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ROUNDTABLE: EUROPEAN TRADING – PREPARING FOR MIFID II I S S U E 4 1 • M AY 2 0 1 0

The prime of EM bonds The human face of high touch trading The raw appeal of OSX The promise of the Saudi market

RIGHTING REGULATION:

What’s on the cards? CAN SECURITIES LENDING RETURN TO ITS GLORY DAYS?

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FTSE GLOBAL MARKETS • MARCH/APRIL 2010

HERE’S AN UNEASY peace reigning in the global capital and investment markets. It’s a waiting game it seems. While market professionals undertake the day to day tasks required of their businesses, there is uneasy sense that the big and meaningful market developments remain on hold while regulators decide on the final patina of legislation that will ultimately support or stymie domestic and international money flows. Our cover story this month discusses the pros and cons of varied efforts across the US and European markets to make sense of the crisis of the last three years and what they might do about moving into a post-recessionary reconstruction period. Much now depends on how quickly the Democratic administration can push the financial reform bill through the Senate in May. Europe for one is watching the outcome carefully; particularly as the EU has reforms of its own to implement. However, on the Continent, advancement of concrete legislation will likely have to wait until at least early 2011. Worryingly perhaps, the sting of the financial crisis itself appears simply to refuse to go away; at least outside of pockets of promising growth in the AsiaPacific and Latin America. If you don’t believe that you simply have to look at the continuing strains in the bond markets. The US and European governments still need to raise record volumes of debt over the next three to four years to finance their rescue of the global banking system and help stimulate domestic growth. As Andrew Cavenagh outlines in his polemic on the near term sovereign issuance calendar, the development raises two fundamental questions. Who is going to buy it, and at what price? Both questions are particularly pertinent to US Treasury bonds, the largest sovereign market, which is set to experience the biggest expansion in its history. Federal debt will rise from $7,500bn (equivalent to 53% of national gross domestic product) at the end of 2009, to $15,000bn by 2019, by which time it will represent 67% of GDP, according to recent forecasts from the Congressional budget office. Add to that the requirement to finance President Obama’s universal healthcare programme (reckoned to cost $1trn over the next decade) and you have not only an estimated annual government interest bill of at least $700bn by 2019; but also a generational political shift. For at least half that time, most developed nations will continue to live in straightened circumstances that will severely test liberal notions of the role of the state. Moreover, if legislators do not get right the fine balance between fail-safe but market restrictive regulation and the need to encourage competition and growth, the impact of the financial crisis will be with us all for much longer than a decade. Substantive paradigm shifts are in the wings, it seems. On the upside, conflict (economic or political) often redraws strategic alliances and institutions. If the financial crisis has done anything, it has highlighted the changing role of the IMF and the World Bank and brought into sharp focus their future roles. Moreover, and surprisingly perhaps, it has underscored the utility of confederate institutions such as the European Union, in divining new responses to prospective changes in the global markets. For the purpose of this edition, we have focused on the impact of impending modifications to the EU’s Markets in Financial Instruments Directive (MiFID) on the European trading markets. Our special report on trading combines editorial coverage of the Nordic markets, high touch trading, a roundtable discussion of the benefits or otherwise of market fragmentation following the first iteration of MiFID, as well as an overview of changes in the Asian trading markets.The moral of the story perhaps is that if you don’t get it absolutely right the first time, keep on changing the rules to fit the requirements of a free and competitive market. In that sense, as the old chestnut says: it is sometimes better to travel than to arrive.

Francesca Carnevale, Editorial Director May 2010

Contents COVER STORY RIGHTING REGULATION ......................................................................................................Page 46

The Obama administration is bent on passing substantive legislation that limits risk taking among US financial institutions and creates a new consumer financial protection agency. If the US Senate passes the legislation (which now depends on support from a handful of Republicans), it is likely to provide a catalyst for a number of far reaching reforms to be implemented across the G20 financial markets; calling into question even the operation of supranational agencies, such as the World Bank and IMF. Will regulators spur the emergence of new paradigms for the governance of the global financial and investment markets?

DEPARTMENTS MARKET LEADER

......................................................................................Page 6 Neil O’Hara reports on the growing appeal of emerging market bonds.

BLUE SKY THINKING

THE RETURN OF THE INVESTOR ..........................................................Page 14

IN THE MARKETS

James West, at Standard & Poor’s on the efforts to reignite investor confidence in ABS.

A GROWING CONFIDENCE ........................................................................Page 18 Ian Williams on the growing sophistication in sovereign wealth fund investing.

INDEX REVIEW

UK ELECTION BLUES ......................................................................................Page 22

COUNTRY REPORT

THE GROWING APPEAL OF SAUDI’S CAPITAL MARKETS ....Page 24

FACE TO FACE

ARAB BANK: PREPARING FOR CHANGE ......................................Page 31

Simon Denham, managing director of Capital Spreads takes the bearish view.

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

Executive chairman, Abdel Hamid Shoman explains the bank’s forward business strategy.

GOLD: STEADY AS SHE GOES ................................................................Page 34

SECTOR REPORT

Are analysts too ready to write off gold as a safe haven?

WHY THE WORLD IS WARMING TO NUCLEAR POWER Page 35 Ian Williams on the nuclear industry’s new power brokers.

REAL ESTATE

BRAZILIAN PROMISE ......................................................................................Page 39

DEBT REPORT

THE SOVEREIGN TIDAL WAVE ..............................................................Page 42

SECURITIES SERVICES COMPANY PROFILE

Mark Faithfull reports on key real estate projects in Rio and Sao Paulo.

Andrew Cavenagh reports on the impending stresses in the sovereign debt market.

EUROPEAN SECURITIES LENDING: THE RISK ELEMENT ..Page 50 Lynn Strongin Dodds reports on the industry’s efforts to return to the glory days.

THE VALUE OF COLLATERAL ..................................................................Page 58 By Keith Haberlin, head of securities lending, EMEA, Brown Brothers Harriman.

THE WALGREENS WAY ..............................................................................Page 90 Art Detman reports on the redrawing of America’s pharmacy giant.

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

MARCH/APRIL 2010 • FTSE GLOBAL MARKETS

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Contents FEATURES THE TRADING REPORT

THE FIRM HAND OF NORDIC TRADING........................................................Page 61

The Nordic stock exchanges began their ascent in 2003, when the Stockholm Stock Exchange merged with the Helsinki Stock Exchange to form OMX. By 2006, OMX had also acquired the Copenhagen and Icelandic stock exchanges and a 10% stake in Oslo Børs, later divested. Scandinavia saw three major developments combine last year which brought the region closer to the rest of Europe: standardisation of tick sizes, a central counterparty (CPP) and the introduction of new international trading platforms. Ruth Hughes Liley reports.

THE NEONET/ORC MERGER ......................................................................................Page 65

Will the merger between NeoNet and Orc create a technology and trading behemoth in the Nordic markets? Simon Nathanson outlines the advantages and ambitions of the merger.

KEEPING PACE WITH CHANGE ..............................................................................Page 67

With demand for over-the-counter (OTC) derivatives and other esoteric products continuing to mount, asset managers will require much more consistent trade-cycle data, pricing standards and, above all, increased risk-management tools. For buy side desks on a limited budget, even a nominal degree of process outsourcing is a good way to combat poor inter-operability between legacy systems. From Boston, David Simons reports.

NEW CHALLENGES FOR THE BUY SIDE FRONT OFFICE................Page 71

The pace of change continues to accelerate in the buy-side front office. Although the financial crisis has brought and will continue to bring with it undeniable changes to the securities industry, a number of those issues—particularly those affecting the buyside—have been bubbling under for some time. By Robin Strong, director of market strategy at Fidessa.

HIGH TOUCH SELL SIDE TRADERS IN DEMAND ..................................Page 73

High touch sell side traders once again have a big role to play in equity trading. Although electronic trading has grown to more than 51% of buy side order flow, the bar has been raised for the quality of coverage required from the high touch sales trader. Their market share has dropped but the importance of what they deliver has increased. Ruth Hughes Liley reports.

ROUNDTABLE: THE PROMISE OF MIFID II ..................................................Page 77

Who has benefited most from MiFID’s first iteration? The sell side, claims Clive Williams, head of European equity trading, at T Rowe Price. “If I look at the sell side nowadays: they want to be the client (prop books), they want to be the traditional broker and they want to be the exchange (look at the shareholders of the various MTFs). Is that development necessarily going to suit my business model? Probably not.” Did the rest of the panel agree?

ASIA: SETTING ITS OWN PACE OF CHANGE ............................................Page 86

Asian Pacific equity markets may be enjoying record volumes but they still lag the US and Europe in terms of sophistication and infrastructure. High-frequency trading (HFT) and algorithmic trading, for example, are relatively new phenomenon and exchanges have felt no pressure to strike alliances with each other or Western counterparts. The Singapore and Chi-X joint venture is the notable exception but most markets are expected to continue blazing their own trails. By Lynn Strongin Dodds.

MARCH/APRIL 2010 • FTSE GLOBAL MARKETS

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In the Markets INTERNATIONAL BONDS: FOCUS ON EMERGING MARKETS

Photograph © Sellingpix/Dreamstime.com, supplied April 2010.

BLUE SKY THINKING Bond managers worldwide used to be attracted to invest in the developing countries of North America, Western Europe, Australia and, until not long ago, Japan. The financial crisis changed all that and now it’s the superior growth prospects of emerging markets that seem more appealing. Neil A O’Hara reports. NTERNATIONAL BOND MANAGERS like to invest in countries that have sound public finances: modest budget deficits, a current account in balance or surplus, a reasonable ratio of debt to GDP and a central bank that keeps a close eye on the money supply and inflation. That used to mean the developed countries of North America and Western Europe plus Australia and, until not so long ago, Japan. Emerging markets bonds offered higher yields, but they were risky; the economies were often

mismanaged and prone to currency crises brought on by unsustainable fiscal and monetary policies. The financial crisis has changed all that. Today, it’s the developed countries, led by the United States and UK, that have massive budget deficits, soaring debt-to-GDP ratios and have resorted to quantitative easing, a policy not found in the traditional central banker’s toolkit. Meanwhile, Brazil is running a trade surplus, a balanced budget and has tamed the hyperinflation that

bedeviled its economy for so long. China has amassed enormous foreign exchange reserves as its export-driven development continues at breakneck pace, India is not far behind and Russia, which defaulted only 11 years ago, is also running surpluses. In short, bond managers have to adapt their strategies to a world turned topsy-turvy. Superior growth prospects have long attracted capital to the emerging markets, but all too often the potential went unrealised, either through selfinflicted policy errors or the vulnerability of export-led growth to recessions in the developed world. In the aftermath of the Asian currency crisis, economic management improved and investors began to perceive that the emerging markets might decouple from their dependence on the West. The market meltdown demolished that theory—at least at first—as emerging markets equities and bonds suffered disproportionately large declines. “The diversification people expected to get from many strategies didn’t work,” says Scott Mather, a managing director and head of global portfolio management at PIMCO, the $775bn bond manager based in Newport Beach, California. “We profited by not relying too heavily on historical models and observing new trends that were not present in prior crises.” The sharp recovery in emerging markets asset prices since the March lows has breathed new life into the decoupling idea. Most developing countries escaped the worst effects of the crisis. Their banks are sound, and although public finances have deteriorated somewhat they are still in robust health compared to the industrialised nations, which resorted to extraordinary fiscal stimuli to prop up their faltering economies.“We are going back to a world where differences in

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

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In the Markets INTERNATIONAL BONDS: FOCUS ON EMERGING MARKETS

emerging markets or developed economic performance and nations such as Australia. “I financial markets will reassert wouldn’t be surprised if five years themselves,” says Mather. “We from now people focus on the will move away from the very data coming out of China, Brazil high correlations we had in the and Russia just as much as data last couple of years.” from the US or the European The natural inclination of Union,”he says. managers is to boost the Salib manages about $3.2bn in portfolio weighting in portfolios dedicated either to the emerging markets, but Mather emerging markets or the points out that fixed income developed world. He buys investors face obstacles because mostly sovereign credits, the capital markets in many although for the developed countries have not kept pace market funds he will invest up to with the development of their 30% in high quality corporate economies. Bond markets are credits when the timing is not as liquid as in developed auspicious. The emerging markets, while capital controls markets funds buy corporate on foreign portfolio investment credits, too, although Salib notes restrict access in countries such that the line often blurs in as China. countries like Mexico, where Elsewhere, governments in Brazil and Taiwan have Michael Hasenstab, co-director of international fixed income some corporates are almost introduced taxes on foreign and portfolio manager at Franklin Templeton, the market indistinguishable from sovereign investment flows in order to meltdown underscored the merits of a risk management model risk. He is bullish on corporate keep a lid on the local currency, that focuses on volatility rather than tracking error. He points relative to sovereign credits a move Russia is mulling as out that capitalisation weighted bond indices skew toward today, but not across the board; well. All these impediments countries with the most debt, which may not offer the best it’s a country by country call. Investors’ renewed focus on complicate the portfolio value. While four or five countries dominate the benchmark, fundamentals has manager’s job.“It’s a struggle,” Hasenstab typically has 20 or even 30 in his portfolios.“We’ve credit says Mather. “Five or 10 years always had more diversification than the index,” he says.“That shattered the convergence from now all these countries has helped us over the last couple of years.” Photograph kindly among bond spreads within the will be a much bigger share of a supplied by Franklin Templeton, April 2010. euro zone that was in evidence before the crisis. In early 2007, well diversified fixed income had narrowed to 300 bps by mid- the market wasn’t worried about credit portfolio than they are today.” Other portfolio managers share November 2009.“What is different from risk. The yield spread between Mather’s positive view of the emerging past crises is the majority of emerging German and Italian bonds hovered markets. Ihab Salib, senior portfolio markets rebounded and have fared around 10bps to 20bps even though manager and head of the international much better than expected,”says Salib. Germany boasted debt-to-GDP of fixed income group at Federated “It validated the change in about 60% while the ratio for Italy exceeded 100%. “It was almost Investors, a $400bn money manager fundamentals for most countries.” He expects demand for commodities impossible to make money by picking based in Pittsburgh, Pennsylvania, notes that Mexico, Brazil and Russia to underpin growth in natural resource- the right sovereign credit,” says had crossed over to become investment based economies including Brazil, Michael Krautzberger, a European grade credits even before the crisis. which has not only vast mineral wealth fixed income portfolio manager in the Although the yield spread of the but also a thriving agricultural sector. London office of BlackRock, the Emerging Markets Bond Index over US China and India will remain the engines $1.4trn New York-based global asset Treasuries blew out from 160 basis of global growth and Salib sees manager. “That has changed in a points (bps) in 2007 to 900 bps at the countries that can hang on to their coat- dramatic fashion. Sovereign credit 2008 peak, it soon bounced back and tails doing well, whether they are other analysis has become much more

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

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In the Markets INTERNATIONAL BONDS: FOCUS ON EMERGING MARKETS

important in a portfolio context and as a source of performance.” In midNovember, for example, the spread between Greek and German bonds shot up 40bps to more than 170bps in one week after the Bank of Greece revealed that the country’s commercial banks were disproportionately dependent on emergency liquidity just as the ECB plans to scale back its funding support. Like most international bond managers, BlackRock has shifted its emerging markets exposure away from US dollar-denominated bonds towards local currency instruments in recent years. Krautzberger treats the currency risk as an independent investment decision; he may go long the currency alone through the forward market or buy bonds for a play on interest rates and either hedge the currency or not. It is always a conscious decision, however. “We never say we like the interest rate market and just take the currency risk,”he says. Although the funds Krautzberger manages do have benchmarks, he can still switch as much as 20% of the portfolios between asset classes. He used that flexibility to scoop up corporate bonds in the spring when market prices implied that almost 20% of investment grade corporates would default within five years. The subsequent rally vindicated his wager, but he has begun to take profits.“The beginning of the year was the time for big asset allocation calls. There were dramatic mis-valuations on an asset class level,” says Krautzberger, “That has corrected. At the moment it is much more about management of volatility and relative value both within and across asset classes.” The corporate spread play also caught the eye of Ken Buntrock, portfolio manager for the global fixed income group at Boston-based

Three years ago, Loomis Sayles had no trouble getting $150m of an issue even if it was oversubscribed, but today competition from new participants has trimmed that back. “It’s unusual for us to get more than $50m now,” says portfolio manager Ken Buntrock.”There’s almost a forced diversification across managers in allocations of new issues in the last six months.” Loomis, Sayles, which has $139bn under management. He admits a bias toward corporate credits; even when spreads were at their tightest in 2007 he had a 20% weighting, 4% more than in the Barclays Capital Aggregate Index. “As spreads widened, we took corporate exposure up to more than 50%”says Buntrock.“We brought that number down over the course of 2009 to about 30%, a more typical overweight position for us.” In the second half of 2009, Buntrock found good value among hard currency sovereign credits, including government-related entities in the Middle East, South Korea and Indonesia. He says these bonds offered spreads similar to investment grade corporates, but the issuers have government support in some form.They have also been sold at par, which plays to Buntrock’s aversion to bonds that trade at a premium. After the rally in corporate bonds, he was happy to sell corporates at 110 or higher and replace

them with new sovereign issues. It has become harder to get the allocations he would like from new issues because so many investors who were not active in the bond market before the crisis have thrown their hats into the ring. The apparently boundless investor appetite for bonds this year has driven sovereign spreads to levels that tempt Eric Stein, a portfolio manager at Eaton Vance, a $155bn asset manager based in Boston, to go short sovereign credit in the Global Macro Absolute Return Fund, a fund he runs that has no benchmark constraints. “Dollar bond spreads are back to what I consider very tight levels in most countries,” he says. “The exposure in local bonds is a lot more attractive. We see more value in currencies from the long side.” Stein favours emerging markets with large populations that can stimulate domestic demand to replace exports to the developed world, which are likely to

G3 Sovereign Bond Issues - Asia (excluding Japan) Pos.

Institution

Amt US$ m

No.

1 2 3 4 5 6 6 6

Barclays Capital Citi Deutsche Bank Credit Suisse HSBC Nomura Mitsubishi UFJ Financial Group Daiwa Capital Markets Total

1,493 989 832 660 504 339 339 339 5,494

4 2 3 1 2 1 1 1 5

27.2 18.0 15.2 12.0 9.2 6.2 6.2 6.2 100

Source: Dealogic, supplied April 2010

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

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In the Markets `

INTERNATIONAL BONDS: FOCUS ON EMERGING MARKETS

“The diversification people expected to get from many strategies didn’t work,” says Scott Mather, a managing director and head of global portfolio management at PIMCO, the $775bn bond manager based in Newport Beach, California. “We profited by not relying too heavily on historical models and observing new trends that were not present in prior crises.” grow more slowly in the future. China, India, Indonesia, Poland and Brazil all have the potential to boost domestic demand as their emerging middle classes start to consume more—and Stein expects their currencies to appreciate against the dollar as a result. In contrast, he is leery of South Africa; the currency has already run up so much that it is hurting the economy and the political winds are blowing in the wrong direction. From a risk management perspective, Stein fears that investors are slipping back into old habits— stretching for yield by extending duration and chasing lower quality assets—that fuelled the credit bubble. “We have this great asset reflation engineered by global governments and central banks,” he says. “Sometimes it’s better to put your money in cash and look for other investments as opposed to getting sucked in to the carry trade or the stretch for yield.”He has no interest in long duration at the moment, particularly in the developed markets. For Michael Hasenstab, co-director of international fixed income and portfolio manager at Franklin Templeton, the market meltdown underscored the merits of a risk management model that focuses on volatility rather than tracking error. He points out that capitalisation weighted bond indices skew toward countries with the most debt, which may not offer the best value. While four or five

countries dominate the benchmark, Hasenstab typically has 20 or even 30 in his portfolios. “We’ve always had more diversification than the index,” he says.“That has helped us over the last couple of years.” Hasenstab bet big on the euro against the dollar through early 2008, but scaled back over the summer in anticipation that the move had played out. He has been Michael Krautzberger, a European fixed income portfolio overweight Brazil and manager in the London office of BlackRock, the $1.4trn New Indonesia for some time in York-based global asset manager. Krautzberger treats the the belief that these currency risk as an independent investment decision; he may economies are going go long the currency alone through the forward market or buy through structural bonds for a play on interest rates and either hedge the transformations that will currency or not. It is always a conscious decision, however. permanently lower risk “We never say we like the interest rate market and just take premiums, but added the currency risk,” he says. Photograph kindly supplied by more emerging markets BlackRock, April 2010. exposure when spreads blew out between October 2008 and abandoned home country bias in March 2009. Now he’s looking for their equity allocations some years currencies that could benefit when ago, it had persisted on the fixed yields begin to climb in the developed income side. “People have begun to world, commodity plays such as Brazil, question the debt sustainability, Chile and Peru. He likes Poland, too, inflation, or just the level of yield in which he feels has been tainted by their home country,” he says. “They proximity to the troubled Baltic States have a greater willingness to look despite public finances that are in much abroad.” The new attitude is one more indication that international better shape. managers today find Hasenstab says clients are looking bond for more international exposure in themselves on the other side of the their portfolios, too. While investors looking glass.

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

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In the Markets BOOSTING FAITH IN VALUATIONS

RESTORING INVESTOR CONFIDENCE Photograph (c) Bertrandb/Dreamstime.com, supplied April 2010.

According to the Q4 2009 Securitisation Report—released in March 2010 by the Association for Financial Markets in Europe (AFME)—the total value of European Residential Mortgage Backed Securities (RMBS) issuance for 2009 stood at £215.2bn. That is less than half the total in 2008 and still markedly below pre-crisis levels. James West, a director of the Valuations & Risk Strategies group at Standard & Poor’s, examines what can be done to return the asset class to the desired levels of both issuance and investor confidence. T IS A widely held view that the market for residential mortgage backed securities (RMBS) played a fundamental role in triggering the global financial crisis. Over the course of the past year and a half, participants from all sides of the structured finance market have stated repeatedly that “normality”may only be restored with the restoration of investor confidence in the asset class. Calls for valuation

transparency have come repeatedly from influential sources. Regulators, market participants and even a G20 communiqué have pushed for increased levels of transparency and consistency regarding how security valuations are carried out. This is because a crucial component of improving confidence depends on restoring investors’ faith in valuations. Therefore, improving transparency

and awareness of the processes and methodologies used to value RMBS assets should help reduce problematic information gaps between buyers and dealers of these assets. Consequently, knowing the consensus view of the market should help investors assess and justify their own input assumptions, increase confidence among potential buyers and possibly even encourage new participants into the market. To contribute towards achieving this aim the Valuations & Risk Strategies group has been working with investors to develop a consensus, or benchmark, of the key assumptions used when market players undertake intrinsic valuations of structured finance assets. This has been manifested in the form of a series of quarterly consensus surveys, in which participants in the US and European structured finance market, equally split between the buy side and sell side, are invited to quantify the four key assumptions they make when stress-testing the underlying collateral behind UK, European and US RMBS transactions—the largest asset class in the asset backed security market. The key assumptions identified in the surveys are constant default rates (CDRs): that is, the percentage of debtors not keeping up repayments leading to repossession or delinquency; loss severity; the severity of any losses occurring on the collateral in default; constant prepayment rates (CPRs), the percentage of debtors making early repayment of principal, and recovery lag, the time it takes to recover any monies due. Survey respondents—primarily risk managers, credit analysts and portfolio managers—are asked to provide these key assumptions on an asset class level (for example, for

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

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

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ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟŽŶ ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

In the Markets BOOSTING FAITH IN VALUATIONS

Prime RMBS, Non-Conforming Loan RMBS, Sub-Prime RMBS etc), a vintage level, and also on an individual deal level. Considering results across the various surveys provides us with detail about how investors’ expectations for the performance of underlying collateral are changing. The survey is structured to allow developing trends in intrinsic valuation methodologies to be seen. The most recent survey was conducted in January 2010 and related to Q4 2009. The results—released to participants in February—imply signs of buy side and sell side valuation methodologies becoming more aligned since the previous survey. Nevertheless, there remain concerns

vintages over the next 12 months is 4.61%, a fall from 9% polled in Q3. For Prime UK mortgage default rates, the 12 month average forecast for all vintages also fell, from 2% in Q3 to 1.09%. Forecasts for Spanish, Italian and Dutch mortgage default rates also reduced. For all vintages of UK Prime RMBS collateral, 12-month loss severity estimates dropped to 26.7% from 27.6% in Q3 and for NCL RMBS collateral they dropped back to 33% from 36% in Q3. In contrast, 12month US Prime RMBS collateral loss severity estimates have risen close to the level of lower quality US mortgage classes. For 2005, 2006 and 2007 vintages, US Prime RMBS collateral `

For UK Non-Conforming Loan (NCL) RMBS collateral, the predicted rate for an average of vintages over the next 12 months is 4.61%, a fall from 9% polled in Q3. for the performance of some classes of mortgage collateral, particularly in the US, and there are still some disparities between the valuation approaches of different sides of the market. In terms of the key input assumptions, when considering expected default rates on the underlying mortgage collateral, survey respondents’ estimates on virtually all classes and vintages of US RMBS have increased significantly since the previous survey. Indeed, predictions for 2004 US sub-prime adjustable rate RMBS collateral defaults have moved out from 13% to 26%. These assumptions contrast with a definite improvement in expectations for default rates across all classes and vintages of UK RMBS collateral. For UK Non-Conforming Loan (NCL) RMBS collateral, the predicted rate for an average of

loss severity forecasts now average 59% (up from 47% polled in Q3). These deteriorating assumptions around US Prime RMBS collateral may reflect the commonly held view that housing markets recover primarily at the bottom section of the market. It is possible that sales of lower-value properties triggered the housing trough but as higher-value properties begin to sell there could be further weakness in house prices in this upper segment of the housing market. When examining participants valuation methodologies, the results from the Q3 survey implied that buy side institutions in Europe were significantly more likely to examine collateral pool data than European sell side institutions. In the Q4 survey, 75% of the European buy side state they use loan-level data (down from 79%) versus 55% of the sell side (up from

52%). Thus the results from Q4 may imply this imbalance is being redressed. One area of disagreement between the buy side and the sell side (and between the US and UK markets) concerns the determination of when, exactly, default takes place. In the UK, nearly 90% of buy side respondents consider default to occur at repossession, versus 47% of the sell side. On the other hand, 43% of US respondents state that foreclosure (or repossession) is the point of default while a slight majority of US participants use delinquency as their point of default. In terms of how European participants’ valuation assumptions are mapped out in the future, 56% of both buy side and sell side institutions surveyed now use input assumptions that are vectored (rather than flat). This represents a convergence of approaches since the last survey when levels were 70% and 46% respectively. This may reflect a trend towards increasing sell side sophistication, a trend suggested by how participants construct their future loss severity assumptions. Some 63% of the European buy side now uses month-by-month (vectored) inputs, up from 50% in Q3, while as much as 46% of the sell side is now using vectors for their loss severity inputs, up from 18% in Q3. With issuance levels of RMBS in Europe totalling £45.3bn in the fourth quarter of 2009 it seems that the need for increasing investor confidence in the asset class will be continuing in the foreseeable future. Looking ahead to the next survey, it is hoped that enough data will be accumulated to create a benchmark of input assumptions and a consensus of methodologies, providing a set of standards around valuation that will assist people undertaking economic (or intrinsic) and market valuation of otherwise hard-to-value securities.

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

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In the Markets THE CHANGING APPROACH OF SOVEREIGN WEALTH FUNDS

A Better Sense of Worth In general, sovereign wealth funds (SWFs) as an investor segment have not had a bad crisis. Many of their coffers are fuelled by energy revenues, which have held up better than expected. As well, their investment strategies have tended to be conservative, which has also helped. Their image perhaps, has possibly altered the most. Having once been regarded with suspicion, they are now viewed in a new light; not only for some inventive investments but also as respected guardians of national wealth. Even so, questions still arise, especially with regards to the transparency of many SWFs. Ian Williams reports. OVEREIGN WEALTH FUNDS seem to have emerged from the financial crisis with a greater sense of their own worth. Alternative assets industry data provider Preqin’s latest report, the 2010 Preqin Sovereign Wealth Fund Review, holds that the aggregate total assets of all SWFs continued to increase through 2009; helped in part by some recovery in the global equities; though the report says that some funds have been utilised to cover budget deficits and to sheer up local, and in some cases foreign financial institutions. According to Preqin, the value of SWFs grew by 9% last year to top $3.5trn, they have been increasingly assertive.While various SWF’s responses to the crisis varied, the Norwegian Government Pension Fund-Global set the gold standard. Not only does it have the highest standards of corporate governance and transparency, it has managed to combine ethical investment standards with aggressive investment policies that would have made the Vikings proud. The Norwegian SWF kept on bargain hunting and ended 2009 25% more valuable than it started, crashing over the $400bn mark by the beginning of this year. Others fared less well perhaps. Sam Meakin, managing editor of the 2010

Preqin Sovereign Wealth Fund Review, points out, the Russians drew down over 54% of their fund reducing it to $60bn. “Their hand was forced to plug the gap in their budgets, when oil prices went down so they had to use the funds.”He adds that the Chilean social and economic fund was depleted by about 45%, down to $11bn, but also deduces that, if anything, this proved the value of the SWFs: one of their roles is as a rainy day fund, and it was surely raining!

New approaches to SWFs A number of governments are now looking to SWFs, with their typically longer investment horizons, to help them with longer-term strategic energy and infrastructure packages that are part and parcel of economic stimulus plans. For example, the British government this year announced that it was looking to SWFs to fund a green bank to invest in alternative energy sources, especially wind farms. Officials at the same time dismissed British institutional investors for an alleged lack of an investment track record in infrastructure; leaving them with little option but to look for foreign SWFs for support. It is ironic that having removed the dead hand of the British state from privatised British airports operator BAA, the same government has

Photograph © Belisksk/Dreamstime.com, supplied April 2010

welcomed recent stakes taken in Gatwick Airport by the SWFs South Korea and Qatar. The ideological aversion from Wall Street and London to state management has largely evaporated in the face of domestic government bailouts and a desperate need for liquidity. Indeed, foreign SWFs looked particularly attractive in this regard, since their investments are not a charge on the domestic state borrowing figures. It remains to be seen however just how permanent the changes are in national attitudes. The crisis has written traditional fears over sovereign dependency out of the window. Preqin editor Sam Meakin thinks that some of the problem was fear of the unknown and that now“SWFs are just a more commonly accepted part of the investor landscape”. However, Columbia/Vale Centre’s professor Karl Sauvant counters:“SWFs were also hit by the crisis and, in response, reoriented a good part of their activities toward domestic markets and also emerging markets. While the latter were partly a response to the less than welcoming attitude of developed countries, during the crisis itself, SWFs were welcome to help bailout financial

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

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In the Markets THE CHANGING APPROACH OF SOVEREIGN WEALTH FUNDS

companies in particular. However, once the crisis is over, I suspect that a more critical attitude will again prevail.” In part that is the fault of many SWFs. At the height of pre-crisis xenophobia, SWFs agreed to the Santiago Principles on transparency, but after two years only about half of them are halfway compliant. We know how much, say, New Zealand or Chile or Norway has in assets. In contrast, the Abu Dhabi Investment Authority does not do transparency; even so, there is a widespread belief that it operates to strict ethical standards. At the far end of the scale SWFs, such as that belonging to Equatorial Guinea, opacity does not translate into the same level of comfort. Even so, SWFs have not extended their reach as rapidly as some analysts expected. Morgan Stanley projected its assets could exceed official reserves by 2011, and Standard Chartered foresaw them reaching $13.4trn over the next decade. There are few signs of such growth by any objective assessment, even in Preqin’s estimates, which are on the generous side. Rachel Ziemba of RGE Monitor estimates that in reality the SWFs only manage something over $2trn in assets; less than a third of the total reserves held by the world’s central banks (currently estimated at some $8trn). Even so, the segment dwarfs the hedge funds segment and Ziemba agrees that they are still highly significant as investors: “They are important investors, especially in some sectors such as energy and resources, and some countries.” Preqin’s Reagan comments: “The Norwegians were quite active when things were at their worst, and of course appreciation of the kroner helps.” Ziemba agrees: “Of course the funds are very opaque, but my sense is that some were placed in a very opportunistic way to take advantage. In

2008, Norway was mandated to increase the equities share of its portfolio to 60%, so some came in high but the bulk were when assets were lower. Also, some in the Gulf liquidated some holdings, so they would have cash ready for the upturn in 2009.” It does seem likely that in the future SWFs, which have traditionally been fairly passive investors, in the case of China making it a point to invest through external managers, might now become more actively involved. Ziemba comments:“Even before 2008, SWFs wanted to know what they were getting for these inflated management fees and now they are using their leverage as some of the largest investors in the market place to make the point even more strongly.”

Clearer ideas The issue came into the open with a meeting in New York in March where the Institutional Limited Partners Association (ILPA), whose SWF and pension fund members claim more than $1trn in assets, met with their private equity (PE) counterparts to demand a new deal that shifted some of the profits from the partners to the investors. The move seemed in part to reflect the general public mood against self-enriching bankers as it did any substantial losses in the PE sector. So where are these funds going now? While some have been happily bottom feeding during the crisis, others fled to safety, but are now coming out with clearer ideas of where they want to invest. Nearly 80% of SWFs are known to invest in public equities, a similar number invest in fixed income, while 55% are known to invest in private equity, 51% in real estate, 47% in infrastructure and 37% in hedge funds. Meakin reports that many were reactivating the portfolio diversification that they had been considering before—with some tweaks towards

clean energy and infrastructure. In the Middle East, food security is the topic du jour. Qatari sovereign wealth fund, the Qatar Investment Authority QIA has already invested almost $1bn in a special agriculture fund in Vietnam to develop agribusiness and export produce back to Qatar. Similar initiatives are under way in Indonesia. Kuwait has invested in Cambodia, Laos and Myanmar in similar ventures. Norway’s global fund last year announced plans for a new environmental investment portfolio to include natural resources, clean technology, environmental services and renewable energy. Others, including Bahrain, announced plans for real estate investment in the US, UK and Japan, presumably bargain hunting in the depressed market. Others, such as China, expressed interest in hedge funds with CIC parking a billion with Oaktree Capital management. Infrastructure and energy, particularly green energy, seem to be more attractive, where the longerterm views of the SWFs are particularly appropriate. Interestingly, both Kuwait and Qatar have been in discussions about taking a stake in Areva, the French nuclear energy giant, signalling that they are taking seriously depletion of oil and gas reserves, although in the case of Qatar, they seem to be considering a nuclear powered plant to liquefy the natural gas, in a marriage of energy forms. Of course, it helps that the investments harmonise with the governments’ strategic development plans, which involve the building of a nuclear energy sector. Ziemba comments that this represents an increasing trend of “SWFs taking stakes in foreign companies that were in sectors supportive of domestic policy goals, like nuclear, and they are looking for joint ventures that bring investment back home, with technology transfer”.

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

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Index Review UK ELECTION: WHO WILL LEAD THE GOOD SHIP CORPORATE UK?

Election Fever The UK General Election is upon us. Come May 6th, either the Labour or Conservative Party will have their hand on the tiller and will be expected to lead Corporate UK through turbulent waters and out of the downturn. The outcome of the election will have a significant bearing on market confidence—both within the UK and from foreign investors into the UK—in the near term. By Simon Denham, managing director of spread betting firm Capital Spreads.

Simon Denham, managing director of spread betting firm Capital Spreads, May 2010

Actually, the FTSE 100 has been taking the calling of a UK general election in its stride; whereas sterling has seen an increase in volatility. The financial markets have made it clear what result they would rather see. For sterling to survive and UK borrowing costs to remain low, it must deal with its budget deficit faster than the current administration proposes. The recent weakness in sterling shows that the financial markets are wary of a hung parliament. An election result with no clear majority will lead to political wrangling that will only cause delays to needed action and any recovery will falter. The worst case scenario for sterling (and more for the FTSE 250 than the FTSE 100) is a hung parliament. While the FX and bond markets are expected to be affected more by the result of the election, different scenarios could mean different implications for different sectors in the equity markets. The electorate ignores these warnings at its peril. This is not the view of “greedy” bankers (the scourge of the majority of UK voters), it’s the view of global investors. Both domestic and foreign investors are concerned that the UK’s budget deficit is too big and will result in a credit rating downgrade. It’s almost guaranteed that the UK will be downgraded if government spending

is not reined in and fast. National insurance hikes are not the answer and only serve to punish those people who are meant to sustain our recovery. Moreover, other tax hikes will not be enough to address the UK’s fiscal issues. It seems the public sector needs to suffer similar pains to that of the private sector. A Tory majority could benefit some sectors as you’d expect to see sterling strengthen on the back of such a result. It would also be to the good of real estate, albeit in the short term. Overall, an outright Tory majority would be seen as good for UK equities and the FTSE100 and FTSE250 will rally. However, there are concerns that their plans to cut earlier and sharper than Labour will send us hurtling back into recession. This is plausible, however not a certainty as it won’t be government spending cuts that’ll reverse the recovery, rather it’ll be weaker consumer spending resulting from rising taxes (the Tories will have to up some taxes) and interest rates. In the event of a Labour majority this will certainly help to remove uncertainty, the market’s worst possible enemy, but their path of deficit reduction has been acknowledged by the markets and seen as wanting. The days ahead will be interesting. As ever, ladies and gentlemen, place your bets.

ITH GROWTH TRIGGERED by continued infusions of government largesse, the UK walks a very narrow tightrope between an ignition of inflation or— when the tap of public money turns off—a return into recession. Current premier Gordon Brown says he worries that any Tory cuts in public sector spending might send the country back into recession. The problem with this argument is that it is his mess in the first place, and the longer the country delays in tackling its deficit, the greater the problem will become. Populist measures also pose a risk. A case in point is the Conservative commitment to unilateral taxes on the banking sector. Banks are, at the end of the day, just businesses, like any other. A country that burdens completely portable businesses with unwarranted taxes deserves to lose them. A possible pointer is the recent departure of the chief executive officer of HSBC to Hong Kong. He has given up on all the political, envious reporting and 50% tax rate problems for the Far East and 15% earnings tax. Just this one person will probably cost the UK exchequer a million quid a year. Be sure too that where the chief executive officer goes, the rest of the senior board will follow. It seems politicians are risking London’s financial hegemony.

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

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Country Report SAUDI ARABIA LURES FOREIGN INVESTORS

DOMESTIC MARKET OF 25m people, significant hydrocarbon wealth and large number of highly investible global and regional companies such as Saudi Basic Industries Corporation (SABIC) and Aramco, makes Saudi Arabia a definite port of call for investors seeking exposure in the Gulf region. However, restrictions on direct equity investment by non-Gulf Cooperation Council (GCC) nationals and low levels of local bond issuance have tempered international institutional investment appetite. The launch on March 28th 2010 on the Tadawul of the kingdom’s first exchange-traded fund (ETF) and a $450m bond issuance on behalf of Dar Al-Arkan Real Estate Development Company (DAAR Dar Al-Arkan), a leading residential real estate developer in the Kingdom of Saudi Arabia, look set to ignite interest further.

Market capitalisation Downtown Riyadh. Photograph © Msteckiw/Dreamstime.com, supplied April 2010.

SLIDING DOORS The launch on March 28th 2010 on the Tadawul (Saudi stock market) of the kingdom’s first exchange-traded fund (ETF) and a $450m bond issuance on behalf of Dar Al-Arkan Real Estate Development Company (DAAR Dar Al-Arkan), a leading residential real estate developer in the kingdom, looks set to ignite interest further from foreign investors. Despite concerns over the limitations imposed on foreign investment inflows, international investor activity has been growing in Saudi Arabia. According to figures released for February by the Tadawul, foreign swap arrangements accounted for 1.4% by value of all sell orders and 1.9% of all buy orders. While still relatively small in relation to the market as a whole, this level of activity is significantly higher than the levels witnessed 12 months earlier when foreign swap agreements accounted for only 0.2% of all trading activity on the exchange. If this growth rate continues, foreign swap arrangements will outstrip trades by Saudi mutual funds by the end of the year.

The Tadawul is by far the largest exchange in the region and at one point when the Tasi (the Tadawul All Share Index)—the main benchmark index— hit 20634 on February 25th 2006, it was the tenth largest exchange in the world by market capitalisation. Even at the end of February 2010 with the Tasi hovering around 6437 the Tadawul still had a market capitalisation of SAR1,272bn ($399bn). Like stock exchanges in much of the region, the market is dominated by domestic retail investors who in February accounted for, by value, 90% of all sell orders and 84.5% of all buy orders (see table 1). Though open to investors in the other GCC states, until 20 months ago the market has been closed to international investors who could only gain exposure through locally listed mutual and investment funds. That all changed in August 2008 with the introduction of new rules by the Capital Market Authority (CMA) that

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Country Report SAUDI ARABIA LURES FOREIGN INVESTORS

Table 1: Tadawul Trading By Nationality & Type Statistics for February 2010 Nationality

Investor Type

Saudi

Individual

Saudi

Corporate

Saudi

Mutual Fund

GCC Citizens Arabs (NON-GCC) Foreigners (NON-Arabs & GCC) Foreigners (Swap Agreement)

Type

Volume

Number of Trades

Value

Sell Buy Sell Buy Sell Buy Sell Buy Sell Buy Sell Buy Sell Buy

2,123,987,193 1,927,686,406 100,905,898 282,358,902 64,915,292 53,992,286 28,960,054 35,444,006 40,286,497 38,532,699 6,045,728 3,866,870 16,165,402 39,384,895

89.2% 81.00% 4.20% 11.90% 2.70% 2.30% 1.20% 1.50% 1.70% 1.60% 0.30% 0.20% 0.70% 1.70%

1,995,284 1,907,908 20,276 73,112 20,715 24,279 11,615 17,720 41,716 61,540 4,686 5,513 7,811 12,031

94.90% 90.80% 1.00% 3.50% 1.00% 1.20% 0.60% 0.80% 2.00% 2.90% 0.20% 0.30% 0.37% 0.57%

47,533,293,439.90 43,966,084,383.65 1,983,234,504.20 4,959,336,349.55 1,720,630,374.00 1,907,125,418.65 910,422,617.75 1,124,380,270.95 948,000,489.80 925,497,257.00 136,447,557.15 105,594,443.60 767,412,151.30 1,011,423,010.70

88.00% 81.40% 3.70% 9.20% 3.20% 3.50% 1.70% 2.10% 1.80% 1.70% 0.30% 0.20% 1.40% 1.90%

Source: Tadawul, supplied April 2010

allowed investment for foreigners through an innovative swap arrangement with brokers who then invest in the equities themselves. (See FTSE Global Markets issue 32). There was some criticism of this mechanism at the time amid investors growing fears of counterparty risk particularly after the collapse of Lehman Bothers the month after the swap arrangement was introduced. This is because the shares themselves are not technically owned by the international investors, they are technically exposed to potentially a great degree of counterparty risk should their brokerage for any reason enter into administration. International investors are therefore reliant on the

CMA to protect their interests in the event of a default. The lack of direct ownership also prevents international investors who build significant stakes in companies from pushing for representation on the board or from voting in the event of a takeover.

Swap agreements Despite these concerns, international investor activity has been growing. According to figures released for February by the Tadawul, foreign swap arrangements accounted for 1.4% by value of all sell orders and 1.9% of all buy orders (see table 1). Whilst still relatively small in relation to the market as a whole, this level of activity is significantly higher than the levels

One of the benefits of foreign investors is that they behave differently to the retail market. Over the past 12 months foreigners through swap agreements were net investors in the Tadawul, the Saudi stock market, to the tune of SAR3bn. In this way they are beginning to act as a useful counterweight to Saudi retail investors who, for instance, were net sellers to the tune of SAR3.57bn in February, whereas the foreign swap investors were net buyers of shares worth SAR244m.

witnessed 12 months earlier when foreign swap agreements accounted for only 0.2% of all trading activity on the Tadawul. In fact, if this growth rate continues, foreign swap arrangements will outstrip trades by Saudi mutual funds by the end of the year. One of the benefits of foreign investors is that they behave differently to the retail market. Over the past 12 months foreigners through swap agreements were net investors in the Tadawul to the tune of SAR3bn (see table 2). In this way they are beginning to act as a useful counterweight to Saudi retail investors who, for instance, were net sellers to the tune of SAR3.57bn in February, whereas the foreign swap investors were net buyers of shares worth SAR244m. If the number of foreign investors continues to rise then so too will the ameliorating effect they have on the large swings in retail investment flows. For those investors who feel uncomfortable with the swap arrangement, the launch on March 28th of the first ETF in the kingdom is a welcome development. The Falcom Saudi Equity ETF is managed by regional investment bank Falcom and is 95% invested in its own F30 index. The Sharia-compliant index represents 30

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Country Report SAUDI ARABIA LURES FOREIGN INVESTORS

of the largest companies listed on the Tadawul, excluding institutions such as the Kingdom’s non-Islamic banks, with fund rebalancing taking place quarterly. Hitoricly the F30 has closely tracked the Tasi, a trend that Falcom expects to continue. According to figures released from Falcom, the fund attracted SAR151m on its first day of trading and accounted for 8% of all of the trades on the Tadawul.“It’s our honour to be the first ETF provider in the Gulf region to be domiciled here and we are also the first shariah-complaint ETF in the region,”explains Falcom chief executive officer Adeeb Al-Sowailim.“

International investors “The launch of this ETF is an historic event as a new chapter begins for the capital markets for the region. We have been working exceptionally hard on all fronts to make this happen for our clients and they have responded by giving their overwhelming support. The first day was really heartening and we would like to thank the CMA and Tadawul. We are now ready to invite international investors through this gateway,”he adds. The big advantage of this ETF for international investors (over and above the usual advantages associated with ETFs of greater diversification,

transparency abut with lower costs than equivalent mutual funds) is that they can invest and trade directly in the fund and are not required to purchase or invest through the swap arrangement. Other ETFs from both Falcom and alternative providers are planned, including an ETF that tracks the kingdom’s hydrocarbon related stocks. These are expected to have great appeal not just for international investors but also for the kingdom’s estimated 15m retail investors. It will give them the opportunity to diversify their share portfolio without committing to a traditional investment or mutual fund. Richard Groves, managing director at SABB, agrees that the introduction of ETFs is a positive development but that it should be seen in the wider context. “The introduction of ETFs is another step in the opening up of the Saudi equity markets to responsible international investors. However, to further encourage this group may require some form of Qualified Foreign Institutional Investor scheme (QFII) that will prevent hot money flooding the market but will allow direct investment into the market.” It is not just the Saudi equity markets which are opening up to international investors. February saw the first 144a bond issue by a company

in Saudi Arabia, the landmark $450m sukuk made it possible for US investors to directly participate in a Saudi Arabian issue for the first time. The sukuk, issued through the Dar AlArkan Sukuk Company II, marks Dar Al-Arkan’s fourth sukuk issue. The company previously issued two international sukuks with a total value of $1.6bn in 2007. The company also raised SAR750m through a locally issued sukuk in May last year. According to Ikbal Daredia, head of capital markets, institutional banking and treasury at Unicorn, which colead managed the issue, there was significant interest from investors in the GCC, Europe, Asia and the US. “We are pleased at the positive response that we received from the international financial community, particularly given recent events in both the GCC region and Europe and the prevailing uncertainty in the international capital markets”.

Future projects Dar Al-Arkan is one of the largest residential real estate developers in Saudi Arabia. The sukuk, which offers a yield of 11%, will be used to finance the company’s current and future development projects. The relatively high rating of Ba2 attributed to Dar Al-

Table 2: Foreign Swap Transactions Total Market percentage by value Feb 2009 - Feb 2010 Mar Apr May June July August Sept Oct Nov Dec Jan Feb Total

Sell

Value SAR

Buy

Value SAR

Difference SAR

0.3 0.2 0.3 0.66 0.5 0.5 0.5 1 1.7 1.1 1.1 1.4 9.26

262286023.00 269179836.00 585203359.00 986628410.00 513439338.00 407948022.00 268687759.00 1117675097.00 1329143592.00 564044204.00 744749240.00 767412151.30 7816397031.30

0.4 0.9 0.5 0.58 0.6 0.8 1.5 1.6 1.2 0.8 1.6 1.9 12.38

356616783.00 1232159894.00 992465846.00 867119839.00 631886894.00 622155288.00 920907814.00 1770075617.00 944168995.00 407595198.00 1032295423.00 1011423010.70 10788870601.70

94330760.00 962980058.00 407262487.00 -119508571.00 118447556.00 214207266.00 652220055.00 652400520.00 -384974597.00 -156449006.00 287546183.00 244010859.40 2972473570.40

Source: Tadawul, supplied April 2010

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

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Country Report SAUDI ARABIA LURES FOREIGN INVESTORS

Table 3: Sukuk Secondary Trading Month

Value of Trades SR

Number of Trades

Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10

11,269,575 9,384,185 5,154,250 50,500 98,000 1,012,500 2,534,000 64,878,700 298,268,900

27 17 8 1 0 1 1 3 36 18

Source: Tadawul, Berlinguer, supplied April 2010

Richard Groves, managing director at SABB, agrees that the introduction of exchange-traded funds (ETFs) is a positive development but that it should be seen in the wider context.“The introduction of ETFs is another step in the opening up of the Saudi equity markets to responsible international investors. However, to further encourage this group may require some form of Qualified Foreign Institutional Investor scheme (QFII) that will prevent hot money flooding the market but will allow direct investment into the market.”Photograph kindly supplied by SAAB, April 2010.

Arkan by Moody’s (their mean rating of global homebuilding companies is Ba3) and the willingness of international investors to invest is a clear indicator that the property market in Saudi Arabia remains attractive to international investors. It is just one of the sukuks likely to come to market this year. Total and Aramco are in the process of closing a project sukuk before the summer to part fund their $12bn joint venture refinery project. Exact details are not available but it looks likely to be a domestic non-recourse publicly issued sukuk with a 16-year tenor. There will also be investment of $1bn from the government backed Public Investment Fund and eventually an initial public

offering (IPO) for 25% of the project, though this is unlikely to occur for at least another two to three years. The refinery itself is scheduled to begin operations in early to mid-2013. “The large infrastructure requirements of the kingdom and enormous levels of investment taking place are going to require a mix of funding sources,”thinks SABB’s Groves. “The long-term funding required by many of these projects and the large sums involved make it impossible to simply rely on bank lending which is in turn reliant on retail deposits that are by their very nature short term. The natural source to plug this funding gap will be the sukuk market with its wider investor base, many of whom, such as insurance

companies and pension funds, would welcome the opportunity to match their liabilities against long-dated paper.” A criticism of the Saudi sukuk market has often been that a shortage of issuance has created a “buy-andhold” environment where little secondary trading took place. This was borne out after the Tadawul introduced a sukuk trading platform which, after a flurry of trades, saw little to no activity. Following this slow start, volumes on the secondary trading platform have risen significantly in recent months and the value of trades in March was 216% greater than the previous nine months combined. (see table 3). “We are definitely witnessing more trading,” says Rajiv Shukla, regional head of debt capital markets for HSBC. Some of this is he puts down to local investors diversifying more into fixed income in addition to equities, but he also believes investors are becoming more comfortable with the trading platform. He also notes that the platform only allows for the trading of public issuances, the majority of which are floating rate notes (FRNs). “The secondary trading of the only privately placed fixed rate sukuk dwarfs the levels seen for both private and public FRNs and this suggests even stronger investor appetite for this kind of product,”he adds.

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

Face to Face ARAB BANK PREPARES FOR CHANGE

Responding to change The largest bank in the Middle East, Amman-headquartered Arab Bank, achieved pre-tax and after provisions profit of $782.8m; with total assets topping $50.6bn through the 2009 financial year. The bank’s profits were generated from the core income streams. The drop in net profit compared to 2008 is primarily due to the bank’s prudent policies, based on which the group has booked additional provisions of $204m against nonperforming and watch list credits. FTSE Global Markets spoke Adbel Hamid Shoman, Arab Bank’s executive chairman, about the bank’s future plans and prospects. Some three months into 2010, what do you think are Arab Bank’s key strategic priorities over the 20102011 periods? As our global economy gradually stabilises, the global banking industry will still encounter new challenges. Increasing competition requires the best of banks to deploy concerted efforts in order to enhance all aspects of efficiency and price various products competitively while carefully articulating and understanding their true risk profile and risk appetite framework. Arab Bank will continue to focus on these areas in 2010. The quality of any bank’s liquidity reserves is as important in 2010 as it has been in the past. Arab Bank will also continue to build and maintain its liquidity reserves in 2010 by continuing to invest in high quality and highly liquid bonds. It will also remain the case that liquidity characteristics of prospective investments are of paramount importance. Arab Bank will sacrifice opportunities to make speculative gains in return for a stable, high quality and highly liquid bond portfolio. Strength in depth in the terms of services has always marked Arab Bank’s service set in recent years. Asset management has been less prominent. What elements do you need to have in place to secure the

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

bank’s dominance in this regard across the GCC and MENA region? The asset management business in particular is a complex state of affairs which requires a very unique set of skills including quality professionals with various qualifications and experiences, as well technical knowledge. To judge/evaluate an asset management institution requires a very long track record during which comparable markets’ performances on a risk adjusted basis are taken into consideration. Given that the human factor is critical in the asset management business, employee stability over long periods of time is vital and is actually a basic due diligence information required by institutional investors looking to invest in the MENA region. Therefore, to be a dominant leading provider in the asset management business, we will continue to invest heavily in our human resources over the long run, while simultaneously establishing and developing a state of the art infrastructure of support services. The long term objective is to institutionalise a shared culture of knowledge and creativity, and most importantly a culture that values the highest standards of practice and codes of ethics as a critical element of differentiation. Moody’s recently assigned Arab Bank plc a financial strength rating

Abdel Hamid Shoman, executive chairman, Arab Bank.

(BFSR) of C+, which translates into a Baseline Credit Assessment (BCA) of A2. The rating derives from Arab Bank’s franchise as the largest bank in Jordan as well as from the group’s geographic diversification. The BFSR also reflects the bank’s strong capitalisation, profitability, liquidity and generally very good financial fundamentals. Concurrently, the rating is constrained by certain asset concentrations and certain troubled loans as well as by the bank’s exposures to some countries with high economic and political risks. How fair is this assessment and what efforts is the bank making to reduce its NPL portfolio? The NPLs issue is tackled by the Arab Bank at different levels and based on remedial loan book multi-prong management strategy as detailed later below. However, in the beginning we must say that excluding the recent classification of certain exposures, Arab Bank’s NPLs are considered at a very healthy low ratio of: 3.3% of gross loans and advances. This ratio is well within

Face to Face ARAB BANK PREPARES FOR CHANGE

the global pre-financial crises NPLs to GLA ratios or industry norms of 3.5%. If we are to look at the current global NPLs landscape, ratios of 8% are common in many markets and at major global banks. Nevertheless, Arab Bank is taking a very aggressive and systematic approach to reduce and resolve its NPLs by a number of elements. These include early warning signals (EWS), which are taken very seriously as they are analysed for account/relationship strategy purposes. Relationship managers are drilled on detecting, analysing and communicating such signals to eliminate/reduce default risks. Z-Scores are usually made part of any fresh loan credit facility so as to have a future reading of credit default possibilities. Secondly, remedial accounts are managed and closely supervised by four levels of managers. As well, the bank employs an aggressive and prudent classification system that is stricter than that required by regulators. Moreover, the bank proactively restructures facilities and clients’ balance sheets at the first sign of EWS’, with the application of risk classification categories, such as monitor, special mention, watch, substandard, doubtful and loss. Additionally, the bank applies conservative and prudent P&L management with specific provisions initiated at the earliest default or lateness in repayment or weak account movement. Our provisioning policies are considered the gold standard in the region as many central banks are guided by our bad loans provisioning policies. Finally, most of our NPLs are fully provided for, but is kept on the books to preserve our rights to collect, based on legal reasons. Figures released by the Jordanian finance ministry have revealed the kingdom’s gross domestic and foreign debt rose 12.9% to JD9.66bn ($13.6bn) in 2009 against the

previous year, Reuters has reported. Foreign debt, mostly to major Western donors and international financial institutions, rose by 6% to JD3.869bn at end of December against JD3.64bn at the end of 2008. Public debt is expected to reach beyond a record $14bn this year, nearing a legal limit of 60% of GDP, as recession reduces local revenue and foreign aid. How much does the broader financial situation impact on your annual business strategy and in these market conditions, what are the important business tactics and strategies that the bank is employing in the domestic market? It is true that Jordan’s budget and debt situations were affected by the severe global recessionary environment that prevailed over the past two years. However, it is equally true that many countries including the USA, UK, Japan, Lebanon, and Egypt to cite a few examples underwent similar or in some cases much worse deficit and debt deterioration. Starting this fiscal year, the Jordanian government has been implementing a tight spending programme which, in tandem with the new tax law and improvement tax collection system, will hopefully help reverse unfavourable budget trends, especially as global and regional economies recover and global and regional growth resumes. During this downturn Arab Bank managed, along with other banks in Jordan, to maintain positive and robust credit expansion and allocations across sector and economic niches and to provide loans at nearly normal rates whether to private business or to retail customers. In 2009 we were the first bank to announce and implement initiatives to lend at lowered rates to certain economic segments that were seeking credit and deemed good customer base. We have extended lending to large and small business

and customers including loans for housing and real estate customers. What are your principal international ambitions in 2010? We will continue to focus on the MENA market as a whole. We are not actively seeking new markets at the present time, however, should the appropriate opportunity present itself at the right time we would be interested in exploring it, specifically in MENA. With extensive contacts in both the Saudi financial markets, as well as in the wider GCC and MENA regions, what do you think are the key opportunities and challenges presenting to the evolution of the Jordanian financial and investment markets over the short and medium term? How might the Arab Bank play a role in these developments going forward? I believe that the MENA region will be on track for sustainable growth as of late 2010, and early 2011. As early as 2010 with oil prices hovering at the $80-$90 per barrel level, the expectation is that the region will grow between 4% and 5% over the period. This will permit the resumption of project growth in a menu of sectors including construction, power and water, ports, housing, education and health facilities. Power projects in the GCC countries are estimated to be worth $200bn. Other countries including Libya, Syria, Jordan, Morocco and Egypt have been pursuing economic and financial reform that will undoubtedly open up new opportunities in a compendium of niches; including tourism, hotels, finance and construction among others. The interplay of demographic momentum and economic growth has produced a burgeoning society that will require all sorts of social services and infrastructure including roads, ports, energy, schools, clinics and hospitals etc. Building such a massive

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and highly diversified network of projects avails opportunities in terms of banks’ funding. Arab Bank is a pioneer when it comes to nurturing and responding to lending requirements as they arise. 2010 is a time of challenge for almost all the world’s financial markets: with everyone either on the brink of an upswing, or double dip back into recession. In your view what are the generic requirements of a high growth economy in this period? How much can Jordan depend on these requirements going forward? One important lesson learned during the crisis was the importance of being prudent and keeping your shareholders’ and customers’ best interest at the forefront ultimately pays off. Those who stuck to banking basics are now winners. Another of the lessons of the financial crisis is that economies should strike a balanced dose of internallygenerated and externally-led growth potential. While following an integrated set of prudent financial, macroeconomic and regulatory policy packages, a certain measure of self reliance and dependence on domestic and regional markets is important to anchor growth. Likewise appropriate investment and economic environments need to be encouraged that can mobilise resources domestically and help convince foreign investors of the fruitfulness of domestic investment opportunities. This includes improvements in Jordan’s alreadyfriendly investment laws, the availability of human capital and sound economic, judicial and social infrastructures. More than 70% of exports in MENA are energy-related and provide a significant portion of revenues. Exports and foreign exchange are indispensible for the government purse, and hence we look for the resumption of global trade as an engine of growth. Sectors including manufacturing, agriculture, and

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

Al-Salt, Amman, Jordan. Photograph © Aatwan/Dreamstime.com, supplied April 2010.

tourism remain viable and could be made more competitive to sustain pressures in the international markets. We also continue to improve the efficiency of our financial and economic institutions and improve the functioning of fiscal and monetary policy as drivers of growth as well. Jordan has been one of the reform pioneers in the region, whether in investments, trade, judicial or political arenas. The government has concluded many free trade agreements and relentlessly pursued trade and investment reforms. The Middle East has always been a market for experienced financiers: it has never been an easy market for newcomers to penetrate. Even so, there is another wave of inward investment ready and willing to enter the market in the search for investment returns. What role might Arab Bank play in this regard? High quality banking is never an easy ride. Arab Bank’s strong and successful historical performance was a result of long term, prudent and thorough banking practices. For those who intend to work in MENA we offer our banking services almost everywhere and provide the necessary

advice in the markets we are well experienced in and have established a strong track record. Could you kindly outline the role of the bank in encouraging the deepening of the risk and insurance services segment in Jordan and the wider region? Arab Bank has, over the past several years, enhanced its approach to insurance on two fronts: On the business side, we offer bancassurance products through our branch network in Jordan and Egypt with the view of entering other markets in the region. These product offerings are originated through either a partnership arrangement with key regional players, or via the bank’s own investment in insurance companies. In addition, and within Group Risk Management, a dedicated Insurance Division has been established to centrally manage all internal insurance requirements and ensure that risk areas are adequately mitigated. It is also worth mentioning that Arab Bank is one of the leaders in Jordan when it comes to risk management, as it is the first bank to have a dedicated division in the field.

Sector Report GOLD: DEMAND OUTLOOK STABLE

STEADY AS SHE GOES While gold and gold equities have outperformed through 2009, it looks like analysts now expect some underperformance over the coming year. Are analysts right, and are white metals such as platinum the ‘new gold’ in 2010? It is a pertinent question, given that investors also expect the US Federal Reserve to begin hiking interest rates later this year, or at least in 2011. What then? ISTORICALLY, ACCORDING TO analysts at RBC Capital Markets, gold equities tend to outperform benchmarks, such as the S&P/TSX composite in the run up to an interest rate hike. However, in a study of the last nine cycles by RBC Capital Market’s analyst team, they also found that afterwards prices lag for periods of up to nine months after the hike. Then, says the team, prices rebound and peak 18 months later. However the team thinks that in this latest cycle there is less volatility in the markets and consequently they anticipate a more muted market reaction to tightening monetary conditions. In other words, negative real short-term interest rates, central bank gold buying and strong demand from gold ETFs will likely support gold in the $1,000 to $1,250 per ounce range throughout 2010. “Although inflation concerns could reappear and provide a stimulus for higher gold prices as observed in the early 1980’s, we believe we are currently in a deflationary environment, although the extraordinary amount of monetary and fiscal stimulus could create significant inflation concerns with a full global economic recovery likely in 2011,”says the RBC analysts report. The RBC Capital Markets team concedes however that bucking the expected trend, gold stocks have indeed lagged the broader TSX since the fourth quarter of 2009; thereby acknowledging that 2011 might not necessarily be a bad year for gold

shares. Moreover, the wide range of relative performance patterns of both spot gold and gold stocks in the past nine cycles might even point to more good times ahead for the metal. According to the World Gold Council’s (WGC’s) Gold Demand Trends, published in February 2010,”Regardless of whether the economic recovery falters, we believe that western investment demand will remain well underpinned.”The WGC believes that if the western economies falter over the coming year then investors will continue to look towards gold “for its diversification and portfolio insurance properties. Conversely, if the economic recovery becomes firmly entrenched, then inflation concerns are likely to continue to gain prominence.” Even so, traditional expectations of the behaviour of gold prices over the recent financial crisis have sometimes turned on its head in recent years, indicating that perhaps, the drivers of demand for gold are diverging away from its traditional rationale. Certainly gold did not behave as a ‘safe haven’ during the financial crisis in the autumn of 2008. The price of gold was a meagre $712 an ounce as investors opted to buy dollars. As the US dollar has weakened however, gold began to see an upside, which ultimately drove the price up to $1215.70 by early December last year. Since that point, the price has fallen moderately to the midpoint between the expected range for this year. The question now hangs: will the dollar

Photograph © Jgroup/Dreamstime.com, supplied April 2010.

continue to weaken; and if so, will gold benefit or has demand and investor interest shifted to white metals such as platinum and palladium, driven largely by demand from the Asia market and a growing requirement for catalytic converters as the automotives industries fortunes show a modest hope of revival. While valuable white metals do well in times of rising demand from industry, the glitter of gold is unlikely to be dimmed for long; with most analysts conceding that gold will likely rise again in price alongside platinum and palladium. Palladium is one to watch because of its vulnerable supply-demand position. Restricted supplies from South Africa, combined with a drop in Russian stockpile sales as well as rising demand will continue to put pressure on its availability and pricing will reflect its premium status. Modest gains in industrial demand are also impacting on demand. The electronics industry, which typically accounts for nearly 70% of the industrial off-take of gold, enjoyed something of a rebound in the last quarter of 2009, with further gains in the first quarter of this year; a subsequent replenishment of inventories across the supply chain, has helped stabilise prices. However, any gains in this regard could be temporary if manufacturers shift into cheaper, alternative metals.

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Sector Profile

Nuclear power will take on a new complexion over the coming years. Climate change has offered a new marketing pitch to nuclear enthusiasts who claim that it can safely and economically replace coal and gas. The worldwide resurgence of interest in new nuclear reactors has been accompanied by a rebranding of the industry as inherently green. What is left unproven is whether nuclear power generation itself can thrive, or even survive, without government assistance. Indeed, the one sure thing about nuclear energy and weaponry is the fission they induce between truth and public statements. By Ian Williams.

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THE GLOBAL WARMING TO NUCLEAR POWER

NUCLEAR REBRANDED

Indian Prime Minister Manmohan Singh, right, and Russian Prime Minister Vladimir Putin speak during a signing of agreements in New Delhi, India, Friday, March 12th 2010. Putin held talks with Indian leaders during a day’s visit that was expected to conclude with the signing of a slew of agreements on defence, space and civil nuclear energy cooperation, Indian officials said. On the table Friday was an agreement to build two additional nuclear power reactors in the southern Indian state of Tamil Nadu, where Russia is already installing two nuclear power plants. Photograph by Manish Swarup, for Associated Press. Photograph supplied by Press Association Images, April 2010.

HERE ARE TWO toxic dates and places for the world nuclear industry—Chernobyl, 1986 and the World Trade Centre, 2001. One showed what nuclear materials could do when scattered, and the other graphically suggested how terrorists could attack reactors to scatter them. Adding to the costs of an already dubiously selfsufficient industry, modern designs now have to factor in not only an internal meltdown and explosion but also the prospect of a loaded jumbo jet flying into the outer shell. However, American reluctance to build nuclear plants precedes Chernobyl; the accident at the Three Mile Island reactor in 1979 was enough to persuade most Americans that they did not want one in their backyard. It also dissuaded financiers and insurers from putting up their own money. Other countries also faced popular reluctance to go nuclear. For example, Sweden, 45% dependent on nucleargenerated electricity, voted even before Chernobyl to phase out its reactors. However, all that may be consigned to the past as nuclear promises to come into its own as a safe and economic replacement for carbon fuels. “As the world moves to address climate change, nuclear energy will play an

Sector Profile THE GLOBAL WARMING TO NUCLEAR POWER

indispensable role,”declares US energy secretary Steven Chu, stating the Obama administration is going with the global tide, albeit somewhat against the liberal eddy that put the president in power. Indeed, mesmerised as the public has been by the crisis and healthcare battle, there has been relatively little debate, let alone dissent, with President Barack Obama’s espousal of the nuclear cause. What is left unproven is whether nuclear power generation itself can thrive, or even survive, without government assistance. Indeed, the one sure thing about nuclear energy and weaponry is the fissures they induce between truth and public statements. Even on core costs, in the US, the Congressional budget office (CBO) estimated that new build nuclear was only competitive on the assumption that carbon costs $45 a tonne. Most of the differential is in the capital cost of the reactor, including its decommissioning, since fuel costs are relatively small once the show is on the road. There are plentiful supplies of uranium, many opportunities for alternatives, and even relatively large cost increases would have far less effect on electricity costs than the carbon-based fuel increases that the world fears.

More than money However, there is more to nuclear power than mere finance. The financial market itself is chary of the risks. Nuclear reactors entail national prestige, international alliances and strategic decisions about future trends in self-sufficiency, and so governments make the decisions. Hence Obama’s commitment of $54bn in loan guarantees to kick-start the current interest in nuclear generation in the US. An initial tranche of $8.3bn in guarantees has just been announced for three plants

If NIMBY (not in my backyard), applies to reactors, NWHM (not within a hundred miles) applies to nuclear waste, and the Obama administration’s cancellation of theYucca Mountain waste depository in Nevada after decades of building not only symbolises the power of nuclear-averse communities to derail expensive plans, it also spreads high costs across the industry. Photograph © Seagrave/Dreamstime.com, supplied April 2010.

in Georgia, the first new reactors in the US for 30 years. The Tea Party fanatics castigating the president will get little support from the nuclear industry, which applauds Obama’s relaunch of nuclear energy under the green flag. From Obama’s point of view, future energy self-sufficiency and less carbon emissions are almost just bonuses. The capital and labour intensive business of building nuclear power stations and equipping them is an economically virtuous stimulus mechanism employing untold thousands of skilled, highly-paid workers over a long period. Here is the rub: certainly in most European and American operations, those workers will be employed far longer in the construction than the

estimates promise. The most recent Congressional budget office study invoked previous experience to suggest that there is a 50% failure rate. The CBO statistics show an average cost over-run of 200% for the two decades before 1986. Indeed, the US landscape is littered with unfinished reactors, but it is not just some Detroit-like American thing. The Olkiluoto 3 reactor being built by French company Areva in Finland is three and half years behind schedule and 50% over budget. It is such contingencies that the loan guarantees are intended to counter, since otherwise private capital would not enter at all. Of course, nuclear power has had other hidden state benefits—guaranteed rates from government utility regulators, and some fast accountancy about amortising the costs of storing the nuclear waste that the US alone, for example, produces 2,000 tons of annually. The energy department, in another not-so concealed subsidy, was supposed to take over the waste more than ten years ago. If NIMBY (not in my backyard), applies to reactors, NWHM (not within a hundred miles) applies to nuclear waste, and the Obama administration’s cancellation of the Yucca Mountain waste depository in Nevada after decades of building not only symbolises the power of nuclear-averse communities to derail expensive plans, it also spreads high costs across the industry. The cancellation of the Yucca scheme means that it will be a long time before any new waste site could be completed. Moreover, the nuclear waste will inevitable accumulate at reactor sites. Current plans envisage up to a century’s storage on-site, and thousands of years in special, yet to be built depositaries to add to the 60 years or so for decommissioned reactors. It’s an anti-terrorists’ nightmare scenario.

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Reducing dependency However, the idea of clean, efficient power stations which are not dependent on the vagaries of the international oil markets—not to mention powerful lobbies of nuclear engineering companies and governments seduced with the concept of modernity represented by the atom—has provoked market interest across the globe. At present, according to the World Nuclear Association, there was slightly less nuclear energy produced worldwide in 2008 than the year before. The new reactors being built only just replace the capacity of those reaching the end of their lifecycle. However, many more are under discussion, with China considering 100 new reactors and India a further 50. For carbon poor nations such as Japan and Korea, or even Germany and

France, nuclear power offers energy security to outweigh safety and costs concerns. In the case of China, the location of the coal reserves far inland from the centres of economic development—not to mention the notorious pollution that led to Beijing practically closing down industry to ensure cleaner air for the Olympics— provide pressing reasons for why the nature of the society mitigates the effect of public opposition that has been so potent in places including the US. Not just Iran, but many of the Gulf States are exploring nuclear options to carry them beyond oil. For example, Qatar and Abu Dhabi have both been in talks to take stakes in French nuclear giant Areva, to keep their financial options open on a new source of energy and to explore domestic reactor commissioning. However, in all cases, the business

has depended on close nexus between governments and the international consortia that build the reactors. Indeed, the recent $40bn United Arab Emirates contract for reactors for the Korean consortium ($20bn for construction and the same again for maintenance and fuelling) sent shockwaves through the markets, as the UAE had been expected to opt for a western contractor. It sent a clear signal about who was most likely to benefit from the new demand. The UAE, subject to blandishments from President Sarkozy for the French bid—tied as it is with potential arms sales— apparently tried to get other bidders to come in lower, but in the end the Koreans made a serious offer the Emirates could not refuse. Their breakthrough not only caused a bad case of radioactive grapes from

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F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

Sector Profile THE GLOBAL WARMING TO NUCLEAR POWER

the French, American and Japanese contenders, but also inspired Chinese and Russian hopes, backed as they also are by governments whose commitment to private enterprise and the spirit of competition is less rigid even than the norm for nuclear business. As we have seen, in all spheres, government backing goes a long way in nuclear matters.

Aiming for market share Hyundai, along with Doosan and Samsung, have been consistent and successful nuclear partners and together with the Korean Electric Power Corporation (KEPCO), South Korea’s state-owned electricity monopoly, they claim to offer an unbeatable build and operate deal. Rivals murmured about Korea skimping on safety compared with Western anti-9/11 designs, but in fact South Korea, looking anxiously to its erratic Northern neighbour, had designed in defence in depth for its cores. The package has particular appeal in emerging markets. Vietnam is among the first in the market, ordering four reactors. The Korean target is 20% global market share by 2030, and their chances are enhanced for the same reason that Hyundai cars outsold Detroit’s: their products are cheaper and more reliable. They also have considerable recent experience. South Korea is building six reactors at home and another 14 are on the drawing board while its 20 existing reactors were completed far closer to schedule than any of their rivals. Clearly, countries such as the US or Britain that have had a 30-year hiatus in actual new build are at a considerable disadvantage in the growing market, not to mention that many of the potential customers are from the developing world and from political systems wary of Western leverage over such important developments.

The long term downside effects of nuclear power. In this March 14th 2010 photo, a radioactive caution sign is attached to the railing of a 15-to-17 foot deep pit, dug to expose and repair a leak in underground plumbing that released radioactive tritium at the VermontYankee nuclear power plant in Vernon,Vt. Officials at the plant believe that the main sources of the leak have been repaired, however, as the plant’s owners fight for a 20-year extension to its operating license, discussions about the leak and its handling have just begun. Photograph by Jason R Henske for Associated Press. Photograph supplied by Press Association Images, April 2010.

Indicatively, the British government joined the fray in its retreat from both non-nuclear and neo-liberal policies by announcing an £80m loan to Sheffield Forgemasters to build a massive 15,000 tonne steel press to supply castings for reactor covers. At present, a Japanese company has pretty much the world monopoly, which makes it interesting that the British project is in collusion with Westinghouse Electric, now owned by Toshiba. The years of relative nuclear quiescence have led to an established industry that is as complicated as a table of sub-atomic particles, with more than a degree of quantum uncertainty. Some of the companies combine different permutations, some are generators, some are fuel producers and yet others are designers and builders. Hitachi and General Electric have a joint venture but each is pushing two rival reactor designers; then they

combined with Toshiba to develop yet another model, until the latter bought Westinghouse in 2006 and began to promote its designs. As a sign that Tokyo is not coaching its nuclear team, Mitsubishi has its own ambitions. Majority French state-owned Areva has spread tentacles everywhere, not just in new build but also in the lucrative maintenance sector. However, it is in competition with its compatriot company EDF, and Sarkozy had to blow the whistle on their squabbling. Under the circumstances, it is perhaps no surprise that the Korean’s coordinated effort can run away with the ball. Despite its advantages, it should be careful in case it gets what it wants. Much of its technology has been built on purchases and transfers from foreign suppliers. If it gets its wishes for contracts from Beijing, one wonders how long it is before China begins to sell its own products to a waiting world.

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Real Estate

Brazil, forever the bridesmaid, is finally going to the wedding not once but twice. The one member of the BRIC economies to be constantly overlooked as the world embraced the real estate opportunities in the globe’s biggest emerging markets, Brazil will host the FIFA World Cup in 2014 and, in becoming the first South American country to win the rights, to the Olympics in 2016. Both events will bring billions of dollars of property funding and tourist and business investment, while the country’s low debt and strict economic management mean it has new-found popularity among real estate investors, writes Mark Faithfull. RAZIL’S MOMENT HAS taken a long time coming. Despite the country’s potential and the possibilities of its huge consumer market, young demographic and its sheer scale—especially the size of its twin economic drivers Sao Paulo and Rio de Janeiro—concerns about the economic and political stability of Latin America and its relative isolation from European and Asian real estate investors has left Brazil overlooked, underresearched and generally unloved. So it is fitting that sport, at the core of the nation’s soul, should be so intrinsic to the country’s revival. In all, 12 cities will share the benefits of having been chosen to host the FIFA World Cup in 2014: Belo Horizonte, Brasília, Cuiabá, Curitiba, Fortaleza, Manaus, Natal, Porto Alegre, Recife, Rio de Janeiro, Salvador and São Paulo. Several of those cities are already enjoying strong commercial real estate growth and the prospect of infrastructure investment and facilities for foreign visitors should continue to boost that trend. On top of the World Cup, Rio will also host the 2016

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

Olympics and the city plans to stage all the competitions inside the metropolis, bringing what the organising company describes as “dynamics to the Games and facilitating the athletes’ interaction”. There will be seven competition centres in four Olympic regions— Barra, Copacabana, Deodoro, and Maracana—with football matches held in the cities of Belo Horizonte, Brasilia, Salvador and Sao Paulo. Its bid is divided into a $2.8bn budget for operating costs, and $14.4bn for construction and security. That money will be needed. Despite the considerable sports infrastructure built for the 2007 Pan-American Games, Rio will need to build new venues and renovate others to meet the Olympics’ minimum requirements. In addition, Rio has a population of more than 14m but lacks the transport infrastructure to link city centre hotels to the Barra de Tijuca area where most of the venues will be concentrated, and consequently the city has outlined a $5bn plan to develop rapid-transit bus lines between Barra and the beachside neighbourhoods of

OLYMPICS & WORLD CUP BOOST BRAZIL PROPERTY

A sporting chance Photograph of downtown Sao Paulo. Photograph © Ventil/Dreamstime.com, supplied April 2010.

Copacabana and Ipanema. Rio also needs to build several other complexes, including the OlympicVillage, to provide over half of the 48,000 hotel rooms needed for the Games.

The resource angle Brazil is rich in natural resources and importantly also has the energy reserves to fuel a construction boom. Following decades of severe energy shortages, Brazil embarked on a green energy revolution to flip its reliance on imported oil, with hydroelectric power and ethanol-based fuels powering the country and its road vehicles. After taking these initiatives, oil company Petroleo Brasileiro in 2007 unveiled the largest Western Hemisphere oil discovery in 30 years in offshore territorial waters, moving Brazilian president Luiz Inacio to call the find, and its fiscal boost, a “gift from God”. The macro-economics are positive too, although unwelcome distractions are nibbling at the edges. Brazilian interest rates were held by the central bank in a 5-3 split vote in

Real Estate OLYMPICS & WORLD CUP BOOST BRAZIL PROPERTY

March, although many investors had anticipated a rate increase. The bank’s decision delayed a tightening cycle by at least six more weeks. While Brazil’s economy is recovering and generating inflationary pressures, there is little consensus on whether inflation justifies a tighter monetary policy. The political backdrop is also complicating the situation, with speculation that the government is pressuring the bank to hold rates in a bid to boost Dilma Rousseff, the presidential candidate from the ruling Workers’ Party, as voters enjoy recordlow borrowing costs. Even Henrique Meirelles, the highly-regarded central bank head, found himself immersed in political rumour-mongering. Meirelles openly pondered a run for public office in the October elections. However, Meirelles announced on April 1st that he was to stay in his job, dropping his bid for office, and renewing his commitment to slowing inflation in his final nine months atop the bank. Meirelles made the decision to give up offers to run for the Senate and Governor of his home state of Goias after talking with President Luiz Inacio Lula da Silva, who had been urging him to stay. That said, structural economic reform has been in place for some years and has impressed the investment market. Against that backdrop, the market for corporate office space remained stable last year and lease values were on average 8.7% higher in the core metropolitan areas than they had been in the previous years, driven principally by cities outside the Rio-Sao Paulo axis. The highest annual increases in lease values were in Brasilia (69%) and Curitiba (22%), with Porto Alegre and Rio at the opposite extreme, reporting a drop in average monthly leases of 11.2% and 4.53%

respectively, says Milena Morales, market research manager for Cushman Wakefield South America. However, she points out that Rio absorbed a record 149,000 sq metres of Class A office space, over 53% of the total around the country, although vacancy rates in Brazil increased from 7.8% to 8.3% across the year.“In 2010 lease values are expected to stabilise at 2009 levels but net absorption of office space could be 50% higher than last year, meaning that vacancy rates will drop off,”she says. Although New York (Midtown) remained the most expensive office location in the Americas during 2009, the Brazilian cities of Rio de Janeiro and Sao Paulo are now the second and third most expensive locations respectively within the region. Rio has also jumped from a ranking of 23rd to 13th in the global list of highest office rental costs. Both cities experienced an appreciating exchange rate and a less significant rental decline to move above Boston and NewYork (Downtown).

Investor mix “Both domestic and foreign investors are striving to acquire Brazilian properties or to invest in funds, although overall investment volumes are still low due to lack of existing assets for sale,” reflects Fábio Maceira, chief executive officer of agent Jones Lang LaSalle in Brazil. He says that investors remain keen to acquire properties or invest in funds and cites investment management companies such as Tishman Speyer,Vision and Prosperitas, among others, as undertaking foreign fund raising. Local pension funds are actively acquiring development projects or existing buildings. “Investment volumes are still low mainly due to the lack of existing assets for sale,”he says.“Most office buildings are condominium-style with multiple owners, so investors are opting for the

development route. Capitalisation rates are running between 10.5% and 11.5% for Class AA offices, compared to local interest rates at 8.75%. A lack of high quality properties on the market may contribute to some compression in capitalisation rates over the short term.” The burgeoning middle class is creating a particular demand for retail, as Brazilians become homeowners and their disposable income increases. In the latest survey of high net worth individuals in 57 global markets by Knight Frank and Citi Private Bank, both Rio and Sao Paulo featured in the top 11 for price increases in prime residential property in a leader board dominated by Asian cities. Brazil does have a number of large shopping centres and a highly developed retail sector, but compared with more mature markets it has a relatively low density by the standard measure of retail sq metre per 1,000 head of capita. New development and development funds have sprung up as recently as the past few weeks, with the Brazilian arm of Portuguese shopping centre specialist Sonae Sierra confirming expansion of one of Brazil’s largest malls, Parque D Pedro shopping centre in Campinas, São Paulo. The expansion is part of the strategy defined by Sierra Brazil for 2010, pledging a total of €116m in investments for this year alone. “That value includes the expansion of Shopping Metrópole, in São Bernardo do Campo [Sao Paulo], and the first construction stages of three new developments located in the states of Paraná, Minas Gerais and Goiás”, adds João Pessoa Jorge, chief executive officer of Sonae Sierra Brazil. UK-based Squarestone Brazil is also pressing ahead with plans to raise between £150m and £250m on AIM on the London Stock Exchange and it plans to focus initially on the greater Sao Paulo area. The fund will be run by Tony Campbell, former deputy chief

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executive of grocery retailer Asda, who will become chairman. He stresses: “A listing will allow us to continue to capitalise on the attractive opportunities already presented by the Brazilian shopping mall sector by enabling access to a broader capital base. We believe our strategy of bringing international mall retailing standards to Brazil will resonate more fully with an international investment audience outside of Brazil.” On admission to AIM, the company will buy two existing shopping malls, Bonsucesso Mall and Golden Square Mall in Sao Paulo, and currently managed by Squarestone Brasil II Administraçaoe Participaçâo, which itself will also be bought on admission. Campbell adds: “The company is committed to addressing what it perceives to be a gap in the market, by combining an international approach to shopping mall design, development and management while appealing to the local culture, tastes and fashions of Brazil in order to deliver a higher quality, tailored retailing experience for Brazilian consumers.” Neil Varnham, the recentlyappointed president of UK shopping centre organisation BCSC, will act as a consultant for the fund and is also fund director of London-based Pradera, which itself is “very interested” in Brazil, which Varnham describes as“having lots going for it”. He points to Sao Paulo as the most enticing entry point and concurs with Squarestone’s view that with 20m people and a lack of retail supply, the city presents an obvious retail opportunity for developers. “Brazil will attract more US money and I think Brazil generally and Sao Paulo in particular are on the edge of a lot of property funds’ radars,” he says. “However, there is a big difference still between looking and acting. At the moment the issue is that there are not

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Photograph © Adamgregor/Dreamstime.com, supplied April 2010.

NOVA LUZ: A NEW TEMPLATE FOR SAO PAULO AO PAULO’S CITY hall is attempting to revitalise a run down inner urban area of the city with a well established development funding model which it also hopes could create a new template for urban living, relieving some of the pressure on Sao Paulo’s embattled public transport infrastructure. Nova Luz—The New Light—covers approximately 225 acres of an area stigmatised as “Cracolândia”, with high levels of urban decay and all the social issues that go with it. The area is, however, adjacent to some of the cities most important cultural buildings and has been earmarked for a major redevelopment. The ongoing project will involve an estimated $1.5bn real estate investment for nearly 500,000 sq metres of built space and will set out to create a mix of new housing and new public facilities, with the first stage targeting 23 blocks. The headquarters of the municipality and the department of services, for example, will be transferred to a new area and the space they occupy will be transformed into a new park. Laws and regulations have been established to create a tax incentive for companies to set up in the region and in the blocks selected as a pilot for the project, which will give rise to the new headquarters of the municipality of the cathedral and the department of services, the metropolitan civil guard and a school hall. Funding is being raised through additional construction bonds (CEPACs), which are tradable bonds issued by Sao Paulo’s city hall on the Brazilian stock exchange and which grant additional construction rights to companies which are then allowed to build beyond the established trading area in the CEPAC region, or to trade the CEPACs. “This is an established technique which has run since 1992,” says city hall international relations manager Luan Baptista Ribeiro. “It has been used to revitalise other areas of Sao Paulo and gives the private companies buying them considerable development advantages.” Ribeiro points out: “Sao Paulo’s transport system is under huge pressure. At Nova Luz we want people to work, live and play in a prime position in the city rather than commuting into the area from outside.”

Debt Report SOVEREIGN DEBT: HANDLING THE TIDAL WAVE OF ISSUANCE

Eurogroup president Jean-Claude Juncker, right, and European commissioner for economic and monetary affairs Olli Rehn, address the media at the European Commission headquarters in Brussels, Sunday April 11th this year. Finance ministers of the 16 euro nations met in a video conference to discuss the technical details of a financial aid package for Greece. Photograph by Yves Logghe for Associated Press. Photograph supplied by Press Association Images, April 2010.

THE STING OF DEBT Sovereign bond markets are facing their real test this year. The quantitative easing measures (essentially the printing of money) adopted by all the world’s leading economies in response to the recession created something of a false market in 2009. Governments began to issue record volumes of debt without any significant impact on yields and spreads—as central banks were able to absorb the slack. However, that set up cannot continue indefinitely and now sovereign issuers will need to find more genuine buyers for the unprecedented volumes of debt they still have to issue. How easily they will be able to do so will be the central theme of the capital markets through 2010. Andrew Cavenagh reports. OVEREIGN RISK HAS become the dominant consideration for fixed-income investors. The explosion of government borrowing— and particularly the sharp rise in fiscal deficits as a consequence—has seen credit risk replace interest-rate risk as the main determinant for investment decisions. “It is the year of sovereign risk,” asserts Mohamed El-Erian, chief executive of leading global investment manager, the Pacific Investment Management Company, LLC (PIMCO). “It is the year in which everybody is going to have to recognise that the sovereign balance sheets themselves are an issue that has to be handled.”

To illustrate the scale of the problem, El-Arian points out that over the past 20 years the percentage of global GDP in countries that were running fiscal deficits of 10% or more had averaged 5%. In the five years leading up to 2008, the figure was zero. It is now 45%. He says this had led investors to view the sovereign markets as a spectrum in terms of credit risk adding:“If you look at Europe, you would place Germany at one end of the spectrum and Greece at the other—and the whole spectrum is moving towards credit risk.” A recent survey of European investors by the Fitch rating agency confirmed the extent to which

sovereign risk is dominating investor thinking. Three quarters of the respondents say they expected to witness substantial deterioration in the credit quality of high-grade sovereign issuers over the next 12 months; in marked contrast to their expectations for other fixed-income asset classes (please refer to chart 1). As US and European governments still need to raise record volumes of debt over the next three to four years to finance their rescue of the global banking system, the development raises two important questions about this tidal wave of impending issuance. Who is going to buy it and at what price? Both questions are particularly pertinent to US Treasury bonds, the largest sovereign market, which is set to experience the biggest expansion in its history. Outstanding Federal debt stood at $7,500bn or 53% of national GDP at the end of 2009, and the figure will double to $15,000bn by 2019, by which time it will represent 67% of GDP, according to forecasts from the Congressional budget office (please refer to chart 2). Assuming the estimates are accurate—and some commentators believe they are conservative given the need now to find $1,000bn to fund President Obama’s universal health programme—the government’s annual interest bill will more than triple to $700bn by the end of the decade. Despite the fact that the dollar is unlikely to lose its status as the world’s

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main reserve currency in the foreseeable future, there has to be real uncertainty as to where the Federal authorities will place this mountain of additional debt—before any potential loss of credit standing is taken into account. It seems highly improbable, for example, that foreign investors will continue to hold about half the US government’s debt as they do at present. China and Japan account for 43% of the foreign investment between them, with holdings of $889bn and $765bn respectively [please refer to chart 3] and for different reasons neither is likely to increase these levels significantly over the next few years—certainly not to the extent required to maintain their current percentages of the total. Japan’s problem is its own domestic debt, which reached 192% of GDP in 2009 and shows no sign of reducing. This has made the country heavily dependent on its high levels of domestic savings to fund its deficits, but the rapid ageing of its population, which is even more acute than in the US, will diminish this source of funding. The government will almost certainly have to invest a greater share of its investment internally to finance itself and this can only limit its ability to buy a lot more US Treasuries. In China’s case, the country’s huge purchases of Treasuries over the past decade reflected its growing trade surplus with the US—as Americans bought Chinese exports with dollars, the Chinese invested them in US government securities. Once exports to the US peaked in 2008 and subsequently stabilised at a lower level, however, the Chinese holdings of Treasuries also stopped growing. There have been growing fears in recent years that the Chinese could destabilise the dollar markets by launching a massive sell-off of their Treasury holdings; which some see as a growing risk as the US takes a

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harder line on China’s refusal to let the yuan appreciate. Even if you discount the likelihood of such a dramatic development, the levelling off of the trade balance means there is little prospect of future Chinese purchases keeping pace with the increase in supply that will be needed to refinance maturing bonds and raise the additional debt. The strong demand for US Treasury issuance through 2009 and so far this year, which has seen increasing volumes of debt placed at relatively low yields, suggests that, for the time being at least, both domestic and foreign investors still see the dollar as a safe haven. However, even if overseas buyers were to continue buying Treasuries at their present rate (with others filling the gap left by China and Japan), the government will still need to find additional investors for the enormous increase in supply envisaged over the next decade. The US retail market is one possibility. While such investors have traditionally favoured the equity markets, their preference could change as the population ages and more of them look to their investments to provide relatively low-risk income rather than capital gains. Given that consumption rather than saving has always been the driving force in US

culture, it seems optimistic to expect this source to fill such an enormous gap. “It seems possible to suggest that, at best, domestic investors could meet some of the need for increased purchases of US debt, but they are not likely to completely erase the technical pressure in the market,” concludes Louise Purtle, senior analyst on macrostrategy at the international research firm CreditSights. One reason that demand for US Treasuries has remained strong over the past 15 months is the difficulty bedevilling the eurozone. As one of the two other big global markets for government bonds (it, the US and Japan account for 84% of all outstanding issuance), the euro is the only feasible alternative to the dollar as a global reserve currency in the foreseeable future. However, as the financial crisis and subsequent recession have had an unequal impact on its member countries—with their different economic, financial and fiscal situations—the sustainability of a single currency for the region is once again under scrutiny. The €20bn to €23bn emergency support package that the European Union (EU) and International Monetary Fund (IMF) agreed for Greece towards the end of March, should the country be unable to raise

Chart 2: US Debt Held by the Public – History and Forecasts $ trillions Actual

$16 $14

Forecast

$12 $10

Jumps to 60% GDP in 2010

$8 $6 $4 $2 $0 69

Source: Congressional Budget Office

Debt Report SOVEREIGN DEBT: HANDLING THE TIDAL WAVE OF ISSUANCE

debt on its own back at viable cost, highlighted how fragile the concept has become. “The Greek situation has brought it more into focus, but there is a realisation that the problem goes well beyond that,” says Mark Ostwald, strategist on the institutional bond desk at Monument Securities in London.“It presents an enormous challenge for the leaders of the EU and the eurozone.” The ability of the weaker countries in the eurozone to continue issuing debt at an affordable cost is now a serious concern. Greece may have been able to issue further debt on the back of its agreement with the EU in the form of a €5bn, seven-year bond on March 29th, but it paid twice the price at which the German government can presently borrow—310 basis points over the mid-swaps benchmark. It will be difficult for the country to sustain such a cost of borrowing in the long term, as it attempts to cut its fiscal deficit from its level of 12.9% in 2009 to less than 3% by 2012. Justin Knight, head of European rates strategy at UBS, says at present rates the cost of servicing Greece’s funding requirement for this year alone would add 0.75% of the country’s GDP every year to the deficit until the debt matured, versus the borrowing costs assumed in Greece’s budgetary plan.“It’s a real problem for Greece,”he notes. More worrying for the Greek government, perhaps, was the much lower level of investor interest in the latest bond it issued than for one of the same size with a 10-year maturity that it launched at the beginning of the month, particularly as it may have to raise around another €10bn before the end of May. Orders for the most recent issue totalled just €7bn, compared with €16bn for the earlier instrument, as the number of bidders dropped from around 400 to 175. The lukewarm response might reflect

Michael Riddell, manager of M&G’s International Sovereign Bond Fund.“There is a real risk that France could be downgraded at some point over the next three to four years, and no one’s really considered that,”says Riddell. “Longer term, I have some concerns about Europe. I think that a few countries may lack the discipline to pay down debt, and if you consider the ageing population, then the only way out for a few of these countries may be default in the long term.”Photograph kindly supplied by M&G, April 2010.

doubts about how effective the EU/IMF support package will prove to be. In theory, it should provide a back-stop that ensures Greece can continue to issue sovereign debt, but despite the triumphant assertion from German Chancellor Angela Merkel that the agreement had “demonstrated Europe’s capability to handle things, and at the same time did something for the stability of the euro and for solidarity with a country that is in difficulty”, important details as to how the mechanism will work are not yet known. As it is a facility of last resort, for instance, does Greece have to wait until it cannot access the capital markets at any price before it can draw on the funds? If not, at what price must it prove unable to sell its own debt before it can resort to the package? “So they want Greece to reach the point of bankruptcy before

they help us?” was the terse reaction of Greek opposition leader Antonis Samaras to the agreement. Then what happens if the package is not enough? There is no provision for further support, and under the terms of the deal, Greece cannot apply to the IMF for assistance on its own account. Finally there is some doubt that the arrangement is even valid under the German constitution. Consequently, concerns remain about the EU’s ability to support Greece and the other weaker, southern European states such as Spain and Portugal—on which Fitch lowered its sovereign rating a notch to double-A minus on March 24— through a period of acute and prolonged financial difficulty. If these countries can no longer access the capital markets in a sustainable way, some form of default is inevitable, and that will have unpredictable, but surely detrimental consequences for the members of the single currency. Furthermore, it is not just the“Club Med”countries that face funding issues. The credit ratings of other countries such as France and Belgium and their future cost of borrowing are under threat as their outstanding national debts approach or exceed 100% of GDP. “There is a real risk that France could be downgraded at some point over the next three to four years, and no one’s really considered that,” says Michael Riddell, who manages M&G’s International Sovereign Bond Fund. “Longer term, I have some concerns about Europe. I think that a few countries may lack the discipline to pay down debt, and if you consider the ageing population, then the only way out for a few of these countries may be default in the long term.” The grim outlook has given ammunition to the prophets of doom, who have long forecast that the euro

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Chart 3: Major Foreign Holders of US Treasuries China 22%

Luxembourg 3%

Asia 4%

Europe 9%

Taiwan 2%

Brazil 4%

Hong Kong 4%

LATAM 2%

Japan 21%

Other 8%

UK 8%

OPEC 5%

Russia 3%

Hedge Funds 5%

Source: Congressional Budget Office

would fall apart during a period of sustained economic stress, as the poorer countries in the system had to pay the price for keeping the currency stable with high unemployment and social upheaval: Greece has already had two violent 24-hour general strikes this year. Despite increasing speculation that the worsening situation across the zone will lead to expulsions, or even voluntary withdrawals, from the system, this still seems unlikely. The cost to any country of leaving the currency would be astronomical. Aside from all the internal expense of re-instituting a currency of its own, all trade contracts within the zone are designated in the euro and renegotiating these would be an administrative and legal nightmare. A more probable outcome is that beleaguered countries will default and then restructure their debt obligations, if not in quite such drastic fashion as the UK government did with its World War I debts back in 1932 (when it simply stopped servicing them). Greece, for example, could simply lower the coupons payable on its outstanding debt from 6% to 4%.“I think it’s more likely that we’ll see some kind of default or debt restructuring,” says Riddell at M&G, than a withdrawal from the euro. This prospect will hardly improve the

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standing of the euro in the eyes of international investors and means that the three currencies that dominate the sovereign bond market, regardless of the dollar’s short-term attraction, are unlikely to have great appeal in future. The same is true of sterling, as whichever UK government emerges from the General Election will have no choice but to increase borrowing massively over the next four years and impose severe fiscal restraint if it wants to preserve a triple-A rating for gilts. The rating agencies avoided action ahead of the UK election but are unlikely to do so for long after, if they do not see firm plans to trim the deficit. “I think what we’ve been saying is that massive fiscal tightening this year would probably be inappropriate, but nevertheless there’s got to be a plan in place by the end of the year for stabilising the fiscal position,” says Brian Coulton, head of European sovereign ratings at Fitch. One near-term consequence for the British government this year, along with its European and (soon) US counterparts, is that it will have to start to offer investors significantly improved yields if a lot more gilt auctions are not to fail.“They’re likely to fail unless they offer the right kind of yields,” says Ostwald at Monument. This year will also see further migration of sovereign investors to emerging-market debt—

advancing a long-term trend that will inevitably increase over the next decade as the balance of the global economy continues to shift—and to the debt of some of the smaller peripheral developed countries that avoided the financial meltdown. Riddell says the M&G International Sovereign Bond Fund has an exposure of just 67% to the big three currencies, as it had diversified into the debt of Canada, Norway, Poland, Switzerland, Mexico, and South Korea. “We see better alternatives to the mainstream currencies,”he explains. Ben Inker, the head of asset allocation at US fund management group GMO, has proposed the more radical strategy of “shorting” sovereign bonds—an interesting development for what has traditionally been the safest of fixedincome havens—as a sensible one in the current environment. “By shorting government bonds you buy a level of protection against inflation,”he explains. “Given the spending habits of UK, US and other governments, inflation is likely to be lurking somewhere, and there’s a good chance it will reappear.” Investors who do so would be exposed if bond yield dropped further, but Inker points out that as they are already at historic lows, with 10-year Japanese bonds currently yielding just 1.3%, the downside is limited even if yields were to fall to zero. “Assuming bond yields cannot go negative, you don’t have the usual infinite equity shorting risk,”he adds. The mechanisms through which investors can “bet against” sovereigns in this way are futures contracts, repurchase (repo) agreements and credit default swaps (CDS). In the last case particularly, however, Inker warns that investors need to be aware of risk that a government could declare the instrument invalid, given the widespread political initiatives to restrict the scope of CDS trading.

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Treasury Secretary Timothy Geithner testifies on Capitol Hill in Washington, Thursday, March 25th 2010, before House State and Foreign Operations subcommittee hearing on the Treasury Department’s International Programs. Photograph by Harry Hamburg for Associated Press. Photograph provided by Press Association Images, April 2010.

RIGHTING REGULATION

The Obama administration is bent on passing substantive legislation that limits risk taking among US financial institutions and creates a new consumer financial protection agency. Treasury Secretary Timothy Geithner holds that the key test for the agency is that it has independent authority to set rules and enforce them across financial firms ranging from banks to ‘payday lenders’. If the US Senate passes the legislation (which now depends on support from a handful of Republicans), it is likely to provide a catalyst for a number of far reaching reforms to be implemented across the G20 financial markets; calling into question even the operation of supranational agencies, such as the World Bank and IMF. Will regulators spur the emergence of new paradigms for the governance of the global financial and investment markets? Or is it all too much and too late? FTSE Global Markets highlights the key changes on the blocs.

ITH RISK-TAKING remaining the very essence of banking, pity the poor legislator designing a financial system for the 21st century that effectively contains risk while harnessing the benefits of free market competition. Ultimately, businesses require financing and healthy financial institutions to provide the engine for economic growth. The question for legislators is: do they place responsibility for safer banking systems with banks themselves, through reserve requirements and good governance mandates? Or, should it be achieved through further formal supervision to safeguard the public interest and detect problems before they become critical? The importance of substantive answers is paramount: any system or institution that is introduced will have to be sustainable, having very long term applicability. Right now, it appears that the preference, particularly in the United States is for further bureaucracy in the system. Treasury Secretary Timothy Geithner told journalists in early April that the Senate was close to a financial reform

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bill that both limits financial risk taking and protects consumers through the operation of an independent authority that monitors financial products and institutions. Core to the projected legislation is that no institution will be regarded as too big to fail and therefore the onus is on the prevention of failure, rather than the provision of further post crisis measures. The Democratic senator for Connecticut and Senate Banking Committee chairman Christopher Dodd wants to bring the reform bill to the Senate floor shortly after Congress returns from its Easter recess, with legislation in some form expected through May. The bill had no bipartisan support at committee stage, but the Obama administration remains hopeful that a handful of Republicans will back its passage through the Senate.

Tougher capital requirements The financial reform bill introduced by Senator Dodd gives the government the ability to seize and liquidate large banks that are on the verge of collapse. Moreover, core to projected legislation is ensuring that larger financial institutions are subject to tougher capital requirements and constraints on risk-taking. Dodd’s financial reform bill was approved by the Senate Banking Committee on March 22nd. The committee’s ranking Republican member, Senator Richard Shelby of Alabama, had raised concerns that the bill will not end the“too big to fail”problem because the emergency lending authority granted to the Federal Reserve under the bill as well as the emergency authority granted to the FDIC and the US Treasury Department to provide debt guarantees in times of economic distress allows a loophole to fund failing institutions. Counter-arguments came thick and fast. Representative Paul Kanjorski, a leading Democrat on the House Financial Services Committee, claims the House bill would ensure no financial firm poses too much risk. Soon after, Federal Deposit Insurance Corp chairman Sheila Bair entered the fray, challenging opponents of the financial reform effort, saying that the bills give the FDIC the power it needs to orderly dismantle large failing firms, in an editorial for the Wall Street Journal. Even so, the bill is less clear on how it might tackle severe market disruption of the magnitude that followed the collapse of Lehman Brothers in 2008. While Republicans have been trying to water down specific provisions, such as an independent agency to police financial institutions and products, and concessions on derivatives rulings, they are nonetheless appearing to work with the Democrats in crafting a workable bill. In common they desire greater protection for the consumer, particularly in the credit card segment. Whatever ends up in the bill, it is clear that the face of banking, at least in the Western world, will change. Stricter limits on leverage and capital are the obvious and expected results. Combined with changes in the way that banks make money, it could result in lower profits for banks. Certainly over the medium term, the challenge of making sufficient profits will test both the application of new

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FDIC Chair Sheila Bair, left, and SEC Chair Mary Schapiro, participate in the Women in Finance Symposium, Monday, March 29th 2010, at the Treasury Department in Washington. Photograph by Pablo Martinez Monsivais for Associated Press. Photograph supplied by Press Association Images, April 2010.

regulations and the business strategies of universal banks. Through most of 2009 and the first quarter of 2010, the West’s bulge bracket and universal banks have made a slew of money from market volatility rather than traditional lending and advisory businesses. In part that has been a response to constrained market conditions in which mergers and acquisition activity, capital goods financing and corporate lending has been at a premium. Going forward through 2011, unless traditional benchmarks of a growth market (M&A, corporate borrowing, and syndicated loans) begin to return in force, banks will be hard pushed to replicate recent profits. Moreover, as government borrowing will continue to dominate the borrowing agenda over the coming decade it will redraw business lines once more.

Sovereign debt The rise in sovereign debt issuance has resonance for the banking sector which will be reeling from a storm of new legislation, stricter Basel II compliance and long term competition from (relatively) unregulated banks in the more sophisticated emerging markets. The sheer extent of government debt expected to be raised by western economies over the coming decade will invariably change the timbre and focus of the banks as market makers in treasuries. The implications of this far-reaching change are yet to be felt; particularly as sovereign debt will no longer be regarded as an AAA safe haven. There are also more complex trends in train. Formerly unregulated off-exchange derivatives markets will have to conform to new procedures; at the same time limiting the way banks hive off risk into the derivatives markets. The vulnerability of the banking sector can only be exacerbated as the power of lenders to package and securitise mortgages and other forms of debt will face new limits.

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Elsewhere, alternative asset gatherers such as hedge funds will continue to face new scrutiny, thereby consigning the less than best of the sector into the mainstream of investment funds.

Born in the USA The Obama administration’s drive is to achieve workable legislation in short order; not only to set the precedents that will form the basis of debate elsewhere. Speed is of the essence as the government hopes to ride the momentum provided by the recent passage of its healthcare reform package. Finally, the administration is keen to put the issue firmly to bed before it gets bogged down in campaigns for the mid-term elections in November. As with healthcare, the going will not be easy. Additional challenges and amendments look to be mounted by a raft of Democrats. Senator Jack Reed of Rhode Island, for one, wants to add an amendment to the financial regulatory reform bill that requires hedge, private equity and venture capital funds to provide information on their dealings to the Securities and Exchange Commission (SEC). Reed, a member of Dodd’s Banking Committee, wants to specifically require private funds with more than $30m in assets to register with the SEC and disclose information that would help regulators determine whether the funds pose any risk to the financial system. The Senate bill

Industry insiders argue that most hedge funds aren’t big enough to threaten the stability of the financial system. Moreover, when a hedge fund crashes, they say, only private investors lose their money. Even so, Reed’s supporters point to the adverse market impact of the 1998 crash of the hedge fund Long-Term Capital Management. At that time New York Federal Reserve Bank organised private lenders to save the failing fund, whose collapse many feared could trigger a chain reaction throughout the financial system. currently requires hedge funds that manage more than $100m to register and open their books to the SEC. Reed is also going after private equity and venture capital funds which remain largely exempt from the requirement. Industry insiders argue that most hedge funds aren’t big enough to threaten the stability of the financial system. Moreover, when a hedge fund crashes, they say, only private investors lose their money. Even so, Reed’s supporters point to the adverse market impact of the 1998 crash of the hedge fund Long-Term Capital Management. At that time New York Federal Reserve Bank organised

private lenders to save the failing fund, whose collapse many feared could trigger a chain reaction throughout the financial system. For all its good intentions, Reed’s amendment could open a new front in the battle over the sweeping financial reforms; threatening the light regulatory touch the bill currently affords alternative funds.

Questions in Europe In Europe, EU member states and the European Parliament has yet to rule on a range of proposed regulations for banks, markets, insurers, hedge funds and private equity groups that will be put forward by Michael Barnier. Barnier is expected to unveil a draft law, referred to as the Markets Infrastructure Directive, which will include mandatory clearing of much of the off-exchange derivatives market, by July this year. Work is also underway on the design of a new supervisory structure for banks, markets and insurers; while further discussions are in train on new regulations for hedge funds and private equity groups. While Europe likes to tread its own path, the expectation is that lawmakers will try to ensure convergence in key legislative segments. To this end, the G20 will continue to play a leading role in reaching consensus. In this regard, the search for answers in Europe continues to verge towards confederacy, at least in the IMF’s view. An EU-wide authority to deal with failed banks is needed to strengthen the region’s post-crisis banking system, Dominique Strauss-Kahn, the head of the IMF, said in a speech on March 19th this year. Speaking to a European Commission conference in Brussels, StraussKahn told delegates that existing schemes for dealing with failed cross-border banks have proved inadequate. As a result, national and cross-border bank failures have been difficult to handle effectively and have been costly for governments and taxpayers.“Europe needs a fire brigade,” said Strauss-Kahn, to extinguish banking problems when they erupt, and intervene when things get out of hand. A proposed European Resolution Authority would be equipped with the tools to deal with failed banks costeffectively; ensuring losses are borne by shareholders and by uninsured creditors. Moreover, the system should be pre-financed by the banking industry, including through deposit insurance fees and levies on financial institutions. To this end, the IMF is currently putting together proposals on ways to tax the financial sector, which will be presented to the G-20 group of advanced and emerging economies later this month. Finally, The Basel Committee on Banking Supervision, a global body of regulators and central bankers, will soon start assessing the impact of its December package of reforms to toughen up bank capital and liquidity requirements across the world. This will be fundamental to the committee’s harder task of “calibrating” or fixing the new higher levels of capital banks will have to hold from the end of 2012 to help avert more huge public bailouts in a future crisis.

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Managing Director of the IMF Dominique Strauss-Kahn pauses before speaking during a meeting on ‘Building a Crisis Framework for the Internal Market’ at EU headquarters in Brussels, Friday March 19tj 2010. In a Friday speech, European Central Bank President Jean Claude Trichet said the credit default swaps market needs to be more transparent to regulators and investors. EU regulators have threatened to ban the use of the naked credit default swaps on government debt to prevent investors buying swaps and they blame swaps traders for unfairly increasing pressure on Greek borrowing costs. Photograph by Virginia Mayo for Associated Press. Photograph provided by Press Association Images, April 2010.

THE IMF UNDER SCRUTINY HE IMF ITSELF is rethinking its role in the postcrisis world to ensure that it is doing the right job for its 186 member countries. At the 2009 IMFWorld Bank annual meetings in Istanbul, the IMF’s membership called on the Fund to review its mandate to ensure that it covers “the full range of macroeconomic and financial sector policies that bear on global stability.” As a first step toward a formal proposal, the IMF has issued a paper, the first in a series of reflections or ideas on how the Fund will approach the global financial markets through this century, promoting global stability. The IMF is also seeking extensive feedback from governments, academics, and civil society before it issues its final report to the International Monetary and Financial Committee in October this year. During the crisis, many countries accessed the IMF’s crisis lending and contingent credit lines on new, more flexible terms. In future, the Fund must be ready to handle not just country crises but also systemic ones. This means it should be prepared to deliver financing rapidly to several countries simultaneously, the way the US Federal Reserve did at the start of the crisis, in the interest of protecting the stability of the overall global financial system. This will require a rethink of the IMF’s size and ability to deliver short-term liquidity quickly. Even if the IMF’s Articles of Agreement already allow for a great deal of flexibility in lending, the IMF should do more to provide countries with necessary insurance against crises. New reforms should seek to reduce the stigma that many countries, especially in Asia, still associate with turning to the IMF for assistance, the paper notes.

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

The paper points to three main challenges. The IMF must improve its ability to assess systemic risks. National regulatory oversight after the crisis is shifting from assessing risk in individual institutions to assessing risk to the entire financial system. The IMF’s surveillance covers both economic policies in individual member countries, and developments relating to the global economy as a whole. But in practice, the bulk of the Fund’s efforts have been at the country level. In future, more attention should be given to the linkages and spill-over between economies. The coverage of financial sector policies is particularly important if the Fund is to be ahead of the curve in crises. Second, in future, the IMF’s crisis lending has to be of a speed, coverage, and size far beyond previous assumptions. The crisis has highlighted the risk of sudden runs on liquidity in advanced, emerging, and developing economies alike. The Fund can help by offering more flexible insurance facilities that build on recent reforms and by expanding its lending capacity. Far-reaching reforms were introduced during the crisis, but more is needed. Finally, the crisis has also cast a spotlight on the tension between the high demand for global liquidity by emerging market economies and the dependence on the stability of just a few suppliers of such liquidity. If the IMF’s ability to prevent and respond to crises is strengthened, this could help alleviate countries’ perceived need to accumulate vast reserves. It may also make sense for the Fund to back the use of a global reserve asset and other initiatives that could reduce risk in the international monetary system.

THE SLOW RECONSTRUCTION OF SEC LENDING

RISK IS THE MAIN CONCERN The collapse of Lehman Brothers, interim restrictions on short selling and a host of prickly problems surrounding the re-investment of cash collateral nearly wrote the obituary for securities lending. While the glory days are long gone, the market is slowly rebuilding its market, character and credentials. Lynn Strongin Dodds reports.

Photograph ÂŠ Headshot/Dreamstime.com, supplied April 2010.

ECURITIES LENDING CAME back on the agenda in Europe at the end of 2009 and volumes were rising in the first quarter of this year. However, the industry may never again enjoy those pre-financial crisis glory days. Participants have not only become more realistic about what their programmes can deliver but they are much more probing and risk averse. In many ways, the industry has returned to the days of being an investment function that can generate incremental and not substantial returns in the portfolio. There is no doubt that the Lehman collapse, bans on short selling and cash reinvestment problems have left their mark. From 2003 to mid-2008, the value of securities for loan in the global markets had been growing at an estimated compound annual rate of 15% to 20%. Those days are gone for now. Although it is not broken down by regions, as of March 2010, Data Explorers, an industry data

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THE SLOW RECONSTRUCTION OF SEC LENDING 52

provider, estimated the size of the securities lending market worldwide to be approximately $11trn in lendable assets, with over $1.9trn in securities on loan. This is a substantial increase when compared to the low of $8trn in lendable and $1.5trn on loan experienced in early 2009, but falls short of the March 25th, 2008 figure when global balances were $14.1trn lendable with $3.6trn on loan. These trends are underscored in a new report by Keefe, Bruyette & Woods entitled Trust and Custody January 2010 Asset Servicing Survey: What Pricing Power? Although it pertains to the US market, the same themes are playing out in Europe. Canvassing about 1,100 organisations, including corporate, government and other public pension plans, endowments and foundations (primarily universities) and investment managers, it found that securities lending activity and revenues will be boosted by higher short-term

Maria Carina, director, collateral services at Euroclear, is also seeing a greater demand for tri-party arrangements. “Two of the main advantages of tri-party are that it mitigates risk and increases efficiency. For example, our tri-party collateral management services provide daily mark-tomarket evaluations of the securities, margin call management, securities substitutions and collateral eligibility checks in an automated and transparent way. There is no manual intervention and collateral movements can be done instantaneously.”

interest as well as more stabilised market conditions but it appears unlikely that the business can approach its prior levels of usage and profitability for the foreseeable future. Other studies, including a recent report by Finadium, a securities and investments research firm, show that although the credit crisis is largely behind them, institutional investors continue to closely scrutinise the business practices in securities lending with risk trumping return as the top concern. Beneficial owners are also evaluating key issues such as the bundling of services, indemnifications, fee structures, collateral management and how cash collateral is reinvested. In Europe, there is more focus on non-cash securities which has historically been the collateral of choice. According to William Gow, senior vice president, business development (EMEA), at eSecLending: “Throughout the last 12 to 18 months, many beneficial owners allocated a significant amount of time reflecting on the lessons learned from the credit crisis. As they review

their programmes, many are looking for greater transparency, control and customised solutions built around their unique risk/return parameters and goals.” Gow adds:“The market has seen an increase in supply as many beneficial owners who suspended their programmes during the peak of the financial crisis in late 2008, reengaged in the business throughout 2009. We are also seeing some beneficial owners who have not lent in the past now entering the market for the first time.” Rob Coxon, head of international securities lending at BNY Mellon, says:“I think there is a feeling that the storms are over and as a result we have seen an increase in the number of clients that have restarted their programmes. Volumes are down to where they were in 2003 and 2004, and I think it will be a long time before we see volumes climb back up to the pre-crisis levels. Clients though have put greater restrictions on their programmes, limiting how much they will lend, what type and quality of collateral are acceptable, as well as being more selective in who they do business with.” This has led to a greater push towards customisation as well as segregation of assets. Paul Wilson, global head of sales and relationship management for securities lending at JP Morgan Worldwide Securities Services, says: “We have always provided segregated accounts that are customised to a client’s specific requirements and risk parameters and have seen increased demand from the marketplace for this type of structure and approach to managing cash collateral. We are also seeing a greater level of scrutiny and due diligence into the types of indemnification and the protection that is being provided. As a result, there is more focus on the firm’s capital base and balance sheet providing these indemnities.” Jemma Finglas, head of securities financing, BNP Paribas Securities Services, echoes these sentiments. Clients are looking at every securities lending option available to them, she says. They have pulled their programmes apart and are examining legal, credit and operational aspects in great detail. They are paying much greater attention to the safety and scurrility of their assets and as a result are asking much more specific questions about risk and the potential exposure to both custodian and counterparty default. This perhaps explains why over the past few months, there has been a marked shift back into tri-party arrangements. They were typically based on the provider’s operational support but today the main focus is on the risk management attributes. Jean-Robert Wilkin, head of product development at Clearstream Global Securities Financing (GSF), agrees: “Segregation and transparency are definitely the main themes for this year, which is one of the reasons why we are seeing an increase in tri-party arrangements.The main driver is the unbundling of the custody from the securities lending function. After the Lehman crisis, beneficial owners wanted different options and wanted to separate their assets from their agent lenders.” Maria Carina, director, collateral services at Euroclear, is also seeing a greater demand for tri-party arrangements.

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

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As a leading securities lending agent, we take a consultative, highly customized approach when it comes to structuring lending programs for our clients. Unlike traditional pooled models, where many lendersâ&#x20AC;&#x2122; portfolios are grouped together and their securities wait to be borrowed on a best efforts basis, we utilize a competitive auction to determine the optimal route to market for their assets. Based upon results from the auction, we manage clientsâ&#x20AC;&#x2122; portfolios either through agency exclusive lending for specific portfolio segments or on a traditional agency basis, where securities are lent individually. 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. H6HF/HQGLQJ $VLD 3DFLÂżF 5HJLVWHUHG RIÂżFH RI 6HFXULWLHV )LQDQFH 7UXVW &RPSDQ\ LQFRUSRUDWHG LQ 0DU\ODQG 8 6 $ WKH liability of the members is limited.

THE SLOW RECONSTRUCTION OF SEC LENDING 54

“Two of the main advantages of tri-party are that it mitigates risk and increases efficiency. For example, our triparty collateral management services provide daily markto-market evaluations of the securities, margin call management, securities substitutions and collateral eligibility checks in an automated and transparent way. There is no manual intervention and collateral movements can be done instantaneously.” Coxon adds: “For securities lending programmes, triparty has become the de facto standard in the way that noncash collateral is handled. The tri-party agents provide such a reliable, scalable and operationally cost efficient service that it really does not make much sense handling this inhouse on a bilateral basis.” Tied to the growth in tri-party arrangements is the increase in demand for using reverse repo when managing cash collateral, which are typically done on a tri-party basis, according to Fredrik Carstens, managing director, co-head of agency securities lending EMEA at Deutsche Bank.“We are definitely seeing a stronger interest in repos than in the past. Europe has always been different from the US which favoured using 2a-7 money market funds for managing cash collateral (which is currently being evaluated by the government and the industry in terms of acceptability of certain types of securities, maturity considerations, credit, issuer limits and liquidity). The advantages of using reverse repo are the flexibility and the ability to trade in different collateral sets.” He adds: “There has been a move away though from taking structured products to more liquid and transparent securities as collateral.” Market participants in Europe have also pointed to the re-emergence of the intrinsic value model of securities lending which produces returns based upon the securities loan itself, with little incremental benefit from collateral reinvestments. Ed Oliver, a director of Data Explorers, believes the focus on value will continue to be a major theme for years to come.“Our research showed that while the volume of securities lending activity fell in 2009, the fees generated for the securities being lent increased over the past year as borrowers focused on hard-to-borrow securities.” Oliver believes that the main driver is the “pressure on borrowers to increase returns on their balance sheets”. He adds: “They need to be more selective in their loans because there is a balance sheet impact in providing collateral that is worth more than the value of the security borrowed. Overall, though, lower volumes and higher fees, with the same overall revenues, is a better result for lenders because this results in lower transaction risk.” Keith Haberlin, head of securities lending in Europe and the Middle East at Brown Brothers Harriman, also notes“the migration away from volume lending of low margin securities towards value lending of higher margin securities”. He adds: “In a value lending programme, the emphasis is on optimising the fee from the security being lent and not from taking risk from the collateral, which had been the case with certain cash re-investment programmes.”

William Gow, senior vice president, business development (EMEA) at eSecLending, a third-party (non-custodial) global securities lending agent, says: “Throughout the last 12 to 18 months, many beneficial owners allocated a significant amount of time reflecting on the lessons learned from the credit crisis. As they review their programmes, many are looking for greater transparency, control and customised solutions built around their unique risk/return parameters and goals,” says Gow. Photograph kindly supplied by eSecLending, April 2010.

Gow agrees that “borrowers continue to seek captive supply of special (high demand) securities and are willing to pay a premium for access”. Gow continues: “In 2009, eSecLending auctioned over $200bn of assets in various markets and asset classes with the majority of this allocated to agency exclusive lending. We received wide participation across many borrowers and strong demand across multiple asset classes. Thus far in 2010, we have auctioned close to $60bn in assets with some of the strongest bidding activity we have seen since inception.” Overall in Europe, high quality government and supranational bonds remain the most popular forms of collateral, according to Haberlin. He notes that cash collateral accounts for only about 20% of the European market while cash comprises virtually 100% of the US market.“I do not see that changing any time soon due to the financial crisis. The majority of European beneficial owners starting or recommencing a securities lending programme just do not want to deal with the complication of cash reinvestment right now.” Others, however, see Europe regaining some of the appetite for cash but in a risk controlled manner. Wilson notes: “It has gone in cycles. Post-Lehman we did see a reduction in the proportion of cash collateral across the market. Now it has swung back a little the other way as the market has tended to be long cash. We are starting to see clients review cash collateral and cash guidelines with

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

THE SLOW RECONSTRUCTION OF SEC LENDING 56

Keith Haberlin, head of securities lending in Europe and the Middle East at Brown Brothers Harriman, also notes “the migration away from volume lending of low margin securities towards value lending of higher margin securities.” He says: “In a value lending programme, the emphasis is on optimising the fee from the security being lent and not from taking risk from the collateral, which had been the case with certain cash re-investment programmes.” Photograph kindly supplied by Brown Brothers Harriman, April 2010.

many now looking beyond the very short end of the curve out to the three to six months maturity range.” Participants also see a move towards equities because of their inherent advantages of liquidity, transparency and ready available pricing information. Many fixed instruments, particularly government and supra-national bonds, have the same attributes although certain segments of the market such as corporate and convertible bonds remain unpopular.

Equities are also on the agenda. Andy Clayton, head of global securities lending at Northern Trust, says: “We are definitely seeing a greater interest from prime brokers to pledge equities as collateral because they wish to utilise their long inventory resulting in cheaper funding. As a result, if you are lending out equities, there is an increasing preference for pledging equities as collateral and potentially generating a greater intrinsic spread. From a risk perspective, and particularly if the currency of the loan and collateral match, this makes sense in that, in theory, asset values are moving in the same direction and there is no currency exposure. However, clients are generally still being cautious and are only likely to accept blue-chip stocks in indices as collateral.” Looking ahead, John Schreyer, managing director, cohead of agency securities lending EMEA at Deutsche Bank, believes that “one of the biggest challenges facing the industry is regulation”. He says: “It is not easy to predict the outcome and as a result difficult to prepare for the impact. However, the one certainty is that risk will remain a major focus.” According to the Data Explorers Yearbook, short selling, which produced a crop of consultations and proposals last year, remains a concern. In Europe, the industry is awaiting feedback from the Committee of European Securities Regulators (CESR) on its consultation paper proposing a pan-European disclosure regime for short selling. The UK’s Financial Services Authority, at the request of Lord Myners, has also undertaken a study of securities lending which highlighted a small number of areas of concern. Most notable is the need for more educational and informational material to be made available for beneficial owners.

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FEDERAL DISTRICT COURT OUSTS ERISA CLAIMS RELATING TO SECURITIES LENDING In March this year the US District Court of Massachusetts granted a motion to dismiss a claim of an alleged ERISA breach of fiduciary duty and prohibited transaction claims involving a bank’s securities lending program. The court decision in the Fishman Haygood Phelps Walmsley Willis & Swanson, LLP, et al. v. State Street Corporation involved the plaintiff law firm’s defined contribution plan, which invested in collective trusts managed by State Street Corp. Certain of the collective trusts participated in defendants’ securities lending program, under which the collective trust would lend securities to brokers and other borrowers. Cash collateral provided by borrowers to secure the loans was invested through commingled cash collateral pools. A portion of the income generated by the investments was retained by the collective trusts as compensation for lending their securities. The plaintiff alleged that the defendants in

fact invested the collateral in instruments with unusually high risk and unusually long duration, including mortgage-backed securities, instead of the short term instruments it had expected to be invested in. The plaintiff alleged that the investments were imprudent and caused injury to the Plan as a result of decreases in the net asset value of the collateral pools based on mark-tomarket valuation. However, claimed the plaintiff the collateral pools at issue did not price on a mark-tomarket basis, but rather used amortised cost pricing, under which the pools maintained a constant $1.00 unit price even when the net asset value of the underlying securities fell below a dollar. In the next edition of FTSE Global Markets we explain how State Street’s legal advisors argued the case for the defence and managed to get a dismissal of the plaintiff’s case. What does it mean for other securities lenders?

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COLLATERAL MANAGEMENT

What is the value of collateral?

Photograph © Tiero/Dreamstime.com, supplied April 2010.

More conservative collateral parameters and closer monitoring of those parameters is a prime example of the securities lending industry’s shift back towards the fundamentals. Instead of taking credit or duration risk with collateral to generate additional return, the emphasis is now back on the primary purpose of collateral, namely to protect principal and secure the loan with the emphasis on stability and liquidity. In turn, this is prompting a focus on lending securities with a high intrinsic value which require minimal collateral risk to be taken, writes Keith Haberlin, head of securities lending, EMEA, Brown Brothers Harriman. HE SECURITIES LENDING industry has certainly rebounded from a low point in 2008 but not without recognition that there are lessons to be learnt. The default of a major borrower in Lehman Brothers, losses in collateral reinvestment vehicles and more recently, sovereign risk concerns, have forced lenders to question their collateral strategies. What should drive this collateral choice? Must principal protection and the generation of returns be mutually exclusive?

Lehman Brothers Collateral falls into two general categories: cash and noncash. The US securities lending market is almost exclusively a cash collateral market whereas non-cash collateral is much more prevalent in non-US markets. The default of Lehman Brothers as a borrowing counterparty and the ongoing distressed credit markets have had significant consequences on both sides of the securities lending trade, in terms of the collateral risk beneficial owners are willing to accept and the cost to borrowers of raising it. The Lehman Brothers insolvency in September of 2008 highlighted the importance of protecting loan principal with collateral that is stable and liquid. This was largely because beneficial owners needed to either liquidate their collateral to purchase replacement securities that were on loan to Lehman Brothers, or return it to borrowers in the event they wished to withdraw from their securities lending programmes. However, as many soon found, what should have been a straightforward process turned into quite the opposite for some lenders, whether their loans were supported by cash or securities collateral. Some beneficial owners invested their cash collateral into segregated or pooled money funds, which while intended to

maintain a $1.00 net asset value (NAV), contained instruments that had either defaulted or had become credit impaired. This meant that some beneficial owners were faced with the choice of either redeeming out of their vehicles at a price below $1.00—thereby crystallising a loss—or continuing to lend in the hope that the impaired assets in the collateral vehicles would eventually mature at par. This has created unedifying public disagreements between beneficial owners and their agents about whether the cash collateral investment guidelines were transparent, properly communicated, or indeed followed. Under this backdrop, many lenders who were investing in enhanced cash reinvestment vehicles have pared back their risk profile and are now utilising guidelines similar to SEC Rule 2a-7, or similar fund structures, or limiting investments to overnight maturities in instruments such as treasury repos or time deposits.

Non-cash collateral In terms of non-cash collateral, many industry practitioners are reflecting on the difficulties faced by some lenders in pricing and disposing of their collateral during the Lehman default and determining what types of collateral to take going forward. As further evidenced by the graph showing equity versus sovereign debt performance, one of the lessons learnt from the Lehman failure was the critical importance of the speed at which collateral could be liquidated to fund the purchase of replacement securities. As global equity markets fell upon the news of Lehman’s insolvency, markets recovered later that week and without the ability to call for additional collateral, programmes that could not be unwound quickly experienced substantial shortfall risk. This was a particular problem for those beneficial owners holding certain illiquid corporate and convertible debt.

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One proposed solution to the recent problems is to take equities as collateral on the basis that they are liquid, price transparent and on a macro price performance level that should at least correlate with the equities on loan, assuming certain parameters are implemented. While this argument may be proved valid and equities are certainly preferable to illiquid corporate bonds or cash invested in impaired assets, closer examination of market reaction in the week following the Lehman insolvency evidenced that the safest collateral to hold is high quality, liquid sovereign debt, which exhibited slight price appreciation, even as equity markets fell upon the Lehman news. A look at the performance of the US, German, and French government bond indices as a proxy for high quality sovereign debt markets, and the S&P 500, FTSE, DAX, and CAC indices as representative of global equity markets, is validation of the view that good quality sovereign debt will benefit from inverse correlation or the classic flight to quality trade in times of financial market stress. Indeed, beneficial owners that held high quality sovereign debt were able to liquidate it and buy replacement securities promptly, in some cases ending up with collateral proceeds far in excess of what was required. Of course, recent well publicised issues regarding sovereign debt in Dubai, Greece and other European countries has highlighted that sovereign debt has its own considerations too. However, it is important to note that all sovereign debt is different and must be evaluated individually. For example, BBH accepts only a carefully selected subset of sovereign debt from the G10 countries which we consider to be the most liquid and creditworthy. This is based upon continual review of factors such as credit default swaps (CDS) pricing, credit ratings, and public debt and budget balances as a percentage of GDP. Another trend which has accelerated after the Lehman default is a requirement from beneficial owners for customised and diversified collateral parameters. Similar to their desire to spread counterparty risk across a diversified set of borrowers, beneficial owners want to ensure that their collateral is not concentrated in one particular market, sector or issuer and, where applicable, parameters are placed between the types of securities lent and the collateral received in return. This increased requirement for customisation also applies to volumes on loan, counterparty limits and reporting and will present opportunities for nimble, specialised lending agents who can more easily accommodate these requirements and provide a tailored programme. Additionally, the triparty collateral management providers are also likely to increase their share of collateral assets given their core business is the maintenance of customised collateral schedules. Whilst a shift towards more conservative collateral parameters will obviously better protect lenders, there are broader issues to be considered. Firstly, certain asset classes have minimal intrinsic value and therefore borrowers may be less inclined to pledge expensive government debt collateral in

exchange for these. Similarly, from a cash collateral perspective, the difference between current reinvestment yields from conservative vehicles and the rebates required by borrowers on their cash collateral are making the lending of easy to borrow securities (“general collateral”) increasingly uneconomical.This means that in order to generate a worthwhile return on these asset types, some level of credit or duration risk is necessary. Our clients have never been willing to take this risk, instead preferring to generate risk-adjusted returns by restricting lending only to hard to borrow securities which command a high intrinsic margin and which they can combine with conservative collateral parameters. This “intrinsic value” approach is generating broader favour in the industry but does require an experienced agent that has a track record of specialising in this discipline, as it is quite different to a volume lending model driven by collateral reinvestment returns.

Is collateral the only protection? Collateral should not be viewed as the only line of defence against counterparty risk. A diversified set of top quality borrowers and, as mentioned previously, the ability to liquidate collateral as soon as possible after an insolvency situation are equally as important as the collateral itself. This is where carefully drafted borrower contracts and an infrastructure to liquidate collateral and execute buy-ins across multiple securities and markets are key. In summary, more conservative collateral parameters and closer monitoring thereof is a prime example of the securities lending industry’s shift back towards the fundamentals. Instead of taking credit or duration risk with collateral to generate additional return, the emphasis is now back on the primary purpose of collateral, namely to protect principal and secure the loan with the emphasis on stability and liquidity. In turn, this is prompting a focus on lending securities with a high intrinsic value which require minimal collateral risk to be taken. If this means leaving a few extra basis points on the table, beneficial owners seem to agree that this is a price worth paying as the focus has shifted to risk-adjusted rather than total returns from securities lending. Comparative Performance of Equity vs. Sovereign Debt Indices Cumulative Index Change Post-Lehman Default

COLLATERAL MANAGEMENT 60

What now?

2.00%

0.00%

-2.00%

-4.00%

-6.00%

-8.00% 9/12/2008

9/15/2008

USG2TR Index S&P 500 Index

9/16/2008

9/17/2008

9/18/2008

9/19/2008

GRG2TR Index

FRG2TR Index

DAX Index

CAC Index

Source: Bloomberg, provided April 2010

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Nordic Trading The Nordic stock exchanges began their ascent in 2003, when the Stockholm Stock Exchange merged with the Helsinki Stock Exchange to form OMX. By 2006, OMX had also acquired the Copenhagen and Icelandic stock exchanges and a 10% stake in Oslo Børs, later divested. In 2008, US exchange NASDAQ bought OMX for a reported $3.7bn and now Nasdaq OMX covers stocks in Sweden, Denmark, Finland, Iceland as well as the three Baltic states of Lithuania, Estonia and Latvia. Scandinavia saw three major developments combine last year which brought the region closer to the rest of Europe: standardisation of tick sizes, a central counterparty (CPP) and the introduction of new international trading platforms. Ruth Hughes Liley explains how the Nordic region is growing in confidence and importance worldwide as a financial warrior. HEN 18 TOP Nordic companies gathered in New York last year at NASDAQ OMX for a seminar organised by Swedish bank SEB Enskilda and delegates rang the NASDAQ Stock Market closing bell, it signified more than the closing of the trading session. It signified the wind of change blowing through Nordic-listed companies and their greater confidence in promoting themselves to US investors and around the world. “There are more and more Nordic-listed companies promoting themselves in the US,” says Bjørn Sibbern, senior vice president of NASDAQ OMX Nordic and president of the Copenhagen Stock Exchange. He predicts that in a year’s time, trading in the three markets of Sweden, Finland and Denmark will have grown 25%, from the current figure of 250,000 trades a day on NASDAQ OMX, worth around $3.5bn in turnover. Similarly in Norway, where Oslo Børs has a partnership with the London Stock Exchange, Oslo Børs reported average daily turnover of NOK6.1bn with around 63,000 trades a day in 2009, a year in which every fourth listed company more than doubled its market capitalisation, and it was the“best year for Oslo Børs since 1983,”they claim.

THE ASCENT OF THE NORDIC TRADING MARKET

The Firm Hand of

Photograph© Edalfo/Dreamstime.com, supplied April 2010.

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

THE ASCENT OF THE NORDIC TRADING MARKET

Oslo Børs in March last year agreed a partnership with the London Stock Exchange under which the LSE would provide its TradElect platform for the equities and fixed income markets. A launch date of February 2010 had been announced, but requests by members for more time to adjust their systems put back the go-live date to April 2010. Once up and running, the use of TradElect and a harmonised trading model will increase access to the London, Milan and Oslo markets for cash equities and Bente A Landsnes, chief executive officer of Oslo Børs, believes the partnership will enhance liquidity as well as general interest in the Norwegian market:“This is a natural development for Oslo Børs, increasing our distribution network throughout Europe.”

International presence Olof Neiglick, chief executive officer, Burgundy. Photograph kindly supplied by Burgundy, April 2010.

As in the rest of Europe, the Nordic incumbent exchanges have had to defend their corner after proliferation of pan-European exchanges and multilateral trading facilities (MTFs), brought competition to the exchange scene, following the introduction of MiFID. The most successful MTF to date, Chi-X, began trading Swedish stocks in March 2008 and has since extended to Norwegian, Danish and Finnish stocks. Last May saw the launch of Burgundy, an MTF trading specifically in more than 800 Swedish, Norwegian, Finnish and Danish listed stocks and backed by leading Nordic banks and brokers. “Eighteen months ago Burgundy was just a powerpoint,” says Olof Neiglick, chief executive officer, Burgundy. In contrast, in March 2010 the exchange was at an all-time high, hitting 6.1% of market share in the OMX S30, according to the Fidessa Fragmentation Index. “The incumbent exchanges are in a difficult position, losing 30%-40% market share to new players. We will see real competitive behaviour, real carnage between platforms and the incumbents will start trying to compete with each other, but primary exchanges are still very strong and cash rich and should not be taken lightly.”

New trading platforms Arguably the biggest technology demand in the region is the migration to new trading platforms at Nasdaq OMX and Oslo Børs. Nasdaq OMX’s INET trading platform was introduced across Sweden, Denmark, Finland, Iceland and Estonia, Latvia and Lithuania, in February 2010. The exchange claims its INET platform is the fastest in the world with the capacity to carry a million messages a second at speeds of less than 250 microseconds. NASDAQ’s Sibbern points out: “This platform is a huge change for us, probably the biggest change in 20 years. To move seven markets at the same time has impacted all banks and brokers, and has had an impact on market data, surveillance, everything.” Not to be outdone, Norway’s

Neiglick points out that three major technology projects at once has been difficult for the region.“Even if my clients had wanted to focus on projects they couldn’t because the pipeline was full. The big London banks with big IT resources could cope with several IT projects at once, but last year there were two or three mandatory projects at once. Now that’s clearing up and you can see immediately the fact that the landscape has improved and the Nordic banks are getting their act together with technology. Having said that the region has always been at the forefront of electronic equity trading and many companies which began in the Nordics now have international presence. We have a strong tradition and very skilled people.” The second large IT project to which banks and brokers had to adjust their technology, was the introduction by NASDAQ OMX of a cash market central counterparty operated by EMCF. Existence of a CCP means that for each and every trade, the CCP becomes the counterparty to both the buying party and the selling party; the CCP enters into the trade as the buyer to the seller; and as the seller to the buyer. In this way, CCP reduces counterparty risk, which is the risk that one party in a trade might lose because the other party cannot fulfill its obligations. With more Nordic-listed shares being traded outside the region, the introduction of a CCP has been crucial, according to Christian Blaabjerg, chief equities strategist, Saxo Bank.“At the beginning, NASDAQ wanted a Nordic pool of markets, but the open source approach where it is possible to pool European stocks is much better. I think the CCP has created better efficiency, and lower prices, due to the price competition between clearing houses, and if you are an investor, that is what you are looking for.” Even more competition is on the way as NASDAQ OMX hopes to have CCP clearing providers Six X-clear and EuroCCP on board later this year. Sibbern says: “We are working on three CCP providers in the Nordic market, but it’s difficult to have a timeline. So much depends on the regulators and on the CCP providers themselves. We are definitely keen to have interoperability. Competition is good on the trading landscape, but it is also important on the post-trading landscape.”

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

The third significant development in the Nordic region during 2009 was the harmonisation of tick sizes across Europe from 25 different tick size regimes, ensuring that the increments by which stocks rise and fall were standardised into just four regimes or tables. Oslo Børs, for example, adopted Table 2 in September last year, while NASDAQ brought Stockholm into line in October for S30 listed shares and Helsinki (H25 shares) and Copenhagen (C20 shares) in January this year. Sibbern admits NASDAQ OMX has been slow to implement, but says the move was carefully thought through with more or less all customers supporting the change in tick sizes. Since the blue-chip stocks have been standardised he has seen a rise in market share: “We have the liquidity and best bid and offer price (BBO) for most of the day, so with the post-tick size advantage, if banks and brokers want to secure best execution, they come to us.” Saxo Bank’s Blaabjerg believes that Burgundy’s arrival played a part in standardisation.“Burgundy’s appearance in the market has led to tick sizes converging towards European standards and the major players—Nasdaq OMX and the Finnish exchange, for example—have followed in Burgundy’s trail. One advantage here is obviously when you are thinking hard about how to split orders going to the Nordic market. It’s a small thing but significant, because now you can invest across all 10 markets and be more confident of the spread.” A particular aspect of equity trading in the Nordic region is the high proportion of retail trade. Neiglick believes many brokers who are still only connected to the incumbent exchanges are in for a nasty surprise as their customers lose out by not getting the best prices. “There are still a surprising number of brokers in Sweden and the rest of the Nordics who are still only connected to two thirds of the market. Because the landscape is changing so quickly and fragmentation has now reached such a large extent, in particular for Swedish and Danish stocks, there is the possibility that retail customers are using the wrong broker to gain access to the markets. If only 10% is traded outside the primary markets you can get away with it, but it is approaching 30% now.” In acknowledgement of the importance of the retail trade, Saxo Bank in March unveiled a new equity platform to enable private investors to have broader access to institutional-style trading and analysis tools, covering 11,000 single stocks on 23 exchanges, single stock contracts for difference (CFDs) and exchange traded funds. The bank is looking to double its number of clients over the next two years. Furthermore, a year ago it acquired a 38% stake in EuroInvestor, a multi-language online investor forum attracting 1.8m users a month. Whereas ten years ago the banks had a monopoly on Nordic trading, now more firms are in competition, bringing costs down and opening the market up, explains Saxo’s Blaabjerg. “The whole revolution in retail investing took place in the Nordic region. Now you can trade online anywhere. The classic banks are now offering online trading as well.”

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

Christian Blaabjerg, chief equities strategist, Saxo Bank. Photograph kindly supplied by Saxo Bank, April 2010.

Transaction costs have tumbled in the region by around 80% some estimate, largely due to the introduction of the central counterparty.“Without CCP and without Burgundy, the market here has been really uncompetitive in terms of trading costs,”says Neiglick. However, it is not simply lower costs which are drawing trade to the region. The increase in speed, particularly on NASDAQ OMX’s platform and the faster speeds of the MTFs active in the area are beginning to attract highfrequency trade. Burgundy reports a trebling of market share this year and says that high-frequency traders are contacting them directly. “It will change the style of trading in the region,” says Sibbern, who expects NASDAQ OMX to sign up 10 more high frequency firms during 2010.“We will have pressure on market share in the near future, but we think the pie will get bigger. Velocity will grow 25% within one year and so we think market size will increase 25% based on current rates of growth. High-frequency trading brings positive benefits to companies, investors and other banks and brokers.” Fragmentation, too, has helped Scandinavia’s institutional clients. “If you have an efficient and liquid market and lower tick sizes, you can move in and out of the market more smoothly than you used to do,”says Blaabjerg. “You need to realise that the Nordic market is a small market. You can’t really talk about the ‘market’, rather a ‘marketplace’, and the Nordic markets are market places. There are just seven blue-chip companies in Sweden, five in Denmark. Plus, the Nordic market can pull contrary to the rest of Europe. With so few big stocks, if heavily traded, they can pull the market contrary to the main trend in Europe. If you want to tilt the FTSE, it wouldn’t be enough to trade just Shell or BP alone, but in Copenhagen it would be enough to trade just 10,000 Maersk shares to move the Danish market. The‘market’term only applies if you do not have single shares that move the market. We are approaching a ‘market’ in the Nordics, but we are still a ‘market place’.”

THE ASCENT OF THE NORDIC TRADING MARKET

Pension funds Pension fund managers are hugely influential in the Nordic region. The Swedish national pension funds for example represent 10% of the total pension assets in the country. The value of AP3, of one of five such funds, stood at SEK206.5bn ($28.5bn) on December 31st 2009. Equities make up nearly half of its portfolio. Norway’s huge global pension fund, said to be the largest in the world, was worth NOK2.640trn ($457bn) on December 31st 2009, holding an estimated 1.78% of all European stocks. The Norwegian national pension fund on the other hand invests in domestic companies on Oslo Børs and was worth NOK98.9bn ($16.31bn) at June 30th 2009. Equities account for 65% of the fund. Blaabjerg says that whereas five years ago the pension funds were using identifiable banks, they are now using both international and local banks for their transactions. “They are starting to use diversification strategies and they are interested in low trading costs so they agree trading volumes for free research, for example.” Neiglick agrees:“Professional customers don’t really care if their stock is trading on Chi-X or Burgundy; they just want good execution.” The region has had a tradition of open trading with full details of trader identities published immediately after the trade. There are signs that this is changing as Blaabjerg points out: “It’s a lot more anonymous in London, but the Nordic region will become more anonymous because I don’t think the special features of the Nordic markets will stand the test of time. There is no reason for the Nordics to

Bjørn Sibbern, senior vice president of NASDAQ OMX Nordic and president of the Copenhagen Stock Exchange. He predicts that in a year’s time, trading in the three markets of Sweden, Finland and Denmark will have grown 25%, from its current figure of 250,000 trades a day on NASDAQ OMX, worth around $3.5bn in turnover. Photograph kindly supplied by NASDAQ OMX, April 2010.

hold on to a particular stance because the market is so small. I think the particular character of the Nordic equity market will disappear as it converges more and more with European standards and norms. The one who has the biggest wallet decides which music to play.”

GETTING THERE IS EASY FTSE Global Markets is your passport to 20,000 issuers, fund managers, pension plan sponsors, investment bankers, brokers, consultants, stock exchanges, and specialist data providers. If you would like to order reprints of any of the articles in this issue or discuss advertising insertions, tip-ons, supplements, sponsored sections, bookmarks or your own special requirements Contact: Tel: Fax: Email:

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M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

Photograph © Blotty/Dreamstime.com, supplied April 2010.

HARNESSING MARKET CHANGE N JANUARY, NEONET announced its plans to open an office in Hong Kong for execution services, sales and support. The firm has been active in Australia, Hong Kong, Singapore and Japan since 2007 and, according to Simon Nathanson, Neonet’s ebullient chief executive: “As the global equity markets become increasingly integrated, it is important for Neonet to offer the best possible service to European and American clients trading in the Asian region. Furthermore, Neonet is experiencing an increased interest from Asian-based institutions to trade European and American equities, utilising the firm’s smart order routing technology and superior execution services.” Hong Kong was an obvious choice for the expansion of the operations, “given its central position in the region’s financial markets,”adds Nathanson.“The fragmentation of trading that we have witnessed in the United States and now increasingly in Europe is likely to occur in Asia as well. With a superior technology platform combined with global market reach, Neonet delivers value in an increasingly global integrated equity market.” Neonet offers brokerage service and trading software solutions. Its activities are divided into two areas: execution services, which are commission based, and system and software services, which is made up of the marketing of the license-based Neonet XG products, comprising a market gateway, smart order router, broker connectivity, execution management system and market data feeds. The firm has built its business remit on two pillars: high-speed services and sophisticated trading functionality. Neonet’s avowed mission is to simplify global trading to enable the company’s clients to capitalise on the increased number of marketplaces and new technical opportunities. Nathanson explains: “By offering access to the most liquid marketplaces and through technical solutions that make global trading more efficient, best execution is feasible regardless of the marketplace.“

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

These elements and the firm’s commitment to innovation, netted the firm the World Finance award for Best Service Provider of 2010. Mixing recognition of Neonet’s achievements and a desire for extra market reach, software company Orc made a public offer to Neonet shareholders in January. The offer involved the transfer of their shares in Neonet to Orc in return for payment in the form of newlyissued shares in the merged entity. The merger was expected to close in April, subject to shareholder approval. Neonet and Orc complement each other very well, holds Nathanson. “It was an obvious move. Neonet’s strong portfolio of equity trading and hosted technology solutions, combined with Orc’s expertise in derivatives trading, means that we will create an extremely attractive customer offering,”he says.

Volatile business cycles Timing of the offer was significant. Late in 2009, the Neonet board set the firm the objective of achieving revenues of at least SEK250m by 2012. Neonet’s revenues consist of transaction revenues from securities trading and license revenues from technology sales. Unlike transaction revenues, the contracted and regularly recurring license revenues do not depend on trading volumes.“The potential represented by Neonet’s technology offering is considerable and this is strengthened as the margin on these services is high. The impact of the impending merger aside, we are of the opinion that our licence revenues will rise at least threefold in a few years’time and will successively cover our fixed-cost base,” says Nathanson, adding that licensing revenue is steady, providing a ready counterweight to volatile business cycles in trading volumes. Orc was offering 0.125 new Orc shares for each share in Neonet in a deal valued at SEK1.277bn (€131m) which constitutes a bid premium of 22% based on the closing

TWO LEADING TECHNOLOGY SUPPLIERS JOIN FORCES

With 2010 well under way, Neonet, the Swedish broker and technology provider, is steadying for growth and further market change. Armed with a suitor anxious to link to its reputation for high-speed services and sophisticated trading functionality, plus an expanded presence in Asia, Neonet is keen to leverage new trading business globally. Francesca Carnevale reports.

TWO LEADING TECHNOLOGY SUPPLIERS JOIN FORCES 66

prices paid on NASDAQ OMX Stockholm on January 22nd. The combined listed entity is likely to be the Orc name, although the Neonet brand may continue to be used for specific services. Thomas Bill is widely expected to continue as chief executive of Orc, though at the time of going to press no announcements had been made on the rest of the management structure. Nathanson says that the two firms will leverage obvious synergies, offering Orc trading solutions service suite via Neonet’s managed service offering. At the same time, he posits, the venture will be able to “benefit from Orc’s focus on derivatives trading solutions and Neonet’s specialisation in both equity trading and hosted technology”.

Significant synergies The merged operation is expected to be split between two key business segments: technology and trading services. The technology side, which is expected to provide the bulk of forward revenue, will offer the merged firm’s technology products through licensing agreements. Trading services will leverage Neonet’s agency brokerage capabilities and comprise a global execution network for equities and derivatives. The statement announcing the intended merger says: “The recurring revenues in technology creates conditions for a minimum operating margin of approximately 20% in the new group. This, combined with the variable revenues within transaction services, creates the conditions for an operating margin that can exceed 35%.” Neonet expects “significant synergies” from the merger, partly through efficiency gains and by combining the companies’ product offerings and expertise. The synergies are expected to take full effect in 2012 at the latest, at which time they are expected to increase operating income by SEK30m, says the merger statement. A third of this is attributable to cost synergies, which are expected to reach full effect by 2011 at the latest. “Because of the lack of product overlap between the two firms, cost savings are expected to come mostly from the benefits of running the companies as a single entity,”explains Nathanson. The official blurb outlining the rationale for the merger notes: “The market for technology and services for advanced trading in financial instruments is characterised by powerful growth and rapid change. This creates development opportunities, above all for the established suppliers. At the same time, suppliers are under growing pressure to continuously develop their offering as a means to stay competitive.”Part and parcel of this trend is the requirement to provide customised solutions, holds Nathanson. This in part, he says, explains the growth of the firm in recent years, particularly as it has been able to leverage its technological solutions and connectivity services by providing access to small and mid-sized brokerages, “which utilise the firm on a best execution basis”. “The fragmentation of equity trading continues apace, and the impact of fragmentation becomes clearer every day,”highlights Nathanson.“Of the trading of the stocks in the FTSE 100, nowadays, some 40% is traded off the London Stock Exchange. If you are trading blue chips,

Neonet’s chief executive officer Simon Nathanson says: “The merger will create a company that offers customers leading technical solutions and services for advanced trading of derivatives and equities. The board of directors of Neonet stands behind the offer and unanimously recommends that it be accepted by the shareholders.” Photograph kindly supplied by Neonet, April 2010.

nowadays you have to access anywhere between three and six or seven different markets.” Moreover, he explains: “Demand from hedge funds and high-frequency trading is putting increasing demand on existing technology systems. In that context, software becomes increasingly important, particularly as there is increased complexity in the market and liquidity is sometimes difficult to reach.” Furthermore, customers are increasingly seeking alternative delivery models; partly in the form of hosted technology solutions and partly as technology integrated in an execution service, notes Nathanson. He adds that Scandinavia’s leading providers of technology and services for financial trading will together “create an even stronger global player in this area”. He says:“The merger will enable us to develop better technology, faster and at a lower cost, to better leverage the changing requirements in the market.” The accent is on the global, highlights Nathanson.“The new group will have a strong technology platform with the bulk of product development and management in Sweden, but approximately 90% of sales will be in the international markets,”he says, adding that“growth expectations remain high in all markets”.

New challenges The challenge for the sell side, notes Nathanson, is the requirement for new alternative venues to match the quality of service and provide the liquidity required. “Otherwise, it will mean that liquidity will constantly veer from one multilateral trading facility (MTF) to another. While MiFID has been a great success from the perspective that is has made it possible for both alternative venues and brokers to compete with exchanges for business, it has exerted a price. That price is technology and the constant requirement to upgrade services; and this requires substantial investment. In that context, I doubt we will be the only merger going forward.”

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

Photograph © Clockface/Dreamstime.com, supplied April 2010.

ITIGATING RISK IN key areas such as compliance, portfolio management and order management using vendor-provided asset management technology (AMT) solutions continues to gain traction within the investment community, and with good reason. When there are pure integration points in place and data can flow freely from the front to the back, operational costs for organisations both large and small can be trimmed substantially—nothing to sniff at during these tentative times. OTC derivatives and other esoteric products in particular require that providers be properly equipped and have the ability to handle the entire realm of processing functions. As demand for these products continues, the industry will need more consistent trade-cycle data and pricing standards and, above all, increased risk-management tools. Naturally, the integration of execution, operating and portfolio-management systems may not be nearly as feasible for all buy side operations, particularly small- to medium-sized companies with limited technology spend. “Those types of companies account for the majority of the business,” says David Kubersky, managing director at

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

SimCorp USA, a provider of front-to-back office investment management software.“The bottom line is that clients can have widely different needs—some wish to achieve a greater degree of compliance than others. To that end, we typically find ourselves working from the top down with many clients. In other words, we look at what can be feasibly achieved within a client’s budgetary and time parameters, and then proceed from there, with the common component being that the client will, and must, achieve the proper level of compliance.” Lowering costs, mitigating risk and fostering growth for clients are the company’s key value objectives. “We believe that a truly integrated enterprise platform helps support those three goals,”says Kubersky. Regular updates are a large part of the equation, he adds. The most recent version of SimCorp’s Dimension enterprise solution 4.7 includes significant changes to front office functionality, and also features risk- and cost-reduction enhancements for middleand back-office processes as well. These ongoing improvements reflect the company’s desire to satisfy the needs of as many different clients as possible, says Kubersky.

ASSET MANAGEMENT TECHNOLOGY: KEEPING PACE WITH CHANGE

AMT TIME

ASSET MANAGEMENT TECHNOLOGY: KEEPING PACE WITH CHANGE 68

“If anything, demand has increased, particularly as new regulations continue to emerge,” he says. For example, Kubersky cites recent updates to the Global Investment Performance Standards (GIPS), a set of universally accepted ethical principles used by investment firms to calculate and report performance results to prospective clients. “Being able to aggregate this kind of new information and present it within the proper context is tremendously important, but GIPS is just the tip of the iceberg—there’s IFRS, GAAP, the list goes on. The point is, as a service provider, you need to have the wherewithal to stay in step.” For buy side desks on a limited budget, even a nominal degree of process outsourcing is often a good way to combat poor inter-operability between legacy systems. “While some firms will choose to outsource the middle and back office in full, others might outsource only select components, such as the settlement part or the fundaccounting part,” says David Campbell, securities product manager, investment services at Fiserv, a provider of information management and electronic commerce systems for the financial services industry.“Of course there are also service bureaux that can cover some of these areas by offering the technology for handling the middle office and settlements, should the client wish to maintain control of the processes themselves rather than fully outsource.” Service bureaux tend to offer products that are typically vanilla in nature, however, which may be less attractive for those outside of a standard asset class or operating environment, says Campbell. Rob Keller, managing director of global product management for ConvergEx Group’s order management system, the Eze OMS, sees the greatest demand for systems that are associated with such esoteric products as OTC derivatives and foreign-currency related vehicles. Like many of his peers, Keller acknowledges that a scaled-down outsourced solution is very often the best approach.“Rather than a full-scale outsourcing solution, clients want us to serve more as an extension of their operations team, allowing us to manage some of their connectivity and testing, or ensuring that transactions are working in conjunction with third-party systems. Obviously there are certain clients that prefer to outsource their entire operations, everything from middleand back-office duties to settlement and custody, but there will always be clients who simply want to host some of their front-office systems.” Start-ups such as hedge funds don’t necessarily want to incur a huge IT expense right from the get-go, and instead may choose to embed the cost of the hardware within a hosting arrangement, whereby the provider purchases the hardware outright and then allows the fund manager to make incremental payments over a period of time as part of its monthly fee. “There are also clients who may just be looking to reduce their IT staff,” says Keller. “In that case, they could leverage ConvergEx for managing the applications on their servers, while having a separate hosting facility managing the actual hardware, with the goal of achieving a much leaner middle office.”

David Campbell, securities product manager, investment services at Fiserv. Photograph kindly supplied by Fiserv, April 2010.

The middle office was created as a way to combat inefficiencies that prevented the front and back offices from effectively communicating with one another. Accordingly, clients are increasingly looking to build out additional middle-office functionality, says Keller.”By partnering with an organisation such as ours, clients leverage our technology and expertise to improve connectivity and communication across the entire firm—they’re asking us to help them incorporate traditional middle-office functions, such as performance attribution, contribution analysis, post-trade compliance, reference data management, and enhanced reporting, into their front-office technology. All of this information really needs to be in the front office in order to give them real-time access to that data so they can make more judicious decisions.”

Direct impact According to Paul Thomas, managing director of international operations, investment services, at Fiserv, post-trade processing solutions like Fiserv’s TradeFlow have had a direct impact on the kind of service level agreements (SLAs) that middle-office outsourcers can offer clients when responding to request for proposals (RFPs) from the asset-management community. “By having a unique middle-office outsourcing service underpinned by an automated post-trade processing solution, outsourcers are able to differentiate themselves from the competition.” In some instances, the front-office system may not have the full capability to reach into the sell side in order to capture the terms and conditions needed to complete the trade affirmation. However, by interfacing with a thirdparty source such as ICE Link, the widely used affirmationand novation-consent platform, companies such as ConvergEx are able to provide their Eze OMS clients a simplified, seamless workflow when trading bespoke instruments or any asset class by leveraging existing tools, “rather than having to build out highly complex, nuanced functionality from scratch,”says Keller.

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

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ASSET MANAGEMENT TECHNOLOGY: KEEPING PACE WITH CHANGE 70

Paul Thomas, managing director of international operations, investment services, at Fiserv. Photograph kindly supplied by Fiserv, April 2010.

Front-office solutions covering areas such as decision support for fund managers, electronic-trading and compliance continue to be a key investment area for the asset-management industry, says Robin Strong, director of buy side strategy for software and service provider Fidessa. Regardless of the type of tools offered, the single-most important objective is the proper integration of technology. “Essentially, the vendor has to be flexible enough to be able to augment its own solutions in order to integrate into a value process chain that is constantly changing, no matter who the customer is. There isn’t a vendor in the world that can adequately cover everyone’s needs using identical approach. That is why the most consistently successful vendors have been able to provide a broad range of product offerings that can be configured to suit each customer. The needs of asset managers are so diverse these days, you can’t just have one system for equities, another for fixed income and yet another for derivatives, and realistically expect to manage risk compliance, reporting and all the other issues that managers must deal with.” Staying in step with ongoing changes to existing regulatory programmes such as Undertakings for Collective Investments in Transferable Securities (UCITS) also helps providers distinguish themselves, says Strong.“For instance, Fidessa offers an out-of-the-box UCITS solution, which is very helpful for clients who manage or may be thinking about launching UCITS-based funds. Without this kind of software availability, the process can become much more involved, particularly when one considers all of the preliminary steps including risk controls, system implementation, and other start-up issues.” The prevalence of manual processes continues to be problematic, however, creating information bottlenecks particularly in areas related to cash such as redemptions and fund transfers, says Fiserv’s Campbell.“As a result, we are seeing significant interest in automating those areas but because it is cash, clients want to be sure that they have the same level of control that currently exists in areas such as equities and fixed income.”Repos, OTC derivatives and

exchange-traded vehicles are also ripe for increased automation, says Campbell. Furthermore, he adds, the ability for institutional asset managers to offer CLS automation in the FX world is seen as a key differentiator. Now more than ever it is crucial that the industry addresses manual or redundant processes—including fax, spreadsheet upload or other measures that are highly vulnerable to errors and lack of audit—that continue to hamper the OTC trade cycle. Strong says: “We have begun to see a lot more standardisation of contractual terms, particularly around semi-liquid products such as interest-rate swaps or creditdefault swaps, and we may see further change that is either centrally mandated or evolves via market forces requiring that these contracts be centrally cleared. That is a model that would help reduce certain risks—because as soon as you’ve introduced central clearing, then you’ve introduced a standardised process. However, I think there will always be a number of niche products that, due to the low trading volumes, will be much more difficult to automate.” Despite all of the efforts to streamline data flow, there are still a surprisingly large number of players—including some of the industry’s biggest and most reputable pension funds—who continue to rely on the oldest of old-school trade-cycle methodologies. Consultants to the pension industry report being“appalled”at the sight of major global businesses processing billions of dollars worth of pension funds using Excel spreadsheets. “That eventually has to change,” says Strong.“Once trustees become aware of the full impact of their responsibilities—not just in terms of picking good managers but also being cognisant of the entire realm of operational controls—I think we will begin to see many more of these firms realising that proper systems need to be put in place, either in-house or through a third-party service provider.”

Operational risks Is it tougher to convince pension funds that are struggling with unfunded liabilities or other constraints of the merits of updating their processing capabilities? “It definitely requires a different type of approach,” admits Strong.“The standard argument with big banks and other large financial institutions is that automating processes reduces headcount and therefore reduces costs. The public sector, however, tends to have fewer opportunities to make significant headcount savings and these firms often dislike wholesale personnel change. Frequently, they are comfortable with existing processes and rely on the longterm knowledge and experience of a few key employees, overlooking the intrinsic operational risks of this model. I think trustees are beginning to understand that, given everything that has happened over the past few years, undocumented manual processes can introduce as much risk as the underlying investment decisions. In fact, consultants that we work with who specialise in pension assessments have been doing the same levels of business in a week as they did in a month prior to the crisis! So yes, the climate in the sector has changed dramatically.”

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Photograph © Provanish/Dreamstime.com, supplied April 2010.

The pace of change continues to accelerate in the buy side front office. Although the financial crisis has brought and will continue to bring with it undeniable changes to the securities industry, a number of those issues— particularly those affecting the buy side—have been bubbling under for some time. Rather than introduce a whole new set of problems, the credit crisis has highlighted, accelerated and increased the focus on existing, known challenges and opportunities. By Robin Strong, director of buy side strategy for Fidessa.

NE ACCELERATED TREND is the need for transparency of the investment process, which has been hovering over the industry for some time, and is now being more forcefully demanded by investors, trustees and consultants. Transparency of process and controls is fundamental. Aligned to this, we are seeing a renewed and more urgent focus on investment compliance, especially pre-trade, and on counterparty exposure monitoring in particular. Increasingly, investors will take their money elsewhere if it cannot be demonstrated that proper compliance and operational controls are in place. At the same time, diversification of portfolios across asset classes to enhance performance and to protect downside is becoming the norm. UCITS III has enabled more traditional asset managers to diversify and also provides a vehicle by which hedge funds can operate market

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regulated funds that are seen as lower risk. The use of derivatives is more prevalent, despite their tarnished reputation in the press, and a fast pre-trade compliance engine that can cater to the complexities of modern derivative contracts and automatically deal with exposures and netting rules is becoming a prerequisite. The buy side operating environment is becoming far more complex. In stark contrast to this, of course, asset managers are no longer operating in a bull market and do not have access to extensive resources to address these renewed issues. Assets under management have fallen and fees have dropped, creating significant pressure on costs. From a systems and operations perspective we are seeing a far greater focus on the total cost of ownership. This is reflected in the consolidation of systems across all asset classes, with the requirement for single vendor

NEW CHALLENGES FOR THE BUY SIDE FRONT OFFICE

RESPONDING TO COMPLEXITY

NEW CHALLENGES FOR THE BUY SIDE FRONT OFFICE

solutions that can manage the diverse requirements of equities, fixed income and foreign exchange workflows as well as the associated derivatives. Asset managers are moving away from one system per asset class; there is greater recognition within the industry that multi-asset or full-asset systems make economic as well operational sense. Asset managers are also seeking to reduce effort and costs by dealing with fewer vendors, also contributing to the rationalisation of systems. The drive to do more with fewer resources is leading asset managers to consider alternative approaches, and this last year has seen greatly increased interest in software as a service (SaaS). At Fidessa LatentZero, we believe this model of software delivery will become the dominant means of accessing mission-critical software for the buy side in the next three to five years, a trend already seen on the sell side, where over 90% of our customers have adopted this approach. While it enables mid-tier asset managers and those in emerging markets to adopt the technology necessary to meet their client and regulator-imposed obligations, we also expect a number of tier one firms to adopt SaaS, with the aim of reducing the total cost of ownership of operations in the front office, and enabling asset managers to focus on their core business of managing funds. One other hot topic of recent years has been that of liquidity fragmentation, most recently in Europe following the implementation of MiFID. The US market fragmented and then consolidated again and although the predicted reconsolidation in Europe is now in evidence, the new trading environment is a changed and more complex one. The question is how much does this really affect the buy side? Certainly, those trading-driven hedge funds and buy side traders who take a very active role in how orders are executed are more impacted. Nonetheless, many buy side traders believe that managing the complexities within the fragmented landscape is part of the service that the broker provides. Certainly, there is a far greater buy side focus on execution quality as investors and trustees take an interest

Robin Strong, director of buy side strategy for Fidessa. Photograph kindly supplied by Fidessa, April 2010.

and managers strive for every last bit of fund performance, with some desks taking a more active trading role, and most buy sides at the very least monitoring the execution performance of their brokers more closely. Quarterly measurement of trading performance now seems somewhat archaic, with real-time transaction cost analysis becoming more commonplace to enable the buy side to identify poorly performing orders or brokers more quickly. This is part of a wider trend where buy sides are looking for better or more quantifiable value from their broker relationships. The separation of broker commissions into research and execution elements is part of this trend, and for some time, the buy side trader has been talked about in terms of “taking more control”. But it is more about transparency and measurement of broker services rather than disintermediation of the sell side. The buy side in general is still perfectly willing to pay for quality broking services. Compliance, transparency, cost control. It is entirely natural that these issues have come to the fore in current circumstances. But, although some might view the credit crisis as a revolutionary event in the securities industry, it is probably more accurate to view it as an accelerator in an ongoing evolution.

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human touch High touch sell side traders once again have a big role to play in equity trading. Although electronic trading has grown to more than 51% of buy side order flow, the bar has been raised for the quality of coverage required from the high touch sales trader. Their market share has dropped but the importance of what they deliver has increased. Ruth Hughes Liley reports.

Photograph © Andreus/Dreamstime.com, supplied April 2010.

HERE’S A PARADOX at the heart of today’s equity trading. Electronic execution now forms more than half of all buy side trading and is rising, yet the role of the human being on the trading desk has rarely been more important. In the first half of 2009 volatility drove flow towards the sales trading desk and away from electronic execution, and yet the reverse has been happening since then and the need for high touch keeps growing. “Traders on the buy side have completed their revolution in trading,” says Laurie Berke, principal with TABB Group. “They have their electronic tools, their algorithms. They understand smart order routing and dark pools. They may make these decisions themselves, but now they need the alpha-generating content and ideas from the sell side trading desk to support their portfolio managers and analysts. “So the high touch sell side sales trader once again has a big role to play. Although electronic trading has grown to be

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TRADING REPORT: HIGH TOUCH SELL SIDE TRADERS IN DEMAND

Electronic trading still needs the

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more than 51% of buy side order flow, the bar has been raised for the quality of coverage required from the high touch sales trader. His market share has dropped but the importance of what he delivers has increased once again”. Berke adds:“The buy side has lost so many assets under management, the most important thing now, going forward, is not so much saving 40 or 50 basis points [bps] on the trading desk, it’s research and ideas and rebuilding performance and assets. The relationship between the buy side and the sell side is now a hybrid between superior electronic trading services and superior content and ideas.” On the face of it, the sales trader has had a tough time with the bulge bracket investment houses and buy side houses paring their expensive, high touch teams back to the bone during the financial crisis. TABB Group in its July 2009 research study Equity Trading in Transition reports lay-offs of 70,000 people at Citi, for example, and Laurie Berke, principal with TABB Group.“Traders on the buy side have completed their goes on to say: “This leaves the buy revolution in trading,” says Berke.“They have their electronic tools, their algorithms. They side wanting more services when they understand smart order routing and dark pools. They may make these decisions themselves, but are least able to afford them—and now they need the alpha-generating content and ideas from the sell side trading desk to support brokers are least equipped to provide their portfolio managers and analysts. Photograph kindly supplied by TABB Group, April 2010. them. What we are seeing is a redefinition of how the equity markets work, and a sectors and can immediately break down what the news means for those names. They generate ideas and identify redefinition of the business models that support them.” Certainly both buy side and sell side are restructuring key indicators across asset classes and are a strong their desks to create the best conditions for the most complement to the risk trader. It’s research in its highest effective trading. While some desks are still organised impact form. People want to know when news breaks how along country and regional lines, others, such as Fidelity, it will affect them.” Grubert points out that this approach is different from have reorganised into sector-based desks. research in that the desk analysts are not publishing or writing research reports.“They are talking to clients on the Specialised service At Fidelity, portfolio managers can call upon in-house phone or directly on Bloomberg chat. It’s immediate and quantitative and technical analysts as well as asset clients have come to expect this service surrounding desk allocation teams. Not only are research notes distributed content,”he says. While some buy side traders are undoubtedly specialists real-time to portfolio managers and research analysts but in stocks, others are specialists in electronic execution, as also to traders themselves. On the sell side, RBC Capital Markets (part of Royal Richard Semark, managing director, client trading and Bank of Canada, which has $623bn in assets), changed its execution, at UBS points out.“We have clients who prefer desk to sector-based 18 months ago, building what it calls to do their own trading electronically, but still want a sales a“desk sector strategy model”. Sector specialists sit on the trader as a point of contact. We have sales traders working trading desk with the risk traders and are on hand to talk in the electronic space in a more specialist and technical role. There’s a clear appetite from clients for contact for to buy side clients, both traders and portfolio managers. “Client desks have become more sectorised in the past market view, opinion and input on how they should be five years, so we have aligned this model to meet approaching their particular execution.” TABB Group reports that 38% of institutional trade was increasing client needs for specialised service,” says Bobby Grubert, head of RBC’s US equities sales and trading.“Our through sales traders in 2009, down from 44% in 2008. desk sector strategists have strong interpretive skills on Meanwhile, as algorithmic trading rose from 24% to 31%, low data, news or information on any equity or any number of touch trading also including DMA, dark pools and crossing

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networks made up more than half buy side executions for the first time. When TABB Group questioned asset managers for their predictions for electronic trading levels in 2010, they estimated 57.7%. In this environment, the brokers are under pressure to smooth the path for their clients. Semark has detected a limit to the adoption of electronic trading. “Firms that were early adopters don’t want to increase their electronic trading any more. Once you are up to 40%-50% electronic with some portfolio trading, that’s the average for large firms, although clearly there is a significant range. Smaller buy side firms tend to be more concentrated, but they still want human input from those counterparties.” Goldman Sachs, whose website declares it “offers both the capital and the high touch expert service necessary to execute transactions”, recently introduced 1CLICK, a simplification of its algorithmic trading service, allowing users to select a trading style rather than a specific algorithm. Electronic trading spokesman Ed Canady says it was introduced in response to client feedback and that today, buy side traders were demanding more than ever from their key trading partners. “Today, the relationships between the buy side and sell side are as important as ever,”he says.“High touch trading is at the core of Goldman Sachs’ client franchise trading strategy. High touch is where complex liquidity problems get solved and market share, and more importantly ‘mind share’, lead to significant transactions. In addition, the high touch traders have evolved to where they are “low touch” experts as well. We have an in-depth understanding of electronic markets and venues and how we can optimally interact with them for best execution. This is what differentiates a sell side desk from its competition in today’s environment.”

Blend of services Richard Balarkas, chief executive officer of agency broker Instinet, adds:“No one relies too heavily on just one route. Traders use a blend of different services. There are some orders where traders might try all the options available. A sales trader might want to buy a large volume of stock and might choose to leave a large portion hidden in a dark pool hoping for a decent match and at the same time might be gently broking it round the market and taking a crack with direct market access [DMA] at any visible liquidity that appears on the screen.” The development of electronic markets has seen a change in the role of sales traders compared with 10 years ago when orders would be put on to a floppy disk and taken round to the dealing desk. Balarkas notes:“The sales trader of today is more of an execution consultant. Preelectronic trading, every single order went to the sales trader and was then passed to the dealing desk. Now the plain vanilla orders don’t go to the sales trader. These get done electronically by the buy side.” Most traders agree that different types of stock need different treatments. Semark sees it as pyramid-shaped.“In the classic theoretical model, you have a pyramid. At the

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

Bobby Grubert, head of RBC Capital’s US equities sales and trading. “”Client desks have become more sectorised in the past five years, so we have aligned this model to meet increasing client needs for specialised service,” says Grubert. “Our desk sector strategists have strong interpretive skills on data, news or information on any equity or any number of sectors and can immediately break down what the news means for those names. People want to know when news breaks how it will affect them.” Photograph kindly supplied by RBC Capital, April 2010.

bottom, there’s a large number of very small trades and it’s difficult for the buy side trader to add value so they are automated either as portfolio trades or using prescribed algorithms. In the middle, there’s a reasonable number of larger but straightforward trades where algorithms are used in combination with sales traders. At the top, there’s a small number of large and complex trades which are intensively worked by the buy side trader who will typically use input from a sales trader. “In the last couple of years with the market becoming more complex, fragmentation of orders, use of smart order routing (SOR) and multiple venues, algorithms have come to be used by everyone, but the value to the buy side from the sales trader having a market view has become more important. It’s the combination of the two people—the buy side and sell side traders—which is so valuable.” Balarkas also identifies that the skilled sales trader is needed in difficult trades.“At the other end of the scale, if you have an order for five days volume in an obscure Lithuanian stock, it’s very difficult to figure out how to complete it. You need to go to a highly qualified individual who is able to tell you about the colour of the market and how it will trade. Algos just don’t come into it. “It’s all a question of the dynamics—the boundaries between electronic trading and sales trading are always in

TRADING REPORT: HIGH TOUCH SELL SIDE TRADERS IN DEMAND 76

a state of flux. Over the past ten years, the sales traders have got more overweight on the difficult orders. They are expensive resources and that’s how they should be used.” RBC Capital’s Grubert believes the skill of high touch traders lies in their ability to distil meaningful information. “There’s a real information glut out there. The client has 300 emails a day and information coming from 40 to 80 brokers. The desk strategy strategist distils this information and makes it actionable for the client. The sales trader has evolved into a relationship manager and delivers the value of the value of multiple RBC products to the client.” Some believe the sales trader is in a difficult position, as Balarkas notes: “Sales traders in the investment banks are still the gateway to banks’ balance sheets. They are dedicated to their client and they manage the client relationship. They are placed in between the client who wants the best price and the bank which needs to make money. They lose money for the bank if they get too good a deal for the client.” With volumes down to levels last seen in 2006, commission is being squeezed and this is also affecting the use of high touch. “Fund managers are getting information from analysts and every time that happens they are indebted to the bank,” explains Balarkas. “In good times they are giving enough business to the bank and they don’t have to worry about bills, but in lean times, they are finding it harder to pay their bills. So they could choose to use a higher cost route rather than an algo or DMA pipe.” While Semark has also noticed this trend, he says this is specific to the circumstances of the past 18 months with lower volumes and lower turnover. He notes a more structural trend as clients increase the proportion of electronic trading they carry out, which is cheaper and generates less commission. “If a client trades using the sales desk at 20 basis points (8bps for execution and 12bps for advisory) and algos trade at, say, 5bps, I’ve seen a huge trend to add additional basis points for advisory, where the client will pay the five basis points for trading algorithmically but will add the 12 basis points on for the advisory. Five per cent electronic trading three years ago had little impact on advisory commission, but if clients are now doing 40% electronically, this obviously has more impact.” Greater use of commission sharing agreements and narrowing down the number of counterparties has led to clients focusing on a tight balance between high and low touch, according to RBC’s Grubert.“The integrated model is what’s required for the future and clients are finding ways to use high and low touch and how to balance and pay for the service. Unless you are in a full-service firm— offering research, investment banking, products, like RBC—it’s difficult to compete as clients have less and less commission to pay out.” The larger buy side dealing desks may have upwards of 10 sales traders on their regional teams. The smaller firms

Richard Balarkas, chief executive officer of Instinet Europe. “No one relies too heavily on just one route. Traders use a blend of different services. There are some orders where traders might try all the options available,” notes Balarkas. Photograph kindly supplied by Instinet, April 2010.

may have only two or three people and buy side desks regularly outsource trade to sell side teams. “It’s always been the case that buy side trading desks have passed on trades to teams on the sell side,” explains Balarkas. “Very large buy side desks are an exception and there’s no way two or three people could know everything about 30 markets and thousands of different stocks. So it has always been the case that in times of stress the fund manager will outsource more to brokers, although I’m not sure this is hugely apparent at the moment, largely because activity is down.” Semark notes that many will outsource simply to maintain a good working relationship: “They want to incentivise their trader by giving them order flow and to pick up their useful information and views.” Certainly, the relationship between buy side and sell side desks is crucial and Semark believes this will remain: “Some buy side desks are being used more and more by portfolio managers and analysts as their eyes and ears. They are looking for more in-depth advice at the micro, macro and stock levels. In the end, for execution of orders, it’s important to deal with someone you trust and someone you have a strong relationship with. You’re not concerned about what they are going to do when they trade an order because you trust them. It’s not just mates talking about football—this relationship is about making the process predictable and precise. This is key in fastmoving markets.”

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THE 2010 EUROPEAN TRADING ROUNDTABLE:

SETTING THE SCENE FOR MIFID II

Attendees

Supported by:

From left to right (top row)

CLIVE WILLIAMS – head of European equity trading,T Rowe Price

MARY McCAVE – senior equity dealer, Legal & General Investment Management RICHARD NELSON – senior vice president & head of dealing, AllianceBernstein From left to right (below)

STEPHANE LOISEAU – managing director, head of cash equity execution, Société Générale JAMES DAY – director, Barclays Capital

SIMMY GREWAL – analyst, European market structure, Aite Group

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

THE 2010 EUROPEAN TRADING ROUNDTABLE 78

Clockwise from left: STEPHANE LOISEAU – managing director, head of cash equity execution, Société Générale; JAMES DAY – director, Barclays Capital; RICHARD NELSON – senior vice president & head of dealing, AllianceBernstein; CLIVE WILLIAMS – head of European equity trading,T Rowe Price; MARY McCAVE – senior equity dealer, Legal & General Investment Management; SIMMY GREWAL – analyst, European market structure, Aite Group.

THE STATE OF PLAY

JAMES DAY, DIRECTOR, BARCLAYS CAPITAL: From Barclays Capital’s standpoint we are focusing our attention around dark trading; regulators too are looking at this space. Even so, only a limited amount of trading takes place in the dark; quite disproportionate to the amount of noise that has been generated by it. In that context we are setting out our views right now, trying to understand what the regulators are looking at and what they will do and making sure that we are well positioned to make ourselves ready for any impending regulatory changes in the dark trading space. MARY McCAVE, SENIOR EQUITY DEALER, LEGAL & GENERAL INVESTMENT MANAGEMENT: At Legal & General, one of our main challenges is to ensure that we have the correct technology to enable us to trade our business as efficiently and effectively as possible. Dark trading is a significant method of trading for us; it has been very successful. However, it is just one part of the picture. The overall trading landscape is undergoing seemingly constant change (for instance, brokers now launching MTFs); so we are watching the space closely, adapting where necessary. STEPHANE LOISEAU, MANAGING DIRECTOR, HEAD OF CASH EQUITY EXECUTION, SOCIÉTÉ GÉNÉRALE: Over the last 18 months we have lived in a rather interesting period on the trading side, with a number of trends coming into play. This includes electronic trading, best execution, algorithmic trading and new topics for Europe such as dark trading. At Société Générale, we are trying to reconcile all these different trends and build strategies that both the buy side and the sell side can apply on their trading desk. For example: how do we utilise those different tools to the best effect? How should we get the right structure in place for each trading service? With topics such as dark trading: how much is too much? How best do you access it and what are the costs associated with it?

Much of our work is looking at evolving regulation, which is a big challenge. We don’t necessarily know what the rules will be. In this context, we’re trying to come up with a comprehensive suite of services that go from high touch all the way to the low touch of the pure electronic business and trying to find the right balance between all of them. A key issue this year is trying to come up with a template of how much order flow should be channelled through each different venue and each different service and trying to find metrics around that—post-trade metrics at this stage, but pre-trade also, in order to be more prescriptive on our trading strategies. SIMMY GREWAL, ANALYST, EUROPEAN MARKET STRUCTURE, AITE GROUP: The scenario in Europe is more complex mainly because the trading landscape in the rest of the world is relatively simple especially in post trade terms: Europe has an assortment of regulators and vertically siloed exchanges, clearing houses and depositories. Moreover, there are serious issues around transparency which are yet to be determined; particularly around pre- and post-trade reporting and dark trading and how much volume is actually executing in these dark venues. Then again, there are questions arising around how to harness information about liquidity, fragmentation and dark trading. RICHARD NELSON, SENIOR VICE PRESIDENT & HEAD OF DEALING, ALLIANCEBERNSTEIN: AllianceBernstein is evolving from being a traditional fund manager; we’re looking more at derivatives, structured products and multi asset class products. We’ve recently hired a new head of global trading and he’s got very different ideas about the role of trading within the organisation and how to approach things. Dark trading is an interesting area; one that we’ll be following closely as we find the product beneficial to our trading style. We will be very interested to see how any regulatory review goes and hopefully any new regulations don’t upset the applecart there too much. We have also invested a lot on systems in the last two years, which has

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enabled us to get better feedback about our trading. A lot of data has been collected and we’re working toward smarter ways to use it for better effect. CLIVE WILLIAMS, HEAD OF EUROPEAN EQUITY TRADING, T ROWE PRICE: T Rowe Price is very much similar to AllianceBernstein; in that we are very much a plain vanilla long only fund manager. Our current efforts centre on making sure that our trading desks are properly equipped to handle trading in today’s world, and a world that is less than transparent. This applies not only to our trading in the developed markets such as European, US and other developed markets, but also to emerging markets.

MiFID: WHO REALLY BENEFITS?

CLIVE WILLIAMS: Who has benefited most? The sell side. If I look at the sell side nowadays: they want to be the client (prop books), they want to be the traditional broker and they want to be the exchange (look at the shareholders of the various MTFs). Is that development necessarily going to suit my business model? Probably not. It has created more competition undoubtedly, but there have been a lot of unintended consequences, such as fragmentation and transparency. STEPHANE LOISEAU: The unintended consequences are effectively the product of those competitive forces you mentioned Clive, which were perhaps a lot stronger than we all expected. Pre-MiFID, when market fragmentation was being discussed, most analysts predicted it to be around 12% to 15% by now. In reality we are already way beyond that point. Equally, when consultants talk about regulation they tend to overstate the consequences: but in this instance they actually understated it. The ferocity of that competition created the level of fragmentation of trading that we have today. There have been other consequences. There has been a reduction in costs: the front end of the equation, as it were. Equally, other costs have arisen that were not there before, on the technology side for instance. I don’t necessarily agree that fragmentation is one of them; fragmentation of trading in itself is not necessarily a cost. It is a cost for firms that can’t really manage it. Fragmentation of reporting is clearly a cost and having more transparency would improve the efficiency of the market place. There is a big technology spend on the back of fragmentation of reporting and on the operational side. These are the aspects that MiFID II hopefully will help resolve, these unintended or unexpected consequences of the rapid arrival of the fragmentation in the market. JAMES DAY: The focus has certainly shifted to the sell side, as it taken on the onus of dealing with the fragmentation in the market. The sell side has worked hard to make the buy side comfortable with what’s been going on and at the same time providing technology to navigate the fragmentation and providing a clearer understanding of new order flow. I am not sure the buy side would have wanted to take on the technology cost associated with fragmentation. Inevitably then, as the sell side increasingly

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

MARY McCAVE – senior equity dealer, Legal & General Investment Management

takes on this multi-purpose responsibility it has perhaps had the unintended consequence of defining a much larger role for the sell side and put it in position of more responsibility perhaps before MiFID came into play. STEPHANE LOISEAU: If we want to be specific, we can look at commission rates. Before and after MiFID commission rates have actually reduced; not only upfront commission rates, but also bid/offer spreads. Then again, the advances in electronic trading would not be where they are today without the fragmentation produced by MiFID.The fact that MiFID came in, encouraged competition, really changed the business model of how market participants interact with the various market centres. Suddenly, some types of trading that were just not possible, technically or economically speaking, before MiFID, and in particular electronic trading, are now fully part of the new market micro-structure. CLIVE WILLIAMS: It is only because the blend rate has changed. It is not that commission rates per se have changed. STEPHANE LOISEAU: Actually, there’s been some changes in the commission rate overall, but you’re right, the blend has also changed. If people are able to do up to 40% of their business electronically, it is because technically and economically it is possible now, whereas three or four years ago it may not have been possible. So it is a mix. MARY McCAVE: Clive’s earlier point about transparency for the buy side in this debate is fundamental. Although this topic has been flogged to death, it is frustrating for the buy side that, two years on, there has been no meaningful resolution of the issue. Of course, the FSA has since published guidance on the way brokers should report their bargains, nonetheless, there is still so much ‘noise’ being reported, meaning we still have no idea what constitutes tradable liquidity? Should we have been able to interact with that liquidity, or not?

THE 2010 EUROPEAN TRADING ROUNDTABLE

STEPHANE LOISEAU – managing director, head of cash equity execution, Société Générale

FRANCESCA CARNEVALE: Does that debate involve a consolidated tape? MARY McCAVE: Yes, a version of a consolidated tape. By using a standard set of trade flags (or condition codes) when reporting a bargain, it would be much easier to consolidate the data accurately. If that were the case, the vendors would potentially be able to make up a consolidated tape for themselves, without the need for the FSA to mandate it. CLIVE WILLIAMS: If you look at pre-MiFID, the LSE guidelines on reporting were something like eight pages long; under MiFID it is three lines. FRANCESCA CARNEVALE: What happened to them? MARY McCAVE: The requirement to use them for reporting ceased when MiFID came into force. RICHARD NELSON: Transparency is very important and particularly if you’re using TCA data to try and come up with estimates for how difficult trades are going to be to execute. If you don’t know whether the volume reported is actionable flow or not, you might as well not even bother, so it is very important that something happens. What do you think it will be? It has taken two years and we still don’t know.

MiFID’s UNINTENDED CONSEQUENCES

MARY McCAVE: The initial argument from the broking side was that, to add back in the condition codes, having ditched them overnight when MiFID came in, would be yet another technology spend, and would take at least sixmonths. Sadly, if we’d have pushed for that, it would have been completed 18 months ago and we would be in a much better position with regards to transparency. SIMMY GREWAL: MiFID was a first step in the right direction.You’re never going to get a regulation that comes into force and gets it all right from the start. However, the movement to create a competitive landscape at the

exchange level was what the markets needed. Even so, transparency is key. If you don’t know what type of liquidity is actually executing in the market, you have no idea if there is volume you’ve missed or it was something you could have participated in. Moreover, nowadays the clearing and settlement side has shifted into focus. If MiFID hadn’t come into play, people wouldn’t be looking at post-trade settlement costs because execution costs were so high. Now they’ve shrunk, and clearing and settlement costs have not; these post-trade costs have now become relatively more important. People are finally saying we need to do something about them. MiFID has certainly moved the market in a positive direction. RICHARD NELSON: It’s more complicated than just the buy side and the sell side with MiFID. MiFID touches right across Europe and so what may be of concern for Mary may be a different concern for somebody sitting in Italy or Spain. There are so many different inputs to MiFID that it is very complicated for the regulator to really understand what it is wrong with MiFID, what people’s concerns are and addressing those individual issues. STEPHANE LOISEAU: Obviously the one big difference is that in the US you have essentially one regulator, whereas in Europe it is clearly a collection of regulators with different histories and different cultures. On the Continent, if you remember, ten years ago every trade was virtually printed on an exchange; that was the rule and that was the market practice also. So when MiFID came in, it tried to create a compromise between two systems that were very opposite in that regard. One basically, knowing the OTC market, managing it, having decent volumes going through the OTC market as well compared to onexchange volumes and therefore had rules, which are the condition codes, as to how you were marking trades when you were printing OTC. Continental Europe didn’t have that. You ended up with the compromise that is MiFID, but in countries that didn’t have a culture of OTC trading, we now have these issues. I would disagree with Mary in the sense that there is progress; it is just not fast enough and it is not visible enough probably from buy side. Everyone really understands how it is in their interests to harmonise reporting rules sooner than later, and therefore there are a number of initiatives from various market participants (brokers, buy sides, exchanges) to harmonise how trades are reported, trying to push the market venues to basically agree on a set of condition codes, a rulebook of condition codes if you will. CLIVE WILLIAMS: The whole problem was that it was descriptive regulation that said basically we’ll let the market sort it out itself for now, so how Société Générale and Barclays Capital interpret rules can be completely different from how Goldman Sachs or UBS interprets them. That was the whole problem. Unless it is prescriptive and set out in black and white, you’re not going to get anywhere. FRANCESCA CARNEVALE: In the US they have a limited consolidated tape, handled by the New York Stock Exchange? Doesn’t it aggregate a portion of the market?

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STEPHANE LOISEAU: In the US, more than 98% of trades are actually reported“on the tape”, and in Europe it is hard to know, but certainly not that high! So 98% would be pretty good! CLIVE WILLIAMS: In the US it’s mandated. STEPHANE LOISEAU: So this would mean that only 2% of trades don’t get reported and these trades are probably some derivative trades or, whatever the exceptions are. They’re minimal. That really highlights the difference with Europe where, if we were to put a number on it, that number would be much, much higher. There are a lot of trades that don’t seem to get reported in a way that they should be. MARY McCAVE: The fact is that if you asked ten different people round the table what they thought that number would be there would be ten completely different views. JAMES DAY: It would probably differ from broker to broker. STEPHANE LOISEAU: That’s a big issue for US institutions trading into Europe; it is one of the big questions that they’re asking because they are so used to the US system where you print a block and it shows up on Bloomberg and you can identify it within seconds, because the rule is 90 seconds over there. When they trade in Europe and they don’t see that print either because they’re not subscribing to the right market data or it is printed on an exchange somewhere else or under a different ticker, or there’s reporting delay, they are very confused. Then they suspect something wrong is happening and that’s why it is in everyone’s interest to clarify reporting disclosures in Europe.

THE QUEST FOR INTEROPERABILITY

SIMMY GREWAL: Interoperability would be a more beneficial model to the European market than a US model, for example, based on the fact that if participants can decide who they can clear their trades with, then you’re going to naturally produce competition in that market. If you produce competition, you’re going to have clearing houses that are working to improve their internal systems to attract customers. Faster more efficient systems will encourage more participants to clear with them. Competition is beneficial for innovations in technology and improves those functions for everyone that utilises them. MARY McCAVE: From a buy side trader’s point of view, the clearing and settlement process is a lot less visible to us than to the sell side. However, its impact on the sell side makes it important to us. In terms of how it functions, my sense would be that interoperability would be the way forward. RICHARD NELSON: Clearing costs are much cheaper in the US and competition, such as a MiFID for clearance, would be quite good, but you have to be aware of the unintended consequences as well. That would have some very important repercussions for the integrity of markets. FRANCESCA CARNEVALE: However, there’s only one institution in the US. That’s the irony. RICHARD NELSON: And it is still cheaper! JAMES DAY: It is just that the sheer volume that pumps through the DTCC means that it enjoys economies of scale,

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SIMMY GREWAL – analyst, European market structure, Aite Group

but in Europe you just don’t have that and the only way of pushing towards that end is having interoperability. CLIVE WILLIAMS: Maybe that’s what we should all have, a regulated utility for exchanges, full stop. STEPHANE LOISEAU: When you compare the US trading environment and the European trading environment, what strikes everyone is difference in the volumes that are traded. The differences in market capitalisations between Europe and the US are not as big as the differences in trade volumes. So some point to the clearing costs, as it could be the lower costs of trading on the US exchanges, that create a lot more volume of trading on exchanges in the US compared to Europe.

DO DARK POOLS ADD VALUE?

RICHARD NELSON: You have to differentiate between dark pools and block crossing networks. Liquidnet and ITG are very different from dark pools, because you can genuinely show large size and get big blocks done. Whereas, in dark pools I have not experienced that yet. You still can show big size and so forth, but very rarely do you get big hits, just the chip-away sort of fills. One thing that strikes me since I’ve been over here is how much the market can leak order information; it is absolutely incredible. I’ve been blown away by the number of times I’ve taken phone calls from brokers saying, “Oh, are you doing such-and-such?” I’m asking myself: how did that get out there? Even so, dark pools and dark crossing networks are here to stay and are very advantageous to our trading style. SIMMY GREWAL: Dark pools are beneficial to the buy side because as the average trade size on exchanges has decreased, it becomes increasingly difficult to unburden a big block execution on an exchange. It is just not going to work. If you have the ability to put it in a crossing network

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or a dark pool it can passively rest waiting for the other side. Depending on how that pool operates and what kind of information or messages it sends out to the market, it could be 100% dark. That information is not getting leaked to other participants and is not as exposing of the order to execution risk. Though there is still exposure to price movement, you’re not impacting or increasing that movement. Today it is actually more transparent than it used to be because in the past it wasn’t disclosed to a client or talked about. Brokers could cross stock internally and not necessarily give their client the upside. Now a lot of brokers advertise that they cross at the midpoint and that midpoint is determined by the primary exchange. If dark pools were called gold pots, we would not be having this discussion. CLIVE WILLIAMS: I do have some problems with how some brokers use dark pools. Some brokers want to ping dark pools aggressively. A dark pool for me is where you want to rest and be rested and do nothing until you find a suitable match on the other side. This goes against the definition that some brokers want to use; they are happy to rest for five minutes and then go and ping other venues. You’ve got be very careful what your definition of a dark pool is and what a broker’s definition is. STEPHANE LOISEAU: If you look at the US, they are probably only two or three dark venues that have an average number of shares crossed of 10,000 shares or more. That’s the top end. Every other venue is below 600 shares. That’s the average ticket size on most dark venues, which equates to what you can observe on lit venues. So if you see 600 shares traded as “a block”, that’s most likely an algorithm, with a distribution of the order throughout a given period of time, and how you effectively internalise that flow and meet with other types of flow on the other side. Dark trading has always existed, but there is a part of it that is automating an activity that has always existed in order to create economies of scale and increase volumes; and another part which is creating new services and, in particular, those around the block side. If you’re trying to cross a mid-cap stock, you might want to go into the block venue because it will make a difference in terms of access to immediate liquidity and price. Once you’ve set these parameters, then you realise there is what I call different shades of grey. Some are mid price, some are pinging, crossing the spread; some are mostly posting, which is sitting on the bid side. Part of the required research going forward is finding out how algorithmic strategies are accessing these different venues, what prioritisation rules they use for example. CLIVE WILLIAMS: One of the reasons for dark pools is you don’t want to split your orders into a hundred different shapes, because the more you do that, the more footprints you leave. As Richard says, it is surprising how little flows you’re getting in block trades when you get into dark pools. Even in large caps the amounts of shares crossing in dark pools can be disappointing. Whatever happened to block trading? SIMMY GREWAL: That will happen as the European space at the moment is in a very evolutionary stage. Obviously MiFID was in some sorts the big bang, the push

RICHARD NELSON – senior vice president & head of dealing, AllianceBernstein

to all this fragmentation of liquidity. Now we’re seeing elements of consolidation and that’s what people are looking for in the future. With the LSE’s incorporation of Turquoise and SmartPool’s absorption of NYFIX’s Euro Millennium, pan-European dark pool consolidation has begun. As this wave of consolidation involving independent dark pools, exchanges and MTFs continues we will see the concentration of liquidity returning to the markets. CLIVE WILLIAMS: It just seems to be that the cycle in the market has completely changed. No one wants to trade. Even if you are a buyer and you or your broker finds the seller, chances are they now want to work over the day and lack any commitment to trade in block .I don’t know any information; chances are the other side knows nothing either, so why don’t we cross and get it done with? SIMMY GREWAL: It is usually because they’re resting their orders in two different dark pools that aren’t connected and as a buy side trader you are completely unaware of it. It is impossible to know categorically, for example, if one dark pool is especially active in a certain stock on a particular day that it will be the same on the following day. Say dark pool ‘A’ has been intensively active in Vodafone for the last 10 days and you are looking to cross a block in the stock so you place your order in the same pool. Unfortunately the previous trader has completed their order, however another party has the other side of the trade but they aren’t connected to dark pool ‘A’ and they place their trade in dark pool ‘B’. Obviously, if there is no information leakage then there will be no way for those orders to cross. RICHARD NELSON: In that example there is no information leakage, but there can be. SIMMY GREWAL: I agree although it depends on the type of dark pool that you’re connected to. Brokers have provided solutions to the buy side in the sense that they can customise which pools they actually interact with. If they don’t want to interact with those dark destinations with which information leakage is linked to, then their orders aren’t routed there. If there are only certain venues that they’re happy to trade on;

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those that they’ve executed successfully on and have good execution statistics for, so they are able to prioritise venues within the algorithms and SOR technology they utilise. RICHARD NELSON: That is true but do you know many buy side firms are able to identify individual venues they think are safer than others? MARY McCAVE: It is a question of gathering information from first-hand experience, but I would also add that we do ask quite searching questions of the different providers that we use. We ask the broker providing the algorithm. We want to know, for example, which venues they access, how they prioritise these, what proportion of trades in their algorithms cross at midpoint, under what circumstances would they cross away from mids etc? The list goes on! It is our responsibility to ask those questions. Those questions are evolving all the time, as suddenly a different situation will hit you and you realise you have to go back and ask all of your providers about that incident, because it was something that didn’t previously occur to you.

MAKING THE BEST OF THE SELL SIDE

FRANCESCA CARNEVALE: Given this evolving and highly complex market and that some dark pools are perhaps more dangerous than others, should more buy side operations such as Mary’s really hammer the sell side relationship and say,“Look, this is where I really need you to add value and help me achieve my strategy?” JAMES DAY: We’re seeing that already, as Mary referred to, and there’s a number of when you get the RFI coming out, the searching questions that the buy side are asking around the dark space: where are you crossing? Where’s the order flow? Do you interact with ELPs? So the level of knowledge and understanding and the desire of the sell side to engage in those issues is really increasing. Actually, it is the job of the broker to help the buy side navigate through that to help on the education process, advise where we’re seeing best fills for their flow, and helping them navigate through any potential minefields. FRANCESCA CARNEVALE: If that’s the case, do you see more dark or grey pools set up that really the test the relationship? After MiFID you seemed to see seepage of significant expertise from the sell side moving over to the buy side. As the sell side appear to be the winners in the post MiFID landscape, do you see that expertise seeping back? Or at least that the buy side becomes more dependent on the sell side going forward? JAMES DAY: It is a difficult one. At one time if you’d got your BT to execute, that would have been left to the discretion of the broker to execute that and there wouldn’t have been any interrogation or questions around“where did you execute it?”as long as you got a good fill. The buy side was comfortable that that broker was servicing its needs and the broker would know if the flow ceased. On the electronics side of it, it is more about partnership right now. It is a situation where the buy side will look at the broker and ask: “How do you navigate through this issue?”

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Actually, a lot of people are asking searching questions and putting the broker on the stand to justify why they’ve gone to certain venues, what were they doing, and why they were going there. I don’t see it going full circle; it is just a natural evolution as trading evolves, and the relationship that the buy side and sell side will continue to evolve with it.

DOES TECHNOLOGY LIMIT THE BUY SIDE?

CLIVE WILLIAMS: Absolutely, and we rely on the sell side guys very much for algorithms, and connectivity, so we definitely outsource all of that. We can help each other and educate each other as to how we want to use these tools most effectively. We have spent the last couple of years, two or three years, working very closely with our algorithm providers, customising all the algorithms to the way that we want, and educating our own traders. And we’re doing a high percentage electronically now, so we’re taking a significant part of our trading back in-house and empowering the traders on our desk to trade the way they see fit, rather than outsource everything to a sales trader who will then interpret it the way they want and pass it onto their trader, who probably shoves it in an algorithm anyway so that it does what the trader wants, which can be poles apart from the original instruction given to the sales trader. RICHARD NELSON: We have a team of quant guys who analyse brokers’ algorithms and see what they do; whether they do what they say they do. Some are better in different markets and you have to identify the right time to use certain algorithms to get the best result. To be able to do this though, you have to invest money in systems and transaction cost analysis. STEPHANE LOISEAU: Algorithmic trading is an art, not a science and because it is art, it constantly evolves and what was true a month ago or was true on small cap, is not necessarily true on other types of trades or in different market conditions. It is definitely not a science because if it were a science, we wouldn’t need to spend so much time discussing it! It would be standard and you would get exactly the same performance every time you trade, which you clearly don’t today. So, at Société Générale, we spend a lot of time analysing that data and we make changes as often as weekly. So when we send our reports through to customers, you see that one week we are very high on ChiX and another week we’re a little bit lower. The reason is because we look at the data dynamically and make the required changes. It is a trial and error process and there is no set formula, there’s no prescriptive determination from the regulator, so right now the best you can do is be methodical, analyse, understand and report the appropriate data and make changes accordingly, as dynamically as possible. We started algorithmic trading probably about four years ago on the customer side—the firm’s done it for ten years or more. Basically every week there’s a new version of the trading algorithm out there. This is that onerous in terms of process.

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sophistication that you’ll move to, so in terms of a full toolkit full of different algorithms, I don’t think you’ll get there. It is just the algorithms that are out there will become more sophisticated and interacting with the order book. MARY McCAVE: A question often asked, is how the buy side differentiates itself when everybody’s got the same algorithms. It comes back to knowing the algorithms insideout, knowing how they behave, customising them where necessary, and taking the necessary steps to amend what you’re doing intra-day. The point is, we don’t just select an algorithm, push a button and walk away. We’re dynamically recalibrating our trading approach for each order, and we’re changing the strategies that we’re using if we’re not getting the results that we were expecting. In other words, although we are not tinkering with the back end of the algorithms as such, what’s going on at the front end is just as important.

THE NEAR-TERM OUTLOOK CLIVE WILLIAMS – head of European equity trading,T Rowe Price

CLIVE WILLIAMS: So if you’re updating your algorithms every week, how often do you release that to the client? STEPHANE LOISEAU: In this fast evolving environment, the biggest challenge is indeed the delivery of the algorithm to the buy side client on their frontend and what we’re trying to do to avoid that step, because that’s a huge cost in terms of lead time and manpower, is effectively to build a lot of the changes in the background. So that’s what people call custom algorithms because we’re customising the strategies ourselves. They’re effectively extended algorithms with a few parameters that you can play with. In the back of it we have something we call the PPX, our algo pre-processor tool, which is currently like a client mapping tool where we say, okay, this is the change we’re going to make; and we make that change ourselves, with no impact on the client front-end, so that it’s available very quickly, yet it allows a very refined customisation of the trading strategy. FRANCESCA CARNEVALE: Is there a natural limit to the continued sophistication of algorithms? JAMES DAY: No, I don’t think it is limitless. It will reach a point where there is a working toolkit.You will have a toolkit of algorithms at your disposal and whether you want to follow volume, follow a benchmark or you want to be aggressive, whatever your trading style is, you’ll have an algorithm that suits that trading style. There are interesting developments ahead around predictive algorithms, such as algorithms that react to the changes in the order book. As the order book changes the algorithm has the ability to look at it and apply a trading feel to it, in the same way that a human trader does; deciding where to put orders and hanging back because it’s noted some momentum on the downside and therefore waits a little bit. Moreover, the algorithm will continually review its actions, asking if that trade was the best thing to do in the circumstances and recalibrate accordingly. That’s the level of the algorithm

RICHARD NELSON: What we have seen in the last couple of months is going to be the theme for 2010. We have seen volume drying up quite significantly and that’s going to be a big challenge for a lot of firms this year. It is going to be seeking liquidity that will see block crossing networks and dark pools become very important. This year we’ll be investing a bit more in terms of quant and be looking into the products offered by our brokers so that we can get a better understanding of which brokers are really on the ball with what’s going on in the marketplace. JAMES DAY: It will be the focus on liquidity. There is a need to keep an eye out for the changes in the liquidity profiles and the overall level of liquidity in the market. Successfully navigating and interacting with the liquidity that is out there, both lit and dark venues. We need to keep a close eye on the potential regulatory changes that are on the horizon, and how these will affect the trading landscape. The industry needs to find solutions to the issues that have come out of MiFID, i.e. Pre- and post-trade transparency. If we look back at this time last year, the markets were at alltime lows and have bounced back considerably since then. There are firms out there that are spotting business opportunities, they feel in a better place and they’re looking out for business opportunities. There’s others that are doing restructuring, which creates opportunity. CLIVE WILLIAMS: I would even go further because I’ve been surprised that commissions—say they were down 50% last year across the board—but in this environment all we had seen was additional capacity on the sell side. Barclays Capital hired aggressively, Nomura was reinvented from Lehman’s and a whole host of niche research and execution-only houses sprung up; no one shut-up shop. I’ve been very surprised that the sell side has actually grown rather than shrunk. ICAP seems to be the first one that’s going to throw the towel in. RICHARD NELSON: Liquidity is going to be the thing that’s going to go missing this year and, to my mind, this reminds me very much of the post 1987, early 1990s period.

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This liquidity drought went on for a couple of years, which was pretty hard. We do still rely on the sell side very much. They’ve got much better resources to analyse what’s going on in the marketplace and are able to advise clients. it is a trend that trading desks are seen as value-add as opposed to cost centres and that value-add comes from trading desks being able, as Clive said, to advise managers, to not buy this, but buy this preference share, it is much better, or this convertible bond for your exposure to this company. The trading desk needs to get that colour and that information from their sell side contacts. It is still necessary to have strong relationships with sell side brokers, if you’re going to go high touch, to locate those blocks; or if you’re in the dark pools and crossing networks, to get sizeable liquidity. The buy side will also need to be more proactive in terms of finding those blocks and getting liquidity, such as asking brokers for some names that they would be interested in making some block prices in and reciprocating with some of our own ideas, so if the broker comes across anything, we’re the first call. JAMES DAY: We are going to continue to see a lot of innovation out there. You’ve seen the effects after MiFID. We’ll continue to see innovation around the dark pools and there will be continued focus on the regulation. The regulators have really caught hold of MiFID. There’s a focus there and you definitely get the sense that there will be change taking place. So that’s going to put more on the trade associations to understand that there were repercussions with MiFID that were not contemplated at the time, and work to resolve these issues re-post-trade reporting. People are much more aware now that these regulations will have implications to the buy side and the sell side, so you’ll start to see a lot more collaboration, a lot more thought processes around the regulation from what could be the impact of this regulation, and how will it affect all parties involved. We will start to see more collaboration and an understanding between the sell side and the buy side. FRANCESCA CARNEVALE: When we kicked this off it was about transparency and in this evolving relationship between yourself and the sell side, how would you like to see that relationship evolve to really address all your concerns going forward? MARY McCAVE: It has been encouraging over the last few years to see the buy side evolve technologically as well as in our mindset, taking more control of our orders rather than outsourcing the responsibility to the sell side. The status quo in our relationship with the sell side has consequently become more balanced, which is healthier. Obviously I do think it is very important that relationships with the key partners on the sell side continue, but we have started to see these evolve into more top-down, strategic relationships throughout the whole company. We can complement these with the trading relationship. CLIVE WILLIAMS: Certainly at our organisation we are a big user of the broker research and we will pay for that and will continue to pay for that. That’s extremely important to us, always has been, always will be. We haven’t changed

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since 1937, and I am pretty confident that whoever is sitting here in 50 years time from T Rowe Price will be saying exactly the same thing, it’s embedded in our DNA. At certain times the pendulum swings against us, but we will always be consistent in what we do and how we do it and we can only hope that our counterparts do likewise. STEPHANE LOISEAU: We are in a healthier environment overall in terms of regulation. The main challenge is the uncertainty. It is not the regulation in itself; it is the uncertainty about the regulation because how do you organise your firm, how do you invest in technology, how do you innovate with your quantitative teams etc? If you don’t know what’s going to be possible and not possible to do in the next three, six, nine months. That is very important. Another aspect of the buy side/sell side relationship which has evolved is the counterparty risk, but I’ll go against what you’ve said, in that I felt that after the crisis everyone was very focused about it and this was sound. There was a lot of talk about optimising broker lists for example to take into account credit risk. There seems to be less focus on that at the moment, and certainly we shouldn’t be oblivious about the risks and continue to promote the awareness that arose during the crisis.

JAMES DAY – director, Barclays Capital

ASIAN EQUITIES: LOCAL LIMITS ON GROWTH 86

Neil Katkov, senior vice president, Asia, at Celent, believes that increases in buy side trading sophistication in Asian equity markets will gradually support advanced trading strategies. Greater utilisation of advanced order types and trading tools such as algorithms and smart order routing will expand in the region, but certainly not to the extent of markets in the US and Europe. The main obstacles are country-specific factors, which have not only limited the potential for an aggregate view of trading in Asian markets but have also acted as a barrier to the penetration of high-frequency trading into individual markets. Lynn Strongin Dodds reports.

ASIA

Many markets have also not been welcoming to alternative trading venues. Lee Porter, managing director of Liquidnet’s Asia-Pacific business, adds:“The landscape is different in Asia Pacific than in the US and Europe. I think it will be the last place to embrace alternative trading because there is no overarching pan-Asian regulatory tailwind or framework such as MiFID or Reg NMS to open competition. Each country has its own rules and levels of openness which makes it difficult for new entrants.” Photograph © Kpargeter/Dreamstime.com, supplied April 2010.

HANGS BACK SIAN PACIFIC EQUITY markets may be enjoying record volumes but they still lag the US and Europe in terms of sophistication and infrastructure. Highfrequency trading (HFT) and algorithmic trading, for example, are relatively new phenomena and exchanges have felt no pressure to strike alliances with each other or Western counterparts. The Singapore and Chi-X joint venture is the notable exception but most markets are expected to continue blazing their own trails. According to figures from the World Federation of Exchanges, about $18,600bn in shares was traded in 2009 on 16 of its member Asia Pacific exchanges, which include Tokyo, China’s Shanghai, Shenzhen and Hong Kong; Australia and Korea. That compared with $13,077bn on 26 members in Europe, Africa and the Middle East. The figure is notable given that Asian exchanges do not have much participation from high-frequency traders. Despite the healthy flows, a new report by Celent, The Evolution of Equities Market Structure in Asia-Pacific, points out that Asian equities market structures and trading developments are still three to five years behind the maturity of the US trading landscape, as well as postMiFID Europe. For example, the Asian exchanges dominate accounting for about 98.9% of equities volume compared with 58% in the US and 70% in Europe.

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Neil Katkov, senior vice president, Asia, at Celent and coauthor of the recent report, believes that “increases in buy side trading sophistication will gradually support advanced trading strategies, including some HFT. Greater utilisation of advanced order types and trading tools such as algorithms and smart order routing will expand in the region, but certainly not to the extent of US and European markets.” The main obstacles are country-specific factors, which have not only limited the potential for an aggregate view of trading in Asian markets but have also acted as a barrier to the penetration of HFT into individual markets. As Rik Turner, a senior analyst in the financial services technology group at consultancy Ovum, which is part of Datamonitor, puts it: “There is no political or monetary union in Asia, so there can be no equivalent of the US Reg NMS or Europe’s MiFID regulations driving changes. You are talking about disparate countries, national interest, currencies, languages, time differences, cultures, not to mention humungous distances between places.” Other main obstacles highlighted in the Celent report include inefficient exchange matching systems, complex clearing mechanisms, stamp duty, as well as the onerous Investor ID process that foreign investors in many countries such as Korea and Taiwan have to undergo in order to obtain a license from the regulators to trade in that market. The region also lacks a mandate for best execution, which is embedded in MiFID and Reg NMS, plus dark pools are not allowed in many countries. In addition, most exchanges require trades to be placed by exchange members which have hampered the development of direct market access (DMA) and algorithms. Many markets have also not been welcoming to alternative trading venues. Lee Porter, managing director of Liquidnet’s Asia-Pacific business, adds: “The landscape is different in Asia Pacific than in the US and Europe. I think it will be the last place to embrace alternative trading because there is no overarching pan-Asian regulatory tailwind or framework such as MiFID or Reg NMS to open competition. Each country has its own rules and levels of openness which makes it difficult for new entrants.”

Long-term outlook Herbie Skeete, managing director of Mondo Visione, adds: “Change will happen and while there eventually may be a pan-Asian trading platform, it will take a long time. In general, local players in many countries in the Asia Pacific region have not wanted to open up their markets to new players such as alternative trading systems. The incumbent exchanges have done their utmost to resist new competition.” Glenn Lesko, chief executive officer of Instinet in Asia, says: “At the moment, there is not that much interest in pan-regional dark pools or alternative liquidity pools but that will change. The main focus is on the development of the market structure of each country and today, the two countries that are ahead of the game and moving at a faster rate are Japan and Australia. Singapore is also going forward but not alone. It is the only exchange to have

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

Robert Laible, head of electronic trading and programme trading sales, Asia-Pacific, at Nomura, puts it: “Japan had an opportunity to be in the big league with New York and London, but for a long time they did not innovate and it allowed Hong Kong to flourish. Arrowhead [the TSE’s next generation trading system for its cash-equities market] looks like it will be successful but it will be a huge catch-up.” Photograph kindly supplied by Nomura, April 2010.

signed a joint venture—with Chi-X—to trade stocks within and outside of the country. People will be looking closely at the impact that these developments have on attracting different types of trading.” Chi-East, which is set to make its debut this July, is a nondisplayed platform that will initially offer block crossing facilities for equities listed on SGX, and on an offshore basis for the Australia, Hong Kong and Japan exchanges. The focus will be on sell side exchange flow, which differs from rivals such as BlocSec and Liquidnet which target the buy side order books or Japan’s JapanCrossing and kabu.com that only operate in their home market. Separately, Chi-X Global is also waiting for license approval for lit platforms in Japan, Hong Kong and Australia. Ron Gould, chief executive of Chi-X Asia-Pacific, says: “Practitioners and regulators in the region have observed what has happened in the US and Europe and has seen how the changes have benefited investors through greater choice, liquidity and market depth. The vision of Chi-X Global has always been to develop a global footprint of interconnected markets. Our next phase will be to look at the significant opportunities available in Taiwan, Korea, India and China. However, it will not be an overnight process as each market requires a high investment in people, technology and working within the regulatory system.” David Jenkins, regional business solutions manager for Fidessa, believes that Chi-East could represent a turning point. “It is the first attempt to launch a pan-Asian

ASIAN EQUITIES: LOCAL LIMITS ON GROWTH

Ron Gould, chief executive of Chi-X Asia-Pacific, says: “Practitioners and regulators in the region have observed what has happened in the US and Europe and has seen how the changes have benefited investors through greater choice, liquidity and market depth. The vision of Chi-X Global has always been to develop a global footprint of interconnected markets. Our next phase will be to look at the significant opportunities available in Taiwan, Korea, India and China. However, it will not be an overnight process as each market requires a high investment in people, technology and working within the regulatory system.” Photograph kindly supplied by Nomura, April 2010.

exchange-backed dark pool and is the biggest development in the region. It is hard to say whether it will be the catalyst in changing the way people trade but I think people will want more sophisticated trading tools and liquidity pools. We are also watching the developments in Japan with the launch of Arrowhead, as well as changes in Australia whereby the Australian Securities and Investments Commission (ASIC) is taking responsibility for market supervision from the Australian Securities Exchange (ASX).” Many would argue these changes are a long time coming, especially with the Tokyo Stock Exchange (TSE), which had been infamous for its lack of speed, capacity issues, and a series of technological glitches and outages. As Robert Laible, head of electronic trading and programme trading sales, Asia-Pacific, at Nomura, puts it: “Japan had an opportunity to be in the big league with New York and London, but for a long time they did not innovate and it allowed Hong Kong to flourish. Arrowhead [the TSE’s next generation trading system for its cash-equities market] looks like it will be successful but it will be a huge catch-up.”

Ongoing discussions Aside from Arrowhead (see page 89), the other notable event is TSE’s introduction of off-exchange clearing in July 2010 with Japan Securities Depository Centre, (JASDEC), which could generate more alternative liquidity venues, or proprietary trading systems as they are called in Japan. There are also ongoing discussions regarding unbundling of commissions, which has gathered momentum in the US and Europe and is beginning to gain traction in the region. The exchange already revised its Remote Trading Participant System in order to allow overseas financial firms without domestic branches to directly trade in Japan, which removed

the need for Investor IDs. However, as the Celent report points out, offshore firms still have to establish physical relationships (including a designated clearing participant and a resident compliance representative) in Japan and connect to the TSE systems via domestic access points. All eyes are also on the impact the regulatory changes in Australia due to be implemented in July will have. Market participants believe that the new supervisory reins given to ASIX will break the dominance of the ASX and open the door for alternative trading systems (ATSs) such as Liquidnet, AXE ECN, and Chi-X, which have been waiting for the past three years to get the licence green light. Previously, crossing rules restricted off exchange trading because only orders over $10m were allowed to be matched on alternative execution platforms, and printing/clearing had to be done on the exchange. As for other Asian markets, the developments are more muted. In India, for example, competing systems offering algorithmic trading are allowed, but dark pools are not. Jenkins says that the Indian market is “benefiting from some aggressive competition between the two existing exchanges and new entrants to the market, triggered by a gradual relaxation of regulations in order to attract flow”. He adds:“The National Stock Exchange and Bombay Stock Exchange have also adopted co-location services to attract algo and programme flow.”

Exchange partnerships Jenkins also notes that smaller exchanges are entering into partnerships. One example is the Malaysian stock exchange listing its derivative contracts on the CME in order to attract overseas investment and increase the volumes available on that market, as well as collaborating on trade-matching services, product licensing and minor cross-equity investments. As for Hong Kong, there are signs that the Hong Kong Exchanges and Clearing (HKEx) is looking to add features of dark pools to its traditional trading platform and is open to working with ATS operators to provide anonymous block trading for stocks listed on the Hong Kong exchange. However, as Gavin Williamson, head of execution trading, HSBC, Asia-Pacific, says: “The Stock Exchange of Hong Kong understands that it needs to move with the times and embrace changes that are happening globally. It will take time and changes will occur at a country level rather than as a region. We feel it is unlikely that they will enter a joint venture like Singapore.” Looking ahead, John Feng, Connecticut-based managing director of Greenwich Associates, believes that “although Asia has been slow to accept dark pools and alternative trading systems, demands for better execution, lower trading costs and anonymity, which is viewed as key to minimising market impact for large trades, will continue to drive the developments”. He adds:“Our research shows that as a result, electronic trading will increase about 3% to 4% a year to reach 28% in the next three years. It currently accounts for 18% of the region’s transactions last year, up from 15% in 2008.”

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

Clare Rowsell, head of client relationship management, Asia Pacific, for ITG, adds:“For a long time, the region has been behind Europe and US in terms of electronic trading but the focus on lowering costs, (which are on average approximately 66% higher in developed Asia-x Japan than the US), will continue to be a main driver of change. We have launched POSIT Marketplace

to make sure that we are well placed now that those changes are starting to happen.” POSIT Marketplace, which is billed as the first of its kind in Asia, will allow fund managers to buy and sell equities anonymously in the group’s own pool as well as other dark venues across the region. The system is currently available for trading Hong Kong equities, with Australia and Japan to follow.

Photograph © Aispl/Dreamstime.com, supplied April 2010

TSE’S ARROWHEAD: A NEW LEADER LTHOUGH IT IS too early to predict the success of Arrowhead, early indications are that the new platform is delivering the goods in terms of lowering latency and increasing trading efficiency. Hedge funds and others who trade large volumes of stocks at lightning speed using algorithmic trading techniques are testing the new waters and this should help restore the reputation of the beleaguered Tokyo Stock Exchange (TSE). Julien Le Noble, chief executive officer of broker Newedge Japan, says: “The latest research, from ITG, showed that Japanese equities brokers saw the cost of trading in TSE fall more than expected in January 2010 by over a third compared to December 2009. Also, the latency gaps between the TSE and European and US markets were significantly narrowed from three to fiveseconds to five milliseconds. This reflects an increasingly competitive marketplace.” The ITG report found that TSE members enjoyed immediate benefits with the cost of trading Japanese stocks dropping 36.7% in January compared to the previous month. This was attributed to the collapse in trading spreads on the exchange, which on average slid to 15% in January as the value of trading increased 16.5%, to $18bn (€13bn). The average size of individual trades—another key indicator of an efficient, electronic market—also fell dramatically, about a third to 400 shares per individual transaction in January from the month before. Arrowhead, which was launched in 2010, was the culmination of three years of work by the TSE to overhaul its legacy trading systems and rebuild the firm’s reputation after several technology failures and outages. It was severely criticised following its failure to cancel an erroneous trade in December 2005 when one of its

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

members, Mizuho Securities, mistakenly sent the exchange an order to sell 610,000 shares for ¥1 rather than one share for ¥610,000. The exchange failed to cancel the trade despite repeated requests by Mizuho, which lost an estimated ¥40.7bn (€285m) as a result. Hiroshi Matsubara, marketing director for Fidessa in Japan, comments: “Arrowhead is a huge event in Japanese equities: it is the equivalent of the country’s Big Bang in the late 1990s. The system is a response to the need to attract liquidity from players, such as highfrequency traders. The TSE had to do something. It has suffered over the last few years due to frequent outages and performance issues and this past year the exchange was overtaken by China as the region’s top exchange in terms of shares traded. The hope is that Arrowhead will help put the exchange back in the top spot.” The new trading system aims to bring the Japanese market closer in line with its Western counterparts such as NYSE Euronext, Nasdaq OMX and the London Stock Exchange, which have been investing heavily in their respective systems over recent years in order to compete more effectively. However, market participants believe the Tokyo exchange still has a long way to go before it is on a par with its rivals. For example, industry research shows that trades executed on Nasdaq OMX take less than one millisecond; the LSE is 2.7 milliseconds while NYSE Euronext is 2-3 milliseconds. Robert Laible, head of electronic trading and programme trading sales, Asia-Pacific, at Nomura, concludes: “So far, Arrowhead is delivering what it has promised and it does seem to be attracting high-frequency traders. However, it is still a big step up to compete with the global exchanges and we need more time to see if spreads remain narrow and volumes continue to increase.”

WALGREEN’S CHAIN GETS A MAKEOVER

Walgreens looks for

growth When Charles Randolph Walgreen III—grandson of the founder and affectionately known by his nickname “Cork”— retired from Walgreen Co in 1998 after 27 years as chief executive, he left behind a financially strong company that since its founding in 1901 had become the nation’s largest drugstore chain, known and trusted by millions of shoppers across America. However, despite 23 consecutive years of sales growth, Walgreens was losing touch with a changing marketplace. After a parade of new chief executive officers, last year, finally, the board found the right man to lead the company into a new century. Art Detman explains why.

Photograph © Kpargeter/Dreamstime.com, supplied April 2010.

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

T WAS AN inauspicious ascension for Gregory D Wasson, a 29-year veteran of Walgreens (WAG) who had been president and chief operating officer since 2007. His boss, chairman and chief executive officer Jeffrey A Rein, the third chief executive since Cork Walgreen retired, resigned abruptly in October 2008 following an unsuccessful bid to acquire Longs Drug Stores, a major California chain. Lead director Alan G McNally—a Canadian banker who joined the board in 1999, a year after Cork’s retirement—was hastily elected chairman and acting chief executive, and a headhunting firm was engaged to search for a permanent replacement. In February 2009 the board concluded that the best candidate was already on board, and Greg Wasson was appointed. If Wasson felt slighted by this insultingly tardy recognition, he didn’t let it slow him down. He moved quickly to recruit senior executives from outside the company, bringing in people from Goldman Sachs, Northern Trust, Sara Lee, Campbell Soup and other blue chips. In a company that had typically promoted from within, this was almost, but not quite, unprecedented. In 2008, Jeff Rein, evidently unimpressed with Walgreens’ cadre of senior officers, had raided Tyson Foods, the world’s largest marketer of chicken, beef and pork, to recruit Wade D Miquelon, Tyson’s executive vice president and chief financial officer, who previously was with Procter & Gamble for 16 years. Miquelon became a senior vice president and chief financial officer. After Wasson took over, he elevated Miquelon to executive vice president (one of two) and praised him as an agent of change. Today, Walgreens is charging forward on several fronts, trying to change both its image and reality as a mundane and old-fashioned retailer. The dozen or more executives recruited from the outside are remaking a century-old behemoth ($63bn in sales last year and 238,000 employees). A programme dubbed Customer-Centric Retailing aims at creating a much more customer-friendly store: wider aisles, lower shelving, better sight lines, more rational arrangement of goods, and elimination of needless product duplication. Already, Walgreens has eliminated 3,500 stock keeping units (SKUs) from its inventory.“It’s across all our 100 product categories,” says Miquelon. “In some cases, we have upped the number of SKUs, and in others they’re down 20% to 30%. At one point, we had something like 17 different hammers. We are a convenience trip many times over, so we need only a couple of hammers. We don’t need 17.”The same proliferation of offerings had affected over-the-counter drugs, resulting in the stocking of 13 brands of head lice killer. “In every category we started with the shopper,” he continues.“What does the shopper want? We found in many categories that there were products the shopper did not want or there was a better alternative. In some cases we have actually gone up in the number of products. It’s very likely that next year we’ll be adding back SKUs but probably in private labels or new areas like food and beer and wine.” Beer and wine were banished during Cork’s regime (Walgreens was once the nation’s largest retailer of alcoholic

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

Gregory D Wasson, president and CEO of Walgreens (WAG) is a 29year veteran of the firm, who had been president and chief operating officer since 2007. His boss, chairman and chief executive officer Jeffrey A Rein, the third chief executive since Cork Walgreen retired, resigned abruptly in October 2008 following an unsuccessful bid to acquire Longs Drug Stores, a major California chain. Lead director Alan G McNally—a Canadian banker who joined the board in 1999, a year after Cork’s retirement—was hastily elected chairman and acting chief executive, and a headhunting firm was engaged to search for a permanent replacement. In February 2009 the board concluded that the best candidate was already on board, and Greg Wasson was appointed. Photograph kindly supplied by Walgreens, April 2010.

beverages). They are widely stocked by Walgreens’ competitors, including CVS Caremark and Rite Aid, but bringing them back won’t always be easy for Walgreens. It has to find shelf space and deal with local laws and sentiment: even in some California communities residents have objected. However, beer and wine go along with Walgreens’plans to offer prepared meals and fresh fruits and vegetables at many urban stores. Miquelon says:“You know, in some markets we are the local grocer, even today, and there is an opportunity in many markets to expand grocery. That doesn’t mean that we are going to become a grocer, but there is a great opportunity with the 12-item-or-less shopper. Why doesn’t the 12-item-or-less shopper come to Walgreens more often? It’s not because of price or convenience; we typically do as well or better on those than supermarkets. The reason is that there are a few basic items that we haven’t had or that the customer thinks we don’t have.” In the new Walgreens, shoppers (most of whom are women) will be able to swing by and pick up a prepared meal, fixings for a salad, fruit such as bananas or oranges, and a six-pack or bottle of wine. In many markets, the key will be

WALGREEN’S CHAIN GETS A MAKEOVER

An archive photo of a Walgreens store is shown, taken Monday, June 25th 2007 in Doral, Florida. At the time the photo was taken drugstore chain Walgreen Co reported its third-quarter profit rose nearly 20%, propelled by a growing market share in its top products and an increase in prescription sales. In the new Walgreens, shoppers (most of whom are women) will be able to swing by and pick up a prepared meal, fixings for a salad, fruit such as bananas or oranges, and a six-pack or bottle of wine. In many markets, the key will be the beer and wine, which saves a trip to another store. Photograph by Wilfredo Lee for Associated Press, Archive photo 2007. Photograph supplied by/Press Association Images, April 2010.

the beer and wine, which saves a trip to another store. To push forward this initiative, Wasson brought in Bryan Pugh, the Tesco USA executive who helped launch the Fresh & Easy Neighborhood Market stores on America’s West Coast. All this hardly sounds like the old Walgreens, which one consultant likens to a flea market because of the clutter. Clearly, change is what Walgreens needs. Despite its steady growth during Cork’s reign, Walgreens had become like your Uncle Wilbur: solid, reliable, dull and out-of-date. Meanwhile, CVS had become a formidable drugstore competitor, a close number two in prescription sales and number of stores and actually far larger in total revenues and market cap. Discounters such as Wal-Mart

Daniel W O’Connor, president of Retailnet Group, a Waltham, Massachusetts, firm, is conditionally optimistic. “Walgreens gets a management team that actually understands convenience foods and convenience merchandising in a way that is relevant to today’s consumers,” he says. “They are buying the next generation prototype for the chain drug environment, which is demonstrated by the new stores that the folks at Duane Reade have built.”

Stores added their own pharmacies, as did many supermarket chains, including Kroger and Safeway. Dollar stores—once confined to rundown parts of town— were becoming more sophisticated and competing with drugstores in not only general merchandise but even beauty products.

In response, Walgreens has not only expanded its business model (please refer to the box on page 93) but abandoned its resistance to acquisitions. Although it lost out on Longs to CVS, Walgreens acquired many smaller chains throughout the country as well as prescription files from drugstores that were going out of business. Then, early this year, it announced what may prove to be not only its largest acquisition but a move that could secure its continued prosperity in an increasingly competitive market. Walgreens is buying Duane Reade, the dominant drug chain in New York City with 257 stores in the metropolitan area and annual revenues of $1.8bn but red ink on the bottom line. The deal should close any day now. Walgreens expects to turn this around in just three years thanks to economies of scale and the exchange of knowledge. Duane Reade is expert in the front end of drugstores—that is, everything except the pharmacy—while Walgreens is the master of pharmacy sales (63% of its revenues compared with less than 50% for Duane Reade). Notably, both Duane Reade chief executive officer John Lederer and chief merchandising officer Joe Magnacca are being retained. The price is just over $1bn, which includes assumption of $457m in debt, and the seller is Oak Tree Capital Partners, a private equity firm. After paying cash, Walgreens’ cash on hand will be about $2bn. Ironically, or maybe amusingly, Standard & Poor’s announced that it may cut its credit rating on Walgreens, even though Walgreens is paying cash for Duane Reade, will have about $2bn in cash left over after the purchase, and generates roughly $1bn in free cash flow every 12 months. After rating packages of toxic sub-prime mortgages AAA, evidently S&P’s has decided to view all transactions with an abundance of caution. Everyone else, it seems, thinks the acquisition is a good idea.“It’s a great move for Walgreens,” says Richard Seesel, principal of Retailing in Focus, a consultancy based in suburban Milwaukee.“Just the sheer number and quality of locations that Duane Reade has all over New York City is something that Walgreens couldn’t begin to duplicate.” Other consultants agree but point to additional advantages.

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

Carol Spieckerman, president of Newmarketbuilders, based in Bentonville, Arkansas (home of Wal-Mart Stores), believes the acquisition is vital because of the blurring of distribution channels as drugstores, discounters, supermarkets and dollar stores increasingly overlap in their product offerings, such as beauty aids. She says: “This will allow Walgreens to start to reclaim its beauty advantage. Walgreens used to be a formidable competitor in beauty; it had the ‘beauty associates’, store employees who were known for their training.Then Walgreens started diminishing all of that. They also started cutting back on their fragrance selection, a market that they practically owned.” Daniel W O’Connor, president of Retailnet Group, a Waltham, Massachusetts, firm, is conditionally optimistic. “Walgreens gets a management team that actually understands convenience foods and convenience merchandising in a way that is relevant to today’s consumers,” he says. “They are buying the next generation prototype for the chain drug environment, which is demonstrated by the new stores that the folks at Duane Reade have built.” The key word in O’Connor’s appraisal is “new”. Most of Duane Reade’s stores were unattractive, cluttered and roundly disliked by their customers. The new-look stores are sleek and modern, even breathtaking in their design, inside and out.“They don’t look like any other chain drug retailer,” says O’Connor.“The new Duane Reade stores are terrifically positioned to where today’s consumer is.” For example, O’Connor—like Spieckerman—believes beauty products are important to the future health of Walgreens. “Go to Duane Reade and you will see that its approach to beauty is much more sophisticated than anything you will see in any other

retailer. Duane Reade has fundamentally raised the bar to a level that no other chain drug retailer in North America has even approached.”What Duane Reade has done is create a store within a store with its beauty-products Look Boutique. These boutiques are very market sensitive. They will probably work in places such as Beverly Hills but not in markets such as Malibu. Miquelon says that they might not be called Look Boutiques everywhere, “but that doesn’t mean that we won’t improve our beauty experience everywhere”. He adds:“I think we will.” This is just another example of how much the Duane Reade acquisition can affect Walgreens’ future. However, O’Connor has a caveat: “All the Duane Reade acquisition does is give Walgreens an opportunity. The question is: can they capitalise on that opportunity?” Miquelon believes Walgreens can because the Duane Reade acquisition fits into an overall plan for tailoring Walgreens’ drugstores to individual markets. A store in Chicago’s Loop may soon look very much like one of the new Duane Reade stores in Manhattan, but a store in Cody, Wyoming, will look quite different. “I don’t think we’ll have 7,000 different looks because we don’t have 7,000 different demographics,” he explains.“However, we may have 10 or 20 or 25 different looks.” Generally, security analysts are upbeat about the new Walgreens.“I have a buy rating on Walgreens,”says Andrew P Wolf of BB&T Capital Markets in Richmond, Virginia.“It’s really my top large-cap pick. The strategies that they are implementing are going to create a lot of shareholder wealth.”Consultant Spieckerman agrees:“I think Walgreens is getting it that the old business model no longer works, and now they are really firing on all cylinders.” Yes, and just in time.

ON THE CORNER OF MAIN AND MAIN IKE MANY OF its competitors, Walgreen Co (WAG) has an online pharmacy, a mail-order operation and a network of in-store healthcare clinics (350 Take Care Clinics). It runs worksite health centres for major companies and oversees a network of 17,000 immunising pharmacists, nurses and others. Last year it became the exclusive provider of drug prescriptions for the employees and retirees of mining, agricultural and forestry machinery manufacturer Caterpillar Inc and currently is in talks with Delta Air Lines to provide the same services. All well and good, certainly, but the heart of the company remains its retail drugstores, more than 7,200 of them in 50 states, the District of Columbia, Puerto Rico and Guam. Walgreens says it has a store within five miles of three out of four Americans. Ideally, the store will

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

occupy its own high-visibility building at a busy intersection—on the corner of Main and Main, as the company likes to say. “We’ve gone after the best corners in America,” says Wade Miquelon, Walgreens executive vice president and chief financial officer. “We’re trying to secure the very, very best real estate.” In contrast, both fast-growing CVS Caremark and struggling Rite Aid prefer locations in strip centres, where they share parking with anchor tenants like supermarkets. Both, however, also have freestanding stores, often in buildings that once housed supermarkets. As for Walgreens, it exited shopping centres in the 1990s and shows little interest in returning to them and even less in taking over abandoned supermarket space. The strategy remains build or buy on the corner of Main and Main.

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 sell side 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

-1

-16

-72

-13

-30

-6

-8

Venue Turnover

Wks

Stock

Description

FFI

GKN.L

GKN ORD 10P

3.29

NXT.L

NEXT ORD 10P

3.04

COB.L

COBHAM ORD 2.5P

3.02

WOS.L

WOLSELEY ORD 10P

3.01

SN..L

SMITH&NEPHEW ORD USD0.20

DGE.L

DIAGEO ORD 28 101/108P

PRU.L

PRUDENTIAL ORD 5P

2.95

-46

WEIR.L

WEIR GRP. ORD 12.5P

2.92

WSM.L

WELLSTREAM ORD 1P

2.9

-19

IMT.L

IMP.TOBACCO GRP ORD 10P

-3

RSA.L

RSA INS. ORD 27.5P

-5

LAND.L

LAND SECS. ORD 10P

2.82

-4

NG..L

NATIONAL GRID ORD 11 17/43P

2.81

-39

ADN.L

ABDN.ASSET.MAN. ORD 10P

2.81

-9

RR..L

ROLLS-ROYCE ORD 20P

2.81

-22

SL..L

STD LIFE ORD 10P

2.8

-50

BG..L

BG GRP. ORD 10P

2.79

-49

SRP.L

SERCO GRP. ORD 2P

2.79

-34

WTB.L

WHITBREAD ORD 76 122/153P

2.79

-17

2 23

KGF.L

KINGFISHER ORD 15 5/7P

2.79

3 2.97

2.9 2.85

Wks = Number of weeks in the top 20 over the last year. Week ending April 2nd 2010

Venue Chi-X London Xetra Paris Milan SIX Swiss BATS Madrid Amsterdam Stockholm Turquoise Helsinki Oslo Nasdaq OMX Brussels Copenhagen NYSE Arca Lisbon Burgundy Dublin

Trades 3,127,910 1,723,381 450,296 1,033,495 533,991 282,277 1,180,183 397,445 458,309 347,670 573,794 184,524 97,334 185,543 111,974 72,031 94,077 60,513 29,989 8,207

Turnover €000’s 20,222,272 17,293,857 12,061,066 11,941,151 7,872,394 7,167,428 6,724,987 6,367,184 5,167,331 3,786,086 2,984,155 1,732,447 1,063,803 940,023 885,674 721,703 531,383 423,431 233,705 93,297

Share 18.69% 15.98% 11.15% 11.03% 7.27% 6.62% 6.21% 5.88% 4.78% 3.50% 2.76% 1.60% 0.98% 0.87% 0.82% 0.67% 0.49% 0.39% 0.22% 0.09%

Figures are compiled from order book trades only. Totals only include stocks contained within the major indices. † market share < 0.01%. Week ending April 2nd 2010

COMMENTARY By Steve Grob, Director of Strategy, Fidessa Much has been written about the decline in the primary exchanges’ market share in favour of the newer alternative trading venues. The London Stock Exchange (LSE) recently enjoyed a temporary boost in volumes driven by the triple witching hour on March 19th when many traders go to the LSE in order to cover their equity options positions. However this was just a small kink in the underlying trend which shows the fragmentation of FTSE 100 stocks seemingly on a never ending incline. The winner in recent weeks has been Chi-X (with around 28%) but BATS Europe is also steadily moving up the rankings and now accounts for almost 10% of the FTSE 100. It makes sense to add the Turquoise share (approaching 4.5%) back to the LSE as they are now its majority owners but, nevertheless, the trend appears to be almost irreversible. Further analysis, however, shows that this might not be the case. If we take a look at average trade size and value rather than actual market share, we see a different picture emerging. During recent weeks both the LSE and Chi-X have executed nearly the same number of trades yet the average trade size and value of the LSE trades has been more than twice those on Chi-X. The difference in trade size was even greater between the LSE and BATS Europe. The newer venues appear to have been successful in attracting smaller order sizes which, typically, are associated with orders that have been sliced and diced algorithmically or generated by the high frequency players. Given that the average order size in FTSE 100 stocks has fallen steadily, it looks like Chi-X and BATS have been especially successful in appealing to these market participants who are now responsible for contributing significant proportions of liquidity to the markets. To play in this game, of course, you need to be able to offer a very fast matching platform. It makes perfect sense, then, that the LSE is going full steam ahead to implement its new lowlatency platform, Millennium Exchange, in September.

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

Venue turnover in major stocks: Week ending April 2nd 2010 (Europe only). (€) August

September

October

November

December

January

February

March

BER

11198473.01

8330897.81

12299869.07

12095979.32

20898115.71

BRG

367,214,270.90

622,622,788.02

559921470.34

362494501.08

274600248.26

485115578.84

664510070.30

1666606979.62

BTE

14,571,686,219.00

22,569,010,036.90

27644041971.79

23573463734.99

19985719530.83

31150258386.00

34090404626.97

39193610957.69

CIX

71,551,307,518.00

84,046,791,321.19

106697966298.67

90039160470.86

75306622295.52

110977110385.49

122737876719.05

127111917698.82

CPH

7,089,257,770.00

7,147,826,212.47

7580961264.52

5706863159.57

5072932715.84

6756826918.10

6640400689.39

6626152423.75

DUS

41944732.75

46475438.04

51353982.31

37525367.53

51415834.33

ENA

30,691,910,028.00

37,393,454,265.25

44333181213.17

32257175002.36

33792253379.23

37999836321.05

37880117626.68

38562044761.19

ENB

7,784,709,480.00

10,086,003,222.10

8942068143.91

6366264426.48

5034992980.75

6008003591.11

6103299182.27

6358216747.07

ENL

2,485,993,487.00

4,261,559,944.59

3485422128.23

2219360066.21

2138868773.27

3106855297.08

3554443804.88

3046713139.88

ENO

482771.59

ENX

59,636,097,679.00

77,685,773,333.81

81861726196.95

65433199147.49

54355876074.24

66228400089.99

75614221011.97

74245298998.52

GER

55,161,793,765.00

69,515,848,590.13

74419073211.90

60908552433.56

52843852540.00

67965895238.29

66776121605.01

72168449445.45

HEL

8,812,985,645.00

10,016,921,672.01

11276385550.29

7451015808.21

6497813980.44

10339952621.77

10058819924.19

11752695115.83

ISE

465074179.96

511570001.10

504915917.70

565269992.07

LSE

82,899,283,778.00

96,477,697,345.69

100753579612.36

88751421724.55

72845386108.12

95983836598.48

101916702001.83

105630799395.16

MAD

35,434,917,111.00

47,318,951,034.98

56848573772.28

42670316078.54

39993245595.41

51066014495.96

52210894242.17

43945312316.04

MIL

50,791,257,494.00

78,086,217,226.28

65232722070.55

58890245107.45

34112242363.73

48728657959.10

51711533820.17

52410490586.85

NAE

75,833,173.13

65,079,038.29

188509367.45

286391174.03

559208778.00

1292687653.19

1825246025.41

2792572924.06

NEU

3,185,323,984.00

4,413,980,819.97

6508249441.66

7449995153.50

5242206607.57

5816854755.80

5574111215.48

6232496049.93

OSL

10,083,367,296.00

13,222,554,868.00

16695154952.77

13184181892.72

11253566686.23

16130924336.37

15871251841.26

13866926910.94

STO

20,842,988,551.00

23,529,554,732.68

25928648845.75

20898321966.79

16954761461.22

22786344725.57

24086268094.82

24125076503.28

TRQ

26,695,607,538.00

26,106,162,960.16

28005208583.96

22895687295.59

15953764952.03

20168098539.34

21028161702.73

20951128258.80

VTX

35,080,948,172.00

37,499,163,419.18

39772295992.78

37198627753.77

31586888591.75

43636990148.75

46961823692.04

44673323239.12

XIM

90362714.08

97403633.80

Index market share by venue: Week ending April 2nd 2010 Primary Index

AEX

Alternative Venues

Venue

Chi-X

Amsterdam

64.45%

22.25%

Turquoise

Nasdaq OMX

2.38%

1.00%

BATS

5.14%

Burgundy

Amst.

Paris

Xetra

4.43%

0.19%

London

NYSE Arca

Stockholm

BEL 20

Brussels

46.76%

19.91%

2.26%

0.87%

3.45%

26.56%

0.04%

CAC 40

Paris

64.20%

21.68%

2.54%

0.77%

4.88%

5.35%

0.18%

DAX

Xetra

70.48%

20.10%

2.21%

0.85%

4.57%

†

0.60%

FTSE 100

London

56.51%

26.50%

4.04%

1.35%

10.48%

1.11%

FTSE 250

London

67.52%

18.45%

5.49%

0.85%

6.74%

0.95%

IBEX 35

Madrid

98.80%

0.93%

0.02%

†

0.02%

†

0.12%

FTSE MIB

Milan

80.21%

9.96%

1.84%

0.78%

6.83%

†

0.07%

0.28%

Lisbon

93.20%

3.89%

1.93%

0.06%

0.91%

†

SIX Swiss

73.28%

15.36%

2.97%

0.69%

6.97%

0.74%

PSI 20 SMI OMX C20

Copenhagen

85.03%

10.11%

1.65%

0.98%

2.15%

0.04%

OMX H25

Helsinki

74.00%

14.81%

3.14%

0.67%

5.62%

0.12%

0.03%

1.17%

0.24%

OMX S30

Stockholm

73.97%

13.62%

2.46%

0.71%

4.61%

4.56%

0.07%

OSLO OBX

Oslo

87.78%

3.87%

1.61%

0.11%

0.96%

0.11%

†

5.54%

Dublin

24.98%

0.39%

0.79%

0.03%

72.41%

0.01%

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.

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

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

FTSE GWA Developed Index 0 ar -1

FTSE RAFI Emerging Index

Se p0

9 ar -0 M

8 Se p0

8 ar -0 M

Se p07

ar -0 7 M

Se p06

ar -0 6 M

Se p05

ar -0 5

Index Level Rebased (31 January 2005=100)

400

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

2,749

251.49

3.2

8.0

57.0

3.2

2.32

FTSE World Index

USD

2,289

588.76

3.2

7.8

55.7

3.2

2.35

FTSE Developed Index

USD

2,000

233.97

3.3

7.6

53.7

3.3

2.35

FTSE All-World Indices

FTSE Emerging Index

USD

749

652.31

2.5

11.6

84.7

2.5

2.15

FTSE Advanced Emerging Index

USD

289

614.72

1.3

12.3

85.4

1.3

2.46

FTSE Secondary Emerging Index

USD

460

757.60

3.6

10.9

85.2

3.6

1.87

FTSE Global All Cap Index

USD

7,385

404.23

3.6

8.5

58.9

3.6

2.23

FTSE Developed All Cap Index

USD

5,894

379.22

3.8

8.0

55.7

3.8

2.25

FTSE Emerging All Cap Index

USD

1,491

866.36

2.4

11.9

87.0

2.4

2.11

FTSE Advanced Emerging All Cap Index

USD

639

827.95

0.9

12.4

86.4

0.9

2.40

FTSE Secondary Emerging All Cap Index

USD

852

969.93

4.0

11.5

89.3

4.0

1.84

USD

726

181.37

-1.0

-3.0

5.9

-1.0

2.83

FTSE EPRA/NAREIT Developed Index

USD

275

2509.00

4.0

8.5

84.5

4.0

3.96

FTSE EPRA/NAREIT Developed REITs Index

USD

183

853.50

5.3

10.7

89.3

5.3

4.93

FTSE Global Equity Indices

Fixed Income FTSE Global Government Bond Index Real Estate

FTSE EPRA/NAREIT Developed Dividend+ Index

USD

201

1816.81

5.0

10.3

90.6

5.0

4.67

FTSE EPRA/NAREIT Developed Rental Index

USD

223

966.82

5.6

10.9

89.6

5.6

4.65

FTSE EPRA/NAREIT Developed Non-Rental Index

USD

1084.29

-0.1

2.8

71.9

-0.1

2.13

FTSE4Good Global Index

USD

661

6336.42

1.8

5.7

56.2

1.8

2.62

FTSE4Good Global 100 Index

USD

103

5338.84

0.6

5.2

49.9

0.6

2.76

FTSE GWA Developed Index

USD

2,000

3638.29

3.4

6.1

66.8

3.4

2.54

FTSE RAFI Developed ex US 1000 Index

USD

1,021

6231.48

0.8

-1.3

70.7

0.8

3.00

FTSE RAFI Emerging Index

USD

359

7018.10

2.8

11.0

86.7

2.8

2.43

SRI

Investment Strategy

SOURCE: FTSE Group and Thomson Datastream, data as at 31 March 2010

M AY 2 0 1 0 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

Americas Market Indices 5-Year Performance Graph (USD Total Return) Index Level Rebased (31 March 2005=100)

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

FTSE GWA US Index M ar -1 0

Se p09

M ar -0 9

Se p08

M ar -0 8

Se p07

M ar -0 7

Se p06

M ar -0 6

Se p05

M ar -0 5

FTSE RAFI US 1000 Index

Table of Total Returns Index Name

Currency

Constituents

Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%pa)

FTSE All-World Indices FTSE Americas Index

USD

771

781.44

5.4

12.0

53.9

5.4

1.92

FTSE North America Index

USD

648

850.10

5.6

11.8

51.6

5.6

1.88

FTSE Latin America Index

USD

123

1205.21

2.1

14.5

99.2

2.1

2.47

FTSE Global Equity Indices FTSE Americas All Cap Index

USD

2,583

359.70

5.8

12.5

56.5

5.8

1.81

FTSE North America All Cap Index

USD

2,395

342.87

6.1

12.4

54.3

6.1

1.77

FTSE Latin America All Cap Index

USD

188

1698.53

1.8

14.6

102.0

1.8

2.42

FTSE Americas Government Bond Index

USD

181

188.30

1.5

-0.1

-0.3

1.5

3.28

FTSE USA Government Bond Index

USD

167

184.14

1.3

-0.3

-0.9

1.3

3.25

FTSE EPRA/NAREIT North America Index

USD

122

3045.59

9.9

19.8

112.1

9.9

3.94

FTSE EPRA/NAREIT US Dividend+ Index

USD

1656.21

9.8

19.6

111.0

9.8

3.94

FTSE EPRA/NAREIT North America Rental Index

USD

118

1033.59

10.2

20.0

112.3

10.2

3.94

FTSE EPRA/NAREIT North America Non-Rental Index

USD

348.94

-0.3

12.1

107.6

-0.3

4.27

FTSE NAREIT Composite Index

USD

128

2944.71

9.5

18.7

99.5

9.5

4.64

FTSE NAREIT Equity REITs Index

USD

106

7177.91

10.0

20.4

106.7

10.0

3.86

FTSE4Good US Index

USD

130

5163.00

4.6

11.7

55.8

4.6

1.77

FTSE4Good US 100 Index

USD

102

4916.44

4.4

11.4

53.9

4.4

1.79

Fixed Income

Real Estate

SRI

Investment Strategy FTSE GWA US Index

USD

592

3213.83

6.3

11.3

61.8

6.3

1.95

FTSE RAFI US 1000 Index

USD

1,005

5808.49

8.9

10.3

79.7

8.9

2.02

FTSE RAFI US Mid Small 1500 Index

USD

1,506

5698.29

10.9

13.1

104.2

10.9

1.12

SOURCE: FTSE Group and Thomson Datastream, data as at 31 March 2010

F T S E G L O B A L M A R K E T S • M AY 2 0 1 0

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)

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

ar -1 0

FTSE RAFI Europe Index (EUR)

Se p09

ar -0 9 M

Se p08

ar -0 8 M

Se p07

ar -0 7 M

Se p06

ar -0 6 M

Se p05

ar -0 5

Index Level Rebased (31 March 2005=100)

5-Year Total Return Performance Graph

MARKET DATA BY FTSE RESEARCH

Europe, Middle East & Africa Indices

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

FTSE Eurobloc Index

EUR

284

239.07

4.5

127.88

0.9

10.0

56.3

4.5

3.15

3.4

50.6

0.9

FTSE Developed Europe ex UK Index

EUR

374

239.42

3.52

3.5

6.9

53.9

3.5

3.18

FTSE Developed Europe Index

EUR

486

235.14

4.1

9.4

54.9

4.1

3.22

FTSE Europe All Cap Index

EUR

FTSE Eurobloc All Cap Index

EUR

1,511

374.23

5.0

10.4

58.0

5.0

3.06

775

379.70

1.4

3.8

52.1

1.4

FTSE Developed Europe All Cap ex UK Index

3.42

EUR

1,053

400.69

4.1

7.5

55.8

4.1

3.08

FTSE Developed Europe All Cap Index

EUR

1,391

370.33

4.7

9.8

56.5

4.7

3.12

FTSE All-Share Index

GBP

628

3821.12

6.4

12.2

52.3

6.4

3.16

FTSE 100 Index

GBP

102

3627.28

6.0

12.5

50.4

6.0

3.27

FTSEurofirst 80 Index

EUR

4817.57

-0.3

3.3

49.9

-0.3

3.74

FTSEurofirst 100 Index

EUR

4402.06

1.9

8.2

51.9

1.9

3.61

FTSEurofirst 300 Index

EUR

311

1534.80

3.8

9.3

52.9

3.8

3.26

FTSE/JSE Top 40 Index

SAR

2932.49

3.8

16.8

42.6

3.8

1.77

FTSE/JSE All-Share Index

SAR

164

3250.11

4.5

16.4

44.1

4.5

2.00

FTSE Russia IOB Index

USD

965.26

4.0

17.1

94.8

4.0

1.77

FTSE All-World Indices

FTSE Global Equity Indices

Region Specific

Fixed Income FTSE Eurozone Government Bond Index

EUR

241

173.81

2.4

6.0

2.4

3.45

FTSE Pfandbrief Index

EUR

389

210.98

2.5

2.7

9.3

2.5

3.42

FTSE Actuaries UK Conventional Gilts All Stocks Index

GBP

2313.54

1.1

-0.9

0.8

1.1

4.06

FTSE EPRA/NAREIT Developed Europe Index

EUR

1902.86

3.6

7.5

66.7

3.6

4.47

FTSE EPRA/NAREIT Developed Europe REITs Index

EUR

688.34

1.8

6.8

64.7

1.8

5.05

FTSE EPRA/NAREIT Developed Europe ex UK Dividend+ Index

EUR

2386.37

6.5

8.7

65.1

6.5

5.05

FTSE EPRA/NAREIT Developed Europe Rental Index

EUR

747.22

3.7

8.2

67.4

3.7

4.58

FTSE EPRA/NAREIT Developed Europe Non-Rental Index

EUR

513.25

0.6

-10.3

47.3

0.6

1.22

FTSE4Good Europe Index

EUR

274

4668.99

3.5

8.5

53.5

3.5

3.33

FTSE4Good Europe 50 Index

EUR

4017.36

2.5

8.3

46.4

2.5

3.56

FTSE GWA Developed Europe Index

EUR

486

3380.76

3.5

6.2

68.8

3.5

3.39

FTSE RAFI Europe Index

EUR

507

5264.41

4.2

2.2

69.7

4.2

3.32

Real Estate

SRI

Investment Strategy

SOURCE: FTSE Group and Thomson Datastream, data as at 31 March 2010

M AY 2 0 1 0 â&#x20AC;˘ F T S E G L O B A L M A R K E T S

Asia Pacific Market Indices Index Level Rebased (31 March 2005=100)

5-Year Total Return Performance Graph 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) M ar -1 0

Se p09

M ar -0 9

Se p08

M ar -0 8

Se p07

M ar -0 7

Se p06

M ar -0 6

FTSE GWA Japan Index (JPY) Se p05

M ar -0 5

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

1,299

290.08

4.6

7.3

60.4

4.6

2.16

FTSE Asia Pacific ex Japan Index

USD

843

574.46

2.4

8.8

79.2

2.4

2.37

FTSE Japan Index

USD

456

83.16

8.8

9.6

29.7

8.8

1.81

FTSE All-World Indices

FTSE Global Equity Indices FTSE Asia Pacific All Cap Index

USD

3,109

491.98

4.6

7.3

61.6

4.6

2.16

FTSE Asia Pacific All Cap ex Japan Index

USD

1,874

711.56

2.4

9.2

81.8

2.4

2.36

FTSE Japan All Cap Index

USD

1,235

262.81

8.8

9.0

29.4

8.8

1.82

FTSE/ASEAN Index

USD

148

596.74

6.2

14.3

98.6

6.2

2.75

FTSE Bursa Malaysia 100 Index

MYR

100

9825.48

5.4

11.6

59.4

5.4

2.44

TSEC Taiwan 50 Index

TWD

6993.40

-4.2

2.7

49.9

-4.2

2.74

FTSE Xinhua All-Share Index

CNY

1,016

9134.16

-2.7

18.1

40.4

-2.7

0.77

FTSE/Xinhua China 25 Index

CNY

23673.73

-1.9

3.5

51.0

-1.9

2.06

USD

225

138.36

-0.1

-3.1

7.6

-0.1

1.33

FTSE EPRA/NAREIT Developed Asia Index

USD

2081.50

0.8

2.1

67.0

0.8

3.76

FTSE EPRA/NAREIT Developed Asia 33 Index

USD

1354.35

1.0

3.0

63.8

1.0

3.90

FTSE EPRA/NAREIT Developed Asia Dividend+ Index

USD

2185.45

1.4

2.8

74.6

1.4

5.38

FTSE EPRA/NAREIT Developed Asia Rental Index

USD

938.42

2.3

0.9

60.6

2.3

6.80

FTSE EPRA/NAREIT Developed Asia Non-Rental Index

USD

1185.21

0.0

3.0

71.4

0.0

2.06

Region Specific

Fixed Income FTSE Asia Pacific Government Bond Index Real Estate

Infrastructure FTSE IDFC India Infrastructure Index

IRP

990.49

1.6

-0.9

81.8

1.6

0.69

FTSE IDFC India Infrastructure 30 Index

IRP

1109.35

1.4

-2.3

82.4

1.4

0.68

JPY

185

3979.18

8.5

9.2

29.9

8.5

1.92

FTSE SGX Shariah 100 Index

USD

100

5466.11

2.8

6.2

50.3

2.8

1.94

FTSE Bursa Malaysia Hijrah Shariah Index

MYR

10821.66

2.2

6.8

44.2

2.2

2.80

JPY

100

1133.03

5.7

9.8

34.3

5.7

1.83

SRI FTSE4Good Japan Index Shariah

FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index

JPY

456

2976.64

10.4

9.9

34.8

10.4

1.92

FTSE GWA Australia Index

AUD

102

4239.49

2.0

4.6

44.8

2.0

4.00

FTSE RAFI Australia Index

AUD

6715.76

0.0

3.5

41.9

0.0

4.01

FTSE RAFI Singapore Index

SGD

8571.68

0.7

11.4

84.8

0.7

3.17

FTSE RAFI Japan Index

JPY

254

4185.92

10.1

12.6

36.5

10.1

1.87

FTSE RAFI Kaigai 1000 Index

JPY

1,026

4397.08

3.9

7.0

65.9

3.9

2.72

HKD

6882.67

-3.1

2.2

56.0

-3.1

2.58

FTSE RAFI China 50 Index

SOURCE: FTSE Group and Thomson Datastream, data as at 31 March 2010

F T S E G L O B A L M A R K E T S â&#x20AC;˘ M AY 2 0 1 0

INDEX CALENDAR

Index Reviews May-June 2010 Date

Index Series

Review Frequency/Type

Effective Data Cut-off (Close of business)

01-May 07-May

MSCI Standard Index Series

Annual review

31-May

TOPIX

Monthly review additions & free float adjustment

29-Jun

31-May

Mid-May

FTSE Med 100 Index

Semi-annual review

21-May

30-Apr

Early Jun

ATX

Quarterly review

30-Jun

31-May

Early Jun

KOSPI 200

Annual review

11-Jun

31-May

Early Jun

CAC 40

Quarterly review

18-Jun

16-Jun

Early Jun

OBX

Semi-annual review

18-Jun

31-May

Early Jun

S&P / TSX

Quarterly review

18-Jun

31-May

Early Jun

RTSI

Quarterly review

14-Jun

31-May

03-Jun

DJ Global Titans 50

Annual review of index composition

18-Jun

30-Apr

03-Jun

DAX

Quarterly review

18-Jun

31-May

04-Jun

S&P / ASX Indices

Quarterly Review

18-Jun

31-May

05-Jun

NZX 50

Quarterly review

18-Jun

31-May

08-Jun

FTSE MIB

Quarterly review

18-Jun

30-May

09-Jun

FTSE UK Index Series

Quarterly review

18-Jun

08-Jun

09-Jun

FTSE Global Equity Index Series (incl. FTSE All-World)

Annual review Emgng Eur, ME, Africa, Latin America

18-Jun

31-Mar

09-Jun

FTSE techMARK 100

Quarterly review

18-Jun

31-May

09-Jun

FTSEurofirst 300

Quarterly review

18-Jun

31-May

09-Jun

FTSE Italia Index Series

Quarterly review

18-Jun

30-May

09-Jun

FTSE/JSE Africa Index Series

Quarterly review

18-Jun

31-May

10-Jun

FTSE EPRA/NAREIT Global Real Estate Index Series

Quarterly review

18-Jun

31-May

10-Jun

FTSE Bursa Malaysia Index Series

Semi-annual review

18-Jun

31-May

10-Jun

OMX I15

Semi-annual review

01-Jul

25-Jun

11-Jun

DJ STOXX

Quarterly review

18-Jun

25-May

12-Jun

S&P Asia 50

Quarterly review - shares

19-Jun

05-Jun

13-Jun

S&P BRIC 40

Semi-annual review - constituents

19-Jun

05-Jun

13-Jun

S&P US Indices

Quarterly review - shares

19-Jun

05-Jun

13-Jun

S&P Europe 350 / S&P Euro

Quarterly review - shares

19-Jun

05-Jun

13-Jun

S&P Global 1200

Quarterly review - shares

19-Jun

05-Jun

13-Jun

S&P Global 100

Quarterly review - shares

19-Jun

05-Jun

13-Jun

S&P Latin 40

Quarterly review - shares

19-Jun

05-Jun

14-Jun

S&P Topix 150

Quarterly review - shares

18-Jun

04-Jun

Mid Jun

VINX 30

Semi-annual review

18-Jun

31-May

Mid Jun

OMX S30

Semi-annual review

30-Jun

31-May

Mid Jun

Baltic 10

Semi-annual review

30-Jun

31-May

Mid Jun

OMX C20

Semi-annual review

21-Jun

31-May

Mid Jun

OMX N40

Semi-annual review

18-Jun

31-May

16-Jun

BNY Mellon DR Indices

Quarterly review

21-Jun

31-May

18-Jun

Russell US Indices

Annual / Quarterly review

25-Jun

28-May

18-Jun

Russell Global Indices

Annual / Quarterly review

25-Jun

31-May

Late Jun

IBEX 35

Semi-annual review

30-Jun

31-May

30-Apr

Sources: Berlinguer, FTSE, JP Morgan, Standard & Poor’s, STOXX

100

M AY 2 0 1 0 • F T S E G L O B A L M A R K E T S

“In my world,

I need an algorithm that knows where to look— and when to listen.” UBS Tap is an equities trading strategy engineered for your world. Seeking liquidity in UBS Price Improvement Network, the Exchanges and non-displayed markets all at the same time, UBS Tap focuses on optimal execution with minimal signaling. Dial it up or down based on your need for speed, versus your desire to minimize market impact or opportunity cost. Whatever your objective, Tap listens to market cues, then intelligently reacts and adapts its behavior so that your order is protected from the risks of gaming or negative selection. After all, its goal is not merely to find liquidity. It’s to find quality execution. We understand the world. Your world.

For more information, please contact us at www.ubs.com/yourworld

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