FTSE Global Markets

NEW APPROACHES TO COLLATERAL MANAGEMENT ISSUE 45 • OCTOBER 2010

Akbank’s summer borrowing bonanza The raw appeal of Saudi real estate Gulf Bank’s return to form Why execution consulting works BofAML’s prime broking charge

Nigeria’s radical economic blueprint ASSET ALLOCATION ROUNDTABLE: TOMORROW’S WORLD

OUTLOOK

EDITORIAL DIRECTOR: Francesca Carnevale, tel: +44 [0]20 7680 5152, email: francesca@berlinguer.com, fax: +44 (0)20 7680 5155 CONTRIBUTING EDITORS: Art Detman, Neil O’Hara, David Simons.

CORRESPONDENTS: Rodrigo Amaral (Emerging Markets); Andrew Cavenagh (Debt); Lynn Strongin Dodds (Securities Services); Vanja Dragomanovich (Commodities); Mark Faithfull (Real Estate); Ruth Hughes Liley (Trading Services, Europe); John Rumsey (Latin America); Ian Williams (US/Emerging Markets/Sector Analysis).

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FTSE GLOBAL MARKETS • OCTOBER 2010

F LAST MONTH’S issue questioned the underlying philosophy of the new high-growth economies, the headline story in this edition is about hope. We’ve focused on the lynchpin economy of Nigeria as our cover story. In the last edition we highlighted the fact that some high-growth economies are limited by a lack of overarching political vision that is married to economic success and the ramifications of that lacuna. In this month’s profile of Nigeria’s new economic road map, we highlight the efforts of new political elites to bring sustainable and very real change to a sometimes corrupt, overly bureaucratic and stagnant economic infrastructure. It is backed by a pragmatic and substantive social agenda, to bring improved hope and living standards to the country’s 150m-strong population, via a stronger, more honest, robust and transparent economy infrastructure that will in turn, hopes the administration, bring in new investment dollars and opportunity for employment growth. However, the programme is fraught with dangers: there remain powerful elites in the country that have directly benefited from the status quo and who will try to stymie change. Planned presidential elections in 2011 now govern the tempo of reform. Will the current administration of president Goodluck Jonathan do enough to convince a somewhat jaded electorate that they have the right blueprint for the future? We spoke to finance minister Olusegun Aganga and Arunma Oteh, the director-general of the Nigerian Securities and Exchange Commission, about the country’s problems, plans and very real prospects.

Regulation and more regulation is a steady melody playing through this issue; ranging from the implications of the Dodd–Frank Wall Street Reform and Consumer Protection Act in the United States to the recently published proposals to instill order and structure on short selling in Europe and the OTC derivatives market. As with most market change, it is not the most obvious institutions that either benefit or feel the real impact of change. MiFID, for example, was designed to provide improved pricing, competition and choice in the equity trading market. What has resulted is a vastly more complex and often opaque trading environment; everyone has cheaper trades, but at what cost elsewhere in the investment and trading spectrum? Similarly, projected change in the OTC derivatives market is expected to (ultimately) benefit the principal derivatives exchanges. Actually, the key beneficiaries will be the clearing and settlement institutions, which look to be on the cusp of a major redefinition of the trading back office. Consolidation is likely, certainly in Europe; though the opportunities are significant for those institutions willing to rise to the occasion. There are few concrete statistics available, but there are suggestions that as much as 60% of OTC contracts could be standardised through central clearing. While not all transactions will be suitable for central clearing; the computation of new business opportunity is obvious as regulation cuts its swathe through the financial markets.

Finally: some housekeeping. Regular readers will see a number of small changes in this edition. We’ve added to the editorial space in the magazine, reducing the margins and fitting in more words per page. We’ve also simplified the design, to attune it more to the seriousness of the content. Moreover, we’ve introduced a couple of new sections. As we now move to ten editions a year there’s more scope for news coverage and we’ve added a new department up front. The data pages have been expanded and we are beefing-up our occasional foreign exchange coverage to a regular section, coupled with the introduction of a new columnist. Erik Lehtis, the exhead of Wolverine Trading in Chicago, with 17 years of interbank spot FX trading and several years of trading FX in the high-frequency space under his belt, will provide us with his rich and sometimes controversial market insights. We will continue to strive to improve the magazine over the coming years and we hope you enjoy the enhanced coverage.

I

Francesca Carnevale, Editor October 2010 Cover photo: Finance Minister Olusegun Aganga speaks at a news conference on key economic issues in the commercial capital Lagos on July 16th, 2010. Photograph by Reuters/Akintunde Akinleye, supplied by Thomson Reuters, September 2010.

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CONTENTS COVER STORY

THE LONG, LONG ROAD BACK TO THE FUTURE

......................................................Page 62 The regime of president Goodluck Jonathan has stated its serious intent to reform the country’s financial markets, privatise and upgrade its carbon-based energy structure and bring growth and rigour to the national economy. It’s a tall agenda. Additionally, Arunma Oteh, director general of the Securities and Exchange Commission in Nigeria, has taken up the cudgels of regulatory responsibility with gusto and no small degree of courage. Will she succeed in turning Nigeria into a creditable and credible financial hub? Francesca Carnevale reports.

DEPARTMENTS

THE NEW NAME OF THE GAME ..........................................................................................Page 6

MARKET LEADER

The era of centrally cleared OTC derivatives is fast approaching but consolidation may take time.

ACT HERALDS THE AGE OF REGULATION ....................................................................Page 12 The Dodd-Frank Wall Street Consumer and Protection Act changes the way the US does business.

SPOTLIGHT

A ROUNDUP OF MARKET NEWS........................................................................................Page 16 SHORT TERM VOLATILITY ......................................................................................................Page 20

IN THE MARKETS

Agricultural commodities prices in the short term are volatile, but what does this mean for investors?

REDEFINING A LONG TERM OUTLOOK ..........................................................................Page 24 Rabobank is carving out growth through initiatives in financing agricultural trade.

BANK PROFILE

BACK TO BLACK ..........................................................................................................................Page 26 Gulf Bank’s Michel Accad talks about rising profits and upgrading the bank’s investment portfolio.

THE ROCK & ROLL ECONOMY ............................................................................................Page 30 Turkey outperforms expectations, but for how long?

COUNTRY/REGIONAL REPORTS

THE NEW JACKPOT ....................................................................................................................Page 36 Akbank sets the pace in Turkish non-sovereign issues.

THE DUAL TRACK DILEMMA ................................................................................................Page 38 Mixed fortunes in the GCC’s finely balanced banking sector.

JEDDAH MAKES ITS MOVE WITH NEW MEGA-PROJECTS ..................................Page 45

REAL ESTATE

Saudi Arabia’s most cosmopolitan city struggles to regain ground with a real estate boost.

POLISH REAL ESTATE EMERGES FROM THE SHADOWS........................................Page 48 Mark Faithfull writes about the not-so-bleak outlook of CEE commercial property.

INDEX REVIEW

QE II & M4 WEAKENING..........................................................................................................Page 52 Simon Denham, managing director of Capital Spreads, on the possible recovery of UK share prices.

THE FIGHT FOR MARKET SHARE ........................................................................................Page 53

FX REPORT

Foreign currency as an asset class for portfolio investors has increased demand for FX options.

A STORY OF TWO HALVES ....................................................................................................Page 56 Erik Lehtis, president of DynamicFX Consulting, on the lack of transparency in the FX market.

DEBT REPORT EXCHANGE REPORT

DATA PAGES

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BONDS ON THE MEND ............................................................................................................Page 57 Corporate bonds recover in August after the turmoil in May, reports Andrew Cavenagh.

THE CHANGE DYNAMIC..........................................................................................................Page 60 The Johannesburg Stock Exchange (JSE) moves into the fast lane.

Fidessa Fragmentation Index ......................................................................................................................Page 103 BlackRock ETFs ..................................................................................................................................Page 105 DTCC Credit Default Swaps analysis ............................................................................................Page 107 Market Reports by FTSE Research ............................................................................................................Page 108 Index Calendar ..................................................................................................................................................Page 112

OCTOBER 2010 • FTSE GLOBAL MARKETS

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CONTENTS FEATURES TRADING REPORT:

GETTING CLOSER TO THE BUY SIDE ........................................................Page 68 By offering solutions specifically tailored to clients on a case-by-case basis, execution consultants can help buy side firms address latency in the trade lifecycle, while allowing them to seek parity in a world increasingly dominated by high-speed “flash” programming. Are the rewards worth the risk of sharing potentially sensitive data with a sell side provider? David Simons reports from Boston.

KEEPING UP WITH THE JONES’s ..................................................................Page 74 From seeking best execution through the murky waters of market fragmentation, to integrating legacy-based systems in a high-frequency trading world, buy side desks have their work cut out for them. The good news? Help is on the way, says David Simon.

THE NEW WATCH ..................................................................................................Page 77 In a market that remains ultra-sensitive to counterparty credit risk and the safety of client assets, all but two of the leading prime brokers are now owned by major universal banking groups. Sylvan Chackman, co-head of global markets financing & futures at BofA Merrill Lynch (BofAML), explains how the bank has established a global, one-touch shop for its prime brokerage services that is now itching to flex its muscles whenever hedge funds regain their taste for leverage. Neil O’Hara reports.

SECURITIES SERVICES:

CHOPPY WATERS FOR TM ..............................................................................Page 80 There are no official league tables but the general consensus of which firms now dominate European transition management (TM) is that BlackRock, State Street and Russell Investments are among the top three contenders. Not surprisingly, the landscape shifted after the financial crisis and the musical chairs of personnel continues. Lynn Strongin Dodds explains the changes.

A BURNING QUESTION ......................................................................................Page 84 Securities lenders who tried to switch their cash reinvestment programmes into more conservative vehicles discovered that commingled pools were unable to meet their demands without selling purportedly cash-equivalent assets at discounts to par. The passage of time has relieved the pressure on troubled reinvestment pools as some illiquid instruments have matured and liquidity has returned to others. The problem has not gone away entirely, however, reports Neil O’Hara.

REVAMPED AND RECOMMITTED ..............................................................Page 88 Despite taking a more conservative approach to reinvestment guidelines, by all accounts beneficial owners remain committed to securities lending. Having gained a greater appreciation for the risks involved, clients continue to refine programme oversight practices, impacting the level of transparency required of their lending agents. David Simons reports from Boston.

ROUNDTABLE:

ASSET ALLOCATION IN A POST CRISIS ENVIRONMENT ..................Page 93 Much has been written about the impact of the recent financial crisis on the banking system, financial products and securities services. Yet one of the biggest impacts has been in the asset allocation segment. Historically, equities assumed as much as 70% of a typical investment portfolio though that is no longer the case. FTSE Global Markets spoke to a group of commentators in the asset allocation space. We publish their take on some of the principal developments in recent years and the intermediate-term outlook, in particular for the commodity and gold segments.

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OCTOBER 2010 • FTSE GLOBAL MARKETS

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MARKET LEADER

OTC DERIVATIVES: CONSOLIDATING CLEARING & SETTLEMENT

The era of centrally cleared over-the-counter (OTC) derivatives may be fast approaching but the endgame will take time to materialise. As always the devil is in the detail and regulators in the US, UK and Europe will be kept busy over the next 18 to 24 months working on the finer points.

Although there is still uncertainty regarding the final outcome, clearinghouses are rubbing their hands in anticipation of an OTC migration. It is too early to predict the winners and losers but the general consensus is that consolidation is definitely on the horizon. Lynn Strongin Dodds reports.

Photograph © Dan Collier / Dreamstime.com, supplied September 2010.

THE NEW NAME OF THE GAME HE OTC DERIVATIVES segment is in flux; with the likely beneficiaries including the main derivatives exchanges, but more importantly, the clearing and settlement institutions which form the backbone of the business. As Paul Bodart, head of Europe, the Middle East and Africa operations at BNY Mellon Asset Servicing, notes: “Competition is a good

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thing and the industry will benefit. There will be certain margin requirements but clearers can compete on price and service.

I think at the moment there are too many clearers. It is not feasible to have eight or nine but three to four makes sense.”

Kevin McPartland, senior analyst at TABB Group, expands on the theme: “The main players, such as IntercontinentalExchange (ICE), Chicago

Mercantile Exchange (CME), Eurex, IDCG (International Derivatives Clearing Group majority-owned by NASDAQ) and LCH.Clearnet all have different models each with their own pros and cons. However, I do not think that they will all survive in their current form.

There will definitely be a transformation over the next five years although I am not sure that we will see a transatlantic partnership in the near future. For example, LCH.Clearnet which is majority-owned by banks, would not want to partner with the CME.” Tony Scianna, executive vice president, product management and marketing for SunGard’s brokerage and clearance business, adds: “Clearing will be very competitive, but as in most industries, there are usually firms that pull ahead of the pack. The big question going forward is whether the US-based firms can leverage their experience in their domestic market to expand into Europe and Asia and become one of the winners. There is a view that one or two global players will emerge in the future as the world becomes smaller. For now, though, it will be interesting to see which clearers win the business for the same instrument.”

These days, most OTC swaps are still executed by voice trades at inter-dealer brokerages or sold by dealers directly to customers. According to a recent report conducted by financial services firm TriOptima on behalf of the industry group, International Swaps and Derivatives Association (ISDA), the value of traded volume in the global derivatives market is close to $605trn, with interest rates being the largest number, accounting for $448.7trn as of March 31st this year. The report noted that central clearing houses held 44% of overall gross notional value while the 14 biggest dealers had 22%

OCTOBER 2010 • FTSE GLOBAL MARKETS

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MARKET LEADER

OTC DERIVATIVES: CONSOLIDATING CLEARING & SETTLEMENT

with smaller dealers holding 32%.

Breaking it down, interest rate swaps totalled $322.2trn, credit default swaps (CDS) accounted for roughly $33trn with forward rate agreements, options and other types of contracts comprising the rest. With that level of volume one can readily understand the scramble for market share.

US and European regulators may have different procedures for passing legislation but both are broadly following the blueprint laid down in G20 meetings. These recommended that OTC derivative contracts be traded on exchanges or electronic trading platforms and cleared via central counterparties by end-2012 at the latest.

Key data is to be reported to trade depositaries while non-centrally cleared or listed derivatives should be subject to significantly higher capital and margin charges. In addition, a CCP would need to comply with high-risk management standards and require counterparties to post appropriate collateral The belief is that a more standardised and transparent OTC market infrastructure will mitigate some of the risks inherent in these opaque instruments, which have been widely blamed (rightly or wrongly) for the financial crisis in late 2008. In addition, mandatory reporting of contracts to trade repositories is expected to significantly enhance information on OTC derivatives exposures, to the benefit of both regulators and market participants.

In the US, these proposals are embedded in the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed in the summer. Europe meanwhile is working along similar lines with the final version of the European Markets Infrastructure Legislation (EMIL) due to be published in the autumn. It is not the end of the story in either region.

Exactly which contracts will need to be cleared, and who will get to clear them, still hangs in the balance.

Regulators in the US [notably the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), will

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Paul Bodart, head of Europe, the Middle East and Africa operations at BNY Mellon Asset Servicing, notes: “Competition is a good thing.

There will be certain margin requirements but clearers can compete on price and service.”

Photograph kindly supplied by BNY Mellon, September 2010.

Kevin McPartland, senior analyst at TABB Group, says: “The main players all have different models each with their own pros and cons. However, I do not think that they will all survive in their current form.”

Photograph kindly supplied by TABB Group, September 2010.

now spend the next several months fleshing out the details of the 2,000 pages of new laws. As for Europe, BNY Mellon’s Bodart points out: “The difference with EMIL is that it is not a directive but a law which each member will have 18 months to implement. The objective of the regulation in the US and Europe is the same: it is to reduce the risk and exposure, increase transparency and push as much OTC contracts as possible on exchanges.”

Judson Baker, senior vice-president and product manager for derivatives at Northern Trust, notes: “At the moment there is uncertainty about which products will be eligible and what the margin requirements will be. I expect though that traditional OTC instruments such as interest rates and credit default swaps will increasingly move over to a centrally-cleared environment.”

There are no concrete statistics, but according to some industry estimates, roughly 60% of OTC contracts could be standardised through central clearing.

Other participants believe that the figure could reach as high as 80% due to capital requirements that will likely be levied for those contracts that are not centrally cleared. Not all derivatives though will be suitable for the mould. Jeroen Wilbrink, a structured solutions specialist at F&C Investments, for one, believes: “There will be a number of transactions that will not be centrally cleared because they do not fit the model. These include equity-backed options, longevity derivatives and other instruments that are targeted to meet a pension fund’s specific risks.”

Clearinghouses are not waiting for the ink to dry and are already drawing the battle lines with LCH.Clearnet, the CME Group, IntercontinentalExchange (ICE), Eurex and IDCG all jockeying for position. On the interest rate swap front, The London-based LCH.Clearnet is the most established player with its SwapClear platform. It currently clears approximately 40% of the global interest rate swap market and has $212trn in notional trades outstanding.

The group is also hoping to expand its

OCTOBER 2010 • FTSE GLOBAL MARKETS

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MARKET LEADER

OTC DERIVATIVES: CONSOLIDATING CLEARING & SETTLEMENT

operations across the Atlantic and is currently seeking regulatory approval to offer its SwapClear service to US futures brokers.

Chicago-based CME, the world’s largest derivatives market, has thrown down its gauntlet and is hoping to make significant forays with its interest rate clearing service slated to begin by the end of the year. Snapping at their heels is newcomer IDCG, which is hoping to make substantial forays into both the US and Europe with its interest swap clearing service.

In the CDS space, ICE is in the lead, capturing almost a third of the clearing business in the US and Europe. Figures from the Atlanta-based group shows its two CDS clearinghouses have processed over $10trn of the contracts since the inception of its services in March 2009.

By contrast, CME has cleared $195m of CDS since beginning its service last December. The group is also trying to get a foothold in the UK while the Parisbased arm of LCH.Clearnet Group recently debuted a new CDS clearing service out of France.

Alberto Pravettoni, managing director of LCH.Clearnet, believes that his firm is in a strong position to be eminent around the world but there will be other players. “Much of what will happen will depend on how the regulations play out in the US, Europe and Asia. It will not be a swift process and the hard work is just beginning in terms of developing the rules. One of the challenges will be to ensure a consistent approach across markets globally as fragmentation would add to systemic complexity and risk.”

One concern is that clearinghouses might undercut each other in order to grab a bigger slice of the clearing pie.

Some industry experts fear that there will be a race to the bottom regarding risk management standards with the clearer that demands the lowest capital attracting the most business. The International Monetary Fund (IMF) noted in its Global Financial Stability Report, published in April this year, acknowledged that a critical mass of OTC derivatives is needed to move to central clearing in order to

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“I hope we do not see too much consolidation because I think competition is healthy and it gives us a choice. I do not want to be forced to use one provider,” says Jeroen Wilbrink, a structured solutions specialist at F&C Investments.

Jeroen Wilbrink, structured solutions specialist at F&C Investments.”There will be a number of transactions that will not be centrally cleared because they do not fit the model,” he says. Photograph kindly supplied by F&C Investments, September 2010.

achieve the multilateral netting benefits of a CCP. However, it also pointed out that close cross border co-ordination of regulatory and supervisory frameworks are required and that, ideally, CCPs would develop linkages that allow for more netting and lower collateral needs.

However, as the international organisation pointed out, legal and political obstacles have made this difficult.

In addition, not everyone believes that bigger is better. There is a fear that the new world order could see the debate of being too big to fail shift from the banking industry to the clearing arena if participants either merge or if one wins the bulk of a business in a particular instrument. This could potentially and ironically create a handful of clearing institutions or exchanges

that are too big to fail. The counterargument is that the central counterparty model should be seen as partially mitigating the problem because it provides transparency in terms of how financial firms and markets are connected through the derivatives markets. This in turn should enable regulators to see and take appropriate action against firms with excessive exposures to specific types of risk or to other financial organisations.

Finally, some market participants like to have more than a handful of players.

As Wilbrink says: “I hope we do not see too much consolidation because I think competition is healthy and it gives us a choice. I do not want to be forced to use one provider.”

Fund management companies, though, despite the rumours, are unlikely to become clearing members themselves, according to Dave Reynolds, principal of Investit. “I think the status quo will remain and that they will continue to use their investment banks or custodians who are already clearing members. I expect though that the cost of clearing will increase in the short to medium term because it is still a very manually driven business and it will take time to automate the processes.

These costs will be passed onto the end user but as technology advances the costs will decrease.”

Baker agrees, adding: “The new regulations will significantly change how traditional OTC derivatives are processed including confirmation to matching, margin calculation, asset categorisation, reporting and accounting treatment. The industry is addressing these issues; the development is another matter. There are still too many manual processes within the OTC derivatives industry and it will take time before we see full automation, given the upcoming changes.”I

OCTOBER 2010 • FTSE GLOBAL MARKETS

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MARKET LEADER

THE DODD-FRANK ACT: CHANGING HOW THE US DOES BUSINESS

The Dodd–Frank Wall Street Reform and Consumer Protection Act addresses two issues: the size and behaviour of the largest financial institutions and genuine consumer protections. The fundamental ideological and political equation is that if banks are too big for the government to allow them to fail, then the government has the right and indeed the duty, to regulate their behaviour to ensure that they do not. As a concomitant, if they have behaved irresponsibly, then government has the right to protect their customers from predatory behaviour. As to whether it will achieve its aim of preventing further financial crises remains to be seen.

By Ian Williams.

House Financial Services Committee Chairman Rep. Barney Frank, Democrat, Massachusetts, left, accompanied by Senate Banking Committee Chairman Sen. Christopher Dodd, Democrat, Connecticut, talks to reporters outside the White House in Washington, Wednesday, March 24th, 2010, after a closed door meeting with President Barack Obama in the Oval Office to discuss financial reform. Photograph by Charles Dharapak for the Associated Press, supplied by Press Association Images, September 2010.

ACT HERALDS THE AGE OF REGULATION HE THOUSANDS OF pages of the Dodd–Frank Wall Street Reform and Consumer Protection Act, passed to ensure“never again”after the financial crisis, are certainly weighty enough to affect how the US does business. However, its lengthy text is only the core of an impending mass of regulation. Passed in the teeth of a war of attrition waged by Republicans, it ushers in an age of regulation—but the regulations have yet to be defined, and the regulators are still being picked.

Indeed, it is difficult to consider the act without the regulatory machinery it has mandated and which is only just being designed, let alone implemented.

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From the rhetoric in the media, the act was either an act of Bolshevism on a par with the storming of the Winter Palace, or it was an example of legislative capture as corporations haggled out richly deserved restrictions on their activities. The Deloitte Center for Financial Service’s Andrew Freeman admits that the act“was to some extent watered down”, but still regards it as“a major legislative achievement, that was really needed, not in least in the face of the jockeying in Congress”.

He predicts that one of the core anticrash provisions, moving the OTC derivatives activities onto exchanges“will be extremely interesting, when we can

assess its economic impact”. He adds: “In economic theory margins should collapse, from the providers’point of view, because until now many of the users of derivatives would not have known whether they were paying a fair price.”

He also points out that the regulations on banking capitalisation are not as strict as those likely to follow Basel III and the G20 talks. While some people see the exclusion of interest rate derivatives from the mandatory exchanges as a victory for bank lobbying, Freeman is more sanguine: “Those were fairly transparent anyway,” and points to another aspect of the act which is already having effects on the banks. “The act was under-

OCTOBER 2010 • FTSE GLOBAL MARKETS

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MARKET LEADER

THE DODD-FRANK ACT: CHANGING HOW THE US DOES BUSINESS

appreciated for separating proprietary trading activities from taxpayer insured activities such as deposits and lending.

The pressure is on to spin these off into separately capitalised entities. Is it adequate? Time will tell, but it is already having an effect,” he says.

“Overall, much of what the act mandates is things that should have been done earlier,”Freeman comments.

Deloitte’s explanation of the act emphasises the need for proper and coordinated data collection and organisation within companies, and he explains: “It’s very easy to prevaricate, but the costs for individual companies in putting off investment in IT really became very large. During the crisis, many of them found themselves incurring huge costs in trying to do manually what they needed to do.”

In the face of those dismissive of the scope of the act, who might think the “consumer protection” in the act’s title is a copywriter’s concession to populist sentiment, he emphasises: “It’s more than just window dressing. There is clearly a very large amount at stake and the introduction of retail protection for banking customers is historic, a step change in the whole competitive field for the large service sector of the US economy.”

The core of the act addresses two key issues: the size and behaviour of the largest financial institutions and genuine consumer protections. The fundamental ideological and political equation is that if banks are too big for the government to allow them to fail, then the government has the right, indeed the duty, to regulate their behaviour to ensure that they do not. As a concomitant, if they have behaved irresponsibly, then government has the right to protect their customers from predatory behaviour.

Most of the activity about the act so far has come from accountancy firms and consultants gearing up to advise clients on what preparations they need to make.

“We know that investment advisers need to register, and that it will have a huge effect in banking and the mortgage banking sector, so we know which

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Most of the activity about the act so far has come from accountancy firms and consultants gearing up to advise clients on what preparations they need to make. “We know that investment advisers need to register, and that it will have a huge effect in banking and the mortgage banking sector, so we know which companies it will have an impact on,” says Grant Thornton’s head of the asset management practice, Winston Wilson. companies it will have an impact on,” says Grant Thornton’s head of the asset management practice, Winston Wilson, adding: “However, we will not really have an idea of how much it will cost. If you are a public company, you know you have to start doing things with compensation and you can start that now.”He suggests that we take Sarbanes-Oxley as a proxy for the act and points out that the accounting profession is reaching its fifth major revision of its standards trying to implement the standards inherent in SarbOx.“Eight years into it, and most of the issues about over-regulation have now died down, but now you have audit commissions and controls, and most companies see their benefits.

Right direction Most observers agree: the Dodd-Frank Act is not necessarily a panacea, but overall it is the right direction to move in bringing better oversight, better regulation. The challenge is to determine how much is just right. The SEC has been meeting with the accounting profession and others and they are doing the right thing, trying to understand things, before bringing in regulation.”

For example, he points out, the act exempts venture funds from registration in what he presumes is an effort to maintain job creation, “but they’ve left the definition of a venture fund until later, and unless you define closely, someone will find a loophole there”.

He points out that the derivatives regulators will need to distinguish so that “Mom and Pop” farmers using crop derivatives are not hit with burdensome regulations and registrations becoming

collateral damage in the effort to stop the excesses of speculation and manipulation in the financial markets.

Similarly, as one of the unintended consequences, the act prohibited companies making public offerings from using rating agency assessments without written consent from the agencies, which stalled the market: “Now there’s a moratorium for six months while they work out how to deal with it and companies not using the ratings,” says Wilson.

“Overall, the act is a skeleton and as time goes on we are going to add more flesh to the bones to make it more real.

Let’s have the skeleton run for a year, and then write version two. Over the next year more will be written and then five years and onward we’ll have a better sense of how it will affect various entities,” he adds.

A similar message comes from energy trading consultant, Sam Van Vactor, who publishes the Energy Market Report and Pacific West Oil Data: “The futures market covers the general trade and benchmark prices and then you have the basis swaps—for example, California gas prices trade differently. If you force them to register all the basis swaps into clearing houses, that becomes costly and you will reduce the volume, because if you can’t hedge the basis trading cheaply, then it reduces the volume of futures. Now some people might think that is a good idea—I don’t. There could be consequences from too heavy a regulatory hand. It will depend very much how the Commodity Futures Trading Commission regulates that a year or two down the way.”

OCTOBER 2010 • FTSE GLOBAL MARKETS

One question mark about the future for this“brave new world”of regulation is the likely war of attrition in the committees and lobbies of Congress as the regulations are drawn up. Some American chief executive officers (CEOs) and their allies are ever quick to see signs of the sky falling down whenever there is the slightest threat to their prerogatives: among which, most sacred, are their rights to nominate their own board and to name their own salary, even if these are carefully disguised behind nomination and compensation committees that they appoint.

The act mandates that companies must compute the ratio between the lowest paid employee and the CEO. It does not mandate a relationship, but it certainly brings what for many will be unwelcome publicity to the ballooning executive remuneration.

Following the act the SEC voted, with the Republican representatives against, to allow shareholders who have held more than 3% of a company for three years to place candidates on the ballot for the board. The resistance to that decision betokens the almost theological element in the opposition to the

legislation pitting those who think that what is good for CEOs is good for companies and good for America against would-be regulators.

It was difficult to argue that shareholders do not have rights to nominate board members, nor that CEO compensation should be public: but it is a measure of the fundamentalism in corporate politicking that, in effect, that is what the conference board and its allies were arguing.

Sinclair Capital’s Jon Lukomnik welcomes the achievement but hastens to point out how limited its effect is.

“Ironically, hedge funds actually hold only for an average of 14 months, which is more than most mutual funds, but the idea that an activist fund is going to wait around for three years for a very limited remedy is laughable”, he notes, pointing out there are other easier options available.

“You are limited to 25% of the board seats rounded down, which means just one on an eight-seat board, but bizarrely, you have to pledge not to seek change of control. If you are an activist seeking major changes, this is of little use to you. After all, it’s a proxy access rule,

not a board access. It just means you’ll be on the ballot, and if you want to win, you still have to campaign.”

It remains to be seen how the regulations and the supposedly independent regulators will stand in the face of such dogged opposition.

Freeman advocates: “Instead of an adversarial war of attrition the industry should try to approach it more constructively, make ambassadorial appointments to negotiate and talk with regulators and politicians to raise genuine and practical concerns in the decision-making process,” although he admits: “It [can be] politically challenging drawing the line between raising legitimate issues and the intensive lobbying that goes too far.”

The consensus is that Wall Street’s entrepreneurial spirit will rapidly find loopholes, which the more responsible will identify and the less so exploit, until the regulators catch up with them. If the regulators are not totally inhibited

by Washington, it will be a fairer fight, and in the wake of the financial crisis, let alone the Gulf crisis, regulation is, for the time being at least, no longer a fourletter word in government. I

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We will be pleased to tailor our reprints to your specific requirements.

FTSE GLOBAL MARKETS • OCTOBER 2010

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SPOTLIGHT

Euroclear Turns On To Yuan

First Euro HighYield Bond ETF

Euroclear Bank to settle transactions in the Chinese currency

New ETF offers exposure to most liquid high-yield bonds

EUROCLEAR BANK, THE international central securities depository, says its clients will be able to settle transactions and deposit Eurobonds and Hong Kong domestic securities denominated in the Chinese yuan renminbi (CNY) by the end of September. Euroclear Bank now offers services in 53 currencies.

Olivier Grimonpont, regional head and general manager of the Euroclear Bank branch office in Hong Kong, explains:“As offshore borrowers look to raise funding in renminbi or to broaden their investor base, investors will be able to settle these transactions in Euroclear Bank and eliminate foreign-exchange risk by having to settle in alternative currencies. The steady supply of renminbi Eurobond issues to date, with ever-increasing sizes and tenors, demonstrates a growing market appetite for these securities.

Olivier Grimonpont, regional head and general manager of the Euroclear Bank branch office in Hong Kong. Photo kindly supplied by Euroclear Bank, September 2010

Euroclear Bank aims to take an early and significant role in servicing these securities for issuers and investors alike.”According to the Chinese central bank, the volume of global trade settled in renminbi has grown from CNY3.6bn (£346m) in the first half of 2009 to CNY70.6bn in the first half of 2010. The People’s Bank of China and the Hong Kong Monetary Authority recently reached an agreement for the offshore renminbi business to be supported in Hong Kong. I

BLACKROCK’S EXCHANGETRADED funds (ETFs) platform iShares in September launched the first euro high-yield bond ETF. The iShares Markit iBoxx Euro High Yield fund addresses the liquidity concerns that have previously made it difficult for investors to access European high yield, by offering exposure to nearly 100 of the most liquid sub-investment grade corporate bonds.

The underlying Markit iBoxx Euro Liquid High Yield index uses multiple pricing sources and is based on an average of the ratings allocated to each debt instrument by Fitch, Standard & Poor’s, and Moody’s. Almost twothirds of the constituent bonds are currently BB-rated with 5% allocated to CCC-rated bonds. In terms of sector breakdown, consumer goods, industrials and basic materials constitute almost half of the index weighting, with no single holding currently making up more than 2% of the index. I

NEWS BRIEFS FTSE GROUP 2009 COUNTRY CLASSIFICATION CHANGES: Index provider FTSE Group has changed the following country classifications. The UAE will be included in the FTSE Global Equity Index Series as a secondary emerging market; Malta is now classified as a frontier market, as is Argentina, which was previously classified as a secondary emerging markets. I

CFTC DATA CHANGE: The Commodity Futures Trading Commission (CFTC) began releasing data on index investing by large funds and swap dealers on a

16

monthly basis in early September.

For the last year the regulator published the data in a quarterly release. The move to increase the frequency of reported data is an effort by the regulator to increase transparency since index funds, pension funds, hedge funds, mutual funds and exchange-traded funds became larger players in commodity markets. Of late a number of long only funds have been in the firing line; criticised for allegedly helping to inflate oil and grain prices. The first monthly report covered July 2010 data, though if the criticisms are real, if is unlikely a two month reporting gap is going to help. I

SRI & SUSTAINABILITY SURVEY: Thomson Reuters and UKSIF, the sustainable investment and finance association, say their 2010 Survey shows buy side firms are placing more emphasis on sustainability issues in the research and advisory services they receive from brokers. Moreover, nearly 90% of buy side firms are planning to increase SRI & sustainability asset allocation in the coming year. Key rankings from survey place Societe Generale, CA Cheuvreux and UBS as the top brokers for SRI research; while Oddo Securities, UBS and CA Cheuvreux dominate corporate governance research. I

OCTOBER 2010 • FTSE GLOBAL MARKETS

SPOTLIGHT

RTS Launches Five-Year Futures Trading in five-year futures on the USD/RUB exchange rate launches on FORTS TRADING IN THE futures contract on the USD/RUB exchange rate with settlement on September 15th 2015 began on FORTS in early September.

FORTS is the derivatives market of RTS and the new contract has longest settlement term of any on the Russian stock market. Russian enterprises and companies engaged in dynamic foreign economic activities or who are subject to currency risks, will now gain the opportunity to plan their financial budget five years in advance. Moreover, the five-year futures on the USD/RUB exchange rate will interest long-term investors with savings, deposits, and loans denominated in US dollars. The use of this future will enable them to protect themselves and their investments from inflation in the USA. “FORTS always does its best to meet the needs of the market participants and give a wide variety of contracts including those different in settlement cycle. The launch was a response to the request from market participants to introduce long-term USD/RUB contracts,”explains Evgeny Serdyukov, director of the futures and options market at RTS Stock Exchange. “There was a project team formed from FX

market participants and it was their decision to launch the five-year contract. The longest term USD/RUB contract [up to that point] was a 15month contract,”he adds.

The USD/RUB contract is the second most traded contract in nominal volume at FORTS and the third by the number of contracts. It is one of the most liquid contracts on the Russian derivatives market. “FORTS is doing more than 60% of RTS total volumes.

The trading volume makes about $4bn-$5bn/day”, says Serdyukov.

“Summer is usually an idle period for all markets but the general trend is still market growth.”

The new futures contract has Si9.15 code in the trading system and it keeps all the advantages and characteristics of three-month currency contracts in its specification.

The price of its first market transaction on the contract amounted to RUB37,950 (£800).“The experience of leading international financial centres demonstrates high demand on long-term currency hedging instruments from the top companies and holdings globally. This trend has been particularly visible over the last

Evgeny Serdyukov, director of the futures and options market at RTS Stock Exchange.

Photograph kindly supplied by RTS, September 2010.

two years when foreign currency market volatility was very high,” notes Serdyukov RTS is not going to stop here. “We are planning to widen commodities contracts and launch a futures contract on copper,”says Serdyukov. I

Will The New BBA Code Be Enough?

BBA’s new financial reporting disclosure code hopes to meet regulators’ requirements THE BRITISH BANKERS’ Association’s (BBA’s) new Code for Financial Reporting Disclosure sets out principles for clear and transparent information about the UK’s largest lending institutions. In complying with the code, says the BBA, UK lenders will undertake not only to provide “high quality disclosures in their annual and interim reports, but also to reevaluate the disclosures given to

18

ensure that they continue to be relevant and of high quality”.

BBA chief executive Angela Knight claims: “[The code] surpasses all of the current international and local reporting requirements and fits with the call from the G20 and others to identify the types of risk disclosure that are relevant and useful to investors.”

The seven signatories of the code include Barclays, HSBC, Lloyds,

Nationwide Building Society, Santander UK, Standard Chartered and Royal Bank of Scotland. UK lenders voluntarily adopted the code in their 2009 accounts and, claims the BBA, “received very favourable feedback from the market”.

Meetings between key bankers and the UK’s Financial Services Authority (FSA) will take place to see whether the code will suffice and to discuss its development. I

OCTOBER 2010 • FTSE GLOBAL MARKETS

IN THE MARKETS

GRAINS: HIGH PRICES, UNCERTAIN OUTLOOK

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

SHORT TERM VOLATILITY More thinly traded than say oil, metals or precious metals, agricultural commodities prices tend to move faster and in a more volatile fashion. They are also highly dependent on weather and disease; too much or too little rain can wipe out a whole harvest and diseases such as foot and mouth can spell the end of a generation of livestock. They are also more political than most other commodities—apart from oil. Too high or too low price levels tend to provoke government interventions. If the short-term trend in these markets is volatility, the long term has to be higher prices. What does that mean for investors? Vanya Dragomanovich reports.

HE SCENE FOR the splurge in interest in the agricultural commodities sector is succinctly drawn by Desmond Cheung and Richard Davis, co-managers of BlackRock’s World Agriculture Fund, which invests in agricultural equities. They report : “By 2050 there will be an estimated 9.2bn people in the world [compared to 6.9bn today]. This is the equivalent of adding a population the size of the UK [60m] every year. Food production will have to rise by 70% above levels in 2005 to 2007 levels to feed them.”

Grains prices are already up on the long-term demographic: not only because they are an essential human food source, but also because they are used as animal

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feed. Moreover, growing affluence in the developing world coupled with an attendant change in food preferences towards meat consumption, is placing significant pressure on land (it takes eight kilograms of grain to produce one kilogram of meat). The UN has warned that arable land is expected to decrease by 100m hectares by 2020. That trend is also exacerbated by a move towards cheaper/cleaner fuel supplies, encouraging farmers to opt for palm oil plantations rather than grains or sugar.

These general trends aside, wheat prices spiked in August as Russia, the world’s third largest exporter of the grain, banned exports of wheat from the middle of August until the end of the year, with

the threat of an extension of the ban through 2011. Even so, with prices at $7.33 a bushel ($7.33/b) they are well below the $12/b at their peak in 2008.

The hottest summer in 130 years kicked off a draught over large parts of the country, culminating in hundreds of forest and peat fires which killed more than 50 people and destroyed villages and crops.

The ban will buy the Russian government some time to assess precisely how much grain has been lost due to drought.

Russia is encouraging Kazakhstan and Ukraine to do the same and the ramifications will be huge if they follow suit. No surprise then that wheat futures prices are at their highest level in two years. “Hold on tight, wheat market volatility will continue. We expect wide price swings to materialise as the market adjusts to the loss of Black Sea wheat supplies,” says Alexander Bos, commodities analyst at Macquarie Bank.

The Russian draught “is very much an ongoing situation, it has by no means been resolved yet,” says Sudakshina Unninkrishnan, analyst at Barclays Capital. She adds that it has yet to be seen how much the dry weather will reduce Russian exports. In 2008, however, other major producing regions such as Australia and India were affected by draught and US reserve stocks were at an historical low; none of these situations applies now.

Short-term view The short-term problem, however, is volatility. The market initially expected there would be a build up in global wheat supplies this year and “the consensus view was to be short of the market, both from a speculative perspective and a physical perspective. As production setbacks were realised, both trade and fund shorts began to cover their positions while at the same time new speculative long positions were being established as news of severe production issues developed. The result has created an extremely volatile market for wheat prices and it has caught many consumers, end users and traders by surprise,”says Luke Chandler, analyst at Rabobank.

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

ĂŶĂůLJƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

IN THE MARKETS

GRAINS: HIGH PRICES, UNCERTAIN OUTLOOK

Once the tightness caused by shortage of Russian supplies is resolved wheat prices are likely to start declining, analysts think. Macquarie Bank, for one, maintains a neutral view of the global wheat market for this year arguing that exportable supplies in the five major exporting countries, US, Canada, Australia, Argentina and Europe, should be adequate to meet demand even after the shortfall in exports from Russia, Ukraine and Kazakhstan.

Not all areas are affected equally.

Jacques Taylor, the head of Standard Bank’s agriculture business in Africa, explains: “Most of the grains that are produced in South Africa are either sold locally or to countries in Sub-Saharan Africa.” Taylor has other concerns: “One of the biggest problems for financing is the lack of a price discovery mechanism.

We still use CBOT as the reference price.”

Currently, CBOT wheat and rice futures are the only grain products settled off Globex, the CME Group’s all encompassing trading platform. There are rumours, unsubstantiated, that CME might change the way grain futures prices are settled, though a CME spokesman declined to answer questions about the rumour. Although the vast majority of all CBOT grain futures volume is traded electronically, settlement prices for corn and soybeans are still established in the pit. The exchange floated a proposal last November to tie settlements for some deferred corn and soy complex contracts to Globex, but shelved the plan a week later, according to US press reports.

The effect of high grain prices is already spilling over into other grain markets such as corn and soybean.

This is in part because corn can be substituted for wheat in animal feed and also from speculative trading, as funds that invest in agricultural commodities frequently peg their investment to commodities indexes and those lump grains together, so increased exposure to wheat results to higher positions in corn, soybean and potentially other grains such as rice and barley. I

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GALTERE’S PRIVATE EQUITY VIEW Investor approaches to agribusiness have varied over time. A favourite method of accessing the growth potential in the sector (aside from grain futures) to opt for single agricultural commodity ETFs. Most recently, however, there has been a game change: with Middle East sovereign wealth funds, for example, buying into agricultural projects outright. Latterly, private equity based investments are also growing in popularity. In early September, former Deutsche Bank executive Renatto Barbieri announced he was heading a specialist core management team to harness opportunities in the agri-sector. altere, a US-registered investment manager with approximately $1bn in assets under management (AUM), has launched an agribusiness private equity strategy that aims to take advantage of growing worldwide demand for commodities from institutional investors.

The firm will make direct investments in industrial scale commodity production facilities in Brazil, Uruguay and Australia, taking a long-term (seven year) position, before monetising its investments via trade sales or public offerings.

The first will concentrate on investments in agricultural production, infrastructure and technology and will be looking at opportunities across soft commodity food staples.

The firm specialises in commoditybased global macro strategies and claims that it differentiates itself from other macro strategies through its theme-based discretionary approach, “combined with systematic entry, exit and risk control”. Galtere’s flagship strategy identifies three to five major multiyear global themes, and chooses around 35 individual positions with a one-year investment horizon. This latest fund has a much longer investment horizon. Galtere is aiming to raise $1bn of assets from institutions, endowments and family offices wanting to invest in the new fund. Renee Haugerud, managing principal of Galtere, explains the rationale: “We see demand for

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commodities growing constantly.

Increasing populations, falling arable land space and the demand for wheat based biofuels to meet carbon reduction targets are all central drivers of this demand.”

Portfolio manager Renatto Barbieri, who previously spearheaded the development of Deutsche Bank Global Markets’ natural resource private equity business, will lead the investment team. His investment approach aims to capitalise on a market trend the firm has termed inverse stagflation, where deflation in financial assets such as equities coincides with inflation in real assets, such as agricultural commodities.

Galtere believes that the trend will see real assets become the dominant asset class in the near future, and hopes to seize on the expected pricing growth in commodities.”We have always advocated a long-term view on commodities markets, rather than reacting to short-term changes, and this is an ideal strategy for investors who share that view,” holds Barbieri. “In the aftermath of the recession, we found ourselves in a new investment landscape; one that we feel is extremely favourable to commodities investors. We believe that inverse stagflation will see the investment world move away from financial assets towards physical, real world assets such as agricultural commodities,” adds Haugerud.

OCTOBER 2010 • FTSE GLOBAL MARKETS

Equally weighted Introducing the FTSE/JSE Equally Weighted Top 40 index The Johannesburg Stock Exchange (JSE) together with global partner FTSE Group, have launched the FTSE/JSE Equally Weighted Top 40 Index as an alternative to indices weighted by market capitalisation.

Joining the existing FTSE/JSE Index Series, this independent and publicly available index serves as a benchmark for measuring performance, other than peer group performance, particularly for equity portfolios or funds achieving risk diversification. Compliant with current legislation, it measures its constituents' price characteristics.

The new index is the first of its kind to be launched in South Africa within the FTSE/JSE Index Series, and is aimed at fund managers globally, as well as other professional investors, traders and banking institutions. In being an alternative, it affords greater risk diversification and enhanced performance benchmarking.

More about the FTSE/JSE Equally Weighted Top 40 Index: • It comprises the JSE's largest 40 companies • All constituent companies have the same weighting (unlike the FTSE/JSE Top 40 Index) • A company's importance in the index does not depend on its market capitalisation • It assumes the same rules for construction (quarterly index reviews, eligibility, price data) • A range of daily data services is available

WHODUNNIT? | 09 2010

For more on the FTSE/JSE Equally Weighted Top 40 Index, contact the JSE on +27 11 520 7019, infoproductsales@jse.co.za or visit www.jse.co.za.

JOHANNESBURG STOCK EXCHANGE

IN THE MARKETS

RABOBANK: LONG BONDS AND TRADE FINANCING

Armed with a business strategy that involves raising Asian income by at least 50% over the next three years Rabobank has embarked on a number of initiatives with leading Asian financial institutions over the first half of this year. Business build across Asia can be expensive, but Rabobank is carving out growth through an innovative mix of joint initiatives and a specialisation in financing agricultural trade. Lucky then that the Dutch bank, which is now the world’s leading agricultural lender stole a march in mid September with a ground-breaking $350m 100 year bond.

REDEFINING A LONG TERM OUTLOOK GRIBUSINESS AND TRADE finance specialist Rabobank beat expectations in mid September with a $350m worth of 100 year senior bonds, at a virtual knock down price of 5.8%. The transaction set two firsts: the first 100-year senior bond offering by a bank and the lowest yield for a security of that maturity. Twelve investors from Asia, the US and Europe contributed funds to the facility, which was increased by $100m following soundings over the level of investor demand.

Lead managed by Goldman Sachs and Credit Suisse, the deal had particular appeal to pension funds and insurance companies looking for long dated investments; moreover the current low rate of interest increased its attractiveness.

In the event, some 12 investors were reported by the bank to have bought into the issue. Triple A-rated Rabobank on the other hand, on the basis of its strong credit rating, is benefiting from being able to borrow money at historically low levels. Rabobank joins a thin list of 100 year bond issuers, including IBM, Ford Motor Company, Motorola and, most recently railway specialist Norfolk Southern Corporation.

The bonds, which mature in 2110, sold at par to yield 5.8%, at a risk premium of 200 basis points, or 2

A

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percentage points over 30-year Treasury bond, itself at historic low; though according to Morningstar the average 30 year Treasury yield over the past 20 years is at 5.83%, thereby putting the Rabobank pricing into a new context.

The bank is not a stranger to the long bond market, having issued a 50 bond last summer. More recently, the bank’s Australian unit launched an AUD300m increase to its 2013 bond line, which comprises AUD350m of 6% fixed rate notes and AUD700m of floating rate notes. Joint lead managers in the offer are Commonwealth Bank of Australia and Westpac Banking Corp., with BNP Paribas acting as co-manager.

Rabobank is on something of a roll right now; with a firm growth strategy based on its expertise in agricultural finance, an increasingly popular financing segment for institutions heavily focused on leveraging emerging market growth and rising consumer demand. In June this year the bank announced that it had signed a memorandum of understanding with Agricultural Bank of China (ABC), in which Rabobank will provide technical support and training to ABC personnel in the segments of trade finance, leasing and rural banking. The bank will also help finance the expansion of Chinese food businesses overseas. To underscore its

commitment to building its trade and corporate finance business in Asia, Rabobank was a substantial investor in ABC’s $22.1bn initial public offering (please see FTSE Global Markets, issue 44, page 81).

Although Asia represents only 5% of the bank’s business book, its Asian clients are almost entirely in the food and agricultural sector, playing to one of the bank’s key strengths. It is natural therefore that the bank would expect to be able to leverage Asia’s near term growth potential.

Moreover, increasingly food security is the trend du jour among expert emerging market investors. Abu Dhabi’s and Qatar’s sovereign funds, for example, have been significant investors in agricultural projects throughout southern Asia of late.

Rabobank has less of a strategic superstructure, preferring instead to develop a specialisation in the food processing segment and corporate M&A opportunities. Moreover, it is not confining its Asian business build only to China. Earlier this year the bank supported Singapore’s Wilmar International’s bid for Australian sugar manufacturer Sucrogen, in a deal worth $1.5bn, and the bank has been heavily involved in agribusiness projects in Latin America as well.

Because of the historical links between the Netherlands and Indonesia, the bank has already a substantial branch network throughout Indonesia (with some 90 or so branches). Now Rabobank is keen to add to that infrastructure with branches in India and China. So far its efforts in India have been concentrated in the non-finance segment, running specialist agricultural consultancy Rabo India Finance. Strict rules in India on foreign ownership limits in local firms have so far been a curbing influence on the bank in the country. I

OCTOBER 2010 • FTSE GLOBAL MARKETS

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BANK PROFILE

GULF BANK: RETURNING FROM THE BRINK

BACK TO BLACK In August 2009, Gulf Bank named Michel Accad, a highlyexperienced banker who most recently had worked at Jordan’s Arab Bank, as its new chief executive officer and chief general manager. Accad joined with a substantive task-list, to return the bank to high growth rates and to upgrade Gulf Bank’s loan and investment portfolio following a testing period when the bank had run into difficulties because of the runaway risks taken by some of its clients in the derivatives markets back in 2008.

Francesca Carnevale talks with Accad about his successes to date and the remaining challenges ahead.

ICHEL ACCAD, GULF Bank’s urbane talks fast and acts fast.

He has had to. Tasked with simultaneously taking Gulf Bank into sustainable and rising profits and upgrading the bank’s loan and investment portfolio, his actions have had to match the rhetoric. It looks like so far, so good.

By July Gulf Bank was tabling a a notable improvement in its operating profit for the first half of this year, amounting to KWD87.1m (just under $304m) compared to KD51.1m in the first half of 2009, an increase of some 70%; some KD22m of this operating profit came from the disposal of part of the international investment portfolio. In the results release at the time, the bank noted that according to its conservative policy: “most of this profit was retained to meet the provisions for the risk of credit facilities portfolio”.

Ultimately, Gulf Bank posted KWD2m in net profit for the first half year, compared with a loss of KWD7.5m over the same period a year earlier.

“The Bank’s provisional requirements up to end of June 2010 have been provided for,”notes Accad: “and we are hopeful that the forthcoming periods will witness an improvement in the net profit, which is of course, in part, dependent on the economic situation,”he adds.

While modest by global bank standards, Gulf Bank under Accad has had something of a remarkable turnaround. Only two years ago, the bank reported a net loss of KD359.5m

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Michel Accad, chief executive officer and chief general manager of Gulf Bank. “When you come in as new management, it is easier to draw a line under the past, take decisions that might have been too difficult for any previous administration to take and face up to the problems,” he concedes. Photograph kindly supplied by Gulf Bank, September 2010.

(well over $1bn) for the 2008 financial year, mainly due to exceptional losses in derivative transactions, but also from losses on its investment and loan portfolios relating to the global financial meltdown. In January 2009 the Bank successfully raised KD376m as share capital and share premium in a right

offering to existing shareholders with the unsubscribed portion of 16% taken up by Kuwait Investment Authority (KIA), which still retains its shareholding in the bank. It was a shocker, concedes Accad.“When you have lost over a $1bn, there’s not much further to fall. The bank, fuelled by the recapitalisation exercise, approached 2009 as a year of rebuilding,” he explains. In addition to the Bank’s re-capitalisation in January of last year, by April 11th, the bank’s shareholders had elected a new board of directors to execute a new business development plan, and enhance the control and guidance rules in the bank.

Accad was hired as part of that strategy.

“We realised the quality of the bank’s credit book was not great, and the business environment was not exactly working in our favour. However, when you come in as new management, it is easier to draw a line under the past, take decisions that might have been too difficult for any previous administration to take and face up to the problems,”he concedes. “We took the view that we would have to make some aggressive provisioning. In addition, the bank embarked on a revisionist programme, which involved overhauling internal processes,” he adds.

The bank began to identify and implement ‘best practices’ throughout the organisation, defining every business by ‘customer driven’ priorities’. The second element was to reverse a pattern of underinvestment in the bank’s technology, branch network and staff training. More importantly, perhaps, the bank moved to shore up its risk management approaches, to reassure both shareholders and account holders.

Credit risk, market risk and operating risk and internal control processes remain tightly monitored, notes Accad.

In May this year Gulf Bank finalised an agreement for purchase and implementation of an Enterprise-Wide

OCTOBER 2010 • FTSE GLOBAL MARKETS

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BANK PROFILE

GULF BANK: RETURNING FROM THE BRINK

Risk Management System from SunGard.

Gulf Bank now uses the system for four separate risk management streams: capital computation under Basel II for credit, market and operational risks, asset liability management (ALM) and funds transfer pricing (FTP), market risk management, which covers the banking and trading books and operational risk management. The moves to upgrade the bank’s internal processes have earned it accolades from both JP Morgan and Citi, which have recently awarded the bank special citations for the efficiency and professionalism of its letters of credit and bank transfer businesses.

Part of its ability to effect a turnaround holds Accad, is the fact that technology aside, the bank adopted a focused strategy: disavowing the temptations of fund management and investment banking, and focusing instead on the bank’s retail network, which allowed it to provide customers with its particular expertise in retail services, such as fund distribution.

“We quickly came to understand our strength in fund distribution, as opposed to fund manufacture, for instance. We had no capacity to manufacture new funds and were averse to entering new markets. With these considerations in mind, the strategy made the best sense,” Accad explains.

Kuwaiti domestic market In no small part, the strategy was prescribed by the vagaries of the Kuwaiti domestic investment market.“Often the subject of irrational exuberance, Kuwait’s investment market is very shallow,” concedes Accad, consisting mainly, he explains, of the stock market and real estate investments. In this regard, high value customer services along a tightly controlled product set, was a clear and distinctive market-focused approach. It also produced rapid results. In the event the bank managed to announce operating profits of KD83m for 2009.

However, provisions requirements of KD111m for the credit portfolio led to a net loss of KD28m for the year.

The same approach is extant in the 2010-2011 business period, suggests

28

Accad.“We are still focused on our core competencies, which are rooted in both retail and commercial banking services.

The government has announced a substantial project finance programme and our model dovetails nicely into that opportunity,”he adds. Even so, the bank has not forgotten the recent past and in consequence, any lending is supported by what Accad terms:“a fortress balance sheet, which is supported by aggressive provisioning, isolation of the ‘bad’ bank from the ‘good’ bank, and properly rewarding management for good decision making and building new business lines.”

“Superior customer service must now be our differentiating factor,” holds Accad. The future, he says, is beginning to look much brighter. “We’ve got the full support of the board behind our business model, and we have secured a budget range of some $30m in our investment in technology across the bank. Moreover, we now have in place at least 60 fully trained corporate relationship managers in place in the domestic market; about half of whom are dedicated to managing complex or structuring situations, and half dedicated to bringing in new business from existing or new corporate clients.”

The bank has also recently enjoyed some unexpected wins, which have helped the turnaround. Accad explains that the bank had some investments in the Paulson hedge fund,“which worked for us, and which gave us an extraordinary item worth some KWD14m.

That helped us be a little bit more aggressive on provisioning, shoring up our position earlier than we might have otherwise been able to do.”Then in May this year Fitch Ratings, upgraded Gulf Bank’s individual ratings to ‘D/E’ from ‘F’.

The Bank’s other ratings were affirmed at Long-term Issuer Default (IDR) ‘A+’, Short-term IDR ‘F1’, Support ‘1’ and Support Rating Floor ‘A+’, with a stable long term outlook. “Gulf Bank is the first bank in the GCC to get an upgrade since 2009,”notes Accad adding: “The upgrade our ratings reflects the improvements in risk management systems and controls combined with our progress in

strengthening the balance sheet and a greater focus on our core business activities. It was an important signal that our strategy is working.”

Despite the turnaround Accad allows that while Gulf Bank is out of intensive care, it is still in recovery mode.“It is by no means a situation that can be described as business as usual,”he says.

“It is at least a two year recovery plan and with that in mind, in the immediate term at the very least, we have no intention of looking for expansion abroad. Now that might change by the end of 2011, by which time we intend to have the appropriate capital and liquidity position to allow us either to look abroad for an investment, or at home. We might, for example, work on building an Islamic compliant brand or expanding our investment banking capabilities.

Although my own feeling is that a good international move makes sense.”

Competitive drivers Gulf Bank is in no rush, says Accad. In part that is because of the relatively stability of the Kuwaiti market in terms of competition. “Foreign banks remain restricted to a one branch operation; so that means we are very familiar with our domestic market competitors.”

Funding of small and medium sized enterprises, the contracting sector and trade are the immediate areas of business growth, says Accad, who acknowledges that these are areas were the bank is “ramping out and building out as part of the new growth strategy.”

It is also unlikely that the bank will come to market in search of funds for its normal business requirements in the foreseeable future.“We have more than enough liquidity and we remain comfortable in our debt maturity profile and the bank’s capital ratio, at 16%, remains comfortable and adequate for our future organic growth requirements,” notes Accad. “We have come out of a very dark period; we have fought out way out of a crisis situation and with a strong management team in place have begun to rebuild the bank’s future and prospects.

It’s been a hard won fight; but worth it.”I

OCTOBER 2010 • FTSE GLOBAL MARKETS

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COUNTRY REPORT

TURKEY: OUTPERFORMING EXPECTATIONS, BUT FOR HOW LONG?

Turkey’s country classification was changed in late September from secondary emerging to advanced emerging status by index provider FTSE Group. The amendment reflects Turkey’s advancement in recent years along the spectrum of capital markets diversification, an increasingly rigorous regulatory infrastructure and consistent economic credentials. Moreover, the political environment is stable; with a recent much vaunted referendum on constitutional reforms receiving substantial voter support. What now for the country?

Photograph © Murat Cokeker / Dreamstime.com, September 2010.

THE ROCK & ROLL ECONOMY URKEY’S ECONOMY CONTINUES to outperform; buoyed by a faster than expected economic recovery fuelled by rising domestic demand and continued compression in long term interest rates, which continue at historical lows, combined with an improving inflation outlook. According to a spokesman at Is Investment,“Turkey has been a major beneficiary of the rally in global markets over the last eighteen months. The stock exchange index has outperformed global markets with a wide margin thanks to a sharp cyclical economic recovery, and strong earnings performance of banking shares.

Moreover, the bond market has seen record low yields on the back of a declining budget deficit, lower rollover requirements and massive rate-cuts by

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the central bank. The billion dollar question now is whether Turkey can extend its current rally through to the end of 2010.”

In the second quarter (Q2) of the year GDP accelerated to 10.3% on an annualised basis, according to economic reports by both Nomura and Yapi Kredi and 3.7% quarter on sequential quarter.

Even so, Nomura thinks that the sustainability of Turkey’s economic performance is not necessarily clear cut.

“This very rapid jump in GDP growth, takes Turkey out of the dip, with seasonal and working-day adjusted GDP reaching the same peak as in Q1 2008,” says Nomura analyst Olgay Buyukkayali in London, adding: “We have been suggesting for a while the upside risks to our full-year growth forecast. Following

the Q2 GDP release, we have revised our GDP forecast to 5.9% for 2010. This implies a growth rate of 3.9% year on year for Q3 and a slowdown in growth lasting one quarter of 0.8% in Q4. For 2011, we still forecast 4.4% growth.”

“Arguably,” notes Buyukkayali, explaining that: “there are still upside risks to our 2010 forecast. Nevertheless, the way in which the current recovery resembles historical patterns, also makes us question its sustainability, though monetary and fiscal policy remain somewhat stimulative. Net imports, inventories and private consumption have once again driven the recovery.”

Nonetheless, a continuing strong banking segment; low household leverage and a helpfully buoyant stock exchange, inevitably add to the general air of positivity in the country’s capital markets.

The Istanbul Stock Exchange has been a bellwether of Turkey’s recent economic expansion; and following a fallow period in the middle of the decade, it has now sprouted wings and adopted a more inclusive and expansive growth strategy.

Amid a plethora of initiatives over the last two years, including the establishment

OCTOBER 2010 • FTSE GLOBAL MARKETS

COUNTRY REPORT

TURKEY: OUTPERFORMING EXPECTATIONS, BUT FOR HOW LONG?

of an Emerging Companies Market, the exchange has now improved the timbre of exchange trading rules, and will move to allow the cancellation of orders on the exchange by the end of October at the latest. Until now, orders can only be amended in one direction (upward); whereas by the end of the month, orders can be either amended downwards or cancelled altogether. The change means that the exchange can move ahead with encouraging the widespread adoption of electronic trading in Turkey.

The move is also significant in that it comes at a time when the financial markets regulator, the Turkish Capital Markets Board, appears keen to establish an internal regulatory structure that is closely in tune with the wider European financial landscape. Being MiFID compliant is now de rigueur in Turkish trading circles. The introduction of order cancellation on the ISE comes as the government seeks to make amendments to the Turkish Capital Markets Law, which governs all aspects of trade in

the country, to bring it into line with regulatory developments in Europe such as MiFID. In this regard, the regulator is also looking at opening the market to high frequency trading, though no concrete announcements have been made up to now.

In July, the ISE announced that it had decided to list TRY20m worth of warrants

by Deutsche Bank via its Turkish subsidiary Deutsche Securities Istanbul (DSI), which is also acting as market maker for the securities. The warrants will be listed in batches over a twelve month period and will be traded on the Corporate Products Market. UniCredit and TSKB are expected to follow suit.

The referendum effect The much awaited referendum on constitutional reforms was held in mid September. With nearly all of the votes counted, almost 60% of voters supported the package of constitutional changes backed by the government, while 40% voted against it, on a 77% turnout of

the eligible electorate. The outcome was much stronger than that suggested by a number of opinion surveys conducted prior to the referendum, with most political watchers predicting only marginal support of the amendments.

It has to be noted that the outcome of the referendum was a clear indication that the majority of the Turkish population is increasingly acquiescent to the growing presence of overt religious conservatism in daily life. Certainly, the constitutional changes are far-reaching.

The key amendments include changes to the way that the Turkish judiciary, including the Supreme Board of Judges and Prosecutors (HSKY) are elected; strengthening of equality and childrenâ&#x20AC;&#x2122;s rights; the right to membership of more than one labour union; the right of military court decisions to be appealed and making military personnel accountable to civilian courts; the right of lawmakers to remain in Parliament even if their party is banned from politics by the Supreme Court.

Turkey main investment market indicators December 2008 317 119,698 16.9%

December 2009 315 235,996 38.21%

May 2010 322 238,735 38.6%**

Investors Deposit Balance (% of Total) Foreign Domestic

67.5 32.5

67.3 32.7

65.2 34.8

Number of open mutual accounts Number of pension funds participants

2,938,904 1,859,824

2,998,648 2,141,287

2,950,726 2,249,015

145 104 41

144 103 41

144 103 41

Investment Funds NAV* Mutual Funds NAV ($m) Pension Funds NAV ($m) Foreign Funds NAV ($m)

19,776 15,768 3,973 35

26,086 19,921 6,126 39

25,518 19,031 6,451 36

Investment Trusts NAV ($m) Real Estate Investment Trusts NAV ($m) Venture Capital Investment Trusts NAV ($m) Number of Portfolio Management Companies Portfolio value of Portfolio Management Companies ($m)

364 2,808 90 23 20,213

479 3,172 103 23 26,694

443 3,089 102 23 25,447

Number of ISE Companies Market capitalisation of ISE companies ($m) Market capitalisation as a % of GDP

Intermediary institutions Brokerage Firms Banks

*NAV: Net Asset Value; **GDP as of December 2009.

32

Source: Turkish Capital Markets Bulletin, supplied August 2010.

OCTOBER 2010 â&#x20AC;˘ FTSE GLOBAL MARKETS

COUNTRY REPORT

TURKEY: OUTPERFORMING EXPECTATIONS, BUT FOR HOW LONG?

Turkey's relatively prosperous European Thrace region and coastal territories along the Aegean and the Mediterranean voted decisively against the amendments. Moreover, Kurdishdominated south-eastern Turkey responded to calls by the pro-Kurdish Peace and Democracy Party to boycott the vote, reflecting continuing tensions between Kurdish nationalists and the Turkish state; a fact that is not likely to change under the current administration.

However, there are hints of larger developments in play. While most of the 26 articles to be amended in the plebiscite had broad support; some of the changes are seen by staunch secularists in Turkey as a threat; particularly those amendments which limit the powers of the judiciary and the military, which are regarded as reliable guardians of the secular legacy of Ataturk. The fact that the referendum garnered substantial support also points to the likelihood that the pro-business ruling AKP is set to win a third consecutive general next year and could form a single party government. The success of the referendum might even encourage the current government administration to establish a powerful French-style presidential system of government under a new civilian constitution. If so, it would divert power away from the parliament into the hands of the president, thereby changing the political structure in the country entirely, with as yet unpredictable consequences.

The government has enjoyed substantial popularity, largely on the basis of improving living standards across the board for the country’s 73m strong population. Moreover, Turkish households have proved to be fiscally conservative, with a low level of household debt; though consumer lending is on the rise. Historically underbanked, Turkish households and corporations now have a bewildering array of lenders, both local and foreign that are active in the market and with interest rates at historical low levels, the opportunities for new borrowing opportunities are plentiful.

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Historically under-banked, Turkish households and corporations now have a bewildering array of lenders, both local and foreign that are active in the market and with interest rates at historical low levels, the opportunities for new borrowing opportunities are plentiful.

With that in mind, the country’s banks expect to continue to sustain earnings momentum; although the pace of growth could begin to slow in 2011, say foreign banking analysts, as asset quality comes under strain. At first glance, the deterioration in asset quality is beginning to bite, if only as yet in some institutions.

Turkey’s largest financial houses remain, for the short term at least, inured.

Improved loan collections As a segment, the country’s banks generally report that loan collection rates have improved, as interest rates remain at a very manageable 7% in a high growth environment. As templates for the wider trend, Turkiye Garanti, reported second-quarter profit gains of 20% as the company cut provisions and collected more non-performing loans, while net income increased to TRY919.9m (around $613m), up 16.8% compared with the second quarter of 2009. Provisions for losses on loans and other receivables fell 84% compared to the second quarter of 2009 to TRY79.6m.

Income from other operations, which includes non- performing loan collection, surged more than six-fold to 161.4m.

Equally, Yapi Kredi, which is partowned by Italy’s UniCredit, reported a 28% uptick in second quarter profit, more than expected, again because of improved non performing loan collections. However, the signs of a small wind-change are apparent with Vakifbank, the state owned bank with substantial market share in the small to medium sized company segment. In a release filed at the stock exchange, the bank reported that profit in the second quarter fell as the bank set aside more provisions for loan losses. Net income at the Ankara-headquartered bank dropped to TRY234.6m in the three

months to June from TRY300.8m in the same period of last year.

Despite some credit worsening, one of the problems in Turkey remains the limited routes to market for corporate raising finance. The stock exchange is one source, and now with a fully functional smaller company platform, it has provided a useful fillip to the corporate finance market. However, the domestic bond market is still dominated by Treasury issues. Only five companies raised new money via bond issues in the first half of this year, raising a modest combined total of $188m. Moreover, for the time being, the value of securities in the local corporate bond market remain are too small for any meaningful secondary bond market to develop. That could change if the regulator opens up the domestic bond markets to Turkish banks.

Any signs of diversification in the fund raising market still look set to come from the international loan market for the time being. A clear example was set by the $100m sukuk arranged by both Citi and Liquidity Management House, a subsidiary of Kuwait Finance House (KFH) for Kuveyt Turk Katilim Bankasi, which it itself owned by KFH. The three year facility pays a coupon of 5.25%.

The Capital Markets Board has however opened up the possibility of Turkish banks raising funds via sukuk in late April this year.

Undoubtedly, the Turkish banking segment is poised for substantial evolution on the back of financial reforms which could redraw the market as a major regional financial hub over the long term. For that to happen however, the government has to press ahead with a slew of reforms that will open up the market to competition and deepen the range of securities available to local and foreign investors. I

OCTOBER 2010 • FTSE GLOBAL MARKETS

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COUNTRY REPORT

AKBANK SETS THE PACE IN TURKISH NON-SOVEREIGN ISSUES

THE NEW JACKPOT In terms of accessing the capital markets, Turkey’s Akbank set a blistering pace through the summer months. In July, the bank sold a $1bn five year Eurobond at 350bp over US Treasuries, in a landmark transaction which will likely open the floodgates for other big ticket issues from Turkish banks. Not content with setting one benchmark, the bank opted for another; finalising the first diversified payments rights (DPR) securitisation for at least a year. What should the markets expect next from Turkey’s principal banks? Francesca Carnevale reports.

OLLOWING THE RECEIPT of permission from Turkey’s capital markets supervisory board, in late July, Akbank came to market with a $1bn senior unsecured Eurobond, offering a yield of 5.256% and a coupon of 5.125%, maturing in 2015. Bank of America Merrill Lynch, Citi, JP Morgan and Standard Chartered Bank were among the principal issue managers.

The transaction was the first direct bond issue from a Turkish private sector borrower. It is a significant turn in a market in which banks have tended to approach the syndicated loan market for short term, usually up to one year, to help finance local exporters.

Akbank’s Eurobond now opens up a world of possibilities for Turkish bank borrowers and a host of more diversified funding structures have now been made much more likely. It is not really about the singularity of the Eurobond, though that in itself has significance. After all, Bank Pozitif raised a modest five year bond worth $150m last year, via Commerzbank; though that was structured as loan participation notes. More important perhaps, Akbank’s deal set another key benchmark: it was the largest security ever sold by a Turkish issuer, excepting sovereign issues. Moreover, it was priced with the lowest ever coupon for a non-sovereign Turkish issuer.

Although Yapi Kredi came to market in April with a total of $1bn of syndicated loans in April, the loans were in two

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separate transactions: one worth $324m and the second $691m, with a tenor of one year; and therefore not comparable with Akbank’s feat. In comparison too, Yapi Kredi’s all-in cost came in at 1.5 percentage points above benchmark rates; a level which Akbank had set in its March 2010 dual currency, dual tenor facility worth $1.2bn.

The sovereign itself achieved its own benchmark the previous month with $1bn of 11-year dollar bonds at 2.03 percentage points above 10-year US Treasury bonds on March 12th its lowest yield on record year to date. However, having raised some $5.4bn in funds so far this year the sovereign is unlikely to come to market again this year.

New regulations Ironically, Akbank’s Eurobond comes at a time when changes to local financial regulations have imposed a 10% withholding tax on directly issued bonds.

That may possibly subdue an expected landslide of similar issues through to year end while the government reviews the efficacy of the move; which it may have to do if it undermines its efforts to establish Turkey as a regional financial hub. There is no withholding tax charged on syndicated loans; a factor that underscores their popularity among bank issuers. Even so, in Akbank’s transaction, the bank has agreed to pay the withholding tax on coupons.

“The bank has a great story,” says Hülya Kefeli, executive vice president,

head of international banking at Akbank.

“Akbank keeps its reliance on wholesale funding at around 10% of its total funding. As well, the bank’s nonperforming loan ratio (of 2.9%) is well below the sector’s (4.9%) average and profits have been strong. With all this in the mind of investors, we ended up at the tighter end of the initial guidance pricing range. Demand was strong, with 165 investors in the transaction and outstripped availability, with the order book totalling $3bn. In the end the allocations were made to long term investors. The initial price came in at 99.431, though following the issuance its price has seen levels around 102.25, giving a yield of 4.70%.” Currently, the bond trades around the issuance price.

Some 45% of the deal went to US investors, 24% to UK based investors, 17% to other European investors, 9% to Swiss investors and Asian investors bought up 3%. As to the type of investors in the deal: Kefeli says that asset managers took the bulk (56%), hedge funds account for 18%, private banks 11%, other banks 8% and institutional and private offices 7%.

The scarcity of Turkish risk, especially at non-sovereign level, helped.“It was a useful window,” cedes Kefeli. “The government had by then completed its borrowing for the year. Moreover, concerns over Greece had begun to subside by that point and that obviously helped with the outcome,” she states.

“Investors were also attracted by Akbank’s strong position in the Turkish banking sector.” Akbank is majority owned by Sabanci Holding and the Sabanci family, with Susan Suzan Sabanci Dincer being the chairman. Citigroup owns 20% of the bank and 28.6% is in free float, listed on the Istanbul Stock Exchange. “Citi’s stake in the bank helped, no doubt about it,” says Kefeli. “Overall it was a great experience for us, which we will bring to bear in future offerings.”

OCTOBER 2010 • FTSE GLOBAL MARKETS

One month later, Akbank came to market again, securing the first diversified payments rights (DPR) securitisation concluded in the EMEA region over the last twelvemonth period.

Akbank’s deal was executed under its securitisation programme, which is backed by foreign export receivables, cheques and foreign exchange transfers totals $860m, of which $300m is new funding and $560m is refinancing of existing loans. The special purpose vehicle through which funds are channelled is based in Jersey. The taxation rules have changed here also, notes Kefeli, with 1% withholding tax on the international payments.

The new funding portion was arranged by a group of lead managers including Standard Chartered, WestLB, Wells Fargo, the European Investment Bank and the International Finance Corporation, the private sector funding arm of the World Bank.“We secured better terms with the new funding portion, compared to the market and with a longer maturity. We have improved the costs through refinancing part of our current securitisation loans,” holds Kefeli, explaining that: “Extending the maturity of the liabilities to achieve a healthier balance sheet structure is critical in terms of effective risk management. We were pleased we were able to access longer term finance and to come to market at a time when it appropriate to do a re-tap for the remaining portion.” At least half of the funds will be on-lent to Turkish small and medium sized enterprises (SMEs). “The element we were really pleased about in this deal was the participation of the IFC and the EIB,” she adds. The market is 300 basis points above benchmark for the five year securitisation,”though Akbank’s actual spread in this new issuance is lower than that, closer to the level of two year syndications,”holds Kefeli.

More or less simultaneously, the bank also secured a €1bn equivalent, dual tenor dual currency term loan facility. Worth approximately €780m has a one year tenor at Libor/Euribor + 1.30% and €220 m is a two year loan at Libor/Euribor + 1.75%,

FTSE GLOBAL MARKETS • OCTOBER 2010

Hülya Kefeli, executive vice president, head of international banking at Akbank. Photograph kindly supplied by Akbank, September 2010.

For the time being, Akbank can rightly rest on its laurels for the feat of raising substantial sums, at good terms over longer tenors; illustrating how far Turkey’s banks have remained resilient in the post financial crisis period. thereby extending the bank’s ability to secure financing of this type over a longer maturity; a move that Kefeli thinks other Turkish banks will follow. This latest deal, which was structured as a club deal, also widened the range of investors in Akbank risk, with a preponderance of Middle Eastern investors involved in the transaction, from countries as diverse as Lebanon, Jordan, Bahrain and Oman; a feature “helped by Akbank’s new office in Dubai,”says Kefeli. In March, Akbank had secured $1.2bn with a 1 year dual currency syndicated loan with tranches of €584.5m and $437m and all-in cost above 1.5 percentage points above the benchmark rates. With the participation of 55 banks from 21 countries, the loan had attracted the highest number of participating banks in the EMEA region and “Akbank had achieved significant

success by realising a roll-over rate of over 200%,”notes Kefeli. With these loans, Akbank has secured almost $2.5bn from the syndicated loan market in 2010. In both these facilities, Akbank achieved a reduction in cost and set benchmark pricing which inevitably benefited other Turkish banks.

Akbank’s summer borrowing spree comes at a time of potentially substantive change in the Turkish capital market. The country’s banking regulator, the Banking Regulation and Supervision Agency (BDDK) has announced that it is near to deciding how local banks can issue Turkish lira denominated corporate bonds, that can be sold to both Turkish and foreign investors. As Akbank’s issues illustrate the best means of providing bank liquidity in Turkey is to secure medium to long term financing at good rates. Backed by a strong national economic performance, Turkey’s banks now have the opportunity to borrow substantial funds at longer maturities and heighten the stability of their already conservative loan books.

Akbank itself said in June it may issue a lira-denominated corporate bond if given a green light by regulators, and Kefeli acknowledges the increased flexibility such a move would bring to the Turkish banking segment, as well as providing a boost for the local capital markets.

For the time being, Akbank can rightly rest on its laurels for the feat of raising substantial sums, at good terms over longer tenors; illustrating how far Turkey’s banks have remained resilient in the post financial crisis period. The most recent issue to tap the market is that of Isbank, which has raised $1.2bn in a dual currency, dual tranche syndicated loan, led by German bank WestLB, with maturities of one and two years. Isbank has €1.2bn of loans maturing this year.

The bank signed $891m worth of oneyear loans in a dual tranche, dual currency facility in May this year, which carries an all-in cost of 150 basis points above benchmark rates. It is unlikely however, that any other Turkish bank will be able to mirror Akbank’s feat through the rest of 2010. Next year, it may be another story however. I

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REGIONAL REPORT

GCC BANKING: RESPONDING TO TESTING CONDITIONS

Photograph © Paul Moore / Dreamstime.com, September 2010.

THE DUAL TRACK DILEMMA Back in early 2008, buoyed by comprehensive national development plans, healthy though not ruddy carbon receipts and robust liquidity levels, Gulf Cooperation Council (GCC) country banks could look forward to an immediate future of powerful consolation as the developed world tottered on the financial brink. These days, market perceptions of the GCC banking sector are more sanguine, as continued though by no means universal, issues over asset valuations in the real estate market, continue to bite into bank profit performance. More significantly perhaps, the financial crisis has brought into full view the fact that many GCC economies are not backed by large enough populations to sustain such a large and diversified banking segment. What’s the way forward?

VEN NOW, GULF economies are suffering from their own debt mountains, which had been lovingly crafted during the boom years, and for many banks, nonperforming loans are still a fact of life. Worst hit are financial institutions in the United Arab Emirates, which have the biggest exposure to Dubai World, and in Kuwait and Bahrain, where many firms overextended themselves by investing in real estate and other illiquid assets. The GCC banking story though is a story of two halves. In the first half of the year, analysts blithely highlighted the comparison between conditions in Saudi Arabia, Abu Dhabi and Qatar on the one

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side and Kuwait, Bahrain and Dubai on the other. The argument was that the former were the stronger economies and their domestic banks were best able to leverage local economic growth and from the willingness of their respective governments to intervene, when the situation demanded it, to deal with any bad assets.

That top down analysis has not always stood water through 2010. Even so, it highlighted one fact that non performing loans were a bigger issue in some markets than others and that not all GCC markets were as equally liquid and financially endowed.

It wasn’t always this way, and the biggest shock perhaps was the hole that Bahrain sunk into. [The financial meltdown that Dubai experienced has been more than covered expertly elsewhere, and will not be revisited in this article.] Expected to continue growing at an unprecedented 20% a year as recently as 2008, Bahrain’s banks were the darling segment of the GCC financial industry. In 2008, the banking sector, buoyed by expectations of double digit growth over the medium term encouraged local banks to think they were secure enough to look at overseas investments. Local firms, Ahli United

OCTOBER 2010 • FTSE GLOBAL MARKETS

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REGIONAL REPORT

GCC BANKING: RESPONDING TO TESTING CONDITIONS

Bank (AUB) went into a venture with UK-based firm Legal and General Group, offering investment services and Shari’a-compliant insurance and Gulf Finance House kicked off Shari’a compliant investment banking operations. Foreign banks too began to look at Bahrain in earnest as an obvious base for wider GCC operations. Bank of Baroda opened an office targeting high net worth individuals and corporations, while India’s HDFC Bank began wholesale banking operations.

All were hoping to leverage the country’s strong regulatory structure, which had been carefully constructed by the Bahrain central bank, to create a Switzerland of the Gulf. Even ultra-liquid National

Bank of Abu Dhabi indicated that Bahrain was a preferred overseas location from which to build out new business and mentioned it in the same breath as Hong Kong.

Fuelled by strong oil prices (which at one point in the summer of 2008 were bringing in $2.5bn a day into the GCC) and abundant global liquidity, credit growth across the Gulf averaged a dizzying 23% a year from 2003 through 2008, according to the IMF. Unsurprisingly nonperforming loans surged to 5.4% of all loans by the end of September 2009, compared with 2.7% at the start of the year, and the volume of troubled loans is likely to remain high for some time. Two years on and the

outlook for Bahrain's banking system remains negative, reflecting continued weakness in the Bahraini real estate sector continues to exert a negative pull on the banking segment, and expectations that challenging credit and business conditions will continue over the medium term, notwithstanding the modest rebound in the economy in 2010, says Moody's Investors Service in its new Banking System Outlook on Bahrain.

Moody’s pessimism is reportedly based on the continued weakness in Bahraini and regional real estate and the impact it is having on the rest of the economy.

The negative outlook is also driven by “ongoing franchise challenges at Bahrainibased wholesale lenders, as they try to

QFC’s ASSET MANAGEMENT ASPIRATIONS n an significant step towards realising both Qatar’s and the Qatar Finance Centre’s (QFC’s) desires to become a regional hub for asset management, the QFC Regulatory Authority (QFCRA) has released a consultation paper on proposed rules to extend the QFC’s collective investment scheme regime and develop the financial and business centre into an asset management hub for the region, backed by the strong regulatory credentials provided by QFCRA. The initiative is the latest move in an effort to establish the QFC as the heart of an overarching strategy that will lead to Qatar being a substantive financial centre, based on three key specialisations. These include asset management, captive insurance and reinsurance. At the beginning of August the QFC Authority, which sets the strategy for the business and financial centre, announced that it had hired Yousuf Al-Jaida as director, Strategic Development, responsible for asset management and banking. A Qatari national, Al-Jaida most recently held the position of

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head of indirect investment at the Qatar General Retirement and Pension Authority, which included overseeing the management of hedge fund, private equity, real estate, fixed income and equity portfolio investments.

In the meantime, the proposed rules, on which further feedback is invited, continue to be published on the regulator’s website. The principal changes proposed include the operation of a non-QFC scheme, a retail regime for QFC schemes, prescriptions covering the marketing of non-QFC retail schemes and the extension of functions that can be carried out by the entity running a scheme.

Moreover, the regulator is also asking for comment on a proposal to develop specialist schemes in the QFC. The consultation period will close at the end of the third week in October. “Qatar’s asset management sector will see significant growth over the coming years as the economy of Qatar and the region continues to expand. We intend to support this growth by ensuring that we have the

appropriate regulatory structures in place to facilitate the development of the sector in the QFC in line with international best practices,” says QFCRA deputy chief executive officer Michael Ryan.

The QFC consists of a commercial arm, the QFC Authority and the regulator, the QFCRA. The QFCRA is actually an independent statutory body which supervises those firms that conduct financial services activities in or out of the QFC. Meanwhile, the QFC also has an independent judiciary which comprises a civil and commercial court and a regulatory tribunal. The QFC aims to help all licensed firms in the business centre generate new, and sustainable, revenue streams. It provides access to local and regional investment opportunities and the business of licensees can be transacted inside or outside Qatar, in local or foreign currency. QFC allows 100% ownership by foreign companies, and all profits can be remitted outside of Qatar. Firms licensed by the QFC can locate anywhere in Doha, and pay local market rents.

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REGIONAL REPORT

GCC BANKING: RESPONDING TO TESTING CONDITIONS

refocus their business towards more profitable segments; and also by the more severe challenges at investment banks, which in many cases do not possess sufficient franchise depth to cope with the sharply lower private investment activity and depressed regional asset values,” notes the report, which also assumes further deterioration in at least some aspects of Bahraini banks' franchises and risk profiles. Despite the pessimistic tone of the Moody’s report, significant positive factors remain. The strong capitalisation of most retail and wholesale banks provides significant loss-absorption capacity, and most of the retail banks have sound liquidity profiles. Moody's acknowledges that “while systemic banking risk is an issue in Bahrain, in view of the large size of the banking sector relative to the size of the economy, the regulatory authorities have shown that they are able to contain this risk,”explains George Chrysaphinis, Moody's analyst and author of the report.

Risk management is now a big topic in Bahrain; a fact reflected in Ahli United Bank’s (AUB’s) latest performance report.

The bank reported a net profit attributable to its shareholders of $135.9m for the first half of this year, compared with a profit of $143m over the same period in 2009; a 5.3% drop.

The bank had reduced its usual loan loss provision charge for the half year to a smidgen over $80m, because it noted of improved risk management measures.

“We have continued to make progress on our strategy of taking the Group to new markets and further consolidating our ownership status in existing AUB Group banks. During 2010, we have increased our stake in AUB (Egypt) to 85.1% through two tender offers which concluded in January and July respectively. We have concluded a 40% stake acquisition in United Bank for Commerce & Investment (UBCI) in Libya which opens a new market for the AUB Group. Furthermore a tender offer is currently in process to increase our stake in Commercial Bank of Iraq (CBIQ) from 49% to 60% subject to market response. These moves are all

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integral to our business model of building a stronger regional banking platform focused on meeting our clients’ cross-borders needs and delivering outstanding value to our customers across the region and beyond,”highlights Fahad Al-Rajaan, Chairman, AUB. Equally, he points out, the half year also saw the successful conversion of AUB’s 75% subsidiary, BKME, into a fullyfledged Shari’a compliant bank and its consequent rebranding as Ahli United Bank, Kuwait, with a full quarter of profitable operations under its belt in its new Shari’a compliant format.

Naturally perhaps, Bahrain’s banks are more optimistic about the medium

balance of 2010 will now be modest and 2011 is the year we expect to show real progress and success."

The reality for many Gulf based banks however is that growth rates will increasingly come from operations outside the home market; outside of Saudi Arabia, local population numbers remain thin, thereby ultimately limiting the potential at home. As Bahrain’s Arab Banking Corporation pointedly noted in its first half profit report: total operating income in the second quarter had grown 4% over the previous three month period,“driven by strong growth from our Brazilian subsidiary, treasury and retail operations.“ It’s an ill wind, as sages say, which

Bahrain’s banks are more optimistic about the medium term outlook and most have and/or are taking steps to reposition their businesses to take advantage of gradually improving market conditions at home and abroad. term outlook and most have and/or are taking steps to reposition their businesses to take advantage of gradually improving market conditions at home and abroad. Bahrain-based Gulf Finance House (GFH), for instance, announced in August that it was seeking further capitalisation of the bank through the issue of equity linked murabaha securities, worth up to $300m, ostensibly to fund acquisitions and business growth. Deutsche Bank was appointed as its structuring agent.

Cognisant of the difficulties the bank has faced with its real estate portfolio, it has appointed GFH founding director Esam Janahi as new executive chairman to help lead the bank into positive growth. According to Tom Petty, GFH’s chief executive officer: "In late 2009 and in the first half of 2010 we have taken the hard decisions to clean up our balance sheet, re-schedule our long term debt and develop a leaner operating model.

We now need to aggressively pursue new business in new markets and Esam has an enviable track record in leading such initiatives. Our losses for the

blows no-one any good. In that regard, there’s a notable divergence between those stronger GCC banks which are already beginning to report stronger earnings, while others continue to struggle with problem loans. Those stronger banks moreover do not heed traditional strong economy/weaker economy fault lines.

It has been a growing feature of the GCC banking segment since early this year and the stresses look set to remain in the system for some time to come.

Even so, all banks across the Gulf stand to benefit from improving global markets, the steady pricing of oil around the $80 per barrel market and in particular fast growing economies in the wider Middle East and North African region which are providing new opportunities at home and abroad.

A template for change and a traditionally strong bank is stalwart National Bank of Kuwait. Moody’s latest credit analysis report for the bank underscores "dominant position in domestic commercial banking", and cites “the strength and depth of NBK’s

OCTOBER 2010 • FTSE GLOBAL MARKETS

Ibrahim Dabdoub, NBK’s group chief executive officer. “The 15% net profit growth recorded by NBK in the first half of 2010 adds to the bank’s achievements and its long record of weathering different crises,” he says. Photograph kindly supplied by NBK, September 2010.

management team, the bank’s clear strategy, and strong financial metrics, particularly the resilience of its asset quality and strong profitability despite the weakening operating environment".

The ratings agency pointed out the bank’s non-performing loan ratio to gross loans had fallen to a market best of 1.76%.

With a dominant market share in the Kuwaiti market of some 30% the bank is now well positioned, suggests Moody’s to structure and underwrite large capital market transactions. Good news for a financial institution with a strong history in M&A, private equity and big ticket project finance. Ibrahim Dabdoub, NBK’s group chief executive officer, underscores the performance: “The 15% net profit growth recorded by NBK in the first half of 2010 adds to the bank’s achievements and its long record of weathering different crises. NBK’s profit generation capacity remained very strong despite the ongoing consequences of the global financial crisis, sovereign debt distress in Europe and the low interest rate environment”.

Nonetheless, NBK also concedes the growing importance of foreign

FTSE GLOBAL MARKETS • OCTOBER 2010

operations to the bottom line.“With net profit contribution in excess of 22%, NBK’s regional and international operations continue to be very successful, especially in Egypt and Qatar,”explains Dabdoub, adding that: “The bank’s successful move into the Islamic banking space through the acquisition of a strategic stake in Boubyan Bank should further enhance NBK’s domestic market position.”

Equally, Qatar, the poster child of GCC analysts, clearly defines the growing chasm between those institutions that have and those that have appreciably less. Commercial Bank of Qatar, the country’s second largest lender reported a 23% increase in second quarter profit, as it reduced funds set aside to cover loan losses. Net income rose to $112m, up 18% on the same period a year earlier.

Equally, Qatar National Bank (QNB) reported a 36% uptick in second quarter profits. In contrast, Qatar Islamic Bank, bucked a region wide trend for a return to Islamic financing, and posted a 35% decrease in second quarter profits, the fourth consecutive quarter in which the

bank reported falling profits. Although the bank has reported strong loan growth, it did not lift earnings.

Qatar’s cash rich government has sought to bolster lenders, including Qatar Islamic, by acquiring stakes in banks and purchasing their real-estate assets. Qatar Islamic reportedly sold a 5% stake to the country’s sovereign wealth fund in the autumn of 2009 for QAR956m ($262m at today’s prices). In June, the bank bought QAR1.25bn riyals of Islamic bonds offered by the government. The bank is expected to continue to provide provisions for nonperforming real estate loans through the second half of the year.

With an economy that is expected to grow in excess of 16% this year, it is hard to understand the real challenges facing Qatar’s banks. Pursuing new avenues of growth, in areas such as wealth management is now however an imperative. The country’s continuing financial windfall from strong oil and gas sales is not matched by the prospects of a banking segment that is still tightly defined by domestic rather than global opportunity. By and large Qatari banks follow a conventional banking business model, generating income from the spreads between deposits and lending.

The country’s 1.6m population is served by more than 18 separate banking brands, though QNB and Commercial Bank of Qatar dominate the market.

Combined, Qatari banks represent 11% of assets in the Gulf, compared with 35.6% in Saudi Arabia, 15.5% in Kuwait, and 30.6% in the United Arab Emirates, according to figures released mid-year

by Kuwait based research firm KAMCO. Backed by revenue flows from projected carbon resources that at current rates of extraction are expected to last over 200 years, Qatar is throwing money into establishing the country into a modern financial powerhouse, with particular emphasis on asset management, insurance and reinsurance. This is cold comfort for banks with only limited local potential for business growth and a burgeoning banking market that is seen as fertile

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REGIONAL REPORT

GCC BANKING: RESPONDING TO TESTING CONDITIONS

hunting grounds for foreign banks with medium term corporate financing expertise. Few local GCC banks can compete in this space, with the exception of names such as NBK and QNB. Until issues in the real estate markets are resolved, concerns about the ability

of the region’s banks, with a few notable exceptions, will remain and, as a result, will continue to weigh negatively on the cost of market funding for banks.

Much now depends on whether the global economy continues its inexorable rise to growth and whether carbon

energy resources are placed under demand pressure once more to really kick start a new phase of growth for the region’s banks. As China’s Chou En Lai, once famously responded, when asked if the French Revolution was a good thing: “It is too early to tell.” I

REPORT SAYS SLOW COMEBACK FOR DUBAI COMMERCIAL REAL ESTATE Given the importance of real estate asset values to the GCC banking sector, the most recent release from Jones Lang LaSalle, the real estate investment and advisory firm, which predicts commercial real estate vacancies will decline most quickly in Dubai’s central business district and will not return to sustainable levels until 2013 or 2014, gives pause for thought. ccording to Jones Lang LaSalle, the global real estate investment firm, central business districts (CBDs) in emerging markets tend to outperform other commercial areas and despite the current market situation, Dubai’s office sector can draw strong parallels with the experience of other emerging markets. “The clear learning [sic] from overseas cities such as Shanghai, Singapore and Moscow is that office markets all go through periods of excess supply similar to those characterising Dubai at the present time,” says Graham Coutts, head of management services at Jones Lang LaSalle MENA. “The experience of these cities is that vacancies do not remain at excessive levels for sustained periods and vacancies for CBD space typically fall to more sustainable and balanced levels within two to four years. We expect Dubai to follow this same pattern with vacancies for CBD space peaking in 2011/ 2012 and then declining again over the following two to three years,” he adds.

According to the real estate specialist, Dubai currently has one of the highest levels of office space per person in the world; hinting

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that, in current market conditions, the level of supply has increased ahead of the maturity of the market,” says Coutts.

“International experience suggests that measures to restrict supply will be critical to the recovery of the Dubai office market. Another feature of such markets has been adaptive re-use (the conversion of office buildings to other uses) as well as the ‘mothballing’ of partially completed projects. Both of these initiatives are required to allow for the excess supply currently available to be absorbed.”

The Dubai office market, he says, has experienced high absorption levels over the past few years in comparison to both established cities and emerging BRIC economies. Despite this strong demand, excessive levels of new supply have resulted in an oversupply of office stock. While the total level of occupied office space in Dubai increased by over 13msquare feet between December 2007 and June 2010, the same period shows supply expanding by twice this level, with around 28m square feet of additional space completing.

“Dubai has experienced very strong take up over the past two and a

half years, with the total level of occupied office space increasing by more than 70%, since the end of 2007. During this period Dubai has been one of the fastest growing office markets worldwide, with positive net absorption being recorded even after the financial crises of 2008-2009. While demand has remained positive, this has triggered an even stronger level of supply, increasing by around 140% (around twice the level of net absorption) over the past two and a half years. This has increased vacancies across the market and provided increased opportunities for tenants and occupiers due to increased choice and significantly reduced pricing” adds Matthew Hammond, head of agency, at the firm.

According to Hammond, Dubai’s office market will become increasingly ‘tenant-favourable’ over the next 18 to 24 months with vacancies rising further throughout the market. This will, say the Jones Lang LaSalle commentators, boost the competitiveness of Dubai and increase its attraction as the major business and financial hub of the MENA region. Similar to overseas markets, Dubai is also witnessing the emergence of a two-tier market where demand is currently focussed on the twin CBD locations of Financial CBD and TECOM areas. Outside these CBDs, vacancies are likely to remain at excessive levels for many years.

OCTOBER 2010 • FTSE GLOBAL MARKETS

REAL ESTATE

SAUDI REAL ESTATE: THE JEDDAH FACTOR

Photograph © Theo Gottwald/Dreamstime.com, supplied September 2010.

The real estate sector in Saudi Arabia continues to grow, despite the global recession and property market downturn. Total investment in the Kingdom’s real estate sector is expected to exceed $400bn by the end of 2010, playing a vital role in the Gulf state’s non-oil economy and making a contribution to gross domestic product of over 7.2%, up over 50 basis points (bps) in five years. A financial injection into the economy means Saudi Arabia is expected to carry out ongoing projects at a total cost of $500bn, with its most cosmopolitan city, Jeddah, at the heart of the expansion. Mark Faithfull reports on Jeddah’s efforts to regain ground on capital Riyadh and to leverage its strong business, leisure and religious roots.

JEDDAH MAKES ITS MOVE WITH MEGA-PROJECTS HE SAUDI PROPERTY sector is going to need around $640bn in investments over the next 20 years, to help build another 5m housing units, according to a recent strategic plan announced by Jeddah Municipality.

The municipality believes there is a shortage of 283,000 housing units in Jeddah itself, including 80,000 in the city’s low-income group.

The plan forecasts that Jeddah will need almost one million housing units by 2030 to cope with the increasing number of expats settling in the city and an influx of nationals from more rural areas; the local government is implementing a 20-year redevelopment programme involving initiatives such as the enhancement of the suburban areas and the rehabilitation of the city’s

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FTSE GLOBAL MARKETS • OCTOBER 2010

central and historic districts. “Megaprojects in Jeddah will see the city and its infrastructure transformed across the board during the next two decades— creating an enormous range of partnership opportunities,” says Tareq Telmesani, chief executive officer of the Jeddah Development and Urban Regeneration Company (JDURC), a private company set up by Jeddah Municipality to spearhead the city’s regeneration projects. Jeddah will account for a large proportion of the kingdom’s ongoing property developments both short and long term.

Jeddah is already the second largest city in Saudi Arabia and the principal entry point to the holiest Islamic sites.

Its infrastructure is being overhauled to better accommodate pilgrims, accelerate

business growth, and support a population density that is rising at a rate of 20%-28% each year. Jeddah’s growth from a traditional port to a sprawling urban city clearly requires more balanced development among its districts and its relationship with King Abdullah Economic City (KAEC)—the city being built by governmentcontrolled Emaar Economic City, which will be completed in 2025 at a cost of $27bn and which will cover an area the size of Brussels.

As part of the government’s bid to shift from home rental to home ownership, Saudi Arabia recently passed legislation to allow foreigners to own property for the first time, with King Abdullah Economic City chosen as the first place to change the ownership model.

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SAUDI REAL ESTATE: THE JEDDAH FACTOR

Announcing the move late last year, Fahd Al-Rasheed, Emaar Economic City’s chief executive officer, says: “This is the first freehold city in Saudi Arabia.

A lot of people want to invest in the Saudi market and see it as a frontier for real estate investment because of the population explosion here.”

Just north of Jeddah, Emaar is designed to house 2m people and to generate one million jobs and is part of a $400bn plan announced by the Saudi government in 2008 to invest in the country’s infrastructure and make it less dependent on oil. Economic stability has been achieved by the government reinvesting surplus revenues into the private sector through large infrastructure projects and increased spending on the education and health sectors. The government has also stimulated the economy by pouring

money into the household sector through large increases in civil service employment and wages.

As part of the fiscal stimulus, the government added 70,000 civil service employees in 2008—the biggest year-onyear increase in more than two decades— and there were further increases in staffing levels in 2009 and early 2010, making the government the biggest source of demand in the office space market.

John Harris, head of Jones Lang LaSalle in Saudi Arabia, adds: “The Saudi economy enjoys scale, growth and stability attributes which have seen it weather the recent economic crisis relatively well. In Jeddah in particular, we have seen a slowdown in property markets. However, the medium and long-term outlook is very positive with major infrastructure projects working to drive growth

alongside investments in the office, residential, retail and hospitality sectors.”

He believes that investors are increasingly focusing on those markets with strong demand fundamentals, driven by domestic population, and those with strong core economic growth drivers such as oil and gas. “Saudi Arabia is the only country in the region that offers a combination of these two factors, but this is not the easiest real estate market for investors to enter,” adds Andrew Charlesworth, head of capital markets at Jones Lang LaSalle MENA. Jeddah’s population is estimated at around 3.4m, accounting for some 14% of the national total. There are an estimated 1.6m expatriates in Jeddah, representing 47% of the total population, the highest ratio of expatriates anywhere in the kingdom.

KINGDOM HOLDING RATIONALISES ITS PORTFOLIO n late August this year, Kingdom Hotel Investments (KHI), a subsidiary of diversified Saudi conglomerate Kingdom Holding Company (KHC), chaired by Prince Alwaleed Bin Talal Bin Abdulaziz Al Saud, finalised the sale of a 43.7% minority interest in the Four Seasons Hotel in Cairo to Arab Company for Hotel and Tourism Investments, a subsidiary of the Egypt-based Talat Moustafa Group holding company for $145m, giving the Saudi investment giant an exit multiple of 13 times 2009 EBITDA. Talat Moustafa Group already owned a majority share in the hotel. According to Prince Alwaleed: “The hotel remains under the management of Four Seasons in which Kingdom Holding holds a 47.5% stake.”

Separately, Kingdom Holding Company, the holding company, also owned by Prince Alwaleed, has finalised a SAR700m ($186.6m) refinancing of the Kingdom Centre (Trade Centre Company Ltd) in

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Photograph © Michal Steckiw/Dreamstime.com, supplied September 2010.

which it holds a 36% stake. The Kingdom Centre, which was completed in 2002, is one of Saudi Arabia’s most identifiable landmarks. The refinancing, which

is Shari’a compliant, was arranged

by Samba Financial Group, with funds raised to be used for expansion and investment purposes. “The refinancing of Kingdom Centre comes in light of KHC’s objective to continue to monetise and extract value out of the company’s local investments portfolio,” notes Prince Alwaleed.

The Kingdom Centre occupies 94,230 square meters of land and comprises the Al Mamlaka shopping mall and a 300 metre office tower which was, when built, the tallest building in the Middle East. The mall’s anchor tenants include Debenhams, with 8,364 sqm, and SAKS Fifth Avenue, with 5,273 sqm. The mall is targeted toward younger and more affluent shoppers and contains stores representing a number of international luxury brands. The third floor of the mall is for women only. Management estimates that approximately 230,000 persons visit the mall each week.

OCTOBER 2010 • FTSE GLOBAL MARKETS

THE UPS & DOWNS OF SAUDI REAL ESTATE With the push to expand the residential population, the Jeddah office market continues to experience a period of significant new supply. A total of 67,000 sqm was completed in 2009, including Jameel Square and the Shemeisy, Bin Suleiman and HMS buildings. Most of this new development is located in the north of the city and completions would have been higher but for a number of delays and deferments due to scarce credit.

In the longer term, there are three new large projects that could add more than 150,000 sqm to stock in 2011 and 2012.

Tenant demand started to recover in the second half of 2009 and this continued into the first half of 2010. The strongest demand has come from those sectors associated with the big increase in public spending on infrastructure, healthcare and social education. Moreover, a number of large new deals were announced towards the end of 2009, reducing the stock of vacant office space available.

While there continues to be demand from private sector tenants, these leases have tended to be smaller than their public office counterparts. Leases signed recently include PwC, Punj Lloyd, Mars Foods, Regus, LG and the Islamic Development Bank.

With a number of large new projects being completed in the north-west of Jeddah over the next two years, tenants will have increased opportunities to upgrade to better quality space and some occupiers are expected to pull out of central Jeddah, which lacks a well defined central business district, to suburban locations. The completion of more office space in Bay La Sun project at KAEC will also have a dampening effect on the performance of the Jeddah market as it will be competing with Jeddah for tenants. The market is therefore expected to remain competitive, even as the economy starts to grow again.

Following a period of high supply over the past two years, the shopping centre pipeline has been turned off. There have, however, been a couple of major new completions over the past six months.

Stars Avenue on Malak Road added around 38,000 sqm of stock in the Ana

FTSE GLOBAL MARKETS • OCTOBER 2010

ot surprisingly, with its substantive and fast growing population (around 27m), real estate prices are on the rise in parts of Riyadh and Jeddah as demand for residential properties remains high.

Fuelled by a big rise in the number of foreign workers, the Saudi Arabian population has grown by almost 20% over the last five years.

In consequence, low-cost housing projects are expected to rise in number, with demand stretching to as much as 1.5m new housing units by 2015. This high level of demand is in part due to the lack of a developed mortgage market in the country. A mortgage law has been on the cards now for over a year, but the ultra conservative government is anxious not to liberalise the market and cause a

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retail strip. The opening of the largest new project, Central Park has been delayed in the face of slow absorption levels, but this centre should be operational within the next six months.

Interest in malls There has been a clear shift of tenant interest toward the large new malls such as Mall of Arabia, Red Sea Mall and Andalus Mall, although street retailing remains in demand, especially the street facing units beneath office buildings such as Jameel Square, where space fronting Tahlia Street has been taken by Van Cleef & Arpels, Chanel, Piaget and Fauchon.

There are two hotels under development beside the Mall of Arabia close to the airport: Marriott Courtyard and Four Points Sheraton. Elsewhere, Holiday Inn Express is converting a hotel in downtown Jeddah and has also announced plans to develop a hotel in the Industrial Valley at King Abdullah Economic City. Already under development in KAEC is a four-star hotel in the Bay La Sun Business Park, which will be operated by Southern Sun. Looking further ahead, Rocco Forte and Kempinski will also set up in Jeddah.

Consequently, Jeddah’s hotel room supply is expected to increase to around

real estate bubble. Moreover, legislators are still reportedly finalising terms under the law should a borrower default.

While Saudi banks extend loans to well-off Saudis, they are less likely to lend more widely. Local borrowers are left to access the state-run Real Estate Development Fund (REDF), which offers Shari’a-compliant, interest-free loans, though it only finances around 8% of the low-cost housing sector each year. In part, the lack of low and mid-income housing stock is due to an imbalance in supply. Most new developments are targeted at the highincome segments of the population which constitute a relatively small share of existing demand, thereby exacerbating the shortfall in supply to the low and mid-income segment.

5,519 quality hotel rooms by 2013. The seasonality of the Jeddah hotel market is modulated somewhat by demand from three different sources: business travel, summer tourism and religious tourism. A number of transportation investments are also going to increase travel capacity, in particular the new King Abdulaziz International Airport (KAIA) terminal and the high-speed railway linking Jeddah to Makkah, Madinah and KAEC. KAIA was the kingdom’s first international airport and was established in 1981.

Covering an area of 105 sq km, KAIA is considered the main gateway for pilgrims coming from all over the world for Haj and Umrah. Meantime, contracts for the rail link have been awarded and civil works have already commenced.

The new airport will have an initial capacity of 30m passengers and will be suitable for large aircraft such as the Airbus A380 superjumbo. The airport’s ultimate capacity is estimated at 80m passengers and 3m tonnes of cargo per annum.

While supply of commercial real estate has controlled capital and income appreciation in Jeddah, its unique position in Saudi Arabia and its multi-stream income potential should ensure that the kingdom’s second city remains a major draw for investment. I

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CEE COMMERCIAL PROPERTY: A MIXED OUTLOOK

POLISH REAL ESTATE EMERGES FROM THE SHADOWS The bald facts show that Central and Eastern European (CEE) commercial property delivered a negative 6.5% total return in 2009. Figures from real estate benchmark the IPD CEE Annual Property Index were significantly lower than the 0.6% total returns achieved in 2008 and are the first time the index, which covers 27 portfolios worth €9.1bn across Poland, Czech Republic, Hungary and the rest of CEE, has delivered a negative annual total return in its five-year history. Furthermore, capital values fell 12.5% during the year, compared with a 5.3% drop the previous year. It makes for dismal reading, until you start to extract national data, where two countries shine out, writes Mark Faithfull.

ENTRAL AND EASTERN European (CEE), for so long lumped together as the homogenous mass of emerging market real estate to the right of Europe proper, has shifted tracks with at least a threelane market evolving and two clear frontrunners: Poland and the Czech Republic. No wonder—Poland was the only country in Europe to avoid recession in 2009, with preliminary data suggesting that the economy grew by 1.7%. BMI forecast Polish GDP growth rates of 3.4% and 3.8% for 2010 and 2011 respectively, the highest of any EU27 country with the exception of Lithuania.

In a risk-adverse environment, unsurprisingly it is Central Europe’s capital cities which account for the vast majority of investment deals this year, led by German funds. However, transactions are not easy; many analysts believe banks are delaying recovery by holding on to problem assets, the so called “extend and pretend” financing strategy, and

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institutional investors continue to focus on Central European capital city markets at the expense of regional towns.

CEE commercial real estate investment turnover reached €1.7bn in the first half of 2010, a 190% increase compared to activity levels recorded in the first six months of 2009, according to the latest data from CB Richard Ellis (CBRE). On a quarterly basis, investment activity in the region rose to €970m in the second quarter of 2010, an increase of 34% compared with volumes seen in Q1 2010, but still considerably lower than the levels seen in the period before Q4 2008.

Of the €1.7bn transacted in the first half of 2010, German open-ended funds accounted for €300m (or 17%) of CEE investment. Jos Tromp, director of CEE research at CBRE, reflects: “This level of activity is remarkable, especially in light of the turbulence in the German sector and continuing economic uncertainty across Europe.” Investment activity was concentrated in Poland, the

Czech Republic and Russia; however, mainly outside the prime segment.

“Most prime yields compression reflects a change in sentiment and is not backed by transaction evidence yet,” adds Tromp. “Despite the current shift in prime yields, there is still a difference in the trend for pricing between prime and secondary properties.”

Over the past 10 years the Warsaw market has shed 300 basis points (bps) of “risk”, taking the average of London City and West End, Paris and Frankfurt prime office yields as a benchmark.

Prime office yields in Warsaw are circa 6.75% and are expected to fall by a further 25bps by year end, according to agent King Sturge. In the long term, yields are likely to move in further as the real estate risk margin relative to bonds reduces and the Polish economy, already the seventh largest in the EU, continues to grow and sovereign risk, market size and illiquidity issues decline.

OCTOBER 2010 • FTSE GLOBAL MARKETS

Of the €1.7bn transacted in the first half of 2010, German open-ended funds accounted for €300m (or 17%) of CEE investment.

Photograph © Julien Tromeur / Dreamstime.com, supplied September 2010.

Office stock in Warsaw grew by 269,000 sqm in 2009 to almost 3.25m sqm and completions during 2010 will add a further 185,000 sqm, all of which is under construction.

In the aftermath of the banking failures of late 2008, letting activity during the first half of 2009 was 60% below the same period a year earlier before recovering in the latter half. From 2000 up until the end of 2008 net absorption averaged 209,000 sqm per annum, outstripping supply and causing vacancy rates to tumble from a high of 16% in 2002 to below 3%. Last year, net absorption was only 116,000 sqm.

Combined with one of the highest levels of new supply in recent years, the vacancy rate shot up to 7.3%, although based on modelling by agent King Sturge, vacancies will reduce slightly this year and again in 2011 to 6.8%.

Rents have reduced most in the city centre where growth had previously been highest, falling by around 30%

FTSE GLOBAL MARKETS • OCTOBER 2010

from their mid-2008 high of €34/sqm/month. Headline rents are now €23 to €25/sqm/month.

The majority of modern office stock outside Warsaw is concentrated in six locations—Katowice, Kraków, Poznan, Tricity, Lodz and Wrocław—and amounts to 1.6m sqm of which 230,900 sqm was delivered in 2009. New supply during 2010 is likely to be around 300,000 sqm and vacancy rates vary dramatically between cities, with the highest rate (23.6%) in Lodz and the lowest (7.5%) in Katowice.

Retail segment In the retail sector, more than 650,000 sqm of shopping centre space was completed in 2009, and the three largest shopping centres to open last year were TriGranit’s 91,000 sqm Bonarka in Kraków; Neinver’s 54,000 sqm Galeria Malta outlet mall in Poznan, and GTC’s 49,000 sqm Galeria Jurajska in Czestochowa. The pace of development

has slowed, with only around 400,000 sqm of new space to come to the market this year. In 2011 it is likely a further 600,000 sqm will be delivered as many postponed projects will restart.

Indeed, shopping centre development has become a major investment driver and Warsaw in particular has become an important retail destination, although wider Poland remains a tough retail market and profitability is far from assured. In a frank assessment of Klépierre Ségécé’s retail holdings across Europe, leasing director Gontran Thuring says that, this year, turnover in the developer’s seven Polish shopping centres is down in four and up in only three.

Across the CEE, Q1 rental income in 2010 was at 95.5% of the Q1 period for 2009 in the CEE but at 99.2% in Western Europe. In addition, outstanding payments due were at 10% in the CEE, representing 39% of the total outstanding payments due across Europe. “Clearly there is a lot of work to do in Poland,” he admits. “The situation in the CEE is more difficult than in Western Europe.”

Krzysztof Bocianowski, head of asset management for ING Real Estate in Poland, believes that the principal objective for developers coming to market with completed schemes across the CEE now is simply to minimise losses.

“There is still too much optimism in the CEE and developers should remain focused on how they can optimise their schemes to protect themselves from losses,” he says, stressing that many investors and developers have still not faced up to the fragility of the market across the region.

While shopping centre giants such as Zlote Tarasay and Arkadia in Warsaw remain packed, some retail professionals believe that the downturn may have

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CEE COMMERCIAL PROPERTY: A MIXED OUTLOOK

done Poland a favour, striking just at the point where the country was on the brink of following neighbours such as Romania and Bulgaria into a period of ill-conceived over-development.

Deeper concerns exist for the Czech Republic. Some analysts believe that the cosmopolitan capital Prague skews investor expectation unrealistically and that the rest of the country offers a weak platform for commercial real estate development.

There is also concern in both Warsaw and Prague that legislative changes to German open-ended funds may require them to hold more capital and consequently dampen their ability to invest in the CEE. Transaction volumes have already slowed while the funds await a final decision by the German government says Angus Wade, managing director of King Sturge’s Prague office. “The uncertainty has fed through to the local market, although there has been more movement from the Czech capital, probably the highest we’ve known,”he says. “Hopefully, the German situation is temporary, but it will make a massive difference depending on the outcome.”

Jason Sharman, managing director of the King Sturge Warsaw office, adds that a lot of investors have been “spooked” by the domestic German legislative uncertainty and this had led to a “flight to quality”. That said, Sharman believes that transaction volumes in the CEE will be up to 2008 levels by the end of 2010. Headline deals bear out the assertion. The largest singleasset transaction in the CEE to close so far in 2010 has been Allianz Real Estate’s acquisition of a 50% share of the €200m Allee shopping centre in Budapest, while more recently Vienna-based property investor CA Immobilien has agreed to pay €272m for Austrian fund and asset manager Europolis, owner of a €1.5bn CEE real estate portfolio. The deal is expected to complete in January.

The Austrian company beat off competition from three other bidders, including US private equity firms Perella Weinberg and TPG Capital, and New

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Over the past 10 years the Warsaw market has shed 300 basis points (bps) of “risk”, taking the average of London City and West End, Paris and Frankfurt prime office yields as a benchmark. Prime office yields in Warsaw are circa 6.75% and are expected to fall by a further 25bps by year end, according to agent King Sturge.

York-based fund manager Area Property Partners. “The Europolis portfolio produces a 7.2% yield and we acquired it at a net asset value discount of 14%,”says Bruno Ettenauer, chief executive of CA Immo.“Bearing in mind the high quality of the assets and their tenants, this was a good price to pay. The acquisitions also fit perfectly with our existing portfolio.”

Other retail deals closing in the first quarter of this year include UnibailRodamco’s agreement to acquire Simon Ivanhoe, a jointly-held European subsidiary of the Simon Property Group and Ivanhoe Cambridge, with a portfolio which includes shares in Wilenska Station and the enormous Arkadia mall on the fringes of Warsaw’s centre.

Major transactions German fund deals include the acquisition by German fund manager Union Investment of IVG Immobilien’s Horizon Plaza in Warsaw’s Mokotów business district for around €100m. The deal reflects a net yield of 7.25%, which reflects a slight yield tightening compared with 7.4% for GLL Real Estate Partners’ purchase of the 56,000 sqm Marynarska Point in the city last year from Skanska Property Poland.

In February, SEB Immo Portfolio Target Return Fund bought Ghelamco Group’s Trinity Park III, the 75,000 sqm third and last phase of the Trinity Park complex in the Polish capital, for around €93m. Also, Union Investment acquired IVG’s 35,000 sqm Horizon Plaza office block in Warsaw.

Other major transactions include Bermuda-based investor MGPA’s purchase of two new shopping centres in Poland for its MGPA Europe Fund III. MGPA also took an option on a third from DTC Finance for a total of €236m.

MGPA’s assets, Karolinka and Pogoria,

were acquired for €187m, and are located in the Silesia region.

Prague has also attracted investor interest. Last October, Deka Immobilien paid €110m for Austrian property investor Sparkassen Immobilien’s 40,000 sqm Gemini office project in the city’s 4th district. The price reflected a yield of around 7.25%. “Quality stock is becoming quite tough to find,” says Sharman. “Some investors are now looking at regional shopping centres in the Czech Republic as an alternative and yields have moved quite a bit.”

Dr Frank Porschke, chairman of Eurohypo, says: “The issue in the future for CEE markets will not be about risk or valuation, but about liquidity. Across the CEE there will be those markets which are liquid and those which are not, and that will determine where investment interest is targeted.”

Poland also has the impetus of the Euro 2012 football tournament, which it is co-hosting with Ukraine, presuming that the latter fulfils its obligations to football body UEFA, a prospect which is looking more likely for at least three of the four designated cities.

“The advantages split into two areas,” reflects Sharman. “On the one hand, the tournament itself will no doubt be positive because of the influx of visitors, but it’s really the infrastructure programme that will count. The Euros have given Poland a deadline for road building and creating facilities and it will want to make sure it presents itself in the right way.”

Its place in the limelight could just cement Poland’s reputation as different from the rest of the CEE and see its risk rating fall further, as more investors discover the allure of Europe’s star player. I

OCTOBER 2010 • FTSE GLOBAL MARKETS

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INDEX REVIEW

UK SHARE PRICES: CAN THEY RECOVER?

Sovereign problems are not always corporate problems and, for all the wailing and gnashing of teeth over the summer, the plain fact is that company profitability is actually almost back at the levels pertaining before the fabled financial tsunami hit. With 10-year bond yields for the major US and European states now below 3% (with annual inflation actually above this level in some instances) the returns on even the most expensive FTSE stocks look very attractive indeed. Unfortunately, the unpalatable fact is that this has been one of the ongoing arguments “for” equities for quite some time without having any noticeable impact. By Simon Denham, managing director, Capital Spreads.

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

QE II & M4 WEAKENING E CONTINUE TO lurch from one crisis to another and from one “new dawn” to the next, and the equity markets have followed in their wake.

Even so, commentators and investors agree that while growth is not great and public fiscal positions are dire, the overall environment is not necessarily disastrous for shares.

However, the good news bearers have had little actual impact on prices. That’s because everyone is paralysed by fear of the probable extent of the inevitable public sector fiscal squeeze in the West and it is overshadowing all else.

The good news is that as politicians have become more fiscally responsible, the idea of any further quantitative easing (QE) has drifted away from centre stage. Moreover, central bankers now question whether creating ever more liquidity is really an efficacious short-term or even long-term solution. QE advocates hold that banks continue to tighten lending and use this as an argument to reignite the process.

However, much of the reason behind the lower lending levels is falling demand. Mortgage applications over the past few months have slumped in both the US and the UK and it is a worry in the UK as summer is usually boon time for removal men.

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There are real job fears in the UK too, especially as the new class of 2010 is looking for employment and finding slim pickings. A jobless recovery coupled with ageing employees, working for longer and longer means fewer opportunities for 16-21 year olds. Of course, the UK needs new jobs in new sectors.

Unfortunately, the UK cannot deliver right now, particularly with such a high cost rate and tax hikes. While FTSE 350 firms, who can target expansion anywhere, don’t think it too much of a problem, it’s a massive headache for politicians.

For FTSE component equities, what we must look at is not the micro issues (UK jobs, house prices, inflation, PSBR etc) but the macro worldwide situation. Here the news is actually rather good. Global growth will top 4.5% in 2010 and do better in 2011 and aside from the struggles in the UK, US, Japan and Southern Europe, the rest of the world looks rather peachy. So, will the big debtor nations slide into a deflationary spiral (aka Japan)? If so, will this drag down the rest of global economy?

Deflation doesn’t look to be a problem in the UK right now, but I would like to raise my standard flag (yet again) for M4 numbers. Over the last three or four years I’ve beaten the drums warning what this

number is telling us; from when it was expanding at 10% to 14% in 2006/2008 without showing corresponding increases in growth/tax revenues/prices, to 2009/2010 when, even with £250bn of QE, it was falling to virtually nothing). Without growth in M4, GDP acceleration may prove to be elusive and with money supply now stuck around 2% this may be on the cards and if M4 continues to weaken, the prospect of a deflationary trap increases.

Investors may very well look with a jaundiced eye on any corporate with a high exposure to the UK market; in particular, the retail and domestic public sector spending sectors.

Growth in these areas will probably prove to be tougher than in others.

Fortunately for the FTSE an everincreasing percentage of business has nothing whatsoever to do with Britain. We may well find however that a weakening pound runs into an improving world economy which would do no harm whatsoever for those looking for returns on many UK equities. It is a fine line to run when you fear for your domestic economy but are actually reasonably upbeat about prospects for its stock market!

Now may just be such a moment.

As ever ladies and gentlemen, place your bets. I

OCTOBER 2010 • FTSE GLOBAL MARKETS

FX OPTIONS

THE FIGHT FOR MARKET SHARE The emergence of foreign currencies as a recognised asset class for portfolio investors has led to growth in demand for FX options—either to hedge exposures, or to express a directional view. Over-the-counter (OTC) trading has so far dominated the segment and derivatives exchanges have tried desperately to substantially increase their piece of the action. Right now, regulatory authorities appear to be on the side of the exchanges. Is that enough to overturn the preference of much of the trading community for the flexibility offered by the OTC market? Neil O’Hara reports on a dynamic asset class.

IKE THE UNDERLYING currency markets, FX options used to trade almost exclusively over the counter (OTC) despite repeated efforts by the Chicago Mercantile Exchange (CME), the Philadelphia Stock Exchange and others to foster trading in listed contracts. In the past couple of years, however, trading volume in listed FX options has picked up, albeit from a low base. The exchanges may be poised to make further inroads into this bastion of OTC trading as regulators try to shift

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FTSE GLOBAL MARKETS • OCTOBER 2010

more derivatives trading into a centrally cleared environment, but they face an uphill battle against market participants long accustomed to the flexibility bespoke OTC products offer.

For the CME, it’s a case of back to the future. The exchange introduced listed FX options back in the 1980s, and while they never threatened to displace the dominant OTC contracts, they did find a following. The advent of electronic trading in futures and the phenomenal success of Globex diverted the CME’s

FX OPTIONS: EXCHANGES VIE FOR A PIECE OF THE PIE

Photograph © Stasys Eidiejus / Dreamstime.com, supplied September 2010.

attention to developing those markets, while interest in its pit-traded FX options withered. The effort to revive interest in FX options began about four years ago, when Craig LeVeille joined CME as director of FX products with a brief to rebuild the options business.

Exchange-listed derivatives only attract liquidity if there is an active market in the underlying instrument so that market makers can easily hedge their exposures. Even though CME lists options on 15 emerging markets currencies, trading volume is concentrated in six of the G10 currency crosses against the US dollar: euro, yen, sterling, Australian dollar, Canadian dollar and Swiss franc.“Right now, we are focused on developing liquidity in our primary contracts,” says LeVeille.

“Our underlying futures are extremely liquid in those names.”

Hard numbers on the size of the OTC FX options market are scarce, but LeVeille estimates that CME trading amounts to just 3% to 5% of daily FX options trading.

The exchange punches above its weight, however; it does represent a significant single source of liquidity in the market, trading $10bn to $12bn in notional amount; a recent record day exceeded $20bn. “That got the attention of the major bank and buy side OTC participants,” says LeVeille. “They see the value of our liquidity and diversified client base so they are interested in connecting to our platform.”

The vast majority of FX options traded OTC are plain vanilla in structure, which means in theory they could easily move to exchange trading.

In practice, though, users are reluctant to forgo the ability to set the precise expiration date and strike price they want—a feature only the OTC market can offer. On an exchange, expiration dates and strike prices must be standardised in order to make contracts fungible; in effect, liquidity gets concentrated on the chosen intervals at the expense of flexibility in terms.

That trade-off is anathema to commercial participants in the market, who are typically hedging transactions

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FX OPTIONS

FX OPTIONS: EXCHANGES VIE FOR A PIECE OF THE PIE

related to normal business operations: sales, purchases, or payment and receipt of interest and dividends. The corporate treasurer of a large US manufacturer tendering for a fixed-price contract in euros who expects the winning bidder to be notified on November 15th can get that precise expiration date and a strike price that matches the exchange rate assumed in pricing the bid if he hedges in the OTC market. To replicate that in listed options, he would have to calculate what blend of the nearest strike prices is equivalent to the rate used in the bid; in addition, he has to pay for extra time to the next nearest standard expiration date and will lose the bidoffer spread in liquidating the hedge if a competitor wins the contract.

The desire for flexibility is not limited to commercial participants, either. Ron DiRusso, vice president and a portfolio manager at FX Concepts, a $8bn hedge fund based in New York, trades FX options every day, but never uses exchange-traded options because he can’t get an at the money strike, which is by definition delta neutral.“Options that are delta neutral to start off with fit in well with our models,” he explains.

“We trade from one week out to one year, typically at-the-money straddles, although we do trade out of the money as well.” He has no objection in principle to trading on an exchange if it can offer the same flexibility he currently enjoys in the OTC market, but CME’s quarterly expiration cycle in fixed strike intervals doesn’t come close when the trade DiRusso executes most often is a one week at-the-money straddle.

Despite DiRusso’s reservations, financial players—banks, hedge funds, asset managers, and proprietary trading shops—dominate FX options trading at the CME. These investors do some hedging, but many are taking a view on currency direction to generate investment returns. For them, standard strikes and expiration dates don’t present a problem; indeed, they may be an advantage. “These participants don’t need a customised solution,” says LeVeille. “They need a liquid solution.”

54

Craig LeVeille, director of FX products at the Chicago Mercantile Exchange (CME).

Exchange-listed derivatives only attract liquidity if there is an active market in the underlying instrument. Photograph kindly supplied by CME Group, September 2010.

Vincent Craignou, head of global FX and precious metals options at HSBC in London, estimates that the overwhelming majority by number of trades in FX originate from commercial flows. Photograph kindly supplied by HSBC, September 2010.

The CME offers fast, reliable execution capability along with clearing and global reach, an attractive package for its customers, he claims.

transparent, too; even in the darkest hours in late 2008, liquidity never dried up.“The liquidity gives comfort to investors to venture into FX,”says Craignou. “It is not only hedge funds, but also asset managers, pension funds and private clients who express a view on currencies.”

Regulatory efforts to shift derivatives settlement into central clearing should have little impact on OTC trading volume, in Craignou’s view. The obstacles to central clearing are mostly technological—the need for common protocols and agreed procedures—along with margin calculations and how to capitalise the central counterparty.

Moving execution to an exchange is another matter altogether. “How do you replicate the flexibility in maturities and strikes?” asks Craignou. “I don’t think you can replace a market which is bespoke by nature with a bunch of exchange-based contracts that are standardised.”

Exchanges could try to meet the need with flex options, listed contracts that permit the user to alter certain terms from the standard contract, including the strike and expiration date. Flex options can accommodate complex orders like spreads and straddles, too, but

Commercial flaws Such investors are in the minority, however. Vincent Craignou, head of global FX and precious metals options at HSBC in London, estimates that the overwhelming majority by number of trades in FX originate from commercial flows, even though financial transactions probably constitute more than half the trading by value. A 2009 ISDA survey of the world’s largest 500 companies found that 94% of treasurers used derivatives to hedge currency risk.

Although the survey did not break out options from swaps, futures and forwards, Craignou says commercial participants do use options extensively, at least in the OTC market.

He attributes the rise of FX as an asset class to the recognition that currencies represent an effective way to play macroeconomic themes—the crisis of confidence in the euro in spring or the development of the BRIC economies over the past five years, for example. The FX market is extremely liquid and

OCTOBER 2010 • FTSE GLOBAL MARKETS

although they have been available for more than 15 years on the CME for a handful of equity indices, they have not attracted significant interest.

As an intermediate step, exchanges could narrow the strike increments and add more expiration dates to the standard contracts. The International Securities Exchange (ISE), which already trades monthly FX options on 10 currency pairs, has received regulatory approval for more strikes and is considering whether to offer weekly expirations, according to Kris Monaco, ISE’s director of new product development. ISE attracts mostly retail flow to its FX options today, but it has ambitions to capture institutional business as well. “It is tough to break people away from their decades-long trading practices,” says Monaco.

He is quick to point out that exchange listed options are the only ones centrally cleared at the moment. That may account for the recent uptick in their popularity because it mitigates the credit risk inherent in traditional bilateral OTC contracts. Monaco also notes that exchanges can offer complex order types like spreads and straddles without legging risk as well as data on volatility and options characteristics like delta, gamma, theta and vega that may not be readily available in the OTC market.

Clearing remains the principal benefit of trading on an exchange, however, but it’s an edge that hasn’t lured most market participants—and it won’t last anyway.

A top priority among global regulators ever since the financial crisis has been to shift more derivatives trading into a cleared environment; some would go further and insist that all standardised contracts should trade on an exchange.

Industry participants have embraced the concept of clearing for non-commercial trades, although the clearing houses would prefer it to be encouraged by regulators rather than mandated. The question is when, not whether, clearing houses will offer their services for FX options traded OTC, which will eliminate the primary competitive edge exchangelisted options now enjoy.

FTSE GLOBAL MARKETS • OCTOBER 2010

Matt Woodhams, global head of E-commerce at GFI Group in London, has been an active participant in industry efforts to shape the new regulatory framework for derivatives.

Photograph kindly supplied by GFI Group, September 2010.

Kris Monaco, director of new product development, International Securities Exchange (ISE). ISE attracts mostly retail flow to its FX options today, but it has ambitions to capture institutional business as well. Photograph kindly supplied by the ISE, September 2010.

Matt Woodhams, global head of Ecommerce at GFI Group in London, has been an active participant in industry efforts to shape the new regulatory framework for derivatives. GFI runs an interdealer FX options broking business that handles everything from major

currencies through emerging countries to exotics for its bank clientele. It also offers FENICS Professional™, proprietary software that provides a single interface for price discovery, bilateral trade execution and risk management (including straight through processing) to a variety of customers.

At first, industry lobbyists struggled to dispel the confusion even among regulators between the choice of trading venue and post-trade processing, an effort that appears to have succeeded.“When people talked about exchange trading they were really thinking about clearing,” says Woodhams. “They now differentiate between trading on an exchange and trading electronically OTC and clearing through a central counterparty that may belong to an exchange.”

In Woodman’s view, exchanges have little or nothing to offer over electronic OTC platforms as an execution venue.

The regulations governing OTC venues may be slightly less onerous, but they are still subject to strict rules to protect market participants. In fact, product design distinguishes the venues more than the regulatory framework; OTC FX options trade in terms of volatility with European-style expiration, whereas traditionally-listed options are priced at a premium over the underlying strike with American expiration, a practice familiar to retail investors from the equity options market. “It comes down to the type of user a platform is targeting,” says Woodhams. “That is the bigger diffentiating factor.”

It’s a distinction that the CME acknowledges, too. Much as LeVeille hopes and expects to see more volume in CME’s listed FX options, the bigger business opportunity for the group may lie with its clearing house. “There are numerous OTC execution platforms out there that function well. Many customers don’t see a need for another,” he says.

“We can add value in the clearing of OTC traded FX options.” The exchanges may be able to grab a bit more market share in FX options, but the core business will remain OTC for the foreseeable future. I

55

FX VIEWPOINT

REGULATION, OR THE LACK OF IT: THE DRIVING FORCE FOR CCP

Welcome to our new monthly columnist, Erik Lehtis, president of DynamicFX Consulting in Chicago, and who is dedicated to the foreign exchange market. Which FX market? The FX market that only adopts technology that has been vetted, if not proven obsolete, in the equities world? Or the one that averages $4trn a day in turnover, exceeding the collective volumes of all equity exchanges? Actually, both of them.

A STORY OF TWO HALVES ECAUSE FOREIGN EXCHANGE is the exchange of fungible monies, there are no underlying securities to settle, borrow against, or lend. Each transaction is therefore a bilateral pledge to make a payment in one currency, in exchange for the receipt of payment in another. Most transactions are for spot value (T + 2 days, except for USD/CAD, which is T + 1), and active participants will execute tens of thousands of transactions a day, averaging well over $1m per trade.

Knowing all that, you’d expect that the FX market has adopted a centrally cleared model, with full daily netting across currencies, to minimise the number of transactions. You’d be wrong. Some degree of netting does occur, but all trades are executed bilaterally between counterparties.

This creates an elaborate matrix of extremely short-term counterparty risk. As a market, we may have the Flash Crash of May 6th to thank for what three-plus decades of experience hasn’t otherwise generated—the impetus to establish a true centrally cleared mechanism for all FX trades with real pair-by-pair netting.

Regulation, or the lack of it, will be the real driving force for cerebral counterparts (CCP). The FX market prides itself on its self-regulated constitution. The relative lack of transparency in FX (no central exchange, no NBBO, no central

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56

clearing, low-grade published market data) has until now been insufficient to cause any noticeable hiccups in intra-day liquidity beyond those expected by overall market conditions.

“If it ain’t broke, don’t fix it!” cry the banks and traders that comprise the FX community, and indeed any potential regulator would be hardpressed to find justification in terms of past market performance for any sort of overhaul of reporting or transactional requirements.

Whether this cliché is a more powerful argument than the equally trite “don’t wait till the horses are out of view to shut the barn door” platitude remains to be seen. What is not in question is the fact that spot FX remains the least transparent yet most liquid asset class in the financial marketplace. Front running is not only legal; it’s an accepted and expected behaviour in FX. Flash orders? The term doesn’t exist. Dark pools? The major banks are all in process of establishing their own dark pools, and tout them as a solution to the problem of liquidity. Indeed, the practices that appear medieval in the equity space are not just common in FX, they are seen as part of the fabric which makes FX uniquely sound as a self-regulated community. Whether this is actually the case is the stuff of longer discussions than we have space for here, but whatever side you choose in

Erik Lehtis, president of DynamicFX Consulting in Chicago.

the debate, you have to accept the fact that these dynamics potentially open up the industry to a level of scrutiny that other assets classes have long since adjusted to.

One of the benefits (or drawbacks, depending on which side of 1975 your birthday falls on) of going electronic is that you no longer need to know what words like “given” and “paid” mean, let alone “yours” and “mine”. FX traders were using pidgin English on Reuters dealing long before cell phones were even a gleam in the eyes of our young ‘uns (“hihi”,“tks n bifn”). My favourite was the msg interest one particular bank would use when sending orders: “pass out” sounded more like an instruction than a request. Much of the charm of the FX market in its pre-API heyday lay with the lingo, the secret knock and password of the guild, and the ethos of professionalism.

Even now, if you are working a large order from a customer, you are free to front-run it, but if the price prints even once anywhere, the customer is owed a fill. As such, certain professionalism does govern your behaviour, but within the bounds of this abstract code of honour, anything goes and your cleverness is what sets you apart. Mastery of the game isn’t indicative of any particular intellect, but you need savoir-faire to pick it up.

No one just lays it all out for you. I

OCTOBER 2010 • FTSE GLOBAL MARKETS

DEBT REPORT

August was a good month for the corporate bond markets.

Global high-yield issues had their best week mid-month, while investment-grade bond volumes touched $1.3trn year to date, though volumes were still 12% down on last year. Dollar issues have dominated the new issue calendar, while some eurofunded deals have been tough to close as the market became saturated in the first half of the year. Market watchers think the trend might continue through to year end, as US investor approaches to European bank dollar-based issuance improved in the weeks following the results of recent bank stress tests.

Andrew Cavenagh reports.

OTH TURKISH AND Italian banks led the way through summer with $1bn five-year issues (from Akbank and Intesa Sanpaulo). As banks continue to need to bolster their balance sheets, expect more of the same. The attraction of investment-grade corporate debt has rebounded sharply over the past two months, as fears of an imminent sovereign default in Europe have receded, company performance has continued to improve, and equity markets remain volatile.

It has to be said: things were not looking good in the early part of this year.

Corporate bonds took a considerable hit in May, as heightened fears of a sovereign default and, to a lesser extent, concerns that the global economic recovery might be stalling (on the back of disappointing economic data from the US and China) prompted another flight to safety. “It forced people to take money off the table and was fairly indiscriminate,” explains John Stopford, head of global fixed income at Investec Asset Management in London. “Our back-of-the-envelope analysis was that the market was pricing in about a 50% probability of a shift back into recession within six to 12 months, whereas we think the chance is only about one in five.”

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FTSE GLOBAL MARKETS • OCTOBER 2010

Primary issuance had also fallen away sharply in the US—where companies issued just $47bn of new debt over the month against $183bn in April—and dropped to a trickle in Europe, which saw just €11.5bn of issuance in May, all of it from financial institutions. Meanwhile, a massive sell-off in the secondary market took spreads back out to more than 200 basis points (bps) over benchmark treasuries. In the absence of any aggregate statistics, the activity of the Bank of England’s Asset Purchase Facility (APF) over the period offers a glimpse of the extent to which investors had deserted company debt. Between the weeks ending May 6th and June 10th, the APF bought £267m of corporate bonds compared with just £34m in the preceding five weeks.

Since then, however, the combined rescue packages worth €860bn that the European Union (EU) and International Monetary Fund (IMF) put in place at the start of May to support Greece and the other struggling eurozone members— including Spain, Portugal, Ireland and Italy—have allayed market fears that any of these countries will default on their debts in the near term. Though how the bond markets would respond if one of them was to actually draw on

CORPORATE DEBT: RECOVERY AFTER THE TURMOIL IN MAY

BONDS ON THE MEND

the emergency facilities remains uncertain. Even so, we are now witnessing a substantial return of investor appetite for corporate debt.

Roger Sadewsky, investment director for corporate and aggregate funds at Standard Life Investments in Edinburgh, says the diminishing fears of a sovereign default had led investors to focus once more on “yieldy” assets and that “corporate bonds are currently a good way to get that”.

By the end of July, yields on corporate bonds were averaging 180bps to 190bps over the sovereign debt of the nonimpaired EU countries such as Germany, France and the UK. Inevitably, given the receding likelihood of near-term sovereign disaster, this began to look highly appealing in an environment where interest rates look destined to remain at record lows for several more months at least. Sadewsky, who oversees part of Standard Life’s £25bn of cash credit, consisting of sterling, euro and dollar assets, adds the rider that his firm’s investment decisions are still based on assessments of individual names rather than broad sectors. He points to financial institutions, whose debt spreads took a hammering back in May when the sovereign concerns hit their peak, as a good case in point.“We now think it’s alright to invest in the debt of the more diversified institutions—such as HSBC, JP Morgan, and Bank of America Merrill Lynch—but we would be more wary of the stand-alone investment banks,” he says. “We have also tried to avoid exposure to Greece and secondtier Spanish banks.”

Sadewsky adds that the right senior bank paper offered good value in the medium term, because while the current situation, where the senior spreads of financial debt were trading at significantly wider spreads than those of the companies to which they were lending, could persist, it was really an anomaly.

“Financial conditions remain stressed, but even good banks are paying up and represent an opportunity,”he notes.

The continuing improvement in the financial metrics of most companies this year, as they focus on de-leveraging their

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DEBT REPORT

CORPORATE DEBT: RECOVERY AFTER THE TURMOIL IN MAY

balance sheets and controlling costs, has reinforced investor appetite for their paper.

Juan Esteban Valencia, credit analyst at SG Corporate and Investment Banking in London, points out that the results of 66% of the European companies to have reported by late July had beaten analysts’ expectations. Moreover, about the same percentage had seen their net income grow from last year. “The overall positive results on the earnings front we have seen so far is reassuring enough to show that investment-grade credit at least remains a safe investment,” he maintains.

“It offers a much higher return than the safe-haven government bonds, even at these low yields.”

Björn Uhlin at SEB’s Merchant Banking Division, Capital Markets, in Stockholm comments: “In an environment where European government debt, outside the PIIGS area, as well as swap yields, have dropped to an all-time low, it appears increasingly appealing to buy debt issued by well performing corporate borrowers.

In this yield environment we see very strong demand for longer-dated investment grade assets from the insurance and pension sectors, and in parallel an unprecedented demand for high-yield assets from the fund management industry.”

Stopford at Investec says this broadbased improvement in company fundamentals means that the widespread sell-off in May had left a lot of “embedded

Roger Sadewsky, investment director for corporate and aggregate funds at Standard Life Investments in Edinburgh. Sadewsky says the diminishing fears of a sovereign default had led investors to focus once more on yieldy [sic] assets and that “corporate bonds are currently a good way to get that”.

Photograph kindly supplied by Standard Life, September 2010.

value” in the corporate arena and spreads could come back in appreciably over the months ahead. “The scope for them to tighten is certainly there.”

Apart from the right names in the financial sector, Stopford says Investec is increasing its exposure to the slightly less cyclical sectors, such as media, and even some of the cyclical ones that stood to gain from a sustained recovery, such as consumer capital goods. Analysts believe the improving outlook for companies and receding fears of a government default

Volume of US investment grade corporate debt Issue Date Total 1/1/2010 1/1/2010 4/1/2010 1/1/2010

-

9/13/2010 3/31/2010 (Q12010) 6/30/2010 (Q2 2010) 6/30/2010 (1H2010)

INDUSTRY TOTAL

Proceeds (US$m)

Market Share

478,778.7 215,792.4 106,122.9 321,915.3

40.0 18.0 8.9 26.9

No. of Issues 520 201 148 349

1,197,586.3

100.0

1,318

Volume of European investment grade corporate debt Issue Date Total 1/1/2010 1/1/2009 1/1/2010 4/1/2010 1/1/2010

-

9/13/2010 9/13/2009 3/31/2010 (Q1 2010) 6/30/2010 (Q2 2010) 6/30/2010 (1H2010)

INDUSTRY TOTAL

Proceeds (US$m)

Market Share

714,761.7 828,588.6 372,557.1 170,072.5 542,629.6

39.2 45.4 20.4 9.3 29.7

1,168 1,106 542 354 896

100.0

2,703

1,825,918.2

No. of Issues

Source: Thomson Reuters, supplied September 2010.

58

will see the dominant influence that sovereign pricing has exerted on corporate spreads so far this year start to abate. The spreads on both corporate bonds and the price of their credit default swaps (CDS) have moved largely in line with those of sovereign debt in the impaired European countries in the first seven months of 2010, reflecting the high perceived risk of contagion from a sovereign default.

Although the correlation between the CDS levels of corporations in the“safe” European countries and those of the beleaguered sovereigns actually became more sensitive in June and July (after the EU and IMF had announced their support packages), this almost certainly reflected general market unease over the condition of European banks ahead of the stress tests that the EU conducted on 91 financial institutions. “As a result, the CDS of the five troubled eurozone countries should play a smaller role in influencing the performance of [European] corporate CDS spreads, at least for credits not located in one of those five countries,” says David Watts, senior credit analyst at the international research firm CreditSights.

SEB’s Uhlin says: “Already at an early stage during the sovereign driven turmoil in May we saw that, in particular, Northern European corporate credits were relatively well insulated against the credit spread volatility which impacted the sovereign and financial sectors. The lack of quality corporate supply in the European market has meant that investors have become increasingly loath to dispose of these types of assets.”

This has already happened in the US, where since May movements in the CDS levels of American corporations have become increasingly de-linked from those of the at-risk European sovereigns after the EU-IMF bail-out provisions removed the main near-term risk that those countries posed to US companies, in particular its financial institutions; that of a near-term sovereign default or restructuring.

Investors also stand to gain from a change in the relationship between corporate and sovereign spreads in the

OCTOBER 2010 • FTSE GLOBAL MARKETS

Bookrunners: Investment grade corporate debt (Europe) Rank

Book runner

YTD 2010 Proceeds (US$Mil)

Mkt. Share

No. of issues

Bookrunners: Investment grade corporate debt (US) Rank

Book runner

YTD 2010 No. of Proceeds (US$Mil) issues

1

Barclays Capital

58,011.1

8.1

150

1

JP Morgan

73,289.5

195

2

Credit Suisse

54,425.4

7.6

149

2

BoA Merrill Lynch

59,343.0

199

3

Deutsche Bank AG

53,802.9

7.5

168

3

Citi

42,036.8

128

4

BNP Paribas SA

51,511.5

7.2

196

4

Morgan Stanley

39,713.6

110

5

HSBC Holdings PLC

44,988.3

6.3

122

5

Barclays Capital

38,219.8

120

6

RBS

37,326.0

5.2

127

6

Deutsche Bank AG

36,909.8

115

7

UBS

32,652.9

4.6

106

7

Goldman Sachs & Co

35,946.3

102

8

Credit Agricole CIB

30,724.8

4.3

123

8

Credit Suisse

32,418.3

81

9

Société Générale

29,938.9

4.2

94

9

UBS

22,882.4

70

10

JP Morgan

28,715.9

4.0

87

10

RBS

21,385.9

63

INDUSTRY TOTAL

717,764.7

INDUSTRY TOTAL

478,778.7

520

1,168

Data to August 31st, 2010.

medium term. The current crisis has seen the historical maxim that the former should always price off (higher than) the latter reversed in some instances, although such breaches of the “sovereign floor” have been much more common in the CDS market, where the cost of insuring the debt of companies such as Portugal Telecom and Spain’s Telefónica against default has been appreciably less than that of their national governments.

The anomaly between the cash and CDS markets owes much to technical factors, such as the absence of natural protection sellers on the sovereign CDS of developed countries, and is likely to continue. Nonetheless, the CreditSights analysts believe that in a scenario where one of the European countries defaults and restructures but still remains within the eurozone “the most geographically diversified corporate [sic], and possibly even banks, could justifiably trade within their sovereigns”.

Stopford at Investec says while the relationship between sovereign and corporate spreads was undoubtedly “looser than it used to be”, he expected the former would continue to exercise some restraint on the latter. Nevertheless, it would be feasible for a large multinational in one of the troubled countries, if its operations had sufficient geographical diversity, to trade inside the debt of its government in the medium term.

The growing appetite for corporate risk has led to a dramatic pick-up in primary

FTSE GLOBAL MARKETS • OCTOBER 2010

Source: Thomson Reuters, supplied September 2010.

market activity in the US, where many of the largest industrial companies and retailers have rushed to take advantage of the soaring demand. The volume of new issuance doubled as early as the first week of July to $13.8bn, as Time Warner raised $3bn in a three-part issue—its largest since 2006. Wal-Mart raised the same amount the previous week (also in a three-part issue), while Alcoa, Duke Energy, and Kimberley-Clark were among the other big names to tap the burgeoning market.

Jeffrey Rosenberg, head of global credit strategy at Bank of America Merrill Lynch, says the bank still expected to see $700m of high-grade US corporate debt issued over the course of 2010 (against its $800m forecast at the beginning of the year).

Recovery in early summer After the virtual shutdown in May, the flow of new issues in Europe also began to recover in June and July. Air Liquide, the world’s largest producer of industrial gasses, and the state-owned German railway company Deutsche Bahn, led the return of non-bank issuers to the market as they each launched a €500m, 10-year bond in the first week of June. While most of the issuance since then has continued to come from financial institutions, a growing number of other corporations has also raised new debt, including Volkswagen, Deutsche Telekom, BG Energy and Schneider Electric; though the euro-denominated market appears much drier through August. The UK’s

two largest rail rolling stock companies, Porterbrook Leasing and Angel Trains, chose June and July respectively to launch inaugural bond issues, which raised a total of £1.32bn to refinance shortly maturing bank debt. The triple-B rated companies had to pay around 300bp over comparable UK government gilts for the debt, which had maturities ranging from ten to 16 years, but more importantly established platforms for their future long-term funding requirements.

Uhlin at SEB says:“Although we expect the new issue market to be relatively active during the remainder of the year, it is a fact that a large number of corporates prefunded or over-funded during 2009 as markets gradually opened up, leaving very limited needs to raise further financing.

Furthermore, given tight cost controls, limited capex and a very slow M&A activity, a large portion of European corporates are simply very liquid.”

“We’re starting to see some more senior debt issuance now,”comments Sadewsky at Standard Life.“There seems to be an appetite for long-dated corporate debt.”

That’s good news for the big European banks, which will need to issue considerable volumes of further debt over the next year to refinance all the government-guaranteed bonds they had to issue in the first half of 2008 to maintain liquidity, most of which had three-year maturities. However, it will not all require refinancing, as the banks have trimmed their balance sheets considerably. I

59

STOCK EXCHANGE REPORT

JSE MOVES INTO THE FAST LANE

THE CHANGE DYNAMIC The latest World Economic Forum (WEF) Competiveness report ranks South Africa first out of 139 countries in for its regulation of securities exchanges, overtaking Sweden for the top position.

The Johannesburg Stock Exchange (JSE) has much to shout about. It has a strong relationship with its regulator, the Financial Services Board (FSB) and even in the middle of the recent financial crisis; the exchange did not have to resort to either banning short selling, or introducing circuit breakers. Most recently JSE Limited, the company that operates the stock exchange, reported an uptick in equity volumes and profit. Francesca Carnevale spoke to Ana Forssman, the JSE’s senior general manager, Information Products, about the exchange’s latest initiatives.

14.5% OR SO increase in revenue combined with controlled operating costs led the JSE Limited, to report a 13.1% increase in net profit after tax to ZAR207.6m (just over a tot over $29m) over the first six months of the year, compared to a profit of ZAR183.5m in the first half of 2009.“Increased market volatility has been good for JSE Ltd. The results were encouraging considering increased competition in the global exchange industry,”notes Ana Forssman, JSE’s senior general manager, Information Products. This comes at a time of increased regulation and a proliferation of alternative trading venues.

These results are largely due to increased trade on the spot equities market. Foreign inflows continue as foreigners were net investors, investing ZAR19.1bn in South African equities and R36.2bn in local bonds. Liquidity on the equities market rose to 53% for the period.

Investors were less hesitant about equity derivatives in the first half of the year while commodity derivatives recovered somewhat, rising 15.9% to ZAR20.6m.

It has been a year of change and consolidation for the JSE, explains Forssman. Among a somewhat long and complex task-list for the year has been the expansion of the FTSE/JSE Africa Index Series with the introduction of a new investment strategy index; the FTSE/JSE EquallyWeighted Top 40 Index.

The new index consists of all stocks included in the FTSE/JSE Top 40 index, with constituents being equally

A

60

The Johannesburg Stock Exchange in Sandton, the financial centre of South Africa. Photograph © Erik Forster / Dreamstime.com, supplied September 2010.

weighted. The index provides an alternative to market capitalisation based weightings, while reducing stock specific and/or sector biased risk.

“The JSE Top 40 index was very resource intense,”notes Forssman.“The equal weighting offers much greater diversity of returns to the investor.”

Forssman cites the example of BHP Billiton which had the largest single weighting in the original JSE FTSE Top 40 Index. Stocks are free-float weighted to ensure that only an investable opportunity set is included within the index. The equal weighting index allows investors to have a much larger slice of top rated firms such as Arcelor-Mittal, which in the original index had a much

smaller weighting. Investment interest in the new index and a resulting ETF based on a customised version of the equally weighted index, has been gaining steady traction since March.

“The response has been quite positive,” notes Forssman. “We’ve already had some returns and once we have sufficient data to compare Q1 with Q2 data, we expect that it will be a positive story,” she adds.

The move is part of an overarching strategy by the JSE to diversify its product suite and index series. “We are beginning to look at the possibility of equally weighted indices in other sectors offering greater diversity to investors.”Although not inured to the changes in the global exchange market, the JSE has a strong market base; moreover, index based investment in South Africa is still much lower as a percentage of total market volume than say the United States and/or Europe.“There is still a very active based investment community in South Africa,” notes Forssman,”however post-financial crisis period, investors are beginning to question their returns versus cost, often asking to what extent can active managers beat the index long term. Our approaches to index construction should be seen in that light.”

Following the acquisition of the Bond Exchange of South Africa (BESA) in 2009t, dialogue continues with interest rate market participants and industry groups to introduce a strategy which will succeed in growing the exchange traded interest spot and derivative market.

OCTOBER 2010 • FTSE GLOBAL MARKETS

A quick guide to the JSE Month end Aug-10

YTD 2010

YTD 2009

% Change year-on-year

2009

2008

2007

2,008,241 5,690 245,076

16,119,685 49,047 2,020,170

13,414,287 55,799 1,796,311

20.2 -12.1 12.5

20,950,750 82,855 2,796,077

17,398,986 83,778 3,263,065

11,553,877 70,870 2,980,110

7,138 834 41,815

63,419 6,876 368,333

68,965 9,303 394,294

-8.0 -26.1 -6.6

105,188 13,064 581,568

94,934 11,343 607,015

89,960 9,669 572,269

2006

JSE central order book and reported trades

Trades Volume (m) Value (ZARm) Reported Trades Trades Volume (m) Value (ZARm)

Foreign trading on the JSE equity market (ZARm)

Purchases Sales Net (Sales) / Purchases

35,407 32,748

309,081 283,304

353,312 293,390

-44,231 -10,086

524,492 449,074

586,986 641,425

649,041 585,769

2,659

25,777

59,922

-34,145

75,418

-54,439

63,272

Acquisition of Assets 485.0 Rights Issue 1,364 Share Incentive 424 Via Prospectus Waiver of Pre-emptive rights 1,406 Other

8,415 17,982 4,706 -

46,645 7,210 6,463 -

-81.96 149.41 -27.18 -

55,846 14,256 9,023 -

11,689 21,241 9,493 -

61,918 7,382 10,040 -

49,141 955 15,437 122

9,874 -

20,407 -

-51.62 -

27,859 -

34,267 -

45,447 64

21,807 -

TOTAL

40,977

80,725

-49.24

106,984

76,690

124,851

87,462

Equity capital raised on the JSE (R Million)

3,679

Note: The totals may vary monthly Companies/Securities listed & Market Cap Mainboard, Venture,Development Capital & Africa board

Companies Listed No of New Listings No of Delistings

335 1 -

335 7 10

337 5 18

-0.59 40.00 -44.44

334 6 22

348 18 18

347 25 40

364 18 23

73 -

73 1 -

76 2 1

-3.95 -50.00 -100.00

76 4 3

77 5 2

75 37 -

37 19 1

No of New Listings No of Delistings Foreign Listings Domestic Listings

1 49 359

8 10 49 359

7 19 49 364

14.29 -47.37 -1.37

10 25 47 363

23 20 46 379

62 40 37 385

37 24 30 371

Companies Listed

408

408

413

-1.21

410

425

422

401

No of Securities Listed

885

885

979

-9.60

966

992

1,174

1,047

5,816.7

-

5,419.6

7.33

5,929.1

4,541.9

5,696.8

5,041.5

AltX

Companies Listed No of New Listings No of Delistings Overall JSE

Market Capitalisation (Rbn at period)

Source: JSE Ltd., supplued September 2010.

Moreover, she adds, the JSE continues to pursue its Africa strategy.

The Africa Board segment, which is part of the JSE main board, aims to encourage African companies domiciled outside South Africa to take a secondary listing in Johannesburg. There has been considerable flow of funds into African investments as investors search for better returns, notes Forssman.

“Correlations between African capital markets and the developed world are relatively low, allowing investors to diversify portfolios and manage unsystematic risk,” she says. Investing in Africa is however riddled with many challenges, which if not managed may

FTSE GLOBAL MARKETS • OCTOBER 2010

outweigh the benefits of diversification, she acknowledges, such as lack of liquidity and price discovery, high friction costs, often weak corporate governance standards, regulatory inconsistencies between markets and a sometimes asymmetric flow of information. “The standards we maintain are exceptionally high and investors can benefit from Africa’s growth story while minimising the risk,” notes Forssman.

The JSE continues along the path of replacing its back office technology.

“This is in test phase and initial tests have been satisfactory,”she explains. In the equity derivatives market, the

exchange continues to encourage onexchange central order book trading. It will also work on providing services to clients who previously traded offexchange but that now want to trade on-exchange to manage risk. Other initiatives include introduction of new hard commodity instruments, such as silver and copper derivatives, which add to the existing suite of foreign-referenced commodity derivatives contracts under licence from the CME Group. In the immediate term, the JSE she says:“will continue to focus on increasing liquidity and improving the competitiveness, as part of our role to serve the issuer and the investor”. I

61

NIGERIA: A VITAL ECONOMIC ROUTE MAP

Acting Nigerian president Goodluck Jonathan speaks at the Council on Foreign Relations in Washington, Monday, April 12th, 2010.

Photograph by Jose Luis Magana/AP/Press Association Images. Photograph kindly supplied

by Press Association Images, September 2010.

THE LONG, LONG ROAD BACK TO THE FUTURE Nigeria stands at an important tipping point: journeying either to a refulgent future, or back to the hackneyed mire in which too many African nations are entrenched. It’s a delicate time for the country, which up to now has sometimes wasted its myriad resources and 150m-strong population. Nigeria is sub-Saharan Africa’s second-largest economy after South Africa and the fifth-largest source of US crude imports. The regime of president Goodluck Jonathan has stated its serious intent to reform the country’s financial markets, privatise and upgrade its carbonbased energy infrastructure, and bring growth and rigour to the national economy. It’s a tall agenda: can it be done? Francesca Carnevale reports.

IGERIAN FINANCE MINISTER Olusegun Aganga told a press conference in London in early September that he envisaged “strong appetite” for a planned tenyear $500m Eurobond for either late October or early November.

The bond will, says Aganga, set a benchmark for Nigeria in the global capital markets for both corporate and government debt. It will also help fund a widening budget deficit.

Nigeria has been spending and talking big and confidently over the year; variously announcing a series of structural reforms designed to set the country on the path to prosperity. Is Nigeria, like a number of other sub-Saharan states, finally to get its act together? Or will upcoming presidential elections, higher government spending, and gradually depleting foreign exchange reserves (now at a four and a half year low) scupper both investor confidence and the government’s well-meant plans?

N

62

The pick-up in the volume of talk about economic reform began in earnest when Goodluck Jonathan, became acting president in early February, taking over from Umaru Yar’Adua, who had travelled to Saudi Arabia the previous November for medical treatment. Although Yar’Adua returned to Nigeria, he died soon after and Jonathan remains in train. In April, Jonathan took the bit by the teeth and named 38 new cabinet members to help fast-track the country’s new economic road map. Actually, it was a call to arms. Jonathan told local reporters at the time: “The process of our development is the most important task in the life of our nation. Our present and future depend on it.”

It cut to the heart of the matter. Unemployment now stands at over 20%, with the most affected being younger workers.

Many economic sectors are moribund and pervasive corruption at all levels still exerts a drag on economic efficiency.

OCTOBER 2010 • FTSE GLOBAL MARKETS

Among the incomers into Jonathan’s cabinet was Olusegun Aganga, previously managing director at Goldman Sachs, who took on the role of finance minister. Aganga, who has degrees from Oxford and Ibadan, heads a team that briefs Jonathan every two weeks on the state of the economy. The minister is a qualified accountant, having worked at Ernst & Young before joining Goldman Sachs in London in 2001, where he started at the European prime brokerage division. Other key appointments include Diezani Alison-Madueke, who took on the mantle of petroleum minister, and who is tasked with upgrading the country’s carbon resource output, currently capped at 2.6m barrels a day by outdated infrastructure. Then there is Arunma Oteh, tasked with rebuilding the credibility of the Nigerian financial markets in her role as director general of the Nigerian Securities and Exchange Commission.

The economic imperative Aganga has a budget of NGN4.6trn ($30.7bn) for fiscal 2010 and a rather tall order: to balance the budget and provide consistent growth while the government invests in an expensive, careworn and outdated infrastructure, involving roads, bridges, houses, schools and power plants. It is an expansive, almost Herculean task. That’s because Nigeria’s former military rulers singularly failed to diversify the economy away from an overdependence on the capital-intensive oil sector.

The country has also had a chequered credit history. In the shadow of an International Monetary Fund (IMF) standby facility, agreed in August 2000, Nigeria restructured its foreign obligations with Paris Club creditors. It then received $1bn in IMF credits; both facilities were, however, contingent on the strict application of economic reforms. In the event, Nigeria pulled out of the IMF programme in April 2002, after failing to meet spending and exchange rate targets. Moreover, the pullout pulled the plug on any immediate further Paris Club rescheduling and consigned the country to the credit wilderness for a time. Even so, a few significant reforms took place: fuel prices were deregulated and four refineries were privatised. The government also established the National Economic Empowerment Development Strategy, modelled on the IMF’s own growth, fiscal management and poverty

reduction facilities. The Paris Club subsequently restructured around $18bn of debt (with some $6bn in obligations forgiven).

By 2007 the country’s GDP was on the rise (thanks largely to increased oil exports and high oil prices).

Under the leadership of Yar’Adua however, in 2008 the government began to show signs of a more vigorous commitment to economic reform. The banking system was modernised and consolidation encouraged; excessive wage demands were curbed and the government made serious efforts to resolve regional disputes over the distribution of carbon wealth.

A $4bn bailout of banks last year was a bold step to try to stop the drying up of credit. A new Asset Management Corporation was created by a National Assembly-sponsored law, designed to mop up toxic loans and take them off the banks’ books. Then, in August last year, central bank governor, Lamido Sanusi fired the managing directors of several major banks and tightened regulations and oversight in the banking sector as a whole. This has had the unfortunate consequence of tightening credit at the banks once more. A $3bn special interim financing fund was subsequently set up by the central bank to help refinance bank lending to firms in critical economic sectors, such as manufacturing and power generation; though it has had limited impact. Interest rates remain preternaturally high, sometimes reaching as much as 24%; highlighting the need for a deepening of the local capital markets, and an opening up of the local stock market to encourage firms to seek alternative sources of finance.

To cap a strained period, ratings agency Standard & Poor’s downgraded Nigeria’s national scale short-term rating to ngA1 at the same time, reflecting the agency’s view of “reduced fiscal flexibility due to costs associated with the bailout of the country’s five largest domestic banks (which reportedly cost NGN420bn) and the fall-off in government oil revenue”.

The reasons for the downgrade were manifold. The country had gone to a current account deficit of some 7.2% of GDP in 2009 from a current account surplus in 2008. Although the central bank had moved to impose currency controls in late 2008 to protect the country’s dwindling currency reserves, it invariably limited the access local banks had to any crossborder funding.

Nigeria v. BRICS and other African States

China Brazil Russia India South Africa Egypt Morocco Nigeria Kenya Ghana Zambia Zimbabwe

GDP/Capita in $

Population (m)

Equities value traded in $m

Stock Exchange market capitalisation*

3,565.73 7,737.32 8,873.61 1,032.71 5,635.19 2,450.41 2,847.50 1,089.30 841.95 638.79 1,026.92 303.14

1,334.30 191.48 141.39 1,203.28 49.22 76.7 31.87 151.87 35.88 23.1 11.97 11.732

19,472.37 2,118.83 4,000 1,855.62 113.26 123.34 16.589 19.29 2.146 0.62 0.216 0.212

3,285,964 855,185 1,050,000 700,029 370,000 109,656 65,709 40,000 11,000 10,880 5,002 4,203

*In $m as of August 31st, 2010.

FTSE GLOBAL MARKETS • OCTOBER 2010

Source: Office of the Director General, Securities and Exchange Commission of Nigeria, supplied September 2010.

63

NIGERIA: A VITAL ECONOMIC ROUTE MAP

Nigeria v all-Africa GDP and Banking Assets Nigeria contributes 14% to Africa’s GDP 17% South Africa

25% Other SSA

5% Angola 14% Nigeria

9% Algeria

17% Other North Africa

13% Egypt

Total Banking Assets in Africa, 2008 1% Rest of Africa 15% Nigeria

25% Egypt

45% South Africa

13% Algeria Source: Office of the Director General, Securities and Exchange Commission of Nigeria, supplied September 2010.

Even now, while the worst of the latest financial crisis is over, Nigeria still suffers from structural economic problems.

Reserves stand at a four and a half year low and the Excess Crude Account (ECA) is depleted. Nigeria’s parliament has approved spending of more than NGN4.8trn (around $32bn) this year, an increase of 50% on 2009, thereby widening the budget deficit to more than 5% of GDP (though that is low by some developed country standards). The monthly disbursal of oil revenues and windfall savings to the various levels of government reached a new peak in July. The move left Nigeria’s ECA, which accumulates windfall oil savings, with just $460m compared to $20bn at the beginning of the current presidential term in 2007.

Aganga has a more positive take on the account. He told the press conference that he would like to establish a sovereign wealth fund in October, dedicating most of the money to investment in infrastructure. “We have, just recently, had a beauty parade by all the legal and investment advisers who are keen to assist and we will shortly be appointing the advisers.”In the early summer, a committee of three ministers and six state governors had been set up to work out the legal framework for a “quick take-off” of the fund. The decisions of the committee on where funds could come from have not been released, however, Aganga is on record as saying he would like the wealth fund to replace the ECA, into which Nigeria currently saves oil revenue above a benchmark price.

The fund will be utilised to finance the construction of roads, railways and ports, in cooperation with private investors, he

64

told the press conference. A third part of the sovereign wealth fund will be a stability fund, which will be similar to the current Excess Crude Account, though harder for the government to access. The ECA currently has over $500m in it, noted Aganga, which could rise to as much as $1bn by year end, which will be transferred to the sovereign wealth fund, he added.

That might be wishful thinking in the run up to national presidential elections next year. The extent of spending needs was clearly illustrated in August when Nigeria sold NGN126.46bn ($833.9m) of 20-year, five-year and three-year sovereign bonds at its eighth debt auction of the year, all of which were reopenings of previous issues. The sovereign sold NGN41.64bn in 20-year paper, NGN42.33bn in fiveyear bonds and NGN42.49bn in three-year instruments at auction, ultimately raising 20% more than it originally planned; with the issues oversubscribed (NGN202.86m was raised in total).

The high level of interest in the papers was a result of the release of large budgetary allocations (worth a total of NGN704bn) to various states in July, which raised liquidity in the economy. The marginal rate on the three-year bonds rose slightly to 7.54% from 7.48% the previous month, the five-year paper was up to 9.25% from 8.85% and the 20year bonds climbed to 11% from 10%. However,“the original coupon rates of 5.5%, 4% and 10% for the three-year, fiveyear and 20-year respectively will be maintained”, the Debt Management Office notes in a statement. Naturally, stresses remain: and while Nigeria’s foreign exchange reserves rose 3% to $38.2bn by mid-August from the end of July, they are still lower than the $43.3bn registered a year ago due to demand pressure from importers and a reduction in accruals from oil exports.

Power and the investor Following president Jonathan’s announcement in late August this year that the government will dissolve the state power monopoly and expand and upgrade the country’s rackety power distribution network, Aganga says he has received interest in the projected privatisation programme from investors in China, Brazil and Germany.

Power outages are a daily occurrence in Nigeria, where demand for electricity is almost double the current supply of 3,000 megawatts (MW).

Nigeria’s oil production is gradually increasing after an amnesty for militants in the Niger Delta region reduced attacks on the industry, Aganga explains, though it has struggled to stay above 2m barrels per day (b/d) for some years now. “Crude output is currently 2m barrels/day,” he says. Oil and gas account for 90% of Nigeria’s export earnings and 16% of the country’s GDP. Power generation is a lynchpin in Nigeria’s future growth. Like presidents Olusegun Obasanjo and Yar’Adua before him, Jonathan has made power generation a priority. However, local entrenched interests have scuppered previous efforts to tackle the problem. In a nutshell: Nigeria has to reform power distribution, to kick start sustainable growth. That cannot

OCTOBER 2010 • FTSE GLOBAL MARKETS

Nigeria’s External Debt Stock as of June 30th, 2010 (in $M) Category

Principal Balance

Principal Arrears

Interest Arrears

Total

Percentage

MULTILATERAL World Bank Group 58.92

0.00

0.00

58.92

3,218.17

0.00

0.00

3,218.17

57.95

0.00

57.95

ADB

124.82

0.00

0.00

124.82

ADF

287.20

0.00

0.00

287.20

EDF

109.64

0.00

0.00

109.64

IDB

3.98

0.00

0.00

3.98

3,860.68

-

-

3,860.68

BILATERAL

181.38

0.000

0.000

181.38

Commercial

227.65

0.00

0.00

227.65 409.03

9.58%

0.00

0.00

4,269.71

100.00%

IBRD IDA IFAD African Development Bank Group

SUBTOTAL

90.42%

NON-PARIS

SUBTOTAL GRAND TOTAL

409.03 4,269.71

Note: The decrease in the current debt stock compared to that of 31.03.2010 is as a result of Loan Repayments despite additional disbursements on existing Loans.

Source: Debt Management Office of Nigeria, supplied September 2010.

happen without the Niger Delta peace process succeeding. In turn, the Niger Delta peace process cannot succeed without corruption being tackled; and that is a big task. There is no guarantee, no matter how well intentioned, this administration will fare any better than others in tackling Nigeria’s chronic corruption. Early signs look promising however. Its efforts in capping dissent in the Niger Delta region has enabled the government to forcefully announce a new agenda of change.

“The way forward is to open up the power sector,” says Professor Barth Nanji, special adviser to the president of Nigeria on energy matters.“We plan to privatise generation of power and distribution of power, through the launch of shares on the stock exchange and some trade sales. The president has tasked us with achieving 5,000 megawatts of capacity to come from the private sector to power growth in the country.”

The core of the administration’s plans is the sell-off of shares in some 17 state-owned power generation and distribution firms and the construction of a new transmission system, at a potential cost of some $3.5bn. Some 11 new electricity generation companies will be established as joint ventures, between specialist private sector firms (which will hold 51%), together with interests held by state entities. The companies will be unbundled from the Power Holding Company (PHCN), though it is not yet clear whether the holding will be wound up. In the interim, the government has also provided a special NGN57bn fund to settle arrears in PHCN employee benefits.

The plan involves government guarantees on the amount paid to new power generating companies to encourage them to invest, and the creation of a new government agency that will guarantee payments to independent power producers (IPPs), to encourage them to build natural gas and other power generation facilities. Nigeria has the world’s seventhlargest natural gas reserves.

The need is pressing. Demand from domestic energy producers is expected to rise to 3bn cubic feet/day by 2015, up from around 800m cu ft/day now. Additionally, cities, towns and industries are regularly incovenienced by power cuts.

FTSE GLOBAL MARKETS • OCTOBER 2010

Unreliable power supply is a pain for both retail consumers and industry in Nigeria and it has been estimated that the high cost of power in the country can add up to 40% of the cost of production. Actually, much of the country relies on diesel generators because of constant power outages, at a cost of NGN1.56trn a year, according to recent central bank figures.

Past efforts at power sector reform have foundered on charges of opaque deal-making; a habit that the current administration might find hard to kick. According to Nanji, a special retreat will take place in October where potential investors will be able to ask questions directly of the government on the overall plan. It will be interesting to see whether the October retreat will result in a fully transparent offer and bid process; and whether proper qualified investors do actually win the bids.

There’s a sense of urgency about Nigeria’s economic programme. Not least because the current government’s term of office runs out in May 2011. Time is at a premium for Jonathan and his team to make sufficient impact on the country in the run up to an election. Inevitably there will be a tussle over fiscal discipline, as it is difficult for governments to rein in spending when ballot papers are about to be issued. Some time was lost in the run up to February this year when Jonathan took over the reins of power from Yar’Adua. The question is: will he have enough time to see through his vision for Nigeria? Returning to sound fiscal balances at a time when the country needs sustained investment across the board will be challenging enough for Jonathan and his team; particularly while donor countries, which could provide some valuable ballast, are bogged down in budgetary problems of their own.

Harnessing the private sector and inward direct and indirect investment are key to achieving many of Jonathan’s reforming goals; however that might come at a price (both in terms of new debt raisings, increased fiscal deficits and the ceding of control in strategic industries) that might be too rich for the country’s entrenched revisionary interests. So far, so good. Let’s hope the map proves durable. I

65

CLEAR-CUT REGULATION TO CLEAN-UP NIGERIA’S MARKET 66

A CLEAR AGENDA Arunma Oteh, director-general of the Securities and Exchange Commission in Nigeria, takes no prisoners. A veteran of the African Development Bank, Oteh returned to Nigeria with a hard-headed mission: to head up the national regulator and to impose international standards and order on a sometimes chaotic and corrupt capital market. An idealist, with clear-cut views and the stomach to take difficult decisions, Oteh has taken up the cudgels of regulatory responsibility with gusto and no small degree of courage. Will she succeed in turning Nigeria into a creditable and credible financial hub?

HE SERIOUS AND purposeful approach that Arunma Oteh has brought to Nigeria’s Securities and Exchange Commission has perhaps been best exemplified by the firing of the director general of the Nigerian Stock Exchange, Ndi Okereke-Onyiuke. The SEC says the move was essential; aimed at restoring confidence in the capital markets following concerns over alleged inadequacies in oversight of the exchange, ongoing litigation and governance challenges.

Okereke-Onyiuke had been scheduled to retire in November in any case; but Oteh appears to have used the opportunity to both restructure the management of the exchange and to set down a clear marker of intent. It was a brave move.

Okereke-Onyiuke has important connections to former president Olusegun Obasanjo, chairing the board of Transcorp, a company which was established by the ex-president.

Make no mistake; Oteh is travelling a rough, dangerous and lonely road. She is fighting long-entrenched and powerful local interests that have been enriched by past lax regimes and who are unwilling to give up their benefits without a fight.

Some country watchers also worry that the current reform agenda is too dependent on a few key players: Oteh herself, central bank governor Lamido Sanusi and finance minister Olusegun Aganga. Certainly while Goodluck Jonathan remains in power, they’ve got the wind in their sails; but much will depend on their ability to get the job done quickly and instigate some serious reforms in an otherwise slow and bureaucratic system in the run up to elections next year.

Even so, Oteh’s determination to extirpate malpractice in the Nigerian capital markets was emphasised in August by the announcement that the SEC will take as many as “260

T

Arunma Oteh, director-general of the Securities and Exchange Commission in Nigeria, is leading the reform charge based on an approach to the management of the SEC as one which combines regulatory oversight with capital markets development. Having made clear her willingness to impose the full weight of the law on market transgressions, she is now focusing on expanding and strengthening Nigeria’s capital markets infrastructure. Photograph kindly supplied by the Securities and Exchange Commission in Nigeria, September 2010.

individuals and entities, including banks and other capital markets operators” to a special tribunal over alleged pricefixing, fraud and insider trading committed between 2006 and 2008.“The key thing to do is to make people realise that the game has changed,” Oteh told journalists in London in a press conference in early September. Investors have made it clear that improving the reputation of the exchange was crucial to the overall perception of Nigeria, she added.

OCTOBER 2010 • FTSE GLOBAL MARKETS

A few days later, Oteh says she will not be deflected from the task in hand, her years dealing in the political milieu of the African Development Bank will stand her in good stead, and that if a job has to be done: “it had best be done well”.

With that in mind, in August the SEC announced that Emmanuel Ikazoboh, a former executive at accounting firm Deloitte in West and Central Africa, has been appointed as interim administrator of the exchange. A new management team will be brought in by the start of next year, she says, in a move that will allow the exchange to move forward to demutualisation and listing, part of a wider strategy of diversifying Nigeria’s bank-dominated stock market. Moreover, the exchange will likely be managed by a team involving both national and international professionals.

Oteh is caught in particular by the experience of global institutions such as the Chicago Mercantile Exchange (CME) and its shareholding in key regional exchanges. “I look at Brazil’s BM&FBOVESPA and the opportunities that have arisen for the exchange in its relationship with the CME. I am also looking at the experience of Bursa Malaysia; its demutualisation and the diverse products that can now be listed on that exchange. Moreover, I am also interested in its route to becoming a venue for the listing of Islamic products.

As you know, about half of Nigeria’s population is Muslim and this offers opportunities for the development of an Islamic financing industry; with the stock exchange as a natural listing venue,” she says.

Oteh says she was shocked to“find that we had not done much in the Islamic finance space. We are keen to learn from Malaysia and have established the Islamic Finance Working Group to that end, to take credible action. I understand however that we already have some Islamic ethical funds.”

Building blocks Oteh believes that Nigeria is replete with opportunity; as long as the progress towards change conforms to the strictest international standards. In February this year in an early speech as director general, Oteh acknowledged that the Nigerian stock market: “... when measured against comparable markets, it still consistently fell short of the benchmark in several key market performance indicators such as market depth/breadth, market liquidity, sector concentration and transaction costs.” However, she goes on to note that these are in fact, important building blocks for the future: “In the aftermath of the global and local crises, we have a dual opportunity to learn from our mistakes, and those of other markets, and to emulate the best regulatory and operational practices. We must also build a solid foundation and restore investor confidence by eliminating the sharp practices that have characterised the last two years.”

Oteh is leading the reform charge based on an approach to the management of the SEC as one which combines regulatory oversight with capital markets development. Having made clear her willingness to impose the full weight of the law on market transgressions, she is now focusing on expanding and strengthening Nigeria’s capital markets infrastructure.

FTSE GLOBAL MARKETS • OCTOBER 2010

Oteh has in mind a clear goal for 2020.

“If we put in place the right building blocks we could be a top 20 economy. What is important for us is to put viable institutions in place that facilitate change. For instance, we have approached Oxford University to look at ways in which we can develop (perhaps jointly) professional training schemes to bolster financial market expertise.”

There are some easy wins, she avers and first among these is the expansion of the number of firms listed on Nigeria’s main board.“Nigeria’s upstream oil producers are generally joint ventures between government, with a majority stake, and international oil firms such as Royal Dutch Shell, Exxon Mobil and Chevron. The aim would likely be to list part of the government-owned component on the stock exchange. I would love to see that happen sooner rather than later, possibly as soon as next year,” she says.

In addition, the government’s privatisation plans will also create new opportunities for companies to list on the exchange.

“This is just the beginning,” notes Oteh, listing among her plans for change, the upgrade of the Nigerian Stock Exchange trading platforms to take account of the expected growth in the Nigerian capital market, the expansion of services to cover the small and medium sized enterprise (SME) segment, and the creation of a vibrant collective investment fund management that brings expertise to the retail sector and transforms it into a credible institutional market.“Expanding the range and type of companies that have access to finance via the stock exchange to include SMEs will enable Nigeria tackle social issues such as unemployment,”she adds, pointing to examples such as the JSE’s Alt-X market and the London Stock Exchange’s AIM. High on Oteh’s agenda is the establishment of a strong fixed income market in Nigeria, “The goal is to have a fixed income market that is bigger than the equities market,” she avers.

Oteh has in mind a clear goal for 2020.“If we put in place the right building blocks we will certainly be a top 20 economy.

We are well endowed with resources. The list of advantages is long. What is important for us is to put viable institutions in place that facilitate change.” Acknowledging the crowded development agenda, Oteh is not dismayed and displays something of a missionary zeal for the task in hand.“You have to understand, the Nigerian stock market has been in place for 50 years. This is an august institution that deserves its place in the international markets,” stresses Oteh.“I also believe that this is Nigeria’s time. We have a road map that clearly articulates how we will build a world class capital market. We have zero tolerance for improper behaviour and sharp practices as market integrity is key to ensuring that our capital market is an investor’s preferred destination.We now invite local and international investors come and join us in building a mutually rewarding future for the Nigerian capital market.”I

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EXECUTION CONSULTING: ARE THE REWARDS WORTH THE RISK?

By offering solutions specifically tailored to clients on a case-by-case basis, execution consultants can help buy side firms address latency in the trade lifecycle, while allowing them to seek parity in a world increasingly dominated by high-speed “flash” programming. Are the rewards worth the risk of sharing potentially sensitive data with a sell side provider?

David Simons reports from Boston.

Photograph © Kuzma / Dreamstime.com, supplied September 2010.

GETTING CLOSER TO THE BUY SIDE SSET MANAGERS RELY on many different types of strategies and processes, and the demands they place on their internal trading teams can vary wildly. This, in turn, can have a direct impact on the services they require from their providers on the sell side.Yet by settling for a onesize-fits-all solution—or not having better insight into the customisable tools at their disposal—buy side firms run the risk of seriously under-performing the competition.

This scenario has helped raise the profile of a fast-growing niche enterprise known as execution consulting. An advisory buy side service covering a multitude of needs, execution consultants are capable of providing firms with stock ideas and algorithm strategies as well as basic research insight, and can also offer advice about upcoming or existing regulatory issues and how trading processes can be structured to properly comply.

The elements that comprise execution consulting have been around for quite some time. However, within the past

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year providers have been able to hone in on a central theme: analysing how individual buy side firms can maximise their execution capabilities and, above all, how they can better access precious sources of liquidity. This not only involves determining how a suite of trading products can best be utilised, but often examines wider issues such as market structure and connectivity.

By gaining a deeper understanding of their clients’ internal processes, sell side providers have been able to better tailor their product offerings, allowing the buy side to reduce investment latency, and, in the process, recoup “lost” alpha, say consultants. Perhaps most significantly, execution consulting seeks to address issues related to gaming, flash trading other products of an increasingly aggressive, highspeed world that, in some instances, have put institutional players at a severe disadvantage. Can execution consulting help traditional buy side firms redress the balance? Plus, is

OCTOBER 2010 • FTSE GLOBAL MARKETS

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EXECUTION CONSULTING: ARE THE REWARDS WORTH THE RISK? 70

The various disciplines of execution consulting have been in place for years, confirms Lee Morakis, head of execution services sales at Bank of America Merrill Lynch. However, like others in the business, over the past year Morakis and his colleagues have begun to see a much greater need for understanding the mechanisms that buy side firms use to execute their orders. the reward of a more streamlined and competitive execution platform worth the risk of sharing potentially sensitive information with a third party?

An electronic education Raymond Tierney, chief executive officer and president of global electronic agency brokerage Bloomberg Tradebook, calls execution consulting “something that has always been near and dear to me”. He should know. In his 16 years at Morgan Stanley, Tierney served on both the sell side and buy side, the latter coming during a four-year stint as global head of equity trading for the company’s Investment Management division. Today, Tierney is working to enhance Tradebook’s own execution-support facility, which includes a team of consultants offering guidance on the world of electronic trading and is led

by Robert Shapiro, himself a Morgan Stanley veteran, who serves as Tradebook’s global head of trading and execution consultation.

If firms have been adept at pushing technology, often they’re not nearly as good at providing information about what the technology has to offer, says Tierney. Therefore, one of Tradebook’s key objectives is enhancing education around the electronic experience.

“Throughout the course of my career, I always found it somewhat remarkable that we were offering all of these tools, yet few people really understood what the tools did— it was always just a case of ‘set it and forget it,’” says Tierney.

“Not any more. Not only are sales traders today compelled to know how the tools work, they must also have the ability to distribute these order flows into the different strategies, whether it’s liquidity, urgency or size.”

Tierney believes that the buy side and sell side are currently at a turning point in their relationship—and as the buy side continues to take greater control of their orders, the sell side is searching for new ways to add value. “It’s true that the buy side is no longer dependent on the sell side for execution.

Still, I think those that can package and deliver high-quality liquidity solutions to these firms will see an increase in both the top and bottom lines.”

The ability to take that discipline across multiple asset classes holds great promise in the years to come, says Tierney.

“Just as high-frequency trading has moved across the aisle, the same mechanism will be sought out for the likes of futures, options and FX. So when people are thinking about providing clients with solutions along the lines of an execution

Lee Morakis, head of execution services sales at Bank of America Merrill Lynch. “We’ve had this enormous growth in electronic trading, particularly in equities, options and FX, and, to a lesser extent, fixed income,” says Morakis. Photograph kindly supplied by Bank of America Merrill Lynch, September 2010.

Oliver Sung, head of execution consulting, Bank of America Merrill Lynch, says: “Compared to a straight-out-of-the-box solution, obviously this kind of hands-on approach is something that clients have been very responsive to.” Photograph kindly supplied by Bank of America Merrill Lynch, September 2010.

OCTOBER 2010 • FTSE GLOBAL MARKETS

consultant, they really need to be looking at it from the perspective of numerous asset classes. ”Greater understanding around market infrastructure and microstructure needs to be brought to bear when approaching clients who are engaged in these different types of businesses. “The point is, product differentiation, education and execution analysis will all be driven by the execution consultant,”says Tierney. Accordingly, sell side providers will be forced to adapt if they are to succeed in this field, “because these are the areas that I believe have the greatest potential for execution consultants”.

In order to deliver high-quality liquidity solutions to the client base, consultants should have the ability to access the flows within the client’s organisation, covering all applicable businesses. “Packaging must be fully transparent and client-driven, with a focus on enhancing the client’s implicit P&L, covering everything from information leakage and market impact, to momentum and venue choice,” says Tierney. The fact is, a lot of the explicit stuff like commissions, which represent only about 13% of the trade, is pretty much out of your hands to begin with, because market forces drive that behaviour. It’s the other 87% that really matters, because that portion is all about the implicit cost savings.

So if you can start to find liquidity, manage impact, as well as use the right kind of execution solutions to properly match up with that liquidity, the likelihood of reducing your implicit costs is pretty significant.”

Furthermore, says Tierney, consultants must be able to reclassify orders and subsequently channel those executions to the proper venue and/or commission structure, including maintaining a full and thorough understanding of the client firm’s electronic offerings.

Consultation disciplines The various disciplines of execution consulting have been in place for years, confirms Lee Morakis, head of execution services sales at Bank of America Merrill Lynch. However, like others in the business, over the past year Morakis and his colleagues have begun to see a much greater need for understanding the mechanisms that buy side firms use to execute their orders. “We’ve had this enormous growth in electronic trading, particularly in equities, options and FX, and, to a lesser extent, fixed income,” says Morakis. “As a result the sell side has been offering buy side clients a lot of different tailored products to help them respond to this rampup in electronic trading.”

Rather than continue to seek newer products, however, Morakis found that clients instead wanted a more thorough analysis of the products already at their disposal, so they could decide which ones would provide them with the best execution methodology for a particular asset class, market environment or sector.

“By talking with clients and understanding how their trading strategies might vary from that of another client, we were able to show them the best way to use our tailored strategies in order to perform execution with the least amount of slippage. That’s what has really brought this department together over the past year.”

FTSE GLOBAL MARKETS • OCTOBER 2010

Bradley Katsuyama, head of RBC’s global electronic sales and trading.

“In today’s world, however, market-structure insights have become just as valuable to the trading desk as the latest earnings report,” he says.

Photograph kindly supplied by RBC Capital Markets, September 2010.

By levering three unique disciplines—quantitative consulting through transactional cost analysis (TCA), macro research, as well as market-structure analysis—Bank of America Merrill Lynch is able to provide clients with the wherewithal to trade electronically, as well as more efficiently, adds Oliver Sung, head of execution consulting, Bank of America Merrill Lynch.

As part of their menu of services, consultants may perform “deep dive” analysis on a client’s current algo arrangement to ensure that overall performance is adequate, making adjustments as needed or suggesting possible alternative strategies. “Compared to a straight-out-of-the-box solution, obviously this kind of hands-on approach is something that clients have been very responsive to,” says Sung.

Not only has this analysis led to improved strategies for clients, it has also provided Sung’s team with a road map for providing ideas to enhance its suite of products. “We have been able to continually update our anti-gaming regimen based on our analysis to account for the constantly changing marketplace,” he says.

While laying the foundation for its electronic service offering launched in May, RBC Capital Markets approached various buy side clients in an effort to determine how to best structure its new platform. “Over and over again, clients were telling us that they felt a lot of the products were commoditised,” says Bradley Katsuyama, head of RBC’s global electronic sales and trading. “They saw a lot of big marketing, bells and whistles, but very little in the way of explanation.Yet once we started to research further, we found that electronic trading was anything

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EXECUTION CONSULTING: ARE THE REWARDS WORTH THE RISK? 72

but commoditised—it was all about the way it was being presented. The point is, if you get into a level of unnecessary complexity, trader’s will be unlikely to use it.”

While running RBC’s high touch market making desk, Katsuyama had first-hand experience dealing with the problems and challenges associated with high-frequency trading (HFT).

“I saw the flickering quotes, cancellations, and adverse price moves, and was consistently frustrated with the lack of answers,” says Katsuyama. “So when many of our top clients outlined the exact same issues, we became dedicated to effectively diagnosing the problem and it started with acquiring knowledge.”

The rapid growth of high-frequency trading (HFT), according to Katsuyama, has had the effect of shaking up the marketplace, and, in the process, became a real catalyst for RBC’s electronic services platform.

“Suddenly, HFT was this very significant, high-volume competitor, and while many of our larger clients were initially quite opposed to HFT, rather than choosing sides we decided to step back and examine how HFT worked, what the traders’ strategies were about, and how we might be able to shift the balance of power back to the institutions. So when it came time to build our client-facing electronic tools, we went out and actually hired individuals with HFT expertise, in an effort to bring some parity to the institutional-client segment of the market. By doing so, we were able to gain meaningful insight into the strategies and technologies surrounding HFT—and that has allowed us to take a very differentiated approach to our service offering.”

Market insights Clients are cognizant of the tremendous focus on micro-market structure, and therefore rely heavily on their broker counterparts to be well researched in this area. “Two years ago, you might have been able to get away with handing a client a TCA report and feeling like you fulfilled your duty as a service provider,”says Katsuyama. “In today’s world, however, market-structure insights have become just as valuable to the trading desk as the latest earnings report. It’s a clear sign that both the markets and the sophistication of clients have evolved.”

Filling gaps in electronic trading begins on a much different level—that is, building trust between these two disparate client groups. “There are certain things that a client won’t ever divulge to the broker. We have found that once we have established a certain level of trust, clients are quite willing to approach us from an ideas standpoint—they’ll bring us into workflow discussions where we learn about the challenges that they’re trying to overcome. Coming from the sell side, you get a much different level of appreciation from listening to the people on the front lines who have to deal with these pressures on a daily basis.”

One area where virtually all firms wish to improve performance—and where execution consultants can truly add value—is shortening the process chain from investment decision to execution. Research suggests that the delay between a fund manager’s decision to invest and the actual market execution of that decision can often cost as much as 400 basis points. A gap this wide can lead to diminished

Raymond Tierney, chief executive officer and president of global electronic agency brokerage Bloomberg Tradebook, states: “Product differentiation, education and execution analysis will all be driven by the execution consultant.” Photograph kindly supplied by Bloomberg Tradebook, September 2010.

performance by fund managers. “A lot of people on the buy side are looking to streamline their workflow—and as soon as the order gets into the sell side’s hands, the focus is really all about access to liquidity. Through our conversations with clients, we found that liquidity access—or lack thereof— was the number one point of frustration. So that has really become the cornerstone of our approach. Particularly when you consider that HFT represents anywhere from 50% to 70% of total volume, that ‘access to liquidity’ actually means ‘understanding HFT’. However, it’s also about being intuitive—we have to be able to sit down with the client and explain why we’ve built a particular product, here’s the rationale based on what we’ve heard from research and discussions with our clients, and this is what we’re doing to address the problem.”

Playing the role of advocate goes a step beyond basic consultancy, contends Bobby Grubert, head of US Equity Sales and Trading for RBC Capital Markets. “It requires deeper engagement, greater trust and true transparency. Our consistent focus on viewing every situation through the client’s lens has led them to rely on us as a sounding board so that new ideas can be shared and tested in a collaborative manner. This has allowed us to provide customised solutions in a commoditised world.”

At the end of the day, says Tradebook’s Tierney, the primary goal of the execution consultant is to solve liquidity sourcing challenges for the client, while driving down the implicit costs of trading. “This is effectively a high-touch service in a low-cost world, and in order for you to gain a competitive edge, you’ll have to be best in class. It’s that simple. However, my general view is that if you can gain mindshare, you’ll get market share as well.” I

OCTOBER 2010 • FTSE GLOBAL MARKETS

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BUY SIDE TRADING STRATEGIES: HELP IS ON THE WAY

Photograph © Nmedia / Dreamstime.com, supplied September 2010.

From seeking best execution through the murky waters of market fragmentation, to integrating legacy-based systems in a highfrequency trading world—buy side desks have their work cut out for them. The good news? Help is on the way.

David Simons reports from Boston.

KEEPING UP WITH THE JONES’s HERE WAS A time when those manning buy side stations could simply pick up the phone and make trading decisions quickly and spontaneously. Times have changed. Today, traders have become much more discerning about the way they conduct business, and with good reason. Particularly in the years since MiFID, buy side desks have become increasingly responsible for ensuring best execution, including seamlessly filtering and relaying information to and from portfolio managers and analysts.

Lack of system integration, however, can make the going much tougher as the buy side attempts to access a multitude of execution venues in a perpetually fragmented marketplace.

The onus has also been placed on the buy side to locate attractive liquidity prospects as they become available so that firms can react in a timely manner. Accordingly, algorithmictrading strategies now occupy a much bigger piece of the buy side execution regimen. While predominantly a USbased phenomenon, a ramp-up in buy side algo usage is forecast in Europe as well, particularly as multilateral trading facilities (MTFs) continue to flourish.

Meanwhile, pressure from investors to secure independent fund analysis, including non-affiliated trading, custody, lending and administration duties, continues to compel buy side firms to seek third-party sources of valuation and other

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data; increasingly stringent reporting and transparency requirements have only accelerated this outsourced trend.

Through it all, the buy side has become quite cognisant of the substantial investments in time and technology that will be required to keep pace. Rather than go it alone, sharing the expense through a variety of service vendors has become key to survival. In a report issued last spring, New York-based research and advisory firm Celent argued that sell side firms can help their buy side peers—and fatten their own wallets at the same time—by providing certain value-added services that would enable the buy side to focus on its core competencies.

The report, Transaction Cost Analytics Stuck in Neutral: Accelerating At-Trade Adaptation, suggests that top-flight trade-cost analysis (TCA) vendors offer the kind of granular data required of these emerging methodologies, using tools specifically tailored to monitor execution-cycle performance.

“The TCA discipline continues to evolve so that leading edge buy side firms can more effectively refine their execution strategies,” notes report co-author David Easthope, senior analyst with Celent’s Capital Markets group. “Today, those firms that have embraced TCA are moving beyond simple measurement and intermittent evaluation of execution strategy to actually adapting strategies at the point of trade.” Using “at-trade” technologies, buy side firms will be far better

OCTOBER 2010 • FTSE GLOBAL MARKETS

equipped to keep execution costs in check, and will be able to move beyond the soon-to-be-outdated “measure it and forget it” approach. Furthermore, an emerging niche business, execution consulting, can enable buy side firms to get the most out of their best-of-breed tools by solving liquidity sourcing challenges on a case-by-case basis, while driving down trading costs as well. Says Raymond Tierney, chief executive officer and president of agency broker Bloomberg Tradebook, an execution-consulting specialist: “If you can start to find liquidity, manage impact, as well as use the right kind of execution solutions to properly match up with that liquidity, the likelihood of reducing your implicit costs is going to be fairly significant.”

Sophisticated trading infrastructure While the electronic trading of equities approaches 95% in some areas, fixed-income continues to lag, creating some problems between the strategies a firm can employ on equities versus what they can pursue in debt. “The trading infrastructure for equities certainly is much more sophisticated than it is on the fixed-income side,” says Paul Squires, head of trading at buy side firm AXA Investment Managers. “As a result, like other buy side dealing desks, delivering straightthrough processing (STP) for fixed income was not nearly as cost-effective for us to implement.”

Pragmatism being part and parcel of today’s buy side world, companies such as AXA IM have instead found alternative methods of improving fixed-income vehicle delivery. For instance, AXA IM makes use of such webbased platforms as TradeWeb, primarily a government-bond based trading facility, as well as MarketAxess, which facilitates the electronic trading of corporate bonds as well as other types of fixed-income instruments.

“By connecting our order-management system to these stand-alone platforms during the release and post-execution stages, we are able to ensure a reliable straight-through process which, while different from the fixed connectivity of the equity side, still allows us to sidestep many of the operational risks that can arise while trading manually,”says Squires.

A vivid consequence of the highly fragmented European market post-MiFID is that trade-cost analysis (TCA) faltered due to the inability to consistently gather credible consolidated data. Says Squires:“As reporting moved to a number of different locations post-MiFID, companies such as ours were suddenly forced to pay to view all of the different post-trade data.”

Which is one of the reasons why firms including AXA IM have called for the introduction of a consolidated post-trade tape system as part of a MiFID II review programme. A onestop source for post-trade data, consolidated tape, could help reduce the cost of data collection while improving price discovery for all buy side trading firms, say proponents such as Squires.“Boosting post-trade volume and price visibility is crucial, particularly for traders like ours who are accustomed to dealing with very large institutional-sized orders.”

Despite losing some credibility post-MiFID, Squires believes that TCA still plays a significant role for buy side desks. “For instance, TCA allows my traders to monitor how our brokers

FTSE GLOBAL MARKETS • OCTOBER 2010

Vernon Barback, president and chief operating officer of GlobeOp Financial Services. “Maintaining some separation of custodial and pricing functionality helps ensure integrity and keeps the all-important checks and balances in place,” he says. Photograph kindly supplied by GlobeOp Financial Services, September 2010.

are performing, gives our fund-manager clients the opportunity to see how their orders are being executed and, above all, helps generate a healthy dialogue for everyone involved.”

Analysis, quantitative or otherwise, can never paint the whole picture, says Squires. “Say a fund manager wants to execute an order immediately because of a client instruction or due to cashflow considerations, but the trader bulks because it won’t look good on their TCA numbers—right away you’ve got a confrontation in the making. So while TCA can be a very useful part of the evaluation process, it is important to keep the analysis in the proper context.”

OTC derivatives usage continues to show strength across many asset classes, underscoring the role that these instruments can play in the management and hedging of risk. As such, outfitting the buy side with proper tools for pricing, trading and risk management of derivatives and related investments has become a major opportunity for well-placed providers, according to Zohar Hod, senior vice president for business development and strategic sales at SuperDerivatives.“This might mean establishing exchangetraded capability for derivatives, or perhaps giving firms the ability to centrally clear and mark-to-market these instruments as a back-office function,” says Hod. Making pre-trade, price-discovery analysis available to the portfolio manager on a mobile basis has also gained traction of late, says Hod. This month SuperDerivatives launches SD10, a new multi-asset front office system including a mobile application designed to help managers analyse derivatives-based information in real time while on the road.

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BUY SIDE TRADING STRATEGIES: HELP IS ON THE WAY 76

Paul Squires, head of trading at buy side firm AXA Investment Managers, says: “As a result, like other buy side dealing desks, delivering straight-through processing (STP) for fixed income was not nearly as cost-effective for us to implement.” Photograph kindly supplied

by AXA Investment Managers, September 2010.

Zohar Hod, senior vice president for business development and strategic sales at SuperDerivatives. “This might mean establishing exchange-traded capability for derivatives, or perhaps giving firms the ability to centrally clear and mark-to-market these instruments as a back-office function,” says Hod. Photograph kindly supplied by SuperDerivatives, September 2010.

Meanwhile, SuperDerivatives’ Revaluation Investigation and Analysis System (RIAS), launched in June 2010, seeks to replace Excel sheets with a more streamlined, web-based application that gives users a more detailed view into the valuation process, using price-sensitivity comparisons, stress testing and similar tools. This kind of centralised valuation source is also key to keeping risk levels at bay, says Hod.

portfolio liquidity and other pertinent information. This kind of heightened reporting mechanism is particularly timely as the investment community continues to focus on fund governance, notes Barback.

As part of the campaign for more comprehensive compliance, Richard Semark, head of client trading and execution at UBS, has witnessed a marked increase in client communications. “We’ve seen a lot of compliance-driven requests from our clients—for example, they may ask us to look at several different trades and confirm that each one has met our best-execution guidelines, or perhaps the client has analysed their own trades, and would like to know if we agree with their findings.”

While this kind of inquiry can often be handled through a quarterly or semi-annual meeting with the head of trading and the fund manager, sometimes a more significant debate between the buy side desk and the portfolio manager may develop—which, as Semark points out, isn’t really a bad thing: “Because when you come right down to it, the greater the understanding, the better the quality of the data, the better the performance of the trading process.”

Semark acknowledges that ongoing market and data fragmentation post-MiFID continues to be a source of frustration, affecting OTC trading in particular. All the more reason for establishing a consolidated-tape system, says Semark, which could serve as a central record for this and other types of trading activity. “We at UBS believe this is crucial to the efficient functioning of these markets, in terms of giving investors the ability to properly analyse all of their post-trade data.”

Given the burden of proof that has been placed on the buy side, traders must be able to have proper visibility into their environment if they are to improve the quality of their work. “It is very hard to accomplish this if you don’t have good data in front of you,” notes Semark. “So I think that remains a key challenge for TCA—that is, working towards bolstering the efficacy of that data.” I

Pricing functionality The decision to move to outsourcing, rather than relying exclusively on internal functions, is good news for investors and an obvious step in the right direction, says Vernon Barback, president and chief operating officer of GlobeOp Financial Services, a financial administrator for the hedge-fund space.

“Maintaining some separation of custodial and pricing functionality helps ensure integrity and keeps the all-important checks and balances in place,” says Barback.

Whether responding to increased investor demands or having anticipated the regulatory changes that could comprise MiFID version 2.0, many management firms have already sought to close obvious compliance gaps, says Barback. At the same time, firms must reckon with the costs associated with managing data at a much higher standard. Thus, the benefits of having an aggregating entity should be readily apparent, says Barback.

“A fund that is trading several different types of instruments— and therefore requires a number of different pricing sources— may find it quite unfeasible to purchase all of the required data directly,” says Barback. “Whereas having an aggregator that can bring the disparate technologies together, including all processes and controls around the technologies as well as wholesale purchasing capabilities, can make it all work.”

To help managers provide their investors with greater visibility into the monthly calculation of a portfolio’s net asset value (NAV), earlier this year, GlobeOp launched its GlobeOp NAV Transparency Report, featuring independent confirmation of pricing sources, position reconciliation,

OCTOBER 2010 • FTSE GLOBAL MARKETS

In a market that remains ultra-sensitive to counterparty credit risk and the safety of client assets, all but two of the leading prime brokers are now owned by major universal banking groups. They include Barclays Capital (which acquired the American equity finance franchise of Lehman Brothers), JP Morgan (which bought Bear Stearns in the spring of 2008) and Merrill Lynch, which has recovered strongly since its acquisition by Bank of America. Sylvan Chackman, co-head of global markets financing & futures at BofA Merrill Lynch (BofAML), explains how the bank has established a global, one-touch shop for its prime brokerage services that is now itching to flex its muscles whenever hedge funds regain their taste for leverage; and how the bank intends to give top rated prime brokerage operations such as Deutsche Bank and Credit Suisse a run for their money. Neil O’Hara reports. to Beijing and Sao Paolo to ANK OF AMERICA Sydney. The secret of its phoenix(BofA) tripped up in 2008 like success lies in an integrated when it sold its prime approach that offers clients onebrokerage business to BNP stop shopping for all their Paribas, a transaction that could financing needs. “After the not have been timed worse. The merger, we combined all the deal closed in October, just financing businesses—repo, after the Lehman Brothers futures, prime brokerage in bankruptcy lit the touch paper equity, fixed income and foreign on a wholesale redistribution of exchange, swaps, securities market share among prime lending and clearing of OTC brokers. BofA could only watch derivatives,”says Chackman. “We from the sidelines as hedge have one touch point in terms funds abandoned long-time of sales and client service, and market leaders, Morgan Stanley we look at risk globally across and Goldman Sachs, in a mad multiple asset classes.” scramble to diversify their At many prime brokers, these sources of financing. By the time various functions are separate BofA’s shotgun marriage with lines of business with their own Merrill Lynch was consummated income statements, which can in January 2009, leading prime foster in fighting rather than brokers—especially Credit co-operation for the firms’ Suisse, Deutsche Bank and JP overall benefit. With that in Morgan—had signed up scores Photograph © Paul Fleet / Dreamstime.com, mind, BofAML lumps them of new clients. supplied September 2010 together for internal financial BofA then went on to inherit reporting purposes—and Merrill Lynch’s prime broker compensation calculations. book, which had also suffered client defections as the brokerage giant stumbled at the height “Our competitors are not getting the economies of scale, of the financial crisis. Luck comes in many guises; and so it the ability to price and win new business the way we can,” has proved as Merrill Lynch’s prime broking business has claims Chackman. “We avoid internal turf battles.”

Hedge funds make up the bulk of BofAML’s clients, of provided the combined entity with a solid foundation upon which to rebuild market share. Today, the business has bounced course, but it also services long-only institutions that need back under the Bank of America Merrill Lynch (BofAML) financing for their futures and foreign exchange investments. banner and picked up enough market share to be a major The sales effort targets entities based on their overall league contender, alongside the five other big prime brokers. relationship—actual or potential—with the entire bank. For Based in BofAML’s airy and eco-friendly new offices in mid- example, while Chackman may accept a hedge fund with town Manhattan, Sylvan Chackman, managing director and co- less than $50m in assets if it is affiliated with an existing head of global markets financing and futures, runs a BofAML client from whom the bank derives other revenues, the division that has employees scattered far and wide, from London minimum size will be higher for a standalone relationship.

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FTSE GLOBAL MARKETS • OCTOBER 2010

PRIME BROKING: BofAML’S COMEBACK PLAY

THE NEW WATCH

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PRIME BROKING: BofAML’S COMEBACK PLAY 78

Steve Keller, managing director and head of Americas financing sales at Bank of America Merrill Lynch.

Photograph kindly supplied by Bank of America Merrill Lynch, September 2010.

Steve Keller, managing director and head of Americas financing sales, points out that the merger allowed BofAML to tap the vast Merrill Lynch equity franchise for client prospects. It helped that the taint that may have attached to the Merrill Lynch name in 2008 has since evaporated. Indeed, the fact that the prime broker is part of a commercial bank is a huge advantage in snagging new business. “Every single hedge fund we see is thrilled to market BofAML as counterparty to an investor base that is increasingly interested in business risk,” holds Keller. “Many entities that left us during the financial crisis have come back.”

BofAML may have missed out on the easy pickings in late 2008 but it has taken full advantage of a secondary shake-out among prime brokers over the past 18 months. Moreover, since 2008 a number of major prime brokers have also shown a willingness to shed some of the smaller funds; though these were not the only trends in play. The relationship between prime brokers and hedge funds has changed irrevocably as pressure on hedge fund managers to diversify their counterparty credit risk exposure by appointing more than one prime broker continues, for instance.

Any which way, BofAML has not been slow to spot and leverage opportunity. Chackman says small hedge funds that used to have only one prime broker now have two or three, while the biggest funds that may once have had eight or more have cut back to four or five as assets under management tumbled and trading volumes declined. “We have benefited from both sides,” he says. “We have seen hedge funds who only had one add us as a second or third, and we have seen big hedge funds cut two or three other prime brokers and add us.”

Year to date, BofAML’s client roster has expanded by an estimated 300 hedge funds run by 100 different managers, some of which were new customers to the bank as well as to the equity division. Financing balances have jumped, and although low interest rates have squeezed profit margins, BofAML’s prime broker revenue is almost flat at a time when its major competitors have reported sharp declines. In 2009, for example, Goldman Sachs’ securities services revenue (which includes prime brokerage) slumped 41%, while

Mike Stewart, co-head of Global Equities at Bank of America Merrill Lynch. Photograph kindly supplied by Bank of America Merrill Lynch, September 2010.

Morgan Stanley’s prime broker revenue fell 20%. Chackman sees BofAML’s revenue poised to surge when hedge funds’ appetite for leverage returns.

The gains won’t come only from its existing client base, either. Even though Morgan Stanley and Goldman Sachs are now bank holding companies, they don’t have the balance sheet power that established commercial banks can bring to bear. “The monoline broker model is outdated,” says Chackman. “They are holding on pretty well in a low leverage environment, but when that turns they could have trouble deploying balance sheet at a competitive price.”

He expects those banks that signed up so many new clients in 2008—such as Credit Suisse, Deutsche Bank and JP Morgan— might in future struggle to retain them all, too. Wishful thinking?

No, says Chackman. It’s about underlying business dynamics; and the global BofAML footprint appeals to hedge funds that want to borrow stock in Japan, do a swap in Brazil and repo in New York under a cross-margin arrangement that minimises the collateral they have to put up, holds Chackman. “Hedge funds want simplicity today,” he says.“They want to execute, clear and finance with one firm.”

Global reach The demand for global reach could put even JP Morgan at a disadvantage. The old Bear Stearns prime broker business it acquired was a domestic US franchise, a focus it retains under the JP Morgan umbrella. That leaves Credit Suisse and Deutsche as BofAML’s primary competitors on the international stage, a contest in which Chackman and Keller reckon BofAML is gaining an upper hand. “We have a world-class prime broker that we can scale globally,” says Keller. “Merrill had not only a leading position in the US but also a strong presence in the Pacific Rim and the former Smith New Court business in London.” BofAML offers execution and financing in more than 60 countries around the world, they boast.

“In today’s marketplace, our global distribution and reach, combined with research and equity, state of the art infrastructure, pricing and margining, make us an interesting counterparty for a hedge fund,”says Mike Stewart, co-head of Global Equities at BofAML.

OCTOBER 2010 • FTSE GLOBAL MARKETS

For all the emphasis on creative financing solutions for clients, Chackman admits that prime brokers make relatively little money from margin loans and other long position financing. Stock lending has always been the critical driver in prime brokerage, accounting for more than half the revenue at most firms. From the borrowers’ perspective, the key is not just the ability to find hard-to-borrow stocks, but securities that will not be called away. That’s where BofAML’s unmatched retail presence comes into play: an enormous pool of stable assets only its clients can tap.“Every prime broker has access to the other big custodian banks,” says Chackman.“We have access to $2trn in total client assets handled by our nearly 20,000 financial advisers. It is a huge differentiator.”

Even though stock loan demand is depressed at the moment—the specials to general collateral ratio today is about 3%, a far cry from the normal 15%—BofAML’s retail assets served its clients well last year when demand for stocks such as Citi and General Motors soared. Prime brokers who source from the custodian banks have to play the game by their rules.

For every dollar of general collateral taken, they will get an allocation of specials, typically 10% to 15%. The retail box gives BofAML a proprietary pool that is cheaper and does not require a quid pro quo, an edge that the bank thinks will pay dividends when stock loan balances bounce back.

Retail assets also play a part in capital introduction, an area in which BofAML excels: hedge funds gave the firm top rank in two recent surveys. It’s a critical function for hedge fund managers. If BofAML can add 20 basis points (20bps) to a fund’s annual return through its processing and financing services, the manager earns 4 bps in its 20% incentive fee. On every new dollar invested, however, the manager makes a 2% management fee—50 times as much.

Low-risk business It’s a low-risk business for BofAML too; better to be on the same side providing services to the people who run hedge funds than committing capital to take the other side of their trades. With six participants vying for leadership, the securities financing business is more competitive than ever. Hedge funds have cut their leverage dramatically, and while many delivered robust performance in 2009 gains have been elusive in this year’s choppy markets.“If you are a hedge fund chief finance officer or chief operating officer, how do you help maximise returns?”asks Chackman. “In the last six months, we have seen more negotiations around pricing and terms.”

The smart funds don’t push for every last nickel and dime, however. They know that at some point they will need more leverage and resources—and prime brokers will be more accommodating to funds that didn’t press too hard when times were tough. “You don’t want to be transactional about this business,”says Chackman. “The bigger funds understand that. They want strategic partnerships.”

Those relationships have helped BofAML ride the crest of the UCITS wave in Europe, where even before the merger Merrill Lynch had staked a claim to market leadership. The UCITS framework permits money managers to sell funds registered in a single country throughout the European Union

FTSE GLOBAL MARKETS • OCTOBER 2010

Sylvan Chackman, co-head of global markets financing & futures at Bank of America Merrill Lynch. “After the merger, we combined all the financing businesses—repo, futures, prime brokerage in equity, fixed income and foreign exchange, swaps, securities lending and clearing of OTC derivatives,” says Chackman. Photograph kindly supplied by Bank of America Merrill Lynch, September 2010.

without having to meet onerous requirements for a local offering in each jurisdiction. Keller says BofAML has already launched UCITS vehicles for six big hedge funds and expects to sign up another dozen or so clients before year end—with more to follow in 2011. “The UCITS franchise we have in Europe is unmatched,”he says. The big hedge funds are likely to get bigger over the next couple of years, too. The new US regulations that require broker-dealers to scale back their proprietary trading—the “Volcker rule”—will be good for hedge funds because it will free up investment bank capital and resources to service clients rather than in-house proprietary trading desks. Traders are likely to jump ship as well, either to join existing hedge funds or to start their own operations.

Meanwhile, the barriers to entry keep going up, as does the minimum economic size for an existing fund. “I see a massive consolidation among hedge funds,” says Chackman. “Many funds that are below their high-water mark may be forced to fold.”He believes the 7,000 hedge funds that exist today could shrink to 4,500 or 5,000 in two years’ time—but does not expect assets under management to shrink. He explains: “The tail is so long, 14% of the hedge funds control 85% of the assets.

It’s the small funds that are at greatest risk.”

In fact, some large funds have taken in so much money that they are already closed to new investors.“Many hedge funds are having a very difficult time raising money, but the biggest are now so successful they are closing,” says Keller.

The trend will play to BofAML’s strength among hedge funds with assets in excess of $10bn, another survey category in which it topped the bill. I

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EUROPEAN TM: THE DEBATE OVER WHICH IS THE BEST PROTOTYPE CONTINUES 80

There are no official league tables but the general consensus of which firms now dominate European transition management (TM) is that BlackRock, State Street and Russell Investments are among the top three contenders. Views seem to differ regarding the ranking of the others but most agree that Goldman Sachs, JP Morgan, BNY Mellon, Morgan Stanley, Northern Trust, Citi and Credit Suisse should be included on the roster. Legal & General as well as Nomura, especially for equities, are also seen as worth a mention while there is some talk that the industry could see Fidelity, HSBC and Macquarie enter the ring. Not surprisingly, the landscape shifted after the financial crisis and the musical chairs of personnel continues. Lynn Strongin Dodds explains the changes.

CHOPPY WATERS FOR TM T HAS BEEN all change in the European transition management (TM) arena. Some players have exited or scaled back operations, others have merged while new providers are rumoured to be entering the space. As a result, the distinction between the various contenders is blurring as talent seems to be giving up their buy, sell and custodial allegiances and going where the opportunities lie. Activity has picked up over the past few months but the challenge for all will be to navigate the continued choppy market waters in a controlled and cost-effective manner.

Rick Di Mascio, chief executive and founder of Inalytics, says: “One of the most significant changes in transition management is that two years ago there were about 12 to 18 main providers while today there are between six to 12. The irony is that the number of providers is shrinking but the number of instruments that managers are using in a transition is increasing.”

Not surprisingly, the landscape shifted after the financial crisis, with Lehman and Bear Stearns being the obvious casualties. Other investment banks such as UBS and Royal Bank of Scotland withdrew from the transition stage while

I

Photograph © Mike Monahan / Dreamstime.com, supplied September 2010.

Citi pulled in its reins in the UK after the head of the group, Tom Wilkinson, left in March 2009 together with six other transition managers to Mellon Transition Group. Meanwhile, the two formidable teams at BlackRock and Barclays Global Investor merged when their companies joined forces at the end of 2009. The newly combined group is being led by managing directors Peter Walker, previously head of transition management at BlackRock, and Lachlan French, former European head of transition management at BGI. The musical chairs of personnel continues with Wilkinson recently leaving Mellon to reportedly join Russell Investments while Citi has bolstered its ranks with the recent hire of Steven Dalzell to head the group in the EMEA region as well as Andrew Cooper, who is rejoining the firm after his stint at Mellon. In addition, John Minderides, who was instrumental in restructuring JP Morgan’s transition management group, has left the firm. He will not be replaced but Michael Gardner will continue to lead the EMEA business and global products with Robert Saffer remaining at the helm of the US transition management business.

As for which firms now dominate, there are no official league tables but the general consensus is that BlackRock, State Street and Russell Investments are among the top three contenders. Views seem to differ regarding the ranking of the others but most agree that Goldman Sachs, JP Morgan, BNY Mellon, Morgan Stanley, Northern Trust, Citi and Credit Suisse should be included on the roster. Legal & General as well as Nomura, especially for equities, are also seen as worth a mention while there is some talk that the industry could see Fidelity, HSBC and Macquarie enter the ring.

Despite the changes, the debate between which prototype— the fiduciary or broker dealer model—is better continues to reverberate. The buy side will claim that having project

OCTOBER 2010 • FTSE GLOBAL MARKETS

management, trading through third parties and pre and posttransaction measurement under one umbrella is preferable to using an investment bank, which is seen as creating potential conflicts of interest through trading a client’s assets with or against those on their own books Mark Dwyer, managing director and head of Europe, Middle East and Africa for Mellon Transition Management, says: “I think the differentiation between the sell, buy side and custodian is still relevant. I am not saying that one is better than the other but just that the client should take these differences into consideration. For example, the classic asset manager-type transition manager acts as a fiduciary manager.

There is no potential for conflict of interest during the trading process. There is transparency regarding where the fees are being generated and this is important for some clients.”

Lachlan French, managing director, and co-head of the transition management Europe, Middle East and Asia team at BlackRock, believes that “what really matters is the DNA of the firm and the origins of the team”. He adds: “An investment manager already has the applications and reporting systems required for transition management. These processes are not natural to the business of a bank or custodian and they have to be developed. The trend, though, that we are seeing is that clients are spending much more time on due diligence of a firm.”

Others disagree, arguing the lines of distinction are becoming hazy. Robert McElvanney, senior investment consultant at Hewitt Associates, notes:“The most important thing when looking at these management changes is whether they will weaken or strengthen the team. What is happening is that the skill sets across the different providers are converging. In the past, the sell side was known for its trading skills while custodians were seen as being good project managers. That differentiation no longer holds true and what we are really looking at today is whether a transition team has the skills and expertise to do a transition.”

Graham Dixon, director at Inalytics, notes: “There are far more similarities than differences in transition management today. The investment banks have gone to extraordinary lengths to ring fence and build Chinese walls around their transition management teams while the asset management firms were forced to significantly raise their game in their trading capabilities.

They looked at their weaknesses after the financial crisis and have strengthened and added value to their offerings.”

Trading capabilities All agree though that institutional investors have become much rigorous in their due diligence. Chris Adolph, head of transition management EMEA at Russell Investments, agrees, adding: “Clients have definitely become more demanding and the TCharter [a code of best practice for transition managers] has provided a good framework as well as help raise awareness in terms of what types of questions to ask. While the main areas that it covers—the disclosure of conflict of interests, cost estimates, remuneration and systems and processes—continue to be important, we are also seeing clients increasingly asking about the commitment of the firm and its team members to the

FTSE GLOBAL MARKETS • OCTOBER 2010

Lachlan French, managing director, and co-head of the transition management Europe, Middle East and Asia team at BlackRock, says: “An investment manager already has the applications and reporting systems required for transition management.

These processes are not natural to the business of a bank or custodian and they have to be developed.”

Photograph kindly supplied by BlackRock, September 2010.

business due to the significant movement that has taken place in the industry. It is not necessarily seen as a negative because new expertise might be brought on board and the processes are embedded in the organisation and not just the people, but significant departures or changes could be symptomatic of deeper structural issues and this might well raise concerns.”

In terms of a checklist, McElvanney recommends putting a firm’s processes, project management skills, pre-trade analysis and risk management systems at the top. “It is also important to look at whether their systems are integrated because mistakes can be made if there is too much manual input. Other key criteria include the sustainability of the transition management business, quality, experience and skill set of the people as well as the track record.”

Performance measurement though can be tricky and continues to be a hot topic of discussion. One of the main problems is not all firms are forthcoming with the figures, making it difficult to get an independent view. Initiatives are under way. Last November an industry working party was formed to assess whether the Global Investment Performance Standards (GIPS)— a set of standardised, ethical principles that provide investment firms with guidance on how to calculate and report investment performance—can be applied to transition management. The goal is to provide information on the cost estimates of the trades of transition managers and the realised results.

Meanwhile, Inalytics along with Mercer and Hewitt proposed a transition management performance database to help pension funds conduct their due diligence. Dixon says:“Pension funds want to see evidence that transition managers are doing what they say they do. At the moment they are not getting the full picture. About half of the transition managers release their performance data in full, a quarter provides summary statistics only, and the rest will not give any data at all.”

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EUROPEAN TM: THE DEBATE OVER WHICH IS THE BEST PROTOTYPE CONTINUES 82

Mark Dwyer, managing director and head of Europe, Middle East and Africa for Mellon Transition Management, says: “I think the differentiation between the sell, buy side and custodian is still relevant.” Photograph kindly supplied by Mellon Transition Management, September 2010.

Typically a manager will calculate the pre-trade benchmark used to compare his performance against, as well as the implementation shortfall benchmark of the transition, and then write a report to show the results. Di Mascio, who stepped down as chairman of the T-Charter working group earlier his year, points out this is not beneficial to the client. “In many ways it is like the fund management industry of the 1970s where they would tell pension funds that they were doing a good job but not showing any proof. Here you have the transition manager saying: ‘Trust me I am a transition manager.’ In effect, they are setting their own questions, marking their own papers and creating their own reporting cards. There needs to be more focus on developing independent track records and I think it is an encouraging sign that the new chairman of the T-Charter is from the buy side, namely Martin Mannion, director, pensions finance, investments and risk, at GlaxoSmithKline.”

Although opinions are likely to remain divided over performance measurement and the different models on offer, all industry participants agree that transitions have been more complicated over the past two years across Europe.

The difference between continental Europe and the UK is that the later relies more on the consultant industry whereas the institutional investors deal directly with fund managers.

In addition, countries such as the UK, the Netherlands and in Scandinavia are greater proponents of liability-driven strategies because of regulatory changes that force them to better match their assets and liabilities.

However, all institutional investors are looking at a wider range of instruments although multi-asset class trading has not gained traction. The bulk of transitions continue to focus on equities and particularly fixed-income instruments. Dwyer says: “The investment strategies of a pension fund are becoming much more complex. When I first started you were asked to transition from manager X to Y in a short space of time and it was usually equity based. Now transitions take longer and there is a greater use of derivatives and overlay strategies, which is why the transition manager is asked to become involved earlier on in the process and not just at the execution stage.”

French notes: “Although there is no one theme on the type of transitions that are being done, all of our major clients

Rick Di Mascio, chief executive and founder of Inalytics, says: “One of the most significant changes in transition management is that two years ago there were about 12 to 18 main providers while today there are between six to 12. “ Photograph kindly supplied by Inalytics, September 2010.

are looking to take risk off the table. They had time to reflect after the major disruption and dislocation of markets and are now reacting to current market conditions. We have some clients that have asset allocation mandates tied in with passive mandates, while others are LDI-related. Most though have a strong focus on fixed income which are more complicated than equities to execute because they are not traded on a screen and you have to go to the different participants in the market to get a price.”

Ben Gunnee, principal and senior consultant within the Mercer Sentinel Group, also sees “a move to re-risking and LDI-based mandates which involves hedging instruments such as swaps”. He adds: “We are also seeing clients terminate a fund manager and use the transition manager as an interim manager until they find a new home for the assets. The assets are not being actively managed but the transition manager is set a particular benchmark such as the MSCI Global Index with some parameters until a new manager is found.”

Ed Pennings, senior managing director and head of the portfolio solutions group at State Street Global Markets, also sees a general shift to passive from active management because after the financial crisis it was difficult for active managers to outperform. “We are also seeing a move to shorter duration, fixed-income instruments as clients are preparing for an eventual rise in interest rates.”

In addition, Simon Hutchinson, head of transition management for Europe, the Middle East, Africa and AsiaPacific at Northern Trust, points to“a move from segregated to pooled funds which is a more complicated process. This is because the pooled funds have different dealing dates and from the operational side you have to ensure that you transition the assets with minimal market exposure and tracking error.”

The increasing complexity has forced the providers to enhance their risk management, reporting and governance tools although the providers have not been able to recoup the investments through higher fees. Despite the smaller number of players in the market, there is still pressure on rates.

McElvanney says: “Before the crisis, greater competition for business could result in low commission rates being quoted.

However, today transition managers are still prepared to negotiate but they are less prepared to do it at any cost.” I

OCTOBER 2010 • FTSE GLOBAL MARKETS

COLLATERAL MANAGEMENT MORE CRUCIAL THAN EVER

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COLLATERAL MANAGEMENT: MORE CRUCIAL THAN EVER

The risks of aggressive reinvestment programmes became all too apparent in autumn 2008, when the Lehman Brothers bankruptcy raised fears that other counterparties might follow suit.

Liquidity dried up as the entire repo market drew in from an average maturity of 30 days to a week or less—indeed, many participants retreated to overnight lending only. Securities lenders who tried to switch their cash reinvestment programmes into more conservative vehicles discovered that commingled pools were unable to meet their demands without selling purportedly cash-equivalent assets at discounts to par. Lending agents responded by restricting redemptions, an unpopular step that nevertheless forestalled a run on the funds that would have left the last investors out the door holding the most illiquid assets trading at the deepest discounts. The passage of time has relieved the pressure on troubled reinvestment pools as some illiquid instruments have matured and liquidity has returned to others. The problem has not gone away entirely, however, reports Neil O’Hara.

A BURNING QUESTION Photograph © Kobets / Dreamstime.com, supplied September 2010.

OLLATERAL MANAGEMENT HAS always been critical to success in securities lending, but during the financial crisis market participants discovered that cash is no longer king. In Europe, where the collateral of choice is high-quality, non-cash instruments, lenders came through the turmoil almost unscathed; while in the US many lenders incurred losses even though more than 90% of collateral taken in that market is cash.

The difference lies in what lenders—or agents acting on their behalf—do with the collateral they receive and who has title to it. Non-cash collateral sits on the lending agent’s books in a segregated securities account. If the instruments have any value for re-hypothecation the borrower is likely to call them back and substitute other securities—and lenders derive no

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benefit from pooling non-cash collateral. In contrast, nobody leaves cash idle; it is reinvested, and all but the largest lenders can boost the return if they place cash collateral in a commingled vehicle to reap economies of scale. The cash may even be commingled with the lending agent’s own assets, exposing the lender to agent credit risk.

“We have to ask how safe is cash as collateral, particularly in a reinvestment scenario,” says Stefan Lepp, who is responsible for global securities financing at Clearstream, a leading European settlement and post-trade service provider.

“Unless you have a dedicated legal structure that puts the cash or reinvestment vehicle in a separate and accessible fiduciary account, you may not have the protection you are looking for, either.” Clearstream does not accept cash as

OCTOBER 2010 • FTSE GLOBAL MARKETS

collateral in its securities lending programmes; instead, it holds securities in a segregated account to which it would have instant access if the broker went bust.

It’s up to lenders, of course, to determine how much risk they are willing to take in a cash reinvestment programme. Lending agents typically offer multiple options to accommodate clients that have different risk tolerances, ranging from pension funds, insurance companies and asset managers to banks, central banks and supranational organisations. Some put safety first and do nothing more exotic than overnight repo at the most creditworthy counterparties, while others are willing to accept longer duration or lower credit quality in exchange for higher returns on their cash.

The risks of aggressive reinvestment programmes became all too apparent in autumn 2008, when the Lehman Brothers bankruptcy raised fears that other counterparties might follow suit. Liquidity dried up as the entire repo market drew in from an average maturity of 30 days to a week or less—indeed, many participants retreated to overnight lending only. Securities lenders who tried to switch their cash reinvestment programmes into more conservative vehicles discovered that commingled pools were unable to meet their demands without selling purportedly cashequivalent assets at discounts to par. Lending agents responded by restricting redemptions, an unpopular step that nevertheless forestalled a run on the funds that would have left the last investors out the door holding the most illiquid assets trading at the deepest discounts.“The initial response from some lenders post-Lehman was to take in fixed income as collateral, however we did see the return to equity collateral given the liquidity and transparency in the pricing of equity, explains Staffan Ahlner, managing director, Broker Dealer Services at BNY Mellon.

Illiquid instruments The passage of time has relieved the pressure on troubled reinvestment pools as some illiquid instruments have matured and liquidity has returned to others. The problem has not gone away entirely, however. Pools that invested in certain AAA-rated tranches of asset-backed securities with an expected life of two or three years at the time they were purchased saw subsequent credit losses wipe out the junior tranches, pushing out the duration of the senior tranche. “The expected life in some cases has become the legal final maturity date, which may be 30 years from issuance,” says John Arnesen, a senior business consultant at Data Explorers, a London-based firm that tracks the securities lending markets. “These pools will have underperforming assets for a long time.”

Although State Street, one of the largest agency lenders, avoided investing in riskier credits to enhance the yield in its cash reinvestment pools, it did lengthen duration and also held some structured debt on which the expected maturity blew out, according to Nicholas Bonn, head of securities finance. “Our programme has had no defaults or material impairments,” says Bonn. “We obtained a higher yield for our clients through extended spread duration or maturity

FTSE GLOBAL MARKETS • OCTOBER 2010

Nicholas Bonn, head of securities finance at State Street. “Our programme has had no defaults or material impairments,” says Bonn.

“We obtained a higher yield for our clients through extended spread duration or maturity profile, and after Lehman failed, the longer-dated assets we held did not trade at par due to the lack of market liquidity.”

Photograph kindly supplied by State Strret, September 2010.

profile, and after Lehman failed, the longer-dated assets we held did not trade at par due to the lack of market liquidity.”

Prices have recovered from lows seen at the height of the crisis but they remain below par and until recently clients still could not come and go as they pleased.

In July, State Street announced moves intended to restore liquidity to its collateral pools. It made a cash contribution to those associated with index investment products managed by its affiliate State Street Global Advisors to restore the $1 per share target net asset value (NAV), which freed clients to redeem at will. Pools associated with State Street’s agency lending business continue to limit redemptions, but will be split by year end into a liquid pool managed to a $1 per share NAV and a longer duration pool that will be subject to restrictions on redemptions. By dividing the funds into these two pools, clients will have greater control over their use of liquidity and the level of participation in the securities lending programme.

Until that split occurs—expected by year end—clients seeking full liquidity can redeem their interests in kind.

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The potential returns from securities lending are under pressure from reduced intrinsic value in some asset classes as well as low interest rates. The yawning US budget deficit has generated a huge increase in the supply of US Treasuries that has outstripped borrower demand. a contribution that has since plummeted: it was just 16% in the 12 months through June 2010.

In fact, margins on general collateral have shrunk to the point where lending certain asset classes is no longer economic for lenders who set conservative reinvestment guidelines. For example, if cash is reinvested in US money market funds, which now yield about 27 basis points (bps), the lender makes just 2bps after a broker rebate of 25bps on a portfolio of US Treasuries.

Two years ago, that same loan netted 75bps to 100 bps, thanks to declining interest rates and pressure from the market dislocation. Today’s tight general collateral spreads may not cover the costs of managing a securities lending programme, let alone compensate for the risk. “You have to put a lot of securities on loan at 2bps to make a decent return,”says Payson.

Under pressure Stefan Lepp, who is responsible for global securities financing at Clearstream. “Unless you have a dedicated legal structure that puts the cash or reinvestment vehicle in a separate and accessible fiduciary account, you may not have the protection you are looking for, either,” he adds. Photograph kindly supplied by Clearstream, September 2010.

Any lender that reaches beyond overnight repo in search of higher yields, exchanges cash for cash-equivalents; and in doing so assumes the risks associated with investment management. Yet until the financial crisis hit, many lenders did not subject cash reinvestment programmes to the same level of due diligence they applied to other investment mandates. “People now realise cash reinvestment is not an adjunct to custody,” says Mark Payson, manager of global securities lending at Brown Brothers Harriman (BBH). “It’s an investment management product that needs proper attention. That is a significant change.”

Payson draws a distinction between securities lending, which extracts the intrinsic value from securities that are hard to borrow, and securities financing, general collateral lending in which returns derive primarily from reinvesting cash balances. While both are legitimate lending strategies, he sees a stronger focus among lenders today on intrinsic value; if lending alone provides an acceptable return, aggressive cash management isn’t necessary. It’s a model Brown Brothers has long followed; Payson’s clients typically do not participate in low-margin lending.

The shift toward intrinsic value shows up in the revenue split, too. Data Explorers estimates that cash reinvestment accounted for as much as 45% of the revenue from US securities lending in the 18 months before Lehman failed,

The potential returns from securities lending are under pressure from reduced intrinsic value in some asset classes as well as low interest rates. The yawning US budget deficit has generated a huge increase in the supply of US Treasuries that has outstripped borrower demand. Kathy Rulong, global head of securities lending at BNY Mellon, has seen hardly any specials in either Treasury or government agency bonds for more than a year, unlike earlier periods when demand for on-the-run Treasury issues often exceeded supply. In Europe, it’s a different story, however—borrower demand for sovereign debt has soared as bond prices have tanked in Greece, Spain, Portugal, Italy and Ireland amid concerns about potential debt restructuring or default.

“Some of the specials in Europe have eased off a bit but in many instances demand outstrips supply and those continue to trade special,” says Rulong.

In markets such as Europe where non-cash collateral predominates and opportunities to enhance returns through cash reinvestment do not exist, general collateral lending tends to play a more limited role than in the US. Lenders insist on high-quality collateral: sovereign debt issued by the G7 countries, for example. While lenders may be happy to accept these securities against a loan of Greek government bonds that trade special, they can’t make much money from taking bonds in one G7 country as collateral against a loan of bonds in another even if borrowers want to do the trade.

“In our European tri party book we manage more noncash collateral for securities lending than in the US. Post Lehman we have seen lenders taking a practical approach to collateral; ratings are not necessarily the drivers, what is key is liquidity and the ability to sell the collateral,” says BNY

OCTOBER 2010 • FTSE GLOBAL MARKETS

Kathy Rulong, global head of securities lending at BNY Mellon, has seen hardly any specials in either Treasury or government agency bonds for more than a year, unlike earlier periods when demand for on-the-run Treasury issues often exceeded supply. In Europe, it’s a different story, however. Photograph kindly supplied by BNY Mellon, September 2010.

Mark Payson, manager of global securities lending at Brown Brothers Harriman (BBH) says: “People now realise cash reinvestment is not an adjunct to custody. It’s an investment management product that needs proper attention. That is a significant change.” Photograph kindly supplied by BBH, September 2010.

Mellon’s Ahlner. “Whilst the title of transfer in Europe, regarding equity, gives certainty of ownership of an asset class with a transparent price, it does create portfolio servicing challenges for income and corporate actions. In the European tri-party programme we manage the process to enable lenders to select equity as an asset class,” he adds.

anonymity.” Portfolio utilisation in the ASL+ programme has been consistently higher than market averages even though margins are thin.

On the cash collateral side, Data Explorers’ Arnesen says some market participants who pulled back cash reinvestment to one week repo during the credit crisis are beginning to take more risk again. The guidelines tend to be name-specific rather than referring to credit ratings. However, a lender may be willing to reinvest collateral in commercial paper issued by, for example, Toyota Motor Credit, but not in other automobile finance companies. “Agent lenders have become credit experts,” says Arnesen. “If they were not before, they have developed those processes with a keen eye.”

Nobody is rushing back into the assets that caused all the trouble, but BBH’s Payson, a 20-year veteran of the securities lending industry, points out that cash reinvestment pools have hit potholes before—in 1994 and 2004, for example. Institutional memories are short, and despite protestations to the contrary, lenders will reach for yield through duration the next time interest rates are falling, just as they have in the past. Next time they will do it with their eyes wide open, however. “Was it made clear to customers what they were participating in?” Payson asks.

“That will be the change in future. Lenders will have a complete understanding of the risks involved.”I

Anonymity of central bank lenders Narrow spreads may not matter to some lenders, however.

Clearstream runs a programme called ASL+, developed at the request of central banks which were interested in lending their portfolios—almost all government securities—but were concerned about market reaction if they were identified as counterparties. Rather than competing with its major customers, Clearstream co-opted the best lending desks as partners to distribute the securities to borrowers. In effect, Clearstream acts as a blind to protect the anonymity of central bank lenders, whose insistence on the highest quality collateral keeps lending spreads tight.

Although the product was launched before the financial crisis, it has grown rapidly in the past two years as central bank balance sheets have ballooned. “In the past, profit and utilisation were the key drivers of securities lending,” says Lepp.“Now there is more interest in collateral quality and accessibility; counterparty quality; and in some cases

FTSE GLOBAL MARKETS • OCTOBER 2010

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US SECURITIES LENDING: CUSTOMISATION, REPORTING & TRANSPARENCY

Photograph © Dan Collier / Dreamstime.com, September 2010.

REVAMPED AND RECOMMITTED Despite taking a more conservative approach to reinvestment guidelines, by all accounts beneficial owners remain committed to securities lending. Having gained a greater appreciation for the risks involved, clients continue to refine programme oversight practices, impacting the level of transparency required of their lending agents. David Simons reports from Boston.

RIOR TO THE great wake-up call of late 2008, securitieslending programmes served as a very reliable—some say too reliable—generator of revenue for beneficial owners. Not surprisingly, a high level of complacency developed among many of these institutional participants.

Now, two years since the unravelling began, the question remains: what have beneficial owners learned about the process of loaning stock and investing collateral? Have they gained a more thorough understanding of these investment

P

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programmes, including the knowledge that there is inherent risk in anything that provides an appreciable rate of return?

“We’ve seen this happen before—there’s a shock to the system, causing beneficial owners to withdraw, pull back or become more conservative,”says Brian Lamb, chief executive officer of EquiLend, a provider of trading and operations services for the securities finance industry. “Once owners have had a chance to re-assess—and particularly after they figure out that they are missing the revenue—they tend to get involved again, though on a risk-mitigated basis. That is what appears to be going on right now.”

Owners who took a direct hit have, in many instances, paused to assess the benefits of continuing in a securities lending programme. While a few beat a hasty retreat, by all accounts most have stayed the course, and are now running their programmes with a far greater degree of customisation, and with an emphasis on timely reporting and transparency.

Given current market conditions, in many respects clients have had little choice but to stay put. “In a higher interestrate environment, you have many more options,”says Lamb.

OCTOBER 2010 • FTSE GLOBAL MARKETS

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Current conditions present a unique challenge for firms including State Street; despite reduced revenues and pressure from clients to boost transparency, companies must maintain a steady stream of capital to cover technology expenditures and other enhancements.

“You can be conservative and still achieve some respectable returns. However, when there’s no yield curve, your choices are quite limited.”

Cash lenders, however, now assume a much more dominant role in the marketplace, a positive step in the effort to gain transactional equilibrium. “Dealers are no longer necessarily in the position to always decide where clearing should take place,”observes Paul Wilson, global head of client management and sales for JP Morgan’s Worldwide Securities Services’ financing and markets products division.“We are starting to see the early signs of a far more balanced market, which could ultimately lead to both dealers and lenders operating across all clearing platforms. Also, we feel that is a real positive for the tri-party market.”

Lender retention Kathy Rulong, executive vice president, global securities lending, BNY Mellon Asset Servicing, says that most of the firm’s securities-lending clients have already reviewed their risk profile from both a lending as well as reinvestment standpoint, and, on balance, retention has been strong. “While a small percentage have left or are in the process of pulling out of securities lending, most have recommitted with few or any changes made to their programmes. Some clients have chosen a more conservative approach to their reinvestment guidelines, which, as we know, has been the greatest source of concern for clients. Others are now requiring minimum intrinsic-value loan spreads—they have a set maximum rebate rate that we will pay which then produces the desired loan spread, based on that client’s particular investment guidelines.”

Mark Payson, global head of trading and asset liability management for Brown Brothers Harriman in New York, sees little evidence of client reticence. BBH clients have experienced good performance throughout the financial crisis, says Payson, and thus remain committed to lending and are actively participating in the markets. “This didn’t happen by accident—we apply a very hands-on approach to lending and understand that each client has different needs, and we tailor programmes to each client’s specific risk profile. We are also proactive about educating our clients to ensure they are comfortable with the risks involved in lending and what we do to mitigate them.”

As beneficial owners have gained appreciation for the risks involved, programme oversight practices have changed and the level of transparency required of a lending agent has increased as well. “This increased transparency is evident in

Paul Pricoli, managing director and chief operations officer, ConvergEx Group, says that regulations established in 2008 mandating that hedge funds maintain a locate-confirmation system have had a dramatic impact on hedge fund fail rates. Photograph kindly supplied by ConvergEx Group, September 2010.

all aspects of securities lending programmes, but particularly with respect to the cash-collateral side,”says Payson.“Beneficial owners now understand how important it is to have proper oversight of a cash-collateral programme, including a set of rigorous asset-liability management controls. The majority of problems in cash collateral pools resulted from a mismatch of assets and liabilities—in short, the maturity and credit profiles in many cash reinvestment programmes were too aggressive to support securities lending. The response of many beneficial owners has been to unbundle cash management from lending, and to view these as separate but interrelated functions. BBH fully supports this philosophy.

We have always offered clients the flexibility to manage cash themselves or to select their own cash manager.”

Having weathered a global financial crisis, clients appear particularly well informed and are able to demonstrate a suitable dose of caution when presented with the types of aggressive earnings projections certain providers make for securities lending, says Jeffrey Benner, deputy head of global securities lending at Northern Trust in Chicago. “We look at it this way—optimising revenue potential will always be important, but factors like flexibility, transparency and risk

OCTOBER 2010 • FTSE GLOBAL MARKETS

management are now a larger part of the equation when clients are evaluating their securities lending participation.”

Efforts to enhance pricing and stock-locate capabilities within the hedge fund space have gained momentum, says John Dolan, director of Advanced Program Management for ConvergEx Group’s Eze Castle Software. “We’ve seen a significant uptick in demand from hedge fund clients to have more processes and controls in place to help automate the locate process as well to manage their securities borrowing and lending data.” Introduced last year, the company’s Eze Locate module, built directly into the order-management system, has enabled clients to improve workflow by ascertaining information related to stock availability, price sensitivity and other data, says Dolan.

Additionally, providers such as ConvergEx have been able to help hedge funds comply with current and anticipated regulatory measures. Says Dolan: “For instance, if a fund wants to execute a short trade, our compliance monitoring ensures that they have the required amount of shares located within the system, thereby preventing the manager from inadvertently executing a naked short.”

Paul Pricoli, managing director and chief operations officer, ConvergEx Group, says that regulations established in 2008 mandating that hedge funds maintain a locate-confirmation system have had a dramatic impact on hedge fund fail rates.

“The Street as a whole is protected from firms shorting stock without the proper controls in place.”

Changing values Rather than increasing their utilisation to the maximum level, a majority of clients have embraced “value” versus “volume” lending during the post-crisis period by limiting their cashcollateral reinvestment guidelines or by requiring a minimumlending spread. This change in strategy—which favours securities in high demand and high-fee income, along with a more conservative cash-collateral investment approach— has contributed to a marked decrease in lending supply and, concurrently, demand as well, says Rulong.

“Although conditions have improved marginally, particularly in the equity and corporate fixed-income markets, the lack of leveraging within the hedge fund arena has certainly kept demand at much lower levels. Constraints on supply that are the by-product of this volume-to-value lending shift have been concentrated mainly within general-collateral names—when it comes to ‘special’ stocks, there are still more than enough takers, for one reason or another.”

Nick Bonn, State Street executive vice president and head of the company’s securities-finance business, agrees that hedge fund de-leveraging has impacted demand, while lenders that have instituted caps or exited the business altogether have put a damper on supply as well. Despite this, Bonn reports that State Street’s on-loan balances have remained stable during this “sideways” market.

“Throughout the industry, balances are down from the market’s top of a few years ago. I think we’ve done a pretty good job of earning money for our clients with the existing assets out on loan, despite the challenging supply-demand

FTSE GLOBAL MARKETS • OCTOBER 2010

Paul Wilson, global head of client management and sales for JP Morgan’s Worldwide Securities Services’ financing and markets products division observes: “Dealers are no longer necessarily in the position to always decide where clearing should take place.” Photograph kindly supplied by JP Morgan, September 2010.

dynamic.” Furthermore, Bonn believes that as beneficial owners continue to become acclimated to the new lending climate, caps will gradually be lifted.“I think a lot of these lenders understand that securities-lending income, while not nearly what it once was, still represents a vital part of the risk-return budget—and they really cannot afford to do without it.”

From his standpoint, JP Morgan’s Wilson considers the transition from volume to value as a natural reaction to fluctuating market conditions, rather than a “seismic shift”.

He says: “When the environment is marked by lower leverage and reduced broker-dealer balance sheets, government-sponsored liquidity programmes and a lack of short strategies by hedge funds, then it’s logical to expect volumes to be down considerably. Should the markets eventually begin to witness more robust hedge fund activity, stronger IPO activity, new sources of demand coming into the market, and a more steeply-shaped yield curve that would be favourable to the reinvestment side, then you would expect some shift back toward volume lending. So I don’t think we’ve seen the last of volume lending. It just needs to be driven by the right market conditions.”

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US SECURITIES LENDING: CUSTOMISATION, REPORTING & TRANSPARENCY 92

As beneficial owners have gained appreciation for the risks involved, programme oversight practices have changed and the level of transparency required of a lending agent has increased as well.

Given the lack of value and high level of risk inherent in a volume-lending general collateral (GC) arrangement, switching to value has been the only logical choice, says Payson. “The current reinvest environment—zero spread above risk-free rate—is just not conducive to GC lending, and therefore the trend toward intrinsic value lending will continue to cause a move away from more aggressive management of cash collateral, and a more heightened focus on collateral in general. A pure intrinsic value lending philosophy can be supported with a conservative collateral profile, while still providing very attractive returns.”

Likewise, Lamb, while acknowledging that a trend exists, says that changes in the lending environment made the push toward “value” more of a necessity than an option.

“This emphasis on ‘hot’ or ‘in-demand stocks’ sounds exciting and looks good on paper, but really, when fund spreads are such that you’re only getting pennies from general collateral anyway, of course ‘value’ is going to be the preferred route. Besides, intrinsic value has always been a part of seclending strategy; any top-tier lender should be able to attribute value versus alpha under any circumstances. So to say that this is a whole new era and suddenly everyone has ‘gone value’ is a bit of an overstatement.

Historical lens Current conditions present a unique challenge for firms including State Street; despite reduced revenues and pressure from clients to boost transparency, companies must maintain a steady stream of capital to cover technology expenditures and other enhancements.

“The industry landscape has changed, and as securities lending providers, we must provide significant levels of transparency to our clients,”says State Street’s Bonn. “At the same time, no one is doing quite as well as they did back in 2008 and 2009. We continue to adapt to the new market environment, which includes a more normalised rate of return for the securities lending business.”

Though today’s sec-lend earnings may seem a bit shabby compared to the high-octane returns of a few years ago, it is important that clients—and their lending agents—keep things in perspective. Says Rulong: “The period 2008-09 was an anomaly, the result of huge LIBOR spreads over Fed funds.

Though current spreads may be significantly lower, they are much more consistent with long-term sec-lending activity.”

Should interest rates begin to rise and M&A heats up, demand should begin to improve, she adds.

Even if it hasn’t always been smooth sailing, clients who have stuck with the sec-lend programme have certainly seen more good times than bad—and the current recommitment by a vast majority of traditional lending parties seems to

Brian Lamb, chief executive officer of EquiLend. “We’ve seen this happen before—there’s a shock to the system, causing beneficial owners to withdraw, pull back or become more conservative,” he says. Photograph kindly supplied by EquiLend, September 2010.

underscore that notion. Says Rulong: “There is a general understanding that securities lending, while not nearly the income generator it was during the ‘outlier’ period, still represents a good, consistent source of incremental revenue for asset owners, and is still capable of supporting efficiently functioning markets.”

Today, clients have a much better understanding of risk as it relates to securities lending, where previously it may have been viewed as an operational exercise, concurs Bonn.

“Securities lending can offer a relatively low level of risk for a relatively moderate rate of return, but it has never been completely risk free,”he says.“There used to be significantly different levels of transparency among securities lending providers. Now, on an industry-wide basis, most providers are stressing the risk-return scenario to their lending clients. I think it will help put the whole industry on a better footing going forward. As long as our clients maintain that focus, then everything should work out fine.”

Adds Lamb: “The most successful beneficial owners are the ones who consistently allocate resources and apply professional investment-management processes and approaches to their programmes—and as history has shown, one can’t afford not to be an educated investor.” I

OCTOBER 2010 • FTSE GLOBAL MARKETS

VIEWPOINT: EXPERT MARKET INTELLIGENCE

ASSET ALLOCATION IN A POST CRISIS ENVIRONMENT Much has been written about the impact of the recent financial crisis on the banking system, financial products and securities services. Yet one of the biggest impacts has been in the asset allocation segment. Historically, equities assumed as much as 70% of a typical investment portfolio though that is no longer the case. FTSE Global Markets spoke to a group of commentators in the asset allocation space. Here is their take on some of the principal developments in recent years and the intermediate-term outlook, in particular for the commodity and gold segments.

Photograph © Pei Ling Hoo / Dreamstime.com, September 2010.

Commentators

Supported by:

RUPERT ALLAN, head of commodity asset management, Prudential Bache NICHOLAS BROOKES, head of research and investment strategy, ETF Securities MARCUS GRUBB, managing director, investment, World Gold Council JUDY SAUNDERS, chief investment officer, West Midlands Pension Fund IVAN RUDOPH-SHABINSKY, director, fixed income, AllianceBernstein ANDREW WEIR, senior research analyst, Stenham Asset Management

FTSE GLOBAL MARKETS • OCTOBER 2010

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VIEWPOINT: EXPERT MARKET INTELLIGENCE

CURRENT APPROACHES How has the financial crisis changed the rules of asset allocation?

NICHOLAS BROOKS, HEAD OF RESEARCH & INVESTMENT STRATEGIES, ETF SECURITIES: The rules of asset allocation haven’t changed. However, after the crisis investors are far more sensitive to the underlying liquidity of the instruments they own and the counterparty risk they are taking on when they buy a security. In addition, it is likely investors will now be more rigorous in their analysis of the correlation of the various assets in their portfolios during “extreme” events to ensure true diversification.

IVAN RUDOLPH-SHABINSKY, DIRECTOR, FIXED INCOME, ALLIANCEBERNSTEIN: After an era of remarkably stable economic growth and inflation, we believe that the credit crisis and ensuing recession have ushered in a new era, characterised by greater uncertainty. This implies more volatility and more widely varied returns—both from individual assets over time and between different asset classes and markets at the same time. While this means more opportunities for asset managers, it also translates to higher risk. We believe that the best way to generating sustainable returns in a volatile environment is to manage the portfolio more actively, switching between assets and asset classes when necessary or opportune.

Moreover, strategy should be benchmark-agnostic, so it is not driven by the vagaries of index construction.

Many asset allocation strategies are essentially modelled on the basis that substantial investments will be made via the equity markets. Can this assumption be taken for granted going forward?

MARCUS GRUBB, MANAGING DIRECTOR, INVESTMENT, WORLD GOLD COUNCIL:There are clear indications that many fund managers and investment strategists are considering broader allocation policies. For example, a recent asset allocation survey by bFinance suggests that European pension fund preferences have begun moving away from equity investment and possibly down the liquidity scale, investing into assets previously perceived as riskier and diversifying into alternatives such as infrastructure, commodities and private equity. This is not surprising when we consider that, when measured in mid-2009, equity markets in the developed world had underperformed nearly every other asset class over the previous five and ten years. However, it is still a minority move and is, perhaps, hindered by the wide range of motives directing investors towards a number of very different assets. Realistically, it is unlikely that investors will turn away from substantial equity-based investments, but we strongly suggest that, if they wish to be in a position to again pursue riskier alpha, they should also equip themselves with an “insurance” asset or assets. It is all about protection from downside risk.

How far is too far? As investors increasingly look towards emerging markets and ever more “alternative” asset classes,

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is there a limit to what can justifiably be called an investment asset class?

JUDY SAUNDERS, CHIEF INVESTMENT OFFICER, WEST MIDLANDS PENSION FUND: One obviously must have sound economic and well thought out reasons backed up by evidence for investing outside the recognised mainstream asset classes. However, assuming this is the case, it is then the responsibility of the trustees, officers and advisers of individual pension funds to decide“how far is too far”. Over the last ten years the West Midlands Pension Fund has gradually lowered its quoted equity allocation from 82% to 50% and has correspondingly increased its allocation to alternatives from 8% to 25%, plus a further 10% allocation to private equity, which may be viewed by some as an alternative investment. It is all very subjective; for example, I gather some investors still view emerging market equities as an alternative, despite the fact their GDP, particularly that of the BRICS, is so much stronger than that of the developed market economies, representing an estimated 25% of global GDP by 2011.

ANDREW WEIR, SENIOR RESEARCH ANALYST, STENHAM ASSET MANAGEMENT: “How far”depends on risk appetite in terms of tolerance for volatility, permanent loss and potentially low liquidity, as well as return objectives.

More “alternative” asset classes may offer diversified return streams, but in many cases the risks inherent in these strategies are not fully understood, and sometimes undersold. Emerging markets, for example, may offer superior returns/yields to developed markets, but historically these returns have been subject to higher levels of volatility, and, due to the “flight to quality”to developed markets in times of market stress, asset price volatility can also be accompanied by weakening exchange rates, which if left un-hedged could result in further losses. It may be possible that the risks in these alternative strategies be managed and monitored in such a manner that the risk/reward profile of the asset class is attractive; but it is vital to invest with alternative asset class specialists that provide experience as well as a structured and thorough due diligence and risk management process.

Does diversification really matter?

MARCUS GRUBB: Absolutely. Although, in the wake of the credit crunch, there have been an increasingly vocal number suggesting otherwise, with many asset managers clearly disappointed by the failure of so-called diversification strategies to weather the stormy conditions, as both mainstream and supposed “alternative”assets converged on a downward path.

We would argue that, rather than dispense with diversification theory, greater attention should be given to the search for effective diversifying assets through which it might be implemented. Without adequate diversification, portfolios are simply far less robust. The problem is that genuinely uncorrelated assets are fairly rare but there is now a substantial amount of historical and statistical evidence regarding gold’s independence from other assets and market drivers to reinforce the case for gold as a strategic asset and potent diversifier.

OCTOBER 2010 • FTSE GLOBAL MARKETS

Nicholas Brookes, head of research and investment strategy, ETF Securities

diversified portfolios with only a few low-cost transactions.

ETFs now provide investors easy access to most of the world’s key equity and bond benchmarks. In addition, because they are listed on major stock exchanges they provide a transparent, liquid method of gaining exposure to areas that in the past have been difficult to access. Commodities stand out as a key example of this, as do some of the more exotic emerging markets, real estate and other alternative investment segments.

More recently currency ETCs have been listed, providing investors with easy access to emerging market currencies such as the Chinese renminbi, the Indian rupee as well as most developed economy currencies.

RISKS & RETURNS For many investors, alternative asset classes are synonymous with hedge funds. Is there a case for differentiating based on investment style rather than asset class?

ANDREW WEIR: The term “hedge fund” refers to a broad set of investment styles/strategies that differ greatly in terms of their objectives, application and risk/reward profiles.

Currently, strategy naming convention in the hedge fund industry combines elements of both style and asset class: Event Driven, Equity Long Short, Relative Value and Global Macro. Each strategy represents an alternative investment style (some across asset classes) that can be combined effectively within a multi-strategy hedge fund portfolio or as an “alternative” style within a traditional investment portfolio. The fact that alternative asset class strategies are synonymous with hedge funds should not preclude them from inclusion in traditional investment portfolios, as they may add diversification benefits. For example, an equity long short hedge fund could add an “alternative” style and therefore diversification to a traditional equity portfolio.

How much flexibility do products such as ETFs provide investors when making asset allocations?

JUDY SAUNDERS: The West Midlands Pension Fund uses ETFs in the mainstream quoted equity markets, in particular, the UK, Europe, US and Canada. However, ETFs are only used marginally and the fund currently has around £100m invested in them, compared to the remaining £3.75bn held in quoted equities. ETFs provide the fund with an effective way of achieving immediate exposure to the markets either for TAA purposes or to maintain its strategic benchmark if there are significant market movements in either direction. ETFs are flexible but can lead to small tracking errors and of course there are associated costs when dealing in them; however, they are a useful tool for supporting the £2.5bn of index funds that we manage in-house.

NICHOLAS BROOKES: ETFs are tremendously useful asset allocation tools as they allow investors to access whole asset classes and sub-sets of those asset classes through the purchase of one security. Besides the convenience this provides, it also keeps transaction costs low by allowing investors to create

FTSE GLOBAL MARKETS • OCTOBER 2010

How can investing in non-correlated assets such as gold or real estate help hedge against a fall in an overall investment portfolio?

JUDY SAUNDERS: I suppose one of the lessons we learnt from the 2008/2009 financial crisis was that the theory of noncorrelation does not actually hold in times of severe economic/market stress. I continue to take the simplistic view however that diversification and a deliberate policy of introducing non-correlated assets into your fund’s overall investment strategy should mitigate some of the risk over the long term.

We have made a conscious move to lower the fund’s reliance on the equity risk premium and acknowledge the fact that in a bull market we will not be “shooting the lights out”. Equally however, when there is a repeat performance of 2008 then the potential downside should not be as severe. The fund has an 8% allocation to absolute return strategies in addition to emerging market debt, infrastructure, commodities and real estate, which between then represents a further 17%, making a 25% allocation to alternatives in total.

MARCUS GRUBB: This takes us right back to basic portfolio theory and, again, the case for investment in a properly balanced and diversified set of assets in order to reach an optimal riskreturn balance. A portfolio’s overall behaviour is more than the sum of its parts and investors need to be aware of the covariance of each and all components over time. Assets should be included which can reliably offset any convergent behaviour across other asset classes. Our asset allocation research suggests gold is certainly an asset that can fulfil this counter-balancing function. We are confident it can be proven to add to optimal risk-return balance across a portfolio, particularly when risk tolerances are raised. Gold also has distinct advantages over an asset class such as real estate in terms of both liquidity and being far more insulated from recessionary pressures.

Is it possible to follow a dynamic asset allocation strategy and adequately manage risk?

IVAN RUDOLPH-SHABINSKY: Yes. A dynamic asset allocation strategy should respond both to changing return opportunities and changing levels of risk in the marketplace.

Our dynamic asset-allocation research seeks to measure

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VIEWPOINT: EXPERT MARKET INTELLIGENCE

short-term risks and returns in order to rein in volatility and cut down on extreme outcomes, without giving up return potential. We believe such an approach can deliver a more consistent investment experience, regardless of the capital-market environment.

RUPERT ALLAN, HEAD OF COMMODITY ASSET MANAGEMENT, PRUDENTIAL BACHE: No one approach will provide a failsafe solution. There will always be market events or situations that will impact any approach attempting to effectively manage risk. That said, in many circumstances a dynamic asset allocation strategy that has a clearly defined set of “operating” rules will allow risk to be controlled. Commodity markets are different to equity markets and fixed income markets. Therefore, a dynamic asset allocation strategy should be naturally tailored to the specifics of that asset class. As a provider of commodity index products, we embrace the clear benefits that investing in indices brings to an investor, and equally as a index provider focusing on the commodity asset class we also are very cognizant of the drivers of commodity prices and their specific characteristics. This is why we employ a dynamic asset allocation strategy within the Bache Commodity Index that is driven by changes in commodity prices over a series of three timeframes: short, medium and long-term time frames that will cause individual commodity exposure to be increased or decreased, within minimum and maximum defined parameters. As an example of its application, the dynamic asset allocation strategy applied to the Bache Commodity Index reacted to the severe price declines across the commodity sector in the second half of 2008 by reducing commodity exposure and thus successfully managing the risk in the portfolio.

How can you manage volatility in volatile markets?

ANDREW WEIR: Within our portfolios we attempt to combine hedge fund strategies which provide returns in most market environments. Specifically, we use long volatility and short credit strategies to provide protection to our portfolios. These strategies provide negatively correlated asymmetric return profiles if executed correctly, with low downside in rallying environments and high upside in volatile environments.

IVAN RUDOLPH-SHABINSKY: Even a thoroughly diversified portfolio is vulnerable to large losses, particularly when a financial market shock occurs. We believe that dynamic tools should be used to adjust an asset-allocation strategy systematically as market conditions change. Our own research shows that by focusing on controlling risk, and being sceptical about making changes to portfolio weights based solely on expected returns, dynamic asset allocation can smooth out volatility and mitigate extreme outcomes, without sacrificing performance in the long run. Also, market risks can be more reliably forecast than returns, largely because volatility trends tend to persist for extended periods across all major asset classes. Contrary to popular belief, periods of high volatility are often not followed by large gains. It’s crucial for investors to measure how well they are being compensated for accepting more risk. Return

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forecasting can help to indicate when markets are most vulnerable and when they are likely to be most rewarding.

Factors such as valuations, levels of corporate profitability, the level and direction of interest rates, and credit spreads can provide early warning signals.

After the recent downturn, are institutional investors once again investing in absolute returns rather than simply beating the benchmark?

JUDY SAUNDERS: In January 2009, following the unprecedented market turmoil of second-half 2008, the fund undertook a major review of its investment strategy, which led to a further increase in its allocation to alternatives, this primarily involving an 8% allocation to absolute return strategies, a new concept for the fund. Although it is a move away from the traditional equity or bond benchmarks, the funds in which we have invested still have a benchmark against which to perform, simply, Libor plus X%. At the moment there are 18 investments in the portfolio, of which some but not all are hedge funds and there is a current emphasis on distressed. We have a year’s performance history for seven of the funds and to date these are all positive; however it is still very early days.

How must portfolios be constructed to prepare for extreme events?

ANDREW WEIR: Avoid high levels of leverage, stay liquid and diversified.

NICHOLAS BROOKES: Maintaining strategic weightings in “insurance” assets that will provide liquidity and that will tend to appreciate during extreme events is one way to reduce a portfolio’s vulnerability to extreme events. During the financial crisis of 2008, two assets that fit these criteria were high-rated government bonds and gold. A major change in investor perception towards gold has occurred since the crisis with physically-backed gold exchange-traded products (ETPs) seeing a surge in demand. Total global holdings of physical gold ETPs now stand near $86bn, up from around $50bn a year ago.

How important is counterparty risk in determining allocations to alternative asset classes such as commodities or real estate? Are there effective processes in place to manage counterparty risk?

MARCUS GRUBB: Much of the investor interest in gold in the US and Europe, particularly at the retail level, has been prompted by concern regarding counterparty risk and the search for assets that are fairly straightforward, transparent and relatively secure. Credit issues and a general uncertainty as the stability and trustworthiness of financial products and institutions have driven many to turn to gold and other similarly tangible assets. Gold is both a stable monetary asset and a hard asset, underpinned by a very liquid market, and these qualities offer investors a confidence that is in relatively short supply. Unfortunately, many other assets classified

OCTOBER 2010 • FTSE GLOBAL MARKETS

Judy Saunders, chief investment officer, West Midlands Pension Fund

Marcus Grubb, managing director, investment, World Gold Council

under the “alternatives”umbrella are far less liquid and less easily comprehended, and when approaching these, investors will probably be required to be far more vigilant in their due diligence and risk management procedures.

investment infrastructure. A direct physical investment in commodities is not a natural route for many investors who have to take into account all the complexities of transportation, delivery and storage that a direct physical investment requires when considering a broad range of commodities, such as live cattle or cocoa. Using these two examples, it may be difficult to identify stocks that are pure plays on either live cattle or cocoa. With the added issues that have to be analysed and taken into account when one considers investing in commodity-related stocks, questions arise relating to company management—whether it is well managed or not could have a more direct influence on the stock price than the underlying commodity nature of their business. Commodity futures give investors a transparent and efficient way of accessing commodities. Active investment managers, typically known as CTAs, offer investors sophisticated trading approaches that seek to identify market movements in commodity futures both up and down. However, these approaches can be opaque and may be accompanied with high investment fees.

Commodity futures can also be offered to investors through commodity indices that have developed second generation approaches to remedy some of the issues associated with the early traditional commodity Index products. The Bache Commodity Index is one such new, enhanced index that offers investors a transparent methodology that ensures broad, diversified exposure to the commodity sector while combining an active, quantitative element that will adjust exposure according to market conditions. This element facilitates participation in market advances while reducing participation during market declines.

ANDREW WEIR: Physical investment in some types of commodities is not always possible or practical, and commodity futures and commodity stocks may be the only way to access commodity exposure. Commodity investment, especially via the futures market, is a highly specialised skill set and is best left to experienced experts, who are able to manage the technical aspects and volatility inherent in these markets. Within Stenham Global Resources we combine investments with both commodity–related equity long short managers and commodity futures traders to provide a balanced exposure to commodity markets.

MARCUS GRUBB: There are four key factors to consider when choosing an investment vehicle for exposure to

COMMODITIES When investing in commodities, how should investors choose between direct physical investment, a portfolio of commodity-related stocks or commodity futures? Does this vary between different types of commodities?

JUDY SAUNDERS: I am not in a position to advise others on how best to achieve their allocation to commodities but the West Midlands exposure is through a number of specialised vehicles. None of them are plain vanilla indexed funds, as from what I can gather commodity investing is one of the few areas where active managers beat index investing over the long term. The pension fund made its first investment in early 2007 and there are now six funds making up the commodity portfolio. These funds have been chosen to be deliberately different, complementing one another. There is no one dominant index, so the total portfolio has less than a 50% weighting in energy. In addition one of the investments is a reasonably defensive fund of funds with an absolute return target which successfully protected the capital during 2008.

NICHOLAS BROOKES: In my view it makes the most sense for investors to look at commodity equities in the context of their equity portfolio and to look at direct investment in commodity returns—either through ETCs or commodity futures—as a separate asset class. While commodity equities are generally (though not always) correlated to the commodity their business is involved in, they are almost always more highly correlated to the equity market they are listed on.

Therefore, while there are many good reasons for investing in commodity equities and ETFs tracking commodity companies, they will rarely provide the diversification benefits of investing in the underlying commodity markets.

RUPERT ALLAN: The answer will depend on each investor’s specific situation which may be influenced by regulation, time frame, the way they view commodities and where they have positioned commodities in the portfolio and their

FTSE GLOBAL MARKETS • OCTOBER 2010

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VIEWPOINT: EXPERT MARKET INTELLIGENCE 98

commodities: regulation, cost and risk and return. By filtering the universe of investment possibilities using these four criteria, an investor will better match their exposure to their investment objectives. Firstly, regulation will ultimately serve as the first filter criterion. Depending on where the investor is domiciled, there will inevitably be restrictions on what instruments they are allowed to invest in. Secondly, cost must be a consideration and will in many cases restrict the investor’s choice of vehicle.

While many securities such as futures, options and exchangetraded funds have become increasingly accessible to most investors, minimum initial outlays, margin requirements, storage costs and more will ultimately determine which vehicles are viable. Thirdly and fourthly, risk and return are always essential considerations for any investor. The myriad of commoditybased securities on offer today feature very different risk/return profiles and may have “hidden” costs (such as negative rollyields in futures). Additionally, there is the issue of liquidity risk. Investors must ultimately choose what type and level of risk they are happy to be exposed to in relation to the total return they would expect to achieve.

How can you capitalise on the growth outlook for commodities?

NICHOLAS BROOKES: The most direct route for capitalising on the outlook for commodities is to invest directly in the commodities themselves. ETCs provide a convenient way to do this. Commodity equities are another method, though as mentioned earlier, they will generally not provide the diversification benefits of the underlying commodity. Another method, less discussed, is to capitalise the growth outlook for commodities by buying currency ETCs tracking currencies of countries with high exposure to commodities such as the Australian dollar, the Norwegian krone, the Canadian dollar. In many cases the correlations of these currencies to the commodities the country is a major producer of is very high, and often they benefit from relatively high interest rate return.

RUPERT ALLAN: If you want a broad, constant exposure to a basket of commodities that will benefit from a benign growth environment, then investing in a commodity index will give you that opportunity. An index offers many advantages: the index methodology is defined in detail and allows a potential investor to understand the methodology that the index provider has determined as their approach to managing the index.You can assess whether the construction of the index gives you a well diversified, broad exposure to commodities within the energy, agricultural and metals sector and that it avoids sector or commodity concentration and that it rebalances frequently to ensure that the index weights are adhered to. The use of commodity futures, which is the primary way that indices get their commodity exposure, must also mean that the index has a robust approach to rolling futures positions. It is perhaps more efficient to avoid the large, public, once-a-month rolls that some commodity indices adopt, and instead look at commodity indices, like the Bache Commodity index, that follow a clearly defined approach that has a daily continuous

Ivan Rudolf-Shabinsky, director, fixed income, AllianceBernstein

role in the front and next month, which smoothes the whole roll process and benefits the investor. An index solution does not suffer the issues that relate to investing in commodityrelated stocks, where more equity market-related concerns can affect the stock price or the skill set of a more active portfolio manager that is attempting to make trading decisions that may be concentrated in specific commodities and be too early or too late in entering a position, for example. An active, enhanced index such as the Bache Commodity Index will offer all the benefits of a traditional index—clear methodology, broad diversified exposure across the commodity sector—and combine it with a quantitative model that will actively change the exposure within the index according to price momentum.

What different ways can you invest in gold and what are the advantages and disadvantages of each?

MARCUS GRUBB: Gold can be advantageous to most aspects of portfolio construction and management, but its primary benefits for longer-term investors are rooted in its ability to reduce volatility and exposure to market risk and contribute to more robust and consistent returns. That said, other analysts have focused on gold’s monetary function, both as a dependable store of value and as a potential provider of liquidity when markets are severely constrained and the value of other portfolio components may be compromised.

These reasons have prompted us to believe that gold should be considered a strategic“foundation”asset, fundamental to portfolio composition—representing a buffer against downside and tail risk, and providing a hedge against currency weakness and corrosive inflation.

NICHOLAS BROOKES: Gold has outperformed most key asset classes over the past ten years (up 330%) and these returns have come with a lower volatility than many major equity benchmarks (18% annualised). Gold was one of the few assets to rise during the financial crisis in second half 2008 and has historically tended to perform well during periods of extreme macroeconomic and financial dislocation.

Gold is also one of the few assets to maintain a low to negative correlation with most risk assets, including equities. If these relationships hold, gold can play a key role in a traditional equity and bond portfolio as a diversifier and as“insurance”

OCTOBER 2010 • FTSE GLOBAL MARKETS

Andrew Weir, senior research analyst, Stenham Asset Management

against extreme events. With rising government debt and concerns about currency debasement (either through inflation or nominal currency depreciation) likely to be with us for some time to come, gold is likely to continue to play a key role as an alternative store of value and hedge against the continuing risks of government fiscal and monetary mismanagement.

MARCUS GRUBB: The routes to gold investment are far more varied and developed than they were even a decade ago. The most obvious innovation has been the development of the gold ETF market which now represents well over $80bn in assets under management, in vehicles that only really came into existence five years or so ago. Even so, we should not forget the return to physical gold investment in Western Europe and, to a degree, the US over the last few years. In Europe, a generation that had largely turned its back on gold has rediscovered it as an asset. We expect this to result in further product innovations, both in terms of securitised instruments and distribution channels. We are witnessing this now, with a number of additional gold-backed and gold-tracking vehicles recently made available to institutional and high net worth investors.

Commodities and in particular gold are often seen as an inflation hedge. Does this tend to overshadow the other benefits on commodities?

are often an intrinsic and causal part of inflationary cycles— so-called “cost-push” inflation. In the case of gold, its strength as an inflation hedge and store of value is also related to its long-established role as a monetary asset and store of value.

But focusing solely on an asset’s inflation-hedging capabilities might result in an overly tactical and somewhat short-sighted perception. Our asset allocation research strongly suggests that gold can benefit portfolios across economic cycles. Gold is also a more potent protector against dollar depreciation than any other of the major commodities and certainly far less volatile. In other words, we believe gold can offer investors the benefits of the commodities complex and more besides, and we have published a range of research to support this.

Commodities are often seen as an inflation hedge. Does this tend to overshadow the other benefits of commodities?

IVAN RUDOLPH-SHABINSKY: It’s true that commodity futures can serve as a reasonable hedge against accelerating inflation. During all four episodes of rising inflation since the early 1970s, commodity futures have outperformed both stocks and bonds. Periods of strong economic growth are often associated with accelerating inflation; commodity prices rise as the demand for goods—along with the raw materials needed to make them—increases. More importantly, history has shown that few investments provide as much diversification as commodities. Over the past two decades, the S&P GSCI (formerly the Goldman Sachs Commodities Index) has exhibited very low correlations to other major asset classes. There is a proviso to this, however. While many people think of commodities as one fairly homogeneous asset class like stocks or bonds, commodities are not a cohesive group. They have different performance drivers and, for example, there has historically been massive dispersion in the performance of individual commodity futures contracts.

Accordingly we believe they are best evaluated on a case by case basis. This is one reason why we advise against having a long-term strategic allocation to a commodity index, and instead recommend a more opportunistic, actively managed (preferably short as well as long) approach.

How effective is gold as a long-term inflation hedge?

JUDY SAUNDERS: Although I recognise that they are regarded as an inflation hedge, the risk-adjusted returns of adding commodities to a portfolio are more beneficial than just the traditional mix of equities and bonds, which is our primary reason for holding them. Other than diversification benefits, they perform best during periods of high inflation and growth so conversely they tend to perform poorly when GDP falls. Historically, I believe the gold price tends to rise when investors want a hedge against dollar weakness so as gold has no fiscal dimension one could argue that it may be attractive for those investors who are also wary of other currencies, especially in times of low interest rates, when the opportunity cost is low.

MARCUS GRUBB: Commodities are frequently perceived as inflation hedges, not least because rising commodity prices

FTSE GLOBAL MARKETS • OCTOBER 2010

IVAN RUDOLPH-SHABINSKY: Gold has characteristics of both a currency and a commodity, while providing protection against both inflationary and deflationary environments. Gold production is driven largely by the level of real interest rates and less by prevailing spot prices. Mine operators have the choice of extracting gold today or leaving it in the ground to extract in the future. As real rates rise, the present value of future extraction falls, so the desire to extract today rises. But even when global production is “high”, it rarely amounts to even 2% of all above-ground stocks. This price-insensitive supply response means that changes in demand are often met by explosive price responses rather than production responses. Demand for gold tends to rise with uncertainty about the global—and

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VIEWPOINT: EXPERT MARKET INTELLIGENCE

particularly US—financial system, with gold acting as a currency of last resort. Extreme inflationary and deflationary outlooks heighten uncertainty. So gold, uniquely, provides a hedge against both environments. The real gold price tends to rise in periods of high interest rate volatility, a proxy for monetary uncertainty, and fall in periods of low rate volatility. Investors tend to flock to gold as a disaster hedge, regardless of whether the feared disaster takes the form of a huge inflationary or deflationary shock. However, this unique, asymmetric form of hedging comes at a steep cost. The long-term expected price appreciation for gold (as for all commodities) is equal to the expected increase in the marginal cost of production, which, for hundreds of years, has roughly equalled broader measures of inflation.

In other words, barring “peak gold”-type arguments, the long-term expected return on a gold investment equals inflation less storage costs—far below the long-term expected returns on stocks or even bonds.

How can investors optimise ETFs and ETCs as part of their overall investment allocation strategies?

NICHOLAS BROOKES: ETFs and ETCs can be used to create stand-alone diversified portfolios or to complement the holdings of more traditional portfolios constructed of direct holdings of individual equities and bonds. One of the key advantages of ETFs and ETCs is they can provide investors with a convenient and simple way to gain access to investment themes and asset classes that otherwise would be difficult and/or expensive to create in-house. Exchange-traded commodities (ETCs) have seen tremendous success by providing investors access to the diversification benefits of commodity returns without having to become directly involved in commodities futures trading or buying and storing physical precious metals. Thematic investing has also become easier, with ETFs tracking baskets of companies involved in gold mining, alternative energy, shipping, water, agribusiness, among others.

OUTLOOK What are the next frontier markets for investors?

IVAN RUDOLPH-SHABINSKY: While today’s opportunity set is not as extraordinary as it was in early 2009, we continue to see a wide range of pricing inefficiencies, anomalies and opportunities in the alternative space. One of these, arising directly from the credit crisis, is distressed investing. With many firms having been forced to recapitalise and restructure, we see deep-value potential in investing in stressed and distressed companies and in looking for merchant finance opportunities in the small- and mid-cap markets. This could involve investing in public or private equity, bonds, loans, structured products or related derivatives. A second postcredit-crisis opportunity is real estate, particularly in the US, where commercial real estate fundamentals remain under pressure despite a recovering economy. A flood of real estate

100

loans will reach maturity in the coming years, with limited funds available for refinancing. We believe that these refinancing needs will offer a once-in-a-generation opportunity to enter the commercial real estate market at attractive valuations. A third, more perennial source of added value, in our view, is active currency management. Our research suggests that a reliable risk premium is embedded in the currency market, which can be systematically exploited. Over time, this risk premium has been weakly correlated with stocks and bonds. Active currency strategies can be executed easily using derivatives, without committing significant capital and, since the currency market is highly liquid, trading costs are modest. Ultimately, we think the managers most likely to succeed in coming years will be those that nimbly employ multiple strategies and trades to exploit inefficiencies and anomalies in a global opportunity set, pursuing “asymmetric” returns, such as using options to limit downside. We recommend a multi-tiered approach to risk management, including measures like stop-loss procedures and dynamic tail-risk hedging.

Over the short term, will equities continue to lose out to other asset allocations?

JUDY SAUNDERS: The honest answer is that I have no idea. I can only speak on behalf of the West Midlands Fund and our investment strategy has been to reduce quoted equities during the last ten years by over 30%. However, I would add that we take a long-term view and have a 20year plus horizon so our move away from equities is definitely not short term. The objective behind further diversification is that it will hopefully position the fund more defensively when and if we see a repeat performance of the market turmoil experienced in 2008. As far as I’m aware as at the end of March the average local authority pension fund still had a 66% allocation to quoted equities.

IVAN RUDOLPH-SHABINSKY: Risk aversion engulfed financial markets in the second quarter, capping a miserable ten-year run for equities and a stellar period for safe assets such as government bonds. But investors need to exercise caution before extrapolating recent results. The future looks much brighter for riskier assets like equities and credit-related securities. Indeed, the flight to the perceived safety of some government bonds has further depressed their projected returns. Meanwhile, the long-term prospects for equities have improved as valuations fell amid a positive earnings and economic outlook. Our Capital Markets Engine (CME), a proprietary simulation model that generates forecasts for long-term asset returns, takes current market conditions into account so investors can best gauge the likelihood that their strategic asset allocation will meet their plan objectives. At this time, our model suggests that it’s unlikely to be a good time to de-risk. Normally 70%, or 7,000 out of 10,000 scenarios the CME forecasts, would show equities beating bonds over ten years. But today, according to our model, the chances of equities delivering higher returns than sovereign bonds have risen to 91%. The odds of outperformance are unusually high

OCTOBER 2010 • FTSE GLOBAL MARKETS

Rupert Allan, head of commodity asset management, Prudential Bache

for small-cap stocks, corporate bonds (especially high yield) and inflation-protected securities. By contrast, we project ten-year returns far below normal for cash and both nominal and inflation-linked government bonds because yields are very low and their prices will likely decline as market yields rise when historically unprecedented monetary easing by central banks is reversed.

Is investing in emerging markets now part of the mainstream?

due to a weaker exchange rate, as well as a rise in asset prices, and, via the“wealth effect”, increase consumption and therefore inflation. On the flip side, if central banks choose to reduce/withdraw quantitative easing measures, deflationary effects might be the result. Based on current central bank (Fed) rhetoric, the US appears likely to stay on the path of Quantitative Easing, which could be negative for the US dollar if they choose to expand the programme, but inflationary for US bond, credit and equity markets.

Within Europe, rhetoric is more austere, which is likely to result in a lower growth and inflation environment over the next few years.

MARCUS GRUBB: While there may be considerable debate regarding quite when inflation will arrive and to what degree it will come to dominate the horizon, it is difficult to comprehend how central banks and financial policy makers will extricate their economies fully from the aftermath of the collapse in credit and the current burden of sovereign debt without creating inflationary pressures. This is something that we have been looking closely at over the last few years and our analysis shows that gold’s role as a leading indicator of inflation is reflected in increased allocations when, using established optimisation techniques, we seek to define optimal portfolio compositions to offer protection against escalating and high inflation.

Is the time still right to begin investing in gold?

JUDY SAUNDERS: Certainly emerging market equities have formed part of the West Midlands Fund’s mainstream quoted equities portfolio for many years. However, the fund is still underweight when compared to global market indices, although not as underweight as the average pension fund.

At the end of June 2010 we had 7% of the fund in emerging market equities which I believe is slightly above the average weighting. The fund also has a 3.5% allocation to emerging market debt which at the moment sits under the alternatives umbrella but which going forward may well switch to the mainstream fixed-interest portfolio. In addition we have an allocation to emerging markets in our property and infrastructure portfolios which sit within alternatives, so it really depends in which asset class one is getting the emerging market exposure as to whether it is mainstream or not.

MARCUS GRUBB: The case for gold, at least for most longer-term institutional investors, is actually not dependent on its return profile, even though gold has been one of the best performing assets over the last decade, when compared with nearly all other asset classes, both mainstream and “alternative”. It is worth noting that when we have performed our portfolio optimisation research we generally enter very conservative return expectations for gold. Even so, the research results consistently indicate an allocation to gold is optimal in maintaining a stable risk-return profile across a range of time and market scenarios. This is, again, because of gold’s strengths as a diversifier—qualities underpinned by solid market fundamentals and an almost uniquely diverse demand base extending across sectors and geographies.

What is the inflation outlook for the US and Europe in 2011? What impact will this have on asset allocation?

Bearing in mind the global outlook, which countries should investors be targeting in 2011?

ANDREW WEIR: Inflation and more specifically central bank reactions based on the outlook for inflation, are likely to have a material effect on currencies and asset prices over the next few years, and should be of particular concern to asset allocators. Organically-driven inflation in the US and Europe is likely to be mild over the next couple of years as these economies experience a period of sub-par growth.

Inflation may however be distorted by stimulus and easy monetary policy established by central banks to stave off deflation. Quantitative Easing (aka money printing or currency debasement) may lead to higher import prices

ANDREW WEIR: Over the past decade, globalisation of world trade has resulted in regional economies and markets becoming more correlated. Nevertheless the economic growth outlook for emerging market countries appears much stronger than Western economies and should lead to a degree of decoupling over the next few years, with domestic demand strength offsetting the negative effects of a weakening export customer in the West. Brazil in particular appears to have a strong domestic story. Of the Western economies, Germany, with its export-driven economy, will continue to benefit from a weak euro. I

FTSE GLOBAL MARKETS • OCTOBER 2010

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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

LW

Wks

Stock

Description

TW

LW

Wks

Stock

Description

1

-25

p

36

SSE.L

SCOT.&STH.ENRGY ORD 50P

2.92

11

-10

q

33

RR..L

ROLLS-ROYCE ORD 20P

2.79

2

-5

p

6

REL.L

REED ELSEVIER ORD 14 51/116P

2.91

12

-13

p

36

IMT.L

IMP.TOBACCO GRP ORD 10P

2.78

3

-38

p

17

BNZL.L

BUNZL ORD 32 1/7P

2.9

13

-14

p

7

CHTR.L

CHARTER INTL ORD 2P

2.77

v

5

ITRK.L

INTERTEK GROUP ORD 1P

2.87

14

-64

p

1

BBY.L

BALFOUR B. ORD 50P

2.76

4

FFI

FFI

5

-6

p

22

NG..L

NATIONAL GRID ORD 11 17/43P

2.87

15

-1

q

7

VCT.L

VICTREX ORD 1P

2.76

6

-15

p

26

ULVR.L

UNILEVER ORD 3 1/9P

2.86

16

-78

p

2

CLDN.L

CALEDONIA INV. ORD 5P

2.74

7

-2

q

14

ANTO.L

ANTOFAGASTA ORD 5P

2.85

17

-34

p

26

RDSB.L

RDS 'B' 'B' ORD EUR0.07

2.73

8

-20

p

32

PRU.L

PRUDENTIAL ORD 5P

2.83

18

-29

p

6

BT.A.L

BT GROUP ORD 5P

2.73

9

-12

p

16

PSON.L

PEARSON ORD 25P

2.83

19

-19

tu

39

DGE.L

DIAGEO ORD 28 101/108P

2.71

v

1

GCC.I

C&C GROUP PLC

2.82

20

-42

p

5

RRS.L

RANDGOLD RES. ORD $0.05

2.69

10

EUROPEAN TRADING STATISTICS

THE FIDESSA FRAGMENTATION INDEX (FFI)

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

COMMENTARY

By Steve Grob, Director of Strategy, Fidessa RegNMS in the US and MiFID in Europe were two pieces of legislation that introduced the concept of 'best execution' for both retail and institutional investors. The national stock exchange monopolies have been dismantled and we've seen the emergence of an array of low cost alternative venues. Having invested in the latest matching technology these ECNs in the US and MTFs in Europe have been able to aggressively compete with the incumbent exchanges for trading volumes.

Because the equity markets in the US and Europe have been so profoundly altered in the wake of these respective regulations, it is only natural that market participants are looking at how their considerable investment in achieving best, or better execution, can be applied in other regions.

In Japan and the rest of Asia market forces and technological advances, rather than regulation, are shaping the relationship between brokers and their buy-side clients.

Broker crossing networks and alternative PTSs such as SBI Japannext and Kabu.com have existed in Japan for some time. Last month saw the launch of Chi-X and while it is still early days, there is considerable interest in what they, and the other alternative venues, are doing. With the introduction by the Tokyo Stock Exchange of its new generation matching platform, 'arrowhead', Japanâ&#x20AC;&#x2122;s primary bourse is now on a par with other global exchanges in terms of speed. This in turn has opened the door for the ELP/HFT community that was responsible for fanning the flames of fragmentation across the US and Europe in the first place.

So, despite the lack of any fundamental legislative change, a number of very real fragmentation scenarios are already being played out across Asia. Other initiatives are underway too as the global banks and brokers seek to leverage their huge investment in internalisation, smart routing and best execution across the different global regions.

It will be interesting to see if the Asian fragmentation experience provides a better or worse end result for the investment community.

The results between the US and Europe have varied but, in both markets, trading costs have fallen in the face of greater competition.

Overall volumes have generally increased, too, as more venues means more opportunities for the HFT players. On the other hand, posttrade processing and transparency have suffered as unbiased, reliable and timely information on which stocks actually trade becomes harder and harder to come by.

It will be interesting to see if the free market competition we are seeing across Asia produces a more level playing field than the highly deterministic approach taken by regulators elsewhere.

FTSE GLOBAL MARKETS â&#x20AC;˘ OCTOBER 2010

103

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

February

March

April

May

June

July

August

BER

12299869.07

12095979.32

20898115.71

20869157.28

21547869.80

12544985.0101

13641903.28

13296970.42

BRG

485115578.84

664510070.30

1666606979.62

1484895339.18

1160801695.44

1216508271.49

1195324763.93

1198926068.11

BTE

31150258386.00

34090404626.97

39193610957.69

42331175110.88

53758623911.83

43271117580.49

39224595971.05

35763525199.09

CIX

110977110385.49

122737876719.05

127111917698.82

138532607106.82

186077857047.41

147121672027.29

129336311240.04

113506083036.17

CPH

6756826918.10

6640400689.39

6626152423.75

6351788793.70

7783026044.28

6714633960.89

5164430434.81

7419297544.75

DUS

51353982.31

37525367.53

51415834.33

61803818.36

67538425.06

43568831.22

41470859.08

46990440.85

ENA

37999836321.05

37880117626.68

38562044761.19

41692637528.93

52300438953.01

37199905323.05

33138564079.87

29501836678.34

ENB

6008003591.11

6103299182.27

6358216747.07

5988625536.27

9369541614.81

6715329462.90

5804421360.41

5702438845.10

ENL

3106855297.08

3554443804.88

3046713139.88

3727720527.61

4752180275.24

3879426528.86

3202087103.91

2434222432.33

ENO

-

482771.59

-

-

-

-

-

-

ENX

66228400089.99

75614221011.97

74245298998.52

78769429844.17

113106867629.24

86578715614.33

72993302174.38

61417839780.09

GER

67965895238.29

66776121605.01

72168449445.45

86885537242.87

112634642716.91

74523500152.04

62270047277.53

59215904905.54

HEL

10339952621.77

10058819924.19

11752695115.83

12864278423.44

12677237276.57

9736157069.77

8784893287.07

7975546392.05

ISE

511570001.10

504915917.70

565269992.07

647314249.60

607747772.36

707067734.88

520395496.86

342913517.78

LSE

95983836598.48

101916702001.83

105630799395.16

95825409974.98

132946145050.97

114402642810.45

98764001813.56

89317583229.77

MAD

51066014495.96

52210894242.17

43945312316.04

52313552809.86

69919778842.24

51380354411.28

47534238133.14

34292981256.70

MIL

48728657959.10

51711533820.17

52410490586.85

60842288388.66

98165692121.29

73306011499.90

49371204223.43

43794833465.90

NAE

1292687653.19

1825246025.41

2792572924.06

2501941839.46

2151564476.49

1754428128.16

1833689873.43

1626201638.34

NEU

5816854755.80

5574111215.48

6232496049.93

6066724036.03

3388942662.98

1738062092.43

9195060.22

-

OSL

16130924336.37

15871251841.26

13866926910.94

16588222829.50

17276093344.48

14866575211.08

11428538424.94

13736301307.17

STO

22786344725.57

24086268094.82

24125076503.28

28675024013.03

31806593342.57

23890648411.14

22628837567.40

20937138585.42

TRQ

20168098539.34

21028161702.73

20951128258.80

22059392685.24

29039242985.51

27884374356.60

26816523838.01

24196960473.32

VTX

43636990148.75

46961823692.04

44673323239.12

41985051551.14

47323284922.30

40448981935.02

40353368433.82

36071286098.97

XIM

-

90362714.08

97403633.80

43510060.39

47325856.70

24778850.52

43880708.03

25499713.27

Index market share by venue: Week ending September 10th 2010 Primary Index

AEX

Alternative Venues

Venue

Share

Chi-X

Amsterdam

64.18%

21.34%

Turquoise

Nasdaq OMX

4.70%

-

BATS

6.16%

Burgundy

-

Amst.

Paris

Xetra

-

3.32%

0.19%

London

NYSE Arca

-

-

Stockholm

-

BEL 20

Brussels

51.98%

20.22%

4.96%

-

3.95%

-

-

18.79%

†

-

-

-

CAC 40

Paris

64.94%

20.37%

4.46%

-

4.74%

-

4.69%

-

0.19%

-

-

-

DAX

Xetra

69.81%

19.92%

3.58%

-

5.40%

-

†

-

-

-

0.17%

-

FTSE 100

London

58.05%

25.48%

6.78%

-

9.28%

-

-

-

-

-

0.41%

-

FTSE 250

London

66.86%

19.04%

8.15%

-

5.52%

-

-

-

-

-

0.43%

-

IBEX 35

Madrid

98.08%

1.44%

0.16%

-

0.12%

-

†

-

0.09%

-

-

-

FTSE MIB

Milan

85.11%

8.28%

1.29%

-

5.10%

-

†

†

0.04%

-

0.16%

-

PSI 20 SMI

Lisbon

91.51%

5.26%

1.72%

-

1.50%

-

-

-

†

-

-

-

SIX Swiss

68.48%

19.29%

3.74%

-

7.95%

-

-

-

-

-

0.54%

-

OMX C20

Copenhagen

82.09%

10.12%

1.98%

-

5.52%

0.06%

-

-

-

-

0.23%

OMX H25

Helsinki

66.80%

18.66%

3.03%

-

7.26%

0.83%

0.05%

-

2.58%

-

0.44%

OMX S30

Stockholm

72.17%

14.73%

3.07%

-

5.20%

4.63%

-

-

-

-

0.20%

-

OSLO OBX

Oslo

89.54%

3.44%

0.84%

-

1.54%

0.04%

-

-

-

-

†

4.61%

Dublin

24.80%

1.16%

1.45%

-

†

-

-

-

-

72.26%

0.05%

-

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.

104

OCTOBER 2010 • FTSE GLOBAL MARKETS

As at end of July 2010 Index Provider MSCI S&P Barclays Capital Russell FTSE STOXX Markit Dow Jones NASDAQ OMX Deutsche Boerse Topix Hang Seng Nikkei EuroMTS SIX Swiss Exchange NYSE Euronext CAC WisdomTree Indxis CSI Intellidex BNY Mellon Morningstar S-Network Zacks Value Line Other Total

No. of ETFs 323 277 78 60 163 214 92 151 54 40 53 12 9 29 15 16 15 35 6 27 38 11 10 15 14 3 522 2,282

July 2010 Total Listings AUM (US$ Bn) 1038 $263.9 488 $244.3 189 $110.3 101 $67.9 359 $47.6 730 $44.2 226 $41.8 278 $40.5 86 $26.9 143 $24.2 65 $13.3 32 $13.0 15 $12.3 91 $11.1 28 $7.5 34 $7.2 26 $6.5 42 $5.9 7 $3.9 28 $2.7 41 $2.3 12 $2.3 10 $1.6 33 $1.1 15 $0.6 3 $0.2 752 $92.2 4,872 $1,095.2

% Total 24.1% 22.3% 10.1% 6.2% 4.3% 4.0% 3.8% 3.7% 2.5% 2.2% 1.2% 1.2% 1.1% 1.0% 0.7% 0.7% 0.6% 0.5% 0.4% 0.2% 0.2% 0.2% 0.1% 0.1% 0.1% 0.0% 8.4% 100.0%

No. of ETFs 58 44 8 -1 37 10 22 15 11 10 0 3 1 7 2 6 -3 -10 -1 16 -4 0 0 2 0 -2 106 337

Total Listings 284 112 30 1 75 104 68 58 23 52 1 9 4 40 5 22 0 -3 -1 17 -11 0 0 2 0 -2 155 1,045

YTD Change AUM (US$ Bn) $20.1 -$4.9 $22.8 $1.9 $4.8 -$6.8 $3.6 -$0.4 $0.4 $0.7 $0.9 $1.2 -$0.2 $0.1 $0.1 $1.1 -$1.0 $0.1 $1.1 $0.2 -$0.3 $0.0 -$0.1 -$0.1 $0.0 -$0.1 $13.8 $59.1

% AUM 8.2% -2.0% 26.0% 2.9% 11.3% -13.3% 9.5% -1.0% 1.4% 3.0% 7.0% 10.0% -1.5% 1.0% 1.7% 17.0% -13.9% 2.1% 40.5% 9.8% -10.0% -2.0% -4.6% -4.9% 5.4% -23.8% 17.5% 5.7%

% TOTAL 0.6% -1.7% 1.6% -0.2% 0.2% -0.9% 0.1% -0.3% -0.1% -0.1% 0.0% 0.0% -0.1% 0.0% 0.0% 0.1% -0.1% 0.0% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.8%

GLOBAL ETF SUMMARY

Global ETF assets by index provider ranked by AUM

Source: Global ETF Research and Implementation Strategy Team, BlackRock, Bloomberg.

Top 5 global ETF providers by average daily turnover As at end of July 2010 Provider

Average Daily Turnover (US$ Mil) Jul-10 % Mkt Share Change (US$ Mil)

Dec-09

% Mkt Share

Change (%)

SSgA

$19,861.8

39.2%

$29,894.3

45.0%

$10,032.5

50.5%

iShares

$14,572.0

28.7%

$17,089.0

25.7%

$2,517.0

17.3%

ProShares

$3,891.8

7.7%

$5,784.0

8.7%

$1,892.24

8.6%

Direxion Shares

$3,446.7

6.8%

$3,941.1

5.9%

$494.5

14.3%

PowerShares

$3,219.9

6.4%

$3,699.9

5.6%

$480.1

14.9%

Others

$5,712.8

11.3%

$5,962.0

9.0%

$249.2

4.4%

Total

$50,705.0

100.0%

$66,370.4

100.0%

$15,665.4

30.9%

5.6%

9.0%

PowerShares

Others

5.9% Direxion Shares

45.0% SSgA

8.7% ProShares

25.7% iShares

Source: Global ETF Research and Implementation Strategy Team, BlackRock, Bloomberg.

Top 20 ETFs worldwide with the largest change in AUM As at end of July 2010 ETF SPDR S&P 500 Vanguard Emerging Markets iShares Barclays Short Treasury Bond Fund Vanguard Total Bond Market ETF iShares EURO STOXX 50 (DE) iShares Barclays TIPS Bond Fund iShares Barclays 1-3 Year Credit Bond Fund iShares Russell 2000 Index Fund Vanguard Short-Term Bond ETF iShares MSCI EAFE Index Fund iShares FTSE/Xinhua China 25 Index Fund iShares MSCI Brazil Index Fund SPDR Barclays Capital High Yield Bond ETF iShares EURO STOXX 50 iShares S&P U.S. Preferred Stock Index Fund ETFlab DAX E Fund SZSE 100 MSCI Emerging Markets Source ETF iShares iBoxx $ High Yield Corporate Bond Fund iShares FTSE/Xinhua A50 China Index ETF

Country listed US US US US Germany US US US US US US US US Germany US Germany China United Kingdom US Hong Kong

Bloomberg Ticker SPY US VWO US SHV US BND US SX5EEX GY TIP US CSJ US IWM US BSV US EFA US FXI US EWZ US JNK US EUN2 GY PFF US ETFDAX GY 159901 CH MXFS LN HYG US 2823 HK

AUM (US$ Mil) Jul 10 $72,000.9 $29,124.4 $4,077.4 $8,344.6 $4,397.1 $20,498.5 $6,844.7 $14,955.1 $5,498.2 $33,585.2 $8,222.1 $9,479.4 $5,061.8 $4,329.4 $4,708.8 $1,002.8 $2,795.0 $1,383.9 $5,953.0 $7,436.7

AUM (US$ Mil) Dec 09 85,676.3 19,398.7 1,752.1 6,268.4 6,425.0 18,551.8 4,908.3 13,115.1 3,696.6 35,339.3 9,975.3 11,190.7 3,444.5 5,932.9 3,122.6 2,568.8 1,321.3 4,569.2 6,115.3

Change (US$ Mil) -13,675.5 9,725.7 2,325.3 2,076.2 -2,027.9 1,946.7 1,936.4 1,840.1 1,801.6 -1,754.2 -1,753.2 -1,711.3 1,617.4 -1,603.6 1,586.2 -1,566.0 1,473.7 1,383.9 1,383.8 1,321.4

Source: Global ETF Research and Implementation Strategy Team, BlackRock, Bloomberg.

FTSE GLOBAL MARKETS â&#x20AC;˘ OCTOBER 2010

105

GLOBAL ETF SUMMARY

Global ETF listings As at end of July 2010 ASSETS UNDER MANAGEMENT (US$ Bn) Location

US Europe Austria Belgium Finland France Germany Greece Hungary Ireland Italy Netherlands Norway Slovenia Spain Sweden Switzerland Turkey United Kingdom Canada Japan Hong Kong China Mexico South Korea Taiwan Australia Singapore South Africa Brazil Malaysia New Zealand India Thailand Saudi Arabia UAE Indonesia Chile Egypt Israel Philippines Sri Lanka ETF Total

CHANGE IN ASSETS

No. Primary Listings

New in 2009

New in 2010

Total Listings

2009

July 2010

US$ Bn

%

866 969 1 1 1 250 371 2 1 14 13 11 6 1 10 16 85 10 176 151 72 37 11 14 57 12 11 20 24 7 4 6 14 3 2 1 1 -

121 215 55 80 1 7 1 7 20 2 42 32 7 11 1 7 17 1 1 2 6 1 1 -

117 150 34 40 2 1 4 35 34 40 4 14 4 1 10 7 11 1 3 1 2 1 2 -

866 3,117 21 1 1 426 1,059 2 1 14 442 106 6 1 44 46 461 10 476 176 75 66 11 274 57 14 32 71 24 7 5 6 14 3 2 1 1 50 -

$705.5 $226.9 $0.1 $0.1 $0.3 $53.5 $96.2 $0.1 $0.0 $0.2 $1.9 $0.2 $0.8 $0.0 $2.4 $2.1 $21.7 $0.2 $47.1 $28.5 $24.6 $20.7 $6.3 $8.1 $3.2 $2.7 $2.4 $2.6 $1.8 $1.7 $0.3 $0.5 $0.2 $0.1 $0.0 -

$741.3 $236.3 $0.0 $0.0 $0.2 $53.5 $93.2 $0.1 $0.0 $0.3 $1.8 $0.3 $0.7 $0.0 $1.4 $2.1 $28.3 $0.1 $54.2 $32.5 $25.8 $23.8 $9.7 $8.5 $4.3 $3.0 $2.9 $2.6 $1.8 $1.6 $0.4 $0.4 $0.3 $0.1 $0.0 $0.0 $0.0 -

$35.8 $9.4 $0.0 $0.0 -$0.1 $0.0 -$3.0 $0.0 $0.0 $0.1 -$0.1 $0.0 -$0.1 $0.0 -$1.0 $0.0 $6.6 $0.0 $7.1 $4.0 $1.2 $3.1 $3.4 $0.3 $1.1 $0.4 $0.5 $0.0 $0.0 -$0.1 $0.0 -$0.1 $0.1 $0.0 $0.0 $0.0 $0.0 -

5.1% 4.2% -37.3% -30.8% -19.5% 0.0% -3.1% -23.9% -10.7% 27.1% -3.7% 7.3% -8.5% -3.7% -42.5% -0.9% 30.4% -20.4% 15.1% 13.9% 4.9% 15.0% 54.5% 4.0% 34.9% 13.0% 21.1% 0.5% 1.6% -6.8% 11.1% -27.9% 27.6% -13.9% 100.0% 100.0% -7.3% -

30 35 1 1 1 9 9 2 1 2 4 4 2 1 2 2 6 4 9 4 6 10 9 2 11 2 4 8 7 2 3 2 6 2 1 1 1 -

2 18 1 1 1 1 2 1 1 1 1 1 1 1 1 1 1 1 1 1 2 1 2 1 1 1 1 1 1 1 1 1 2 1 1 1 1 1 -

808 80*

2,282

423

368

4,872

$1,036.0

$1,095.2

$59.1

5.7%

124

42

970

*Includes 21 undisclosed RBS ETFs, 10 undisclosed HSBC ETFs To avoid double counting, assets shown above refer only to primary listings.

No. of No. of Providers Exchanges

Planned New

10 2 1 13 1 8 5 2 1 12 0 2 0 14 0 0 3 0 0 1 5 1 1

Source: Global ETF Research and Implementation Strategy Team, BlackRock, Bloomberg, Bank of Israel.

Regulatory Information BlackRock Advisors (UK) Limited (‘BlackRock’), which is authorised and regulated by the Financial Services Authority in the United Kingdom, has issued this document for access by professional clients and for information purposes only. This document or any portion hereof may not be reprinted, sold or redistributed without authorisation from BlackRock. This communication is being made available to persons who are investment professionals as that term is defined in Article 19 of the Financial Services and Markets Act 2000 (Financial Promotion Order) 2005 or its equivalent under any other applicable law or regulation in the relevant jurisdiction. It is directed at persons who have professional experience in matters relating to investments. This document is an independent market commentary document based on publicly available information and is produced by the ETF Research & Implementation Strategy team. Specifically, this is not marketing nor is it an offer to buy or sell any security or to participate in any trading strategy. Affiliated companies of BlackRock may make markets in the securities of ETFs and provide ETFs in the form of iShares. Further, BlackRock and/or its affiliated companies and/or their employees may from time to time hold shares or holdings in the underlying shares of, or options on, any security of ETFs and may as principal or agent buy securities in ETFs. This document does not provide investment advice and the information contained within should not be relied upon in assessing whether or not to invest in the products mentioned. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities discussed in this commentary may not be suitable for all investors. BlackRock recommends that investors independently evaluate each issuer, security or instrument discussed in this publication and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives The value of and income from any investment may go up or down and an investor may not get back the amount invested. The value of the investment involving exposure to foreign currencies can be affected by exchange rate movements. We also remind you that the levels and bases of, and reliefs from, taxation can change and is dependent upon individual circumstances. Although BlackRock endeavours to update and ensure the accuracy of the content of this document BlackRock does not warrant or guarantee its accuracy or correctness. Despite the exercise of all due care, some information in this document may have changed since publication. Investors should obtain and read the ETF prospectuses from the ETF Providers and confirm any relevant information with ETF Providers before investing. Neither BlackRock, nor any affiliate, nor any of their respective, officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. The trademarks and service marks contained herein are the property of their respective owners. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. © 2010 BlackRock Advisors (UK) Limited. Registered Company No 00796793. All rights reserved. Calls may be monitored or recorded. 921784

106

OCTOBER 2010 • FTSE GLOBAL MARKETS

(Week ending September 10, 2010) Reference Entity

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

Federative Republic Of Brazil

Government

Sector

Market Type

Sov

13,930,014,123

155,527,872,636

11,755

Americas

DC Region

United Mexican States

Government

Sov

6,966,766,997

114,800,741,910

9,574

Americas

JPMorgan Chase & Co.

Financials

Corp

5,290,478,921

84,957,899,149

9,279

Americas

Bank Of America Corporation

Financials

Corp

5,817,828,161

79,854,254,780

9,114

Americas

Telecom Italia Spa

Telecommunications

Corp

2,654,950,473

68,200,861,063

7,974

Europe

Consumer Goods

Corp

2,875,855,833

60,726,872,442

7,714

Europe

Daimler Ag General Electric Capital Corporation

Financials

Corp

11,482,907,889

94,440,446,390

7,710

Americas

Government

Sov

6,075,711,793

134,514,802,773

7,689

Europe

Telecommunications

Corp

2,976,736,061

63,442,623,017

7,546

Europe

Financials

Corp

4,983,551,271

59,699,917,575

6,917

Americas

Market Type

Republic Of Turkey Deutsche Telekom Ag Wells Fargo & Company

Top 10 net notional amounts (Week ending September 10, 2010) Reference Entity

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

Republic of Italy

Government

Sector

Sov

25,981,085,953

244,330,168,071

6,848

Europe

DC Region

Federal Republic of Germany

Government

Sov

15,256,732,925

78,302,924,845

2,265

Europe

Kingdom of Spain

Government

Sov

14,638,266,474

113,117,066,570

4,973

Europe

Federative Republic of Brazil

Government

Sov

13,930,014,123

155,527,872,636

11,755

Americas

French Republic

Government

Sov

12,029,413,477

65,374,363,286

2,746

Europe

Financials

Corp

11,482,907,889

94,440,446,390

7,710

Americas

General Electric Capital Corporation UK and Northern Ireland

Government

Sov

9,808,276,586

52,745,266,725

3,625

Europe

Republic of Austria

Government

Sov

8,240,092,558

45,161,269,809

1,954

Europe

Portuguese Republic

Government

Sov

7,871,067,812

63,630,032,600

2,944

Europe

Hellenic Republic

Government

Sov

7,037,445,527

78,102,847,841

4,248

Europe

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending September 10, 2010)

(Week ending September 10, 2010)

Single-Name References Entity Type

Corporate: Financials

Gross Notional (USD EQ)

3,320,124,042,845

Contracts

References Entity

449,043

Republic of Italy

2,574,720,999

101

Bank of America Corporation

1,844,735,540

176

Sovereign / State Bodies

2,299,257,615,155

171,232

Corporate: Consumer Services

2,203,466,728,999

378,772

Corporate: Consumer Goods

1,624,768,070,908

270,306

Corporate: Technology / Telecom

1,341,899,355,372

218,832

Corporate: Industrials

Gross Notional (USD EQ)

Contracts

Republic of The Philippines

1,663,871,100

174

Kingdom of Belgium

1,342,286,667

131

United Mexican States

1,339,004,075

139

Wells Fargo & Company

1,313,472,283

147

1,284,889,450,930

231,644

Federal Republic of Germany

1,259,700,000

34

Corporate: Basic Materials

927,979,420,372

159,992

Republic of Korea

1,242,302,971

114

Corporate: Utilities

757,279,707,381

126,457

French Republic

1,233,121,818

47

Corporate: Oil & Gas

473,166,444,637

89,242

Southwest Airlines Co

1,188,366,488

176

Corporate: Health Care

341,597,825,882

63,086

Corporate: Other

201,459,790,229

22,903

Res. Mort. Backed Securities

84,424,112,087

16,945

CDS on Loans

68,827,200,406

17,965

Com. Mor. Backed Securities

23,002,299,940

2,029

Other

2,818,472,528

268

FTSE GLOBAL MARKETS • OCTOBER 2010

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts

All data © 2010 The Depository Trust & Clearing Corporation This data is being provided as is and can only be used by you pursuant to the terms posted on the DTCC website at dtcc.com/products/derivserv/data_table_i.php

107

5-Year Performance Graph (USD Total Return) Index Level Rebased (31 August 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

50

FTSE GWA Developed Index

0

Au g05 De c-0 5 M ar -0 6 Ju n06 Se p06 De c-0 6 M ar -0 7 Ju n07 Se p07 De c-0 7 M ar -0 8 Ju n08 Se p08 De c-0 8 M ar -0 9 Ju n09 Se p09 De c-0 9 M ar -1 0 Ju n10 Au g10

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

2,768

231.29

1.4

-2.0

3.9

-5.1

2.63

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

USD

2,298

537.94

1.0

-2.7

2.9

-5.7

2.66

FTSE Developed Index

USD

1,996

213.22

0.8

-3.1

1.9

-5.8

2.65

FTSE Emerging Index

USD

772

640.17

5.7

6.0

19.6

0.6

2.45

FTSE Advanced Emerging Index

USD

302

583.64

4.4

2.9

17.4

-3.8

2.86

FTSE Secondary Emerging Index

USD

470

765.92

6.9

8.8

21.4

4.8

2.09

USD

7,310

372.82

1.3

-1.6

4.9

-4.4

2.52

FTSE Global Equity Indices FTSE Global All Cap Index FTSE Developed All Cap Index

USD

5,804

346.66

0.6

-2.6

3.0

-5.1

2.53

FTSE Emerging All Cap Index

USD

1,506

853.61

6.2

6.5

20.5

0.9

2.44

FTSE Advanced Emerging All Cap Index

USD

638

790.44

4.8

3.4

18.2

-3.6

2.85

FTSE Secondary Emerging All Cap Index

USD

868

983.68

7.4

9.4

22.4

5.4

2.08

USD

740

192.45

7.5

4.6

5.4

5.1

2.19

FTSE EPRA/NAREIT Developed Index

USD

281

2519.42

6.9

7.5

15.1

4.4

3.93

FTSE EPRA/NAREIT Developed REITs Index

USD

186

874.83

6.5

9.8

21.3

7.9

4.72

FTSE EPRA/NAREIT Developed Dividend+ Index

USD

201

1852.57

7.6

9.2

20.5

7.0

4.51

FTSE EPRA/NAREIT Developed Rental Index

USD

228

991.06

7.0

10.2

21.2

8.3

4.47

FTSE EPRA/NAREIT Developed Non-Rental Index

USD

53

1029.02

6.8

0.4

0.5

-5.2

2.41

FTSE4Good Global Index

USD

662

5713.27

1.2

-4.0

-1.2

-8.2

3.00

FTSE4Good Global 100 Index

USD

103

4755.47

1.1

-5.3

-2.9

-10.4

3.20

FTSE GWA Developed Index

USD

1,996

3298.65

1.1

-3.5

0.0

-6.2

2.92

FTSE RAFI Developed ex US 1000 Index

USD

1,016

5651.00

4.5

-2.2

-5.9

-8.6

3.31

FTSE RAFI Emerging Index

USD

357

6788.28

4.3

5.0

16.7

-0.6

2.73

Fixed Income FTSE Global Government Bond Index Real Estate

SRI

Investment Strategy

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

108

OCTOBER 2010 â&#x20AC;˘ FTSE GLOBAL MARKETS

Americas Market Indices 175 150

FTSE Americas Index

125

FTSE Americas Government Bond Index FTSE EPRA/NAREIT North America Index

100

FTSE EPRA/NAREIT US Dividend+ Index 75

FTSE4Good USIndex 50

FTSE GWA US Index

25

FTSE RAFI US 1000 Index

Au g05 De c-0 5 M ar -0 6 Ju n06 Se p06 De c-0 6 M ar -0 7 Ju n07 Se p07 De c-0 7 M ar -0 8 Ju n08 Se p08 De c-0 8 M ar -0 9 Ju n09 Se p09 De c-0 9 M ar -1 0 Ju n10 Au g10

Index Level Rebased (31 August 2005=100)

5-Year Performance Graph (USD Total Return)

FTSE Renaissance IPO Composite Index

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 Americas Index

USD

779

708.24

-2.7

-3.6

6.0

-4.5

2.20

FTSE North America Index

USD

645

769.32

-3.1

-3.9

5.2

-4.4

2.17

FTSE Latin America Index

USD

134

1156.62

5.5

2.9

23.3

-2.0

2.58

FTSE Global Equity Indices FTSE Americas All Cap Index

USD

2,518

328.22

-2.7

-2.9

7.7

-3.4

2.07

FTSE North America All Cap Index

USD

2,329

311.61

-3.2

-3.3

6.7

-3.6

2.04

FTSE Latin America All Cap Index

USD

189

1644.11

6.1

3.4

24.4

-1.5

2.53

Fixed Income FTSE Americas Government Bond Index

USD

192

201.78

4.7

6.6

8.3

8.7

2.23

FTSE USA Government Bond Index

USD

179

197.60

4.8

6.6

8.2

8.7

2.19

FTSE EPRA/NAREIT North America Index

USD

124

3159.03

3.1

13.8

33.2

14.0

3.96

FTSE EPRA/NAREIT US Dividend+ Index

USD

85

1728.98

3.3

14.7

33.1

14.6

3.96

FTSE EPRA/NAREIT North America Rental Index

USD

120

1077.55

3.3

14.5

34.1

14.9

3.94

FTSE EPRA/NAREIT North America Non-Rental Index

USD

4

294.12

-5.1

-12.1

1.1

-16.0

5.20

Real Estate

FTSE NAREIT Composite Index

USD

133

3050.51

2.6

13.3

30.8

13.4

4.71

FTSE NAREIT Equity REITs Index

USD

111

7437.87

2.6

14.2

32.7

14.0

3.89

FTSE4Good US Index

USD

130

4582.01

-4.7

-5.5

2.3

-7.2

2.07

FTSE4Good US 100 Index

USD

102

4370.34

-4.5

-5.4

2.0

-7.2

2.09

FTSE GWA US Index

USD

589

2880.29

-3.9

-4.9

3.0

-4.7

2.22

FTSE RAFI US 1000 Index

USD

999

5250.90

-4.1

-3.0

3.8

-1.5

2.33

FTSE RAFI US Mid Small 1500 Index

USD

1,458

5054.64

-9.8

-4.3

9.0

-1.6

1.36

USD

145

-4.33

9.0

-1.6

0.0

USD

0.88

SRI

Investment Strategy

IPO Indices FTSE Renaissance IPO Composite Index

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

FTSE GLOBAL MARKETS • OCTOBER 2010

109

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

250

FTSE Europe Index (EUR) FTSE All-Share Index (GBP)

200

FTSEurofirst 80 Index (EUR) 150

FTSE/JSE Top 40 Index (SAR)

100

FTSE Actuaries UK Conventional Gilts All Stocks Index (GBP) FTSE EPRA/NAREIT Developed Europe Index (EUR)

50

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

0

Au g05 De c-0 5 M ar -0 6 Ju n06 Se p06 De c-0 6 M ar -0 7 Ju n07 Se p07 De c-0 7 M ar -0 8 Ju n08 Se p08 De c-0 8 M ar -0 9 Ju n09 Se p09 De c-0 9 M ar -1 0 Ju n10 Au g10

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)

3.44

FTSE All-World Indices FTSE Europe Index

EUR

564

232.69

2.9

4.9

10.2

1.7

FTSE Eurobloc Index

EUR

284

119.33

1.2

0.8

0.6

-5.9

3.78

FTSE Developed Europe ex UK Index

EUR

374

229.20

2.7

3.2

6.1

-0.9

3.50

FTSE Developed Europe Index

EUR

488

228.66

3.0

4.6

9.4

1.3

3.52

3.33

FTSE Global Equity Indices FTSE Europe All Cap Index

EUR

1,519

365.16

3.0

5.3

11.1

2.4

FTSE Eurobloc All Cap Index

EUR

764

354.77

1.3

0.9

1.5

-5.2

3.66

FTSE Developed Europe All Cap ex UK Index

EUR

1,040

383.66

2.7

3.4

7.0

-0.3

3.39

FTSE Developed Europe All Cap Index

EUR

1,376

361.04

3.1

5.1

10.2

2.1

3.40

Region Specific FTSE All-Share Index

GBP

624

3594.33

1.7

0.4

10.6

0.1

3.37

FTSE 100 Index

GBP

102

3389.74

1.6

-0.5

10.1

-1.0

3.51

FTSEurofirst 80 Index

EUR

81

4496.62

1.5

0.5

0.3

-6.9

4.11

FTSEurofirst 100 Index

EUR

100

4212.79

2.2

2.7

6.2

-2.5

3.93

FTSEurofirst 300 Index

EUR

311

1493.92

3.1

4.6

9.3

1.0

3.57

FTSE/JSE Top 40 Index

SAR

42

2762.12

0.3

1.8

9.8

-2.2

2.20

FTSE/JSE All-Share Index

SAR

165

3109.27

0.9

3.2

11.7

0.0

2.37

FTSE Russia IOB Index

USD

15

869.81

2.5

-1.4

15.6

-6.3

1.76

Fixed Income FTSE Eurozone Government Bond Index

EUR

245

180.43

2.8

4.6

7.2

6.3

3.04

FTSE Pfandbrief Index

EUR

405

215.97

2.4

3.2

6.5

4.9

3.20

FTSE Actuaries UK Conventional Gilts All Stocks Index

GBP

38

2517.87

5.7

9.7

8.0

10.1

3.27

Real Estate FTSE EPRA/NAREIT Developed Europe Index

EUR

82

1914.82

9.4

7.4

9.6

4.3

4.59

FTSE EPRA/NAREIT Developed Europe REITs Index

EUR

36

690.75

9.2

6.9

7.9

2.2

5.20

FTSE EPRA/NAREIT Developed Europe ex UK Dividend+ Index

EUR

40

2428.63

13.4

8.6

15.5

8.4

5.16

FTSE EPRA/NAREIT Developed Europe Rental Index

EUR

72

752.43

9.7

7.4

10.2

4.5

4.69

FTSE EPRA/NAREIT Developed Europe Non-Rental Index

EUR

10

510.04

3.3

5.8

-8.0

0.0

2.27

FTSE4Good Europe Index

EUR

276

4533.67

3.6

4.3

8.1

0.5

3.74

FTSE4Good Europe 50 Index

EUR

52

3858.63

3.7

2.7

6.2

-1.5

4.04

FTSE GWA Developed Europe Index

EUR

488

3246.68

3.4

3.6

5.5

-0.6

3.88

FTSE RAFI Europe Index

EUR

506

5041.18

2.3

4.6

1.9

-0.2

3.63

SRI

Investment Strategy

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

110

OCTOBER 2010 â&#x20AC;˘ FTSE GLOBAL MARKETS

Asia Pacific Market Indices 5-Year Total Return Performance Graph FTSE Asia Pacific Index (USD)

350

FTSE/ASEAN Index (USD)

300

FTSE/Xinhua China 25 Index (CNY) 250

FTSE Asia Pacific Government Bond Index (USD)

200 150

FTSE EPRA/NAREIT Developed Asia Index (USD)

100

FTSE IDFC India Infrastructure Index (IRP) FTSE4Good Japan Index (JPY)

50 0

FTSE GWA Japan Index (JPY)

Au g05 De c-0 5 M ar -0 6 Ju n06 Se p06 De c-0 6 M ar -0 7 Ju n07 Se p07 De c-0 7 M ar -0 8 Ju n08 Se p08 De c-0 8 M ar -0 9 Ju n09 Se p09 De c-0 9 M ar -1 0 Ju n10 Au g10

Index Level Rebased (31 August 2005=100)

400

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

1,296

275.20

4.0

1.2

6.6

-0.7

2.53

FTSE Asia Pacific ex Japan Index

USD

842

558.98

7.1

4.7

15.8

-0.3

2.72

FTSE Japan Index

USD

454

67.94

-8.7

-9.7

-15.3

-11.1

2.21

FTSE Global Equity Indices FTSE Asia Pacific All Cap Index

USD

3,095

467.83

4.1

1.5

6.9

-0.5

2.52

FTSE Asia Pacific All Cap ex Japan Index

USD

1,870

692.84

7.3

4.9

16.3

-0.3

2.70

FTSE Japan All Cap Index

USD

1,225

215.64

-8.7

-9.3

-15.3

-10.7

2.20

Region Specific FTSE/ASEAN Index

USD

145

658.62

13.5

19.2

34.7

17.2

2.80

FTSE Bursa Malaysia 100 Index

MYR

100

10587.36

10.9

13.1

23.5

13.6

2.41

TSEC Taiwan 50 Index

TWD

50

6925.12

6.3

3.7

11.9

-5.2

3.92

FTSE Xinhua All-Share Index

CNY

1,136

8329.29

8.1

-6.7

13.7

-11.3

0.97

FTSE/Xinhua China 25 Index

CNY

25

22626.44

0.5

1.5

3.1

-6.3

2.50

USD

228

156.55

10.3

8.1

13.8

13.0

0.99

FTSE EPRA/NAREIT Developed Asia Index

USD

74

2068.50

9.0

4.2

6.8

0.2

3.65

FTSE EPRA/NAREIT Developed Asia 33 Index

USD

33

1346.50

9.2

4.2

8.2

0.4

3.83

FTSE EPRA/NAREIT Developed Asia Dividend+ Index

USD

43

2222.07

10.7

5.7

15.0

3.1

4.88

Fixed Income FTSE Asia Pacific Government Bond Index Real Estate

FTSE EPRA/NAREIT Developed Asia Rental Index

USD

35

999.41

11.9

9.7

17.6

8.9

5.84

FTSE EPRA/NAREIT Developed Asia Non-Rental Index

USD

39

1130.74

7.3

1.0

1.0

-4.6

2.31

FTSE IDFC India Infrastructure Index

IRP

89

949.27

4.1

4.2

0.9

-2.6

0.72

FTSE IDFC India Infrastructure 30 Index

IRP

30

1058.02

3.7

3.5

-0.4

-3.3

0.69

JPY

184

3213.12

-9.3

-10.8

-17.5

-12.4

2.40

FTSE SGX Shariah 100 Index

USD

100

5045.61

2.0

-1.3

2.3

-5.1

2.35

FTSE Bursa Malaysia Hijrah Shariah Index

MYR

30

11391.08

9.5

8.5

14.4

7.5

2.76

JPY

100

913.44

-9.4

-10.7

-14.8

-14.8

2.16

Infrastructure

SRI FTSE4Good Japan Index Shariah

FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index

JPY

454

2462.32

-8.1

-8.7

-13.9

-8.7

2.33

FTSE GWA Australia Index

AUD

101

3854.80

-0.1

-4.4

1.5

-7.3

4.50

FTSE RAFI Australia Index

AUD

56

6116.53

0.3

-5.4

0.7

-9.0

4.48

FTSE RAFI Singapore Index

SGD

18

8670.42

5.5

5.6

17.3

1.9

3.26

FTSE RAFI Japan Index

JPY

252

3431.34

-8.8

-8.7

-14.5

-9.8

2.22

FTSE RAFI Kaigai 1000 Index

JPY

1,023

3570.42

-6.8

-8.1

-11.7

-15.6

3.05

HKD

49

6712.22

2.5

2.3

4.9

-5.5

2.99

FTSE RAFI China 50 Index IPO Indices FTSE Renaissance Asia Pacific ex Japan IPO Index

USD

99

1720.06

6.5

4.6

11.9

2.3

0.94

FTSE Renaissance Hong Kong/China Top IPO Index

HKD

31

2384.88

4.2

0.1

2.1

-3.8

0.75

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

FTSE GLOBAL MARKETS â&#x20AC;˘ OCTOBER 2010

111

INDEX CALENDAR

Index Reviews October-December 2010 Date

Index Series

Review Frequency/Type

Effective Data Cut-off (Close of business)

05-Oct 07-Oct 07-Oct Late Oct 05-Nov 12-Nov 16-Nov Mid Nov Early Dec Early Dec Early Dec Early Dec Early Dec 02-Dec

FTSE Xinhua Index Series TOPIX TSEC Taiwan 50 FTSE / ATHEX 20 TOPIX Hang Seng MSCI Standard Index Series Russell/Nomura Indices CAC 40 ATX OBX S&P / TSX RTSI FTSE Global Equity Index Series (incl. FTSE All-World) DAX S&P / ASX Indices NZX 50 TOPIX FTSE MIB FTSE/JSE Africa Index Series FTSE UK Index Series FTSE techMARK 100 FTSE Euromid FTSEurofirst 300 FTSE Italia Index Series FTSE EPRA/NAREIT Global Real Estate Index Series FTSE Bursa Malaysia Index Series OMX I15 DJ STOXX S&P BRIC 40 S&P US Indices S&P Europe 350 / S&P Euro S&P Topix 150 S&P Asia 50 S&P Latin 40 S&P Global 1200 S&P Global 100 VINX 30 OMX C20 OMX S30 OMX N40 Baltic 10 BNY Mellon DR Indices Russell US Russell Global Indices IBEX 35

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

15-Oct 29-Nov 18-Oct 30-Nov 30-Dec 03-Dec 30-Nov 30-Nov 17-Dec 31-Dec 17-Dec 17-Dec 14-Dec

17-Sep 29-Oct 30-Sep 30-Sep 30-Nov 30-Sep 30-Oct 31-Oct 15-Dec 30-Nov 30-Nov 30-Nov 30-Nov

Annual review / North America Quarterly review Quarterly review Quarterly review Annual review (constituents) Quarterly review - shares & IWF Quarterly review Annual review Quarterly review Quarterly review Quarterly review Quarterly review

17-Dec 17-Dec 17-Dec 17-Dec 28-Jan 17-Dec 17-Dec 17-Dec 17-Dec 17-Dec 17-Dec 17-Dec

30-Sep 30-Nov 03-Dec 30-Nov 31-Dec 30-Dec 30-Nov 07-Dec 30-Nov 30-Nov 30-Nov 30-Nov

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

17-Dec 17-Dec 03-Jan 17-Dec 18-Dec 18-Dec 18-Dec 17-Dec 18-Dec 18-Dec 18-Dec 18-Dec 17-Dec 20-Dec 31-Dec 17-Dec 31-Dec 20-Dec 24-Dec 24-Dec 31-Dec

30-Nov 30-Nov 31-Dec 23-Nov 20-Nov 04-Dec 04-Dec 03-Dec 04-Dec 04-Dec 04-Dec 04-Dec 30-Nov 30-Nov 30-Nov 30-Nov 30-Nov 30-Nov 30-Nov 30-Nov 30-Nov

03-Dec 03-Dec 04-Dec 07-Dec 08-Dec 08-Dec 08-Dec 08-Dec 08-Dec 08-Dec 08-Dec 09-Dec 10-Dec 10-Dec 10-Dec 12-Dec 12-Dec 12-Dec 13-Dec 12-Dec 12-Dec 12-Dec 12-Dec Mid Dec Mid Dec Mid Dec Mid Dec Mid Dec 15-Dec 17-Dec 17-Dec Late Dec

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

112

OCTOBER 2010 • FTSE GLOBAL MARKETS

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*Source: AutEx 2008. In the U.S., securities underwriting, trading and brokerage activities and M&A advisor activities are provided by UBS Securities LLC, a registered broker-dealer that is a wholly owned subsidiary of UBS AG, a member of The New York Stock Exchange and other principal exchanges, and a member of SIPC. © UBS 2010. All rights reserved.