FTSE Global Markets by FTSE Global Markets

SOVEREIGN VERSUS COVERED BOND RISK ISSUE 48 • FEBRUARY 2011

The DR bounce Sec lending & the CCP debate Russia’s real estate rebound The inflexibility of Solvency II

Food fight: A&P in the middle ROUNDTABLE: COUNTING THE COST OF BASEL III

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OUTLOOK

EDITORIAL DIRECTOR: Francesca Carnevale, tel: +44 [0]20 7680 5152, email: francesca@berlinguer.com, fax: +44 (0)20 7680 5155 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); Ian Williams (US/Emerging Markets/Sector Analysis); David Craik (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 2011. All rights reserved.] FTSE™ is a trademark of the London Stock Exchange plc and the Financial Times Limited and is used by Berlinguer Ltd under licence. FTSE International Limited would like to stress that the contents, opinions and sentiments expressed in the articles and features contained in FTSE Global Markets do not represent FTSE International Limited’s ideas and opinions. The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors. All information in this magazine is provided for information purposes only. Every effort is made to ensure that any and all information given in this publication is accurate, but not responsibility or liability can be accepted by FTSE International Limited and Berlinguer Ltd, for any errors, or omissions or for any loss arising from the use of this publication. All copyright and database rights in the FTSE Indices belong to FTSE International Limited or Berlinguer Ltd or its licensors. Reproduction of the data comprising the FTSE indices is not permitted. You agree to comply with any restrictions or conditions imposed upon the use, access, or storage of the data as may be notified to you by FTSE International Limited, or Berlinguer Ltd and you may be required to enter into a separate agreement with FTSE International Limited and Berlinguer Ltd.

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FTSE GLOBAL MARKETS • FEBRUARY 2011

S OUR MARKET Leader on depositary receipts proclaims, it appears that international investors cannot get enough of emerging markets right now. Good job then that this edition has a decidedly emerging and frontier markets cast. You know when emerging markets have finally become part of the mainstream when traditionally ultra-conservative European clearing and settlement facilities establish operations and ventures abroad. Euroclear Bank now offers post-trade services for Brazilian equities and domestic fixed-income securities. Transactions in these securities will be sent to Euroclear Bank’s local agent for processing in one of the three Brazilian central securities depositories (CSDs), with which it has had agreements in place through a memorandum of understanding since 2007. Frédéric Hannequart, chairman of Euroclear Bank’s board, says the move was inevitable, given that: “Brazil’s capital markets are attracting growing international investor interest. Our clients will now be able to settle transactions in Brazilian domestic securities through our agent, Citibank, in the Brazilian market”. Brazil is already the third Latin American market where Euroclear Bank offers services for domestic securities. While insurer Aon’s latest political risk map raises the unwelcome spectre of rising political risk in a number of frontier markets, downgrading some 19 countries, some 11 markets were upgraded, including Ghana, Gabon and Nigeria, “where more international trade and investment is occurring, leading to a greater need for political risk insurance cover,”notes Beverley Marsden, associate director of Aon Risk Solutions. The fact remains, however, that the emerging markets look likely to retain their appeal through 2011. With that in mind we look at one of the new brokerage operations to emerge out of China, with the potential, eventually, to become a global player. Ian Williams looks at Ping An Securities, which brought to market the largest number of Chinese IPOs last year, and explains its medium term strategic outlook. Global emerging market bonds were among the best performing assets in 2010 with corporate and sovereign bonds in local currencies doing especially well, writes Vanja Dragomanovich in her article on the growing appeal of ruble denominated bonds. The ruble bond market enjoyed one of its best ever years in 2010 and there are signs that after a brief slowdown in the first part of this year, the trends will continue. If investors in western markets are looking for positive market indications closer to home, then the pickings remain relatively slim. In part, increased regulation is causing some headaches. However, according to Andrew Cavenagh’s article, covered bonds have begun the year with a bullet, as the threat to other categories of senior debt from changes in banking regulation has actually given substantial impetus to covered bond issuance. Certainly, the level of primary issuance in the first half of January was impressive. Some $30bn of new issuance had come to market by mid-month. On the securities services side, providers continue to raise the bar. As David Simons notes in his feature on fund administration, while providers have been able to leverage the opportunities provided by the improving fortunes of hedge funds, increased regulation and client expectations have forced them to enhance the reporting service set and improve transparency. Increasingly, the business is coalescing around the main fund administrators as the cost of investments in technology required to provide these heightened services levels is resulting in an increasingly challenging business environment for niche players. Signs that the large global players are beginning to set a new agenda is clear from developments in the FX market also. Regular columnist, Erik Lehtis, looks at the potential consequences of the establishment of Pure FX, a banks-only liquidity pool for electronic foreign exchange trading. The continued rise of the proprietary trading segment, he notes, has spurred bankers to create a liquidity pool all of their own. Cornering liquidity and removing an element of transparency from the market may not be the objective of the venture: but it sure looks that way. What now?

Francesca Carnevale, Editor February 2011 Cover photo: Sam Martin, President and chief executive officer for the Great Atlantic and Pacific Tea Company (A&P), speaks at the 2010 Reuters Consumer and Retail Summit in New York. Photograph by Reuters/Brendan McDermid, supplied by Reuters, January 2011.

CONTENTS COVER STORY

A&P: STUCK IN THE MIDDLE ....................................................................................................Page 75 The 151-year-old Great Atlantic & Pacific Tea Company (A&P) was once the world’s largest retailer, the Wal-Mart of its day. Nowadays it is a pale shadow of its former self: the victim of changing consumer preferences, among other things. Even so, Erivan Haub of Germany’s Tengelmann Group and Ron Burkle of California’s Yucaipa Companies, are squaring up to battle for control of what is virtually the corpse of A&P. Is it too much far too late? Will victory be worth the effort? Art Detman reports. DEPARTMENTS

MARKET LEADER

THE WHEEL OF FORTUNE TURNS FOR LATIN AMERICAN DRS ..........................Page 6

SPOTLIGHT

RISING POLITICAL RISK IN FRONTIER MARKETS ........................................................Page 12

Corporations need more capital to expand than local markets can provide.

Capital markets reviews and news items.

THE HEAVY HAND OF SOLVENCY II ................................................................................Page 16 New regulation could spell trouble for the insurance industry.

IN THE MARKETS

OFFSHORE CENTRES COMPETE FOR A SLICE OF CHINESE GROWTH ............Page 20 Carey Olson’s Guy Coltman surveys the service set.

MARKET CATALYST OR BIT PLAYER? ..............................................................................Page 23 Emmanuel Carjat, CEO of Atrium Network, looks at the future of HFT.

COUNTRY REPORT

CAN SOME SPANISH FIRMS BEAT EXPECTATIONS IN 2011? ..............................Page 25

INDEX REVIEW

BAD NEWS DOESN’T ALWAYS BEAR DOWN ON MARKETS ..............................Page 26

Spain’s leading firms look for growth overseas. Rodrigo Amaral reports..

Simon Denham, managing director of Capital Spreads, takes the bearish view.

GERMANY: EUROPE’S STRONG PERFORMER ..............................................................Page 28 Joe Morgan reports on the pressures Europe places on German debt.

NEW REGULATION BOLSTERS COVERED-BOND ISSUANCE

..............................Page 31

Extraordinary issuance levels underscore the strength of covered bonds.

DEBT REPORT STILL ON THE PRECIPICE: CAN EXPORTS HELP? ........................................................Page 34 Who will now rescue Ireland? Andrew Cavenagh surveys the options.

THE STEADY RISE OF THE RUBLE BOND MARKET ..................................................Page 35 Foreign investors remain sceptical of the outlook for Russian bonds. Why?

ARE BANKS TAKING FX BEHIND CLOSED DOORS?

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

Dynamic FX Consulting’s Erik Lehtis outlines market fears over Pure FX.

FX VIEWPOINT THE SLOW LIFT-OFF FOR CNY-RUB TRADING..............................................................Page 39 What is the medium-term outlook for the new trading duo? Joe Morgan reports.

POSITIVE SHIFTS IN ARGENTINA’S OUTLOOK

............................................................Page 40

Argentina’s GDP grew 9% last year; but 2011 may be less sparkling.

BANKING REPORT

DUTCH BANKS SCOUT FOR NEW BUSINESS OPENINGS........................................Page 43 Can Holland’s banks find new areas of growth? Lynn Strongin Dodds reports.

FEBRUARY 2011 • FTSE GLOBAL MARKETS

CONTENTS DEPARTMENTS

WORLD CUP SETS RUSSIA NEW GOALS ........................................................................Page 46

REAL ESTATE

Mark Faithfull reports on the prospects for Russian real estate investment.

FINANCE FINDS THE MIDDLE GROUND..........................................................................Page 48 Demographics determine Egypt’s real estate investment potential.

A HOME-GROWN BUSINESS FOCUS ................................................................................Page 50

FACE TO FACE

Ian Williams explores the prospects and strategies of Ping An Securities.

A JOB FOR SECFINEX ................................................................................................................Page 53 Why Basel III will shake up securities-lending. Dave Simons reports.

DATA PAGES

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

FEATURES SECURITIES SERVICES:

TOMORROW’S WORLD TODAY ............................................................................Page 55 Hedge funds made impressive gains through 2010, giving fund administrators cause for joy as a stream of new outsourcing opportunities came their way. Shame then, that it coincided with a slew of regulatory and client demands for greater independence, transparency and enhanced reporting services. Which institutions were in a position to step up to the new bar? David Simons reports.

NEW CONNECTIONS DRIVE ASIAN SECURITIES LENDING ........................Page 59 Although the securities lending business has not recovered from the financial crisis there are pockets of hope, writes Lynn Strongin Dodds. One of them is the Asia-Pacific region, whose rate of growth is outshining others. While both traditional funds and hedge funds are setting up new shops in the region, the pace of change might be too slow for some.

TRADING REPORT:

DATA REVS UP TO NEAR THE SPEED OF LIGHT ............................................Page 65 The one million messages a second transmitted through servers to the trading desktop are a long way away from the ticker-tapes of long ago. Data analysis is one of several trends in trading technology that will become part and parcel of daily trading and the integration of pre-trade, trading and post-trade will finally become real. Ruth Hughes Liley reports.

NEW HORIZONS FOR MULTI-ASSET TRADING

..............................................Page 68 Far from being something of a gimmick, multi-asset trading is a natural evolution of e-trading, argues Ali Pichvai, chief executive officer of Quad Financial. Driven primarily by the buy side, which now wants access to a wider range of assets, the adoption of multi-asset trading is well under way. Which institutions are leading the charge? Ruth Hughes Liley reports.

THE RUN TO REAL TIME TCA ................................................................................Page 72 The rush to real time transaction cost analysis (TCA) is not without pitfalls. Accelerated analysis ratchets up the importance of reliable and consistent data inputs, many of which are not designed to facilitate TCA. Moreover, portfolio managers who obsess over minimising market impact might actually, in some cases, miss out of investment opportunities. Ruth Hughes Liley explains why.

ROUNDTABLE:

TOWARDS A BETTER UNDERSTANDING OF BASEL III

..................................Page 79 During the recent financial crisis, many banks ran out of cash quickly. Are many banks too fragile still to comply with Basel III liquidity requirements that say banks should hold enough cash and liquid assets to survive for at least 30 days without access to markets? Our latest roundtable provides the answer to this and other pressing questions.

FEBRUARY 2011 • FTSE GLOBAL MARKETS

MARKET LEADER

DRs: GROWTH IN LATIN AMERICAN ISSUANCE

Photograph © Nicholas Burningham / Dreamstime.com, supplied January 2011.

The wheels of fortune turn for DRs International investors cannot get enough of the emerging markets right now, and Latin America is no exception. It’s a two-way street, of course; the largest companies in Latin America, particularly in natural resources, financial services and telecommunications, need more capital to expand than local markets can provide. This symbiotic relationship has fuelled rapid growth in both issuance and trading of Latin American depositary receipts (DRs) in recent years—and forthcoming regulatory changes may accelerate the pace. Neil O’Hara reports. OR ISSUERS, THE natural home for depositary receipts (DRs) in Latin America has long been New York, located in the same time zone and offering access to the world’s largest capital market. A research and back office infrastructure focused on Latin America has taken root in the US, leaving companies little reason to tap London despite its renowned expertise in the mining sector. “In other regions you do see activity in London as well, but 99% of Latin American companies list on the New York Stock Exchange,” says Nancy Lissemore, global head of

depositary receipts at Citi. Not surprisingly, Brazil dominates the Latin American depositary receipts market. In fact, two Brazilian blue chips, mining powerhouse Vale and oil giant Petrobras, regularly feature among the ten most actively-traded issues on the NYSE. Citi reckons that companies based in Brazil account for 80% of the trading volume in Latin American depositary receipts, followed by Mexico with 14%—led by cement producer CEMEX, mobile telecommunications provider America Movil and media conglomerate Televisa. Chile, Argentina, Peru and

Colombia each account for less than 1% of volume and the balance comes from other South American countries. The 2008 financial crisis put a damper on initial public offering (IPO) activity in the depositary receipts market, but secondary market trading volume in Latin American issues has continued to grow. Capital markets have remained receptive to existing issuers, however. For example, Petrobras raised $10bn in 2010, the bulk of it through depositary receipts issued to foreign investors. Issuers have also used depositary receipts to finance acquisitions, including the purchase of Brazilian bank Unibanco by its larger rival, Banco Itaú, and the merger of America Movil with Telmex International, a Mexico-based international telecommunications company. “Investors are accustomed to the American depositary receipts [ADRs] programme,” says Nuno Da Silva, the regional head for Latin America depositary receipts at BNY Mellon. “Latin American ADRs often have higher trading volume than the local shares.” Ample liquidity in Latin American depositary receipts has prevented the underlying shares from migrating back to their home market, a problem that bedevilled some European ADR pro-

FEBRUARY 2011 • FTSE GLOBAL MARKETS

Send a strong signal to the global capital markets. Who’s helping you? Connecting issuers to investors is critical to the success of every depositary receipt program. BNY Mellon’s unparalleled expertise and outreach initiatives are central to this connection. Operating in 74 countries, we have opened a world of opportunities for issuers and investors — making us the world’s leading depositary bank. Working together, we can help reach your strategic goals.

For more information on Depositary Receipts, please contact: Asia-Pacific: Gregory Roath +852 2840 9821 Central Eastern Europe & Africa: Anthony Moro +1 212 815 5838 Latin America: Nuno da Silva +1 212 815 2233 Middle East: Mahmoud Salem +1 212 815 2248 Western Europe: Marianne Erlandsen +1 212 815 4747 bnymellon.com/dr Products and services are provided in various countries by subsidiaries, affiliates, and joint ventures of The Bank of New York Mellon Corporation, including The Bank of New York Mellon, and in some instances by third party providers. Each is authorized and regulated as required within each jurisdiction. Products and services may be provided under various brand names, including BNY Mellon. This document and information contained herein is for general information and reference purposes only and does not constitute legal, tax, accounting or other professional advice nor is it an offer or solicitation of securities or services or an endorsement thereof in any jurisdiction or in any circumstance that is otherwise unlawful or not authorized. Depositary Receipts: NOT FDIC, STATE OR FEDERAL AGENCY INSURED; MAY LOSE VALUE; NO BANK, STATE OR FEDERAL AGENCY GUARANTEE. ©2011 The Bank of New York Mellon Corporation. All rights reserved.

MARKET LEADER

DRs: GROWTH IN LATIN AMERICAN ISSUANCE

Nuno Da Silva, regional head for Latin America depositary receipts at BNY Mellon. “Investors are accustomed to the American depositary receipts [ADRs] programme,” he says. “Latin American ADRs often have higher trading volume than the local shares.” Photograph kindly supplied by BNY Mellon, January 2011.

Depositary receipts give investors easier access to non-resident companies, a concept usually applied to American, European or Asian investors channelling money to developing nations. The mechanism works just as well in reverse, however, which has led to the emergence of a market in Brazilian depositary receipts (BDRs) traded on Bovespa, the local stock exchange. grammes in the past. If anything, the tide flows in the opposite direction— the recent imposition of taxes on foreign exchange transactions in Brazil (intended to curb the real’s inexorable rise) has shifted even more trading in Brazilian issuers from local shares to depositary receipts in New York. While access to capital is an important consideration for many issuers, others set up depositary receipt programmes to raise their profile among global investors. A company whose competitors already have a following in the international investment community can enhance its standing through membership of what is still a relatively exclusive club. “Certain foreign fund managers will only invest in a Brazilian or Mexican company, whether in depositary receipts or local shares, if it has a US listing,” says Da Silva. “Having an SEC [US Securities & Exchange

Commission] registration gives issuers a lot of credibility. Corporate governance and disclosure have improved in Latin America but investors still have more confidence in the US model.” Four banks have dominated the depositary receipts business for years: BNY Mellon, Citibank, JP Morgan and Deutsche Bank. It’s a low-margin game that requires a significant investment in systems and expertise, but the biggest barrier to entry is structural. In sponsored ADR programmes, corporations sign contracts that usually run for five years with the bank that manages the programme. Institutional inertia makes it difficult for potential entrants to build critical mass even if they can overcome the natural reluctance to hire an untested organisation. “Why would an issuer give the business to a bank that has no experience in the depositary receipts market over one with a long

track record?” asks Da Silva. BNY Mellon handles the largest number of Latin American depositary receipts programmes, accounting for more than 70% of the total. Although the list includes five of the ten most active programmes in 2010, the total value traded is less than 40% of the figure for the four most active programmes handled by JP Morgan. About 35% of the BNY Mellon names were issued in connection with private placements that trade infrequently on NASDAQ’s PORTAL system. Another 37% are Level 1 sponsored programmes that trade over the counter but in much smaller volumes than Level 2 or Level 3 listed programmes, which require the underlying issuer to register with the SEC and comply with US securities laws. Listed issuers must also provide disclosure information in English and, unless their financial statements conform to International Financial Reporting Standards (IFRS), must provide reconciliation between the originals and statements prepared under US generally accepted accounting principles (GAAP). BNY Mellon’s competitors argue that trading volume is a better measure of market share and say they focus on programmes that have higher liquidity. Citi’s Lissemore notes that Latin American issues account for a disproportionate 25% of global trading volume in depositary receipts. “The number of programmes in Latin America is concentrated, but those programmes have very high volumes,” she says. Deutsche Bank has only recently turned its attention to the Latin American depositary receipts market. In October 2009, Deutsche won its first Level 3 sponsored programme in Brazil, for CPFL Energia, an electric utility. This mandate brought the bank widespread local recognition that generated more invitations to compete for business; it has since added several Level 1 programmes, according to Edwin Reyes, global product manager for depositary receipts at Deutsche Bank. The bank does take a selective

FEBRUARY 2011 • FTSE GLOBAL MARKETS

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MARKET LEADER

DRs: GROWTH IN LATIN AMERICAN ISSUANCE

approach, however. “We focus on programmes where Deutsche Bank can add value from the issuer’s perspective,” he says. Depositary receipts give investors easier access to non-resident companies, a concept usually applied to American, European or Asian investors channelling money to developing nations. The mechanism works just as well in reverse, however, which has led to the emergence of a market in Brazilian depositary receipts (BDRs) traded on Bovespa, the local stock exchange. These are typically programmes for international companies that have strong ties to Brazil; for example, Telefónica, the Spanish telecommunications provider that owns Telesp, the telephone service provider for Sao Pãulo, set up a BDR programme to facilitate local trading in the parent company. Two companies with operations almost entirely in Brazil have incorporated in foreign jurisdictions for tax purposes and issued Brazil DRs back into Brazil, while Banco Patagonia, an Argentine bank, combined an initial public offering in Argentina with an issue of BDRs in Brazil and a private placement of ADRs in the US. Brazilian banks, including local affiliates of the four major players, administer the BDR programmes and although trading volumes remain low at the moment, the new market could be a harbinger of things to come elsewhere. “Maybe in the future we will see Mexican depositary receipts, companies from Central America listing in Mexico, but we are not there yet,” says Alex Ibrahim, regional head for Latin America at NYSE Euronext. Ibrahim expects the Latin American depositary receipts business in New York to ramp up now that the SEC permits non-US companies to file financial statements prepared in accordance with IFRS. Brazil, Chile and Colombia require public companies to use IFRS standards from 2011 and Mexico will follow suit in 2012. “Companies, lawyers and bankers tell us the biggest cost for a company to access

Nancy Lissemore, global head of depositary receipts at Citi. “In other regions you do see activity in London as well, but 99% of Latin American companies list on the New York Stock Exchange,” she states. Photograph kindly supplied by Citi, January 2011.

Candice Teruszkin, Latin America depositary receipts sales executive at JP Morgan. Photograph kindly supplied by JP Morgan, January 2011.

the US capital markets is the reconciliation to US GAAP,” says Ibrahim. “That cost will disappear. It is a huge advantage for Latin American companies.” He says foreign issuers now recognise that the Sarbanes-Oxley Act is not the insuperable obstacle it once

appeared. In the early years after implementation, the NYSE lost a few German and UK listings, but those have been replaced and institutional familiarity has smoothed compliance procedures. “It doesn’t look good if managers say they don’t want to access the US because of Sarbanes-Oxley,” says Ibrahim.“Investors are looking for good governance and that’s what it’s all about: internal controls, active boards and so on.” That may be true for companies large enough to contemplate an NYSE listing, but Candice Teruszkin, Latin America depositary receipts sales executive at JP Morgan, still finds resistance to Sarbanes-Oxley among smaller companies. The Brazilian stock market has become more sophisticated and accessible to foreign investors in recent years, allowing smaller companies to raise money either without tapping New York at all or only through a US private placement in conjunction with an offering in Brazil. “It depends on the size and where the company wants to go,” says Teruszkin. “How much work are the investor relations people willing to do? Do they have the support of senior management to do road shows and attend investor conferences?” For larger companies, a full listing is the only option, no matter what the cost. When JP Morgan helped Banco Santander Brasil raise $8bn through an IPO in October 2009, nothing less than a Level 3 ADR programme would do. “It was the right place for them to come,” says Teruszkin. “They could not have done a private placement because the offering was huge.” In addition, the major Brazilian competitors already had a US presence: Banco Bradesco and Itaú were listed in New York, while Banco do Brasil had a Level 1 ADR. The Spanish parent company, Banco Santander, and its Chilean affiliate had already listed in New York, too. “Big issuers are no longer afraid of Sarbanes-Oxley,” says BNY Mellon’s Da Silva. “They see the benefit—a valuation premium is unlocked through a listing in the US.”I

FEBRUARY 2011 • FTSE GLOBAL MARKETS

DR Going UP:

By Roy Marmelo Latin America Sales Head Citi Depositary Receipt Services

Five Key Trends in LatAm Depositary Receipts

ven a casual observer canâ&#x20AC;&#x2122;t help but notice that Latin Americaâ&#x20AC;&#x2122;s presence in the global financial community has expanded significantly over the past few years. By nearly any standard, the region is experiencing robust economic growth. One category that bespeaks LatAmâ&#x20AC;&#x2122;s healthy growth is depositary receipts, or DRs. Local DRs are on the rise, and local asset management pools are growing and deepening. As of December 2010, more than $10.3 billion was raised in follow-on DR offerings in the region.

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It appears that is only the beginning. Tremendous additional DR opportunities have begun to emerge across LatAm â&#x20AC;&#x201D; led by Brazil, Colombia and Mexico, in particular â&#x20AC;&#x201D; across multiple sectors and industries. As the region continues to grow, new investment options continue to present themselves. Institutional investors are not only pumping dollars into traditional DRs, but are also exhibiting an increased appetite for more innovative products as well. There is no question, then, that the LatAm region is showing positive trends in the depositary receipts area. Following are the most noteworthy of themâ&#x20AC;Ś

5. Liquidity is high, flow-back is low. How does the liquidity of Latin American DRs compare to rest-of-world? Measured by trading volume per program, LatAm has the globeâ&#x20AC;&#x2122;s most liquid programs, with 381 million DRs traded per program, vs. 117 million in Asia and 270 million in EMEA. It should be noted that the LatAm market is highly concentrated with the top 10 issuers account for 80% of the regionâ&#x20AC;&#x2122;s DR liquidity.

1. Trading volumes are on the rise. For the three-year period ending December 2010, total LatAm trading volumes have increased at CAGR 14%, with most of the growth coming from Brazil and Mexico. The LatAm region totaled approximately $36.7 billion in depositary receipts in the 12-month period ending December 2010 (nearly all from companies that trade on the New York Stock Exchange). That accounts for about 25% of total exchange-listed DR liquidity â&#x20AC;&#x201D; a proportion that has remained constant over the last three years. 2. Brazil leads the way. For the year ending December 2010, Brazil led the region with about 82% of total trading volume, driven by large companies such as Vale ($8.6B), Petrobras ($6.2B), Itau ($2.9B) and Bradesco ($2.5B). Mexico was the second-most active country, with about 14% of trading volume, driven by Cemex ($2.7B) and America Movil ($0.9B). Chile, Argentina, Peru and Colombia also posted gains. 3. Global, capital-intensive companies are most active. The companies that have been most active in issuing depositary receipts are those with outsized capital requirements and an international presence. They cut across multiple industry sectors, including basic materials (36% of DRs), financials (22%) and energy (17%), which have collectively contributed three-quarters of total liquidity. Of particular note: In 2010 Brazilian energy giant Petrobras raised $10 billion in follow-on capital. 4. Major global players are buying. The principal purchasers of Latin American depositary receipts are global household names in Investment Advisory and Mutual Fund Management services. These sectors account for more than 75% of investment in LatAm DRs. The top five LatAm DR holders are:

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[visual: â&#x20AC;&#x153;LatAm DR Investors by Categoryâ&#x20AC;? pie chart]

While liquidity is high, flow-back is low, in comparison to some Asian countries, LatAm does not show a strong flow-back trend, cancellations being part of standard flow-back activity, more often followed by subsequent issuances. Overall, LatAmâ&#x20AC;&#x2122;s DRs outstanding have grown by 16% since 2007. Overall, these are positive, exciting times in the LatAm DR space. No matter how one evaluates the category â&#x20AC;&#x201D; whether via quantitative metrics or qualitative trends â&#x20AC;&#x201D; 2011 is shaping up as a potentially record-setting year. And over the longer term, DR activity will grow as the regionâ&#x20AC;&#x2122;s visibility and global expansion continue to increase. About the author Roy Marmelo is ADR Regional Director of Sales and Account Management for Latin America for Global Transaction Services (GTS) of Citibank. He has over 17 years experience working n Depositary Receipts and Corporate Trust services, with the Latin American Capital Markets and corporate issuers. Prior to re-joining Citibank in 2007, Roy was with JPMorgan and Bankers Trust. He holds a BS in 'JOBODF BOE .BSLFUJOH GSPN /PSUIFBTUFSO 6OJWFSTJUZ Roy can be reached at roy.marmelo@citi.com or 1-212-816-6827. About Citi Citiâ&#x20AC;&#x2122;s Depositary Receipt Services is a leader in bringing quality issuers to the 6 4 BOE PUIFS NBSLFUT BOE QSPNPUJOH %FQPTJUBSZ 3FDFJQUT %3T BT BO FGGFDUJWF capital markets tool. Citibank began offering ADRs in 1928 and today is widely SFDPHOJ[FE GPS QSPWJEJOH OPO 6 4 DPNQBOJFT XJUI B HBUFXBZ UP UIF SFTPVSDFT of Citi and the means to diversify shareholder bases and increase liquidity. For further information, visit www.citi.com/dr. As a leading global financial services company, Citi has approximately 200 million customer accounts and does business in more than 140 countries. Through its two operating units, Citicorp and Citi Holdings, the bank provides consumers, corporations, governments and institutions with a broad range of financial products and services, including consumer banking and credit, corporate and investment banking, securities brokerage, and wealth management. Additional information may be found at citi.com.

SPOTLIGHT

Rising political risk in frontier markets AON’s political risk map outlines key changes WHILE THE WORLD economy is broadly on the road to recovery, the level of political risk has risen in more countries than it has declined, according to Aon’s 18th annual Political Risk Map. “Political risk will continue to be a major influencer for businesses transacting in emerging markets in 2011,” says Beverly Marsden, associate director of Aon Risk Solutions’ crisis management practice, the global risk management business of Aon Corporation. “While the apocalyptic predictions many made at the beginning of the financial crisis did not come to fruition, a new norm in world trade is being established. We believe that political risk will remain elevated while the markets are unstable, but will return to traditional levels as the world economy improves.” Aon Risk Solutions measures the political risk of 211 countries and territories based on the level of risks such as currency inconvertibility and exchange transfer; strikes, riots and civil commotion; war; civil war; sovereign non-payment; political interference; supply-chain disruption and legal and regulatory risk. “The

perceived or actual risk of sovereign non-payment continues to be an issue in countries across the globe. For example, we have seen 13 island nations move into a higher risk category this year because of the effect of a decline in tourism on their economy,” she adds. The map ranks countries on a sixpoint scale from “low risk” to “very high risk”. A total of 19 countries were downgraded on the 2011 map while 11 countries were upgraded. Iceland, for instance, this year became the first Western European country to be downgraded to “medium”. “This year’s map also highlights the continued emergence of several markets in Africa, such as Ghana, Gabon and Nigeria, where more international trade and investment is occurring, leading to a greater need for political risk insurance cover,” she adds. “There is good news too: over the past five years, the map has highlighted a 30% increase in the number of countries in the middle of the risk rankings—”medium low” to “medium high” categories—as these countries have become more active

in the world economy and their prosperity has increased. Globalisation has been blamed for recent incidents of economic volatility, but it has also had a positive impact on global political and economic stability. Many countries previously designated as “medium high” or “high” have taken advantage of global trade links and seen political risk levels decrease. Foreign exchange, sovereign nonpayment, political interference and civil war or conflicts are key areas of concern highlighted by the map. The 2011 map shows 34 countries with a significant level of the risk of war, civil war or insurrection breaking out, up from 29 last year. These countries include Madagascar, Niger, Venezuela, Kyrgyzstan and Thailand. Angola, Chad, Belize, Austria and Bahrain are posted as possible areas of sabotage or terrorism. Meanwhile, 76 countries could see problems this year in making payments in contract currency or in transferring currency outside the country due to the imposition of local currency controls. I

RBI €1bn benchmark issue oversubscribed First Austrian bank unsecured bond issued in over two years RAIFFEISEN BANK INTERNATIONAL AG (RBI) has issued €1bn in senior notes in the form of a fixed-rate bond with a three-year tenor. The pricing was fixed at the lower end of original price guidance at mid-swaps plus 145 basis points (bps). The bond pays a coupon of 3.625% and the transaction was jointly led by DZ Bank, Deutsche Bank, HSBC and

RBI itself. The bond, which marks the first unsecured bond issued by an Austrian bank in more than two years, was oversubscribed within a few hours. “The success of this issue reflects the outstanding reputation of the Raiffeisen brand and the positive macroeconomic outlook for our home market, Central and Eastern Europe,” claims Martin Grüll, chief financial officer of RBI. “The bond was not only more tightly priced than issues of banks

with a comparable rating, but also significantly oversubscribed due to the strong demand for it,” he adds. The long-term debt ratings of RBI are as follows: A1 (Moody’s), A (Standard & Poor’s) and A (Fitch). The bulk of the distribution was to Western Europe, with demand spanning various classes of investors such as funds, banks, money market managers, pension schemes and insurers, as well as retail investors. I

FEBRUARY 2011 • FTSE GLOBAL MARKETS

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

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ĂŶĂůǇƐŝƐ ŝŶƚŽ ĂĐƟ ŽŶ

SPOTLIGHT

New rules on rep offices in China Bureaucracy and business costs could rise

Photograph © Kheng Guan Toh / Dreamstime.com, supplied January 2011.

Ratings Agency Backs Down On Bond Strategy Covered-bond programmes safe from downgrades STANDARD & POOR’S has backed away from a change in rating strategy that would have forced it to downgrade many covered-bond programmes—potentially by several notches from the triple-A level that is still the norm for the asset class. S&P had proposed to introduce new criteria for all its structured finance ratings that would take much more account of the counterparty risk involved. This would have been potentially far more damaging to the covered-bond market than the agency’s previous change a year ago, which linked the ratings of bonds more closely to those of their issuers, for two reasons. It would have led to considerable uncertainty over the impact on ratings of outstanding transactions (as the names of counterparties are not usually publicly disclosed), and more importantly could have prompted far more drastic downgrades than the earlier change, most of which only involved a migration from the triple-A to double-A level. S&P announced that the new counterparty criteria would apply to securitisations but not covered bonds until it had reviewed the situation. I

FROM MARCH 2011, the costs and formalities of establishing and operating a representative office in China may increase. Foreign companies and their existing representative offices in China will need to conform to shorter time limits, new reporting obligations and stricter limitations on their business scope. Tougher penalties will be imposed if related legal restrictions are violated. For many foreign companies, establishing a representative office has been the most efficient first step to enter into the Chinese market to date. From 2011, this form of business structure will need to be carefully considered. The Regulations for Administration of Registration of Resident Representative Offices of Foreign Enterprises were published by the State Council on November 19th last year and will take effect as of March 1st. The new rules define the nature and scope of a representative office of a foreign enterprise in more detail, making the registration procedures more burdensome. The rules reinforce the restrictions on the business scope of a representative office, which will only be permitted to carry out market research, presentation and promotional activities in relation to its parent company’s products or services. In addition, representative offices will also be allowed to undertake liaison activities in relation to product sale, service provision, domestic procurement and domestic investment. The current local practice of tolerating operational businesses by a representative office may no longer be continued and the authorities will pay closer attention to such activities. The rules also increase the administrative burdens and expenses of establishing and operating a

representative office significantly. Some new requirements were introduced in January 2010 by a circular issued by the State Administration for Industry and Commerce and are now standard, for instance. Only foreign enterprises that have existed for more than two years can set up a representative office in the People’s Republic of China (PRC) and the office can hold a maximum four staff, including the chief representative. Moreover, while restrictions on the location of representative offices no longer apply, the State Administration for Industry and Commerce (SAIC) can order a representative office to relocate in accordance with the requirements of national security and public interests. Also, the articles of association of the foreign enterprise must now also be submitted to the SAIC. An annual report on the offices business activities must be filed with the SAIC, which must also be notified of any changes concerning its registration or authorised signatories, corporate structure, capital (assets), business scope or legal representative of its parent company within 60 days. If a representative office has been ordered to shut down or its registration certificate has been revoked or cancelled by the SAIC, no new representative office of this foreign enterprise can be registered within the following five years. The exception to this is voluntary deregistration. Fines for breaches of the rules have also been increased. The new rules can be seen as a clear signal that the PRC government no longer tolerates operational activities carried out by representative offices. Foreign investors who engage in operational activities in China are encouraged to consider restructuring their business into the form of a wholly foreign-owned subsidiary. I

FEBRUARY 2011 • FTSE GLOBAL MARKETS

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IN THE MARKETS

INSURANCE: REGULATION & INVESTMENT IN A LONG, SOFT MARKET

Photograph © Roberto Pirola / Dreamstime.com, supplied January 2011.

The heavy hand of Solvency II Insurance companies tend to be conservative investors. Their focus on the long run and reliance on safe assets has enabled the investment portfolios of most insurers to avoid the worst effects of the global crisis. Nonetheless, a surge of new regulation threatens to tie the hands of their chief investment officers. It could spell trouble not only for the insurance industry, but also for the global economy as a whole. Rodrigo Amaral reports. NSURANCE COMPANIES ARE no small-time investors in capital markets. Swiss Re, a leading reinsurer, has estimated that, collectively, the sector held assets worth $22.6trn by the end of 2009. That puts them on a par with mutual funds and pension funds, and way above flashier players such as hedge funds. Moreover, insurers allocate most of their investments to government and high-quality corpo-

rate bonds, and often keep them in their books to maturity, in an effort to marry long-term liabilities to long-term assets. It doesn’t mean, however, that they don’t need sophisticated strategies, or that they abhor investing in riskier instruments. They deploy such weapons anyway, not least to diversify risks, a wise move especially in times when government bonds are looking less safe than ever. That’s why the words

Solvency II have, of late, kept many an investment officer awake at night. They fear that a new set of European rules for the insurance sector could make it more difficult to use some vital tools in their trades. Solvency II, which is expected to come on stream in January 2013, is a European-wide prudential regulation which will try to ensure that the insurance industry will always have enough money on hand to pay out against claims. In a marked difference from previous rules, it will govern the way insurance companies manage risks inherent in their businesses. Experts accept that such an approach makes sense: after all, insurers earn their bread and butter by taking responsibility for risks that other companies or individuals don’t want to keep to themselves. Being solvent is therefore a must for any given company, and the perception by buyers that insurers are financially sound is paramount. Even so, some people believe that regulators could be applying too much of a heavy hand in the drafting of Solvency II, at least when it comes to investments. Once the directive is in place, insurers will assign a risk weighting to each asset class that is represented in their investment portfolios. To clarify things a little, the authorities are also devising a standard formula that, although nonmandatory, will certainly inform how investment officials must proceed. “The standard model is very rigid and applies fairly penal rates on certain asset classes,” says David Osborne, a senior consultant at Meridian, an investment advisory firm. “From the point of view of an investment manager, you can only wonder whether the authors of the directive have been influenced by political approaches to vehicles [such as] hedge funds, which are penalised very severely.” The fact that Solvency II penalises some asset classes does not mean that insurers cannot invest in them; but it forces insurance companies to put aside more capital as a buffer to the eventuality that their investments come belly up. As the

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IN THE MARKETS

INSURANCE: REGULATION & INVESTMENT IN A LONG, SOFT MARKET

directive is expected to greatly increase capital requirements for insurance companies, in practice it risks turning investments in certain assets into a non-option for all but the largest and best capitalised firms. This recognition has set off the alarm bells. In France, Juan Azéma, the chief executive officer of Groupama, a large insurer, has warned that Solvency II could drive insurers’ capital out of equity markets, a trend that, according to him, has already cost €400bn worth of investments for French-listed companies in recent years. He recalled that a recent conference on Solvency in Paris showed that insurers are major investors in France’s capital markets, whereas pension funds are not significant players. Surveys among French insurance companies have found that even after the 2009 equity boom, they have steered away from equities and private equity funds, as they wait to see how the directive will treat such investments. In a recent study, the Boston Consulting Group has also noted that Solvency II’s “capital requirements will be much more sensitive to corporate credit quality”. It could mean bad news for companies looking forward to raising money in the capital markets in times of scarce banking credit, especially if they are seeking long-term capital. It might be less traumatic to get shortterm funding, though. Consultancy firm Oliver Wyman stressed in a recent report that three to five-year corporate bonds should become the asset class of choice for European insurers, thanks to Solvency II. All these restrictions could also hinder the ability of chief investment officers to deliver the performance that insurance companies need to meet their actuarial commitments and maintain a healthy balance sheet. Investments in sovereign bonds, for example, will also be weighed according to the issuer, with Organisation for Economic Co-operation and Development (OECD) countries being favoured by the regulators. The same goes for other securities, which could prevent European insurance companies

benefiting from opportunities in high growth, economically solid emerging markets, such as China and Brazil. “I welcome the focus on the asset liability framework, though find in the current market environment the regulatory-induced preference for government bonds not unproblematic,”notes Guido Fürer, the head of the chief investment office at Swiss Re. “Interest rates remain unusually low and their outlook uncertain. Furthermore, 2010 has clearly shown that government bonds are not ‘risk-free’ either,”he says.

Impact of inflation It is likely that the job of investment officials will become, if anything, much more complex. Hedging investment risk will become ever more important. Osborne points out, for instance, that Solvency II will make insurers concerned about the impact of inflation on their investments, and look for ways to reduce this risk. “Some assets can be reasonably good tools for it, like equities, index-linked bonds, property. Or they can use derivatives to pass on inflation risk to somebody else. This will be new for many insurers, especially small and medium size companies,” he says. Where there is risk, there is opportunity, and the changes to be implemented by Solvency II could turn into a kind of a blessing for asset managers, even if they find it even more difficult to sell insurers their most creative products. In a fiendishly competitive and complex field, many insurers could decide to delegate a larger share of their asset management activities to third parties in order to focus on managing their risks. “It will be more important for insurers to have a strong capability in liability management,” argues Astrid Jaekel, an insurance expert at Oliver Wyman.“If they have a solid liability management approach, the fact that they keep their asset management activities in-house or outsource them is not a determinant.” It could, therefore, go down to cost considerations, an important consideration for medium and small compa-

nies, as Solvency II is expected to load them with extra costs and administrative burdens. Insurers can maintain much of their freedom to implement their investment strategies by developing their own investment risk management models that could replace the standard formula while keeping in line with the regulators’ requirements. Even so, developing new models costs millions of euros, and only the largest insurers and reinsurers can keep pace. “In firms with a strong capital position, the investment department will have much greater scope for adding risk adjusted value,”argues JP Morgan Asset Management in a recent paper. “ In firms with a weak capital position, investment departments will need help.” Deutsche Bank has already reported that it has been sought out by a growing number of insurance firms that are considering outsourcing their asset management activities in the wake of Solvency II. Swiss Re, for its part, notes in a report that this is a trend already under way all around the world. Despite the concerns, if well calibrated, the new rules could help European insurers to become stronger and even more competitive in the long run. “Lower financial market volatility benefits institutional and long-term investors as well as the real economy,” Fürer says. It is not all plain sailing. In its report, Swiss Re observes that “poor investment performance would make the sector less attractive to shareholders and bondholders, thereby raising insurers’ costs of capital”. Too heavy a hand could also hamper the ability of European insurers to compete with their rivals from elsewhere in a very tough market. As insurers continue to live through a long soft market, there is an assumption, says Osborne, that European insurers will have to put up significant amounts of extra capital to comply with Solvency II. “That is likely to become a competitive disadvantage, especially as nobody seems to be expecting to make a profit in 2011.” I

FEBRUARY 2011 • FTSE GLOBAL MARKETS

IN THE MARKETS

CHINA SYNDROME: OFFSHORE JURISDICTIONS OFFER SOLUTIONS

China’s foreign direct investment (FDI) rose to $58.35bn in the first seven months of 2010, having topped $95bn in 2009, according to the United Nations Conference on Trade and Development (UNCTAD); no mean feat for foreign investors who have to tackle several hurdles to be able to invest in the country at all. Both China’s national and regional governments remain nervous about the prospect of the wealth flowing out of the country and have erected barriers to make it difficult for wealthy Chinese to invest abroad and for foreign investors to enter the domestic market. Corporate partner Guy Coltman at Carey Olsen in Jersey focuses on what offshore jurisdictions can offer to investors who want to leverage China’s growth story.

Offshore centres compete for a slice of China’s growth NVESTORS ARE KEEN to take advantage of the ever-burgeoning Chinese economy, particularly in construction, real estate and some consumer-driven products. To date, the country’s foreign direct investment (FDI) is most commonly structured through holding companies incorporated in offshore jurisdictions. The Cayman Islands and the British Virgin Islands (BVI) have been, and continue to be, the offshore jurisdictions of choice for these structures. However, there are many other offshore jurisdictions keen to get a significant part of the Chinese pie and are doing much to make themselves known in China. Jersey Finance has opened an office in Hong Kong and GuernseyFinance has opened an office in Shanghai. These Channel Islands offshore international finance centres are keen to demonstrate their advantages to investors looking at China, and Chinese/Hong Kong residents looking at setting up structures offshore, but there are some hurdles in China’s rules governing foreign investment. For example, the Chinese government appears to be shutting down avenues for foreign investment— through Circular 10—and the commerce ministry has ordered local authorities to halt the approval of some foreign property investments and stop speculative purchases. Circular 10 is designed to tighten up on “round-trip investments”. This

Photograph © Shenie / fotolia.com, supplied January 2011.

applies where Chinese domestic companies are reorganised into an offshore holding company structure and their ownership is moved to the offshore level. This type of restructuring has often been used to facilitate private equity investments in Chinese companies and to prepare companies for listings on global stock markets. The Chinese government has become uncomfortable with round-trip investment structures since it can lead to the transfer of ownership outside of China and Circular 10 requires Chinese nationals and residents to obtain both national and local gov-

ernment approval before transferring assets into an offshore vehicle. Such approval can be difficult to obtain.

Asset transfer regulations Several international investors have established deal structures which are compliant with the asset transfer regulations, including maintaining assets within the ownership of a People’s Republic of China (PRC) entity, which contracts to provide the economic benefit of those assets to an offshore vehicle owned jointly by the foreign investors and PRC residents. The struc-

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IN THE MARKETS

CHINA SYNDROME: OFFSHORE JURISDICTIONS OFFER SOLUTIONS

Several international investors have established deal structures which are compliant with the asset transfer regulations, including maintaining assets within the ownership of a PRC entity, which contracts to provide the economic benefit of those assets to an offshore vehicle owned jointly by the foreign investors and PRC residents.

Guy Coltman, corporate partner at Carey Olsen. Photograph kindly supplied by Carey Olsen, January 2011.

tures also ensure that the PRC founders of an offshore vehicle, which is whollyowned by foreign investors, will be able to take a stake in that vehicle over a period of time. There is always the risk that the Chinese government will decide these structures no longer comply but, for now, it is an opportunity for investors despite the apparent tightening of the rules. China has extremely strict requirements that a non-resident must meet in order to qualify for tax benefits under its tax treaties and recent guidance issued by the State Administration of Taxation (SAT). Shelf or conduit companies may not be used only for the purpose of enjoying treaty benefits. The SAT will scrutinise every structure to ensure it has both commercial and economic substance. The SAT has issued Circular 698 to discourage transactions with the dominant objective of avoiding China’s capital gains tax through an indirect transfer of shares. The SAT, using the “substance over form”principle, can disregard the existence of the intermediary holding company if it lacks a reasonable business purpose and was established for the purpose of avoiding tax. The result would be that the foreign investor would be subject to Chinese withholding tax on capital gains derived from the transfer. Where the

offshore holding company can show substance, then the structure should not fall foul of this principle. For China’s growing high net worth investors there is a distinct lack of opportunity to invest outside the republic due to strict government rules but this appears to be easing. According to the China Daily newspaper, the government of the eastern Chinese city of Wenzhou has launched a pilot programme to allow residents to invest directly overseas. A Wenzhou resident can invest overseas directly, with a cap of $200m a year and the amount invested in a single project must not exceed $3m. Under the trial, residents are not allowed to invest in overseas property or equities markets. It is a small step but it indicates some motivation towards the liberalisation of current investment rules.

QDII requirements There is also the Qualified Domestic Institutional Investor (QDII) scheme, which allows Chinese outbound investment. The scheme lets investors invest in foreign securities markets via certain fund management institutions, insurance companies, securities companies and other asset management institutions which have been approved by the China Securities Regulatory Commission (CSRC). It allows Chinese institutions and residents to entrust Chinese commercial banks to invest in financial products overseas. Numerous requirements need to be fulfilled under the QDII scheme but one that has the traditional Crown Dependency offshore jurisdictions (Guernsey, Isle of Man and Jersey) currently out in the cold is that the stocks invested in or the fund linked must be listed on, or be

incorporated in, an approved jurisdiction that has signed a memorandum of undertaking with the CSRC. The Crown Dependencies have yet to do this. The biggest issue for offshore jurisdictions in the first instance however, remains how to attract investors to their jurisdiction over the commonlyused Cayman and BVI. Certainly, Singapore and Hong Kong are trying to make inroads. Recent tax changes in China mean it can be more tax advantageous to use a Hong Kong or Singapore company. Further afield there is Jersey and Guernsey. While much of the investment world knows that the Channel Islands offer a highly attractive proposition, China is relatively unfamiliar with this part of the world. It is fair to say that in the past Chinese investors have looked for the quickest and simplest way to set up their investment structures and continue to use the BVI and Cayman Islands due to the low cost and familiarity of the services they offer. However, now that Jersey companies can, and have, listed on the Hong Kong Stock Exchange, and the fact that Jersey companies seem to be the jurisdiction of choice for Chinese businesses looking to obtain a London listing— over a quarter of Chinese businesses listed on the London Stock Exchange’s AIM market use a Jersey holding company—China’s familiarity with Jersey is growing. As China becomes more accessible to the rest of the world and, in particular, investors from the US and Europe, matters such as a jurisdiction’s reputation, regulatory framework and the quality of its professional services will start to count for more than simply costs and familiarity. I

FEBRUARY 2011 • FTSE GLOBAL MARKETS

HFT TRADING: BECOMING PART OF THE MAINSTREAM

Photograph © Andrei Radzkou / Dreamstime.com, supplied January 2011.

Market catalyst or bit player? Regulators question whether it is fair that high-frequency trading (HFT) firms, with the budgets and intellectual capacity to exploit the market, should be permitted to co-locate next to exchange servers. Why all the fuss? HFT technology is just a toolset which helps firms achieve better execution. The fact is that nowadays in some quarters HFT has become a pejorative term and is blamed for allegedly fuelling the “Flash Crash” and for stoking market volatility. A very real risk is that anticipated regulation may be overly burdensome, even restrictive, in enabling true competition to thrive. Encouragingly, the highfrequency trading firms have responded publicly and some have formed a lobbying group to counteract industry and media hype. Emmanuel Carjat, chief executive officer of Atrium Network, explores the role of HFT and sets out some considerations in anticipation of heightened regulation. HESE DAYS, ANY high-frequency trading (HFT) seminar is populated by delegates who are often not representatives from HFT firms; instead they are dominated by teams from the buy side, the organisations that trade on behalf of pension funds. The pension industry is up-scaling, increasing investments, trading toolsets and investigating technological possibilities in the realisation that they must innovate to survive. Their challenge lies not in choosing between technology provision but in the firm’s ability to embrace it. Actually, it is often smaller, more agile firms that can often adopt new technologies rapidly to secure competitive advantage. In comparison, larger more cumbersome buy side firms sometimes struggle to do the same. In which case: should smaller firms be pe-

FTSE GLOBAL MARKETS • FEBRUARY 2011

nalised and instructed to hold back on change to allow larger firms to catch up? Obviously, the answer is no—the focus should be on helping the larger firms overcome internal obstacles to invest in the technology on offer. Trading strategies must be adapted in much the same way, particularly as right now order sizes are down and volumes up, orders must be broken down so the market cannot second guess trading intentions. With buy and hold strategies adapting, both trading tools and strategies must evolve together.

‘Flash Crash’ concerns There has been a great deal of consternation about last May’s “Flash Crash” happening in other markets. Actually it is very difficult for that to happen; in fact it would not happen at all in Europe.

The US markets operate using the socalled “trade-through rule” under the regulatory auspices of Regulation National Market System (Reg NMS). When trading an order on a venue (exchange or ECN), in the event of a better price being available on another venue, it is the responsibility of the venue to on-route the order to that venue. As prices began to plummet, the trade-through rule redirected trades to other venues and, some would argue, exacerbated the price implosions. Moreover, unlike Europe, where there are circuit breakers in place; none were in place last year in the US. Breakers have now been implemented in the US markets and ensure trading is halted and the market is given a chance to adjust and avoid the acceleration of falling prices. HFTs certainly cannot be blamed for the impact of plummeting prices last year. One question is pertinent however: should HFTs have continued to make markets during the Flash Crash and put up liquidity? Perhaps, but it is important to remember that they were under no obligation to do so. Had they been, those responsible for the running of a fair and orderly market surely would have held them accountable for their regulatory obligations. Tellingly perhaps, we have seen no fines imposed. Actually, some of those HFTs now operate under the regulatory obligation of market makers to put up prices. It is also interesting to note the mixed views

IN THE MARKETS

HFT TRADING: BECOMING PART OF THE MAINSTREAM

about whether the HFTs ran away from the market and prices fell or they stayed and manipulated the market. The naysayers cannot have it both ways. That said, the Flash Crash was terrible. It wiped billions of dollars from stocks and many were trading at a penny for some 20 minutes. Five years ago, the markets would have closed in entirety, but in today’s markets, the markets were up and trading at previous prices within the hour. That is market evolution. No question. HFTs are not saints; they are hungry and highly competitive. Indeed, they could destroy companies as quickly as the next HFT firm and they have certainly changed the shape of market as trading participants. Even so, as is the case in other business sectors, competition should encourage innovation. Look at Google taking on Microsoft taking on Netscape. That is the marriage of capitalism and technology in play; it should be no different in the capital markets.

Innovation will continue HFT trading technology can be likened to Formula One racing: there are small niche players, who have the necessary investment, the strategic thinking and the bank accounts to bank-roll new technological development. Take, for example, field-programmable gate array (FPGA). Historically, latency efficiencies have been achieved through network and software programming. FPGA is about hardware programming which exponentially improves latencies but FPGA changes this. Instead of programming software, FPGA enables programming directly onto the hardware itself, removing any software connectivity latency and re-inventing opportunities for speed advantage. To extend the Formula One analogy, both HFT and F1 racing exist in a changing regulatory environment, teams are competing fiercely and continually using technology to achieve their ambitions—faster racing to improve performance and faster trading to get a better execution performance.

Emmanuel Carjat, chief executive officer of Atrium Network. Photograph kindly supplied by Atrium Network, January 2011.

Dark pools serve a useful purpose, helping buy side firms trade larger positions without alerting the market to their trading intentions. As any buy side firm will tell you, trying to unwind a five-day trading position is hard. Without using dark liquidity it becomes an order of magnitude worse—and of course HFTs are using dark pools—as they are plugged in to the various multilateral trading facilities (MTFs). Like any other liquidity taker, it will likely be involved in a bit of a fishing expedition, but ultimately they serve a purpose by representing the other side of a trade, either in a lit or dark market. If they do find the other side, who can blame them for being there? No one would blame a buy side firm, why blame an HFT? Again, it is important to note that dark liquidity only represents about 3% or 4% of total market volumes. Dark pools have a role to play as do other sinister sounding components in the trading world (such as iceberg orders) and we encourage regulators in ensuring that as new broker dark pools (or systematic internalisers) are launched, they too are regulated to the same standards as the MTF and exchange dark order books.

Increased volumes One driver for change in equities and HFT trading has been in straightthrough-processing. At the end of the 1990s the US operated on a T+5 model. The trade was made by phone, agreed,

entered into the system and everything was accounted for manually. Once all the systems were aligned manually and duplicative processes removed, more efficient machines began taking over. Less or no rekeying has enabled faster trading and accelerated high-frequency trading, and we will see the same applied to over-the-counter (OTC) trading. As soon as trading information can be standardised and distributed in an electronic format—in the same way as FIX and other protocols— there will be increased efficiencies which will generate increased volumes.

Sophisticated traders The markets continue to innovate and where the equity trading market has led, markets in other asset classes will no doubt follow. Many of these are highly complex, fragmented and operate largely on an off-exchange/OTC basis. HFTs are, as all sophisticated traders, fast to exploit investment performance opportunities whether FX currency pairs, OTC derivatives and contracts for difference, even mutual fund trading. Clearing and settlement is also in line for substantive change. Today, clearing costs in Europe are still eight to ten times higher than in the US and as interoperability becomes a reality, the European markets must become more attractive to the international trading community. In a world increasingly governed by regulatory caution, regulators should perhaps remember the hard-fought struggles for efficient, improved technology and innovation. Moreover, market relationships are also in flux: in many ways the sell side has now became the buy side. More change is under way with the enforcement of the Volker rule in the US, and proprietary trading desk staff are now leaving to set up their own trading firms. Come what may, one thing is for certain: innovation must continue because ultimately this will make the markets more efficient, which will benefit the end investors and make the European markets more attractive on an international scale. I

FEBRUARY 2011 • FTSE GLOBAL MARKETS

COUNTRY REPORT

ADRID’S IBEX 35 HAS been one of the heaviest hit indexes over the past 12 months, while European stock markets have performed pitifully. “Spanish equities have suffered with the increase of risk aversion in the market, and also with the effects of the European sovereign crisis,” says Alberto Roldán, the head of research at brokers Inverseguros, in Madrid. Between January and September 2010, the IBEX 35 lost almost 10% of its value, mainly due to concerns over the Spanish economy. Long gone are the days the IBEX 35 tipped 16,000 points, its peak in 2007. In 2008, the index fell below 7,000, but recovered strongly in 2009 to around 12,000. Recent months, however, have seen a downward slope for Spanish stocks. The index has been languishing at around 10,500 recently. According to the most recent forecasts by the European Union (EU), economic recovery will be very modest in 2011, when GDP should grow by 0.7%. However, unemployment levels, which hover around 20%, give little sign of a turnaround. It’s not helped by the fact that the economy has lost competitiveness since the adoption of the euro. The fiscal position of the government is deteriorating, private debt is very high and the bursting of the country’s massive property bubble has undermined the long-term health of Spain’s banking sector. The outlook for other sectors is also bleak and Spanish businesses appear unlikely to push stock prices up in the near term. However, those companies that made the effort to expand their international businesses in the run up to 2008 might benefit this year, potentially boosting their stock price. “The best hope for the Madrid exchange to resume gains is the fact that a large share of rev-

FTSE GLOBAL MARKETS • FEBRUARY 2011

Photograph © creative / fotolia.com, supplied January 2011.

Spain’s equity markets had a poor 2010 as listed companies paid the price for the lack of confidence in the domestic economy. Even so, analysts believe that Bolsa de Madrid, could recover in the short term, even if the Spanish economy continues to disappoint. If Spanish equities have any reason for cheer in the near future, it will almost most certainly come from abroad. Rodrigo Amaral reports from Madrid. enues of the IBEX companies come from outside Spain,” explains Pedro Valín, the head of Forecast, an analysis firm in the Spanish capital. “If the United States, Germany and the emerging economies continue to recover, Spanish stocks could receive a boost.” According to Bolsas y Mercados Españoles (BME), the company that owns a slew of Spanish exchanges, more than half of the IBEX 35 companies’ revenues come from outside Spain, and the ratio is on the rise. Spanish multinationals in areas such as energy (especially renewables), banking and infrastructure have set out their stalls in the US, Eastern Europe, Asia and Latin America. “The market makes too close a connection between Spanish equities and the Spanish economy, and that’s not the real situation,” Roldán says.

EQUITY MARKET: HOPE AMID THE GLOOM

Could some Spanish firms buck the trend in 2011? The mismatch looks clear in the cases of Telefónica, Banco Santander and BBVA, the three largest stocks listed in Madrid, which account for almost 40% of the IBEX index. Telefónica has consistently released positive results, even though its Spanish business has been unimpressive. However, more than two thirds of Telefónica’s revenues in the third quarter last year came from outside Spain. It’s a similar tale with the country’s two largest financial institutions, whose operations are spread around Latin America, the US, the UK and Europe. “To a certain extent, we can say that, from a risk point of view, Banco Santander and BBVA are not Spanish banks,” Valín says. That perception is still not shared by the markets. Banco Santander and BBVA stocks are among the main losers every time investors lose confidence in Spain, even though they have often been described as some of the major winners of the global financial crisis and in a risk-averse market. However, few firms look as risky today as banks in a post-property bubble economy. Roldán says that most of the money that has gone away from the Madrid exchange belongs to Spanish investors (international investors account for 40% of flow). For instance, retail investment funds have moved away from equities, as potential clients have looked elsewhere in order to make their money work. “Spanish investors are opting for bank saving accounts, where they can get rates of 3% of 4%, and are fleeing from equities,” he points out. Spain’s financial markets are unlikely to see better days until the simmering European debt crisis fades into grey. That may take some time and will certainly outlast 2011. I

INDEX REVIEW

UK EQUITY MARKETS: DELIGHTING IN BEING PERVERSE

Bad news doesn’t always bear down on markets Most of the forecasts for 2011 have started off with the rosetinted view of the overall situation and with the first few weeks trading sessions seeming to back this up, many of our clients have been quietly building long positions. This sense of comfort was reinforced by the FTSE 100 5940/50 support holding steady on several occasions. Into this reassuring scenario, the news that China was going to act aggressively to counteract an overheating economy burst like a bomb. What now? Simon Denham, managing director of spread betting firm Capital Spreads, takes the bearish view. S WE ALL know, the FTSE 100 is heavily weighted towards energy and mining and fears over the projected growth patterns of these behemoths have not gone down well. Investors will now have to decide whether the words from the East are likely to be backed up with deeds sufficient to slowdown the express train that is the Chinese economy. Added to this is the generally dire news on the domestic UK economy over the past month or so. Aside from actual growth numbers, virtually every other indicator is slipping into the red: employment, the trade deficit, the budget deficit and inflation are all substantially worse than expected and investors must add these into their calculations. Externally, it must also be acknowledged that a vast percentage of our export business (both visible and invisible) is with Ireland and mainland Europe and while Germany is performing almost unbelievably well the same cannot be said for the rest. The ever present and simmering European debt problem will continue to be an annoyingly recurrent item on the news wires. Not only that—finally, just to squeeze the last pips, the Bank of England and the European Central Bank look to be moving away from the ultra-loose fiscal stance of the

past two years and will soon inflict a return to higher interest rates (3% to 4% by 2013). The question is: why are we not in a disastrous bear market as opposed to expecting a rally? Probably because the market believes they are already written into investor expectations and (in any case) the global growth story is more powerful than the merely domestic woes of the US and Europe. Global growth is expected to be in the region of 4% this year and therefore local problems can, to a degree, be discounted. Most of the component parts of the FTSE, DAX, and CAC etc operate outside of the countries in which they are quoted. That is why China’s news affected the markets far more than the grim domestic situation. Talk of Far Eastern tightening will probably remain just that. Or, if it does happen, will merely slow growth from a runaway 10%-plus to a merely rapid 7%-8%. Analysts think 2011 will be quite a volatile year. I am sceptical, as policymakers are still in a “print more money” frame of mind. As long as this continues the flow of cheap funds into the equity markets will not be capped. At some point the pile of debt will become too great to sustain but until that point is actually reached, (if indeed it ever is)

Simon Denham, managing director of spread betting firm Capital Spreads. Photograph kindly supplied by Capital Spreads.

everything will appear to be under control—at least until the moment that it isn’t. Markets will most likely remain composed until such time. The real problems will probably start to surface when several years of hairshirt existence have been experienced by long suffering voters and then even more is demanded. At some point, the burden of paying for the past may become too much for the present. Even so, investors must be watchful for any sudden deterioration in Spanish and/or Italian credit worthiness which may well be the only early warning signal something worse is on the horizon. Until then, any pull back in the market is attracting clients into the buy side. The bull market is still with us and, as is usually the case in any market, it is unwise to stand too aggressively in the way of any directional momentum. On the technical side, the FTSE looks stuck below 6060/80 for the moment but supported around 5840/60 and also by the rising bull trend line from July last year, which is (as I write) at around 5900 and rising sharply. A break in either direction may well attract further momentum. As ever ladies and gentlemen, place your bets. I

FEBRUARY 2011 • FTSE GLOBAL MARKETS

PASLA & RMA

Annual

Conference on

Asian Securities Lending 1-3 March 2011 | Ritz-Carlton, Millenia Singapore Co-sponsored by the Pan Asia Securities Lending Association (H.K.) and the Risk Management Association (USA), the first industry-wide cosponsored conference in Asia developed by securities lending and borrowing professionals for securities lending and borrowing professionals.

The business program will include a securities lending tutorial and for the first time a high-level roundtable focusing on operational issues in the current markets. The conference will also include various regional market updates and panel discussions on:

“The opportunity to discuss recent market events and various regulatory actions impacting the securities lending industry is invaluable,”

t Hedge Funds

– Kirtes Bharit, Director, Credit Suisse, Hong Kong, Conference Co-Chair “This conference typically discusses best market practices and standards in the regional markets. As the world of securities lending changes, it will help to define the future and will certainly influence lending markets in the region and worldwide,” – Patrick Avitabile, Managing Director, Citi’s Global Transaction Services, New York, Conference Co-Chair. Keynote Speaker - The Outlook for Global and Asian Equity Markets Garry Evans, Global Head of Equity Strategy, HSBC, Hong Kong

t Fixed Income/Cash Reinvestment t Dodd-Frank Act and Basel III

Planning to Attend: Visit RMA’s website at www.rmahq.org/RMA/ SecuritiesLending/ for information as it becomes available. Or email Kimberly Gordon at kgordon@rmahq.org. For Event Sponsorship opportunities email Loretta Spingler at LSpingler@rmahq.org

Conference Co-Chairs Kirtes Bharti PASLA Committee Credit Suisse Hong Kong Patrick Avitabile RMA Securities Lending Committee Citi New York

For more information about the conference or to register visit the RMA website at www.rmahq.org/RMA/SecuritiesLending/ or email Kimberly Gordon at KGordon@rmahq.org

DEBT REPORT

EURO PRESSURE RESTS ON GERMAN SHOULDERS

Opposing forces battle in eurozone As the rest of Europe’s major economies languish in debt traps, Germany has emerged like the proverbial phoenix from the flames of the financial crisis. Europe’s largest economy is forecast to grow by 2% or 3% this year, making it the strongest performer among the Economic and Monetary Union (EMU) nations. The increase in January in the cost of insuring German debt against default using credit default swaps (CDS) came as no surprise. The rise in the premium to insure German debt rose amid market jitters over speculation that additional powers and lending capacity could be given to the eurozone rescue fund, heaping further financial pressure on the German government. Joe Morgan reports. HILE A BLIP in volatility across credit default swaps (CDS) markets is very unlikely to result in any changes to the sovereign debt policy of the German government, the fundamental challenges facing the eurozone continue to loom heavily upon the continent’s biggest economy. Berlin opposes a series of proposals for dealing with the euro crisis, including an increase to the size of the European Financial Stability Facility (EFSF) bailout fund and the issuance of Eurobonds, loans with common interest rates across the eurozone. “Germany faces a growing count-me-out opposition [in the domestic political debate], which rejects guarantees that are at the cost of the German taxpayers,” comments Handelsblatt, a Dusseldorf-based daily business newspaper. Stung by press comments and the rise in the CDS premium, Germany’s Finance Agency, a service provider controlled by the federal ministry of finance, insists demand for German government debt will remain strong in 2011. In an interview with the Financial Times, Dr Carl Heinz Daube, head of the Finance Agency, says: “Bunds have been proved to be a most liquid

asset within the eurozone, especially in times of uncertainty.” Stefan Schneider, chief international economist at Deutsche Bank Research in Frankfurt am Main, says: “If there is one large country in Europe in the aftermath of the global financial crisis which is in a position to get its sovereign debt situation under control, it would be Germany.” It is a timely acknowledgement. In the run up to important state elections in Germany, particularly one in the south-western state of Baden-Württemberg at the end of March, German chancellor Angela Merkel wants to demonstrate her will to prevent German taxpayer money being wasted to pay for mistakes made by the profligate governments from Europe’s less responsible nations who borrowed beyond their means.

Boosted optimism The initial signs this year are encouraging for a Germany reluctant to come to the rescue of its debt-troubled European neighbours. Spain, Italy and Portugal all oversaw successful bond auctions in early January. Italy sold €6bn of fiveyear and 15-year debt while Spain issued €3bn in five-year bonds. These successful sales boosted optimism in fi-

nancial markets that the eurozone is beginning to tackle its sovereign debt crisis in the aftermath of the bailouts for Greece and Ireland last year. Furthermore, the current size of the European Financial Stability Facility (EFSF) is too small to have an impact on demand for triple-A rated sovereign debt issued by Germany, even in the event of Portugal falling into default, according to bond analysts. However, should Spain (a country which German banks have high levels of exposure to) be forced to seek a bailout it will have a major impact on demand for sovereign debt across Europe. “Investors in Spanish debt would have to go somewhere else. Perhaps Italy would be preferable to Germany. However, should Italy become embroiled in the contagion, investors could switch to securities issued by the EFSF or Germany,” says a credit market source. Despite the unwillingness of the German electorate, a Spanish default could also force the German government to make a further sizeable contribution to another bailout. Merkel has said that Germany will do “whatever is necessary so that the euro remains stable”. Even so, Merkel is doubtless mindful of harsh criticism such as that

FEBRUARY 2011 • FTSE GLOBAL MARKETS

Photograph © petrovod / fotolia.com, supplied January 2011.

made by Frank-Walter Steinmeier, parliamentary leader of the centre-left Social Democrats (SPD), who has accused her of not comprehending the seriousness of the crisis. Steinmeier wrote an opinion piece for the Financial Times with former SPD finance minister Peer Steinbrück in which the pair demanded a “more radical, targeted effort to end the current uncertainty” and they called for a partial restructuring of the debts of Greece, Ireland and Portugal, guarantees for the bonds of stable countries, and the limited introduction of eurobonds. “If Spain defaults, we could see contagion spreading to Italy and Belgium as well. Things evolve at a crazy pace. The statements made by Germany [against measures such as eurobonds in the past] may in the future have to be re-evaluated as the alternatives do not look very encouraging,” says a credit market source. Meanwhile, finance minister Wolfgang Schäuble has pledged to cut net new borrowing to €57.5bn in 2011 to adhere to a national debt brake, enshrined in a constitutional amendment in 2008. The amendment is designed to reduce Germany’s structural deficit, step-by-step. In five years time

FTSE GLOBAL MARKETS • FEBRUARY 2011

the running deficit, which is currently estimated to stand at about 3% of gross domestic product (GDP), is expected to be near zero. Dr Stefan Bach, a public finance researcher at economic think tank DIW Berlin, says: “As the government succeeds in cutting down deficits, backed by the currently booming economy, emissions of new debt in Germany will decline correspondingly. However, of course, the existing debt has to be refinanced every year so there is a big market for government bonds and similar products of public debt.” He adds: “The debt stock in Germany should stabilise at about 76% of gross domestic product. The debt stock ratio will be reduced slightly over time when the deficit nears zero and the GDP growth rate would be about 3% per year.” Germany’s Finance Agency will in 2011 reduce annual bond issuance (which is issued in four main pillars of two-year, five-year, ten-year and 30-year tranches) to €302bn from €323bn in 2010. “Our strategy for the management of the debt portfolio is to reach a target portfolio according to the long-term cost and risk preferences of the issuer: structuring the annual issuance calendar and using interest rate

swaps; adjusting the financing activities based on macroeconomic analysis and improved diversification in the portfolio as a result of using a broader variety of funding tools. We have a savings target of about €500m in interest costs per year,” explains Jörg Müller, a spokesman for the Finance Agency in Frankfurt am Main. The Finance Agency estimates that the outstanding volume of tradeable euro-denominated German government securities stood at €1.077trn in December 2010. Total trading volumes of German government securities in 2010 stood at about €3trn, with a monthly average of €497bn, according to the Finance Agency. “The strategy this year is not very different from 2010. Gross issuance is 6% lower and net issuance—most importantly—is -31% lower, which is one of the reasons why German government bonds can outperform versus other European core bonds,” says Ioannis Sokos, a bond analyst at BNP Paribas in London.

Funding breakdown Sokos expresses surprise at the German government’s decision to reduce the 30-year share of total supply, which fell from 5.1% to 4.3%. “Since monetary policy tightening is ahead, you would expect the treasuries and the funding agency to adjust their funding breakdown and their funding strategy respectively,” he says. “I would expect more issuance in the 30-year to be honest, which didn’t come. If anything it decreased by 0.8%.” The German government bund contract, which is deliverable in the Eurex futures contract, an interest rate product traded almost exclusively on the Frankfurt-based derivatives exchange, has the tightest bid/offer spreads in the eurozone. More than 70 nominal Benchmark issues are outstanding across the euro yield curve, according to sources at the Finance Agency. “German bonds are benefiting from the flight to quality flows and from all the stress in the periphery markets. If something big happens in

DEBT REPORT

EURO PRESSURE RESTS ON GERMAN SHOULDERS

Stefan Schneider, chief international economist at Deutsche Bank Research in Frankfurt am Main. “If there is one large country in Europe in the aftermath of the global financial crisis which is in a position to get its sovereign debt situation under control, it would be Germany,” he states. Photograph kindly supplied by Deutsche Bank Research, January 2011.

Dr Stefan Bach, a public finance researcher at economic think tank DIW Berlin. “As the government succeeds in cutting down deficits, emissions of new debt in Germany will decline correspondingly. However, of course, the existing debt has to be refinanced every year,” he says. Photograph kindly supplied by DIW Berlin, January 2011.

the next few months and we see a big improvement in the general sentiment towards the European periphery, then I would expect some of the premium which is embedded in German bonds prices to be removed. There would be some rise in yields from this effect, which could be stronger in short-dated bonds than in longer-dated ones,” says Sokos of BNP Paribas.

mation into leaner and meaner shape was accompanied by a decline in the labour income share and a more uneven income distribution, major factors behind the mediocre performance of private consumption during the last decade,” writes Schneider in a DB Research paper, Germany: With strong tailwind into 2011. “These factors should become less of a burden. In addition, Germany is one of the two G7 countries where household indebtedness did not increase during the last ten years. Moreover, the asset side of households’ balance sheets has not suffered from bursting asset bubbles. Combined with the relatively comfortable fiscal position—the deficit should fall below 3% of GDP in 2011—this should allow Germany to maintain healthy growth rates beyond 2011.” A major potential stress point in the German economy which has the potential to derail a healthy economic growth rate would be any strong deceleration in export demand, particularly

A stronger performance? Meanwhile, the German economy appears poised for a strong performance in 2011 powered by an exportdriven boom. Deutsche Bank Research forecasts the economy enjoying 2% growth in GDP in 2011. Schneider of Deutsche Bank Research identifies reforms over the past decade made in areas such as corporate tax, labour market and pensions—coupled with a strong globalisation push of the corporate sector—as factors which changed wage setting behaviour in the country, serving to underline its economic resilience.“Germany’s transfor-

as “growth has been export orientated over the past few years”, explains Bach of DIW Berlin. Additional stress points include any further problems in the eurozone and the strength of private consumption. “We see private consumption growing this year but have a rather cautious view, estimating that it will grow by 1.25% or 1.5%. This is because we think the income situation will not improve quite as dramatically as some observers expect. For example, the preliminary retail sales figures in November showed quite a substantial month-tomonth drop. One should not get carried away,” says Schneider. Nevertheless, the German government’s plans for deficit reduction should be propelled forward by robust economic growth. The imponderables of the sovereign debt crisis make the near-term outlook for the performance of German sovereign debt less certain. Perhaps the only certainty in 2011 is the absence of certainty in how the sovereign debt crisis in countries such as Portugal and, more significantly, Spain will play out, and what possible subsequent action would be taken by Europe’s central banks.

Underlying strength “Headlines surrounding more imminent intervention could come to nothing. It is near impossible to trade the short-term sovereign story unless luck is on your side as wire stories and the ECB interventions this past week have completely overtaken proceedings,” writes Jim Reid, a credit strategist at Deutsche Bank, in a fixed-income research paper published in early January. However, in the longer term, the outlook for Germany’s sovereign debt appears far more stable and predictable. Germany can only benefit from the underlying strength of its economy and a continuing flight to quality in investment flows. This should place the debt policy of the German government firmly on course as the country assumes its place as Europe’s economic powerhouse with vigour. I

FEBRUARY 2011 • FTSE GLOBAL MARKETS

COVERED BONDS: SAFETY FIRST

Photograph © Scanrail / fotolia.com, supplied January 2011.

of 2013 (and all debt issued up to that point will be “grand-fathered” to exempt it from the new legislation), similar requirements are already in force at national level. The Bank Restructuring Act that the German Bundestag passed at the end of November, came into effect on January 1st this year and includes special resolution powers that enable the German regulator Bafin to transfer the assets of a failing institution into a new “good bank” and leave bondholders’ claims with the “bad bank”.

Immune from bail-ins?

New regulation bolsters covered-bond issuance Covered bonds have begun 2011 with an unprecedented bang, as the threat to other categories of senior debt from changes in banking regulation has given extra impetus to the usual surge in activity at the start of the year. The determination of governments to make sure that taxpayers do not have to bear the brunt of any future financial crisis has meant that the oldest form of capital market debt is also now looking like the safest. Andrew Cavenagh reports. HE LEVEL OF primary issuance in the covered bonds market in January was extraordinary. By the middle of the month, the volume of publicly-sold covered bonds across Europe had reached €30bn and was comfortably on course to beat the record for the month. Within the first six days of the year alone, issuers from France, Spain, Germany, the Netherlands, Norway and the UK had sold more than €14bn to both European and non-European investors. The rampant market owes much to the action that the European Union (EU), its individual member states, and governments elsewhere are taking to ensure that public finances never again have to shoulder the burden that they

FTSE GLOBAL MARKETS • FEBRUARY 2011

did in 2008. The changes they are introducing include measures that will increase the risk for corporate bondholders, such as obligatory debt-forequity swaps and “hair cuts” (capital losses) on the senior unsecured debt of failing financial institutions before there is any recourse to the public purse. On January 7th, the European Commission (EC) published its proposals for dealing with future bank failures within the EU. These would give financial regulators in the individual member states wide discretionary powers in such circumstances with the clear aim of greatly reducing the likelihood—and extent— of any future public support. Although these EU-wide regulations will not take effect until the beginning

The political momentum for so-called “bail-in” measures, including enforced debt-for-equity swaps and hair cuts, is clearly irresistible, and they will have a serious impact on the senior unsecured markets. The ratings of corporate bonds will inevitably drop and the cost of issuing such debt will rise accordingly. The markets’ reaction to the EC’s proposals gave an indication of what to expect as the price of credit default swaps (CDS) on senior unsecured bank bonds shot up, taking the relevant Itraxx index (senior financials) over 200 basis points (bps) from its level of around 170bps at the start of the year. It is hard to see any circumstance, however, in which “bail-in” provisions could apply to covered bonds, given the fundamental principle of the instruments that gives investors a secondary claim on pools of collateral in the event that the issuer defaults. Any legislation that retrospectively prejudiced that priority claim to the specified collateral would destroy the basis of a market that has provided European financial institutions with their most stable source of capital market debt for almost 250 years. Given that the European Central Bank (ECB) and national regulators have repeatedly underlined the importance of the covered-bond market in providing a stable source of funding in difficult times, it is unthinkable that they would countenance such action; the commission’s proposals specifically

DEBT REPORT

COVERED BONDS: SAFETY FIRST

excluded the instruments, along with derivative contracts. “It is generally perceived that covered bonds will be immune from bail-ins,” confirmed Heiko Langer, senior credit analyst for the instruments at BNP Paribas in London. “The whole principle of a covered bond would be perverted if they are not.” This assumption of immunity led SG Corporate and Investment Banking (SGCIB) recently to recommend that investors buy the bonds of three Irish banks. SGCIB’s covered-bond team pointed out that while the instruments were offering spreads over mid-swaps of up to 900bps—against 465bps for Irish sovereign debt of comparable maturity— the risk of any loss was negligible. While it is “nearly impossible” to restructure the instruments (even if hair cuts were applied to the debt of the bank in question), analysts say the cover pools will almost certainly protect investors from losses under any restructuring of the banks. For the covered bonds of the issuers involved, including Allied Irish Bank, Bank of Ireland, and EBS, have current levels of over-collateralisation ranging from just under 40% to 75%, while the net present losses in their cover pools range from just 0.7% to 2%. Such dynamics are clearly enhancing the attraction of covered bonds for investors, and they should encourage higher levels of issuance in the years ahead as, from the issuers’ perspective, the spread differentials with the senior unsecured markets can only widen. The rules that govern the eligibility of collateral for covered-bond programmes and the requirements for over-collateralisation—some of which banks will still have to fund in the senior unsecured market—will, of course, impose limits on how much more of their funding banks can raise from this source. It is difficult to come up with an accurate overall figure for the potential growth, as the scope for further issuance obviously varies significantly from institution to institution. Ralf Grossmann, head of covered-bond

Tim Skeet, adviser at the International Capital Markets Association. “As long as you have got the sovereign crisis going on, you are not going to stop investors looking at that in the first instance,” he says. Photograph kindly supplied by Merrill Lynch, January 2011.

Ralf Grossmann, head of covered-bond origination at SGCIB. “I think there is a bit more room for banks to use covered bonds. There are a lot of European banks that have not yet optimised their asset-liability management,” he says. Photograph kindly supplied by SGCIB, January 2011.

origination at SGCIB, believes the primary market in Europe could grow to a level of €220bn to €230bn a year, compared with the €180bn of new issuance in 2010. “I think there is a bit more room for banks to use covered bonds,” he says. “There are a lot of European banks

that have not yet optimised their assetliability management.” In the near to medium term at least, however, the market for covered bonds in any given country will remain vulnerable to whatever is happening to that country’s sovereign debt. Recent experience has shown that if the market for the latter closes, so does its national coveredbond market. The influence of sovereign concerns has been plain to see in the relative spreads that issuers have been able to achieve so far this year. Spain’s two strongest banks, Santander and BBVA, had to price their offerings at 225 basis points over mid-swaps while Germany’s Unicredit was able to issue a pfandbrief backed by public-sector loans flat to the benchmark. “As long as you have got the sovereign crisis going on, you are not going to stop investors looking at that in the first instance,” holds Tim Skeet, the former head of covered-bond origination at Merrill Lynch who is now advising the International Capital Markets Association. In the longer term, however, there is the intriguing possibility of a reversal in the relationship between covered bonds and sovereign debt. For while most of the attention on bail-in measures so far has focused on the senior debt of banks, there has to be a real likelihood now that the principle will extend to the sovereign debt of the peripheral eurozone countries if they default, as many now expect.

Sovereign v. covered bond risk Following the €85bn EU bailout of Ireland in December, it has become apparent that Germany and France will probably not support an unlimited expansion of the €440bn European Financial Stability Facility (EFSF) to underwrite the sovereign obligations of all other member states that may ultimately need such backing. If one or more of those countries then cannot access the capital markets at viable cost to refinance its obligations, default will be inevitable, along with debt restructuring that cannot fail to involve some

FEBRUARY 2011 • FTSE GLOBAL MARKETS

capital loss for bondholders. The risk of loss consequently looks higher than on a covered bond, on which investors will only lose if the underlying collateral pools were to deteriorate to the point where the realisable value of the assets no longer matched the outstanding debt. The present situation therefore threatens to overturn one of the prevailing core principles of the modern capital-market era—that sovereign debt represents the most secure credit in any given jurisdiction and the benchmark off which other classes of debt are priced. “That long-held tenet has been fundamentally undermined by what has happened this year,” says Skeet. “We are having to redefine the interplay between the two, and it’s still very much work in progress as to how they will fit together.” Those familiar with the history of covered bonds point out that on a number of occasions over the past 200 years, the instruments have actually justified a ranking above sovereign debt. “You have example after example of covered-bond investors being paid when governments have simultaneously defaulted,” maintains Ted Lord, head of covered bonds at Barclays Capital in Frankfurt. Lord points to Denmark in 1815, Austria in 1914, and Germany in 1933 where this had happened. More recently, Icelandic covered bonds paid out in 2008 (when the country’s banks had defaulted, though the government did not), and there was evidence that investors acknowledged. “We have also recently seen some covered bonds trading tighter than sovereigns,” he adds. While there have been a number of instances since the onset of the financial crisis where this has occurred in the secondary market, however, it would be a very different matter for a new coveredbond issue to launch either flat to, or inside, its prevailing sovereign spread. This is known to be a real concern at present in the government treasury departments of Greece, Portugal, Ireland, and (particularly) Spain. For the covered bonds that BBVA and Santander

FTSE GLOBAL MARKETS • FEBRUARY 2011

Scott Garrett, the Republican representative for New Jersey has been promoting covered-bond legislation in the US Congress since 2009. Photograph by Charles Dharapak/AP/Press Association Images, supplied by Press Association Images, January 2011.

launched in the first week of January priced at only about 15bps to 20bps wider than Spanish sovereign debt of the same maturity, all evidence suggests that the differential is continuing to shrink. “Spain is going to be a fascinating testing ground for the new order,” says one close observer.

Time to address liquidity If the covered-bond market is to become a more central element of the capital markets mix, another issue it will need to address is its relative lack of liquidity. Most covered-bond markets remain heavily dependent on a large domestic investor base, and the flurry of primary issuance in January threatened to overheat the market at one point. The key to improving the overall capacity and liquidity of the market will be to enlarge the pool of investors, and there are already signs that this is happening. At one extreme, hedge funds have started to come in and take advantage of risk-pricing mismatches created by the sovereign-induced volatility, such as the opportunity that the SGCIB team identified with Irish bonds. Moreover, there has also been a wider move into the market by asset managers, who have accounted for the lion’s share of most issues this year. “The real money is dominating, but we also see that the banks are coming back,” confirms Grossmann at SGCIB. It may ultimately be the growing appetite of US investors for covered

bonds, however, that provides the degree of liquidity that regulators and investors would like to see. European and Canadian issuers placed around $30bn of bonds with American buyers in 2010, including jumbo offerings from Barclays, Handelsbanken, DNB and Norway’s Sparebank. “That is a very significant potential dynamic,” says Skeet. “I think American investors have been a bit quicker in recognising the shift in the market.” Arranging banks are looking for US purchases of foreign bonds to increase significantly in 2011. “We believe that the volume of US dollar issuance could double this year, with most of the additional supply coming from Europe,” adds Grossmann at SGCIB. What will undoubtedly increase US demand for all covered bonds exponentially, however, is the passage of legislation that will enable American banks and other lenders to issue the instruments under a legal framework, and there is growing confidence that this will finally happen in 2011. Scott Garrett, the Republican representative for New Jersey who has been promoting covered-bond legislation in the US Congress since 2009, narrowly failed to get the latest version of his proposal included in last year’s Dodd-Frank bill. However, he believes his bill now has sufficient bi-partisan congressional support and industry backing to ensure that it passes through both Houses of the US legislature this year. I

DEBT REPORT

IRELAND: EXPORTS PROVIDE A GLIMMER OF HOPE

Still on the precipice: can exports help? EITHER THIS LATEST round of austerity measures nor the back-stop of the EU/IMF rescue package has managed to restore the much-needed market confidence in Ireland’s financial outlook, without which it will impossible for government to meet its borrowing needs in the years ahead at a sustainable cost. On the contrary, investors appear to have grown more nervous than they were before Ireland accepted the EU/IMF support, as the cost of insuring the country’s sovereign debt against default—always the most immediate and blatant barometer of market sentiment—has risen sharply in the interim. The credit default swap (CDS) on five-year Irish bonds hit 640 basis points (bps) in the first week in January, compared with 448bps at the same point in October, six weeks ahead of the bailout. This put the CDS on Ireland’s debt well above those for Romanian and Ukrainian government debt, which stood at 474.5bps and 295.5bps respectively. The uncertainty that results from the imminent general election, which Fianna Fail Taoiseach Brian Cowen was forced to call in response to the opposition parties’ unanimous condemnation of the EU bailout, has done nothing to improve matters, and the situation could yet trigger a further downgrade in the country’s sovereign credit rating. All three rating agencies cut their ratings on Ireland’s sovereign debt in December; in Moody’s case a five-notch downgrade to Baa1. “The Irish government’s financial strength could decline further if economic growth were to be weaker than currently projected or the cost of stabilising the banking system turns out to be higher than currently forecast,” the agency warned. Meanwhile, the predicament of Ireland’s banks (whose

Photograph © Benjamin Haas / fotolia.com, supplied January 2011.

Since the government succumbed to pressure and accepted an €85bn bailout from the EU and the IMF, the general perception might be that Ireland’s situation has worsened. The severe Budget announced in December will impose a further €6bn of spending cuts on the economy in 2011, on top of the €14.6bn that has already been axed over the past two and a half years. Ireland needs to reduce its budget deficit to 3% of national GDP by 2014 (from its present level of 11.6%) in line with its commitment to the EU. It also needs a government to do it. Andrew Cavenagh reports. profligate lending to the country’s property and construction sectors was largely responsible for the present national plight) appears to be deteriorating further. Recent figures suggest they are running out of collateral they can use to acquire short-term liquidity from the European Central Bank (ECB) and— as they have significant customer deposits over the past few months—have had to turn increasingly to their own

central bank for funding. This had reached €51bn by the end of December, on top of the €132bn of borrowings from the ECB. As this borrowing will inevitably end up on the national debt, it threatens to make the task of meeting the government’s deficit-reduction targets even more difficult. There is nevertheless a small chink of light. For all the difficulties in the banking sector and the continuing contraction in domestic demand because of drastic cuts in public and unemployment remains obstinately around 13%, falling prices over the past two years have significantly improved the country’s international competitiveness. This produced a big enough surge in exports in 2010 to return the overall economy to growth. According to Bank of Ireland midJanuary figures, GDP grew by 1.6% over the first nine months of 2010 (with most of the improvement coming in the third quarter), as exports helped provide some €764m more in corporation tax revenue than forecast at the start of the year. Dan McLaughin, chief economist at Bank of Ireland, says the trend should continue this year. “Both exports and inventories look set to offset the decline in domestic spending, with the result that we expect GDP to record positive growth in 2011.” In the longer term, Ireland’s finance minister Brian Lenihan says his department estimates that the continuing strength of the export market should support average annual GDP of 2.75% per annum over the next four years. This singular strength relative to other peripheral eurozone countries, has led commentators to take a less pessimistic view on the country’s prospects for avoiding default. “The situation is less acute than it was two months ago,” says Marc Ostwald, senior bond strategist at Monument Securities. However, he says that if a different government after the election attempts to unstitch the EU/IMF agreement, the situation could change rapidly.“That would put Ireland straight back into the spotlight.” I

FEBRUARY 2011 • FTSE GLOBAL MARKETS

Can ruble bond volumes be sustained? Global emerging market bonds were among the best performing assets in 2010 with corporate and sovereign bonds in local currencies doing especially well. Low interest rates in advanced markets coupled with a smouldering sovereign debt crisis in Europe have channelled investor interest towards those emerging markets with strong fundamentals and high yields. Although Russia has achieved less in terms of inflows than some of its BRIC peers, the ruble bond market nevertheless enjoyed one of its best years in 2010. There are further indications that after a brief slowdown early this year the trend will continue. By Vanya Dragomanovich UBLE BONDS HAVE largely been the domain of local banks up to now, but the Moscow Interbank Currency Exchange Group (MICEX) is considering radical changes to regulation that will make it easier for foreign investors to ride the wave of rising domestic bonds. “There is a nice appetite for Russian bonds from institutional investors,” explains Lars Christensen, senior analyst at Danske Bank. “We are on track for a healthy recovery [of the domestic economy] in 2011; we are emerging from a crisis and we are looking for the ruble to strengthen.”

FTSE GLOBAL MARKETS • FEBRUARY 2011

All of this will work in favour of investing in ruble debt but also in the growing ruble eurobond market. Amid the mayhem in the European debt markets, Russia is currently one of the most credit-worthy players. It has no solvency problems and its debt-toGDP level is less than 10%. Local bonds are doing well with yields down to below pre-crisis levels. Moreover, investors have seen a healthy 12% ruble return on corporate bonds and over 8% on sovereigns in 2010. The success of the ruble bond market has not gone unnoticed by major inter-

RUBLE BONDS: A SECOND PROSPEROUS YEAR?

Photograph © Lavitreiu / Dreamstime.com, supplied January 2011.

national players, and banks such as Deutsche Bank and HSBC Holdings have both made new hires in Moscow to strengthen their local debt origination. If MICEX does push through its planned changes, others will no doubt follow. Ironically, it was the credit crisis that fuelled the expansion of the local debt market. The Russian banking system went through a difficult period in 2009 and although the worst of it was over by early 2010, a large number of corporate defaults had left banks with significant liquidity but still cautious about lending money to local companies. “These years [2009 and 2010] were characterised by monetary easing as the Central Bank of Russia (CBR) reduced interest rates on the back of falling inflation, which had reached historical lows due to the severe world credit crunch and the poor local economic recovery. CBR’s refinancing rate came down from an historical high of 13% to an all-time low of 7.75%,” says Andrew Bershadsky, fixed income investments manager for Pioneer Investments in Moscow. Enter ruble bonds. With large players such as Gazprom needing to find ways to finance its RUB1.35trn debt and unable to procure loans of that size from other sources, issuing ruble bonds became the preferred solution. Commercial banks found they could provide companies with bigger financial injections than through direct loans (which were capped by government regulation to protect banks from loan defaults) while at the same time generating roughly the same yield. Dmitri Sredin, managing director, head of debt financing, at Renaissance Capital in Moscow, says domestic commercial banks dominate Russia’s ruble bond market. “The Russian bond market is de facto dominated by commercial banks, which are the main investors. The share of banks in a primary bond issue is between 70% and 80%, which is drastically different from three years ago. The crisis has made banks much more risk averse, thus limiting the list of issuers able to

DEBT REPORT

RUBLE BONDS: A SECOND PROSPEROUS YEAR?

tap the market. However, we are seeing that the tide is changing with appetites growing for higher yielding names.” According to data compiled by analytics company Dealogic, the top three banks underwriting ruble-bond issues in 2010 were VTB Bank, which held 21% share of the market, Troika Dialog, and Gazprombank. Austria’s Raiffeisen Bank and Citigroup were the only two foreign names among the top ten book runners for ruble bond deals last year. So far, foreign investor involvement has been hampered by requirements such as the need to deal through a costly local broker and having to deposit all the money upfront for an auction, both of which MICEX is considering scrapping. “The local ruble bond market in Russia is still more complicated than established and more liquid local markets like South Africa, Turkey or Poland. For all investors, euro-clearable ruble bonds are the better choice since one can avoid installation costs of setting up a local account in Moscow,” explains Andreas Burhoi, head of emerging markets fixed income at asset management firm DWS Investments, part of Deutsche Bank group. However, if MICEX sees through its plans, the playing field will widen to allow more foreign investors.

New issue pipeline Last year, Russia’s finance ministry issued RUB585bn-worth ($19.6bn) of federal state bonds (OFZs) while companies raised slightly more than that in ruble debt. The government said that in 2011 it would raise as much as RUB1.4trn to finance most of the budget, a figure high enough to potentially disconcert investors. “They will probably issue significantly less, something closer to RUB500bn,” estimates Renaissance Capital’s Sredin. The government has made its financing need calculations deliberately conservative by assuming a lower price of oil then the level at which it is currently trading. In the meantime, oil prices have gone from around $80 a barrel for most of last

In December, Russia delayed its first ever sale of ruble bonds to foreign investors as appetite for higher risk assets was dampened by the European debt crisis and the Irish bank bailout. While the domestic ruble bond market is fairly sheltered from what is happening in the rest of Europe, this is not the case for eurobonds. year to close to a $100/bbl and forecasts suggest that they will stay higher. Also, last year the government planned for a budget deficit of 5.3% of GDP though in the end it came in at 3.9% GDP. Investors can expect the coupon to be close to yields on OFZs. The OFZ due in 2016 is yielding around 7.5%. In comparison, Brazilian notes with similar maturity yield about 500 basis points (bps) more. Like many emerging markets, Russia will face higher inflation in 2011 and the first rate hikes are expected in the first quarter of 2011. “Many local banks have ample liquidity and we do not expect a quick rise in local yields but a gradual, smooth yield widening along with a strong ruble appreciation,” says DWS’s Burhoi. In the much smaller eurobond market, Russia in December delayed its first ever sale of ruble bonds to foreign investors as appetite for higher risk assets was dampened by the European debt crisis and the Irish bank bailout. While the domestic ruble bond market is fairly sheltered from what is happening in the rest of Europe, this is not the case for eurobonds. Apart from the situation in European debt markets, a key factor will be quantitative easing, which “makes money cheap and fuels the rally in emerging markets,” says Michael Ganske, head of emerging markets research at Commerzbank. The focus so far has been on lowrisk strategies that involved the most stable bonds: sovereign and quasi-sovereign bonds—bonds of companies that are government owned—but the mood in the market is changing in favour of slightly higher risk. This will make both regional bonds and corporate bonds of less well established

issuers more interesting, according to Ganske. “It is a little bit more tricky to do due diligence on regional governments because their capacity to make money depends on what they can keep from their taxes,” he notes.

Corporate bond market As it did last year, the corporate bond market is likely to attract the most attention. Otkritie Bank says that Russian corporate issues amounted to $25bn in 2010 and that this year is likely to see a slightly lower volume of $21bn. The top three corporate issuers last year were the Russian agricultural bank Rosselkhozbank, the federal grid company United Energy Systems and export bank Vnesheconombank. Other issuers included Russian Railways, diamond producer Alrosa, gas producer Gazprom, state hi-tech firm Rosnano and VTB Bank. Some of the names may come on the market again, such as Gazprom Neft, while additional companies indicating that they are interested in issuing bonds include potash producer Uralkali, hydropower company RusHydro, Alfa Bank, Suek, Metalloinvest and Megafon. VTB Bank plans to be active in the local bond market “with an initial target to issue around RUB30bn,” according to Alexander Smolin, head of debt finance at VTB Bank. He adds: “The bank has no particular plans to issue ruble-denominated eurobonds at the moment. However, given an existing investor demand we may consider ruble-eurobond issuance later this year.” Meanwhile, Renaissance Capital’s Sredin believes that metals and mining companies and oil and gas companies will remain the most interesting bond plays, while financials and construc-

FEBRUARY 2011 • FTSE GLOBAL MARKETS

tion companies will be a less good bet. Uralsib’s fixed income analyst Dmitri Dudkin believes new placements by companies such as Gazprom will draw a lot of demand as foreign investors seek liquidity. “We do not see any notable credit issues here: Russia’s oil companies are little levered, and Gazprom managed to reduce its debt burden in 2009 and 2010. From a spread standpoint, Russian IG credit continues to offer a premium over comparable emerging market risk.” He points out that bonds for Brazilian company Petrobras, the PETBRA 18, is trading at 4.6%, while the GAZPRU 18 offers 5.4%. Dudkin names diamond producer Alrosa, steelmakers Evraz and Severstal, and mobile phone firm Vimpelcom, as a good buying opportunity. Besides the most well known Russian companies this year, the market is likely to see more issuances from companies that have a slightly lower rating, though Pioneer Investment’s Bershadsky is cautious about their potential for return. “Spread-wise we think that second-tier or BB-rated corporations are expensive even against pre-crisis levels, while

first-tier or BBB-rated quasi-sovereign names like Gazprom and Russian Railways are priced in line with the spread levels last seen in the pre-crisis environment,” he says. Bershadsky adds that local ruble bond investors do not have much to gain this year, since real returns from quality local bonds will be negative because of the high inflation. For foreign investors, however, “this market might become interesting because of higher yields and stronger ruble, although the eurobond market is still less expensive than local ruble debt”.

Underdeveloped legislation Looking further down the ratings list, market watchers say that while highyield bonds issued by second and thirdtier companies have the potential to be the most interesting plays, they are also by far the riskiest. The bulk of such companies defaulted in late 2008 and in 2009 as a result of poor credit and poor term structure of the bond which frequently meant no collaterals, no proper guarantors and no covenants. Given the underdeveloped legislation in the country it was impossible to sue such issuers and

consequently most of them preferred to default rather than work with investors to restructure their debt. In such cases local knowledge is invaluable and can make the difference between a high return and a serious loss. Otkritie Bank expects that outside the high-risk, high-yield environment, the domestic eurobond market will grow by between 5% and 6%, or far more moderately then the double-digit rise of 12% last year. However, the Russian market does not stand alone and the flows will be determined also by how the situation develops across other markets with the continuous sovereign default treat in Europe, the Federal Reserve’s continued quantitative easing programme, the introduction of more aggressive capital control measures across emerging markets and China’s need to bring in long-term measures to stop its economy from overheating. Some of these factors will work in favour of investing in Russian markets as although investors at times are still sceptical about the country, it is becoming an increasingly stable investment compared with other markets. I

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FTSE GLOBAL MARKETS • FEBRUARY 2011

FX VIEWPOINT

FOREX: THE EMPIRE STRIKES BACK?

Are banks taking FX behind closed doors?

Erik Lehtis, president of DynamicFX Consulting in Chicago. Photograph kindly supplied by DynamicFX Consulting.

Participants in the foreign exchange market were greeted on December 9th last year with news that a putative oligarchy of the largest banks was forming a venture called Pure FX, a banksonly liquidity pool for electronic FX trading. According to a story in the Wall Street Journal, this is a business proposition driven by the banking community and in search of a technology platform. While no one has confirmed their involvement, likely key members include Deutsche, UBS, Barclays, Goldman Sachs, and JP Morgan. The move raises some serious questions. Erik Lehtis, president of Dynamic FX Consulting, gives the trader’s view.

banks don’t deserve to make money in FX. They are the market makers of last resort, are often forced to warehouse massive positions due to illiquid conditions or predatory customers, and structure complex solutions for customers. They earn their tariff. Even before this latest development, a noticeable shift from ECNs to singlebank platforms had been under way. The bank-hosted portals are very attractive to many customers and their no-fee value proposition is hard to ONSIDERING THE CURRENT years dominated liquidity. Having sold resist. The bank provides prices, but also appetite for greater transparency EBS to ICAP in 2006, the consortium oversees the match and can reject a and access in global markets, the appeared satisfied with the state of FX; but the continuing rise of the trade for any reason. This inherent lack Pure FX initiative may strike the casual proprietary trading segment has once of transparency makes a healthy observer as being more than a little again spurred the bankers to create a exchange-traded alternative all the counter-intuitive. Following the 2008 liquidity pool all their own. Non-bank more essential to the FX ecosystem. By credit crisis and the May 6th Flash attempting to divert exchange-traded Crash last year, a hue and cry for greater trading activity now consumes around flow to a venue without open access, it’s oversight of markets has arisen and, as 40% of the volume on EBS. While it is likely intended to be just what the almost as if the banks are asking for should be obvious to all, access to bankers say—a wholesale pool in which some form of regulation. liquidity is a crucial aspect of nonthey don’t have to compete for liquidity Actually, the world the banks are regulatory remedies for opacity in the with the non-banks—Pure FX may trying to create existed once before—it price discovery process. Nevertheless, appear to some to be the banking was called the direct market. Then, the these banks have apparently decided banks traded directly with each other, that now is the time to band together to empire’s Death Star, poised to annihilate those rebels who have over telephone and via Reuters Dealing, take FX behind closed doors. wrested absolute control of the FX governed by carefully crafted, timeFor long-time members of the FX market out of the bankers’ hands. honoured conventions and a high community, this development may degree of professionalism. This began to come as no surprise. It’s called the die in the late 1990s when the sheer size “interbank foreign exchange market” Critical functions of the largest players (those same banks for a reason. Originally the exclusive It should be noted that banks have province of commercial banks, the FX always performed two functions critical behind Pure FX) frequently exploited the obligations of direct dealing. market has evolved to embrace a wide to FX: access to credit and provision of Smaller banks had to cry uncle—they pool of participation. It began in the liquidity. FX trades are still cleared via couldn’t afford to support the volumes 1980s, when the then-pervasive voice an archaic system of bi-lateral credit— large banks were clearing. brokers began putting phone lines into only banks can be final counterparties. Cornering liquidity by removing investment banks over fierce objection Herein lies one of the ironies of this by the commercial banks. The voice latest development—the very presence transparency from price discovery not the objective of Pure FX, but it could be market and direct trading accounted for of non-bank players in the market almost 100% of interbank volume at today is due to access made possible by perceived that way. If this comes to that time. prime brokerage; in other words, by the pass, it’s just a matter of time before some politician fancies himself as Luke The major banks formed a same banks that now want to start a Skywalker, and makes a show of casting consortium in the early 1990s to build “banks-only, you’re-not-invited” club. the banks as Darth Vader. That’s a sequel an alternative to Reuters. EBS was the FX is one of the most profitable of outcome of that effort, and within two none of us wants to sit through. I banking activities. That’s not to say

FEBRUARY 2011 • FTSE GLOBAL MARKETS

FOREIGN EXCHANGE

RUBLE-RENMINBI: TRADING PAIR SET FAIR

Economist and bestselling author Dambisa Moyo’s new book, How the West Was Lost: Fifty Years of Economic Folly—And the Stark Choices Ahead, suggests that China’s new hegemony could include the “redback” renminbi replacing the “greenback” dollar as the world’s favourite currency. In September last year, China and Russia started trading directly in each other’s currencies. Does the move presage an avalanche of CNY-RUB pair trading? Or will it be a damp squib? Joe Morgan reports on the outlook for the trading duo.

Slow lift-off for CNY-RUB trading HE MOSCOW INTERBANK Currency Exchange (MICEX) last December announced the launch of trading in the ruble/renminbi currency pair. Igor Marich, vice-president at MICEX, says he sees interest from banks in the new currency instrument, despite a modest start with MICEX’s first day of trading in the pairing resulting in the conclusion of just 29 transactions, totalling CNY4.9m (RUB22.7m). MICEX’s launch of the pairing is the first institutional infrastructure to emerge facilitating trading in the instrument after it first began last September. Subsequent daily trading volumes have amounted to an insignificant blip in the context of the multi-trillion dollar global forex markets. Sources at Deutsche Bank say daily volumes traded on MICEX amount to the equivalent of between $100,000 and $700,000. Deutsche Bank says it has not been “really involved” in trading due to a lack of interest from its clients. Nevertheless, currency market participants have described Russia and China’s decision to begin trading in each other’s currencies as an important milestone in a seemingly inexorable decline of the dollar’s reserve currency status. Richard Yetsenga, the global head of emerging market FX strategy at HSBC in Hong Kong, says: “We have probably opened up some cracks in the dyke that are permanent.You have probably seen and will continue to see some permanent loss or decline in the dollar’s role as the only global currency.”

FTSE GLOBAL MARKETS • FEBRUARY 2011

Eugene Kasevin, a managing partner at EmergingMarkets. Photograph kindly supplied by EmergingMarkets.me, January 2011.

Mirza Baig, an FX strategist at Deutsche Bank in Singapore.. Photograph kindly supplied by Deutsche Bank, January 2011.

He expects MICEX’s launch to improve the liquidity of the pairing and reinforce a shift away from the dollar as the global transaction currency. Eugene Kasevin, a managing partner at EmergingMarkets.me, a Moscow-based financial news and information service,

describes ruble-renminbi trading as a “small yet practical step in challenging the hegemony of the US dollar”. “The supreme leaders of Russia and China are seeing more and more coverts to their idea of creating an alternative reserve currency to the dollar ever since Lehman Brothers imploded in late 2008, which triggered a global credit crisis and a currency exodus to the so-called safety of the greenback,” says Kasevin. HSBC’s Yetsenga says there is “unquestionably pent-up demand” for the pairing but he describes the current state of trading in the instrument as very much embryonic. Further institutional support is needed to put market infrastructure in place to support the pairing. For example, Hong Kong-based FX traders continue to carry out transactions almost exclusively in US dollar currency pairs. “I would even be cautious about using the term market at this point,” says Yetsenga. “There is the ability to directly transact between the ruble and the renminbi, but the number of transactions is still quite small.” Mirza Baig, an FX strategist at Deutsche Bank in Singapore, says: “On the directional outlook for the RUB/CNY cross, we are fairly neutral. Basically we see both RUB and CNY appreciating this year as their central banks are likely to favour stronger exchange rates to curb imported inflation. In both currencies we expect a 5% to 8% appreciation verses the US dollar.” However, Yetsenga says if the US dollar continues to weaken in the medium term, there could be a “quite rapid”uptake in opportunities to transact in the pairing. China-Russia trade is currently valued at about $40bn per year. “Half of China’s overall trade will be transacted in renminbi over the next five years,” he says. I

BANKING REPORT

ARGENTINE BANKS: HOPING TO BUILD ON LAST YEAR’S PERFORMANCE

Photograph © Nicemonkey / Dreamstime.com, supplied January 2011.

Positive shifts in Argentina’s outlook It is fair to say that 2010 was not a good year for bank stocks, unless, that is, they were listed in Argentina. The country that, in the early 2000s, took expressions such as “financial instability” and “banking crisis” to a whole new level is living an economic boom that has shot banking shares through the roof. Moreover, it appears there is sustained potential for the sector to keep on growing, although analysts believe 2011 will bring some new challenges. Rodrigo Amaral looks at the prospects and problems. ENEFITING FROM THE strong performance of commodity markets and enjoying no small uplift from the solid economic performance of Brazil, its main trading partner, Argentina’s GDP is understood to have grown by to 9% in 2010; one of the fastest growth rates in the world last year. It is a remarkable turnaround after dismal years in the early part of the century caused by the economic and social turmoil of 2001. That year, the country’s government was brought down by protesters against economic mismanagement, and a giant devaluation of the peso caused a deposit run that put many a banking outfit out of its

misery. At the time, more than 200 banks had been active in the country but only 80 work the market today. Argentine banks had to endure some very meagre pickings before the economy got back on track in the middle of the last decade. The process was not painless but, by 2010, banking shares were among the best performers on the Buenos Aires stock exchange (BCBA), delivering returns of almost 200% in one instance. For some, it may be hard to believe that a sector that was on its knees a decade ago could be delivering such performances in a country that still gives investors the “jitters” for its sometimes messy approach to economic

management. Even so, the general improvement of Argentina’s economy, achieved despite the meddling of its government, has enabled banks to cash in on opportunities available in an underdeveloped market. “Our stock market has probably been playing some catch up,” says Daniel Llambías, chief executive officer at Banco Galicia, the outfit which posted the impressive returns outlined previously. “The increase of the value of the bank is mostly due to the performance of our business.” It is estimated that the combined profits of the banking industry closed 2010 at ARS11bn (around $2.8bn), its best results to date. The fortunes of the entire banking sector have changed. According to Argentine daily newspaper La Nación, over the past five years, profits totalled more than ARS32bn, compared with accumulated losses for the sector of some ARS23.6bn in the previous five years.

Economic stability As in other emerging markets, much of the merit can be attributed to a period of relative macroeconomic stability that has allowed banks to offer better loan conditions and boost their credit activities. According to Adeba, a local banking association, the volume of loans increased 36% in 2010 alone, after posting an already strong 20% hike the year before. Despite the fast growth of loans, delinquency rates continue to be low. The good news for banks is that the Argentinians are finally developing consumer instincts; though the country’s credit to GDP ratio remains a tiny 22%. For instance, in Brazil, a country that is also living a credit boom, the ratio is 55%, Adeba says. Banks claim that there still is much potential for growth, especially if the comparison is made with developed countries. In the US, Adeba points out, loans amount to 180% of GDP. “We expect that the dynamics of the credit market will be even better this year,” says Jorge Brito, the chairman of Adeba, who is also the head of Banco

FEBRUARY 2011 • FTSE GLOBAL MARKETS

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BANKING REPORT

ARGENTINE BANKS: HOPING TO BUILD ON LAST YEAR’S PERFORMANCE

A government-supported campaign is under way to motivate Argentinians to make more use of banking services, not least because it would help to fight the rampant black economy that costs the official purse plenty in tax revenues. Macro, another listed bank. Retail banking is regarded as a particularly attractive segment. Some credit activities, such as commercial loans to companies, have just started to recover from the lows of the global crisis. The granting of mortgage loans is still a marginal segment, barely reaching 1% of GDP (compared to 7% in Chile), and bankers expect that, following a trend already under way in neighbouring countries, Argentines will begin to have more access to such products in the near future. Credit cards, for their part, have done very well, and should carry on strongly over the near term. Llambías says that Banco Galicia alone expects to add 500,000 new clients to its portfolio of 4m credit card holders in 2011.

Historical trend Argentina’s banks, along with the country’s government, are also working hard to enhance access to banking services among the population, in a quest to revert one of the lowest bank penetration rates in the sub-continent. It won’t be an easy task: a recent survey has shown that about half of all Argentinians prefer to keep their savings at home rather than in a bank account. “That’s a historical trend, and not only related to the events of 2001,” Llambías says. “Even in the peak days of the 1990s, the ratio of deposits to GDP didn’t breach the 20% threshold, and today it stands at 16%,” he points out. Moreover, those retail and high net worth investors who can, have also tended to buy foreign currency (especially dollars) in order to protect themselves from the ups and downs of the peso. The stability of recent years and the current weakness of the dollar and the euro could help the task of changing these habits, say bankers. A government-supported campaign is under

way to motivate Argentinians to make more use of banking services, not least because it would help to fight the rampant black economy that costs the official purse plenty in tax revenues. “This is probably our most fundamental challenge today,” Brito remarks. By the end of 2010, the central bank had introduced a new rule that requires banks to open branches in less populated and prosperous areas of the country, as a condition of expanding their networks in more affluent areas. While the rule smacks of meddling by an already invasive government, some firms, such as Banco Macro, believe that the road to riches leads directly to the interior of the country. The firm already has 85% of its branches outside the main metropolitan areas, according to Brito. The nascent state of the economy in the Argentine is another reason Brito believes banking shares will still rise. Banco Macro’s own shares were up 80% in the year to mid-January, and its chairman remains upbeat about the future. “We have not hit the ceiling in terms of stock market growth, and Argentina’s banks will keep delivering good results in 2011,” he states. Banco Galicia and Banco Macro are the two largest banks controlled by Argentinian shareholders. They rank fifth and sixth in the market in terms of deposits, behind two stateowned banks and the local units of Banco Santander and BBVA, two Spanish multinational groups. High profit levels and strong growth could be a tad harder to repeat this year, though. Brito himself notes that a substantial share of the profits achieved in 2010 were due to the strong appreciation of government bonds that the bank holds in large quantities. Analysts believe it is unlikely that the bonds rally will keep going this year. Furthermore, Brito says that Argentine banking

clients still have a tendency to keep their money in the bank only for the short term, opting for deposits of less than six months. “It clearly makes it more difficult to provide loans with longer maturation periods,” he stresses. Some respite could be found in international markets, as Argentine banks have been finding it a little easier than in previous years to access funding abroad. It helps that there has been a gradual change of perception about Argentina by investors, aided by a successful debt swap agreed last year with international creditors that were hit by Argentina’s latest default, in 2001. “As the country risk keeps going down, interest rates will carry on falling, and loan periods will be extended,” Brito argues.

Dysfunctional politics When the subject is a country such as Argentina, however, it is always salutary to keep an eye on the clouds that inevitably can be seen on the horizon. The main reason for concern for both domestic and international investors is the country’s dysfunctional politics. The government of president Cristina Fernández de Kirchner has for a long time had a knack for meddling in private businesses and to spend freely. It has also been accused of manipulating statistics to hide the real rate of inflation that has been fuelled by its lack of discipline and the economy’s strong growth. Unofficial estimates have put inflation as high as 25% and the topic is certainly, as Brito points out, “at the top of the list of priorities of economic agents”. Even so, no small degree of optimism seems to have created roots in the country, especially in the banking system.“ Argentina’s economy did very well in 2010, so the banking business had a good performance, too,” Llambías says. “We don’t see any reasons why it should be different in 2011. Even factoring in some risk of political instability in the wake of this year’s elections, we believe the economy will grow by 5.5%. It could be even more than that, if the political situation remains stable,” he concludes. I

FEBRUARY 2011 • FTSE GLOBAL MARKETS

THE NETHERLANDS: RESTRUCTURING CONTINUES

Photograph © Norebbo / Dreamstime.com, supplied January 2011.

Times still tough as Dutch banks look for new business The financial crisis continues to reverberate throughout the Dutch banking landscape with restructuring remaining a major theme in 2011. While there are signs of recovery, most of the major players have their work cut out for them in restoring their balance sheets to a healthier state. It is not an easy task but even greater challenges lie ahead in capitalising on existing business lines as well as unearthing new areas of growth. Lynn Strongin Dodds reports. VER THE PAST two years, the Dutch banking sector, which is still dominated by only a few participants, has undergone a significant makeover which has involved both consolidation and fragmentation. The most high-profile casualty was ABN Amro Holding, which disappeared from the international banking scene after being bought and split in

FTSE GLOBAL MARKETS • FEBRUARY 2011

2007 by a consortium of Fortis, Royal Bank of Scotland and Banco Santander in a €71bn takeover, the biggest ever in the financial sector. The domestic operations were subsequently merged with former Dutch-Belgian financial services giant Fortis Holding as part of a Dutch government two-prong rescue programme. At €30bn, it ranked as one of the costliest bailout packages of the

financial crisis and also included nationalising Fortis’ Dutch insurance business, now known as ASR. ING has also had its fair share of problems and is in the process of halving its balance sheet as part of the €10bn government lifeline it received. European regulators approved the deal on certain conditions: the insurance and troubled US online banking divisions had to be sold and additional payments to the state had to be made for the €21.6bn risk transfer of US mortgage assets. Meanwhile, SNS Reaal is also being forced to put its house in order as part of an €750m injection it received. The country’s fifth largest bank also obtained a €500m infusion from Stichting Beheer SNS Reaal, a foundation that holds a majority stake in the company.

BANKING REPORT

THE NETHERLANDS: RESTRUCTURING CONTINUES

It agreed to relax repayment terms, giving the group more time and flexibility to redeem the support. The only bank to escape relatively unscathed is Rabobank, the cooperative bank which has retained its coveted triple-A credit rating. Its conservative lending practices have held it in good stead and although it was impacted by the financial crisis, it suffered far less than its competitors. As a result, the bank has usurped ABN Amro’s prime position as the number one bank, accounting for around 30% to 32% of market share, according to industry estimates. ABN Amro has dropped to third place with around 24%, although exact figures are hard to tally due to the integration of Fortis, while ING is somewhere in the middle with an estimated market share of 25%.

Operational risks Moody’s Investor Services has reservations about the sector and has kept its negative rating first imposed in 2009. The ratings agency says that Dutch banks are still challenged by operational risks, the possibility of lower demand and higher credit costs due to an improving but still low domestic economic growth, as well as the general fragility of the broader economy within the European Union (EU). It added that “under such conditions, the Dutch banking system will be challenged to return to comparatively normal profit levels”. Nick Hill, head of financial institutions ratings for the Benelux and France at Moody’s Investors Services, says: “Since the financial crisis, the banking system in the Netherlands has been undergoing a major transformation and although the operating environment has improved, there are still three major risks. These include a tricky macroeconomic outlook as well as the refinancing needs of the sector due to the state aid of varying degrees.” Looking at the big picture, Alain Branchey and Claudia Nelson, both senior directors at Fitch Ratings, believe that Dutch banks have begun to show improved profitability, but

Thomas Nagtegaal, a banking analyst at Royal Bank of Scotland in the Netherlands, thinks that the sector will continue to witness “significant cost-cutting programmes, repricing of outstanding loans to better reflect market conditions and the adoption of a more back to basics approach”. point to several stumbling blocks which could hamper growth in the short term. The first is that the cost of credit on corporate loans is expected to continue to impinge on profitability. The Netherlands may have emerged from recession, but corporate bankruptcies and unemployment often lag a recovery. Impairment charges are expected to exceed their long-term average of about 0.30% of average gross loans for the major banks in 2010 as was the case in 2009. While net interest income should continue to benefit from the positive yield curve, it remains vulnerable to changes in interest rates, they note. Moreover, as banks continue to focus on retail funding and seek to limit reliance on wholesale markets, Branchey and Nelson expect deposits to remain more expensive than before the crisis. Overall, Branchey and Nelson note: “Growth prospects for banks are likely to be limited given the Benelux banking market is very mature.” They explain that Dutch banks are reducing their service range and these days are concentrating on their domestic franchises and becoming less international at a time when the domestic economic recovery is only gradual. Moreover, restructuring plans agreed with the European Commission (EC) are leading some of the Dutch banks to sell off a slew of business lines at the same time that many institutions across Europe are trying to shed businesses. Inevitably, industry-wide, sale prices may fall and sale processes lengthen. Thomas Nagtegaal, a banking analyst at Royal Bank of Scotland in the Netherlands, thinks that the sector will continue to witness “significant

cost-cutting programmes, re-pricing of outstanding loans to better reflect market conditions and the adoption of a more back to basics approach”. He adds: “There was a lot of slack in the Dutch banking market because of the acquisition sprees that many undertook over the past 15 years. There is now a much greater focus on generating better cost efficiencies and banks are looking at key markets where they can make a difference. I think these three main themes will continue this year but banks are at different stages of their recovery.”

ABN Amro back in the black? Not surprisingly, this is particularly true of ABN Amro, which is in the middle of the long, arduous process of integration with Fortis. Cor Kluis, senior equity analyst, Benelux financial sector, at Rabobank Equity Research, adds: “It is too early to predict how the integrated bank will rebuild itself but the old ABN Amro is gone for good. One of the problems was that ABN Amro was too big for the Dutch market. While most of the Dutch banks were focused on their domestic markets, with some international operations, ABN Amro was looking to be a universal bank to compete with global players such as Citi, JP Morgan and Deutsche Bank. However, they were not able to do so at the same level.” The newly integrated entity will in many ways be a shadow of the former ABN Amro. It will have much less of an international presence and will comprise of a large Dutch retail franchise, a Europe-focused private banking unit and an investment bank focused on the Netherlands. It will also target certain niche markets such

FEBRUARY 2011 • FTSE GLOBAL MARKETS

as energy, commodities and transport. The total cost of the integration is estimated to be around €1.6bn with roughly 6,500 layoffs. ABN Amro chief executive Gerrit Zalm recently stated that he expects the bank to be in the black this year and to complete the merger by 2012. Although it reported a nine-month net loss of €352m, it recorded a €341m net profit in the third quarter due to lower operational costs, higher net interest income and a drop in bad loan charges. As for paying back the government, the bank is expected to make a gradual return to the market with a minority stake instead of the whole enterprise being put on the block. The rationale is that a gradual flotation may result in a better price for the government, which is facing pressure from the public to recoup taxpayer money. Analysts currently estimate the bank’s value at between €10bn to €12bn but it could be higher once the integration is completed and synergies are realised. As Nelson says: “Everything is going in the right direction and the underlying profitability is showing improvement. However, I think the integration may take longer than expected due to current market conditions. One of their biggest challenges is to find new revenues that will offset the businesses that they have lost due to the merger.”

Setting the stage The recovery stories are far less complicated for the other banks. ING, for example, is setting the stage for two IPOs: a mainly European deal, which would include operations in Asia and Eastern Europe, and another for its insurance operations in the US that will focus on retirement services. Although no definitive timeline or order of preference was given, analysts believe that the group will be able to replenish the government coffers during the first half of 2012. According to Jan Willem Weidema, an analyst at ABN Amro, ING will also divest WestlandUtrecht (WU) bank, a retail bank with a mortgage loan port-

FTSE GLOBAL MARKETS • FEBRUARY 2011

Jan Willem Weidema, an analyst at ABN Amro. “We see Deutsche Bank or a Scandinavian player (such as Svenska Handelsbanken) as most logical buyers. If Deutsche buys WU it will gain market share and its total market position moves towards that of the large retail banks in the Netherlands. If a Scandinavian bank will buy it, we expect a more aggressive market player in the Netherlands as Scandinavian banks are all well capitalised and positioned for growth,” he says. Photograph kindly supplied by ABN Amro, January 2011.

folio of €34.4bn. “We see Deutsche Bank or a Scandinavian player (such as Svenska Handelsbanken) as most logical buyers and estimate the transaction price between €600m to €1bn. If Deutsche buys WU it will gain market share and its total market position moves towards that of the large retail banks in the Netherlands. If a Scandinavian bank will buy it, we expect a more aggressive market player in the Netherlands as Scandinavian banks are all well capitalised and positioned for growth,” he says. Meanwhile, SNS Reaal is also making process and aims to step up the restructuring pace amid concerns that the bank may need a capital

increase in order to repay the aid because it lacks earnings power. The group recently reported a jump in third-quarter net profits of €63m from €26m a year earlier on the back of an improved performance of its retail bank and insurance operations. However, loan losses at its international property finance business remained high and the bank would have a made a net profit of €163m without this unit. SNS Reaal has insisted though that that it has no intention to issue shares but plans instead to sell certain businesses. Weidema says: “SNS Reaal had a bigger exposure to real estate than the other domestic players and it needs to de-emphasise those business lines in order to free-up capital and payback the government. I think we will see it sell its international property finance and phase out a part of its Dutch real estate portfolio over the next two to three years or so.” As for Rabobank, analysts are optimistic that it can keep its pole position. Nelson says: “It is a well capitalised bank which did not lose too much money as a proportion of its overall business from its US and Irish subsidiaries. As a result, it has weathered the crisis well but has actively implemented measures to improve its cost efficiency. It continues to reduce the number of branches and staff, which was down by about 2% in the first half.” Although they are all at different stages of their restructuring, they all face the same long-term challenges. As Hill notes: “The Dutch banks used to be quite international and they are being left with a more significant domestic bias. They can enhance their profitability through cost efficiency but that only works for a limited period of time. They need top-line growth and the big question is where can they generate that from in a relatively small and mature country? Asset management and private wealth will likely contribute but we are still sceptical that these will be long-term panaceas. This is one of the main reasons why we have a negative outlook on the sector.” I

REAL ESTATE

RUSSIAN REAL ESTATE: A WHOLE NEW BALL GAME

World Cup sets Russia new goals When Russia trumped rivals with its 2018 World Cup bid, the country completed a hat-trick of sporting triumphs, having already secured the 2014 Winter Olympics and a Formula One grand prix, which will run for six years from 2014. However, hosting some of the biggest sports competitions in the world comes with a price tag. For all that the triumvirate of events will enhance the country’s sporting reputation and ring the cash tills, it will also require the Russian government to invest tens of billions of dollars into the country’s crumbling infrastructure and inject finance into its real estate development sector, writes Mark Faithfull. HE GOOD NEWS for Russia is that private investment has already begun to creep back into Moscow and some other key citybased real estate schemes after two years in which international funding all but disappeared off the radar amid widespread investment caution. In times of trouble, Russian real estate was quickly perceived as high risk. However, in 2010 almost $5bn was invested in Russian property—not far off the peaks of 2007 and 2008—and 2011 is expected to fare even better. Naturally, the 13 cities in the four regional clusters hosting World Cup matches will feel the most immediate benefit of the bid win and all will receive massive injections of investment to upgrade transport and tourism facilities, plus the construction of 13 stadiums and refurbishment of three. A precedent has been set in Sochi, on the Black Sea, which will host the Winter Olympics. Several renovation schemes are already taking place, notably state-owned shipping company Sovkomflot’s $280m Port of Sochi Grand Marina mixed-use waterfront development, which covers seven hectares, including a marina, a 250room hotel, office and retail space. However, construction of the Winter Olympics has been hugely expensive

and the Russian authorities had to set up a special body to cut through the country’s interminable red tape and complex planning laws. Because of the distances between cities, most visitors are expected to travel by air and the government has committed itself to doubling airport capacity at Moscow and St Petersburg by 2015 and tripling capacity for Ekaterinburg by 2012, with similar upgrades planned for Kaliningrad and Samara by 2018 and 2020 respectively. Capacity in Kazan and Sochi is to be quadrupled by 2018, while a new airport will be built at Rostov-on-Don by 2017. Of the 13 football cities, six are to be connected by Sapsan high-speed trains to the Moscow-St Petersburg and Moscow-Nizhny Novgorod lines, which opened last year. A link to Sochi should be in place by 2013, while Kaliningrad will be connected by 2016. Similarly, Russia’s motorway network will also be upgraded through privatepublic partnerships (PPP). By 2018, Moscow and St Petersburg will be connected by the Khimki toll highway— built on an operator concession basis by a group including France’s Vinci Construction—while existing motorways linking the capital with other host cities will be upgraded using similar PPP deals. “I think the fact that the Russian

Photograph © Michael Knight / Dreamstime.com, supplied January 2011.

government has gone down the PPP route for both rail and road shows that they get it, and that they realise the way forward is not simply to sink oil and gas money into these projects,” says Darrel Stanaford, managing director of Magazin Magazinov, part of the CB Richard Ellis network. “A lot has been made about hold-ups in the highway’s development because of environmental protests (the first time the government has had to face public opinion) but less of French investment and involvement in the project.” “There is no doubt that infrastructure spend is desperately needed, especially in some of the millioniki cities, where even now almost all real estate is based off the one main road through the city,”

FEBRUARY 2011 • FTSE GLOBAL MARKETS

WORLD CUP 2018: RUSSIA IN NUMBERS USSIAN PRIME MINISTER Vladimir Putin in mid-January announced that he had established an organising committee for the 2018 World Cup and ordered an increase in spending on domestic sports. “Our task isn’t only to prepare well for them and hold these events to the highest possible standard, but ensure our teams perform successfully,” he told journalists. Russia’s successful bid for the 2014 Winter Olympic Games and the 2018 World Cup is expected to generate investments worth $50bn, largely financed by the government, involving spending on airport expansion, highspeed rail links and new toll motorways. The private sector, meanwhile, will be encouraged to find between $10bn and $15bn to provide supporting infrastructure for the events. The government has meanwhile earmarked RUB90bn (about $3bn) on

says Tom Devonshire-Griffin, head of capital markets, Russia and CIS, Jones Lang LaSalle. “Those improvements will broaden where new office and retail space can be built.” David Jenkins, head of hospitality, Russia & CIS, at Cushman & Wakefield, underscores the need for hotel development: “Certainly the country needs hotels of all levels. The important part will be in the initial planning stages to create hotels that are commercially driven and operate at all segments—especially affordable hotels which will appeal most to the travelling football fans—and afterwards to business travellers.” Russia’s retail real estate sector had already started a modest recovery

FTSE GLOBAL MARKETS • FEBRUARY 2011

before the World Cup announcement, notably in the retail industry in and around Moscow. Construction of the €100m Fashion House Development (FHD) Outlet Centre, near Moscow’s Sheremetyevo Airport, will begin this April, with the opening planned for the following November. Funded by investment fund Liebrecht & Wood, FHD holds a second plot in St Petersburg. Devonshire-Griffin points out transaction volumes have been boosted by a lack of available debt. Prior to the crisis, few Russian property owners were interested in selling real estate, which was appreciating in both capital and income earning terms. Now, developers need to sell in order to finance new projects. However, he warns: “Senior debt has returned to the Russian market but where it is still lacking is for construction financing, where only the state-run banks will provide funding. So this is another area which needs to be addressed. Of course, a lot of the construction will be carried out by Turkish companies, which have a strong presence in Russia, and it will be interesting

investment in sports and school sports facilities over the next three years, of which just over a third will be dispersed in 2011. It was Putin’s personal goal to bring both the 2014 Sochi Winter Games and the 2018 World Cup to Russia as part of a wider drive to raise the country’s prestige abroad. He said the events could also help improve the quality of life and make the nation healthier. Russia will spend at least $10bn on upgrades to infrastructure in 13 cities to host World Cup matches, of which $3.8bn is allocated for either the building or upgrading of some 16 stadia. It will also invest more than $30bn in preparations for the 2014 Winter Games in the Black Sea resort of Sochi. A further $11bn is also expected to be invested in building or upgrading as many as 20,000 hotel rooms to accommodate fans.

to see if foreign investment comes into the market.” Shopping centre development has focused on Moscow but Oleg Voytsekhovskiy, managing director of the Russian Council of Shopping Centers, warns that new build is not the only priority. “It is not rare for the best locations to be occupied by schemes that could hardly be described as shopping centres,” he reflects. “We must improve the situation, even if it means bringing an old shopping centre down.” Stanaford is also encouraged by the wider impact of the World Cup on other real estate projects, noting that stabilisation of the occupier market and an end to distress sales have created a solid platform for the real estate sector. “There is undoubtedly a lot of work to do but upgrading the infrastructure to the host cities will help to take the focus off Moscow, which acts like a magnet for both people and investment,” he says. “A proper logistics platform gives businesses, and therefore people, more choice about where they are based and the current poor state of the infrastructure has held up that movement.”I

REAL ESTATE

EGYPT: NEW APPROACHES TO PROPERTY INVESTMENT

Aerial view of Palm Galleria. Photograph supplied by Mark Faithfull, January 2011.

Finance finding the middle ground As real estate investment flows out of the Middle East and into North Africa, Egypt has led the charge for growth and property opportunities, fuelled by demand from its rapidly expanding and youthful population. Yet the demands and affluence of Egypt’s 80m population are very different to those in the Gulf, and the Egyptian government is working with developers and investors to find the right formula to relieve congested capital Cairo and to capitalise on property opportunities, writes Mark Faithfull. HILE EGYPT’S NEW compounds and gated communities have been a major success with the most affluent Egyptians and international buyers, they are well beyond the reach of the the country’s lower and middle classes. Investment bank Naeem estimates an annual demand of some 200,000 homes for what it describes as a middle annual income bracket ranging from $4,700 to $35,000. Such housing is required to fulfil Egypt’s masterplan to expand the desperately over-crowded capital Cairo, with new suburbs being constructed to relieve the pressure. “Any real estate company must realise that within five years, if it is not primarily involved in middle-income housing backed by a strong mortgage market, it will be missing the good pie [sic],” reflects Maher Maksoud, chief executive officer of one of Egypt’s biggest developers, Sixth of October

Development & Investment Company (SODIC). Along with Palm Hills Developments (PHD) and Talaat Moustafa Group (TMG), the triumvirate is behind many of Egypt’s biggest residential schemes and more recently has diversified into commercial property. Nonetheless, Patrick Gaffney, real estate analyst with HSBC, warns: “Affordability continues to be an issue and could be exacerbated by inflationary pressures. Inflation was 10.2% yearon-year in November and we believe that developers will try to raise prices in 2011, although potentially not by as much as the rate of inflation. Nevertheless, it will still hurt affordability.” One way to unlock this middle income property market would be to expand mortgage lending. Mortgages make up less than 0.5% of Egyptian GDP, compared with 14% in neighbour Morocco, representing less than 100,000 Egyptian customers. New laws

may start to address some of the problems but there are systemic issues, for example less than 30% of the country's property is registered. “For lower and middle income Egyptians the vast majority of homes are self-built and illegal, so there is no resell value, they are simply constructed to put a roof over their heads,” reflects Serge Vidal of CI Capital. “But there is huge potential in this market, with estimates of a 750,000 unit shortfall by 2015.”

Legal jolt Legal challenges contesting state land sales have also jolted the market and came to a head after a court ruling that the land contract for TMG’s flagship Madinaty project was illegal as it was not sold at auction. The government scrapped the original contract but resold the land to TMG under its right to act in the public interest. Investors welcomed the speedy resolution but it has not prevented further cases, although most have been settled. Gaffney adds: “Legal issues are mainly behind us. TMG’s new contract with the government appears to have reassured the market that it will retain ownership of the Madinaty land [circa 70% of its total land bank] and the management of TMG and PHD expect new legislation in parliament, most likely in the first quarter of 2011, which will provide a permanent solution.” Maksoud remains confident, however: "With the initiation of the delivery cycle, SODIC will be finally reaping the benefits of the $690m of unrecognised contracted sales achieved

FEBRUARY 2011 • FTSE GLOBAL MARKETS

over the past few years. The introduction of a well diversified product range in 2010 contributed to $293m of contracted sales year to date (more than double 2009). Looking forward, we are planning to launch more projects.” HSBC believes diversification will be the main future driver and that SODIC and PHD are better placed than TMG by launching differentiated projects from other offerings in the market and because of PHD’s land bank.

Under-supply and strong sales Vidal cites massive under-supply in both the office and retail markets. “Office quality is very poor with occupancy rates of around 99% for premium grade office space,” he says. “However, there have been a number of new developments such as Smart Village at 6th of October City, which is a Silicon Valley style business park, Pyramid Heights, and office space at the Citystar mixed-use, retail-led development.” However, he concedes that there is definitely great potential for more development. “SODIC’s two main upcoming developments, Eastown and Westown, will be mixed use, and we expect future supply will be one third residential, one third office and one third retail/hospitality,” says Gaffrey. “Deliveries at Allegria have relieved investors’ concerns over execution. Allegria was the first project of the new management team which took over in 2006. We expect that as deliveries come through, buyers and investors will become more comfortable with management’s execution ability.” Similarly, PHD reported a 15% yearon-year rise in net earnings to $26.5m as it announced its consolidated financial and operational results for the third quarter of 2010. Performance in the quarter was marked by strong growth in both new sales and revenues at PHD, which has a land bank in excess of 48.3m sqm across 22 separate projects. “Strong sales at Palm Hills’ North Coast developments underpinned our record sales in the third quarter. Palm Hills Developments has benefited from

FTSE GLOBAL MARKETS • FEBRUARY 2011

strong organic sales momentum in a quarter during which we had no new project launches,” says Palm Hills Developments chairman and chief executive officer Yasseen Mansour. “We remain confident in the real estate sector’s broad demand fundamentals and believe that PHD’s extremely diverse land bank will perform well. For 2011, our emphasis will be on construction with the goal of beating our delivery schedule on select developments.” Retail has led out the commercial real estate sector, with a series of projects now under construction or at planning. Retail density is very low currently, with just 600,000 sqm of modern retail space in Cairo, representing 40 sqm per 1,000 of capita, compared with 800 sqm in Dubai. By 2015 another 1.9 sqm will have been added, much of it backed by Saudi and Kuwaiti money. Furthest along the line is Cairo Festival City, developed by Al Futtaim and modelled on the existing Festival City in Dubai. Leasing director Phil Evans, who is also overseeing another Festival City in Doha, Qatar, adds: “Cairo is lacking a venue to attract the strong latent demand from international retailers and Cairo Festival City will also serve the local population of New Cairo and the new residential elements of the project.” However, it has rivals in the shape of retail newcomer Cleopatra Group (Real Estate Projects) and Mall of Arabia. The former is planning a 120,000 sqm centre with 300 stores on three levels, 50,000 sqm of hotel space, 50,000 sqm of office space, and a $350m investment. Located in 6th of October City, to the west of Cairo, on completion Cleopatra Mall will be one of the largest projects in Egypt. Meanwhile, Mall of Arabia is located close to Smart Village. PHD’s latest project is the 32,000 sqm Palm Galleria, which is now under construction in New Cairo. The first mall in Egypt to feature a retractable roof, the three-level mall is due to open in October this year with 100 retailers, 17 restaurant and food outlets and a

six-screen cinema. Located in the emerging downtown part of New Cairo, it has been funded through a joint venture with UK-based fund manager Pradera, one of the first investors to enter Greece and Turkey, and the pair plan to own two malls by this autumn and grow to six malls eventually, which would create a fund in the region of €800m. Pradera group property director John Glassett says that after watching Egypt for some time, Pradera believed the timing had become right. “It’s always a difficult call to make but we felt the pricing and opportunity made this the correct time to make our move,” he explains. “Other investors are looking at North Africa, especially Egypt, and importantly the retailers are very interested in the opportunities in Egypt.” Pradera is looking to source local investment first before attracting overseas institutional investment in the future, although Glassett concedes that the Egyptian investment scene still lacks maturity. “It is not organised in the same way as Europe and the banks are more cautious about lending, however there is finance available and we are hoping to make our second acquisition very soon,” he says. “Our initial interest is in developments in Cairo and Alexandria but as we progress I’m sure other cities will also become attractive.” Vidal adds that a debt market has emerged in Egypt, enabling commercial real estate projects to proceed on 50% to 60% debt-to equity ratios, with finance coming from both Egyptian lenders and GCC funding. “European funds are looking but little has happened yet,” he reflects. “However, this is likely to change.” The numbers say it all: Egypt's population of circa 83m is expected to reach 91m by 2014, and is increasing at an annual rate of 2.5%. Moreover, people under the age of 35 make up 70% of the total population. The fast-growing population is also increasingly prosperous, and expected GDP growth in fiscal 2010/2011 is running at 5.8% to 6.0% I

FACE TO FACE

PING AN SECURITIES: NEW BEGINNINGS

A home-grown business focus For one of China’s most important and innovative financial institutions, the Ping An Group maintains a remarkably low international profile. It is not so much that it is hiding, but preoccupied with building its domestic business. Even so, the group, and its innovative securities subsidiary, is preparing for an eventual expansion overseas, and bankers should be prepared for a formidable rival. Rongnian Xue, head of subsidiary Ping An Securities, notes the firm has already set up its own subsidiary company in Hong Kong to develop the securities business. Ian Williams reports on the firm’s immediate prospects. N THE SHORT term, “our focus remains on China’s capital market, and on providing customers with better services,” holds Rongnian Xue, head of Ping An Securities. Even across the Straits to Taiwan is a splash too far, at least in the near term, he says. However, the company has in recent years “initiated personnel exchange programmes with Taiwan. Our fixed income unit, for instance, imported structural products professionals a few years ago from Taiwan where the securities market is sufficiently developed.” Looking ahead, the firm is intent on recruiting selected 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,“explains Xue. Ping An was one of the first firms in China to attract overseas stakeholders, with Goldman Sachs, Morgan Stanley and HSBC being significant, albeit minority, shareholders in the holding company. It also prides itself on its application of international corporate governance standards and its management board is laden with expatriate expertise. Ping An began as an insurance company in Shenzhen not long after Deng Xiaoping chose the greenfield site

on the Hong Kong border for his economic experiments. In business terms, of course, the experiment succeeded beyond all expectations, not least for Ping An. The group has expanded into other financial sectors: retail and investment banking, and wealth management, for example. A securities department was set up in 1991 and became a separate company in 1995. Expanding from its regional base to a national network, it has benefited from the boom in IPOs in China and Hong Kong. The latter, for example, raised $52.8bn and the People’s Republic of China $66.9bn in 2010 compared with a mere $42bn in the US. Xue also points out that the securities firm has “positioned itself in the Growth Enterprise Market (GEM), which can provide relatively more room for its development.” In the face of the subsequent reform of the Chinese Enterprise’s joint stock system in 2005, the introduction of the SME board and the official launch of the GEM board in 2009, Ping An Securities, says Xue, had a “vision and was a pioneer in setting up its strategic layout in the market, thereby grasping the valuable opportunities for rapid business growth [sic]”, he adds. “Of the 518 companies listed on the SME board currently, 54 were underwritten by Ping An Securities, a share of 10.4%, ranking second in the

market.” We also underwrote 21 of the 142 companies listed on the ChiNext board, ranking first in the market with a share of 14.8%,”he continues. Proud of its innovation, he claims that the company “ventures into areas and takes on projects that other securities firms fail to grasp”. So far, Ping An has helped several companies from various sub-industries to be the first to list their shares, including industry leaders such as media firm Northern United Publishing, pesticide manufacturer Noposion, Jiangsu Yuyue Medical Equipment, sea farming firm Zhangzidao Fishery Group and textile maker Lovo. To explain the firm’s success, Xue claims that Ping An’s “business philosophy of being innovative, bold and pragmatic”, and the company’s comprehensive compliance and risk control system are significant factors in a high growth market. The firm’s financial clout has also helped and, he adds, “was boosted further with the increases in registered capital in 2009, from RMB1.8bn to RMB3bn”. The firm has also benefited from the brand strength of the Ping An Group, and the holding company’s client base across its insurance businesses has provided the securities firm with a readymade network for expansion of its brokerage services. Xue refers to the company’s “brand awareness, track record and pioneering corporate culture” as “crucial to the success of our investment banking business”. He adds: “After more than two decades of development, the Ping An Group has accumulated more than 50m retail customers and more than two million corporate clients, which has built 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.” The synergies across the group derive from the sharing of internal resources through its “one customer, one account, multiple products, one-

FEBRUARY 2011 • FTSE GLOBAL MARKETS

stop shop service” strategy, which, he explains, “requires a technical framework of great reliability and scale”. Moreover, a strong focus on customer value means some “90% of our clients come back and we always have sufficient reserves for our projects”. Despite the closely integrated resources, Xue stresses that the group operates well-established risk management practices which it marries with “Chinese walls” between its various businesses. He explains that senior financial management staff are not allowed to hold concurrent posts within the group or any of its subsidiaries, nor are they allowed to interfere in the day-to-day business or managerial operations of any subsidiary. Xue attributes the company’s success to its human capital as much as its financial capital, and points out proudly that its management “has an average tenure at the firm of over ten years and are veterans in the IPO market”. He adds: “Our team shares a common vision and goal to which the management is deeply and personally committed, so we’ve managed to accumulate rich client resources and professional experience.” The company “values team work and the management team manages to pass our culture to all staff: we respect the skills and knowledge of others”. He adds: “Over the past few years, we grasped the growth opportunity of China’s capital market during this invaluable and historical moment; for instance, in 2009, faced with an unprecedented complex situation and increasingly keen competition, and carried out reformative changes.” Presumably it worked, as he explains: “The company has managed to achieve a significant growth of 95% in its annual net profit. Our investment bank business continued to maintain its leading advantages in the SME and ChiNext markets. The company ranked first in the underwriting scale. Its fixed-income business was excellent in areas such as bond underwriting and trading. The market share of its brokerage business continued to increase and the advantages of its integrated financial services

FTSE GLOBAL MARKETS • FEBRUARY 2011

Rongnian Xue, head of subsidiary Ping An Securities. Photograph Kindly supplied by Ping An Securities, January 2011.

began to take effect and its asset management, research consultation and institutional business grew steadily along with the company’s influence in these markets.”

Quality of listings There have been some concerns at the quality of the companies launched in the ChiNext market, with allegations of founder managers cashing in and leaving, possibly at the expense of investors. How justified are those fears? Xue sturdily defends it. “This is a question often raised by the media and investors in China. The fact that the offering price, PE and fundraising size of ChiNext listings are often seen to be excessively high could be because of profiteering by speculators. As investors incur losses it is understandable that they have such doubts.”

However, he cautions: “We should look at this issue objectively and rationally. First, it is unreasonable to look at the PE ratio solely to judge whether the offering price is too high or too low. A high-growth company deserves a high PE, while companies with lower growth ought to have lower PEs. This problem is unavoidable in any developing market. China’s market has limited investment channels and it has its share of problems with new issues and speculation. ChiNext companies are often smaller in scale compared to main board companies, which has created relatively strong expectations of their growth prospects, and leads to the perceived high valuations of highgrowth companies.” In addition, Xue explains that ChiNext has offered a large number of quality SMEs a platform to raise funds, thereby “solving the problem that fastgrowing enterprises are often faced with, which is a bottleneck in financing”. He adds: “This ensures quality enterprises are supported by market capital, and it is a powerful driving force for the fast and healthy development of SMEs. It has encouraged China’s private enterprises to be more disciplined in their operations.” It has also provided venture capital and private equity with a new exit option and been effective in directing market capital and economic resources. “That helps restructure the country’s economy and provides powerful capital support to innovative enterprises. The ChiNext market also allows the Chinese people to enjoy the fruits of their country’s economic success, the development of the capital market, and share in the opportunities created by innovative enterprises.” He concludes firmly: “We believe its advantages far outweigh the disadvantages.” Xue sums-up that the main effort at present is “to build Ping An Securities into one of the best financial brands in China’s capital market”, but there is little doubt that it would be a launch pad for expanding internationally. Watch out Wall Street and London.I

FACE TO FACE

SEC-LENDING CLEARING: BASEL III RULES SET TOUGH TARGETS

Tougher capital requirements from Basel III will fundamentally shake up the way securitieslending transactions are processed, forcing the business to move away from bilateral market practices while favouring more efficient centralised trading and clearing facilities. SecFinex stands ready to reap the benefits. Dave Simons reports from Boston. S THE SECURITIES-lending business seeks to rid itself of lingering risk while promoting processing efficiency, the old bilateral methods of securities-lending trading that exist between custodian agents and prime brokers have become an easy target. Central counterparties (CCPs) and their inefficiency-busting, electronic-trading platforms are widely viewed as key to sprucing up seclending practices. The timing is ripe for Europe’s pioneering securities-lending exchange, SecFinex, as it looks to expand its own centralised securities lending clearing programme through Europe’s major markets. CCPs now have regulatory momentum. The introduction of the Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States, has helped set the stage, as it requires the US Securities and Exchange Commission (SEC) to introduce a set of rules that will encourage transparency in the securities lending business arena over the next 24 months. The incorporation of CCPs into the mix is a, some say, necessary condition if transparency is to be achieved and they point to the derivatives markets where CCPs have provided price and operational transparency and enhanced risk management. Looking at the wider picture however, more may be required. While securities lending volumes have been rising through the latter part of 2010, volumes are still well down on the benchmark levels set in 2007. While electronic-trading platforms come to the fore in high-volume markets, current market conditions have meant that take up of electronic trading by the securities lending segment is still far from ubiquitous. The SecFinex CCP model for stock borrowing and lending dates back to 2000 when NYSE Euronext developed a method for facilitating sell/buybacks

FTSE GLOBAL MARKETS • FEBRUARY 2011

A job for SecFinex

Allen Postlethwaite, chief executive officer of SecFinex. “Trading members want to be able to easily see that their counterparty is actually the central counterparty,” he says. “To that end, we are currently working with SIX x-clear to facilitate this kind of visibility, well ahead of any regulation that may be handed down through EMIR.” Photograph kindly supplied by SecFinex, January 2011.

on an end-of-month basis, following France’s implementation of its T+3 (trade date plus three days) settlement system. “At that time, many retail clients liked the idea of purchasing shares and not being required to pay for them until month’s end,” says Allen Postlethwaite, chief executive officer of SecFinex. With the arrival of T+3, however, clients lost that privilege. In response, NYSE Euronext devised an arrangement whereby French brokers could continue to sell these buybacks directly through the exchange, as well as through central clearing. Seeing the benefits of offering a similar provision through other markets—and rather than build an entirely new system from scratch—in

2007, NYSE Euronext secured a majority stake in SecFinex, which was founded in 2000. Using the investment clout of NYSE Euronext to advantage, SecFinex began laying the groundwork for a CCP for its SecFinex Order Market, a realtime anonymous bid/offer system for sec-lending transactions. In mid 2009, SecFinex debuted its innovative centrally-cleared system, using LCH.Clearnet for the Euronext markets of France, the Netherlands, Belgium and Portugal, and SIX x-clear to centrally clear the markets of Germany, Norway, Austria, Finland, Denmark, Sweden and Switzerland. A SIX x-clear-based model for the UK is being developed and is due to launch this year.

FACE TO FACE

SEC-LENDING CLEARING: BASEL III RULES SET TOUGH TARGETS

As beneficial owners gain greater insight into the risks involved in lending securities, oversight practices have changed, and the level of transparency required of lending agents has increased. Along the way, participants have gradually become aware of the advantages of using a CCP for the clearing of securities financing transactions. Recent regulatory measures will likely accelerate this trend. Included in the new Basel III guidelines are rules that profoundly impact the use of capital by large banks and brokerdealers, particularly when trading bilaterally with certain counterparties. Solvency II includes similar measures affecting insurance companies (please refer to page 16 in this edition). Stricter capital-adequacy guidelines under Basel III would present “significant challenges to the existing securities lending business model and would inhibit growth in the industry,” note consultants Andrew Howieson and Roy Zimmerhansl in the recent report Good, Bad or Inevitable: The Introduction of CCPs in Securities Lending.

Major opportunity These developments underscore the importance of centralised trading and clearing facilities for securities lending. Such facilities “provide a framework for more effective regulatory supervision and a basis for documentation of borrower compliance with short-selling rules”. Tougher regulatory measures make inevitable the broad adoption of CCPs in securities lending, giving the industry a major opportunity to reduce systemic risk, increase participant earnings and reduce overall cost structure, while also providing a foundation for sustained growth, according to the report. Says Postlethwaite: “Many of the losses incurred at the height of the financial crisis involved reinvestment programmes, and this has compelled participants to re-examine the nature of their bilateral trading partners in an effort to mitigate or completely remove risks involved, which, in turn, has led to the surge in interest in central clearing.”

Lee Hodgkinson, chief executive officer of multilateral trading facility SmartPool, and head of European sales and relationship management at NYSE Euronext. Photograph kindly supplied by SmartPool, January 2011.

Postlethwaite points to a proposal under the European Market Infrastructure Regulation (EMIR) calling for CCPs to be retooled in an effort to provide trading members with greater transparency into clearing activity. “Trading members want to be able to easily see that their counterparty is actually the central counterparty,” says Postlethwaite. “To that end, we are currently working with SIX x-clear to facilitate this kind of visibility, well ahead of any regulation that may be handed down through EMIR.” Tougher capital requirements resulting from Basel III may force banks to thoroughly reassess the type of business they conduct, says Postlethwaite. “Banks may have to drastically revamp their operating model, remove entire segments of their business, or, conversely, raise a lot of new capital in order to continue to run the business as is,” he adds. Naturally, a lot depends on the wherewithal of the individual bank. “However, one way or another, banks will have to take some form of action,” Postlethwaite adds. This could result in certain counterparties no longer serving as trading partners with some of the banks, and vice versa, he says. Equally stringent capital requirements under Solvency II aimed at addressing risk in the trading books of

insurance companies are likely to have a similar impact. As a result, says Postlethwaite: “There will come a point when the amount of required margin renders certain types of trades unprofitable.” By contrast, CCPs are not impacted by changes in capital requirements under Basel III, making the value proposition more attractive than ever, explains Lee Hodgkinson, chief executive officer of multilateral trading facility SmartPool, and head of European sales and relationship management at NYSE Euronext. “We have done some internal research to try to assess what a bilateral trade today might look like through a CCP, compared to the outcome if one continued to work on a bilateral basis. Naturally, much depends on the type of counterparty involved, and because each bank has a different type of risk model, it is difficult to come up with specific verifiable data. Still, given the numbers that are outlined in Basel III, it is safe to say that the old bilateral model may no longer be a viable one.”

Tangible impact Hodgkinson agrees that many of the benefits of using a CCP are weighted towards borrowers, because, in general, lendors do not apply capital to their business the same way banks do. However, he adds: “When one considers the demand among big brokerdealers and banks, it doesn’t take long to figure out that if the demand side winds up saving tens of millions in capital just by using a CCP, they will ultimately start to put pressure on the lending side to utilise the exact same model.” That, says Hodgkinson, is just one example of how Basel III regulatory changes will begin to have a very tangible impact on the lending arena. Moreover, from the perspective of NYSE Euronext, the SecFinex CCP model is unusually well poised to reap the benefits. Says Hodgkinson: “Current conditions within the marketplace, as well as the direction the markets are likely to take from a regulatory perspective, really make a very strong case for the SecFinex value proposition.”I

FEBRUARY 2011 • FTSE GLOBAL MARKETS

FUND ADMINISTRATION Photograph © Bertrandb / Dreamstime.com, supplied January 2011.

TOMORROW’S WORLD TODAY Hedge funds, the bread and butter of the administration business, made impressive gains during the latter part of 2010, resulting in a stream of outsourced opportunity for well-placed providers. At the same time, incessant demands for independence and transparency continue to fuel newer and tougher regulations, forcing providers to pony up for enhanced reporting tools—and potentially accelerating the make-or-break point for those with limited capital. Dave Simons reports. HOUGH THE YEAR is new, the refrain is still the same: the need for transparency into the valuation and liquidity of instruments being held, as well as the level of governance in place to protect shareholders on both the retail and institutional side, continues to fuel newer, tougher laws in both the US and EU. With regulatory proposals in various stages of completion, however, administrators find themselves in the somewhat unenviable position of having to meet the requirements of fully baked rules (such as those set forth in the US under the DoddFrank reform initiative), while at the same time making business decisions based on legislation that may or may not see the light of day. “In other words, it is forcing administrators to anticipate which regulations will actually become law,” explains Mark Kelley, Americas markets executive, JP Morgan Worldwide Securities Services. “Which is tricky—because if a piece of legislation turns out to be different from what you’ve planned for, you then have to go out and spend even more to account for the discrepancy.” Understandably, many players have been hesitant to take the plunge for fear of guessing wrong, says Kelley. That is why, he avers, administrators with a more diverse roster of clients have less at stake.“As a provider that caters to investors with many different types of risk profiles and levels of tolerance, we are compelled to spend on technologies and core platforms covering the entire range of strategies, both traditional and alternative. It’s not like, should I put half of my investment capital with this group, or spend it on this other class instead; we have to allocate in equal proportion, no matter what. When you have to cover the entire plot, so to speak, in many ways it makes things that much easier,”he adds. Alan Flanagan, head of private equity fund services

FTSE GLOBAL MARKETS • FEBRUARY 2011

product management for BNY Mellon’s hedge-fund administration division, Alternative Investment Services (AIS), agrees that it has been difficult to determine how global regulatory initiatives will ultimately play out. “In Europe, for instance, the Alternative Investment Fund Managers directive (AIFM) has gone through significant changes since its early stages,”says Flanagan,“and now that it is beginning to take shape, we have a much better sense of what it will all mean for managers in the long run.” Still, central themes have emerged and in fact have become magnified, among them transparency and independence.“Which, of course, plays to the strength of our type of business model,” continues Flanagan. Rather than wait for regulations to be implemented, institutional allocators have already been busy pushing for a much stronger third-party presence within the administration space—and providers like BNY Mellon have been listening. Now a year old, the company’s asset validation and price verification service (AV/PV) allows BNY Mellon to effectively reconcile clients’ portfolios and confirm counterparty positions, while at the same time enabling fund managers to maintain records in-house for the purpose of calculating NAV. Flanagan says that this kind of offering has become increasingly crucial, particularly as the notion of asset and price verification independence becomes more firmly established throughout the industry. The four pillars of BNY Mellon’s AIS group, covering single-manager hedge funds, fund-of-hedge funds, private-equity funds as well as prime custody, each comes with its own dedicated technology platform—which, according to Flanagan, speaks to the importance of technology in the provision of those services. Last year, BNY Mellon announced it would pay $2.3bn in cash for the global investment servicing business of Pitts-

FUND ADMINISTRATION

burgh-based PNC Financial Services Group in an effort to widen its hedge- and traditional-fund administration capabilities. As a result of the acquisition, BNY Mellon has been able to offer middle-office outsourcing on a global basis, and has been able to respond more effectively to client’s increased demands for performance-attribution and riskreporting services. At the same time, BNY Mellon has broadened its existing services such as cash-collateral and risk reporting. “The response from our existing clients has been very positive,”says Flanagan.“It opens a lot of doors for new clients, such as spin-outs or managers who are trying to get up and running, since these types of platforms and their infrastructure require a significant up-front investment, with a steady stream of continued investment to keep upgrading to meet client demands.” While portions of proposed new regulation in the United States may be subject to additional tweaking, the picture is considerably clearer in Europe, says Fahey of Northern Trust. “Looking at AIFM and UCITS IV, for instance, things are quite a bit further along—this month, for instance, the Hungarian presidency of the EU was already calling for a drafting of a UCITS V paper as soon as UCITS IV goes live in July. The point is, all of these regulations will have a multijurisdictional impact, resulting in a greater number of managers having a global outlook, whether it be launching products outside of their home jurisdiction, or perhaps just acquiring international assets for their home products. While there are obviously local sovereignty issues to consider, generally speaking there has been a fairly across-the-board effort to figure out exactly what went wrong—as well as how to address these issues going forward so that the same mistakes are not repeated.” Valuation—the area where most participants experienced the greatest amount of pain in the aftermath of the crisis— continues to be a key driver of technology investment capital, explains Fahey.“Particularly with regard to the OTC derivatives space, here at Northern Trust we’re using tools that can more accurately gauge valuations as they come in from the market. Additionally, we’re making the most of our strategic alliance with Numerix, which has deployed financial engineers alongside our own staff, to expand the valuation expertise we bring to our clients.” According to Kevin Sloane, account manager for Linedata, a global provider of financial information technology solutions, the period immediately following the global market collapse was “a rather stagnant pond, during which time companies were mainly assuming a defensive posture—only the very brave were really thinking in terms of changing their outsourced provider or software platform. Building for future growth was hardly at the top of the list.” It has been refreshing, then, to see firms starting to take action, says Sloane, particularly evident since the last quarter of 2010. “Not necessarily because we’ve entered this new phase of dramatic growth, but rather it is more the realisation that one can’t afford to just stand still any longer,” he says, adding that: “People need to be continually reviewing their systems and services in order to keep pace with the

Jane Pearce, group director of Ogier Fiduciary Services in Jersey. “The smaller service providers generally sit closer to and understand the niche requirements of the smaller funds they administer,” she says. Photograph kindly supplied by Ogier Fiduciary Services, January 2011.

Kevin Sloane, account manager for Linedata. “The period following the global market collapse was a rather stagnant pond, only the very brave were really thinking in terms of changing their outsourced provider or software platform,” he states. Photograph kindly supplied by Linedata, January 2011.

level of change that is coming along.” Having had that long hiatus, Sloane says that companies are now “smartsourcing”—that is, looking for outsourced services platforms that are far more sophisticated and intelligent than in the past. “While they’re still not looking to spend huge amounts of capital, nonetheless there has been real activity, and I think that’s very good news for the industry,” he adds. The ongoing institutionalisation of hedge funds has, for several years now, contributed to a pronounced two-tiered market for fund administration, with large multi-service administrators controlling the lion’s share of activity, and the remainder going to niche players capable of servicing startups and other independent boutiques. While this ‘barbelling’ will no doubt continue to shape the administration space, Sloane believes that current conditions present a bit more of a challenge to those seeking clients at the niche end of the spectrum.

FEBRUARY 2011 • FTSE GLOBAL MARKETS

“It can be like a nursery service’ in that you’re bringing in all of these small start-ups,”says Sloane.“But the fact of the matter is that there is a lot of opportunity for those in the niche space—provided they can continue to maintain critical mass. Because as we all know, while some start-ups can turn into great institutional players, others can turn into nothing.” While there is far less expenditure at that end of the business,“providers need to have substantial infrastructure in order to provide an adequate menu of software and services. Still, I think that market will continue to expand, as it will likely be some time before the big global players try and reach into that space, since the services required are very complex and there is simply not enough volume to really make it worth their while,” he continues. Having enough capital on hand to support required technologies and subsequent upgrades remains a delineating factor within fund administration. However, Sloane is quick to point out that solutions from third-party players such as Linedata continue to reduce the chasm between haves and have-nots. “For some organisations, using an applicationsservice provider, a software-as-service provider or other hosted service offering allows small companies in particular to fix their costs for perhaps as three to five year period, during which time the supplier will be taking care of all the upgrades and ensuring that the system is properly maintained. This can be quite helpful, particularly when you’re trying to keep an eye on overheads.” Kelley of JP Morgan also sees an acceleration of the barbelling effect within the administration arena.“Players who can provide a menu of robust services across a fairly broad geographical area—be it regional such as pan-Europe or pan-North America, or, better yet, globally—will be better equipped to compete for the biggest and most complex books of business.” The same goes for boutique service providers that are able to successfully craft a product that fulfills the needs of their start-up or smaller client base, says Kelley. “Most players in the industry ideally want to work with just a few administrators, including a global partner that can cover a multitude of geographic regions and, in turn, service the majority of the client base. At the same time though, they may also retain a boutique administrator on an independent basis, one that is capable of handling certain ‘unique’ strategies, such as leveraging real estate within a hedge-fund portfolio, for instance, or any other area that may not necessarily fall under a larger player’s field of expertise.” Jane Pearce, group director of Ogier Fiduciary Services in Jersey, agrees that opportunity exists for smaller providers that understand the impact of regulations relative to comparably sized funds.“The smaller service providers generally sit closer to and understand the niche requirements of the smaller funds they administer.” Enhanced reporting tools don’t always come cheap, however, putting added pressure on those with limited capital and potentially accelerating the make-or-break point for some companies. “The smaller boutique firms can’t afford to operate in a highly regulated market,”says Pearce,“and therefore a number of firms will ultimately opt out and discontinue the line of business and look

FTSE GLOBAL MARKETS • FEBRUARY 2011

Mark Kelley, Americas markets executive, JP Morgan Worldwide Securities Services. “Players who can provide a menu of robust services across a fairly broad geographical area will be better equipped to compete for the biggest and most complex books of business,” he says. Photograph kindly supplied by JP Morgan, January 2011.

to sell the portfolio of work to larger administrators, whilst the larger administration firms are actively looking for boutique firms to acquire. Further consolidation of the market will undoubtedly be a continuing trend.” Indeed, the outgoing year saw a number of smaller fund administrators fall by the wayside, the result of lower volumes, fewer fund start-ups, as well as a surplus of administration providers. Meanwhile, clients are continually assessing their overall service offering to make sure that they are getting the biggest bang for their buck.“Combined with new requirements that are constantly being placed on providers, today’s field of administrators have more responsibility than ever before,”highlights Fahey of Northern Trust. Changes to a client’s business model that may have occurred in the interim can often determine whether or not a client retains its provider.“Given that, I think we will begin to see a much narrower field of administrators who are in the position to properly support these asset managers and, in turn, the managers’ clients.” Alan Greene, executive vice president of State Street’s US global services business, calls the increasingly demanding environment in both the US and abroad “a fundamental opportunity” for global players to craft workable solutions for clients, particularly at the macro level. State Street’s weighted average life calculations will help clients more effectively navigate newly imposed money-market reform rules, adds Greene. Detailed monthly management reporting that is tailored to clients’ specific requirements is key to maintaining open, adequate and comprehensive channels of communication, and is a prerequisite for growing professionalservices partnerships, particularly as investment strategies become more intricate, says Greene. “All of this additional complexity, coupled with the level of investment capital required to stay current and to provide all of the products and services, makes it more difficult for the small-to-mid-tier players that are trying to do a lot of different things within their organisation.” By contrast, asset servicing continues to represent a significant part of State Street’s core business, which, says Greene, allows the company to invest accordingly. “Hence, we feel very positive about our ability to invest in order to protect our industry position.”I

ASIAN SECURITIES LENDING

Photograph © Andreus / Dreamstime.com, supplied January 2011.

NEW CONNECTIONS DRIVE SECURITIES LENDING Although the securities lending industry has not yet recovered from the financial crisis, there are pockets of hope. This is particularly true of the Asia Pacific region, whose contributions may pale in comparison to the West but its rate of growth outshines its counterparts. Hedge funds and traditional fund managers are setting up shop but the pace is still expected to be slow and steady. Lynn Strongin Dodds reports on the key trends. HE LATEST FIGURES from Data Explorers have revealed a major increase in Asia’s total equity lending income last year, coupled with predictions of further growth in 2011. Will Duff Gordon, a senior researcher at Data Explorers, which monitors the volume of securities made available to lend by investors and the amount taken by short-selling hedge funds and other market makers, says: “Our recent figures show that Asia accounted for 18% of the total equity lending income in 2010, which is up from 14% the previous year. The 125 delegates at our recent conference predicted that Asia’s contribution could increase to between 20% and 25% of global equity lending income over the coming year for equities. I am not sure whether it will happen that fast but the opportunities for growth are much greater than elsewhere. It is important, though, to put the numbers in context. Securities lending is definitely growing in Asia but it will be some time before it overtakes that of Europe or the Americas.”

FTSE GLOBAL MARKETS • FEBRUARY 2011

Custodians and other securities lenders are optimistic on the back of strong stock market performance and corporate activity. “Last year, the MSCI Far East returned roughly 23% in comparison to the MSCI’s All Country’s 9.7% and the 0.35% of the firm’s European index. Asia also dominated the IPO market, outstripping its Western counterparts. Figures from data provider Dealogic revealed that Asia-based issuers comprised over 60% of the $280.1bn global tally. China led the way, accounting for 37.2% of all IPOs at $104.3bn, up from 2009’s $50.6bn. The most notable deal and the largest on record—the sale of $22.1bn shares—was from Agricultural Bank of China. As with many Chinese IPOs, it had a double listing in Shanghai and Hong Kong. The region also produced a buoyant crop of merger and acquisition (M&A) transactions. South East Asia was particularly fertile and while the increase in numbers may not have been that impressive, the size of the deals was. The region recorded 2,755 deals worth $108.6bn last year, up from 2,744

ASIAN SECURITIES LENDING

Hong Kong also has come a long way since the start of 2008, when it only produced 24% of Asia’s income. It benefits from not only having one of the world’s most advanced capital markets framework but it also boasts the most prominent listing exchange for Chinese equities.

Giselle Awad, senior vice president, Asia-Pacific, at eSecLending in Australia. “ The economies in Asia are growing, which equals more IPOs and M&A activity. As a result, hedge funds have increased their activity and are allocating more of their trading business to these markets, which in turn is driving the securities lending business.” Photograph kindly supplied by eSecLending, January 2011.

valued at $55.1bn in 2009. Francesco Squillacioti, Asia-Pacific regional business director for State Street’s securities finance division, says: “Increased mergers and acquisition activity is a key driver for the growth of securities lending. This is because the upward growth in those types of corporate events generates demand for stock.” Andrew Cheng, head of securities lending, clients sales management, Asia ex-Japan & Australia, JP Morgan Worldwide Securities Services, adds: “The securities lending outlook in Asia Pacific is extremely strong. We’re expecting to see significant activity in Asia when compared with Europe in terms of mergers and acquisitions and IPOs, and market prices for securities generally are also higher. We’re also seeing many fund management houses setting up offices in Hong Kong, Singapore and Australia while hedge funds are increasing their business in the region. The other side of the equation is that there has been reduced activity in other parts of the world such as the US and Europe.” Figures from Data Explorers show that since the end of September 2008, the number of stocks based in Asia available to lend jumped 19%, whereas in Europe it has shrunk by almost 3%. Demand to borrow in the main securities lending markets in Europe and the US has also fallen sharply. This is mainly due to a lack of shorting activity on the back of tighter regulations and volatile markets which has made market participants less enthusiastic about taking directional bets.

Giselle Awad, senior vice president, Asia-Pacific, at eSecLending in Australia, echoes these sentiments: “What we are seeing are fewer trading opportunities in the traditional western markets. Conversely, the economies in Asia are growing, which equals more IPOs and M&A activity. As a result, hedge funds have increased their activity and are allocating more of their trading business to these markets, which in turn is driving the securities lending business.” Last year, roughly ten leading hedge fund managers either set up shop or returned to the region. Soros Fund Management, Viking Global Investors and GLG Partners hung up their shingle while Fortress Investment Management decided to stage a comeback. Meanwhile, DE Shaw moved one of its six-person executive committee to Hong Kong and Maverick Capital added additional analysts to its Hong Kong office. While the migration is expected to continue fuelling further securities lending business, activity is expected to remain within the confines of the four major markets— Hong Kong, Japan, Australia and Singapore. According to participants at a recent Data Explorer conference, the speed and clarity of regulatory reform will impact the future success of the industry in Asia. As Rob Coxon, head of international securities lending at BNY Mellon, says: “When you look at Asia in terms of securities lending, it is a two-tier market. There are the main established and mature markets and the more embryonic markets such as Korea, Taiwan, Thailand and the Philippines. This is because the markets are at different stages of regulation.”

Attractive returns Robert Lees, head of securities lending trading for Asia Pacific, Brown Brothers Harriman, notes: “Overall, we believe that the region, from both a supply and demand perspective, will continue to deliver attractive returns for our clients. Markets that will continue to evolve and develop will be Taiwan, Thailand and South Korea from both regulatory and liquidity perspectives. Separately, India and China will also become much more important and we are supportive of the regulators’ efforts in developing market structures for investors.” Obviously China represents an attractive proposition and although there are encouraging signs coming from the market regulators, Lees believes it is important to exhibit some patience regarding a fully established platform. “Separately, Indian regulators seem to be stepping up their efforts to

FEBRUARY 2011 • FTSE GLOBAL MARKETS

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ASIAN SECURITIES LENDING

Rebecca Nordhaus, global head of regulatory strategy for securities lending, Brown Brothers Harriman. “Hong Kong regulators had a different response but I think the regulators in Australia were responding to local political pressures. There is certainly pressure for Australia to move in line with the rest of Asia,” she says. Photograph kindly supplied by BBH, January 2011.

encourage the participation of the securities borrowing and lending programme. With continued efforts, we expect that this may become more of a key market in the future,” he adds. The signs are encouraging, with the Chinese authorities meeting last summer to hammer out the details of an operational framework. The key questions being debated included whether funds should participate in the securities lending business, when stakeholder meetings might be needed, how to price securities packages, and whether capital raised through securities financing should be re-invested. Earlier last year, a government backed programme was introduced which allowed margin and securities lending products on a limited basis. The mechanism, which is still being reviewed, could potentially open a universe of stock worth $3.2trn to investors and short-sellers, according to industry estimates. Squillacioti says: “That China has implemented a pilot programme for lending is directionally interesting. It is for the domestic market and I would hope that once there is comfort with the framework, consideration will be given to including offshore participants.” As for India, securities lending has been a feature for several years with the Securities and Exchange Board of India (SEBI) allowing the first transaction as early as 1997, via authorised intermediaries. A range of financial instruments was allowed, including cash, bank guarantees, government securities, credit default swaps (CDS) and other registered securities. As in China, the focus of Indian regulators was on the domestic market and the rules were geared

Robert Lees, head of securities lending trading for Asia Pacific, Brown Brothers Harriman. “Overall, we believe that the region will continue to deliver attractive returns for our clients. India and China will also become much more important and we are supportive of the regulators’ efforts in developing market structures for investors,” notes Lees. Photograph kindly supplied by BBH, January 2011.

towards reducing the risk of settlement failures rather than developing securities lending as a financial product in its own right. However, over the years SEBI has relaxed regulations allowing short selling and more recently it has increased flexibility in the tenor of the contract and added a facility for borrowers and lenders to make an early recall/repayment of securities.

Jostle for position Activity is increasing although market participants expect it to be gradual. As a result, the leading markets are expected to continue to jostle for position. Hong Kong upset the pecking order last year, having overtaken Japan as the top Asian market in terms of revenues, according to Duff Gordon of Data Explorers. Hong Kong accounted for 34% of overall Asian lending revenue, which may have only been one per cent higher than Japan’s share but the latter country’s income has been gradually falling. Hong Kong also has come a long way since the start of 2008, when it only produced 24% of Asia’s income. It benefits from not only having one of the world’s most advanced capital markets framework but it also boasts the most prominent listing exchange for Chinese equities. Activity is being driven by demand to borrow outstripping supply, which in turn is leading to higher fees being charged by custodians. According to Data Explorers fourth-quarter statistics, custodians reaped an average fee of 84 basis points (bps) for Hong Kong equities compared to 56bps for Japan and just

FEBRUARY 2011 • FTSE GLOBAL MARKETS

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ASIAN SECURITIES LENDING

Regulation will remain one of the stumbling blocks hampering the growth of the industry outside the major markets. “The regulatory environment will be a key factor in driving demand and supply of securities available for lending,” states Andrew Cheng, head of securities lending, clients sales management, Asia ex-Japan & Australia, JP Morgan Worldwide Securities Services

Francesco Squillacioti, Asia-Pacific regional business director for State Street’s securities finance division.”Increased mergers and acquisition activity is a key driver for the growth of securities lending. This is because the upward growth in those types of corporate events generates demand for stock,” he says. Photograph kindly supplied by State Street, January 2011.

Kong regulators had a different response but I think the regulators in Australia were responding to local political pressures. There is certainly pressure for Australia to move in line with the rest of Asia. Indeed, a recent study showed that disclosure rules alone result in a 20% to 25% reduction in equity market short selling, which in turn results in lower trading volumes, wider bid-ask spreads, and greater intraday volatility.” Overall, regulation will remain a dominant subject and one of the stumbling blocks hampering the growth of the industry outside the major markets. As Cheng notes: “I think the way the business develops throughout the region will depend on the particular regulations of a specific market. The regulatory environment will be a key factor in driving demand and supply of securities available for lending. While the global economy will present challenges, there are also many market opportunities for the sector due to the robust nature of the region and its comparative good health when compared with other parts of the world.”

Challenge of harmonisation 2bps for Australian equities. About 61% of the loans were against non-cash and only two per cent of the income was generated from cash re-investment. Looking ahead, Hong Kong is expected to retain its pole position while activity is expected to remain steady in Japan although supply outstrips demand. Australia, on the other hand, will keep its third place ranking although some participant believe that stringent restrictions on short selling are prompting investors to leave and hampering the securities lending business. By contrast, Hong Kong has been praised for its non-interventionist policies when markets collapsed. As Coxon says: “Regulators in both Hong Kong and Singapore did not introduce any draconian rules after the financial crisis. Their regulation has been consistent and robust and, as a consequence, Hong Kong has been a strong lending market.” Awad at eSecLending explains:“Hong Kong had a robust regulatory framework and made little to no changes. Australia, though, did implement tighter regulations over the past two years, not to curb securities lending but to allow greater transparency into practices. While greater transparency is welcomed, how some of the regulations are being enforced is affecting liquidity in the market.” Rebecca Nordhaus, global head of regulatory strategy for securities lending, Brown Brothers Harriman, adds: “Hong

Squillacioti says: “In many ways the greatest challenges also present the greatest opportunities. Asia is a big and varied region and there are many moving parts to keep track of. Countries are also at different stages of evolution with regard to their thoughts on lending. As a firm, we have to ensure that we understand the developments and have the right frameworks in place.” Nordhaus also believes that a pan-Asian solution could be in the offing, albeit in the distant future.“Market participants and regulators are focused on harmonisation given the likely development of distinctive regulatory schemes at regional and global levels. However, as we have seen with the European short sale regulations, harmonisation is challenging to execute because of perennial sovereignty concerns, local operational nuances and of course, local political pressures. I am certain harmonisation will be a goal this decade but am not sanguine about prospects for success.” Despite the differences, Squillacioti believes: “The one thing the region has in common though with other markets is that there has been a greater demand for transparency and risk management products, especially since the financial crisis. Clients want to make sure that there is greater oversight and that they can set parameters around the lending programme in a much more granular way.” I

FEBRUARY 2011 • FTSE GLOBAL MARKETS

TRADING TECHNOLOGY Photograph © Hannu Viitanen / Dreamstime.com, supplied January 2011.

DATA REVS UP TO NEAR THE SPEED OF LIGHT The one million messages a second transmitted through today’s servers are light years away from ticker-tape in 1870s New York. The amount of data today runs beyond the wit of human beings to capture and analyse it and it is one of the challenges which looks likely to tax the ingenuity of IT workers in 2011. Ruth Hughes Liley dissects the key trends.

ATA ANALYSIS IS one of several trends in trading technology, which experts predict will this year become essential tools in the buy side and sell side armoury. Rhom Ram, head of Autobahn sales at Deutsche Bank, says: “In equities, you want to know which equity is going to perform and then you want to be able to trade it without having to re-enter all the details of the trade, and finally, once you have entered it, you want to see how it has performed. So there will be a real thrust to the integration of pre-trade, during and post-trade.” It is going to be important in 2011 for a number of reasons, he explains. New over-the-counter (OTC) clearing rules will mean all OTC trade are going to have to be cleared “and you will need to be able to monitor the margins you made”. He adds: “Equity prime brokerage is pretty far advanced down this route in equities, but with cross-asset, you’ll also want to see how all your trades performed across all the asset classes.” Alison Crosthwait, director, global trading research, Instinet, predicts that transaction cost analysis (TCA) will evolve to include real-time rather than end-of-day algorithm and venue-specific analytics. This will allow traders to adjust strategies intra trade. “However, obtaining detailed data in the context of the parameter settings used for an algorithm to ensure valid comparisons is difficult. Further complicating the process is the recent trend towards algo customisation; to the extent that alpha signals are incorporated into the TCA process, the measurement of trading becomes inextricable from the measurement of the investment process.” Meanwhile, Richard Balarkas, chief executive Instinet Europe, says: “It is a new world, not just for TCA, but for execution performance itself. We trade in a world where

FTSE GLOBAL MARKETS • FEBRUARY 2011

Vodafone lists on 16 exchanges, on which the price can change more than a 1,000 times a second, and to execute well you have to have the ability to get that data in, make a decision and fire orders out extremely quickly if you are to grab liquidity opportunities at the best prices.” Crosthwait also says that portfolio managers themselves will be subject to TCA analysis through systems that will uncover the differences between managers. “While we are in the early stages with this functionality—which draws upon myriad data factors and thus requires incredibly complex analysis—manager profiling will become another example of TCA contributing to the bottom line,” she concludes. This Big Brother scenario will, like all technological developments, be dependent on available budget and willingness for buy side and sell side to invest. Balarkas believes low volumes will hit many sell side budgets in 2011. “No one likes admitting this but if you are in technological warfare, you have to keep upping your game. A large number of brokers are simply not making sufficient money whilst volumes are thin and those who can’t afford to re-invest will fall further behind in 2011. “Perversely, the reduced levels of market activity have caused some buy side firms to become less demanding of their brokers. Some who have failed to unbundle have become so focused on paying their research bills to the extent that they forfeit getting best execution and driving technological innovation.” On the other hand, Vijay Kedia, president and chief executive officer of technology vendor, FlexTrade Systems, a four times winner of FX Week’s best vendor for algorithmic trading technology award, believes that the buy side are indeed in the technology driving seat again and their influence

TRADING TECHNOLOGY

on electronic multi-asset trading cannot be underestimated: “They are demanding more control over trading and we are seeing that they want to start trading these instruments on multi-asset platforms. They all wish, for example, that fixed income was more technology-based and are anxiously waiting for this. This is a massive asset class and once that opens up, there will be a growing need for top technology.” His assertions are backed up by Aïte Group, which, in its report Multi-Asset Portfolio Systems, estimates that vendor sales to the buy side will pick up towards the second half of 2011. Report author Denise Valentine also identifies several trends among vendors: migration to .NET, internet-based technology; a trend to “dashboard mania” where screen views allow chart creation, research and flexible viewing methods; better front office tools, which connect order and execution management systems; and technological enhancements to identify risk. “New era, new tools” was the slogan given by Thomson Reuters to its $1bn investment programme in 2010, including Elekton, launched last April, a high-speed financial markets network and hosting infrastructure. Elektron is “cloud” based and has 11 networked hosting centres positioned near exchanges around the world, through which firms can trade, access data from 350 exchanges and platforms and interact with one another. Cloud technology is where third parties host, provide and manage infrastructure and applications, which clients can access remotely. “Firms of all sizes will benefit from significantly lower operational costs and drastically reduced time to market, plus the opportunity for the open exchange of data, transactions and new business opportunities,”says Thomson Reuters, which claims Elektron delivers information up to 20 times faster than the traditional aggregated data networks.

Fighting physics Indeed, the need to eliminate anything that slows traders down will continue to be a trend in 2011, according to Scott Atwell, manager, FIX Trading and Connectivity at American Century Investments and co-chair, global steering committee for FIX Protocol Limited (FPL). “You are fighting physics in many places—fighting against the speed of light. There are companies which are able to make a huge investment and set themselves apart from their competitors. By laying new fibre optic cables in a more direct route, they may take out 30 miles of fibre from the route and they will charge more money because you can gain a fraction of a fraction of a second.” Many technology providers are outdoing one another in the speed stakes. Private telecoms provider Spread Networks “trenched” a new 825-miles route and claims a 13.3 millisecond (ms) round trip between New York and Chicago with dark mainly unused fibre cables on private networks or 15.5ms for Spread’s shared network using wave technology. In December 2010, euNetworks, announced a new, lowlatency route between London and Stockholm—a round trip of 22.4 ms. Showing that low-latency demand is not just a flash in the pan, in the third quarter of 2010, the company signed 22 contracts for new routes linking Slough to London

Richard Balarkas, chief executive, Instinet Europe. “No one likes admitting this but if you are in technological warfare, you have to keep upping your game,” he states. Photograph kindly supplied by Instinet, January 2011.

and London to Frankfurt. Atrium Network also announced a Frankfurt to Stockholm link of 11ms. FlexTrade’s Kedia says: “Speed and performance will always continue to be important because speed and performance leads to arbitrage opportunities. As such, our software continues to focus on scalability and cross-asset trading because, when you use speed, our buy side clients can find the inefficiencies and places to get the best opportunities.” In fact, Kedia predicts that speed improvements through hardware will be important in 2011. “Firms will start looking at hardware-driven acceleration with some software functionality being shifted to hardware. For example, imagine two computers running graphic images—the computer with the faster processor will show crisper images rendered on screen.” In addition, desktop technology at the end of the pipes will also continue to see significant improvements in 2011, a trend Aïte Group’s Valentine calls “dashboard mania”. She adds: “This multi-asset portfolio system category has discovered the ease and simplicity of dashboard views with charting, drill-down capability and flexible views. This change reflects their [vendors’] efforts in marketing to the investment management community. The vendor’s traditional client base on the sell side generally has their own tools to customise views or build technology platforms to display data. This isn’t generally true on the buy side.” As third-party vendors respond to this, the capacity of desktop screens to present news, analytics and trading tools in simple-to-use formats, will expand in a world where markets, geographies and asset classes are increasingly correlated. For example, Thomson Reuters Eikon launched in September 2010 and is being rolled out to half a million participants over the next three years. This new version of Reuters 3000 Xtra is aimed directly at the iPad and social media generation and the firm claims it “aggregates the best of social networking technology and allows for seamless mobile interchange from the office, home or while on the move”. A core innovation of Eikon is to harness social networking technology for financial markets and to connect financial professionals to create global communities. So clients can use Eikon in conjunction with Reuters Insider, an interactive, on-demand video platform, to send video content direct to their own clients.

FEBRUARY 2011 • FTSE GLOBAL MARKETS

According to Larry Tabb, founder and chief executive officer of TABB Group: “Markets are changing faster than ever, just as governments are altering how the financial world operates. Everything is in flux. To succeed, financial professionals increasingly need new trading tools that offer a high degree of personalisation, the ability to intelligently search for information and the facility to collaborate globally. New and better desktops will enable the individual to analyse and adapt to this increasingly complex and changing environment.” The ability to key in the name of a firm, rather than its trading code, to gain access to all the latest information, videos, trading statements and so on for that company will become essential, as will availability of the information on mobile phones and other electronic devices. Tim Blake, Credit Suisse’s managing director and head of North American interest rate products, says the firm is working towards getting information and trading capabilities on to mobile devices. “We are not necessarily looking to recreate the full desktop experience in a mobile way, and desktop applications remain our core strategy, but we know that our hedge fund clients, for example, are calling in to us and standing in hotel rooms in their underwear and trading with us. So having a mobile device that can do as much as it is capable of doing is going to be really important. We have demoed it to clients and you can see the wheels start turning in their heads. In addition, you will be able to plug in your mobile phone to your hotel monitor and have a display as big as the one in your office.” Innovation may be key to how traders use technology, but does it actually drive market change? High-frequency trader Getco thinks so. A recent paper by the firm, in a defence of high-frequency trading, states: “In recent years, technology has made markets more efficient, competitive and innovative, and has driven changes in market structure. Given the increase in automated trading, it is critically important that regulators are aware of how technology is used to effect transactions.” Though presenting new challenges, technology can also assist regulators in effectively overseeing markets and detecting and deterring market abuse. There are other con-

siderations too. Steve Grob, director of group strategy, Fidessa, recently pointed out in his blog that the technology of speed has permitted faster and faster trading and has allowed firms to reduce their exposure time to risk. “Where it is supporting electronic market making then speed is crucial as the market maker needs to minimise his ‘exposure time’, i.e. that period when he cannot modify a quote in response to changing market conditions. At least for market making, then, high speed is actually a way of reducing risk rather than increasing it.“ However, Instinet’s Balarkas is worried about the quality of debate: “What most commentators fail to provide when opining on whether HFTs improve market efficiency, bring liquidity to the market, and if so at what cost, are hard facts and numbers. In the absence of real data this important topic will increasingly become a political football.” In November the UK government announced it had assembled a group of experts to analyse high-frequency trading to determine its exact role in the markets and whether further regulation is needed. FIX Protocol has also set up a working group, which meets regularly to discuss changes in risk management and in January it released guidelines to minimise the risk of executing electronic algorithmic and DMA orders. They cover pre, intra and post-trade to limit financial exposure and ensure compliance with the rules of the marketplace. They include checking symbols to ensure errors do not creep in at order stage, being aware of high notional order values, which might indicate a“fat finger”error, and suggesting incorporating order validation checks into the platform. “We believe it is important for the industry and our clients to establish core risk management standards in electronic trading for all institutional market participants,” holds Timothy Furey, managing director with Goldman Sachs. FIX’s Atwell concludes: “Some regulatory issues are prescriptive and firms have clear instructions about what they need to do. Other changes are more standard-setting, so firms have to ask themselves whether they have met the standard or not or whether they need to do more work. People are expecting an impact from MiFID II in Europe and issues surrounding a consolidated tape, so everyone’s needs may be different.” I

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FTSE GLOBAL MARKETS • FEBRUARY 2011

MULTI-ASSET TRADING Photograph © Marilyn Volan / Dreamstime.com, supplied January 2011.

NEW HORIZONS Back in 2006, Quod Financial, a supplier of order management systems, published a white paper predicting that multi-asset trading would be a new frontier. “Far from being another gimmick, multi-asset trading is the natural evolution (in the Darwinian sense) of e-trading, and can only be ignored at an institution’s own risk,” Ali Pichvai, chief executive officer of Quod Financial, noted at the time. Driven primarily by the changing investment and execution strategies of buy side institutions, which now want to invest and hedge a wider range of assets, the adoption of multi-asset trading is already under way. Ruth Hughes Liley reports on the latest trends. HE CONVERGENCE OF order and execution management systems has undoubtedly helped the development of multi-asset trading, says Bruce Boytim, vice-president of NYSE Technologies. “Many electronic systems have become multi-asset capable: there is one screen as opposed to three or four. Having all the information aggregated on one screen lessens the friction and makes it easier to trade cross-asset.” Sell side firms have responded to the challenge as the buy side have demanded more and in consequence, investment in multi-asset platforms continues to rise. Eighteen months ago, agency broker Instinet pushed deep into multi-asset trading with the launch of Newport 3, the third release of its execution management system (EMS), in response, it says, to client demand for a global, broker-neutral, multi-asset EMS platform. At the same time, Instinet bought TORC Financial, a US broker-dealer and derivatives trading technology provider, to augment its options trading capabilities. It is now adding currencies in the US. Exchanges, too, have also been investing in multi-asset technology upgrades and in February 2010, CME Group, the world’s largest futures exchange, and Brazil-based BM&FBovespa announced they would together develop a single multi-asset class trading platform, initially for BM&FBovespa in its cash equities and derivatives markets. When it launches later this year, both exchanges will be able to license the platform to other exchanges internationally. CME Group chief executive Craig Donohue sees the partnership as an opportunity to invest in and partner with multiasset class exchanges.“This enhances CME Group’s opportunities to selectively diversity into the cash equity and options segments in emerging markets, where we believe the ºgrowth and profit opportunities are most attractive.”

Meanwhile, this month, the Bahrain Financial Exchange (BFX) is due to launch the first multi-asset exchange in the Middle East and North Africa after two years preparation, trading Islamic products, currencies, commodities and equity indices on a single exchange. Even so, nuances exist. Deutsche Bank’s Rhom Ram, head of Autobahn sales, for instance, sees a clear difference between the execution of simple cross-asset hedging and installation of fully integrated single-access platforms. “At execution level it is still very specialist. Firms are still specialised in cash equities, currency overlay, credit, for example, and there is not a tremendous amount of multi-asset trading, but from an electronic point of view, people are starting to want the ability to trade things together, so you may want to trade government bonds against futures and interest rate derivatives.” That is different from the single sign-on, he stresses, where on one system dealers can put all their trades through one firewall. “You may not necessarily be trading stuff together, but you want the same platform to do it on. In this instance, if you are a senior fund manager, it makes sense to have multi-asset connectivity because you can see all your risk across all asset classes.” Jonathan Kellner, president of the Americas at Instinet, believes there is an increased appetite for risk, with people reviewing their asset allocation once again. “The buy side is looking to boost returns, and [to achieve] this they are increasingly looking beyond equities. Technology has improved transparency in some asset classes, so at the moment, many buy side dealers are educating themselves about multi-asset trading. Technology has enhanced the ability to control risk and move across asset classes, making it much easier to diversify.” The proportion of electronic trading rose over 2010 in spite of lower volumes overall. Research and advisory firm

FEBRUARY 2011 • FTSE GLOBAL MARKETS

Scott Atwell, manager, FIX Trading and Connectivity at American Century Investments and co-chair, Global Steering Committee for FIX Protocol Ltd (FPL). Photograph kindly supplied by FIX Protocol, January 2011.

Steve Wood, chief executive officer of Global Buy Side Trading Consultants. Photograph kindly supplied by Global Buy Side Trading Consultants, January 2011.

Celent estimates that the percentage of active traders adopting FX algorithms has grown from one third in 2008/9 to around half in 2010.“With comfort levels increasing, the growth rate will be sustained in 2011,” the report notes. Marek Robertson, head of European e-distribution at Barclays Capital, says: “Algorithms are emerging in multiasset trading. For example, a four-way contract spread position using German bonds and futures and US bonds and futures might involve more than 16 contracts. You could set it all up on our platform, press the button and away it goes. Or you might use VWAP [volume-weighted average price] algorithms to help you slice a larger order within a single market into smaller pieces or across venues. Some algo concepts have been adopted from equities and others are emerging more specific to fixed income, currencies and commodities.” Boytim says that customisation of algorithms is essential: “The type of algorithm you use is going to be specific to the underlying risk. So a very liquid stock will be different from a

less liquid stock and you would tweak the algorithm to trade these different assets. So for example, you might be more aggressive on the open with your cash equities and then as the market sways you might level back off. Other algorithms will look at risk-return profiles, so when you are trading different instruments it becomes more relevant. However, you can multiply these ideas to infinity in terms of which algo and how to customise. There are endless ways to look at it.” With the amount of data generated for options—some commentators estimate a million pieces of data per second, many more than cash equities—technology has become an essential tool. Nonetheless, in October 2010 the consultancy Aite Group reported that voice-only trading of interest rates swaps made up three-quarters of all IRS trading with electronic at only 10%. “There are still specialists in electronic and still specialists in voice,” says Ram, whose sales and voice teams are integrated at Deutsche Bank. However, he adds: “Over time we expect to see most clients doing simple trades electronically themselves

FIX support for Equities and Derivatives No support

Some support

Good support

Message Support 4.0

4.1

4.2

4.3

Not applicable

Fix Version 4.4

4.5

5.0

5.0 SP1

5.0 SP2

Equities Futures and Options Fixed Income Foreign Exchange Exchanges and Markets General Program Trading Algorithmic Trading Security and Position Reporting Collateral Management (Listed Derivatives) Transport Independence Framework Regulatory Compliance* *MiFid, Reg NMS, Reg SHO, OATS, ACT, NYSE 80A Note: levels of support are based on fields incorporated into the core protocol at a given stage. This rating does not include custom fields, which can be added to earlier versions of the protocol to achieve given functionality.

FTSE GLOBAL MARKETS • FEBRUARY 2011

Source: FIXProtocol, supplied January 2011.

MULTI-ASSET TRADING

and the sales guys will have to service that trade. For the more complicated trades—big, the client hasn’t done it before, a change of market environment—they will require voice service,”he adds. Robertson at Barclays Capital says: “It is quite rare for a client to want to trade a portfolio of transactions cross-asset through one point. A large shift might be broken down as the portfolio manager uses the in-house execution desks with expertise relevant to each particular part of the deal. They in turn would trade through asset-class specific voice and electronic channels.” Steve Wood, chief executive officer of Global Buy Side Trading Consultants, explains: “There are electronic management systems that can cope with multi-asset trading but they tend to be jack of all trades and master of none, although they have improved immensely in recent years because of synergies between over-the-counter (OTC) trades and trades on exchanges. On the derivatives side, for example, equity futures are traded in a very comparable way to equities now.” Kevin Rush, Barclays Capital’s head of global e-distribution, agrees: “Over time the electronic execution component of our fixed-income businesses will converge towards the electronic equity trading model.” When Barclays Capital restructured in the late 1990s it sold off its equity business. Ten years later, the company bought Lehman Brothers’ US equity business and in the intervening period the BARX platform grew from a relatively bespoke FX, cash bond and interest rate swap trading solution to today’s multi-asset system, including equities. Rush says that 95% of Barclay’s Capital’s top 200 clients now trade in eight products or more. With more than 10,000 clients, he believes one of the key attractions to a multi-asset platform is liquidity. “There are such a small number of actively-traded bonds that it is very difficult for a dealer to provide streaming prices unless they have access to a wide pool of liquidity gained from a large customer platform. In this world, being big in fixed income, currencies and commodities is important in contrast to equities, where you can be small and boutique and still find liquidity. ‘Big’ is going to be more important in the next 20 years; an ability to leverage underlying sources of liquidity across all times zones and a diverse client base will be important. So if a pension fund manager wants to sell their bond holdings in Europe, we could find a buyer in, say, Asia wanting to buy, thanks to the 10,000 people on the platform,” explains Rush. It is a significant advantage, he claims:“We have been called a ‘flow monster’. We are actually quite pleased about that, because to have that flow means we can source liquidity and manage the risk necessary to support our client business.” As regulators push assets towards being traded on exchanges, there will be greater transparency in over-the-counter (OTC) trading. In the US, the Dodd-Frank Act passed in July 2010 means that all derivatives will have to be traded on exchanges. Similar law may be heading Europe’s way under MiFID II. The OTC derivative market was worth $614.7trn in December 2009 and turnover in foreign exchange (FX) markets was worth some $4trn in Q3 2010, according to the Bank for International Settlements (BIS). Instinet’s Kellner

2010 Semi-annual OTC derivatives statistics (at end June 2010) Notional amounts outstanding, by instrument, counterparty and currency

Instruments/Counterparty

Total (in$m)

Forward rate agreements with reporting dealers with other financial institutions with non-financial institutions

56,241,786.00 30,227,840.00 23,797,698.00 2,216,250.00

Interest rate swaps with reporting dealers with other financial institutions with non-financial institutions

347,508,057.00 79,717,130.00 235,720,778.00 32,070,148.00

Options sold with reporting dealers with other financial institutions with non-financial institutions

35,711,042.00 21,910,418.00 11,743,233.00 2,057,393.00

Options bought with reporting dealers with other financial institutions with non-financial institutions

34,553,034.00 22,454,780.00 10,764,929.00 133,326.00

Outright forwards & FX swaps with reporting dealers with other financial institutions with non-financial institutions

25,624,836.00 8,369,684.00 11,872,134.00 5,383,017.00

Currency swaps with reporting dealers with other financial institutions with non-financial institutions

16,346,706.00 7,006,054.00 7,279,041.00 2,060,612.00

FX Options sold with reporting dealers with other financial institutions with non-financial institutions Total including gold

7,911,505.00 4,471,755.00 2,231,341.00 1,208,409.00 8,025,707.00

FX Options bought with reporting dealers with other financial institutions with non-financial institutions Total including gold

7,785,733.00 4,615,991.00 2,092,133.00 1,077,610.00 7,905,915.00

Commodity swaps & forwards

224,185.00

Commodity options sold

114,202.00

Commodity options bought

122,181.00

Total CDS contracts Reporting dealers Other financial institutions Central counterparties Insurance and financial guaranty firms SPVs, SPCs & SPEs Hedge Funds Other financial customers Non-financial institutions

23,246,823.00 15,776,253.00 7,016,873.00 1,588,644.00 205,078.00 320,672.00 261,026.00 704,346.00 453,697.00

Source: Bank for International Settlements, supplied January 2011.

says: “Transparency, listing and clearing are the three big themes that have emerged in the two years since the financial crisis. The sub-prime crisis showed that many products, traded over the counter, were intermingled and were not transparent or centrally cleared. If these were exchange-trade, liquid assets, people would be able to move

FEBRUARY 2011 • FTSE GLOBAL MARKETS

Kevin Rush, Barclays Capital’s head of global e-distribution. Photograph kindly supplied by Barclays Capital, January 2011.

Jonathan Kellner, president of the Americas at Instinet. Photograph kindly supplied by Instinet, January 2011.

in and out of them much more efficiently.” Kellner believes there is going to be more growth in multi-asset trading because of the general push towards transparency and electronic trading. “People want liquidity in their products, so anything that can boost liquidity—which electronic trading historically does—is going to be a driver,”he says. Wood believes investment banks are still silo-based and that it is the buy side that will drive multi-asset trading, partly because it saves the buy side money to have one platform that can cope with different asset classes and brings efficiencies once expensive set-up costs are paid for. However, the need is less clear from the trading perspective. “Balanced mandates are out of fashion at the moment and I think that’s the way it will stay from the fund manager’s and plan sponsor’s point of view. How far buy side firms go down the multi-asset approach largely depends on the size of the business and also the structure. If you have a structure which is silo-based with fixed income, equities, foreign exchange etc., all on different floors, it’s very hard to have one trader looking at all the different asset types.” Kellner agrees: “The buy side isn’t going to ‘swivel-chair’. They want to go with a broker that has expertise in multiple asset classes, someone with the necessary tools and market structure knowledge. Traders on both buy side and sell side are increasingly pressed to develop their skills across asset classes. Just because you trade equities does not mean there isn’t a learning curve to understand how other asset classes [can be traded].” The personnel issue also extends to IT, where top developers with skills and knowledge to build multi-asset platforms are in short supply. According to Paul Bennie, managing director of Bennie MacLean headhunters: “There is a scarcity of bona fide people who have true cross-asset capabilities on their track record. Many have architectural responsibilities or programme management responsibilities, but not all the skills. People have struggled to build true multi-asset platforms, but on the other hand you may hire someone with strong FX skills so that you can add that on to your equities platform. People are broadening out what they already have.” Nonetheless, the sell side is beginning to change the way it is structured. For example, Citi has altered the way it treats risk in its equities business and last year launched a centralised risk book that links single-stock blocks, programme trades, sector and index trades and Delta 1,

FTSE GLOBAL MARKETS • FEBRUARY 2011

Marek Robertson, head of European e-distribution at Barclays Capital. Photograph kindly supplied by Barclays Capital, January 2011.

allowing the bank to trade and price risk more efficiently. “By combining our activities in the cash market with derivatives, Delta 1 and ETFs, we are able to trade a little bit smarter,” notes Mike Pringle, Citi’s head of equities in EMEA. “We are able to price risk more efficiently and our dialogue with our most sophisticated clients has been elevated.” Breathtaking amounts are spent on technology systems. Aïte group says that vendors in the $2bn global portfolio systems business have done much to streamline workflows, improve user interfaces, establish connectivity and integrate systems. “All evidence of the initial convergence of traditional and multi-asset portfolio systems and the combination of lowered solution cost and the buy side increase in use of OTC derivatives has created a stronger market for the multi-asset class portfolio system in the traditional investment management market.” Scott Atwell, manager, FIX Trading and Connectivity at American Century Investments and co-chair, Global Steering Committee for FIX Protocol Ltd (FPL), says: “These trades can get really complicated with multiple legs and you can get disjointed elements which have to be traded out. Even in these trades, there are still similar elements: the quantity, the limit price, the order type and analysing the results.” One of the main reasons dealers are using FIX is that it allows the automation of information electronically, notes Atwell. “This has the benefit of eliminating fat finger errors. If you have that capability in equities, you want the same kind of benefits for other asset classes as well. It also allows you to take more granular detail and analyse it electronically rather than manually. It’s not uncommon to have a couple of thousand fills for one order with each trade at a certain price and time and venue. No human is going to do that.” Similarities with equities trading are already becoming evident, including increased activity by high-frequency traders. The trend to faster trading means that latency matters much more in a multi-asset trade, according to Boytim at NYSE Technologies: “A large portion of derivatives trades take place in Chicago. This could be 1,000 miles away from the other leg of the trade. While this doesn’t mean that multi-asset trading is confined within the boundaries of one country, it just means that you have to fine-tune your technology to deal with these issues.” However, the days when totally seamless switching between fixed income and equities are a long way off. I

TRANSACTION COST ANALYSIS

Photograph © Anastasiya Hlumakova / Dreamstime.com, supplied January 2011.

Transaction cost analysis (TCA) started out as a compliance obligation, but the more sophisticated asset managers soon recognised they could use the information to improve their investment process as well. TCA has become a valuable tool not only to measure implementation shortfall but also to evaluate the performance of brokers, trading venues and traders. Demand for actionable information has forced TCA service providers to speed up the feedback loop: reports that were once generated quarterly or monthly are now available daily—and increasingly even intraday on traders’ screens.

TCA RACES TOWARDS REAL TIME HE RUSH TO real-time transaction cost analysis (TCA) is not without pitfalls. Accelerated analysis ratchets up the importance of reliable and consistent data inputs, many of which are drawn from systems not designed to facilitate TCA. In addition, no matter how valuable TCA is, portfolio managers who obsess over minimising market impact may forgo investment opportunities—impairing, rather than improving, their performance. The sheer quantity of market data to be processed keeps escalating as trading venues proliferate and declining average ticket sizes send tick volumes through the roof. Effective TCA requires reliable time stamps for every fill and accurate market data around that point to assess market impact—a tall order even in the US where every trade prints on a consolidated tape. In Europe, it’s an almost impossible task, albeit one that will become easier when plans to introduce a consolidated tape come to fruition. “TCA lives on its data inputs,” says Ian Domowitz, a managing director at Investment Technology Group (ITG) in New York. “It is not possible to catch everything as it comes over the wire.” ITG offers TCA to institutional clients ranging from hedge funds to traditional asset managers. Domowitz says bad data most often arises from simple changes: the system doesn’t pick up a new security identification number, for example, or an upgrade to a client’s order management software alters the location of a data point—and every client’s system is slightly different. In a quarterly TCA

reporting cycle, providers have time to scrub the data but they can’t do that for daily reports, let alone intraday. “New demands for analysis raise idiosyncratic problems every day,” says Domowitz. “It is something every TCA vendor has to grapple with.” TCA also demands a benchmark to measure against, which has to take into account the urgency of a particular order. If a portfolio manager anticipates immediate price movement in reaction to earnings or news of a takeover, he will accept greater market impact in exchange for a quick fill. In that case, the best benchmark is typically last sale at the time the order reaches the trading desk. The trader must decide how best to handle the order. The goal is a fast fill that nevertheless minimises the variance between the reference price and the average cost. By contrast, a manager looking for price action over an extended period may choose to execute an order over several days to minimise market impact. For that type of order, a volume weighted average price benchmark is appropriate and the trader can pick whatever execution method he feels will enable him to do better. “The goal is not to have a single benchmark,” says Jason Lenzo, head of equity and fixed income trading at Russell Investments in Seattle. “The trick is to capture performance over the lifespan of an order. We want to know what the portfolio manager and traders have been able to do well— or in some cases not so well.”

FEBRUARY 2011 • FTSE GLOBAL MARKETS

The appropriate starting point for TCA depends on the purpose of the analysis, too. For an asset management firm using the data to monitor its traders’ performance, the gun goes off when the order reaches the trading desk. If the aim is to evaluate a broker, the mark will be later, when the order goes out to the broker. To assess the entire investment management process, TCA should begin earlier, perhaps even before the portfolio manager enters a trade into the order management system. Despite the increasing demand for instant TCA, some trends emerge only from longer-term reports. Lenzo says: “The real-time tick level analysis does have value, but you have to look over longer time periods to see trends. You need both.” Differences in execution quality for a particular type of order—whether handled by direct market access to an exchange, a crossing network, a multilateral trading facility (MTF), dark pools, algorithms or using a broker—only come to light when the system has enough data. Real-time TCA also suffers from a logical flaw: the object is to determine what the market price would have been without the investor’s trade—while that trade is in progress. It’s like the observer effect in physics: the act of observation alters the phenomenom being observed. “It’s a huge problem,” says John Comerford, global head of trading research at Instinet. “We can’t ever know what the precise market impact is. The pre-trade estimate is the best shot at it, even though by definition that has estimation error.” Insight, Instinet’s TCA software product, meshes with the firm’s execution management system which lets customers run intraday reports, change benchmarks at will and even devise their own TCA questions. Its sophisticated customer base skews toward hedge funds and active traders who value the ability to create their own reports. “The system lends itself to people who want to improve trading rather than check the compliance box,” says Comerford.

Level of detail To that end, Insight captures where every single share of an order trades and displays routing information so that customers can see where the order was exposed before it was filled, a level of detail few competitors can match. Not that it’s a crowded field; only a handful of independent firms, including Instinet, ITG, Abel/Noser, Elkins McSherry and Quantitative Services Group, can afford the enormous technology investment required to support TCA. The big integrated securities houses offer TCA services as well, but sophisticated buy side players prefer a broker-neutral product. To maximise the benefits Insight can provide, the software requires access to an execution management system, which does store all the relevant data. In the end though, the quantity of information available is less important than its interpretation. “We can give customers enormous amounts of data, but what does that matter unless they know how to look at it?” asks Comerford. In a perfect world, TCA would be able to track an order all the way from when the portfolio manager made the decision to trade through to its arrival on the trading desk, measure

FTSE GLOBAL MARKETS • FEBRUARY 2011

Mat Gulley, head of global trading at Franklin Templeton in San Mateo, California. “It takes some effort to get all the data aligned, but if you execute across the world and use a big enough data set, the trends should still be statistically significant,” he states. Photograph kindly supplied by Franklin Templeton, January 2011.

Ian Domowitz, a managing director at Investment Technology Group (ITG) in New York. “TCA lives on its data inputs. It is not possible to catch everything as it comes over the wire,” he says. Photograph kindly supplied by ITG, January 2011.

how effectively the manager communicated the urgency of the trade and monitor the trader’s execution strategy until the order is filled. While quantitative managers can already do that because a computer makes the trading decision, fundamental managers cannot—yet the potential opportunity cost in the decision chain far exceeds the likely impact of choosing one trading venue over another. “We need to think about attribution all the way through the process of getting a position into the portfolio,” says Mat Gulley, head of global trading at Franklin Templeton in San Mateo, California. The starting point may need to be a few days prior to the trade: if the trade price is normally 5% higher than it was at T-5, the manager may be chasing momentum, whereas a 5% lower trade price suggests a manager buying on weakness. The data could uncover prejudices even if managers never articulate them, but the study of pre-trade attribution has so far been confined to the quant world. TCA is already complicated at big shops such as Franklin Templeton, which typically bundle orders from different portfolio managers. Traders often receive conflicting instructions for trades in the same stock. The internal systems have to keep track, but even if they do it is hard to match fills to a benchmark if an order is not active all the time.

TRANSACTION COST ANALYSIS

Harrell Smith, head of product strategy at Portware. “The day of the buy side trader being a glorified order clerk is long gone. Traders now are using pre and post-trade analytic tools to gauge their performance,” he says. Photograph kindly supplied by Portware, January 2011.

For global managers, the problems compound. Fragmented markets in Europe, where some trades may be reported on two different venues and others not on a timely basis, make it hard to match up volume and price, the two most critical data points. Some Asian markets—Thailand, for example— have foreign ownership limits that may restrict the opportunity set from time to time: a US manager can buy local shares (which are usually cheaper) if there is room beneath the cap, but not otherwise. If a company has issued international depositary receipts, DRs), the available liquidity should include the DR market as well as the underlying shares. “You have to be aware of the difficulties, but it doesn’t invalidate the analysis,” says Gulley. “It takes some effort to get all the data aligned, but if you execute across the world and use a big enough data set, the trends should still be statistically significant.” Franklin Templeton uses ITG’s TCA software, but although it is moving toward an intraday view, it at present relies more on daily reports. It can see data either aggregated or broken down by trading desk, stock, country or portfolio manager as well as the best and worst executions relative to benchmarks tied to the particular investment style. “We want to capture as much of the opportunity as the analyst is projecting but we don’t want to push the stock in one direction and lose alpha,” says Gulley. “If we had no benchmark or sense of the manager’s urgency we would be at the whim of a random decision.” Asset managers that want to see intraday TCA need to collect market and fill data in real time. Harrell Smith, head of product strategy at Portware, provider of an execution management system that fully supports TCA, sees the ability to measure execution cost driving buy side firms to upgrade the quality of staff on their trading desks. “The day of the buy side trader being a glorified order clerk is long gone,” he says. “Traders now are using pre and post-trade analytic tools to gauge their performance.” Smith says one European client is using TCA derived from Portware’s system to prune its broker list based on an analysis of liquidity provider performance. Some of the largest traditional asset managers are on the leading edge in the use of TCA to direct order flow and minimise implementation shortfall. “Five years ago people talked about TCA as a tick the box requirement,” says Smith. “Now they are using it in a more sophisticated way to drive their order routing.” On the cutting edge, firms now integrate TCA into

James Benincasa, head of equities at FlexTrade. “As clients amass more data, they can make more informed decisions about which algorithms to use for an aggressive small-cap stock order as opposed to a passive large-cap stock,” he says. Photograph kindly supplied by FlexTrade, January 2011.

decisions about which algorithms to use, which venues to tap and in what sequence, whether a market or limit order is appropriate and what the size and price parameters for each trade should be. Algorithms are becoming more flexible, too. UBS’s Tap product allows the trader to set an overall guideline for how aggressively it will seek liquidity, but then uses real time TCA feedback to tweak the execution based on market conditions. “If it detects an increase in liquidity, Tap will determine whether it is likely to persist and then execute a little faster or slower within bounds set by the investor,” says Robert Kissell, an executive director in the client trading and execution group at UBS.

Trading strategies Sell side firms including UBS now offer execution consulting services, working with buy side clients to tailor trading strategies to match the style of individual managers. A momentum player looking for short-term price moves needs much quicker fills than an index fund manager who is only trading to accommodate cash flows or index changes, for example. “We don’t want to lose sight of the larger objective,” says Kissell. “We are not trying to reduce execution costs to the point where we start to lose alpha.” As TCA gets closer to real-time, the line between pre and post-trade analysis begins to blur. A trader who gets an order in a small capitalisation stock that represents a significant proportion of average daily volume may pick a particular algorithm to handle the order, but if TCA feedback suggests the price is moving too much he can switch the rest of the order to a different algorithm. “As clients amass more data, they can make more informed decisions about which algorithms to use for an aggressive small-cap stock order as opposed to a passive large-cap stock,” says James Benincasa, head of equities at FlexTrade, a New York-based trading technology provider. “That information is becoming more and more important.” It is part and parcel of the buy side taking greater control over orders than ever before. With control comes responsibility; buy side traders want a picture of what is going on in the market and how the stock is performing relative to its sector. “They need real-time data, an idea of where they are relative to VWAP, where volume is compared to the previous day or a longer-term average,” says Benincasa. “Feedback and almost real-time analysis is not a luxury, it’s a necessity.” I

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COVER STORY

Photograph © Blotty / Dreamstime.com, supplied January 2011.

A&P IN THE MID-AISLE Once the world’s largest retailer, the 151-year-old Great Atlantic & Pacific Tea Company (A&P) is today a bankrupt husk, the victim of a half century of changing consumer prefences. Even so, two larger-than-life figures, Erivan Haub of Germany’s Tengelmann Group and Ron Burkle of California’s Yucaipa Companies, appear ready to fight it out for control of the company. Will victory be worth the effort? Art Detman reports. T WAS THE Wal-Mart of its day, a mighty, national chain of stores that struck fear into the hearts of local grocers, undersold the competition, manufactured high-quality food products under its own brand, was the target of a wrathful US congressman, and evolved from 16,000 small stores during the 1930s into 4,000 supermarkets in the 1950s. At one time, A&P’s sales represented 11.6% of the US retail food industry. In many major markets A&P was by far the largest food retailer, and it was number one nationally from 1927 to 1975. Yet when it filed for bankruptcy in December, it was a ghost of its former self, with only 395 stores in eight north-east states. These stores operate under six banners, including A&P, Walbaum’s, Food Emporium, Super Fresh, Pathmark and Food Basics. Tellingly perhaps, their combined sales account for less than 1% of America’s trillion dollar retail food industry. Also, revenues plunged, from $9.5bn in fiscal 2008 (ended in February) to $8.4bn for the 12 months ended last September 11th. The company’s earnings before interest, taxes, depreciation and amortisation (EBITDA) fell even faster, from $333m in FY2008 to $104m for the 12 months ended September 11th last year. This was merely 1.2% of sales, the after-tax profit margin of any well-managed supermarket chain, and not nearly enough to even service the company’s billion-dollar-plus debt load.

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The December Chapter 11 filing was not a pre-packaged bankruptcy, which means the company and its creditors will be arguing in court about who gets what for months, perhaps years. Against assets of $2.5bn, A&P has liabilities of at least $3.2bn and allegedly is burning through cash at the rate of $5m a week. Even so, A&P was able to secure debtor-in-possession financing of $800m from JPMorgan Chase to pay its day-to-day bills and keep its stores open. However, the clock is ticking and repayment of the Chase financing is due in 18 months. “There is no easy path back,” says Daniel O’Connor, president of RetailNet Group, a consulting firm based in Waltham, Massachusetts. “It is solidly in the valley of death.” This is a grim assessment and one that the two major shareholders of A&P (over-the-counter: GAPTQ) hope to refute. One is Erivan Karl Haub, 78, the notoriously reclusive head of Tengelmann Group, which owns more than 2,000 supermarkets and other food stores in Germany and has controlled A&P since 1979. The other is Ronald Burkle, 58, the swashbuckling co-founder of The Yucaipa Companies, a private investment group in Los Angeles. Burkle gained fame and fortune by buying and selling supermarket chains, often at a huge profit: for example, he cleared $200m in profits in 1998 with the sale of Dominick’s to Safeway.

COVER STORY

Burkle’s latest coup was in 2007, when he sold to A&P Pathmark’s 141 stores for $1.4bn, of which $475m was borrowed money. It soon became evident that Christian Haub, A&P’s 47-year-old executive chairman and son of Erivan, had overpaid. The integration of Pathmark into A&P went badly and further weakened an already infirm A&P. It may also have put Burkle, who reportedly bought much of A&P’s secured debt prior to the bankruptcy, in a position to snatch away control of the company from the Haub family. A&P’s total debt exceeds $1bn, a quarter of which was incurred in 2009 alone. Running low on working capital, A&P issued $253m in second lien notes. It also raised $162m through the sale of 175,000 shares of convertible preferred stock—115,000 to Yucaipa and 60,000 to Tengelmann. It even borrowed $10m from the elder Haub. However, A&P’s desperate need for money exacted a high price: the notes come due in 2015 and bear an 11.375% coupon, while the preferred shares require mandatory quarterly dividends of 8% (cash) or 9.5% (in kind). Meantime, Erivan Haub’s IOU is unsecured and carries a modest 6% rate.

Momentum shift Although Haub has appointed more board members than Burkle, the momentum seems to have shifted in the latter’s favour. Last August, a month after the company’s latest turnaround plan was announced, Frederic Brace was appointed chief administrative officer—a new position—at the behest of Burkle. Jake Brace had been with UAL, parent of United Air Lines, and was UAL’s chief restructuring officer during its successful Chapter 11 reorganisation, which took more than three years. Brace is now fulfilling the same role for A&P. Did Burkle expect that A&P would soon enter bankruptcy when he proposed Brace for chief administrative officer? We don’t know, for Burkle isn’t talking to the press these days. Neither is anyone at A&P for that matter. In his petition to the bankruptcy court, Brace displays some humour, presumably unintended. He attributes A&P’s longevity to “a consistent focus on customer satisfaction,” a statement that would bring a sardonic smile to the faces of customers and store clerks alike. The fact is that ever since the 1960s, A&P has been known for out-of-stocks on both advertised specials and everyday products, long lines at checkout counters, and ill-kept stores. “They have never really gotten over the hump in terms of providing a shopping experience that the customer really embraces,” explains Jim Wisner, head of Wisner Marketing Group in Chicago, once a stronghold of A&P. However, there’s nothing funny about the “legacy” costs identified in the petition. One is the obligation to pay rent on 73 stores that A&P closed and are now dark because A&P hasn’t been able to sublease them. In many instances, A&P simply handed over the keys to the landlords and walked away—of the 90 lawsuits currently pending against A&P, 69 are rent-related. Another is the agreements made with two vendors for distribution and transportation services. In 2005 A&P sold most of its US distribution operation to C&S Wholesale Grocers

Archive photograph of Ronald Burkle, co-founder of The Yucaipa Companies, gained his fortune by buying and selling supermarkets. Photograph by Keith Srakocic/AP/Press Association Images, supplied by Press Association Images, January 2011.

of Keene, New Hampshire, which then became A&P’s distributor for 70% of its grocery supplies. The sale produced much-needed operating cash but sharply reduced A&P’s already narrow gross profit margin. Now, A&P says the terms are onerous and wants to change them. Despite months of intense negotiations last year, A&P could not persuade C&S to alter its contract. In addition, A&P wants out of a contract with a company that provides transportation and logistics services to the company’s Pathmark stores. “A&P’s operating income dropped dramatically after it outsourced more and more of its distribution,” suggests Bert Flickinger, managing director of the Strategic Resources Group in New York City. “The biggest drop [appears] to coincide with the near-complete outsourcing of distribution. It was then that EBITDA sank like a stone in a swimming pool.” The third legacy cost cited by Bruce involves under-funded pension plans, employee health and welfare programmes, and high store labour costs as a percentage of sales—95% of A&P’s store employees belong to a union—and last, but certainly not least, is the highly leveraged balance sheet. The company was just days away from a due date for $13.4m in interest payments when it filed for bankruptcy. Furthermore, a string of interest and principal payments in coming years seems to stretch to the horizon. The story of A&P is fascinating for both the company’s extraordinary success and its agonising decline. It was started nearly 152 years ago because George Hartford was tired of the dry goods business in Boston. He moved to New York City

FEBRUARY 2011 • FTSE GLOBAL MARKETS

and took over his brother’s business of selling tea door-todoor from a horse-drawn wagon. At the age of 26 he persuaded a home-town acquaintance, George Gilman, to finance expansion of his business. The two Georges founded their company in 1859 but didn’t get around to naming it until 1861, when they called it The Great American Tea Company. Hartford had discovered that one reason tea was so expensive was the multiple layers of distributors. Another was that stores took a high profit on tea in order to charge lower prices on sugar, salt and flour. He arranged to buy tea direct from a Chinese exporter and sold only tea, at first by mail and later in small stores, for much less than competitors. After the transcontinental railroad was completed in 1869, the two Georges changed their company’s name to The Great Atlantic & Pacific Tea Company. By 1878 there were more than 100 A&P stores, which stocked a variety of packaged groceries, including sugar, salt and flour (that were then essentials in every kitchen) and a line of private label products included A&P Baking Power and Eight O’Clock Coffee. By then, A&P had adopted promotional practices common in the industry, including trading stamps, in order to build customer loyalty.

Daring proposal By 1912 the company had 400 stores but was essentially indistinguishable from its competitors. Profits were lean. So John A Hartford made a daring proposal to his father, who was running the company alone, after Gilman died. Hartford Jnr said the company should run a bare bones operation focused solely on selling goods for the lowest possible price. Hartford senior was dubious but gave John $3,000 and six months to test his idea. He was not allowed to use the A&P name. John rented a small store on a side street around the corner from a busy A&P in Jersey City, New Jersey. He eliminated every unnecessary selling expense, including selling on credit (then very common), home deliveries, phone orders, trading stamps, premiums of all kinds, and even advertising. He hired one clerk as the store’s only employee. Prices were set to achieve a 12% gross profit margin instead of the 20% to 22% that was the industry’s norm. The store was an astounding success and within six months put the nearby bigger and flashier A&P out of business. The elder Hartford adopted his son’s audacious idea. Only one-year leases were signed in order to give the company flexibility in case a store location did not work out. Shelving and other fixtures were basic and easily moved and reused. Over the next 15 years, the chain grew from 480 stores with revenues of $24m to 15,000 stores that generated more than $1bn in sales. All the while the company was fixated on selling food at the lowest possible price. A&P expanded its existing manufacturing capabilities and by the 1930s was producing more than 30 widely-used products, such as mayonnaise, salad dressing, condensed milk, canned beans, shortening, ketchup, jellies, jam and, of course, farina. Most carried the Ann Page brand and in each case the product was formulated to duplicate the best-selling national brand.

FTSE GLOBAL MARKETS • FEBRUARY 2011

Karl Erivan W Haub, managing director and general partner of the Tengelmann Group at the annual press conference at the headquarters in Mulheim. Photograph by Roland Weihrauch/DPA/Press Association Images, supplied by Press Association Images, January 2011.

“I think they had 80 buying offices around the world and 67 manufacturing plants,” says Flickinger. The Ann Page brand was the nation’s largest-selling private label. By the 1930s, A&P had stores in California, Washington State, along the Gulf Coast, in the Great Lakes states and the North-east. It easily weathered the onset of the Great Depression because of its one-year policy on leases; besides, as the economy got worse, people wanted to save money on everything, especially groceries. It was a retailing colossus with its own warehouses and trucking operations, a highly profitable manufacturing division, and the expertise to keep prices low. Local grocers howled, and Representative Wright Patman of Texas proposed a federal tax on chain stores that would have amounted to 30% of A&P’s revenues (it was never enacted). When competitors opened supermarkets—it’s not clear which company was first—A&P didn’t know how to respond. Because of their larger size, supermarket locations required longer leases (typically at least five years) and more elaborate shelving. Each supermarket did the volume of ten A&P stores, none of which was much bigger than today’s convenience stores and all of which required clerks to fetch products from shelves behind the sales counter, a labourintensive way of selling goods. A&P opened 300 supermarkets on a test basis in 1937. A year later it had 1,100, a number that rose to above 4,000 in 1950 and revenues that year were $3.2bn. “A&P’s market share was then higher than Wal-Mart’s is today,” says Flickinger. “A&P was bigger than Safeway and Kroger

COVER STORY

combined, which were the number two and three chains in the country. A&P was bigger than either US Steel or Standard Oil and second in worldwide sales only to General Motors. It accounted for 33% of the sales of the top ten chains.” John Hartford died in 1951. His brother George, then 87, remained chairman of the board. William Walsh, who rose from store clerk to executive vice president and board member at A&P, believed John’s death was the turning point in A&P’s fortunes. In his book The Rise and Decline of The Great Atlantic & Pacific Tea Company, he wrote: “When the sad day finally arrives when A&P is no more, let it not be written that this giant was driven to extinction by a government’s oppression or by fierce competitor aggression. Let the record show it was death by its own hand… However long it finally takes, it started at the very moment John died.” Walsh’s eerily prescient book was published in 1986 and died four years later. Throughout the 1950s, management became more centralised and less responsive to changes in the market. A&P was slow to follow its customers to the suburbs and made it difficult for zone managers to respond to challenges from newer and larger supermarkets. It introduced trading stamps in 1961 in a futile attempt to build sales without making capital expenditures. Its market share steadily declined even as it continued to build new warehouses and manufacturing plants. Bizarre formulas for “potential profit” were devised at headquarters and store managers were faulted for not achieving this profit. Over the years, various heirs had sold their shares and in 1958 A&P went public and was listed on the New York Stock Exchange. Many investors were likely unaware of a basic problem in the capital structure. The Hartford Foundation, a charity established by the two Hartford brothers, owned 40% of the company and relied on dividends to fund its good works. Typically, A&P’s chief executive officer was also a trustee of the foundation, which created a conflict of interest—reinvest in the business or pay dividends? In the four years following its public listing, a key period in the development of supermarket design, A&P paid out 92% of its profits as dividends.

Inflation raged In 1969 the company abandoned its California stores and began a long retreat in which it sold off stores, warehouses and manufacturing plants. Every few years, turnaround plans were announced. From time to time acquisitions were made but rarely to good effect. In 1982, for example, it bought the chain of Kohl’s supermarkets based in Milwaukee. Kohl’s had smartly designed stores that were bright, airy and inviting. Years earlier it had passed A&P as the market leader in Wisconsin. After being acquired by A&P, sales declined and eventually the stores were sold. “The Kohl’s chain was mismanaged,” says David Livingston, a supermarket consultant based in Milwaukee. “A&P had the reverse Midas touch.” In the 1970s, as inflation raged and shoppers became extremely price-sensitive, management converted many stores to a discount format under the Warehouse Economy Outlet name, which later was changed to Where Economy

Originates. They failed. Safeway passed A&P as America’s largest supermarket chain. The stock, which hit a high of $70 in 1961, fell below $7 in 1977. Both heirs and the foundation wanted to sell. In 1979, Erivan Haub’s Tengelmann Group agreed to buy 42% of the stock for $75m—less than A&P had spent in the prior two years building 80 new stores. The takeover was hailed as A&P’s salvation. After all, wasn’t the Tengelmann Group one of the largest and most successful retailers in the world? Soon Germans were filling key slots in management. Haub’s American-born son Christian, then 27, became a vice president and board member. Later he would be chief executive officer and then chairman, overseeing a succession of chief executives, four in just the past 18 months. Market share continued to shrink. Turnaround plans continued to be announced but all seemed to entail selling off parts of the company in order to raise cash. “A&P’s idea of a turnaround is spinning in place,” says Jim Wisner. In 2005, A&P sold its Canadian division, which accounted for 33% of FY2004 sales and 100% of operating profits. That was also the year of the ill-fated sale of A&P’s remaining major distribution operation to C&S.

Competition and hope Meanwhile, the marketplace just gets more competitive. Wal-Mart long ago became the number one food retailer in the US, and now Target is ramping up its food operation. Specialty chains like Whole Foods and Trader Joe’s have become major players; both are likely to pass A&P in sales this year. Dollar stores are offering not only packaged foods but fresh produce as well. Even drug stores such as Walgreens and CVS are expanding their food departments. Despite all this, there is hope for A&P. Clearly Burkle thinks so. Among others who think the company could survive is Jim Hertel, a managing partner of the Willard Bishop consultancy in Chicago. “Their locations are pretty good,” he says. “What they don’t have are modern, clean, and up-to-date stores.” Because supermarkets remain a fragmented business, with local banners counting for more than national names, Hertel believes A&P could shrink further and still prosper. “They could probably go down to maybe 150 stores and still not lose very much from the standpoint of what they have to pay for product.” Peter Cohan, a Massachusetts-based consultant and venture capitalist, puts it this way: “The problem with A&P is that it is stuck in the middle. It has higher prices but its quality isn’t higher.” He doubts that A&P can ever regain its low-price advantage. “The only alternative is to sell higher-quality products for higher prices, and somehow be able to do that with a cost structure that allows them to make money.” In any event, there are other companies that likely would want to acquire parts of A&P. Kroger and Safeway are two candidates, as are Ahold USA and Delhaize America, both foreign-owned. Will Burkle get the chance to work his magic on A&P? If he does, there’s no certainty that he will be successful. Not all of his food retail investments have worked out. A&P would be one of his smaller deals but almost certainly it would be his most difficult. I

FEBRUARY 2011 • FTSE GLOBAL MARKETS

THOUGHT LEADERSHIP ROUNDTABLE

Photograph © Rolffimages / Dreamstime.com, supplied January 2011.

TOWARDS A BETTER UNDERSTANDING OF BASEL III REQUIREMENTS (and its implications for banks over the coming decade) Commentators PARKSON CHEONG, general manager & group chief risk officer & MONDHER BELLALAH, head of market risk, National Bank of Kuwait BERT BRUGGINK, chief financial officer, Rabobank CHNG SOK HUI, chief financial officer, DBS Bank MARK CONNOLLEY, UK head of the Finance, Risk & Compliance Practice, CAPCO GOH CHIN YEE, senior vice president, MIS & Capital Planning, OCBC Bank DR STEFAN SCHMITTMANN, chief risk officer, Commerzbank

FTSE GLOBAL MARKETS • FEBRUARY 2011

ROUNDTABLE

Q: According to Basel III, banks will have to increase their core tier-one capital ratio to 4.5% by 2015. In addition, they will have to carry a further “counter-cyclical” capital conservation buffer of 2.5% by 2019. Any bank that fails to meet the new requirements is expected to be banned from paying dividends to shareholders until it has improved its balance sheet. How feasible is this requirement and what reasonable action can be taken against those financial institutions that do not comply? GOH CHIN YEE, SENIOR VICE PRESIDENT, MIS & CAPITAL PLANNING, OCBC BANK: For any bank, the ability to maintain adequate capital buffer for its normal business activities and to meet additional pro-cyclical capital requirements while operating within its risk appetite is a fundamental requirement for sound capital and risk management. For those jurisdictions that adopt the prudential regulatory regime, this requirement is already being addressed under the Basel II Pillar 2 Internal Capital Adequacy Assessment Process (ICAAP). However, under Basel III, this becomes a regulatory as well as disclosure requirement for banks to comply with. CHNG SOK HUI, CHIEF FINANCIAL OFFICER, DBS BANK:The capital conservation and countercyclical buffers are distinct, each of which could account for an incremental 2.5% in additional core capital requirements beyond the minimum 4.5%. Taken together, and until the BCBS provides further clarity on the admissibility of other forms of fully lossabsorbing capital in meeting the countercyclical buffer requirements, banks could be subject to a minimum core equity requirement of 9.5%. However, as a newly-introduced policy tool, the efficacy of the countercyclical buffer remains to be assessed. Issues that regulators should examine include the ease with which the countercyclical buffer could be calibrated, as economic indicators could be subject to possible variations in interpretation. The countercyclical buffer also does not recognise a bank’s own capital planning or its risk management process; it does not adequately differentiate banks that have lent heavily and those that are more prudent. Judgement is also required to evaluate whether other policy tools, besides the imposition of a buffer, could have been better options in achieving the desired outcome. The other area of concern is the discretion granted to jurisdictions to, relative to the BCBSspecified transition arrangement, either accelerate the build-up of the capital conservation and countercyclical buffers, or to implement larger countercyclical buffers. These have potentially level-playing field implications. Q: Why should we all care so much about bank capital? PARKSON CHEONG, GENERAL MANAGER & GROUP CHIEF RISK OFFICER AND MONDHER BELLALAH, HEAD OF MARKET RISK, NATIONAL BANK OF KUWAIT: The main reason is that capital is often seen as a guarantee for stakeholders and mainly debt-holders in the case of default or liquidation. DR STEFAN SCHMITTMANN, CHIEF RISK OFFICER, COMMERZBANK: Capital is needed to compensate for possible losses in difficult market environments and therefore adequate capital levels are fundamental to the stability of the

system. Even so, the real question is: shouldn’t we care more about where the capital is allocated to? Basel I and Basel II have both been calibrated to demand far less capital per unit of risk for market risks (that is, trading business) compared to credit risks (that is, lending business). The massive losses of the last crisis—overwhelmingly stemming from trading business— should cast doubt on this assumption. The new trading book rules currently being implemented go some way towards bridging the gap. However, capital in the system is not yet fully aligned with the sources of underlying risk. Over-capitalised stable businesses (and banks) subsidise undercapitalised ones and, as a result, capital is not held where it is needed most. Actually, Basel III—by raising capital levels across the board— does not yet address this fact directly. Q: Do you think the period for full compliance with Basel III (by 2019) is too long? PARKSON CHEONG & MONDHER BELLALAH: The answer to this question varies and depends heavily on the size of the bank; small banks may be less able and prepared and need a longer period than the big diversified international banks. BERT BRUGGINK, CHIEF FINANCIAL OFFICER, RABOBANK: Although the phase in period as defined by the regulators is quite long, we think that the market will force banks to comply with the new guidelines much faster than regulators foresee. So in practice the phase-in period will be only a few years, instead of almost ten years as laid down in the Basel proposals. MARK CONNOLLEY, UK HEAD OF THE FINANCE, RISK & COMPLIANCE PRACTICE, CAPCO: We think that the period is too long and it introduces a risk that if banks have too many current issues to consider that it is effectively out of mind. Or, potentially, there is the possibility that another crisis unfolds which requires additional future regulatory developments. DR STEFAN SCHMITTMANN: No. A great many banks with low ratios will be required to build up additional core capital; or, alternatively, they will be forced to cut balance sheets to reduce business with high capital consumption under regulatory rules. Building bank capital up organically will take time; generating corresponding demand on the capital markets (with a large number of banks seeking to raise capital almost simultaneously) will also clearly take time as well. There is no quick fix with this sort of massive new requirement. CHNG SOK HUI: The Basel Committee on Banking Supervision (BCBS) has taken on board the industry’s concerns on possible unintended consequences that Basel III could trigger and the transition arrangement reflects what it has deemed to be an appropriate balance between the desired prudential responses to the crisis and the pace with which it could be implemented. As mentioned earlier, there appears to be regulatory discretion to accelerate the compliance timeline. In addition, certain banks have also proactively undertaken capital raising exercises with a view to comply with Basel III immediately. This could be in response to market and investor pressures: while the regulatory regime may prescribe a more permissive time period for compliance, the financial markets

FEBRUARY 2011 • FTSE GLOBAL MARKETS

Bert Bruggink, chief financial officer, Rabobank. Photograph kindly supplied by Rabobank, January 2011.

actually differentiate between “winners and losers” straight away. The likelihood of banks targeting early compliance in response to the demands of key constituents is high. Q: During the recent financial crisis, many banks ran out of cash quickly. Are many banks too fragile still to comply with Basel III liquidity requirements that say banks should hold enough cash and liquid assets to survive for at least 30 days without access to markets? BERT BRUGGINK: The Basel III liquidity requirements are quite strict with respect to type of instruments that qualify for the liquidity buffer. A number of instruments that banks used to hold in their liquidity buffer will no longer qualify, and should therefore be replaced by other qualifying instruments. This has both a cost impact on banks, as well as it could require additional funding (for as far as internally securitised paper has to be replaced). It will therefore be challenging for a number of banks to comply with the requirements on short notice, in particular if also government and central bank support is being reduced. MARK CONNOLLEY: The measure makes sense in its objective and language. We view this as an extension, or formalisation, of the stress testing and contingency planning approach of the last Basel regime. As then, it is as much a resources challenge as it is a system, process and business model challenge around the principles of sound risk management. Q: Or, is the problem that a lot can happen between 2011 and 2015 when Basel III’s liquidity requirements come into force? MARK CONNOLLEY: We believe the problem is one of over-prescriptive regulation. This takes the focus away from commercial risk management to regulatory compliance where the rules are supposed to be the minimum standard above which the banks are expected to operate. All too often with such prescriptive rules the effort is spent in complying with the letter of the law, without regard to the spirit. This, we feel, introduces an element of moral hazard in the sense that what isn’t explicitly regulated is implicitly unregulated. That is clearly counter-productive to the final intent of the regulation. There has been a failure of regulation—but not in the content sense, rather in the less than rigorous application and policing of the principles. Q: Is there a risk of another crisis developing in the interim? PARKSON CHEONG & MONDHER BELLALAH: Yes, because of several signals observed about sovereign debt and high swings in currency markets and the start of currency wars, among other things. MARK CONNOLLEY: An area we feel Basel III has addressed most effectively by recognising the issue of systemic risk through inter-connectedness of market participants is

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macro-prudential supervision. Coupled with intrusive oversight and closer monitoring by local regulators, the new structures will go some way in addressing the issue of systemic risk. However, the extended implementation time frame coupled with the moral hazard inherent in a prescriptive regulatory regime does create conditions for future problems. The market will always find ways to“boom and bust”. Q: Are Basel III liquidity requirements too onerous in any case? PARKSON CHEONG & MONDHER BELLALAH: Yes, for at least two reasons: the first concerns identifying/acquiring highly liquid assets and in preserving stable deposits in cases of crises; the second concerns implementing systems and in devoting resources to liquidity management. MARK CONNOLLEY: Instead of taking a prescriptive approach, the focus should remain on rigorous stress testing, contingency planning and a suitably diverse funding base. In the UK context, we have always known them to exist within the ICAAP process as part of Pillar II liquidity standards under the Basel II regime. Reducing the collaborative dialogue between the regulator and the regulated to a prescriptive box-ticking exercise, we feel, detracts from the efficacy of the new regime. BERT BRUGGINK: In particular, the net stable funding ratio is quite harsh as it tries to incorporate all different business models of banks into one single ratio, without taking into account essential elements in managing a bank’s balance sheet and it’s funding, like the credit rating, market access, client relationships and so on. It also hinders the transformation function of banks, as retail lending, which is by nature long term, requires a higher degree of stable funding than corporate and wholesale lending which can be shorter term. Q: In terms of capital quality, the current round of Basel III consultation suggests that Tier I capital will become mostly common shares, retained earnings and certain subordinated instruments. This will apparently be achieved by introducing stricter criteria for other elements of Tier I capital to ensure they are sufficiently loss absorbent. What does this mean in practice for banks complying with this directive? CHNG SOK HUI: Basel III has clearly shifted the capital mix in favour of core equity and capital instruments with stronger loss-absorbing features. In this regard, the BCBS has recently finalised additional loss absorbency requirements for Tier 1 and Tier 2 capital instruments, and it continues to deliberate the role of contingent capital. The regulatory focus on core equity will constrain opportunities for leverage (although some manoeuvre room may be possible during the 2013 – 2019 transition period), which has been a key driver in generating shareholder returns in the past. Correspondingly, the internal generation of capital takes on added importance: revenue generation and discretionary payments e.g. bonus payments, dividend policy will come under greater board and management scrutiny. Growth options, both organic and inorganic, may become prohibitive if equity deployment is acute. Therefore, prioritising among competing demands on capital is critical.

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PARKSON CHEONG & MONDHER BELLALAH: For banks complying with this directive, this means that they have to raise capital in the form of common shares. The issue of debt instruments and hybrid securities is strongly dependent on national legislations and regulatory treatment. BERT BRUGGINK: First of all, this will mean an increased focus of banks on retaining earnings, as this is the easiest way to increase the core capital base. In addition, new Basel III compliant instruments will have to be invented, which will allow banks to replace part of the existing non-Basel III compliant instruments that will be phased out in the coming years. DR STEFAN SCHMITTMANN: Markets will be saturated by the high demand for fresh high-quality capital, and so banks will need to take a two-pronged approach: building up capital through retained earnings or selective share issues, but also looking to their own balance sheets to ensure that each unit of capital held is put to best use. Stronger criteria for capital quality will push many banks to reconsider allocations of this scarce resource. GOH CHIN YEE: The stricter capital definition under Basel III will restrict the range of capital instruments currently available to banks as regulatory capital and drive up the cost of the qualifying capital instruments. Besides raising the cost of capital, the aggregate effects of Basel III’s stricter capital definition, higher minimum capital ratios, the imposition of additional capital conservation buffer and countercyclical capital buffer, as well as higher risk charge, could also lower the return on equity for banks complying with this directive. Given its far-reaching consequences, if Basel III is not implemented on a global scale, this could create an uneven playing field for banks and result in potential capital arbitrage across different jurisdictions. MARK CONNOLLEY: In the first instance it clearly means issuing new equity, but we believe that banks will want to address this issue in a multi-pronged way. We believe there is a real opportunity for banks to redesign their balance sheet for efficient capital utilisation. In that regard we believe banks will need to look closely at group structures, minority holdings and particularly impact of SPVs/VIEs. Secondly, and even though risk-adjusted return on capital (Raroc) is not a new concept, we believe this period of capital austerity will drive rigour around business/market and investment/transaction selection through a focused application of risk-based pricing principles. Thirdly we believe that banks will need to invest significantly in the improvement and upgrade of the process, data and MI infrastructure used to make those vital go/no-go decisions. For instance, improvements in counterparty static data quality and use of a single golden-source across the banking group should allow for greater netting of positions with counterparties within and between the various business lines—which drives down balance sheet and capital usage Q: Banks will have to raise hundreds of billions of euros in fresh capital under new regulations designed to prevent the repeat of another financial crisis. What do you think the impact will be on the debt capital markets in 2012 and beyond?

Chng Sok Hui, chief financial officer, DBS Bank. Photograph kindly supplied by DBS Bank, January 2011.

PARKSON CHEONG & MONDHER BELLALAH: The debt capital markets will show two effects: the effect of low interest rates and the desire to issue straight debt or convertible debt. However, it is important to note that the costs of issuing debt and the costs of issuing equity or equity-like instruments are different from one country to another and depends on the issue method. In any case, the flow of funds in one market or the other will contribute to the efficiency of capital markets, liquidity and transparency. MARK CONNOLLEY: Markets will always chase yield and banks motivated to approach the markets for balance-sheet reasons; funding, liquidity, or restructuring. That will ensure consistent supply. It is our belief that capital markets have a finite appetite for bank risk so that will dampen demand. The dynamic is tougher to predict because of the complex interplay of monetary policy, inflation and global recovery. How these factors play out in 2012 remains to be seen. GOH CHIN YEE: The market and investment community will expect banks to meet the Basel III standards ahead of the phase-in implementation period. Banks that currently fall short of Basel III’s capital and liquidity standards are expected to start raising equity capital as well as debt instruments well before the phase-in timeline. According to the results of the comprehensive quantitative impact study released by the Basel Committee on Banking Supervision in December 2010, it is estimated the industry will need €600bn of additional Tier 1 capital in order to achieve the Common Equity Tier 1 target level of 7.0% and an additional stable funding in excess of €2trn had the Basel III requirements been in place at the end of 2009. The equilibrium between demand and supply will depend on the pace of capital raising and debt issuance by banks as well as the characteristic (e.g., loss-absorbency features) and pricing of these instruments, The exclusion of financial institutions’ debts from qualifying liquid assets under Basel III may lead to further in-balance between the demand and supply. DR STEFAN SCHMITTMANN: History shows that markets are too diverse and, sometimes, too volatile for crises to be avoided fully. That’s why we need capital (and indeed more capital) in the system, and that’s why we need the sound aspects of Basel III. But will Basel III succeed in providing a better basis for managing future crises? That is a tough question, given how complex and interdependent the proposed rules are. People who say that they have a clear picture of how the complicated new rulebooks for asset weighting, capital quality, liquidity requirements, etc. will interact to shape banks and markets going forward are simply not being honest with themselves. And that’s yet another reason why long phase-in and observation periods are so important. CHNG SOK HUI: With respect to capital financing, how conventional debt investors will react to the loss absorption

FEBRUARY 2011 • FTSE GLOBAL MARKETS

features that the BCBS has introduced as additional criteria for capital instruments remains unclear. Not all investors have the necessary risk appetite or investment mandates to take on hybrid or convertible instruments which could become equity risk. Besides the change in structures for capital instruments, investors will also need to closely evaluate the risk and return profiles of banks operating in the new Basel III regime. It will be some time before the market locates its equilibrium in terms of demand and pricing. Q: In an environment of capital scarcity do you think that the cost of capital will invariably rise? PARKSON CHEONG & MONDHER BELLALAH: Yes, sure, because in efficient market the cost of capital should reflect scarcity in capital markets. GOH CHIN YEE: Yes, the cost of capital will increase. This is further compounded by the possibility of capital being diverted to non-regulated financial intermediaries that could provide relatively higher return on capital. CHNG SOK HUI: It is possible that capital scarcity could result, due to attrition in the traditional investor base as risk appetites realign, and investors perceiving the banking industry to be yielding unattractive returns as a result of a more stringent regulatory environment. Moreover, the shift in banks’ capital mix towards core equity will also raise the weighted cost of capital as they will be financing their activities with the most expensive element. MARK CONNOLLEY:Yes, that seems to be inevitable. While the re-balancing of supply-demand dynamics for bank risk is obviously a driver, we believe a more fundamental adjustment will occur in the overall risk-based-pricing environment—especially in the secondary markets. Firstly, we see counterparty risk as being more widely and transparently priced into this cost. Secondly, liquidity valuation adjustments will play a significant role in pricing as markets adjust to the enhanced requirement by banks to match-fund their books and go back to classical banking principles. Q: Do you also expect funding maturities to lengthen significantly? BERT BRUGGINK: The Basel III liquidity requirements will indeed make banks lengthen the maturity of their wholesale funding. The overall gap of stable funding as calculated by the Basel committee based on the QIS amounts to several thousand billions. MARK CONNOLLEY: With the introduction of the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) we believe funding maturities should lengthen. However, the impact will not be uniform across the banking ecosystem. We believe banks need to invest, now, to understand the impact and generate mitigating strategies in terms of target-operating-models specific to their strategic ambitions and the changing dynamics of the economy. CHNG SOK HUI: For senior funding, maturities have to be aligned with a bank’s desired funding profile, which would take into account regulatory considerations. Funding maturities for capital instruments have always been an outcome of a rather complex interplay among prescribed rules, market demand and a bank’s own needs. Capital instruments that are raised

FTSE GLOBAL MARKETS • FEBRUARY 2011

Mark Connolley, UK head of the Finance, Risk & Compliance Practice, CAPCO. Photograph kindly supplied by CAPCO, January 2011.

during the transition period may have maturities that are tailored to coincide with the extent to which they are admitted to the overall capital structure as this period evolves. Q: Do you think that Basel III can succeed in preventing another financial crisis? PARKSON CHEONG & MONDHER BELLALAH:Yes, in the short term and maybe no in the long run. In fact, Basel III is an answer to the serious limitations of Basel II in our economic context today. But, if the economic activity is modified there will be other risks that may emerge and a new version of Basel rules should be implemented. BERT BRUGGINK: No, regulation will never totally prevent the occurrence of financial crisis. MARK CONNOLLEY: Our biggest concern is the risk of unintended consequences that only become apparent later. There will always be demand for yield/volatility and regulation is but one determinant of market behaviour. Basel III has departed from its predecessors in being radically more prescriptive about rules and procedures. That, however, opens the door for moral hazard in the sense of pushing what is not explicitly regulated into being implicitly unregulated. We feel a principles-based approach tackles such issues more appropriately and builds greater ownership for outcomes among the regulator and the regulated. For obvious reasons the whole system has become politicised. I would now call for a calming and realignment to a more mature dialogue between banks and regulators. That said the“too-big-to-fail”issue has caused a dichotomy where the governments have had to intervene in the free markets. A more concerted effort to diversify the market into smaller participants would be a welcome direction. CHNG SOK HUI: Basel III is very much targeted at regulated entities. It is possible that the next financial crisis could be triggered by unregulated ones. Q: The precise calculation of leverage ratios has still to be determined: what are you expecting? MARK CONNOLLEY: Use of leverage ratios as a backstop to managing risk is borrowed from the Pillar II requirements of the last Basel regime. However, the more prescriptive nature of Basel III does not address the fundamental failing in the application and monitoring of the standard. We expect the industry to engage in an exploratory period in the first instance to ascertain impact and generate mitigating strategic options. Secondly, we expect the industry participants to engage with the regulators to work through the specific impact vis-a-vis their unique business model and strategy. We feel such discussions will go a long way during the investigation period in determining not only the precise calculation, but also the method of application. Q: Do you think that a harmonised international minimum leverage ratio to constrain the build-up of gross leverage in the banking sector will work?

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PARKSON CHEONG & MONDHER BELLALAH: The idea of capping the leverage ratio is acceptable because most economists think that there is an optimal leverage ratio within institutions and the economy. However, this can distort the behaviour of decision makers who can show a preference toward more risky assets. BERT BRUGGINK: I think it will work, but the level is set at such a level that, except for certain specific situations, it will not really change business models. MARK CONNOLLEY: In principle, any global harmonisation of standards is a welcome development, but consideration should be given to the purpose and intent of such an approach. The diversity of the banking and financial services landscape will probably pose a challenge in determining the minima. In arriving at an acceptable figure there is the danger of reverting to the lowest common denominator. That, we feel, may be in keeping with the letter of the law, certainly not the spirit. Q: One way to avoid problems associated with riskweighting is not to do it at all: simply calculate the ratio of capital to assets, without any weighting; in other words, the leverage ratio, which is a traditional and well known way of measuring bank safety. Basel III also includes a leverage ratio, but is this requirement set too low (at only 3%)? BERT BRUGGINK: In general one would say that having 3% of capital against the assets is not very conservative. The problem with the leverage ratio is that it tries to capture a wide variety of business models into one ratio. CHNG SOK HUI: One factor contributing to the magnitude of the last financial crisis has been excessive leverage, which has to be managed down. The introduction of the leverage ratio has invited considerable criticism; as a policy tool, the leverage ratio is acknowledged to be crude, and the desire for international harmonisation and conceptual simplicity has arguably made it even more so. I believe the BCBS, in introducing a transition period that will comprise of both a supervisory monitoring period and a parallel run period, is seeking to assess the efficacy of this measure in achieving the intended prudential outcome. During this period, an assessment will be made if the proposed 3% is appropriate over credit cycles, business models, definitions of exposures and differences in national accounting frameworks. We can expect further changes in due course – at this juncture, it is at least clear that low risk products e.g. housing loans, certain off-balance sheet trade products could be unduly penalised, and many of these have important roles to play in the socioeconomic context. BCBS will have to ascertain how any unintended consequences that the leverage ratio could have, in this regard, can be managed. MARK CONNOLLEY: We definitely see potential for confusion when capital requirements can be specified on two parameters—RWAs and Gross Assets. We think the old regime, as it was implemented by the FSA in the UK, handled this dichotomy particularly well by keeping the RWA-based metric a Pillar 1 requirement and the assetsbased metric a Pillar 2 requirement. This also handled well the challenges of application as they relate to the diversity of market participants’ business models and strategies. With the new, more prescriptive, global minimum standard approach,

we feel the regulator may have opened the door for potential regulatory arbitrage. That said a lot can be achieved during the investigation period by actively consulting with the industry while market participants articulate the specific nuances of implementation as it relates to them. Q: Basel III is also about raising the consistency of the capital base by harmonising regulatory adjustments across Basel Committee countries. Should Basel III distinguish more effectively between countries and markets in this regard? Can banks in high-growth emerging markets be harmonised to this degree? DR STEFAN SCHMITTMANN: The crisis has powerfully reinforced the fact that banking regulation must be coordinated closely across borders. While there is always scope for national discretion in rule-making on some issues, we need clear international guidelines and consistency on the fundamentals. And this should, for instance, include guidelines specifying which types of capital instruments regulators (consistently) view as “high-quality”. PARKSON CHEONG & MONDHER BELLALAH: There are pros and cons since harmonisation is preferable but it will ignore the specifications of each country and financial system. MARK CONNOLLEY: The intent is definitely there, but so is a real danger of it becoming a political window-dressing exercise. Whereas the emphasis should be on monitoring and enforcement, it may shift to the legal interpretation of an overly prescriptive set of rules. A case can also be made for a more rigorous implementation of Basel II removing the need for many sections of the new Basel III. Q: There seems to be a desire within the Basel III framework to reduce cyclicality and encourage the building of capital buffers. What are the main avenues that Basel III proposes to achieve these aims? MARK CONNOLLEY: The direct means of addressing this are specifications relating to the capital conservation buffer and the counter-cyclical buffer. The capital conservation buffer at 2.5% of Tier 1 capital could see imposition of income distribution constraints should banks fail to meet the standard. Implementation of the counter-cyclical buffer has been left to the local regulators though the Basel Committee recommends a range between 0% and 2.5%. The buffer would build up during periods of rapid aggregate credit growth if, in the judgment of national authorities, this growth is increasing system-wide risk. Conversely, the capital held in this buffer could be released in the downturn of the cycle. The intention is thus to mitigate pro-cyclicality and attenuate the impact of the ups and downs of the financial cycle. Clearly the committee has chosen to be prescriptive when addressing this issue, but it is not a new concept as such. GOH CHIN YEE: Banks can build up their capital buffer through ways like earnings retention, shifting towards lower risk and capital-light business models or adopting proactive capital planning. As these require sufficient lead time to take effect, Basel III phases in the requirement for the capital conservation buffer and countercyclical buffer to start in January 2016 with progressive implementation over three years for full adoption by January 2019.

FEBRUARY 2011 • FTSE GLOBAL MARKETS

Goh Chin Yee, senior vice president, MIS & Capital Planning, OCBC Bank. Photograph kindly supplied by OCBC, January 2011.

Q: What are the main challenges in achieving accounting uniformity and global comparability? CHNG SOK HUI: The largest hurdle at this stage, evident from their respective consultation papers, is the divergent views of the IASB and FASB over fair value accounting. If implemented as-is, the need for prudential filters to achieve more aligned capital and leverage ratios will be fairly pronounced. The IASB has also recently consulted on the proposed effective dates for the various standards that it is currently reviewing. It will be useful for the IASB, in its deliberations, to consider how each proposed effective date could impact the overall Basel III programme. Q: The G20 wants common global accounting rules by mid-2011; will this help or hinder this element of Basel III reporting requirements? BERT BRUGGINK: It should not be the case that difference in accounting rules will have a substantial impact on the outcome and impact of complying with the Basel III requirements. Common global accounting rules are therefore welcomed, but difficult to realise. CHNG SOK HUI: An internationally-harmonised accounting framework is important to Basel III. The leverage ratio is a clear instance where accounting requirements will dictate its computation. Certain accounting standards, for example the one on leasing, are likely to impact balance sheet items which go into the computation of the leverage ratio. In fact, any accounting standard that impacts a bank’s balance sheet and P&L will have Basel III implications, directly or indirectly. For example: Basel III’s proposal not to do any adjustments to the accumulated other comprehensive income and other disclosed reserves will impact banks differently, depending on whether they are operating under FRS 39, or have adopted IFRS 9 Phase 1, or are on FASB rules. Moreover, Basel III is also promoting stronger provisioning policies and very much in favour of an EL approach that “captures actual losses more transparently and is also less pro-cyclical than the current incurred loss approach”. As provisioning is an important element impacting bank profitability and soundness, added clarity on what the IASB will eventually propose on IFRS 9 Phase 2 takes on added importance. If implementation dates are not aligned, then the desired consistency in regulatory and other prudential ratios may be compromised, resulting in reduced transparency for markets. Q: Do you think that it is feasibly to expect regulators across the globe to agree the implementation of a consistent leverage ratio? PARKSON CHEONG & MONDHER BELLALAH: Yes for some countries and maybe not for others (those that are fast growing, for instance). Q: Basel III also seems to require a new level of administrative transparency and reporting; requiring banks to

FTSE GLOBAL MARKETS • FEBRUARY 2011

disclose all elements of capital together with a detailed reconciliation to the reported accounts. What are the costs and/or implications of these requirements? PARKSON CHEONG & MONDHER BELLALAH: The costs may be high because of the modifications to information systems. GOH CHIN YEE: Besides the additional administrative requirements and higher operating costs for regulatory compliance, the prescribed disclosure requirements can provide more transparency and comparability across Basel III-compliant banks. However, in implementing the enhanced disclosure requirements, banks should not be required to disclose proprietary information that could undermine their competitiveness, e.g. pricing, funding, capital raising, etc. Q: Is harmonisation of reporting requirements feasible and practical? DR STEFAN SCHMITTMANN: Transparency is generally a good thing, but it must have a clear purpose. As a rule, regulators already have (or can demand) detailed transparency regarding banks’ capital positions and receive regular full reporting on individual capital positions. While this regulatory transparency is surely important, there’s no clear“to do”on this front. It is equally not immediately clear what benefit investors might reap from yet more complexity in the reported accounts. Our efforts should be focused on enhancing public transparency by removing complexities, not on reporting them in ever greater detail. Q: Basel III enhances risk coverage by strengthening the capital requirements and risk management requirements for counterparty credit risk exposures arising from derivatives/repos/securities financing, for example. The G20 calls for greater standardisation and central clearing of privately arranged, over-the-counter (OTC) contracts by end 2012. Can current clearing and settlement infrastructures cope with the influx of transactions over the period? PARKSON CHEONG & MONDHER BELLALAH: No, because there should be a harmonisation in information systems and a general agreement on the clearing and settlements methods and approaches. Q: What are the capital incentives to move OTC derivatives exposures to central counterparties? MARK CONNOLLEY: Most directly, these incentives relate to reduced capital usage. Clearing with central counterparties, by definition, leads to better netting of positions and hence smaller balance sheets. Coupled with a reduced risk weighting for trades facing CCPs implies a double win for the banks. That said, in the short term we may see an adverse impact on liquidity and funding costs as participants exit bilateral collateral arrangements and begin posting margin to the CCPs. Q: Do you anticipate an increased focus on counterparty risk management and collateral management? PARKSON CHEONG & MONDHER BELLALAH: Yes because of the volume that can be enhanced if there is a unified approach to clearing and settlements. BERT BRUGGINK: Yes, in particular because the use of collateral in transactions has increased in the past years and also because of the increased attention from regulators.

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MARK CONNOLLEY: This is an area we know is receiving immediate attention. Basel III specifies two new measures in regards to counterparty risk management – the counterparty credit (default) risk regulatory capital (CCR) and the credit value adjustment (CVA) for MTM [mark-to-market] counterparty risk losses. In terms of collateral being a key counterparty risk mitigant, we feel the focus of market participants will be further sharpened by the specification of qualitative collateral management requirements in the current Basel regime. Q: There is an explicit inclusion of “wrong way risk” and “CVA risk”: can you kindly elucidate what this means? MARK CONNOLLEY: “Wrong way risk” relates to the positive correlation between the future exposure to a specific counterparty with the counterparty’s probability of default. For instance, accepting bonds issued by a counterparty as collateral for an outstanding, say, interest rate swap with that counterparty is an example of “wrong-way-risk”. In this instance the exposure on account of issuer risk and that on account of counterparty risk are perfectly correlated (as it is essentially the same entity) and magnify the overall exposure on account of the trade. CVA is meant to capture the risk of MTM losses on expected counterparty risk to OTC derivatives and as an addition to the counterparty credit-default risk calculation. Q: What will it mean for those financial institutions with significant derivatives operations? MARK CONNOLLEY: Across the board, and particularly for institutions with significant derivatives operations, we will see a renewed focus on systems and controls. Specifically we foresee investments in risk target operating models, the ICAAP process and developing adequate controls relating to systems, processes and reporting. Q: Do you expect a renewed focus by many banks on building retail business? BERT BRUGGINK: In particular the search for stable funding as a result of the liquidity requirements of Basel III will indeed make many banks focus more on building retail business. In addition, trading activities do require more capital than before, which will make some banks rescale these capital consuming activities. DR STEFAN SCHMITTMANN: Current Basel rules are tough on retail business, and Basel III does nothing to change that. In order to subsidise the historical relative “capital shortfall” for market risks (made dramatically evident by the financial crisis), the Basel framework has been calibrated to overcapitalise lending businesses. Empirical research by academics and even regulators suggests that asset correlations, the parameters used by supervisors to fine-tune the cost of credit risk in advanced Basel II banks, are 30%–50% too high for most lending. Worst hit in this regard is bread-and-butter lending to private customers and to small and medium-sized corporations. As long as this remains unaddressed, it is a big challenge for banks defending the retail business they have and growing selectively in retail. Q: Do you anticipate any changes in the banking business mix; reducing traditional book exposures, for instance?

Dr Stefan Schmittmann, chief risk officer, Commerzbank. Photograph kindly supplied by Commerzbank, January 2011.

DR STEFAN SCHMITTMANN: Even under Basel III, banking books—the buy-and-hold base of any non Investment Bank—will continue to face tough conditions. It is not yet clear that the historical incentives to book risks in the trading book rather than the banking book have been fully addressed by the new regulation. Even under the proposed rules, open questions remain. Will a plain vanilla loan to a large cap in the banking book require the same amount of regulatory capital as a bond from the same large cap held in the trading book? It appears that it will not; held in the trading book, it will usually require less. Does this make sense? As long as this sort of regulatory arbitrage is possible, risks will move to businesses, books and banks where the required capital charge is lowest. Aligning risk with capital held: that should be our top priority. Q: Do you think that the way that banks approach the balance sheet will change and that long run risk and capital costs will become more prominent considerations? PARKSON CHEONG & MONDHER BELLALAH: Yes, it would because of the costs of the capital and the trade-off between risk and return in the business. Q: Do you expect your institution to make substantive changes to pricing strategy? PARKSON CHEONG & MONDHER BELLALAH: Yes, subject to regulators and banking supervision directives. Q: Do you expect your institution to pass on some costs to end customers to compensate for increased capital and/or funding overheads? BERT BRUGGINK: In general, the increased capital and liquidity requirements will force banks to evaluate their business models, and adjust them for those activities that have to deal with substantially increase capital or (stable) funding needs. As long as the availability of capital and/or stable funding is sufficient, it will be a matter of price, as the increased costs will have to be earned back. This will result in increased pricing for customers, who will take the consequences as long as it will be industry-wide and not too bank specific. In a number of cases the required amount of additional capital and/or stable funding will simply not be available, or not at economically acceptable pricing levels. As also government and central bank support with respect to capital and liquidity will be reduced in the coming years, it will be unavoidable that certain banks will have to restructure their balance sheets and activities. CHNG SOK HUI: Basel III will not impact all banks uniformly. The effect is going to vary depending on market landscape, regulatory culture and philosophy, sophistication of the banking sector and the role of banks in the respective economies, political willpower in implementing changes etc. Suffice to say that all constituents will have to reflect and interact to find the appropriate equilibrium.I

FEBRUARY 2011 • FTSE GLOBAL MARKETS

(Week ending 14 January 2011) Reference Entity

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

DC Region

Federative Republic of Brazil

Government

Sov

15,569,043,567

163,559,167,996

11,528

Americas

United Mexican States

Government

Sov

7,691,049,550

112,501,077,804

9,076

Americas

Bank of America Corporatio

Financials

Corp

5,951,686,990

81,411,210,700

8,940

Americas

JPMorgan Chase & Co.

Financials

Corp

5,127,148,089

81,021,724,496

8,648

Americas

Republic of Turkey

Government

Sov

6,633,466,967

137,958,422,547

8,29

Europe

Republic of Italy

Government

26,458,329,207

275,211,347,063

8,119

Europe

General Electric Capital Corporation Telecom Italia SPA Daimler AG Deutsche Telekom AG

Financials

Corp

12,258,427,738

96,556,498,204

7,690

Americas

Telecommunications

Corp

2,589,128,208

69,125,455,027

7,582

Europe

Consumer Goods

Corp

3,040,687,411

62,343,171,802

7,334

Europe

Telecommunications

Corp

3,139,683,614

64,848,718,133

7,089

Europe

DC Region

Top 10 net notional amounts (Week ending 14 January 2011) Reference Entity

Sector

Market Type

Net Notional (USD EQ)

Gross Notional (USD EQ)

Contracts

Republic of Italy

Government

Sov

26,458,329,207

275,211,347,063

8,119

Europe

French Republic

Government

Sov

18,769,030,746

83,367,805,471

4,371

Europe

Kingdom of Spain

Government

Sov

16,354,448,007

134,510,157,521

6,063

Europe

Federal Republic of Germany

Government

Sov

15,672,845,018

81,729,095,825

2,514

Europe

Federative Republic of Brazil

Government

Sov

15,569,043,567

163,559,167,996

11,528

Americas

Financials

Corp

12,258,427,738

96,556,498,204

7,690

Americas

General Electric Capital Corporation UK and Northern Ireland

Government

Sov

12,006,901,993

61,080,970,230

4,351

Europe

Portuguese Republic

Government

Sov

7,971,219,457

69,458,870,864

3,556

Europe

United Mexican States

Government

Sov

7,691,049,550

112,501,077,804

9,076

Americas

Republic of Austria

Government

Sov

7,170,182,895

49,144,593,235

2,143

Europe

Ranking of industry segments by gross notional amounts

Top 10 weekly transaction activity by gross notional amounts

(Week ending 14 January 2011)

Single-Name References Entity Type

Corporate: Financials

Gross Notional (USD EQ)

3,215,886,866,592

Contracts

References Entity

423,873

Republic of Italy

7,290,182,300

278

French Republic

3,663,176,500

293

Sovereign / State Bodies

2,483,880,061,794

185,055

Corporate: Consumer Services

2,097,566,415,478

346,867

Corporate: Consumer Goods

1,592,484,580,745

254,996

Corporate: Technology / Telecom

1,306,838,974,192

202,723

Corporate: Industrials

Gross Notional (USD EQ)

Contracts

Kingdom of Spain

3,213,895,500

232

Republic of Turkey

2,961,897,000

161

Federative Republic of Brazil

2,718,352,000

137

Republic of Austria

2,490,620,031

133

1,220,200,648,785

211,079

Hellenic Republic

2,073,827,000

167

Corporate: Basic Materials

964,481,792,476

155,606

Portuguese Republic

1,980,099,000

167

Corporate: Utilities

748,599,570,766

118,523

Kingdom of Belgium

1,540,576,200

129

Corporate: Oil & Gas

453,133,957,387

84,359

Japan

1,507,350,000

156

Corporate: Health Care

322,360,519,945

57,378

Corporate: Other

145,344,218,501

15,042

Residential Mortgage Backed Securities

73,041,468,886

14,675

CDS on Loans

70,804,640,759

18,578

Commercial Mortgage Backed Securities 20,767,883,914

1,928

Other

4,931,054,825

FTSE GLOBAL MARKETS • FEBRUARY 2011

567

DTCC CREDIT DEFAULT SWAPS ANALYSIS

Top 10 number of contracts

All data © 2011 The Depository Trust & Clearing Corporation This data is being provided as is and can only be used by you pursuant to the terms posted on the DTCC website at dtcc.com/products/derivserv/data_table_i.php

The Fidessa Fragmentation Index (FFI) was launched to provide a simple, unbiased measure of how different stocks are fragmenting across primary markets and alternative lit trading venues. In short, it shows the average number of lit venues you should visit in order to achieve best execution when completing an order. So an index of 1 means that the stock is still traded at one venue. Increases in the FFI indicate a fragmentation of trading across multiple venues and as such any firm wishing to effectively trade that security must be able to execute across more venues. Once a stock’s FFI exceeds 2 liquidity in that stock has fragmented to the extent that it no longer “belongs” to its originating venue. The Fidessa Fragulator® allows you to query several billion trade records to get a complete picture of how trading in a given stock is broken down across lit venues, dark pools, systematic internalisers and bilateral OTC trades.

FFI and venue market share by index Week ending 7th of January, 2011 VENUES

INDICES

FTSE 100

CAC 40

DAX

OMX S30

SMI

FFI

2.47

1.86

1.99

2.01

11.83%

1.97 5.45% 5.47%

6.09% 0.02%

6.40%

9.94%

26.46%

21.80%

7.19% 15.34%

19.45%

0.40%

0.84%

Europe

Amsterdam BATS Europe Berlin Burgundy Chi-X Europe Deutsche Börse Dusseldorf Equiduct Frankfurt Hamburg Hanover London Madrid Milan Munich NYSE Arca Europe Paris SIX Swiss Stockholm Turquoise Xetra

19.02% 70.55% 0.08% 0.27% 0.87% 0.10% 0.01%

56.28%

0.15%

0.08% 0.08%

0.13%

2.82%

68.56% 2.38%

62.09% 67.18% 4.88%

VENUES

4.34% 0.02%

3.43%

VENUES

INDICES

S&P 500

INDICES

S&P TSX Composite

FFI

5.13

4.55

FFI

2.04

2.06

BATS

12.55%

11.97%

Alpha ATS

18.77%

19.27%

BYXX

3.00%

2.82%

CBOE

0.10%

0.23%

CHXE

0.51%

0.49%

EDGA

7.70%

8.41%

S&P TSX 60

Chi-X Canada

9.21%

9.68%

Liquidnet Canada

0.70%

0.42%

Omega ATS

2.29%

3.00%

Pure Trading

3.21%

3.09%

EDGX

7.99%

7.31%

NSDQ

22.57%

21.30%

Toronto

63.36%

62.08%

NQBX

3.04%

3.08%

TriAct MATCH Now

2.46%

NQPX

2.09%

1.68% VENUES

CINN

1.04%

0.80%

NYSE

22.73%

25.21%

INDICES FFI

AMEX

0.11%

0.23%

ARCX

16.58%

16.48%

VENUES

INDICES

S&P ASX 200

HANG SENG

FFI

1.00

Asia

Canada*

DOW JONES

INDICES

Australia Hong Kong

100% 100%

Japan

GLOBAL TRADING STATISTICS

Fidessa Fragmentation Index (FFI) and Fragulator®

INDEX NIKKEI 225

Chi-X Japan JASDAQ Kabu.com Nagoya Osaka SBI Japannext Tokyo ToSTNet-1

1.25 0.69% 0.00% 0.06% 0.00% 0.00% 0.85% 89.06% 9.34%

Figures are compiled from lit order book trades only. Totals only include stocks contained within the major indices. *This index is also traded on US venues. For more detailed information, visit http://fragmentation.fidessa.com/fragulator/.

FEBRUARY 2011 • FTSE GLOBAL MARKETS

COMMENTARY By Steve Grob, Director of Group Strategy, Fidessa

ITH BATS AND Chi-X in exclusive negotiations that could see BATS acquire Chi-X, this month's report looks at the potential impact on the European trading landscape of a tie-up between these rival trading venues.

2. European lit turnover breakdown (year 2010) 10.58% Deutsche Börse Group*

As the chart below shows (Chart 1), BATS Europe and Chi-X combined were responsible for matching more than 35% of trades in the FTSE 100 last year (excluding non-lit trading such as OTC, Dark Pools and SI). This represents a sizeable pool of liquidity in the continuing battle with the London Stock Exchange. 1. European lit turnover breakdown, FTSE 100 (year 2010) 9.47% BATS Europe 4.67% Turquoise

26.29% Chi-X

0.61% NYSE Arca

0.07% Equiduct

0.69% Nasdaq Europe

58.20% LSE

Over the same period the two venues combined accounted for more than 25% share in both the CAC 40 and the DAX, thereby representing a considerable threat to the primary exchanges in those respective markets too.

0 the complete European picture, it's pretty clear just Looking at how powerful a combined entity would be (Chart 2). With this proportion of market share and a comparatively low cost base,

7.07% Madrid 5.99% SIX Swiss

8.50% Nasdaq OMX*

25.67% LSE Group*

24.04% BATS Europe and Chi-X

17.85% NYSE Euronext*

* LSE Group: LSE, Milan, Turquoise NYSE Euronext: Amsterdam, Brussels, Paris, Lisbon, NYSE Arca Nasdaq OMX: Copenhagen, Helsinki, Oslo, Stockholm, Nasdaq Europe Deutsche Börse Group: Deutsche Börse, Frankfurt, Xetra International

they would surely be expected to move fairly quickly into profitability and sustainability. The chart below (Chart 3) also helps highlight the way in which trading in European equity markets has changed since the introduction of MiFID. Today, we see trading conducted very much along pan-European lines rather than national boundaries. Faced with this, the primary exchanges continue to seek ways in which to differentiate their offerings, doubtless realising that they cannot all continue to trade what is effectively the same pan-European ‘product’ in the longer term. The smaller MTFs such as Equiduct, Quote MTF and TOM will also need to find successful niches in order to compete with the primary markets. If the BATS/Chi-X deal goes ahead then the battle for Europe will have entered a new and intriguing phase. I

3. European lit turnover share LSE Group*

NYSE Euronext*

Deutsche Börse Group*

BATS Europe and Chi-X

35% 30% 25% 20% 15% 10% 5% 0% 05 Dec 2008

05 Feb 2009

05 Apr 2009

05 Jun 2009

05 Aug 2009

05 Oct 2009

05 Dec 2009

05 Feb 2010

05 Apr 2010

05 Jun 2010

05 Aug 2010

05 Oct 2010

05 Dec 2010

* LSE Group: LSE, Milan, Turquoise; NYSE Euronext: Amsterdam, Brussels, Paris, Lisbon, NYSE Arca; Deutsche Börse Group: Deutsche Börse, Frankfurt, Xetra International

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

FTSE GLOBAL MARKETS • FEBRUARY 2011

GLOBAL ETF SUMMARY

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

No. of ETFs 389 315 84 70 161 221 138 112 45 61 41 53 13 9 29 17 35 18 6 31 36 16 10 15 11 3 520 2,459

YE-2010 Total Listings AUM (US$ Bn) 1,329 $337.8 566 $301.1 211 $111.2 101 $80.5 385 $54.9 780 $48.7 258 $47.6 312 $45.1 171 $32.0 101 $31.7 84 $16.6 64 $16.6 34 $15.3 16 $14.7 111 $9.5 30 $9.0 42 $8.5 21 $7.7 7 $5.8 33 $3.6 39 $2.8 17 $2.6 10 $1.9 33 $1.7 12 $0.8 3 $0.3 784 $103.4 5,554 $1,311.3

% Total 25.8% 23.0% 8.5% 6.1% 4.2% 3.7% 3.6% 3.4% 2.4% 2.4% 1.3% 1.3% 1.2% 1.1% 0.7% 0.7% 0.6% 0.6% 0.4% 0.3% 0.2% 0.2% 0.1% 0.1% 0.1% 0.0% 7.9% 100.0%

No. of ETFs 124 82 14 9 36 17 2 42 15 18 6 0 4 1 7 4 -10 6 -1 20 -6 5 0 2 -3 -2 124 516

Total Listings 575 190 52 1 102 154 38 154 80 38 37 0 11 5 60 7 -3 6 -1 22 -13 5 0 2 -3 -2 212 1,729

YTD Change AUM (US$ Bn) $94.1 $51.9 $23.7 $14.5 $12.2 -$2.3 $6.6 $6.9 $8.6 $5.2 $2.1 $4.1 $3.5 $2.2 -$1.5 $1.6 $2.7 $2.3 $3.0 $1.1 $0.3 $0.3 $0.2 $0.5 $0.2 $0.0 $31.1 $275.3

% AUM 38.6% 20.8% 27.1% 22.0% 28.6% -4.4% 16.2% 18.1% 36.5% 19.7% 14.8% 33.4% 29.7% 17.4% -14.0% 21.9% 46.2% 42.7% 108.5% 46.0% 10.0% 13.0% 14.5% 43.0% 40.0% 5.7% 43.0% 26.6%

% TOTAL 2.2% -1.1% 0.0% -0.2% 0.1% -1.2% -0.3% -0.2% 0.2% -0.1% -0.1% 0.1% 0.0% -0.1% -0.3% 0.0% 0.1% 0.1% 0.2% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.9%

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

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

Average Daily Turnover (US$ Mil) YE-2010 % Mkt Share Change (US$ Mil)

Dec-09

% Mkt Share

SSgA

$19,861.8

39.2%

$18,667.3

40.3%

4.0% Change (%)

-$1,194.5

Direxion Shares

14.5% Others

-6.0%

iShares

$14,572.0

28.7%

$14,028.5

30.3%

-$543.5

-3.7%

5.2%

ProShares

$3,891.8

7.7%

$2,660.7

5.7%

-$1,231.1

-31.6%

PowerShares

$3,219.9

6.4%

$2,413.3

5.2%

-$806.6

-25.0%

PowerShares

Direxion Shares

$3,446.7

6.8%

$1,860.7

4.0%

-$1,586.0

-46.0%

Others

$5,712.8

11.3%

$6,710.2

14.5%

$997.4

17.5%

Total

$50,705.0

100.0%

$46,340.7

100.0%

-$4,364.2

-8.6%

5.7% ProShares

40.3% SSgA

30.3% iShares

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

Top 20 ETFs worldwide with the largest change in AUM As at year end 2010 ETF Vanguard Emerging Markets iShares MSCI Emerging Markets Index Fund Vanguard Total Stock Market ETF iShares Russell 2000 Index Fund SPDR S&P 500 SPDR S&P® Dividend ETF iShares S&P 500 Index Fund S&P 400 MidCap SPDR iShares MSCI Emerging Markets PowerShares QQQ Trust iShares S&P U.S. Preferred Stock Index Fund SPDR Barclays Capital High Yield Bond ETF iShares iBoxx $ High Yield Corporate Bond Fund Vanguard Total Bond Market ETF iShares S&P MidCap 400 Index Fund Energy Select Sector SPDR Fund Vanguard REIT ETF Vanguard Dividend Appreciation ETF ZKB Gold ETF (CHF) db x-trackers MSCI Emerging Market TRN Index ETF

Country listed US US US US US US US US United Kingdom US US US US US US US US US Switzerland Germany

Bloomberg Ticker VWO US EEM US VTI US IWM US SPY US SDY US IVV US MDY US IEEM LN QQQQ US PFF US JNK US HYG US BND US IJH US XLE US VNQ US VIG US ZGLD SW XMEM GY

AUM (US$ Mil) December 2010 $44,569.8 $47,551.5 $18,236.0 $17,498.4 $89,915.3 $5,037.1 $25,799.2 $12,211.0 $6,821.7 $22,069.9 $6,120.7 $6,358.5 $7,376.7 $9,054.5 $9,332.0 $8,396.4 $7,503.7 $4,608.9 $7,810.8 $6,263.3

AUM (US$ Mil) December 2009 $19,398.7 $39,178.3 $13,570.1 $13,115.1 $85,676.3 $1,252.4 $22,024.8 $8,485.1 $3,234.9 $18,735.8 $3,122.6 $3,444.5 $4,569.2 $6,268.4 $6,598.8 $5,665.1 $4,774.6 $1,893.2 $5,125.8 $3,606.8

Change (US$ Mil) $25,171.1 $8,373.2 $4,665.9 $4,383.3 $4,238.9 $3,784.7 $3,774.3 $3,725.9 $3,586.8 $3,334.1 $2,998.1 $2,914.1 $2,807.5 $2,786.1 $2,733.2 $2,731.3 $2,729.0 $2,715.7 $2,685.0 $2,656.4

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

FEBRUARY 2011 • FTSE GLOBAL MARKETS

Global ETF listings As at year end 2010 ASSETS UNDER MANAGEMENT (US$ Bn)

CHANGE IN ASSETS

No. of No. of Exchanges Providers (Official)

No. Primary Listings

New in 2009

New in 2010

Total Listings

2009

YE-2010

US$ Bn

US Europe Austria Belgium Finland France Germany Greece Hungary Ireland Italy Netherlands Norway Poland Portugal Russia Slovenia Spain Sweden Switzerland Turkey United Kingdom Canada Japan Hong Kong China Mexico South Korea Australia Singapore Taiwan South Africa Brazil New Zealand Malaysia India Thailand Saudi Arabia UAE Indonesia Chile Israel Egypt Sri Lanka Philippines

896 1,071 1 1 1 257 387 3 1 14 23 12 6 1 3 1 1 10 25 108 12 204 157 80 40 15 19 62 19 21 12 26 7 6 4 16 4 2 1 1 -

121 215 55 80 1 7 1 7 20 2 42 32 7 11 5 7 17 1 2 1 6 1 1 -

173 268 55 59 1 12 2 1 3 1 13 58 3 60 51 12 18 8 6 15 15 12 3 3 1 4 1 2 1 -

896 3,699 21 23 1 433 1,179 3 1 14 492 101 6 1 3 1 1 66 65 604 12 672 185 83 69 15 298 62 40 74 15 26 7 6 5 16 4 2 1 1 50 -

$705.5 $226.9 $0.1 $0.1 $0.3 $53.5 $96.2 $0.1 $0.0 $0.2 $1.9 $0.2 $0.8 $0.0 $0.8 $0.0 $0.0 $2.4 $2.1 $21.7 $0.2 $47.1 $28.5 $24.6 $20.7 $6.3 $8.1 $3.2 $2.4 $2.6 $2.7 $1.8 $1.7 $0.5 $0.3 $0.2 $0.1 $0.0 $0.0 $0.0 -

$891.0 $284.0 $0.1 $0.1 $0.3 $59.9 $110.7 $0.1 $0.0 $0.4 $2.5 $0.3 $0.7 $0.1 $0.0 $0.0 $0.0 $1.2 $2.8 $38.0 $0.2 $66.7 $38.4 $32.2 $26.3 $10.1 $8.2 $5.3 $3.9 $3.6 $2.8 $2.3 $1.9 $0.4 $0.4 $0.4 $0.1 $0.0 $0.0 $0.0 -

$185.6 $57.1 $0.0 $0.0 $0.0 $6.4 $14.5 $0.0 $0.0 $0.2 $0.6 $0.1 -$0.1 $0.1 -$0.8 $0.0 $0.0 -$1.2 $0.7 $16.3 $0.0 $19.6 $9.9 $7.6 $5.5 $3.8 $0.1 $2.2 $1.5 $1.0 $0.1 $0.5 $0.2 -$0.1 $0.1 $0.2 $0.0 $0.0 $0.0 $0.0 -

26.3% 25.2% 34.6% -24.7% 7.8% 11.9% 15.1% -31.8% -12.3% 77.0% 32.9% 36.8% -12.9% 100.0% -96.4% 100.0% -32.9% -49.2% 31.2% 75.1% -4.7% 41.6% 34.6% 30.7% 26.7% 60.6% 0.9% 69.2% 64.1% 40.3% 4.3% 30.3% 11.4% -16.0% 16.6% 70.2% 11.7% 100.0% 100.0% -19.9% -

28 39 1 1 1 9 10 2 1 2 4 4 2 1 2 1 1 2 2 7 5 9 4 7 9 12 3 12 6 8 2 8 2 2 3 7 3 1 1 1

2 22 1 1 1 1 2 1 1 1 1 1 1 1 1 1 1 2 1 1 1 1 1 2 1 2 1 1 1 1 1 1 1 1 1 2 1 1 1 1 1 -

883 119*

ETF total

2,459

427

593

5,554

$1,036.1

$1,311.3

$275.3

26.6%

136

1,097

Location

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

Planned New

8 0 2 20 1 8 3 1 5 15 0 0 3 16 0 1 4 0 0 5 1 1 1

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

Regulatory Information BlackRock Advisors (UK) Limited (‘BlackRock’), which is authorised and regulated by the Financial Services Authority in the United Kingdom, has issued this document for access by professional clients and for information purposes only. This document or any portion hereof may not be reprinted, sold or redistributed without authorisation from BlackRock. This communication is being made available to persons who are investment professionals as that term is defined in Article 19 of the Financial Services and Markets Act 2000 (Financial Promotion Order) 2005 or its equivalent under any other applicable law or regulation in the relevant jurisdiction. It is directed at persons who have professional experience in matters relating to investments. This document is an independent market commentary document based on publicly available information and is produced by the ETF Research & Implementation Strategy team. Specifically, this is not marketing nor is it an offer to buy or sell any security or to participate in any trading strategy. Affiliated companies of BlackRock may make markets in the securities of ETFs and provide ETFs in the form of iShares. Further, BlackRock and/or its affiliated companies and/or their employees may from time to time hold shares or holdings in the underlying shares of, or options on, any security of ETFs and may as principal or agent buy securities in ETFs. The opinions expressed are those of BlackRock as of September 2010, and are subject to change at any time due to changes in market or economic conditions. They should not be construed as a recommendation, investment advice, offer or solicitation to buy or sell any securities or to adopt any investment strategy. In particular, BlackRock has not performed any due diligence on products which are not managed by BlackRock and accordingly does not make any remark on their suitability. Prospective investors should take their own independent advice prior to making an investment decision. This document does not provide investment advice and the information contained within should not be relied upon in assessing whether or not to invest in the products mentioned. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities discussed in this commentary may not be suitable for all investors. BlackRock recommends that investors independently evaluate each issuer, security or instrument discussed in this publication and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives The value of and income from any investment may go up or down and an investor may not get back the amount invested. The value of the investment involving exposure to foreign currencies can be affected by exchange rate movements. We also remind you that the levels and bases of, and reliefs from, taxation can change and is dependent upon individual circumstances. Although BlackRock endeavours to update and ensure the accuracy of the content of this document BlackRock does not warrant or guarantee its accuracy or correctness. Despite the exercise of all due care, some information in this document may have changed since publication. Investors should obtain and read the ETF prospectuses from the ETF Providers and confirm any relevant information with ETF Providers before investing. Neither BlackRock, nor any affiliate, nor any of their respective, officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. The trademarks and service marks contained herein are the property of their respective owners. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. © 2010 BlackRock Advisors (UK) Limited. Registered Company No 00796793. All rights reserved. Calls may be monitored or recorded.

FTSE GLOBAL MARKETS • FEBRUARY 2011

5-Year Performance Graph (USD Total Return) Index Level Rebased (30 December 2005=100)

250

FTSE All-World Index 200

FTSE Emerging Index FTSE Global Government Bond Index

150

FTSE EPRA/NAREIT Developed Index

100

FTSE4Good Global Index

FTSE GWA Developed Index 0

De c-0 5 M ar -0 Ju 6 ne -0 6 Se p06 De c-0 6 M ar -0 Ju 7 ne -0 7 Se p07 De c-0 7 M ar -0 Ju 8 ne -0 8 Se p08 De c-0 8 M ar -0 Ju 9 ne -0 9 Se p09 De c-0 9 M ar -1 Ju 0 ne -1 0 Se p10 De c-1 0

MARKET DATA BY FTSE RESEARCH

Global Market Indices

FTSE RAFI Emerging Index

Table of Total Returns Index Name

Currency

No. of Constituents

Index Value

3 M (%)

6 M (%)

12 M (%)

Yield (%pa)

2,835

275.73

8.7

24.5

13.2

2.32

FTSE All-World Indices FTSE All-World Index

USD

FTSE World Index

USD

2,356

643.10

9.0

24.8

12.7

2.34

FTSE Developed Index

USD

2,052

254.23

8.9

24.2

12.3

2.31

FTSE Emerging Index

USD

783

762.69

7.4

26.8

19.8

2.33

FTSE Advanced Emerging Index

USD

304

724.27

10.9

34.3

19.4

2.73

FTSE Secondary Emerging Index

USD

479

878.69

4.2

20.3

20.2

1.95

USD

7,301

447.86

9.2

25.4

14.8

2.23

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

USD

5,781

416.88

9.5

25.2

14.1

2.21

FTSE Emerging All Cap Index

USD

1,520

1017.83

7.4

27.2

20.4

2.31

FTSE Advanced Emerging All Cap Index

USD

639

980.62

11.0

34.5

19.5

2.71

FTSE Secondary Emerging All Cap Index

USD

881

1130.03

4.1

20.9

21.1

1.92

USD

762

193.63

-1.7

5.9

5.7

2.65

FTSE EPRA/NAREIT Developed Index

USD

282

2905.70

6.2

25.7

20.4

3.66

FTSE EPRA/NAREIT Developed REITs Index

USD

191

995.08

6.5

24.8

22.8

4.46

Fixed Income FTSE Global Government Bond Index Real Estate

FTSE EPRA/NAREIT Developed Dividend+ Index

USD

227

2124.17

5.6

25.4

22.7

4.26

FTSE EPRA/NAREIT Developed Rental Index

USD

232

1140.21

6.9

26.2

24.5

4.17

FTSE EPRA/NAREIT Developed Non-Rental Index

USD

1194.88

4.1

24.3

10.1

2.16

FTSE4Good Global Index

USD

656

6713.00

7.3

22.8

7.9

2.69

FTSE4Good Global 100 Index

USD

103

5508.81

6.3

21.4

3.8

2.88

FTSE GWA Developed Index

USD

2,052

3894.36

8.2

23.6

10.7

2.58

FTSE RAFI Developed ex US 1000 Index

USD

1,010

6644.75

6.3

25.3

7.5

2.95

FTSE RAFI Emerging Index

USD

357

8073.54

8.0

24.9

18.3

2.59

SRI

Investment Strategy

Source: FTSE Group and Thomson Datastream, data as at 31 December 2010

FEBRUARY 2011 â&#x20AC;˘ FTSE GLOBAL MARKETS

Americas Market Indices 175

FTSE Americas Index

150

FTSE Americas Government Bond Index

125

FTSE EPRA/NAREIT North America Index

100

FTSE EPRA/NAREIT US Dividend+ Index

FTSE4Good USIndex FTSE GWA US Index

FTSE RAFI US 1000 Index 25

FTSE Renaissance IPO Composite Index

De c-0 5 M ar -0 Ju 6 ne -0 6 Se p06 De c-0 6 M ar -0 Ju 7 ne -0 7 Se p07 De c-0 7 M ar -0 Ju 8 ne -0 8 Se p08 De c-0 8 M ar -0 Ju 9 ne -0 9 Se p09 De c-0 9 M ar -1 Ju 0 ne -1 0 Se p10 De c-1 0

Index Level Rebased (30 December 2005=100)

5-Year Performance Graph (USD Total Return)

Table of Total Returns Index Name

Currency

No. of Constituents

Index Value

3 M (%)

6 M (%)

12 M (%)

Yield (%pa)

FTSE All-World Indices FTSE Americas Index

USD

833

854.38

10.6

23.8

15.2

1.90

FTSE North America Index

USD

699

929.07

10.9

23.6

15.4

1.85

FTSE Latin America Index

USD

134

1367.45

6.8

29.1

15.9

2.59

FTSE Global Equity Indices FTSE Americas All Cap Index

USD

2,503

399.72

11.3

25.2

17.6

1.80

FTSE North America All Cap Index

USD

2,320

380.24

11.6

24.9

17.6

1.75

FTSE Latin America All Cap Index

USD

183

1947.87

7.1

29.7

16.7

2.53

Fixed Income FTSE Americas Government Bond Index

USD

203

197.71

-2.1

0.5

6.5

2.78

FTSE USA Government Bond Index

USD

189

193.25

-2.2

0.4

6.4

2.76

FTSE EPRA/NAREIT North America Index

USD

126

3564.08

7.3

22.4

28.6

3.70

FTSE EPRA/NAREIT US Dividend+ Index

USD

1921.33

6.5

20.8

27.4

4.00

FTSE EPRA/NAREIT North America Rental Index

USD

122

1211.16

7.0

22.0

29.2

3.72

FTSE EPRA/NAREIT North America Non-Rental Index

USD

387.32

21.6

39.9

10.7

3.13

FTSE NAREIT Composite Index

USD

143

3431.62

7.7

21.0

27.6

4.31

FTSE NAREIT Equity REITs Index

USD

119

8347.58

7.4

21.2

27.9

3.54

FTSE4Good US Index

USD

132

5513.47

10.3

21.3

11.7

1.75

FTSE4Good US 100 Index

USD

102

5246.35

10.1

21.1

11.4

1.77

FTSE GWA US Index

USD

627

3476.17

11.1

22.8

15.0

1.88

FTSE RAFI US 1000 Index

USD

990

6397.90

11.9

24.4

20.0

2.00

FTSE RAFI US Mid Small 1500 Index

USD

1,434

6648.01

17.1

30.2

29.4

1.10

USD

203

283.66

15.5

26.9

21.9

0.76

Real Estate

SRI

Investment Strategy

IPO Indices FTSE Renaissance IPO Composite Index

Source: FTSE Group and Thomson Datastream, data as at 31 December 2010

FTSE GLOBAL MARKETS â&#x20AC;˘ FEBRUARY 2011

5-Year Total Return Performance Graph 250

FTSE Europe Index (EUR)

Index Level Rebased (30 December 2005=100) De c-0 5 M ar -0 Ju 6 ne -0 6 Se p06 De c-0 6 M ar -0 Ju 7 ne -0 7 Se p07 De c-0 7 M ar -0 Ju 8 ne -0 8 Se p08 De c-0 8 M ar -0 Ju 9 ne -0 9 Se p09 De c-0 9 M ar -1 Ju 0 ne -1 0 Se p10 De c-1 0

MARKET DATA BY FTSE RESEARCH

Europe, Middle East & Africa Indices

FTSE All-Share Index (GBP)

200

FTSEurofirst 80 Index (EUR)

150

FTSE/JSE Top 40 Index (SAR)

100

FTSE Actuaries UK Conventional Gilts All Stocks Index (GBP) FTSE EPRA/NAREIT Developed Europe Index (EUR)

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

FTSE RAFI Europe Index (EUR)

Table of Total Returns Index Name

Currency

No. of Constituents

Index Value

3 M (%)

6 M (%)

12 M (%)

Yield (%pa)

FTSE All-World Indices FTSE Europe Index

EUR

566

256.84

6.7

14.4

12.2

3.09

FTSE Eurobloc Index

EUR

278

130.81

4.0

12.2

3.2

3.51

FTSE Developed Europe ex UK Index

EUR

376

253.50

5.8

13.4

9.6

3.22

FTSE Developed Europe Index

EUR

490

252.12

6.5

14.2

11.6

3.16

2.97

FTSE Global Equity Indices FTSE Europe All Cap Index

EUR

1,504

406.21

7.3

15.4

14.0

FTSE Eurobloc All Cap Index

EUR

744

391.77

4.7

13.1

4.7

3.36

FTSE Developed Europe All Cap ex UK Index

EUR

1,020

428.27

6.6

14.6

11.3

3.08

FTSE Developed Europe All Cap Index

EUR

1,361

401.39

7.2

15.2

13.5

3.04

Region Specific FTSE All-Share Index

GBP

627

4111.90

7.4

22.0

14.5

2.89

FTSE 100 Index

GBP

102

3854.46

6.9

21.6

12.6

3.00

FTSEurofirst 80 Index

EUR

4857.80

2.8

10.8

0.6

3.83

FTSEurofirst 100 Index

EUR

100

4572.53

5.0

12.9

5.8

3.56

FTSEurofirst 300 Index

EUR

313

1641.08

6.2

13.9

11.0

3.20

FTSE/JSE Top 40 Index

SAR

3310.90

9.9

24.6

17.2

2.02

FTSE/JSE All-Share Index

SAR

164

3701.33

9.5

24.0

19.0

2.20

FTSE Russia IOB Index

USD

1058.49

15.6

30.2

14.0

1.43

3.90

Fixed Income FTSE Eurozone Government Bond Index

EUR

247

172.48

-3.4

-1.1

1.6

FTSE Pfandbrief Index

EUR

406

208.75

-2.4

-0.7

1.4

4.22

FTSE Actuaries UK Conventional Gilts All Stocks Index

GBP

2452.37

-2.1

1.4

7.2

3.70*

Real Estate FTSE EPRA/NAREIT Developed Europe Index

EUR

2145.56

4.8

20.6

16.8

4.16

FTSE EPRA/NAREIT Developed Europe REITs Index

EUR

761.82

3.8

19.3

12.7

4.83

FTSE EPRA/NAREIT Developed Europe ex UK Dividend+ Index

EUR

2751.41

2.7

23.6

22.8

4.66

FTSE EPRA/NAREIT Developed Europe Rental Index

EUR

845.28

5.0

21.3

17.3

4.25

FTSE EPRA/NAREIT Developed Europe Non-Rental Index EUR

536.19

1.9

5.7

5.1

1.99

SRI FTSE4Good Europe Index

EUR

273

4917.96

5.2

13.2

9.0

3.46

FTSE4Good Europe 50 Index

EUR

4075.12

3.4

11.3

4.0

3.76

FTSE GWA Developed Europe Index

EUR

490

3481.67

4.2

12.4

6.6

3.63

FTSE RAFI Europe Index

EUR

502

5535.85

5.6

14.3

9.6

3.26

Investment Strategy

*Semi-annual redemption yield.

Source: FTSE Group and Thomson Datastream, data as at 31 December 2010

FEBRUARY 2011 â&#x20AC;˘ FTSE GLOBAL MARKETS

Asia Pacific Market Indices 400

FTSE Asia Pacific Index (USD)

350

FTSE/ASEAN Index (USD)

300

FTSE China 25 Index

250

FTSE Asia Pacific Government Bond Index (USD)

200

FTSE EPRA/NAREIT Developed Asia Index (USD)

150

FTSE IDFC India Infrastructure Index (IRP)

100 50

FTSE4Good Japan Index (JPY)

De c-0 5 M ar -0 Ju 6 ne -0 6 Se p06 De c-0 6 M ar -0 Ju 7 ne -0 7 Se p07 De c-0 7 M ar -0 Ju 8 ne -0 8 Se p08 De c-0 8 M ar -0 Ju 9 ne -0 9 Se p09 De c-0 9 M ar -1 Ju 0 ne -1 0 Se p10 De c-1 0

Index Level Rebased (30 December 2005=100)

5-Year Total Return Performance Graph

FTSE GWA Japan Index (JPY) FTSE RAFI Kaigai 1000 Index (JPY)

Table of Total Returns Index Name

Currency

No. of Constituents

Index Value

3 M (%)

6 M (%)

12 M (%)

Yield (%pa)

FTSE All-World Indices FTSE Asia Pacific Index

USD

1,298

328.09

9.2

24.1

18.4

2.28

FTSE Asia Pacific ex Japan Index

USD

844

673.51

7.6

27.6

20.1

2.53

FTSE Japan Index

USD

454

76.82

8.8

8.3

0.5

1.84

FTSE Global Equity Indices FTSE Asia Pacific All Cap Index

USD

3,095

558.40

9.2

24.3

18.7

2.26

FTSE Asia Pacific All Cap ex Japan Index

USD

1,862

836.70

7.7

28.2

20.4

2.50

FTSE Japan All Cap Index

USD

1,233

243.54

8.7

8.0

0.9

1.85

Region Specific FTSE/ASEAN Index

USD

145

756.02

5.0

25.3

34.5

2.73

FTSE Bursa Malaysia 100 Index

MYR

100

11681.54

6.3

19.0

25.3

2.57

FTSE TWSE Taiwan 50 Index

TWD

8259.84

10.5

28.9

13.1

3.28

FTSE China A All-Share Index

CNY

1,156

9022.05

6.6

27.2

-3.9

0.90

FTSE China 25 Index

CNY

24975.42

1.5

8.6

3.5

2.35

USD

236

162.03

2.1

9.5

17.0

1.17

Fixed Income FTSE Asia Pacific Government Bond Index Real Estate FTSE EPRA/NAREIT Developed Asia Index

USD

2419.34

6.1

27.1

17.2

3.42

FTSE EPRA/NAREIT Developed Asia 33 Index

USD

1564.67

5.3

26.3

16.7

3.74

FTSE EPRA/NAREIT Developed Asia Dividend+ Index

USD

2606.11

6.1

27.4

20.9

4.26

FTSE EPRA/NAREIT Developed Asia Rental Index

USD

1188.96

10.4

32.2

29.6

5.41

FTSE EPRA/NAREIT Developed Asia Non-Rental Index

USD

1307.14

3.5

23.9

10.3

2.11

FTSE IDFC India Infrastructure Index

IRP

107

1002.25

-6.4

3.5

2.8

0.87

FTSE IDFC India Infrastructure 30 Index

IRP

1122.00

-6.2

3.6

2.6

0.85

JPY

178

3633.23

9.2

8.1

-0.9

2.01

FTSE SGX Shariah 100 Index

USD

100

6163.59

11.6

26.1

15.9

1.97

FTSE Bursa Malaysia Hijrah Shariah Index

MYR

12244.50

5.4

14.6

15.6

2.56

FTSE Shariah Japan 100 Index

JPY

100

1061.61

8.8

11.4

-1.0

1.74

FTSE GWA Japan Index

JPY

454

2775.92

9.3

8.6

2.9

2.00

FTSE GWA Australia Index

AUD

100

4178.22

3.5

11.8

0.5

4.61

FTSE RAFI Australia Index

AUD

6613.08

3.4

11.6

-1.6

4.38

FTSE RAFI Singapore Index

SGD

9387.91

3.6

11.0

10.3

3.16

Infrastructure

SRI FTSE4Good Japan Index Shariah

Investment Strategy

FTSE RAFI Japan Index

JPY

250

3902.40

9.2

9.5

2.6

1.83

FTSE RAFI Kaigai 1000 Index

JPY

1,021

4100.98

4.7

14.4

-3.1

2.70

FTSE RAFI China 50 Index

HKD

7608.36

4.3

14.0

7.1

2.83

FTSE Renaissance Asia Pacific ex Japan IPO Index

USD

163

1916.54

2.1

16.4

14.0

0.57

FTSE Renaissance Hong Kong/China Top IPO Index

HKD

2711.76

4.4

17.7

9.4

0.39

IPO Indices

Source: FTSE Group and Thomson Datastream, data as at 31 December 2010

FTSE GLOBAL MARKETS â&#x20AC;˘ FEBRUARY 2011

INDEX CALENDAR

Index Reviews February - April 2011 Date

Index Series

Review Frequency/Type

Effective (Close of business)

Data Cut-off

04-Feb

TOPIX

Monthly review - additions & free float adjustment

25-Feb

31-Jan

10-Feb

Hang Seng

Quarterly review

04-Mar

31-Dec

14-Feb

Russell/Nomura Indices

Quarterly IPO addtions

28-Feb

31-Dec

14-Feb

MSCI Standard Index Series

Quarterly review

28-Feb

31-Jan

22-Feb

DJ Stoxx

Quarterly review

18-Mar

31-Jan

24-Feb

Russell US & Global Indices

Monthly review - shares in issue change

28-Feb

23-Feb

Early Mar

ATX

Semi-annual review / number of shares

31-Mar

28-Feb

04-Mar

FTSE Vietnam Index Series

Quarterly review

18-Mar

25-Feb

04-Mar

AEX

Annual review

18-Mar

31-Jan

04-Mar

PSI 20

Annual review

18-Mar

31-Jan

04-Mar

BEL 20

Annual review

18-Mar

31-Jan

04-Mar

DAX

Quarterly review

18-Mar

28-Feb

04-Mar

CAC 40

Quarterly review

18-Mar

28-Feb

04-Mar

S&P / ASX Indices

Annual / Quarterly review

18-Mar

25-Feb

07-Mar

TOPIX

Monthly review - additions & free float adjustment

30-Mar

28-Feb

08-Mar

FTSE China Index Series

Quarterly review

18-Mar

21-Feb

08-Mar

FTSE MIB

Quarterly Review

18-Mar

07-Mar

09-Mar

FTSE UK

Quarterly review

18-Mar

08-Mar

09-Mar

FTSEurofirst 300

Quarterly review

18-Mar

08-Mar

09-Mar

FTSE techMARK 100

Quarterly review

18-Mar

08-Mar

09-Mar

FTSE/JSE Africa Index Series

Quarterly review

18-Mar

08-Mar

10-Mar

FTSE Asiatop / Asian Sectors

Semi-annual review

18-Mar

28-Feb

10-Mar

FTSE/ASEAN 40 Index

Annual review

18-Mar

28-Feb

10-Mar

STI and FTSE ST Index Series

Semi-annual review

18-Mar

28-Feb

n/a

FTSE Renaissance Asia Pacific IPO Index Series

Quarterly review

18-Mar

28-Feb

10-Mar

FTSE Italia Index Series

Quarterly Review

18-Mar

08-Mar

11-Mar

S&P / TSX

Quarterly review

18-Mar

28-Feb

11-Mar

Dow Jones Global Indexes

Quarterly review

18-Mar

28-Feb

11-Mar

DJ Global Titans 50

Quarterly review - no composition changes only rebalance/shares/float changes 18-Mar

28-Feb

11-Mar

S&P Asia 50

Quarterly review

18-Mar

04-Mar

11-Mar

S&P US Indices

Quarterly review

18-Mar

10-Mar

11-Mar

S&P Europe 350 / S&P Euro

Quarterly review

18-Mar

04-Mar

11-Mar

S&P Topix 150

Quarterly review

18-Mar

04-Mar

11-Mar

S&P Global 1200

Quarterly review

18-Mar

04-Mar

11-Mar

S&P Global 100

Quarterly review

18-Mar

04-Mar

11-Mar

S&P Latin 40

Quarterly review

18-Mar

04-Mar

11-Mar

NZX 50

Quarterly review

18-Mar

28-Feb

15-Mar

Russell US & Global Indices

Quarterly review - IPO additions only

31-Mar

28-Feb

29-Mar

Russell US & Global Indices

Monthly review - shares in issue change

31-Mar

28-Mar

07-Apr

FTSE TWSE Taiwan Index Series

Quarterly review

15-Apr

31-Mar

07-Apr

TOPIX

Monthly review - additions & free float adjustment

29-Apr

31-Mar

08-Apr

FTSE Value-Stocks Korea Index

Semi-annual

15-Apr

31-Mar

27-Apr

Russell US & Global Indices

Monthly review - shares in issue change

29-Apr

26-Apr

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

FEBRUARY 2011 • FTSE GLOBAL MARKETS

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