve very differently than other markets in Asia, such as Singapore, Taiwan, and Hong Kong which have opened themselves up

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the current investor mindset, compete with the relatively easy access to stock exchanges and progressively educate for the future. International houses will continue to play an important role in the evolution of the industry in this region.

They already have through distribution of their UCITs products, and by helping to nurture a localised industry and skill sets. Meanwhile indigenous asset gatherers will get larger in number, bigger and better with their offerings. They will continue to progressively broaden their business horizons and investment into other asset classes including much more cross border, initially focusing on their more immediate region. They will increasingly attract talent from international houses. It is a natural and healthy evolution.

TACKLING MARKET FRAGMENTATION

DR AU KING-LUN, chief executive officer, FRM Hong Kong Ltd

to the cross border products resulting in the lack of an impetus to establish a strong, locally-domiciled fund industry. The QDII framework in China provides fertile ground for the establishment of a vibrant locally domiciled fund management industry with strong growth prospects.

COLIN LUNN: In this respect, Asia is fragmented.

However, if Asia wants to develop as an asset manager centre then it will need to develop its own domiciles to enable product manufacture. I would argue that you are beginning to see this between China, Hong Kong and Taiwan with cross-listings of ETFs and the recent Taiwan signing of an MOU with China to enable local Chinese to invest into Taiwan through QDII. Now they just need to focus on developing a robust funds domicile, sort out the tax issues and allow passporting of funds.

BILL ROSENSWEIG: Agreed the “Greater China” region has great potential which will only increase as ties become increasingly close between China, Hong Kong and Taiwan.

ALASTAIR POW: I suppose this is obvious, but what drives the landscape for any industry is demand. So where is the demand coming from? How are investors going to behave, or what are they going to want to buy now, in five years, in ten years? Undoubtedly the investor market in Asia is going to get bigger, more mature and more sophisticated. It would be nice to think that more investors in Asia will buy and hold products with longer-term investment horizons; but no one can guarantee that other than by instituting compulsory pension schemes. Even today, a high proportion of wealth is still kept in cash with the remainder typically allocated to quite high risk investments. So if a fund manager is to be successful in Asia, they’ve got to provide products that meet

FTSE GLOBAL MARKETS • MARCH/APRIL 2010

ALASTAIR POW: Inefficiencies are sometimes a good thing because it challenges the service provider to be creative; particularly if a client needs to be supported across markets that are difficult to access and understand. However, if you are a service provider that depends on a high degree of standardisation or automation then fragmentation is obviously less attractive.

BILL ROSENSWEIG: It is hard to disagree with that.

However fragmentation-driven inefficiencies usually only offer short-term opportunity. The world is running out of “frontier markets” and that will mean, eventually, more standardisation and less fragmentation. In the long run, the business models of both security services providers and asset managers will need to be based on delivering sustainable value above and beyond being able to provide market access and manage fragmentation.

ELIZABETH CHIA: Market inefficiency does offer opportunities for service providers. Efficient handling of complex market regulations and restrictions is a key differentiator of a service provider. Our business model is to provide value and delivering solution to the clients. Also, market inefficiencies provide service providers and industry players with an opportunity to try to perhaps lead changes, identify best practices and influence market regulations in new emerging yet dynamic markets before some of the regulatory changes are cast in stone. We do invest much time formulating different market practices, presiding over various market practice groups to try to help evolve market infrastructure and best practices, working with regulators as well as industry personnel to bring about positive change to the industry.

SOON KIAN LEE: With regard to the potential for standardisation within Asia excluding Greater China, our take is that this sub-region is at the moment too diverse: in stages of market developments, in regard to investors’ sophistication and needs, and in product offerings.

Moreover, the regulatory environments within each jurisdiction are very different, each having been developed to suit their particular circumstances and needs. For standardisation to occur, like the EU framework, this would

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COLIN LUNN (left), head of business development, Asia-Pacific Fund Services, HSBC Securities Services and ALASTAIR POW (right), director, global head of product, fund services, transaction banking, Standard Chartered Bank

require substantial political impetus and commitment from various governments across the entire sub-region. We are not there yet in terms of political will to do this. Most importantly, as long as within this sub-region there is a “winner and loser” mentality, standardisation is a no “go”.

What do I mean by “winner and loser” mentality? Well, countries are very much aware that when there is standardisation, inevitably, there will be “winning” cities and “loosing” cities. In other words, with standardisation, some cities/countries will gain from strong regulatory and pro-business environment. Others will lose out. This has happened in the EU and can be expected to be repeated here. The mere risk that their cities/countries may loose out in the financial services arena may not be exactly an attractive idea for some governments. Hence, we think that the lack of political will is one key factor that needs to be overcome before any steps towards standardisation can become a reality in this sub-region. This, however, does not mean that the sub-region will remain fragmented forever.

CHOU YOON CHONG: Right now, it is now too much of an issue because there is plenty of straightforward money that can easily be sourced. Let’s start with rich professional investors and family offices. If they want to invest, there is no stoppage of their capital flows really, so those funds probably could end up in Singapore or Luxembourg if they wanted.

That form of money has no boundaries anyway so whether we have a standardisation, pan-Asia, Asian, they will just say it doesn’t really matter. What matters are the developments at the institutional level.Ten or 15 years ago, the Government of Singapore Investment Corporation showed by example that you can outsource your fund management requirements to other companies.That was very important and in Hong Kong you saw it replicated much later on. Standardisation will be important, maybe 15 to 20 years from now, but at the moment from the buyside to the distribution side, money doesn’t know that much about this, or at least the rich people’s money. Then secondly what matters is quasigovernment institutional money, which again has its own dynamics. If China wants to put more money overseas, they will just allocate 100bn overnight. Ultimately, it’s a decision made by government or quasi-corporate government forces, and much less to do with regulation.

AU KING-LUN: Clarity is what we want. I can cite a few examples, such as in the area of taxation, of problems that dogged both service providers and fund managers; problems that up to now have not been clarified, particularly in jurisdictions such as India and China.

RISK MANAGEMENT & INVESTOR PROTECTION ALASTAIR POW: Asset managers and service providers don’t govern investor protection, regulators do. Do we have a role to play in how that gets developed and making recommendations? Well, as good corporate citizens we would hope so. Nonetheless, from a non-trustee perspective, the degree of direct responsibility you have to underlying investors should be minimal to non-existent.

After all, these investors are not actually clients of the service provider. Given recent events, it is not unexpected that regulators are revisiting the issue of investor protection. The typical reaction is to enforce greater regulatory responsibility on a third party service provider to the fund or a trustee. If the division of prescribed responsibilities are implicit rather than explicit and/or are impractical, it results in ambiguity and may in fact render them obsolete. Across Asia we have two fundamental legal structures for funds but in every market there is a high incidence of unclear guidelines/policies regarding the roles and responsibilities of parties to a fund. It is often difficult to understand how some of these truly increase protection whereas they always increase the cost to investors. It is worth considering whether investors would be best served by giving ultimate responsibility and accountability to a single management entity even if they do or are required to outsource certain activities. Applying fiduciary responsibilities to a custodian is actually quite inconsistent with the fundamental safekeeping role custodians are engaged and paid to perform.

BILL ROSENSWEIG: Such as local compliance monitoring.

ALASTAIR POW: Exactly, yes. Should a custodian be a fiduciary? I would say no. It can undertake activities on behalf of the manager but the manager ought to be the entity that handles its own investors in the event of a dispute.

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COLIN LUNN: At the end of the day we are all supposed to

play a part. This is fully documented and disclosed in the offering memorandum and prospectus of the products.

However, when things do blow up, a lot of this goes out the window. In today’s environment, is it sufficient to say that “we followed the requirements of the prospectus and all the boxes were checked?”Unfortunately, I would argue not and that reputation, size and balance sheet are the insurance premiums and there is a cost associated with that.

BILL ROSENSWEIG: In terms of asset servicers, I don’t think we’re in a particularly good position to be advising on suitability in any way. It’s not what we’re hired to do. If we’re doing fund administration and compliance monitoring, then we make sure that the assets are being invested per the guidelines but it’s not our role to determine if the product is appropriate for the end investor. Globally however there’s been a lot of focus on the investment suitability and this has only increased post the financial crisis. It has certainly been a big deal in Hong Kong and Singapore with the mini-bond issues. At the end of the day though, the critical component of investor protection is disclosure to the investors and making sure, both from a fund manager perspective and an asset servicer perspective if providing compliance monitoring, that the assets are being managed as it indicated on the tin. Then it’s really up to the investor to decide what they want to buy.

ELIZABETH CHIA: Post the financial crisis, clients are asking for more support on risk analytics, compliance reporting and performance measurement services. Such requirements were in the past more selective than core. A need to monitor stricter compliance and tighter risk management is the main driver. In addition to these valueadded services, where the service provider is appointed a trustee under the Collective Investment Scheme of a unit trust structure, the trustee undertakes full due diligence and care, protecting the underlying assets of the fund and ensuring that investment guidelines are strictly adhered as per trust deed and validating all cash instructions to safeguard its assets. During the crisis, when many funds were adversely affected, regulators were questioning on investors’ protection. In the aftermath of the crisis, regulators have questioned the obligations of all parties involved, heightening awareness of even stricter due diligence and care on the trustee.

CHOU YOON CHONG: I want to add support to this view.

I’d say, you always should follow the most onerous regulation and your own standards must always conform to the best regulation. If you set up a business for just one fund in the US, the chances are everyone has to be licensed; everyone has to make sure they follow the rules.

Whether times are good or bad good, all I can say is that the administrative work has increased. As a director, the one thing we always make sure we train our junior directors is when you press the button signing off a valuation, know what you’re pressing. Coming out of this crisis, valuation of contracts, products, is vital and again, as you get each one of these crises, be it a mini-bond, the

FTSE GLOBAL MARKETS • MARCH/APRIL 2010

ALASTAIR POW, director, global head of product, fund services, transaction banking, Standard Chartered Bank

impact is global because it just starts a procedural change involving that product and then regulatory changes follows that. Risk audits make sure that your actions are advertised internationally, so everyone follows the same principles.

ALASTAIR POW: Actually, trust structures sometimes provide false comfort; there are many areas we can pick on.

We mentioned valuation several times. Trustees are fairly ill-equipped organisations to be responsible for knowing how or why an asset may be valued in a particular way.

Why impose a duty on an entity to approve a value or a valuation agent when they have little to no expertise to do so? Why create an environment which doesn’t practically work or truly protect the investor other than provide access to another deep pocket? The industry should look to mechanisms that really contribute to investor protection and education AU KING-LUN: Actually, this is a corporate governance issue though it is extremely difficult to find trustees or directors that are able to fully understand hedge fund strategies. Therefore, it comes down to the fact that it relates to people. There is also the question as to whether custodians are pricing their risk properly because regulators always look to them when something goes wrong. The mini-bonds are a good example of this fact. I also agree with Alistair, trustees just have no control of what fund managers do.

COLIN LUNN: Trustees, boards of directors; you can have all the corporate governance in the world, but when everything hits the fan, you gravitate to the deeper pockets.

That’s lesson number one! At the end of the day we are also

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trying to adapt different types of vehicles, trusts, corporates, etc., into something that perhaps may no longer be appropriate for the industry. Even though you try to put all this regulation around it, is the vehicle itself ultimately appropriate? Should it in that case have responsibility and accountability?

BILL ROSENSWEIG: Issues related to the securities lending programmes of some custodians has strained many longterm custodian/client relationships. There was a general lack of appreciation of the responsibility of institutional investors or fund directors with many simply having taken the default position of signing up the lending programme offered by their custodian. Only when things went sour did both parties pull the agreements out of the desk and start looking at them at which point they realised that all programmes are not the same in terms of their lending approach, indemnification models, etc. Securities lending when done appropriately is beneficial to markets and offers investors good risk-adjusted rates of return based on the intrinsic value of the securities being lent. Like many things, there is generally an 80:20 rule for securities lending, where 80% of the securities lending returns come from 20% of the assets, and that would imply that maybe only 20% should be lent. However, in a lot of these cases 80%-90% of portfolios was being lent out to get to cash collateral on which to generate additional return at the expense of incremental risk. While that was all working I don’t think any of the fund managers who are now suing some of the custodians you mentioned were complaining.

It’s only when it stopped working that there was a reckoning. We’ve discussed the topic of partnership and the value chain between the asset managers and service providers throughout this session. In all of the cases where money was lost, partnerships are most under stress which is resulting in many asset managers evaluating longstanding service provider relationships.

ALASTAIR POW: .As a provider of investment products, does a fund manager have a responsibility beyond ensuring the product is suitable for that investor’s risk profile when selling that product? Has the notion of independent custodian and/or administrator and their actual roles and responsibilities been oversold to the extent that investors are subject to a degree of misled comfort? Repeated incidents such as Madoff continue to reaffirm the value to investors in having assets independently custodised and administered to ensure existence and an accurate book of record. However, even with this worthwhile segregation of activities, the actual valuation of underlying assets held by the fund is beyond the responsibility of an administrator/custodian. Administrator/custodians are limited to collecting prices for those underlying assets and then accurately incorporating these into an overall valuation at the fund level. I sometimes wonder if this important distinction is truly understood by all investors.

ELIZABETH CHIA: Following on from what Colin said on providing services as trustee, custodian or administrator, our job is not to guarantee a fund; our job is to be the

WILLIAM (BILL) ROSENSWEIG – managing director, investor services and markets, Brown Brothers Harriman (HK) Ltd

watchdog and the custodian, ensuring that guidelines and processes are adhered to. That understanding must be clearly agreed with clients to avoid a mismatch of expectations and risk damaging relationship with clients.

COLIN LUNN: You’re only talking about the trust function, right Elizabeth? Ultimate accountability for how the fund is run, how it’s governed, regardless of whether it outsources activities or not, should reside with the fund manager or the board of directors. Just the fact that they’re outsourcing does not diminish their responsibilities or their accountability. They have an obligation to make sure that they appoint the right provider, and to Bill’s point, they understand if they’re buying securities lending, what that is and the risk that that represents.

ELIZABETH CHIA: I agree with you, our clients don’t outsource responsibility, only the functions. But that fact must be made clear from the very outset; not when things go wrong.

THE LAST WORD CHOU YOON CHONG: I worked in the UK over the last

decade and I tell you, in Asia, you have simple growth without financial engineering, and that’s the beauty of this region. You don’t need to speculate what happens behaviour-wise; you just know the demographic consumer cycle, married with rising knowledge of what the investment sector can offer, will drive institutional savings over a long, long term. That is why the financial infrastructure in Asia will grow and grow, and that’s where the region is right now.

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Carl Icahn’s purchase of the bankrupt and unfinished Fontainebleau hotel-casino is a vote of confidence in the Las Vegas Strip, a fantasyland of casinos, hotels, entertainment, fancy restaurants and high-end retail that has been devastated by the great recession. The deal, along with a handful of hopeful economic indicators, suggests that the Vegas economy is turning around.

Owning the towering Fontainebleau will almost certainly enrich Icahn but that doesn’t necessarily mean it is good for the rest of Vegas. After visiting “Sin City”, Art Detman describes the difficult problems facing what was once America’s fastest-growing community.

Perhaps no place in the US has taken a harder economic hit than Las Vegas. The unemployment rate has zoomed to 13%, the second highest in the US. In foreclosures,Vegas is number one, a ranking it’s held for three years running and is likely to retain for some while. Last year, one in eight of the city’s residential units received a default or foreclosure notice. As many as 60% of homeowners owe more on their mortgages than their houses are worth.

Photograph (c) Photo168/Dreamstime.com, supplied February 2010.

FTSE GLOBAL MARKETS • MARCH/APRIL 2010

OR 20 YEARS, no place in the US and few anywhere else in the world grew as fast as Las Vegas, America’s gambling, entertainment and convention capital, tucked into the southern-most corner of Nevada, just over the state line from California. The area’s population exploded from 797,000 in 1990 to around 1.95m. The number of hotel rooms grew from 74,000 to 149,000 by the end of 2009. Famous hotel-casinos like the New Frontier, Dunes, Sands and Desert Inn fell to the wrecking ball—or, spectacularly, to explosives that imploded them—and were replaced by fairy-tale resorts that cost a billion dollars or more with names such as Bellagio, Venetian, Palazzo, Luxor, Mandalay Bay and Encore.

The 1995-2005 period saw frenzied growth as companies large and small borrowed heavily to build, build and build some more. John Restrepo of Vegas-based Restrepo Consulting Group calls that decade the area’s“gilded age”, when the economy grew by 5% to 6% every year.“All of a sudden that became the rule instead of the exception to the rule,” he says.“Companies started believing their own PR, that they were immune to the laws of economics. I think we have learned from this recession that this kind of thinking was based on a false premise.”

F

COVER STORY: FANTASYLAND’S RECOVERY COULD TAKE YEARS

Place your bets on Las Vegas

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Sherman R Frederick, publisher of the Las Vegas Review-Journal.

“However, the gaming and visitor economy was so strong that it took the wind out of the sails of diversification,” he says. As a result, fully 29% of the economy remains leisure-related, something that Somer Hollingsworth, head of the Nevada Development Corporation, hopes to changes.“Our target industries are technology, life sciences, biomedical, medical technology and alternative energy,” he adds. Photograph kindly supplied by the Las Vegas Review-Journal, February 2010.

Indeed, perhaps no place in the US has taken a harder economic hit than Las Vegas. The unemployment rate has zoomed to 13%, the second highest in the US. In foreclosures, Vegas is number one, a ranking it’s held for three years running and is likely to retain for some while.

Last year, one in eight of the city’s residential units received a default or foreclosure notice. As many as 60% of homeowners owe more on their mortgages than their houses are worth. Home prices are down more than 50%, and lenders are overwhelmed with delinquencies. Around 15,000 residents last year packed up; others are living rentfree. “We have people in Las Vegas who haven’t made a mortgage payment in a year, and they still haven’t been foreclosed on simply because their bank hasn’t gotten around to them yet,” says Dr Mary Riddel, head of the Center for Business and Economic Research at the University of Nevada’s Las Vegas campus. She reckons that Vegas has a surplus of 12,000 hotel rooms and 25,000 to 30,000 houses.

In 2009, gross gambling revenues fell sharply, visitor volume declined 3%, and taxable sales were off 19%, which has led to big deficits in local and state budgets.

Commercial real estate is bleeding, with vacancy rates of 10% for retail, 15% for industrial, 19% for medical, and 23% for office. Several hotel towers have been shut and many properties are in bankruptcy—such as Lake Las Vegas and Summerlin, two of the nation’s largest planned communities, and the company that owns the Las Vegas Monorail, the nation’s only privately-owned mass transit

system—or were in bankruptcy (including the Fontainebleau), or narrowly avoided bankruptcy, notably MGM Mirage, as it struggled to complete its mammoth CityCenter project.

Once the recession ends, Restrepo expects the Vegas economy to grow by only 1% or 2% a year, and he doesn’t expect any major new developments to be started on the Strip for seven to ten years, a view widely shared.

Although the recession’s onset is dated at December 2007, business on the Strip was strong through all of 2007 and much of 2008. “We saw very solid room pricing,” says Daniel J D’Arrigo, chief financial officer of MGM Mirage, the largest resort operator in Vegas with 15 hotels, more than 45,000 rooms, and well over 1m sq ft of casino space.

“In some instances, we experienced our all-time highest price points in terms of our average daily rates.”Then in September 2008 came the collapse of Lehman Brothers and the near-meltdown of the world’s financial system.

“Whether you were a business traveller or a tourist, everyone froze,” D’Arrigo says. “Cancellations were outpacing future bookings. Some of our hotels were running at only 60% or 70% occupancy”; down from the usual rate of 90% or more.

The big resort operators had seen this movie before, right after the attacks of September 11th 2001, so they knew what to do. Room rates and expenses were cut. Layoffs, shorter hours and even reduced pay were widespread.

Meanwhile, marketing was revved up. With business travel in freefall, the resorts focused on tourists and international visitors. MGM, for example, drew upon its database of 1,600 names in the travel industry. “We were able to shift the business from the meeting business, which we lost almost overnight as a result of the financial crisis, into some of the leisure markets,”says D’Ariggo.“We had to make it a value proposition to get people to hit the road again, to look at Las Vegas when they were planning their weekends and vacations, to make it one of their top choices.”Slowly, occupancy rates were brought up but only at the price of profits. According to the Las Vegas Convention and Visitors Authority (LVCVA), the average room rate plummeted from $119 in 2008 to $93 last year, a 22% drop. The occupancy rate fell from 86% to 81.5%. Those are just yearlong averages. Early in 2009 occupancy rates plunged, dragging room rates with them. At some of MGM’s properties, occupancy rates dipped to 60% and room rates were cut by up to 30%. Even today some low-end hotels and motels offer rooms for as little as $29 midweek.

D’Arrigo concedes: “Our buildings are not as profitable as they were in years past, but they are still producing significant cash flows. It’s still a nice margin cash-flow business, and we got our occupancy rates back up, well over 90% in every one of our buildings here in Las Vegas.”

For MGM Mirage (no longer associated with the troubled Metro-Goldwyn-Mayer film studio), 2009 was a nightmare year. Five years earlier, as the Strip’s growth was steadily gaining momentum, the company gave the green-light to an audacious plan to build CityCenter, an $8.5bn, 67-acre

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complex on the Strip between its flagship Bellagio hotelcasino and its Monte Carlo property. Early last year the project nearly came to a crashing halt in a dispute with its partner, Dubai World, which sued MGM. After MGM put up additional collateral in the form of land and casinos, the project’s lenders agreed to continued funding and Dubai World dropped its lawsuit. According to chief executive officer James Murren, MGM Mirage avoided bankruptcy not by a matter of hours but a matter of minutes.

Not all landmark properties were so lucky. Not far from CityCenter, work continues on the Cosmopolitan, which is now owned by its lender, Deutsche Bank. This $3.9bn hotel-casino will include 3,000 rooms, 150,000 sq ft of meeting space, and a 75,000 sq ft casino. It is scheduled for completion in the autumn. Elsewhere, the 3,815-room Fontainebleau, which at 68 stories is the Strip’s tallest hotel (or will be, once it’s opened), fell into bankruptcy last June.

Condo sales, which had been expected to help finance construction, lagged projections and a worried Bank of America refused to provide further funding.

Meanwhile, a project that could rival CityCenter—the 87acre Echelon, budgeted at $4.8bn—has been put on indefinite hold, at the north end of the Strip not far from the Fontainebleau. In 2007 the fabled but aging Stardust was imploded to make way for four hotels with 5,300 rooms, 25 restaurants and bars, and a 1m sq ft convention center. After lenders refused to continue funding, Echelon owner Boyd Gaming halted work in August 2008. President Kevin Smith has said he expects to resume construction work in three to five years, but this appears to be a very soft timeline. He did not say if the steel frame would be taken down.

“They have to spend $500m to start building a seven-story hotel,” says Jeremy Aguero, a principal of Vegas-based Applied Analysis, a consulting firm.“The steel frame should be torn down and the land flattened. From an economic standpoint, there is certainly a stigma in having that uncompleted structure standing there on the Strip. On the other hand, scrapping a half billion dollars’ worth of investment doesn’t make a whole lot of sense to me either.”

As for the Fontainebleau, it was 70% completed when the plug was pulled. When the bankruptcy court called for bids, Penn National Gaming, a Pennsylvania-based company, offered $145m (this on a project that has consumed at least $2bn so far). Carl Icahn bid $156.2m, and Penn National refused to counterbid. The court ruled that Icahn’s was the only qualified offer, and the property went to him in January. By some estimates, the property requires an additional $2bn-worth of work to complete it, a figure Icahn believes is too high. In classic Icahn behaviour, he hasn’t revealed his plans.

The consensus in Vegas is that Icahn will mothball the building until the present oversupply of hotel rooms is absorbed by a revival of demand. But by paying roughly eight cents on the dollar, Icahn has lots of room to manoeuvre. His cost-per-room will be far below that of other hotels on the Strip, so he doesn’t need boom times to return in order to operate the Fontainebleau at a profit. He

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Somer Hollingsworth, head of the Nevada Development Corporation.

“Our target industries are technology, life sciences, biomedical, medical technology and alternative energy,” he says.“We have been really successful in bringing solar power plants here. Now we’re dealing with a couple of manufacturers of solar panels, which is really where we want to go. They pay real good wages and they might employ 400 or 500 people.” Photograph kindly supplied by the Nevada Development Corporation, February 2010.

could conceivably complete and open the property even in face of a surplus of Strip hotel rooms. Icahn is an old hand in the business, having at one time owned the Stratosphere, across the street from the Fontainebleau.

Whatever he does will surely be good for him, even if it isn’t good for the rest of Vegas.

“For now, the big question forVegas operators is this: will the New Austerity shown by American consumers become the New Norm? Even if they desire to go back to their freespending ways, will the credit card industry put tighter controls on people’s spending?” wonders Restrepo. It’s a view indirectly hinted at by Riddel of UNLV, who notes that $4trn in personal wealth disappeared when the housing bubble popped, pretty much ending cash-out refinancings.

“Before, they would take out a second mortgage and use the money to come to LasVegas and have a great time,”she says. “Now, they have found out that they spent money they never had.”

Riddel takes a grim view of the next several years. In the past, new properties created their own demand. With each new hotel, the pie grew larger. That is no longer the case.

Vegas is now playing a zero-sum game, she believes, and even a spectacular complex such as CityCenter can only cannibalise existing hotels and casinos. In turn, this will lead to continued discounting and still lower occupancy rates.

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In the real world, the breakeven occupancy point for most hotels is 70%—but not in Vegas, where it’s 85%.

Hotels on the Strip cost much more per room than elsewhere because each it is in itself an attraction, with storybook design and features such as fountains, carefullytended gardens and blazing lights 24-hours a day.

[Astronauts say that Vegas at night is the single brightest point on earth.] Furthermore, hotels offer free entertainment ranging from the hokey (a battle between sirens and pirates at Treasure Island) to the classy (Bellagio’s 10-acre pool with fountains that sway back and forth as music plays on hidden loud speakers).

In recent weeks, there have been signs that the Vegas economy has bottomed out. The visitor count rose 1.5% in December compared with the corresponding month in 2008, the fourth consecutive month of gains. Convention attendance was up 11.6% in December, while the number of conventions was up 10%. People like D’Arrigo at MGM and Aguero at Applied Analysis believe the worst is over.

Predictably, the recession has brought renewed calls for economic diversification. “For 30 years we always said, ‘We have to diversify,’” says Sherman R Frederick, publisher of the Las Vegas Review-Journal. “However, the gaming and visitor economy was so strong that it took the wind out of the sails of diversification.” As a result, fully 29% of the economy remains leisure-related, something that Somer Hollingsworth, head of the Nevada Development Corporation, hopes to changes.

“Our target industries are technology, life sciences, biomedical, medical technology and alternative energy,” he says.“We have been really successful in bringing solar power plants here. Now we’re dealing with a couple of manufacturers of solar panels, which is really where we want to go. They pay real good wages and they might employ 400 or 500 people.” Another promising area is medical tourism. The Cleveland Clinic, for example, has decided to build a facility in Las Vegas. “Almost every place a patient goes for advanced procedures shuts down at 10pm and may not have nice places for family members to stay. If someone goes across the country for a cancer operation or to get a transplant, usually the family goes along with him. And we think this offers an opportunity for us.”

In an economy where jobs are still being lost, not added, it’s a tough task to persuade companies to move, even to Nevada, which prides itself on being super friendly toward businesses in terms of taxes and regulation. Another problem is Nevada’s educational system, which by some measures is bottom among the 50 states. Chances are that, as tourists return to Vegas in larger numbers and spend more money, it will no longer seem urgent to diversify.

After all, what Vegas does best and does better than any place else in the world, is right there on the Strip for all to see. A Disneyland for adults, a 24-hour fantasy of gambling, drinking, dining, entertainment, shopping and sight-seeing. Granted, it will take some while before the Strip recovers lost ground. But it will.You can bet on that.

Daniel J D’Arrigo, chief financial officer of MGM Mirage, the largest resort operator in Vegas with 15 hotels, more than 45,000 rooms, and well over 1m sq ft of casino space.“In some instances, we experienced our all-time highest price points in terms of our average daily rates.”Then in September 2008 came the collapse of Lehman Brothers and the nearmeltdown of the world’s financial system.“Whether you were a business traveller or a tourist, everyone froze,” D’Arrigo says.“Cancellations were outpacing future bookings. Some of our hotels were running at only 60% or 70% occupancy”; down from the usual rate of 90% or more.

Photograph kindly supplied by MGM Mirage, February 2010.

Jeremy Aguero, a principal of Vegas-based Applied Analysis, a consulting firm.“They have to spend $500m to start building a seven-story hotel,” says Aguero of the Echelon project.“The steel frame should be torn down and the land flattened. From an economic standpoint, there is certainly a stigma in having that uncompleted structure standing there on the Strip.

On the other hand, scrapping a half billion dollars’ worth of investment doesn’t make a whole lot of sense to me either.” Photograph kindly supplied by Applied Analysis, February 2010.

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Archive photo of billionaire investors and financier Carl Icahn attending a news conference about Time Warner Inc. On Tuesday, February 7th, 2006 in New York. At the time the photo was taken, Icahn led a group of investors who asked for a shake-up at Time Warner. Icahn’s demands included larger share buybacks and a complete spinoff of Time Warner’s cable TV division. Photograph by Shiho Fukada for Associated Press. Photograph supplied by PA Photos, January 2009.

WHY LAS VEGAS IS PARADISE ast year, Las Vegas had more than 36m visitors.

Some came just once to the Jewel of the Desert, as civic boosters call it. Some visited several times. Most stayed at hotels on the Strip, that portion of Las Vegas Boulevard that stretches four miles south from Sahara Avenue and is perhaps the most glittering urban corridor in the world. Whether they won or, almost certainly, lost in the casinos, and whether they enjoyed themselves or (rarely) did not, they thought they were in Las Vegas. They weren’t.

To understand why, look at a bit of history. Las Vegas Valley is a flat expanse of desert encircled by mountains; it sits above a huge aquifer. In the early 1800s, Mormons established a village there to protect the travel corridor from Salt Lake City to California, then a major destination for Mormons.

Outfought by Indians, they gave up in 1857. It wasn’t until 1905 that present-day Las Vegas was established, mainly as a water stop for thirsty steam locomotives. Six years later, Las Vegas became an incorporated city.

The place that teetotal Mormons abandoned immediately embraced drinking and gambling. Under pressure from the federal government, Nevada outlawed gambling. But in 1931, as the Great Depression crushed the American economy, gambling was again legalised. Almost certainly, it saved the state’s economy. In the 1950s, people such as Bugsy Siegel and Meyer Lansky arrived to build major hotelcasinos just outside of the Las Vegas city limits, on a barren road called Los Angeles Highway. Soon, the

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road was renamed Las Vegas Boulevard South, and in 1953 The New York Times reported that there were 1,800 hotel rooms located there, the best of which commanded $7.50 a day.

By the 1980s, operators with reputed criminal ties had been eased out and large publicly-traded corporations had moved in. Resorts where entertainers including Frank Sinatra, Dean Martin, Sammy Davis Jr and Ronald Reagan once performed were torn down.

The Strip—a stretch of road then often without sidewalks and dotted with vacant lots—was growing up.

Today, the City of Las Vegas remains home to many hotel-casinos, among them the Golden Nugget, Fremont, Red Rock Resort and Binion’s (which has temporarily shuttered its 365 hotel rooms). The city’s mayor, Oscar Goodman, is a criminal defence lawyer who formerly represented such colourful clients as “Tony the Ant.” Goodman is the political face of Las Vegas even though North Las Vegas and Henderson have their own mayors and the real power resides with Clark County officials. A proposal to combine the county and the cities into a single municipality, first made 40 years ago, appears hopeless even though annual savings are forecast at $23m.

Meanwhile, most of the gambling action is south of the Las Vegas city limits, on the Strip, mainly in the township of Paradise. Politically speaking, townships like these are just creations of Clark County, Nevada’s most populous county. However, for millions of visitors and gamblers, they don’t exist at all. These people think they’re in Las Vegas, but they’re really in Paradise.

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US CUSTODY: BUILDING INFRASTRUCTURE

It’s in the

GENES Coming off a gruelling year of stress tests and other trials, US-based custodian banks entered 2010 in remarkable shape, as evidenced by a uniform rise in assets under custody. Fees remain the key revenue driver, compelling many to make fresh securities-servicing acquisitions while bringing new tools to market. However, with margins constantly under pressure and demands for capital on the increase, custodians have little time to rest on their laurels. From Boston, David Simons reports.

Photograph © Rolffimages/Dreamstime.com, supplied February 2010.

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HE PASTYEAR and a half has been no picnic for toptier US custodial banks, the mainstay of the assetservicing industry. Challenging global market conditions contributed to a pronounced drop in tradingservices and securities-finance revenue during 2009, while a more risk-conscious investment clientele helped keep volumes in check. Through it all, custodians were compelled to maintain service quality, particularly in the area of risk analytics, in order to shore-up investor confidence and satisfy ongoing regulatory demands.

Ironically, walking through the fire appears to have made many in the custody business tougher than ever. Fourthquarter earnings from custody bigwigs Bank of New York Mellon and Boston-based State Street Corp reflected the improved environment coming into 2010. State Street posted fourth-quarter (Q4) net income of $1-per-share, nearly twice as much as the same quarter the previous year, while BNY Mellon reported an adjusted profit of 60 centsper-share during the same period. Custody-based assets at the major banks continued to swell, led by Chicago’s Northern Trust, which reported assets under custody up 22% year-to-year. At JPMorgan, assets under custody increased 13% from the prior year to $14.9tn, while custodised assets at State Street and BNY Mellon rose 18% and 10%, respectively.

Beefing-up revenue through the fee-based world of record keeping, accounting and other custodial duties has been key to this effort. In February, BNY Mellon announced it would pay $2.3bn in cash for the global investment servicing business of Pittsburgh-based PNC Financial Services Group in an effort to widen its hedge and traditional-fund administration capabilities. Weeks earlier, no. three-ranked custodian State Street boosted its own global-administrative capabilities by acquiring the securities-servicing division of Intesa Sanpaolo, the Turin, Italy-based, banking group, for $1.8bn.

With margins constantly under pressure and demands for investment capital on the increase, a minimum amount of scale will be required in order to stay afloat, says Nick Rudenstine, global head of JP Morgan’s custody business: “You have to be able to invest in the products and the people, and therefore you need to make sure that your priorities are in order.”

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Risky business An extended period of risk revaluation and fine-tuning has led to a more stable client-custodial environment, and the ability to effectively manage risk on an ongoing basis continues to be an integral part of the custodian’s compulsory skill set. Yet with regulatory proposals increasingly putting the burden of proof on fund administration, there is little time for custodians to rest on their laurels.

“Many of these measures could result in a transfer of significant risk to service providers,” says Rudenstine.

“Custodians need to figure out the best way to digest these risks, and whether or not they are being compensated to

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Paul d’Ouville, global head of product management for Chicago-based Northern Trust. For custodians, the re-awakening of risk management continues to manifest itself in areas such as independence, transparency, and cost reduction.“Clients are trying to deal with all of these issues, and our job as an asset servicer is to provide them with the solutions that can easily answer their questions,” says d’Ouville. Photograph kindly supplied by Northern Trust, February 2010.

make the adjustments. Naturally, a lot of this is still in the planning stages—however, it is a major area of focus for service providers these days.”

Risk management has taken on a whole new meaning for custody clients, says Vince Sands, executive vicepresident and head of US custody, BNY Mellon. “Clients want to make sure that they thoroughly understand all of the points along the risk spectrum—who the counterparties are, where the assets are located, things of that nature.” For years, collateral was traditionally held outside of the custody firm, and, until fairly recently, that was not a big problem. “Now investors are frequently asking, ‘Who is holding the collateral?’ And if there is a broker involved, they will likely want to know about the firm’s reputation and whether or not it has a solid performance record. More often than not, clients appear to be more comfortable having the custodian handle anything that relates to the safekeeping of collateral. So that is one aspect of risk monitoring that is continuing to evolve, and it has had a direct impact on the settlement process, as well as related tools and technologies.”

For custodians, the re-awakening of risk management continues to manifest itself in areas such as independence, transparency, and cost reduction.“Clients are trying to deal with all of these issues, and our job as an asset servicer is to provide them with the solutions that can easily answer their questions,”says Paul d’Ouville, global head of product management for Chicago-based Northern Trust.

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the availability of an environmental emission analytics programme as part of its existing suite of investment risk and performance analytics solutions, giving investors insight into the carbon footprint of their global portfolios.

Independence day

Nick Rudenstine, global head of JP Morgan’s custody business. With margins constantly under pressure and demands for investment capital on the increase, a minimum amount of scale will be required in order to stay afloat, says Rudenstine.“You have to be able to invest in the products and the people, and therefore you need to make sure that your priorities are in order.” Photograph kindly supplied by JP Morgan, February 2010.

As custodians become increasingly responsible for reconcilement, collateral and other duties that in the past would have been typically outside of their purview, the consolidation of services has paved the way for a wealth of other opportunities, says Sands. “For instance, as we become the natural repository for all of this information, we are now in a position to be more of an accounting agent, as well as provide performance measurement and risk products.”

Pooling remains a proven strategy, one that assists multinational corporations with governance and oversight of global investment opportunities, while at the same time giving asset managers a platform with which to provide fund vehicles to institutional investors on a tax-efficient basis. “In other words, it is a capability that can address both risk management as well as distribution and business expansion,”says d’Ouville.

Risk-assessment programmes that have traditionally focused on duration and data are continually evolving, and now include more dynamic, forward-looking strategies such as scenario analysis and other stress test based analytics, offered through a workbench or portal.

There have been other new wrinkles as well. Among the tools currently in development at Northern Trust is a mobile application linked to the company’s online portal, Passport, which will allow clients to view risk exposures and other portfolio information directly from an iPhone or BlackBerry device. In December, the company announced

At the behest of investors, the industry will continue on its path toward fully independent administration, custody and broker-dealer services, making it all the more difficult for self-administered hold-outs to buck the trend. “In this environment, it is very difficult to explain to a trustee, for instance, why an independent administrator who can offer a sophisticated asset valuation and accounting service has not been appointed,”says Chris Adams, head of product for alternative funds, BNP Paribas Securities Services. If investors don’t see a tangible response to requests for third-party services, they may simply decide to go elsewhere, he says.

Market forces have already compelled many in the asset management business to take action. Still licking their wounds from the sell-off in global equities, cash-strapped managers require greater efficiency and are eager to add value wherever possible. To wit, fund management firms accounted for a large portion of the $52bn in new-business wins recorded by BNY Mellon in its most recent quarter.“In many instances, these firms had multiple relationships in place, and it was to their benefit to consolidate a portion of that business,” says Sands.“Rather than building out their own technology and products, managers can simply leverage the investments that the custodian already has on board. So for those reasons as well, I believe that the bundled approach will continue to expand.”

As alternative asset managers continue to outsource back and middle-office duties, they are increasingly relying on service providers to take on such tasks as performance calculation as well as trade processing and trade flow. While clients may retain an independent consultant to perform such services, custodians, who are situated in the middle of the data flow and are already linked to best-of-breed providers of valuation services, make a compelling alternative, offers d’Ouville:“In short, we are able to leverage our position in the information food chain to help bring solutions more effectively and efficiently to our clients.”

As liquidity improves, institutional players have shown renewed confidence in private-equity and hedge fund strategies—good news for custodians who have made alternatives a significant portion of their business model.

“Because we support hedge-fund administration services, naturally we stand to benefit as these fund managers continue to find their way back,” says Sands.“The bottom line is that these strategies are not going away—I think the profile is changing, reflecting the need for plan sponsors and beneficial owners to have increased transparency into fees and investments as well as having a legal structure that is more easily understood. However, the recent returns show that the alternative structure itself has the ability to thrive, albeit in a different form.”

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“That is exactly the sort of bundling concept that we are The market for OTC derivatives continues to move forward, compelling service providers to develop simpler interested in now, particularly as the alternative space and easier-to-support investment strategies covering the continues to grow in importance. Customers are full value chain for OTC processing and risk management, demanding different kinds of bundles, rather than just including trade affirmation and confirmation, cash flow custody with sec lending, or custody with fund calculation and settlement, investment compliance, accounting—it has to be much more creative than that. For independent pricing and collateral management. In instance, we can offer custodial services to our asset and January, Northern Trust announced a strategic alliance with wealth-management divisions that often invest in Numerix, the New York-based independent analytics commodities and other non-traditional instruments. Tying together those strategies for provider for derivatives and that particular customer set is structured products, in an a very valuable offering.” effort to enhance its platform Helping clients process the for derivatives processing on flow of data across the behalf of hedge funds, various service offerings is a investment managers and leading factor in the value institutions requiring daily equation. Rudenstine says: independent pricing for “Providing easy access and structured products. proper packaging of “The derivatives industry, information as it pertains to regulators, investors and our custody and accounting is clients globally are increasingly important to demanding increasing clients, and will become even independence and transparency for OTC more so over the next several derivative valuations,” notes years. For large global Peter Cherecwich, chief custodians who operate on a operating macro level, information officer for such as fund flows, trading corporate and institutional flows and other kinds of services at Northern Trust. aggregate market data are “Derivatives perform critical increasingly in demand.” functions for investment Today, it is nearly managers and institutional impossible for a custodian to investors, and our global avoid having a frank and alliance with Numerix brings open dialogue with clients a range of valuation about matters related to risk capabilities and depth of as well as other aspects of knowledge to help our clients ongoing business exercise greater control over operations—which, says valuation of these assets Vince Sands, executive vice-president and head of US custody, Rudenstine, is completely while meeting the standard BNY Mellon. As custodians become increasingly responsible for appropriate and long for transparency demanded reconcilement, collateral and other duties that in the past would overdue. “This is a very by sophisticated investors.” have been typically outside of their purview, the consolidation of Service bundling is complex and evolving services has paved the way for a wealth of other opportunities, another key differentiator for business—things are so says Sands.“For instance, as we become the natural repository much different than they custody players.

Last for all of this information, we are now in a position to be more were just a few years ago in autumn, JPMorgan of an accounting agent, as well as provide performance terms of how the business is announced the formation of measurement and risk products.” Photograph kindly supplied by constructed and what that its Prime-Custody Solutions BNY Mellon, February 2010. means from a risk Group, a team responsible for delivering the firm’s integrated prime brokerage and perspective.You have to always be on top of the issues and custody platform to clients. The unit serves hedge funds maintaining a proactive stance, whether you’re a client or a and asset managers seeking a combination of prime provider, plus there were many people on both sides who brokerage capabilities and securities services. Another went a long time without being totally up to speed about tool, EPIC, ties together cash trade, execution with how things had evolved and how it would impact them. As custody. Both allow JP Morgan to use its global scale in a result, they are now asking a lot of very tough questions. both custody and prime services to deliver value to its The thing is, if everyone was always asking tough questions, it wouldn’t be such a shock should a crisis emerge.” customers, says Rudenstine.

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BERMUDA: LEVERAGING OFFSHORE STRENGTH

SAFE PORT IN A STORM

Photograph (c) Dreamstime.com, supplied February 2010.

With an insurance market comprising nearly 1,400 companies, total assets of $442bn and gross premiums of $142bn, Bermuda boasts the third largest insurance market in the world. Listed insurance companies and insurance-linked securities have a combined market capitalisation of some $39bn on the Bermuda Stock Exchange (BSX). In October last year, the new Insurance Amendment Act 2008 came into effect, under the auspices of the Bermuda Monetary Authority (BMA). The Act is intended to cement Bermudaâ&#x20AC;&#x2122;s role as a rising insurance hub and spur innovation of new insurance product, with particular regard of late to catastrophe bonds.

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ogically, with a strong and broadening regulatory regime, an increasingly sophisticated stock exchange and a fortunate location between the US and European markets, Bermuda is a natural meeting point for the insurance and capital markets segments. No surprise then that according to Andre Perez, chief executive officer of Horseshoe Group, the Insurance Amendment Act provides specific risk based regulations for the establishment of special-purpose insurers (SPIs) as a new class of insurer within Bermudaâ&#x20AC;&#x2122;s insurance class system. It also recognises and facilitates the structure of insurance linked securities (ILS), such as catastrophe bonds (cat bonds).

Moreover, the listing of these securities on the BSX, an internationally recognised stock exchange, makes the securities significantly more attractive for potential investors, suggests Perez. The BSX now has a new opportunity to play a significant role in the convergence of the insurance and capital markets, he adds. Certainly, the RG/BSX Bermuda Insurance Index has become a bellwether indicator of the market performance of publicly listed reinsurance and insurance companies, with both mind and management in Bermuda. At the same time, seven catastrophe bonds, with a combined value of $370m, are now listed on the exchange; the most recent being the Montana Re Principal at Risk Variable Notes cat bond, which listed in December 2009.

Under the new act, SPIs may be established as a special class of insurer, making vehicle creation far quicker, more cost effective and more efficient. Once an SPI is licensed, attention is placed on the original insured, shifting the focus from the SPI to the ceding entity. This is because the SPI is, by definition, fully funded and therefore perpetually solvent.

For example, the minimum capital requirement for an SPI incorporated in Bermuda is just $1 and it no longer has the same financial reporting and audit obligations as under the previous classification system, provided the issuer has met all of its own regulatory obligations. Also, provided all documents are presented correctly to the BMA, the SPI approval process can be completed within a week.

In addition, the BSX has specific regulations for ILS listings, which are not always mirrored by other jurisdictions.

These focus particularly on transparency, something that has become even more important to the end-investors who, in the wake of the current financial market crisis, are looking for higher levels of comfort through enhanced disclosure.

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Why cat bonds?

Cat bonds are an alternative asset class and a compelling diversification tool due to their low correlation with global stock and real estate markets, being linked instead to natural disasters. It is generally felt that they are likely to be used more frequently as a mechanism for capital raising to ensure sufficient levels of coverage for catastrophic events. Like every other asset class, they were impacted as a result of the global financial market dislocation. Since then however, the cat bond market has recovered significantly, with the Swiss Re Catastrophe Bond Total Return Index rising 10% in the first three quarters of 2009, according to Bloomberg. Some

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The BSX is internationally recognised as an attractive venue for the listing of: Hedge Funds Investment Fund Structures Equities Fixed Income Structures Derivative Warrants Insurance Linked Securities Established in 1971, the Bermuda Stock Exchange is the most widely recognised, offshore securities market platform.

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experts believe“there is easily enough risk transferred in the market today to fuel a $50bn per year market,”notes Peter Nakada in an article Insurance-Linked Securities: Last Asset Class Standing, published in RMS RiskMarkets.

According to Guy Carpenter’s Capitalideas.com despite the challenging financial conditions of late 2008 and early 2009, the catastrophe bond market continued to play a critical role for both sponsors and investors over the past 12 months. Throughout the year, as financial markets stabilised generally, catastrophe bond issuance conditions continued to improve. In 2009 some $3.4bn of risk capital was issued through 18 transactions; off sharply however from more than $7bn issued in 2007. In terms of risk capital, the 2009 issuance calendar saw a 25% increase over 2008. Moreover, after declining over the first two quarters of 2009, total catastrophe bond risk principal outstanding increased from $12.0bn at year-end 2008 to $12.2bn at year-end 2009, reflecting a particularly strong fourth quarter for issuance.

Underscoring this uptick, more than $1.2bn of cat bonds were issued in the fourth quarter of 2009, representing more than 40% of the issuance for 2009, representing an optimistic trend line in 2010. A fourth quarter accounting for over 40% of any year’s total issuance has only been reached once, in 2004 notes BSX chief executive officer, Greg Wojciechowski.

“Bermuda can play an important role in supporting this dynamic and growing market by providing listing services for these securities on an internationally recognised stock exchange, a regulatory environment overseen by a well respected regulator, with insurance focus, and some of the largest players in the re-insurance market, all in one place.”

“While we realise that the Cayman Islands have been a leader in cat bonds, we are confident that Bermuda now provides a viable alternative,”adds Perez.

In a post-Lehman world however, jurisdictions need to be noted for their high standards of regulation and transparency if they are to attract new listings and bring investors back to the capital markets. It is this very fact that the Bermuda Stock Exchange is banking on says Wojciechowski. Horseshoe Group’s Perez supports this sentiment:“Since Hurricane Andrew, Bermuda has emerged as the foremost property catastrophe reinsurance market in the world and this new SPI regulation is a step towards consolidating this lead by making it easier for cat bonds to be done out of Bermuda,”he adds.

Regulated by the BMA, the exchange’s rules are conducive, not prohibitive, to innovative products, holds Wojciechowski. He points to the fact that the BMA has recently been commended

by Michael Foot in his Final Report of the Independent Review of British Offshore Financial Centres, and has been appointed as a member of the executive committee of the International Association of Insurance Supervisors. The BMA has also set itself a roadmap for achieving European Directive, Solvency II equivalence and aims to ensure equivalence under the US Reinsurance Modernisation Initiative, he adds.Among the list of achievements cited by Wojciechowski, the Exchange is a full member of the World Federation of Exchanges; a recognised stock exchange of the UK’s Revenue & Customs, considered a

“designated offshore securities exchange”by the US SEC and a designated investment exchange by the UK’s FSA.

Robust backdrop According to Wojciechowski Bermuda stands out as a leader in risk based solvency regulation for the global insurance and reinsurance sectors, backed by the jurisdiction’s credential’s“as an economic success story, with a solid track record of macroeconomic stability” at a time when many other countries are experiencing economic problems.

Bermuda has a high per capita income of over $97,000 and its “public debt ratios still compare quite favourably with those of ‘AA’ peers” noted Fitch Ratings in September 2009.

The Exchange chief executive points to Bank of Butterfield’s $200m preference share offering and successful BSX listing in the first half of 2009, guaranteed by the Bermuda government, “as a perfect example of Bermuda’s ability to cope on its own and also demonstrates that there is a healthy investor appetite here”.

Stable economic growth and high per capita incomes, combined with easy access to the North American and European markets has proved a catalyst for attracting not just business, but intellectual capital to the island.“In addition to a tailor-made regulatory regime for cat bonds, Bermuda has an ideal geographical location, and world-class service providers, [including] law firms, insurance managers, and accounting firms, to ensure top of the line service,”stresses Perez.

Even so, cedes Wojciechowski, Bermuda’s close ties to the US markets mean the jurisdiction hasn’t been completely unaffected by the recent global financial turmoil. Even so, he says: “This has given the Bermudian government and private sector the opportunity to prove its ability to succeed in difficult as well as good times. Unlike some other British overseas territories, Bermuda is financially independent from the UK and it has remained so throughout this international financial upheaval.”

Bermuda’s indigenous re-insurance industry has developed strongly and now supports the global insurance industry, particularly in the US, providing approximately 40% of US and EU broker placed catastrophe covers, according to the Association of Bermuda Insurers and Reinsurers (ABIR). Moreover, the jurisdiction is now the most important offshore supplier of insurance, reinsurance, and payer of property and casualty losses to the US says the Bermuda International Business Association (BIBA).

For those market watchers who continue to be suspicious of offshore jurisdictions, they should be comforted by the BMA’s strengthened regulations governing money laundering and terrorism financing, thinks Wojciechowski.

An independent Financial Intelligence Agency has been established to monitor suspicious transactions, he notes, adding that: “After signing 18 tax information treaties, Bermuda has not only secured its place on the OECD’s white list—a high profile recognition that the country is committed to tax transparency and fully implementing established international standards, but it also has a vice-chair position on the steering group of the OECD’s new Global Forum”.

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The world’s major stock exchanges may perhaps be forgiven for not noticing, but they face a challenge from upstarts located on islands both tropical and temperate that harbour grandiose ambitions. Once viewed as little more than the securities industry equivalent of “flags of convenience,” the offshore stock exchanges today crave recognition as bona fide financial centers able to command the respect of investors and the onshore exchanges. It’s a hard sell, however. Offshore exchanges do provide a valuable service in listing funds, debt instruments and other securities issued by entities domiciled in foreign jurisdictions, but the notion that they pose a threat to London, Frankfurt, Paris, New York and Tokyo is nonetheless a little far-fetched. Neil O’Hara reports.

Photograph © Dreamstime.com, supplied February 2010.

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F ONLY WE saw us, as others see us, goes the old chestnut. The same goes for offshore exchanges. The Irish Stock Exchange (ISE) “does not see itself in the offshore category,”and indeed it does reside within the EU. Then again, Christian Descoups, secretary general of the Luxembourg Stock Exchange (LuxSE), insists it “is not an offshore exchange” and says its clients are “mainly blue chips and large financial institutions.” Moreover, the Channel Islands Stock Exchange (CISX) chief executive Tammy Menteshvilli, who is keen to move the discussion away from onshore versus offshore comparisons, says that

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after 11 years in business the CISX“competes directly with exchanges in other financial centres.”

The numbers tell a different story. The CISX has listed more than 3,000 securities since its 1999 inception with a total market capitalisation of $17bn, but daily trading volume is insignificant. At year end 2009, the LuxSE lists more than 45,600 securities, including 30,805 bonds and 7,285 investment funds, but at €1.08m per day average trading volume doesn’t move the needle. Meanwhile, the New York Stock Exchange (excluding its affiliated European exchanges) lists more than 4,000 securities that have an aggregate market value measured in trillions and trade on average $100bn every day—almost six times the market value of every security ever listed on the CISX. Notwithstanding geographic and jurisdictional semantics, what sets the “offshore” exchanges apart is a business model that relies on listing fees rather than secondary market trading for the primary revenue stream.

For the most part, those listings relate to entities that are not organised under local law either: the LuxSE boasts that it lists securities from more than 4,200 issuers in 105 different jurisdictions, for example.

Investment funds and debt issues dominate the listings at all the offshore exchanges, whose raison d’être remains in large part the satisfaction of regulatory restrictions in countries that permit local investors to buy securities issued by foreign issuers only if they are listed on a recognised stock exchange. It’s a way for local regulators to outsource due diligence and ensure that foreign issuers must submit to some level of regulatory oversight in order to tap the domestic capital market. Domestic regulators guard against the “flag of convenience” risk by requiring offshore exchanges to register and meet minimum standards before listings are recognised under local investment guidelines.

Competition between the offshore and onshore exchanges may be a pipedream, but the offshore exchanges do maintain a spirited rivalry among themselves. Public relations assumes great importance in a business where growth depends on snagging new listings and the exchanges are still trying to dispel pejorative connotations associated with“offshore”financial centres.

Descoups is quick to note that the LuxSE appears on the EU list of Regulated Markets, a designation it shares with its “onshore” rival, the ISE. CISX does not qualify for that EU seal of approval, but touts its status as an Affiliate Member of the International Organisation of Securities Commissions (IOSCO), its registration with the World Federation of Exchanges (WFE) as a “corresponding market” and recognition as an exchange by authorities in the United Kingdom, the United States and Australia. Greg Wojciechewski, chief executive officer of the Bermuda Stock Exchange (BSX), points out that the BSX enjoys the same level of recognition in the US and UK as the CISX, but is a full member of the WFE (as are the LuxSE and ISE), not a mere correspondent.

This regulatory and reputational one-upmanship may be crucial to the offshore exchanges, but from the outside the

Michael Champion, head of product development at Schroder Investment Management in London.“We focus more on what kind of investors the fund will be sold to, which has implications for where we domicile it, the features it will have and how we structure it,” he says. Listing is almost an afterthought, and may even occur after the fund launch if marketing reveals a need for it among potential investors. Photograph kindly supplied by Schroder Investment Management, February 2010.

significance appears more comic than cosmic. Nevertheless, genuine differences between the offshore exchanges do exist.

Gavin Nangle, head of business development for State Street International (Ireland) Limited in Dublin, says the ISE and LuxSE dominate the listings business in the EU for offshore funds (most domiciled in the Cayman Islands, Bermuda or the British Virgin Islands), while players such as CISX have found other niches.“The CISX has developed expertise in property and private equity funds,” he says,“Jersey and Guernsey are more boutique in style. Ireland and Luxembourg dominate the traditional offshore fund business.”

Nangle says fund sponsors seek a listing primarily to make the vehicle available to a wider investor base—and they are not shy about flashing the badge of honour to market the fund. “They will talk about where the fund is domiciled, the investment management process and the quality of the custodian and administrators,” he says, “but they will also point out that the fund is listed on the relevant stock exchange.”The listing signals that a regulatory body other than the jurisdiction of domicile has oversight authority, which may induce some investors to get over the hump and open their wallets.

No matter how vital listings are to the exchanges, the decision whether and where to list a fund comes late in the design and development process, according to Michael Champion, head of product development at Schroder Investment Management in London. “We focus more on what kind of investors the fund will be sold to, which has implications for where we domicile it, the features it will have and how we structure it,”he says. Listing is almost an afterthought, and may even occur after the fund launch if marketing reveals a need for it among potential investors.

The listing venue must meet whatever regulatory obstacle investors have to overcome, but beyond that the sponsor’s convenience often dictates the choice. Funds that comply with the EU’s UCITS directives dominate Schroder’s business; the majority of which are domiciled and have at

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least one share class listed in Luxembourg. It has tapped Jersey and Cayman for local expertise (e.g. property funds in Jersey), to meet the needs of target investors or even to follow historical precedent if a similar fund is already listed on a particular exchange. “If we have good contacts with administrators and a sleek process to set up funds in a timely and cost-effective manner then we tend to repeat the formula,”says Champion.

The offshore stock exchanges are typically one piece of a broader fund servicing capability available in the same location. State Street’s Nangle estimates that the fund service industry employs more than 16,000 people in Dublin, of which the ISE listing group is a relatively small part.

“When fund sponsors make the decision to come to Ireland, they want to see a full package,”he says,“Is there a good set of custodians, accountants, lawyers and tax advisors? Is there an exchange? Listings are an extension of the same market.”

Although the major exchanges could in theory pursue fund listings, it would be a marginal business at best for them, dwarfed by revenue from secondary market trading and primary capital raising. Onshore exchanges also have to consider what effect rule changes may have on their core business, whereas exchanges that depend on listing fees have every incentive to keep up with the latest fund structures and make any necessary changes in their rules to accommodate them in a timely manner.

Investor base The offshore exchanges serve a different investor base, too.

Gerry Halischuk, head of markets and compliance at the Cayman Islands Stock Exchange (CSX), says the exchange aims to meet the needs of issuers who market their offerings to institutional and high net worth investors rather than the retail market. “The CSX offers a tax neutral, low cost niche market with listing expertise on products that are of little if any interest to onshore exchanges,” he says,“The rules are tailored to the latest structures and products; they emphasise disclosure of all relevant information without imposing unnecessarily onerous restrictions.”In addition to reviewing the initial listing document, the CSX reviews on an ongoing basis the suitability of service providers, directors and officers; it also checks that annual audited financial statements and other required disclosures are filed in a timely manner.

Established in 1996, the CSX has listed more than 3,000 securities to date, of which about 2,000 are investment funds, leveraging off the Cayman Islands’ popularity as a tax-free domicile for offshore hedge funds and its full range of fund service providers. Another 1,000 listings are structured debt products, including asset-backed, collateralised debt obligations, credit-linked securities, Eurobonds and, more recently, sukuks and catastrophe bonds.“We provide a high quality listing environment and a high level of service at a low cost,”says Halischuk. He notes that the CSX became the favoured listing venue for catastrophe bonds because it was quick to adapt its listing rules to the features of these instruments.

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The BSX has also gone after catastrophe bond listings; a product Wojciechewski considers a natural for Bermuda, which hosts the third largest pool of insurance capital in the world (please refer to the article A safe port in a storm on page 82). Although trading volume is miniscule at the moment, he has ambitions to develop an active secondary market for catastrophe bonds now that the BSX has comprehensive clearing, settlement and depository facilities. “We’re using less than 1% of our transaction processing capacity,” says Wojciechewski, “We have a very different exchange than the other offshore venues.”

The BSX has about 690 listings today, including 340 investment funds, 255 derivative warrants and 34 secondary equity listings of international companies.

Wojciechewski emphasises that the capital pool sets Bermuda apart because it enables companies to raise money in the local market as well as seek a listing. In some ways, Bermuda is in a different league from other offshore venues, with strong links to the developed economies through the insurance industry. Wojciechewski says Bermuda reinsurance companies underwrite 40% of the catastrophe cover in the US and in Lloyd’s of London, for example, not to mention insuring 250,000 farms in the US. “We are part of a global trading arena,”he says,“We’re not just a nice place to pop up a quick incorporation or get a listing.”He sees an opportunity for the exchange to develop secondary market trading on the back of growing investor interest in insurance-linked securities.

The investment fund listing business at the CSX and BSX however faces a threat from the implementation of the UCITS III directive across Europe, which enables sponsors to sell UCITS-compliant funds domiciled in a member country throughout the EU. In the longer term, though, the growing recognition of UCITS as a brand even outside the EU could undermine the need for a listing anywhere. NonEU regulators know that decades of experience in investor protection have shaped the UCITS framework. “In crude terms, regulators are saying that if these funds are good enough for the Europeans, they are probably good enough for us,”says State Street’s Nangle.

In the past year, hedge fund managers have begun to set up UCITS-compliant vehicles to complement or replace their offshore funds, a trend that favours the ISE and LuxSE over non-EU listing venues. Technically, a listing is not needed to sell a UCITS fund in Europe, but Champion says Schroder typically lists them in Luxembourg anyway. “The network that we sell through is incredibly broad, both geographically and by client type,”he says,“It is hard for us to say unequivocally whether or not a listing is needed. It is relatively cheap to maintain a listing, so we do.”

If fund developers treat listings as little more than a box to be ticked to help sell their products, the offshore exchanges face an insurmountable obstacle to their quest for recognition as peers of the major onshore exchanges. They thrive on a listings-based business model that provides a specific service to certain investors, but among the world’s stock exchanges they will never be more than a footnote.

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FROM DARK TO LIGHT It appears that regulators continue to push for reform of the over the counter (OTC) derivatives market. In early February, European member of parliament, Werner Langen published a draft report on OTC derivatives reforms to be considered by the European Parliament’s Economic and Monetary Affairs Committee in its decision on how the European derivatives markets should be regulated going forward.

Those deliberations began on the 22nd February. The United States is also in the process of clarifying approaches to OTC derivatives products.

Various measures continue to be discussed, revolving around standardising OTC contracts; ensuring that they are traded on lit trading venues (either exchanges or alternative trading platforms) and that all of them are cleared through central counterparties (CCPs). It has also been recommended that those that aren’t cleared are subject to higher capital requirements. Richard Hemming explains some of the dynamics.

UROPEAN MEP WERNER Langen’s report to the European Parliament’s Economic and Monetary Affairs Committee generally supports the mandatory clearing of standardised derivatives through independent clearing between financial institutions. It further endorses the need for greater risk management, transparency and the use of independent central counterparty (CCP) clearing. In those regards, the EU looks to be treading more or less the same path trodden out by US regulators and politicians in an effort to introduced transparency and robust risk controls in the OTC derivatives market.

The report reflects Langen’s view that an important means of reducing risk in the derivatives space is through the utilisation of CCPs, particularly regarding the reduction of counterparty risk. However, Langen also suggests in his report that Europe’s clearing houses, and their risk management systems, should not be owned by their users, nor should they be allowed to compete with each other. Needless to say, the move for further independence in CCP ownership has not found favour with some financial institutions which currently have shareholdings in CCPs.

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Photograph (C) Spectral-design/Dreamstime.com, supplied February 2010.

Langen’s report appears to stress the need to distinguish between the use of OTC derivatives by companies and the trading of derivatives by financial institutions; believing that because corporations rely on being able to hedge risk they should be regarded differently to pure capital markets speculative transactions. Langen also believes that substantive regulation should be put in place to govern any riskier types of transactions that may be entered into by financial institutions. However, in a nod to market dynamics perhaps, the report acknowledges that any regulation emanating from the European Commission must invariably allow financial institutions to continue to clear bilateral trades, as long as they can demonstrate that clear risk assessments are applied and sufficient funds are allocated to meet any regulatory capital requirements.

Separately, the report assumes that the European Commission will ensure that exemptions are available, in defined circumstances, and lower capital requirements are applied to small and medium sized companies accessing the OTC derivatives market to hive off risks. In similar vein, to proposals outlined in the United States, the Langen report states that trade repositories should be introduced

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for all off-exchange transactions and that the European Securities and Markets Authorities should monitor all clearing activity within the European Union and also assumes responsibility for the supervision and regulation of trade repositories.

Although the Langen report is comprehensively drawn and in many respects reflects similar initiatives in the United States and encourages the development of a uniform and international regulation of the derivatives market, it does raise doubts on the efficacy of a new stream of separate European regulations covering the derivatives markets.

This is an encouraging recommendation and may point to a lighter touch in Europe than in the US. Even so, the report is clear that its conclusions are mindful that OTC derivatives did in fact contribute to the escalation of the global financial crisis. In other words, the report has taken a pragmatic stance, with particular reference to the need for regulators to accept that the OTC and exchange driven derivatives markets play a vital role in risk mitigation as well as risk creation. As this edition went to press it was too soon to gauge either market reaction or the projected route that the Parliamentary Committee would take on its findings.

The importance of doing something Even so, regulators and politicians know that in the wake of the financial crisis, they must be seen to be doing something. And in the public’s mind, much of the blame for the crisis lies at the doorstep of complicated derivatives in the OTC market. Of most concern is the lack of transparency in a market where neither the authorities, nor other market participants know of the underlying exposures or liabilities of any two parties in an OTC derivatives contract.

Advancing the case for reform is the fact that during the crisis those derivatives that were standardised and traded on exchanges did not fail. This is because a clearing house stood between the two parties in a trade, guaranteeing that the transaction was completed even if one party defaulted.

And just as important, the clearing houses did not fail. The absence of a clearing mechanism in most of the OTC derivatives markets prior to the Lehman Brothers default was one of the reasons why the explosions in the financial system reverberated so widely. Some call this the “systemic”effect.

The OTC derivatives markets constitute a massive part of the global financial system. Exchange traded futures and options only represent something like 20% of the overall derivatives market. The remainder is OTC. That gives them importance to the wider financial system. This point was burned into policy makers’ minds in the aftermath of the collapse of Lehman Brothers in September 2008, leaving many OTC trades incomplete and causing complete panic.

“What authorities are concerned with is transparency; that what happens in OTC market is reported and companies can’t run up huge positions without anyone knowing,”says David Jenkins, the European Energy manager at Tradition, one of the top three interdealer brokers in the world. Most

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commentators on the derivatives markets agree that there is a need to limit the systemic risk. Equally, most think that in the post-crisis period there have been changes in the financial markets that are heading in the exact direction that the regulators would want.

A growing preference for clearing One example of the market adjusting on its own is that many more OTC derivatives are being cleared in the wake of the crisis (around 60% now, compared to 10% before the crisis). Jenkins says that two years ago, an OTC derivatives contract would simply be between two parties such British Petroleum and Goldman Sachs, today, in the majority of cases, a clearing house is involved: “There would be a straight contract between BP and Goldman Sachs, but instead of there being a contract between the two, they would each have a contract with a clearing house or central clearing counter-party (CCP). Now, instead of having an obligation to each other, each now has (an obligation) to the CCP,”adds Jenkins.

In the wake of the crisis, it’s also clear that the market has backed away from the products that lost institutions (and eventually the tax payer) billions of dollars. These products include derivatives relating to mortgage collateralisation such as credit default swaps. “OTC markets are not opaque,” says Alex McDonald, the chief executive of the Wholesale Market Brokers Association (WMBA), which represents inter-dealer brokers in the OTC markets.

“What were opaque structured products in credit have largely disappeared because people didn’t want to buy them. They couldn’t value them, so they couldn’t sell them.

That market died a death. In the past few months we’ve seen some ordinary asset backed securities come back onto the market, but these are old fashioned asset backed securities; ones that are based on secure mortgages.”

Dangers involved Even so, the ambition for all OTC products to be cleared is fraught with danger, according to the WMBA. That danger can be summarised in the term: regulatory arbitrage. This acknowledges that capital moves into areas where regulation is weakest and hence the argument goes that systemic problems will re-occur. “Overly stringent rules in the European Union and the US risk causing banks to move into other regimes such as Singapore and the UK,” says the WMBA’s chairman David Clark. Some consider a more immediate concern the divergence that is happening between Europe and the US.There is an increasing likelihood that the American legislation will be more interventionist than the European, which will probably be more pragmatic,” says Ruben Lee, chief executive officer of the consulting firm, Oxford Finance Group, and author of a new report on the governance of financial market infrastructure.

A bill was finalised in the US House of Representatives in December that mandates the clearing of OTC derivatives that a clearing house will accept for clearing and which regulators believe should be cleared. Although legislation

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has not been passed, this is an indication of why the US is seen as adopting a more“prescriptive”approach compared to Europe.

According to Clark, capital will migrate to countries whose capital charges are lowest. Another big issue is the clearing houses themselves. Many believe that if compulsory clearing is adopted, this will place clearing houses themselves at risk, because many OTC products simply cannot be valued and hence sold. “The big question is what constitutes a standardised derivative,”adds Lee.“For clearing houses to work, they need to be able to price assets because they could end up owning those assets. There also needs to be liquidity in the market for that product.”

The defining principle for the eligibility of an OTC product for clearing is that it can be relatively easily sold in a secondary market. And on the other side of the coin, some of those eligible products have not previously been cleared, because it was against the interests of some of the big banks, says Mr Lee. “Some banks don’t want these products to be centrally cleared because they had relatively good credit worthiness compared to other parties, so those parties had to deal with them. Plus, if (an OTC derivative) doesn’t go through a (clearing house) the market may be more opaque with bigger spreads, so the banks can make more money.”The question of ownership of clearing houses has been raised in the United States. An amendment in the US has proposed that any clearing house not be owned more than 20% by any one bank, on the basis of there being a conflict of interest. However, opponents of the proposal have pointed out that it is in the member banks’ interests to ensure the capital adequacy of any clearing houses in which they part-own. The idea behind this is that if one member of the clearing house goes down, the others have to step in to cover its debts – that is, unless the clearing house is adequately provisioned to take them on.

Standardisation One proposal that received more support from those interviewed was to increase the capital requirements OTC derivatives, to encourage participants to use standardised products. This view acknowledges that there will always be a highly specialised or bespoke market for OTC derivative products. “There has to be encouragement for people to go to more standardised products because there are less capital requirements,” says New York based Ed Greene, a partner in the law firm Cleary, Gottlieb, Steen & Hamilton LLP. However, standardisation implies the need to know what all the participants have in terms of exposure to the OTC market and secondly it requires an understanding of how much capital is required for each product. The first point is being answered in the US by the Depository Trust & Clearing Corporation (DTCC) and a similar body is being set up in Sweden. The DTCC’s depository provides custody and asset servicing for 3.5m securities issues from the United States and 110 other countries and territories,

valued at $28trn. In 2008, DTCC settled more than $1.88 quadrillion in securities transactions. The second element: how much capital is required by parties in OTC derivatives transactions is being addressed by the Financial Stability Board. At the G20 Summit in Pittsburgh on the 25th September 2009 the following declaration was issued:“All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end 2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements. We ask the [Financial Stability Board] and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.”

At the operational level the OTC market for derivatives has changed a great deal as participants seek to reduce counterparty risk. This introduces a whole new set of risks for the market, according to Steve Ingle, global derivatives product manager at BNY Mellon Asset Servicing, a New York based securities services group: “Since the economic crisis we have seen static volume but lower overall value, because players are buying more contracts for smaller value. One deal could be worth £1bn was previously done with one counter-party, but now the deal is split into five deals with five counter-parties.”

This leads to a need to monitor many more counter parties and their collateral for any particular transaction.

Ingle says that this represents a problem for the majority of his clients, which are mainly asset managers and pension funds: “From a servicing perspective it’s a risk to clients because they don’t have the expertise or the infrastructure to deal with this.”

The key problem that crops up in relation to creating standardised OTC products is valuation because by definition these products may have little or no value beyond that which the parties involved hold for them:“It’s how you value an OTC product that counts, as the valuation is theoretical; if the holder is a pension fund and it matches their liability 50 years hence, then the value is in the net effect on the portfolio, not today’s modelled value for the product.” As the market changes, so do the institutions charged with operating it. As the business of clearing is getting bigger and bigger, there is an increasing tendency for this business to merge with others as companies see the dollar signs.” The difference between clearing houses, OTC inter-dealer brokers and exchanges is becoming blurred,” says Tradition’s Jenkins. “You have exchanges buying clearing houses and OTC brokers trying to buy clearing houses and even exchanges. The old days of saying we’re an exchange, or we’re an OTC broker, or we’re a clearing house are very much gone.”With this in mind, policing the giant derivatives industry could prove to be a bigger headache than the well-meaning politicians and regulators had imagined.

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LIFE THROUGH Financial institutions are worried that regulators have failed to understand the impracticality of some of their proposals to clean-up the derivatives markets, and the fact that lawmakers are backing the proposals is prompting even more cause for concern. The need to ameliorate the system and provide regulators with more power to identify weaknesses has spurred the lawmakers into action. Paul Whitfield reports.

HE USE OF a growing array of derivatives and the related application of more sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions,” said Alan Greenspan, in May 2005.

Greenspan, then chairman of the US Federal Reserve, was wrong. With the benefit of hindsight it is apparent that the “use of a growing array of derivatives” was integral to the creation of a toxic mix of over confidence, miscalculation and risk concentration.

When the largest financial institutions were tested, in 2008, by a dip in US house prices, many were not only less resilient as a result of their exposure to derivatives they were proven to be positively, and expensively, fragile.

American International Group (AIG), one of the most enthusiastic hoarders of a certain type of high risk

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A LENS? derivative, called credit default swaps (CDS), collapsed and was subsequently bailed out by the US government at a cost of $18bn.

Inevitably, and justifiably, the role that derivatives played in the near-global collapse of the financial system has thrust them centre stage as lawmakers reassess the instruments’ regulation and investors reassess their worth.

That process has polarised commentators, politicians and even market participants. Advocates for a light regulatory touch claim that those who have fingered derivatives for the financial crisis have the wrong culprit. Worse, they say, heavy-handed intervention and misguided laws risk crippling a market that benefits the global economy.

“Derivatives weren’t the cause of the crisis. That is the bottom line and there is no credible case to show that they were,” says Richard Metcalfe, head of policy at the International Swaps and Derivatives Association (ISDA), a derivatives trade association. “The cause was poor lending practices and a miscalculation of risk.”Those on the other side of the argument, meanwhile, fret that governments are

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letting the derivatives’industry off too easily. Joseph Stiglitz, the Nobel laureate economist and lecturer at Columbia University, in January warned that rules proposed by the Obama administration do not go far enough in curtailing institutional use of derivatives. That, he claimed, risks leaving“institutions too intertwined to fail”.

Derivatives, as their name suggests, are contracts that derive their value from something else, typically one of: interest rates, equities, credit markets, foreign exchange or commodities. The contracts are typically leveraged. Most require only a small margin to be placed as security. In their most simple form they can provide the right to buy at a future date at a fixed price. The value of the derivative in this instance is determined by the cost of the underlying object compared to its contract price in the derivative.

Called futures or forwards, these derivatives are widely used by industry to fix the cost of inputs allowing them to better plan for future expenses or fix profits made in foreign markets by locking in a specific exchange rate. Banks often use interest rate futures to lock in rates, allowing them to offer mortgages at a fixed rate.

Derivatives come in other forms: options provide the holder with the right but not the requirement to buy or sell at a given price; swaps exchange one type of contract for another (for example a floating rate loan for a fixed rate loan); while a swaption combines both. Derivatives might be linked to almost any risk that is quantifiable and, more importantly, that two parties are willing to trade. CDS, for example, are linked to the likelihood of debtor default. They are also not necessarily utilitarian in nature. Financial institutions, including banks, have booked billions in annual profits from trading derivatives on their own behalf, a practice known as proprietary trading.

The OTC market Derivatives can be traded on exchanges, which operate in much the same way as stock markets. Yet by far the largest market, both in terms of contract size and in total value, is the over-the-counter (OTC) market. Here, bespoke derivatives, details of which are rarely released, are created through direct negotiation between“dealer”banks and buyers.

The derivatives market matters because it is huge. Some 94% of corporations in the Fortune 500 use derivatives to manage business and economic risk, according to a 2009 survey conducted by ISDA. The use of derivatives in the financial sector is almost universal, the survey found, while only service companies report usage rates lower than 90%.

The notional amount of all the outstanding OTC derivatives was about $605trn at the end of June 2009, according to the Bank for International Settlements. That is about 15 times the size of the global equity market and 28 times the size of the securitised debt market. Yet the notional figure inflates the size of the market by overvaluing some contracts and effectively double counting others.

A better figure is the gross credit exposure, which describes the settlement value of derivative contracts and strips out bank claims against each other that would either

Richard Metcalfe, head of policy at the International Swaps and Derivatives Association (ISDA), a derivatives trade association.

“Derivatives weren’t the cause of the crisis. That is the bottom line and there is no credible case to show that they were,” says Metcalfe. “The cause was poor lending practices and a miscalculation of risk.”

Photograph kindly supplied by ISDA, February 2010.

way cancel each other out during settlement. That figure is about $3.7trn in OTC contracts, according to the Bank for International Settlements. That is still significant but now less than 1% of the notional value of the market and less than 10% of the size of global stock markets. However, it is not just size that makes the derivatives market important as regulators and governments discovered in 2007 and early 2008. It is the way that the contracts tend to connect financial organisations, making them interdependent and potentially exposing the entire system to mismanagement at key points in the chain.

The need to ameliorate the system and provide regulators with more power to identify weaknesses has spurred lawmakers into action. In May 2009 in a letter to Congress, Treasury secretary Timothy Geithner identified four key goals of new regulation: to prevent activities in the OTC derivatives market from posing a risk to the financial system; to promote the efficiency and transparency of that market; to prevent market abuses; and to ensure that OTC derivatives were not inappropriately marketed to unsophisticated parties. Much the same targets have been identified by the European Commission, which has promised “global consistency,” though it is lagging the US in implementing new regulations.

“The default of Lehman Brothers, the near-collapse of Bear Stearns and the bailout of AIG highlighted to all involved the significant role played by OTC products,”says Edmund Lakin, of London and Brussels-based Cicero Consulting, a financial services public policy consultancy.

“The key focus [of regulators in the wake of the financial

MARCH/APRIL 2010 • FTSE GLOBAL MARKETS

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crisis] has been on bringing more transparency [to the derivatives market], which has in practice meant trying to move derivative trades onto exchanges, standardising OTC derivatives, introducing central counterparty clearing and increasing reporting to trade repositories.”

Can OTC go on-exchange?

The Obama administration in December lined up behind Geithner’s proposals when it published a House of Representatives Bill called the Wall Street Reform and Consumer Protection Act, which includes the Derivative Act. The act expands the powers of two regulators, the Securities and Exchanges Commission [SEC] and the Commodity Futures Trading Commission (CFTC) to oversee the derivatives market with responsibility split depending on the type of derivative.

It also seeks to standardise much of the OTC trade in derivatives and push it on to exchanges and through central clearing platforms operated by authorised central counterparties, or CCPs. This should make the market more transparent, both in terms of the products being traded and the positions held by participants. It is also likely to make it more resistant to shocks. CCPs will require margins and collateral to be posted on all derivatives—it is already common practice in many instances—adding a buffer to the system should an institution fail. The faith in CCP’s ability to do this was bolstered in the financial crisis when LCH.Clearnet, the largest clearer of interest-rate swaps, helped to unwind Lehman’s position by quickly processing its $9trn, approximately, of OTC interest rate derivatives.

The ideas sound good in theory, but critics of the proposals fear that they risk making some useful derivatives prohibitively expensive and that legislators have anyway failed to understand the impracticality of some of their proposals. Non-financial firms have made their opposition to the new initiatives clear. An open letter from the European Association of Corporate Treasurers to the commissioners of the European Union, which was signed by companies including EDF, Nokia and Marks & Spencer, declared European industry to be “deeply concerned by some of the proposed reforms”.

“The intent to drive OTC derivative transactions into central clearing and on to exchanges will increase liquidity risk [to the hedging company] and funding costs through the requirement to post cash collateral, and reduce flexibility to match underlying concerns,” the letter said. A similar letter, from the heads of US industry, was sent to Capitol Hill in October last year. It is not only the non-financial participants in the derivatives market who are concerned.

“Higher capital charges on credit linked instruments in the trading book will be material,”according to ISDA’s Metcalfe.

He claims that the capital cost of trading books will rise between three and 11 times their current level.

Given the amount of capital that banks and other financial institutions have already had to raise, and given the ongoing strictures in the capital market, that could prove prohibitive. Financial institutions are also worried

FTSE GLOBAL MARKETS • MARCH/APRIL 2010

that regulators have failed to understand the impracticality of some of their proposals. They point out that the idea of standardised contracts is at odds with the OTC market, which exists, theoretically, because of the need for nonstandard contracts to match specific needs. It also stands to reason that many contracts with unusual terms are by their nature illiquid and thus unsuitable for exchanges. The size of many of the OTC contracts, which are often very large, also mean they are likely to have significant effects on exchange pricing, making the market in derivatives uncomfortably volatile. “For a derivative to be clearable safely—in other words without actually adding to systematic risk—it must also be liquid,”said Metcalfe.“Not all lawmakers appear to have come to terms with that.”

Inevitably, some derivative trading will remain in an OTC-like market. Even so, there will be a cost associated with that privilege. Lawmakers want derivatives that are not cleared to attract even larger capital and margin requirements. They will also have to be logged with a central repository, though exactly what kind of body that is, and how accessible its records will be, remains to be determined. The book-keeping requirements for all participants in the derivatives market will also be increased, with swap dealers and major participants required to keep audit logs and daily trading records.

Clamping down on bank trading Alongside laws focused on dragging the trade in OTC derivatives out of the shadows, governments have also announced intention to clamp down on bank trading in derivatives. The Obama administration proposes banning banks from trading on their own account, a practice known as proprietary trading, except where it is necessary as part of their market making business.

This facet of the legislation has had fewer critics. The moral case against banks undertaking trading activities that might threaten the rest of their operations is hard to dispute.

Banks, many of which are still sheepish following their bailouts, are little inclined to argue. Indeed, many of the previously most active proprietary traders of derivatives have anyway curtailed their operations under pressure from shareholders and, through unofficial channels, governments who are newly wary of riskier banking activities.

If much of the legislation appears focused on crimping the supply side of derivatives, it is also worth noticing that there has been a dip in demand, too. “That is a structural trend, banks are no longer keen on the [higher risk] products but neither are the customers as they want products they understand,” a senior manager at a French bank said last year.“There will be demand for simpler products.”

Simpler products, more transparent derivative markets and risk averse banks all point to a more secure financial future, if potentially less profitable for some in the derivatives business. Yet vigilance will remain the key.

Derivatives will not become benign, no matter how they are regulated, and it will be once the spotlight has passed from the market that the risk of abuse will return.

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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

LW

1

-10

2

-3

3

-6

4

-49

5

-7

6

-14

7

-1

8

-34

9

-67

10

-20

11

-60

12

-16

13

-8

14

-69

15

-5

16

-29

17

-31

18

-22

19

-12

20

-21

Wks

Stock

Description

FFI

6

SL..L

STD LIFE ORD 10P

2.95

25

DGE.L

DIAGEO ORD 28 101/108P

2.94

22

RSA.L

RSA INS. ORD 27.5P

15

CPI.L

CAPITA GROUP ORD 2.066666P

2.86

22

RR..L

ROLLS-ROYCE ORD 20P

2.79

32

SSE.L

SCOT.&STH.ENRGY ORD 50P

2.78

17

WPP.L

WPP ORD 10P

2.78

8

SHP.L

SHIRE ORD 5P

2.77

4

LSE.L

LON.STK.EXCH ORD SHS 6 79/86P

2.76

13

BNZL.L

BUNZL ORD 32 1/7P

2.74

13

NG..L

NATIONAL GRID ORD 11 17/43P

2.74

10

COB.L

COBHAM ORD 2.5P

2.72

26

IMT.L

IMP.TOBACCO GRP ORD 10P

2.72

3

MPI.L

MICHAEL PAGE ORD 1P

2.72

9

PRU.L

PRUDENTIAL ORD 5P

2.71

9

EXPN.L

EXPERIAN ORD USD0.10

1

AML.L

AMLIN ORD 28.125P

7

SGE.L

SAGE GRP. ORD 1P

2.69

10

PFC.L

PETROFAC ORD USD0.025

2.69

18

KGF.L

KINGFISHER ORD 15 5/7P

2.68

2.9

2.7 2.69

Wks = Number of weeks in the top 20 over the last year. Week ending February 5th 2010

Venue Turnover for the week ending February 5th 2010 Venue Chi-X London Xetra Paris Madrid Milan SIX Swiss BATS Amsterdam Stockholm Turquoise Oslo Helsinki Copenhagen Brussels Nasdaq OMX Lisbon Dublin Burgundy

Trades 5,592,511 3,196,819 869,947 1,682,245 961,798 1,110,571 530,341 1,951,299 809,245 750,003 1,163,332 334,447 332,042 169,938 226,279 350,442 192,162 15,359 51,001

Turnover €000’s 35,815,614 30,031,391 19,812,870 19,490,156 18,094,738 15,600,619 12,542,274 10,266,909 9,210,802 7,665,030 6,211,364 4,696,478 3,071,145 1,926,755 1,693,381 1,645,852 1,271,270 172,504 163,749

Share 17.96% 15.06% 9.94% 9.78% 9.08% 7.82% 6.29% 5.15% 4.62% 3.84% 3.12% 2.36% 1.54% 0.97% 0.85% 0.83% 0.64% 0.09% 0.08%

Figures are compiled from order book trades only.

Totals only include stocks contained within the major indices. † market share < 0.01%

COMMENTARY

By Steve Grob, Director of Strategy, Fidessa The beginning of 2010 has seen no let up in the rate of fragmentation across Europe (the FFI of the FTSE 100, for example, has increased by more than 7% just since the beginning of January). Chi-X remains the runaway leader in the alternative space, although BATS Europe has now taken over the second place spot from Turquoise.

Turquoise itself has now been acquired by the LSE and will be re-launched using the LSE’s latest matching engine technology – Millennium.

Both of these facts highlight the growing focus on latency from platform providers. The reason for this is that low latency platforms attract the high frequency trading community which thrives on exploiting minute pricing differences between the same stocks traded on different platforms. This process is made more complicated by the fact that these trading strategies also need to take in to account the differing trading tariffs at each venue especially as the venues themselves are constantly experimenting with different pricing models.

Nevertheless the HFT community now contributes very significant proportions of liquidity (in the US this is estimated to be up to 60% by some industry observers). It will be interesting to see therefore if the LSE’s new platform will succeed in reversing its declining market share. It will also be interesting to see exactly what happens to Turquoise when it is fully under the LSE’s control as currently part of its operation competes directly with the LSE’s main market.

Further change looks afoot at NASDAQ OMX Europe (NEURO) too. NEURO was last of the MTFs to launch and has struggled to gain much traction. Nasdaq is attempting to revive its fortunes by trying to combine the potential for equity in the MTF with commitments to trade there. This is the model that has worked well for Chi-X and other MTFS although whether the trading community wants to own another MTF is open to speculation.

Comparisons of trading patterns between January and a year ago also show that average trade size in FTSE 100 stocks has fallen by around 25% which reflects the increasing impact of algorithmic and SOR engines that are cutting up orders into ever smaller pieces in order to search across the growing list of lit and non displayed venues. As the adoption of these technologies becomes even more widespread we can expect to see average trade sizes shrink even further.

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Venue turnover in major stocks: Week ending January 2010 (Europe only). (€) June

July

August

September

December

January

BTE

19,819,573,785.00

17,136,125,014.00

14,571,686,219.00

22,569,010,036.90

October 27644041971.79

November 23573463734.99

19985719530.83

31150258386.00

CIX

76,420,127,929.00

73,902,822,016.00

71,551,307,518.00

84,046,791,321.19

106697966298.67

90039160470.86

75306622295.52

110977110385.49

CPH

5,812,371,514.00

4,870,382,666.00

7,089,257,770.00

7,147,826,212.47

7580961264.52

5706863159.57

5072932715.84

6756826918.10

ENA

30,976,601,902.00

31,385,199,230.00

30,691,910,028.00

37,393,454,265.25

44333181213.17

32257175002.36

33792253379.23

37999836321.05

ENL

2,198,642,157.00

2,070,066,025.00

2,485,993,487.00

4,261,559,944.59

3485422128.23

2219360066.21

2138868773.27

3106855297.08

ENX

65,114,762,913.00

60,333,614,213.00

59,636,097,679.00

77,685,773,333.81

81861726196.95

65433199147.49

54355876074.24

66228400089.99

GER

59,810,363,156.00

59,120,911,176.00

55,161,793,765.00

69,515,848,590.13

74419073211.90

60908552433.56

52843852540.00

67965895238.29

LSE

109,576,000,000.00

92,086,424,632.00

82,899,283,778.00

96,477,697,345.69

100753579612.36

88751421724.55

72845386108.12

95983836598.48

MAD

46,007,528,734.00

45,653,082,841.00

35,434,917,111.00

47,318,951,034.98

56848573772.28

42670316078.54

39993245595.41

51066014495.96

MIL

50,337,737,317.00

43,251,626,085.00

50,791,257,494.00

78,086,217,226.28

65232722070.55

58890245107.45

34112242363.73

48728657959.10

NEU

2,718,970,582.00

3,543,693,008.00

3,185,323,984.00

4,413,980,819.97

6508249441.66

7449995153.50

5242206607.57

5816854755.80

OSL

13,002,357,861.00

8,191,066,040.00

10,083,367,296.00

13,222,554,868.00

16695154952.77

13184181892.72

11253566686.23

16130924336.37

STO

19,326,314,013.00

18,390,750,978.00

20,842,988,551.00

23,529,554,732.68

25928648845.75

20898321966.79

16954761461.22

22786344725.57

TRQ

19,593,680,671.00

22,795,819,570.00

26,695,607,538.00

26,106,162,960.16

28005208583.96

22895687295.59

15953764952.03

20168098539.34

VTX

33,892,649,428.00

32,849,258,499.00

35,080,948,172.00

37,499,163,419.18

39772295992.78

37198627753.77

31586888591.75

43636990148.75

HEL

8,465,193,200.00

8,937,741,770.00

8,812,985,645.00

10,016,921,672.01

11276385550.29

7451015808.21

6497813980.44

10339952621.77

ENB

6,529,627,899.00

5,189,313,861.00

7,784,709,480.00

10,086,003,222.10

8942068143.91

6366264426.48

5034992980.75

6008003591.11

NAE

75,833,173.13

65,079,038.29

188509367.45

286391174.03

559208778.00

1292687653.19

BRG

367,214,270.90

622,622,788.02

559921470.34

362494501.08

274600248.26

485115578.84

BER

11198473.01

8330897.81

12299869.07

DUS

41944732.75

46475438.04

51353982.31

465074179.96

511570001.10

ISE

Index market share by venue: Week ending February 5th 2010 Primary Index

AEX BEL 20

Venue

Alternative Venues Share

Chi-X

Turquoise

Nasdaq OMX

BATS

Burgundy

Amst.

Paris

Xetra

Stockholm

Amsterdam

61.07%

20.34%

3.75%

0.67%

5.25%

-

-

8.66%

0.16%

-

Brussels

52.10%

19.48%

2.84%

0.68%

4.22%

-

-

20.49%

0.05%

-

CAC 40

Paris

62.65%

21.43%

3.52%

1.05%

5.34%

-

5.44%

-

0.17%

-

DAX

Xetra

66.96%

22.87%

2.92%

0.86%

5.32%

-

†

-

-

-

FTSE 100

London

58.49%

27.07%

4.32%

1.30%

8.20%

-

-

-

-

-

FTSE 250

London

66.24%

20.07%

6.30%

0.57%

6.04%

-

-

-

-

-

IBEX 35

Madrid

99.42%

0.41%

0.04%

†

†

-

†

-

0.05%

-

FTSE MIB

Milan

81.84%

9.86%

1.55%

0.39%

6.14%

-

†

†

0.04%

-

PSI 20

Lisbon

92.66%

3.62%

3.15%

0.11%

0.43%

-

-

-

†

-

SIX Swiss

75.53%

15.84%

3.22%

0.90%

4.13%

-

-

-

-

-

Copenhagen

89.91%

6.44%

1.77%

0.27%

1.61%

0.01%

-

-

-

-

SMI OMX C20 OMX H25

Helsinki

79.99%

10.59%

4.09%

0.85%

2.57%

0.07%

0.05%

-

1.58%

-

OMX S30

Stockholm

77.18%

12.51%

4.09%

0.99%

3.60%

1.61%

-

-

-

-

Oslo

93.76%

2.69%

0.91%

0.09%

0.82%

0.04%

-

-

-

1.69%

Dublin

28.83%

0.17%

1.64%

0.03%

†

-

-

-

69.08%

-

OSLO OBX ISEQ

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 • MARCH/APRIL 2010

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5-Year Performance Graph (USD Total Return) 350

FTSE All-World Index

300 250

FTSE Emerging Index

200

FTSE Global Government Bond Index

150

FTSE EPRA/NAREIT Developed Index

100

FTSE4Good Global Index

50

FTSE GWA Developed Index -1

l-0

0

9

9

FTSE RAFI Emerging Index

Ja n

Ju

-0 Ja n

8 Ju

l-0

8 -0 Ja n

7 l-0 Ju

7 -0 Ja n

6 l-0 Ju

6 -0 Ja n

l-0 Ju

-0

5

0

5

Index Level Rebased (31 January 2005=100)

400

Ja n

MARKET DATA BY FTSE RESEARCH

Global Market Indices

Table of Total Returns Index Name

Currency

Constituents

Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%pa)

FTSE All-World Index

USD

2,745

233.19

1.7

8.7

42.7

-4.3

2.49

FTSE World Index

USD

2,292

545.79

1.7

8.6

40.9

-4.3

2.52

FTSE Developed Index

USD

2,001

217.11

1.7

8.2

38.3

-4.1

2.52

FTSE All-World Indices

FTSE Emerging Index

USD

744

601.23

1.9

12.7

84.2

-5.5

2.24

FTSE Advanced Emerging Index

USD

291

560.76

2.2

14.9

83.1

-7.6

2.55

FTSE Secondary Emerging Index

USD

453

705.08

1.5

9.9

86.4

-3.6

1.94

FTSE Global Equity Indices FTSE Global All Cap Index

USD

7,298

373.86

2.1

9.2

44.1

-4.2

2.40

FTSE Developed All Cap Index

USD

5,846

350.84

2.1

8.7

39.6

-4.0

2.42

FTSE Emerging All Cap Index

USD

1,452

799.36

2.5

13.3

87.2

-5.5

2.20

FTSE Advanced Emerging All Cap Index

USD

620

757.45

2.8

15.1

85.8

-7.7

2.49

FTSE Secondary Emerging All Cap Index

USD

832

902.23

2.2

10.9

89.7

-3.3

1.92

USD

712

183.85

-1.6

2.7

6.2

0.4

2.81

FTSE EPRA/NAREIT Developed Index

USD

273

2275.13

-0.5

11.9

49.6

-5.7

4.19

FTSE EPRA/NAREIT Developed REITs Index

USD

181

774.92

3.8

21.9

47.4

-4.4

5.22

FTSE EPRA/NAREIT Developed Dividend+ Index

USD

202

1640.58

1.4

16.1

53.3

-5.2

4.98

FTSE EPRA/NAREIT Developed Rental Index

USD

221

875.94

3.1

21.2

49.3

-4.3

4.93

FTSE EPRA/NAREIT Developed Non-Rental Index

USD

52

985.37

-9.1

-7.8

50.4

-9.2

2.26

FTSE4Good Global Index

USD

650

5920.88

0.5

7.2

42.3

-4.8

2.81

FTSE4Good Global 100 Index

USD

103

5000.02

-0.3

6.1

38.0

-5.8

2.98

FTSE GWA Developed Index

USD

2,001

3385.60

1.3

8.7

50.6

-3.7

2.67

FTSE RAFI Developed ex US 1000 Index

USD

998

5870.40

-2.7

6.0

52.8

-5.0

2.85

FTSE RAFI Emerging Index

USD

356

6477.07

2.8

11.7

87.5

-5.1

1.95

Fixed Income FTSE Global Government Bond Index Real Estate

SRI

Investment Strategy

SOURCE: FTSE Group and Thomson Datastream, data as at 29 January 2010

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Americas Market Indices Index Level Rebased (31 January 2005=100)

5-Year Performance Graph (USD Total Return) 300 250

FTSE Americas Index

200

FTSE Americas Government Bond Index

150

FTSE EPRA/NAREIT North America Index

100

FTSE EPRA/NAREIT US Dividend+ Index FTSE4Good US Index

50

FTSE GWA US Index Ja n-

10

-0 9 Ju ly

09 Ja n-

-0 8 Ju ly

08 Ja n-

-0 7 Ju ly

07 Ja n-

-0 6 Ju ly

06 Ja n-

-0 5 Ju ly

Ja n-

05

0

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 Americas Index

USD

776

711.16

4.0

9.8

37.3

-4.1

2.04

FTSE North America Index

USD

653

775.06

4.3

9.4

35.0

-3.7

2.01

FTSE Latin America Index

USD

123

1078.07

0.8

17.7

87.0

-8.6

2.48

FTSE All-World Indices

FTSE Global Equity Indices FTSE Americas All Cap Index

USD

2,593

326.27

4.6

10.4

39.0

-4.0

1.93

FTSE North America All Cap Index

USD

2,405

311.21

4.8

10.0

36.7

-3.7

1.90

FTSE Latin America All Cap Index

USD

188

1524.57

1.2

18.4

90.0

-8.6

2.42

FTSE Americas Government Bond Index

USD

176

188.26

0.2

1.7

1.2

1.4

3.14

FTSE USA Government Bond Index

USD

162

184.34

0.1

1.8

0.6

1.5

3.12

FTSE EPRA/NAREIT North America Index

USD

120

2630.95

8.5

26.2

50.9

-5.0

4.22

FTSE EPRA/NAREIT US Dividend+ Index

USD

85

1428.39

7.9

25.7

47.3

-5.3

4.20

Fixed Income

Real Estate

FTSE EPRA/NAREIT North America Rental Index

USD

117

890.91

8.4

25.8

51.4

-5.0

4.21

FTSE EPRA/NAREIT North America Non-Rental Index

USD

3

325.77

11.3

40.3

29.0

-6.9

4.46

FTSE NAREIT Composite Index

USD

128

2562.66

8.5

23.6

45.6

-4.7

5.11

FTSE NAREIT Equity REITs Index

USD

106

6184.30

8.6

25.1

46.7

-5.2

4.14

FTSE4Good US Index

USD

132

4725.05

4.4

9.9

42.6

-4.3

1.89

FTSE4Good US 100 Index

USD

102

4508.04

4.2

9.4

41.3

-4.3

1.91

USD

597

2945.49

4.7

11.2

43.6

-2.6

2.07

SRI

Investment Strategy FTSE GWA US Index FTSE RAFI US 1000 Index

USD

979

5194.23

5.2

12.9

54.7

-2.6

1.70

FTSE RAFI US Mid Small 1500 Index

USD

1,435

4997.93

8.4

16.1

71.5

-2.7

0.93

SOURCE: FTSE Group and Thomson Datastream, data as at 29 January 2010

FTSE GLOBAL MARKETS • MARCH/APRIL 2010

97

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300

FTSE Europe Index (EUR)

250

FTSE All-Share Index (GBP) FTSEurofirst 80 Index (EUR)

200

FTSE/JSE Top 40 Index (SAR) 150

FTSE Actuaries UK Conventional Gilts All Stocks Index (GBP)

100

FTSE EPRA/NAREIT Developed Europe Index (EUR)

50

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

Ja n1

0

09 Ju ly-

9 Ja n0

08 Ju ly-

8 Ja n0

07 Ju ly-

7 Ja n0

Ju ly-

06

6 Ja n0

Ju ly-

05

0

5

Index Level Rebased (31 January 2005=100)

5-Year Total Return Performance Graph

Ja n0

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 (%)

12 M (%)

YTD (%)

Actual Div Yld (%pa)

FTSE Europe Index

EUR

546

222.95

4.7

11.1

36.2

-2.6

3.32

FTSE Eurobloc Index

EUR

284

120.77

2.4

7.9

32.0

-4.7

3.73

FTSE Developed Europe ex UK Index

EUR

374

223.33

3.2

9.4

34.1

-3.5

3.34

FTSE Developed Europe Index

EUR

486

219.23

4.4

10.4

34.3

-2.9

3.38

FTSE All-World Indices

FTSE Global Equity Indices FTSE Europe All Cap Index

EUR

1,514

348.75

5.0

11.9

37.8

-2.2

3.22

FTSE Eurobloc All Cap Index

EUR

776

358.45

2.7

8.8

33.4

-4.2

3.63

FTSE Developed Europe All Cap ex UK Index

EUR

1,054

373.48

3.7

10.4

35.7

-3.0

3.24

FTSE Developed Europe All Cap Index

EUR

1,393

345.04

4.7

11.2

35.9

-2.5

3.29

Region Specific FTSE All-Share Index

GBP

623

3462.44

3.6

14.7

33.2

-3.6

3.34

FTSE 100 Index

GBP

102

3282.37

3.5

14.3

30.4

-4.1

3.47

FTSEurofirst 80 Index

EUR

80

4560.42

2.2

7.4

31.4

-5.6

3.95

FTSEurofirst 100 Index

EUR

100

4139.41

4.2

9.4

31.5

-4.2

3.80

FTSEurofirst 300 Index

EUR

311

1431.90

4.1

10.0

32.2

-3.2

3.43

FTSE/JSE Top 40 Index

SAR

41

2717.69

1.8

11.2

33.0

-3.8

2.03

FTSE/JSE All-Share Index

SAR

163

3001.79

1.4

11.3

33.2

-3.5

2.28

FTSE Russia IOB Index

USD

15

928.61

7.1

28.2

134.3

0.0

1.79

FTSE Eurozone Government Bond Index

EUR

232

170.40

0.5

1.7

6.0

0.4

3.66

FTSE Pfandbrief Index

EUR

384

207.65

1.1

3.9

8.4

0.8

3.64

FTSE Actuaries UK Conventional Gilts All Stocks Index

GBP

37

2303.76

-1.1

2.5

4.3

0.7

4.06

FTSE EPRA/NAREIT Developed Europe Index

EUR

79

1804.34

0.2

19.2

41.0

-1.7

4.57

FTSE EPRA/NAREIT Developed Europe REITs Index

EUR

36

660.08

0.0

18.1

39.8

-2.3

5.17

FTSE EPRA/NAREIT Developed Europe ex UK Dividend+ Index

EUR

40

2241.56

1.1

22.5

40.1

0.0

5.27

FTSE EPRA/NAREIT Developed Europe Rental Index

EUR

70

708.31

0.4

19.6

41.4

-1.7

4.68

FTSE EPRA/NAREIT Developed Europe Non-Rental Index

EUR

9

491.04

-7.5

7.3

30.4

-3.8

1.25

FTSE4Good Europe Index

EUR

264

4364.27

3.5

9.5

33.6

-3.3

3.51

FTSE4Good Europe 50 Index

EUR

52

3756.73

3.0

7.8

27.8

-4.1

3.72

FTSE GWA Developed Europe Index

EUR

486

3158.26

2.9

9.5

47.4

-3.3

3.48

FTSE RAFI Europe Index

EUR

514

4893.61

1.5

8.2

45.0

-3.1

2.80

Fixed Income

Real Estate

SRI

Investment Strategy

SOURCE: FTSE Group and Thomson Datastream, data as at 29 January 2010

98

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Page 99

Asia Pacific Market Indices 600

FTSE Asia Pacific Index (USD)

500

FTSE/ASEAN Index (USD)

400

FTSE/Xinhua China 25 Index (CNY) FTSE Asia Pacific Government Bond Index (USD)

300

FTSE EPRA/NAREIT Developed Asia Index (USD) 200

FTSE IDFC India Infrastructure Index (IRP) 100

FTSE4Good Japan Index (JPY)

0

10

09

Ja n-

lyJu

09 Ja n-

08

08

lyJu

Ju

Ja n-

ly-

07

07 Ja n-

06 lyJu

Ja n-

lyJu

Ja n-

06

05

FTSE GWA Japan Index (JPY)

05

Index Level Rebased (31 January 2005=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

1,290

268.66

0.7

5.5

46.9

-3.1

2.36

FTSE Asia Pacific ex Japan Index

USD

832

527.17

0.2

8.9

77.4

-6.0

2.56

FTSE Japan Index

USD

458

75.81

1.6

-4.1

17.0

-0.8

2.04

FTSE All-World Indices

FTSE Global Equity Indices FTSE Asia Pacific All Cap Index

USD

3,009

455.69

0.7

5.7

48.1

-3.1

2.35

FTSE Asia Pacific All Cap ex Japan Index

USD

1,765

653.19

0.7

9.3

80.5

-6.0

2.53

FTSE Japan All Cap Index

USD

1,244

239.59

1.0

-4.4

16.5

-0.8

2.06

Region Specific FTSE/ASEAN Index

USD

148

547.49

4.9

11.1

80.3

-2.6

2.89

FTSE Bursa Malaysia 100 Index

MYR

100

9257.51

2.0

8.4

49.3

-0.7

2.54

TSEC Taiwan 50 Index

TWD

50

6881.04

3.6

9.6

77.9

-5.8

2.83

FTSE Xinhua All-Share Index

CNY

1,017

8620.88

1.6

-8.2

65.7

-8.2

0.81

FTSE/Xinhua China 25 Index

CNY

25

21921.02

-9.0

-6.8

55.1

-9.2

2.21

USD

225

141.88

0.7

6.5

0.8

2.5

1.27

FTSE EPRA/NAREIT Developed Asia Index

USD

74

1924.37

-6.2

-1.4

46.6

-6.8

4.01

FTSE EPRA/NAREIT Developed Asia 33 Index

USD

33

1255.34

-5.1

0.0

42.5

-6.4

4.15

FTSE EPRA/NAREIT Developed Asia Dividend+ Index

USD

44

2016.75

-4.3

3.8

55.2

-6.4

5.72

FTSE EPRA/NAREIT Developed Asia Rental Index

USD

34

898.29

0.5

14.8

40.7

-2.1

7.05

FTSE EPRA/NAREIT Developed Asia Non-Rental Index

USD

40

1073.82

-9.8

-9.4

51.1

-9.4

2.18

Fixed Income FTSE Asia Pacific Government Bond Index Real Estate

Infrastructure FTSE IDFC India Infrastructure Index

IRP

76

931.83

6.5

-1.1

68.5

-4.4

0.71

FTSE IDFC India Infrastructure 30 Index

IRP

30

1039.30

4.5

-3.1

70.0

-5.0

0.70

JPY

184

3652.46

1.4

-5.3

16.9

-0.4

2.20

FTSE SGX Shariah 100 Index

USD

100

5136.90

3.2

5.3

36.5

-3.4

2.14

FTSE Bursa Malaysia Hijrah Shariah Index

MYR

30

10365.98

-0.4

5.0

38.1

-2.1

2.68

JPY

100

1036.87

1.8

-2.0

23.5

-3.3

2.02

SRI FTSE4Good Japan Index Shariah

FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index

JPY

458

2710.64

1.8

-3.8

24.7

0.5

2.17

FTSE GWA Australia Index

AUD

102

3929.09

-0.9

11.4

38.6

-5.5

4.28

FTSE RAFI Australia Index

AUD

60

6311.37

0.3

11.3

41.7

-6.1

4.86

FTSE RAFI Singapore Index

SGD

17

8047.72

5.7

5.7

67.1

-5.4

3.17

FTSE RAFI Japan Index

JPY

277

3795.43

2.3

-3.9

21.4

-0.2

2.04

FTSE RAFI Kaigai 1000 Index

JPY

1,000

3934.25

0.2

3.9

57.0

-7.0

2.43

HKD

51

6488.61

-8.7

-5.0

60.0

-8.7

2.60

FTSE RAFI China 50 Index

SOURCE: FTSE Group and Thomson Datastream, data as at 29 January 2010

FTSE GLOBAL MARKETS â&#x20AC;˘ MARCH/APRIL 2010

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INDEX CALENDAR

Index Reviews March-June 2010 Date

Index Series

Review Frequency/Type

Effective Data Cut-off (Close of business)

Early Mar Early Mar Early Mar Early Mar 02-Mar 03-Mar 05-Mar 05-Mar

ATX CAC 40 S&P / TSX RTSI FTSE All-World DAX S&P / ASX Indices TOPIX

31-Mar 19-Mar 19-Mar 14-Mar 19-Mar 19-Mar 19-Mar

28-Feb 17-Mar 26-Feb 28-Feb 26-Feb 26-Feb 26-Feb

06-Mar 09-Mar 10-Mar 10-Mar 10-Mar 10-Mar 10-Mar 10-Mar 10-Mar 12-Mar 12-Mar 13-Mar

29-Apr 19-Mar 19-Mar 19-Mar 19-Mar 19-Mar 19-Mar 19-Mar 19-Mar 19-Mar 19-Mar 19-Mar

31-Mar 28-Feb 26-Feb 26-Feb 26-Feb 09-Mar 26-Feb 26-Feb 26-Feb 26-Feb 26-Feb 05-Mar

13-Mar 14-Mar 14-Mar 14-Mar 14-Mar 14-Mar 15-Mar 17-Mar 19-Mar 19-Mar 06-Apr 07-Apr

NZX 50 FTSE MIB FTSE Asiatop / Asian Sectors FTSE/ASEAN 40 Index FTSE UK FTSEurofirst 300 FTSE techMARK 100 FTSE Italia Index Series FTSE/JSE Africa Index Series FTSE4Good Index Series DJ STOXX FTSE EPRA/NAREIT Global Real Estate Index Series S&P Asia 50 S&P US Indices S&P Europe 350 / S&P Euro S&P Global 1200 S&P Global 100 S&P Latin 40 S&P Topix 150 BNY Mellon DR Indices Russell US Indices Russell Global Indices FTSE/Xinhua Index Series TOPIX

Semi-annual review / number of shares Quarterly review Quarterly review Quarterly review Annual review Asia Pacific ex Japan Quarterly review Annual / Quarterly review Monthly review - additions & free float adjustment Quarterly review Semi-annual review Semi-annual review Annual review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Semi-annual review Quarterly review

19-Mar 20-Mar 20-Mar 20-Mar 20-Mar 20-Mar 20-Mar 19-Mar 22-Mar 26-Mar 26-Mar 16-Apr

26-Feb 06-Mar 06-Mar 06-Mar 06-Mar 06-Mar 06-Mar 05-Mar 26-Feb 26-Feb 26-Feb 19-Mar

08-Apr 26-Apr Late April 01-May 07-May

TSEC Taiwan 50 Hang Seng FTSE / ATHEX MSCI Standard Index Series TOPIX

28-May 19-Apr 01-Jun 31-May 31-May

30-Apr 31-Mar 31-Mar 31-Mar 30-Apr

Mid-May Early Jun Early Jun Early Jun Early Jun Early Jun Early Jun 03-Jun 03-Jun 04-Jun 05-Jun 08-Jun 09-Jun 09-Jun

FTSE Med 100 Index ATX KOSPI 200 CAC 40 OBX S&P / TSX RTSI DJ Global Titans 50 DAX S&P / ASX Indices NZX 50 FTSE MIB FTSE UK Index Series FTSE Global Equity Index Series (incl. FTSE All-World) FTSE techMARK 100 FTSEurofirst 300 FTSE Italia Index Series FTSE/JSE Africa Index Series

29-Jun 21-May 30-Jun 11-Jun 18-Jun 18-Jun 18-Jun 14-Jun 18-Jun 18-Jun 18-Jun 18-Jun 18-Jun 18-Jun

31-May 30-Apr 31-May 31-May 16-Jun 31-May 31-May 31-May 30-Apr 31-May 31-May 31-May 30-May 08-Jun

18-Jun 18-Jun 18-Jun 18-Jun 18-Jun

31-Mar 31-May 31-May 30-May 31-May

09-Jun 09-Jun 09-Jun 09-Jun

Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review Quarterly review - IPO additions only Quarterly review - IPO additions only Quarterly review Monthly review - additions & free float adjustment Quarterly review Quarterly review Semi-annual review Annual review Monthly review - additions & free float adjustment Semi-annual review Quarterly review Annual review Quarterly review Semi-annual review Quarterly review Quarterly review Annual review of index composition Quarterly review Quarterly Review Quarterly review Quarterly review Quarterly review Annual review Emgng Eur, ME, Africa, Latin America Quarterly review Quarterly review Quarterly review Quarterly review

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

100

MARCH/APRIL 2010 â&#x20AC;˘ FTSE GLOBAL MARKETS

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