FTSE Global Markets by FTSE Global Markets

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ROUNDTABLE: STRESS TESTING THE PFANDBRIEF ISSUE 42 • JUNE 2010

ERISA stands firm: State Street’s win The timbre of Nordic asset servicing Redrawing the future of GGP

TURKCELL: A winning bet

on the long game

PROGRAM TRADING: UPDATING EXECUTION STRATEGIES

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Outlook EDITORIAL DIRECTOR: Francesca Carnevale, tel: +44 [0]20 7680 5152, email: francesca@berlinguer.com, fax: +44 (0)20 7680 5155 SUB EDITOR: Roy Shipston, tel: +44 [0]20 7680 5154 email: roy.shipston@berlinguer.com CONTRIBUTING EDITORS: Art Detman, Neil O’Hara, David Simons. CORRESPONDENTS: Rodrigo Amaral (Emerging Markets); Andrew Cavenagh (Debt); Lynn Strongin Dodds (Securities Services); Vanja Dragomanovich (Commodities); Mark Faithfull (Real Estate); Richard Hemming (FX & Derivatives); Ruth Hughes Liley (Trading Services, Europe); John Rumsey (Latin America); Paul Whitfield (Asset Management/Europe); Ian Williams (US/Emerging Markets/Sector Analysis). FTSE EDITORIAL BOARD: Mark Makepeace (CEO); Donald Keith; Imogen Dillon-Hatcher; Paul Hoff; Andrew Buckley; Jerry Moskowitz; Andy Harvell. PUBLISHING & SALES DIRECTOR: Paul Spendiff, tel +44 [0]20 7680 5153 email: paul.spendiff@berlinguer.com AMERICAS, AFRICA & RUSSIA SALES MANAGER: James Ikonen, tel +44 [0]20 7680 5158 email: james.Ikonen@berlinguer.com EUROPEAN SALES MANAGER: Nicole Taylor, tel +44 [0]20 7680 5156 email: nicole.taylor@berlinguer.com OVERSEAS REPRESENTATION: Can Sonmez (Turkey) SUBSCRIPTION SALES: Carol Cremin, tel: +44 [0]20 7680 5154 email: carol.cremin@berlinguer.com DATABASE MANAGEMENT: Emrah Yalcinkaya, tel: +44 [0]20 7680 5157 email: mandates@berlinguer.com PUBLISHED BY: Berlinguer Ltd, 1st Floor, Rennie House, 57-60 Aldgate High Street, London EC3N 1AL Tel: +44 [0]20 7680 5151 www.berlinguer.com ART DIRECTION AND PRODUCTION: Russell Smith, IntuitiveDesign, 13 North St., Tolleshunt D’Arcy, Maldon, Essex CM9 8TF, email: russell@intuitive-design.co.uk PRINTED BY: Headley Brothers Ltd, The Invicta Press, Queens Road, Ashford, Kent TN24 8HH DISTRIBUTION: DHL Global Mail, 15, The Avenue, Egham, TW 20 9AB TO SECURE YOUR OWN SUBSCRIPTION: Please visit: www.berlinguer.com Subscription price: £497 each year (9 issues) FTSE Global Markets is published nine times a year. No part of this publication may be reproduced or used in any form of advertising without the express permission of Berlinguer Ltd. [Copyright © Berlinguer Ltd 2010. All rights reserved.] FTSE™ is a trademark of the London Stock Exchange plc and the Financial Times Limited and is used by Berlinguer Ltd under licence. FTSE International Limited would like to stress that the contents, opinions and sentiments expressed in the articles and features contained in FTSE Global Markets do not represent FTSE International Limited’s ideas and opinions. The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors. All information in this magazine is provided for information purposes only. Every effort is made to ensure that any and all information given in this publication is accurate, but not responsibility or liability can be accepted by FTSE International Limited and Berlinguer Ltd, for any errors, or omissions or for any loss arising from the use of this publication. All copyright and database rights in the FTSE Indices belong to FTSE International Limited or Berlinguer Ltd or its licensors. Reproduction of the data comprising the FTSE indices is not permitted. You agree to comply with any restrictions or conditions imposed upon the use, access, or storage of the data as may be notified to you by FTSE International Limited, or Berlinguer Ltd and you may be required to enter into a separate agreement with FTSE International Limited and Berlinguer Ltd.

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

FTSE GLOBAL MARKETS • JUNE 2010

HE CURRENT REFINANCING gap for middle market companies, created by banks’ unwillingness to lend, has opened up some attractive mezzanine debt investment opportunities, according to the consulting and advisory firm Mercer. In its latest paper Mezzanine debt—An attractive lending opportunity, the firm notes that as banks have reduced their lending levels following the global financial crisis, mezzanine debt funds have emerged as the main source of financing for middle-market companies. The current high demand for this type of financing, both from middle market companies and the private equity sector, has resulted in a near-doubling of return rates for investors compared to prior market cycles. Mercer believes the investment case is also supported through analysis of the demand side, with approximately $500bn of capital still to be deployed for future private equity investing (and thus potentially requiring mezzanine support) and the refinancing of approximately $1trn in high yield and leveraged loans maturing between now and 2015. That hybrid debt/equity mix and private equity is a light but recurring theme in this month’s edition. In the case of the GCC, opportunities abound long term, particularly in the Saudi market as new funding strategies take root in the postrecessionary period. Elsewhere,“Private equity activity has started to come back; clearly not yet at the historic levels, but so far this year private equity has accounted for a much greater percentage of deal volumes versus the same period in 2009,”says Giuseppe Monarchi, head of mergers and acquisitions, EMEA, in the investment banking department of Credit Suisse. Paul Whitfield reports on the key trends. In this delicate period as the capital markets tentatively rebuild, the role of lawmakers in clarifying obligations of parties to contracts becomes paramount. We’ve taken two separate legal disputes as cases in point in the edition. Andrew Cavenagh looks at the progress (or more accurately, the lack of it) in the legal battle involving the estate of now defunct Lehman Brothers. At the heart of the matter lies the so-called Dante Programme of synthetic collateralised debt obligations (CDOs) sponsored by the once mighty bank. Provisions in the documentation of all CDOs issued out of the programme that subordinate the claim of the credit default swap provider to the transaction’s collateral to that of the bondholders in the event that the former defaults under the terms of the swap agreement, are in dispute. A fast resolution of this particular case would have undoubtedly helped fledgling efforts to revitalise the still moribund securitisation market. Diametrically opposed decisions of judges either side of the Atlantic have put paid to any hope of an immediate resolution and uncertainty over some of the underlying principles of securitised debt structures will linger, at least until the end of 2011. Elsewhere, David Simons analyses the impact of judicial decisiveness. In March, the District Court of Massachusetts dismissed breach of prudence and loyalty claims against State Street Bank over the use of pension plan assets in a securities lending arrangement. Actually, the dispute is one of many raging through the financial markets as a result of the financial crisis as assets burned; much to the all too natural chagrin of beneficial owners. In this particular case, the prosecution claimed that the bank chose investment that were“illiquid, highly leveraged and unduly risky”and were“inappropriate investments for retirement plans”. However, expert analysis in testimony for the defence stated that the bank’s investments consistently outperformed hypothetical investments in short term treasuries and money market funds, leading the judge to rule in favour of the defendant. Investment decisions linked to cash collateral held in securities lending programs have frequently been the focus of ERISA-based litigation, and has risen dramatically following the credit crisis.The moral of the ruling, if there is any, seems to be that investors need to be cognisant of the inherent risks involved in trying to achieve any appreciable level of return and what, if any, risk controls are in place. Even so, this latest decision bears watching. It may yet become a touchstone in cases based on losses caused by mark-to-market falls in asset values.

Francesca Carnevale, Editorial Director June 2010

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Contents COVER STORY TURKCELL: THE COMPETITIVE EDGE......................................................................Page 48

The going has been tough for Turkcell, Turkey’s major mobile phone operator over the last two years. Cutthroat competition and a reduction in mobile phone acquisitions and usage have tested the provider to the limit. Even so, despite an aggressive grab for market share by rival Avea and its parent Turk Telekom, the country’s main landline provider, Turkcell has managed to hold its own. Koray Ozturkler, Turkcell’s deputy chief executive officer, explains how.

DEPARTMENTS MARKET LEADER

..........................................................................Page 6 David Simons reports on the rise of foreign exchange as an asset class.

IF IT AIN’T BROKE, WHY FIX IT?

DANTE’S INFERNO ..........................................................................................................Page 14

Andrew Cavenagh reports on the long running legal tussle involving the Lehman Brothers’ estate.

IN THE MARKETS

RISK CONTROLS AND DELTA ONE PRODUCTS ..................................Page 20 Jean-Baptiste Gaudemet, product manager, Investment Banking at Sophis, explains.

ERISA STANDS FIRM ......................................................................................................Page 23

David Simons explains a recent ruling on the use of pension fund assets in a sec-lending program.

ARE RATINGS REALLY IN RUDE HEALTH? ..............................................Page 26

Tony Angel, head of Europe, Middle East and Africa at Standard & Poor’s (S&P) thinks so.

REGIONAL REPORT REAL ESTATE INDEX REVIEW SECTOR REPORT COUNTRY REPORT FACE TO FACE ASSET SERVICING DATA PAGES 2

POST RECESSIONARY DIVERSITY IN GCC BANKING ..............Page 27 GCC banks look to the future.

....................................................................................Page 33 Mark Faithfull reports on the outlook for General Growth Properties.

BILLION DOLLAR MAYBES

................................................................................Page 36 Simon Denham, managing director of Capital Spreads takes the bearish view.

IT’S THE ECONOMY, ISN’T IT

................................................................................................Page 37 Vanja Dragomanovich on the impact changes in the gas shale extraction market.

SHALE GAS HEATS UP

THE GOOD TIMES ROLL FOR TURKISH BANKS ................................Page 40

Leveraging a return to form.

..............................................................Page 45 Akbank deputy CEO Hakan Binbasgil explains the bank’s award winning business strategy.

AKBANK: THE RETAIL DIMENSION

PLOUGHING NEW FURROWS ............................................................................Page 71

Lynn Strongin Dodds reports on the challenges asset service providers face in frontier markets

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

JUNE 2010 • FTSE GLOBAL MARKETS

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Contents FEATURES THE TRADING REPORT

PROGRAM TRADING: NEW EXECUTION STRATEGIES ......Page 52

CANADA: ATS THREAT TO TORONTO EXCHANGE..............Page 59

It appears that major Canadian dealers have thrown their collective weight behind Alpha Trading Systems, where execution was cheaper than on the TSX. In October 2008, the TSX accounted for more than 96% by value of shares traded in Canada, but its market share has declined in every subsequent month and by early April 2010 it had slipped below 60%. Neil O'Hara reports.

ROUNDTABLE

STRESS TESTING THE PFANDBRIEF ....................................................Page 63 In the post-crisis period a number of banks are looking anew at the Pfandbrief as an additional funding instrument. According to Jens Tolckmitt, executive director of the Association of German Pfandbrief Banks, many institutions have come to realise that the only instrument that offered access to liquidity in extremely difficult times was the Pfandbrief. Now a new set of changes to the German Pfandbrief Act are in train. What does it mean for issuers and investors?

ROUNDTABLE

THE NORDIC VIEW: CHANGE FROM ABOVE ............................Page 75

Regulatory driven initiatives will increasingly impact the investment community, both in the Nordic region and more widely across Europe. It involves work around risk mitigation and compliance monitoring and for service providers; the onus is on them to maintain a high standard of service even while margins are under pressure. Can it be done?

PRIME BROKING

THE CUSTODIAN ELEMENT ......................................................................Page 83

The prime brokerage (PB) model that developed in the wake of the global credit crisis continues to gain traction, as funds seek greater choice and a wider range of services. Custodian providers have been keen to muscle in on the traditional preserves of the overall prime brokerage offering. Can they really keep pace with the changing and diverse investment approaches of hedge funds in the same way that traditional prime brokers have done?

PRIVATE EQUITY

LEVERAGING THE M&A PICK-UP ........................................................Page 87

JUNE 2010 • FTSE GLOBAL MARKETS

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Market Leader FOREIGN EXCHANGE: HIGH VOLUME, LOWER MARGINS

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

IF IT AIN’T BROKE, DON’T FX IT! As an asset class, foreign exchange (FX) continues to make serious gains among institutional players, prompting banks to invest heavily in FX infrastructure in order to handle the pronounced growth. Things are going so well, in fact, that regulators continue to exempt a good deal of FX activity from their tightening agenda—at least for the time being. From Boston, David Simons reports. UELLED IN LARGE part by the enormous growth of electronic trading activity, foreign exchange (FX) has become a more competitive, higher volume and lower-margin business than ever before. At the same time, improved accessibility continues to make FX an asset class well worthy of consideration by institutional investors. Acknowledging that all is well, the major regulatory agencies have maintained a hands-off approach to FX. Under the Wall Street Reform and Consumer Protection Act of 2009, approved by the US House of

Representatives last December, forex swaps and forwards continue to be exempt from mandatory clearing requirements. While the imposition of a central clearinghouse to handle FX trades in the near future could eventually begin to alter the way the industry operates, observers believe this will likely be a gradual evolution, rather than something that occurs overnight. Still, with cross-border investing increasingly becoming the norm, investors need to be cognisant of foreign exchange risk, particularly given the levels of volatility across both developed and emerging FX markets.

Jonathan Butterfield, director of communications for CLS Group, which provides CLS settlement services for the global FX markets, still refers to the events of late September 2008 as the organisation’s “greatest moment of vindication”. With the sky falling, CLS settled some $150bnworth of Lehman FX transactions without failure, in the process adding a large piece of stability to an otherwise extraordinarily torrid marketplace. The validation of the CLS model has been enough to convince former sceptics that the time has come to get behind broadening participation. There are two basic policy objectives that support having a trade repository in place, says Butterfield. One is a way for regulators and potentially all other market participants to obtain a clearer understanding of trading flows and where they stand in the event of a crisis; the other is to provide improved price transparency. “Short of issuing an actual mandate, the central banks have nonetheless been very persuasive about getting the major financial institutions to acknowledge the importance of eliminating FX settlement risk,” says Butterfield. This has led to a much greater appreciation for the services offered by CLS, he says.

Cross-border investments Perhaps the most significant surge in participation has come from longmoney funds with cross-border investments that generate enormous FX volume. “That group of participants has risen nearly 65% year over year,” notes Butterfield. This increase in demand means CLS has to continue to ensure that its technology and operations are as bulletproof as possible. In addition to settling nearly all member-to-member volume, CLS

JUNE 2010 • FTSE GLOBAL MARKETS

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Market Leader FOREIGN EXCHANGE: HIGH VOLUME, LOWER MARGINS

Clients are also looking estimates that it currently for trades to be time settles over 75% of all stamped, he adds. As a inter-dealer volumes from result of the dramatic the major banks and is improvements in data also increasing its share of processing, keeping track second- and third-tier of foreign exchange banks and fund-related volumes settled. This has movements on a minutemade CLS the de facto by-minute basis is no industry repository for longer the opaque inter-dealer FX trades, says process it once was. “It Butterfield. The service used to be much more matches trades within 30 difficult to go back and minutes of execution reconstruct those daily while also maintaining a rate movements—you complete historical record might be able to tell of all trades settled. where the rates were Improvements aimed at every hour, but not what providing intra-day happened in between. reporting through added Now it is possible to pinpoint an FX rate down capacity are in train. There to the minute, if need be. are also plans to So even if you haven’t got strengthen the repository’s an investment manager infrastructure. providing live oversight Offering a benchmark of the rate, time stamping within a single product allows you to revisit the can be extraordinarily movement later on.” useful for institutional organisations that have Over the past several Jonathan Butterfield, director of communications for CLS Group, which exposures to a range of years many emergingprovides CLS settlement services for the global FX markets, still refers to diverse currencies.“Being market currency funds the events of late September 2008 as the organisation’s “greatest moment of able to look at indices as have delivered yields in vindication”. With the sky falling, CLS settled some $150bn-worth of a hedge and execute the order of 10%, and Lehman FX transactions without failure, in the process adding a large against a number of perhaps twice that piece of stability to an otherwise extraordinarily torrid marketplace. The currencies and only within the last year validation of the CLS model has been enough to convince former sceptics having to settle in one alone. However, there that the time has come to get behind broadening participation. Photograph base currency is a much are other advantages as kindly supplied by CLS Group, May 2010. more affordable option well, says Gosling.“More for these types of investors,” says Les the benefit of netting by allowing them and more, institutional investors are Gosling, head of EMEA at TwoFour, a to balance and subsequently offset looking for ways to diversify and technology-enabled business- purchase and sales over the course of spread their risk across their entire solutions provider. “I believe it has the trading day. Meanwhile, an hourly portfolio. By accessing the appropriate really contributed to the opening up of fixing rate provides clients with the systems that can deliver real-time these markets.” ability to hedge a foreign-exchange blended quantitative and qualitative Investors are increasingly making exposure in real time. “Clients have information, stepping into these use of benchmarks such as the been seeking such tools as a way to markets and taking advantage of WM/Reuters Closing Spot Rate (4pm improve control—it was just a opportunities that arise no longer UK time), says Peter Gloyne, global question of making them aware that requires a high degree of head of foreign exchange for Chicago- these benchmarking alternatives were specialisation. For instance, one can based Northern Trust.This gives clients already in place,”says Gloyne. now view a set of positions covering a

JUNE 2010 • FTSE GLOBAL MARKETS

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Market Leader FOREIGN EXCHANGE: HIGH VOLUME, LOWER MARGINS

Mark Warms, general manager, EMEA for international electronic foreign-exchange platform FXall.“It used to be that banks wouldn’t even consider trades under a certain size. At the same time, the number of tickets has exploded. Additionally, retail FX wasn’t really even a product 10 years ago— now the adverts are everywhere. So as an asset class, FX has made tremendous gains in recent times. As a result, we have seen banks really investing in the infrastructure needed to handle this intense growth.” Photograph kindly supplied by FXall, May 2010.

number of different markets, including alpha-type currencies that may offer higher yields. These and other types of services are now very much within the reach of these institutional organisations, or the banking institutions that provide them with these services.” With the continued proliferation of electronic venues, FX trades have become incrementally smaller, says Mark Warms, general manager, EMEA for international electronic foreignexchange platform FXall.“It used to be that banks wouldn’t even consider

trades under a certain size. At the same time, the number of tickets has exploded. Additionally, retail FX wasn’t really even a product 10 years ago — now the adverts are everywhere. So as an asset class, FX has made tremendous gains in recent times. As a result, we have seen banks really investing in the infrastructure needed to handle this intense growth.” Such enhancements have, undoubtedly, contributed to the resiliency of FX throughout this period of upheaval, says Warms.“As an asset class, FX appears to be working quite well. Switching to a model that entails going through a clearing entity will require firms to alter their infrastructure with significant timelines and huge costs involved. Not surprisingly, there is a perception within the industry that, ‘if it isn’t broken, then why fix it?’” Increased volatility kept FX trading volume in record territory during the past year. While volume remains strong, volatility has returned to more normalised levels — which, in turn, has created opportunities for participants who are looking for creative hedging strategies, says Chris Zingo, senior vice-president for the Americas for SuperDerivatives, a provider of derivatives pricing, trading and risk management solutions “The price of an option is directly reflected by the underlying implied volatility — therefore, when volatility is lower, it becomes cheaper to buy options.”

Greater transparency Additionally, as volatility decreases, spreads narrow, boosting transparency and making it easier to properly evaluate these instruments from a price perspective. “Of course, greater transparency helps boost liquidity as well,”adds Zingo. This has been particularly helpful for US-based portfolios with

Les Gosling, head of EMEA at TwoFour, a technology-enabled business-solutions provider.“Being able to look at indices as a hedge and execute against a number of currencies and only having to settle in one base currency is a much more affordable option for these types of investors,” says Gosling.“I believe it has really contributed to the opening up of these markets.” Photograph kindly supplied by TwoFour, May 2010.

allocations in the emerging markets, says Zingo.“For instance, hedging that exposure becomes much more attractive, especially in areas where currencies are rallying relative to the dollar. Investors are looking for these kinds of relationships in the market, because having the opportunity to hedge portfolio returns is such an important element.” Improving transparency remains a central theme for FX investors, says Zingo.“Transparency is huge, because if the types of hedges investors are structuring or the type of yieldenhancement products they are buying are not completely transparent, it becomes extremely difficult to

JUNE 2010 • FTSE GLOBAL MARKETS

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Market Leader FOREIGN EXCHANGE: HIGH VOLUME, LOWER MARGINS

understand the true nature of the risk they are taking on. At the end of 2008, for instance, we saw a lot of creative hedges sold to the corporate marketplace that had imbedded complex options structures that were extremely hard to understand. When the markets finally dislocated, these institutions wound up being short the market and incurred significant losses. The point is, if you don’t understand the true nature of your market risk, you’re much more capable of making the wrong decision—suddenly when an unexpected event occurs, you stand to lose X, when you thought you were really losingY.” Having proper price transparency makes it much easier to understand actual values on the execution side as well, particularly where options are concerned. “To paraphrase George Soros, the knowledge we get from the markets is imperfect—so even if you can observe a particular price point in the market, if you don’t understand where that price came from or the assumptions being used, it is very difficult to ascertain whether or not that price is actually valid.” Using an independent entity helps investors eliminate such biases, says Zingo. “Independent parties don’t directly benefit from the information provided. On the over-the-counter market, for instance, the visibility of many of the data providers is limited to their own positions, or to their

Having proper price transparency makes it much easier to understand actual values on the execution side as well, particularly where options are concerned.

perceptions of where things should be trading. Hence, to the extent that you are casting a much wider net, independence becomes a very crucial element, and that has become a major theme for investors in today’s market; which, in turn, creates tailwind for companies like ours, who can provide price discovery and transparency, and who are fully independent and free from the traditional biases that tend to skew levels within the market.” On the whole, FX is still largely viewed as a means to facilitate other global investments, and, not surprisingly, institutional investors continue to use foreign-exchange funds sparingly, says Northern Trust’s Gloyne. By comparison, the same players are much more likely to utilise FX as a vehicle for active hedging.“That in, and of itself involves a degree of alpha generation from the FX product, and, of course, we have seen a number of clients who have been passively hedging their foreign-exchange exposures, which remains much more the norm.” Electronic platforms will likely foster a continuation of the current high-volume, low-spread and lowermargin business model. “Electronic trading is here to stay, without a doubt,” says Gloyne.“Buy-side clients in particular will move in this direction in greater numbers, to the benefit of straight-through processing—that will be an ongoing trend. In many cases, it’s just a question of the client having the will as well as the resources to make the necessary investments in the technology. “On the sell-side, banks will still feel the need to maintain a personal connection—clients will always want to call in and discuss the state of the markets—however, the actual FX trading itself will become increasingly electronic, simply because of the need to continue to eliminate potential errors in the cycle.”

Peter Gloyne, global head of foreign exchange for Chicago-based Northern Trust. Investors are increasingly making use of benchmarks such as the WM/Reuters Closing Spot Rate (4pm UK time), says Gloyne. This gives clients the benefit of netting by allowing them to balance and subsequently offset purchase and sales over the course of the trading day. Photograph kindly supplied by Northern Trust, May 2010.

Chris Zingo, senior vice-president for the Americas for SuperDerivatives, a provider of derivatives pricing, trading and risk management solutions. Improving transparency remains a central theme for FX investors, says Zingo.“Transparency is huge, because if the types of hedges investors are structuring or the type of yield-enhancement products they are buying are not completely transparent, it becomes extremely difficult to understand the true nature of the risk they are taking on. Photograph kindly supplied by SuperDerivatives, May 2010.

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In the Markets LEHMAN BROS: DIVERGENT RULINGS CREATE UNCERTAINTY

A legal battle involving the bankrupt Lehman Brothers’ estate will likely hamper efforts to revive international securitisation volumes until late next year in the wake of adverse rulings in the British and US courts. The diametrically opposed decisions of judges on either side of the Atlantic would suggest there is little chance of a speedy resolution of the case. It also means that the uncertainty it has cast over one of the key principles of structured finance will linger until well into the second half of 2011 at the earliest. Andrew Cavenagh reports.

Photograph © Kurshid Alam/Dreamstime.com, supplied May 2010.

DANTE’S INFERNO HE DANTE PROGRAMME of synthetic collateralised debt obligations (CDOs) that Lehman sponsored is in legal dispute. At the crux of the case are provisions in the documentation of all the CDOs issued out of the programme that subordinate the claim of the credit default swap (CDS) provider to the transaction’s collateral [triple-A ranked securities purchased with the proceeds of the bonds] to that of the bondholders in the event that the former defaults under the terms of the swap agreement, in other words ceases paying the premium. When Lehman and its subsidiaries filed for bankruptcy from September 2008 onwards, Lehman Brothers

Special Financing (LBSF)—the swap provider or counterparty in the transactions concerned—stopped paying the swap premiums. Two trustees representing bondholders in 12 issues out of the three of the Dante special purpose vehicles (SPVs), including Saphir Finance, Zircon Finance, and Beryl Finance, subsequently attempted to secure the collateral from its trustee, Bank of New York Mellon. However, lawyers acting for the bankrupt estate challenged the validity of the subordination provisions under the US Bankruptcy Code, and they secured an important decision in their favour in the US Bankruptcy Court of the Southern

District of New York on January 25th this year, when Judge James Peck determined that the subordination provisions in the structures did “violate the ipso facto provisions of the Bankruptcy Code”. In the event, this judgement was at odds with rulings that both the UK High Court and Court of Appeal handed down on the case in 2009, after the two bondholder trustees, Belmont and Perpetual, had launched an action in the UK to determine the legitimacy of the provisions under British law (on which the deal documentation was based). Furthermore, Judge Peck clearly indicated that, in his view, US law should prevail in the case.“Despite the

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In the Markets LEHMAN BROS: DIVERGENT RULINGS CREATE UNCERTAINTY

The potential for the resulting cross-border bankrupt estate to gain from conflict,” his ruling stated,“the this strategy is considerable, United States has a strong as many of the notes are interest in having a US currently trading at a bankruptcy court resolve significant discount to their issues of bankruptcy law, face value; largely as a result particularly in a circumstance of the uncertainty that the such as this where the litigation has created. They provisions of the Bankruptcy will probably have a year or Code provide far greater protections [to the bankrupt more to do, as there as the UK entity] than are available under Supreme Court’s ruling, applicable provisions of whichever way it goes, will by foreign law”. no means spell the end of the What the US judge did not litigation. Not only will the do, however, was “enter an bondholder trustees appeal order” to implement his the Peck ruling in the US, decision; a necessary step potentially to three levels of before the other parties can appellate court; but also the Lehman estate will then appeal his ruling to a higher petition the UK Chancellor to court in the US. This will apply US rather than English certainly not happen now until bankruptcy law to the case, next year, because in the under the UN Commission meantime the Lehman lawyers on International Trade Law have been granted leave to (UNCITRAL) regulations for appeal the UK decisions to the dealing with cross-border British Supreme Court. Judge Kevin Kendra, managing director of Fitch Ratings in New insolvencies. Peck meanwhile, has said he York. Kendra says that: “I know people are trying to come up would await its decision before How long it will take to with a workable solution, but nothing we have seen has given entering an order to conclude these further legal us comfort around the uncertainty yet.” Photograph kindly implement his judgement in actions is hard to predict. supplied by Fitch Ratings, May 2010. the US. All indications are that However, the slow pace of the the UK’s ultimate court of appeal is on April 20th this year to grant the US litigation to date—in marked unlikely to hear the case before March Lehman administrators permission to contrast to the high priority that the next year. use the funds at their disposal to buy British courts assigned to the case, The frustrated Dante bondholders bonds issued by the Dante vehicles both in terms of the speed with which believe that the extended delay is a and other Lehman-sponsored CDO they conducted the hearings and the deliberate strategy on the US judge’s programmes. This secondary ruling seniority of the judges who heard it— part. “He’s playing a bit of a waiting enables them to buy up to $25m of annot inspire much confidence that game, where he thinks his decision notes in any single transaction, and (if there will be any resolution before late will put pressure on the parties to they acquire a sufficient majority of next year, at best. “I’m afraid that’s settle,” said a legal adviser to one. the notes on any deal) they can pass a what tends to happen when you take “One can only speculate as to why vote to redeem the bonds and pocket a case right the way through the that might be, but I think it’s fairly the bulk of the collateral. At the system in both jurisdictions,” clear that there’s some unwillingness hearing, Lehman’s counsel confirmed commented another of the legal on the other side of the pond to let the this would be their strategy. “If the representatives involved. senior appellate courts there rule on debtors acquire a sufficient number of In the meantime, attempts to revive the issue.” the notes or a percentage of the notes, securitisation in the US and Europe Such scepticism has been reinforced they may be able to direct the are hamstrung by doubts over whether a fundamental historical by Judge Peck’s subsequent decision liquidation of the collateral.”

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In the Markets LEHMAN BROS: DIVERGENT RULINGS CREATE UNCERTAINTY

tenet of the business—that securitised bonds are protected from the bankruptcy of the deal’s participants—will withstand legal scrutiny. Some analysts think the outlook for the business will be bleak if Judge Peck’s interpretation prevails. “We believe that if this decision holds upon further appeal (assuming there is one) it could have a negative impact on the future of securitisation and structured credit, as it challenges the very foundation of the business,” holds Atish Kakodkar at the international research firm CreditSights. For different reasons, however, the case has not yet had much visible impact on either the existing transactions that were in place before the market shut in mid-2007 or those few that have been launched as it has trickled back to life over the past 18 months. Concerns that the rating agencies would slash the ratings on up to 1,000 deals to the levels of their swap counterparties have not materialised. Largely, this is because the ratings on most synthetic CDOs (the type of transaction on which swap counterparty risk is greatest, or “most material” in rating agency parlance) have long since plunged below those of their swap counterparties anyway. A lot of these deals are also approaching maturity. Meanwhile, swaps and other types of derivative contracts (or perhaps, more relevantly, the failure of their counterparties) are for the most part nothing like as important to the simple, granular, and fully funded securitisations of assets such as creditcard or auto-loan portfolios that are the current focus of the primary markets in the US and Europe. Nevertheless, these transactions tend to require hedging arrangements to manage interest-rate risk and/or currency risk (in the case of European deals), while some older deals

In the meantime, attempts to revive securitisation in the US and Europe are hamstrung by doubts over whether a fundamental historical tenet of the business–that securitised bonds are protected from the bankruptcy of the deal’s participants–will withstand legal scrutiny. Some analysts think the outlook for the business will be bleak if Judge Peck’s interpretation prevails.

(including synthetic CDOs) need to renew their swap arrangements. There is ample evidence that the LBSF action is making the whole process more difficult, as it inevitably restricts availability. European issuers, for example, are clearly trying to avoid US involvement in their swap contracts.“At the moment, the market is managing the risk by choosing not to do business with US counterparties,” said a senior director in the European structured finance team at one of the rating agencies.“They are either using genuine European entities or the European subsidiaries of US counterparties.” However, whether the use of a European subsidiary of a US institution will isolate a deal from legal action is far from certain, and that risk clearly is evidently too great for some.“We are aware of one issuer who has said they’re not issuing any more swaps until this is resolved,” says an adviser to the Dante bondholders. “We’re seeing the problem more in the context of existing [securitisation] structures that need new swap arrangements.” There have also been attempts, notably in the US, to devise securitisation structures that do not rely on the change of subordination for investor protection, but hedging arrangements continue to play an important role in many of the transactions that are currently being proposed from the jurisdiction.“We’re

certainly still seeing proposals where there would be a material reliance on the derivative to perform to maintain the ratings on the notes,” confirmed Kevin Kendra, managing director of Fitch Ratings in New York. “I know people are trying to come up with a workable solution, but nothing we have seen has given us comfort around the uncertainty yet.” Given that no one structuring a deal will be able to rely on traditional subordination provisions where any US counterparty in involved for at least another 18 months, it remains to be seen if any of these efforts succeed in the interim. Even if they do, however, a final ruling in favour of the Lehman estate will surely be damaging to the long-term future of the business. For it would show investors that transaction documentation that the industry widely accepted and sold as bankruptcy-remote in the market’s heyday can prove to be anything but when times change and lawyers start looking for loopholes. It would be asking a lot of investors to expect them to believe that any new form of words or contract that the lawyers devise would prove any more bullet-proof than the Dante-style subordination provisions in similar circumstances.“There are lot of people who’ve been misled,” concluded the second legal representative involved in the case.

JUNE 2010 • FTSE GLOBAL MARKETS

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In the Markets DELTA ONE: THE ROLE OF TECHNOLOGY IN BALANCING RISK

Driven by the need to improve liquidity and an overall requirement to reduce the risk of investments, the last 12 months have seen many banking organisations strengthening their securities financing business and use of Delta One instruments such as basket swaps and total return swaps. Theoretically, the use of Delta One instruments should be risk neutral for banks. However, as the size of deals is often in the billions, if something does go wrong, it can have a significant impact on the profit and loss account. According to Jean-Baptiste Gaudemet, product manager, Investment Banking at Sophis, chief risk officers should ask whether current systems and controls are up to the task of managing the complexity of processes involved in running this business securely and efficiently. Photograph ÂŠ Mailthepic/Dreamstime.com, supplied May 2010.

OPTING FOR DELTA ONE ECURITIES FINANCE REFERS to the business of stock lending and borrowing, and the use of repos for short-term borrowing requirements. Delta One products are a class of financial derivative that are non-optional and as such have a delta of one: that is, a 1% move in the underlying results in a 1% move in the derivative. They often incorporate a number of underlying securities and as such give the holder an easy way to gain exposure to a basket of securities via a single instrument such as a basket swap. In addition to the more traditional business of stock lending and borrowing, securities finance teams

can use Delta One products to provide long or short market exposure, financing and leverage to investors and hedge funds. This offers investors the opportunity to invest in a basket of underlying assets, which can include different combinations of asset classes such as equities, commodities or bonds, without having the expense of purchasing them directly. Delta One products are nothing new, but have experienced a recent resurgence as investors move away from exotic and complex structured products, and banks require a more efficient way of providing exposure and managing risk with collateral management.

Market conditions, the need for greater liquidity and better managed risk are key drivers behind the flight to Delta One. As a result, there has been huge growth in interest in Delta One trading, both from large international banks and from financial institutions that want to improve liquidity by trading in basket swaps. Delta One products present two key advantages compared to repos and buy and sell back trades. They are more secured than collateralised lending (such as repos) because the lender legally fully owns the security. They are also more flexible than buy and sell back contracts since they provide full flexibility on the structure of the funding leg.

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

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dŚĞ D ĂůŐŽƌŝƚŚŵ ŝƐ ƵƐĞĚ ŝŶ ƌĂĚŝŽ ĂƐƚƌŽŶŽŵǇ ƚŽ ĐůĂƌŝĨǇ ƚŚĞ ŽďũĞĐƚƐ ƵŶĚĞƌůǇŝŶŐ Ă ŵĂƐƐ ŽĨ ĚĂƚĂ͖ ǁŝƚŚ ŝƚƐ ĂďŝůŝƚǇ ƚŽ ŚĂŶĚůĞ ŵŝƐƐŝŶŐ ĚĂƚĂ ĂŶĚ ƐŚĞĚ ůŝŐŚƚ ŽŶ ƵŶŽďƐĞƌǀĂďůĞ ǀĂƌŝĂďůĞƐ͕ ŝƚ ŝƐ ǁĞůůͲƐƵŝƚĞĚ ƚŽ ƉƌŝĐŝŶŐ ĂŶĚ ŵĂŶĂŐŝŶŐ ƚŚĞ ƌŝƐŬ ŽĨ ŝŶǀĞƐƚŵĞŶƚ ƉŽƌƞŽůŝŽƐ͘ dŚĞ D ƉƉůŝĐĂƟŽŶƐ ƌŝƐŬ ŵŽĚĞů ĂŶĚ ĂƩƌŝďƵƟŽŶ ƚĞĐŚŶŝƋƵĞƐ ĂƌĞ ďĂƐĞĚ ŽŶ ŽƌŝŐŝŶĂů ǁŽƌŬ ďǇ ů ^ƚƌŽǇŶǇ ĂŶĚ ƌ dŝŵ tŝůĚŝŶŐ͘

ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟŽŶ ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

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In the Markets DELTA ONE: THE ROLE OF TECHNOLOGY IN BALANCING RISK

Financial institutions Delta One products such as basket swaps are being used by financial institutions in three ways. The first is to finance swaps. Say a financial institution that owns a portfolio of assets needs funding but does not want to lose the economic performance of the portfolio. A bank with a good credit rating might borrow money cheaply to fund the purchase of the portfolio of assets from the financial institution. They would then enter into a basket swap where the bank sells the performance of the portfolio (basket) to the financial institution in exchange for a periodic interest payment based on Libor plus a spread. The bank makes money, as the interest rate it receives in the basket swap is higher than the interest rate that it has to pay for the funding of the purchase of the portfolio. The bank is fully hedged as it owns the portfolio (long) and has sold the performance in the basket swap (short). Two, Delta One products provide market access. A financial institution such as a hedge fund will invest in the performance of a basket swap (long or short) rather than buying or selling the actual underlying instruments. This allows the institution to enter a market without having to raise all the money to invest in the underlying instruments and leverage its cash more effectively. Collateral is required to cover the credit risk associated with the deal. The bank will ensure that it hedges the exposure; this can be done using different linear derivatives or the actual underlying. Three, Delta One products can be utilised in index arbitrage. Banks make money from the difference between the implied financing rate of the future and the actual financing cost of the bank. The financial institution that bought the

Banks and third parties increasingly recognise that they need to manage basket swaps using systems that can cope with highly complex and fast-changing trading conditions including front-to-back-office management of trade life cycle events, risk reporting and collateral/credit risk management. performance in the basket swap needs to post cash collateral (initial margin) with the bank to ensure it can pay the bank in case the performance is negative.

Challenges The challenge with Delta One trading is that there are so many variables and trade life cycle events over the period of the deal. For example, the stocks in the basket can be substituted for others; the price differential can be reset each quarter, month, and week or at the end of the contract; profit & loss on the performance of the basket can be paid at reset periods or accrued in a separate account. Moreover, corporate actions relating to the underlying stock of the basket swap must be processed on the swap. There are also tax implications for the owner of the underlying instruments related to entitlements such as dividends and coupons. All of these aspects can put significant pressure on the middle office in terms of the resources required to manage the controls and modifications for each contract and the cost of computing daily pricing and managing margin calls, especially if a firm is essentially managing these contracts on spreadsheets. Inevitably, the variable nature of these products means that standard systems and spreadsheets struggle to cope. Banks and third parties increasingly recognise that they need to manage basket swaps using systems that can cope with highly complex and fast-changing trading

conditions including front-to-backoffice management of trade life cycle events, risk reporting and collateral/credit risk management. Furthermore depending on how Delta One products are considered in a financial institution the profit and loss is accounted for either in accrual or net present value. Some institutions use both methods depending on the books holding the trades. Any system therefore needs to be flexible to support both methods.

Implications for technology Many institutions are attempting to manage basket swaps using in-house systems based on spreadsheets. Not only can these systems be inaccurate, they stand alone from other financial systems within the organisation so that information does not flow safely from front office through to backoffice and reconciliation becomes an issue. If the bank is not aware that positions are not properly hedged or there is a difference between frontand back-office positions, they face the very real risks of lost income and reputational damage—as was demonstrated in the Jérôme Kerviel Société Générale case. The flight to Delta One and securities finance is unlikely to slow over the next year or two and financial institutions are to gain a lot from it. However it will be vital to have the right systems and processes in place to manage these instruments if financial institutions are to avoid the significant implications of not balancing the books.

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In the Markets Photograph © Leftwing/Dreamstime.com, supplied May 2010.

N APRIL 2008, New Orleansbased business law firm Fishman Haygood Phelps Walmsley Willis & Swanson, LLP launched a federal class-action lawsuit against State Street Corp., alleging that the Bostonbased financial company’s overly aggressive securities-lending practices had caused the firm’s definedcontribution plan to suffer substantial losses. The plaintiff, an investor in the American Bar Association Members/State Street Collective Trust (ABA Trust), argued that the reinvestment of securities lending collateral in long-term, high-risk instruments constituted a breach of “prudence and loyalty,” and, as such, violated State Street’s fiduciary contract under the Employee Retirement Income Security Act (ERISA). However, in a decision handed down in March, the US District Court of Massachusetts dismissed the charges against State Street on the grounds that the plaintiff’s 401(k) plan did not suffer any injury from State Street’s actions, and therefore was not subject to ERISA Article III fiduciary guidelines. According to the details in Fishman Haygood Phelps Walmsley Willis & Swanson, LLP, et al. v. State Street Corporation, the plaintiff’s definedcontribution plan had invested in collective trusts managed by State Street,

STANDS FIRM

FTSE GLOBAL MARKETS • JUNE 2010

which included a securities-lending arrangement. Cash collateral, used to secure the loans, was invested through commingled collateral pools, and portions of the income produced by the investments were held in the collective trusts in order to compensate beneficial lenders for putting their securities on loan to institutional borrowers.

The heart of the matter Rather than using short-term, instruments such as treasuries or money market funds, which the prosecution team deemed to be ‘stable’, prosecutors alleged that State Street“instead chose investments that were illiquid, highly leveraged and unduly risky, including mortgagebacked securities and other securitised debt instruments that were inappropriate investments for retirement plans.”Furthermore argued the plaintiffs, allegedly the collateral pools did not price on a mark-tomarket basis, but instead relied on amortised cost pricing, under which the pools maintained a constant $1 unit price, even when the NAV of the underlying securities fell below a

US COURTS BACK STATE STREET SEC-LENDING PRACTICES

In a potentially important decision handed down in March, the US District Court of Massachusetts dismissed breach of “prudence and loyalty” claims against State Street Bank over the use of pension-plan assets in a securities lending arrangement. What impact might this decision have on beneficial owners lending their stock and investing collateral in general? From Boston, Dave Simons reports.

dollar. Such investments were imprudent, argued the plaintiff, and resulted in substantial decreases in the value of the collateral pools based on mark-to-market valuation. However, expert analysis provided on behalf of State Street by Dr Robert Mackay, senior vice president and chair of global securities and finance practice for Boston-based NERA Economic Consulting, stated that investments made by the bank between January 1st 2007 and January 31st, 2010 consistently outperformed hypothetical investments in shortterm treasuries and money-market funds. In her decision, US District Judge Patti B Saris underscored this finding, adding that the law firm’s own trust had been able to transact cash collateral pool units at par, despite the fact that mark-to-market values of the cash-collateral pool units had fallen below par. How might the State Street decision impact beneficial owners loaning stock and investing collateral? Perhaps a more thorough understanding of investment programs in general is in order, offers Travaglini, head of Michael

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In the Markets US COURTS BACK STATE STREET SEC-LENDING PRACTICES

Massachusetts’ Pension Reserves Investment Management board (PRIM), which oversees the state’s pension fund. PRIM, which uses State Street Global Advisors (SSgA) as part of its emerging and internationaldeveloped markets investment strategy, ended its own participation in securities-lending arrangements in 2007 because, according to Travaglini, the ends didn’t always justify the means. “In the past such programs were often sold as a way to make easy money—you just loan your securities, it’s all good and there is never any risk of losing anything. But I’m not really all that surprised that State Street wasn’t found liable, because when you come right down to it, this is really a‘buyer-beware’ kind of business. And if you go out and buy something and you don’t quite understand what it is you’re getting into, then the blame is really on you.”

Acknowledging inherent risk The bottom line, says Travaglini, is that investors need to acknowledge the inherent risk when attempting to achieve any kind of appreciable return. “You want to get 8% on an annualised basis? Then you’re taking risk, that’s all there is to it. I mean, you could buy T-bills and clip coupons with all of your assets, and sure, you’ll never lose any money—but you won’t get anywhere near that 8%. Though ours is a very controlled environment, the fact of the matter is that here at MassPRIM, we take risk, and it is something I always remind all of the cities and towns that invest with us. My main peeve with the people who have filed litigation following the seclending blow-ups is that they really should have known that these were not risk-free investments. Could I have anticipated that things were going to come apart quite as badly as they did? Probably not. Still, it was really a question of understanding all

In expert analysis provided on behalf of State Street by Dr Robert Mackay, senior vice president and chair of global securities and finance practice for Boston-based NERA Economic Consulting, investments made by State Street from the period January 1st 2007 to January 31st 2010 in fact consistently outperformed hypothetical investments in shortterm treasuries and money-market funds. In her decision, US District Judge Patti B Saris underscored this finding, adding that the law firm’s trust had been able to transact cash collateral pool units at par, despite the fact that mark-to-market values of the cash-collateral pool units had fallen below par. of the guidelines and what kind of risk controls were in place.” Travaglini believes that burned investors would be best served focusing on preserving unscathed assets—and, more importantly, learning their lessons. “Like many others, we had some exposure to Madoff and incurred losses as a result. Right away, people began asking,‘Why aren’t you suing [hedge-fund manager] Austin Capital?’ The fact of the matter is that while we lost $12 million over Madoff, I was more interested in retrieving the additional $170 million that Austin still controlled at the time. We made a bad decision in hiring Austin—our own due-diligence just wasn’t good enough. Therefore, I wasn’t going to feel any better by going out and suing them.” During its period of securities lending activity, MassPRIM relied on a third party, Goldman Sachs, as a go-between, adds Travaglini. “We wouldn’t use a custodian for our securities lending, because of the potential for conflict and hidden incentives. Even so, Goldman disagreed with our decision to withdraw from the securities lending program. I’d like to say that we were prescient—but we weren’t. There was just something about it that didn’t seem right, even though we couldn’t quite quantify the risk. And so when the sky started falling,

we were already out. I guess sometimes it’s better to be lucky than good.”

Frequent litigation Investment decisions linked to cash collateral held in securities-lending programs have frequently been the focus of ERISA-based litigation, which has risen dramatically since the start of the credit crisis. Northern Trust’s outof-court settlement to the University of Washington in 2008 following allegations of securities-lending mismanagement served as a bellwether case, and sparked scores of similar lawsuits against leading custodians. Misappropriation of collateral and the inability for investors to easily withdraw assets have typically been the cornerstones of such litigation. However, some observers believe that the State Street decision bears watching, and may become a touchstone in cases that are based on unrealised losses caused by mark-tomarket values falling being below par. The Fishman case gives State Street back-to-back dismissals involving pension-plan claims. In Kenney v. State Street Corp. also issued in March, the company and its retirement plan fiduciaries were absolved of most charges centering on the use of complex conduits as part of an employee stockownership plan’s investment strategy.

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In the Markets HAVE CREDIT RATINGS WITHSTOOD THE CREDIT CRISIS?

The financial crisis and economic recession have been the most severe stress test for credit ratings for decades. Contrary to popular belief, they have generally stood up well in the tough conditions and fulfilled their role as benchmarks of default risk. Yet there are lessons to be leant and changes to be made, says Tony Angel, head of Europe, Middle East and Africa at Standard & Poor’s (S&P).

STRESS TESTED RATINGS uch has been said recently about the value of credit ratings, not all complimentary. Even so, the test of their effectiveness is their overall track record in identifying credit risk. This is measured empirically by the correlation over time between different rating levels and defaults, and the rate at which ratings at different levels change. Do ratings effectively measure default risk? Do highly rated credits display lower default rates (and greater stability) than credits with lower ratings? The performance of ratings in US residential mortgage backed securities (RMBS), and collateralised debt obligations (CDOs) has been disappointing, and steps addressing that have been taken. Elsewhere ratings have performed well. In a highly stressed environment (with a record 264 defaults among rated companies and financial institutions in 2009) S&P’s global corporate ratings remain robust. Investment grade ratings continue to show significantly lower default rates than speculative grade ratings. Only 0.32% of investment grade entities defaulted last year, compared with 9.23% speculative grade. Indeed, 86% of all corporations that defaulted in 2009 had an original rating of‘BB-’or lower. Strong performance is also evident in the relative stability of investment grade ratings compared with speculative grade ratings. Some 84.67% of issuers rated in the ‘A’ category at the beginning of 2009 were still rated‘A’ by the year-end, compared with only 69.34% of issuers rated in the

‘B’ category. Despite tough economic conditions, 64.45% of corporate ratings were unchanged in 2009. Since 1981, the average five-year default rate for investment grade corporate issuers is 1.24%, compared with 17.90% for speculative grade companies. Even in a highly challenging credit environment, S&P’s corporate ratings serve as an effective measure of relative credit risk. European structured finance ratings show similar strength. While market valuation of many securities may have been depressed over the course of the crisis, their credit performance has been in line with expectations. Default rates have been modest, even among securities with lower original ratings, and those securities with high investment grade ratings have been stable in credit terms. Between mid-2007 and the end of 2009, only 0.39% of European structured finance instruments rated by S&P defaulted. Again, the higher the rating, the lower the likelihood of default: 0.36% of investment grade tranches defaulted compared with 4.17% of speculative grade tranches. Despite the recession and rising delinquencies and defaults in both corporate and consumer loans backing many structured securities, their cushioning against credit losses has meant their ratings have held up; 88% of European structured finance ratings have been stable or even raised during the crisis, and only 12% have been downgraded. The ratings performance of European structured securities backed by

residential mortgages and other consumer debt has been particularly strong, with a default rate of only 0.03% during the crisis and a downgrade rate of only 2.5%. A high rating is not a guarantee that an issuer will not default. Creditworthiness can and does change, sometimes because of unexpected and unpredictable events. However, higher ratings are less prone to default and tend to be more stable than lower ratings. Investors also want ratings to be comparable across asset classes, geography and time. Ratings performance should not diverge wildly in any particular area. Because of that, S&P has started using stress scenarios as tools for calibrating our criteria, which represent hypothetical conditions corresponding to each rating category. We use a scenario of extreme economic stress, on par with the Great Depression, for ‘AAA’ calibration, which should be able to withstand that level of economic stress without defaulting. The criteria for rating US mortgage backed securities and CDOs have also been upgraded; raising credit enhancement levels for these types of securities and changing certain assumptions regarding defaults and recoveries on the underlying assets. Moreover, the firm recognises greater correlation among securitised assets, more conservative criteria for ratings derived from other ratings and structures dependent on market prices, and the need for more qualitative analysis. It is now more difficult to assign high ratings to securities or issuers in sectors that have displayed poor credit performance.

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Regional Report

A NEW ROAD

GCC BANKING: NEW BEGINNINGS

Photograph © GTMq8/Dreamstime.com, supplied May 2010.

Economic prospects for the countries of the Middle East and North Africa, and specifically the Gulf Cooperation Council states, have improved with the resumption of capital inflows and rising, or at least stable, crude oil prices. For the GCC banking segment, it is a curate’s egg: good in parts. The promise of the region as both an investment destination and a source of investment funds continue to outstrip the performance of the GCC’s banking infrastructure in the immediate post recessionary period. In fact, increasingly the banking system is dependent on the effectiveness and willingness of governments to spend on capital projects to help kick start the region’s economies into high growth once more. Francesca Carnevale reports. HE IDIOSYNCRATIC PATCHWORK quilt that is the banking segment in the Gulf Cooperation Council (GCC) countries has rarely been so colourful or varied. Saudi Arabia, despite a sometimes limited and lacklustre capital markets, is now emerging as the region’s long term financial powerhouse; backed by a fast growing population that other GCC markets can only long for. “Over the long term, Egypt, Saudi Arabia, Turkey and Iran will set the running in this regard over the wider region,” confirms Hani Kablawi, managing director, head of Middle East & Africa at BNY Mellon. It is leaving other countries in the region with important questions about their future. Over the last few years has been an informal dynamic that each member of the GCC would find its own specialisation; that would

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Regional Report GCC BANKING: NEW BEGINNINGS

distinguish it from other member states and help lift the exceedingly loose confederation into a regional financial powerhouse. Dubai, Bahrain and Qatar, with varying degrees of success have established ‘offshore’ financial centres which are designed to become magnets for incoming financial, insurance and investment institutions and harness the large latent pools of liquidity in the region. Qatar was to be all about gas, capital projects, insurance and education. Dubai was envisaged as a high level entrepôt; backed by an extensive Anglo Saxon financial system that had both onshore and offshore elements. Bahrain meantime, courtesy of an enthusiastic central bank, has worked hard to establish its credentials as the quiet Swiss style financial hub; drawing up a sophisticated network of trust, fund and capital markets legislation (both traditional and Islamic) and letting it be known that the ‘real money’ in the Gulf resided in its quiet financial towers. Democratic Kuwait on the other hand is simply rich and everyone goes along with the fact that any efforts at sustained financial liberalisation are sometimes stymied by a fractious parliament and a leadership. This patchwork has created its own challenges for the region’s banking sector; which despite outstanding levels of wealth (both public and private) at home have often had to look for growth overseas as the size of the local market retail segment was limited. It is a dynamic that is creating new growth strategies among the region’s leading financial institutions. Looking overseas for expansion is part and parcel of that process. No surprise then that Bahrain’s Ahli United (AUB) announced in January this year that is was increasing its stake in Ahli United Bank Egypt (AUBE) by a substantive slug, increasing its shareholding from

In this regard, two follow-on developments are key to the effective management of supply and demand over the medium term. “The first is the need to better match assets and liabilities; the second is the correct pricing of risk in a post-recessionary environment. In the heyday of syndicated lending there was an obvious mismatch of assets and liabilities; capital markets players, particularly locally, now know better,” adds Atzeni. 35.3% to 79.6%. According to Fahad Al Rajaan, chairman of AUB & AUBE, the offer broke the mould in the local market, “providing all shareholders a choice between a full cash sale or a security exchange”, adding that the investment “reflects our confidence in the future economic prospects of Egypt and will be followed by significant investments to upgrade our corporate and retail capabilities in AUBE”. Note the emphasis on retail: with Egypt’s slug of 70m population a signal draw.

Shifting sands There are also other dynamics in play. Saudi Arabia for one is a bellwether for the dichotomy or disconnect between the immediate outlooks for the banking segment compared with the outlook for the region’s economy as a whole. In part this dichotomy is systemic; in part a result of a gradual shift in economic drivers.“With a population of more than 25m growing at an average rate of 2.2% over the past decade, domestic demand and spending are rising rapidly, and consumers are under-leveraged by both regional and global standards,” says Ahmed Heikal, founder and chairman of Citadel Capital, a private equity firm in the Middle East and Africa with $8.3bn in investments. Heikal thinks that as the Saudi economy diversifies away from oil, new opportunities will become available for private-sector players

beyond the country’s traditional investment driver. Saudi Arabia’s latest budget, with projected spending of SAR540bn, is its largest ever, and has a project pipeline worth more than $692bn widely distributed across construction, petrochemical, oil and gas, infrastructure and power projects. Moreover, the tightening of banking credit to the private sector has also raised awareness of the importance of alternative sources of finance and growth capital. In Heikal’s specialist view of course, this is creating“new awareness of private equity’s value-add as well as sparking a new market for corporate control as Saudi companies look to divest non-core and non-performing assets.” Private equity activity in the Middle East and North Africa (MENA) has largely been dominated by Egypt, which attracted 24% of industry investments by value in 2009 (excluding Citadel Capital’s $1bn investment in Egyptian Refining Company), according to industry data. Saudi Arabia meantime has attracted a 17% share of MENA private equity investments. As the world’s largest oil producer, Saudi Arabia holds an immense amount of potential as it builds a broad-based economy and continues to liberalise and modernise its business climate, holds Heikal, noting the turnaround,“Our firm has long attracted private equity funds from the Riyadh, but today we are actively studying potential investments in Saudi Arabia.”

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LIBYA

Best Bank in the Middle East, 2009

Best Bank in Bahrain

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Regional Report GCC BANKING: NEW BEGINNINGS

In Saudi Arabia the local banking market remains dominated by locally listed banks such as SABB, Samba and Riyad Bank. While a number of regional and international banks have been awarded full bank licenses none have taken up the challenge of competing with the local players in the highly competitive retail banking space. Even in the high net worth and investment banking space, aside from HSBC Middle East, which is also part owned by SABB, the global banks have made limited progress in their efforts to build momentum in the Kingdom. Yet while global players have struggled the smaller local boutique banks who started operations around the same time have gained some real traction, such as Falcom. Elsewhere, the banking system emerges as a victim of the excesses of the so-called noughties when, according to Randa Azar, chief economist at National Bank of Kuwait (NBK), the“investment sector in Kuwait grew rapidly because of surplus liquidity.” In that environment, notes Azar, it was “exceedingly easy for anybody to generate returns. Even then, leverage was not the issue when the downturn came. Actually it was the mismatching of maturities between assets and liabilities that proved to be so debilitating for everyone, and I do not mean at banks. Because of the relative stability of private local deposits which fund their loans, banks usually manage maturity mismatches rather easily. However, other financial institutions such as investment companies without access to deposits, which were quickly covered by government guarantees after the crisis broke out, could not. In most GCC countries, companies that acted as investment vehicles and financed their long term investments with shorter term credit could roll over their loans and that’s when the strains in the entire system became apparent.”

In Kuwait, a conventional bank is not allowed to offer Shari’a compliant on-balance sheet products,” notes AlFulaij. “It cannot establish a specific branch to do this. In the case of NBK, this legal nicety has now been overcome by its acquisition of a majority stake in Boubyan Bank. NBK obtained “a special approval from the Central Bank of Kuwait to own 40% of Boubyan Bank and to manage the bank. The approval was later raised to 60%,” adds Al-Fulaij. Those stresses have created an environment in which alternative business lines are now paramount to secure short term for banks.“It was a wake up call,” notes Salah Al-Fulaij, chief executive officer of NBK Capital. Current growth is likely to be driven by an increase in private equity investment and increased spending on capital projects to help revitalise local economies once more. “Certainly, there is a desire to see a return to the volume of IPOs that we saw in 2007 and we are all keen to see the market enjoy positive momentum sooner rather than later. However, we have signed a number of significant mandates of late and now it is a question of when, rather than if, they come to market. We are holding on patiently in the best interests of our clients,”he adds. It is a view reflected by Peter Gotke, vice president, Depositary Receipts at BNY Mellon in Dubai. “There are some 19 or 20 family firms lined up to do IPOs when the conditions are deemed appropriate; on the DR side, we are trying to find 19! Kuwait is the most active in terms of planning for DR issuance and is the second largest market in the region in this segment, followed by Qatar where there is a raft of smaller companies waiting to come to market. The lack of limits on foreign investment is helping these markets, whereas in Dubai, corporate financing

issues aside, there is a 49% limit on foreign holdings and that is curtailing activity, particularly in these postrecessionary times.” Historically banks in the Middle East have wanted to blend traditional investment banking activities with their retail and private banking businesses. However, in the normal scheme of things, in countries such as Kuwait, even ‘money centre’ banks do not offer investment products. “The products may be developed by the investment banking subsidiaries or affiliates (as is the case with NBK and BNK Capital) and sold by the commercial (retail) bank. As for investment banking activities (such as advisory, M&A, debt capital markets, etc) these are only provided by the investment bank to either clients of the commercial (corporate) bank or others,” notes Al-Fulaij. As corporate finance opportunities have contracted through the recession and demand for new local loans remains low, the search is on for new business lines at home; or at least an extension of alternative business lines. One particular trend is an increasing willingness to marry diverse business lines, such as offering both Islamic and traditional financing; outside traditional business windows. In Kuwait, a conventional bank is not allowed to offer Shari’a compliant onbalance sheet products,” notes Al-

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Fulaij. “It cannot establish a specific branch to do this. In the case of NBK, this legal nicety has now been overcome by its acquisition of a majority stake in Boubyan Bank. NBK obtained“a special approval from the Central Bank of Kuwait to own 40% of Boubyan Bank and to manage the bank. The approval was later raised to 60%,”adds Al-Fulaij. The Kuwait Investment Authority (KIA) had auctioned off its shares in Boubyan Bank, the second largest Islamic bank in Kuwait, back in July 2009 in three tranches of 77m shares each. NBK had bought two of them, equivalent to 31.2% of the bank with the balance of 26.8% bought in the open market. A further 20% of Boubyan Bank shares were owned by Commercial Bank of Kuwait (CBK) and remain in the bank’s name, however there is an outstanding legal dispute between Investment Dar, the Kuwaiti private equity investment firm, and DBK over ownership.

Same principals The issues in Qatar are fundamentally the same, even though it starts off from a much stronger liquidity base. Here is the creation of a substantive local market and a search for new investment opportunities overseas that is really driving the economies and the local banking segment. This has encouraged increased diversity in a system which traditionally has been limited to a number of small, regionally focused banks. The new business imperative is clear: larger investment entities that are looking “offshore for big ticket investments with long term maturities; then added to that a slew of family offices investing offshore. For smaller Qatari companies, the investments are entirely locally focused,” says a spokesman at a leading Qatari investment bank.

FTSE GLOBAL MARKETS • JUNE 2010

Salah Al-Fulaij, chief executive officer of NBK Capital. Photograph kindly supplied by NBK, May 2010.

Qatar’s capital market has seen a notable change in tempo as a result, with only five global bonds issued through 2009; with the country’s traditional project financing focus having evaporated through the last eighteen months. “It has encouraged Qataris to move through alternative routes, such as IPOs,” says the spokesman, “and the banks to focus more on bi-lateral relationships. The syndication market is still not reflated.” Even so, there is still some $28bn worth of project related business in the pipeline, which given underlying stability in the country’s overall balance sheet, means that the country will remain a firm favourite for incoming investment inflows; though increasingly more of that money will likely come from regional rather than global sources.

The localisation of the GCC’s debt capital markets is a key trend in 2010 and 2011, thinks Giambattista Atzeni, vice president, Corporate Trust, at BNY Mellon in Dubai, given the paucity of available funds out of Europe, the traditional backbone of capital goods financing in the region. In this regard, two follow-on developments are key to the effective management of supply and demand over the medium term.“The first is the need to better match assets and liabilities; the second is the correct pricing of risk in a post-recessionary environment. In the heyday of syndicated lending there was an obvious mismatch of assets and liabilities; capital markets players, particularly locally, now know better,” adds Atzeni.

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Real Estate GENERAL GROWTH PROPERTIES

BILLION DOLLAR MAYBES Of all the mall owners internationally, the one whose fate might just be calling the elusive bottom of the global retail real estate market is arguably the unlikeliest. General Growth Properties, America’ second largest shopping centre, has been sitting in Chapter 11 for the best part of a year, the victim of an overleveraged strategy which made a painstakingly assembled portfolio of prime retail real estate a financial millstone of unmanageable debt. Right now though, General Growth Properties (GGP) has a new future on the horizon and in establishing the exact direction of its new beginnings the impact should be felt around the world. Mark Faithfull reports. USTRALIAN SHOPPING MALL giant Westfield Group ruled out a bid for General Growth Properties Inc. (GGP), in late May instead preferring to cherry pick individual assets its bankrupt US rival may put on the market. GGP, which is in Chapter 11 bankruptcy protection, already has a preferred $6.5bn bid from a consortium led by Brookfield Asset management Inc (BAM); though nothing is confirmed. Such is the volatile nature of GGP’s situation that its conclusion has been repeatedly put off, with negotiations swinging from the financial minutiae to the uncomfortable bruising of egos in a North American heavyweight contest. At the time of writing the ultimate conclusion to the gigantic hostile bid from Simon Property Group is still awaited although by publication it may well be known. For the global real estate transactional market the question of who wins the ownership battle for GGP is almost incidental; because the ramifications are already being felt far across The Pond either way. Indeed, if the European investment market was looking for an indication of market sentiment and the future importance of scale, then surely Simon Property Group’s bid for GGP is it.

FTSE GLOBAL MARKETS • JUNE 2010

For those not familiar with the tale, here’s a long story told short. In February this year, Simon Property Group, America’s largest real estate group and also its biggest and best known mall-owner, offered $10bn for GGP, in a bid to create a shopping centre behemoth. GGP had become the property industry’s largest casualty in April 2009 when it filed for Chapter 11 bankruptcy protection after failing to refinance some of its debt. As its opening gambit Simon, one of the few mall owners to make it through the US recession relatively unscathed, said that it had $9bn in cash ready to do the deal, including $7bn to pay off General Growth’s substantial list of creditors. Unsecured creditors immediately put their support behind the bid and David Simon, chairman and chief executive of Simon, claimed that the initial offer was the “best possible outcome for all General Growth stakeholders”. However, Simon’s offer is competing with Brookfield Asset Management, a Canadian investment company that has proposed a financial injection of $1bn-$2bn of capital into General Growth to help it out of Chapter 11. In return, Brookfield would receive an equity stake in the

company and, crucially, GGP would remain in control of its own destiny. Indianapolis-based Simon, probably best known as owner of Mall of America in Minneapolis, owns all or part of almost 400 malls around the world. The combined company would hold a third of America’s mall market, including half of the country’s so-called A-quality outlets that generate rental income of more than $40/m2 each year. In the intervening months of high level haggling since the initial offer, Simon has topped Brookfield’s offer by proposing an identical structure but forgoing a package of warrants worth nearly a billion dollars. But GGP’s board, knowing Simon ultimately wants to buy the whole company, is still leaning toward a deal with the consortium that could preserve its independence. The question is whether GGP shareholders should endure the dilution of the Brookfield consortium’s warrants to keep Simon at bay. Moreover, GGP doesn’t have to rely solely on price when making a case to the bankruptcy court, as the preferred bidder needs to have the best bid on the table, not necessarily the highest. Simon has pledged to reduce its voting control to mitigate concerns over a conflict of interest between the two parties should its bid be successful.

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Real Estate GENERAL GROWTH PROPERTIES

Brookfield consortium warrants That said, the Brookfield consortium’s warrants are a heavy financial burden. On top of dilution, the warrants would in all likelihood prevent rival bidders from approaching GGP since the offer includes a breakup fee equivalent to their full value. A committee of GGP shareholders with a say in the decision has said the warrants are too large. Greg Maloney, president and CEO of Jones Lang LaSalle Retail, USA, reflects: “My suspicion, if you look at what Simon has done in the past, is that Simon will work something out. They have made other acquisitions and perhaps the deal will simply involve a smaller number of shopping centres.” He notes that General Growth appears intent on maintaining as much control as possible of its business and that may mean that the company simply accepts a future where it holds a smaller portfolio but at least emerges at the helm of its own destiny. “After all this is a problem about finance, not about real estate,”he points out. “If they can fix their finances then whatever they have left will still be a good portfolio of malls,” he adds. Maloney says that the bid in itself could well unlock the constraints on transactional volumes imposed by a lack of clarity in the market.“The main problem at the moment is the lack of transactions and the difficulty in calling value,”he stresses.“The Simon move may well help resolve that because they will have to value all the General Growth shopping centres and those prices will give the market a clearer idea of where we are. At the moment you have lots of experts calling the drop from the high of September 2007 by 20%, or 30% but without transactions these are really best estimates. “In addition, Simon will almost certainly be asked to release some

malls because of the monopoly situation so that should create some movement in its own right,”he says. All of these possible eventualities point to long-anticipated movement in the market. Figures from the US Department of Commerce show the country posted GDP growth of 5.9% last year. Moody’s reported a 1% increase in commercial property prices for January and added that since October 2009 prices have improved by 6.3% and are now 40.2% down from the peak of October 2007. However, as Maloney points out, those estimates are only as good as the number of deals that have been done, which is currently not a lot.

REITs have performed well US real estate investment trusts (REITs) have been performing well in recent months, as investors make preemptive acquisitions in listed property securities ahead of the market’s anticipated recovery. The latest data from FTSE Group and the US National Association of Real Estate Investment Trusts (NAREIT) shows that the sector had a total return of +5.3% in February. This was led by strong performance from the regional shopping centre REITs, which had overall returns of +11.9%. The shopping centre sector had total overall returns of +8.9%. Private equity real estate funds are also targeting America. Private equity property funds have an estimated $189bn of capital to invest globally, and of that $99bn of this is expected to be heading for North America, especially debt and residential investments. In another move symptomatic of the interest in the US retail market, Plaza Centers has, through a joint venture subsidiary, bought a stake in Macquarie Group subsidiary Macquarie DDR Trust, a company which owns two REIT portfolios in the US.

The joint subsidiary, EPN, which was formed in February to take advantage of retail property opportunities in the US, will buy a 15% stake in MDT for €6.6m through a private placement. It will then take part in a €67m recapitalisation of the portfolios, which contain 78 properties totalling 1.3m sq m across 23 US States. Plaza Centers used to focus on Central and Eastern European shopping centres but switched interest to the US because it believes it has identified a strong value case in North America. Ran Shtarkman, president and chief executive of Plaza Centers, says of the thinking behind what is, admittedly, a small deal by value: “The joint venture between Plaza, Elbit and Eastgate has significant equity to deploy and will continue to evaluate other opportunities in the US retail market and we therefore hope to be able to announce further transactions in the near future.” Meantime, Jones Lang LaSalle Retail’s Maloney is particularly optimistic about the near term prospects in US retail real estate and the conclusion of the GGP saga: “We feel the second half is going to be very positive either way.”

The month the market turned Whatever the outcome of the bids for GGP (and clearly it will be highly significant for the US retail real estate sector and for the national chain retailers which populate those malls) February 2010 will probably be remembered as the month the market turned. There are other deals which reinforce that contention. Earlier in the year Europe’s largest retail property company Unibail-Rodamco acquired the European shopping centre venture formed—ironically enough—by Simon Property Group and Ivanhoe

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People move through New Park Mall, a General Growth Properties mall in Newark, California, Tuesday, February 16th 2010. Simon Property Group, the United States’ largest shopping mall owner, made a $10bin hostile bid on the day to acquire rival General Growth Properties. Photograph by Paul Sakuma for Associated Press. Photograph supplied by Press Association Images, May 2010.

Cambridge (a division of Canada’s biggest pension fund manager) for €715m. The transaction will give Unibail-Rodamco a stake in seven malls in France and Poland plus development rights on five projects in France which will remain 50% owned by Simon Property and Ivanhoe Cambridge. Guillaume Poitrinal, chairman of the management board and CEO of Unibail-Rodamco, says of the deal: “This transaction represents a unique opportunity to reinforce further our presence in the large shopping centre segment, in French and Polish cities. These assets and the development projects offer excellent growth prospects.” The transaction is the largest acquisition by the French company since Unibail Holding combined with Rodamco Europe to create the world’s second-largest REIT in 2007. Hot on the coat tails of this megadeal and another was signed, as developer Corio entered into a €1.3bn agreement with Multi after the two parties first confirmed negotiations

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shortly before Christmas. Corio will acquire an operational portfolio consisting of four shopping centres in Germany, Spain and Portugal for €662m and a development portfolio of five projects in Germany (subject to German merger clearance for two projects), requiring a total expected investment of €660m. The deal will be funded through a combination of a follow-on offering of new ordinary shares and Corio’s existing bank facilities. Corio aims to raise up to €600m, of which approximately €450m will be used to partially fund the acquisition. Dutch pension fund asset manager APG Algemene Pensioen Groep has entered into a commitment to participate in the offering, pro-rata to its current holding of approximately 36.8%. Corio’s deal reflects what a doubleedged sword retail property investment really is and how far off the mark analysts can be. There was a heavy consensus within the industry that the days of portfolio deals were over and that transactions in 2010 and onwards

would instead be predominantly stock selective given that many analysts have concluded that portfolio buys to enter markets and countries have largely disappointed. However, Peter Gold, head of crossborder retail investment at CBRE, points out that the Unibail-Rodamco and Corio deals do not necessarily predicate a wider series of upcoming transactions in Europe. “In the US these sorts of deals are easier,”he says. “You have one market, one regulatory authority. I do believe we will see more mergers and acquisitions in Europe but my sense is they will be more country-specific.” Certainly deals between companies seem more likely in Europe given the virtual standstill at which the development market finds itself, meaning there may be comparatively few opportunities to buy prime individual assets. Last year saw the sharpest decrease in new retail space in almost 15 years, with around 7.4m sq m of new shopping centre space completed, a 19% fall on 2008. This year should see around 6.1m sq m being completed. In 2011 shopping centre development is expected to hit its lowest level in seven years with around 5.0m sq m due to be completed, 46% down on the peak of around 9.3m sq m in 2008. Yet what is clear as we await the eventual new ownership structure of General Growth Properties is that the very act of the bidding war has created its own dynamic. Historically, a landmark deal tends to signal the beginning of a depressed commercial property market coming out of the doldrums and Simon’s attempt to rest ownership of GGP is just such a marquee deal, whether it comes to fruition or not. The wall of capital that has been waiting impatiently to be deployed might finally be ready to be unleashed.

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Index Review FTSE STANDSTILL IN 2010 ON EUROLAND WOES

IT’S THE ECONOMY, ISN’T IT? For investors in the FTSE350 the unpalatable fact is that they will have to raise their gaze away from the woes in the UK and focus increasingly on the global situation. Cameron and Clegg will matter little to FTSE equity markets in the long run except for those (few) companies which are heavily exposed to the British market. HE FTSE MARKETS are rather reactive at the moment, not to much that goes on in Britain but to external events in Europe, Australia and the US. UK Equities hardly batted an eyelid over the political shenanigans of the election, rises and falls in sterling or dire debt and inflation numbers. Instead it reacted time and again to the problems in the Eurozone, windfall taxes in Australia or GDP/employment numbers emanating from the United States. For all of the chaotic events in Europe, the US and Asia continue to grow strongly and “Corporate Europe/UK” will likely be pulled along with them. This bodes well for medium to long-term equity prices as long as national governments do not begin to slap ever-increasing“windfall”taxes on successful segments of the economy. Unfortunately this may become a big ask, as taxes continue to rise and personal state support falls. Events in Greece, while extreme, show how limited governments have become in the face of international markets and there is nothing that politicians hate more than someone making hay as they wallow in discomfort. Unfortunately while most will put up with wearing a hair shirt for a few years eventually we risk the rise of extremism, as the fringes of political society promise a seemingly cheap way out of their woes. Perhaps the only real solution for Greece is to pull out of the Euro straightjacket; especially with the

increasing burden of ever rising debt to contend with as well. Euroland is suffering. For political reasons, countries were permitted entry even though everyone knew that the economic criteria for inclusion were fudged over and over again. With noninflationary world growth able to quash growing imbalances for almost a decade things appeared to be fine. However, the continued failure of the southern states to, even vaguely, match German and French productivity levels, meant it could not last. We are now reaping the harvest of political ambition versus hard hearted economics. In the UK, domestic growth will probably be affected for much the same reasons as Ireland, Spain, and Portugal. Too many funds being sucked into an under-performing public sector and too little revenue is being generated to pay for it. While the private sector in the UK has had productivity gains in every single year since the arrival of the Labour administration the same cannot be said for the public sector. Productivity has actually fallen on a like-for-like basis making for a truly spectacular imbalance. Unfortunately, for any incoming government the 13 years of profligacy is going to have to be unwound in a very short time. This will almost certainly cause extreme unhappiness in the 34% of the working population employed by the state, another 10% to 12% who rely on state/regional/local government

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

contracts and the untold numbers who exist on state handouts. Chances are that the impact of cuts and revenue hikes will mean that the winners of this election will not win the next and this does not bode well for very long-term investment in the UK. Not only this but, worryingly, the politics of envy seem to have gained traction even in theTory party and this may well impact inward investment as top managers will not be keen to relocate to a country with such a high tax burden. The UK faces the prospect of a slow leakage of high earners (especially from the South East) and where they go, eventually, you run the risk of the entire business (or at least the head office) following. London still attracts the world for a multitude of reasons but corporations eventually deal in the bottom line and on a host of levels the UK is now pricing itself out of the market. For the markets it seems that they should just about get the benefit of the doubt for the time being. This said, with the FTSE100 at 5300, the S&P 500 at 1140 and the DAX at 5900, there seem few reasons to sell at the moment especially as the various European and US Treasuries seem keen to spend even more money to prop up their economies. The sins of the past and present may well become the woes of the future, but— probably—not just yet! As ever ladies and gentlemen, place your bets.

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Sector Report NEW TECHNOLOGY CHANGES GAS OUTLOOK

SHALE GAS ALTERS THE FLOW Two new technologies—hydraulic fracturing and horizontal drilling—which started being used by independent US gas producers in the mid-1990s and eventually took off in 2007, have changed the gas landscape completely. The technologies have created something akin to a gold rush in the US, which has become the world’s major gas producer. Three years ago the US was running short of gas. Now it is self sufficient and domestic deposits are estimated to be large enough to supply the country for a century. What are the implications for the sector as a whole? Vanya Dragomanovich reports.

Photograph © Alexander Mitiac/Dreamstime.com, supplied May 2010.

calculations were right. Fortunes were made and more frequently lost because if the gas was not there, the producer would have to move the drill and start again nearby, possibly never finding the deposit. Two new technologies that started being used by independent US gas producers in the mid-1990s and eventually took off in 2007 have changed the gas landscape completely. Hydraulic fracturing, a method by which water is pumped into the hydrocarbon-containing rock to break the sediment and release the gas, made it possible to access gas that had been unrecoverable. The second technology, horizontal drilling, meant that drills which initially go into the ground vertically can be redirected to go sideways, covering a radius of between 400m to 1,500m from the drilling point, even potentially accessing deposits beneath populated areas. The technologies have created something akin to a gold rush in the US. Laurent Key, a commodities analyst at Société Générale, estimates that US shale gas producers are profitable at gas prices of $2.8 per million metric British thermal units

(mmBtu). Some isolated producers even said that they can break even at around $1.5/mmBtu. This compares with current low prices of about $4/mmBTu and expected average gas prices of between $5 and $6/mmBtu for the rest of the year.“Even if the market is down as it is now, shale gas producers can make profit because they are low cost,” says Key. Although shale gas drilling requires more capital then conventional drilling in the early stages of their operations, over time it becomes the more cost-effective option. In 2008, shale gas made up 5% of the total US gas extraction, while this rose to 22% in 2009, says Key. According to US consultancy Advanced Resources International, North American gas shales already contribute over 250m cubic metres per day and are projected to grow rapidly. Arlington expects that in ten years gas shales will account for a third of North American natural gas production. The country has at least 24 shale basins, one of the biggest being the Marcellus Shale that runs under the states of New York and Pennsylvania, others being the Barnett Shale in Texas, the first large basin to be

IL PRICES ARE back above $80 a barrel and most other commodities are on their way up—but not gas. Alongside sugar, it has been one of the worst performing commodities this year and analysts say prospects for recovery are faint. The game changer is a new technology, shale gas extraction, that has not only brought fresh amounts of the commodity into the market that is already saturated with supplies but is also profoundly altering the global flows of gas. While the US last year became the top gas producer, Russia, the previous number one, had to rethink its export strategy, reconsider the construction of some pipelines and put the development of at least one large field on ice. Qatar is becoming a serious contender in the European market, while Trinidad and Tobago had to look for new clients after the US as good as stopped all imports of the country’s natural gas. Up until a few years ago the main way gas was extracted was through plain, vertical drilling. Producers would find a spot they thought contained a gas deposit and drill straight down, hoping their

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Sector Report NEW TECHNOLOGY CHANGES GAS OUTLOOK

developed, and Haynesville in Louisiana. The US energy department estimates that the country has shale gas reserves of 125trn cu ft but producers peg the number at a multiple of that. How the picture has changed. Only three years ago the US was running short of gas, it was competing with China for imports, and it was spending millions on infrastructure to bring in liquefied natural gas (LNG) from main importer Trinidad and Tobago and countries such as Nigeria, Russia, Qatar. LNG, the darling technology of the industry before shale gas, made it possible to import gas from places that had no pipeline connection to the US. The gas is cooled down to minus 161 degrees Celsius, which not only turns it into liquid but also shrinks it 600 times. That way, gas can be loaded onto a tanker and shipped around the globe from any producer, no matter how far. The rapid expansion of shale gas coincided with a massive boom in prices—oil rose to $147 a barrel in the spring of 2008 and gas trailed the move to a peak of $13/mmBtu in June the same year—followed by political hysteria over being dependent for supplies on countries seen as unreliable and a fast rising consciousness about carbon emissions.

Self sufficiency For the US, shale gas ticked all the boxes. The country is now self sufficient in gas supplies and domestic deposits are estimated to be large enough to supply the country for a century. Over one half of the power generated in the country comes from highly polluting coal plants. Natural gas is the world’s cleanest fossil fuel, emitting 45% less carbon dioxide than coal and 30% less than oil. Being able to substitute coal with the much cleaner natural

gas satisfies the green requirements of the US administration, which is expected to bring in a bill that could cap such emissions. Finally, the gas is now so cheap that it is also financially a good alternative for power producers. This, however, only works in a certain price range. The US and Canada are the most active in shale gas extraction but the giddy prospect of finding a lot of cheap gas from previously littleknown deposits has spread across the globe and exploration uncovered significant deposits in Australia, Russia, China and India. In Europe, Shell is drilling holes at sites in Sweden, ExxonMobil and ConocoPhillips have leased and are exploring for gas shales in Poland, while Austria’s OMV is active in the Vienna basin. The downside of this is that the extra supply is coming into a market that is already overflowing with gas after industrial demand for the commodity shrank across the globe during the credit crunch. Gas is used mainly to generate electricity, be it for industrial production or residential consumption. Demand from the industry depends mainly on the state of the economy and in the US it has been recovering at a cautious pace. Residential demand fluctuates with the season, being the highest in the winter because of heating and then in the summer for cooling. The seasons in between are usually a low point, which is one of the reasons prices at the beginning of April fell to less than $4/mmBtu. Francisco Blanch, commodity strategist at Bank of America Merrill Lynch, says: “The weakness in US natural gas prices will not dissipate any time soon,” and forecasts that prices for the rest of the year will average $5/mmBtu. He also notes that the amount of gas drilling in the US

fell in January 2009 when prices fell below $6/mmBtu, but some shale producers that were profitable at those prices ramped up production. On top of that, the number of horizontal rigs in operation started rising again and recently reached a new high. “Despite the sharp fall in prices, producers in some key shale plays have managed to remain profitable. Unless even lower prices force producers to slow horizontal drilling, natural gas production could soon recover to last year’s levels. On top of that, rising LNG imports and a sluggish demand recovery could also weaken the balance this summer,” notes Blanch.

The demand curve Blanch is not much more optimistic on demand. Cheap gas prices will entice some US electricity users that have combined heat and power generation plants to switch from coal to natural gas but this only works in a narrow price range. “Gas is now trading in line with coal but power producers will only use gas as long as it is in the $3-$5/mmBtu price range,” says Blanch. At prices above $5/mmBtu they will turn back to coal. This year’s cold winter and heavy snow nibbled away on some of the stored gas in the US. The market is everything but tight and there is still an ample amount of inventories in the country. BoA Merrill Lynch forecasts that inventories will stay high on an historical level, keeping prices low. What does that mean for investors? Société Générale’s Key says that one interesting investment play would be to go short of gas exchange-traded funds (ETFs). He says: “Natural gas ETFs are losing value because they have a huge contango. One option would be to go short of the ETF.” Contango is a situation in which future prices are higher than spot prices.

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Another option is to look at independent shale gas producers, which are increasingly becoming takeover targets for big oil names. Most of the shale gas is being extracted by small and mid-sized companies, These companies have purchased or leased land with shareholder money or by raising debt, and because of their small size had to go swiftly ahead with extraction despite the fact that prices are low, says Teymur Huseynov, head of Eurasia forecasting at Executive Analysis.“A lot of these companies are now up for sale because extraction at current prices is not profitable,” Huseynov adds.

ExxonMobile ties up with XTU Late last year, ExxonMobile bought the biggest US independent shale gas producer, XTU, for around $30bn.“For big names it works on two levels— one is economy of scale and secondly they can afford to sit on the project and wait for prices to go up. All the estimates indicate that gas prices should be up at around $7/mmBtu to $8/mmBtu by 2012,”says Huseynov. Apart from XTU, other companies active in shale gas are Chesapeake Energy, Petrohawk, Devon Energy, Range Resources and Canada’s Talisman Energy. Fadel Gheit, an analyst at Oppenheimer in New York, says that Chesapeake Energy, the second largest of the independent shale gas producers, is the most undervalued company in the oil and gas industry. She says:“After sharply outperforming its large-cap E&P peers in 2009, Chesapeake has gained 7% in 2010. It is outperforming the peer average, which is up 2%. Chesapeake shares trade 8% below the 12-month high and 108% above the low, compared with 6% and 93% for its peers.”Gheit adds that the company will have to work relentlessly on restoring

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One company that has been hit by the developments has been Russia’s gas giant Gazprom. Before the shale gas expansion, Gazprom had been developing several large gas fields specifically for liquefied natural gas (LNG) exports. The Shtokman field in the Murmansk region was earmarked to sell LNG to the US but now that the US no longer requires the gas, Gazprom has put development plans on ice for the next three years. Photograph © Olga Selezneva/Dreamstime.com, supplied May 2010.

investors’ confidence by shedding the image of excessive risk-taking. Chesapeake has struck several lucrative financing deals with bigger oil companies which have agreed to finance some of the drilling programmes. In March, Norway’s Statoil made a deal with Chesapeake to increase its stake in the Marcellus Shale by 20%, paying $235m for it. One company that has been hit by the developments has been Russia’s gas giant Gazprom. Before the shale gas expansion, Gazprom had been developing several large gas fields specifically for LNG exports. The Shtokman field in the Murmansk region was earmarked to sell LNG to the US but now that the US no longer requires the gas, Gazprom has put development plans on ice for the next three years. Demand for Russia’s LNG from Japan and South Korea is still strong and there has been some increase in demand for LNG in Europe, where Gazprom’s share of the market is being challenged by Qatar. Qatar’s exports to Europe rose by 113% in 2009 mainly because it offers more favourable pricing than Russia.

Gazprom pegs its gas price to a basket of oil and oil products resulting in a gas price that trails oil by three to six months. This means that even when oil prices fall, buyers end up paying high prices for their gas contracts. Gazprom’s main buyers, EDF, E.ON and GDF Suez, have long complained about the practice while Gazprom defended it, saying that less stable prices would not allow it to make major investments in the building of pipelines and LNG infrastructure. Qatar’s pricing mechanism, on the other hand, although also pegged to an oil price basket, is much more elastic. While Gazprom was charging around £350 per 1,000 cubic metres, Qatar was selling gas at around $75/1,000 cubic metres, says Huseynov. The upshot is that, like the new horizontal drills, the gas market now requires a full 360 degree analysis. Looking in one direction is no longer enough as the supply and demand and global flows change as swiftly as new technologies.

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Country Report TURKEY: THE GOOD TIMES ROLL

Turkey started the ball rolling on a banner year in January with a $2bn, 30-year bond arranged by HSBC, JP Morgan and UBS, which attracted more than $7bn worth of orders from investors, only a quarter of which were which tied up just under a third of Turkey’s overseas borrowing requirement in 2010. In March this was followed by $1bn in 11 year denominated bonds at the lowest yield on record. Moreover, early in the year the government auctioned a 10 year fixed rate domestic bond issue, the first fixed rate deal of its kind. Most recently Akbank came to market with a syndicated dual tranche loan worth $1.2bn; the highest valued syndicated bank loan this year. Turkey’s international debt market performance provides the clearest indication not only of an economy on form, but also the increasingly rude health of its banking segment. Francesca Carnevale reports. LTHOUGH HOPES OF an IMF deal in early 2010 were ultimately dashed, unlike its near neighbour Greece, Turkey’s decisiveness on its debt management policy, has paid off in spades. The country was the first emerging market sovereign to issue in 2010. The government’s bold targeting of a 30year maturity issue (not always open to EM borrowers) signalled the country’s newfound confidence, even though economic growth had contracted through 2009 by around 5% by year end. It also proved fortuitous timing, as by mid May, the outlook for emerging markets sovereign issuance as an asset class was decidedly murky. That aside, Turkey outrageous fortune has continued unabated so far this year.

Photograph © Dennis Thompson/Dreamstime.com, supplied May 2010.

A BANNER YEAR The Istanbul Stock Exchange (ISK) index reached an all-time peak in April this year, buoyed by the Turkish economy’s relative resilience through the financial crisis. Investor appetite was also helped by a double-notch upgrade by Fitch from ‘BB-’ to ‘BB+’ in December last year; a move that has filtered across the board. According to the most recent Ata Invest 2010 Turkish investment strategy report Riding the Bosphorus Waves, Akbank, Garanti, Isbank, Tupras, Turkcell, TEB, Coca Cola and YKB are now rated investment grade by Fitch. The general positive air in the economy is also fuelled by historically low interest rates (at 6.5% at the short overnight end and 9% at the long end), which moved into single figures in 2009, the lowest levels for some 30 years.“Even though we assume some bounce back in the 2010-2011 period, due to a tightening in the global markets, average annual interest rates will remain at the lowest levels that Turkey has experienced in living memory. Moreover, Turkey has

achieved impressive progress in reducing both inflation and currency volatility. Therefore at current and expected levels of interest rates this year, the ISE has no reason to trade at a discount to emerging market average valuation multiples. We expect the ISE, which trades at around a 10.3 multiple of the 2010 price to earnings ratio to converge towards emerging market average of a multiple of 14,” holds Mehmet Sami, executive board member at Ata Invest, one of the largest independent full service brokers in Turkey. The government is expecting double digit growth in the first half year; a view supported by the fact that Turkey’s industrial output rising a reported 21% in March alone. The OECD’s more conservative view is that Turkey’s economy will grow by 6.8% in 2010 and 4.5% in 2011. Whichever outlook you take, the news is upbeat. It has been a boon for the country’s banks, which faced some issues through the first half of 2009 in raising new funds overseas, not least in

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have the capacity and an increase in margins on liquidity to provide leverage, syndications. Although the we have to be careful. funding tap has rarely Certainly, going forward, we been turned off for Turkish will be keeping a close eye borrowers, as liquidity on regulatory tightened, the margins on developments, both at borrowings topped 2.5% home and abroad, with this over LIBOR for one year in mind.” syndications through a Energy has dominated large chunk of last year. foreign direct investment “That cost of funding has (FDI) in recent years and dropped to below 1.5% should continue to lead for over LIBOR,”notes Hakan Binbaşgil, deputy chief the foreseeable, as demand executive officer of for energy has been rising Akbank. That rate has rapidly says Egeman.Turkish been consistent so far this government estimates year as Isbank’s latest predict annual rates of syndicated loan with dual growth in demand of about tranche for $193.5m and 4% on average through 2020, with the investment €565.2m illustrates. The requirement in the segment one year loan, with an expected to top $120bn over option for a further year the coming decade; much of extension, came in at Libor it from the private sector. plus 1.5% and Euribor FDI inflows into Turkey plus 1.5%, respectively. Ilhami Koç chief executive officer of investment bank Is Invest.“On the real remain well below their peak The country’s economic sector side, unemployment is a built-in problem for Turkey; a direct result of (back in 2007, when inflows growth rate will exceed recent contractions in economic activity. However the economy is expected to topped $20bn). The banking that of the European grow substantially this year. Our economic research team expects first quarter segment were the prime Union for the foreseeable 2010 growth of 10%; though likely this will balance down to around 5% to beneficiaries of direct future, a nice irony perhaps 6% over the course of the year because of the lack of demand in our export investment inflows through given the reluctance of markets,”says Koç. Photograph kindly supplied by Is Invest, May 2010. some union members to the opening years of the add Turkey to its membership list.“The lending to emerging European century, with the likes of National Bank Turkish economy and its banking sector countries with stronger fiscal positions of Greece, EFG Eurobank, NBK, BNP have remained resilient during the has increased, particularly as the Paribas, GE Capital and Citi principle economic downturn, having weathered deterioration in Turkey’s fiscal position investors, either acquiring strategic stakes global volatility in the markets relatively last year was moderate compared to in leading Turkish financial institutions or well when compared to other other countries in the region,” adds developing greenfield operations. It is developed markets,” holds Tolga Egeman. “In that regard, considering likely however that this year will see an Egemen, executive vice president of relatively lower levels of FDI in Turkey outflow in this regard: GE Capital, for Garanti. Turkey’s banks posted record compared to other emerging markets, one, anxious to cash in on its profitable profits in 2009 after the central bank cut we think there is substantial room for sake in Garanti, is reportedly looking at interest rates by a total of 10.25 capital inflows through 2010. That will an exit strategy; though the move is more percentage points, widening net interest inevitably flow through to mergers and a reflection of GE Capital’s financials. In margins. Elsewhere in the economy, the acquisitions business, and corporate fact it looks like another banner year for figures look promising. expansion. Even so, it we have taken Turkey’s largest listed lender, which “Considering the worsening financial any lessons from the debt crisis it is this; posted a 54% rise in first-quarter net performance of many European that we must continue to control the profit driven by lending growth and an countries, the relative attractiveness of expansion of debt and while we now increase in net interest income.

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in association with

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19th Annual

International Securities Lending Conference 22-24 June 2010 | Adlon Kempinski, Berlin, Germany

/PX JO JUT UI ZFBS UIJT JT UIF POMZ FWFOU PG JUT LJOE JO &VSPQF BUUSBDUJOH JO FYDFTT PG TFOJPS NBSLFU QBSUJDJQBOUT GSPN CBOLT CSPLFS EFBMFST BTTFU NBOBHFST QFOTJPO GVOET IFEHF GVOET BOE QPMJDZ NBLFST CONFIRMED SPEAKERS INCLUDE: r "OUIPOZ #ZSOF Global Head of Securities Lending and European Head of Prime Services, Deutsche Bank r .BSL %FBSMPWF Managing Director, Head of Global Liquidity, Barclays Capital

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Country Report TURKEY: THE GOOD TIMES ROLL

While western economies continue to deal with economic contraction, Middle East and Asian investors are increasingly keen to leverage Turkey’s growth story. Kuwait Finance House, for instance, began operations in Turkey’s insurance segment in 2009, intending to develop its Turkish operations as centre for Islamic insurance product sales to targeted communities throughout the Black Sea states. Tourism and research and development (such as the planned Istanbul technopark) are key industries the government is hoping to develop in the 2010/2011 period and attract inward investment. Changes in the direction of FDI inflows away from the country’s traditional dependence on Europe and out into a more global base will create new banking and business opportunities, thinks Ata’s Sami, and will eventually feed into the M&A market. “We’ve seen a number of approaches from the Gulf States and we think this trend will continue.” Tied to these developments is a reactivation of privatisation initiatives. “Privatisation and M&A transactions slowed significantly through 2009,” holds Sami,“yet pricing has remained fairly competitive, especially in the utility distributions segment. We expect privatisations to speed up this year; with the country’s privatisation agency targeting revenue targets in excess of $7bn. Privatisation through block sales has recently attracted more local interest than FDI, which may remain the case for the future.” There are also seismic shifts in the patterns of Turkish trade, which will ultimately feed into new banking relationships over the longer term. While Europe remains Turkey’s main export market accounting for 57% three years ago, the Middle East (including Israel), South Africa and Russia are seeing increased activity

from Turkish exporters, particularly in areas such as white goods and Europe’s share has fallen to around 45%. “It is a trend that has been underway for years, though it has speeded up over the last couple of years,”says Ilhami Koç chief executive officer of investment bank Is Invest. While these moves remain positive for the country, it is not all plain sailing concedes Koç, “On the real sector side, unemployment is a builtin problem for Turkey; a direct result of recent contractions in economic activity. However the economy is expected to grow substantially this year. Our economic research team expects first quarter 2010 growth of 10%; though likely this will balance down to around 5% to 6% over the course of the year because of the lack of demand in our export markets.”

Credit expansion As the economy and private demand begin to recover, the country’s banking sector, with its high capital levels, significant liquidity and low loan-todeposit ratio, will allow credit expansion to accelerate, further supporting economic recovery, suggests Koç. Average household indebtedness remains low, and combined with historically low interest rates, should support loan demand, he adds. It is a reassuring trend in a market that is still, relatively underbanked. Akbank has set plans to open 50 new branches through 2010, as well as renewing its customer-focused business strategy to leverage obvious market opportunities, holds deputy chief executive Hakan Binbasgil. The Turkish banking sector is still a long way from maturity; offering substantive business development opportunities, says Garanti’s Egemen. As of the third quarter of 2009, Turkish banking assets were about 80% of GDP, compared to 350% in the EU he

says. Loans by Turkish banks were only 36% of GDP compared to 196% in the EU.“These figures indicate that there is still room for growth for Garanti, and we will do so by expanding our network to 875 branches by the end of 2010 and increasing our geographical coverage,”he adds. According to IsInvest’s Koç the country’s low interest rate environment is encouraging banks to offer a much broader range of services, particularly to high net worth clients and institutional investors. “New products include capital guaranteed funds, currency, country or gold based,”he explains. Moreover, he adds the bank is bringing more corporate bonds to market. Traditionally, he adds, “Investors tended to conservative approaches, with treasuries dominating portfolios, but now we are seeing slightly more adventurous approaches and these days some part of an investment portfolio will include equities. This has fed through to the ISK, which reports that the performance of the main index is increasingly a function of local rather than international investors.” Additionally, Koç believes that Turkey will see a growing number of small portfolio management firms establish operations in the country and expects to see an uptick in stock lending and borrowing, margin trading and custody accounts as markets deepen and electronic trading becomes more prevalent. Opportunities are also rising in the transfer agency and distribution space, particularly as the IPO and privatisations take hold once more. The impending initial public offering of Akfen Holding, on the Istanbul Stock Exchange lead managed by the investment bank, is expected to comprise 30% local investment and 70% international, underscoring the increased confidence of local investors.

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Face to Face AKBANK: A BENCHMARK IN 21ST CENTURY BANKING

INANCIAL CRISES TEND to be bellwether events. While short term fire-fighting is the order of the day, clever firms also think of the long term implications and implement strategies that will (hopefully) carry them through the next financial challenge. Thus Akbank’s response to the 2001 banking crisis in Turkey was to overhaul the bank’s business approaches in entirety. “At the time,” notes deputy chief executive officer Hakan Binbasgil, “the crisis, high interest rates and high inflation meant that radical solutions had to be found that encompassed new approaches to customer service, technology and risk management. In that context, the bank’s retail segment took on a new importance to the bank’s overarching business growth strategy.” Says Binbasgil: “In its time, in its context, the move was revolutionary. Remember, that until that point, the profitable business line for Turkish banks was in treasuries, not in real customer business.” Even so, Binbasgil acknowledges that while a number of banks did not survive the 2001 crisis,“all remaining Turkish banks have done well in recent years and have learnt to manage their businesses effectively through market turbulence.” In part, this market probity was imposed from above. The Turkish banking regulator, the BRSA, insisted on lower leverage; the banking sector now averages a leverage ratio of 7, compared to averages between 30 and 40 elsewhere in Europe. In part, it is due to a turnaround in business approaches (driven by lower interest rates) which means that Turkish banks now manage liquidity via widespread deposits rather than short term money markets. In part also, it is driven by an increased willingness on the part of the Turkish population to engage with the private financial

Hakan Binbasgil, Akbank’s deputy chief executive officer and head of consumer banking, payment systems, and corporate communications, May 2010.

THE LONG VIEW Akbank’s 2001-2006 New Horizons Restructuring Program redrew the bank’s customer focused business growth strategy. Its implementation, at a time of change stress in the Turkish banking system, ultimately led to a 21.9% return on equity, a 3% return on assets and a capital adequacy ratio of some 18% by the end of the bank’s 2007 financial year. The focus of a recent Harvard University John F. Kennedy School of Government research paper, the continuation of the spirit of the program continues to impact positively on Akbank’s performance and the bank is now implementing new changes. Deputy chief executive officer and head of consumer banking, payment systems, and corporate communications Hakan Binbasgil, talked to FTSE Global Markets about the process of change.

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Face to Face AKBANK: A BENCHMARK IN 21ST CENTURY BANKING

sector to improve their standard of living; though, notes Binbasgil, the level of market penetration in key segments such as mortgage lending (at 4.4% of GDP) still remains relatively low. The New Horizons program was driven not only by Akbank’s aggressive drive for market share, but also by the realisation that the banking sector was undergoing fundamental change. The most important consideration then became the development of a customer focused infrastructure. Akbank segmented its market into corporate, commercial, small business and consumer clients, with the last being further divided into mass, affluent consumer clients and private banking. It then designated business units to serve each of these segments, though it combined mass consumers and small businesses into the same retail unit and allotted each business unit its own branch network to serve as its distribution outlets. The bank also reconfigured its branch office space, limiting back office functions to a maximum 20% of total space. In practise this meant that each branch only had one or two back office staff, compared to 10 to 15 customer facing executives.

Customer focus To ensure that customers remained the key focus, new remuneration packages were put in place with pay elements tied to performance targets. This reorientation also put pressure on operational departments, such as credit processing and risk management, notes Binbasgil. The bank invested heavily in technology to enable it to make full use of credit scoring in its loan evaluation procedures. Moreover, it also invested in communications technology that connected its

branches to the bank’s central office in real time; vital in that all its back office operations were concentrated there. In turn, it allowed the bank to determine the viability of customer loans in some cases in a matter of minutes. It utilised Turkey’s burgeoning online credit bureau system, its own internal scoring system and online government data to verify customer information. It also sought loose partnerships in the sales and distribution sectors in commerce, automotives and real estate. Auto dealers themselves originated up to two thirds of the bank’s auto loans; while real estate agencies helped generate about a third of the bank’s home loan business; and selected partnerships with retailers allowed customers to apply for credit from the bank. The bank also utilised mobile telephony and the internet to help generate general purpose loans and upgraded its ATMs allowing automated deposits and withdrawals. Even so, the branch network still brought in 80% of general purpose lending business.

A new phase Binbasgil now stresses that the bank is taking the elements of the New Horizons project into the next phase. “Where you operate is important and Turkey offers a substantial population of 20m active customers in a general population of just over 70m.” The opportunities in that context are immense, particularly with a fast growing population between 18 and 25 that, adds Binbasgil,“will take that 20m and turn it into 40m in short order. Turkey is a young country, with 52% of the population is 29 or younger. Understanding the dynamics, pitch and rate of that change is critical.” There are other structural numbers that also work in the Turkish banking

segment’s favour. The loan to deposit ratio is around 75%, household indebtedness is a tad under 13% of GDP, compared to an EU average of 56%.“In that context you might think you are successful today, but it you are servicing only half of the potential offered in the market, then you are falling short. Approaches to growth in that context are fundamental,” stresses Binbasgil. Now the bank is reviewing three areas which it believes are critical for success, he says. The first is senior management. We have to ensure that we have the right people, setting the right strategy and that our approaches are sustainable and cost efficient. Then, he notes, the bank is looking at the quality of its people: “Can we attract and retain the very best people?” and finally, Akbank is reviewing its infrastructure once more. “Do we have the best technology in place? What are the optimal distribution networks of tomorrow? However, all those elements have to be examined in a broader context. We are looking to understand both obvious and underlying trends to allow us to shape the future and realign the business accordingly.” Significant trends that Binbasgil and his team are looking at are aimed at understanding the customer of the future and the way in which they will prefer to conduct their financial affairs.“In Turkey alone there are 28m MSN users, 21m Facebook users, 30m internet users, 65m mobile phones. All these elements help us define approaches. How you deliver is very important. In this regard we are looking at lots of different business channels. We call it Freedom Banking and we want customers to enjoy real choice in this regard,” says Binbasgil. It is an acknowledgement of the fact that of the bank’s 8m customers, around a quarter (2m) do

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not utilise branches at all, preferring interacting with Akbank via ATMs and mobile telephones.

Customer facing services Even so, customer facing services will still be at the forefront. In Turkey, any decisions about the efficacy of opening new branches are numbers games. There are some 9,600 bank branches in the country, and this number continues to grow at a pace of around 7% a year. However, notes Binbasgil, in Turkey there are only 130 branches per 1m (130/m) people, compared to say Poland where the comparable figures is 339/m or Portugal where it is 602/m. “While the branch network will remain core to the bank’s services, we anticipate that the operating model will change significantly,”he adds.“The internet is a more cost efficient way of interacting with the client; and elsewhere 90% of total number of bank’s cash transactions are done through ATMs in the retail segment; add to that 60% of total number of deposits are now handled by BTMs.” What that will mean in practice is that branches will be transformed into high level sales and distribution centres. “We anticipate more advisory style services, helping people manage their money and mortgages and that will be hiring more relationship managers and fewer tellers.”

Alternative delivery channels High on Binbasgil’s agenda are alternative delivery channels. “It is part of a movement that really started in Turkey around 2005, when we came up with Mobile Lending. We gave our clients a number to call, they provided their social security number and we could give them an answer within minutes as to whether we could extend a loan or not. Some 20% of new lending was generated

FTSE GLOBAL MARKETS • JUNE 2010

Not content to rest even on these laurels, Akbank is now beginning to provide Avatars on their communication banking networks, which at the touch of a button will dispense market intelligence and provide investment advice. It is a service that 200,000 of the bank’s customers are already utilising. Photograph kindly supplied by Akbank, May 2010.

through the mobile telephony channel rather than the bank’s branch network over the 2005 to 2009 period, so that tells you something about the way in which customers want to interact with their bank going forward. Now the bank is working on an instant access cash loan service dispensed via special machines; believed to be the first service of its kind in the world. Customers can apply for immediate loans worth up to TL 10,000 (around $7,000).

Applications scan the customers signature and ID, evaluates the loan request and if approved dispenses a plastic card with cash to the value of the loan loaded onto it. The customers can then go to an ATM and download all or a portion of the cash as required. “You have to be able to read the future and offer the best available options for customers to receive money via any number of viable outlets if you are to succeed over the long term in this business,” holds Binbasgil. That future will also concentrate on mobile phone banking, particularly as Binbasgil notes that clients access the internet more via mobile phones than through their PCs these days. “We currently offer clients the ability to buy shares, transfer money, hold account checks and make credit card payments via mobile phone though we expect this service range to increase exponentially in short order.” Not content to rest even on these laurels, Akbank is now beginning to provide Avatars on their communication banking networks, which at the touch of a button will dispense market intelligence and provide investment advice. It is a service that 200,000 of the bank’s customers are already utilising. Moreover, the bank has committed to an ATM on demand policy; they are asking existing customers where they want new ATMs and if there is sufficient interest, they will set it up. The future is freedom to bank anywhere, anytime holds Binbasgil. “We want to continue as a market leader, grow the business profitably and offer the most flexible and top flight banking services to our key customer segments. In that regard, we will keep on testing the boundaries of our current service level and hopefully keep on increasing the quality of that level. It’s our commitment to our customers, both today and tomorrow.”

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COVER STORY: TURKCELL

TELECOMS IN THE ROUND With 63 m subscribers across eight countries and armed with annual revenues of TRY8.9bn and a market capitalisation of some $15.5bn as of year-end 2009, Turkcell is gaining ground in the greater Black Sea region. Turkcell is not only the leading communications and technology company in Turkey, but is also the second biggest operator in Europe in terms of subscriber numbers, epitomising the strength of key brands in the emerging markets telecommunication segment. HE ONLY TURKISH firm to be listed both on the New York Stock Exchange and the Istanbul Stock Exchange (ISE), Turkcell is pushing its way into the top quartile of global firms. Even so, Turkcell’s outlook is strictly regional; with the firm targeting Turkey’s hinterlands as core markets. Established in February 1994, Turkcell kicked off GSMbased mobile communication in Turkey. Four years later, Turkcell signed a 25-year GSM license contract with the Ministry of Transportation of Turkey, which defined its core business lines; based on mobile audio and data communication, in which the firm has invested some $10.8bn in technology including 2G and 3G license fees as of 2009 year end. Turkcell’s founding shareholders include the Çukurova Group, which is active in insurance, media, trade, industrial services, communications, information technology, and tourism and Sonera Holding, formerly known as Telecom Finland Ltd (and is itself currently owned by TeliaSonera. TeliaSonera was formed in December 2002 with the merger of Sonera Corporation, a Finnish telecommunications provider, and Telia, a telecommunications operator in Sweden), and MV Holding.

Turkcell deputy chief executive Koray Ozturkler. Photograph kindly supplied by Turkcell, May 2010.

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Despite an aggressive competitive environment in Turkey, Turkcell’s market share has remained broadly unchanged against two other principal mobile telephone providers: Vodafone and Avea, a subsidiary of land line major Turk Telekom. Despite some encroachment on market share by Avea, and efforts by Turk Telekom itself to encroach on Turkcell’s historic market dominance, Turkcell managed to keep its market share relatively constant through 2007 (57%) and 2009 (56%). Vodafone has a similar tale, having recorded a 26% market share in 2007 and registering a 25% share in 2009. Nonetheless, Avea has increased its share from 17% to 19%, with an aggressive marketing strategy in the transition to and implementation of Mobile Number Portability (MNP) in the Turkish market. Turkcell managed to maintain its revenue market share as well, particularly through the lean years of the recent financial crisis and a tough competitive environment. Through 2009, as the Turkish mobile market underwent a veritable flood of change, rival UK-based Vodafone took a particularly cold bath, having to write down the value of its Turkish operation by over £2bn over the year. MNP, which was introduced in November 2008, has been one of the main pillars underpinning sometimes cutthroat competition in the Turkish mobile market. MNP allows mobile subscribers to keep their phone numbers when switching to different carriers; thereby escalating competition. Additionally,“MNP also resulted in a shift in traffic composition from on-net towards off-net along with the implementation of flat rate offers by Avea,” explains a Turkcell spokesman. To add to the market’s competitive wave, Avea launched a groundbreaking unlimited, flat-rate tariff for calls made to any network to grab customers from the other two providers and upended the industry’s prevailing business model. By the middle of last year, Avea was on the brink of overtaking Vodafone as Turkey’s second largest mobile operator (in terms of revenue) while dragging down profitability in the market dramatically with increasing offnet traffic. In terms of subscribers however, Avea’s market share, which increased along with MNP implementation, stayed at the 19% level. In part, this was because Turkcell managed to broadly maintain its market share; having adopted a strategy that clearly focused on a valuable post-paid subscriber base. Second, there is an argument that Avea lost momentum and the opportunity to increase its market share because of a slower rollout of 3G technology. While market share at the margins has been under pressure, it seems that Turkcell managed to leverage its more advanced 3G network to mop up more of the high value contracts that are still available, and at the same time has managed to continue to improve its cost of delivery. However, it was not plain sailing. Turk Telekom’s own WiFi launch indicates the wide range of business growth tactics that incumbents have needed to constantly adopt as their competitive landscape has changed and toughened.

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Despite current challenges, Turkcell ultimately resides in a so-called sweet spot. In terms of mobile line penetration in its local market still remains relatively low, compared with Greece say (one of the highest users in the EU market) and Italy. With 62.8m mobile lines as of 2009, the ratio of mobile line penetration to the total population is only 87%, a relatively small market compared to the 219% rate of Greece.

Turkcell claims that it runs over the most advanced 3G network and is among the first operators in the world to reach a speed of 42.2 Mbps with its 3G technology. On the data business front, the uptake of advanced data services has been impressive, particularly in terms of the sales volumes of USB modems, netbooks and notebooks; though growth in sales has since slowed. Turkcell has not stood still however and lately has bundled offers with terminals and data packages and believes that the increasing use of smart phones will drive data revenues going forward. On the fixed line front, an official ordinance made it possible for fixed line subscribers to switch between operators starting from September 10th last year; though in practice it has been hard to implement. The Turkish Competitive Telco Operators Association (TELKODER) made it clear that it would encourage competition between fixed line and mobile service providers, as competitive call services and portability for fixed line numbers were crucial for a healthy market. It gave Turk Telekom, the country’s land line operating giant an excuse to enter the fray, with its fixed/mobile Wi-Fi offering, emulating other European landline operators by offering wi-fi to enhance its brand based broadband offering. Additionally, the introduction of so called “naked” ADSL, which permits ADSL to be provided without any subscription to a fixed telephone line, further raised the stakes. It marked a turning point for Turkcell, which had undercut Turk Telekom’s DSL offering with its own broadband package priced at a mere €14 a month with two-year contract, which it had positioned as a fixed as well as mobile connection. There have been other market niggles to deal with as well. Mobile termination rates (MTRs) the wholesale charges that operators make to connect calls to each others’ services have faced significant decline of late and tariffs have been under pressure, both from competition and market liberalisation. The recession also bit into the acquisition rates of new handsets, and sales through a large part of 2009 visibly slowed. A recent report by the Turkish

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COVER STORY: TURKCELL

division of global research company GfK, for instance, found in a market survey that nearly 450,000 less mobile phones were sold in the first six months of 2009, despite strong promotions from all Turkish mobile operators. In the January-June period of 2008, Turks purchased 5.46m devices, whereas they bought only slightly more than 5m phones in the same period in 2009. The rate of decline was much more drastic in terms of turnover, however. The total earnings of mobile phone sellers over the period amounted to €557m, a 30% fall says the GfK survey. According to the study, more models were introduced in the first six months of last year due as new entrants, especially from China, flooded the market with new devices. In early 2008, Turkish handset buyers could choose from a range of some 765 devises, which rose dramatically to 1,119 by July 2009. Inevitably, the effect on prices was equally striking. In 2008, the average price of mobile phones in Turkey was €145 compared with €110 last year.“The macroeconomic environment in Turkey remained challenging in 2009 with acceleration in GDP contraction. In 2009, GDP contracted by 4.7%. Additionally, the aggressive unlimited flat rate offers introduced following mobile number portability implementation led to a shift in traffic trends towards off–net calls, putting pressure on profitability across the Turkish market, reducing multiple SIM card usage and resulting in a drop in mobile line penetration to 87% in 2009, down from 92% in 2008,” explains Turkcell deputy chief executive Koray Ozturkler. In part, Turkcell has been cushioned as it also provides mobile services internationally. It offers services via Fintur and its affiliates in partnership with TeliaSonera in Azerbaijan, Kazakhstan, Georgia and Moldova and has a majority owned business in the Northern Cyprus as well as in Ukraine and Belarus based on the Life brand. “Throughout the year, our competitors focused on increasing customer acquisition while aggressively promoting unlimited flat rate offers. Meanwhile, we remained focused on the retention of high value subscribers and increasing voice and data usage, particularly with respect to mobile internet. We also continued to emphasise our strong value propositions, with initiatives aimed at various subscriber segments. We achieved our highest levels of usage since 2001 and grew our post-paid subscriber base with 1.9m net additions through effective communication of offers and strong sales channels,”explains Ozturkler.

Still a sweet spot Despite current challenges,Turkcell ultimately resides in a socalled sweet spot. In terms of mobile line penetration in its local market still remains relatively low, compared with Greece say (one of the highest users in the EU market) and Italy. With 62.8m mobile lines as of 2009, the ratio of mobile line penetration to the total population is only 87%, a relatively small market compared to the 219% rate of Greece. In this particular cut Turkey ranks 10th in Europe, according to the Merrill Lynch Global Wireless Matrix Q4 2009. Moreover, Turkey still has a relatively low level of market penetration in the broadband segment, with only a 39.6% household penetration (in line with Portugal and Poland). However, as Turkey is the second most populated nation in Europe, with a population of some 73m, companies such as Turkcell can still become the second largest mobile operator in Europe without having to aim for above-100 penetration rates. The firm’s performance and future outlook was noted by a recent Best Managed Companies in the CEE Euromoney survey, which awarded Turkcell the title of Most Convincing and Coherent Business Strategy in the Telecoms - Cellular sector; moreover, the firm was ranked third in the Overall Best Managed Company in CEE category. The firm has also been an innovator in leveraging mobile phone technology. It offers applications in cooperation with local banks that enable on-line banking, such as mobile signature and is in talks to launch new services such as mobile wallets. Elsewhere, it has been a leader in the mobile advertising market, which came about through the use of mobile Internet portals. All three main operators, Turkcell, Vodafone and Avea, use such mobile portals to provide quick access to services such as email, instant messaging and social networks and an ability to target advertisements according to user types. One of the most successful implementations of mobile advertising in Turkey is Turkcell’s TonlaKazan service, which allows subscribers to select branded, ad-funded content as their Ringback Tone (RBT), or a replacement to the regular ring-tone that callers hear, and provides them an opportunity to win prizes depending on how many people listen to the tone. The scheme rapidly became popular among young people, who opt for songs by their favourite artists as their RBT, was developed by the stanbul-based mobile advertising solutions firm 4play. The service ultimately gained global recognition, with Turkcell winning the Best Mobile Entertainment Service for TonlaKazan at the 14th Annual GSM Association Global Mobile Awards last year.

TURKCELL’S MARKET SHARE IN ITS KEY MARKETS AS OF 2009 YEAR END COUNTRY

BRAND

SUBSCRIBERS

MARKET SHARE

TURKEY KAZAKHSTAN AZERBAIJAN GEORGIA MOLDOVIA BELARUS NORTHERN CYPRUS UKRAINE

Turkcell Kcell Azercell Geocell Moldcell BeST KKTCell LIFE

35.4m 7.2m 3.8m 1.9m 0.7m 1.2m 0.3m 12.2m

1 1 1 1 2 3 1 3

Source: Turkcell, May 2010.

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In mid March, Fitch Ratings confirmed Turkcell’s longterm foreign and local currency issuer default ratings (IDR) at BBB- respectively, with a stable outlook. The ratings reflect the company’s leading market share despite increased competition,“strong credit metrics compared with peers in the neighbouring region and rising political and regulatory pressure on the company in the short-term”. It seems that the ratings agency did not think that elevated competition since 2007 and the initiation of mobile number portability (MNP) have had a major impact on the market share of Turkcell.“However, operating performance in 2009 was affected by the economic downturn, increased competition, and regulatory pressures in the form of mobile termination rate (MTR) and maximum price cap cuts or the company’s existing tariffs. EBITDA margin retreated to 33.3% at FY09 from nearly 37% in FY08,”acknowledged the ratings agency’s official release. Moreover, while acknowledging ongoing pressure from MTRs, Fitch also notes that Turkcell has sufficient headroom in its ‘BBB-’ ratings to accommodate modest margin deterioration in the medium-term with no negative rating action.

The downside of liberalisation Turkcell’s business is now impacted by continued liberalisation of the Turkish telecommunications market, and the introduction of fast moving technology such as 3G in the cellular space.“Prior to launching 3G technology, we promoted smart phones and 3G—enabled handset bundled offers which, in addition to our comprehensive service portfolio, superior coverage, and the fastest 3G network in Turkey, created higher than expected demand for our services from day one,”claims Ozturkler.“Moreover, high uptake of our USB modems, netbooks, and notebooks, led to a hike in our mobile internet revenues that improved to TRY261.1m in 2009, almost doubling 2008 revenue in this regard. In total, our mobile data and services revenues improved by 13% in TRY terms and comprised 16% of our consolidated revenues in 2009, compared to 14% in 2008.” Even so, market liberalisation has had less salubrious effects. “In February 2010, the Information and Communications Technologies Authority (ICTA) enforced a reduction in termination rates and the maximum price cap level. We find these rate cuts to be excessive and unforeseen. This is why we have taken necessary legal actions. On the other hand, we have been trying to minimise the negative impacts of these decisions through the redrawing of tariffs and new offers. These decisions combined with irrational price competition i.e. sole price focused competition negatively affected profitability of the sector and more so the profitability of the competitors has significantly decreased. Specifically, for example the third operator has pleasingly increased its EBITDA margin in Q1 2010 to 6% from 1% in Q4 2009 through more commercially oriented actions. We hope also the second player will adapt similar behaviour in time.”concedes Ozturkler.

FTSE GLOBAL MARKETS • JUNE 2010

All clear ahead? Clearly, the price wars that swept the Turkish mobile phone market through 2009 “was not sustainable,” concedes Ozturkler. “The exact impact of the ICTA’s most recent decisions on pricing and traffic trends going forward are at present difficult to assess. However, in terms of market conditions, we have seen signs of more rational competitive behaviour with some limitations to usage incentives and price adjustments during Q1 2010. We expect this trend to continue going forward.” As the dust settles from the battle for market share in a recessionary market, it is clear that Turkcell has emerged careworn but a still a winner. Although Turkey is years behind other countries in rolling out 3G, Ozturkler says the firm and the country has not suffered from any delay in implementation. “In fact, Istanbul is now blanketed with a mobile broadband network that provides the highest average mobile internet speed than what’s available in key cities in Europe such as London,” he avers, and the future’s bright: “We estimate that there is less than 5% smart phone users in Turkey, so we see a tremendous growth potential in mobile data business through increasing smart phone penetration and mobile internet revenues.” Despite expected pressure on EBITDA margins and cash outflows related to its international operations in Ukraine and Belarus, Turkcell is expected to maintain low financial leverage in the medium-term, suggested Fitch in its statement.“Competition from Vodafone and Avea remains intense with both operators operating close to breakeven in an attempt to capture revenue market share from Turkcell”. Though Fitch does not see this as sustainable over the long-term, the level of competition is not expected to return to normal in the mid-term. Other concerns are recent tax investigations into Turkcell’s accounts, legal issues with Turk Telekom which the company has partly provisioned for and regulatory intervention on existing tariffs. Moreover, continuing uncertainty about the shareholder structure of the company, with major shareholders in various disputes in international courts, is not expected to be resolved in the near-term (for a detailed synopsis of these disputes, please refer to FTSE Global Markets, June 2008, Issue 26). However, TeliaSonera and Altimo’s decision to join forces in their court battle against Cukurova Holding has revitalised hopes that there could be a resolution in the medium-term. As for the anticipated developments in 2010 and beyond, a merger between the Radio and Television Supreme Council (RTÜK) and the Turkish telecommunications authority, the telecommunications sector’s two regulatory authorities, is likely to take place this year with so far unknown repercussions on the pace of change in the broad sector. The state also plans to offer its shares in Türk Telekom for sale to the public. Once privatisation of the land line major takes place, it will begin to re-write the competitive landscape once more.

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Photograph © Vicente Barceló Varona/Dreamstime.com, May 2010.

PUTTING NEW MONEY TO WORK

Improvements in trading technology have allowed greater productivity on the program trading desk, without which the opportunity to slice large numbers of orders up in different ways would not have been achievable. As liquidity has fragmented, the decisions about where and how much to trade have been supplemented by the integration of smart order routers or execution based algorithms. Nowadays, technology can be employed to import whole baskets of stocks, automatically generate lists and sort them by customised profile, modify strategies and adjust individual stocks. Where next? Ruth Hughes Liley reports. “ E SEE SEVERAL drivers that have increased program trading flow over the last four quarters in the US,” says Jason Crosby, head of Americas Portfolios at Morgan Stanley, a top program trading firm on Wall Street, along with Goldman Sachs, Credit Suisse, UBS, Barclays Capital, Deutsche Bank, JP Morgan, Merrill Lynch and others.“After the credit crisis, in the fourth quarter of 2008 and the first quarter of 2009, there was an asset reallocation from active to passive investments, specifically broad index-based funds. Investors diversified their portfolios into money markets, bonds, and passivelymanaged equity funds,”he adds.

In the third and fourth quarter of 2009: “We saw new money being put to work in the market by actively managed funds and insurance companies.” explains Crosby. “As fundamental fund inflows increased, we experienced uplift in global program volume. During this time asset managers utilised proven global program trading partners. In addition we saw a significant number of fund consolidations which resulted in an increase in transition program trading. The MSA portfolio analytics, direct market access, and portfolio risk management capabilities of our program trading platform enabled our team to efficiently implement these large global transitions for our clients.” Fund and portfolio consolidations occur for several reasons, but one which has emerged recently is due to mergers between asset management firms. “It’s not that buyside desks have become smaller,” says Kevin Bourne, global head of eEquities, in HSBC’s investment banking division.“Rather it’s that program trades have come out of acquisitions as asset management firms have got larger. Only one trading desk survives but their workload goes up and there’ll be a need to rebalance. In addition, credit officers are becoming stricter about who counterparties are, and they want to be sure that they have the guarantees. So business is coming our way because of our strong balance sheet.” According to Phil Slavin, head of European product strategy at trading systems company Fidessa, the evolution of program trading has benefited greatly from

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Steve Wood of Global Buy Side Trading Consultants Ltd.“Two or three brokers will come back with a risk price, based on the mid, and it’s the premium over the mid that you pay. The alternative is agency program trading where a portfolio will be given to a broker to work in the market. But this can cost a lot and you don’t know the outcome from the start. In this case the preferred option for the buy side trade is to work the agency program themselves via an execution management system using DMA, algorithms and dark pools; this enables the buy side trade to control the implementation cost.” Photograph kindly supplied by Global Buy Side Trading Consultants Ltd, May 2010.

developments in technology. “Trading technology allowed greater productivity on the program trading desk without which the opportunity to slice large numbers of orders up in different ways would not have been achievable. As liquidity fragmented, the decision of ‘how much’ to trade and ‘when’ to trade - the basis of all benchmark related automated trading - has been supplemented with ‘where’ to trade by the integration of smart order routers or execution based algorithms.” Nowadays, technology can be employed to import whole baskets of stocks, automatically generate lists and sort them by customised profile, modify strategies and adjust individual stocks. Baskets can be sorted and filtered for preand post-trade analysis, as offered by Portware’s Enterprise system specially designed for portfolio trading. Furthermore most of the bulge bracket investment banks are continuing to develop specific portfolio trading algorithms. Goldman Sachs’ portfolio algorithm, for example, is part of its broader multi-asset suite of algorithms which includes equities, futures, synthetics and options. Elsewhere, Morgan Stanley’s program trading algorithm, MS Port, released in March 2010, takes into account correlations between assets as well as volatility and projected market impact. It also supports equities, futures and exchange-traded funds. “A successful program trade will effectively balance benchmark risk, execution costs and trade anonymity,”says Crosby.“This algorithm utilises pretrade and intra-trade analytics to significantly reduce the benchmark risk, and empower traders to place multiple orders on different exchanges at strategic price points to facilitate best execution for our clients.”

Chris Woolley, who heads Goldman Sachs’ portfolio trading desk in London, sees technology as fundamental to portfolio trading: “Portfolio trading has a high technology cost. As a result, we do a lot of innovation in the portfolio trading business and also think of it as an algorithm laboratory, taking a trader’s DNA and putting it into an algo. Portfolio trading is an expensive business to run because it requires a lot of technology to ensure you have connectivity to the markets, speed of access and so on.” As use of list management trading methods crosses over into the traditional cash trading role it has extended to include multi-asset and global execution capability. “Introducing currency, time-zone and global market access within a single program of orders requires a sophisticated trading solution that is implicitly market‘aware’,”holds Slavin. HSBC’s Bourne agrees that portfolio managers would rather keep a global program as a whole, where it could be handed over to the sell side to work the order.“This is a big issue for clients. A portfolio manager wants a counterparty that can take it all and deal in different time zones as well as the more difficult markets. More and more people are looking, not just at emerging markets—and that definition is changing as the BRICs are very substantial markets—but also at frontier markets such as Panama, Palestine or Armenia, where we became members eight weeks ago. $200m in a small emerging market is a big trade and clients need the assurance that their counterparty has the credit to take the trade.” Robin Strong, director of buy-side strategy, at Fidessa, has also seen more multi-asset class trading requirements develop. “Some program trading requirements need to combine equity program trades with futures, foreign exchange or other instruments that are part of an active trading strategy or as risk reduction techniques. In a market neutral trade, hedge funds often need to mix index and sector futures with equity programs to achieve their desired exposure profile. More and more, these are being handled by a single desk.”

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A New Approach in Equity Style Benchmarking A Q&A session with Kal Ghayur, CEO & CIO, Westpeak Global Advisors, LP and Paul Walton, Business Development Director, FTSE Americas, Inc. Q: FTSE and Westpeak recently launched the FTSE ActiveBeta Index Series. What is the potential benefit for investors? Kal Ghayur: Our research shows that a significant portion of active equity returns appears to come from sources other than managers’ stock selection skill. Two such sources, price momentum and value, arise from the systematic behavior of earnings growth and discount rates over time. Momentum captures the source of active equity returns associated with the trending behavior of short-term earnings growth, and value captures the source associated with the mean reversion of long-term earnings growth and stock-specific risk. These return sources are systematic in nature, similar to market beta, but have been mischaracterized as skill. The FTSE ActiveBeta Indices have been developed to provide investors an efficient, transparent, and cost-effective vehicle for capturing these systematic sources of returns. Q: You argue that the FTSE ActiveBeta Indices better reflect the investment styles of active managers than value and growth. Why? Kal Ghayur: We argue that persistent investment styles emanate from systematic sources. Value and momentum are shown to represent two systematic sources of active returns. Growth investing, as currently defined, does not constitute a systematic source of return, and growth indices do not properly reflect the investment process of so-called growth managers, who are also shown to be momentum players. As such, we argue that value and momentum better reflect the investment styles of active managers than value and growth. Paul Walton: We offer investors a new perspective on style investing. Traditionally, growth investing has simply represented the non-value universe of securities. Given the long-term underperformance of growth indices compared to the core indices from which they are derived, we find it difficult to believe that growth is a style that active managers willingly follow. The FTSE ActiveBeta Index Series provides investors an internally consistent global family of momentum, value, and combined momentum and value indices, which more accurately reflect the investment processes of growth, value, and core managers, respectively. Therefore, in our opinion, they also constitute better benchmarks for assessing the skill of these managers. Q: Why is it better for investors to invest in a combined momentum and value index? Kal Ghayur: Although momentum and value independently provide positive active returns in the long run, an independent capture of either source is subject to significant tracking error and relative return drawdown. A combined capture of momentum and value, on the other hand, provides an improved active risk-return trade-off, arising from the negative correlation of momentum and value excess returns. In a combined capture, the tracking error and drawdown are significantly reduced, without sacrificing returns.

600 500 400 300 200 100

FTSE Developed ActiveBeta Momentum and Value Index (MVI)

FTSE Developed Index

FTSE Developed ActiveBeta Value Index

00 9 De c-2

00 8 De c-2

00 7 De c-2

00 6 De c-2

00 5 De c-2

00 4 De c-2

00 3 De c-2

00 2 De c-2

00 1 De c-2

00 0 De c-2

99 9 De c-1

99 8 De c-1

99 7 De c-1

99 6 De c-1

De c-1

99 5

99 4

Index rebased (31 December 1994 = 100)

Q: How have the FTSE ActiveBeta Index Series performed? Paul Walton: Both the FTSE ActiveBeta Momentum Index and FTSE ActiveBeta Value Index generally have outperformed the selection benchmark across all markets and market segments globally. The combined FTSE ActiveBeta Momentum and Value Index (MVI), with its superior diversification properties, has outperformed the underlying benchmark in all universes since inception in 1995 and has generated a highly respectable information ratio, especially from the perspective of a passive investment. Further, the FTSE ActiveBeta MVI has outperformed the selection benchmark nearly 60% of the months, in virtually all universes.

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THE FTSE I WANT TO INVEST MORE INTELLIGENTLY INDEX FTSE. It’s how the world says index. Because investors always want superior returns, FTSE has developed a range of investment strategy indices that are designed to offer an enhanced risk / return profile. Alongside traditional indices, we offer indices that use alternative weighting criteria, which include sales, cash flow, book value and dividends, instead of market capitalisation. www.ftse.com/invest_intelligent © FTSE International Limited (‘FTSE’) 2010. All rights reserved. FTSE ® is a trade mark owned by the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE under licence. ActiveBeta® is a registered trade mark of Westpeak Global Advisors, LP (“Westpeak”) in the United States, Europe, and Japan. The ActiveBeta Index Construction and Maintenance Methodology is the patent-pending property of Westpeak.

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Phil Slavin, head of European product strategy at trading systems company Fidessa, the evolution of program trading has benefited greatly from developments in technology.“Trading technology allowed greater productivity on the program trading desk without which the opportunity to slice large numbers of orders up in different ways would not have been achievable. As liquidity fragmented, the decision of ‘how much’ to trade and ‘when’ to trade - the basis of all benchmark related automated trading - has been supplemented with ‘where’ to trade by the integration of smart order routers or execution based algorithms.” Photograph kindly supplied by Fidessa, May 2010.

Irrespective of technology, human intervention in program trading is still vital. “In risk portfolio trading, the buyside will request a risk price from a broker upfront for a basket of stocks using a bid sheet with enough information to price it, but not enough to show which direction you are going,” explains Steve Wood of Global Buy Side Trading Consultants Ltd.“Two or three brokers will come back with a risk price, based on the mid, and it’s the premium over the mid that you pay. The alternative is agency program trading where a portfolio will be given to a broker to work in the market. But this can cost a lot and you don’t know the outcome from the start. In this case the preferred option for the buy side trade is to work the agency program themselves via an execution management system using DMA, algorithms and dark pools; this enables the buy side trade to control the implementation cost.” Woods further explains that:“It’s a challenge for the buyside either way - you need expertise to create the bid sheet or to decide which is going to be a more cost effective route if you go down the agency path. How do you choose between the three? That’s down to the skill of the buyside trader. Down the second route, you can’t tell the price until you have done the deal; the third option gives the buy side trade control and flexibility over the program so the buy side trader skill is vital in determining which course of action to take.”

Back in March 2000 FIX Protocol Ltd added messages to FIX 4.2 to automate the bidding process, following market participant demand. Although it has users, it has not yet been universally adopted. This doesn’t concern Kevin Houstoun, co-chair of the Global Technical Committee at FIX, who likens the basket to an over the counter (OTC) instrument. “You are talking about a basket of say 50 different stocks and it’s something where you are often going to have a human being involved in the negotiation. Another example is in allocation and confirmation functionality, introduced into FIX in 1996, but only now is the industry truly benefiting from this support as it is reaching critical mass adoption. Adopting new FIX functionality can take a decade or more.” “The bidding process is more human-based than technology-based,” agrees Fidessa’s Strong, explaining that: “Buy-side firms want to minimise execution costs, but not at the expense of information leakage. This is where personal relationships and a certain amount of negotiation are involved. Automation comes in once a broker is chosen. The key point about program trading is that it’s a container provided to the broker by their client; that is, a package of trades. The broker needs to remember those original stocks in the pack, even if they split the list across desks or optimise the execution via internal crossing and other smart routing techniques. If the broker takes 50 orders from one package and 50 from another and trade an aggregated list (a subset) as a child of the parent list, they have to ensure that all the information goes back into the correct parent orders once executed. This has to be automated, not just because of speed and price optimisation, but to avoid errors from rekeying in orders.” A number of people in the market believe that the fragmentation of trades has helped keep program trading anonymous. It is an important development, particularly considering that programs regularly have the potential to run into billions of dollars. With the overall trade size on NYSE being 150 shares and similar fragmentation in other markets, traders have looked to technology to randomise the trade across exchanges and price points. Sang Lee, co-founder and managing partner at research firm Aite Group stresses: “Program trading is simply one method of getting a large trade done. It is certainly part of the overall trading business and continues to offer a way to institutional investors to work their order, but single stock trading is still the predominant way to doing things.” Indeed, while program trading is growing in value terms and some estimate that in Europe it now constitutes a third of all trade in value terms. Actually, the remaining twothirds are conducted in blocks and in single stocks. At Goldman Sachs, where hundreds of portfolios cross their desk every day, the program trading desk has added single stock traders to the team. “We have added single stock trading expertise into the portfolio business as we have seen more demand from active management clients,” says Woolley. “If you go back several years, clients would view portfolios as efficient tools to get the job done. Now

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

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they want colour around single stock moves and macro colour in the market such as economic events and news flow. We are always aiming for consistency of execution and a meaningful dialogue with clients. The basic thing for us is ‘how do we add alpha to a client’s performance?’” “List trading methods are set to be adopted across the whole trading floor,”agrees Slavin.“Why would anyone not want to leverage the productivity and trading tools that have been deployed on program trading desks? If I am trying to manage all my orders that are ‘on close’ I should consider this to be a ‘temporary’ list so I can do all my trading effectively in waves. Then, as a single order trader the time saved can be best spent focusing on the more difficult-to-execute orders.” At Goldman Sachs, Woolley has seen portfolio trading going further down the high touch route in the 15 years he has sat on program trading desks.“We have got to the point where the portfolio trading business is quite a high touch business. I think that’s going to continue to develop.” Meantime, Steve Wood believes the future for program trading will depend on the different environment created by new regulation: “Change in the future of program trading will depend on whether regulators go down the European Best Bid and Offer (EBBO) route or down the post-trade consolidated tape route. If it’s the EBBO route (the NMS trade-through rule as in the US) this will involve different tax regimes, different currencies and technology demands on firms. However, if they go down the post-trade route, they’ll need to ensure the quality of data is clean and the trade only gets printed once. If the EBBO route happens, they won’t need such sophisticated smart order routers.This will be better for the buy side although with the explosion of providers off algorithms via multi-broker/ broker-neutral EMS platforms it’s become a lot tougher to choose the right algorithm when there are 100 to choose from.”

Robin Strong, director of buy-side strategy, at Fidessa, has also seen more multi-asset class trading requirements develop.“Some program trading requirements need to combine equity program trades with futures, foreign exchange or other instruments that are part of an active trading strategy or as risk reduction techniques. In a market neutral trade, hedge funds often need to mix index and sector futures with equity programs to achieve their desired exposure profile. More and more, these are being handled by a single desk.” Photograph kindly supplied by Fidessa, May 2010.

Slavin says it’s a broad touch approach that is needed today: “By offering a choice of execution styles (be it high touch, program, algorithmic or DMA), coupled with strong pre- and post- trade analytics as part of a full service solution, brokers should now look to offer a ‘broad touch’ approach to sales and trading.”

WHAT’S IN A PROGRAM TRADE? rogram trading has evolved much since the 1980s, when it received a portion of blame for the stock market crash of October 19TH 1987, the day the Dow Jones Industrial Average index lost 23% of its value amid a slump in world markets. The rise and fall of program trading activity has been tracked on the New York Stock Exchange since 1989. As a percentage of flow, in the aftermath of 1987 program trading flow has been on the rise, reaching 46.4% of all trading by June 2006. During the credit crisis in October 2008, the proportion slumped to 16%, but had climbed back to 40% by Christmas. More commonly, it averages around a quarter of total volume of shares bought, sold and sold short on NYSE. In the week ending April 23rd, 2010, for example, it was 21.7% of the total ADV of 2,498m shares with equal numbers of buy and sell programs.

The official definition of a program trade on NYSE is one containing a basket of at least 15 securities regardless of value. (Until September 2007, it had been defined as a basket worth at least $1m.) In Europe, pre-MiFID, the London Stock Exchange defined a basket as 20 stocks, a definition which has relaxed post-MiFID now that trades can be executed on a variety of exchanges, although it is still generally accepted as at least 10 names. Program trading falls across different types of trading: index arbitrage (although as measured on NYSE, this only makes up 3% of total program trading), transition management, long-only cash management of portfolios, long/short portfolio rebalancing, and more recently trading in exchange traded funds and sector-based portfolio trading.

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The changes under way in Canada could have happened earlier, but the major players had no reason to initiate changes that would upset the established, and highly profitable, model. Although the Canadian Securities Administrators (CSA) opened the door to alternative trading systems (ATS) in 2001 and added a requirement for brokers to monitor prices on ATS in 2005, the first fully-fledged alternative trading venue, Pure Trading, did not launch until September 2007. Others soon followed but the new venues had made only limited inroads before the Toronto Stock Exchange (TSX) took defensive action. In October 2008, in a bold move to attract high frequency trading firms, it introduced maker-taker pricing, which offers a rebate to participants who add liquidity by placing passive limit orders on the book and charges a fee for market orders, which absorb liquidity. The major Canadian dealers threw their collective weight behind Alpha Trading Systems, where execution was cheaper than on the TSX. In October 2008, the TSX accounted for more than 96% by value of shares traded in Canada, but its market share has declined in every subsequent month and by early April 2010 it had slipped below 60%. Neil O’Hara reports. LGORITHMIC TRADING, THE advent of alternative trading systems (ATS) and an influx of high frequency trading have transformed the cash equity market in Canada over the past 18 months. The Toronto Stock Exchange (TSX) has seen its near-monopoly evaporate as upstart trading venues with superior technology siphoned off volume by offering faster and cheaper execution. Bid-offer spreads have collapsed, the volume and value of shares traded has soared and average ticket size has plummeted. It is a pattern already familiar to market participants in the US and Europe, who experienced similar changes about five years ago. Canada has its quirks, though, and they extend beyond its unique culture to the structure of its financial markets. For example, the brokerage business is unusually concentrated; the five big banks—Royal Bank of Canada (RBC), BMO Financial, CIBC, TD Bank and Scotiabank— have dominated equity trading for years. The concentration of order flow in so few hands fostered a vigorous upstairs market in block trades as the banks were often able to match buyers and sellers among their own customers without tapping third-party liquidity on the TSX. The major players also benefited from the so-called broker preference, a rule that defines the priority in which trades are executed on the TSX. Equity markets in most

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ATS THREAT TO TORONTO EXCHANGE

A TRADING REVOLUTION

Photograph © Isak86/Dreamstime.com, supplied May 2010.

other countries apply strict price-time priority, which means that whichever broker puts up the best price first will get filled before any other bids or offers at the same price. On the TSX, however, an order can jump the queue if both sides of the trade are using the same broker. If RBC enters an order to buy 1,000 shares at $10 and CIBC comes in later with an identical order, RBC gets filled first if a seller comes in through TD. Should CIBC find a seller of 1,500 shares at $10, the broker preference moves the CIBC buy order ahead of RBC to be filled in its entirety, while RBC buys only 500 shares and must wait for another seller to complete its order. Although the rule is unpopular with international investors, brokers love it and many Canadian institutions that are used to it are in no hurry to give it up either.“No one thinks it’s fair to be able to jump the queue but if they are the ones jumping the queue then they like it,” says Renée Colyer, founding principal at Forefactor, a Torontobased research firm specialising in financial services and capital markets. High frequency trading firms can use the rule to their advantage, too, particularly if they use a broker that has a large market share—which may explain why CIBC’s campaign to attract these firms has been so successful. Broker preference can frustrate conventional investors

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authority, opened the door to ATS trying to execute large orders, who in 2001 and added a requirement may find they never get to the for brokers to monitor prices on front of the queue because a high ATS in 2005, the first fully-fledged frequency trading shop either gets alternative trading venue, Pure there first or skips ahead. Trading, did not launch until The rule tends to favour brokers September 2007. Others soon that have strong order flow followed: Omega in November anyway. It allows brokers to keep 2007, Chi-X Canada (a subsidiary their own flow in-house in an of Instinet) in April 2008 and exchange environment, Alpha Trading Systems (owned by eliminating the incentive for banks to set up dark pools to a consortium of Canadian banks achieve the same result. Indeed, and brokers) in November 2008. the only dark pools operating in The new venues had made only Canada at the moment are limited inroads before the TSX took defensive action. In October independently owned: an affiliate Rick Meslin, head of Canadian Equities at UBS 2008, in a bold move to attract of US-based Liquidnet and Securities Canada. Photograph kindly supplied by high frequency trading firms, it MATCH Now, operated by Triact UBS Securities, May 2010. introduced maker-taker pricing, Canada, a subsidiary of which offers a rebate to Investment Technology Group participants who add liquidity by (ITG). Neither has a significant placing passive limit orders on the market share. book and charges a fee for market “Broker preference has forestalled orders, which absorb liquidity. dark pool development in Canada,” “That’s what changed the game in says Ray Tucker, head of equities at Canada,” says Laurie Berke, a TD Bank, “For small order flow, it principal at TABB Group, a New does take out the cross first.” With technology costs plummeting, he York and London-based financial nevertheless expects to see more services research and consulting Canadian dark pools emerge in the firm. “At that point, the dealers had to decide what to do.” next year or two. The major Canadian dealers Doug Clark, managing director, threw their collective weight quantitative execution services, at behind Alpha, where execution BMO Capital Markets, argues that was cheaper than on the TSX. the broker preference is superior Alpha also offered maker-taker to current practice in the US, pricing, a critical component of the where broker-owned dark pools high frequency trading business have coalesced into consortia that model, as did Pure and Chi-X. It route an order through the didn’t take long for Getco and participants’ dark pools before Tradebot, two of the largest US sending it out to the market. He high frequency trading shops, to acknowledges that the broker preference is unfair to investors move into Canada, and others Doug Clark, managing director, quantitative execution who see stock trading at the same soon followed. Meanwhile, some services, at BMO Capital Markets. Photograph kindly price while their orders languish if banks embraced the new supplied by BMO Capital Markets, May 2010. another broker has both sides of environment—CIBC in the trade, but a system that routes orders only to a limited particular—while others resisted, arguing that high number of preferred dark venues precludes investors from frequency trading was harmful to investors and posed a tapping liquidity in other dark pools.“I would hate to see systemic threat if the software that generates orders were to us get rid of broker preferencing and adopt the US run amok.“The exchanges made the decision whether to go structure,” says Clark,“Do we keep it just so that we don’t after this business or not, and so did the banks,”says Berke. “Within months, the whole volume profile changed.” go to something worse?” In October 2008, the TSX accounted for more than 96% by The revolution now under way in Canada could have happened earlier, but the major players had no reason to value of shares traded in Canada, but its market share has initiate changes that would upset the established—and declined in every subsequent month and by early April 2010 highly profitable—model. Although the Canadian had slipped below 60%. The big beneficiaries were Chi-X Securities Administrators (CSA), the local regulatory and Alpha, which grabbed 9% and 23% respectively by

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February 2010. The other lit venues and the dark pools have made little headway, although they have seen more business as the overall market has grown: average daily volume has risen from 450m shares in 2008 to about 650m in 2010. Alpha’s success is hardly surprising, given its backers. “The banks like to own their flow, and they are dominant,” says Alison Crosthwait, director of research at ITG Canada. “Alpha would not be where it is if the banks did not own the majority of it.” The banks are in no hurry to support competing venues including ITG’s MATCH Now, either, which explains why it struggles to maintain a market share just under 1.5%. Chi-X is a recognised international brand that has succeeded in part by attracting new participants to the Canadian market. Tal Cohen, chief executive officer of ChiX Canada, says global investors feel more comfortable trading on Chi-X because it applies the familiar price-time priority, the only venue so far to forgo the broker preference. Foreign investors have flocked to Canada in recent years, lured by its sound public finances—rare among developed nations these days—a robust financial system that came through the credit crisis relatively unscathed and plentiful natural resources that benefit from high commodity prices. The influx of foreign capital has boosted the market share of bulge bracket securities firms that have operations in Canada at the expense of domestic players. Rick Meslin, head of Canadian Equities at UBS Securities Canada, says the global move toward commission sharing arrangements, which let investors separate execution costs from research, has accentuated the trend.“Asset managers are shortening their brokerage lists,”he says.“They end up with one or two dealers in a particular region to whom they pay all their execution dollars and have those dealers pay part of the commissions to third parties for research.” Global clients now apply the concept across borders, too; they may execute a trade in Canada but direct commission dollars to pay for research in Stockholm or Singapore. With about 75% of its clients already based in other countries, UBS Canada is well-placed to attract more business from abroad.“We can access 50 markets, so we are in a sweet spot,”says Meslin.“Global clients want to shave their broker lists and we can offer them competitive access to Canada.” Many of the high frequency trading firms active in Canada are based abroad—mainly in the US and Europe, where they have operated for several years. The varying degrees of enthusiasm for high frequency trading at the Canadian banks reflects the trade-off they must make between their traditional high margin full-service business and the low margin high-volume world of electronic trading. BMO and Scotiabank, which had profitable and powerful block desks, along with independent Canaccord Financial, have been the most vocal critics. In contrast, CIBC, which already had the technology infrastructure to handle small orders for its large retail customer base, was quick to see the potential for marrying that flow to passive

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The influx of foreign capital has boosted the market share of bulge bracket securities firms that have operations in Canada at the expense of domestic players. Rick Meslin, head of Canadian Equities at UBS Securities Canada, says the global move toward commission sharing arrangements, which let investors separate execution costs from research, has accentuated the trend. orders from high frequency trading desks. Rik Parkhill, global head of capital markets sales and cash equities at CIBC, says the firm has doubled its market share from 9% to 18% in 18 months. It expanded its block and electronic trading services, and tapped new clients from outside the country, many of whom had never traded in Canada before. “Large asset managers don’t want broker-dealers to tell them how to trade. They want services that allow them to trade more efficiently,”he says.“We provide our customers with a full spectrum, and tell them we are agnostic about how they trade as long as they trade through us.” Unlike most of its competitors, which typically license algorithms developed in Europe or the US and tweak them to work in Canada, CIBC has a financial engineering group that develops original algorithms tailored to the Canadian market. Parkhill estimates that algorithmic trading accounts for 20%-25% of volume, excluding high frequency trading, which he puts at 30% to 35%. Retail flow is about 20%, and the once-dominant institutional block trading business has shrivelled to 15%-20%. “Our biggest growth area is sales traders using algorithms to handle order flow,”he says.“The appropriate choice of algorithms, an understanding of liquidity characteristics and market structure are becoming a larger part of the value sales traders add.” CIBC’s elevated market share may not be sustainable, however. Like most of the other big banks, BMO does not offer naked access at the moment—but that will change unless Canadian regulators follow moves by the US Securities and Exchange Commission (SEC) to ban the practice.“We are not going to be the lone guy on the high horse,” says BMO’s Clark. “We have to compete on the same terms as everyone else. We would like to see some clarity on naked access in Canada.” High frequency trading firms would like to do business with all the big banks to take advantage of the broker preference, but Clark says they have clustered at CIBC because it alone offers them naked access. CIBC will face renewed competition from BMO and others if the regulator blesses the concept, while a ban would eliminate the edge CIBC now enjoys over its peers. Meanwhile, Clark says BMO has picked up market share in traditional direct market access flow.“A large institution doing direct market access (DMA) through us still gets first shot at our retail

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Alison Crosthwait, director of research at ITG Canada. Photograph kindly supplied by ITG, May 2010.

Rik Parkhill, global head of capital markets sales and cash equities at CIBC. Photograph kindly supplied by CIBC, May 2010.

flow,”he says.“At a firm that has numerous high frequency trading clients, more often than not they will be ahead in the queue. DMA investors get crowded out.” Whatever the regulator decides, high frequency trading firms are in Canada to stay. If naked access is banned, they will either migrate to brokers that provide the lowest latency pre-trade screening—or they may register as broker-dealers and escape screening altogether, as Getco and Tradebot have already done. The rise of algorithmic trading and direct market access—sponsored or otherwise—lets the buy side take control of how orders are handled rather than relying on brokers, and many are taking advantage of it. At UBS, clients using the firm’s algorithms without broker intervention now account for 75%-80% of Canadian direct execution orders, according to Stuart. “The percentage of volume traded with algorithms is increasing, but there is substitution within that from traditional direct market access,” he says. “The portions of business clients want to do themselves have grown.” The brokers make less money from client-controlled orders, so they need higher trading volume just to maintain revenues. Margins are under pressure from higher trade processing costs, too. The clearing and settlement infrastructure in Canada was built around a single trading venue. If a 1,000-share order was filled in five separate trades on the TSX, the broker’s software could compress that to a single ticket before handing it off to IBM or Broadridge, the two major back office service providers in Canada that interface in turn with the central securities depository (CDS). Today, that same order could be filled on five separate venues—and the broker has to submit five tickets because the clearing system can’t handle cross-venue compression. At CAD1.50-CAD2.00 per ticket, processing costs threaten to eat up whatever commission the broker earned on the order. “The dealers are terrified of spiralling internal and external costs from orders being split across multiple market centres,” says Eric Stoop, chairman of Omega. “That’s why they resisted mandatory connectivity and were reluctant supporters of the trade-through rules.” Stoop is also managing director of Tactico, an international advisory firm that implements strategic and

Laurie Berke, a principal at TABB Group, a New York and London-based financial services research and consulting firm. Photograph kindly supplied by TABB Group, May 2010.

tactical solutions for the financial services industry, which acquired a 24% stake in Omega in February. The smallest of the Canadian ATS, Omega aims to be fast and cheap. It eschews maker-taker pricing; passive orders pay nothing, while active orders pay about a third as much as takers on the other trading venues. Omega has never attracted much volume, but now that the major dealers are all connected and venue-level trade-through protection is on the horizon (in February 2011) Stoop expects its market share will grow, aided by innovative pricing plans he has up his sleeve. Those may include reversing maker-taker pricing to pay a rebate for market order flow that absorbs liquidity, a concept pioneered by Direct Edge in the US on its successful EDGA venue. ITG’s Crosthwaite sees potential for that model to work in the Canadian market, too. Although passive orders have to forgo a rebate offered by other venues, traders know that smart order routers often start with the cheapest venue, which means orders placed on EDGA are likely to get filled first. If a fast fill is the top priority, a venue that pays for active flow may be the best place to go even for a passive order. A low cost venue could attract more flow even from the banks. Stoop points out that tension is building at the banks between the retail business, a large source of market orders for which the broker has to pay taker fees, and the institutional side, which has a new revenue stream from maker rebates. Under intense cost pressure, the retail divisions may not be willing to toe the corporate line and route their orders to Alpha if a cheaper alternative is available. “Alpha seems somewhat overconfident in the face of this,” says Stoop “They are riding high on commitments from their owners, but I don’t think it is sustainable.” Stoop isn’t the only one to question how much longer the banks will give wholehearted support to Alpha, but that doesn’t necessarily mean Omega or Pure will pick up the business. Global brands such as BATS Trading or Direct Edge that can leverage technology across multiple markets may have an advantage over home-grown Canada-centric players—as Chi-X has already demonstrated. It seems equity trading in Canada has changed beyond recognition in the past 18 months, but the revolution has not yet run its course.

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THE FINANCIAL CRISIS:

STRESS-TESTING THE PFANDBRIEF

Attendees

Supported by:

From left to right

Jörg Homey, AVP analyst, Moody’s Investor Services

Jens Tolckmitt, executive director of the Association of German Pfandbrief Banks (VDP) Daniel Rauch, fund manager, Union Investment

Andreas Schenk, managing director,Treasury, Deutsche Pfandbriefbank

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SETTING THE SCENE

DANIEL RAUCH, FUND MANAGER, UNION INVESTMENT: Definitely the important issue today is transparency and everything which tends to frustrate transparency. We are now seeing a new set of changes in the German law, the new amendments to the Pfandbrief Act. It is a detailed process and is being conducted in a way that laws should be modernised; being regularly updated. However, the process is never ending and there are other proposals now emerging, particularly in combination with the work of the Covered Bond Investor Council, which is funded on a European basis. Among the key initiatives in this regard is the establishment of a transparency working group, which is a welcome prospect. JENS TOLCKMITT, EXECUTIVE DIRECTOR, THE ASSOCIATION OF GERMAN PFANDBRIEF BANKS: As an industry body, our principal concern is to take all measures needed to ensure that the benchmark status that Pfandbrief has in the covered bond market (but also in the broader capital market) as a safe investment is secured for the future, both over the medium and long term. A current issue is obviously the amendment of the Pfandbrief Act that has recently been published. Another very important element is the renewal of the Jumbo Minimum Standards. Some kind of real commitment has to be in place to ensure both market making and post-trade transparency. Finally, we are working intently on increasing transparency for the product itself. JÖRG HOMEY, AVP ANALYST, MOODY’S INVESTOR SERVICES: As everyone has mentioned, transparency is key in the current market. We have observed that the number of investors calling us directly has increased significantly over the last year. Therefore, in this context, we believe that Moody’s, as a rating agency, can provide added value by answering questions about the credit quality of the collateral, refinancing or structural risks. We believe that we have played an important role in encouraging issuers to disclose the pool composition of covered bonds and we have been able to provide homogenous information. We have started to publish quarterly performance overviews on covered bonds and this is something which we believe will benefit the market. With respect to the currently discussed changes to the German Pfandbrief Act, Moody’s views the new Pfandbrief Act amendments positively as a mitigant to address refinancing risk. ANDREAS SCHENK, HEAD OF TREASURY, DEUTSCHE PFANDBRIEFBANK: The challenges and the priorities are perhaps a little bit different for us. Deutsche Pfandbriefbank re-established itself in the capital markets in the second half of last year. We are now trying to increase our issuance volumes and our standing in the market. That puts us in a special situation. If I look at the overall Pfandbrief market I agree with the rest of the panellists on transparency; and we can always continue to improve. Looking back, I think that the Pfandbrief has proved to be a stable funding instrument for

banks even during the crisis compared to many other markets, particularly other covered bond markets. We definitely believe in the Pfandbrief product and we are building our business model on it.

THE FINANCIAL CRISIS: STRESS-TESTING THE PFANDBRIEF

JENS TOLCKMITT: I think the Pfandbrief passed this real stress test quite impressively. For the first time, really, its overall framework was tested and it was tested successfully, particularly compared with its peer products in Europe, which did not perform as the Pfandbrief did. However, and this is an important point, at the Association we don’t think we can now lean back and be complacent. On the contrary, we are underscoring the quality of the Pfandbrief and at the same time looking at the challenges ahead and putting everything into improving the quality of the Pfandbrief in order to make it even more resilient against future challenges or crises. I think what was an interesting development was that investors remained with the Pfandbrief all through the crisis. Now, in the post-crisis environment, a number of banks are looking at the Pfandbrief as an additional funding instrument. I think many institutions have come to realise that the only instrument that offered access to liquidity in extremely difficult times, or almost all the time, was the Pfandbrief. I would therefore go as far as to say the Pfandbrief is a kind of winner from the crisis. FRANCESCA CARNEVALE: Andreas, over the period of the crisis were you reassured by the actions taken in shoring up the Pfandbrief infrastructure? Separately, as an issuer, do you have to do a lot more in terms of the cover pool, to improve investor appeal in the product? ANDREAS SCHENK: It is a bit difficult for me to judge because out of our particular situation. We had to do much more than other issuers given our recent history and what happened during the crisis with Hypo Real Estate Group. We definitely had to re-establish ourselves in the market and do a lot of work in this respect. The important thing is that you reengage in a dialogue with investors. However, we also learned a lot from this situation, we applied this new knowledge and we now have many more investors we can approach. In fact, there are many more names in the order book. Maybe in the past the spreads were not sufficient for some investors, maybe they considered the market unattractive. The good news is that many more investors are interested in the Pfandbrief market. DANIEL RAUCH: I need to go back to explain a little the steps in our investment process, how we evaluate and analyse credit and the covered bonds we invest in. We do a lot of number-crunching and have done for some years. The analysis always starts with the bank, on an unsecured basis; after all, it is an obligation of the bank itself. Then the next steps include analysis of the cover pools, the regulatory framework and so on. We have not changed our requirements, but we have been more focused on the analysis of the deals and that in turn puts more onus on issuers in terms of what they are providing. If you look at

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different jurisdictions outside of Germany, there is still a lot of a kind of unwillingness“to deliver”. I think in the case of Germany, you have had this teamwork involving a strong association, which worked closely with its members and investors. In other jurisdictions this was not the case. That teamwork and the presence of a strong association have put Pfandbrief way ahead in this regard. JÖRG HOMEY: Issuers seem to be committed at looking at ways they can address post-crisis demand in order to protect covered bond investors. As a consequence, issuers have been willing to provide more support to protect credit ratings. The primary stress on covered bond ratings has come from the fall in the senior unsecured ratings of the banks supporting the covered bonds. Moody’s methodology involves a linked approach where the credit rating of the issuer itself is an input for our covered bond rating. If the issuer’s own rating is under pressure, that certainly puts pressure on the covered bond rating. However, an issuer may be able to offset the negative rating pressure by adding further collateral to a cover pool. ANDREAS SCHENK: The issue we have with ratings, and I am not talking about any agency in particular, but about rating agencies in general, is that over the last year ratings approaches changed a couple of times. In fact, at times it was pretty difficult for issuers and investors to follow the different rating approaches. Moreover, different agencies may view the same deal differently. Other times, the ratings agencies would change their minds about what was important and what was not. Therefore it was not an easy time reacting to changing methodologies or matching up the different ratings between agencies. The last few months have been particularly difficult in this regard. JÖRG HOMEY: I see your point; however, please note that Moody’s covered bond methodology has been robust since we published it in June 2005. We have not changed our methodology. We have always stated that there is linkage between covered bond ratings and issuer’s ratings, mainly due to the uncertainty surrounding refinancing and liquidity risks upon issuer default. Before the crisis we had made our position clear in this respect. We had already explained to the market that refinancing risk cannot be measured with sufficient confidence for us to achieve our highest rating levels without highly rated issuers supporting the covered bond programmes. DANIEL RAUCH: I think now it’s up to the investor to say something about different rating approaches. Pretty much you’re talking about three rating agencies with different approaches and the trend towards the big picture in the way they rate issues is streamlined nowadays and, actually, we welcome this development. However, it does make it rather difficult to dig into the details of an issue. You might have a pure academic view of what is the perfect Pfandbrief or covered bond; but that view might not actually gel with what an investor would like. For example, in non-German jurisdictions we have the option of issuing soft versus hard bullets. We don’t have that option in Germany. Now I might understand that a soft

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DANIEL RAUCH, fund manager, Union Investment.

bullet has its benefits and a ratings agency will appreciate those benefits. However, as an investor we have a preference for issues coming to market with a hard bullet.

THE PROBLEM WITH RATINGS AGENCIES

FRANCESCA CARNEVALE: At times over the past year, the VDP [Verband Deutscher Pfandbriefbanken, the Association of German Pfandbrief Banks] has been very vocal over some of the decisions of the rating agencies, such as changes in methodology, the downgrading of some of the banks by Fitch, for instance. Are those tensions still in place? JENS TOLCKMITT: To a certain extent, yes. There are a number of problems. One is procedural; that is, the question of whether and how a rating agency utilises required information. Historically, in many countries there are clear laws, procedural processes and guidelines in place, explaining clearly the information required of a publiclylisted company and the way they are published, particularly given that both the information and the issues are marketsensitive. I’m really concerned that this is not the case for rating agencies. There is a possibility for a rating agency to undertake a consultation process for more than ten months and obviously shaping market opinion on a certain product, or a group of products in that process. Then, they can overturn their approach and come up with a final version

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that might be substantially different from the first draft; but by that time it is too late, as market opinion has already been conditioned. This is a very big concern going forward. The second aspect is, and this became clear during the crisis, how difficult it is to measure precisely the inherent strength of a Pfandbrief by standards that are not necessarily measurable. I am thinking of say, the differences between securitisations and structured finance per se and Pfandbrief that ultimately might raise the rating of a Pfandbrief; or external legislative factors. It is not clear how these soft factors are calculated into ratings and how they are calculated between different jurisdictions. There is an influence but what the exact influence is, is not clear. I always have the feeling that, coming from a structured finance background, it’s difficult to understand and difficult also to build into the models that there are other security or safety features within a legally-based product than there are in contractually-based securitisation transactions. JÖRG HOMEY: It is difficult to translate certain soft factors into hard, quantitative, measurable factors. However, I will give you examples where Moody’s is giving benefit within our analysis to the strong commitment of the German Pfandbrief community and the support by the German covered bond issuers to the Pfandbrief product. Looking at the law you mentioned, I just want to highlight two facts. One is the present value test, which includes a 2% over-collateralisation in stressed environments, and, secondly, there’s a 180-day liquidity requirement. Both can be factored in by way of how we look at the market stresses to which the covered pool is exposed after issuer default. That is something we can indeed quantify in our models. So, you get a benefit there. There are more soft factors, as you mentioned, like public support from the government for instance, which is something that Moody’s takes comfort from and we therefore apply less refinancing stress on a German Pfandbrief, compared to other covered bond market segments in Europe. You can see an example of this in our recently re-published covered bond rating methodology, where we mention some of the refinancing margins we apply in different markets. It clearly shows that refinancing margins which we apply for Pfandbriefe are among the lowest across Europe. So the strong expected support and the strong value of the Pfandbrief brand have been incorporated into our analysis.

MARKET DATA INITIATIVES

DANIEL RAUCH: We put high value on such reports but not in terms of the German market where there are strong transparency requirements or laws. It gives us much more value when we look outside Germany and move into other jurisdictions because the degree of transparency in some cases is much lower and therefore such tools, in our view, are highly welcomed. In this respect we put a lot of value on it. We would rather ask the association to think about maybe contractual amendments to what further information can be provided by issuers and the market itself. Can we, for instance, have detailed data on the LTV

ANDREAS SCHENK, managing director, Treasury, Deutsche Pfandbriefbank

[loan to value] distribution? We could maybe have margin data on other covered bond jurisdictions. That, actually, is really valuable information that we would really like to have. Equally, what we really like in the new amendment to the Pfandbrief Act is the requirement for the delivery of timely information. Perhaps the VDP could add a database of this type of information for its members on its platform. JENS TOLCKMITT: I have good news for you. On the timeliness issue, as you may have seen, the draft of the new amendment also foresees a deadline for publishing required data. It is published quarterly and the new law allows for a deadline of one month until the data is published; the only exception being the last quarter of each year, where data must be published within two months. Secondly, regarding market transparency, Paragraph 28 of the Pfandbrief Act was introduced because investors would benefit from such a standardised reporting framework.VDP worked closely with investors and other market participants to get it right. Our aim is to increase the market knowledge of investors and provide them with sufficient data to make them less dependent on ratings agencies. Actually, this is what investors want, to be able to make up their own mind as to the attractiveness of issuers.They want to make up their own mind whether they like a certain business model or they like a cover pool and so on. The thing is, it is difficult to marry all the different views of investors. There is not necessarily consistency in the range and depth of information required by different firms. If there was firm demand for particular information we would aim to provide it. As the industry association we have worked closely with our members to arrive at a broad understanding of the precise requirements laid out in Paragraph 28 of the Pfandbrief Act. In autumn this year, VDP will start to provide all member banks’ individual

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data on its website based on this common understanding. This is a milestone for issuers and investors to have one point of access, consistency in presentation and common definitions of what is included. Moreover, data will be provided in a format that allows users to work with the data in their own spread sheets. Finally, VDP continues looking for consistent themes and requirements among investors and strives to comply with them as soon as possible. ANDREAS SCHENK: This is a very important development. Many of the international investors are not fully aware of the fact that we have one common reporting standard, defined by law. If you add the database to this standard, it will set the market apart. If you have a look at other covered bond jurisdictions, everybody’s reporting something but it’s not to the same standard. Then you have the problem of comparing the figures, as they are often defined in multiple ways. Consistency is really important for us as an issuer.Therefore, in that context we are committed to working with the association and investors on improvements in this area. However, as a bank it’s also important that we really stick to this information. We really want to stick to one set of information rules and range, which every investor has access to in the sense of fair disclosure. DANIEL RAUCH: There is an interesting point here. Marrying the requirements of a wide range of investors was the starting point for the foundation of the Covered Bond Investor Council. There are still many investors that are not members, however principal investment firms have signed up to it; including us. Within the Transparency Working Group we have worked on a kind of a template, and we are still working on it, to have a common form for information which most of the market participants can work with and draw value from. Our chairman has presented various ideas on how the template would look and work, so perhaps we should, together with the chairman of VDP and other national associations, discuss these emerging formats. FRANCESCA CARNEVALE: For the benefit of readers unfamiliar with German regulations, could you please define Paragraph 28? JENS TOLCKMITT: Paragraph 28 of the Pfandbrief Act governs Pfandbrief banks’ regular disclosure requirements. It caters for the group’s transparency, the basis of which was laid back in 2004 in the last amendment of the former Mortgage Bank Act. It prescribes a number of disclosure obligations for Pfandbrief banks regarding both cover pool and the setup of the cover pool and the funding side of their business, basically. So, based on Paragraph 28, the data will be compiled and aggregated on theVDP website in a usable format and based on common definitions. My understanding is, as I said, that many investors think that, as a first step, consistency in reporting is more important than the provision of additional information. What we don’t want to do is end up with more information than is useful. DANIEL RAUCH: There’s a fine line, definitely, between what is also workable. How much data can you really handle?

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JENS TOLCKMITT: It’s especially small investors, and it’s them who are telling us so, who really work under certain restrictions and have to be provided with the truly important information. It is especially with a view to this group that the initiative is aimed at, maybe even more than big institutions. So, yes, there is a certain limit in what everyone can actually process internally. ANDREAS SCHENK: That’s really important. You just have to look at the profile of Pfandbrief investors. The big firms usually take the benchmark issues and Jumbo Pfandbrief; those firms might be German or foreign. Then there are the private placements with many smaller investors. These investors are very important for us and while we are keen to provide them with as much information as possible, we have to understand that they might not have a big credit department or several analysts just focusing on covered bonds. It might be one, and he might be covering a multitude of investible products. We must be careful not to overload this important segment. JÖRG HOMEY: In fact, we are publishing LTV distributions for mortgage covered bond transactions rated by us. Obviously not all covered bonds in Europe are rated by Moody’s, so the universe is not complete in that sense, but at least for the universe we do rate (I believe there are over 180 covered bond programmes that carry our ratings) we provide a means of comparing cover pool data. DANIEL RAUCH: One final point: it is up to the issuer to provide this information and not a third party. At the end of the day, the Pfandbrief is a direct interaction between an issuer and an investor. FRANCESCA CARNEVALE: Again, for the benefit of our readers, what are the key features of the latest amendment? JENS TOLCKMITT: The amendment basically addresses two aspects, centred on the so-called cover pool administrator who manages the cover pools and respective Pfandbrief liabilities after a Pfandbrief bank has become insolvent. In the end the Pfandbrief Act may be seen as a special insolvency law that centres on what happens if something goes wrong with the issuing bank. The amendment clarifies the legal status of the cover pool administrator after insolvency of an issuing bank, for instance, retaining partial bank status that enables him to act more flexibly in the management of cover pools than before. For international investors especially, it makes clear that contrary to some other jurisdictions, in case of insolvency of a Pfandbrief bank, all cover pools are explicitly taken out of the insolvency estate of the bank. That is simply for explanation, but it is an important difference to other jurisdictions where investors in covered bonds have a preferential claim but within the insolvency estates of the bank. In our case, cover assets are exempt from the insolvency procedures and they will retain a partial bank status. Cover assets are administered like a going concern. Secondly, the amendment gives the administrator the ability to raise bridge financing externally and bring in liquidity from outside by issuing Pfandbrief. By that, liquidity may be provided over the whole life of the pools.

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TIERED MARKETS IN COVERED BONDS?

FRANCESCA CARNEVALE: Do you think that the quality of the underlying regulatory regime will mean that much of the covered bond investor market will coalesce around the Pfandbrief, preferring it over other jurisdictions? JÖRG HOMEY: It’s a good question. Covered bond products differ country by country and legislation by legislation. That’s a fact that always was and always will be the case. Over the last few years many cover bond products came to the market and market participants are innovative. That is actually the function of a market, to provide innovation. However, we would be careful about making sweeping generalisations. Within each country there are marked differences on the credit quality of cover pools and the issuers. Furthermore, a number of covered bond markets have performed strongly over the crisis. In summary, while we expect to see a varied and diverse market going forward, we do not believe we will see a simple“two-tier”market with the Pfandbrief on the one hand and all other covered bonds on the other. JENS TOLCKMITT: I don’t see a two-tier market, also because there are so many factors to be looked at. It’s not just about quality; it’s about liquidity and so on. However, throughout the crisis we have seen that for the first time in a long time there was differentiation in spreads, which suggests a certain view of the market on the inherent quality of the different products. That has not led to a two-tier market but to a multi-tier market.The interesting thing is that before July 2007 spreads were very close to each other, no matter which jurisdiction was behind it, and that changed after the first signs of crisis in 2007 and after Lehman Brothers’ collapse when spreads widened tremendously. We thought as a consequence of the ECB Covered Bond Purchase Programme there would be a certain risk that covered bond spreads will tighten back to pre-crisis levels. That has not happened for most products. Since October last year we observe the persistence of covered bond spread differentiation that I think will remain. Secondly, domestic and international investors confirm there is a certain kind of division in play, at least for now. They explain that the Pfandbrief and some other products enabled them to get out of positions even during the crisis at any time, which other products did not. Finally, the challenge, I think, is coping with the spreading of the covered bond idea to new countries and potentially new asset classes. When I look at the US, for example, they are definitely getting serious about the introduction of covered bonds. In terms of new asset classes, the inclusion of student loans and credit card receivables in the US Covered Bond Act could perhaps lead to a further tiering of the market. It is something we follow closely.

HARMONISATION OF THE EUROPEAN COVERED BOND?

FRANCESCA CARNEVALE: Given some of the problems that some structured products faced across Europe, what cross-border efforts are in place to ensure consistency and

the robustness of security packages and covered pools, for instance? In Europe, do you think that the market thrives on that difference rather than seeking harmonisation? DANIEL RAUCH: The first point I would like to make is the branding of the covered bond and I definitely agree with the association because I can remember times in the beginning of 2007 where I had several meetings with innovative investment banks about what the covered bond should look like. We gave clear guidance of what we required. However, it conflicts with the terms that we are seeing in the first drafts coming out of the US. For us it is important that the collateral needs to comprise of something which has, let’s say, economic importance for the country. Now, you can discuss student loans and auto loans and car loans, and the different degrees of their economic importance, but in Germany right now we are limited, really, to the housing market and to the public debt segment. That gives potency to the brand; but it is an issue when we talk about moving the product globally or internationally. In terms of harmonisation, it does exist in terms of the fact that we have more and more legal-based regulation. Now, you can discuss the different degree of the quality in these jurisdictions, that’s a fair point, but at least the direction is there. I think harmonisation is on its way, but now you have to discuss whether it is large scale harmonisation or small scale. Here I agree with Jörg that we will always have national specifics and not a completely homogenous product which is called covered bonds and which have similar requirements in each country. JENS TOLCKMITT: I don’t really believe that we will have harmonisation for the same reasons that were mentioned— too many different systems with too many different details. I don’t really know whether we would want harmonisation in the real sense because the advantage of the current multitude of products is that there is competition between different systems and elements within different systems, and such competition will really enhance the overall quality of the covered bond. As difficult as it may be to find a common covered bond label, the idea of it is to at least define the status quo in Europe, what we see as a covered bond also with a view to EU legislation. This is of value and I understand it is also a value for investors (from the CBIC again) that the industry has a common understanding of what a covered bond is and what future covered bonds should look like if they want to belong to this group. However, that is very far from harmonisation. It’s simply about finding agreement on some very high-level criteria. ANDREAS SCHENK: If we had only one covered bond, I think it would be also a compromise of the lowest common denominator. From an investor viewpoint, a variety of products is always an advantage because they have choice. There is also disagreement over what is the best covered bond format. The driver is investor choice: if I offer a product which nobody wants to buy, then I have to increase my spread. It’s getting more expensive and therefore it’s a natural way that the market culls the least effective structures and it is perhaps the most efficient.

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NEW ISSUES

FRANCESCA CARNEVALE: What is the outlook for new issuance in 2010? DANIEL RAUCH: There’s a statement from the CBIC which I’d like to mention. We’ve noted in the last couple of issues, beginning in 2009, that primary deals are coming to the market while using so-called IOI shadow books: essentially pre-soundings. There were benefits: it helped investors, it helped smooth the markets and it helped government interventions. Now that we have more stable markets, I think that if you have a decent syndicate or originator, then we no longer need these pre-soundings, because actually, in the end, it causes a lot of confusion. So we and the CBIC are hoping for a change there. Elsewhere, public sector covered bonds are on a diminishing curve, so much more residential or commercial-backed covered bonds will come to the market. Moreover, a number of universal banks are now exploring ways to harness the Pfandbrief as a natural part of their funding strategy. That’s a big change, as in the past only specialist banks moved in this market. ANDREAS SCHENK: If you look at new issuance you also have to look at maturity profiles. I think we will see more mortgage Pfandbriefe and mortgage covered bonds in general. On the other hand, looking at the maturity profiles, particularly with regard to public sector covered bonds; the question is how much supply we will see at various maturity levels. Deutsche Pfandbriefbank will concentrate on originating new business in the public finance and real estate finance area. Buying secondary market bonds, adding them to the collateral pools and issuing Pfandbriefe against it will not work going forward. The focus will be on self originated business, also of smaller loans. I agree that the issuance on the market will be less. Taking the maturities into account and this year’s specific situation, it may turn out to be an asset class where there’s more demand than supply. Coming back to pre-sounding, I agree that this was overdone. It was also very difficult for either smaller investors or investors who were not part of this pre-sounding process to be part of the book. It’s reasonable that you have a pre-discussion with a selected group and perhaps your main investors. More and more we will do this ourselves rather than through a syndicate in order to achieve a direct relationship also between the bank and the investor. DANIEL RAUCH: There will be always communication from us as to what we would like to buy and at what maturities. We did this before the crisis and continue to do it, so I am not talking about having no communication at all. JENS TOLCKMITT: I would like to add two points. The diminishing volume of public Pfandbriefe is not a result of the crisis. It is a process that has been going on since 2000, when the overall market volume peaked and it has been diminishing ever since more or less constantly. According to our estimates, the trend will continue this year. This is because the public sector business model is changing and it’s less large volume tickets but more traditional loan business.

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JÖRG HOMEY, AVP analyst, Moody’s Investor Services

Actually, I think, it is positive for the product. So, this is a long ongoing process and it will continue. With regard to issuance, just to give some figures we estimate the overall issuance in Pfandbriefe this year to reach €100bn and the same is true for 2011. However, we will see a reduction in the overall market volume, according to our estimates, to around €700bn, down from €720bn. In 2011 we envisage redemptions and new issuance will balance out. FRANCESCA CARNEVALE: Redemptions are much higher now, aren’t they? JENS TOLCKMITT: They are now higher, yes and that is why the overall volume has been diminishing for the last nine years. ANDREAS SCHENK: But do your figures include private placements? JENS TOLCKMITT: Everything. ANDREAS SCHENK: That’s very important because many other research papers only have benchmarks but not private placements. FRANCESCA CARNEVALE: How much of the total will be Jumbo Pfandbriefe? JENS TOLCKMITT: We have estimated the jumbo part at 25% to 30% of the overall volume, somewhat less than in the past, but if you look at the development of the product and also the lessons learnt from the crisis, then one comfort issuers had was that they could approach the market with smaller traditional issues that are easier to handle at any time. Moreover, registered issuance has proven to be possible at all times and more easily manageable than large redemptions at one point in time.

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LOOKING TO THE FUTURE

JÖRG HOMEY: Our covered bond ratings are linked to the underlying issuer rating. In our methodology we have the timely payment indicator, in short, the TPI, which works as a cap for the covered bond rating. A TPI limits how many notches a covered bond can be rated above the underlying bank supporting the covered bond. The TPI cap reflects our opinion that a covered bond with an exposure to material refinancing risk should not have the highest possible rating if not backed by a highly rated entity. So, if the issuer rating is downgraded, then at a certain stage, depending inter alia on the structure of the covered bonds and the quality of the cover pool assets, the covered bond rating would start to migrate as well. At the start of 2010 the majority of the issuers supporting the covered bonds we rate either had a negative outlook or were on review for a possible downgrade. Against this background the overall outlook for covered bond ratings for the next year is negative. Another credit driver seen last year was refinancing risk. We believe that in 2010 refinancing risk will remain a volatile risk. However, rating actions due to the increased assessment of refinancing risk have been limited to date, in part due to support that has been forthcoming from issuers. DANIEL RAUCH: There are several issues out there that will be solved in one way or another over the next couple of years. One big trend in Germany will be the questioning of some business models and the further survival of those models and how banks behave in future. I also imagine that the landscape that we are in right now in terms of which issuers dominate will definitely change. We will see much less public sector collaterals than we have, though this is not a really difficult forecast. I think there will also be more discussion around market-making and the sourcing of liquidity and how we can improve these processes. I also hope that post-trade transparency, which is currently in the pipeline, will finally find its way into the market. JENS TOLCKMITT: I expect new issuers to come to the Pfandbrief market that want to access the market with regard to the value that Pfandbrief provides especially during difficult market conditions. I also expect the mortgage Pfandbrief to increase in importance in a more normalised market after the crisis and public sector issuance to diminish. As Daniel said, a key issue is market making and the question of post-trade transparency. It’s fundamental to developing the product further. Although Pfandbrief is a long-standing product, it is the issuers’ job to maintain it as an innovative product. At first glance Pfandbrief sometimes seems to look a little bit unexciting but, on the other hand, if you look at the developments that we have seen over the past two decades, in terms of the legal and market frameworks, the Pfandbrief proved to be quite innovative for the whole industry. We as issuers have to be clear that we can only differentiate ourselves if we keep such innovation going. With regard to post-trade transparency, we are working on a distinct kind of

JENS TOLCKMITT, executive director of the Association of German. Pfandbrief Banks (vdp)

transparency and liquidity framework for large liquid issues. We are working on robust market-making standards where price indications will be quoted and transparency is provided on the quotes. So, this would be post-trade transparency, basically. FRANCESCA CARNEVALE: Will there be a tape or board with all prices quoted? JENS TOLCKMITT: That’s work in progress, actually, but I think we have come a long way and maybe are further down the road than other jurisdictions. ANDREAS SCHENK: There will definitely be volatility in many markets. I am convinced that the German Pfandbrief will be a market with lower volatility compared to other markets going forward. It is all very promising. We certainly will have some consolidation on the German banking side so that issuers will disappear, but new issuers will come to the market. The Pfandbrief market will definitely be one very, very big market in Europe and pretty stable compared to other markets. JÖRG HOMEY: When the 2005 Pfandbrief Act was introduced, I believe it was also intended that it should facilitate the consolidation of the issuer landscape. What we have actually seen since then is a more diversified spectrum of issuer. I would expect that we will see some more diversification going forward, not only in terms of issuer but also perhaps in terms of cover pools. For example, Postbank is using its residential book as cover assets for its Hypothekenpfandbriefe while Deutsche Bank is using its commercial book. Furthermore, we have seen a trend whereby more international assets are added to the cover pools.

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Photograph Arete ÂŠ Dreamstime.com, supplied May 2010.

In their quest for diversification, yield and extra return, asset service providers have for a few years now been active in emerging markets, recently adding those in the Middle East, Africa and sub-Sahara to Asia and Latin America, but with their main priority the safe keeping of assets. There are, though, common underlying themes such as risk management, counterparty risks, transparency and increased regulation. One of the key challenges for asset managers is to cater to the varying needs of both international and domestic investors and to carefully explain the risks involved in operating in these markets. Illiquidity, immature infrastructure, political and market instability, individual idiosyncrasies, cultures, languages, currencies and tax regimes also come into play, reports Lynn Strongin Dodds.

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VER THE PAST few years, asset managers have forged a path into the burgeoning emerging markets, looking for diversification, yield and additional return. Although these markets differ widely, the safe keeping of assets is the main priority, particularly since the financial crisis, with albeit the more sophisticated investors also opting for value and services. One of the key challenges for asset service providers is to cater to the varying needs of both the international as well as domestic investors and to carefully explain the risks involved in operating in these markets. Traditionally, emerging markets in Asia and Latin America have been the main beneficiaries of increased inflows but there has recently been a push into the unchartered territories of the Middle East, Africa and subSahara as investors look for non-correlated assets. Francis Jackson, head of new business development and client

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PLOUGHING NEW FURROWS

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Francis Jackson, head of new business development and client management, EMEA, at JP Morgan Worldwide Securities Services, says: “Macro issues have been driving these trends. After the financial crisis, investment managers have been searching for new pockets of performance and there has been a huge move into emerging as well as frontier markets.” Photograph kindly supplied by JP Morgan, May 2010.

management, EMEA, at JPMorgan Worldwide Securities Services, says: “Macro issues have been driving these trends. After the financial crisis, investment managers have been searching for new pockets of performance and there has been a huge move into emerging as well as frontier markets.” These trends are borne out by data provider EPFR Global, which showed that dedicated frontier funds managing about $7bn of assets globally have seen inflows of $420m so far this year, almost already matching 2007’s total. These are still small sums but the free float of the frontier markets (excluding Persian Gulf countries) is only $50bn, or 2% of emerging markets. Overall, inflows into emerging markets are reaching new highs, particularly bond funds, which have attracted $11.6bn so far this year, compared with the previous all-time high of $9.7bn set in 2005. Meanwhile, equities hit a six month high in midMarch taking net inflows for the year to $10.8bn. Custodians are, of course, following their more adventurous clients and expanding their own networks. While global players such as JP Morgan and BNY Mellon have been in these frontier markets, others such as Standard Chartered are hoping to make their mark. The bank recently purchased Barclays Capital’s African custody to provide direct custody services in eight African markets—Botswana, Ghana, Kenya, Mauritius, Tanzania, Uganda, Zambia and Zimbabwe—and indirect capabilities in a further eight markets—Egypt, Cote d’Ivoire, Malawi, Morocco, Namibia, Nigeria, Tunisia and South Africa through a network of third party sub-custodians via an operations hub in Mauritius. The main differences between these frontier countries and their more established emerging market countries such as India or Brazil is their small size, illiquidity and immaturity of the infrastructure. Political and market instability also comes into play for all emerging markets, which is why in some cases those in the premier league can be relegated. For example, last year, Argentina and Pakistan were both downgraded from emerging to frontier status by MSCI Barra. The former implemented capital controls that

reduced the ability to convert foreign currencies into the local currency, while the latter provided artificial supports to its stock market by restricting daily declines at the peak of the financial crisis. Not surprisingly, custodians are expected to play a larger role in these nascent markets. Jackson says: “In many of these markets, while there is a stock exchange with tradable stocks, they may be relatively illiquid. Clients are asking us to provide an end to end integrated service, which means not only offering custody, compliance and fund administration but also the cash settlement and execution. Local execution is a significant challenge because there are not that many broker dealers in these countries. As a result, there needs to be an increased level of due diligence.” Simon Cleary, global product head, custody services, at Standard Chartered, points out: “The requirements and what is expected will differ because each market is in a different phase of development. It is important though to separate emerging markets within Asia, which typically feature strong infrastructure and sophistication that can support significant activity, from some frontier markets such as in the Middle East and Africa, where they are looking to create that infrastructure and level of operational processing capacity as the markets develop.” Overall, market participants are mindful of not applying the same brush to all emerging markets and to factor in the individual idiosyncrasies, cultures, languages, currencies, regulations and tax regimes. Ramy Bourgi, head of emerging markets for Société Générale Securities Services (SGSS), says:“The differences pose the greatest challenges for the global custodian because you cannot take a solution that works in France and plug it into an emerging market country. The services and products that clients are looking for in India, for example, differ from Eastern Europe.” There are, though, common underlying themes such as risk management, counterparty risks, transparency and increased regulation. Tony Lewis, head of global custody for HSBC Securities Services, which provides access for clients into 92 markets, 41 of which are HSBC’s own sub-

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custody locations, agrees, adding: “From a custody and operational point of view, emerging markets are at different stages of evolution and maturity. However, the volatility that we have experienced in the markets highlights the need to have automated, scaleable operations where the operational risk can be effectively managed. This is as true for the emerging as it is for the developed markets,”he notes. In terms of new emerging or frontier markets, Lewis says: “We are finding, though, that international asset managers increasingly prefer to use one supplier to provide a single point of access. A key driver for this approach is that it provides the investment manager with the same high quality level of services and products across all markets.” Penelope Biggs, head of institutional business development for Europe, Middle East and Africa at Northern Trust, also believes there is a sharper focus on the core custody business as well as tools to aid transparency: “While the key challenges are political, market and liquidity risks, all investors have become much more aware of the importance of the safe keeping of their assets since the financial crisis. They want stricter control mechanisms and have the ability at a touch of a button to see where their assets are located, the holdings in their portfolios, counterparties they trade with and their exposure to particular companies, markets, sectors, etc. As a result, compliance monitoring has become much more important as well as tools to help clients analyse risk and measure performance.” Impending regulation, especially if the legal responsibilities for depositaries are increased, could also change the game. For example, Article 17.5 of the Alternative Investment Fund Managers (AIFM) would have European depositaries, which typically perform safekeeping and record-keeping services for investment funds, responsible for compensating investors for the wrongdoings or bankruptcy of sub-custodian banks and prime brokerages. This means that custodians using depositories in local markets would have to reimburse a fund’s investors for “any loss of financial instruments”— either the actual securities or the value of the assets lost—unless it can prove that “it could not have avoided the loss”. If passed, this will have significant ramifications in the emerging markets where most global custodians rely on sub-custodial networks to service their clients. The European Securities Services Forum (ESSF), representing custodian and investment banks, has said the European Commission should not consider the sub-custodian contract to be an outsourcing arrangement and that any potential wrongdoing or bankruptcy of these firms should be absorbed by the fund manager. The ESSF states: “The reasons for appointing a sub-custodian are not driven by the commercial considerations of the global custodian, but from the need to support the investment transactions of the client in a broad range of jurisdictions”

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Andrew Rand, head of network management at Brown Brothers Harriman, adds: “In most markets we operate in, we assume certain risks for the appointment of an agent. We conduct careful due diligence of operational risks in each market and there are only a few, such as Tunisia and Ecuador, where we would not take on the risk because the sovereign and bank ratings are below investment grade.” Photograph kindly supplied by BBH, May 2010.

Jackson notes that JP Morgan has engaged the services of Thomas Murray, which provides ratings and risk assessments of depositories to analyse local players. “One of the biggest challenges for us and the industry is to assess which risks we are willing to underwrite from an operational perspective. However, not all emerging markets are the same, and clients need a greater understanding of those risks and that they will differ in Brazil, Botswana, China or India. In certain circumstances we will take the liability, but our clients understand there is additional cost for this. Custody is no longer like a zero premium insurance business. Andrew Rand, head of network management at Brown Brothers Harriman, adds: “In most markets we operate in, we assume certain risks for the appointment of an agent. We conduct careful due diligence of operational risks in each market and there are only a few, such as Tunisia and Ecuador, where we would not take on the risk because the sovereign and bank ratings are below investment grade.” Overall, the level of scrutiny being conducted over subcustodians has intensified not only due to regulation but also because of increased fears over counterparty risk. Biggs comments: “We already had robust and stringent

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ASSET MANAGERS TARGET EMERGING MARKETS

Ramy Bourgi, head of emerging markets for Société Générale Securities Services (SGSS). Overall, market participants are mindful of not applying the same brush to all emerging markets and to factor in the individual idiosyncrasies, cultures, languages, currencies, regulations and tax regimes. “The differences pose the greatest challenges for the global custodian because you cannot take a solution that works in France and plug it into an emerging market country. The services and products that clients are looking for in India, for example, differ from Eastern Europe,” explains Bourgi. Photograph kindly supplied by Société Générale Securities Services (SGSS), May 2010.

procedures in place for sub-custodian selection but the financial crisis has only strengthened them. We are totally agnostic in terms of the name of the organisation we work with. Sometimes it will be a local player and other times it will be a global player. Two of the most important criteria are the credit rating, which denotes financial strength, and quality of service, which represents their investment in their business. However, we will not consider use a sub-custodian if they do not meet our high rating requirements.” Custodians also expect local governments to raise the bar in terms of investor protection, which is why it is crucial that they keep abreast of the local rules and regulations. Cleary of Standard Chartered notes that“clients are looking

for a higher engagement and strong relationships with the regulators”. He adds: “In many ways they want you to be their eyes and ears on the ground, and to be involved in helping the regulators develop market practices that meet international standards.” This has also translated into an educational role. Chong Jin Leow, head of Asia-Pacific, BNY, says: “Asia Pacific is a highly fragmented market that covers the more developed countries such as Japan, Australia and Singapore as well as emerging markets such as China, India, Thailand and Taiwan. There is no uniform operating platform, regulatory system, culture, language or regulations and one of the key challenges is to understand these differences. For example, China has QDII (qualified domestic institutional funds) and a domestic bank has to appoint the global custodian and not the other way around. This is a longer and more involved process than in other parts of the region.” Overall, regional activity has been sluggish but market participants expect that to change. Alastair Murray, fund services, Asia at HSBC Securities Services, says:“Due to the regulatory environment in Asia Pacific, there has been a slowdown in the number of new launches. Regulators want to ensure the proper controls are in place so they are placing local fund managers under greater scrutiny and conducting more due diligence. However, we have seen an increasing number of new fund launches recently and we expect that to continue for the rest of the year.” Although the investments regimes may differ, international investors in emerging markets expect the same full product suite of custody, fund accounting, transfer agency, risk analytics, timely reporting and efficient processing that they would find in developed countries, according to Chong.“Clients are also looking much more at a provider’s data management capabilities and their ability to compile data for their reports.” As for the local investors, Bourgi of SGSS notes that the levels and services depend on the sophistication of the domestic pension fund industry: “For example, we are seeing a greater demand for value added services such as risk analytics, compliance measurement and performance measurement in India because the local pension fund industry is more developed. Fund administration has typically been done by the fund managers but we are beginning to see that change and being outsourced.” The same trends can be applied to domestic investors in Brazil and Chile as well as Poland, which house highly developed local pension fund industries as well as global investors, all of whom are requiring a full service. This is in sharp contrast to the Middle East where the asset management community is small and dominated by the behemoth sovereign wealth funds and investments managed from within the region’s banks. The bulk of the fund administration and custody work is still carried out internally by fund managers and there is no regulatory requirement yet for external service providers. In addition, these large investors typically prefer their home markets although that is beginning to change.

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NORDIC ASSET SERVICING ROUNDTABLE:

CHANGING LANES:

THE NEW DYNAMICS OF ASSET SERVICING IN THE NORDIC REGION

Attendees

Supported by:

From left to right

Jorgen Hjemdal, managing executive director, DNB Nor Asset Management Tom Fearnley, investment director, Norwegian Ministry of Finance Niklas Nyberg, global head of GTS Financial Institutions, SEB Tor Sydnes, director, Gabler Wassum

Oliver Berger, managing director business executive, Germany, Switzerland & Nordics, JP Morgan Francesca Carnevale, editor, FTSE Global Markets

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SETTING THE SCENE

OLIVER BERGER, MANAGING DIRECTOR BUSINESS EXECUTIVE, GERMANY, SWITZERLAND & NORDICS, JP MORGAN: Some 18 months ago, the transaction business of JP Morgan expanded our business here in the Nordic Region by acquiring the institutional global custody business of Nordea; although we have been active in the region for the last 15 years. We have four offices, one in each of the capitals in the Nordic countries. We are bringing a global approach into the local market, and obviously trying to compete head to head with the local banks, providing services with which our clients can upgrade their investment infrastructure. We also provide depot services. Clearly, the key influence is the financial crisis and its consequences for investors, which for us are banks, pension funds and asset managers, in terms of heightened attention to operational risk, risk measurement. NIKLAS NYBERG, GLOBAL HEAD OF GTS FINANCIAL INSTITUTIONS, SEB: I head up the bank’s financial institutions unit within merchant banking, providing asset servicing, outsourcing and cash management solutions to institutional investors, mainly in the Nordics, Germany, Luxembourg and the Baltics. We think that regulatory-driven initiatives will impact the investor community both in the Nordic region and more widely across Europe, involving a lot of work around risk mitigation and compliance monitoring. We are helping clients to control risk, improve transparency and bring dependable products to market. The onus is on us to maintain a high standard of service provision to support our clients in this changing environment. TOR SYDNES, DIRECTOR, GABLER WASSUM: We work in investment consulting, pension advising and actuarial consulting. Increasingly over the last couple of years, clients are focusing more on the control of risk, changes in investment strategies and working or choosing new managers. We have been through a period where managers have not perhaps performed as well as in the good years from 2003 to 2006. We have been working very hard to understand what kind of managers are able to handle today’s markets; particularly equity markets. Interestingly, compared to the crisis we went through in 2001/2002, our clients have been more relaxed this time; perhaps because the last crisis was still in their minds. At the end of 2002 and beginning of 2003, our clients were very focused on adopting strategies to minimise risk, not only over the immediate term, but over the long term as well. This time, they are taking it in their stride. TOM FEARNLEY, INVESTMENT DIRECTOR, NORWEGIAN MINISTRY OF FINANCE: As one of the investment directors at the Norwegian Ministry of Finance, my perspective is perhaps a little bit different from that of the others on this panel. The ministry is responsible for the management of the Government Pension Fund—Global (GPFG), one of the largest sovereign funds in the world. In addition, we are responsible for the smaller, but still significant Government Pension Fund—Norway (GPFN). The operational management of the GPFG has been given

to Norges Bank Investment Management (NBIM), a division of the Central Bank, whereas the operational management of the GPFN is done by Folketrygdfondet. We are therefore a truly GLOBAL investor with a focus not only on the Nordic region, but on the world markets. The financial crisis hit these markets hard in 2008, which led to large losses on investments. Much of these losses were reversed in 2009. The financial crisis taught us the importance of a disciplined investment process, of not overreacting when markets go against you. We also saw the importance of properly identifying and communicating risk exposures in the active management. The same goes for benchmark risk, or longterm risk factors. Transparency is a key element in our investment strategy, and it has been a great asset. Our well known ethical guidelines and emphasis on ESG issues are also important pillars in a robust investment strategy. JORGEN HJEMDAL, EXECUTIVE DIRECTOR, DNB NOR ASSET MANAGEMENT: The most important issues for our business now, coming out of the crisis, are how markets develop going forward. Stable and strong markets will be very important for us. What’s also important is how to find new platforms for growth, and develop market share in the new markets, both on the retail side and the institutional side. We see the most potential in third-party distribution; both in the Nordic region and throughout Europe.

EVOLVING RELATIONSHIPS

NIKLAS NYBERG: Interestingly, I’d say that cost pressure or servicing price pressure have not been major issues. Of more significance are control, transparency and compliance, and clients want us, as a service provider, to contribute more in these areas than we have done in the past; for example, to act as an independent third party in terms of valuation and compliance monitoring. Over the past year, compliance and the depository function has become a far more important focus area. Previously, clients considered the depository or trustee function as a base line service but they now recognise the value of this service. Having the right provider that delivers a high quality service adds a seal of approval on their products, which has become particularly important for end investors. TOR SYDNES: Is that an issue from the asset management side; or the end investor? NIKLAS NYBERG: Both the end investor and the beneficial owner of the fund now ask about transparency and control: how does the asset manager manage its portfolios and how do they undertake specific tasks? In addition, the depository puts pressure on the asset manager, which in turn puts pressure on us as a service provider. OLIVER BERGER: It runs from the retail investor to the institutional investor and specific asset managers, the whole spectrum. There is a new standard at work in terms of the control of the depository fund, and, perhaps, historically it was probably neglected a little. It was a function which was there, prescribed in law; but, as Niklas says, now it’s an added value function. It has lifted the whole barrier in terms of checks and controls. So, today they’re done on a daily

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basis and online. At any point in time the asset management firm now knows if it is potentially in breach of an investment guideline, set either by the funds themselves or by the institutional investor or beneficial owner. Moreover, while the appetite for risk and return remains, it has changed and there is an acknowledgement that investment approaches have to be more sustainable.Therefore there is a shying away in some instances from products such as structured securities, which promised a big return. Now the starting point from an investor perspective is transparency and knowing exactly what you are buying. It is a sea change. TOM FEARNLEY: We have always had a focus on transparency, and this has only been strengthened by the financial crisis. NIKLAS NYBERG: There is a definite shift in the market. We see even that tier two and smaller institutions are looking for one-stop service providers that can cover the whole investor value chain. In doing so, they can ensure that they achieve more transparency along the entire investment process instead of having multiple providers specialising in specific areas or products. Clients are seeking a provider that can offer an integrated and holistic offering that covers their entire spectrum of activities and investment classes from advisory services through to execution, asset servicing and reporting. Larger institutions on the other hand are still more inclined to select individual services from providers, and I would expect this trend to continue for some time. JORGEN HJEMDAL: My experience of servicing large institutions is that we see a definite move back to basics. They want more transparency, better reporting, good risk management and predictability from their providers. We also see the value of longer-term relationships coming to the forefront. TOR SYDNES: There are two important factors in play. One is obviously transparency. We now look much more intently at what asset managers do, step by step and we demand transparency; we are no longer willing to invest in black boxes. Moreover, after the collapse of Lehman Brothers, understanding counterparty risk and knowing your counterparty became important. I think that everybody learned that from that particular situation. Equally interesting is the current focus on custodian services and deposit services for clients. We previously had a system in Norway whereby if you invested domestically you did not need a depo or custodian without outside VPS. However, if one invested internationally you did. Obviously, larger institutions were well aware of the requirements and their significance; but it was not necessarily the case in tier two or lower institutions. We saw the importance of this requirement some years ago with the Terra Securities scandal. Norwegian municipalities had invested up to NKR1bn in structured assets issued by international banks and the asset manager that sold them the structured products went bankrupt. It turned out the securities were neither in a depot or with a custodian; instead they were kept somewhere in Europe in a special account held by the asset manager. Obviously that was a very difficult situation

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OLIVER BERGER, managing director business executive, Germany, Switzerland & Nordics, JP Morgan

for the municipalities as for some time they were unsure whether they could exercise their rights to the securities as legal owners. You would not be able to get away with that now. Everything has tightened up by a lot of notches.

SETTLEMENT AND CLEARING

FRANCESCA CARNEVALE: Within a context of risk mitigation, what role can clearing and settlement infrastructure play? Much more responsibility in this segment appears to reside with service providers here than elsewhere in Europe. Do you think that situation will continue or will it change, as ancillary institutions, such as the Børs developing these vital structures? TOR SYDNES: We will see a change, but it will take time. Certainly many investors would like new structures to evolve and this has been discussed for some time. I think that increasingly the end investor will provide the drive for this kind of development. OLIVER BERGER: Clearly, going forward we are going to have to differentiate between the roles of various institutions: who should and who does provide functions such as T2Securities? Who do they serve and who should they serve? Invariably, the introduction of new institutions will bring more competition as people utilise them directly, rather than through existing providers. Tor is right that change is being driven by investors who are clamouring for value services above and beyond core settlement systems. They are looking for performance measurement and they’re looking for risk mitigation, compliance and control; that in itself is having a targeted impact on counterparties. Certainly it will come, but it will come as part of a much wider picture; investors are looking for much more than a centralised clearing and settlement infrastructure.

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NIKLAS NYBERG: The introduction of CCP in the Nordic region, and specifically in Norway, is having a real impact on our services and the way in which we provide services to clients. It is a positive industry development, even though for us, the net effect is a reduction in revenues. However, from an investor perspective, prices are coming down and counterparty risk is mitigated. As for initiatives such as T2S that Oliver mentioned, it will enable institutions to gain direct access to the new structures and thereby bring down execution costs, which is of benefit. I also think T2S will encourage a panEuropean as opposed to regional trading infrastructure. It will increasingly enable issues to be addressed at a continental rather than regional level; market battlegrounds will no longer be defined by the Nordic region, or by individual countries such as Sweden or Germany; they will be Europewide and that will exert even more downward pressure on costs. Again, this can only benefit the end investor. OLIVER BERGER: In this regard, it’s just an extension to the transparency which we are seeing elsewhere in the investment process, not only for services but also for marketing infrastructure, which, in turn, will create lower prices. NIKLAS NYBERG, global head of GTS Financial Institutions, SEB

THE IMPACT OF EUROPEAN REGULATION

FRANCESCA CARNEVALE: Do you think developments in the wider European market harbour significant structural change also for the Norwegian market? Do you think that the plethora of directives issued from the European Commission will actually strengthen the role of the custodian providers? Some banks appear to have embraced the opportunities provided by directives such as MiFID; offering a much broader array of services and product, and have become stronger as a result. Do you see the Nordic banks and the organisations operating in the Nordic environment really taking advantage of that as well, Niklas? NIKLAS NYBERG: The new landscape in this MiFID environment has become actually more complex than it was before. Instruments can be traded on several exchanges, and you have to be online all the time to get best execution. Many client institutions simply do not have the capacity, or even the confidence to fulfil these changing requirements. Therefore, they need providers that will deliver the solutions, technology, infrastructure and competence so that asset managers or investors can execute their strategies in addition to more traditional asset servicing capabilities. As to the increasing power of banks in this changing landscape, if as a bank you can provide both pre-trade and post-trade capabilities, of course your position will be strengthened; indeed, it is vital for a bank to provide these in a new landscape. So, you may be right. JORGEN HJEMDAL: If anything, it benefits the larger players, as complying with all these regulations takes a lot of resources. From an asset manager’s point of view, I would say that we have a lot of the systems in place now to really benefit from these market changes. Even so, I saw an article in a financial magazine recently about MiFID and best execution, where the magazine had polled larger, local

investors about their responses to MiFID. I was surprised that so few had not risen to the challenges. For us, it has been an area of interest and focus for some considerable time. So perhaps it is the larger players, such as us, that will benefit the most from developments elsewhere in Europe. OLIVER BERGER: Initiatives such as the drive for best execution definitely benefit the mutual funds distributed to the public. A lot more transparency has been created in that space over the last five years. However, institutional investors have always played a slightly different game compared with the smaller, niche investors. What I mean is that they already demand a very sophisticated approach to transparency and controls, fee performance and market structures. The developments of the last four to five years have, in any case, been in line with their day to day requirements. The change is across the board: the times of asset manager, broker, custodian, everything in one place is now a cracked nut. Choice and independence of action is out there right now. While everyone clamours for a holistic approach in terms of reporting, everyone now has their own space and expertise. That is the way that larger investors now buy services: picking and choosing according to expertise and price. FRANCESCA CARNEVALE: Does the Nordic region always comply with developments in the rest of Europe? Do you think the changes in the wider European market have been more to the benefit of service provider or the client? TOR SYDNES: I think the benefits have accrued much more obviously to the service provider. As the market demands transparency and sophistication, asset managers can no longer go it alone. They need a much broader service set, for instance, accurate and independent reporting if they are to maintain their professional integrity. So in that respect, the immediate beneficiary is the service provider who can sell many more products to their clients.

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BEST PRACTICE IN COMPLEX MARKETS

FRANCESCA CARNEVALE: Investment strategies have become more internationally focused, more complex and multilayered. How have you each responded to this complexity? NIKLAS NYBERG: Mid-sized institutions are demanding a wider range of services from us as a service provider, to mitigate these risks. For example, we can see that the need for collateral enhancement services has increased during the past two years. Clients are increasingly moving into alternative asset classes and alternative strategies, and combining them in a single portfolio, which requires us to deliver a broader and more sophisticated range of services. From our perspective, therefore, we can see that the need for a holistic, integrated approach to service delivery for mid-sized institutions. OLIVER BERGER: Custodians today provide what I would call investment control infrastructure and it’s a very important role. It involves looking at the exact requirements of the investor; the investment guidelines and the controls and checks in place on the value of the risk. Equally it involves attribution analysis in terms of performance of their managers. It is a broad array of services. We are very focused and customised in our response to these needs, covering the investor end to end.

SECURITIES LENDING

FRANCESCA CARNEVALE: Is securities lending regarded as an integral part of the value chain or, in this post-crisis period, as a risk mitigation strategy? NIKLAS NYBERG: Securities lending did decrease during the crisis, but still it is an important component in the total delivery package, and it is a vital part of our clients’business. OLIVER BERGER: In securities lending, the approach of the investor is fundamental. Securities lending can be many things: you can look at agent programmes; you can look at principal programmes, or auctions. Even so, the risk comes with how you reinvest your cash collateral, if you accept cash as collateral. The question for clients is: how much risk are you willing to take? As a custodian running a securities lending programme, we point out risks and we manage counterparties. At the end of the day however, the client sets its own agenda, when it comes to how much risk he wants to accept in terms of investing cash collateral. There is also the other extreme, where the client doesn’t want to accept any cash collateral and just accepts government securities as collateral, which then together with our indemnified lending programme, where JP Morgan steps in, if a broker goes into default, provides a high degree of safety. In either case, however, the custodian is today I think fundamental to both the investor and the way in which he manages risk. TOM FEARNLEY: Properly executed, securities lending should enhance returns, and it thus fits into enhanced indexing as well as more active management strategies. But it requires proper risk management of the collateral. OLIVER BERGER: The cash reinvestment strategy is really your cash strategy, but you shouldn’t reinvest your cash and securities lending in any different way than you invest your normal cash.

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TOR SYDNES: Tom, I totally agree with what you’re saying and it sounds very natural, what you say, but we have seen up to 2008, late 2008, that some investors did invest their cash differently from their actual strategy, and that was a mistake. It was a time of easy money or cheap money from securities lending. It was easy to invest in assets that were quite different to your basic strategy and some investors went in enthusiastically as it gave them the opportunity to overcome any performance backlog. It is vastly different now and I think the market has learned a lot from the mistakes of the previous boom. OLIVER BERGER: It wasn’t any different than some people invested in Triple-A rated money market funds, and these funds had all sorts of leverage in them.

THE IMPACT OF UCITS

FRANCESCA CARNEVALE: What advantages do you feel that the service side has in facilitating your client’s desire to link into wider developments, such as UCITS? NIKLAS NYBERG: We believe that this will have a great impact on the market; not another big bang type of change, but significant nonetheless. Understanding and awareness of the potential for the new UCITs structure is very strong in the Nordic region. From a service provider’s perspective, it is also an interesting and exciting development. We have to take into account structural changes, as we see that many firms are considering consolidating their assets and favouring particular

TOR SYDNES, director, Gabler Wassum

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tax jurisdictions. We think that Luxembourg will benefit enormously in this regard and will be a very strong centre going forward. Ireland may also benefit. However, within the Nordic region, Finnish companies are less inclined to move their assets as other companies in the Nordics, as Finnish tax legislation is already favourable. In these instances, it is becoming more common to offer these clients outsourcing solutions. Such solutions will enable them to take advantage of new opportunities that will become available from next year, and to provide them with sound, pragmatic support on investment strategies, and legal advice in terms of the prospectus and how to construct their fund structures. JORGEN HJEMDAL: We also view Luxemburg as a very important platform for launching new products. Luxemburg is viewed as a domicile that offers a favourable regulatory environment. So in terms of the asset management businesses in Sweden and Norway, Luxembourg looks to offer a meaningful alternative. We are launching new Luxembourg-based funds in the market as we speak. OLIVER BERGER: From a custodian’s perspective, or a depo bank perspective, we follow a pan-European fund strategy. We span across Dublin, Luxemburg, Frankfurt, Zurich, so we’re trying to capture both the mutual fund side in the Nordic region as well as the institutional investor, who might have different needs, which might be driven from the pension fund side, which are looking at the potential of the UCITS platform. What we have in each of these locations is what we call a component manufacturing architecture; that is true for our traditional services, as well as any potential outsourcing or insourcing in this case. It’s really the pick and mix of different services. FRANCESCA CARNEVALE: Do you see a mass change in the geography of the asset management architecture across Europe, or do you think it will happen at the margins? NIKLAS NYBERG: At this stage, it is not clear what will happen, although we’re certain to see a change. As I mentioned, I’m quite certain that many will take advantage of Luxembourg as a base, and Ireland as well. On the other hand, looking at different reports, it is clear that some companies believe that other factors are more important, such as proximity to the holding company, and possibly proximity to their investors. So, while individual companies’ behaviour will depend on their individual strategy, I’m certain that we will see movement towards Luxembourg and/or Ireland. TOR SYDNES: I agree with what’s said here, but from our perspective, we start looking at the good manager, and then we look at what strategy we would like that manager to manage, and then we come down to the product. We look at what kind of product it is and where the product is located. What kind of hub is Luxemburg, or Dublin, or maybe Norwegian domestic or Swedish domestic, and what are their relative benefits? We like to see product being registered at one of those places. Earlier we were more open to products on platforms, in the Channel Islands or elsewhere. We are not as fond of those structures anymore; we prefer to look at the larger jurisdictions such

TOM FEARNLEY, investment director, Norwegian Ministry of Finance

as Luxemburg, Ireland or domestic markets in the Nordic region. I am not thinking of the Channel Islands specifically. I am more talking about offshore markets in general. It has to do with transparency. FRANCESCA CARNEVALE: What do our asset management participants think of the potential of UCITS structures in terms of your own long-term investment outlook? TOM FEARNLEY: From my perspective, UCITS is just one way of improving the risk understanding among investors. One of the reasons that the financial crisis came about was a lack of transparency and risk awareness, so this is a step in the right direction, towards more transparency. FRANCESCA CARNEVALE: Do you think the application of new fund structures will encourage a more sophisticated, multi-regional, multi-asset approach to investing by Nordic asset management firms? JORGEN HJEMDAL: In terms of Asia, we have had an operation in Hong Kong for 15 years, and also India, so we are continuing to expand that part of our business. I do not see us moving into new and exotic products or regions. I would caution: stick to what you’re good at, and try and do what you say and do not over-complicate the investment strategy; don’t try to be too fancy or too complex. Ultimately, the investor is looking for predictability, and managing and meeting the client’s expectations is what it’s all about. FRANCESCA CARNEVALE: What would you say you are good at? JORGEN HJEMDAL: Being a large Norwegian institution, with also a large presence in Sweden, we have expertise in the Nordic markets. We also have strong teams on Asia and some global sectors, such as energy, transportation, technology and healthcare. TOR SYDNES: Would you like to be more adventurous if you are distributing funds to clients from abroad, than you are in your core business? Are you then able to bring in more exciting funds to the Norwegian investors?

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JORGEN HJEMDAL: I don’t think so. Whatever we do, we need to have a clear understanding of where we come from, what we’re good at and what our clients expect from us. In hindsight, there were product launches that did not create customer value. The industry needs to be a lot more disciplined going forward. FRANCESCA CARNEVALE: How can the asset service providers help in this regard? OLIVER BERGER: The pricing side has become a massive component to this whole drive to transparency. It covers either classical cash investments like on the equity side, and bonds. When you talk about bonds, you can talk about domestic bonds which don’t get priced automatically by the large providers. So, there you are looking at evaluating pricing through yield curves, or you’re looking at ABS or any asset backed kind of securities which are highly complex in the way they are structured. We can take them into components, value the components and also not only do the valuation, based on a mathematical formula and based on the term sheet, but also we will test in the market, if there is demand for these securities, just to get away from a purely theoretical price, to a more market tested price. At the end of the day, you will only get for securities what the market pays when you try to sell them.

VALUE-ADD SERVICES: TRANSITION MANAGEMENT

NIKLAS NYBERG: This is part of our overall value proposition, but in general, it is a separate offering, depending on the client and their specific needs. OLIVER BERGER: From a JP Morgan perspective it is part of our added value suite of products. The product is both focused on local market requirements and scale of the overall programme. We have distinct programme management to manage these sometimes very complex trades and support the execution as part of our trading business. FRANCESCA CARNEVALE: Tor, transition management is a complex, very highly specialised service. How far does your role as an aiding consultant help in that process? Do you help clients put together panels? Do you help them choose the best transition manager for their portfolios? TOR SYDNES: Normally, we don’t have a situation that requires a specific transition manager. We have had some situations over the years, but normally, today we have a rather stable client base, I’m afraid. We would like to have some new ones as well, but it’s been stable over some years now, and if you don’t change managers, you don’t do a large change at one time, so if you change from one fund to another, or from one fund to the other funds, etc., you change, then we are involved, and we try to keep risk exposure, questions, etc., we have to analyse and to take care of that. JORGEN HJEMDAL: We don’t use transition managers as such, as a component. Of course, we come across the clients using these, and normally these issues are resolved in a very orderly fashion.

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FRANCESCA CARNEVALE: Niklas, in this, in offering the transition services, do you find more of your clients use a panel of transition managers? Or, do they work closely with you in choosing a good transition manager for them? NIKLAS NYBERG: Clients typically use different transition managers. They often treat these events as isolated activities, so even though they may use one custodian, it is not always certain that they will use that custodian for the transition. They can choose someone else, often depending on price and execution strategy, so in that regard, many clients see transition management as an isolated product, although the specific requirements differ from client to client.

LOOKING TO THE FUTURE

OLIVER BERGER: Even though we are a global bank and work to a global rather than regional dynamic, we are now drilling down more effectively in both regional and domestic markets. That means we really have to comply with all the local requirements, and that’s exactly where we want to be. We want to be a local bank at the client interface. Even so, the global element comes increasingly into play as we also have to cater for all of the international developments and requirements that our clients and/or the regulators have. That includes initiatives such as T2S and developments in Luxembourg and Dublin. The challenge is really as a business to ensure that we have appropriate resources and investments to really cater for the chosen markets which we have entered; that we remain a competitive provider in these markets, and that we come across as local, for example, a Norwegian bank with a global heritage. That’s actually a big challenge and that also will show us the way of how much more we can capture local markets and going into tier two and tier three on these markets. Cost pressures naturally play a role in an ever-evolving market, which is looking for more efficiency, but that is part of the asset services core competency. TOR SYDNES: I think the key question is where should you be invested over the next five, ten years? We are looking at a difficult picture, where the risks in equity markets remain high, the interest rate might go up, and real estate is still not very attractive. So, the question is where is the opportunity? Moreover, how will markets evolve going forward? We still see a need for diversification, and we are not very keen on the newer kind of instruments, alternative or more adventurous investments. Caution is paramount. TOM FEARNLEY: The risk and return outlook is a key issue, and not only medium term or one year ahead, but really long term, which reflects our very long investment horizon. We are reviewing and communicating our longterm risk and return expectations every year. We do that in our annual reports to the Storting [Norwegian parliament] on the management of the Government Pension Fund. Diversification, state of the art asset management and risk control, best practice fund governance, appropriate and effective ethical guidelines and an integrated ESG approach are what we are aiming for.

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FRANCESCA CARNEVALE: When you say further diversification, do you mean geographical diversification or asset diversification? TOM FEARNLEY: We are already diversified geographically, so I am talking mainly about asset diversification here. Our decision to invest in real estate is one step in that direction. JORGEN HJEMDAL: Our main concern going forward is how to stay competitive in a very competitive environment, and that means attracting and retaining top talent. It means controlling costs, and also at the same time being able to invest in new areas of growth. It means finding a balance between launching new products while making sure that sufficient resources are allocated to our existing product range. Of course, then the biggest concern is how will saving patterns and markets develop, going forward. NIKLAS NYBERG: I agree with Jorgen that the challenge going forward is the need to stay competitive. We have very distinguished and well-respected institutions based in the Nordic region, we have chosen to have an outspoken standalone strategy in the investor services business, and we have a very strong position here. Our senior management and our board have a good understanding of this business; this is a particular advantage and less often the case with our competitors. So I’d say our task is to continue to be very close to our clients and to develop an in-depth understanding of their underlying business needs. In combination with that, we have to be agile and rapid in anticipating and responding to the needs of our clients, and to continue to invest in both technology and competence. FRANCESCA CARNEVALE: Do you think that the investment requirement going forward will provide a natural barrier to entry to new competition? Or, do you see new providers coming into play. Or, perhaps, do you think that the drive for global multi-asset platforms will concentrate the business in the hands of a few service providers? OLIVER BERGER: You have to differentiate: there are niche providers, regional providers and global providers. In terms of global providers, the investment into technology is critical and we’re talking hundreds of millions every year, not only to maintain but also to develop systems. If the global providers, such as JP Morgan, who want to play on a world-wide scale and be local at the same time, then that is an absolute critical piece of the business, and cutting back on technology investment for a year, that is just something you can’t afford to do. A consequence of that is that, in my view, niche or regional providers will find it that more difficult to cater for some of these requirements, depending on how costly these system developments are. NIKLAS NYBERG: From a macro perspective, the underlying business has been growing for many years, which should attract new providers; however, the barriers to entry are very high in this business. You need to have significant access to funding to invest in technology and competence, and a very sophisticated infrastructure in place, which takes a lot of upfront investment. Consequently, even though the market as a whole is growing, I don’t envisage that new providers will emerge in

JORGEN HJEMDAL, executive director, DNB Nor Asset Management:

this region, particularly generalist service providers. There may be some niche market entrants, but I don’t think that we will see a great deal in terms of new competition. OLIVER BERGER: We have seen already that some providers have exited, sold the business. Others are seeking co-operation with larger players, so consolidation is also a growing trend in the asset servicing industry, which in my view, will continue. FRANCESCA CARNEVALE: On the asset management side: do you want to partner with people on an eternal, long-term basis, to expand your global reach, or do you feel that it’s horses for courses and that you, Jorgen, when you’re in India, you will deal with the local firms, and when you’re in Norway, you will deal with local firms? JORGEN HJEMDAL: As of today, we use our own bank in Norway and Sweden. Globally however, we use different providers. We use a local provider in Luxemburg, for example, and I don’t see that changing any time soon. Finding strong partners in different markets, and making them all work together in a good way has proven to be a good strategy so far. FRANCESCA CARNEVALE: Tor, you get the last word. In balancing the needs, the changing needs of asset beneficial owners and the asset management industry, are you with this local focus, or are you increasingly tending towards the advantages of the global product, in terms of asset service provision? TOR SYDNES: From an asset owner’s perspective, it’s not important to have one set, because you need to have the overview or a total picture of your assets. From the investor’s side, it’s always normal to have one provider. He might subcontract with other providers in the local markets, but in the end, you have one provider servicing you with the total picture of your investments, and that hasn’t changed. In addition, as the markets become more complex, it’s more important to work with solid and recognisable names. You need to encourage a flight to quality. They have to be solid, to be trustworthy and many of our clients are public clients, funds, public pension funds, etc. If they list names in their annual reports, the names of the service providers and asset managers should be known names.

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The prime-brokerage (PB) model that developed in the wake of the global credit crisis continues to gain traction, as funds seek greater choice and a wider range of services. Over the coming months we will look in detail at ways in which the relationship between funds and their prime brokers have changed. In this essay, David Simons looks at the reasons why custodian providers have been keen to muscle in on traditional preserves of the overall prime broking service offering. Can they really keep pace with the changing and diverse investment approaches of hedge funds in the same way that traditional prime brokers have done? In this dynamic landscape which firms have the wherewithal to stay in step as the PB landscape rapidly evolves? From Boston, Dave Simons reports.

T IS DIFFICULT to fathom the business of prime broking as it existed only a few short years ago. The undoing of credit markets in 2008 touched off a manic flight-to-quality among hedge funds which feared losing control of their assets should their prime brokerage firms hit the wall.“Counterparty risk”quickly became the law of the land as money subsequently flooded to custodians, the perceived leading safe haven for hedge-fund capital. Having gained a foothold in the PB sector, custodians weren’t about to cede an inch. Rather than being a temporary measure, custody providers have remained in the prime broking space and have since expanded their product range. In addition to offering an alternative to a service once traditionally provided by investment banks with supreme trading expertise, custodians also act as an important intermediary in the market. Whereas a single prime broker (or perhaps two at the most) was once all that was required, hedge funds now have upwards of four or five providers to choose from. Not only does this give hedge funds access to numerous areas of expertise, keeping their eggs in multiple baskets ensures they can spread the potential risk. The desire to streamline the trade lifecycle remains a major incentive for prime-services and third-party technology providers alike. The upward trend in algo-based

PRIME BROKING: MORE CHOICE, LESS RISK

THE CUSTODIAN ELEMENT

Photograph Arete © Dreamstime.com, supplied May 2010.

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trading activity, for example, has only increased the need for smart-order routing and other advanced mechanisms, compelling brokers to refine their methods of execution in order to guarantee greater transparency and speed to market. This best-of-breed approach to prime broking is, needless to say, in its nascent phase. Investment banks continue to pride themselves on their ability to access any market and any asset class. However, due to their increased access to multiple brokers, larger funds have begun to carefully consider the potential benefits of expanded asset-class offerings (particularly in the exotic emerging markets, where local expertise is a fundamental requirement). Add to this mix the smaller, independent players, who have seen their own market share rise amongst sub-$500m funds that have been shut out by the market’s largest players. As start-up funds look to soft launch and work for a year to amass a track record, “mini-prime” players are attempting to lure these newbies with lower fees and a boutique-like feel.

Pre-crisis model The prime-brokerage model that developed in the wake of the global-credit meltdown continues to gain traction. “Back then, enormous sections of the market were migrating towards what they considered to be the safest of credit havens,” says Brian Ruane, chief executive officer of Alternative Investment Services (AIS) for BNY Mellon. “If that continues to be one of the leading prerogatives, then, as a major custody player, we win. We do see that remaining a very strong driver.” Firms that formerly didn’t have the time or the inclination to change their approach have since revisited their situation, and have begun to respond to input from investors as well as professional advisors as to the most prudent method of restructuring their business model. “Every two years or so there is usually some element of concern that crops up within the markets and becomes a key driver for risk mitigation,”says Ruane.“Right now it is the impact of Greece, which is why there are a lot of hedge funds re-examining exposures to that particular situation. So it really seems like this will be an ongoing evolution for the prime-brokerage field.” Though currently in the vicinity of $145bn in prime custody assets under management, BNY Mellon believes there is still plenty of room to move. “Our most recent quarter saw significant growth, which we feel is reflective of these ongoing concerns in sovereign-credit and related issues,” says Ruane. “So it is very much a reminder that there continues to be risk out there—and if you have the ability to combine the strongest of counterparties within a firm that can mobilise and report on collateral while avoiding the potential for conflicted interests that can occur with a full-scale prime broker, that’s a very good thing.” Lines have been blurred significantly in the years since the Bear Stearns blow-up. Once the exclusive domain of the major prime-brokerages; the ability to service corporate-actions contracts is now a standard offering among prime-custody players.“The old concerns over the

Daniel Simpson, chief executive officer of Cadis, a London-based data management provider for the buy side. Simpson sees even the smallest players using at least two brokerages, and upwards of four or five for the largest hedge-fund clients. Despite the many advantages, the multi-prime method has in fact created a whole new set of operational challenges for clients. Photograph kindly supplied by Cadis, May 2010.

ability to mobilise collateral rapidly have evaporated,” says Ruane. “Today, firms feel that they have the flexibility to move within their various prime-brokerage relationships and respond to their clients needs to have assets in safekeeping whenever they are not being utilised within the markets. Those attributes have certainly helped prime brokers win over new business during recent times.” Of course, having the playing field considerably leveled by the arrival of the multi-prime model has been perhaps the most notable part of the PB story.“Being able to quickly and efficiently distribute collateral between a number of different prime brokers has made business much less limiting for hedge-fund managers,”says Ruane. Catering to the needs of small- to medium-sized hedge funds are companies such as NorthPoint Trading Partners, the Atlanta-based boutique prime-brokerage business recently acquired by New York’s financial-technology solutions provider ConvergEx Group. The new partnership allows NorthPoint to take advantage of ConvergEx’s customisable, global-servicing capabilities in order to expand its integrated prime-services program, which include such offerings as advanced algorithmic-trading strategies and derivative execution-management technologies. “Our niche is the type of client that feel as though they wouldn’t get the same number of services at the big bulgebrackets, whether it is due to their size or that they simply would like to outsource a greater portion of their infrastructure,”says Douglas Nelson, chief executive officer of NorthPoint Trading Partners.

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That client list has grown considerably over the past several years, particularly as bulge-brackets continued to streamline by dropping accounts that weren’t quite big enough or didn’t otherwise fit into their leaner business model, in the process creating a wealth of opportunity for so-called “mini-primes.” Nelson says that the current environment continues to favour those integrated prime brokerages that can offer multiple clearing options in combination with boutique back-office solutions. “I think these kinds of providers have really dominated the landscape over the last three or four years—that is where most of the gains in market share have taken place.” In many ways the market has already outgrown the mini-prime model—today, clients not only want a boutique-style feel, they are also demanding more robust and far-reaching service offerings than companies that are still stuck in mini-prime mode are able or willing to offer.“I think you can only achieve that level of service by partnering with the kind of company that has the existing resources to make it financially feasible. The integrated approach makes a company like ours a very viable second or third prime-brokerage option for funds that use a bulgebracket for a majority of their business, but want to diversify their custody as well,”adds Nelson. Michael DeJarnette, president of NorthPoint, says the company’s main attribute is acting as an aggregator for clients who otherwise might not be able to afford these kinds of topshelf prime services. “The ConvergEx acquisition essentially added much more depth to our basis business proposition. Compared to just a few years ago, it has become extremely difficult for much smaller, independent firms to stay in step, particularly when you consider the resources that are needed to successfully service your clients.”

Multiple providers Using multiple brokerages has become the norm rather than the exception, says Daniel Simpson, chief executive officer of Cadis, a London-based data management provider for the buy side. Simpson sees even the smallest players using at least two brokerages, and upwards of four or five for the largest hedge-fund clients. Despite the many advantages, the multi-prime method has in fact created a whole new set of operational challenges for clients.“A lot of the funds we have worked with have had their back-office accounting systems hard-wired into a single prime broker, and perhaps also a fund administrator. Then along comes a second prime broker, who begins sending files that are in a completely different format, some for margin calls, others for trades and positions, and so forth. So now the fund has to deal with all of these files, and clock is ticking. Given this situation, you can easily see how the level of complexity can increase dramatically.” Increased mergers-and-acquisitions activity has had a similar impact, says Simpson. Hence, companies such as Cadis are frequently called upon to help integrate the acquired company’s systems into the acquiring company’s back-office infrastructure.“In this kind of scenario we really

FTSE GLOBAL MARKETS • JUNE 2010

Douglas Nelson, chief executive officer of NorthPoint Trading Partners. Nelson says that the current environment continues to favour those integrated prime brokerages that can offer multiple clearing options in combination with boutique back-office solutions.“I think these kinds of providers have really dominated the landscape over the last three or four years—that is where most of the gains in market share have taken place.” Photograph kindly supplied by NorthPoint Trading Partners, May 2010.

become more of an operational dashboard,”says Simpson. “We will take in all of the files from the external counterparties, reconcile them, and also put up any brakes and exceptions as needed.” With the market currently flooded with providers, a period of consolidation seems inevitable. Therefore, how does one properly distinguish oneself in order to rise above the fray? For starters, speedy implementation, says Simpson.“When it comes to IT, hedge funds have a particularly short attention span. They just don’t like projects that go on for months and months, you really have to get the job done over a much shorter period of time. Compared to our competitors who are used to installing sell-side platforms that might take years to finalize, we can provide a hedge fund with a completed installation within seven to eight weeks. So that really has become one of the cornerstones of our operation—getting our clients up and running that much faster.”For those who do not mind having their data exist outside of the firewall, Cadis offers a software-as-a-service solution (SaaS), using the client’s pre-existing choice of brokers and back-office systems. This approach has the potential to cut the time-tomarket nearly in half, says Simpson. Additionally, Cadis keeps a sharp eye on best-practice, and offers pre-configured plug-ins to trade-cycle solutions providers such as Omgeo and DTCC, and additionally allows clients to directly link into all major primes and administrators. “Companies that feel that investments in technology in the current climate are counterintuitive need only calculate the true cost of operational risks involved in

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PRIME BROKING: MORE CHOICE, LESS RISK

order to understand the profits at stake,”adds Simpson.“With the right processes in place, we believe that many firms will be able to see immediate benefits to the bottom line.” Northern Trust has seen a continued flight to quality, as managers seek rock-solid financial partners to custody their assets, says Peter Cherecwich, chief operating officer for corporate and institutional services at Northern Trust. Investment managers and institutional investors are much more focused on counterparty risk as a result of the financial crisis, which is helping to fuel interest in true custody and safekeeping, says Cherecwich.“In addition, we offer fully integrated, multi-custodian reporting analytics and risk data, so the manager can have a better view of performance and risk across their portfolios. So many of the managers that come to us for custody subsequently find significant additional value in our collateral management, independent valuation, FX, cash management, and global middle-office platform.” Last fall, Northern Trust entered into an agreement with Merlin Securities, a prime-brokerage services and technology provider for hedge funds and managed account platforms. The alliance gives Merlin’s prime-brokerage clients fully integrated access to Northern Trust’s global custody and administration services.“It is indicative of how prime brokers in the U.S. as well as Europe are trying to differentiate themselves by partnering with Northern Trust in an effort to provide custody as an integrated part of their service to investors.” E

Lines have been blurred significantly in the years since the Bear Stearns blow-up. Once the exclusive domain of the major prime-brokerages; the ability to service corporate-actions contracts is now a standard offering among prime-custody players. “The old concerns over the ability to mobilise collateral rapidly have evaporated,” says BNY Mellon’s Ruane.

Responding to increased demand for hybridised primebrokerage and securities services, last fall JP Morgan launched its Prime-Custody Solutions Group, responsible for handling the company’s combined integrated-prime and custody services platform. Like many of her peers, managing director Devon George-Eghdami believes current market trends are compelling fund managers to gravitate towards brokerages that can provide a separate safe haven for assets while also delivering added efficiency through the likes of improved execution and consolidated reporting services. Prospective clients include both long-only hedge funds seeking to custody certain assets, as well as traditional asset managers using long/short strategies that require the financing capability of a prime broker, says George-Edgdami.

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“The main obstacle to increased M&A activity is the valuation gap [between buyers and sellers], says Giuseppe Monarchi, head of mergers and acquisitions, EMEA, in the investment banking department of Credit Suisse. “A further strengthening of the equity markets could well help close this gap and lead to the material pick up in M&A activity that everyone is expecting.” If that is a somewhat less than glowing appraisal of the possibility of 2010 being the year that M&A stages a revival, then the good news is that it is not one shared by everyone. Some industry participants admit to being surprised by the speed with which deal making returned in 2009 and are bullish about the likelihood that it will continue to accelerate into 2010. Private equity is about to re-awake, reports Paul Whitfield T HAS BEEN a barren couple of years for European merger and acquisition (M&A) activity. The flood of deal-making that characterised much of the last decade, and which reached a high-water mark near the end of 2007, was drained by the banking crisis of 2008 and despite nascent signs of life in late 2009 has remained subdued. Is 2010 going to be the year that European M&A makes its comeback? The signals are mixed, as are the opinions of the experts, and are likely to remain so for much of the year. “If you compare the year to date volumes to the same period last year, we are pretty much in the same place, so there has been no clear evidence of a pick up,”says Giuseppe Monarchi, head of mergers and acquisitions, EMEA, in the investment banking department of Credit Suisse. “January was busy, February was relatively quiet, there was a pick up in March then April was relatively slow again.” That inconsistency has its roots in conflicting M&A drivers and ongoing uncertainty. On the one hand there are still bargains to be had; valuation multiples of potential targets remain appealing, say bankers. However, there remains a lack of visibility on corporate earnings and equity valuations. Fears over the future of the banking sector and the global economy, both of which dominated 2008 and early 2009, have not completely dissipated either. Greek sovereign debt woes and the possibility of wider contagion in markets from Spain to the UK, though to a lesser extent,

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M&A PICK-UP TO RELAUNCH PE ACTIVITY

MAKING A

Nicolas de Nazelle, chief operating officer and managing partner at Paris-based Triago one of the world’s largest global fund placement agencies.“Deals don’t happen when investors don’t feel they have visibility into the future,” he says.“They are beginning to happen now because buyers are able to project themselves into the future but there is still caution.” Photo kindly supplied by Triago, May 2010.

mean there is still widespread caution with regards to the sustainability of Europe’s nascent economic recovery. “The main obstacle to increased M&A activity is the valuation gap [between buyers and sellers], says Monarchi. “During the last couple of years, it was about financing and the valuation gap; today, financing is much less of an issue but a lot of the valuation gap remains. A further strengthening of the equity markets could well help close this gap and lead to the material pick up in M&A activity that everyone is expecting.”

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If that is a somewhat less than glowing appraisal of the possibility of 2010 being the year that M&A stages a revival, then the good news is that it is not one shared by everyone. Some industry participants admit to being surprised by the speed with which deal making returned in 2009 and are bullish about the likelihood that it will continue to accelerate into 2010. “During the second half of 2009 we saw an upturn in M&A activity in Europe as the pent-up demand of the previous year was unleashed,”says Michal Berkner, a corporate partner in the Londonoffice of Skadden, Arps, Slate, Meagher & Flom, a law firm that specialises in M&A. “This activity has continued in the first quarter of 2010 as loosening credit markets and the stockpiling of cash has given strategic buyers the ability to consider offering cash as part of the consideration.” The accumulation of cash, hoarded during the deal-making hiatus of 2008 and early 2009, has meant many would-be buyers have found themselves little hampered by the ongoing anaemic flow of bank lending. It is little surprise to see companies in business with high levels of cash generation, such as miners, utilities and pharmaceuticals, cutting some of Europe’s biggest deals in 2010. Mining, energy and pharmaceuticals are also examples of sectors in which deals have been driven by consolidation and where larger players have been able to take advantage of their relative strength to pick off smaller rivals. “Those companies that have not been able to right themselves following the economic downturn may find themselves targets,”says Berkner. “In contrast, those companies that have been able to navigate the adverse conditions will see increasing acquisition opportunities.” Consolidation-type deals also have the inherent advantage of

Michal Berkner, a corporate partner in the Londonoffice of Skadden, Arps, Slate, Meagher & Flom, a law firm that specialises in M&A.“This activity has continued in the first quarter of 2010 as loosening credit markets and the stockpiling of cash has given strategic buyers the ability to consider offering cash as part of the consideration.” Photo kindly supplied by Skadden, Arps, Slate, Meagher & Flom, May 2010.

Giuseppe Monarchi, head of mergers and acquisitions, EMEA, in the investment banking department of Credit Suisse.“Private equity activity has started to come back; clearly not yet at the historic levels, but so far this year private equity has accounted for a much greater percentage of deal volumes versus the same period in 2009,” says Monarchi. Photo kindly supplied by Credit Suisse, May 2010.

industrial logic, which in a market that remains sceptical of acquisition for the sake of it, has the advantage of strong strategic rationale. The limited availability, at least compared to recent history, of bank financing for M&A is likely to be a feature for much of the year. Many lenders’ attention remains focused on rebuilding capital bases that were depleted by the events of 2008 and in expectation of the need to boost reserves to comply with Basel III regulations that will come into force in 2012. The notable absence of large private equity deals, which characterised the pre-financial crisis M&A market, is a symptom of the continued reluctance of banks to underwrite riskier deals with large loans. “Private equity activity has started to come back; clearly not yet at the historic levels, but so far this year private equity has accounted for a much greater percentage of deal volumes versus the same period in 2009,” says Monarchi. Given that the PE market was in virtual lock-down this time last year, that is not as positive as it might first sound. Also, most commentators agree that the halcyon days of private equity, when the likes of TPG and Blackstone, backed by mammoth syndicated loans, wracked up multi-billion dollar deals, are gone. “Financing is available again for leveraged buyouts, and for increasingly larger deals, but certainly not yet for the megadeals we saw before the financial crisis started,”says Monarchi. If there is understandable caution regarding the renaissance of bank lending, some commentators are far more bullish. Indeed there is, according to some, very good reason to believe that the banks may once again lead a credit-fed M&A feast over the rest of the year. “The banks are eager to lend again,” said Nicolas de Nazelle, chief operating officer and

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managing Top five announced partner at Paris-based deals of the Triago, yearone to end-March of the world’s 2010toward the last quarter of 2010 or Q1 2011, meaning that a Announced

Target

Sector

Bidder

Value ($bn)

Jan. 4 Jan. 5 Jan. 20 Mar. 18 Mar. 15

Alcon NK Russneft Areva T&D Ratiopharm Tommy Hilfiger

Pharma Energy/Mining Energy/Engineering Pharma Consumer

Novartis M. Gutseriyev (private) Alstom/Schneider Teva Pharmaceutical Philips-Van Heusen

18.25 4.6 4.1 3.6 2.2

Source: Merger Market

largest global fund placement agencies, noting conversations he has had with investors concerned over the possibility of a new bank lending bubble.“Banks have to do business after the long hiatus—they need the revenues, the margins on lending have become more attractive [making loans more attractive] and they need to restock their collateralised loan obligations (CLOs), which means making loans. No matter what the view on banks’ participation in M&A, there is consensus that funding, which dried up so spectacularly and devastatingly in 2008, is available again for higher quality deals. Nowhere is that more evident than in a renewed appetite for stock. The corporate bond market has proven robust, particularly at the lower risk end, is likely to remain a largely untapped but substantive potential source of funds for dealmaking for the rest of the year, according to commentators. The bond market has been“supported by strong demand even if there has been a lack of offers on the part of issuers,” according to a note published in May by analysts at the European private bank Pictet & Cie. At the same time investors have also shown a willingness to back equity market capital raising, though Berkner notes that the initial public offerings (IPO) market, which is all important for private equity, is likely to remain unstable. If the ability to raise funds is unlikely to be a limiting factor for higher-quality, large companies, the picture is not so clear for European mid-market companies. The credit bubble of pre-2008 had fuelled a boom in midmarket deal making, much of which was driven by private equity funds which found they could rely on cheap debt to buy, refinance and then flip companies in rapid succession. “We will see higher quality deals,”says de Nazelle.“That means less leverage and investment in companies with good visibility of cash flow and earnings.” The revival, or otherwise, of private equity activity in the European M&A market is likely to turn on a couple of factors. Two of the most important of those will be the ability of the fund managers to both raise new capital and to exit their existing investments. The two are linked, explains de Nazelle: “There have been some profitable exits in recent months and that has meant the LP [limited partners who invest in private equity funds] community has become more positive about private equity prospects.” The return of acquisition activity amongst private equity funds is likely to be one of degrees rather than a rush. Fund raising amongst private equity firms has been on hold since the financial crisis and is yet to begin in earnest. The expectation is that the funds will begin fund raising again

FTSE GLOBAL MARKETS • JUNE 2010

return to“normal”M&A activity by private equity could still be some way off. Predicting the fate of M&A activity in Europe naturally comes with its share of uncertainty, not least because it is so closely pinned to the fate of the still fragile equity markets. “Deals don’t happen when investors don’t feel they have visibility into the future,” says de Nazelle. “They are beginning to happen now because buyers are able to project themselves into the future but there is still caution.” However, improving markets have not been an unqualified boon for all would-be acquirers. Targets have often proved reluctant to sanction deals that they claim are pegged to share prices that are still below fair value. “We are seeing intensification in the levels of hostile activity,”says Berkner. Would-be buyers have responded by using their own stock in deals, a trend that is likely to continue over the rest of the year, providing investors with the opportunity to benefit from strengthening equity markets. “There is an increasing willingness to use stock either alone or with cash as acquisition currency, with European buyers in particular more willing to register stock in the US,”says Berkner. No matter what the fate of the wider European M&A market, there are likely to be pockets of activities, while other sectors, which can be divided on the basis of both activity and geography, will remain moribund. “In the UK, as a result of the crisis, the banks have ended up holding companies [which broke loan agreements] that they are now looking to get off their books,” says de Nazelle. “This is going to have a particular impact on middle, smaller and turn around markets and could be a great source of deals.” De Nazelle compares that positive outlook for the UK market with the pressure on the Spanish market. He tips the Iberian peninsular to remain subdued over the rest of the year as it struggles with the fallout from the popping of its inflated real estate bubble and the recent downgrading of Spanish sovereign debt that has called local economic growth into question. . Credit Suisse also believes that the M&A market will be characterised by pockets of activity rather than a marketwide boom. “We see natural resources, energy and financial institutions as key sectors driving M&A activity in 2010,” says Monarchi.“Within the financial institutions space the pace of activity could pick up considerably later in the year once there is more clarity on the impact of new regulations [notably Basel III] on the bank’s capital requirements.”

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EUROPEAN TRADING STATISTICS

THE FIDESSA FRAGMENTATION INDEX (FFI) The Fidessa Fragmentation Index (FFI) was designed to provide the trading community with an accurate, unbiased measurement of the state of liquidity fragmentation across the order driven markets in Europe. Liquidity is fragmenting rapidly as new MTFs have unveiled a range of low-cost alternative trading platforms. It is essential for both the buy and the 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

Wks

Stock

Description

-3

DGE.L

DIAGEO ORD 28 101/108P

FTSE 100 Market Share by Venue FFI 3.15

RWD.L

ROBERT WISEMAN ORD 10P

3.15

-6

SPT.L

SPIRENT ORD 3 1/3P

3.08

-2

SRP.L

SERCO GRP. ORD 2P

3.07

-22

BAB.L

BABCOCK INTL ORD 60P

3.07

-40

ADN.L

ABDN.ASSET.MAN. ORD 10P

3.05

-4

PRU.L

PRUDENTIAL ORD 5P

3.01

-9

RR..L

ROLLS-ROYCE ORD 20P

3.01

VTG.L

VT GROUP ORD 5P

2.99

9 10

-27

QQ..L

QINETIQ ORD 1P

2.98

-12

ULVR.L

UNILEVER ORD 3 1/9P

2.95

PFG.L

PROVIDENT FIN. ORD 20 8/11P

2.91

-91

KAZ.L

KAZAKHMYS ORD 20P

2.88

-77

BNZL.L

BUNZL ORD 32 1/7P

2.87

-10

RSA.L

RSA INS. ORD 27.5P

2.86

-25

SSE.L

SCOT.&STH.ENRGY ORD 50P

2.86

-74

CPI.L

CAPITA GROUP ORD 2.066666P

2.85

-14

PSON.L

PEARSON ORD 25P

2.84

-5

SN..L

SMITH&NEPHEW ORD USD0.20

2.84

-51

JMAT.L

JOHNSON,MATTH. ORD #1

2.84

Venue LSE Chi-X BATS Turquoise NEURO

Week ending 23 April 2010 53.66% 28.47% 10.53% 4.57% 1.87%

Week ending 13 February 2009 74.02% 15.33% 2.33% 8.13% 0.19% Week ending April 2nd 2010

Fidessa Fragmentation Index 3.0

2.5

DAX

AEX

FTSE 100

CAC 40

2.0

1.5

1.0 Wks = Number of weeks in the top 20 over the last year. Week ending May 7th 2010

May

Jul

Sep

Nov

Jan

Mar

May

Jul

Sep

Nov

Jan

Mar

COMMENTARY By Steve Grob, Director of Strategy, Fidessa Since our last analysis NASDAQ OMX has confirmed that it would be closing NEURO, its London based MTF, at the end of May. The two tables above show how NEURO failed to gain any real traction whilst the market share of both Chi-X and BATS Europe has grown significantly (the market share of Turquoise has declined too, but this was driven more by uncertainty over its future given its impending acquisition by the London Stock Exchange). Irrespective of the fact that NEURO launched at the height (depth) of the credit crisis, it always seemed to struggle to develop a real brand identity of its own. Chi-X was first and Turquoise had nine mainstream investment banks providing it with seed liquidity through substantial market making commitments. BATS was also able to attract seed liquidity by using its low latency platform to appeal to the high frequency trading community. NEURO also offered a smart routing solution which served only to further confuse the market as to its true intentions – was it trying to become an established alternative venue or a smart broker instead? Despite the closure of NEURO the rate of fragmentation continues unabated. The chart above confirms this for the major European indices. In fact this shows that the rate of fragmentation in London is starting to accelerate away from other European indices. With this in mind, it will be interesting to see how the new order matching platform that the LSE is installing in its main market and newly acquired MTF (Turquoise) performs. The LSE has an aggressive rollout schedule for this technology and hopes to win back some of the HFT liquidity that is currently being sent to the MTF community and so the stakes have never been higher.

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Venue turnover in major stocks: Week ending May 7th 2010 (Europe only). (€) September

October

November

December

January

February

March

April

BER

11198473.01

8330897.81

12299869.07

12095979.32

20898115.71

20869157.28

BRG

622,622,788.02

559921470.34

362494501.08

274600248.26

485115578.84

664510070.30

1666606979.62

1484895339.18

BTE

22,569,010,036.90

27644041971.79

23573463734.99

19985719530.83

31150258386.00

34090404626.97

39193610957.69

42331175110.88

CIX

84,046,791,321.19

106697966298.67

90039160470.86

75306622295.52

110977110385.49

122737876719.05

127111917698.82

138532607106.82

CPH

7,147,826,212.47

7580961264.52

5706863159.57

5072932715.84

6756826918.10

6640400689.39

6626152423.75

6351788793.70

DUS

41944732.75

46475438.04

51353982.31

37525367.53

51415834.33

61803818.36

ENA

37,393,454,265.25

44333181213.17

32257175002.36

33792253379.23

37999836321.05

37880117626.68

38562044761.19

41692637528.93

ENB

10,086,003,222.10

8942068143.91

6366264426.48

5034992980.75

6008003591.11

6103299182.27

6358216747.07

5988625536.27

ENL

4,261,559,944.59

3485422128.23

2219360066.21

2138868773.27

3106855297.08

3554443804.88

3046713139.88

3727720527.61

ENO

482771.59

ENX

77,685,773,333.81

81861726196.95

65433199147.49

54355876074.24

66228400089.99

75614221011.97

74245298998.52

78769429844.17

GER

69,515,848,590.13

74419073211.90

60908552433.56

52843852540.00

67965895238.29

66776121605.01

72168449445.45

86885537242.87

HEL

10,016,921,672.01

11276385550.29

7451015808.21

6497813980.44

10339952621.77

10058819924.19

11752695115.83

12864278423.44

ISE

465074179.96

511570001.10

504915917.70

565269992.07

647314249.60

LSE

96,477,697,345.69

100753579612.36

88751421724.55

72845386108.12

95983836598.48

101916702001.83

105630799395.16

95825409974.98

MAD

47,318,951,034.98

56848573772.28

42670316078.54

39993245595.41

51066014495.96

52210894242.17

43945312316.04

52313552809.86

MIL

78,086,217,226.28

65232722070.55

58890245107.45

34112242363.73

48728657959.10

51711533820.17

52410490586.85

60842288388.66

NAE

65,079,038.29

188509367.45

286391174.03

559208778.00

1292687653.19

1825246025.41

2792572924.06

2501941839.46

NEU

4,413,980,819.97

6508249441.66

7449995153.50

5242206607.57

5816854755.80

5574111215.48

6232496049.93

6066724036.03

OSL

13,222,554,868.00

16695154952.77

13184181892.72

11253566686.23

16130924336.37

15871251841.26

13866926910.94

16588222829.50

STO

23,529,554,732.68

25928648845.75

20898321966.79

16954761461.22

22786344725.57

24086268094.82

24125076503.28

28675024013.03

TRQ

26,106,162,960.16

28005208583.96

22895687295.59

15953764952.03

20168098539.34

21028161702.73

20951128258.80

22059392685.24

VTX

37,499,163,419.18

39772295992.78

37198627753.77

31586888591.75

43636990148.75

46961823692.04

44673323239.12

41985051551.14

XIM

90362714.08

97403633.80

43510060.39

Index market share by venue: Week ending May 7th 2010 Primary

Alternative Venues Turquoise

Nasdaq OMX

23.28%

3.42%

0.33%

5.08%

20.33%

2.75%

0.24%

3.32%

65.04%

21.46%

3.20%

0.36%

4.56%

4.73%

71.58%

19.67%

2.76%

0.24%

4.48%

†

London

53.71%

31.13%

3.90%

1.01%

9.63%

London

62.81%

21.01%

7.07%

0.58%

7.73%

IBEX 35

Madrid

97.98%

1.83%

0.02%

†

FTSE MIB

Milan

79.68%

11.82%

1.77%

0.18%

6.27%

PSI 20

Lisbon

93.65%

3.59%

1.95%

0.14%

0.66%

Index

Venue

Chi-X

Amsterdam

63.17%

Brussels

48.46%

CAC 40

Paris

DAX

Xetra

FTSE 100 FTSE 250

AEX BEL 20

SMI

BATS

Burgundy

Amst.

Paris

Xetra

London

NYSE Arca

4.36%

24.66%

Stockholm

0.20%

0.05%

0.22%

0.44%

0.61%

0.81%

†

0.06%

†

0.05%

0.21%

†

SIX Swiss

71.88%

18.30%

2.91%

0.19%

6.33%

0.39%

Copenhagen

87.73%

9.16%

1.57%

0.08%

1.33%

0.04%

0.08%

OMX H25

Helsinki

73.18%

15.83%

3.05%

0.23%

5.91%

0.32%

0.03%

1.24%

0.04%

OMX S30

Stockholm

72.95%

16.78%

3.22%

0.15%

4.12%

2.74%

0.05%

Oslo

91.54%

4.02%

1.07%

0.04%

0.50%

0.03%

†

2.79%

Dublin

20.90%

0.62%

1.30%

76.87%

0.02%

OMX C20

OSLO OBX ISEQ

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

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

FTSE GLOBAL MARKETS • JUNE 2010

GM EDITORIAL 42.qxd:.

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Page 92

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 r-1

FTSE RAFI Emerging Index

Oc t-0

9 r-0 Ap

8 Oc t-0

r-0

7 Oc t-0

7 r-0 Ap

6 Oc t-0

r-0

5 Oc t-0

r-0

Index Level Rebased (30 April 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

2,747

252.02

8.1

9.9

40.3

3.4

2.34

FTSE World Index

USD

2,286

589.52

8.0

9.9

39.3

3.3

2.36

FTSE Developed Index

USD

1,997

234.22

7.9

9.7

38.1

3.4

2.36

FTSE All-World Indices

FTSE Emerging Index

USD

750

658.72

9.6

11.6

58.2

3.5

2.21

FTSE Advanced Emerging Index

USD

289

617.52

10.1

12.6

57.4

1.8

2.47

FTSE Secondary Emerging Index

USD

461

768.74

9.0

10.7

60.4

5.1

1.98

FTSE Global Equity Indices FTSE Global All Cap Index

USD

7,369

406.69

8.8

11.1

42.0

4.3

2.24

FTSE Developed All Cap Index

USD

5,877

381.26

8.7

10.9

39.9

4.3

2.25

FTSE Emerging All Cap Index

USD

1,492

876.35

9.6

12.4

60.0

3.6

2.16

FTSE Advanced Emerging All Cap Index

USD

639

832.91

10.0

13.1

57.9

1.5

2.41

FTSE Secondary Emerging All Cap Index

USD

853

986.20

9.3

11.7

63.7

5.7

1.94

USD

724

180.60

-1.8

-3.3

5.6

-1.4

2.80

FTSE EPRA/NAREIT Developed Index

USD

275

2572.45

13.1

12.5

56.8

6.6

3.91

FTSE EPRA/NAREIT Developed REITs Index

USD

183

890.40

14.9

19.2

62.1

9.8

4.75

FTSE EPRA/NAREIT Developed Dividend+ Index

USD

201

1866.87

13.8

15.4

61.1

7.8

4.58

FTSE EPRA/NAREIT Developed Rental Index

USD

223

1004.71

14.7

18.2

62.1

9.7

4.51

FTSE EPRA/NAREIT Developed Non-Rental Index

USD

1072.02

8.8

-1.1

43.5

-1.2

2.23

FTSE4Good Global Index

USD

660

6290.32

6.2

6.8

37.7

1.1

2.67

FTSE4Good Global 100 Index

USD

103

5252.69

5.1

4.8

34.5

-1.1

2.84

FTSE GWA Developed Index

USD

1,997

3626.87

7.1

8.5

41.0

3.1

2.56

FTSE RAFI Developed ex US 1000 Index

USD

1,019

6144.63

4.7

1.8

39.0

-0.6

3.04

FTSE RAFI Emerging Index

USD

359

7051.89

8.9

11.9

56.0

3.3

2.50

Fixed Income FTSE Global Government Bond Index Real Estate

SRI

Investment Strategy

SOURCE: FTSE Group and Thomson Datastream, data as at 30 April 2010

JUNE 2010 â&#x20AC;˘ FTSE GLOBAL MARKETS

GM EDITORIAL 42.qxd:.

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Page 93

Americas Market Indices 5-Year Performance Graph (USD Total Return) Index Level Rebased (30 April 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 r-1 0

FTSE RAFI US 1000 Index

Oc t-0 9

r-0 9 Ap

Oc t-0 8

r-0 8 Ap

Oc t-0 7

r-0 7 Ap

Oc t-0 6

r-0 6 Ap

Oc t-0 5

r-0 5

Table of Total Returns Index Name

Currency

Constituents

Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%pa)

FTSE Americas Index

USD

770

792.14

11.4

15.8

41.3

6.8

1.91

FTSE North America Index

USD

647

863.00

11.3

16.1

39.8

7.2

1.86

FTSE Latin America Index

USD

123

1199.13

11.2

12.1

68.7

1.6

2.52

FTSE All-World Indices

FTSE Global Equity Indices FTSE Americas All Cap Index

USD

2,576

366.44

12.3

17.4

43.5

7.8

1.79

FTSE North America All Cap Index

USD

2,388

349.78

12.4

17.8

42.0

8.2

1.75

FTSE Latin America All Cap Index

USD

188

1693.56

11.1

12.5

70.9

1.5

2.45

FTSE Americas Government Bond Index

USD

183

189.83

0.8

1.0

1.9

2.3

3.18

FTSE USA Government Bond Index

USD

169

185.66

0.7

0.8

1.4

2.2

3.16

FTSE EPRA/NAREIT North America Index

USD

122

3245.14

23.3

33.8

73.4

17.1

3.71

FTSE EPRA/NAREIT US Dividend+ Index

USD

1768.67

23.8

33.6

70.3

17.2

3.69

Fixed Income

Real Estate

FTSE EPRA/NAREIT North America Rental Index

USD

118

1103.06

23.8

34.2

74.2

17.6

3.70

FTSE EPRA/NAREIT North America Non-Rental Index

USD

350.06

7.5

19.6

48.2

0.0

4.26

FTSE NAREIT Composite Index

USD

128

3138.77

22.5

32.9

66.0

16.7

4.36

FTSE NAREIT Equity REITs Index

USD

106

7676.20

24.1

34.8

68.7

17.7

3.61

FTSE4Good US Index

USD

130

5221.02

10.5

15.4

41.8

5.8

1.76

FTSE4Good US 100 Index

USD

102

4970.20

10.3

14.9

40.6

5.5

1.78

USD

591

3261.47

10.7

15.9

43.2

7.9

1.94

SRI

Investment Strategy FTSE GWA US Index FTSE RAFI US 1000 Index

USD

1,003

5961.18

14.8

20.8

55.0

11.8

1.97

FTSE RAFI US Mid Small 1500 Index

USD

1,496

6117.74

22.4

32.7

72.1

19.0

1.06

SOURCE: FTSE Group and Thomson Datastream, data as at 30 April 2010

FTSE GLOBAL MARKETS • JUNE 2010

GM EDITORIAL 42.qxd:.

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Page 94

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)

0 r-1

FTSE RAFI Europe Index (EUR)

Oc t-0

9 r-0 Ap

8 Oc t-0

8 r-0 Ap

7 Oc t-0

7 r-0 Ap

6 Oc t-0

6 r-0 Ap

Oc t-0

r-0

Index Level Rebased (30 April 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

547

237.55

6.5

11.6

FTSE Eurobloc Index

EUR

284

124.87

3.4

5.8

35.1

3.8

3.23

26.4

-1.5

FTSE Developed Europe ex UK Index

EUR

374

235.89

5.6

3.59

9.1

31.3

1.9

3.26

FTSE Developed Europe Index

EUR

487

233.21

6.4

11.0

33.9

3.3

3.31

FTSE All-World Indices

FTSE Global Equity Indices FTSE Europe All Cap Index

EUR

1,507

373.03

7.0

12.3

36.5

4.7

3.12

FTSE Eurobloc All Cap Index

EUR

772

371.73

3.7

6.5

27.9

-0.7

3.48

FTSE Developed Europe All Cap ex UK Index

EUR

1,049

395.71

6.0

9.8

33.0

2.8

3.14

FTSE Developed Europe All Cap Index

EUR

1,387

368.51

6.8

11.8

35.3

4.2

3.19

Region Specific FTSE All-Share Index

GBP

628

3768.05

8.8

12.7

36.6

4.9

3.24

FTSE 100 Index

GBP

102

3553.91

8.3

12.1

35.8

3.8

3.38

FTSEurofirst 80 Index

EUR

4673.21

2.5

4.8

25.3

-3.3

3.87

FTSEurofirst 100 Index

EUR

4322.32

4.4

8.8

30.8

0.0

3.73

FTSEurofirst 300 Index

EUR

311

1519.28

6.1

10.5

32.8

2.7

3.37

FTSE/JSE Top 40 Index

SAR

2920.00

7.4

9.4

41.2

3.4

1.82

FTSE/JSE All-Share Index

SAR

164

3248.17

8.2

9.8

41.8

4.4

2.03

FTSE Russia IOB Index

USD

967.18

4.2

11.5

58.8

4.2

1.79

FTSE Eurozone Government Bond Index

EUR

242

172.91

1.5

2.0

4.8

1.9

3.55

FTSE Pfandbrief Index

EUR

393

210.65

1.4

2.5

8.8

2.3

3.51

FTSE Actuaries UK Conventional Gilts All Stocks Index

GBP

2328.68

1.1

0.0

2.7

1.8

4.01

FTSE EPRA/NAREIT Developed Europe Index

EUR

1842.48

2.1

2.3

34.4

0.3

4.79

FTSE EPRA/NAREIT Developed Europe REITs Index

EUR

669.17

1.4

33.8

-1.0

5.31

FTSE EPRA/NAREIT Developed Europe ex UK Dividend+ Index

EUR

2258.27

0.7

1.9

36.7

0.8

5.51

FTSE EPRA/NAREIT Developed Europe Rental Index

EUR

722.58

2.0

2.5

34.7

0.3

4.89

FTSE EPRA/NAREIT Developed Europe Non-Rental Index

EUR

516.11

5.1

-2.8

26.5

1.1

2.00

FTSE4Good Europe Index

EUR

274

4621.80

5.9

9.6

32.7

2.4

3.46

FTSE4Good Europe 50 Index

EUR

3919.24

4.3

7.5

28.8

0.0

3.74

FTSE GWA Developed Europe Index

EUR

487

3330.99

5.5

8.6

34.4

2.0

3.51

FTSE RAFI Europe Index

EUR

507

5228.04

6.8

8.4

35.6

3.5

3.38

Fixed Income

Real Estate

SRI

Investment Strategy

SOURCE: FTSE Group and Thomson Datastream, data as at 30 April 2010

JUNE 2010 â&#x20AC;˘ FTSE GLOBAL MARKETS

GM EDITORIAL 42.qxd:.

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Page 95

Asia Pacific Market Indices Index Level Rebased (30 April 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)

0 r-1

FTSE RAFI Kaigai 1000 Index (JPY)

Oc t-

9 r-0 Ap

08 Oc t-

8 Ap

r-0

07 Oc t-

7 r-0 Ap

06 Oc t-

6 r-0 Ap

Oc t-

r-0

FTSE GWA Japan 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

1,297

292.66

FTSE Asia Pacific ex Japan Index

USD

843

583.16

8.9

9.7

43.4

5.6

2.19

10.6

10.9

57.3

4.0

FTSE Japan Index

USD

454

83.55

10.2

2.43

11.9

19.6

9.3

1.79

FTSE All-World Indices

FTSE Global Equity Indices FTSE Asia Pacific All Cap Index

USD

3,104

497.16

9.1

9.9

44.6

5.7

2.18

FTSE Asia Pacific All Cap ex Japan Index

USD

1,874

722.82

10.7

11.4

58.9

4.0

2.41

FTSE Japan All Cap Index

USD

1,230

264.85

10.5

11.7

20.1

9.7

1.79

Region Specific FTSE/ASEAN Index

USD

148

624.24

14.0

19.6

74.7

11.1

2.74

FTSE Bursa Malaysia 100 Index

MYR

100

10000.29

8.0

10.2

42.1

7.3

2.42

TSEC Taiwan 50 Index

TWD

7097.55

3.1

6.9

33.1

-2.8

2.70

FTSE Xinhua All-Share Index

CNY

1,042

8439.75

-2.1

-0.5

24.0

-10.1

0.83

FTSE/Xinhua China 25 Index

CNY

23569.08

7.5

-2.2

34.2

-2.4

2.36

USD

222

137.89

-2.8

-2.1

7.4

-0.4

1.26

FTSE EPRA/NAREIT Developed Asia Index

USD

2108.07

9.5

2.8

49.8

2.1

3.78

FTSE EPRA/NAREIT Developed Asia 33 Index

USD

1369.69

9.1

3.5

47.8

2.2

3.93

FTSE EPRA/NAREIT Developed Asia Dividend+ Index

USD

2212.53

9.7

5.0

57.0

2.7

5.40

FTSE EPRA/NAREIT Developed Asia Rental Index

USD

991.76

10.4

10.9

61.2

8.1

6.51

FTSE EPRA/NAREIT Developed Asia Non-Rental Index

USD

1171.05

9.1

-1.6

43.7

-1.2

2.15

Fixed Income FTSE Asia Pacific Government Bond Index Real Estate

Infrastructure FTSE IDFC India Infrastructure Index

IRP

1016.56

9.1

16.2

55.1

4.3

0.68

FTSE IDFC India Infrastructure 30 Index

IRP

1131.76

8.9

13.8

54.4

3.5

0.68

JPY

184

3995.47

9.4

10.9

17.0

9.0

1.92

FTSE SGX Shariah 100 Index

USD

100

5480.23

6.7

10.1

34.6

3.1

1.96

FTSE Bursa Malaysia Hijrah Shariah Index

MYR

11017.10

6.3

5.8

30.0

4.0

2.82

JPY

100

1132.42

9.2

11.1

21.4

5.6

1.84

SRI FTSE4Good Japan Index Shariah

FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index

JPY

454

2992.18

10.4

12.4

21.2

11.0

1.90

FTSE GWA Australia Index

AUD

102

4180.08

6.4

5.5

34.3

0.5

4.05

FTSE RAFI Australia Index

AUD

6607.76

4.7

5.0

30.8

-1.6

4.07

FTSE RAFI Singapore Index

SGD

8821.08

9.6

15.8

65.5

3.7

3.11

FTSE RAFI Japan Index

JPY

252

4228.31

11.4

14.0

21.5

11.2

1.85

FTSE RAFI Kaigai 1000 Index

JPY

1,025

4425.94

12.5

12.7

39.3

4.6

2.72

HKD

6820.36

5.1

-4.1

34.4

-4.0

2.79

FTSE RAFI China 50 Index

SOURCE: FTSE Group and Thomson Datastream, data as at 30 April 2010

FTSE GLOBAL MARKETS â&#x20AC;˘ JUNE 2010

GM EDITORIAL 42.qxd:.

4/6/10

11:04

GM_Asi

Page 96

INDEX CALENDAR

Index Reviews June–August 2010 Date

Index Series

Review Frequency/Type

Effective Data Cut-off (Close of business)

Early Jun Early Jun Early Jun Early Jun Early Jun Early Jun 03-Jun 03-Jun 04-Jun 05-Jun 08-Jun 09-Jun 09-Jun

Quarterly review Annual review Quarterly review Semi-annual review Quarterly review Quarterly review Annual review of index composition Quarterly review Quarterly Review Quarterly review Quarterly review Quarterly review Annual review - Emgng Eur, ME, Africa, Latin America Quarterly review Quarterly review Quarterly review Quarterly review

30-Jun 11-Jun 18-Jun 18-Jun 18-Jun 14-Jun 18-Jun 18-Jun 18-Jun 18-Jun 18-Jun 18-Jun

31-May 31-May 16-Jun 31-May 31-May 31-May 30-Apr 31-May 31-May 31-May 30-May 08-Jun

18-Jun 18-Jun 18-Jun 18-Jun 18-Jun

31-Mar 31-May 31-May 30-May 31-May

10-Jun 10-Jun 11-Jun 12-Jun 13-Jun 13-Jun 13-Jun 13-Jun 13-Jun 13-Jun 14-Jun Mid Jun Mid Jun Mid Jun Mid Jun Mid Jun 16-Jun 18-Jun 18-Jun Late Jun 06-Jul 07-Jul

ATX KOSPI 200 CAC 40 OBX S&P / TSX RTSI DJ Global Titans 50 DAX S&P / ASX Indices NZX 50 FTSE MIB FTSE UK Index Series FTSE Global Equity Index Series (incl. FTSE All-World) FTSE techMARK 100 FTSEurofirst 300 FTSE Italia Index Series FTSE/JSE Africa Index Series FTSE EPRA/NAREIT Global Real Estate Index Series FTSE Bursa Malaysia Index Series OMX I15 DJ STOXX S&P Asia 50 S&P BRIC 40 S&P US Indices S&P Europe 350 / S&P Euro S&P Global 1200 S&P Global 100 S&P Latin 40 S&P Topix 150 VINX 30 OMX S30 Baltic 10 OMX C20 OMX N40 BNY Mellon DR Indices Russell US Indices Russell Global Indices IBEX 35 FTSE Xinhua Index Series TOPIX

18-Jun 18-Jun 01-Jul 18-Jun 19-Jun 19-Jun 19-Jun 19-Jun 19-Jun 19-Jun 19-Jun 18-Jun 18-Jun 30-Jun 30-Jun 21-Jun 18-Jun 21-Jun 25-Jun 25-Jun 30-Jun 18-Jul

31-May 31-May 25-Jun 25-May 05-Jun 05-Jun 05-Jun 05-Jun 05-Jun 05-Jun 05-Jun 04-Jun 31-May 31-May 31-May 31-May 31-May 31-May 28-May 31-May 31-May 18-Jun

07-Jul 08-Jul Mid Jul Mid Jul 06-Aug

IPC TSEC Taiwan 50 OMX H25 SMI Family Index TOPIX

30-Aug 01-Aug 19-Jul 02-Aug 17-Sep

30-Jul 30-Jun 30-Jun 30-Jul 30-Jun

07-Aug 17-Aug

Hang Seng MSCI Standard Index Series

Quarterly review Semi-annual review Semi-annual review Quarterly review Quarterly review - shares Semi-annual review - constituents Quarterly review - shares Quarterly review - shares Quarterly review - shares Quarterly review - shares Quarterly review - shares Quarterly review - shares Semi-annual review Semi-annual review Semi-annual review Semi-annual review Semi-annual review Quarterly review Annual / Quarterly review Annual / Quarterly review Semi-annual review Quarterly Review Monthly review - additions & free float adjustment Semi-annual review Quarterly review Semi-annual review - consituents Annual review Monthly review - additions & free float adjustment Quarterly review Quarterly review

29-Sep 03-Sep 31-Aug

31-Aug 30-Jun 31-Jul

09-Jun 09-Jun 09-Jun 09-Jun 10-Jun

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

JUNE 2010 • FTSE GLOBAL MARKETS

GM_Asian Sectors-1.qxd:Layout 14/5/10 GM EDITORIAL 42.qxd:. 4/6/10 111:04 Page14:29 IBC1

Page 1

THE FTSE ASIAN SECTOR BY SECTOR INDEX FTSE. It’s how the world says index. With 18 new pan-Asia sector-based indices to choose from, it’s never been easier to create a diversified portfolio to spread your risk. From straight sector allocations to sophisticated strategies such as sector rotation and long/short sector plays FTSE’s Asian Sector Index Series is the first of its kind to be built ground up from an Asian investors’ perspective. www.ftse.com/asiansector

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© FTSE International Limited (‘FTSE’) 2010. All rights reserved. FTSE ® and FTSE4Good are trade marks jointly owned by the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE under licence.

GM EDITORIAL 42.qxd:. 4/6/10 PagePage OBC11 UBZ1664FTSEAd_InvCycle 5/24/10 11:04 3:45 PM

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