FTSE Global Markets by FTSE Global Markets

OTC DERIVATIVES TO FALL IN LINE UNDER BARNIER’S GAZE ISSUE 46 • NOVEMBER 2010

The tussle for control of Chinese custody Anonymous trading: Hi-tech hide and seek The new future of structured finance Latam pension funds diversify investments

UK DEBT: Paradise regained? SECURITIES LENDING ROUNDTABLE: THE RISK FACTOR

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); Joe Morgan (Berlin); John Rumsey (Latin America); Ian Williams (US/Emerging Markets/Sector Analysis). PRODUCTION MANAGER: Maria Angel Gonzalez, tel: +44 [0]20 7680 5161 email: mariangel.gonzalez@berlinguer.com SUB EDITOR: Roy Shipston, tel: +44 [0]20 7680 5154 email: roy.shipston@berlinguer.com FTSE EDITORIAL BOARD: Mark Makepeace (CEO); Donald Keith; Imogen Dillon-Hatcher; Chris Woods; Paul Hoff; Jerry Moskowitz; Andy Harvell. PUBLISHING & SALES DIRECTOR: Paul Spendiff, tel +44 [0]20 7680 5153 email: paul.spendiff@berlinguer.com AMERICAS, AFRICA & RUSSIA SALES MANAGER: James Ikonen, tel +44 [0]20 7680 5158 email: james.Ikonen@berlinguer.com EUROPEAN SALES MANAGER: Nicole Taylor, tel +44 [0]20 7680 5156 email: nicole.taylor@berlinguer.com OVERSEAS REPRESENTATION: Can Sonmez (Turkey) PUBLISHED BY: Berlinguer Ltd, 1st Floor, Rennie House, 57-60 Aldgate High Street, London EC3N 1AL Tel: +44 [0]20 7680 5151 www.berlinguer.com ART DIRECTION AND PRODUCTION: Russell Smith, IntuitiveDesign, 13 North St., Tolleshunt D’Arcy, Maldon, Essex CM9 8TF, email: russell@intuitive-design.co.uk PRINTED BY: Headley Brothers Ltd, The Invicta Press, Queens Road, Ashford, Kent TN24 8HH DISTRIBUTION: DHL Global Mail, 15, The Avenue, Egham, TW 20 9AB TO SECURE YOUR OWN SUBSCRIPTION: Please visit: www.berlinguer.com Subscription price: £497 each year (10 issues) FTSE Global Markets is now published ten times a year. No part of this publication may be reproduced or used in any form of advertising without the express permission of Berlinguer Ltd. [Copyright © Berlinguer Ltd 2010. All rights reserved.] FTSE™ is a trademark of the London Stock Exchange plc and the Financial Times Limited and is used by Berlinguer Ltd under licence. FTSE International Limited would like to stress that the contents, opinions and sentiments expressed in the articles and features contained in FTSE Global Markets do not represent FTSE International Limited’s ideas and opinions. The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors. All information in this magazine is provided for information purposes only. Every effort is made to ensure that any and all information given in this publication is accurate, but not responsibility or liability can be accepted by FTSE International Limited and Berlinguer Ltd, for any errors, or omissions or for any loss arising from the use of this publication. All copyright and database rights in the FTSE Indices belong to FTSE International Limited or Berlinguer Ltd or its licensors. Reproduction of the data comprising the FTSE indices is not permitted. You agree to comply with any restrictions or conditions imposed upon the use, access, or storage of the data as may be notified to you by FTSE International Limited, or Berlinguer Ltd and you may be required to enter into a separate agreement with FTSE International Limited and Berlinguer Ltd.

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FTSE GLOBAL MARKETS • NOVEMBER 2010

EFLECTING THE MUTED colours adorning the season’s trees, this issue is multi-hued and packed with a broad range of topics that don’t necessarily gel together under a single theme. Sometimes it goes that way, as various seasonal cross winds blow through the markets. Looking at some of the highlights and low lights in the edition, you might want to check out the following if you are looking for trends that will run through at least the first quarter of 2011. The first is the eurobond market. While the summer months were pretty moribund for equities, the eurobond markets have been quietly powering along, as investors have opted into higher yielding emerging markets issues, rather than high risk G7 assets. Governments and companies have issued well over $150bn of dollar-denominated bonds this year, as unprecedented volumes of capital continue to flow into emergingmarket funds. According to figures from EPFR Global, the international market data firm based in Cambridge, Massachusetts, net investment in emerging-market bond funds over the first nine months of 2010 totalled $39.5bn against $1.6bn for the comparable period of 2009. The inflow has been much greater than this, however, as the figure does not include investments by credit and cross-over funds. While the balance sheets of emerging market sovereigns and companies have been in good shape through 2010, spreads have now reached very low levels, which a number of commentators are reading as a warning sign. Andrew Cavenagh reports on the key trends and issues to watch over the remainder of this year. Perhaps it’s a backlash to recession fever but even Latin American pension funds are looking at alternative investment strategies to secure higher rates of returns for their investment portfolios and are fast ditching their traditional dependence on their local Treasury bond market. It is not a difficult about turn, given that those one time high-risk/high-yield local government bonds no longer provide the level of returns of yesteryear. Economic stability has brought down interest rates throughout the subcontinent, and improved fiscal management has resulted in the upgrading of Latin American sovereign risk (with a few notable exceptions). Pension funds now have to find new ways to replicate or even improve the performance of previous years. Rodrigo Amaral looks at some of the salient strategies. G7 sovereign debt will run and run as an underlying risk factor for at least a decade, particularly if the current rate of debt amortisation lasts through the next half decade. In Europe, Japan and the US, at least, it looks like things will get a lot worse before the level of debt begins to subside to truly inconsequential levels. The old chestnut used to go: If the US catches a chill, then the rest of the world catches influenza. What happens when, as now, most of the G7 is in need of intensive care? Actually it looks like very little. The markets appear to have factored in both the extension of the financial crisis and the extensive debt pile in most developed countries, almost like an overdue library ticket. How long we can actually live on borrowed time is another matter. Over coming editions we will be looking increasingly at market risk. Part of this analysis will involve a 36,000 foot view of the national debt of individual G20 countries, for good or bad. We kick of this mini-series with a cover story on UK debt. Actually, while in real terms, on an annualised basis, the UK’s debt is actually serviceable, there are two huge problems the country is facing. One is that over the next five years it is actually planning, according to the June pre-budget forecast, to borrow at least another £500bn. Second, over the next ten years, UK debt payments will take up at least 11% of the government spending pot. In other words, there are no quick fixes for the UK’s debt problems: like all the best and worst soap operas, it will simply run and run.

Francesca Carnevale, Editor November 2010

Cover photo: British Chancellor of the Exchequer George Osborne waits before the start of the EU Finance Minister’s Meeting in Brussels on 13 July, 2010. Photograph by Matthew Busch for AP, supplied by Press Association Images, October 2010.

CONTENTS COVER STORY

UK DEBT: AT HEAVEN’S GATE? ..............................................................................................Page 53 Saddled with over £862bn of accumulated sovereign debt (not counting the money laid out to save the UK banking segment), the United Kingdom faces at least a decade of massive debt obligations before the going gets easier. Will the country’s coalition government have the wherewithal and the guts to see through a radical agenda of spending cuts? Francesca Carnevale reports. DEPARTMENTS

MARKET LEADER

OTC DERIVATIVES: UNDER THE SHADOW OF REGULATION................................Page 6

SPOTLIGHT

FEAR OF FRAUD & OTHER STORIES ..................................................................................Page 12

Joe Morgan looks at the impact of Michel Barnier’s efforts to tame the derivatives Wild West.

A round-up of quirky market news and reviews.

EUROPE’S INNOVATIVE ETFS ................................................................................................Page 16 Neil O’Hara reviews the rapid diversification of exchange traded funds.

LATAM PENSION FUNDS DIVERSIFY THEIR INVESTMENTS ..................................Page 20

IN THE MARKETS

Rodrigo Amaral explains why Latam funds don’t depend on T-bills any more.

A GEM OF AN OPPORTUNITY ..............................................................................................Page 24 Surveys say investors favour GEMs, we spoke to one to find out if it is true.

THE GUERNSEY CONNECTION ............................................................................................Page 26 Why Indian firms use the offshore jurisdiction as a stepping stone to listing abroad.

KING COAL THREATENS TO CLEAN UP ITS ACT ........................................................Page 29

COMMODITIES

Ian Williams surveys the return of coal as an energy source.

ROCK, PAPER, SCISSORS ..........................................................................................................Page 32 Vanja Dragomanovich on the opportunities opening up in the iron ore paper market.

EXCHANGE REPORT

A Q&A WITH THE RTS STOCK EXCHANGE ..................................................................Page 34

INDEX REVIEW

THE NEW DEAL? ..........................................................................................................................Page 38

The future is FORTS, says RTS, find out why.

Simon Denham, managing director of Capital Spreads on the likelihood of fiscal probity in the UK.

STRUCTURED FINANCE’S SLOW WALK TO FREEDOM ..........................................Page 39 Andrew Cavenagh reports on the return of the securitised debt market.

DEBT REPORT

THE FAST AND THE FURIOUS ..............................................................................................Page 42 The rising popularity of emerging market eurobonds.

MEXICO’S ULTRA LONG BOND

..........................................................................................Page 45

Rodrigo Amaral explains Mexico’s emerging fiscal strategy.

BRAZIL’S BANKS IN THE SPOTLIGHT ................................................................................Page 46

COUNTRY REPORT

John Rumsey reports on the impact of rising competition for high touch business.

OPTING FOR THE RIGHT PLATFORM

..............................................................................Page 49

High frequency trading threatens to change Brazil’s equity markets for time to come.

FX VIEWPOINT DATA PAGES

CURRENCY WARS ........................................................................................................................Page 52 Erik Lehtis, president of Dynamic FX Consulting, on the renminbi and its effects on the US economy.

DTCC Credit Default Swaps analysis ..............................................................................................Page 87 Fidessa Fragmentation Index ........................................................................................................................Page 88 BlackRock ETFs ....................................................................................................................................Page 90 Market Reports by FTSE Research................................................................................................................Page 92 Index Calendar ....................................................................................................................................................Page 96

NOVEMBER 2010 • FTSE GLOBAL MARKETS

CONTENTS FEATURES SECURITIES SERVICES:

PROBLEMS & PROSPECTS: CHINA’S CUSTODY BANKS FACE THE FOREIGN CHALLENGE ......................................................Page 57 With their vast client relationships, branch networks and distribution capabilities, China’s local custody banks play a key role in servicing the domestic investor community. Meanwhile, international custody providers have begun to make inroads, lured by a friendlier regulatory environment and the tremendous potential of China’s vast investment population. Yet can these players seriously compete against the powerful Chinese banks that control the lion’s share of local assets under custody? Dave Simons reports.

GERMANY’S DEPOTBANKS: BATTLE REGULATION & GLOBAL PLAYERS ....................................................Page 60 Many banks in the custody sector are struggling to compete in an increasingly regulated market place inhabited by major global players. There is widespread expectation among market participants that the number of domestic custodians will be whittled down by acquisition as more global financial institutions enter the market. As the global financial system continues to feel the tremors of the financial crisis, it is far from business as usual for banking custodians in Germany. Joe Morgan reports.

ROUNDTABLE:

THE RISK FACTOR: NEW PARADIGMS IN EUROPEAN SECURITIES LENDING ............................Page 63 According to Matt Boyd, director of securities lending at BlackRock: “One of the most salient characteristics of the market today is the lack of demand to borrow securities. Looking at some statistics from Data Explorers comparing the present to mid-2007, global equity balances are down roughly 33% and European equities are down 40%. Find out why and how the market is fighting back.

TRADING REPORT:

WHY SMART SOR IS HERE TO STAY..................................................................Page 72 As soon as MiFID allowed stocks to be traded on different venues (leading to market fragmentation) the door was open for the development of smart order routers (SORs) in Europe as brokers sought liquidity. Globally however, last year, an estimated $772m was spent by clients for access to smart order routers and Aite Group for one, believes this figure could top $1bn this year, 95% of it spent with sell side brokers. Ruth Hughes Liley reports on the implications.

ANONYMITY: HI TECH HIDE & SEEK ................................................................Page 78 Algorithms have given buy side traders the ability to control their orders as never before, but they must understand where each algorithm will route orders to make sure they do not reveal too much to the market. While traders can exclude venues deemed undesirable in the first instance, it is harder to police whatever links exist between a particular venue and others. Neil O’Hara explains why buy side traders are sceptical, cynical and have to be detectives.

REVAMPED AND RECOMMITTED ......................................................................Page 81 The post-MiFID influx of newer and increasingly efficient multilateral trading facilities (MTFs), along with the recent arrival of major cash-market central counterparties (CCP), has clearly altered the balance of power in the Nordic trading arena. Yet against this backdrop, some see the incumbent Nordic exchanges not only keeping pace but perhaps shifting the momentum back in their favour, using more durable technologies while emphasising natural advantages in local research and relationship-based client service. Dave Simons reports.

CRUDE STRENGTH: UAE LEADS A COMMODITIES CHARGE ..................Page 84 The United Arab Emirates is learning to play to its strengths: oil and gold. The Dubai Gold and Commodities Exchange now offers contracts in gold, silver, steel, WTI Light Sweet, Brent Crude Oil, fuel oil and currency pairs. Meanwhile, the Dubai Mercantile Exchange which offers the flagship DME Oman crude oil contract, most recently launched the World Gold Council’s Shari’a-compliant gold shares on NASDAQ Dubai, in conjunction with the Dubai Multi Commodity Centre.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

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MARKET LEADER

OTC DERIVATIVES: THE SHADOW OF EUROPEAN REGULATION

Michel Barnier, commissioner for internal market and services, said that no financial market “can afford to remain a Wild West territory” when he announced the European Commission’s (EC’s) proposals for the equity derivatives market. The regulatory proposals include plans for information on OTC derivatives contracts to be reported to trade repositories and be accessible to supervisory authorities, with the aim of improving transparency and efficiency by collecting trade data on both standardised and non-standardised contracts. Joe Morgan reports. European Union Commissioner for Internal Market and Services Michel Barnier gestures while talking to the media during a press conference at the EU Commission headquarter in Brussels. The European Commission proposed that the European Union establishes an EU network of bank resolution funds, to ensure that any future bank failures are not at the cost of the taxpayer or destabilising to the financial system. Photograph by Thierry Charlier for the Associated Press (AP Photo), supplied by Press Association Images, October 2010.

EC AIMS TO CLEAN-UP ‘WILD WEST’ DERIVATIVES N UNPRECEDENTED DARK shadow of impending regulatory change has fallen on the overthe-counter (OTC) equity derivatives market. While uncertainty remains over what the new trading landscape will look like, sell side dealers are under no illusion that the structure of the market will be very different in a few years time. Michel Barnier, commissioner for internal market and services, announced the European Commission’s (EC’s) plans

for the regulation of the over-thecounter (OTC) derivatives market in September. Barnier highlighted the “absence of any regulatory framework” for OTC derivatives as a cause of the financial crisis. “No financial market can afford to remain a Wild West territory… We are proposing rules which will bring more transparency and responsibility to derivatives markets, so we know who is doing what, and who owes what to

whom. As well as taking action so that single failures do not destabilise the whole financial system, as was the case with Lehman’s collapse,” states Barnier. The proposals include plans for information on OTC derivatives contracts to be reported to trade repositories and be accessible to supervisory authorities, with the aim of improving transparency and efficiency by collecting trade data on both standardised and nonstandardised contracts.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

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MARKET LEADER

OTC DERIVATIVES: THE SHADOW OF EUROPEAN REGULATION

The commission also proposes that standard OTC derivative contracts be cleared through central clearing counterparties (CCPs), with the aim of reducing counterparty credit risk. Once adopted, the regulations would apply from the end of 2012. Marcus Zickwolff, head of system design, Eurex, and a member of the European Association of Central Counterparty Clearing Houses (EACH) executive board, says: “The CCP model has one risk model in place which is equal for all positions. In bilateral trades, this can vary because of business reasons and it is not transparent.” Zickwolff says the capacity of a CCP to provide netting of trades—which does not happen on a bilateral basis— has created an additional incentive for dealers to use CCPs. “In the past, at least one-third of the overall OTC derivatives market has not really been collateralised—there is no protection against risk, like driving a car with no insurance. Sufficient collateralisation is important in the future,” he says.

Bob McDowall, research director, Europe, at Tower Group in London, argues that there have not been any significant changes in the market behaviour of major sell side firms such as Citi, Goldman Sachs and JP Morgan as a result of the impending regulations from Brussels.

Impact of change Bob McDowall, research director, Europe, at Tower Group in London, argues that there have not been any significant changes in the market behaviour of major sell side firms such as Citi, Goldman Sachs and JP Morgan as a result of the impending regulations from Brussels. “There is less proprietary trading. The capital costs and the risk profile are less acceptable than they were before. However, these sorts of changes are not happening as a result of anticipation of future regulations. Basically, financial institutions lobby against regulations to get them amended and watered down right up to the last minute,” says McDowall. Bob Giffords, a UK-based banking and technology analyst, also does not believe that the EC’s impending regulations have had a significant impact on equity derivatives trading volumes, thus far. He points to the Undertakings for Collective Investment in Transferable Securities (UCITS) regulations as “really

Marcus Zickwolff, head of system design, Eurex, and a member of the European Association of Central Counterparty Clearing Houses (EACH) executive board. Photograph kindly supplied by Eurex, October 2010.

driving the use of equity derivatives” as an “alpha enhancement or hedging overlay” for institutional investors pursuing a variety of strategies using equity derivatives. “Volumes in OTC derivatives have been dropping since the Lehman crash, but that is not due to the regulators. Exchange-traded futures and options flow was also down, especially in the US. Market leader Société Générale has complained of volatility spikes, high correlation and declining markets last year as the reasons for its fall in income,” says Giffords.

However, regulatory pressure to standardise OTC trades and increase levels of transparency in the market has already resulted in equity derivatives trading moving on to emerging electronic platforms. David Sagnier, chief executive officer of RFQ-hub, a multi-dealer bilateral request-for-quote and electronic trading platform for listed and OTC equity derivatives, says that over the past year major sell side dealers have had to reassess an assumption that the Markets in Financial Instruments Directive (MiFID) would apply exclusively to cash equities, resulting in a recognition that the trading of OTC products needs to be standardised. “There was the view that we do not need an electronic trading platform because MiFID does not include derivatives. Then it became very clear that MiFID will include derivatives,” says Sagnier. “Now the banks have already to a large extent positioned themselves for the back end of the CCP with MarketSERV [a service provider for OTC credit derivatives transactions which large major sell side firms have a stake in].” Tradeweb, a provider of electronic marketplaces owned by Thomson Reuters and ten leading global dealers, in September announced the launch of a new equity derivatives platform. Tradeweb’s offering facilitates trades of large blocks of single-name and index options for institutional customers by allowing them to compare quotes from brokers online. The marketplace has already secured the participation of 12 broker-dealers including Goldman Sachs, RBS and Société Générale, who together represent a majority of the market for over-thecounter and exchange-traded trades of large blocks of equity options. The platform

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MARKET LEADER

OTC DERIVATIVES: THE SHADOW OF EUROPEAN REGULATION

The marketplace has already secured the participation of 12 broker-dealers including Goldman Sachs, RBS and Société Générale, who together represent a majority of the market for over-the-counter and exchange-traded trades of large blocks of equity options.

Nick Carew Hunt, market secretary at NYSE Liffe. “It may look like healthy business as usual [at NYSE Liffe], but the dynamics have changed,” says Hunt. Photograph kindly supplied by NYS Liffe, October 2010.

electronically confirms trades via MarketSERV, which has interoperability functionality, connecting to the different clearing services of major exchanges. The EC’s draft regulation on OTC derivatives, central counterparties and trade repositories (EMIR), which is expected to come into force from the end of 2012, will also impose obligations on CCPs to provide interoperability between each other. Interoperability agreements have already sprouted up in the cash equities market. For example, LCH.Clearnet, the London-based independent clearing house, and SIX x-clear, the Zurich-based CCP, have an interoperability agreement serving the London Stock Exchange and SIX Swiss Exchange. The bank-owned MarketSERV matching engine has interoperability functionality, linking together CCPs such as LCH.Clearnet and Eurex

Clearing. Sagnier of RFQ-hub has voiced concerns about sell side firms’ increasing involvement in the clearing process of trades, along with any future steps taken for interoperability to take place between CCPs on OTC trades. “If you have ten CCPs it is not going to work. You really need a CCP to be centralised. The CCP model does not achieve the level of protection it was supposed to achieve otherwise. There is systemic risk if you have too many CCPs [interoperating with each other] which will be counterproductive,” says Sagnier. The EC has recognised that the complexity of OTC products—and the additional risks which they bring— makes it inappropriate to widen the provision of interoperability between CCPs to include the financial instruments until a robust model has been developed which ensures that there is not an increase in counterparty credit risk. The new European Securities and Markets Authority (ESMA), will report to the EC by September 2014 on whether interoperability should be extended beyond cash equities to include OTC products. In the meantime, Nick Carew Hunt, market secretary at NYSE Liffe, says the pan-European derivatives exchange has already witnessed an increase in OTC equity trading volumes moving on to Bclear, NYSE Liffe’s own cleared service for OTC equity and commodity derivatives, which has been driven partly by the regulatory push for increased transparency in the market. This year, Bclear registered volumes of 284,009,039 from the start of January to the end of September, a 39% increase on the same period last year, according to statistics provided by the exchange. “It may look like healthy business as usual [at NYSE Liffe], but the dynamics have changed.

Plus they will change further when the regulations are in force because then there will potentially be clearing mandates created though the regulatory process where you will have more business directed towards CCP clearing,” says Carew Hunt. Guillaume Heraud, head of clearing services for institutional clients, at Société Générale Securities Services (SGSS) in Paris, says the buy side clearing for OTC derivatives could now be provided by some CCPs but there are limited volumes for this in Europe at the moment. “There is no clear interest for buy side counterparties to go for these contracts right now. What would trigger this movement would be to have the pressure from the regulators,” says Heraud.

Legal framework “In the US, pressure for this is increasing. The legal framework is close to being enforced and this will put the pressure on banks to clear their operations. It is expected to be the case in the middle of 2011. However, I would say the US would be ready first. Europe does not yet have the regulatory framework to go for this sort of clearing of these instruments in the coming months. So it will take more time here for sure and we will probably have to wait until 2012.” As OTC markets move inexorably towards increased levels of standardisation for equity derivatives trading, CCPs and electronic trading platforms will inevitably have more involvement in the trading and clearing process. While a dramatic shift in trading patterns remains latent, the major sell side firms will aim to ensure that their influence in the market does not recede in the landscape that emerges after the new regulations come into force.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

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SPOTLIGHT

Fear of fraud holds back firms from expanding overseas Kroll report shows a 20% increase in money lost to fraud over the year The latest edition of the Kroll Annual Global Fraud Report, says 48% of over 800 companies surveyed say that fraud has dissuaded them from pursuing business opportunities in at least one foreign country. Moreover, the markets expected to exhibit the highest levels of growth over the next five years are those where fraud is causing companies to avoid investment. This year’s study shows the amount lost by businesses to fraud rose from $1.4m to $1.7m per billion dollars of sales in the past 12 months; a 20% increase. Average compound annual real GDP growth rates in the G7 over the next five years are expected to be below 2%. In comparison, the figure for the BRIC economies over the same period is predicted to exceed 7%. Companies that choose to stay out of emerging markets because of fraud means they are sacrificing growth prospects that are more difficult to realise in developed countries, holds the report, and may be unable to establish a position in countries which

Taiwan index renamed TSEC Taiwan Index Series changed to FTSE TWSE Taiwan Index Series FTSE Group, the global index provider, says that the Taiwan Stock Exchange Corporation’s (TWSE’s) leading domestic TSEC Taiwan Index Series will be renamed FTSE TWSE Taiwan Index Series from January 3rd next year. Created by FTSE and TWSE in 2002, the TSEC Taiwan Index Series has become a recognised domestic tradable index series for the Taiwan market. The

2009. In contrast, reported incidences of theft of physical assets or stock declined slightly from 28% in 2009 to 27.2% in 2010. Additionally, it seems that companies are unprepared for regulation. Increased regulation through the Foreign Corrupt Practices Act (FCPA) and the introduction of the UK’s new Bribery Act has created new challenges for companies. According to the survey, nearly twothirds, 63%, of businesses with operations in the US or UK believe the laws do not apply to them or are unsure. As a result, many are unprepared to deal with the regulatory risks: less than one half, 47%, are confident that they have the controls in place to prevent bribery at all levels of the operation, compared with 42% who say they have assessed the risks and put in place the necessary monitoring and reporting procedures. Fraud continues to be an “inside job” for those companies which have been affected by fraud over the past year, junior employees and senior management were the most likely perpetrators at 22% each, followed by agents or intermediaries at 11%.

will be leading the markets in the future. Fraud has deterred 11% of those surveyed from doing business in China and Africa and 10% in Latin America. Respondents claimed they managed risk in these countries simply by avoiding the regions, even though they may offer attractive investment opportunities. This is not just a problem for the developing world; 7% of those surveyed say that fraud has dissuaded them from operating in North America. However, developing countries appear to have more issues. Globally, the leading worry is corruption, which has dissuaded 17% of all business and 37% of those businesses have in fact been deterred from pursuing investment opportunities. Corruption was named by 63% of respondents as the main reason for not doing business in Africa and 59% for avoiding central Asia. The survey also found that theft of information at global companies surpassed all other forms of fraud for the first time, mostly involving theft of information and electronic data. Theft of information or assets was reported by 27.3% of companies over the past 12 months, up from 18% in

The existing indices under the TSEC Taiwan Index Series will be renamed to the following: Current Index Description

New Index Description

TSEC Taiwan 50 Index

FTSE TWSE Taiwan 50 Index

TSEC Taiwan Mid-Cap 100 Index

FTSE TWSE Taiwan Mid-Cap 100 Index

TSEC Taiwan Eight Industries Index

FTSE TWSE Taiwan Eight Industries Index

TSEC Taiwan Technology Index

FTSE TWSE Taiwan Technology Index

TSEC Taiwan Dividend+ Index

FTSE TWSE Taiwan Dividend+ Index

TSEC Taiwan Shari’a Index

FTSE TWSE Taiwan Shari’a Index

TSEC RAFI Taiwan 50 Index

FTSE TWSE RAFI Taiwan 50 Index

TSEC RAFI Taiwan 100 Index

FTSE TWSE RAFI Taiwan 100 Index

Source: FTSE TWSE Taiwan Index Series, supplied October 2010.

Index Series is also the basis of exchange-traded funds (ETFs) and derivative products, including the Polaris Taiwan Top 50 Tracker Fund, one of the top ten ETFs by assets in

Asia ex Japan, according to BlackRock. Rebranding the Index Series will, it is hoped, increase the global visibility of the Taiwanese markets.

NOVEMBER 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

dŽ ŐĞƚ Ă ďĞƩ Ğƌ ŚĂŶĚůĞ ŽŶ ƌŝƐŬ͕ ĐŽŶƚĂĐƚ͗ ǁǁǁ͘ĞŵĂƉƉůŝĐĂƟ ŽŶƐ͘ĐŽŵ +44 20 7125 0492 ƐĂůĞƐΛĞŵĂƉƉůŝĐĂƟ ŽŶƐ͘ĐŽŵ

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

SPOTLIGHT

CA validations for equity derivatives DTCC includes listed equity derivatives in its corporate actions validation service The Depository Trust & Clearing Corporation (DTCC) has expanded its Global Corporate Actions Validation Service (GCA VS), which is part of its subsidiary DTCC Solutions services, to include coverage of listed equity derivatives. Historically, financial services firms had to use manual processes to locate and adjust derivatives contracts to account for the effects of corporate actions, such as stock splits, mergers and special dividends, on the underlying security. “As trading in equity derivatives has grown, customer firms reached out to DTCC last year to see if we could publish through GCA VS details on the impact of corporate actions on listed derivatives,”explains Patrick Kirby, managing director, DTCC Asset Services. “Our client firms no longer have to trawl through various exchanges’ website to find these updates and re-key them into their systems themselves.” Every time a corporate action occurs on an underlying equity, each exchange with a listed derivative on that equity issue publishes a notice to members detailing the required adjustment method, adjustment factor, lot size change, and strike price change for the derivatives contract. GCA VS now aggregates this information and delivers it to any interested customer firm through an electronic central information hub in a standardised format, saving firms time and effort and reducing exposure risk. GCA VS will initially publish information from five main global exchanges and infrastructure organisations for equity derivatives, including the Options Clearing Corporation, NYSE Euronext, Eurex, Borsa Italiana and the Tokyo Exchange, and will continue to add other exchanges as the service

M&A volume down, but values up Latest data from Experian says M&A activity is down but deal values rise and the UK has fared a little better than Europe Information services provider Experian’s latest data sets show that mergers and acquisitions (M&A) and equity capital market (ECM) activity, including flotation, rights issue and placements, show that the number of deals in Europe and the UK fell off through Q3 2010 compared to the same period in 2009. According to Wendy Smith, business development manager at Experian Corpfin: “Although the UK returned to growth in the final quarter of 2009, the level of deal making in the UK since then has yet to reflect this. Deals tend to slow down during Q3 of any year, so quarter-onquarter figures show a seasonal decline. However, the year-on-year view reveals that while some regions held up a little better than others, there was still decline in the volume of M&A and ECM activity overall. The UK still fared a little

better than Europe.” The total number of UK M&A and ECM transactions during Q3 2010 fell by 22.7% compared to the same period last year, from 1,110 deals in Q3 2009 to 859 deals in Q3 2010. However, the total values of deals in the quarter were up 45.3% on Q3 2009; from £41.07bn to £59.67bn. Then again, compared to Q2 2010, there was a 23% decrease in M&A volume in the UK, but a 4.8% increase in value, from 1,115 deals worth £56.96b to 859 deals worth £59.67b. In Europe meantime, M&A and ECM deal volume fell off by 25.1% through Q3 2010, with only 2,140 deals concluded compared to 2,858 transactions in Q3 2009. Value increased by 4.16% from £149.664bn in Q3 2009 to £155.883bn in Q3 2010; though relative to Q3 2009 value fell off by 3.4%. Deals announced by value (£m)

Deals announced by volume RankQ2 2010

DealsQ3 2101

Financial advisor

RankQ2 2010

DealsQ3 2101

Financial advisor

JP Morgan Chase & Co.

20,759 JP Morgan Chase & Co

Rothschild

17,602

Goldman Sachs

Credit Suisse

16,237

BofAML

Cenkos Securities

14,230

Morgan Stanley

BofAML

11,635

UBS Investment Bank

Lazard

11,438

Credit Suisse

Evolution Securities

10,371

Rothschild

Grant Thornton

9,058

Citigroup

Goldman Sachs

8,835

Deutsche Bank AG

UBS Investment Bank

7,964

BNP Paribas

Source: Experian, supplied October 2010.

develops. Earlier this year, DTCC added coverage of structured securities handled by the US Federal Reserve Bank (mostly securities created by Fannie Mae and Freddie Mac) to GCA VS, along with scheduled payments for global fixed income securities. DTCC

has also been spearheading an effort along with XBRL US and SWIFT to promote straight-through processing in corporate actions by electronically capturing data directly from the issuers in a standardised form when a corporate action is first announced.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

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IN THE MARKETS

ETFs: EUROPE SEES UPTICK IN ETF INNOVATION

The European ETF market has evolved primarily as an institutional market, although individuals do participate indirectly through private banks that manage money for high net worth investors. In addition to providing convenient asset allocation, ETFs also offer access to products that certain institutions cannot buy for themselves. For example, European pension funds typically cannot trade futures, which effectively precludes them from the commodities markets. However, they can buy a UCITS vehicle that holds a diversified portfolio of futures—and as a result commodity ETFs now represent about 7% of European ETF assets. Fixed income ETFs have grown rapidly in Europe, too, particularly since the financial crisis erupted in 2008. Neil O’Hara reports. Photograph © Sergey Galushko / Dreamstime.com, supplied October 2010.

LESS VOLUME, BUT MORE PRODUCT IN EUROPEAN ETFs E

XCHANGE-TRADED FUNDS did not arrive in Europe until eight years after the first launch in the US and although assets under management now exceed $220bn, they amount to less than 30% of US ETF assets. By number of products, it’s a different story, however: Europe has at least 985 ETFs against 871 in the US. Product proliferation in Europe is inevitable in an economic bloc

consisting of multiple countries with different tax regimes and investor preferences rather than a single homogeneous market like the US, but other factors are at work. A regulatory regime that permits the use of derivatives in European ETFs has allowed sponsors to push product development into waters uncharted in the US, and innovation in Europe continues at a frenetic pace.

In most European countries, banks control the distribution of financial products; local institutions dominate each country but most have limited capabilities elsewhere. Banks don’t like to sell a competitor’s product, so the index providers decided to offer multiple licences in Europe. That encouraged banks to create their own ETFs based on the same underlying index: more than 30 ETFs track the Euro STOXX 50 Index, for example. In the US, Standard & Poor’s has licensed just two ETFs that track the Standard & Poor’s 500 Index, but when its exclusive licence to State Street Global Advisors in Europe expired earlier this year another seven additional sponsors immediately jumped in to offer ETFs that track the US benchmark. “Everyone wants to trade the Standard & Poor’s 500,” says Matthew Tagliani, head of ETF product for Europe/Asia at Morgan Stanley in London. “Banks can’t tell clients to go to a competitor if they want to trade.” All ETFs that track the same index are not identical, however; they may track total return, net return after tax on dividends or the raw index price. Even identical ETFs may not stand on an equal footing to every investor. The UCITS III framework allows sponsors to sell a fund incorporated in one jurisdiction throughout the European Union, but local tax and regulatory constraints can still affect whether investors prefer a domestic product. “A French investor leans toward a Frenchdomiciled fund because the tax treatment is more favourable than for an Irish fund,” says Tagliani. The advent of UCITS IV will further simplify the cross-border passport process for investment products but pan-European

NOVEMBER 2010 • FTSE GLOBAL MARKETS

IN THE MARKETS

ETFs: EUROPE SEES UPTICK IN ETF INNOVATION

tax harmonisation remains a long-term ambition at best. The baton for product innovation passed to Europe in large part because UCITS permits the use of swaps in ETFs. The Securities and Exchange Commission does permit the use of swaps in leveraged and short ETFs but the agency has never approved their use in conventional unlevered long only ETFs. The UCITS rules prompted the major swaps dealers, who already made markets in cash ETFs sponsored by asset managers, to develop their own European ETFs based on swaps. As a result, almost half the ETF assets in Europe are now in synthetic vehicles that use swaps to track the underlying index rather than traditional cash ETFs. “Synthetic ETFs leverage the fact that broker-dealers are little index replication factories,” says Tagliani. “We are very good at trading index inventory, options and cash baskets.” Synthetic ETFs managed by proprietary trading desks rather than asset managers fall outside the purview of MiFID, which imposes an obligation on fund managers to ensure best execution, diversify counterparty risk and maintain adequate collateral. Current MiFID rules do not require OTC trades in Europe to be reported on a stock exchange as they are in the US, either. Estimates vary, but market participants reckon that between half and two-thirds of trading in European ETFs takes place over the counter (OTC) and is never reported. An ETF that is not covered by MiFID could simply take the swap price given to it by the sponsor, while a MiFID-compliant fund would have to check competitive bids. “It can make a big difference to performance,” says Daniele TohméAdet, head of ETF and indexed funds development at BNP Paribas Asset Management. “An ETF on the same index replicated the same way may have different performance relative to the index because of the swap costs.” The absence of reliable data on the cost of replication makes it hard to compare the performance of identical ETFs from different sponsors. Bid-offer

Stephen Cook, chief operating officer of global ETF services at BNY Mellon Asset Servicing. “In a cash ETF, you have to deploy index sampling methodology, and that leads to higher tracking error,” he says. Photograph kindly supplied by BNY Mellon, October 2010.

spreads shown on a market data screen may not reflect what is happening in the OTC market, either. “Some ETFs don’t trade on the exchanges but they do trade OTC,” says Tohmé-Adet. “One must be very careful with studies that provide tracking error analysis comparing different ETFs on the same index. They can easily be biased if the tracking error is not calculated on an identical basis.” The different treatment of cash and synthetic ETFs will disappear if the proposed MiFID II rules take effect, which as currently proposed will extend best execution and reporting rules to derivatives and OTC transactions.

Swaps and ETFs Swaps enable sponsors to create ETFs tied to benchmarks that are hard to replicate in cash, according to Manooj Mistry, head of db x-trackers UK. For example, db x-trackers, whose entire product range is swaps-based, created an ETF that tracks the performance of a basket of hedge fund managers. The money doesn’t go into hedge funds, which typically offer only monthly liquidity and valuations; instead, the managers run parallel portfolios on

Deutsche Bank’s managed accounts platform. “We have visibility as to what their positions are to do daily valuations,” says Mistry. “We can have access as often as we need to adjust our hedge in those different strategies.” Holding swaps lets the ETF outsource tracking error to the swap counterparty; it is Deutsche Bank, not db x-trackers, that bears the risk if the performance of the hedge does not match the returns the hedge fund managers actually generate. Swaps-based ETFs also minimise tracking error between the fund and the index, a big advantage for funds that have a low asset base trying to track an index with so many names that it is impractical to buy the smaller components. “In a cash ETF, you have to deploy index sampling methodology, and that leads to higher tracking error,” says Stephen Cook, chief operating officer of global ETF services at BNY Mellon Asset Servicing. Even some large cash ETFs in the US have resorted to index sampling, including funds that track the MSCI Emerging Markets Index, which has about 780 components, including a significant number that have poor liquidity. Cash ETFs in the US based on this index have experienced significant tracking error—6% or more in 2009. “No institutional investor in Europe would accept such a product,” says Mistry. “They want products that do what it says on the package.” A swapbased ETF that follows the same index has negligible tracking error—just the fund expenses, including the swap cost. Synthetic ETFs such as db x-trackers deliver exactly what they promise, but unlike cash ETFs they expose investors to counterparty risk. UCITS limits the maximum counterparty exposure to 10% of fund assets, but does not require sponsors to disclose how much the unhedged exposure is nor does it specify how often swaps must reset. When Credit Suisse, a leading sponsor of cash ETFs in Europe, launched its first synthetic ETFs in September, the bank tried to allay potential investor concerns by posting the swap portfolios

NOVEMBER 2010 • FTSE GLOBAL MARKETS

for each ETF on its website and using daily swap resets to minimise the counterparty risk. “At the end of every day, the swap value is reset to zero,” says Dan Draper, managing director and global head of ETFs at Credit Suisse in London. “We are offering higher quality, more transparent products at a competitive price.” Draper expects to see consolidation in the fragmented European ETF market, particularly among smaller product designers and authorised participants, the entities that carry out arbitrage trades to keep ETF share prices in line with net asset values. He expects three or four brands will come to dominate manufacturing and a similar number, though not necessarily the same firms, will corral creation and redemption trading. Distribution is likely to remain fragmented for some time, however. In an ETF market dominated by funds that hold physical securities, like the US, established index asset managers such as State Street,Vanguard and iShares have an overwhelming advantage in scale and a huge investment in information technology, which represent a significant barrier to entry. In Europe, Draper says the synthetic structure makes it feasible to set up an ETF distributor that relies on products manufactured and/or supported in the aftermarket by third parties. Source, an ETF sponsor founded by Morgan Stanley, Goldman Sachs and Bank of America Merrill Lynch—later joined by JP Morgan and Nomura—is a good example. In 2009, it introduced sector ETFs specifically designed to meet the needs of hedge funds. US hedge funds often sell short sector ETFs to hedge market risk when they expect a particular stock to outperform its peers, but poor liquidity and the inability to borrow stock in European sector ETFs drove local hedge funds to use swaps instead. Source drew on the expertise of its backers to devise a new mechanism that allows for the creation of new units in order to facilitate a short sale. The new products have been a huge hit with European hedge funds.

FTSE GLOBAL MARKETS • NOVEMBER 2010

Daniele Tohmé-Adet, head of ETF and indexed funds development at BNP Paribas Asset Management, says: “An ETF on the same index replicated the same way may have different performance relative to the index because of the swap costs.” Photograph kindly supplied by BNP Paribas, October 2010.

Vinayak Bhattarcharjee, head of EMEA intermediary business at State Street Global Advisors in London. “The big thing that is missing in Europe is the wrap account. Those platforms were one reason ETFs took off in the US,” he says. Photograph kindly supplied by State Street Global Advisors, October 2010.

Retail investors were also quick to adopt ETFs in the US, a market dominated by fee-based financial advisers who embraced a cheap and effective tool for asset allocation. That distribution channel is only now beginning to emerge in Europe, however. In the UK, new rules governing independent financial advisers will promote fee-based compensation, which encourages advisers to find the cheapest product to meet a client’s needs rather than the product that pays the adviser the biggest commission—but the rules don’t take effect until 2013. “The big thing that is missing in Europe is the wrap account,” says Vinayak Bhattarcharjee, head of EMEA intermediary business at State Street Global Advisors in London. “Those platforms were one reason ETFs took off in the US.“ The European ETF market has evolved primarily as an institutional market, although individuals do participate indirectly through private banks that manage money for high net worth investors. In addition to providing convenient asset allocation, ETFs also offer access to products that certain

institutions cannot buy for themselves. For example, European pension funds typically cannot trade futures, which effectively precludes them from the commodities markets. However, they can buy a UCITS vehicle that holds a diversified portfolio of futures—and as a result commodity ETFs now represent about 7% of European ETF assets. Fixed income ETFs have grown rapidly in Europe, too, particularly since the financial crisis erupted in 2008. The trick for existing sponsors and would-be entrants alike is to develop products that are different in a crowded field. It could be through structural innovations—those introduced by Credit Suisse and Source, for example—or access to new asset classes like commodities; a simple me-too product will struggle to attract assets beyond whatever captive distribution the sponsor has. “You have to create products that provide value to investors,” says Bhattarcharjee.“They are looking for solutions to portfolio construction problems.” The pay-off for sponsors that develop a better mousetrap is huge, giving them every incentive to keep up the pace of innovation.

IN THE MARKETS

LATIN AMERICAN PENSION FUNDS: DIVERSIFYING THEIR INVESTMENTS

LATAM FUNDS DIVERSIFY Latin American pension funds are looking for higher rates of returns for their investment portfolios; that’s not easy when traditional investments (the purchase of high-risk, high-yield local government bonds) are not providing the level of returns of yesteryear. Economic stability has brought down interest rates throughout the subcontinent, and improved fiscal management has resulted in the upgrading of Latin American sovereign risk (with a few notable exceptions). Pension funds now have to find new ways to replicate or even improve the performance of previous years. Can they do it? By Rodrigo Amaral. N COUNTRIES SUCH as Brazil, Peru, Chile and Colombia, capital markets and investment-hungry sectors, including energy and transportation, are creating plenty of opportunities for investors. However, for many years, pension funds have been prevented from benefiting from them. Conservative regulations, which were introduced to transmit confidence to workers who were not fully convinced of the value of complementary pensions, have tended in the past to put the brakes on even the most daring pension fund managers. Even so, regulators are showing they are responsive to changing market conditions, and in consequence are loosening restrictions. The leverage given to fund managers to invest in risk assets varies from country to country. In Chile, pension funds are allowed to keep a large share of their overseas investments; at the other extreme, Uruguay, has barely loosened the shackles on the dependence of pension funds on local government bonds. However, the trend looks to be clearly towards liberalisation, and international investment houses are trying to assess the opportunities to make a few bob themselves with the whole process. “Latin American pension funds have a huge amount of capital available, and they are looking for professional managers to help them to invest it,” says Sam Pollock, a senior managing partner at Brookfield Asset Management, a Toronto-based firm

LatAm AUM by country (%) As of December 2009. 66.5% Brazil

3.2% Argentina 1.8% Peru

11.8% Chile

4.7% Colombia 12% Mexico

Source: BofA Merrill Lynch, LatAm Economic Weekly report, supplied October 2010.

which is developing infrastructure projects in Peru and Colombia along with local pension funds. The introduction, in some countries, of a multi-funds system in which participants can chose the level of risk that applies to their savings have also increased the urge to find alternatives to achieve higher rates of return. No Latin American country has gone as far in terms of allowing investment diversification than Chile, which in August last year implemented a bill that enabled pension funds to invest up to 60% of their assets outside the country. In February 2009, Chilean pension funds had 24.1% of their assets invested

abroad. Last August, the ratio had reached 43.9% of the portfolio, according to Superintendencia de Pensiones, the industry regulator. Global equities, mostly via mutual funds, amounted to almost two out of every three dollars invested outside the country, or a total of $36.2bn. The remaining third was invested in mostly fixed income mutual funds, which received $19.4bn from Chilean pension funds by the end of August. “There are many international groups providing a wide range of products to Chilean funds,”says Rodrigo Acuña, a partner at Primamerica, a Santiago-based consultancy. BlackRock, Fidelity, Schroder, Vanguard and JP Morgan Stanley are among the most active, according to reports. Other countries have preferred to follow more cautious ways. In Peru, a star performer in Latin America of late, fund managers have urged regulators to relax the rules, with the argument that the financial crisis has shown that diversification is of the essence in order to mitigate risks. Asociación de AFPs, Peru’s pension fund industry association, has pressed the point that, in May 2008, when the country suffered the worst of the crisis, portfolios were hard hit as they were highly exposed to Peruvian equities. As panicking global investors flew the Lima Stock Exchange, stocks plummeted and took down pension fund portfolios, which lost almost one quarter of their combined value. Pedro Zalba Flecha, the chairman of the association, has noted that Peru’s AFPs, as pension fund management firms are known, didn’t panic and stuck to their holdings even though prices were in free fall. As a result, once emerging markets diverted from the rich world and began to recover, they made a killing. In less than one year, he says, most of the funds managed by AFPs had come back to pre-May 2008 levels.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

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IN THE MARKETS

LATIN AMERICAN PENSION FUNDS: DIVERSIFYING THEIR INVESTMENTS

Even so, the experience showed to regulators that diversification may not be a bad idea. As a result, the maximum limit for investments abroad by pension funds has been increased from 15% to 24%, and soon afterwards AFPs were reporting to have got close to that ceiling. International asset managers eager to find new buyers for their products could do worse than pay attention to the news from Peru. The country is expected to grow by up to 8% this year, and measures are being taken to increase the participation of workers in its incipient private pension funds, which have been around only since 1993. In fact, AFPs are optimistic to the point that assets under management could double in a few years, breaching the $50bn mark between 2014 and 2016. Inevitably, the biggest prize is likely to be Brazil, for its sheer size and economic potential. Aside from Chile, where contributions to private pension funds are mandatory to most workers, in Brazil, like the UK, private schemes are complementary to a public system that provides meagre incomes for most retired workers. For a long time, Brazilian pension funds relied heavily on the country’s stratospheric interest rates to meet their actuarial targets by purchasing plenty of Brazilian government bonds. However, the past few years of economic stability have pressed rates down, and the government has had to pay lower premiums for its bonds after the country was granted investment grade status by the three big credit rating agencies. Regulation had to change and has. “Brazil’s legal framework has been changing, adapting itself to the new economic environment,”says Luis Carlos Afonso, the head of investments at Petros, Brazil’s second largest pension fund. “The changes are allowing pension funds to take advantage of the opportunities that are being created in the Brazilian economy.” The new rules were implemented last year and Petros, for instance, was quick to make use of the new leverage it was granted. Now, pension funds can invest up to 70% of their assets in Brazilian equities, and

LatAm pension fund AUM ($bn) 1,330

1,400 1,200 1,000 800

523 600 400 200 0 2007 08

12 13 14 2015 Forecast

Source: BofA Merrill Lynch, LatAm Economic Weekly report, supplied October 2010.

20% in structured products, an asset class that includes private equity funds. Petros has increased its exposure to equities from 23% to 34%, while reducing the participation of fixed income from 71% to 61%. Brazilian funds have little freedom to look for diversification abroad—only 10% of their portfolios can be invested outside the country, and this was another novelty implemented last year. Afonso says that, now, Petros doesn’t have any assets abroad anyway. The reason is simple: it is hard to find better investment opportunities abroad than in Brazil, which already has a large economy and is expected to grow by up to 8% this year. “We’ve been meeting international firms, but the opportunities we find in Brazil at the moment look more suitable for our goals,” he says. In the future, however, international markets could provide important ways to diversify risks, he says. In Brazil and in other countries, the growing activity of pension funds is seen as a further boost to the global capital markets. Moreover, infrastructure investment is never far away from institutional investment strategies in Latin America as a whole, and Brazil is no exception in this regard. Afonso, for example, notes that Petros has purchased

a 10% stake in the Belo Monte dam project, which will build one of the world’s largest hydroelectric plants in the north of the country. “It is a very interesting investment for us, as it feels almost like a fixed income investment,” he remarks. He explains that most of the contracts to sell the energy produced by the plant in the future have already been signed, guaranteeing a long-term income revenue for the pension fund. “We are interested in infrastructure projects that offer low risk and some guarantee of return, and that’s the case of Belo Monte,” he adds. In Uruguay meanwhile, the government has gone as far as recently designing new rules for pension fund investments that will enable them to put a larger share of their assets in infrastructure projects. In a couple of years, the local AFPs, which today can keep up to 90% of their assets in government bonds, will only be allowed to invest in sovereign issues to a maximum of 75% of their portfolio. That will force them to look for new investment opportunities, although they won’t be allowed to look abroad unless (ironically) their strategy is to buy high-quality (and low return) government bonds. Investments in securities issued in Uruguay will be allowed to reach 50% of their portfolios, up from the current 25%. However, Uruguay’s capital markets are very small, which is not a surprise considering that the country has a mere 3.5m inhabitants. “In practice, the change is not too relevant, as today investments in private securities amount to only 5% to 6% of funds’ portfolios,” says Marcos Rivero, the head of investments at Unión Capital AFPA, a local pension fund. “The government is creating the conditions for a wave of infrastructure investments by private entities, and this measure will open the way for pension funds to be active players in the process,”he says. In Uruguay and elsewhere, foreign investors are likely to play a part too, and partnerships with local pension funds should be an important entry point for many of them.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

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IN THE MARKETS

INVESTORS TARGET GLOBAL EMERGING MARKET EQUITIES

According to a BoA Merrill Lynch survey of fund managers released in October, investors continue to channel most of their renewed risk appetite into global emerging market equities (GEM) in the wake of an expected second wave of quantitative easing. That’s good news for specialist emerging markets investment vehicles after a relative drought in 2009. Is the return of the GEM investor a mid-term or longer-term trend? We spoke to specialist GEM investment firm Somerset Capital Management’s Dominic Johnson about the key trends.

A GEM OF AN OPPORTUNITY T HE LEVEL OF risk that investors are taking in their portfolios rose more sharply in September than in any month since April 2009, acknowledges a BoA Merrill Lynch survey of fund managers. Among the key findings of the report is that hedge funds continued to add to their net equity exposure. As well, the proportion of asset allocators’ overweight equities nearly tripled to a net 27% from a net 10% in September, while they extended underweight positions in bonds. The report says the proportion of portfolio managers overweight cash fell to a net 6% from a net 18%. The vast majority of this movement into equities was into GEM. A net 49% of asset allocators are overweight GEM, a monthly rise of 17 percentage points. Appetite for US, eurozone and Japanese equities remained stable while the panel became less bearish about the UK. Portfolio managers are more optimistic about China’s growth over the coming year. A net 19% expect China’s economy to strengthen in the next 12 months, up from a net 11% in September and 38 percentage points above August’s level. “While improved risk appetite is to be welcomed,”holds Dominic Johnson, chief executive officer and one of the three founding partners in Somerset Capital Management LLP, which has some $700m under management.“The question is how narrow the focus is on GEMs right now. We believe that the baton has now been passed to the emerging markets and the key these days is not to overpay for growth.” The firm’s investment process centres “around picking well managed, cash-

Dominic Johnson, specialist at Somerset Capital Management. Photograph kindly supplied by Somerset Capital, supplied October 2010.

flow generative companies, at the right price,”explains Johnson.“Our managers do not invest according to index weights, believing this to increase rather than decrease risk, and we take a very serious view of valuations. Personal knowledge of the companies in which our funds invest is a cornerstone of the Somerset Capital Management approach and one that Johnson holds should be de rigueur for all specialist GEMs.“That means that we invest substantial time in visiting companies in which we invest. It is only through complete qualitative and quantitative checks that the serious (but often common) mistakes can be avoided and this, we believe, is our most effective risk control, especially in a convictiondriven portfolio such as ours,”he adds. Even so, macro-economic considerations are also in play, he concedes. “In many emerging markets the cycle has now come to an end. Therefore we are now looking at much more advanced markets

for returns. The lessons of 1998 have been well learned and we look for markets with responsible government and deeper consumer markets.” In this regard, India provides a typical template for the firm, with Johnson citing factors such as a strong rule of law. Even with a commitment to advanced emerging markets, risk controls are and must remain paramount, says Johnson. “We believe that the key to investing in emerging markets is to avoid the substantial country and stock risks that are represented in this asset class. As a result, we limit stock investment to 5% of the fund NAV and country and sector exposure to a maximum of 20% of the fund's overall total.” While GEMs remain an investment destination of choice, it seems that firms such as Somerset Capital Management conform to a new operational paradigm. The firm stakes its claim to a commitment to transparency, which Johnson believes is imperative within a GEM context. “The days of smoke and mirrors in emerging market investments are truly over. At the core of our firm’s philosophy lies a belief in transparency and we not only publish our partnership structure but we also welcome our investors to join an advisory board. This group meets annually, with direct oversight of the ownership structure and investment plans, ensuring that the interests of fund managers are fully aligned with the risk appetite of investors.”Moreover, the firm has joined with other specialist investment firms to “share our vision of transparency in our investment approach”. Johnson holds: “It is the only feasible way forward in this investment segment.”

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IN THE MARKETS

HARNESSING INDIAN INVESTMENT OPPORTUNITIES

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

THE GUERNSEY CONNECTION Whenever there is talk of the opportunities for investment in India, Bollywood is a recurring topic. The Indian Film Company (IFC) is a Guernsey-registered company established as a closedended investment fund. The IFC was admitted to the Alternative Investment Market (AIM) in 2007 and raised some £55m in order to invest in a diverse portfolio of Indian films. The deal was notable as IFC is the leading film investment company listed on AIM, and highlights the role that can be played by specialist jurisdictions such as Guernsey as an investment facilitator. In fact, Guernsey’s growing expertise in the Indian market has received a ringing endorsement from a number of recent admissions to London’s AIM, writes Tom Carey, corporate partner, Carey Olsen. UERNSEY IS STEADILY trading on international links to become the jurisdiction of choice for Indian businessmen to encourage and facilitate cross-border investment by European and UK investors in India. On the securities side, Indian bank ICICI recently established ICICI Ventures in Guernsey. The fund’s objective is to invest in Indian equities, having subsequently raised some £50m from European and UK investors. On the private equity side Alchemy and Ashmore Group recently established the AA India Development Capital Fund as a joint venture with an Indian based investment management

team. This Guernsey-registered limited partnership, which is a feeder fund for an underlying Mauritius-based fund, raised commitments of $80m with a view to partnering with management teams to build the next generation of Indian companies. Guernsey companies are increasingly being used as listed vehicles, whether on the main market of the London Stock Exchange (LSE), the Alternative Investment Market (AIM) of the LSE or elsewhere. Indeed, GuernseyFinance, the promotional body for Guernsey’s finance industries, takes India’s potential very seriously. GuernseyFinance has sent, and will be continuing to send,

delegations to the key cities with a view to “drumming up” new business. It would be wrong to paint a picture of a flood of new work from Indian businesses using Guernsey. It is more of a steady flow but this will grow as the region grows and the Guernsey work will increase alongside as the jurisdiction gains in reputation for experience and expertise when dealing with the structures best suited for investing in India. Most recently, in the area of renewable energy, India Energy Limited (IEL), a Guernsey-registered company, was admitted to AIM last year and that listing opened the company up to a wider UK investor audience and raised capital to acquire additional wind power assets as well as another new wind farm in India.. IEL is now looking to become the largest provider of wind energy in India. The group currently owns and operates 41.2MW across two wind farms (one on the Gadag plains in Karnataka and another, newly commissioned, farm at Theni, Tamil Nadu). IEL is looking to acquire a portfolio with an aggregate of 300MW of annual generating capacity by the end of the 2012/2013 financial year. While IEL provides a good example of what can be achieved, the firm has tapped a rising trend. Caparo Industries, and its associates, floated Caparo Energy on AIM in October this year, the latest firm to try to leverage growing interest in the Indian renewable energy market. The company is also registered in Guernsey and acts as the holding company of Caparo Energy India and other members of the group. The company seeks to generate predictable and long-term cash flows by building up a portfolio of wind power generating assets in the Indian wind energy market which, it believes, is currently fragmented. The group intends, in due course, to acquire and develop a portfolio of wind farms with a target total annual generating capacity of up to 5,000MW. The reasons for heightened interest in this space is obvious; there is a marked deficit of energy supply and as a result wind energy is being seen as a profitable source of renewable energy in India.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

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IN THE MARKETS

HARNESSING INDIAN INVESTMENT OPPORTUNITIES

The Indian government has created legislation which has enabled an attractive tariff and fiscal structure for private sector investors, which has stimulated the growth of this type of industry in the country, allowing the demand for energy to be satisfied. Investors can see the benefits of this type of investment in India because private enterprise is driving the investment and there is no need for government subsidies. Not having to rely on subsidies to generate returns removes one of the risks in respect of the long-term pricing of electricity. To be candid, Guernsey has not seen much, or indeed any, work where Indian investors are looking for overseas opportunities. They are very much concentrating on the domestic market at present but as the wealth grows, and the entrepreneurs seek new opportunities, Indian investors may indeed look elsewhere. Indian businesses are now much more concerned about finding the right jurisdiction with the appropriate structures to facilitate raising the capital needed domestically. Guernsey is attractive for a number of reasons, not least the access to European and UK investors and the ease and expertise available on the island to assist with listings on AIM and the LSE.

Investment opportunities While some analysts highlight the risk elements in India’s creaky infrastructure others see real opportunity. Certainly, there is no lack of commitment by local government and authorities to tackle infrastructure deficits and the Indian government is part way through a commitment to spend $500bn, though to the end of 2012, to upgrade internal transport and technology networks. The speed of change will also accelerate as more foreign or local firms seize the opportunity to get into the market at a relatively early stage and benefit from expected returns. The second area ripe for investment is the country’s burgeoning information economy. Call centres might be the

INDIA-GUERNSEY: THE LEGAL CONNECTION HE TYPE OF structure for making investment into India that Guernsey lawyers have seen is the establishment of a Guernsey-registered holding company with a wholly-owned subsidiary, based in Mauritius, and the operating company based in India. The shares of the Guernsey holding company are then placed with UK and European institutional investors and listed on the LSE or AIM. A Guernsey-registered holding company mitigates many of the tax issues and gives the business respectability that may not be achieved by solely using Mauritius. The double tax treaty entered into between Mauritius and India means that a foreign credit in respect of the tax suffered in India may be offset against the Mauritian liability, subject to local requirements. The consequence is that Mauritian tax may be payable by

public face of this knowledge-intensive society but behind the scenes there are banks, consumer giants and software providers and many other sectors looking for human capital at a cheaper cost than in the West. India’s government is doing its best to broaden its educational offering to meet this voracious demand. These young entrepreneurs are tapping into a wealth of international support on offer such as Microsoft assisting Indian businesses to improve information technology infrastructure. Goldman Sachs is spending $100m on encouraging female entrepreneurship with many related projects located in emerging markets. In India, local entrepreneurs are mining new local markets such as mobile video gaming and online karaoke. At present, India has time on its side. The economy is expected to expand by 8.5% this year, according to Morgan

the Mauritian company on dividends received from the Indian company at a possible maximum effective rate of 3%. Dividends paid by the Mauritian company will generally not be liable to tax in Mauritius nor will they be subject to Mauritian withholding tax. Typically, any dividends which are paid out by a Guernsey holding company will, where the company has exempt status, be exempt from income tax on the island (except, in certain circumstances, where dividends are received by shareholders who are resident on the island). No withholding tax will be payable on the dividends to shareholders who are not resident. Essentially, the island offers a tax neutral platform to raise capital for the India-based business. In other words, incorporating in Guernsey will not add to any taxes which are otherwise due.

Stanley and, while China’s economy is four times bigger, India’s growth rate could overtake China’s by 2013, if not before, aided by a much stronger regulatory and legal infrastructure. Some economists think India will grow faster than any other large country over the next 25 years, taking into account its rapid growth rate, its population (1.2bn and counting) and a distinctly youthful population profile. This is in sharp contrast to China’s ageing population or indeed the ageing population profiles in many leading Western countries. By 2020 the median age in India will be 28 compared with 38 in America, 45 in Western Europe and 49 in Japan. India’s working age population will be 136m by 2020 and, with the government encouraging entrepreneurship and inward foreign investment, it could become a powerhouse of talent and wealth.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

COMMODITY REPORT

COAL: NO LONGER ON THE COMMODITIES SLAG HEAP

In the past 20 years, the amount of coal traded internationally has almost doubled, from 498m tons yearly to 941m tons last year, and closer to 1bn tons this year. The key to coal’s future trading prospects is, of course, China, followed by India, which although they are the biggest producers, have both followed the US in becoming major net importers and meet much of their insatiable demand for electricity from burning coal. While the European market is coasting, in both the US and the European Union there is much talk of “clean coal” that will mitigate environmental pressures. However, its proponents confuse the issues. It is relatively cheap to control toxic emissions and mitigate acid rain—at least with strong government regulation—but controlling carbon emissions, while currently feasible, is highly expensive and unlikely to take off without strong governmental intervention. If it does, under pressure from climate change conventions, then King Coal is set to take off for a renewed reign. Ian Williams reports.

Photograph © Teprzem / Dreamstime.com, supplied October 2010.

OAL HAS BEEN the Cinderella of the energy commodities. It has so much history that until recently financial markets seemed to overlook its future. Although it was the fuel that kicked off the industrial revolution, most people in developed countries do not now have the intimate relationship their parents and grandparents had with it. In many ways, it is out of sight, out of mind. Even their clean, battery-charged cars are likely to be powered largely by coal-generated electricity, but few heat their homes directly with it, and no one fills the tank in their car with a scuttlefull of nutty slack. Oil has had more liquidity in every sense: its sources tended to be far from the countries that consumed it, so production, distribution and above all valuation, have been global. In contrast, until relatively recently, both the industries that consume coal, and the customers for the electricity it made, tended to be based close to the mines. Coal never went out of fashion.

FTSE GLOBAL MARKETS • NOVEMBER 2010

OLD KING COAL COULD CLEAN UP Belying coal’s old-fashioned image, even Israel, with not a nugget of the stuff within its borders, uses coal to make 63% of its electricity, while the Asian tigers, cuttingedge countries of modern technology such as China, Japan, South Korea and Taiwan, are the biggest importers. In the past 20 years, the amount of coal traded internationally has almost doubled to 941m tons last year, and closer to 1bn tons this year. Even so, over 80% of the world’s coal production is consumed in the same country in which it is mined, which has inhibited the growth of financial trading in the commodity. However, that is changing,

and David Price, director of the Global Steam Coal Advisory Service, IHS CERA, and research director for IHS McCloskey’s, which compiles some of the definite coal indices, points out that the soaring physical trade is being matched by burgeoning financial market attention. Price says:“The coal consumers started off, and now almost the entire sector is on board; but now there is also a great deal of hedging of physical contracts and over the last three to five years first the banks and then the hedge funds have moved in so there is a whole new trading industry emerging.”

COMMODITY REPORT

COAL: NO LONGER ON THE COMMODITIES SLAG HEAP

It is also worth remembering that coal is not just for burning. Coking coal is used to make over 70% of the world’s steel which, new technologies and materials notwithstanding, is still the foundation of the modern economy. Moreover, about a third of the global trade is coking coal. McCloskey’s recently started indices in coking coal, and Price points out: “Decent coking coal is in short supply, so that market is getting quite exciting, and there’s plenty of volatility likely.” For example, on September 12th, the Chicago Mercantile Exchange (CME) began trading its coal instruments, and CME’s Justin Bozzino says the move is a response to demand from existing customers who already trade oil and gas and want to cover all legs of the energy tripod. Indeed, he points out, the exchange had already dealt in US coal, dry freight, and iron ore, so there is a manifest synergy.“We have 15,000 customers accessing the Clear Point platform, and bringing coal in not only mitigates credit risks, it will help grow the markets.”

Widely traded Potential customers for the new coal instruments are “producers, end-users such as utilities, trading houses, banks, and since we are listing options, anyone can clear them,”says Bozzino. To begin with, the trades will be dominated by swap/futures and options on the two most widely traded indices for steam

Doyle confidently predicts: “The Pacific Basin will overshadow the Atlantic Basin. “Until recently, it wasn’t traded much at all. Most was coming into the Atlantic basis, and only 17% of South African coal was going into Asia, but last year it was 57% and so people are now trading that spread between the Newcastle (Australia) and API 4.” coal; API 2, which has been established for almost 20 years, and API 4, for South African coal, which has been around for ten. Price, whose company, along with Argus, compiles the indexes, explains: “They both traded a lot because generators wanted to play forward markets as they did with gas and carbon, particularly in Europe where there has long been a free market in electricity.” Generators wanted to protect their positions in the face of potential volatility in coal prices. Most Asian markets have heavily-regulated power generators and of course, until recently, China and India were net coal exporters. Trading has expanded from London’s ICE to Singapore and now Chicago, and the players have expanded from coal consumers. Steve Doyle, a veteran coal trading consultant, set up the first swap, for Peabody, back in 1998. He reminisces: “No one knew what a swap trade was”, and also notes the rush of interest.“There are so many new global trading participants that have come into the market and moved into coal, and many

of them are oil companies. They see where the liquidity is going.” He puts global trading volume, mostly in Atlantic basin coals, and including domestic production and trading there, at somewhere between 2.2bn and 2.5bn tons. He adds: “Some 80% to 85% is financial and the rest is physical”, and points to the API 2 price currently at $91, which gives a notional financial volume of over $200bn. Price confirms the spreading market interest:“It has always been an OTC market but when the crash came there were a lot of concerns about credit, and our prices are now listed on IntercontinentalExchange (ICE), CME, Singapore, so they are getting in on the act.”In fact, he says: “Asia is where the demand growth is.” The financial crisis in the Atlantic basin and environmental pressures in Europe have kept physical trading stagnant, but the Asia Pacific basin, which, according to Doyle, only accounts for 10% of financial trading, has roaring demand. Doyle confidently predicts:“The Pacific Basin will overshadow the Atlantic Basin”, citing the API 4 contract for South

THE RESOURCEFULNESS OF KING COAL CCORDING TO THE World Coal Institute there are over 847bn tonnes of proven coal reserves worldwide, providing enough coal to last us around 119 years at current rates of production. In contrast, proven oil and gas reserves are equivalent to around 46 and 63 years at current production levels. Coal reserves are available in almost every country, with recoverable reserves in around 70 countries. The

biggest reserves are in the United States, Russia, China and India, however the assessed level classified as proved recoverable reserves can vary widely. Over recent years there has been a fall in the reserves to production (RP) ratio, which has prompted questions over whether the world has reached ‘peak coal’. Peak coal is the point in time at which the maximum global coal production rate is reached after

which the rate of production will enter irreversible decline. However, recent falls in the RP ratio can be attributed to the lack of incentives to prove up reserves, rather than a lack of coal resources. Exploration activity is typically carried out by mining companies with short planning horizons rather than state-funded geological surveys. There is no economic need for companies to prove long-term reserves.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

African coal. “Until recently, it wasn’t traded much at all. Most was coming into the Atlantic basis, and only 17% of South African coal was going into Asia, but last year it was 57% and so people are now trading that spread between the Newcastle (Australia) and API 4.” Similarly, he points out that McCloskey has started an Indonesian contract for sub-bituminous coal. “At the moment it is small, barely a pulse, but as Indonesia is the biggest producer of steam coal, it will grow in importance.” The key to coal’s future trading prospects is, of course, China, followed by India, which although they are the biggest producers, have both followed the US in becoming major net importers and meet much of their insatiable demand for electricity from burning coal. China’s airports might be clogged with cuttingedge electronics going out, but the roads to Beijing have week-long traffic jams from coal trucks coming in. Doyle points out: “India has a trading mentality and of course so does China, so even without an open market for electricity you have so many middlemen involved. There is a big enough population of people who need to hedge the risk. There are plenty of players. It’s a real market, and it will grow.”

Growing relationship Connected to the move of oil and gas traders into the coal market is a growing relationship between the price fluctuations in the various forms of carbon. Price points out: “There’s no physical reason for a link between coal and oil, since they operate in completely different markets, but there is an indirect link because gas prices are largely set with an indexation to oil prices and coal and gas in the Atlantic are both used to generate power. If you compare the curves, they do track each other, and we have had periods where coal prices have seemed to respond to oil, to currency and even stock market fluctuations.” The traditionally limited global market has had consequences. The figures for oil reserves are subject to global scrutiny, and for decades the price of oil has been determined globally, with cutting-edge financial instruments both tracking and

FTSE GLOBAL MARKETS • NOVEMBER 2010

Top five proven coal reserves at end of 2009 (Million tonnes)

US Russian Federation China Australia India TOTAL WORLD of which: European Union OECD Former Soviet Union Other EMEs

Anthracite and bituminous 108,950 49,088 62,200 36,800 54,000 411,321 8,427 159,012 93,609 158,700

Sub-bituminous and lignite 129,358 107,922 52,300 39,400 4,600 414,680 21,143 193,083 132,386 89,211

TOTAL 238,308 157,010 114,500 76,200 58,600 826,001 29,570 352,095 225,995 247,911

Share of total (%) 100% 3.6% 42,6% 27.4% 30.0%

Source: BP, supplied October 2010.

Global coal consumption by region* (Million tonnes)

Total North America Total South and Central America Total Europe and Eurasia Total Middle East Total Africa Total Asia Pacific TOTAL WORLD of which: European Union OECD Former Soviet Union Other EMEs

2008 1,079 258.8 956.7 324.8 143 1,197.5 3,959.9 703.4 2,182.7 192.3 1,584.9

2009 1,025.5 256 913.9 336.3 144.2 1,206.2 3,882.1 670.8 2,072.7 184.1 6,625.4

Change 2009 over 2008 4.7% 0.8% 4.2% 3.8% 1.1% 1.0% 1.7% 4.4% 4.8% 4.0% 2.8%

2009 share of total 26.4% 6.6% 23.5% 8.7% 3.7% 31.1% 100% 17.3% 53.4% 4.7% 41.9%

*Inland demand plus international aviation and marine bunkers and refinery fuel and loss. Consumption of fuel ethanol and biodiesel included. Source: BP, supplied October 2010.

moulding the price structures. In contrast, figures for coal reserves have been national prerogatives, unchecked by market disciplines. Some indication of their accuracy was in 2004 when German hard coal reserves were written down from 23bn tons to 183m tons, less than 1% of the previous estimate. Some estimates have gone the other way, notably India, whose hard coal reserves were revised upwards from 12.6bn tons in 1987 to 90bn in 2005, and Australia, whose reserves went from 29bn in 1987 to 38.6bn tons in 2005. However, while Germany was an extreme case, world coal resource assessments generally have been downgraded continuously from 1980 to 2005 by an overall 50%—and one reason for the reassessment is that the coal industry is globalising. One thing is sure. Peak Coal is much farther off than Peak Oil. For example, the United States, though financially battered, is still the

world’s largest economy and has the largest coal reserves. Coal generates more than 50% of its electricity and the 30% of the planet’s reserves it holds will last for 250 years at current use levels. However, even the US is now importing it. While the European market is coasting, in both the US and the European Union there is much talk of “clean coal” that will mitigate environmental pressures. However, its proponents confuse the issues. It is relatively cheap to control toxic emissions and mitigate acid rain— at least with strong government regulation—but controlling carbon emissions, while currently feasible, is highly expensive and unlikely to take off without strong governmental intervention. If it does, under pressure from the UN’s Climate Change Convention, then King Coal is set to take off for a renewed reign in the Atlantic as in the Pacific. His courtiers in the markets will be there cheering.

COMMODITY REPORT

IRON ORE: OUTLINING NEW MARKET CHANGES

IRON ORE CHASES A PAPER MARKET As befits a mineral that makes up 5% of the earth’s crust, the iron ore market is going through tectonic changes. Iron ore is the key ingredient in steelmaking and together with steel it is the second largest commodity after oil in terms of total value of trade. Yet the paper market for the ore is still in its infancy. This is about to change however. A 40-year tradition of settling prices annually was abandoned in the spring, blowing the market wide open to financial providers, exchanges and speculative players. By Vanya Dragomanovich CCORDING TO SIMON Overy, ICAP’s manager for iron ore in the UK, the iron ore paper market “is a fraction of what it could be”. The Singapore Exchange clears something between one and 1.5 tonnes every month. We are talking about an almost 1bn tonne market and the volumes of derivatives trade could be five to six times that.” In 2008 the value of seaborne trade was around $100bn. If that is multiplied by the derivatives market the way it is in other commodities, the total worth of paper in the iron ore market could rise to something like $500bn. Compared to other metals, iron ore, and even steel, are coming late to the party. Copper has been trading on the London Metal Exchange for over a hundred years while steel futures were only introduced in early 2008. Iron ore is still only traded via over-the-counter swaps. It took a long time for exchanges to find the right steel contract that would appeal to a diverse range of buyers and sellers and other attempts at futures have not been particularly successful. Eventually the LME opted for steel billet, a form of half-finished product that is used in the construction industry. Though the timing of the futures launch proved unfortunate in hindsight—they started trading in April 2008 at the absolute peak of commodity prices which was followed by a global recession

and crashing prices—the exchange seems to have finally cracked the code and volumes of trade have been rising to record highs since March. The exchange has tweaked its steel offering over the past few months, unifying its Mediterranean and Far East contracts into one. Stephen White, an LME spokesman, says: “In the last few months we have seen record volumes of trade in steel and this has not been only the function of the fact that we merged two contracts. August numbers will again show record levels.” In July for the first time more than 1m tonnes had been traded in a single month with a notional value of $550m. The LME also brought in delivery points in the US in a nod to the fact that heavy industries in the US are beginning to recover.

OTC iron ore swaps This bodes well for iron ore, which is intrinsically linked to steel. Although the paper market for iron ore is more basic than that for steel exchanges, banks and brokerages are beginning to change this. Shortly after steel futures were introduced Deutsche Bank, Credit Suisse, JP Morgan, Morgan Stanley and Barclays Capital started offering overthe-counter iron ore swaps settled against one of the three main steel indices. Exchanges came on board soon after with the Singapore Exchange

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

currently clearing the largest amount of swap trade. As of this summer the CME started clearing iron ore swaps, too. All of these financial institutions are breaking into a market that for 40 years underwent a very specific price setting ritual. The three largest global producers, BHP Billiton, Rio Tinto and Brazil’s Vale, would sit down once a year with the large Chinese steel producers and negotiate the annual contract price over a period of several months. The three miners produce around 35% of global iron ore but in terms of exported ore, also called seaborne trade, they hold over 60% of the market. Most of this ore is bought by China. The annual negotiations worked as a system for setting contract prices until prices for iron ore sold freely in the market started oscillating up to 20% in a space of a month. The negotiations between the big three and Chinese buyers would typically take from the end of the year until the following April. The moment of agreeing the price was like white smoke from the Vatican, a signal for the rest of the industry to set their prices based on this as a benchmark. With iron ore prices rising over 300% between 2000 and 2008 and then rapidly falling in late 2008 and through 2009, however, the two sides ended up arguing fiercely over what should be paid. The negotiations started pushing beyond April until the

NOVEMBER 2010 • FTSE GLOBAL MARKETS

system eventually collapsed this year. Now the big three and the steel mills settle prices quarterly. This is the chink in the armour that the financial industry had been waiting for; it has opened the opportunity to start pricing iron ore differently and allowed speculative players to get involved.

Speculative action ICAP’s Overy estimates that over a third of the swap market participants at present are financial institutions. “You have a mixture of participants in the market from producers to steel mills with banks and speculators making up something like 40% of the trade,” he says. Traders also note that a lot of speculative action in iron swaps comes from hedge funds that use it to hedge their exposure to mining companies such as Newmont Mining and steel maker such as Arcelor Mittal. Very few funds are involved directly in iron ore and those are mainly based in Asia, one of the largest ones being Beijingbased China United Mining Fund. Western funds still mostly opt for shares in iron ore miners rather than any direct exposure to ore derivatives but this could change as the paper market becomes more sophisticated. A trading company running a successful steam coal trading platform, globalCOAL, has launched globalORE, an iron ore trading platform with standardised iron

FTSE GLOBAL MARKETS • NOVEMBER 2010

ore trading agreements before the end of this year. “The argument for this is that if you look at steam coal, it is a 680m tonne market with derivatives trade of 2.5bn tonnes, a multiple of the physical trade. With iron ore you have a 900m tonne market that is being moved yet only 30m tonnes are traded in swaps,” says Eoghan Cunningham, chief executive of globalCOAL. “Everybody is getting excited about the iron ore market because it has large potential for growth.” Initially globalORE will offer spot and forward contracts but plans include offering iron ore futures in three to four years. Cunningham is sober about the pace of progress his platform is likely to make. “At present the market is fractured and people argue about what the contract specification should be. If you look at copper for instance, nobody argues about the copper price. It is settled at the LME and everybody accepts that. It will take time to develop that kind of market in iron ore. It took seven to eight years to develop the steam coal market”, and now it is going great guns, explains Cunningham. Iron ore attracted extra attention this spring when spot prices hit a two-year high on the back of the rising equity markets. They peaked at $182 a tonne but in line with the general mood in the global economy dropped down to $137/t. How they will do going forward will depend on where the global recovery is going as they are closely linked with heavy industries. Analysts estimate that the autumn will at best see current market conditions over an extended period and at worst a slight decline in prices. Jeffrey Kabel, executive director of ferrous metals at JP Morgan, expects prices to move in a narrow range in the medium term. “The backwardation in the iron ore market has come up by 10% to 20% in the last month. I expect range trading in the next four to five months,” he notes. For commodities, forward prices are typically higher than cash prices because they reflect not only the price of the commodity but also how much it costs to store it over a period of months. Backwardation is the reversal

of that, a situation in which forward prices are lower, indicating lower demand further ahead. Looking at the leading Asian markets, Chinese steel production and consumption has grown at an astonishing pace over the past 18 months. The size of the Chinese steel industry is now near 700m tonnes, though Chinese demand is beginning to slow down. “The steel and steelmaking raw materials markets in Asia have entered into a period of negative cyclicality,” says Deutsche Bank metals analyst Daniel Brebner, adding that industrial production in China is decelerating more quickly than anticipated. It grew 13.7% year-onyear in June compared with 18% in March and April.

Window of opportunity Brebner notes that Deutsche Bank economists expect industrial production in China to rise by 9% to 10% in the fourth quarter of this year. “Iron ore imports could fall 10% to 15% over the course of the next few months,”he says, adding that Chinese steel producers are cutting prices and volumes for particular products because of a slowdown in domestic demand. This will create a window of opportunity to buy cheap iron ore this autumn before the combination of falling prices and rising input costs starts creating a squeeze in the third quarter and forces local mills to start buying again. He recommends buying at $105/t to $110/t. Looking into next year he expects prices to converge towards $130/t. In Europe the situation has improved sharply over the past few months as the weaker euro worked in favour of local steel exporters though this may not be enough to offset the decline in Chinese demand. Nevertheless, with its capacity for quick moves, iron ore is a market worth keeping an eye on, particularly now that there are more financial instruments available and more market players are providing additional liquidity. The effects of the tectonic shifts will yet become apparent.

STOCK EXCHANGE REPORT

RTS Q&A: UPGRADING SERVICES FOR FOREIGN INVESTORS

BUILDING FOR THE FUTURE Starting in late October, FORTS, the futures and options market of Russia’s RTS stock exchange, will start a cash-settled futures contract on raw sugar quoting in rubles per long ton with settlements in March, May, July and October. The new contract is one of a stream of initiatives introduced by the exchange to broaden its appeal to both local and foreign investors. In a special Q&A, the exchange outlines the role of FORTS, RTS’s derivatives market, and some of the technological and product advances it has introduced in recent months. ORTs, THE DERIVATIVES trading market for the RTS Stock Exchange now ranks among the world’s top ten derivatives exchanges and has worked hard to expand the set of 46 contracts and 13 options based on the RTS Index, shares of Russian companies, short term interest rates, currency, oil, silver, gold and most recently sugar. This year and last have been banner years for the exchange with volumes seeing a steady increase. In early October, RTS reported trading records on its gold futures contract, with the volume of contracts traded valued at just under $88m. “Uncertain and unstable recent movements on currency and spot markets have encourage the majority of investors to use precious metals as a proven and reliable way of capital protection. Gold futures at RTS has a number of incontestable advantages compared to alternative ways of purchasing this metal, and this is why we are seeing more and more investors attracted to our gold futures contract”, explains Evgeny Serdyukov, director of FORTS. The exchange hopes to enjoy equal success with its new sugar futures contract. Explains Serdyukov: “A cash-settled futures contract based on raw sugar is a convenient instrument for both sectoral participants and private traders who use different trading strategies on the commodity derivatives market. Launching this contract is the next step in broadening the range of commodity contracts on the RTS futures and futures market.”

Andrey Salaschenko, director of RTS’s department of interaction with authorities and organisations Photograph kindly supplied by RTS, October 2010.

Starting from October 18, 2010 FORTS, futures and options market of RTS, will start trading on options contracts on Brent oil. What type of investment strategies will the options support and how do you think the options will be utilised? Obviously, the move is directed at investors who will use options to support high-performance strategies on the utilities derivative market and for major Russian oil producers and consumers for hedging against risks related to price fluctuations on the global oil markets. The options spreads Brent/RTSI will give players profits from both the difference in options’implied volatility and discrepancy

in the assets’ movements. The options themselves will be raising the effectiveness of capital use or protect from possible losses. Now there is a straightforward opportunity to hedge a position in the RTS index futures contract with the oil options, which broadening the means for effective reactions to changing market conditions. Sharp short-term movements, typical for the oil market, can be effectively used when buying naked put and call options. A player can also buy an option for the price far from a strike price which reduces expenses on options or use riskier strangle and straddle strategies which create considerable potential in case prices move dramatically (in any direction). These opportunities are best applied when the market fluctuations are extreme. The contracts will also encourage the creation of structured products based on oil. The point of this type of product is in providing risk equal to zero when betting on any movement of the underlying asset price. If you believe that the oil market price is going to rise, you can buy oil options instead of buying the physical oil and deposit the rest of the funds in a bank at interest, which will refund the money used to buy an option. FTSE GM: Trading records have been set on FORTS on the gold futures contract in recent weeks. What were the underlying reasons for the record volume? What are the advantages of gold futures on RTS? RTS Exchange: The growth of trading volume in the gold futures contract is the direct result of the gold price growth and the rising concern over the weakening global currencies (first of all, concerns over the US dollar). Gold has grown in price for the last month by 10% which makes this commodity one of the most attractive investment assets. Exchange players buy and sell futures contracts on precious metals basing on their expectations and prognosis of the gold price. When doing that they can take advantage of all the benefits of exchange-traded instruments on precious

NOVEMBER 2010 • FTSE GLOBAL MARKETS

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STOCK EXCHANGE REPORT

RTS Q&A: UPGRADING SERVICES FOR FOREIGN INVESTORS

metals, such as the absence of VAT (saving 18% as opposed to buying bullions); the favourable price of purchase/sell of exchange-traded contracts (which as a rule, are three to five times more profitable than spreads as opposed to price of purchase/sell from unallocated bullion accounts at a bank); and finally, the convenience of trading, having access to trading via the Internet (naturally, with all appropriate network security rules, as well as the opportunity to trade after office hours, or at least until 23.50 Moscow time. FTSE GM: Volume on FORTS has been rising steadily. How has the exchange contributed to liquidity? RTS Exchange: The exchange closely works with market participants to educate them in the derivatives market opportunities and strategies. The exchange has made concerted efforts to attract new segments of market participants, such as asset management companies and algorithmic traders. Additionally, and partly because of the deepening of trading on the exchange, there has been a noticeable increase from foreign investors coming to the market and helping to raise the liquidity of the Russian market in general. FTSE GM: Does the exchange plan new investible derivatives in either 2010 or 2011? RTS Exchange: Could you please outline the exchange’s plans in this regard? The exchange plans to add to the traded range of financial instruments several futures in different currency pairs. By the end of this year the Exchange plans to launch trading in futures contracts on USD/GBP exchange rate, USD/AUD, and in the upcoming year will introduce USD/JPY and USD/CHF futures. Over the longer term, the exchange is considering a possibility of launching trading in USD/CAD. As for the commodities sector, cash-settled futures on raw sugar will be launched on October 25th this year and plans are well underway to launch trading in copper futures contract later in the autumn. FTSE GM: What are the exchange’s plans to encourage further foreign inward

investment onto the RTS Stock Exchange? In which segments is the exchange focusing its efforts in this regard? RTS Exchange: The exchange has consistently encouraged increased foreign investment, working on two levels. The first is its role in developing a strong regulatory infrastructure for investors. Second, the exchange has collaborated extensively with the Russian Federation in the design, development and upgrading the exchange’s services for foreign market participants. It is actively expanding, for instance, the range of listed products. In particular, the derivatives market FORTS now offers several derivative contracts on currency which give foreign investors an opportunity to hedge currency risks. In the legislative sphere a lot is being done to improve the regulation of the securities market. The exchange participates in the development of draft legislation within defined working groups. To give you an example: in collaboration with representatives of legislative bodies and securities market participants the exchange participated in drafting a proposal to the Draft Law On Prevention of the Illegitimate Use of Inside Information and Market Manipulation which has now been adopted by the State Duma of the Russian Federation. The exchange has also contributed important ideas and concepts to the drafts of the new regulatory act which allows admittance of securities of foreign companies to public offering and distribution in the Russian Federation. FTSE GM: What are the benefits to traders of utilising the RTS Stock Exchange? What are the exchange’s particular strengths? RTS Exchange: There are a number of advantages to trading on the exchange. Not least is the increasing depth of product, as we mentioned earlier, the exchange is now working now to develop a multi-currency settlement feature which will allow market participants to trade and settle in foreign currency. It is also fair to say that the exchange currently offers the widest range of financial instruments with narrow spreads, specifically the spread on futures based on the RTS Index, which is the most liquid

instrument on the Russian financial market, is the tightest: at 0,01% to 0,015%. Russian market volatility allows market participants to successfully realise arbitrage and speculative strategies and also the client base on RTS is constantly growing, with both the number of foreign and domestic players is on increase. Foreign clients (non-residents) on the cash market now represent 72 countries, whereas nonresidents on the derivatives market represent 60 countries, as of the end of the first quarter of this year. FTSE GM: How important is technology at the exchange? RTS Exchange: Obviously the upgrading of trading technologies aimed at improving the efficiency of the market the following features is paramount. Among the leading initiatives the exchange has undertaken is the launch of trading in the most liquid Russian stocks without 100% advance deposits. This is the first cash market of its kind in Russia and is characterised by a portfolio approach to risk management in the derivatives and cash equity markets, standard T+4 settlement and central counterparty technology. Moreover, trading hours have been extended so that international players can make transactions on RTS with Russian securities and derivative instruments within North-American and European trading hours. This enables individuals and professional market participants to manage their positions with regard to global trends well after the closure of day trading on the local market. Advanced technologies such as central counterparty clearing, unified settlement of futures on stocks on FORTS and RTS Standard markets, intraday clearing session, netting and others, have been applied at RTS for quite a long time and have proved to be very efficient. RTS specialists constantly work to improve the services at the Russian securities market and are confident that high trading technologies and the guarantee of the investments safety will play an important role in raising attractiveness of the RTS markets for the international investors.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

INDEX REVIEW

UK CSR: THE IMPACT OF THE COMPREHENSIVE SPENDING REVIEW

According to Simon Denham, managing director of spread betting firm, Capital Spreads, we have been in something of a buy the rumour/sell the fact state of mind in the lead up to the Comprehensive Spending Review (CSR). The question is, whether the measures implemented in the CSR go far enough to fix the issue at hand. The chancellor has the unenviable task of walking a tightrope between dispensing a mild twinge to inflicting excruciating agony. Either way, it is likely he also had half an eye on the polls and the prospects for the Tories at the next election. However, he is in a bind: if he really does what is needed to bring the UK’s finances to heel, then he will likely hand the next election back to the Labour Party.

THE NEW DEAL? HE ISSUE IN play right now is not whether anything is being done about the UK’s overweening debt; but whether enough is being done. The UK’s prized Triple A gilt-edged standard is to be protected at all costs: any movement on this front would substantially increase the percentage of tax revenues going towards interest payments on debt and, in a cascade event, impact the budget deficit even further. This is not an academic problem, as Ireland, Spain and Greece will unhappily testify. Aside from this, activity continues to contract in the UK as politicians fume at bank lending policies. In one sense, this is not just wanting cake but eating it too. The government wants banks to lend “more responsibly” (especially mortgages) and put aside ever more capital in case of disaster. Yet, it still rails at financial institutions because they are not pouring money out into the economy. We cannot have both: more capital means less lending, and higher deposit requirements on house purchases mean fewer sales. Oddly enough, we are currently in a situation where the need for growth is such that it might be more prudent to be actually relaxing capital and liquidity requirements, not tighten them! Even so, I have to admit that

after the events of 2007/09 there is little chance of this happening. The Money Supply (M4) level, a particular bugbear of mine, remains moribund. For all of the QE injection of the past, present (and possibly) future, demand for money is falling as business leaders in the UK view the possible impact of budget cuts. Management can be forgiven for thinking that there is little point in gearing up if their customers might suddenly slash demand; and one strong argument suggests this stalemate could last well into 2012 as the brunt of the cuts filters through the economy. Actually even this will not stop the government blaming the finance sector for every ill wind. What we will see however is that the banks and their staff are starting to get just a little tired of the constant jibes. There are small news stories popping up that quality staff, from across the globe, are not so willing to move to London as in the past (the UK used to be a prized posting) and that any number of treasury operations are already moving out of the European jurisdiction. Implementing decisions that have little to do with economic reality but everything to do with retribution and envy is not sensible or statesmanlike; particularly as economic power is

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

shifting ever eastwards. Britain is in a very difficult position right now as excessive financial rules and regulations (which have very little impact on the vast majority of the European nation states making them) may severely harm an industry which has taken three or four centuries to build and which supplies a very large invisibles trade income to our treasury. Elsewhere, bond markets have rallied to unheard of levels with tenyear yields on nearly all solid sovereign debt now well below 3%. This compares to equity market dividend yield of well over 3% for even gilt-edged stock and this return is mainly calculated on the last year (which was hardly favourable), especially when you note that Lloyds and RBS cannot actually pay anything and are therefore dragging the average down. Currently, markets have been quietly wending their way higher with nearly every asset class at or near to their year highs, propelled by an ever-increasing pool of cheap money, and we face a curious prospect of, on the one hand, the Western economies cutting back on expenditure while, on the other, the Fed, the Bank of England and the European Central Bank are pondering whether to print another trillion dollars or so in quantitative easing. Alice in Wonderland is nothing on reality. As ever ladies and gentlemen, place your bets.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

DEBT REPORT

CLIMBING BACK As the two main markets for structured finance—securitisation and covered bonds—re-establish themselves in a post-crisis environment, there will be far-reaching changes in the way that both operate in future. Andrew Cavenagh reports. HE PRIMARY MARKET for securitisation, which was hit much harder than that for covered bonds, has inevitably taken longer to return. While the Federal government’s Term Asset-backed securities Loan Facility (TALF) programme maintained a much-reduced flow of non-mortgage transactions in the US from early 2009,

FTSE GLOBAL MARKETS • NOVEMBER 2010

the European market remained virtually shut for the first nine months of the year (discounting the large volume of retained transactions that banks hastily structured to access liquidity via the repo markets). This year has seen a sharp increase in the volume of meaningful new issuance, however, as more big issuers of residential

DEBT REPORT: CHANGES AFOOT IN STRUCTURED FINANCE

Photograph © Dawn Hudson / Dreamstime.com, October 2010.

mortgage-backed securities (RMBS)— always the dominant asset class in Europe—have returned to the market since HBOS re-opened primary activity in the sector with its £4bn Permanent 2009-1 issue in September last year. While a trickle of new issues backed by auto loans, credit cards and other non-mortgage consumer receivables up to that point in 2009 brought the total of (non-retained) issuance for the year to €19.4bn, the first nine months of 2010 have already seen €44.6bn of publiclysold transactions. Moreover, there were definite signs in the second half of September that the rate of European RMBS issuance will continue to accelerate in the months ahead. Royal Bank of Scotland, in which the UK government currently owns a controlling stake of over 80%, indicated it would be coming to the market again as it launched a £4.6bn issue out of its Arran Mortgage Funding master trust, the largest RMBS transaction since the crisis. “We are confident that we can build the programme further,” says Stephen Hynes, head of secured funding at RBS Group Treasury. Meanwhile, Lloyds TSB, the other UK bank in which the British taxpayer holds a majority stake, is also following up the £2.5bn RMBS issue it launched in January with a second deal before the year end—which will be the first European RMBS transaction to include a yen-denominated tranche. Perhaps the most positive signal that the big issuing banks believe a functioning market is on the way back came from Spain’s Santander, which inherited two large UK RMBS programmes with its acquisitions of Abbey National and Alliance & Leicester in 2004 and 2008 respectively. The Spanish bank, which has already issued four deals worth over £8bn out of Alliance & Leicester’s Fosse RMBS master trust this year, took steps in the first half of October to place a further £6.9bn of new bonds in the market in the coming months out of the Holmes master trust, which Abbey set up. Santander redeemed various

DEBT REPORT

DEBT REPORT: CHANGES AFOOT IN STRUCTURED FINANCE

Holmes issues for this amount that it had structured and retained since mid2007 to ensure Abbey (now renamed after its parent bank) had sufficient liquidity over the next two years (via the Bank of England’s Special Liquidity Scheme), and ABS analysts read the move as a clear sign that Santander now believes it can place this volume of paper with investors. Vanessa Hardman, securitisation partner at Allen & Overy, who advised Santander on the Fosse issues this year, says there was still a clear need for banks to securitise their assets and investor confidence in the asset class was obviously continuing to improve. “We think the outlook is optimistic, although there will be no quick return to the levels of activity seen in mid-2007.” Even non-prime RMBS issuers are looking to the market once more. After Bank of America pulled its planned £744m Moorgate Funding 2010-1 issue in August, the specialist UK buy-to-let lender Paragon Mortgages announced in late September that it was re-opening its origination business after securing a £200m warehousing facility from Macquarie Bank. Paragon made the announcement after staging a number of non-deal roadshows, during which it determined there was sufficient investor appetite for BTL risk. The big UK originators are also under some pressure to revive the market, as they will need to refinance a large volume of maturing RMBS in 2011. JeanDavid Cirotteau, credit strategist at SG Corporate and Investment Banking in Paris, says he expected redemptions from the UK master trusts alone to total at least £50bn next year. The problem for issuers is that, despite the clear improvement in demand, the investor base for RMBS has shrunk dramatically since they were issuing bonds in those volumes. The investor base remains fragmented with a limited number of accounts that have differing investment objectives. Cirotteau said the flurry of issuance out of the UK in the last quarter had consequently saturated the market for

Vanessa Hardman, securitisation partner at Allen & Overy. She stated that there was still a clear need for banks to securitise their assets and investor confidence in the asset class was obviously continuing to improve. Photograph kindly supplied by Allen & Overy, October 2010.

the time being. “I think for 2010 we have nearly exhausted this capacity,” he maintains. “Obviously it will now be more difficult to place much more this year.” This has forced issuers to look further afield for investors, and some of the 2010 deals have had a heavy dollar component; the recent RBS Arran issue had three tranches denominated in the US currency totalling $2.73bn, 8.5% of the total deal by value. The same consideration was behind Lloyds’ decision to tap the Japanese market with its upcoming issue. The appetite of US investors for European RMBS— in the continuing absence of any domestic product (as the American housing market remains at an all-time low)— is mostly restricted to short-term

paper, and it remains to be seen where the required numbers of longer-term investors will come from. Another big change in the market is the cost of debt. Spreads relative to the Libor and Euribor benchmarks are wider by a factor of five or six over the levels of around 20 basis points (bps) that prevailed before mid-2007, and those days have almost certainly gone for good. The experience so far this year suggests issuers will be paying spreads in the 110bps-160bps range—depending on the weighted average life (WAL) of the bonds—for the foreseeable future. However, this is not proving a deterrent to issuance at present, given the benchmarks remain at historic lows and the overall cost of funding still makes sense, as banks have restored their margins in mortgage lending. In the US meanwhile, the ending in March of the TALF programme for most asset classes has not halted a flow of issues backed by non-mortgage collateral: prime and sub-prime auto loans, student loans, equipment loans and leases, tax liens, and CLOs (collateralised loan obligations). The week beginning September 20th was particularly active, with 12 new issues totalling $9.6bn, although year-to-date issuance at the month end was slightly down on 2009, at $102.4bn against $116bn, mainly due to a lower level of credit-card transactions. Another encouraging sign in the US market is that while there is little prospect of a resumption of domestic RMBS issuance in the near-to-medium term, commercial mortgage-backed securitisation (CMBS) is starting to come back slowly. JP Morgan has led the way, and the bank’s $1.1bn issue in September—the largest so far this year— has led analysts to project a total of $11bn for the sub-sector in 2010 (although that figure would still represent a tiny fraction of the $230bn issued in 2007). Covered bonds, by contrast, have seen strong levels of primary issuance since European Central Bank’s €60bn purchasing programme to support the market ceased at the end of June.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

After Bank of America pulled its planned £744m Moorgate Funding 2010-1 issue in August, the specialist UK buy-to-let lender Paragon Mortgages announced in late September that it was re-opening its origination business after securing a £200m warehousing facility from Macquarie Bank. German, French, Dutch, Italian, UK and Scandinavian banks have all issued further bonds in the subsequent months, and overall issuance for the year had reached €168bn in the first half of October. A notable difference in the market, however, is the degree of spread differentiation between jurisdictions, which largely reflects investor concerns about sovereign debt. Consequently, spreads on German pfandbriefe and Dutch bonds have tightened sharply against those of the peripheral European countries. This enabled German mortgage bank Munchner Hyp, in the final week of September, to price a three-year pfandbrief backed by public-sector loans at just one basis point over mid-swaps, the lowest level seen on a new benchmark issue in two years. By contrast, the spreads on Greek and Irish covered bonds shot out to more than 200bps over the swaps benchmark, and the cedulas of the leading Spanish banks such as BBVA and Santander are trading at levels so close to that of their senior unsecured debt they say it no longer makes sense for them to issue covered bonds (given the latter markets remains open to them). Tim Skeet, a covered bond expert who is currently advising the International Capital Markets Association, says the narrowing differential reflected investor concerns in part about the underlying assets, which were not always easy to identify in Spanish portfolios. “Gone are the days when investors would or could just buy without doing the credit work,” he explains. “Covered bonds, like every asset class, now have a credit component.” The really interesting development in the market, however, has been the growing appetite of US investors for the instruments. Non-bank American institutions have bought $18.6bn of

FTSE GLOBAL MARKETS • NOVEMBER 2010

bonds issued by Canadian and European banks so far this year, and demand keeps growing. At the end of the first week in October, Norway’s DnB NOR became the fourth European bank to issue a dollardenominated bond in 2010, with a $2bn, five-year instrument that was priced at 68bps over mid-swaps. The deal followed earlier issues from Barclays, CFF and Svenksa Handelsbanken, and several Canadian banks, including CIBC, Royal Bank of Canada, Toronto Dominion, and Bank of Nova Scotia. The surging demand has come from non-bank investors—big sophisticated funds with the resources to carry out the necessary analysis—who are attracted by the yield pick-up that the triple-A rated instruments offer over US Treasuries and agency paper. “It represents the biggest potential increase in the [covered bond] investor base,” maintains Skeet. It also, no doubt, reflects frustration that the US government has yet to enact a legislative framework for the instruments. An attempt to tack the necessary enabling legislation on the Financial Reform Bill earlier this year failed largely because the Federal Deposit Insurance Corporation (FDIC), which protects depositors in bank insolvencies, is objecting to the structural subordination of the overcollateralisation in the cover pools. “It proves there’s a market in the US for it and that investors want it,” holds Skeet. “It’s ironic that European banks can fund their mortgage lending from US investors in this way but US banks cannot, for now, at least.” A further consideration for both the covered bond and securitisation markets is the impact of impending European legislation. The provisions of the Basel III capital accords and the European

Tim Skeet, a covered bond expert who worked at Merrill Lynch, said the narrowing differential reflected investor concerns in part about the underlying assets, which were not always easy to identify in Spanish portfolios. Photograph kindly supplied by Bank of America Merrill Lynch, October 2010.

Union’s Capital Markets Directive, which takes effect from the beginning of 2011, will potentially make it more expensive for banks to hold ABS—particularly lower-rated tranches—and the extent to which this deters market activity remains to be seen. However, most analysts expect the measures will be “spread neutral” for covered bonds. Meanwhile the Solvency II Framework for insurance companies, which is due to take effect in October 2012 and impose spread-risk charges on their investments in accordance with their ratings, should favour investment in covered bonds over their corporate equivalents as it will impose a slightly higher capital charge (0.9%) on triple-A corporate bonds (of which there are now only a handful) that similarly rated covered bonds (0.6%).

DEBT REPORT

EUROBONDS: EMERGING MARKETS EXPLOIT G7 WEAKNESS

Photograph © Roy Mattappallil Thomas / Dreamstime.com, supplied October 2010.

THE BIG SURGE The past three months have seen a surge in Eurobond issuance from emerging-market countries, with the promise of a lot more to come as both corporate and sovereign issuers take advantage of huge demand for their paper to secure as much medium and long term debt as they can at interest rates that are near record lows. Andrew Cavenagh reports. OVERNMENTS AND COMPANIES have issued well over $150bn of dollardenominated bonds this year, as unprecedented volumes of capital continue to flow into emerging-market funds. “Money is just pouring in,” says Marc Ostwald, strategist on the institutional bond desk at Monument Securities. “People don’t want lowyielding, high-risk G7 assets.” According to figures from EPFR Global, the international market data firm based in Cambridge, Massachusetts, net investment in emerging-market bond funds over the first nine months of 2010 totalled $39.5bn against $1.6bn for the comparable period of 2009. The inflow

has been much greater than this, however, as the figure does not include investments by credit and cross-over funds. “It’s very difficult to know how much money is going into emergingmarket debt,” says Mike Riddell, who manages the M&G International Sovereign Bond Fund. “Even so, the demand for it is absolutely phenomenal.” The eurobond market offers investors who are disenchanted with the minimal returns on offer in the US and Europe the twin advantages of enhanced yield and exposure to countries with a much better economic outlook than the industrialised world. It offers these advantages without the costs of setting up the clearing and settlement accounts they

would need to invest locally.“It’s just what people now want,”says Ostwald. On the corporate side, Russian institutions have been among the most active this year, racking up $12.1bn of issuance by the end of September. While it has been the country’s banks that have issued most of the debt so far, with the largest lender Sberbank and Alpha Bank each selling a further $1bn worth of bonds in the third week of September, big non-financial companies are now following their lead. The country’s leading steelmaker Severstal, the diamond monopoly Alrosa, and shipping group Sovcomflot all came to the market in the second half of October, with issues totalling almost $3bn and maturities ranging from seven to 10 years. The giant statecontrolled gas monopoly Gazprom also awarded JP Morgan and Calyon the mandate to arrange a $1bn issue to be launched in November, in what will be the company's first sale of longterm international debt since July 2009 (although it placed a €600m commercial paper programme just over a year ago in September). While emerging-market governments surprisingly made less

NOVEMBER 2010 • FTSE GLOBAL MARKETS

use of the market in the first nine months of 2010 than they did in 2009, the year has nevertheless seen some highly significant developments in their issuance of sovereign debt. One was Mexico pushing out the envelope on tenors in the first half of October, when it sold a $1bn bond with a 100-year maturity (please refer to page 45) the longest on record for a Latin American country. The only previous 100-year emerging-market sovereign bonds were issued by China and the Philippines in the second half of the 1990s. The Mexican finance ministry reported that the issue was 2.5 times oversubscribed—a reflection of the current strength of demand for emerging-market debt. Brazil is now expected to follow its example with a bond of the same or similar maturity. In Africa, meanwhile, the government of Nigeria has appointed Barclays Capital to advise it on the launch of a debut $500m bond before end of the year. The announcement came the week after Morocco successfully placed a $1bn, 10year instrument (its first since 2007) and several other African countries, including Ghana, Tanzania, and Kenya, plan to issue eurobonds in the months ahead to help finance their infrastructure programmes. The cost of debt that emerging-market sovereign and corporate issuers have been able to achieve this year has been way below what they could have hoped to realise just 18 months ago thanks to the combination of US and European interest rates remaining at record lows and the burgeoning investor appetite. Moreover, the pricing on issues is continuing to fall. The coupon on Mexico’s 100-year instrument was 5.75%, and the bond was priced to offer a yield of 6.1%, below the 6.22% at which the Mexican government sold 30-year bonds in April. Sberbank was also able to place its recent $1bn, seven-year bond at a yield of 5.4%. The downward pressure on pricing looks set to continue, as the credit ratings of most of the large

FTSE GLOBAL MARKETS • NOVEMBER 2010

Emerging markets issues league table: (eurobonds only) YTD

Rank

Book Runner equal to each book runner*

Proceeds Amount + Overallotment Sold This Market (US$ Mil)

Market Share

Number of Issues

JP Morgan

13,449.5

9.6

Citi

13,379.0

9.5

Deutsche Bank AG

13,210.3

9.4

HSBC Holdings PLC

12,539.5

8.9

Barclays Capital

11,052.6

7.9

Credit Suisse

10,586.2

7.5

BofAML

7,528.1

5.4

RBS

6,923.9

4.9

31 19

Morgan Stanley

5,456.8

3.9

BNP Paribas SA

4,754.4

3.4

Goldman Sachs & Co

4,300.4

3.1

Standard Chartered PLC

4,084.4

2.9

VTB Capital

3,950.6

2.8

UBS

3,254.7

2.3

Santander

3,237.4

2.3

Itau Unibanco

2,978.3

2.1

Banco do Brasil SA

1,648.6

1.2

Banco Bradesco SA

1,460.2

1.0

Credit Agricole CIB

1,364.9

1.0

Qatar National Bank

1,153.5

Societe Generale

1,111.6

DZ Bank

1,010.1

National Bank of Abu Dhabi

836.2

ING

831.4

Oversea-Chinese Banking

663.5

100.0

225

140,384.2 *Ex. related to ECM Issuer.

emerging-market corporations continue to improve. Moody’s indicated at the beginning of October that it may upgrade China’s A1 sovereign rating, along with those of several smaller emerging-market countries such as Turkey, Colombia, Paraguay, Bolivia and Uruguay.

Investor concern The tide of emerging market eurobond issuance is starting to concern some investors and analysts, however, who fear that the increasing flood of money into these countries will create serious asset bubbles as too much capital chases too few assets. While this is a clearly a bigger risk for equities than bonds, some

Source: Thomson Reuters, supplied October 2010.

believe the pricing on recent issues is starting to make the latter look expensive. Bhanu Baweja, head of the emerging market strategy team at UBS in London, says that while the balance sheets of emerging market sovereigns and companies have been in “pretty good shape”, spreads had now reached very low levels, which is a warning sign.“This is the sort of market in which emergingmarket asset bubbles develop, and although we are not there yet, I certainly think credit markets are being a little complacent here.” Justin Urquhart Stuart, marketing director at Seven Investment Management, says he thought emerging-market

DEBT REPORT

EUROBONDS: EMERGING MARKETS EXPLOIT G7 WEAKNESS

investors had “pushed a good story too far”particularly in Asia and should now start exercising more caution.“If the risks of loss are increasing, don’t do it,” he cautions. “There’ll be time to buy back in later on.” One big concern for investors as the glut of issuance continues is the impact that a sudden precipitous slide in the value of the US dollar could have on the economies and financial stability of many emerging-market countries. The risk of a dollar collapse is widely seen to be increasing, as the Federal Reserve embarks on a second round of quantitative easing and political momentum gathers in some quarters of Washington over a currency war with China. The US currency’s sharp slump on October 14th against the euro, sterling and in particular, the yen (which hit a 15-year high against the dollar) began reinforcing fears.

Inflation and its effects A dramatic devaluation of the dollar would further fuel inflation in emerging markets, due to the dominance of dollar in the global pricing of oil and other commodities. Any surge in the price of energy and food will hit the emerging countries disproportionately harder than the industrialised world, because the poorer a country is in per-capita wealth terms, the higher the percentage of its spending inevitably goes on those two items (two thirds in the case of India). Since, energy and food“form a much larger part of their inflation basket, it’s going to hit their economic growth as well,” holds Riddell at M&G. “I’m concerned about the inflation problem building in emerging markets, although it’s probably two years away.” Runaway inflation in these countries would soon see the flow of foreign capital reversed and a sharp and rapid depreciation in their currencies. This could invariably raise the spectre of further foreign-debt crises for many, as the cost of servicing debt denominated in other currencies might quickly become insupportable. These considerations are already leading some investors to be

Justin Urquhart Stuart, marketing director at Seven Investment Management, says he thought emerging-market investors had “pushed a good story too far” particularly in Asia and should now start exercising more caution. “If the risks of loss are increasing, don’t do it,” he cautions. “There’ll be time to buy back in later on.” wary of the long-maturity bonds on offer. Riddell for one cautions that his now limiting his emerging-market investments to shorter-dated debt and currency positions. Whether or not such a crisis occurs in the near-to-medium term will depend heavily on the outcome of the dispute between the US and China over the relative valuation of the dollar and yuan. The issue was the dominant theme of the International Monetary Fund’s (IMF’s) October meeting in New York, as IMF president Dominique StraussKahn warned of the dire consequences of a currency war. The problem is that the two countries now epitomise the diametrically different situations and objectives of most of the G7 and the emerging markets. On the one side, there are huge trade surpluses, foreign reserves, low indebtedness, but low per-capita wealth (China, despite having the second highest GDP in the world, is still the 99th ranking country on this basis). On the other, there is an enormous gross national debt and budget deficit, serious socio/economic funding issues (such as future pension provision and benefit entitlements) but high (largely debt-financed) net individual worth. The Chinese recognise that the yuan needs to appreciate to reflect the current balance of global trade, but they are adamant that the process will be a gradual one and are not going to allow sudden or sharp adjustments to bail the US out of its problems. However, several commentators have pointed out that there can only be one winner of a currency war between the two, given there is ultimately no limit to the amount of money the Federal Reserve can print. A dramatic devaluation of

the dollar would also hit China’s massive reserves of the US currency. The markets face a nervous period while this struggle plays out.

Reducing dollar exposure As it does so, the leading emergingmarket countries, led by China, Russia, and Brazil, are all looking to reduce exposure to the dollar by expanding the use of their own currencies for settlement. The swap lines that the Bank of China has set up with its centralbank counterparts in countries such as Brazil and Mexico to limit the dollar requirements for trade finance between their countries is one example. There are also initiatives under way to establish regional currencies for Asia, the Middle East and Latin America, although the present difficulties in the euro-zone have obviously not helped these efforts. The Russian government is also planning its first overseas sale of roubledenominated debt, possibly the equivalent of $3bn, to boost the currency’s position in global bank reserves. Finance minster Dmitry Pankin said in September that he hoped the necessary enabling legislation would be in place by the end of November, although no timing for the sale had yet been set. Three smaller countries, the Philippines, Chile and Columbia have already raised a total of around $2.8bn from international sales of locally denominated bonds this year, as the continuing rally in emerging-market domestic bond market has seen it improve by 54% over the past 18 months.“They know that their currencies are probably going to go up in the long run,” says Ostwald at Monument Securities.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

Mexico broke new ground in October by issuing a 100-year sovereign bond to tap $1bn from international investors. It was the first ever century bond put into the market by a Latin American sovereign and the largest 100-year bond ever issued, according to the Mexican government. For analysts, it was a bold and opportunistic move that took full advantage of current market conditions. The Mexican authorities, for their part, have claimed that the operation shows that global markets have confidence in the prospects of the country. LTRA LONG BONDS are gaining traction and the PR noise emanating from Mexico's finance ministry reflects the growing popularity of the 100 year novelty deals. The issue was 2.5 times oversubscribed, and demand was so strong that, at the last moment, the government decided to add $100m to the original $900m issue. The bond offered an interest rate of 6.10%, with a 5.75% coupon. Not bad for a country that has just celebrated its 200th anniversary, and which during the past 100 years has faced more than its fair share of revolutions and financial crises (not to mention debt defaults) and which some analysts fear could become a narco-state. Even so, the Mexican sovereign has tapped a wellspring of goodwill following efforts by the government to tame spending and reduce its debt obligations, especially foreign debt. The government has some reason to crow: in 2000, the amount owed to foreigners amounted to 45% of total government debt, while today it is the equivalent of a much more amenable 19.4%.

Less risk aversion Global investors also appear to be much less averse to emerging market risk than in previous years. The bond confirms that emerging markets are currently in a better shape than developed economies,” says Claudia Calich, the

FTSE GLOBAL MARKETS • NOVEMBER 2010

Photograph © Hugolacasse / Dreamstime.com, supplied October 2010.

head of emerging markets at Invesco in New York. However, it also reflects a market where opportunities to achieve decent returns are becoming increasingly scarce.“This bond tells us more about global risk appetite than about the Mexican economy,” says Enrique Alvarez, head of research for Latin American financial markets at IDEAglobal in New York. “Mexico is not one of the fastestgrowing economies in Latin America,” Alvarez points out. “It has some fundamental problems and a very high degree of dependency on the United States. Yet, markets received the bond well because there is a growing need for yield and there remains a very low

MEXICO'S 100-YEAR-BOND: WILL BRAZIL FOLLOW?

MEXICO OPTS FOR ULTRA LONG BOND

level of availability of new issues from established names in the emerging market spectrum.” As if to underscore the point, he 6.10% interest rate on the bond, although pretty bearable for the government (in April the government had issued a 30-year bond paying 6.22%) must have looked very enticing for investors trapped in the bottom-low rates of rich world sovereigns. Not surprisingly, most of the bonds were reportedly swallowed up by American institutional investors, in particular insurance companies, which are partial to ultra long maturity securities. Nonetheless, the Mexican government deserves some kudos from getting the deal away, holds Alvarez.“The Mexican authorities have been very clever and taken advantage of very low current benchmark yields,”he says. The century bond may have been the most conspicuous example of its daring approach, but not the only one. Alvarez notes that they have recently issued securities taking advantages of peaks in the value of the dollar and the strong yen. By pushing a 10-year Samurai bond in Japan to raise about JPY150bn, Mexico expects to take advantage of the current high value of the yen, which the Japanese government seems determined to bring down. As the yen depreciates, the burden of the bond will be less heavy for Mexico to carry, Alvarez explains. The best might be behind the government now: it is unlikely however that Mexico will tap the markets any more until the end of 2012, and by that time the brouhaha around emerging capital market issuance might be very different. In the short term however, other Latin American countries appear keen to emulate Mexico’s success. According to Calich:“If they decide to follow the same route, other emerging markets won't issue long term bonds as cheap as Mexico's, but I believe there would be demand for them anyway.” Alvarez believes the time is riper for some than others; for instance, he says:“a very long-term Brazilian bond would be absolutely devoured by the market right now.”

COUNTRY REPORT

BRAZILIAN BANKING: SPOILT FOR CHOICE?

MULTI-FACETED GROWTH Brazilian banks are living a golden age. A consumer boom and high spreads on loans are lifting profits and rushing leaders up the ranks of the top global banks. A more thrusting, international corporate sector is luring Brazilian banks overseas to serve this blue chip client base. To fully capitalise on these opportunities, banks need to balance domestic and overseas opportunities carefully, however. They also have to keep a close watch on resurgent public banks and negotiate Brazil’s boisterous economy. John Rumsey reports. HE RICH PICKINGS that have fed into the Brazilian banks are reflected in their global rankings. ItaúUnibanco, the country’s largest private sector bank, has become number ten in the world by market capitalisation. It continues to have the most valuable brand in Brazil according to Interbrand, which today values it at BRL20.7bn ($12.5bn), a figure that has doubled since 2008. In part, the good times enjoyed by the country’s banks are a natural consequence of being ring fenced from any real competition. The market is dominated by local banks, which have been shrinking in number thanks to sector consolidation. Itaú’s merger with Unibanco and Santander’s purchase of ABN Amro’s Brazilian business are just two examples. Moreover, the continental size of Brazil has effectively deterred new entrants from building organically while sky-high share prices and a lack of sellers mean that there are unlikely to be large acquisitions from banks abroad, most of whom are still nursing wounds inflicted in the crisis.

Rip-roaring mood Meanwhile, the Brazilian economy continues to be in rip-roaring mood, and although there was a slowdown in the second quarter that is seen as natural after a spectacular first three months. Most economists are predicting a return to sustainable, if less spectacular, growth

in the third quarter. Overall, this year growth is expected to be 7.5%, according to Itaú-Unibanco. Longer-term predictions see sustainable annual growth of around 5%. ”Spreading the benefits of growth across different segments of society has been a boon for domestic demand. With the economy expected to grow by 8% this year, we believe that retailers, real estate companies and banks should continue to prosper. On the campaign trail Dilma [Rousseff] has indicated that she will promote many of [president] Lula’s pragmatic policies, including government support for lowincome housing (good for homebuilders), government financing of student loans (good for education companies) and further investment in infrastructure, especially in advance of hosting the 2014 World Cup and 2016 Olympics Games,” says Dean Newman, head of emerging markets equities at Invesco Perpetual. The consensus view that Brazil is enjoying a Goldilocks recovery is not shared by all economists, however. The more pessimistic ones believe that the warning light is already flashing amber with industrial production figures at an unsustainable 15% to 20% in recent months and higher inflation than the central bank’s target. May’s inflation came in at 5.22% over a year earlier, the fifth consecutive month above the bank’s 4.5% target.

These economists also point to the interest rate tightening cycle which has seen the base Selic rate head back to 10.25% from 8.75% at the start of the year. They point out that although inflation is currently subdued, generous wage settlements and easier credit are pushing up consumption. Moreover, the trade balance is worsening as the high real encourages imports. If the government is unable to subdue the currency, Brazil could face a balance of payments crisis in a couple of years, they postulate. There are few signs of a slowdown to date and the domestic credit market continues to be the largest driver of profits for Brazilian banks. Lending has been steadily increasing and outstanding credit reached BRL1.53trn in June, up 2% in a month and 19.7% over a year, according to data from the Central Bank of Brazil. In the cards market, revenue per card posted a significant increase of 5% in real terms in the second quarter which, together with a 7.75% increase in the number of cards, accounts for a major increase in the revenue of this segment, according to Itaú’s second quarter report. The credit market was dominated by private banks, but the crisis curbed their appetite and, spurred on by the government, public banks have grown portfolios hugely. Indeed today, stateowned banks are in top slots in both assets and lending.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

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

Leading the pack by assets since the second quarter of last year has been Banco do Brasil, followed by Itaú, Bradesco and Santander. In the first quarter, the state-owned bank controlled BRL710bn or 22% of the total assets, according to data from the central bank and mergers and acquisitions boutique Queluz Gestão de Ativos. Banco do Brasil also leads in credit, according to Ivan Monteiro, the bank’s chief finance officer. The bank expects the total market for credit to hit BRL2trn by year-end, an increase of 17.7% in one year. In the year to March, the bank’s credit portfolio grew 26% when contributions from the acquisition of Banco Votorantim which is now included in the bank’s figures, he notes. Spreads continue to be extremely generous at 28.9% in July this year, according to Central Bank data, making Brazil a world leader in the amount it charges clients to take out loans. However, they have been consistently falling. Spreads were at 31.87% at the start of the year compared to 50% at the start of 2004, for example. That is slowly turning credit from a high margin to a high volume business. Brazilian bankers like to point out that overall loan-to-GDP ratios in Brazil are conservative compared to other countries, particularly the developed world where households are deleveraging. At 45.3%

FTSE GLOBAL MARKETS • NOVEMBER 2010

of GDP in May, credit in Brazil lags other developing nations such as the UK that has seen rates top 100%. Even Chile has a credit-to-GDP ratio of over 60%, points out Monteiro. The overall ratios may be low but the very high base interest rates and whopping margins in Brazil put a natural curb on credit: customers that have the financial means to do so prefer to pay in cash. There is increasing awareness among sophisticated consumers of the very high levels of interest they are incurring thanks to growing media attention. That is accelerating a move by banks to hunt further down the social scale for consumer hungry individuals who have been starved of credit and are willing to pay up. Celina Vansetti-Hutchins, analyst at Moody’s in New York, points out that as all banks have been chasing the safest markets, especially payroll deducted loans, and the new leg of credit growth involves a poorer and less sophisticated layer of consumers, who are often accessing loans for the first time. The ability of these customers to pay back remains untested, she notes. “We have not seen the seasoning of these credit portfolios. There may be a whole new trend of delinquencies in these lower classes,” she fears. As yet, there are few signs of deterioration at the Banco do Brasil with indicators of allowance for loan losses over 90 days decreasing, ending the first quarter at 6.7%, 20 basis points less than December last year. Finally, banks continue to be constrained by high reserve requirements and taxes. Reserve requirements were eased during the crisis to stimulate lending but the central bank has been raising them again. In March, it increased compulsory deposits, for example.

Formulating plans The boom times in domestic markets are leading to substantial investments by banks to capture this market. At the same time, the internationalisation of Brazilian companies is compelling them to look at how they can follow clients overseas. The cream of Brazilian companies are now international and spanning an ever

greater array of industries. These are not just the obvious candidates which are known outside of Brazil, such as state oil company Petrobras and iron ore mining giant Vale together with the steel industry that grew up around cheap iron to take advantage of prices. Today, the Brazilian meatpacking industry boasts the largest companies in the world, including Marfrig and JBS Friboi. Soft commodities from the sugar/ethanol complex, to soy and coffee and orange juice also continue to grow fast. IT and technology companies, such as Totvs and TIVIT, are busy carving out niches overseas. They are increasingly demanding a global banking presence.

Regional expansion Itaú is a case in point: the bank is focused on integrating Unibanco and is formulating plans to expand abroad in areas such as capital markets banking. The bank is focused on regional expansion and already has a presence in many of Brazil’s neighbours. Still, the bank’s international operations account for just over 15% of its total. Bradesco meantime has been more cautious still. Its executives believe that Brazil offers richer pickings than are available abroad with faster corporate banking at home and opportunities arising in infrastructure, especially with the planned World Cup and Olympics events in Brazil. All that manoeuvring has allowed Banco do Brasil to take the lead. Monteiro explains that Banco do Brasil overseas aims to be a “niche bank that will provide solutions for Brazilians and for Brazilian companies”. The bank purchased a 51% stake in Banco de Patagonia in Argentina for $480m earlier this year and is looking to pursue a policy of following Brazilian companies and communities abroad. Brazilian communities are concentrated in selected states of the north-east of the United States and Florida, as well as Japan and Portugal. Many analysts question the bank’s strategy. They see little reason for a foray in Argentina thanks to erratic politics and the small size of the economy. “I can see no reasons to be in Argentina except for political ones,” says Plinio Chapchap,

COUNTRY REPORT

BRAZILIAN BANKING: SPOILT FOR CHOICE?

partner at Queluz Gestão de Ativos and professor of finance at Profins Business School. Moreover, the middling size of Banco Patagonia as well as its commercial focus and limited geographic reach does not make it the best entry to the country, adds Vansetti-Hutchins. “It doesn’t make much sense for Banco do Brasil to expand aggressively outside Brazil with so many opportunities at home.” Monteiro argues that Argentina is vital for Brazil in this regard and many of the largest companies there are Brazilian, making the bank’s presence indispensable. Recent bond spreads suggest the economy is less risky than European countries such as Greece, he notes.

Economic growth

Dean Newman, head of emerging markets equities at Invesco Perpetual. ”With the economy expected to grow by 8% this year, we believe that retailers, real estate companies and banks should continue to prosper,” he says. Photograph kindly supplied by Invesco Perpetual, October 2010.

The rapid growth of the domestic capital markets and Brazilian corporate appetite for foreign expansion is also forcing banks to balance growth at home and overseas in their brokerage and investment banking arms. Itaú Securities, the most successful Brazilian bank capital markets franchises, has expanded in centres such as New York and Tokyo. However, this appears mostly to be able to serve Brazilian companies rather than compete headon with large global banks. It has grown in New York and is providing equities coverage in Latin American countries outside Brazil. The overall idea is to offer Brazilian multinationals more products and get into syndicates with US banks to distribute debt, equities and ADRs of Brazilian companies. Santander is uniquely positioned as a large global retail bank with a significant presence in Brazil. The country is becoming a centre for financial transactions in Latin American business throughout the region, says João Teixeira, executive vice president. The bank anticipates sustained economic growth and higher growth in capital markets as Brazilian companies still have a long way to go to access multiple sources of funding, he says. The Brazilian economy is entering a new phase of large investments and, as the growth spurt in industry means that utilisation is close to capacity, companies

need to invest heavily just to keep expanding, he says.“Companies need to raise long-term capital, they can’t just depend on short-term instruments any more,” he believes. Furthermore, the infrastructure needs implied by the World Cup in 2014 and Olympics in 2016 require major public investments, too. Much of the investment will come from foreign investors who dominate Brazil’s equity markets. That puts banks with a retail presence in Brazil and distribution overseas in a key position to exploit opportunities, thinks Teixeira. Moreover, a growing number of multinationals are planning to list their Brazilian subsidiary on Bovespa as the multiples are higher than local markets to reflect relative economic growth, says Teixeira, who is in talks with a number of companies planning such a strategy. Santander itself carried out an IPO of its Brazilian business last year, raising $7bn. A drive to develop Brazilian Depository Receipts to attract more international companies will diversify Bovespa offerings further, says Teixeira. “There is a very significant movement to modernise the structure of capital markets,” he says. That is adding to pressure on local banks to develop their investment banking capacity at home and overseas simultaneously. International investment banks have

been ploughing funds into developing capital markets franchises with top salaries in São Paulo now substantially above those in New York, making the development of a full service investment bank an expensive proposition. A final consideration is the evolving role of politics, a vital consideration in a country where a strong industrial policy is rapidly becoming a cornerstone belief. State banks have long enjoyed privileges. They have cheaper access to funding than their private sector rivals because they have access to government business, such as judicial accounts, where interest payments are very low. That gives them a cheaper deposit base. Monteiro does not see the state banks losing this privilege and says that private banks will find it impossible to match the low loan rates that Banco do Brasil can offer customers.

Political control State banks don’t have it all their own way, however, and often have to follow the fiat of government policies. Banco do Brasil’s old management knows this all too well: when they resisted government moves to step up lending in the crisis, many were fired or quit, including president Antonio Francisco do Lima Neto. The question of political control and manipulation always hangs over the bank and explains why its shares trade at a discount, says Vansetti-Hutchins.“The question with Banco do Brasil is always: Who’s really in control?”she says. Dilma Rousseff, favourite candidate to win the end of October presidential runoff, has said little about the role that state banks will play under her government. Whichever way the presidential elections fall, most analysts see more intervention and the promotion of selected Brazilian multinationals abroad. That suggests state banks may get more access to cheap funding but suffer from more intensive government intervention. Brazilian banks need to weigh up myriad opportunities to position themselves for coming years; those that get it right will consolidate their leading positions. No wonder bankers display both optimism and anxiety about their future.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

BRAZIL HFT: EFFORTS TO BOOST ELECTRONIC TRADING MAY SNAG

HE BM&FBOVESPA markets have come a long way in a short time. Volumes have more than quintupled in six years on Bovespa where daily trading volumes are expected to hit BRL6.5bn (£2.46bn) per day this year while volume at the BM&F has more than tripled and should reach 2,543m contracts per day. That comes in spite of the 2% tax suddenly imposed on foreigners in October 2009 and the subsequent 1.5% tax slapped on American Depository Receipts (ADRs). The BM&FBovespa believe that the government is not mulling further tax measures to kill the golden goose of capital markets. After all, it wants investors to pay for the country’s huge infrastructure needs. They include the stadia, airports, local transport and housing associated with the 2014 World Cup and 2016 Olympics as well as the $225bn in pre-salt capitalisation for Petrobras. More sceptical economists point out that the continued strength of the real, which was cited by the government for the transaction tax in the first place, is continuing to infuriate Brazilian industry. Political pressures to protect vulnerable sectors and keep Brazil competitive may push the government to step up the tax to prevent portfolio investment and “hot” money if the currency strengthens, they argue.

Photograph © Deniscristo / Dreamstime.com, supplied October 2010.

CHOOSING BETWEEN HFT PLATFORMS Phenomenal trading growth has generated enough liquidity on the mercantile and futures exchange, BM&F, and stock market, Bovespa, to allow quants to flourish and even the first highfrequency trading strategies to sprout. The exchange is investing heavily to encourage electronic trading with more capacity and faster speeds while maintaining its respected, safe platform. High trading and co-location costs, restrictions on high-frequency trading (HFT) market making, and a lack of quant fund expertise will hamper these efforts.

FTSE GLOBAL MARKETS • NOVEMBER 2010

Stepping on the gas Whatever the tax outcome, the exchange is working to draw in new investors. One of its stated aims is to entice five million Brazilian retail investors over the next four years. That will help diversify the investor base and dampen volatility. At the same time, the exchange wants to build a more international platform. It is working to position São Paulo as a Latin American hub as well as kick-start the Brazilian DR market by getting foreign blue chips listed on Bovespa and encouraging the listing of exchangetraded funds (ETFs), says Christian Zimmer, superintendent of quantitative research, Itaú-Unibanco in São Paulo. The seven existing ETFs turn over about

COUNTRY REPORT

BRAZIL HFT: EFFORTS TO BOOST ELECTRONIC TRADING MAY SNAG

BRL30m per day and new funds will have greater specificity, for example, tracking the financial sector, he notes. The exchange has made significant investments in its electronic trading platforms too with investments worth some BRL300m this year, says André Demarco, operations officer and director of operations at BM&FBovespa in São Paulo, the third largest exchange in the world in terms of market value. Until the end of this year, BM&FBovespa aims to be able to process three million trades per day on the equities segment, a doubling in a year. Over the same period, the futures market BM&F will also double its capacity to 400,000 trades per day, he says. Trade processing is moving out of downtown São Paulo to the suburbs and a tripling of space will enable far greater co-location by brokers and asset managers and reduce latency, adds Demarco. Daniel Borin, manager at broker Alpes Corretora in São Paulo, states: “In two years, the BM&FBovespa has achieved what it took 10 years to do in the United States.” These upgrades are welcomed by both the sell and buy side and direct market access (DMA) has already captured a 40% market share. That has encouraged an ambitious role out of choices. Since 2008, the BM&F has provided four modules. DMA1 and DMA2 represent access through a broker infrastructure and authorised access provider, respectively, while DMA3 offers direct access and DMA4 co-location, explains Demarco, noting that all four modules must have a broker house as intermediate. The BM&F segment has already generated ten clients for colocation, he says. In September, the four options of DMA will be extended on to the Bovespa segment and clients will soon use co-location there as well. These upgrades should underpin HFT and enable it to grow substantially, says Demarco, noting that it has already captured a 6% market share. HFT could represent as much as 30% of the market by the end of next year, thinks Borin. He adds that the client base his company

André Demarco, operations officer and director of operations at BM&FBovespa in São Paulo. The BM&FBovespa defends its pricing policy on co-location and discounting. Trading platforms have proved to be stable and the exchange offers a full service, including central counterparty clearing, notes Demarco. Photograph kindly supplied by BM&FBOVESPA, October 2010.

sees for HFT is mostly composed of hedge funds, asset managers and proprietary trading desks using basic quant or mixed fundamental and quant strategies and only a small number of true quant funds.

Quant strategies For now, such funds remain thin on the ground in Brazil with perhaps ten at most. Quant strategies are developed by an individual or small team at a broker running basic algorithms. The most common strategy is pairs trading, followed by trend strategies although not necessarily based on moving averages, according to Zimmer. Other more elaborate strategies are emerging, however. Itaú-Unibanco, with a team that includes six PhDs, is developing new, more complex sets of rules to generate trade ideas and gain speed, says Zimmer. Many do not require HFT as they are trend following and carried out with low-

frequency options. One problem is that positions are held to maturity as it is very expensive to get out of positions, he cautions. “Intra-day trading is hard as trades have to support the costs from both the broker and exchange. You can’t afford to make too many mistakes,” says Zimmer. Only some strategies require an HFT platform and include more obvious arb opportunities, such as that between standard and mini contracts, designed to encourage retail investors, which are fully fungible on a ratio of 5:1 and where trading to capture price discrepancies requires great speed, he says. Other common trades are long-short pairs between ordinary and voting shares and between ADRs and local stocks, he adds. The efficacy of simple strategies is being erased by new entrants and DMA. When Kosmos Asset Management started in 2003, arbitrage spreads were wide even on basic trades such as between Bovespa-

NOVEMBER 2010 • FTSE GLOBAL MARKETS

listed stocks and American DRs, says Alberto Araújo, chief operating officer in São Paulo. New players came in and chipped away at spreads. It’s difficult to find pure arbitrage plays at all today and “managers are both fighting for a place in the queue for instant opportunities so profits are just pennies or fractions of pennies”, says Araújo. That makes colocation, which enables asset managers to come to the head of the queue, indispensable for immediate arbitrage opportunities, he notes. The company has $50m under management. Kosmos, too, is increasing the sophistication of strategies to stay ahead of the game; looking at correlations between countries, for example. That includes trading ETFs in the US versus components in other countries and could include an ETF based on the MSCI Brazil against local market futures.“We had to diversify. Every day, it’s getting harder to cash in on opportunities. It’s a new era for everyone,” he says.

Achilles heel? The most oft-heard complaint of quant investors is the cost of transacting. The BM&FBovespa market has a monopoly position, which is allowing it to gouge on prices, say investors. “When you speak to Bovespa, they say that the stock price of NYSE fell when they introduced price discounting for HFT and so they are not going to do it in the same way,” says one source. Co-location costs are exorbitant compared to the United States, says Zimmer. The CME charges $1,500 per month while in Brazil the cost for full access is BRL15,000 ($8,700) for the same period. Some exchanges even allow colocation for free if volumes are high enough, adds Araújo. Overall, Zimmer predicts little demand for DMA4 as so few companies will be able to make money thanks to these high costs. Moreover, planned discounts for HFT based on trading volumes and to be introduced in November are set too high, complain investors. “Only the largest financial institutions will be eligible for the discounts. For any other

FTSE GLOBAL MARKETS • NOVEMBER 2010

Processing times in milliseconds Share market Derivatives market

2007 450 70

2008 300 25

2009 10 10

2010 One digit One digit

2008 770 245 414 200 29 49

2009 1,500 332 591 200 39 76

2010 3,000 416 634 400 68 152

Source: BM&F Bovespa, supplied October 2010.

Processing (in thousands of trades) Share market daily capacity Daily average Peaks Derivatives market daily capacity Daily average Peaks

2007 390 153 343 55 23 42

Source: BM&FBovespa, supplied October 2010.

investor, it will be really hard to reach this,” says Araújo. On Bovespa, a company will need to trade over 500m reais per day to be eligible for the maximum discount. That is about 7% of the total trading on the market, points out Zimmer. Even then, the full discount is parsimonious compared to other markets: the cost of HFT on Bovespa after discounting is about ten times more than the post-discount price on the NYSE, he points out. The BM&FBovespa defends its pricing policy on co-location and discounting. Trading platforms have proved to be stable and the exchange offers a full service, including central counterparty clearing, notes Demarco.“I would not say that our co-location is expensive. We carried out a survey of global exchanges and we feel our pricing is in line with global norms. We include electricity, security, air conditioning and space for offer at a discount of BRL5,000 to BRL15,000 for those using co-location for both the BM&F and Bovespa,” he notes.

Alternative platforms Other obstacles to the development of the Brazilian HFT market include the lack of a market making capability as naked trading is not allowed. Anonymous dark and grey pools are also disallowed by current regulations. In international markets, some 40% of HFT strategies are driven by market

making, notes Zimmer. Investors expect to see alternative trading platforms emerge to challenge BM&FBovespa and foresee that their introduction will have a substantial impact on pricing. The regulator, the Comissão de Valores Mobiliários, is keen to encourage the proliferation of new platforms and Brazilian legislation allows them. Partnership between an exchange and a local bank is considered to be the most likely route and discussions between such parties are said to have taken place. One difficulty will be adapting the trading platform for the Brazilian market. Any foreign newcomer will need to set up a central counterparty clearing system and involve brokers. Restrictions may seem onerous and keep trading prices high while limiting liquidity creation, but may have played a key part in preventing a Brazilian version of the dramatic events of May 5th when the Dow Jones Industrial Average plunged by 9%. The Bovespa fell only 4%, points out Demarco. The BM&FBovespa exchanges impose price control mechanisms that compare prices to recent trades and will not accept those that are outside a range, says Demarco. It imposes a five-minute restriction on trades when the Ibovespa has dropped by 3%, he adds. There is, of course, a price to be paid for such safety and it remains to be seen how far HFT flies given these restrictions.

FX VIEWPOINT

INTERVENTION & CURRENCY VALUES: GOING IT ALONE NEVER WORKS

Currency-related news has dominated the global financial headlines lately; meaning good times for those who trade the FX market. Continued reversal of the carry trade has caused the yen to strengthen so much that the Bank of Japan (BOJ) has intervened to reduce the yen’s momentum. Meanwhile, a war of words, or at the least a running verbal skirmish, has broken out between the US and China over the strength (or lack thereof) of the renminbi and subsequent effects on the US economy. Comments from US leaders including President Obama to the effect that China must act to align the value of its currency more realistically led Chinese Premier Wen Jiabao to warn of a “disaster for the world” should China acquiesce to the American demands for a revaluation of the renminbi versus the dollar. Erik Lehtis, president of DynamicFX Consulting in Chicago, sets the scene.

CURRENCY WARS HE EURO HAS seen a reversal of fortune over the summer and autumn. In May, severe lack of confidence in the European Union in general, and the ability of the Greek government in particular to honour its debt obligations, created conditions for the flash crash, but also led to a precipitous weakening of the euro below $1.20. Since then, the euro has rallied some $0.20, or 16%. The Australian dollar is approaching parity with the US dollar, the Swiss franc has exceeded it, and these trends look to continue. The BOJ has seen its initial efforts fail to halt the strengthening yen. Intervention in currency markets has a checkered history. If not coordinated and designed to punish rampant speculation, it generally fails. What’s more, successful interventions in the past have sometimes been too effective: the Plaza Accord of 1985 was so successful in weakening the dollar versus the yen and Deutschmark that the Louvre Accord of 1987 was necessary to halt the dollar’s decline. Unfortunately, the US trade deficit with Japan was not cured. The BOJ’s first effort in midSeptember, appears a miserable failure so far, as the yen subsequently reached new levels against the dollar and appears set for more.

Given the deep global recession, it is small wonder that the current world economic environment feels a little like every man for himself. The IMF and World Bank noted that currency wars are under way and such activities could lead to other forms of protectionism that would only hurt global recovery. Despite the usual lip service paid to traditional strong dollar policies in the US, it is clear America now wants to encourage dollar weakness as a means of making US products more competitive overseas. In 2011, we will see emerging economies competing with established ones in a race to weaken their currencies against each other. Quantitative easing already conducted by the Fed (as well as the next round everyone anticipates) has created a natural oversupply of dollars that can only be accommodated by lowering their price on world markets. What’s in doubt is whether this monetary gambit will help push the US economy out of its doldrums and generate real growth. Those who hope the US can devalue its way out of recession are doomed to disappointment, as the structural noncompetitiveness of US products goes far beyond exchange rates. The game of growth is being played in the US and

Erik Lehtis, president of DynamicFX Consulting in Chicago.

China according to very different rules, and in the short-to-medium term, a market economy cannot hope to compete against a hybrid economy with a government mandate to win and vast resources being exploited. Even so, by blaming the Chinese for US economic woes, we refuse to take responsibility for our own lack of planning and resource allocation. Furthermore, by failing to coordinate with other countries, we will not achieve global currency stability, however much currency traders may profit from the opportunities created by this turmoil. We should remember that intervention is merely a tactic, and that currency rates are but a strategy to achieve the ultimate objective of economic growth. To succeed, the US plan to weaken the dollar against the renminbi must be executed globally, in co-ordination with other trading partners, and as part of a long-term plan to renew competitiveness through strategic internal investment and development of resources. American labour capital is poorly trained for the growth opportunities. This fundamental lack of competitiveness needs to be addressed. Re-educating and re-positioning the US’s human resources is essential if America wants to build anything worth exporting. We will also have to develop foreign markets where they don’t already exist. It’s safe to assume that if we don’t, China will.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

AT HEAVEN’S GATE? NOT UNTIL 2021 AT LEAST! T USED TO be said that there were only two certainties in British life: death and taxes. Now there are three. Until at least 2021, debt will be an unpalatable but indisputable component in any discussion of the British economy. In the Comprehensive Spending Review (CSR) announced to the UK parliament on October 20th, George Osborne, chancellor of the UK exchequer, highlighted a £109bn structural budget deficit for the year, which he claimed was the highest in Europe, and that debt interest payments in the current fiscal year would amount to £43bn. He subsequently outlined a comprehensive plan to slash up to £84bn of government spending over four years. Some commentators have heralded CSR as a milestone. UK

populist newspaper the Daily Mail dubbed the cuts“historic”, claiming:“After decades of relentless spending, the Chancellor set out plans for nothing less than a dismembering of the welfare system and a rolling back of the bloated public sector.” Rhetoric aside, however, it is hard to see how the chancellor will be able to avoid having to roll back a lot more in state spending in the intervening period between now and 2015 if he is to achieve a balanced budget by the next general election, for two reasons. The first is the nature of the beast. In the UK, public spending plans are actually an uneasy cocktail of specific, costed items and promises to meet agreed spending targets over a defined period; which actually makes a spending review a much woollier process than it immediately appears. Some

COVER STORY: THE LONG TERM PROFILE OF UK DEBT

The recent hyperbolic headline on Forbes’ website entitled: Chancellor Addresses UK’s Dreadful Debt, Saves Economy, has typified the largely Panglossian coverage enjoyed by the UK government since Chancellor George Osborne’s Comprehensive Spending Review (CSR). Aside from the 24-hour trumped-up froth of the UK populist press’ concern with the relative ‘fairness’ of the Treasury’s inevitable cost cuts, the attention of the UK’s chattering classes looked by the first weekend after CSR to have been rapidly redirected towards the shock resolution of the medium term career plans of Wayne Rooney, arguably one of England’s best footballers. Have the chattering classes and the press got the right perspective? Has George Osborne really saved the UK economy? Or will the UK’s own kitchen sink debt drama run and run, even unto the next generation? Francesca Carnevale goes in search of some answers.

Country

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011*

Cause for concern?

US Japan Germany France UK Canada

34.8 66.3 36.7 36.7 23.2 44.3

37.4 72.6 40.8 41.8 23.7 42.6

40.7 76.5 43.5 44.2 23.9 38.7

42.3 82.7 47.5 45.3 25.9 35.2

42.7 84.6 49.8 43.2 27.1 31

41.8 84.3 47.9 37.2 27.7 26.2

42.3 80.4 42.9 34 28.8 23.1

47.2 84.4 45 44.3 33.1 22.4

56.4 96.5 50.2 53.1 46.9 28.6

65.2 104.6 54.7 60.7 59 32.6

72.2 112.7 58.1 67.3 69.9 35.7

Countries everyone worries about

Greece Ireland Portugal Spain Italy

92.9 13 30.5 41.5 95.8

94.7 14 34.6 40.3 95.7

87.2 11.6 37.2 36.8 92.7

87.7 9 42.1 34.6 92.5

85.3 6.5 45 30.2 93.7

77.7 1.2 44 24 90.6

70.4 -0.3 44.1 18.7 87.1

73.9 11.4 47.8 22.8 89.6

86.1 24.9 55.6 33.2 97.4

94.6 38 62.6 41.6 100.8

101.2 49 68.8 48.9 103.4

Countries that have it all under control

The good, the bad and the ugly: National debt of leading OECD countries as a % of GDP (2001 - 2011*)

Norway -85.1 Sweden -2.4 Denmark 21.9 New Zealand 21.4 Australia 6.3

-80.6 4 20.4 17.1 4.4

-95 -0.1 17.7 11.1 2.6

-104.4 -3.1 12.1 4.9 0.6

-122.4 -8.3 8.6 -1.5 -0.9

-136.3 -20 1.7 -8.2 -4.5

-142.2 -25 -4.1 -13.4 -6.6

-124.6 -18.2 -6.1 -16.2 -7.3

-140.4 -16.7 -3.9 -14.7 -5.7

-143.6 -13.1 1.6 -10.9 -1.3

-146 -10.5 5.5 -6.4 1.8

*Projected.

FTSE GLOBAL MARKETS • NOVEMBER 2010

Source: OECD website, October 2010.

COVER STORY: THE LONG TERM PROFILE OF UK DEBT

UK Illustrative gross financing requirements 2011-2015 for a fuller explanation of these figures). We repeatedly approached the UK Treasury to find out if the government had changed any of these projections in light of the CSR; but received no response. A spokesman from the DMO, however, explained that any changes to these figures will be provided by the Office of Budgetary Responsibility (OBR) in late November, which will outline the fund raising remit of the DMO over the near term. We will follow up any changes to the 50 year projected debt repayment profile printed below in a subsequent issue.

Paradigm shifts: where they fall elements of the review (the fully costed ones) are the most likely to be implemented. The targets? Well, all things being equal and if the economy does or does not go into a tailspin at any point, or if public opinion is deemed too hostile, they may or may not be met. There are natural limits then to what can be expected on that score. Two, the cuts may not go far enough. Sadly, for all their concomitant pain, in the context of the current debt profile of the United Kingdom, £84bn in cutbacks over four years, in the immortal words of Humphrey Bogart, “don’t amount to a hill of beans.” That is not written lightly. The following facts are known. As of October 7th this year, UK sovereign debt obligations over the next 50 years exceed £852bn. Moreover, according to figures from the UK Debt Management Office (DMO), the gross financing requirement of the government will approach the capital markets for a further £500bn in borrowing between now and the end of the 2014/2015 financial year, of which £311bn is central government net cash requirement (CGNCR) and the balance is gilt redemptions (please refer to the table

For all the bluster surrounding CSR, and its impact, the review itself does not appear to point to a massive paradigm shift in allocations of the public purse. After all, in real terms, the country’s welfare bill is projected to contract in real terms by 1.9% over the maturity of the review; hardly a dismemberment of the welfare system. The National Health Service has largely been inured to cuts, and overseas aid is up 37% (albeit from a low base) over the term of the review. The real victims of the review will be education, whose budget will fall 3.4% in real terms between now and 2014, and in particular spending on local government, which is taking a massive 27% hit. This is where the real sea change will take place in UK economic life: some local authorities will merge, others will combine their back office operations to gain efficiencies and some will completely redraw their remit and some will simply run out of cash. This is also where the efficacy of the fiscal medicine applied by the government will be severely tested; for while their cash flow is slashed, ironically local authorities

80,552.44 586,184.04

47,704.19 538,479.85

100,537.90 437,941.95

190,596.70 247,345.25

247,345.25 38,586.00

Cumulative repayments

Payment 5-yr period

UK Debt analysis: gilt market future redemptions 2010 - 2060

60,000 50,000 40,000 30,000 20,000 10,000 0 2010/11 11/12 12/13 13/14 14/15 15/16 16/17 17/18 18/19 19/20 20/21 21/22 22/23 23/24 24/25 25/26 26/27 27/28 28/29 29/30 30/31 31/32 32/33 33/34 Data as of 7th October 2010.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

2014-15

121

Gilt redemptions

Gross financing requirement

170

143

112

CGNCR change since March 2010 Budget

-17

-21

-29

-39

*Figures may not sum due to rounding. **Central Government Net Cash Requirement Source: DMO Paper: Budget June 2010: revision to the DMO’s financing remit 2010-2011, supplied October 2010.

have been devolved more powers. It is a potentially damaging flashpoint and the coalition government can ill afford the complete collapse of services on the front line at key points over the next five years. That’s because irrespective of cuts, the debt servicing requirement for the UK will put government finances under severe pressure for the entire run of the government’s term. In the June interim budget, the so-called pre-budget forecast, issued by the incoming coalition government a clear indication, if there is any of the government’s intention to shift the circulation of money in the economy from the public to the private sector is the government’s anticipation of contribution to GDP growth projections covering the 2009 to 2014 period. In the document, while GDP growth will move from 1.3% this year to a projected 2.6% in 2014. Meanwhile, private consumption, which fell off by 2.1 percentage points in 2009 is expected to rise by 1.3 percentage points a year in the 2013/2014 period. The key change

Worrisome for the government is that even with the cuts envisioned by the CSR, debt interest payments will rise from £43bn in the 2010/11 financial year to £63bn by 2014/2015 (up 35%). That’s £63bn out of a projected total budget spend of £562bn over the year; 11% of the government spend will be on interest payments alone by 2014. According to the June 2010 Budget plans, it intends to borrow £87bn that year, of which £35bn is CGNCR and £52bn will be gilt redemptions. Debt will be a millstone round the coalition government’s neck right up to and beyond the next election whatever it does.

48,607.80 767,883.78

30,644.74 737,239.04

666,736.48

70,502.56

Key concerns for the government

33,920.42

816,491.58

Redemption change since March 2010 Budget

850,412.00

2011-12 2012-13 2013-14 CGNCR** projections

however is that business investment is expected to move from a negative 2.1 percentage point change in 2009 to a positive 1.3% percentage point change over 2013 in 2014 and the government contribution is expected to fall overall, from a net 0.8 percentage point increase in 2009 to a negative 0.5 percentage point annual decrease in 2012, 2013 and 2014. It also seems that the pre-budget forecast was a much more accurate prediction of the October spending review than was perhaps at first appreciated. The pre-budget forecast then acknowledged that while private sector demand contracted sharply through the recession in the UK, government spending contributed positively to GDP growth, though it pre-supposed that there has been and will continue to be a recovery in private sector demand. It also anticipated increases in GDP growth to 2.5% in 2011 and again to 2.75% in 2012 as it expects credit conditions to ease. All components of private sector demand are expected to strengthen while government expenditure “detracts from growth.”

816,491.58

UK: Illustrative gross financing projections* (£bn)

Conventional debt (£m) Index-linked debt (£m)

34/35 35/36 36/37 37/38 38/39 39/40 40/41 41/42 42/43 43/44 44/45 45/46 46/47 47/48 48/49 49/50 50/51 51/52 52/53 53/54 54/55 55/56 56/57 57/58 58/59 59/60 Source: UK Debt Management Office website, October 2010.

FTSE GLOBAL MARKETS • NOVEMBER 2010

COVER STORY: THE LONG TERM PROFILE OF UK DEBT

UK Official holdings of international reserves

UK Government’s net foreign currency reserves UK Government’s gross foreign currency reserves Bank of England net foreign currency holdings Bank of England gross foreign currency holdings

Level at end of August 2010 ($m)

+754 +555 +11 -1,049

35,526 73,258 5 24,653

Source: UK Treasury website, supplied October 2010.

Revised planned gilt issuance (2010 - 2011) Type of issue

Auction

Syndication Mini-tender

TOTAL

Short-dated conventional £ bn

52.6

% of total

31.6

Medium-dated conventional £ bn

38.2

% of total

23.2

Long-dated conventional £ bn

24.2

12.8

3.4

% of total

40.4 24.5

Index-linked £ bn

13.2

3.6

% of total TOTAL % of total

33.8 20.5

132

165

100

Source: DMO Paper: Budget June 2010: revision to the DMO’s financing remit 2010-2011, supplied October 2010.

The good news for now is that the UK financial markets have been little moved either by the CSR or the magnitude of the government’s debt repayment schedule. It seems the market was largely reassured by the consistent message relayed by both the CSR and the June 2010 budget plans. According to Gemma Tetlow, a senior research economist at the Institute for Fiscal Studies (IFS), the independent research institute, the latest official figures suggest that government borrowing is broadly on course to meet the June pre-budget forecast of £149bn for the financial year as a whole. Though central government spending continues to grow slightly more quickly than forecast for the year as a whole, tax revenues also continue to come in more strongly.” Even so, Tetlow concedes that: “This should still be the second highest level of borrowing since the end of the Second World War; surpassed only by the level of borrowing of last year.” The good news for now is that the UK financial markets have been little moved either by the CSR or the magnitude of the government’s debt repayment schedule. It seems the market was largely reassured by the consistent message relayed by both the CSR and the June 2010 budget plans. The yield to maturity on 10 year gilts has remained a 3% and

Movement in August 2010 ($m)

FTSE 100 index remained relatively steady, closing at 5741 by end of play on the Friday following CSR. That means the likelihood of capital markets blood and guts following the announcement of cuts were actually mopped up in the moribund summer equity markets and that CSR has simply added some muscle to the skeleton of change. They say that governments lead through a mix of luck and judgement. It might be that the coalition is luckier than most people might expect and that a steady pick-up in economic fortunes will help sustain their short term plans. Certainly, central government receipts in September this year were 7.8% higher than they were a year ago while cumulative receipts for the six months to September were up 9.3% on the same period in 2009. Overall, receipts were 2.6 percentage points higher than anticipated. Then again, the bad news is that government spending is 10% higher in September this year than it was in September last and is 6.7% higher over the six months to September, compared with the same period in 2009. It is difficult to extrapolate, at this distance, any key optimistic trends other than corporate tax receipts (excluding VAT) over the month were 23% higher than in September 2009, even though traditionally only a small portion of annual payments of corporation tax are received in September. The monthly figure appears to confirm a six month trend where corporation tax receipts were 28.7% higher this year over the previous six months than between April and September 2009, which might outstrip government projections for this year and next for an annual uptick of 18.7%. What’s obvious four months on from the pre-budget report is that the UK continues in a phoney war period in its battle strategy against the size and maturity of UK debt. The feeling is that aside from the dismemberment of a flurry of quangos, much of the slash and burn will take place in 2011 and beyond. That is something of a surprise for a country with a total debt burden of this magnitude: £862bn and counting. As Shakespeare’s Macbeth stridently noted: “If it were done when ‘tis done, then ‘twere well it were done quickly.” What’s left for the remainder of 2010 is for the DMO to continue to carry on regardless. As the magazine went to press, the fund raising agency announced an additional £256.6m nominal of 3¾% Treasury Gilt 2020 created for settlement October 22nd. The additional stock was sold at the average accepted price of £105.88 and will take the total outstanding for the sovereign’s latest bond the 3¾% Treasury Gilt 2020 to £13.8bn. In other words, aside from the newspapers (and the brouhaha lasted only three days), the government has retained its rating, if not its creditworthiness. Makes you want to become a footballer. I

NOVEMBER 2010 • FTSE GLOBAL MARKETS

With their vast client relationships, branch networks and distribution capabilities, China’s local custody banks play a key role in servicing the domestic investor community. Meanwhile, international custody providers have begun to make inroads, lured by a friendlier regulatory environment and the tremendous potential of China’s vast investment population. Yet can these players seriously compete against the powerful Chinese banks that control the lion’s share of local assets under custody? Dave Simons reports. Chinese banks that control the lion’s N CONTRAST TO the sluggishness share of assets under custody? Are of many of the world’s major markets, they better off working in collusion China continues to show incredible or in competition with these local resilience, with growth rates expected institutions? in the vicinity of 11% this year. Joining the queue of global and domestic players have been some of the world’s leading Beneficial relationships custodians, many having already secured Legislation allowing the custody of new mandates via quotas recently issued assets in China was first introduced by China’s State Administration of some 13 years ago. Though still in its Foreign Exchange (SAFE) for both nascent stages, today nearly all of Qualified Domestic Institutional China’s major banks maintain custody Investors (QDIIs) and Qualified Foreign status. With their extensive client Institutional Investors (QFIIs). relationships, branch networks and The number of foreign participants distribution capabilities, as well as operating in China has risen dramatically connections to regulators and market of late. Brown Brothers Harriman opened participants, China’s local providers a Beijing representative office in July of play a critical role in servicing the last year; this September, Northern Trust domestic investor community, says Photograph © Brainbrain / Dreamstime.com, was awarded a branch licence, allowing Francis Braeckevelt, head of planning supplied October 2010. the company to offer custody services and development/Asia Pacific, BNY directly from Beijing, rather than through regional hubs. BNY Mellon Asset Servicing. At the same time, international subMellon was also granted a Beijing branch licence by the China custodians have been able to bring an added level of comfort, Banking Regulatory Commission (CBRC) earlier this year. as well as a trustworthy infrastructure, to this new and largely Regional business opportunities continue to increase as well, unfamiliar marketplace. as evidenced by the recent launch of BNP Paribas Securities “The global custodians typically liaise with both the local Services’ suite of settlement and custody services for Chinese and international sub-custody providers to service their global RMB-denominated bonds in Hong Kong. client base and provide them with a consistent and familiar However, with overseas investments on the rise, China is look and feel of the various servicing and reporting likely to be more than a match for even the largest international deliverables,” says Braeckevelt. “Accordingly, the various players in the years to come. For example, last year the number providers largely complement each other when servicing the of securities-investment funds under the custody of the broader market. As the market continues to evolve, we do Industrial and Commercial Bank of China (ICBC) nearly expect some convergence to take place and the lines between quadrupled, while insurance assets under custody rose almost the different providers to become increasingly blurred.” 50% through the period. ICBC claims to have the most QFII Given the structural make up of the country, however, local customers among all Chinese banks, and continues to providers will continue to play a critical role as a domestic dominate the market for QDII assets under custody. Total partner to the international providers, adds Braeckevelt. NAV under ICBC custody rose some 58% from the previous “Given the rapid change in the market mechanics and the year, to roughly $250bn. Which raises the question: how do growing sophistication of the investors and providers, this international firms hope to seriously compete against powerful interaction between local and international providers will,

FTSE GLOBAL MARKETS • NOVEMBER 2010

CHINA’S CUSTODY BANKS: FACING THE FOREIGN CHALLENGE

PROFITABLE OR PROBLEMATIC?

CHINA’S CUSTODY BANKS: FACING THE FOREIGN CHALLENGE 58

in our opinion, generate the best results if conducted in a spirit of cooperation rather than competition.” New fund launches, as well as regulatory changes allowing China’s insurance sector to further diversify overseas asset allocations, point to continued growth for both the QFII and QDII segments. Given the region’s significant wealth generation, however, China’s overall domestic custody business is expected to easily outpace these markets and will command the lion’s share of interest among domestic, regional and international asset managers and service providers in pursuit of further revenue opportunities, says Braeckevelt. Sam Shi, vice president, relationship management for China, Brown Brothers Harriman, also believes that collaboration, rather than competition, best serves the needs of both local and global entities. “By definition, international providers are more familiar with the practices and client requirements of the global markets than their local counterparts, and therefore have traditionally been able to deliver products and services which are better adapted for clients who invest globally,” says Shi. By the same token, many find it difficult to compete with a leading local bank due to regulatory limitations as well as differences in the service coverage that can be delivered locally, says Shi. “For example, although some international banks have been operating in China for more than 20 years, many still do not have a licence from the local regulator to provide custody services for locally domiciled mutual funds. In China, the custody service is often linked to the distribution service for mutual funds, and as a result, the majority of custody business goes to local banks with vast fund distribution capabilities.”

Stronger relationships The ability to use international financial intermediaries as subcustodians in China gives large local players a significant advantage, says Tim Liu, head of product management for Deutsche Bank in Taiwan. “Reciprocity from their outflow business has resulted in a tremendous number of QFII deals, allowing the local players to continue to build up their pipelines,” says Liu. “Additionally, these local participants usually have much stronger relationships and better communications with Chinese regulators, compared to international non-Chinese competitors. However, as international providers continue to build their relationships with market intermediaries, in time local providers might experience a greater challenge.” Given that China’s main banks have a leg up on the local custody market, Northern Trust’s business model dictates forging long-term relationships with the local players in order to provide QDII participants with best-in-class service, says Michael Wu, chief representative for Northern Trust in Beijing. “While we benefit from the local banks’ wellestablished relationships with domestic asset owners who are looking to diversify their investment in overseas markets, local banks look to gain from us the expertise in servicing investments in foreign markets, along with our global technology and infrastructure support.” Even with a custody service licence in place, an international bank operating a few dozen branches in China cannot come

Michael Wu, chief representative for Northern Trust in Beijing. “The caveat is that brokerage companies may only lend stock that they own, which is different from the standard securities-lending model,” he says. Photograph kindly supplied by Northern Trust, October 2010.

close to a local bank and its thousands of branches across the country. The logical solution, then, is to work in close collaboration with a local Chinese bank. “By doing so, both parties can benefit from the other’s expertise and infrastructure,” concurs Shi. Technology is a case in point. As China evolves from a purely domestic to an increasingly diversified and international investment culture, its financial-market infrastructure poses something of a challenge for its domestic providers, who have traditionally relied on reporting tools that are geared toward the specific requirements of the local market participants. Accordingly, issues may arise when attempting to adapt to international and multi-currency investments or the global-investment community, says Braeckevelt. “By comparison, international providers operate systems and infrastructure that are capable of dealing with the intricacies of managing and reporting on multi-currency investments.” Furthermore, the increasingly sophisticated nature of China’s front-office infrastructure has compelled back and middle offices to act quickly in order to keep pace. While this puts added pressure on local providers, it also gives them an incentive to adopt state-of-the-art technology that, in some instances, has the capacity to leapfrog the infrastructure of many existing international providers. “If we have learned anything from the recent financial turmoil, it is the importance of continued investments in people, technology and flexible reporting tools as a cornerstone to a successful and competitive franchise,” says Braeckevelt. What they may currently lack in technological sophistication, China’s leading providers more than make up for in their ability to address regulatory requirements and respond to client expectations, says Shi. “The local banks understand the local regulatory and client reporting requirements better than the international players, and their reporting systems are already developed to cater to local requirements. Their mastery of the Chinese language is clearly an advantage. Plus there are additional cost implications for international players to develop Chinese reporting systems.”Though opportunities for the servicing of assets held outside of China exist under

NOVEMBER 2010 • FTSE GLOBAL MARKETS

the QDII scheme, current regulations in China prohibit market participants from fully outsourcing local asset-management activities to third-party service providers. While some domestic companies have experimented using outsourced solutions for fund accounting and valuation, cultural barriers have often prevented global players from providing accurate processing according to Chinese GAAP, says Shi. Still, demand for certain securities services, including FX and performance and risk analytics, may ultimately create some openings. China’s private equity market is growing fast on the back of a very strong economy, and the country’s investors are facing many of the same challenges experienced in other parts of the world. Says Northern Trust’s Wu: “Investors are looking to professional asset-servicing providers such as Northern Trust to help with maintaining accounting records, calculating performance returns as well as providing cash-flow forecasting and allocation modelling.” China has also recently introduced stock-index futures, allowing investors to borrow stock from brokerage companies in an effort to profit from declines in share prices. “The caveat is that brokerage companies may only lend stock that they own, which is different from the standard securities-lending model,” says Wu. Nevertheless, it is another step in the development of the local capital markets and their alignment with global-market practices, he adds. As the country’s liberalisation process continues and the market becomes more comfortable with specialist providers, the regulatory framework will evolve in tandem, contends Braeckevelt, creating additional opportunities for global providers like BNY Mellon. “Regulators’ willingness to promote greater cooperation between local and foreign providers, to grow the level of expertise and experience of the market as a whole and to leverage some of the international best practices that are common in the mature markets, is very encouraging. Although it may be a while before solutions in China can be fully outsourced, we expect that further opportunities will emerge as regulations continue to evolve and local providers become increasingly engaged with global providers.”

Patience required While processes and practices often converge with maturity in many emerging markets, China’s regulators are eager to create a framework for the local market infrastructure that facilitates an orderly growth, duly protecting its investors and infrastructure, suggests Braeckevelt. “The authorities have shown a keen interest in furthering the local market in a well organised and controlled manner by leveraging the expertise and experience of the international and regional banks through joint ventures, alliances, or by granting domestic licenses,” says Braeckevelt. “Even though we have seen an ongoing commitment of China’s regulators to promote several liberalisation measures, we fully expect the supervisory bodies to create a structure tailored to the specific local market needs and requirements.” Shi believes that China’s regulators will use guidelines employed by other regional or international participants as a point of reference. “However, in all likelihood they will base their regulations on

FTSE GLOBAL MARKETS • NOVEMBER 2010

Sam Shi, vice president, relationship management for China, Brown Brothers Harriman. Shi believes that China’s regulators will use guidelines employed by other regional or international participants as a point of reference. Photograph kindly supplied by BBH, October 2010.

the local conditions and consider how to help develop local providers into competitive global players, to create a strong local market. As a result, a hybrid market structure, which partly resembles the global situation and partly reflects the local requirements, would be forged.” Liu of Deutsche Bank agrees: “Changes within the Chinese financial markets are usually introduced slowly, and regulators won’t move until they are confident that the market can operate in a controlled manner, because, from their point of view, market stability is a far greater concern than market liquidity and profitability. That is why onshore short selling and securities borrowing and lending have not been marketed in China. Also, the intensive regulatory requirements placed on QDII and QFII business mean there are additional costs for international players to bear when entering the Chinese securities-services market.” Certainly China’s regulators will continue to take their cue from the experiences of market participants in other countries or regions, adds Liu. “Having said that, the information collected and experience learned may be interpreted in a different way, and, as a result, a unique kind of market structure may ultimately develop.” Along the way, non-domestic participants must continue to be cognisant of the potential pitfalls and structural issues associated with pursuing a purely domestic strategy. “China is a vast country, creating significant challenges of scale and reach,” says Braeckevelt. “Additionally, the strong relationshipbased banking culture in China and the reliance on the large distribution and branch networks of the local banks may add to the challenges for international or regional providers to pursue a successful domestic market strategy on their own.” While hopes are high that China’s burgeoning custody business will ultimately become fully available to foreign companies, “this will only happen once regulators believe that the local banks have become as skilled as their competitors in servicing the major global markets,” says Shi. If history is any indication, international players will need to be extremely patient before they can reap the benefits of servicing China’s vast investment clientele. I

GERMAN DEPOTBANKS: BATTLING REGULATION AND GLOBAL PLAYERS 60

Photograph © Solarseven / Dreamstime.com, supplied October 2010.

UNDER PRESSURE Many banks in the custody sector in Germany are struggling to compete in an increasingly regulated market place inhabited by major global players. There is widespread expectation among market participants that the number of domestic custodians will be whittled down by acquisition as more global financial institutions enter the market. Joe Morgan reports. S THE GLOBAL financial system continues to feel the tremors of the financial crisis, it is far from business as usual for banking custodians in Germany. As is the case across global financial markets, counterparty credit risk and transparency have become the key criteria governing the decisions of market participants. The depotbank banking sector in Germany, which acts as custodian trustees for investment funds, is populated by a variety of large global players including BNP Paribas, JP Morgan Chase and State Street along with big domestic concerns such as Commerzbank and the smaller, regional Landesbanken. Exposure to structured products linked to US sub-prime mortgage debt resulted in a multi-billion euro bailout of the state-owned Landesbanken in the form of fresh capital and loan guarantees. Many banks in the sector are struggling to compete in an increasingly regulated market place inhabited by major global rivals. There is widespread expectation among market participants that the number of domestic custodians will be whittled down by acquisition as more global financial institutions enter the market. “We see further concentration in the market. The strategy at the state-owned, regional Landesbanken is being rethought and there is talk of mergers and concentrating on key competencies. We see a chance in the long term to conquer

the number one position in the market,” says Juergen P Frank, chief executive officer and chairman of the board of managing directors at BNY Mellon in Frankfurt. BNY Mellon announced in August that it had completed its acquisition of BHF Asset Servicing from BHF-BANK Aktiengesellschaft and Sal Oppenheim Jr & Cie SCA in a deal which also included the purchase of BHF Asset Servicing’s fund administration affiliate, Frankfurter Service KapitalanlageGesellschaft (FSKAG). The acquisition marked BNY Mellon’s entry into the local German custody sector, making it the second largest provider in Germany by assets held. BNY Mellon’s new German business has €569bn in assets under custody and an administration and depotbanking volume of €122bn. Michelle Grundmann, member of the board of managing directors at BNY Mellon Asset Servicing in Frankfurt, expects the trend of consolidation and acquisition in the country to carry on as an increasing regulatory burden continues to put pressure on custodians and German depotbanks to invest in infrastructure development. She expects the depotbanks in Germany to be cut to a third of the current number of around 60 players within the next five years. “Infrastructure costs are set to be foisted upon market participants by regulators to comply with regulatory guidelines and controls on pricing, aimed at providing greater transparency in the market. The costs of compliance will exceed a lot of the infrastructure capabilities of the existing players,” Grundmann says. Financial institutions’ near obsession with credit risk in a post-financial-crisis world has made all players in the German custodian market reassess the importance of price and quality of service, which topped the list of priorities before the near collapse of the financial system. “What we have seen is a considerable redefinition of collateral reinvestment guidelines by clients. This has had an impact on their returns,” says Grundmann. “While volumes in our lending programme

NOVEMBER 2010 • FTSE GLOBAL MARKETS

are starting to increase, clients are having their collateral reinvested in much more conservative vehicles.” Grundmann says BNY Mellon has experienced an increasing demand for its derivatives collateral management services through its Derivatives 360 suite of products, which include services that enable its clients to enhance their client reporting and risk mitigation capabilities. Jörg Ambrosius, managing director of State Street Bank in Munich, says German asset management firms’ use of increasingly sophisticated financial instruments has resulted in growing demand for “insourcing solutions” for back and middle office functions over the past two years, after German regulators approved the use of such services. State Street—a leading provider of such services along with BNY Mellon, BNP Paribas and Société Générale—has experienced growing demand for its collateral management services. “It is a real challenge for a lot of traditional depotbanks to account for and price these instruments,” says Ambrosius. “We monitor our clients’ exposure on OTC instruments. The more sophisticated your investors are, the more they require this type of service.” German custodians have also recently experienced an upsurge in demand from clients demanding access to multilateral trading facilities (MTFs) such as Chi-X, which is taking increasing equity trading volumes away from the incumbent exchanges in Europe such as the Deutsche Börse. For example, BNP Paribas Securities Services is offering its clients in Germany access to trading platforms such as Chi-X via its Clearsuite integrated post-trade solution. “Initially, MTFs were used heavily by algorithmic traders. Now Chi-X has 23% market share of German shares, capturing a high percentage of liquidity away from Xetra,” says Cornelia Raif, head of sales and relationship management at BNP Paribas and a member of the advisory board of Clearstream in Frankfurt. “Asset managers and pension funds are increasingly moving into MTFs, being attracted by price and liquidity.” Raif of BNP Paribas says clients of German custodians are now much more cautious about who they appoint as a partner, paying much more scrutiny to credit rating status. Daniel Brueckner, director, bereichsleiter business development at HSBC Trinkaus & Burkhardt, reaffirms this view, emphasising that the size of the balance sheet and credit rating strength have now become of critical importance in the market. “Clients look at the ratio of assets under custody and your balance sheet,” he says. “Another additional requirement is increased reporting requirements to increase control processes within a client’s operations. There has also been a true flight to quality in terms of real-time, complex reporting,” says Raif. “In the asset serving area they are looking for every detail of a corporate action or proxy voting service. Status reports are requested much more frequently, which puts a much greater stress on custodians.” Brueckner says a further consequence of risk aversion in the marketplace has been a trend of German custodians making use of alternative investment vehicles retreating from offshore locations that had been popular, pre-crisis. “Investors now want to see alternative investment vehicles wrapped

FTSE GLOBAL MARKETS • NOVEMBER 2010

Michelle Grundmann, member of the board of managing directors at BNY Mellon Asset Servicing in Frankfurt. “The costs of compliance will exceed a lot of the infrastructure capabilities of the existing players,” she says. Photograph kindly supplied by BNY Mellon, October 2010.

Martina Gruber, head of relationship management Europe at Clearstream. “Custodians will have to decide country by country what they will offer in future and how they will connect themselves to the T2S platform,” she says. Photograph kindly supplied by Clearstream, October 2010.

as a German regulated fund under the legal framework of the Investmentgesetz [the German Investment Act],” he says. BaFin, Germany’s financial regulator, in July this year issued a Rundschreiben directive—a notice of compliance outlining how regulations should be interpreted by market participants— which imposes new obligations on depotbanks to monitor their legal and contractual investment limits within fund portfolios. Brueckner says that while major players in the market already have systems in place to comply with such rules, the regulations are onerous for smaller niche players.

GERMAN DEPOTBANKS: BATTLING REGULATION AND GLOBAL PLAYERS 62

Juergen P Frank, chief executive officer and chairman of the board of managing directors at BNY Mellon in Frankfurt. “The strategy at the state-owned, regional Landesbanken is being rethought and there is talk of mergers and concentrating on key competencies,” he says. Photograph kindly supplied by BNY Mellon, October 2010.

Cornelia Raif, head of sales and relationship management at BNP Paribas and a member of the advisory board of Clearstream in Frankfurt, says: “Asset managers and pension funds are increasingly moving into MTFs, being attracted by price and liquidity.” Photograph kindly supplied by BNP Paribas, October 2010.

“Many depotbanks have in the past not had the ability to do this. Now they are faced with a situation where they quickly have to invest in a new systems infrastructure to enable them to do this or come up with a more creative solution,” explains Brueckner. Target2-Securities (T2S), a pan-European IT platform being developed by the European Central Bank, will also have a major impact on the German custodian market. The launch in 2013 of the platform that will facilitate the settlement of all bonds and equities traded in Europe has created uncertainty among German custodians preparing for the legislation, which is aimed at harmonising the fragmented securities settlement infrastructure in Europe. Grundmann of BNY Mellon says the impending introduction of T2S has left many clients of custodians in a “waiting mode”. “There will be a revalidation of pricing concepts [when T2S comes into effect] for settlement and custodian services,” she says. T2S will open up the German market, resulting in German custodian banks having to be prepared to offer clients access to other European markets while the legislation could also open up the market to further competition from abroad. “Each bank has to decide which is the most beneficial set up for when T2S comes into force. There are various options and the clients are still in a waiting mode. In the T2S project, there are still some uncertainties about technical details and also the whole area of pricing or rather the overall costs that would be involved are still unknown,” says Raif of BNP Paribas. The increased competition which T2S brings will also put further pressure on smaller players in the German custodian market that have not already built systems to facilitate crossborder transactions outside their homeland. “Custodians will have to decide country by country what they will offer in future and how they will connect themselves to the T2S platform. When we connect to T2S we will give our customers the opportunity to have only one connection which is already established into a variety of different settlement locations. We do this already via our cross border services

initiative, offering access to Denmark, Switzerland and Austria and we will launch Spain very soon,” says Martina Gruber, head of relationship management Europe at Clearstream. “What you are going to see is a much more thinly structured landscape with higher efficiency in transaction processing around Europe. This will result in the provision [by custodians] of a much more aligned service across the region. It won’t be a case of each country doing its own thing. We will evolve eventually to central European clearing,” says Grundmann. She expects another consequence of the increasing regulatory burden and competitive pressure is for KAG fund administration firms and some of the smaller depotbanks seeking to outsource portions of their operations to insourcing providers such as BNY Mellon. “That particular business development in terms of business growth will lead us into 2011 and possibly 2012 and beyond,” Grundmann says. The European Commission’s draft directive on Alternative Investment Fund Managers (AIFM), which is designed to improve levels of risk management and investor protection among alternative investment fund managers set up in the European Union, is also cited by Grundmann as legislation best suited to the “strongest providers” with the “deepest pockets”. “Custodians will be forced to come up with additional control capability around the German fund industry. A lot of closed-end funds will require depotbank wrappers around them for control and transparency reasons. We anticipate this having a large impact on the services that we will provide,” says Frank of BNY Mellon. A combination of regulatory pressure and the fierce competition that global markets bring should enhance a trend of a market inhabited by large global banks offering a full range of services while smaller participants specialise in single asset classes and niche offerings. Meanwhile, midside players in the German market will have to decide which business model best serves them, which should enhance the development of outsourcing services provided by global players such as State Street and BNY Mellon. I

NOVEMBER 2010 • FTSE GLOBAL MARKETS

SECURITIES LENDING ROUNDTABLE

THE RISK FACTOR: NEW PARADIGMS IN SECURITIES LENDING

Attendees

(from left to right)

Supported by:

DON D’ERAMO, senior managing director and securities finance regional business director for EMEA & Canada, State Street KEVIN McNULTY, chief executive of the International Securities Lending Association MATT BOYD, director securities lending trading, BlackRock ROB COXON, international head of lending, BNY Mellon GERARD MOORE, financial controller, Merseyside Pension Fund SIMON LEE, senior vice-president EMEA, eSecLending

FTSE GLOBAL MARKETS • NOVEMBER 2010

SECURITIES LENDING ROUNDTABLE 64

LIVING IN THE AFTERMATH MATT BOYD: One of the most salient characteristics of the market today is the lack of demand to borrow securities. Looking at some statistics from Data Explorers comparing the present to mid-2007, global equity balances are down roughly 33% and European equities are down 40%. That is a drastic reduction in the amount of securities borrowed. Bonds on loan are also down roughly 25% globally. Invariably this has a dramatic impact on all of our businesses. The source of demand has also changed. In the current market, event-driven demand has primarily been the result of capital-raising activities. Directional shorts have not been specific to individual stocks but rather focused on instruments providing broad exposure such as ETFs or unit trusts. Both sell side and independent research is clearly pointing to a risk aversion from hedge fund managers as it relates to single, unstructured, stock exposure. Proprietary trading is on the wane as well, particularly post Dodd-Frank. Couple this with a distinct lack of leverage in both the hedge fund and proprietary trading space, and it becomes obvious why returns from securities lending programmes are down year over year. SIMON LEE: We are now two years past the Lehman Brothers’ default, and many lenders have experienced challenges with their securities lending programmes as a result. I would not say everyone is out of the woods, however in recent months there has been a noticeable increase in activity, and beneficial owners are looking at their securities lending programme in a more optimistic manner. They now allocate more time and have the determination to focus less on fire-fighting, and more on development opportunities. Many institutions are in the process of either making decisions, or considering decisions around their lending programmes, and how they want their programmes managed. Against the backdrop of some of the comments Matt made about falling demand and falling revenues, one of the first questions that lenders are asking is whether or not they want to be actively engaged in securities lending and whether the revenues that their programme generates are meaningful. Assuming that the answer is yes and they do want to continue to participate, many lenders recognise that there is a choice in providers and the traditional routes they chose historically are not necessarily the best routes for their programme today. Many beneficial owners are also looking at their collateral management profiles and are making decisions around the forms of collateral they wish to accept, and the impact those decisions have on revenue and on risk. Specifically, with respect to cash collateral, beneficial owners are evaluating whether this is best serviced by cash management specialists rather than by their securities lending provider. DON D’ERAMO: Over the past 20 months we’ve heard such a lot about intrinsic value lending. In fact, intrinsic value lending has always been an important ingredient of our lending programme. More importantly, we see beneficial owners wanting to clearly understand the types of programmes that they are in and the different choices their provider can offer. It is not always an asset/liability construct. It could equally be in a very derisked type of portfolio. The old adage of understanding what

Gerard Moore, financial controller, Merseyside Pension Fund.

your risk parameters are and operating within those parameters has been a key consideration both for us and for our beneficial owners. Intrinsic value lending is a phrase that a lot of people throw around nowadays. It is what beneficial owners really value. KEVIN McNULTY: I’m wondering whether there is a change in the demand profile in terms of who’s out there borrowing securities. My sense is that that’s changed quite significantly over the last two or three years as well, and demand has become more evenly spread between prime brokers. DON D’ERAMO: I would agree with that. I would also add to that the focus on capital and the balance sheet has forced people to look at the true costs of doing business. The old leverage-style business, in that context, might be a changing model. Distribution channels and borrowers are paying a lot of attention to where they’re allocating capital. Carrying the general file balances of three years ago really isn’t an option any more. Understanding that and understanding what a beneficial owner wants out of the programme are vital to the industry going forward. GERARD MOORE: If we move onto the supply side, in the investment community I represent, most, but not all, pension funds have recommenced lending. Some, on a selective basis, are participating just for the European dividend season. However, concerning that, and given the possible extension across Europe of the principle of free movement of capital, meaning you can get more tax back; more funds will re-evaluate the equation; whether it’s worth getting a fee for lending plus a manufactured overseas dividend, compared with the more generous tax allowances when directly receiving higher net dividends. ROB COXON: The key thing on the broker borrower/demand side is very much how they’re managing their balance sheets; and they’re very sensitive to any factors that may impact it. We are seeing that they are very selective regarding how much they want to borrow, and the durational tenure they’re prepared to accept. Also, there’s certain asset types that are much easier to lend than others, which actually explains why there is this refocusing on intrinsic lending. For example, there is no intrinsic value in the US treasury market because clearly there has been a lot of government issuance, the US treasury market doesn’t behave like it used to. Moreover, because of the sensitivity around balance sheets, brokers are using in-house supply or supply that they’ve accumulated through their natural prime brokerage activities. They’re putting that to work much more keenly than ever before, and that’s affecting the demand that the institutional supply side is seeing. In terms of clients, I

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would say that if you see a 40% reduction in demand, then the supply side is probably down by 10% to 15%. Additionally, our clients remain sensitive to counterparty risk and they’re scrutinising their programmes, and have been doing so even more keenly over the last year. Even so, many of our clients stayed in the programme, and those that left have since rejoined. That shows that they’re confident with the way that the market is operating.

ADJUSTING TO LOWER VOLUMES: WHAT’S NEEDED TO REKINDLE THE MARKET? KEVIN McNULTY: From all quarters it is apparent that demand is down quite considerably from where it was two or three years ago. What would re-kindle demand? It is going to be a combination of things, such as confidence in markets, trading opportunities, companies essentially becoming stronger again and embarking on corporate acquisition strategies. Hedge funds have been under pressure in Europe, particularly with the uncertainty of regulation and a lack of performance. If that gets resolved hopefully there will be a return to confidence, and we’ll see new money flows into hedge funds and proprietary trading strategies. SIMON LEE: I would echo Kevin’s points, but to see a material increase in volumes you need those factors to happen in unison. It might be that all of them may come to pass over the next year or two, but unless those events occurred simultaneously, you won’t necessarily see a material increase in volumes. Importantly, there may be other factors that are influencing volumes toward a downward trend, so it’s difficult to try and predict how things will look next year. DON D’ERAMO: While I acknowledge Kevin and Simon’s points, perhaps we are looking at volumes with the wrong slant. Perhaps 2008 was an anomaly in terms of volume. If you take the years 2002 through 2005, and project them forward, it normalises to a compound annual growth that is probably a lot more applicable to today’s securities lending volumes. Perhaps that is a better benchmark. Obviously when you look at events in retrospect, you have 20-20 vision. Black swan events, such as the financial crisis, force markets to change and most of the time they change for the better. KEVIN McNULTY: That is certainly a valid viewpoint. I agree, what’s been noticeably over the last few years, and not just the last two years, is that the industry has done a good job of making itself much more efficient. In that context, in terms of weathering a (hopefully) temporary downturn, the securities lending business is in as good a shape now as it could feasibly be. I would say that most firms are operating highly efficient systems, highly efficient platforms and have adopted market technology that really helps firms do business in a highly efficient manner. ROB COXON: The normalisation of markets, and/or central bank’s intervention through quantitative tightening and the rising of interest rates will also help the mix, particularly in terms of generating yield for cash reinvestment funds and so on. Moreover, not only has the industry been very strong in

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Matt Boyd, director securities lending trading, BlackRock.

terms of efficiency, it’s been very good at unearthing supply, and Gerard alluded to this: it could well be that supply needs to contract and that some clients may well decide that they don’t want to be in the market, simply because the returns aren’t there or they don’t want the risk. That could certainly happen and it could be a positive thing for those lending clients that remain in the market. GERARD MOORE: From the viewpoint of somewhat smaller beneficial owners, in hindsight they were probably too dependent on guidance and relied too much on their agent lender rather than fully understanding the risks themselves. Since the collapse of Lehman Brothers there has been significant investment over the last 18 months in educational documents and events (such as beneficial owners’ breakfast discussions at conferences) that has greatly benefited smaller beneficial owners and trustees. As a result, there is far more awareness of risk and reward than previously. Will owners choose to take a step back thinking it’s not worth the risk or, will they think they’re more confident managing those risks? Some funds will go more confidently down the securities lending road: others might decide to step back.

RISK AND REWARD FRANCESCA CARNEVALE: Is the risk/reward ratio clear right now? Everybody talks about it, but what does it actually mean? Is there a measurable ratio out there? How is it measured? MATT BOYD: When you look at the transparency that has been introduced to the securities lending marketplace, it has focused on the return side of the equation. What I think you can say is that there is a good comparison point for returns amongst providers. This is a great benefit as beneficial owners finally have the ability to look beyond split, which has often been a red herring, and have visibility into the relative yield that is being generated for their accounts. Unfortunately, there is not a clear benchmark for the risk embedded in different programmes; I am not convinced that there will ever be one that is as clear cut as a return benchmark. There are tools in development that can help beneficial owners stress test their programmes, but at this point I don’t believe there is a substitute for old fashioned due diligence. On the bright side, the credit crisis has ensured that no one can deny that there is market risk implicit in securities lending. In 2005/2006, there wasn’t a lot of focus on market risk; it was almost dismissed as not relevant to this business. It is different now and this is something the industry has to address. As we continue to move forward, the business

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Kevin McNulty, chief executive of the International Securities Lending Association.

is going to be focused on exactly what risks are and are not acceptable to our clients and ensuring we have solutions that meet their needs. KEVIN McNULTY: The challenge that this industry has is that revenue is very tangible. It’s very easy to measure it. Risk is much more difficult to measure. So if you’re looking for a simple quantitative answer to your question, it’s not out there at the moment. Individual firms can and do model risk in quite sophisticated ways for their own risk management purposes. You would then have an additional challenge in that a lot of beneficial owners would not necessarily be in a position to think about this business on such technical lines. However, if you look at the core of the business in simple terms from a beneficial owners’ perspective where you’re perhaps lending through an agent, receiving good quality collateral, you may have indemnification from your agent, and you’re perhaps not doing cash collateral reinvestment. Start at that point and you undoubtedly have to say this is a low-risk, but not risk-less, business. The question then becomes what do you lay on top of that to take additional risk? Moreover, are you getting rewarded for those additional risks that you’re taking? That is the job of lending agents: to help their clients understand those types of things. ROB COXON: Certainly in the instances where clients are looking to eliminate risk or take on very low risk—for instance taking in sovereign debt collateral and there is an indemnification—the rewards are very, very small because of the way the market is currently working. This harks back to the question: should those types of clients actually participate in securities lending? In reality, at the end of the day, there is no free lunch. There is always going to be some degree of risk, and what’s key in that regard is to really understand the level of that risk you are taking and mitigate it as much as possible. That in turn involves properly understanding the lending contract that you have with your provider, and it also means taking time to understand the securities lending market and monitor the product. DON D’ERAMO: The market continues to become much more transparent. We are able to have very good granular discussions with beneficial owners and to understand where they want to be. So, if it is a strictly non-cash programme with very, very conservative guidelines, you can provide the client with a model of the profiles or revenue streams that are possible. The discussion of whether the client will or will not be in a programme will obviously follow that. These days however, we are seeing that some of our clients really want to understand

the drivers behind the revenue streams and the risks associated with them. These clients know specifically which parts of the market they want to participate in. It is not a question of all in or all out. Actually, that is just part of being able to offer a bespoke product for customers, and we’re going to see more and more of that going forward. SIMON LEE: Just to add to that, many lenders have different views on the question of risk versus reward, and lenders vary in their perceptions and measures of risk. It differs from lender to lender. Also, when you look at revenue, lenders have different views of their revenue, whether they’re measuring in absolute terms or whether they’re measuring as a performance-based return, all of which can cause different opinions.You also need to factor in the level of involvement that the lender has in their programme. For instance, one lender’s level of involvement may be active and voluntary because they are a lender who likes to be engaged in the management of their programme. Another lender’s involvement may be involuntary and subject only to when problems arise. These factors will influence whether the lender participates or not, and whether they feel that the question of risk and reward is adequately addressed.

REINVESTING CASH COLLATERAL: HOW RISKY IS IT? KEVIN McNULTY: I’ll start by saying it is important to understand it’s not necessarily very risky to invest cash. We’ve spent quite a bit of time in the past couple of years convincing people that had a view that cash was great, that it may not always be great and, conversely, convincing those that think cash is evil that actually it may not be evil either. It’s all about what happens to that cash and how it’s reinvested. In my view, speaking to firms, there’s no doubt that most lenders that take cash collateral, and there are still a lot of them, have made adjustments to their reinvestment guidelines to make them as comfortable as they need to be. They’ll continue to take cash collateral. DON D’ERAMO: Naturally, clients are adopting more conservative guidelines. They are putting their focus on ensuring that their agent lender is assessed properly, from having the right infrastructure to being able to manage cash in all market environments. The trend has been to de-risk and build liquidity in the portfolios, which is not a bad thing. The emphasis has shifted to really understanding your guidelines and making sure that the agent lender truly has the commitment, the core, and the infrastructure to manage through the difficult times that we have seen. ROB COXON: The lending of securities is essentially a trading and over the counter (OTC) market activity but when it comes to cash collateral reinvestment, the client is moving into investment management, and therefore into a new area with a different set of risks around it. We tend to talk about securities lending very generically, but cash reinvestment is an investment management activity and should be approached as such by any firm that undertakes it. Moreover, because its investment management, the clients that participate have to fully appreciate the risks in terms of market, interest, credit and liquidity risk.

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KEVIN McNULTY: That’s a really important point. What we want to see in the industry is lenders making proper decisions about their security lending programmes based on real facts and understanding of the business. Once you have that it is reasonable that beneficial owners and lenders or investors would have different levels of risk aversion, and may decide to structure their programmes in very different ways. It’s ultimately about them making informed decisions. Don D’Eramo, senior managing director and securities finance regional business director for EMEA & Canada, State Street.

Certainly, you’d hope that in this day and age clients aren’t slipping into cash reinvestment through the backdoor, via a securities lending programme. Securities lending and cash reinvestment management are two very different disciplines. It is important they are properly educated on that point. GERARD MOORE: I agree with that. Again, in my community, a lot of people see cash reinvestment as a further step up the ladder, requiring an extra set of skills, due diligence, expertise and competences. Some may be reluctant to take that extra step and may want to stick with a more simple approach. Usually your custodian is your agent lender. If you wish to keep it simple, I would say: get your solid indemnity, and avoid the extra complexities of taking cash collateral. There’s far greater awareness now, certainly in the last two years, of the implications and options when taking cash collateral and beneficial owners have to ask themselves the question: do they have the competence and knowledge to take that further step up the ladder? SIMON LEE:The cash collateral environment you’re describing is somewhat dated now and the industry has evolved significantly since then. If you spoke to every agent lender in the market, they would have a very different approach to the reinvestment of cash collateral now than they would have two years ago. Also, to echo Gerard’s point, most lenders that take cash collateral have better understanding of that aspect of their programme. MATT BOYD: There’s another component to this. This was a market-wide phenomenon and virtually everyone was fundamentally mispricing risk in the 2005-2008 period. One of the largest investment banks in the world went bankrupt because of that mispricing and two other major financial institutions were only spared due to government intervention. The over-emphasis on cash collateral programmes may be a bit of a distraction as this segment of the market should have learned its lesson through the credit crisis. As providers, we must be diligent in ensuring the lessons of the past are understood and that new controls and practices are adopted, but we cannot afford to myopically focus on the risk that hit us recently or we will lose perspective on new risks that will inevitably develop. ROB COXON: Perhaps also to clarify: cash reinvestment guidelines as a “norm” is more based along the lines of the short duration US money market 2A7-type funds. They are more conservative, but some clients may want to take an additional risk and may want to go further up on the curve, and they’re perfectly entitled to do that. That’s their prerogative. We always maintain that we are acting as agent and we are facilitating that for them.

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SHORTING AND THE EU: THE CONSEQUENCES OF REGULATION ROB COXON: I don’t know what the impact is going to be in the short term; my understanding is that the regulation will be introduced by July 2012, so as an industry we have time to gear up for the changes. My personal thoughts are that it’s going to have a negative impact on demand. What concerns me most is not so much the fact that you will have to have your shorts covered, because that is already market practice, and whether you choose to formalise it or not is down to a regulatory preference. In the Hong Kong market we have to complete regulatory reporting on all potential securities located for shorts, so that’s not insurmountable for the European markets. What worries me most, however, is the proposed public disclosure threshold limit of 0.5% for short sales, which I believe is too low. This will invariably impact upon the amount of business the hedge funds do or the amount or level of trading activity they take on in any particular arbitrage play. Additionally, most people would agree that you’d want equality between long positions and short positions in terms of reporting. You’d think that would make sense. MATT BOYD: Short selling is an important component of an efficient marketplace; academic studies clearly demonstrate this. Impingement on, or discouragement of, short selling is a problem and will impact the efficiency of the marketplace. It will have a negative impact on long investors as bid-ask spreads widen. Short selling is also one of the practices that creates demand to borrow securities and many beneficial owners depend on the alpha their securities lending programmes generate to offset fees and improve investment performance. Considering the pressure many pension funds face due to liabilities outstripping assets, limiting an important source of revenue for these plans seems contrary to the spirit of the proposed regulations. GERARD MOORE: From a beneficial owner’s perspective, it might be a double whammy, in the sense that it would reduce the income from securities lending, but also, as most pension funds also invest in hedge funds, lower volume might be delivering lower returns from those as well. DON D’ERAMO: Everyone agrees with more transparency, whether it’s in short selling or market exposure, but to what point or to what degree? Will that have an effect on clients wanting to hold certain positions or lead to restrictions of certain assets? Also, will that have a knock-on effect on the availability of liquidity in the marketplace? I think we have to consider these issues.

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SIMON LEE: I’m going to take a slightly contrary view to what Don’s just said. Looking at certain European domiciles where there is still an element of uncertainty about securities lending amongst beneficial owners. There may be more lenders sitting on the sidelines than in other jurisdictions. When regulatory comments on securities lending are issued, there is a secondary effect in that further clarity is provided to beneficial owners with respect to what the regulator’s view is therefore there is an element of an implicit endorsement of lending. So in some jurisdictions it may actually help lenders who want to lend. It may give them that extra level of comfort to have the regulators comment on the industry. KEVIN McNULTY: Speaking to our members, there are a number of concerns with what is being proposed. One of the biggest, particularly among prime brokers, is the public transparency provision. The problem that they already see in cases where there is a requirement for public transparency is that their investor clients won’t short sell beyond the threshold. They just don’t want to signal their trading or investment strategies, and in some cases there is concern about being associated with short selling. So that’s likely not to help demand, and that’s not good for the securities lending industry or the efficiency of the market. Other provisions in the proposed legislation, such as the requirement to reserve shares before placing a short sale order, a mandatory buy-in procedure on T+4, and the flagging of short sale orders are all costly to implement and have questionable benefits to anyone. The fundamental concern we have is that this is a very politically-driven piece of legislation. There seems to be a desire to knock short selling. We don’t think there’s a theoretical basis for wanting to hit short selling hard. We are sympathetic to regulators needing to see what goes on in the markets (and that’s why we’ve been supportive of private transparency) but the biggest issues for the industry are the public disclosure and reserving elements. One of the stated aims of the commission is to create some information symmetries. As Rob notes, this proposal will require short sellers to disclose an awful lot more than long investors. FRANCESCA CARNEVALE: I don’t want to put anybody on the spot, but do you feel that the description of the legislation by the commission was done with a full understanding of the impact on the market? KEVIN McNULTY: I went to see the commission, which does understand the benefits of short selling, and they do understand the arguments that the market has made. The challenge they have is they’re under a lot of political pressure to do something about regulating short selling. I don’t think the problem is necessarily short selling or the commission’s understanding, and Rob alluded to the fact that this is draft regulation at the moment, and the industry, including ourselves, will be likely going to see some politicians through the next few months to see whether we can influence their thinking. FRANCESCA CARNEVALE: Who is exerting this political pressure? I have to tell you, it’s not the man on the street. He wouldn’t know what short selling was if it hit him in the face. SIMON LEE: Through the mainstream media, it is the man on the street. There is an awareness of short selling but some people may not understand the whole picture. The press have

certainly talked about it, and will likely continue doing so. Many conclusions can be drawn from where that political pressure’s coming from. KEVIN McNULTY: I don’t honestly know what’s driving it, but the sorts of things that could are that when things are not going well, for economies and for political parties, it’s natural to look for things to fix. Presenting some fixes for things like short selling or for hedge funds in an environment where there is a general anti-banks sentiment may be a natural thing for them to want to do. MATT BOYD: If you rewind the clock two years and you asked the managers of companies with plummeting share values who was causing problems for their firms, they would have said it was the short sellers. It is ironic that some of the individuals toeing this line had revenue streams dependent on hedge fund businesses heavily engaged in short selling. This sentiment was blown out of proportion as the asset bubble began to deflate in 2008 and 2009; all of a sudden you had growing public sentiment against the“malicious”or“evil”short sellers. Under pressure, people tend to find scapegoats and market participants engaged in short selling wore the scarlet letter through the credit crisis and its aftermath. SIMON LEE: Also, if you go back 18 months and picked up any newspaper there would be something about short selling, whether in the financial press, broadsheets or tabloids. At that time I thought it was a given that there would be some form of regulation in the future as a result. If these regulations had been announced 18 months ago, when these stories were first published, would they have the same effect? Or are we having these conversations because of the time that has elapsed. GERARD MOORE: My community are sometimes seen as politically-exposed investors, and this is why terms such as short selling can get translated as“a bad thing”. A lot of trustees’ education has taken place, and is continuing, to provide that better understanding. It’s not just what they see in the headlines. Again, going back to the educational documentation just produced, a lot will hinge on how successfully that reaches out to trustees, on the time invested in training and learning, and getting a better understanding of the true impact of short selling. It behoves those of us who perhaps have a decent insight into the subject to spell out the pros and cons to the investing community who basically need the confidence that whichever route they choose, they know the risks and the rewards associated with their decisions.

CAPITAL REQUIREMENTS RULE, AND THEN THERE’S LIQUIDITY... KEVIN McNULTY: The publications that Gerard is referring to emerged out of an FSA review of the securities lending market last year. Generally I don’t think they found anything of particular concern, however, when they called on a sample of pension fund trustees, they found a varying degree of awareness about securities lending, and so we were challenged as an industry, to try to do something about that. We worked with a number of other trade associations, such as the NAPF, ABI and the IMA, and produced the documents that Gerard

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Rob Coxon, international head of lending, BNY Mellon.

referred to, one of which is an introductory guide to securities lending, aimed specifically at pension fund trustees. We are in the process of pushing these documents out and working hard to get them to the right readership. Separately, we are in a perfect storm of regulation. Basel III and the developing regulations governing the management of bank liquidity are something we should be concerned about. My sense is that many firms have been examining the impact of these types of rules at the enterprise level for some time, but now the discussions are filtering down to business units. For the first time, firms are starting to figure out what it might mean for the securities finance businesses, and I expect that that’s going to be a very interesting set of developments. We’ll see how that impacts on the business because there’s no doubt in my mind firms will have to set more capital aside for this business. It is after all a stated aim of the new regulatory measures that banks should set aside more capital for all of their activities. The question is how much and whether it impacts the types of businesses that they can continue to do. MATT BOYD: I’d like to jump in quickly here because it’s a really important event in the industry right now that I do not believe it is well understood. Basel III is getting attention at the moment due to the recent press releases, but people do not tend to correlate Basel III or the FSA liquidity regulations with securities lending. As banks continue to be under pressure to improve earnings while operating in an environment focused on balance sheet, we are starting to see their financing desks reach out to pension fund assets as liquidity backstops. This essentially means that banks are transferring that liquidity risk to someone else. I am not convinced that regulators are necessarily thinking about the potential impact of that liquidity problem being transferred to pensioners. Is that really the intention of these regulations? Even if the programme is indemnified, does the provider really have the balance sheet to backstop this type of agreement in a distressed market? How does this impact the liquidity of the underlying client’s investments? These are core questions in which the industry needs to invest both the time and energy. ROB COXON: Picking up on that point: what a pension fund will probably do is try and transfer that risk back to their provider, their custodian or agent lender, in a form of indemnification— and once again, I’m not sure that we particularly think that’s a good trade off, to be honest, in terms of the use of our balance sheet. Obviously it needs to be looked at in detail, but I’m just thinking that, with Basel III, Solvency II, or the FSA liquidity ratios, whether that is going to be a catalyst for the CCPs. CCPs had their initial burst, if you like, of raising their profile and pushing

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themselves up the agenda. It’s gone reasonably quiet now. I guess we’re all in consultation mode with CCPs, but I’m wondering whether this will be a catalyst for more business to be conducted through CCPS. If we all start to have balance sheet issues, whether it’s because we’re acting as principle or because we have indemnifications and so forth, then as I said that could be a catalyst. DON D’ERAMO: I would just underscore on the indemnity front that the focus on capital costs will definitely change. It may cause changes to structure. It may change principal/agency relationships. However, indemnities are still going to be there whether it’s an upgrade or downgrade. I guess the question becomes: has the industry priced indemnities correctly in the past and what will it look like going forward? FRANCESCA CARNEVALE: Is this an opportunity to redraw the institutional framework? Is there room for a new breed of institution to rise up to service these requirements? MATT BOYD: Yes. Inevitably new institutions are going to form and new solutions will be created. That is the beauty of a capitalist system. People are going to find ways to conduct business within the regulatory framework that create an opportunity to make money. Data Explorers and Equilend are great example of companies that did this over the last decade. If accessible capital becomes the focal issue, then, sure, someone is going to come up with a solution that makes money. Someone will take on the liquidity risk. I don’t know who that person will be, but hopefully they will have better infrastructure and management than some of their failed predecessors that offered similar services in other industry segments.

TURNING UP THE HEAT: THE PROVIDER’S PERSPECTIVE DON D’ERAMO: From an asset servicing perspective and maybe a custody perspective, for a number of years now we’ve had this cycle going on where we’ve continually been asked to reduce our fees. To a certain extent that’s been possible because we’ve been able to find operational efficiencies. Today, we are asked to do more work on the back end to satisfy regulatory and client requirements, which can translate into added cost on the servicing side. ROB COXON: When you look at the value chain, we asset servicing providers take far less out of it than probably anybody else, and we do an incredible amount of work. If you heap onto us more risk in order to fulfil regulatory requirements, then our answer to that is: “Yes, we want to provide a service to our clients, but we need to be paid for taking on that additional risk”. DON D’ERAMO: Increasing efficiencies is an ongoing effort. Whether it’s creating centres of excellence to drive down the efficiencies on the cost side, or other initiatives, purely from a securities lending perspective, we’re going to see more and more solution selling to our clients. Clients are becoming more sophisticated and selective. Inevitably, this emphasises how crucial it is to continue developing the right business model. As a firm, we must make sure that we are committed to investing in the business globally and delivering economies of scale.

SECURITIES LENDING ROUNDTABLE

Demand will surface from new markets, and you need to ensure that you have the right product development initiatives and tax analysis to ensure that beneficial owners are not disadvantaged. I think it continues to develop as it is more of a solution-oriented type of product going forward. MATT BOYD: I just want to ask a broad question here, following a comment made by Rob around how providers tend to take a smaller cut of the business these days. I took this to mean a smaller split relative to what you pay beneficial owners. I wonder, and I’d love to get your opinion on this; are prime brokers achieving an unfair premium for the services they offer to both hedge funds and principal lenders? They have, after all, been a huge profit centre for investment banks over the course of the last ten years due to the spread between the wholesale and retail market. How overpaid do we think they are? Why are their commissions so high on a somewhat commoditised service? Moreover, what portion of the economics do you think should come back to our clients based on the risks they are taking lending their securities, and how much should the hedge fund receive that is principal to the short position? Where do you think that shakes out when you consider indemnity? We are seeing more demand for risks to be moved from banks to our clients and ourselves; shouldn’t that mean that the returns for prime brokers relative to beneficial owners will shrink as compensation for that risk? ROB COXON: It goes back to that question of being able to price the risk. I don’t think we as an industry have always done that very well, to be honest. We’ve always been hungry to win the business, to compete amongst ourselves in what is a very competitive space, and everyone does a good job at that—but not in terms of pricing the risk. But that will change as better risk/reward analytical tools are introduced. DON D’ERAMO: Actually, I think that the market itself will change. You are already starting to see things such as prime custody and custody offerings that are dabbling in the active or leverage space. That will beget more price transparency and get you a better understanding of the total value and although there is a cost, it is principle business. In turn, it suggests we are moving towards a better understanding of how much more is there.

ROUTES TO MARKET: THE STRAIGHT AND THE NARROW SIMON LEE: I don’t think there’s been a fundamental change in the routes available to the market. Whether it’s a custody programme, a third party programme, an agency exclusive, or a direct exclusive, they’ve all been there for some time and will remain as such. It is arguable as to how much direct exclusive business will be undertaken in the future, given the rise in concerns around single counterparty concentration risks postLehman default, but in terms of custodial, third party, and agent exclusive programmes, they will continue to be the most widely accepted routes to market. There is a clear trend toward unbundling lending from custody, and similarly, there is an increased trend for providers actively marketing their third party capabilities who have not done so historically. I’m not

Simon Lee, senior vice-president EMEA, eSecLending.

just talking about eSecLending; I’m talking about other agent providers that will now talk about their third party lending services. As a result, beneficial owners are far more cognisant of the options available to them in terms of providers which have increased the recognition of third party models. GERARD MOORE: I’d agree with that; we have to recognise the difference in scale between the large asset managers on one hand and some of the modest pension funds on the other. We can be talking chalk and cheese, but generally, when it comes to re-pricing custody mandates, more pension funds will be looking to get quotations both with and without securities lending, and that might offer more opportunities for the third party option. From the perspective of larger pension funds, the days of “let us lend out your securities and we charge you nothing for your custody”are behind us now. People are aware that these are two different activities. On the subject of different routes to market: pension funds tend to be quite conservative. I’d be quite shocked if relatively small pension funds suddenly jumped into bed with a little-known custodian, for example. There would be quite a huge risk on the table there, and we tend to be quite risk averse by nature. However, larger funds will be better positioned to explore other options; as it were, being able to grab the steering wheel rather than sitting in the passenger seat being driven by their custodian. DON D’ERAMO: I agree with Gerard that there is a greater awareness of securities lending among clients, which is driving them to look carefully at the partners they choose for both custody and securities lending. That said, we have seen clients migrating towards larger providers with established global operations. GERARD MOORE: From the pension fund side, there’s still a great fear of concentrated counterparty risk. SIMON LEE: There is that issue of perception but the reality is that there is more diversification when using a model like ours where the increased level of transparency is inherent in the process and provides our clients with that comfort. I would also add that certain portfolios or assets do not suit the exclusive model, and lenders always need to consider which programme is optimal given their individual goals and objectives. DON D’ERAMO: From the custodian’s perspective, we invest heavily in that business and have made distributions capabilities for clients. Gone are the days where you made x amount of dollars each month, and the cheque’s in the mail. It’s really about understanding the programme and understanding where the revenues are coming from, and that’s a commitment to ensuring that transparency moves forward and to investing in the technologies that enable us to provide it. MATT BOYD: I speak from a slightly different perspective working for an asset management company. In a lot of ways the

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route to market question can be a distraction for what a client really needs to consider. I believe clients should focus on: what sort of returns am I receiving? What sort of optimised performance is my provider achieving based on specific risk parameters? Part of that is what Don was talking about earlier. It’s the infrastructure and the in-house expertise that providers can offer. Part of it’s what Rob was talking about earlier in relation to cash reinvestment and the need for it to be part of an investment management discipline. I’d actually take that one step further and say non-cash collateral management also has to be considered an investment management discipline. The risk you run in a non-cash program represents real exposures and has similar liquidity and credit constraints in a default situation. Securities lending is a front office activity. It’s not a back office cover fails activity like it may have been 20 years ago. There is significant market risk in this business that requires the management expertise of investment professionals. DON D’ERAMO: It is definitely a front office activity, that’s why clients are looking closely at all of their options. While it may make sense for some clients to unbundle, there are other clients out there that want it to remain bundled because they get pricing leverage from their provider. It all depends on what the client wants, and at the end of the day, it’s not as simplistic to say, it’s a custody securities lending relationship. Asset servicing encompasses many aspects nowadays. There’s back office processing, there’s derivatives processing, fund accounting and so on. If a client wants bundled, then we’re happy to accommodate that, and vice versa if they want unbundled. KEVIN McNULTY: The advent of third party lending has generally been a good thing for the industry. It has required everybody involved in the business to sharpen their pencils a bit. Whether we see a significant shift towards more of that, I’m not sure, but certainly the unbundling of fees is happening and will continue to happen. The reality is probably third party lending options are currently really limited to the largest of beneficial owners and those that have particularly attractive funds to lend. Not everybody has the choice that the largest investors have.

NEW BUSINESS GROWTH: SHOULD WE BE OPTIMISTIC? MATT BOYD: Optimism or pessimism? I guess it depends on your expectations, really. Generally speaking, I’m very optimistic about the future of securities lending and excited that it is getting both the attention and the investment it warrants. It is tremendous that there is recognition of the implicit market risk in this business and the requirement to have investment professionals manage risk and return in securities lending programs. Managing risk within a framework that meets client needs while optimising returns through continued investment in both people and technology is what will differentiate providers in the future. I am very optimistic that BlackRock is well positioned to further demonstrate our expertise in this segment of the market as transparency continues to increase. SIMON LEE: If you’re in this business and not optimistic then you should consider moving to a new industry. From an agent

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lender’s perspective, what’s important now is what will be important in the future, which is providing a high-quality product to your customers, optimising returns, and minimising and managing risks. For an agency lending business, that will remain the case in the future. In terms of future opportunities, much will be driven by the growth in third party lending, and as more institutions look to change provider, opportunities will surface. That’s where optimism comes from. ROB COXON: You’ve got to be optimistic, otherwise you’d go mad! What I love about this business, and I’ve been doing it for a plenty of years now, is that it is an evolving business. Always has been, and—regardless of the challenges of new regulation, regardless of balance sheet constraints—it will evolve and move on, and it will grow. There are plenty of things at the moment that are working against us. As soon as the economic environment improves, and trading opportunities start to present themselves, this business will grow from a volume perspective, and also from a market participant perspective. So I’m optimistic. GERARD MOORE: Optimist or pessimist? At the risk of sounding corny, I hope I am a realist. As markets change, as new providers emerge, as regulations change, we’ve have to continue to strike the right balance between risk and reward. If I describe the pension fund assets as a cake, it’s nice to have a thin layer of icing on the cake. It’s even nicer if the layer of icing is thicker, but not at the risk of losing even the smallest slice of the cake. It’s vital to keep that balance right. DON D’ERAMO: I’m optimistic about the ability to develop this market. This marketplace will likely become a lot more solution oriented, a lot more bespoke, and that will be the challenge. However, securities lending is an evolving and changing market. It is up to us to continue to listen to our client base, our beneficial owners, and help them to achieve their goals through an agent lending programme. Our industry faces a lot of uncertainty around regulation and I think that translates into an opportunity for us as providers to help shape solutions for our client base. KEVIN McNULTY: It is important to remind ourselves that the securities lending business has in many ways fared quite well over the past two to three years. Of course, there have been some problem areas, such as where some lenders lost out in cash collateral reinvestment programmes. Aside from that, the core business of securities lending performed very well. If you think that Lehman Brothers was one of the most significant counterparties to participants in this business, that most people liquidated their collateral positions and didn’t suffer any form of loss was a major, major positive. We’ve also talked a lot about demand being down and Don made some very good points that we have tended to use 2007/2008 as our benchmark, which is probably not the right thing for us to do. If we took a longterm view, the trending is still reasonably okay. I have to think that once we get through the next period, and I don’t know whether that’s one year, two years, or three years, of regulatory reform and hopefully through an economic cycle which is pretty challenging, that demand will pick up again. I like to think that the outlook is a good one, and we shouldn’t be too pessimistic about this business. I

SMART ORDER ROUTING: TECHNOLOGY PUSHES SOR TO THE LIMIT 72

SMART IS HERE TO STAY As soon as MiFID allowed stocks to be traded on different venues—fragmentation—the door was open for the development of smart order routers (SORs) in Europe as brokers sought liquidity. Globally last year, an estimated $772m was spent by clients for access to smart order routers and Aite Group believes this figure will reach $1bn this year, 95% spent with sell side brokers. Ruth Hughes Liley reports on the growth of SORs. MART ORDER ROUTERS (SORs) were once a simple matter of finding liquidity at the best price. Today, the technology has advanced to the point where it also has to decide between two markets with the same price, whether to trade where the greatest size is displayed, whether to offset lower cost venues against higher chances of taking liquidity, passive orders, or physical closeness to a venue: and all this within fractions of a second. The speed at which SOR has been adopted illustrates how competitive the market is for brokers, believes Natan Tiefenbrun, commercial director, Turquoise. “Once some brokers began to see the benefits of smart order routing, others who didn’t have one had no choice but to go down that path.” “When we built the Bloomberg Tradebook smart order router, we designed it with more than just Europe in mind. We knew that fragmentation of the global exchanges would continue, so we built our SOR with the potential to work in every market,” says Ronald Taur, Bloomberg Tradebook’s global head of algorithmic trading. “There was a big dash for connectivity in Europe when MiFID was introduced,” agrees Owain Self, global head of algorithmic trading at UBS. “Initially a lot of work was required to connect to the new venues, but now we can leverage this foundation meaning additional work for subsequent venues is limited. Given the surge has slowed, once we have evaluated a venue and decided it’s worth connecting to, it doesn’t take long.” As soon as MiFID allowed stocks to be traded on different venues—fragmentation—the door was open for the development of smart order routers in Europe as brokers sought liquidity. Fragmentation has now reached the point where in the week ending October 1st, to trade Imperial Tobacco Group, for example, an average of 2.88 markets had to be visited in order to achieve best execution, according to the Fidessa Fragmentation Index. Globally last year, an estimated $772m was spent by clients for access to smart order routers and Aite Group believes this figure will reach $1bn this year, 95% spent with sell side brokers. Bill Capuzzi, president, ConvergEx’s G-Trade Services, says that current low volumes have contributed to the need for smart order routers. “When liquidity starts to dry up and the only place your broker has fast access to is the primary

Photograph © Madartists / Dreamstime.com, supplied October 2010.

exchange with no smart order router—that’s significant. Low volumes will hurt and we are all battening down the hatches, but markets are cyclical and there’s no better time than right now to invest in next generation SORs. The markets will rebound in six to 12 months’ time and the smart brokers are gearing up for that.” Tiefenbrun on the other hand believes low volumes and less commission may have the opposite effect and slow down adoption: “Having an SOR and connecting to multiple venues, and having clearing arrangements with multiple CCPs, and paying for connectivity for market data—it’s expensive. It’s easier to pay for new infrastructure when there’s plenty of commissions to pay for it.” “Bloomberg’s SOR is tightly coupled with our algorithms. Smart order routers aren’t simply about selecting the best venue, but also about preserving our customer’s queue position. Therefore, we coupled our SOR with knowledge of every customer order that is currently on the exchange,” says Taur.

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SMART ORDER ROUTING: TECHNOLOGY PUSHES SOR TO THE LIMIT 74

As soon as MiFID allowed stocks to be traded on different venues— fragmentation—the door was open for the development of smart order routers in Europe as brokers sought liquidity.

Brian Schwieger, head of EMEA algorithmic trading at Bank of America Merryll Lynch. “Your competitive edge drops if you don’t continue to invest. You have to continue to invest if you want to sit at the top table,” he says. Photograph kindly supplied by Bank of America Merryll Lynch, October 2010.

Brian Schwieger, head of EMEA algorithmic trading at Bank of America Merryll Lynch, says the development of SORs is a constant process as firms respond both to client demand and new ideas and models coming from exchange venues. “Your competitive edge drops if you don’t continue to invest. You have to continue to invest if you want to sit at the top table.” To some extent, this means that the medium to smaller buy side firms are becoming more heavily reliant on the sell side for their technology. Schwieger says: “Development of algorithms involves a significant amount of money and you need to get that economy of scale for this to make sense.” Richard Balarkas, chief executive officer of agency broker Instinet Europe, believes smart order routing has developed along three paths: aggressive trading, where you need to grab the best price and liquidity, passive trading, where dynamic queue management is important, and the search for dark liquidity. “Obviously with dark liquidity you can’t see it, so if you are taking liquidity, the best you can do is sweep the dark pools giving higher priority to those where there is a higher probability of finding liquidity and those with lower latency. You leave your passive orders where the chances of a fill are highest. SORs take account of which dark venues it thinks have been active and can also route visible business to dark pools before lit books,” he explains. This sweeping of dark liquidity is not a new phenomenon, and dark trading has grown fast in popularity in Europe, in particular. Trading systems provider Fidessa is seeing an increase in dark trading volumes up to 20% of total trading in places, and a growing emphasis on internal crossing with brokers increasingly using dark SORs and dark-seeking

algos. Proving the point, NYSE Euronext’s SmartPool, a broker-backed non-display trading platform, in October announced a 28.3% rise in matched volumes in the third quarter (Q3) 2010, marking six consecutive quarters of growth. This fast adoption has encouraged buy side use of smarter algorithms and order routers, points out Andrew Morgan, European head of Deutsche Bank’s electronic trading service Autobahn, which in March launched a dark liquidity-seeking algorithm, SuperX (pronounced Super Cross). Morgan says: “Dark pools are becoming more significant for the buy side. As more products become available, customers are using these as they look for more help to navigate dark pools.” According to Capuzzi: “The smart router needs to be able to quickly send an order to the dark and rebalance an order from dark to light. In the US, a lot of flow is directed into the dark. It’s self-fulfilling; the more that ends up in dark, the more it will continue to grow, as people invest in that technology.” He says that in the US, with its trade-through rule, exchanges are mandated to pass on an order for best execution: “There’s a natural backstop at the exchange level for brokers using smart routers, although with the need for speed you never want to rely on the exchange to do the route because of the latency involved. In Europe you don’t have that and it really puts the onus on the broker to ensure they have linkages to every single viable liquidity source.” Recent years have seen a convergence of DMA, algorithmic and smart routing technology and brokers debate whether smart routers are better integrated with the firm’s algorithms or kept apart. At Deutsche Bank all algorithms are fully integrated with the bank’s dark and lit-seeking smart order router, while at UBS, the SOR and algorithms are functionally separate components. Deutsche Bank’s Morgan says: “You can use a smart order router without an algorithm, but it’s very unusual to use an algo without an SOR.” Balarkas also sees a convergence:“Three years ago I might have referred to technical diagrams that showed three almost distinct system components—smart order routing, algorithms and internal crossing systems. But over time it has become blurred.”Instinet’s Nighthawk is an example of this blurring being both an algorithm and a smart order router. “With an ability to search out dark liquidity, it has been the firm’s fastest growing algo in terms of usage,” he adds. Customisation of smart routers and algorithms is essential and Ian Salmon, head of Enterprise Business Development at Fidessa, says:“The next generation SORs strike the balance between a black-box programmable solution and a more flexible solution that enables firms to configure their own analytics tools.” Dr Giles Nelson, deputy chief technology officer, Progress Software, whose clients include hedge funds,

NOVEMBER 2010 • FTSE GLOBAL MARKETS

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SMART ORDER ROUTING: TECHNOLOGY PUSHING SOR TO THE LIMIT 76

brokers, regulators and exchanges, says:“Clients don’t want us to sell exactly the same software we have sold to them to their competitor down the road.” In September, the company released the Progress Apama SOR Accelerator to help traders create and deploy SOR strategies more quickly, a solution, they say, particularly relevant in India, where in August the Securities and Exchange Board of India (SEBI) allowed the Indian stock exchanges to trade through SOR technology and extended SOR and wireless trading to all classes of investors. The Accelerator uses complex eventprocessing technology allowing buy side and sell side to quickly design, test, deploy and evolve strategies. As buy side knowledge of technology grows, Aite Group reports that among the more traditional firms, an average of 26% of order flow is executed via low-touch, although this ranges from 45% at some firms to only 15% at others. Even so, Aite puts total flow conducted by algorithms and DMA, by both traditional and high-frequency trading firms in Europe, at 70% by 2012. “The rate of adoption of algorithmic strategies and smart order routing technology by buy side traders in Europe has been significantly more rapid than that of US traders,” says Simmy Grewal, an analyst with Aite Group in her report, The European Equity Electronic Trading Market, March 2010. Grewal says this is partly down to US colleagues educating European colleagues and partly because the infrastructure for smart routing already existed in the US and could be leveraged for Europe. Schwieger agrees: “The core SOR technology came from the US and then we did a lot of work on it to make it work in Europe, with its different currencies, regulations and different types of venues, for example. Now some of those ideas are being exported back to the US.” Self believes the growth in understanding of the buy side has been significant in 2010, even though “99%, the vast majority”, are still using broker smart order routers. “Two years ago, clients would simply ask: Do you have a smart order router? Now clients are interested in the specific details and how exchanges and MTFs operate with different order types, how they are integrated and where they are located.” Nonetheless, Balarkas believes the buy side’s appetite for competition among venues in Europe is variable. He says Instinet has received letters from buy side compliance departments insisting that trading is only conducted on primary exchanges. “Some believe that any fragmentation is bad and some continental countries have utterly failed to take advantage of the new competitive environment.” Among buy side fears is that brokers use order routers to trade on the cheapest venue rather than one where the clients are likely to achieve the best result. Balarkas points to the rise in trading on some MTFs when they have adjusted their tariffs in order to buy flow from brokers, even if it means operating at a loss. “Why does liquidity shift in response to MTF pricing?” he asks. “Under MiFID, brokers are not required to get the best price, only to be capable of demonstrating to the client that they have completed the trade according to their execution policy. That leaves huge

Natan Tiefenbrun, commercial director, Turquoise. “Once some brokers began to see the benefits of smart order routing, others who didn’t have one had no choice but to go down that path,” he says. Photograph kindly supplied by Turquoise, October 2010.

Bill Capuzzi, president, ConvergEx’s G-Trade Services. “When liquidity starts to dry up and the only place your broker has fast access to is the primary exchange with no smart order router—that’s significant,” he states. Photograph kindly supplied by ConvergEx, October 2010.

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scope for brokers to boost margins by matching business internally or going to venues with rebate schemes.” Certainly the exchanges seem to use rebates as a marketing tool and encouraging brokers to connect their smart routers. Turquoise, the share-trading platform bought out by the London Stock Exchange earlier this year, was bringing in a new fee scheme from November 1st 2010 for 60 liquid stocks under which they will give a rebate of 0.4 basis points (bps) for posting liquidity and will charge 0.3bps for taking it. While initially it will be loss-making in those stocks, Tiefenbrun is hopeful that it will draw liquidity and new participants to the new Millennium platform with its low latency and capacity. Grewal points out another issue: “If you have the same price on two different venues and the broker has a stake in a particular MTF, would the broker be more likely to route there? Every broker will say they are independent, but their clients need to ask the following questions: how are their smart order routers calibrated and what is the decision-

As buy side knowledge of technology grows, Aite Group reports that among the more traditional firms, an average of 26% of order flow is executed via low-touch, although this ranges from 45% at some firms to only 15% at others. making process that ultimately determines where their orders are finally executed?” Owain Self is wary that some investment banks may prioritise routing to rebate-giving venues at the cost of their clients’ execution quality and says:“There can be an inherent conflict of interest for a broker trying to minimise their trading costs while still achieving best execution. Some brokers may be inclined to post only on the exchange with the highest rebate, but this may have a significant impact on probability of execution in the short term. As an agent, we are trying to get the best price for our client. If in order to achieve that I incur increased settlement costs by trading in multiple venues and/or have to trade on relatively expensive ones, then so be it.” Whether brokers set their routers to connect to one venue or another still depends on the client’s investment strategies and Tiefenbrun says traders these days are looking at the probability of getting an order done. “With multiple venues at the best quote, brokers increasingly look at certainty of execution to determine where to route—favouring faster venues. For passive order flow, to maximise likelihood of execution you want to choose a venue where you will be traded against quickly, looking at the order book queue depth considering which markets aggressive trades seeking liquidity will favour.” Balarkas believes much of the decision is based on historical data. “We look at venues actively trading today. If a venue hasn’t traded a stock, why would we leave an order there— you would move your trade. If you simply join the shortest

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Andrew Morgan, European head of Deutsche Bank’s electronic trading service Autobahn. He says: “Dark pools are becoming more significant for the buy side.” Photograph kindly supplied by Deutsche Bank, October 2010.

queue it may turn out to be on an exchange with low velocity, and you may have been filled faster joining a longer queue on a more active book.” Smart routers can direct orders sequentially, sending to venues one after another, or in parallel, spraying all venues at once. BATS, for example, unveiled parallel routing strategy in September, which routes orders to all market centres with a quote at each price level simultaneously. Each price level will be exhausted before moving on to the next. “Due to increased competition in the marketplace and increasing participation of high frequency traders, Bloomberg Tradebook SOR sprays venues simultaneously to attempt maximum price improvement and liquidity capture. This takes into account the varying latency of each venue as part of its anti-gaming techniques,” says Bloomberg’s Taur. The sell side still bears the brunt of the expense of developing and connecting when regulation determines a change of direction. “It’s part and parcel of being in the business,” says Andrew Morgan. “You have to do things in a compliant way, but the expense also represents an opportunity if you are able to respond more quickly than the competition.” As the debate on smart routing continues, the Fidessa Fragmentation Index expanded to near global coverage in September; India now allows SOR technology; Canada and Asia are beginning to see liquidity fragment. A glance around the world sees the need for smart order routing is not going away. I

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HI-TECH HIDE AND SEEK

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

Algorithms have given buy side traders the ability to control their orders as never before, but they must understand where each algorithm will route orders to make sure they do not reveal too much to the market. While traders can exclude venues deemed undesirable in the first instance, it is harder to police whatever links exist between a particular venue and others. For example, a broker may have reciprocal agreements with other brokers to route unmatched order flow to each other’s dark pools before it goes to the open market. Every time an order is exposed before it is filled increases the risk that someone will take advantage of it. Neil O’Hara explains why buy side traders are sceptical, cynical and have to be detectives. UY SIDE TRADERS never stop worrying that other market participants will figure out what they are doing and trade against them. The affliction isn’t new; it was bred in the bone even in the days when the exchanges were the only place to trade and investors used smaller brokerage firms as “beards” to cover their tracks. Today, traders can choose from multiple execution venues and have an arsenal of algorithms and other technological aids to help them disguise their intentions—but the fear that information will leak to the market persists. The desire for anonymity hasn’t disappeared, it has just gone hi-tech. Traders are also somewhat schizophrenic. They try to give out as little information as possible about their orders, but they have to tell somebody something or the trade will never get executed at all. Much depends, of course, on the time horizon; a portfolio manager who is anticipating or reacting to news will want the trade done yesterday, while a patient manager pursuing a long-term play may be content to buy or sell over several days. The trader has to decide whether to go for a quick fill anyway: it may move the price by 2%, whereas accumulating the position over the course of a trading day may cut the impact to 25 basis points. If the price goes up 10% during the day, however, the higher cost fast execution is the better trade.

“We are always juggling market impact against opportunity cost,” says Michael Buek, a portfolio manager in the quantitative equity group at The Vanguard Group, a Valley Forge, Pennsylvania-based asset manager best known for its low-cost mutual funds. The nature of the investment portfolio affects the way best execution is handled, too. For index funds, Buek prefers to trade at the closing price to minimise tracking error against the benchmark. In an actively-managed portfolio, if he has to buy 100,000 shares in a mid-cap name that only trades 100,000 shares on an average day, he’s likely to try independent block crossing networks like ITG POSIT or Liquidnet before he goes to lit venues such as the legacy exchanges. If there is a match at the right price, he can get the trade done in a dark pool before anyone other than the seller knows the order existed. Most of the time the match isn’t there, so he has to tap other trading venues. Buek sees broker dark pools as a substitute for upstairs trading, in which a buy side trader gives the order to a trusted broker who contacts investors it knows are interested in the stock. Ideally, the broker finds a natural buyer on the first call and the trade goes through, but it usually takes several calls—and with each call, someone

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else knows about the order. “Suppose they call one of our major competitors that happens to be a buyer: will it get more aggressive in buying the stock?” asks Buek. “You have all this leakage of information.” Dark pools reduce that leakage by allowing the trader to indicate an interest in trading without alerting anyone who isn’t willing in principle to take the other side. All dark pools are not created equal, however. While Liquidnet’s block crossing facility is open only to buy side firms, broker-owned dark pools permit wider access in an effort to maximise the opportunities for internal crosses. That may include retail flow, which poses no threat, but it may also include high-frequency trading firms which place small orders in an attempt to discover whether any big buyers or sellers are active in a stock. “I might put a minimum quantity of 1,000 or 5,000 shares, depending on the stock, so they can’t get information for only 100 shares,” says Buek. “I try not to trust anybody; I assume people are up to no good. It’s healthy paranoia to be careful.” That’s why Vanguard always uses limit orders, a policy that protected the firm against wacky executions during the flash crash. The outlier trades on May 6th this year were all computer driven, of course, but Kevin Cronin, director of global equity trading at Invesco, a $558bn Atlanta, Georgia-based money manager, does not blame algorithms for causing the problem. He cites instead the proliferation of trading venues that do not all work the same way in a fast market or major dislocation. The solution, in his view, lies in changes to the equity market structure: the introduction of limit up and limit down on price movements, a concept already familiar to investors in the commodities markets; a collar on market orders so that they won’t execute more than, say, 5% away from the last sale at the time the order is entered unless they are reconfirmed by the investor; and curbs on the ability of high-frequency trading firms to pull back from the market. “Some traders have an advantage in speed from co-location,” says Cronin. “Where there is privilege there needs to be a corresponding obligation.” Algorithms have given buy side traders the ability to control their orders as never before, but they must understand where each algorithm will route orders to make sure they do not reveal too much to the market. While traders can exclude venues deemed undesirable in the first instance, it is harder to police whatever links exist between a particular venue and others. For example, a broker may have reciprocal agreements with other brokers to route unmatched order flow to each other’s dark pools before it goes to the open market. Every time an order is exposed before it is filled increases the risk that someone will take advantage of it. “We have always been paid to be sceptics and cynics,” says Cronin. “Now, we also have to be detectives.” It’s a function Richard Balarkas, chief operating officer of Instinet Europe, believes buy side traders should always have fulfilled—and was arguably even more important years ago when the buy side relied more on banks and brokers using their capital to facilitate trades. The market makers of yore had only one purpose: to make money off the trade. “How would the buy side ever know how profitable the trade was for the

FTSE GLOBAL MARKETS • NOVEMBER 2010

Richard Balarkas, chief operating officer of Instinet Europe, believes buy side traders should always have fulfilled the function of detectives—and was arguably even more important years ago when the buy side relied more on banks and brokers using their capital to facilitate trades. Photograph kindly supplied by Instinet, October 2010.

sell side?” he asks. “If there is a need for detective work now, there was a greater need then. Adding it to the buy side’s responsibilities is necessary and appropriate.” As a pure agency broker, Instinet is agnostic about where a trade is executed; indeed, it was often the first to sign up as multilateral trading facilities sprang up across Europe, which Balarkas says gives it access to more liquidity than even the banks can muster. Just because it has access does not mean a particular venue will be used for every order, though; Instinet’s traders still tailor execution based on liquidity in the stock, the order size relative to that liquidity and how fast the client wants the order filled. “We have clients whose alpha horizon is measured in seconds, while at the other extreme it may be ten to15 years,” says Balarkas. “We will use every tool we have at our disposal.” Instinet has its own suite of algorithms, which handle many trades that in the past would have gone through an upstairs block trading desk. They are only a tool, however, and in the right circumstances Instinet will fall back on the old play book and make quiet contact with a few clients it trusts that have in interest in the stock a client wants to trade. For the most part, though, algorithms provide a cheaper way to execute than paying a broker to take on risk and can be just

ANONYMITY: WHY PARANOIA IS HEALTHY FOR THE BUY SIDE 80

Tony Barchetto, head of strategy, US equities, at Liquidnet Holdings, comments: “Traders don’t want to broadcast their interest too widely in these smaller names. That is where we add the most value. If they need size and anonymity they are going to come to us.” Photograph kindly supplied by Liquidnet, October 2010.

as fast if traders use them properly. “Markets are illiquid compared to what they were three or four years ago,” says Balarkas. “If people do not control the algorithms they are using, the market impact of execution performance can be much worse.” Just how much worse became apparent during the flash crash when investors who used stop-loss orders—a crude form of algorithm—were filled at prices far below the stoploss threshold. Once a stop is tripped, the order is executed at the market with no guarantee of what the price will be. That can be risky in a fast market, especially when the highfrequency traders who have become the default liquidity providers are not obliged to make a two-way price at all times. Balarkas insists, however, that investors know—or should know—how the order works. “I don’t have much sympathy for clients whose stop losses trigger under the exact circumstances they defined who then complain that the broker should have had a crystal ball and realised the market was going to bounce a few minutes later,” he says. The absence of liquidity led to some extraordinary fills on May 6th, but even in normal market conditions large orders have a bigger impact on less liquid stocks. That explains why Liquidnet dominates trading in small and mid-capitalisation names, where the ability to trade in the dark and only with other natural investors can significantly reduce the market impact. “Traders don’t want to broadcast their interest too widely in these smaller names,” says Tony Barchetto, head of strategy, US equities, at Liquidnet Holdings. “That is where we add the most value. If they need size and anonymity they are going to come to us.” The average ticket on Liquidnet in the US has remained stable at around 50,000 shares despite the reduction in equity trading volume in the past two years. The firm’s overall market share has slipped a bit, but its core constituency of buy side institutions is doing as much business as ever. “If highfrequency trading has increased, we don’t look at that as lost market share,”says Barchetto. “It was never ours to capture.” Liquidnet also works hard to ensure participants in its dark

Kevin Cronin, director of global equity trading at Invesco. “Some traders have an advantage in speed from co-location. Where there is privilege there needs to be a corresponding obligation,” he says. Photograph kindly supplied by Invesco, October 2010.

pool behave like natural investors and respect the rules—it will banish firms that don’t, a sanction it has applied in every year of its existence. Buy side traders will trade in anonymous block crossing networks if they can, but the other side of a particular trade may not be there. At that point, the optimum execution technique changes and a game of cat and mouse begins. Mat Gulley, director of global trading at Franklin Templeton Investments, a $600bn money manager based in San Mateo, California, says he rarely trades in blocks any more to thwart market participants who use software designed to detect trading patterns. He also avoids volume weighted average price algorithms that target a fixed percentage of trading volume, an easily recognisable footprint. “Traders are getting smarter,” says Gulley. “They are aware the tracking technology is out there and are changing their trading strategies.”

The absence of liquidity led to some extraordinary fills on May 6th, but even in normal market conditions large orders have a bigger impact on less liquid stocks. To some extent, the degree of urgency in a trade may depend on the manager’s investment style. A growth manager is more likely to have a short time horizon that requires a trader to tap both dark and lit venues, while a value manager may be patient and allow the trader to stay in the dark. Different types of orders may be better suited to one venue over another as well. “You start to see a pattern in where orders of a similar type get executed,” says Gulley. “We have venues of choice for certain types of orders where the contra side tends to match up.” No doubt some market participants would give their eye teeth to know which orders fit which venues, but Gulley isn’t saying. Like any good buy side trader, he’s paranoid about anonymity. I

NOVEMBER 2010 • FTSE GLOBAL MARKETS

NEWER VENUES MAKE THEIR MARK The post-MiFID influx of newer and increasingly efficient multilateral trading facilities (MTFs), along with the recent arrival of major cash-market central counterparties (CCPs), has clearly altered the balance of power in the Nordic trading arena. Yet against this backdrop, some see the incumbent Nordic exchanges not only keeping pace but perhaps shifting the momentum back in their favour, using more durable technologies while emphasising natural advantages in local research and relationship-based client service. Dave Simons reports. INCE THE ARRIVAL of MiFID three years ago this month, the Nordic incumbent exchanges, like their counterparts throughout Europe, have been forced to take evasive action following the proliferation of pan-European exchanges and multilateral trading facilities (MTFs), which continue to bring intense competition to the region. Chi-X, which launched in Sweden in early 2008 and subsequently moved into neighbouring regions, has been the most successful MTF to date. Meanwhile Burgundy, an MTF that trades specifically in more than 800 Swedish, Norwegian, Finnish and Danish listed stocks and is backed by leading Nordic banks and brokers, recently announced plans to colocate its matching engines to Stockholm in an effort to boost capacity and attract high-frequency flow to the venue. These developments have had a pronounced impact on the region’s incumbent exchanges, with some estimates putting loss of market share in the vicinity of 35%. The sheer number of venues has taken its toll on some newcomers as well. Last spring, NASDAQ OMX Group sent tremors through the industry when it announced the cessation of its pan-European trading platform known as NASDAQ

FTSE GLOBAL MARKETS • NOVEMBER 2010

OMX Europe, or Neuro, after the two-year-old MTF failed to gain sufficient market share in the wake of increasingly stiff competition. The closure may suggest further MTF consolidation in the area, according to some observers. Despite this, NASDAQ earlier this year completed the roll out of its highly touted INET trading system in all seven of its equities markets in Copenhagen, Helsinki, Iceland, Stockholm, Riga, Tallinn and Vilnius. According to NASDAQ, INET is capable of handling 1m messages per second at sub-250 microsecond average speeds, making it the world’s fastest trading system to date, says NASDAQ. During 2010, NASDAQ also brought to market its cashmarket central counterparty (CCP), operated by the European Multilateral Clearing Facility (EMCF), one of several CCPs recently launched in the region. Because CCPs serve as both buying and selling agents for each and every trade, their introduction has been crucial, particularly as a greater number of Nordic-listed shares become traded outside the region. Price competition between the various clearinghouses, though intense, has nonetheless created greater efficiency as well as lower prices. With clearing providers such as SIX x-clear

NORDIC TRADING: INCUMBENT EXCHANGES CAN GRAB BACK MOMENTUM

Photograph © Nmedia / Dreamstime.com, October 2010.

NORDIC TRADING: INCUMBENT EXCHANGES CAN GRAB BACK MOMENTUM 82

While standard algos can be adapted, particularly as the region’s market structure becomes increasingly similar to the rest of Europe, many favour algos that are specifically geared toward the nuances of the Nordic markets.

and EuroCCP set to offer interoperability by the end of January next year, that trend is likely to continue. Against all of this activity, the region’s primary exchanges appear to be holding their own, and then some. In what many viewed as a concerted effort to contain further loss of market share, in June, Norway’s main exchange Oslo Børs rolled out its own vertically integrated central counterparty, Oslo Clearing, covering all equities, equity certificates and ETFs traded on Oslo Børs as well as Oslo Axess. In addition to boosting competitiveness, the new CCP structure will help mitigate risk while lowering costs, asserts Bente Landsnes, chief executive officer of Oslo Børs. Finally, the harmonisation of tick sizes across Europe represents yet another key development in the Nordic region. The consolidation of 25 different tick-size regimes into a far more manageable four regimes promotes standardisation of incremental stock movements, allowing Nordic traders to benefit from lower overall transactional costs as well as increased liquidity.

MTF effect While fragmentation of liquidity across the Nordic exchanges is patchy at best, the newer venues are having an impact, says David Pearson, head of new business marketing for Fidessa, a provider of technology solutions and data to the global financial markets. In particular, Pearson sees local brokers placing increased emphasis on technologies required to properly access the incoming MTFs. “The initial stampede for smart technology has shifted, and today smaller brokers are seeking a partner that can offer technology as part of the overall trading service,” says Pearson. “Looking ahead, the broking community will increasingly use technology-driven relationships to maintain their place in the local markets, while at the same time remaining focused on providing services to their client base.” The ability for all brokers to execute Nordic equities trades themselves through a single trading venue would appear to have dire consequences for the regional exchanges. This, however, may not necessarily be a foregone conclusion, asserts Christian Hyldahl, head of investment banking, Nordea. “Market shares are currently being pushed towards specialised technology firms and global houses used to multivenue trading,” says Hyldahl. “However, the regionals still control the majority of the investor flows, and are also continuously upgrading their technologies.” As such, Hyldahl expects that the momentum will shift in favour of the regional brokers, supported by the constant demand for newer and

Miranda Mizen, principal at Boston-based TABB Group. “Fragmentation still lags, and at the same time, many Nordic brokers are getting up the curve in terms of smart-routing technology,”she says. Photograph kindly supplied by TABB Group, October 2010.

more efficient trading mechanisms. Given the extent of their corporate relationships, local brokers are also in the best position to understand the fluctuating trends of the Nordic investor base, adds Hyldahl. Asa Palm, head of algo trading, SEB, says that increased fragmentation from the influx of MTFs has compelled brokerage houses to adopt smart-order routing technology at a much faster pace in an effort to localise Nordic liquidity efficiently, while the introduction of Nordic CCPs has resulted in lowered transactional costs. Meanwhile, reduced trading volume, combined with the increase in regional venues, has resulted in a far more competitive marketplace, says Palm. “The average trade size has diminished by more than 50% over the past year, and in some instances margins have dried up completely,” says Palm. “This is having an impact on both local and international players who are fighting over liquidity while bearing higher costs to sustain a competitive advantage. While one might assume that this works to the advantage of larger international players, we feel that well-positioned local players such as SEB Enskilda will benefit from the higher level of flexibility required to keep up with the technical requirements going forward.” While the impact of CCPs in the region is more difficult to quantify in general terms, the reduction of trading costs will obviously be a major benefit for the broking community as a whole, says Pearson. “It will bring new players to the Nordic markets, and the landscape will change as more electronic/HFT trading firms participate.” Having a CCP act as the main clearing agent for trading activity is highly significant for the region, says Miranda Mizen, principal at Boston-based TABB Group. Still, she adds, competition will drive longer-term change. “Global banks gain commission dollars and rank amongst the top as they have a wide reach, but the need to pay for regional research and the lack of unbundling in the region also keeps commissions tight.”

NOVEMBER 2010 • FTSE GLOBAL MARKETS

Pearson agrees that the local venues have experienced a liquidity pullback as a result of changing market conditions. “None of the domestic markets in Europe has resisted the rise of the MTF where the regulatory and clearing framework is fair and even,” says Pearson. It is therefore imperative that local brokers make the necessary changes so that they can retain their place in the domestic markets. This can be accomplished by offering bespoke services to institutions and retail clients, suggests Pearson. “Investing in technology and relationships gives them the opportunity to move forward and improve their trading capability and level of service.” Demand for sound local research will likely continue to play to the strengths of the incumbent venues, adds Mizen. “Every market has good niche players, and a lot depends on the kind of research that is required. However, there will always be a healthy market for those with the closest relationships and corporate access. While that isn’t always de facto a local broker, they often can provide a level of niche expertise backed by differentiated order flow and market colour.”

Keeping pace Smaller tick sizes and lower-latency trading, combined with an increase in market fragmentation in the region, have created a fertile ground for high-speed trading activity. Current estimates suggest that roughly 30% of all Nordic trading activity is HFT-based. “It was illuminating to hear several non-equity European exchanges state openly that they have slowed their processing down in order to ensure a level playing field for the retail customer and the brokers and trading houses,” says Pearson. “Their view was that if the market has significant retail flow, then the retail investor should be able to trade on an equal footing.”

Mizen, however, says that the balance of power hasn’t necessarily shifted just yet. “Fragmentation still lags, and at the same time, many Nordic brokers are getting up the curve in terms of smart-routing technology.” In an increasingly high-speed world, traditional venues widely regard algo usage as key to maintaining equilibrium. While standard algos can be adapted, particularly as the region’s market structure becomes increasingly similar to the rest of Europe, many favour algos that are specifically geared toward the nuances of the Nordic markets. “The effect of wider spreads and unusual liquidity distribution in the order-book depth in some markets can give the general ‘European’VWAP/POV algorithm problems,” says Pearson. “Smarter technology that is able, for instance, to use local volume curves and statistical parameters will manage the local market nuances better. So the algorithms can be regional, but the parameters that drive them are tailored. The argument can be placed the other way round however, in that differences in the style of trading between local markets have reduced because of the use of algorithms.” Mizen adds: “Market structures can be similar but not necessarily identical. An algorithm may fit one market well but be less appropriate for the ebb and flow of another market without tweaking. Customisation adds the extra edge for optimal execution. Make-up of participants, variety of flow, pricing, latency and clearing elements amongst other things do play a part. The added complexity is also the dark environment the algorithm may be accessing.” While not necessarily a requirement, regionally tailored algos can certainly add significant value, says Palm. “Particularly as the product offering becomes standardised across the board, having the ability to meet the needs of individual clients can serve as a key success driver over the long haul.”I

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FTSE GLOBAL MARKETS • NOVEMBER 2010

DFSA COMMODITIES: UAE LEADS THE COMMODITY CHARGE 84

The United Arab Emirates (UAE) is learning to play to its strengths: oil and gold. No surprise then that the two main commodity exchanges in the region focus on these commodities. The Dubai Gold and Commodities Exchange (DGCX) now offers contracts in gold, silver, steel, WTI Light Sweet, Brent Crude Oil, fuel oil and currency pairs. Meanwhile, the Dubai Mercantile Exchange (DME), which offers the flagship DME Oman crude oil contract, most recently launched the World Gold Council’s Shari’a-compliant gold shares on NASDAQ Dubai, in conjunction with the Dubai Multi Commodity Centre. Arsheen Saulat, manager of the markets division at the Dubai Financial Services Authority (DFSA), the regulator of DME and NASDAQ Dubai, examines the development of the commodity exchange within the UAE and the challenges ahead.

Photograph © Barna Szoke / Dreamstime.com, October 2010.

CRUDE STRENGTH HE UAE’S GEOGRAPHIC location between Europe, America and the Far East cements Dubai’s markets as as a strategic bridge between the three global financial hubs. Historically, Dubai started out as a focal point on the international gold trading routes, a role it has enhanced over the years. Today, the World Gold Council ranks the emirate as the second largest physical re-distributor of bullion globally. The increase in gold demand is being underpinned by uncertainties in the current market and the equity markets recent woes have prompted investors to diversify their portfolios into less volatile commodities. China’s recently published proposal to improve the development of the domestic gold market stimulates the potential for growth of gold ownership. Coupled with the tight domestic supply in China and the growing global demand, Dubai’s markets are presented as a window of opportunity. It is no surprise that Dubai Gold Securities (DGS), which listed on NASDAQ Dubai in early March last year, has enjoyed substantial demand. These exchange-traded commodities (ETCs) track the gold price almost perfectly. Unlike derivative products, the securities are 100% backed by physical gold held mainly in allocated form. ETCs had a major impact on the gold market, representing an annual average of 32% of identifiable investment, according to the World Gold Council. In similar vein, growing economic activity in Asia is also driving the demand for global crude oil. The Middle East continues to be the world’s largest exporter of crude oil with Asia now the world’s largest importer. Currently around 70% of Asian crude oil imports come from the Middle East and over 65% of the Middle East crude oil exports go to Asia. The Middle

East accounted for approximately 57% of global crude oil proved reserves, 30% of global crude oil production, whilst accounting for 8.7% of consumption for 2009 (BP Statistical Review of World Energy, June 2010). A one-on-one comparison of the same figures for the Americas (North, South and Central)—21% proved reserves, 25% production and 33% consumption— clearly illustrates the dominance of the region and provides the catalyst to the development of energy commodity exchange in the Middle East.

DME Oman Crude Prior to the launch of DME there was no futures exchange in the UAE or the region on which sour crude oil was priced, and by extension there was no robust mechanism for pricerisk management. Dubai crude oil became established as a benchmark in the 1980s, historically trading in over-thecounter (OTC) markets with pricing assessments reported by price reporting agencies or through using differentials to marker crude oil benchmarks; namely NYMEX Light Sweet Crude Oil futures contract (WTI) and ICE Brent futures (Brent) when sold to the West, and Dubai when sold to Asia. WTI and Brent benchmarks are highly liquid and useful for pricing sweet/light crude oil; they were less suitable for pricing sour/heavy crude oils, which represent a large percentage of the Middle East’s total crude oil exports. With Dubai crude oil production declining over the past two decades, the Dubai crude oil benchmark has became more and more susceptible to price irregularities by a handful of OTC participants in the price assessment window. This makes a less credible Middle East crude oil benchmark in a growing and

NOVEMBER 2010 • FTSE GLOBAL MARKETS

Gold: Consumer demand grows

China Hong Kong Taiwan Indonesia India Middle East USA Europe ex CIS France Germany Russia Total Above Other World Total

Consumer Demand* Q2 2009 88.9 3.9 0.4 11.6 164.2 70 52.9 64.3 0.6 28 13.9

Consumer Demand* Q2 2010 111.7 5.1 3.3 6.7 164.5 65.5 56.4 84.8 0.4 44.4 16.3

Percentage change 26 32 803 -42 0 -7 6 32 -29 59 17

498.7 120.6 619.3

559.1 92.7 651.8

12.1 -23.1 5

*Consumer Demand in Jewellery and Net Retail Investment. Source: World Gold Council, supplied October 2010. Consumer demand in selected countries: (tonnes)

increasingly important international market. Compare this to the DME Oman Crude long-term and stable production levels of 850,000 barrels per day. Market participants of the DME Oman Crude are also subject not only to international standards statutory regulations of the DFSA, but also exchange market conduct rules to provide a fair and transparent platform and, further, by the government of the Sultanate of Oman, which committed to calculate its official selling price (OSP) with reference to the settlement price of the DME’s Oman crude oil futures contract. This was followed by the Dubai government doing the same. Over the past two decades there have been many failed attempts to launch a sour crude futures contract. The Singapore International Monetary Exchange (SIMEX) launched the world’s first sour crude futures contract in June 1990. Due to low trading volumes this was terminated in February 1992. Also, in 1990, International Petroleum Exchange (IPE, now ICE) launched a similar crude contract, but due to the Gulf Crisis at the time, forward interest in Dubai crude dried up with the embargo on Iraqi and Kuwaiti crude and the contract was terminated in November 1992. More recently, contracts based on the Oman/Dubai crude price were introduced by exchanges such as NYMEX, in 2000, and the Singapore Exchange. The NYMEX contract was terminated in April 2001 and the Singapore Exchange later agreed to work with the Tokyo Commodity Exchange (TOCOM) in a doomed attempt to increase liquidity. DME Oman Crude today stands as the largest physically delivered oil futures contract in the world. What differentiates DME’s Oman Crude contract from its predecessors and competitors and makes it successful? Two out of every three new futures contracts fail and are de-listed within the first two years of being introduced. A new contract means altering ways of doing business for the potential market participants and the question is how liquidity can be assembled, to which there is no definite answer.

FTSE GLOBAL MARKETS • NOVEMBER 2010

Is the answer to list a contract which has proven success or the riskier approach to innovate with a new contract filling a market niche? A comparison between the DGCX WTI contract and DME Oman Crude illustrates that it is not always the case that “tried and tested”guarantees success. DGCX launched a copycat WTI contract in October 2009, with limited success. Bloomberg shows that this contract remained inactive for over six months with trading resuming in August 2010. In contrast, the innovative Oman Crude contract during the same period of inactivity showed increased trading volume and open interest. The graph (next page) shows the growth of DME Oman Crude Open Interest from June 2007 to September 2010. DME Oman Crude is the benchmark for 6% of easternbound crude, as stated by DME. With continuously growing volumes, and in May 2010 seeing a record of 14m barrels delivered, DME Oman Crude, and subsequently DME, are primed to make the transition from fledgling exchange to an established contender in the global market.

Capitalising on market strength Are UAE energy commodity exchanges poised to capitalise on their advantageous position and continue along their trajectory into the major player’s ballpark? In order to answer this it is important to understand the current environment that these commodity exchanges are operating in. In the summer of 2008, traders bid oil prices up to $147 a barrel due to extremely restricted global supplies. Later that year, the sharp fall in commodity prices to just under $33 a barrel led many to question the traditional rationale of investing in commodity futures to reduce portfolio volatility. Some market participants began wondering as to whether commodities provided any diversification benefits whilst other assets in the portfolio were also sinking. Although prices have seen some retraction since 2008, criticism has been directed at the commodity market regulators for their alleged failure to curb 2008’s unprecedented spike in oil prices.

DFSA COMMODITIES: UAE LEADS THE COMMODITY CHARGE 86

DME: The growth of the DME Oman Crude Open Interest from June 2007 - September 2010 25,000

20,000

15,000

10,000

5,000

0 June

Aug. Sept. 2007

Nov.

Jan.

Mar.

May July 2008

Sept.

Nov.

Jan.

Mar.

May July 2009

Sept.

Nov.

Jan.

Mar.

May 2010

June

Sept.

Source: DFSA, supplied October 2010.

Two names which currently dominate the discussion around commodity derivatives transparency are those of Dodd and Frank. On July 21 2010, President Obama signed the DoddFrank Wall Street Reform and Consumer Protection Act, introducing the new legislative framework for, amongst other things, derivatives. This follows, but is not related to, the September 2009 Pittsburgh summit, where the G20 members agreed to “improve the regulation, functioning, and transparency of financial and commodity markets to address excessive commodity price volatility”, particularly in the global oil markets. At first glance, and listening to the initial buzz surrounding the Dodd-Frank Act, you could be forgiven for thinking that there would be a significant impact on the energy derivatives exchanges. However, a closer look reveals that the focus of the act is not on the commodity exchanges specifically; rather, the act extends current futures exchange regulation to a wide variety of OTC swaps. The act revises the definition of a swap and also defines deals covered by master agreements as swaps. This is important for the energy industry where master agreements are an accepted method of trade. The act makes swap trading unlawful unless the swap is not required to be cleared, is cleared in a clearinghouse or is given an exemption. Exemptions detailed include trades where the counterparty is not a financial entity, is using the swap to hedge or mitigate financial risk, or if the entity notifies the commission detailing the particulars of the arrangement. How much does all this affect the UAE energy commodity exchanges? Liquidity of the Dubai Oman crude contract has increased by 130% since 2008, with a daily average of 2,930 lots this year so far, equivalent to almost 3m barrels of oil daily. The volume of the spot and OTC swap market based on Dubai and Oman crude is less clear but estimated to be a multiple of that number. However, with the exemptions in place, together with the knowledge that participants of the energy market in this region are for the most part non-financial entities, and/or true hedgers, it may be a fair assessment that any effect of the new legislation

would be minor. In January 2010, the Commodity Futures Trading Commission (CFTC) proposed position limits designed to prevent any one participant from developing a concentration of futures positions. The proposed limits would have restricted the position energy traders could hold and addressed concerns of the regulators following the oil price spike of 2008. The Dodd-Frank Act provides a more expansive mandate, allowing the CFTC to set aggregate position limits across all markets on non-commercial market participants. These mandates may have a significant impact on the energy futures market globally. Energy traders will now face position limits with respect to the energy contracts that were previously largely unregulated. Does this create an opportunity for nonUS energy exchanges to step in and capture some of their market share? Market participants who use the DME Oman Contract do so to mitigate the risks presented with oil and the oil producers east of the Suez Canal, and, therefore, are not in direct competition with the established exchanges for their market share and the impact may be largely negligible. Today’s energy trading environment is subject to change; some have even gone as far as to say there is a paradigm shift under way, driven by demand for transparency in the derivatives markets by the G20 governments and caution following recent global events. Where oil price discovery through financial markets is concerned, perhaps this is more an alignment with the regulatory obligations for securities markets than the revolutionary change it is depicted to be. Whether alignment, evolution or revolution, energy commodity exchanges and their regulators are embarking on a journey of change. The question remains as to whether the UAE markets are ready to take this chance. Whether this challenge should be met through innovation, which has proven successful in the UAE, or through replication and consolidation on the successes of developed exchanges, is yet to be seen. The months ahead promise interesting and challenging times for UAE commodity exchanges and regulators alike. I

NOVEMBER 2010 • FTSE GLOBAL MARKETS

(Week ending October 8, 2010) Reference Entity

Federative Republic of Brazil JP Morgan Chase & Co. Bank of America Corporation

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Government

Sov

14,997,130,791

149,068,299,951

11,122

Americas

Financials

Corp

5,124,579,826

84,641,038,805

9,106

Americas

Financials

Corp

5,751,681,797

80,624,262,052

9,069

Americas

United Mexican States

Government

Sov

7,118,145,356

108,753,380,082

8,944

Americas

Republic of Turkey

Government

Sov

5,969,755,200

135,633,670,034

7,814

Europe

Financials

Corp

11,907,125,995

95,276,822,876

7,739

Americas

Telecommunications

Corp

2,807,138,017

71,353,519,409

7,680

Europe

Consumer Goods

Cor

3,042,079,586

63,892,293,827

7,548

Europe

Telecommunications

Corp

3,299,763,023

65,603,206,767

7,275

Europe

Government

Sov

28,487,676,795

256,165,059,244

7,095

Europe

General Electric Capital Corporation Telecom Italia Spa Daimler AG Deutsche Telekom AG Republic of Italy

Top 10 net notional amounts (Week ending October 8, 2010) Reference Entity

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

Republic of Italy

Government

Sov

28,487,676,795

256,165,059,244

7,095

Europe

DC Region

Federal Republic of Germany

Government

Sov

15,458,997,447

81,287,347,663

2,350

Europe

Kingdom of Spain

Government

Sov

15,399,151,997

116,684,262,570

5,082

Europe

Federative Republic of Brazil

Government

Sov

14,997,130,791

149,068,299,951

11,122

Americas

French Republic

Government

Sov

13,173,988,027

69,936,987,977

2,998

Europe

Financials

Corp

11,907,125,995

95,276,822,876

7,739

Americas

General Electric Capital Corporation UK and Northern Ireland

Government

Sov

10,332,842,644

54,894,855,623

3,758

Europe

Republic of Austria

Government

Sov

8,593,547,787

47,877,106,819

2,034

Europe

Portuguese Republic

Government

Sov

7,520,870,164

64,793,269,029

3,070

Europe

Hellenic Republic

Government

Sov

7,143,613,687

80,013,426,224

4,335

Europe

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending October 8, 2010)

Single-Name References Entity Type

Corporate: Financials

Gross Notional (USD EQ)

3,420,080,822,803

Contracts

References Entity

444,581

Republic Of Italy

4,037,389,318

129

Federative Republic Of Brazil

2,852,450,000

306

Sovereign / State Bodies

2,345,198,139,423

172,031

Corporate: Consumer Services

2,214,842,938,721

366,021

Corporate: Consumer Goods

1,662,158,666,396

267,128

Corporate: Technology / Telecom

1,366,313,621,002

212,882

Corporate: Industrials

Gross Notional (USD EQ)

Contracts

French Republic

2,522,906,230

185

Kingdom Of Spain

2,239,260,209

119

United Mexican States

1,705,961,263

245

Unicredit, Societa Per Azioni

1,554,356,616

190

1,302,788,692,614

224,253

Republic Of Turkey

1,465,915,938

127

Corporate: Basic Materials

953,681,085,482

155,845

Ireland

1,412,973,343

112

Corporate: Utilities

789,257,691,827

125,079

Intesa Sanpaolo Spa

1,404,415,608

187

Corporate: Oil & Gas

473,650,682,857

88,073

Federal Republic Of Germany

1,399,075,968

Corporate: Health Care

346,828,483,513

62,421

Corporate: Other

223,982,026,441

25,762

Residential Mortgage Backed Securities

79,906,948,807

16,018

CDS on Loans

68,951,954,644

18,030

Commercial Mortgage Backed Securities 21,945,029,360

1,976

Other

3,008,445,280

FTSE GLOBAL MARKETS â&#x20AC;˘ NOVEMBER 2010

283

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts

All data ÂŠ 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

Week ending 15th of October, 2010 The Fidessa Fragmentation Index (FFI) was launched to provide a simple, unbiased measure of how different stocks are fragmenting across primary markets and alternative venues. In short, it shows the average number of venues you should visit in order to achieve best execution when completing an order. So an index of 1 means that the stock is still traded at one venue. Increases in the FFI indicate a fragmentation of trading across multiple venues and as such any firm wishing to effectively trade that security must be able to execute across more venues. Once a stock’s FFI exceeds 2 liquidity in that stock has fragmented to the extent that it no longer “belongs” to its originating venue. INDICES

VENUES INDICES

FTSE 100

CAC 40

DAX

OMX S30

SMI

FFI*

2.44

1.95

1.91

1.95

2.02

3.72%

†

11.27%

5.47%

5.17%

6.12%

8.31%

Amsterdam BATS Europe Burgundy

Europe

EUROPEAN TRADING STATISTICS

Fidessa Fragmentation Index (FFI) and venue market share by index

5.74%

Chi-X Europe

26.09%

London

56.99%

22.59%

21.81%

Madrid

†

Milan

0.11%

0.06%

NYSE Arca Europe

0.37%

15.61%

20.53%

0.17%

0.54%

0.20%

Paris

63.98%

SIX Swiss

66.82%

Stockholm Turquoise

69.44% 5.28%

Xetra VENUES

3.90%

3.26%

0.23%

69.50%

INDICES

VENUES

DOW JONES

S&P 500

INDICES

FFI*

4.69

4.21

FFI*

BATS US

11.51%

10.94%

CBOE

0.19%

0.26%

Chicago Stock Exchange

0.38%

0.45%

7.24%

6.21%

Canada

INDICES

EDGA

2.91%

INDEX S&P TSX Composite 1.95

Alpha ATS

15.27%

Chi-X Canada

8.72%

Omega ATS

0.31%

Pure Trading

1.78%

Toronto

58.57%

EDGX

6.28%

6.23%

TriAct MATCH Now

1.75%

NASDAQ

24.43%

26.77%

**US venues

13.60%

NASDAQ BX

3.17%

2.60%

NQPX

0.45%

0.39%

VENUES

INDEX NIKKEI 225

INDICES

NSX

1.26%

1.17%

NYSE

27.64%

25.61%

Chi-X Japan

NYSE Amex

0.10%

0.37%

Fukuoka

†

JASDAQ

†

Kabu.com

0.05%

17.31%

VENUES

18.87%

INDICES

S&P ASX 200

HANG SENG

FFI*

1.00

1.16

FFI*

Japan

NYSE Arca

Asia

3.79%

0.03%

Nagoya

†

Osaka

†

SBI Japannext

0.50%

Tokyo

92.55%

ASX Trade Match

100%

ToSTNet-1

6.87%

Hong Kong

100%

ToSTNet-2

0.00%

Figures are compiled from lit order book trades only. Totals only include stocks contained within the major indices. * FFI in red denotes a figure lower than the previous week; green is higher, black indicates no change. ** This index is also traded on US venues. For more detailed information, visit http://fragmentation.fidessa.com/fragulator/. † market share < 0.01%.

NOVEMBER 2010 • FTSE GLOBAL MARKETS

COMMENTARY By Steve Grob, Director of Group Strategy, Fidessa

New opportunities and challenges in global equities HE CONCEPT OF better or fairer execution was first introduced with RegNMS and it has now been picked up and modified by other regulatory bodies around the world. The effect of this has been to completely reshape the face of global equities trading and create new opportunities and challenges for all players. Like it or not, the fragmentation genie is firmly out of the bottle and now even affects markets where no regulatory mandate for change exists.

The central issue at stake is whether old style concentration rules or the dispersal of liquidity over competitive venues creates a better or “fairer” market. Different geographic regions have taken different approaches by placing the emphasis either on trade through rules at venue level or on compelling brokers to best execute on behalf of their clients (or some combination of the two). In any event, the national, natural or historical monopolies of the primary exchanges are being severely challenged. In their place, we are seeing, a dazzling array of alternative lit and dark trading venues that offer lower costs of trading and, in some cases, completely new business models. This is important for all market participants. Brokers need to understand which venues to participate in and how and where to point their SOR Technology. Traditional buy sides need to distinguish between different broker capabilities and be able to select and measure those that are best equipped to trade a particular security. And, of course, the HFT community is constantly trying to spot new opportunities and back test theories to capitalize on them. Most commentators are agreed that the abolition of concentration rules has driven down prima facie trading costs but what about those hidden extras and how do market participants navigate the new liquidity landscape? The introduction of MiFID in Europe provides a useful illustration of the issues. Unlike RegNMS, the European legislation eschewed trade through rules and a consolidated tape. Instead it created a principles-based approach that allows brokers to route to any venue(s) they like providing that they are clear to their clients and the

regulator what they are doing. The net effect of this is that, in many cases, any gains in lower trading costs have been more than offset by higher workflow costs, and reduced transparency all round. Whilst these issues may well get fixed in subsequent legislation, the fact remains that Europe is rapidly moving towards a two speed model - those that are equipped to make sense and exploit fragmentation and those that can't. Asia represents another version of the global fragmentation “experiment” although this time it is market forces not regulation that is driving change. Many global players are keen to leverage their investment in meeting the challenges of fragmentation in their domestic markets. So, for example, we have seen the arrival of Chi-X Japan to bolster the ranks of the domestic PTSs that have existed there for some time. Chi-X Japan is also joined in Asia by a growing array of broker sponsored dark pools many of which will be familiar to traders in the USA and Europe. And, global buy sides operating in Asia are starting to ponder the same execution issues that their colleagues in the USA and Europe have been asking for some years now. We can look to the US for some pointers as to how it might all shake out. Average trade size in the S&P 500 is now around just 300 shares, five times smaller than the FTSE 100 in London and more than 10 times smaller than the Nikkei in Japan. This emphasizes the role of the HFT community and the smart algos that are chopping parent orders into smaller and smaller sizes to exploit the dispersal of liquidity across a wide variety of venues. Even the distinction between venues, brokers and buy-sides is starting to blur as market participants borrow technology and business models from each other in order to exploit the new fragmented trading paradigm. Whichever way you look at it, the dispersal of liquidity is very much here to stay - and the arrow of fragmentation only points one way - upwards. The crucial debate is whether this is providing a better deal for the retail and institutional investor communities. Without reliable tools to compare and contrast what is really going on, this will be very hard to assess. I

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

FTSE GLOBAL MARKETS • NOVEMBER 2010

GLOBAL ETF SUMMARY

Global ETF assets by index provider ranked by AUM As at end of August 2010 Index Provider MSCI S&P Barclays Capital Russell FTSE Markit STOXX Dow Jones NASDAQ OMX Deutsche Boerse Topix Hang Seng Nikkei EuroMTS SIX Swiss Exchange NYSE Euronext CAC WisdomTree Indxis CSI BNY Mellon Intellidex Morningstar S-Network Zacks Value Line Other Total

No. of ETFs 336 278 81 60 163 92 214 150 55 40 53 12 9 29 15 16 15 35 6 27 11 38 10 15 14 3 531 2,308

August 2010 Total Listings AUM (US$ Bn) 1054 $258.7 505 $227.9 192 $111.9 101 $62.7 360 $46.1 226 $43.0 731 $41.8 277 $38.7 87 $23.7 143 $23.4 65 $12.8 32 $12.6 15 $11.2 91 $10.5 28 $7.6 34 $7.6 26 $6.3 42 $6.0 7 $4.0 28 $2.7 12 $2.3 41 $2.2 10 $1.5 33 $1.1 15 $0.7 3 $0.2 764 $94.8 4,922 $1,061.9

% Total 24.4% 21.5% 10.5% 5.9% 4.3% 4.1% 3.9% 3.6% 2.2% 2.2% 1.2% 1.2% 1.1% 1.0% 0.7% 0.7% 0.6% 0.6% 0.4% 0.3% 0.2% 0.2% 0.1% 0.1% 0.1% 0.0% 8.9% 100.0%

No. of ETFs 71 45 11 -1 37 22 10 14 12 10 0 3 1 7 2 6 -3 -10 -1 16 0 -4 0 2 0 -2 115 363

Total Listings 300 129 33 1 76 68 105 57 24 52 1 9 4 40 5 22 0 -3 -1 17 0 -11 0 2 0 -2 167 1,095

YTD Change AUM (US$ Bn) $14.9 -$21.3 $24.4 -$3.3 $3.4 $4.8 -$9.2 -$2.2 -$2.8 $0.0 $0.3 $0.8 -$1.3 -$0.5 $0.3 $1.5 -$1.2 $0.2 $1.2 $0.3 -$0.1 -$0.4 -$0.2 -$0.1 $0.1 -$0.1 $16.4 $25.9

% AUM 6.1% -8.5% 27.9% -5.0% 7.9% 12.6% -18.1% -5.5% -10.5% -0.1% 2.7% 6.5% -10.1% -4.7% 3.9% 23.8% -15.9% 2.8% 44.3% 12.4% -2.3% -16.5% -11.2% -8.7% 10.6% -25.5% 20.9% 2.5%

% TOTAL 0.8% -2.6% 2.1% -0.5% 0.2% 0.4% -1.0% -0.3% -0.3% -0.1% 0.0% 0.0% -0.1% -0.1% 0.0% 0.1% -0.1% 0.0% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 1.4%

Source: Global ETF Research and Implementation Strategy Team, BlackRock, Bloomberg.

Top 5 global ETF providers by average daily turnover As at end of August 2010 Provider

Average Daily Turnover (US$ Mil) Aug-10 % Mkt Share Change (US$ Mil)

Dec-09

% Mkt Share

Change (%)

SSgA

$19,861.8

39.2%

$26,652.0

46.3%

$6,790.2

34.2%

iShares

$14,572.0

28.7%

$15,049.4

26.2%

$477.4

3.3%

ProShares

$3,891.8

7.7%

$4,366.8

7.6%

$475.0

12.2%

Direxion Shares

$3,446.7

6.8%

$3,083.2

5.4%

-$363.4

-10.5%

PowerShares

$3,219.9

6.4%

$2,965.0

5.2%

-$254.9

-7.9%

Others

$5,712.8

11.3%

$5,400.0

9.4%

-$312.8

-5.5%

Total

$50,705.0

100.0%

$57,516.4

100.0%

$6,811.5

13.4%

5.2%

9.4%

PowerShares

Others

5.4% Direxion Shares

46.3% SSgA

7.6% ProShares

26.2% 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 August 2010 ETF SPDR S&P 500 Vanguard Emerging Markets iShares MSCI EAFE Index Fund PowerShares QQQ Trust Vanguard Total Bond Market ETF iShares FTSE/Xinhua China 25 Index Fund iShares Barclays 1-3 Year Credit Bond Fund iShares EURO STOXX 50 (DE) E Fund SZSE 100 iShares S&P U.S. Preferred Stock Index Fund iShares MSCI Brazil Index Fund iShares Barclays TIPS Bond Fund iShares Barclays Short Treasury Bond Fund Vanguard Short-Term Bond ETF SPDR Barclays Capital High Yield Bond ETF iShares EURO STOXX 50 iShares iBoxx $ High Yield Corporate Bond Fund iShares iBoxx $ Investment Grade Corporate Bond Fund Financial Select Sector SPDR Fund ZKB Gold ETF (CHF)

Country listed US US US US US US US Germany China US US US US US US Germany US US US Switzerland

Bloomberg Ticker SPY US VWO US EFA US QQQQ US BND US FXI US CSJ US SX5EEX GY 159901 CH PFF US EWZ US TIP US SHV US BSV US JNK US EUN2 GY HYG US LQD US XLF US ZGLD SW

AUM (US$ Mil) August 2010 $62,200.1 $30,207.6 $31,875.6 $15,845.7 $8,920.5 $7,563.0 $7,229.8 $4,228.1 $3,510.0 $5,254.1 $9,081.7 $20,541.0 $3,703.1 $5,632.5 $5,356.7 $4,046.4 $6,337.7 $14,460.4 $5,170.3 $6,784.9

AUM (US$ Mil) December 2009 $85,676.3 $19,398.7 $35,339.3 $18,735.8 $6,268.4 $9,975.3 $4,908.3 $6,425.0 $1,321.3 $3,122.6 $11,190.7 $18,551.8 $1,752.1 $3,696.6 $3,444.5 $5,932.9 $4,569.2 $12,755.9 $6,868.6 $5,125.8

Change (US$ Mil) -$23,476.3 $10,808.9 -$3,463.8 -$2,890.1 $2,652.0 -$2,412.3 $2,321.5 -$2,196.9 $2,188.7 $2,131.5 -$2,109.0 $1,989.2 $1,950.9 $1,935.9 $1,912.2 -$1,886.5 $1,768.5 $1,704.5 -$1,698.3 $1,659.2

Source: Global ETF Research and Implementation Strategy Team, BlackRock, Bloomberg.

NOVEMBER 2010 â&#x20AC;˘ FTSE GLOBAL MARKETS

Global ETF listings As at end of August 2010 ASSETS UNDER MANAGEMENT (US$ Bn) No. Primary Listings

New in 2009

New in 2010

871

121

Europe

985

215

Austria

Belgium

Finland

CHANGE IN ASSETS

Total Listings

2009

Aug 2010

US$ Bn

124

871

$705.5

$715.7

$10.3

1.5%

787

167

3,140

$226.9

$230.9

$4.0

1.7%

74*

$0.1

$0.0

-38.3%

$0.1

$0.0

-33.4%

$0.3

$0.2

-$0.1

-23.2%

France

250

426

$53.5

$51.0

-$2.5

-4.6%

Germany

Location

No. of No. of Providers Exchanges

369

1,057

$96.2

$90.2

-$6.0

-6.2%

Greece

$0.1

$0.0

-32.7%

Hungary

$0.0

-15.5%

Ireland

$0.2

$0.3

$0.1

25.8%

Italy

447

$1.9

$1.7

-$0.2

-8.4%

Netherlands

106

$0.2

$0.0

-1.3%

Norway

$0.8

$0.6

-$0.2

-23.0%

Russia

$0.0

0.0%

1 1

Planned New

Slovenia

$0.0

-6.4%

Spain

$2.4

$1.3

-$1.1

-45.3%

Sweden

$2.1

$2.0

-$0.1

-4.6%

Switzerland

474

$21.7

$29.5

$7.8

35.7%

Turkey

$0.2

$0.1

$0.0

-19.0%

United Kingdom

179

479

$47.1

$53.5

$6.4

13.5%

Canada

150

176

$28.5

$31.6

$3.1

10.7%

Japan

$24.6

$24.3

-$0.4

-1.5%

Hong Kong

$20.7

$23.1

$2.3

11.3%

1 14

China

$6.3

$11.5

$5.3

83.8%

Mexico

290

$8.1

$7.9

-$0.3

-3.3%

South Korea

$3.2

$4.3

$1.1

35.6%

Taiwan

$2.7

$2.6

-$0.1

-3.0%

India

$0.2

$0.3

$0.1

44.9%

South Africa

$1.8

$0.0

1.1%

Brazil

$1.7

$1.6

-$0.1

-8.4%

Singapore

$2.6

$2.8

$0.2

9.4%

Australia

$2.4

$2.8

$0.4

17.6%

New Zealand

$0.5

$0.3

-$0.1

-30.2%

Malaysia

$0.3

$0.4

$0.0

13.6%

Thailand

$0.1

$0.0

-4.5%

Indonesia

$0.0

-11.9%

UAE

$0.0

100.0%

Saudi Arabia

$0.0

100.0%

Chile

Israel

Egypt

Sri Lanka

Philippines

ETF Total

2,308

427

401

4,922

$1,036.0

$1,061.9

$25.9

2.5%

129

944

*Includes 21 undisclosed RBS ETFs, 10 undisclosed HSBC ETFs To avoid double counting, assets shown above refer only to primary listings.

Source: Global ETF Research and Implementation Strategy Team, BlackRock and Bloomberg.

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. The opinions expressed are those of BlackRock as of September 2010, and are subject to change at any time due to changes in market or economic conditions. They should not be construed as a recommendation, investment advice, offer or solicitation to buy or sell any securities or to adopt any investment strategy. In particular, BlackRock has not performed any due diligence on products which are not managed by BlackRock and accordingly does not make any remark on their suitability. Prospective investors should take their own independent advice prior to making an investment decision. 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.

FTSE GLOBAL MARKETS • NOVEMBER 2010

Index Level Rebased (30 September 2005=100)

5-Year Performance Graph (USD Total Return) 250

FTSE All-World Index

200

FTSE Emerging Index

150

FTSE Global Government Bond Index 100

FTSE EPRA/NAREIT Developed Index 50

FTSE4Good Global Index FTSE GWA Developed Index

Se p05 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 Se p10

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

2,773

253.76

14.6

0.9

9.0

4.2

2.48

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

USD

2,298

590.06

14.5

0.2

8.1

3.4

2.52

FTSE Developed Index

USD

1,996

233.55

14.1

-0.2

7.4

3.1

2.50

FTSE Emerging Index

USD

777

710.29

18.1

8.9

21.5

11.6

2.37

FTSE Advanced Emerging Index

USD

302

653.10

21.1

6.2

19.3

7.6

2.78

FTSE Secondary Emerging Index

USD

475

843.34

15.5

11.3

23.5

15.3

1.99

USD

7,311

409.95

14.8

1.4

10.0

5.1

2.37

FTSE Global Equity Indices FTSE Global All Cap Index FTSE Developed All Cap Index

USD

5,794

380.66

14.3

0.4

8.4

4.2

2.38

FTSE Emerging All Cap Index

USD

1,517

947.73

18.5

9.4

22.4

12.1

2.34

FTSE Advanced Emerging All Cap Index

USD

638

883.80

21.2

6.7

20.0

7.7

2.76

FTSE Secondary Emerging All Cap Index

USD

879

1085.12

16.1

11.9

24.7

16.3

1.96

USD

744

196.92

7.7

8.6

5.4

7.5

2.27

FTSE EPRA/NAREIT Developed Index

USD

279

2737.32

18.4

9.1

18.4

13.4

3.76

FTSE EPRA/NAREIT Developed REITs Index

USD

187

934.57

17.2

9.5

21.2

15.3

4.59

Fixed Income FTSE Global Government Bond Index Real Estate

FTSE EPRA/NAREIT Developed Dividend+ Index

USD

226

2010.76

18.7

10.7

22.1

16.2

4.31

FTSE EPRA/NAREIT Developed Rental Index

USD

228

1066.69

18.1

10.3

22.3

16.5

4.31

FTSE EPRA/NAREIT Developed Non-Rental Index

USD

1148.01

19.5

5.9

8.9

5.8

2.24

FTSE4Good Global Index

USD

657

6254.81

14.4

-1.3

4.3

0.5

2.82

FTSE4Good Global 100 Index

USD

103

5183.79

14.2

-2.9

2.2

-2.3

3.00

FTSE GWA Developed Index

USD

1,996

3598.79

14.2

-1.1

4.9

2.3

2.69

FTSE RAFI Developed ex US 1000 Index

USD

1,012

6249.26

17.9

0.3

-1.0

1.1

3.13

FTSE RAFI Emerging Index

USD

357

7472.42

15.6

6.5

18.2

9.5

2.65

SRI

Investment Strategy

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

NOVEMBER 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

FTSE RAFI US 1000 Index

Se p05 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 Se p10

Index Level Rebased (30 September 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 Americas Index

USD

777

772.34

11.9

-1.2

10.7

4.2

2.06

FTSE North America Index

USD

644

837.95

11.5

-1.4

10.2

4.1

2.02

FTSE Latin America Index

USD

133

1280.73

20.9

6.3

21.7

8.5

2.54

FTSE All-World Indices

FTSE Global Equity Indices FTSE Americas All Cap Index

USD

2,500

359.10

12.5

-0.2

12.3

5.6

1.94

FTSE North America All Cap Index

USD

2,318

340.63

11.9

-0.7

11.7

5.4

1.90

FTSE Latin America All Cap Index

USD

182

1819.52

21.1

7.1

22.8

9.0

2.49

Fixed Income FTSE Americas Government Bond Index

USD

195

201.88

2.6

7.2

7.1

8.8

2.26

FTSE USA Government Bond Index

USD

182

197.51

2.6

7.3

6.9

8.7

2.23

FTSE EPRA/NAREIT North America Index

USD

124

3322.03

14.1

9.1

30.6

19.9

3.85

FTSE EPRA/NAREIT US Dividend+ Index

USD

1803.40

13.4

8.9

30.2

19.5

4.06

Real Estate

FTSE EPRA/NAREIT North America Rental Index

USD

120

1132.44

14.0

9.6

31.5

20.8

3.83

FTSE EPRA/NAREIT North America Non-Rental Index

USD

318.44

15.1

-8.7

2.3

-9.0

4.80

FTSE NAREIT Composite Index

USD

134

3187.27

12.4

8.2

28.5

18.5

4.59

FTSE NAREIT Equity REITs Index

USD

112

7770.14

12.8

8.3

30.3

19.1

3.78

FTSE4Good US Index

USD

133

4999.84

10.0

-3.2

8.2

1.3

1.88

FTSE4Good US 100 Index

USD

102

4763.50

10.0

-3.1

7.9

1.1

1.90

FTSE GWA US Index

USD

588

3129.01

10.6

-2.6

8.4

3.5

2.02

FTSE RAFI US 1000 Index

USD

999

5718.11

11.2

-1.6

8.6

7.2

2.17

FTSE RAFI US Mid Small 1500 Index

USD

1,454

5676.38

11.2

-0.4

12.7

10.5

1.23

USD

148

245.58

11.2

-0.4

12.7

10.5

0.91

SRI

Investment Strategy

IPO Indices FTSE Renaissance IPO Composite Index

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

FTSE GLOBAL MARKETS • NOVEMBER 2010

5-Year Total Return Performance Graph 250

FTSE Europe Index (EUR)

Index Level Rebased (30 September 2005=100) Se p05 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 Se p10

MARKET DATA BY FTSE RESEARCH

Europe, Middle East & Africa Indices

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)

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

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)

3.26

FTSE All-World Indices FTSE Europe Index

EUR

566

240.62

7.2

0.6

10.7

5.1

FTSE Eurobloc Index

EUR

279

125.72

7.9

-1.7

1.6

-0.8

3.58

FTSE Developed Europe ex UK Index

EUR

376

239.53

7.2

0.0

7.0

3.5

3.32

FTSE Developed Europe Index

EUR

490

236.73

7.3

0.7

10.2

4.8

3.33

3.15

FTSE Global Equity Indices FTSE Europe All Cap Index

EUR

1,511

378.44

7.5

1.1

11.6

6.2

FTSE Eurobloc All Cap Index

EUR

746

374.16

8.0

-1.5

2.3

-0.1

3.46

FTSE Developed Europe All Cap ex UK Index

EUR

1,022

401.90

7.5

0.3

7.8

4.4

3.21

FTSE Developed Europe All Cap Index

EUR

1,368

374.59

7.5

1.2

11.1

5.9

3.21

Region Specific FTSE All-Share Index

GBP

628

3829.42

13.6

0.2

12.5

6.6

3.17

FTSE 100 Index

GBP

102

3605.52

13.8

-0.6

11.8

5.4

3.30

FTSEurofirst 80 Index

EUR

4726.36

7.8

-1.9

1.4

-2.2

3.85

FTSEurofirst 100 Index

EUR

100

4356.74

7.6

-1.0

7.1

0.8

3.73

FTSEurofirst 300 Index

EUR

312

1545.69

7.3

0.7

10.1

4.5

3.37

FTSE/JSE Top 40 Index

SAR

3012.97

13.4

2.7

20.0

6.7

2.17

FTSE/JSE All-Share Index

SAR

166

3381.14

13.3

4.0

21.1

8.7

2.34

FTSE Russia IOB Index

USD

915.28

12.6

-5.2

11.1

-1.4

1.31

Fixed Income FTSE Eurozone Government Bond Index

EUR

245

178.63

2.4

2.8

5.2

3.24

FTSE Pfandbrief Index

EUR

403

213.78

1.7

1.3

4.0

3.8

3.49

FTSE Actuaries UK Conventional Gilts All Stocks Index

GBP

2504.44

3.6

8.3

7.3

9.5

3.36

Real Estate FTSE EPRA/NAREIT Developed Europe Index

EUR

2046.50

15.0

7.5

15.6

11.4

4.25

FTSE EPRA/NAREIT Developed Europe REITs Index

EUR

734.02

15.0

6.6

13.9

8.6

4.83

FTSE EPRA/NAREIT Developed Europe ex UK Dividend+ Index

EUR

2678.94

20.3

12.3

22.1

19.6

4.64

FTSE EPRA/NAREIT Developed Europe Rental Index

EUR

805.33

15.5

7.8

16.6

11.8

4.33

FTSE EPRA/NAREIT Developed Europe Non-Rental Index

EUR

526.21

3.7

2.5

-8.0

3.1

2.14

FTSE4Good Europe Index

EUR

274

4675.18

7.6

0.1

8.6

3.6

3.55

FTSE4Good Europe 50 Index

EUR

3940.59

7.6

-1.9

6.2

0.6

3.80

FTSE GWA Developed Europe Index

EUR

490

3339.95

7.8

-1.2

4.9

2.2

3.67

FTSE RAFI Europe Index

EUR

503

5243.58

8.3

-0.4

1.8

3.8

3.43

SRI

Investment Strategy

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

NOVEMBER 2010 â&#x20AC;˘ FTSE GLOBAL MARKETS

Asia Pacific Market Indices 400

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)

Se p05 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 Se p10

Index Level Rebased (30 September 2005=100)

5-Year Total Return Performance Graph

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

1,292

300.52

13.6

3.6

11.2

8.4

2.38

FTSE Asia Pacific ex Japan Index

USD

839

626.08

18.6

9.0

18.5

11.7

2.59

FTSE Japan Index

USD

453

70.58

-0.5

-15.1

-6.9

-7.6

1.99

FTSE Global Equity Indices FTSE Asia Pacific All Cap Index

USD

3,101

511.49

13.8

4.0

11.6

8.7

2.36

FTSE Asia Pacific All Cap ex Japan Index

USD

1,866

777.08

19.0

9.2

19.2

11.8

2.56

FTSE Japan All Cap Index

USD

1,235

223.99

-0.7

-14.8

-7.1

-7.2

1.99

Region Specific FTSE/ASEAN Index

USD

144

719.89

19.3

20.6

37.9

28.1

2.68

FTSE Bursa Malaysia 100 Index

MYR

100

10994.21

12.0

11.9

24.9

18.0

2.48

TSEC Taiwan 50 Index

TWD

7476.39

16.6

6.9

9.8

2.4

3.63

FTSE Xinhua All-Share Index

CNY

1,136

8462.31

19.3

-7.4

9.4

-9.8

0.96

FTSE/Xinhua China 25 Index

CNY

24594.70

6.9

3.9

7.5

1.9

2.38

USD

229

158.69

7.3

14.7

11.1

14.6

0.98

FTSE EPRA/NAREIT Developed Asia Index

USD

2279.76

19.8

9.5

11.8

10.4

3.49

FTSE EPRA/NAREIT Developed Asia 33 Index

USD

1486.46

20.0

9.8

13.0

10.9

3.62

FTSE EPRA/NAREIT Developed Asia Dividend+ Index

USD

2456.29

20.1

12.4

15.5

14.0

4.29

Fixed Income FTSE Asia Pacific Government Bond Index Real Estate

FTSE EPRA/NAREIT Developed Asia Rental Index

USD

1077.27

19.8

14.8

15.9

17.4

5.71

FTSE EPRA/NAREIT Developed Asia Non-Rental Index

USD

1263.14

19.7

6.6

9.7

6.6

2.15

FTSE IDFC India Infrastructure Index

IRP

107

1071.29

10.7

8.2

7.1

9.9

0.79

FTSE IDFC India Infrastructure 30 Index

IRP

1196.50

10.5

7.9

5.3

9.4

0.78

JPY

178

3327.09

-1.0

-16.4

-8.7

-9.3

2.18

FTSE SGX Shariah 100 Index

USD

100

5522.44

13.0

1.0

7.3

3.9

2.10

FTSE Bursa Malaysia Hijrah Shariah Index

MYR

11617.58

8.7

7.4

14.6

9.7

2.90

JPY

100

975.46

2.4

-13.9

-5.5

-9.0

1.88

Infrastructure

SRI FTSE4Good Japan Index Shariah

FTSE Shariah Japan 100 Index Investment Strategy FTSE GWA Japan Index

JPY

453

2540.52

-0.7

-14.7

-6.2

-5.8

2.08

FTSE GWA Australia Index

AUD

101

4035.71

8.0

-4.8

-0.4

-2.9

4.36

FTSE RAFI Australia Index

AUD

6397.81

8.0

-4.7

-1.4

-4.8

4.32

FTSE RAFI Singapore Index

SGD

9065.00

7.1

5.8

17.8

6.5

3.13

FTSE RAFI Japan Index

JPY

251

3574.56

0.3

-14.6

-3.8

-6.0

1.99

FTSE RAFI Kaigai 1000 Index

JPY

1,022

3915.27

9.3

-11.0

-4.7

-7.5

2.88

HKD

7296.28

9.3

6.0

8.4

2.7

2.91

FTSE Renaissance Asia Pacific ex Japan IPO Index

USD

105

1877.32

14.0

7.1

20.3

11.6

1.09

FTSE Renaissance Hong Kong/China Top IPO Index

HKD

2598.00

12.8

3.3

10.9

4.8

0.78

FTSE RAFI China 50 Index IPO Indices

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

FTSE GLOBAL MARKETS â&#x20AC;˘ NOVEMBER 2010

INDEX CALENDAR

Index Reviews November-December 2010 Date

Index Series

Review Frequency/Type

Effective Data Cut-off (Close of business)

05-Nov

TOPIX

Annual review (constituents)

30-Dec

30-Nov

12-Nov

Hang Seng

Quarterly review

03-Dec

30-Sep

16-Nov

MSCI Standard Index Series

Quarterly review

30-Nov

30-Oct

Mid Nov

Russell/Nomura Indices

Annual review

30-Nov

31-Oct

Early Dec

CAC 40

Quarterly review

17-Dec

15-Dec

Early Dec

ATX

Quarterly review

31-Dec

30-Nov

Early Dec

OBX

Semi-annual review

17-Dec

30-Nov

Early Dec

S&P / TSX

Quarterly review

17-Dec

30-Nov

Early Dec

RTSI

Quarterly review

14-Dec

30-Nov

02-Dec

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

Annual review / North America

17-Dec

30-Sep

03-Dec

DAX

Quarterly review

17-Dec

30-Nov

03-Dec

S&P / ASX Indices

Quarterly review

17-Dec

03-Dec

04-Dec

NZX 50

Quarterly review

17-Dec

30-Nov

07-Dec

TOPIX

Annual review (constituents)

28-Jan

31-Dec

08-Dec

FTSE MIB

Quarterly review - shares & IWF

17-Dec

30-Dec

08-Dec

FTSE/JSE Africa Index Series

Quarterly review

17-Dec

30-Nov

08-Dec

FTSE UK Index Series

Annual review

17-Dec

07-Dec

08-Dec

FTSE techMARK 100

Quarterly review

17-Dec

30-Nov

08-Dec

FTSE Euromid

Quarterly review

17-Dec

30-Nov

08-Dec

FTSEurofirst 300

Quarterly review

17-Dec

30-Nov

08-Dec

FTSE Italia Index Series

Quarterly review

17-Dec

30-Nov

09-Dec

FTSE EPRA/NAREIT Global Real Estate Index Series

Annual review

17-Dec

30-Nov

10-Dec

FTSE Bursa Malaysia Index Series

Annual review

17-Dec

30-Nov

10-Dec

OMX I15

Semi-annual review

03-Jan

31-Dec

10-Dec

DJ STOXX

Quarterly review

17-Dec

23-Nov

12-Dec

S&P BRIC 40

Annual review

18-Dec

20-Nov

12-Dec

S&P US Indices

Quarterly review

18-Dec

04-Dec

12-Dec

S&P Europe 350 / S&P Euro

Quarterly review

18-Dec

04-Dec

13-Dec

S&P Topix 150

Quarterly review

17-Dec

03-Dec

12-Dec

S&P Asia 50

Quarterly review

18-Dec

04-Dec

12-Dec

S&P Latin 40

Quarterly review - shares & IWF

18-Dec

04-Dec

12-Dec

S&P Global 1200

Quarterly review - shares & IWF

18-Dec

04-Dec

12-Dec

S&P Global 100

Quarterly review - shares & IWF

18-Dec

04-Dec

Mid Dec

VINX 30

Semi-annual review

17-Dec

30-Nov

Mid Dec

OMX C20

Semi-annual review

20-Dec

30-Nov

Mid Dec

OMX S30

Semi-annual review

31-Dec

30-Nov

Mid Dec

OMX N40

Semi-annual review

17-Dec

30-Nov

Mid Dec

Baltic 10

Semi-annual review

31-Dec

30-Nov

15-Dec

BNY Mellon DR Indices

Quarterly Review

20-Dec

30-Nov

17-Dec

Russell US

Quarterly review - IPO additions only

24-Dec

30-Nov

17-Dec

Russell Global Indices

Quarterly review - IPO additions only

24-Dec

30-Nov

Late Dec

IBEX 35

Semi-annual review

31-Dec

30-Nov

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

NOVEMBER 2010 • FTSE GLOBAL MARKETS