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US TRADING ROUNDTABLE: DRAWING TOMORROW’S WORLD I S S U E 4 3 • J U LY / A U G U S T 2 0 1 0

High time for US high yield debt Commodity ETFS in the spotlight Realigning the custody value chain

BP WORKING

AGAINST THE FLOW THE FUTURE OF ALGORITHMIC TRADING

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Outlook EDITORIAL DIRECTOR: Francesca Carnevale, tel: +44 [0]20 7680 5152, email: francesca@berlinguer.com, fax: +44 (0)20 7680 5155 SUB EDITOR: Roy Shipston, tel: +44 [0]20 7680 5154 email: roy.shipston@berlinguer.com CONTRIBUTING EDITORS: Art Detman, Neil O’Hara, David Simons. CORRESPONDENTS: Rodrigo Amaral (Emerging Markets); Andrew Cavenagh (Debt); Lynn Strongin Dodds (Securities Services); Vanja Dragomanovich (Commodities); Mark Faithfull (Real Estate); Richard Hemming (FX & Derivatives); Ruth Hughes Liley (Trading Services, Europe); John Rumsey (Latin America); Paul Whitfield (Asset Management/Europe); Ian Williams (US/Emerging Markets/Sector Analysis). FTSE EDITORIAL BOARD: Mark Makepeace (CEO); Donald Keith; Imogen Dillon-Hatcher; Paul Hoff; Andrew Buckley; Jerry Moskowitz; Andy Harvell. PUBLISHING & SALES DIRECTOR: Paul Spendiff, tel +44 [0]20 7680 5153 email: paul.spendiff@berlinguer.com AMERICAS, AFRICA & RUSSIA SALES MANAGER: James Ikonen, tel +44 [0]20 7680 5158 email: james.Ikonen@berlinguer.com EUROPEAN SALES MANAGER: Nicole Taylor, tel +44 [0]20 7680 5156 email: nicole.taylor@berlinguer.com OVERSEAS REPRESENTATION: 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 now published ten 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

HERE IS A distinctly regulatory cast to this edition. In part, re-regulation of the financial markets is a natural response to the financial crisis, to ensure, if possible, that conditions which led to this latest crisis cannot be repeated. In part, however, it seems that national and supranational authorities are aboard a financial regulatory juggernaut that the market, logic and calm consideration is finding increasingly hard to stop. Witness the latest initiative by the European Commission, which at the beginning of June presented plans for tougher controls on credit rating agencies in response to concerns that they have“contributed to the economic and financial crisis”. “There is an emerging view in Europe and internationally that the deficiency in the current rating processes has not yet been sufficiently addressed,” noted José Manuel Barroso, European Commission president as he announced draft legislation that will the EU powers to fine credit rating agencies up to 20% of their annual income or turnover if they are guilty of conflicts of interest. It hopes to place ratings agencies under the supervisory control of an EU-wide authority, and require them to share information with potential rivals. Ideas being floated by the Commission involve the establishment of a European ratings agency that could compete with incumbents, and empowering export credit agencies (ECAs) and credit insurers (CIs) to issue their own ratings. A draft proposal is set for publication sometime in the autumn. While there are legitimate questions about the independence of ratings that are ultimately paid for by a corporation or issuer securing a rating, there is a dangerous whiff of retribution about this move. It looks to be aimed squarely at ratings agencies because they downgraded the sovereign ratings of Portugal, Spain and Greece during the eurozone debt crisis. Barroso has denied that the European Commission is looking for scapegoats for the crisis undermining the Union, relying on the now overly-worn fallback that the ratings agencies had “underestimated the risks”faced by the banking sector prior to the collapse of Lehman Brothers in September 2008. Even so, the Commission is showing distinct signs of being the lapdog of the French and German governments in this regard. Both Nicholas Sarkozy and Angela Merkel seem more than keen to place far more supervisory power at the European level that is acceptable to any free marketeer. Funnily enough, the Commission has also just launched a consultation on possible measures to restrict short-selling of securities in the EU, at the same time that the German government issued proposals to extend its existing ban on naked short selling of eurozone sovereign debt, credit default swaps on eurozone sovereign debt, and shares in ten leading German financial firms. Germany believes naked short selling exacerbated the debt crisis by allowing speculators to bet that eurozone countries will default. It looks like Barroso does too. If you’ve not had enough of regulatory crackdowns, then fill your boots with Andrew Cavenagh’s review of the equity derivatives markets, Vanja Dragomanovich’s overview of the impending regulation of the OTC metals trading market and Richard Hemming’s rapid summary of the status of the AIFM Directive. However, it is not all doom, gloom, and re-regulation, despite this month’s cover story on the continuing travails of BP. There’s a pert and pertinent overview of the US trading market in this edition’s expert roundtable; and there are clear signs that the asset servicing and global custody markets are in for something of a revival on the back of incoming regulation. Enjoy if you can.

Francesca Carnevale, Editorial Director July 2010

Journalistic code set by the Munich Declaration.

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 0

Contents COVER STORY BP: WORKING AGAINST THE FLOW........................................................................Page 41

BP contra mundum. The vagaries of exploration for oil in difficult, deep waters, such as those found in the Gulf of Mexico, or having to work with new technology to exploit carbon resources in oil sands or shale, mean that the halcyon days of oil companies are well and truly over. Nowadays the business is as much about cost efficiency and downstream diversification as it is about new and difficult finds. The repercussions of this latest and major Gulf of Mexico oil spill will reverberate for at least a decade. Vanya Dragomanovich reports.

DEPARTMENTS MARKET LEADER

............................................................Page 6 Andrew Cavenagh looks at the impact of regulation on equity derivatives.

BETWEEN A ROCK & A HARD PLACE

REDRAWING THE LINES ............................................................................................Page 14

IN THE MARKETS

Lynn Strongin Dodds reviews the changing alternative fund administration landscape.

COUNTRY REPORT

MEXICO ON THE PATH TO TAX REFORM ......................................Page 24

COMMODITIES

............................................................................................Page 26 Vanya Dragomanovich reviews an impending regulatory programme.

A BETTER SORT OF DB PENSION SCHEME ............................................Page 21 Matthew Bale of PensionsFirst Analytics looks at the impact of IAS 19 changes. Rodrigo Amaral explains Mexico’s emerging fiscal strategy.

ETCs UNDER SCRUTINY

DEBT REPORT

......................................................................................................Page 81 Why OTC commodity trading volumes are up, even while a shake-up looms.

THE TIPPING POINT

HIGH TIMES FOR US HIGH YIELD....................................................................Page 30 Neil O’Hara reports on the steady revival of the corporate high yield market.

FRENCH COVERED BONDS STAND FIRM ................................................Page 36

Paul Whitfield reports on the tenacity of obligations foncières.

....................................................................................Page 39 Intent on increasingly liquidity, Bursa Malaysia upgrades its indices.

MALAYSIA UPS THE ANTE

INDEX REVIEW FACE TO FACE

..........................Page 40 Simon Denham, managing director of Capital Spreads on the need for fiscal probity.

YOU’VE GOT TO PICK A POCKET OR TWO, EH?

..........................Page 64 Instinet CEO Richard Balarkas explains the firm’s commitment to neutral agency broking.

INSTINET: A COMMITMENT TO TRANSPARENCY

........Page 85 Richard Hemming asks whether London can remain a competitive financial hub?

WILL TAXATION UNDERMINE LONDON AS AN EM CENTRE?

ASSET SERVICING

DATA PAGES 2

..............................................................Page 88 Rodrigo Amaral reports on move to increase transparency in Spain’s equity market.

IMPROVING SHAREHOLDER VISIBILITY

Fidessa Fragmentation Index ................................................................................................Page 90 Market Reports by FTSE Research ......................................................................................Page 92 Index Calendar............................................................................................................................Page 96 J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

Navigating the Equity Markets RBC offers integrated trade advisory services that include: a team of experienced professionals, a global network of trading and research resources, and broad-reaching industry relationships. Our focus on building close client relationships and providing high-quality service has allowed us to consistently deliver results. Integrated Trading Platform: Equity Trade Advisory, Electronic Execution, Program and Options Trading

www.rbccm.com This communication is for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument. RBC Capital Markets is a registered trademark of Royal Bank of Canada. RBC Capital Markets is the global brand name for the capital markets business of Royal Bank of Canada and its affiliates, including RBC Capital Markets Corporation (member FINRA, NYSE and SIPC); RBC Dominion Securities Inc. (member IIROC and CIPF) and Royal Bank of Canada Europe Limited (authorized and regulated by FSA). ÂŽ Registered trademark of Royal Bank of Canada. Used under license. ÂŠ Copyright 2010. All rights reserved.

Contents FEATURES THE TRADING REPORT

THE FUTURE OF ALGO TRADING ........................................................Page 45

Algorithms are moving beyond cash equities, with futures and options trading using algorithms developing fast. In April 2010, Bank of America Merrill Lynch (BofAML) added six major European index futures to their algorithm offering during London opening hours, complementing their DMA futures offering already available, and is about to roll out further futures contracts in the US and fixed income markets for algorithmic trading. What does bode for traditional equity markets? Ruth Hughes Liley finds out.

US TRADING ROUNDTABLE......................................................................Page 51

According to Jon Clark, head of fundamental equity trading – Americas, at Blackrock: “If 2009 was about “How we do more with less”, this year we are more focused on: “How can we do things better?” Just how much better is the underlying theme of this month’s expert roundtable discussion.

CAN AGENCY BROKERS HOLD THEIR MARKET SHARE? ....Page 60

The advent of commission sharing arrangements several years ago sent a chill through the agency brokerage community amid concerns that buy side institutions would concentrate trading at the bulge bracket securities houses. Without the resources to compete head to head, smaller firms feared clients might yank their order flow and pay for research in cash instead of commissions. It hasn't worked out that way, however. Neil O’Hara reports.

ASSET SERVICING REPORT

THE ASSET SERVICING VALUE CHAIN ............................................Page 66 In the wake of the collapse of Lehman, stock market volatility and the financial crisis, the bread and butter function within asset servicing has risen to the top of the client wish list. As Seán Páircéir, Partner at Brown Brother Harriman, puts it, “There is a much greater appreciation of the quality of the custody product [following] the financial crisis. In the past, the safekeeping of assets had been somewhat taken for granted but asset managers are no longer doing that. The value of custody has become much clearer.” Lynn Strongin Dodds reports.

RISK MANAGEMENT TO CENTRE STAGE ......................................Page 70 After every financial crisis, risk management tends to rise to the top of the agenda and then falls to the bottom when markets recover. This time around though may be different as the severity of the crash has prompted a plethora of regulation that will force asset managers to implement more rigorous practices. Many have and will look towards their asset service providers who in turn have been more than happy to step into the breach. Lynn Strongin Dodds reports.

THE GLOBAL/LOCAL DEBATE..................................................................Page 74

Lower volumes, combined with exceedingly low interest rates, have made it more challenging for global custodians to realise an appreciable revenue stream from “implicit” fees surrounding areas such as cash management, securities lending and foreign exchange. With asset flows continuing to move in the direction of emerging regions such as Asia and Latin America, custodians will have to place increased emphasis on bolstering local client services. From Boston, Dave Simons reports.

THE SAFETY FACTOR......................................................................................Page 78

ERISA provides a very clear methodology and strictures which eliminates any conflicts that an arm’s length, non-fiduciary broker/dealer has when trading as principal at the direction of a non-affiliated third party fiduciary transition manager. Charles Shaffer and Lance Venga, global co-heads, transition management at Credit Suisse, explain the mechanics and the direct benefit to clients.

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

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Market Leader THE IMPACT OF REGULATION ON EQUITY DERIVATIVES

BETWEEN A ROCK AND A HARD PLACE The market for global equity derivatives faces a testing period over the next few months. It will it have to adjust to exceptional levels of volatility as fears mount that the sovereign debt crisis (and attempts to control it) will jeopardise global economic recovery and also comply with the raft of new regulations that will soon apply to all over-the-counter (OTC) derivatives markets. Andrew Cavenagh reports. ONCERNS OVER THE level of sovereign debt in the eurozone reached new heights from early April, after the European Union hastily (and not entirely convincingly) put together its €750bn rescue package for ailing member states on the back of the near-default of Greece. This rapidly reversed the recovery of confidence in all forms of equity investment that had taken place in the first quarter of 2010. Investors had been lured back into the equity markets—particularly those in the United States and Asia— through both direct share purchases and derivative strategies in the belief that equities offered the best opportunity to profit from economic recovery. However, as the worsening sovereign situation in southern Europe cast a fresh blight over the prospects of revival, the trend came to a halt. For although the bonds of some large southern European companies actually traded inside the spreads of their sovereign debt of comparable maturities through April and May, only those few with significant geographical diversity beyond their home borders will be able to maintain that status in a worsening sovereign environment. “While we believe that yields on some [corporate] credits within the

troubled eurozone countries will trade inside their respective governments, we also see a rocky road in the near term for European corporations generally, and those domiciled in the five troubled countries in particular,” concludes David Watts, European credit strategist at the international research firm CreditSights. In response to such perceptions, the VIX index (which uses option prices to determine how volatile prices of companies in S&P 500 are likely to be over the next 30 days and is often referred to Wall Street’s‘gauge of fear’) reached its highest point at the end of May since the market meltdown in March 2009; having hit a two-year low on April 12th this year. “What we’ve seen in the equity derivative markets is that volatility levels have risen very sharply since early April,” says Pam Finelli, managing director at the equity derivatives research group at Deutsche Bank in London. As protection against losses became the overwhelming priority for investors, the volatility skew between out-of-themoney puts and calls also hit a new spike.“That’s really because you’ve had a lot of protection buying,” said Finelli. “There’s been a scramble for cover.” This left institutions that had shortvolatility or short-correlation positions exposed, as they were unable to find

Senators Tom Harkin (Democrat for Iowa) left, and Robert Casey, (Democrat for Pennsylvania) right, listen as Senator Blanche Lincoln (Democrat for Arkansas), speaks at a news conference on how Wall Street reform will bring transparency and accountability to the derivatives market on Capitol Hill in Washington, Tuesday, April 20th 2010. The photograph was taken by Harry Hamburg for the Associated Press. Photograph supplied by Press Association Images, June 2010.

protection sellers at an acceptable price to cover their positions. Meanwhile, demand for the more complex and exotic equity-derivative products designed to maximise investment returns predictably fell away. “There’s been less trading of exotics than we saw a few months ago,”says Finelli. She added that positions in lessliquid products such as dividend futures and dispersion structures (in other words, bets on the variance between an index and its constituent stocks) had been unwound as investors sought to shed risk. The dislocation in volatility skews, which has seen some indices hit their highest levels for 10 years, has naturally provided trading opportunities for both bullish and bearish investors. It was consequently no surprise that the volume of equity derivative trading picked up towards the end of May. Stephane Mattatia, head of financial engineering and advisory in the Global Equity Flow division at SG Corporate and Investment Banking in Paris, says volatility and skew spikes inevitably gave investors pause for thought but this was always a short-term hiatus followed by larger volumes.“Every time there is a change in the volatility

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

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Market Leader THE IMPACT OF REGULATION ON EQUITY DERIVATIVES

environment, it takes investors a little time to adjust their strategies but they have been very reactive in last May.” Mattatia pointed to the prophecies of doom in the first half of 2009 that the equity derivatives market would not return to its previous level or range of activity for 25 years.“Actually what’s striking to me is that it took six months for the market to normalise.” He says dispersion trading is a good example. Whereas no one was interested in taking short correlation a year ago, the trade was now back “in huge volumes”. Furthermore, he says, the business is no longer mainly the preserve of hedge funds. “Now we are seeing some institutional investors such as pension funds in those strategies.” Deutsche Bank’s recommendations at the beginning of June included a sixmonth risk reversal play (a long call funded by a short put) on the DAX, based on expectations of strong growth in Germany through the rest of the year, and selling a three-month put on quality stocks with high current skews. It identified E.ON, Deutsche Bourse, Phillips and Siemens as promising candidates. Despite the opportunities in either direction, however, riskaversion seems likely to dominate most investors’ strategy for at least the next few months, as correlations among equity price movements (which always tend to increase in a downturn) reached 10-year highs of around 90% at the end of May. It was noticeable, however, that intra-index correlation (that between the constituents of an index) was more pronounced than the inter-index correlation (that between different global indices), reflecting the extent to which the sell-off was focused around Europe. Demand for more exotic and aggressive equity derivatives, particularly highly geared structures, seems likely to remain more limited

Pam Finelli, managing director, equity derivatives research group, Deutsche Bank in London. Photograph kindly supplied by Deutsche Bank, June 2010.

for the rest of this year at least.“I think that the complacency we saw in March and April probably won’t come back in the near term,” concludes Finelli at Deutsche Bank. “Markets seem to be over-reacting to news both good and bad. It is a very different climate compared with two months ago.”

Impending regulation Looking slightly further ahead, impending legislation on both sides of the Atlantic to regulate the wider OTC derivatives business is a source of uncertainty for the market. New regulations will take effect in the US first, after the Senate in Washington DC passed the Restoring American Financial Stability Act of 2010 on May 20th. A joint Congressional committee is now at work to reconcile that bill with a similar one passed by the US House of Representatives in December, and expects to produce a final version of the legislation for President Obama to sign into law by July 4th this year.

While the process of reconciliation will inevitably lead to some amendments, both bills contain sweeping provisions to regulate swaps and other OTC derivatives. These will impose new requirements on the vast majority of such transactions in respect of clearing, exchange trading, capital and margin calls, registration, record keeping, and business conduct. The Senate bill also includes a controversial provision that would prohibit Federal assistance—such as insurance through the FDIC or advances from any Federal Reserve credit facility—for institutions in respect of activities in the derivatives market. If enacted, this would force FDIC-insured banks to hive off such operations into separate corporate entities, at an estimated cost of around $20bn. However, there seems to be lukewarm support for this measure in both the House of Representatives and the Obama Administration, and it may well be a casualty of the reconciliation process. Even if the provision is removed from the final bill, however, the cost of the legislation to large financial institutions is likely to be considerable. Jamie Dimon, chief executive officer of JP Morgan Chase, warned in April— weeks before the Senate passed its bill—that the new rules could cost his bank between $700m and $2bn. Tom d’Ambrosio, the partner who heads the derivatives business at US law firm Morgan Lewis & Bockius in New York, says there will certainly be significant cost implications for equityderivatives trading from the new collateralisation and clearing requirements.”Many equity-derivative trades are based on the premise of some sort of collateral—but never substantial collateral—and we don’t know what the level of collateral imposed by regulators in future will be,” d’Ambrosio explains.

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

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Market Leader THE IMPACT OF REGULATION ON EQUITY DERIVATIVES

Stephane Mattatia, head of financial engineering and advisory in the Global Equity Flow division at SG Corporate and Investment Banking in Paris. Photograph kindly supplied by Société Générale, June 2010.

He agrees there is a risk that the additional cost could well render some current transactions uneconomic for one or other of their participants. Meanwhile, he notes that the additional clearing requirements would impose higher capital charges on a large number of equity-derivative trades that were sufficiently bespoke or unique not to require clearing at present.“There are likely to be higher capital charges and margin calls associated with most of these products,”he concludes.

European regulation Higher collateral and margin requirements, along with higher capital charges on bilateral deals that are not subject to a central clearing obligation, also look set to feature in the legislation that the EU is preparing for the OTC derivatives markets. The European Commission is expected to publish draft legislation before the end of July, on which it will seek industry feedback before submitting a final proposal to the European Parliament in the third quarter of 2010. While the EU is keen to harmonise derivatives legislation on a global basis as far as possible, the draft proposals are expected to go into considerably more detail than the bills that have passed through the two houses of the US Congress. Two areas where EU regulation is likely to be more specific than its US counterpart are determining which OTC derivative contracts will require mandatory central clearing across the EU and which non-financial corporate end users will be exempt from these central-clearing requirements. Two earlier “communications” from the Commission this year implied the greater diversity and complexity of the European market demanded a more detailed solution.

Industry fears, however, that Brussels will end up passing legislation that is so prescriptive and inflexible it will close the OTC markets to many of its present participants may be overdone. At the beginning of June, the European Parliament’s Economic and Monetary Affairs Committee (ECON), which advises the Commission, recommended that the latter should ensure that the legislative proposals it put forward distinguished between the use of derivatives for “legitimate” corporate hedging purposes and for speculative trading. ECON has also called for lighter regulation for non-financial corporate end users that require tailor-made derivatives from time to time to cover the particular risks to which they are exposed. It says the European Securities and Markets Authority should determine the threshold at which such deals need central clearing and supports the Commission’s plan for lower capital requirements for bilateral derivatives contracts of small and medium-sized enterprises; provided they are put in place to hedge risk. Before the new legislation makes it to the statute books on either side of the Atlantic, at least one significant

initiative will be underway to improve the overall transparency of the market for financial regulators. At the end of July, the US-based Depositary Trust and Clearing Corporation (DTCC) will launch a trade repository service for equity derivatives [see sidebar], which will provide not only regulators (including central banks) but market participants with the most comprehensive source of data on the instruments to date. The DTCC is also developing an equity cash-flow matching tool to reduce risk and settlement costs, which it is aiming to launch in midNovember. This platform is intended to match the cash flows relating to all types of OTC equity-derivative trades. Robert Green, the DTCC vicepresident running the project, says the key benefits of the new service would be that it would enable market participants to reach “payment certainty” and avoid nostro breaks (discrepancies between expected and actual cash settlements that one or other counter-party usually only discovers at quarterly reconciliations). The DTCC will start industry-wide testing of the platform in August and has set a target for the start of cash-flow matching on November 15th this year.

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

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Market Leader THE IMPACT OF REGULATION ON EQUITY DERIVATIVES

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

DTCC’S ELECTRONIC TRADE REPORTING REPOSITORY FOR EQUITY DERIVATIVES EXPOSURES ROM AUGUST 13TH, financial regulators around the world will—for the first time—have a clear idea of both overall and individual levels of exposure in the equity derivatives market. That will be the first day that the Depository Trust & Clearing Corporation’s electronic trade reporting repository will provide aggregate figures for the overwhelming majority of equity-derivative exposures, including all those at leading international banks and other big buy side organisations. “I think it’s going to be around 75% of the notional value [of the entire equity derivative OTC market,” says Andrew Green, vice-president for business development at the DTCC in London. The figures that regulators will be able to access via a web tool will show all the open equity-derivative positions of the participating institutions for eight defined products—options, dividend swaps, equity swaps, variance swaps, accumulators, portfolio swaps, contracts for differences and “others”, as of the end of July. The participants have 10 working days to upload and correct their figures before the DTCC makes them available. It is only the regulators and the market participants themselves who will be to access the data. The DTCC (along with the trade processing company that it jointly owns with Markit) developed the electronic repository to help meet the commitment that the markets gave to the G20 governments in June 2009 for greater openness and transparency in the dealing of derivatives. It will initially provide monthly figures (with a time lag of 10 working days), though Green says this was likely to change to weekly reporting within about six months.

Whether or not the repository will subsequently take the further step to daily reporting is not clear at this stage. Green says that was “a discussion for the industry and regulators,” and explains that the DTCC’s experience with the similar platform it set up for credit derivatives in late 2006 would enable it to adapt the equity-derivatives repository as required. “We’ve got a lot of experience in how to run a platform of this kind that is flexible,” he notes. The repository is also designed to offer an even more comprehensive take on the market, should it decide to report the transactions of smaller institutions and those who deal less frequently in equity derivatives. While some of these more peripheral market players may not ultimately be subject to more costly obligations such as compulsory clearing and mark-to-market valuations, all regulators have highlighted the importance of global repositories—the European Commission certainly did so in the briefing paper it published in May. There clearly arguments in favour of less onerous requirements for infrequent market participants, but there seems to be little reason why all should not have to comply with this basic function of reporting all trades to a repository. “We believe that central repositories per asset class—where trades are maintained throughout their life cycle—is an important means of providing greater transparency into the OTC derivatives market,” explains Green. He adds that the DTCC had designed the tool with this in mind. “We’ve worked very hard to make sure the global repository is as open and simple to access as possible.”

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

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In the Markets ALTERNATIVE FUND ADMINISTRATION: NEW PARADIGMS

REDRAWING THE LINES

Photograph © Zubarcuic Dumitru/Dreamstime.com, supplied June 2010.

The hedge fund sector is edging back towards historic highs, according to HFMWeek’s latest Assets under Administration (AuA) Survey. The industry has climbed a massive 21% over the last 12 months to post a total AuA of nearly $2.7trn in April 2010. Fund administrators working in the alternative space obviously welcome the uptick. Even so, the welter of regulation running through the US and Europe could force a restructuring of the alternative fund administration segment. It is unlikely that all the current set of providers will be able or even want to shoulder the burden of a heavier workload. What might the post regulation fund administration industry look like? Lynn Strongin Dodds reports. ITH A TOTAL of single manager assets worth $2.657trn; the hedge fund segment’s appeal is back on track; good news then not only for prime brokers, but also fund administration specialists. According to an HFM Week survey the industry has now enjoyed a full year of growth, up 9% in the last six months, from $2.44trn in

October 2009, and 21% in the last 12 months, from a record low for recent times of $2.2trn. The revival of the hedge fund segment comes in two parts: the first is solid performance; the second is an inflow of fresh assets. US mutual fund allocations to hedge fund strategies in particular look to be on the increase. That is because

managed accounts open up a way for mutual funds to tap non-correlated returns offered by many hedge funds which are now adhering to much improved levels of transparency and which can boast access to liquidity. It is a signal trend, particularly as the industry remains nervous about income streams in a still tight capital raising climate.

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

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In the Markets ALTERNATIVE FUND ADMINISTRATION: NEW PARADIGMS

As William Keunen, director The results are balm to a of Citco Group’s fund services sometime parched alternative division, says, “There will fund administration industry. undoubtedly be changes in the Not all of the current cautious nature of the industry. Given goodwill is entirely the result of that there will most likely be improving hedge fund fortunes. greater reliance on independent The fund administration functions; we anticipate that industry has been able to win a there will be opportunities for host of institutional mandates administrators in areas such as through better due diligence, valuations, disclosure and increased transparency and a reporting to investors and wider move into new products, regulatory compliance.” such as managed accounts and Susan Ebenston, managing UCITS. The managed accounts director, product executive at space has seen a number of JP Morgan Worldwide new additions in recent Securities Services, adds, months, including Butterfield “Regulation will underscore Fulcrum’s new $1bn platform what the future trends will be, Altinus, the first from a hedge but after Madoff there was fund administrator. In terms of already a move towards UCITs, recent growth has been transparency and outsourcing sparked largely by European of services to third party managers; though there are administrations instead of signs of nascent interest hedge funds doing things inemanating from the US. house. Regulation will only Mergers and acquisitions accelerate this and I expect to involving administrators see hedge funds moving continue to be a feature of the deeper into the value chain of segment, with the acquisition David Aldrich, managing director, BNY Mellon, UK and services. It is early days of PNC by BNY Mellon Ireland, also believes there will be further development on though and until the acquired PNC in February for the prime custody services front.“We are definitely seeing legislation settles, it is difficult $2.31bn. Further along the more links between the prime broker, hedge fund and to know the exact details. food chain Credit Suisse custodian to improve the model and to mitigate the risks.” However, it will be a gradual remains poised to buy Fortis Photograph kindly supplied by BNY Mellon, June 2010. process and we are currently Bank Nederland’s hedge fund services unit, Prime Fund Solutions. A groundwork for higher quality and reviewing all the options in number of private equity firms have more granular reporting, robust risk conjunction with our clients.” Dermot Butler, chairman at Custom management systems, independent also shown interest in the space. Despite calmer sailing the industry valuation (particularly around OTC House Global Fund Services, agrees tighter operational “that the main challenges are unlikely remains cautious. Natural concerns derivatives), over European sovereign debt procedures and new products.There has to change dramatically from those exposure and a slower than expected also been further development of prime that administrators have faced over return of consumer demand is custody services as hedge funds looked the past 12–18 months. There has been a greater acceptance after beginning to unnerve markets. to diversify their counterparty risk. A recent report from Boston-based Madoff that there needs to Another great unknown of course is TABB Group showed that many hedge independent verification of valuations how the regulation will pan out. Ever since the worst days of the funds did move much of their of assets that comprise the net asset financial crisis and, particularly in the unencumbered securities and cash out value. One of the differences I think wake of the Madoff scandal, fund of prime brokerages to global we will see in the future is that there will be much more pressure on the administrators have been laying the custodians for safekeeping.

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

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In the Markets ALTERNATIVE FUND ADMINISTRATION: NEW PARADIGMS

One area that the Council and Parliament do largely agree upon is the proposal whereby every alternative investment fund manager must have a registered depositary or custodian to take charge of, and safeguard, its clients’ assets. The fund manager itself cannot act as a depositary. Depositaries can delegate tasks to other firms, but must maintain oversight of them. They are liable for all losses caused by its mistakes or mistakes of the firms it has delegated functions to. This would have a significant impact on administrators, particularly those tending to emerging markets funds, which often rely on subcustodians or depositaries in those markets. Seán Páircéir, partner at Brown Brothers Harriman, Dermot Butler, chairman at Custom House Global Fund says, “The AIFM proposals Services.“The main challenges are unlikely to change over depositaries is an item of dramatically from those that administrators have faced over concern. It puts custodians in the past 12–18 months. There has been a greater acceptance an inappropriate role because after Madoff that there needs to independent verification of they are being asked to be valuations of assets that comprise the net asset value. One of Regulatory trends responsible for risks they the differences I think we will see in the future is that there Although there are various cannot control.” Stainrod also will be much more pressure on the verification of the actual proposals on the table for over believes that “if custodians are the counter derivatives and existence of some assets of the fund. This had not been one of being asked to be more UCITS IV, the one that is the main requirements of hedge fund administrators in the accountable then they will generating the most headlines past. One of the challenges will be to make sure that systems have to be compensated.” is the European Union’s are up to date and to automate as much as the process as One of the main issues is Alternative Investment Fund possible,” says Butler. Photograph kindly supplied by Custom that the increased liability Management Directive (AIFM). House Global Fund Services, June 2010. would prevent some One of the main sticking points in the current negotiations is over the Parliament, comprising directly elected companies from acting as a third country provisions concerning representatives, which recommends depositary in the EU, leading to a of risk. Not funds and managers based outside the that funds domiciled outside the EU concentration EU. The European Council, which should only gain a passport if the surprisingly, it would be the larger consists of ministers from the bloc’s country of domicile meets certain asset servicers who would be better national governments, is proposing to equivalency criteria. A vote on the final placed to deal with the more onerous allow non-EU funds to be marketed draft of the directive is due in the requirements. As Ebenston puts it, within the union using national private parliament on July 6th; although “Under the proposals, the custodian placement regimes. This position market participants believe this would have to return the assets to the holder and then pursue contrasts with that of the European timetable may slip. verification of the actual existence of some assets of the fund. This had not been one of the main requirements of hedge fund administrators in the past. One of the challenges will be to make sure that systems are up to date and to automate as much as the process as possible.” Darren Stainrod, head of alternative fund services at UBS Global Asset Management also believes there will be “more consolidation in the hedge fund space. The barriers to entry will be greater and they will need to strengthen their infrastructure, technology and systems to deal with the regulation. I think we will see consolidation at the smaller end of the scale. At the larger and medium sized end, we are already seeing an increase in request for proposals for outsourcing, especially middle office services.They want to show investors that they have that independent stamp.”

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

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In the Markets ALTERNATIVE FUND ADMINISTRATION: NEW PARADIGMS

compensation through the courts. As a result, you need a strong balance sheet to be able to do this.” Keunen says, “The issue of depositary responsibility and liability is a controversial measure which if adopted in its current form will restrict the choice of suitable service providers from a cost or risk perspective, which seems counter-intuitive to the objective of providing greater protection to investors.” Views are mixed though as to whether the larger players will be the only ones to benefit from the shifting landscape. Ebenston believes:“ those in the middle ground will be hurt and that there will be a polarisation between a handful of niche firms and the bigger players who have the infrastructure and experience of applying the lessons they have learnt in the long only space to the alternative space.” Chris Adams, global head of product for alternative funds at BNP Paribas Securities Services, on the other hand, argues that “small is not beautiful in this situation. Going forward, I think hedge funds will be partnering with a smaller number of asset service providers that can offer a bundled package which includes a wide range of services, such as custody, fund accounting, risk management as well as alternative fund administration products. The organisation also needs to have a strong enough balance sheet and scale to meet the clients growing and evolving needs.” George Sullivan, executive vice president of State Street’s alternative investment solutions group adds,“We have seen a flight to quality and I think that hedge funds will gravitate towards the larger providers who have a broad service offering. These larger firms have been able to demonstrate that they possess a well-established organisational structure that includes

the intellectual capital, infrastructure and technology necessary to handle highly regulated products efficiently.”

Independence Day Ron Tannenbaum, managing director of GlobeOp Financial Services, an independent hedge fund administrator believes that“there is an increasing demand for independent fund administrators wholly dedicated to investing in and providing administrative services, and who are not commercial counterparties to the fund for any trading or custody services. Investors want administrators to be free of conflict since they are the one party sitting in the middle of the funds and their counterparties - the custodians, prime brokers and broker/dealers. The administrator’s role is then to offer the independent reconciliations, reporting and oversight investors now demand.” Although views differ depending on their positions as to who will carve out a larger slice of the pie, all agree that the threat of onerous legislation is likely to push more hedge funds over to the UCITS camp. This is because the regulatory oversight embedded in the UCITS framework not only addresses the regulatory issues but also mitigates the cost that might arise of distributing non-European funds. The same holds true for managed accounts. Butler says, “We have definitely seen an increase in demand in the managed account space and I expect this to continue because investors feel more secure and safer with the transparency, flexibility and liquidity of these types of accounts. However it is important to have an understanding of what the investment manager is doing. If you don’t understand the strategy, you won’t know exactly why a particular instrument is in the portfolio, or how to value it.”

George Sullivan, executive vice president of State Street’s alternative investment solutions group adds, “We have seen a flight to quality and I think that hedge funds will gravitate towards the larger providers who have a broad service offering.” David Aldrich, managing director, BNY Mellon, UK and Ireland, also believes there will be further development on the prime custody services front. “We are definitely seeing more links between the prime broker, hedge fund and custodian to improve the model and to mitigate the risks.” For example, Deutsche Bank s Global Prime Finance recently launched a hybrid custody version of prime brokerage, named DB Integrated Prime Custody. It enables funds to hold unencumbered assets that were typically held within their prime brokerage in a separate custody account held at BNY Mellon or within Deutsche Bank’s separate custody division. It also offers an open architecture approach should clients have a preference for a particular custodian. Looking ahead, Aldrich believes that “one of the biggest challenges will be to provide the quality and breadth of services for hedge funds of every size in a cost effective manner. Smaller funds and start-ups have more difficulty. One way we have addressed this is that we have support operating centres in Poland and India which handles components of the administration business such as fund accounting. This helps reduce the overall cost of the outsourcing.”

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

IAS 19 CHANGES: A BETTER SORT OF DB PENSION SCHEME

IASB CHANGES WILL AID RISK MANAGEMENT Much has been written about the detrimental effects that proposed changes to IAS 19 (the international accounting standard for employee benefits) will have on the profit and loss accounts of defined benefit (DB) pension scheme sponsors, potentially wiping a reported £8bn of profit off the value of the FTSE 100 alone. Yet few have stopped to consider how the recent proposals from the International Accounting Standards Board (IASB), which may ultimately be adopted by the Financial Accounting Standards Board (FASB), will remove a significant barrier to companies’ effective pension risk management. Matthew Bale, a vice president at PensionsFirst Analytics, reports. OW INTEREST RATES, improving life expectancies and volatile stock markets have seen DB pension deficits reach historical highs in the UK, Europe and the US.Yet under current international accounting standards, pension accounts do not always provide a reliable picture of the financial position of the sponsoring company’s pension scheme. Indeed, one area of criticism has been that companies are taking advanced credit for the longterm expected outperformance of pension assets, recording an amount of “profit”in their profit-and-loss accounts irrespective of whether or not the return is actually achieved. This preferential treatment of pension asset returns within a sponsoring company’s financial reports often hinders effective derisking decisions, by incentivising sponsors to hold riskier assets in their pension scheme.

For companies that fall under UK, US or international accounting regulation, there are three critical elements to pension profit-and-loss accounting: service cost, interest cost and expected return-on-assets. The initial two “cost” elements are straightforward, providing for additional benefits earned by current employees and the discount rate applying to future liabilities. However, the expected return-onassets component poses a serious dilemma to pension scheme sponsors when assessing potential de-risking strategies. Essentially, it provides schemes with an incentive to hold higher risk assets (such as equity or property), whereby sponsoring companies can take advantage of the advanced credit given to the expected long-term outperformance of these investments. Most companies allow for an equity return in the region of 8%, safe in the knowledge that any actual deviations from this figure need not be immediately visible in the profit-andloss accounts.There is the potential then to book short-term profit at the expense of longer-term financial stability. Although the investment strategy is ultimately a decision for the pension scheme’s trustees, corporate sponsors often negotiate with trustees with a view to retaining the positive profit and loss impact of holding riskier assets. Even when other factors point clearly to a path of de-risking, the profit and loss implications can often result in a more aggressive investment policy.

Proposed changes Thankfully, the IASB has indicated the need to revisit the expected return-onasset component of pension accounting. A key change would remove the expected return-on-assets from the profit-and-loss calculation.

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 0

The removal of the “corridor” option would mean that all changes in the value of pension scheme assets and post-employment benefit obligations would be recognised immediately on the balance sheet. Evidently, this will have a negative profit implication and the removal of the “corridor” may add billions of pounds, euros or dollars of unrecognised liabilities to some companies’ balance sheets. However, many equity analysts already adjust financial disclosures to eliminate these accounting anomalies.

Positive impact With risk management fast climbing up treasurers’ and financial directors’ agendas, the removal of the accounting benefit of riskier assets is a huge step in the right direction. It incentivises sponsors to look at ways to transfer risk off of their balance sheets whether it be to the insurance market (via buy-in/buyout opportunities) or the capital markets (through such tools as longevity swaps). Furthermore, their efforts in doing so will be aided by more accurate, up-todate and transparent pension-risk management tools that enable sponsors and trustees to implement and regularly monitor the effectiveness of such derisking strategies. The proposed changes to IAS 19 are clearly removing an obstacle to substantial de-risking of DB pension plans. In a world where there is greater transparency of pension exposure and risk, the market can only look favourably on companies that demonstrate a clearer understanding and control of their significant balance sheet liabilities. Therefore, those companies that embrace the opportunities afforded by IAS 19 changes may well be seen more favourably by investors.

Country Report MEXICO: THE NEED FOR TAX REFORM

PATCHY TAX REFORM Tax reform is the order of the day in a world where governments need to raise revenues. Mexico has introduced two sets of tax reforms over the past three years. Moreover, the government is mooting a further round of reforms this year. However, few commentators believe that the reforms will herald long term benefits that the Mexican economy really needs. They look more like temporary patches to minimise the country’s current fiscal problems. Rodrigo Amaral reports. EW TAX RULES that came into effect in Mexico at the start of this year were lauded by the IMF as a strong set of measures that could help the government to raise revenues to cover any budgetary deficits resulting from the 6.6% contraction of the economy in 2009. Changes have included an increase in corporation income tax rates from 28% to 30%. Mexico’s aggregate value tax went from 15% to 16% across most of the country, and 10% to 11% in the border regions which are allowed to charge more favourable tax rates. New excise taxes on telecommunication services and alcoholic beverages were also created or expanded. If the goal was to give an immediate shot to the state’s fiscal health, the new rules seem to be successful. Tax receipts collected by the federal government received a boost in the first quarter of the year, and the IMF estimates that the new taxes will yield the equivalent to 1% of GDP of extra revenues to the government. A fiscal shot in the arm is what the Mexican government needs, after having seen its hydrocarbon cash cow dwindle in recent years due to declining oil production and prices. Taxes generated by the oil industry in Mexico amounted to 8.9% of GDP in 2008, but will fall to 7% by the end of this year, according to the IMF. In

2015, the ratio could drop as low as 6.2%, the Fund says. By increasing the tax burden on companies, the government has managed to offset the permanent loss of revenues, claims the IMF in a recent report. However, many observers note that more need to be done to guarantee that the decline won’t cause troubles over the long run.

Immediate concerns “The 2009 tax reform only covers immediate fiscal needs of the government. It doesn’t change the Mexican tax system in a significant way,” says Alejandro Aceves, a tax partner at KPMG in Mexico.“In order to do that, the government would have change the structure of indirect taxes such as IVA (essentially VAT) and reduce rates of direct taxes, such as income tax, to expand the base of the country’s taxpayers,”he argues. Even with the recent hike, IVA in Mexico is lower than in countries such as Argentina (21%), Brazil and Chile (19%). However, such changes would be clearly unpopular. According to Gerardo Nieto Martínez, a partner and tax expert at Mexico City-based law office Basham, Ringe y Correa. “The price paid is too high: companies have been suffocated.” Nieto stresses the sense of unfairness that has accompanied some of the measures announced last

year.“IETU [corporation tax] is applied on unreal profits of companies, since they cannot deduct many necessary expenses from taxable income,” says Nieto. “Now they can’t even credit their IETU payments from the corporate income tax rate. It’s unfair and it’s crazy.” The co-existence of corporate income tax and IETU is a matter that requires urgent attention from lawmakers, Aceves says. While companies and individual taxpayers strain under the tax leash, truth be told Mexico gathers little tax revenues, compared to other countries. Even with the latest hikes, corporate income tax levels remain lower than the world average. According to the OECD, total tax revenue amounted to a mere 21.1% of GDP in 2008, well below the average among Latin American countries, whose average hovers around 35%, and is the lowest ratio in the OECD. The problem is that, in an economy where millions make their money from the black market, very few people actually pay taxes. “Tax evasion is widespread,” points out Aceves. “The important investments that have been done to implement technological solutions and increase efficiency of tax collection only affect captive taxpayers who have been bearing with all the burden of paying tax in the country. Technological progress should also help to reach a wider base of taxpayers,” he says.”The informal economy has grown so powerful that, if the government tries to tackle it decisively, it might even generate violence,” Nieto points out. “It is a similar problem with drug traffic. It was allowed to become so large that it is very difficult to face it now.”

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

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

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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.

FTSE Developed ActiveBeta Momentum Index

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.

Commodities Report POPULAR COMMODITY ETFs COME UNDER SCRUTINY

Photograph © Agnie Westre/Dreamstime.com, supplied June 2010.

WATCHING A RISING TREND Commodities remain flavour of the month. As the global economy slowly crawls out of a dark hole, market watchers are looking to the light of an uptick in demand for metals, oil and food. However, the playing field in commodities has changed dramatically as exchange traded funds (ETFs) have opened up the investment landscape that was once the preserve of very speculative investors such as hedge funds and commodities producers. Additionally, ETFs themselves have generated demand for commodities and helped move prices higher, attracting the attention of regulators in the process. Vanya Dragomanovich reports. OMMODITY ETFS ATTEMPT to track the price of a single commodity, such as gold or oil, or a small group of commodities by holding the actual commodity in storage, or by buying futures contracts. Because futures provide leverage (providing more exposure than the actual cash invested) ETFs that use futures contracts have free

cash, which they usually deposit in interest-bearing government bonds. The interest on the bonds is used to cover the expenses of the ETF and to pay dividends to the holders. The appeal of ETFs to investor is straightforward. Commodity ETFs are cheaper and easier ways to access commodity price movements, compared with say the futures

market or physical trading. There are several advantages to trading a commodity ETF to the actual commodity. There is no holding of the actual physical commodity involved, which brings with it storage costs, for example. Funds which are restricted from investing in futures because they are perhaps perceived as too risky can invest in ETFs because they trade like shares and are listed on recognised securities exchanges. Administration fees are also on the low range of the spectrum (usually between 0.35% and 0.5% per year) and compare favourably against equity funds which invest in sectors such as energy or mining. Commodities that lend themselves to ETFs based on physical holding are – unlike a herd of cattle or a tanker full of liquid natural gas – easy to store,

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

don’t require a lot of space and are not easily perishable. Physically backed ETFs tend to be only in precious metals: gold, silver, platinum and palladium. According to recent National Stock Exchange figures net cash inflows into commodity ETFs totalled $13.4bn in 2008, and by the end of 2009 this number had more than doubled to $30.1bn. There are now well over 90 commodity ETFs available and the rate of proliferation is showing no signs of abating particularly as one of the top performers, PowerShares DB Agriculture Double Short ETN, had gone up over 40% earlier this year. “Institutional investors are using some of the niche products more often, such as SPRD Gold Shares, to gain access to asset classes that previously had inefficient markets prior to ETF proliferation,” says Paul Justice, ETF strategist with Morningstar, The world’s largest commodity ETF, Standard& Poor’s SPDR Gold Shares, or ‘spider’ to friends, is a typical example. SPDR’s $40m under management dwarfs the competition but other precious metals ETFs are becoming increasingly popular. A similar product in the US is BlackRock’s iShares Comex Gold Trust. In London ETF Securities runs physically backed ETFs in all four precious metals and the firm launched platinum and palladium ETFs in the US at the beginning of this year, which have already attracted $800m in inflows.“The listing was timely. There is growing demand for assets geared for the upturn in the business cycle,” says Nicholas Brooks, head of research and investment strategy for the ETF Securities group of companies. Brooks cites the example of platinum, which is used in catalytic car converters to reduce emissions of carbon dioxide. He explains that one

ETF provides multiple plays, giving: “exposure to China, the car industry and global emissions,”he says. Although returns on precious metals have been good, one drawback with precious metal ETFs is that they attract a high tax on the particular metal that they hold as a deposit. Moreover, bulky commodities such as metals and oil, involve the significant expense of storage costs; therefore many of the ETFs dealing in these markets are invested either in futures or basket indexes.

While physically-backed ETFs will bear a very close correlation to the price of the underlying commodity, futures based ETFs can deviate in price because of the roll yield. If an ETF holds copper futures, for example, the ETF will sell the futures contract close to their expiry date and buy a new future for a date further ahead in order to avoid landing with thousands of tonnes of copper once the future expires. If the market is in contango, that is, the forward price is higher than that at present, long term investors will lose money every time the ETF manager rolls over their holding. This is not just a hypothetical situation. In

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 0

2009, the United States Natural Gas Fund (UNG) lost more than 55% of its value despite the fact that natural gas prices ended the year flat. However, if the futures market is in a backwardation (where forward prices are lower than current prices) as it was for metals for large parts of 2009, this can work in investors’ favour, giving them extra returns on the roll process.

Optimised products ETF providers are wising up to the fact that their investors are losing out in contango situations and are beginning to provide instruments that aim to smooth that loss out. ETF Securities’ Brooks explains that his firm launched its first all-commodities three-month forward ETF in order to reduce the impact of the roll yield. The ETF, ETFX DJ-UBS All Commodities Forward 3 Month Fund is traded on the London Stock Exchange. “Investors have asked for optimised products; products that they easily understand. We back-tested several (longer-term) products and found that they performed well,” says Brooks adding that ETF Securities now offers Brent crude ETFs one month, one, two and three years ahead. There is another version of a futures-based ETF now available. These are exchange traded notes that are linked to futures-based commodity benchmarks. Société Générale runs two such funds: the Lyxor ETF Commodities CRB and Lyxor ETF Commodities CRB NonEnergy. They track the Reuters/Jefferies CRB Total Return Index and the Reuters/Jefferies CRB Non-Energy Total Return Index respectively. INVESCO’s range of PowerShares DB funds are based on Deutsche Bank Liquid Commodity Indices while Barclay’s iPath runs a host of ETFs either based on single commodity indexes or sector indices.

Commodities Report POPULAR COMMODITY ETFs COME UNDER SCRUTINY

Oil, gas, gold and sugar have attracted the most ETF inflows so far. In terms of performance the energy and precious metals funds lead the pack while the agriculture, base metals and livestock markets have all faced significant falls this year. Sugar ETFs have been particularly hard hit as sugar prices dropped rapidly this spring. The iPath Dow Jones-UBS Sugar Total Return ETN fell more than 40% on the year. According to Morningstar some of the top performing commodities ETFs this year are the PowerShares DB Agriculture Double Short ETN with a year-to-date return of around 43%, PowerShares DB Agriculture Short ETN with year-to-date return of around 20% and UltraSilver ProShares returning 11.9% What sticks out on this list is that the biggest moves are in double short notes. Until recently ETFs held mostly long-only positions. One of the arguments in favour of ETFs was that, unlike with commodity futures, the loss incurred by investing in an ETF was only the initial investment rather than a multiple of it. Olivier Jakob of oil research consultancy Petromatrix in Zug says the lines are blurred now that ETF providers have brought in double short and double long positions.

Impending regulation? The trend towards increasing speculation in commodities has regulators worried, particularly in the US, because the prices for some essential commodities are starting to have an impact on the functioning of the rest of the country’s economy. The US commodities regulator, the Commodities Futures Trading Commission (CFTC) is considering setting limits on the amount of positions investors can hold in a certain commodity.

Most of the hubbub is focused on the United States Gas Fund (UNG) which had to stop issuing shares in July last year after the CFTC began strictly enforcing its position limit rules across all market participants, according to Morningstar’s Paul Justice. “UNG itself had grown so large so quickly that it became the largest investor in the front-month contracts for natural gas futures. This is problematic because the fund is a passive rules-based instrument that will systematically sell all those contracts when they near expiration in order to purchase the next contract; and this volume occurs over a five-day window. One could argue that UNG itself is responsible for the prolonged state of contango in natural gas markets,”Justice says. The CFTC is currently considering comments from all parties, mostly complaints from ETF providers who are not keen on this regulation. Nicholas Brooks, analyst at ETF Securities in London says the implications this will have for ETF trading “depend on the detail on how they will implement control. In agriculture such controls already exist. It will depend on whether the CFTC decides to limit positions by type of investment or by the company holding it.” If limits are imposed it will likely have the most impact on energy commodities and potentially the least on the agricultural sector where position limits are in place. In the case of sugar, the regulation should have little impact, says Sudakshina Unnikrishnan, commodity analyst at Barclays Capital. “What will have far more impact on sugar are fundamentals, the amount of sugar harvested in India and Brazil, than the actual regulation,”she adds. The case for commodities is that they are a separate asset class from

Although returns on precious metals have been good, one drawback with precious metal ETFs is that they attract a high tax on the particular metal that they hold as a deposit. stocks and bonds and provide some diversification to a portfolio. Demand for commodities, particularly metals and energy commodities, will continue to rise not only as the Western economy continues to bounce back but also as China, India and other developing country continue on the fast track of economic expansion. The case against commodities ETFs is that unlike dividends or yields they don’t generate income, so an investment is a pure bet on price moves or a diversification move out of more traditional asset classes. On top of that the expenses charged by ETF providers, the cost of storing physical precious metals, or the trading expiring futures, eat away on the underlying value. In the long term commodity ETFs will likely provide less return than the actual commodity. Even so, if watched closely, they can provide a more cost effective and lower risk alternative to direct investment in metals, oil or wheat, say analysts.

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

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Debt Report HIGH YIELD DEBT: RALLY IN BOND PRICES

HIGH TIMES FOR US HIGH YIELD Photograph © Ashestosky/Dreamstime.com, supplied June 2010.

What a difference a year makes. In March 2009, the high yield market was closed to new issues and bonds were trading in the secondary market at deep discounts to par; prices less than 50 cents on the dollar were not uncommon even for high quality credits. Spreads over Treasuries blew out to almost 20%, a level that implied default rates in excess of 15%, consistent with an economic collapse on the scale of the Great Depression. Doomsday never arrived, however. Emergency government programmes relieved the liquidity crisis and stimulated the economy, restoring investor confidence and igniting a powerful rally in bond prices that has continued through early 2010. Neil A. O’Hara reports. IGH YIELD NEW issuance revived and then boomed; hitting a total of $180bn in 2009 and racking up another $77bn in the first quarter of this year. Companies that had been shut out of the market rushed to refinance debt maturing in the next couple of years, and strong demand from investors allowed them do so on relatively favorable terms.“It’s amazing,”

says Gershon Distenfeld, senior vice president and director of high yield at AllianceBernstein, “Companies whose bonds people were not willing to buy a year ago at 50 cents they are happy to refinance at par today.” Take, for example, International Lease Finance Corporation, the aircraft leasing subsidiary of troubled insurer AIG. In early 2009, the company couldn’t raise

money at any price even through a deal secured on the aircraft it owns, but in March 2010 it raised $1bn in five-year 8.625% bonds and $1bn in seven-year 8.75% bonds on an unsecured basis. The firm then reopened the offerings in April for an additional $250m and $500m respectively. Seasoned high yield portfolio managers such as Distenfeld recall similar swings in sentiment in earlier cycles, albeit on a smaller scale. As usual, the first companies able to tap the market when it reopened were relatively strong credits willing to offer senior secured bonds. The vast majority of proceeds (76% in 2009) were used to refinance existing debt rather than to finance capital spending or acquisitions, and while that proportion fell to 68% in the first quarter this year it remains far higher than in the heyday of the leveraged buyout (LBO) craze when refinancing accounted for only 35% of issuance. The transaction deals that come to market now will be less leveraged than they were in 2006/2007, too. Michael Kimble, co-portfolio manager for the MainStay High Yield Opportunities Fund at McKay Shields, expects to see LBO sponsor equity as high as 40% at first, a level that will quickly erode to the low 30s and then drift down to the low 20s if the economic recovery stays on track for another couple of years. “The players change, but the basic story is the same,”he says,“It’s like Greek tragedy.” The predominance of financial companies among the fallen angels in this cycle had no precedent, however. The business models for financial companies don’t work if they have to pay typical high yield rates. Indeed, Distenfeld says many high yield managers didn’t have an analyst who covered the financial sector because they had never needed one. As a result, buyers were even more scarce than usual during the redistribution of bonds

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

Debt Report HIGH YIELD DEBT: RALLY IN BOND PRICES

that follows a downgrade to junk status when institutions that are not allowed to own bonds rated below investment grade have to sell.“These bonds traded to very low prices,”says Distenfeld,“We picked up certain hybrid securities at 10 or 20 cents on the dollar.” Ann Benjamin, chief investment officer for high yield strategies at Neuberger Berman, and her colleague Tom O’Reilly, co-managers of the Neuberger Berman High Income Bond Fund, see opportunity among the stricken financials, too. Companies such as Ford Motor Credit and GMAC can now raise money on an unsecured basis at rates that allow them to turn a profit, which could set the stage for them to rise out of the ratings doghouse.“Their business models do work,”says O’Reilly, “We think the auto finance companies will be rerated back to investment grade in the next year or two.” He’s not alone in that view. Kimble at McKay Shields points out that many of the financials in the high yield index today are among the world’s largest financial institutions, including subordinated notes issued by Citi, Bank of America and Wachovia. Although in principle he would rather not own the lower tiers of highly leveraged capital structures—which all banks have—he has an overweight position in financials at the moment. “Major financial institutions can’t operate in the long run as high yield companies,” says Kimble, “Within a couple of years virtually all the financials in our index are going to be investment grade.” While fallen angels give high yield managers a chance to buy bonds on the cheap from forced sellers, the crossover play works in the opposite direction, too. Rising stars that return to investment grade experience a pop in price as a much larger universe of potential buyers snaps up paper trading at a discount to its investment grade peers. Crossover upgrades happen most

Tom O’Reilly, co-manager of the Neuberger Berman High Income Bond Fund. Photograph kindly supplied by Neuberger Berman, June 2010.

Ann Benjamin, chief investment officer for high yield strategies at Neuberger Berman. Photograph kindly supplied by Neuberger Berman, June 2010.

often during an economic upswing when credit quality is improving and investors have a greater appetite for risk. Although US high yield bonds are trading close to the long term average spread over Treasuries, market

participants believe spreads have room to tighten from these levels. “If we can buy bonds at a spread of 600 basis points over Treasuries in companies that are doubling or tripling their operating income year over year that is very attractive,” says Douglas Forsyth, high yield portfolio manager at Allianz Global Investors Capital. He favours consumer cyclicals such as housing, airlines, auto parts or retailers that are well-placed to take advantage of the economic recovery. In market dislocations, high yield spreads blow out to extraordinarily high levels for a brief period but bounce back close to the average a year later. The peak levels distort the mean, however, which explains why AllianceBernstein prefers to look at median spreads.“Over the past 20 years, spreads have been tighter than they are now 65% of the time,”Distenfeld says,“A year ago was a once in a lifetime opportunity, but the market is still cheap.” By its nature, the high yield market generates substantial cash flow available for reinvestment that tends to support prices and help absorb new issuance. The average duration hovers around 4.1 years throughout the cycle (excluding the influence of occasional large fallen angels, which may have bonds outstanding that are noncallable for up to 30 years). In a market now valued at $1trn, coupons alone generate $85 to $90bn in annual cash flow, while maturities and calls can more than double that amount. Unless investors make net withdrawals from high yield bond allocations, managers have to reinvest cash equal to about 25% of a high yield bond portfolio every year. When the new issue market shuts down—as it did for four to six months after Lehman Brothers failed—managers have to buy high yield bonds in the secondary market, which in turn revives demand for new paper.

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

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Debt Report HIGH YIELD DEBT: RALLY IN BOND PRICES

The turnover allows the composition of the high yield bond market to change much faster than its investment grade counterpart. Neuberger’s O’Reilly points out that the credit quality of outstanding high yield bonds has soared in the past year and is now“better than it has been in a very long time”. For a start, 20% of the market either defaulted or went through distressed exchanges in 2009, which eliminated most issues from companies that were in serious trouble due to the recession. In addition, the collateralised loan market was effectively closed last year and has only just begun to show signs of life, which prompted companies that might otherwise have rolled over maturing bank debt at the top of their capital structure to refinance in the high yield bond market instead. The shift from bank debt to bonds has created some tension between issuers and investors, however. Bank debt is typically pre-payable at any time without penalty, whereas high yield bond investors traditionally enjoy call protection for several years to compensate for the risk of a junior position in the capital structure of lower quality credits.“We are trying to find a middle ground,” says O’Reilly, “We are losing some call protection but we are getting much better credit quality that will provide higher recovery rates in the event of default.” Many of the issuers that tapped the market in 2009 had publicly traded equity, another indication that the market was most receptive to betterknown companies with robust earnings prospects. From an investor’s perspective, high yield bonds are hybrid instruments. They carry a fixed coupon like bonds, but whether the issuer continues to pay the relatively high interest rate depends on the economic fundamentals that drive its business; rather like equity, but with a

Douglas Forsyth, high yield portfolio manager at Allianz Global Investors Capital. Photograph kindly supplied by Allianz Global Investors, June 2010.

Gershon Distenfeld, senior vice president and director of high yield at AllianceBernstein. Photograph kindly supplied by AllianceBernstein, June 2010.

coupon attached rather than discretionary dividends. Compared to the investment grade bond market, high yield issuers have fewer choices over the terms the market will accept, according to Jonathan Blau, managing director and head of leveraged finance strategy and portfolio products at Credit Suisse. Deals typically mature in eight to ten years, and covenants are fairly standard, governing restricted payments and asset sales, for example, although the terms do ease in cyclical upswings and tighten during downturns. Companies that refinanced bank debt with bonds last year did so not to save a buck on the interest rate or wriggle out of uncomfortable constraints but because it was the only way they could raise money—even if it meant they had to offer collateral to get it. “High yield has two states: The cash window is either open or shut,”says Blau. New issues tend to be rated either B or BB, but the overall market includes bonds rated CCC as well, most of which started out higher up the ratings scale. The proportion of CCC bonds shot up during 2009 to a peak of almost 30%, but had declined to about 20% by the end of the first quarter this year. New CCC issuance was moribund throughout this period. A significant proportion of CCC bonds do end up in default, and market participants like to track the recovery rate on those bonds. At one time, this much-misunderstood yardstick measured how much bond holders got back when a financial re-organisation was complete, but today it reflects the price at which defaulted bonds trade when an auction is held to settle outstanding credit default swaps, typically four to six weeks after the event of default occurs. By that definition, the low for this cycle—27 cents on the dollar in December 2009—

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

was similar to the level seen in past downturns, but low rates persisted for longer than usual this time. “When the price of the riskiest assets, the CCC-rated bonds, falls to the same level as the recovery rate, that is normally a buy signal,”says Blau,“That happened in February 2009, but the recovery rate kept going down for a period and has only recently rebounded.”At the end of the first quarter this year, the recovery rate had ticked up to 34 cents on the dollar, still below the long term average of about 40 cents. Default rates—and market expectations of future default rates— follow a similar cyclical pattern, although the averages can be misleading. By convention, default rates are quoted on a rolling latest 12 month basis, which delays the impact of turning points. The average default

rate continued to increase through the fourth quarter of 2009, even though monthly defaults crested in June; indeed, the annualised default rate for the first quarter of this year was less than 1% and in March no high yield bonds defaulted at all. For 2010 as a whole, the Neuberger Berman team expects the default rate to be between 1% and 2%, while Benjamin says the market is still pricing in a rate of 4% to 6%. The discrepancy leaves scope for spreads to tighten further, which should offset the impact of the anticipated increase in interest rates in the Treasury market later this year. “We won’t be Treasury-sensitive with rates where they are,” says Benjamin, “We collect around a 9% coupon on an average portfolio, and with some spread tightening returns should be in the low double digits.”

Jonathan Blau, managing director and head of leveraged finance strategy and portfolio products at Credit Suisse. Photograph kindly supplied by Credit Suisse, June 2010.

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F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 0

Debt Report FRENCH COVERED BONDS STAND FIRM THROUGH CRISIS

STANDING FIRM It has been a rollercoaster few years for covered bonds. Appetite and issuance has waxed and waned as the markets lurched from global banking crisis to European sovereign debt woes. Even the highest quality loans have found themselves buffeted. The tribulations have provided the sternest test yet for France’s covered bonds market, which was launched in 1999, with the introduction of laws that ushered in obligations foncières, and then expanded in 2006, with new rules that paved the way for contract-based covered bonds. Have France’s obligation fonciére withstood the storm? Paul Whitfield, in Paris, went in search of answers. HE GLOBAL BANKING crisis of 2008/2009 and the more recent EU sovereign debt concerns have provided uncomfortable moments and tested the mettle of French covered bonds. In doing so, they have proven their merit, say commentators. “Compared to other jurisdictions, {such as] the UK, or cédulas hipotecarias in Spain, the French market has proven more resilient, closer to Germany’s pfandbrief,” says Paul Dudouit, deputy director primary market at Credit Foncier de France, one of France’s biggest issuers of obligation fonciére. Pfandbrief remain the gold standard of covered bonds and any assessment of national markets is always made in comparison to Germany. So it has been reassuring for French market participants that during the recent periods of stress their covered bond market has behaved much like that of Germany.”There is a premium for the recognised reputation of legislations that have proven they are efficient,” explains Fabrice Faure-Dauphin, a

partner in the Paris office of Allen & Overy, where he advises the sponsors and originators of covered bonds. “That is the key driver of the success of the German market and the French market can [now] point to the same strengths. “France’s covered bond market doesn’t have more than 100 years of non-default history [unlike German pfandbrief] as it is only 10 years old, but the market is deep enough and has been established long enough that investors can assess reliability and have confidence in the legal environment.” That is not to suggest that recent events have not had an effect. The collapse of Lehman brothers in September 2008 led to a complete cessation of activity in the French covered bond arena, as it did throughout the wider European covered bond market. “We saw in the crisis and the following credit dislocation that even high quality assets were traded at heavy discounts and there was a big spread widening,” said Nicolas Malaterre, a Paris-based covered bond analyst at Standard & Poors.

Photograph© Artcp5/Dreamstime.com, supplied June 2010.

Narrowed spreads The width of the spreads on covered bonds, even after the market began to find its feet again, resulted in new issues slowing to a dribble. The situation in France and across Europe spurred the European Central Bank to act and, in May last year, it announced plans to purchase €60bn of covered bonds in both the primary and secondary market. “Directly after the ECB announcement spreads tightened significantly in the following months,” notes Boudewijn Dierick head of structured covered bonds at BNP Paribas SA. “That was followed by a period of stability and then in the last four weeks they widened again. In France the spread increased about 10 basis points (bps), which was less than in many other countries”

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That most recent spread expansion was driven by concerns about the Greek sovereign debt crisis and associated fears that Spain, Portugal and other countries could also be dragged into problems. Even so, participants in the French covered bond market appear sanguine about the threat of sovereign frailty within the EU. “Sovereign concerns have an impact, but they can be mitigated by the quality of collateral [in the covered bond],” explains Diereck. He cites the example of a recent BNP Paribas covered bond that, because of the quality of the underlying assets, priced just inside the sovereign secondary level. “Interestingly given the climate there seems to be increased appetite for covered bonds backed by public exposure [government guaranteed loans],” says Faure-Dauphin. “That appears a bit of a contradiction when you see what is happening to public sector debt but it reflects investors desire to tap quality public debt.” Dexia, Société Générale and BNP have all recently launched successful covered bonds using governmentbacked debt as collateral. “The interesting aspect was that the types of public exposure were all different,” highlights FaureDauphin, who worked to help construct the BNP Paribas bond. Dexia’s bond was underpinned by municipal loans; Société Générale also used those loans but added some structured public exposures such as guarantees from credit export agencies, while BNP Paribas’ bond was almost exclusively credit agency guarantees. Faure-Dauphine believes that the success of both the Société Générale and BNP Paribas bonds means more covered bonds using credit agency debt will come to the market in the near future.

French mortgage debt It is not only French government debt that has won support through uncertain times. The robustness of French mortgage debt has also given confidence to investors. That strength has its roots in the conservative manner in which French banks operate their mortgage books.“France does not have a subprime market and I think the reason for that is legal, for the most part,” explains FaureDauphin “A subprime type of mortgage simply wouldn’t work given the legal environment, which offers a lot of protection to the mortgage holder. It may be very difficult to foreclose and claim residential assets.”

Dexia, Société Générale and BNP have all recently launched successful covered bonds using government-backed debt as collateral. “The interesting aspect was that the types of public exposure were all different,” highlights FaureDauphin, who worked to help construct the BNP Paribas bond. The upshot of that is that French banks have little interest in the value of the underlying property asset, focusing solely on the ability of mortgage holders to meet loan repayments. That has made them far less likely to allow borrowers to overstretch themselves, meaning that even when house prices stalled, as they recently did, their loan books, which form the collateral that underpins much of the covered bond market, remained sound.

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There are also legal factors inherent in the regulation covering French covered bonds that make them less risky than many other markets. “The law of June 1999 [which underpins issuance of obligation fonciére] is both strict, transparent and under the French Banking Authority’s control. With a dedicated balance sheet and a sole purpose the issuer benefits from bankruptcy remoteness from its parent company,”adds Dudouit. The reason for that, says Dudouit, is that the French regime dictates a separation of the balance sheets of the banks and the covered bonds, which is not the case in Germany. That creates what is known as a dual recourse instrument, offering investors recourse to both the bank and to a pool of assets if the bank defaults. This duality and strength of French covered bonds was recently recognised by Standard & Poors when it adjusted its criteria for rating covered bonds to include both bank and bond risk. “Following the review of all issuers, inline with the new S&P criteria for rating covered bonds, all remained at the highest AAA rating,”says Standard & Poor’s Malaterre. “French covered bond issuers have done a good job of managing asset/liability mismatches [one of the key risk factors in a covered bond], keeping them to a minimum, and there are no BBB or less banks issuing covered bonds.”

Regulation French regulators are working to further strengthen the domestic covered bond. New law, which is on schedule to be introduced in the autumn, will bring many contractual covered bonds, i.e. those not currently covered by the 1999 obligations foncière’s legislation, under the remit of formal regulation. “The additional law will introduce a new legal category called Société Financement a l’Habitat

Debt Report FRENCH COVERED BONDS STAND FIRM THROUGH CRISIS

Credit Foncier recently launched a dollar denominated $2bn covered bond, 62% of which was placed in the US, and has plans to launch other nonvanilla vehicles. (SFH),” says BNP’s Dierick, who has been involved in the consultation process to formulate the new rules. “They will have a legal framework and will have to appoint a specific controller to monitor and report back to the French banking authority.” The assets that can be used to construct the bonds (namely mortgage debts and government secured debt) will remain the same but the covered bonds will be enhanced with a minimum coverage ratio of 102% and will now have a 180 day liquidity requirement, bringing them inline with obligations fonciére with regards to those two elements. If those enhancements to the regulation seem sure to have a

positive effect on the French covered bond market then other aspects of the future are less certain. The ECB’s intervention in the covered bond market will come to an end in June 2010 and is not likely to be extended. Importantly the bank has also said that it won’t seek to sell its paper, meaning the secondary market will not see a spike in selling. French covered bond experts tend to believe that the end of the program will not have a material effect on their market. “I think that the market will remain on the same trend through 2010,”says Dudouit.“We don’t foresee spread’s widening at the end of the purchase program.” Others are not quite so confident. “The important question will be what is happening in the wider market [when the program finishes]”, notes Dierick. “If the wider market is stable then the ECB program ending won’t have much effect [on the French market].” There are other factors at play over the medium term too. Basel III, the third iteration of the rules governing bank capitalisation, is likely to increase the liquidity buffer banks are

THE READY GUIDE TO OBLIGATION FONCIERE The two types of French covered bonds: Obligation foncières: These are French regulatory covered bonds, which can only be issued by a société de crédit foncier (SCF), a credit institution licensed for that purpose. The obligation foncières rank ahead of all other creditors including the French treasury in the event of bankruptcy of the SCF. The vehicles can be secured by first ranking mortgages, and in some circumstances real estate securities and loans used to finance a real estate asset, some types of high-grade transferable securities and loans from qualified public entities.

required to maintain. “The impact of that should be favorable for high quality assets such as covered bonds,” said S&P’s Malaterre. In the even shorter-term Malaterre also sees a positive dynamic for issuers of French covered bonds in a pending wave of redemptions of covered bonds outside of the French market.“That will start this year and it will mean investors may have to look beyond their domestic markets,” he says, adding that German investors, which are traditionally home bound in their investments are increasingly finding the French covered bond market appealing. The issuers in the French covered bonds are already responding with strategies aimed at boosting their international customer base. Credit Foncier recently launched a dollar denominated $2bn covered bond, 62% of which was placed in the US, and has plans to launch other nonvanilla vehicles. “We have developed specific formats for the German market and because of initiatives like this we are in a position to issue new instruments even in a difficult environment,”says Dudouit.

Contractual covered bonds: These bonds are established by financial institutions which refinance assets by establishing a credit institution, known as a covered bond company (CBC). These are structured as bankruptcy remote vehicles with the express purpose of issuing bonds and granting loans secured by nominated assets, typically mortgage loans or public entity loans. The assets are pledged to the vehicle in accordance with the Financial Collateral Arrangements Directive which, in the event of pledgor bankruptcy, allows investors special rights to recoup their investments. Because CBCs are not regulated the composition of the portfolio underlying the bond is fixed on a purely contractual basis, enabling them to include a wider range of assets than obligation foncières.

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Index Review In March this year in its bi-annual Quality of Market assessments, index provider FTSE Group commended Malaysian institutions, such as Bursa Malaysia, the central bank and regulators in conducting a robust engagement programme with international investors. Back in September of last year, FTSE placed Malaysia on its Country Classification Watch List in preparation for a possible upgrading of the country to advanced emerging status in September 2011. N MARCH THIS year FTSE Group upgraded Malaysia’s Quality of Market assessment to ‘Restricted’ status in the area of‘non [sic] or selective incidence of free and well developed foreign exchange market’ noting that, while mechanisms are in place for foreign investors generally to conduct currency trading efficiently, “a 24/7 offshore market in the Malaysian ringgit remains lacking”. Even so, the index provider has commended efforts by Bursa Malaysia and government agencies for their coordinated approaches to the broaden of investor appeal in the country. Malaysia has a strong story to sell; not least in the service set of Bursa Malaysia. The basis for a broadening array of investor-led products, such as ETFs, was laid down in 2006 when, in conjunction with FTSE Group, the Bursa launched a comprehensive set of indices. The family has been added to over time to now cover all eligible companies on the recently revamped Bursa Malaysia main board and ACE market. The Kuala Lumpur Composite Index (KLCI) was transitioned to the FTSE Bursa Malaysia KLCI to be the primary market benchmark for Malaysia in July 2009. The number of firms in the benchmark was reduced from 50 to 30, and calculated according to FTSE’s globally accepted index standards for domestic and international investors,”highlights Paul Hoff, managing director of FTSE

Group in Asia. “We applied a very different approach to the methodology, taking simply the largest listed companies on the exchange. This step created a more transparent, investable and tradable benchmark to stimulate the creation of ETFs, derivatives and other index-linked products.” The index series was also expanded in 2009 to include three new sector themed indices with the launch of the FTSE Bursa Malaysia Palm Oil Plantation Index Series, offering exposure to Malaysia and Asia’s lucrative palm oil plantation industry. All in all, the transition to a new set of real time indices will improve the performance measurement of the major capital segments of the Malaysian market, neatly slicing it into large, mid, small cap, fledgling and Shari’acompliant portions, “giving investors a wider selection and the flexibility to measure and invest in these distinct segments,”notes Hoff.

Responding to competition The strain for Bursa Malaysia, as with all national exchanges, is to secure and increase liquidity and, at the same time, encourage the establishment of a broad investor base; an increasingly difficult task in a skittish global equity market that is increasingly fragmented. Malaysia has been a regional leader in this regard, moving to diversify its capital markets in the early 1990s with the widespread adoption of both a growing array of

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MALAYSIA STEPS UP A GEAR

ADVANCING YEARS

derivatives, equity based and Shari’a compliant financial and investment instruments. “While Shari’a investment instruments have been slow to take off generally,” notes Hoff, “Malaysia is working hard to find ways to access those investors whose bandwidth may not have allowed them to reach other investible instruments in the market,”he adds. To underscore the search for depth in Shari’a products, FTSE Group has worked with the Bursa to develop Shari’a indices for the local market, “supported by somewhat softer criteria than is required by the international institutional investment community. We have noted however an increasing number of investors picking up various FTSE Shari’a indices for benchmarking,”adds Hoff. In May this year, Bursa Malaysia expanded the reach of its products through its strategic partnership with the CME Group. The CME announced the launch of a dollar-denominated, cashsettled crude palm oil futures contract. Crude palm oil is the most consumed edible oil in the world, as it is contained in a multitude of diverse products, from cooking oils and soaps to biodiesel fuel. Settlement prices at expiration of the new electronically traded futures contract will be based on Bursa Malaysia Derivatives Berhad Crude Palm Oil futures, the global benchmark for crude palm oil pricing that is traded in Malaysian ringgit. Hoff thinks that 2010-2011 might be a banner time in terms of new offerings. It is likely that the Khazanah state holding concern will divest some of it’s assets.“Obviously this will increase the flow of paper in the market and give people retail access to the country’s growth story,”notes Hoff. In a global market hungry for new IPO opportunities, Malaysia’s upcoming new equity issuance calendar should help spur inward investment. The country’s underlying growth story is certainly more positive this year.

Index Review COST CUTTING: THE LONG DISTANCE RUNNER

Although the FTSE depends for much of its weighting on events outside of the UK the message from the Treasury will shape expectations and events for some little time. While the economic position is dire it is not disastrous and prompt and decisive action should win the day. Of course, misguided decisions or accommodations made for ‘political’ reasons might yet make a bad situation worse. Simon Denham, managing director of spread betting firm Capital Spreads, gives us his personal view.

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

PICK A POCKET OR TWO, EH? O NE OF THE problems for the markets is that, no matter what is announced, the effectiveness of sovereign cost cutting policies will not be felt for some little time, making snap assessments dangerous in the extreme. Fortunately for the Tory/Lib pact, the feeling through the investment markets seems to be rather cuddlier these days, which might well give them the breathing space required to take effective action. On the other hand, expectations have become so immediate in recent years that time is one thing that politicians no longer have. A week seemed a long time in politics to Harold Wilson in the 1960s; only 30 minutes can seem a lifetime to the current incumbents. Public sector cuts are on everyone’s lips right now, and while much of the likely details have been leaked already we now have two opposing forces within the UK administration to deal with. The Tories have always distrusted excess government input and can generally be relied on to take a cautious route; meanwhile the Liberals are still in their historic zone of ‘Public Sector Good/Private Sector Bad’; even in the face of vast swathes of evidence to the contrary. Fortunately however recent comments from all parties seem to show that nearly everyone is ‘on side’ with solutions—even down to Deputy Premier Nick Clegg’s warning

over public sector pension liabilities. If such inviolate areas as this are under the microscope, then it could bode well for the overall package, as the statement indicates that it is not just current expenditure that is being addressed but also the future burden of the public sector as a whole. So much of the UK domestic market relies on the public purse that the effects of any government cuts will have ramifications well beyond the headline numbers. Some 32% to 35% of the working population is directly employed by the state. These people, in their turn, then rely on the services provided by the private sector. The income generated here is then spent again in an ever decreasing spiral. It does not take a genius to work out that the multiplier effect of that series of cuts. If the tightening of purse strings was just confined to the UK economy we might be reasonably sanguine. Even so, over 50% of UK exports are to the Eurozone where recent events have hardly been conducive to strong economic growth. The jury is still out on what the eventual effects of some of the budget cuts in Spain, Portugal, Ireland, Italy and Greece will be. However, it could be said that the incidence of all these nations acting the same way at the same time is risking a descent into a deflationary spiral. Actually, the vast PR machine of the European Union seems to have

managed to put a stopper on the constant destructive speculation as to the indebtedness of its Southern members. This has given the markets a welcome oasis in which to try to rebuild a bit of Euro confidence. Sadly, this state of affairs is unlikely to last. The Germans, for one, are still smarting from having to bail out the South and the pot of €750bn in ‘new’ money is unlikely to last long; in other words, this story is likely to run and run. As I write the FTSE is trading at 5250. My forecast, made last December, for the year end 2010 was 5250. At the half way point we are pretty much back where we started it. Even so, the travails of BP could hardly have been expected and, without its decline, the market would be considerably higher. The bulls will be hoping that with the usual‘May’blip behind us and, with the World Cup likely to fill the headlines for a while, there does not seem to be too much to worry us in the near/medium term. Corporate numbers continue to be on the side of the angels and recent economic data has been solid (without being exuberant). If it were not for the sovereign issue still weighing over our heads most analysts would be calling the markets extraordinarily good value. “As ever, Ladies and Gentlemen, place your bets”

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RIPPLE EFFECTS Notwithstanding the blowout of the Deepwater Horizon rig 50km off the coast of Louisiana, which cost eleven lives, BP’s easiest days look to be behind it. The vagaries of exploration for oil in difficult, deep waters, such as those found in the Gulf of Mexico, or having to work with new technology to exploit carbon resources in oil sands or shale, mean that the halcyon days of oil companies are well and truly over. Nowadays the business is as much about cost efficiency and downstream diversification as it is about new and difficult finds. The repercussions of this latest and major Gulf of Mexico oil spill will reverberate for at least a decade. Vanya Dragomanovich reviews the principal, short term concerns. IG WORK IS a dangerous job as summed up in the title of a book by Paul Carter, a rig worker, entitled Don’t Tell Mum I Work on the Rigs (She Thinks I am a Piano Player in a Whore House). The inference is that there is plenty that can go wrong as technology battles the elements, and that’s why operating an oil rig, like flying a plane, involves a series of procedures that are designed to make sure that if it does a number of failsafe procedures are in place to prevent a disaster.

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For reasons that will no doubt be uncovered by an ongoing investigation by the US Department of Justice these failsafes failed at the BP’s Deepwater Horizon rig 50 km off the coast of Louisiana. As everyone now knows, a resulting explosion destroyed the rig and left 11 workers dead and a seemingly unstoppable geezer of oil emptying into the waters of the Gulf of Mexico. Until a containment cap was put on the well in early June, the well was estimated to have leaked between 15,000 and 20,000 barrels of oil per day. The accident is now the largest environmental disaster in the US. Not only that, it did for BP, and the rest of the oil industry, what the credit crunch did for banks. It made them reviled by the general public. Actually, BP is not the only company this has happened to. Remember the Exxon Valdez disaster. More recently, since 2001, there have been 858 fires and explosions in the Gulf of Mexico alone, according to the federal Minerals Management Service. As many of the shallower wells have already been discovered and exploited, oil companies have had to move to ever greater water depths to retrieve precious oil. Invariably, these efforts have resulted in state-of-the-art drilling technologies; though sometime safety and spill containment procedures have struggled to keep pace with every more complex exploration demands.

COVER STORY: THE IMPACT OF THE GULF OF MEXICO OIL SPILL

President Barack Obama meets with members of his Cabinet to discuss the response to BP Deepwater Horizon oil spill, Monday, June 7th, in the Cabinet Room of the White House in Washington. From left are, White House Adviser on climate and energy Carol Browner, the president, National Incident Commander Admiral Thad Allen, and Homeland Security Secretary Janet Napolitano. Photograph by Pablo Martinez Monsivais for Associated Press. Photograph kindly supplied by Press Association Images, June 2010.

COVER STORY: THE IMPACT OF THE GULF OF MEXICO OIL SPILL 42

It appears that BP already has form in this regard. In 2005 15 workers were killed in the Texas City refinery and the subsequent investigation later found that the refinery explosion was caused by an allegedly lax safety culture and aggressive cost-cutting. BP was charged with violating federal environment crime laws and ended up with an $87m fine. Ask any oilman in Aberdeen, the centre of the UK offshore oil industry, about the Gulf of Mexico BP rig incident and the vitriol kicks off. It reflects concerns not only about the oil giant’s cutting programme in America; but also the laxness of the US safety regulations compared to those enforced in Europe. Under Tony Hayward, the current chief executive, BP has cut some 7,500 jobs and created savings of $4bn to the delight of its shareholders who have benefited from dividends as high as 14 pence per share and share prices of 613pence. The efficiency drive has also pushed down BP’s cost of production to one of the lowest in the industry to the point that the company has now overtaken Exxon Mobil as the lowest-cost operator. It must be stressed. There is no evidence that cost cutting led to this recent explosion, and an investigation by the US Department of Justice will probably clarify that.

from paying its dividend,” says Edward Meir, commodity analyst at oil brokerage MF Global. So what does all this mean? By the 14th June, the company’s shares had fallen to 392 pence (a fall of more than 40%), wiping a massive $73bn of its value. One of the sharpest intraday falls happened when the company was reported by the Times to be looking into suspending dividend payments in order to stock up cash for the mounting costs of the spill. Certainly, the company is generating sufficient cash to meet the current estimates for its liabilities which most analysts peg at a maximum of around $40bn. However, some forecasters predict the final cost could reach as high as $60bn to $70bn. Absolute worst case? If the numbers were high enough it could lead to the company opting for bankruptcy in order to limit liabilities. Before the spill, BP had assets of $241bn and liabilities of $136bn, or net assets of $105bn. The company has cash flow before capital expenditure and dividends of between $25bn and $40bn per year. If the company stopped all dividend payments and temporarily did not spend on capital expenditure (capex) it would be able to handle even the worst case scenario.

The blame game

Vulnerable to a takeover?

In the meantime though, the US government, and specifically President Obama, is holding BP directly responsible for the cleanup of the spill. Estimates of how much this could cost range between $7bn and $40bn. Even so, the company might yet face a stream of civil or criminal penalties that could dwarf the immediate cost of the cleanup. Additionally the company has now had to set up a special $13bn compensation fund imposed upon it by the Obama administration. In fact, the litigation has already begun. BP is being sued by fisherman and shrimpers in the Gulf who claim to have lost their livelihoods. There are also a raft of claims from some of it shareholders on the grounds that the company allegedly failed to monitor safety on the rig and exposed itself to potentially enormous liabilities. Up to now, more than 160 class action lawsuits have been filed. More than two dozen class action lawsuits have against the rig’s owner, Transocean Ltd. and against Halliburton Energy Services, the Halliburton Co. unit that which provided cementing services, and Cameron International Corp., which supplied blowout-prevention equipment. The Halliburton unit had completed the final cementing of the oil well and pipe just 20 hours before the blowout. The US Associate Attorney General recently told a committee of the House of Representative that his office is looking very closely to “ensure that these companies have funds available to compensate the taxpayers, the individuals harmed throughout the Gulf, the families of the individuals who were killed, or who have been injured,”and that it was planning to take action. “This is not particularly friendly language and implies that the Justice Department is looking at whether it can legally issue an injunction to prevent BP

In the meantime the drastic loss in BP’s share value is making the company vulnerable to a take-over. If so, there are less than a handful of companies that would have enough resources to buy the giant which used to be Britain’s largest company and they are ExxonMobil, Chevron, ConocoPhillips and Royal Dutch Shell. None of them is likely to make a move until it becomes clear how much liability would come with the purchase.The Department of Justice’s investigation could take at least a year, the law suits are likely to take even longer. Big national oil companies, such as China’s PetroChina and Saudi Arabia’s Saudi Aramco, might also very likely be interested to in BP assets in the mainland US. However, there is not even a slim chance of that happening. The US is prickly about allowing countries which it sees as potentially hostile gaining any kind of strategic foothold on its soil, allowing China or Saudi Arabia to control one third of its domestic oil supply would be anathema; and while BP accounts for 15% of the value of the FTSE100, twothirds of its employees are US based. Just how far US neurosis extends in this regard is exemplified by events in 2006. Then the US blocked a proposed takeover of British ferry operator P&O ferries by Dubai Ports World because it would have meant that an Arab Emirates’ company would have ended up owning six ports in the US. Even so, with a weakened share price BP is vulnerable to other slings and arrows. Russia’s president Medvedev for instance has already hinted that BP’s current problems might jeopardise the company’s future in Russia.“Investors may take that as a sign that the Russian government may again increase pressure on BP to sell its stake in the Kovykta gas deposit required to supply gas to China,”said Chris Weafer, analyst at UralSib bank.

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The ripple effect The ripples from the Gulf of Mexico will not stop at BP. The disaster will have implications across the oil industry; for three reasons. The administration brought in a six month moratorium on drilling in the Gulf of Mexico stopping work at 33 deepwater wells. “It is likely that drilling rigs priced at up to $500,000 per day, and other equipment, may be moved out of the region to keep them gainfully employed during the Gulf moratorium. If this happens, bringing equipment back to Gulf would take time, so there could be a drag effect on new drilling,” says consultancy Wood MacKenzie. “If tightened regulation and new drilling practices cause longer drill times, both exploration and development well costs will increase causing operators to re-evaluate project economics. Since development drilling costs can be up to 70% of total capex, the impact on overall project economics could be detrimental to the extent that it challenges the commerciality of a number of projects, both large and small,”Wood MacKenzie notes. Second, it will encourage fund managers to revisit investment approaches. Swedish bank Nordea recently said its ethical fund had sold off all investments in BP after the spill shifting the focus on a number of other ethical funds which still hold BP and other oil stocks. Meanwhile, Oliver Crawley of Somerset Asset Management in London thinks that in any case pension funds need to tap into a source of income that does not have such large exposure to single stocks that are cyclical and capital intensive. “This episode is certainly a wake-up call,” highlights Crawley. “We limit exposure to a single stock at 5% of the portfolio.” “We are seeing other funds moving out of UK equity income into a global emerging markets income strategy and we expect more of the same. It is not sensible right now to have too many eggs in the UK equity income segment. We would certainly encourage our client to introduce more diversification into the portfolio mix,”says a fund manager in London. Third, the cost of health and safety will go up. The industry has been battling to cut costs, but after Deepwater Horizon it will find it hard to oppose new offshore rules being proposed by an irate Obama government. Even so, in spite of these immediate concerns, it is likely that oil majors across the board will see minimal impact on their share value. High income generation is a given over the medium term, and not only in the US. Wherever the car remains king, demand for gasoline remains high. Although shares in Exxon, Shell, Conoco and Chevron appeared to dip slightly in the aftermath of the Gulf rig explosion, more recently they are showing signs of stabilisation and of moving slightly higher.

A problem for smaller firms It might however, be a different story for those small and mid-sized and companies in the underbelly of the oil industry such as drillers, rig operators and helicopter suppliers flying to rigs. Anadarko Petroleum which holds a 25% stake in Deepwater Horizon has seen its shares

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The Transocean Discoverer Enterprise burns off some natural gas as it takes on oil from the broken BP wellhead at the bottom of the Gulf of Mexico Tuesday, June 8, 2010. The cap over the broken BP wellhead is collecting more gushing crude day by day. BP is preparing enhancements to the LMRP cap containment system to increase the rate of capture of oil in the Gulf of Mexico. On June 12th, the oil giant collected 15,000 barrels of oil and 32.9m cubic feet of natural gas were flared. The first planned addition, to operate in addition to the LMRP cap system, will take oil and gas from the choke line of the failed Deepwater Horizon blow-out preventer (BOP) through a separate riser to the Q4000 vessel on the surface. Both the oil and gas captured by this additional system are expected to be flared through a specialised cleanburning system. Photograph by Dave Martin for Associated Press. Photograph kindly supplied by Press Association Images, June 2010.

BP FUNDAMENTALS (as of 14th June 2010) Shares in issue (m) Market Cap (m) PE Ratio Operating Margin (%) Profit Margin (%) Turnover per Share PEG Factor Div per Share (DPS)(p) Div Yield (%) Div Cover Beta (f) EPS Diluted EPS Undiluted ROCE

18,793.78 81,452.26 10.59 6.93 6.93 8.19 -1.93 8.70 5.87 1.58 0.84 68.50 68.50 12.73

Source: Daily Telegraph website, June 14TH 2010.

COVER STORY: THE IMPACT OF THE GULF OF MEXICO OIL SPILL 44

plunge some $30 from $71 in April. The company estimates that insurance coverage for its stake in the leaking oil well will cost $178m. Anadarko is moving three rigs away from the Gulf in response to the moratorium, putting them elsewhere to meet production goals; but it is a costly move. Moreover, oil services companies such as Schlumberger are keen to put as much blue water between themselves and the Gulf as possible; rushing to reassure investors that the spill will have little impact on them. The firm has stressed that only 3.5% of its income comes from the Gulf. Nevertheless, Schlumberger shares have fallen from around $73 when the explosion happened to $59 in early June. Closer to home, shares in Transocean, the offshore driller that operated the Deepwater Horizon rig fell 47% and its debt rating has been lowered by Moody’s Investors Services to two steps above junk. Transocean has not been held responsible for the explosion and is not paying for current clean-up efforts. However, in the aftermath of the clean-up and when class actions against BP come into their own, it is unlikely that BP will allow Transocean or even Halliburton not to be pulled into the proceedings.

THE BP QUICK GUIDE ntil the explosion of its oil rig in the Gulf of Mexico, BP (once known as British Petroleum) was the UK’s largest company and oldest oil company. Royal Dutch Shell and Vodafone are now bigger. BP’s shareholder base is a mixture of large institutional shareholders and small retail investors; about 40% are from the UK and another 40% are from the US. Although BP is widely regarded as a UK company, it has interests globally. It is one of the largest oil majors working in the US, which accounts for around 12% of the company’s sales revenue. As exploration has become more difficult and expensive, firms such as BP have looked to improve margins. BP chief executive, Tony Hayward, reportedly cut $4bn of costs last year. While under normal circumstances, financial caution would normally spur plaudits, it has had the opposite effect in the wake of the Deepwater Horizon blowout. Around a quarter of the firm’s oil (and about a third of its gas) is exploited from US fields. A further third is generated in Russian fields, mainly through a joint venture with TNK-BP. Another 30% comes from fields in South America. Its traditional North Sea fields only account for about 8% of the company’s oil extraction volume these days, with the balance of oil extraction sourced out of African fields. Like other oil majors BP’s easiest days are behind them. More oil companies are exploring for oil in difficult, deep waters, such as those found in the Gulf of

Ratings under stress Ratings on the debt of oil servicing firms are under stress. Standard and Poor’s Rating Services has lowered ratings on BP, Transocean and Anadarko’s debt. Further afield, other companies have also come under the spotlight. The ratings agency has lowered non-investment grade ratings on ATP Oil & Gas, a small-cap oil exploration and production company, Hercules Offshore, a provider of shallow-water drilling services, Helix Energy Solutions, an offshore company that develops and operates its own wells, and Hornbeck Offshore Services, a small-cap provider of shipping services to offshore rigs. The outlook for Seacor Holdings, also a shipping services provider, was revised downward from‘stable’to‘negative. PHI, a small-cap services company that provides air transportation to Gulf rigs and platforms was put on‘watch’status for further downgrade. This may be the time to look into buying BP shares. Although they are far from being ready to recover there is likely limited down side as long as US consumers continue to buy oil at the same rate as they do now. There is only a small issue to consider: that of limited opportunities for investors to collect dividends over the near term.

Mexico, or having to work with new technology to exploit carbon resources in oil sands or shale. The company has also diversified downstream into the refinery business and own brand petrol sales outlets. Oil fields in the Gulf of Mexico are some of the most productive in the world; though in deep waters oil is much harder to extract. The Gulf’s importance has been underscored of late as sovereign oil cartel OPEC recently cut production as demand dipped over the near term. President Obama now appears to have banned new drilling in the Gulf of Mexico, following the Deepwater Horizon accident; though this is unlikely to be maintained over the longer term. Some analysts suggest that a permanent ban on new wells could cut local production by up to 300,000 barrels per day (equivalent to around 25% of the Gulf’s output). While OPEC cut production while demand contracted in the wake of the financial crisis, it is likely to respond to signs of growing demand as (at least) some of the major emerging markets look likely to rebound quickly through 2010 and 2011. The investigations into the Deepwater Horizon disaster are focusing on two crucial failures: what caused the initial explosion; and why a blow-out preventer (BOP) device did not block-off the well during the blowout, thereby preventing a leak. On the floor of the Gulf of Mexico, a cap installed in early June over the gushing well was funnelling some oil 5,000 ft up to boats at the surface. The containment rate is expected to increase as engineers slowly close vents in the cap, raising the hopes that BP is finally making significant progress in its efforts to stem the underwater geyser of oil.

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Photograph © Erol Öz/Dreamstime.com, supplied June 2010.

Algorithms are moving beyond cash equities, with futures and options trading using algorithms developing fast. TABB Group in a report last year called US Futures Markets: In the crosshairs of the algorithmic revolution estimates near-universal adoption of advanced execution algorithms within five years. In April 2010, Bank of America Merrill Lynch (BofAML) added six major European index futures to their algorithm offering during London opening hours, complementing their DMA futures offering already available, and is about to roll out further futures contracts in the US and fixed income markets for algorithmic trading. What does bode for traditional equity markets? Ruth Hughes Liley finds out. NEW RELEASE from FIX Protocol, the non-profit organisation that standardises the language of electronic messages, is rapidly reducing the time it takes for an algorithm to be deployed to the buy side. FIX’s algorithmic trading definition language (FIXatdl) will allow trading strategy providers to release their specifications in an industry standard, computer readable XML format. Currently, when the sell side produces a new algorithm, it can take several weeks (supplying detailed documentation requiring coding and testing and working with vendor companies) for the buy side to be able to see it operational on their desktops. Scott Atwell, co-chair of the FIX Protocol Global Steering Committee and manager of FIX Trading and Connectivity at American Century Investments, says that early adoption of FIXatdl has been outstanding.“It’s still early days, but I think the tipping point will be adoption by order

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management and execution management service providers. It will revolutionise the deployment process for algorithms,”he adds. According to Atwell, “Strategies and parameters are changing all the time, and the buy side has to keep up. With FIXatdl it’s simply a matter of loading a new file from the broker, and we can pilot it in one machine, or with one trader, and test it. This saves having to build, or re-build a whole screen. Everyone wins: the sell side because their algorithms will be deployed into buy side hands more quickly; the buy side because they won’t have to wait, what could be six months, to use new and innovative trading strategies. It should enable OMS/EMS providers to include new algorithms in their systems more quickly.” FIXatdl is not tied to any asset class, so trading Vodafone is the same as trading an FTSE future or a German bond. “Algo-based multi-asset will become much easier and it also supports multiple languages very well so there’s an opportunity for providers to tap into non-English markets more easily. I think you’ll see more experimentation because there’s less frictional costs in getting it into the hands of someone who wants to use it,”says Atwell.

TRADING ALGORITHMS ON THE MOVE

THE NEXT GENERATION

Beyond cash equities Algorithms are indeed moving beyond cash equities at a quickening pace in 2010. A report from technology company, StreamBase, estimates that 60% of foreign exchange firms either already use algorithms or are planning to do so. Richard Tibbetts, chief technology officer, StreamBase, says the area is“ripe for innovation”. Futures and options trading using algorithms is also developing fast and TABB Group in a report last year called US Futures Markets: In the crosshairs of the algorithmic

TRADING ALGORITHMS ON THE MOVE 46

Carl James, global head of dealing, BNP Paribas Investment Partners. James says customisation is a Pandora’s Box.“I want an algorithm customised to fit XYZ, but next time, I could need ABC. It’s a costly business to keep up,” he states. Photograph kindly supplied by BNP Paribas, June 2010.

revolution estimates near-universal adoption of advanced execution algorithms within five years. In April 2010, Bank of America Merrill Lynch (BofAML) added six major European index futures to their algorithm offering during London opening hours, complementing their DMA futures offering already available, and is about to roll out further futures contracts in the US and fixed income markets for algorithmic trading. The algorithms have already been in use internally for two years and Richard McCall, director, EMEA Execution Sales, BofAML, says: “Algorithmic trading lends itself well to volume tracking and scheduling, using strategies such as VWAP and Percentage ofVolume, but in addition to this we see benefit in providing strategies to quantitatively schedule futures into the cash close and work aggressively whilst trying to improve executions.” Ashok Krishnan, head of EMEA Execution Services, BofAML, says: “Algos lend themselves to any liquid product traded in sufficient quantity and time frequency. The six futures index contracts that we currently offer are liquid—they represent 70% of European equities futures traded by volume—so they are a prime candidate for trading with algorithms.” McCall adds: “While the use of electronic trading is increasing in the futures world, there will always be a place for high touch trading, particularly around less liquid contracts. We haven’t yet reached the point where clients will exclusively mandate a machine to trade leveraged products such as futures and options, although we believe it is only a matter of time.” Ian Peacock, global head of execution services, CA Cheuvreux, says the complexity of algorithms depends on the awareness of the client base.“Algorithms are definitely a growing part of the business as clients get more aware. It comes down to partnership. At one end, you can simply take a standard algorithm and tweak some of the

parameters, but at the other extreme, at the more sophisticated end, we work closely with clients on simulators, on different scenarios to develop algorithms. We call it quantitative consulting, where there is a relationship with the client at a deeper level where the client himself is extremely knowledgeable, often with a quant background.”CA Cheuvreux, one of Europe’s largest agency brokers, has twelve quant consultants supporting the algorithmic trading desk working directly with clients in Europe and the US. Owain Self, UBS’s global head of algorithmic trading, agrees that client demands have led to innovations in algorithms. “Technology and the market do not stand still,”he says.“Changes in fragmentation across displayed markets have led to an increased appetite for clients for dark liquidity, for example. So there’s a need to have algos that are more intelligent. Most of the changes we see now are modifications to existing algorithms to keep up with the changing market place. I don’t expect a brand new revolution in the algo space. Twelve to 18 months ago, we saw them going into multi-asset, multi-stock, now we are just seeing people enhancing and finetuning. Everyone is trying to incorporate more signals and features into algorithms.”

Innovation One example of innovation within existing boundaries is Goldman Sachs’ newly launched iceberg strategy designed to provide iceberg-style execution in the multi-venue environment in Europe. Just like a traditional iceberg execution method, it will post one or more smaller orders to primary and alternative liquidity sources and use stockspecific statistics to route orders to venues where the best execution performance is expected. Goldman Sachs claim a 40% improvement in liquidity capture compared to their primary-only iceberg order.

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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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TRADING ALGORITHMS ON THE MOVE 48

problems for the trader. “With the fragmentation Knight Capital’s new of the European equity Oasis algorithm is a marketplace, there has been smart-order execution an increasing demand for algorithm in Europe that traditional order types to sources liquidity for small adopt a more holistic or and mid-cap orders; these consolidated approach,” are stocks which are thin explains Michael Seigne, and more difficult to trade European head of electronic and where higher sales at Goldman Sachs volatility and reduced Electronic Trading. liquidity pose challenges Financial technology for traders. provider, ConvergEx Group, While at one end of launched Abraxas, a tactical the spectrum clients are algorithm, in February 2010 to talking with the sell side deal with more sensitive and deciding how they orders. Abraxas dynamically want to trade using balances orders among the execution based most desirable market venues algorithms, at the other to take advantage of liquidity end is the high-speed, in both the dark and light high-frequency trader, markets. Scott Daspin, using automation not managing director, global only for execution, but electronic sales, ConvergEx, also for decisionsays: “In the rapidly evolving making. Self says:“In the dark pools space, it is clear that Scott Atwell, co-chair of the FIX Protocol Global Steering Committee high frequency world, an not all non-displayed venues and manager of FIX Trading and Connectivity at American Century algorithm is a more are created equal and we are in Investments. Atwell says that early adoption of FIXatdl has been continual thing, making a unique position to maximise outstanding. Photograph kindly supplied by American Century continual decisions on fills in the venues where the Investments, June 2010. which stocks to buy or safest liquidity resides.” With the search for liquidity paramount, agency broker sell. It’s an automated version of how people have always Instinet has built a dark pool aggregator which aggregates picked stocks. Some of these indications and signals are liquidity from 13 venues and is in discussion with more dark very, very short-lived and very, very subtle and to pick up pool operators.“It’s a growing trend,”says Foster.“If I go to on those and react to them requires high speed.You can go the supermarket (the lit pool) and look for organic apples in and out of positions in a very short period of time and but I get a phone call telling me that there’s a much better they are extremely profitable for those users. “At the execution algo end, we are constrained by the stock of apples at the farmers’market, which I can’t see, but which I’m assured is there, then I will go to that dark pool. parameters of the order and the client’s need to trade. At So algorithms which can incorporate dark and lit liquidity the more fluid end, the prop traders and so on, they have will become increasingly popular. We’ve seen average fill more flexibility to do what they want,”he adds. James, whose trading desk at Fortis is on average 50% rates go up and up and up using Nighthawk, Instinet’s Dark algorithm, from a 5% fill rate in January 2009 to 18% by high touch and 50% low touch, says: “On the buy side we still have to receive the order via the OMS, think about the January 2010 and it’s up to 27.4% year to date.” Customisation of algorithms according to client demand has strategy, choose an algorithm, push the button and watch itself almost become commoditised as UBS’s Self explains. it. The buy side still has to keep on watching it.” Alexandra Foster, head of sales UK at Instinet questions “Customisation of algorithms is something we have talked about and done for years. We continue to offer clients tailored the human element in decision-making.“There’ll always be algorithms that behave in a specific way to suit their investment a place for the sales trader, but it is getting increasingly style. There’s a huge amount of work around consulting with difficult for human beings to trade due to the multiple clients, using analysis and modifications to algorithms to venues and the importance of speed in many transactions.”“Market structure favours the faster person,” improve their execution process and performance.” On the buy side, Carl James, global head of dealing, BNP says Richard Tibbetts. “In the 1920s it was those with the Paribas Investment Partners, says customisation is a Pandora’s bicycles and rubber-soled shoes who were executing trades Box.“I want an algorithm customised to fit XYZ, but next time, faster. I think you’ll see a continued escalation as long as I could need ABC. It’s a costly business to keep up.” Indeed, there’s money to be made by trading faster but it’s certainly many algorithms have been developed to solve specific not the only way to run a stock exchange.

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“There are two types of latency. One is the latency involved in executing orders and the other is the latency involved in modifying your trading strategies. Algos have a short shelf life and you need to be capable of changing tack at a moment’s notice in order to remain competitive. Traditionally it would take 10 weeks to build and implement a new algo. Now, with the proper technology, it can take as little as two weeks,” she adds. As speed increases, so has the need for anti-gaming technology, which Foster believes is absolutely vital.“Algos need to look out for any signals. The game we are in is an arms race and you have to have the technology,”she says. Indeed, the development of faster technology has supported the development of high frequency trading. Algo Technologies, for example, headed by Hirander Misra, former chief operating officer, Chi-X Europe, has launched ALGO M2, which takes 16 microseconds or 16 millionths of a second from the customer sending an order and receiving acknowledgement of trades, Independently verified, the measurement was based on sending more than 300,000 messages a second across multiple stocks and client connections. Research and advisory firm Celent has identified what it calls the innovation pyramid, where technological innovations have supported the development of high frequency trading. This now constitutes an estimated 40% of trading in Europe and 50% in the US. Celent’s report states:“HFT, as a means not an end, is at the pinnacle of the innovations pyramid, enabled and supported by successive market innovations.” At the base are new venues and attendant smart order routers to reach them, which in turn allow the new venues to thrive as access is simplified. The next layer is the development of algorithms to measure execution performance against benchmarks; then as some traders became more concerned with speed, direct market access services and direct strategy allow the buy side to take greater controls using basic algorithms; finally technology developed after regulation allowed the advent of ATSs in the US and multi-lateral trading facilities in Europe with the consequent development of dark pools.

High volatility High volatility encourages use of algorithms. In May 2010, the Chicago Board Options Exchange’s volatility index, the VIX, touched above 48 mid-month, although not near the 70 to 80 range following September 2008. TABB Group has estimated that at that time, at the height of the credit crisis, volatility led to a 54% increased use of algorithms as broker smart order routers and algos had access to the most accurate data and could react more quickly to market movements than a buy-side trader. When the Dow Jones Industrial Average plunged 998.50 points on May 6th this year, it was put down to markets acting in the correct way. During a nervous market, according to Tibbetts, high frequency traders left the market when stop-loss algorithm adjustments came into

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Owain Self, UBS’s global head of algorithmic trading, Self agrees that client demands have led to innovations in algorithms.“Technology and the market do not stand still,” he says.“Changes in fragmentation across displayed markets have led to an increased appetite for clients for dark liquidity, for example. So there’s a need to have algos that are more intelligent.” Photograph kindly supplied by UBS, June 2010.

play.“It took everybody else 15 minutes to realise that the data they were trading on didn’t exist. Firms should take this as a wake-up call.You need a good system for cleaning data,”he says. Whether algorithms that can interpret news data can be trusted to make decisions partly depends on the client, according to Owain Self: “Some algos are built with more discretion than others which affects the ability of clients to control the micro level decisions. If a client has a definitive short term objective of how they want to trade a stock, it might be sub-optimal for them to use an algorithm with a high amount of discretion. Especially if the algo were to use that discretion to react to a short terms news event which goes against the view of the better informed trader, conversely, when the trader has a limited short term view, they maybe very willing to allow the algo to use as much discretion as possible.”

TRADING ALGORITHMS ON THE MOVE 50

News-readable algorithms require huge computer systems to accept and analyse data and more firms are coming up with ever more powerful ways to capture and distribute the data for firms to take advantage of. Aite Group recently estimated that market data services have overtaken listings as a source of revenue for some exchanges – 19% of average revenue, compared with 13% for listings.“Aite Group expects this trend to continue, as almost every exchange we spoke with has fully committed to the data business for the long haul,”says Fritz McCormick, senior analyst with Aite Group and co-author of the report.“Market data groups are proven profit centres for the exchanges.” The London Stock Exchange, for example, with its Infolect real-time information delivery system, was voted Data Provider of the Year for two consecutive years at the Inside Market Data awards. It made £103.7m from sales of its real-time data to year end 31 March 2010, just half of its total revenue from its information and technology services. It has 93,000 professional users of its information. Last year saw big moves in white-labelling by the sell side, wrapping up their algorithms for other buy side brokers to use as

their own. Peacock of CA Cheuvreux says it provides a mechanism for the middle range of brokers to have a product that they otherwise could not easily develop. “An estimated 70% of European commission comes from the top 100 European clients. They are discerning and they don’t have everyone’s algos on their desktops; but if you are a small broker you cannot [do without] algos. White labelling gives brokers without big budgets the mechanism to provide the product. If a client wants to trade with you, you have to have sales, brokers, DMA, algos and you have to provide all the touch points. If you are a small broker, you don’t have low touch points unless you buy them in.” However, BNP Paribas’Carl James admits he is cynical about whether the sell side will provide their best algorithms:“I don’t think the sell side have given us the super-smart algos. Why would they spend millions and then give them to us. Why not use them for their prop desk to make money for themselves. If they make £1m a day with an algo, they’ll ask themselves, if we release it to the buy side will they give us £1m a day in commission? As time goes on, your original algo becomes less effective and that’s when they release it to the buy side.”

THE EVOLUTION OF ALGORITHMS t took 50 years for algorithms to take hold in the field of equity trading after the death in 1954 of Alan Turing, an English mathematician heralded as the person to formalise computer algorithms. It has taken fewer than 10 for algorithms to have changed the entire way in which equity markets have developed. When algorithms first appeared they were rulesbased and linear offering straight-forward slicing of an order either over time or by volume, using timeweighted average price or volume-weighted average price, according to Alexandra Foster, head of sales Alexandra Foster, head of sales UK, Instinet. Photograph kindly UK, Instinet. “Since then they’ve become far more supplied by Instinet, June 2010. complex as firms continue to develop them,” she Analysis (TCA) is increasingly seen as the key to says. “Development of algorithms can’t stand still. Just successful performance. because you have built a Formula One car, doesn’t While algorithms in the past have predominantly mean you can leave it standing there. You have to keep focused on equities, as the market evolves demand for tweaking and honing your algorithms so that they can algorithmic tools that go beyond the traditional realm of deal with all the latest requirements.” the equity world is steadily rising. This has been driven With electronic trading now accounting for more than heavily by the presence of multi-asset class hedge funds. 50% of buy side order flow, and use of algorithms in The ability to tweak sell-side algorithms is a major the US at more than 30% in 2009 and rising, trend likely to continue to occur in the new wave. By according to TABB Group figures, awareness of new streamlining the process of algorithm alteration, an developments in this area is increasingly important. increasing amount of power is being placed in the Once the choice to use an automated strategy has hands of the buy-side trader. It is yet to be seen been made, the question of which specific algorithm to implement then has to be addressed. The ability to rate how much power the buy-side will take from their sell-side counterpart. and rank algorithms through effective Transaction Cost

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US TRADING ROUNDTABLE:

DRAWING TOMORROW’S WORLD

Attendees

Supported by:

From left to right (top row) BILL YOST, head of trading, Quotient Investors BRIAN FAGEN, managing director and global head of electronic trading, Barclays Capital BOBBY GRUBERT, head of US Equities sales & trading, RBC Capital GREG ROSENBERG, head of trading, Americas, Alliance Bernstein JONATHAN CLARK, head of fundamental trading – Americas, BlackRock

From left to right (below) JOHN FENG, consultant, Greenwich Associates DR ROBERT KISSELL, trading strategies and TCA expert, UBS MATTHEW ROWLEY, head of quantitative trading Americas, CA Cheuvreux: DAVID SCHIFF, deputy head of equity trading for the Americas, JP Morgan Asset Management

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US TRADING ROUNDTABLE

JOHN FENG, CONSULTANT, GREENWICH ASSOCIATES: As Greenwich Associates is a consulting firm my comments are less about the markets and more about what we observe in terms of how the buy side/sell side relationship has evolved. There has always been a symbiotic relationship between the buy side and sell side. In the last couple of years, there were trends that pushed the two closer together; and there were trends that strained that relationship. On the one hand, when the buy side experienced meaningful declines in assets under management and revenues, and some reduced internal resources as a result, they became more reliant on the sell side for research and access provision. At the same time, the diminishing role of proprietary trading on the sell side removed some of the potentially antagonistic elements of the finely balanced relationship, and most of the firms on the sell side are clearly paying more attention to client flow and client relationships. On the other hand, counterparty risks, staff turnover and reduction of balance sheet availability caused plenty of dislocation in relationships during the credit crisis. With the recovery, many are putting that phase behind them, but market and business uncertainties clearly remain. As a research-based consulting firm, our role is to ensure that we continue to provide timely and relevant market intelligence to management at both buy side and sell side firms to help them navigate their businesses. BILL YOST, HEAD OF TRADING, QUOTIENT INVESTORS: Quotient Investors is a quantitative equity management firm that was formed and funded under the CalPERS manager development program. We trade exclusively in US equities and my primary focus is lowering our transaction costs. We manage large cap and small cap funds and our interest is in finding new technologies, new algorithms, new dark pools that can help us lower our costs and capture alpha. As stock specific volatility has come down, so have our transaction costs, but the challenge continues to be to collect more and better transaction cost data in order to gain a better understanding of our costs. Pre-trade our investment process incorporates transaction cost forecasts and average daily volume data to influence our buy and sell lists. Post-trade we measure the market impact of all of our transactions against a variety of benchmarks. Specifically for us, arrival price and previous close are the critical benchmarks that determine our trading success.

John Feng, consultant, Greenwich Associates

JON CLARK, HEAD OF FUNDAMENTAL EQUITY TRADING - AMERICAS, BLACKROCK: It’s surreal to look back at the period we’ve just gone through. My hope is that all of the fear and despair is behind us. And while 2008 and early 2009 were rather bleak, the silver lining is that many of us, including those of us in the room, are leaner, stronger and more focused than we’ve ever been. So while last year’s focus was:“How can we do more with less?”I am glad to say that we can move forward a little bit and focus on other issues. Fortunately so, because there are weighty issues before us; including the market structure debate which goes on and it’s louder than ever. Financial regulation is on our doorstep as well and that will certainly require tremendous attention. While it’s imperative to stay on top of this issue, I don’t want to overlook the mundane. The mundane could simply be focusing on things like transaction costs, upgrading platforms and handling relationships. If 2009 was about “How can we do more with less”, this year we are more focused simply on:“How can we do things better?” BRIAN FAGEN, MANAGING DIRECTOR, GLOBAL HEAD OF ELECTRONIC TRADING, BARCLAYS CAPITAL: The constant evolution of the equity marketplace requires us as a large broker dealer to constantly evolve our model. We are continually focused on adapting our equity trading platform, which includes our access to liquidity and the underlying technology that supports it. In my 20-plus years in the business I can’t recall a time where we ever felt this process was finished. Similar to others in the market, we have been very focused on the more recent changes in the trading and liquidity dynamic that has been evolving over the last two years. We have seen a massive change in how equities trade as well as the types of counterparties that are trading. The growth of high frequency trading, dark pools, exchanges, and ECN’s has required us to rapidly adjust our trading platform. Understanding how to interact with all of this disparate liquidity, consolidate it, and deliver it back to our clients in a meaningful way is key to success in equity trading. This drives our development of new technology, products, and tools; such as algorithms, internalisation engines, and analytics; for both our traditional high touch and our electronic trading businesses. BOBBY GRUBERT, HEAD OF US EQUITIES SALES & TRADING, RBC CAPITAL: Just by way of brief background, RBC Capital Markets is part of the Royal Bank of Canada. The way to describe us is somewhat of an 85year-old overnight sensation. Pre-crisis RBC had a strategy, one that was methodical and thoughtful. Also, we had little brand recognition outside of Canada. Post-crisis we are emerging with a lot of interest in who we are, what we’ve built, how we’ve built it. Throughout the crisis we added 100+ people across our platform. We identified gaps in building a business that meets all client needs and included our clients in that process. This level of client engagement helps to ensure our success. We broke the challenges we face down into three categories. One is the client consolidation of key strategic relationships and commissions spend. These reversed during the crisis and rapidly re-reversed post-crisis

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BillYost, head of trading, Quotient Investors

and has resulted in intense competition. Two, competition is all focusing on client-facing roles. Three, regulation reform has created several unknowns. We are dealing with all the implications of these trends on our business model. In summary, all of these elements underscore an emphasis on investing in our people, building a client-service culture, and improving our business model and moving forward. GREG ROSENBERG, HEAD OF TRADING, AMERICAS EQUITY TRADING DESK, ALLIANCE BERNSTEIN: We are currently in an environment that is faced with pending regulatory and legislative changes that will affect the structure of our markets. We just don’t know how restrictive they will be. The role of trading has really evolved over the past few years, particularly in terms of sophistication. We have spent a lot of time trying to move the trading role further upstream into the investment process and become a full extension of the portfolio manager. We have made a large investment in technology and quantitative tools as we try and provide alpha generation from the trading desk. Given the environment over the past few years, traders have had to become risk managers in how they approach their job. Investment risk, operational risk, and counterparty risk are all important themes within the investment process. We’ve also had to become much better educated in many other asset classes away from equities. We’re spending just as much time focused on currencies, commodities, sovereign CDSs and so forth, as these markets have become so interwoven.” DAVID SCHIFF, DEPUTY HEAD OF EQUITY TRADING FOR THE AMERICAS, JP MORGAN: Nowadays at large firms, there’s a much sharper focus as to the contribution demanded from a trading department. For a desk like ours, one which has experienced a major transformation in the past 18 months, the overarching challenge is to reinsert ourselves into the investment process in a meaningful way. This requires that every member of the team – traders, business analysts, technology personnel – needs to ask themselves the question:“How can I best move the needle in my area of specialisation?” Bobby mentioned the need to be client-facing. Indeed, as a major buy-side desk, we approach our investment teams in much the same way. We need to fully understand their investment objectives, their portfolio construction process, and their tolerance for

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risk. Whereas a portfolio manager may concentrate on the two to five year horizon and an analyst on a three to twelve month time frame, a trader is uniquely positioned to “own” the five minute to five day space; and we need to apply that expertise in ways that materially contribute to our “clients’” performance. Moreover, we serve as a resource both within the asset management division and, where appropriate, to other areas of the firm. That’s a heavy challenge and one that is the driving force behind what our trading department is currently constructing. The Flash Crash heightened awareness in a very significant way from a risk perspective. In many respects, May 6th was not an isolated case but symptomatic of a larger issue. It seems like every other week we are faced with a“perfect storm”event. In that sense, we need to anticipate problems and prepare for them. DR ROBERT KISSELL, TRADING STRATEGIES & TCA EXPERT, UBS: New policies and strategies are coming into play. There is increased sophistication behind algorithms and smart order routers; here we are talking about proper utilisation and allocation across dark pools, crossing systems, and the displayed venues.Two, since emerging from the crisis, there has been an increase in the amount of buy side-directed customisation of algorithms. Moreover, many algorithms are now incorporating transaction cost analysis (TCA) feedback loops. We see many offerings that are actively engaged in synchronising pre-trade, post-trade and current market conditions via real-time TCA in order to improve performance.There is also an increase in partnership between buy side traders and their portfolio managers. These participants are starting to actively work together in order to ensure that the trading goals are consistent with the investment objective of the fund. Finally, there is a growing offering of execution consultants and services. Sell side execution consultants are actively partnering with the buy side firms to ensure that the trading needs, algorithms, and algorithmic settings are consistent with the money manager’s investment objectives and the fund’s overall view of the market. How do I ensure that my execution strategy is in line with my initial goals? A lot of desks are taking a much more proactive approach toward the assessment of best execution and the management of their execution strategies. We see partnering across traders, managers, and brokers when determining strategies that best maximise the likelihood of achieving the investment objective. This involves the trading side working a little more closely with portfolio managers, determining when and why they’re acquiring or selling certain stocks, in order to determine the most appropriate strategy, timing and level of urgency that these transactions should utilise. Finally, one of the bigger trends we’ve seen involves portfolio implementation and portfolio algorithms. What’s the best way to trade baskets, programs, or lists of stock? For example, I don’t just want quick execution of an order; I also want to ensure that my execution strategy and trade in any single name is not going to harm the overall risk and execution performance of the basket. Portfolio implementation is really about understanding overall risk composition during the entire trading cycle.

US TRADING ROUNDTABLE

MATTHEW ROWLEY, HEAD OF QUANTITATIVE TRADING AMERICAS, CRÉDIT AGRICOLE CHEUVREUX: We’ve gone beyond customisation now; looking not just at consultation but fully outsourced quantitative projects. For example: We’re doing a project right now which is to do with alpha signals, believe it or not; as an agency broker, but we’re helping a particular buy side client because they don’t have enough staff perhaps. We’re hoping to create professional services around deep quantitative consultancy. We’re seeing a lot of usage of our liquidity seeking type algorithms; how to navigate liquidity across dark and lit venues. We hook up to about 25 dark pools in the US from my side; it’s a lot of work. We have to talk to each destination, work out the sweet spots, figure out the best way of interacting with them, technological challenge, that type of thing, and also we work heavily on the mathematical side. We conducted collaborative studies with universities in France, and we used a very clever technique called stochastic optimisation to try to figure out optimal balancing across light and dark pools. It gets very intense, but it is great to see heavyweight mathematics having a great effect. Moreover, I’m seeing a lot around dealing with smaller caps, especially in the algorithmic space. I’ve heard that some algos have failed in this segment, so we are working with our clients to find ways to find liquidity in this space. I don’t know if algos are always the panacea or be able to do everything, we are trying to stretch the boundaries as we go. I really believe in the idea of a human algorithmic hybrid; we’re looking at real-time monitoring systems to enable traders to scale better, to interact with algos, maybe there is an algo working on a small cap name and when it starts to go wrong there’s immediate feedback to a trader that makes a decision he attracts the algo. I wouldn’t trust the algo in a black box sense to just deal with it; it needs that assistance.

TOWARDS A NEW PARTNERSHIP

ROBERT KISSELL: We’ve seen a much higher degree of partnership occurring in the industry recently. This is not just occurring between the trader and portfolio manager, it is also occurring between the sell side and the buy side: across the sell side trader, buy side trader, and portfolio manager. These parties are actively working together to achieve the highest level of performance possible for the firm—in essence working jointly to achieve best execution. The biggest performance improvements in this area, we find, are from those firms who have a thorough understanding of the overall investment process and who are matching their specific investment goals with properly-optimised trading algorithms. This involves determining the most suitable trading strategy: i.e. determining the appropriate trading approach, such as an algorithmic order, high touch, low touch; single stock or basket, etc; properly allocating the order across venues and determining the right mix of market and limit orders; utilising smart order routing capabilities; and identifying necessary anti-gaming logic. Once we truly understand what the fund is trying to accomplish we are better positioned and equipped to help clients achieve their goals.

Jonathan Clark, head of fundamental trading – Americas, BlackRock

MATTHEW ROWLEY: We have a phrase at Cheuvreux; we say the sell side is like the technology and execution proxy for the buy side. It comes down to a question of do you build inhouse or outsource? Perhaps you use your sell side brokers as a way of outsourcing.You may still have a good sense of what you want to achieve and we do a lot of work on trying to align your investment policies with algorithmic execution. We can actually try to predict the how our algorithms work have worked on sample order data provided by prospects. We can use order and trade data to calibrate market simulators and then can give sophisticated clients the simulation tools. For a buy side to build out such a market simulator would be impossible if you don’t have the data. It’s a deep collaborative vision in how the buy side uses the sell side. BRIAN FAGEN: If you go back to pre-algorithmic trading in the 1990s you could argue that the buy side had 100% dependency on the sell side for high touch execution, because there really was no other way to execute. Algorithms were originally developed as efficiency tools for sell side trading desks, meant to outsource some of the more mundane trading activities such as VWAP. The market structure was also significantly simpler, dominated by two exchanges with one dark pool and little or no high frequency trading. As the market structure evolved the technology and brokers’tools evolved as well, not solely for delivery to clients, but also for our own trading needs. We had to continue to evolve our trading skills to be able to supply all types of execution, whether it was agency execution or capital execution which created positions that we then had to trade out of. We had our own business imperatives for building out these tools. As the market structure evolved alongside these tools, electronic trading became a real business. Looking back to 2003 and 2004, many of the larger firms didn’t even have an electronic trading business; only a few were set up to supply electronic trading to the buyside. All of the firms had some form of algorithms, but not all of them were delivering with clients. This more recent evolution has turned the trading desk from a cost centre to a profit centre or an alpha generator. While it may be difficult to prove that a trading desk is an alpha generator, it certainly can be an alpha preserver, right? The change in the dialogue is that as the buy side elevates their trading expertise and skill set in the search

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for ‘best execution’ they are actually demanding much more expertise and support from the sell side. We have to deliver it in an electronic format as well as across all of our businesses. The more efficiently we trade out of our facilitation book, the better capital we can provide when clients need capital. The buyside/sellside dialogue around execution is a lot more collegial at this point rather than being a vendor relationship. GREG ROSENBERG: Years ago there was really only one venue for execution. A buy side trader would call his sell side counterpart on a sales trading or trading desk and enter the order. Regardless of whether there was capital commitment involved or it was just an agency order, there was really only one venue, away from a simple dot machine. Now, with the level of sophistication that has moved to the buy side, both in terms of people and technology, there are many multiple ways to execute an order. A buy side trader has so many more tools in the toolbox to come up with the most efficient strategy to execute each order. Buy side traders understand their stocks, sectors and markets better than they ever have and are much less reliant on the sell side for that guidance. Quantitative tools provide pre-trade analytics enabling the trader to have a high degree of confidence in the expected market impact ahead of each order entry. I do think the buy side/sell side relationship is still strong. It has just evolved over time.” BOBBY GRUBERT: The relationship, between the buy side and sell side, has gotten a lot stronger, largely driven by the increase in transparency from the buy side. We bracket it out and make two distinctions. One, we differentiate the building of resource liquidity and excellent execution; you absolutely have to be able to advise a client in that area, and prove just how you’re preserving alpha, or you’re not even in the game. Separately, you have to understand that the investment process is much closer to the trading desk these days. You need look across the spectrum of products in the markets and be able to provide insight into how all items affect the general market in individual stocks at a macro, micro, or fundamental level. We have invested in that trend in two business units. In cash trading, we have built a desk sector strategy team dedicated to delivering sector insights to both traders and PM’s. In electronic trading, we rebuilt our platform with an intense focus on market microstructure and

Brian Fagen, managing director and global head of electronic trading, Barclays Capital

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understanding market inefficiencies that impacted our clients. We also have a third-party TCA service that provides independent oversight, measuring both execution and delivery to the client. We think it is the only way to go.

MAY DAY MAY DAY

JON CLARK: Brian, don’t you think that the tone has changed? The May 6th air pocket that the market hit was frightening and as a result I feel that the tone has finally changed. We have talked a lot about the fact that the buy side/sell side relationship has improved and are more in sync, but here is one area where I’m not sure we are all on the same page. This is not to point fingers, but let’s use high frequency trading as an example. High frequency traders were anointed the“new”market maker because they gave us penny wide markets that were hundred shares a side. We all rejoiced and said:”Wow, look at this new market structure. Isn’t it great, they’re going to stand up and provide liquidity?”The sceptics were all reassured that this was the new paradigm. Low and behold we all bore witness to May 6th and market structure gurus are still scratching their heads and have more questions than answers. At a minimum, I am grateful that the tone has changed a little bit and there may be some further inspection of our current market structure—specifically high frequency trading. BRIAN FAGEN: It is not just about looking at one component; it has exposed additional issues that essentially have existed since 2005, when Regulation NMS came into effect. These are issues that can open up after each regulatory cycle, which create opportunities for some participants to find a way to profit from them. High frequency trading is said to account for 60% of all market volume in the US, which may be a cause for concern. BOBBY GRUBERT: It’s only the start, because we’ve identified inconsistencies across all stages, and we now know how fragile the markets can be. We all need to understand the full picture of us what’s actually going on out there and then we will know how to combat it. BILL YOST: I’m sceptical that the buy side and sell side have the same interests. High frequency trading generates considerable sell side revenue and at the same time probably hurts our alpha strategies. Certainly returns generated by sell side prop desks and commission dollars earned by sell side trading desks are big contributors to their bottom line. From that standpoint, do we have the same interests? We may have competing interests as the sell side may have a greater interest in protecting the high frequency business— correct me if I’m wrong—while it’s something that those of us on the buy side would be more inclined to see regulated. BRIAN FAGEN: The bulge bracket sell side firms in general do not derive significant revenues from the high frequency firms. Most of these firms create their own broker dealers and execution facilities and do not utilise our trading platforms. One area where we do interact with these firms would be in our dark pools where high frequency firms are active liquidity providers.

US TRADING ROUNDTABLE

DAVID SCHIFF: There is much frustration resulting from the present regulatory environment. Increasingly, it seems that new proposals within the industry are reactionary in nature and those that are adopted lead to a cascade of unintended consequences. This stems from a lack of sufficient appreciation of the delicate interrelationships that Brian has discussed. Given the furious pace of change in our marketplace, it is vital that regulators become even more informed so that they are able to bring proactive reform to bear rather than constantly reacting to that which has transpired. There is no lack of sophisticated minds, representing the full spectrum of the investing landscape, to help nourish and accelerate discussions with regulators.

Bobby Grubert, head of US Equities sales and trading, RBC Capital

BOBBY GRUBERT: Why do markets exist? They exist to facilitate capital allocation between investors and companies. You look at the contracts trade; it’s not only the 75,000 share contract you may trade, but 400,000 is de minimis, and look at the affect this had on the market. It’s 19bn notional and in context that means it’s 315bn notional traded on the day. On a typical day you should be able to absorb what were risk reduction trades, with no fat fingers. What happened highlighted the fragility of the market structure? If you look back at what happened in 2008, that was different; it was tactical, we were trying to survive. This latest event: well, there’s a business model implication, there’s market structure implications, and there will be, to the point around the table here, unintended consequences. There will be other issues that emerge as we work to solve these problems; but we have to start somewhere. GREG ROSENBERG: The SEC is probably going to spend the next number of months analysing and trying to figure out what happened on May 6th, rather than trying to be more predictive about what the next event could be. If there is a silver lining to all this, as mentioned, is that we’ve got away from discussing the minutia of flash orders which, in the end, were not really an event and not worth discussing anyway. There is a much better consensus on the high frequency debate and we are going to discuss and address the real issues which are the market structure issues. Hopefully the SEC can take a step back and really

go slow and come up with something that makes sense, rather than putting in short-term band-aids on some problems that probably won’t come back again. MATTHEW ROWLEY: We need to have more of a scientific, evidence-based approach; maybe the flash crash will be the start of that, right? Hopefully the SEC does have the intellectual resources that we have on the buy side and sell side to help determine the right outcome, and we can perhaps assist in that approach. I don’t believe there’s going to be a Holy Grail market structure. There’s always going to be those types of events. Maybe, hopefully, we can mitigate the risk of such an event. However, what I’m concerned about the most is bad regulation and any regulation is a pain for me because I have to then spend a lot of time and resources on technology and figure out what it means. Even if we begin to focus on what high frequency trading involves, that’s a start. Everyone talks about it as one big thing. Actually, there are classes within high frequency trading and perhaps within some of those classes there are traders that are less than ideal market participants. Not all those players are bad apples; but a scientific approach that recognises dark and light and shades of grey might help get us to a better place. ROBERT KISSELL: What you’re saying about the classification of high frequency trading is the most important part of regulation. In the simplest sense, high frequency trading refers to someone who is trading a lot of shares quickly. However, if you look at ways to try to classify the objectives driving the use of high frequency trading, there are four categories or classifications that emerge. First, there is the traditional market making function where participants are providing liquidity and maintaining an orderly market. The second classification is more of an opportunistic market making function. These are traders who aren’t required to make two sided markets or maintain quotes throughout the day, and do so only when their alpha signal is telling them that it’s appropriate to do so. A third classification includes traditional quant traders. These are the players who are trading on the basis of information that’s readily and equally available to all market participants at the same time and are employing quantitative mathematical models or technical analysis to generate buy and sell signals. Right now, given current computational power and the access to real-time data, this information is available much more quickly and can be processed at a much faster rate, which allows for effective intraday and short-term trading strategies. The fourth classification is the liquidity trader. These are the participants who try to infer information and trading intentions from the market, and seek to profit from this information and the rebates made available by our maker/taker model. These participants may employ techniques or resources that are not readily available to all investors, such as co-location services to achieve additional speed and access trade data just ahead of other market participants. Matthew is right; you cannot treat all high frequency traders the same way.

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THE END OF FRAGMENTATION?

BRIAN FAGEN: The expansion of fragmentation is over. It appears that we will soon see the beginnings of a contraction with the smaller venues that are doing de minimis volumes start to get absorbed. Clearly, there’s no reason for more than 40 execution venues in the United States. Broker dealer ATS products and internalisation engines, will remain and continue to grow as they provide an important tool for firms to both manage costs and provide better execution. How those dark pools continue to evolve is going to depend upon the regulatory aspects we just talked about. If new regulation puts restriction on high frequency trading it will have a significant impact on the amount of volume that occurs in a lot of dark pools. In many respects, there are very few dark pools out there today that are doing a good job of representing the true nature of a dark pool is supposed to be, which is block liquidity. In most dark pools trade sizes are 400 shares or less, clearly not what people had in mind. A key question about dark pools is not about quantity but quality, right? That’s where the focus should be. There should be more transparency around the quality of any type of flow the buy side client is interacting with in a dark pool. Our internal dark pool provides clients with the ability to choose the types of flow they interact with, based upon the performance metrics we supply of their orders versus that flow; this is the future for effectively utilising dark pools. GREG ROSENBERG: Being a larger organisation we have the luxury of having the resources and quantitative tools to have done a lot of work on this. We’re at the point where we can really identify where we’re having positive experiences in terms of performance and finding liquidity and where we are getting adversely affected. We work with our strategic partners to make sure we channel our flow away from those venues we’ve identified as hurting performance. This continues to be a dynamic process as we are constantly refining and redirecting our flow to the venues that provide us the best outcomes. I do think over time there will be some contraction or consolidation in the space because in the end not all venues provide enough true liquidity.” JON CLARK: It’s funny, a year or so ago the battle cry seemed to be:“I just want liquidity!”Orders would be routed to broker dealers who would then shoot them around the horn, seeking liquidity at the expense of a tremendous amount of information leakage. Now though, there is a much better understanding of the trade off between liquidity and information leakage and as a result there is a healthy two-way dialogue with our executing brokers. Rather than indiscriminately firing my orders out through just any algo or algo provider, we optimise our approach.You don’t need to hit every dark pool; you don’t have to have every algo strategy on your desk- to be successful you need to fine tune your approach while at the same time stay current and remain open reminded regarding evolving trends in the low touch space. BOBBY GRUBERT: We think the market and the SEC are going in the right direction. They’re seeing an incomplete picture with inconsistent regulation across a number of

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Greg Rosenberg, head of trading, Americas, Alliance Bernstein

exchanges. The number’s ten but there’s the 40 plus ATSs and the countless internalisation systems. We certainly would like to request that we understand it better, see more transparency. That will certainly be a by-product of reconsolidation. FRANCESCA CARNEVALE: Does the evolving market structure favour the larger firms over the smaller players in this regard Bill? BILL YOST: In terms of how and where we trade, relative to the bigger firms, my guess is it’s fairly similar. We use the same algorithms and platforms as the larger buy side firms, although the larger firms have more influence over the original design of algos and platforms developed on the sell side. I also think we have the same access to dark pools as the larger firms. We are active participants in dark pools as we prefer dark pool crossing to actively trading in displayed markets. We utilise dark pools with more than 60% of our trades now and that number continues to go up. Regarding the changing market structure, it felt like a couple of years ago there was a new dark pool a week, and it was very difficult for algorithms and trading platforms to keep up with all of the changes. Now, it’s slowed down a bit, as the algorithms and dark pools we use today are not that much different than the ones we used a year ago. DAVID SCHIFF: The elephant in the room is that it’s not just a consolidation of dark pools per se; it’s also a consolidation of broker/dealers. Is there a need for X number of brokers? Can I conduct my business properly with X percent fewer counterparties? To some degree, and this was certainly borne out by the events of May 6th, everyone was accustomed to abdicating the ultimate control of an order downstream. The buy side would release an order to the broker/dealer; the broker/dealer would release the order to the various execution venues. How many constraints were placed on the order and, like a child’s game of telephone, were the parameters at the point of execution consistent with the original intent at the order’s inception? Consider a market order placed with a broker. Does a market order really mean: ‘execute with no constraints’? Or, do I assume that the broker will use judgement to operate within reasonable tolerance levels? Do the broker’s instructions communicated to the execution venue assume some level of risk tolerance—circuit brokers, if you will—whereby trust is placed in a downstream mechanism? Does the ultimate execution resemble the expectation from where the order originated, and in extreme cases, who bears the responsibility of risk should things go awry? The greater interconnectivity that exists does allow for more control and, increasingly, we now have the ability to

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control the entire lifecycle of an order, to control the price discovery process, to overlay more strategic analytics and to retain control and responsibility for each execution.The events of May 6th shed some uncomfortable but much needed light on to the conversation of risk controls. Going forward, we will see highly constrained orders controlled almost entirely by the buy-side including choice of strategy, choice of aggression levels, choice of venue and choice of analysis. This too will signal the industry that fewer participants will be necessary in that continuum to ensure price discovery and best execution.

INVESTMENT STRATEGY & THE TRADING DESK

GREG ROSENBERG: With what has transpired over the past few years, equities are slightly out of favour in the asset allocation process. Currently, we are seeing more money flow into fixed income and alternative products. We are spending a lot of time as an organisation, building out our alternative product capabilities from both trading and a portfolio and product offering perspective. Because of this, we have needed to build out our breadth of relationships with our sellside counterparts into many multi-asset product areas. This trend plays into the hands of the bulge bracket firms that have the resources and bandwidth of products to cover us across all asset classes. This differentiated content delivery is definitely a focus going forward. JOHN FENG: If you think about how this relationship is evolving, and how the buy side firms are utilising different products across multiple asset classes, or across multiple geographies, one common theme is that electronic trading is growing, regardless of whether you look at the US market or the international markets across Europe and Asia-Pac, even for futures and options. Whatever experiences and expertise that buy side firms accumulate in trading US cash equities electronically will help them in-source trade execution as they move into those other areas. One notable fact is that, based on some of the work that we’ve done recently, this past year was the first time that active funds raised their US equity lowtouch trading above 50% of total volume, and high touch has gone below the 50% mark. Even though the percentage change year on year is not huge, it is a watershed event. What’s also interesting in terms of similarity across different markets is that dark pool-related execution, proportionally speaking, is seeing the largest increase across various channels of electronic trading. Additionally, the unit cost of execution has gone down, in part because of the migration towards low touch execution, which is another important element of change in the buy side/sell side relationship. This is the case whether you measure high touch rates or low touch rates, separately or as a single“blended”unit. However, the buy side demand for sell side services, not just within the realm of execution but also in terms of research, corporate access and so forth, has not diminished. Therefore there is potentially a smaller pool of revenue that will be taxed to pay for all of these important services. That’s an interesting dilemma that the buy side and sell side are trying to work out.

David Schiff, deputy head of equity trading for the Americas, JP Morgan Asset Management

BRIAN FAGEN: The breadth of the buy side/sell side relationship, as Greg mentioned, is really becoming more important again in terms of the ability to drive a broad set of products across the content and execution spectrum. There was a short term movement away from this during the financial crisis in late 2008 and early 2009 but things have quickly started to revert back. There is a very high correlation between the flow dynamics and the breadth of product offering. The demand for the content side of the equation continues to grow at the same time as the demand for capital. This makes it much harder to be a key provider if you focus on a more limited product offering. Going into the financial crisis CSA’s were viewed as the major vehicle for the buy side to manage the broker list. After the crisis, the CSA remains as a tactical tool, however prudent risk management dictates that multiple CSA providers are in order, similar to prime brokerage providers. We are seeing the clear trend towards broker consolidation with execution volumes being focused on fewer providers. The key differentiator is the delivery of the breadth of product and content that the larger firms are able to provide. DAVID SCHIFF: Sales coverage has now been re-branded as “franchise sales”which truly reflects the requirement that every person who touches a client is expected to‘deliver the firm’en masse. That means regardless of whether I’m talking to a position trader, a product specialist or a syndicate head, that person will be largely fluent in multiple asset classes and can provide insights well beyond their immediate area of focus. Quite the same could be said of the demands placed upon the buy-side equity trader.We are expected to introduce perspective informed by a broad array of insights across asset classes.That’s legitimate and appropriate. Does that translate over to the execution side and across asset executions? I don’t think we’re quite there yet, but we just may move in that direction. Of late, we have clearly seen an accelerant for the bifurcation of the industry. There will always be a place for niche players as there will always be a place for that specialisation. Certainly though, a focus on the larger firms, given their breadth of product, will be the main driver of sustainability. Finally, we are far more myopically focused on our executions than ever before and exquisitely more attuned to developments, no matter how tangential, which may affect the equity space.

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ROBERT KISSELL: One of the biggest changes on the investing side as we mentioned, is a growing partnership between the portfolio manager and the trader. It’s important to have the people who are running the trading process seamlessly engaged with the people who are running the investment process, in order to fully understand the overall investment objectives and translate them optimally to their trading goals. This ultimately leads to more efficient execution, reduced transaction costs, and higher profits. For example, funds have begun to partnering with traders, managers, and execution consultants to bridge the gaps between trading and investing. On the trading side, participants always talk in terms of theoretical risk aversion, but what does that really mean? When we partner with the portfolio managers, however, we see that trading risk aversion directly relates to the Sharpe Ratio of the fund. By partnering, we are bringing real-world practical meaning to what was once considered a theoretical and almost amorphous trading term—risk aversion. Here, traders are using the Sharpe ratio as the specified level of risk aversion in portfolio optimisation algorithms in order to determine the initial execution trajectory, urgency level, and timing risk of the basket trade. Then, based on actual market conditions and real-time TCA, traders are adapting to changing market conditions and taking advantage of prices and liquidity in ways to be most beneficial to the fund. FRANCESCA CARNEVALE: How is the market changing in term of multi-assets? ROBERT KISSELL: There’s a lot of talk about algorithmic trading across different asset classes, and the best way to trade multi-asset baskets. One of the trends surrounding multiasset trading of global equity baskets involves coupling the necessary FX executions with the underlying stocks. It is not so much an issue of measuring the impact of the FX trade, but more about efficiency and risk management of the underlying basket. If I have a global equity basket across multiple markets, or more importantly across multiple currencies, it’s very important from a risk management perspective to manage those FX executions at the right points in time, or continuously and in conjunction with the equity transactions. Another trend that is gaining steam is pre-trade TCA for Futures trading. That is, what is it going to cost to transact a futures contract of a specified value? And finally, this has been going on in the investing side: attempts to bridge the differences between the current portfolio and the targeted portfolio. Portfolio managers are better arming their traders with the direction that helps them to collaborate on the achievement of their targeted portfolio. Now the trading desk has the opportunity to really understand and factor in the real-time market conditions, adapting to changing liquidity conditions, prices, and momentum in a manner that is consistent with the longer range target objectives for the fund. BILL YOST: One of the things that we see coming from the buy side, which is really driven by the larger public funds and other larger institutional investors, is that everyone is going global. Fewer are just pursuing US-only equity strategies. Clearly there’s more of an interest in investing in global equity funds, where buy side firms need to move and trade money

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Robert Kissell, trading strategies and TCA expert, UBS

Matthew Rowley, head of quantitative trading, Americas, CA Cheuvreux

across different countries and different regions. We’re looking at possibly putting together a global strategy and, as we do that, we’ll try and put together a global trading platform that will replicate in many ways what we’re doing here in the US. At the same time, there’s more and more interest in strategies that include ETFs and, again, all of these big investors are looking for strategies that require trading platforms that are global in nature and handle multiple asset classes. BOBBY GRUBERT: We’re building into London, with now 75+ people.We’ve understood that you have to be global. We’re aligning ourselves with where the client is going, most importantly to be relevant and add value in that top tier, because outside the top tier there is a big drop off. We believe that without an integrated model, without all products and each product adding value, it’s a very difficult period coming up. JON CLARK: We manage a broad array of products and services that are multi-asset and global in nature. As a result, we have a tremendous amount of intellectual capital. We are able to come together on a daily basis as part of our morning call and say, “This is what I am seeing.” Everyone has the ability to contribute their own two cents. So I would say that what we ask of ourselves is no different from what we’re asking of the sell side; the best information possible in order to make the best investment decisions possible. As it relates to research, our global partners must offer the highest quality in traditional content and corporate access. Execution services must be equally strong as well—whether it be high touch coverage or low touch access; we want nothing but the best. Ultimately, we are seeking partners who will enhance our investment process. Those firms that perform well on both sides of the aisle (that is, research and execution) are firms that will be successful with firms such as ours.

CAN AGENCY BROKERS HOLD THEIR MARKET SHARE? 60

Photograph © Susan Findlay/Dreamstime.com, supplied June 2010.

Finely Balanced The advent of commission sharing arrangements several years ago sent a chill through the agency brokerage community amid concerns that buy side institutions would concentrate trading at the bulge bracket securities houses. Unbundling execution and research seemed to favour the major houses, which offered clients a single conduit to local trading operations in the most important markets worldwide, the ability to tap proprietary dark liquidity pools, and information technology support including algorithms, smart order routers, and transaction cost analysis. Without the resources to compete head to head, smaller firms feared clients might yank their order flow and pay for research in cash instead of commissions. It hasn’t worked out that way, however. Neil O’Hara reports. HE FINANCIAL CRISIS revealed an unforeseen risk in commission sharing arrangements: The cash was not in a segregated account. Lehman Brothers customers lost millions when money with which they expected to buy research from third parties became an unsecured claim against the bankruptcy estate. Efforts to cut broker lists went into reverse as the buy side scrambled to diversify counterparty risk. Brokers outside the bulge bracket were the biggest beneficiaries, including Robert W Baird & Co, a middle-market broker based in Milwaukee. Although Baird had offered commission sharing arrangements for some time to a few big accounts as a favour, it rolled out the service to a broader client base only two years ago. As a latecomer to the party, it was able to design the system to keep client money separate, a huge selling point few other firms can match.“The funds are literally segregated from our firm,” explains Dan Renouard, chief operating officer of Robert W Baird & Co’s institutional equities division.“That resonates with a lot of people.”

The bulge bracket firms also had to pull back from using capital to facilitate customer trades; depriving them of what had been a competitive edge in doing business with certain clients. The acquisitions of Bear Stearns by JP Morgan, Merrill Lynch by Bank of America and Wachovia by Wells Fargo demonstrated once again that in brokerage firm mergers the revenues of the combined entity seldom equals the sum of the parts.“Several basis points of market share slid to the second-tier firms,” says Dan McMahon, director of institutional equity trading at Raymond James & Associates,“It also got more evenly distributed among the bulge bracket firms.” The higher market share may not stick now that the major houses are beginning to flex their muscles again. Laurie Berke, a principal at TABB Group, a New York and London based financial services research and consulting firm, says the bulge bracket has begun to re-assert its dominance, but market share gains are coming at the expense of brokers that specialise in execution rather than

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research. During the bull market, the buy side directed business to execution-only firms as a way to cut costs and boost reported performance a few basis points at a time when good stocks and bad floated up indiscriminately. In its January 2010 study, US Institutional Equity Brokerage, however, TABB found that the buy side is now allocating a smaller piece of the commission pie to execution services. Performance in the current market depends on original investment ideas, for which portfolio managers are more willing to pay.“Firms that do not have a research product are going to find themselves challenged,” says Berke, “Managers have to bring back the investor and generate positive relative return. The way to do that is to get good ideas and content.” In an implicit recognition of the predicament they face, Berke says execution-oriented brokers have begun to add a research dimension to their offerings. For example, ITG has invested in Disclosure Insight, an independent research firm, and dark pool operator Liquidnet has launched InfraRed, a corporate access service, in partnership with NYSE Euronext. Brokers are fighting over a smaller commission pie as well; the result of relentless pressure on rates, lower asset values and lower average trading volume.“The onus is on agency brokers to make clients want to trade with us”says McMahon at Raymond James,“We have to offer a research product that people want. Customers expect us to dig deep and know the companies we follow better than anyone else.” Like many agency brokers, Raymond James & Associates specialises in small and mid-capitalisation companies. In fact, some 80% of the names it covers on the investment banking side and in equity research fall into that category. The major houses may not even have analysts that follow these companies, and limited liquidity makes these stocks unsuitable for the electronic trading techniques in which bulge bracket firms excel.“To get in and out and minimise market impact, institutional investors often go to a firm that knows where the bodies are buried and has experience in trading less liquid stocks,”says McMahon. Most agency brokers carve out a niche in either industry or geographic expertise, too. Baird has long been known for its research on industrial companies in the mid-West. Among them is Harley-Davidson, the iconic motorcycle manufacturer, whose headquarters are just a mile up the road from Baird’s own. “We’re among the top traders in many mid-cap industrials and Harley is a name we traffic in frequently”says Renouard. Regional brokers often know where all the stock lies in the companies they know best; if an investor wants to buy a million shares and not move the price, the firm that has the axe in a stock is the place to trade for best execution. In the past ten years, Robert W Baird & Co has broadened its research effort beyond its rust belt roots. The number of companies it follows has grown from 250 to more than 600, encompassing healthcare, technology, consumer, financials, energy and real estate as well as industrials. The nature of research has changed, too; the

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Dan Renouard, chief operating officer of Robert W Baird & Co’s institutional equities division. Brokers outside the bulge bracket were the biggest beneficiaries, including Robert W Baird & Co, a middle-market broker based in Milwaukee. Although Baird had offered commission sharing arrangements for some time to a few big accounts as a favour, it rolled out the service to a broader client base only two years ago. Photograph kindly supplied by Robert W Baird & Co, June 2010.

classic printed comment on quarterly results is no longer enough to attract order flow. “What people care about is channel checks, derivative calls, and unique surveys and talking to private companies,” says Renouard; “One thing that separates us from the pack is the amount of deep field research that our analyst teams conduct.” Such detailed research has a double pay off: Investors lap it up and it earns the respect of company management, who become more willing to participate in the conferences and road shows for which investors have an insatiable appetite. To convert the goodwill engendered into as much order flow as possible, Baird directs its traders to concentrate on names the analysts cover. “I line up our trading resources with the research,”he says,“Our research focus has driven our trading success.”

CAN AGENCY BROKERS HOLD THEIR MARKET SHARE? 62

its information technology up a notch, too, giving sales traders the tools they need to bring in more business. Most agency brokers rely on outside vendors and partnerships with the integrated houses to procure the software they need to compete in a market where electronic execution accounts for an ever-increasing proportion of trades. Cowen has developed a few algorithms of its own, but O’Donoghue has no ambition to create a business around financial engineering. “The buy side doesn’t necessarily look for the best algorithm all the time,” he says, “They have become a commodity. Customers value good investment ideas and research support. They can click on a screen, hit a drop-down menu and decide whether to pay Cowen or somebody else.” The bulge bracket firms are keen to have other brokers use their trading platforms because the incremental order flow adds liquidity that benefits their own customers. For the smaller players, it’s a mixed blessing: They get state of the art Laurie Berke, a principal at TABB Group, a New York and London based financial services research and technology on the cheap, but consulting firm. Berke says the bulge bracket has begun to re-assert its dominance, but market share gains they have to reveal their order are coming at the expense of brokers that specialise in execution rather than research. Photograph kindly flow to a competitor. That’s why supplied by TABB Group, June 2010. Raymond James prefers to use outside vendors that have no ties to a particular broker for Corporate access Corporate access plays an increasingly important role at its technology needs. “You can white-label the technology Cowen & Co, a broker built on the back of a strong middle as if it is your own,”says McMahon,“We can offer the same market research franchise in healthcare, technology and technology as the bulge bracket firms. The vendors are consumer products. Cowen is not strictly an agency broker; independent, so we are not providing our competitors with it does commit capital to facilitate trades—as do both Baird a heat map of our order flow.” and Raymond James on a limited basis—but more out of competitive necessity than conviction. “Our business The technology race model is to monetise our research as much as we can,”says While the largest agency brokers have kept pace in the John O’Donoghue, head of equities at Cowen,“We want to technology arms race, their smaller brethren have fallen punch above our weight.” behind, undermining their ability to attract order flow. O’Donoghue is trying to recreate a bulge bracket firm on “Client feedback suggests the execution quality difference a smaller scale at Cowen & Co while preserving its research between large middle market and bulge bracket firms heritage. He has turned the firm’s ad hoc corporate access versus the small players is bad and getting worse,” says efforts into an organised programme, doubling the number Baird’s Renouard. In a world where the spread of of non-deal management road shows it has arranged in the commission sharing arrangements encourages past two years while maintaining its long-standing unbundling, that may prove fatal to some trading desks, at commitment to conferences. He has kicked the quality of which point the line between an agency broker and an

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independent research shop begins to blur. Meanwhile, some independent research shops that were set up after the Spitzer settlement several years ago are heading in the opposite direction, adding execution capability in an attempt to milk more money from their franchise. The business model that seems to work best for agency brokers combines institutional sales and trading, retail brokerage, asset management and investment banking, all of which leverage off a core research expertise. That approach has served Chicago-based William Blair & Company well for 75 years, and Robert Newman, a member of the firm’s executive committee and director of equity research, sees no reason to change a winning formula. William Blair, the last Wall Street firm of meaningful size that has always been a partnership, is a pure agency broker. “We don’t have proprietary trading,” Newman says, “The customers know they are dealing with a natural investor on the other side of the trade. Our interests are aligned with theirs.” William Blair covers 420 names in business services, consumer products, financials, healthcare and technology, most of which are small or mid-cap growth companies. Like its peers, the firm has ramped up a corporate access program, anchored in William Blair’s case by its annual Growth Stock Conference, an event that draws top names among both corporate and investor participants. “About 80% of the 200 companies that attend our conference each year send their CEO,” says

Robert Newman, a member of Chicago-based William Blair & Company’s executive committee and director of equity research. Newman sees no reason to change a winning formula. William Blair, the last Wall Street firm of meaningful size that has always been a partnership, is a pure agency broker.“We don’t have proprietary trading,” Newman says. Photograph kindly supplied by William Blair & Company, June 2010.

John O’Donoghue, head of equities, at Cowen & Co, a broker built on the back of a strong middle market research franchise in healthcare, technology and consumer products. Cowen is not strictly an agency broker; it does commit capital to facilitate trades—as do both Baird and Raymond James on a limited basis—but more out of competitive necessity than conviction.“Our business model is to monetise our research as much as we can,” says O’Donoghue.“We want to punch above our weight.” Photograph kindly supplied by Cowen & Co, June 2010.

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Newman, “That is indicative of who they believe they will see at the conference and how they view our research.” It’s a virtuous circle; the more CEOs attend, the more likely it is that top portfolio managers will come—and vice versa. William Blair isn’t resting on its laurels, however. It has expanded research coverage to include Chinese firms in its sectors that have listed their shares in the US and has built up an institutional client base in London, Zurich and, to a lesser extent, Tokyo. The big domestic asset gatherers are William Blair’s largest revenue producers, but the firm has cultivated strong relationships with smaller money managers, too. “We recognise that mid-sized firms cannot do business with everybody,” says Newman,“If they choose to do a disproportionate amount of business with us we tend to give them high service levels even though the absolute dollars may not be that big.”It is a strategy that caters to asset managers who find themselves relegated to second class citizens at bulge bracket firms, which tend to focus on hedge funds because they generate more commission than traditional money managers of the same size and have other revenue potential, too. Successful agency brokers understand that they have to earn their keep in a competitive marketplace where nobody is forced to trade with them. “It is a relationship business,” says Raymond James’s McMahon, “People want to do business with people they trust and where they know they are going to get a quality execution.”

FACE TO FACE: RICHARD BALARKAS, CEO, INSTINET EUROPE 64

When Instinet won Financial News’ best agency broking award in September last year, the firm’s chief executive officer Richard Balarkas noted: “The definition of agency broking has become blurred, with even some of the world's largest banks today declaring that they provide an agency service.” Some would argue that the agency model is the model of the future in a post-crisis regulation-driven market. Others, that the complexity of today’s equity trading markets and the technology required to effect new and trusted trading strategies will ultimately mean a flight to ‘quality’; and that the service set of the bulge bracket banks will concentrate business in their hands. In our regular FACE to FACE segment, we spoke to Balarkas about these dynamics and the need for transparency in a fast changing equity trading landscape.

Richard Balarkas, chief executive officer of Instinet Europe. Photograph kindly supplied by Instinet, June 2010.

A COMMITMENT TO MARKET TRANSPARENCY

NSTINET IS ONE of the world’s largest agency-only brokerage. A wholly owned subsidiary of Nomura Holdings Inc, Instinet Europe is the European arm of the a global network of agency-only broking, involving sales trading, direct market access, commission management services and independent research, offering access to its suite of algorithms and its own dark book, the MTFregistered ‘BlockMatch’. The key point of differentiation holds the firm is that Instinet operates on pure agency basis. “The word ‘Agency’ is a very blurred term in the market,” underscores Richard Balarkas, chief executive officer at Instinet Europe.“We take a strict view: as our clients’ agent we will not seek to profit from their business in any way other than through the agreed fee they are paying us. This means we are 100% aligned with our clients interests and nobody here is incentivised or has any motive to do anything other than work for the client. I do not think many of the other ‘agency’ brokers adopt this standard. By ‘agency’ they tend to mean not focusing on proprietary trading, but [that they are] willing and able to take positions,” he explains, adding that: “Clients can be confident that Instinet’s smart order router will not preference to any venues—including our own dark pool—based on shareholding, rebate or cost.” As the equity trading markets have become more complex, the relationship between broker and client has become

multi-dimensional. A fundamental question is whether the agency model has the depth to service that complexity. Balarkas is adamant that transparency is fundamental to today’s service equation: “The agency model is key to our relationship. We have found that as the markets get more complex so the scope for some firms to manufacture revenue from client flow has increased, along with the ability to be less than clear about how and when this is happening. That they do this is great, because in contrast we look like the Julie Andrews of broking. As other brokers’models and execution policies get murkier and more opaque, ours gets clearer and clearer. Take all the new conflicts of interest that are thrown up by smart routers. For example: do I route where it is cheapest for Instinet to trade? Or, do I chase the best price for the client, possibly paying higher costs? We set all these conflicts out in our 10 commandments of smart routing, how we intend to address them, and published it.” This is grist to the mill of Balarkas’ underlying Darwinian view of market evolution; that the best and brightest win and that strength does not always emanate from arcane investment banking structures. He should know, prior to assuming the head job at Instinet Europe, Balarkas was a key member of Credit Suisse’s alternative equity execution and algorithmic trading teams that presented the market with the groundbreaking Guerrilla trading algorithm.The bulge bracket

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institutions do not hold all the cards in today’s markets by any means, he avers.“The argument should be that as trading gets more complex and needs continued investment any firm not up to scratch will have problems staying in the game. I think this also applies to many bulge bracket houses though, as they are suffering badly in these times of no deal flow and low market volumes.They are restricting spend, they have to; doing the minimum to get by,”says Balarkas. At the same time, he acknowledges that technological proficiency is now a basic building block of the trade services offering. All of Instinet’s technology has been developed inhouse, he explains. Developments and enhancements to its core system architecture, global smart order routing technology, algorithms, connectivity applications and the Newport Execution Management System are undertaken by the firm’s own team of programmers. Instinet’s stated goal is to ensure that clients benefit from the emerging dark trading opportunities.“As part of our ongoing efforts to ensure that clients are connected to every available pool of nondisplayed liquidity, Instinet has enhanced the dark liquidity seeking functionality of its European SmartRouter to include dark liquidity aggregation logic, also known as ‘Nighthawk’,”he expands. Instinet’s dark-pool aggregation logic aims to access as many MTF dark pools as possible and seeks to connect to as many broker dark pools as will permit. Currently, Nighthawk Europe connects to Instinet’s BlockMatch™, Credit Suisse dark book ‘Crossfinder’; ITG Posit; Chi-Delta, and Turquoise Dark, among others. The firm’s smart order router functionality also includes an option within the algorithm to place a percentage of the order across dark venues. “This additional functionality helps clients take advantage of specific price and liquidity opportunities, without having to micro-manage their orders; ultimately helping them improve execution performance,”says Balarkas. That involves first mover advantage concedes Balarkas. “While we want to be known to be good at trading, with all the component parts that entails, if clients were to be asked: ‘Who is the smartest broker in Europe when it comes to smart routing, handling fragmentation and using dark pools?’We want Instinet to be the first name on clients’ lists. Actually, I think our plan is working. We have always been ready to connect first to every new venue. We have always been wholly transparent about where we trade and why, and we have always been transparent about the results achieved. Moreover, we have recently been pleasantly surprised by independent verification that our smart router is REALLY smart. Nearly 60% of the shares we trade get a better price than had we simply sent a market order to the primary market. Across all our flow we are capturing 40% of the spread, that’s roughly 5bp of price improvement. This number was way above what I reasonably expected. I genuinely believe our smart router is better than any other firms, including all the investment banks.” Multi-asset trading is now, finally, becoming a reality, offering new business lines and a new set of competitive strains in the business. Balarkas remains upbeat about the implications: “I

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hope it will be largely positive. The long term in equity market structure is typified by an increase in buyer power, and the ability of investors to become price makers as well as price takers. It’s what I call the democratisation of the markets.These trends have yet to start in the markets for other classes.” Competitiveness runs high in the Balarkas constitution and provides a uniquely focused view of the changing buy side/sell side dynamic. A current trend is the reduction of the space between the sell side trading desk and the portfolio manager. Studies released through 2010 show that there is a real cost (as much as 400 basis points at the top end) in the time lag between a portfolio manager deciding on acquiring or selling stock and final order execution. Leading sell side houses now heavily sell their execution consultancy services to leverage this trend. “We do the same,” acknowledges Balarkas, who adds his unique spin to the mix: “Because of our un-conflicted status and alignment with our clients’ interests we do not consider ourselves the best sell side trading desk but the best buy side trading desk.” Despite the hype, the rather thoughtful and soulsearching Balarkas thinks the equity markets are in line for further shake-ups. In part that will come from the introduction of the new Markets in Financial Instruments Directive (MiFID II), in part from the uneasy marriage of a trading community in flux and a regulation driven commitment to highly tuned management of market risk. Balarkas believes it will have significant repercussions on the industry for years to come.“I think regulators are battered on all sides by lobbyists and vested interest groups and their ability to make sense out of all the noise they hear must be very difficult,” he concedes. “As a result I think I do get a sense that some regulators and politicians especially believe innovation has gone too far, that the markets are too liberal. However, I worry that the process of democratisation that we have seen over the last 25 years, which has resulted in huge progressive changes to the market structure that have benefited all investors could be about to stop or, even worse, go into reverse. The debate has an air of negativity about it. In the past the regulatory debate has been positive, about imposing change, about driving through changes that lead to innovation and more competition.” In the meantime, Balarkas continues to establish and build the firm’s independent agency broking credentials. In May this year, he secured a deal with Euler Securities, a specialist research firm providing customised research on large-cap, global companies across a variety of sectors and asset classes. Buy-side clients using Euler Securities’ research will use Instinet Europe as their exclusive execution broker and can use Instinet’s global, brokerneutral commission management platform, Plazma®, to direct payments to Euler. The transaction plays to Balarkas’ commitment to market transparency as a key element of its business strategy going forward. “Instinet’s clients in Europe can use Plazma® to access more than 100 independent research firms, confident in the knowledge that they understand what they are purchasing and how much they are paying for it,”he says.

THE ASSET SERVICING VALUE CHAIN

IN SAFE CUSTODY Photograph © Elenaray/Dreamstime.com, supplied June 2010.

Before the financial crisis exploded, asset servicing firms were assigned marks on their innovation, technological prowess and specialist expertise. Ironically, custody, which is the bedrock of the business was a given and often much farther down the list. Fast forward to today and the collapse of Lehman and stock markets has elevated the bread and butter function to the top of the list. As Seán Páircéir, Partner at Brown Brother Harriman, puts it, “There is a much greater appreciation of the quality of the custody product [following] the financial crisis. In the past, the safekeeping of assets had been somewhat taken for granted but asset managers are no longer doing that. The value of custody has become much clearer.” Lynn Strongin Dodds reports.

NN DOHERTY, MANAGING director of JP Morgan Worldwide Securities Services underscores the resurgence of custody as a service set.“In many ways what we are seeing is clients refocusing on the basics of the service.They are paying much more attention to the security of their assets. [Additionally,] they are conducting greater due diligence to ensure that a firm can deliver what it promises.” Charles Cock, head of sales & relationship management of BNP Paribas Securities Services echoes the sentiment. “Since the crisis, people have discovered the importance of the security of their assets. It was always on the checklist but it is now in the middle of the radar screen. The big question that institutional investors want to know— particularly after Lehman—is: how easily I can retake control of my assets? As a result, they are looking at dealing with a handful of players who have a strong geographical presence and capital base.”

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firm can achieve internally. The current crop of It is also about leveraging magazine-led surveys and the vast data flows to data based rankings seem to deliver the risk bear this out. The management and behemoths such as BNY analytics services that help Mellon, State Street, Citi and clients monitor and JP Morgan as well as the manage their exposures. firms the next tier down Jim Connor, director of BNP Paribas, such as European investment Société Générale Securities management services at Services, Northern Trust, Navigant Consulting, says, RBC Dexia, Brown Brothers “Cost containment is a big Harriman and HSBC theme particularly for Securities Services medium sized asset continually to appear on the management firms who league tables. Their rankings cannot invest in the may change from one year technology or infrastructure. to the next but as the latest If a custodian can help them R&M Global Custody cut costs then this will help Survey, the benchmark for them drive profitability. This service quality in the could translate into product industry, showed custodians or distribution support or stepped up to the plate and the most effective way to improved their client service enter a market.” support and efficiency. They Cock notes, “The trend not only offered the bread across the whole industry and butter services but also has been to reduce costs were able to extract and use third party information from their providers. This is extensive data banks to help particularly true for middle untangle counterparty risk sized players who are plus develop tighter overall Charles Cock, head of sales & relationship management of BNP realising that their model risk management structures. Paribas Securities Services.“Since the crisis, people have discovered of doing back and middle The R&M survey, which the importance of the security of their assets. It was always on the office functions in house is canvassed 850 asset checklist but it is now in the middle of the radar screen. The big not sustainable particularly managers and institutional question that institutional investors want to know— particularly after as they move into more investors, also notes that the Lehman—is: how easily I can retake control of my assets? As a result, complex instruments such services delivered by they are looking at dealing with a handful of players who have a as derivatives.” custodians have become strong geographical presence and capital base,” he says. Photograph Doherty agrees, adding, increasingly consistent; kindly supplied by BNP Paribas, June 2010. “What is clear in this thanks to the greater automation of operations, markets becoming paperless and environment is that clients are definitely turning to us to communications being standardised and electronic. Market help them cut costs in a meaningful way. Research has participants believe that the differentiation comes down to the shown that headcount accounts for about 70% to 80% of quality of service, attention to detail and the ability to help an asset manager’s total costs and as a result they are their clients contain their costs. The latter has become increasingly looking across their operations to see what increasingly important in this uncertain economic world as they can outsource.” Doherty also says that asset managers are asking their asset managers once again refocus on their core competencies providers to play a larger advisory role not only in and assess which operations can easily be outsourced. This is not a new trend. The same pattern was followed helping them distribute and structure funds but also for in the aftermath of the dot.com debacle when investment guidance through the current regulatory minefield. “Our managers looked to parcel their back office functions and traditional and alternative asset management clients are hand them over to a custodian. The difference today is that asking us for help in setting out strategies. We are also it is more likely to be on a more component based. The goal leveraging our firms’ expertise and providing information though is the same: to reduce the cost throughout the on a range of issues, particularly on the impact that the investment lifecycle by using scale and a global technology different regulations currently being debated will have on that delivers cost efficiencies no investment management their operations.”

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THE ASSET SERVICING VALUE CHAIN

Consultative basis Wade McDonald, a senior vice president at State Street and head of customer relationship management for the company’s Global Services team in the UK, the Middle East and Africa, explains that:“We are spending more time with our clients on a consultative basis and helping them brainstorm about what their top priorities are. For us to drive value we need to have a strategic understanding of what each client set (traditional and alternative asset managers as well as asset managers) require.” Already there has been an uptick in the demand for services in the middle office realm on the back of impending regulation. Although the legislative process is at different stages in different jurisdictions and the exact blueprints to emerge are hard to predict, asset managers are gearing up for a more rigorous milieu where transparency and risk management are the order of the day. This has translated into requests for daily and intraday reports, real-time reporting, multi-asset class and multimarket monitoring, valuation and analytical solutions and tools. Collateral management as well performance measurement and independent valuations on of over the counter products are also on the list. Sébastien Danloy, global head of sales and relationship management at SGSS,“We are definitely seeing an increase in the outsourcing of middle office activities. The level is different depending on the country and the maturity of the market with asset managers in the UK more advanced than their peers in continental Europe but this is changing.”

Transparency/regulation One of the biggest challenges for all asset managers, according to Doherty is achieving the high levels of transparency that the regulation is likely to dictate. “This poses significant data management issues. Several asset managers do not have extensive compliance and legal teams, as well as the large middle and back offices to be able to produce this type of reporting. It is an area where we are seeing increased demand because securities services providers, who are holders of investment data, are best placed to provide the reporting and processes that are and will be required,”she says. As for which regulations will have the greatest impact, all eyes are on the European Union’s Alternative Fund Investment Managers Directive (AIFM) which could affect both European Union and non EU alternative investment managers. To date, the European Parliament and the European Council, which each passed its own version of the AIFM are in the process of negotiating a compromise with the aim of producing a final report in July. It will require asset managers to be authorised by and provide detailed information to local financial markets regulators, and to meet minimum capital adequacy requirements. The most contentious issues though are depositary liability and the ramifications this will have on custodians as well as proposals for third country managers. This could impose an explicit ban on institutional investors, no matter how sophisticated,

Ann Doherty, managing director of JP Morgan Worldwide Securities Services underscores the resurgence of custody as a service set.“In many ways what we are seeing is clients refocusing on the basics of the service. They are paying much more attention to the security of their assets. [Additionally,] they are conducting greater due diligence to ensure that a firm can deliver what it promises.” Photograph kindly supplied by JP Morgan, June 2010.

accessing non-EU hedge funds that do not meet its standards, or who come from jurisdictions – including the US – with no bilateral regulatory agreements in place. Over the counter (OTC) derivatives are also generating a great deal of attention. In the US, the House of Representatives and Senate are in the process of hammering out a deal together on their respective interpretations while the EU is preparing its proposals for consultation for the summer. European participants are also grappling with Committee of European Securities Regulators consultations over investor protection and intermediaries; transaction reporting; and equity markets as well as the Undertaking for Collective Investment in Transferable Securities IV. The directive which comes into force next year is being hailed as a true game changer in terms of how funds are structured and distributed. The main provisions are introduction of the management company passport (MCP), enabling funds to be managed by a company located in any EU member state as well as simplifying and accelerating the UCITS notification procedure. Other proposals include clarifying the rules for cross-border mergers between UCITS fund and introducing rules to create U CITS master-feeder (pooling) structures. A survey conducted last year by RBC Dexia Investor Services and KPMG which canvassed 52 European fund managers, reveals that about 49% are planning to

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restructure their fund ranges as a result of UCITS IV directive. There are also expectations that hedge funds will increasingly wrap some of their strategies in these regulated wrappers to assuage investors and regulators. Meanwhile, a recent survey by Alternative Decisions, a research organisation, found that fund management groups consider the UCITS structure a credible way forward in terms of security, liquidity and transparency. Most groups saw the structure as a means of rebuilding trust in hedge funds and reaching out to a wider audience of absolute return investors. According to Doherty, UCITS IV will requires asset managers to make major decisions about how funds are managed on a pan-European basis. “While traditional UCITS managers already have established sophisticated distribution channels and marketing strategies, this is not the case with hedge funds. It is a departure for them and they do not have the technology, infrastructure or operational processes to deal to with for example the risk management, measurement and reporting that is required.” Danloy of SSGS says,“Distribution services are more and more in demand than a few years ago. In Europe, although there are directives, each individual country has its own approach and regulation for fund distribution. It is key that providers have an on the ground presence and can provide the local assistance with the different structures, rules and tax systems.” Europe though is not the only region where the distribution door of opportunities is opening. Market participants are also looking to add value to the process in the emerging markets in Asia as well as Latin American where fund management is at different stages of development. Connor says,“We have already seen several custodians jump on the distribution support bandwagon. They are in a strong position to provide these services because they have the technology and local capabilities / expertise to help asset managers enter into a new market and distribute their funds. Tax, regulation and product structures in new markets are important issues asset managers need to get right and asset servicing firms are increasingly being called upon to provide the advice as well as the servicing support.”

Service levels Sean Páircéir at BBH reiterates the importance of having a global reach. “You need to have a certain scale, execution capability and operational infrastructure to be able to support a client’s distribution needs. Not surprisingly, distributing a fund in Japan is markedly different from Latin America or South Africa. It is important to be able to deal with the differences in regulation, tax systems and service needs of the major clearing houses.” Despite the high expectations, asset managers do not surprisingly want to see a corresponding rise in fees. The leading global custodians have been able to keep costs down because as they have grown in size, they have achieved ever greater economies of scale and ever lower

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unit costs. Danloy says,“The challenge for an asset service provider in today’s market is to ensure high quality service at the right price. Clients may want a service that is specific to that organisation but they may not be willing to pay a premium for it. They must understand though that there will be certain areas such as client reporting that needs to be tailored to their own firm and that in the end the value that it will bring them will offset the price they may have to pay.” McDonald of State Street says, “It is the 80/20 rule whereby 80% of the services and products you offer are standardised and mainstream while 20% are more specific and higher up the value chain. These include performance measurement and attribution as well as client reporting.” Connor adds, “Where customisation has paid off is when you have an asset manager who wants to bring something new that is wanted by the market and is asking its custodian to help them stay ahead of the curve. We saw that with derivatives. In time though the customised‘thing’ becomes part of the standard model and the focus shifts to something new.” Although providers aim to keep pace with their client’s evolving needs and investment structures, the one area where they will not be venturing into is asset allocation advice. Danloy comments, “Our role is to ensure that the post trade activity takes place in an efficient way. It is not to act as an advisor in the pre trade space. They are two different roles.”McDonald adds,“I do not think custodians should play another role but to keep the assets safe, provide timely and accurate information and other services to support the investment process functions. We are enablers that support their investment strategies and not advisors on what the investment strategies should be.” Market participants also note though that there is a growing trend for asset service providers to work with fiduciary managers who are appointed to provide investment advice, implementation and oversight, subject to the instruction of the fund’s trustees. The strategy could include implementing a liability matching strategy through the use of derivatives, such as inflation and interest rate swaps. Just as with other types of funds, the custodian would be called in to provide a range of services such as performance measurement, accounting and independent valuation of OTC derivatives. Overall, the larger asset managers have a clear understanding of the role of the asset servicing provider and the risks they undertake although the smaller ones might not have such a detailed knowledge. As a result, they are encouraged to employ the right legal advisors and read the fine print of their service level agreements. As Cock highlights,“Post Lehman Brothers, clients paid much more attention to the safekeeping of their assets, how they were segregated and the counterparty risks they were taken. However, sometimes the legal language can be confusing and there needs to be a clearer definition of who is responsible and liable for what in certain jurisdictions. For example, the European legislation is more open to interpretation than the Anglo Saxon laws.”

GLOBAL CUSTODY AND RISK MANAGEMENT

After every financial crisis, risk management tends to rise to the top of the agenda and then falls to the bottom when markets recover. This time around though may be different as the severity of the crash has prompted a plethora of regulation that will force asset managers to implement more rigorous practices. Many have and will look towards their asset service providers who in turn have been more than happy to step into the breach. Lynn Strongin Dodds reports.

RISK TO

CENTRE

STAGE D

Photograph © Connie Larsen/Dreamstime.com, supplied June 2010.

R ANTHONY KIRBY, director at Ernst & Young’s regulatory and risk management practices. “We have just conducted a survey on risk management which polled 29 heads of risk and chief risk officers at leading fund management groups in the UK and continental Europe. The main themes that emerged are that asset managers have elevated both the risk governance and function to centre stage. They are paying more attention to how they manage investment risks to ensure that there is adequate independent evaluation. They are also looking more carefully at regulation and what they will need in order to comply with the new rules emerging from the G20 agenda.” Custodians were obvious ports of call as many of the larger contenders such as BNY Mellon, JP Morgan, Citi, BNP Paribas, State Street and Northern Trust already boasted comprehensive suites of performance and risk attribution systems and compliance engines designed to highlight investment portfolio holdings, associated risks and market positions. As Jim Connor, director of European investment management services at Navigant Consulting notes: “Custodians already had several of the pieces of risk management such as valuations, performance measurement and analytics in their toolbox. The collapse of Lehman showed that all these pieces needed to be pulled together in a meaningful way and I think asset managers are increasingly looking towards their asset servicing firms to play a role in doing this. The thinking today is I can build

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the infrastructure myself or I can leverage some of the capabilities of my service provider who is already providing custody, fund administration, clearing and settlement. The evolving and bespoke nature of risk management means asset managers are not only looking for products and services but also for strategic partnerships.” Kirby agrees, adding,“Our research showed that the risk function is changing from a perception of a risk monitoring function where managers react to events to a more strategic enabler which is integrated more with other control functions such as finance, compliance, legal or internal audit. In other words, they are looking at risk in a much more holistic manner. Asset service providers can and already are helping them set redefining their strategies and frameworks.” In other words, they need a much more coordinated approach. One of the problems in the past was that many asset management groups viewed risk through a prism that split the problem into silos such as market, credit, counterparty, operational and liquidity. There was no coordinated approach with different systems being bought from various vendors. The meltdown following the Lehman Brothers bankruptcy focused their collective minds on the importance of looking at the total picture within an organisation.

The holistic challenge One of the biggest challenges is bringing multiple analytical solutions together holistically on a timely basis”, according to Ian Castledine, global head of investment risk product, for asset servicing, at Northern Trust.“A robust risk management policy should provide insight and transparency as well as be able to account for changes throughout a portfolio. This requires huge amounts of data covering risk in all its forms—market conditions, credit, liquidity, regulatory and counterparty risks.” Systems need to be in place that can feed these significant amounts of data into models that then can be gleaned into meaningful information using a robust risk framework that includes the concept of risk budgeting. Integrated tools should provide insights across multiple risk categories, such as dedicated credit models, value-at-risk models, stress and scenario tests, and exposure analysis. The new world order also places more emphasis on analytics such as real time integrated data encompassing all instruments, asset classes and regions in a single portfolio that provide a better insight into a portfolio’s varied dimensions of risks and exposures. Trustees not only want to drill down into individual portfolio performance but they also want technology that will look at the scenarios to identify what could go wrong in their particular portfolios under different circumstances. Seán Páircéir, Partner at Brown Brother Harriman, says, “The proposed changes to mandated risk management programmes require a significant amount of additional data. The goal for an asset servicing firm is to ensure that clients receive the right information to support those processes.”

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Dr Anthony Kirby, director at Ernst & Young’s regulatory and risk management practices.“We have just conducted a survey on risk management which polled 29 heads of risk and chief risk officers at leading fund management groups in the UK and continental Europe. The main themes that emerged are that asset managers have elevated both the risk governance and function to centre stage. They are paying more attention how they manage investment risks to ensure that there is adequate independent evaluation. They are also looking more carefully at regulation and what they will need in order to comply with the new rules emerging from the G20 agenda.” Photograph kindly supplied by Ernst & Young, June 2010.

John Gruber, head of global product management, performance & risk analytics at BNY Mellon notes, “The bottom line is that asset managers and owners are looking for more guidance, stress testing and interpretations of the data to identify the specific risks whether it is credit, liquidity, counterparty, market or operational risk. Asset servicing firms are a natural place to go because it makes sense as a starting point to go the place where the data sits which is with the custodian.“ The environment is expected to only become tougher as the regulation currently churning through the system takes form. Although it is too early to predict the final outcome, there is no doubt that the impact will be far reaching. For example, take the UCITS IV directive in Europe, which is due to be implemented in 2011. The several changes being proposed will require fund managers to upgrade their risk management systems. The first is that the distinction between sophisticated and non-sophisticated funds which was introduced under UCITS III in 2004 will be abandoned.

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In the past, sophisticated funds used VaR but there less savvy counterparts used were allowed to stick to the traditional ‘commitment’ approach, measuring the exposure of the fund and ensuring that the exposure is not higher than double the fund’s net asset valuation. While the choice will still be there, the general consensus is that all of the industry will move towards aVaR approach. This will mean that asset managers currently only using a commitment approach will need to invest in VaR-based processes. In addition, there will be mandatory model back-testing as well as a dedicated liquidity risk management process including stress tests and scenario analysis on market liquidity risk. The proposals on over the counter derivatives on both sides of the Atlantic will also require fund managers to implement more rigorous procedures for portfolio reconciliation, margin calls and collateral management systems. Although the details have not yet been finalised, the main thrust is in line with the G20 recommendations which is calling for OTC derivative contracts be traded on exchanges or electronic trading platforms and cleared via central counterparties by end-2012 at the latest. Key data is to be reported to trade depositaries while non-centrally cleared or listed derivatives should be subject to significantly higher capital and margin charges. According to a recent report from TowerGroup, industry participants—broker-dealers, custodians, and traditional and alternative asset managers—need to improve the technology and operational infrastructure that supports OTC derivatives. The survey, which canvassed 63 firms in the different disciplines, revealed that there was a gap between what needs to be done to accommodate central clearing and what is actually being done. Stephen Bruel, author of the report believes, that“OTC derivatives players must begin to bolster their clearing operations and technology. Although this regulatory initiative may not come to fruition for months, it is imperative that firms appreciate the impact of clearing and begin to ensure they have the right processes in place.” Bruel believes there needs to a new integrated approach to operations and technology in order to help reduce the risk of trading OTC derivatives. He noted that effective risk management depends on good upstream processes, technology alignment, and robust data classifications and management around valuations and other aspects of the business. One of the key components is stronger collateral management practices, which helps mitigate counterparty risk. At one time, collateral management was the preserve of the prime brokers, but asset managers have been increasingly calling upon their custodians who have been busy bolstering and fine-tuning their offering. The fear over counterparty risk and a move towards more conservative types of collateral such as higher-quality, liquid and transparent securities have sparked a flight to quality and a safe pair of hands. Connor says,“There are definitely opportunities for asset servicing firms in analytics and servicing. They are well

placed because it fits in with their overall business proposition. The emergence of collateral management services is an example. They are already custodian of the assets that needs to be pledged and as a result, collateral management is a natural outgrowth of those services.” Bernard Tancre, head of product management for fund administration and transfer agency at BNP Paribas, says, “We are continuing to see a greater demand for collateral management products and we are further strengthening our offering in this area. Our clients are responding to regulatory pressures but the collapse of Lehman Brothers was a wake- up call and investors are strengthening their collateral arrangements due to concerns over counterparty risk.” Overall, custodians have been anticipating change and have tried to stay a step ahead of the regulators in developing and enhancing new risk management products. For example, a year ago, BNY Mellon struck a strategic alliance with Investor Analytics, a risk analysis and risk management solutions firm, to provide enterprise-wide risk analysis and reporting for asset owners and managers. It offers clients access to tools to measure and manage investment risks across multiple asset classes, strategies and portfolios using state of the art risk analytics, calculations, portfolio stress testing, and historical scenario analysis. More recently, Northern Trust Investment Risk and Analytical Services (IRAS) group recently introduced an

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integrated reporting tool which consolidates predictive risk management, performance evaluation, and compliance analysis on Northern Trust’s Fundamentals dashboard. The tool is designed to save clients’ time, help them with regulatory compliance—particularly related to UCITS III— and make it easier for them to manage their investments. The newly integrated reporting dashboard which is refreshed daily allows institutional investors to view a timely analysis of VAR (conduct expansive stress and scenario based testing as well as compare historical (ex post) and predictive (ex ante) risk exposures alongside performance attribution and compliance analysis. Northern Trust’s Castledine says, “Clients are increasingly faced with a plethora of predictive risk, compliance and performance analytics and this new tool consolidates all the data into one report. We developed the dashboard about 24 months ago to give them a snapshot view across all their asset classes but in general we have risk management products that cater to the different requirements of the asset managers and owners, and they are priced accordingly. For example, asset owners may only want to look the information once a quarter whereas asset managers will want much more granularity and sophisticated tools.” Looking ahead, though, market participants believe that the regulatory changes could have an upwards pressure on prices. As BBH’s Páircéir notes,“I think the cost of risk management

systems will rise because the infrastructure that is required to process and manage the data is expensive. However, in two to three years time, there will likely be greater standardisation of risk management and performance measurement and the cost will then be reduced.” Not surprisingly, the global custodians are likely to carve out a bigger market share due to their fiduciary role, balance sheet, geographical reach, and range of services. Connor notes, though,“No single custodian will be able to be competitive in all services across all jurisdictions. Some will have stronger product lines, specialist strategies or regional focuses. However, the big four: BNY Mellon, JP Morgan, State Street and Citi and selected mid-tier firms, are distinguishing themselves as cross-border (global) solutions are increasingly demanded.” Their product offering, state of the art technology, inhouse expertise and skill-set albeit important are not the only reasons why asset managers will chose a provider. Clare Vincent-Silk, a principal at investment management consultancy Investit says, “Due to the concerns over counterparty and operational risk, we are increasingly seeing asset managers conducting greater due diligence on how asset service providers are managing their own inhouse operational risk. One reason is that the asset owner has become more interested in which firms they are outsourcing to and whether they have the right internal systems and frameworks in place.”

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GLOBAL CUSTODY AT THE CROSSROADS

Photograph © Raimundas/Dreamstime.com, supplied June 2010.

THE

GLOBAL/LOCAL

DEBATE

HIS HAS BEEN the most eventful period in my 25plus years in the business,”surmises Jim Palermo, cochief executive officer of BNY Mellon Asset Servicing. According to Palermo, both providers and clients have experienced an enormous amount of pressure as a result of the proliferation of very complex instruments such as derivatives and exchange traded funds (ETFs), greater emphasis on regulatory reporting and calls for more

transparency, not to mention the complete reshaping of the securities lending environment.“At the same time, clients are being asked to do more with less; and, as a result, are really looking to their providers to help them pull it all together.” Palermo says that lower volumes and volatility, combined with exceedingly low interest rates, have made it all the more difficult for providers to realise an appreciable revenue stream from“implicit”fees surrounding areas such as cash management, securities lending and foreign exchange.“Back in 2007-2008, roughly half of our revenue came from hard-dollar fees, and the other half from the capital markets,” says Palermo. “[However,] because the capital-markets component has fallen off, hard-dollar fees now account for more than 60% of revenues and that isn’t necessarily a reflection of increased fees either.” Those directly affected by recent financial events— including beneficial owners which experienced an unexpected interruption in liquidity or were unable to immediately withdraw from a securities lending program— have in many instances paused to re-assess the benefits of

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Jim Palermo, co-chief executive officer of BNY Mellon Asset Servicing. Photograph kindly supplied by BNY Mellon, June 2010.

putting their securities on loan. While some have ended their participation altogether, others have taken a far more conservative approach to collateral reinvestment and, in general, are spending more reviewing and evaluating their securities lending arrangements. Experts such as Palermo believe that this proactive approach to securities lending management is here to stay. Accordingly, as clients continue to clamour for more frequent and detailed investment data, the increased cost of providing that information will have a dramatic impact on custodians’ bottom line. All of which underscores the advantages of having substantial in-house resources with which to build out services such as advanced trade cycle technology systems and, perhaps most importantly, relationship management capabilities. “As a result of the merger between Bank of New York and Mellon several years back, we were able to realise some very significant cost synergies, and we have continued to enjoy those benefits, particularly during this challenging period. Our investments in technology have given us some tremendous productivity and efficiency gains as well.”

Market challenges The markets continue to be challenging from both an interest-rate and trading-activity perspective, remarks Nick Rudenstine, global head of JP Morgan’s custody business.“That’s just the nature of the world we’re living in right now; there are a lot of things that we can’t do anything about. However, there are some issues that can be directly addressed, including those related to current

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and future risk as well as regulatory matters.” Rudenstine cites the European Union’s Alternative Investment Fund Managers directive (AIFM), currently nearing completion, which has the potential to significantly increase liability surrounding certain custodial duties. Similarly challenging are the requirements of Basil III and its impact on liquidity, adds Rudenstine. “There is no easy answer for how to deal with AIFM,” continues Rudenstine.“Custodians are going to be asked to make risk adjustments, but I’m not sure they really know how to deal with it just yet, since they are just now coming to grips with what that risk might look like. Of course, no one will really know for sure until AIFM is finally passed and then implemented by the various markets. That is a huge issue for global banks going forward. The bottom line is that custodians will need to make some serious changes in order to respond to all of these risks.” Unlike the relatively tranquil pre-crisis years, the rapidly evolving environment will likely compel providers without a well-established business model to exit the custody business, in the process quickening the already steady pace of consolidation.“It could certainly have an impact on some of the smaller banks in particular, as well as those who are in this business but in a limited fashion,”says Rudenstine. While the US, UK and most European markets pose few challenges for global providers, the increasingly complex emerging markets are a much different story. With asset flows continuing to move in the direction of emerging regions such as Asia and Latin America, custodians will place increased emphasis on bolstering local client services. “That is where clients need the most support and are

GLOBAL CUSTODY AT THE CROSSROADS 76

asking for value-added services,” says Rudenstine. “For instance, in certain markets proxy voting can be quite challenging, therefore clients are often asking for notifications so they can be certain the event has taken place. Or it may come down to helping clients understand complicated tax laws in a country such as Peru and their possible impact on fund management. So it really is a case-by-case situation.”

New revenue streams In order to keep revenue streams healthy, are custodians considering viable alternatives to traditional revenue drivers such as securities lending and FX, or is it simply a matter of trimming the fat and focusing on efficiency? Executives such as Rudenstine believe it is really a combination of the two. “For global providers with considerable assets under management, having scale is obviously a major advantage. At JP Morgan, we have sufficient capacity to be able to invest heavily in systems that can bring us greater efficiency. Obviously that is a major component. In addition to building a leaner operation, the other strategy is finding additional ways of delivering value that can in turn bring in fee-based revenue.” Last fall, JP Morgan announced the formation of its Prime-Custody Solutions Group, a team responsible for delivering the firm’s integrated prime brokerage and custody platform to clients. The unit serves hedge funds and asset managers seeking a combination of prime brokerage capabilities and securities services. Another tool, EPIC, ties together cash trade, execution with custody. Both allow JP Morgan to use its global scale in both custody and prime services to deliver value to its customers, says Rudenstine.

Steve Smit, executive vice president and head of State Street’s Global Services business for the UK, Middle East and Africa. Photograph kindly supplied by State Street, June 2010.

Steve Fradkin, president of corporate and institutional services for Northern Trust’s custody business. Photograph kindly supplied by Northern Trust, June 2010.

“I think clients really understand the value potential there. We recognise that some of the old revenue drivers just aren’t what they used to be, and if you’re not able to really achieve adequate scale in this environment, it is going to be that much harder to compete.” Steve Smit, executive vice president and head of State Street’s Global Services business for the UK, Middle East and Africa, sees continued strong demand for its custodial services. “I think it is fair to say that there were many asset managers who didn’t react quite fast enough to reduce their expense base in response to the falling value of their assets under management, and consequently are now very interested in pursuing outsourcing as a way for them to get a handle on the variablecost element. We have been seeing tremendous demand as a result. In fact, from a newbusiness pipeline perspective, things haven’t been quite this robust for some time. From our point of view, the challenge is to try and structure these transactions in the most commercially attractive way possible for both sides.” With transparency continuing to occupy center stage, demand for advisory services linked to risk management and compliance monitoring remains high. Client interest in alternative-investment vehicles is also on the rise, and, accordingly, firms such as State Street, which recently acquired Mourant International Finance Administration, a provider of alternative fund-administration services, have worked to expand their range of custody and administration offerings in that arena. “Reaching into different areas is a key part of the global-custody evolution,” explains Smit.

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The impact of regulation While posing considerable challenges, the changing regulatory environment particularly in the US and in Europe is at the same time creating new opportunities for asset-servicing institutions, says Smit. “Clients are obviously looking for a clearer line of sight into their portfolios, and firms like State Street need to be able to have the resources to meet these needs.” Custodians whose purview is limited to local markets or sub-regions remain vulnerable, given the scale that is currently needed to invest in that part of their business.“Certainly this may not be a core activity for many parent organizations, particularly if the organisation is stressed and under pressure to raise additional capital. So yes, we believe that this will lead to further consolidation, both within the core long-only space, as well as in the alternative-asset servicing arena.” As asset owners become increasingly focused on the security of their investments, providers continue to grapple with more onerous legal guidelines around servicing contracts, liabilities and indemnification. Because part of that focus centres on the duties of the sub-custodian, institutions such as State Street have made a greater effort to vet their sub-custodians through more robust duediligence and contingency plans.“Furthermore, regulatory changes encouraging greater use of central clearinghouses and counterparties will likely have some impact on the future of sub-custodial networks as well.” Clearly, the environment in which institutional investors operate has changed, bringing forth obvious downstream consequences, holds Steve Fradkin, president of corporate and institutional services for Northern Trust’s custody business.“It isn’t simply about the downward drift of one’s portfolio—pension funds that were once over-funded are now under-funded in many instances—the expected draw on endowments has been scaled back, and so on. The impact on custodians has been multi-dimensional, influencing investment choices, asset allocations, risk oversight, and more. Transparency has changed profoundly as well. [These days] investment committees, board members and all other affiliated parties need to know exactly what is going on at all times through more detailed information and reporting.” Right now, many clients seek to maximise risk-adjusted returns through the likes of private equity, hedge funds and other alternative products, which typically requires more intensive (and expensive) forms of risk reporting. “At that point, you’re not just settling a normal trade—you need much more information, more data sources, more qualified staff,” explains Fradkin. “Costs tend to rise under those circumstances. However, there are ways of dealing with that. One is to provide value, which clients are still willing to pay for if the service meets their needs. If you are more transparent, thoughtful and focused, and, above all, creating actual value, clients will stay with you.” Additionally, prevailing conditions have made it more compelling for both providers and clients to utilise service bundles.“We are capable of offering a lower unit of cost if clients elect to do more business with us. So thinking about

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Nick Rudenstine, global head of JP Morgan’s custody business. Photograph kindly supplied by JP Morgan, June 2010.

the kind of bundle that a particular client needs allows us to provide them with a truly viable service offering.” As a result of the financial crisis, custodians have also seen renewed interest in standard offerings such as backoffice servicing. “When times are good, asset managers tend to look at something like the back office and think: ‘Sure, it’s a headache, but we’re making lots of money, so we’ll just take care of it.’ When times are bad though and your cost structure is suddenly under pressure, managers start to really focus on their core duties. So even though back-office outsourcing has been around for nearly a decade now, the crisis, though bad for everyone, is nevertheless creating an opportunity for service providers.” Traditionally, areas such as collateral management, securities lending and FX have helped custodians boost margins. What other services might help accomplish the same goal? What kind of strategies should custodians employ in order to maintain and improve client relationships going forward? “The pace of innovation has increased to match the challenges facing global investors,”says Fradkin.“Today, nearly all of our top 50 clients use our risk and analytic solutions, up from just two-thirds in 2007. Multinational pooling continues to gain momentum, as clients seek improved governance and efficiencies in an environment where every basis point counts. New pooling assets increased ten-fold in 2009 over the previous year. And we have also seen attractive revenue growth from our Hedge Fund Monitor, Private Outlook, and OTC Derivatives solutions, which help streamline the challenging job of tracking liquidity and cash forecasting for these relatively illiquid asset classes.”

TRANSITION MANAGEMENT: ERISA PLAN STANDARDS OF CARE

THE SAFETY FACTOR Photograph © Zuboff/Dreamstime.com, supplied June 2010.

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ERISA provides a very clear and strict exemption for affiliate broker/dealers of ERISA fiduciaries. Prohibited Transaction Exemption 86-128 (PTE 86128) requires that the affiliate broker/dealer of an ERISA fiduciary execute transactions only as agent for the ERISA plan; thereby eliminating entirely any conflicts that an arm’s length, non-fiduciary broker/dealer has when trading as principal at the direction of a non-affiliated third party fiduciary transition manager. Charles Shaffer and Lance Venga, global co-heads, transition management at Credit Suisse, explain the mechanics and the direct benefit to clients. INCE IT’S DEVELOPMENT nearly twenty years ago through to its acceptance as best practice today, transition management has evolved as a financial service category unlike any other. What other financial service product has been invested in and provided by a broad church, comprising global investment banks, regional broker/dealers, custody banks, asset managers, and consultants? With such a wide group of providers and business models, asset owners have long been presented with a dizzying array of choices and sometimes contradictory justifications for the different practices. One potential explanation for the wide dispersion in transition management business models is the possibility that execution technology and market structures may have evolved faster than transition management best practices. In the days before the advent of global agency and electronic trading platforms, asset owners often required an intermediary to manage the conflicts of interest of that were rife in the broker/dealer universe. As most bulge bracket broker/dealers in the 1990s were generating record profits from principal trading, block trading and other ‘facilitation’ practices that required capital commitment, few broker/dealers were interested in the decidedly lower margin business of electronic, agency trading. While the pre-electronic/agency practices created record profits for broker/dealers and specialists, there were persistent questions about the price being paid by investors who had few other viable execution alternatives. Transition management transactions (which more often than not generate significant amounts of material, nonpublic information regarding the timing and structure of pending multi-billion dollar transactions) only heightened these concerns. In response to the justified suspicion of the preelectronic, principal trading broker/dealer models, many asset owners elected to hire fiduciary transition managers to act as an intermediary between the plan and the broker/dealers executing the transition. While the intermediary fiduciary status of the transition manager added an additional layer of explicit cost on the transition, it ensured that the transition manager could in no way use the information generated from the transition to generate any principal trading profit, as ERISA provided no

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exemption for principal trading in equity and fixed income by the transition manager fiduciary. What soon developed was a category of transition manager without global execution capabilities or the technology that powered such infrastructures. Custody banks, asset managers and consultants built transition desks operating on the traditional asset management model charging a fee for the “management” (albeit nondiscretionary in transitions) and then executed externally with an arm’s length broker/dealers. The third party execution broker/dealer also charged an execution fee creating an additional layer of cost to the transition client. Third party fiduciary transition managers essentially outsourced the trading execution and risk management technology in order to provide protection to the asset owner and expertise in managing the interface with the broker/dealers, who were understood to have too many conflicts of interest to face the asset owner directly. There was only one problem with this solution: while the outsourced execution model ensured that the third party fiduciary transition manager facing the asset owner could not profit from any conflict of interest by trading as principal, that same transition manager wasn’t actually executing any transactions. Instead, they sent the actual trade instructions to arms length broker dealers who executed the transition trades. Moreover, by outsourcing the execution responsibility to an arm’s length broker/dealer, the standard of care required of the broker/dealer was downgraded from the strict requirements of an ERISA Fiduciary to the far more permissive requirements of ‘best execution’.

Conflicts from the model The most obvious conflicts include the fact that there is no ERISA fiduciary protection over broker/dealer executing transition trades. Additionally, arm’s length broker/dealers are not required to transact under the exemptions required by affiliates of an ERISA fiduciary (Prohibited Transaction Exemption 86-128, or PTE 86-128) and instead transact under the broad ‘best execution’ guidelines. Third, best execution is a far more permissive standard that allows for the following potential conflicts: Conflict 1: “Marking” executions in non-US markets. All US domiciled pension clients must face US registered broker/dealers. However, the practices governing how US broker/dealers face affiliates and/or local broker/dealers in local markets provide for many profit opportunities and potential conflicts. For instance, a US broker/dealer may instruct its local market affiliate to buy a stock on behalf of a client with the intention of “back-to-backing” that execution via its US broker/dealer to its client. However, the US broker/dealer has no obligation to pass on the exact price its local affiliate receives if its local affiliate is deemed to take some risk during the execution. Many broker/dealers accept this as a standard practice, allowing for mark ups or mark downs of price between global broker affiliates as long as the principal book was

TRANSITION MANAGEMENT: ERISA PLAN STANDARDS OF CARE 80

deemed to take risk to facilitate the transaction. This market practice (known as ‘marking’) may qualify as a ‘best execution’ practice as long as the broker dealer evidences some risk taken to help facilitate the execution. In short, the US broker/dealer (which must face US domiciled clients) may execute in local market via local affiliated broker/dealer at one price and then deliver execution to US broker/dealer at another price; and all of this can be done under the broad auspices of“best execution”. Conflict 2: “Providing liquidity” and “Reversion Trading”: Principal trading allows broker/dealers the ability to provide liquidity to the client at points favourable to the broker/dealer. This practice is one of the most profitable areas for proprietary trading desks and one with the most blatant conflicts of interest. For example, a broker/dealer trading desk may take an order to sell a stock or basket of stocks into the market on behalf of the client. By selling the stock or basket of stocks in the market, the broker/dealer creates market impact which lowers the price of the stock or basket of stocks being sold. After the stock or basket of stocks have moved sufficiently lower due to the selling pressure generated by the broker/dealer’s sales, the broker/dealer may step in and provide liquidity to the client by buying the last portion of the order directly from the client into the broker/dealer’s proprietary book at the depressed prices the broker’s trade sequence created. When those names revert back to fair value, the broker dealer sells them at a profit thereby ‘playing the reversion’. While there is risk to the proprietary trading desk that the price never reverts or that the desk may be forced to sell before they do, it is a distinct trading edge and one that has generated untold profits for proprietary books—all the while legally meeting the requirements of best execution. Both of these examples are acceptable under ERISA as long as the third party transition manager does not participate directly in the profit of the arms length broker/dealer. The test of best execution is also arguably met if the broker/dealer is deemed to have taken acceptable levels of risk in the facilitation of the trade. However, the $34bn in proprietary trading and investment profits that another bulge bracket broker/dealer reported in 2009 highlights that a broker/dealer can meet the requirements of best execution for its clients and still make huge principal trading profits. Although the third party fiduciary transition manager cannot participate directly in these profits, it is not prevented from utilising other valuable services and resources from the broker/dealer it has permitted to trade as principal—including research, access to initial public offerings (IPOs), and discounted commissions it might have to pay the broker/dealer on future transitions. Despite the conflicts of interest that exist within principal trading, there are of course situations where principal transactions can be beneficial to asset owners undertaking a fund restructuring and the conflicts can be

effectively managed. Timing constraints, benchmark considerations, settlement modifications and ETF creation/redemptions are all examples of transition objectives requiring principal transactions. Careful evaluation of all transition strategies and constraints is an important part of any transition analysis.

Leveraging technology By facing a fiduciary transition manager that has the infrastructure and proven ability to execute directly as agent across global markets, the asset owner can extend the fiduciary protections of ERISA and cure many of the lapses in ERISA protections that the third party fiduciary transition manager model presents (we call this the ‘Extended Fiduciary Platform’). ERISA provides a very clear and strict exemption for affiliate broker/dealers of ERISA fiduciaries. PTE 86-128 requires that the affiliate broker/dealer of an ERISA fiduciary execute transactions only as agent for the ERISA plan – thereby eliminating entirely the conflicts that an arm’s length, non-fiduciary broker/dealer has when trading as principal at the direction of a non-affiliated third party fiduciary transition manager. In short, by requiring a fiduciary transition manager to execute via its affiliated global, agency execution platform, the ERISA plan raises the standard of care it receives on those executions from “best execution” to the standards articulated under PTE 86-128 and removes one of the most potentially dangerous conflicts that exist in transition management. While this heightened standard of care must be weighed against the quality of the fiduciary transition manager’s global, agency execution capabilities, there is no dispute that it raises the standard of care required of the executing broker/dealer. This extended fiduciary platform ensures that every execution will be covered by the standard of care required as a fiduciary under ERISA (including the prudence rule and the exclusive benefit rule). It also requires that all executions must be agency only and cannot be “excessive” in either ‘amount or frequency’, as outlined in PTE 86-128. The client, transition manager and executing agents interests are perforce then aligned 100% and there is zero conflict of interest as principal trades are prohibited. Further, no mark up or mark downs in global markets allowed. Finally it eliminates the possibility for broker/dealer to “provide liquidity” opportunistically and profit from the market impact it generates by selling or buying client’s names. The marriage of ERISA’s best protections with the evolution of global, electronic agency trading has provided asset owners with the ability to better realise the protections of ERISA and raise the standard of care they receive from broker/dealers. If asset owners elect to put in place the ERISA protections provided by the extended fiduciary platform in markets with agency execution structures, they can ensure that at no point in their transition would any broker/dealer be able to profit via principal transactions

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

THE TIPPING POINT The over-the-counter commodities market is booming again with levels of trade are heading back to the peaks seen in 2008.This happy ship though is heading into choppy waters. Lawmakers and regulators on both sides of the Atlantic have not forgiven and forgotten the fact that over-thecounter (OTC) traded credit derivatives swaps nearly brought on the collapse of financial markets a couple of years ago. They are only weeks away now from bringing in regulation that will re-write the rule book on how off-exchange trade is conducted. By Vanya Dragomanovich HEN IT COMES to financial instruments based on commodities, on-exchange traded commodities such as gold or copper futures are just the tip of the trade iceberg. The bulk of this massive edifice is made up of OTC transactions, bilateral deals between counterparties, usually banks on the one side and industrial companies hedging their exposure to commodities on the other. Those deals are not reported anywhere and are cleared through clearing houses that are not regulated like exchanges. Unlike listed derivatives, OTC contracts are not backed by the credit worthiness of the clearing house, although the parties have to offer some form of collateral. Commodity OTC products such as swaps, forwards and options have been increasing in popularity with speculators including hedge funds over the last few years, with the gross market value hitting a peak in 2008 of $2.2trn. This number dropped off significantly in 2009, mainly because commodity prices fell, but now that most of the commodities markets have recovered, the big commodity banks say that trade flows are close to 2008 levels.

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Nervous regulators While this is good news for investors, regulators continue to be nervous about OTC markets and the lack of transparency they represent, arguing that they pose a serious risk to the entire economy. The Lehman Brothers case is a good example of what could go wrong again. After the company declared bankruptcy, close to $400bn worth of credit default swaps were presented for settlement. However, once offsetting bilateral trades were netted, only $6bn changed hands. The offsetting trades were invisible to the outside world and the implication of this interconnection was that if one player defaulted they could potentially precipitate a crippling domino effect that has the capacity to bring the whole industry down. Another aspect of OTC derivatives that regulators are unhappy about is that the actual valuation of an OTC contract is down to each broker-dealer. This state of affairs stems partially from the nature of the instruments which are always individually tailored, but as there is no active marketplace or exchange, traders find it difficult to obtain market data for valuation of similar contracts. Many institutions, including major hedge funds, were sorepressed in the winter of 2008-2009 to provide accurate valuations of their OTC portfolios. Policy makers in the US and Europe are pushing for very similar changes; they want to see individual transactions being reported, the introduction of mandatory central clearing and higher collateral requirements for some types of deals. In the US two different bills are currently being reconciled and the final version could potentially be signed into law before Congress breaks up for the summer at the beginning of July. In Europe, the European Parliament will vote on proposed changes to the derivatives market in June.

OTC COMMODITIES VOLUME UP EVEN AS SHAKEUP LOOMS

Photograph ÂŠ Robert Davies/Dreamstime.com, supplied June 2010

OTC COMMODITIES VOLUME UP EVEN AS SHAKEUP LOOMS 82

The regulation will be tailored to affect the two main types of participants in the OTC markets, but in different ways. On the one hand are what is typically referred to as commercial players or companies which use OTC products to hedge commodity exposure, and on the other are banks which provide the products and dealers and hedge funds that trade them. The burden of regulation will largely be carried by the banks and speculators while commercial hedgers will be mostly allowed to continue business as usual. A number of banks and trading houses are less than happy with the proposals. A group of them have written a letter to global regulators proposing less direct supervision and suggesting alternatives that involve less regulation and more voluntary changes such as data repositories for noncleared OTC derivatives, assisting global supervisors with oversight and surveillance activities and clearing for standardised derivative products. “This [proposed change] could destroy the OTC market,” says one commodities OTC trader in a London “The reason why the futures market is much smaller than the over-the-counter market is because you have to be a clearing house member to trade on-exchange. Our clients trade over-the-counter because this means they don’t have to pay clearing costs. If these costs are imposed on them they will simply stop trading,”he said. Another criticism of the proposals on the table is that increased regulation could result in the OTC trade moving away from New York and London into less regulated jurisdictions.“Limiting the flexibility of these markets may lead to reduced or inadequate corporate risk management, or the movement of these transactions to friendlier, offshore jurisdictions,” says a report from PriceWaterhouseCoopers. Currently the amount of collateral needed for a derivative transaction, the circumstances in which it should be posted, and the form of such collateral, are negotiated between counterparties. A contract can also be tailored to include less liquid collateral that a user may have as part of its ongoing business operations. “To achieve greater transparency, current proposals would require conducting OTC transactions on exchanges or through clearinghouses. Yet these entities typically require posting a substantial amount of cash collateral or other highly liquid instruments in amounts in excess of the fair value amount of the derivative contract. As such, these proposals would reduce corporate liquidity, thereby lowering return to shareholders and driving up the cost of capital—all at a time when credit is tight and earnings are under severe stress,” PriceWaterhouseCoopers says. If the new rules are brought in as proposed, they will eat away on bank and trading houses’ profits and may reduce some of the volume of trade on the speculative end, but if one looks at the main reason why OTC commodity products exist it becomes clear that volume will not evaporate.

“We had very heavy activity all of this year, particularly in the last couple of weeks, brought on by the sovereign risk,” says James Steel, commodity analyst at HSBC. “I don’t see anything that will interrupt this trend, the currency markets remain volatile and sovereign risk remains in place,” he adds. Protection from volatility OTC commodity derivatives came into being as companies tried to protect themselves from the wild price fluctuations commodities are prone to. It began with agricultural producers trying to fix the price of grain and livestock months before the harvest or of cattle maturing, but now hedging has spread across most industries. A mining company wanting to hedge against a fall in copper prices for instance, will choose an OTC instrument rather than an on-exchange future, while a car company will typically hedge its large purchases of raw materials such as steel, aluminium and platinum, or an airline its purchases of jet fuel. In all cases, the hedge, though costly, buffers the company from jumps in prices and gives it some predictability for its balance sheet. According to the International Swaps and Derivatives Association, more than 90% of Fortune 500 companies use customised OTC derivatives to manage specific financial risk, as do half of the midsized companies in the US and thousands of smaller companies. This trading landscape, however, is bound to be affected by the new regulation. “What this might do is just get rid of some of the smaller players in the market, particularly some smaller hedge funds, and make room for bigger institutions and bigger hedge funds. On top of that commercial hedgers may not be affected at all,” says Edward Meir, senior commodity analyst at MF Global, an energy commodities brokerage. Some players are beginning to embrace change even before it is written into law. ICAP Energy, a unit of the biggest interdealer energy swaps broker ICAP Plc, says it would start delivering OTC oil prices on a new electronic trading platform using technology provided by InterContinental Exchange (ICE). The difference between futures, which are traded on the exchanges, and derivatives such as swaps, forwards and options, is that for futures, a clearinghouse is the middleman between buyers and sellers. Although the central clearing counterparty can be a bank or a simple clearing entity, exchanges have their own clearing houses and an increasing number of those are present in the commodities space, such as the ICE, the Chicago Mercantile Exchange (CME) which is planning on expanding its OTC commodity clearing activities to include energy derivatives, and Singapore Exchange.

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Rising trade volume At present there is no indication that trade in OTC commodities is declining ahead of the anticipated new regulatory era. Official statistics provided by the Bank of International Settlements are available only twice a year, with the next set of data due to be published in June. Anecdotal evidence, however, shows that the market is booming. This is particularly the case with gold, which is drawing inflows from investors spooked by the Greek sovereign debt crisis and the insecurity surrounding the euro. In London, where all of the gold is traded over the counter, the major houses such as HSBC, Barclays, JP Morgan, the Bank of Nova Scotia— ScotiaMocatta, Deutsche Bank and Société Générale are reporting roaring business. The latest London Bullion Market Association data, for instance, published in June is demonstrated record high clearing levels for gold transactions in the City. “We had very heavy activity all of this year, particularly in the last couple of weeks, brought on by the sovereign risk,” says James Steel, commodity analyst at HSBC. “I don’t see anything that will interrupt this trend, the currency markets remain volatile and sovereign risk remains in place,”he adds. There is a similar situation in metals derivatives, which is dominated by a similar group of banks. “There is no central data on the amount of flow in OTC metals but if you look at the levels of trade on the London Metal Exchange that is a good proxy for the overall market and those levels have been rising,” says a trader at Royal Bank of Scotland Sempra. Commodities, both on the counter and over the counter, will remain an attractive investment as longer term forecasts for global economy continue to be positive. The

OECD recently reported that growth is picking up in the OECD area, at different speeds across regions, and at a faster pace than expected in the organisation’s previous Economic Outlook, although it pointed out that there are bigger risks to the global recovery given the instability in sovereign debt markets. The OECD expects strong growth in developing economies and the rapid rebound in world trade to underpin global growth at 4.6% in 2010 and 4.5% in 2011. This will bode well for demand for industrial metals such as copper, aluminium, zinc and steel and energy products such as oil, gas and electricity. Gold will remain a favourite for investors as some European countries continue to sail close to the wind with their sovereign debt. Although the outlook for gold remains solid the same could not be said about other precious metals, which were sold as risk aversion emerged, according to Robin Bhar, analyst at Credit Agricole. Separately, one segment of the market that will instantly benefit if the reforms go ahead are clearing houses and exchanges that provide clearing for OTC derivatives, the two most obvious ones being the ICE and CME. ICE recently reported a net profit of $101m or $1.36 per share for the quarter, up from $72m and 98 cents per share. The CME reported a 21% rise in net income and the best quarterly results since 2008. The OTC commodity business could become less profitable for banks on a per trade basis, but volumes are likely to continue to rise as prices for commodities are set to ascend again, and although percentage returns going forwards will likely be lower, OTC trading will still be a profitable business.

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COULD LONDON LOSE ITS EM APPEAL?

Photograph © Norebbo/Dreamstime.com, supplied June 2010.

TAXATION: A TICKET TO RIDE Emerging markets fund managers continue to believe that London will remain the hub for their operations, but this might not be the case indefinitely. There is certainly evidence of some decamping already in the broader financial services sector, such as the high profile exit from the City to Hong Kong of banking giant HSBC’s chief executive and Fidelity’s star stock picker Anthony Bolton. Firmly in London’s favour is its location, from an emerging markets perspective. Fund managers dealing in the emerging markets space must deal with a wider gap in time zones than other finance professionals. Richard Hemming reports. T’S AN OBVIOUS point to make, but ‘emerging markets’ covers everywhere from Latin America to East and Central Asia and then on to the Asian Subcontinent; and from Eastern Europe to the Middle East and then Africa. “For a central office, in terms of trading across countries London is the obvious place as a hub of finance and from a time zone perspective,”says Jerome Booth, the head of research at Ashmore Investment Managers, which manages $31bn and specialises in these markets.

However, Booth says that despite its natural advantages in terms of location, this position is“not a God-given right” and is being gradually undermined.”Politicians are quite capable of wrecking perfectly good situations. The political risk has increased significantly over the past two years. Investing today is often based on tax rates yesterday.” Booth’s comments are echoed by other emerging markets managers who are angry about increasing taxes, but not angry enough to go elsewhere, unlike Michael Geoghegan, the chief executive of one of the world’s biggest banks, HSBC. He clearly sees which way the economic winds are blowing. This year he moved from London to Hong Kong and said in May: “From my new base in Hong Kong, the shift from west to east is clearer than ever. In developed markets, the risks of double-dip recession and stagnation haven’t gone away. In contrast, the recovery in emerging markets looks secure.” Last year developed countries’ gross domestic product contracted 3.5% and forecasts of weak growth of (about 2.5%) in 2010. Meanwhile, the emerging countries largely avoided the worst of this recent recession and are expected to return to a healthy 6.3 3% growth this year. However, the dynamics of location reside not only in general economic wellbeing; at least not in good times. Ever closer to the beating heart of an emerging markets

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

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COULD LONDON LOSE ITS EM APPEAL? 86

fund manager is taxation. A point brought up by David Livingston, a portfolio manager with Thurleigh Investment Managers who has spent the past four months in Hong Kong on a secondment with a private equity firm based there. “In Hong Kong you pay 15% tax, compared to the 50% tax rate in London. Individuals are always looking for lower tax jurisdictions. [Moreover,] Hong Kong offers all the attractions of a big city.” Bryan Collings an emerging markets fund manager with Hexam Capital agrees and speaks as a part-owner of his business.“We’re being taxed at 50% on our profits as individual partners, yet we’re taking the same risks as a corporation that operates in funds management and which gets taxed at 30%. If you tax the hell out of us, we’ll move.”

Moving offshore There is no way emerging markets participants envisage closing up shop in London, after all, there will always be the need for a sales force in the United Kingdom and Europe. However, high profile emerging markets specialists have been moving overseas. Last year, Anthony Bolton, a star stock picker at UK-based Fidelity International, scrapped his retirement and decamped to Hong Kong to launch an equities fund that invests in companies in China. The whole industry has been buoyed by what has turned out to be the largest fund issue in over 15 years. Bolton’s Fidelity China Special Situations trust

raised £450m and began trading on April 19th this year. Although it didn’t reach its target of £650m, the large retail take-up was typical for investment trusts in Asia. At the launch, retail investors outnumbered those from institutions by approximately two to one. Other signs that the wider investment markets are looking again at Hong Kong is that some big initial public offerings are on the table. It was the biggest market for IPOs in 2009, although it has been much quieter this year in the wake of financial ructions in Greece. Interestingly, Hong Kong is increasingly seen as a viable secondary offering centre. Rusal approached the market at the opening of the year, though demand disappointed—not surprising given that retail investors were largely excluded from the offering. More recently, in early May, shares of skincare products retailer L’Occitane International S.A. the first French company listing in Hong Kong, were floated raising $708m. Singapore also has appeal, offering ‘light touch’ regulations for banking, as well as individual tax rates in the region of 15%. Executives also say that with property costing less than in Hong Kong, and the fact that there is less pollution, it is more“family friendly”. According to emerging markets executives, funds run out of Hong Kong tend to focus on Asia, whereas those run out of Singapore have a more global orientation. Brazil’s financial capital Sao Pãulo is also emerging as a centre for funds management.

UPDATE ON THE AIFM DIRECTIVE he AIFM Directive has now gone to the next stage of the EU legislative process, the so-called trilogue negotiations. The three main bodies of the European Union (namely, the parliament, council and commission) will now have to agree the precise wording of the directive that will then be presented to the parliament for a vote. A plenary vote is expected at some time in July, though if negotiations on the final wording are protracted, and the suggestion is that it will be, it is unlikely to be presented to the European Parliament until much later this year. Once the final directive is passed into law, it will come into force in 2012. The directive will generally apply to fund managers of alternative investment funds (“AIF”), including private equity funds, real property funds and hedge funds; in fact, all fund managers not currently regulated under the UCITS Directive. It is expected to have a significant impact on almost all fund managers operating in Europe in terms of increased administrative and compliance requirements, with an attendant impact on costs. Few fund managers appear to be happy with the directive. The private equity industry is railing against disclosure requirements which will force them to declare the level of debt in each

investment portfolio to regulators and investors in the AIF should they acquire controlling interests in firms; referred to as the portfolio company disclosure obligation. Moreover, if private equity firms take a controlling share in a company, they will have to articulate a communication policy with employees and show how they will reconcile conflicts of interests to the representatives of the employees of the portfolio company. There is likely to be an exemption for the disclosure obligation in respect of small or medium size (SME) portfolio companies, but it is yet uncertain what the qualifying employee threshold for an SME will be in the final consolidated proposal of the AIFM Directive. The administrative burden could, say market commentators, put private equity at a competitive disadvantage against other investors. Additionally, there are significant areas of the directive which still need clarification. A case in point is the directives so-called third country elements relating to the marketing of non EU funds in the EU and the marketing by non EU managers in the EU. In fact, many elements of the AIFM Directive need further elaboration (including the impact of the remuneration principles on carried interest and performance fees), and may be subject to further amendment during the triloque negotiations.

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

One group actively expanding in emerging markets and moving its executives out there is UK-based fund Threadneedle. In May it announced that is opening an office in Dubai to take advantage of the strong fund flows coming out of emerging markets. The group said it received a licence just after Easter to open an office in Dubai in the first half of the year, headed by Derek Angus, a senior executive in the institutional client group. The office aims not only to sell to the firm’s global client base from the region, but also to target local individuals and companies. Threadneedle also relocated William Lowndes, head of Asian distribution, to the Hong Kong office in April.”We have about 15 staff in the region and I would hope to double our efforts there over the next two to three years,” explains the group’s head of distribution Campbell Fleming.“We have seen strong growth in appetite for our funds among Asian-based investors. Everyone has realised that the Western economies are essentially ex-growth, apart from rebooking business, so they are looking to emerging markets to grow their businesses.” The fund house is also looking to expand in Singapore, where its deputy head of Asian distribution Jon Allen is based, and into Latin America. Globally it aims to add 12 to 24 more people in distribution over the next two years. This is in addition to the dozen that have come on board since Fleming joined in November.

The search for light touch regulation The markets are keeping a close watch on the range and depth of legislation coming to bear on segments deemed‘risky’. The hedge fund segment has been the focus of much regulatory concern. Given that the UK is home to around 80% of the

$1.3trn industry it is no surprise that the EU Directive on Alternative Investment Fund Managers (AIFM) industry has targeted the industry without much compunction; after all continental Europe has few ties with the hedge fund sector. Since the AIFM directive was initially put forward it has drawn criticism not only from the hedge fund and private equity industries, but also investment trusts and funds that invest in venture capital, property and commodities and emerging markets as well.They all say the legislation will drive up costs, reduce investor choice and burden corporate with further regulations. Moreover, it also impacts on hedge funds domiciled abroad; which could potentially be locked out of Europe if it does not meet AIFM requirements. Tim Geithner, the US Treasury Secretary, in March warned that the legislation could cause a transatlantic rift. He said that it“would discriminate against US firms and deny them access to the EU market that they currently have”. Although these are wider concerns for the industry, s closer to home the UK coalition government’s tough stance on bankers’remuneration, could turn out to be more than rhetoric. In March David Cameron, announced plans for a new tax on banks, even if other countries decided not to do so. In a speech he declared that the levy was “necessary” and that the banks were one of the “vested interests” he was determined to confront. Ashmore’s Jerome Booth says bank bashing by politicians is not helpful: “We still have an atmosphere where people want to do business with banks in London. However, if the trend towards bank bashing continues for say another five years, emerging markets funds could easily leave. Any industry has its tipping points.”

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

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 0

Paul Spendiff 44 [0] 20 7680 5153 44 [0] 20 7680 5155 paul.spendiff@berlinguer.com

NEW ASSOCIATION UPS THE GAME FOR SPANISH ISSUERS 88

Photograph (c) Dmitry Panchenko/Dreamstime.com, supplied June 2010.

TESTING THE VALUE OF SHAREHOLDERS Spain’s listed companies have finally come together to voice concerns about the lack of transparency in the country’s equity markets. A new issuer association has emerged, Emisores Españoles, that intends to push for changes in the way that investors interact with companies. It’s main concern is the lack of transparency in the share owning market. Rodrigo Amaral reports from Madrid. MISORES ESPAÑOLESIS, THE association of Spanish issuers, claims that as corporate governance rules make ever more inroads in the Spanish business community, having more information about shareholders has become an imperative. Otherwise, companies could find themselves unable to provide the improvements in communication with minority investors that are increasingly required by the countries regulators. Emisores Españoles also holds that a little more transparency could also resolve a problem that has worried listed companies around the world for the past few years: the actions of aggressive short-sellers. Issuer associations are a feature of many other European countries (France along has three of them), and when Endesa, Santander and others floated the idea of setting up a Spanish-based entity, it was received with enthusiasm, Salvador Montejo, the chairman of the association recalls. In its first months of work, Emisores Españoles has already been able to officially contribute to a number of debates being developed in Spain aimed at refining the countries capital markets infrastructure.

“[The] visibility of investors is our flagship subject [sic],”says Montejo, who is also the secretary-general of Endesa, an energy group.“We want responsible investors. It doesn’t mean they should not be allowed to short a stock. [However,] what we should not allow is that a group of investors agree to act in a concerted way against a stock.” Emisores Españoles is pushing for Spanish regulators to provide its members with wider access to information related to stock buyers, especially concerning foreign investors. Being under a bright spotlight, it is believed, would make it harder for any predatory traders exploit the market. As of today, companies are allowed to access the share register only once a year, at the time that a general meeting is called. Moreover, they only have access to the identities of investors based in Spain. There is no way that companies know which foreign institutional buyers are acquiring their stock via a Spanish-based nominee. In some companies, that means that managers are not aware of the identities of more than half their investors, which sometimes represent, combined, more than 70% of the firm’s capital. “Markets need to be free, but with some limits,” concedes Juan Prieto, the managing director of Corporate Services at Banco Santander and the vicechairman of the association. Prieto describes the fact that non-financial firms can only check the share register once a year as “absurd”, considering that in other countries issuers can have daily access to such information.“In this respect, Spain is not in the Champions League. We still play in the second division,” he says. “Right now, we don’t occupy the place we should, considering the size and sophistication of our

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

market. We need clear legislation both on short selling and securities lending.” Although he concedes that in some countries the situation is even worse. In Italy, for instance, investors can opt to remain anonymous. Emisores Españoles argues that Spain’s capital markets legislation dates back several decades and has not accompanied the impressive evolution of the wider global marketplace. As of today, the country’s stock exchange deals, in a single day, with a volume of business that is equivalent to one year of average volume throughout the 1980s. Even so, last year, three Spanish shares, Telefonica, Banco Santander and BBVA, were the most traded stocks in the Euro Stoxx index, notes Prieto. Moreover, he adds, international investors are ever more present in the trades of companies listed in the IBEX 35 Madrid Exchange. Prieto adds that, if interpreted by the letter, Spanish rules do not allow short-selling or securities lending.“[Though] such practices take place in the marketplace all the time,” he says. It is time to update the rules in order to get closer to the sophistication of markets such as the UK, Germany and France, the association claims and, at the same time infuse more transparency in the process. The current bad blood towards short-sellers prevalent throughout Europe could provide an extra boost to discussions on shareholders’visibility not only in Spain, but in other countries too. The subject has been pursued with interest within the European Central Bank, in the context of the Target 2 Securities (T2S) project, which primarily aims to reduce settlement costs in Europe by creating a platform that, in practice, will establish a single market for securities trading. In a report released in November, the T2S working group has presented several reasons why issuers want to identify their end-investors. Although there is no reference to shortsellers, the report mentions the need to analyse investors’ behaviour. The emphasis in the report lies in corporate governance, improved communication channels between issuers and investors and guarantees that all shareholders can participate in annual general meetings. Emisores Españoles stresses that governance is a key pillar underpinning market transparency. Prieto also says that new settlement and register systems rules being drafted by CVM, the Spanish securities commission, will encourage firms to set up appropriate communications channels with investors, even minority shareholders and small investors. However, he adds:“This is equivalent to begin building a house from the roof. How can you open a channel for shareholders [if] you don’t even know who they are?” Montejo, thinks that the spur to companies to promote shareholder participation is timely. “As of today, very few people vote in general assemblies, even though companies have made a huge effort to implement improvements like electronic voting,” he says. Prieto meantime adds an edge to the discussion. “Long-term shareholders should get more power in meetings. New arrivals should not be

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 0

Prieto also says that new settlement and register systems rules being drafted by CVM, the Spanish securities commission, will encourage firms to set up appropriate communications channels with investors, even minority shareholders and small investors. However, he adds: "This is equivalent to begin building a house from the roof. How can you open a channel for shareholders [if] you don’t even know who they are?"

allowed to exert the same degree of power than them, as the interests of the firm and its investors congerge in the long run,”he argues. Although shareholder visiblity is the main concern of Emisores Españolesis, it is not the only one. Its 38 members, which include more than 60% of the companies in the IBEX 35 and more than half of those listed in Madrid, also want to press for other legal changes to the way capital markets are regulated.“The law in Spain is a stranger to the reality of listed companies [sic],” Montejo says. “For instance, the law says that anyone holding at least 5% of the shares [in a firm] can add an item to the agenda seven days after a meeting is called. If such a thing happens, it creates a huge problem for many companies, [particularly for] those firms that are also listed in the United States.” Although Emisores Españoles claims not to be a lobby, but a technical group that works together with regulators, it aims to make the case for clarification of these rulings in the current round of discussions covering market regulation in Spain. “There are many improvements to be made in the Spanish market, and we want to have a voice in the process,” Montejo remarks. “CVM, the Spanish securities commission, has a consultation committee that includes a representative of issuers, but which was chosen by means of a lottery. The result was that sometimes it was an odd player, such as a foreign fixed income issuer that had come to market with one issue in Spain, that ended up representing us in the forum.” Emisores Españoles is up for a long battle, concedes Montejo. Although the changes asked by the group don’t require legislative action by the government, only directives issued by the local regulator, the deep financial crisis which now has Spain in its grip will not the adoption of extensive reforms that affect the activities and cost base of many companies, he says. Moreover, he adds, Spanish regulators have a tendency to act only after receiving some kind of sign from the European Union. “Before we got together, when regulators were developing new rules, they didn’t have the time or inclination to to consult anyone on the issuing side,” says Montejo. Emisores Españoes wants to make sure that, this time, their voice will be heard.

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.

Trading in the FTSE 100 Index

European Top 20 Fragmented Stocks TW

17 18

Wks

Stock

Description

ABF.L

A.B.FOOD ORD 5 15/22P

3.01

RSA.L

RSA INS. ORD 27.5P

2.96

JLT.L

JARDINE LLOYD ORD 5P

2.88

WPP.L

WPP ORD 10P

2.86

ULVR.L

UNILEVER ORD 3 1/9P

2.86

SRP.L

SERCO GRP. ORD 2P

2.83

RDSA.L

RDS ‘A’ ‘A’ ORD EUR0.07

2.83

DGE.L

DIAGEO ORD 28 101/108P

2.83

WEIR.L

WEIR GRP. ORD 12.5P

2.83

PRU.L

PRUDENTIAL ORD 5P

2.82 2.82

FFI

LAD.L

LADBROKES ORD 28 1/3P

PFC.L

PETROFAC ORD USD0.02

KESA.L

KESA ELECT. ORD 25P

2.79

CHTR.L

CHARTER INTL ORD 2P

2.78

ADN.L

ABDN.ASSET.MAN. ORD 10P

2.76

LGEN.L

LEGAL&GEN. ORD 2 1/2P

2.76

HLMA.L

HALMA ORD 10P

2.72

RDSB.L

RDS ‘B’ ‘B’ ORD EUR0.07

2.72

SMIN.L

SMITHS GROUP ORD 37.5P

2.72

GSK.L

GLAXOSMITHKLINE ORD 25P 2.72

2.8

Monday, June 14, 2010 to Friday, June 18, 2010

Trading on Lit Venues NYSE ARCA

0.32%

TURQUOISE

3.03%

NASDAQ EUROPE BATS EUROPE CHI-X

0.5%

4.65% 15.2%

LSE

37.12%

Trading on Dark Venues BATS DARK

NOMURA NX LIQUIDNET

SMARTPOOL

TURQUOISE DARK

Wks = Number of weeks in the top 20 over the last year. Week ending June 11th 2010

0.18% 0.19% 0.28% 0.47% 0.54%

SOURCE: FIDESSA JUNE 19TH 2010

COMMENTARY By Steve Grob, Director of Strategy, Fidessa As fragmentation continues its upward trajectory we’re confronted with increasing amounts of data but it’s not always easy to get a really clear understanding of what’s happening. Take for example the FFI for a FTSE 250 stock - Balfour Beatty (BBY.L) - for the week ending 11 June 2010. Despite the fact that its FFI is comfortably above 2, and has been for most of the last year, it’s actually not the most fragmented FTSE 250 stock. In fact, it’s 50th in the FTSE 250 Fragmentation league table which just goes to show the extent to which fragmentation has impacted the mid and smaller caps as well as the blue chip stocks that it all began with. If you look at the pattern of trading in that same stock for both lit and dark venues, an even more interesting picture emerges. In that same week, 62% was traded on lit venues whilst the rest was spread over dark MTFs, Systematic Internalisers and OTC trading. However, the average trade size between the dark MTFs and the lit venues was almost identical. It seems clear that the interaction of lit and dark trading is going to become a key stronghold as both types of venue seem to be covering pretty much the same territory in terms of order size. This being the case, is the additional cost and complication of routing to the dark books actually worth it? When you consider that the 7 dark books concerned accounted for only 1.5% of that week’s volume you start to wonder whether the best execution imperative is all going a bit too far. This seems to be especially the case for the buy side – many of whom prefer to deal in chunky blocks rather than have their orders diced into smaller and smaller pieces and sent to a large range of different lit and dark platforms in search of execution. This is a particular issue for the buy side as it tries to understand how stocks are really trading so as to make sure that they are being effective. This makes it difficult to select the right broker and to assess their overall effectiveness in terms of execution. Last month six major investment banks—Citi, Credit Suisse, Deutsche Bank, J.P. Morgan Cazenove, Morgan Stanley and UBS—announced their intention to publish their dark pool volumes via Markit’s post-trade reporting service. Whilst this is a welcome step towards greater transparency of non-lit trading in Europe, these reports only provide a combined number of some broker dark pool trades in each country in Europe, representing only a fraction of the total non-lit volumes being reported across dark MTFs, OTC trades and Systematic Internalisers. It’s still not possible to get an accurate, independent figure for broker dark pool trading in any given stock or index. Maybe what we need is a concept of "good enough" execution as the extra cost and complexity involved in going for best is getting harder and harder to achieve.

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

Venue turnover in major stocks: Week ending May 28th 2010 (Europe only). (€) October

November

December

January

February

March

April

May

BER

559921470.34

11198473.01

8330897.81

12299869.07

12095979.32

20898115.71

20869157.28

21547869.80

BRG

362494501.08

274600248.26

485115578.84

664510070.30

1666606979.62

1484895339.18

1160801695.44

BTE

27644041971.79

23573463734.99

19985719530.83

31150258386.00

34090404626.97

39193610957.69

42331175110.88

53758623911.83

CIX

106697966298.67

90039160470.86

75306622295.52

110977110385.49

122737876719.05

127111917698.82

138532607106.82

186077857047.41

CPH

7580961264.52

5706863159.57

5072932715.84

6756826918.10

6640400689.39

6626152423.75

6351788793.70

7783026044.28

DUS

41944732.75

46475438.04

51353982.31

37525367.53

51415834.33

61803818.36

67538425.06

ENA

44333181213.17

32257175002.36

33792253379.23

37999836321.05

37880117626.68

38562044761.19

41692637528.93

52300438953.01

ENB

8942068143.91

6366264426.48

5034992980.75

6008003591.11

6103299182.27

6358216747.07

5988625536.27

9369541614.81

ENL

3485422128.23

2219360066.21

2138868773.27

3106855297.08

3554443804.88

3046713139.88

3727720527.61

4752180275.24

ENO

482771.59

ENX

81861726196.95

65433199147.49

54355876074.24

66228400089.99

75614221011.97

74245298998.52

78769429844.17

113106867629.24

GER

74419073211.90

60908552433.56

52843852540.00

67965895238.29

66776121605.01

72168449445.45

86885537242.87

112634642716.91

HEL

11276385550.29

7451015808.21

6497813980.44

10339952621.77

10058819924.19

11752695115.83

12864278423.44

12677237276.57

ISE

465074179.96

511570001.10

504915917.70

565269992.07

647314249.60

607747772.36

LSE

100753579612.36

88751421724.55

72845386108.12

95983836598.48

101916702001.83

105630799395.16

95825409974.98

132946145050.97

MAD

56848573772.28

42670316078.54

39993245595.41

51066014495.96

52210894242.17

43945312316.04

52313552809.86

69919778842.24

MIL

65232722070.55

58890245107.45

34112242363.73

48728657959.10

51711533820.17

52410490586.85

60842288388.66

98165692121.29

NAE

188509367.45

286391174.03

559208778.00

1292687653.19

1825246025.41

2792572924.06

2501941839.46

2151564476.49

NEU

6508249441.66

7449995153.50

5242206607.57

5816854755.80

5574111215.48

6232496049.93

6066724036.03

3388942662.98

OSL

16695154952.77

13184181892.72

11253566686.23

16130924336.37

15871251841.26

13866926910.94

16588222829.50

17276093344.48

STO

25928648845.75

20898321966.79

16954761461.22

22786344725.57

24086268094.82

24125076503.28

28675024013.03

31806593342.57

TRQ

28005208583.96

22895687295.59

15953764952.03

20168098539.34

21028161702.73

20951128258.80

22059392685.24

29039242985.51

VTX

39772295992.78

37198627753.77

31586888591.75

43636990148.75

46961823692.04

44673323239.12

41985051551.14

47323284922.30

XIM

90362714.08

97403633.80

43510060.39

47325856.70

Index market share by venue: Week ending June 11th 2010 Primary Index

AEX

Alternative Venues

Venue

Chi-X

Amsterdam

62.73%

23.85%

Turquoise

Nasdaq OMX

3.73%

0.16%

BATS

5.59%

Burgundy

Amst.

Paris

Xetra

3.70%

0.14%

London

NYSE Arca

Stockholm

BEL 20

Brussels

47.33%

22.03%

3.71%

0.04%

3.73%

22.98%

0.04%

CAC 40

Paris

64.06%

21.87%

3.67%

0.21%

5.13%

4.48%

0.25%

DAX

Xetra

66.41%

25.07%

3.01%

0.04%

4.74%

†

0.17%

FTSE 100

London

56.67%

28.24%

5.38%

0.98%

8.23%

0.51%

FTSE 250

London

62.98%

22.61%

7.28%

0.34%

6.15%

0.64%

IBEX 35

Madrid

98.14%

1.64%

0.03%

†

0.01%

†

0.10%

FTSE MIB

Milan

84.32%

9.77%

0.96%

†

4.80%

†

0.03%

PSI 20

Lisbon

93.59%

3.64%

2.10%

0.02%

0.62%

†

SMI SIX

Swiss

68.55%

18.63%

3.98%

0.02%

8.09%

0.72%

OMX C20

Copenhagen

84.70%

11.69%

1.98%

0.02%

1.49%

0.02%

0.09%

OMX H25

Helsinki

67.94%

19.02%

3.50%

0.03%

6.76%

0.31%

0.02%

2.05%

0.15%

OMX S30

Stockholm

71.72%

17.25%

3.51%

0.02%

4.30%

3.16%

0.05%

OSLO OBX

Oslo

88.74%

5.32%

1.19%

0.02%

0.62%

0.04%

†

4.08%

Dublin

24.86%

0.58%

0.80%

†

73.44%

†

ISEQ

0.10%

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

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

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 0

5-Year Performance Graph (USD Total Return) Index Level Rebased (31 May 2005=100)

350 300

FTSE All-World Index

250

FTSE Emerging Index 200

FTSE Global Government Bond Index

150

FTSE EPRA/NAREIT Developed Index

100

FTSE4Good Global Index

FTSE GWA Developed Index ay -1 0

FTSE RAFI Emerging Index

No v09

ay -0 9 M

No v08

ay -0 8 M

No v07

ay -0 7 M

No v06

ay -0 6 M

No v05

ay -0 5

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

2,751

228.10

-3.3

-4.4

15.2

-6.4

2.56

FTSE World Index

USD

2,290

532.54

-3.7

-4.7

14.8

-6.6

2.58

FTSE Developed Index

USD

2,000

211.55

-3.8

-4.8

14.1

-6.6

2.57

FTSE All-World Indices

FTSE Emerging Index

USD

751

605.53

0.3

-2.0

24.0

-4.9

2.43

FTSE Advanced Emerging Index

USD

290

559.25

-1.4

-4.4

24.7

-7.8

2.69

FTSE Secondary Emerging Index

USD

461

716.26

1.8

0.3

22.7

-2.0

2.20

FTSE Global All Cap Index

USD

7,361

368.21

-2.8

-3.3

16.7

-5.6

2.44

FTSE Developed All Cap Index

USD

5,868

344.61

-3.2

-3.5

15.7

-5.7

2.45

FTSE Emerging All Cap Index

USD

1,493

803.77

0.3

-1.7

24.5

-5.0

2.38

FTSE Advanced Emerging All Cap Index

USD

640

753.90

-1.4

-4.2

24.6

-8.1

2.62

FTSE Secondary Emerging All Cap Index

USD

853

915.64

1.8

0.7

24.0

-1.9

2.16

USD

729

179.07

-2.6

-7.1

1.7

-2.2

2.62

FTSE EPRA/NAREIT Developed Index

USD

276

2356.74

0.5

1.2

27.5

-2.3

4.18

FTSE EPRA/NAREIT Developed REITs Index

USD

183

821.80

3.2

6.0

40.8

1.4

5.02

FTSE Global Equity Indices

Fixed Income FTSE Global Government Bond Index Real Estate

FTSE EPRA/NAREIT Developed Dividend+ Index

USD

201

1722.29

1.5

3.5

34.0

-0.5

4.83

FTSE EPRA/NAREIT Developed Rental Index

USD

224

926.61

3.0

5.7

39.7

1.2

4.76

FTSE EPRA/NAREIT Developed Non-Rental Index

USD

963.90

-5.9

-9.8

1.3

-11.2

2.51

FTSE4Good Global Index

USD

663

5647.28

-5.1

-7.8

12.3

-9.2

2.94

FTSE4Good Global 100 Index

USD

103

4702.78

-6.3

-10.2

9.2

-11.4

3.16

FTSE GWA Developed Index

USD

2,000

3263.23

-4.5

-5.9

13.2

-7.2

2.80

FTSE RAFI Developed ex US 1000 Index

USD

1,019

5409.83

-6.4

-11.5

7.7

-12.5

3.35

FTSE RAFI Emerging Index

USD

360

6511.44

0.7

0.0

24.0

-4.6

2.73

SRI

Investment Strategy

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

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

Americas Market Indices 5-Year Performance Graph (USD Total Return) Index Level Rebased (31 May 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 -1 0 ay

No v09

FTSE RAFI US 1000 Index

-0 9 ay M

No v08

-0 8 M

v07 No

-0 7 ay M

v06 No

-0 6 M

v05 No

-0 5

Table of Total Returns Index Name

Currency

Constituents

Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Actual Div Yld (%pa)

FTSE All-World Indices FTSE Americas Index

USD

770

727.97

-1.0

0.2

21.0

-1.8

2.10

FTSE North America Index

USD

647

793.79

-0.8

0.7

20.7

-1.4

2.06

FTSE Latin America Index

USD

123

1096.67

-2.4

-5.4

27.1

-7.1

2.75

FTSE Global Equity Indices FTSE Americas All Cap Index

USD

2,570

337.26

-0.2

1.9

23.2

-0.8

1.97

FTSE North America All Cap Index

USD

2,382

322.04

-0.1

2.4

22.9

-0.4

1.93

FTSE Latin America All Cap Index

USD

188

1549.81

-2.6

-5.2

28.8

-7.1

2.67

FTSE Americas Government Bond Index

USD

185

192.69

1.8

1.0

4.4

3.8

2.94

FTSE USA Government Bond Index

USD

171

188.58

1.7

0.9

4.3

3.8

2.92

FTSE EPRA/NAREIT North America Index

USD

122

3062.67

10.3

18.4

57.9

10.5

4.01

FTSE EPRA/NAREIT US Dividend+ Index

USD

1673.81

11.0

18.5

57.6

10.9

4.01

FTSE EPRA/NAREIT North America Rental Index

USD

118

1042.69

10.8

19.1

58.4

11.2

3.99

FTSE EPRA/NAREIT North America Non-Rental Index

USD

309.93

-7.3

-6.6

37.3

-11.4

4.86

FTSE NAREIT Composite Index

USD

128

2972.37

10.4

17.7

54.1

10.5

4.68

FTSE NAREIT Equity REITs Index

USD

106

7250.53

11.3

19.1

56.0

11.1

3.92

FTSE4Good US Index

USD

130

4808.15

-0.8

0.0

24.1

-2.6

1.95

FTSE4Good US 100 Index

USD

102

4576.19

-0.9

-0.5

23.2

-2.8

1.97

Fixed Income

Real Estate

SRI

Investment Strategy FTSE GWA US Index

USD

591

2998.24

-1.1

0.7

21.7

-0.8

2.15

FTSE RAFI US 1000 Index

USD

1,002

5474.99

1.2

4.7

31.5

2.7

2.18

FTSE RAFI US Mid Small 1500 Index

USD

1,488

5605.72

6.1

18.8

48.7

9.1

1.18

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

F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 1 0

300

FTSE Europe Index (EUR)

250

FTSE All-Share Index (GBP) FTSEurofirst 80 Index (EUR)

200

FTSE/JSE Top 40 Index (SAR) 150

FTSE Actuaries UK Conventional Gilts All Stocks Index (GBP)

100

FTSE EPRA/NAREIT Developed Europe Index (EUR)

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

ay -1 0

FTSE RAFI Europe Index (EUR)

No v09

ay -0 9 M

No v08

ay -0 8 M

No v07

ay -0 7 M

No v06

ay -0 6 M

No v05

ay -0 5

Index Level Rebased (31 May 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

551

226.21

2.0

5.1

21.8

-1.2

3.56

FTSE Eurobloc Index

EUR

284

117.88

-0.5

-1.7

13.4

-7.0

3.92

FTSE Developed Europe ex UK Index

EUR

374

223.20

0.5

2.0

18.5

-3.5

3.59

FTSE Developed Europe Index

EUR

490

222.05

1.6

4.5

21.1

-1.7

3.62

FTSE Europe All Cap Index

EUR

1,508

354.62

2.3

5.7

22.8

-0.5

3.43

FTSE Eurobloc All Cap Index

EUR

770

350.35

-0.3

-1.2

14.4

-6.4

3.80

FTSE Developed Europe All Cap ex UK Index

EUR

1,047

373.61

0.7

2.5

19.6

-2.9

3.46

FTSE Developed Europe All Cap Index

EUR

1,387

350.31

1.9

5.2

22.0

-1.0

3.49

FTSE All-Share Index

GBP

630

3533.48

-1.3

2.7

22.9

-1.6

3.51

FTSE 100 Index

GBP

104

3336.69

-2.0

1.7

21.8

-2.5

3.67

FTSEurofirst 80 Index

EUR

4428.44

-1.1

-2.9

12.6

-8.3

4.25

FTSEurofirst 100 Index

EUR

101

4123.52

0.5

1.8

17.5

-4.6

4.09

FTSEurofirst 300 Index

EUR

313

1448.74

1.4

4.1

20.3

-2.0

3.69

FTSE/JSE Top 40 Index

SAR

2754.11

1.5

0.1

19.6

-2.5

2.07

FTSE/JSE All-Share Index

SAR

164

3082.13

2.3

2.0

21.9

-0.9

2.26

FTSE Russia IOB Index

USD

848.69

-3.8

-3.9

7.7

-8.6

2.04

FTSE All-World Indices

FTSE Global Equity Indices

Region Specific

Fixed Income FTSE Eurozone Government Bond Index

EUR

242

175.45

1.7

2.6

7.8

3.4

3.37

FTSE Pfandbrief Index

EUR

397

210.83

0.7

1.9

8.5

2.4

3.55

FTSE Actuaries UK Conventional Gilts All Stocks Index

GBP

2381.58

3.8

1.4

6.1

4.1

3.79

FTSE EPRA/NAREIT Developed Europe Index

EUR

1750.10

-1.9

0.5

26.4

-4.7

5.08

FTSE EPRA/NAREIT Developed Europe REITs Index

EUR

632.67

-2.1

-1.1

25.6

-6.4

5.75

FTSE EPRA/NAREIT Developed Europe ex UK Dividend+ Index

EUR

2142.03

-4.2

-0.9

25.1

-4.4

5.97

FTSE EPRA/NAREIT Developed Europe Rental Index

EUR

686.17

-2.0

0.6

26.9

-4.7

5.18

FTSE EPRA/NAREIT Developed Europe Non-Rental Index

EUR

493.97

2.4

-1.7

12.7

-3.2

2.21

FTSE4Good Europe Index

EUR

277

4376.39

0.6

2.8

19.1

-3.0

3.88

FTSE4Good Europe 50 Index

EUR

3720.57

-1.0

0.7

14.9

-5.1

4.23

FTSE GWA Developed Europe Index

EUR

490

3139.53

0.1

1.6

18.1

-3.9

3.89

FTSE RAFI Europe Index

EUR

509

4927.10

2.2

2.6

19.7

-2.4

3.77

Real Estate

SRI

Investment Strategy

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

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

Asia Pacific Market Indices 5-Year Total Return Performance Graph 550

FTSE Asia Pacific Index (USD)

Index Level Rebased (31 May 2005=100)

500

FTSE/ASEAN Index (USD)

450 400

FTSE/Xinhua China 25 Index (CNY)

350

FTSE Asia Pacific Government Bond Index (USD)

300 250

FTSE EPRA/NAREIT Developed Asia Index (USD)

200 150

FTSE IDFC India Infrastructure Index (IRP)

100

FTSE4Good Japan Index (JPY)

ay -1 0

-0 9

FTSE RAFI Kaigai 1000 Index (JPY)

No v

ay -0 9 M

-0 8 No v

M ay -0 8

No v07

M ay -0 7

No v06

M ay -0 6

-0 5

FTSE GWA Japan Index (JPY) No v

M ay -0 5

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

264.64

-2.7

-2.2

14.7

-4.5

2.39

FTSE Asia Pacific ex Japan Index

USD

843

521.97

-2.2

-3.5

22.2

-6.9

2.64

FTSE Japan Index

USD

454

74.40

-1.1

5.8

-0.5

-2.6

1.98

2.38

FTSE All-World Indices

FTSE Global Equity Indices FTSE Asia Pacific All Cap Index

USD

3,101

449.23

-2.5

-2.1

14.9

-4.5

FTSE Asia Pacific All Cap ex Japan Index

USD

1,872

645.78

-2.2

-3.4

22.2

-7.1

2.63

FTSE Japan All Cap Index

USD

1,229

236.14

-0.7

6.0

-0.1

-2.2

1.99

FTSE/ASEAN Index

USD

147

580.22

5.0

7.6

38.4

3.3

2.90

FTSE Bursa Malaysia 100 Index

MYR

100

9549.97

2.0

4.3

27.6

2.5

2.55

TSEC Taiwan 50 Index

TWD

6514.07

-2.4

-4.5

8.2

-10.8

2.94

FTSE Xinhua All-Share Index

CNY

1,042

7702.63

-13.7

-16.7

7.5

-17.9

0.95

FTSE/Xinhua China 25 Index

CNY

22506.11

1.0

-7.8

10.6

-6.8

2.55

USD

224

141.95

-1.9

-4.5

7.5

2.5

1.23

FTSE EPRA/NAREIT Developed Asia Index

USD

1897.66

-4.4

-6.7

9.2

-8.1

4.05

FTSE EPRA/NAREIT Developed Asia 33 Index

USD

1233.02

-4.6

-6.4

10.7

-8.0

4.16

FTSE EPRA/NAREIT Developed Asia Dividend+ Index

USD

2006.71

-4.6

-5.1

16.6

-6.9

5.59

FTSE EPRA/NAREIT Developed Asia Rental Index

USD

892.92

-2.0

-0.9

27.1

-2.7

6.77

FTSE EPRA/NAREIT Developed Asia Non-Rental Index

USD

1054.06

-5.8

-9.8

0.3

-11.0

2.41

Region Specific

Fixed Income FTSE Asia Pacific Government Bond Index Real Estate

Infrastructure FTSE IDFC India Infrastructure Index

IRP

911.96

0.1

-1.7

-2.2

-6.4

0.73

FTSE IDFC India Infrastructure 30 Index

IRP

1020.37

-0.1

-2.7

-3.8

-6.7

0.72

JPY

184

3544.36

-1.6

4.3

-3.2

-3.3

2.12

FTSE SGX Shariah 100 Index

USD

100

4948.76

-3.2

-0.9

11.6

-6.9

2.12

FTSE Bursa Malaysia Hijrah Shariah Index

MYR

10401.75

-0.9

-0.4

17.1

-1.8

3.03

JPY

100

1008.06

-1.4

5.7

1.5

-6.0

1.97

SRI FTSE4Good Japan Index Shariah

FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index

JPY

454

2680.11

-0.6

6.3

0.5

-0.6

2.08

FTSE GWA Australia Index

AUD

102

3858.09

-4.3

-3.6

22.9

-7.2

4.50

FTSE RAFI Australia Index

AUD

6097.68

-5.7

-5.6

21.6

-9.2

4.52

FTSE RAFI Singapore Index

SGD

8220.58

0.1

2.9

22.3

-3.4

3.34

FTSE RAFI Japan Index

JPY

252

3763.01

0.1

9.6

0.4

-1.1

2.03

FTSE RAFI Kaigai 1000 Index

JPY

1,025

3832.14

-1.4

-1.2

11.6

-9.4

3.00

HKD

6549.21

-0.1

-7.7

9.5

-7.8

3.05

FTSE RAFI China 50 Index

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

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

INDEX CALENDAR

Index Reviews July–September 2010 Date

Index Series

Review Frequency/Type

Effective Data Cut-off (Close of business)

Late Jun 06-Jul 07-Jul

IBEX 35 FTSE Xinhua Index Series TOPIX

30-Jun 18-Jul

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 Early Sep Early Sep

Hang Seng MSCI Standard Index Series ATX CAC 40

29-Sep 03-Sep 31-Aug 30-Sep

31-Aug 30-Jun 31-Jul 31-Aug

17-Sep

15-Sep

Early Sep

S&P / TSX

Early Sep 03-Sep 03-Sep

RTSI DAX S&P / ASX Indices

17-Sep 14-Sep 17-Sep

31-Aug 31-Aug 31-Aug

04-Oct 07-Sep

NZX 50 TOPIX

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 Semi-annual review / number of shares Annual review of free float & Quarterly Review Quarterly review - constiuents, shares & IWF Quarterly review Quarterly review/ Ordinary adjustment Quarterly review - shares, S&P / ASX 300 consituents Quarterly review Monthly review - additions & free float adjustment

17-Sep 17-Sep

28-Aug 31-Aug

28-Oct

30-Sep

07-Sep

FTSE Global Equity Index Series (incl. FTSE All-World) FTSE MIB FTSE UK Index Series FTSE / JSE Africa Index Series FTSE Italia Index Series FTSE Global Equity Index Series (incl. FTSE All-World)_ FTSE techMARK 100 FTSEurofirst 80 & 100 FTSEurofirst 300 FTSE Euromid FTSE Italia Index Series FTSE Multinational FTSE4Good Index Series FTSE EPRA/NAREIT Global Real Estate Index Series FTSE Asiatop / Asian Sectors DJ STOXX S&P Asia 50 S&P US Indices S&P Europe 350 / S&P Euro S&P Latin 40 S&P Global 1200 S&P Global 100 S&P Topix 150 BNY Mellon DR Indices Russell US Indices Russell Global Indices

Annual review / Japan Semi-annual constiuents review Quarterly review Quarterly review Quarterly review

17-Sep 17-Sep 17-Sep 17-Sep 17-Sep

30-Jun 31-Aug 07-Sep 31-Aug 31-Aug

Annual review / Developed Europe Quarterly review Annual review Quarterly review Quarterly review Quarterly review Annual review Semi-annual review

17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep 17-Sep

30-Jun 31-Aug 31-Aug 31-Aug 03-Sep 31-Aug 30-Jun 31-Aug

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

17-Sep 17-Sep 17-Sep 18-Sep 18-Sep 18-Sep 18-Sep 18-Sep 18-Sep 17-Sep 20-Sep 24-Sep 24-Sep

31-Aug 31-Aug 24-Aug 04-Sep 04-Sep 04-Sep 04-Sep 04-Sep 04-Sep 03-Sep 31-Aug 31-Aug 31-Aug

07-Sep 08-Sep 08-Sep 08-Sep 08-Sep 08-Sep 08-Sep 08-Sep 08-Sep 08-Sep 08-Sep 09-Sep 09-Sep 09-Sep 10-Sep 11-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 13-Sep 15-Sep 17-Sep 17-Sep

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

J U LY / A U G U S T 2 0 1 0 • F T S E G L O B A L M A R K E T S

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