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ASIAN TRADING ROUNDTABLE: GEARING UP FOR CHANGE ISSUE 44 • SEPTEMBER 2010

The search for interoperability MiFID up for renewal The sov ereign debt trap Sukuks bloom in Asia

WILL NEW CHINA IPOs FOLLOW ABC’s PATH? ROUNDTABLE: EUROPEAN SECURITIES SERVICES IN THE SPOTLIGHT

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FTSE GLOBAL MARKETS • SEPTEMBER 2010

VERY WHICH WAY, there’s an awful lot about China and change in this edition. We’ve hammered home the point in issue after issue that there are serious paradigm shifts blowing through the political-economic world and only now are we getting the measure of wind speed and direction. It is patently clear that the Chinese economy is firmly in the fast lane, driving the economic equivalent of a Maserati, while the rest of the world pootles along in an ageing Honda. However, one might drive an economic supercar, but as many an emerging market driver (even a very rich one) can tell you, you can’t always guarantee that you are on a clear highway. Roads in emerging markets (hey, even developed markets these days) are decidedly pot-marked. The imagery is rather strained perhaps, but the point is acute. What does a ranking position among the top three of the G8 economies now mean in the modern economic order? As the BRIC countries threaten to surge above the G8 parapet, what now defines a G8 economy? How can an economy be the second-most powerful in the world when it does not offer high-tech/innovative product? It does not export any meaningful resource (other than people perhaps); or have an economy that stretches out beyond a handful of rich, city-state governed provinces? How do you reasonably define yourself as the world’s second most powerful economy by GDP alone? Surely there must be more? Or, at a more arcane level, is China exhibiting a consistent cultural as well as economic message that has resonance above and beyond the moment? Certainly it is spending more money on the military and in establishing resource-based trade relationships —but is that enough? Is China willing to exert influence above and beyond the economic obvious? As the BRIC economies dominate the second decade of this shapeshifting century, will we be confronted with new dichotomies in the emerging market mix? Will we see the return of the city super-state; but this time on a global scale? Will Ricardian theories on centre-periphery economies finally prove their worth? Or, will the global economy be marked by a series of blackhole economies, which suck up resources for domestic consumption without adding to the socio-economic well being of the remaining global eco-system? While the true impact of globalisation and the resurgence of ancient empires are beginning to exert their influence on the affairs of man, there is clearly a philosophical lacuna. What are the aspirations of the nouveau riche emerging economies? Is there a political philosophy that drives the destiny of global society in this most dynamic of periods? Or have functionalist philosophers finally triumphed? Not only has there been an end put to history, but also to political economy? Will we end up just with economics? This edition does not hope to answer most of these questions; we leave that to wiser men than us. Hopefully, it will stimulate new fields of enquiry and discussion. There’s so much going on—in terms of regulation, risk mitigation and navel gazing in the developed economies that they stand in danger of missing important turning points in a world that is changing at breakneck speed. There are no easy answers: for either the emerging markets or the socalled developed ones. Both are sickening under the burden of change, albeit in different ways. We’ve hopefully pointed out some emerging trends in the main articles in this edition. It does not always make comfortable reading; but that’s not what trade magazines are about, are they?

Francesca Carnevale, Editorial Director September 2010 Cover photo: Xiang Junbo, Chairman of Agricultural Bank of China Ltd. attends a press conference in Hong Kong, China. Agricultural Bank of China Ltd, the country's largest lender by customers, will seek to raise as much as HK$88.4 billion ($11.4 billion) in the Hong Kong portion of its initial public offering, according to three people with knowledge of the price range. Photograph supplied by Press Images Association, August 2010.

Contents COVER STORY AS EASY AS ABC?

....................................................................................................................Page 81 China has been a reliable source of IPOs this year; some of them huge, such as ABC’s mega $22bn debut. However, the take up of corporate equity has been mixed. Even ABC’s IPO was scaled back from its original target of $30bn. It’s not as if investors have been spoiled for choice and China is still a big growth story. Moreover, big buyers of Chinese IPOs have often been Middle Eastern investors rather than the large western funds. What’s the buzz?

DEPARTMENTS MARKET LEADER

SO, WHAT’S THE DEAL WITH OTCQX?

..........................................................................Page 6 Ian Williams looks at the changing dynamics of the US equity listings market.

REGISTRATION RULES OK? ..............................................................................................Page 14 The SEC and adviser registration for private fund managers. COMMODITY INNOVATION ............................................................................................Page 18 Why Barclays thinks ETNs are a good idea.

IN THE MARKETS

SOVEREIGN DEBT: IT DOESN’T GO AWAY ............................................................Page 22 Andrew Cavenagh says the worst is not over for over-indebted states. SUKUK: THE ASIAN LINK....................................................................................................Page 28 The growing bandwagon for Islamic issues. THE AFRICA-BRAZIL TRADE LINK ................................................................................Page 32 Rodrigo Amaral explains why Brazilian corporations love to invest in Saharan countries.

EXCHANGE REPORT

BURSA MALAYSIA LEADS AN INVESTOR CHARGE........................................Page 35 The drive to attract foreign inward investment.

HAVE SHOPPING MALLS LOST THE PLOT?................................................................Page 37

ASSET ALLOCATION

Mark Faithful looks at the new approaches towards retail investment.

MOUNTAIN HIGHS ..................................................................................................................Page 40 Paul Whitfield wonders if gold prices can stay the course

A TALE OF TWO HALVES ....................................................................................................Page 43

COUNTRY REPORTS

John Rumsey asks whether Petrobras is a flawed platform for growth.

NORDIC BANKS SNAP BACK ............................................................................................Page 47 Lynn Strongin Dodds writes about a resurgent Nordic bank segment.

INDEX REVIEW TRANSITION MANAGEMENT CLEARING & SETTLEMENT DATA PAGES 2

INFLATION AHOY! ..................................................................................................................Page 53 Simon Denham, managing directors of Capital Spreads on continuing market jitters.

CUTTING THE RISKS

............................................................................................................Page 107 David Simons explains why transition management in the US has changed forever.

CHANGING TIMES FOR ASIAN TM ..............................................................................Page 110 Why Asian TM has to evolve to compete.

THE WATCHDOG TAKES AIM ........................................................................................Page 113 The EC has turned its attention to post trade services writes Paul Whitfield.

THE LONG AND WINDING ROAD TO INTEROPERABILITY

............................Page 118

Lynn Strongin Dodds outlines the trends. Fidessa Fragmentation Index ..............................................................................................Page 121 DTCC Credit Default Swaps analysis ..............................................................................Page 123 Market Reports by FTSE Research ....................................................................................Page 124 Index Calendar..........................................................................................................................Page 128

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

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Contents FEATURES THE TRADING REPORT THE PROBLEM WITH COMPETITION ................................................................Page 54 European exchange venues are promoting themselves heavily as competition has become fierce across all forms of exchange and as still more players enter the market. Ruth Hughes Liley reports on the implications.

FACE TO FACE WITH ANDY SILVERMAN ........................................................Page 58 Do dark pools really offer innovative and anonymous trading techniques and is that what the market really wants? Francesca Carnevale talks to Andy Silverman, managing director of Morgan Stanley’s electronic trading business.

TRADING TECHNOLOGIES: THE AGENT OF CHANGE....................................Page 60 A fusion of technology and trading has seen increasingly blurred boundaries between conventional market structures as client demand has called for increasingly flexible models, writes Ruth Hughes Liley.

ASIAN TRADING ROUND TABLE:

BUILDING THE NEW GATEWAY ............................................................................Page 67 Despite it being largely retail in structure, Asia’s trading market is moving along at a clip; mirroring many of the changes that have already taken place in the US and Europe. How much more fragmented can it feasibly become?

RUSSIA: FROM WILDFIRES TO NEW TRADING PLATFORMS

......................Page 76 Foreign funds are unlikely to seriously restart buying Russian stocks until they are convinced that the global recovery is sustainable, writes Vanya Dragomanovich

ASSET SERVICING REPORT CANADIAN SECURITIES LENDING: WHY CASH IS NOT KING ................Page 86 The resilience in Canadian securities lending derives in part from the country's increasing attraction to international investors. While most developed nations have trashed their public finances in an attempt to revive economic growth, Canada escaped the crisis relatively unscathed. Neil A O'Hara reports.

CANADA: IS IT THE GATEWAY TO RECOVERY? ..........................................Page 91 Canada finds itself in a fortunate position at the intersection of the drivers of the economic growth (energy and materials, for instance) across a diversified range of emerging economies, and the financial architecture and economic stability that investors seek.

ASSET SERVICING ROUND TABLE:

EXPANDING THE SERVICE SET................................................................................Page 93 Changing regulation and a more considered approach to the bundling of services across the spectrum are reference point for the buy side and the sell side. But what now constitutes added value in a post recessionary period?

TRANSACTION BANKING: SUBCUSTODIANS FACE UP TO CHALLENGES ....................................................................................Page 102 In a world of lower management fees, greater technology needs and fierce competition, ranking sub-custodians are by no means living on Easy Street. Dave Simons reports from Boston

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Market Leader EUROPEAN GIANTS DESERT NYSE FOR OTCQX

The OTCQX marketplace is the premier tier of the US over-the-counter (OTC) market, providing investors with an objective measure to distinguish the best OTC-traded companies. More than a dozen major West European companies, including British Airways, Allianz and BASF, have ditched their NYSE listing in favour of being “in the pink” by being quoted on OTCQX. They have not pulled out of the US, but changed the structure through which they are quoted. Ian Williams explains why OTCQX, which might earn the nickname Wall Street-lite, provides a soft landing for companies that jump off the Big Board.

Photograph © Aspect3d / Dreamstime.com, August 2010.

NEW YORK EXODUS OR YEARS, MULTINATIONAL companies listed on multiple exchanges across the financial world, hoping that the increased international exposure and liquidity would reflect in their stock prices. In addition, companies wanted to build brand equity with listings in markets in which they also had business operations, partly because it made for good politics and PR, but also because it allowed them to make stock available for their overseas employees’ pension funds and incentive schemes. Making a New York listing even more desirable was the somewhat parochial attitude of many US investors and

financial regulators, who did not accept international accounting standards, and were reluctant to invest abroad. Indeed, many of the institutions had rules preventing them from investing in stocks not listed on a US exchange. Some still do, which is why it pays to maintain an ADR. In the past year, however, there has been a rush to the exits with major German companies in particular delisting from NYSE. In fact, they are late in following the trend. British Airways was one of the first to fly out of New York as soon as the SEC allowed easier exits. Until 2008, NYSE was like The Eagles’ song Hotel

California, you could never leave, short of abysmal failure, a share price plunging to below a dollar and your American stockholders’ numbers falling below three hundred. The German companies’ rush to the exit seems to have been a response both to the financial crisis and the ease of electronic trading that made the crisis possible. Economy-conscious German directors found that the costs of listing in New York, typically quoted at over €10m, are not worth the expense when American investors or their brokers are as likely to click on their screens and trade in Frankfurt as they are on NYSE, and where a listing

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

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Market Leader EUROPEAN GIANTS DESERT NYSE FOR OTCQX

satisfactory to most existing American ADR holders could be maintained at a much lower cost. Despite the exodus, it should be stressed that four very large German companies, like many other international giants, remain on NYSE: Deutsche Bank, Fresenius Medical Care, SAP and Siemens. They all work in regulated industries with large US sales, still have liquidity in their stock stateside—and although none of them would admit it, they might also be contemplating, or at least anticipating, stock-financed M&A activities, which is of course much easier via Wall Street and NYSE. In contrast, with 84,000 Americans holding its ADRs and over 500 through Frankfurt, Allianz delisted because, it said, “trading of our shares on nonGerman stock exchanges accounted on average for significantly less than 5% of the total trading of Allianz shares”. In response, the company says it is “focusing on trading of its share on the Frankfurt Xetra trading platform as the market with the highest liquidity”, adding: “The objective was to adjust to international trading practices and in doing so, reduce the complexity of Allianz’s presence in the capital markets. The delistings have no impact on the strategic orientation of Allianz nor on its presence in the individual geographic markets.” The company admitted a slight drop in ADR holders, but the experience of its compatriot companies suggests that is mitigated by more trading through Frankfurt. Akbar Poonawala, managing director and head of global equity services, Deutsche Bank, comments: “There has been a noticeable trend where more than a dozen well known index companies from Western Europe have delisted from the NYSE and NASDAQ. Interestingly, several of these companies have elected to be quoted through OTCQX, so it is not so much that they have pulled out of the US as

Akbar Poonawala, managing director and head of global equity services, Deutsche Bank, comments: “There has been a noticeable trend where more than a dozen well known index companies from Western Europe have delisted from the New York Stock Exchange and NASDAQ. Interestingly, several of these companies have elected to be quoted through OTCQX, so it is not so much that they have pulled out of the US as the headlines might suggest, rather that they have changed their structure through which they are quoted.” Photograph kindly supplied by Deutsche Bank, August 2010.

In the past year, however, there has been a rush to the exits with major German companies in particular delisting from NYSE. In fact, they are late in following the trend. British Airways was one of the first to fly out of New York as soon as the SEC allowed easier exits. the headlines might suggest, rather that they have changed their structure through which they are quoted.” He explains: “Direct buying is an option for some investors who have the means to do so, particularly in Western Europe, where the time zones overlap for some hours, so there is the possibility for investors to choose the ADR or GDR, as long as there is sufficient liquidity, versus the local shares. Typically, investors look for cost

savings, and ADRs, for example, may trade at a discount. The sum cost of holding an ADR may be less than in the home market, depending on custody and brokerage fees in the home market.” Most of the companies delisting convert to a level one ADR, which entails the least US regulation, but since they are large, blue-chip companies, with visible compliance in their European homes, so far anecdotally, the change

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

Market Leader EUROPEAN GIANTS DESERT NYSE FOR OTCQX

has not led to any significant reduction in US holdings. Far from representing a retreat from globalism, most of the companies and those concerned in overseas stock trading, point out the global convergence of accounting principles and compliance standards for corporate governance and disclosure has meant that listing on other exchanges is no longer necessary to reassure investors. Indeed, the process is two way: for example Colgate-Palmolive from the Paris Euronext in April and Amsterdam in June, explaining that if anyone really wanted to trade its stocks, they could do so in New York, where in fact, almost all its shares were bought and sold. Indeed, they cited less than 0.1% trading in the European exchanges. The German companies say the same about the Frankfurt exchange, but still do proportionately far more business in New York. However, they can now have their American pie and eat it as well. Cromwell Coulson is chief executive of Pink OTC Inc, whose OTCQX platform offers a soft landing for those jumping off the Big Board. It costs $15,000 as opposed to $100,000 for Big Board listing, which can be 100 times more than the listing costs, but is close to zero for OTC. In the past, OTC, the pink sheets, were the underworld of stock trading, the home of the penny stocks, whose shares were subject to pumping and dumping and any amount of scams. They made a black hole seem transparent. It was the last place a respectable German company would want to be seen. That has changed, and many of the European companies are now listing on it, giving it a valuation of $750bn and making up 35% of the total OTC valuation. BNP Paribas, Zurich Financial, BASF and Deutsche Telekom are just some of the big names listed there, along with a growing number of Canadian and Australian companies which appreciate

OTCQX Market Summary

OTCQX OTCQB Pink Sheets Current Pink Sheets Limited Pink Sheets No Info Total

No. of Securities 118 3,826

$ Volume

Volume

$178,389,425 $56,720,731

7,952,7963 1,065,228,471

1,298 761 3,372 9,375

$186,470,291 $40,164,746 $6,750,528 $468,495,721

1,050,282,675 1,719,620,216 1,890,400,600 5,733,484,758

% of $ Volume 8.1% 12.1% 39.8% 8.6% 1.4%

Notes: Current market as of August 20th 2010: Volume $8,600,833; Sahre volume 1,286,177; Trades 749; Advancers 18; Decliners 38. OTCQX market cap is over $750bn (as of July 23rd, 2010) more than 35% of the total dollar volume for the securities on the platform is in OTCQX stocks. Source: OTCQX, supplied August 2010.

a reputable and inexpensive exposure to American investors along with their domestic listings. Coulson explains that the OTCQX platform was a response to the trends his company had noticed: “Stock exchanges are nationalistic, but companies’ managerial skill sets are focused on meeting one, usually their own domestic disclosure standards. That trend is helped because across the world, standards are converging, and rising. In all of them disclosure has been improved—no one is competing to lower standards!” While institutions could happily click on their screens and deal in Europe, the US has a large pool of retail investors who want to deal domestically, not to mention the institutions whose rules insisted on US stocks. “So we looked and reasoned companies want to meet one listing standard, and they all had great compliance, disclosure, so we segmented our OTC market into different tiers and provided one, OTCQX, where high-quality companies that are investor friendly have high quality of information and provide the services to investors, as if they were listed on US. It has trading transparency, with full depth of book freely available, and publishes their home company disclosure, in English, on our website.” He adds: “The US is a fabulous market place for trading stocks but before, you traded on an exchange, or

you didn’t trade there at all. The OTC was dark, opaque and inefficient. Our company, Pink OTC, changed that. It was a game changer, the real time quotes went on Bloomberg, e-trade, all the others had access to real-time prices. By making that, we transformed the trading process… but then we looked at the listing process.” Coulson stresses: “We have a quality control check, so that we have a reputable third party attesting to their compliance. We take all the information they use for their primary listing and make it available in the US.” He concludes: “If I moved to Germany, I would get a German driver’s license. If I am only going on a four-week vacation then I won’t bother, I’ll keep my US license. There’s no need for a full listing in the US if most of your trading is at home.” BASF is one of the German companies that has recently delisted on NYSE and taken advantage of the OTCQX platform. Typically, Michael Grabicki, corporate media relations director at BASF, says: “We listed on NYSE, in 2000, to make our brand better known, to find more shareholders and to give our US employees the opportunity to use our shares for their pensions, their 401Ks since some funds could only use listed shares. “It was a good idea to go to NYSE: it was a real success. We measured it and our brand had become more popular

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

Market Leader EUROPEAN GIANTS DESERT NYSE FOR OTCQX

and our proportion of US shareholders rose significantly from 8% to 20%.” However, despite the success, he adds: “Most of our shares were bought in London and Frankfurt, and so New York was not a major place for trading, and after we listed, the bureaucracy became more complex and more costly.” After the SEC rules changed, it became much easier to delist, but one reason for hesitation was, he points out, “that it is very necessary that the US shareholders get the same transparency and services afterwards”. BASF listed their stock on the OTCQX so they could. So far the change has not led to any perceptible reduction in US shareholders, “although,” Grabicki adds, “it is of course difficult to tell, because of ups and downs with the economy”. Since the company has only just moved to listed shares, as opposed to the common German bearer stock, he cannot estimate how many Americans hold stock bought directly in Frankfurt, but other German companies claim that this is significant. Coulson estimates that the companies that delisted kept 70% to 80% of their stockholders, and certainly companies including Deutsche Telekom went out of their way to check with their major holders before making the move, and report that they had not seen significant unhappiness from them. Off the record, some German companies admit that one reason for delisting is a perception among their directors that they could be caught up in shareholder litigation, but Grabicki discounts that: “Litigation is tough in the US, but since we are working in the US we would be at risk anyway.” Coulson suggests: “Most of our companies have a culture of compliance, not trying to game the system, but they don’t want to get tripped on technicalities of a listing system they are not familiar with.” So what are the prospects for companies in other parts

of the world taking advantage of Wall Street-lite? Coulson admits: “There’s been a pent-up demand for delisting following the 2008 change, and European companies are the most sophisticated, with a long background in IR in the US, and they know how to use the markets. Now we’re getting the first movers, then we are going to see.” Under consideration are the BRICs. Another banker suggested: “It’s certainly possible that some of the BRICs might go that way, but the European companies have had 20 years building a cadre of investors in the US, quarterly reports, investor meetings and so on. The BRICS have not. They do not have the same tenure. Even so, some companies are

issue implies that there will not be too much appetite for delisting from Asian companies for example. Poonawala suggests: “Major institutions will still buy an ADR or GDR, if there is a financial advantage, or if they have a big ticket order off hours. Indeed, Coulson points out that the traffic is not necessarily one way. “Companies can test the water with an OTC listing and build investor interest and familiarity before they have the confidence and investor base to list on NYSE and NASDAQ. ”He instances life science companies from Australia which have used their OTCQX listing to build out from their home exchange and present at US roadshows. `

After the past few years, US compliance does not appear to be the gold standard it once was, but that pile of gold that glisters in the US markets is every bit as attractive as it ever was. best in class in their respective markets, such as Infosys, which has been around since 1999, but some of them might be using these as a tool for the US Employee Stock Ownership Plans (ESOPs), or they have a whole lot of clients in the US. Such companies are setting up a track record with employees, clients, investors. So my sense is that BRICs have not reached the stage yet.” Poonawala also points out that there is a time factor involved: “An NYSE listing is more attractive if you are a large blue-chip DAX30 company and it is appealing to have that extra time to trade in New York after your own market has closed. Companies have to weigh that advantage against the costs. ” While there is reasonable trading hours overlap between Europe and New York—almost as much in fact as between New York and the West Coast—the time zone

Coulson comments: “We’re not a competitor with home listing … we are complementary: offering investors access who might not have access, and points to the splash-back effect that access to the larger pool of US liquidity has had with Toronto-listed companies. It gives them great traction, not only did Canadian companies increase their US volume by 338%, within 90 days of an OTCQX listing, their volume on TSX went up by 58%.” After the past few years, US compliance does not appear to be the gold standard it once was, but that pile of gold that glisters in the US markets is every bit as attractive as it ever was. A combination of credible compliance elsewhere and access could well provide the alchemy that Cromwell Coulson promises for overseas companies and American investments. He has already gilded the base metal of the OTC. ■

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

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In the Markets PRIVATE FUND MANAGERS: SEC ADVISOR REGISTRATION

The wave of regulation that has been headed toward the alternative investment industry for some time is now plunging towards the shore. The United States has moved first, with the enactment last month of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). This new legislation will require all sizeable private fund managers, including non-US based firms that operate US funds or raise capital from investors in the US, to register with the Securities and Exchange Commission (SEC) no later than July 2011. By Stephanie Biggs (partner), Scott Moehrke (partner) and Josh Westerholm (associate), from Kirkland & Ellis’ global investment management team.

Democrat representative Senator Maxine Waters (centre) looks on as President Barack Obama signs the Dodd-Frank Wall Street Reform and Consumer Protection Bill at the Ronald Reagan Building, Washington DC, on .Wednesday July 21st, 2010. Also pictured: Sen. Harry Reid (Dem., Nevada); Sen. Mel Watt (Dem., New York City) and Sen. Chris Dodd (Dem. Connecticut). Photograph by Charles Dharapak/AP, supplied by Press Association Images, August 2010.

REGISTRATION RULES OK? NVESTMENT ADVISERS WITH more than $25m of assets under management (AUM) have, up to now, been subject to federal regulation in the United States, under the provisions of the Investment Advisers Act of 1940 (the Advisers Act), with smaller US-based firms typically regulated at the state level. Any private fund managers advising fewer than 15 “clients”(including private funds, each of which is generally considered a “client”) in any 12-month period were exempted from SEC registration provided (broadly speaking) that they did not advise regulated mutual funds, or publicly hold themselves out as investment advisers. Most private fund managers, including private equity, hedge and real estate fund managers, fell within the scope of this exemption and so were not required to register under the Advisers Act. The new Dodd-Frank Act abolishes the fewer-than-15-client exemption, with the result that almost all alternative

investment firms with substantial AUM and a US connection will now be required to register with the SEC. There are some material exceptions, however. The SEC is required to adopt an exemption for firms that only manage venture capital funds. Until the SEC publishes a rule proposal for comment, it is difficult to assess the likely scope of this exemption. However, given that an exemption for private equity fund managers was expressly considered and rejected, this exemption is likely to be narrowly drawn. Equally, foreign private advisers are also exempted from registration if they have no place of business in the United States, fewer than 15 clients in the United States and less than $25m AUM attributable to US clients. Each US investor will count as a client, as well as each US fund managed. The SEC is also required to adopt a new exemption for mid-sized private fund managers. For this exemption to apply, the firm must manage only private funds, being funds that are exempt from

registration under the Investment Company Act of 1940, either because the fund has fewer than 100 investors [also known as a 3(c)(1) fund] or because all investors are “qualified purchasers” who meet certain net worth thresholds [often called a 3(c)(7) fund] and in each case for non-US funds counting or qualifying only US investors under these tests, and have AUM of less than $150m in the United States. Again, the scope of this exemption will not be wholly clear until the SEC publishes its rule proposal. It is still not clear to what extent non-US firms will be able to take advantage of this exemption, as the foreign private adviser exemption (which is expressly targeted at overseas firms) is extremely limited. Those firms who are caught by the new rules—and there will be many— will need to submit an application for SEC registration by April or May next year in order to ensure registration by the final deadline of July 21st, 2011. The Dodd-Frank Act also imposes information

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In the Markets PRIVATE FUND MANAGERS: SEC ADVISOR REGISTRATION

collection and reporting requirements on private fund managers, obliging firms to provide the SEC and the new US Financial Stability Oversight Council with information about core data points that are considered to impact overall financial stability, such as AUM, use of leverage, trading and investment positions, side letters and valuation policies.

Getting SEC registered The first step is to establish whether SEC registration is required and, if so, which entities within the organisation are required to register, as both management companies and general partner entities are likely to be caught. Those entities that are required to register must complete a Form ADV Part 1 with key information about the firm, including basic business information, management and ownership structure, services provided and funds advised, as well as information on conflicts and details of custody arrangements. The form is submitted to the SEC using a web-based filing system, and the registration process takes a minimum of 45 days from the date of filing. Applicants should also fill in a Form ADV Part 2 disclosure document for investors, containing certain prescribed information about the investment team and the fund product offered. In the coming months, this document will also be required to be filed with the SEC, and will be publicly available. Form ADV must be updated annually and promptly following any material change. SEC registration has a number of requirements: the firm must appoint a chief compliance officer with responsibility for overseeing and managing compliance issues within the firm. This person must be sufficiently senior for their opinion to carry weight with the firm’s management team. The firm must adopt comprehensive compliance policies and procedures to ensure compliance with the Advisers Act. The core policies include proxy voting,

custody, a code of ethics, personal account trading and investment allocation. The firm should also expect to be subject to periodic, and possibly surprise, inspections by the SEC. The Advisers Act requires disclosure obligations (most notably, a requirement to prepare an investor disclosure document), a requirement to implement pre-clearance and reporting procedures for personal transactions in securities, advertising rules (which prescribe, for example, the way in which track record information is to be presented in marketing materials), custody requirements, change of control limitations (which require investor consent for any ownership change of a stake of as little as 25% or more in the fund manager) and extensive books and records requirements. Firms advising 3(c)(1) funds may charge performance fees/carried interest only if each US investor has a minimum net worth of $1.5m, or has invested $750,000 or more with the sponsor. This amount will be adjusted for inflation in July 2011. Following recent scandals, a new rule was introduced in June 2010 prohibiting registered and non-registered investment advisers from participating in “pay-toplay” practices, where political contributions are effectively used as a means of soliciting investment by government entities such as US state or local pension plans. Non-registered investment advisers are already subject to the Advisers Act anti-fraud rule, which requires information provided to investors to be complete and accurate, and restrictions on principal transactions between the fund manager itself and the funds it manages. These requirements apply equally to SEC-registered firms. On the plus side, SEC registration does have certain advantages. The firm may benefit from greater structuring flexibility, for example, greater freedom to offer managed accounts alongside more traditional fund products.

Registered IAA status may also bring marketing advantages, as the firm may advertise more freely and some investors favour SEC-registered firms because they are more extensively supervised. Sanctions for failing to register are significant. The Advisers Act voids advisory contracts, including fund agreements, involving a violation of the act—for example, non-registration by an adviser that is including both management fees and performance fees/carried interest—and the firm may be subject to SEC enforcement actions, fines and injunctions. Once registered, a firm will be subject to SEC supervision, and the SEC has a wide range of enforcement powers at its disposal in the event of compliance breaches.

Steps to take The first step is to establish whether registration is required. For smaller firms, including non-US firms with relatively small amounts from US investors, it may be necessary to wait until the SEC publishes its rule proposals for the venture capital fund manager and mid-sized private fund adviser exemptions before reaching a final conclusion, but for many larger firms the answer will be clear. If the firm is required to register, a substantial amount of legwork must be undertaken before the firm will be in a position to apply for registration under the Advisers Act. The firm’s policies and processes will need to be thoroughly reviewed, and it is likely that new policies and procedures will need to be prepared and implemented. The firm may also need to review and revise its marketing materials, and it may take some time to pull together all the information needed to complete Form ADV Part 1 and Part 2. As a result, firms should consider getting the process underway in fall 2010 to ensure that everything is in place within the required time frame. ■

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In the Markets INVESTING IN COMMODITIES: ARE ETNS THE WAY FORWARD?

Photograph ÂŠ Rolffimages / Dreamstime.com, supplied August 2010.

COMMODITY INNOVATION Ultimately, it is only through direct investment in commodities that investors can obtain a pure form of exposure to commodity market trends, diversification benefits and alternative risk exposures. With investor interest continuing to grow, the asset class has matured, evolving from passive investment in commodity indices to more flexible strategies incorporating many tactical and sophisticated vehicles of investment such as exchangetraded notes (ETNs), structured products and enhanced indices strategies. By Jigna Gibb, director, Barclays Capital. O COMMODITIES CONTINUE to diversify a balanced portfolio? Commodities weathered the beginning of the financial crisis relatively well: true to their characteristic of a contrarian asset. The DJ-UBS index yielded net positive returns of 33% compared to the negative 15% return on the S&P 500 from the fourth quarter (Q4) 2007 to Q3 2008. However, throughout the worst times even commodities surrendered their leading position, leaving investors

questioning whether the asset class had lost its golden touch. Analysis from testing mean reversion in commodity correlations with equity benchmark indices highlights that there are fluctuations in their relationship. The case for commodities as a portfolio diversifier persists. Looking at the data over the past 40 years, it has been observed that there are periods of high correlation followed by periods of negative correlation. The magnitudes of the correlations have

been moving more to the extremes over time so we should anticipate a period of very negative correlation with equity markets for commodities. Commodity markets have continued to witness the commingling of strong commodity fundamentals and investor uncertainty throughout 2010. The dampening of sentiment has been primarily driven by macroeconomic pessimism influenced by European debt crisis, tightening financial conditions in emerging markets and potential changes in US banking regulations. However, after a slow start to the year, the notional invested in commodities soared to $292bn, gathering pace with growing investor risk appetite, supported by consistent strength in emerging markets demand, in conjunction with decreasing inventory levels and tightening supply constraints. Many investors continue to believe that they are exposed to the commodity markets via commodity linked equities. However, these investments tend to have strong positive correlation with the underlying benchmark equity index and have limited correlation with the relevant commodity sub-indices. Traditionally, large institutional investors such as asset managers and pension funds investors gained entrance into commodity markets through passive strategies such as index swaps. From 2004, we have seen a steady progression of investors accessing commodities via structured products which offered principal protection on investorsâ&#x20AC;&#x2122; initial notional in addition to providing leveraged participation on the upside performance. However, the economics behind the structured products simply do not exist any more, as many commodities switched from being in backwardation to contango and volatility in the markets increased. Hence the development of new economical structures emerged: the exchange-traded products (ETPs). ETPs provide investors

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In the Markets INVESTING IN COMMODITIES: ARE ETNS THE WAY FORWARD?

access to commodities in the same way that they buy and sell equities. There have been significant recent developments within the ETP market as investors seek more liquid access to key markets. Exchange-traded funds (ETFs), first brought to market 20 years ago, have grown in popularity as investors seek exposure to specific markets within a low cost fee structure. The development of exchange-traded commodities (ETCs), established by select players, advanced the market further. However, some potential risks in the underlying collateral and swaps used in ETCs highlight levels of complexity embedded in their construction and these are not always apparent to investors. The latest part of the evolutionary cycle of exchange-traded products for commodities is the exchange-traded note (ETN), which offers additional access into hard-to-reach markets without the complexity of multiple swap counterparties. These innovative investment products are attractive for investors, as ETNs have retained the appealing characteristics of simplicity, liquidity and transparency over other exchange-traded products, however, carrying bank issuer credit risk. Barclays innovated in the ETN space with the launch of the iPath franchise in the US. Since their launch in 2006, iPath ETNs have had up to $6bn of notional invested at the peak. Earlier this year, Barclays expanded this platform into Europe with the launch of nine broad and sector commodity ETNs and three equity volatility products. Some 42% of the total notional invested in commodities ($121.5bn) is accessed via ETPs, accommodating strategic as well as tactical allocations. Inflows into medium-term notes gradually returned in Q2 2010 as investor aversion to bank issuer credit risk subsided with $59.5bn currently invested. In 2005, benchmark indices represented

Assets under management (Notional Invested) continued to rise Institutional and retail commodity AUM Cumulative national value of commodity medium term note issuance Exchange traded commodity products Barcap estimates of Index AUM attributable to institutional investors

320 $bn 280 240 200 160 120 80 40 0 Q2 Q2 Q2 Q2 2005 2006 2007 2008

Q2 Q2 2009 2010

Source: Bloomberg, MTN-i, various ETP issuer data, Barclays Capital, August 2010

Share of major emerging economies in commodity demand Combined Brazil, China, India and M. East share of global demand for selected commodities 50% 40%

Soybeans Primary energy exc. oil

Aluminum Oil

30% 20% 10% 0% 91 93 95 97 99 01 03 05 07 09 Source: Barclays Capital, The Commodity Refiner, 16 July 2010, supplied August 2010.

Chinese Demand for Oil Relative to OECD member countries demand (mb/d) China Japan 9 8 7 6 5 4 3 2 1 0 70 75 80 85 90

Germany

95 00

05 10

Source: Barclays Capital, The Commodity Refiner, 16 July 2010, supplied August 2010.

84% of the overall investments, while this dollar-notional ($111bn) has remained steady through to 2010 as it has decreased as a percentage of overall investment. Of those that have invested they are now allocating into more enhanced index strategies (such as Pure Beta, Momentum Alpha and Optimal Roll) as well as opportunities in capturing commodity alpha. More broadly, commodities have become embedded in everyday news; even retail investors have become much more familiar with key commodities such as WTI crude oil, gold and copper. Some would now consider themselves to be more in tune on the outlook on different commodity opportunities. For example, 2010 has witnessed a reemergence of safe-haven buying, with a flight to quality and increased demand for precious metals. However, market sentiment is beginning to favour a more optimistic outlook on the global recovery, with recent forecasts highlighting positive real GDP growth on the up for 2010 and 2011. Accounting for over 25% of this global economic growth, emerging economies such as China, India, the Middle East and Brazil present themselves as key drivers of future global commodity demand, creating bullish scenarios for crude oil, copper and corn. However, demand is only one side of the equation: in the natural gas markets, despite hot temperatures and an aboveaverage hurricane season anticipated in the US, the oversupplied balances limit the longer-term upside. These variations in prices may offer profitable and strategic opportunities for investors in commodity markets whether they are investing for the first time or managing an established allocation. The unique factors around supply and demand trends, geopolitics, price behaviour in commodity markets, deviates from those of other asset classes, therefore creating opportunities for portfolio diversification. â&#x2013;

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In the Markets SOVEREIGN DEBT: STILL-STRAINED INVESTOR APPEAL

Photograph © Michael Mcdonald /Dreamstime.com, supplied August 2010.

THE SEARCH FOR SAFE HAVENS

Sovereign bond markets have experienced a period of uneasy calm, punctuated by brief alarms, since the European Union and the International Monetary Fund put up €860bn of emergency funding facilities at the start of May for any eurozone countries that found themselves unable to access the markets at viable cost. The unprecedented package of supra-national support removed the threat that Greece and any of the other struggling countries (Spain, Portugal, Ireland and possibly Italy) would default or have to restructure their debt in the near term. Even though a measure of normality has returned to debt raising, concerns remain. By mid-August weaker than expected growth in Greece and a hike in Irish interest rates continued to unnerve markets. Investors are still fleeing to haven assets, Andrew Cavenagh reports. VEN THE MOST beleaguered governments in Europe have been able to resume issuing further long-term debt—if still at record spreads to the benchmark German bunds. The reassurance of the EU/IMF backstop has given yield-desperate investors the confidence to take advantage of the high pricing on offer (relative to the miserable returns available on German, Dutch, French and UK government bonds). “Everyone has started looking at the mouth-watering yields on offer,” says Marc Ostwald, strategist on the

institutional bond desk at Monument Securities in London. “You’ve got this situation where German bunds may offer a safe haven, but they also offer extremely poor value.” Spain, for example, was able to raise just under €3.5bn from a mix of 10year and 30-year bonds in mid-June, selling both instruments at yields that were actually below their secondary market prices at the time. The €3bn of 10-year debt sold at a yield of 4.86% (compared with 4.97% ahead of the auction), while the €497m of 30-year

debt achieved a yield of 5.9% (against 5.98%). Portugal also auctioned off €1.68bn of one-year and nine-year bonds in July at yields of 3.159% and 5.304% respectively; although the latter represented a higher cost of funding than Lisbon could have accessed from the European Financial Stability Facility. The stronger continental European countries have also tapped the market heavily since the beginning of May. France’s debt-management agency AFT issued more than €50bn of long-term OATs and medium-term BTANs

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In the Markets SOVEREIGN DEBT: STILL-STRAINED INVESTOR APPEAL

between May 6th and July 15th. Only Germany has still to raise the main bulk of its debt-financing this year, but timing is not really a concern for the benchmark European sovereign. Meanwhile, the Debt Management Office (DMO) in the UK approached the halfway mark for its lower revised target of £165bn of gilt sales in the 2010/11 financial year, after issuing £6bn of longterm index-linked gilts via a syndicated offering at the end of July [please refer to box: UK DMO opts for syndication, on page 26]. All of the distressed European countries have now covered their sovereign refinancing requirements through to the first quarter of 2011, which has further calmed fears that any of them will face a funding or liquidity crisis in the next few months. Confidence remains fragile, however, to say the least. This has been evident from the disproportionate impact that relatively insignificant and predictable negative events have had on general risk perception (and spreads) of all peripheral European sovereign debt since early May. Moody’s decision to downgrade Portugal’s sovereign rating two notches to A1 at the end of the first week of July, and the collapse of Hungary’s negotiations with the IMF later in the month are just two examples. This sudden volatility in spreads and liquidity has changed the composition of the investor base for European sovereign debt over the past eight months. While indexed bond investors have continued to invest in the peripheral European sovereigns—albeit reluctantly in some cases— others, particularly many of those outside the euro area, have not. “Many non-EU investors have largely abandoned the peripheral European states,” explains Justin Knight, head of European rates strategy at UBS. “The dynamic of continued high issuance in the European periphery into a smaller pool of investors means that something has to give at some point.”

Gross Issuance of Troubled European Sovereigns (€bn) Country Italy Spain Portugal Ireland Greece

2007 170.2 23.5 9.5 6 35.8

2008 186.9 47.2 11.8 11 36

* forecast ** rough forecast

Some of the appetite for the more recent issues from these countries has certainly come from short-term investors, including hedge funds, who have been seeking a more profitable home for three-month deposits than the money markets. These same hedge funds appear not to necessarily have any confidence in the long-term outlook for those economies.“The carry [over the three-month money markets] is enormous, without going very far down the curve,” says Ostwald at Monument Securities. As the peripheral countries still have large volumes of debt to raise this year and next [see table above], the shrinking pool of investors for their bonds is a clear threat to their continuing ability to sell debt.

Investor pool Spain may well be the country that stretches the diminished investor pool to breaking point. The country was the focus of most of the nervousness in the market from the time that the EU and IMF put their rescue package in place to the point at which it successfully completed a big bond redemption at the end of July, and it still has a huge amount to issue (relative to historical levels) over the next 18 months. The Spanish government is aiming to sell a further €40bn of sovereign debt this year, which would take its total issuance for 2010 to €97bn, and it will need to raise more than another €100bn in 2011. While these figures roughly match that for 2009, they represent more

2009 253 107 14.8 32 47.7

2010* 240 97 20 20 18.4

2011** 221 108 21 23 0

Source: UBS, supplied August 2010.

than double the 2008 total of €47bn and quadruple the €23.5bn raised in 2007. “Essentially you’ve got continuing record levels of issuance—at four times 2007 levels— into an investor base that is much smaller than it was,” explained Knight at UBS. With so many US and Asian investors now shunning the bonds of peripheral European states, the chances of Spain being able to place all this debt at a sustainable cost do not look good. Further ratings downgrades in the month ahead will reduce the appeal of peripheral sovereign debt yet further. For example, Moody’s seems certain to follow Standard & Poor’s and Fitch in downgrading Spain’s triple-A rating after the three-month review it began conducting in late June. As a result of all these pressures, Knight and his team at UBS believe the European sovereign debt crisis is not yet over and that the EU will have to make decisive decision, about the future of the eurozone at some point in the next 18 months. Because the scale of the funding requirements mean, there is unlikely to be enough time for the markets to return to normal operation (without the support of the European Central Bank’s bondpurchase programme and the existence (but not use of the EU/IMF package), the choice will be between fiscal union or a break-up of the euro area. Given the economic and political cost of dismantling the euro, a move to fiscal union seems the more likely

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

measure it understand it apply it sĂZ ƌĞŵĂŝŶƐ Ăƚ ƚŚĞ ŚĞĂƌƚ ŽĨ ƌŝƐŬ ĞƐƟ ŵĂƟ ŽŶ ĨŽƌ ďĂŶŬƐ ĂŶĚ ĂƐƐĞƚ ŵĂŶĂŐĞƌƐ But a single VaR number is not the whole story D ƉƉůŝĐĂƟ ŽŶƐ Excerpt ĚĞůŝǀĞƌƐ͗ ^ŚŽƌƚͲƚĞƌŵ ĂŶĚ ůŽŶŐͲƚĞƌŵ sĂZ hƐĞƌ ĚĞĮ ŶĞĚ ƌŝƐŬ ĂƩ ƌŝďƵƟ ŽŶ ŽŵƉƌĞŚĞŶƐŝǀĞ ŝŶƐƚƌƵŵĞŶƚ ĐŽǀĞƌĂŐĞ ƌŽďƵƐƚ ƐƚĂƟ ƐƟ ĐĂů ŵŽĚĞů ĂƐǇ ŝŶƚĞŐƌĂƟ ŽŶ ŝŶƚŽ ǇŽƵƌ ŝŶǀĞƐƚŵĞŶƚ ƉƌŽĐĞƐƐ

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ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

In the Markets SOVEREIGN DEBT: STILL-STRAINED INVESTOR APPEAL

outcome. That certainly would be the particular outcome favoured by Germany, which is a prime mover of the European project and one of the largest beneficiaries of the single currency. The euro has kept its exports far more competitive than they would otherwise have been, given the extent to which its fiscal policies are already aligned to the European central bank. Sovereign investors are meanwhile rebalancing their portfolios towards the emerging markets, much of whose debt now offers a combination of yield and reassuring fundamentals that most of the industrialised world cannot match; and are unlikely to for the foreseeable future. Indonesia has been the star performer this year. Its local-currency bonds have given investors a return of 15%, while Fitch and Standard & Poor’s both upgraded the country’s sovereign rating in January and March respectively (in Fitch’s case to the highest notch below investment grade). “People are waking up to the fact, finally, that the fiscal position in most of the developing world is so much better than in the G7 countries,” holds Ostwald at Monument. Further evidence of the growing importance of developing world debt to the sovereign markets came in the first half of July, when the world’s leading bond investor PIMCO launched two further indices to cover sovereign bonds in the first half of July. Both are weighted by the GDP of the country involved rather than the traditional criterion of market capitalisation (or issuance volume). Ramin Tolui, PIMCO executive vicepresident and portfolio manager at the firm’s Newport Beach office in California, explains that the PIMCO Global Advantage Government Bond Index and the European Advantage Government Bond Index would make it easier for investors to identify the value of sovereign (and corporate) debt

instruments in the countries that are accounting for an increasing share of global GDP. As the explosion of debt issuance in the industrialised countries continues to re-shape the sovereign debt markets, he says the new indices will avoid the bias of the historical counterparts towards high-volume issuers and focus on more favourable performance criteria. Mike Riddell, who manages M&G’s International Sovereign Bond Fund, warns, however, that the rush into developing country debt could lead to serious valuation anomalies. He points out that at the beginning of August double-B rated Indonesian bonds with a 10-year maturity were trading at 130 basis points (bps) over US Treasuries, while comparable Bermudan debt (rated 10 notches higher at double-A plus) was out at 200bps. “In terms of credit ratings that is huge,” says Riddell. Emerging market debt will also be vulnerable to the real “elephant in the room” in the sovereign markets—that yields on US Treasuries come under upwards pressure from a combination from the country’s continuing policy of fiscal stimulation (in marked contrast to all the European economies) and a second economic downturn. Worrying economic data out of the US over the past two months have suggested this is a serious risk. Ratings agencies have been careful to warn of the dangers; Moody’s warned in May that the country’s triple-A rating could come under threat if the government did nothing to curb spending. With outstanding US government debt forecast to double over the next decade from its level of around US$7,500bn at the end of 2009, there is clearly now a real prospect that the world’s ultimate reserve currency will come under unprecedented pressure with dire consequences for all others. “If US Treasury yields start spiking up, it will affect the entire financial market,” says Riddell. ■

UK DMO OPTS FOR SYNDICATION he DMO chose to sell the Index Linked Treasury Gilt 2040, which pays a coupon of 0.625%, through a syndication rather than auction to increase the size of the issue. Recent auctions for long-term index-linked gilts have seldom sold much over £1bn, and given current constraints on the balance sheets of primary dealers, syndication clearly offered the chance of building a much larger book. The strategy was highly effective. Within two hours, joint book runners Deutsche Bank, Goldman Sachs, HSBC and Royal Bank of Scotland were able to close the book with 64 bids totaling £9.8bn, pricing the deal at the bottom end of initial guidance (flat to the yield on the 1.125% Index Linked Treasury Gilt 2037). Pricing at £89.914 per £100 of nominal value, the sale raised proceeds of £5.6bn and took the DMO’s total issuance for the year to £75.6bn. Meantime, receipts from syndicated offerings rose to £17.3bn (out of a target of £26bn). Domestic investors accounted for 99% of the issue, with strong interest from fund managers, pension funds and insurance companies. Robert Stheeman, the DMO chief executive, says the issue had again seen the “mobilisation of high-quality demand from our core investor base” to create a 30-year index-linked gilt of benchmark size.

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

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In the Markets SUKUK: NOMURA’S ISLAMIC DEBUT MARKS NEW ASIAN ISSUE UPSURGE

THE NEW WAVE

If there was ever an indication that Islamic finance is fully embedded in the mainstream of global finance then investment bank Nomura’s debut commodity murabaha facility in July, which raised $70m through syndication, is it. Within days, the bank also listed a $100m two-year Sukuk al-Ijarah on Bursa Malaysia, in a listing arranged by Kuwait Finance House; the first sukuk listing by an Asian (or Japanese for that matter) entity. By Francesca Carnevale. OMURA INCREASED THE size of its three-year Shari’a compliant commodity murabaha facility in July from $50m to $70m due to investor demand. Takuya Furuya, Nomura’s chairman for the Middle East and Africa, acknowledges the transaction, “exceeded our initial expectation ... The issuance [sic] is part of Nomura’s strategy to diversify funding both geographically and by product, and comes at a time when we have simultaneously launched a sukuk in Malaysia”. He adds: “The facility marks the first Islamic funding exercise by a Japanese corporate [sic] in the region and we hope that it will strengthen the financial ties between the Far East and the Middle East.” The facility, lead arranged by ABC Islamic Bank, offers a profit margin of 175 basis points (bps) a year. As it is largely a symbolic debut transaction by Nomura in Islamic finance, the funds will be utilised for general liquidity management purposes. “ABC Islamic has a strong syndication team and it was the strength of the relationships that they were able to demonstrate that helped us to choose ABC Islamic for the murabaha,” adds Furuya. The murabaha was competitive with traditional syndications, acknowledges Furuya.“However, it is important to realise

that the strength of the Nomura franchise in our home market means that international issuance/syndication outside our home market is by default more expensive. However, taking this differential into account, using the secondary levels of our conventional international issues as a pricing guide and the differential arising from documentation differences, we felt that the pricing was competitive,” he says. Moreover, the issue achieved a key goal for the bank which was pleased to see the emergence of new investors in its fund raising efforts. “Regarding investor class,”adds Furuya,“We did see a significant difference. This diversification was one of the key goals for this issuance.”

Ijara sukuk In late July, Nomura followed up with a listing of a $100m Ijara (a type of leasing structure) sukuk on Bursa Malaysia, arranged by Kuwait City-based Kuwait Finance House (KFH). The transaction was rated BBB+ by Standard & Poor’s. NBB Ijarah (NBBI), a special purpose legal entity, will sell its legal interests in two aircraft assets to the trustee and will act as the transaction’s servicing agent. NBBI will then purchase the underlying assets at maturity. Nomura will guarantee all of NBBI’s obligations to the trustee. The listing is part of Nomura’s ongoing push

to diversify its funding sources to drive growth, says Furuya. The sukuk came in at 160 bps above Libor. “Islamic investors and Islamic finance are a very important and rapidly growing sector globally and this transaction is highly significant for Nomura and for corporate Japan. We wanted to diversify our investor base; to demonstrate our ability to structure Shari’a compliant products and to provide our Japanese clients with an alternative financing structure. It was therefore important that Nomura was the first to tap this market in a shari’a compliant manner. We were impressed by the speed with which KFH was able to help us structure a transaction. We also liked the depth of their relationships across both the MENA and Far East,” he adds. Both issues were substantially oversubscribed, and while the Nomura brand invariably counts for much, Furuya was not particularly surprised at the level of demand: “We have recently actively sought to diversify our funding sources away from our home market in Japan. We have re-entered the global debt markets with a €1bn five-year transaction, for instance, which was nearly three times oversubscribed. In addition, we launched a global note programme in the US with both five and ten-year tranches (overall some

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

Photograph © Sergey Skrebnev / Dreamstime.com, supplied August 2010.

$3bn was issued) and this was over four times oversubscribed. We have therefore seen a considerable demand for Japanese financial credits as investors seek to diversify their holdings. Therefore, the oversubscription we saw on these transactions was not surprising, but re-assuring nonetheless.” Nomura’s listing also underscored the growing prominence of Malaysia as the most active corporate sukuk market, which now boasts some $2.9bn-worth of sukuk programmes, across 15 sukuk by 13 separate issuers. Two are international. Says Yusli Mohamed Yusoff (see also A new way with investors, pages 35/36) says: “We certainly have made great strides in the sukuk market and the listing of Nomura’s sukuk is further demonstration of foreign players’ confidence towards Islamic securities and instruments issued out of Malaysia.” The next Japanese Islamic bond is set for the third quarter this year, according to local Malaysian press reports. Sumitomo Corporation is reportedly set to tap investors for a Shari’a compliant structure, though the firm declined to comment when we approached them for verification. If the reports are true, Sumitomo is said to want to issue a yendenominated sukuk in its home market, which would be a first, as local banking regulations are not really set up for an

FTSE GLOBAL MARKETS • SEPTEMBER 2010

Nomura’s listing also underscored the growing prominence of Malaysia as the most active corporate sukuk market, which now boasts some $2.9bn-worth of sukuk programmes, across 15 sukuk by 13 separate issuers. offering of this type. Last year Japan’s finance ministry and the central bank amended local regulations, allowing the foreign subsidiaries of Japanese financial institutions to raise finance via Shari’a compliant structures, such as investment funds and sukuk. However, more extensive reform of the country’s financial laws that would allow the full scale introduction of Islamic financing instruments in the country is still on the back-burner. If Sumitomo does issue a debut sukuk in Japan, it is likely that it will be a variant on a traditional asset-backed structure, with an Islamic wrapper. Actually, Japanese institutions are not strangers to the Islamic finance industry. Nomura is the fund manager for the Al-Tawfeek Investment Company’s Islamic Japanese Equity

Fund and Daiwa Securities who launched an Islamic exchange-traded fund a couple of years ago which is still listed on the Singapore Stock Exchange and which tracks the FTSE Asia Shari’a 100 Index. In the takaful (insurance) segment, Tokyo Marine & Fire Insurance Company works in joint venture with Malaysia’s Hong Leong Islamic Bank and also writes insurance in some GCC markets. Although corporations continue to dominate the Islamic issuance calendar (accounting for around three quarters of total issuance), this year a number of prominent national issuers have made the headlines. According to Husam Hourani of law firm Al Tamimi & Company, “Islamic offerings by sovereign issuers have increased due to the relative stability of governments in the GCC and Asia at a time when corporate Islamic offerings based on real estate assets have suffered as a result of instability in the real estate markets.” The most active sovereign issuers of Islamic debt instruments so far have been Malaysia, Qatar, Bahrain, and Pakistan, along with some of the multilateral institutions, including the Islamic Development Bank and the World Bank. Geographically, Asia, and especially Malaysia, continues to lead the global Islamic volume league tables, though issuance in the GCC is

In the Markets SUKUK: NOMURA’S ISLAMIC DEBUT MARKS NEW ASIAN ISSUE UPSURGE

beginning to play catch up which is “due to the continued attractiveness of Islamic investments to both institutional and retail local investors throughout the GCC and MENA region”, says Hourani. There is also increasing diversification at the sovereign level, particularly in Malaysia. Bursa Malaysia is already the leading exchange for Islamic sukuk. Other South-east Asian governments, such as Singapore and Indonesia, also appear to understand the strategic importance of tapping into the enormous potential of Islamic capital markets and are taking a long-term perspective by investing in developing products and services to attract Middle East capital investments. For Middle East investors, the Asia-Pacific region looks to be a viable alternative investment destination than the developed markets in Europe and the United States.

Issuance calendar The Asian sovereign Islamic issuance calendar looks to remain constant through the remainder of this year, and many expect Islamic issuances to continue to increase throughout 2011, says Hourani. Following the success of Malaysia $1.25bn murabaha dollar bond, arranged by Bank Negara, in late May— its first global offering in eight years— the government has now decided that Khazanah, the state holding company, will also utilise the Islamic capital market. Malaysia’s May Sukuk I three-year notes had provided a benchmark for pricing Shari’a compliant bonds in the domestic market, which was priced at 5% per annum with profit payments made quarterly. Malaysia had last issued a global bond back in 2002, when it debuted an international sovereign sukuk, valued at $600m. Now the government is keen to see its state holding establish its own benchmarks overseas. In early August, Khazanah quickly set the pace, selling both a five-year and a ten-year sukuk, worth a combined $1.1bn

Husam Hourani of law firm Al Tamimi & Company: “Islamic offerings by sovereign issuers have increased due to the relative stability of governments in the GCC and Asia at a time when corporate Islamic offerings based on real estate assets have suffered as a result of instability in the real estate markets.” Photograph kindly supplied by Al Tamimi & Company, August 2010

under a sukuk wakala structure, in Singapore. The transaction is the first SGD sukuk issuance out of the Malaysia International Islamic Financial Centre (MIFC) initiative. The MIFC initiative promotes Malaysia as an Islamic finance global hub. The Khazanah SGD Sukuk issue is also the jurisdiction’s largest Islamic bond issue to date. The sukuk, which was arranged by Malaysia’s CIMB, and Singapore’s DBS and OCBC, was divided into notes worth a total of SGD600m with a maturity of five years at 2.615% and SGD900m worth of notes with a maturity of 10 years at 3.725%. The value of the sukuk was increased from SGD1bn, due to substantial oversubscription. The deal attracted 78 local and international investors

comprising financial institutions, asset management firms, statutory bodies and insurance companies from Singapore, Malaysia, Hong Kong, Brunei and Europe, according to a Khazanah official release. The bond issue followed on quickly from Khazanah’s successful takeover of Singapore’s Parkway holdings at the end of July, in a transaction valued at $3.5bn. Elsewhere, Indonesia, which had been expected to come to market at the beginning of the fourth quarter this year with a global sukuk worth between $500m and $600m, has now decided to scale back its 2010 issuance calendar by up to a quarter. Larger than expected revenues and good growth expectations have encouraged the government to cut back on its original plans to issue $6.4bn worth of debt by around $1.7bn. Even so, the Islamic bond is expected to go ahead. State-owned Islamic Bank of Thailand is also expected to come to market in the last quarter with a modest issue, worth around $150m (around THB1bn). The issue of bonds in the Thai market has been on the back-burner for a number of years given investor concerns around the lack of clarity in the country’s withholding tax regime.

Kazakhstan debut Further afield, following the decision by the Kazakhstan government to cancel a planned $750m eurobond which had been expected to launch in the third quarter, after it had secured $1bn in financing from the World Bank, reports abounded that the sovereign issuer might soon tap the Islamic sukuk market. Of late, Kazakh issues have gone from hero to zero, following the country’s banking crisis in 2008. Moody’s rates the sovereign issuer’s debt at Baa2, its second lowest investment grade rating. It will be interesting to see whether a shift towards Islamic finance will establish a new investor profile for the hard-pressed Kazakhs. ■

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In the Markets GLOBAL TRADE: CHANGING LANES

In the post financial crisis period it is increasingly apparent that trade momentum has shifted away from the West to the emerging markets. The growing purchasing power of Asian consumers is fuelling global trade, and will be especially significant with respect to fostering intra-emerging market trade. China has been boosting its economic presence in Africa for more than a decade and India has not been far behind as an investor in the subcontinent. Brazil is the latest emerging economic powerhouse to try and stamp its mark on Africa. However, in contrast with China, it is Brazil’s private sector that is breaking ground mostly by itself in countries such as Sudan and Angola. The expectation is cultural affinities, technological ability and, hopefully, maybe a little push from the government in the form of favourable trade credit lines will help. Rodrigo Amaral reports.

BRAZIL STEPS UP THE PACE IN AFRICA DIPLOMATIC PRIORITY for the government of president Luiz Inacio Lula da Silva of Brazil has been to strengthen commercial links with Africa. Trade with the region has been on the rise in the past two decades. Since Lula came to power in 2003, exports to African nations increased fourfold to $10.2bn by the end of 2008. The global economic crisis made a dent in the country’s performance, but volumes look to be recovering. In 1989, Brazilian exports to Africa, excluding Middle Eastern countries, amounted to less than $1bn. In 2010, the same benchmark was breached in the first two months of the year. Trade in the other direction has increased even more steeply. In 1989, Brazil imported less than $600m of African products; last year, the volume was $8.5bn. Even if the raw numbers look impressive, there is a feeling among many Brazilian companies that much more can be done to take advantage of the rapid development of Africa, as the share of Brazilian exports represented by sales to

Africa still amounts to less than 6% of the country’s overseas sales. Major Brazilian multinationals such as Petrobras (oil), Vale (mining) and Oderbrecht (construction) have for some time added Africa to their range of international operations. Now, however, even smaller companies are beginning to engage in their own African adventures. A sector where interest has been greatest is agribusiness. Brazil has transformed itself into a major agriculture power over the past two decades and companies have identified conditions in Africa to replicate some of their successful experiences at home. In April this year, Grupo Pinesso, a large agriculture conglomerate based in the farming state of Mato Grosso, announced it would begin producing soy beans and cotton in Sudan. The deal is based on a partnership with Agadi, a Sudanese company, and stipulates that the Brazilians will oversee the cultivation of 400 hectares of cotton and 100 hectares of soy beans, while

providing technical expertise. The investment, worth $200m over four years, will spread cultivation over a total of 100,000 hectares. Net profits will be shared between the two companies. The project reflects two facets of doing business in Africa. On one hand, it is necessary to rebuild capacity lost over decades of mismanagement or war. On the other, there is the opportunity to find new areas of cultivation where African countries can excel. In the Sudan, for instance, where there is a long history of cotton cultivation which was degraded over the years through neglect and mismanagement, an opportunity now exists to change to soya cultivation, as production costs are projected to be only half those in Brazil.

Prime location “The Sudanese had never planted soy beans before,” says Paulo Hegg, a foreign trade consultant based in São Paulo who helped to develop the contacts between the Brazilians and the Sudanese. Hegg thinks that Sudan could be producing the commodity with techniques similar to those that catapulted Brazil into the top league of agricultural producers. When he announced the Sudan deal, Pinesso highlighted not only the favourable production conditions of the land, but also its prime location for Brazilian companies to reach near markets such as India and China. There are also opportunities closer to home. Hegg points out that, being

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

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In the Markets GLOBAL TRADE: CHANGING LANES

made in a poor African country, Sudan’s agricultural products enjoy very favourable conditions to enter European markets; something that Brazilian producers can only dream about. Setting up shop in a country such as Sudan could be a strategy to reach a protectionist market that is usually very hard for them to tackle.“We are taking a shortcut, albeit one that is longer than the actual road, to European markets,” he says. Hegg also points out that Tirolez, a dairy company owned by his family, is thinking of creating a cheese manufacturing plant in Sudan. “Sudan has the land and plenty of sun, and they are in a good geographic position to export to markets such as Europe and Saudi Arabia,” agrees Everardo Mantovani, a director of Irriger, an engineering and consultancy firm that has been managing irrigation projects in the country. Companies like his represent another facet of Brazilian business with Africa, mainly the transfer of technologies that could help boost the local economy. Irriger, itself a small company, has been working in Sudan since 2008 and has four representatives living there. “There are irrigation projects in Sudan that we would not even dare thinking about in Brazil,” Mantovani says. “Here, a large project involves some 5,000 hectares of land. In Sudan, they routinely talk about 10,000, 50,000 or 100,000 hectares for a project.” Brazilians are world-beaters in technology for agriculture, and the state-owned company Embrapa is a world-class reference of research in the area. This is another key that is opening doors for Brazilian entrepreneurs in the continent. Hegg says that during a meeting of the Brazilian government with 43 African agricultural ministers in May, almost all of them asked whether it would be possible for Brazil to take Embrapa to their countries.

Sugar and ethanol Sudan has also been favoured by a number of Brazilian companies that produce sugar and ethanol, and which have identified the country as a place where the production of sugar cane and its subsequent processing can be done at very reasonable costs. Some ethanol projects are being developed with the participation of firms such as Irriger and Kenana, a Sudanese firm, which purchased a €15m plant in Brazil in 2009 to begin producing ethanol there. Although the transfer of prime technology in a nascent, strategic industry like ethanol to a possible future competitor could be a risky thing for Brazilian companies to do, market players say that this is exactly what Brazil should do to advance its long-term interests in the sector. “Today, nobody wants to be dependent on a single provider of fossil energy,” explains Antonio Carlos Christiano, chief executive officer of Sermatec, a leading provider of equipments to sugar and ethanol plants. “In the same way, nobody will want in the future to rely on a single producer of ethanol. We need to consolidate an international market for ethanol, and helping Africa to produce it is a tool for it.” He adds: “We see Africa as a region with great potential to produce ethanol in a similar way that Brazil does. The weather, the land and the water sources are much like the conditions we have in Brazil. Therefore, we at Sermatec see Africa as a huge commercial opportunity.” His firm is involved in an initiative to create a large ethanol complex in Angola, another country that is firmly in the radar of Brazilian firms. The $200m Biocom project has among its partners Odebrecht and Sonangol, the stateowned Angolan oil producer. Thanks to an oil bonanza and the efforts to rebuild the country after a long civil war, Angola is living an economic boom and, not only for technological

reasons but cultural ones, too, is particularly welcoming to Brazilian companies, according to Christiano. There are cultural affinities to play on as well. “The Angolans love Brazilians,”he says. Other companies say that the favourable view of Brazil, which boasts the largest population of African origin outside of the African continent, is an asset for them elsewhere, too. Many Sudanese, for example, appreciate the fact that Brazilians don’t subscribe uncritically to American-inspired views of the country, which have turned Sudan into a pariah with the West. “Sudan is a very little-known country,” says Mantovani. “No one denies the problems in Darfur, for instance. Behind the American embargo is the fact that the Americans have been left out of oil exploration there, to the benefit of the Chinese.”

Upside and downside Not everything, however, is conducive to improving Brazil’s economic links to Africa. “Other companies are coming to Sudan,” says Mantovani. “It is a big movement, but a recent one, too. The main hurdle right now is the lack of official credit lines to trade with Africa, and it is hard to compete with the Chinese and their costs.” BNDES, a state-owned Brazilian development bank which provides favourable credit lines for companies that trade with countries such as Argentina and other main commercial partners of Brazil, is said to be studying the creation of such instruments. However, firms acknowledge that this is not an easy thing to do, due to the financial and political risks involved. However, if Brazil wants to fulfil its pledge to become a major player in Africa, as China has done, something of this sort will have to be arranged. “Brazil is expected to become the fifth largest economy in the world,”says Hegg. “We have to begin to think big as well.” ■

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

Stock Exchange Report BURSA MALAYSIA LEADS NATIONAL INVESTOR CHARGE

As part of the government’s “new economic model”, launched earlier this year, Malaysia is stepping up efforts to attract foreign investment; direct and indirect. Bursa Malaysia is a keystone in this multiple, pronged strategy that involves firming the exchange’s dominance as a venue for Islamic issuance, privatisation of state-owned firms within the Khazanah Nasional holding and continuing to upgrade the exchange’s infrastructure and product set. It’s a multi-agency, collaborative effort, which involves Bursa Malaysia, the Securities Commission (SC), Bank Negara (the central bank) and other state agencies. Francesca Carnevale spoke to a Malaysian delegation that visited London in July.

A NEW WAY WITH INVESTORS TATE-OWNED INVESTMENT arm Khazanah Nasional formally kicked off Malaysia’s latest investment expansion programme in March this year when it announced plans to divest its controlling 32% stake in Pos Malaysia. Though actually Khazanah has been steadily selling down its stakes in a number of government-linked companies (GLCs) such as Tenaga Nasional, Malaysia Airports Holdings and PLUS Expressways, since the middle of last year. Since March however, a number of firms have been slated for either strategic sales or listings on Bursa Malaysia, including Percetakan Nasional Malaysia, CTRM Aero Composites, and biotech firms Ninebio and InnoBio. Although it will benefit from a subsequent increase in IPO opportunities, the real challenge for Bursa Malaysia is twofold. One, how can it effectively compete for liquidity in a global marketplace strained of funds and which is increasingly placing those funds into high-growth markets such as Turkey, Singapore, Brazil and India? Second,

FTSE GLOBAL MARKETS • SEPTEMBER 2010

how does it increase liquidity at home? Up to now, only a handful of pension funds, such as the Employees Provident Fund (EPF), dominate daily trading volumes on the exchange. EPF itself, has assets worth around MYR30bn ($9.6bn), with about a quarter invested in the local stock market. Bursa Malaysia’s total market capitalisation is a smidgen over MYR1trn. Firms such as EPF are being encouraged to invest directly into the Malaysian economy to diversify its portfolio and help stimulate growth; however, funds including EPF are now also looking overseas for investment returns. Already around 6% of the fund is invested offshore. In July, a delegation comprising the Securities Commission Malaysia and Bursa Malaysia arrived in London during a tour of Europe’s financial capitals. Explains Yusli Mohamed Yusoff, chief executive officer, Bursa Malaysia: “We want to make inroads into the European investor base; it is a process of engagement with the industry; letting people know the fundamental benefits of investing in Malaysia—rapid,

Photograph © Bahar Bostanci / Dreamstime.com, supplied August 2010.

sustainable growth, financial stability and a pro-active policy to stimulate investment. This latest economic transition is all-encompassing, involving a shift from an agricultural to an industrial production base, a movement to higher value and the reposition of the country to take advantage of global changes.” “The creation of new products to facilitate diversification of investment portfolios by investors and fund managers is an important feature of our market,” notes Ranjit Ajit Singh, managing director, Securities Commission Malaysia. “The World Bank, Asian Development Bank and International Finance Corporation have all raised funds through our bond market and we have seen foreign companies seeking both primary and secondary listings for their bonds on Bursa Malaysia.” Unit Trusts is one of the fastest growing segments of the Malaysian capital market in the investment management industry, notes Yusli. Malaysia has the largest unit trust industry in ASEAN and a fund management industry that, adds Singh,

Stock Exchange Report BURSA MALAYSIA LEADS NATIONAL INVESTOR CHARGE

“has been the fastest-growing segment of our capital market over the past few years”. As of the end of June this year, the total net asset value of unit trust funds stood at MYR207bn (around $66bn), representing almost 20% of Bursa Malaysia Securities market capitalisation. Malaysia’s bond market, however, is the icing on the cake. As a percentage of GDP, the Malaysian bond market is the second-largest market in Asia (exJapan). Most notably, Malaysia has, over the years developed one of the largest, or at least the most comprehensive, Islamic capital markets in the world, offering an array of Shari’a-compliant products. Over 88% of the stocks listed on Bursa Malaysia making up 64% of total market capitalisation are Shari’a compliant. “Our sukuk market has experienced unprecedented growth over the years. In 2009, over 59% of all bonds approved by the SC were sukuk,” notes Singh. Two benchmark deals this year have cemented the country’s dominance in the sector. In May, the Malaysian government raised a $1.25bn sovereign sukuk; the largest US dollar sovereign sukuk globally to date, attracting more than 270 international investors. In July, Cagamas Berhad, the national mortgage corporation, launched a benchmark Sukuk al-Amanah Li al-Istithmar under its MYR5bn ($1.53bn) Islamic Commercial Paper (ICP) and Islamic Medium Term Note (IMTN) programmes. The Islamic unit trust industry has also made significant progress. Malaysia currently has 151 Islamic unit trust funds with a total NAV amounting to MYR22.69bn (just over $7bn). “The Islamic fund management segment has been fully liberalised with attractive tax incentives as well as mandates to foreign players,” highlights Singh. “We now have 14 full-fledged Islamic fund managers operating in Malaysia's Islamic capital market.” It is a comprehensive, multi-layered approach, concedes Yusli. Bursa Malaysia

had also been involved in the government-sponsored Corporate Governance Week at the end of June, to help promote good corporate governance practices among publicly-listed companies, a theme that has been at the heart of Yusli’s long-term promotion of firms on the exchange. “It is a necessary precondition to sustained investment,” he avers. “This is even more important at the present time as stakeholders and investors demand company directors to be more transparent, and practice sound governance. It formed an important part of our new framework for listings and equity fund raisings, which we introduced, together with the Securities Commission, in August last year. Enhanced standards of due diligence, disclosures and corporate governance were part of the package.”

Different approach Hand in hand with other changes, such as the expansion of the exchange’s securities lending programmes, it also revamped its benchmark indices. The Kuala Lumpur Composite Index (KLCI) was transitioned to the FTSE Bursa Malaysia KLCI to become the primary market benchmark and the number of firms in the index was reduced from 50 to 30. According to Paul Hoff, director of FTSE Group in Asia, a very different approach was applied to the methodology,“ taking simply the largest listed companies on the exchange”. He adds: “This created a more transparent, investible and tradable benchmark, which also will stimulate the creation of ETFs, derivatives and other index linked products.” Sing says: “We have an internationally benchmarked regulatory infrastructure that has been assessed to be highly compliant with international standards, and our investor protection framework has been rated consistently by the World Bank as being among the top four in the world. We continue to be mindful

of the need to strengthen our regulatory framework and ensure appropriate supervision and oversight. We must heed the lessons of the global financial crisis and ensure that we continue to pay attention to investor protection.” Europe is but one hunting ground, however. Malaysia has also made inroads into the Chinese market, on the back of a long-term and substantive trade finance business. Malaysia's total trade with China exceeded $36bn over the last 12 months. China is now Malaysia's largest trading partner, with exports to China in the first five months of this year rising by 82.2% to $19.1bn. However, the level of cross-border participation and investment in the capital markets between China and Malaysia remains relatively low. “With the recognition of Malaysia as a QDII investment destination, it is our hope that Chinese participation in the Malaysian capital market and vice versa will show a step jump in improvement,” adds Yusli. While international business lines are a priority; Bursa Malaysia has not ignored the local retail segment; a significant element in any Asian equity market. In early August, Bursa Malaysia, the Securities Commission Malaysia and Bank Negara Malaysia introduced an electronic share payment facility to promote the use of e-payments in the stock market. With e-Share payment, a stockbroker can directly deposit share sales proceeds directly into the investors' bank accounts. Investors in shares can now initiate payments to their stockbrokers via electronic channels or can avail auto-debit facility by authorising their banker to debit their designated bank account directly. The facility does away with the need to deposit and collect cheques, and eliminates issues of misplaced, lost or expired cheques. Investors can subscribe to e-Share with their respective brokers. The service will be provided by all the stockbrokers at no extra charge. ■

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

Asset Allocation SHOPPING MALLS: DO THEY NEED A SPRING CLEAN?

Where have all the new shopping centres gone? Time was when malls were being thrown up in all parts of Europe, nowhere more so than Central and Eastern Europe. Post-recession, the development pipeline has all but frozen and new space is coming to market at a slow trickle. With debt facilities still scarce and most malls worth considerably less than their owners paid for them, few shopping centres are changing hands either. With investors hunkered down for the long term, the emphasis has switched from capital growth to income optimisation. The age of asset management has well and truly arrived, says Mark Faithfull.

A BIRD IN THE HAND D

ISTRESSED ASSETS AND opportunity or vulture funds were supposed to unlock the moribund retail real estate transaction market, yet the anticipated feeding frenzy never came. Most banks and institutional investors have preferred instead to hold on to their retail stocks and to wait it out for better times. Instead, the brakes have all but been slammed on development, and owners have been forced to re-examine their portfolios and their individual assets microscopically. The result is an about-face in investment emphasis, the emergence of outperforming niche sectors, asset leverage to fund new investment and a looming future retail crisis. The situation favours those with strong reputations in what in retail parlance is known as asset management. Exactly what comes under that umbrella depends to some extent on who you speak to, but in an asset class where tenant churn is expected to be somewhat dynamic and where success is based on both footfall and centre-wide sales, it broadly breaks down to reinvigorating the retail mix, optimising revenue streams, improving centre features and attractions and minimising voids (empty shops). At its most aggressive, it can involve reformating or even repurposing a mall to give it longer-term viability, and those who have proven themselves best at it are already reaping the rewards.

FTSE GLOBAL MARKETS • SEPTEMBER 2010

In June, Dutch investor PGGM invested about €75m in Standard Life Investments’ UK Shopping Centre Trust. Launched in 2005, the trust has built up a €1.3bn portfolio, structured as a closed-end Jersey Property Unit Trust providing investors with access to a sub-sector where lot size continues to present a barrier to entry. It is a portfolio of nine prime UK shopping centres; key assets include Brent Cross and Whiteleys, both in London, and Churchill Square, Brighton.

Troubled by voids Standard Life’s asset management history swayed the deal. Mathieu Elshout, senior investment manager at PGGM, concurs: “While the portfolio is essentially core in nature, the assets are actively managed and the management team demonstrated a deep understanding of the market.” Standard Life has focused on prime assets. Its biggest holding is Brent Cross, one of the original malls to open in the UK and which recently won planning permission for extension and improvement as part of a wider urban regeneration plan. Despite their strong locations, Standard Life’s malls have not been left unaffected by the recession and it has been troubled by voids. However, it has responded with an aggressive asset management programme which persuaded PGGM

that there is still potential for income growth. Helen Gordon, property director at Legal & General Life Fund, says her company has launched a fundamental review of its assets and repurposed a number of malls. “We had to make a decision between voids and valuation and in the end we decided to concentrate on keeping voids to a minimum, so we have moved to turnover rents where necessary, working to lower costs, taking out underperforming retailers and using temporary lets,” Gordon explains. Legal & General also took a hard line on company voluntary arrangements (CVAs) and pre-pack administrations. The firm now believes that supporting an ailing retailer is often not compatible with looking after successful competitors. Gordon says that shopping centres need to become more relevant to their local environment, more attuned to local influence, churn retailers more regularly and carry out more and smaller refurbishments. In Ealing Broadway shopping centre, West London, where, faced with competition from the then newly-opened mega-scheme Westfield London nearby, Legal & General took out the department store anchor, moved retailers and made some units larger to create a strong fashion centre which served the local catchment’s regular needs. Claire Barber, senior asset manager at REIT British Land, says the adaptation of ownership strategy really began about two years ago. At Meadowhall shopping centre in Sheffield in Yorkshire, the strategy has brought a fresh approach to asset management, with incentive packages, turnover rents and other

Asset Allocation SHOPPING MALLS: DO THEY NEED A SPRING CLEAN?

shorter leases offered “for the right retailers”. However, she insists that with voids down at 1.9% and falling, rentfree periods are decreasing and turnover rents will only be considered where British Land is satisfied it can establish a benchmark figure.“It has been used as an opportunity to freshen up the shopping centre,”she adds. “We’ve really looked to reposition the retail mix and we’ve strengthened footfall as a result.” Ian Parish, head of retail at King Sturge, thinks this increased flexibility will rub off in Europe as a whole. He notes that US retailers sign shorter leases and often move around a mall at lease breaks, aligning their asset write-off period and shop fit costs to shorter tenures.“ It adds to the dynamism of the shopping centre and freshens up the performance of both mall and store,” he says. For investors it means a change of mindset. Long-term, fixed leases provide income certainty yet such an approach is sharply at odds with the dynamic, shorter-term time frame of not only retailers but also consumer preferences. However, they now need to move with the times. Dutch pension fund ABP, for instance, was recently behind a threeway purchase of the highly-sought after Cap 3000 shopping centre in Nice, Southern France. ABP bought with French retail developer Altarea, in which ABP holds an 8% interest. Life insurer Predica was the other financial partner in the deal and also controls a 12% stake in Altarea and is a subsidiary of Crédit Agricole Assurances. Robert-Jan Foortse, head of European non-listed property investments at the asset management unit of ABP, is highly sceptical about real estate per se but ABP likes the look of the French market. He says: “We always invest indirectly in real estate. The closest we will come to direct investments is a joint venture or a partnership like in this purchase. We like the long-term risk-return characteristics of investments in the retail sector.

The Duke of Westminster’s property company, Grosvenor, has initiated talks with four banks that hold a £500m debt facility used to finance the Liverpool One development—Royal Bank of Scotland, HSBC, Barclays and Eurohypo. The debt does not mature until 2012, but Grosvenor is hoping to tap into the current appetite among banks to lend against good quality assets with strong income credentials, owned by strong companies. Last year, Grosvenor raised £20m of new equity from investors in its £521m shopping centre fund, to refinance a £297m RBS debt facility which had been close to breaching loan to-value covenants. It may well go hunting again, with France and Germany favourite for investment. The company has a core French retail fund targeted at pure downtown assets and up to €400m. However, Grosvenor plans a wider European fund that will also look at Germany and other markets outside its traditional focus on France, Spain, Italy and Belgium.

Lack of projects Grosvenor has €12.3bn under management globally. In continental Europe, the group has around €1.9bn invested—over half of which is wrapped up in its holding in Portuguese shopping centre developer Sonae Sierra. The lack of development projects however is storing up a big headache for the retail sector, which threatens to turn into a crisis. Retailers are generally shifting to larger, modern units; a trend seen everywhere in Europe. In mature markets this has manifested itself in store groups closing smaller shops in secondary towns and focusing on developing larger, regional flagships. In emerging markets the impact is even more crucial. In the meantime, it is the niche sectors that are benefiting, notably the fashion outlet sector, which has shown positive growth throughout the downturn. Henderson picks out

European retail warehousing and outlet malls as two of its top niche opportunities, believing that growth in these sectors and mispricing outside core offer the best investment returns in Europe. Henderson senior investment analyst Michael Keogh says value opportunities will remain because of lack of market knowledge about these two retail areas. “Pricing in these markets is interesting, they are not as well known as high street and shopping centre portfolios. The opportunities for growth and for investment exist across Europe,” he reflects. Keogh says that fundamentals include understanding and managing risk, looking at incorrectly priced assets as fear fades in the market, good asset management and repositioning of assets, plus local representation. There’s also a new type of investor in town. The UK’s LXB, chaired by Phil Wrigley, former chief executive of value fashion phenomenon New Look, and Metric being perfect examples. Metric Property Investments, a retail investment vehicle set up by former British Land directors Andrew Jones, Mark Stirling and Valentine Beresford, spent the earlier part of the year raising funds for some targeted acquisitions, notably retail parks. By aiming for less fashionable retail centres—prime malls already look overpriced in most European markets— it can use its management experience to create substantial additional revenue. Andrew Jones, chief executive of Metric, explains: “Acquisitions must satisfy the key investment criteria we set out at the time of the IPO, of acquiring well-let retail investments off low rents and where our retail customers trade successfully.” Metric is being followed by others and it seems highly likely that the investment sector will effectively split in two; with the big institutional funds targeting larger portfolio acquisitions well down the risk curve and specialist funds established at the sub-€500m level to exploit niche, lower level opportunities. ■

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

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Asset Allocation GOLD IS AT AN ALL-TIME HIGH: CAN IT STAY THE COURSE?

MOUNTAIN HIGHS Photograph © Bahar Bostanci / Dreamstime.com, supplied August 2010.

XTREME GOLD BUGS, investment analysts that are bullish on the metal’s prospects, think that investment portfolios should have allocations to gold in excess of 50%. That might be too rich for many investors, but some facts are undisputable. Gold has been on an almost ten-year bull run since 2001 and while its progress over that period has been mostly steady, it has accelerated markedly since the financial crisis of 2008. The principle reason for that price hike appears to have been renewed interest from Western investors and that is an interest principally driven by fear. “We don’t see any really attractive alternative to gold,” says Egon von Greyerz, managing partner of Matterhorn Asset Management AG in Zurich. Von Greyerz is an ardent gold bull, which is probably a good thing given that his view of other assets is grim. “Stock markets are still

In UK terms, gold has outperformed bonds by more than 200% over the last decade. The gold price touched a record high of $1,266 per ounce in June and, despite some backsliding, remains near that historic value. Underpinning the role of gold as a hedge against risk, it should come as no surprise that demand for gold-based exchange-traded funds (ETFs) has begun to outstrip demand for gold bars and coinage. Because of its outperformance over such a sustained period, experts are divided as to the future. Some hold that gold is in the foothills of future peaks; others say the metal is already near its summit. Who has the buzz? Paul Whitfield reports from Paris. over-inflated, and will probably resume their fall in the second half of the year. Rates can’t go lower, property markets will fall, bond markets will come down and money will become virtually worthless,” he intones. How high can gold go? Von Greyerz describes a target price of $7,200 per ounce as “reasonable” but also suggests that should the world economy deteriorate further than even

his pessimistic forecasts, then that price target may prove conservative. In von Greyerz’s view, the credit bubble and resultant banking and sovereign debt problems have locked Western markets into one of two outcomes. Either the value of assets will decline as quantitative easing is reined in, leading to a deflationary spiral, or governments continue to print

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

money as a means of inflating their way out of their credit woes. Gold stands to benefit as it is adopted as a safe haven, in either case. “If the situation deteriorates… you can’t predict what level [gold prices] will reach. In the Weimar Republic in the early 1920s, gold went from DM100 to DM100trn!” Alarmist predictions aside, von Greyerz holds that his $7,200 price target is based on historical precedent. Citing the last notable gold bull market, which culminated in 1980 when gold reached about $850 per ounce, he explains: “If you adjust for real inflation, as it was measured in the 1980s in the US before the calculation became manipulated to suit the government, then the 1980 price peak… would be the equivalent today of about $7,200.” Demand from investors for gold has typically played a secondary role to that of the jewelry industry. That changed in 2009, when for the first time, investment in gold funds, principally ETFs, and direct investment in bullion outstripped the demands of the makers of necklaces, rings and watches, according to statistics collated by the World Gold Council. In that year acquisitions of physical gold, principally bars and coins, rose 12% in tonnage to 1,323 tonnes. Over the same period investments in ETFs and similar products, which are favoured by many fund managers and private investors, increased by just under 100% to 617 tonnes. The total 1,940 tonnes accounted for about 48% of all demand. It was also some 10% higher than the 1,759 tonnes used by the jewelry trade; a figure that was 20% down on the previous year. Demand from industry and dentists fell over in 2009, down 15% to 373 tonnes. To put that in perspective, over the past five years jewelry demand has accounted for an average 60% of total demand and was as high as 80% as recently as the early part of the last decade.

FTSE GLOBAL MARKETS • SEPTEMBER 2010

Interestingly, while total demand in dollar terms rose in 2009, total demand in tonnage terms dipped, down 9% year on year. That it in itself might not affect the price, as only 60% of annual demand is met by new mine supply (2009 figures), with the balance derived from recycling. Yet any effect that might have had on the gold price has been swamped by the sharp growth in investment demand. “The reaction to

and historically there is a lag between base money growth and inflation. Moreover, there is the coincidence of continued weakness in the euro, which has been unable to leverage the recent weakness of the US dollar to become a viable alternative reserve currency, particularly while Southern Europe languishes in debt mire. “Gold has been rediscovered as a cash substitute in many portfolios,” acknowledges Grubb.

“If you adjust for real inflation, as it was measured in the 1980s in the US before the calculation became manipulated to suit the government, then the 1980 price peak…would be the equivalent today of about $7,200,” says Egon von Greyerz, managing partner of Matterhorn Asset Management AG in Zurich.

the banking crisis and now the sovereign debt crisis, which has been to expand the monetary base, has brought us back to the importance of one of gold’s core attributes, which is that it is a scarce currency that can’t be printed,”explains Marcus Grubb, managing director at the World Gold Council.

High inflation As some analysts have pointed out, gold returns are robust during periods of high inflation. Important questions now reside about inflationary trends in developed markets in the second half of this year and the start of 2011. Interest rates remain low, as safeguarding economic recovery is deemed more important than tackling inflation; a strategy that is aided by a continuing downtrend in the real estate segment (both business and at retail level). However, that approach is not sustainable over the medium term, particularly if Western economies begin to register growth in consecutive quarters. US base money growth has continued unabated,

At the same time, the opportunity cost of holding gold, which pays no income, has rarely been so low. As a defensive asset, gold tends to compete with government bonds or cash. With overnight rates and dividends from UK Treasury bonds and German bunds near record lows there is a credible argument that investors in gold can reasonably ignore lost income and bet on capital gains. The real question for those considering an investment in gold is not whether it is a good investment if global finances implode—because it will be—but rather what are the risks involved if the world economy muddles through its current woes. The answer to that depends on your view of the evolution of global gold demand. It is here that the complexity and conflicts of the sources of gold demand become important. If fears of global financial calamity ease in the coming years then demand from investors in gold will inevitably fall away. There are already some signs of that happening. Identifiable investment

Asset Allocation GOLD IS AT AN ALL-TIME HIGH: CAN IT STAY THE COURSE? 42

Marcus Grubb, managing director at the World Gold Council. “The reaction to the banking crisis and now the sovereign debt crisis, which has been to expand the monetary base, has brought us back to the importance of one of gold’s core attributes, which is that it is a scarce currency that can’t be printed,” explains Grubb. Photograph kindly supplied by the World Gold Council, August 2010.

Egon von Greyerz, managing partner of Matterhorn Asset Management AG in Zurich. “We don’t see any really attractive alternative to gold,” says Von Greyerz. “Stock markets are still over inflated and will probably resume their fall in the second half of the year,” he intones. Photograph kindly supplied by Matterhorn Asset Management AG, August 2010.

demand in the first quarter of 2010 was 186.3 tonnes, down 69% on the same period a year earlier, according to World Gold Council data. Demand from ETFs fell off a cliff, dropping from 465.1 tonnes in the first quarter of 2009 to 3.8 tonnes in Q1 2010. ETF demand is notably volatile, not least because it is a liquid means of taking pure exposure to gold. That, coupled with the familiarity of ETFs to many sophisticated managers, has served to make the funds the preferred route of institutional investors as well as many wealthy individuals. John Paulson, the founder and president of New York-based hedge fund Paulson & Co, has an estimated $3.4bn stake in US-domiciled SPDR Gold Trust, the world’s largest gold fund. The dip in investor demand in the last quarter might have proven the end of

the gold rush had jewelry demand not come to the rescue. Demand from jewelry makers rose 43% in the first quarter year-on-year to 471 tonnes. That is not a surprise say the gold bulls, who insist that the recent dip in demand for gold to make trinkets is the anomaly, not the sudden increase in demand from investors. “Many developing nations are increasing their levels of jewelry consumption from the low levels experienced in early 2009, reflecting consumer sentiment. Likewise, industrial demand which is linked to the business cycle has improved as well,”holds Juan Carlos Artigas, manager, investment research at the World Gold Council. “The emerging markets story is important for jewelry demand and the prospects for economic growth and growing wealth in those markets are not about to suddenly go away,” he adds.

The three biggest geographic markets for gold jewelry are India, which typically accounts for about one-quarter of all gold jewelry sales, China, at 23%, and the Middle East at 10% to 15%. Demand from jewellers has tended to be price elastic. That could be changing. The return of jewelry buyers in the last quarter, even at the current high prices, is seen as evidence that as Indians and Chinese become wealthier they will accept higher gold prices without necessary modifying their demand. Artigas also points to a shift in the flow of gold from central banks as providing further long-term support for the current gold price. “Developing nations have started to acquire gold to add to their reserves,” notes Artigas. “China, Russia and India have all bought gold. At the same time European banks appear to have offloaded much of their gold, particularly throughout the 1990s, and some may feel more comfortable with the current level.” This shift in central bank activity has transformed global central banks from net sellers to net buyers. “We consider this a structural shift,”says Artigas. The implication is that the increase in the gold price is sustainable even without the risk of global crisis.

Alternative currency Not everyone is convinced. “Looking at supply from the mines and demand from jewelry makers, the current price cannot be justified,” says Eugen Weinberg, the Frankfurt-based head of commodity research at Commerzbank. “Gold has re-emerged as an alternative currency and an insurance policy and while there is perception of heightened risk in the market the price can be maintained.” Even so, high net worth investors and institutional buyers are increasing their allocations to the precious metal. Whatever the view of gold, there is one undoubted fact: for an asset touted as a safe haven there appears to be a lot of uncertainty attached to it. ■

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

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Country report PETROBRAS: A FLAWED PLATFORM FOR GROWTH?

Pre-salt finds in Brazil offer a once-in-a-century opportunity for the country to boost its coffers and tackle pressing social problems. If balanced with interests from other stakeholders, the oil will indeed be transformational. However, the mere thought of the money is already proving tempting for politicians, who risk smothering the golden goose with bickering and heavy-handed intervention. Brazil is sitting on some of the most promising oil discoveries in the world and the government is determined its national champion, Petrobras, should benefit. However, cack-handed interventions in fund raising and technical uncertainties are beginning to undermine investor enthusiasm for the stock in the short term. John Rumsey reports from São Paulo.

A TALE OF TWO HALVES “

HE PETROL IS ours!” The rallying cry of Brazilian nationalists when petrol was first pumped from offshore fields in the 1950s still echoes in Brazil. Only now it has been appropriated by a new generation eager to stake a claim to the country’s fastgrowing proven reserves. So far, the country’s oil reserves are concentrated in three areas: Tupi, in the Santos Basin, and nearby Iara and Guara. Together, they contain between 9.1bn and 14bn barrels of oil equivalent, according to official estimates from Petrobras. That could be just the start. Early in the process, the managing director of the National Agency of Petroleum (ANP), Haroldo Lima, announced that there could be as much as 33bn barrels-worth of oil still unexploited, and was quickly slapped down by Petrobras. More recently, Márcio Rocha Mello, president

of the Brazilian Association of Petroleum Geologists, went much further. He estimates there may be much more in the pre-salt layer and has devised a figure of up to 100bn barrels available.Even staying within Petrobras’ more modest forecasts, increases in production from existing fields promise to be significant. Petrobras president Sérgio Gabrielli has said that the company will be able to up its production from 2.5m barrels of oil and natural gas equivalent per day to 3.9m per day in 2014 and 5.4m per day by 2020. The new finds, however, catapult Petrobras further up the league of energy companies. It became the world’s fourth largest energy company at the end of last year, up five places in a single year, according to Washington-based consultancy PFC Energy. It is already the largest company in Latin America by market capitalisation at $149bn.

Naturally, the long-term story looks profoundly appealing to investors especially as the finds are in a jurisdiction which has regulated its oil industry mostly fairly. However, excitement is increasingly tempered by a growing anxiety that the country’s oil supplies will become a political football. Politicians are already jockeying to divvy up the oil spoils and pushing for the jobs bonanza to remain within Brazil and not bring in foreign workers or oil majors. The government is rewriting the rules; making Petrobras the lead in all development of the country’s fields and planning to change the tax structure from a royalty-based regime to a production-sharing one. Equally, the challenges in successfully exploiting the deep sea pre-salt deposits are daunting. Over the next five years, Petrobras estimates it will need to spend as much

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

Brazil's president, Luiz Inacio Lula da Silva (left) is seen alongside Petrobras president, Sergio Gabrielli, during a ceremony to validate a law authorising the government to capitalise Petrobras, the state oil company, in Brasilia, on Wednesday, June 30th this year. Photograph by Ed Ferrera for Agencia Estado. Photograph supplied by Press Association Images, August 2010.

as $220bn in capital expenditure to develop the discoveries, trapped five to seven kilometers beneath the waters under shifting layers of salt. The difficulties inherent in deep water drilling, brought into relief by the BP Gulf of Mexico disaster, are also weighing on investors’ minds. These considerations continue to exert pressure on the value of Petrobras shares, which slid by 16.17% in a 12-month period to close at BRL32.04 ($18.10) on July 31st this year, compared with the performance of the Bovespa index, which is up 23.93% over the same period. A number of foreign investors have sliced Petrobras positions in consequence. William Landers, fund manager at BlackRock, which has some $8bn of investments in Latin America, believes a number of issues are reducing visibility and adding risk for Petrobras investors.

FTSE GLOBAL MARKETS • SEPTEMBER 2010

These include how much the government will pay for reserves, and whether there are more surprises, he says.“Up to one year ago, Petrobras was seen as a clean company. Regulatory uncertainties and the large equity offering make us more careful with the stock,” says Landers. Even normally buoyant analysts have been split. At the end of July, some 61.11% had a buy recommendation on Petrobras common shares, while a full 33.33% had a sell recommendation with the balance of analysts having the company under review. The most immediate issue is the government’s role in raising capital for Petrobras’ massive capital expenditure plans. The former is selling Petrobras the rights to extract 5bn barrels of oil at a price per barrel yet to be determined. The embryonic nature of exploration means that the cost of extraction is difficult to estimate and the size of the area needed for Petrobras to recover this quantity is unknown, which has led to fears of overcharging by the government. Petrobras will then carry out an equity issue, which may bring in $25bn, with the government paying for its stake through a bond issue and diluting minority shareholders that do not participate. Petrobras and the country’s governing political party, the ANP, have strived to prove that the pricing process for the 5bn barrels is transparent. Both have hired international consultants to oversee the process: Petrobras brought in the respected DeGolyer & MacNaughton, while more recently the ANP contracted Gaffney, Cline & Associates. The

government has also promised that it will provide further exploration areas if insufficient oil is found in those areas it initially designates. Ahead of the pricing, fund managers are operating in the dark.“If the price is $5 per barrel, we would consider that decent and fair; if it is more than $6 per barrel, the deal starts to look pricey,” says Rafael Sales, partner and coportfolio manager at Constellation Asset Management in São Paulo. He points out that the whole process of extraction could last years, bringing in the risk of operating in very different markets.

Late valuations Meanwhile, Walter Mendes, chairman of the Association of Investors in Capital Markets (AMEC) in São Paulo, worries that the ANP has left the valuation to the last moment and fears it will be rushed to allow the equity offer to get under way in September, before elections. “This is a very short period for an evaluation and the market has some doubts that it can be done so quickly,” he says. Mendes adds that the range most commonly being discussed is $3 to $8 with some predicting as much as $10 per barrel, which he describes as “extremely expensive”. The planned equity offering is also controversial. The government says the deal is separate from the sale of oil, but investors see the two as related and see the government using the proceeds from the sale of the 5bn barrels to underwrite its share in the equity offering. “Any fifth grader can look at this deal and tell you that the government is trading oil for shares. It’s a very significant danger not just for Petrobras but capital markets as a whole,” says Mauro Cunha, head of equities at Mauá Sekular Investimentos in São Paulo. Brazilian legislation dating back to 1976 clearly states that every time there is a rights’ issue where one shareholder contributes with assets not cash, this needs to be approved by the

Country report PETROBRAS: A FLAWED PLATFORM FOR GROWTH?

other shareholders, he notes. Cunha adds that the delays are reducing the strategic value of the oil and that new finds, such as those in the North Sea, threaten to steal some of the thunder from Brazil. Mendes would like to see minority shareholders consulted more closely on the equity deal and believes they should be able to decide whether the deal gets the green light. “We would like minority shareholders to vote on this issue in the General Assembly and the controlling shareholder, that is the government, should abstain from voting,” he says. That has not happened. Mendes says the share price tumble shows just how much the government plans are deflating investor interest. “The uncertainty related to the deal is the reason the stock has suffered so much,” he says. “The government has not chosen the best way to raise capital,”avers Sales. It is interested in enlarging its position in Petrobras and seems to be quite comfortable in diluting minority shareholders, he adds. He believes that the best way to raise capital would be to farm out some exploration areas to international players but concedes that this might not be politically feasible. All this impacts Sales’ view of the value of shares. Currently trading at an average of eight to nine times earnings, Petrobras shares are aligned with other oil majors. If the government charges a high price for the five billion barrels, those ratios could spike up to a pricey 11 to 12 times earnings, Sales says. The other area of concern comes from the deepwater disaster in the Gulf of Mexico, which has raised a red flag over deep water drilling and emergency procedures worldwide. “We are not discussing sufficiently what has been going on and how it applies to Petrobras. People don’t want to talk about this, but we need to,”believes Claudio Andrade, fund manager at the boutique asset manager Polo Capital in Rio de Janeiro,

“Any fifth grader can look at this deal and tell you that the government is trading oil for shares,” says Mauro Cunha, head of equities at Mauá Sekular Investimentos in São Paulo. which has some BRL2bn in assets under management. Investors have been too focused on capital raising and the presalt discoveries, he believes. Although Petrobas has a good safety record today, it has not always been so. The company was responsible for a leak in Rio’s picturesque Guanabará Bay that spilled 800,000 litres of crude oil in 2000 and the next year the sinking of its P-36 platform killed 11 people. The disasters seemed to have acted as a spur for the company to clean up its act. Today, Brazil has some of the best safety legislation in the developing world, says Sales. Petrobras is possibly the best deepwater drilling company globally, agrees Mendes. Moreover, deepwater may prove to have some positive effects on Petrobras. In the short term, the disaster could help reverse the trend for increases in prices for equipment related to deepwater drilling.

Longer-term effects The longer-term effects are likely to be less benign with stricter safety and environment regulations imposed across the board. Petrobras has said that it will review its safety procedures once a conclusive report on the cause of the accident is released. Meanwhile, the ANP is set to review safety procedures at oil companies under its remit and has solicited information on well-control systems and asked to see companies’ emergency plans. The other issue is the government’s insistence on locally-sourced materials, which is likely to prove a constraint in the development of the pre-salt area, but is in line with the political demand to spread the benefits of the discoveries and is non-negotiable in an election year. Petrobras’ demand for steel alone in 2020 could constitute up to 25% of

Brazil’s current production, putting enormous strain on the local industry and driving up prices. “Availability of equipment is certainly a concern especially with requirements that 60%70% of content is sourced locally. This is very tough,” says Sales. The Brazilian oil services and equipment industry is not as developed or as efficient as some in Asia, he notes. It is not clear whether Brazil can meet these ambitious targets and it is already proving a headache for foreign companies eager to provide services to Petrobras, says Sales. These foreigners are seeking to persuade the government to water down the targets on domestic sourcing, he adds. Firms such as Baker Hughes, Transocean and Halliburton, which have or are establishing offices in Brazil, are eager to curry favour with the government but say they need more time to find local content, he says. The inauguration of a new government may lead to further upheaval. If opposition leader José Serra, who heads the PSDB party, wins, he may seek to alter regulations. “Under the previous PSDB government political interference in Petrobras was much, much lower, and performance improved a lot as the company focused on profitability,”notes Mendes. Senior PSDB figures have said that they do not like the shape of the current deal, but Serra has remained curiously quiet, notes Mendes. However, if the government pushes ahead with the capitalisation the deal may be too far progressed to turn back. Change may not be appreciated by investors anyway. Cunha admits to feeling nervousness about the “new government and the possibility of them doing things in a slightly different way,” now that so much has been decided. ■

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

Country Report NORDIC BANKS: SECTOR REBOUNDS BUT IS NOT OUT OF THE WOODS

Photograph © Spectral-design / Dreamstime.com, supplied August 2010.

NORDIC BANKS SNAP BACK Having struggled with debt problems in the Baltics, Nordic banks are now considered among the best capitalised and performing and are predicted to show the sharpest provision snap-back of any banking sector in Europe. Among the challenges facing them is to be able to exploit opportunities against a volatile background. Although mergers and acquisitions might be considered, the more preferred route is likely to be a focus on organic growth and the strengthening of balance sheets. Lynn Strongin Dodds reports. OT TOO LONG ago, the Nordic banking sector was grappling with the mounting debt woes of its Baltic neighbours. Today it is considered among the best capitalised

FTSE GLOBAL MARKETS • SEPTEMBER 2010

and performing, thanks to early capital raising and setting aside massive loanloss provisions. Going forward, the challenge will be to exploit opportunities against a volatile background. Although

mergers and acquisitions might be one route, the more likely scenario is a focus on organic growth and the strengthening of balance sheets. According to Nick Davey, an analyst at UBS, the Nordic banks in Sweden, Norway, Denmark and Finland are decoupling from the rest of their European peers due to asset class recovery, robust funding and the prospect of early interest rate hikes: “We think that in a European context, the banks are relative winners and have proven to be a defensive play in investment terms. One of the main reasons is that they are operating in countries where the macro-

Country Report NORDIC BANKS: SECTOR REBOUNDS BUT IS NOT OUT OF THE WOODS

economy is relatively strong. The Nordic countries are not running huge deficits, they have relatively low unemployment and the banks were among the first to raise capital.” Davey estimates that the Nordic banks will enjoy the sharpest provision snapback of any European banking sector. “We expect 2010 to be largely characterised by a rebuild of nonperforming loan coverage levels, and for 2011 to see a sharp fall towards ‘new normal’ impairments in Sweden, Norway and the Baltics. For example, assuming through impaired-loan coverage of 50%, we note that SEB would need to suffer 35%-plus growth in impaired loans to require incremental reserving in its Baltic division. This is relative to a stock of impaired loans that contracted in the first half.” Davey also believes the sector is well placed to weather the withdrawal of government funding. “We expect the market to differentiate increasingly between regional banking systems based on their relative central bank reliance. With the three and six-month repo windows at the Riksbank now discontinued, and with no banks incrementally participating in the government guaranteed funding programme, we see the Nordic banks as having a credible and early-cycle exit strategy from central bank funding reliance,“ he says. In addition, the Baltic region is rebounding faster than many analysts anticipated, although a full recovery will take time. Estonia is ahead of its peers and set to join the European Union next January, while Latvia and Lithuania are scheduled for ascension in 2014. In a recent report, Helge Pedersen, chief economist at Nordea, noted that Estonia is benefiting from impending inclusion into the euro-zone club as well as strong exports. The same holds true for Lativia, although there will be increasing economic uncertainty in the run-up to

Chintan Joshi, an analyst at Nomura, notes: “The Nordic banks realised early in the recession that they needed to raise capital and they came to the market when other banks were procrastinating.” Photograph kindly supplied by Nomura, August 2010.

the parliamentary elections in October. Lithuania is the laggard in the group and is expected to experience lacklustre growth this year. The irony is that in some ways the Baltic experience mirrored the Nordic banking crisis of the 1990s, and some analysts found it surprising that these seasoned veterans did not see the writing on the wall. Sweden in particular experienced rampant unemployment and the near-collapse of the banking system after the property bubble burst, but it was the country’s banks, particularly SEB and Swedbank, that were the most exposed to the vagaries of the Baltic’s debt problems. Overall, Swedish banks had about $75bn in loans to the Baltic states, according to the Bank for International Settlements (BIS). Chintan Joshi, an analyst at Nomura, notes: “The Nordic banks realised early in the recession that they needed to

raise capital and they came to the market when other banks were procrastinating. Also, unlike in the 1990s, real estate did not blow up and the asset bubbles were contained. They seemed to have learnt lessons from that crisis and had implemented much more rigorous mortgage lending practices. What they failed to recognise though was that the ingredients in the Baltics were the same as their problems in the 1990s. What saved the Nordic banks was that lending to the Baltics accounted for a small percentage of their overall lending.” The improving picture in the Baltics as well as in the Nordic domestic economies is reflected in the latest crop of second-quarter results with most of the major players beating analysts’ estimates. Sveska Handelsbanken was the only one that missed the mark, albeit slightly. The Swedish bank, which outperformed its Nordic peers due to limited exposure to the Baltics, reported a 2% rise in second-quarter net profits, slightly missing forecasts as net interest income—hit partially by operations at its mortgage unit and by higher funding costs—fell short of expectations. Net profit in the three months to June 30th was SEK2.57bn ($360m), up from SEK2.53bn a year earlier but under analyst forecasts of SEK2.66bn. According to the bank’s chief financial officer, Ulf Riese, funding costs were higher in the second quarter due to a decision to refinance virtually all bonds due in 2010. “In the shorter term, this is an investment that did have a negative impact on net interest income, but this also has put the bank in a good position to manage both market turbulence and a recovery in the real economy.” Nordea, the largest bank in the region, exceeded expectations and posted a €245m net loan loss in the second quarter, lower than the forecast of a €287m loss and smaller than the €261m loss in the first quarter. Earnings slipped to €537m from €616m a year ago, but

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

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Country Report NORDIC BANKS: SECTOR REBOUNDS BUT IS NOT OUT OF THE WOODS

The irony is that in some ways the Baltic experience mirrored the Nordic banking crisis of the 1990s, and some analysts found it surprising that these seasoned veterans did not see the writing on the wall. still came in higher than the average analyst estimate of €522m. Nordea chief executive officer Christian Clausen notes: “We see clearly that impaired loans are starting to decrease and we also see that rating migration is really slowing down, so the credit quality in general is going up and therefore we now expect loan losses to be lower.” Meanwhile, DnB NOR, Norway’s largest bank, saw profits in the second quarter almost triple with net income rising to NOK3.3bn ($550m) from NOK1.2bn a year earlier. This was slightly above the average analyst estimate of NOK3.2bn. Loan losses fell 62% to NOK878m. Although lending in the Baltics took its toll, the bank coped better than other Nordic lenders, partly because Norway’s economy fared better than those of Sweden and Denmark. Since 2007, DnB has leapfrogged four other banks to become the Nordic region’s secondlargest bank by market value after Nordea. Swedish banks Swedbank and SEB also showed that they had turned the corner and returned to profitability as provisions for bad loans from the Baltics fell. SEB reported net profits of SEK1.99bn in the three months to June 30th, compared with a loss of SEK193m in the same quarter last year, surpassing analysts’ consensus forecast of about SEK1bn. Total net interest income was also better than anticipated at SEK4.1bn, down 24% from last year but an improvement on the previous quarter. According to SEB’s chief executive Annika Falkengren:“There are still a lot of issues to work through but the drip feed of new bad loans has stopped, so we do not have to add extra provisioning.” As for Swedbank, net profit for the

second quarter was SEK1.57bn compared to the SEK2.01bn net loss a year earlier and a SEK536m net profit in the first quarter. Net interest income fell 28% to SEK3.80bn from SEK5.24bn while loan-loss provisions stood at SEK846m, down from SEK6.14bn a year earlier and SEK1.78bn in the first quarter—sharply lower than analysts’ estimates of SEK2.26bn. Chief executive Michael Wolf comments: “In line with our expectations, net interest income fell during the quarter; however, a number of factors are gradually starting to impact net interest income positively. Market interest rates have risen from very low levels, pushing up interest-rate margins. Our interaction with the corporate market resulted in a higher number of credit applications while re-pricing continues as fixed-rate contracts mature.”

Stress test Sweden’s Financial Supervisory Authority said in an official release at the end of July that the country’s four biggest banks all passed a European Union stress test, “with a comfortable margin” and were strong enough to withstand another period of financial crisis. The banks, including Nordea, SEB, Handelsbanken and Swedbank “have enough capital to weather even more severe scenarios than what was assumed in this stress test. Thus, there is currently no need for any of the major banks to strengthen their capitalisation, from a regulatory perspective,” noted the release. Even so: “In extreme scenarios the market may require even higher capital ratios, which requires the banks to have capital contingency plans.”

Looking ahead, the banks are not out of the woods and face the same economic uncertainties as their Western peers. Søren Brinkmann, a partner at Danish law firm Lett, says: “In general, the banks have done well in relation to other European banks and all the bluechip banks in the region passed the recent European Union stress test. However, the challenges are the same as for many banks—to improve liquidity and tighten their balance sheets.” Consolidation is also seen as one way forward but analysts do not expect any activity in the immediate future although the region is ripe for mergers. This is because local markets are mature, regional growth opportunities are limited and players are too small to compete on a pan-European basis. Analysts believe that a tie-up between the six main banks—Nordea, SEB, Swedbank, Handelsbanken, DnB NOR and Danske—could create synergies. In fact, recent research from Finnish insurance

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

Nordea President and chief executive Christian Clausen speaks to reporters during a news conference to announce first quarter results in Stockholm on April 28th, 2010. Nordea, the Nordic region’s largest bank, said that its first quarter profit rose by 3%, helped by higher fee and commission income. Photograph by AP / Claudio Bresciani. Photograph supplied by Press Association Images, August 2010.

group Sampo, which owns a 20.3% stake in Nordea, shows that a merger between two of the largest Nordic banks would generate around €500m in savings. However, the overriding negative sentiment of creating behemoth banks is likely to prevail for the next couple of years. Davey says: “There are always rumours of mergers, especially in Sweden, but I do not expect large-scale M&A in the short term, particularly with the regulation that is being put in place restricting banks from getting too big to fail. This will act as a barrier for now.” Joshi agrees, adding: “Talk of consolidation is not new in the region. In 2001, Swedbank and SEB agreed to a merger but the European Union ruled against it on competition grounds. DnB NOR was also interested in making an acquisition in Sweden but the Norwegian government, which owns 30% of the bank, required the headquarters of any merged entity to be in Norway as a precondition, which makes offers

FTSE GLOBAL MARKETS • SEPTEMBER 2010

unattractive. I do not think we will see mergers in the near term because the banks want to get their houses in order and pursue organic growth opportunities. It might be a different story when the economy fully recovers.” Brinkmann notes: “I do see consolidation taking place but not between the tier one banks. I think there is the greatest potential in the smaller end, especially in Denmark, which has 110 banks for a population of 5m. Every little village has a bank. Although that figure was 180 before the financial crisis, there is still plenty of scope for mergers. I do not expect to see a foreign bank coming into the region and making an acquisition because I think there are greater opportunities in the fast growing economies of Asia.” As for the Nordic banks going farther afield, the Baltics and Central Europe are likely to remain their prime hunting grounds. For example, Poland has become a real focus for Nordea, which

opened 159 there at the end of the first quarter with plans to expand to 210 branches by the end of 2010. The aim is for a total of 400, more than in any country it operates in, including Sweden. The move is predicated on the bank’s forecast of income growth of at least 30% in Poland, Russia and the Baltic states. Acquisitions, though, are currently off the table due to the high price-tags. Fridtjof Berents, an analyst at Norwaybased Arctic Securities, believes: “Most banks have regional ambitions and if they do go outside the Nordics, it will be to the closest regions such as the Baltic countries. Although it has had its problems, the banks still see these countries as attractive opportunities over the longer term. I expect that activity will start with smaller banks, particularly in Norway and Denmark, merging to become larger regional or national entities. At the larger end, Sweden is the most ripe for consolidation although Nordea is likely to be the acquirer of certain parts of Swedbank, which has a strong foothold throughout the country.” Handelsbanken is one of the few banks to have tested the waters outside the region, having built a presence in the UK through organic growth. The Swedish bank has spent the past eight years building a branch network of 80 outlets, which remains a relatively modest number by UK standards but places the country above Norway, Denmark and Finland as the bank’s second-biggest market after Sweden, where it has 460 branches. ■

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Index Review QUICK-FIX FISCAL POLICIES: NO SUBSTITUTE FOR LONG-TERM STRATEGY

Markets appear in no mood for halfway measures and the initial reading is that the attempt by the US Federal Reserve to be all things to all men may fall flat on its face. Once again, hard decisions are being put further and further down the line and the consequence of this will undoubtedly be a bigger bill in the end. The immediacy of the political requirement for instantly successful fiscal policy (rather than long-term strategic planning) is doing no good either in the US or in Europe and the UK. Trying to formulate policies in which there are no losers is just not realistic. Simon Denham, managing director, Capital Spreads, gives the bearish view.

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

INFLATION AHOY! HERE SEEMS TO be a certain amount of nervousness around at the moment with equity markets holding their recent ranges (the FTSE to the middle/top and the US/DAX to the middle/bottom) and gold pushing for the upside. In times of concern, gold has frequently been a canary in the coalmine (although not always) warning of imminent but unquantifiable fears around the corner. Most companies have now downscaled workforces and capacity to reflect the current market, and we face an ongoing situation of reasonable corporate numbers (although not stellar) coupled with an ever-widening gap between the “have jobs and likely to retain them” and the newly unemployed who will probably struggle to get back into the stable employment situation they enjoyed in the past. Companies that rely on marginal levels for profit will no doubt struggle. In the UK, retailers are likely to be in this group until such time as they can cut down floor space to match demand; especially with the public sector cutback in the pipe line. We might have seen some headline slicing of the PSBR but the press has

FTSE GLOBAL MARKETS • SEPTEMBER 2010

been curiously silent, as have the politicians, over the fact that proposed swingeing cuts do not actually reduce debt levels, they just slow down its rate of increase. Unfortunately, UK plc is relying on growth (and, whisper it quietly, a bit of low interest rate inflation) to reduce the overall GDP/debt ratio. If growth is substantially lower than hoped, the UK risks a very real interest rate on its debt burden in the coming years. Government spending is still running at a £10bn surplus a month, so even if all the spending cuts were implemented now, it would still involve a £5bn per month increase in the total. The last month or so has seen something of a hiatus for the equity markets with tight ranges dominating and the odd day or two-day break out giving some interest. The drop in the middle of August came out of the blue and, worryingly for many of the global indices, there has been no significant rebound—the FTSE being the notable exception. News stories about the sovereign fiscal problems of much of Europe have been muted over the summer, but this is likely to change as the political classes return from their

extended holidays. The headlines have gone away, but the ECB-led €750bn support package has not made much of a dent. Moreover, inflation, which these days is continually disregarded by too many central banks in their drive to resuscitate growth, appears to be on the upswing. Inflation is becoming rather sticky in the UK and, worse, is at a near two-year high in Europe. Not that the bond markets seem to have noticed. The Bund and gilts are at an all-time high. This is because base rates are likely to remain very low for quite some time as central banks continue to attempt to stimulate economies through the tried (and one would have thought “busted”) route of cheap money. No surprise then that long-dated yields have finally followed them down. With China and other cheap manufacturing bases now experiencing inflationary pressures, it is difficult to see where any external disinflationary impulses are going to come from. We may find that the “new” era of cheap money runs full tilt into a full blown inflationary spiral. As ever, ladies and gentlemen, place your bets! ■

EUROPE’S EXCHANGES COMPETE FOR MARKET SHARE 54

Photograph © Petrafler / Dreamstime.com, supplied August 2010.

THE NEW DEAL European exchange venues are promoting themselves heavily as competition has become fierce across all forms of exchange and as still more players enter the market. More than 90% of trading is on lit venues, while dark trading has climbed steadily each quarter between mid-2008 and the end of 2009 to reach 9.8% in both regulated markets and multi-lateral trading facilities (MTFs). Competition with all its benefits has been the big winner in the past three years, according to Mark Hemsley, chief executive of multi-lateral trading facility, BATS Europe. However, fragmentation is an outcome of competition and further consolidation is likely. Ruth Hughes Liley reports. N THE CARD game of Pit, players compete noisily to corner the market in one of half a dozen commodities. Trading does not start until someone calls “market open”, after which it is up to each player to shout and deal as quickly as possible until they have 100% market share. The stock exchanges of Europe have been competing with each other for market share since European regulators declared “market open” three years ago with the introduction of the Markets in Financial Instruments Directive (MiFID). All European exchange venues are promoting themselves heavily as competition has become fierce across all forms of exchange and as still more players enter the market. At one end, NYSE Euronext announced the launch of a new Londonbased securities listings market, NYSE Euronext London, in direct competition with the London Stock Exchange, while at

the other end, US marketmaker Getco announced Getco Execution Services would begin operating a dark pool in Europe, including central counterparty (CCP) clearing for all participants. In addition, broker crossing engines have come under the regulators’ spotlight; investment banks are setting up their own multi-lateral trading facilities (MTFs); incumbent exchanges are running dark pool MTFs such as NYSE Euronext’s partnerbased SmartPool, and the LSE has a 51% stake in the MTF Turquoise. More than 90% of trading is on lit venues, with prepublished prices, while dark trading has climbed steadily each quarter between mid-2008 and the end of 2009 to reach 9.8% in both regulated markets and MTFs. Competition with all its benefits has been the big winner in the past three years, according to Mark Hemsley, chief

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executive of multi-lateral trading facility, BATS Europe.“We had a series of national silos with little or no competition. Now customers can join MTFs and don’t have to pay a membership fee or any connection fee; they can trade panEuropean stocks; execution costs are lower; with onward routing, brokers can reach different markets from one venue and therefore have greater access to liquidity. MTFs are a compelling proposition for executing brokers, market makers and statistical arbitrage (stat arb) traders.” BATS Europe itself burst on to the scene in October 2008 with an inaugural loss-making pricing policy, essentially paying firms to trade. Since then it has steadily gained market share and its own estimates claim its best European market share of 5.6% in July. Hemsley says:“The competition is not between the MTFs: they are all growing. The firms that aren’t growing are the exchanges. We are getting our flow from the incumbent exchanges. Once the MTFs get to break-even levels, there will be even more pressure on incumbent exchanges to consolidate or restructure.” His assertion is backed up by figures from broker CA Chevreux, which estimates that while Swiss index SIX suffered most from market fragmentation during May and June, losing five percentage points to BATS and Chi-X, the LSE also lost three percentage points, at the time Chi-X topped 30% on several days in May. However, figures conflict as the LSE reported its market share of cash equities trading had increased in the second quarter (Q2) to 62.4% in June, up from 60% in April, and remains the reference point for pricing UK stocks. “The evidence for that is that when the primary market stops trading, everybody stops trading,”says Natan Tiefenbrun, chief executive officer at Turquoise, which moved from 4.3% to 5.4% market share in the first quarter (Q1) this year. “They are the source of official calculations and when you arbitrage a share across different venues, you need to have that link back to what is happening on the main exchange. “However, fragmentation is an outcome of competition and further consolidation is likely. We don’t know how many venues will ultimately survive, but most people believe we will end up with three to five pan-European MTF/exchange groups in the long run. The LSE believes its future place is as a pan-European exchange group and other exchanges are taking a similar view. While other MTFs say they are strong enough not to be acquired, we’ve already been acquired and we are beginning to see synergies as part of the wider LSE Group.” One interesting development in the past year has been the way non-displayed “dark” venues have gained in popularity and have begun to differentiate themselves. Chi-X’s non-display order book, Chi-Delta, for example, claimed top spot in Q1 2010 with total value traded of €11.3bn. Another example is MTF SmartPool, the NYSE Euronext-led dark venue created in partnership with BNP Paribas, HSBC and JP Morgan, which also declared record volumes in Q2 2010 of €5.7bn, a huge increase of 473% over Q1. It includes a dark market share of 26.3% in FTSE MIB, 16.5% in FTSE 100 and 27.3% in Xetra Dax and currently

FTSE GLOBAL MARKETS • SEPTEMBER 2010

Mark Hemsley, chief executive of multi-lateral trading facility, BATS Europe. “The competition is not between the MTFs: they are all growing. The firms that aren’t growing are the exchanges,” he says. Photograph kindly supplied by BATS, August 2010. `

BATS Europe itself burst on to the scene in October 2008 with an inaugural loss-making pricing policy, essentially paying firms to trade. Since then it has steadily gained market share and its own estimates claim its best European market share of 5.6% in July. trades more than 2,200 securities across 15 European countries. Smartpool chief executive Lee Hodgkinson says: “Broadly speaking, people are increasingly learning how to use and benefit from dark pools more than they used to. In the last 12 months usage is up 17%, according to Thomson Reuters, while overall equity numbers have stabilised.” Tiefenbrun says part of the reason is that as cost of trading falls in the lit markets and order sizes with it, a growing proportion of volume has come from high-frequency traders. “That’s driven traders to seek alternatives venues,” he says. SmartPool, like all MTFs and regulated markets, is legally obliged to allow anyone to trade on its venue. Hodgkinson explains that SmartPool offers a minimum acceptable fill, so an order of 200,000 shares, for example, could only be executed in blocks of 50,000. “This stops people finding out what’s there, helps contribute to natural liquidity and discourages gaming,” says Hodgkinson. “We are legally obliged to let in high-frequency traders, but a minimum acceptable quantity is discouraging and we do have conversations with customers. Our ability to conduct

EUROPE’S EXCHANGES COMPETE FOR MARKET SHARE 56

Natan Tiefenbrun, chief executive officer of Turquoise. “The evidence for that is that when the primary market stops trading, everybody stops trading.” Photograph kindly supplied by Turquoise, August 2010.

executions at large size is in no small part down to trusted working relationships. If we see a particular client’s average execution size falling, for example, we will provide the appropriate information and advice to address that.” However, SmartPool’s volumes pale when compared with certain internal broker crossing engines. Credit Suisse’s Crossfinder has reported €19.63bn trade by volume in Q2, a rise of more than €3bn from Q1, while total trade on broker crossing networks amounted to €58.9bn in the first quarter of this year, the equivalent of 1.5% of all trading in European Economic Area (EEA) countries, according to estimates by the Committee of European Securities Regulators (CESR). On July 29th 2010, CESR released a series of recommendations to the European Commission over the future of equity trading in Europe as part of the review into MiFID. One recommendation was the creation of a new regulatory regime for crossing networks, under which firms would be required to make public aggregated information at the end of each day, including the number, value and volume of all transactions executed in the system, and limiting the amount of business that can be conducted on it before being required to become an MTF. Because MTFs have to be open to anyone and can only cross at the mid-point of the spread between bid and offer, that can limit the freedom for the sell side to use their discretion in creating the most efficient execution for a client. Nevertheless, UBS announced its intention to launch a dark pool MTF which will sit alongside the bank’s own internal discretionary crossing engine, UBS PIN (Price Improvement Network). Meanwhile, Nomura inherited the LX dark pool from Lehman Brothers in September 2008, changed the name to NX and registered it in January 2010 as an MTF. Nomura now claims it is the fourth largest dark pool in Europe by volume and Rosenblatt calculates that Nomura has the highest average trade size at $16.490 in their July figures.

Lee Hodgkinson, Smartpool chief executive says: “Broadly speaking, people are increasingly learning how to use and benefit from dark pools more than they used to. In the last 12 months usage is up 17%.” Photograph kindly supplied by Smartpool, August 2010.

Adam Toms, managing director and head of Nomura’s Market Access Group, covering programme and electronic trading, distinquishes between a flow dark pool, where flow is on its way to a display market, and a block dark pool, which is specifically trying to attract latent flow not on its way to a display market but sitting on traders’ blotters. “We wanted NX to be a block venue, so we did four things to differentiate it to make it act like a block dark pool. We slowed it down by introducing a random auction; we give rewards for leaving resident liquidity in the pool through a maker/taker-style tariff, which means that ‘immediate or cancel’ orders gain 25% (mid minus 25%) of the spread while the resident order gains 75% (mid plus 25%)—and it has well formed market checks, which pulls back and validates the soundness of the reference price, one of our anti-gaming features. Lastly, we added layers of minimum acceptable fill thresholds. All this makes the venue look different and hopefully it starts to give people some comfort that it is acting in a more block capacity,” says Toms. Alasdair Haynes, chief executive, Chi-X Europe, believes that broker-dealers will be forced down the MTF route: “I think the internal crossing systems will become more regulated, with less capability to trade inside a spread. It’s not necessarily the best thing for the market and it has become political. I want to see sensible regulation, fair for all, that enhances growth.” “Internalisation has been going on for a very long time,” points out Drew Miyawaki, head of trading desk, Liquidnet Europe. “Any upstairs, off-exchange trading before algos, before DMA, was internalisation. The buy side would get a quiet call from a broker and do a deal. Now, as technology has advanced, and you combine this with algos, internalisation is happening faster and on a larger scale. Plus from the sell side’s point of view, if you can internalise the trade, it’s free of charge.” The question of pre-trade transparency in price setting is hovering over the European market place and CESR’s more rules-based recommendations for pre-trade transparency will

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have a direct impact, if they are introduced, on the structure of the equity trading scene in Europe. MiFID required both primary exchanges and MTFs to make public, on reasonable commercial terms, details of best bids and offers and the depth of trading interest at those prices. Pricing is one of the challenges we are facing,”agrees Daemon Bear, head of ICAP’s BlockCross, which covers nearly 6,000 UK securities, and became an MTF in September 2009. “If we were to rely on a European Best Bid and Offer [EBBO] system, there could be problems. The majority of stock we cover still relies on primary exchange liquidity, where an EBBO may not be relevant. In the result of an outage, we may end up referencing prices on an anonymous venue and why would our clients trust us for that? We are still fairly comfortable that we take prices from the primary exchange as long as they have the biggest proportion of a stock’s volume.” Nevertheless, Miyawaki welcomes CESR’s call for a mandatory consolidated tape of pre-trade information about prices of shares traded across Europe. “It’s what the markets want. The behemoth is that it’s such a difficult thing to implement in Europe. The problem that the buy side faces now is that there are so many places to trade and so many possibilities of liquidity. If the buy side doesn’t have the connections, they are not accessing that liquidity and not getting best execution. If you have to choose between 20 different venues, by the time you find that liquidity, prices have moved against you. Opportunity cost doesn’t show up on receipts, but tends to eat into your investment.” Nevertheless, choice of venue is welcomed on the sell side. Toms recalls a trader on his floor being “amazed” at achieving high dark fill rates for a particularly difficult trade: “He said how helpful it was to have a choice of venues. There is a multitude of venues, but we have the smart order routing technology to deliver the best execution result.” Agency broker Instinet has a smart order router that includes dark liquidity aggregation logic, called Nighthawk, which allows traders to place a percentage of an order across as

many dark venues and broker dark pools as possible. Richard Balarkas, chief executive at Instinet, believes that dark trading should be multiples of the volume traded in the lit book. “Every day portfolio managers have ideas they can’t implement. There’s a huge amount of business out there which is impossible to measure. It’s why I find dark pools such a thrilling idea in that they can create an efficient mechanism for crossing large volumes without damaging execution performance. Dark liquidity has the most amazing potential when it comes to growing the amount of trading in the equity markets.” Haynes agrees: “Dark pool trading is not going to be a huge amount, but if the total market grows, there’s still massive growth potential. The growth of dark venues has been meteoric in the last year. Does a finance director start worrying if his stock is trading on lots of different exchanges? Fragmented liquidity is still valuable to finance directors. He knows that the liquidity of his stock is growing if you get five times the amount of trading through competition.” While acknowledging the secondary markets play host to more speculative traders than long-term investors, Balarkas says regulatory confusion arises from the lack of consensus about what function the market should perform. “On the one hand I can’t help have some sympathy with Lord Myners: if you own a share, you are intrinsically linked to the ownership of that company and associated issues of corporate governance. On the other hand, the reality is that traders can buy in and out of that company many times in less than a second. There has always been a huge divide between the role of the secondary markets and the function of the primary markets and until that is acknowledged, the objective of market regulation will never be clearly defined. “Competition is not a bad thing; innovation is not a bad thing and both have their own momentum and so even if new regulations get written and miss the point, they won’t stop progress.” ■

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FTSE GLOBAL MARKETS • SEPTEMBER 2010

Face to Face FACE TO FACE WITH ANDY SILVERMAN, MORGAN STANLEY

The proliferation of dark pool trading is not always synonymous with market transparency. After all, do traders not have the right to know exactly where their order is going and how all orders are being executed? Do dark pools really offer innovative and anonymous trading techniques and is that what the market really wants? Francesca Carnevale talks to Andy Silverman, managing director and global co-head of Morgan Stanley’s electronic trading business.

THE CHALLENGE OF TRULY DARK TRADING ARK POOLS HAVE endured something of an ambivalent buzz point in this year’s regulatory calendar. While popular—dark pool trading has accounted for more than 11% of total US volume some months this year—and traditionally held as useful in helping the buy side keep its large orders private, dark pools have had their particular issues. Sometimes they are prone to leakage. Under current US SEC rules for instance, the dark pool venues are not required to provide access to everyone until they’ve executed 5% of their average daily volume for a stock in four of the previous six months. However, in January this year, the regulator questioned whether the threshold was too high.“If I go to zero, my competition then becomes the exchange and I lose all discretion,”said Andy Silverman. Dark pools shouldn’t be required to provide“unfettered access to predatory order flow,”he added, thereby highlighting the ambiguities of any debate around the role of dark pools in the trading spectrum. It is not just a US talking point; dark pools are now a global phenomenon and not only the US is embracing a regulatory response; Europe is, too. Potential reforms in Europe include the reclassification of ‘Broker Crossing Systems’ to ‘Multilateral Trading Facilities’ once they reach a specified size, the introduction of additional notification and surveillance requirements and improvements to post trade transparency. Ultimately, however, scrutiny hangs on the inherent contradiction between the growth in dark trading and the need for improved market transparency and price discovery. Silverman suggests that few sell side firms offer full disclosure of their dark pool and order handling practices. “The buzz

Andy Silverman, managing director and global co-head of Morgan Stanley’s electronic trading business. Photograph kindly supplied by Morgan Stanley, August 2010.

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about transparency and rumblings about increased regulation are motivating some broker-dealers to become more open. However, if both the regulators and the buy side demand it, transparency will become commonplace. Either way, buy side traders should ask questions because they have a right to know the answers.” Dark pools in the US are operated by broker-dealer members of the Financial Industry Regulatory Authority (FINRA), and must report their trades within a 90 second period to a trade reporting facility (TRF). Both NYSE Euronext and NASDAQ have their own TRFs, which they operate with FINRA. These trades are identified as over-the-counter offexchange trades and the identity of the dark pool where the trade was executed is not disclosed to the consolidated tape. By comparison, exchange reported trades identify the exchange that executed the order. The question now is whether the SEC will close the regulatory gap between dark pools and exchanges, and instigate some kind of uniform trade reporting. Since March this year, the SEC has gone quiet on the issue; but that doesn’t mean that out of sight is out of mind. There are no easy answers or quick-fire solutions, says Silverman. Take the trading of illiquid stocks, for example: “If real-time post trade reporting of dark pool identity becomes a requirement, information leakage could result for large orders in illiquid stocks that take days to execute.”

Complexity Silverman is adamant that the US market needs less rather than more complexity. The choice of dark environments has been beneficial to the marketplace, given the fecundity of non-displayed platforms and the large volume of order flow that needs to be executed. There are more than 30 dark pools available to US traders, according to the SEC in the release. Most are run by full-service broker-dealers such Morgan Stanley. Moreover, add other lit venues to the mix and the ability to keep control of order routing is difficult with so much fragmentation. Although the benefits are obvious, in a fragmented trading landscape, he says, the key is lessening the friction to trade. He notes:“The friction to trade has never been lower, with the buy side navigating through multiple trading venues, both dark and lit, at the lowest cost ever.”Silverman also concedes that it is not a game for the uninitiated. “The buy side needs to know the strengths and pitfalls of individual dark strategies, how to choose the most appropriate dark strategy and how best to measure the success of a particular strategy,”he warns. According to Silverman, choosing the most appropriate dark strategies entails evaluating market microstructure factors such as execution quality, costs, trade size and the potential for information leakage. As dark trading continues to evolve, Silverman thinks that buy side firms will and should rely even more on sell side counterparties for the best technology to access the ever-increasing number of dark venues. In other words, the search for quality execution becomes a symbiotic responsibility, between the buy side that seeks it and the sell side that provides it.“Ultimately, the long-term relationship with the client is all that matters,” he says.

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Then again, Silverman confirms that dark does not always mean totally opaque. Most dark pools are perhaps best described “in shades of grey,”he says. Inevitably, however, opportunitycost is involved with the use of such pools.“Grey pools offer a trade-off between bits of information leakage that may impact the price and quality of the execution versus totally dark pools where no information is revealed and there is minimal impact on the price and quality of the execution,”he explains.

Protection One of the biggest concerns, concedes Silverman, is the buy side search for protection against toxic order flow. Adverse selection is no longer as straightforward as it once was or as easy to avoid. Traders need to understand with whom they are dealing when they “only want to show their orders to those who truly intend to trade,” says Silverman. Equally, traditional buy side traders are now faced with a rapidly expanding high-frequency trading (HFT) segment which sometimes presents its own challenges for traders looking for quality block executions in dark pools. HFT firms make good money ($21bn last year, at the latest count by TABB Group) derived by capturing short-term alpha sometimes at the expense of traditional buy side traders. It’s costly for both sides. TABB Group says that Europe’s dark pool operators alone could spend as much as $21m on antigaming and dark pool surveillance to help the buy side avoid negative selection and gaming. `

TABB Group says that Europe’s dark pool operators alone could spend as much as $21m on anti-gaming and dark pool surveillance to help the buy side avoid negative selection and gaming. Morgan Stanley has been careful about dark pool surveillance and anti-gaming right from the start, explains Silverman. The bank’s development of MS POOLSM, which he claims is truly opaque and is “designed to prevent information leakage by denying entry to those orders that are seeking out information to trade against immediate or cancel orders (IOCs).”He explains: “The pool blocks IOCs and orders must remain in the pool for some resting time.” MS POOLSM also does not send out indications of interest (IOIs) to select liquidity. These rules “ensure we are nothing but truly dark”. Silverman says that it is the responsibility of the buy side to be proactive in seeking “trustworthy partners, a comprehensive view of their trades and a better understanding of the methodology and decision making around how and where orders are handled by the sell side.” In other words, choice is good, provided it is understood. Moreover, that understanding should be reached in tandem with the sell side. “Our operational motto is: your trade is none of our business,” avers Silverman.“That trust has to be inherent in any relationship of this kind,” he stresses. ■

TECHNOLOGICAL ADVANCES DRIVE THE TRADING INDUSTRY 60

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

THE AGENT OF CHANGE Alasdair Haynes, chief executive, Chi-X Europe, predicts completely seamless pan-European trading in the next two years and, within 10 years, global trading will be possible. Seeds of pan-global trading are being sown today in the convergence of buy side, sell side and exchanges. A fusion of technology and trading has seen increasingly blurred boundaries between conventional market structures as client demand has called for increasingly flexible models, writes Ruth Hughes Liley. HEN THE DOW Jones Industrial Average plunged nearly 1,000 points on May 6th, 2010 in the so-called “flash crash”, technology was among the things blamed. However, according to a Securities and Exchange Commission (SEC) analysis, “as quickly as the market dropped, it suddenly and dramatically reversed itself, recovering 543 points in approximately a minute and a half, to 10,415.65”. “It was a great day for technology,”comments Alasdair Haynes, chief executive, Chi-X Europe. “Within 20 minutes and certainly 24 hours, stability had been restored, whereas 50 years ago markets would have stayed closed for weeks. What would the markets have looked like had we not had the technology to deal with this volatility?”

Indeed, technology is the agent of change in the industry, according to Haynes, who predicts completely seamless panEuropean trading in the next two years. “There has to be a problem for technology to solve in order for business to succeed and markets to progress in line with customers’ demands. Pan-European trading and, within 10 years, global trading will be possible with technology to enable you to overcome the barriers of time zones, currencies and so on. We are just scratching the surface of what’s possible.” Seeds of pan-global trading are being sown today in the convergence of buy side, sell side and exchanges. A fusion of technology and trading has seen increasingly blurred boundaries between conventional market structures as client demand has called for increasingly flexible models. Stephen Bruel, research director with Tower Group, says: “Lines between buy side and sell side and sell side and exchange are blurring, in particular as the buy side takes on more responsibility themselves, whether hiring more research people or whether hiring trading strategists. Brokers realise they need to do new things for buy side clients so brokers are moving into exchange territory. This is forcing the exchanges to change as well, offering co-location and expanding into other asset classes.” Donal Byrne, chief executive, Corvil, a latency management firm, adds: “There’s also a blurring of lines between venues

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

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TECHNOLOGICAL ADVANCES DRIVE THE TRADING INDUSTRY 62

Craig Lax, an executive managing director at ConvergEx Group, says: “What’s advantageous in one venue today is disadvantageous in the same venue next month, so you can’t get a good feel for that unless you are routing an enormous amount of order flow.” Photograph supplied by ConvergEx Group, August 2010.

and technology suppliers; the sell side is offering dark pool liquidity, the buy side are taking in direct market access. This is a natural or inevitable effect from the evolution of trading. It goes hand in glove.You can’t be a success in trading without having success in technology.” Recent months have seen a spate of alliances and consolidation in all three areas. Exchanges have merged or collaborated to extend their offering: the London Stock Exchange, for example, merged the multi-lateral trading facility Turquoise into the LSE Group. NYSE Euronext and Warsaw Stock Exchange announced a strategic partnership in July where WSE will use NYSE Euronext’s platform for its cash and derivative markets and for “mutually beneficial business initiatives” in the multi-year agreement. Exchanges are also acting to enhance their technology to improve revenues. Last year, the London Stock Exchange bought Sri Lankan company Millennium IT, providing itself with a fast platform to replace TradElect. Turquoise will migrate to the new system in October 2010 and the rest of the LSE in November, although the new order book for bonds will remain on the current system until 2011. In addition, exchanges are reaching out to the buy side directly as Tower Group’s Stephen Bruel points out in his report The changing electronic trading landscape. “Exchanges are coming to see the buy side as an eventual client, abandoning the member-owned mindset they had before demutualisation. They now offer services and solutions tailored to the buy side, further helping the buy side trader become an active participant in the trade execution business.”

Emmanuel Carjat, chief executive, Atrium Network, which he co-founded four years ago, believes the trend will be for large buy side firms to become members of exchanges. “As regulators start to look more closely at sponsored access and naked access, the best way to link directly to exchanges is to become a broker yourself and have the proper systems and balance sheets to do it. As technology provided by brokers is more available in the market, I think this is going to be a trend going forwards.” Natural synergies are being exploited in relationships between technology companies and agency brokers. Earlier this year, for example, Orc Software merged with agency broker Neonet to create a combined Swedish-based company offering technology solutions and execution. Lee Griggs, president EMEA, Orc, sees the merger as an extension of their technology offering, while allowing them to offer hosted management services and transactions. For Griggs, it’s all about connectivity. He believes that convergence is inevitable and that in two years’ time, customers’ trading strategies will continue to become more autonomous than they are now. He thinks this will have two effects: to raise the importance of client retention of intellectual property (IP) and to increase the use of managed services. “Vendor trading software offers many cost benefits. However, if you have spent years fine-tuning proprietary algorithms, in a downturn, with redundancies, you don’t want your main programme traders leaving and becoming a competitor with your proprietary system information,” says Griggs. Orc’s Liquidator allows the client to write their own strategies,

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programming in freely available Java script, but with the valuable IP remaining with the client. “People are looking for more autonomy from the algo and the event-driven side and this algo trading application protects their IP. They don’t need to expose their core IP to a vendor. Griggs adds: “Managed services is a huge trend at the moment. It’s where technology companies buy the server and host all the infrastructure, with the clients free to look after their core business. They pay a fee and we take care of all the hardware, software, connectivity and so on. It saves the banks huge amounts of time and money. I see this as a big growth area.” Byrne adds that while it’s good for the buy side to have their own technology because it gives them control over their destiny, the downside is cost and the risk is that you might not develop something better than is available to the competition off the shelf. “People who do it have to do it well enough to achieve a competitive edge,” he says. As connections between all sides increase, so does the technological capacity to do so. In 1965 Intel co-founder Gordon Moore predicted that every two years until 2015 the number of transistors able to be placed on an integrated circuit board would double. The accuracy of Moore’s Law has been borne out—despite its investor now saying it is not infinite— in the trading world as capacity has increased and computers have become smaller, more powerful and faster. Byrne of Corvil says speeds are still increasing. “Last year we had a handful of trades trading in milliseconds (a thousandth of a second). This year in April, we had trades trading at 16-20 microseconds (16-20 millionths of a second) and two weeks ago we did our first measurement of less than a microsecond, measured in nanoseconds (a thousandth of a microsecond). A real trade for a client, not just a lab measurement.” Byrne is, however, wary of speed for speed’s sake. “It can get as fast as you want but ultimately, it’s dictated by profit versus cost. Can I get zero latency? Yes, but for infinite cost. So you find there is a natural finishing point which is determined by the ability to make profits. If I wanted to try to get to the airport to make a flight, there’s a huge difference in journey time depending on when I leave my office. If I leave at 9pm I will get there much faster than in rush hour. If you have a system that can determine how fast in real time your system can operate at, you will be able to make decisions in real time when and where to trade. The choice of investing in the technology is linked to the choice of information systems surrounding it. If you have your radio on and hear about a traffic jam, you will work around that to get to your flight.” Carjat is seeing more clients demanding trades routed globally as technology paves the way for high-speed global trading. Atrium claims high-speed rings between New Jersey and Chicago and Toronto, for example. “Globalisation started at firm level, as US firms set up in Europe to trade there, for example. Until now, algos couldn’t cope with the latency involved in long distances. However, with our increasing ability to direct trade faster down pipes we are starting to see globalisation at the trading level.”

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Stephen Bruel, research director with Tower Group, says: “Lines between buy side and sell side and sell side and exchange are blurring, in particular as the buy side takes on more responsibility themselves, whether hiring more research people or whether hiring trading strategists.” Photograph kindly supplied by Tower Group, August 2010. `

Natural synergies are being exploited in relationships between technology companies and agency brokers. Earlier this year, for example, Orc Software merged with agency broker Neonet to create a combined Swedish-based company offering technology solutions and execution. Duncan Higgins, head of electronic sales at agency broker ITG, believes it was the financial crisis that changed the direction in which integration of buy and sell side was moving. “If you went back a couple of years and looked forward, you might have expected more buy side firms to be developing execution tools themselves. The financial crisis changed things. There is less money to invest and where they might have decided to create their own algorithms or upgrade their systems they are coming to us and together we design something suited to their trading style. “We are seeing more outsourcing. The balance has shifted in the last couple of years to firms paying for something as and when they trade, rather than making a big capital investment up front.” Byrne, too, sees the balance shifting: “Venues still turn cartwheels to accommodate the sell side and the sell side

TECHNOLOGICAL ADVANCES DRIVE THE TRADING INDUSTRY 64

Emmanuel Carjat, chief executive, Atrium Network. “As regulators start to look more closely at sponsored access and naked access, the best way to link directly to exchanges is to become a broker yourself and have the proper systems and balance sheets to do it,” he says. Photograph kindly supplied by Atrium Network, August 2010.

will do the same for the buy side. The buy side has tried to take control of its own destiny, bringing more in-house and doing more themselves, but I think we are about to see a reversal of that as they move back to the sell side who have just revamped their systems to win back the buy side relationship and business.” In Colombia, where three regional exchanges merged to form Bolsa de Valores de Colombia in 2001, technology provider Rapid Addition will deploy u-Trader, a buy side trading application, connecting traders to multiple counterparties including execution venues. The application allows institutions to automate their flow of equity orders, options, programme list and portfolio trades. Similarly, Charles River Development has brought out version nine of its investment management system, which combines order and execution management in a single system “to allow buy side traders to focus on generating alpha rather than managing various workflows for multiple applications”. Nevertheless, whether the buy side will develop their own smart order routers (SORs) is still under debate and the cost of building these technologies is “extreme”, according to Scott Daspin, a managing director in global electronic sales at ConvergEx Group. “Buy side SORs are not likely to happen because they don’t have the large budgets for the technologies behind them,” he says. Craig Lax, an executive managing director at ConvergEx Group, says: “What’s advantageous in one venue today is disadvantageous in the same venue next month, so you can’t get a good feel for that unless you are routing an enormous amount of order flow.” ConvergEx, by its very name, is an example of the converging of technology and agency execution.

Lax says: “Our entire execution strategy is based on delivering proprietary technology to our customers and enabling them to use it on their desktops or for us to use it on their behalf. We win a lot of business due to our agency nature. All clients have the use of all our tools, whereas some of the investment banks might only give their proprietary technology to a small percentage of their top clients who demand it.” A multi-tiered market seems to be developing, with technology a major contributing factor, according to Bruel. “Firms with advanced trading tools and techniques can more quickly access market information, leaving less sophisticated users of technology behind.” Higgins agrees: “There’s a top tier of probably five or six firms which are able to maintain a level of investment required to provide a full, top quality execution service. Then there’s a number that operate a generic service, without customisation, which can meet the needs of some clients. Frequently, we are working with other sell side firms to provide them with algorithms and white labelling solutions. This isn’t restricted to small firms; larger sell side firms are also outsourcing their algo trading technology.” Whether two tiers of firms will develop is based on the nature of the firms themselves, believes Lax. Some firms make technology their core, while others offer more traditional services and offer capital risk and market making. Which survive depends on their customers’ needs. “We have committed to the technology side and this has changed the entire focus of our firm,” says Lax. ConvergEx Group now has 30% of its employees on the technology side and more if technical staff supporting the trading teams are included. Byrne also believes that technology, as a driver in the industry, has an effect on the types of people employed.“If you look at the trader today, he needs a combination of trading acumen and an ability in maths to deliver an overall approach.”

Extreme changes Tower Group estimates that 20%-30% of top trading management of large US buy side firms “cut their teeth on the sell side or formerly ran sell side trading desks”, and Stephen Bruel predicts that some firms may have to undergo “a huge cultural change”, part of which would be to relocate investment analysts in close physical proximity to traders as Pyramis Global Advisors (Fidelity Investments’ asset management business) has done. However, firms decide to organise their desks, they have to look ahead when deciding on levels of technological investment. As Thomas Smykowski, ConvergEx head of global portfolio execution, says:“Decisions to build are made six months ahead of time. It’s like a puzzle, where you are always looking ahead to find where the right pieces are. This carries certain challenges and you have to have cooperation along all lines: a good suite of engineers, traders giving the ideas and being guided through the implementation process. Developments of six months ago are already outdated so you have to have good conversations for these delicate decisions. The technology field is always changing and you’ve got to be completely involved in what is needed next year.”■

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

MULTI-ASSET TRADING:

Field of Dreams or Nightmare on Wall Street? The market infrastructure for trading may be strictly segregated down the lines of asset classes, but most buy side firms are inherently multi-asset. Even when individual funds are asset class specific, almost all buy side firms cover multiple asset classes across their investment universe. The advantages for the buy side (and their clients) are clear. At a time when alpha is elusive and risk looms large, a diversified portfolio offers both significant speculative and hedging opportunities. Robin Strong, director, buy side strategy at Fidessa, reports. HE DAYS OF the 60-40 balanced portfolio are pretty much gone, now challenged by client mandates of evergrowing complexity. Bonds, for example, are no longer solely a means to bring stability to earnings or to preserve principal. Even before Europe’s sovereign debt crisis, the view that equity provides capital appreciation while bonds offer income had largely been dismissed. Even though financiers, investors and the general public have fallen out of love with collateralised debt and other higher yielding but potentially risky instruments, fund managers are still looking at more complex instruments to enhance portfolio returns, match liability cash flows and increase margins. Futures, options and swaps have become all but common place, and more complex synthetic instruments are becoming more widely used, especially since fund structures such as UCITS III and 130-30 permit their use. It seems the buy side is moving away from the long-only equity fund. Diversified portfolios are well established, and it follows that buy sides are investigating the benefits of diverse transactions, incorporating several instrument types into a single order. There are multi-country, multi-currency firms that want to hedge a trade with an appropriate future, but in another currency which requires a corresponding foreign exchange transaction. As it stands, however, multi-asset trading is rather like doing the Christmas shopping from several websites in one go. You have several shopping carts full of presents, drinks, food and clothes, and while attempting to compare the price of each, work out the postage costs and negotiate delivery times, some of your items will go out of stock. Or the price will

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go up. To save time, and ensure you get exactly what you want, you could confine your efforts to one site, but the chances are that you’ll be paying over the odds for the privilege. Fortunately, asset managers (unlike Christmas shoppers) can take advantage of a multi-asset order management system (OMS), which goes some way to help mitigate these problems. A truly multi-asset OMS can create multiple orders and send them simultaneously to multiple counterparties via FIX. However, it is not yet a perfect solution. Even the most sophisticated of buy side OMSs cannot cater for price movements and missed limits across multiple asset classes. Nor does it handle issues such as finding liquidity, request for quote (RFQ) workflows, collateral management or netting, for example. Traditionally buy sides leave those kinds of problems on the broker’s doorstep, and take on the cost because the value of the trade will, hopefully, outweigh the increased costs from the broker. The problem here though is that the markets are even less able to handle such a transaction in an efficient manner. Broker-dealers generally operate in traditional asset silos. The technology that is widely deployed is usually built along single asset lines, and the total cost of ownership of multiple systems (one per instrument type) makes it prohibitive for sell sides to go beyond one or two asset specialities, except for the bulge bracket brokers who have made some progress in this area. Even when a broker is capable of working several asset types, it is across multiple trading desks. Depending on the trade, an inefficient combination of these multiple trading desks is required in order to fulfill their buy side clients’ requests.

NEW ASSETS IN THE TRADING MIX

Photograph © Jenny Solomon / Dreamstime.com, supplied August 2010.

NEW ASSETS IN THE TRADING MIX Robin Strong, director, buy side strategy at Fidessa. The days of the 60-40 balanced portfolio are pretty much gone, now challenged by client mandates of ever-growing complexity, he writes. Photograph kindly supplied by Fidessa, August 2010.

Although there is growing adoption of platforms that can handle equities and equity options alike, the more complex trades involving bonds and structured products are more a question of seeking out a colleague on the appropriate trading desk and asking for manual support. Since exchanges, venues and clearing networks also tend to cater for a single asset class, it is easy to see why the move to a multi-asset trading desk has not yet taken off on the sell side. This creates difficulties for the buy side, which has to carry the transaction risks for multi-asset trades themselves. With a few exceptions, notably pairs trades and option strategies (or even structured products that have been specifically created) the responsibility and the liability lies solely with the asset manager. From the buy side perspective this is, of course, far from desirable. The question is whether the buy side can persuade the sell side to do anything about it. The challenges are, after all, formidable. The importance of operational transparency, and the penalties for failing to meet regulatory minimums in this

regard, raises the question of how best to manage client exposures and asset allocation across stove-piped trading desks. As regulation becomes stricter, and client mandates continue to include a number of interdependencies and complexities, this problem is a major sticking point. Then there is the issue of reporting. Most sell sides have extensive reporting capabilities at their finger tips; even more so since negotiating fragmented markets while demonstrating best execution became the focus of much of their activity. Daily client reports on trade confirmations and transaction cost analysis become much harder to achieve once a multiasset requirement is included. Indeed, trading multiple asset classes makes it much more difficult to achieve best execution in the first place. This is both concerning and complex when dealing with bonds, as attempts by the regulators to clear the murky fixed income waters have not yet made significant progress and any initiatives that result in spread compression will likely be resisted by the broker-dealers and market-makers who benefit most from the current structure. Perhaps the biggest hurdle right now is that of counterparty risk. The market has had far too many illustrations of the consequences of inadequate management of counterparty and credit risk of late. The focus for compliance departments has therefore switched from analysis of individual instruments held in portfolios, such as the credit rating of a corporate bond issuer, to who the trading counterparties were, for example in a swap agreement. To perform valid analysis extra information is now needed: individual trades instead of aggregated holdings; counterparties, or more particularly the legal entities and hierarchies within each counterparty; and the guarantor/obligor relationships. If separate aspects of one complex, multi-asset trade are with different divisions within the same entity, a firm can soon find itself exceeding its credit limits and in breach of internal risk parameters. Over-the-counter trades only exacerbate this problem. Whatâ&#x20AC;&#x2122;s more, when a firm has two different counterparties, it has to post collateral for two sides of a trade. The result is that they have to post a lot more collateral, because they may net off to a relatively low exposure profile. Multi-asset trading, by its very definition, makes this analysis of counterparty credit risk more complex, more time consuming and more inefficient. Inevitably then, we find there is a disconnection between the sell side and its buy side clients. Risk is unequally dispersed, and the incentives for sell sides to meet buy side demand for greater multiasset functionality are not yet prevalent enough to overwhelm natural reluctance to invest in a new technological arms race. Nonetheless, just as the buy side has responded to demands from their clients to adopt a more multi-asset focused strategy, if sufficient pressure is placed on the sell side it seems likely that brokers will start to provide a more comprehensive multi-asset service. The inherent problems are not completely solvable, and it must be acknowledged that the market will not achieve a state of multi-asset nirvana. Nonetheless there are moves that can be made on both sides to achieve a more equitable distribution of multi-asset capabilities-and to achieve the goals of investors. â&#x2013;

SEPTEMBER 2010 â&#x20AC;˘ FTSE GLOBAL MARKETS

ASIAN TRADING ROUNDTABLE:

BUILDING THE NEW TRADING GATEWAY

Attendees

Supported by:

From left to right (top row) MARK WHEATLEY, head of Japan equities, & regional head, electronic trading, Bank of America Merrill Lynch MATT SAUL, regional head of trading, Asia (ex-Japan), Fidelity Investment Managers MATT McKEITH, global head of equity dealing, First State Investments RICHARD COULSTOCK, director, head of dealing, Prudential Asset Management (Singapore) From left to right (below) JOHN ADAIR, co-head, equity sales, Asia, Nomura ANDY CHAN, head of sales trading and portfolio trading, Asia, UBS MICHAEL KIM, managing director, & head of electronic equities product management, Asia, Barclays Capital:

FTSE GLOBAL MARKETS â&#x20AC;˘ SEPTEMBER 2010

ASIAN TRADING ROUNDTABLE 68

ENTER THE DRAGONS MICHAEL KIM, MANAGING DIRECTOR, & HEAD OF ELECTRONIC EQUITIES PRODUCT MANAGEMENT, ASIA: As I’m pretty sure everyone is aware, we are fairly new to the equities business in Asia. Following the purchase of Lehman Brothers’ operations in North America, we have been building out the franchise in Asia and have been working closely with the US in this regard. Right now, we are in the second year of the build out. We are in a phase of heavy investment, establishing new infrastructure and a new way of looking at the business in order to build our equities franchise and leverage business development in the region. We have been given an interesting opportunity, because we can build a high touch business and an electronic business and other parts of the business all simultaneously. I am not sure many other firms have enjoyed this kind of opportunity—to do it from a blank piece of paper. As the Asian market is becoming more focused on electronic and low-latency execution, and on the platform-based infrastructure of the region, this freshstart approach plays to both our investment strategy and our business build-out strategy in Asia. RICHARD COULSTOCK, DIRECTOR, HEAD OF DEALING, PRUDENTIAL ASSET MANAGEMENT (SINGAPORE): Over the last four years we have driven forward the way to execute our equity trades: in terms of looking at the systems that we use, looking at benchmarking, looking at the alternative execution venues that are arising in Asia and making sure we’ve got access to as many venues as we believe are appropriate and relevant for us, taking into account best execution requirements. We’ve pretty much got the equity side to where we want it to be and about a year and a half ago we merged our equity dealing desk with other asset classes, and we now cover all asset classes on one desk. Now we are increasing attention on workflows, systems and benchmarking for fixed interest and FX, for example. ANDY CHAN, HEAD OF SALES TRADING AND PORTFOLIO TRADING, ASIA, UBS: Over the last ten years I have seen UBS build a leading market position in derivatives, prime brokerage and electronic trading based on the back of our strong traditional advisory business. The last few years have been pretty tough on UBS, like everyone else in the financial services industry. As a whole, the UBS franchise, the depth of our client relationships and our investment in technology have helped the firm to rise above most of the difficulties that we’ve faced. It was vital that we continued to invest in technology and more importantly client relationships over the last three years. We introduced an entirely new technology infrastructure in 2007 and we’ve managed to maintain the level of technology spend each year since and, in that regard, we’ve come out pretty much better than a lot of competitors. An important consideration for us over the short term, however, is our individual country focus. Countries we’ve recently made a significant commitment to, such as China and India, are going to be fundamentally important to all our businesses.

JOHN ADAIR, CO-HEAD EQUITY SALES, ASIA, NOMURA: Over the last year and a half, from a personal and professional perspective, it has been really interesting to be part of Nomura’s global transformation. Our objectives over that period have involved taking a Japan-focused, traditional cash, content-driven, high-touch business model and transforming it into a truly global, world-class investment bank. That involves providing the whole spectrum of execution services to clients as well as multi-product diversification into Asia Pacific, and at the same time, modifying and upgrading the infrastructure and technology and incorporating it into the whole Nomura platform. We are focused on delivering the product, increasing the client base and rapidly growing our flow business. After investing heavily in our content platform, and combining it with our execution capabilities, we are starting to see results—number one on the LSE, ranked second for II Europe research, dominant market share on the TSE, ranked first by II for Japan and China research and second for Asia research. We are also concentrating on expanding the global footprint in the US and building out the product there. We are receiving very positive feedback from clients around the recent hires and momentum in terms of market share. MATT SAUL, REGIONAL HEAD OF TRADING, ASIA [EX-JAPAN], FIDELITY INVESTMENT MANAGERS: We are a pretty vanilla long pension manager, heavily involved in all the markets around the region from Australia and New Zealand through to India—even Pakistan. We have a sizeable operation in Hong Kong, with 14 traders between the two desks of Japan and ex-Japan. Unlike Richard, we are confined mainly to equities, and long equities predominantly, very little in the way of derivatives. We still try to position ourselves as a pretty aggressive trading group. We’re always open to new ideas and new execution venues, new trading tools. Our biggest challenge every day is trying to squeeze liquidity out of all these markets. It’s certainly gotten tougher in the last few months, and that’s why we continue to look to the new, new thing to see if it can improve our outcomes. Our big push right now is with local regulators; to get them to understand our concerns, our requirements and what we are doing to protect investors in all our markets, while satisfying their specific local concerns. It can be quite challenging, obviously, as there are a host of very different regulatory regimes involved. Equally, we raise assets in virtually every market in Asia and that is another challenge for us to deal with. MARK WHEATLEY, HEAD OF JAPAN EQUITIES, & REGIONAL HEAD, ELECTRONIC TRADING, BANK OF AMERICA MERRILL LYNCH: Joining the Asia business at Merrill Lynch from Europe, I felt I was coming to a slightly lower footprint in terms of research penetration, and building around a trading product that, in this region, was much more standalone and self-sufficient. One key difference in Asia involves the beginnings of the build out of new trading venues, where we are having to deal with multiple and widely differing regulators and exchanges; most of which I physically can’t communicate with. You have to deal through local personnel, and, in doing that, knowing that you’re probably not getting the right questions asked and certainly not always

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Andy Chan, head of sales trading and portfolio trading, Asia, UBS

getting the right answers either. Historically, we have been more a high touch franchise, and while it is true that in some ways it may be easier to start with a blank canvas, we are working at it. We also have some challenges around achieving load balance: actual spend and where you invest it. As with everyone, there is not a bottomless pit of funding to support the build; be it in general technology or specific targets. You have to make certain assumptions and in some cases anticipate start up trading venues or new markets in the hope that it pays off over the long run. MATT McKEITH, GLOBAL HEAD OF EQUITY DEALING FOR FIRST STATE INVESTMENTS: Our emphasis is to continue progressing the build out of an effective global front office platform across our global business— encompassing multi strategies, multiple offices, and of course, from the external point of view, different speeds of development of the markets and adoption of technology in each of the regions. That continues to be quite a significant focus for us and, like a lot of people have already said, it’s about choosing and picking the right technology—some of the biggest decisions we make on an ongoing basis.

THE BUY SIDE/SELL SIDE RELATIONSHIP: A FEAST OF CHANGE MARK WHEATLEY: In Asia, the relationship between the buy and the sell side has been mostly straightforward. The US and Europe enjoy a far more simplistic structure these days, in part because of the relative uniformity of regulation and the fact that they have regional regulators, and whilst Asia clearly doesn’t and won’t likely soon, it has been a relatively stable environment. However, what we want to try and achieve is a similar level of service right the way across all the markets, and to some extent in the past that’s been very much about shielding the buy side from some of the vagaries of the underlying market. Clearly in some markets we have the issues of registration and IDs, and obviously you cannot cover every eventuality. However, from a trading perspective and a service level perspective, that’s really what the driver has been. Moreover, over the last 12 to 18 months, there has been a sea change in terms of the amount that buy side trading desks take on themselves. Our job now isn’t necessarily to protect them, but to guide them if we can and also to take notice of

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their particular requirements. Market by market we’re offering much more customisation of service around what our clients actually do or don’t need. JOHN ADAIR: The dynamic between clients, brokers, regulators and exchanges is slowly evolving, but down a similar path to the rest of the world. However, we are behind the curve as to where things stand in the US and Europe. We lack a single structure in Asia so we’re operating on exchanges with different mandates and client bases. Whereas the US and Europe has had big-bang events such as MiFID and Regulation NMS, Asian regulators and exchanges still operate very independently. It comes down to commonality of purpose and I think we all share a pretty strong fundamental view of where we want to be as an industry. The broker-client relationship has evolved to the point where we have both faced off together with regulators; we share a common viewpoint. We’ve visited regulators in India, Hong Kong and Korea as a consortium. Ultimately, I agree with Mark, we have to deal with fragmentation in the short term, but over the longer view, whether it starts in Australia or elsewhere in Asia, we will start to have some consistency across the region. MATT SAUL: There is definitely a mutual interest between buy side firms and sell side firms to try and progress the regulatory issues. Companies, such as ourselves, that perhaps have more of a global outlook can see the benefits that have been achieved in the US and Europe. The challenge is finding a way to encourage local entities, regulators or exchanges to move along the same development trajectory, while developing in a way that is appropriate to the environment here: you can’t just take what worked in the US and drop it into Asia and say: “Off you go!”However, I don’t think those are the expectations necessarily from the buy side and the sell side, but things continue to move very slowly and it is quite obvious, especially for firms that import global practices, that there’s still a lot of work to do. RICHARD COULSTOCK: I’ve been in Asia for four years now and in that period there have been some quite substantial and significant changes in the way that executions are done locally. For example, dark pools are coming into the region. There has been a proliferation of execution management systems, and then electronic trading and so forth. Four years ago we had no electronic trading; now our current run rate is something around about 15% of overall turnover. However, I have been getting feedback recently that within certain asset management firms, that percentage may be up to 40% in Asia. That’s pretty significant, because in my mind if you’ve got an equity execution desk with access to the best systems, electronic trading and all the various pools of liquidity, then there is a substantial change in mentality, in that the buy side can and is now taking responsibility for its own executions. The other thing is that we tend to look at broker relationships as partnerships rather than a customer/client framework. One of the things I’m fortunate about in PAMS is that we tend to maintain long-standing, stable broker relationships— we don’t chop and change constantly. That allows you to build up a better working relationship and mutual understanding with counterparties.

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MICHAEL KIM: We are all pretty much in unison on the unlikelihood of significant and consistent change across the region any time soon. However, looking at individual countries, developments have been both considerable and encouraging. If you look at Japan, for instance, there are about eight alternative venues already up and running, but not much traction at this point. They only have about 1% of TSE volume trading offexchange. A lot of the resistance is coming from both the sell side and the buy side. Local participants are not able to fully leverage the changes, either for reasons of technology or simply mindset. In Japan, there could really be a push for a lower bid offer spread and a lower cost of trade, because essentially if you’re a proprietary trading system (PTS) you can charge whatever you want; or you can charge nothing! Right now, we don’t really have a player in Japan who is taking that kind of outside-the-box view. But assuming Japan is a market ready to take that leap—and I believe it is— then we are already prepared in some parts of the market to start moving forward. Having said that, if you look at some of the regulators’responses to the“flash crash”, using it as a justification of their conservative stances, there may be longer-term consequences to the event than we would like, and in this instance, it may even have set us back a couple of years. MATT McKEITH: That’s absolutely right and as movements in some markets might suggest, for example, an over-vigorous defence of a monopoly exchange’s previous operating model, the flash crash has certainly handed quite a lot of people who have a vested interest in not proceeding so rapidly with change or embracing it, perhaps, reasonable grounds for saying:“Hold on a minute.” It’s not just the flash crash, it’s also what’s happened in the markets globally over the last couple of years, such as the rapid enhancement of risk profiling across companies. Regulators obviously jump-start into action, especially following unfortunate instances like Lehman’s bankruptcy. In that respect, the pendulum has swayed back a little and that’s what’s interrupted perhaps the development in the Asian region in areas such as technology and opening up of the markets. There is a much more hesitant and questioning approach in many of the exchanges and among regulators; the flash crash has given them more reason to put on the brakes. ANDY CHAN: There hasn’t been any knee-jerk reaction so far from the regulators in Asia, which is good. This may be because some of the systems are simply behind in terms of technology. However, competition promotes change. If you look at ASX for example, once they adopted ESIC, you’ve seen the exchange leap forward. Now they’ve acquired two different, new matching systems that they will roll out in November, I understand. Moreover, you’ve now seen how competitive forces encouraged the Tokyo Stock Exchange to embark on its Arrowhead initiative. Once competition heats up, change may come about in Asia much more quickly than we might currently expect. In terms of current developments, we should be looking at the Chi-East franchise; let’s see if it kicks off well. We might still witness an aggressive reaction from some exchanges in the future; but I think the process of change is very much in train.

John Adair, co-head, equity sales, Asia, Nomura

MATT McKEITH: We have already seen some knee-jerk reactions from regulators, for example locally in HK they were looking recently at Goldman’s dark pool offering. Perhaps there is a sufficient reason to look at them but I mean these were questions they weren’t thinking of asking before. Investors have been accessing internal broker dark pools for some time, and regulatory or other government bodies now feel as though they need to be seen to be asking questions in light of disappointment with markets over the last couple of years and lapses in certain areas. MATT SAUL: Yes, it’s a bit of a contentious point. We constantly feel like we’re in a dance that is two steps forward, one step back. Every time we make some progress then six months later we go on backwards a bit. There’s a bit of defending their own interests from the incumbents, whether it’s the ASX or the Hong Kong exchange, and so forth, and that’s natural, I guess. Equally, there were some clearly poorly-built systems which led to the events that happened say a couple of months ago. There’s nothing wrong with applying a bit of a spotlight on some of these dark pools and saying:“Look, how do they work and what’s actually happening in them?”In Asia it’s a bit of an academic question, if you were to dive into the dark pools currently out there, you would probably break your neck because they are not very deep! That’s the crux for us: it is not that regulators are cutting off initiatives, but that a lot of these alternative venues are still in their infancy. MICHAEL KIM: If you look at the content of dark pools you have a lot of questions about who is on the other side of your trades and you really want to know who or what you’re trading against. Looking back at the US model, the Designated Market Maker (DMM) is actually rewarded for providing liquidity instead of making money on the spread. So, for example, with regard to the Flash Crash, and given that BarCap is the largest DMM at the NYSE, we provided a significant amount of liquidity to the market during that period. The DMM gets rewarded for what is fairly market-neutral activity. A true market maker is not an alpha player but should provide fair bid offer spreads and actually be on the other side of the trade whenever there’s a lack of market participants. This piece is missing in Asia at this point. If somebody would take the initiative, even from a dark pool or PTS/MTS perspective, that might significantly change the game in the short term.

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MATT McKEITH: Dark pools are almost insignificant to the challenges the larger institutions’ face in terms of finding liquidity. There is only one venue at the minute that has any real sense of success and in a neutral structure (buy side to buy side only) that we certainly favour and would love to see it in somewhere like India, for obvious reasons. Ultimately, it is really a question for the sell side as to why these dark pools are not taking off the way they could. Is the retail structure in the region one of the reasons why maybe these dark pools just aren’t going to work in the same way they might be working in other parts of the globe? Or is it the case that they are more restricted by market structures and regulation? Even so, the buy side can say what we’d like to see and how we’d like them to work; especially in terms of providing liquidity.

of liquidity fragmentation) to the point where it achieves tangible improvements for our end clients, which is what we’re about at the end of the day. I’m very happy to push back on the sell side in some of these areas. There is a point where we will just not participate unless we can see advantages to it. I mean it must be very clear that if we take the example of internal broker pools, the participation rates in these pools is telling you something: that the clients aren’t really getting involved in this. So the sell side can use them for their own internal benefits, big firms such as UBS can pool and cross their own flow across wide parts of their business. Or they can start finding a way to share that dark liquidity in a broad sense to make the access easier and more meaningful in terms of hit rates and outcomes for buy side desks who like the option. Ultimately it’s their decision.

WHO REALLY BENEFITS FROM CHANGE? MARK WHEATLEY: I don’t necessarily think it is clear. There are lessons from Europe after MiFID. The buy side had been given a very clear mandate to own best execution themselves, which was a bit of a shock to the system; it became very difficult to manage and visibility disappeared. Even though MiFID was flagged, it was pretty clear few people had really prepared for it. It was impossible to miss that there was no national best bid and offer (NBBO) obligation and none of the venues really fed information real time. That early period was very painful. A lot of money had been spent on technology to fragment liquidity and a lot of money had to be spent to recombine it into a single picture. Nowadays, of course, it is much better. Now buy side desks are in a good position to control their execution, simply because they can see what happens in the market and they get a lot more information from the buy side because they interact with all the different brokers. You can definitely use technology to pick and choose which venues you interact with, regardless of whether it is direct or through a broker pipe.You can control how much you actually want to deal. So, on a buy side trading desk you’re generally much better off than you were before, but the cost of staying that way is significantly higher. The question is: how much money do you want to spend on owning the dealing and a technology infrastructure? MATT McKEITH: Take the example of ASX and the way it has responded. There’s been an immediate shift to head off the possible competition they may face. Then again, you can also see the benefits of the Arrowhead initiative in Tokyo. Singapore is another exchange which is gearing up to meet the potential challenges. We’ve all seen charts of how spreads come in, liquidity goes up, and cost of trading comes down. I don’t think buy side firms such as ourselves will sit there thinking that’s no good to us. Obviously competition is good but there is a tipping point: how much is enough and what ultimately is effective? Other changes are coming but you have to ask: well, what was the cost for the gain achieved? For us there is ultimately an efficiency“limit”of competition in each market of the region, as there is in a buy side desk looking to structure itself to interact with those changes (e.g. extent

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Mark Wheatley, head of Japan equities, & regional head, electronic trading, Bank of America Merrill Lynch

MICHAEL KIM: There are two parts to this: one, you can leverage technology to a certain point and then you stop; or, you keep going, adapting as technology continues to evolve— which is where the US is heading. We’ve just taken the first step in Asia with leveraging dark pools, etc. Once the right infrastructure is in place, a lot of the onus of searching for liquidity can be handed off to the sell side, as long as you have a clear indication and intelligence as to what you’re trading against and the quality of the pool that’s in there. Market participants need to be aware that not every bid offer order sitting in a dark pool is actually equal. You’ve got different types of flow coming in, and it’s really important for us to give clients access to various choices. At the same time, we must give clients clear intelligence as to what they are trading against, so they can make informed choices as to how to execute in these pools. Those parameters should be given back to buy side firms so that they can tweak them to suit their trading style and not force them to limit the number of pools they are comfortable using. That said, it may ultimately go that way because of the high cost of maintaining so many pools.You can get to a point

ASIAN TRADING ROUNDTABLE

where certain pools will have the majority of the flow and the other pools will eventually disappear. MATT McKEITH: It will be interesting to know where the end might be: is it just one market and we go full circle? There’s a precedent. In the 1970s, Hong Kong had four separate equity trading markets or exchanges, and I’m sure when they moved to a single exchange in the mid-1980s everybody was telling their clients about the advantages of having one exchange. This is one reason why I don’t embrace everything that’s happening in this part of the market, because everything, including our industry, moves in cycles. This is the cycle driven by technology. Maybe the exchange monopoly model was staid and needed shaking up; certainly that is happening. The question is: do we go full circle back to one liquidity venue, maybe a much more intelligent venue, but one all the same? MICHAEL KIM: The exchanges and regulators will never move at the rate that the most ambitious market participants want them to move. So no matter how much the regulators are “pushed”and no matter how much competition the sell side provides, regulators will always move at their own pace. If market participants don’t continue to innovate and come up with alternative ways to execute, then the speed of change through regulation will be slow. If you look at what happened in Australia, much of this should have happened years ago, but they lost of lot of their momentum, particularly for those venues that started early but did not managed to accomplish their objectives. If you look at other markets where participants remained committed to innovation and adopted a certain amount of self control, they have tended to make progress much more quickly. Of course, that is the way that we want to go here in Asia.

costs and allow greater speed, etc. If we were to introduce some competition, that would be a good start. However, we just need to control the consistency and compliance among the competition through the regulators. We can try to shape it so it brings the most benefit to investors. JOHN ADAIR: What the TSE has done is a pretty good indication of what is possible. Three years ago we would have said the speed and access of the TSE will lead to dark and lit pools opening up the doors to competition. The TSE realised that and responded accordingly. The game changers were obviously co-location, where everything’s operating a lot more efficiently with a lot less latency, faster tick data, and reduced tick sizes along with reduced costs. Also, the cost of the exchange itself is relatively low. Other exchanges around the region, having observed the TSE’s Arrowhead initiative in terms of making its platform competitive with outside competitors and increasing efficiencies, will surely take note, particularly if they want to attract more high-frequency players. Then there is the consideration that the TSE could drive it up one more level and try to take some share away from other markets at some point—which is a very strong possibility.

TACKLING THE MONOPOLY EXCHANGE STRUCTURES IN ASIA RICHARD COULSTOCK: There is an inherent problem if you have a monopolistic exchange that is publicly listed and one of its main goals is to make profits for its shareholders (if it makes those profits, that is). If I want to cross stock against another asset manager, why should we pay the exchange for the privilege of doing that? Exchanges charge us to make profits for their shareholders, so we do need a degree of competition to temper any possible conflict of interest. I don’t think anyone wants proliferation and I’m not sure if anybody’s advocating that. MATT SAUL: I doubt very much we will get proliferation. RICHARD COULSTOCK: If you’ve got a multi-market, multi-regulatory environment it is very difficult for one participant to come in and replicate what’s happened elsewhere in the world. ANDY CHAN: I agree, if there’s a little bit of competition it is good, but it is not healthy to go overboard. With Europe it’s slightly different. Most of the current MTFs launched at a time when the markets all trended completely down, volumes just disappeared. That was over late 2007 to mid-2008, so they were a little bit unlucky then. What you’re trying over here is to encourage the exchange to move towards reducing frictional

Matt Saul, regional head of trading, Asia (ex-Japan), Fidelity Investment Managers

ANDY CHAN: That’s a great example. I saw some statistics somewhere that in January, was it Japannext was trading about $100m a day and today it’s probably trading on $30m a day, so a significant portion has been taken back by the TSE. MICHAEL KIM: Some of that has to do with the regulatory change around short selling that had an adverse impact on the TCX. ANDY CHAN: It remains to be seen. ASX would be a good example to watch and personally I would like to see Chi-East succeed. At least it forces major players such as the Hong Kong Stock Exchange to think a little bit longer term and strategically in terms of what the markets want them to do. As a sell side provider, I look at the costs of the Hong Kong Stock Exchange with a single clearing firm. Trades are getting smaller and therefore we are trading more frequently than we did five or

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six years ago, but the Hong Kong Stock Exchange has fixed costs in terms of fees. So my absolute costs have actually gone up. Therefore, the introduction of competition, whether it’s a dark pool or additional clearing facility will help the sell side, which quickly translates to savings to the buy side. It has to be a process managed across the spectrum—from multi venues to a multi-clearing model or multi-regional clearing model—for it to work effectively, deliver choices to the clients, and assist in lowering transaction costs. MARK WHEATLEY: The cost savings post-MiFID in Europe were 80% or so on the trading side but also about 80% on the clearing side because of competition. In terms of the technology build, few benefited because it’s expensive, but costs declined dramatically for the execution and clearing bill for running a trading business. Much of that was passed on to clients and I haven’t seen execution rates go up much in the past. I like to see these changes at exchanges and the dynamics that drive change; but do we really want multiple venues that potentially fold due to lack of profit? Look at Turquoise, where seven or eight investment banks got round a table and created a market place as a utility. It was clearly very hard to do when everyone’s views were equally important but often different! The main drivers were in part competition, in part greed (you saw a valuation of the LSE, for example and naturally extrapolated that Turquoise was a billion-dollar company, and of course, most recently it has been sold off to the LSE for considerably less than that). However, the whole exchange model has now changed. Yes, you can look at ChiX and say it is not actually making a lot of money in Europe, but it’s not charging for data, services, or co-location, and now it has a 25% to 30% market share. It’s going to be very hard to get rich from running an exchange, but I like the reduction in friction.

IS THERE TOO MUCH SPACE BETWEEN THE PORTFOLIO MANAGER & THE SELL SIDE TRADING DESK? MATT McKEITH: That whole argument hinges on what fundamental process or strategy the fund is being run. If a fund manager is investing because of a particular price point in the market it might be important, but when they’re investing over five years because they like the valuation of an investment concept, it is not. All the talk about latency, for mainly long only fundamental analysis investors, it means almost zero to us as a firm. The same applies to how far back you take the measurement of certain aspects of trading? It’s a lot more complex than to do with a three microsecond slippage before the trade actually hits the market. This is one of my bugbears: and it started with the transactional cost analysis guys coming into firms such as ours and consultants and persuading us of their importance because they could go back and show you the slippages by way of black and white statistics. It’s far from a black and white reality. RICHARD COULSTOCK: A previous boss back in Scotland used to say that if it takes his fund manager three months to

FTSE GLOBAL MARKETS • SEPTEMBER 2010

Matt McKeith, global head of equity dealing, First State Investments

decide what stock to buy or sell, does he really care about one or two nanoseconds getting to an exchange? It is not really an issue for us as such, but I do think there is an issue with market impact; and one of the things about Asia is that every market is really quite different. If you take India, for example, information leakage is a huge issue and you probably don’t have that as much in the European exchanges or in the US. It may be going off at a tangent a little bit, but in Asia you have to understand each market and handle each market differently according to its own nuances. To bring this back a little bit to electronic trading, if you look at Asia ex-Japan, you’ve got far more confidence in speaking to a sales trader and handling a high-touch order event. At PAMS we’ve got an Indian specialist on our desk and he wouldn’t show a high-touch order to a sales trader in a month of Sundays because within five, ten minutes of him doing so, the chances are the stock could move 5%, 10% away from him. For Indian orders, we will tend to handle high-touch orders ourselves electronically and give the smaller orders to sales traders, whereas for high-touch orders in Asia ex-India we generally still use a sales trader service. MATT McKEITH: Do you need traditional sales trading desks? Richard was demonstrating that the value chain between buy side and sell side is not about how far back you take it to portfolio manager. There may be some value for some firms, sure, and it can eliminate a few things, but because of the markets in Asia and the particular issues we face, it’s related more to the issue Richard has highlighted in India, and perhaps that’s where value can be generated. Or, it’s the value of the relationship between the buy side and the sell side on the assumption you feel confident the sell side in these situations are working for both your mutual benefit to get your business done. MATT SAUL: Technology, coupled with the tighter business environment, has changed the relationship between the buy and sell side. In the last couple of years in particular we saw the relationship break down into silos; but it has now reverted

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Richard Coulstock, director, head of dealing, Prudential Asset Management (Singapore)

back to being a total relationship. Rather than the sell side feeling threatened by us changing channels, depending upon the trade, depending upon the day, depending upon the market volatility, depending on whether I’m in meetings instead of being at my desk, it is a big shift in terms of behaviour. Now we may then have to tweak how we manage our relationship to fit the fact that one channel’s a lower cost than another, but fundamentally if we don’t pay the street they’ll stop the services. All this is coming around to saying that there’s not a conflict between the buy side and the sell side, there’s just a partnership to work out where value can be captured and how it can be paid for. JOHN ADAIR: If you look beyond the trading desk relationship and you take a look at the traditional value proposition, it is research, it is corporate access, it is good sales calls, it is good analyst calls, and it is differentiating ways of packaging research and content across sectors. It is tying global themes together. Then you look again at the trading relationship and at some level the traditional sales trader almost doesn’t exist anymore; it’s the truly global brokers where most of the buy side people round this table want to execute their businesses. That function has largely been driven by technology. We’re all going to have smart order routers, access to multiple venues, some of us are going to provide capital commitment and most of us have good access to differentiating flow from varying sources. To Matt’s point, where we’re concentrating our effort is to differentiate ourselves by the quality of the products we can bring to the table to make the client more efficient in their pursuit of best execution. Whether they want confidential direct market access execution, over-the counter flow volume trading or high touch sales trading, capital commitment etc, we help them express their views of the markets efficiently. That’s what we call our liquid market sales platform across sales trading, the portfolio trading desk and electronic desk as well as the multi-strategy sales desks, and linking them together with our content. On some level the conclusion I’ve come to is that you have to be best in breed in almost every part of that whole value proposition across trading and content, and most of us around this table are actually going down that path right now. ANDY CHAN: I’m not sure I agree with John. The traditional sales trading role has evolved. We mentioned earlier on that

the programme trading desk, the electronic trading desk and cash trading as we see it has grown in terms of delivering an increasing percentage of execution from a cash perspective. However, the sales trader has evolved over the last couple of years in terms of value and in terms of content they deliver to clients. There’s a capital and content commitment, access products and derivatives, so it’s changed quite a little bit in terms of where they add the value. The traditional sales trader is now a solution provider to the buy side. It’s a partnership that is meant to enhance performance. JOHN ADAIR: I’ll even take that a step further in the value proposition and say that the sell side has gotten a lot better though it still has a long way to go, in general, about connecting fixed income businesses together with equities: whether it’s helping with FX solutions or executing the broader mandates for the institutional client base or with the hedge funds that are truly multi-strategy across asset classes. MICHAEL KIM: We’re in the process of building out our Japan franchise. We’ve been building for about a year and a half. Research is a product that’s getting us into a lot of different areas. Things had bifurcated over the past five years, but now, as many people mentioned, the research value proposition is coming back. The electronic relationship, programme trading and high touch, these really should funnel through a common point to sell the whole firm. That’s really what we realise more and more. I’ve been with BarCap for about a year now and I definitely see that things have changed significantly, and there is an accelerating trend back towards an integrated model. RICHARD COULSTOCK: We have built a desk that has dealers with different skill sets. For example, one dealer is very experienced in derivatives and increasingly we are giving feedback to our fund management team in terms of derivative strategies. I believe that one way for dealing desks to evolve is to become more involved in the investment process and give that sort of feedback rather than just sitting quietly and accepting whatever trades are given to them. If there are alternatives, the dealers could discuss these with the portfolio manager.

LIQUIDITY & TECHNOLOGY: FUNDAMENTALTO FUTURE GROWTH ANDY CHAN: The basis of running a successful equities trading business is technology. Obviously, we are all in something of a trough right now and inevitably in the short term there will be some pain in the market, but everything always goes in a cycle and as the market turns around, technology will enable you to capture the first volume cycle while some of the competition are just starting to rehire again. Now when I put myself in a client’s shoes, as I plan for growth, I am not that interested in just execution skills per se, I am looking for solution providers; people who are able to bring a multitude of products together to achieve my investment objective. I probably see them more as creative people who are solution providers, but they are also capable of superb execution. MARK WHEATLEY: If you are looking at the plain vanilla cash market, clearly there’s a lot of focus on the high-frequency space, though in Asia it is still pretty light as a percentage of

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overall trading compared with other regions. Initiatives such as Arrowhead and the multiple venues springing up around the region will result in a natural increase in automated trading. It’s a business opportunity, but it depends on your objectives. If you seek a large profit then that’s not going to be it because it’s really at the fine end of utility trading and you’re often providing a technology service, as opposed to an added-value trading service. In terms of growing the market overall and opening up your ability to trade around the region in a much more cohesive way with less regulatory pain, paperwork, and documentation, all this will combine to generate new types of investors that are willing to come into the market. Asia still has that going for it; the fact that it is still painful to invest here to a certain extent and people do stay away for that reason. In terms of the derivatives business, the necessity to bring things into a visible arena—whether it’s reporting after the event on an exchange or actually trading there—is vital. We’ve had the Tdex+ platform in Japan which has so far been a failure if you measure success by volume. At the end of the day, it is down to the buy side and sell side to bring liquidity into the system. FRANCESCA CARNEVALE: Matt, do you see a continuation of a limited number of counterparties at your level? MATT SAUL: I’d love to see proliferation but I don’t think it’s about to happen. I’d love to see the return of some of the hedge fund participants, as they’ve very much retreated from equities too, but my sense is that they are sticking to their knitting in credit and FX nowadays rather than these difficult equity markets. For us, it’s all about regulatory change and the evolving competitive landscape in these growing markets: Korea is a great example, particularly the rise of domestic institutions; hopefully we’ll see really the re-emergence of QDIIs in China and the Indian on-shore domestics for instance. Even in South-east Asia you really want to see aggregation of money at an institutional level in those markets, and the growth of a credible level of developed counterparties for us to interact with. That would be the best case scenario for us in the next five to ten years. JOHN ADAIR: It’s clear that growth in the world is being driven here in the region. We’ve all invested a lot of time in helping develop the markets and the future is bright on that front. As an industry participant in this group, the discussion we’ve had today is pretty indicative that we’re continuing to move in the right direction. Among the conclusions we’ve reached is that we are continuing to drive the regulatory environment and exchange environment in tandem; and that both the buy side and sell side are full participants in this debate. In terms of flow, all forecasts point to the continued growth of the capital markets structure in Asia across the board: in terms of IPOs, market capitalisation, and the growth of assets under management (on both the domestic and international sides). MATT McKEITH: In a way, in Asia, the technology side is the easy part because it’s already been done in the US, in Europe, and the technology can be modified, lifted, and imported in to the region especially by the global houses. Going forward, one of the greatest challenges, particularly

FTSE GLOBAL MARKETS • SEPTEMBER 2010

for large institutional firms in the region, is to work with the sell side and define certain expectations in terms of creating liquidity opportunities. Then there are some very particular challenges such as the perceived problem of India information leakage issues and other issues there which are, in essence, fairly basic challenges; and again, technology cannot provide a solution in these instances.

Michael Kim, managing director, & head of electronic equities product management, Asia, Barclays Capital:

RICHARD COULSTOCK: The word that comes up quite a lot here is “liquidity”. Our fund managers, like most fund managers in most asset management houses, will sit on“wish lists” of stocks that they’d like to trade, but they will take a look at liquidity and won’t release them to the trading desk. If I had that list of wish list stocks on my OMS I could start to put them out into dark pools and that might generate more liquidity. Elsewhere, one way I see my role developing is to ensure the equity desk is properly equipped to deal with any changes that might come into play in Asia. That might involve making sure our fund managers are aware of how we operate and changes that are likely to happen in the dealing environment. The last thing I want on day one of a brand new initiative coming in is our fund management or compliance teams saying:“Hold on, we’ve never heard of this before, you can’t use it.” MICHAEL KIM: From our perspective, this is a very interesting time. You have technology that’s interacting with the business model and, in fact, you’re turning into a completely different business. So it’s really combining technology, the service model and the regulatory environment, all of which hopefully bring a new and better environment going forward. As a new entrant to this market, we are excited by the opportunities and intend to take full advantage of them. Like John at Nomura, BarCap has traditionally been a major fixed income house, so we have a lot of relationships with clients where our distribution and trading teams run across fixed income and equities. That gives us the opportunity to cross sell and this is where we will take the greatest advantage of the growing business opportunities in Asia.■

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Photograph © Paul Moore / Dreamstime.com, supplied August 2010.

RUSSIA’S LONG HOT SUMMER Russian stocks remain undervalued compared to other BRIC countries as foreign funds still view Russia as critically dependent on the global recovery because so much of the country’s income comes from resources such as oil, gas and metals and the capacity of other countries to buy and pay for those raw materials. Foreign funds are unlikely to seriously restart buying Russian stocks until they are convinced that the global recovery is sustainable, writes Vanya Dragomanovich. ERCURY HAS BEEN rising in Moscow and 10m Moscovites, more accustomed to below zero temperatures than those above 30 Celsius, are suffering. The discomfort is compounded by news of hundreds of forest fires across the country which have destroyed villages, cost lives and impacted the country's grain harvest. However, the heat and the bad news are not the only things causing the odd migraine in the city’s financial district. There has been a huge recovery in liquidity in local markets this year, new trading platforms are making access to local shares easier and a pipeline of stocks is coming on sale from next year. However, some of the tax programmes now being debated by the government have the capacity to throw a spanner in the works of renewed foreign fund investment into the country. In the first six months of 2010 the average monthly trade volume on the RTS stock market rose 6.4 times from the same period last year with the value reaching $8.8bn, according to Andrey Salaschenko, RTS’s director of the department of interaction with authorities and organisations. The RTS has launched a new equity market, RTS Standard, a new market for liquid Russian stocks with rouble settlement and CCP technology. RTS Standard has been the main contributor to the growth in volumes on the exchange, Salashenko noted. In the same period, average daily trading volumes on the RTS’s derivates market FORTS rose 2.8 times to $3.6bn. Foreign funds were coming back into the market all of this spring, liquidity was getting back to about half of pre-crisis

levels, oil prices were rising and the banking sector, though still fragile, started stabilising. Then the Greek crisis disrupted cross-border investing dynamics, causing funds to adopt a more cautious approach and wait. “Funds have been rebuilding their positions in the last six to nine months because Russian stocks are still cheap,” says Chris Weafer, analyst at Uralsib bank in Moscow. He adds: “Funds were overweight Russian stocks in 2008, they were underweight in 2009 and since this spring they are neutral. When we talk to funds they tell us that they have built up their cash positions, that they have money to spend and that they intend on adding more Russian stocks at the end of the summer.” There are a number of new elements that are working in favour of investing in the country. Local regulators have started indicating that they wanted to change regulation to make it easier for foreign investors to trade in Russia and there has been renewed talk of the two main exchanges, MICEX and RTS, merging. If the merger went ahead it would address the relatively thin liquidity, an issue frequently raised by foreign investors. “There has been talk on this [merger] on and off for a few years now,” says Salaschenko.“The question of whether the merger is planned or not should be addressed to shareholders as it is the owners that should decide whether it should be done and, if yes, how it should be done. However, each trading floor is unique in its way with each infrastructure being based on unique technology,” he notes.

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FROM WILDFIRES TO NEW TRADING PLATFORMS 78

Another positive for the market is the biggest partprivatisation scheme since the 1990s. Stakes in ten or 11 staterun firms will go on sale between next year and 2013 and could potentially fetch a total of between $23bn and $30bn. The state will still keep just over 50% in most of the companies— this is a rule applied to all industries that the state considers as strategic—but on offer will be stakes in some of the country’s largest and most actively traded companies such as major

lenders Sberbank and VTB Bank and the oil company Rosneft. There was talk of privatising the state railway operator Russian Railways but the company is more likely to sell off whole units rather than offer more shares. Up for sale will also be stakes in energy pipeline operator Transneft, the country’s largest generator of hydro-electric power, Rushydro, power grid operator FSK, shipper Sovcomflot, agricultural bank Rosselkhozbank and mortgage agency AlZhk.

RTS TARGETS FOREIGN INVESTORS Vanja Dragomanovich talks to Andrey Salaschenko, director of RTS’s department of interaction with authorities and organisations about the exchange's plans to attract foreign investors and simplify access to trade in Russia. n increase of foreign traders on the RTS exchange is a priority, says Andrey Salaschenko, director of RTS’s department of interaction with authorities and organisations. “We constantly develop and implement innovative solutions. More than a year ago we launched trading in the most liquid Russian stocks without requiring a 100% advance deposit and trading hours were extended so that international players can make transactions on the RTS within North-American and European trading hours.” The RTS is structured so that it can deal with both over the counter (OTC) and exchange traded activities. In general, the efforts the RTS has made to build on exchange liquidity and to streamline posttrade services does mean that some business, which previously would have been conducted OTC is now traded on the RTS platform, explains Salaschenko. “Due to international regulatory pressure after the credit crunch in 2008 more exchange-trading and CCP was encouraged as opposed to OTC, so there is an externally driven trend in this direction,” he says. Additionally, to conform to the global standards, the exchange launched RTS Standard just over a year ago, with settlement on T+4 basis. “It is the most convenient form of settlement for the

international players and had been long awaited by foreign market participants,” adds Salaschenko. The exchange has also streamlined its benchmark index calculation. As of last year the RTS Index is now calculated in parallel with trading sessions in Europe and the US: “which enables market participants to manage their positions with regard to global cues after the closure of day trading on the local market,” he adds. “Advanced technologies such as central counterparty, portfolio-style approach to margining, intraday clearing session, netting and others have been applied at the RTS for a long time. The RTS’s risk management system is the only system in Russia that stood the stress test in 1998 and 2008. During volatile times all obligations of the market participants were fulfilled,” he adds. As an additional marketing drive, in April this year RTS opened an office in London. The move “was a conscious choice,” explains Salaschenko. “International investors can now be provided with a full set of services required to enter the Russian market; the RTS trading system is available in English. Mindful of the effects of market fragmentation across Europe, RTS has also strived to remain competitive in terms of fees. The

Andrey Salaschenko. Photograph kindly supplied by RTS, August 2010.

fee for trades based on indirect orders on the RTS Standard market is 0.01% of the trade value, “If an investor opens and closes his position in the same instrument within one trading day the fee is charged only once off the biggest trade amount. Fees for derivative trades are not high either and is in the range between $0,02 to $0,07 per contract depending on the contract type,” he adds.

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

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FROM WILDFIRES TO NEW TRADING PLATFORMS 80

The sale is one of the solutions to the government’s plans to cut the budget deficit to 4% of gross domestic product next year and to just below 3% in 2012. The deficit this year is expected to be around 5%, which translates into some $80bn, an improvement on last year’s 7.9% deficit. What has investors worried is the possibility of a drastic increase in taxes on gas extraction and mining. The proposal on the table is a 61% increase for gas extraction taxes next year and annual increases after that based on the forecast inflation rate. Despite heavy lobbying from the oil industry, the government also plans to raise oil extraction taxes from next year by the same rate as inflation. There will also likely be a sliding scale of export taxes for nickel and a 10% export tax on copper from 2011. The taxes could bring another $30bn in revenue and a final decision is likely to be made when the budget comes out in the autumn. Foreign investors can trade rouble-denominated or dollarrenominated shares either on MICEX or RTS’s new platform RTS Standard, using either a local brokerage or a foreign broker with a registered office in Moscow. Both exchanges offer clearing through separate subsidiaries. There is no central custody at present but most of it is handled by Citibank and ING. Otkritie, a UK-registered and FSA regulated broker operating in Moscow, addressed the issue of having to deliver stock and cash ahead of trade execution with the launch of its new trading platform that allows foreign investors to execute trades on MICEX without pre-depositing the cash or stock, or alternatively pay for broker financing. “You have vast liquidity on MICEX but the problem until now has been with the pre-delivery. Institutional investors don’t want to carry that kind of risk,”says Tim Bevan, senior sales executive for Oktritie. The new platform allows foreign investors to bypass MICEX’s same-day processing and provides direct market access while all orders are settled in a third party custody account backed by ING. “This is primarily a legal agreement between Otkritie Ltd. which is FSA-regulated and ING Moscow,” he notes.

Improved liquidities Liquidity in the past 12 months has improved not only on the back of foreign funds re-entering the market but also because local funds started playing a bigger role. When it comes to foreign funds, the market is very established. Ovanes Oganisian, head of strategy for Russian equity research at Renaissance Capital, says:“You have the same players in the emerging markets as you had for the last 20 years, and in Russia the same players in the last ten years. What has changed is that the ratio used to be 60:40 in favour of foreign funds but over the last year this has changed to 60:40 in favour of domestic funds. “There are more domestic mutual funds and pension funds. They receive inflows from the government but there is also more money from companies as exporters are generating more income. One of the biggest ones is Lider, a management company that handles pensions for several large companies including Gazprom," notes Oganisian.

Oganisian also says that most market participants are “cautiously optimistic”about Russia at present, having gone through a period in which they expected a double dip that did not materialise. “The stock market has a limited downside and we are seeing modest inflows,” he adds. Russian stocks remain undervalued compared to other BRIC countries as foreign funds still view Russia as critically dependent on the global recovery because so much of the country’s income comes from resources such as oil, gas and metals and the capacity of other countries to buy and pay for those raw materials. Foreign funds are unlikely to seriously restart buying Russian stocks until they are convinced that the global recovery is sustainable. “The feedback that we are getting from fund managers is that they still need to be convinced that the global recovery will be sustained before continuing to buy Russian stocks,” says Uralsib’s Weafer.

The price of oil The key for the decision to come back into local equities will be the price of oil, which is pivotal to Russia’s budget and financial spending. The country’s finance ministry estimates that the budget is in balance when oil prices are between $75 and $80 a barrel.“This is a cautious estimate because the government does not want to encourage too much spending,” adds Weafer. If oil prices are above that level then the government feels comfortable to spend money on expansion and largescale projects such as massive infrastructure investment programmes which were planned before the crisis. Below that level, spending programmes get cut and growth grinds to a halt, like last year. With oil prices not teetering on the edge of the required range there is no clear signal to go back into local equities. Fund managers are not the only ones currently being slightly sceptical about Russia. Justin Greig, global head of fiduciary services for Standard Bank, says: “If we are talking about high net worth individuals in Russia, there is still a lot of scepticism about the safety of investment in the country. Some of the credibility has been lost during the credit crunch and that has not come back yet.” Standard Bank has expanded operations in the country this year with the purchase of a 33% stake in Troika Dialog, a leading Russian investment bank. As ever with Russia, the approach by foreign investors wears between exuberance and exaggerated scepticism. The situation on the ground probably merits something between the two extremes. The fact remains that some of the most spectacular fund gains in the last decade happened right here—think of the 1,500% return achieved by Swedish fund managers East Capital. This dizzy number is likely out of reach but some of the high gains are likely to be replicated, particularly for those investors who tread carefully. Renaissance Capital’s Oganisian forecasts a 20% rise in equities in the second half of this year. “In the absence of major volatility, things will be alright in Russia.” ■

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

As easy as ABC? Despite a tepid reception in its mainland China debut, Agricultural Bank of China’s (ABC’s) dual-listing entered the 2010 record books with a massive initial public offering (IPO) worth $22.1bn, following the exercise of an over-allotment option for its Shanghai share sale. Meantime, the stock started trading in Hong Kong at HK$3.25, some 1.6% above its offer price of HK$3.20, and rose as high as HK$3.31 in the first hour in its Hong Kong debut in mid-July. Will the issue now ignite a generally muted emerging markets equity issuance calendar? Or will it be the high point of a drawn out Chinese IPO calendar? HINESE COMPANIES COULD end up raising as much as CNY500bn (a tad under $75bn) through IPOs through 2010 after a substantial pick up in the corporate issuance calendar in the first half of the year. The country’s companies had already sourced just under CNY213bn (just over $31bn) via IPOs this year. In total, around 300 IPOs are expected to come to market through the year, with the bulk listed on the Shenzhen Stock Exchange and 20-25 listed in Shanghai. While the attraction of selected China stocks remains and Chinese issuers will maintain a lead in the IPO market, most firms will debut in a somewhat muted market; irrespective of whether they list at home or abroad. The Hong Kong Stock Exchange remains the most popular bourse for Chinese mainland companies hungry for funds, with the United States the destination of choice for small, high-growth info-tech

FTSE GLOBAL MARKETS • SEPTEMBER 2010

companies. Up to now, the domestic mainland exchanges have had to compete with Hong Kong and foreign stock exchanges; however Shanghai, with government backing, is readying to launch its international board, which could change the game plan for many firms going forward. The Shanghai Stock Exchange is growing rapidly; its market capitalisation has expanded tenfold and continues to rise. With China retail investors a growing source of ready liquidity, red chip firms that are already listed overseas are expected to issue further shares on the Shanghai international board. Actually, Agricultural Bank of China’s (ABC’s) IPO highlighted a number of underlying problems in the Chinese equity markets even as it soared towards its benchmark fundraising total. Perhaps reflecting weaker domestic market conditions and an over-extended issuance calendar, Chinese investors were lukewarm towards the stock on ABC’s domestic

COVER STORY: HAS CHINA’S IPO BUBBLE BURST?

Agricultural Bank of China Ltd. executives (L-R) Pan Gongsheng, vice president; Zhu Hongbo, secretary of the party discipline committee; Zhang Yun, vice chairman and president; Xiang Junbo, chairman; Yang Kun, vice president and Guo Haoda, vice president attend a photo call during press conference in Hong Kong, China. Agricultural Bank of China Ltd., the country’s largest lender by customers, will seek to raise as much as HK$88.4bn ($11.4bn) in the Hong Kong portion of its initial public offering, according to three people with knowledge of the price range. Photograph by ChinaFotoPress/Photocome for Press Association. Photograph kindly supplied by Press Association Images, August 2010.

COVER STORY: HAS CHINA’S IPO BUBBLE BURST? 82

TOP TEN CHINA IPOs 2009/2010 DATE

SECTOR/OUTLOOK

COMPANY/VENUE

VALUE

COMMENTS

July 2009

Transport (company is a toll road operator). Between 2000 and 2008, revenue/passanger/km grew by 184%

Sichuan Express Railway/Shanghai Stock Exchange

$264m

Very popular IPO. Retail investors bought 70%; Institutional Investors (IIs) bought 30%; the institutional investors tranche was 388 times oversubscribed!

July 2009

Construction Construction spend is expected to grow by around 9% a year until at least 2014. Non-building construction is actually the fasted growing segment, based on the State’s priority to upgrade infrastructure.

China State Construction Engineering Corp/Shanghai Stock Exchange

$7.3bn The IPO ended the first day of trading up 56.2% on the debut share price. Demand meant the company was valued at 51.3% 2008 earnings.

This set the benchmark (in terms of size) last year and really kick-started the current China IPO calendar. A part privatisation (40%), it ended up raising $1bn more than the government had originally expected.

September 2009

Healthcare China is expected to become the world’s third largest healthcare market by 2011. The rising income of middle-class citizens, an ageing population and expansion of insurance coverage due to China’s healthcare reform are all expected to drive growth. The issuer has just under 11% market share.

Sinopharm Group/ Hong Kong Stock Exchange

$1.13bn The IPO was 570 times oversubscribed.

35% sold to retail, 65% to instituional investors. Bank of China and China Construction Bank were among the investor group. China’s largest drug distributor sold its shares at HK$16 - at the top of its indicative range. Total orders reached HK$884bn. The IPO valued the firm at 25 times forecast 2010 earnings. The Government of Singapore Investment Corporation was among the leading buyers of the stock.

September 2009

Industrial Asia-Pacific’s states are consuming more and Chinese steel production has tripled since 2001.

Metallurgical Corporation of China/Dual listing on Shanghai Stock Exchange and Hong Kong Stock Exchange.

$5.13bn

The second largest China IPO of last year. The retail tranche was 205 times oversubscribed; the instituional investors tranche 10 times oversubscribed. Early investors included China Life Asset Management and Och-Ziff.

September 2009

Consumer/Textiles The clothing industry is on a roll in China and expected to grow by 18% a year.

Peak Sport/Hong Kong Stock Exchange

$221m

Shares closed 17% down on the first day of trading. It was a disappointing result for a company ranked alongside Nike Inc and Li Ning, as a footwear brand.

September 2009

Real Estate The jury was still out at the time of the IPO as to whether China was undergoing a real estate bubble.

Glorious Property Holdings Ltd/Hong Kong Stock Exchange

$1.28bn Ultimately priced at the low end at $0.68 per share.

Came late to market; the IPO was originally scheduled in July. Perhaps it suffered because of the concentration of IPOs in September. In any case, the share price dropped 15% on the first day of trading.

October 2009

Chemicals

Yingde Gases/Hong Kong Stock Exchange

$409m

Shares surged 10.42% after the first day of trading.

October 2009

Metals & Mining

China Vanadium/Hong Kong Stock Exchange

$266m A 29.4% stake in the firm

Traded up 2.6% on first day of trading. Essentially a private equity deal that came to market. Green Globe Investment was the main beneficiary.

March 2010

Waste Water China’s water pollution and water scarcity creates huge opportunities in this segment.

Chongqing Water Group Co/Shanghai Stock Exchange

$511m 500m shares at $1.2 each, at the top of its pricing range.

The deal was 67 times covered and apparently sported a rather cheap valuation (p/e valuation stood at 34.9x). By the end of the first day of trading, shares had climbed 74%.

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

Shanghai debut in mid-July, when it closed a meagre 1% above its IPO price, at CNY2.71. In Shanghai, where yuandenominated shares are sold only to domestic buyers, the bank sold off some 25.5bn shares within a set price range of CNY2.52-CNY2.68 per share. In Hong Kong, whose market is open to foreign investors, the bank’s shares rose a lacklustre 2.2% on their July 16th debut. Despite the size of ABC’s IPO, the bank had expected to raise as much as $23.2bn from the simultaneous offering in both Shanghai and Hong Kong. Then again, the bank had already cut the size of the IPO down from the stratospheric $30bn it had originally expected to raise. Both domestic and international investors in the dual tranche offering were cautious, because of slowing consumer demand in China and some concerns over the strength of the asset quality of its rural lending book. Other factors also came into play: China’s stock market has slumped 23% since the start of 2010 (compared to a 5% drop in Hong Kong’s Hang Seng Index). Moreover, at the time of the IPO, most of China’s major banks were trading in Shanghai at a 15% to 20% discount to their Hong Kong-listed counterparts. ABC is the last of China’s “Big Four” banks to list on an exchange and the country’s third-largest lender by assets. Bank of China is the country’s largest lender, closely followed by the Industrial and Commercial Bank of China, which previously held the record for the world’s largest IPO, coming in at $21.9bn back in 2006. However, ABC, rightly or wrongly, is seen as weaker and less profitable than its peers, given that it operates a costly network of far-flung rural branches, and its non-performing loan ratio is higher than other major Chinese banks, at about 3%. ABC management holds that the

bank’s strong presence in the countryside is an untapped engine for growth and, according to Moody’s Investor Services, the bank enjoys a 21.6% share of deposits in the country’s rural areas. Even so, although Chinese banks are currently lionised in the West because of their limited exposure to those troublesome securities that unleashed a financial crisis elsewhere, some analysts have pointed out the poor credit controls in many Chinese banks. Certainly, government bailouts of the country’s banks topped $150bn in the 20022005 period. Another spike in bad loans is now expected following the lending boom of 2009, encouraged by the Chinese government’s economic stimulus plans. ABC’s IPO has been meticulously prepared for by the government. In 2007, the bank was saddled with a nonperforming loan portfolio conservatively estimated to be worth CNY819bn, equivalent to almost a quarter of its total loan book. Some CNY800bn of bad debts were hived off the bank’s loan book at the end of 2008, supplemented by a reported $19bn cash injection from the government. In its prospectus, ABC claims to have a bad loan portfolio equal to just under 3% of its total loan book. In that context, it was important that the Chinese government achieved a successful launch of ABC shares in the capital markets; hiving off some of the state’s assets is seen as a keystone in its efforts to bring the Chinese banking sector up to date. The value of ABC’s rural constituency should not be underestimated. China’s rural communities have a population in excess of 928m (just under 70% of the country’s overall population); and generated around half of the country’s total GDP in 2008. The republic’s rural areas are also the focus of the government’s new economic development strategies,

ABC’s CORNERSTONE CORPORATE INVESTORS s part of ABC’s international offering, the IPO’s joint bookrunners and the bank entered into so-called cornerstone investment agreements with 11 investors, including:G Archer-Daniels-Midland Company: the agricultural foods processing firm, which took $100m at the offer price (around 0.077% of the IPO). In addition, on June 11th this year, ABC entered into a nonbinding memorandum of understanding with ADM covering a long-term cooperation relationship. G Cheung Kong Ruperta: the investment holding took $100m at the offer price. G China Resources Commotra: the securities investment holding

company took $200m at the offer price CTS Holdings’ China Travel Finance & Investment: the investment holding, securities trading and money lending firm, took $150m at the offer price. Kuwait Investment Authority: the sovereign wealth fund took $800m at the offer price. Qatar Investment Authority: the sovereign wealth fund took $2.8bn at the offer price. Rabobank International Holding BV: the financial services provider took $250m at the offer price. Standard Chartered Bank: the financial services provider took $500m at the offer price.

Seven Group Holdings: the Australian operating and investment firm took $250m Temasek’s Cairnhill Investments (Mauritius): the fund, took $200m at the offer price. United Overseas Bank: the financial services provider took $100m at the offer price. Archer-DanielsMidland, the Kuwaiti Investment Authority, Qatar Holding, Seven Group Holdings, Standard Chartered Bank and Rabobank Holding have agreed to hold on to the shares for a minimum 12 months and separately have entered into a memorandum of understanding with ABC covering strategic cooperation, according to ABC’s IPO prospectus.

Source: Agricultural Bank of China’s Global Offering Prospectus, July 2010

FTSE GLOBAL MARKETS • SEPTEMBER 2010

COVER STORY: HAS CHINA’S IPO BUBBLE BURST?

Global IPO activity: distribution of IPOs by region (by number of deals), 2009 - 2010 Q1 First Quarter 2009 19% Europe, Middle East and Africa

Foreign investors

8% North America 73% Asia-Pacific

Fourth Quarter 2009

12% Europe, Middle East and Africa 73% Asia-Pacific

12% North America 3% Central, South America and Carribean

First Quarter 2010

66% Asia-Pacific

2% Central, South America and Carribean

Source: Ernst & Young Q1 2010 Global IPO Update. IB data sourced from Thomson Financial, Ernst & Young and Dealogic.

which involve the expansion of domestic consumption, the raising of national income levels, increased urbanisation and balanced regional development. In that, thinks ABC, the segment is a significant growth opportunity. Funds raised by the IPO will come in useful for ABC’s own business growth programme. It provides China’s rural community with a widening range of financial products through its 2,048 county-level sub-branches and 22 business departments of tier-2 branches. The bank claims to have the largest number of rural branch outlets among the country’s

Investors in ABC have been encouraged by a number of considerations: one is a declared intention by the bank to increase its market share at a time when rural incomes are beginning to rise. Two, increased competition from rival banks keen to establish a foothold in the rural market through the establishment of specialised financing firms (a move that is still awaiting regulatory approval), is expected to spur the bank into implementing a clear new business strategy and introduce further internal efficiencies. Investors were also consoled by the announcement, prior to the IPO, that ABC reported a 40% profit increase for the first half of its trading year to CNY46bn (around $6.8bn). Fee-based income surged 60% in the six months to June 2010 while new lending grew 11.2%. Demand for ABC’s IPO shares was also strengthened by a large number of so-called cornerstone investors, which were secured by the IPO’s lead managers early on in the run up to the IPO. The investor group ranged from China Life Insurance to Qatar’s sovereign wealth fund, and required to hold the stock for at least 12 months (Please see box: ABC’s cornerstone corporate investors, page 83). Their reasons for supporting the share sale are political as well as financial, with big mainland investors under government influence and overseas buyers keenly aware of how much Beijing wanted the sale to be successful. ABC set aside a bigger portion of the IPO to cornerstone investors than any other major Chinese banks to help support the offering.

The new issue calendar

19% Europe, Middle East and Africa 13% North America

large commercial banks, with “the majority of our 12,737 branch outlets in the county areas located in economically more developed county centres and towns,” states ABC’s IPO prospectus.“We maintain a large customer base with a focus on mid to high-end customer segments.”

While China’s issuance calendar is expected to set a new benchmark, there are already signs that the pace of issuance is being tempered and the muted markets of Hong Kong and Shanghai have put a number of key new listings on the back burner. Xinjiang Goldwind Science and Technology, for example, which had been expected to come to market with a $1.17bn IPO, and Shenzhen-based Shirble Department Stores, which operates 11 department stores in southern China, have put plans to list in Hong Kong on hold. Bank of China, which had planned to raise funds this year by selling CNY60bn of shares in Hong Kong, has switched instead to a rights issue in Hong Kong and Shanghai. China Construction Bank has also adopted a similar strategy with its planned CNY75bn rights offer scheduled for the autumn. A switch to bond issues is also prevalent. ICBC has announced plans to issue some CNY25bn late in the third quarter of the year. Elsewhere, Russian oligarch Oleg Deripaska’s Strikeforce Mining & Resources, which reportedly planned to raise $200m in Hong Kong this year, has withdrawn from the market. Deripaska’s own aluminium major Rusal was the first nonAsian company to launch a primary listing in Hong Kong at the

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

Global IPO activity by stock exchanges* Top 10 by total capital raised Primary exchange Tokyo Stock Exchange (TSE) Shanghai Stock Exchange (SSE) Shenzhen Stock Exchange (SSE)** Hong Kong Exchanges & Clearing Ltd (HKEx) New York Stock Exchange (NYSE) Sao Paulo Stock Exchange (BOVESPA) London Stock Exchange (LSE) Korea Stock Exchange (KSE) Toronto Stock Exchange (TSX) NASDAQ

Top 10 by number of deals

Capital raised US$m $11,014 $8,693 $8,623

% 20.7% 16.4% 16.2%

$3,925 $3,411

7.4% 6.4%

$3,295 $1,875 $1,834 $1,816 $1,351

6.2% 3.5% 3.4% 3.4% 2.5%

Primary exchange

No. of deals

Shenzhen Stock Exchange (SZE)**

30.3%

Bombay Stock Exchange (BSE)

7.1%

New York Stock Exchange (NYSE)

6.0%

NASDAQ

4.9%

Australian Securities Exchange (ASX)

4.5%

KOSDAQ Hong Kong Exchanges & Clearing Ltd (HKEx)

4.5%

4.1%

Shanghai Stock Exchange

3.8%

New Connect - Warsaw

3.0%

London Alternative Investment Market (AIM)

2.6%

*Data based on domicile of the exchange, regardless of the listed company domicile. **Shenzhen Stock Exchange includes listings in Mainboard and ChiNext Source: Ernst & Young Q1 2010 Global IPO Update. IB data sourced from Thomson Financial, Ernst & Young and Dealogic.

start of this year, performing dismally in the immediate aftermarket, falling 9% in the first few minutes of trading and ending the first day’s session 11% down. The stock had been launched at the lower end of the pre-float pricing range. At the time, dealers blamed the Rusal share rout on a combination of bad timing and a recent dent in overall market confidence. However, Rusal had its own share of difficulties; retail investors were barred from taking a position on the float (a key element in any successful Hong Kong offering). Moreover, it was common knowledge that Rusal was saddled with substantial debts; in that context Deripaska was rightly pleased with the offering. Elsewhere, some firms are looking further afield for liquidity. China-based company Leader Environmental Technologies launched its initial public offering in mid-July for a Singapore Exchange main board listing. The group is a one-stop environmental protection solutions provider for industrial waste gas and wastewater emissions. The offering involves the sale of 116.5m shares at 21 cents each for a total 26.4% of the company. Stirling Coleman Capital is the issue manager, underwriter and placement agent. The fair, but not outstanding, performance of this year’s Hong Kong IPOs comes at a sensitive time for the exchange. For Hong Kong, which has previously admitted that it had had to bend its usual listing rules to host the Rusal initial public offering, the price drop was an early blow to prestige. The exchange is not only keen to present itself as the primary listing venue of choice for European and Russian companies, it is also eager to tout itself as the main Chinese exchange before Shanghai starts to invite listings by major foreign companies. Certainly, both Shanghai and Shenzhen appear to be benefiting from a continual flow of Chinese companies issuing equity. Some CNY500bn (about $74bn) in new equity issues is anticipated to come to market by year end. In the first half

FTSE GLOBAL MARKETS • SEPTEMBER 2010

of this year, 176 companies had launched IPOs on the Shanghai and Shenzhen bourses, raising almost CNY213bn. According to a recent release by PricewaterhouseCoopers, some 43% of companies listed in the first half came from the manufacturing industry, 27% were engaged in telecommunications and the information technology industry, while 26% originated out of the retail and service industries. August continued muted, and not just for Chinese IPOs. The latest issuer, medical device company China Kanghui Holdings (KH,) recovered from a slow start on its first day of trading in mid-August on the New York Stock Exchange with its IPO gaining 4% by noon despite a broader market that was trading poorly. Morgan Stanley (MS) and Piper Jaffray Cos. (PJC) managed the offering, involving the sale of 6.7m ADS, which on its debut came in at the midpoint of an expected $9.25 to $11.25 price range. Based in Jiangsu province, China Kanghui makes orthopaedic implants such as plates and screws used for bone fractures and spinal surgery. Despite the ups and downs of the Chinese new issuance market, there is little doubt that the ABC IPO is a nexus. The two biggest investors in the AgBank IPO are the Qatar Investment Authority (QIA) and the Kuwait Investment Authority (KIA). The QIA put up $2.8bn, the KIA $800m, which indicates an increasing shift in capital flows from east to west to east to east. It comes as no surprise then that in 2009 China overtook the United States as the biggest exporter to the Middle East; a relationship ultimately built on energy sales. The repercussions are even narrower. In the past, other BRIC issuers might have looked primarily to London or New York for their international listings; now they will have the greater choice of liquid markets in Hong Kong and Shanghai to add to the mix. Global IPO activity looks set for something of a rebound in the late 2010/early 2011 period, driven primarily by emerging market issuers. The question for exchanges now is whether their IPOs will trend eastwards as well. ■

CANADIAN SECURITIES LENDING: CASH IS NOT KING

Photograph © Gudron / Dreamstime.com, supplied August 2010.

THE NEW FOOTFALL The resilience in Canadian securities lending derives in part from the country’s increasing attraction to international investors. While most developed nations have trashed their public finances in an attempt to revive economic growth, Canada escaped the crisis relatively unscathed: Its banks are sound, it needed only modest fiscal stimulus to keep the economy going and it has a strong natural resource base. Indeed, it has many attributes of an emerging market without the risk of political instability or maverick economic management. Neil A O’Hara reports. ANADA’S FINANCIAL MARKETS are tied to the US in so many ways—about 220 Canadian stocks are interlisted on US exchanges, for example—that it’s easy to overlook the differences beneath the surface. Take securities lending, for example, an opaque but highly profitable business that boosts returns on lenders’ investment portfolios and

C 86

creates incremental liquidity to keep the market efficient. In principle, it’s a low-risk business: lending buttressed by collateral that is marked to market every day. That collateral takes a different form above the 49th however: lenders in Canada typically take securities, while cash accounts for at least 90% of collateral south of the border. Regulations play a part; of course. Under ERISA rules, US pension funds are permitted to take only cash as collateral in securities lending transactions, while Canadian funds can accept—and generally prefer— non-cash collateral. US rule makers may have thought cash was the conservative choice, but the financial crisis revealed a flaw in that logic. Lenders don’t keep idle cash sitting under a mattress; they reinvest it to augment the return. The temptation to jack up the yield by moving beyond overnight repo with the most creditworthy counterparties proved irresistible to many: lenders ended up buying instruments with longer duration, lower credit quality or both. When liquidity dried up in late 2008, these “cash-equivalent” instruments proved to be anything but—and lenders incurred unexpected losses in their cash collateral reinvestment programmes as a result.

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

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CANADIAN SECURITIES LENDING: CASH IS NOT KING 88

Peter Bassler, managing director of business development at eSecLending, an independent agent that specialises in customised lending programmes, sees an opportunity in the lack of differentiation among the big Canadian lending agents: eSecLending eschews pooled programmes and relies on auctions to capture the best return for each client, but it’s a hard sell in a market resistant to change. “ Photograph kindly supplied by eSecLending, August 2010.

By contrast, non-cash collateral—mainly high-quality government bonds—retained its value. Data Explorers, a London-based firm that tracks the securities lending markets, estimates that non-cash represents about 80% of collateral used in Canadian securities lending transactions, which helped local lenders avoid the losses that plagued their US counterparts. Cash collateral does play a more significant role in Canada than it used to, however. State Street introduced the first commingled vehicle for cash collateral in 2003. Prior to that, little or no cash was used in Canadian securities lending, according to Don D’Eramo, senior managing director for Canada in State Street’s securities finance division. The range of acceptable non-cash collateral has expanded in recent years to include equities and corporate bonds as well as government bonds, which has encouraged more general

collateral lending. “The broader the non-cash guidelines on acceptable collateral are, the easier it is to optimise utilisation and returns on general collateral,” says D’Eramo. A lending agent must understand what clients expect from securities lending and design each programme to match the potential return with the client’s tolerance for risk. Without the opportunity to enhance returns through aggressive cash management, lenders who take non-cash collateral have to rely on securities lending fees alone, which discourages lenders from chasing low-margin, general collateral opportunities. “Lending is based on intrinsic value as opposed to aggressive spreads from cash reinvestment,” says Yvonne Wyllie, head of securities lending market products and services at RBC Dexia. The growing use of cash in Canada has fostered more general collateral business, although it remains less prevalent than in the US and other markets focused on cash collateral. Wyllie says Canadian lenders typically specify cash reinvestment guidelines that are more conservative than those prevalent in the US, too. The juice in securities lending has never been in general collateral anyway: it comes from specials, securities that become hard to borrow—often for technical reasons related to dividend payments, mergers or initial public offerings. On the run government bonds still go special in Canada, too, a feature that has vanished from a US market drowning in Treasury paper issued to finance the bloated fiscal deficit. By definition, specials are in limited supply, which gives lending agents the power to exert subtle pressure on borrowers: the more general collateral they take, the better access they will have to specials. “We don’t have difficulty lending our general collateral securities,” says David Sedman, securities lending manager for Northern Trust Company, Canada.“Borrowers know we have a large, diverse pool of assets, including the securities most in demand in the market. They will come to us for their general collateral needs as well.” Data Explorers estimates that Canadian beneficial owners hold $875bn in lendable assets, about 8% of the $11.2trn global market. Of the $90bn assets on loan in Canada, bonds— primarily federal and provincial government bonds—represent 74%, while equities—mostly Canadian—make up the balance. More than 90% of securities lending is handled by just four lending agents: CIBC Mellon, RBC Dexia, Northern Trust and State Street. The proportion of non-Canadian assets lent by Canadian beneficial owners is increasing as a result of tax and regulatory changes implemented in 2008. Under the old rules, lenders could lend only securities that were listed on a “prescribed” stock exchange, a definition that excluded many foreign exchanges. Now, however, lenders are free to offer securities for loan as long as they are listed on any stock exchange, not just a government-approved list. “Canadian market participants were at a distinct disadvantage by not being able to lend in certain markets where US participants were able to, such as South Korea, Turkey and Greece,” says Sedman. Canada eliminated another obstacle to lending foreign assets when it repealed a withholding tax that covered

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The range of acceptable non-cash collateral has expanded in recent years to include equities and corporate bonds as well as government bonds, which has encouraged more general collateral lending. payments of interest, rebates, securities lending fees and compensation in lieu of dividends. The regulatory changes have spurred technological innovation in the Canadian market. EquiLend, the developer of AutoBorrow, a low-cost electronic trading platform for securities lending transactions, opened an office in Toronto in September 2008. It offered only post-trade comparison services until Canadian regulators gave the green light to its trading platform in September 2009. However, since then EquiLend has expanded its client list to include three lending agents and two brokers. “Our system adds efficiency and lowers the risk for participants,” says Alexa Lemstra, vice president, business development at EquiLend Canada. “It takes away the manual procedure.” The company enjoys the backing of 10 leading

global players in securities lending, including Northern Trust and State Street. In addition to operational efficiency, EquiLend offers access to its global network in Europe, Asia and the US, putting Canadian clients on an equal footing with foreign participants. “Their counterparties were always able to use AutoBorrow, but Canadian entities could not,” says Lemstra. “We see trades now between Canadian counterparties, plus CanadaUS and Canada-Europe. It’s not all within Canada.” The four big agency lenders dominate the Canadian market, but principal lending does exist on a limited scale. Wyllie at RBC Dexia points out that only the largest US lenders have embraced exclusive deals and auctions as alternate distribution channels. In the much smaller Canadian market, fewer institutions have the scale to capitalise on non-agency lending even if they have an appropriate portfolio. “Not all portfolios are suited to all routes to market,” says Wyllie. “It depends on the mix, the size of the portfolio and the cost effectiveness of each route.” From the borrowers’ perspective, the major lending agents have similar infrastructure and expertise, although each has a unique pool of domestic and international securities, according to Claude Robillard, executive director, prime

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CANADIAN SECURITIES LENDING: CASH IS NOT KING 90

Regulations that govern securities lending in Canada fix minimum collateral at 102% of market value, but in practice lenders only concede 102% on cash collateral; they still insist on 105% for non-cash collateral.

Yvonne Wyllie, head of securities lending market products and services at RBC Dexia. “Lending is based on intrinsic value as opposed to aggressive spreads from cash reinvestment,” she says. Photgraph kindly supplied by RBC Dexia, August 2010.

brokerage at CIBC World Markets. “The environment is competitive but participants must also work with each other all the time,” he says. “Maintaining good relationships is important, and there is mutual appreciation for conservative practices that help foster a stable market.” Peter Bassler, managing director of business development at eSecLending, an independent agent that specialises in customised lending programmes, sees an opportunity in the lack of differentiation among the big Canadian lending agents: eSecLending eschews pooled programmes and relies on auctions to capture the best return for each client, but it’s a hard sell in a market resistant to change. “Canada has been slower to accept third-party models compared to the US and Europe,” says Bassler. The beneficial owners who lend securities in Canada are the usual suspects: mutual funds, endowments, insurance companies and pension plans. Canadian institutions didn’t pull back as much as their US equivalents after the financial crisis, however. Although lenders did review their programmes they made few changes to collateral guidelines; they had no reason to alter a model that held up through the greatest stress the markets have seen in 80 years.

The resilience in Canadian securities lending derives in part from the country’s increasing attraction to international investors. While most developed nations have trashed their public finances in an attempt to revive economic growth, Canada escaped the crisis relatively unscathed: its banks are sound, it needed only modest fiscal stimulus to keep the economy going and it has a strong natural resource base. Indeed, it has many attributes of an emerging market without the risk of political instability or maverick economic management. “People I talk to, whether in Zurich, São Paolo or Shanghai, see Canada as a source of stability,” says CIBC’s Robillard. “They love our commodities underpinning and the robust financial architecture.” The enthusiasm has boosted demand for general collateral lending among international investors. Meanwhile, the domestic market has grown as the local hedge fund industry has expanded. Canadian lenders are paying more attention to counterparty risk, a trend that plays into the hands of RBC Dexia and the other big agents. Wyllie says: “There has been consolidation in the industry. Smaller niche players have exited the business. In this market, indemnification is a key component of any lender programme.” Lending agents typically undertake to replace securities if a borrower does not return them, a guarantee that carries more weight when backed by a major financial institution. Indemnification does not extend to investment losses in cash collateral pools, however. Regulations that govern securities lending in Canada fix minimum collateral at 102% of market value, but in practice lenders only concede 102% on cash collateral; they still insist on 105% for non-cash collateral. On average, Canadian lenders take more collateral than their US counterparts (who are satisfied with 102%), but the disparity reflects the preferred form of collateral in the two markets more than a conservative mindset among Canadian lenders. In fact, lending procedures in Canada and the US have converged despite the difference in collateral preference. “With the exception of collateral management, professional practices on a lending desk in New York are very similar to those in Toronto,” says CIBC’s Robillard. Beneficial owners in Canada derive the most value from portfolios of small and mid-cap equities, just as they do in the US. The two markets have become even more alike since the regulatory changes in Canada took effect two years ago. “We provide the same lending programme, including risk and collateral management, regardless of the market,” says Northern Trust’s Sedman. “It is not as big a difference as it was 10 years ago. It is a function of the Canadian market maturing.” ■

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

Canada finds itself in a fortunate position: at the intersection of the drivers of the economic growth (energy and materials, for instance) across a diversified range of emerging economies, and the financial architecture and economic stability that investors seek. In that sense, the economies of the world meet, figuratively, in Canada. For that matter, the world meets literally in Canada, too, as it played host to the G8/G20 summits this summer to the tune of this year’s theme “Recovery and New Beginnings”. Canada embraces its position with measured enthusiasm. S WE DISTANCE ourselves from the nadir of global market sentiment, discussions on the shape of recovery can be heard in boardrooms and cafés around the globe. What if we shifted focus from the shape of the recovery to the location? While traditional economies have been quick to stimulate and rehabilitate, there is widespread recognition of the new “place cards” at the table; emerging, and reemerging economies in other jurisdictions. It has been well-documented that emerging markets have at least partially offset the negative after-effects of a period of pronounced market dislocation in North America and Europe. Rising economies, and corresponding GDPs, have given economists and portfolio managers alike a dose of much-needed optimism. The question is, how best to address global market opportunities in what remains of 2010, and beyond? While emerging markets are often described in unison, each carries idiosyncratic risks and rewards. The common thread throughout is an appetite for the building blocks of transitioning economies. Suppliers of resources benefit from a diverse group of buyers—steady demand from “traditional” consumers of energy and materials, and a wide array of new consumers driven by investment in infrastructure, and higher consumption levels resulting from rising domestic wealth. Canada finds itself in a fortunate position: at the intersection of the drivers of the economic growth (energy and materials, for instance) across a diversified range of emerging economies, and the financial architecture and economic stability that investors seek. In that sense, the economies of the world meet, figuratively, in Canada. For that matter, the world

FTSE GLOBAL MARKETS • SEPTEMBER 2010

CANADA: IS IT THE GATEWAY TO RECOVERY?

RIGHT PLACE, RIGHT TIME?

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

CANADA: IS IT THE GATEWAY TO RECOVERY? 92

meets literally in Canada, too, as it played host to the G8/G20 summits this summer to the tune of this year’s theme “Recovery and New Beginnings”. While no one has been immune to global market turbulence, Canada has, arguably, come in for a smoother landing. In 2008, the World Economic Forum ranked Canada’s banking system the healthiest in the world. Canada was topranked in G7 economies in terms of GDP growth over 19972007, and is positioned to lead growth in G7 nations, according to the OECD. Correspondingly, international interest in Canada is rising. This is reflected in foreign direct investment (FDI) statistics; inbound FDI more than doubled in the last ten years, and more than quadrupled from the period a decade earlier. Last May, China Investment Corporation invested over $1bn in what was the third major energy deal to date to emanate from the region. In the same month, foreign investors bought over $23bn in Canadian securities, the highest level in over six years. This included more than $5bn in Canadian stocks, the largest amount in any month this year. While the headlines reflect global interest in commodities, increased FDI invariably results in increased trade opportunities in other sectors, and a virtuous circle for the Canadian economy emerges. What has this meant for Canadian capital markets? Greater international profile, higher volumes of securities traded and, correspondingly, greater activity in market corollaries such as securities lending. Last year saw equity loan balances increase by nearly 50%, with a nearly proportional increase in lendable assets. Recent themes in securities lending bode well for further momentum: increased international interest, stability in credit markets, and increased agility in collateral practices. In short, loan balances are on the rise, but demand for underlying securities tells only part of the story. On a macro level, an increase in lending activity reflects an international proclivity towards investing in Canada based on its creditworthiness and robust financial architecture. Concurrently, Canadian investment abroad has grown. Global fluidity of capital and a penchant to uncover returns in any market has led to similar themes materialising across borders. From the international investor’s perspective, Canada is in the age of the interconnected marketplace, and subsequently, investors are looking further afield for opportunities than ever before. Themes that currently echo in international markets, in turn, are resonating in Canada. Absolute return, diversification, transparency and risk management are on everyone’s agenda. Canada arguably answers the call in each category. Return drivers, aside from the aforementioned commodities streams, include sectors that are at times eclipsed by the global resource story: strength in technology and financial services, for instance. In terms of return stream diversification, Canada offers a defensible investment thesis to a wide array of investors. Bullish on oil? Check. Believe in an eventual recovery in the US? Strategic trade partner. Bullish on the BRICs? Check. Inclined to invest in gold? So on and so forth. Meanwhile, transparency and risk management are wellrepresented. Canada has fared well in recent periods of global

Claude Robillard, executive director, prime brokerage, CIBC World Markets Inc. Photograph kindly supplied by CIBC, August 2010.

Canada has fared well in recent periods of global disruption and offers a mature, comprehensive and sophisticated financial and regulatory infrastructure. To borrow an analogy from a leading national pastime, when you are “facing-off” with a credit counterpart, Canada’s well-capitalised financial institutions find a receptive audience. disruption and offers a mature, comprehensive and sophisticated financial and regulatory infrastructure. To borrow an analogy from a leading national pastime, when you are “facing-off” with a credit counterpart, Canada’s well-capitalised financial institutions find a receptive audience. As investors set their sights on Canada, how has it responded? Perhaps it will not shock to suggest Canada has taken a measured approach: a steady stream of innovation and investment in market architecture on the part of market participants and the national stock exchange, continued emphasis on international trade missions to raise Canada’s profile, and a business environment that strikes a balance between the conservative and the entrepreneurial. A tangible example of innovation and investment that relates specifically to securities lending is the recent launch of an important initiative: the Canadian Securities Lending Association (CASLA). Established in 2009, CASLA has already substantially increased the profile of the Canadian securities lending market, while promoting best practices, increased industry transparency and providing a forum for market participants to discuss key risk and return drivers. In conclusion, securities lending in Canada continues to grow, benefiting from increased investor interest driven by a wide variety of factors. Canada offers international investors an all-weather market and a gateway to mature and reemerging economies. It’s a position the nation embraces with enthusiasm. Measured enthusiasm, of course. ■

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

EUROPEAN ASSET SERVICING ROUNDTABLE

FINDING THE RIGHT BALANCE IN THE ASSET SERVICE SET

Supported by:

Attendees From left to right PAUL STILLABOWER, global head of business development, fund services, HSBC Securities Services TIM REUCROFT, director, investor services, Thomas Murray ROSS WHITEHILL, business manager, asset servicing, BNY Mellon Asset Servicing GÖRAN FORS, global head of custody services, SEB NIALL MOWLDS, head of service management, Threadneedle Investments JOHN MORLEY, managing director, JP Morgan JIM KANDUNIAS, principal, Esemplia Emerging Markets

FTSE GLOBAL MARKETS • SEPTEMBER 2010

EUROPEAN ASSET SERVICING ROUNDTABLE 94

BIG MANDATES, BIG ELEPHANTS PAUL STILLABOWER, GLOBAL HEAD OF BUSINESS DEVELOPMENT, FUND SERVICES, HSBC SECURITIES SERVICES: Changing regulation is the big elephant in the room for most of our businesses. How we deal with the shifting sands of increased capital requirements, transparency and the various directives that different governments and regulators are introducing globally is quite important. Secondly, post the credit crunch, HSBC is dealing with numerous opportunities as customers look to banks that have large balance sheets and truly global footprints. More considered bundling of services across the spectrum is quite important for clients: for example they are more focused on how collateral is being used and linking value added services such as distribution and financing to their decisions. These are all starting to come into play and impact securities servicing. GÖRAN FORS, GLOBAL HEAD OF CUSTODY SERVICES, SEB: Our business, like the region we work in, is going through some pretty big changes. In the Nordic region, driven by the crisis two years ago, we were quick to introduce a CCP in each of the countries, which has changed the way that brokers clear. Today’s business model has grown out of the changes in the region, as have the models of our competitors. Of course, as Paul notes, we are all under pressure from regulatory bodies. However, changes are not confined to ourselves. I expect the mutual fund industry, which has been pretty secluded, but is a big area for retail investors, to open up. It’s grown enormously; it’s going to face a number of changes. Competition will force them to re-shape their business quite a lot, and the AIFM directive will force them to evaluate how they look in the future. NIALL MOWLDS, HEAD OF SERVICE MANAGEMENT, THREADNEEDLE INVESTMENTS: The biggest driver for our operating model is meeting clients’requirements. Regulation features in that; but our clear focus is on our clients. Our response has been twofold: operationally, it’s very much a consolidation and upgrade of the business model. We’ve asked ourselves is it robust enough in terms of transparency, demonstration of risk management, quality of information we can furnish to a client or to any stakeholder? As an industry, we’ve struggled on occasion, to keep that client focus. We get a bit carried away sometimes with the requirements of the other stakeholders. As a business, Threadneedle has undertaken quite a significant international push and we’ve expanded our products and distribution capability across Europe and more recently Asia. This international aspect brings a very different set of challenges. The model that we had built for a primarily long equity, UK-centric manager no longer applies as we’ve extended well beyond those boundaries. We are now dealing with both of these challenges in an environment where regulators are quite rightly getting more interested in what we’re doing, and understandably forcing us to be far more transparent. ROSS WHITEHILL, BUSINESS MANAGER, ASSET SERVICING AT BNY MELLON ASSET SERVICING: Regulation targeted at securities servicing is the backdrop against which we’re currently operating, though other change

Paul Stillabower, global head of business development, fund services, HSBC Securities Services.

drivers are impacting our business. Outsourcing opportunities have become more prevalent than they were: it is something of a renaissance actually, a re-energising of the outsourcing opportunities. I am responsible for a number of diverse geographies, and those geographies are responding differently to the credit crisis and the financial crisis generally. If we look at money market funds, we see yields are extremely low in that area, so we’ve seen redemptions away from them. We’re seeing a shift into the beta-type products. Exchangetraded funds, for instance, have taken off very significantly. Distribution is also in focus. We are being challenged constantly by clients asking: “How can you help us to distribute our funds to get better market share? How can you help us with a cross-border distribution strategy so that we can put more assets on?” I would say each is probably weighted as significantly as the other, and each day the focus is different. TIM REUCROFT, DIRECTOR, INVESTOR SERVICES, THOMAS MURRAY: Asset safety is what our clients all want and they’re willing to pay for it. There has been a massive switch from an emphasis on fees and new products to asset safety, and that’s also what we’re seeing at the moment as the regulatory focus. Governments are looking for big balance sheets, so if anything goes wrong they don’t have to bail out the financial sector ever again. This is exactly what’s happening in the industry space as well, where everything’s going into CCPs; all the risk has been self-mutualised. Governments and regulators are looking for asset safety. Clients are looking for asset safety, and that’s where it’s all going, and that’s going to put a massive brake on new product development. ROSS WHITEHILL: The asset safety point and the big balance sheet are fascinating, and Tim says people are prepared to pay for it. Actually, we’re not seeing the same sort of concern about asset safety as we did maybe five years ago, or even before the crash. People are saying to us: actually we don’t really care about the balance sheet or the credit rating as much as we used to, because we know that whoever we go with, they’re going to be backed by the federal government of whatever country we may be contracting with. This approach has startled us, because we’ve sold very much to our clean balance sheet, high net assets, strong credit rating and so forth, but really, we’re just not seeing that level of interest you’re talking about. Even then, while clients acknowledge

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the clean balance sheet, the strong credit rating, the ability to invest in technology and the low likelihood of bank failure, they still remark on fees being x% higher if we price in asset safety. I have to say, our experience is rather different Tim. PAUL STILLABOWER: We are seeing a combination of things; some customers fret over asset safety, and we get questions such as:“How are you registering our assets? How do we get our hands on our assets if there is a problem?”— very understandable following the Lehman crash. It is all about segregation, transparency, and safety. As Ross says, I don’t think it’s filtering through on the price as yet. We always hear that “it’s not a price-led decision, factors such as asset safety are key!”, but in the end it seems to come down to price. I would tie that back to the fact that clients are also feeling the pain. It goes back to the point Ross made on distribution. On a global basis, whenever I talk to alternative clients, they all start a conversation with:“How can you help me get more assets into our funds?” In this market the end investors are driving a lot of activity based on whom they place their money with, and why. They will be critical to determining how this will all play out, and I think it’s very difficult to tell today what the marketplace for securities services is going to look like in three to five years. NAILL MOWLDS: The question of asset safety in its broadest sense has increased on our and our clients’ agendas. We have seen this both in the increased focus on the actual safekeeping arrangements and also in the asset management strategies that our clients want, particularly a growth in absolute return/capital preservation strategies. We see the inevitable demand from clients and potential clients to understand the actual safekeeping arrangements we have in place, and often to seek to impose their own. We’ve also seen a growth of interest in structures with bankruptcy-remote vehicles. Clients are also very interested in the regulatory position and status, both of the fund and the manager. I think this focus on the manager’s position will be highlighted with the implementation of AIFMD. Ultimately, our clients are demanding much more transparency of arrangements; no longer will they take these matters on trust. ROSS WHITEHILL: There’s much greater due diligence now than ever before. The lesson from a service provider perspective is that we’ve got to be transparent. We’ve got to be prepared to show our clients and their own clients how we’re holding those securities and what we do to minimise the risk to them and to ourselves. Equally though, as service providers, we have to be much clearer with whom we’re doing business, and exactly what it is clients want.

REDEFINING ROLES AGAINST A MOVING BACKDROP PAUL STILLABOWER: Certainly, we have a rapidly changing backdrop following the events of 2008. It is not yet clear how this is going to play out. With respect to asset servicing, governments and regulators are clearly starting to focus on the capital position of organisations that are providing these services, for example in the AIFM Directive, where an outcome

FTSE GLOBAL MARKETS • SEPTEMBER 2010

Niall Mowlds, head of service management, Threadneedle Investments.

might be immediate restitution of assets. However, this moving regulatory backdrop is unresolved and won’t be for a few years. Even so, asset servicers continue to try to move up the value chain, even when clients have not asked for this. What clients ask of asset servicers is to“get the basics right”. Often that is lost on the provider side of the business where a lot of the focus has been on launching new services that arguably not every supplier is suited to provide. So there’s a skills gap for asset servicers that move too far up the chain. Within HSBC we’ve thought long and hard about the client segments we want to be in, the services we’d like to excel at. We believe in the universal bank model where we can leverage the whole product range. For example, we saw opportunity in the prime services space—to fill a need with customers in the hedge fund arena looking for transparency and security of assets. We could do this because, as a base, we have a segregated custody model. We segregate client assets not just from HSBC proprietary assets but also from other customers. In addition, we have a global markets division that can offer all of the sophisticated trading and financing that this client base requires. Combined, it offers a very different option than the old prime brokerage model, which is floundering. Even so, organisations are still trying to find their space in this new environment and the eventual changes will take time. GÖRAN FORS: We have a pretty differentiated product set depending on the type of client, and whether the client is creditworthy. It is for the clients that we offer the type of service they need through to the product, the type of asset classes they want to have serviced. The combination of clients needing more differentiated services, due to what they do and also the need for the providers to separate their services because of the risks involved, will probably trigger different offerings than we’ve seen in the past. We might even have to look at different set-ups and probably different price models. NIALL MOWLDS: I am not sure I agree with the assertion made earlier that a lift-out means that providers are taking on the characteristics of their clients. When I’ve looked at the history of lift-outs, I would argue that the opposite appears to be the case, whereby providers have not always understood the objective or purpose of the processes they took over and as a result post lift-out have lost some of the essence of the previous service delivery. For instance, asset prices are used

EUROPEAN ASSET SERVICING ROUNDTABLE 96

for different purposes at different points during the day. In a daily-priced fund, the fund accountant will price the asset at the official valuation point for NAV and dealing purposes. The same asset will likely be priced at the end of day for decision support and analytical purposes. The sensitivity to accuracy and timeliness of that price will vary enormously across these two processes. This difference in purpose and objective is often misunderstood. I see many asset servicing providers looking to re-use or “leverage”their fund accounting capabilities and processes, often at the expense of understanding the objective of the process. This desire to expand scope of services has potentially been at the expense of a real understanding of the purpose to which the output is directed. There is a danger that the desire to achieve economy of scale and efficiency is at the expense of delivering an output that is fit for purpose. The truly successful asset service providers will be the ones who understand their segments and products well, and deliver against their commitments. I believe there’s benefit in bundling, but each component has to be individually credible. JOHN MORLEY, MANAGING DIRECTOR, JP MORGAN: I’d put it in a slightly different way. The whole industry is struggling to find the right linkage/interface between what should be an asset management function and an asset servicing provider function. In part, that is because there is no way that service providers could or should provide every asset management function across the complete spectrum of activities from front to back office. Therefore, finding the right product combination and the right service boundary between asset managers and service providers is what everyone is struggling with. Services are segment and client driven; and so it is not just about developing new asset servicing products, but providing the correct linkages between products that clients in every segment want. Moreover, as the service providers move further up the value chain with a client, better integration of data is as important as the integration of activities. There is always debate around whether you have the data structure with the asset manager or with the service provider. If a service provider is managing data consolidation, it has to make sure all of the individual services can be integrated in data terms and delivered to the asset manager. That’s what integration is all about. JIM KANDUNIAS, PRINCIPAL, ESEMPLIA EMERGING MARKETS: John is spot on in terms of being clear about where asset management starts and finishes and where services providers start and finish. I would say that one needs to be precise around what a prime broker actually is and does. If we were having this discussion several years ago, one would probably have defined the term along lines of an aggregation of a range of services provided to (typically) a hedge fund. The investment banks quickly worked out that there was a market for those who no longer wanted to continue to work within a large investment bank or asset manager. The prime broker evolved to the point where the prime broker (actually an investment bank itself and sometimes the bank that the hedge fund principals / staff previously worked for) could provide a range of services to

a “start up” including infrastructure. It was really, with the greatest respect, a very clever packaging exercise. Today, the world has changed for those firms that are not really established within the asset management space. TIM REUCROFT: What we’re talking about there is a new class of client. If you go back 15 years, you had what was then called global custody, and it was servicing the buy and hold client. Then hedge funds appeared on the market and they required a service that was christened prime brokerage because you only used the one broker so he was your primary broker. Then global custody was renamed security services— with the emphasis on securities, but now it is called asset servicing since the asset classes have expanded. So, you’ve seen that whole transition. We haven’t quite gone as far as liability servicing yet. LDIs [liability driven investments] are getting a bit close, but we’re still stuck in this asset servicing space and what does it actually involve? Can you be all things to all men? Very few people can do it. There are quite a few people around this table who claim they can but can’t. Clients used to do just one class of assets, but then a whole new

Jim Kandunias, principal, Esemplia Emerging Markets

class of assets was invented and next they’re into wine and property and alternatives and hedge funds and commodities and FX, all as separate asset classes. The firms that used to do securities servicing all of a sudden ask:“Why can’t we service FX or commodities or property?” ROSS WHITEHILL: It is absolutely clear that none of us attempts to be all things to all funds. There are very specific things that asset servicers can do and it’s been an aspiration for many of us in the asset servicing industry to build out our capabilities. The strategy of firms like ours around the table has really been to develop a model that surrounds the flows of capital. Whatever the sort of information, if it relates to cash or securities, then the asset servicer would want to be at least able to provide a service to support that movement of securities or cash or provide information around that. There definitely has been an attempt to increase the range of

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

Tim Reucroft, director, investor services, Thomas Murray.

products and services that relate to the asset management community but, again, what each of us has done is to acknowledge and define that this is an asset manager, that’s a pension fund, that is an insurance company, and that’s a broker. These are the products and services they require, to what extent is there an overlap and where do we need to build out? What do we need in terms of technology, market coverage, asset allocation coverage and so on? While we haven’t sought to be all things to all funds, we’ve certainly tried to build out products and services to meet the needs of the core client base. Have we done everything in an absolutely first-class fashion? You’ll hear from the asset managers around the table that, no, there’s still plenty of room for improvement. NIALL MOWLDS: Whilst I would agree that there are different categories of client, the challenge I would raise is to what extent do the providers offer product silos that the client must integrate rather than the supplier delivering an integrated service? Today I would say I am buying a set of independent or functional products from the same entity that I need to integrate. JIM KANDUNIAS: What we do is manage emerging markets investments for institutional investors. The challenge we’ve found is that the service segment is clearly much more competitive than it was. However, it is not driven by the same model that you would have thought of in a prime brokerage service. Even a firm of the size of Legg Mason, our parent that runs a number of affiliates on a number of core functions, has decided to question that model and say, actually, we ought not to do many of these services in-house. It doesn’t make sense. PAUL STILLABOWER: This goes to outsourcing and it also ties in the bundling and unbundling debate. Say a client has gone the outsource route; it has chosen a provider, and received economic benefit from bundling all the services with that provider. It’s unlikely that the provider will keep exactly in track with the client’s needs, but if the client then starts to unpick the bundle and, say, appoint new providers to do these special things, then they’ll start to lose the economic benefit of having a single provider. I think it is a trade off: good providers of outsourcing spend the majority of their time trying to keep up with the changes that their customers

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require. That is because customers are not static: how their business looks today, will certainly be quite different from what it was five years ago or one year ago. For the asset servicing industry, being all things to all people was pretty easy in the bull market. It is very difficult today because the economics break down much more rapidly. JOHN MORLEY: We’re all engineering our services to support a range of client segments. The bundles of products differ and the interaction of those bundles of products differs. New ones need to be added, old ones need to be taken out. The engineering task is extremely difficult. What we’re all trying to do is to reinvent ourselves technically and operationally so that we can provide that diversity of options to a set of clients but still make money by having efficient operating models and that’s the true challenge of all the providers around the table, to try and achieve client and segment customisation using a standard, cost effective set of operations and technology.

THE VALUE (OR OTHERWISE) OF RE-REGULATION JIM KANDUNIAS: If the thesis is that regulators are starting to introduce things to limit what you can do for your clients, I don’t accept that because I come from an institutional perspective. Not that I am biased for or against the comments by regulators but more from the fact that much of what is being stated of late reflects the (commonly) accepted standards within the institutional community. In essence regulators are using those standards and reflecting them to a higher level across the broader market; that is, beyond just institutions. A lot of things resonate: for example, around transparency, security of valuation or confidence in valuation, for the sake of argument, in the pricing, the valuation of the securities in the portfolio, the methodology by which they’ve been undertaken, the process by which a client can be assured of receiving the report and the report is accurate, and independently-verifiable if need be. Then there is the consideration of liquidity within the constraints of the asset class in which they’re invested in. The last bit is the only area where I have some concerns: for example, the possibility that investors and indeed some quarters within the investment community may end up with a belief that by having a UCITS tag it gives you potentially some better form of liquidity, or potentially some better form of comfort about access of money. I use the word potentially very carefully because in emerging markets, provided the portfolio is in liquid securities and we don’t have an event like we had in 2008 or liquidity in the market doesn’t dry up overnight, it doesn’t matter what fund structure you have. Liquidity is ultimately a product of the underlying securities in the portfolio. So let’s be careful about how we push that concept forward. TIM REUCROFT: Regulators/governments have got their own agenda and regulators are just a voice for governments and what do the governments want to do? They want to make sure that they never have to bail out the financial sector again and, as a consequence, they’ve got to force people into safe

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investments. That’s why they’ve got to force people into UCITS. That’s why they’re going to put all these major constraints in the AIFM Directive and that’s why they’re looking for big banks to pick up the risk. They are going to force investors out of those things that they don’t really understand where you’ve got problems with valuations etc., and they’ll do that through a CCP mechanism. Everything will have to go through a CCP and if it’s a risky product and nobody understands it, it won’t go through a CCP. Hopefully you will get good valuations and good liquidity and all the other benefits as a result. What happens to your returns is another question. ROSS WHITEHILL: Maybe though, Tim, if it’s not the regulators who are trying to design out risk, what they’re trying to do is to put more of the onus and responsibility on the people with the deepest pockets. We saw that with the events of recent years, the compulsory restitution and that to me signalled an end to sanity. We have so much responsibility under that policy, so much responsibility for assets that we don’t even hold in bank. Jim, you talked about property trusts and things. We actually don’t hold the property within our custody. Equally, the same will apply for a swap and yet we as asset servicing providers are going to have the responsibility for full restitution, if the regulations go that way, but we’ve gone too far. We’ve taken leave of our senses and we’re shifting the responsibility back to those awful bankers that caused this global recession when, quite honestly, none of us had the balance sheet to support full restitution. So, it’s just complete nonsense for any investor to believe that they have total protection. GÖRAN FORS: I could challenge this. Is it really that big a change, both for the asset managers and for the providers, or is it just that we are now pushed to change how we work? During the more or less 25 years I’ve been in this industry, we’ve been facing a number of cases, like Barings and SocGen and other issues. The risks have been very much highlighted again due to happenings in the markets and obviously came to a very clear focus this time and there were a lot of mistakes, not just by the providers and the asset managers but also very much by the regulators themselves.You can question why the regulators now start talking so much about regulating specific areas when they, at the same time, two years ago failed to follow up on the regulations that were already there. I reckon that we are now looking at it in a different way or we are being pushed to look in a different way on things that we’ve been working with very clearly for many, many years. It’s just the same and it is important that we do this the best way without too much regulation that can harm the business. JOHN MORLEY: I’ve seen the pendulum swing between regulations that restrict the industry’s ability to provide services that investors need and regulations that don’t actually succeed in protecting investors. I’ve never seen it settle in the middle and part of the reason is that although the motive to protect the investor is good, the outcome can restrict investor choice. There’s also often a disconnect between the intent and the delivered product from the regulator point of view. Somewhere between looking at what’s required and assessing the impact on the industry, drafting the regulations, getting agreement and enactment, the original purpose can be lost. I believe

Ross Whitehill, business manager, asset servicing, BNY Mellon Asset Servicing

there will be some changes in the AIFM proposals. For example, depository responsibility started out as full restitution, now it’s moved back a little bit from that. The answer is more trust and understanding between the regulators and the industry in achieving a desired goal. Creating new regulation is always a struggle and it doesn’t need to be. PAUL STILLABOWER: It is interesting that the day Tim Geithner wrote the letter to the European Commission saying that the AIFM Directive was unfair to US hedge fund managers and global custodians was the same day Airbus and Northrop Grumman said the RFP process for the US military contract for refuelling planes was unfair! When the drivers are political, rules that practitioners might think are crazy and unworkable could still get enacted because the decisions are taken at a higher level. Unintended consequences would be dealt with later! Clearly, if the AIFM Directive, which offers the highest level of protection for the wealthiest investors, goes through, then the concept will get rolled into UCITS. We then have a much bigger problem in that the industry is not built to provide that level of protection. However, the regulators are right to be circling around the issue of having capital in the securities services industry. You have two core functions, namely safekeeping and valuations, and providing that in an independent manner is becoming quite important. Firms that are offering those services without a balance sheet are correctly being viewed as flawed.

ALL THE WORLD’S A STAGE PAUL STILLABOWER: The chief executives of our clients don’t place the highest value on securities services. They expect the service to be managed by their COO and they just want the product to work. The chief executive or the chief investment officer quite frankly would rather talk about ways in which their key partners might help their business grow. This industry will commoditise, whether in five years or 55 years, because that is what our clients would prefer. In addition, the barriers that keep us profitable and healthy will gradually reduce. Eventually, regional differences will blur and disappear and it will be the providers that can bundle a multitude of truly valued, global, growth services that will thrive. Otherwise, what are clients paying for? Over time, if you are purely an asset servicing company then it’s like making buggy whips when Henry Ford’s got the Model T starting to roll off the production line.

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JIM KANDUNIAS: It is interesting you make that assumption, because you’re HSBC, right, so you view the world through a prism, whereby I would suspect a substantial amount of resources and attention is being placed on emerging markets? PAUL STILLABOWER: True. JIM KANDUNIAS: For you in a sense it’s not healthy to have too much concentration, but we should bear in mind a couple of factors. One is the landscape of investments is changing and if a few years ago some of them had even dared contemplate the idea of a Chinese-listed bank becoming the most highly capitalised bank in the world, everyone would have said:“Jim, are you feeling well?”However, the world is changing. Could there potentially be a bank coming out of China or a part of Asia or Korea that has a significant custody and servicing business relevant to those markets and investors who wish to access those markets? Yes. On the flip side, if you go into the US and you look at institutional investors, they have been focused on strategic asset allocation to the US, to Europe, Japan and then this other EM bucket, on the side. That is clearly changing. Dedicated GEMS mandates, and dedicated Asian mandates, are now in play and it will not be long before these big players opt for China as a dedicated allocation in itself. When that happens, then you’ll have another bout of this change. I don’t think that the status quo is going to go like that and contract further. It will polarise. NIALL MOWLDS: We’ve mispriced some of the risk in the financial system for the last ten years. We now understand that and more importantly are now actually putting a proper price on risk. The size of investment in the infrastructure that a firm like HSBC has made over the full economic is paying off over the cycle, and not just in the peak year; that’s the key point. Whether you are JP Morgan, BNY Mellon or HSBC: are you in this business for the next year or for the next decade, and does that dictate how you view the economics of the business? There is an interesting challenge around what do we, as an industry, want to make cheaply as a commoditised utility? If the servicing industry consolidates and we go towards utility provision for some part of that value chain then I don’t see that as a particular problem. I think that there is enough of a community of stakeholders involved to mitigate the risks. I also think it frees up and recycles the human and financial capital to focus on the next set of challenges. As a firm, we constantly challenge ourselves to focus on those things we are good at and can add value, and look to source the rest from expert providers. ROSS WHITEHILL: It’s fascinating that the regulatory environment is“punishing”the banks when, actually, you’ve got to question at the asset servicing level how much has been done that’s wrong or disadvantageous to the end client. Madoff is an aberration that people have got hold of and said: “Okay, the person who’s got to pay for that is the custodian or the trustee because, after all, it was their responsibility to ensure there was good governance of the assets and proper valuations, so I know that the assets exist.” We’re seeing some interesting pressure not necessarily from regulators, but from lawyers and accountants. We’re seeing pressure to absorb greater risk and to take greater responsibility

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than we ever had in the past and, because the people that are doing this work are banks, we’re paying that awful price for some of the misdemeanours of people who are largely on the outside of this industry. That’s a great worry for us, that we’re tarred with the same brush and regulation. TIM REUCROFT: Well, we started off with unintended consequences. Even the regulators say we don’t care what the consequences are, we’re just going to do this and we’re not listening to you. We don’t care what you say: whether the medicine works or not; we are just going to do it. There are all sorts of inconsistent regulations coming out, which is an absolute joke. We may well end up with six or seven major players and that does tend to make you think: well, why not just go for a utility solution? We’re getting that in Europe. Target2Securities is a securities solution run by the ECB, and it’s only a question of time before they grab the asset services piece of that as well and the trade matching and all the rest of it. My point is that, okay, you want the utility solution. Where it’s appropriate, absolutely fantastic, I fully support it. However, I do not think the government should run it. It should be run by the market for the market. The danger is that the regulator will say they are just going to take this whole thing over. If you can’t run it properly, we’ll do it for you. Then we’re in real big trouble.

Göran Fors, global head of custody services, SEB.

GÖRAN FORS: I represent a bank that has been told we should get out of the business for the last 15 years and we still haven’t and we have certainly never wanted to. I don’t think there will be only six or seven providers left. Maybe there will be fewer providers that we will truly call global-global providers. A global-global provider offers global custody to clients on a global basis .That is a very challenging position to be in. However, I don’t even think there will be changes in the way that providers and also buyers will look at the business as a whole. There will be regional players coming up, like Chinese banks. I definitely believe that they will be global custodians at some point and we will see that trend in various regions as well. You can compare it with the airline industry. We have a number of huge airlines today that dominate a global position, but you can’t really see any of them taking over

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the world of travelling and I don’t think that’s going to happen in the world of securities either. PAUL STILLABOWER: By the way, I don’t want it thought that I agreed that there will be six or seven providers left. Göran said it a moment earlier, that there’ll be a smaller number of properly global providers. Elsewhere, the local banks in many markets are and will continue to be very, very hard to dislodge from this business. For example, I see various Chinese banks very regularly and they fully intend to be players in the global custody industry in the future and they understand what the industry is about. ROSS WHITEHILL: Actually, the discussion around how many participants there are going to be, as far as I can remember, commenced about 1989, about five years after “global”custody was really launched. Even then, people said that by the year 2000 there will only be four global providers. Obviously that is not the case. The Chinese may come in but they’re not going to be genuine global custodians providing a full service suite right around the globe. I believe the position of the truly global banks is secure for the future. I would posit that the future is secure for those people who are building up that global capability and I don’t think China is going to be there any time in the next ten years.

THE COST OF SERVICES AND THE AIFM DIRECTIVE NIALL MOWLDS: It comes right back to the earlier prime brokerage example; in particular it’s about understanding what’s important to the user of that service. A fund in Abu Dhabi, for instance, may want clarity of custody arrangements in a Middle Eastern market, which may not be the most important thing I want to buy from the providers around this table. If you understand the objective or the process you’re delivering for any client there will always be an element that can be commoditised but inevitably there is an element that is a bespoke service. TIM REUCROFT: It comes back to regulation; regulators want to restrict what people can invest in. If they are successful at that, then we’ll have a much narrower-focused world. You might not get performance but hopefully you’ll get more safety, which is what the regulators are obsessed with now. There might be new products designed to facilitate investments or trading, but regulators appear to want to curtail these new products coming along. The thinking is: algorithmic trading doesn’t add any real social value, so why do we want it? It will be the same with ETFs if the AIFM Directives come in; they will simply be stifled. Innovation is being stifled. So where will it all end up? It’s not a nice scenario. FRANCESCA CARNEVALE: But if it’s stifled in Europe and the US for example, wouldn’t it just move elsewhere? TIM REUCROFT: Yes, that was one of the first questions we had, wasn’t it? All this stuff is going to go I know not where but it’s not going to be Fortress Europe. FRANCESCA CARNEVALE: Won’t that change the landscape for a long, long time? Niall and Jim can go overseas and Paul and John and Ross can redirect their business focus

John Morley, managing director, JP Morgan

out of Europe, out of a more restrictive environment, into an easier jurisdiction. The world’s their oyster, really. TIM REUCROFT: So Niall, where are you going then? NIALL MOWLDS: I’m staying here. I’m not as pessimistic as you. Clearly there are both macroeconomic and macropolitical influences at play; part of it is trade protection, part of it financial system protection. I look at AIFM and I won’t say I like every bit of every draft I’ve looked at but for someone who is an institutional asset manager providing a broad product range to customers, it’s largely positive for us because it focuses us on the rigour of the platform in totality. So, the example of two men and their dog in a Regus-rented office with a free Bloomberg terminal from some bank running a fund can no longer compete with us; rightly so, in my view. When we’re talking about that amount of capital (potentially in the UCITS wrapper) I’m struggling to see why robust and comprehensive regulation of the manager is a bad thing. Independent valuations, asset safety—all of these themes are embedded in it and are very positive and welcome. For me, AIFM is more positive than negative. TIM REUCROFT: I don’t think it’s the only initiative that we’re seeing. There are lots of other conflicting things happening that are going to restrict the quality of investing enormously. JIM KANDUNIAS: Really? Who are we talking about restricting? If you look at AIFM stripped back to its bare essentials, the broad tenet being that certain types of investors were put to one side and those types of investors retain autonomy to basically do whatever they deem appropriate for their fund and investment policies. The reason is because they have the governance processes in play, they have the staff, they have the systems and, more importantly, they are accountable to their constituents for what they do. It’s not unreasonable to think that if I’m setting up a fund-to-funds, promoting that fund-to-funds to retail investors, then I should be accountable for the selection of the underlying managers within the funds whether those managers are a large firm or smaller firm within a prime broker. PAUL STILLABOWER: For asset service providers the concern really is around the“immediate restitution of assets”

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because there will be a capital implication. How much is the capital implication? It is not yet clear. If, however, there’s a charge on the balance sheet for providing this service, some firms will not be able to offer the service. They don’t have the balance sheet. Then again, other firms that do have the balance sheet might think this isn’t a great business to be in. The proposals change the dynamics of what is a low risk-weighted asset business so that there are potentially real repercussions.

TECHNOLOGY SPEND IN STRAIGHTENED TIMES JOHN MORLEY: As an industry we’ve come from silo’d products, whether that’s asset management or asset services providers, that’s where we’ve all come from. Technology is meant to move us away from that environment so we really do need business models that enable us to integrate different services, or integrate different asset management products, and that’s a major challenge for us all. We’re all going through that at different stages and ironically at the time when we really have to spend a lot of money on infrastructure improvements, it’s harder to fund the investment. Responding to changing regulations is also going to make it harder to allocate investment to strategic projects. ROSS WHITEHILL: At a time like this, when we’ve seen so many major outsourcing opportunities that are going to require significant technology investment, what we’ve got to do is determine who we want to put the resources into, who do we think is going to be the long-term successful provider. Balancing the capital cost we’re going to have related to that, against the increased demand for risk and compliance reporting from existing clients, we have to put a terrific amount of pressure not just on technology but upon the resources that sit underneath that. It’s a very, very challenging time. GÖRAN FORS: We’re already in an industry where the knowledge and competence and experience are still very, very important and it’s going to be important. The knowledge of our people has to be supplemented by very, very efficient technology that drives down cost and makes everything safer and less risky. JIM KANDUNIAS: Technology is such a broad term that we find more time spent on required to have rather than nice to have. It’s a balancing act. It’s the cost versus benefit and we found in our firm there are a number of things you can do when you strip back to essentials, and I’ll be fairly broad here but sometimes a straightforward spreadsheet can be the most useful tool. The fact that you put an interface above it that an external provider provides to you that makes it look pretty, doesn’t alter the fact that the underlying analytic runs on a spreadsheet-based type macro. If you have a Bloomberg interface, there are certain things that come off that in terms of trading, the guideline monitoring, guideline advice, pre and post trade etc. Those things are critical. They tick all the boxes. You need them. Then when you go into analytics, and especially risk metrics and portfolio attribution etc., you might actually surprise yourself that the interface is not as important. JOHN MORLEY: I was really talking about the global

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economy and organisations’ ability to divert funds into future investment rather than putting fires out. NIALL MOWLDS: Jim’s points resonate at lots of levels. In my view, the asset management industry has been a cottage industry for many years and to a large degree remains so in that fund managers tend to want to do things their way. That said a lot of the analytics we want can be done on Exceltype tools. The key is getting the right position, price and cash data in a timely fashion. The asset servicing community is fundamental to delivering this data and this interface with the asset servicing world is critical. There’s a shortfall of technology investment, and now when we need it most, we haven’t got the money in the system to pay for it. The suggestion that the services need to be repriced (upwards) to allow for these technology and migration costs will be a difficult one to accept, particularly in an environment of depressed asset value and tighter fee margins. It will be an interesting debate over the next three to five years. JOHN MORLEY: I would draw a parallel with some of the boutiques now looking for broad support and some of the smaller hedge fund managers with no infrastructure that have come out of other houses. They’re traders and they’re looking for organisations to provide full asset servicing support. If you go back 10 or even 15 years asset managers were asking the same thing of suppliers, which is: I just want you to do everything for me. I want it done on time, I want it done cheaper than I can do today and, by the way, I want you to keep up with my development. It’s matured a lot since then and service requirements are better defined, but it hasn’t matured far enough. Then there is the whole issue around data requirements; not only combining data across different products, but also understanding what that data is, because sometimes data is used for the wrong purpose. Having talked to a lot of asset managers and because of the way the business has developed and diversified, they’ve got a number of different platforms which purport to have the same data that when added together gives you a consolidated view. In practice though, it’s actually an apple and a pear and an orange trying to look like a banana. For an asset manager to understand every individual item of data, definitions need to be very clear. In an accounting view a holding may be at a NAV point. In an asset management view a holding may be based on the trade that’s just been done. An important difference if you are trading based on a holding. I agree: the promise of outsourcing being the answer to life and everything hasn’t yet matured enough to deliver on that promise, but that is because standard operating models, service boundaries and data solutions haven’t yet emerged. PAUL STILLABOWER: HSBC is actually investing more in technology right now. We have a programme called OneHSBC through which every like platform and process across all businesses was reviewed to see whether the technology or the processes could be shared, rationalised, or could enable revenue growth. One of the benefits of being a universal bank is that you can swim against the spending stream as you’re not tied strictly to the revenue that’s generated by one particular business. ■

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TRANSACTION BANKING: SUB-CUSTODIANS FACE CHALLENGES 102

Photograph © A-papantoniou / Dreamstime.com, supplied August 2010

SIZING UP SUB-CUSTODY Transaction banking remains a valuable commodity, and as a result, well-established regional sub-custody players in particular have come through the fire in fine form. However, in a world of lower management fees, greater technology needs and fierce competition, ranking sub-custodians are by no means living on Easy Street. Dave Simons reports from Boston. T THE NETWORK Management (NeMa) 2010 conference held in Malta in early June, sub-custodians from across the globe gathered to assess their standing in the rapidly evolving asset-servicing space. Included among the list of key themes was the notion of realigning one’s subcustody network, so that today’s leading sub-custodians could still have a place in tomorrow’s world. Speaking at the NeMa conference, Colin Brooks, global head of sub-custody and clearing for HSBC Securities Services, said that demand for back and middle-office outsourcing remains strong, particularly among broker-dealers, who are keen to offload duties such as clearing services to a third-party agent as a way of moving from a fixed to a variable-cost scenario in an effort to improve their bottom line. For sub-custodians, this means having an infrastructure that is rugged enough to handle these new demands as they make themselves available. While business activity remains healthy, the prevailing,

historically-low interest-rate environment will compel providers to seek alternative sources of revenue. Thus, providers will be compelled to re-invest in systems that can keep risk at bay while enhancing the flow of communications. These days, sub-custodians are called upon to do it all: clear, settle, automate, move up the value chain, lower fees and reduce risks. All through the post-trading process, there are risks to be found. These include sovereign risk, counterparty risks, transaction risks, and liquidity risks, among others. “As a global custodian, we want to ensure that we hire custodians who can help us to indentify and mitigate these risks,”comments Andrew Rand, head of network management at Brown Brothers Harriman. “While technology spent is certainly an important indicator of a sub-custodian’s commitment to the business, an equal measure of commitment can be found in the amoun of time and energy that is invested in the lobbying for improved market conditions.” Add to this mix the insatiable appetite for scale among the industry’s key players—not to mention the ongoing pace of industry consolidation—and it becomes readily apparent why sub-custodians continue to tweak their business model in an effort to boost their client base while bolstering their product line. For years, sub-custodians operated under the assumption that doing big business with US-based bulge-bracket fund firms and global banks with seemingly impenetrable balance sheets was a foolproof strategy. “Because at the end of the

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day, that balance sheet would still be there and everything would be just fine,”says Alan Cameron, global head of clearing, settlement and custody, BNP Paribas.“Of course as we now know, that assumption wasn’t 100% accurate.”The difference now is that sub-custodians understand that they’re dealing with actual transactions, rather than a phantom balance sheet. Today, sub-custodians need to ascertain how much cash they’ve put forward on any individual transaction, as well as what their method is for recouping that cash should something go awry. “Rather than cutting back on credit altogether, they must learn to look at all of the data from a much more granular perspective,” says Cameron. The number of markets in which banks maintain a presence has risen dramatically in recent years. As such, the old system of maintaining different systems for different regions is no longer a workable solution. “A few years ago it wasn’t as critical to receive all information in real time, particularly if you believed that there wouldn’t be any problems with the balance sheet,” says Cameron. “However, given what we now know, I think all banks are working towards having a real-time picture of what is happening. Yet because transaction banking has become such a scale game, getting real-time all the time is easier said than done. Furthermore, in order to achieve real scale, you need to have geographical or market diversity, which in turn can lead to having many different systems on board,” adds Cameron. “Therefore, the other challenge is to be able to pool together all of that information in a coherent manner.” Whereas only a few years ago a settlement engine need only be powerful enough to handle real-time transactions by the thousands, today it is more likely to be measured in the tens or even hundreds of thousands. According to Ulf Noren, global head of sub-custody, client relations, at Stockholm-based SEB, sub-custodians are seeking the kind of technologies that can enable them to continue to address inefficiencies and redundancies within the system, while at the same time supporting increasingly popular high-frequency trading mechanisms and other emerging solutions.

Shifting structures “Market structures are shifting much faster these days, particularly as trading moves increasingly from exchanges to multilateral trading facilities [MTFs],” says Noren. The completion of the Target 2 Securities (T2S) integrated securities settlement system will further reduce the cost of trade settlement, he adds. Accordingly, the entire chain must be secure, and contingency solutions between the central counterparties (CCP) and the MTFs, as well as between CCPs and direct clearing members (DCM) or general clearing members (GCM) must be waterproof. Because, says Noren: “If the data is broken, missing or delayed, it doesn’t really matter if it is in real-time.” Interoperability between the CCPs and the sub-custodian is another area of concern. “There are still many important issues that need to be addressed, including risk management, governance modeling, and also cost,”says Noren. While sub-custodians may prefer to take a hands-off approach to trade settlement, this is only possible if there is a direct link

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connecting the central counterparty, central securities depository (CSD) and all market participants, says Tim Faselt, deputy global head of sub-custody and clearing, HSBC Securities Services. “Though this is the case in most markets, there is still much work to be done. Today’s technologies have to operate in real time, and if the systems are still only batch processing, you will be left behind. So while our clients may still rely on our SWIFT messaging to update their systems automatically, we see increased usage of our internet-based system, HSBCnet, to supplement this reporting.” Indeed, clearing solutions can vary greatly by region. In the absence of a centralised counterparty, many of Asia’s markets have automated pre-matching solutions, which allow clients to match instructions with the counterparty based on a previously agreed set of parameters. Such solutions can help clients address risk related to settlement, cash management and other areas of concern, says David Gilmour, managing director, transaction banking, North Asia, Standard Chartered Bank. “It is imperative that custodians continue to invest in these matching engines in order to provide clients with a consistent regional approach not supported by the market infrastructure.” `

Only a few years ago, a settlement engine need only be powerful enough to handle realtime transactions by the thousands. Today it is more likely to be measured in the tens or even hundreds of thousands. Because automation is not nearly as prevalent in emerging regions as it is in more developed markets, sub-custodians such as SCB place a high priority on clearing and assetservicing systems, depository interfaces as well as other tools such as online portals for trade initiation and fund-services reporting, says Gilmour. “This creates a mechanism for providing clients with the highest straight-through-processing rates in order to facilitate the most effective through-put to and from the market. This will ultimately reduce costs, while paving the way for higher trading volumes.” Looking ahead to a world with T2S, sub-custodians will be required to have a network that is far more extensive than which currently exists. Says Noren of SEB: “Sub-custodians that assume a more defensive posture might offer solutions that secure a certain amount of settlement activity, while also handling all asset-servicing needs. Without any kind of settlement-related activity on board, a sub-custodian may be viable for anywhere from three to eight years, but will ultimately be reduced to the kind of position that monomarket custodians occupy at present.” However, those who elect to take a more pro-active approach will seek to expand their current footprint using a combination of build and partnership, while at the same time investing capital in order to forge new customer relationships, intensify client coverage, expand distribution in globalfinancial centres, as well as revitalise emerging-markets

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Sébastien Danloy, global head of sales and relationship management, Société Générale Securities Services. “Sub-custodians need to be able to operate across an exceedingly vast geographic region,” asserts Danloy. Photograph kindly supplied by Société Générale, August 2010.

support to its core clients, says Noren. Transparency continues to be the leading mantra for the asset-management industry as a whole, and sub-custody is no exception. According to Noren, the focus has shifted to monitoring positions from a risk and collateral perspective. “Some have the idea that all risk can be mitigated as long as it is regulated, or is passed along to someone else,”says Noren. “However, I believe that clients will become more insistent that sub-custodians assume more of the risks. Therefore, subcustodians must become much better at visualising what it is to take on this risk, even in so-called plain vanilla areas such as settlement and parts of asset servicing—and be able to charge for that risk assumption as well.” Educating clients about risk is another “must,” argues HSBC’s Faselt: “Regardless of the level of mitigation, providing this kind of information allows investors to decide if the risk is acceptable as part of the larger investment decision-making process. ”To address certain market-infrastructure risks, subcustodians, often in the form of a local custodian’s association, will explore these issues with the relevant market participants and subsequently recommend solutions, says Faselt.

Multi-market methods Can one still realistically get by with a more regionallyfocused business model? According to Sébastien Danloy, global head of sales and relationship management, Société

Générale Securities Services, having a presence in a number of different markets allows sub-custody clients to leverage the kind of regional banking power that in all likelihood would not exist with a single-market provider. “Sub-custodians need to be able to operate across an exceedingly vast geographic region—covering one market at a time just isn’t feasible any more,” asserts Danloy. Additionally, in order for clients to feel more comfortable establishing a longer-term relationship, they need to be reassured that the sub-custodian is committed to the business, says Danloy, particularly as more and more players continue to step away from the industry. Obviously different markets have different levels of maturity; however, savvy sub-custodians can use this knowledge to good advantage when approaching prospective clients. “The ability to demonstrate expertise developed through working in numerous countries and regions not only gives you a competitive advantage, but also allows you to offer assistance to the regional market participants,”says Danloy. “For example, having strong relationships with the local regulators and being able to work with them on behalf of the clients is very important—it allows you to serve as your clients’ eyes and ears, which is a powerful value component.” As the recent financial environment has shown, value is still in the “eye of the beholder”, says Michael Aschauer, co-head of sales and relationship management for Deutsche Bank's Direct Securities Services. As such, sub-custodians must be able to respond to the varying requirements of its client base, while covering an expanding network that currently encompasses over 30 markets worldwide. “We are keenly aware of these infrastructure challenges, and are ready to seize opportunities where value can be enriched and risks mitigated,” says Aschauer. “That is why we offer bespoke solutions for a client, as opposed to a ‘one-sizefits-all’ type of service. ”Because value is no longer measured from a single-market or single-region perspective, a subcustodian’s balance sheet is once again front and centre as is its commitment to multiple regions,” says Aschauer. The ability to work within a local market’s infrastructure in order to improve the overall investment environment is an essential part of what international investors pay for when utilising the services of a well-established custodian, he adds. “It is part of the activity we classify as ‘market advocacy’—an ongoing process that takes into account new client requirements and the dynamic development around emerging products and regulatory changes. For instance, at present we are discussing how to further improve risk controls around CCP clearing and standardised messaging within the various infrastructures. There are a number of initiatives already under way that are aimed at regulating market infrastructures in Europe—and sub-custodians are key to making this debate a success.” While a basic requirement of any top-shelf provider, having a strong and flexible technology infrastructure isn’t necessarily the most critical link between any market and the end investor. “Our staff are the first and arguably most important component in the effort to bridge local practices with international standardisation,” says Aschauer. “Investors

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

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TRANSACTION BANKING: SUB-CUSTODIANS FACE CHALLENGES 106

Lowering operational costs through streamlining has been a key mechanism among asset servicers for years. Assuming that current market-infrastructure costs will remain unchanged, further belt tightening is unlikely to produce any meaningful cost savings going forward. Therefore, says Faselt: “We all have to go out and get more business, more assets, and more volumes flowing through our existing platforms in order to bring down our unit costs.” HSBC is also exploring initiatives such as allowing broker-dealer clients to outsource portions of their middle and back offices, thereby providing HSBC with a fresh revenue stream. `

Sub-custody has more than its fair share of challenges, a fact that Alan Cameron, global head of clearing , settlement and custody at BNP Paribas readily acknowledges.

Alan Cameron, global head of clearing, settlement and custody, BNP Paribas. “Rather than cutting back on credit altogether, they must learn to look at all of the data from a much more granular perspective,” says Cameron. Photograph kindly supplied by PNB Paribas, August 2010.

simply cannot bypass the sub-custodian, plug directly into a market and still expect STP—because despite years of ‘standardisation,’ each market will always retain a certain local flavour. Therefore, at the end of the day, it is the successful marriage of people and technology people that will ensure that efficiencies are realised.” Targeting and expanding business generated by local institutional clients should be a key part of the sub-custodian’s overall growth strategy, says SCB’s Gilmour. To achieve this, it is necessary to have a robust and scalable fund-services offering over and above the basic sub-custody product line. “For example, SCB offers fund administration, alternativefund administration, broker back-office outsourcing, thirdparty securities lending and other services as well,” says Gilmour. SCB continues to invest in its regional-custody platform while expanding its fund-services offering, thereby providing customers with one-stop shopping for both local and international investments. HSBC’s Faselt agrees that one of the best ways for a subcustodian to broaden its customer base is through its existing clientele. “After all, prospective clients can be current clients in other markets,”he says. “Hence, the value proposition to these clients becomes the confidence they have in our central business-management process to ensure a level of consistency and high quality that clients have come to expect from HSBC in all the markets we serve—existing or new ones.”

Costs savings, however, should never prevent a subcustodian from responding to the needs of the customer base. “At HSBC, our focus is always on the client—providing the processing they need while adding value such as helping to manage potential risks will ultimately help bring further business to the platform.” Though the era of the mono-market custodian has all but evaporated, by comparison, well-established regional providers like BNP Paribas, Citi and Deutsche Bank in Western Europe, as well as ING in Eastern Europe, have come through the fire in fine form and, as such, appear to be in it for the long haul. “Transaction banking remains a valuable business for the majormarket banks,” says Cameron. “These last few years haven’t been easy for transaction banks, but then again, it hasn’t been life threatening the way it has been for many other businesses.” Still, like the rest of the financial world, sub-custody has more than its share of challenges, a fact that Cameron and his sub-custody comrades readily acknowledge. While transactions and asset valuations have improved to some degree, in many instances gains have been offset by the continued downward trend in management fees. So while sub-custodians are still able to pay the bills at the end of the month, “we’re not on Easy Street by any stretch,”admits Cameron.“Still we’ve made substantial investments in our workforce and our systems; we think we have further value to add to our clients.” With clearing in Europe remaining fragmented, BNP’s status as a general clearing member for the various European central counterparty facilities continues to provide clients with ongoing post-trade support covering numerous territories. “Right now in Europe there are 10 CCPs that clear equities, and there are many more CCPs on the way. As a result, we’ve seen continued demand for our GCM service, which offers clients an easy and flexible path into these markets. Plus, of course, asset servicing has become quite complex and will certainly become even more so in the near future, particularly as all of the corporates around the world seek to re-build their balance sheets. So asset servicing remains key as well. Yes, we plan on being here for a while yet.” ■

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

While transactional costs have improved, the global financial crisis has irrevocably altered the way that transition management in the US is conducted. Clients who now wish to implement portfolio re-allocations are seeking a much clearer and more detailed plan of action, including error-free communications and airtight risk-preventive measures, in order to ensure that all goes well throughout the transition period. From Boston, Dave Simons reports. ITH INTENSE MARKET volatility keeping transactional costs at record levels, transitions remained in check during much of 2009 as plan managers stayed put rather than incur further expense. Though re-allocation reticence has since subsided, investors remain heavily focused on risk and cost management. Additionally, clients have gravitated in greater numbers towards the use of derivatives in an effort to more effectively manage regional— or market—exposure risk during the transition process. This in turn has compelled stateside transition managers to gain a clearer understanding of a participant’s requirements in order to ensure the smoothest transitions possible. Still, managers continue to grapple with a host of ongoing challenges. For instance, as technology moves forward, regulatory checks will be needed to help ensure that trading systems reflect actual market conditions, says Mark Keleher, chief executive officer for Mellon Transition Management. “It is imperative that technology be kept up to date, so that if algorithms are being used and suddenly bids disappear, you don’t just go into a freefall. To that end, we’re very happy with the investments in technology that we have made, and we feel that we continue to be ahead of the curve with respect to trading technology.” The credit crisis has irrevocably changed the way the business of transition management is conducted, says Kal

FTSE GLOBAL MARKETS • SEPTEMBER 2010

Photograph © Concepting / Dreamstime.com, supplied August 2010

Bassily, head of global transition management at ConvergEx Group in New York. Accordingly, keeping a tighter lid on risk has risen to the top of investors’ request list. “Though risk management certainly wasn’t totally overlooked precrisis, it certainly didn’t go quite far enough,” concurs Bassily. “Today, we are finding a much greater emphasis on mitigating risk within a transition-management context, covering investment and execution risk in particular. ”This is due in large part to the pronounced volatility post-crisis and the significant increase in transactional costs that followed in its wake, says Bassily. Plan managers who were previously loath to liquidate certain fixed-income assets due to higher costs and wider spreads have once again begun to effect changes to their portfolios. In the meantime, investors have been trending towards passive-management vehicles across most asset classes as a way of addressing risk. “Liquidity may never be the same as it was three or four years ago,”says Ross McLellan, senior managing director of State Street Global Markets. “However, comparatively speaking, transaction costs have come down dramatically, and as a result we have seen a great deal of fixed-income activity, particularly during the first two quarters of this year.” Not that it’s been all smooth sailing; the crisis in Europe, for instance, prompted yet another spike in fixed-income

US TRANSITION MANAGEMENT: CUTTING THE RISKS

US TM PLAYS SOFTBALL

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US TRANSITION MANAGEMENT: CUTTING THE RISKS 108

transaction costs, leading some clients to once again assume a defensive posture. “Thankfully it was a short-lived event, and clients subsequently regained their confidence as the markets gradually improved,” says McLellan. Forward-thinking transition managers have been inspired by market events to develop newer and more innovative ways of managing costs and the accompanying risks. For instance, derivatives-based overlay strategies have become an integral part of investment-risk management, says Bassily. While exchange-traded funds are, under the right circumstances, a viable alternative (particularly for clients who are prohibited from entering into derivatives-based contracts), futures are ultimately a much more efficient way of managing investment risk, says Bassily. Not surprisingly, derivatives usage has risen sharply since the second half of 2009, and the trend has continued this year. In order to achieve optimum risk-measuring efficiency from their derivatives products, it is essential that clients have the right kind of technology on board, adds Bassily, including top-shelf analytics, as well as high-performance data feeds that can bring in marketplace data on a real-time basis. “While in the past we have used a combination of proprietary and over-the-counter tools for this purpose, by and large we now rely on technologies that have been developed in-house and that are capable of measuring risk in what we believe is the most accurate manner possible.” Multifactor models designed to measure the historical tracking errors of the portfolio to be transitioned, including the origination point of any underlying errors such as a country or sector mismatch, are key to this effort. Bassily adds: “Once you get to the root of the problem, you are then able to turn to a second set of analytics, which can help you formulate the most reliable basket of risk-mitigating futures products.” Technologies that support optimised trading, as well as those capable of examining the profile of the portfolio pre and post-transition in order to eliminate potential elements of risk while at the same time balancing liquidity considerations, remain a high priority at State Street, says Justin Balogh, senior managing director, State Street Global Markets. “We have put a lot of effort into developing proprietary trading tools and algorithms as part of our technology spend for the purpose of dealing with these types of issues. That’s become more important than ever for our TM business.” Reducing the cost impact of making cash infusions and extractions has become a key focal point, particularly for larger plans. Rather than simply taking a pro-rata slice from an over-weighted asset class, managers such as State Street are working with clients in an effort to fully optimise benefits payments.“Some of these plans may be raising upwards of a billion dollars per month—therefore, finding the best way to manage these kinds of payments is crucial,”says McLellan. “For instance, you may be dealing with a closed small-cap fund that won’t allow you to put assets back in, or perhaps your fees may jump once you withdraw more than a certain amount of assets. So we’ve come up with a way to institute some constraints, so that the client can safely make these large cash extractions or infusions without significantly impacting

Kal Bassily, head of global transition management at ConvergEx Group in New York. “Though risk management certainly wasn’t totally overlooked pre-crisis, it certainly didn’t go quite far enough,” he says. Photograph kindly supplied by ConvergEx Group, August 2010.

Mark Keleher, chief executive officer for Mellon Transition Management, says: “It is imperative that technology be kept up to date, so that if algorithms are being used and suddenly bids disappear, you don’t just go into a freefall. Photograph kindly supplied by Mellon Transition Management, August 2010.

transaction costs, while at the same time meeting their target level of risk—and, just as importantly, their forward-looking target level of return.” None of this research comes cheap, of course. By the time a client has finished installing one application, an updated version is often immediately required. “Any process that relies on real-time data demands that you go back in and re-calibrate the model once you can see the actual results. That

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

is because market conditions are always in flux—so even if a model may be performing well in a low-volatility environment, it may not fare quite as well once volatility is introduced. That is where the human factor really comes into play—in other words, it is incumbent upon the provider to ensure that the technology is doing its job by properly assessing the prevailing market conditions and providing the client with the right results.”

More market fluidity After a long period of widening spreads and general illiquidity, the market for fixed income has since shown signs of improvement, says Keleher. Additionally, problems related to securities-lending arrangements—including collateral that had in some instances been invested in impaired assets— have since been addressed, says Keleher. “Transition processes have become more fluid, and we’re seeing a great deal of activity throughout the world, including multi-billion dollar programmes in the US, Europe, Asia, Australia and elsewhere. Investors are once again shifting their asset allocations and moving into new regions—so it is a very interesting time to be in transition management.” Predicting the near-term direction of interest rates has had an impact on fixed-income duration strategy with the TM space. Though State Street’s clients, like others, have long preferred lengthier fixed-income portfolio durations, times have changed. “We’ve seen many of our clients significantly decrease their durations, which is quite unique,” says McLellan. “Instead of a traditional ten to 12-year duration, benchmarks in the order of one to three years, or perhaps even an aggregate portfolio with a 4½-year duration, are becoming more commonplace. It really is a tactical shift in anticipation of rates inevitably heading back up, after having been down for such a long period of time.” Though transaction costs have dropped, they remain well above 2007-2008 levels, the result of ongoing market fragmentation across a number of trading platforms. Additionally, without the central platforms of the major exchanges to act as an order aggregator, investors have had to weather wholesale algorithmic breakdowns, including the heart-stopping “flash crash” that sent indices into a virtual freefall in early May. Accordingly, as technology continues to move forward, regulatory checks will be needed to help ensure that trading systems reflect actual market conditions, says Keleher. “It is imperative that technology be kept up to date, so that if algorithms are being used and suddenly bids disappear, you don’t just go into a freefall. To that end, we’re very happy with the investments in technology that we have made, and we feel that we continue to be ahead of the curve with respect to trading technology.” While trading processes continue to evolve and have become more efficient, the increased complexity compels transition managers to raise new investment capital in order to keep systems running smoothly. Keheler adds: “Like in any business, you need to continually re-invest in your technology—because if you don’t, you’re going to be in serious trouble in no time at all.”

FTSE GLOBAL MARKETS • SEPTEMBER 2010

Justin Balogh, senior managing director, State Street Global Markets. “We have put a lot of effort into developing proprietary trading tools and algorithms as part of our technology spend for the purpose of dealing with these types of issues. That’s become more important than ever for our TM business,” he says. Photograph kindly supplied by State Street Global Markets, August 2010.

“As volatility decreased in late 2009 and into this year, we have seen clients make the changes they want, though with a much greater focus on risk and cost management,” says Simon Hutchinson, head of transition management, international, Northern Trust Global Investments. Despite recent shocks (such as the currency crisis in Greece), clients have remained steadfast in their commitment to the reallocation process, notes Hutchinson.“If anything, we have seen evidence that clients may have even sped up some of their decisions to make transitions.” Such events, however, have sharply influenced clients’ demands for clearer reporting and more detailed estimates, he says. “As a transition manager, we examine all of the outstanding risk characteristics and prepare a strategy to minimise the costs, utilising derivatives when necessary or through the managing of the underlying trading.” Providing clients with a comprehensive reporting package is particularly important for Asian investors who may not be as familiar with the ins and outs of transitional management, says Hutchinson. State Street’s Balogh agrees that risk management has become far more important to TM users. “As managers, we’ve had to respond to clients’ desire to understand the available techniques for managing risk and volatility, as well as the capabilities of the providers in this space.” All of which has contributed to a greater use of derivatives-based hedging, increased focus of the influence of currencies on a rebalancing exercise, and, in general, an acceptance that the risk expectations and outcomes prior to the third quarter of 2008 are far different from what can happen today, says Balogh. “In other words, clients can no longer expect to apply a single risk model to many different market environments— because market regimes are so changeable, strategies for handling transactions within different regimes have to change as well.” ■

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THE EVOLUTION OF ASIAN TRANSITION MANAGEMENT 110

CHANGING TIMES FOR ASIAN TM While traditional allocations such as fixed income remain the transition of choice for the majority of Asia’s institutional investors, a palpable shift into equities is already under way. Meanwhile, complex instruments such as derivatives and exchange-traded funds (ETFs) for use as hedging or exposure-management tools have gradually become an essential part of the regional TM service offering, compelling managers to evolve or be left behind. What might be the impact of these and other changes in the coming years? From Boston, Dave Simons reports. FTER A RELATIVELY laconic 2008-2009, transition management in Asia is once again on the rebound. While actual data related to volume/frequency of transitions in the region is difficult to quantify, due in part to the discrete nature of TM. Tom Wyse, head of Credit Suisse's transition management division for Asia Pacific, says that the semi-cyclical nature of TM bodes well for the business.“During the period when volatility was high across all asset classes, transition size and frequency remained low. The return of stability, however, has boosted investor confidence, allowing them to feel more comfortable adjusting their portfolios.” As TM is a still a relatively new concept for many Asian investors, discussions continue to revolve around ways providers can add value, as well as the type of services that are available to clients. This educational role remains an integral part of Asia’s transition-management process. Transparent reporting as well as the ability to provide liquidity venues whenever possible are also key to ensuring successful transitions in the region. Despite a palpable shift towards equity investing, by and large, Asian transitions remain largely fixed-income based. Even so, the use of derivatives and exchange-traded funds (ETFs) as hedging or exposure-management tools has become

an essential part of the TM service offering, compelling managers in the region to evolve—or be left behind. Indeed, some TMs have already thinned their ranks, while others have exited the business altogether. At the same time, opportunistic providers have sought to take advantage of the available space by increasing headcount while bolstering their commitment to their base of local clients. Still, even the most surefooted of managers face a number of challenges that are unique to the region. Looking ahead, how will the gradual move towards equities impact the overall transition process? Furthermore, what steps are managers taking to account for the greater usage of derivatives, as well as other complex instruments, by local institutional clients?

Fixed-income fixes As the vehicle of choice for many investors in Asia, fixed income has, to their benefit, become far more liquid over the past year and a half, says Mark Keleher, chief executive officer for Mellon Transition Management. “If a fixed-income investor came to us and asked to liquidate a portfolio 18 months ago when bonds were trading at around a 3% to 5% discount to fair value, we were still having to return roughly 30% of those

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

Photograph © Rolffimages / Dreamstime.com, supplied August 2010

depending on a transition manager's level of expertise, can produce vast discrepancies between an investor’s estimated and actual costs, says Wyse. With transition processes growing more fluid and easier to manage, TM’s such as Keleher have seen a pronounced pickup in transition-based activity, including multi-billion dollar programmes in Asia and Australia. “Investors are once again shifting their asset allocations and moving into new regions— so it is a very interesting time to be in transition management.” Providing clients with a comprehensive reporting package is particularly important for Asian investors, who may not be as familiar with the ins and outs of transitional management, says Simon Hutchinson, head of transition management, international, Northern Trust Global Investments. “As a transition manager, we examine all of the outstanding risk characteristics and prepare a strategy to minimise costs, utilising derivatives when necessary or through the management of the underlying trading activity.” Justin Balogh, senior managing director, State Street Global Markets, agrees that market volatility has helped make the concept of risk management far more important to Asia’s transitioning clients. “As managers, we’ve had to respond to their desire to understand the techniques available for managing risk and volatility, as well as the capabilities of the providers in this space.”

Increased focus

bonds as un-saleable, on average. Conditions have got much better since that time—while it can still take a while for certain issues to liquidate, there are bids out there now, and as long as you’re not holding a truly distressed asset, bonds can be traded once more.” Wyse of Credit Suisse says that asset-allocation weighting remains the fundamental difference between Asia and USbased transition markets. “ Asian sovereign-wealth and pension funds have a more pronounced skew towards fixedincome assets, with an empirical ratio of around 70-30 in favour of fixed income, compared to about a 60-40 equity weighting within the US. That said, over the past 18-24 months, Asian investors have increasingly turned their focus to equities, bringing the ratio closer to 60-40.” While the strategies used to accommodate fixed-income investors do not fundamentally differ from those employed by more equity-oriented US managers—both require detailed pre and post-trade analysis and planning, as well as experienced execution teams—the systems, type of analyses and trading-mechanisms required to handle fixed-income transitions are themselves unique. One particularly notable distinction is the discovery process for bond pricing—which,

FTSE GLOBAL MARKETS • SEPTEMBER 2010

All of which has contributed to a greater use of derivativesbased hedging, an increased focus on the influence of currencies on a rebalancing exercise, and, in general, an acceptance that the risk expectations and outcomes prior to the third quarter of 2008 are far different from anything that might happen today, says Balogh. “In other words, clients can no longer expect to apply a single-risk model to many different market environments— because market regimes are so changeable, strategies for handing transactions within different regimes have to change as well.” Balogh agrees that the historical bias towards fixed income has presented some significant challenges for Asia’s investors, who until fairly recently were somewhat constrained in their ability to shift out of significantly under-performing assets. “Because of their concern about selling into a market that was somewhat depressed due to the bid profile of that asset class, many were understandably reluctant to act on certain manager terminations, which, of course, resulted in a very inactive period, particularly through the first half of 2009,”says Balogh. Investors who utilised derivatives overlays, however, were able to cover their exposures without physically selling their instruments.“Also, as the dealing environment gradually improved, we eventually began to see a selling-down of some poorly performing fixed-income portfolios,”adds Balogh. “Perhaps the most notable trend since that time has been a move back towards passive fixed-income investing, as investors increasingly exited the more concentrated active mandates that often carried fees that led to their underperformance of standard benchmarks.”

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THE EVOLUTION OF ASIAN TRANSITION MANAGEMENT 112

Duncan Klein, executive director and head of transition management at JP Morgan Worldwide Securities Services, based in Singapore. “The types of demands that are typically associated with Asia’s fixed-income mandates are a true differentiator among transition managers,” asserts Klein. Photograph kindly supplied by JP Morgan, August 2010.

Tom Wyse, head of Credit Suisse's Transition Management division for Asia Pacific.. “During the period when volatility was high across all asset classes, transition size and frequency remained low. The return of stability, however, has boosted investor confidence, allowing them to feel more comfortable adjusting their portfolios,” he says. Photograph kindly supplied by Credit Suisse, August 2010.

While Australia remains relatively up to speed in terms of transition-management products and usage, there are still many parts of the Asia-Pacific region that are not nearly as product-savvy, says Balogh: “Which is why advisory research remains a key objective for us—we are constantly working with clients much higher up the decision chain over things like hedging strategies, how investments are allocated or portfolios are structured, or how clients are managing risk at the total portfolio level.” While US transitions tend to be more corporate focused, in Asia, TM centres mainly on public-oriented vehicles such as government pensions and sovereign-wealth funds, notes Duncan Klein, executive director and head of transition management at JP Morgan Worldwide Securities Services, based in Singapore. Accordingly, Asia’s transition managers are accustomed to having a smaller base of clients, as well as fewer, if larger-than-average, mandates, says Klein. Also, because public entities in Asia must follow internal approval processes and often issue public tender, the TM appointment process in the region tends to be much lengthier than in the US, he adds. Additionally, Asian clients often need to be convinced that transition managers fully understand the unique cost characteristics of fixed-income mandates which, at least compared to the more transparent, exchange-traded equities model, tend to more opaque and less liquid. “The types of demands that are typically associated with Asia’s fixed-income mandates are a true differentiator among transition managers,”asserts Klein. “Some investment-banking providers offer a single price on each asset in a non-competitive manner, while custody or asset-management-profiled TM providers deliver agency trading strategies offering multidealer pricing. At JP Morgan, for example, we deliver a unique fixed-income trading model offering agency, principal and hybrid trading solutions in order to achieve best execution.” Pre-trade analysis, which can frequently highlight significant

differences between an estimated trading price and the evaluation price, is an integral part of the transition process. It is essential that clients are made aware of these types of potential pricing discrepancies prior to the execution of an order, says Klein, particularly in situations involving assetbacked securities (ABS), mortgage-backed securities (MBS) or commercial mortgage-backed securities (CMBS) instruments. Given the steady pick-up in global-equity mandates, managers such as Klein continue to encourage clients to leverage the services of a transition manager in order to clearly distinguish the cost of implementation from the performance of the portfolio. “We have yet to see a substantial asset allocation shift from bonds into equities, but rather active managed portfolios into passive,” says Klein. Hence derivatives serve as an appropriate interim tool during the appointment process, helping clients maintain their exposure benchmark until the succeeding portfolio is up and running.

Competitive market Though the effects of the global financial crisis continue to be felt, Asia continues to be widely viewed as a major growth market by a host of financial services leaders. Accordingly, transition management will in all likelihood become far more competitive in the years to come, as a vast number of investment and custody banks vie for a piece of Asia’s burgeoning TM business. As the activity heats up, Wyse of Credit Suisse believes that providers with a solid record of service in the region will make the best choice for transitioning investors. “Having experienced management teams on hand that can assist clients with issues related to bond-price discovery, complete trade analysis and other key TM processes will always help ensure the smoothest transitions possible.” Adds JP Morgan’s Klein: “Our message is clear—we are here for the long haul, which is why we are continuing to invest and expand our services as part of our total global transitionmanagement strategy.” ■

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

WATCHDOG TAKES AIM During the last three years, the European market for post trade services has undergone a revolution. Pressure from new entrants has sent prices tumbling by about 98% in some European countries. For all the improvement, there is still work to be done if real competition is to break out. That watershed may be on its way, writes Paul Whitfield. HE EUROPEAN COMMISSION has its sights on post trade services. The competition watchdog for the 27nation European Union has identified the barriers in the clearing and settlement sector as one of the key impediments to true pan-European capital market competition. At the heart of the plans is the desire to make so-called central counterparties (CCPs) interoperable. That would enable the exchanges that use their services, and by proxy investors that use the exchanges, to shift between CCPs at will. “Interoperability is encouraged at the European Commission level but the practice is more difficult than the theory,” says Willem Mooijer, director, sales and customer relationship marketing, at European Multilateral Clearing Facility (EMCF) NV. “Today they are consulting on new legislation and, if that [legislation] stated very clearly that interoperability was mandatory for CCPs and exchanges, then it would make a difference. However, I fear that won’t be the case.” Such fears are reflected throughout the industry—or, more correctly, they are present among those CCPs with an interest in seeing the barriers to competition dismantled. Clearing and settlement operations linked to the large exchanges, such as Deutsche Börse’s Clearstream, are understandably

FTSE GLOBAL MARKETS • SEPTEMBER 2010

less enthusiastic about the prospect of exposing domestic clearing operations to real competition for the first time. History suggests that they have good reason to be concerned. The effect of competition on the cost of clearing and settlement on pan-European exchanges has been nothing short of stunning. New competitors undercut incumbent CCPs in some markets by more than half at launch and have since driven prices lower and expanded their geographic reach. The catalyst for that change was the launch in 2007 of the Markets in Financial Instruments Directive (MiFID) and the concurrent launch of a new breed of pan-European stock exchanges, known as multilateral trading facilities (MTFs). “When the MTFs thought about their business model and what customers would want from a post trade perspective, they realised that it had to be pan-European and should be substantially lower cost than incumbent clearing houses,” says Adrian Farnham, chief operating officer at Turqouise, an ETF that was bought in late 2009 by the LSE. “So from the outset, pan-European CCPs introduced a radical change in pricing in clearing.” The agents of that change were the new CCPs, which launched to meet the demands of the MTFs. “At the start, our simple idea was to provide the same service as existing CCPs but at half the price,” explains EMCF’s Mooijer, who describes his company as a “child of MiFID”.“We launched in the UK and Dutch markets with a price of €0.18 and €0.30, respectively. Today we clear 16 geographical markets in Europe and the price is €0.03 for the first 100,000 trades for each client and €0.01 for all contracts in excess of 100,000.”

EC TURNS ITS ATTENTION TO POST TRADE SERVICES

Photograph © Sashkinw / Dreamstime.com, supplied August 2010

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EC TURNS ITS ATTENTION TO POST TRADE SERVICES 114

Adrian Farnham, chief operating officer at Turqouise. “When the MTFs thought about their business model and what customers would want from a post trade perspective, they realised that it had to be pan-European and should be substantially lower cost than incumbent clearing houses,” he says. Photograph kindly supplied by Turquoise, August 2010.

The focus on pricing has worked as a business model. EMCF has grown from new entrant to Europe’s biggest equity CCP in Europe with, by its own estimates, about 30% to 35% of all cash equity clearing on a daily basis. Yet despite the inroads made by EMCF and other independent CCPs such as LCH.Clearnet and EuroCCP, competition remains far from perfect. There are problems of comparability, which are linked to complex and often incomparable pricing models. At the most basic level some CCPs bundle their services into a single price, while others choose to break out each service, giving customers more choice about what they pay for. Bundlers claim their system is more transparent as clients know up front the full cost of their service. However, there is a flip side to that argument. “Our customers want transparency,” says Manuel Schmitt, head of pricing and account planning at Clearstream. “They have specific profiles and want tailored solutions and they don’t want to pay for something they don’t use.” The one point of agreement is that comparing prices, and thus enabling competition, is not always straightforward. “Clearing is reasonably comparable [in terms of pricing] but comparing settlement costs is more tricky,” says Farnham. “As a trading venue we always try and have a simple and predictable tariff to enable customers to model execution costs into their trading algorithms.” Yet for all its complexity, pricing remains the small impediment to competition next to the bigger bugbear of the lack of interoperability.

“The current situation, where there are many trading platforms and most of them use single CCPs, is inefficient because customers trading on multiple platforms have to put up margin with several CCPs,” says Patrick Humphries, a spokesman for the LSE Group.“Interoperability can help in reducing this cost by allowing customers to pick a single CCP for all their business,” It would also allow exchanges to rapidly shift between clearing providers, enabling them to chase best value pricing or service improvements. That would expose the market to almost daily competitive pressure and, so the argument goes, force prices down. Even so, interoperability comes with its own problems. The first and most significant in terms of its implementation by regulators is the inherent necessity of exposing CCPs to some degree of each others’ operational risk. At the moment a client wishing to use a clearing service must lodge cash, known as a margin, with a CCP. That margin sits on the CCP’s books and is only used in the event that a counterparty to a trade can’t meet its responsibilities, i.e., can’t supply stock that it has agreed to sell or can’t meet the cost of stock it has agreed to buy. Exchanges or large banks could lodge cash with multiple CCPs, thus enabling them to shift their business as they wish, a move that would mean they were effectively underwriting their own interoperability. The expense of having so much cash sitting on the accounts of multiple CCPs makes that unrealistic. The upshot is that the only functional way to implement interoperability is to allow these margins to be transferable, by implementing a common IT infrastructure, or by establishing a central margin fund that can be drawn on by all CCPs. Both systems would expose CCPs to the risk inherent in the business models of other CCPs.

Transfer regulation Concerns over the potential for the failure of a clearing house to damage the wider financial system has emerged as the chief stumbling block to regulator support for interoperability. In late July, the UK Treasury went further than its continental counterparts when it said it was proposing to transfer regulation and supervision of CCPs and settlement to the Bank of England. The move, which is in the consultation phase, recognises “the key role of systematic market infrastructure in safeguarding the stability of the financial system”, the Treasury said. Fear that CCPs could become a weak link in the financial system is heightened by their increasingly central role, a role that is set to grow as a result of US regulation that requires a host of new over-the-counter derivatives to be processed by CCPs. “The more links that there are to other clearing houses the more they become systematically dependent on each other,” explains Humphries. “Unfortunately, the regulatory response to this seems to be to require more margin, negating many of the benefits of interoperability.” He adds:“We believe that properly regulated and recognised CCPs with common minimum standards of risk management should be able to interoperate without any additional margin payments.”

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

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EC TURNS ITS ATTENTION TO POST TRADE SERVICES 116

Manuel Schmitt, head of pricing and account planning at Clearstream, says: “Our customers want transparency.They have specific profiles and want tailored solutions and they don’t want to pay for something they don’t use.” Photograph kindly supplied by Clearstream, August 2010.

Willem Mooijer, director, sales and customer relationship marketing, at European Multilateral Clearing Facility (EMCF) NV. “Interoperability is encouraged at the European Commission level but the practice is more difficult than the theory,” he says. Photograph kindly supplied by EMCF, August 2010.

Standardisation is the key to management of CCP interoperability risk. With the support of the industry, such standardisation should not be impossible to achieve, though it would likely require a mixture of consensus and regulatory imposition. The problem is that such support is not universal. “A lot of trading in the market is still being done with incumbent exchanges and clearing houses and there is resistance to opening the market for obvious reasons,” says Mooijer. “If clearing houses become interoperable and trading venues (MTFs and exchanges alike) were to allow CCPs access to their trade feeds and members could choose who they use, then the market would change. We believe there would be a huge shift to lower priced providers so long as they could meet service and risk management demands.” To understand why that is not in everyone’s interest it is only necessary to take a look at the pricing model of a CCP with a captive market. Deutsche Börse’s Clearstream operates two separate businesses. Its Luxembourg-based International Central Securities Depository (ICSD) provides post trade services to international customers while its Frankfurt-based Central Securities Depository (CSD) operation does the same for the German market. The key difference between the two is that the German CSD operation has a captive German market; it is the sole clearer for all deals done on Deutsche Börse, Germany’s dominant exchange and one of Europe’s largest. ICSD meanwhile competes against other panEuropean CCPs to clear trades in the largest European stocks. CSD charges a total €0.475 settlement fee for each trade, not including volume discounts that kick in at 5% for more than

50,000 transactions per month, rising to 17.5% for 150,000 transactions or more per month. ICSD, meanwhile, charges a maximum €2.25 per transaction for clients conducting less than 250 transactions during a month.Volume discounts mean that the fee rapidly falls from there, so that customers conducting 150,000 to 200,000 transactions per month pay €0.15, less than half the comparative cost for CSD clients. “Luxembourg and Frankfurt share the same basic pricing logic, but we price on a separate basis between ICSD and CSD,” says Schmitt. He notes that the difference in price is accounted for by differing levels of service and claims that competition has not had as big an impact on Clearstream revenues as other industry trends. “In general, revenues can be under pressure due to the customer consolidation effect,”he says.“If a bank buys another bank they become bigger and would benefit from a lower marginal price.” Clearstream’s competitors are sceptical. Opposition to interoperability from some of the most powerful participants is not going to dissipate, laments Mooijer. He adds:“You have to consider the interests at stake. [In June] Euronext said it would launch its own CCP, terminating its agreement with LCH. They expect to spend about $60m to set up the clearing operation.”The argument is that the exchange would not be spending that sort of money if it couldn’t be sure of a profitable business with decent margins. “For us, that makes it quite obvious that full interoperability won’t happen,”says Mooijer. Investors, who ultimately bear the cost of the lack of competition, can only hope he is wrong. ■

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

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THE LONG AND WINDING ROAD TO INTEROPERABILITY 118

THE QUEST FOR FREEDOM Despite the best efforts of the regulators and some participants, the clearing landscape is still dominated by six larger players, including EMCF and EuroCCP, LCH.Clearnet, Deutsche Börse's Eurex Clearing, the London Stock Exchange's (LSE’s) Italian clearer CC&G and SWX Group's SIX x-clear. The last three adhere to the vertical silo whereby an exchange owns its post-trade operations, thereby ensuring user lock-in from execution to settlement. Some market participants are not waiting for the new framework and are heading in a different direction. Lynn Strongin Dodds reports. HERE WAS HOPE that the European Code of Conduct, launched in 2006, would herald a new era of interoperability in the world of clearing. Fast forward to today and the road has been anything but smooth. In many ways it is a story of two halves with some central counterparties (CCPs) trying to forge alliances while certain exchanges, such as NYSE Euronext, have reverted to the vertical silo model. Opinion is divided as to the future but all agree the gridlock needs to be broken in order to reduce post-trade costs. Alasdair Haynes, chief executive of Chi-X Europe, says:“If you would have asked me four months ago, I would have said that interoperability was the way forward. However, I now struggle to see how it will work. We know it has been successful in the US and Canada but there has been too much politicking at the national level in Europe. At the end of the day it is about the lowest price and the fastest times.” There was hope that the emergence of multilateral trading facilities (MTFs) and the new generation of clearers that created—European Multilateral Clearing Facility (EMCF), 78%-owned by the Dutch-controlled Netherlands operations of Fortis Bank and 20%-owned by Nasdaq OMX, plus EuroCCP, the London-based subsidiary of US-based The Depository Trust & Clearing Corporation (DTCC)—would have given impetus to interoperability set down in the Code of Conduct. The code’s aim was to forge links between clearing houses as well as provide choice, price transparency, access and interoperability and unbundling of services and

accounting. However, despite the best efforts of the regulators and some participants, the clearing landscape is still dominated by six larger players, including EMCF and EuroCCP, LCH.Clearnet, Deutsche Börse's Eurex Clearing, the London Stock Exchange's (LSE’s) Italian clearer Cassa di Compensazione e Garanzia (CC&G) and SWX Group's SIX x-clear. The last three adhere to the vertical silo whereby an exchange owns its post-trade operations, thereby ensuring user lock-in from execution to settlement. Many CCPs signed up to the Code of Conduct, but so far there has only been one market-sharing arrangement in place, between SIX x-clear and LCH.Clearnet. Progress has been made in that these two CCPs along with EuroCCP and EMCF joined forces in the second quarter of 2009 with the goal of interoperability by the first quarter of 2010. However, late last year the CCPs’ individual regulators and respective central banks in the UK, Holland and Switzerland, unexpectedly blocked their plans due to concerns over risk and collateral management. They noted that interoperability in the light of the Lehman collapse created additional counterparty risks that needed to be mitigated by additional collateral to that already provided to cover members’ risks. Alberto Pravettoni, managing director, group corporate strategy, at LCH.Clearnet, says: “We were ready in September but interoperability had been put on hold by the regulators. They were concerned about the additional risk that can be introduced. If someone was trading stocks on two exchanges they would have two positions and that would create risk

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

on two CCPs and therefore the two CCPs would want margin for that exposure. It becomes even more complicated when there are more CCPs.” The CCPs have had to resubmit their applications having “priced in”the appropriate arrangements for managing interCCP risk. The UK’s Financial Services Authority (FSA), Holland’s Authority for Financial Markets (AFM), Switzerland’s banking watchdog FINMA and the Dutch and Swiss central banks stopped short of prescribing how such additional collateral would be collected, suggesting only that CCPs might consider increasing their default funds or charging supplementary margin sums to participants. The four CCPs have been working closely together to hammer out a structure and the proposals for collecting extra collateral to manage inter-CCP risk. Marco Strimer, chief executive officer of Swiss SIX x-clear, is optimistic that interoperability between the four will be a reality by the end of 2010. He says: “The technical and trading platforms to deliver the trades are mostly ready although there still needs to be work done on the legal requirements. I expect we will see the first transactions from multiple clearers on x-clear by the end of the year. I will be disappointed if it doesn’t happen by then. The next stage will be for CCPs to resubmit the link agreements with the new framework.” Some market participants are not waiting for the new framework and are heading in a different direction. NYSE Euronext, for example, recently announced plans to sever ties that its derivatives exchange, NYSE Liffe, had with LCH.Clearnet, and build two new purpose-built clearing houses for equities and derivatives in London and Paris. The project is due to be finished by late 2012 at the estimated cost of €47.5m but NYSE Euronext projects it would earn $100m in clearing revenues annually from 2013. The move is likely to put pressure on the LSE to follow suit by building a fully-integrated clearing house in the UK.

Risk Exposure Oslo Børs also introduced a vertically-integrated clearing model in an attempt to stem the loss of market share to rival trading venues and allow the exchange’s members to reduce their risk exposure when trading with each other. Until now, transactions between Oslo Børs members have been cleared bilaterally and settled through Verdipapirsentralen, the Norwegian central securities depository. In future, its new CCP, Oslo Clearing, will clear equity certificates and exchangetraded funds as well as Norwegian-listed equities. A default fund using contributions from its clearing members has also been established. Not surprisingly, against this background, harmonisation seems like a long way off. Rob Scott, co-head of global sales and relationship management at Deutsche Bank's Direct Securities Services, argues that “interoperability was never meant to be an end state. It was seen as a means to harmonisation but Target 2 Securities and the financial crisis has changed that. People are now looking much more closely at the risks and costs and what has evolved is a fragmented market with different approaches. What we are seeing is

FTSE GLOBAL MARKETS • SEPTEMBER 2010

Rob Scott, co-head of global sales and relationship management at Deutsche Bank's Direct Securities Services, argues that “interoperability was never meant to be an end state. It was seen as a means to harmonisation but Target 2 Securities and the financial crisis has changed that.” Photograph kindly supplied by Deutsche Bank, August 2010.

large clients wanting to partner with banks such as ourselves to find creative solutions in the post trade services world.” Marcus Zickwolff, head of trading and clearing system design at German clearing house Eurex Clearing and chairman of clearing trade body CCP12, adds: “We spent so much time and effort on the interoperability agreement but the perception of risk has changed. A few years ago we all agreed on the Code of Conduct but the priority today is on the integrity and safety of the market. Nowadays we have more, not less, players because more and more markets involve CCP clearing to improve integrity." Guillaume Heraud, head of clearing services for institutional clients at Société Générale, says: “Interoperability has been discussed for a long time by everyone in Europe. It was a good idea as a way to accelerate harmonisation, but to be honest interoperability would be difficult to implement because of the fragmentation of Europe and the weak support of the European community for the initiative. We need to find an alternative solution.” Bob McDowall, a research director at adviser TowerGroup, believes that a clearing and settlement directive could be the answer: “What we have ended up with is fragmentation not only at the front end in terms of trading but also at the clearing end. As part of its MiFID review, the Committee of European Securities Regulators (CESR) is looking into clearing and settlement. I think the blueprint is there for a directive and it would be one of the most pragmatic approaches because it could pull all the various solutions into one directive.” Other market participants believe that the impending European Market Infrastructure Regulations (EMIR, previously known as EMIL) and Securities Law Directive (SLD) could act as catalysts to interoperability and harmonisation. Paul Bodart, head of Europe, the Middle East and Africa operations

119

THE LONG AND WINDING ROAD TO INTEROPERABILITY 120

Diana Chan, chief executive of EuroCCP. “Harmonisation and transparency is being achieved among the four CCPs but it is still difficult for a fifth CCP to join our club. It would require signing bilateral contracts with the other four, which is a lengthy process,” she says. Photograph kindly supplied by EuroCCP, February 2009.

at BNY Mellon Asset Servicing, notes: “There had been little progress made on the Code of Conduct because it meant increased competition and lower revenue from fees. As a result, CCPs had little interest to promote it. However, the difficulty in implementing interoperability should not be minimised. I think what will happen now is that regulations such as EMIR, which focuses on capital, interoperability and risk management, as well as the Securities Law Directive, will mandate interoperability.” Diana Chan, chief executive of EuroCCP, agrees, pointing out: “Harmonisation and transparency is being achieved among the four CCPs but it is still difficult for a fifth CCP to join our club. It would require signing bi-lateral contracts with the other four, which is a lengthy process. However, in the draft consultation of EMIL there was a paragraph on interoperability and if the legislation is passed then everyone will have to respect it. This is because EMIR, as it is now known, is a regulation and will become law immediately. This is in contrast to a directive which takes a long time because each market needs to implement it and will have its own interpretations.” In line with the G20 recommendations, the legislation is proposing that by the end of 2012 all standardised OTC derivative contracts traded on exchanges or electronic trading platforms will be cleared through central counterparties. The objective is to strengthen Europe’s clearing houses by introducing common safety, regulatory, risk management, fair pricing and operational standards for CCPs, as well as recognition of thirdparty clearers. However, the paragraph on interoperability applies to equities and bonds and will be extended to overthe-counter (OTC) derivatives when the legislative framework for clearing is defined in about 12 months’ time.

Robert Barnes, chief executive of UBS MTF, says: “Interoperability for cash equities should be considered separate to that of other instruments. Cash equities interoperability exists for some markets and we hope soon will be available to deliver significant benefits, safely, for many more European markets based on a year of CCP and multiple country regulatory dialogue. We encourage the commission to allow this to continue as quickly as possible.” SLD, on the other hand, tackles the settlement component and aims to provide a consistent regulatory framework for central securities depositories (CSDs) across the European Union. Among other topics, it will deal with Giovannini barrier number nine, which proposed that issuers be allowed to choose the securities settlement system and their CSDs. There is also T2S, which was recently delayed from 2013 to 2014. The aim remains the same: to provide settlement in central bank money for euro-denominated securities via a single settlement platform instead of the plethora of different domestic platforms. According to Celent senior vice president Axel Pierron: “While T2S is attempting to increase the integration of the European securities market, harmonisation and a level playing field cannot be created solely by a new settlement infrastructure. Political will and changes in national regulation, taxes and market practices will also have to be addressed.” Pierron also believes that there needs to be “greater clarity in the implementation of the T2S”. He adds: “We also need to ensure that there is a plan B in case some of the CSDs in Europe choose to stay out of it. Lower participation might have a lot of impact on the extent of cost savings, which in turn will lead to questions over the need to have T2S as opposed to a market-led solution.” According to Pierron, the two CSDs that are best placed in the new environment are Euroclear and Clearstream, due to their settlement volumes, assets in custody and geographical reach. Mark Gem, head of business management and a member of Clearstream’s executive board, believes that T2S is a validation of Clearstream’s Link-Up initiative which allows customers to access other depositories’ markets via their own.“I do not think there is a need for further regulation because interoperability is a viable way to harmonisation. It offers the same practical benefits of consolidation in terms of reduction of cost and time to market as well as cross-border settlement efficiency without the political, financial and technical issues of merging platforms.” Stephan Pouyat, director, product management, at Euroclear, also notes that interoperability between international central securities depositories (ICSDs), Euroclear Bank and Clearstream, between ICSDs and central securities depositories (CSDs), and among CSDs themselves, has existed for decades. He adds: “For example, we have links with over 40 markets. What is new is the impact that T2S will have in Europe. In theory, it should provide a single settlement platform for 27 markets, which means that the ICSDs and European CSDs will have one single entry point to reach all of Europe’s CSDs. Cross-border settlement will be a much more seamless process.” ■

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

The Fidessa Fragmentation Index (FFI) was designed to provide the trading community with an accurate, unbiased measurement of the state of liquidity fragmentation across the order driven markets in Europe. Liquidity is fragmenting rapidly as new MTFs have unveiled a range of low-cost alternative trading platforms. It is essential for both the buy and the sell-side to understand how different stocks are fragmenting across the new venues. To make it easy to measure and compare fragmentation across Europe, the Fragmentation Index provides a single number to show how a stock or index is fragmenting. It is calculated using proven mathematical principles and shows the average number of venues that should be visited to achieve best execution when completing an order. An FFI value of 1 therefore means that the stock is still traded at a primary exchange. An FFI value of 2 or more shows that the stock has been fragmented significantly and can no longer be regarded as having a primary exchange. The FFI is calculated daily across all the constituents of the major European indices, which illustrates how many stocks are fragmenting and the rate at which they are doing so.

European Top 20 Fragmented Stocks TW

Wks

Stock

Description

RTN.L

RESTAURANT GP ORD 28 1/8P

Wks

Stock

Description

3.51

FFI

-18

PRU.L

PRUDENTIAL ORD 5P

2.86

FFI 2.84

-7

PFC.L

PETROFAC ORD USD0.02

3.11

-4

SRP.L

SERCO GRP. ORD 2P

-13

SN..L

SMITH&NEPHEW ORD USD0.20

3.06

-45

PSON.L

PEARSON ORD 25P

2.83

-22

BNZL.L

BUNZL ORD 32 1/7P

3.02

-40

DGE.L

DIAGEO ORD 28 101/108P

2.83

-31

WTB.L

WHITBREAD ORD 76 122/153P

-8

RDSB.L

RDS 'B' 'B' ORD EUR0.07

2.81

-19

QQ..L

QINETIQ ORD 1P

2.93

-86

BT.A.L

BT GROUP ORD 5P

2.81

-20

CPG.L

COMPASS GROUP ORD 10P

2.93

-50

SSE.L

SCOT.&STH.ENRGY ORD 50P

2.81

-63

BRBY.L

BURBERRY GRP ORD 0.05P

2.9

-39

BG..L

BG GRP. ORD 10P

-23

ULVR.L

UNILEVER ORD 3 1/9P

2.89

-36

AGK.L

AGGREKO ORD 20P

2.8

-29

RRS.L

RANDGOLD RES. ORD $0.05

2.87

-17

ANTO.L

ANTOFAGASTA ORD 5P

2.8

Wks = Number of weeks in the top 20 over the last year.

COMMENTARY

EUROPEAN TRADING STATISTICS

THE FIDESSA FRAGMENTATION INDEX (FFI)

By Steve Grob, Director of Strategy, Fidessa

FTSE 100 share during the first six months of 2010

This is in stark contrast to the same period last year when its market share plummeted by nearly 20 percentage points.

An alternative view is that the concept of trading away from primary market centres will increasingly gain acceptance in the market and that those institutions that have eschewed trading on MTFs will find them increasingly hard to ignore. These firms are typified by the more conservative elements of the investment community that still view trading away from the primary market as a "risk". One of these perceived risks concerns corporate actions since a listed firm is only obliged to inform its primary venue of listing (i.e. not the MTFs) of a proposed takeover, for example. As more and more volume moves away from the primary market centres, these sorts of risks diminish and so fuel even further fragmentation. The introduction of any kind of European consolidated tape would probably be the final factor in "legitimising" the alternative venues in the mind of the super conservative investment manager. There's probably some truth in both these views and so markets are finally balanced and it won't take much either way to retrench volume back onto the primaries or ignite another wave of fragmentation across Europe.

FTSE GLOBAL MARKETS • SEPTEMBER 2010

Billions

60 50 40 30 20 10 0

Jan

Feb

Mar

Apr

May

Jun

100 90 80 70 60 50 40 30 20 10 0

FTSE 100 share during the first six months of 2009 Total shares (volume)

Total shares (GBP)

LSE % market share

70 60 50 Billions

One of the interpretations of this is that there is a level or type of trading at the LSE (and perhaps other primary market centres, too) that is, in some sense, core and less susceptible to fragmentation. This core volume would perhaps exclude the HFT volumes and would represent the more traditional trading activities of the market. If this is true then the LSE may find it's in a strong position especially when it completes the move to its faster Millennium Exchange matching platform later this year. When this happens it will have both the machinery (a low latency platform) and the lure (substantial liquidity) to win back the HFT community which, up to now, has been a strong supporter of the alternative MTF venues.

Total shares (GBP)

LSE % market share

Percentage

Total shares (volume)

40 30 20 10 0

Jan

Feb

Mar

Apr

May

Jun

100 90 80 70 60 50 40 30 20 10 0

Percentage

The chart (right) shows the London Stock Exchange’s market share of the FTSE 100 in the first six months of this year (including the lit and dark volume from Turquoise which it acquired at the end of last year). Also included in the graph are the total FTSE 100 shares traded by both volume and value over the same period. As you can see the LSE’s market share of its benchmark index seems to be flattening out and possibly even coming back a little bit.

121

??????????

Venue turnover in major stocks: Week ending July 10th 2010 (Europe only). (€) BER

December

January

February

March

April

May

June

July

8330897.81

12299869.07

12095979.32

20898115.71

20869157.28

21547869.80

12544985.0101

13641903.28

BRG

274600248.26

485115578.84

664510070.30

1666606979.62

1484895339.18

1160801695.44

1216508271.49

1195324763.93

BTE

19985719530.83

31150258386.00

34090404626.97

39193610957.69

42331175110.88

53758623911.83

43271117580.49

39224595971.05

CIX

75306622295.52

110977110385.49

122737876719.05

127111917698.82

138532607106.82

186077857047.41

147121672027.29

129336311240.04

CPH

5072932715.84

6756826918.10

6640400689.39

6626152423.75

6351788793.70

7783026044.28

6714633960.89

5164430434.81

DUS

46475438.04

51353982.31

37525367.53

51415834.33

61803818.36

67538425.06

43568831.22

41470859.08

ENA

33792253379.23

37999836321.05

37880117626.68

38562044761.19

41692637528.93

52300438953.01

37199905323.05

33138564079.87

ENB

5034992980.75

6008003591.11

6103299182.27

6358216747.07

5988625536.27

9369541614.81

6715329462.90

5804421360.41

ENL

2138868773.27

3106855297.08

3554443804.88

3046713139.88

3727720527.61

4752180275.24

3879426528.86

3202087103.91

ENO

482771.59

ENX

54355876074.24

66228400089.99

75614221011.97

74245298998.52

78769429844.17

113106867629.24

86578715614.33

72993302174.38

GER

52843852540.00

67965895238.29

66776121605.01

72168449445.45

86885537242.87

112634642716.91

74523500152.04

62270047277.53

HEL

6497813980.44

10339952621.77

10058819924.19

11752695115.83

12864278423.44

12677237276.57

9736157069.77

8784893287.07

ISE

465074179.96

511570001.10

504915917.70

565269992.07

647314249.60

607747772.36

707067734.88

520395496.86

LSE

72845386108.12

95983836598.48

101916702001.83

105630799395.16

95825409974.98

132946145050.97

114402642810.45

98764001813.56

MAD

39993245595.41

51066014495.96

52210894242.17

43945312316.04

52313552809.86

69919778842.24

51380354411.28

47534238133.14

MIL

34112242363.73

48728657959.10

51711533820.17

52410490586.85

60842288388.66

98165692121.29

73306011499.90

49371204223.43

NAE

559208778.00

1292687653.19

1825246025.41

2792572924.06

2501941839.46

2151564476.49

1754428128.16

1833689873.43

NEU

5242206607.57

5816854755.80

5574111215.48

6232496049.93

6066724036.03

3388942662.98

1738062092.43

9195060.22

OSL

11253566686.23

16130924336.37

15871251841.26

13866926910.94

16588222829.50

17276093344.48

14866575211.08

11428538424.94

STO

16954761461.22

22786344725.57

24086268094.82

24125076503.28

28675024013.03

31806593342.57

23890648411.14

22628837567.40

TRQ

15953764952.03

20168098539.34

21028161702.73

20951128258.80

22059392685.24

29039242985.51

27884374356.60

26816523838.01

VTX

31586888591.75

43636990148.75

46961823692.04

44673323239.12

41985051551.14

47323284922.30

40448981935.02

40353368433.82

XIM

90362714.08

97403633.80

43510060.39

47325856.70

24778850.52

43880708.03

Index market share by venue: Week ending August 6th 2010 Primary Index

AEX

Alternative Venues

Venue

Chi-X

Amsterdam

64.45%

21.37%

Turquoise

Nasdaq OMX

3.89%

BATS

6.21%

Burgundy

Amst.

Paris

Xetra

3.78%

0.16%

London

NYSE Arca

Stockholm

BEL 20

Brussels

51.68%

20.12%

4.21%

3.36%

20.46%

0.01%

CAC 40

Paris

65.96%

20.70%

3.70%

4.68%

4.13%

0.21%

DAX

Xetra

67.98%

22.02%

3.29%

5.57%

†

0.21%

FTSE 100

London

55.79%

27.88%

6.80%

8.93%

0.61%

FTSE 250

London

65.00%

19.81%

8.48%

6.08%

0.62%

IBEX 35

Madrid

98.20%

1.44%

0.14%

0.02%

0.01%

0.10%

†

FTSE MIB

Milan

78.90%

10.67%

1.67%

8.47%

†

0.05%

0.21%

PSI 20 SMI

Lisbon

93.18%

4.05%

1.75%

0.99%

†

SIX Swiss

69.02%

18.85%

4.43%

7.24%

0.46%

OMX C20

Copenhagen

84.76%

10.54%

2.12%

2.10%

0.04%

0.44%

OMX H25

Helsinki

67.13%

19.71%

3.38%

7.75%

0.22%

0.03%

0.90%

0.70%

OMX S30

Stockholm

67.76%

17.97%

4.01%

6.05%

3.76%

0.45%

OSLO OBX

Oslo

88.99%

5.82%

1.23%

0.92%

0.03%

†

3.01%

Dublin

23.64%

0.82%

1.17%

73.96%

0.15%

ISEQ

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

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

122

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

Week ending 13th of August 2010 Reference Entity

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Americas

FEDERATIVE REPUBLIC OF BRAZIL

Government

Sov

14,031,525,943

152,008,442,465

11,425

UNITED MEXICAN STATES

Government

Sov

6,654,107,121

111,023,588,630

9,149

Americas

JPMORGAN CHASE & CO.

Financials

Corp

5,190,037,247

85,097,632,124

9,145

Americas Americas

Financials

Corp

5,895,086,622

79,986,006,898

8,975

REPUBLIC OF TURKEY

BANK OF AMERICA CORPORATION

Government

Sov

6,410,938,413

143,272,464,571

8,466

Europe

REPUBLIC OF THE PHILIPPINES

Government

Sov

2,295,681,017

70,102,250,202

8,250

Asia Ex-Japan Asia Ex-Japan

REPUBLIC OF KOREA

Government

Sov

3,617,165,908

68,727,501,947

7,655

TELECOM ITALIA SPA

Telecommunications

Corp

2,636,458,520

65,991,842,784

7,566

Europe

Financials

Corp

11,141,993,701

92,494,421,065

7,372

Americas

Consumer Goods

Corp

2,796,427,799

58,165,249,132

7,209

Europe

GENERAL ELECTRIC CAPITAL CORPORATION DAIMLER AG

Top 10 Net Notional Amounts Week ending 13th of August 2010 Reference Entity

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

REPUBLIC OF ITALY

Government

Sov

23,457,072,311

236,419,393,927

6,568

Europe

FEDERAL REPUBLIC OF GERMANY

Government

Sov

15,252,017,495

82,649,357,122

2,290

Europe

KINGDOM OF SPAIN

Government

Sov

14,724,962,160

113,678,769,209

4,967

Europe Americas

FEDERATIVE REPUBLIC OF BRAZIL

Government

Sov

14,031,525,943

152,008,442,465

11,425

FRENCH REPUBLIC

Government

Sov

11,323,546,276

67,851,275,826

2,720

Europe

Financials

Corp

11,141,993,701

92,494,421,065

7,372

Americas

UK AND NORTHERN IRELAND

Government

Sov

9,900,080,578

52,763,147,647

3,638

Europe

REPUBLIC OF AUSTRIA

Government

Sov

8,208,265,115

47,747,126,290

2,015

Europe

PORTUGUESE REPUBLIC

Government

Sov

8,077,622,940

64,098,660,000

2,918

Europe

HELLENIC REPUBLIC

Government

Sov

6,895,744,873

79,237,279,391

4,265

Europe

GENERAL ELECTRIC CAPITAL CORPORATION

Ranking of Industry Segments by Gross Notional Amounts

Top 10 Weekly Transaction Activity by Gross Notional Amounts

Week ending 13th of August 2010

Single-Name References Entity Type

Gross Notional (USD EQ)

Contracts

References Entity

Gross Notional (USD EQ)

Contracts

Corporate: Financials

3,193,371,936,841

427,668

REPUBLIC OF ITALY

2,413,303,731

107

Sovereign / State Bodies

2,357,218,958,233

175,994

KINGDOM OF SPAIN

2,225,570,784

133

Corporate: Consumer Services

2,127,104,496,207

360,883

FEDERATIVE REPUBLIC OF BRAZIL

1,503,550,000

114

Corporate: Consumer Goods

1,559,763,794,048

255,808

UK AND NORTHERN IRELAND

1,359,755,199

Corporate: Technology / Telecom

1,294,814,013,039

205,197

MBIA INSURANCE CORPORATION

1,350,419,000

175

Corporate: Industrials

1,238,666,508,268

219,834

IRELAND

1,343,688,162

Corporate: Basic Materials

954,571,732,291

158,955

PORTUGUESE REPUBLIC

1,274,385,364

Corporate: Utilities

734,793,709,523

121,029

GENERAL ELECTRIC CAPITAL CORPORATION

1,158,121,872

Corporate: Oil & Gas

448,626,507,225

83,677

UNITED MEXICAN STATES

1,017,905,360

REPUBLIC OF TURKEY

1,011,740,000

Corporate: Health Care

328,531,926,843

59,847

Corporate: Other

259,685,279,241

32,160

Residential Mortgage Backed Securities

88,624,618,990

17,734

CDS on Loans

69,030,831,976

17,981

Commercial Mortgage Backed Securities

23,086,826,160

2,027

3,056,097,282

294

Other

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 Number of Contracts

For additional data on CDS contracts, please visit http://www.dtcc.com/products/derivserv/data/

FTSE GLOBAL MARKETS • SEPTEMBER 2010

123

5-Year Performance Graph (USD Total Return) Index Level Rebased (29 July 2005=100)

300 250

FTSE All-World Index

200

FTSE Emerging Index

150

FTSE Global Government Bond Index

100

FTSE EPRA/NAREIT Developed Index FTSE4Good Global Index

FTSE GWA Developed Index Ju l-1 0

Ja n10

Ju l-0 9

Ja n09

Ju l-0 8

Ja n08

Ju l-0 7

Ja n07

Ju l-0 6

Ja n06

Ju l-0 5

MARKET DATA BY FTSE RESEARCH

Global Market Indices

FTSE RAFI Emerging Index

Table of Total Returns Index Name

Currency

No. of Constituents

Index Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Yield (%pa)

USD

2,771

239.61

-4.9

2.8

11.7

-1.6

2.52

FTSE All-World Indices FTSE All-World Index FTSE World Index

USD

2,301

558.48

-5.3

2.3

11.1

-2.1

2.55

FTSE Developed Index

USD

1,999

221.47

-5.4

2.0

10.4

-2.2

2.54

FTSE Emerging Index

USD

772

651.38

-1.1

8.3

22.1

2.3

2.41

FTSE Advanced Emerging Index

USD

302

601.72

-2.6

7.3

23.3

-0.8

2.77

FTSE Secondary Emerging Index

USD

470

770.27

0.2

9.2

20.0

5.3

2.08

FTSE Global Equity Indices FTSE Global All Cap Index

USD

7,327

386.32

-5.0

3.3

12.9

-1.0

2.42

FTSE Developed All Cap Index

USD

5,820

360.25

-5.5

2.7

11.6

-1.4

2.42

FTSE Emerging All Cap Index

USD

1,507

866.33

-1.1

8.4

22.8

2.4

2.40

FTSE Advanced Emerging All Cap Index

USD

638

812.69

-2.4

7.3

23.5

-0.9

2.75

FTSE Secondary Emerging All Cap Index

USD

869

986.71

0.1

9.4

21.3

5.8

2.07

USD

737

188.94

4.6

2.8

5.5

3.2

2.45

FTSE EPRA/NAREIT Developed Index

USD

281

2533.19

-1.5

11.3

24.6

5.0

3.94

FTSE EPRA/NAREIT Developed REITs Index

USD

186

880.04

-1.2

13.6

38.5

8.6

4.73

FTSE EPRA/NAREIT Developed Dividend+ Index

USD

201

1862.73

-0.2

13.5

31.8

7.6

4.52

FTSE EPRA/NAREIT Developed Rental Index

USD

228

996.60

-0.8

13.8

37.9

8.9

4.48

FTSE EPRA/NAREIT Developed Non-Rental Index

USD

1034.30

-3.5

5.0

-3.2

-4.7

2.40

FTSE4Good Global Index

USD

663

5978.90

-5.0

1.0

8.3

-3.9

2.87

FTSE4Good Global 100 Index

USD

103

4990.97

-5.0

-0.2

5.9

-6.0

3.05

FTSE GWA Developed Index

USD

1,999

3450.14

-4.9

1.9

10.7

-1.9

2.79

FTSE RAFI Developed ex US 1000 Index

USD

1,018

5893.63

-4.1

0.4

6.5

-4.6

3.17

FTSE RAFI Emerging Index

USD

357

6980.55

-1.0

7.8

20.3

2.2

2.70

Fixed Income FTSE Global Government Bond Index Real Estate

SRI

Investment Strategy

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

124

SEPTEMBER 2010 â&#x20AC;˘ FTSE GLOBAL MARKETS

Americas Market Indices 5-Year Performance Graph (USD Total Return) Index Level Rebased (29 July 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 0

Ju l-1

Ja n1

9 Ju l-0

9 Ja n0

Ju l-0 8

Ja n08

Ju l-0 7

Ja n07

Ju l-0

6 Ja n0

Ju l-0

FTSE RAFI US 1000 Index

Table of Total Returns Index Name

Currency

No. of Constituents

Index Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Yield (%pa)

FTSE Americas Index

USD

780

739.86

-6.6

4.0

14.3

-0.2

2.11

FTSE North America Index

USD

646

803.94

-6.8

3.7

13.5

-0.1

2.07

FTSE Latin America Index

USD

134

1185.06

-1.2

9.9

29.4

0.4

2.63

FTSE Americas All Cap Index

USD

2,529

342.71

-6.5

5.0

16.0

0.8

1.98

FTSE North America All Cap Index

USD

2,340

325.85

-6.8

4.7

15.1

0.8

1.94

FTSE Latin America All Cap Index

USD

189

1680.39

-0.8

10.2

30.5

0.7

2.58

FTSE Americas Government Bond Index

USD

190

197.85

4.2

5.1

6.9

6.6

2.55

FTSE USA Government Bond Index

USD

177

193.63

4.3

5.0

6.9

6.6

2.52

FTSE EPRA/NAREIT North America Index

USD

124

3193.09

-1.6

21.4

53.1

15.3

3.91

FTSE EPRA/NAREIT US Dividend+ Index

USD

1746.51

-1.3

22.3

53.7

15.8

3.91

FTSE EPRA/NAREIT North America Rental Index

USD

120

1089.22

-1.3

22.3

53.8

16.2

3.89

FTSE EPRA/NAREIT North America Non-Rental Index

USD

296.46

-15.3

-9.0

27.6

-15.3

5.10

FTSE NAREIT Composite Index

USD

134

3092.76

-1.5

20.7

49.2

15.0

4.62

FTSE NAREIT Equity REITs Index

USD

111

7542.56

-1.7

22.0

52.6

15.6

3.81

FTSE4Good US Index

USD

131

4845.08

-7.2

2.5

12.7

-1.8

1.95

FTSE4Good US 100 Index

USD

103

4617.10

-7.1

2.4

12.0

-2.0

1.97

FTSE GWA US Index

USD

590

3026.75

-7.2

2.8

14.3

0.1

2.10

FTSE RAFI US 1000 Index

USD

1,000

5526.46

-7.3

6.4

20.2

3.6

2.20

FTSE RAFI US Mid Small 1500 Index

USD

1,468

5484.23

-10.4

9.7

27.4

6.7

1.22

FTSE All-World Indices

FTSE Global Equity Indices

Fixed Income

Real Estate

SRI

Investment Strategy

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

FTSE GLOBAL MARKETS • SEPTEMBER 2010

125

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)

Ju l-1 0

Ja n10

Ju l-0 9

Ja n09

Ju l-0 8

Ja n08

Ju l-0 7

Ja n07

Ju l-0 6

Ja n06

Index Level Rebased (29 July 2005=100)

5-Year Total Return Performance Graph

Ju l-0 5

MARKET DATA BY FTSE RESEARCH

Europe, Middle East & Africa Indices

FTSE RAFI Europe Index (EUR)

Table of Total Returns Index Name

Currency

No. of Constituents

Index Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Yield (%pa)

3.33

FTSE All-World Indices FTSE Europe Index

EUR

564

236.00

-0.7

5.9

17.6

3.1

FTSE Eurobloc Index

EUR

284

124.07

-0.6

2.7

10.9

-2.1

3.62

FTSE Developed Europe ex UK Index

EUR

374

234.56

-0.6

5.0

14.9

1.4

3.38

FTSE Developed Europe Index

EUR

488

231.95

-0.5

5.8

16.8

2.7

3.41

3.23

FTSE Global Equity Indices FTSE Europe All Cap Index

EUR

1,520

370.26

-0.7

6.2

18.8

3.9

FTSE Eurobloc All Cap Index

EUR

764

368.40

-0.9

2.8

11.8

-1.6

3.51

FTSE Developed Europe All Cap ex UK Index

EUR

1,040

392.41

-0.8

5.1

15.9

1.9

3.27

FTSE Developed Europe All Cap Index

EUR

1,377

366.19

-0.6

6.1

18.0

3.5

3.29

Region Specific FTSE All-Share Index

GBP

627

3602.42

-4.4

4.0

19.3

0.3

3.28

FTSE 100 Index

GBP

102

3393.66

-4.5

3.4

18.2

-0.8

3.41

FTSEurofirst 80 Index

EUR

4668.52

-0.1

2.4

9.9

-3.4

3.94

FTSEurofirst 100 Index

EUR

100

4298.35

-0.6

3.8

13.6

-0.5

3.79

FTSEurofirst 300 Index

EUR

311

1515.49

-0.2

5.8

16.4

2.5

3.45

FTSE/JSE Top 40 Index

SAR

2877.89

-1.4

5.9

17.7

1.9

1.98

FTSE/JSE All-Share Index

SAR

165

3224.60

-0.7

7.4

19.5

3.7

2.18

FTSE Russia IOB Index

USD

907.16

-6.2

-2.3

25.3

-2.3

1.88

Fixed Income FTSE Eurozone Government Bond Index

EUR

246

175.98

1.8

3.3

5.0

3.7

3.39

FTSE Pfandbrief Index

EUR

406

210.68

0.0

1.5

5.4

2.3

3.67

FTSE Actuaries UK Conventional Gilts All Stocks Index

GBP

2411.69

3.6

4.7

7.3

5.4

3.75

Real Estate FTSE EPRA/NAREIT Developed Europe Index

EUR

1904.69

3.4

5.6

25.8

3.7

4.59

FTSE EPRA/NAREIT Developed Europe REITs Index

EUR

691.25

3.3

4.7

23.7

2.3

5.16

FTSE EPRA/NAREIT Developed Europe ex UK Dividend+ Index

EUR

2406.78

6.6

7.4

31.6

7.4

5.20

FTSE EPRA/NAREIT Developed Europe Rental Index

EUR

748.45

3.6

5.7

26.4

3.9

4.69

FTSE EPRA/NAREIT Developed Europe Non-Rental Index

EUR

507.30

-1.7

3.3

10.9

-0.6

2.23

FTSE4Good Europe Index

EUR

276

4604.05

-0.4

5.5

15.5

2.0

3.61

FTSE4Good Europe 50 Index

EUR

3888.50

-0.8

3.5

11.6

-0.8

3.93

FTSE GWA Developed Europe Index

EUR

488

3334.88

0.1

5.6

15.7

2.1

3.72

FTSE RAFI Europe Index

EUR

507

5174.53

-1.0

5.7

14.4

2.5

3.47

SRI

Investment Strategy

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

126

SEPTEMBER 2010 â&#x20AC;˘ FTSE GLOBAL MARKETS

Asia Pacific Market Indices 5-Year Total Return Performance Graph Index Level Rebased (29 July 2005=100)

450

FTSE Asia Pacific Index (USD)

400

FTSE/ASEAN Index (USD)

350 300

FTSE/Xinhua China 25 Index (CNY)

250

FTSE Asia Pacific Government Bond Index (USD)

200

FTSE EPRA/NAREIT Developed Asia Index (USD)

150

FTSE IDFC India Infrastructure Index (IRP)

100

FTSE4Good Japan Index (JPY)

Ju l-1 0

Ja n10

Ju l-0 9

Ja n09

Ju l-0 8

Ja n08

Ju l-0 7

Ja n07

Ju l-0 6

FTSE GWA Japan Index (JPY) Ja n06

Ju l-0 5

FTSE RAFI Kaigai 1000 Index (JPY)

Table of Total Returns Index Name

Currency

No. of Constituents

Index Value

3 M (%)

6 M (%)

12 M (%)

YTD (%)

Yield (%pa)

FTSE All-World Indices FTSE Asia Pacific Index

USD

1,298

279.81

-4.4

4.2

9.9

0.9

2.42

FTSE Asia Pacific ex Japan Index

USD

844

566.01

-2.9

7.4

16.9

0.9

2.61

FTSE Japan Index

USD

454

71.80

-14.1

-5.3

-9.2

-6.0

2.09

FTSE Global Equity Indices FTSE Asia Pacific All Cap Index

USD

3,100

475.27

-4.4

4.3

10.3

1.0

2.41

FTSE Asia Pacific All Cap ex Japan Index

USD

1,874

700.58

-3.1

7.3

17.3

0.8

2.59

FTSE Japan All Cap Index

USD

1,226

227.94

-13.9

-4.9

-9.0

-5.6

2.08

Region Specific FTSE/ASEAN Index

USD

146

645.19

3.4

17.8

30.9

14.8

2.77

FTSE Bursa Malaysia 100 Index

MYR

100

10184.60

1.8

10.0

19.2

9.3

2.53

TSEC Taiwan 50 Index

TWD

6994.72

-1.4

1.7

11.4

-4.2

3.65

FTSE Xinhua All-Share Index

CNY

1,135

8001.02

-5.2

-7.2

-14.8

1.00

FTSE/Xinhua China 25 Index

CNY

23522.21

-0.2

7.3

0.0

-2.6

2.41

USD

225

151.92

10.2

7.1

14.1

9.7

1.07

FTSE EPRA/NAREIT Developed Asia Index

USD

2055.85

-2.5

6.8

5.3

-0.4

3.72

FTSE EPRA/NAREIT Developed Asia 33 Index

USD

1325.54

-3.2

5.6

-1.1

3.93

FTSE EPRA/NAREIT Developed Asia Dividend+ Index

USD

2205.07

-0.3

9.3

13.5

2.3

5.00

FTSE EPRA/NAREIT Developed Asia Rental Index

USD

975.79

-1.6

8.6

24.7

6.3

6.08

FTSE EPRA/NAREIT Developed Asia Non-Rental Index

USD

1135.98

-3.0

5.8

-4.2

-4.1

2.30

FTSE IDFC India Infrastructure Index

IRP

967.96

-4.8

3.9

2.7

-0.7

0.69

FTSE IDFC India Infrastructure 30 Index

IRP

1076.32

-4.9

3.6

0.3

-1.6

0.67

JPY

184

3407.64

-14.7

-6.7

-11.6

-7.1

2.26

FTSE SGX Shariah 100 Index

USD

100

5207.37

-5.0

1.4

6.8

-2.0

2.20

FTSE Bursa Malaysia Hijrah Shariah Index

MYR

11022.25

0.0

6.3

11.7

4.1

2.86

JPY

100

975.64

-13.8

-5.9

-7.8

-9.0

2.02

Fixed Income FTSE Asia Pacific Government Bond Index Real Estate

Infrastructure

SRI FTSE4Good Japan Index Shariah

FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index

JPY

454

2593.08

-13.3

-4.3

-8.0

-3.8

2.22

FTSE GWA Australia Index

AUD

102

3920.71

-6.2

-0.2

11.1

-5.7

4.29

FTSE RAFI Australia Index

AUD

6224.28

-5.8

-1.4

9.8

-7.4

4.28

FTSE RAFI Singapore Index

SGD

8881.89

0.7

10.4

16.6

4.4

3.08

FTSE RAFI Japan Index

JPY

252

3622.73

-14.3

-4.6

-8.3

-4.7

2.10

FTSE RAFI Kaigai 1000 Index

JPY

1,026

3867.97

-12.6

-1.7

2.1

-8.6

2.90

HKD

6907.04

1.3

6.4

1.1

-2.8

2.91

FTSE RAFI China 50 Index

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

FTSE GLOBAL MARKETS â&#x20AC;˘ SEPTEMBER 2010

127

INDEX CALENDAR

Index Reviews September-November 2010 Date

Index Series

Review Frequency/Type

Early Sep

ATX

Early Sep

CAC 40

Early Sep

S&P / TSX

Early Sep 03-Sep 03-Sep

RTSI DAX S&P / ASX Indices

04-Oct 07-Sep

NZX 50 TOPIX

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

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 FTSE Xinhua Index Series TOPIX TSEC Taiwan 50 FTSE / ATHEX 20 TOPIX Hang Seng MSCI Standard Index Series Russell/Nomura Indices

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 05-Oct 07-Oct 07-Oct Late Oct 05-Nov 12-Nov 16-Nov Mid Nov

Effective Data Cut-off (Close of business) 30-Sep

31-Aug

17-Sep

15-Sep

17-Sep 14-Sep 17-Sep

31-Aug 31-Aug 31-Aug

17-Sep 17-Sep

28-Aug 31-Aug

28-Oct

30-Sep

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 Quarterly review Annual review (constituents) Quarterly review Semi-annual review Annual review (constituents) Quarterly review Quarterly review Annual review

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 15-Oct 29-Nov 18-Oct 30-Nov 30-Dec 03-Dec 30-Nov 30-Nov

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 17-Sep 29-Oct 30-Sep 30-Sep 30-Nov 30-Sep 30-Oct 31-Oct

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

128

SEPTEMBER 2010 • FTSE GLOBAL MARKETS

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