FTSE Global Markets by FTSE Global Markets

ROUNDTABLE: WHO REALLY BENEFITS FROM MARKET FRAGMENTATION? ISSUE 47 • DECEMBER 2010 / JANUARY 2011

20-20 A S : LL

TARS

QIA leads the pack London’s commercial real estate rebound Why green bonds have investor appeal Irish crisis props up dollar THE MALTA REPORT: THE NEW BUSINESS OPPORTUNITY

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); David Craig (London). 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.

ISSN: 1742-6650

HANGE IS A big theme in this edition, across the range of markets from investment flows to market infrastructure. Past editions have concentrated on regulation. We’ve taken a breather this time to focus on market dynamics across a section of asset classes. Not all change is good; and there are some notable sub-trends that are beginning to impact the overall market outlook for 2011 and beyond. The tide of emerging market Eurobond issuance is starting to concern some investors and analysts, for example, who fear that the increasing flood of money into emerging markets will create serious asset bubbles as too much capital chases too few assets. While this is clearly a bigger risk for equities than bonds, some believe the pricing on recent issues is starting to make the latter look expensive. In developed markets, for the first time in more than half a century, yields on benchmark government bonds in the US, UK and Europe are lower than the returns of high yield equities. This is due to the investor stampede into triple-A rated sovereign bonds on the back of fears over the global economy and the threat of a double-dip recession in the US and UK. Industry reports reveal that the dividend yields in Europe stand at around 4%, more than 1.5 percentage points above government bonds. Historically, defensive sectors such as oil and gas, telecoms and consumer staples have been the most popular dividend plays due to their strong and secure cash flows. We report on the implications. Elsewhere, increasing market complexity and the need for risk management run through this edition like the wording through Blackpool Rock. We’ve tried to include all the main strands, from the infrastructural modifications outlined by the DTCC’s Don Donahue through to the very real market changes outlined in our bond trading, securities lending and ETF coverage. The theme of change and evolution also plays through our trading editorial. As speed and competition have increased in the equity trading world, so has pressure, not only on incumbent exchanges but also on the multilateral trading facilities in Europe and alternative trading platforms in the US, to maintain investment in their technological infrastructure. Inevitably, exchanges that provide a better service will naturally attract more flow and therefore force others to react to the demand for continuous improvement. As we come to the close of the year and a sense of seasonal renewal takes hold, it is perhaps as well to chart the new configurations of the global financial markets. Next year looks to be even more complex, challenging and transformational than this. To help fill in time in the interim we’ve accumulated a debate-worthy selection of high achievers in our annual 20-20 All Stars coverage. Some contenders are obvious, others less so; with their inclusion based more on expectation than past performance. The hope of the analysis is the coalescing of some of the key themes of this year: the seismic shifting of economic power from West to East, the deepening and broadening of the investor services product set and the growing emphasis on regulation, transparency and risk management, particularly in the US and Europe. This is a pivotal year and the selection of this year’s star performers reflects the strength of financial crosscurrents. We are already looking forward to next year’s crop and hope you find enough in this year’s selection to open your mind to the potential of 2011.

Francesca Carnevale, Editor December 2010/January 2011

Cover photo: Qatar Prime Minister Sheikh Hamad Bin Jassem Bin Jabor Al Thani delivers his speech during the opening of the 5th Finance and Investment in Qatar Forum in Paris. Photograph by Francois Mori/AP, supplied by Press Association Images, November 2010.

Journalistic code set by the Munich Declaration.

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

CONTENTS COVER STORY

20-20 ALL STARS ..........................................................................................................................................Page 46 The global financial markets remain in flux and this year’s crop of 20-20 All Stars have all risen to the challenge. The nominations are not awards, rather a simple acknowledgement of some of the innovation in the global markets and a nod to individual and group achievements in stilltrying circumstances. DEPARTMENTS

MARKET LEADER

DTCC: THE NEW WORLD OF RISK MITIGATION ......................................................................Page 6 Don Donahue, chief executive of the DTCC, explains the dynamics of change at the DTCC.

IRISH CRISIS UNDERPINS US TREASURIES ..................................................................................Page 12 US bonds rebound as the problems in the eurozone worsen. By Andrew Cavenagh.

WHEN FREDDIE MET FANNIE ..........................................................................................................Page 14 Mark Faithfull writes about the spiralling rescue costs of America’s most expensive bailouts.

IN THE MARKETS

THE NEW RISK/RETURN EQUATION ............................................................................................Page 18 Neil O’Hara reports on the lowlights and highlights of fixed income securities.

THE SHOCK OF THE NEW ..................................................................................................................Page 24 Investors are adopting ETFs with enthusiasm but there may be unforseen consequences.

BACK TO THE FUTURE? ......................................................................................................................Page 28 Lynn Strongin Dodds explains why high yield equity returns are better than government bonds.

INDEX REVIEW

MORE WOOD THAN TREES ..............................................................................................................Page 31

BANKING REPORT

THE MERGED STRENGTH OF RBI ..................................................................................................Page 32

FX VIEWPOINT

CLUELESSNESS AND CURRENCY WARS......................................................................................Page 33

REAL ESTATE

A CAPITAL PERFORMANCE ..............................................................................................................Page 34

DEBT REPORT

THE STEADY GLOW OF GREEN BONDS ....................................................................................Page 36

Simon Denham, managing director of Capital Spreads writes on the over-indebted EU nations.

The new Austrian bank’s emerging markets result.

Erik Lehtis, president of Dynamic FX Consulting, on the Fed’s “implicit” currency manipulation.

Mark Faithfull on the rising central London’s real estate prices, despite the recession.

The use of green bonds to fund sustainable projects.

THE NEW STRONG SUIT

....................................................................................................................Page 38

Jean-Claude Petard, head of Equity Markets at Natixis, offers a French trader’s perspective.

FACE TO FACE

CUSTOMER CHOICE IN THE DRIVE FOR BEST EXECUTION ............................................Page 40 UBS’s Owain Self explains his views on dark pools, algorithms and trading in the US and Europe.

HARNESSING A RISING TREND

......................................................................................................Page 42

Mohammed Al Omar, chief executive officer of KFH, describes the bank’s business strategy.

COMMODITIES DATA PAGES

THE PHYSICAL CHALLENGE ..............................................................................................................Page 44 The challenges of trading physical commodities place new demands on existing systems and expertise. DTCC Credit Default Swaps analysis ........................................................................................................Page 119 Fidessa Fragmentation Index....................................................................................................................................Page 120 BlackRock ETFs..............................................................................................................................................Page 122 Market Reports by FTSE Research ..........................................................................................................................Page 124 Index Calendar ..............................................................................................................................................................Page 128

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

CONTENTS FEATURES PROFIT PROFILES:

A MOULD BREAKING COMPANY QUARTET

................................................Page 66 Through the “great recession” some companies not only remained profitable but positioned themselves for continued growth by adhering fiercely to their core principles. Art Detman profiles four such companies—three American and one Canadian.

CANADIAN TRADING:

HFT TIPS THE DARK POOL AGENDA

..............................................................Page 70 High-frequency trading has shaken up a Canadian equity market long dominated by the incumbent exchange and five big banks. Investors anxious to avoid HFT order flow are turning to dark pools, which have been slow to develop in Canada thanks to its unusual broker preference trading priority. Neil O’Hara reports.

STOCK EXCHANGE TECHNOLOGY:

SPEED IS KING ..............................................................................................................Page 74 Stock exchanges are now caught in a technology frenzy-seeking lower latency, introducing more efficient matching engines and new order types. The raison d’etre is that the buy side have increasingly dynamic expectations. Is that really true? Or are the reasons much more diverse? Ruth Hughes Liley reports

EUROPEAN TRADING VENUES ROUNDTABLE:

WHO REALLY BENEFITS FROM MARKET FRAGMENTATION?................Page 79 In the roundtable discussion, Paul Squires, head of trading at AXA IM says: “Our market is complex and technical and not everything has fitted into the principles-based regulation that is MiFID, and it has created many problems for market participants. It is no great secret that the buy side is looking at MiFID II to address some of those concerns.” What did the rest of the panel think?

BOND TRADING:

FRATERNITY, LIQUIDITY, TRANSPARENCY ......................................................Page 89 The past two years may go down in history as the best fixed-income market seen, following the confluence of high volatility, low interest rates, tight spreads and high demand. Ruth Hughes Liley reports.

TRANSITION MANAGEMENT:

A DEEPER PRODUCT SET ........................................................................................Page 92 The transition management product set has deepened, now often encompassing a cradle-to-grave relationship between beneficial owners and their mandated asset managers. Now that relationship begins much earlier in the asset management process, explains Mark Dwyer, managing director and head of EMEA at Mellon Transition Management and Beta Management at BNY Mellon.

THE MALTA REPORT: THE NEW BUSINESS OPPORTUNITY THE NEW FINANCIAL HUB ..........................................................................................Page 95 THE MED’S ATTRACTIVE ALTERNATIVE....................................................................Page 96 MALTA’S ONSHORE APPEAL TO FUND MANAGEMENT ....................................Page 100 PUNCHING ABOVE ITS WEIGHT ..............................................................................Page 104 MSE AIMS TO BE A GLOBAL PLAYER ......................................................................Page 110 A PRIVATE EQUITY DOMICILE ..................................................................................Page 113 MORE FOR MORE: POSITIONING FUND ADMINISTRATION ..............................Page 115 DIRECTORY ....................................................................................................................Page 117

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

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©2010 NYSE Euronext. All rights reserved. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of NYSE Euronext. NYSE Euronext and its affiliates do not recommend or make any representation as to possible benefits from any securities or investments, or third-party products or services. Investors should undertake their own due diligence regarding securities and investment practices. This material may contain forward-looking statements regarding NYSE Euronext and its affiliates that are based on the current beliefs and expectations of management, are subject to significant risks and uncertainties, and which may differ from actual results.

MARKET LEADER

THE DTCC AND RISK MANAGEMENT: CHANGES AND IMPLICATIONS

Don Donahue, chief executive of the DTCC, explains the dynamics, and its implications for its clients. Photograph kindly supplied by the DTCC, November 2010.

THE NEW WORLD OF RISK MITIGATION Landmark financial reforms are in process globally; banks face much tougher capital standards and the global financial industry is involved in a radical reappraisal of how it manages risk. In that respect, the Depository Trust & Clearing Corporation (DTCC) is not immune to the metamorphosis taking place in the global financial markets. Don Donahue, chief executive of the DTCC, explains in an open letter, the dynamics and the implications for its clients. N THE WAKE of the Lehman Brothers’ collapse, the DTCC closed out more than a half trillion dollars in open positions, thereby preventing losses for the industry, and perhaps ultimately for taxpayers, that could have been in the hundreds of millions or billions of dollars. The DTCC did all this without having to draw on any of the self-insurance funds on deposit with us. Many of you, in turn, told us of the quick actions you took, and the sometimes painful decisions you made,

to get your firms through the crisis. Together, our stories made a compelling tale about our success in fighting a number of dangerous fires. Actually, people outside the financial industry don’t care what we had to do to put the fire out. They want to know why it started in the first place, why it burned so fiercely, and why as an industry we hadn’t taken preventive action. The prevailing view, as far as the public, their elected representatives and our regulators are concerned, is that the fire itself was the

product of a shocking and fundamental failure of risk management and oversight in the markets we serve. Moreover, they continue to be very unhappy about it, because they view our failure as having led not just to a financial crisis, but also a harsh global recession, a staggering loss of jobs and wealth, and extreme damage to public finances in the developed nations as they bailed-out failing institutions and sought to stabilise their economies. Unavoidably, in the new post-crisis world, governments and regulators will understandably be focused on financial risk to a much greater extent than previously. To address these issues, the private sector will have to work with our regulators as partners, rather than adversaries, to improve our risk management operations. After all, the relationship between regulator and financial enterprise is symbiotic. Regulators want the financial services companies they supervise to be healthy and safe, and they know that firms cannot be safe and sound unless they earn strong risk-adjusted returns—in fact, regulators have for generations utilised rating systems that have included earnings, along with other important factors such as capital and liquidity, as a key measure of the health of financial services firms.

Industry context At the DTCC we understand that the bar of regulatory expectations on risk has been raised and what used to be normal or standard operating procedure is fast becoming history. As a result, we’re now initiating a top-to-bottom transformation in how the DTCC thinks about risk, how we oversee risk, how we manage risk and how we plan to address risk—all aspects of risk—both within the DTCC and within the financial system we are a key part of. This is a sweeping all-hands-on-deck initiative that comes at the direction of our board. This journey will be an extremely ambitious undertaking that forces the DTCC to rethink many of the assumptions behind the practices we’ve employed and the services we’ve been offering our participants for decades.

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

MARKET LEADER

THE DTCC AND RISK MANAGEMENT: CHANGES AND IMPLICATIONS

In other words, it will alter—in some ways significantly—how we support and work with you to further mitigate risk. We are firm in our understanding of this new responsibility. We are clear that our regulators and supervisors view it as imperative that we address this new responsibility. We also received a very similar message from many of you earlier this year when we polled our member firms about our strategic direction and planning. The principal message that came back to us from those interviews was to keep focused on our core services and, above all else, to ensure risk mitigation.

Risk margining Those familiar with the DTCC’s Enterprise Risk margining systems know that they are calibrated against a 99% confidence level; the margins the systems will require have to be sufficient to cover 99% or more of the instances we face. It also serves as a timely symbol for how we have tended to think about risk, namely that the measure of our performance was 99% and that the last 1% was something we would handle “in the moment” rather than through a systemic solution. However, in this post-crisis period, the strong message from governmental overseers, regulators and bank supervisors at home and abroad shifts the weighting a bit. As vital as meeting the 99% standard is, the public sector is now saying that the 1% is equally if not more critical. In the case of another financial meltdown, it may be that an institution such as the DTCC is the only thing standing between our member firms/issuers/investors and total meltdown. Therefore, we need to be absolutely sure that we will come through in that extreme situation. So we have implemented the “DTCC 3.0” programme, which represents the sea change in our thinking to focus on what can happen in that last 1% and how we need to prepare ourselves for that. I will outline what I call The Seven Habits of Highly Effective Infrastructures as a guide to the principles we have to guide us through this change. First: do no harm; or what we can think of as the 99% rule.

Very simply, whatever we do, whatever changes the DTCC may require, we must still be sure that we can conduct the day’s activities, close down tonight and open up tomorrow with the same level of rocksolid stability and resilience that we are expected to deliver day in, day out. As we think through the changes required to meet the 1% test, we have to ensure we keep the system stable and performance rock solid. Two: stuff happens. Controls will never be perfect; that means we can’t ever assume that what exists in terms of our design or our implementation of controls and risk management structures is good enough, because they haven’t been designed to be 100% foolproof. Even in a stable environment, we will have to cultivate a constant dialogue about how we can improve controls and riskmanagement structures. Three: the better we get at risk mitigation, the more risks people will take. Principle two says even in a stable system things can go wrong, but of course systems are not stable, they change and grow. The better we become in terms of controls the more those controls will be tested by new types of assets, new types of transactions, new activities that our systems will have to cope with. So we have to be vigilant about industry trends and developments. Ironically, we are keenly aware that the better we become at identifying this cycle of new risks and figuring out how to mitigate them, the faster the cycle will move and the more people will be willing to take risks, confident that we’ll be able to continue as a safety net. Four: financial systems naturally tend toward instability. As economist Hyman Minsky notes, financial systems inherently are biased towards instability and crisis, as favourable financial conditions push people to make riskier financial decisions and as that dynamic feeds on itself. Five: lowering the water is as good as raising the bridge. Sometimes we won’t identify risks that are evolving, or understand what new controls or strengthened controls we need to address them. So, in parallel, we need

to “lower the water”; finding ways to make core risk systems stronger, more resilient, to withstand anything that gets thrown at it, even when we didn’t see it coming. However good we are though at identifying and addressing risks in advance, at some point we are going to experience another financial crisis. Therefore, we have to be absolutely sure about the resilience of our risk management process; even in circumstances where the gravitational forces of a market crash get absolutely ferocious. Six: you never know where or who the next key insight will come from. The point being that everyone in a company knows some of the things that are critical to the success of the new risk-management paradigm, but no one knows all of them. How do we create a culture that allows people to voice their questions and concerns and then gets all of us to react to them? It is a key question. Finally, most of the answers are in structures, not standards. In other words, how we institutionalise risk management changes. We are clear that we need to make changes, about what the change involves and where it will take us. We are clear that change is ongoing, continuing through cycles of risk mitigation and risk taking, but it also needs to be supported by something structural in the organisation.

Raising our risk-intelligence quotient Internally we’ve used economist Hyman Minsky’s theories and other similar views, to help our staff understand the challenge of renewal we face at the DTCC. As a core industry infrastructure, we must understand and act upon Minsky’s insight—that stability itself is destabilising. We are also utilising the DTCC’s experience in the wake of 9/11. In that event, the DTCC realised that as good as our business continuity planning had been, it would have to be transformed. We could no longer focus primarily on surviving natural disasters, or assume that the problem to be solved was our

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

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MARKET LEADER

THE DTCC AND RISK MANAGEMENT: CHANGES AND IMPLICATIONS

inability to operate; we had to recognise that we were responsible for safeguarding against events that caused the system to become temporarily inoperable. In that reimagining, we will be working with the “three lines of defence” model. The first line is our individual business units. They have to identify and measure risks, and judge how effectively they’re being controlled. Today’s new premise though is that risks that once might have been tolerated now must be addressed and ways to reduce them implemented. Moreover, every time we reduce particular forms of risk, we have to go back and assess the risk picture again with an even more powerful lens. Our second and third lines of defence rest with our specific risk-control areas— the “enterprise” and “operational” riskmanagement units and our Internal Audit group, respectively. Their capabilities will be upgraded to ensure that these areas are prepared to challenge our thinking about the levels of risk we think we need to tolerate. In short, we’re ratcheting up the organisation’s risk-intelligence quotient (RIQ). Fundamentally, this is a zero-based remaking of our approach. We’re going to start at the baseline, and that may force us to rethink many of the assumptions behind the practices we’ve employed and the services we’ve been offering our participants for decades.

Customer impact and innovation I imagine many of you are beginning to ask: “What’s this going to do to my business and the way I use DTCC services and what will it cost?” Actually, we don’t have all the answers yet—and that’s the unpredictable environment we’ll need to manage in the coming years. For example, our subsidiary, National Securities Clearing Corporation (NSCC), has never applied any kind of “debit cap” restriction on the end-of-day net settlement balances its members can build up during a day; that has been industry practice since NSCC was founded. However, that does impose serious liquidity risk on the clearing corporation, and we need to find a way of controlling that. Remaking an entire process with far

more checks and balances will not be easy or cheap, and that will likely drive some increases in fees. Mitigating risk is not simply a matter of increasing the margin reserves against it. This new challenge of mitigating risk will demand relentless experimentation, and the bursts of innovation that can flow from that. In fact, we already have innovative initiatives under way that will help you to efficiently use your capital. New York Portfolio Clearing, for example, our joint venture with NYSE Euronext, is designed to provide a simultaneous view of both futures and cash markets for government securities and much larger efficiencies in margining. Or, consider our intent to launch a new central counterparty (CCP) for mortgagebacked securities. It will provide the safety of a trade guarantee to this market for the first time ever, but it will also reduce risk and costs in the handling of the underlying mortgage pools.

Writing new financial rules The challenge of overhauling our systems and processes from the ground up seems daunting, but we can do it. Part of the challenge, of course, is that we’ll be doing it within a regulatory environment that’s already been set in motion by the Dodd-Frank Act. The DTCC has long had a close working relationship with our regulators and the new world of risk mitigation will demand that this becomes an even closer, tightly coordinated relationship. A new player in the regulatory field will be the new Financial Stability Oversight Council which Congress created in the Dodd-Frank Act; an independent 10-member committee, including representatives from the Treasury Department, the Federal Reserve, the SEC, and five other agencies. The council has authority to determine whether the DTCC is a “systemically significant” financial market utility. If it does, then the Federal Reserve becomes the prudential regulator for all of our subsidiaries, as it is today for The Depository Trust Company (DTC) and Warehouse Trust

Company (WTC). To back up its powers for monitoring systemic risk, the new oversight council will also rely on a new agency, the Office of Financial Research (OFR), to collect and standardise data from financial services companies, to perform research, and to develop risk measurement and monitoring tools. We expect that the OFR will collect significant amounts of position, transaction and counterparty exposure data from throughout the industry. Given our unique position in the cash equity and fixed income markets, and quality of the over-the-counter (OTC) derivatives data we keep in our Trade Information Warehouse, we have a role to play in aggregating data for the OFR. In Europe, too, we have spent a lot of time and effort meeting with policymakers to make sure that the European regulatory consensus on OTC derivatives also provides for reporting those trades to a single repository for each asset class. We’ve taken concrete steps to allay European concerns about access to the data that we hold in our trade repositories. In October, we launched a European subsidiary called DTCC Derivatives Repository, which will maintain global credit default swap (CDS) data identical to that maintained in our New York-based Trade Information Warehouse. This European-based repository will support a wide variety of critical functions, including, most importantly, CDS trade reporting. Last year, the DTCC won the contract to build a similar repository for global OTC equity derivatives, and we have now opened that facility in London as well. Our goal is to avoid a proliferation of redundant trade repositories that would fragment data and introduce further systemic risk. We’ve made clear to regulatory agencies that function outside the US that the data we collect from across the globe will be available to any of them with a legitimate interest. Another step we took in August this year was to add additional data to what we already publish about credit default swaps. We’re working hard to expand transparency in this global market. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

Benjamin Fussien Karl Adm

Investors affirm once again Global Provider in Equity Derivatives Société Générale’s Risk magazine June 2010 Institutional Investor Rankings leadership & expertise

YOUR PARTNER IN GLOBAL MARKETS THANK YOU FOR YOUR LOYALTY AND TRUST For the second consecutive year, the global institutional investor community has voted Société Générale Corporate & Investment Banking the #1 Global Provider in Equity Derivatives in the Risk magazine 2010 Institutional Investor Rankings. “With more than 20 years of experience in Equity Derivatives, SG CIB continues to lead the industry through its comprehensive coverage of worldwide equity underlyings, consistency and continuity of service and tradition of innovation. Throughout the world, the challenge of addressing your specific needs and the trust you have placed in us over the years push our teams to reinvent the Equity Derivatives industry every day. We are driven by our commitment to our clients and we would like to thank you for your continued loyalty.” SG CIB Global Equity Flow Team. www.sgcib.com

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IN THE MARKETS

BONDS: US SOVEREIGN REBOUND HELPED BY EURO FALL

IRISH CRISIS UNDERPINS US TREASURIES US Treasury bonds suffered from a predictable—and widely anticipated—sell-off in the first half of November after the Federal Reserve confirmed it was to embark on a second round of quantitative easing. However, the crisis in Ireland provided a sharp reminder that the problems in the eurozone are far from over, and the run on the market was short-lived. Andrew Cavenagh reports. FTER THE FEDERAL Reserve announced on November 4th that it would buy up to a further $600bn of Treasuries by the end of June under the QE2 programme, a wave of selling pushed yields out over the next two weeks with that on benchmark tenyear Treasury bond reaching 2.96% on November 16th, its highest level for three months. Yields had come back by the end of the week (the ten-year bond retrenching to 2.82%), however, as debt markets decided that the Irish government’s commitment to support the country’s stricken banks was insupportable and would necessitate some form of European Union bailout. The contagion once again spread to the sovereign debt of the other beleaguered euro countries—Portugal, Spain and Greece. Michael Woolfolk, senior currency strategist at BNY Mellon in New York, says there was “no question” that the Irish situation had underpinned the US Treasury market, as the latest panic in the eurozone had provided hard evidence that the single European currency still had fundamental issues to address. “The problem has not been resolved yet,”he says. “It has merely been papered over.” Even without a fresh eurozone crisis, there was little to suggest a sustained flight from US government bonds was imminent at this stage. Analysts attributed much of the sell-off in the first half of November to a natural correction, as hedge-fund investors and others unwound positions they had taken ahead of the QE2 announcement—selling on the fact of having bought on the rumour.

The latest official figures from the US Treasury department, published on November 16th, certainly showed that foreign demand for long-term government securities had remained strong throughout September. Net foreign purchases of Treasury bonds and bills came to just under $80bn for the month, split almost evenly between private investors ($38.8bn) and central banks ($39.5bn). While the total was a decline on the $117.1bn of net purchases recorded in August, it still represented the third highest monthly total this year. Moreover, China and Japan, by far the two largest investors in US sovereign debt, actually increased their overall holdings to $883.5bn (with net purchases of $15.1bn) and $865bn ($28.4bn) respectively over the month, despite market expectations that both countries would start to scale back their investments in US Treasuries to reduce their exposure to the dollar. Woolfolk says he had been “impressed” by the strength of foreign demand for Treasuries in September, particularly on the back of the high level of demand seen in the previous month. He points out that the surge in purchases by foreign central banks was largely a move to defend their own currencies from appreciating against the dollar. Nevertheless, QE2 is likely to slew the market for Treasuries in the months ahead, because the Fed’s purchasing programme is going to focus on bonds with maturities in the middle of the curve. The US central bank will not be buying much debt with a maturity of 17 to 30 years, and this uneven support for

Photograph © Bpro / Dreamstime.com, supplied November 2010.

the market will inevitably have an influence on the future direction of yields. Kevin Flanagan, chief strategist in the fixed-income division of Morgan Stanley in New York, suggests that a trifurcation of the Treasury market was likely, in which the Fed’s commitment to QE and near-zero interest rates would anchor the yields on short-term instruments (with maturities of three years or less), while those on five to ten-year bonds would benefit from QE2 purchases but those on longer-term bonds—which are vulnerable to inflation expectations— would widen significantly. Flanagan believes that yields on tenyear Treasuries could go as low as 2.25% once the Fed purchases start to kick in. He then expects them to move within a range of 2.5%-3.5% between now and the end of next year.

Long-term pressures The independent Financial Forecast Center based in Houston, Texas, is predicting a slightly tighter range for the benchmark bond: a fluctuation of between 2.61% and 2.94% over the next six months and then a rise to 3.15% in June 2011. Yields on longer-term bonds, which are not impacted by short-term Fed policy, seem certain to continue rising, reflecting the real and long-term pressures on the US economy and currency, as the government continues to issue record volumes of further debt to finance an expected aggregate budget deficit over the next ten years of $8.5trn. “The very long Treasury yields are a truer, undistorted picture of the market price,” maintains Mike Riddell, who manages M&G’s International Sovereign Bond Fund. “The point is that you can’t increase debt levels forever, and at some point that will be a problem for the US. They have to address their budget deficit and debt-to-GDP ratios.” I

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IN THE MARKETS

FANNIE MAE & FREDDIE MAC: THE SPIRALLING RESCUE COSTS

The rescue of Fannie Mae and Freddie Mac is shaping up to be one of America’s most expensive bailouts, exceeding the cost of the savings and loan crisis that saved small banks and thrifts in the 1980s and the Trouble Asset Relief Program (TARP) of 2008, which threw a lifeline to financial companies and car-makers. Analysts and government have issued conflicting estimates of the spiralling bill for the US taxpayer amid questions about whether Freddie Mac and Fannie Mae should have a future in America’s broken housing market, writes Mark Faithfull.

WHEN FREDDIE MET FANNIE ANNIE MAE AND Freddie Mac, the US government-owned mortgage finance companies, could cost the country’s taxpayers as much as $363bn to the end of 2013, according to their regulator—less than some of the worst-case scenarios, but more than projections by the White House. Since they were rescued by the government in 2008, Fannie Mae and Freddie Mac have drawn $148bn from the US Treasury to stay afloat as losses on bad loans underwritten during the housing boom have continued to turn bad. In August, the Congressional Budget Office said Fannie and Freddie would need $390bn in federal subsidies to the end of 2019. The White House’s Office of Management and Budget (OMB) had in February estimated the cost to be just $160bn for the same period, providing the economy continues to strengthen. The Federal Housing Finance Agency (FHFA), which regulates the two entities, says it was possible losses could be less than $363bn. If house prices rebounded, interest rates remained low and unemployment fell, Fannie and Freddie might only need $221bn in cumulative aid. However, most analysts believe this scenario is too optimistic, as the US economic recovery stalls and the housing market remains stagnant. In addition to covering projected losses on bad loans, an increasing portion of taxpayer aid will be used to pay dividends on preferred stock issued by the Treasury department as part of the terms of its rescue. Excluding these dividend

Photograph © Anthony Furgison / Dreamstime.com, supplied November 2010.

payments, Fannie and Freddie would need less money to stay afloat, $142bn in the best-case scenario and $259bn in the worst.Yet if the US housing market continues to crumble, taxpayers could face a total bill of more than $400bn to bailout the duo by 2013. Those two entities hold about $6.8trn in all mortgage obligations, or nearly 57% of outstanding home loans in the US. Confused? The number of numbers being bandied around adds to uncertainty and recently RealtyTrac, which monitors repossession activity, confirmed that the foreclosure crisis in the US had spread across a wider area than previously thought. Foreclosure notices increased across a majority of large metropolitan areas, including Chicago and Seattle. Previously, these cities had seen relatively low levels of activity.

RealtyTrac’s report says that California, Nevada, Florida and Arizona remain the worst affected areas. The trend is the latest sign that the US foreclosure crisis is worsening as homeowners— facing high unemployment, slow job growth and uncertainty about house prices—continue to fall behind on their mortgage payments. Meanwhile, the announcement from Wells Fargo that it would re-file thousands of foreclosure documents is the first admission from the bank of possible problems in the way it repossesses homes. In a statement, the bank said it had identified “instances where a final step in its processes relating to the execution of the foreclosure affidavits ... did not strictly adhere to the required procedures”. Despite the raft of worrying news, Frank Nothaft, vice president and chief economist, Freddie Mac, says: “When rates fall to new lows we typically see more ‘rate and term’ refinancers, who are looking only to reduce their interest payments, and relatively fewer cash-out borrowers. Now we’re also seeing a very large share of borrowers reduce their mortgage debt when they refinance. Consumer debt across the board is down since the start of the recession, with nonmortgage consumer debt falling more than 5% since 2008.” However, US house prices are being weighed down by an overhang of unsold, repossessed properties, falling again in August after the expiry of homebuyers’ tax credits. Prices were down 0.3% versus the previous month, on a seasonallyadjusted basis, according to the CaseShiller index of 20 major US cities. A tax credit for homebuyers expired in April, leading to a steep drop in home sales over the summer. That same effect now appears to be feeding into houseprice data. Compared with last year, the

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

IN THE MARKETS

The top five US metropolitan foreclosures in Q3 2010 City, State

FANNIE MAE & FREDDIE MAC: THE SPIRALLING RESCUE COSTS

index published by rating agency Standard & Poor’s was up 1.7%, somewhat lower than analysts’expectations of a 2.1% yearon-year rise. However, prices remain 29% below their peak of May 2006, according to the index, having only recovered some 5% since bottoming out in May 2009. Fannie Mae’s Economics & Mortgage Market Analysis Group is in downbeat mood. “The labour market has yet to make significant progress, which is the primary reason for our continued weak growth forecast,” says Fannie Mae chief economist Doug Duncan.“With economic growth slowing, job creation also has been tepid, keeping the unemployment rate high. Housing sales will likely be soft until the labour market strengthens.” “The housing market appears to have stabilised at new lows,” adds David Blitzer, chairman of the index committee at Standard & Poor’s. “At this time, it does not seem that any of the markets are hanging on to the temporary momentum caused by the homebuyers’ tax credits.” The FHFA used estimates from rating agency Moody’s to devise its best and worst-case scenarios. In the best case, housing prices will have fallen 34% from their peak in 2006 to their trough in the third quarter of 2011. The worst case calls for a deeper decline in prices of 45%. The results could shape the debate over the long-term role that the government should play in the mortgage market. Some Republicans argue the government should focus on shrinking Freddie and Fannie and eventually privatise them. However, the Obama administration, which has promised to outline its proposed overhaul of the broader housing-finance system by January, has said a government role may still be needed to preserve the long-term, fixedrate mortgages that have become the keystone of the US mortgage market. Under the regulator’s most positive home-price scenario, Fannie and Freddie would lose $6bn over the next three years and they would still have to ask the government for 11 times that amount to make dividend payments. On its most likely projection—which assumes an end to the housing crisis is close and that

home prices will stop falling soon—they will lose $19bn in the same period. On the other hand, if the economy slides back into recession and home prices fall by another 20% to 25%, the companies could cost taxpayers an additional $124bn, before dividend payments. Another drop in values could lead to more delinquent borrowers with fewer options to avoid foreclosure. Price declines could also lead to losses on the almost 200,000 homes the firms have taken back through foreclosure. The vast majority of the firms’ losses stem from such delinquent and defaulted mortgages that the firms bought or guaranteed between 2005 and 2008. Since then, the companies have tightened underwriting standards, and loans made over the past two years are not expected to lose money.

Mortgage delinquencies Fannie and Freddie own or guarantee around half of the nation’s $10.6trn in mortgages. While the Obama administration has said the $700bn Troubled Asset Relief Program (TARP) could cost a fraction of the initial investment, the tab for Fannie and Freddie has swelled as mortgage delinquencies have mounted. The National Bureau for Economic Research warns: “The foreclosure process problems and pause on foreclosures pose a risk to our outlook of the housing market as they create uncertainty for potential homebuyers. Foreclosed homes account for a substantial part of the existing home market and therefore a pause on foreclosures, if it spreads through the nation, has the potential to suppress home sales in the near term and interfere with the housing recovery.” The legacy of poor mortgage lending has led bankers into a two-front war, pitting them against US homeowners challenging the right to foreclose and mortgage-bond investors demanding refunds that could approach $200bn. While federal regulators and state attorney generals have focused on flawed foreclosures, a bigger threat may be the cost to buy back faulty loans that banks

Foreclosures

Las Vegas, Nevada

32,288

Cape Coral, Florida

10,352

Modesto, California

4,825

Stockton, California

5,929

Merced, California

2,072

Source: RealtyTrac, supplied November 2010.

bundled into securities. JPMorgan Chase, Bank of America, Wells Fargo and Citigroup have set aside just $10bn in reserves to cover future buybacks. Bank of America alone says pending claims have jumped 71% from a year ago to $12.9bn of loans. The biggest risks for banks may be loans packaged into mortgage-backed securities during the housing bubble, of which $1.3trn remains. The aggrieved bondholders include Fannie Mae and Freddie Mac, bond insurers and private investors. Fannie Mae and Freddie Mac may be owed as much as $42bn just on loans they bought directly from lenders, according to Fitch Ratings. Pimco, BlackRock, MetLife and the Federal Reserve Bank of New York are seeking to force Bank of America to repurchase mortgages packaged into $47bn of bonds by its Countrywide Financial Corp unit. JPMorgan Chase took a $1bn thirdquarter expense to increase its mortgagerepurchase reserves to about $3bn. Citigroup raised its reserves to $952m in the third quarter, from $727m in the previous period. Wells Fargo reduced its repurchase reserves to $1.3bn, from $1.4bn in the second quarter. “These issues have been somewhat overstated and to a certain extent, misrepresented in the marketplace,” says Wells Fargo chief financial officer Howard Atkins. “Our experience continues to be different than some of our peers in that our unresolved repurchase demands outstanding are actually down.” The other front in the battle is the potential cost to banks of improper documentation used in foreclosures. Attorney generals in all 50 states are investigating foreclosure procedures. Litigation costs for such cases may reach $4bn, while a three-month delay in foreclosures would add an additional $6bn to industry expenses, FBR Capital Markets estimated in November. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

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IN THE MARKETS

FIXED INCOME SECURITIES: LOWLIGHTS AND HIGHLIGHTS

Photograph © Beliksk / Dreamstime.com, November 2010.

THE NEW RISK/RETURN EQUATION A major liquidity squeeze in 2008 created unprecedented demand for funding trades, with fixed income securities lenders who stayed the course cleaning up. Now, with interest rates at rock bottom, massive issuance by the US Treasury and tight collateral reinvestment guidelines, the “Cinderella” moment for securities lending has passed. However, there are still a few bright sparks. Neil O’Hara reports. WO YEARS AGO, fixed income securities lenders couldn't believe their luck. A gigantic liquidity squeeze created unprecedented demand for funding trades just as many lenders pulled back from the market amid widespread worries about counterparty risk. Players who stayed the course cleaned up, shovelling out general collateral at spreads normally associated with specials. It couldn't last, of course. Two years later, rock-bottom interest rates, tighter collateral reinvestment guidelines, massive issuance by the US Treasury and persistent deleveraging throughout the financial system have squeezed lending margins. The “Cinderella” moment for the ugly stepchild of securities lending

has passed, but bright spots still sparkle amid the ashes. Lending fixed income securities has never been as profitable as equities, a market in which participants have long been willing to pay through the nose for the privilege of borrowing particular names. Until the last year or two, fixed income borrowers in the US drew the line at zero rebate on hard-to-borrow securities; they refused to incur a negative rebate under any circumstances. Record low interest rates and the introduction of a 300 basis points (bps) penalty on failed trades in the US Treasury market shattered that resistance not only for Treasuries but for other fixed income assets. The change came even though specials have virtually disappeared from the

Treasury market. “Ever since the issuance sizes have increased, most off-the-run Treasuries are financed at or very close to general collateral levels,” says Vincent Laudati, US fixed income trading manager, securities lending, at Citi Global Transaction Services in New York. The margin squeeze reflects an extraordinary shift in the balance between supply and demand. Treasury issuance was $209bn in the fiscal year through September 2007, but by 2009 it had ballooned to more than $1.74trn and was still a whopping $1.47trn in fiscal 2010. “Before 2007 we could generate an average of 14bps on the two-year,” says Shirley McCoy, global head of fixed income lending, financing and markets products at JP Morgan in New York. “Now it is about 7bps.” US Treasury portfolio utilisation rates, which used to hover close to 100%, have dropped back to 60% to 65% as a result. Lender psychology has changed, too. Before the financial crisis, clients used to ask Paul Wilson, global head of client management and sales, financing and markets products, JP Morgan in London,

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

The diffeerence between perform and outpe outperform. form.

IN THE MARKETS

FIXED INCOME SECURITIES: LOWLIGHTS AND HIGHLIGHTS

about utilisation rates all the time. “It is very seldom that clients talk about utilisation now,” he says. “They are more concerned about what level of overall return we are generating under what risk parameters.” Fears that lenders would desert the market altogether in a low interest rate environment have proved unfounded, however. After the widely publicised problems in some cash collateral reinvestment pools two years ago, every lender—whether or not they incurred losses—reviewed their reinvestment programme and in most cases revised the guidelines to focus on shorter duration and higher quality assets. The conservative stance combined with low interest rates has made some financing transactions uneconomic for borrowers like banks and securities dealers, but lenders are happy to pick up a few extra basis points when investment returns are so low. “While returns are not what they used to be, we remind clients that the returns seen a couple of years ago were created by extreme market conditions that were not good for the industry,” says Nick Bonn, head of securities finance at State Street Corporation in London.

Substantial premium Opportunities to earn higher returns do exist for lenders who are willing to take more risk. New liquidity regulations for banks and broker-dealers have boosted borrower interest in term lending commitments. Citi's Laudati sees particular interest in three-month loans; borrowers are seeking to pledge a wider range of collateral, too. Lenders willing to extend credit beyond one year, a period that affords borrowers regulatory capital relief, can pick up a substantial premium, as well. “The market is a bit polarised,” says JP Morgan's Wilson. “Dealers will pay to lock up securities for a longer period, but very few lenders will commit as far as one year.” Margins may have shrunk in US Treasuries, but the same cannot be said for European sovereign debt. Market

Nick Bonn, head of securities finance at State Street Corporation in London. “We remind clients that the returns seen a couple of years ago were created by extreme market conditions that were not good for the industry,” he says. Photograph kindly supplied by State Street, November 2010.

Kathy Rulong, global head of securities lending at BNY Mellon. “After the BP oil spill, energy-related bonds were in great demand,” says Rulong. “For a while it was airline bonds. To some degree, demand for corporate bonds parallels equities.” Photograph kindly supplied by BNY Mellon, November 2010.

fears about parlous public finances in Portugal, Ireland, Italy, Greece and Spain drove their sovereign debt securities well into special pricing territory earlier this year, although the premiums eased off over the summer. Borrowers have snapped up debt securities issued by core European Union countries, too. “There has been a substantial increase in demand since 2008,” says Bonn. “France and Germany almost trade like specials instead of general collateral.” Borrowers have also been chasing sovereign debt in emerging European countries that have serious fiscal imbalances, according to Kate Lander, head of the London trading desk for fixed income securities lending at Northern Trust. Volume has risen, albeit from a low base, and the margins can be fat. “Emerging markets and corporate high yield have performed as well or better than equities,” she says. Corporate bonds are another bright spot in the fixed income lenders' universe. Kathy Rulong, global head of

securities lending at BNY Mellon, has seen corporate balances double in the past two years. The lendable asset base has increased as clients have raised their allocations to fixed income securities and asset values have rebounded, but higher demand from borrowers has absorbed enough supply to keep the utilisation rate fairly steady. Specials arise either from specific events or general market sentiment. “After the BP oil spill, energy-related bonds were in great demand,” says Rulong. “For a while it was airline bonds. To some degree, demand for corporate bonds parallels equities.” Credit default swaps (CDS), an alternative way to take short exposure to corporate credit, tend to siphon off borrower demand for cash bonds. Traders can compare the relative cost, but although they have an incentive to choose the cheaper alternative, pricing between the two markets does not move in lockstep. The choice varies by security and is not necessarily consistent. “A

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

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IN THE MARKETS

FIXED INCOME SECURITIES: LOWLIGHTS AND HIGHLIGHTS

security that trades at negative 500bps rebate may not go to the credit default swaps market even though one that trades at zero rebate does,” says State Street's Bonn. “It depends on the trade.” The decline in popularity of credit default swaps since the financial crisis has revived borrower demand for corporate bonds. The DX Long-Short Ratio for corporate bonds, compiled by London-based DataExplorers, has fallen from 19.9 in May 2009 to 13.5 in November 2010 as short interest has risen. Regulatory pressure to trade standardised credit default swaps through a clearing house or on an exchange may cut credit default swaps volume even more. McCoy expects clearing house margins to be set relatively high, perhaps 15%–30% of the notional amount, more than enough to push traders back toward corporate bonds. Market participants have already taken notice: corporate bond balances have doubled in the past year at JP Morgan—and it's profitable business. “Volumes are much lower than in government bonds, but corporate bonds have more intrinsic value,” says McCoy. “When you look at where revenue is being generated, corporate bonds are the winners.” The credit default swaps market isn't all bad news for cash bond lenders anyway. Swaps dealers like to maintain a near-neutral book, and cash bonds are an obvious way to offset their unmatched exposure. Tom Wipf, head of fixed income financing at Morgan Stanley in New York, says: “It's far from a one-to-one correlation, but we do see a lot of hedging of credit default swaps using cash bonds.” Custodians including BNY Mellon, State Street and Northern Trust lend primarily to the big international banks and prime brokers, putting them at one remove from the end-users of most borrowed securities. Wipf is on the front line, lending to hedge funds, other broker-dealers and banks to cover fails or traditional short sale transactions— but also to facilitate financing. Long holders of securities may lend them out

Brian Lamb, chief executive officer of BondLend. “We operate as a utility, so we can compete quite effectively on price,” says Lamb. Photograph kindly supplied by BondLend, November 2010.

Tom Wipf, head of fixed income financing at Morgan Stanley in New York, says: “It's far from a one-to-one correlation, but we do see a lot of hedging of credit default swaps using cash bonds.” Photograph kindly supplied by Morgan Stanley, November 2010.

for a modest fee and take back as collateral either securities that pay more than the ones lent out or cash the lender can reinvest to earn a higher return. “A long holder is sourcing leverage through the secured financing market,”says Wipf. “It's not traditional securities lending, it's a repo or funding transaction.” Although these trades were more popular before 2008 when banks and broker-dealers faced fewer regulatory capital constraints, funding trades still drive the lending market in US Treasuries. In today's low-rate environment, every basis point matters, which explains why the market has embraced BondLend, an electronic fixed income lending and trade processing platform created by EquiLend. Brian Lamb, chief executive officer of BondLend, says volume has risen from 60,000 transactions in the first quarter of 2010 to 80,000 in the third quarter, and he expects more growth before yearend as BondLend signs up additional customers. The system can handle any type of transaction but so far users have focused primarily on general collateral lending. Automated lending and straight-through trade processing allow lenders to place large volumes of general collateral on loan fast and efficiently, exactly what is needed at a time when margins are wafer thin. “We operate as a utility, so we can compete quite effectively on price,” says Lamb, who anticipates that customers will use the platform for higher value trades as well in the future. That may be a tough sell, however. While lenders value the BondLend service, they aren't about to abandon conventional trading for their most valuable specials. “The hard names trade by hand,” says State Street's Bonn. It's an open secret that custodian lenders dole out specials to favoured clients based on how much general collateral they are willing to take. Lenders will use all the technological help they can get in the high-volume, low-margin general collateral game, but for now at least human beings still trade the crown jewels in the lenders' portfolios. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

Spotlight on Norway: A Q&A Session with Global X Funds founder and CEO Bruno del Ama Why did you choose the FTSE Norway 30 Index as the basis for Global X’s newest Exchange Traded Fund? Norway is one of the most developed economies in the world, and is an exporting powerhouse. This has generated an extremely large trade surplus, which has resulted in one of the largest sovereign wealth funds in the world. Furthermore, Norway has not adopted the Euro, which helps it to maintain its status as one of the world’s most stable currencies and economies. All of these factors have driven investor demand for a vehicle to invest in Norwegian equities. The FTSE Norway 30 Index represents the performance of the 30 largest and most liquid Norwegian equities listed on Oslo Bors Stock Exchange. Stocks are liquidity screened to ensure that the index is tradable, and a unique capping methodology makes it suitable for the use as the basis for investment products such as derivatives and Exchange Traded Funds (ETFs).

What is the name of the new ETF? The fund’s name is the Global X FTSE Norway 30 ETF. It began trading on NYSE Euronext on November 10, 2010, under the ticker symbol NORW.

What is the performance story? 130 120 110 100 90

FTSE Norway 30 Index

0 Oc t-2

10 20 Se

10 20 Au g-

0 01 l-2 Ju

-2

01 0

0 01 r-2 Ap

01 ar -2 M

20 Fe b-

FTSE Nordic Index

0 01 -2 Ja n

De c-2

20 09 No

00 Oc t-2

00 9

80 9

Index Level Rebased (30 Oct 2009=100)

The index has outperformed broader equity benchmarks, including the FTSE Developed Europe index, over the 3-month, Year-to-Date and 12-month periods.

FTSE Developed Europe Index

SOURCE: FTSE Group, data as at 29 October 2010

What kinds of companies are found in the FTSE Norway 30 Index? Companies within the index are classified using the Industry Classification Benchmark (ICB), a global standard developed in partnership between FTSE and Dow Jones. Hard asset producers represent over half of the index, including Oil & Gas producers with a 41.49% weight, Chemicals with a 5.70% weight, and Basic Resources with a 4.78% weight of the index. The largest five companies in the index are: Rank Constituent Name

ICB Sector

Index Market Cap (USDm)

Index Weight (%)

Statoil ASA

Oil & Gas Producers

21,780

18.60

DnB NOR

Banks

16,633

14.20

Telenor A/S

Mobile Telecommunications

13,314

11.37

Yara International

Chemicals

6,680

5.70

SeaDrill Ltd

Oil Equipment, Services & Distribution

6,455

5.51

64,862

55.38

Totals SOURCE: FTSE Group, data as at 29 October 2010

Call 888-GXFUND-1 to request a prospectus, which includes investment objectives, risks, fees, expenses and other information that you should read and consider carefully before investing. Investing involves risk, including possible loss of principal. International investing may involve risk of capital loss from unfavorable fluctuations in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Narrowly focused investments and securities focusing on a single country may be subject to higher volatility. Index performance is for illustrative purposes only. The Funds are distributed by SEI Investments Distribution Co., which is not affiliated with Global X Management Company, FTSE, or any of their affiliates.

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IN THE MARKETS

ETFS: NEW PARADIGMS IN ETF INVESTING

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

THE SHOCK OF THE NEW One can never discount the caution of market watchers who worry about unforeseen destabilising consequences of ETFs being adopted with such bubbling enthusiasm by investors. Particularly as they now engender intense interest from hedge funds, not to mention being the subject of much ingenuity by financial engineers. Ian Williams reports on the deepening of the asset class. HE TIDAL FLOWS of cash into exchanged-traded funds (ETFs) continue, most notably in the US, but also in Europe, and even in Asia where, for example, Ping An Securities has teamed with Value Traders of Hong Kong to offer an ETF based on the FTSE Value-Stocks China Index, which tracks the performance of 25 quality value stocks amongst Chinese companies listed on the Hong Kong Stock Exchange. Vanguard’s ETF product line-up attracted over $5bn, in October, making them the most successful issuers but iShares also took in $3.6bn and State Street $1.4bn. The reasons for investor enthusiasm are clear. Bob Monks, formerly of the Lens Fund and long-time campaigner for investor rights, confidently asserts: “The indexes outperform all but a very few of the managers every year, and they have far less costs. So the net to the investor of buying an index fund year in and year out compares very favourably with all but the most gifted investors, who, after all, invest for themselves; they don't invest for you.” Monks estimates that if you take indexing and closet indexing—people who charge fees as if they were active, but are really indexers—it's about 40%

of the market. His prognostication is that once the saturation of indexes/ETFs reaches around 60%, problems begin with the market chasing its own tail, as indexers are indexing themselves. As is normal in the hothouse ecology of the financial markets, ETFs have rapidly evolved under the dual pressures of investor demand and managerial ingenuity as funds developed more and more complex products, for which, of course, increased fees can be charged. Despite the explosion in the number of ETFs and the consequent decline in the popularity of more actively-managed funds, managers are rapidly adapting to the changing environment. As well as country and regional funds, offerings now include silver based indexes, airline indexes, and almost any conceivable slicing and dicing of region, product and even time. However, despite the rapid growth in these more complex offerings to more adventurous investors, the liquidity of ETFs seems to be enhancing customer fickleness as many investors move to more cheaply run funds. Vanguard’s emerging market fund, for example, has been growing rapidly compared with competitors using the same MSCI index, primarily, it would

appear, because its costs are only one third of theirs. Carl Delfeld of ETF Passport questions the survival of many of these new products. “I’ve never been keen on issues like retirement year funds. It comes down to marketing, they want to come up with new ideas. Obviously there is going to be a big shakeout, a consolidation of ETFs at some point. Economics demand that you have around $100m to make it worthwhile, depending on how much you spend on marketing,—and I bet most of them haven’t. Probably the top ten ETFs account for about half the funds.” Investors seem to be voting with their dollars for the more simple, transparent ETFs that retain ETFs’ distinctive low cost transparency. On the face of it, fund managers should be worried by the defection of so many of their clients and their money, but they seem to be reacting with typical ingenuity to an unbeatable challenge—by setting up and marketing their own ETFs. The complexity of some of the offerings, almost invariably dependent on a more active and expensive management, has led to some of the new offerings looking like a more liquid version of mutuals.

Sea of complexity Delfeld comments: “Even activelymanaged ETFs are different from mutuals because you can buy and sell them on an exchange, and use some risk management tools, such as trailing stop losses, but actively-managed ETFs tend to be less transparent, more expensive, less tax efficient. What was supposed to be an easy, straightforward tool is now a sea of complexity with more than 1,000 ETFs trading on US exchanges; I guess the future is really how investment advisers use them.You have to have some sort of strategy to use ETFs for your clients and choose between the pure index ETFs and the actively managed ETFs.” He thinks that the new complex products are more of a retail product than those aimed at professional managers. “There are some interesting ones out there, but keeping it simple and transparent, I’m not sure that having

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

IN THE MARKETS

ETFS: NEW PARADIGMS IN ETF INVESTING

a basket of 30 or so ETFs for your clients is serving them very well.” Lisa Dallmer, chief operating officer of European Cash Market Execution Services for NYSE Euronext, is sanguine about the competition between traditional mutual funds and ETFs. She reports that in the US there is some $900bn in exchange-traded product assets under management. “This September, consolidated dollar volume turnover represented approximately 30% of all consolidated US dollar value traded. By share volume, they represented approximately 17% of all US consolidated shares traded.” In Europe, euro value traded in ETFs on NYSE Euronext grew by 5% over the previous year while the number of trades in the same period has grown by 19%; indicating more trading by more users. She also considers that the fund managers have decided that ETFs and mutual funds can coexist, “if you look at the expansion of ETF offerings from mutual funds managers. People sometimes prefer the features of mutual funds, for example they have dollar cost averaging, while an ETF doesn’t necessarily. Ultimately the ETF managers do hold the physical securities. We think that there is room for expansion out there, as the market has returned and people are looking for yield this year, there are a lot more emerging market ETFs, country specific, region specific, illustrated as overall asset gathering expands. Both mutual funds and ETF providers are trying to meet demand and expand their products, but there will always be managed funds, and room for managers seeking alpha.” Vin Bhattacharjee, head of EMEA Intermediary Business at State Street Global Advisors, also stresses that indexes and ETFs are different products from mutuals and so do not necessarily compete in the same space. Even so, he reports: “Retails investors are obviously moving from mutual, actively-managed funds with their generally higher costs. The fundamental issue is the fact that 80% of any portfolio returns come from asset allocation rather than stock or security selection, so you will get over

Vin Bhattacharjee, head of EMEA Intermediary Business at State Street Global Advisors. “Retail investors are obviously moving from mutual, actively-managed funds with their generally higher costs,” he says. Photograph kindly supplied by State Street, November 2010.

80% of your returns from the equity, bond, fixed income mix rather than by, picking say, Coca Cola over General Motors.” He adds: “The only way to achieve equivalent results is by taking huge portfolio risk. So there is no reason to go for activelymanaged funds; to take beta exposure from the underlying beta, the best way to do that is by getting an index.” He agrees that the penetration of the index funds is causing the correlation between the underlying securities and the overall index, and for example, the correlation between the individual equities and S&P 500 has gone up over the years with portfolio trading. However, while it might look like a dog chasing its own tail, he stresses: “That will create a lot of active opportunities, because it’s impossible for all the stocks to behave identically since they represent different businesses, and that will create arbitrage opportunities, alpha creation opportunities. Already, we see a lot of hedge funds are now playing single stock positions against index.”

Rush of funds So where do ETFs go from here? Bhattacharjee reflects: “There are always more ways to skin a cat.” He discounts the possibility that the rush of funds into BRICs and emerging markets-based indexes and ETFs is causing bubbles. “They are just a way of executing a position so I don’t think they are causing major inflows, just reflecting underlying trends. The developed markets face a major debt overhang which is being monetised with, for example, QE2 in

the US, whereas the developing markets have exactly the opposite with very low leverage ratios, so that is enough to explain the capital flows,” he says, adding that in reality calling these markets “emerging” is a misnomer. “Their capital markets are sounder now than the so-called developed markets!” He foresees continued interest in the emerging markets as long as the euro and dollar maintain their external debt overhang. Similarly, “investors will want safe havens with other currencies, fixed income, gold and other precious metals, commodities and that trend might be reflected in ETFs”. “There’s still a lot of room to grow in fixed income funds,” he suggests. Lisa Dallmer also foresees even more offerings, explaining: “Indexers can build a whole portfolio in an ETF… there are now even ‘retirement date’ ETFs, where the index adjusts the allocation of assets between equities and fixed income to maximise returns for the preferred retirement year.” She also notes wide room for geographic expansion. While ETFs are strongest in the US and growing in Europe, they are only just taking off in Asia, and she points out a large expansion of ETF offerings in, for example, Hong Kong and Japan over the last three years from 47 to nearly a hundred. Dallmer discounts the dangers of a bubble with the rush into sectors like commodities and emerging markets. “These products create an access point where investors can get entry into assets that would otherwise be difficult unless you were prepared to build specialised portfolios with brokers, and this year we’ve seen more offerings in emerging markets, fixed income.” Delfeld differs about the bubble aspects, considering that the ease of ETFs, whether in commodities or emerging markets, has made it easier for investors to access these classes. “For example, gold and silver have certainly been boosted since ETFs have made it easier, rather than gambling on dicey mining stocks, and it has been the same with emerging markets.”I

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IN THE MARKETS

HIGH YIELD EQUITIES: A BETTER BET THAN GOVERNMENT BONDS

For the first time in more than half a century, yields on benchmark government bonds in the US, UK and Europe are lower than the returns of high yield equities. This is a result of the investor stampede into triple-A rated sovereign bonds on the back of fears over the global economy and the threat of a double-dip recession in the US and UK. Industry reports reveal that the dividend yields in Europe stand at around 4%, more than 1.5 percentage points above government bonds. Historically, defensive sectors such as oil and gas, telecoms and consumer staples have been the most popular dividend plays due to their strong and secure cash flows. They are particularly appealing today because they did not partake in the rally last year and consequently are the most undervalued. Lynn Strongin Dodds reports.

BACK TO THE FUTURE? LTHOUGH THEY MAY be at the less exciting end of the investment scale, high yield equities have come back into favour. This trend started as a short-term defensive play but, increasingly, institutional investors have hopped on the bandwagon to tap into steady returns. Sectors such as oil and gas, banking, telecoms and pharmaceuticals, have traditionally been prime targets but now a broader approach is being taken. One of the main contributing factors is that for the first time in more than 50 years, yields on benchmark government bonds in the UK, Europe and US are lower than the returns of high yield equities—those that distribute higher than average dividends. This is due to the investor stampede into triple-A rated sovereign bonds on the back of fears over the global economy and the threat of a double-dip recession in the US and UK. There are also concerns over the plethora of regulations, the tightening of Chinese monetary policy and the sovereign debt crisis in Europe. Ireland’s negotiations over a multi-billion dollar loan package from the International Monetary Fund and European Union could be followed by Portugal and Spain making similar moves. The flight into bonds pushed yields to new lows while, simultaneously,

company profits rebounded. Equally as important, a significant number of companies is sitting on dividend yields that are higher than what they are paying on their own debt, which reflects both the attraction of high-yielding equities and the equity market overall. Richard Turnill, manager of BlackRock’s global equities fund, notes: “There is an extraordinary anomaly in the financial markets today where if investors want to buy yield in the bond markets, they have to buy lower quality assets, but we have the opposite situation in equities. Institutions now have the opportunity to invest in the highest quality businesses at reasonable prices, plus they are also getting an inflation hedge. This is why I think there is such a compelling structural case today for dividends.”

A similar picture Looking at the big picture, industry reports reveal that the dividend yields in Europe stand at around 4%, more than 1.5 percentage points above benchmark government bonds. They are also competitive with yields on triple-B rated investment corporate bonds which are close to 5%. In the UK, yield in the gilt fund sector currently averages 2.78%, although some funds are yielding as little as 1.4%-1.6% compared to the

3.5% being generated on the FTSE AllShare index. A similar picture is being painted in the US. Calculations by fund management group Federated Investors show total returns for dividend-paying companies have outpaced the broader market by nearly 190 basis points since January while data compiled by Bloomberg reveals that US companies are being the most generous with their dividends since 2003. In addition, the S&P 500 Dividend Aristocrats Index, which tracks large cap firms that have sought to increase dividends every year for at least 25 consecutive years, has risen 8.6% compared with the broader S&P 500 index, which gained 2.5%. There are also encouraging signs for the future. The latest figures from fund management group Fidelity show that 210 companies in the UK have raised their dividends so far this year while 55 have left them unchanged, and 30 have cut them. Over the same period in 2009, only 156 companies reported increases while 51 left them unchanged and 86 withdrew them. As for next year, Newton Investment Manager is predicting dividend growth between 8% and 22%. The forecast is predicated on the level that BP reinstates its dividend which is slated for early 2011 as well as the dollar-pound exchange rate. The oil giant pulled its dividend and announced plans to sell $10bn (€8bn) of assets and cut capital expenditure due to the Gulf of Mexico oil slick crisis. This came as something of a surprise to investors who relied on their regular cheques. According to estimates from the National Association of Pension Funds (NAPF), BP stock accounts for

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

IN THE MARKETS

HIGH YIELD EQUITIES: A BETTER BET THAN GOVERNMENT BONDS

about 1.5% of a typical UK pension fund portfolio and, before the crisis at least, around 6% of the FTSE 100 index. According to Tineke Frikkee, portfolio manager of the Newton Higher Income Fund: “If BP reinstates its dividend at the consensus level of $0.105 per quarter, at $1.56 to the pound, then 2011 market dividend growth is likely to be around 14%. If it comes in at the previous level of $0.14 per quarter at $1.56 then the figure could be higher at 18%. The dollarpound exchange rate is important for the forecast range of dividend growth as more than 40% of UK dividends is declared in dollars. If sterling was to weaken to its recent low of $1.43 to the pound, and BP was to reinstate dividends to previous levels, then UK market dividend growth could reach 22%.” As for other contributors, Frikkee points to HSBC, Vodafone, British American Tobacco, National Grid, Anglo American, GlaxoSmithKline and Xstrata. HSBC is the largest company in the UK in terms of market capitalisation, at 7.4% of the FTSE All-Share Index, and around 7.8% of expected UK market dividend income in 2011. Vodafone’s market weighting is 5.1% and the company contributes 8.3% of all UK market dividend income in 2011. Recent research from Barclays supports the view about HSBC as well as a select group of other European banks, which includes SEB, Swedbank, UniCredit, Société Générale, BNP Paribas, Standard Chartered and BBVA. The bank believes that instead of hoarding capital as has been the recent practice, clarity on Basel III capital rules should allow some banks to loosen their grip and deploy surplus capital. The bank’s analysts’ notes say: “In the four years pre-crisis, the sector paid dividends of €131bn yet only generated free cash flow of €52bn. Over the next four years, we estimate free cash flows of €213bn and dividends of €107bn Historically, defensive sectors such as oil and gas, telecoms and consumer staples have been the most popular dividend plays due to their strong and secure cash flows. These companies have

Tineke Frikkee, portfolio manager of the Newton Higher Income Fund. “If BP reinstates its dividend at the consensus level of $0.105 per quarter, at $1.56 to the pound, then 2011 market dividend growth is likely to be around 14%,” she says. Photograph kindly supplied by Newton Higher Income Fund, November 2010.

Sonja Schemmann, manager of Schroders Global Equity Income Fund. “Typically, telecoms, food producers, big cap oil companies and healthcare have been the most popular high-yield investments,” she notes. Photograph kindly supplied by Schroders Global Equity Income Fund, November 2010.

also been the most generous in terms of payouts and have enjoyed the highest yields. They are particularly appealing today because they did not partake in the rally last year and consequently are the most undervalued. However, as the BP experience demonstrates, past performance should not always be an indication of future payouts. As Sonja Schemmann, manager of Schroders Global Equity Income Fund, notes: “Typically, telecoms, food producers, big cap oil companies and healthcare have been the most popular high-yield investments. However, it is important to look at companies on an individual basis and make sure that they have sustainable growth prospects and strong management teams.” To that end, Folmer Pietersma, head of Robeco’s Property Equities Fund strategy, recommends real estate investment trusts (REITs). “REITs are on dividend yields of 4% to 5%, which is much higher than cash and bond investments. We think the cash flows and dividend growth of a significant number of listed real estate companies should continue and that real estate will remain an attractive investment in today’s low interest rate environment. The focus should be on strong balance sheets and prime portfolios in good locations.” Overall, though, a long-term view

should be adopted. As John Velis, head of capital markets research, EMEA, at Russell Investments, points out, dividends and dividend growth and not capital gains drive the performance of stock markets over several years. “I am a strong believer that if investors hold equities over a long-term period they will be able to take advantage of the profits the companies generate because they are returned to shareholders in the form of dividends. History suggests that stock prices only rise if the market believes that dividend payouts will rise.”

Rate of return For example, the US equity market between 1937 and 2009—the longest period of data available—shows that on average equities returned nearly 16% per annum over a ten-year holding period, which in real terms equals 11.5% per annum. Breaking it down, the rate of return accounted for by real price appreciation was only 1.9% or less than one-eighth of the total real return. Data for the UK (from 1962 through 2009) reveals a similar story. Of the 13.1% annualised return over that period, 7.1% is due to inflation and just 1.1% to price appreciation. The remaining 4.9% of FTSE All-Share returns is attributed to a combination of dividend income and dividend growth. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

INDEX REVIEW

THE OVERBEARING HEAVINESS OF EUROPEAN DEBT

They’re back! Those over-indebted European nations, led by the Celtic ‘Tiger’, have come to haunt any prospect of an optimistic start to the New Year. Usually, the late November to end December period is rather boring in market terms. This year the markets may be in for a spook-fest. Simon Denham, managing director of spread betting firm Capital Spreads, gives the bearish view.

MORE WOOD THAN TREES he sums being loaned to the Irish look almost unbelievable if you equate it to a per employed person scale. Some 2.2m people work in the Republic and this new bailout will add at least another €40k to the average citizens’ debt pile. That’s on top of all the private and public debt exposure already in place. With unemployment now approaching 14% the obvious question is: how on earth they will ever get out of the hole that has been dug for them? Once again Europe appears to be pushing problems ever further into the future in the hope that something will turn up. The markets are less sure it will. Irish long term debt is now yielding over 8%, having briefly hit 9%. This is the price with what appears to be a reasonable European guarantee. In a wider context though (with German, French and UK debt at or lower than 3%) it is clear that the international debt markets remain suspicious of European political promises. It is worrying to admit but there is a growing number of otherwise sensible people across Europe who are now drifting into the camp that holds there is no point in paying all this debt. After all, they say, it will get bigger next year, no matter how fast we pay it off. As a result, democracies may be put under heavy

pressure from the simple solution brigade from both the left and right whose cry of “Let the banks die!” will get louder and louder. The argument that this will bring everything down around our heads may not count for much if the general populous feels that this has already happened. How is this likely to affect the equity market? As I mentioned back in September the search for yield was possibly a likely beneficial argument for the FTSE’s component parts, as even the most expensive stock was giving a reasonable return. This is especially true when added to the fact that—aside from Southern Europe, the UK and the US—the world economy is still looking rather good, thank you very much. Commodity prices continue to surge as demand increases and in many places the argument is more about raising interest rates to curb inflationary pressures rather than trying to boost growth with vast amounts of quantitative easing. While, on the one hand we have the wealthy First World busily becoming poorer, emerging high growth countries surge ever higher as domestic demand finally starts to rise above ‘background noise’ levels and fuels their rising trajectory in international markets. Old World democracies are struggling under the misplaced need for politicians

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

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

and central bankers to deliver instant, virtually pain free, answers. It’s leading, in many instances, to good money being thrown after bad. The idea of cutting losses and delivering pain in selected, high cost/low return areas is foregone for a general “one size does not fit all” policy burden. Growth companies in the UK are now hampered by this type of policy. The result is that any portable business is rightly decamping to the east. The net effect, of course, is to move vital tax receipts eastwards as well, thereby increasing the burden for those who are forced to remain. It might not take much to turn this trickle of tax-jumpers into a flood. Already, the tax receipts side of the UK’s deficit has been a lot weaker than the GDP numbers would suggest. Might we already be seeing some of the impact of this migration? It could also frighten the equity markets over the short term. However, it’s reasonable to assume that globalisation has already been factored in and stocks remain very reasonably priced for the longer horizon. No matter where a company is based the bigger economic picture is getting rosier. However, in the UK we are seeing rather more wood than trees. As ever ladies and gentlemen, place your bets. I

BANKING REPORT

RAIFFEISEN BANK INTERNATIONAL: A NEW OUTLOOK

THE RBI BOUNCE RZB and Raiffeisen International (RI) announced in late February that they were looking at possible merger of the two companies, bringing RZB’s business with Austrian and international corporate customers together with those of Raiffeisen International. The merged company, launched under its new moniker as Raiffeisen Bank International AG (RBI) in early October. The parties expect the merged bank to strengthen develop as a leading universal bank in Central and Eastern Europe through the combination of RI’s broad distribution network in the CEE region and RZB’s comprehensive product portfolio. NE OF THE key arguments for the merger between RI and RZB lay in the improved access to capital and money markets that the merged bank would enjoy in comparison to Raiffeisen International’s prior status. “This step would also contribute to Raiffeisen International’s risk diversification and would make it possible to further optimise risk management for the Group in the future,” notes Herbert Stepic, chief executive officer of the merged entity. The bank remains listed on the Vienna Stock Exchange and offers retail (in CEE), corporate and investment banking services. The business associated with RZB's function as central institution of the Austrian Raiffeisen Banking Group has now been hived off into a non-listed bank holding, says Stepic.“This merger strengthens us to the benefit of our clients and business partners, both of whom will profit from our optimised offering of products and services,” he adds. RBI is expected to take full advantage of the renewed strength of economic growth in Central and Eastern Europe, he adds. To facilitate the merger, a capital increase was agreed and now RBI's free float amounts to around 21.5%, (it had previously amounted to about 27.2% for Raiffeisen International). RZB's indirect shareholding in RBI amounts to around 78.5%. Both entities brought solid financial credentials to the mix. For

Photograph © Risto Viitanen / Dreamstime.com, supplied November 2010.

the time being the merged entity is reporting financials on a pro-form basis. Third-quarter's consolidated profit more than doubled compared to preceding quarter, posting a consolidated profit of €311m for the third quarter of 2010 (Q3), an increase of 125% over Q2 2010. The main driver for this increase came from valuation results for financial investments and derivatives. By the end of the third quarter its profit is projected to stand at €997m, while its consolidated profit (after tax and minorities) is reported as €783m, with provisioning for impairment losses reported at €913m. “Our results ... reflect the friendlier overall macro-economic environment,” notes Stepic.”Our non-performing loan (NPL) ratio stood at 8.8% at the end of September. This quarter-on-quarter increase ... was largely attributable to

developments in Central Europe—above all in Hungary and the Czech Republic. We assume that NPL volumes have already reached a peak in some countries, but that we will only reach that peak at the Group level during the course of next year. At the moment, it's not possible to tell whether that development will take place at the middle of the year or only in the second half of 2011,”added Johann Strobl, chief risk officer for RBI as well as for the RZB Group. RBI's pro-forma balance sheet total as per 30 June 2010 stood at €147.9bn, which represents an increase of 1.3% since the end of 2009 and return on equity before tax stood at 12.2%. On the basis of the same pro forma figures, RBI's core capital ratio (tier 1), credit risk stood at 12%, while its core capital ratio (tier 1), total stood at 9.5%. The merger brings together Raiffeisen International's distribution network of around 3,000 outlets in 17 CEE markets with RZB’s product know-how in capital markets products for commercial customers, financial institutions and sovereigns. More generally, the merger makes possible a sensible reallocation of resources towards those CEE markets with sustainable growth; a substantial consideration given that the Austrian bank also has a strong presence in Asia's emerging markets. The significant outcome in the merger is that Herbert Stepic has become chief executive of the new entity, which will invariably define the character of the new entities growth strategy. Stepic is a long term emerging markets expert and will likely continue the group’s expansion into high growth markets. When he led RI, it was one of the first institutions to break into the CEE zone, initially through greenfield developments. Only after 2000 did the bank start to look at an accretive acquisitions-led business growth strategy, as interest in the CEE from other foreign financial institutions began to step up. Stepic has always believed in the potential of the CEE region, at a very visceral level, and over the years he has continued to claim that:”It is the future growth engine of Europe.”I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

FX VIEWPOINT

CLUELESSNESS & CURRENCY WARS ERHAPS THE UNITED States’ policy is less clueless than Herr Schauble suggests, and the hypocrisy accusation unfair, given that any reductions in the value of the dollar will be side effects rather than primary objectives? After all, the marketplace is a funny thing, and one can never rely on it to react predictably. Explicit, direct currency manipulation is hard enough to achieve (just ask Japan), let alone tangential coercion of the sort he alleges. Chances are the market has already priced in this round of quantitative easing, and we will begin to see a market rapprochement with the dollar. The amount of money involved is not as massive as it sounds, given the size of the US economy, and most of it will remain within American borders. As such, fresh shorts of the dollar should be made carefully or may struggle to show positive results. We’ve already seen some pretty significant appreciations of the G10 currencies against the buck, so while some further moves in that direction are possible, the momentum has shown signs of fading. Better shorting luck may be had in choosing amongst the beneficiaries of recent dollar weakness. The eurozone is not lacking for economic warts and hidden booby traps. With the Greek panic receding, we need not look far to find other sources of anxiety: Ireland, Portugal, Spain and Italy head the A-

list of countries with serious balance sheet repair issues in the years ahead, and the amount of domestic pain awaiting them when the demands of entitlement reform necessitated by inevitable austerity measures can no longer be put off will elicit some very sharp headline cries. Do not underestimate the ability of labour unions and other political groups to rally sentiment against measures that threaten hallowed entitlements. Moreover, German taxpayers will not continue to finance what they increasingly perceive to be welfare states within the eurozone. There is a large divergence between the constituent nations in terms of fiscal rectitude, and the political consequences of that will now play out. Truly, there is a reckoning to be made in the years ahead in Europe, one that will test the strength of the bonds that created the euro. This cross-border political dynamic does not exist internally for the dollar—or any other currency, for that matter. Europe needs only look north to see the way out. Sterling has benefited from the budget measures envisioned by UK prime minister David Cameron. There will be protests, and a gnashing of the teeth amongst the hoi polloi, but Great Britain has something Europe lacks: a sense of collective resolve, not to mention a history of shared sacrifice. If the budget measures promulgated by

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

FX: WILL A RECEDING TIDE CONTINUE TO LOWER ALL BOATS?

In the wake of the Federal Reserve Bank’s announcement of its plan to spend $600bn buying back US treasuries over the next eight months, much has been made of the implicit devaluation of the US dollar this represents. Germany finance minister Wolfgang Schauble recently described US policy as “clueless” and “hypocritical”, given American rhetoric targeted at China for artificially pegging the RMB below its natural levels. Erik Lehtis, president of Dynamic FX Consulting, gives a trader’s view.

Erik Lehtis, president of DynamicFX Consulting in Chicago.

Cameron prove to be fair, they will probably be enacted even if harsh. Hanging on in quiet desperation is the English way, and so is belt tightening when facing a national threat; mores the eurozone simply cannot duplicate. Commodity currencies have gained handsomely over the past year, led by everyone’s favorite proxy for the RMB, the AUD. Given the demand for the kind of natural resources found there, we can expect the causality between global growth and AUD strength to hold for the foreseeable future. As strong as the Aussie dollar is now, there is simply no imaginable scenario short of another global recession under which it could significantly retrace. The Kiwi will mostly follow AUD, as usual, and thus looks to consolidate recent gains in the months ahead. The Canadian dollar has also benefited from worldwide demand for natural resources that provide the inputs for manufacturing, and this has amplified its traditional alternative-tothe-US status dynamic. Having reached parity with the US, a period of consolidation is not out of the question, even though it has shown an historic tendency to recoil from massive psychological barriers. The emerging markets may be the biggest beneficiaries of quantitative easing, if a strengthening currency can be labelled a benefit. The Asian rim continues to exhibit impressive growth prospects, and the launching of “QE2” should lift the local tide with an influx of investment dollars to the extent they leave US shores. If you lack the stomach for long dollar exposure, consider AUD, KRW, GBP and CAD, all at the expense of the EUR. I

REAL ESTATE

LONDON BUBBLE: COMMERCIAL PROPERTY SECTOR BREAKS RECORDS

A CAPITAL PERFORMANCE Amid the worst of the recession, central London's commercial real estate sector has achieved an extraordinary performance compared with the rest of the UK. Prime retail has broken records and the office market has benefited from a slowdown in development. Yet with continuing concerns over the health of the British economy, can the capital's office market continue to grow as rising prices for prime office space could force investors to look elsewhere, asks Mark Faithfull. FTER DISMAL PROJECTIONS about an exit from the City of London due to higher personal tax rates, the UK capital has shrugged off concerns and forged ahead in 2010. Split into four main markets, different drivers have supported growth across the capital and a severe slowdown in development has also helped keep availability rates low. The story of the next two years is likely to focus on office churn and redevelopment as investors swoop on key assets and refurbished premises, if they can achieve value. That last point is a big question. Prime office space is in short supply and a weight of money chasing the best buildings, meaning prices for prime are being pushed up and could force investors to look for better value elsewhere, such as Paris or Madrid. However, the central London office market has seen take-up levels rise well above trend in the third quarter (Q3) of 2010, according to agent CB Richard Ellis, which notes that the market saw the return of large pre-letting deals, which boosted take-up to 3.5m square feet (sq ft), 27% above the previous quarter, and an increase of 12% over the long-term average. Pre-letting is an important indicator of development sentiment as pre-lets both provide investors with the assurances they need about income streams, postconstruction, and show that demand from occupiers remains robust.

Supply was squeezed to 15.4m sq ft at the end of Q3, fuelled by large falls in the availability of second-hand space, and led to a sharp increase in prime rents in the City, Chancery Lane, Covent Garden and Holborn areas. Availability across the market as a whole is now nearly 6m sq ft lower than at the most recent peak at the end of Q2 2009. “We have had two years of low supply and we are scheduled to have two more,” reflects Andrew Burrell, partner in the research team at agent King Sturge. “There is undoubtedly a London

bubble, with very healthy take-up by occupiers and with the lack of newbuild, growth opportunities will really lie in the refurbishment market, especially if landlords can secure prelets. That’s what investors are looking for and there are plenty of opportunities to drive rental growth.” According the CB Richard Ellis prime rent index, annual rental growth in the City was 19.2%, the largest of any central London market. The West End—which is influenced by different dynamics to the City—grew by 8.5% in the same period,

Central London office property: Q3 2010 highlights Leasing: G

The UBS deal of 700,000 sq ft at 4-6 Broadgate, EC2, was the biggest in the market by a considerable distance. There were five other deals above 50,000 sq ft, including Bovis Lend Lease taking 79,600 sq ft at British Land’s Regents Place: Phase 2, NW1, and Bloomberg taking 71,900 sq ft at Park House, Finsbury Circus EC2.

The banking and finance sector was the driver behind recent deals, accounting for a 45% share of take-up

Vacancy rates fell to 5.9%, a fall for the fifth successive quarter.

Six schemes completed during the third quarter. The largest of these was the St Botolph building, EC3, of which 278,000 sq ft is available

Rent free periods on a ten-year lease fell slightly over the quarter and are now at 24 months in the City and 20 months in the West End.

Investment: G

Investment turnover stayed at £1.9bn, constrained by a lack of quality stock.

Prime West End yields hardened to 4%.

Only three deals were recorded over £200m, with the Carlyle Group’s purchase of Thames Portfolio for £400m and Alban Gate, London Wall, for £271m.

Domestic investors maintained a strong interest in the market with UK property companies (12%) and UK institutions (11%) particularly active, although overseas investors remain the key driver.

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

Photograph © Roland Nagy / Dreamstime.com, supplied November 2010.

SKYSCRAPERS REACH FOR THE SKY AGAIN RITISH LAND, THE UK’s secondlargest real estate investment trust, in October revived a plan to build the “Cheesegrater” tower in London’s main financial district, just a week after another skyscraper project was restarted. British Land will develop the 47-storey building in a joint venture with Oxford Properties Group, a unit of Toronto-based Ontario Municipal Employees Retirement System, at a cost of about £340m. Land Securities Group, the country’s largest REIT, announced on October 19th that the “Walkie-Talkie” development, officially known as 20 Fenchurch Street, would proceed.

and to the east, London Docklands rents rose by 4.2%. With only 0.4m sq ft of an expected 4m sq ft of scheduled completions due to be delivered during the last quarter of the year, there are few signs of supply problems easing, and a rapidly diminishing completion rate of 1.6m sq ft is expected in both 2011 and 2012, meaning the squeeze on suitable space will continue. In the investment market, CB Richard Ellis reports strong interest in quality stock which pushed West End yields to a very tight 4.0% and left prime City yields unchanged at 5.5%, although they have since hardened further. Importantly, overseas buyers continue to show a strong interest in central London offices, accounting for 68% of transactions by volume in the third quarter. This echoes general outside interest from investors about UK prime property, partly driven by the weak pound but predominantly because there is a general perception that the UK has been one of the first European real estate markets to fully price correct. Kevin McCauley, head of central London research at CB Richard Ellis, reflects: “Despite the strength of the market in 2010, the level of uncertainty among occupiers has increased recently, amid a relatively muted economic outlook. Some cooling in demand can be anticipated, and this has been reflected in the amount of space under

offer at the end of the third quarter, which fell to 0.8 sq ft from 1.6m sq ft in the previous quarter.” Some analysts are even more bullish. London offices have been described as the “pin-up” sector for the UK market because of the improvements in both investment and occupier trends, by Cushman & Wakefield. Its own estimate of prime property yields stood at 5.72% at the end of September. However, it also notes that investors are still sensitive to lot size, and points to investments in the £15m to £40m range as the area of greatest demand.

Investor demand Second-sell UK private and institutional investor demand is also strong but most are still struggling to find the quality of stock they want, Cushman says. Although there is an increase in the supply of investment property for sale, secondary property is coming forward and banks, receivers and Irish investors are the most notable sellers. “Attention is on these players and the type of stock they will sell, the speed with which they will want to sell and the price they hope to achieve versus that which the market will consider,” Cushman points out. While the demand for City office property is driven by financial and legal institutions, in the West End, demand from property and hedge fund companies

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

No tenants have been lined up for either project but Land Securities said the £500m “Walkie-Talkie” tower would proceed after the company formed a venture with Canary Wharf Group, which is backed by Qatar Holding and China Investment Corp. In June, Land Securities sold its Park Place development on London’s Oxford Street to Qatar’s Barwa Real Estate Co. British Land had halted construction of its 224 metre-high tower officially named the Leadenhall Building after completing the demolition and preliminary basement work. Construction is scheduled to start in January.

had pushed availability down. Despite a weakening in these sectors, availability has continued to decline. There is currently 4.4m sq ft of available office accommodation in 248 units in the West End, which represents a significant 8% decrease on the previous quarter and a 26% fall over the previous 12 months. That said, supply remains just above the 25-year average of 4.2m sq ft. Agent King Sturge points to a fall in supply in Q2 attributable to above-average transactional levels and the relatively limited amount (499,000 sq ft) of newly marketed space hitting the market in Q3. This level of supply equates to a vacancy rate of 5.5%, which represents a 50 basis point fall over the previous three months. The vacancy rate remains below 6%, historically the trigger rate for rental growth. The reduction in availability seen over the past six months is set to continue over the next two years, with availability falling below the 25-year average by the year-end. It is this fall, coupled with the low levels of speculative space set to be delivered from the development pipeline, especially in the core areas, that supports strong prime rental growth, even in the event of more muted demand generally. “There are dangers of an economic dip,” admits Burrell. “However, there are few signs of anything that the market hasn’t already coped with.”I

DEBT REPORT

Photograph © Davidarts / Dreamstime.com, supplied November 2010.

GREEN BONDS: ONE WAY TO CLEAN-UP IN AN UNSTABLE MARKET

In the equities market there is an abundance of investment opportunities for those wanting exposure to sustainable and environmentally friendly projects. To start with, there are the clean-tech companies such as wind turbine manufacturers, fuel cell makers or solar power developers but, alternatively, investors can opt for indexes such as the Dow Jones Sustainability Index, the OkoDAX or the FTSE4Good Index series. However, until the World Bank’s green bonds there was little in the fixed income market that was orientated towards investors interested in green investment. The triple-A rating and the fact that the World Bank is backed by 186 countries is one of green bonds’ biggest selling points, particularly in the current climate, writes Vanya Dragomanovich.

THE STEADY GLOW OF GREEN BONDS A T TIMES WHEN the financial press has been full of the Irish debt crisis and mainstream UK newspapers carry bleak pictures of empty houses and the unemployed in Ireland, it is comforting to find an investment that is fairly secure and likely to provide predictably solid returns. Green bonds are proving just such an asset. To date, the World Bank and the International Finance Corporation (IFC) have issued around $1.5bn of green bonds, the European Investment Bank has produced its own version, called the climate awareness bond, and there is talk of the UK doing something similar to finance clean investment. The World Bank’s bonds are all plain vanilla, fixed income products that offer the opportunity to take part in financing projects that help mitigate climate change. They have similar features to regular bonds issued by the World Bank, including credit rating and size. The World Bank’s first green issue in 2008 was lead managed by SEB bank, denominated in Swedish krona, and the main takers were large Swedish institutional investors, such as the country’s second and third national pension funds, AP2 Fonden and AP3 Fonden. Issues in the dollar and 14 other

currencies followed with pension industry heavyweights coming on board in the shape of the California Public Employees’ Retirement System (CalPERS), the California Teachers Retirement System (CalSTRS), the NewYork City Employees’ Retirement System (NYCERS) and the UN Joint Staff Pension Fund. One of the key appeals for CalSTRS, explains spokesman Ricardo Duran, is that “they satisfy CalSTRS’ strategic aim of integrating sustainability into its investments”. He adds: “There is a great deal of confidence in management's ability to protect the interests of investors and to keep themselves economically viable.” The pension fund bought $10m of green bonds from the World Bank and another $10m from the IFC. In the equities market there is a whole host of investment opportunities for those wanting exposure to sustainable and environmentally friendly projects. To start with, there are all the clean-tech companies such as wind turbine manufacturers, fuel cell makers or solar power developers but, alternatively, investors can opt for indexes such as the Dow Jones Sustainability Index, the OkoDAX or the FTSE4Good Index Series. However, until the World Bank’s green bonds there was little in the fixed income

market that was orientated towards investors interested in green investment. “We have a lot of focus on SRI [socially-responsible investment] in equities but it has been hard to find this kind of investment on the fixed income side,” says Ole-Petter Langeland, head of fixed income at Sweden’s AP2 pension fund. When the fund was approached by the World Bank and SEB to buy green bonds, AP2 hired an outside adviser to look at how the proceeds of the bond would be channelled and which projects would be chosen, Langeland adds. The verdict was positive and over the years AP2 bought more than $100m-worth of green bonds issued either by the World Bank or by the associated International Fundraising Congress (IFC). Though green bonds constitute a relatively small portion of the pension fund’s fixed income portfolio, which stands at $12bn, it is not one likely to become smaller. The SEK-denominated bonds held by AP2 reach maturity in 2014, “and after that we intend to roll it over, that is, buy a new issue when it comes out,” says Langeland. The triple-A rating and the fact that the World Bank is backed by 186 countries is one of green bonds’ biggest selling points, particularly in the current climate. The coupons are designed to be slightly above comparable bonds; the Swedish krona-denominated issue offers a coupon of 0.25% above the yield of Swedish government bonds. This is enough to justify the investment

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

into the bonds while at the same time fulfilling the rising interest in environmentally-friendly investment. What has in the past put off investors from investing directly into green or environmental projects, particularly if those were in emerging markets, was the high credit risk associated with financing, for instance, projects in Africa, says Klas Eklund, a senior economic adviser for SEB, who was involved in creating the first green bonds for the World Bank. Green bonds take that element of risk away because the projects have been thoroughly researched by the World Bank: not only are they are a known quantity but also the actual investment is indirect and therefore carries little risk for institutional investors. “The appeal for investors is that they know exactly where and how the money is being spent, they know which project the World Bank will finance, and there is transparency that you don’t necessarily have in similar cases that investors finance directly,” says Eklund. One of the criticisms sustainable and environmental investment has faced in the past is that it provided slimmer returns than comparable mainstream investments. “We naturally don’t buy a lot of green investments but in this case we didn’t have to give up returns for the sake of green credentials. This was an interesting investment partly from a yield perspective and interesting as an investment that will do some good in the world,” says Lars-Goran Orrevall, head of asset allocation at Skandia Liv Asset Management, the investment arm of the Swedish part of insurance group Skandia. A disadvantage of green bonds versus regular bonds is that the secondary market is fairly thin although it is slowly getting better because of the sheer size of the World Bank’s issuances and also because other providers are coming on board. The European Investment Bank (EIB), also a triple-A borrower, issued climate awareness bonds and linked their return to the FTSE4Good Environmental Leaders Europe 40 Index that consists of large European companies with top environmental practices.

Stuart Kinnersley, chief investment officer at Nikko Asset Management in Europe.”The key aspect is that we are getting exposure to emerging market currencies but are not buying the debt of those governments,” he says. Photograph kindly supplied by Nikko Asset Management, November 2010.

“Liquidity was one of our concerns although we have not traded our green bonds in the secondary market. Liquidity is getting better,” says AP2’s Langeland. Spreads are still fairly wide, certainly wider than for respective government bonds, which means that green bonds are better as a long-term investment, held until maturity. “If you compare green bonds with Swedish government bonds, they have so far performed a little better. However, transaction fees for these bonds are higher than for government bonds or even Swedish mortgage bonds and we don’t hold them in our trading portfolio but rather in the stable part of our portfolio,” says Skandia Liv’s Orrevall. “My guess is that most people are sitting on them as a longterm investment because the extra yield could be easily taken away if you try and buy and sell them,” he adds. What does appeal to investors is the exposure to a number of emerging market currencies, that, again because of the World Bank’s triple-A rating, buffers out some of the risk involved in investing in emerging market debt. Nikko Asset Management issued two funds in February based on the World Bank’s green bonds and was instrumental in initiating issuances in 11 of the 16 currencies, according to Stuart Kinnersley, chief investment officer at Nikko Asset Management in Europe. The currencies on offer include the South African rand, the Russian rouble, the

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

Brazilian real and the Turkish lira. The two funds—one aimed at Japanese retail investors and the other at institutions in Europe and the Middle East—use a composite benchmark with an emerging markets and developed markets component. “The key aspect is that we are getting exposure to emerging market currencies but are not buying the debt of those governments which have a much lower credit rating. All of our portfolio will be AAA,” says Kinnersley. Unlike in the developed markets, when the World Bank issues in an emerging market currency, it does so with a lower yield then the respective government because the bank’s credit rating is so much higher. Nikko’s Kinnersley argues that in the current climate in the debt markets it is more appropriate for investors to have a higher exposure to emerging markets then developed world debt. “The sovereign debt crisis is really focusing on the developed world. The fiscal positions, the debt to GDP ratio, are really a G7 problem. In contrast, many of the emerging markets have a much better fiscal position because they have reformed their finances over the last ten years,” he adds.

Showing interest This approach was clearly shared with Japanese investors who were far more enthusiastic about Nikko’s funds than institutions in Europe. Nikko AM’s fund aimed at Japanese retail investors has $250m under management while the one aimed at institutional investors in Europe and the Middle East has $25m. However, now that it has run for six months and was up 13.5% in that period, which is more than 1% higher than the benchmark, more investors are showing interest, Kinnersley added. The benchmark consists of 50% of Citigroup World Government Bond Index (WGBI) and 50% of the JP Morgan Government Bond Index Emerging Markets (GBI-EM). We may be far from the spring but with the sovereign debt crisis caused by the Emerald Isles, green is definitely the colour of the season. I

FACE TO FACE

NATIXIS: EQUITY MERGER AIMED TO MEET CHANGING MARKET NEEDS

Jean-Claude Petard, head of Equity Markets at Natixis, stresses the new single business line, which has resulted from the merger of its equity teams, to deliver a “comprehensive and enhanced” range of solutions to its clients. The service set includes access to the primary equity market, broking on secondary cash and derivative markets, structured products and global equity research and sales. Jean-Claude Petard, who heads up the new department, says the new structure meets the post credit-crunch constraints on the market. David Craik reports.

THE NEW STRONG SUIT N JUNE, FRENCH banking giant Natixis completed the merger of its equity teams to form a single equity business line and rebuilt the division from the ravages of the credit-crunch. The move saw subsidiary Natixis Securities transfer all of its activities to Natixis, the parent company. The new department, which handles all equity cash products and derivatives, is headed by Jean-Claude Petard, head of Equity Markets at the bank. For Petard, the merger of operations has signalled the completion of one of his key priorities when he joined Natixis from rival Société Générale in February 2009. He explains that the aim of the reshuffling was not to reduce costs but to meet changing market and client needs. “We wanted to group together all the equity units at Natixis, including the equity derivatives department and the two cash brokers in New York and Paris, which were previously acting as independent and fully autonomous firms. The thinking was to have one person in charge of all equity matters at investment banking board level and developing an equity strategy,”he says. “Most importantly, the objective was to rebuild the equity division after the market turmoil in 2008,” he adds. Natixis’ merged teams now deliver an improved, wide-ranging and allinclusive solutions suite, including primary market access, broking on secondary cash and derivatives markets, structured products and global equity research and sales. “We want to react properly and immediately to any further shocks and significant movements in the market,” says Petard. “We want to

develop a new fully-integrated commercial strategy servicing all our European and US-based institutional clients as well as retail banking in a onestop shop trading platform. The client is provided with all the equity investment instruments worldwide that we can deliver, including emerging markets, Asia and the US.” Petard says the new structure meets the post-credit crunch constraints on the market square on: “Until very recently all investment managers were investing money outside the equity market to varying degrees, but no one was positive. It therefore became increasingly important to provide asset allocation tools in order to help clients limit risk; hence the merger of our activities. A new market trend is clearly emerging, with a more flexible approach to asset allocation within equities and cross-assets. Clients want to be able to switch swiftly between assets and enjoy more diversified exposure. The main focus is European equities, based on the bank’s French foundations, and its traditional firm hold, or “grip” on the market. Petard describes it as a “cornerstone”of the bank’s new equity strategy. The sales force has been organised around cash and flow derivatives such as straight cash, convertible bonds, listed derivatives, OTC derivatives and all forms of Delta One products. Structured derivatives resulting in “more complex pay-offs” are also offered to institutional investors or retail networks in a variety of wrappers such as funds. “The benefit for clients is that they now have one single account manager covering

their needs and requests. It is no longer fragmented and as such we have a richer dialogue,”holds Petard. “They also have a new array of quantitative research products available on our website which were previously only developed for our traders. They cover European sectors and equity strategy.” Moreover, Petard claims that the new products, such as market predictor and asset allocation tools, are“very technical and mathematical” and are based on a new methodology different from those offered by its competitors. Principle investments are another service offering. It hinges on three main units—equity finance, flow derivatives trading and correlation trading, with baskets of single stocks, indexes and multi currencies. Petard states: “It’s another differentiating factor. There are not many houses able to deliver a payoff based on the correlation of various asset classes.” The success of the new strategy depends on high equity trading volumes and therefore lucrative commission income. Volumes in France were in the doldrums for most of the summer with some increase seen in early autumn. “The market has remained sluggish in 2009 and 2010 with some strong movements in the second quarter this year,” says Petard. “Very recently we have seen in the results of the main banks that the movement away from collecting equities has stopped and that banks are collecting money again. We have reached the bottom and are probably in the middle of a shift of money from fixed income or foreign exchange and sovereign debt to equity.

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

Jean-Claude Petard, head of Equity Markets at Natixis. Photograph kindly supplied by Natixis, November 2010. © Fabrice Vallon

Yields are higher than those from government bonds and that is very rare.” However, he cautions: “It is a bit too early and there is still too much uncertainty in the market for us to see massive movements of money from the less risky assets to the most risky ones. We are at the beginning of this new movement and we don’t anticipate any brutal shift because of low inflation and high unemployment and modest economic forecasts in most countries. There are also concerns over sovereign risk from certain weakened European economies. There has been a strong improvement in investor sentiment but it is still negative.” One of the key market pillars this decade, namely hedge funds, has also suffered in recent times. “Between 1998 and 2008 we lived with an easy way of reading the market because hedge funds were the leading industry in flows and execution. They were the price leaders for all equities and many asset classes,” Petard explains. “Today the hedge fund industry is recovering. It is reestablishing itself but it does not dominate the market as it did before.“ There has also been strong divestment from another key player—insurance companies. According to Petard, that

movement has now stopped and he predicts they will soon return to the equity market. “They can’t stay outside because of the expected performances of equities,”he says. “They will have to come back in a form which meets regulatory constraints but I am expecting them to raise funds and we will see a period of net investment from now on.” With regard to commission incomes, Petard says they have been falling “slowly every year”for 15 years; a trend that continued through 2010. He states: “I don’t think it is reversible. The cash offer is the cornerstone but it has been unbundled.” Because of this, Petard adds, there is an increased requirement to improve trading efficiency and deliver more value added products such as Delta One to “enhance the efficiency of execution for our clients and for ourselves”. Yet is the trend in fees really irreversible? “Unless there is massive merger and acquisitions activity between all the major investment banks and there is a cartel forcing up commission fees, then no, it won’t reverse,” answers a frank Petard. “It is a fragmented and very competitive market. There is no leader who can establish an increase in fees. The clients themselves are very

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

fragmented despite the mergers and acquisitions activity we have seen recently. I don’t envisage a movement that would push an increase in fees.” Inevitably, competitive pressures are also at the forefront of Petard’s thinking. The French banking sector is indeed compact and highly competitive. Even so, Petard suggests that French banks have also proved more inured to the recession than other global banks, especially in those in the United States. Moreover, he holds that the French banking sector has been further strengthened as it has been assiduous in repaying any and all state payouts. Equally, Petard is adamant that Natixis’ new equity strategy is successfully differentiating itself from its peers. “We have a fully integrated chain of skills geared to our clients,” Petard declares. “We have a worldrenowned range of equity research. Our new strategy is proving effective and working quite well. In the second quarter of 2010 we proved our ability to trade and manage our portfolios when we were probably the only bank on this planet not to lose money. We have shown our resilience.” So what lessons has he learned from the last two years? “Equities are the most liquid asset, whatever happens. There is always an ability to move the books when properly managed and organised,”he says.“No bank withdrew from the equity market despite suffering some massive losses and there were even newcomers to the market such as Barclays Capital. We also learned to service not only niches [sic]. Every asset class is important.” As for the future, he says: “We have to adjust to [the] new regulatory hurdles. This will diminish principle trading activities and that in turn diminishes liquidity in the market if it is not replaced by something else. Nevertheless, we are seeing most of the industry recovering. The fear of a double-dip in equities is behind us now and market valuations are becoming strongly attractive. We will keep growing on a healthy basis.” I

FACE TO FACE

OWAIN SELF, UBS INVESTMENT BANK

CUSTOMER CHOICE IN THE DRIVE FOR BEST EXECUTION Owain Self, managing director and global head of algorithmic trading at UBS, explains his views on dark pools, the differences in trading behaviour between the US and Europe, algorithms, best execution, technology and, particularly, transparency, of which he is a champion. TSE GM: What are the salient differences, if any, in approaches to trading and, in particular, utilisation of dark pools between the US and Europe? Owain Self: Many of the differences are a function of differences in market structure. Alternative liquidity regulations differ slightly, which has an impact on how you access alternative venues in trading strategies. The existence of a National Best Bid and Offer (NBBO) in the US makes the process of price discovery easier and more efficient. The composition of order flow in the two marketplaces varies a bit, as well, which affects how and when you interact with specific kinds of venues. As part of the execution process, we interact with non-displayed liquidity in a variety of ways. Our sales traders, traders and systems will source liquidity to achieve the execution objectives of the client. Clients will control their access to non-displayed liquidity predominantly via their direct use of our algorithms. This includes access to external venues as well as internal liquidity, or system internalisers, such as our own UBS PIN. Algorithms have come a long way from the fixed schedule, rigid structures of the past. They are now fully dynamic systems, using complex mathematical models to drive both macro level decisions of speed and urgency and micro level order placement. The sophistication of these models will continue to adapt and evolve based on client demand and market structure change. To some degree technology will

continue to play its part, as calculations or optimisations—which were too slow to be useful in the past—can now be performed quickly enough to be incorporated into the decision process. FTSE GM: Dark pool trading is now part of the mainstream: but how much of dark trading is truly dark? Owain Self: “Dark” is not as dark as it used to be, because in part almost everyone is connected to almost everything and many of the industry’s liquidity-seeking algorithms utilise similar logic and triggers. An execution in a non-displayed venue demonstrates an immediacy of market impact now that was not previously the case. This is particularly true in the US, given the existence of a consolidated tape. Also, the changing nature of dark liquidity—and the preponderance of short-term liquidity in the current marketplace—means that you are, by definition, interacting with more nonnatural flow. This has a significant impact on cross rates, particularly crossing against quality liquidity. If your cross rates are not being impacted, you need to question the nature of that flow you’re interacting with and how intelligently your broker strategy is interacting with all types of venues and order flow. It’s important to be aware of the trade-offs you’re making between cross rates, urgency and information leakage/price impact protections—and choose them consciously. FTSE GM: There seem to be three main types of dark venues: dark orders in lit pools, e.g. exchange icebergs;

public or semi-public dark pools such as Liquidnet; and broker dark pools. Are there other types evolving? Owain Self: It’s important to remember that dark is not a virtue unto itself. But when accessed well, with the right goals in mind, it can greatly enhance execution. There are several ways to access nondisplayed liquidity: The first is through a broker’s internalisation process—via internal networks of dark liquidity that exist as a result of our “best execution” requirements. A broker has an obligation to give their diverse clients the opportunity to achieve the best possible execution, which means if there is an opportunity to execute a cross between two matching orders before they hit the market; the broker has a responsibility to make that happen. The second way is through an ATS or MTF that operates a fully dark order book. Based on which type of dark pool with which you’re interacting, the venue’s regulatory environment/rules and the individual business model that pool operates, a good algorithmic trading strategy will behave slightly differently. For example, given the differences in models within the US ATS marketplace, our algorithms use an order management logic that is influenced at the venue level by their participant base, the order types they support and the ways in which crosses can happen. In EMEA, an MTF is required to be open to all participants who meet eligibility requirements, so our algorithms are more likely to treat MTFs as if they are somewhat closer to lit markets. Finally, one can access dark liquidity by utilising dark or hidden order types in grey pools or on lit exchanges. We tend to judiciously use these venues and order types based on the client’s

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

urgency levels and sensitivity to information leakage. FTSE GM: You have been an advocate of transparency leading ultimately to best execution: encouraging clients to understand the full chain of decision making in order flow, and of understanding who is on the other side of a trade. Could you kindly elucidate your thinking in this regard with regard to dark pools? Owain Self: When a client order matches with a corresponding order in a non-displayed venue, information related to that order is thereby provided to the counterparty and to the marketplace at the time of execution. This exchange of information in consideration of an execution is generally an acceptable “trade” from the standpoint of seeking the order’s best execution. In the US, all equity trades, including non-displayed, are already required by regulation to be immediately reported to the tape. UBS agrees with this important rule and believes that the transparency afforded by this requirement is an essential part of an orderly marketplace. Real-time trade execution reporting serves an important price discovery function allowing the market to gauge relative actionable demand. Transparency undoubtedly serves a vital role in the financial markets, and the bank is an active proponent of meaningful transparency at all stages of the trade cycle. The quest for transparency, however, must be balanced with protection from the risks of gaming. A functional definition of transparency as it relates to the markets might be “clarity and fair availability of information”. These should be basic tenets in non-displayed as well as displayed venues. “Clarity” means that information provided to a participant must be explicit, factual and unambiguous. It should be free from pretence or deceit, and easily understood. No participant should be misled or misinformed, either by design or by omission of data. Information should be delivered in a way that is consistent. “Fair availability” means

Owain Self, managing director and global head of algorithmic trading at UBS. “It’s important to remember that dark is not a virtue unto itself. But when accessed well, with the right goals in mind, it can greatly enhance execution,” he says. Photograph kindly supplied by UBS, November 2010.

that no participant should suffer singular discrimination or arbitrary exclusion from information. The availability of information should conform to established rules. When combined with effective surveillance, another aspect of transparency that provides regulatory agencies with the information they require to monitor participants’ rule compliance will assist the marketplace in maintaining a level playing field. It’s important to try to strike the right balance. A 100% pre-trade transparency rule will drive orders back to the clients’

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

desktops, and decrease overall liquidity in the market. As brokers or investors, we are constantly changing our techniques to find the best balance between dark and lit interactions to achieve best execution. The market structure needs to protect the less sophisticated investor, but at the same time allow for natural market forces to drive positive change. Time should be spent understanding the cause of investor appetite for this functionality, as well as on managing the market place effect of this demand. FTSE GM: How does the sell side help in achieving best execution in an increasingly complex landscape? Owain Self: From investment strategy creation to trading execution, the unique and ingenious variations and tactics investors apply all have a meaningful impact on their ability to seek profit opportunities. A broker must be a proactive ally to the investor in that process, delivering opportunities for competitive advantage via technological infrastructure, access to liquidity, and astutely innovative order execution capabilities. A basic premise of the broker’s role is to serve the buy side investing public and deliver best execution. Thus, it is our obligation to provide opportunities for reduced price impact, price improvement, and reduced trading costs, while additionally protecting our clients’ confidentiality. As we talk with and serve our clients on a daily basis, we hear consistent themes from the buy side regarding the issues that are important to them, including a variety of choices in nondisplayed liquidity venues, ability to protect themselves from information leakage, access to quality internal crossing opportunities, and high speed/low latency market access. On the client front, we see a demand for a simpler order interface and strategic decision processes. Our clients tell us that they want to reduce the need for unnecessary keystrokes—they want their decision process to be simpler or more intuitive, and they want their workflow to be streamlined as much as possible. I

FACE TO FACE

KUWAIT FINANCE HOUSE: NEW BENCHMARKS IN ISLAMIC FINANCE

Kuwait Finance House (KFH), the second largest Islamic bank, has been expanding aggressively over the past few years, purchasing stakes in companies domestically and abroad. The bank has also led a slew of benchmark Islamic issues through the year. KFH’s chief executive officer Mohammed Al Omar talked to Francesca Carnevale about the bank’s 2010-2011 business strategy.

HARNESSING A RISING TREND HILE ISLAMIC FINANCE sets a blistering pace of growth, Kuwait Finance House (KFH) reckons that it is worth investing a dollar or two to secure its international footprint, and the bank has data to back up its claims. A report released in September by the bank holds that the Islamic banking industry accounts for 35% of total banking assets in Kuwait and just over 16.6% of banking assets in the Gulf Cooperation Council (GCC) countries (as of the end of March this year). Moreover, the report says, depending on market factors such as supporting regulation, economic growth rates and continued demand, the Islamic financing industry as a whole should grow between 15% and 20% a year for the foreseeable future. “It is food for thought,”acknowledges Mohammed Al Omar, KFH’s chief executive officer.“It is clear that Islamic finance is a growing business segment and we are set fair to be at the heart of this growth. The report clearly indicates that Kuwait ranks first among the GCC countries in terms of Islamic banks assets to total banking assets and that there are many opportunities still available for Islamic finance solutions in the region.” It is also a call to arms for a region which has of late been eclipsed somewhat by south-east Asia in terms of Islamic finance origination; a trend which KFH itself has also leveraged this year through its Kuala Lumpur

operation, having structured and listed a $100m Ijara (a type of leasing vehicle) on Bursa Malaysia on behalf of Nomura. The deal marked the first US dollardenominated sukuk for a Japanese multinational corporation issued out of Malaysia.“The GCC’s Islamic banks are at the heart of the Islamic banking industry, with some of the world’s largest Islamic banks originating from the region, including Kuwait Finance House; and this is expected to trend higher on the back of increased demand for Islamic banking products and services in the region,” avers Al Omar. The local KFH unit has the parent company’s solid back-up and potential investments in Malaysia and the Asia-Pacific region are high on KFH’s radar screens, notes Al Omar, adding: “There are some more issues in the pipeline and we will be working with our subsidiary banks on more sukuk issuances.”

Fuelling demand To meet the growing needs of Shari’acompliant financing in the region, most conventional banks have either opened a new subsidiary or introduced an Islamic window within their existing infrastructure. A few banks, such as Saudi Bank in Bahrain and Dubai Bank, have also converted themselves into Islamic banks. In terms of financing, opportunities for Islamic banks in the GCC include residential mortgages, underpinned by a high level and still

rising demand for home mortgages within the local market. Moreover, the region’s high GDP per capita, coupled with a relatively young population profile, will continue to support consumer spending and investment, in turn fuelling demand for Islamic financial products and services.” The real estate segment is a key selling point for the bank. Its international real estate portfolio is now worth some $1.5bn and, according to Al Omar, has not been impacted by the recent financial crisis. He says KFH is currently considering “numerous markets that have rewarding revenues, especially in North America, East Asia, and the Gulf”and explains that the bank’s approach to investment in the segment involves“consistently observing markets and foreshadowing their future limits, particularly investment risks”. He adds that KFH’s current investments are focused in Malaysia, Saudi Arabia, Canada, America and China, “since those markets enjoy governmental support, which attracts foreign investors”.

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

Mohammed Al Omar, KFH’s chief executive officer. “It is clear that Islamic finance is a growing business segment and we are set fair to be at the heart of this growth,” he says. Photograph kindly supplied by Kuwait Finance House, November 2010.

The bank has been expanding its financing reach in the wider region for some time, marked by a succession of benchmark sukuk issuance. In Turkey, via the bank’s Liquidity Management House subsidiary, and working with Citi, KFH-Turkey arranged a $100m sukuk (rated BBB- by Fitch), one of the few substantive sukuk deals to have come to market in the country. “KFH-Turkey is developing at a dramatic pace and the market is ripe for new financing tools and product, especially now that major corporations in the country are expanding at home and abroad,”explains Al Omar. “The three-year sukuk involved the participation of some 19 banks and financial institutions from the Middle East, Gulf region, Europe and Asia, and we hope to list the sukuk on the London Stock Exchange.” Al Omar says the bank’s international operations are spearheading the growing utilisation of Shari’a compliant instruments. Turkey is a particularly ripe market, holds Al Omar, citing the recent

listing of the first gold Shari’a compliant investment fund on the Istanbul Stock Exchange. Specifically for KFH, the Ijara or leasing segment has been particularly opportune. In May this year the bank signed a deal with Turkish Airlines to lease three Airbus A320-200 aircraft for seven years, where Alafco will finance the purchase and lease of the aircraft, in addition to managing the deal on behalf of KFH. The bank now has around $5bn worth of assets in Turkey, which has lately become a key target market in terms of generating international business. The same, explains Al Omar, can be said of Malaysia, though he points out that he has high hopes for recently established entities in Dubai, Bahrain, Kazakhstan and Germany. While the Shari’a compliant corporate financing has been a strong point in Malaysia, the bank has been equally assiduous in encouraging retail business, including the opening of three currency exchange operations in key transportation hubs in the country. “The bank’s financial coverage was reinforced after its capital was increased,”explains Al Omar, “in order to meet the growth in its operations and demand for its services, particularly that the bank is interested in medium and long-term investments with high revenues in the wider region.” With local business growth in mind, KFH has recently embarked on a set of local initiatives, ranging from upgrading staff training, the launch of innovative retail products and services and the establishment of a common technology platform which links all KFH systems “that meets all of KFH’s expansion and business diversification requirements as well as upgrading data security through the bank”. Al Omar esplains: “It is an inevitable consequence of growing and fierce competition in the field of Islamic

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

banking coupled with our desire to offer best in class service.” As with many emerging market institutions, the national interest figures heavily in new business calculations. In this regard, with its status as a semiprivate institution, the bank is well placed to build business in the Kuwaiti market thinks Al Omar, on the basis that, “the governmental initiative of increasing public expenditure according to an economic plan that includes major initiatives, and in allowing the private sector to participate in it, eliminated the obstacles and legislations that hinder the role of the private sector and limit investment opportunities in the country”.

Concerted efforts Even so, the bank is mindful of its balance sheet. In spite of some obvious success in the Islamic capital markets the bank has enjoyed through 2010, the going has been challenging, he concedes. It was only in July that the bank’s positive A/A-2 rating was affirmed by ratings agency Standard & Poor’s, and KFH was removed from the agency’s credit watch. In part, the rating was earned by the bank’s concerted efforts to turnaround underlying business; in part the rating was leveraged by KFH’s status as a Kuwaiti government-owned entity and the robustness of the bank in securing liquidity and arranging financing for its clients. Al Omar points to the current trend of positive results. The bank reported gross profit for the first half of KWD172.8m ($617m), which includes net profit payments to shareholders of KWD80.7m. Assets were up 11% to KWD12bn, while deposits rose 7% to KWD7.3bn compared with the same period in 2009. Al Omar cedes: “By securing the rating, it creates further motivation. KFH attaches great importance at this stage to quality and achievement through governance and maximum utilisation of the opportunities extant both in the market and within the bank itself. We encourage the highest degree of professionalism while adopting the highest standards of risk management and well-advised practices.”I

COMMODITIES

ENERGY MARKET: HOW TO MANAGE RISK

The global commodity markets are undergoing a period of unprecedented change, with some bumper times in recent years fuelled by buoyant demand for raw materials from a rapidly industrialising China. This sustained rise in prices is sparking the interest of bullish investors seeking to sidestep the diminishing margins and falling returns of some other asset classes. However, the unique challenges of trading physical commodities place new demands on existing systems and expertise. Stuart Cook and Richard Philcox of Baringa Partners identify the difficulties and explore the possible approaches.

THE PHYSICAL CHALLENGE ANKS AND COMMODITY trading houses have been longstanding investors in “paper” commodities, but it is against this backdrop that they, along with energy and utility companies, are starting to turn to physical commodities such as coal, oil, freight and liquid natural gas (LNG) as a lucrative opportunity to diversify their portfolios. However, this is a highly volatile market. Of course this volatility could put early movers who call the market correctly in line for some stellar returns.Yet at the same time, recent high-profile corporate failures have illustrated all too well the perils of falling foul of a volatile market, driving a fresh emphasis on risk management as a core part of organisational strategy for all firms trading in the energy commodity markets.

Inadequate systems In many ways, the fundamentals of trading in physical commodities are similar to those of their financial counterparts, but there are some significant differences when it comes to the degree of complexity. Indeed, the very fact of physical delivery creates a whole new set of implications and challenges, especially given the fact that physical supply-chain management brings with it complex optimisation problems, which have not always been fully understood in the financial world. The institutions considering testing the waters in the physical commodities market are therefore beginning to realise that there is a significant gap both in their systems and expertise. This leaves them

Photograph © Jesse-lee Lang / Dreamstime.com, supplied November 2010.

managing diversified portfolios with one hand tied behind their back. Traditionally, many organisations have relied heavily on resource-intensive, paper-based processes to manage their critical information flows on physical commodities. When combined with a barrage of systems, these error-prone processes often led to requests arriving in disparate formats, with the resulting action involving multiple steps across different departments.

Better visibility The complexities of trading physical commodities make it more important than ever that companies have full visibility and integration throughout the supply lifecycle. That visibility into key business processes across the front, middle and back offices depends on access to accurate and real-time views

of each stage of the physical commodities process from demand analysis to delivery of the commodity. Take the case of oil. Purchasing the oil itself is just the start of the story. Quality and quantity issues can have a knock-on impact on the invoicing process. For example, if a lower quality of oil to that originally requested is delivered to the end buyer, the value of the oil will be lower than expected, leading to a discrepancy in the invoicing system. This lower value must be accurately tracked through the system and reflected in the final invoice. In another instance, by the time the cargo is delivered to its disport—or final destination—it could have suffered a serious leakage. This lower quantity would also need to be recorded and accounted for at the end of the invoicing process. The valuation of floating stock is another

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important factor. The difficulty arises when a cargo of oil is midway between its load port and disport markets: even if its destination is known, that destination can change. The company must take a decision on whether to establish the value based on the load or the disport market, and more importantly, it needs to apply this decision consistently. There can be significant liquidity risks present through transporting cargoes in this way, especially if there is an inability to hedge, or the lack of awareness of the opportunity to do so. This amounts to noteworthy stranded cargo risk. Tax is another complicated issue that must be addressed by a robust commodities trading and risk management (CTRM) system. The VAT paid on a physical commodity changes according to the jurisdiction to which it is routed, so extra tax advice will be needed or a tax-rules engine that can apply the right rates of VAT depending on location. Companies also need to consider the implications for the balance sheet of holding physical commodities. However, to do so can be beneficial as physical stock held can be used as collateral against trading positions.

Complex trading process The raft of fees involved in the delivery process also needs to be efficiently handled by the energy trading and risk management (ETRM) system. These are the non-commodity costs that are incurred during the process of moving cargoes between locations, including port authority fees, insurance and stevedore fees. Nor can the freight implications of delivering physical commodities be ignored, with multiple considerations—ranging from the choice between time and voyage chartering to securing bunker fuel—which need to be rigorously tracked and recorded. Contracts are a critical consideration, with many organisations now looking to manage structured contract portfolios in a consistent manner. Unlike paper commodities, the structured contracts themselves must be physically delivered and settled and require daily contract

For organisations that are making their first, tentative foray into the market, integrating physical commodities into their existing infrastructure may represent a more cost-effective short-term option than investing heavily in a new system. management to deal with nominations and deliveries via a system that can manage different trading horizons. Contracts can also carry force majeure clauses which bring with them an element of operational risk, the most extreme of which would be failure to deliver physical stock. In addition, the high number of nonstandard contracts in physical commodities—in part to manage these complexities—leads to extended lead times of months or even years for legal departments, delays which can obviously have a knock-on effect on liquidity. In the LNG market at least, things look set to change following the LNG DES Master Sale and Purchase Agreement for spot transactions from the European Federation of Energy Traders (EFET). Industry insiders believe that more standardised contracts should open up the LNG market to new players and facilitate back-to-back trading.

Flexible ETRM system There is no one-size-fits-all approach to handling physical commodities within an ETRM system. Companies have a variety of options based on their particular strategy and the extent of their intended involvement in the market. For organisations that are making their first, tentative foray into the market, integrating physical commodities into their existing infrastructure may represent a more cost-effective shortterm option than investing heavily in a new system. For more active players in the market, on the other hand, a new system architecture can often represent the best way to manage the increasing operational complexity that comes with higher trade volumes. Organisations at this stage of the development may find that a single CTRM

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

platform represents an effective way to handle the complexities of physical commodities. However, some traditional platforms are still relatively weak in this area and so companies looking to dive deeper into physical commodities might prefer to take a new system designed to handle physical commodities. Of course, if that option is chosen it must be able to function alongside other systems, with the ability to be seamlessly integrated into the organisation’s enterprise-wide trading system for consolidated reporting.

Frontline knowledge The choice of platform is not the only consideration when it comes to dealing in physical commodities. This is a specialist area that requires specialist knowledge. People working within the operations area have a different perspective on the market. As the heaviest users of the system, their frontline experience of the day-to-day minutiae gives them access to valuable knowledge. Organisations are increasingly seeking to enhance performance and guarantee compliance by establishing a coherent overview of their trading activities. A far more sophisticated approach to value-chain optimisation is now the order of the day, with assets treated as elements in a single diverse portfolio, rather than separate asset silos. Above all, today’s portfolio requires integrated thinking to close the gap between optimisation and risk management. With investors of all types engaged in the relentless pursuit of profit opportunities, many will rush to ride the wave in physical commodities. In a market epitomised by its complexity, the successful among them will be as serious about investing in their trading systems as they are about investing in physical commodities. I

20-20 ALL STARS: QIA: THE NEW SWF TEMPLATE 46

SHEIKH HAMAD BIN JASSIM AL-THANI G QIA Stakes in Santander, Agricultural Bank of China, J Sainsbury, Harrods, Fairmont Raffles, Credit Suisse and Barclays and the recent launch of a $5bn commodities and real estate focused fund in conjunction with the Malaysian government, clearly illustrate the Qatar Investment Authority’s (QIA) dual pillar investment strategy: high profile stakes in western companies, accompanied by a fast growing and highly diversified portfolio in emerging markets. What now for the sovereign fund?

Qatar's First Deputy Premier and Foreign Minister Sheikh Hamad bin Jassem bin Jabor Al Thani, answers a question from media during a news conference with Iranian Foreign Minister Manouchehr Mottaki in Tehran, Iran. Photograph by AP Photo/Hasan Sarbakhshian, supplied by Press Association Images, November 2010.

A HIGH STAKES GLOBAL STRATEGY LTHOUGH NOT ONE of the world’s prominent sovereign wealth funds (SWF) the QIA, which is reputed to be worth between $85bn and $100bn, has more than most become a bellwether for change in SWF investment approaches. It has been some time since the balance of power between SWF investors and recipient markets has changed. The financial brouhaha of 2007-2009 pretty much saw to that. The consequences have been manifold. Among them, investments, once discrete have become much bigger; prestige investments are no longer the norm; but instead are mixed with long term strategic intent and to smooth out inherent volatility as much as possible. That also means that outright ownership is no longer a fundamental requirement and instead strategic stakes are most appropriate. Regarding investment in real estate, there is a notable shift from direct acquisition to indirect investment, either via property equities or through real estate funds. Equally, incipient changes in the east-west balance of power increasingly encourage a more diversified approach to emerging markets investment. In the case of smaller or more discrete funds, such as the QIA, it enables them to spread risk and not have the inconvenience of direct costs (through the establishment of local offices and/or management for example). Historically, London and Paris have been important investment centres for Qatar, with substantial investments in real estate, particularly hotels; however in common with other Middle Eastern SWF’s the QIA has spotted that Asia offers the new main chance. To this end, the QIA was reported as far back as 2007 to have plans to increase its Asian investments to 40% of its overall portfolio over the following decade. QIA this year signed a $5bn preliminary agreement with Malaysia to invest $5bn in real estate and energy, as well as a $1bn joint venture with Indonesia focusing on sectors including natural resources and infrastructure. Moreover, the QIA put as much as $2.8bn into the initial public offering by Agricultural Bank of China mid-year when the banking giant came to market with its long awaited IPO. In common with other SWF’s in largely mono economies, the QIA is using its investments in real estate, infrastructure,

agriculture and consumer and high end retail entities to help build capacity in their its home market. In this respect, SWFs differ markedly from other asset gatherers in that there is a distinctly political component to proceedings; though on a day to day basis, the SWF tends to work on a similar basis to a long term private equity fund. In this regard and as part of a financial diplomacy drive, Qatar has formed joint investment links with countries such as Malaysia and is in the process of establishing comprehensive links with Indonesia and Greece. Most recently, the QIA reconfirmed its commitment to invest up to $5bn in Greece, a move announced in an official statement issued after the meeting of Qatar-Greece Joint Committee held in Athens earlier this year. Finally, smaller SWFs are learning that they can walk further in company than alone. In QIA’s case it has a long standing investment fund (worth in excess of $2bn) together with the Abu Dhabi sovereign fund. It also has joint venture funds with Dubai Holding. Most significant perhaps, as a sign of growing maturity, the QIA is happily mixing investments in which it holds either 100% or the majority of the shareholding into a multifaceted portfolio which contains investments that are essentially minority stakes. In September 2007, for instance, it reckoned on a 20% stake in Chelsfield, to which it added a £600m stake in the decommissioned Chelsea Barracks, a 14.5% stake in Canary Wharf and a 20% interest in the Shard of Glass trophy property near London Bridge; a mix of long term, real estate and one-off opportunistic investments. The QIA really came into its own in the difficult period of 20072009, when it took strategic stakes in both Barclays and Credit Suisse providing them with much needed capital and in return securing their services as regular arrangers and advisors for most of the SWF’s subsequent investments and asset purchases. Headed by Sheikh Hamad bin Jassim al-Thani, the dealmaker and prime minister, and spiralling down through a new cadre of foreign bankers and a small pool of home-grown talent has subsequently added to its list of high profile investments. Last year, it ploughed $10bn into Volkswagen and Porsche and there has also been time to pick up Harrods as a trophy asset.

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

20-20 ALL STARS: CHI-X GLOBAL: THE CHANGE AGENT

As Qatar’s gas exports have increased, the government has also been able to borrow cheaply to underpin its SWF’s investment strategy. Some 70% to 75% of the SWF’s funds are siphoned off into Qatar Holding, with the remainder destined for global fund managers reporting to QIA. Qatar Holding is the direct investment arm, run by Ahmed alSayed, which tends to buy strategic stakes in banks and other high end companies. Remaining funds are either allocated to third party asset management firms, or allocated to specific funds, such as the fund. Other active funds in which the QIA has invested includes Hong Kong-based Primus Pacific Partners, which invests in financial services companies in the Asia-Pacific region. The QIA has extensive expertise in real estate. It has also established a separate operation to manage real estate

TAL COHEN G CHIEF EXECUTIVE OF CHI-X GLOBAL If any one brand name has struck fear into the hearts of monopoly exchanges it is Chi-X. The brand has been a harbinger of market change, ultimate fragmentation and a new focus on technology and cost efficiency. In Europe, for instance, Chi-X dominated the discussion around market fragmentation even before MiFID came into being. Chi-X Global, part of the same group, but an entirely different entity, has rolled out more of the same across a large swathe of markets; a herald of further market diversity, choice and cost efficiency. It has come at a price for both. How much longer can the moniker ring the changes?

THE HERALD OF CHANGE A

SK MARAT: LEADERS of revolutions don’t always survive to see the fruits of their labour. Will Chi-X Global? Change has been brewing for some time. In September John Lowrey, its chief executive was moved over to technology company Market Prizm, the infrastructure service arm of Chi-Tech and which is now also up for sale, and was replaced by Tal Cohen, who used to head up the firm’s Canadian operations. The surprise move comes as Chi-X Global has been expanding rapidly in Asia, led by Lowrey. By November, Chi-East, the independent panAsian trading platform, in which Chi-X Global has a joint venture stake in partnership with the Singapore Exchange (SGX), announced that it has commenced operations to support the non-displayed trading of Asian securities to complement the region’s increasingly dynamic trading environment. Chi-East also represents a number of firsts: including the introduction of the first Central Counterparty Clearing (CCP) model for selected securities in Asia, as well as the first pan-Asian liquidity aggregator focusing on brokers and high frequency clients. However, unlike Chi-X, Chi-X Global has been burning through cash, with questions over how far it can expand on still limited revenue streams. Chi-X Global operates

investments: Qatari Diar Real Estate and the Qatari Diar Real Estate Investment Company and Barwa Real Estate Investment Company, which is listed on the Doha Securities Market. Going forward, the emerging markets remain a strong focus for the SWF. Its recent $2.7bn investment in Santander Brazil is further proof of its commitment to leveraging high growth markets. Increasingly, as well, expect to see a distinctly political sub-text to investments: a natural evolution of the growing links between the emirate and the Far East and other buyers of Qatari carbon exports. The Santander deal comes in the wake of a January trip by the emir to South America, for example. As the QIA itself concedes, the SWF: “is always ready to partner with experienced and respected partners where they can add value in any particular market.” I

Chi-X Canada – which competes against the Toronto Stock Exchange and which has an approximate 10% market share – Chi-X Japan and Chi-Tech. With Chi-X Canada and ChiX Japan continuing to build momentum, the launches of Chi-East and Chi-X Australia and rollout of new initiatives such as Chi-FX, this is obviously an important time for our business,” explains Tal Cohen, chief executive of Chi-X Global. Aside from expansion into Japan and Australia, it has agreed a joint venture pan-Asian dark pool with the Singapore Stock Exchange. In Latin America, the firm has made its presence felt through Chi-FX Brazil, which will develop FX trading platform, allowing foreign investors to enter orders with limit prices in their base currency and facilitate the simultaneous paired execution of the equity and forex legs of the transaction, thereby mitigating intraday FX risk. Chi-X Global will develop and help support the platform, and BVMF will market the service to its participants and provide facilities, expertise and front line customer support. Chi-X Global is a subsidiary of electronic trading pioneer Instinet Incorporated, a wholly-owned subsidiary of Nomura Holdings, Inc. It is possible that the sale of Chi-X Global could follow the same ownership model as Chi-X Europe. Instinet for the time being holds a 34% stake in Chi-X Europe, but the pan-European MTF has been the subject of a potential bid, widely believed to be US-based exchange operator BATS Global Markets. Other shareholders in ChiX Europe include BNP Paribas, Citadel, Citigroup, Credit Suisse, Goldman Sachs, Bank of America Merrill Lynch, Morgan Stanley, and UBS. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

*References the 2008 Forbes Tax Misery & Reform Index

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BUSINESS ENERGY

20-20 ALL STARS: STANDARD CHARTERED: RIDING THE REMNIMBI WAVE 50

NEIL DASWANI G MANAGING DIRECTOR, TRANSACTION BANKING, NORTH ASIA, STANDARD CHARTERED BANK In August this year Standard Chartered Bank (Hong Kong) Limited launched the first renminbi (RMB) denominated corporate bond for the McDonald’s Corporation. It is the first ever RMB bond launched for a foreign multinational corporate in the Hong Kong debt capital market signifying the commencement of a new funding channel for international companies to raise working capital for their China operations. It is, holds Neil Daswani, managing director, transaction banking, North Asia, “a significant contribution to the development of the offshore RMB debt capital market in Hong Kong”.

ENTER THE DRAGON HE FIRST RMB200m 3% notes (due September 2013) generated good investor interest for its high credit quality, name recognition and rarity value.“Following on the bank’s introduction of RMB-denominated structured investments, we were pleased to bring to market a RMB bond offering by a globally-recognised household name,” says Neil Daswani, Standard Chartered’s managing director, transaction banking, North Asia.“This transaction reinforces Hong Kong’s status as an RMB offshore centre. Right now it is still at an early stage, but the currency is gaining ground as a store of value and wealth in Hong Kong.” Already one of the three leading players in RMB trade settlement and offshore RMB bond trading services (the others being Citi and HSBC), Standard Chartered is taking a proactive role in increasing utilisation of the RMB as a regional currency for investment, trade and reserves. The bank’s prominence in RMB cross-border trade settlement has been more than a year in coming. In a pilot programme launched in July 2009, Standard Chartered Bank Hong Kong was the first foreign bank to complete a two-way trade settlement with China. One month later, Standard Chartered Bank China was the first foreign bank to be appointed the agent and settlement bank for RMB cross border settlement. “The scheme has been expanded to Macau, then ASEAN and is now fully global. Internally the scheme began with five pilot cities and has now been expanded to 20 provinces,”notes Daswani. The numbers may be small, but the renminbi is quietly taking more bold steps in its gradual journey towards internationalisation in bonds, forex trading, and in trade loans. Standard Chartered’s bond deal was the first concrete offshore renminbi transaction, following a separate announcement by the Industrial and Commercial Bank of China in early August that it was ready to sign an RMB50m

Neil Daswani, Standard Chartered’s managing director, transaction banking, North Asia. Photograph kindly supplied by Standard Chartered, November 2010.

line of credit with an Indonesian buyer. Standard Chartered, maintains Daswani, remains one of the first international banks to offer cross-border renminbi trade settlement. The bank began a mission to broaden usage of remnimbi transactions early in the year, as it organised a roadshow, together with officials from the Shanghai Municipal Office of Finance Service, People’s Bank of China (PBOC) and State Administration of Foreign Exchange (SAFE) Shanghai in Malaysia, Thailand, and Singapore; the first partnering of officials from government and regulatory bodies in China and an international bank on a roadshow. Building on the momentum, explains Daswani, the bank has also been working to expand the reach of RMB trade settlement to other regions outside ASEAN such as the Middle East, India, the United Kingdom and Germany, North America and in selected African countries, such as Zambia. The growing number of nostros set up by banks from these markets is indicative of the underlying demand for RMB trade settlement, enabling banks such as Standard Chartered to engage effectively with the Chinese government to expand a scheme initially restricted to ASEAN members. “With the gradual relaxation of regulations for RMB trade settlement, this presents increasing opportunities for traders in China and ASEAN to grow their existing businesses outside of Asia. We are very excited about its growth potential. Our systems are ready and with our extensive footprint across Asia, Africa and Middle East, we look forward to playing a key role in further expanding the scope for RMB trade settlement,” says Daswani. Redenomination has huge implications. Around $2.2bn worth of trade is denominated in RMB, though Daswani thinks that could multiply to around 15% of global trade within the next three to five years. Moreover, he thinks that Hong Kong will be the major trading centre, as remnimbi treasury operations multiply in this jurisdiction. “The CNH market, the offshore Chinese yuan market in Hong Kong, used to be a nondeliverable forward market (NDF), now it is definitely deliverable forward (DF). Earlier this year the spot market was worth between $30m to $50m a day, now you are looking at $350m to $500m. It is a massive turnaround,”he adds. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

TEAM DRIVEN GROWTH It has been a banner year so far for Ping An Securities having weathered the financial crisis by “optimising our asset allocation” according to chief executive Rionzhuang Xue, in timely manner. It seems to have reached safe harbour triumphantly, reporting RMB1, 176m ($175m) net profit for the three quarters of the year, a 111.5% year on year increase, helped by its sponsorship of more than 30 IPOs, while being lead underwriter on seven refinancings of Chinese corporations. “We ranked top in the league table by number of deals and volume of underwriting fees received,” boasts a Ping An Securities official spokesman, playing an innovative role, for example in introducing a new (to China) ETF and a steady increase in “high margin products” for individuals. HE STORY OF the Ping An financial group covers the whole period since Deng Xiaoping began his momentous experiments with opening up China to market forces back in 1991. Beginning in Shenzhen, the city Deng created as the conduit between the world’s markets and China, Ping An Insurance group has been a market force in itself. The insurance company and its interrelated subsidiaries, its bank and securities operations, now joined by its private asset management branch, reinforce each other. The group’s 3rd Quarter report is almost a paradigm of China Inc’s own spectacular growth. Over the first three quarters of this year its assets grew 17.5% to over RMB1,000bn ($150bn), its total equity grew by 26.6% and its net profit up 8.4% year on year to RMB13,bn (approximately $2bn). In Western terms Ping An could almost be considered a financial conglomerate; nonetheless, from trying to penetrate the corporate structure for interview, there are no“Chinese Walls”between the various management groups. In the early summer Ping An Securities finalised the acquisition of a strategic stake in Shenzhen Development Bank (SDB), pushing ahead the merger of its Ping An Bank with SDB, and working towards its strategic goal of creating a unified business platform for the Ping An Group companies of which Ping An Securities is a part. More specifically, it has helped Ping An secure strategic co-operation with a national commercial bank. Rionzhuang Xue, head of Ping An Securities, confirms the drive, citing the investment bank’s“highly-centralised business management, inter-connected operation system between main business lines and supporting business lines, and cooperation between front-line and middle-line businesses. In this regard, Ping An’s operation services, quality control, pricing and issuance, external coordination can penetrate into every single line of business, making team operation possible and enhancing overall competitiveness [sic].” He also invokes“standardised operation procedures and business model in order to ensure standardisation of the project workflow of top-tier salespeople, manage operation risk and effectively enhance service quality.” Certainly in terms of marketing, its integrated operations give the securities operation almost a captive market! The

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

numbers are numbing. Xue points to its 50m retail customers and more than two million corporate clients. He adds,“This has created a platform for the development of the securities business, for it to maximise the business potential of each customer. The synergistic effect is immense, and it is crucial for the development of Ping An Securities.” He credits the company’s “One Customer, One Account, Multiple Products, One Stop Shop Service”strategy,”which allows“this immense network” of all the subsidiaries of Ping An “to successfully share the internal resources.” The brokerage has played a large part in the development of IPOs for the SME, GEM and most recently, the ChiNext platform, the SME segment of the Shenzhen Stock Exchange. The brokerage’s network is well placed to serve the Chinese retail demand for IPO opportunities. While there have been some complaints about Chinese founding entrepreneurs cashing in their IPO chips a little hastily to take advantage of the high price to earnings (P/E) ratios (over 70 on average on ChiNext), one cannot help but suspect their profits might well be heading towards Ping An Trust’s private asset management. However, with its market almost entirely domestic with only incipient operations in Hong Kong, and some personnel outreach, Ping An is relatively unknown outside the PRC. Xue says“In the short term our focus will remain on China’s capital market, and on providing customers with better services.” Even so, he also looks ahead, admitting, for example,“we are intent on recruiting certain talent from abroad, so that we can continue to learn from the experiences of the more developed markets overseas and apply them to our business, from corporate governance to strategic management, products and services to day-to-day operations.” China accounts for more than a third of the $155bn raised in IPOs this year. Companies have raised over $53bn in Shanghai and Shenzhen, and Ping An has outstripped historic China IPO leaders Goldman Sachs and UBS in Shenzhen, as smaller firms opt for local brokerages. When the colossus considers itself ready for the global markets, one almost wonders if Wall St will end up like downtown Detroit in face of the competition wielding the cash of untold millions of Chinese savers and investors.I

20-20 ALL STARS: PING AN SECURITIES: THE CHINA IPO KINGS

RIONZHUANG XUE G CEO, PING AN SECURITIES

20-20 ALL STARS: BBH: HIGHLY FOCUSED, MARKET SEGMENTED STRATEGY 52

DOUGLAS DONAHUE G MANAGING PARTNER, BBH

CUSTOMER FOCUS Douglas “Digger” Donahue, managing partner at BBH. Photograph kindly supplied by BBH, November 2010.

“Having a privately owned structure that promotes collaboration is part of what differentiates our culture,” says Douglas “Digger” Donahue, managing partner at Brown Brothers Harriman (BBH). “If you’re going to grow organically as we must, you’d better do a good job on behalf of your clients. There is a lot of discipline involved with this kind of approach—you have to work much harder at it in order to make it successful, especially given the nature of today’s markets.”

N A WORLD of constantly changing faces and places, a privately held and fully customer funded organisation such as Brown Brothers Harriman (BBH) is a rare thing indeed, says Douglas “Digger” Donahue, BBH managing partner. He adds: “It takes discipline to go against the grain, to maintain your convictions when others are piling into any given asset class, but having the ability to think independently has paid off for us in the long run.” A highly focused market-segment strategy has allowed BBH to properly position itself in emerging regions such as China, where the company recently opened a representative Beijing office in the hope of furthering its already significant mainland banking business—BBH’s clients include seven of the country’s largest banks; at present, Asia accounts for 20% of BBH’s global revenue. “This kind of investment represents a stepping-up in our commitment to the region,” says Donahue. “Our approach to China is consistent with the methods that we’ve established in the past—that is, to work in a complimentary, partnering fashion with leading local institutions. Based on our longstanding track record, they can trust us to be true to that strategy— we are happy to remain in the background as a valued and specialised wholesale partner with excellent cross-border credentials and domain expertise.” Donahue considers the sustained consolidation within the financial markets an opportunity for BBH to truly differentiate itself. “Having that kind of continuity within a private-company setting allows you to pursue your strategies and control your own destiny, without any interference from outside constituencies,” says Donahue. Some may argue that BBH’s model is too constrained to do battle in today’s rapid-fire marketplace; without making dramatic acquisitions or doubling the business overnight, undue pressure is placed on the company and its clients. Donahue has a simple comeback :“Is that kind of approach really that good for your clients, not to mention your staff, many of whom could be eliminated during a major consolidation? The fact that we haven’t grown through a string of acquisitions saves clients from the need to transition from one system to another and promotes stability in our service model. We have a single integrated platform, which allows us to achieve scale at much lower levels of transactional volume.” Donahue disputes the notion that today’s industry is built for scale players only. “In fact, if you pursue it intelligently and

selectively, it can be just the opposite.” A decade ago, says Donahue, BBH was one-tenth the size of the market’s largest players—before the various M&As that were supposed to put some daylight between the haves and the have-nots. “Guess what? Today we’re still one-tenth the size of the biggest players. The point being that, through organic growth and having the right clients and the right products, we’ve clearly been able to hold our ground.” For much of that period, BBH managed to outperform the competition in percentage growth in profits, growth in custody of assets, improvement in margins and many of the other standard institutional rubrics, says Donahue. It has been the leaner, crisis years that have compelled Donahue and his BBH colleagues to truly earn their keep and differentiate their approach. “During a prolonged period of volatility when all hell is breaking loose, clients need you to be there for them like never before,” says Donahue. “That’s why I believe that this isn’t really an absolute-scale business—rather, how scaled you are within each of your relationships. If you were to run this like a utility, you’d take all-comers and just throw them all into the machine. However, there are some things that just aren’t that scalable, and can often hold you back. That’s the handicap of the growth-by-consolidation approach—you spend half of your time trying to normalise all of these systems you’ve inherited, rather than moving your technology forward. So there are built-in advantages to doing it our way—and the proof has been in the financial results.” Donahue points to BBH’s securities-lending programme, which had no impairments or realised credit losses during the credit crisis and has experienced its best new business year in its 11-year history (with assets increasing by 30%-40%) as evidence of the company’s economies-of-scale in action. Explains Donahue: “It takes discipline to go against the grain, to maintain your convictions when others are piling into any given asset class. Having the ability to think independently, to trust the perspective of your partners and colleagues who have been working at this business for decades through all of the ups and downs and the many different market cycles has paid off for us in the long run. We consider ourselves stewards of this franchise—and our main goal is to have the kind of management teams that can keep the business going for yet another 200 years.”I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

Seth Merrin, CEO, founder and president of Liquidnet. Photograph kindly supplied by Liquidnet, November 2010.

THE BUY SIDE MODEL The sheer magnitude of supply and demand, combined with the number of competing interests in today’s marketplace—including the surge in high-frequency trading activity—requires that there be venues where institutions can trade in a more anonymous unlit manner, says Seth Merrin chief executive officer, founder and president of Liquidnet. “The problem is that highfrequency traders in particular can easily take advantage where there is a supply-demand imbalance and who pays the price?” he asks. Anyone with a pension plan, a 401k plan, or a mutual fund. Hence, all the more reason to begin looking at a real separation of those markets.” RANDING ISSUES ASIDE, Merrin says that his company has allowed the rapidly evolving—and, at time, liquidity challenged—institutional sector to find avenues of opportunity in markets that might otherwise be impenetrable. “Over the last 30 years we’ve gone from having a very momand-pop kind of industry, to one that now includes over 100m investors in the US alone,” says Merrin. “Yet the market structure itself hasn’t always kept pace with the changes. In recent years, the orders that were coming in from these institutional investors were so large, in fact, that they were capable of regularly moving the markets in a very significant way. The more the stock moved, the greater the tax was on our returns. People just assumed that Wall Street is as efficient as it can possibly be—but in reality, it hasn’t been completely in tune with the problems that these institutions are experiencing in terms of owning stock and how much their returns have been affected. As a result, Liquidnet needed to come up with a different kind of model in order to properly accommodate

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

the wholesaler. It’s that simple.”For his part, Merrin, has sought to allow institutions to act as their own suppliers of liquidity, thereby creating a wholesale marketplace where there once was none. The platform is not unlike an eBay for stock trading, says Merrin—institutions place their order requests, and the system finds the appropriate buyer or seller worldwide, instantaneously. “There is no manual searching involved, and all of the liquidity gets re-aggregated into a single pool,” says Merrin. “The bottom line is, the less work that people have to do, the more successful you’re likely to be. Obviously we’ve been helping to solve a problem that has existed for years—because we’ve been pretty successful as a result.” To its credit, he says, the Securities and Exchange Commission (SEC) has indicated in recent testimony that it understands not all dark pools are created equal, and has responded accordingly. “When you consider all of the regulatory frenzy that’s been going on, I think it is important that they were able to step back and re-assess, rather than just make a knee-jerk kind of pronouncement—and the distinction they seem to be making with dark pools is that if a firm can provide real value above and beyond what is found on the exchanges, that is true innovation and should be left alone. If, however, you’re not capable of offering major price improvement, or you can’t provide an execution size that is markedly different from the exchanges, then there is a problem, because, at that point, the regulators just perceive a lot of different private exchanges that are only degrading the pricing mechanism and really aren’t benefiting the overall market structure.” Despite his efforts to streamline the global marketplace through Liquidnet, Merrin understands that change doesn’t always come easy. “The notion that a country’s main exchange isn’t the ‘be-all-end-all’ hits at the heart of national pride, and helps to explain why the arrival of these new trading venues has been so disconcerting for local regulators as well as the countries themselves. Like all aspects of deregulation, initially there can be problems and annoyances—we all remember what it was like to get those weekly calls from yet another new telecom following the break-up of Ma Bell. However, in the US the SEC is responsible for ensuring that the market structure maintains its integrity—that no one gains at someone else’s expense.” The company has also found a receptive audience in countries including Poland, Mexico, New Zealand and Israel. “The fact that we are trading in 37 different markets is tremendously important to us, particularly when you have economies such as Singapore, which is currently in the vicinity of 10% GDP growth. Like other companies, Liquidnet has been forced to make some personnel cuts due to weakness in overall global trading activity. To stay on track, says Merrin, the company has expanded opportunities in rapidly growing emerging regions such as Asia Pacific (where trading volume has already surpassed last year’s total of $10.2bn), and has expanded its menu of offerings to include the likes of corporate-access servicing (via its InfraRed application, launched late last year). I

20-20 ALL STARS: LIQUIDNET: SERVING THE BUY SIDE IN THE DARK

SETH MERRIN G CHIEF EXECUTIVE OFFICER, FOUNDER AND PRESIDENT OF LIQUIDNET

20-20 ALL STARS: AKBANK: BREAKING ACROSS THE BOND BARRIERS

HULYA KEFELI G EXECUTIVE VICE PRESIDENT, HEAD OF INTERNATIONAL BANKING, AKBANK

KNOCKING DOWN BOND BENCHMARKS

Turkey’s private sector bond sales have been a standout this year; with Akbank taking a good slug of the year’s new issuance, led by Hülya Kefeli, the bank’s head of international banking. Following permission from Turkey’s capital markets supervisory board, in late July, Akbank came to market with a $1bn senior unsecured Eurobond, offering a yield of 5.256% and a coupon of 5.125%, maturing in 2015. The transaction was the first direct bond issue from a Turkish private sector borrower. KBANK’S EUROBOND OPENED up a new world for Turkish bank borrowers as a host of more diversified funding structures are now much more likely. Akbank’s deal set other benchmarks; it was the largest security ever sold by a Turkish issuer excepting sovereign issues and was priced with the lowest ever coupon for a non-sovereign Turkish issuer. Ironically, Akbank’s Eurobond came at a time when changes to local financial regulations imposed a 10% withholding tax on directly issued bonds. There is no withholding tax charged on syndicated loans, hence their popularity among local issuers. “The bank has a great story,” says Hülya Kefeli, executive vice president, head of international banking at Akbank. “We ended up at the tighter end of the initial guidance pricing range. Demand was strong, with 165 investors in the transaction and outstripped availability, with the order book totalling $3bn. In the end, the allocations

were made to long-term investors. The initial price came in at 99.431, though following the issuance its price has seen levels around 102.25, giving a yield of 4.70%.” The scarcity of Turkish risk, especially at non-sovereign level, helped. “Investors were also attracted by Akbank’s strong position in the Turkish banking sector. Citi’s stake in the bank helped, no doubt about it,” says Kefeli. A month later, Akbank came to market again, securing the first diversified payments rights (DPR) securitisation worth $860bn concluded in the EMEA region for a year, under the bank’s securitisation programme, backed by foreign export receivables, cheques and foreign exchange transfers. The bank also secured a €1bn equivalent, dual tenor, dual currency term loan facility. The loan extends the bank’s ability to secure financing of this type over a longer maturity; a move that Kefeli thinks other Turkish banks will follow. I

JOSE DARIO URIBE G GOVERNOR, CENTRAL BANK OF COLOMBIA

THE TURNAROUND TALE Once torn by civil unrest and racked by drug trafficking, Colombia is a modern day tale of a sound economic turnaround. Y Q3 2008, Colombian economic growth, its currency and consumption were decelerating fast; the result of previous tight monetary policy and the effect of the relative price increases of raw materials and foodstuffs. Public investment fell drastically due to delays in public works. Inflation was moving well above its target range for the year (3.5%4.5%) and Colombia’s sovereign risk premium jumped to 500bps. Two years on and it’s a very different story. Colombia’s central bank is attempting to push down the peso by buying a minimum of $20m daily for at least four months to mop up US currency from the foreign exchange market and by keeping oil dividends abroad. The central bank

Hülya Kefeli. Photograph kindly supplied by Akbank, November 2010.

held its benchmark interest rate at 3% for a seventh straight month at its latest monetary policy meeting, citing low inflationary readings and a strong economic outlook. It also expects its inflation target range for next year is 2% to 4%, the same target range it set for 2010. Prices through the 12 months through October stood at 2.33%. In terms of gross domestic product activity, the bank reaffirmed its 2011 forecast of 4.5% economic growth, compared to 0.8% in 2009 The bank's view of the economy has included political problems, such as its dispute with Venezuela, which has blocked bi-lateral trade. Uribe predicts $1.2bn worth of trade with Venezuela this year, compared with $7bn in 2008. There has been an increase in confidence among consumers and businesses. Investment is coming primarily in hydrocarbons, mining and infrastructure. Mining is particularly attractive as the country branches out from coal to precious and base metals. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

For most financial institutions, growth has been painfully won since the financial rumblings that began in mid 2007. If there is one bank that, at least on the surface, has grasped the opportunity of the downturn to establish an extensive global footprint it is JP Morgan. As some of the stars of the global banking industry have waned, JP Morgan is waxing pretty. In part that is due to stringent internal risk management discipline which has provided the bank with free capital to invest in growth; in part it results from a clear determination to build out a dominant global footprint based in large portion on Asian business growth.

THE ASIAN PLAY G

RAB, BULL AND horns spring to mind when it comes to JP Morgan and its chief executive Jamie Dimon. Dimon has spearheaded substantive growth in the treasury services business, a full-service provider of cash management, trade finance and treasury solutions, particularly in the Asia Pacific region. Over the last year the bank has strengthened the organisational structure of its global trade practice to better address the industry’s increasing demand for supply chain and trade finance solutions; hiring a slew of new senior managers and upping the trade and supply support team. Across Asia, the bank has hired an additional 500 staff in the treasury services segment alone. The new structure introduces centres of excellence for all trade products across the world; regional trade advisory teams; and solution delivery teams supporting trade sales specialists. The bank is positioning itself for unprecedented growth in its global trade business, leveraging its US commercial bank franchise and supporting the bank’s global corporate bank expansion strategy. Change has been coursing through JP Morgan for some years, since it instigated the three year $1bn global investment plan in late 2008. In line with the incipient economic order, most of the investment focus has been on Asia. The goal has been to take a complex multi-currency, multi-regulated environment and make it easier, cheaper and faster for our clients to conduct cash management activities. On the ground, a host of initiatives have included enhancements to the bank’s domestic cash management capability in East Asia, mainly South Korea and a new rep office in Bangladesh. The bank has built up client networks in India, Nepal, Sri Lanka and the Maldives and escrow services have been established in Australia and Singapore. The bank’s US dollar clearing operations have been upgraded with Swift MT-103 message formatting, providing clients with faster, more secure cross-border credit transfers. A web based receivables management platform has been rolled out and a freight payment and auditing capability has been launched to help clients improve control of global transportation operations. Most recently the bank has launched an advisory programme in mainland China to help local corporations improve cost and risk management. The bank’s investment banking operations have also seen a

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

JP Morgan chief executive officer, Jamie Dimon. Photograph by Lawrence Jackson, supplied by AP Photo/PA Photos, November 2010.

substantive uptick. Led by Jes Staley, who took over the reins in late 2009, the investment bank has a three pronged growth strategy, based on lowering return on equity, increasing the investment bank’s share of global banking feels and reducing the error rate for processing trades. The investment bank has set a 20% return on equity target. Since 2006 it has only reached this once – when it hit 21%. Over the last five years the average has been 12% and as the bank has increased equity this year to £40bn, up from $30bn last year, that kind of performance is a big ask. Asia figured largely in growth play this year, with a projected doubling of market share in Asia from 4% to 7%. Its equity and debt capital markets segment has steamed up most new issuance league tables through 2010, with emerging markets debt issuance a particular outperformer. What it all adds up to is that while other banks are struggling to comply with Basel II and the financial reform process, JP Morgan is using the hiatus to become more global, offer a deeper service set across the group, and in the process dominating emerging market business opportunities. Why not: particularly now when there are only a handful of banks that can compete in the space. The bank’s 2010 Q3 numbers are doing some satisfying talk. Through 2010 to date, the company loaned or raised over $1trn in capital on behalf of its global clients and its small-business originations have risen 37%. The bank’s Q3 earnings per share ballooned to $1.01, or 19 cents more than Q3 of 2009, and the company improved net income ($4.4bn) by 23% over the year-ago period. Moreover, its balance sheet—which went from a Tier 1 common ratio of 7% at the start of 2008 to a current 9.5%—continues to show signs of strength. Says Dimon: “We believe that the quality of our balance sheet will position us well for the eventual implementation of new capital standards being developed by bank regulators,” holds Dimon. I

20-20 ALL STARS: JP MORGAN: STRENGTH IN DEPTH

JAMIE DIMON G CHIEF EXECUTIVE OFFICER, JP MORGAN

20-20 ALL STARS: AFC: PROMOTING AFRICA’S CAPITAL MARKETS 56

ANDREW ALLI G PRESIDENT AND CHIEF EXECUTIVE OFFICER OF AFRICA FINANCE CORPORATION

PASSION FOR HOMELAND POWERS AFC BOSS While Africa has not been ignored by the global financial community, Andrew Alli, president and chief executive officer of Africa Finance Corporation (AFC), points out that the flow of foreign investment into the continent has been “heavily skewed” towards natural resources such as oil, gas and mining. “There are huge power deficits across the whole of Africa, so power is a really important sector to get growth going in,” he says. The Lagos-based bank’s capacity to fund such projects and be a creditable partner to international investors is bolstered by a strong balance sheet, capitalised with $1.1bn. Joe Morgan reports. NDREW ALLI, PRESIDENT and chief executive officer of Africa Finance Corporation (AFC), would like to be nowhere else but the country of his birth—Nigeria. A distinguished career in finance has taken him from being an investment banker in the City of London to Washington, where he served as an investment officer working at the International Finance Corporation (IFC), the private sector financing arm of the World Bank Group. However, it is his passion for developing the finance industry in his homeland that drives him. “AFC specialises in projects aimed at catalysing investment in infrastructure within Africa,” says Alli. “This is hugely vital for the economic development of the continent.” AFC was formed in 2007 under an international treaty between sovereign states, with current members including host-nation Nigeria plus Guinea-Bissau, Sierra Leone, The Gambia, Liberia and Guinea. The Central Bank of Nigeria provided anchor capital and holds a 42% stake, with other shareholders, including African financial institutions and corporations. Exemplifying the very type of deal that AFC was set up to do is the project financing of an undersea fiber optic cable, which stretches from Portugal to Lagos, connecting West Africa to the information superhighway. AFC is the largest investor in the $240m Africa-led funded Main One Cable System, which has provided a tenfold increase in broadband capacity in the region. Alli describes the project as being “hugely transformational” for Africa’s IT and telecoms sectors. “It will allow companies to start thinking about opening business process outsourcing operations which they have not had the bandwidth to do,” he says. AFC last year obtained a 46% controlling stake in Cenpower Generation Company, which is developing the Kpone

Andrew Alli, president and chief executive officer of AFC. Photograph kindly supplied by AFC, November 2010.

independent power plant in Tema, Ghana. AFC sells power to the government of Ghana through its electricity company, Electricity Company of Ghana (ECG). “We are putting this together as a project which can be bankable,” says Alli. “This has created considerable interest and is something we hope to take to financial close next year.” Alli points to the funding of the $450m plant—which will help power continued economic growth in Ghana—as an example of how AFC can bridge the gap that exists between pent-up demand among international investors to finance projects in Africa, and the required local expertise among financial institutions in the region to ensure such initiatives are well structured. “We create transactions, rather than waiting for others to do so. A lot of investors like to look at deals that are well-packaged with everything in place. So all they have to do is write a cheque,” says Alli. Another more long-term focus for AFC is the formation of capital markets in Africa, developing markets for “infrastructure bonds” and project-related bonds in local currencies, which removes the currency risk international investors can face. Alli points out that “mobilising” domestic financial markets is a proven model to facilitate the flow of foreign investment into an emerging market economy. “We are also looking at creating private equity funds which specialise in infrastructure, an asset class we see there being a lot of interest in,”he says. AFC plans to obtain authorisation from the international credit rating agencies to issue bonds to raise additional funding and finance projects such as the power plant in Ghana. “If the market is sufficiently well developed, we may issue local instruments either to wholly or partly refinance projects, which will lower risk and increase participation in local capital markets,” says Alli. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

Bradesco’s chief executive officer, Luiz Carlos Trabuco Cappi, will need his much vaunted charisma as the bank stands firmly at a nexus of change for Brazilian banks. The largest private-sector bank in the country until 2008, Bradesco has never really recovered from the trauma of seeing its chief rival Itaú buy its second biggest rival Unibanco and leapfrog it to gain pole position at the end of 2008. The move effectively trumped Bradesco’s 50-year crown as Brazil’s leading bank. Trabuco is determined to leapfrog the leapfrogger.

BETTING ON THE HOUSE U

NDER ITS NEW, charismatic leader, Luiz Carlos Trabuco Cappi, Bradesco is exploiting its almost universal presence in the country and its leadership in key areas, including insurance in which Trabuco has substantial experience. Trabuco’s bet on the local market and lower income consumers implies that Bradesco will be less diversified than its main rivals. Family-run Bradesco is conservatively managed and retains a feel of its early mandate to bring banking to the masses. The theme is fashionable again thanks to pent-up demand from Brazil’s lower income consumers. Trabuco has said that he believes Brazil may support as many as 220m accounts by 2020, up from 130m today. One of Trabuco’s first moves as president was to re-create regional centres within the bank to identify client trends in each region, something that he believes to be impossible from a centralised location in São Paulo. Another initiative is credit

card brand Elo, which Bradesco is launching in partnership with state-owned Caixa Econômica Federal and Banco do Brasil to challenge Visa and MasterCard for lower spenders who do not need international services and the bells-andwhistles embedded in more expensive cards, such as expensive guarantees and foreign-exchange transactions. Bradesco is a “brand that is being built from the bottom up,”says Trabuco. That Bradesco is doing well and still trailing its rivals points to the giddy growth rates of Brazilian banks. Although the financial crisis slowed business in 2008/2009, the 7.5% growth in GDP this year coupled with rapid growth in Brazil’s credit markets, means banks are in optimistic mood. The ratio of credit-to-GDP is in frank expansion and this year is estimated to reach 48%, giving scope for further growth. Executives at Bradesco believe that Brazil offers richer pickings than are available abroad, not only through consumer credit but more corporate banking at home and opportunities arising in infrastructure, especially with the planned World Cup and Olympics events in Brazil. That is not to say that Bradesco is completely out of the internationalisation game, but rather that the company is seeking to do it in a managed, slow way and only in selected sectors. It is opening offices in London, including a securities arm, as well as in Luxembourg and New York to offer asset management and securities activities for European and US investors. I

20-20 ALL STARS: BRADESCO: HOME GROWN SOLUTIONS

LUIZ CARLOS TRABUCO CAPPI G CHIEF EXECUTIVE OFFICER, BRADESCO

EMERGING MARKET EUROBONDS

THE RISE OF EM BONDS Emerging markets bond issues came to the fore this year. In November, for example, a slew of debut sovereign eurobonds were either issued or in the pipeline. MONG THE MOST recent of the growing crop of emerging market issuers this year Jordan launched its debut Eurobond in November which ended up with commitments for $750m 3.875% notes due 2015 and listed on the London Stock Exchange. Originally the country had wanted to come to market with a $500m bond, but investor demand outstripped supply and the sovereign upped the value of the bond. Investors have been eager to buy high-yielding, emerging and frontier market debt this year to compensate for lower yields in advanced markets. Lebanon also debuted on the same day, with a $500m 5.15% notes due 2018 and $225m of 6.10% notes due 2022. The finer pricing of the Eurobond was clearly

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

exhibited when Credit Libanais issued $75m worth of subordinated bonds due January 2018, a few days later, which came in at 6.75%. A few days earlier, EFG-Hermes holding stood a 65% interest in the Lebanese bank for $542m, the largest single foreign investment in Lebanon to date. Long term tenors are also in play. Russia’s Vnesheconombank (VEB) updated its $30bn loan participation notes programme, with the issue of a $600m 5.45% tranche due 2017 and $1bn 6.80% due 2025 under the programme. Compare that with pricing of the $1bn 6.902% notes due 2020 issued earlier this year in the first international debt offering by a Russian state corporation. Citi, Credit Agricole, HSBC and JP Morgan were joint lead managers for VEB's latest offerings of Notes, which were sold in the United States to qualified institutional buyers under Rule 144A and outside the United States under Regulation S. Meanwhile JSC National Company KazMunayGas came to market with a $1.25bn bond due 2021. I

20-20 ALL STARS: eSECLENDING: THE LONG VIEW AUCTIONEERS 58

CHRIS JAYNES G CO-CHIEF EXECUTIVE OFFICER OF eSECLENDING Securities lending is today increasingly viewed as an asset-management and trading process, rather than a back-office or operational function, says Chris Jaynes, co-chief executive officer of eSecLending. Accordingly, more lenders are themselves using third-party providers and seeking alternative routes to market. This evolution has been great for business; to date, eSecLending has auctioned more than $2trn in global assets and manages more than $300bn in lendable assets with over $50bn on loan. Dave Simons reports from Boston.

eSEC LEADS THE WAY F

ORMED INITIALLY IN the late 1990s to service the portfolios of the United Asset Management group (UAM), in October 2000 Boston-based eSecLending opened shop with a singular mission: to provide institutional investors with an alternative approach to traditional custody lending programmes by introducing a unique auction-based lending model. Back then, many traditional providers actively discouraged the use of third party agents for lending assets, recalls Chris Jaynes, co-chief executive officer (along with Karen O’Connor) of eSecLending. “It was a concept that the entrenched agents really fought quite hard against a decade ago,” says Jaynes. While the industry may have ultimately evolved, the onset of the credit crisis, which infused the markets with a shot of much-needed scrutiny, has since brought many more investors around to eSecLending’s way of thinking. “Unbundling, transparency, customisation and control—all common buzzwords in today’s environment—are the core features that our model was designed around and are concepts we’ve been promoting for ten years. While the credit crisis has brought attention to the market for negative reasons, we think in the long run the increased focus is a positive thing because it forces everyone to sharpen their level of understanding and improve their product offerings,”says Jaynes. Today, securities lending is increasingly viewed as an assetmanagement and trading process, rather than a back-office or operational function, says Jaynes. Accordingly, more lenders are themselves using third-party providers and seeking alternative routes to market. This evolution has been great for business; to date, eSecLending has auctioned over $2trn in global assets and manages more than $300bn in lendable assets with over $50bn on loan. “Here we are ten years later, and most of the large custodial banks are now in agreement that third-party lending is a portable investment product rather than a custody-based

Chris Jaynes, co-chief executive officer of eSecLending. Photograph kindly supplied by eSecLending, November 2010.

service,” says Jaynes. “In other words, it is the realisation that providers should be selected on the merits of their model, their approach and their product—as opposed to whether or not they are providing custody services. That is a dramatic change from the world we entered in late 2000.” One thing that hasn’t changed over the years is eSecLending’s approach to the mechanics of securities lending. “Right from the start, our goal has been to bring investmentmanagement-type disciplines to the industry by promoting transparency, competition, benchmarking and performance measurement, as well as better service and reporting, all areas that we felt were lacking in the market. What continues to differentiate eSecLending from traditional agency providers is that, rather than utilise a pool or queuing system, we treat each client as an entirely separate book of business—in short, ours has been a much more tailored approach to sec-lending based around each client’s unique assets, risk tolerances and goals, as opposed to a volume-based, one-size-fits-all kind of operation. Unlike other providers, securities lending on a third-party basis remains the company’s core competency.” Given the fluctuating political climate in the US, it remains to be seen how—and to what degree—some of the recently drafted regulatory measures will be implemented. However, Jaynes believes that new regulations will, in general, be supportive of securities lending, whatever form they should take. “Calls for greater transparency and increased focus on affiliate transactions certainly works to the advantage of eSecLending’s business model, given that we are independent and therefore free of some of the perceived conflicts of interest that can exist in the market.” Though the company’s basic operating principles have remained fairly constant throughout, its menu of capabilities has become much more diverse, says Jaynes. “Where we were once focused almost entirely on exclusivebased auction programmes, we’ve since broadened our approach to include a full discretionary programme, and we are also in the process of rolling out new products in the treasurymanagement space.”Under Jaynes’watch, eSecLending has also expanded its global reach; today, the once exclusively domestic enterprise now has equal parts US and non-US clients, and maintains offices in both the U.K. and Australia, in addition to its flagship Boston location. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

LAST MOVER ADVANTAGE The financial shocks of 2007/2008 forced a sea change in the traditional relationship between a hedge fund and its prime broker. Although hedge funds became more selective in their prime broking relationships, they also began to add new prime broker agreements and opened up to a new set of custodian relationships as they moved unencumbered securities and cash into global custodians for safekeeping. At the same time, large custodians moved into the prime broking market at a sustained clip on the back of hedge fund fears over counterparty risk and a desire for improved collateral management. However, HSBC, under the leadership of Cian Burke, is attempting a truly seamless offering. Is it the model of the future? F LATE, THE alternative investment services space has been a two carriage highway as hedge funds have moved money into custodian accounts because of perceived dangers to their assets; while prime brokers increasingly have recognised the need to adopt more custodialtype processes. The result is a number of hybrid service structures. In the US, for example, Northern Trust offers Merlin Securities’ prime brokerage clients access to its global custody and administration service, and custody behemoths State Street and BNY Mellon have been promoting securities lending to hedge fund clients. The latest buzz is for larger global-service banks to merge their custody and prime brokerage arms. JP Morgan launched a prime custody group, which has combined the prime brokerage unit it acquired when it took on Bear Stearns with its custody arm. HSBC meantime has attempted a seamless offering through the merger of its traditional asset servicing business with a nascent prime broking service that it has been building steadily since 2009. The Prime Services offering has been led by Cian Burke, who also now heads up HSBC’s Securities Services (HSS) together with Drew Douglas; reporting directly to Samir Assaf, group general manager and head of global markets. By the promotion of a seamless service, the bank hopes to secure a substantial portion of a market which is still in flux and at a time hedge funds are still launching long-only funds and seeking structures that allow them to house certain assets with custodians and traditional asset managers are executing long/short strategies that require financing through a prime broker. “We did not want to be Morgan Stanley Mark II, but to harness market expertise and build something that was right for HSBC, and meets the needs of hedge fund managers and their investors,”says Burke.“Last mover advantage is decisive in this respect.”The question now is how much can HSBC capitalise on hedge funds’ flight to safety (or quality) and create a lasting template? Ten years ago, hedge funds with more than one broker were a rarity. A triumvirate of Goldman Sachs, Bear Stearns and Morgan Stanley governed a tip over 60% of the business.

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

Although still highly concentrated, the prime brokerage club is today somewhat more inclusive. Recent Hedge Fund Research figures show that in Q3 2009 six large global prime brokers (JP Morgan, Goldman Sachs, Morgan Stanley, Credit Suisse, Citigroup and Deutsche Bank) service almost three-quarters of the global Cian Burke. hedge fund market. The trend is confirmed Photograph by consultant Aite research, which holds kindly supplied that nowadays even larger hedge funds are by HSBC, gravitating toward firms that offer a broader November 2010. service set, including research, securities lending, investment banking, fund administration, capital introduction and consulting, leading-edge software and services in trading, analytics, risk and reporting. In the post financial crisis world, security is everything, holds Burke. “Now it is entirely about how to segregate customer accounts. The ability to provide clients with full security and transparency over their assets in segregated accounts, together with the opportunity to use some of these assets as security for financing, enhances the product offering. Add to that questions around safety and those banks with the strongest balance sheets have begun to dominate." HSBC’s entry into the market in late 2009 took traditional prime brokers by surprise. Actually, HSBC has stronger credentials in the hedge fund segment than it is often given credit for. Apart from aiding a range of hedge fund investors through its established private banking division, HSBC is one of the world’s largest managers of fund of hedge funds assets, overseeing some $23bn, while its custody arm already holds over $10bn in hedge fund assets. Burke is clear that the evolution of the bank’s prime services offering was entirely client-driven.“There was a desire among investors and clients to have a prime services provider that could offer them leverage without transferring the title of their assets. The client proposition was about taking what we’d built in Custody Plus and wrapping around that a broader prime services offering,” says Burke.“Remember we have a significant OTC business, we have global execution capabilities, we provide funding and equity financing and we have Custody Plus. All-in, it’s a very strong proposition.”I

20-20 ALL STARS: HSBC: A SEAMLESS SERVICE SUITE

CIAN BURKE G HSBC GLOBAL HEAD OF PRIME SERVICES AND CO-HEAD OF HSBC SECURITIES SERVICES

20-20 ALL STARS: SOCIÉTÉ GÉNÉRALE: EVOLUTIONARY DYNAMISM 60

DAVID ESCOFFIER and GIAN-LUCA FETTA G CO-HEADS OF SOCIÉTÉ GÉNÉRALE’S GLOBAL EQUITY FLOW TEAM

EVOLUTIONARY TRENDS If you remember, 2008 was not a good year for Société Générale. Trader Jérôme Kerviel incurred €4.9bn losses in the January, almost wiping out all the bank’s entire annual profits. Moreover, as the year progressed, along with other banks, it also began to suffer the fallout from the sub-prime crisis. “The support we received from clients at that time was really comforting,” says David Escoffier, co-head (with Gian-Luca Fetta) of the bank’s Global Equity Flow team. “We had announced a major event and we had survived. In terms of the business, it was a big crisis but it has been important to learn the lessons and we have been investing heavily in risk systems since then.” ONTHS BEFORE THE Kerviel episode, the financial barometer had slowly begun to swing in a different direction and the management at Société Générale was already planning how it was going to adapt to the new financial environment. In July 2009, the bank went live with a total review of its business model, known internally as Evolution. In a swoop, it created a flatter business model, decompartmentalising silos and showing a single face to the client. It comprised three main areas: Coverage and Investment Banking for strategic clients; Global Finance consolidating capital-raising and financing across both debt and equity; and, finally, Global Markets. With the creation of Global Markets, all the rates, credit, currencies, commodities and equities were brought together into one integrated platform, to deliver a complete range of services and solutions across all asset classes. Fetta says: “Evolution had one main objective, to focus on clients and as part of this, to beef up the investment banking capabilities on the advisory side, from mergers and acquisitions to debt capital markets and coverage of corporate clients. It has made it easier for stakeholders in the bank to serve clients’ needs.” Global Markets was organised into two areas: one to service clients for flow trades on the more standardised products, divided into the three asset class-based teams of fixed income and currencies, commodities and equities, under which the bank’s Delta One and exchange-traded funds (ETFs) businesses fall. Second is the cross-asset solutions department, which provides clients with investment advice and financial engineering through category-specific teams, for example, clients with a huge need for advice in the light of Basel III, which set minimum levels of capital in banks of 7% of their

David Escoffier (left) and Gian-Luca Fetta, co-heads of Société Générale’s Global Equity Flow team. Photograph kindly supplied by Société Générale, November 2010.

risk-bearing assets. (Incidentally, while it is expected that most banks will need to raise hundreds of billions of euros of capital under Basel III, SocGen announced in November that it was confident it would not need to do this.) Fetta says: “The cross asset solution team provides clients with a tailor-made approach drawing on all sections of the bank, but of course, the solution you propose is fed back for implementation through the different asset classes.” The reorganisation also created what Escoffier terms the “equity chain”. “This ensures that from origination, M&A, right down to equity research through trading and sales departments, we are fully aligned to deliver the bank to clients,” he says. The bank’s equity derivatives team, long regarded as industry leaders, has maintained its position at the top. It has also had the highest return on equity among all leading investment banks of 59%, estimates JP Morgan Cazenove in a September 2010 research report. “We have a growing equity franchise unlike our competitors, but it’s a tough market.” says Escoffier. “We are still very cautious and we live quarter by quarter.” A major contributor to the recent success of Global Markets’ has been the growth of SocGen’s Delta One and ETF business. Delta One products are the simplest type of derivative where the derivative moves in line with the underlying asset. While equity volumes and derivative volumes generally have remained low this year in the industry, Delta One and ETF volumes have stayed buoyant and Greenwich Associates estimates that 55% of European institutions are expecting to increase their usage of flow equity derivatives products in 2011. Additionally, JP Morgan Cazenove estimates total revenues wallet from this area in the industry accounted for $10.7bn in 2009 and will grow 9% to $11bn in 2011, driven by volume growth in ETFs, equity swaps and certificates. For SocGen, the largest Delta One player in Europe, it will bring in estimated revenues of $1.1bn globally, according to Cazenove. In July 2010, the bank enhanced its lending and borrowing ETF service for European institutional investors and became a market maker in five new options on Lyxor sector-based and emerging markets ETFs. It joined NYSE Liffe for the launch and is believed to be the first market-maker offering clients access to the quoted underlyings. A dedicated platform of options (OTC or listed) on ETF allows investors to set up strategies to optimise their portfolio management. The bank’s expansion and investment outside its traditional marketplace of France—it holds the number one market share on Euronext—has also provided clients with greater choice. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

CETIP, the Brazilian CSD, will have a cross-border collateral management deal with Clearstream up and running by the second half of 2011. Both companies have agreed to jointly develop, promote and distribute triparty collateral management services, acknowledging in the process the trend towards global consolidation of collateral management activities. The agreement is one of a stack of initiatives which has put Clearstream at the forefront of change in settlement and custody, securities financing and investment fund services on a global, rather than regional scale.

BOLD BRUSH TACTICS LEARSTREAM’S GLOBAL PRODUCT suite is a substantive turnaround for a business which only a decade ago defined itself as a vertical service set attached to the Deutsche Börse Group. Clearstream, the ICSD, started as a provider of the post-trade infrastructure for the Eurobond market and, as a central securities depository (CSD), providing post-trade infrastructure for the German securities industry. In the interim, Clearstream has expanded not only its business set, but also its business reach and these days the firm is increasingly defined as a global, rather than regional operator. Settlement and safekeeping of eurobonds is still Clearstream’s core business, accounting for more than 40% of its revenues, and with a market share of 37% as of October this year. Jeff Tessler, Clearstream’s chief executive, explains that: “One of Clearstream’s goals is about bringing simplicity to the post-trade services industry by offering the complete range of our services through a single window. We continue to build competitiveness in the cross-border securities processing area through interoperability and partnerships.” That is however, a moveable feast: 2010 alone has been marked by a stream of initiatives which continue to add to its diversified product offering. The firm now offers services covering cross-border securities processing, investment funds services, and global securities financing, where it is one of the four global providers of collateral management services. Within those product sets, the firm has been diligent in deepening the overall service range. Most recently, carbon emission rights and the Chinese renminbi held outside mainland China have become eligible for settlement in Clearstream; an inevitable development as Asian investors seek to maximise renminbi denominated investments in their portfolio. The firm plans to expand its settlement services to the Brazilian real and the Indian rupee. Clearstream has been willing to wield a bold brush and work in partnership with other specialists. For instance, the company has created the first European trade repository together with Bolsas y Mercados Españoles (BME), called REGIS-TR. The system will collect and administer details of all OTC transactions, giving market participants and regulators access to a consolidated global view of OTC derivative positions; an overview that is currently not available, but which will be required by European regulators. Moreover, Clearstream customers can now also cover their margin exposure to Oslo Clearing through Clearstream’s collateral pool, the Global

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

Jeff Tessler, Clearstream’s chief executive. Photograph kindly supplied by Clearstream, November 2010.

Liquidity and Risk Management Hub. According to Tessler, the diversification strategy is a natural evolution of the times: “Life is much more difficult for everyone. In this ‘new normal’ our clients and partners are looking for infrastructure which supports their business at a time when there are substantial shifts in the global financial system. Providers such as ourselves must and should differentiate themselves around providing our clients with improved functionality, safe haven services and risk management related to counterparty risk.” It is also a function of the semi-regulatory role that traditional clearing and settlement institutions have always played in the fungible securities segment, as highly commoditised, rules based and process centric operations. Clearstream is notable for breaking out of that mould, while still adhering to a strict transparency and principles-based operating model. For one, it has a diversified global client profile that is the envy of many a national securities depository, that encompasses broker/dealers, asset managers, asset gatherers and central banks, comprising 2,500 institutions in some 110 countries. Through its latest initiatives it is also carving a significant role in both the onexchange and OTC derivatives market segments, such as its agreement with CETIP, and through enhancements to its collateral management services. Finally, it has successfully rolled out its operations across the globe. In the Middle East it has secured a strong client base among the region’s central banks. Today, approximately 20% of the Clearstream revenues are coming from Asia – a share that is set to grow. Moreover, China is amongst Clearstream’s top 10 largest markets. I

20-20 ALL STARS: CLEARSTREAM: AN ENHANCED GLOBAL OFFERING

JEFF TESSLER G CLEARSTREAM’S CHIEF EXECUTIVE

20-20 ALL STARS: BARCLAYS: THE IMPACT OF REGIME CHANGE 62

ROBERT E DIAMOND JR G CEO, BARCLAYS CAPITAL

LAST MAN STANDING? When Robert E Diamond Jr, an energetic and entrepreneurial American, was passed over as chief executive of Barclays in 2003 in favour of a younger and much more reserved Englishman, he put on a brave face. “I’m not disappointed,” he told the press. “I’m all pumped up.” Would he remain at the bank even six months? “I promise,” he said. He not only stayed but, as Barclays’ number two executive, built an investment banking profit machine, guided it through the worldwide financial crisis of 2007-08, acquired Lehman Brothers for a song, avoided government bailouts, and generated praise and criticism on both sides of the Atlantic. Next April he takes over as chief executive of a Barclays that is much different from the one he joined 15 years ago and is largely of his own making. Art Detman explains why Diamond’s greatest challenge may lie ahead. OB DIAMOND AND British banking is an odd coupling. In an industry known for conservative tradition, and hierarchy, Diamond is a maverick. As head of Barclays Capital (BarCap), he frowned upon limousines, forbade personalised stationery for senior executives, proposed eliminating titles from business cards (he was dissuaded from that), weeded out bankers who were not team players, and worked feverishly to build BarCap into a major player in investment banking. He also vigorously defended the concept of a universal bank—one that, like Barclays, combines retail banking with investment banking. More controversially, Diamond champions US-size pay packages, it’s a world view that has polarised opinion but not diminished his stature. That Diamond would achieve all this perhaps wasn’t apparent in October of 2003 when Barclays announced a typically orderly management transition. Retiring chairman Sir Peter Middleton would be succeeded by chief executive Matthew W Barrett, who would be replaced by John Varley, an Oxford-educated lawyer who had been with Barclays for more than 20 years and was viewed as a highly competent, risk-averse manager. After BarCap’s failed bid for ABN Amro in 2007, questions were raised about the direction the investment bank would take. By late 2007 the banking meltdown was well under way and among its high profile casualties, the collapse of Lehman Brothers brought Diamond another opportunity to shine. Diamond, who had written down $3.6bn in bad investments over the summer, saw Lehman as the vehicle for turning round BarCap by greatly expanding its presence in the US. The acquisition became one of the fastest takeovers in Wall Street history. Diamond quickly sold off Lehman’s Asia-Pacific and European investment banking and equities units and after only three months Diamond declared that Lehman was fully integrated into BarCap and contributing to the bottom line. Investors were sceptical. They feared that Barclays’ profit reports would be inflated by one-time gains from the Lehman deal. By January 2009 Barclays stock was selling for one third of its tangible book value. Barclays was more prey than predator, and the UK’s Financial Services Authority (FSA) pressed Barclays to take advantage of the government’s asset protection plan. Varley and Diamond resisted, saying that participating

Robert E Diamond Jr, CEO of Barclays Capital. Photograph kindly supplied by Barclays Capital, November 2010.

in the scheme would restrict the bank’s decision-making freedom. However, it was clear that Barclays, having taken a writedown of £5bn in 2008, had to raise more capital. In early 2009 Barclays struck a deal to sell iShares, the exchangetraded funds operation that was the crown jewel of Barclays Global Investors, which managed more than $1trn in assets through offices in 15 countries. Diamond’s success has brought criticism, especially in the UK. When a BBC business editor asked a British government official for reaction to Diamond’s appointment as Barclays next chief executive, the answer was: “Bank taken over by casino.” Diamond bristles at comments like this. He insists that its investment banking business is solely client-driven. There are more substantial problems facing Diamond. One is the relatively weak performance of the retail side of Barclays, particularly outside of the UK. Investment banking profits, hardly existent before Diamond took over BarCap, but now account for 70% or more of Barclays’pre-tax earnings. Diamond praises the universal bank model because it provides balance, but 70/30 is not balanced. Some people would prefer to split retail and investment banking, as the Glass-Steagall Act did in the US until 1999. Diamond remains adamant in his advocacy of universal banking and large size. Defending both are political battles he’s likely to face soon after taking office as Barclays’ boss. The fight ahead might even Diamond another chance to sparkle. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

Since the merger between BM&F and Bovespa back in 2008, the exchange has transformed itself from an investment backwater to one of the world’s hottest exchanges, having made strides in regulation, market development and building links with other international exchanges. Even so, the exchange needs to continue to manage fast growth and possibly gear up for competition. John Rumsey reports.

THE MONOPOLY PLAY REVIOUSLY CHIEF EXECUTIVE of BM&F, Edemir Pinto, has led BM&FBovespa since the merger with Bovespa in 2008. According to Pinto, the merger of the exchanges was a pivotal event, helping to strengthen the Brazilian capital markets, offering a vertical exchange/clearing model, that incorporates four clearing houses (equity, derivatives, foreign exchange and other securities) as well as a full service central securities depositary. Certainly, the BM&FBovespa walks tall these days; its managers reel off impressive statistics about growth, market capitalisation and local rankings. This year, it pulled off the world’s largest secondary offering, from oil giant Petrobras worth BRL$120bn. The launch of the Novo Mercado soon after the turn of the new century is seen as a turning point. Companies that wished to join the new market had to obey much higher governance standards, including tag along rights in the event of a take-over. The merger between Bovespa and BM&F was the second pivotal event. A third pillar is the local regulator, the Comissão de Valores Mobiliários (CVM). Both the exchange and its regulator have built a reputation as the most solid managers of markets in Latin America, notes Sandra Guerra, founder of São Paulo-based Better Governance and coordinator of the company circle Latin America. The exchange recorded net revenue of BRl$486.9m, an increase of 27.1% year-over-year, says Eduardo Refinetti Guardia, CFO and investor relations officer at the exchange. That came primarily due to a 70.7% surge in volumes traded on the BM&F. In October, trading hit the highest daily volume on record at BRl$7.7bn, he notes. Even so, the crisis has, however, acted as a wakeup call. Management has understood that it is necessary to broaden out the shallow base of foreign capital by attracting in new foreign investors, particularly from Asia and the Middle East. Meanwhile, the exchange’s BRAiN initiative was launched this year, spearheaded by Paulo Oliveira, the exchange’s chief business development officer. BRAiN is a more sophisticated operation than its market promoting predecessor BEST. Strategic relationships have been a cornerstone of the exchange’s deepening of its service offering; though its key stakeholders were in place prior to the merger. BM&F had a cross-share swap with the CME Group. In practice, an order routing agreement enables customers in more than 80 countries using CME Globex, CME Group’s electronic trading platform,

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

Edemir Pinto (left), CEO of BM&FBovespa. Photograph kindly supplied by BM&FBovespa, November 2010.

to trade BM&FBOVESPA products directly, via the Brazilian exchange’s electronic trading platform, GTS. These products include futures and options on one day inter-bank deposits, the Bovespa Stock Index, commodities, energy, and metals. The partnership between CME Group and BM&FBOVESPA also allows Brazilian investors to trade CME Group products directly through the GTS system. Investment in technology is another element, involving the upgrading of trading platforms, which offer greater capacity and safer systems and will encourage new trading strategies, including high frequency trading, which the exchange views as a prestige programme. The exchange is also working to develop its nascent non-sponsored Brazilian Depository Receipt (BDR) programme, notes Guardia. Myriad challenges remain: from deepening the culture of retail shareholding on the one hand and respect for minority shareholder rights on the other; driving down trading prices for clients; and building a range of new products. The last area for work is to deepen some of the markets. Brazil’s corporate bond market, for example, has struggled to develop. That is in part thanks to high interest rates and plenty of government issuance which have provided sufficient risk-free returns to deter diversification. But it is also because the secondary bond market lacks transparency, liquidity and efficiency. According to Pinto, the vertically integrated systems at BM&FBovespa are a cornerstone of the enlarged exchange’s success. That can play either one of two ways: either it can adopt the monopolistic heavy hand that its strategic investor CME Group plays to great effect in the United States as a driver of future growth or, it will have to change and evolve even more as it faces growing competition from newcomers anxious to leverage the very real opportunities in the market. I

20-20 ALL STARS: BM&FBOVESPA: A NEW STRATEGIC OUTLOOK

EDEMIR PINTO G CEO, BM&FBOVESPA

20-20 ALL STARS: JP MORGAN: THE TRENDSETTER 64

CONRAD KOZAK G CEO, JP MORGAN SECURITIES SERVICES “We are now back in that mould of developing new strategies to leverage cross currents of change in the global financial markets. The difference is that this time around there is a greater emphasis on better quality data, market transparency, risk management and operational risk,” holds Conrad Kozak, chief executive officer of JP Morgan’s securities services business. “It provides us all with opportunity and challenges.” The tip in 2010 has been in local custody; a move encouraged by the shift of responsibility onto depositary banks and away from the sub-custodian. Moreover, the bank is stepping up its global risk and collateral management offerings to the nth degree: it is re-writing the business book and JP Morgan is leading the charge.

DOWN AND DUTIFUL NE OF THE things that annoy Conrad Kozak, chief executive of JP Morgan’s securities services business, is the “charge of commoditisation. If you are delivering services on a global basis, without screwing up, that’s not a commoditised offering,”he avers. It is a particular truth as the one time gulf between traditional and alternative investment approaches narrows to nothing. “The approach to business and our business models have not changed,” he explains, “rather we used to be able to draw a line between hedge funds and traditional asset managers; and it has meant that we have to be fleet of foot in tying our suite of services together to provide the same set of services to both. We sometimes might struggle with the complexity of reporting, for instance. The fact remains however: the events of the last few years have accelerated the need for us to become integrated across asset types and all geographies.” It has resulted in a slew of services upgrades. In the US, for instance, the bank recently enhanced its offering of regulatory reporting services for money market funds to assist asset managers in complying with SEC revised Rule 2a-7 requirements. Thereby ensuring higher credit quality, improved liquidity, and shorter maturity limits, including the calculation of weighted average life. The bank is also helping advisors meet enhanced disclosures of fund level, class level and security level data requirements. Equally, it has ratcheted up services to assist clients prepare new financial statement derivatives disclosures. Elsewhere, the bank has introduced Auto Substitution, a new functionality that helps reduce the sizeable credit risks historically associated with the $2trn tri-party repo market, while allowing dealers to retain access to securities required for intra-day trading. The move is part of the bank’s efforts to help investors and dealers mange their collateral and mitigate risk through its Global Collateral Engine initiative, a strategic investment programme to deliver enterprisewide collateral management. The trend is picking up helter-skelter. “There’s a requirement for counterparty risk analysis and all of a sudden an asset manager wakes up to the need to know what the risk is to all his counterparties and if he is using multiple custodians it’s more complicated,” adds Kozak.

Other trends are also in train. Because the world is a more dangerous and complex place, it has encouraged the bank to refocus on the sub-custody business, at least where it makes sense and can be done as cheaply as local providers. “Two years ago, we would not have looked at it; now we feel more comfortable and it has changed the way we think about and approach risk,”he explains. It is also symptomatic of a sea-change in the sources of new business.“Some 60% of revenue is now outside the US,” says Kozak, with Europe and Asia dominating new business. China is the bellwether of this change:“It is a very different market, where the award of custody business is traded off distribution. We have been successful in capturing a clutch of outbound businesses, but a huge amount is inbound and is captive with local banks that distribute. In North Asia and Australia however, it is like the rest of the world,” cedes Kozak. For now the struggle is between the excitement of the opportunity of new growth models, such as that presented by the recent Nordic deal (JP Morgan two years ago acquired Nordea’s institutional custody business) and new offices in places such as Abu Dhabi, and the need to maintain the integrity of the overall service offering and a centralised operational structure based on regional administrative and processing hubs. “Essentially we want to be as local as possible, with maximum usage of big factories.” Added to this, is the ability to provide a long suite of products utilising specialist skills available elsewhere, such as investment banking operations. Strength in depth of service offering is key in this regard, cedes Kozak, who points to the recent agreement with NASDAQ OMX Stockholm AB, through which JP Morgan became the first non-Nordic custodian for the NASDAQ OMX Derivatives Markets.“If we are going to be a winner in the securities services business, it has to be based on the connection with our investment bank and the cross-business opportunities that presents. If we get that right, as we are doing with the prime broking segment, for instance, it is a massive uplift for the client, who benefits from one point of contact across a slew of high quality products, not some of the time, not most of the time, but all of the time.”I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

TAKING IT TO THE LIMIT

Atsushi Saito, CEO, Tokyo Stock Exchange. Photograph kindly supplied by TSE, November 2010.

When Atsushi Saito, an industry veteran who spent 35 years at Nomura Securities, took over as president and chief executive officer (CEO) of the Tokyo Stock Exchange (TSE) in June 2007, the leading Japanese equity market was on its way to becoming a financial backwater. Average order execution times were measured in seconds, a Stone Age standard compared to leading international markets in Europe and the United States where milliseconds (ms) were already the norm. Moreover, co-location services did not exist, which prevented high frequency trading firms from bringing their expertise and liquidity to the TSE. UTDATED TECHNOLOGY TURNED the TSE into a quaint relic anchored in the previous century. That all changed in January 2010, when the TSE launched its arrowhead trading system, designed to cut order execution times to five milliseconds (ms) and achieve 3ms data distribution times. The amount of market data made available was increased, too, from five quotes either side of the central price to eight—all made available in real time through a new data service called FLEX Full. In practice, the arrowhead system has performed even better than expected in the ten months since its launch, notching up average execution times of 2ms to 3ms and 2.5 ms for data latency. It’s no exaggeration to say that arrowhead has transformed how the TSE functions. The number of daily orders has jumped from 6m to 10m, driven in part by high frequency trading firms, which have come from nowhere to account for an estimated 30% of trading based on the volume routed through the TSE’s new co-location facilities. Although the development of arrowhead began in March 2006, 15 months before Saito was appointed TSE president and chief executive officer, he played a crucial role in shepherding the project to its successful conclusion. He took a personal interest, repeatedly emphasising to the chief executive officer of Fujitsu, which designed the system, the importance of top quality reliability and the lowest possible latency in both execution and data distribution. Saito also spearheaded marketing to both domestic and international brokers and investors, an effort that has borne fruit in wider participation by non-Japanese investors after the arrowhead launch. The introduction of high-frequency trading has had the familiar effects observed in other markets of cutting average ticket size and narrowing bid-offer spreads. The TSE also amended its trading rules to permit narrower tick sizes and streamline the operation of daily price limits and opening price auctions. It also eliminated half-day trading sessions. The increased flexibility has not yet translated into higher share trading volume, however; in the first ten months of 2010, the TSE’s First Section traded a daily average of 42.8bn shares versus 46.6bn in the same period in 2009—although

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

without the new trading system share volume might well have fallen even more. Tighter dealing spreads translate into lower trading costs, of course; by some third party consultants’ estimates, execution costs for Japanese equities have tumbled 30% this year thanks to arrowhead. The biggest reduction has been for midcapitalisation stocks, where tick sizes have tightened the most, but liquidity has improved across the whole market. Domestic and foreign investors alike have welcomed the new system, which has proved its operational resilience: no significant problems have occurred during the first ten months. While arrowhead was essential to prevent the TSE losing ground to other financial centers in the region, it has also opened up new business opportunities for the exchange. Co-location has attracted high-frequency trading firms— particularly from abroad—which pay for the privilege, an entirely new revenue stream derived from market participants whose share of trading volume has shot up from zero to 30% and is still growing. A 65% increase in order flow has generated incremental trading fees for the TSE, too. The transformation of trading on the TSE is part of Saito’s wider vision for the future of Tokyo as the pre-eminent financial centre in a region destined to play an increasingly important role in the global economy. Asia is a massive economic bloc, home to two-thirds of the world’s labour force, whose rising prosperity has unleashed local consumer demand that will shift the balance of economic activity permanently eastward. Regional financial centres that have long played second fiddle to New York and London will gain in stature, and Saito’s mission is to ensure that the TSE capitalises on expertise and experience gained over many years as a leading international market to propel Tokyo to the fore against stiff competition from Shanghai, Hong Kong, Singapore and others. “The liberalisation of Chinese markets will have a large impact on international financial markets,” says Saito. “We view them as worthy rivals and valued business partners. I believe this provides an opportunity for the TSE, Hong Kong and Shanghai to consider what can be done to benefit all our markets in the long term.” I

20-20 ALL STARS: TSE: ARROWHEAD, THE GAME CHANGER

ATSUSHI SAITO G TOKYO STOCK EXCHANGE CEO

PROFIT PROFILES: NORTH AMERICAN QUARTET SHINES 66

A MOULD BREAKING COMPANY QUARTET In a period where good news is at a premium, here’s some welcome uplift. Through the “great recession” some companies not only remained profitable but positioned themselves for continued growth by adhering fiercely to their core principles. Their success offers lessons for other companies. Art Detman profiles four such companies—three American and one Canadian. EXANS LIKE TO brag about how everything is bigger in their state, but Richard Evans Jr made his company better, and in the long run almost certainly bigger as well, by giving up a large chunk of business. Dick Evans is chief executive of San Antonio-based Cullen/Frost Bankers (CFR), and back in 2000—as a boom in home loans began that eight years later would nearly bring down the world’s financial system— he stopped making residential mortgage loans. “We had no crystal ball,” Evans says. “We did exit that business, which was about $200m a year in mortgages we were creating, because we felt that it did not stay focused on our mission.” Evans emphasises that Cullen/Frost was built on long-term relationship banking, not on transactional banking. So as homeowners began refinancing their loans nearly as casually as they applied for new credit cards, he saw trouble ahead. “Our mission statement says that we will grow and prosper by building long-term relationships based on top-quality service, high ethical standards, and safe, sound assets,” he says. “That’s not a mission statement that just hangs on the wall and nobody pays attention to—we live it. Our core values are caring, integrity and excellence. Our value proposition that has come out of all this is that we want all our customers and staff to feel significant and to recognise that we’re about excellence at a fair price and that we’re a safe, sound place to work and do business.” In describing Cullen/Frost, Evans again and again uses the term “safe, sound”. It describes not only the bank’s decision to walk away from the booming home loans market but its overall approach to lending. The company’s Frost National Bank subsidiary aggressively seeks business customers, but it is uncommonly judicious in making loans.

Its “safe and sound” policy is a throwback to another era, when bankers actually felt responsible and accountable for how their banks operated. Although Cullen/Frost has suffered through some tough times during its 142-year-history, it has not only survived, it has triumphed. Today, with $17bn in assets, it is the largest bank headquartered in Texas and ranks fifth among all banks doing business in the state. As recently as 1985 it was among the state’s smaller banks, but as the boom in oil prices turned into a bust—the price of crude fell 60% in seven months—commercial real estate loans tanked. Meanwhile, the savings-and-loan (S&L) crisis was unfolding, bringing down S&Ls that had depended too much on volatile short-term deposits to finance shaky longterm loans. Of the ten largest Texas-based banks, Cullen/Frost was the only one that survived intact. “Although it got pretty beat up during that time, the management—which is pretty much in place today—learned a lot of lessons,” says Bain Slack, an analyst at Keefe, Bruyette & Woods. “So as credit became very easy during this decade, specifically during the middle part, the Cullen/Frost management team quickly realised that they’d seen this movie before and were determined not to get caught in the same cycle that had caught many of their brethren in the previous cycle. When a lot of banks were lowering their standards to get loan growth, Cullen/Frost kept its standards fairly high with regard to its underwriting.” When the financial crisis struck, hitting many small Texas banks as well as US national giants like Wachovia and Washington Mutual, the impact on Cullen/Frost was relatively mild. Loan-loss provisions rose and per share earnings declined in 2009, but dividends, book value and assets all increased.

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

From left to right: Dick Evans from Cullen/Frost Bankers, Scott Di Valerio of Coinstar, Frank Sullivan from RPM International and Dennis “Chip” Wilson from Lululemon Athletica.

When the US Treasury came calling to enroll Cullen/Frost in the Troubled Assets Relief Program (TARP), which has since become a four-letter word, Evans said no. “We did not take TARP because it was not in the best interests of our shareholders. We had strong capital and our financial analysis of the cost showed it was 11% in the early years, not 5%. We were the first bank to publicly say: ‘Thank you, but no thank you.’” Today, Cullen/Frost is sitting pretty. It has 110 banking offices throughout Texas, including ones in three of America’s ten most populous cities (Houston, San Antonio and Dallas). Its market share is not quite 3%, so there is plenty of room for growth. “We could double the size of the bank if we took less than 5% of the business away from the top banks that operate in Texas,” Evans says. Whereas Cullen/Frost sees opportunity for further expansion within the state of Texas, RPM International (RPM) of Medina, Ohio, seeks growth on a global scale. It manufactures in more than 20 countries and sells in nearly 150. Founded in 1947 as Republic Powdered Metals, RPM is the very model of an industrial company, manufacturing a wide variety of specialty chemicals, sealants, preservatives, caulks, coatings, roofing systems, adhesives and other products that protect the surfaces of buildings, bridges and other structures. About 65% of its products go into the industrial market, while 35% are sold through hardware stores and other retailers to consumers. DAP, Flowcrete, illbruck, Rust-Oleum, and Tremco are among its many brands. The housing crash barely fazed RPM, whose sales fell just 7.6% in fiscal 2009 and edged up to $3.4bn in the following 12 months. For most shareholders, the most important thing was an increase in dividend, the 37th consecutive annual

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

increase. Elliott Schlang, an analyst with Soleil Securities, reckons that during the past five years RPM’s dividend has grown at the compounded rate of about 6.5%, “and the 4.5% yield, or whatever it is right now, looks extremely attractive, especially given the strong cash flow that the country has and the consistency of its growth historically”. RPM chief executive officer Frank Sullivan attributes the consistency and profitability to the company’s entrepreneurial operating structure and philosophy. “We’re big believers in pushing decision-making to the market,” he says. “We operate with 50 independent companies, and a third of our businesses are operated by the original founder-owner or a second or third generation family member. Versus our big peers in either building materials or paints-and-coatings, we are the only one who has this very decentralised, entrepreneurial operating philosophy.” When RPM makes an acquisition, sometimes it buys a specific product, occasionally manufacturing capacity, and more often than not a distribution channel. However, what’s most important is management. Sullivan says: “We look for companies with good management teams who want to stay and operate the business as part of RPM, and I think we have enough of a hands-off approach to encourage and energize them to continue to run their business.” One example is Euclid Chemical, which was a small Cleveland-based company when RPM acquired it in 1984. Founder Larry Korach handed management to his son Jeff. When Jeff moved up to run the Buildings Solutions Group (which includes Euclid), his brother Ken took over at Euclid. Both recently retired and Jeff’s son, Randy (a 15-year company veteran), succeeded him as head of Building Solutions Group. “This is a great example of the kind of family heritage we’re looking for,” Sullivan says. “Fortunately for us at RPM, we’ve had three generations of Korach entrepreneurial zeal. So I don’t think it’s just a coincidence that the original business, which was about eight million bucks in sales when we acquired it, is now more than a billion dollars.” RPM typically has years of experience in dealing with a company before it makes an offer to acquire it. “In some cases, a couple of years,” says Sullivan. “In others, 10 or 15 years. During this time we develop a very good understanding of their business and what drives their growth, and they develop a good understanding of RPM and how we operate.” As a result of this careful courtship, acquisitions almost always go smoothly. “I can’t think of a time when we had to replace a founder or a founding family member who was there when we acquired the company. We’ve never had an entrepreneur walk away, and we’ve never fired one. The challenge comes down the road, when the entrepreneur is set to retire. We have had instances where we have struggled to find leadership that would continue running the business with the same passion as the management that was in place when we acquired it.”

PROFIT PROFILES: NORTH AMERICAN QUARTET SHINES

RPM’s strategy is to achieve first or second place in each of the niche markets it serves. “They do this through savvy, strategic acquisitions and internal product development,” says Schlang. “They have done a wonderful job, in roof coatings especially. No matter how bad the real estate market is, the last thing any owner of an office building or industrial plant is going to do is not put something on the roof to prevent water damage. That replacement business is golden for them.” The sealants and coatings business is fragmented, so there is plenty of room for RPM to grow. “For the past 25 years, including the recessionary periods, our annual compounded revenue growth has been around 11.9%,” Sullivan says. “About five percentage points of that is from acquisitions, and slightly more than 6% has been from internal growth.” If Cullen/Frost and RPM demonstrate how businesses can be built on personal relationships, Coinstar (CSTR) shows how success can come from providing services in an impersonal but highly convenient way. Based in Bellevue, just east of Seattle, this young company (founded in 1991) is heir to more than a century of vending machine development, stretching back to the early 1880s, when coin-operated dispensers of postcards were introduced in London. As its name suggests, Coinstar’s original product is a coincounting machine that accepts loose change and issues a voucher that can be redeemed in whichever store the machine is located. The fee, which is shared with the retailer, ranges up to 9.9%, depending on the country. If the coins are donated to a charity, their full face value is credited. If the coins are redeemed as a gift card, to be used at the participating retailer, again the full face value is credited.

Publicity coup About 19,000 machines are in use in the US and UK, both of which have enough compulsive hoarders to support a profitable if modest level of business. John Kraft, an analyst at DA Davidson, expects the coin business to bring in $272m in revenues this year compared with $1.7bn for DVD rentals. “Our 2011 estimate is $278m for the coin business—almost flat,” he says. “Our estimate for the DVD business is $2.38bn, up almost 20%.” Coin-counting is a steady, humdrum business that once in a while produces a human interest story, such as that of the penny-saver in Alabama whose local bank refused his 1.3m coins—$13,000 worth. Sensing a publicity coup, Coinstar sent an armoured truck to pick up the pennies, which weighed 4.5 tons. The truck sank in mud in front of the house and had to be towed out. There aren’t any stories like that about Redbox. The concept was developed at McDonald’s, which was seeking products that would drive traffic into its fast-food outlets. Because of its experience in placing automated machines in retail locations, Coinstar got involved and, when McDonald’s decided Redbox was too much of a diversion, became the dominant partner. In February 2009 Redbox acquired McDonald’s remaining interest for $175m. “McDonald’s didn’t want the distraction of this little company, so Coinstar got Redbox for what basically was a steal,” says Kraft.

When the financial crisis struck, the impact on Cullen/Frost was relatively mild. Loan-loss provisions rose and per share earnings declined in 2009, but dividends, book value and assets all increased. When the US Treasury came calling to enroll Cullen/Frost in the Troubled Assets Relief Program (TARP), chief executive Richard Evans said no.

Maybe so, but until then the company had struggled to achieve clarity in its business model. At one time it owned a grab bag of businesses, including coin-operated arcade games, pre-paid credit card kiosks, and a money-transfer operation. All are gone, and a new management team headed by chief executive officer Paul Davis is in place. Today, the company is focused on providing self-service kiosks for the “fourth wall”—that area of a store, restaurant, bank or similar establishment that normally is empty. “We convert what otherwise would be dead space into the highest profit per square foot in their stores,” says Scott Di Valerio, Coinstar’s chief financial officer. “We look at that space and use it to fulfill unmet needs that the consumer has by serving the consumer in a selfservice fashion,” he explains. “If you think about our coin business, where we process $3bn-worth of coins a year, and our Redbox business, where we are serving up new-release DVDs at a dollar a night, it’s really all about meeting unmet consumer demand from a self-service perspective in an efficient way that represents value and convenience.” Each Redbox kiosk stocks around 210 titles, and in some locations Coinstar has installed a second unit. By the end of fiscal 2010, Di Valerio expects the company to have 30,000 Redboxes in 26,000 locations. This should increase further in the next few years as the result of an agreement reached recently with CVS Caremark, which has more than 7,000 pharmacies across America. The growth of Redbox and its competitor Netflix (which sells by mail and through internet downloads) may spell doom for traditional bricks-and-mortar outlets. Last February smallish Movie Gallery filed for bankruptcy and in September giant Blockbuster, a chain of 3,300 stores that once dominated the DVD rental business, also entered bankruptcy (although, for now at least, many of its stores will remain open). Should Blockbuster liquidate, any markdowns in its inventory would hurt Redbox rentals. Yet this would be temporary and likely be offset by new business from the CVS deal. However, if Redbox and Netflix can bring down Blockbuster, will video-on-demand (VOD) over the internet bring down Redbox? It’s a question management has clearly pondered. One response may be a link-up with a hi-tech company such as Apple in order to provide VOD. Davis has acknowledged “a long-standing relationship with Apple”, and said that Coinstar is “exploring multiple opportunities” in online delivery.

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

Another response is further diversification in the selfservice automated kiosk business. “We have a number of initiatives to drive internal growth in new concepts,” says Di Valerio. One is coffee. Coinstar has hired a Starbucks executive and is working with the coffee company to develop kiosks that would dispense Starbucks’ Seattle’s Best brand. Another promising area involves recycling cell phones. “We made an investment in a company in San Diego called ecoATM,” Di Valerio says. “It’s a small company, five or six kiosks, that is leveraging the second-hand market for cell phones, predominately in developing countries.” The idea is that a cell phone owner could take an existing phone to a kiosk, which would run a number of automated inspections and then make an offer to purchase the phone. If accepted, the phone would be deposited into the kiosk and its seller would receive a voucher that could be used to buy a new phone. “It’s a good example of a business that meets a need in the automated retail space,” Di Valerio says. In contrast to Coinstar, Lululemon Athletica (LULU)— another Pacific Coast company, this one based in Vancouver, British Columbia—is intensely people-oriented. Founded by Dennis “Chip”Wilson in 1998, this designer and retailer of yoga-inspired apparel is expected to have sales of perhaps $630m this year, on which it will net $87m, for an after-tax profit margin of 13.8%. Wilson, who once headed a sportswear company, created Lululemon after taking up yoga. He became convinced that yoga provides optimum exercise for people of all ages but thought its apparel— heavy cottons and polyester blends—could be improved. Today, he is chairman and chief designer. His chief executive officer is Christine Day, a 20-year Starbucks veteran who joined the company in 2008. Neither was willing to talk to FTSE Global Markets, which may be just as well. The company is flushed with its initial success and parts of its press kit read like statements from the early days of Google, which Chip and Chris might find a bit difficult to explain with a straight face to journalists. Example: “At Lululemon Athletica, we have an original intent—to elevate the world from mediocrity to greatness.” So far, there’s no sign of that, but without a doubt the company has achieved remarkable success in a very tough business, and it has done so by creating superior products for a specific audience and marketing those products very effectively to this audience. As a result, it has built up an enthusiastic following among Wall Street analysts, some of

Lululem Athletica is flushed with its initial success and parts of its press kit read like statements from the early days of Google, which Dennis “Chip” Wilson and Christine Day might find a bit difficult to explain with a straight face to journalists. Example: “At Lululemon Athletica, we have an original intent—to elevate the world from mediocrity to greatness.”

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

whom flatly state that Lululemon, small as it is, already is a great company. “The product is unique, differentiated, technologically advanced and highly effective for its intended task—yoga, indoor athletics, that sort of thing,” says Richard Jaffe, managing director of Stifel Nicholaus, who ticks off specific product advantages: “Four-way stretch, breathable, lightweight, wicking, functional pockets, non-binding waistbands.” Another Lululemon advantage: “The corporate culture within the stores, within the company itself. This creates a unique in-store experience, a unique shopping experience, and a unique attribute in the brand.” The company has about 130 stores in the US, Canada and Australia, but has been adding stores at a steady clip and expects to open at least 15 more in 2011. Because the apparel designs are mainly function-driven rather than fashion-driven, markdowns are infrequent. This is offset partly by the high degree of personal service provided by the sales clerks, or “educators,” in Lulu-lingo, who are both knowledgeable and passionate about yoga. Another extra cost is working with yogis and athletes on a local basis, which provides product feedback. In early 2009 the company began selling through its website, and analysts expect sales here to increase sharply, with a resulting boost to margins.

Relentless focus Lululemon caters primarily to young, affluent urban women who are health conscious and can afford the company’s premium prices. Jaffe and others believe that the company can grow from this base into other areas, such as skiwear, swimwear, casual clothing and footwear. “They have expanded to include some running gear, and they’ve experimented in a very small way with apparel for biking,” he says. “Their men’s business is a very small part of their franchise and could be further developed.” In just four years Lululemon’s sales have increased threefold, while its gross margin has held steady and its operating margin and net profit margin have climbed. The key, analysts believe, is management’s relentless focus on its corporate identity. “The company has been very judicious in its growth,” says Edward Yruma, a vice president at KeyBanc Capital Markets. “It has really strived to protect that unique in-store culture, where employees offer great customer service that we don’t see in many other places in retail.” As for Chip Wilson and Christine Day: “They are one of the best management teams in specialty retail.” So there you have it: A Texas bank that doesn’t make mortgage loans, an Ohio manufacturer that strives for multigenerational management, a Washington State company that focuses on monetising the fourth wall of retailing, and a Canadian apparel maker that has a quirky press kit and great clothes. They might seem like a diverse lot, but actually they are more alike than different. Each has a clearly defined sense of purpose, a strong corporate culture, and a determination to adhere to core values in good times and bad. The world could use more companies like these. I

CANADIAN TRADING: IS THE FUTURE THE DARK SIDE?

Photograph © Eugenesergeev / Dreamstime.com, supplied November 2010.

HFT TIPS THE DARK POOL AGENDA High-frequency trading has shaken up a Canadian equity market long dominated by the incumbent exchange and five big banks. In late 2008, the Toronto Stock Exchange (TSX) beefed up its infrastructure and embraced maker-taker pricing in an attempt to blunt the challenge from alternative venues such as Pure Trading and Chi-X Canada that already accommodated high-frequency trading. The TSX has still lost market share—by late October 2010, it had slipped below 70%—though probably less than if it had not changed its pricing model. Investors anxious to avoid high-frequency trading order flow are turning to dark pools, which have been slow to develop in Canada thanks to its unusual broker preference trading priority. Neil O’Hara reports. N CANADA, LIKE other markets where high-frequency trading has taken hold, bid-offer spreads have collapsed and trading volumes have soared. Advocates often cite the benefit increased liquidity brings; and for retail investors, the advantage may be real. They can trade against other market participants on a more equal footing. It’s a different story for institutions that want to trade blocks, however— and it’s a nightmare for traditional broker-dealers, who face soaring trade processing costs. High-frequency trading firms use small orders, which drive down the average ticket size per trade. Executions get broken up across multiple trading venues, too, which makes it harder for brokers to process multiple fills on a single ticket. Brokerdealers must connect to every venue in order to meet best execution obligations—and face ongoing costs for market data at each venue as well. “For regulators to monitor highfrequency trading they will have to increase their technology spend significantly. This investment will largely be paid for by the sell side broker-dealers,”explains Greg Mills, managing director of global equity sales and trading at RBC Capital Markets. “It is just wrong.”

Mills argues that the liquidity high-frequency trading provides is illusory for anyone trading in size. Algorithms typically tap the cheapest venues first, which may not be where the high-frequency trading order flow rests. As soon as a buyer or seller begins to absorb cheap liquidity, highfrequency traders will cancel their offers or bids on other venues, raising the market impact cost. “You will see one million shares of a big liquid stock offered across several venues, but you can’t buy that much,” says Mills. “Highfrequency trading firms take the information advantage but don’t have any commitment to trade.” RBC is fighting back, however. In April, it introduced its Thor algorithm, which delivers an order simultaneously to every selected venue so that bids and offers cannot be pulled. Mills says Thor grabs 100% of the displayed liquidity in most cases. To Dan Kessous, chief operating officer of Chi-X Canada, high-frequency traders just have a different profile. “Whether investors buy and hold a stock for a few seconds, a week or a month, they are all trying to make money,”he says.“Highfrequency traders are willing to trade with other participants. It is in my mind real liquidity.”Chi-X Canada handles about 9% of Canadian share volume, making it the second largest alternative trading venue (after Alpha Group, owned by the five major Canadian banks, which handles about 15%). Kessous attributes Chi-X’s success to its strong brand recognition among global investors and its introduction of innovative order types—hidden orders and pegged orders, for example—that other venues didn’t have at the time and in some cases are still not available anywhere else. The first alternative trading system launched in Canada was Pure Trading, a subsidiary of CNSX Markets, but the firm hasn’t capitalised on its first mover advantage. Pure captured just 2.9% of trading volume in October even though it was the first venue to facilitate high-frequency trading. “At the time Pure was developed, Canadian trading infrastructure was not up to the latency or capacity demands of electronic market making, statistical arbitrage, pairs trading, cash vs. derivative index arbitrage, ETF arbitrage, all of which are ordinary course activities today,” says Richard Carleton, who is responsible for the operations, technology and sales at Pure.

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

Regulators fostered alternative trading systems to break the incumbent exchange monopolies, but in so doing they opened the door to high-frequency trading—an even bigger regulatory concern. The irony is not lost on Steve Grob, director of group strategy at Fidessa in London, who says that regulation and technology are being combined in different ways in different countries in a “huge global experiment”. In Canada, the best execution obligation extends only to Canadian trading venues—but for the 220 stocks that are interlisted in the United States the best price may be on NASDAQ, the New York Stock Exchange, BATS or Direct Edge. “What is the broker supposed to do?” asks Grob. “Maybe he can do a better job for his customer by not following Canadian best execution obligations and trading south of the border.” In one week in late October, for example, the Fidessa Fragulator tool shows most of the trading in Research in Motion, the Canadian maker of Blackberry devices, took place on US venues. Real trading patterns simply don’t fit the tidy boxes regulators want to put them in. High-frequency trading is the latest iteration of a wellworn market strategy. Grob argues it is similar to firms that located their offices closer to the exchange, put more traders on the exchange floor, or invested in hand-held devices. In every case, the goal was faster execution—only today, the edge is measured in microseconds rather than physical distance. Some Fidessa customers argue that high-frequency trading firms, which have become the de facto default liquidity providers, should have an obligation to make a market at all times, not just when they want to. Others are not worried who is on the other side as long as their orders get filled. Grob won’t take sides, though he acknowledges it is a “legitimate question”.

Jackie Allen, a director at Bank of America Merrill Lynch. “Algorithms and buy side self-execution is becoming a bigger percentage of the volume traded,” says Allen, “but the information sell side traders can provide is still a valuable—and valued—service in Canada.” Photograph kindly supplied by BofAML, November 2010.

Rogue orders Every microsecond counts to high-frequency trading firms, which explains their preference for co-located direct access to trading venues, which minimises latency. Best of all from their point of view is so-called naked access, in which they rent a broker’s identification number and enter their trades without any prior intervention by the broker. Canadian regulators have so far refused to clarify their attitude toward naked access despite confusion among market participants. CIBC has aggressively pursued the business, but the other big banks have stayed on the sidelines pending regulatory clarification. In early November the SEC adopted a rule that requires brokers to pre-filter trades, a policy Canada is widely expected to follow. A filter at the broker level may not eliminate the risk of rogue orders, however. Although most high-frequency trading firms are not registered as broker-dealers, they could do so— in which case they would still have access to the exchanges without third party review of their trades. “Where do you put the fuse box?” asks Grob. “Is it at the sender of the flow, the broker in whose name the flow goes through, or the venue where it is matched?” He suggests the responsibility should lie with the exchanges, which have an obligation to maintain an orderly market—a solution that would prevent high-

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

Greg Mills, managing director of global equity sales and trading at RBC Capital Markets. “High-frequency trading firms take the information advantage but don’t have any commitment to trade,” he says. Photograph kindly supplied by RBC Capital Markets, November 2010.

frequency trading firms from skirting the SEC’s new rule. Pure Trading’s Carleton believes Canadian regulators may prefer the model proposed by IOSCO in its August 2010 paper on electronic trading. It requires brokers to have sophisticated risk management controls to protect against

CANADIAN TRADING: IS THE FUTURE THE DARK SIDE? 72

Every microsecond counts to high-frequency trading firms, which explains their preference for co-located direct access to trading venues, which minimises latency. aberrant trades, but markets could still provide hosting services. “That does not necessarily mean a ban on naked access,”he says. “As a general rule, the best risk management systems in the securities industry are at the high-frequency trading firms. They far exceed the capabilities of any agency broker I have ever seen.” Institutions in Canada have begun to adapt their trading techniques to prevent high-frequency traders from gaming their orders. Jackie Allen, a director at Bank of America Merrill Lynch, sees clients using urgent order types and sophisticated algorithms that take into account live market conditions as well as historical statistics. Upstairs block trading has dwindled as buy side traders turn to algorithms and the banks cut back the capital they commit to facilitate trades. The upstairs desks still have a role to play, however, particularly in less liquid stocks that attract little interest from high-frequency traders. “Algorithms and buy side self-execution is becoming a bigger percentage of the volume traded,” says Allen, “but the information sell side traders can provide is still a valuable— and valued—service in Canada.”

The rise of dark pools The broker preference priority of trades that applies on every venue except Chi-X allows brokers to jump the queue if they have the other side of a trade, even if another broker was there already at the same price. In effect, the rule lets brokers internalise order flow on an exchange, forestalling the need for the broker-owned dark pools that achieve the same result. Moves are afoot to bring more dark pools to Canada, however, and Allen expects innovation with dark order types as well. “The trading community tells us that dark can offer tremendous added value in illiquid names,”she says. “Dark has a long way to go in Canada.” Liquidnet launched its Canadian dark pool in 2006 but the product has struggled, although volume did pick up this year. Lower average ticket sizes have reduced the threshold at which market impact costs kick in; one customer told Robert Young, chief executive officer of Liquidnet Canada, that a 50,000 share handled by an algorithm today can have as much impact as a 500,000 share block had in the past. The flash crash also made portfolio managers and plan sponsors aware of how toxic some liquidity can be, something traders already knew. “It empowers the buy side trader to use tools like Liquidnet more when others on the investment team see the value,” he explains. International investors accustomed to the strict price-time priority that applies in most other markets worldwide see broker preference as unfair. Chi-X Canada doesn’t allow it, but the rule enjoys strong support among local investors as well as brokers. “Rather than removing broker preference entirely, venues will offer an alternative, and let traders make

Richard Carleton, who is responsible for the operations, technology and sales at Pure, comments: “As a general rule, the best risk management systems in the securities industry are at the high-frequency trading firms. They far exceed the capabilities of any agency broker I have ever seen.” Photograph kindly supplied by Pure, November 2010.

the choice,”says Bryan Blake, vice president at Bank of America Merrill Lynch. The TSX recently announced plans to launch TMX Select, a parallel liquidity pool that will apply strict price time priority. The new venue, which will use existing TSX infrastructure to minimise costs, will go live in the second quarter of 2011 if regulators give the go-ahead. Another new facility expected to go live in late 2010 is Alpha IntraSpread, a dark order type proposed by Alpha Group that would allow brokers to keep their entire order flow internal as long as it matches or beats the National Best Bid and Offer (NBBO) at the moment the trade takes place. Broker preference on lit venues today allocates any unmatched portion of an order to other participants based on price time priority. “The Alpha IntraSpread facility takes internalisation to the next level,” says Allen. Some market participants are concerned that dark pools designed to exclude high-frequency trading could harm the lit markets. If regulators amend the rules selectively to accommodate dark pools, the diverted liquidity will no longer aid price discovery on the exchanges. “Allowing sub-penny pricing and relief from the order disclosure rule on dark markets would potentially disadvantage visible markets,” says Evan Young, head of DMA and algorithmic trading at Scotia Capital. “We think market regulation should promote visible liquidity.” High-frequency trading has renewed interest in dark pools among brokers in Canada, notwithstanding the broker preference. Clients have approached RBC about creating a dark pool that would allow them to expose orders without being picked off by high-frequency traders. The idea appeals to Mills, who recognises that a liquidity pool free from toxic elements would be a compelling proposition. “It is all about whether someone is getting an information advantage without a commitment,”he says. “That creates an unlevel playing field.” The future for Canadian trading may well lie in the dark. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

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STOCK EXCHANGE TECHNOLOGY: GLOBAL EXCHANGES COMPETE TO BE FASTEST 74

Photograph © Kheng Ho Toh / Dreamstime.com, November 2010.

Stock exchanges are now caught in a technology frenzy-seeking lower latency, introducing more efficient matching engines and new order types. The raison d’etre is that the buy side have increasingly dynamic expectations. Is that really true? Or are the reasons much more diverse? Ruth Hughes Liley reports

SPEED IS KING LIKED IT SO much, I bought the company.” So said Victor K Kiam, the American entrepreneur, who famously bought Remington after liking the performance of his new electric razor. It seems large stock exchanges are doing just that in order to have the latest electronic capacity: the London Stock Exchange (LSE) bought super-fast Sri Lankan-based platform MillenniumIT and rolled it out in November as its new trading platform; Nasdaq bought OMX, which sells technologies around the world; Nasdaq OMX is buying Australia-based Smarts Group, a global leader in surveillance technology; and two-year-old NYSE

Technologies combines several technology companies bought over the years by NYSE Euronext. As speed and competition have increased in the equity trading world, so has the pressure on not only the incumbent exchanges, but also multilateral trading facilities in Europe and alternative trading platforms in the US, to maintain investment in their technological infrastructure. Gerhard Lessmann, board member, Deutsche Börse Systems, believes it is the demand for higher speeds and state-of-the-art risk management, as well as greater competition, which is driving the development of technology at the heart of exchanges: “We have customers who are interested in the lowest possible latency, so we will continue to focus our technology efforts in this area.” Certainly lower latency lies at the heart of much upgrading. In April 2010 the Toronto Stock Exchange (TSX) announced completion of the first phase of its equity enterprise expansion project, migrating the TSX and TSX Venture Exchange trading engines on to infrastructure which more than doubled its speed, giving TMX group clients record low latencies, claims the exchange. This drive to lower latency comes at a cost as Lessmann points out: “Computer system matching engines need to be

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

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STOCK EXCHANGE TECHNOLOGY: GLOBAL EXCHANGES COMPETE TO BE FASTEST 76

faster and smarter and these things are very expensive. For a small exchange, it becomes more and more difficult to keep up. It’s mostly a fixed-cost business so once you have the technology, you can trade ten times the volume at pretty much the same cost, but it is costly to keep it up to date.” This cost has led some exchanges to set up partnership arrangements with other exchanges to ensure they have the latest technology. Warsaw Stock Exchange, for example, is to migrate to NYSE Euronext’s global Universal Trading Platform as part of a multi-year commercial agreement. In addition, consolidation has begun to occur in Europe. The London Stock Exchange’s purchase earlier this year of a majority stake in Turquoise brought together a 300-year-old incumbent exchange with one of its new MTF rivals, which has its own implications. Richard Balarkas, chief executive officer of agency broker Instinet Europe, is baffled why exchange technology is considered complex: “They match buy and sell orders. It really is that simple. It’s a very commoditised process and all that has changed is that it’s much faster than it used to be. The acquisition of Turquoise by the LSE should become a text-book example of a reverse takeover as, if the Turquoise platform and pricing works, why wouldn’t you just switch to the more efficient model? When it comes to their transaction matching services, this downsized model is the long-term direction in which the large exchanges are heading.” Nonetheless, acquisition does seem to be one of the ways that exchanges are diversifying and expanding their technology. Through its acquisition of Smarts Group, Nasdaq OMX has entered the surveillance and compliance market. In a statement in July when the group announced a 39% rise in profits in the second quarter, chief executive officer Bob Greifeld said: “These results demonstrate that our diversified business model is capable of delivering solid results while simultaneously allowing us to pursue growth initiatives to drive our business forward.”

Operational savings The LSE purchase of MillenniumIT at a cost of $30m has given the LSE a platform with sub-millisecond trading latencies, a footprint in Asia and a replacement for TradeElect, Infolect and other interfaces. MillenniumIT’s in-house software development team will also gradually replace the LSE’s current suppliers and bring intellectual property within the company despite glitches when it was introduced in November. In July, while the LSE announced a fall in turnover at its UK cash equities business over the previous year, the acquisition of MillenniumIT pushed sales from the technology services business to £12.7m. It is also expected to create operational savings of £10m from 2011-12. Rollout of the new platform to Turquoise and the LSE was due to begin in November, while Borsa Italiana, also part of LSE Group, will migrate later. The Johannesburg Stock Exchange, which has a technology agreement with the LSE going back to 2001, expects to migrate to MillenniumIT in April 2011. LSE Group claims MillenniumIT is the world’s fastest platform,

Richard Balarkas, chief executive officer of agency broker Instinet Europe. “They match buy and sell orders. It really is that simple. It’s a very commoditised process and all that has changed is that it’s much faster than it used to be.” Photograph kindly supplied by Instinet, November 2010.

turning messages round in fewer than 100 microseconds. Tony Weeresinghe, chief executive of MillenniumIT and director of global development at LSE Group, says: “The implication for members will essentially be to change to the FIX or Native gateway. They’ll also have to connect to the FIX/FAST or ITCH market data gateways and might also have to tune their performance to accept orders at a high rate and quick response time.” The two protocols, FIX/FAST and ITCH, are already a recognised standard in the industry and offer clients a choice of feeds with different attributes. FIX/FAST takes up less bandwidth than ITCH, while ITCH is low latency and streaming. Deutsche Börse Group, meanwhile, has for some years been developing a new global trading infrastructure. At a technology open day in September, the group launched two new interfaces in its bid to simplify the way its customers link to Xetra and Eurex, the exchange’s electronic trading platforms. Lessmann says one of the interfaces offers differentiation for the exchange’s high-frequency customers, optimised for low latency, while the other is a basic FIX-enabled interface for the more traditional members. “In addition, there’s also a graphical user interface with solutions for traders to be able to connect via a browser from their desktops. This reduces clients’ infrastructure costs and means less effort for them.”

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

Exchanges are also benefiting from sales of their technology. Deutsche Börse, where around 1,200 people are employed in IT in its various locations, has sold its Xetra platform technology to customers including the Irish and Bulgarian stock exchanges, Wiener Börse and the EEX European Energy Exchange. LSE Group’s MillenniumIT platform sales are growing at 100% and Weeresinghe, not surprisingly, praises the benefits of offthe-shelf technology: “It makes the most sense for the majority of exchanges as it tends to be the most cost effective. The core requirements of most regulated markets are quite similar. Why re-invent the wheel? Why go through an expensive, time-consuming and potentially risky internal build when you can simply buy a solution.” Also, revenues can be significant. NYSE Euronext’s information and technology solutions division revenue rose $24m in the second quarter of 2010 to $107m or 29% compared to the second quarter of 2009 and in the same three months, NYSE Technologies closed several lucrative multi-year software and infrastructure deals including one with Tokyo Stock Exchange to build and support a new futures trading platform for the exchange. Meanwhile, Nasdaq OMX market technology business, which sells technology to more than 70 market places, announced total order value—the value of orders signed that have not yet been recognised as revenue—of $453m in the second quarter of 2010, up from $315m in the second quarter of 2009. As competition increases between exchanges, Owain Self, UBS’s global head of algorithmic trading, notes its impact. “Exchanges are having to evolve to compete in an increasingly demanding market place with enhancements such as latency reduction, for example. We are seeing a lot of innovation with improvements in matching engine technology, new order types, etc. The driving force for this change doesn’t come from the sellside, per se. The buy side have dynamic expectations of what constitutes best execution, and they expect their brokers to determine where to trade in order to achieve it. So while we don’t tell the exchanges what they need to do, the exchanges that provide a better service will naturally attract more flow and therefore force

Florian Miciu, chief technology officer, Chi-X Europe, explains the relationship: “An exchange is very, very complex. On the one hand you fine tune to the investment community and on the other hand you fine tune to the regulatory aspects and the geopolitical situation.” others to react to the demand for continuous improvement.” In Canada, where fragmentation has taken hold, and there are four lit alternative trading systems, market places are also feeling the competition. Three-year-old Omega ATS saw a 1,134% volume increase in the year to July 2010, for example. The best price obligation law, which currently puts the onus on brokers, has been robustly enforced since January 2010. In February 2011, this onus will switch from the dealers to the exchanges. “This is a big change in Canada,” says Omega’s new president and chief compliance officer, Mike Bignell, who believes regulation is one of the main drivers behind advancement of technology. “It’s a compliance-driven industry and it used to be a sales-driven industry. These days you need to be a compliance officer with sales skills. If you are a stock market you have to put yourself in a position to succeed.” The highly-automated, low-staffed multilateral trading facilities in Europe owe their very existence to a change in regulation. Florian Miciu, chief technology officer, Chi-X Europe, explains the relationship: “An exchange is very, very complex. On the one hand you fine tune to the investment community and on the other hand you fine tune to the regulatory aspects and the geopolitical situation.” He believes an exchange can only compete successfully when it has its own technology and its own pool of knowledge. “It’s critical to be able to respond fast to the regulatory and business environment and the problem with a system supplied by a vendor is that the vendor will respond

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FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

STOCK EXCHANGE TECHNOLOGY: GLOBAL EXCHANGES COMPETE TO BE FASTEST 78

With messages travelling down fibre optic cables at 67% of the speed of light, or 200,000km per second, according to Chi-X Europe figures, technology connecting to the exchange has to be sound. Chi-X Europe handles 225,000 messages a second, for example, while MillenniumIT has been tested to 1m orders a second.

Mike Bignell,Omega’s new president and chief compliance officer. “It’s a compliance-driven industry and it used to be a sales-driven industry. These days you need to be a compliance officer with sales skills. If you are a stock market you have to put yourself in a position to succeed,” he says. Photograph kindly supplied by Omega, November 2010.

to this only when the majority of clients are requesting a change.” While Nasdaq OMX is buying Smarts Group to provide market surveillance technology, Chi-X Europe took the decision last year to build its own. Deutsche Börse has had a variety of surveillance technology in place since 2002, including automatic circuit breakers or “volatility interruptions”, similar to those launched on Nasdaq OMX in September. If a stock price moves too quickly, an automatic stop comes into place and the trade reverts to an auction model that gives all participants time to readjust. “We are pretty certain that something like the flash crash in the US couldn’t happen on our platform,” says Heiner Seidel, a spokesman for Deutsche Börse. The so-called flash crash on May 6th, when the Dow Jones plummeted, was the subject of an investigation by the US regulator, the Securities and Exchange Commission. On September 30th it published its findings, among which it highlighted “the integrity and reliability of market data centres’ processes, especially those that involve the publication of trades and quotes to the consolidated market data feeds”. Weeresinghe says: “One of the main things surveillance technology is looking for is to perform real-time surveillance and a system that can handle a large volume of data. Surveillance is also looking for automated pattern recognition, automated relationship recognition and online case

management. It also needs flexibility to perform intra-day alerts. Threats come from many angles—from a bad algorithm, from a rogue trader, from market manipulation practices or even from system hackers. We deal with this on a daily basis but our system is a highly flexible, real-time surveillance system which has many algorithms to trace the unexpected.” With messages travelling down fibre optic cables at 67% of the speed of light, or 200,000km per second, according to Chi-X Europe figures, technology connecting to the exchange has to be sound. Chi-X Europe handles 225,000 messages a second, for example, while MillenniumIT has been tested to 1m orders a second. Speed is indeed king and one aspect often overlooked is the time to cancel an order. Miciu says: “Traders like to live in a deterministic world. They need to shoulder a great deal of risk and typically, they have to wait a few seconds between sending messages and confirmation of receipt. In those few seconds the landscape can be dramatically different. Exchanges have to respond much faster to the incoming orders and cancellations. “It’s a fine line: many people think about ‘how fast did you get my order and confirm it?’—but the risk carried in a decision to buy an order is primarily an opportunity risk. Whereas if you have taken a decision and have exposure to a few hundred million euros, the question to be answered is: ‘How quickly can you cancel my order?’ Many of the trading systems in the world don’t even mention the time to cancel. On Chi-X Europe there’s only a 15 microsecond difference between the time a new order is acknowledged and the time an existing order is cancelled.”

Time-sensitive strategies High-frequency traders seek their route to speed through co-location, where brokers’ servers are placed as close as possible to the exchange. While brokers are busy lining up for space in specific exchanges data centres—one is being upgraded in Frankfurt for Deutsche Börse’s clients at a cost of €12m—they are also identifying where to locate their servers to service two or more exchanges. “Co-location is critical for time-sensitive strategies,” says Chi-X Europe’s Miciu. “You want to be there first and you want to be sure your order is received as fast as possible. The best place for a UK-side trading strategy might not be in the middle of London for the LSE and Chi-X Europe, but might be nearer its periphery. It’s not a geographical decision, it’s more in terms of community networks and in terms of how direct the route is.” I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

EUROPEAN TRADING VENUES ROUNDTABLE

WHO REALLY BENEFITS FROM MARKET FRAGMENTATION?

Attendees

Supported by:

(Front row, from left to right) DAVID MILLER, senior dealer, Invesco Perpetual ALAN CAMERON, head of client segment, broker dealers & investment banks, BNP Paribas Securities Services PAUL SQUIRES, head of trading, AXA IM (Back row, from left to right) STEVE GROB, director, Group Strategy, Fidessa MARK MONTGOMERY, director, Barclays Capital LISA DALLMER, chief operating officer, European cash market execution services, NYSE Euronext

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

EUROPEAN TRADING VENUES ROUNDTABLE 80

THE RUN UP TO MiFID II: DID MiFID I HELP OR HINDER MARKET TRANSPARENCY? PAUL SQUIRES, HEAD OF TRADING, AXA IM: It is very easy to dismiss MiFID as something that was badly thought through. Nonetheless, it’s fair comment that MiFID has resulted in some unintended consequences. Our market is complex and technical and not everything has fitted into the principlesbased regulation that is MiFID, and it has created many problems for market participants. It is no great secret that the buy side is looking at MiFID II to address some of those concerns. I’d like to highlight an important example. Transparency has really deteriorated. I want to be clear about what this means in practice. While there is a mechanism for price discovery—the almost investigative work that is undertaken by traders because of the proliferation of different types of venues as a result of MiFID—the buy side trader has nevertheless subsequently found it very difficult to get a true picture as to where and at what price genuine investment trading is taking place. Knowing where to find liquidity is a key component of the buy side traders’ added value to their organisation and that added value has been marginalised. However, there have been positive developments, such as the reduction in spreads. Even there, while spreads may look like they have narrowed, when you are trading institutional-size orders, reduced spreads are not really relevant due to the smaller order sizes at those prices. Finally, another important issue right now is that the depth of markets is not there anymore and therefore fragmentation is a concern. STEVE GROB, DIRECTOR, GROUP STRATEGY, FIDESSA: When we talk to any of our buy side customers and ask them:“Do you feel you’re getting a better deal since the introduction of MiFID?”Almost unanimously, they say “No”. Actually, they say it quite vociferously. Sometimes they might say:“I don’t know”. That’s usually in the context of Paul’s point about transparency. Now all this might be down to the fact that much of their trading style is trading large blocks which are hidden in a much wider variety of different dark venues. Therefore, the answer ultimately depends on your perspective as a market participant. However, for the people MiFID was supposed to be good for, which are either institutional investors or retail investors like me, the answer is that it has been fallen somewhat short of the mark. LISA DALLMER, CHIEF OPERATING OFFICER, EUROPEAN CASH MARKET EXECUTION SERVICES, NYSE EURONEXT: The real question here is: what is liquidity? It’s not just the price on the screen; it’s depth of quote, the opportunity cost, the search cost and it’s also the cost of technology to connect to these fragmented places. Innovation in a vacuum can be fantastic and wonderful; but innovation that is disharmonious with the environment can cause problems. MiFID did not apply like regulation for like activity, and therefore doesn’t yet create a level playing field. Sometimes disruption can be good if at first it brings competition. Even so, you do have to look at the whole value chain. Although, as Steve mentioned, there might be lower costs at the dealer level, you have to follow that through and

David Miller, senior dealer, Invesco Perpetual

wonder: how do those lower transaction costs on 200 shares at the dealer level translate to a buy side trader? STEVE GROB: When you say: “like regulation for like activities”, was there one specific thing you were thinking about? LISA DALLMER: For example: we have MTFs, systematic internalisers and broker crossing networks. Not all are clearly defined in MiFID and actually, some of the regulators across Europe apply it differently. So if you’re matching trades, we think that like activity should have a like level of regulation to the extent that liquidity right now is impacted by many things: the depth of quote is not what it used to be, institution order size is not what it used to be, opportunity cost has gone up, search costs have gone up; it is all of that. To some degree, because there’s an unlevel playing field and like activity is not getting like regulation that, call it implicit subsidy if you will, it has created the opportunity for costs to go up in ways that we aren’t yet ready to analyse. The issues facing institutional traders is where you really see that friction in the outcomes of MiFID. DAVID MILLER, SENIOR DEALER, INVESCO PERPETUAL: Speaking as a buy side dealer, we see liquidity as a mixture of retail flow blended with proprietary flow from the likes of Barclays Capital and other large trading houses. We understand the delayed trade reporting regime, and we have to accept it as a cost of utilising capital. In an ideal world I’m going to deal all day anonymously through whatever system is available; we just need to find the other side. STEVE GROB: It becomes meaningless because the crucial difference, to my mind, is the matching; it’s not about whether you’re matching orders, it’s whether it’s discretionary or nondiscretionary. So if I put an order in to an MTF dark pool at the mid-point, it will match if there’s the other side to it. That’s completely different from a broker-operated crossing network which is operating on a discretionary basis. It's a different service that should be charged for on a different basis and reported on a different basis. A lot of people are trying to call for the same regulation between those two entities and I simply don’t think they are the same thing at all. MARK MONTGOMERY, DIRECTOR, BARCLAYS CAPITAL: There are a number of moving parts to this. The government and politicians are engaged with the debate as are market participants, so MiFID II will certainly get to the nub of some of these issues. We are thoroughly engaged in the process and we feel that things are moving in the right direction because the regulatory issues getting raised are cutting to some of the difficulties the financial market has encountered. We continue to innovate and evolve for our clients and we’re carefully balancing the cost of that development against the need to deliver a profitable revenue stream.

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

CHANGING LANES: THE SELL SIDEBUY SIDE DYNAMIC MORE CHOICE BUT FEWER OPTIONS STEVE GROB: If you were to speak to a large bank or broker, they’d say that, whatever it is that they spend on technology in order to smart route flow across all these venues that extra cheque they write out is more than offset by the lower trading costs that they’re getting around the world. So, where there’s a potential problem is that, for the big guys, it does make sense to incur this extra cost as they achieve the economies of scale, whereas some of the smaller and mid-tier brokers are finding themselves under a lot of pressure to invest in the appropriate technology. On top of this they have to deal with more complicated downstream workflow, but they haven’t necessarily got any more net flow coming in through the front door to compensate. This could be a worry for the buy side as well, as they are going to find fewer larger brokers perhaps to trade with. DAVID MILLER: It seems to us that sales trading desks in general are shrinking. We are still getting multiple market flow and news flow emails and other forms of communication. There is a perception that we are using far more electronic access to markets than we really are. Because of the added expense of establishing direct market access and of providing algorithmic trading, it is understandable why this is happening. The number of phone calls I get in the morning has more than halved in the last year or so. We still value high-touch broking where we can get it. Institutional trading is pretty labour intensive and we are constantly looking for liquidity or for the other side of the trade. STEVE GROB: Is it the case you want to split it into one pile that’s the easy stuff, you just want to DMA out; and then the other pile is the tricky stuff where you want a high-touch approach? DAVID MILLER: To be fair, every order, whether it’s for 1,000 shares or 1,000,000, is handheld. Tactics, such as DMA, algo or whether we should consider using a specialist broker, are decided on a number of factors. Some orders do lend themselves to electronic access so we may use a combination of tactics. There are many more tools at our disposal than in the past. PAUL SQUIRES: We miss the balance sheet/principle/capital commitment approach we used to have with some of the bigger banks. It is part of a relationship. I also agree we have seen a really savage reduction in sales trading resource among our bigger brokers. The explanation might be that everyone thought the buy side were fairly quickly going to evolve and 50%-plus of their order flow would be electronic. Unfortunately, there are so few sales traders that you end up empowering your own buy side traders to self-direct trades. We talk now about best selection rather than best execution. Today, the buy side trader is doing a lot of due diligence before they release an order anywhere. In the past you would have a sense of who has been active in a stock, who’s got a good market share, or who has good market intelligence in a stock or a sector, and there was a time when you would pick up the phone to someone and have an intelligent discussion with them before you

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

Alan Cameron, head of client segment, broker dealers & investment banks, BNP Paribas Securities Services

decided on your strategy.You can’t do that anymore. It’s hard to know whether we have a voice and can ask for those sales traders back because we feel they’re better resourced to inform us on the best strategy, or whether they can ask a trader for the best risk price, for example. Although we have invested a lot of money in technology it is not at the same level as the bigger brokers. We see high-frequency traders in some of those gaps now rather than the old market makers. We also see other institutional dealers being wary of opening up their order size so even institution to institution flow has become fragmented. It seems very hard to get back to the previous landscape where we felt quite empowered, with a few key relationships to help us do what we feel we we’re paid to do. DAVID MILLER: Back in the late 1980s and into the 1990s it certainly seemed that there were certain monopolistic characteristics surrounding the national incumbent stock exchanges. This helped pave the way for new crossing networks and alternative exchanges such as Tradepoint to come into being. STEVE GROB: Yes, but do you think Tradepoint would have been more impactful if that had regulatory support? DAVID MILLER: Of course it had regulatory support. It was regulated by the SFA, predecessor to the FSA; it had a full exchange licence and so provided a proper functional and regulated exchange. Unfortunately nobody used it but it was there and it set the tone. It was one of the first fully functioning order-driven stock exchanges in this country. MARK MONTGOMERY: We’ve seen an interesting development here: because of technology, the buy side have, in some ways, evolved more effectively in their day-to-day working tools and day-to-day duties to their own clients, than on the sell side. The reason I say that is because many buy side traders now have an order management system (OMS) that enables them to manage their order flow across asset classes and to trade electronically in all these instruments from a single desk. A few years ago this would have been managed by different teams often manually over the telephone. The OMS or EMS sees an instrument, a quantity and direction and can route to the optimal destination smartly through FIX. The contrast for sell side work flow is that we’ve created dedicated silos, partly for the benefit of protecting buy side anonymity and confidentiality of orders, to operate programme trading, cash trading and electronic trading separately. We think you’ll see hybrid sales traders develop out of this. Why? Because the thing that makes your relationship with the cash sales trader work is trust. The difference between sales trading a block of stock and finding the other side in a dark pool is not that great; but the sales trader has the skill and market knowledge to minimise information leakage. By the same token, an electronic sales

EUROPEAN TRADING VENUES ROUNDTABLE 82

Paul Squires, head of trading, AXA IM

trader should be able to give you coverage on the market, information about IPOs and everything else that goes with it that a traditional cash sales trader does. I can see the two roles merging over time. PAUL SQUIRES: How much has technology benefited our clients? Actually I am struggling to say that was our cost and therefore this is the net benefit to our end users—at least in equities alone. Certainly our TCA numbers look great and we can dazzle people with our suite of algorithms and smart-order routing, but it has come at a large investment cost on our part. However, when this infrastructure is rolled out to other asset classes, in fixed income and foreign exchange, it’s been fantastic. Of course, for us the key initial step was to put in a multi-asset class OMS platform. We trade fixed income and FX through the same OMS platform as for equities. We’ve established STP in those other asset classes because you can use the standalone platforms and integrate them within the OMS. So we now do over 50% of our buy orders (by number) in fixed income electronically. They are smaller in size but still that’s a significant amount of our business. In foreign exchange as well we have used the OMS to get to a stand-alone platform and thereby reduce user error, trader error, manual error, and that is a very tangible benefit. Technology has been fantastically advantageous in the multi-asset space and dealing errors hardly ever occur now as a result. To my own mind this justifies the expense from the outset, but in the equity space it seems so loaded, so technology-based, compared to those other asset classes, and for only marginal benefit. LISA DALLMER: It is not unusual in fixed income and FX. Paul is able to effectively bring his costs down quickly using the existing lessons learned in technology for equities. Certainly, technology is the enabler but the key is how you’re applying it to fixed income or FX or futures, to give you the greatest gains. Although technology is already fairly well entrenched in the equities space it is harder, to use a sporting metaphor, to bring your golf handicap down that last couple of points. Don’t underestimate what we’ve seen over the past 15 years, starting all the way back at the beginning of the supply chain. For example: 15 years ago IBM would announce earnings and you’d get out your papers and your Lotus 1-2-3 spreadsheets to rerun the model and it might take days to drop in inputs. A week later you would formulate a view to buy or sell IBM. Now IBM files electronically in XML or XBRL, that digital information is fed into the model, and bam, you know exactly where you price the next trade. Information is getting faster and more compressed therefore it is no surprise that technology enables the buy side to get closer to the sell side. To some degree Paul’s decision making (with regard to algorithm models or which dark pool) is about choice: the buy side contemplating decisions that were traditionally sell side core competencies. Meanwhile the sell

side is asking exchanges to implement smarter market structure and make the technology footprint smaller and cheaper. As a collective industry we are more interlinked than ever, so we have to look at the whole process to evaluate if the end-client has benefited, or if the regulatory environment is harming investors and those who look after their assets. STEVE GROB: I agree with your sentiment but the idea that the trading process is solely about people looking at the performance of a stock as the basis of their buy/sell decision is perhaps misplaced. In the US, for example, 60% of what’s traded is by HFT players who don’t care much about IBM’s earning statement. They’re just arbitraging from one venue to another and, while they are completely legitimate market participants, they create noise that can distract the traditional institutional investor, because they are not making decisions based around the fundamentals of a stock. MARK MONTGOMERY: As a provider we see our role as helping to equalise or normalise the way different market participants integrate together. As exchanges evolved, the nature of their membership has changed dramatically. For example, we have clients who are broker dealers, who are without their own exchange membership and use our pipes for DMA. Moreover, we’ve got institutional clients who have their own membership on exchanges or MTFs.Years ago, that would never have been the case, because to be a broker dealer you’d have to have your own membership on the exchange. STEVE GROB: I challenge the whole level playing field argument. It seems to me that it’s always been uneven. People make money out of having an information advantage, whether it's having an office nearer the exchange, more traders on the floor or more handheld devices in the pit. People have always sought gain by exploiting technology or information, and the only thing that’s different now is that instead of measuring things in miles or people, we’re measuring them in nanoseconds, but the game is still the same. LISA DALLMER: It is a level playing field on those aspects because you can choose to invest in technology or not. It’s just chosen investment. Where do you want to put your office? The answer might be right next to the exchange. How many people do you want to have on the floor? Those are business decisions but from an access perspective it is the same set of choices. MARK MONTGOMERY: People evolve, or rather, people have had to evolve. If you take some of the traditional mid tier brokers who’ve actually really invested in making their retail offering work. They’ve got a research channel and can provide a personal service combined with the key addition of robust technology and a website that a diverse audience can interact with. There are other firms, who had a strong retail franchise 20 years ago, but who have not invested and now feel they’re too small to survive. Now, take a look at what happened in the US a few years back and find that through technology small can be beautiful. Three or four guys with a server can now not only survive but can take 20%/30% market share because they’re small, because they’re nimble, and because the market has evolved. It is a question of looking at where the market is going to be in three or four years’ time and then shaping and adapting to that view.

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

Lisa Dallmer, chief operating officer, European cash market execution services, NYSE Euronext

CLEARING & SETTLEMENT: WHERE NOW? ALAN CAMERON, HEAD OF CLIENT SEGMENT, BROKER DEALERS & INVESTMENT BANKS, BNP PARIBAS SECURITIES SERVICES: Clearing follows what happens on the trading side and in many ways the story is similar. We saw Chi-X and Turquoise set up and they looked at pan-European clearing and couldn’t find any of the existing CCPs capable of doing it at the price that they wanted. They therefore appointed EMCF and EuroCCP—both effectively start-up entities. So we have had fragmentation in clearing just like the fragmentation on the trading side of the business and the outcome has been determined by the MTFs who have become king-makers in the process. We got into a rather strange situation where the fees were falling dramatically on a trade basis but we had to deal with a proliferation of CCPs. There are now 20 CCPs in Europe and there’s another five or so on the way. So the savings that were being made on one side from this quasi-competitive market are being eaten up by the costs of connectivity and the additional margins being paid as a result of competition; hence the requirement for interoperability, and that’s really where we are today. Achieving interoperability is not easy. This is because CCPs are being asked to cooperate rather than to compete, which is quite an unnatural thing to do. Also, you’re dealing with risk rather than just processing. The real question is where does the risk end up and can you get interoperability without increasing risk as well? So today’s objectives are rather curtailed. The Code of Conduct wants participants to be able to choose where to clear and settle independently at each part of the trade life cycle. What we’re seeing right now is a debate about interoperability among four CCPs. So, hopefully, we will see interoperability for a rather small group of CCPs sometime next year, but it’s not the interoperability that people envisaged right at the beginning. FRANCESCA CARNEVALE: Alan, how does Clearstream’s initiative, Linked-Up Markets, fare as an interoperability exercise? ALAN CAMERON: It really is about the CSDs dealing in a more efficient manner with each other. Over time, it might be an important development but it will need to make progress not just with settlements but also with asset servicing—and that tends to be harder. For now, the jury is out. With T2S coming along there will be a very fundamental shift towards interoperable CSDs. Of course, the other interesting thing about Clearstream is that they are part of a group that participates at different levels of the trade life cycle and the whole question of vertical and horizontal integration remains unresolved. Three years ago everyone was saying we must have horizontal competition, we don’t want vertical silos. There’s been so little progress and interoperability that this debate has kicked-off again.

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

FRANCESCA CARNEVALE: Lisa, NYSE Euronext has always been keen on the horizontal model, hasn’t it? LISA DALLMER: We’ve always believed in the most appropriate market model and so we recently announced intention to open a clearing house that will be able to mix equity derivatives with equities clearing. In part, we are motivated by the total lack of clearing innovation and real activity on interoperability; we could not control our destiny. We felt it was more important to actually manage the technology and clearing functions ourselves and be able to bring in equity derivatives with equities as it will generate efficiencies that are not currently available. Since it was such a crucial part of our process, many people looked at where we did clearance and settlement as part of our collective trade costs for members and until we could control it and bring that down, it was going to be a hindrance. So we’ve decided that influencing consolidation in clearing and adding innovative technology are the primary reasons we want to venture into the clearing space and we will have an open platform that will allow us to add flow, scale and in turn reduce fees. It is something we are planning for 2012. ALAN CAMERON: I guess most participants in the market would say that the onus really has to be on the exchanges to show why this integration makes sense and the general feeling is that that hasn’t really happened as yet. I’m not saying it’s not going to happen, but it’s an argument that hasn’t been made in such a coherent fashion as yet. We look forward to hearing it. FRANCESCA CARNEVALE: From the buy side perspective, have any gains that you have made in trading costs been lost or negated by the rise in clearing and settlement costs? PAUL SQUIRES: We have not specifically gone to our brokers and said, as a result of all the different MTFs and the reduction in execution costs, we want to lower our commission costs with you. We don’t micro-manage commission costs. There are a number of different entry points into our organisation from the brokers, and therefore with our key counterparts having a relationship is the most important element. Secondly, if you put it in the context of what we’re trying to do, which is either reduce or add significant positions for our fund managers with minimal market impact, it might only constitute a basis point of savings in execution costs. When you look at our transactional cost analysis and see that on some orders we beat the benchmark by 100 basis points you will realise that focusing on the venue costs to the broker is really missing the point. The second limitation is a practical one. Do we want to carve up an order into multiple commission rates applied to each individual trade fill according to the venue? We are not a quant house doing thousands of small trades a day, but even so there’s a practical limit. Of course, we are aware that we should be slightly more commercial for our brokers now but, equally, when you enter those dialogues, they’ll point out that because of fragmentation the costs of clearing are that much higher. So you’re right. You need to be aware of the downstream aspects as well as the execution. DAVID MILLER: We don’t micro-manage the settlement side and while costs associated with trading do have a bearing

EUROPEAN TRADING VENUES ROUNDTABLE

on best execution; it is the price that is more important. Our job is simply to buy or sell a particular stock at the best available price. Trading costs are encompassed within the fully bundled rate; we’re not looking for a change here. STEVE GROB: If you do what we do, which is providing a workflow-based system to both the sell side and buy side, you have to deal with the added complexity of multiple clearers and multiple venues. We take a client order, split it into different destinations, receive a bunch of different fills associated with different clearers, different fees and different pricing structures, and seamlessly manage the whole process. The secret to all this is ensuring that the experience is as straightforward as possible and that the trader is protected from all this complexity. LISA DALLMER: There is a cost of re-aggregating the fragmentation on both the pre-trade and the post-trade basis. It looks seamless but at the point of trading it is fairly fragmented while the software providers, vendor packaging and middle office costs are real for re-aggregating information. FRANCESCA CARNEVALE: Given that much current regulation is around transparency and managing counterparty risk, as the clearing and settlement side does fragment, doesn’t it make it harder for institutional investors and their trading desks to manage their exposure effectively? MARK MONTGOMERY: One of the big differences between Europe and the US is a lack of institutional investors clearing securities for their OTC leg with the investment bank. That’s a very hard thing to get to today in Europe when we have all these different CCPs. Some of the CCPs are pushing hard to try and get that conversation going. When I speak to institutional investors about it, they all say it’s a great idea but it’s not at the top of my list of things I want to do. So there’s an acknowledgement that we want to get there but there’s no real urgency behind it right now. PAUL SQUIRES: All of our dialogue is about CCPs. Right now, when you actually get to the point of trade execution, you’ve only got the legal documentation with one broker, so guess what? You’ve only got one place to ask for a competitive price. That’s not great. So definitely, the move to CCPs is good but then it’s fairly evident that we would have to bear a lot of the cost of change. That invariably influences the investment decision of the fund managers. They might want to trade some CDS, for example, but the costs of adapting your architecture to enable a CCP process? When considered against the likely performance gains and relative amount of activity in OTC it might look expensive. What starts off looking like a great way forward starts to be affected by cost considerations and that’s something we need to be careful about.

POST-TRADE ANALYSIS: UNDERSTANDING FRAGMENTED DATA STEVE GROB: There are two problems. One is the fact that different participants are using the different categories under MiFID (OTC, dark pools, etc) in different ways. The other is that all the venues that have been created have, for completely benign reasons, come up with their own trade-type definitions.

Mark Montgomery, director, Barclays Capital

To deal with this we've put together a whole team of analysts that spend their time mapping and cross-referencing these codes in order to provide the best view we can of what’s going on. On top of this, different brokers will naturally provide their own analysis of their smart order routing (SOR) and algo performance, produced in different ways and reflecting different formulae. So the buy side must find it pretty hard to form a truly objective view as to which broker is doing the best job. LISA DALLMER: The first step is to decide what aspects of pre and post-trade data can be consolidated in order to do the mapping. Then we have to figure out what is the minimum set we can agree to. There are several steps before we even get to have a record to reflect against for benchmarking TCA and other things. I believe there’s a CESR working group that is identifying the trade flags, the mappings; actually we have had a small army working on it too. DAVID MILLER: We’re looking for some sort of consolidated best bid and ask, which we’re now getting through technology, whether it’s via Reuters, or Bloomberg. They’re all presenting us with the right sort of display to enable effective price discovery. However, within that, of course, you’ve got all the dark and semi-dark liquidity You can time stamp and recreate the best bid-and-ask on the lit exchanges, but that still leaves a big gap and we’ve got to be able to prove what we’ve done within that gap. We’re getting pressure from our clients, the funds we trade for, to prove that we’ve gone to the right venue. As Paul says, best selection really is the most we can achieve. It’s almost impossible nowadays to actually prove best execution. LISA DALLMER: Because best execution is about many things and not only price, from our perspective, we understand the buy side and the sell side’s needs for providing risk trades. We believe the large in scale waivers is an appropriate mechanism for providing confidentiality. However, we are observing significant OTC activity that is retail sized and it’s happening away from the best-bid-and-offer. Notwithstanding the need for confidentiality, we should evaluate the appropriateness of who needs this confidentiality and why it’s needed. DAVID MILLER: In some respects that’s always been a bit of an issue. When a risk trade is taken on, the question is how long and how deserved is the delay in trade reporting that the market allows to protect the provider of risk? Another challenge at the moment comes from fund managers who are keen to pursue a certain tactic, such as working an order as a percentage of volume. While I do not have an issue with that tactic, the trade reports we or the broker are following can have a dramatic influence on final price, especially if, the broker is unable to participate in all available liquidity. STEVE GROB: That’s the thing about transparency; you want it for everybody else but not yourself! One of the things that

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

puzzle me is people calling for a European version of the NBBO that exists in the States in terms of pre-trade transparency. This is because any broker in Europe is allowed to determine its own best execution policy in terms of what it includes and excludes. Vendors like us already provide a custom virtual market that allows traders to switch venues on or off in order to reflect whatever their best execution policy is. The real problem lies in post-trade transparency and that's important because it's the basis for tomorrow's pre-trade decision. PAUL SQUIRES: I’m not too concerned about pre trade. We’re kind of getting there. For me it is all about post trade. It’s about getting the right definitions of certain types of trade to determine standard reporting timeframes, whether it’s retail, OTC, risk, broker pricing, crossing, or anything else.

HOW MANY trading VENUES DO YOU really NEED? FRANCESCA CARNEVALE: To the outsider, post-MiFID, a host of new trading venues cropped up. Few have made money and they skew liquidity every which way. Does the market really need this level of differentiation? What’s the point? I can see, for example, the need for dark pools, but do you need every major broker/dealer to provide its own dark pool? How many is enough? LISA DALLMER: You’re asking a macroeconomics question that happens in every industry. How many competitors is the right number in the pharmaceutical industry? How many knee replacement providers does the world need? DAVID MILLER: You can’t blame people setting up dark pools because they perceive there’s value in it. There’s a lot of money to be matching trades within an ever widening spread. LISA DALLMER: The question becomes is their business model sustainable and at what point does consolidation appear in the industry? As an industry player, looking at the opportunities as consolidation takes place, it’s about the timing. During this time when we have a lot of providers in the market, there is innovation. Had we not experienced some of the innovations emerging in the industry in recent years, we wouldn’t be able to cope quite as well with the downturn in trading turnover that we are facing today. So there’s a lot of value, but yes, I agree, in the long run, stand alone businesses can’t operate at a loss. They can’t even operate at near loss. Moreover, taking into account some of the issues we’ve raised; uneven regulation, and to the extent that the regulatory landscape creates essentially an implicit subsidy for a period of time, I’d ask to consider the disadvantages and risk to investors. STEVE GROB: I guess the question is whether people think that LSE and NYSE Euronext would have cut their fees, and introduced new business models, without the competition they now face. You only have to look at the Tokyo Stock Exchange and its introduction of arrowhead and what's going on at the ASX in Australia for further confirmation of this. Moreover, the idea that you need hundreds and hundreds of people to run a market venue just isn’t true. The alternative venues are completely entitled to come up with newer, faster technology and lower overhead businesses. While you're right that you

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

Steve Grob, director, Group Strategy, Fidessa

have to question the viability of their business models, the same applies within primary markets where they can look at their less performant platforms in the overall scheme of the business. If NYSE Arca and Smartpool were standalone businesses, should they be closed down because they are not making any money yet? When you are looking at the profit and loss of a platform, you have to view it in the broadest context and the long-term interests of its shareholders. LISA DALLMER: Exchanges have clear rules about when and how to manage the conflicts of having brokers as owners or shareholders. I’m not sure all the MTFs have those. We’re talking about motives of keeping the businesses running, and I agree, as an exchange, we embrace the competition, the innovation, and therefore have a multi product offering in regulated markets and MTFs. Would it have happened without competition? It’s hard to say. Innovation always creeps its way into every industry. Sometimes you’re reacting to change; sometimes you’re leading that change. Remember that trading is just one part of capital raising in the exchange business, keep in mind there is a whole value chain there and market quality across all those services is different than market share just in the top 20 stocks. MARK MONTGOMERY: There’s also the subject of data ownership and selling it which seems to have helped certain exchanges have a different model to some of the new arrivals. It’s always interesting to hear people, particularly on the buy side, saying they haven’t just had to buy trade data from one source; they’ve had to go and buy from other venues as well in order to get a consolidated view. That’s certainly a frustration when it’s their trades in the first place. This is another area where we’re going to see costs forced down. FRANCESCA CARNEVALE: Regulators are encouraging a lot of derivatives to be on exchanges in future: is that fair or unfair competition? Will it reduce choice for the buy side and the sell side? Alan. ALAN CAMERON: It’s not just into the exchanges; the regulators appear keen to see these instruments moved into the CCPs as well. This should simplify risk management for participants. LISA DALLMER: There are two points. Is the encouragement pre trade or is it post trade? These are two different aspects, two different dimensions, and they’re very much targeting the post-trade aspect for the counterparty risk management issues we talked about. ALAN CAMERON: Ultimately, it will bring the end investor clients in to the CCP world, although the easiest and most cost-effective route may be through General Clearing members. Long dated instruments will need to be cleared for a long period in the CCPs.

EUROPEAN TRADING VENUES ROUNDTABLE 86

STEVE GROB: As long as they can be standardised to the point that there’s sufficient volume in it to make it worthwhile, then that makes sense. However, there is a level of OTC business that is so obscure that it will never fit a centralised clearing model. MARK MONTGOMERY: The ETF market has expanded dramatically to fill a gap here. It presents an opportunity for people to be innovative in the product suite and has given the buy side greater flexibility around how they can invest in these markets in a balanced and risk controlled way. PAUL SQUIRES: We want this sort of CCP progress, but we have a strong feeling that it’s going to cost us money. We’ve got to decide whether that’s worth the extra cost.

tomorrow’s world PAUL SQUIRES: Do I expect to go into work after MiFID II and find everything’s much easier, more transparent and people are happier? No, but I’m mildly optimistic. The dialogue in the lead up to MiFID II has actually been framed the right way. However, I do have concerns. There’s too much stereotyping and there are too many negative connotations: high frequency is bad, dark pools are bad and monopolies are bad, for instance. The other thing that concerns me is that there is so much lobbying going on by the MTFs, the exchanges and by the brokers, that it is really hard for the buy side to be represented. DAVID MILLER: We are all far more engaged in MiFID II than I believe we were for MiFID I. Many on the buy side let it happen the first time round and we’ve seen what’s happened, some of it is good but some is not so good. So with MiFID II there is a considerable increase in engagement and with the help of various trade bodies we are able to have continued involvement in its progress. There are even more vested interests at stake this time, whether it’s from the buy side or the sell side or all those between the two. At least we can’t turn round and say, we didn’t try and make our point this time. FRANCESCA CARNEVALE: Do you think that MiFID II will evolve in your favour this time around? DAVID MILLER: I hope so, but the process of buying and selling shares is constantly evolving. I must admit that my perennial dream would be to have a single, consolidated marketplace for everything financial, stocks, bonds, and futures, in harmony, which in some ways is what MiFID was designed for. That, of course, would be the buy side dealer’s version of the Holy Grail. Equities are an important investment for us, it’s what we do. I believe in the long term, the retail investor will remain interested in owning shares, whether he does it individually as a shareholder, or collectively through a unit trust. MARK MONTGOMERY: It us up to us, the practitioners, to provide constructive feedback where we can. I feel that Paul’s definitely got a point that perhaps the voices of the banks will be louder than areas of the buy side. Hopefully, we have a lot of interests that are aligned and certainly if we can eradicate some common misconceptions about our

business, then that can only be for the good. As far as the future, some of the things we’ve discussed have to inevitably progress: some form of consolidated symbology around trade data is a must. We want to see costs of clearing opened up, and we hope the markets learn from what’s happened in the US in terms of economies of scale. In that regard, the market should become cheaper and more efficient now. There will be areas of fragmentation and while we are seeing signs of consolidation with MTFs, someone else will pop up. There’ll be some new innovation with technology that will allow someone else to come into the space. As we have all acknowledged, we need to see the status quo challenged. I’m bullish in the medium term, but no doubt there will be a little bit of pain along the way before we reach a conclusion where all the issues are dealt with and the landscape is clear. ALAN CAMERON: On the clearing side, I can’t see interoperability or consolidation happening quickly enough to get us where we need to be. We are going to continue to face a fragmented, comparatively expensive infrastructure. On the settlement side, I’d like to think that T2S will usher in a new era of harmonisation and simplicity; perhaps even a shortened settlement cycle is coming. I would imagine that could happen quite quickly and that we’ll see T+2 across Europe much more quickly than we would probably have envisaged a year ago. LISA DALLMER: The important trend is that there will always be innovation, there’ll always be change and sometimes it takes a disruptive event to kick that off and get that going. MiFID has tended to benefit the wholesale level, the professional market, and therefore I hope MiFID II will include changes that are more specific, and that it contains prescriptions that protect retail investors. We also have to look carefully at having an indisputable price reference so that all investors can reasonably ask: how do I feel about that activity, that trade? How do I evaluate it? As Steve noted, yesterday’s post-trade data is today’s pre-trade information in terms of decision making. To bring it all together, as an exchange we are committed to listening to clients to facilitate the required innovation with regard to the rules, the fragmentation, and the industry’s health. Overall, this is the best place you can hope to be. STEVE GROB: I’m optimistic but unfortunately it’s got nothing to do with my view of regulators. Really, there are two problems: one is that they have to separate political polemic from the facts—that seems pretty crucial to me. Someone made the point that monopolies are inherently bad. I challenge that. There’s a view that HFT is bad and dark pools are bad. I challenge that too. All those things are just way more complicated and subtle than is sometimes acknowledged and even if some people do figure that out, there’s a bigger problem in play, namely the pace that regulation can move just gets outstripped by technical innovation and commercial interests. So, by the time MiFID II has sorted out all the problems of today, everyone around this table will be thinking about completely different things and doing completely different things. That’s just a fact of life. The regulatory process will never keep pace but we just have to live with that. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

Sponsored Article: MTS

fixed coupons, floating coupons, zero coupons and index linked coupons. In terms of capacity, the level of throughput that MTS Cash can sustain is continuously improving and considered first class in the fixed income arena. The average round trip time of transactions is currently less then 1 millisecond (see Figure 1). In the interdealer market, MTS supports an automatching system with participants streaming prices. On execution, MTS sends the relevant information directly to the central counterparty or depository to be cleared or settled.

e-fixed income trading for the dealer-to-client segment MTS has also developed BondVision for the buy side, giving funds and other clients direct access to the source of the market and the major players in Eurozone debt. The majority of primary dealers in Europe now use the MTS-run BondVision platform to connect with clients, such as real money managers, central banks and hedge funds and demand continues to grow. MTS has developed single dealer pages on BondVision to enable banks to stream either indicative or executable quotes directly to their clients. A buy side client using BondVision to manage its fixed income portfolio has access to optimal trading and workflow technology together with a range of functionality including the ability to make requests for quotes (RFQs) for up to 20 legs of a trade at any time. MTS delivers both its interdealer and dealer-toclient solutions across an open architecture for seamless integration with ISV solutions and existing internal systems, delivering significant cost benefits. This ensures MTS attracts professional counterparties with real interest in the fixed income arena, which creates a virtuous circle of liquidity. The B2C market in e-bond trading is primarily bilaterally settled. The STP capabilities of a system

such as BondVision allows a fund manager to generate an order from their portfolio management system (PMS) or order management system (OMS), stage it in BondVision and then execute the trade which will then be uploaded automatically. Settlement is then handled outside of the trading venue itself.

The importance of market data and latency Irrespective of asset class, informed trading and management decisions rely on access to the optimal market data. MTS supports pre-trade, trade execution and post-trade capabilities across cash and repo markets, and delivers independent benchmark market data and comprehensive fixed income indices. Fabrizio Testa says: “In the B2C market, counterparties can engage electronically with more confidence in a professional market if they have superb market data based on real executable prices, not calculated or derived. That is a pre-requisite to e-trading. “The independence and quality of MTS data is unique.The interdealer MTS Cash market generates electronic market prices which in turn feed back into our system, so users are assured they have the best information available.” Latency remains a key issue in all electronic markets and minimising it continues to be a focus for all professional trading platforms, irrespective of asset class.The interdealer market in particular has a constant need for performance and low latency to better manage the risk of quoting a high number of securities. European debt, as an example, is trading against other products like swaps and futures.Traders need the performance of a bond on the platform to accurately reflect the performance in all relevant hedging products. In the B2C space, latency between a fund manager and MTS’ BondVision platform has shor tened dramatically. It used to take a phone call, email or fax for execution, then the trader on the execution desk

Figure 2: CMF transaction capacity and average response time 16

15,00

7,000 5,800

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6,000 5,000 4,000

4,300

9,00

4,500

8 5,15

4,15

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R2 04/12/06

R3 12/03/07

R3.1 23/07/07

14 12

4,600

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R4 03/12/07

R5 12/05/08

1,40

R6 (only CAT) 24/11/08

R6 26/01/09

0,958 R6.1 23/11/09

2 0

Round trip time (milliseconds)

8,000

would run the trade through over the phone, a process which could sometimes takes several minutes. Anything can happen in the markets during that time. BondVision’s functionality now enables dealers to stream prices back to clients with the same performance, speed and minimal latency as the core interdealer market. The time between a por tfolio management system giving the order to execute and the time it gets to the front end has been shor tened dramatically. Once integration between a PMS and the trading venue is in place, counterparties get a huge range of efficiencies as they can manage more orders in less time with less manual intervention.

The future for e-fixed income Recent market upheaval and the resultant regulatory push have led to demands for more standardised traded products with a focus on post-trade and clearing. Fabrizio Testa adds: “Investors have become more confident in using e-solutions for trading. At the beginning clients traded smaller deals electronically and still picked up the phone to handle larger amounts. Then we star ted seeing the trend of bigger size deals on our dealer-to-client BondVision system, which means their confidence grew to trade these larger tickets electronically as well as multi-leg – switch, butterfly and basket. “Of course, there will always be multi-asset deals, which may naturally be transacted over the phone, while standardised products are much more suited to be traded electronically. “Overall, I think we will continue to see the electronic fixed income market evolve and grow. Our role and responsibility is to respond to the needs of our clients. “It is our main focus to ensure they get robust and stable trading technology with access to optimal pricing, liquidity and workflow to help them deliver their chosen fixed income business model with precision, control and confidence. “There is no doubt that electronic trading in European fixed income will continue to grow. It is a pattern we have observed in other asset classes as institutions have seen the benefits. “Investors are attracted to MTS as the key venue for fixed-income investments of strong credit quality with a very high degree of liquidity, possibly the most prized factor of all. “The increasing volumes we’re seeing both in terms of deal tickets and daily activity is mirrored by feedback from both the buy and sell side that etrading is the way forward for European fixed income and these are ser vices they want. MTS is well positioned to continue to facilitate this need.” I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

FRATERNITY, LIQUIDITY, TRANSPARENCY REENWICH ASSOCIATES ESTIMATES that 38% of US fixed-income trading volume is now executed through electronic platforms and the figure in Europe is 41%. About half of US institutions use e-trading systems for fixed income, and 60% in Europe, the two biggest users being real-money investors and central banks. “Much of the growth in electronic trading volume in the US was generated in interestrate derivatives, investment grade credit and short-term fixed income,” says Greenwich Associates consultant Andrew Awad. In Europe, the products traded most are government bonds, followed by interest rate differentials (IRDs). Tim Blake, head of North American interest rate products at Credit Suisse, says the period since 2008 has been exciting: “Market participants will probably look back on these two years and see it as a boom for electronic trading in fixed income because the concept held up well when bonds were one of the most active parts of the financial markets. While we’ve had electronic bond trading for ten to 15 years, we’ve really been at a plateau in terms of technology. Now it’s really the time for the next evolution.” In this atmosphere, many third-party providers of trading platforms and electronically aggregated data and prices have seen a direct correlation between volumes and business conducted electronically. For example, MTS, majority-owned by the London Stock Exchange and a leading platform for government bond trading in the eurozone, has a daily turnover of €85bn and has seen trading volumes double in France over the past 12 months and rise 75% in the Netherlands and Spain. MTS chief executive officer Jack Jeffery says: “Liquidity and transparency have become more and more important and have resulted in inter-dealer brokers directing trade on to electronic platforms. Also, in the last three months, bid-offer spreads have narrowed and there is a clear correlation between bidoffer spreads narrowing and volumes increasing. The advantages for people trading on an electronic platform are that you can clearly see the price changes in the market.” Client access to liquidity has been the driving force behind Credit Suisse Onyx, the bank’s algorithmic fixed-income trading platform, which since 2006 has executed more than $10trn notional of government bonds and exchange-traded futures

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

BOND TRADING: READY FOR THE NEXT EVOLUTION

The past two years may go down in history as the best fixed-income market seen, following the confluence of high volatility, low interest rates, tight spreads and high demand. In fact, in 2009, according to a JP Morgan Cazenove report, fixed income amounted to 55% of the total investment bank revenue, while that from equities lanquished at 27%. Although the bank expects the total fixed-income wallet to fall to $130bn, down 23% on 2009, the proportion of electronic trading in fixed income has leapt forward over the same period. Ruth Hughes Liley reports.

contracts. Originally developed for internal use by its own traders, in June 2010, the bank decided to give clients access to it with a suite of algorithmic execution for pairs strategies between cash US Treasuries and futures. In November, the firm added the ability to conduct direct trading of cash US Treasuries, providing an alternative to traditional request-forquote systems by allowing clients to enter their own trade parameters directly to access the firm’s pool of liquidity. The

BOND TRADING: READY FOR THE NEXT EVOLUTION 90

firm plans to roll out the same capability in Europe next year. Blake says that the liquidity offered through Onyx is anchored by the bank’s position as a primary dealer of US government bonds and by its broad client base. “We have brought in electronic market makers from the ranks of hedge funds, the equity world and a lot from rates. This is really prime time for rates and we think Credit Suisse Onyx is a very powerful model.” Derrick Herndon, European head of credit at UBS, which gives prices on 8,000 bonds, believes that fixed income liquidity is not really driven by delivery method: “Over the last 18 months, dealers have been carrying more inventory, but in May and June 2010 liquidity evaporated quickly. It didn’t matter whether it was voice or electronic. In fact the more volatile the market is, and the more the market is influenced by external factors such as Greece or Ireland, it’s that macro risk focus which generally shrinks the breadth of names traded.” Jeffery, meanwhile, believes electronic trading is in fact changing the very nature of the market. “Following the European debt crisis, I think we will move increasingly to an order-driven market and away from a quote-driven market. These markets of natural interest are where people will trade on the platform because they want to trade, not because they have to. The market place will drive this change. As liquidity thrives, it becomes self-fulfilling and you have a secondary market place that operates itself.” Certainly the traditional process of seeking prices via requestfor-quotes (RFQs) has been simplified, mainly through use of technology; with the improvement of trading platforms and electronic methods to aggregate prices and allow investors to compare prices with a few clicks. TradeWeb and Bloomberg ALLQ, for example, have offered electronic trading for more than ten years. Majority-owned by Thomson Reuters and ten banks, TradeWeb offers a mechanism to automate RFQs for European government bonds under its well-established TradeWeb Plus enabling comparisons of either several bonds from one dealer or one bond from different dealers. However, the more complex a trade, the harder it is to automate and Robin Strong, director of buy side strategy at Fidessa, which has recently been signing up sell side customers to its fixed income platform, says: “Portfolio managers often don't really mind exactly which bond they buy, as long as it meets their underlying strategy: they might want to increase portfolio duration using, say, German bonds in a specific sector with the right duration and credit rating. There may be a choice of suitable cash bonds or the manager may choose to use a derivative to give his portfolio the desired exposure profile. These trades are harder to automate as you are no longer dealing with a specific instrument. “Other clients will keep their corporate bond portfolios fully invested in less risky government bonds until the right opportunities arise, then will do a switch trade to sell exactly the right number of government bonds to buy the corporate bond. [However,] it has to be exactly the right amount and this can get quite complex with a number of different legs to the trade. In this respect, it's more like auctioning a mini programme trade. They are harder to automate as the pricing is often quoted

Tim Blake, head of North American interest rate products at Credit Suisse. “We’ve really been at a plateau in terms of technology. Now it’s really the time for the next evolution,” he says. Photograph kindly supplied by Credit Suisse, November 2010.

Jack Jeffery, MTS chief executive officer. “Liquidity and transparency have become more and more important and have resulted in inter-dealer brokers directing trade on to electronic platforms,”he says. Photograph kindly supplied by MTS, November 2010.

as a yield spread between the different bonds,” says Strong. Undaunted, MTS recently launched Multi-Leg, new functionality of the BondVision platform that enables trade in up to 20 legs. Jeffery says: “It is moving away from commoditised simple trades to more complex ones. Although it’s fairly limited at the moment, it shows that there’s a demand for electronic trading in an even more complex structure.” While most electronic trading is in government bonds, electronic trading in corporate bonds is also developing. Market Axess, a leading platform for corporate bonds trading, has seen record volumes in 2009 and 2010, In October it announced a record third-quarter trading volume of $100.5bn, up 25% on the same period in 2009, while revenues of $37.4m were up 24.7%. Major stock exchanges are also upping their game. Deutsche Börse resumed trading in 700 corporate bonds on Xetra in

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

October, the same month Singapore Exchange began offering corporate bond trading for smaller listed issues to retail investors. In February 2010 the London Stock Exchange also launched an electronic order book for retail bonds. Introduced, it says, in response to strong private investor demand for greater access to fixed income, the platform offers continuous two-way pricing for trading in UK gilts and retail-size corporate bonds onexchange. Before this order book, none of the 10,000 listed bonds on the LSE system was traded electronically. Initially, 49 gilts and ten corporate bonds were available for trading, including securities issued by Tesco, BT, National Grid, GlaxoSmithKline, Morgan Stanley, GE Capital, Enterprise Inns and a bond issued specifically for the service by Royal Bank of Scotland. Since then the number of bonds available on the platform has risen to 141. Investors can see prices on-screen, and trade in increments as low as £1 for gilts and £1,000 for corporate bonds, in a process similar to share dealing. The initiative is modelled on Borsa Italiana’s fixed-income platform, MOT, which conducted €230bn-worth of trading in 2009. Since June 2009, ExtraMOT, the segment of MOT dedicated to corporate bonds issued by Italian and foreign companies, has announced new additions to the platform around six times a month. Moreover, in November 2010, MTS announced plans to launch a pan-European corporate bond trading platform for the wholesale market. The proposed market will be open for the listing and trading of euro-denominated debt instruments and will operate on an electronic order-driven model. It will be managed by the EuroMTS multilateral trading facility and offer straight-through processing to Europe’s major clearing houses and central securities depositories. Even though the capacity to trade corporate bonds electronically is increasing, the complexity remains. UBS’s Herndon explains: “If you want to express an opinion in equities, there’s one stock for each company. For that same company’s bonds, there might be many different bond issues outstanding— as much as 20 or more for larger issuers. Each deal may have its own characteristics and different breadth of ownership, hence different liquidity. The different liquidity characteristics of each issue may lead to price discrepancies between them, and also the ability to transact in desired sizes.” The bulge bracket firms, which have invested heavily in electronic equity trading platforms, seem to have the edge over smaller rivals because of their greater ability to invest in technological infrastructure. Deutsche Bank and JP Morgan have both emerged as the two largest players in the fixedincome scene in the US, and Greenwich Associates says it is no accident that these two dealers lead in rates products and that they both deploy “top-notch electronic trading platforms”. However, Greenwich Associates consultant Frank Feenstra points out: “Complicating the issue for large and small dealers alike is the question of whether future trading volumes and sell side margins will meet the expectations of firms that are now making large investments in their fixed income platforms”. “There’s no doubt it’s easier for investment banks to invest,” says Herndon. “The more seamless the linkage from investor to trader to trade processing and settlement and the more it can be automated, the more effective it is. However, I view electronic

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

Robin Strong, director of buy side strategy at Fidessa. He says: “Portfolio managers often don't really mind exactly which bond they buy, as long as it meets their underlying strategy.” Photograph kindly supplied by Fidessa, November 2010.

trading as an extension to the mix. It’s not necessarily a substitute for voice. Electronic may be a supplement for execution with large accounts and a more efficient way to reach the smaller or less active part of an accounts list, for example.” Canada’s fledgling Omega ATS is squaring up to its larger rivals as it is about to begin electronic trading in Canadian government bonds including the ten-year benchmark bond. “There’s no transparency in bond trading in Canada and the retail investor takes what they are given,” says Michael Bignell, Omega’s president and chief executive officer. “Regulators in Canada have been looking for ways to promote transparency in the bond markets, but as much as they say they would like to, they can’t just walk into a darkened room and turn the lights on. At the major banks the profits from the fixed-income desks dwarf the equities desks so they are not motivated to change. It’s about time that someone threw the lights on.”

Slowdown expected In Canada, overall fixed income trading surged ahead by 42% on a matched sample basis from 2009 to 2010—”an extraordinary period”, according to Greenwich Associates. In a matched sample of 80 of Canada’s largest institutions, trading volume in government bonds increased 93%, although a slowdown is expected. Electronic trading saves time and adds to transparency. While it might help transparency, it can still be hard to prove best execution, points out Robin Strong. “Soliciting quotes from multiple brokers is the accepted method of price discovery and accepting the best quote is generally considered best execution.Yet it is hard to prove best execution for more complex trades that have multiple legs and include swaps or other derivatives. Some will delegate this to the broker or use internal models to analyse how the bonds should cost, but these models can only provide a guide and at this level of complexity the bond market struggles in the area of best execution.” “Over time there will be a movement to benchmark prices and US and Europe will move closer together,” says Jeffery. “That’s not to say there will never be a place for over-thecounter trading and I think it would be unreasonable to expect a platform to cope with some of the complex product structures around today.” I

TRANSITION MANAGEMENT: NEW SERVICE DEFINITIONS

Transition management has undergone substantive changes over the past two years as long established teams have merged, divided, or folded. Even so, the transition management product set has deepened, now often encompassing a cradle-to-grave relationship between beneficial owners and their mandated asset managers. At one time, beneficial owners called in transition teams to facilitate the movement of a portfolio from legacy to destination managers only after the manager selection process was completed. Now that relationship begins much earlier in the asset management process, explains Mark Dwyer, managing director and head of EMEA at Mellon Transition Management and Beta Management at BNY Mellon.

A DEEPER PRODUCT SET F

TSE GM: The transition management industry has changed significantly. What are the factors driving change? Mark Dwyer: The industry has changed beyond recognition; both in depth of service and in terms of when transition managers become involved in the investment cycle. Five or ten years ago, you would typically only use a transition manager when doing an equity to equity transition. Now, transition management teams provide a substantially broader range of services such as fixed income transitions; project management, hedging, interim management, and beta overlay; sometimes we also help investors with asset allocation decisions. Many of our clients consult with us throughout the entire process. Moreover, there was a time when you called your transition manager after the investment manager selection process was complete. Now investors create panels of transition managers that they can turn to much earlier in the decision process, making it much easier to access transition expertise.

Mark Dwyer, managing director and head of EMEA at Mellon Transition Management and Beta Management at BNY Mellon. Photograph kindly provided by BNY Mellon, November 2010.

DECEMBER 2010 / JANUARY 2011 â&#x20AC;˘ FTSE GLOBAL MARKETS

FTSE GM: Transition managers are not necessarily seen as experts at asset allocation or manager selection, are they? Mark Dwyer: Certainly not all transition managers should advise on asset allocation, and cannot credibly claim that they should be part of the process. Asset allocation and manager selection involve decisions about risk and return over the long term. Transition managers tend to focus on shorter time frames, but can contribute to understanding risk and return and investors benefit when they have access to a different perspective. In this regard, we leverage the BNY Mellon Asset Management platform. Not only can we offer best in class ideas on asset allocation to clients, but it also gives us the capability to manage assets on short-term, interim, or long-term mandates. There are many factors that drive the change of an asset allocation or asset managers and each factor involves different kinds of costs. The benefit of bringing in transition expertise as early as possible can be significant to the end value of a portfolio. It is a significant piece of additional information that should be factored into the decision making process. FTSE GM: Is this information not available elsewhere? Mark Dwyer: Transition managers have specialist systems and access to analytics that may not otherwise be available to investors. The information we can provide is not limited to cost and details market and operational risk. The cost and risk of a transition should not be the decisive factor in an asset allocation or fund manager selection process, but it is an important piece of information, needs to be readily accessible, and explicitly considered. In some cases we have gone much further than looking simply at the cost and risk of a proposed transition. In one recent case, we examined the cost of establishing and also the ongoing costs of maintaining a small cap index portfolio compared to a large cap one. We then generated a set of expected returns using our models from the asset management business, and were able to discuss with our client the expected returns after both immediate and ongoing maintenance transaction costs. Our approach is consultative, and we are able to show a broader picture around implementation, and provide metrics to support our view. FTSE GM: Can you give us an example of these project management services? Mark Dwyer: For a complex transition where project management was a large element of our involvement we were recently involved in a fiduciary manager change. This involved a pension fund moving all its assets from one fiduciary manager to another. The asset allocation and asset managers were all different and the operational risks involved were huge. We also had to ensure cash flows and liquidations were co-ordinated so that the client, and more importantly the fundâ&#x20AC;&#x2122;s beneficiaries, remained fully invested. There are many moving parts in a large scale transition such as this, but we have the experience and capability to identify and manage all those operational risks. FTSE GM: What are some of those risks? Mark Dwyer: Aside from operational risks, the investmentrelated risks are complex (bonds, equities, currencies, derivatives,

FTSE GLOBAL MARKETS â&#x20AC;˘ DECEMBER 2010 / JANUARY 2011

etc) and require a well thought out strategy, as well as the aforementioned capability for practical, tactical execution. FTSE GM: How does it work in practice? Mark Dwyer: The determination of the optimal path from legacy to target portfolio can readily be compared to rocket science. You know where you are starting from, and where you are going. To get there, several paths will be considered, trajectories calculated and compared, so as to arrive at a proposed optimal path, where advantages are clear and pitfalls known in advance. In a transition, multiple models of spread levels and market impact calculations must be used against historical and forward looking data with due considerations for the existing market environment, with sensitivities closely aligned to the potential trade execution methods, in a manner that can be employed equally for each individual security. Maximisation of in-kind opportunities is the first step, as these incur no market impact or opportunity costs. Yet operational considerations can have significant effect even at this stage, particularly in international securities where ownership transfer rules and custodial fees vary widely. Crossing opportunities must be carefully analysed against the metrics of market impact and opportunity risk (adverse price movement costs of delaying transactions) as unintended costs can accumulate.

The determination of the optimal path from legacy to target portfolio can readily be compared to rocket science. You know where you are starting from, and where you are going. To get there, several paths will be considered, so as to arrive at a proposed optimal path. FTSE GM: How does interim management work in practice and what are the benefits? Mark Dwyer: Interim management is about finding efficient short-term solutions and can involve a combination of securities and derivatives. Take a client looking to exit a portfolio invested in European equities where the target portfolio is global equity. The investment committee has made the re-allocation decision, but the target manager has not been selected. There is often a substantial time lag between an investment committeeâ&#x20AC;&#x2122;s decision and its implementation. According to a study released in October by consulting firm Mercer, the majority of respondents say it took about one to three months to execute a decision. With interim management, the risk that there is a change in the relative value of the legacy and target can be substantially reduced. In this example, one option would be to liquidate the European portfolio and create an overlay to the relevant global equity index until the new manager is funded. The disadvantage of this approach is that in-kind transfers, often a very significant means to reduce total transaction costs, are lost. An alternative is to create an optimised basket of both physical equities and derivatives. The advantage of this interim portfolio is that it

TRANSITION MANAGEMENT: NEW SERVICE DEFINITIONS

can have a low tracking error to the target portfolio, and some securities can be retained for in-kind transfer to the new target portfolio. Another type of interim management is the overlay of free cash, sometimes referred to as equitisation. The cash could have been generated from the investment portfolio or by new injections of cash into the fund. Using a derivatives overlay, this cash can be “put to work” in the market both fast and efficiently. Moreover, the overlay can be constructed in such a way as to move the actual portfolio closer to the target asset allocation. FTSE GM: Are you suggesting that a transition manager should also be involved in transitions for assets which are not transferable, such as derivatives? Mark Dwyer: Transition managers tend to offer much more value when they can directly trade the securities in the transition. However, there are significant exceptions, where the transition manager can offer cost and risk minimisation where no securities are traded directly. We were recently involved in a transition where there was a significant element of liability-driven investment (LDI). The LDI legacy portfolio and target portfolio were swaps which were non-transferable. In this particular case, we were asked to examine the liquidation process of the legacy manager and the swap construction process for the target manager. The optimal approach was to provide detailed instructions to the legacy manager on the date and swaps to liquidate with associated price limits. As the swaps were liquidated, we created a duration hedge, which we subsequently unwound as soon as a target manager established his own swap portfolio. FTSE GM: Have you changed your business model to adapt to client requirements or do you claim to lead the product development process? Mark Dwyer: Client portfolios are becoming increasingly

complex and an expert transition manager can deliver more value in this instance. To some extent, the client demand for more complex asset classes has driven the transition manager product development process. However, we have also developed new products and services. We offer products now that were once traditionally looked after by asset management rather than a transition manager. It is our responsibility to stay ahead of the developments in asset class diversification. We cannot let the complexity of the investment or asset processes trap our clients in a particular investment structure. The more complex the investment structure the more sophisticated the transition solutions we must provide. That is why transition management is constantly evolving and that in turn makes it fascinating. FTSE GM: BNY Mellon’s transition team in London has changed over the past year. Where do you now see opportunity, and how does the composition of the current team support your forward business plan? Mark Dwyer: We have the opportunity to bring our approach to transition management to the broadest global audience, and we have made great strides to reflect this in the structure of our business. A foundation of our approach is to use specialists, creating a clear separation of duties, eliminating key-man risk and enabling us to handle great complexity. Now, our presence in London can fulfil all of the key roles we utilise during a transition. We also have an incredibly experienced team, covering the full gamut of sales, operations and investments. We are confident about the team in place, and feel that we have one of the strongest regional transition management team, with experience in every major region – EMEA, Australia/Asia, and the USA. Deep experience, common infrastructure and processes, and a consistent application of our approach form the premise of our truly global offering. I

DRAWN A BLANK? If you need reprints for your marketing needs Simply call or email Contact: Paul Spendiff Tel: 44 [0] 20 7680 5153 Email: paul.spendiff@berlinguer.com

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

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

THE NEW FINANCIAL HUB OR MALTA, THE recession has proved short and shallow, with a peak-to-trough decline in GDP of 3.4%, as against 5.3% in the euro area. While GDP contracted by 2.1% in 2009, it rebounded to a very positive 4% in the first half of 2010, which suggests, says the central bank, the outturn for the full year could top 3%, driven by brisk export activity and a strong accumulation of inventories. The country has been relatively inured to the vagaries of the global recession, for good reasons. The first is the government’s commitment to diversifying the economy towards high value services, which have proved resilient to the downturn impacting the rest of Europe. Two, the jurisdiction is emerging as a natural fund domicile. Figures released by the MFSA indicate a 13% growth in the Net Asset Value (NAV) of investment funds domiciled in Malta during the first six months of 2010, confirming a same trend seen in the second half of 2009. Total NAV at the end of June stood at €7.93bn (up from €6bn at the height of the crisis in June 2009). The strongest expansion is in the Professional Investor Fund (PIF) segment, despite the restructuring that has been taking place in this area to reflect changes in investor appetite. All 51 funds licensed by the MFSA in the first six months of 2010 were PIFs, bringing the total of PIFs in Malta to 331. UCITS funds in comparison stood still at 45, while the number of non-UCITS stood at 33, three down on December 2009. Another 26 overseas funds are authorised to be retailed in Malta. Out of 104 Schemes into which the funds are grouped, 72 are multi-fund structures, 20 are stand-alone funds and 12 are Master/Feeder structures. Diversified funds were the largest asset category, accounting for almost 51% of all the locally based funds. Equity funds were the second most common category with a share of 19% of the total number of funds while derivative funds accounted for 12%. Malta’s stable financial sector also remains a key strength, albeit, as a banking centre Malta’s credentials are perforce modest, with total banking assets as at the end of 2009 standing at a tip over €41bn. Substantially liquid, Malta’s banks have however avoided the toxic shocks which have rocked the industry just about everywhere else; instead they have taken a largely old-fashioned approach, preferring to act as intermediaries between retail borrowers and depositors. According to the World Economic Forum’s Competitiveness Index 2010-2011, the soundness of Maltese banks is now ranked 10th globally, up two

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

Kenneth Farrugia, chairman, Finance Malta. Photograph kindly supplied by Finance Malta, November 2010.

MALTA REPORT: EUROPE’S NEW FINANCIAL GATEWAY

Finance and related administrative services account for around 12% of Malta’s GDP, with the government aiming to build this segment to around a quarter of GDP by 2015. The financial sector’s gross value added in nominal terms grew by a rather respectable 22% last year and net financial inflows have contributed substantially to the contraction in the country’s long standing current account deficit. Over the decade, Malta has distinguished itself as a cost effective, serious and adaptable jurisdiction in the field of financial services, backed by The Investment Services Act, 1994 and a robust regulatory environment, overseen by the Malta Financial Services Authority (MFSA). 2011 promises to be a challenging year, though the jurisdiction expects continued robust growth, despite some internal stresses. By Kenneth Farrugia, chairman, Finance Malta.

notches from the previous report. Moreover, Malta itself has moved into 11th position in financial market development. Admittedly not everything is rosy. A continued weakness is the slow growth in productivity and private consumption, which has undermined economic performance in recent years. The public sector also remains relatively over-manned. Additionally, too few people in Malta participate in the formal labour market (55%), compared to the rest of Europe (65%), with the activity rate among women and older workers particularly low. Not all the issues are domestic. Given continued strains in the global economy Malta can only expect modest growth in export markets in the near term, particularly as the Eurozone is expected to grow a mere 1.5% in 2011. However, the government has acted fast. Aside from introducing new work incentives, a restructuring of the pension system is in hand, thereby boosting incomes in retirement, and encouraging private saving to close the saving/investment gap. While the continued repercussions of the financial crisis will continue its low level impact on the country’s domestic growth statistics, Malta’s stable appeal as a fund management centre continues apace and the jurisdiction expects 2011 to provide a new raft of funds utilising the jurisdictions robust regulatory environment, market flexibility and low cost services. I

MALTA REPORT: AN EMERGING FINANCIAL HUB

THE MED’S ATTRACTIVE ALTERNATIVE Malta has a new status in financial circles as it emerges as a sought after and reputable international financial services centre. Hailed by the City of London’s Global Financial Services Index (2010) as one of the five financial centres to grow in importance over the coming years, the island is carving a niche for itself in the global funds industry. In the light of impending regulation in both Europe and the US, fund investors and managers are evaluating ever more carefully the jurisdiction of their choice. In the emerging new financial order, Malta is regarded as a feasible alternative financial centre. Charles Azzopardi, managing director, HSBC Securities Services (Malta) Limited outlines the opportunities. HAT MAKES MALTA so attractive? Malta, as a jurisdiction, has been firmly placed on the map of financial centres within the European Union. It has a number of attractions which include a robust yet dynamic legal and regulatory environment with an independent judiciary, where innovation is encouraged. It also has the benefit of a single regulator, the Malta Financial Services Authority (MFSA), which is very approachable and committed to providing an expeditious and prompt service to new fund applications. The island also offers political and economic stability. Malta joined the EU in 2004 and adopted the euro as its national currency in 2008. It has emerged from the financial crisis virtually unscathed and, in spite of the economic downturn, was one of the best performing EU countries with above plan GDP growth; in fact, Malta was one of two EU countries that managed to reduce its deficit in 2009. Despite the global recession, the financial services industry in Malta grew by 22% last year, and employment in the sector rose to almost 7,000. Malta offers a well developed infrastructure, a skilled and sophisticated work pool and service providers with excellent language skills. Moreover, its infrastructure and work pool are also competitively priced. Skilled labour, professional fees and excellent office space with relatively low rents, are cost competitive, especially when compared to other EU jurisdictions. Malta provides good telecommunications and air/sea transportation links with a high usage of Information Communication Technology (ICT). Malta is also within the

Charles Azzopardi, managing director, HSBC Securities Services (Malta) Ltd. Photograph kindly supplied by HSBC Malta, November 2010.

Central European Time (CET) zone—a somewhat underestimated yet quite important factor. Favourable fiscal and tax considerations including exemptions from tax and stamp duties at both fund and investor levels, together with potential benefits from Malta’s extensive tax treaty network with over 50 countries, add to the jurisdiction’s appeal. Equally, it offers other no less important benefits, such as a unique culture, rich in historical treasures, an enviable Mediterranean climate and a socially enjoyable and secure environment. This compelling package is increasingly attracting the attention of fund investors and managers, particularly at a time when the pressure for a higher level of supervision, transparency, reporting and organisational requirements is increasing. On the banking front some 25 licensed credit institutions have already established operations in Malta of which 20 are EU-country based. An October 2010 survey The future of manager migration, fund servicing and domiciliation in the Mediterranean: The alternative to Ireland & Luxembourg? carried out by the London-based International Fund Investment Limited, underscores Malta’s growing appeal and a salient trend for funds to re-domicile to onshore jurisdictions with comprehensive yet flexible legislation. Some 76% of participants interviewed in the survey acknowledge that Malta offers significant potential as a base for their funds or to open an office, while the majority of investors (83%) are aware that Malta is becoming a sought after alternative to Ireland and Luxembourg. When asked if they would consider relocating funds to Malta or Gibraltar as an alternative to Luxembourg or Ireland, 18% said they are looking at moving funds to Malta or Gibraltar while a further 26% are open to the idea, particularly if these locations continue to offer fund servicing on the same level as Ireland or Luxembourg but at lower costs. When questioned about their views on the regulatory environment in the Mediterranean domiciles, all those respondents who visited the Malta Financial Services Authority had positive comments to make about the proactive approach that the Maltese regulator has taken. One manager said that this was“Malta’s biggest selling point”. When asked if investors have any views on the quality of fund service provision in the Mediterranean domiciles, one interviewee said that he was aware of the fact that several international fund administrators had recently launched offices in Malta and regarded this as a positive step for the country.

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

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7 reasons why international financial institutions are dropping anchor in Malta: English as an official language; Cost competitive skilled workforce; EU member with euro as its currency; Consistently highly ranked quality of life; Meticulous yet accessible single regulator; Robust yet flexible legal and regulatory framework; Secure and stable business environment and a world class IT infrastructure.

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MALTA REPORT: AN EMERGING FINANCIAL HUB

To reinforce the point: Malta is now ranked 50th among 139 economies in a World Competitiveness Report issued by the World Economic Forum for 2010-2011. The same report ranks the soundness of Maltese banks in 10th place.

strategy can be accommodated within this structure). The UCITS brand will undoubtedly enhance the marketing reach of the fund as it is a brand that affords higher significant investor protection and transparency.

The Vision 2015 strategy

Reporting and regulation

The government of Malta has set an ambitious target to double the financial sector’s contribution to the island’s GDP to 25% over the next five years as part of its Vision 2015 strategy. So far, so good: over the first six months of the year the financial services sector’s gross value-added increased by a significant 75%, suggesting that Malta is on the right track. No surprise then that that the number of funds registered in Malta rose by 26% in 2008 and 27% in 2009.

The requirements set out by the Malta Financial Services Authority to enable the re-domiciliation of funds to Malta are comprehensive and include the following requirements: G The existing fund has to be incorporated under the laws of an approved jurisdiction (including EU, EEA, OECD) as well as most offshore centres such as Cayman Islands, British Virgin Islands, etc; G The legal vehicle has to be similar in nature to a company; G Re-domiciliation is possible under the laws of the jurisdiction where the fund is currently domiciled; G Re-domiciliation is permitted in the fund’s Memorandum and Articles of Association; and G Re-domiciliation is approved by way of an extraordinary resolution. Naturally, once the fund is re-domiciled to Malta, the licensing requirements that would apply to a new fund will have to be met as well. Malta has also taken a balanced approach towards the hedge fund segment. Hedge funds have been regulated in the jurisdiction since the introduction of the Investment Services Act, which came into law in the mid-1990s. The approach to hedge funds by the local regulator has been flexible and while stringent due diligence procedures are obligatory both in the licensing procedures and reporting regimes, different categories of alternative investment funds have been recognised and regulations in the jurisdiction are tailored to meet the needs of different types of investors. Malta is also cognisant of the globalisation of the funds industry and funds are allowed to have external administrators and custodians in recognised jurisdictions. Both the regulator and local service institutions are geared to interface with the emerging regulatory structure in the European Union and will be sufficiently equipped to deliver effective services to the financial sector as Malta grows in stature and confidence as a new global financial market structure starts to take new form and shape. I

Redomiciliation of Funds Since 2002, Malta has set up a statutory framework that allows the re-domiciliation of companies in and out of the island in a seamless manner. The utilisation of these rules for re-domiciliation of a fund to Malta has a number of advantages. For one, the corporate existence of the fund remains undisturbed and it is therefore not necessary to wind up the existing fund and set up a new structure in Malta. As a consequence of this continuity the investor’s capital gains/losses are not crystallised and therefore there should not be any tax consequences to investors. Investors can also continue to measure the performance of the fund by reference to their original investment. Equally, the fund can maintain its same service providers (fund administrators, custodians, prime brokers etc) and existing agreements can remain unchanged. Additionally, investors in the fund are not impacted and their holding in the fund will not change in any way. Likewise, the portfolio of the fund can continue to be managed in the usual manner without any liquidations or transfers. Moreover, funds that are already listed outside Malta can continue to retain their existing listing (subject to approval of the exchange where the fund is listed). Malta adopts international financial reporting and auditing standards and because of that no major financial reporting changes may be required post re-domiciliation. Fund managers also have the opportunity to change the regulatory status of their fund to a UCITS scheme (provided the fund’s investment

HSBC at the financial heart of Malta

S MALTA’S LEADING international bank, HSBC Bank Malta p.l.c. provides global custody services to investment funds, whilst HSBC Securities Services (Malta) Limited provides a full range of services including fund accounting and transfer agency. Both these companies form part of the HSBC Group which has one of the strongest balance sheets in the industry

and which has the people and the technology necessary to provide an exceptional client service to investment funds seeking re-domiciliation to Malta. HSBC Malta is connected to the Group’s global network to tap best of class products, systems and customer service, and is committed to playing a pivotal role in the development of the Maltese financial services sector. HSBC

Malta has not only found Malta to be a good country in which to do business, but also a country where the potential exists to expand operations and to diversify into new areas. Malta offers a compelling package and we are convinced that Malta has a very bright future.

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

MALTA REPORT: AN INCREASINGLY DIVERSIFIED FUND DOMICILE 100

MALTA’S ONSHORE APPEAL TO FUND MANAGEMENT The real driver of growth in Malta is, and will be for the foreseeable future, the alternative investment fund area, according to Dr David Griscti, head partner and founder of law firm David Griscti & Associates. Although hedge funds have been the most popular, he says the country has also worked on setting up funds in a variety of other alternative asset classes, including private equity, property, commodities, alternative energy and even art. Market participants also expect to see further growth from re-domiciliation. There has been a move from offshore to onshore jurisdictions over the past two years, says Anthony O’Driscoll, managing director of Apex Malta, because investors want to see greater transparency and reporting processes as well as the internal controls and risk management systems of their fund managers. “In many cases, what we are seeing is not so much pure re-domiciling but instead fund managers setting up onshore funds in Malta while keeping their offshore fund in the Caymans or Bermuda.” Lynn Strongin Dodds reports. T WAS NOT too long ago that Malta did not appear on the radar screens of fund service providers. They were more interested in setting up shop in the larger domiciles of Luxembourg and Ireland. Today, Malta is a firm feature on the map thanks to a thriving fund industry and a relatively healthy economy. Hedge funds are the main focus but other funds are expected to be included as the country expands its product and geographical reach. Brendan Conlon, business development director at SGGG Fexco Fund Services, Malta, says:“At the moment fund servicing mainly caters to the hedge fund industry but I expect that will change with UCITS IV and the Alternative Investment Fund Managers (AIFM) directive. They both will help to broaden the fund set and investor base and in the future I think we will see both hedge fund and long only managers setting up funds in Malta because of the lower cost of doing business here and the strong regulatory framework.“ Dr David Griscti, head partner and founder of law firm David Griscti & Associates, says: “The real driver of growth in Malta is, and will be for now, the alternative investment fund area. Although hedge funds have been the most popular, we have also worked on setting up funds in a variety of other alternative asset classes such as private equity, property, commodities, alternative energy and even art. Professional investment fund (PIF) regulation is flexible enough to accommodate different structures.” Market participants also expect to see further growth from re-domiciliation. As Anthony O’Driscoll, managing director of Apex Fund Services, Malta, notes:“There has been a move from offshore to onshore jurisdictions over the past two years because investors want to see greater transparency and reporting processes as well as the internal controls and risk management systems of their fund managers. In many cases, what we are seeing is not so much pure re-domiciling but instead fund managers setting up onshore funds in Malta while keeping their offshore fund in the Caymans or Bermuda.

“One of the main attractions of Malta is that it is a lowcost jurisdiction that offers a favourable taxation system for investor funds. This is not only due to the exemption of income tax and capital gains tax at the fund and non-resident investor level but the country also has about 50 double taxation treaties in place.” Joseph Camilleri, head of Valletta Fund Services Business Development Unit, adds:“The financial crisis has been a major catalyst for fund managers who have had to rethink their strategies in relation to the domicile of their investment vehicles. Investors are placing more emphasis on risk and as a result fund managers are looking for well-regulated jurisdictions with a strong reputation for high quality people and professional support. To date, the most popular types of funds have been PIFs set up by mainly Europe-based fund managers, but we are now seeing other fund managers set up UCITS schemes.” According to recent research conducted by research and publishing group International Fund Investment, regulation is a driving force behind the move onshore. Its latest study found that 62% of alternative fund managers canvassed in the US and Europe either have—or are planning to—redomicile their funds or launch mirror funds in the European Union (EU). Breaking it down, 18% have already redomiciled their funds or are planning to, while 44% have launched EU-domiciled “mirror” funds or expecting to. In terms of the domicile, Ireland emerged as the most popular choice by half of respondents, followed by Luxembourg (27%) and Malta (20%). However, many are considering Malta as well as Gibraltar as viable alternatives to Luxembourg or Ireland, with 18% saying they are thinking of moving to the smaller jurisdictions while a further 26% are open to the idea, particularly if these locations continue to offer fund servicing on the same level as Ireland or Luxembourg but at lower costs. Respondents also saw the increase in the number of international fund administrators in Malta as a positive step.

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

Bank ank of Valletta Valletta Bank of Valletta has contributed to the economic development of Malta ta for the past two centuries. T Today oday we actively endorse the nationâ&#x20AC;&#x2122;s drive and ambition to transform itself into a centre ENQ jM@MBH@K DWBDKKDMBD With a well-developed network of correspondent banks and QDOQDRDMS@SHUD NEjBDR VD G@UD SGD HMEQ@RSQTBSTQD @MC DWODQSHRD to manage corporate banking for companies registered across international jurisdictions. !DHMF jQL ADKHDUDQR SG@S DBNMNLHB @BGHDUDLDMS CNDR MNS RTARHRS NM HSR NVM VD G@UD OKDCFDC NTQ BNLLHSLDMS SN NTQ country to aim towards success while acting responsibly towards the society within which we operate. S !@MJ NE 5@KKDSS@ VD @ROHQD SN DWBDDC BTRSNLDQ DWODBS@SHNMR AX NEEEEDQHMF @ SQTRSDC FDMTHMD @MC SQTKX B@QHMF RDQUHBD @CCHMF value every time we connect because your success is our goal.

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www.bov.com + 356 2131 2020 Valletta alletta p.l.c. is licensed to Bank off V conduct investment services business and to provide trustee services by the Malta Financial Services Authority. Valletta alletta p.l.c., Issued byy Bank of V arryy Street, 58, Zachar a V T 1130 - Malta VL Valletta

In the time it takes you u to read read this pageâ&#x20AC;Ś â&#x20AC;Śyou would have discovered an alter e European fund domicile and a fund administration partner ,@KS@ G@R @ QNATRS XDS kDWHAKD QDFTK@SNQX ETMCR EQ@LDVNQJ @M @BBDRRHAKD QDFTK@SNQ BNRS BNLODSHSHUD RDQUHBD OQNUHCDQR @MC @ RDQUHBD CQHUDM BTKSTQD @K resulting in a highly effective time to market. S 5@KKDSS@ %TMC 2DQUHBDR +HLHSDC ,@KS@ R K@QFDRS ETMC @CLHMHRSQ@SNQ VD RTOONQS ETMC OQNLNSDQR @S SVN d levels: at the set-up stage through our Turnkey Fund %NQL@SHNM 2DQUHBD @MC NMBD SGD ETMC HR KHBDMRDC we provide a comprehensive range of fund services es BNUDQHMF ETMC @BBNTMSHMF @MC U@KT@SHNM SQ@MRED agency as well as corporate support services.

Visit our website at www www.vfs.com.mt .vfs.com.mt or call Kenneth Farrugia or Joseph Camilleri on +356 21227311 5@KKDSS@ %TMC 2DQUHBDR +HLHSDC 3& "NLOKDW 2THSD +DUDK !QDVDQX 2SQDDS ,QHDÄŽDK !*1 - Malta. Valletta Fund Services Limited is recognised by the Malta Financial Services Authority to provide fund administration services.

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MALTA REPORT: AN INCREASINGLY DIVERSIFIED FUND DOMICILE 102

Joseph Camilleri, head of Valletta Fund Services Business Development Unit. “Investors are placing more emphasis on risk and as a result fund managers are looking for well-regulated jurisdictions with a strong reputation for high quality people and professional support,” he says. Photograph kindly supplied by Valletta Fund Services, November 2010.

According to Kenneth Farrugia, chairman of FinanceMalta and chief officer, Valletta Fund Services, the number of investment services licence holders totals 88, a significant jump from 59 in 2006. There are about 15 fund administrators but the past two years has been particularly busy with Apex, SGGG Fexco Fund Services, Custom House and Praxis setting up shop. Meanwhile, Bank of Valletta, which had been the leading player, spun off its fund services operation as a separate business to capitalise on the growing trend for fund administration.” Under the PIF regime where hedge funds fall, funds can chose service providers such as investment managers, fund administrators, custodians and prime brokers established outside Malta. These providers in turn can also tend to funds authorised in other jurisdictions if the rules comply with Malta. However, the latest survey taken in December 2009 shows that domestic players are gaining momentum with around 47% of the total funds located in Malta being administered by local firms. Overall, according to figures from the Malta Financial Services Authority, there are about 431 funds domiciled in the country. Although activity dipped during the recession, HSBC’s statistics show that the industry regained its lustre with the number of new funds rising 26% in the first quarter of this year compared to 22% in 2009 and 30% in 2008. This is a far cry from the 104 registered funds ten years ago. Although both the number of funds and administrators continue to rise, the industry seems to still be dominated by four players, with Valletta and HSBC being frontrunners followed by Custom House and Apex. This is expected to change as the fund business widens and develops. Camilleri of VFS, says: “Competition is definitely increasing but this is healthy and one which I deem as being the evolutionary

process. The result is the industry is set to grow exponentially by way of not only the establishment of new fund administrators but also the increasing incidence of fund management companies setting up in Malta.” Chris Bond, head of global banking and markets at HSBC in Malta, adds: “The dynamic growth of the fund administrator business has prompted us to sharpen our pencil. We have the advantage of being one of the global players and also being able to leverage off the strengths and global footprint of the HSBC group. However, the growth of the market and new entrants means that we need to ensure that we continue to have the best products and services.” HSBC has the full range of products, including net asset value calculations, investor record processing, corporate management services and turnkey fund solutions for new launches. Outsourcing has also become a major theme especially in the middle office arena. O’Driscoll says: “The collapse of Lehman Brothers and emphasis on counterparty risk forced fund managers in Europe and the US to look towards the multi-prime broker models. This requires support for multiple execution platforms, complex reconciliation, trade allocation and counterparty risk. As a result, many managers find it more cost-effective and efficient to outsource these activities to administrators who can provide not only post-trade services but also pre-settlement trade processing and support, position and trade reconciliation, fund accounting and risk management reporting.” Camilleri echoes these sentiments: “Currently, at Valletta Fund Services, we provide our fund management clients with a comprehensive suite of fund services to include turnkey fund formation solutions, as well as the determination of net asset value and transfer agency services, anti-money laundering reporting services and company secretarial services. We are also experiencing an increased demand for middleoffice reporting services as a result of fund managers deciding to outsource this function to their administrators.” Although market participants are optimistic about the future growth prospects of Malta, many see the dearth of custodians on the island as a stumbling block to further development in the UCITS space. This is because under UCITS IV, managers can set up funds in any EU domicile, and manage these cross border, but the custodian has to be based in the same domicile as the UCITS. All eyes are on Deutsche Bank, which recently upgraded its licence in the country. The German bank is keeping tightlipped about its plans, only issuing a statement confirming that it was granted a“credit institution licence in March 2010, replacing its existing financial institution licence. The bank currently continues with its existing business and might also look into further business opportunities in the future.” Farrugia says:“The industry is experiencing the development of a cluster by way of the setting up of international fund administration companies as well as fund management organisations. It is however yet to experience growth in the depositary/custody sector. I am confident that over the course of next year, Malta will experience the setting up of other international custody service providers”. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

MALTA REPORT: GROWING IN STATURE AS A GLOBAL PLAYER 104

Since its accession to the European Union six years ago, and the adoption of the euro in 2008, Malta’s profile as an onshore jurisdiction has been firmly established. The latest 2010 Global Financial Centre Index named the island in the top three financial centres most likely to succeed in the next couple of years, along with Dubai and Shanghai. Also, Malta climbed to 11th from 13th in financial market development on the World Economic Forum’s Competitiveness 2010-2011 Index. Lynn Strongin Dodds explains how a small country with a population of less than half a million is building up the financial muscle to be able to compete with the big boys.

PUNCHING ABOVE ITS WEIGHT ALTA MAY BE a fraction of the size of Luxembourg and Ireland, but it has enjoyed success on the global alternative investment fund stage. The country plans to increase its market share in the wake of regulatory calls for greater transparency and the ensuing migration to onshore jurisdictions. The funds setting up shop may be small today but the goal is to provide the right environment for them to flourish. Since its entry to the European Union in 2004 and the adoption of the euro four years later, the country’s profile as an onshore jurisdiction has been cemented. The latest 2010 Global Financial Centre Index (GFCI) named Malta along with Dubai and Shanghai as one of the top three financial centres most likely to succeed over the next two to three years. In addition, as the country continues to punch above its weight, it climbed to 11th from 13th in financial market development on the World Economic Forum’s Global Competitiveness Index 2010-2011. Kenneth Farrugia, chairman of FinanceMalta, and chief officer of Valletta Fund Services, says:“Malta's fund industry is fast gaining growth traction and is today being increasingly recognised as an EU-based fund domicile alongside Luxembourg and Ireland. Malta sits in a unique geographical position as a member of the EU and very close to the south and south-east fascia of the Mediterranean. This inherently means that Malta is positioned to act as an important gateway to the European market and at the same time to North Africa

and the Middle East. This makes the country a highly compelling proposition for both EU and non-EU financial institutions seeking to gain access to European investors and the Arab world at the same time.” Low costs have also been a major selling point. Industry estimates place professional fees, salaries and office expenses at roughly two-thirds of those in the more established centres. Anthony O’Driscoll, managing director of Apex Malta, which is part of the Apex Fund Services, says:“Although Malta will never be a Dublin or Luxembourg because it will not attract the same deal volume, the country is a viable option. The main attractions are not only the low set-up costs, but a strong regulatory framework, fast-track approval process, quality global service providers and an extensive double tax treaty network. The average size of the fund may start small—€5 to €20m—but we have in the past seen clients grow their assets under management quite quickly having started at that base.” Dr David Griscti, lead partner and founder of law firm David Griscti & Associates, a specialist in investment services law, says:“The fund industry took off after our entry into the EU. Some would say that it has been a negative that we did not initially attract the larger players. I, however, see it as a positive because the country was not then in a position to handle it. Attracting the smaller players allowed the professional service’ firms to grow their internal resources and as a result we are now able to deal with the larger funds.”

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MALTA REPORT: GROWING IN STATURE AS A GLOBAL PLAYER 106

Dr David Griscti, lead partner and founder of law firm David Griscti & Associates. “Attracting the smaller players allowed the professional service’ firms to grow their internal resources and as a result we are now able to deal with the larger funds,” he says. Photograph kindly supplied by David Griscti & Associates, November 2010.

Chris Bond, head of global banking and markets at HSBC in Malta, agrees that“Malta has a strong professional infrastructure as well as a robust regulatory framework which is aligned with EU requirements”. He adds: “Our regulator in general has adopted a firm but flexible approach. The other benefits of working in Malta are a multilingual and educated workforce and a well capitalised and sound banking system. Due to a strong liquidity position and prudent asset/liability management, none of the banks needed a bailout from the government.” Prof Joseph Bannister, who has been chairman of the Malta Financial Services Authority (MFSA) since 1998, concurs that its hands-on approach has been one of the secrets of Malta’s success on the fund scene. He has been instrumental in navigating the country from being an offshore domicile in the pre-EU days to its current onshore status. With him at the helm, the MFSA implemented a raft of reforms in preparation for EU membership, plus it became a single regulator amalgamating the work carried out by several agencies. More recently, the MFSA underwent a further restructuring and shed its silo-based structures in favour of an integrated and harmonised organisation. The main thrust was removing the authorisation and regulatory development oversight functions from each of its three supervisory groups—securities and markets, banking and insurance and occupational pensions—and creating two separate units. This was to ensure greater consistency in licensing, supervision and internal communications. Bannister notes: “The nature of the regulatory regime is one of the key things that financial institutions look at when they are considering setting up in a new jurisdiction. I think our model as a single regulator is unique. We cherry-picked the best practices from countries such as Germany and Sweden and have been very proactive in the development of both EU as well as national legislation. Our goal is to enact laws that allow business to develop innovative practices.”

Griscti adds: “The fund industry took off post-EU membership, mainly driven by flexible and market sensitive regulation that reacts swiftly to market changes and issues that arise. However, the key drivers are the professional firms, like ourselves, whom are extremely proactive in going out to get the business. We, for example, target asset managers and visit them in their offices to discuss how we can help them set up funds.” In terms of regulation, the linchpin has been the Investment Services Act, which is a comprehensive regulatory regime for investment services and collective investment schemes (CIS), including professional investment funds. Overall, the fund industry has enjoyed significant growth since ten years ago when the net asset value (NAV) of the funds domiciled in Malta stood at just €500m. The recession took its toll but total NAV has recovered, climbing steadily from its low point of about €6bn during the height of the crisis in June 2009 to €7bn in December 2009 and €7.9bn for the first half of 2010. Personal investment funds (PIFs) continue to account for the bulk of the 431 funds domiciled in Malta and the 51 funds that were granted licences during the first half of 2010. By contrast, the number of Undertakings for Collective Investments in Transferable Securities (UCITs) funds remained the same at 45 while non-UCITs fell three to 33. Joseph Camilleri, partner at PricewaterhouseCoopers in Malta, says: “Asset managers can choose from a range of fund structures, including UCITs, but PIFs have been the most popular to date. The PIF regime is flexible and allows for a smooth and efficient application process. The vast majority are start-up funds and most of the investors are from Europe, although we are seeing some interest from North America.”

Minimum threshold PIFs are broken down into three categories, with the experienced investment fund at one end of the scale. It requires a minimum investment threshold of €10,000. These funds are not bound by any investment restrictions as is the case with retail funds but they are still required to appoint a custodian and can only leverage up to 100% of NAV. In the middle is the most common—the qualifying investor fund—which requires a minimum investment of €75,000. These funds are not subject to investment or borrowing restrictions and may make unlimited use of leverage. They also do not need to appoint a custodian or prime broker provided adequate safekeeping arrangements are implemented. Last but not least is the extraordinary investors category, which joined the fold in 2007. They are geared towards private equity investors and family offices with the minimum investment threshold standing at €750,000. The turnaround process is faster than the other two and they have proved popular for those looking to move from an offshore to onshore location. According to Farrugia:“The MFSA has ensured the presence of a comprehensive legal and regulatory framework to cater for the different needs of fund managers and their clients. The regulatory framework for PIFs is highly flexible and accommodates a variety of fund structures to cater for a wide range of fund strategies, which amongst others include long

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

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MALTA REPORT: GROWING IN STATURE AS A GLOBAL PLAYER 108

short strategies, arbitrage funds, directional, global macro and algorithmic funds. The MFSA also has in place policies to accommodate property funds which may likewise be structured as PIFs. We have also experienced the PIF regulatory framework being used to structure private equity and venture capital funds.” Looking ahead, market participants expect to see further growth opportunities on the back of UCITS IV and the Alternative Investment Fund Managers Directive (AIFM) which was recently approved by the European Parliament. On the UCITS IV front, Malta hopes to capture business from changes within the master and feeder structure. Under the new rules, the master and feeder funds are not required to be situated in the same member state plus they may also have different depositories and auditors, subject to implementing adequate information-sharing arrangements. For example, fund providers could establish a management company under UCITs IV in Malta while keeping their fund administration in Luxembourg or Ireland. There is also hope that both pieces of legislation will bring different types of funds to the country as well as accelerate the trend of hedge funds wrapping certain strategies in a UCITs umbrella. Farrugia says: “We have seen an increase in the number of so called ‘Newcits’ funds in Malta, or hedge funds that create UCIT funds to mirror their strategies. This is being driven by investors who want a more transparent and tightly-regulated product in the wake of the Madoff scandal and financial crisis.”

Liquidity for investors Bond, however, is more circumspect about the Newcit product: “Newcits account for a relatively small percentage of the €5.5trn UCITs market. There are still constraints, bans on short selling and OTC derivatives rules which will make certain hedge fund strategies ineligible for a UCITs structure. Liquidity for investors is also a major issue. Having said that, Malta is still seeing growth in the UCITS space.” Although Europe is an important region, Malta is also hoping to capitalise on its ties with its North African and Middle Eastern neighbours. To that end, Farrugia notes: “Malta is also seeking to attract the setting up of Shari’ahcompliant funds. Within this context, in March 2010, the MFSA published a guidance note for Shari’ah-compliant funds, which enable the setting up in Malta of such funds. This regulation allows these funds to be set up either as retail funds (UCITS or non-UCITS) or as PIFs. However, in the specific case of Ijarah funds (which are structured around a specific asset, such as a building, property, or infrastructure), commodity funds, and Murabaha funds—a method of financing the purchase of a house according to Islamic principles—these can only be set up as PIFs, due to the largely non-conventional assets in which these funds invest.” The country is also looking towards Asia and the MFSA signed a memorandum of understanding (MoU) earlier this year with the China Securities Regulatory Commission to “protect and promote the development of the securities markets by providing a framework for co-operation, increased mutual

Chris Bond, head of global banking and markets at HSBC in Malta. “Malta has a strong professional infrastructure as well as a robust regulatory framework which is aligned with EU requirements,” he says. Photograph kindly supplied by HSBC, November 2010.

understanding and the exchange of information”. According to Bannister, the deal allows Chinese “qualified domestic institutional investors”(fund managers) to invest on behalf of Chinese investors into Malta-domiciled investment funds, both PIFs and UCITS, while Maltese fund managers will also be able to tap into Chinese investments under certain circumstances. As for the obstacles ahead, economic uncertainty is of course a concern. Bond notes: “As Malta has an open economy it was not isolated from the global downturn. However, we did not shrink as much as others. Our GDP growth rate is currently estimated at about 3.4% this year, which is better than the European average.” The other big challenge is a skills shortage which might not be surprising in a population of around 413,000. Companies as well as MFSA and trade organisations are trying to rectify the problem by running professional development courses and retraining to ensure members of the sector are up to speed with the latest developments and techniques. Bannister notes: “Although our population is small, there are over 10,000 fulltime university students and an additional 11,000 in vocational training. We also have several training institutes which have come together to design programmes aimed to train the middle layer; asset managers, risk managers, fund accountants and underwriters.” Expats are also coming back but as Camilleri notes:“Human resources and a limited talent pool in a dynamic and growing sector is one of the biggest problems the financial services sector in general faces. Over the past five to ten years, we exported our graduates but recently, due to the growth in financial services, there has been a huge demand for the best and brightest and we are now importing people from other European countries to meet the demand. We are still sending people on long-term strategic deployments to different countries to learn certain skills and bring back their expertise.”I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

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MALTA REPORT: MSE STRIVES FOR A PIVOTAL MARKET ROLE 110

The Malta Stock Exchange intends to capitalise on its positions in the league tables with the objective of internationalising and promoting itself to investors as well as issuers. It has taken its show on the road and has been proactively marketing its pre and post-trade wares to an audience which is more interested in onshore locales in the wake of the financial crisis. Eileen Muscat, chief executive of the MSE, says: “We see ourselves as acting as a gateway for issuers from non-European countries to tap into a European investor base and vice versa.” Lynn Strongin Dodds reports.

MSE AIMS TO BE A GLOBAL PLAYER HE EXTERIOR OF the 19th century British Garrison Chapel, which is home to the Borza Malta or Malta Stock Exchange, may have retained its period features but the offices inside are anything but old-fashioned. Stateof-the-art technology coupled with innovative ideas and a determination to be a player on the global stage are its hallmarks. The MSE may be small in stature but its plans are on a much larger scale. Eileen Muscat, chief executive of the MSE, says: “European Union membership and entry into the euro was transformational because it helped us attract a wider investor and issuer base. However, the performance of our stock market during the financial crisis combined with the 2010 Global Financial Centre Index Report, which named Malta as one of the top three financial centres for the future, has definitely raised our profile and boosted investor as well as issuer confidence. We are not complacent and what we are doing now is trying to capitalise on our positions in the league tables.” Muscat, who took over the helm this year and has been with the exchange since it opened in 1992, is driving the changes laid down by her predecessor, Mark Guillaumier. The objective is to internationalise and promote the exchange to investors as well as issuers. It has taken its show on the road and has been proactively marketing its pre and post-trade wares to an audience which is more interested in onshore locales in the wake of the financial crisis. She says: “To date, the exchange has been largely a domestic operation with activities geared towards the local market. However, growth is finite because we are a small country and

our strategy has been to push for international listings and participants. We see ourselves as acting as a gateway for issuers from non-European countries to tap into a European investor base and vice versa. This is especially true of North Africa and the Middle East investors and issuers who we have cultural ties with because of our geographical position in the Mediterranean. We are currently holding several discussions to see what fund managers in the region are doing and what products clients would like to see being developed.” Muscat notes that the MSE’s plan to expand its reach and product offering is part of the government’s 2015 Vision initiative which aims to make financial services account for 25% of the country’s GDP. She says: “Financial services along with healthcare, tourism, information technology and communications are the four pillars of growth that the government is targeting for development. We think that attracting more local and foreign companies onto the exchange will have a domino effect. We are looking to not only list more funds and bonds but also smaller cap companies. We believe that they may find it easier to deal with us than some of our larger competitors. We offer a fast, efficient and personal service at very cost competitive prices.” The MSE, which is small by international standards with a market capitalisation of about €7.6bn, operates two markets— the Regular Market, consisting of equities, corporate and government bonds, and the Treasury Bill Market—but it has come a long way in its almost 20 years. Muscat recalls: “When we started there were only about 8,313 accounts in the central securities depository. Today we have about 170,000 accounts.

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

Step ahead. What is the significance of Deloitte becoming the worldâ&#x20AC;&#x2122;s largest professional services firm? In all honesty, we believe very little. Our focus is on helping our clients establish, define and achieve their vision so that they can step ahead with confidence in all aspects of their business. And our aim has always been, and will always be, to put our clients first. At Deloitte we have a dedicated team of individuals specialised in providing assurance, advisory and tax services to companies operating in the investment services sector. For more information on how we can help, please contact Steve Paris at sparis@deloitte.com.mt or Andrew Manduca at amanduca@deloitte.com.mt or visit ww.deloitte.com/mt

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MALTA REPORT: MSE STRIVES FOR A PIVOTAL MARKET ROLE 112

Eileen Muscat, chief executive of the MSE. “Financial services along with healthcare, tourism, information technology and communications are the four pillars of growth that the government is targeting for development,” she says. Photograph kindly supplied by MSE, November 2010.

We started with government bonds and then moved to corporate bonds and equities. Aside from government bonds and treasury bills, we have about 20 listed equities and 40 corporate bonds as well as over 300 funds from global players including HSBC, Fidelity and Lloyds TSB. Culturally, Maltese people are buy and hold investors but that is slowly changing and the numbers who are regular traders is growing.” Although Malta navigated the financial storm better than many of its larger contemporaries, the stock market did take a hit on the equity trading side with turnover dropping to €23.5m in 2009 compared to €49.1m the previous year. Total turnover though climbed 13.3% to €553m, an increase of 13.3% compared to 2008, mainly thanks to record activity in the corporate bond arena which saw 12 new listings, 11 new government securities issues as well as a €1.6bn treasury bill listing. The MSE is building upon its successes and is currently undertaking four to five major projects, including the development of investor access facilities, improvement of connectivity and the revamping of research and marketing functions. It is also looking at listing a wider selection of funds, including exchange traded and Shari’ah-compliant. While it has been successful in listing retail collective investment schemes, it has had less luck with hedge funds and the alternative sector. The hope is that it will be able to tap into a new vein of business on the back of regulatory changes that are encouraging products to be exchange traded instead of traded over the counter. The other major plank in its strategy is to the replacement of its trading platform. Unlike many of its contemporaries though, latency is not the main focus. Muscat says: “Although there have been several discussions around high-frequency traders, they have not been an issue in Malta because we do not generate the same level of volumes on the equity side. We do not see technology as an end in itself but a means to an end in order to improve our connectivity and functionality. The main goal is to attract more liquidity. “We are also working on our first cross listing, which we hope will happen by the end of the year or the first quarter of next year. I am on a learning curve from an operational point of view but I hope that once it is finished it will raise our profile.” The MSE has also been working on the finer points. It recently revised trading limits to plus or minus 10%, giving

a daily range of 20% in order to allow market participants to react faster when a company announcement is made. Although trade ranges had been revised several times since the exchange’s inception 18 years ago, many believed the methodology and procedures needed to be more proactive. In addition, the MSE launched a product in line with the EU’s shareholder directive, that enables shareholders to take part in annual general meetings electronically. It will be rolled out initially to domestically-listed companies before going to non-listed companies such as fund managers and administrators who need to maintain company records and a share register. On the post-trade front, the MSE has been busy forging technical links with other exchanges, depositories and settlement systems. It recently joined Euroclear’s FundSettle, a system that facilitates order routing, cash settlement and fund servicing across national, European and international borders. It is used as a settlement platform between fund distributors and transfer agents acting for fund promoters. The platform provides access to more than 50,000 funds and 520 transfer agents in 24 domiciles, including Malta. The MSE also struck a partnership with Clearstream, the post-trade arm of Deutsche Börse Group, to offer settlement for Maltese domestic securities. Both parties will be working closely together with the aim to improve cross-border settlement ahead of the implementation of Target2-Securities, the settlement system that the European Central Bank plans to introduce in 2014 for cross-border settlement.

A work in progress Although the deal is still a work in progress, Clearstream and the MSE will offer settlement in Clearstream via the Maltese Central Securities Depository (MCSD) for all types of Maltese securities including stocks, government securities and investment funds against Central Bank money. Muscat says: “The Clearstream deal will be done in phased stages but it allows us to offer a wider range of services to our clients. All Maltese stocks will be cleared and settled in Clearstream, which will make them more marketable and easier for international investors to invest in. The most difficult part of the process was the legal, regulatory and operational framework and that part has been completed.” As for its involvement in TS2, Muscat notes: “We are currently involved because we are one of the 27 CSDs, although we are one of the smallest. Although no one is arguing against the common principle there are still fundamental questions, particularly pricing and governance structures. These are all open to discussion and agreements may not be easy because of the diverse needs of the various users.” In terms of the MSE’s challenges, Muscat points to human resources as the biggest obstacle. “It is a problem in Malta overall but like any small organisation we need the resources in order to achieve these goals. With the best will in the world, you can only stretch as far as your finances and people. Also, as the market becomes more international and sophisticated, you need people with greater expertise and knowledge. This is changing and we have sent many people for training but it takes time.“ I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

THE NEW PE DOMICILE RIVATE EQUITY FUNDS have traditionally used Maltese special purpose vehicles to invest in target companies in view of Malta’s common law based company law regime, favourable fiscal environment for holding entities bolstered by the benefits of the relevant EU tax directives and an extensive OECD based double taxation treaty network (56 in number with effect from the first of January 2011). However Malta has rarely, up until now, been resorted to as the domicile of choice for the main fund vehicle itself or for its general partner. Malta’s regulatory framework allows private equity funds to be set up as so called professional investor funds which may be made available to different types of investors. From a structural point of view most private equity funds are typically set up as limited partnerships. Limited partnership legislation has formed part of the Maltese Companies Act for a number of years. A Maltese limited partnership has its obligations guaranteed by the unlimited and joint and several liability of one or more partners, called general partners, and by the liability, limited to the amount, if any, unpaid on the contribution, of one or more partners, called limited partners. In 2003 new provisions were introduced in the Companies Act which specifically provided for the possibility for collective investment schemes to be set up as limited partnerships with a partnership capital divided into shares. Indeed such partnerships fall within a clean and concise corporate framework which allows a limited liability company to act as the general partner of the fund, albeit the general partner would be unlimitedly liable for the obligations of the fund. The general partner would not be required to obtain a licence or other authorisation from the Malta Financial Services Authority (MFSA) so long as it is not providing investment management services to the fund. Nevertheless, the Companies Act was still unclear where limited partnerships with a partnership capital which is not divided into shares were concerned. Indeed the law did not specifically provide that such partnerships could also be collective investment schemes so doubt subsisted as to whether it was indeed possible for investment funds to be setup as such types of partnerships. In addition the general partners of such a vehicle had to be an individual or else a body corporate (i.e. an entity with separate legal personality) which has its obligations guaranteed by the unlimited and joint and several liabilities of one or more of its members.

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

MALTA REPORT: PRIVATE EQUITY FUNDS AND THEIR TAXATION

The uncertainty created by the AIFM Directive together with the changes which are expected to occur to the European regulatory landscape have encouraged private equity funds to seek alternative onshore domiciles to what has traditionally been an offshore industry. The success of the Channel Islands in attracting private equity funds from all over the globe is a well known fact and a statistic which speaks for itself. Now Malta is setting out its stall as a natural home for the private equity segment. Steve Paris, head of Financial Services at Deloitte and Dr. Andre Zerafa, partner, Ganado and Associates, Advocates outline the advantages.

These somewhat archaic rules made it unrealistic for promoters to set up their fund in Malta as a limited partnership not divided into shares since the general partner could not be a limited liability company in its own right. So while the issue of the corporate form of the general partner was resolved in 2003 with regard to limited partnerships with a partnership capital which is divided into shares it remained for those limited partnerships with participation rights rather than share capital. Considering that the vast majority of private

113

MALTA REPORT: PRIVATE EQUITY FUNDS AND THEIR TAXATION 114

Dr. Andre Zerafa, partner, Ganado and Associates, Advocates. Photograph kindly supplied by Ganado and Associates, Advocates, November 2010.

Steve Paris, head of Financial Services at Deloitte. Photograph kindly supplied by Deloitte, November 2010.

equity funds are set up as limited partnerships with participation rights this meant that Malta has not always been perceived to be a viable domicile of choice for limited partnerships without share capital. These limitations are now being addressed through new regulations which will enable a Maltese limited partnership with a partnership capital which is not divided into shares to have a general partner in the form of a Maltese or a foreign constituted limited liability company. Furthermore if the fund is constituted under a foreign law (such as Cayman, English or Scottish law) then it would still be subject to licensing in Malta so long as it is carrying on any activity in Malta. The MFSA has taken the view that the active marketing of such funds in Malta to Maltese professional clients would trigger a licensing requirement in Malta. It is then the choice of the promoter whether to incorporate the general partner in Malta or elsewhere, although it is necessary for the general partner to be a company resident in Malta in order for the fund to be resident in Malta for Malta tax purposes. Another alternative used over the years by some promoters was to set up the fund as a SICAV which is a variable share capital company. SICAVs are generally open ended investment vehicles however the Maltese Companies Act provides for sufficient flexibility for SICAVS to lock-in investors for a number of years as long as a mechanism is included in the fund’s memorandum and articles on the manner in which the fund will handle redemption requests. Specific regulations have also been issued on the manner in which SICAVs can make drawdowns from investors. This was a welcome clarification since SICAVs are not allowed to issue partly paid shares nor are they allowed to issue shares at a discount. The MFSA have also issued supplementary conditions which apply across the board to all types of funds which have a drawdown mechanism embedded in their structure. The main principles of these conditions stipulate that any request on committed funds shall be effected pro-rata among all relevant investors in the fund and that the fund may only make a fresh call for further commitments once all outstanding commitments from existing investors have been requested. Apart from the regulatory and structural aspects, the tax treatment of fund vehicles in Malta is also fundamental and should be considered up front. In terms of Maltese tax law the income of a collective investment scheme is exempt from tax at the level of the fund. Taxpayers also deriving income from other activities or sources remain liable to tax in Malta but the

income or gains derived from the fund’s activities represent an exempt category of income. Certain limitations do apply to the blanket tax exemption, but they should be of no concern to funds investing primarily in assets situated outside Malta. The Malta tax exemption on income or gain derived by the fund’s activities is supported by a zero withholding tax on outbound distributions to all persons, whether individuals or companies, regardless of their country of residence and a exemption from tax in Malta upon the disposal or redemption of the interest held in the fund regardless of its legal form. Similarly no withholding taxes are levied in Malta on the provision of services to persons resident in Malta by persons resident outside Malta, regardless of their country of residence, provided that the supplier does not have, in Malta, a permanent establishment with which the relevant service is effectively connected. Tax exemption at the level of the fund coupled with the possibility of source country withholding tax mitigation through resort to Malta’s tax treaty network and no taxes in Malta on distributions to, or gains realised by, investors brings together the benefits of an onshore location without the costs typically associated therewith. As an EU member state, Malta has implemented the European VAT directive and is thus exempt from VAT transactions in securities and the provision of services relating to the management and administration of funds. While the workings of the EU VAT system may, in practice, result in an element of unrecoverable VAT at the level of the fund or the fund manager, the extension of the VAT exemption to also cover qualifying outsourced services considerably reduces the instances which may give risk to unrecoverable Malta VAT. This aspect coupled with a reasonable degree of appropriate planning typically ensures that Malta VAT does not in fact represent a material cost to a fund or fund manager established in Malta. Malta is rapidly establishing itself as an attractive domicile for private equity funds. The planned innovations to its corporate laws, which are imminently expected, will increase Malta’s attractiveness in an interesting and challenging phase of European regulation where funds will be expected to be more transparent in their dealings and opt for onshore structures, particularly for their European based clients. Malta’s legislative framework should be able to address and accommodate the business models preferred by private equity fund promoters within a robust regulatory framework. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS

The evolution of financial markets and how specific regions react is one of the more interesting observations one can make today. What makes one location more appealing than the next? Why do new centres emerge and others fade and why are some enduring and what will happen in the future? The criteria that define these trends evolve in response to market conditions and also as reactions to successes and failures in the response to these drivers. By Mark Hedderman, chief operating officer, Custom House. ALTA IS ONE of the locations looking to establish itself as a domicile of choice for the funds industry. It faces a challenging time in an environment of fewer new fund start-ups, but it is possible that there are advantages to its emergence in period where there is such a seismic shift in what investors are demanding when they choose to allocate. The drive towards greater transparency, relevant and robust regulation and the increasing importance of the role of the administrator provides this relatively new jurisdiction with an opportunity create a model that will specifically cater to these demands. The hedge fund industry has had to react to the events of recent years and nowhere is this more evident than in the support industries that service it. Specifically, the role of an independent administrator has moved from a position of almost being seen as a necessary expense to playing a critical role in the legitimacy of a fund product. The domicile of the fund and the requirements it puts on the administrator therefore are key elements in the evaluation of the fund and in providing comfort to the investor. Administrators today are presented with increasing challenges to provide more for less. The advance in the demands for further transparency has led to increases in technology requirements as the profile of the average administrator moves from a traditional accounting services only provider to a partner in an overall complex fund product. The challenge for the administrator is to meet these increasing requirements without adding extra cost to the fund and a flexible, low cost, EU centre such as Malta can become a

FTSE GLOBAL MARKETS • DECEMBER 2010 / JANUARY 2011

useful tool for a global administrator. As well as servicing local Maltese funds there is an opportunity for Malta to position itself to service funds of other jurisdictions as part of a global operating model. There are no regulatory barriers to this and the abundant availability of knowledgeable local staff it is possible that we may see Malta emerge as a location for the wider funds industry to take advantage of. Malta has attempted to position itself as an alternative for the industry that offers the experience of what could be called the ‘offshore product’ but with the benefits of an onshore approach. The global trend as we have mentioned is for increased transparency and regulation and empowering the investor. Combining these distinct requirements in a flexible operating environment is where Malta has an advantage.

Practical regulation

MALTA REPORT: POSITIONING FUND ADMINISTRATION FOR NEW BUSINESS

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The Maltese regulator has been quick to identify that the combination of EU membership and a practical regulatory environment will be key factors in its favour to attract managers who look to create a product that can compete with the traditional jurisdictions. When choosing who to partner with in Malta, the fund looks for a local presence with a global reach. There is a challenge when selling Malta to the global market as to why one would choose to do business there and therefore the global recognition of the service provider provides comfort. This is why we now see more and more of the major providers opening offices in Malta. To date the experience has been for the administrator to react to the requirement of the funds to establish in Malta

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rather than the funds choosing to locate there because of the proximity of service providers. This is evident in the concentration of the small number of existing providers around large fund structures. As with all new trends there may be a requirement for a period of time to elapse to establish a footprint and prove that there is substance to what is taking shape. One of the key advantages that Malta has is the presence of some of the major names in the financial services world that exist in a capacity outside the funds industry but are positioned there to support it. The ‘big four’ audit firms have operations there and have already shown a willingness to engage with the administrators in assisting them to support their clients. An interesting new dynamic that we have seen is an openness to assist the administrator outside traditional audit services. A major challenge for hedge fund administrators is the preparation of financial statements as per the stated accounting standards of the fund. It used to be the case that the administrator would hand over their NAV valuations to the auditor who would then prepare the audited financials to IFRS, US GAAP etc. This obvious conflict of interests was identified in recent years as a dilution of the auditor’s function and specific reference was made to this in the famous Sarbanes Oxley Act of 2002. The culmination of this was a move away from the preparation of the financial statements by the auditors and the onus was, correctly, placed on the administrator to provide prepare the statements for audit. This placed challenges on the administrator who was not positioned to handle it and responses varied from the development of an in house function to the full outsourcing to specialist (not big four) accounting houses. What has been refreshing in Malta, which we have not witnessed elsewhere yet, is the willingness of the audit firms to prepare financial statements for funds that they are not the designated auditor of and therefore facilitate the administrator in their responsibilities. This practical and flexible approach has been very useful in the establishment of a new administrative operation where the pressures to start from scratch can sometimes lead to an overlooking of this vital function.

SICAV structures The use of the SICAV in Malta and its ability to handle multiple sub funds with their own cross collateral risk protection has been popular for both the institutional and start up structures. As the administrator of the largest number of funds in Malta, Custom House has been exposed to both ends of this spectrum. On one hand there is the Innocap structure which offers investors access to a wide variety of underlying managers via a suite of products at a feeder level. This structure has approximately one hundred valuations in its overall composition and is valued daily, making it one of the most high volume and complex products for an administrator to handle. At the other end we have the Nascent Fund SICAV which is a new umbrella product specifically designed for emerging managers to cut their teeth in a protected structure that offers legitimacy while they establish their track record.

Mark Hedderman, chief operating officer, Custom House. Photograph kindly supplied by Custom House, November 2010.

The flexibility in the structure means that managers can break free and establish their own stand-alone vehicle once they have reached a suitable size. The SICAV allows for both of these models to exist and the flexibility and protection offered make them attractive in their respective worlds.

The impact of UCITS IV There are already a number of UCITS structures operating successfully in Malta where they have targeted the Italian, Spanish and French markets. Adopting the UCITS IV directive and in particular its impact on the master-feeder structure will place additional reporting requirements on administrators. Efforts are already underway to align reporting requirements with existing models and the successful administrators will be the ones who have flexible report writing capabilities which has become an essential element of any business these past few years as reporting requirements ever expand. The financial services industry grew by over 20% in Malta in 2009. In the context of an environment of fewer fund startups there is obviously traction gaining to the Maltese story. Malta needs to position itself as a brand and also as a legitimate alternative to Dublin and/or Luxembourg. Prioritising the flexible and practical nature of the regulatory environment is vital to ensuring that Malta continues to separate itself from the more established locations. Membership of the EU and what this entails for the international managers and investors should be put to the front along with the adoption of the UCITS IV directive. Malta must ensure that it retains its evolving reputation as a ‘cando’ business centre for both funds and their service providers. It must focus on reigning in inflationary pressures that impact the cost effectiveness of locating there while at the same time continuing to make significant investment in its technology infrastructure. When canvassing potential clients about where they wish to set up their fund the first questions they always ask relate to the nature of the regulation, the cost, the administrators presence and the ability to do business there. The future is bright for Malta if they keep these factors in mind while they expand and do not lose sight of the reasons why other locations are becoming less popular. I

DECEMBER 2010 / JANUARY 2011 • FTSE GLOBAL MARKETS